-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, DUcbfTIAeyIrcbuJVHhrGkmzKMWpOMCpPXBn6fBI6eCs1WDkSG/zhQrEqpxdb3X8 yweB+5XExiT3NNIOvCKhFA== 0000890566-99-000579.txt : 19990503 0000890566-99-000579.hdr.sgml : 19990503 ACCESSION NUMBER: 0000890566-99-000579 CONFORMED SUBMISSION TYPE: 10-K405/A PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 19981231 FILED AS OF DATE: 19990430 FILER: COMPANY DATA: COMPANY CONFORMED NAME: APPLE ORTHODONTIX INC CENTRAL INDEX KEY: 0001031176 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-HEALTH SERVICES [8000] IRS NUMBER: 742795193 FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K405/A SEC ACT: SEC FILE NUMBER: 001-12977 FILM NUMBER: 99607148 BUSINESS ADDRESS: STREET 1: 2777 ALLEN PARKWAY STREET 2: SUITE 700 CITY: HOUSTON STATE: TX ZIP: 77019 BUSINESS PHONE: 7139646882 10-K405/A 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K/A (AMENDMENT NO. 1) ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998 Commission file number: 001-12977 APPLE ORTHODONTIX, INC. (Exact name of registrant as specified in its charter) DELAWARE 74-2795193 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 2777 ALLEN PARKWAY, SUITE 700 HOUSTON, TEXAS 77019 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (713) 852-2500 SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NAME OF EACH EXCHANGE TITLE OF EACH CLASS ON WHICH REGISTERED ------------------- ------------------- Class A Common Stock, American Stock Exchange $.001 Par Value Per Share SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: NONE 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 [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] At April 14, 1999, the aggregate market value of the registrant's Common Stock held by non-affiliates of the registrant was approximately $36,688,746 based on the closing price of such stock on such date of $3.25. At April 14, 1999, the number of shares outstanding of registrant's Class A Common Stock was 11,760,904. DOCUMENTS INCORPORATED BY REFERENCE: NONE Apple Orthodontix, Inc., a Delaware corporation, (the "Company"), hereby amends its Annual Report on Form 10-K originally filed with the Securities and Exchange Commission on April 15, 1999, pursuant to Instruction G(3) to Form 10-K by completing Items 10 through 13 of Part III thereof. In addition to this information, the Annual Report on Form 10-K/A (Amendment No. 1) includes all information required by Parts I, II and IV of Form 10-K that the Company included in its original Form 10-K filed on April 15, 1999. TABLE OF CONTENTS Page ---- PART I Items 1 and 2. Business and Properties 4 Item 3. Legal Proceedings 12 Item 4. Submission of Matters to a Vote of Security Holders 13 PART II Market for Registrant's Common Stock and Related Shareholder Item 5. Matters 14 Item 6. Selected Financial Data 14 Management's Discussion and Analysis of Financial Condition and Item 7. Results of Operations 16 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 20 Item 8. Financial Statements and Supplementary Data 21 Changes In and Disagreements With Accountants on Accounting and Item 9. Financial Disclosure 39 PART III Item 10. Directors and Executive Officers of the Registrant 39 Item 11. Executive Compensation 41 Item 12. Security Ownership of Certain Beneficial Owners and Management 49 Item 13. Certain Relationships and Related Party Transactions 49 PART IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K 51 2 FORWARD LOOKING STATEMENTS This Annual Report on Form 10-K includes certain statements that may be deemed to be "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act"), and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). All statements, other than statements of historical facts, included in this Annual Report on Form 10-K that address activities, events or developments that the Company expects, projects, believes or anticipates will or may occur in the future, including such matters as business strategy, plans and objectives of management of the Company for future operations and future industry conditions are forward-looking statements. These statements are based on certain assumptions and analyses made by management of the Company in light of its experience and its perception of historical trends, current conditions, expected future developments and other factors it believes are appropriate in the circumstances. Such statements are subject to a number of assumptions, risks and uncertainties, including the risk factors discussed herein, general economic and business conditions, changes in laws or regulations and other factors, many of which are beyond the control of the Company. Prospective investors are cautioned that any such statements are not guarantees of future performance and that actual results or developments may differ materially from those projected in the forward-looking statements. ii 3 PART I ITEMS 1 AND 2. BUSINESS AND PROPERTIES OVERVIEW Apple Orthodontix, Inc., a Delaware corporation (the "Company"), provides practice management services (which exclude the management and delivery of orthodontic services) to orthodontic practices in the United States and Canada. The Company offers the orthodontic practices with which it has affiliated (the "Affiliated Practices") a full range of services designed to facilitate the delivery of high-quality, affordable orthodontic treatment to consumers. The Company's Affiliated Practices benefit from the Company's practice operating approach designed to (i) stimulate demand in their local markets by increasing consumer awareness of the benefits, availability and affordability of orthodontic treatment, (ii) improve the productivity and profitability of their practices and (iii) leverage the benefits of orthodontist affiliation by providing basic services that include clinical and financial information management, access to capital and technology, group purchasing and comprehensive marketing techniques. The Company earns revenue by providing these management, administrative, development and other services to its Affiliated Practices. In connection with its initial public offering ("IPO") in May 1997, the Company acquired substantially all the tangible and intangible assets and assumed certain liabilities of, and began providing long-term management services to, 31 orthodontists operating in 58 offices located in 13 states in the United States and in Alberta, Canada (the "Founding Affiliated Practices"). Since its IPO and through April 14, 1999, the Company has affiliated with an additional 36 practices. During that time, the Company has also merged three practices into existing practices and has terminated its affiliation with two practices. As of April 14, 1999, the Company provided services to 62 orthodontic practices representing 88 orthodontists operating in 17 states in the United States and three provinces in Canada. Affiliated Practices are selected based on a variety of factors, including competitive and financial strengths and historical growth of their practices and the potential for future growth in their markets. The Company also considers the local and national reputations of the Affiliated Practices within the orthodontic services industry, their ability to manage multi-location practices providing high levels of quality care and their desire to grow and improve the operating efficiency of their respective practices. The Company selects its Affiliated Practices based on the recommendations of its affiliated orthodontists and management's experience with orthodontic practices in the United States and Canada. INDUSTRY OVERVIEW. The orthodontic services industry is highly fragmented, with over 90% of the approximately 9,000 orthodontists in the United States operating as sole practitioners. The industry currently generates approximately $3.8 billion in annual gross revenues. Seventy percent of orthodontic services are performed on a private pay, fee-for-service basis, 25% are covered by traditional dental insurance (generally with a 50% or greater copayment by the patient), and less than 5% are reimbursed from managed care payor sources due to the elective nature of the service. According to the most recent statistics available from studies by the Journal of Clinical Orthodontists ("JCO"), the median orthodontic practice in the United States generated $518,800 in revenues, started 180 new cases and experienced a case acceptance rate of 67% in 1996. Orthodontic treatments are principally provided by orthodontists who have completed two years of post-graduate studies following graduation from dental school. The number of orthodontists in the United States has grown slowly since 1990, which the Company believes can be attributed to the limited number of schools offering post-graduate orthodontic programs and the small class size at each of those schools. In addition to orthodontists, a number of general dentists provide various orthodontic services. The industry information set forth herein does not include orthodontic treatments provided by general dentists. 4 The table below summarizes certain information from the 1997 JCO Orthodontic Practice Study (the "1997 JCO Study") (the most recent available with respect to average fee per case) concerning the United States orthodontic services industry for each of the years presented: NUMBER OF AVERAGE --------------------------- FEE YEAR ORTHODONTISTS NEW CASES PER CASE ------------------- ------------ ------------ ------------ 1990 8,720 1,308,000 $3,050 1991 8,760 1,314,000 3,221 1992 8,856 1,416,690 3,401 1993 8,958 1,478,070 3,447 1994 9,060 1,540,200 3,492 1995 9,098 1,592,150 3,649 1996 9,115 1,640,700 3,703 THE TRADITIONAL ORTHODONTIC PRACTICE. The traditional orthodontic practice typically involves a single orthodontist, practicing at one primary location or with an average of less than one satellite office, with a small number of orthodontic assistants and business office personnel and, in some cases, an orthodontic associate. On an individual practice basis, the 1997 JCO Study reported median annual revenues of $518,800 and median operating income of $224,000 in 1996. Median overhead as a percentage of revenues was 55%, resulting in a 42% median operating margin before orthodontist compensation, interest and taxes. Median down payments were equal to approximately 25% of the total treatment cost. In 1996, median case starts and active treatment cases were 180 and 400 per practice, respectively, and the median case acceptance rate was 67%. In the traditional practice, the orthodontist manages all business aspects of the practice; the use of third-party management services is not typical. The 1997 JCO Study reports that individual practices, on average, generated over one-half of their referrals from dentists and less than 8% of the practices utilized commercial advertising (and 1.8% utilized television advertising). According to the 1997 JCO Study, orthodontists believed they had the ability to increase case starts by 28%, but the median case starts have not increased significantly since 1981, the first year of data presented in the study. THE APPLE ORTHODONTIX APPROACH The Company believes the traditional orthodontic practice is inefficient and administratively burdensome to orthodontists and can be financially burdensome to patients, who traditionally pay approximately 25% of the total contract amount as a down payment. The Company has developed a comprehensive operating strategy designed to improve efficiency, increase the number of new case starts and active cases handled by each orthodontist and relieve orthodontists associated with Affiliated Practices of time-consuming administrative responsibilities. As part of its practice operating approach, the Company assists its Affiliated Practices in developing and implementing payment programs designed to make orthodontic services more affordable to prospective patients, thereby making their services available to a larger segment of the population in their respective markets. The Company also assists the Affiliated Practices in developing satellite offices to expand the scope of the geographic areas they serve. The Company believes its approach provides benefits to orthodontists who choose to affiliate with it by providing opportunities to: (i) drive internal growth by implementing the Company's operating strategy; (ii) share in the increased profitability resulting from internal growth; (iii) lower costs through economies of scale; (iv) participate in a cost-effective national advertising program; (v) focus on patient care; and (vi) enhance liquidity and diversification. OPERATING STRATEGY Through its practice operating approach, the Company seeks to stimulate increased productivity and internal growth in its Affiliated Practices. To accomplish this objective, the Company has developed an operating approach consisting primarily of (i) implementing practice-building and external marketing programs designed to generate new case starts through increased referrals from existing and former patients and the use of multimedia advertising to stimulate demand for treatment services, (ii) offering more affordable payment plans to patients to broaden the market for orthodontic services, (iii) increasing the operating efficiency of the Affiliated Practices by relieving the orthodontists from various time-consuming administrative responsibilities and realizing economies of scale, (iv) providing a systems-oriented approach to training and education of clinic personnel to improve communications with patients and prospective patients and increase productivity, (v) developing satellite offices to expand the geographic markets served by Affiliated Practices and (vi) utilizing customized management information systems to provide detailed financial and operating data and 5 related analyses to Affiliated Practices and management. The Company believes that its approach has resulted in local market expansion, increased new case starts and practice profitability, increased orthodontist productivity and heightened patient satisfaction in certain of its existing Affiliated Practices. EXPANSION STRATEGY The Company pursued an aggressive expansion strategy upon the completion of the IPO through June 1998. Since September 1998, the Company has attempted to raise additional capital to fund its expansion strategy. This effort has been unsuccessful to date. Consequently, the Company has discontinued its strategy of expansion through acquisitions in order to devote its limited resources to the integration of existing Affiliated Practices. Another element of the Company's expansion strategy is the development of new offices within selected markets served by the existing Affiliated Practices. The Company believes that the new offices will increase the geographic area served by the existing Affiliated Practices, thereby increasing the potential market and leveraging the advertising budget of the existing Affiliated Practices. The Company expects that these offices generally will be located in high traffic areas. The Company has curtailed the development of new offices to be served by existing Affiliated Practices due to funding constraints. The Company was incorporated in July 1996 and conducted no operations before its IPO in May 1997 other than in connection with the IPO and affiliation with the Founding Affiliated Practices. Although each of the existing Affiliated Practices operated independently before affiliation with the Company, the Company has a limited combined operating history. As a result, there can be no assurance that the process of integrating the management and administrative functions of the Affiliated Practices will be successful or that the Company's management will be able to effectively or profitably manage these operations or successfully implement the Company's operating or expansion strategies. Failure by the Company to successfully implement its operating or expansion strategies would have a material adverse effect on the Company's business, financial condition and results of operations. There can be no assurance that the Company's expansion strategy will be successful, that modifications to the Company's strategy will not be required, that the Company will be able to provide services effectively and enhance the profitability of additional Affiliated Practices or that the Company will be able to obtain adequate financing on reasonable terms to support its expansion program. SERVICES AND OPERATIONS The Company generally provides services with respect to all aspects of the operations of its Affiliated Practices other than the provision of orthodontic treatment. Except in Canada, the Company employs all business personnel at the offices of the Affiliated Practices and, where permitted by applicable law and governmental regulations, also employs the orthodontic assistants. ADMINISTRATIVE. The Company earns revenue by providing services to the Affiliated Practices, including staffing, education and training, billing and collections, cash management, group purchasing, inventory management, payroll processing, employee benefits administration, advertising production and other marketing support, patient scheduling, financial reporting and analysis, productivity reporting and analysis, associate recruiting and support for acquisitions, new site development and other capital requirements. The Company believes the orthodontists at the Affiliated Practices benefit from the support provided by the Company and that these services substantially reduce the amount of time the orthodontists are required to spend on administrative matters, thereby enabling them to dedicate more time to the growth of their professional practices. Through economies of scale, the Company seeks to provide these services at a lower cost than could be obtained by any of the Affiliated Practices individually. In addition, because of its size and purchasing power, the Company has been able to negotiate discounts on, among other things, orthodontic and office supplies, health and malpractice insurance and equipment. The Company does not employ orthodontists or control the practice of orthodontics by the orthodontists employed by the Affiliated Practices, and its services revenue generally depends on revenue generated by the Affiliated Practices. In some cases, the fees are based on the costs and expenses the Company incurs in connection with providing services. The profitability of the Affiliated Practices, as well as the performance of the individual orthodontists employed by the Affiliated Practices, affect the Company's profitability. PRACTICE-BUILDING PROGRAM. The Company believes patient satisfaction levels, practice productivity and profitability can be substantially enhanced through a consistent training program emphasizing practice-building techniques. The Company implements programs designed to generate growth in case starts by increasing (i) referrals from existing and former patients and (ii) case acceptance rates. These programs include a full complement of training, operating and monitoring techniques emphasizing improvements in communications with patients and patient satisfaction levels in all facets of operations, including initial telephone contacts with prospective patients, initial consultations and case presentations and written or telephonic follow-ups after office visits. The Company's programs are designed to result in clear, concise and consistent communications between the patient and the orthodontist and his or her staff. The Company believes that these programs have a positive effect on the patients' experience and therefore positively affect the number of patient referrals 6 and case acceptance rates of Affiliated Practices. EXTERNAL MARKETING. The Company and its Affiliated Practices utilize multimedia advertising in certain local markets to stimulate demand for treatment and promote name recognition for the Company and the Affiliated Practices. The general public traditionally has had little information about the availability of orthodontic services or orthodontic fees prior to an initial consultation with an orthodontist. The advertisements address the two primary barriers to receiving orthodontic treatment, availability and affordability, by focusing on the availability of orthodontic services and the more affordable payment plans offered by the Affiliated Practices. The advertisements also stress the quality of care available at the Affiliated Practices and the advantages of receiving orthodontic treatment from a professionally trained orthodontist as opposed to a general dentist. The advertisements also promote a toll-free number for ease of scheduling an appointment with the local Affiliated Practice. Generally, it is anticipated that an Affiliated Practice will spend an amount equal to between 5% and 7% of its net revenues for advertising and marketing, which the Company believes is significantly higher than the industry average for traditional orthodontic practices. The Company is responsible for subcontracting the production of all broadcast advertising, which is tailored to meet local requirements. The frequency and airing times for any television advertisements are determined by regional media consultants retained by the Company and the Affiliated Practice in order to optimize penetration to target market segments. AFFORDABLE PAYMENT PLANS. Orthodontic services primarily involve private pay, fee-for-service treatments. As part of its overall marketing strategy for the Affiliated Practices, the Company encourages the Affiliated Practices to make orthodontic services available to a larger portion of the population in their respective markets by offering more affordable payment plans. Many of the existing Affiliated Practices have historically received a down payment equal to 25% of the total cost of services, with the remaining amount paid equally over the term of treatment. The typical payment plan recommended by the Company consists of a modest initial down payment and monthly payments thereafter for the duration of the treatment period, generally between 26 and 34 months. Existing Affiliated Practices using such payment plans have experienced an initial decrease in working capital; however, the Company believes that the decrease in working capital generally will be offset by an increase in the number of patients receiving orthodontic treatment because of the combined effect of advertising, offering more affordable payment plans and the use of the Company's practice-building program. The Company believes that offering more affordable payment plans combined with the use of advertising has resulted in an increase in the number of patients inquiring about orthodontic treatment. The Company also believes that this increase, combined with the use of its internal marketing programs, has resulted in an increase in the number of patients receiving orthodontic treatment at the existing Affiliated Practices. TRAINING AND EDUCATION. Staff and practice development programs are an integral part of the Company's operating strategy. The Company believes its programs (i) increase the motivation and overall performance of the staff, (ii) improve the level of patient satisfaction achieved by the Affiliated Practices and (iii) improve the Company's ability to attract and retain qualified personnel, which collectively result in increased referrals from existing and former patients and increased case acceptance rates for the Affiliated Practices. The Company provides each Affiliated Practice with consulting and educational services. These services include a full training program covering all non-orthodontic aspects of the practice and specific training designed for the efficient and effective use of the Company's management information system. Specifically, the Company's training program provides each member of the Affiliated Practice, from the receptionist to the orthodontist, with guidelines for addressing questions and concerns of prospective and existing patients, techniques for explaining treatment procedures and length of treatment, parameters for establishing appropriate financial arrangements with each patient and a systematic approach to monitoring the success of each area of training. Training is conducted both at individual clinics and in group sessions and includes proprietary manuals, tapes and role playing activities. MANAGEMENT INFORMATION SYSTEM. The Company believes that access to accurate, relevant and timely financial and operating information is a key element to providing practice management services to orthodontic practices. The Company offers a choice between several financial reporting, productivity measurement and patient management systems to each existing Affiliated Practice. These systems are designed to increase the productivity of the Affiliated Practices by enabling the Company and the Affiliated Practices to cost-effectively monitor the productivity of the Affiliated Practices, identify problem areas and opportunities for improvement and take corrective action in a timely manner. Productivity measures that are monitored include case acceptance rates, treatment times and case starts. In addition, the management information system facilitates optimization of the orthodontists' time through computerized scheduling and diagnostic and treatment recordkeeping systems. 7 LOCATIONS As of December 31, 1998, the Company provided management services in the following locations: NUMBER OF ---------------------------------------- STATE/PROVINCE PRACTICES OFFICES ORTHODONTISTS --------------------- ------------ ------------ ------------ Alberta 5 6 5 Arizona 3 9 3 British Columbia 2 3 2 California 12 17 14 Colorado 7 15 8 Connecticut 5 7 6 Florida 1 1 2 Georgia 1 3 1 Kentucky 2 2 2 Massachusetts 1 2 1 Michigan 1 6 7 Montana 1 3 1 Nevada 1 2 1 New Mexico 1 2 1 New York 1 2 1 Ontario 3 4 7 Pennsylvania 2 4 2 South Carolina 1 2 1 Texas 8 24 17 Utah 3 7 4 Virginia 2 3 3 ------------ ------------ ------------ 63 124 89 ============ ============ ============ SERVICE AGREEMENTS The Company enters into a long-term service agreement ("Service Agreement") with each Affiliated Practice and such practice's orthodontist employees under which the Company is the exclusive administrator of non-orthodontic services relating to the operation of the Affiliated Practice. The following is intended to be a brief summary of the typical form of Service Agreement the Company has entered into and expects to enter into with Affiliated Practices. The actual terms of the various Service Agreements may vary from the description below on a case-by-case basis, depending on negotiations with the individual Affiliated Practices and the requirements of applicable law and governmental regulations. The service fees payable to the Company by the Affiliated Practices under the Service Agreements are calculated in accordance with the Company's three general types of Service Agreements -- the standard form of the Service Agreement (the "Standard Contract"), the alternative form of the Service Agreement (the "Alternative Contract") and a Service Agreement based upon a flat fee (the "Flat Fee Contract"). The Standard Contract calls for a calculation of the monthly service fee based on the total revenues earned by the Affiliated Practices, which is defined by the agreement to represent 24% of the total contract value in the initial month of a patient's treatment, with the remainder of the contract balance earned evenly over the balance of the contract term. From total revenues, the Company retains a percentage of the Affiliated Practices' cash collections. The Alternative Contract is used in certain jurisdictions where use of the Standard Contract is not permitted. It is a cost-plus fee arrangement, whereby the service fee includes the reimbursement of defined expenses incurred by the Company in the course of providing services to the Affiliated Practice plus a percentage of revenues. The Flat Fee Contract is based on a flat fee that is subject to adjustment on an annual basis. It is used when local jurisdictions do not allow use of the Standard Contract or the Alternative Contract. The Company believes the fees generated by each of these formulas are reflective of the fair market value of the service provided and are comparable to the fees earned by other management service companies in the respective jurisdictions where these arrangements exist. