S-1 1 ds1.htm FORM S-1 REGISTRATION STATEMENT Form S-1 Registration Statement
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As filed with the Securities and Exchange Commission on December 29, 2005

Registration No. 333-          


UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 


 

FORM S-1

REGISTRATION STATEMENT

UNDER

THE SECURITIES ACT OF 1933

 


 

VERICHIP CORPORATION

(Exact name of registrant as specified in its charter)

 


 

Delaware   3669   06-1637809

(State or other jurisdiction of

incorporation or organization)

 

(Primary Standard Industrial

Classification Code Number)

 

(I.R.S. Employer

Identification Number)

 

1690 South Congress Avenue, Suite 200

Delray Beach, Florida 33445

(561) 805-8008

(Address, including zip code, and telephone number, including area code, of registrant’s principal executive offices)

 

Kevin H. McLaughlin

Chief Executive Officer

VeriChip Corporation

1690 South Congress Avenue, Suite 200

Delray Beach, Florida 33445

(561) 805-8008

(Name, address, including zip code, and telephone number, including area code, of agent for service)

 


 

Copies to:

 

Seth R. Molay, P.C.

Will Liebmann, Esq.

Akin Gump Strauss Hauer & Feld LLP

1700 Pacific Avenue

Suite 4100

Dallas, Texas 75201

(214) 969-2800

  

Selim Day, Esq.

Wilson Sonsini Goodrich & Rosati

Professional Corporation

12 East 49th Street, 30th Floor

New York, New York 10017

(212) 999-5800

  

Donna M. Petkanics, Esq.

Wilson Sonsini Goodrich & Rosati

Professional Corporation

650 Page Mill Road

Palo Alto, California 94304

(650) 493-9300

 

Approximate date of commencement of proposed sale to the public: As soon as practicable after the effective date of this Registration Statement.

 


 

If any of the securities being registered on this form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933 check the following box.  ¨

 

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

 

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

 

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

 


 

CALCULATION OF REGISTRATION FEE(1)

 


Title of Each Class of

Securities to be Registered

  

Proposed Maximum
Aggregate

Offering Price(2)

   Amount of
Registration Fee

Common Stock, $0.0015 par value per share

   $ 45,750,000    $ 4,895

(1) In accordance with Rule 457(o) under the Securities Act, the number of shares being registered and the proposed maximum offering price per share are not included in this table.
(2) Estimated solely for the purpose of calculating the registration fee pursuant to Rule 457(o) promulgated under the Securities Act of 1933, as amended.

 

The registrant hereby amends this registration statement on such date or dates as may be necessary to delay its effective date until the registrant shall file a further amendment which specifically states that this registration statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the registration statement shall become effective on such date as the Securities and Exchange Commission, acting pursuant to said Section 8(a), may determine.



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The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any state or other jurisdiction where the offer or sale is not permitted.

SUBJECT TO COMPLETION, DATED DECEMBER 29, 2005

 

                     Shares

 

LOGO

 

VERICHIP CORPORATION

 

Common Stock

 

This is our initial public offering of shares of our common stock. We are offering              shares. We expect the initial public offering price to be between $             and $             per share.

 

Currently no public trading market exists for shares of our common stock. We intend to apply to have our common stock quoted on the Nasdaq National Market under the symbol “CHIP.”

 


 

Investing in our common stock involves risks.

See “ Risk Factors” beginning on page 5 of this prospectus.

 


 

Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense.

 

     Per Share

   Total

Public offering price

   $                                $                            

Underwriting discount and commissions

   $                                $                            

Proceeds to VeriChip Corporation

   $                                $                            

 

VeriChip Corporation has granted the underwriters a 30-day option to purchase up to an additional              shares of common stock to cover over-allotments.

 

Merriman Curhan Ford & Co.    
    Kaufman Bros., L.P.

 

The date of this Prospectus is                     , 2006


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LOGO


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You should rely only on the information contained in this prospectus. We have not authorized anyone to provide you with information different from that contained in this prospectus. We are offering to sell, and seeking offers to buy, shares of common stock only in jurisdictions where offers and sales are permitted. The information contained in this prospectus is accurate only as of the date of this prospectus regardless of the time of delivery of this prospectus or of any sale of our common stock. Our business, financial condition, results of operations and prospects may have changed since that date. In this prospectus, “VeriChip,” “we,” “us,” and “our” refer to VeriChip Corporation, a Delaware corporation.

 


 

TABLE OF CONTENTS

 

     Page

Prospectus Summary

   1

Risk Factors

   5

Special Note Regarding Forward-Looking Statements

   16

Use of Proceeds

   17

Dividend Policy

   17

Capitalization

   18

Dilution

   19

Selected Consolidated Financial Data

   21

Unaudited Pro Forma Condensed Combined Financial Statements

   22

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   27

Our Business

   42

Management

   58

Certain Relationships and Related Party Transactions

   71

Principal Stockholders

   74

Description of Capital Stock

   75

Shares Eligible for Future Sale

   80

Material United States Tax Considerations for Non-United States Holders

   82

Underwriting

   86

Legal Matters

   89

Experts

   89

Where You Can Find More Information

   90

 


 

Assetrac, Hugs, WatchMate, Roam Alert, Blastmate and MiniMate are our registered trademarks and HALO, VeriMed, VeriChip, VeriGuard, and HOUNDware are our trademarks. This prospectus contains trademarks and tradenames of other corporations and organizations.

 

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PROSPECTUS SUMMARY

 

This summary highlights information contained elsewhere in this prospectus and it may not contain all of the information that is important to you. You should read the entire prospectus carefully, including the section entitled “Risk Factors” and our consolidated financial statements and the related notes included elsewhere in this prospectus, before making an investment decision.

 

Our Company

 

We develop, market and sell radio frequency identification, or RFID, systems used to identify, locate and protect people and assets. Our goal is to become the leading provider of RFID systems for people in the healthcare industry. We sell passive RFID systems for identification purposes and active RFID systems for location and identification purposes. We have recently begun to market our VeriMed patient identification system which is used to rapidly and accurately identify people who arrive in an emergency room and are unable to communicate. Our VeriMed patient identification system uses the first human-implantable passive RFID microchip, the VeriChip, cleared for medical use in October 2004 by the United States Food and Drug Administration, or FDA.

 

We believe that our patient identification solution is compelling for emergency room physicians as well as for patients who have cognitive impairment, chronic diseases or implanted medical devices. Using our scanners, an emergency room physician can rapidly obtain the patient’s name, primary care physician, emergency contact and other pertinent pre-approved data, such as personal health records. We expect that this rapid and accurate identification process will reduce the risk of a patient being misdiagnosed and the potential liability associated with medical errors.

 

Our active RFID systems have been installed in over 4,000 healthcare locations throughout North America. We intend to leverage our domain expertise in marketing and selling RFID systems to healthcare institutions to market and sell our VeriMed patient identification system to our existing customers as well as to new customers. As of December 15, 2005, 66 hospitals have agreed to implement our VeriMed patient identification system in their emergency rooms.

 

In addition to our VeriMed patient identification system, we market and sell other RFID systems for other applications in the healthcare industry as well as for security and industrial applications. These RFID systems include:

 

    infant protection systems used to prevent mother-baby mismatching and infant abduction;

 

    wander prevention systems used for protection and location of residents in long-term care facilities;

 

    asset location and identification systems used to locate and identify medical equipment;

 

    asset management systems that also incorporate bar code technology used to track mobile assets, equipment and inventory; and

 

    other systems incorporating the implantable VeriChip used for security purposes such as access control, payment verification and military applications.

 

In addition to our RFID systems, we market and sell systems providing engineering, construction and mining professionals with an accurate and efficient means to monitor and document the effects of human-induced vibrations on neighboring structures in an area where blasting occurs.

 

 

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Our Strategy

 

Our objective is to become the leading provider of RFID systems for people in healthcare. To achieve this goal, we intend to pursue the following strategies:

 

    establish our VeriMed patient identification system as the leading patient identification solution in the healthcare industry;

 

    leverage our proprietary technology platform to increase a barrier to entry for our competitors;

 

    market and sell our systems internationally through distribution relationships;

 

    address additional strategic markets for the implantable VeriChip; and

 

    pursue complementary acquisitions.

 

Our History

 

We were formed as a Delaware corporation by our parent, Applied Digital Solutions, Inc., or Applied Digital, in November 2001. We expanded our business during 2005 through two acquisitions. On March 31, 2005, Applied Digital acquired eXI Wireless Inc., a Canadian corporation, which was formed in 1996, and contributed eXI Wireless to us in consideration for 3.3 million shares of our common stock. Subsequent to the acquisition, eXI Wireless was renamed VeriChip Inc., or VCI. In June 2005, VCI acquired Instantel Inc., a British Columbia corporation, for total consideration of approximately $25 million, of which Applied Digital contributed $22.3 million. Instantel was formed in 1982.

 

Risks Affecting Us

 

We are subject to a number of risks that you should be aware of before you decide to buy our common stock. We have not achieved profitability. Our cumulative net losses as of September 30, 2005 were approximately $7.7 million. We have not generated any revenue from our VeriMed patient identification system. While we expect that sales of our VeriMed patient identification system will generate a significant portion of our revenue in the future, we cannot assure you that they will. It is possible that we may never successfully commercialize our VeriMed patient identification system and that we may never become profitable. You should read the discussion in the “Risk Factors” section of this prospectus for more information.

