UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

 

 

 

For the Transition Period from             to

 

Commission File Number 000-22677

 

CLARIENT, INC.
(Exact name of registrant as specified in its charter)

 

DELAWARE		75-2649072
(State or other jurisdiction of incorporation		(IRS Employer Identification Number)
or organization)
31 COLUMBIA
ALISO VIEJO, CA		92656-1460
(Address of principal executive offices)		(Zip code)

 

(949) 425-5700

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x  No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o   No x

 

The number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date:

 

 

 

 

CLARIENT, INC. AND SUBSIDIARIES

 

Table of Contents

 

PART I FINANCIAL INFORMATION				3
Item 1		Financial Statements		3
		Condensed Consolidated Balance Sheets as of March 31, 2008 and December 31, 2007		3
		Condensed Consolidated Statements of Operations for the three months ended March 31, 2008 and 2007		4
		Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2008 and 2007		5
		Notes to Condensed Consolidated Financial Statements		6
Item 2		Management’s Discussion and Analysis of Financial Condition and Results of Operations		13
Item 3		Quantitative and Qualitative Disclosures About Market Risk		36
Item 4		Controls and Procedures		37
PART II OTHER INFORMATION				38
Item 6		Exhibits		38
SIGNATURES				39

 

 

2

 

PART I - FINANCIAL INFORMATION

 

Item 1. Financial Statements.

 

CLARIENT, INC. AND SUBSIDIARIES
Condensed Consolidated Balance Sheets
(in thousands, except share and per share amounts)

(Unaudited)

 

		March 31,			December 31,
		2008			2007
ASSETS
Current assets:
Cash and cash equivalents		$	3,139		$	1,516
Accounts receivable, net of allowance for doubtful accounts of $2,880 and $3,370 at March 31, 2008 and December 31, 2007, respectively		13,767			12,020
Inventories		773			740
Prepaid expenses and other current assets		544			1,006
Total current assets		18,223			15,282
Property and equipment, net		11,672			10,997
Other assets		387			339
Total assets		$	30,282		$	26,618
LIABILITIES AND STOCKHOLDERS’ DEFICIT
Current liabilities:
Revolving lines of credit		$	9,000		$	13,997
Related party line of credit, net of discount		9,621			1,737
Accounts payable		3,876			2,915
Accrued payroll		2,200			1,916
Accrued expenses		3,742			4,327
Current maturities of capital lease obligations		86			1,510
Total current liabilities		28,525			26,402
Long-term capital lease obligations		233			906
Deferred rent and other non-current liabilities		4,074			4,099
Commitments and contingencies
Stockholders’ deficit:
Common stock $0.01 par value, authorized 100,000,000 shares, issued and outstanding 72,182,757 and 72,066,783 at March 31, 2008 and December 31, 2007, respectively		722			721
Additional paid-in capital		142,932			139,758
Accumulated deficit		(146,111		)	(145,177		)
Accumulated other comprehensive loss		(93		)	(91		)
Total stockholders’ deficit		(2,550		)	(4,789		)
Total liabilities and stockholders’ deficit		$	30,282		$	26,618

 

See accompanying notes to condensed consolidated financial statements.

 

 

3

 

CLARIENT, INC. AND SUBSIDIARIES
Condensed Consolidated Statements of Operations
(in thousands, except share and per share amounts)
(Unaudited)

 

		Three Months Ended March 31,
		2008			2007
Revenue		$	15,886		$	8,829
Cost of revenue		6,095			5,076
Gross profit		9,791			3,753
Selling, general and administrative expenses		9,934			7,015
Loss from operations		(143		)	(3,262		)
Interest expense		319			395
Interest expense to related parties		476			493
Other income, net		(4		)	(65		)
Loss from continuing operations before income taxes		(934		)	(4,085		)
Income taxes		—			23
Loss from continuing operations		(934		)	(4,108		)
Income from discontinued operations		—			5,397
Net income (loss)		$	(934	)	$	1,289
Basic and diluted net income (loss) per common share:
Loss from continuing operations		$	(0.01	)	$	(0.06	)
Income from discontinued operations		—			0.08
Net income (loss)		$	(0.01	)	$	0.02
Weighted average number of common shares outstanding		72,070,169			71,273,016

 

See accompanying notes to condensed consolidated financial statements.

 

 

4

 

CLARIENT, INC. AND SUBSIDIARIES
Condensed Consolidated Statements of Cash Flows
(in thousands)
(Unaudited)

 

		Three Months Ended March 31,
		2008			2007
Cash flows from operating activities:
Net income (loss)		$	(934	)	$	1,289
(Income) from discontinued operations		—			(5,397		)
Adjustments to reconcile net income (loss) to net cash used in operating activities:
Depreciation and amortization		869			803
Amortization of deferred financing and offering costs		112			23
Provision for doubtful accounts		1,436			161
Amortization of warrants		191			349
Stock-based compensation		279			587
Changes in operating assets and liabilities:
Accounts receivable, net		(3,183		)	(1,016		)
Inventories		(33		)	80
Prepaid expenses and other assets		302			(177		)
Accounts payable		962			(1,990		)
Accrued payroll		284			124
Accrued expenses		(450		)	45
Deferred rent and other non-current liabilities		(25		)	158
Cash flows from operating activities of discontinued operations		—			(802		)
Net cash used in operating activities		(190		)	(5,763		)
Cash flows from investing activities:
Additions to property and equipment		(1,544		)	(594		)
Proceeds from sale of discontinued operations, net of selling costs		—			10,350
Cash flows used in investing activities of discontinued operations		—			(132		)
Net cash (used in) provided by investing activities		(1,544		)	9,624
Cash flows from financing activities:
Proceeds from exercise of stock options		33			164
Borrowings on long-term debt, including capital lease obligations		322			—
Repayments on long-term debt, including capital lease obligations		(2,419		)	(431		)
Borrowings on revolving lines of credit		10,543			8,788
Repayments on revolving lines of credit		(15,540		)	(7,756		)
Borrowings on related party debt		10,420			—
Cash flows from financing activities of discontinued operations		—			(230		)
Net cash provided by financing activities		3,359			535
Effect of exchange rate changes on cash and cash equivalents		(2		)	(1		)
Net increase in cash and cash equivalents		1,623			4,395
Cash and cash equivalents at beginning of period		1,516			448
Cash and cash equivalents at end of period		$	3,139		$	4,843
Supplemental disclosure of cash flow information:
Cash paid for interest		$	372		$	525
Cash paid for income taxes		$	—		$	23
Non cash financing activities - issuance of warrants in connection with borrowings from related party		$	2,727		$	273

 

See accompanying notes to condensed consolidated financial statements.

 

 

5

 

CLARIENT, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements

(Unaudited)

 

(1)           Basis of Presentation and Liquidity

 

These interim condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s annual report on Form 10-K for the fiscal year ended December 31, 2007 filed with the Securities and Exchange Commission.

 

The accompanying unaudited condensed consolidated financial statements reflect all adjustments, which, in the opinion of management, are necessary for a fair presentation of the financial position and the results of operations for the interim periods presented. All such adjustments are of a normal, recurring nature. Certain amounts have been reclassified to confirm to the current year presentation. The results of operations for any interim period are not necessarily indicative of the results to be obtained for a full fiscal year.

 

The Company’s financial statements have been prepared on a going-concern basis, which assumes that the Company will have sufficient resources to pay its obligations as they become due during the next twelve months and do not reflect adjustments that might result if we were not to continue as a going concern. The Company has incurred operating losses in every year since inception, its accumulated deficit as of March 31, 2008 was $146.1 million and stockholders’ deficit was $2.6 million. The Company also has a working capital deficiency of $10.3 million at March 31, 2008. The Company has a history of operating losses and negative cash flows from operations, and future profitability is uncertain. In addition, the Company has not had a history of complying with the covenants within its credit agreements. Also, in order to comply with the covenants in the current debt agreement, the Company must achieve operating results at levels not historically achieved by the Company. Although previous defaults under the Company’s credit facilities were waived and the Company has agreed to a new financial covenant relating to tangible net worth in its credit facility with Comerica Bank for 2008, there can be no assurance that the Company will be able to maintain compliance with this and other covenants contained in its credit facilities. Failure to maintain compliance with the financial covenants in the Company’s Comerica Facility would constitute an event of default under that facility and a cross-default under the New Mezzanine Facility. Absent a waiver from both lenders, borrowings under both facilities would become immediately due and payable. See Note 8 “Lines of Credit” for discussion of these facilities.  The Company does not currently have the ability to repay borrowings under these facilities. Should the Company’s sources of funding be inadequate, management’s plans would include seeking waivers from existing lending sources, pursuing additional sources of funding, or curtailment of expenses. There can be no assurance that the Company will be able to fully access existing financing sources or obtain additional debt or equity financing when needed or on terms that are favorable to the Company and its stockholders, or will be able to obtain waivers from its lenders in the event of non-compliance with its debt covenants. As a result, there is a substantial doubt about the Company’s ability to continue as a going concern.

 

Recent Accounting Pronouncements.

 

In September 2006, the FASB issued SFAS 157 which defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. In February 2008 the FASB issued FSP 157-2, Effective Date of FASB Statement No. 157, which delays the effective date of SFAS 157 for non-financial assets and liabilities to fiscal years beginning after November 15, 2008. The adoption of SFAS 157 related to financial assets and liabilities did not have a material impact on the Company’s consolidated financial statements. The Company is currently evaluating the impact, if any, that SFAS 157 may have on its consolidated financial statements related to non-financial assets and liabilities.

 

In November 2007, the EITF issued a consensus on EITF 07-1, “Accounting for Collaborative Arrangements” (“EITF 07-1”). The Task Force reached a consensus on how to determine whether an arrangement constitutes a collaborative arrangement, how costs incurred and revenue generated on sales to third parties should be reported by the partners to a collaborative arrangement in each of their respective income statements, how payments made to or received by a partner pursuant to a collaborative arrangement should be presented in the income statement, and what participants should disclose in the notes to the financial statements about a collaborative arrangement. This Issue shall be effective for annual periods beginning after December 15, 2008. Entities should report the effects of applying this Issue as a change in accounting principle through retrospective application to all periods to the extent practicable. Upon application of this Issue, the following should be disclosed: a) a description of the prior-period information that has been retrospectively adjusted, if any, and b) the effect of the change on revenue and operating expenses (or other appropriate captions of changes in the applicable net assets or performance indicator) and on any other affected financial statement line item. The Company is currently evaluating the impact, if any, of the adoption of EITF 07-1 on its consolidated financial position, results of operations and cash flows.

 

In December 2007, the FASB issued SFAS No. 141(revised 2007), “Business Combinations” (“SFAS 141(R)”). This statement requires an acquiror to recognize the assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at the acquisition date, measured at their fair values as of that date. SFAS 141(R) replaces the cost-allocation process of SFAS No. 141, “Business Combinations” (“SFAS 141”) which required the cost of an acquisition to be allocated to the

 

 

6

 

individual assets acquired and liabilities assumed based on their estimated fair values. This statement applies prospectively to business combinations for which the acquisition date is on or after January 1, 2009. Earlier adoption is prohibited.

 

(2)           Discontinued Operations

 

On March 8, 2007, the Company sold its instrument systems business, consisting of certain tangible assets, inventory, intellectual property (including the Company’s patent portfolio and the ACIS and ChromaVision trademarks), contracts and other assets used in the operations of the instrument systems business (the “Technology business”) to Carl Zeiss MicroImaging, Inc. and one of its subsidiaries (collectively, “Zeiss”) for an aggregate purchase price of $12.5 million, consisting of $11.0 million in cash and up to an additional $1.5 million in contingent purchase price, subject to satisfaction of certain post-closing conditions relating to intellectual property (the “ACIS Sale”). As part of the transaction, the Company entered into a license agreement with Zeiss pursuant to which Zeiss granted the Company a non-exclusive, perpetual and royalty-free license to certain of the transferred patents, copyrights and software code for use in connection with imaging applications (excluding sales of imaging instruments) and the Company’s laboratory services business. The acquisition agreement also contemplates that the Company and Zeiss will each invest up to $3 million in cash or other in-kind contributions to pursue a joint development arrangement with respect to rare event detection. The acquisition agreement contemplated that the parties would cooperate to enter into a definitive agreement with respect to such an arrangement within 120 days following the closing date, which was extended to October 31, 2007. The Company has not commenced any projects or entered into any definitive agreements in connection with such plan as of March 31, 2008. The Company has no obligation to invest any cash or other in-kind contributions should the parties be unable to agree upon terms for such a definitive agreement.

 

(3)           Equity-Based Compensation

 

On January 1, 2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123(R)”). SFAS 123(R) requires recognition of the cost of employee services received in exchange for an award of equity instruments in the financial statements over the period the employee is required to perform the services in exchange for the award. SFAS 123(R) also requires fair value measurement of the cost of employee services received in exchange for an award.

 

Stock-based compensation related to continuing operations recognized in the Condensed Consolidated Statements of Operations is as follows (in thousands):

 

 

The Company’s 1996 Stock Option Plan expired on December 11, 2006.  At the Company’s annual meeting on June 27, 2007, the stockholders voted in favor to approve the Company’s 2007 Incentive Award Plan (the “2007 Plan”).  The 2007 Plan provides for the grant of incentive stock options and nonqualified stock options, restricted stock, stock appreciation rights, performance shares, performance stock units, dividend equivalents, stock payments, deferred stock, restricted stock units, performance bonus awards and performance-based awards. The maximum numbers of shares of Company common stock available for issuance under the 2007 Plan is the sum of 4,000,000 shares plus any shares which are subject to awards under the Company’s 1996 Stock Option Plan as of the effective date of the 2007 Plan that terminate, expire or lapse for any reason.

 

During the three months ended March 31, 2008 the Company granted 660,000 options under the 2007 Plan.  The options have four-year vesting terms, and ten-year contractual lives.  The fair value of $0.9 million for these stock-based awards was estimated at the date of grant using the Black-Scholes option-pricing model. The risk-free rate of 2.5% was based on the U.S. Treasury yield curve in effect at the end of the quarter. The expected term of 5 years was estimated using the historical exercise behavior of option holders. The expected volatility of 79.6% was based on historical price volatility, measured using weekly price observations of the Company’s common stock for a period equal to the stock option’s expected term.  The Company estimates forfeitures of stock options using the historical exercise behavior of its employees. For purposes of this estimate the Company identified two groups of employees and estimated the forfeiture rates for these groups to be 5% and 8% for the first quarter of 2008.

 

The Company’s 1996 Stock Option Plan expired on December 31, 2006, therefore no options were granted during the first quarter of 2007.