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations -- Overview". Pursuant to each Service Agreement, the Company, among other matters, (i) acts as the exclusive manager and administrator of non-orthodontist services relating to the operation of the Affiliated Practice, subject to matters reserved to the Affiliated Practice, (ii) administers the billing of patients, insurance companies and other third-party payors and collects on behalf of the Affiliated Practice the fees for professional orthodontic and other services and products rendered or sold by the Affiliated Practice, (iii) provides, as necessary, clerical, accounting, payroll, legal, bookkeeping and computer services and personnel, information management, tax return information, printing, postage and duplication services and transcribing services, (iv) supervises and maintains custody of substantially all files and records, (v) provides 8 facilities, equipment and furnishings for the Affiliated Practice, (vi) prepares, in consultation with the Affiliated Practice, all annual capital and operating budgets, (vii) orders and purchases inventory and supplies as reasonably requested by the Affiliated Practice and (viii) implements, in consultation with the Affiliated Practice, advertising programs. Under each Service Agreement, the applicable Affiliated Practice retains the responsibility for, among other things, (i) hiring, compensating and supervising orthodontist employees and other licensed dental professionals, (ii) ensuring that orthodontists have the required licenses, credentials, approvals and other certifications appropriate to the performance of their duties and (iii) complying with federal and state laws, regulations and ethical standards applicable to the practice of orthodontics. In addition, the Affiliated are exclusively in control of all aspects of the practice of orthodontics and the provision of orthodontic services. During the term of the Service Agreement (generally 20 to 40 years) and, subject to certain exceptions and limitations, for a period of two years thereafter, the existing Affiliated Practices have agreed not to compete with the Company or the other Affiliated Practices within a specified geographic area. In addition, each orthodontist employee has agreed, subject to certain exceptions and limitations, not to compete with the Company or the other Affiliated Practices within a specified geographic area until the later of (i) the fifth anniversary date of the Service Agreement or (ii) five years from the date the employee becomes a stockholder of the Affiliated Practice, and for a period of two years after the earlier of his or her termination of employment with the Affiliated Practice or termination of the applicable Service Agreement. The existing Affiliated Practices also have agreed not to disclose certain confidential and proprietary information relating to the Company and the Affiliated Practices. Each Affiliated Practice is responsible for obtaining professional liability insurance for the employees of the Affiliated Practice (which names the Company as an additional insured). ORTHODONTIST EMPLOYMENT AGREEMENTS The revenues of the Affiliated Practices (and, therefore, the success of the Company) are dependent on fees generated by the orthodontists the Affiliated Practices employ. Each Affiliated Practice is a party to an employment agreement with each orthodontist associated with its practice (the "Orthodontist Employment Agreements"). The Orthodontist Employment Agreements are generally for an initial term ranging from five to seven years and continue thereafter on a year-to-year basis until terminated under the terms of the agreements. The Orthodontist Employment Agreements generally provide that the orthodontist will not compete with the Company within a specified geographic area for a period of two years following termination of the agreement. The Company does not employ orthodontists and, where prohibited by applicable law, does not employ orthodontic hygienists or orthodontic assistants. A substantial reduction in the number of orthodontists employed by or associated with the Affiliated Practices could have a material adverse effect on the financial performance of the Company. The ability of the Affiliated Practices to replace existing orthodontists by attracting new orthodontists may be constrained by the limited number of new orthodontists completing post-graduate orthodontic programs each year. In addition, a shortage of available orthodontists with the skills and experience sought by the Company would have a material adverse effect on the Company's expansion opportunities. Failure by the Affiliated Practices to employ a sufficient number of orthodontists (whether by renewals of existing employment agreements or otherwise) would have a material adverse effect on the Company's business, financial condition and results of operations. COMPETITION The Company faces substantial competition from other companies to establish affiliations with additional orthodontic practices. A number of other public and private practice management companies focus on orthodontics, and several companies are pursuing similar strategies in dentistry and other segments of the health care industry. The Company is aware that general dental practice management companies have provided, or intend to provide, orthodontic services and have sought, or intend to seek, to affiliate with or employ orthodontists. Certain of these competitors have greater financial and other resources than the Company. Additional companies with similar objectives may enter the Company's markets and compete with the Company. In addition, the business of providing orthodontic services is highly competitive in each market in which the Company operates. The Affiliated Practices face local competition from other orthodontists, general dentists and pedodontists (dentists specializing in the care of children's teeth), some of whom have more established practices. Dentists are not restricted by law or any governmental authority from providing orthodontic services. The Company believes the increase in recent years in dentists providing orthodontic services has limited the growth of patient case starts performed by orthodontists. There can be no assurance that the Company or the Affiliated Practices will be able to compete effectively, that additional competitors will not enter their markets or that additional competition will not have a material adverse effect on the Company. EMPLOYEES As of December 31, 1998, the Company had 698 employees, of which 46 were employed at the Company's headquarters 9 and 652 were employed at the locations of the existing Affiliated Practices. None of the Company's employees is represented by collective bargaining agreements. The Company has not experienced any work stoppages as a result of labor disputes and the Company considers its employee relations to be good. The Company's future performance depends in significant part on the continued service of its senior management and other key personnel. In May 1998, the Company replaced its president and its vice president of business development. In August 1998, the Company replaced its chief executive officer and chief financial officer. There can be no assurance that the Company's senior management and other key employees will continue to work for the Company. Loss of services of those employees could have a material adverse effect on the Company's business, results of operations and financial condition. The success of the Company's growth strategy also depends on the Company's ability to attract and retain additional high-quality personnel. INSURANCE The Affiliated Practices provide orthodontic services to the public and are exposed to the risks of professional liability and other claims. Such claims, if successful, could result in substantial damage awards to the claimants that may exceed the limits of any applicable insurance coverage. Although the Company does not control the practice of orthodontics by the Affiliated Practices, it could be asserted that the Company should be held liable for malpractice of an orthodontist employed by an Affiliated Practice. Each of the existing Affiliated Practices has undertaken to comply with all applicable regulations and legal requirements, and the Company maintains liability insurance for itself and is named as an additional insured party on the liability insurance policies of the existing Affiliated Practices. The existing Affiliated Practices maintain comprehensive professional liability insurance, generally with limits of not less than $1.0 million per claim and with aggregate policy limits of not less than $3.0 million per orthodontist. The Company expects that it will require future Affiliated Practices to maintain comparable insurance coverage. In the event an Affiliated Practice employs more than one orthodontist, that practice will maintain insurance with a separate limit for claims against that practice in an amount acceptable to the Company. There can be no assurance that a future claim or claims will not be successful or, if successful, will not exceed the limits of available insurance coverage or that such coverage will continue to be available at acceptable costs. The Company and the existing Affiliated Practices maintain professional liability insurance coverage on a claims-made basis. Such insurance provides coverage for claims asserted when the policy is in effect regardless of when the events that caused the claim occurred. GOVERNMENT REGULATION The orthodontic services industry in the U.S. and Canada is regulated extensively at both the state, provincial and federal levels. Regulatory oversight includes, but is not limited to, considerations of fee-splitting, corporate practice of orthodontics and state insurance regulation. CORPORATE PRACTICE OF ORTHODONTICS; FEE-SPLITTING The laws of many states in the U.S. and provinces of Canada prohibit business corporations such as the Company from engaging in the practice of orthodontics or employing orthodontists to practice orthodontics. The specific restrictions against the corporate practice of orthodontics, as well as the interpretation of those restrictions by state regulatory authorities, vary from jurisdiction to jurisdiction. The restrictions are generally designed to prohibit an entity not wholly owned by orthodontists (such as the Company) from controlling the professional assets of an orthodontic practice (such as patient records and payor contracts), employing orthodontists to practice orthodontics (or, in certain jurisdictions, employing dental hygienists or orthodontic assistants), or controlling the content of an orthodontist's advertising or professional practice. The Company does not acquire any professional assets and, as provided in the Service Agreements, does not control the practice of orthodontics or employ orthodontists to practice orthodontics at any of the Affiliated Practices' locations. Moreover, in jurisdictions in which it is prohibited, the Company does not employ orthodontic hygienists or orthodontic assistants. The Company provides management services to the Affiliated Practices, and believes that the fees the Company charges for those services are consistent with the laws and regulations of the jurisdictions in which it operates. Therefore, the Company believes it would not be regarded as "owner," "operator" or "manager" of the Affiliated Practices within the meaning of those terms under applicable orthodontic practice acts and believes that its operations comply with the above-described laws to which it is subject. The laws of many jurisdictions also prohibit orthodontists from sharing professional fees with non-orthodontic entities. Dental boards do not generally interpret these prohibitions as preventing a non-orthodontic entity from owning non-professional assets used by an orthodontist in an orthodontic practice or providing management services to an orthodontist for a fee provided that the following conditions are met: (i) a licensed dentist or orthodontist has complete control and custody over the professional assets; (ii) the non-orthodontic entity does not employ or control the orthodontists (or, in 10 some states, orthodontic hygienists or orthodontic assistants); (iii) all orthodontic services are provided by a licensed dentist or orthodontist; and (iv) licensed dentists or orthodontists have control over the manner in which orthodontic care is provided and all decisions affecting the provision of orthodontic care. Applicable laws generally require that the amount of a management fee be reflective of the fair market value of the services provided by the management company and in certain states require that any management fee be a flat fee or cost-plus fee based on the cost of services performed by the Company. In general, the orthodontic practice acts do not address or provide any restrictions concerning the manner in which companies account for revenues from an orthodontic practice, subject to the above-noted restrictions relating to control over the professional activities of the orthodontic practice, ownership of the professional assets of an orthodontic practice and payments for management services. There can be no assurance that a review of the Company's business relationships by courts or regulatory authorities will not result in determinations that could prohibit or otherwise adversely affect the operations of the Company or that the regulatory environment will not change, requiring the Company to reorganize or restrict its existing or future operations. The laws regarding fee-splitting and the corporate practice of orthodontics and their interpretation are enforced by regulatory authorities with broad discretion. There can be no assurance that the legality of the Company's business or its relationship with the Affiliated Practices will not be successfully challenged or that the enforceability of the provisions of any Service Agreement will not be limited. STATE INSURANCE REGULATION Although the Company does not anticipate entering into managed care contracts, there are certain regulatory risks associated with the Company's role in negotiating and administering managed care contracts. The application of state insurance laws to other than various types of fee-for-service arrangements is an unsettled area of law and is subject to interpretation by regulators with broad discretion. As the Company or the Affiliated Practices contract with third-party payors, including self-insured plans, for certain non-fee-for-service basis arrangements, the Company may become subject to state insurance laws. Specifically, in some states, state insurance regulators may determine that the Company or an Affiliated Practice is engaged in the business of insurance because some of the managed care contracts to which an Affiliated Practice may become a party may contain capitation features. In the event that the Company or an Affiliated Practice is determined to be engaged in the business of insurance, it could be required either to seek licensure as an insurance company or to change the form of the relationships with third-party payors and, as a result, the Company's revenues may be adversely affected. HEALTH CARE REFORM PROPOSALS The U.S. Congress has considered various types of health care reform, including comprehensive revisions to the current health care system. It is uncertain what, if any, legislative proposals will be adopted in the future or what actions federal or state legislatures or third-party payors may take in anticipation of or in response to any health care reform proposals or legislation. Health care reform legislation could have a material adverse effect the operations of the Company, and changes in the health care industry, such as the growth of managed care organizations and provider networks, may result in lower payment levels for the services of orthodontic practitioners and lower profitability for Affiliated Practices, which would reduce the service fees payable to the Company. CANADIAN MATTERS The Alberta Dental Association ("ADA"), after receiving a complaint (the "Alberta Complaint") filed by certain orthodontists who compete against the orthodontists affiliated with Apple in Calgary, Alberta, determined (after conducting a preliminary investigation) that a disciplinary hearing with respect to the agreements between Apple and its Affiliated Practices in that Province was required. An orthodontist affiliated with Apple then applied to the ADA for its approval of his affiliation with Apple, which caused the postponement of the disciplinary hearing relating to the Alberta Complaint. In October 1998, the ADA refused to grant its approval of that orthodontist's affiliation with Apple. An application has been filed for judicial review of that ADA decision. On review, the Alberta court will have the power to confirm the decision, set the ADA's decision aside, or find that the legislation on which the decision is based void on either constitutional or administrative law grounds. The ADA attempted to cause the disciplinary hearing relating to the Alberta Complaint to proceed in advance of the judicial review. The Alberta court granted an injunction which prevented the ADA from dealing with the Alberta Complaint until the application for judicial review of the ADA's decision is heard or the Alberta court orders otherwise. The judicial review is scheduled for April 20 and 21, 1999. There can be no assurance that the judicial review or any ADA disciplinary hearing with respect to the Alberta Complaint will not limit the enforceability of the Service Agreements between Apple and its Affiliated Practices in Alberta. In addition, a similar complaint has been filed with the Ontario Dental Association, with respect to which no substantive action has been taken as of April 14, 1999. 11 EXTENT OF PROTECTION OF PROPRIETARY RIGHTS The Company relies in part on trademark, service mark, trade dress, trade secret, unfair competition and copyright laws to protect its intellectual property rights. There can be no assurance that actions taken by the Company will be adequate to protect its intellectual property rights from misappropriation by others, that the Company's proprietary information will not become known to competitors, that others will not independently develop substantially equivalent or better intellectual properties that do not infringe on the Company's intellectual property rights or that others will not assert rights in, and ownership of, proprietary rights of the Company. Furthermore, the Company's rights to its "APPLE ORTHODONTIX" common law service mark may be limited in market areas where a similar trademark or service mark may already be in use. The Company has not applied for or obtained any registrations of its trademarks or service marks. The Company is aware of several other businesses that utilize an "APPLE" service mark in connection with the provision of general dental services, some of which have obtained federal or state trademark registrations. The Company is aware of one other orthodontic practice in the United States that utilizes a service mark similar to the Company's, which practice is not located in a market where any of the existing Affiliated Practices' offices are located. ITEM 3. LEGAL PROCEEDINGS On December 10, 1996, Orthodontic Centers of America, Inc. ("OCA") filed a complaint in the United States District Court for the Eastern District of Louisiana against the Company, Dr. Vondrak, John G. Vondrak, P.C. and John G. Vondrak Apple Orthodontix, Inc. ("JGVAOI"), alleging, among other things, misappropriation of trade secrets and certain breaches of a confidentiality agreement executed by Dr. Vondrak, on behalf of John G. Vondrak, P.C., in favor of OCA. While the Company is not a party to the confidentiality agreement, OCA alleged that the Company should be bound by its terms as a result of the relationship between Dr. Vondrak and the Company (specifically, OCA alleged that Dr. Vondrak and Apple are alter egos and, alternatively, that Dr. Vondrak was acting as the Company's agent when he executed the confidentiality agreement). OCA's complaint stated that OCA was seeking monetary damages in excess of $75,000. In August 1997, the court dismissed OCA's claims without prejudice on the grounds that the court lacked jurisdiction. There can be no assurance that OCA will not seek to overturn the court's decision or file a similar suit in another jurisdiction. In August 1997, the Company filed a declaratory judgment action in the District Court of Harris County, Texas (164th Judicial District) seeking a finding by the court that neither the Company nor Dr. Vondrak has violated the terms of the confidentiality agreement, otherwise used confidential information supplied by OCA or unfairly competed against OCA. In October 1997, OCA filed an answer generally denying the Company's allegations, as well as asserting a counterclaim against the Company, JGVAOI, Apple Orthodontix of Texas, Inc., Apple Acquisition of Texas, Inc., Dr. Vondrak, John G. Vondrak, P.C., one of the Founding Affiliated Practices and the orthodontist associated with such practice. OCA's counterclaim alleges, among other things, unfair competition, misappropriation of trade secrets, tortious interference with prospective contractual arrangements and certain breaches of confidentiality agreements executed by each of Dr. Vondrak, on behalf of John G. Vondrak, P.C., and the affiliated orthodontist, on behalf of the Founding Affiliated Practice referred to above, in favor of OCA. While the Company is not a party to these confidentiality agreements, OCA alleged that the Company should be bound by their terms as a result of the relationships between Dr. Vondrak, the affiliated orthodontist and the Company (specifically, OCA alleged that Dr. Vondrak and the Company are alter egos and that the Company and abetted or conspired with Dr. Vondrak and the affiliated orthodontist in their wrongful conduct). OCA's complaint states that it is seeking monetary damages in excess of the minimum jurisdictional limits of the court, punitive damages, injunctive relief, prejudgment interest and attorneys' fees. The Company intends to vigorously defend the claims made by OCA, which the Company believes are without merit. This lawsuit is still pending, and the Company cannot predict whether it will succeed in obtaining the declarations sought from the court or, if it is not successful, what effect this may have on the Company. On February 11, 1999, the Company filed a complaint in the United States District Court for the Southern District of Texas against David V. Young, D.D.S., M.D.S., and David V. Young, D.D.S., M.D.S., L.C. (collectively, the "Young Parties") alleging, among other things, breach by the Young Parties of the Services Agreement dated December 1, 1997 among the Young Parties and the Company (the "Young Services Agreement"), tortious interference by the Young Parties of the relationships of the Company with its employees resident in the State of Utah and fraud by the Young Parties in connection with the repayment by the Company of certain debts of Dr. Young. The complaint seeks a declaratory judgement that the Young Services Agreement is in full force and effect notwithstanding the purported termination of the Young Services Agreement by the Young Parties on January 14, 1999. On April 7, 1999, J. Darwin King, D.D.S., M.D.S. ("King") filed a motion for judgment (the "Motion") in the Circuit Court of the County of Henrico, Virginia against the Company alleging, among other things, actual and constructive fraud and violations of the Virginia Securities Act. The Motion states that King is seeking compensatory damages of at least $1.0 million and punitive damages of $1.0 million, plus a return of the consideration King paid for his stock in the Company, interest, reasonable attorney's fees, costs and all other relief as the case may require. The Company intends to 12 vigorously defend the claims made by King, which the Company believes are without merit. This lawsuit is still pending, and the Company cannot predict whether it will succeed or, if not successful, what effect this may have on the Company. The Company is not currently a party to any material claims, suits or complaints relating to services and products provided by the Company or the existing Affiliated Practices, although there can be no assurance that such claims will not be asserted against the Company in the future. The Company is subject to certain pending claims as a result of successor liability in connection with its affiliations with existing Affiliated Practices; however, the Company believes that the ultimate resolution of those claims will not have a material adverse effect on the financial position or operating results of the Company. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders in the fourth quarter of 1998. 13 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS (a) The Company's authorized common stock consists of 25,000,000 shares of Common Stock and 4,106,852 shares of Class B Stock. The Company's Common Stock has been publicly traded on the American Stock Exchange under the symbol AOI since the Company's IPO offering on May 22, 1997. The following table sets forth the range of high and low sales prices for the common stock from May 22, 1997 though April 14, 1999: HIGH LOW --------------- ------------- 1999 Second quarter through April 14, 1999 3 3/8 2 First quarter ended March 31, 1999 4 7/8 2 3/8 1998 Fourth quarter ended December 31, 1998 6 2 1/4 Third quarter ended September 30, 1998 5 15/16 2 5/8 Second quarter ended June 30, 1998 16 1/2 4 1/8 First quarter ended March 31, 1998 14 1/4 10 7/16 1997 Fourth quarter ended December 31, 1997 16 1/16 10 Third quarter ended September 30, 1997 16 1/4 9 May 22, 1997 through June 30, 1997 12 15/16 7 3/8 The Company's Class B Stock is not publicly traded. There were approximately 190 shareholders of record (including brokerage firms and other nominees) of the Company's Common Stock as of April 14, 1999. The number of record holders does not bear any relationship to the number of beneficial owners of Common Stock. The Company has never paid any cash dividends and does not anticipate paying cash dividends on its Common Stock or Class B Stock in the foreseeable future. The Company currently intends to retain earnings to support operations and finance expansion. In addition, the Company's existing credit facility prohibits the payment of dividends. ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA The Selected Consolidated Financial Data set forth below is derived from the audited consolidated financial statements of the Company included elsewhere in this Report. The Company believes that comparison of results for 1998 periods to those for 1997 and 1996 periods is not meaningful because the Company was effectively not in operation for the first five months of 1997 or for any of 1996. 14 The Selected Consolidated Financial Data should be read in conjunction with the accompanying Consolidated Financial Statements of Apple Orthodontix, Inc. and subsidiaries and the related notes thereto and "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations."