 

About Us

 

Our principal executive offices are located at 1690 South Congress Avenue, Suite 200, Delray Beach, Florida 33445. Our telephone number is (561) 805-8008. Our web site is http://www.verichipcorp.com. The information found on our web site is not part of this prospectus.

 

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The Offering

 

Common stock to be offered

                     shares (plus an additional                  shares if the underwriters exercise their over-allotment option in full)

 

Common stock outstanding after this offering

                     shares

 

Directed share program

At our request, the underwriters intend to reserve up to     % of the shares in this offering for sale at the initial public offering price to persons who are stockholders of our parent company, Applied Digital. The number of shares of our common stock available for sale to the general public will be reduced by the number of directed shares purchased by participants in the program.

 

Use of proceeds

We intend to use approximately $                 million of the net proceeds from this offering to repay our outstanding indebtedness owed to Applied Digital at the time of the consummation of this offering and approximately $1.0 million to reimburse Applied Digital for a portion of the purchase price paid to acquire Instantel, with the remaining proceeds to be used for general corporate purposes, which may include research and development, capital expenditures and sales and marketing, including marketing of our VeriMed patient identification system to hospitals and physicians. You should read the discussion in the “Use of Proceeds” section of this prospectus for more information.

 

 

Risk factors

You should read the “Risk Factors” section and the other information in this prospectus for a discussion of the factors that you should consider before you decide to invest in our common stock.

 

Proposed Nasdaq National Market symbol

CHIP

 

Unless otherwise indicated, the number of shares of our common stock outstanding after the offering is based on shares outstanding as of December 15, 2005. This information excludes:

 

    6,097,133 shares of our common stock issuable upon the exercise of outstanding options under our stock plans at a weighted average exercise price of $0.62 per share;

 

    636,201 additional shares of our common stock reserved for future issuances under our stock plans;

 

    66,667 shares of our common stock issuable upon the exercise of outstanding options that were issued outside of our stock plans at an exercise price of $1.82 per share;

 

    1,332,667 shares of our common stock issuable upon the exercise of outstanding warrants at a weighted average exercise price of $0.97 per share; and

 

                         shares of our common stock issuable to Perceptis, L.P., the former indirect beneficial owner of all of Instantel’s ordinary shares, upon the consummation of this offering in exchange for certain shares of Applied Digital that it owns.

 

Except as otherwise indicated in this prospectus, information in this prospectus:

 

    gives effect to a 2-for-3 reverse stock split effectuated on December 20, 2005; and

 

    assumes that the underwriters do not exercise their over-allotment option to purchase additional shares in the offering.

 

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SUMMARY CONSOLIDATED FINANCIAL DATA

 

You should read the following summary consolidated financial data in conjunction with our financial statements and related notes, “Selected Consolidated Financial Data,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the “Unaudited Pro Forma Condensed Combined Financial Statements” appearing elsewhere in this prospectus. The statement of operations data for the nine months ended September 30, 2005 and 2004, and the balance sheet data as of September 30, 2005, are derived from our unaudited interim consolidated financial statements. The statements of operations data for the years ended December 31, 2004, 2003, 2002 are derived from our audited financial statements. In the opinion of management, our unaudited interim financial statements include all adjustments, which are only normally recurring adjustments, necessary for a fair presentation of the financial position and results of operations for the unaudited periods. The historical results are not necessarily indicative of results to be expected for future periods and the results for the nine months ended September 30, 2005, are not necessarily indicative of results that may be expected for the entire year ending December 31, 2005. We acquired two significant subsidiaries during the first half of 2005 and, accordingly, our historical results only include their results since their respective dates of acquisition. The pro forma results reflected below give effect to the acquisitions of these two subsidiaries as if they had occurred at the beginning of the respective periods.

 

    Nine Months Ended September 30,

    Year Ended December 31,

 
   

2005

Pro forma(1)


   

2005

Actual


   

2004

Actual


   

2004

Pro forma(1)


   

2004

Actual


   

2003

Actual


   

2002

Actual


 
    (Unaudited)     (Unaudited)     (Unaudited)     (Unaudited)                    
    (in thousands, except per share data)  

Consolidated Statements of Operations Data:

                                                       

Net revenue

  $      17,800     $         9,115     $ 179     $       19,846     $ 247     $ 545     $  

Loss before income taxes

    (3,874 )     (2,740 )     (1,353 )     (1,076 )     (2,011 )     (1,710 )     (1,341 )

Net loss available to common stockholder

    (2,992 )     (2,688 )     (1,353 )     (1,314 )     (2,011 )     (1,710 )     (1,385 )

Net loss per common share-basic and diluted

  $ (0.18 )   $ (0.17 )   $        (0.10 )   $ (0.08 )   $ (0.15 )   $ (0.13 )   $ (0.10 )

(1) See Unaudited Pro Forma Condensed Combined financial statements appearing elsewhere in this prospectus.

 

     At September 30, 2005

     Actual

    Pro forma(1)

  Pro forma
as adjusted(2)


     (Unaudited)          
     (in thousands)          

Consolidated Balance Sheet Data:

                

Cash and cash equivalents

   $             2,103          

Working capital

     (32 )        

Total assets

     49,368          

Total debt

     6,709          

Total stockholder’s equity

     29,955          

(1) The balance sheet data as of September 30, 2005 on a pro forma basis is unaudited and gives effect to the issuance of          shares of our common stock to Perceptis, L.P. upon the consummation of this offering, based on an assumed initial public offering price of $         per share.
(2) The balance sheet data as of September 30, 2005 on a pro forma as adjusted basis is unaudited and gives effect to (i) our receipt of net proceeds from the sale of          shares of common stock in this offering at an assumed initial public offering price of $         per share, after deducting estimated underwriting discounts and commissions and estimated offering expenses and (ii) the receipt and use of proceeds as set forth in the “Use of Proceeds” section of this prospectus.

 

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RISK FACTORS

 

An investment in our common stock involves a high degree of risk. You should carefully consider the following risks described below together with all of the other information in this prospectus, including our consolidated financial statements and the related notes, before making a decision to invest in our common stock. If any of the following risks actually occurs, our business, financial condition and results of operations could materially suffer. In this case, the trading price of our common stock could decline, and you may lose all or part of your investment.

 

Risks Related to Our Business

 

Our VeriMed patient identification system is in the early stage of commercialization and we may never achieve market acceptance or significant product sales of this system.

 

We expect sales of our VeriMed patient identification systems to generate a significant portion of our total revenue in the future. In October 2004, we began marketing our VeriMed patient identification system that involves implanting the implantable VeriChip into people. We have not generated any revenue from the sale of our VeriMed patient identification system. If the market does not accept our VeriMed patient identification system, our anticipated revenue growth attributable to sales of this system may not materialize and our business prospects could be materially adversely affected.

 

Our future growth depends on the adoption of the VeriMed patient identification system by hospitals and physicians.

 

We believe that we must educate hospitals and physicians regarding the benefits of our VeriMed patient identification system. We target our sales efforts to emergency room personnel and to primary care physicians who diagnose and treat patients who have cognitive impairment, chronic diseases or implantable medical devices. If we do not educate hospitals and physicians about the benefits of our VeriMed patient identification system, they may not adopt our system. To date, while over 4,000 health care locations have installed our active RFID systems, only 66 hospitals have agreed to implement our VeriMed patient identification system. In addition, we believe that only an insignificant number of people have been implanted with the implantable VeriChip to date. If we are not successful in educating hospitals and physicians, they may not adopt our system and our ability to increase our revenue may be impaired.

 

Misperceptions about the use of the implantable VeriChip could prevent us from gaining commercial acceptance for our VeriMed and VeriGuard systems.

 

Several of our systems incorporate the implantable VeriChip. The use of the implantable VeriChip, which is used in conjunction with a database containing a patient’s vital statistics and other patient pre-approved information, may give rise to misperceptions about the use, and risk of misuse, of these systems, including misperceptions that the use of these microchips could intrude on privacy or allow “tracking.” The use of the implantable VeriChip in humans is from time to time the subject of negative publicity. This publicity may negatively affect our ability to sell our systems, which may adversely impact our revenues.

 

In addition, we cannot assure you that our business and operations will not be harmed by any misperceptions or negative publicity that prompts legislative or administrative efforts by politicians or groups opposed to the development and use of human-implantable RFID microchips. We cannot assure you that legislative or administrative restrictions directly or indirectly delaying, limiting or preventing the use of human-implantable RFID microchips or the sale, manufacture or use of such systems will not be enacted in the future.

 

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Our ability to compete may decline if we do not adequately protect or enforce our intellectual property rights.