 

7

 

(4)           Net Income (Loss) Per Share

 

Basic and diluted income (loss) per common share is calculated by dividing net income (loss) by the weighted average common shares outstanding during the period. Stock options, restricted stock and warrants to purchase an aggregate of 12,008,101 and 12,696,596 shares of common stock were outstanding as of March 31, 2008 and 2007, respectively. These common stock equivalents were not included in the computation of diluted earnings per share for either of the three months ended March 31, 2008 or 2007, because the Company incurred a net loss from continuing operations in all periods presented and hence, the impact would be anti-dilutive.

 

(5)           Comprehensive Income (Loss)

 

The total comprehensive income (loss) is summarized as follows (in thousands):

 

 

(6)           Business Segment

 

The Company operates primarily in one business segment engaged in the delivery of critical oncology testing services to community pathologists, biopharmaceutical companies and other researchers. Substantially all revenues are generated within the United States of America.

 

(7)           Stock Transactions

 

Due to its beneficial ownership of approximately 59% of the Company’s outstanding common stock, Safeguard Scientifics, Inc., has the power to elect all of the directors of the Company, although Safeguard has contractually agreed with the Company that a majority of the board of directors will consist of individuals not specifically designated by Safeguard. The Company has given Safeguard contractual rights enabling it to exercise significant control over the Company.

 

(8)           Lines of Credit

 

The Company currently has a $12.0 million revolving credit agreement with Comerica Bank, which was amended and restated on February 28, 2008 to extend the maturity to February 2009 (the “Comerica Facility”). Borrowings under the Comerica Facility totaled $9.0 million at March 31, 2008 and are being used for working capital purposes, and the remaining availability under the Comerica Facility was used to obtain a $3.0 million stand-by letter of credit for the landlord of the Company’s leased facility in Aliso Viejo, California. The Comerica Facility matures on February 26, 2009, and, as of March 31, 2008, the Company had no additional availability under the Comerica Facility.

 

During 2007 and prior to the amendment and restatement on February 28, 2008, borrowings under the Comerica Facility bore interest at the prime rate minus 0.5% and included one financial covenant related to tangible net worth. Under the amended and restated Comerica Facility, at the Company’s option, borrowings will bear interest at the prime rate minus 0.5%, or a rate equal to the London Interbank Offered Rate (“LIBOR”) plus 2.45%, provided, however, that upon the achievement of certain financial performance metrics the rate will decrease by 0.25%.

 

The Company was not in compliance with the minimum tangible net worth covenant as of December 31, 2007 (and in certain prior periods), and, on March 21, 2008, the Company obtained a waiver from Comerica Bank with respect thereto. Under the terms of the amended Comerica Facility, the Company is required to maintain a minimum tangible net worth, which is defined as the sum of capital stock and additional paid in capital, plus retained earnings (or minus accumulated deficit), minus intangible assets, of the following amounts: ($6,500,000) for the period from January 1, 2008 through March 31, 2008, ($8,000,000) for the period April 1, 2008 through June 30, 2008, ($9,000,000) for the period from July 1,

 

 

8

 

2008 through September 30, 2008, ($9,500,000) for the period from October 1, 2008 through December 31, 2008 and ($9,500,000) plus 50% of profits (profit recapture) thereafter. Comerica has agreed that the carrying value of any unexercised warrants recognized in the Company’s consolidated financial statements will be considered as tangible net worth for the purposes of determining compliance with the Comerica Facility debt covenants. Safeguard guarantees borrowings under the Comerica Facility in exchange for an annual fee of 0.5% of the amount guaranteed and an amount equal to 4.5% per annum of the daily-weighted average principal balance outstanding ($12.0 million as of March 31, 2008, inclusive of the above-referenced letter of credit). Additionally, under the Comerica Facility we are required to pay Safeguard a quarterly usage fee of 0.875% of the amount by which the daily average principal balance outstanding under the Comerica Facility exceeds $5.5 million. We also issued warrants to Safeguard in January 2007 as consideration for their guarantee as follows: warrants to purchase 100,000 shares for an exercise price of $0.01 (as a commitment fee for Safeguard’s guarantee) and warrants to purchase 166,667 shares for an exercise price of $1.64 (as a maintenance fee for Safeguard’s guarantee). The Company recorded $337,000 of interest expense related to these warrants which is the full fair value of the warrants determined under the Black-Scholes option pricing model. The full fair value of the warrants was expensed in the quarter ended March 31, 2007, since, at the time the warrants were issued, the line of credit was to expire within the same quarter. The Safeguard guarantee was also extended along with the renewal of Comerica Facility on February 28, 2008 under the same terms as the 2007 extension. No additional warrants were issued as part of the 2008 extended guarantee. The total usage fees expensed for the three months ended March 31, 2008 and 2007 were $167,000 and $48,000 respectively, and are included under interest expense to related parties within the Condensed Consolidated Statements of Operations.

 

GE Capital Line of Credit.

 

On September 29, 2006, the Company entered into a Loan and Security Agreement with GE Capital (the “GE Capital Facility”). The financing arrangement consisted of a senior secured revolving credit facility pursuant to which the Company could borrow up to $5.0 million, subject to adjustment. Borrowings under the credit agreement could not exceed 85% of the Company’s qualified accounts receivable after application of certain liquidity factors and deduction of certain specified reserves, and repaid daily by a sweep of the Company’s cash-collections lockbox. The credit agreement included an annual collateral monitoring fee of $12,000. The interest rate under the GE Capital Facility was based on the lower of the one-month LIBOR, plus 3.25% or prime rate, plus 0.5%. The credit agreement provided for a prepayment fee of 2.0% of the commitment amount if terminated during the first year and 1.0% of the commitment amount if terminated any time thereafter prior to the maturity date. The GE Capital Facility had a two-year term and was secured by the diagnostic services business accounts receivable, along with all of the other assets of the Company and its subsidiaries. As of December 31, 2007, the Company was not in compliance with the GE Capital Facility minimum tangible net worth covenant, which was the same as described above for the Comerica loan agreement. However, the Company repaid all indebtedness under the GE Capital Facility on March 17, 2008 in conjunction with the New Mezzanine Facility discussed below. The Company expensed loan costs in the amount of $46,000 and $15,000 during the three months ended March 31, 2008 and 2007, respectively. The Company also incurred loan payoff costs of $50,000 that were expensed during the three months ended March 31, 2008.

 

Safeguard Mezzanine Financing.

 

On March 7, 2007, the Company entered into a senior subordinated revolving credit facility with Safeguard (the “Initial Mezzanine Facility”). The Initial Mezzanine Facility originally provided the Company up to $12.0 million in working capital funding, but was reduced by $6.0 million as a result of the ACIS Sale. Borrowings under the Initial Mezzanine Facility bore interest at an annual rate of 12%. In connection with the Initial Mezzanine Facility, the Company issued to Safeguard: (1) warrants to purchase 125,000 shares of the Company’s common stock with an exercise price of $0.01 per share, expiring March 7, 2011; (2) warrants to purchase 62,500 shares of common stock with an exercise price of $1.39 per share (reflecting a 15% discount to the trailing 10-day average closing price of our common stock prior to March 7, 2007), expiring March 7, 2011; and (3) four-year warrants to purchase an aggregate of 93,750 shares of common stock for an exercise price of $0.01 per share in connection with borrowings that the Company made thereunder. The fair value of the warrants of $273,000 related to the warrants for 125,000 and 62,500 shares, was determined under the Black-Scholes option pricing model. The costs related to these warrants are being recognized over the term of the line of credit agreement. The Company expensed $37,000 and $12,000, related to these warrants during the three months ended March 31, 2008 and 2007, respectively. Prior to the refinancing of the Initial Mezzanine Facility described below, the Company borrowed an aggregate of $3.0 million under the Initial Mezzanine Facility in the fourth quarter of 2007 and the first quarter of 2008 and, in accordance with the terms of the Initial Mezzanine Facility, issued to Safeguard warrants to purchase 93,750 shares for an exercise price of $0.01 per share in connection with these borrowings.  The fair value of these warrants (an aggregate of $185,000) was determined under the Black-Scholes pricing model and will be recognized over the term of the line of credit agreement. The Company expensed $33,000 related to these warrants during the three months ended March 31, 2008.

 

On March 14, 2008, the Company entered into an amended and restated senior subordinated revolving credit facility with Safeguard (the “New Mezzanine Facility”) to refinance, renew and expand the Initial Mezzanine Facility. The New Mezzanine Facility, which has a stated maturity date of April 15, 2009, provides the Company access to up to $21.0 million in working capital funding. Borrowings under the New Mezzanine Facility will bear interest at an annual rate of 12%. As of March 31, 2008, the Company had outstanding indebtedness of approximately $12.4 million under the New Mezzanine Facility. Proceeds from the New Mezzanine Facility were used to refinance indebtedness under the Initial Mezzanine

 

 

9

 

Facility, for working capital purposes and to repay in full and terminate the GE Capital Facility and certain related equipment lease obligations. In connection with the New Mezzanine Facility, the Company issued to Safeguard five-year warrants to purchase 1,643,750 shares of common stock with an exercise price of $0.01 per share, which included warrants to purchase 93,750 shares, which were the subject of amounts that had not been drawn under the Initial Mezzanine Facility. The fair value of the warrants (an aggregate of $2.7 million) was determined under the Black-Scholes model and will be recognized over the term of the line of credit agreement. The risk-free rate of 3.5% was based on the U.S. Treasury yield curve in effect at the time of the transaction. The expected volatility of 79.6% was based on historical price volatility, measured using weekly price observations of the Company’s common stock for a period equal to the expected term. The Company expensed $121,000 related to these warrants during the three months ended March 31, 2008. In addition, under the New Mezzanine Facility, the Company is required to issue to Safeguard an aggregate of an additional 2,200,000 warrants in four equal and separate tranches if the balance of the New Mezzanine Facility has not been reduced to $6.0 million on or prior to May 1, July 1, September 1, and November 1, 2008.  The fair value of any warrants issued in conjunction with the Initial Mezzanine Facility and New Mezzanine Facility are initially presented in the accompanying balance sheets as a discount on the related party line of credit and additional paid-in-capital after consideration of the provisions of EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.”  The discount is then accreted to interest expense to related parties in the accompanying statements of operations.

 

The New Mezzanine Facility includes certain restrictive covenants, including (a) requirement to obtain approval from lender for new financing agreements or other significant transactions, (b) requirement to comply with other covenants in any note including the Comerica Facility, and (c) a liquidity event would constitute an event of default.  Failure to maintain compliance with the Comerica Facility would constitute an event of default under this facility.  Absent a waiver from both lenders, borrowings under both facilities would become immediately due and payable.

 

The following table summarizes the Company’s total debt as of March 31, 2008 and December 31, 2007 (in thousands):

 

 

(9)           Equipment Financing

 

In June 2004, the Company entered into a master lease agreement with GE Capital for capital equipment financing of diagnostic services (laboratory) related equipment. The Company financed $2.0 million in 2005 and $2.3 million in 2006 of diagnostic services equipment under this arrangement, which were recorded as capital lease obligations. During 2007, several of the leases entered into during 2004 began to mature at which time the Company exercised its right under the master lease agreement to purchase the equipment at its current fair market value of $519,000. The Company elected to refinance $449,000 of this equipment with GE Capital, which was recorded as capital lease obligations. Each financing had a term of 24 months and a bargain-purchase option at maturity. On March 17, 2008, the Company paid off and terminated all amounts financed under the master lease agreement with proceeds from borrowings under the New Mezzanine Facility. The payoff amount was $2.9 million, which included residual balances, taxes, and miscellaneous closing fees. The Company has a number of outstanding equipment leases with other providers as of March 31, 2008.

 

The Company’s capital lease obligations as of March 31, 2008 are as follows (in thousands):

 

 

 

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(10)         Commitments and Contingencies

 

Voluntary Employee Retirement 401(k) Plan.  The Company has a voluntary employee retirement 401(k) plan available to all full time employees 21 years or older. The plan provides for a matching of the employee’s contribution to the plan for 33.3% of the first 6% of the employee’s annual compensation. The Company’s matching contributions were approximately $45,000 and $43,000 for the three months ended March 31, 2008 and 2007, respectively.

 

Operating Lease Commitment.  The Company utilizes various operating leases for office space and equipment. The Company entered into a lease agreement dated as of July 20, 2005 for a mixed-use building with approximately 78,000 square feet in Aliso Viejo, California. The lease commenced on December 1, 2005 with an initial term of 10 years and an option to extend the lease term for up to two additional five-year periods. The initial annual base rent was approximately $0.5 million. The annual base rent was increased to approximately $1.0 million on June 1, 2006 and as the Company occupies additional square footage, will increase to approximately $1.4 million on December 1, 2008. The base rent is increased 3% annually effective on December 1 of each year beginning in 2006. The Company is also responsible for payments of common area operating expenses for the premises. The landlord agreed to fund approximately $3.5 million of tenant improvements toward design and construction costs associated with the build-out of the facility of which the landlord has reimbursed the Company $3.3 million through March 31, 2008. Such costs are capitalized as leasehold improvements and amortized over the shorter of their estimated useful lives or the remaining lease term, while the reimbursement is recorded to deferred rent and recovered ratably over the term of the lease.

 

At March 31, 2008, future minimum lease payments for all operating leases are as follows (in thousands):

 

 

 

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The Company subleases portions of its facility. Expected future minimum sublease receipts to the Company as of March 31, 2008 are as follows (in thousands):

 

 

(11)         Income Taxes

 

The Company’s consolidated income tax expense was $0 for the three months ended March 31, 2008 and 2007, respectively. The Company has recorded a full valuation allowance to reduce its net deferred tax asset to an amount that is more likely than not to be realized in future years. Accordingly, the net operating loss benefit that would have been recognized in 2008 was offset by a valuation allowance.

 

On January 1, 2007, the Company adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”) which had no impact on the Company’s consolidated statements of operations and financial position.  During the quarter ended March 31, 2008, the Company had no material changes in uncertain tax positions.

 

The Company and its subsidiaries file income tax returns in the U.S. federal jurisdiction and various states and foreign jurisdictions. Tax years 2004 and forward remain open for examination for federal tax purposes and tax years 2003 and forward remain open for examination for purposes of the Company’s more significant state tax jurisdictions. To the extent utilized in future years’ tax returns, net operating loss and capital loss carryforwards at December 31, 2007 will remain subject to examination until the respective tax year of utilization is closed.

 

(12)         Legal Proceedings

 

The Company is not a party to any material pending legal proceedings, the adverse outcome of which, individually or in the aggregate, management believes would have a material adverse effect on the Company’s business, financial condition or results of operations.