PERIOD FROM INCEPTION (JULY 15, YEAR ENDED DECEMBER 31, 1996) THROUGH -------------------------------- DECEMBER 31, 1998 1997 1996 ------------- ------------- ------------- (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) STATEMENT OF OPERATIONS DATA: Management service fee revenues (1) ....................................... $ 47,517 $ 19,186 $ -- Costs and expenses (2): Salaries and benefits ................................................... 18,288 8,411 627 Orthodontic supplies .................................................... 6,312 2,352 -- Rent .................................................................... 4,907 2,156 20 Advertising and marketing ............................................... 2,067 484 -- General and administrative .............................................. 7,717 3,617 232 Depreciation and amortization ........................................... 3,009 943 5 Special compensation expense related to issuance of stock (3) ................................................. -- -- 13,812 Special consulting expense related to issuance of stock (3) ................................................. -- -- 9,613 Special charges ......................................................... 21,726 -- -- ------------- ------------- ------------- Total costs and expenses .............................................. 64,026 17,963 24,309 ------------- ------------- ------------- Operating income (loss) ............................................... (16,509) 1,223 (24,309) Interest expense, net of capitalized interest ............................. 810 274 -- Interest income ........................................................... (416) (191) -- Other income, net ......................................................... (77) (16) -- ------------- ------------- ------------- Income (loss) before income taxes .................................... (16,826) 1,156 (24,309) Income tax provision (benefit) ............................................ (6,496) 439 -- ------------- ------------- ------------- Net income (loss) ..................................................... $ (10,330) $ 717 $ (24,309) ============= ============= ============= Income (loss) per common and common equivalent share: Basic .................................................................. $ (0.75) $ 0.09 $ (7.24) ============= ============= ============= Diluted ................................................................ $ (0.75) $ 0.09 $ (7.24) ============= ============= ============= Number of shares used in calculating income (loss) per common and common equivalent share: Basic .................................................................. 13,783 8,132 3,359 ============= ============= ============= Diluted ................................................................ 13,783 8,344 3,359 ============= ============= ============= DECEMBER 31, --------------------------------------------------- 1998 1997 1996 ------------- ------------- ------------- BALANCE SHEET DATA: Working capital (deficit) ................................................. $ 2,613 $ 2,538 $ (2,324) Total assets .............................................................. 71,462 54,799 1,461 Long-term debt, net of current portion .................................... 23,654 248 -- Stockholders' equity (deficit) ............................................ 29,688 35,112 (884)
(1) Reflects management service fees for the Founding Affiliated Practices since June 1, 1997. Management service fees related to affiliations subsequent to the IPO are included from the date of such affiliation. (2) Corporate office expenses are included for all periods presented. (3) Reflects non-recurring charges related to shares issued to management and advisors of the Company in October and December 1996, at $7.00 per share. 15 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis contains certain statements of a forward-looking nature relating to future events or the future financial performance of the Company. Such statements are only predictions and the actual events or results may differ materially from the results discussed in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, risks associated with affiliations, fluctuations in operating results because of affiliations and variations in stock price, changes in government regulations, competition, risks of operations and growth of existing and new affiliated orthodontic practices, and risks detailed in the Company's SEC filings. The historical results set forth in this discussion and analysis are not indicative of trends with respect to any actual or projected future financial performance of the Company. This discussion and analysis should be read in conjunction with the accompanying Consolidated Financial Statements of Apple Orthodontix, Inc. and subsidiaries and the related notes thereto. OVERVIEW The Company conducted no significant operations before its IPO in May 1997 when the Company acquired the tangible and intangible assets and liabilities of, and entered into Service Agreements with, the 31 Founding Affiliated Practices. Since that time and through August 12, 1998, the Company has affiliated with an additional 35 practices and 59 orthodontists operating in 64 offices. The Company expects that its future growth will come from (i) implementing a comprehensive practice operating approach designed to drive internal growth of the Affiliated Practices, (ii) entering into Service Agreements with new Affiliated Practices and (iii) developing new orthodontic centers, including satellite offices (branch locations of existing Affiliated Practices), with existing and future Affiliated Practices. Through its Service Agreements, the Company provides a full complement of practice management services to Affiliated Practices in return for management service fees. The management service fees earned by the Company are in accordance with three general types of Service Agreements -- the standard form of the Service Agreement (the "Standard Contract"), the alternative form of the Service Agreement (the "Alternative Contract") and a Service Agreement based upon a flat fee (the "Flat Fee Contract"). The Standard Contract calls for a calculation of the monthly service fee based on the total patient revenues earned by the Affiliated Practices, which is defined by the agreement to represent 24% of the total contract value in the initial month of a patient's treatment with the remainder of the contract balance earned evenly over the balance of the contract term. From total patient revenues, the practices retain a percentage of the Affiliated Practices' cash collections. The Alternative Contract is used in certain jurisdictions where use of the Standard Contract is not permitted. It is a cost-plus fee arrangement, whereby the service fee includes the reimbursement of defined expenses incurred by Apple in the course of providing services to the Affiliated Practice plus a percentage of revenues. The Flat Fee Contract is based on a flat fee subject to adjustment on an annual basis. It is used when local jurisdictions do not allow use of the Standard Contract or Alternative Contract. The Company believes the fees generated by each of these formulas reflect the fair market value of the services provided and are comparable to the fees earned by other practice management service companies in the respective jurisdictions where these arrangements exist. The expenses incurred by the Company in fulfilling its obligations under the Service Agreements are generally of the same nature as the operating costs and expenses that would have otherwise been incurred by the Affiliated Practices, including salaries, wages and benefits of practice personnel (excluding orthodontists and, in some cases, orthodontic assistants and other professional personnel), orthodontic supplies and office supplies used in administering their clinic practices, the office (general and administrative) expenses of the practices and depreciation and amortization of assets acquired from the Founding Affiliated Practices. In addition to the operating costs and expenses discussed above, the Company incurs personnel and administrative expenses in connection with establishing and maintaining a corporate office, which provides management, administrative, marketing and business development services. In accordance with SAB No. 48, the acquisition of the assets and assumption of certain liabilities for all of the Founding Affiliated Practices has been accounted for by the Company at the transferors' historical cost basis, with the shares of common stock issued in the Initial Affiliations being valued at the historical cost of the nonmonetary assets acquired net of liabilities assumed. The cash consideration paid at closing on May 29, 1997 is reflected as a dividend by Apple to the owners of the Founding Affiliated Practices in the quarter ended June 30, 1997. SAB No. 48 is not applicable to affiliations effected by the Company after the IPO. The subsequent affiliations resulted in substantial intangible assets being recorded and will continue to result in substantial annual noncash amortization charges for intangible assets in the Company's statements of operations. In this connection, the Company changed, effective April 1, 1998, its estimate of the remaining useful life of its intangible assets in light of recent trends in the practice management industry. From that date, it will use a maximum 25-year useful life for amortizing intangible assets attributable to Affiliations. Prior to that date, these costs were being amortized over a period of 30 to 40 years to match the term of the related Service Agreement. 16 RECENT EVENTS Since the third quarter of 1998, the Company has negotiated the termination of its service agreements with two Affiliated Practices (the "Terminated Practices"). The 1998 management service fee revenues related to the Terminated Practices were $897,130. Two additional Affiliated Practices have alleged breaches of their service agreements by the Company and sought to have the service agreements terminated (the "Threatened Practices"). The Company vigorously denies any breach of the service agreements with the Threatened Practices and intends to strenuously seek enforcement of those service agreements. The 1998 management service fee revenues related to the Threatened Practices were $3.1 million. In addition, the Company is in the process of negotiating the termination of additional service agreements with Affiliated Practices with 1998 management service fee revenues of approximately $1.0 million. On April 23, 1999, the Company executed an assignment agreement with one of the Threatened Practices discussed above (the "Assignment Agreement"). The Assignment Agreement provides for the Company to issue 181,818 shares of Common Stock in return for the assignment of the ownership of the practice to the Company. The Company intends to seek a new orthodontist to whom it will sell this ownership interest. The 1998 management service fee revenues associated with this practice were $2.4 million. Additionally, since April 14, 1999, one additional Affiliated Practice has alleged breaches of its service agreement by the Company and sought to have the service agreement terminated (the "Additional Threatened Practice"). The Company vigorously denies any breach of the service agreement with the Additional Threatened Practice and intends to strenuously seek enforcement of this service agreement. The 1998 management service fee revenues related to the Additional Threatened Practice were $138,499. RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1998 AND 1997 AND THE PERIOD FROM INCEPTION (JULY 15, 1996) THROUGH DECEMBER 31, 1996 MANAGEMENT SERVICE FEE REVENUES The Company generated management service fee revenues of $47.5 million for the year ended December 31, 1998, as compared with $19.2 million for the year ended December 31, 1997. The Company conducted no significant operations from July 15, 1996 through the date of the IPO. Following completion of the IPO on May 29, 1997, the Company began operations effective June 1, 1997. Therefore, management service fee revenues reflect only seven months of operations during the year ended December 31, 1997 and there were no management service fee revenues during the year ended December 31, 1996. COSTS AND EXPENSES The Company incurred costs and expenses of $64.0 million and $18.0 million for the years ended December 31, 1998 and 1997, respectively. As described more fully under the caption MANAGEMENT SERVICE FEE REVENUES above, costs and expenses for the year ended December 31, 1997 reflect only seven months of operations. Costs and expenses for the 1997 period do, however, reflect corporate office expenses (consisting primarily of various legal, accounting, travel, personnel and marketing costs incurred in connection with the IPO and the Initial Affiliations) for the entire period presented. Costs and expenses for 1998 included two special charges. The Company recorded a $3.7 million special charge in the second quarter which reflected severance costs associated with a series of management changes ($3.3 million), costs of terminated transaction negotiations ($382,344) and certain other items ($84,490). The severance costs related to three executive officers of the Company. As of December 31, 1998, the Company had paid $2.7 million in cash and $537,952 in stock related to the second quarter special charge. In the fourth quarter of 1998, the Company recorded an additional special charge of $18.0 million on a pre-tax basis. This special charge, which was primarily noncash in nature, reflected valuation reserves related to the Company's service fee intangibles ($7.0 million), receivables from certain of the Affiliated Practices ($4.9 million), property and equipment ($1.8 million), the discontinuation of the Company's business development program ($1.3 million), lawsuit settlements ($831,000) and the writedown of certain other assets ($2.2 million). Exclusive of the special charges, costs and expenses for 1998 were $42.3 million (89.0% of management service fee revenues). Costs and expenses of $24.3 million for 1996 represented corporate office expenses for the period from inception (July 15, 1996) through December 31, 1996. Of the $24.3 million of costs and expenses for the period ended December 31, 1996, $23.4 million related to the valuing of stock issued to founders, management and advisors of the Company in October and December 1996 at the initial public offering price of $7.00 per share. This valuation resulted in special compensation expense of $13.8 million and special consulting expense of $9.6 million, with a corresponding increase in additional paid-in capital of $23.4 million. There was no net effect on stockholders' equity. The Company also incurred various legal, accounting, travel, personnel and marketing costs during the period from inception (July 15, 1996) through December 31, 1996 in connection with the IPO and the affiliations with the Founding Affiliated Practices. 17 OPERATING INCOME (LOSS) The Company generated operating income (loss) of $(16.8) million, $1.2 million and $(24.3) million for the years ended December 31, 1998 and 1997 and the period from inception (July 15, 1996) through December 31, 1996, respectively. As discussed more fully above, the operating loss for 1998 was primarily attributable to two special charges totaling $21.7 million. The operating income for 1997 reflects only seven months of operations. The operating loss for 1996 was primarily attributable to the compensation and consulting charges totaling $23.4 million. INTEREST EXPENSE Interest expense is summarized as follows (in thousands): PERIOD FROM INCEPTION (JULY 15, YEAR ENDED DECEMBER 31, 1996) THROUGH ------------------------------ DECEMBER 31, 1998 1997 1996 ------------- ------------- ------------- Gross interest ............... $ 976 $ 283 $ -- Less: capitalized interest .. (166) (9) -- ------------- ------------- ------------- Interest expense ............. $ 810 $ 274 $ -- ============= ============= ============= Interest expense increased $536,000 (196%) from 1997 to 1998. This increase was due primarily to higher average debt levels, partially offset by increased capitalized interest on development projects. INTEREST INCOME Interest income of $416,000 for the year ended December 31, 1998 reflected interest earned on notes receivable from certain of the Affiliated Practices. Interest income of $190,669 for the year ended December 31, 1997 reflected interest earned on the Company's net proceeds from the IPO and on notes receivable from certain of the Affiliated Practices. There was no interest income generated during the year ended December 31, 1996. INCOME TAX PROVISION (BENEFIT) The Company generated an income tax benefit of $6.5 million for the year ended December 31, 1998, representing an effective tax rate of 38.6%. The Company incurred an income tax provision of $439,282 for the year ended December 31, 1997, representing an effective tax rate of 38.0%. The Company incurred no income taxes for the period ended December 31, 1996. The benefit of the net operating loss generated during 1996 was fully reserved. NET INCOME (LOSS) As a result of the foregoing factors, the Company generated a net loss of $10.3 million for the year ended December 31, 1998, or a loss per share of $0.75. Excluding the effect of the special charges, the Company generated net income of $3.0 million for the year ended December 31, 1998, or earnings per share of $0.22. This net income amount comprised 6.3% of service fee revenues for the period. The Company generated net income of $716,725 for the year ended December 31, 1997, or earnings per share of $0.09. This net income amount comprised 3.7% of service fee revenues for the period. The net loss of $24.3 million for 1996 represented a loss per share of $7.24. YEAR 2000 IMPACT ON INFORMATION TECHNOLOGY INFRASTRUCTURE The Company is in the process of upgrading the practice management systems at its Affiliated Practices (the "Affiliated Practice Systems"). The purpose of this upgrade includes enhancement of the diagnostic, imaging, scheduling and financial features of the Affiliated Practice Systems. The Company has also conducted an evaluation of its information technology infrastructure, including information technology systems in the Company's corporate office (the "Corporate Systems") and the Affiliated Practice Systems, to analyze the impact of the technical problems anticipated for the year 2000 (the "Year 2000 Issue"). The Year 2000 Issue concerns computer programs written using two digits rather than four to define the applicable year. As a result, any of the Company's computer applications that have date-sensitive programs may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a system failure or miscalculation causing disruptions including but not limited to a temporary inability to process transactions, issue invoices, communicate with customers and financial institutions and update internal accounting systems. If not corrected, such disruptions could have a significant impact on the Company's operations. Following its evaluation, the Company 18 determined that substantially all its Corporate Systems would be unaffected by such problems. Certain of the Affiliated Practice Systems, however, could be affected by the Year 2000 Issue. The Company has initiated a Company-wide program to prepare the Company's computer systems and applications for the year 2000. Based on present information, the Company believes that it will be able to achieve year 2000 compliance through the replacement of current programs with new programs that are already year 2000 compliant. The Company will utilize both internal and external resources to replace and test software for year 2000 compliance. The Company plans to complete the year 2000 conversion project by June 1999. The total project costs are presently estimated not to exceed $250,000 and will be expensed as incurred. Costs relating to the purchase of new software will be capitalized. The Company is taking steps to resolve year 2000 compliance issues that may be created by customers, suppliers and financial institutions with whom the Company does business. However, there can be no guarantee that the systems of other entities will be converted timely. A failure to convert by another entity could have a significant adverse effect on the Company. The costs of the year 2000 conversion project and the date on which the Company plans to complete the project are based on management's best estimates, which were derived using numerous assumptions of future events including the continued availability of certain resources, third party modification plans and other factors. There can be no guarantee that these estimates will be achieved and actual results could vary significantly from current estimates. The Company does not have a written contingency plan to address the issues that could arise should the Company or any of its suppliers or customers not be prepared to accommodate year 2000 issues timely. The Company believes that in an emergency it could revert to the use of manual systems that do not rely on computers and could perform the minimum functions required to maintain the performance of its services and provide information reporting to maintain satisfactory control of the business. Should the Company have to utilize manual systems, it is uncertain that it could maintain the same level of operations and this could have a material adverse impact on the business. The Company intends to maintain constant surveillance on this situation and will develop such contingency plans as are required by the changing environment. LIQUIDITY AND CAPITAL RESOURCES FINANCING ACTIVITIES As a result of the $18.0 million special charge, at December 31, 1998, the Company was no longer in compliance with certain of the covenants of its $25 million unsecured bank credit facility with Chase Bank of Texas, N.A. (the "Chase Facility"). On April 14, 1999, the Company amended the Chase Facility (the "Amended Chase Facility") with respect to certain of the covenants. The Amended Chase Facility provides for the revolving credit period to expire on May 31, 2001 and for a security interest in substantially all the Company's assets. The Company is now in compliance with all covenants of the Amended Chase Facility. At December 31, 1998, the Company had borrowed $23.5 million under the Chase Facility. The Company requires substantial capital to pursue its operating strategy. To date, the Company has relied upon net cash provided by financing activities to fund its capital requirements. The Company's operations have historically been a use of funds. For the years ended December 31, 1998 and 1997, the Company's operations used $4.3 million and $2.6 million, respectively, of cash. Excluding the payment of special charges of $2.7 million during 1998, the Company's operations used $1.6 million of cash for 1998. On April 27, 1999, the Company announced that it had signed a non-binding letter of intent with an investor group in connection with the consideration of a potential investment in the Company. The investment would be in the form of a private placement of $20 million of convertible preferred shares, convertible on a one-for-one basis into shares of the Company's Class A Common Stock. The convertible preferred shares would be issued at a price of $3.00 per share (subject to completion of due diligence satisfactory to the investor group) and would represent, on an as-converted basis, approximately a 32% ownership interest in the Company at that price. The Company anticipates that the net proceeds would be used to repay a substantial portion of the Chase Facility. The proposed investment by the investor group remains subject to further negotiation of applicable terms and conditions (including price), the negotiation of definitive documents, the completion of due diligence satisfactory to the investor group, and the receipt of any necessary approvals and third-party consents. In order to increase its liquidity, the Company has developed the following strategies: (i) suspension of its new practice affiliation program, (ii) substantial curtailment of its new office development program, (iii) implementation of tighter credit policies with its Affiliated Practices, (iv) consideration of terminating the service agreements of selected underperforming Affiliated Practices, (v) reducing costs in the Company's corporate office, (vi) raising additional capital and (vii) the consideration of strategic alternatives which could include, but are not limited to, a sale of the Company or a business combination with another physician practice management company or financial sponsor. Based on its current strategy to enhance cash collections and reduce costs, the Company expects its operations to be a sufficient source of funds to meet its operating capital requirements over the next twelve months. However, there can be no assurance that the Company's strategies will be achieved. In addition, the Company's capital expenditure and other 19 liquidity needs are dependent upon access to additional capital. Any limitation on the Company's ability to obtain additional financing could have a material adverse effect on the Company's business, financial condition and results of operations. As a result of the above factors, there is substantial doubt as to the Company's ability to continue as a going concern. The accompanying financial statements do not reflect any adjustments related to the recoverability and classification of recorded assets or other adjustments which might be required should the Company be unable to continue as a going concern. During 1998, the Company amended the Chase Facility to increase its size from $15 million to $25 million and to increase its bank group from one to two banks. The Chase Facility provides for a revolving credit period expiring on May 31, 2002. Availability under the Chase Facility is tied to the Company's cash flow and liquidity. Advances bear interest, at the Company's option, at a prime rate or LIBOR, in each case plus a margin which is calculated based upon the Company's ratio of indebtedness to cash flow. The Company is required to maintain certain financial covenants regarding net worth, coverage ratios and additional indebtedness. Upon the execution of the Amended Chase Facility, the Company had borrowing availability of $1.5 million and $1.0 million, as of December 31, 1998 and March 31, 1999, respectively. In May 1997, the Company issued and sold 2,702,500 shares of Common Stock in the IPO. The IPO provided the Company with net proceeds of $12.1 million, which it used to fund cash paid for the Initial Affiliations ($6.6 million) and subsequent affiliations ($5.5 million). In November 1997, the Company issued and sold 1,490,014 shares of Common Stock in a public offering (the "Offering"). The Company has used the net proceeds of the Offering ($15.3 million) to repay $12.2 million under the Chase Facility, to affiliate with additional orthodontists, to develop new offices, for capital expenditures and for general corporate purposes. Total long-term debt increased from $247,624 at December 31, 1997, to $23.7 million at December 31, 1998. The increase is attributable to borrowings for the affiliation of new orthodontic practices, the purchase of property and equipment and general working capital needs. The Company's weighted average cost of indebtedness was 7.0% and 8.7% for 1998 and 1997, respectively. CAPITAL EXPENDITURES The Company made capital expenditures for the Affiliated Practices of $3.2 million and $3.6 million for 1998 and 1997, respectively, to fund, among other things, the development of new offices. With the exception of one stand alone de novo office opened during the second quarter of 1998, which cost $1.3 million to develop, the Company incurred an average cost of developing the one de novo and seven satellite offices opened to date of approximately $400,000 each. The Service Agreements provide for advances by the Company to the Affiliated Practices for working capital requirements (including any deficits in cash flows of Affiliated Practices resulting from, among other things, development of satellite offices) and other purposes. Such loans bear interest at prime plus one percent and are repayable over varying periods of time not to exceed five years. Total notes receivable from Affiliated Practices were $4.1 million at December 31, 1998. During 1998, total consideration related to the New Orthodontist Affiliations consisted of 455,604 shares of common stock and $7.1 million of cash, assumed debt and deferred purchase price. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. The Company does not utilize financial instruments for trading purposes and holds no derivative financial instruments which could expose the Company to significant market risk. The Company's exposure to market risk for changes in interest rates relates primarily to its long-term debt obligations discussed in Note 6 to the consolidated financial statements. At December 31, 1998, the Company had outstanding $23.5 million of floating rate debt under the Chase Facility. The detrimental effect on the Company's pre-tax earnings of a hypothetical 100 basis point increase in the interest rate under the Chase Facility would be $235,000. This sensitivity analysis does not consider any actions the Company might take to mitigate its exposure to such a change in the Chase Facility rate. The hypothetical change used in this analysis may be different from what actually occurs in the future. The Company's remaining long-term debt obligations of $154,000 were primarily at fixed rates of interest. 