 

Any patents issued to us, or our suppliers, or licensed by us could be challenged, invalidated, infringed, circumvented or held unenforceable. A key patent under our license agreement with Digital Angel Corporation, our affiliate, which we refer to as Digital Angel, that relates to the implantable VeriChip will expire on May 18, 2010. Our ability to successfully commercialize products incorporating the implantable VeriChip will depend in part on our ability to enforce this patent for the remaining life of the patent in both the United States and in other countries. It is possible that the claims issued for this patent and our other patents may not be sufficiently broad to protect our systems we intend to protect with our patents, and may not provide protection against competitive products or otherwise be commercially valuable. In addition, the patents may be challenged, invalidated, infringed or held unenforceable, and others may be able to design around these patents or develop similar products or other intellectual property that are not within the scope of our patents. Costly and time-consuming litigation could be necessary to enforce and determine the scope of the rights under these patents, and we or Digital Angel, as applicable, may not be successful in enforcing any of these rights. In addition, upon expiration of patents we own or have rights to, we may face an increase of competition by other companies.

 

If we lose our exclusive rights under our license agreement with Digital Angel or if Digital Angel cannot exclude third parties from selling competing products, we could experience an increase in competition, which could have a material adverse effect on the expected growth of our business.

 

Our exclusive amended and restated supply, license, and development agreement with Digital Angel to purchase the implantable VeriChip for identification of people includes a provision that our license will become non-exclusive if we fail to meet specified minimum purchase requirements. If we fail to meet these minimum purchase requirements and lose our exclusivity, Digital Angel may enter into a license with a third party which may increase our competition and have a material adverse effect on the expected growth of our business. The minimum purchase requirements are currently $0, $875,000, $1,750,000 and $2,500,000 for each of 2006, 2007, 2008 and 2009, respectively, and $3,750,000 for 2010 and each year thereafter. In addition, we cannot assure you that our supplier and licensor, Digital Angel, has sufficient rights to exclude, or would ultimately prevail in an action to exclude, third parties from making or selling competing products. In this event, we could face increased competition that could have a material adverse affect on our business prospects.

 

A termination of our license agreement with Digital Angel could harm our business.

 

We could lose our license with Digital Angel prior to its stated term under specified events, including as a result of a bankruptcy event of the other party or an uncured default by us under the agreement. If we lose our rights under our supply, license and development agreement with Digital Angel, we will not be able to purchase or sell the VeriMed patient identification system, or any other products that incorporate the implantable VeriChip, and we may not be able to fulfill our expectations for significant revenue growth.

 

Consumer groups may not want us storing or using personally-identifiable data, such as patient medical information, which could jeopardize our business.

 

Consumer sentiment regarding privacy issues is constantly evolving. Such consumer sentiment may affect the public’s interest in our current or future products. In some cases, consumer groups and individual consumers have already begun to express concern over the storage and/or use of personally-identifiable patient information. Accordingly, privacy concerns of consumers may influence healthcare professionals to refrain from adopting our systems, which could in turn harm our prospects. Moreover, strong consumer attitudes may precipitate significant adverse opinions which may lead to new regulations. If we fail to successfully monitor and address the privacy concerns of consumers, our business and prospects would be harmed.

 

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Our net operating losses may continue; we are unable to predict the extent of future losses or when we will generate significant revenues or become profitable.

 

We were formed as a development company by our parent company, Applied Digital, in November 2001 and have incurred net losses since that time. Our cumulative net losses were $7.7 million as of September 30, 2005 and our net losses available to the common stockholder for the years ended December 31, 2004, 2003 and 2002 were $2.0 million, $1.7 million and $1.4 million, respectively. We expect that our operating expenses may increase over the next several years as a result of the expansion of our marketing efforts for all of our products and we may continue to incur additional net operating losses after our offering. In addition, going forward, we will incur significant amortization expense associated with intangible assets that we acquired as a result of our recent acquisitions of VCI and Instantel, and research and development costs required to identify, validate and develop new systems, and to improve the quality and technical performance of our existing systems.

 

If we are unable to successfully integrate the operations, systems and personnel of our recent acquisitions, our business will be adversely affected.

 

We acquired VCI and Instantel in March 2005 and June 2005, respectively. Prior to these acquisitions, our operations were limited to development and marketing efforts surrounding our VeriChip patient identification system. The addition of VCI and Instantel significantly expanded the scope of our operations in a rapid manner, and the integration of the acquired business’ operations, systems and personnel are ongoing and continue to present us with difficult challenges, including:

 

    the need to determine a sales, marketing and branding strategy with respect to a wide variety of systems spanning various industries;

 

    several new facilities to operate and manage in geographically diverse locations;

 

    the rapid expansion of our employee base;

 

    maintaining and managing our relationships with customers and distributors;

 

    entering markets or types of businesses in which we and our management have limited experience; and

 

    integrating different and complex accounting and financial reporting systems.

 

As part of these efforts, we are in the process of integrating all of our RFID systems onto a technology platform so that our customers can centralize all of their location and identification processing data. A key element of our growth strategy, particularly in the healthcare industry, is to demonstrate the advantages of this common platform and cross-market to our customers our full portfolio of RFID systems. If we are unable to successfully integrate our RFID systems onto our technology platform, our sales efforts and ability to cross-market our systems may be impaired, and our revenues will be adversely affected.

 

We rely on third parties to supply and manufacture most of our systems, making us vulnerable to supply disruption which could delay our product delivery to our customers.

 

We rely on third parties to supply and manufacture most of our systems. If these suppliers and manufacturers are unable to fulfill their commitments to us for any reason, including supply shortages, financial hardships, failure to follow our procedures or failure to comply with applicable regulations, we may not be able to fulfill orders from our customers. This will likely result in an increase in costs to obtain our components and finished products from other third parties. The implantable VeriChip is manufactured for Digital Angel, our supplier, in a facility in Spain. If we are unable to obtain the implantable VeriChip from Digital Angel, we will need to manufacture it in another facility which we currently believe could take three to six months to locate. The cost of production at another facility could be more than we are paying to Digital Angel.

 

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Interruptions to the patient information database may have a negative impact on our revenues, damage our reputation and expose us to litigation.

 

Reliable access to the patient information database is a key component of the functionality of our VeriMed patient identification system. Our ability to provide uninterrupted access to the patient information database operated by us or third parties we contract with will depend on the efficient and uninterrupted operation of the computer and communications systems involved. The patient information database may not function properly if certain necessary third-party systems fail, or if some other unforeseen act or natural disaster should occur. Any disruption of the database services, computer systems or communications networks, or those of third parties that we rely on, could result in the inability of users to access the patient information database for an indeterminate period of time which could cause us to lose the confidence of the healthcare community, lose revenue or face litigation. In addition, our business and reputation will be harmed if the healthcare community believes the patient information database is unreliable. Although certain elements of technological, power, communications, personnel and site redundancy are maintained, the database may not be fully redundant. If the database system fails, our business and prospects could be irreparably harmed.

 

Modifications to the VeriChip may require additional FDA clearance, and a failure or delay in obtaining such clearance may affect our ability to introduce new or enhanced products in a timely manner.

 

The implantable VeriChip is a medical device with respect to its medical or healthcare-related applications and is subject to FDA’s jurisdiction. The FDA clearance we have received for VeriChip limits its use in medical applications by allowing the microchip to only include an identification number. Any additional information, including patient information, must reside in a database contained outside the microchip. Any modification to an FDA-cleared device, such as VeriChip, that would significantly affect its safety or effectiveness or that would constitute a major change in its intended use would require new FDA clearance or approval. Accordingly, if we develop a new or modified VeriChip system that contains more than an identification number, we may be required to seek additional FDA clearance. The process of obtaining FDA clearance is often costly and time-consuming. We may not be able to obtain additional FDA clearance for any such new systems or modifications in a timely fashion, or at all. A failure or delay in obtaining required future clearances would adversely affect our ability to introduce new or enhanced systems in a timely manner, which may constrain our future operations and operating results.

 

If we or our suppliers fail to comply with quality system regulations, our manufacturing operations could be delayed, and our VeriMed patient identification system sales could suffer.

 

Our manufacturing processes and those of our suppliers are required to comply with FDA’s quality system regulation which cover the procedures and documentation of the design, testing, production, control, quality assurance, sterilization, labeling, packaging, storage and shipping of the VeriMed patient identification system. We are also subject to similar state requirements. In addition, we or our suppliers must engage in extensive record keeping and reporting and must make available our manufacturing facilities and records for periodic inspections by governmental agencies, including FDA, state authorities and comparable agencies in other countries. If we or our supplier fail a quality system inspection, our operations could be disrupted and our manufacturing interrupted. Failure to take adequate corrective action in response to an adverse quality system inspection could result in, among other things, a shut-down of manufacturing operations, significant fines, suspension of marketing clearances and approvals, seizures or recalls of our device, operating restrictions and criminal prosecutions, any of which would cause our business to suffer. Furthermore, our key component suppliers may not currently be or may not continue to be in compliance with applicable regulatory requirements, which may result in manufacturing delays for our systems and cause revenue to decline.

 

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Our failure or alleged failure to comply with anti-kickback and false claims laws could result in civil or criminal sanctions that would harm our business.

 

We are or may become subject to various federal and state laws designed to address health care “fraud and abuse,” including anti-kickback laws and false claims laws. The federal anti-kickback statute prohibits the offer, payment, solicitation or receipt of any form of remuneration in return for referring items or services payable by Medicare, Medicaid or any other federally funded healthcare program. This statute also prohibits remuneration in return for purchasing, leasing or ordering or arranging for or recommending the purchasing, leasing or ordering of items or services payable by Medicare, Medicaid or any other federally funded healthcare program. The anti-kickback laws of various states apply more broadly to prohibit remuneration in return for referrals of business payable by payors other than federal healthcare programs.