 

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

Forward-Looking Statements

 

This Quarterly Report on Form 10-Q contains forward-looking statements that are based on current expectations, estimates, forecasts and projections about us, the industries in which we operate and other matters, as well as management’s beliefs and assumptions and other statements regarding matters that are not historical facts. These statements include, in particular, statements about our plans, strategies and prospects. For example, when we use words such as “projects,” “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “should,” “would,” “could,” “will,” “opportunity,” “potential” or “may,” variations of such words or other words that convey uncertainty of future events or outcomes, we are making forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Our forward-looking statements are subject to risks and uncertainties. Factors that might cause actual results to differ materially, include, but are not limited to, our ability to obtain additional financing on acceptable terms or at all, our ability to continue to develop and expand our services business, our ability to expand and maintain a successful sales and marketing organization, continuation of favorable third-party payor coverage and reimbursement for tests performed by us, our ability to maintain compliance with financial and other covenants in our credit facilities, the reaction of third parties to our “going concern” audit opinion and the impact it may have on our operations, whether the conditions to payment of all or any portion of the $1.5 million of contingent consideration from the sale of our technology business to Carl Zeiss MicroImaging, Inc. are satisfied, unanticipated expenses or liabilities or other adverse events affecting cash flow, our ability to successfully develop and market novel markers, including the recently announced Clarient Insight™ Dx Breast Cancer Profile, uncertainty of success in developing any new software applications, failure to obtain Food and Drug Administration clearance or approval for particular applications, our ability to compete with other technologies and with emerging competitors in cell imaging and dependence on third parties for collaboration in developing new tests, and those risks which are discussed in “Risk Factors” below. Many of these factors are beyond our ability to predict or control. In addition, as a result of these and other factors, our past financial performance should not be relied on as an indication of future performance. All forward-looking statements attributable to us, or to persons acting on our behalf, are expressly qualified in their entirety by this cautionary statement. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. In light of these risks and uncertainties, the forward-looking events and circumstances discussed in this report might not occur.

 

Overview and Outlook

 

Clarient, Inc., a Delaware corporation (“Clarient”, the “Company”, “we”, “us” or “our”), was founded and organized in 1993 and is headquartered in Aliso Viejo, California. We are an advanced oncology diagnostics services company.  Our vision is to improve the lives of those affected by cancer by bringing clarity to a complex disease. Our mission is to be the leader in cancer diagnostics by dedicating ourselves to collaborative relationships with the health care community as we translate cancer discovery and information into better patient care.

 

With the completion of the human genome project in the late 1990s, medical science has entered a new era of diagnostics that will move us closer than ever before to understanding the molecular causes for complex diseases, particularly cancer. As a result, the landscape of cancer management is undergoing significant change. There is now an escalating need for advanced oncology testing to provide physicians with necessary information on the cellular profile of a specific tumor, enabling them to select the most appropriate therapies. Significant business opportunities exist for companies, like Clarient, that execute strategies to extract value from this new environment. For this reason, we began performing under a new business plan in the third quarter of 2004 by launching a new business initiative—building a laboratory facility providing comprehensive services focused on cancer testing for both the clinical and research markets—to capitalize on the growth that is anticipated over the next five to ten years in the cancer diagnostics market.

 

In 2005, we changed our corporate name and completed the first stage of the transformation of our business from ChromaVision Medical Systems, Inc. (positioned as a medical device provider with a single application) to Clarient (positioned as a technology and services company offering a full menu of advanced tests to assess and characterize cancer). We gathered an experienced group of professionals from the anatomic pathology laboratory and the in-vitro diagnostics businesses to carefully guide this transition. We have achieved rapid growth by commercializing a set of services to provide the community pathologist with the latest in cancer diagnostic technology, anchored by our own proprietary image analysis technology and augmented by other key technologies. In June 2005, we kicked off the second stage of our business strategy when we signed a distribution and development agreement with Dako A/S (“Dako”), a Danish company recognized as a worldwide leader in pathology diagnostics systems. This enabled us to strengthen our legacy position as the leader in cellular

 

 

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digital image analysis with the ACIS^® Automated Image Analysis System (“ACIS”) and accelerate our market penetration worldwide.

 

In 2006, we focused on the execution of our plan to capitalize on the growth of the cancer diagnostics market. We expanded on our base of immunohistochemistry (“IHC”) with the addition of flow cytometry and fluorescent in situ hybridization (“FISH”) molecular testing. These additions positioned Clarient to move beyond solid tumor testing into the important area of leukemia/lymphoma assessment. We also completed a consolidation of our business by moving into a state-of-the-art facility without disruption to our customers.

 

In March 2007, we entered the third stage of our business strategy by selling our instrument systems business, consisting of certain tangible assets, inventory, intellectual property (including the Company’s patent portfolio and the ACIS and ChromaVision trademarks), contracts and other assets used in the operations of the instrument systems business (the “Technology business”) to Carl Zeiss MicroImaging, Inc. (“Zeiss”), an international leader in the optical and opto-electronics industries (the “ACIS Sale”). The ACIS Sale provided us with additional financial resources to focus our efforts on the most profitable and fastest growing opportunities within our services business. We believe our strength as a leading cancer diagnostics laboratory, our strong commercial reach with cancer-focused pathologists, our unique PATHSiTE™ suite of services, our deep domain expertise and access to robust intellectual property can propel our continued growth through the development of additional tests, unique analytical capabilities and other service offerings.

 

Our focus is on identifying high-quality opportunities to increase our profitability and differentiate Clarient’s service offerings in this highly competitive market. An important aspect of our strategy is to create near- and long-term, high margin revenue generating opportunities by connecting our medical expertise and our intellectual property with our strong commercial team to commercialize novel diagnostic tests (sometimes also referred to as “novel markers” or “biomarkers”), such as the Clarient Insight™ Dx Breast Cancer Profile which was announced in January 2008. Novel diagnostic tests detect characteristics of an individual’s tumor or disease that, once identified and qualified, allow for more accurate prognosis, diagnosis and treatment. In addition, we are working to identify specific partners and technologies where we can assist in the commercialization of third-party novel diagnostic tests. We believe that broader discovery and use of novel diagnostic tests will clarify and simplify decisions for healthcare providers and the biopharmaceutical industry. The growing demand for personalized medicine has generated a need for these novel diagnostic tests, creating a new market expected to reach $1 billion in three to five years based on our internal estimates.

 

In 2008, we are focusing on four primary areas:

 

·                                          Financial discipline to bring us closer to profitability;

 

·                                          Leverage our commercial capability to launch new tests and maintain our revenue growth trajectory;

 

·                                          Expand commercial reach to new customers, as well as capitalize on our expanded menu of additional testing for existing customers; and

 

·                                          Strategic discipline to invest in high-value expansion opportunities to increase shareholder value.

 

Safeguard Scientifics, Inc. and certain of its subsidiaries own a majority of our outstanding capital stock. We refer to Safeguard Scientifics, Inc and/or its subsidiaries and affiliates, collectively, herein as “Safeguard.”

 

Key indicators of our financial condition and operating performance

 

Our business is complex, and management is faced with several key challenges to reach profitability. We made the decision to provide in-house laboratory services in 2004 to give us an opportunity to capture a significant service- related revenue stream from the much broader and expanding cancer diagnostic testing marketplace. We have been experiencing revenue growth since the inception of this business line indicating successful execution of our sales plan and solid market acceptance of our service offerings. Management must manage the growth of this business, particularly the effects such growth has on our billings, collections and business processes. We have yet to reach optimal financial metrics related to cash flow and operating margins due to our limited history in providing lab services.

 

 

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Selling, general and administrative (SG&A) expenses, including diagnostic services administration, for the three months ended March 31, 2008 were 63% of total revenue, compared to 79% in the prior quarter ended March 31, 2007. We expect an improving trend to continue as our revenues increase, offsetting our expenditures for: 1) selling expenses related to the ramp-up of our sales force responsible for our diagnostics services; 2) administration expenses related to diagnostic services, particularly the costs of pathology services and billing; 3) bad debt expenses primarily for uncollectible patient accounts; and 4) expenses in connection with key business development initiatives focused on targeted cancer therapies in various stages of clinical study.

 

Characteristics of our revenue and expenses

 

Revenue and Billing.  Revenues are derived primarily from billing insurers, pathologists and patients for the diagnostic services that we provide.

 

Third-party billing.  The majority of our revenue is currently generated from patients who utilize insurance coverage from Medicare or third-party insurance companies. In these situations, we bill an insurer that pays a portion of the amount billed based on several factors including the type of coverage (for example, HMO or PPO), whether the charges are considered to be in network or out of network, and the amount of any co-pays or deductibles that the patient may have at that time. The rates that are billed are typically a percentage of those amounts allowed by Medicare for the service provided as defined by Common Procedural Terminology (CPT) codes. The amounts that are paid to us are a function of the payors’ practice for paying claims of these types and whether we have specific agreements in place with the payors. We also have a Medicare provider number that allows us to bill and collect from Medicare.

 

Laboratory services provided for patients with the assistance of automated image analysis technology are eligible for third -party reimbursement under well-established medical billing codes. These billing codes are known as Healthcare Common Procedure Coding Systems (HCPCS) codes and incorporate a coding system know as CPT codes. The billing codes are the means by which Medicare and private insurers identify certain medical services that are provided to patients in the United States. CPT codes are established by the American Medical Association (AMA). The Medicare reimbursement amounts are based on relative values, associated with the CPT codes, and are established by the Centers for Medicare & Medicaid Services (CMS) using a relative value system, with recommendations from the AMA’s Relative Value Update Committee and professional societies representing the various medical specialties.

 

The following is a summary of Medicare reimbursement rates for certain CPT codes used in our laboratory services:

 

CPT Code		2007 (1/1/07-12/31/07)			2008 (1/1/08-3/31/08)			Change
88185		$	41		$	52		27	%
88342		107			113			6	%
88361		186			186			—
88368		193			229			17	%
88367		252			269			7	%

 

The above CPT codes represent a significant portion of the Company’s lab volume.

 

The current rates were approved for the first six months of 2008 and are subject to further adjustment as of July 1, 2008.

 

Client (pathologist) billing.  In some situations, we establish direct billing arrangements with our clients where we bill them for an agreed amount per test for the services provided and the client will then handle all billing directly with the private payors. The amounts that may be charged to our clients is determined in accordance with applicable state and federal laws and regulations.

 

Patient billing.  These billings can result from co-payment obligations, patient deductibles, circumstances where certain tests are not covered by insurance companies, and patients without any health insurance.

 

Cost of Revenue and Gross Margin.  Cost of revenue includes laboratory personnel, depreciation of laboratory equipment, laboratory supplies and other direct costs such as shipping. Most of our cost of revenue structure is variable, except for staffing and related expenses, which are semi-variable, and depreciation, which is mostly fixed.

 

 

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Selling, General and Administrative Expenses.  Selling, general and administrative expenses primarily consist of the salaries, benefits and costs attributable to the support of our operations, such as: information systems, executive management, financial accounting, purchasing, administrative and human resources personnel, as well as office space and recruiting, legal, auditing and other professional services. Our current sales resources are targeting community pathology practices and hospitals. The sales process for this business group is designed to understand the customer’s needs and develop appropriate solutions from our range of laboratory service options. In addition, we incur administration costs of senior medical staff, senior operations personnel, billing and collection costs, consultants and legal resources to facilitate implementation and support of our operations. Collection costs are incurred from a combination of in-house services and a third-party billing and collection company that we have engaged to perform these services because of the high degree of technical complexity and knowledge required to effectively perform these operations. These costs are generally incurred as a percentage of amounts collected. During 2008, the Company expects to complete the process of bringing the billing and collection process entirely in-house. The Company expects this will result in expense reductions in selling, general and administrative expense. Bad debt expense resulting primarily from uncollectible patient accounts is also a component of selling, general and administrative expenses.

 

Critical Accounting Policies and Estimates

 

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with United States generally accepted accounting principles. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities and the disclosure of contingent assets and liabilities as of the dates of the balance sheets and revenues and expenses for the periods presented.

 

Management believes that the following estimates are the most critical to aid in fully understanding and evaluating our reported financial results, and they require management’s most difficult, subjective or complex judgments, resulting from the need to make estimates that are inherently uncertain.

 

Revenue Recognition

 

Revenue for our diagnostic services is recognized at the time of completion of services at amounts equal to the contractual rates allowed from third parties, including Medicare and insurance companies. These expected amounts are based both on Medicare allowable rates and on our collection experience with other third-party payors. Because of the requirements and nuances of billing for laboratory services, we generally invoice amounts that are greater than those allowable for payment. The differences between the amounts we bill and the amounts we expect to be paid are described as contractual discounts. We recognize revenue for the amount billed, net of these contractual discounts.

 

Allowance for Doubtful Accounts

 

For estimated bad debts, we review the age of receivables in various financial classes and estimate the uncollectible portion based on the type of payor, age of the receivables, and historical loss experience. However, in all years presented, we outsourced the direct billing and collection of laboratory related receivables, and we worked closely with our outsourced billing partner to review the details of each laboratory related account. As the Company continues to grow its laboratory service operations test volume, we expect bad debt expense to increase.

 

Long-Lived Assets and Accruals

 

We review our long-lived assets, such as fixed assets, for impairment whenever events or changes indicate the carrying value may not be recoverable or that the useful lives are no longer appropriate. If we determine that the carrying value of the long-lived assets may not be recoverable, the asset is then written down to its estimated fair value based on a discounted cash flow basis.

 

For other obligations requiring management’s use of estimates, we review the basis for assumptions about future events and conditions, which are inherently subjective and uncertain. In determining whether a contingent liability should be accrued, management applies standards under Statement of Financial Accounting Standards (“SFAS”) No. 5, “Accounting for Contingencies,” under which we accrue a contingent liability if the exposure is considered probable and reasonably estimable.

 

 

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Three Months Ended March 31, 2008 Compared with Three Months Ended March 31, 2007

 

The following table presents our results of operations as percentages of revenues:

 

		Percentage of Revenue Three months ended March 31,
		2008		2007
Revenue		100.0		100.0
Cost of revenue		38		57
Gross profit		62		43
Selling, general and administrative expenses		63		80
Loss from operations		(1	)	(37	)
Interest, net		5		9
Income from discontinued operations		—		61
Net loss		(6	)	15

 

Revenue

 

Total revenue increased 80% or $7.1 million from $8.8 million for the three months ended March 31, 2007 to $15.9 million for the three months ended March 31, 2008. This increase resulted from the execution of our marketing and sales strategy to increase our sales to new and existing customers. We added 46 new customers in the three months ended March 31, 2008 and increased our penetration to existing customers during the period. In addition, we increased our breadth of offerings to include multiple cancer types, including expanding our lymphoma/leukemia business, and performing testing in other solid tumors such as colon, prostate and lung. This testing was performed using our expanded capabilities in immunohistochemistry, flow cytometry, FISH and PCR. We also increased our depth of offering within each cancer type. We also benefited from an overall increase in Medicare reimbursement rates in the first quarter of 2008, for certain tests we perform. In addition to the Medicare reimbursement rate increase, many of the Company’s third-party contract rates are tied to Medicare rates, which consequently, also increased. We anticipate revenues will continue to increase as a result of increased revenue from existing customers, the addition of new customers and our offering of a more comprehensive suite of advanced and/or proprietary cancer diagnostic tests.  However, current Medicare rates are only effective until June 30, 2008 and, if not made permanent prior to such date, will decrease to the rates in effect during the fourth quarter of 2007.  If these Medicare reimbursement rates were to be reduced, such reduction would result in a reduced rate of revenue growth (though we anticipate that our overall revenues will continue to increase as a result of the other factors described above).