20 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors and Stockholders of Apple Orthodontix, Inc.: We have audited the accompanying consolidated balance sheets of Apple Orthodontix, Inc., a Delaware corporation, and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of operations and comprehensive income, changes in stockholders' equity (deficit) and cash flows for the years ended December 31, 1998 and 1997 and the period from inception (July 15, 1996) through December 31, 1996. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform an audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Apple Orthodontix, Inc. and subsidiaries as of December 31, 1998 and 1997, and the results of their operations and their cash flows for the years ended December 31, 1998 and 1997 and the period from inception (July 15, 1996) through December 31, 1996, in conformity with generally accepted accounting principles. The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the financial statements, the Company has a constrained access to capital and a net capital deficiency that raises substantial doubt about its ability to continue as a going concern. Management's plans in regard to these matters are also described in Note 1. The accompanying consolidated financial statements do not reflect any adjustments related to the recoverability and classification of the recorded assets or other adjustments which might be required should the Company be unable to continue as a going concern. ARTHUR ANDERSEN LLP Houston, Texas April 14, 1999 21 APPLE ORTHODONTIX, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) DECEMBER 31, --------------------- 1998 1997 -------- -------- ASSETS Current assets: Cash and cash equivalents ............................. $ 755 $ 2,114 Restricted cash ....................................... 2,140 2,140 Receivable from orthodontic practices, net of allowances of $5,785 and $69, respectively .... 5,521 2,362 Prepaid expenses ...................................... 464 250 Other current assets .................................. 455 538 -------- -------- Total current assets .................................. 9,335 7,404 -------- -------- Property and equipment, net ............................ 6,649 6,002 Intangible assets, net ................................. 49,347 38,788 Receivable from orthodontic practices, net of current portion ................................................ 3,890 1,642 Notes receivable ....................................... 1,451 600 Receivable from related party .......................... 634 -- Other assets ........................................... 156 363 -------- -------- Total assets .......................................... $ 71,462 $ 54,799 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Consideration payable to orthodontic practices ........ $ 2,098 $ 833 Accounts payable ...................................... 934 1,826 Accrued severance ..................................... 514 -- Payable to orthodontic practices ...................... 454 250 Accrued legal fees .................................... 396 -- Accrued commissions ................................... 333 -- Current maturities of long-term debt .................. 105 1,023 Income tax payable .................................... -- 351 Other accrued expenses ................................ 1,888 583 -------- -------- Total current liabilities ............................. 6,722 4,866 -------- -------- Long-term debt, net of current maturities .............. 23,654 248 Deferred income taxes .................................. 11,394 14,544 Other long-term obligations ............................ 4 29 -------- -------- Total liabilities ..................................... 41,774 19,687 -------- -------- Commitments and contingencies Stockholders' equity: Class A common stock, $0.001 par value, 25,000 shares authorized, 11,699 and 9,980 shares issued and outstanding, respectively ..................................... 12 10 Class B common stock, $0.001 par value, 4,107 shares authorized, 2,325 and 3,177 shares issued and outstanding, respectively ..................................... 2 3 Additional paid-in capital .......................... 64,310 58,295 Warrants ............................................ 1,086 777 Retained deficit .................................... (33,922) (23,592) Foreign currency translation adjustment ............. (1,800) (381) -------- -------- Total stockholders' equity ............................ 29,688 35,112 -------- -------- Total liabilities and stockholders' equity ............ $ 71,462 $ 54,799 ======== ======== The accompanying notes are an integral part of these consolidated financial statements. 22 APPLE ORTHODONTIX, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
PERIOD FROM INCEPTION (JULY 15, YEAR ENDED DECEMBER 31, 1996) THROUGH ------------------------------ DECEMBER 31, 1998 1997 1996 ------------- ------------- ------------- STATEMENT OF OPERATIONS Management service fee revenues ............ $ 47,517 $ 19,186 $ -- Costs and expenses: Salaries and benefits ................... 18,288 8,411 627 Orthodontic supplies .................... 6,312 2,352 -- Rent .................................... 4,907 2,156 20 Advertising and marketing ............... 2,067 484 -- General and administrative .............. 7,717 3,617 232 Depreciation and amortization ........... 3,009 943 5 Special compensation expense related to issuance of stock ............ -- -- 13,812 Special consulting expense related to issuance of stock ............ -- -- 9,613 Special charges ......................... 21,726 -- -- ------------- ------------- ------------- Total costs and expenses ............. 64,026 17,963 24,309 ------------- ------------- ------------- Operating income (loss) .............. (16,509) 1,223 (24,309) Interest expense, net of capitalized interest ..................... 810 274 -- Interest income ............................ (416) (191) -- Other income, net .......................... (77) (16) -- ------------- ------------- ------------- Income (loss) before income taxes ....................... (16,826) 1,156 (24,309) Income tax provision (benefit) ............. (6,496) 439 -- ------------- ------------- ------------- Net income (loss) .................... $ (10,330) $ 717 $ (24,309) ============= ============= ============= Income (loss) per common and common equivalent share: Basic ................................... $ (0.75) $ 0.09 $ (7.24) ============= ============= ============= Diluted ................................. $ (0.75) $ 0.09 $ (7.24) ============= ============= ============= Number of shares used in calculating income (loss) per common and common equivalent share: Basic ................................... 13,783 8,132 3,359 ============= ============= ============= Diluted ................................. 13,783 8,344 3,359 ============= ============= ============= STATEMENT OF COMPREHENSIVE INCOME (LOSS) Net income (loss) .......................... $ (10,330) $ 717 $ (24,309) Foreign currency translation adjustment ............................... (1,419) (381) -- ------------- ------------- ------------- Comprehensive income (loss) ................ $ (11,749) $ 336 $ (24,309) ============= ============= =============
The accompanying notes are an integral part of these consolidated financial statements. 23 APPLE ORTHODONTIX, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (DEFICIT) (IN THOUSANDS)
CLASS A AND B FOREIGN COMMON STOCK ADDITIONAL CURRENCY STOCKHOLDERS' ------------------- PAID-IN RETAINED TRANSLATION EQUITY SHARES AMOUNT CAPITAL WARRANTS DEFICIT ADJUSTMENT (DEFICIT) -------- -------- ---------- -------- -------- ----------- ------------- BALANCE, July 15, 1996 ........................ -- $ -- $ -- $ -- $ -- $ -- $ -- Issuance of common stock ................. 3,347 3 23,422 -- -- -- 23,425 Net loss ................................. -- -- -- -- (24,309) -- (24,309) -------- -------- ---------- -------- -------- ----------- ------------- BALANCE, December 31, 1996 .................... 3,347 3 23,422 -- (24,309) -- (884) Issuances of common stock ................ 4,197 4 27,429 -- -- -- 27,433 Transfers of certain assets and liabilities by founders ............. 3,683 4 495 -- -- -- 499 Special dividend to founders ............. -- -- (6,592) -- -- -- (6,592) Issuance of warrants ..................... -- -- (777) 777 -- -- -- Issuances of stock to new affiliated practices ........................... 1,930 2 14,113 -- -- -- 14,115 Issuances of options to non-employees .... -- -- 205 -- -- -- 205 Net income ............................... -- -- -- -- 717 -- 717 Foreign currency translation adjustment .. -- -- -- -- -- (381) (381) -------- -------- ---------- -------- -------- ----------- ------------- BALANCE, December 31, 1997 .................... 13,157 13 58,295 777 (23,592) (381) 35,112 Issuance of warrants .................... -- -- -- 309 -- -- 309 Issuances of stock to new affiliated practices ........................... 456 1 3,469 -- -- -- 3,470 Issuances of common stock for settlement of contingent obligations related to new affiliated practices from prior years ............................... 314 -- 1,492 -- -- -- 1,492 Issuances of common stock under employee stock option plan, including income tax benefit ........ 20 -- 79 -- -- -- 79 Issuances of options to non-employees ... -- -- 437 -- -- -- 437 Issuances of common stock for compensation expense ................ 77 -- 538 -- -- -- 538 Net loss ................................ -- -- -- -- (10,330) -- (10,330) Foreign currency translation adjustment . -- -- -- -- -- (1,419) (1,419) -------- -------- ---------- -------- -------- ----------- ------------- BALANCE, December 31, 1998 .................... 14,024 $ 14 $ 64,310 $ 1,086 $(33,922) $ (1,800) $ 29,688 ======== ======== ========== ======== ======== =========== =============
The accompanying notes are an integral part of these consolidated financial statements. 24 APPLE ORTHODONTIX, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
PERIOD FROM INCEPTION (JULY 15, YEAR ENDED DECEMBER 31, 1996) THROUGH ------------------------------ DECEMBER 31, 1998 1997 1996 ------------- ------------- ------------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss) ....................................... $ (10,330) $ 717 $ (24,309) Adjustments to reconcile net income (loss) to net cash used in operating activities: Depreciation and amortization ........................... 3,009 943 5 Deferred income tax provision (benefit) ................. (7,082) 88 -- Special compensation and consulting expense paid in stock 538 -- 23,425 Portion of special charge not requiring cash ............ 17,959 -- -- Provision for doubtful accounts ......................... 777 69 -- Changes in assets and liabilities, excluding effects of acquisitions: Receivable from orthodontic practices ................... (7,342) (2,323) -- Prepaid expenses ........................................ (214) (286) -- Other assets ............................................ (731) (83) -- Payables and other accrued liabilities .................. (904) (1,766) 404 ------------- ------------- ------------- Net cash used in operating activities ................... (4,320) (2,641) (475) ------------- ------------- ------------- CASH FLOWS FROM INVESTING ACTIVITIES: Capital expenditures .................................... (2,856) (3,632) -- Payments for new affiliated practices ................... (10,142) (8,318) -- Payment into escrow for a new affiliated practice ....... -- (2,140) -- Advances to third parties ............................... (2,101) (600) -- Advances to related party ............................... (634) -- -- Advances to affiliates .................................. (4,017) (1,868) -- Repayment of advances by affiliates ..................... 236 123 -- ------------- ------------- ------------- Net cash used in investing activities ................... (19,514) (16,435) -- ------------- ------------- ------------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from long-term debt ............................ 23,500 14,934 798 Repayments of long-term debt ............................ (1,012) (15,354) (253) Proceeds from issuances of common stock ................. 79 33,724 -- Cash paid related to common stock issuance costs ........ -- (5,496) (49) Special dividend to founders ............................ -- (6,592) -- ------------- ------------- ------------- Net cash provided by financing activities ............... 22,567 21,216 496 ------------- ------------- ------------- EFFECT OF EXCHANGE RATE CHANGES ON CASH ................... (92) (47) -- ------------- ------------- ------------- NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS ...... (1,359) 2,093 21 CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD .......... 2,114 21 -- ------------- ------------- ------------- CASH AND CASH EQUIVALENTS AT END OF PERIOD ................ $ 755 $ 2,114 $ 21 ============= ============= =============
The accompanying notes are an integral part of these consolidated financial statements. 25 APPLE ORTHODONTIX, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. BUSINESS AND ORGANIZATION GENERAL Apple Orthodontix, Inc. ("Apple" or the "Company") was founded in July 1996 to provide practice management services to orthodontic practices in the United States and Canada. On May 29, 1997, Apple acquired substantially all of the tangible and intangible assets and assumed certain of the liabilities of 31 orthodontic practices (collectively, the "Founding Affiliated Practices") in exchange for 3.7 million shares of its class A common stock, par value $.001 per share (the "Common Stock"), and $6.6 million (the "Acquisitions"). Simultaneous with the Acquisitions, Apple closed its initial public offering (the "IPO") of 2.7 million shares of Common Stock. The net proceeds of the Common Stock issued in the IPO (after deducting the underwriting discounts and commissions) were $17.6 million. Total related offering costs were $5.5 million. Apple effectively began operations with the Founding Affiliated Practices on June 1, 1997. Apple has subsequently acquired the assets and assumed the liabilities of 36 additional practices (the "New Orthodontist Affiliations"). The New Orthodontist Affiliations together with the Founding Affiliated Practices are collectively referred to as the "Affiliated Practices." The acquisitions of the Founding Affiliated Practices have been accounted for in accordance with the Securities and Exchange Commission's Staff Accounting Bulletin ("SAB") No. 48. In accordance with SAB No. 48, the acquisition of the assets and assumption of certain liabilities for all of the Founding Affiliated Practices has been accounted for by the Company at the transferors' historical cost basis, with the shares of Common Stock issued in those transactions being valued at the historical cost of the nonmonetary assets acquired net of liabilities assumed. The cash consideration paid at closing on May 29, 1997, is reflected as a dividend by the Company to the owners of the Founding Affiliated Practices in the quarter ended June 30, 1997. SAB No. 48 is not applicable to affiliations made by the Company subsequent to the IPO. The acquisitions of assets and liabilities of the New Orthodontist Affiliations are accounted for by allocating the fair market value of the consideration paid by Apple to the assets acquired, net of liabilities assumed, including intangible assets. As a result of this allocation process, the Company records a significant portion of the consideration as a service fee intangible. The service fee intangible has resulted and will continue to result in substantial noncash amortization charges for intangible assets in the Company's consolidated statements of operations. RECENT EVENTS In August 1998, the Company's board of directors elected A. Stone Douglass to the office of president and chief executive officer. Mr. Douglass' election came at a time when the Company's rapid growth had placed strains on its management and operations, resulting in the resignation of four of its executive officers during the period from May 1998 through August 1998. The resignation of three of these executive officers contributed to the recording of a special charge in the second quarter of 1998 of $3.7 million on a pre-tax basis. Since August 1998, Mr. Douglass has completed a comprehensive review of the Company's operations. As a result of this review, in the fourth quarter of 1998, the Company recorded an additional special charge of $18.0 million on a pre-tax basis. This special charge, which was primarily noncash in nature, reflected valuation reserves related to the Company's service fee intangibles ($7.0 million), receivables from certain of the Affiliated Practices ($4.9 million), property and equipment ($1.8 million), the discontinuation of the Company's business development program ($1.3 million), lawsuit settlements ($831,000) and the writedown of certain other assets ($2.2 million). As a result of the $18.0 million special charge, at December 31, 1998, the Company was no longer in compliance with certain of the covenants of its $25 million unsecured bank credit facility with Chase Bank of Texas, N.A. (the "Chase Facility"). On April 14, 1999, the Company amended the Chase Facility (the "Amended Chase Facility") with respect to certain of the covenants. The Company is now in compliance with all covenants of the Amended Chase Facility. At December 31, 1998, the Company had borrowed $23.5 million under the Chase Facility. The Company requires substantial capital to pursue its operating strategy. To date, the Company has relied upon net cash provided by financing activities to fund its capital requirements. The Company's operations have historically been a use of funds. For the years ended December 31, 1998 and 1997, the Company's operations used $4.3 million and $2.6 million, respectively, of cash. Excluding the payment of special charges of $2.7 million during 1998, the Company's operations used $1.6 million of cash for 1998. In order to increase its liquidity, the Company has developed the following strategies: (i) suspension of its new practice affiliation program, (ii) substantial curtailment of its new office development program, (iii) implementation of tighter credit policies with its Affiliated Practices, (iv) consideration of terminating the service agreements of selected underperforming Affiliated Practices, (v) reducing costs in the Company's corporate office, (vi) raising additional capital 26 APPLE ORTHODONTIX, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) and (vii) the consideration of strategic alternatives which could include, but are not limited to, a sale of the Company or a business combination with another physician practice management company or financial sponsor. Based on its current strategy to enhance cash collections and reduce costs, the Company expects its operations to be a sufficient source of funds to meet its operating capital requirements over the next twelve months. However, there can be no assurance that the Company's strategies will be achieved. In addition, the Company's capital expenditure and other liquidity needs are dependent upon access to additional capital. Any limitation on the Company's ability to obtain additional financing could have a material adverse effect on the Company's business, financial condition and results of operations. As a result of the above factors, there is substantial doubt as to the Company's ability to continue as a going concern. The accompanying financial statements do not reflect any adjustments related to the recoverability and classification of recorded assets or other adjustments which might be required should the Company be unable to continue as a going concern. 2. SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All intercompany transactions and balances have been eliminated. CASH AND CASH EQUIVALENTS For purposes of the consolidated statements of cash flows, the Company considers all time deposits and certificates of deposit with original maturities of three months or less to be cash equivalents. RESTRICTED CASH In June 1997, the Company placed $2.1 million into an escrow account pending the resolution of certain post-closing contingencies related to one of the New Orthodontist Affiliations closed during the third quarter of 1997. The amount in escrow is considered restricted cash. In January 1999, the Company disbursed $1.9 million in full settlement of this contingent obligation. The remainder of the balance in the escrow account was returned to the Company. RECEIVABLE FROM ORTHODONTIC PRACTICES, NET The Company grants credit to its customers (i.e. the Affiliated Practices), which are located in various geographic regions throughout the United States and Canada. The Company performs ongoing credit evaluations of its customers and generally does not require collateral. The Company maintains an allowance for doubtful accounts at a level which management believes is sufficient to cover potential credit losses. PROPERTY AND EQUIPMENT, NET Property and equipment is stated at cost. Equipment under capital leases is stated at the net present value of the future minimum lease payments at the inception of the related leases. Depreciation of property and equipment is calculated using the straight-line method over the estimated useful lives of the assets. Routine maintenance and repairs are charged to expense as incurred, while costs of betterment and renewals are capitalized. Prior to January 1, 1998, property and equipment were depreciated over the estimated useful life of the asset (ranging from three to seven years). In order to conform with standards in the practice management industry, the Company changed its estimate of the remaining useful lives of its property and equipment to five to ten years effective January 1, 1998 on a prospective basis. If it is determined that the estimated remaining lives require further revision, such revisions would similarly be made on a prospective basis. INTANGIBLE ASSETS, NET Intangible assets consist primarily of service fee intangibles. Prior to April 1, 1998, these intangibles were amortized over the life of the related service agreement (ranging from 20 to 40 years) with the respective Affiliated Practice. In reaction to recent trends in the practice management industry, the Company changed its estimate of the remaining useful life of its intangible assets to a maximum of 25 years effective April 1, 1998 on a prospective basis. If it is determined that the estimated remaining service period requires further revision, such revisions would similarly be made on a prospective basis. 27 APPLE ORTHODONTIX, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) Service fee intangibles represent the excess of the costs of affiliation over the fair value of the net assets acquired. The costs of affiliation include the consideration paid to the owners of the Affiliated Practices, the incremental out-of-pocket costs incurred in connection with the affiliation and the direct costs related to the Apple employees who identify, evaluate, negotiate and close the affiliation. Such costs are recorded as other noncurrent assets until consummation of the affiliation. If an affiliation is not consummated, all such costs are expensed in the period in which the affiliation is abandoned. The Company expensed such costs of $1.7 million during 1998. The Company's management periodically evaluates the realizability of the intangible assets on a practice by practice basis considering such factors as profitability and net cash flow. This evaluation was performed as of December 31, 1998 and resulted in a writedown of service fee intangibles of $7.0 million. REVENUE RECOGNITION The management service fee revenues (the "Service Fees") payable to the Company by the Affiliated Practices under their Service Agreements with the Company (the "Service Agreements") vary based on the fair market value, as determined in arm's-length negotiations, of the nature and amount of services provided. Except with respect to Service Agreements providing for the payment of flat fees (the "Flat Fee Contract"), the Service Fees earned by the Company are in accordance with the Company's two general types of Service Agreements. The standard contract (the "Standard Contract") calls for a calculation of the monthly Service Fee based on the total revenues earned by the Affiliated Practices, which is defined by the agreement to represent 24% of the total contract value in the initial month of a patient's treatment with the remainder of the contract balance earned evenly over the balance of the contract term. From total revenues, the practices retain a percentage of the Affiliated Practices' cash collections. There are adjustments to the service fee designed to both provide incentives for the orthodontists to provide efficient patient treatment and to increase the number of patients treated, as well as to ensure that the orthodontists retain a minimum amount for payment of their compensation from their respective practices on a monthly basis. The alternative contract is used in California (the "Alternative Contract"). It is a cost plus fee arrangement, whereby the service fee includes the reimbursement of defined expenses incurred by Apple in the course of providing services to the Affiliated Practice plus a percentage based on revenues. GENERAL AND ADMINISTRATIVE COSTS General and administrative costs include office expenses, professional fees, clerical and other administrative overhead. INCOME TAXES The Company recognizes deferred tax assets and liabilities for expected future tax consequences of events that have been recognized in the financial statements or tax returns. Deferred tax assets and liabilities are determined based on the differences between the financial statement carrying amounts and the tax bases of assets and liabilities using enacted tax rates and laws in effect in the years in which the differences are expected to reverse. COMPREHENSIVE INCOME Statement of Financial Accounting Standards ("SFAS") No. 130 - "Reporting Comprehensive Income," requires the reporting of comprehensive income in addition to net income from operations. Comprehensive income is a more inclusive financial methodology that includes disclosure of certain financial information that historically has not been recognized in the calculation of net income from operations. The Company adopted SFAS No. 130 effective January 1, 1998. FAIR VALUE OF FINANCIAL INSTRUMENTS The Company's financial instruments consist primarily of cash and cash equivalents, trade receivables, trade payables and debt instruments. The book values of each of these items are considered to be representative of their respective fair values. CONCENTRATION OF CREDIT RISK Financial instruments, which potentially subject the Company to concentrations of credit risk, consist principally of cash deposits, trade accounts and notes receivable. The Company maintains cash balances at financial institutions, which may at times be in excess of federally insured levels. The Company has not incurred losses related to these balances to date. 28 APPLE ORTHODONTIX, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) NEW ACCOUNTING STANDARDS The Emerging Issues Task Force of the Financial Accounting Standards Board (the "FASB") recently issued its Consensus Opinion 97-2 ("EITF 97-2"). EITF 97-2 addresses certain specific matters pertaining to the physician, dentistry and veterinary practice management industries. EITF 97-2 is effective for the Company for the year ended December 31, 1998. EITF 97-2 addresses the ability of certain practice management companies to consolidate the results of certain practices with which it has an existing contractual relationship. The Company currently does not consolidate the operations of the orthodontic practices that it manages. The guidance in EITF 97-2 does not change the Company's accounting method because the Company's arrangements with its Affiliated Practices do not meet the requirements for consolidation as set forth in EITF 97-2. In June 1997, the FASB issued SFAS No. 131 - "Disclosures about Segments of an Enterprise and Related Information." SFAS No. 131 is effective for the Company for the year ended December 31, 1998. SFAS No. 131 did not have a material effect on its financial position or results of operations. In March 1998, the American Institute of Certified Public Accountants ("AICPA") issued Statement of Position ("SOP") 98-1 providing guidance on accounting for the costs of computer software developed or obtained for internal use. SOP 98-1 requires expenditures to be expensed as incurred. The effective date of SOP 98-1 is for fiscal years beginning after December 15, 1998. The Company believes its current policies are materially consistent with SOP 98-1 and the impact on the Company's future results of operations will not be material. In April 1998, SOP 98-5, "Reporting on the Costs of Start-Up Activities," was issued by the AICPA. SOP 98-5 requires that all non-governmental entities expense the costs of start-up activities as those costs are incurred. The Company is required to adopt SOP 98-5 as of January 1, 1999. The Company does not expect the adoption of SOP 98-5 to have a material effect on its financial position or results of operations. USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires the use of estimates and assumptions by management in determining the reported amounts of liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of expenses during the reporting period. Actual results could differ from those estimates. FOREIGN CURRENCY TRANSLATION The Canadian dollar has been determined to be the functional currency for the Company's operations in Canada. Translation gains and losses from operations in Canada are reported as a component of comprehensive income. Translation losses from operations in Canada were $1.4 million and $381,000 for 1998 and 1997, respectively. RECLASSIFICATIONS Certain reclassifications have been made to amounts in prior period financial statements to conform with current period presentation. 