 

False claims laws prohibit anyone from knowingly presenting, or causing to be presented, for payment to third-party payors (including Medicare and Medicaid) claims for reimbursed drugs or services that are false or fraudulent, claims for items or services not provided as claimed or claims for medically unnecessary items or services. Our activities relating to the reporting of wholesale or estimated retail prices of, the reporting of Medicaid rebate information and other information affecting federal, state and third-party payment for, and the sale and marketing of our VeriMed patient information system will be, subject to scrutiny under these laws.

 

The anti-kickback statute and other fraud and abuse laws are very broad in scope, and many of their provisions have not been uniformly or definitively interpreted by existing case law or regulations. Violations of the anti-kickback statute and other fraud and abuse laws may be punishable by criminal and/or civil sanctions, including fines and civil monetary penalties, as well as the possibility of exclusion from federal healthcare programs (including Medicare and Medicaid). If we are found to have violated these laws, or are charged with violating them, our business, financial condition and results of operations and stock price could be materially and adversely affected.

 

We may be subject to product liability claims from the use of our systems that could result in costs or damages payable by us, which could adversely affect our business, financial condition and results of operations.

 

Manufacturing, marketing, selling, testing and operation of our systems entail a risk of product liability. We could be subject to product liability claims in the event our systems fail to perform as intended. Even unsuccessful claims against us could result in the expenditure of funds in litigation and the diversion of management time and resources and could damage our reputation and impair the marketability of our systems. While we maintain liability insurance, it is possible that a successful claim could be made against us, that the amount of indemnification payments or insurance would not be adequate to cover the costs of defending against or paying such a claim, or that damages payable by us would harm our business.

 

Our competitors, including those who have greater resources and experience than we do, may commercialize technologies that make ours obsolete or noncompetitive.

 

There are many public and private companies, public and private universities, governmental agencies and research organizations actively engaged in research and development of RFID and other competing technologies with the same functionality that we have targeted. Many of our competitors have financial, technical, manufacturing and marketing resources that are far greater than ours. If a competitor were to successfully develop or acquire rights to similar or more effective systems for applications targeted by our systems, our business, financial condition or results of operations could be materially and adversely affected. If a competitor were to develop or acquire rights to a competitive product that offers significantly lower costs, or were to enter the market before us with a similar or superior product, our business, financial condition or results of operations could be materially and adversely affected.

 

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Our other intellectual property, particularly our trade secrets and know-how are important to us and our inability to safeguard it may adversely affect our business.

 

We rely on copyrights, trademarks, trade secret protections, know-how and contractual safeguards to protect our non-patented intellectual property, including our software technologies. Our employees, consultants and advisors are required to enter into confidentiality agreements that prohibit the disclosure or use of our confidential information. We also have entered into confidentiality agreements to protect our confidential information delivered to third parties for research and other purposes. There can be no assurance that we will be able to effectively enforce these agreements or that the subject confidential information will not be disclosed, that others will not independently develop substantially equivalent confidential information and techniques or otherwise gain access to our confidential information or that we can meaningfully protect our confidential information. Costly and time-consuming litigation could be necessary to enforce and determine the scope of our confidential information, and failure to maintain the confidentiality of our confidential information could adversely affect our business.

 

Disputes may arise in the future with respect to the ownership of rights to any technology developed with advisors or collaborators. These and other possible disagreements could lead to delays in the collaborative research, development or commercialization of our systems, or could require or result in costly and time-consuming litigation that may not be decided in our favor. Any such event could have a material adverse effect on our business, financial condition and results of operations.

 

Our efforts to protect our intellectual property may be less effective in some foreign countries where intellectual property rights are not as well protected as in the United States.

 

The laws of some foreign countries do not protect intellectual property to as great an extent as do the laws of the United States. Policing unauthorized use of our products is difficult, and there is a risk that our means of protecting our intellectual property may prove inadequate in these countries. Our competitors in these countries may independently develop similar technology or duplicate our systems, thus likely reducing our sales in these countries. Furthermore, some of our patent rights may be limited in enforceability to the United States or certain other select countries, which may limit our intellectual property rights abroad.

 

We are dependent on third parties to create sales, marketing and distribution capabilities to commercialize our systems.

 

We currently have a limited sales, marketing or distribution infrastructure. We have recently entered into a global distribution agreement with a large electronic control systems integrator with respect to our infant protection and wander prevention systems. We have also entered into a strategic relationship with Henry Schein, Inc., a large distributor of healthcare products to office-based practitioners in North American and European markets, through which we expect to distribute our VeriMed patient identification system to health care professionals. Developing sales, marketing and distribution capabilities is expensive and time-consuming. To the extent that we rely on arrangements with third parties, our commercial revenue is likely to be lower than if we marketed and sold our systems on our own, and any revenue we might receive would depend upon the efforts of those third parties.

 

We may need to obtain additional capital to fund our operations which may have negative consequences on our business.

 

We expect to require funding in future years, in addition to the proceeds from this offering, to fully develop and commercialize the implantable VeriChip and any additional technologies or systems that we may license or develop. To the extent we raise additional capital by issuing equity securities, our stockholders may experience substantial dilution. In addition, our business and operations may change in a manner that would consume available resources at a greater rate than we anticipated. In such event, we may need to raise substantial additional capital.

 

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We may seek to raise necessary funds through public or private equity offerings, debt financings or additional strategic alliance and licensing arrangements. If adequate funds are not available, we may be required to delay, reduce the scope of or eliminate one or more of our development programs, and our business, financial performance and stock price may be materially and adversely affected.

 

We may be required to relinquish rights to our technologies or systems, or grant licenses on terms that are not favorable to us in order to raise additional funds through alliance, joint venture and licensing arrangements.

 

The implantation of a VeriChip may be found to cause risks to a patient’s health that limit its use.

 

The implantation of a VeriChip may be found to cause risks to a patient’s health. Potential risks to a patient’s health that may be associated with the implantable VeriChip include adverse tissue reactions, migration of the implantable VeriChip under the skin and infection resulting from implantation. As more people are implanted with the implantable VeriChip, it is possible that these and other risks to health may manifest themselves. The observation of risks to a patient’s health associated with the implantation of the VeriChip could limit its use and adversely affect our business, financial condition or results of operations.

 

Regulation of products and services that collect personally-identifiable information or otherwise monitor an individual’s activities may make the provision of our services more difficult or expensive and could jeopardize our growth prospects.

 

Certain technologies that we currently, or may in the future, support are capable of collecting personally-identifiable information. A growing body of laws designed to protect the privacy of personally- identifiable information, as well as to protect against its misuse, and the judicial interpretations of such laws, may adversely affect the growth of our business. In the United States, these laws could include the Health Insurance Portability and Accountability Act, or HIPAA, the Federal Trade Commission Act, the Electronic Communications Privacy Act, the Fair Credit Reporting Act, the Gramm-Leach Bliley Act, as well as various state laws and related regulations. Although we are not a covered entity under HIPAA, we have entered into agreements with certain covered entities in which we are considered to be a “Business Associate” under HIPAA. As a Business Associate we are required to implement policies, procedures and reasonable and appropriate security measures to protect individually identifiable health information we receive from covered entities. Our failure to protect health information received from customers could subject us to liability and adverse publicity and could harm our business and impair our ability to attract new customers.

 

In addition, certain governmental agencies, like the U.S. Department of Health and Human Services, and the Federal Trade Commission, or FTC, have the authority to protect against the misuse of consumer information by targeting companies that collect, disseminate or maintain personal information in an unfair or deceptive manner. We are also subject to the laws of those foreign jurisdictions in which we operate, some of which currently have more protective privacy laws. If we fail to comply with applicable regulations in this area, our business and prospects could be harmed.

 

Certain regulatory approvals generally must be obtained from the governments of the countries in which our foreign distributors sell our systems. However, any such approval may be subject to significant delays or may not be obtained. Any actions by regulatory agencies could materially adversely affect our growth plans and the success of our business.

 

Failure to comply with recent and developing legislation regarding the concentration of hazardous materials in our systems could prevent us from selling our systems in various jurisdictions.

 

Some of our systems and components may be subject to European Union Directive 2002/95/EC. This directive limits or restricts the use of certain hazardous substances in electrical and electronic equipment. Some of our systems include substances that are covered by the directive. The directive requires

 

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compliance by July 1, 2006. We are currently evaluating our systems to determine whether and to what extent our systems will need to be modified to comply with the directive, but based on our review to date, we believe our systems and components will comply when required. Non-compliant systems could be barred from sale in the European Union. Other countries, including China, are considering similar legislation. We can not currently estimate the effect of such new legislation on our business or results of operations.

 

Applied Digital will have significant voting control over our company which may delay, prevent or deter corporate actions that may be in the best interest of our stockholders.

 

After the offering, Applied Digital will maintain control of approximately     % of our outstanding common stock (    % if the underwriters’ over-allotment option is exercised in full). As a result, Applied Digital will be able to control all matters requiring approval of our stockholders, including the election of directors and approval of significant corporate transactions. This concentration of ownership may delay, prevent or deter a change in control of our company even when such a change may be in the best interest of all our stockholders, could deprive stockholders of an opportunity to receive a premium for their common stock as part of a sale of our company or assets and might affect the prevailing market price of our common stock.