 

Cost of Revenue and Gross Margin

 

For the three months ended March 31, 2008, our gross margin was 62% compared to 43% in 2007. The increase in gross margin in 2008 was attributable to achieving economies of scale in our operations, a shift to more profitable tests, and the impact of the Medicare fee schedule increase noted above. We anticipate gross margins will continue at or near these levels as we more effectively utilize our capacity and expand our breadth of test offerings, subject to potential changes in Medicare rates . Since current Medicare rates are only effective until June 30, 2008, gross margins could decline if  Medicare institutes a reduced fee schedule at that time.

 

Cost of revenue for the three months ended March 31, 2008 was $6.1 million compared to $5.1 million for March 31, 2007, an increase of 20%. These costs include costs associated with laboratory personnel, lab-related depreciation expense, laboratory reagents and supplies, the cost of tests performed by other laboratories, and other direct costs such as courier and shipping costs. As volume and revenue grows these costs will grow as well. However, we expect the growth to be slower than overall revenue growth due to economies of scale, better vendor agreements, and mix of testing.

 

Operating and Other Expenses

 

Selling, general and administrative expenses.  Expenses for the three months ended March 31, 2008 increased approximately $2.9 million, or 42%, to $9.9 million compared to $7.0 million for the three months ended March 31, 2007. As a percentage of revenues, these costs decreased from 80% for the three months ended March 31, 2007 to 63% for the three months ended March 31, 2008. The increase in expenses in 2008 was due primarily to expenses incurred to generate and

 

 

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support revenue growth and to improve infrastructure, including selling and marketing expenses, billing and collection costs, and bad debt expenses. In addition, we have increased headcount and consulting resources in information technology to support our expanded offerings and for future revenue growth. In 2008, we also incurred higher professional fees. We anticipate selling expenses and bad debt expenses will continue to grow as a result of our expected revenue growth, though we expect other general and administrative expenses to decline as a percentage of revenues as our infrastructure costs stabilize.

 

Interest expense and other income.  Interest expense and other income totaled $0.8 million for the three months ended March 31, 2008 and 2007 and consisted primarily of net interest expense. Interest expense relates to borrowings under our financing facilities as well as the amortization of costs relating to warrants issued to Safeguard, our majority stockholder, in partial consideration for the guarantee of our credit facility with Comerica Bank by Safeguard and in connection with the establishment and borrowings under the Initial Mezzanine Facility and New Mezzanine Facility. Amortized costs of $0.2 and $0.3 million related to these warrants was included in interest expense for the three months ended March 31, 2008 and 2007, respectively. The amortized costs for the three months ended March 31, 2007 represent one time warrant costs fully expensed during the quarter.

 

Liquidity and Capital Resources

 

At March 31, 2008, we had approximately $3.1 million of cash and cash equivalents and $8.6 million available under the New Mezzanine Facility with Safeguard. However, we had a working capital deficiency of $10.3 million at March 31, 2008. Cash used in operating activities was $190,000 for the three months ended March 31, 2008 due primarily to our net loss of $934,000, and an increase in accounts receivable of $3.2 million, substantially offset by non-cash costs and expenses of $2.6 million for depreciation, stock-based compensation and bad debt, and an increase in accounts payable of $1.0 million. The operating cash improvement of $5.6 million between the first quarter of 2008 and the first quarter of 2007 is primarily the result of the negative cash flow related to Discontinued Operations of $6.2 million, which occurred during the first quarter of 2007 as well as higher bad debt expense in 2008 and fluctuations in accounts receivable and accounts payable. Cash used in investing activities for the three months ended March 31, 2008 of $1.5 million consisted of capital expenditures related primarily to new laboratory equipment and information technology infrastructure enhancements. The reduction in cash from investing activities of $11.2 million between the first quarter of 2008 and the first quarter of 2007 is primarily the result of proceeds from the sale of Discontinued Operations of $10.4 million, which occurred during the first quarter of 2007. Net cash provided by financing activities for the three months ended March 31, 2008 was $3.4 million and was attributable primarily to net borrowings of $21.0 million under our revolving line of credit and New Mezzanine Facility, which were partially offset by principal payments of $18.0 million on our revolving lines of credit and capital leases. See Note 8 “Lines of Credit” for discussion of the changes in Mezzanine financing.

 

During the first quarter of 2008, we used $2.9 million in borrowings under the New Mezzanine Facility to pay off and terminate all of our equipment lease obligations to GE Capital. We believe that we have substantially all of the laboratory equipment that is required to support our current operating activities; however, a substantial increase in diagnostic service activity in excess of our annual revenue plan may result in a requirement to make additional capital expenditures.

 

In July 2005, we signed a ten-year lease for a new facility, which began December 1, 2005 with two five-year renewal options. We relocated our laboratory operations to the new facility in January 2006 and relocated our corporate headquarters and manufacturing operation to the new facility in the second quarter of 2006. Rent expense, net of sublease payments, was $313,000 for the quarter ended March 31, 2007 and $87,000 for the first quarter of 2008 (reduction due to increased sublease income). During the first quarter of 2007, we entered into sublease agreements with two tenants who made lease and common area expense payments of $44,000 during the quarter ended March 31, 2007 and $214,000 during the first quarter of 2008.

 

On September 29, 2006, we entered into a revolving credit facility with GE Capital (the “GE Capital Facility”) which consisted of a senior secured revolving credit facility pursuant to which we could borrow up to $5.0 million, subject to adjustment. At December 31, 2007, we had $5.0 million of borrowings outstanding under this facility, and had no availability based on the amount of our qualified accounts receivable as of December 31, 2007. We repaid all amounts owed under the GE Capital Facility during the first quarter of 2008 and terminated this facility.

 

We currently have a $12.0 million revolving credit agreement with Comerica Bank, which we amended and restated on February 28, 2008 (the “Comerica Facility”). Borrowings under the Comerica Facility totaled $9.0 million at March 31, 2008 and are being used for working capital purposes, and the remaining availability under the Comerica Facility was used to

 

 

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obtain a $3.0 million stand-by letter of credit for the landlord of our leased facility in Aliso Viejo, California. The Comerica Facility matures on February 26, 2009, and, as of March 31, 2008, the Company had no additional availability under the Comerica Facility. During 2008, borrowings under the Comerica Facility bore interest at the bank’s prime rate minus 0.5% and included one financial covenant related to tangible net worth. Under the amended and restated Comerica Facility, at the Company’s option, borrowings will bear interest at the prime rate minus 0.5%, or a rate equal to LIBOR plus 2.45%, provided, however, that upon the achievement of certain financial performance metrics the rate will decrease by 0.25%. We were not in compliance with the minimum tangible net worth covenant as of December 31, 2007 (and in certain prior periods), and, on March 21, 2008, we obtained a waiver from Comerica Bank with respect thereto. Under the terms of the amended Comerica Facility, we are required to maintain a minimum tangible net worth which is defined as the sum of capital stock and additional paid in capital, plus retained earnings (or minus accumulated deficit), minus intangible assets of the following amounts: negative $6.5 million ($6,500,000) for the period from January 1, 2008 through March 31, 2008, negative $8.0 million ($8,000,000) for the period April 1, 2008 through June 30, 2008, negative $9.0 million ($9,000,000) for the period from July 1, 2008 through September 30, 2008, negative $9.5 million ($9,500,000) for the period from October 1, 2008 through December 31, 2008 and negative $9.5 million ($9,500,000) plus 50% of profits (profit recapture) thereafter. The financial covenant contained in the Comerica facility is based on the assumption that our results from operations in 2008 will significantly improve from our historical results of operations. In addition, we have previously not been able to maintain compliance with prior financial covenants in our credit facilities with respect to certain periods. Therefore, there can be no assurance that we will be able to maintain compliance with the covenant in this credit facility.  As of March 31, 2008, the Company was in compliance with all debt covenants related to the Comerica Facility. Comerica has agreed that the carrying value of any unexercised warrants recognized in the Company’s consolidated financial statements will be considered as tangible net worth for the purposes of determining compliance with the Comerica Facility debt covenants.

 

Safeguard guarantees borrowings under the Comerica Facility in exchange for an annual fee of 0.5% of the amount guaranteed and an amount equal to 4.5% per annum of the daily-weighted average principal balance outstanding ($12.0 million as of March 31, 2008, inclusive of the above-referenced letter of credit). Additionally, under the Comerica Facility we are required to pay Safeguard a quarterly usage fee of 0.875% of the amount by which the daily average principal balance outstanding under the Comerica Facility exceeds $5.5 million. We also issued warrants to Safeguard in January 2007 as consideration for their guarantee as follows: warrants to purchase 100,000 shares for an exercise price of $0.01 (as a commitment fee for Safeguard’s guarantee) and warrants to purchase 166,667 shares for an exercise price of $1.64 (as a maintenance fee for Safeguard’s guarantee). The fair value of warrants issued was determined under the Black-Scholes model, and was fully expensed in the quarter ended March 31, 2007. The Safeguard guarantee was also extended along with the renewal of Comerica Facility on February 28, 2008 under the same terms as the 2007 extension. No additional warrants were issued as part of the 2008 extended guarantee.

 

On March 7, 2007, we entered into the Initial Mezzanine Facility with Safeguard. The Initial Mezzanine Facility originally provided us up to $12.0 million in working capital funding, but was reduced by $6.0 million as a result of the ACIS Sale. Borrowings under the Initial Mezzanine Facility bore interest at an annual rate of 12%. In connection with the Initial Mezzanine Facility, we issued to Safeguard: (1) warrants to purchase 125,000 shares of our common stock with an exercise price of $0.01 per share, expiring March 7, 2011; (2) warrants to purchase 62,500 shares of common stock with an exercise price of $1.39 per share (reflecting a 15% discount to the trailing 10-day average closing price of our common stock prior to March 7, 2007), expiring March 7, 2011; and (3) four-year warrants to purchase an aggregate of 93,750 shares of common stock with an exercise price of $0.01 per share in connection with borrowings that we made thereunder. As of December 31, 2007, the Company had drawn $2.0 million against the Mezzanine Facility, and borrowings under the Initial Mezzanine Facility were refinanced in March 2008 with borrowings under the New Mezzanine Facility described below.

 

On March 14, 2008, we entered into the New Mezzanine Facility to refinance, renew and expand the Initial Mezzanine Facility. The New Mezzanine Facility, which has a stated maturity date of April 15, 2009, provides the Company access to up to $21.0 million in working capital funding. The New Mezzanine Facility will come due earlier upon (i) full repayment by the Company of its senior debt; (ii) certain sales, mergers or consolidations of the Company which would result in a sale of all or substantially all of the Company’s assets or Safeguard no longer owning a majority of the Company’s common stock; or (iii) the liquidation of the Company. In the event the Company completes a financing of debt or equity securities resulting in net proceeds to the Company of at least $15,000,000, the Company will be required to pay down all amounts outstanding under the New Mezzanine Facility and the maximum aggregate size of the New Mezzanine Facility will be reduced to $6 million. Borrowings under the New Mezzanine Facility bear interest at an annual rate of 12%. As of March 31, 2008, the Company had outstanding indebtedness of approximately $12.4 million under the New Mezzanine Facility. Proceeds from the New Mezzanine Facility were used to refinance indebtedness under the Initial Mezzanine

 

 

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Facility, for working capital purposes and to repay in full and terminate the GE Capital Facility and certain related equipment lease obligations. In connection with the New Mezzanine Facility, the Company issued Safeguard five-year warrants to purchase 1,643,750 shares of common stock with an exercise price of $0.01 per share, which included warrants to purchase 93,750 shares, which were the subject of amounts that had not been drawn under the Initial Mezzanine Facility. The fair value of the warrants issued was determined under the Black-Scholes model and the related debt discount is recognized as interest expense over the term of this agreement related to these warrants. In addition, under the New Mezzanine Facility, the Company is required to issue to Safeguard an aggregate of an additional 2,200,000 warrants in four equal and separate tranches if the balance of the New Mezzanine Facility has not been reduced to $6.0 million on or prior to May 1, July 1, September 1, and November 1, 2008.  The fair value of any warrants issued in conjunction with the Initial Mezzanine Facility and New Mezzanine Facility are initially presented in the accompanying balance sheets as a discount on the related party line of credit and additional paid-in-capital after consideration of the provisions of EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.”  The discount is then accreted to interest expense to related parties in the accompanying statements of operations.

 

The New Mezzanine Facility includes certain restrictive covenants, including (a) requirement to obtain approval from lender for new financing agreements or other significant transactions, (b) requirement to comply with other covenants in any note including the Comerica Facility, and (c) a liquidity event would constitute an event of default.  Failure to maintain compliance with the Comerica Facility would constitute an event of default under this facility.  Absent a waiver from both lenders, borrowings under both facilities would become immediately due and payable.

 

Our financial statements have been prepared on a going-concern basis, which assumes that the Company will have sufficient resources to pay its obligations as they become due during the next twelve months and do not reflect adjustments that might result if we were not to continue as a going concern. However, we have a history of operating losses and negative cash flows from operations, and future profitability is uncertain. In addition, we have an accumulated deficit, stockholders’ deficit and a working capital deficiency, and a history of not complying with the covenants within our credit agreements. Such defaults were waived and we have agreed to a new financial covenant relating to tangible net worth in our credit facility with Comerica Bank for 2008. We entered into the amended credit facility with the expectation that we could meet the financial covenant. However, in order to do so, our results of operations in 2008 will have to meet levels not historically achieved by the Company. Failure to maintain compliance with the financial covenants in our Comerica Facility would constitute an event of default under that facility and a cross-default under the New Mezzanine Facility. Absent a waiver from both lenders, borrowings under both facilities would become immediately due and payable. The Company does not currently have the ability to repay borrowings under these facilities. There can be no assurance that the Company will be able to fully access existing financing sources or obtain additional debt or equity financing when needed or on terms that are favorable to the Company and its stockholders, or will be able to obtain waivers from its lenders in the event of non-compliance with its debt covenants. As a result of these matters, there is substantial doubt about our ability to continue as a going concern.

 

See Note 8 “Lines of Credit” for additional discussion of the GE Capital Facility, the Comerica Facility, the Initial Mezzanine Facility and the New Mezzanine Facility.

 

The following table summarizes our contractual obligations and commercial commitments at March 31, 2008, including our facility lease and borrowings on equipment subject to capital leases. These commitments exclude scheduled sublease receipts, any remaining amounts necessary to complete the build-out of our new facility, and a $3.0 million standby letter of credit provided to the landlord under the lease agreement for our facility.