3. NEW ORTHODONTIST AFFILIATIONS During 1998, the Company completed New Orthodontist Affiliations with 15 practices representing 21 orthodontists and 23 office locations. In addition, four orthodontists joined existing Affiliated Practices. Total consideration related to the 1998 New Orthodontist Affiliations consisted of 455,604 shares of common stock and $7.1 million of cash, assumed debt and deferred purchase price. During the period from commencement of operations (June 1, 1997) through December 31, 1997, the Company completed New Orthodontist Affiliations with 21 practices representing 27 orthodontists and 37 office locations. In addition, eight orthodontists joined existing Affiliated Practices. Total consideration related to the 1997 New Orthodontist Affiliations consisted of 1.9 million shares of common stock and $9.9 million of cash, assumed debt and deferred purchase price. 29 APPLE ORTHODONTIX, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) The cost of each of the above New Orthodontist Affiliations was allocated on the basis of the estimated fair market value of the assets acquired and liabilities assumed, resulting in gross service fee intangibles of $55.7 million. These allocations may be adjusted to the extent that management becomes aware of additional information within one reporting year of the affiliation date which results in a material change in the amount of any contingency or changes in the estimated fair market value of assets acquired and liabilities assumed. Such adjustments resulted in an increase in service fee intangibles of $4.8 million with respect to the 21 practices with which the Company affiliated in 1997. The 1998 New Orthodontist Affiliations generated patient revenue of $9.9 million during their most recently completed fiscal years prior to affiliation. The 1997 New Orthodontist Affiliations generated patient revenue of $23.2 million during their most recently completed fiscal years prior to affiliation. Prior patient revenue is not necessarily indicative of the level of patient revenue that these practices may be expected to generate in the future and is not necessarily indicative of the future service fees that the Company will receive in conjunction with these affiliations. Since the third quarter of 1998, the Company has negotiated the termination of its service agreements with two Affiliated Practices (the "Terminated Practices"). The 1998 management service fee revenues related to the Terminated Practices were $897,130. Two additional Affiliated Practices have alleged breaches of their service agreements by the Company and sought to have the service agreements terminated (the "Threatened Practices"). The Company vigorously denies any breach of the service agreements with the Threatened Practices and intends to strenuously seek enforcement of those service agreements. The 1998 management service fee revenues related to the Threatened Practices were $3.1 million. In addition, the Company is in the process of negotiating the termination of additional service agreements with Affiliated Practices with 1998 management service fee revenues of approximately $1.0 million. 4. RECEIVABLE FROM ORTHODONTIC PRACTICES The activity in the allowance for doubtful accounts with respect to the receivable from orthodontic practices is as follows (in thousands): YEAR ENDED DECEMBER 31, -------------------- 1998 1997 -------- -------- Balance at beginning of period ......................... $ 69 $ -- Bad debt provision .................................. 777 69 Special charge ...................................... 4,939 -- -------- -------- Balance at end of period ............................... $ 5,785 $ 69 ======== ======== 5. PROPERTY AND EQUIPMENT A summary of property and equipment is as follows (dollar amounts in thousands): USEFUL DECEMBER 31, LIVES IN -------------------- YEARS 1998 1997 -------- -------- -------- Equipment ................................... 10 $ 1,867 $ 1,435 Furniture and fixtures ...................... 10 1,438 1,366 Computer software ........................... 5 854 1,306 Leasehold improvements ...................... 5 2,646 1,069 Computer hardware ........................... 5 925 485 Construction in progress .................... -- 289 828 -------- -------- 8,019 6,489 Less: accumulated depreciation ............. (1,370) (487) -------- -------- $ 6,649 $ 6,002 ======== ======== Property and equipment at December 31, 1998 is net of a 1998 writedown for impairment of $1.8 million. 30 APPLE ORTHODONTIX, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) 6. INTANGIBLE ASSETS A summary of intangible assets is as follows (in thousands): DECEMBER 31, ------------------------- 1998 1997 -------- -------- Service fee intangible ....................... $ 51,563 $ 39,121 Other ........................................ 46 121 -------- -------- 51,609 39,242 Less: accumulated amortization .............. (2,262) (454) -------- -------- $ 49,347 $ 38,788 ======== ======== Intangible assets at December 31, 1998 are net of a 1998 writedown for impairment of $7.0 million. 7. LONG-TERM DEBT A summary of long-term debt is as follows (dollar amounts in thousands): DECEMBER 31, ---------------------- 1998 1997 -------- -------- Unsecured bank credit facility ..................... $ 23,500 $ -- Notes payable, maturing in varying amounts through October 2002, with interest rates ranging from 7.5% to 9.25% ...................... 121 1,076 Capitalized lease obligations, due in monthly installments through April 2001, with interest rates ranging from 9.5% to 24.66% ...... 138 195 -------- -------- 23,759 1,271 Less: current maturities ..................... (105) (1,023) -------- -------- $ 23,654 $ 248 ======== ======== In July 1997, the Company entered into a three-year, $15 million unsecured bank credit facility with Chase Bank of Texas, N.A. (the "Chase Facility"). During 1998, the Company amended the Chase Facility to increase its size from $15 million to $25 million and to increase its bank group from one to two banks. The Chase Facility provides for a revolving credit period expiring on May 31, 2002. Availability under the Chase Facility is dependent upon the Company's cash flow and liquidity. Advances bear interest, at the Company's option, at a prime rate or LIBOR, in each case plus a margin which is calculated based upon the Company's ratio of indebtedness to cash flow. The Company is required to maintain certain financial covenants regarding net worth, coverage ratios and additional indebtedness. As of December 31, 1998, the Company had $23.5 million drawn under the Chase Facility. As a result of the special charge, at December 31, 1998, the Company was no longer in compliance with certain of the covenants of the Chase Facility. On April 14, 1999, the Company amended the Chase Facility (the "Amended Chase Facility") with respect to certain of the covenants. The Amended Chase Facility provides for the revolving credit period to expire on May 31, 2001 and for a security interest in substantially all the Company's assets. The Company is now in compliance with all covenants of the Amended Chase Facility and had borrowing availability of $1.5 million as of December 31, 1998. The notes payable primarily relate to debts of the Affiliated Practices that were assumed by the Company. Total assets recorded under capital leases and the accumulated depreciation thereon were $263,436 and $138,712 as of December 31, 1998 and $263,436 and $76,052 as of December 31, 1997, respectively. 31 APPLE ORTHODONTIX, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) Aggregate maturities of the Chase Facility, the notes payable and the future minimum payments under capital leases are as follows (in thousands): Year Ended December 31, ----------------------- 1999................... $ 105 2000................... 77 2001................... 23,542 2002................... 18 2003................... 17 ---------- $ 23,759 ========== 8. STOCKHOLDERS' EQUITY COMMON STOCK Holders of the Common Stock are entitled to one vote per share. Holders of the Company's Class B common stock (the "Class B Stock") are entitled to three-tenths (3/10ths) of a vote per share. The Class B Stock is convertible into Common Stock in certain circumstances, including the disposition of shares of Class B Stock by the holder thereof (excluding dispositions to such holder's affiliates). During the years ended December 31, 1998 and 1997, 839,281 and 170,310 shares of Class B Stock, respectively, were converted into Common Stock. DIVIDENDS With the exception of a special dividend paid to the Founding Affiliated Practices in connection with the Acquisitions (see Note 1), the Company has never paid cash dividends on its common stock and has no present intention to pay cash dividends. In addition, the Chase Facility prohibits the payment of cash dividends on its common stock. WARRANTS In May 1997, the Company granted stock purchase warrants that entitled certain venture capital investors to purchase 180,000 shares of the Common Stock at a price of $7.00 per share through May 2002. At December 31, 1997, all of these warrants were vested. These warrants were recorded at their estimated fair value of $777,106 by applying the Black-Scholes option pricing model at the date of grant. In November 1998, the Company granted stock purchase warrants that entitled one of its practice management software vendors to purchase 70,000 shares of the Company's common stock at a price of $2.50 per share through November 2003. These warrants were issued in settlement of a breach of contract claim. At December 31, 1998, none of these warrants were vested. These warrants were recorded at their estimated fair value of $308,766 by applying the Black-Scholes option pricing model at the date of grant. STOCK OPTION PLAN The Company maintains incentive compensation plans which provide the ability to grant non-qualified options, restricted stock, deferred stock, incentive stock options, stock appreciation rights and other long-term incentive awards. Stock options are typically granted under these plans at an exercise price which equals the fair market value of the stock on the date of the grant. The number of shares available for issuance under the Company's 1996 Stock Compensation Incentive Plan at any time is limited to the greater of 1.0 million shares of common stock or 12% of the number of shares of common stock outstanding on the last day of the preceding calendar quarter, although the board of directors of the Company may, in its discretion, grant additional awards or establish other compensation plans. 32 APPLE ORTHODONTIX, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) The following table summarizes the activity relating to the Company's stock option plans (in thousands, except per share amounts):
1998 1997 ------------------------ ----------------------- WEIGHTED WEIGHTED AVERAGE AVERAGE EXERCISE EXERCISE OPTIONS PRICE OPTIONS PRICE ------------ -------- ------------ -------- Options outstanding at January 1 .... 923 7.55 -- -- Granted .......................... 696 4.00 923 7.55 Exercised ........................ (97) 6.17 -- -- Forfeited ........................ (31) 7.80 -- -- ------------ -------- ------------ -------- Options outstanding at December 31 .. 1,491 5.98 923 7.55 ============ ======== ============ ======== Options exercisable at December 31 .. 354 7.41 203 6.80 ============ ======== ============ ======== Option exercise price range at December 31 ..................... $3.00-$15.25 $3.00-$15.25
As allowed by SFAS No. 123, "Accounting for Stock-Based Compensation," the Company accounts for awards under its Incentive Plan in accordance with Accounting Principles Board Opinion No. 25, under which no compensation cost is recognized for stock options issued with exercise prices greater than or equal to the fair market value of the Common Stock at the date of grant. Had compensation cost for these plans been determined consistent with SFAS No. 123, the Company's net income (loss) and income (loss) per share would have been changed to the following pro forma amounts (in thousands, except per share amounts): PERIOD FROM INCEPTION (JULY 15, YEAR ENDED DECEMBER 31, 1996) THROUGH ---------------------- DECEMBER 31, 1998 1997 1996 --------- --------- ------------- Net income (loss) As reported ....................... $ (10,330) $ 717 $ (24,309) ========= ========= ============= Pro forma ......................... $ (10,521) $ 592 $ (24,309) ========= ========= ============= Income (loss) per share As reported ....................... $ (0.75) $ 0.09 $ (7.24) ========= ========= ============= Pro forma ......................... $ (0.76) $ 0.07 $ (7.24) ========= ========= ============= The effects of applying SFAS No. 123 in the pro forma disclosure may not be indicative of future amounts as additional awards in future years are anticipated. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions: PERIOD FROM INCEPTION (JULY 15, YEAR ENDED DECEMBER 31, 1996) THROUGH ---------------------- DECEMBER 31, 1998 1997 1996 --------- --------- ------------- Expected dividend yield ............... 0.0% 0.0% 0.0% Expected stock price volatility ....... 67.5% 67.5% 67.5% Risk free interest rate ............... 5.7% 6.2% 6.2% Expected life of options .............. 10 years 10 years 10 years During 1998 and 1997, the Company issued options to purchase 35,000 and 28,000 shares, respectively, to individuals other than employees and directors of the Company as consideration for the closing of New Orthodontist Affiliations. The fair value of these options was determined using the Black-Scholes option pricing model at the date of grant and capitalized as a cost of affiliation. 33 APPLE ORTHODONTIX, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) PROFIT SHARING PLAN In 1997, the Company established a defined contribution 401(k) profit sharing plan for employees meeting certain employment requirements. Eligible employees may contribute amounts up to the lesser of 15% of their annual compensation or the maximum amount permitted under IRS regulations to their 401(k) account. The Company does not match any portion of employee contributions. 9. INCOME TAXES The Company and its subsidiaries are required to file a consolidated income tax return in the United States and Canada. Affiliated Practices file "short-period" federal returns through their respective acquisition dates and thereafter are included in the Company's consolidated return. The new practices established by the affiliating orthodontists file separate income tax returns and are solely responsible for their tax liabilities on an ongoing basis. The amounts of consolidated federal, state and foreign income tax provision (benefit) are as follows (in thousands): PERIOD FROM INCEPTION (JULY 15, YEAR ENDED DECEMBER 31, 1996) THROUGH ------------------------------ DECEMBER 31, 1998 1997 1996 ------------- ------------- ------------- Current: Federal $ (298) $ 298 $ -- State (53) 53 Foreign 937 -- -- ------------- ------------- ------------- 586 351 -- ------------- ------------- ------------- Deferred: Federal (6,087) 80 -- State (716) 8 Foreign (279) -- -- ------------- ------------- ------------- (7,082) 88 -- ------------- ------------- ------------- $ (6,496) $ 439 $ -- ============= ============= ============= A reconciliation of the Company's income tax provision (benefit) to the amounts calculated by applying the federal statutory tax rate is as follows (in thousands): PERIOD FROM INCEPTION (JULY 15, YEAR ENDED DECEMBER 31, 1996) THROUGH ----------------------- DECEMBER 31, 1998 1997 1996 ---------- --------- ------------- Tax at statutory rate $ (5,721) $ 393 $ (301) Add (deduct): State income taxes (664) 46 (26) Foreign income tax provision in excess of U.S. federal rates (320) -- -- Nondeductible expenses 39 27 -- Valuation allowance 170 (27) 327 ---------- --------- ------------- Income tax provision (benefit) $ (6,496) $ 439 $ -- ========== ========= ============= 34 APPLE ORTHODONTIX, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) The components of deferred income tax liabilities and assets are as follows (in thousands): YEAR ENDED DECEMBER 31, ------------------------- 1998 1997 ---------- ---------- Deferred income tax liabilities: Property and equipment, net $ (32) $ (38) Intangible assets, net (15,211) (14,718) Federal effect of deferred state taxes (390) -- ---------- ---------- Total deferred income tax liabilities (15,633) (14,756) ---------- ---------- Deferred income tax assets: Estimated tax basis resulting from affiliation with founding practices 1,022 1,022 Bad debt reserves 330 26 Accrued expenses 207 186 Reserves relating to special charge 3,702 -- Net operating loss 170 -- Less: valuation allowance (1,192) (1,022) ---------- ---------- Total deferred income tax assets 4,239 212 ---------- ---------- Net deferred income tax liabilities $ (11,394) $ (14,544) ========== ========== Certain reclassifications have been made to the December 31, 1997 disclosures in order to reflect the refining of estimates during 1998. 10. INCOME (LOSS) PER SHARE Income (loss) per common and common equivalent share have been computed based on the weighted average number of shares outstanding. The following table reconciles the number of common shares outstanding with the number of common shares used in computing income (loss) per share (in thousands): PERIOD FROM INCEPTION (JULY 15, YEAR ENDED DECEMBER 31, 1996) THROUGH ----------------------- DECEMBER 31, 1998 1997 1996 --------- --------- ------------- Common shares outstanding 14,024 13,157 3,347 Effect of using weighted average common shares outstanding during the period (241) (5,025) 12 --------- --------- ------------- Shares used in calculating basic income (loss) per share 13,783 8,132 3,359 Effect of shares issuable under stock option plans based on the treasury stock method -- 212 -- --------- --------- ------------- Shares used in calculating diluted income (loss) per share 13,783 8,344 3,359 ========= ========= ============= 11. SUPPLEMENTAL CASH FLOW INFORMATION Supplemental disclosures of cash flow information are as follows (in thousands): PERIOD FROM INCEPTION (JULY 15, YEAR ENDED DECEMBER 31, 1996) THROUGH ---------------------- DECEMBER 31, 1998 1997 1996 --------- --------- ------------- Interest paid during the period $ 824 $ 288 $ -- Income taxes paid during the period 1,045 -- -- The Company acquired assets in capital lease transactions $263,781 in 1997. There have been no other acquisitions of assets in capital lease transactions since inception. 35 APPLE ORTHODONTIX, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) 12. COMMITMENTS AND CONTINGENCIES The Company has entered into various non-cancelable operating lease agreements, primarily for facilities and equipment utilized for operations. Certain of these agreements were negotiated between the Company and its affiliated practices. Rental expense under operating leases was $4.2 million, $1.8 million and $19,676 in 1998, 1997 and 1996, respectively. Minimum future annual lease payments under these agreements are as follows (in thousands): Year Ended December 31, ---------------------- 1999 $ 3,657 2000 3,258 2001 2,872 2002 2,395 2003 1,752 Thereafter 6,012 ------------ $ 19,946 ============ The Company has secured employment agreements with various officers and certain key employees of the Company. The agreements generally provide for the employee's annual base salary and bonus participation. The agreements also generally provide for one year non-competition agreements and severance payments of between one and three year's salary in the event the employee is terminated without cause or if there is a change in control of the Company. The amount of severance payments that would be payable upon a change in control of the Company were $3.3 million as of December 31, 1998. The Company has committed to certain of its practices to build additional satellite offices for those practices. The amount expected to be expended during 1999 related to those additional offices is approximately $1.2 million. The Company has five and three Affiliated Practices in Alberta and Ontario, Canada, respectively. Complaints have been filed with the Alberta Dental Association and the Ontario Dental Association by certain orthodontists who compete with orthodontists affiliated with Apple. Although there can be no assurance that the result of hearings with these dental associations will not limit the enforceability of the Service Agreements between Apple and its Affiliated Practices, management believes that the Company will ultimately prevail. The recorded net assets associated with the Alberta and Ontario Affiliated Practices were $13.2 million as of December 31, 1998. Management service fee revenues from these Affiliated Practices were $10.1 million and $4.3 million for the years ended December 31, 1998 and 1997, respectively. The Company is from time to time party to litigation in the ordinary course of business. There are currently no pending legal proceedings that, in management's opinion, would have a material adverse effect on the Company's operating results or financial condition. The Company maintains various insurance coverages in order to minimize the financial risk associated with certain claims. The Company has provided accruals for probable losses and legal fees associated with certain of these actions in the accompanying financial statements. The Company carries a broad range of insurance coverage, including general liability, comprehensive property damage, workers' compensation, employers' liability, directors' and officers' liability and other coverage customary in the industry. The Company and the existing Affiliated Practices maintain professional liability insurance coverage on a claims-made basis. Such insurance provides coverage for claims asserted when the policy is in effect, regardless of when the events that caused the claim occurred. 13. RELATED PARTY TRANSACTIONS On September 8, 1998, the Company loaned $500,000 to Dr. John G. Vondrak, the Company's Chairman of the Board, pursuant to a promissory note that bears interest at 8.5% per annum and is payable in full on September 9, 2000 (the "Promissory Note"). The Promissory Note is secured by a security interest in 250,000 shares of Class A or B common stock of the Company pursuant to a stock pledge agreement. On September 10, 1998, the Company and Dr. Vondrak executed an amendment to Dr. Vondrak's employment agreement to recognize Dr. Vondrak's change in title and responsibilities with the Company as well as to modify certain of the terms of compensation in the event Dr. Vondrak's employment with the Company is terminated. The Company has also advanced $134,000 to Dr. Vondrak for payment of legal fees. These advances bear interest at the prime rate minus 200 basis points. The amount advanced to Dr. Vondrak for legal fees was $134,000 and $0 as of December 31, 1998 and 1997, respectively. 36 APPLE ORTHODONTIX, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) Mr. Douglass has a financial interest in and is the business partner of the Chairman of the Board of Directors of one of Apple's primary practice management software vendors (the "Software Vendor"). Prior to hiring Mr. Douglass, Apple had entered into a software development, license and support agreement (the "License Agreement") with the Software Vendor. The License Agreement provided for, among other things, the scheduled payment by Apple of $2.5 million in license fees through January 2001. As of December 31, 1998, Apple owed $375,000 under the License Agreement plus a termination fee of $175,000 had it chosen to terminate the License agreement. As of March 1999, Apple owed $666,000 under the License Agreement plus a termination fee of $125,000 had it chosen to terminate the License Agreement. Mr. Douglass has negotiated an oral amendment to the License Agreement to limit the total license fees to $500,000 (of which $250,000 had been paid at December 31, 1998) in return for nine licenses (the "License Agreement Amendment"). As of April 14, 1999, the License Agreement Amendment had not been executed. In 1996, the Company entered into an agreement with TriCap Funding I, L.L.C. ("TriCap"), which is co-owned by a director of the Company, whereby TriCap agreed to provide $3 million to finance costs related to the IPO. The $3 million, to the extent expended, was repaid out of proceeds from the IPO, including interest at a rate of prime plus 25 basis points. The Company also entered into an agreement with TriCap during 1996 that provided for the payment to TriCap of a $500,000 financial advisory fee and the issuance to TriCap of warrants to purchase 180,000 shares of common stock with an exercise price of $7.00 per share, each upon the consummation of the IPO. The practice of a founding stockholder of the Company (the "Founding Stockholder") paid for certain costs and expenses on behalf of the Company prior to the consummation of the IPO. The amount payable to the Founding Stockholder's practice at December 31, 1996 was $30,444 and was included in accounts payable and accrued expenses in the accompanying balance sheet. This amount was repaid with the proceeds from the IPO. 14. CONCENTRATIONS OF SERVICE FEE REVENUE For 1998 and 1997, 15% and 14%, respectively, of the Company's revenues were derived from one Affiliated Practice, which was the only Affiliated Practice that provided 10% or more of revenues. 15. COMBINED PATIENT DATA Combined operating data for the Affiliated Practices for the period from their affiliation date through the end of the applicable year is as follows (in thousands): YEAR ENDED DECEMBER 31, ----------------------------------------------- 1998 1997 ---------------------- ---------------------- PATIENT CASH PATIENT CASH REVENUES COLLECTIONS REVENUES COLLECTIONS -------- ----------- -------- ----------- Practices participating under the Standard Contract $ 36,084 $ 34,101 $ 14,892 $ 13,617 Practices participating under the Alternative Contract 12,058 11,853 4,096 3,982 Practices participating under the Flat Fee Contract 14,522 14,522 6,055 6,055 -------- ----------- -------- ----------- $ 62,664 $ 60,476 $ 25,043 $ 23,654 ======== =========== ======== =========== Combined patient receivables, net of the Affiliated Practices, is as follows (in thousands): YEAR ENDED DECEMBER 31, ----------------------- 1998 1997 -------- -------- Patient receivables $ 5,123 $ 3,471 Unbilled patient receivables 6,903 3,444 Patient prepayments (3,433) (2,410) -------- -------- Patient receivables, net of prepayments $ 8,593 $ 4,505 ======== ======== 37 APPLE ORTHODONTIX, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) 16. OPERATIONS BY INDUSTRY SEGMENT AND GEOGRAPHIC AREA In July 1997, SFAS No. 131, "Disclosures About Segments of an Enterprise and Related Information," was issued. SFAS No. 131 requires certain financial and supplementary information to be disclosed on an annual and interim basis for each reportable segment of an enterprise. SFAS No. 131 is effective for the Company for the year ended December 31, 1998. The Company has only one line of business, which provides practice management services to orthodontic practices. The Company has operations in two geographic areas. The following is a breakdown of revenues and long-lived assets by geographic area (in thousands): UNITED STATES CANADA TOTAL ------------- ------- ------- AS OF AND FOR YEAR ENDED DECEMBER 31, 1998 Management service fee revenues $36,275 $11,242 $47,517 Long-lived assets 37,236 18,760 55,996 AS OF AND FOR YEAR ENDED DECEMBER 31, 1997 Management service fee revenues $14,348 $ 4,838 $19,186 Long-lived assets 27,411 17,379 44,790 17. EVENTS SUBSEQUENT TO THE DATE OF REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS (UNAUDITED) On April 23, 1999, the Company executed an assignment agreement with one of the Threatened Practices discussed in Note 3 (the "Assignment Agreement"). The Assignment Agreement provides for the Company to issue 181,818 shares of Common Stock in return for the assignment of the ownership of the practice to the Company. The Company intends to seek a new orthodontist to whom it will sell this ownership interest. The 1998 management service fee revenues associated with this practice were $2.4 million. Additionally, since April 14, 1999, one additional Affiliated Practice has alleged breaches of its service agreement by the Company and sought to have the service agreement terminated (the "Additional Threatened Practice"). The Company vigorously denies any breach of the service agreement with the Additional Threatened Practice and intends to strenuously seek enforcement of this service agreement. The 1998 management service fee revenues related to the Additional Threatened Practice were $138,499. On April 27, 1999, the Company announced that it had signed a non-binding letter of intent with an investor group in connection with the consideration of a potential investment in the Company. The investment would be in the form of a private placement of $20 million of convertible preferred shares, convertible on a one-for-one basis into shares of Common Stock. The convertible preferred shares would be issued at a price of $3.00 per share (subject to completion of due diligence satisfactory to the investor group) and would represent, on an as-converted basis, approximately a 32% ownership interest in the Company at that price. The Company anticipates that the net proceeds would be used to repay a substantial portion of the Chase Facility. The proposed investment by the investor group remains subject to further negotiation of applicable terms and conditions (including price), the negotiation of definitive documents, the completion of due diligence satisfactory to the investor group, and the receipt of any necessary approvals and third-party consents. 