 

Conflicts of interest may arise among Applied Digital, Digital Angel and us that could be resolved in a manner unfavorable to us.

 

Questions relating to conflicts of interest may arise between Applied Digital, our parent company, or Digital Angel, a subsidiary of Applied Digital, on the one hand, and us, on the other, in a number of areas relating to our past and ongoing relationships. After this offering, three of our six directors will continue to serve as directors of Applied Digital. For as long as Applied Digital continues to own shares of our common stock representing more than 50% of the total voting power of our common stock, it will have the ability to direct the election of all the members of our board of directors and to exercise a controlling influence over our business and affairs.

 

Areas in which conflicts of interest between Applied Digital and us could arise include, but are not limited to, the following:

 

Cross directorships and stock ownership. The ownership interests of our directors in the common stock of Applied Digital or service as a director of both Applied Digital and us could create, or appear to create, conflicts of interest when directors are faced with decisions that could have different implications for the two companies. For example, these decisions could relate to (i) the nature, quality and cost of services rendered to us by Applied Digital, (ii) disagreement over the desirability of a potential acquisition opportunity, (iii) employee retention or recruiting or (iv) our dividend policy.

 

Intercompany transactions. From time to time, Applied Digital or its affiliates may enter into transactions with us or our subsidiaries or other affiliates. Although the terms of any such transactions will be established based upon negotiations between employees of Applied Digital and us and, when appropriate, subject to the approval of the independent directors on our board or a committee of disinterested directors, there can be no assurance that the terms of any such transactions will be as favorable to us or our subsidiaries or affiliates as may otherwise be obtained in arm’s length negotiations.

 

Intercompany agreements. We have entered into a transition service agreement with Applied Digital pursuant to which it will provide us certain management, administrative, accounting, tax, legal and other services, for which we will reimburse it. We have entered into other intercompany agreements, including a loan agreement with Applied Digital. The terms of these agreements were established while we were a wholly owned subsidiary of Applied Digital and were not the result of arm’s length negotiations. We also have entered into an amended and restated supply, license and development agreement with Digital Angel. In addition, conflicts could arise in the interpretation or any extension or renegotiation of these existing agreements after this offering. See “Certain Relationships and Related Party Transactions.”

 

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Risks Related to the Offering

 

An active trading market for our common stock may not develop, and we expect that our stock price will fluctuate significantly due to events and developments unique to our business or the health care industry generally.

 

Prior to the offering, you could not buy or sell our common stock publicly. We intend to apply to have our shares of common stock quoted on the Nasdaq National Market, but an active trading market for our shares may never develop or be sustained following the offering. The initial public offering price for our common stock will be determined through negotiations with the underwriters. This initial public offering price may vary from the market price of the common stock after the offering and you may not be able to sell your common stock at or above the initial public offering price. The stock market has recently experienced significant volatility. Factors that could cause volatility in the market price of our common stock include:

 

    failure of any of our products, particularly our VeriMed patient identification system, to achieve commercial success;

 

    the loss of our right to use the patent for our VeriMed patient identification system;

 

    FDA or international regulatory actions;

 

    announcements of new products by our competitors;

 

    market conditions in the medical device and RFID sectors;

 

    litigation or public concern about the efficacy or safety of existing, new or potential products or technologies;

 

    comments by securities analysts;

 

    rumors relating to us or our competitors; and

 

    third party reimbursement policies.

 

These and other factors may cause the market price and demand for our common stock to fluctuate substantially, which may limit or prevent investors from readily selling their shares of common stock and may otherwise negatively affect the liquidity of our common stock. In addition, in the past, when the market price of a stock has been volatile, holders of that stock have instituted securities class action litigation against the company that issued the stock. If any of our stockholders brought a lawsuit against us, we could incur substantial costs defending the lawsuit and the time and attention of our management may be diverted.

 

Future sales of our common stock, including sales of our common stock acquired upon the exercise of outstanding options and warrants, may cause our stock price to fall and you could lose all or part of your investment.

 

The market price of our common stock could decline as a result of sales by our existing stockholder of shares of common stock in the market after the offering, or sales of our common stock acquired upon the exercise of outstanding options and warrants, or the perception that these sales could occur. These sales might also make it more difficult for us to sell equity securities at a time and price that we deem appropriate. The lock-up agreements delivered by our executive officers, directors, stockholder and certain option and warrant holders provide that Merriman Curhan & Ford & Co. may release those parties, at any time or from time to time and without notice, from their obligation not to dispose of shares of our common stock for a period of 180 days after the date of this prospectus. Merriman Curhan & Ford & Co. has no pre-established conditions to waiving the terms of the lock-up agreements, and any decision by it to waive those conditions would depend on a number of factors, which may include market conditions, the performance of our common stock in the market and our financial condition at that time.

 

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After the offering, we will have 6,163,800 and 1,332,667 shares issuable upon exercise of outstanding options and warrants, respectively. Of these 7,496,467 shares in the aggregate,                  shares of our common stock will be subject to registration rights. In addition, we are required pursuant to a share purchase agreement to issue up to              shares of our common stock based on an assumed public offering price of $             per share. Upon issuance, such shares shall be entitled to registration rights. See “Description of Capital Stock.”

 

Investors in the offering will pay a much higher price than the book value of our common stock and will incur immediate and substantial dilution and may incur dilution in the future.

 

If you purchase common stock in the offering, you will pay more for your shares than the amount our existing stockholder paid for its shares. You will incur immediate and substantial dilution of          per share, representing the difference between our pro forma net tangible book value per share after giving effect to the offering and an assumed initial public offering price of          per share. In the past, we have issued options and warrants to acquire common stock at prices significantly below the assumed initial public offering price. To the extent these options or warrants are ultimately exercised, you will sustain further dilution. Moreover, we may require additional funds to support our working capital requirements or for other purposes, and may seek to raise additional funds through public or private equity financing. We also may acquire other companies or technologies or finance strategic alliances by issuing equity. Any of these or other capital raising transactions may result in additional dilution to our stockholders.

 

We will have broad discretion in how we use the proceeds of this offering, and we may not use these proceeds effectively, which could negatively impact our results of operations and cause our stock price to decline.

 

Our management will have considerable discretion in the application of a portion of the proceeds of this offering, and you will not have the opportunity, as part of your investment decision, to assess whether we are using the proceeds effectively. We intend to use approximately $     million of the net proceeds from this offering to repay our outstanding indebtedness owed to Applied Digital at the time of the consummation of this offering and approximately $1.0 million to reimburse Applied Digital for a portion of the purchase price paid to acquire Instantel, with the remaining proceeds to be used for general corporate purposes, which may include research and development, capital expenditures and sales and marketing, including marketing of our VeriMed patient identification system to hospitals and physicians. We may use the proceeds for working capital purposes that do not yield a significant return, or any return at all, for our stockholders.

 

Provisions of Delaware law or our charter documents could delay or prevent an acquisition of our company, even if the acquisition would be beneficial to our stockholders, and could make it more difficult for you to change management.

 

Provisions of our amended and restated certificate of incorporation and amended and restated bylaws may discourage, delay or prevent a merger, acquisition or other change in control that stockholders may consider favorable, including transactions in which stockholders might otherwise receive a premium for their shares. This is because these provisions may prevent or frustrate attempts by stockholders to replace or remove our current management or members of our board of directors. These provisions, among other things:

 

    provide for our board of directors to be divided into three classes, with each director serving a three-year term and one class being elected at each annual meeting of stockholders;

 

    permit our board of directors to issue, without further action by our stockholders, up to 5,000,000 shares of preferred stock, with any rights, preferences and privileges as they may designate (including the right to approve an acquisition or other change in control);

 

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    establish advance notice procedures with respect to stockholder proposals and the nomination of candidates for election as directors, other than nominations made by or at the direction of our board of directors; and

 

    provide that members of our board of directors may only be removed for cause and only by the affirmative vote of holders of at least 66 2/3% of the voting power of all then outstanding shares of capital stock entitled to vote generally in the election of directors, voting together as a single class.

 

As a result, these provisions and others available under Delaware law could limit the price that investors are willing to pay in the future for shares of our common stock.

 

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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

This prospectus contains forward-looking statements that involve risks and uncertainties. These forward-looking statements, which are usually accompanied by words such as “may,” “might,” “will,” “should,” “could,” “intends,” “estimates,” “predicts,” “potential,” “continue,” “believes,” “anticipates,” “plans,” “expects” and similar expressions, relate to, without limitation, statements about our market opportunities, our strategy, our competition, our projected revenue and expense levels and the adequacy of our available cash resources. This prospectus also contains forward-looking statements attributed to third parties relating to their estimates regarding our industry. These statements are only predictions based on current expectations and projections about future events. There are important factors that could cause our actual results, level of activity, performance or achievements to differ materially from those expressed or forecasted in, or implied by, such forward-looking statements, including those factors discussed in “Risk Factors.”

 

Although we believe that the expectations reflected in these forward-looking statements are based upon reasonable assumptions, no assurance can be given that such expectations will be attained or that any deviations will not be material. In light of these risks, uncertainties and assumptions, the forward-looking events and circumstances discussed in this prospectus may not occur and actual results could differ materially and adversely from those anticipated or implied in the forward-looking statements. We disclaim any obligation or undertaking to disseminate any updates or revision to any forward-looking statement contained herein to reflect any change in our expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based.