 

		Payment due by period
Contractual Obligations		Total			Less than 1 Year			1-3 Years			4-5 Years			After 5 Years
		(in thousands)
Revolving Lines of Credit, net of discount		$	18,621		$	18,621		$	—		$	—		$	—
Capital Lease Obligations		319			86			233			—			—
Operating Leases		12,006			1,324			4,692			3,215			2,775
Total		$	30,946		$	20,031		$	4,925		$	3,215		$	2,775

 

Off-Balance Sheet Arrangements

 

We have no off-balance sheet arrangements that provide financing, liquidity, market or credit risk support or involve leasing, hedging or research and development services for our business or other similar arrangements that may expose us to liability that is not expressly reflected in the financial statements, except for facilities operating leases.

 

As of March 31, 2008, we did not have any relationships with unconsolidated entities or financial partnerships, often referred to as structured finance or special purpose entities, established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As such, we are not subject to any material financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.

 

 

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Recent Accounting Pronouncements

 

Several new accounting standards have been issued and adopted recently. None of these standards had a material impact on our financial position, results of operations or liquidity.

 

In September 2006, the FASB issued SFAS 157 which defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. In February 2008 the FASB issued FSP 157-2, Effective Date of FASB Statement No. 157, which delays the effective date of SFAS 157 for non-financial assets and liabilities to fiscal years beginning after November 15, 2008. The adoption of SFAS 157 related to financial assets and liabilities did not have a material impact on the Company’s consolidated financial statements. The Company is currently evaluating the impact, if any, that SFAS 157 may have on its consolidated financial statements related to non-financial assets and liabilities.

 

In November 2007, the EITF issued a consensus on EITF 07-1, “Accounting for Collaborative Arrangements” (“EITF 07-1”). The Task Force reached a consensus on how to determine whether an arrangement constitutes a collaborative arrangement, how costs incurred and revenue generated on sales to third parties should be reported by the partners to a collaborative arrangement in each of their respective income statements, how payments made to or received by a partner pursuant to a collaborative arrangement should be presented in the income statement, and what participants should disclose in the notes to the financial statements about a collaborative arrangement. This Issue shall be effective for fiscal years beginning after December 15, 2008. Entities should report the effects of applying this issue as a change in accounting principle through retrospective application to all periods to the extent practicable. Upon application of this Issue, the following should be disclosed: (a) a description of the prior-period information that has been retrospectively adjusted, if any, and (b) the effect of the change on revenue and operating expenses (or other appropriate captions of changes in the applicable net assets or performance indicator) and on any other affected financial statement line item. We are currently evaluating the impact, if any, of the adoption of EITF 07-1 on its consolidated financial position, results of operations and cash flows.

 

In December 2007, the FASB issued SFAS No. 141(revised 2007), “Business Combinations” (“SFAS 141(R)”). This statement requires an acquirer to recognize the assets acquired, the liabilities assumed, and any non-controlling interest in the acquiree at the acquisition date, measured at their fair values as of that date. SFAS 141(R) replaces the cost-allocation process of SFAS No. 141, “Business Combinations” (“SFAS 141”), which required the cost of an acquisition to be allocated to the individual assets acquired and liabilities assumed based on their estimated fair values. This statement applies prospectively to business combinations for which the acquisition date is on or after January 1, 2009. Earlier adoption is prohibited.

 

Risk Factors

 

Before deciding to invest in us or to maintain or increase your investment, you should carefully consider the risks described below, in addition to the other information contained in this report and other reports we have filed with the Securities and Exchange Commission. The risks and uncertainties described below are not the only ones facing our Company. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also affect our business operations. If any of these risks are realized, our business, financial condition or results of operations could be seriously harmed. In that event, the market price for our common stock could decline and you may lose all or part of your investment.

 

Risks Related to Our Business

 

We have a history of operating losses, and future profitability is uncertain.

 

We have incurred operating losses in every year since inception, and our accumulated deficit and stockholders’ deficit as of March 31, 2008 were $146.1 million and $2.6 million, respectively. Those operating losses are principally associated with the research and development of our ACIS technology (which we transferred to Zeiss in the ACIS Sale), conducting clinical trials, preparing regulatory clearance filings, developing Dako’s sales and marketing organization to commercialize the ACIS prior to the ACIS Sale, and investments we have made and expenses we have incurred relating to our diagnostic services business.

 

Although we have reduced our operating losses, we expect to continue to incur losses as a result of expansion of our laboratory services. We are unable to predict when we will become profitable, and we may never become profitable. Even if we do achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis. If we are unable to achieve and then maintain profitability, the market value of our common stock will likely decline. These matters raise substantial doubt about our ability to continue as a going concern.

 

 

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                We may require additional financing for, among other things, expansion of our laboratory operations, development of novel molecular tests, capital expenditures and other costs, and it is uncertain whether such financing will be available on favorable terms, if at all.

 

                We will continue to expend funds for development of novel markers, clinical trials and to expand our service offerings. We will also need additional capital if our new business initiatives are not successful or we fail to achieve the level of revenues and gross profit from our services contemplated by our business plan in the time frame contemplated by our business plan.

 

                Our present and future funding requirements will also depend on certain other external factors, including, among other things:

 

·                                          the level of development investment required to maintain and improve our service offerings, including the development of novel molecular tests;

 

·                                          our need or decision to acquire or license complementary technologies or acquire complementary businesses;

 

·                                          competing technological and market developments; and

 

·                                          changes in regulatory policies or laws that affect our operations.

 

                We do not know whether additional financing will be available to us as needed on commercially acceptable terms. If adequate funds are not available or are not available on commercially acceptable terms, we might be required to delay, scale back or eliminate some or all of our development activities or new business initiatives, or to license to third parties the right to commercialize products or technologies that we would otherwise seek to commercialize ourselves. If additional funds are raised through an equity or convertible debt financing, our stockholders may experience significant dilution.

 

                We are required to maintain compliance with financial and other restrictive covenants in our debt financing agreements which can restrict our ability to operate our business, and if we fail to comply with those covenants, our outstanding indebtedness may be accelerated.

 

                Our existing credit facility with Comerica Bank contains a financial covenant requiring us to maintain specified levels of tangible net worth. In addition, our credit facilities with Safeguard and Comerica contain covenants restricting our ability to:

 

·                                          incur additional debt;

 

·                                          pay dividends or make other distributions or payments on capital stock;

 

·                                          make investments;

 

·                                          incur (or permit to exist) liens;

 

·                                          enter into transactions with affiliates;

 

·                                          change business, legal name or state of incorporation;

 

·                                          guarantee the debt of other entities, including joint ventures;

 

·                                          merge or consolidate or otherwise combine with another company; and

 

·                                          transfer or sell our assets.

 

                These covenants could adversely affect our ability to finance our future operations or capital needs and pursue available business opportunities, including acquisitions. A breach of any of these covenants could result in a default in respect of the related indebtedness (and a breach of our credit facility with Comerica or Safeguard would constitute a cross-default under the other facility). During 2006 and 2007, we were unable to comply with certain financial covenants

 

 

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(including the requirement that we maintain a minimum tangible net worth and operating cash) under our credit agreements with General Electric Capital Corporation (which we repaid in full on March 17, 2008) and Comerica. While our lenders waived those defaults and we have agreed to new financial covenants with respect to future periods with Comerica, if a default occurs in the future under either of our credit facilities, Comerica and Safeguard could elect to declare the indebtedness under the applicable facility, together with accrued interest and other fees, to be immediately due and payable and proceed against any collateral securing that indebtedness. We entered into the amended credit facility with the expectation that we could meet the financial covenant. However, in order to do so, our results of operations in 2008 will have to significantly improve from our historical results of operations. In addition, we have previously not been able to maintain compliance with prior financial covenants in our credit facilities with respect to certain periods. Therefore, there can be no assurance that we will be able to maintain compliance with our credit facilities. This, coupled with our history of operating losses, negative cash flows, accumulated deficit, and stockholders’ deficit raise substantial doubt about our ability to continue as a going concern.

 

                We have identified material weaknesses in our internal control over financial reporting.

 

                We have identified material weaknesses in our internal control over financial reporting. In particular, we concluded that the accounting and financial organization of the Company lacks policies and procedures that are effective at ensuring that reporting risks, including changes therein, within its accounting processes, are identified timely and corresponding control activities implemented. In addition, we determined that the Company did not design and maintain controls that were effective at ensuring that the appropriate accounting treatment was applied to information provided by a third party service provider utilized in the billing function. This material weakness resulted in an overstatement of revenue and an understatement of current liabilities for refunds to customers. This misstatement was corrected prior to the issuance of our 2007 Consolidated Financial Statements. We also determined that the Company did not design and maintain controls adequate to ensure that changes in historical collection experience resulted in modifications to the process for determining the estimate of the allowance for doubtful accounts. This material weakness resulted in a misstatement of the allowance for doubtful accounts. This misstatement was corrected prior to the issuance of our 2007 Consolidated Financial Statements. Additional misstatements were identified in connection with the preparation of our Condensed Consolidated Financial Statements ending March 31, 2008, which were corrected prior to the completion of these Financial Statements. Although we are undertaking steps to address these material weaknesses, the existence of a material weakness is an indication that there is more than a remote likelihood that a material misstatement of our financial statements will not be prevented or detected in the current or any future period. In addition, we may in the future identify further material weaknesses in our internal control over financial reporting that we have not discovered to date. The material weaknesses have not been remediated as of March 31, 2008.

 

                We sold our Technology business to Zeiss and we may experience negative consequences as a result of such transaction, including disruptions to our operations, potential indemnification obligations and restrictions on our business operations going forward.

 

                In March 2007, we sold our Technology business to Zeiss in the ACIS Sale for an aggregate purchase price of $12.5 million, consisting of $11 million in cash and up to an additional $1.5 million in contingent purchase price, which is payable in whole or in part (if at all) subject to satisfaction of certain post-closing conditions relating to intellectual property. We cannot assure that those conditions will be satisfied and, as a result, we may be paid only a portion or none of such contingent consideration.

 

                The ACIS Sale resulted in the transfer of our business of developing, manufacturing and marketing the ACIS system, and, as a result, we will no longer derive revenues from that business, including revenues under our distribution agreement with Dako (which we assigned to Zeiss in connection with the ACIS Sale). We also transferred our patent portfolio and other intellectual property of the Technology business to Zeiss and while we have retained a license to certain patent rights, copyrights and software, our use of those intellectual property rights is limited to the field of use specified in the license agreement. We also agreed not to compete with Zeiss in connection with the development, production and sale of imaging instruments for a period of 42 months following the closing date of the ACIS Sale and, as a result, our business will be restricted from engaging in those activities during that period.

 

                In connection with the ACIS Sale, we also made customary representations and warranties to Zeiss and we retained certain pre-closing liabilities relating to the Technology business. As a result, we may have future indemnification obligations to Zeiss upon a breach of such representations and warranties, and in connection with third party claims relating thereto or relating to the liabilities that we retained.

 

 

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                We may not successfully manage our growth, which may result in delays or unanticipated difficulties in implementing our business plan.

 

                Our success will depend upon the expansion of our operations and the effective management of our growth. We expect to experience growth in the scope of our operations and services and the number of our employees. If we grow significantly, such growth will place a significant strain on management and on administrative, operational and financial resources. To manage significant growth, we may need to expand our facilities, augment our operational, financial and management systems, internal controls and infrastructure and hire and train additional qualified personnel. Our future success is heavily dependent upon growth and acceptance of our future products and services. If we are unable to scale our business appropriately or otherwise adapt to anticipated growth and new product introduction, our business, operating results, cash flows and financial condition may be harmed.

 

                The diagnostic laboratory market is characterized by rapid technological change, frequent new product introductions and evolving industry standards, and we may encounter difficulties keeping pace with changes in this market.

 

                The introduction of diagnostic tests embodying new technologies and the emergence of new industry standards can render existing tests obsolete and unmarketable in short periods of time. We expect competitors to introduce new products and services and enhancements to existing products and services. Our future success will depend upon our ability to enhance our current tests, and to develop new tests, in a manner that keeps pace with emerging industry standards and achieves market acceptance. Our inability to accomplish any of these endeavors will likely have a material adverse effect on our business, operating results, cash flows and financial condition.

 

                We face substantial existing competition and potential new competition.

 

                The laboratory business is intensely competitive both in terms of price and service. This industry is dominated by several national independent laboratories, but includes many smaller niche and regional independent laboratories as well. Large commercial enterprises, including Quest Diagnostics and Laboratory Corporation of America Holdings (LabCorp), have substantially greater financial resources and may have larger research and development programs and more sales and marketing channels than we do, enabling them to potentially develop and market competing products and services. These enterprises may also be able to achieve greater economies of scale or establish contracts with payor groups on more favorable terms. Academic and regional medical institutions generally lack the advantages of the larger commercial laboratories but still compete with us on a limited basis. Smaller niche laboratories compete with us based on their reputation for offering a narrow test menu. Pricing of laboratory testing services is one of the significant factors often used by health care providers in selecting a laboratory. As a result of the laboratory industry undergoing significant consolidation, larger clinical laboratory providers are able to increase cost efficiencies afforded by large-scale automated testing. This consolidation results in greater price competition. We may be unable to increase cost efficiencies sufficiently, if at all, and as a result, our operating results, cash flows and our financial position could be negatively impacted by such price competition.

 

                Competition in the pharmaceutical and biotechnology industries generally, and the medical devices and diagnostic products segments in particular, is intense and has increased with the rapid pace of technological development. Our competitors in this area include large diagnostics and life sciences companies. Most of these entities have substantially greater research and development capabilities and financial, scientific, manufacturing, marketing, sales and service resources than we do. Some of these entities also have more experience than we do in research and development, clinical trials, regulatory matters, manufacturing, marketing and sales.

 

                Furthermore, we believe some of our current competitors, as well as other companies that we do not currently consider to be our competitors, are actively conducting research in areas where we are also conducting development activities. The products and services these companies develop may directly compete with our current or potential services, or may address other areas of diagnostic evaluation, making those companies compete more effectively against us. Furthermore, because the diagnostic testing market is sensitive to the timing of product and service availability, a company that can quickly develop and achieve clinical study and regulatory success may have a competitive advantage over its competitors that cannot do so.

 

                Because of their experience and greater research and development capabilities, our competitors might succeed in developing and commercializing technologies or products earlier and obtaining regulatory approvals and clearances from the

 

 

24

 

FDA more rapidly than we are able to. In addition, our competitors also might develop more effective technologies or products that may render our technologies or products obsolete or non-competitive.

 

                We have limited experience in providing laboratory and other services, which may cause us to experience difficulties that could delay or prevent the development, introduction and marketing of these services.