38 APPLE ORTHODONTIX, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. EXECUTIVE OFFICERS OF THE REGISTRANT The following table sets forth the names, ages (as of April 1, 1999) and positions of the Company's executive officers: NAME AGE POSITION - --------------------------- ------ ----------------------------------------- A. Stone Douglass 51 Chief Executive Officer, President and Director W. Daniel Cook 44 Senior Vice President of Practice Affiliations and Director James E. Bobbitt 54 Vice President and Chief Financial Officer Stephen T. Yavorsky 48 Vice President of Business Development Lee Ann Peniche 38 Vice President of Training and Marketing The executive officers of the Company are elected annually by the Board of Directors of the Company and serve at the discretion of the Board. A. STONE DOUGLASS has been Chief Executive Officer, President and a director of the Company since August 1998. From May 1997 until July 1998, he was Chairman and Chief Executive Officer of Aria Wireless Systems. He has been a managing director of Compass Partners LLC, a merchant bank, since September 1995. From March 1992 until July 1995, he was Chairman and Chief Executive Officer of Piper Aircraft Corporation, a manufacturer of general aviation aircraft. W. DANIEL COOK has served as a director of the Company since October 1996 and as Chief Administrative Officer from February 1997 to May 1998. He has served as Senior Vice President of Practice Affiliations since May 1998. From December 1996 to May 1997, Mr. Cook served as a consultant to the Company on various legal matters. Prior thereto he was a partner at the law firm of Breard, Raines & Cook, P.L.L.C. from March 1996 to May 1997 and was associated with the law firm of Page, Mannio, Peresich, Dickinson & McDermott, P.L.L.C. from 1991 to 1995. JAMES E. BOBBITT has been Vice President and Chief Financial Officer of Company since August 1998. From April 1993 to August 1998, he was President of Tristar Web Graphics, Inc. a commercial printing company. From June 1984 to April 1993, Mr. Bobbitt was Executive Vice President and Chief Financial Officer of Shelton Ranch Corporation, which had operations in energy, real estate and agriculture. Prior thereto he was President of WellSource Corporation, a land based contract drilling company from May 1980 to June 1984. From October 1975 to May 1980 Mr. Bobbitt was Vice President and Chief Financial Officer of Petrochem Manufacturing Company, a company engaged in manufacturing and distribution of metal products. Mr. Bobbitt was with Arthur Young & Company, an international accounting firm, from June 1968 to October 1975. Mr. Bobbitt has a BBA and MBA from the University of Texas at Austin and is a Certified Public Accountant. STEPHEN T. YAVORSKY has served as Vice President of Business Development since May 1998. From December 1997 to May 1998, he was an employee of the Company who developed new offices. From March 1995 to December 1997, Mr. Yavorsky served as Executive Vice President of The Walters Group, a real estate development company. From 1988 to 1995, Mr. Yavorsky served as Chairman, Chief Executive Officer and President of Union Land Title Company. Mr. Yavorsky is the brother of Lee Ann Peniche. LEE ANN PENICHE has been Vice President of Training and Marketing since June 1997. Prior to that time, she served as Director of Training of the Company beginning in March 1997. From September 1996 to February 1997, Ms. Peniche served as a consultant to the Company on various practice development matters. In July 1989, Ms. Peniche founded Peniche & Associates, Inc., a consulting firm specializing in the development and implementation of 39 practice development techniques for orthodontic practices throughout North America, where she has served as its President from inception to the date of the IPO. From January 1985 until September 1991, Ms. Peniche was on the faculty of Paradigm Practice Management Company, where she specialized in training orthodontists and their staff in practice development activities. Ms. Peniche is a frequent lecturer with the American Association of Orthodontics, the Pacific Coast Orthodontic Society and numerous other private orthodontic societies. Ms. Peniche is a Registered Dental Assistant, specializing in orthodontics. Ms. Peniche is the sister of Stephen T. Yavorsky. DIRECTORS OF THE REGISTRANT The following sets forth information concerning the Class I, Class II and Class III directors of the Company whose present terms of office will expire at the 2001, 1999 or 2000 annual meetings of stockholders, respectively, including each director's age as of April 13, 1999, position with the Company, if any, and business experience during the past five years. CLASS I A. STONE DOUGLASS. See "-- Executive Officers of the Registrant." ROD L. CROSBY, JR., age 60, has served as a director of the Company since July 1997. Mr. Crosby has served as the Senior Vice President of Business Development of Corporate Express, a supplier of office products and services, since 1995. From 1994 to 1995, Mr. Crosby served as a director of U.S. Delivery Systems, Inc., a delivery service company formed as a result of a combination in November 1993 of a number of delivery companies, including ViaNet, Inc., a company founded by Mr. Crosby. Prior to that time, Mr. Crosby served as Chairman and Chief Executive Officer of ViaNet, Inc. from 1986 until 1993. Mr. Crosby serves on the board of directors of e-CommLink, a software company serving the banking and medical industries. RICHARD J. MARXEN, age 52, has served as a director of the Company since February 1998. Mr. Marxen is the founder of Connective Technologies, Inc., a privately-held business solutions provider for systems integration, and has served as its chairman, president and chief executive officer since 1990. Prior to that time, Mr. Marxen founded a business consulting firm and a management systems consulting firm. CLASS II W. DANIEL COOK. See "-- Executive Officers of the Registrant." WILLIAM W. SHERRILL, age 72, has served as a director of the Company since October 1996. He is an Executive Professor at the University of Houston College of Business Administration and is the Director for the University of Houston's Center for Entrepreneurship & Innovation. Mr. Sherrill was formerly the principal of William W. Sherrill, Financial Consultants from 1974 to 1981. From 1971 to 1974, Mr. Sherrill served as the President of Associates Corporation of North America and was a director of Gulf and Western Industries, Inc. Before joining Associates Corporation, he was appointed by the President of the United States in 1967 to fill an unexpired term as Governor of the Federal Reserve Board in Washington, D.C. and was reappointed to a full 14-year term on the Board of Governors. Prior to his Federal Reserve appointment, he was the Director of the Federal Deposit Insurance Corporation. Mr. Sherrill initially was appointed to the Company's Board of Directors pursuant to the provisions of a funding agreement between the Company and TriCap Funding I, L.L.C. ("TriCap"). See "Certain Relationships and Related Party Transactions" under Item 13. ROBERT L. BREWTON, age 46, has served as a director of the Company since February 1998. Since January 1996, Mr. Brewton has served as the Chief Investment Officer of Residential Company of America, Ltd., a privately-held real estate investment and management company. From 1987 until January 1996, Mr. Brewton served as President of the multifamily division of the Transwestern Property Company, the predecessor of Residential Company of America, Ltd. 40 CLASS III JOHN G. VONDRAK, D.D.S., age 58, has served as Chairman of the Board of Directors since October 1996 and as a Director of the Company since July 1996. Dr. Vondrak is a founder of the Company and served as Chief Executive Officer of the Company from October 1996 to August 1998 and as President and Chief Operating Officer from May 1998 to August 1998. He was the President and sole shareholder of JGVAOI, one of the Founding Affiliated Practices, for more than the past five years. Dr. Vondrak is a licensed dentist, a graduate of an American Dental Association accredited orthodontic program and has maintained a private orthodontic practice for over 24 years. He is a member of the American Association of Orthodontists and the Southwest Society of Orthodontists and served as President of the New Mexico Orthodontic Society in 1979. CLYDE C WADDELL, JR., age 57, has served as a director of the Company since July 1997. Mr. Waddell is the owner, President and Chief Executive Officer of Hester's Office Center, Inc., an office supply company, and has served in such capacity for more than the past five years. Mr. Waddell is a certified public accountant. COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT Section 16(a) of the Exchange Act requires the Company's directors and executive officers and persons who own more than 10% of a registered class of the Company's equity securities, to file with the Commission and the American Stock Exchange initial reports of ownership and reports of changes in ownership of Common Stock. Officers, directors and greater than 10% stockholders are required by SEC regulation to furnish the Company with copies of all such forms they file. Due to inadvertence in connection with several transactions involving the Company's Common Stock, Dr. Vondrak, the Chairman of the Board and former Chief Executive Officer, and Mr. Sherrill, a director, did not timely file reports on Form 4 to reflect changes in their beneficial ownership during 1998. Upon discovery of such inadvertent omission, all such transactions have been reported to the SEC. Based solely on a review of the copies of such reports furnished to the Company and written representations that no other reports were required, the Company believes that all other filings required under Section 16(a) of the Exchange Act have been made. ITEM 11. EXECUTIVE COMPENSATION DIRECTOR COMPENSATION Each director who is not an employee of the Company receives a fee of $2,000 for attendance at each Board of Directors meeting and $1,000 for each committee meeting (unless held on the same day as a Board of Directors meeting). All directors are reimbursed for their out-of-pocket expenses and other expenses incurred in attending meetings of the Board or committees thereof and for other expenses incurred in their capacity as directors. In addition, under the Company's 1997 Stock Compensation Plan, each current nonemployee director has been granted nonqualified options to purchase 10,000 shares of Common Stock. In addition, each newly elected nonemployee director automatically will be granted nonqualified options to purchase 10,000 shares of Common Stock on the date that person first becomes a nonemployee director of the Company. Thereafter, each nonemployee director automatically will be granted nonqualified options to purchase 5,000 shares of Common Stock on the date of the Company's annual meeting of stockholders. Each option will have an exercise price per share equal to the fair market value of the Company's Common Stock on the date of grant. On completion of the Company's IPO in May 1997, Mr. Sherrill was granted an option to purchase 12,500 shares of Common Stock at an exercise price per share equal to the initial public offering price to the public. Each of Messrs. Crosby, Waddell, Brewton and Marxen received an option to purchase 10,000 shares of Common Stock on his appointment to the Board of Directors (July 1997 for Messrs. Crosby and Waddell and February 1998 for Messrs. Brewton and Marxen) at an exercise price per share equal to the fair market value of the Common Stock on the date of grant. All the options granted to the nonemployee directors have a term of ten years, and become exercisable as to one-quarter of the shares on the date of grant, and thereafter in cumulative annual installments of one-quarter beginning on the first anniversary of the date of grant. 41 COMPENSATION OF EXECUTIVE OFFICERS The following table sets forth information regarding the compensation of the Company's chief executive officer and other executive officers who were serving as such at December 31, 1998 (together with the Chief Executive Officer, the "Named Executive Officers") for the years ended December 31, 1998, December 31, 1997 and the period from the Company's inception (July 15, 1996) through December 31, 1996. SUMMARY COMPENSATION TABLE
ANNUAL LONG-TERM COMPENSATION (1) COMPENSATION AWARDS --------------------------------------------- ---------------------- Restricted Shares Other Annual Stock Underlying Name and Principal Position Year Salary(2) Bonus Compensation Awards Options - --------------------------- ---- -------- -------- ------------ ---------- ---------- A. Stone Douglass Chief Executive Officer, President and Director 1998 $ 60,154 $ -- $ 25,000(3) $-- 450,000 W. Daniel Cook Senior Vice President of 1998 120,000 -- -- -- -- Practice Affiliations and 1997 117,564 -- -- -- 70,000 Director 1996 10,000 48,000 -- (4) -- Steven T. Yavorsky (5) Vice President of Business 1998 116,308 -- -- -- Development 1997 10,000 -- 41,917(3) -- 60,000 LeeAnn Peniche (6) Vice President of 1998 133,154 -- 58,906(3) -- -- Training and Marketing 1997 109,541 -- -- -- 60,000 John G. Vondrak, D.D.S.(7) Chairman of the Board, 1998 180,000 -- -- -- -- Former President and Chief 1997 176,763 -- 2,054(8) -- 135,000 Executive Officer 1996 75,000 52,000 -- -- -- Robert J. Syverson (7) 1998 55,962 -- 775,000(9) -- -- Former President and Chief 1997 159,455 -- -- -- 100,000 Operating Officer 1996 56,000 48,000 -- (4) -- H. Steven Walton (7) 1998 45,000 -- 2,387,952(10) -- -- Former Vice President of 1997 404,447(11) 37,000 -- -- 161,850 Business Development 1996 -- -- -- -- --
- ----------- (1) Excludes any perquisites and other benefits that do not exceed the lesser of $50,000 or 10% of the total of annual salary and bonus reported for any Named Executive Officer. (2) Amounts shown for 1996 consist of fees earned as a consultant to the Company. Amounts shown for 1997 include fees earned as a consultant to the Company from January 1997 to April 1997 of $62,500, $62,500 and $40,000 for Dr. Vondrak, Mr. Syverson and Mr. Cook, respectively, and in December 1997 of $10,000 for Mr. Yavorsky. (3) Consists of moving expenses reimbursed by the Company in 1998. (4) Does not include amounts for shares of restricted stock purchased by Messrs. Syverson and Cook in October 1996. For federal income tax purposes, the Company valued the shares purchased in October 1996 at their purchase price ($1,030 for Mr. Syverson and $1,202 for Mr. Cook). For financial statement purposes, the Company recorded special compensation expense for 1996 of $1,029,980 (Mr. Syverson) and $1,201,637 (Mr. Cook). (5) Joined the Company in December 1997 and became an executive officer in May 1998. (6) Joined the Company in March 1997 and became an executive officer in June 1997. 42 (7) No longer an executive officer of the Company. In May 1998, the Company undertook a management reorganization, as follows: Dr. Vondrak was given added responsibilities as President and the chief operating officer, replacing Robert J. Syverson; Mr. Yavorsky, formerly head of real estate operations, replaced H. Steven Walton as a vice president of business development; and Mr. Cook was elected to the new position of Senior Vice President of Practice Affiliations. In August 1998, Mr. Douglass replaced Dr. Vondrak as Chief Executive Officer and President and Mr. Bobbitt replaced Michael Harlan as Vice President and Chief Financial Officer. (8) Consists of moving expenses reimbursed by the Company in 1997. Does not include amounts for shares of stock purchased by Dr. Vondrak in October 1996 in respect of which the Company recorded a special compensation expense of $9,052,346 in 1996. (9) Consists of a severance cash benefit paid to Mr. Syverson in lieu of the benefits which were otherwise payable pursuant to his employment agreement with the Company, which was terminated. (10) Consists of a severance cash benefit of $1,600,000 paid to Mr. Walton in lieu of the benefits which were otherwise payable pursuant to his employment agreement with the Company, which was terminated, $250,000 that was paid to reimburse certain tax liabilities and the forgiveness of a promissory note receivable in the amount of $537,952. The Company paid $1,316,667 of this amount in 1998 and the remainder is payable in 1999. (11) Includes performance-based payment for the completion of new affiliations of orthodontists with the Company pursuant to Mr. Walton's employment agreement with the Company, which was terminated in 1998. OPTION GRANTS The following table sets forth certain information on grants of stock options during 1998 to the Named Executive Officers reflected in the Summary Compensation Table. STOCK OPTIONS GRANTED IN 1998
POTENTIAL REALIZABLE VALUE AT ASSUMED ANNUAL RATES OF STOCK PRICE APPRECIATION INDIVIDUAL GRANTS FOR OPTION TERM (1) -------------------------------------------------------------------------- ---------------------------- Percent of Total Number of Shares Options Granted Exercise underlying options to Employees in Price (per Expiration granted in 1998 1998 share) (2) Date 5% 10% --------------------- ------------------- --------------- ---------------- -------------- ------------- A. Stone Douglass (3) 100,000 17.4% $ 3.00 08/06/2008 $188,667 $478,122 (4) 150,000 26.1 3.00 08/06/2008 283,001 717,183 (5) 200,000 34.8 3.00 08/06/2008 377,334 956,244
- ------------ (1) The potential realizable value through the expiration date of the options has been determined on the basis of the per share market price at the time the options were granted, compounded annually over 10 years, net of the exercise price. These values have been determined based on assumed rates of appreciation and are not intended to forecast the possible future appreciation, if any, of the price or value of the Company's Common Stock. (2) The exercise price of the options granted was equal to the fair market value of the Common Stock on the date of grant. (3) These options were granted in August 1998 and become exercisable with respect to 33 1/3% of the subject shares one year after the date on which the closing price of the Company's Common Stock has equaled or exceeded $12.00 per share for 90 consecutive trading days (the "$12.00 Trigger Date"). The options are 43 exercisable in additional 33 1/3% increments on each subsequent anniversary of the $12.00 Trigger Date. With respect to any shares that have not vested pursuant to the clause described in the preceding sentences, the option may be exercised as to 33 1/3% of the subject shares on each of the eighth and ninth anniversaries of the date of grant and, as to the remaining 33 1/3%, nine years and eleven months after the date of grant. (4) These options were granted in August 1998 and become exercisable with respect to 33 1/3% of the subject shares on August 6, 1999. They become exercisable in additional 33 1/3% increments on August 6, 2000 and August 6, 2001. (5) These options were granted in August 1998 and, as to 100,000 of the subject shares, become exercisable with respect to 33 1/3% of those shares one year after the date on which the closing price of the Company's Common Stock equals or exceeds $7.00 per share for 90 consecutive trading days (the "$7.00 Trigger Date"). The options are exercisable in additional 33 1/3 increments on each subsequent anniversary of the $7.00 Trigger Date. With respect to the remaining 100,000 subject shares, the options are exercisable with respect to 33 1/3% of those shares one year after the date on which the closing price of the Company's Common Stock equals or exceeds $10.00 per share for 90 consecutive trading days (the "$10.00 Trigger Date"). The options are exercisable in additional 33 1/3% increments on each subsequent anniversary of the $10.00 Trigger Date. With respect to any shares that have not vested pursuant to the clauses described in the preceding sentences, the options may be exercised as to 33 1/3% of the subject shares on each of the eighth and ninth anniversaries of the date of the grant and, as to the remaining 33 1/3%, nine years and eleven months after the date of grant. OPTION EXERCISES AND 1998 YEAR-END OPTION VALUES The following table sets forth certain information with respect to unexercised options to purchase Common Stock held by the Named Executive Officers at December 31, 1998. None of the Named Executive Officers exercised options in 1998. YEAR-END 1998 OPTION VALUES
NUMBER OF SHARES UNDERLYING VALUE OF UNEXERCISED IN-THE- UNEXERCISED OPTIONS HELD AT MONEY OPTIONS AT DECEMBER 31, 1998 DECEMBER 31, 1998 (1) -------------------------------------- ------------------------------------- EXERCISABLE UNEXERCISABLE (2) EXERCISABLE UNEXERCISABLE (2) ----------- ----------------- ----------- ----------------- A. Stone Douglass -- 450,000 $ -- $112,500 W. Daniel Cook 35,000 35,000 -- -- Steven T. Yavorsky 20,000 40,000 -- -- LeeAnn Peniche 30,000 30,000 -- -- John G. Vondrak 67,500 67,500 -- -- Robert J. Syverson 50,000 50,000 -- -- H. Steven Walton 42,500 42,500 -- --
- --------- (1) Value of unexercised in-the-money options is calculated based upon the difference between the option price and the closing price of the Common Stock at year end, multiplied by the number of shares underlying the options. The closing price of the Common Stock as reported on the American Stock Exchange on December 31, 1998 was $3.25. (2) All these options become immediately exercisable on a change in control of the Company. EMPLOYMENT AGREEMENTS The Company has employment agreements with Dr. Vondrak and Messrs. Douglass, Cook, Yavorsky and Ms. Peniche. Each of these agreements provides for an annual base salary in an amount not less than $180,000, $170,000, $120,000, $120,000 and $138,000 for Dr. Vondrak, Mr. Douglass, Mr. Cook, Mr. Yavorsky and Ms. Peniche, respectively, and entitles the employee to participate in all the Company's compensation plans (as defined in the agreements) in which other executive officers of the Company participate. Each of these agreements also has a 44 continuous three-year term, subject to the right of the Company and the employee to terminate the employee's employment at any time. With regard to the employment agreement with Mr. Douglass, if his employment is terminated by the Company without cause (as defined in the agreement) or he elects to terminate upon a material breach by the Company pursuant to a change of control (as defined in the agreement), he will be entitled to: (a) all salary and bonus amounts accrued through the termination date, and (b) payment of 100% of the remaining period of time in the initial three-year term or the current renewal term, as the case may be, of his base salary as of the termination date. The employment agreement for Mr. Douglass contains a covenant limiting his right to compete against the Company for a period of two years following termination of employment for cause or for a period of six months following termination of employment without cause. With regard to the employment agreement with Mr. Cook, if his employment is terminated by the Company without cause (as defined in the agreement) or by him with good reason (as defined in the agreement), he will be entitled, during each of the years in the three-year period beginning on the termination date, to (i) periodic payments equal to his average annual cash compensation (as defined in the agreement) from the Company, including bonuses, if any, during the two years (or the period of employment, if shorter) preceding the termination date, and (ii) continued participation in all the Company's compensation plans (other than the granting of new awards under the 1997 Stock Compensation Plan or any other performance-based plan). Except in the case of a termination for cause, any stock options previously granted to the employee under the 1997 Stock Compensation Plan that have not been exercised and are outstanding as of the time immediately prior to the date of his termination will remain outstanding (and continue to become exercisable pursuant to their respective terms) until exercised or the expiration of their term, whichever is earlier. If a change of control (as defined in the agreement) of the Company occurs, the employee will be entitled to terminate his employment at any time during the 365-day period following that change of control and receive a lump-sum payment equal to three times his highest annual base salary under the agreement (plus such amounts as may be necessary to hold the employee harmless from the consequences of any resulting excise or other similar purpose tax relating to "parachute payments" under the Internal Revenue Code of 1986, as amended). The employment agreement for Mr. Cook contains a covenant limiting his right to compete against the Company for a period of one year following termination of employment. With respect to the employment agreement with Mr. Yavorsky, if his employment is terminated by the Company without cause (as defined in the agreement), he will be entitled to six months base compensation and he shall be deemed fully vested as to the stock options for 60,000 shares of the Company's Common Stock that he was granted pursuant to the agreement. The stock options also vest upon a change in control (as defined in the agreement). Mr. Yavorsky's employment agreement contains a covenant limiting his right to compete against the Company for a period of one year following termination of employment. With respect to the employment agreement with Ms. Peniche, if her employment is terminated by the Company without cause (as defined in the agreement), she will be entitled to $50,000 as well as employee benefits for a period of one year following termination. Ms. Peniche's employment agreement contains a covenant limiting her right to compete against the Company for a period of three years following termination of employment. During 1998 Dr. Vondrak's employment agreement was amended to provide that, in the event his employment is terminated by the Company other than for cause (as defined in his employment agreement), the Company and Dr. Vondrak intend to enter into a consulting arrangement whereby Dr. Vondrak will provide requested business development services to the Company for a period of three years for which he will be paid an amount commensurate with the value of the services rendered. The aggregate amount of consulting fees payable is $865,000. The Company will use its best efforts to provide Dr. Vondrak with transaction opportunities during each quarter during the term of this consulting agreement that will generate a minimum consulting fee of $72,081 per quarter. If Dr. Vondrak's employment is terminated by him with good reason (as defined in the agreement), he will be entitled during each of the years in the three-year period beginning on the termination date, to continued participation in all the Company's compensation plans (other than the granting of new awards under the 1997 Stock Compensation Plan or any other performance-based plan) and any stock options previously granted to Dr. Vondrak under the 1997 Stock Compensation Plan that have not been exercised and are outstanding as of the time immediately prior to the date of his termination will remain outstanding (and continue to become exercisable pursuant to their respective terms) until exercised or the expiration of their term, whichever is earlier. Upon a change of control (as defined in his employment agreement), the Company or its successor will pay Dr. Vondrak an amount equal to the difference between $865,000 and all amounts previously paid pursuant to the consulting agreement, if such agreement is 45 then effective. The employment agreement for Dr. Vondrak contains a covenant limiting his right to compete against the Company for a period of one year following termination of employment. The Company also agreed to loan Dr. Vondrak $500,000 pursuant to a promissory note and stock pledge agreement. See "-- Certain Relationships and Related Party Transactions." COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION In September 1997, the Company established a Compensation Committee to make recommendations with respect to salaries and bonuses to be paid to officers and other employees of the Company. The current members of the Compensation Committee of the Board are Messrs. Brewton, Crosby, Marxen, Waddell and Sherrill (chairman), each of whom is a nonemployee director. Prior to completion of the Company's IPO, matters with respect to the compensation of executive officers and other employees of the Company were determined by the members of the Board of Directors as a whole. Messrs. Vondrak and Cook, who were members of the Board of Directors, participated in deliberations concerning compensation. REPORT OF COMMITTEE ON EXECUTIVE COMPENSATION OVERVIEW The Compensation Committee of the Board of Directors of the Company (the "Compensation Committee") is responsible for establishing a general compensation policy for officers and employees of the Company, preparing any reports that may be required relating to officer compensation and approving any increases in