 

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USE OF PROCEEDS

 

We estimate that the net proceeds we will receive from the sale of our common stock in this offering will be approximately $                     million, based on an assumed initial public offering price of $                     per share and after deducting estimated underwriting discounts and commissions and estimated offering expenses. If the underwriters exercise their over-allotment option in full, we estimate that our net proceeds will be approximately $                     million.

 

As of September 30, 2005, we owed our parent company, Applied Digital, approximately $6.7 million in principal and accrued interest. To evidence that indebtedness, on December 27, 2005 we entered into an agreement with Applied Digital providing for a revolving loan to us in principal amount of up to $8.5 million. The loan bears interest at the prime rate of interest as published in The Wall Street Journal and has a stated maturity date of December 27, 2010 and will accelerate and become due and payable upon the closing of this offering. We intend to use up to approximately $         million of the net proceeds from this offering to repay our outstanding indebtedness owed to Applied Digital at the time of the consummation of this offering, and to use approximately $1.0 million of the net proceeds from this offering to reimburse Applied Digital for a portion of the purchase price paid to acquire Instantel, with the remaining proceeds to be used for general corporate purposes, which may include research and development, capital expenditures and sales and marketing, including marketing of our VeriMed patient identification system to hospitals and physicians. We have not yet determined all of our anticipated expenditures and cannot estimate the amounts to be used for each of the purposes discussed above.

 

The amount and timing of what we actually spend for these purposes may vary significantly and will depend on a number of factors, including our future revenues and cash generated by operations and the other factors described under “Risk Factors.” Accordingly, our management will have broad discretion in applying a portion of the net proceeds of the offering. Pending these uses, we intend to invest the net proceeds in short-term interest-bearing, investment grade securities. We cannot predict whether the proceeds invested will yield a favorable return. We may find it necessary or advisable to use portions of the proceeds for other purposes.

 

DIVIDEND POLICY

 

We have never declared or paid any cash dividends on our common stock. We presently intend to retain future earnings, if any, to finance the expansion of our business, and we do not expect to pay any cash dividends in the foreseeable future. Any future determination with respect to the payment of dividends will be at the discretion of our board of directors and will be dependent upon our financial condition, results of operations, capital requirements, general business conditions and other factors that our board of directors may deem relevant.

 

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CAPITALIZATION

 

The following table sets forth our capitalization as of September 30, 2005:

 

    on an actual basis;

 

    on a pro forma basis to reflect the issuance of                  shares of our common stock to Perceptis, L.P. upon the consummation of this offering, based on an assumed initial public offering price of $         per share, and to reflect an amendment and restatement of our certificate of incorporation that increased our authorized shares; and

 

    on an as adjusted basis to give effect to (i) our receipt of net proceeds from the sale of                      shares of common stock in this offering at an assumed initial public offering price of $             per share, after deducting estimated underwriting discounts and commissions and estimated offering expenses and (ii) the receipt and use of proceeds as set forth in the “Use of Proceeds” section of this prospectus.

 

You should read this table in conjunction with information under the captions “Use of Proceeds,” “Selected Consolidated Financial Data” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the related notes, included elsewhere in this prospectus.

 

     At September 30, 2005(1)

     Actual

    Pro forma

   Pro forma
as adjusted


     (Unaudited)
    

(in thousands, except

share and per share data)

Debt, including current portion

   $ 6,709     $    $

Stockholder’s equity:

                     

Preferred stock: No shares authorized, issued or outstanding, actual; 5,000,000 shares authorized, none issued or outstanding, pro forma and as adjusted

               

Common stock: $0.0015 par value, 50,000,000 shares authorized, 16,666,667 shares issued and outstanding, actual; 70,000,000 shares authorized,          issued and outstanding, pro forma; 70,000,000 shares authorized,          issued and outstanding, as adjusted

     25               

Additional paid-in capital

     37,716               

Accumulated other comprehensive loss

     (37 )             

Accumulated deficit

     (7,749 )             
    


 

  

Total stockholder’s equity

     29,955               
    


 

  

Total capitalization

   $ 36,664               
    


 

  


(1) On December 20, 2005, we amended and restated our certificate of incorporation to authorize us to issue 5,000,000 shares of preferred stock and increase the number of shares of our common stock authorized from 50,000,000 to 70,000,000 shares. In addition, we effected a 2-for-3 reverse stock split. The par value and shares issued and outstanding as of September 30, 2005 have been retroactively adjusted to reflect the reverse stock split.

 

The table above does not include the following as of September 30, 2005:

 

    6,087,133 shares of our common stock issuable upon the exercise of outstanding options under our stock plans at a weighted average exercise price of $0.62 per share;

 

    646,201 additional shares of our common stock reserved for future issuances under our stock plans;

 

    66,667 shares of our common stock issuable upon the exercise of outstanding options that were issued outside of our stock plans at an exercise price of $1.82 per share; and

 

    1,332,667 shares of our common stock issuable upon the exercise of outstanding warrants at a weighted average exercise price of $0.97 per share.

 

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DILUTION

 

If you invest in our common stock, your interest will be diluted to the extent of the difference between the public offering price per share of our common stock and the as adjusted pro forma net tangible book value per share of our common stock immediately after the offering.

 

Investors participating in the offering will incur immediate dilution. As of September 30, 2005, we had a historical pro forma net tangible book value of $             million, or $             per share of our common stock. Pro forma net tangible book value per share is equal to our total tangible assets (total assets less intangible assets) less total liabilities, divided by the number of shares of our outstanding common stock after giving effect to the issuance of                      shares of our common stock to Perceptis, L.P. upon the consummation of this offering, assuming an initial public offering price of $             per share. After giving effect to the sale of                      shares of our common stock in the offering at an assumed initial public offering price of $             per share, and after deducting estimated underwriting discounts commissions and estimated offering expenses, our as adjusted pro forma net tangible book value as of                      would have been approximately $             million, or approximately $             per pro forma share of our common stock. This represents an immediate increase in pro forma net tangible book value of $             per share to our existing stockholders and an immediate dilution of $             per share to new public investors in the offering.

 

The following table illustrates this per share dilution to the new public investors:

 

Assumed initial public offering price per share

        $            

Historical deficit tangible book value per share as of                     

   $                 

Increase per share attributable to the offering

         
    
    

As adjusted pro forma net tangible book value per share after the offering

         
         

Dilution in pro forma net tangible book value per share to new investors

        $            
         

 

If the underwriters exercise their over-allotment option in full, the pro forma net tangible book value after this offering would be $             per share, the increase in pro forma net tangible book value per share to existing stockholder would be $             per share and the dilution to new investors would be $             per share.

 

The following table sets forth, on a pro forma basis as of September 30, 2005, the differences between the number of shares of common stock purchased from us, the total consideration paid, and the average price per share paid by existing stockholders and by new investors before deducting estimated underwriting discounts and commissions and estimated offering expenses payable by us, using an assumed initial public offering price of $             per share:

 

     Shares Purchased

    Total Consideration

   

Average Price

Per Share


     Number

   Percent

    Amount

   Percent

   

Existing stockholder

                    %     $                        %     $            

New investors

                    %     $                        %     $            
    
  

 
  

 

Total

        100.00 %   $            100.00 %   $            
    
  

 
  

 

 

If the underwriters exercise their over-allotment option in full, the number of shares of common stock held by existing stockholders will be reduced to             % of the total number of shares of common stock to be outstanding after the offering, and the number of shares of common stock held by the new investors will be increased to                      shares or             % of the total number of shares of common stock outstanding after the offering.

 

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The discussion and tables above assume                      shares of our common stock outstanding on September 30, 2005 and gives effect to the 2-for-3 reverse stock split that was effectuated on December 20, 2005, and excludes, as of September 30, 2005:

 

    6,087,133 shares of our common stock issuable upon the exercise of outstanding options under our stock plans at a weighted average exercise price of $0.62 per share;

 

    646,201 additional shares of our common stock reserved for future issuances under our stock plans;

 

    66,667 shares of our common stock issuable upon the exercise of outstanding options that were issued outside of our stock plans at an exercise price of $1.82 per share; and

 

    1,332,667 shares of our common stock issuable upon the exercise of outstanding warrants at a weighted average exercise price of $0.97 per share.

 

To the extent that these options and warrants are exercised, there will be further dilution to new investors. In addition, we may choose to raise additional capital due to market conditions or strategic considerations even if we believe we have sufficient funds for our current or future operating plans. To the extent that additional capital is raised through the sale of equity or convertible debt securities, the issuance of these securities could result in further dilution to our stockholders.