 

                We began providing the technical component of reference laboratory services in-house beginning in April 2004, and we began to provide additional oncology-focused laboratory services that complement our image analysis and reference laboratory services in December 2004. The success and viability of these initiatives is dependent on a number of factors including:

 

·                                          our ability to develop and provide services that we have provided only for a short time;

 

·                                          adequate coverage and reimbursement;

 

·                                          medical efficacy as demonstrated by clinical studies and governmental clearances; and

 

·                                          our ability to obtain timely renewal of state and federal regulatory licenses.

 

                We may not be successful in any of these areas, we may experience difficulties that could delay or prevent the successful development, introduction and marketing of these services, and we may not adequately meet the demands of the marketplace or achieve market acceptance. Our inability to accomplish any of these endeavors may have a material adverse effect on our business, operating results, cash flows and financial condition.

 

                Failure in our information technology systems could disrupt our operations.

 

                Our success will depend, in part, on the continued and uninterrupted performance of our information technology systems. Information systems are used extensively in virtually all aspects of our business, including laboratory testing, billing, customer service, logistics, and management of medical data and dissemination of test results.

 

                Our computer systems are vulnerable to damage from a variety of sources, including telecommunications failures, malicious human acts and natural disasters. Moreover, despite reasonable security measures we have implemented, some of our information technology systems are potentially vulnerable to physical or electronic break-ins, computer viruses and similar disruptive problems, in part because we conduct business on the Internet and because some of these systems are located at third-party web hosting providers and we cannot control the maintenance and operation of the data centers by such third-parties. Despite the precautions we have taken, unanticipated problems affecting our systems could cause interruptions in our information technology systems, leading to lost revenue, deterioration of customer confidence, and significant business disruption. Our business, financial condition, results of operations, or cash flows could be materially and adversely affected by any problem that interrupts or delays our operations.

 

                If a catastrophe were to strike our facility, we would be unable to operate our business competitively.

 

                Our facility may be affected by catastrophes such as fires, earthquakes or sustained interruptions in electrical service. Earthquakes and fires are of particular significance to us because our laboratory facility is located in southern California, an earthquake and fire prone area. In the event our existing facility or equipment is affected by man-made or natural disasters, we may be unable to process our customers’ samples in a timely manner and unable to operate our business in a commercially competitive manner.

 

                Our ability to maintain our competitive position depends on our ability to attract and retain highly qualified managerial, technical and sales and marketing personnel.

 

                We believe that our continued success depends to a significant extent upon the efforts and abilities of our executive officers and our scientific and technical personnel, including the following individuals:

 

·                                          Ronald A. Andrews, our Chief Executive Officer;

 

·                                          James V. Agnello, our Senior Vice President and Chief Financial Officer;

 

 

25

 

·                                          Ken Bloom, M.D., our Chief Medical Director;

 

·                                          Michael J. Pellini, M.D., our President and Chief Operating Officer; and

 

·                                          David J. Daly, our Senior Vice President of Commercial Operations.

 

                The loss of any of our executive officers, senior managers or key scientific or technical personnel could have a material adverse effect on our business, operating results, cash flows and financial condition. We do not maintain key-person life insurance on any of our officers, managers, scientific and technical personnel or other employees. Furthermore, our anticipated growth and expansion will require the addition of highly skilled technical, management, financial, sales and marketing personnel. Competition for personnel is intense, and our failure to hire and retain talented personnel or the loss of one or more key employees could have a material adverse effect on our business. In particular, we may encounter difficulties in attracting a sufficient number of qualified California licensed laboratory scientists. In addition, our personnel may not be able to fulfill their responsibilities adequately and may not remain with us.

 

                Our net revenue will be diminished if payors do not adequately cover or reimburse our services.

 

                There has been, and will likely continue to be, significant efforts by both federal and state agencies to reduce costs in government healthcare programs and otherwise implement government control of healthcare costs. In addition, increasing emphasis on managed care in the United States may continue to put pressure on the pricing of healthcare services. Uncertainty exists as to the coverage and reimbursement status of new applications or services, as third-party payors, including governmental payors such as Medicare and private payors, are scrutinizing new medical products and services and may not cover or may limit coverage and the level of reimbursement for our services. Additionally, third-party insurance coverage may not be available to patients for any of our existing assays or assays we discover and develop. A substantial portion of the testing for which we bill our hospital and laboratory clients is ultimately paid by third-party payors and any pricing pressure exerted by these third-party payors on our customers may, in turn, be exerted by our customers on us. If government and other third-party payors do not provide adequate coverage and reimbursement for our assays, our operating results, cash flows or financial condition may decline.

 

                A majority of managed care organizations are using capitated payment contracts in an attempt to shift payment risks, which may negatively impact our operating margins.

 

                Managed care providers typically contract with a limited number of diagnostic laboratories and then designate the laboratory or laboratories to be used for tests ordered by participating physicians. The majority of managed care testing is negotiated on a fee-for-service basis at a discount. Such discounts have historically resulted in price erosion and we expect that they could negatively impact our operating margins as we continue to offer laboratory services to managed care organizations.

 

                Third-party billing is extremely complicated and will result in significant additional costs to us.

 

                Billing for laboratory services is extremely complicated. The customer is the party that refers the tests and the payor is the party that pays for the tests, and the two are not always the same. Depending on the billing arrangement and applicable law, we need to bill various payors, such as patients, insurance companies, Medicare, Medicaid, doctors and employer groups, all of which have different billing requirements. Additionally, our billing relationships require us to undertake internal audits to evaluate compliance with applicable laws and regulations as well as internal compliance policies and procedures. Insurance companies also impose routine external audits to evaluate payments made. This adds further complexity and costs to the billing process.

 

                Additional factors complicating billing are:

 

·                                          pricing differences between our fee schedules and the reimbursement rates of the payors;

 

·                                          disputes with payors as to which party is responsible for payment; and

 

·                                          disparity in coverage and information requirements among various carriers.

 

 

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                We incur significant additional costs as a result of our participation in the Medicare and Medicaid programs, as billing and reimbursement for laboratory testing are subject to considerable and complex federal and state regulations. The additional costs we expect to incur as a result of our participation in the Medicare & Medicaid programs include costs related to, among other factors: (1) complexity added to our billing processes; (2) training and education of our employees and customers; (3) implementing compliance procedures and oversight; (4) collections and legal costs; (5) challenging coverage and payment denials; and (6) providing patients with information regarding claims processing and services, such as advanced beneficiary notices.

 

                We currently outsource responsibility for billing and collections for our laboratory services to a third-party. However, in order to maintain necessary controls and reduce processing costs, we have decided to bring the billing and collection process in-house. We anticipate this transition to be complete by the third quarter of 2008. We do not have previous experience in billing our customers and insurance companies directly for our services or in collections activities and, as a result, we may encounter difficulties in transitioning and maintaining responsibility for such functions in-house.

 

                We are dependent on others for the development of products. The failure of our collaborations to successfully develop products could harm our business.

 

                Our business strategy includes entering into agreements with clinical and commercial collaborators and other third parties for the development, clinical evaluation and marketing of new products, including novel molecular tests. Research performed under a collaboration for which we receive or provide funding may not lead to the development of products in the timeframe expected, or at all. If these agreements are terminated earlier than expected, or if third parties do not perform their obligations to us properly and on a timely basis, we may not be able to successfully develop new products as planned, or at all.

 

                We may acquire other businesses, products or technologies in order to remain competitive in our market and our business could be adversely affected as a result of any of these future acquisitions.

 

                We may make acquisitions of complementary businesses, products or technologies. If we identify any appropriate acquisition candidates, we may not be successful in negotiating acceptable terms of the acquisition, financing the acquisition, or integrating the acquired business, products or technologies into our existing business and operations. Further, completing an acquisition and integrating an acquired business will significantly divert management time and resources. The diversion of management attention and any difficulties encountered in the transition and integration process could harm our business. If we consummate any significant acquisitions using stock or other securities as consideration, our shareholders’ equity could be significantly diluted. If we make any significant acquisitions using cash consideration, we may be required to use a substantial portion of our available cash. Acquisition financing may not be available on favorable terms, if at all. In addition, we may be required to amortize significant amounts of other intangible assets in connection with future acquisitions, which would harm our operating results and financial condition.

 

                Clinicians or patients using our services may sue us and our insurance may not sufficiently cover all claims brought against us, which will increase our expenses.

 

                The development, marketing, sale and performance of healthcare services expose us to the risk of litigation, including professional negligence. Damages assessed in connection with, and the costs of defending, any legal action could be substantial. We currently maintain numerous insurance policies, including a $5 million aggregate, $3 million per claim, medical professional liability insurance policy, with a deductible of $25,000. This policy contains customary exclusions, including exclusions relating to asbestos and biological contaminants. However, we may be faced with litigation claims, which exceed our insurance coverage or are not covered under any of our insurance policies. In addition, litigation could have a material adverse effect on our business if it impacts our existing and potential customer relationships, creates adverse public relations, diverts management resources from the operation of the business or hampers our ability to perform assays or otherwise conduct our business.

 

                If we use biological and hazardous materials in a manner that causes injury, we could be liable for damages.

 

                Our development and clinical pathology activities sometimes involve the controlled use of potentially harmful biological materials, hazardous materials, chemicals and various radioactive compounds. We cannot completely eliminate the risk of accidental contamination or injury to third parties from the use, storage, handling or disposal of these materials. We currently maintain numerous casualty policies, including a $1 million per occurrence, $2 million aggregate general liability

 

 

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policy, a $10 million umbrella liability policy and a $5 million technology errors and omissions policy. We also have a property special risk policy to cover our contents, equipment and business interruption as well as a $10 million policy for the perils of earthquake and flood. These policies have deductible ranges from $5,000 to $50,000 and contain customary exclusions. However, in the event of contamination or injury, we could be held liable for any resulting damages, and any liability could exceed our resources or any applicable insurance coverage we may have. Additionally, we are subject on an ongoing basis to federal, state and local laws and regulations governing the use, storage, handling and disposal of these materials and specified waste products. The cost of compliance with these laws and regulations is significant and could negatively affect our operations, cash flows and financial condition if these costs increase substantially.

 

                Any breakdown in the protection of our licensed proprietary technology, or any determination that our licensed proprietary technology infringes on the rights of others, could materially affect our business.

 

                Our commercial success will depend in part on our ability to protect and maintain our proprietary technology. We rely primarily on a combination of copyright and trademark laws, trade secrets, confidentiality procedures and contractual provisions to protect our proprietary rights. However, obtaining, defending and enforcing patents and other intellectual property rights involve complex legal and factual questions. We cannot assure you that we will be able to obtain, defend or enforce patents we may obtain in the future covering our technologies in the United States or in foreign countries, or be able to effectively maintain our technologies as unpatented trade secrets or otherwise obtain meaningful protection for our proprietary technology. Moreover, we cannot assure you that third-parties will not infringe, design around, or improve upon our proprietary technology or rights.

 

                The healthcare industry has been the subject of extensive litigation regarding patents and other proprietary rights and if we are unable to protect our licensed patents and proprietary rights, through litigation or otherwise, our reputation and competitiveness in the marketplace could be materially damaged.

 

                We may initiate litigation to attempt to stop the infringement of our patent claims or to attempt to force an unauthorized user of our trade secrets to compensate us for the infringement or unauthorized use. Patent and trade secret litigation is complex and often difficult and expensive, and would consume the time of our management and other significant resources. If the outcome of litigation is adverse to us, third parties may be able to use our technologies without payments to us. Moreover, some of our competitors may be better able to sustain the costs of litigation because they have substantially greater resources. Because of these factors relating to litigation, we may be unable to prevent misappropriation of our patent and other proprietary rights effectively.

 

                If the use of our technologies conflicts with the intellectual property rights of third-parties, we may incur substantial liabilities and we may be unable to commercialize products based on these technologies in a profitable manner, if at all.

 

                Our competitors and other third parties may have or acquire patent rights that they could enforce against us. If they do so, we may be required to alter our technologies, pay licensing fees or cease activities. Additionally, if our technologies conflict with patent rights of others, third parties could bring legal action against us or our licensees, suppliers, customers or collaborators, claiming damages and seeking to enjoin manufacturing and marketing of the affected products. If these legal actions are successful, in addition to any potential liability for damages, we might have to obtain a royalty or licensing arrangement in order to continue to manufacture or market the affected products. A required license or royalty under the related patent or other intellectual property may not be available on acceptable terms, if at all.

 

                We may be unaware of issued patents that our technologies infringe. Because patent applications can take many years to issue, there may be currently pending applications, unknown to us, that may later result in issued patents upon which our technologies may infringe. There could also be existing patents of which we are unaware upon which our technologies may infringe. In addition, if third parties file patent applications or obtain patents claiming technology also claimed by us in pending applications, we may have to participate in interference proceedings in the United States Patent and Trademark Office to determine priority of invention. If third parties file oppositions in foreign countries, we may also have to participate in opposition proceedings in foreign tribunals to defend filed foreign patent applications. Additionally, we may have to participate in interference proceedings involving our issued patents or our pending applications.

 

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                If a third party claims that we infringe upon its proprietary rights, any of the following may occur:

 

·                                          we may become involved in time-consuming and expensive litigation, even if a claim is without merit;

 

·                                          we may become liable for substantial damages for past infringement, including possible treble damages for allegations of willful infringement, if a court decides that our technologies infringe upon a competitor’s patent;

 

·                                          a court may prohibit us from using a technology or providing a service without a license from the patent holder, which may not be available on commercially acceptable terms, if at all, or which may require us to pay substantial royalties or grant cross-licenses to our intellectual property; and

 

·                                          we may have to redesign our services so that they do not infringe upon others’ patent rights, which may not be possible or could require substantial funds or time.

 

                If any of these events occurs, our business, results of operation, cash flows and financial condition will likely suffer and the market price of our common stock will likely decline.

 

Risks Related to Regulation of Our Industry

 

                We cannot predict the extent of future FDA regulation of our in-house diagnostic laboratory services.