director's fees. The Compensation Committee consists of Messrs. Brewton, Crosby, Marxen, Waddell and Sherrill. The Compensation Committee approves, or in some cases recommends to the Board, remuneration arrangements and compensation plans involving the Company's directors, executive officers and certain other employees whose compensation exceeds specified levels. The Compensation Committee also acts on the granting of stock options to executive officers under the Company's Stock Plan. To assist the Compensation Committee in carrying out its responsibilities, the Company has retained an executive compensation consulting firm to review the compensation paid to the Chief Executive Officer and its other executive officers, and to provide a competitive assessment as to how the components of the Company's compensation program compare to those of companies that compete with the Company for executive employees. The Company's executive compensation program has been designed to assist the Company in attracting, motivating and retaining the executive talent necessary for the Company to maximize its return to stockholders. To this end, this program provides competitive compensation levels and incentive pay levels that vary based on corporate and individual performance. The Company's compensation program for executives consists of three key elements: a base salary; a performance-based annual bonus; and periodic grants of stock options. The Compensation Committee believes that this three-part approach best serves the interests of the Company and its stockholders. It enables the Company to meet the requirements of the highly competitive environment in which the Company operates while ensuring that executive officers are compensated in a way that advances both the short-term and long-term interests of its stockholders. Under this approach, compensation for these officers involves a high proportion of pay that is dependent on maximizing long-term returns to stockholders. BASE SALARY Base Pay is designed to be competitive with salary levels for comparable executive positions at other companies and the Compensation Committee reviews such comparable salary information as one factor to be considered in determining the base pay for the Company's executive officers. Other factors the Compensation Committee considers in determining base pay for each of the executive officers are that officer's responsibilities, experience, leadership, potential future contribution and demonstrated individual performance. The Company has employment agreements with its Chief Executive Officer, its former Chief Executive Officer, Dr. Vondrak, the other three current executive officers named in the Summary Compensation Table and certain of its other officers. These agreements provide for minimum base annual salaries the Company may increase, but cannot decrease. Any 46 increases in these base salaries, the base salaries of the Company's other executive officers and any changes in those salaries will be based on recommendations by the Company's Chief Executive Officer, taking into account such factors as competitive industry salaries, a subjective assessment of the nature of the position and the contribution and experience of the officer. Performance for base salary purposes will be assessed on a qualitative, rather than a quantitative, basis. No specific performance formula or weighting of factors will be used in determining base salary levels. ANNUAL BONUS For 1998, the Company determined that, for 1998, it was their preference to compensate the executive officers primarily in the form of long-term, equity-based compensation, and accordingly, made awards of stock options rather than cash bonuses. The Compensation Committee expects to base future annual bonuses on the Company's financial performance and the individual performance of the awardees, and intends to use qualitative, rather than quantitative, factors for this purpose. STOCK PLAN Prior to the IPO, the stockholders and the Board of Directors of the Company approved the Stock Plan. The objectives of the Stock Plan are to (i) attract and retain superior personnel for positions of substantial responsibility and (ii) provide employees, nonemployee directors, advisors and orthodontists with an additional incentive to contribute to the success of the Company. In August 1998, the Company granted to Mr. Douglass options to purchase 450,000 shares of Common Stock at a per-share exercise price of $3.00. Stock options align the interests of employees and stockholders by providing value to option holders through stock price appreciation only. The Compensation Committee expects that it will make future stock option or other long-term equity-based incentive awards periodically at its discretion based on recommendations of the Chief Executive Officer. Stock option grant sizes, in general, will be evaluated by regularly assessing competitive market practices, the overall performance of the Company the, size of previous grants and the number of options held. In addition, the Compensation Committee may consider factors including that executive's current ownership stake in the Company, the degree to which increasing that ownership stake would provide the executive with additional incentives for future performance, the likelihood that the grant of those options would encourage the executive to remain with the Company and the value of the executive's service to the Company. This posture with regard to stock options is intended to focus management's efforts on maximizing stockholder returns. The number of options granted to a particular participant will also be based on the Company's historical financial success, its future business plans and the individual's position and level of responsibility within the Company, but these factors will be assessed subjectively and not weighted. 1998 CHIEF EXECUTIVE OFFICER PAY As described above, the Compensation Committee will consider several factors in developing an executive compensation package. For the Chief Executive Officer, these factors will include competitive market pay practices, performance level, experience, contributions toward achievement of strategic goals and the overall financial and operations success of the Company. The Company entered into an Executive Employment Agreement (the "Agreement") with Mr. Douglass, the Company's Chief Executive Officer, on August 6, 1998. The initial term of the Agreement is for three years at an initial rate of $170,000 per year. Mr. Douglass is eligible to receive an annual discretionary cash bonus in an amount up to 50% of his base salary. In addition, Mr. Douglass was granted options to purchase 450,000 shares of Common Stock at an exercise price of $3.00 per share. The Compensation Committee believes the terms of the Agreement and this initial option award was appropriate. From the date of the IPO until August 1998, the Compensation Committee took no action respecting Dr. Vondrak's compensation for 1998. The Company's compensation consultant advised the Compensation Committee that Dr. Vondrak's total compensation (base salary and bonus) paid for that portion of 1998 that he served the Company as 47 Chief Executive Officer was within an acceptable range of competitive market levels for compensation paid to the executive officers of comparable companies surveyed by the consultant. Executive compensation is an evolving field. The Compensation Committee monitors trends in this area, as well as changes in law, regulation and accounting practices, that may affect either its compensation practices or its philosophy. Accordingly, the Committee reserves the right to alter its approach in response to changing conditions. This report will not be deemed incorporated by reference by any general statement incorporating this Annual Report on Form 10K by reference into any filing under the Securities Act or under the Exchange Act and will not be deemed filed under either of such statutes except to the extent that the Company specifically incorporates this information by reference. The Compensation Committee Robert L. Brewton Rod L. Crosby Richard J. Marxen Clyde C. Waddell William W. Sherrill PERFORMANCE GRAPH The following performance graph compares the cumulative total stockholder return on the Common Stock to the cumulative total return on the Standard & Poor's 500 Stock Index ("S&P 500") and a peer group, selected in good faith, comprised of Castle Dental Centers, Inc., Coast Dental Services, Inc., Gentle Dental Service Corp., Monarch Dental Corp., Omega Orthodontics, Inc., Orthalliance, Inc. and Orthodontic Centers of America, Inc. (the "Peer Group"), over the period from May 22, 1997, the date of the Company's IPO, to December 31, 1998. The graph assumes that $100 was invested on May 22, 1997 in the Common Stock at its IPO price of $7.00 per share and in each of the other two indices and the reinvestment of all dividends, if any. [LINEAR GRAPH PLOTTED FROM DATA IN TABLE BELOW] 5/22/97 12/31/97 12/31/98 ------- -------- -------- The Company $100 $170 $ 43 S&P 500 $100 $116 $149 Peer Group $100 $115(1) $109 - ---------- (1) The amount reflected for the Peer Group as of December 31, 1997 in the Schedule 14A information filed on June 24, 1998 was $107 rather than $115, as reflected above, due to the exclusion of Omega Orthodontics, Inc. in the prior year Peer Group calculation. The graph is presented in accordance with SEC requirements. Stockholders are cautioned against drawing any conclusions from the data contained therein, as past results are not necessarily indicative of future financial performance. The total return on investment for the period shown for the Company, the S&P 500 and the Peer Group is based on the stock price or composite index at May 22, 1997. The performance graph appearing above will not be deemed incorporated by reference by any general statement incorporating this Annual Report on Form 10-K by reference into any filing under the Securities Act of 1933, as amended (the "Securities Act"), or under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and will not be deemed filed under either of those Acts except to the extent that the Company specifically incorporates this information by reference. 48 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table sets forth the shares of Common Stock and the Class B Stock beneficially owned directly or indirectly as of April 23, 1999 (i) by each person who is known to the Company to own beneficially more than 5% of the Common Stock and the Class B Stock, (ii) each of the Company's directors and Named Executive Officers and (iii) all executive officers and directors as a group. NUMBER OF SHARES BENEFICIALLY OWNED (1) ------------------------------------------------------- COMBINED COMMON PERCENT OF CLASS B PERCENT OF VOTING STOCK (2) CLASS STOCK CLASS POWER ------------------------------------------------------- A. Stone Douglass -- *% -- *% *% W. Daniel Cook 77,698 * 171,687 7.6 1.0 Steven T. Yavorsky 20,000 * -- * * LeeAnn Peniche 81,308 * 80,120 3.5 * John G. Vondrak, D.D.S. 511,231 4.3 1,293,377 57.2 7.2 Robert L. Brewton 6,250 * -- * * Rod L. Crosby, Jr. 22,656 * 28,167 1.2 * Richard J. Marxen 6,250 * -- * * William W. Sherrill 70,625 * 112,400 5.0 * Clyde C. Waddell, Jr. 6,250 * -- * * Robert J. Syverson 75,000 * 130,809 5.8 * H. Steven Walton 142,100 1.2 -- * 1.1 All executive officers and directors as a group (12 persons) 1,019,368 8.3 1,816,560 80.3 12.1 - ------------ * less than 1%. (1) The address of each person listed is 2777 Allen Parkway, Suite 700, Houston, Texas 77019. (2) Includes shares subject to outstanding options that are or will become exercisable within 60 days of April 23, 1999, as follows: Mr. Cook - 52,500 shares; Mr. Yavorsky - 20,000 shares; Ms. Peniche - 45,000 shares; Dr. Vondrak - 101,250 shares; Messrs. Brewton, Crosby, Marxen, and Waddell - 6,250 shares each; Mr. Sherrill - 10,625 shares; Mr. Syverson - 75,000 shares; and Mr. Walton - 63,750 shares. In addition, the shares shown for Mr. Sherrill include 60,000 shares subject to an outstanding exercisable warrant. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS INDEBTEDNESS OF MANAGEMENT On September 8, 1998, the Company loaned $500,000 to Dr. John G. Vondrak, the Company's Chairman of the Board, pursuant to a promissory note that bears interest at 8.5% per annum and is payable in full on September 9, 2000 (the "Promissory Note"). The Promissory Note is secured by a security interest in 250,000 shares of Class A or B common stock of the Company pursuant to a stock pledge agreement. On September 10, 1998, the Company and Dr. Vondrak executed an amendment to Dr. Vondrak's employment agreement to recognize Dr. Vondrak's change in title and responsibilities with the Company as well as to modify certain of the terms of compensation in the event Dr. Vondrak's employment with the Company is terminated. The Company also advanced $134,000 to Dr. Vondrak for payment of legal fees during 1998. These advances bear interest at the prime rate minus 200 basis points. AGREEMENT WITH INFOCURE Mr. Douglass, the Company's Chief Executive Officer, President and a director, has a financial interest in and is the business partner of the chairman of the board of directors of one of the Company's primary practice management software vendors ("Infocure"). Prior to hiring Mr. Douglass, the Company had entered into a software development, license and support agreement (the "License Agreement") with Infocure. The License Agreement provided for, among other things, the scheduled payment by the Company of $2.5 million in license fees through January 2001. As of December 31, 1998, the Company owed $375,000 under the License Agreement plus a termination fee of 49 $175,000 had it chosen to terminate the License Agreement. As of March 1999, the Company owed $666,000 under the License Agreement plus a termination fee of $125,000 had it chosen to terminate the License Agreement. Mr. Douglass has negotiated an oral amendment to the License Agreement to limit the total license fees to $500,000 (of which $250,000 had been paid at December 31, 1998) in return for nine licenses (the "License Agreement Amendment"). As of April 14, 1999, the License Agreement Amendment had not been executed. 50 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a)(1) FINANCIAL STATEMENTS Report of Independent Accountants Consolidated Balance Sheets as of December 31, 1998 and 1997 Consolidated Statements of Operations for the Years Ended December 31, 1998 and 1997 and the period from inception (July 15, 1996) through December 31, 1996 Consolidated Statements of Changes in Stockholders' Equity (Deficit) for the Years Ended December 31, 1998 and 1997 and the period from inception (July 15, 1996) through December 31, 1996 Consolidated Statements of Cash Flows for the Years Ended December 31, 1998 and 1997 and the period from inception (July 15, 1996) through December 31, 1996 Notes to Consolidated Financial Statements (s)(2) FINANCIAL STATEMENT SCHEDULES All schedules and other statements for which provision is made in the applicable regulations of the Commission have been omitted because they are not required under the relevant instructions or are inapplicable. (A)(3) EXHIBITS EXHIBIT DESCRIPTION ------- ---------------------------------------------------------------- *3.1 Restated Certificate of Incorporation (Incorporated herein by reference to Exhibit 3.1 of the Company's Registration Statement on Form S-1 (Registration No. 333-22785)). *3.2 Bylaws (Incorporated herein by reference to Exhibit 3.2 of the Company's Registration Statement on Form S-1 (Registration No. 333-22785)). *4.1 Form of certificate evidencing ownership of Common Stock of Apple Orthodontix, Inc. (Incorporated herein by reference to Exhibit 4.1 of the Company's Registration Statement on Form S-1 (Registration No. 333-22785)). *4.2 Form of Registration Rights Agreement (Incorporated herein by reference to Exhibit 4.1 of the Company's Registration Statement on Form S-1 (Registration No. 333-22785)). *4.3 Registration Rights Agreement among Apple Orthodontix, Inc., John G. Vondrak, D.D.S. and TriCap Funding I, L.L.C. (Incorporated herein by reference to Exhibit 4.3 of the Company's Registration Statement on Form S-1 (Registration No. 333-22785)). *4.4 Registration Rights Agreement between TriCap Partners, L.L.C. and Apple Orthodontix, Inc. (Incorporated herein by reference to Exhibit 4.4 of the Company's Registration Statement on Form S-1 (Registration No. 333-22785)). *10.1 Revolving Credit Facility with Chase Bank of Texas, N.A. (formerly named "Texas Commerce Bank, N.A.") (Incorporated herein by reference to Exhibit 10.1 of the Company's Registration Statement on Form S-1 (Registration No. 333-38817)). +*10.2 Apple Orthodontix, Inc. 1997 Stock Compensation Plan (Incorporated herein by reference to Exhibit 10.2 of the Company's Registration Statement on Form S-1 (Registration No. 333-38817)). *10.3 Form of Option Agreement for the Apple Orthodontix, Inc. 1997 Stock Compensation Plan (Incorporated herein by reference to Exhibit 10.3 of the Company's Registration Statement on Form S-1 (Registration No. 333-38817)). 51 EXHIBIT DESCRIPTION -------- ------------------------------------------------------------------ +*10.4 Employment Agreement between Apple Orthodontix, Inc. and John G. Vondrak, D.D.S. (Incorporated herein by reference to Exhibit 10.2 of the Company's Registration Statement on Form S-1 (Registration No. 333-22785)). +*10.5 Employment Agreement between Apple Orthodontix, Inc. and Robert J. Syverson (Incorporated herein by reference to Exhibit 10.3 of the Company's Registration Statement on Form S-1 (Registration No. 333-22785)). +*10.6 Employment Agreement between Apple Orthodontix, Inc. and Michael W. Harlan (Incorporated herein by reference to Exhibit 10.4 of the Company's Registration Statement on Form S-1 (Registration No. 333-22785)). +*10.7 Employment Agreement between Apple Orthodontix, Inc. and W. Daniel Cook (Incorporated herein by reference to Exhibit 10.5 of the Company's Registration Statement on Form S-1 (Registration No. 333-22785)). +*10.8 Employment Agreement of H. Steven Walton (Incorporated herein by reference to Exhibit 10.7 of the Company's Registration Statement on Form S-1 (Registration No. 333-22785)). +*10.9 Amendment to Employment Agreement of H. Steven Walton (Incorporated herein by reference to Exhibit 10.9 of the Company's Registration Statement on Form S-1 (Registration No. 333-38817)). +*10.10 Second Amendment to Employment Agreement of H. Steven Walton (Incorporated herein by reference to Exhibit 99.2 of the Company's Current Report on Form 8-K dated February 24, 1998). *10.11 Form of Service Agreement for Founding Affiliated Practices (Incorporated herein by reference to Exhibit 10.8 of the Company's Registration Statement on Form S-1 (Registration No. 333-22785)). *10.12 Form of Alternative Service Agreement for Founding Affiliated Practices (Incorporated herein by reference to Exhibit 10.6 of the Company's Registration Statement on Form S-1 (Registration No. 333-22785)). *10.13 Form of Flat Fee Service Agreement for Founding Affiliated Practices (Incorporated herein by reference to Exhibit 10.11 of the Company's Registration Statement on Form S-1 (Registration No. 333-22785)). +*10.14 First Amendment to Employment Agreement of Robert J. Syverson (Incorporated herein by reference to Exhibit 99.1 of the Company's Current Report on Form 8-K dated February 24, 1998). +*10.15 Employment Agreement between Apple Orthodontix, Inc. and A Stone Douglass, dated August 6, 1998 (incorporated herein by reference to Exhibit 10.1 of the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1998). +*10.16 Employment Agreement between Apple Orthodontix, Inc. and James E. Bobbitt, dated August 11, 1998 (incorporated herein by reference to Exhibit 10.2 of the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1998). +*10.17 Agreement Regarding Termination of Employment between Apple Orthodontix, Inc. and Michael W. Harlan, dated August 11, 1998 (incorporated herein by reference to Exhibit 10.3 of the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1998). +*10.18 Agreement Regarding Termination of Employment and Severance Benefits between Apple Orthodontix, Inc. and H. Steven Walton, dated May 6, 1998 (incorporated herein by reference to Exhibit 10.4 of the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1998). +*10.19 Consulting Agreement between Apple Orthodontix, Inc. and Michael W. Harlan, dated August 11, 1998 (incorporated herein by reference to Exhibit 10.5 of the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1998). +*10.20 Promissory Note between Apple Orthodontix, Inc. and John G. Vondrak, dated September 8, 1998 (incorporated herein by reference to Exhibit 10.6 of the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1998). +*10.21 Stock Pledge Agreement between Apple Orthodontix, Inc. and John G. Vondrak, dated September 9, 1998 (incorporated herein by reference to Exhibit 10.7 of the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1998). +*10.22 Amendment to Employment Agreement of John G. Vondrak, dated September 10, 1998 (incorporated herein by reference to Exhibit 10.9 of the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1998). 52 +*10.23 Amendment to Employment Agreement of A. Stone Douglass, dated November 23, 1998. (incorporated by reference to Exhibit 10.23 of the Company's Annual Report on Form 10-K for the year ended December 31, 1998.) +*10.24 Amendment to Employment Agreement of James E. Bobbitt, dated November 23, 1998. (incorporated by reference to Exhibit 10.24 of the Company's Annual Report on Form 10-K for the year ended December 31, 1998.) *10.25 First Amendment to Credit Agreement with Chase Bank of Texas, N.A., dated May 21, 1998. (incorporated by reference to Exhibit 10.25 of the Company's Annual Report on Form 10-K for the year ended December 31, 1998.) +10.26 Agreement Regarding Termination of Employment and Severance Benefits between Apple Orthodontix, Inc. and Robert J. Syverson, dated May 20, 1998. 10.27 Second Amendment and Waiver to Credit Agreement with Chase Bank of Texas, N.A., dated April 14, 1999. *21.1 Subsidiaries of the Registrant (incorporated by reference to Exhibit 21.1 of the Company's Annual Report on Form 10-K/A (Amendment No. 2) for the year ended December 31, 1997). 23.1 Consent of Arthur Andersen LLP. 27.1 Financial Data Schedule. - ------------- * Incorporated herein by reference as indicated. + Management contract or compensatory plan or arrangement required to be filed as an exhibit pursuant to the requirements of Item 14(c) of Form 10-K. (b) REPORTS ON FORM 8-K None. 53 SIGNATURES PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED. APPLE ORTHODONTIX, INC. By: /s/ JAMES E. BOBBITT James E. Bobbitt Vice President and Chief Financial Officer Date: April 29, 1999 54 EX-10.26 2 AGREEMENT REGARDING TERMINATION OF EMPLOYMENT AND SEVERANCE BENEFITS WHEREAS, Robert J. Syverson ("Syverson") and Apple Orthodontix, Inc. ("Apple") have heretofore entered into an agreement dated December 6, 1996 pursuant to which Apple employed Syverson and thereafter amended such employment agreement in certain respects (the amended employment agreement being hereafter referred to as the "Employment Agreement"); and WHEREAS, Apple has terminated Syverson's employment effective as of May 4, 1998; and WHEREAS, Syverson and Apple have agreed to certain commitments and understandings regarding the severance benefits which he is owed as a result of Apple's termination of his employment and desire to evidence such understandings pursuant to this agreement; NOW, THEREFORE, Syverson and Apple agree as follows: 1. Apple agrees that Syverson's termination of employment by Apple is without Cause (as such term is defined in the Employment Agreement) for all purposes of the Employment Agreement. 2. In lieu of the benefits which otherwise would be payable by Apple to Syverson pursuant to Section 5(E)(i) and Section 5(E)(iv) of the Employment Agreement, Syverson agrees to accept and Apple agrees to pay to Syverson a total cash severance benefit payment in the amount of $775,000.00 payable by direct deposit to Syverson's bank account in accordance with the direct deposit instructions in effect on May 4, 1998 with Apple's payroll department as follows: $387,500 no later than 5:00 p.m. Central Standard Time on May 20th, 1998 and $387,500 no later than 5:00 p.m. Central Standard Time on July 1, 1998. 3. Apple agrees that, in accordance with prior agreements, the forfeiture restrictions upon all shares of Apple stock heretofore transferred to Syverson shall lapse as of the date of this agreement and that a certificate evidencing such shares shall be transferred to Syverson upon execution of this agreement. 4. Upon the occurrence of a "Change of Control" of Apple, all payments then remaining payable pursuant to paragraph 2 above of this agreement shall become immediately due and payable. For purposes of this paragraph 4, "Change of Control" means the occurrence of any of the following events: (a) any Person becomes an Acquiring Person; (b) at any time the then Continuing Directors cease to constitute a majority of the members of the Board; (c) a merger of Apple with or into, or a sale by Apple of its properties and assets substantially as an entirety to, another Person occurs and, immediately after that occurrence, any Person, other than an Exempt Person, together with all Affiliates and Associates of such Person, shall be the Beneficial Owner of twenty-five percent (25%) or more of the total voting power of the then outstanding Voting Shares of the Person surviving that transaction (in the case or a merger or consolidation) or the Person acquiring those properties and assets substantially as an entirety. For purposes of the preceding definition of "Change of Control", the following terms shall have the following meanings: (i) "Acquiring Person" means any Person who or which, together with all Affiliates and Associates of such Person, is or are the Beneficial Owner of twenty-five percent (25%) or more of the shares of Common Stock then outstanding, but does not include any Exempt Person; provided, however, that a Person shall not be or become an Acquiring Person if such Person, together with its Affiliates and Associates, shall become the Beneficial Owner of twenty-five percent (25%) or more of the shares of Common Stock then outstanding solely as a result of a reduction in the number of shares of Common Stock outstanding due to the repurchase of Common Stock by Apple, unless and until such time as such Person or any Affiliate or Associate of such Person shall purchase or otherwise become the Beneficial Owner of additional shares of Common Stock constituting one percent (1%) or more of the then outstanding shares of Common Stock or any other Person (or Persons) who is (or collectively are) the Beneficial Owner of shares of Common Stock constituting one percent (1%) or more of the then outstanding shares of Common Stock shall become an Affiliate or Associate of such Person, unless, in either such case, such Person, together with all Affiliates and Associates of such Person, is not then the Beneficial Owner of twenty-five percent (25%) or more of the shares of Common Stock then outstanding. (ii) "Affiliate" has the meaning ascribed to that term in the Securities Exchange Act of 1934 Rule 12b-2. (iii) "Associate" means, with reference to any Person, (a) any corporation, firm, partnership, association, unincorporated organization or other entity (other than Apple or a subsidiary of Apple) of which that Person is an officer or general partner (or officer or general partner of a general partner) or is, directly or indirectly, the Beneficial Owner of 10% or more of any class of its equity securities, (b) any trust or other estate in which that Person has a substantial beneficial interest or for or of which that Person serves as trustee or in a similar fiduciary capacity, (c) any relative or spouse of that Person, or any relative of that spouse, who has the same home as that Person and (d) any stockholder, partner or owner of any equity in such Person. (iv) "Board" means the board of directors of Apple. (v) "Common Stock" means the common stock of Apple. (vi) "Continuing Director" means at any time any individual who then (a) is a member of the Board and was a member of the Board as of May 4, 1998 or whose nomination for his first election, or that first election, to the Board following that date was recommended or approved by a majority of the then Continuing Directors (acting separately or as a part of any action taken by the Board or any committee thereof) and (b) is not an Acquiring Person, an Affiliate or Associate of an Acquiring Person or a nominee or representative of an Acquiring Person or of any such Affiliate or Associate. (vii) "Exempt Person" means (a) (1) Apple, any subsidiary of Apple, any employee benefit plan of Apple or of any subsidiary of Apple and (2) any Person organized, appointed or established by Apple for or pursuant to the terms of any such plan or for the purpose of funding any such plan or funding other employee benefits for employees of Apple or any subsidiary of Apple and (b) Syverson, any Affiliate or Associate of Syverson or any group (as that term is used in the Securities Exchange Act of 1934 Rule 13d-5(b)) of which Syverson or any Affiliate or Associate of Syverson is a member. (viii) "Person" means any natural person, sole proprietorship, corporation, partnership of any kind having a separate legal status, limited liability company, business trust, unincorporated organization or association, mutual company, joint stock company, joint venture, estate, trust, union or employee organization or governmental authority. (ix) "Voting Shares" means: (a) in the case of any corporation, stock of that corporation of the class or classes having general voting power under ordinary circumstances to elect a majority of that corporation's board of directors; and (b) in the case of any other entity, equity interests of the class or classes having general voting power under ordinary circumstances equivalent to the Voting Shares of a corporation. 