 

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SELECTED CONSOLIDATED FINANCIAL DATA

 

You should read the following selected consolidated financial data in conjunction with our consolidated financial statements and related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the “Unaudited Pro Forma Condensed Combined Financial Statements” appearing elsewhere in this prospectus. The statement of operations data for the nine months ended September 30, 2005 and 2004, and the balance sheet data as of September 30, 2005, are derived from our unaudited interim condensed consolidated financial statements. The statement of operations and balance sheet data for the years ended and as of December 31, 2004, 2003, 2002 are derived from our audited financial statements. In the opinion of management, our unaudited interim consolidated financial statements include all adjustments, which are only normally recurring adjustments, necessary for a fair presentation of the financial position and results of operations for the unaudited periods. The historical results are not necessarily indicative of results to be expected for future periods and the results for the nine months ended September 30, 2005, are not necessarily indicative of results that may be expected for the entire year ending December 31, 2005. We acquired two significant subsidiaries during the first half of 2005 and, accordingly, our historical results only include their results since their respective dates of acquisition. The pro forma results reflected below give effect to the acquisitions of these two subsidiaries as if they had occurred at the beginning of the respective periods.

 

    Nine Months Ended September 30,

    Year Ended December 31,

 
   

2005

Pro forma(1)


   

2005

Actual


   

2004

Actual


   

2004

Pro forma(1)


   

2004

Actual


   

2003

Actual


   

2002

Actual


 
    (Unaudited)     (Unaudited)     (Unaudited)     (Unaudited)                    
    (in thousands, except per share data)  

Consolidated Statements of Operations Data:

                                                       

Net revenue

  $             17,800     $             9,115     $               179     $           19,846     $ 247     $ 545     $  

Cost of products and services sold

    7,543       3,606       84       7,861       199       200        
   


 


 


 


 


 


 


Gross profit

    10,257       5,509       95       11,985       48       345        

Selling, general and administrative expense

    11,601       7,001       1,365       10,174       1,930       1,977       1,320  

Research and development

    2,359       1,057             2,606                    

Interest and other income

    (59 )     (39 )     (15 )     137       (15 )            

Interest expense

    230       230       98       144       144       78       21  
   


 


 


 


 


 


 


Loss before income taxes

    (3,874 )     (2,740 )     (1,353 )     (1,076 )     (2,011 )     (1,710 )     (1,341 )

Provision for (benefit from) income taxes

    (883 )     (53 )           238                    
   


 


 


 


 


 


 


Net loss

    (2,991 )     (2,687 )     (1,353 )     (1,314 )     (2,011 )     (1,710 )     (1,341 )

Deemed dividends

    (1 )     (1 )                             (44 )
   


 


 


 


 


 


 


Net loss available to common stockholder

    (2,992 )     (2,688 )     (1,353 )     (1,314 )     (2,011 )     (1,710 )     (1,385 )
   


 


 


 


 


 


 


Net loss per common

                                                       

share-basic and diluted

  $ (0.18 )   $ (0.17 )   $ (0.10 )   $ (0.08 )   $ (0.15 )   $ (0.13 )   $ (0.10 )
   


 


 


 


 


 


 


Average common shares outstanding:

                                                       

Basic and diluted

    16,667       15,556       13,333       16,667       13,333       13,333       13,333  

(1) See Unaudited Pro Forma Condensed Combined Financial Statements appearing elsewhere in this prospectus.

 

     At September 30,

  At December 31,

 
     2005

  2004

    2003

    2002

 
     (Unaudited)                  
     (in thousands)  

Consolidated Balance Sheet Data:

                              

Cash and cash equivalents

   $                     2,103   $        23     $      269     $           –  

Property and equipment

     792     131       147       184  

Goodwill

     18,067                  

Total assets

     49,368     283       782       245  

Long-term debt

                      

Total debt

     6,709     4,221       2,864       1,236  

Stockholder’s equity (deficit)

     29,955     (4,012 )     (2,258 )     (1,264 )

 

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UNAUDITED PRO FORMA CONDENSED COMBINED FINANCIAL STATEMENTS

 

The accompanying unaudited pro forma condensed combined statements of operations reflect our condensed consolidated results of operations for the nine months ended September 30, 2005 and the year ended December 31, 2004, after giving effect to the acquisitions of VCI and Instantel during the first half of 2005. The unaudited pro forma condensed combined statements of operations for the nine-months ended September 30, 2005 and the year ended December 31, 2004, give effect to the acquisitions of VCI and Instantel as if they had occurred at the beginning of the respective periods.

 

The pro forma adjustments do not reflect any operating efficiencies and cost savings nor do they reflect any increased costs and expenses with respect to combining the companies. The pro forma adjustments do not include any adjustments to historical prices for any future price changes, any adjustments to selling and marketing expenses for any future operating changes or any additional costs associated with operating as a publicly-held company.

 

The pro forma adjustments reflecting the consummation of the acquisitions are based upon the purchase method of accounting and upon the assumptions set forth in the footnotes. The required purchase accounting adjustments, including the allocation of the purchase price to the assets acquired and liabilities assumed based on their respective fair values, has been made based upon preliminary valuations prepared by independent third party consultants.

 

On March 31, 2005, Applied Digital acquired VCI through a plan of arrangement under which Applied Digital issued 3,388,407 shares of its common stock valued at approximately $11.7 million to VCI’s shareholders. In addition, all existing VCI options and warrants outstanding were converted into options or warrants exercisable for shares of Applied Digital’s common stock. The value of the options and warrants exchanged was approximately $0.7 million. Included in the aggregate $13.3 million purchase price was approximately $0.9 million of acquisition costs consisting primarily of a finder’s fee and legal and accounting related services that were direct costs of the acquisition. Applied Digital contributed VCI to us effective March 31, 2005 under the terms of an exchange agreement dated June 9, 2005, in consideration for 3.3 million shares of our common stock.

 

On June 10, 2005, VCI acquired Instantel under a share purchase agreement for approximately $25 million, including $22.0 million paid in cash, acquisition costs of $0.3 million, and $3.0 million to be paid in the future in some combination of our common stock and Applied Digital’s common stock, depending on when this offering is completed. Applied Digital funded the acquisition with such funding being recorded as a capital contribution to us. Under the terms of the share purchase agreement, Instantel became a wholly-owned subsidiary of VCI.

 

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UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF OPERATIONS

For the Nine Months Ended September 30, 2005

 

   

VeriChip
Corporation

Historical

Nine Months Ended

September 30, 2005


   

VCI

Historical

Three Months
Ended

March 31, 2005


   

Instantel

Historical

Period Beginning
January 1, 2005
and Ending

June 9, 2005


   

Pro forma

Adjustments


   

Pro forma

Combined
Nine Months
Ended

September 30,
2005


 
    (in thousands, except per share data)  

Total revenue

  $   9,115     $   1,986     $   6,759     $ (60 )(A)   $ 17,800  

Cost of products and services sold

    3,606       575       3,226       136  (B)     7,543  
   


 


 


 


 


Gross profit

    5,509       1,411       3,533       (196 )     10,257  

Selling, general and administrative expense

    7,001       1,355       4,205       (960 )(B)     11,601  

Research and development

    1,057       262       1,040             2,359  

Interest and other income

    (39 )     (20 )                 (59 )

Interest expense

    230             367       (367 )(C)     230  
   


 


 


 


 


Loss before (benefit) provision for income taxes

    (2,740 )     (186 )     (2,079 )     (1,131 )     (3,874 )

(Benefit) provision for income taxes

    (53 )           (1,221 )     391  (D)     (883 )
   


 


 


 


 


Net loss

    (2,687 )     (186 )     (858 )     740       (2,991 )

Deemed dividend

    (1 )                       (1 )
   


 


 


 


 


Net loss available to common stockholder

  $ (2,688 )   $ 186     $ (858 )   $ 740     $ (2,992 )
   


 


 


 


 


Loss per common share – basic and diluted

  $ (0.17 )                           $ (0.18 )
   


 


 


 


 


Weighted average number of common shares outstanding – basic and diluted

    15,556                         1,111  (E)     16,667  (F)(G)

 

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PRO FORMA ADJUSTMENTS FOR THE UNAUDITED PRO FORMA

CONDENSED COMBINED STATEMENT OF OPERATIONS FOR THE NINE-MONTHS ENDED

SEPTEMBER 30, 2005 ARE AS FOLLOWS:

 

(A) To eliminate deferred revenue not recognizable under purchase accounting.

 

(B) To adjust amortization expense for acquired intangible assets with definite lives. The following table presents the pre-acquisition amortization expense as compared to the post-acquisition amortization expense for VCI and Instantel:

 

 

                  Adjustment to:

 
    Pre-Acquisition

  Post-Acquisition

  Pro forma Adjustment

    Cost of Products
and Services
Sold


  Selling, General
and
Administrative
Expense


 
    (in thousands)  

VCI

  $        30   $      165   $      135                

Instantel

    1,425     466     (959 )              
   

 

 


 

 


    $ 1,455   $ 631   $ (824 )   $ 136   $ (960 )
   

 

 


 

 


 

(C) To eliminate interest expense for Instantel’s debt not assumed by us under the terms of the share purchase agreement.

 

(D) To adjust income taxes for the effects of the pro forma adjustments.

 

(E) Represents the number of shares of our common stock that were issued in exchange for VCI under the terms of the exchange agreement between VCI and Applied Digital. For purposes of this pro forma presentation, the common stock issued was deemed to be outstanding for the entire pro forma period.

 

(F) The diluted potential common shares were not included in the computation of diluted loss per share because to do so would have been anti-dilutive. The dilutive potential common shares consist of 4,728,000 weighted average options and 1,181,000 weighted average warrants.