 

                Laboratory-developed tests, or LDTs, are developed and validated by a laboratory for use in test procedures the laboratory performs itself. Such LDTs are commonly referred to as “home brew” tests. The FDA maintains that it has the authority to regulate “home brews”, such as our in house diagnostic laboratory services, under the Federal Food, Drug, and Cosmetic Act, or FFDCA, as medical devices, but, as a matter of enforcement discretion, has decided not to exercise its authority. We cannot predict the extent of future FDA regulation and there can be no assurance that the FDA will not require our in-house diagnostic laboratory testing to receive premarketing clearance, or premarket approval prior to marketing or compliance with other requirements applicable to medical devices. For example, the FDA recently issued draft guidance on certain LDTs that are dependent on an interpretation algorithm. The agency has termed these LDTs “In Vitro Diagnostic Multivariate Index Assays” or IVDMIAs. According to the draft guidance, IVDMIAs do not fall within the scope of LDTs over which the FDA has exercised enforcement discretion because such tests incorporate complex and unique interpretation functions, which require clinical validation. We do not believe that any of our current diagnostic laboratory services meet the definition of IVDMIA in the draft guidance. However, the FDA may consider products that we develop in the future to be medical devices. If the draft guidance or other regulatory interpretations or requirements are finalized, one or more of our current or future tests may become subject to FDA regulation of medical devices. If the draft guidance is finalized, FDA intends to enforce regulatory requirements for IVDMIAs that do not receive clearance or approval within 18 months thereafter. If any or our current or future tests become subject to FDA regulation and we fail to obtain FDA clearance or approval within 18 months after the draft guidance is finalized, we might have to stop marketing our in-house diagnostic laboratory tests until premarket review and clearance or approval is obtained, and the time and expense needed to obtain clearance or approval of our tests under development could increase significantly. Medical devices are subject to extensive regulation by the FDA under the FFDCA and its implementing regulations, and other federal, state and local authorities. These regulations govern, among other things, the design, development, testing, manufacture, premarket clearance and approval, labeling, sale, promotion and distribution of medical device products. Achieving and maintaining compliance with FDA requirements is costly and burdensome, and failure to comply with applicable regulations could result in fines, suspension or shutdown of operations, recalls or seizure of products, and other civil or criminal penalties. Additional FDA regulatory controls over our in-house diagnostic laboratory services could also add additional costs to our operations, and may delay or prevent our ability to commercially distribute our services in the United States.

 

                If we are not able to obtain all of the regulatory approvals and clearances required to commercialize our services and underlying diagnostic applications, our business would be significantly harmed.

 

                If the FDA regulates our current or future diagnostic tests as medical devices, our development and commercialization in the United States may require either pre-market notification, or 510(k) clearance, or pre-market approval (PMA) from the FDA prior to marketing. In the 510(k) clearance process, the FDA must determine that a proposed device is “substantially equivalent” to a device legally on the market, known as a “predicate” device, with respect to intended use, technology and safety and effectiveness, in order to clear the proposed device for marketing. The 510(k) clearance pathway usually takes from two to twelve months from submission, but can take longer. The PMA approval pathway is much more costly, lengthy, uncertain and generally takes from one to two years (but possibly longer) from submission. The PMA approval pathway requires an applicant to demonstrate the safety and effectiveness of the device, in part, on data obtained in clinical trials. Both of these processes can be expensive and lengthy and entail significant user fees, unless exempt. There is no assurance that the FDA will clear or approve a 510(k) notification or PMA application. In addition, the FDA may reject a

 

 

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510(k) submission and require a more expensive and burdensome PMA instead. We do not know whether we will be able to obtain the clearances or approvals required to commercialize these products.

 

                The FDA has made, and may continue to make, changes in its approval requirements and processes. We cannot predict what these changes will be, how or when they will occur, or what effect they will have on the regulation of our products. Any new requirements may impose additional costs or lengthen review times of our products. Delays in receipt of, or failure to receive, United States regulatory approvals or clearances for our new products would likely have a material adverse effect on our business, financial condition and results of operations.

 

                In addition, once clearance or approval is obtained, ongoing compliance with FDA regulations, including among others, those related to operations recordkeeping and marketing and promotion would increase the cost, time and complexity of conducting our business. Applications submitted for FDA clearance or approval will be subject to substantial restrictions, including, among other things, restrictions on the indications for which we may market these products, which could result in lower revenues. The marketing claims we will be permitted to make in labeling or advertising regarding our cancer diagnostic products, if cleared or approved by the FDA, will be limited to those specified in any clearance or approval. In addition, we are subject to inspection and marketing surveillance by the FDA to determine our compliance with regulatory requirements. Specifically, manufacturers of medical devices must comply with various and stringent requirements of the FFDCA and its implementing regulations, including the quality system regulation, or QSR, which sets forth good manufacturing practices for medical devices, regulations governing labeling, medical device reporting, or MDR, regulations, and post-market surveillance regulations, which include restrictions on marketing and promotion. If the FDA finds that we have failed to comply with these requirements, it can institute a wide variety of enforcement actions, ranging from a public warning letter to more severe sanctions, including:

 

·                                          fines, injunctions and civil penalties;

 

·                                          recall or seizure of our products;

 

·                                          operating restrictions, partial suspension or total shutdown of production;

 

·                                          restrictions on labeling and promotion;

 

·                                          warning letters;

 

·                                          denial of requests for 510(k) clearances or pre-market approvals of product candidates;

 

·                                          withdrawal of 510(k) clearances or pre-market approvals already granted; and

 

·                                          criminal prosecution.

 

                Any of these enforcement actions could affect our ability to commercially distribute our products in the United States and may also harm our ability to conduct the clinical trials necessary to support the marketing, clearance or approval of additional applications.

 

                If we were required to conduct additional clinical trials prior to marketing our test(s), those trials could lead to delays or a failure to obtain necessary regulatory approvals and harm our ability to become profitable.

 

                If the FDA decides to regulate our test(s) as medical devices, it could require extensive premarket clinical testing prior to submitting a regulatory application for commercial sales. Conducting clinical trials generally entails a long, expensive and uncertain process that is subject to delays and failure at any stage. If we are required to conduct premarket clinical trials, delays in the commencement or completion of clinical testing could significantly increase our development costs and delay test commercialization. Many of the factors that may cause or lead to a delay in the commencement or completion of clinical trials may also ultimately lead to delay or denial of regulatory clearance or approval. The commencement of clinical trials may be delayed due to insufficient tissue samples or insufficient data regarding the associated clinical outcomes. We may find it necessary to engage contract research organizations to perform data collection and analysis and other aspects of our clinical trials, which might increase the cost and complexity of our trials. If these parties do not successfully carry out their contractual duties or obligations or meet expected deadlines, or if the quality, completeness or accuracy of the clinical data they obtain is compromised due to the failure to adhere to our clinical protocols, applicable

 

 

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regulatory requirements, or for other reasons, our clinical trials may have to be extended, delayed or terminated. Many of these factors would be beyond our control. If there are delays in testing or approvals as a result of the failure to perform by third parties, our research and development costs would increase, and we may not be able to obtain regulatory clearance or approval for our tests. In addition, we may not be able to establish or maintain relationships with these parties on favorable terms, if at all. Each of these outcomes would harm our ability to market our test(s), or to become profitable.

 

                Our operations are subject to strict laws prohibiting fraudulent billing and other abuse, and our failure to comply with such laws could result in substantial penalties.

 

                Of particular importance to our operations are federal and state laws prohibiting fraudulent billing and providing for the recovery of non-fraudulent overpayments, as a large number of laboratories have been forced by the federal and state governments, as well as by private payors, to enter into substantial settlements under these laws. In particular, if an entity is determined to have violated the federal False Claims Act, it may be required to pay up to three times the actual damages sustained by the government, plus civil penalties of between $5,500 to $11,000 for each separate false claim. While there are many potential bases for liability under the federal False Claims Act, liability primarily arises when an entity knowingly submits, or causes another to submit, a false claim for reimbursement to the federal government. Submitting a claim with reckless disregard or deliberate ignorance of its truth or falsity could result in substantial civil liability. A trend affecting the healthcare industry is the increased use of the federal False Claims Act and, in particular, actions under the False Claims Act’s “whistleblower” or “qui tam” provisions to challenge providers and suppliers. Those provisions allow a private individual to bring actions on behalf of the government alleging that the defendant has submitted a fraudulent claim for payment to the federal government. The government must decide whether to intervene in the lawsuit and to become the primary prosecutor. If it declines to do so, the individual may choose to pursue the case alone, although the government must be kept apprised of the progress of the lawsuit. Whether or not the federal government intervenes in the case, it will receive the majority of any recovery. In addition, various states have enacted laws modeled after the federal False Claims Act.

 

                Government investigations of clinical laboratories have been ongoing for a number of years and are expected to continue in the future. Written “corporate compliance” programs to actively monitor compliance with fraud laws and other regulatory requirements are recommended by the Department of Health and Human Services’ Office of the Inspector General, and we have a program following the guidelines in place.

 

                Our laboratory services are subject to extensive federal and state regulation, and our failure to comply with such regulations could result in penalties or suspension of Medicare payments and/or loss of our licenses, certificates or accreditation.

 

                The clinical laboratory testing industry is subject to extensive statutory and other regulation, and many of these statutes and other regulations have not been interpreted by the courts. The CLIA and implementing regulations established quality standards for all laboratory testing to ensure the accuracy, reliability and timeliness of patient test results regardless of where the test was performed. Laboratories covered under CLIA are those which perform laboratory testing on specimens derived from humans for the purpose of providing information for the diagnosis, prevention, treatment of disease and other factors. The Centers for Medicare & Medicaid Services is charged with the implementation of CLIA, including registration, surveys, enforcement and approvals of the use of private accreditation agencies. For certification under CLIA, laboratories such as ours must meet various requirements, including requirements relating to quality assurance, quality control and personnel standards. Since we perform patient testing from all states, our laboratory is also subject to strict regulation by California, New York and various other states. State laws require that laboratory personnel meet certain qualifications, specify certain quality controls or require maintenance of certain records, and are required to possess state regulatory licenses to offer the professional and technical components of laboratory services. If we are unable to maintain our existing state regulatory licenses in a timely manner or if we are unable to secure new state regulatory licenses for new locations, our ability to provide laboratory services could be compromised. Our failure to comply with CLIA, state or other applicable requirements could result in various penalties, including restrictions on tests which the laboratory may perform, substantial civil monetary penalties, imposition of specific corrective action plans, suspension of Medicare payments and/or loss of licensure, certification or accreditation. Such penalties could result in our being unable to continue performing laboratory testing. Compliance with such standards is verified by periodic inspections and requires participation in proficiency testing programs.

 

 

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                We are subject to significant environmental, health and safety regulation.

 

                We are subject to licensing and regulation under federal, state and local laws and regulations relating to the protection of the environment and human health and safety, including laws and regulations relating to the handling, transportation and disposal of medical specimens, infectious and hazardous waste and radioactive materials as well as to the safety and health of laboratory employees. In addition, the federal Occupational Safety and Health Administration has established extensive requirements relating to workplace safety for health care employers, including clinical laboratories, whose workers may be exposed to blood-borne pathogens such as HIV and the hepatitis B virus. These regulations, among other things, require work practice controls, protective clothing and equipment, training, medical follow-up, vaccinations and other measures designed to minimize exposure to, and transmission of, blood-borne pathogens. In addition, the federally-enacted Needlestick Safety and Prevention Act requires, among other things, that we include in our safety programs the evaluation and use of engineering controls such as safety needles if found to be effective at reducing the risk of needlestick injuries in the workplace.

 

                We are subject to federal and state laws governing the financial relationship among healthcare providers, including Medicare & Medicaid laws, and our failure to comply with these laws could result in significant penalties and other adverse consequences.

 

                Existing federal laws governing Medicare & Medicaid and other similar state laws impose a variety of broad restrictions on financial relationships among healthcare providers, including clinical laboratories. These laws include the federal anti-kickback law which prohibits individuals or entities, including clinical laboratories, from, among other things, making any payments or furnishing other benefits intended to induce or influence the referral of patients for tests billed to Medicare, Medicaid or certain other federally funded programs. Several courts have interpreted the statute’s intent requirement to mean that if any one purpose of an arrangement involving remuneration is to induce referrals of federal healthcare covered business, the statute is violated. Penalties for violations include criminal penalties and civil sanctions such as fines, imprisonment and possible exclusion from Medicare, Medicaid and other federal healthcare programs. In addition, some kickback allegations have been claimed to violate the federal False Claims Act (discussed above). In addition, many states have adopted laws similar to the federal anti-kickback law. Some of these state prohibitions apply to referral of patients for healthcare items or services reimbursed by any source, not only the Medicare & Medicaid programs. Many of the federal and state anti-fraud statutes and regulations, including their application to joint ventures and collaborative agreements, are vague or ambiguous and have not yet been interpreted by the courts.

 

                In addition, these laws include self-referral prohibitions which prevent us from accepting referrals from physicians who have an ownership or compensation relationships with us that does not meet an exception specified under the law. The federal law prohibiting physician self-referrals, commonly known as the “Stark” Law, prohibits, with certain exceptions, Medicare payments for laboratory tests referred by physicians who have, personally or through a family member, an investment interest in, or a compensation arrangement with, the testing laboratory. A person who engages in a scheme to circumvent the Stark Law’s prohibitions may be fined up to $100,000 for each such arrangement or scheme. In addition, anyone who presents or causes to be presented a claim to the Medicare program in violation of the Stark Law is subject to monetary penalties of up to $15,000 per claim submitted, an assessment of several times the amount claimed, and possible exclusion from participation in federal healthcare programs. In addition, claims submitted in violation of the Stark Law may be alleged to be subject to liability under the federal False Claims Act and its whistleblower provisions.

 

                Several states in which we operate have enacted legislation that prohibits physician self-referral arrangements and/or requires physicians to disclose any financial interest they may have with a healthcare provider to their patients when referring patients to that provider. Some of these statutes cover all patients and are not limited to beneficiaries of Medicare, Medicaid and other federal healthcare programs. Possible sanctions for violating state physician self-referral laws vary, but may include loss of license and civil and criminal sanctions. State laws vary from jurisdiction to jurisdiction and, in a few states, are more restrictive than the federal Stark Law. Some states have indicated they will interpret their own self-referral statutes the same way that the United States Centers for Medicare & Medicaid Services (CMS) interprets the Stark Law, but it is possible that states will interpret their own laws differently in the future.

 

                The laws of many states also prohibit physicians from sharing professional fees with non-physicians and prohibit non-physician entities, such as us, from practicing medicine and from employing physicians to practice medicine.

 

 

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If we do not comply with existing or additional regulations, or if we incur penalties, it could increase our expenses, reduce or prevent us from increasing net revenue, and/or hinder our ability to conduct our business. In addition, changes in existing regulations or new regulations may delay or prevent us from marketing our products or cause us to reduce our pricing.

 

                Our business is subject to stringent laws and regulations governing the privacy, security and transmission of medical information, and our failure to comply could subject us to criminal penalties and civil sanctions.