5. Should any payments made by Apple to Syverson pursuant to this agreement or resulting from or in connection with his prior employment with Apple, singly, in any combination or in the aggregate, to or for the benefit of Syverson be determined or alleged to be subject to an excise or similar purpose tax pursuant to Section 4999 of the Internal Revenue Code of 1986, as amended (the "Code"), or any successor or other comparable federal, state or local tax law by reason of being a "parachute payment" (within the meaning of Section 280G of the Code), Apple shall pay to Syverson such additional compensation as is necessary (after taking into account all federal, state and local taxes payable by Syverson as a result of the receipt of such additional compensation) to place Syverson in the same after-tax position (including federal, state and local taxes) he would have been in had no such excise or similar purpose tax (or interest or penalties thereon) been paid or incurred. Apple hereby agrees to pay such additional compensation within the earlier to occur of (i) five (5) business days after Syverson notifies Apple that Syverson intends to file a tax return taking the position that such excise or similar purpose tax is due and payable in reliance on a written opinion of Syverson's tax counsel (such tax counsel to be chosen solely by Syverson) that it is more likely than not that such excise tax is due and payable or (ii) twenty-four (24) hours of any notice of or action by Apple that it intends to take the position that such excise tax is due and payable. The costs of obtaining the tax counsel opinion referred to in clause (i) of the preceding sentence shall be borne by Apple, and as long as such tax counsel was chosen by Syverson in good faith, the conclusions reached in such opinion shall not be challenged or disputed by Apple. If Syverson intends to make any payment with respect to any such excise or similar purpose tax as a result of an adjustment to Syverson's tax liability by any federal, state or local tax authority, Apple will pay such additional compensation by delivering its cashier's check payable in such amount to Syverson within five (5) business days after Syverson notifies Apple of his intention to make such payment. Without limiting the obligation of Apple hereunder, Syverson agrees, in the event Syverson makes any payment pursuant to the preceding sentence, to negotiate with Apple in good faith with respect to procedures reasonably requested by Apple which would afford Apple the ability to contest the imposition of such excise or similar purpose tax; provided, however, that Syverson will not be required to afford Apple any right to contest the applicability of any such excise or similar purpose tax to the extent that Syverson reasonably determines (based upon the opinion of his tax counsel) that such contest is inconsistent with the overall tax interests of Syverson. 6. In entering into this agreement Apple intends that Syverson receive without reduction or delay all the intended benefits of this agreement and that those benefits, and the terms and conditions hereof, be construed in a manner most favorable to Syverson; Apple, therefore, agrees that it will strive expeditiously and in good faith to construe and resolve in Syverson's favor and to his benefit any ambiguities or uncertainties that may be created by the express language hereof. If, however, at any time during the term hereof or afterwards: (i) there should exist a dispute or conflict between Syverson and Apple or another person or entity as to the validity, interpretation or application of any term or condition hereof, or as to Syverson's entitlement to any benefit intended to be bestowed hereby, which is not resolved to the satisfaction of Syverson, (ii) Syverson must (a) defend the validity of this agreement, (b) contest any determination by Apple concerning the amounts payable (or reimbursable) by Apple to Syverson, or (c) determine in any tax year of Syverson the tax consequences to Syverson of any amounts payable (or reimbursable) under Paragraph 5, or (iii) Syverson must prepare responses to an Internal Revenue Service ("IRS") audit of, or otherwise defend, his personal income tax return for any year the subject of any such audit, or an adverse determination, administrative proceedings or civil litigation arising therefrom that is occasioned by or related to an audit by the IRS of Apple's income tax returns, then Apple hereby unconditionally agrees: (a) On written demand of Apple by Syverson, to provide sums sufficient to advance and pay on a current basis (either by paying directly or by reimbursing Syverson) not less than thirty (30) days after a written request therefor is submitted by Syverson, Syverson's out of pocket costs and expenses (including attorney's fees, expenses of investigation, travel, lodging, copying, delivery services and disbursements for the fees and expenses of experts, etc.) incurred by Syverson in connection with any such matter; (b) Syverson shall be entitled, upon application to any court of competent jurisdiction, to the entry of a mandatory injunction without the necessity of posting any bond with respect thereto which compels Apple to pay or advance such costs and expenses on a current basis; and (c) Apple's obligations under this Paragraph 6 will not be affected if Syverson is not the prevailing party in the final resolution of any such matter. 7. Apple agrees to pay all legal and other fees, costs and expenses incurred by Syverson in connection with the termination of his employment with Apple including fees, costs and expenses incurred by Syverson in connection with and the negotiation and implementation of this agreement and certain other proposed but ultimately not consummated agreements. 8. Time is of the essence of this agreement. Overdue payments under this agreement shall accrue interest at a rate of 18% per annum through the date of full and complete payment. Any failure by Apple to pay any amounts due under this agreement that continues for more than 10 business days shall constitute a material breach by Apple of this agreement and all then remaining payable pursuant to paragraph 2 of this agreement shall thereupon be accelerated and shall be immediately due and payable. 9. Syverson shall be indemnified by Apple with respect to his prior employment with Apple to the maximum extent permitted by the laws of Delaware, the state of Apple's incorporation, and the laws of the state of incorporation of any subsidiary of Apple of which Syverson is or at any time was a director, officer, employee or consultant as same may be in effect from time to time. 10. Syverson waives and releases all rights, claims, charges, demands and causes of action against Apple, its predecessors, successors, parent companies, subsidiaries and affiliates, and its officers, directors, employees, owners, shareholders and agents, of any kind or character, both past and present, known or unknown, including but not limited to those arising under the Age Discrimination in Employment Act of 1967, Title VII of the Civil Rights Act of 1964, and the Employee Retirement Income Security Act of 1974, all as amended, and any other state or federal statute, regulation or the common law (contract, tort or other), which relate to Syverson's employment with Apple prior to May 4, 1998 or termination of such employment, including but not limited to any alleged discriminatory or retaliatory employment practices, any matter relating to or arising under the Employment Agreement or any other matter. Apple understands and agrees that the foregoing waiver and release shall not serve to waive or release any rights or claims that may arise after the date this agreement is executed whether relating to this agreement or otherwise. Apple waives and releases all rights, claims, charges, demands and causes of action against Syverson of any kind or character, both past and present, known or unknown, arising under any state or federal statute, regulation or the common law (contract, tort or other), which relate to Syverson's employment or termination of such employment any matter relating to or arising under the Employment Agreement or any other matter. Syverson understands that the foregoing waiver and release shall not serve to waive or release any rights or claims that may arise after the date this agreement is executed whether relating to this agreement or otherwise. 11. This agreement is entered into under and shall be governed for all purposes by the laws of the State of Texas. 12. No failure by either party hereto at any time to give notice of any breach by the other party of, or to require compliance with, any condition or provision of this agreement shall be deemed a waiver of similar or dissimilar provisions or conditions at the same time or at any prior or subsequent time. 13. If a court of competent jurisdiction determines that any provision of this agreement is invalid or unenforceable, then the invalidity or unenforceability of that provision shall not affect the validity or enforceability of any other provision of this agreement, and all other provisions shall remain in full force and effect. 14. This agreement and the rights and obligations of the parties hereunder are personal, and neither this agreement nor any right, benefit, or obligation of either party hereto shall be subject to voluntary or involuntary assignment, alienation, or transfer, whether by operation of law or otherwise, without the prior written consent of the other party. 15. This agreement represents the entire agreement between the parties hereto with respect to the matters covered herein and may not be changed, altered, or modified in any respect except by an instrument in writing signed by both the parties hereto. 16. Except as specifically set forth in this agreement, Apple agrees that any and all rights and benefits otherwise accruing to or benefitting Syverson under the terms of the Employment Agreement continue to be in full force and effect. IN WITNESS WHEREOF, the parties hereto have caused these presents to be executed this 20th day of May, 1998. APPLE ORTHODONTIX, INC. By: /s/ JOHN G. VONDRAK John G. Vondrak, CEO ________________________________ Robert J. Syverson EX-10.27 3 SECOND AMENDMENT AND WAIVER TO CREDIT AGREEMENT This SECOND AMENDMENT AND WAIVER TO CREDIT AGREEMENT is made and entered into effective as of the 31st day of March, 1999 (this "AMENDMENT") among, APPLE ORTHODONTIX, INC., a Delaware corporation (the "COMPANY"), the Subsidiaries of the Company listed on the signature pages hereto as Guarantors (together with each other person who subsequently becomes a Guarantor, collectively the "Guarantors"), the banks and other financial institutions listed on the signature pages hereto under the caption "Banks" (together with each other person who becomes a Bank, collectively the "BANKS") and CHASE BANK OF TEXAS, NATIONAL ASSOCIATION, f/k/a Texas Commerce Bank National Association ("TCB"), individually as a Bank "CHASE", and as agent for the other Banks (in such capacity, together with any other Person who becomes the agent, the "AGENT"). WHEREAS, the Company, the Guarantors, and TCB, both as a Bank and an Agent, entered into that certain Credit Agreement dated as of July 28, 1997 (as amended by that First Amendment to Credit Agreement dated May 21, 1998 and as further amended or restated from time to time, the "CREDIT AGREEMENT"), which Credit Agreement provides for a revolving credit facility pursuant to which TCB and the Banks named therein committed to make loans of up to $25,000,000.00 upon the terms and conditions as provided therein. WHEREAS, TCB has changed its name to Chase, and Chase holds all rights and obligations of TCB in, to and under the Credit Agreement. WHEREAS, the Company has requested the Banks and the Agent to amend the Credit Agreement to waive certain terms thereof and to modify other terms and conditions thereof. WHEREAS, said parties have agreed to do so to the extent reflected in this Amendment, provided the Company and the Guarantors ratify and confirm all of their obligations under the Credit Agreement and the Loan Documents, as well as agree to make certain other amendments as set forth herein. WHEREAS, the Company, the Guarantors, the Banks, and the Agent wish to execute this document to evidence their agreement in regard thereto. NOW, THEREFORE, in consideration of the premises and other good and valuable consideration and the mutual benefits, covenants and agreements herein expressed, the receipt and sufficiency of which are hereby acknowledged, the parties hereto now agree as follows: 1. DEFINED TERMS. All capitalized terms used in this Amendment and not otherwise defined herein shall have the meanings ascribed to such terms in the Credit Agreement. 2. AMENDMENT TO SECTION 1.01. (a) Section 1.01 of the Credit Agreement is hereby amended by deleting and restating the following definitions to read as follow: (i) "'COLLATERAL' means all Collateral described in any of the Security Documents and shall include substantially all of the assets of the Company and each of its Subsidiaries, real and personal, tangible and intangible." (ii) "'DEFAULT RATE' means the lesser of (i) the Highest Lawful Rate and (ii) the Alternate Base Rate plus 3%." (iii) "'DESIGNATED PAYMENT DATE' means the last Business Day of each month." (iv) "'EBITDA' means, for any period, the consolidated pre-tax income for such period, plus the aggregate amount which was deducted for such period in determining such consolidated, pre-tax income in respect of interest expense (including amortization of debt discount, imputed interest and capitalized interest), plus depreciation and amortization, excluding any income attributable to any minority interest in any Person or any Foreign Subsidiaries of the Company (other than Foreign Subsidiaries organized under the laws of Canada or one of its provinces, which Canadian Subsidiaries' EBITDA shall be included in EBITDA), unless remitted to the Company or any of its Subsidiaries that is not a Foreign Subsidiary. (v) "MARGIN" means with respect to any Advance, the percentage determined in accordance with the following table as a function of the Funded Indebtedness to EBITDA ratio: FUNDED INDEBTEDNESS/ ALTERNATE BASE LIBOR RATE EBITDA RATIO RATE MARGIN MARGIN > 3.50 1.50% 3.00% >=3.00 but < 3.50 1.25% 2.75% >= 2.50 but < 3.00 1.00% 2.50% >= 2.00 but < 2.50 0.75% 2.25% >= 1.50 but < 2.00 0.50% 2.00% >= 1.00 but < 1.50 0.25% 1.75% < 1.00 0.00% 1.50% If sufficient information does not exist to calculate the Margin, the Alternate Base Rate Margin shall be 1.50% and the LIBOR Rate Margin shall be 3.00%. (vi) "'MATURITY DATE' means May 31, 2001, or such earlier date determined in accordance with ARTICLE IX hereof." (vii) "'SECURITY DOCUMENTS' means all security agreements, pledge agreements, mortgages, deeds of trust, guaranty agreements, and similar items, and UCC financing statements giving notice thereof, executed by the Company and its Subsidiaries in favor of the Agent for the benefit of the Banks and covering substantially all of the assets of said Persons." (b) Section 1.01 is hereby further amended by adding the following definition thereto in appropriate alphabetical order: "'PRACTICE RECEIVABLE REPORT' has the meaning provided in SECTION 6.01(A)." 3. AMENDMENT TO SECTION 2.11. Section 2.11(a) is hereby amended by deleting the reference to "one, two, three or six month" interest periods contained therein and replacing same with a reference to "one month" interest periods. 4. ADDITION OF SECTION 5.17. A new Section 5.17 is hereby added to the Credit Agreement to read as follows: "Section 5.17 GRANTING OF LIENS ON COLLATERAL. On or before May 15, 1999, the Company will, and will cause each of its Subsidiaries to take such steps, to provide such information and execute such documents as the Agent shall reasonably request to grant to the Agent, for the benefit of the Banks, a first and prior lien and security interest in substantially all of the assets of the Company and each of its Subsidiaries, real and personal, tangible and intangible." 5. AMENDMENT TO SECTION 6.01. Section 6.01 of the Credit Agreement is hereby amended by deleting subsection (a) thereof and replacing it with the following: "(a) As soon as available, and in any event within thirty (30) days after the end of each month and forty-five (45) days after the close of each quarter of each fiscal year, the unaudited consolidated balance sheet of the Company and its Subsidiaries as of the end of such period and the related consolidated statements of income and cash flow for such period, and its practice receivable report, containing a listing of accounts receivable by Practice (the "PRACTICE RECEIVABLE REPORT"), setting forth, in each case, comparative consolidated figures for the related periods in the prior fiscal year, all of which shall be certified by the chief financial officer or chief executive officer of the Company as fairly presenting in all material respects, the financial position of the Company and its Subsidiaries as of the end of such period and the results of their operations for the period then ended in accordance with GAAP, subject to changes resulting from normal year-end audit adjustments and inclusion of abbreviated footnotes; provided, however, that delivery of the Quarterly Report on Form 10-Q of the Company for such quarter period filed with the Securities and Exchange Commission shall be deemed to satisfy the requirements of this SECTION 6.01(A) with regard to the delivery of said Financials." 6. AMENDMENT TO SECTION 7.03 Section 7.03 of the Credit Agreement is hereby amended by adding the following provisions to the end of subsection (e) thereof: "provided, no additional new Indebtedness of more than $200,000.00 may be included from the date of the Second Amendment and thereafter." 7. AMENDMENT TO SECTION 7.04 Section 7.04 of the Credit Agreement is hereby amended by redesignating subsection (d) as subsection (e) thereto and adding a new subsection (d) thereto that reads as follows: "(d) liens in favor of the Agent for the benefit of the Banks." 8. AMENDMENT TO SECTION 7.05 Section 7.05 of the Credit Agreement is hereby amended by: (i) deleting the reference to $750,000.00 in subsection (c) thereof and replacing it with $50,000.00; (ii) deleting subparagraph (d) thereof in its entirety and replacing it with the following: "(d) Investments in all or substantially all of the stock, warrants, stock appreciation rights, other securities and/or other assets of physician practice management entities in the field of dentistry or assets of practicing orthodontists or dentists, (i) in which, in the case of a Subsidiary, the Company directly or indirectly owns a majority of the voting equity in such Person or is the surviving entity, (ii) acquired at a time when no Default or Event of Default exists hereunder and (iii) for which (y) the cash and assumed Indebtedness consideration paid does not exceed $500,000.00 in any one year and (z) total consideration paid, including cash, notes, debt owed by the entity acquired (whether or not assumed by the Company) and the value of stock given to any selling entity for any one such Investment which does not exceed $1,000,000.00 in any one year." ; and (iii) deleting subsection (g) thereof in its entirety and replacing it with the following: "(g) short term advances to Practicing Orthodontists or Practices in the form of: (i) Uncollected Service Fees (as such term is defined in the Practice Receivable Report) of not more than $3,000,000.00 outstanding at any one time, and (ii) Cash Advances in Excess of Cash Profit and Sweep Deficit Account balances (as such terms are defined in the Practice receivable Report) of not more than $4,000,000.00, collectively, outstanding at any one time." 9. AMENDMENT TO SECTION 7.10. Section 7.10 is hereby deleted in its entirety and the following substituted therefor: "Section 7.10 MINIMUM NET WORTH. The Company will not permit its Consolidated Net Worth to be less than the greater of: (a) $29,000,000 or (b) 90% of the actual net worth as of the December 31, 1998, plus, in all cases: (i) 100% of the net proceeds resulting from the issuance of any capital stock by the Company or any Subsidiary subsequent to the Execution Date at any time during the term hereof and (ii) 75% of the consolidated after tax income of the Company and its Subsidiaries (to be adjusted each quarter) for each fiscal year during the term hereof (including any Subsidiaries acquired subsequent hereto)." 10. AMENDMENT TO SECTION 7.11. Section 7.11 is hereby deleted in its entirety and the following substituted therefor: "SECTION 7.11 FUNDED INDEBTEDNESS TO EBITDA RATIO. The Company will not permit the ratio of (i) its total Funded Indebtedness to (ii) EBITDA, calculated for the preceding four (4) fiscal quarters on a rolling four (4) quarter basis, PLUS, (A) during the four (4) fiscal quarters ending on the last day of June, September and December of 1998 and March of 1999, the special, non-recurring charges incurred during the quarter ending June 30, 1998 resulting from severance costs associated with management changes, costs of terminated acquisitions and related items, up to a maximum of $3,745,000, and (B) during the fourth fiscal quarter of 1998 and the first three fiscal quarters of 1999, the special non-recurring charges, including adjustments, of up to $18,811,000 taken during the fourth fiscal quarter of 1998, to be greater than that shown on the following chart: QUARTER ENDING RATIO March 31, 1999 3.1 to 1.0 June 30, 1999 3.4 to 1.0 September 30, 1999 3.75 to 1.0 December 31, 1999 3.75 to 1.0 March 31, 2000 and thereafter 3.0 to 1.0" 11. AMENDMENT TO SECTION 7.12. Section 7.12 is hereby deleted in its entirety and the following substituted therefor: "SECTION 7.12 FIXED CHARGE COVERAGE RATIO. The Company will not permit the ratio of (a) EBITDA calculated for the preceding four (4) quarters on a rolling four (4) quarter basis PLUS (A) during the four (4) fiscal quarters ending on the last day of June, September and December of 1998 and March of 1999, the special, non-recurring charges incurred during the quarter ending June 30, 1998 resulting from severance costs associated with management changes, costs of terminated acquisitions and related items, up to a maximum of $3,745,000, and (B) during the fourth fiscal quarter of 1998 and the first three fiscal quarters of 1999, the special non-recurring charges, including adjustments, of up to $18,811,000 taken during the fourth fiscal quarter of 1998, LESS (C) taxes actually paid during the four (4) most recent quarters, to (b) the sum of: (i) the current portion of long-term debt for the upcoming four (4) fiscal quarters, PLUS (ii) interest expense, PLUS (iii) cash Consolidated Capital Expenditures up to a maximum of $2,000,000.00, both items (ii) and (iii) calculated for the preceding four (4) quarters on a rolling four (4) quarter basis, to be less than 2.0 to 1.0 at any time during the term hereof." 12. AMENDMENT TO SECTION 7.13 Section 7.13 of the Credit Agreement is hereby amended by deleting the reference to $10,000,000 contained therein and replacing it with $2,000,000.00. 13. AMENDMENT OF SECTION 7.16. Section 7.16 is hereby amended by deleting subsection (a) thereof in its entirety. 14. ADDITION OF SECTION 7.17. A new Section 7.17 is hereby added to the Credit Agreement to read as follows: "Section 7.17 MINIMUM QUARTERLY EBITDA. The Company shall not permit EBITDA to be less than the amounts shown on the following chart for the periods indicated: Each Quarter Ending March 31 1,520,000 Each Six Month Period Ending June 30 3,045,000 Each Nine Month Period Ending September 30 4,815,000 Each Year Ending December 31 6,510,000" 15. WAIVER OF CERTAIN DEFAULTS OR EVENTS OF DEFAULT. The following provisions of the Credit Agreement, to the extent they resulted in a Default or an Event of Default thereunder or under any of the Loan Documents, are hereby waived for the period indicated: (i) Sections 7.05(g), 7.10, 7.11 and 7.12 for the period ending December 31, 1999. (ii) Section 7.16 (a) for all periods from the Effective Date through the date of the Second Amendment. (iii) Any Default or Event of Default arising from a calculation of EBITDA that included the results of any Subsidiary located in Canada, for all periods from the Effective Date through the date of the Second Amendment. 16. RATIFICATION. The Company and each Guarantor hereby ratify all of their obligations under the Credit Agreement and the Loan Documents, and agree and acknowledge that the Credit Agreement (including the Guaranty contained therein) and each of the Loan Documents shall continue in full force and effect as amended and modified by this Amendment. Nothing in this Amendment extinguishes, novates or releases any right, claim, lien, security interest or entitlement of any of the Banks created by or contained in any of such documents nor is the Company released from any covenant, warranty or obligation created by or contained therein except as expressly provided herein. 17. REPRESENTATIONS AND WARRANTIES. The Company hereby represents and warrants to the Banks that (a) this Amendment has been duly executed and delivered on behalf of the Company, (b) this Amendment constitutes a valid and legally binding agreement enforceable against the Company in accordance with its terms, (c) the representations and warranties contained in the Credit Agreement and the Loan Documents are true and correct on as of the date hereof in all material respects as though made as of the date hereof except as heretofore otherwise disclosed in writing to the Agent (other than those of such representations and warranties which by their express terms speak to a date on or before the date hereof), (d) no Default exists under the Credit Agreement or any of the Loan Documents and (e) the execution, delivery and performance of this Amendment has been duly authorized by the Company. The Company will, upon request by the Agent, provide satisfactory evidence of items (a) and (e) above. 18. MULTIPLE COUNTERPARTS. This Amendment may be signed in any number of counterparts, each of which may be delivered in original or facsimile form, and each shall be construed as an original, but all of which together shall constitute one and the same instrument. 19. CONDITIONS TO EFFECTIVENESS. This Amendment shall be effective upon (i) the execution hereof by all parties and delivery of signed copies to the Agent, and (ii) receipt by the Agent, for the pro rata benefit of the Banks of an amendment fee equal to .5% of the Total Commitment. 20. CHOICE OF LAW. THIS AMENDMENT SHALL BE DEEMED TO BE A CONTRACT EXECUTED BY THE PARTIES UNDER, AND SHALL BE GOVERNED BY AND CONSTRUED IN ACCORDANCE WITH, THE INTERNAL LAWS OF THE STATE OF TEXAS, EXCEPT TO THE EXTENT THAT THE LAWS OF THE UNITED STATES OF AMERICA AND ANY RULES, REGULATIONS OR ORDERS ISSUED OR PROMULGATED THEREUNDER APPLICABLE TO THE AFFAIRS AND TRANSACTIONS OF ANY BANK OTHERWISE PREEMPT TEXAS LAW, IN WHICH EVENT SUCH FEDERAL LAW SHALL CONTROL. 21. ENTIRE AGREEMENT. THIS AMENDMENT AND THE CREDIT AGREEMENT AND THE OTHER LOAN DOCUMENTS REPRESENT THE FINAL AGREEMENT BETWEEN THE PARTIES AND MAY NOT BE CONTRADICTED BY EVIDENCE OF PRIOR, CONTEMPORANEOUS OR SUBSEQUENT ORAL AGREEMENTS OF THE PARTIES. THERE ARE NO UNWRITTEN ORAL AGREEMENTS BETWEEN THE PARTIES. [SIGNATURES BEGIN ON NEXT PAGE] IN WITNESS WHEREOF, the parties hereto have caused this Amendment to be executed by their respective officers thereunto duly authorized as of the date first above written. COMPANY: APPLE ORTHODONTIX, INC. By: /s/ JAMES E. BOBBITT Name: James E. Bobbitt Title: Vice President and Chief Financial Officer GUARANTORS: APPLE ORTHODONTIX OF TEXAS, INC. By: /s/ JAMES E BOBBITT Name: James E. Bobbitt Title: Vice President and Chief Financial Officer AGENT: CHASE BANK OF TEXAS, NATIONAL ASSOCIATION By: /s/ MICHAEL E. ONDRUCH Michael E. Ondruch Vice President BANKS Amount of Commitment: CHASE BANK OF TEXAS, NATIONAL $15,000,000.00 ASSOCIATION By: /s/ MICHAEL E. ONDRUCH Michael E. Ondruch Vice President ADDRESS: 712 Main Street Houston, Texas 77002 Telephone No.: (713) 216-5324 Telecopy No.: (713) 216-6004 Attention: Michael E. Ondruch DOMESTIC LENDING OFFICE See above EURODOLLAR LENDING OFFICE See above BANKS Amount of Commitment: PARIBAS $10,000,000.00 By: /s/ GLENN E. MEALEY Name: Glenn E. Mealey Title: Managing Director By: /s/ ROSINE K. MATTHEWS Name: Rosine K. Matthews Title: Vice President ADDRESS: 2 Allen Center, Suite 3100 Houston, Texas 77002 Telephone No.: (713) 659-4811 Telecopy No.: (713) 659-5234 Attention: DOMESTIC LENDING OFFICE See above EURODOLLAR LENDING OFFICE See above EX-23.1 4 EXHIBIT 23.1 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the incorporation of our report dated April 14, 1999 included in this Form 10-K/A, into the Company's previously filed Registration Statements on Form S-4, File No. 333-28937 and Form S-8, File No. 333-38077. /s/ ARTHUR ANDERSEN LLP Houston, Texas April 29, 1999 EX-27.1 5
5 12-MOS DEC-31-1998 DEC-31-1998 755 0 11,306 (5,785) 0 9,335 8,019 (1,370) 71,462 6,722 0 0 0 14 29,674 71,462 0 53,302 0 64,026 77 0 394 (16,826) (6,496) (10,330) 0 0 0 (10,330) (.75) (.75)
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