 

                The use and disclosure of patient medical information is subject to substantial regulation by federal, state, and foreign governments. For example, the Health Insurance Portability and Accountability Act of 1996, known as HIPAA, was enacted among other things, to establish uniform standards governing the conduct of certain electronic health care transactions and to protect the security and privacy of individually identifiable health information maintained or transmitted by health care providers, health plans and health care clearinghouses. We are currently required to comply with three standards under HIPAA. We must comply with the Standards for Electronic Transactions, which establish standards for common health care transactions, such as claims information, plan eligibility, payment information and the use of electronic signatures, unique identifiers for providers, employers, health plans and individuals, security, privacy, and enforcement. We were required to comply with these Standards for Electronic Transactions by October 16, 2003. We also must comply with the Standards for Privacy of Individually Identifiable Information, which restrict our use and disclosure of certain individually identifiable health information. We were required to comply with the Privacy Standards by April 14, 2003. We must also comply with Security Standards, which require us to implement certain security measures to safeguard certain electronic health information. We were required to comply with the Security Standards by April 20, 2005. The HIPAA privacy and security regulations establish a uniform federal “floor” and do not supersede state laws that are more stringent or provide individuals with greater rights with respect to the privacy or security of, and access to, their records containing PHI. As a result, we are required to comply with both HIPAA privacy regulations and varying state privacy and security laws. These laws contain significant fines and other penalties for wrongful use or disclosure of PHI. We have implemented practices and procedures to meet the requirements of the HIPAA privacy regulations and state privacy laws. In addition, CMS has published a final rule, which required us to adopt a national provider identifier for use in filing and processing health care claims and other transactions beginning May 23, 2007. While the government intended this legislation to reduce administrative expenses and burdens for the health care industry, our compliance with this law may entail significant and costly changes for us in the future. If we fail to comply with these standards, we could be subject to criminal penalties and civil sanctions.

 

                The Standards for Privacy of Individually Identifiable Information establish a “floor” and do not supersede state laws that are more stringent. Therefore, we are required to comply with both federal privacy regulations and varying state privacy laws. In addition, for health care data transfers from other countries relating to citizens of those countries, we must comply with the laws of those other countries.

 

                Federal law and the laws of many states generally specify who may practice medicine and limit the scope of relationships between medical practitioners and other parties.

 

                Under certain federal and state laws specifying who may practice medicine and limiting the scope of relationships between medical practitioners and other parties, we are prohibited from practicing medicine or exercising control over the provision of medical services and may only do so through a professional corporation designed for this purpose. In order to comply with such laws, all medical services are provided by or under the supervision of Clarient Pathology Associates, Inc. (the “P.C.”). We refer to the P.C. and us collectively throughout this report as “we”, “us”, and “our”, except in this paragraph and the related description of our business under the heading “Governmental Regulatory Status” in Item 1. The P.C. is organized so that all physician services are offered by the physicians who are employed by the P.C. Clarient does not employ practicing physicians as practitioners, exert control over their decisions regarding medical care, or represent to the public that Clarient offers medical services. Clarient has entered into an Administrative Services Agreement with the P.C. pursuant to which Clarient performs all non-medical management of the P.C. and has exclusive authority over all aspects of the business of the P.C. (other than those directly related to the provision of patient medical services or as otherwise prohibited by state law). The non-medical management provided by Clarient includes, among other functions, treasury and capital planning, financial reporting and accounting, pricing decisions, patient acceptance policies, setting office hours, contracting with third-party payors, and all administrative services. Clarient provides all of the resources (systems, procedures, and staffing) or contracts with third-party billing services to bill third-party payors or patients. Clarient also provides or procures all of the resources for cash collection and management of accounts receivables, including custody of a lockbox where cash receipts are deposited. Compensation guidelines for the licensed medical professionals at the P.C. are set by Clarient, and Clarient has established guidelines for selecting, hiring, and terminating the licensed medical professionals. Where applicable, Clarient also negotiates and executes substantially all of the provider contracts with third-party payors. Clarient will not loan or otherwise advance funds to the P.C. for any purpose.

 

 

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                Clarient believes that the services Clarient provides and will provide in the future to the P.C. do not constitute the practice of medicine under applicable laws. Because of the unique structure of the relationships described above, many aspects of our business operations have not been the subject of state or federal regulatory interpretation. We have no assurance that a review of our business by the courts or regulatory authorities will not result in a determination that our operations do not comply with applicable law or that could otherwise adversely affect our operations. In addition, the health care regulatory environment may change in a manner that restricts our existing operations or future expansion.

 

Risks Related to Our Common Stock

 

                We have never paid cash dividends on our common stock and do not anticipate paying dividends on our common stock, which may cause you to rely on capital appreciation for a return on your investment.

 

                We currently intend to retain future earnings for use in our business and do not anticipate paying cash dividends on our common stock in the foreseeable future. Any payment of cash dividends will also depend on our financial condition, results of operations, capital requirements and other factors and will be at the discretion of our board of directors. Accordingly, you will have to rely on capital appreciation, if any, to earn a return on your investment in our common stock.

 

                If we raise additional funds you may suffer dilution or subordination and we may grant rights in our technology or products to third parties.

 

                If we raise additional funds by issuing equity securities, further dilution to our stockholders could result, and new investors could have rights superior to those of holders of our common stock. Any equity securities issued also may provide for rights, preferences or privileges senior to those of holders of our common stock. If we raise additional funds by issuing debt securities, these debt securities would have rights, preferences and privileges senior to those of holders of our common stock, and the terms of the debt securities issued could impose significant restrictions on our operations. If we raise additional funds through collaborations and licensing arrangements, we might be required to relinquish significant rights to our developed technologies or products, or grant licenses on terms that are not favorable to us. If adequate funds are not available, we may have to delay or may be unable to continue to develop our products.

 

                Our stock price is likely to continue to be volatile, which could result in substantial losses for investors.

 

                The market price of our common stock has in the past been, and in the future is likely to be, highly volatile. These fluctuations could result in substantial losses for investors. Our stock price may fluctuate for a number of reasons including, but not limited to:

 

·                                          media reports and publications and announcements about cancer or diagnostic products or treatments or new innovations;

 

·                                          developments in or disputes regarding patent or other proprietary rights;

 

·                                          announcements regarding clinical trials or other technological or competitive developments by us and our competitors;

 

·                                          loss of a significant customer or group purchasing organization contract;

 

·                                          the hiring and retention of key personnel;

 

·                                          announcements concerning our competitors or the biotechnology industry in general;

 

·                                          regulatory developments regarding us or our competitors;

 

·                                          changes in coverage and reimbursement policies concerning our products or competitors’ products;

 

·                                          changes in the current structure of the healthcare financing and payment systems;

 

 

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·                                          stock market price and volume fluctuations, which have particularly affected the market prices for medical products and high technology companies and which have often been unrelated to the operating performance of such companies; and

 

·                                          general economic, political and market conditions.

 

                In addition, stock markets have from time to time experienced extreme price and volume fluctuations. The market prices for diagnostic companies is affected by these market fluctuations and such effects have often been unrelated to the operating performance of such companies. These broad market fluctuations may cause a decline in the market price of our common stock.

 

                Securities class action litigation is often brought against a company after a period of volatility in the market price of its stock. This type of litigation could be brought against us in the future, which could result in substantial expense and damage awards and divert management’s attention from running our business.

 

                With the advent of the Internet, new avenues have been created for the dissemination of information. We do not have control over the information that is distributed and discussed on electronic bulletin boards and investment chat rooms. The motives of the people or organizations that distribute such information may not be in our best interest or in the interest of our shareholders. This, in addition to other forms of investment information, including newsletters and research publications, could result in a significant decline in the market price of our common stock.

 

                Future sales of shares by existing stockholders could result in a decline in the market price of our stock.

 

                Some of our current stockholders hold a substantial number of shares which they are currently able to sell in the public market, or which they will be able to sell under registration statements that may be declared effective by the Securities and Exchange Commission, and our employees hold options to purchase a significant number of shares and/or have been issued shares of restricted stock that are covered by registration statements on Form S-8. If our common stockholders sell substantial amounts of common stock in the public market, or the market perceives that such sales may occur, the market price of our common stock could fall. Safeguard owns a majority of our outstanding common stock and has rights, subject to some conditions, to require us to file registration statements covering shares owned by it and to include its shares in registration statements that we may file for ourselves or other stockholders. Furthermore, if we file a registration statement and include shares held by Safeguard pursuant to the exercise of its registrations rights, the sale of those shares could impair our ability to raise needed capital by depressing the price at which we could sell our common stock.

 

                We are controlled by a single existing stockholder, whose interests may differ from other stockholders’ interests and may adversely affect the trading price of our common stock.

 

                Safeguard beneficially owns a majority of the outstanding shares of our common stock. As a result, Safeguard will have significant influence in determining the outcome of any corporate transaction or other matter submitted to our stockholders for approval, including mergers, consolidations and the sale of all or substantially all of our assets. In addition, Safeguard has the ability to elect all of our directors (although Safeguard has agreed that our board of directors will have a majority of directors not specifically designated by Safeguard) and Safeguard could dictate the management of our business and affairs. The interests of Safeguard may differ from other stockholders’ interests. In addition, this concentration of ownership may delay, prevent, or deter a change in control and could deprive other stockholders of an opportunity to receive a premium for their common stock as part of a sale of our business. This significant concentration of share ownership may adversely affect the trading price of our common stock because investors often perceive disadvantages in owning stock in companies with controlling stockholders.

 

                We have adopted a stockholder rights plan and other arrangements which could inhibit a change in control and prevent a stockholder from receiving a favorable price for his or her shares.

 

                Our board of directors has adopted a stockholders’ rights plan providing for discounted purchase rights to its stockholders upon specified acquisitions of our common stock. The exercise of these rights is intended to inhibit specific changes of control of our company.

 

                In addition, Section 203 of the Delaware General Corporation Law limits business combination transactions with 15% stockholders that have not been approved by our board of directors. These provisions and others could make it difficult

 

 

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for a third party to acquire us, or for members of our board of directors to be replaced, even if doing so would be beneficial to our stockholders. Because our board of directors is responsible for appointing the members of our management team, these provisions could in turn affect any attempt to replace the current management team. If a change of control or change in management is delayed or prevented, you may lose an opportunity to realize a premium on your shares of common stock or the market price of our common stock could decline.

 

                Our shares of common stock currently trade on the NASDAQ Capital Market which results in a number of legal and other consequences that may negatively affect our business and the liquidity and price of our common stock.

 

                With our securities listed on the NASDAQ Capital Market, we face a variety of legal and other consequences that may negatively affect our business including, without limitation, the following:

 

·                                          securities analysts may not continue or initiate coverage of Clarient; and

 

·                                          we may lose current or potential investors.

 

                In addition, we are required to satisfy various listing maintenance standards for our common stock to be quoted on the NASDAQ Capital Market. If we fail to meet such standards, our common stock would likely be delisted from the NASDAQ Capital Market and trade on the over-the-counter bulletin board, commonly referred to as the “pink sheets.” This alternative is generally considered to be a less efficient market and would seriously impair the liquidity of our common stock and limit our potential to raise future capital through the sale of our common stock, which could materially harm our business, results of operations, cash flows and financial position.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

 

                We have invested excess cash in short-term debt securities that are intended to be held to maturity. These short-term investments typically have various maturity dates which do not exceed one year. We had no short-term investments as of March 31, 2008.

 

                Fluctuations in interest rates would not have a material effect on our financial statements because of the short-term nature of our debt. We have $9.0 million of variable interest rate debt outstanding at March 31, 2008.

 

 

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Item 4. Controls and Procedures

 

                Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, because of material weaknesses in internal control over financial reporting discussed in Management’s Report on Internal Control Over Financial Reporting included in our Annual Report on Form 10-K for the year ended December 31, 2007 that were not remediated as of March 31, 2008, our disclosure controls and procedures were not effective to provide reasonable assurance that the information required to be disclosed by us in reports filed under the Securities Exchange Act of 1934 is (i) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and (ii) accumulated and communicated to our management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding disclosure.  A controls system cannot provide absolute assurance that the objectives of the controls system are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected.

 

                In light of these unremediated material weaknesses, we performed additional post-closing procedures and analyses in order to prepare the Consolidated Financial Statements included in this report. As a result of these procedures, we believe our Consolidated Financial Statements included in this report present fairly, in all material respects, our financial condition, results of operations and cash flows for the periods presented.  We have begun efforts to design and implement improvements in our internal control over financial reporting to address the material weaknesses as discussed in Item 9A to our Annual Report on Form 10-K for the year ended December 31, 2007, which continue to exist at March 31, 2008.

 

                No change in our internal control over financial reporting occurred during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. 

 

 

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PART II — OTHER INFORMATION

 

Item 1A. Risk Factors

 

                There have been no material changes in our risk factors from the information set forth in our Annual Report on Form 10-K for the year ended December 31, 2007.

 

Item 6. Exhibits

 

                The following is a list of exhibits required by Item 601 of Regulation S-K filed as part of this report.

 

					Incorporated Filing Reference
Exhibit Number			Description		Form Type & Filing Date		Original Exhibit Number
10.	1		Amended and Restated Senior Subordinated Revolving Credit Agreement, dated March 14, 2008, by and between Clarient, Inc. and Safeguard Delaware, Inc.		Form 8-K 3/17/2008		10.1
10.	2†		First Amendment and Waiver to Amended and Restated Loan Agreement, dated as of March 14, 2008, by and between Comerica Bank and Clarient, Inc.		—		—
10.	3		Form of Common Stock Purchase Warrant to be issued pursuant to the Amended and Restated Senior Subordinated Credit Agreement, dated March 14, 2008.		Form 8-K 3/17/2008		10.3
10.	4		Registration Rights Agreement, dated March 14, 2008, by and among Clarient, Inc., Safeguard Delaware, Inc., Safeguard Scientifics, Inc., and Safeguard Scientifics (Delaware), Inc.		Form 8-K 3/17/2008		10.2
10.	5		Amended and Restated Loan Agreement, dated February 28, 2008, by and between Clarient, Inc. and Comerica Bank.		Form 10-K 4/01/2008		10.35
10.	6		Affirmation of Guaranty, dated February 28, 2008, to Comerica Bank provided by Safeguard Delaware, Inc. and Safeguard Scientifics (Delaware), Inc.		Form 10-K 4/01/2008		10.36
10.	7		Second Amendment to Amended and Restated Loan Agreement, dated as of March 21, 2008, by and between Comerica Bank and Clarient, Inc.		Form 10-K 4/01/2008		10.82
10.	8†		2008 Management Incentive Plan		—		—
31.	1†		Certification of Ronald A. Andrews pursuant to Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934.		—		—
31.	2†		Certification of James V. Agnello pursuant to Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934.		—		—
32.	1†		Certification of Ronald A. Andrews pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.		—		—
32.	2†		Certification of James V. Agnello pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.		—		—

†                              Filed herewith

 

*                             This exhibit relates to management contracts or compensatory plans, contracts or arrangements in which directors and/or executive officers of the Registrant may participate.

 

 

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SIGNATURES

 

Pursuant to the requirements of the Securities Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

	CLARIENT, INC.
DATE: May 16, 2008	BY:	/s/ RONALD A. ANDREWS
		Ronald A. Andrews
		Chief Executive Officer
DATE: May 16, 2008	BY:	/s/ JAMES V. AGNELLO
		James V. Agnello
		Senior Vice President and Chief Financial Officer

 

 

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