 

(G) Does not include shares to be issued to Perceptis, L.P. upon the consummation of this offering.

 

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UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF OPERATIONS

For the Year Ended December 31, 2004

 

   

VeriChip
Corporation

Historical

Year Ended

December 31,
2004


   

VCI

Historical

Year Ended

December 31,
2004


   

Instantel

Historical

Year Ended

December 31,
2004


   

Pro forma

Adjustments


   

Pro forma

Combined

Year Ended

December 31,
2004


 
    (in thousands, except per share data)  

Total revenue

  $      247     $   6,004     $ 13,595     $           –     $ 19,846  

Cost of products and services sold

    199       1,763       5,450       449  (A)     7,861  
   


 


 


 


 


Gross profit

  $ 48     $ 4,241     $ 8,145       (449 )   $ 11,985  

Selling, general and administrative expense

    1,930       3,524       6,928       (2,208 )(A)     10,174  

Research and development

          918       1,688             2,606  

Interest and other income

    (15 )     152                     137  

Interest expense

    144             943       (943 )(B)     144  
   


 


 


 


 


Loss before provision benefit for income

  $ (2,011 )   $ (353 )   $ (1,414 )   $ 2,702     $ (1,076 )

Benefit for income taxes

          (24 )     (660 )     922  (C)     (238 )
   


 


 


 


 


Net loss

  $ (2,011 )   $ (329 )   $ (754 )   $ 1,780       (1,314 )
   


 


 


 


 


Loss per common share – basic and diluted

  $ (0.15 )                           $ (0.08 )

Weighted average number of common shares outstanding – basic and diluted

    13,333                       3,334  (D)     16,667 (E)(F)

 

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PRO FORMA ADJUSTMENTS FOR THE UNAUDITED PRO FORMA CONDENSED

COMBINED STATEMENT OF OPERATIONS FOR THE YEAR ENDED

DECEMBER 31, 2004 ARE AS FOLLOWS:

 

(A) To adjust amortization for acquired intangible assets with definite lives. The following table presents the pre-acquisition amortization expense as compared to the post-acquisition amortization expense for VCI and Instantel:

 

                     Adjustment to:

 
     Pre-Acquisition

   Post-Acquisition

   Pro forma
Adjustment


    Cost of
Products and
Services Sold


   Selling,
General and
Administrataive
Expense


 
     (in thousands)  

VCI

   $      115    $      658    $      543                 

Instantel

     3,420      1,118      (2,302 )               
    

  

  


              
     $ 3,535    $ 1,776    $ (1,759 )   $ 449    $ (2,208 )
    

  

  


 

  


 

(B) To eliminate interest expense for Instantel’s debt not assumed by us under the terms of the share purchase agreement.

 

(C) To adjust income taxes for the effects of the pro forma adjustments.

 

(D) Represents the number of shares of our common stock that were issued in exchange for VCI under the terms of the exchange agreement between VCI and Applied Digital. For purposes of this pro forma presentation, the common stock issued was deemed to be outstanding for the entire pro forma period.

 

(E) The diluted potential common shares were not included in the computation of diluted loss per share because to do so would have been anti-dilutive. The dilutive potential common shares consist of 3,509,000 weighted average options and 1,061,000 weighted average warrants.

 

(F) Does not include shares to be issued to Perceptis, L.P. upon the consummation of this offering.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

 

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the “Selected Consolidated Financial Data” and our unaudited interim and audited annual financial statements and the notes to those financial statements included elsewhere in this prospectus. Our discussion contains forward-looking statements based upon current expectations that involve risks and uncertainties, such as our plans, objectives, expectations and intentions. Our actual results and the timing of events could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under “Risk Factors,” “Business” and elsewhere in this prospectus.

 

Overview

 

We develop, market and sell RFID systems used to identify, locate and protect people and assets. Our goal is to become the leading provider of RFID systems for people in the healthcare industry. We have two reportable operating segments: (i) healthcare and (ii) security and industrial. Our RFID systems for the healthcare industry include patient identification systems, infant protection systems and wander prevention systems. Our RFID systems for the security and industrial industries include other systems incorporating the implantable VeriChip for security applications, asset location and identification systems and vibration monitoring systems.

 

To date, a significant portion of our revenue has been derived from the businesses that we acquired. The businesses derived revenue from systems that included infant protection and wander prevention. While we believe sales of these systems will continue to generate revenue in the future, we expect that sales from our recently marketed VeriMed patient identification system will generate a significant portion of our revenue in the future.

 

Background

 

We were formed as a Delaware corporation by our founder and parent, Applied Digital, in November 2001. Our operations began in January 2002. Prior to the expansion of our business through two key acquisitions during the first half of 2005, our activities consisted primarily of developing the markets for our systems using the implanted VeriChip.

 

Effective March 31, 2005, Applied Digital acquired VCI and contributed VCI to us under the terms of an exchange agreement in consideration for 3.3 million shares of our common stock. VCI provides infant protection, wander prevention and asset location and identification systems primarily to the healthcare industry and offers asset location and identification systems to the industrial industry.

 

In June 2005, VCI acquired Instantel for approximately $22.3 million in cash, including $0.3 million in acquisition costs, and agreed to pay an additional $2.5 million to $3.0 million, upon completion of this offering, in some combination of cash, our common stock and Applied Digital’s common stock. The amount actually due is subject to reduction in the event of indemnification adjustment. Instantel provides infant protection and wander prevention systems to the healthcare industry and offers vibration monitoring systems to industrial customers.

 

Our functional currency is the U.S. dollar. However, we have operations in Canada and the majority of our payroll expense is incurred in Canadian dollars. In addition, we may export and import to and from Canada and other countries. Our operations may therefore be subject to volatility because of currency fluctuations, inflation and changes in political and economic conditions in these countries.

 

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Basis of Presentation

 

We currently expect that sales of our healthcare systems will contribute to a majority of our revenue. Substantially all of our revenue to date has come from our recently acquired businesses. Prior to these acquisitions, we had minimal revenues and, therefore, period to period results are not comparable and our historical results are not necessarily indicative of our future results. In addition, in October 2004, the implantable VeriChip received FDA clearance for its medical applications.

 

Going forward, in order to achieve significant revenue growth, we intend to focus the majority of our efforts on generating sales from our VeriMed patient identification system. Given our plans, we anticipate that our business model and financial results will differ significantly from our historical results and trends. Notwithstanding, the significant revenue contributed by the two businesses that we acquired during the first half of 2005, this change in focus should also result in future trends and growth patterns that are not comparable to those reflected in the “Unaudited Condensed Combined Pro Forma Financial Information” appearing elsewhere in this prospectus.

 

Revenue

 

The majority of our revenue is derived from sales from our healthcare segment. We expect that a significant portion of our revenue growth will continue to come from sales from that segment.

 

To date, we have not recorded any revenue from sales of our VeriMed patient identification system. Currently, we are providing scanners to hospitals at no charge in order to seed the infrastructure for our VeriMed patient identification system. The cost of the scanners, which was minimal as of September 30, 2005, is included in our statement of operations for the nine months ended September 30, 2005, as selling, general and administrative expense. After this initial seeding phase, we intend to sell our scanners directly to hospitals and to sell our microchips and scanners to doctors, primarily through group purchasing organizations, or GPOs. Patients will be offered a choice of subscribing to our database registry and/or the database registry of others. For future periods, we expect that sales of our VeriMed patient identification system will become a major part of our revenue, although there can be no assurance that it will.

 

We expect to see growth in sales of our infant protection, wander prevention and asset location and identification systems as we continue to expand the markets for our products and systems and from increased sales through our direct sales force, dealers and distributors.

 

We also generate revenue from sales from our security and industrial segment. We sell our asset location and identification systems for the security and industrial segment solely through our direct sales force. We sell our systems that incorporate the VeriChip for security purposes through international distributors and we intend to seek additional distributors. Similarly, we sell our vibration monitoring systems through distributors in North America and abroad. We expect modest growth in each of these systems going forward.

 

Cost of Products and Services Sold

 

Our expenses are related to cost of products or cost of services sold. Our cost of products sold consists of raw materials, direct labor and finished goods, which are purchased from subcontractors. Our VeriMed and VeriGuard systems are purchased as finished goods under the terms of our amended and restated supply, license and development agreement with Digital Angel. Also included in our cost of products sold is amortization of our patented and non-patented proprietary technology, which we acquired in the acquisitions during the first half of 2005. These intangibles are being amortized on a straight-line

 

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basis over lives ranging from 11.8 to 12.3 years. Cost of services sold consists primarily of third party installation services through direct sales to healthcare customers. In addition, cost of services sold in our security and industrial segment consists of servicing our existing systems.

 

Research and development

 

Our research and development expenses consist primarily of salaries, bonuses and benefits for engineering personnel, costs associated with various projects, including testing, developing prototypes and related expenses. We expect that our research and development expenses will increase for at least the next year due to the additional research staff associated with the businesses that we acquired during the first half of 2005, our efforts to complete the integration of our software and hardware platforms underlying our RFID systems during 2006 and development efforts related to the potential new applications for the implantable VeriChip. As a percentage of revenue, we expect our research and development expenses to decrease as revenue increases.

 

Selling, general and administrative expense

 

Selling, general and administrative expense consists primarily of compensation for employees in executive and operational functions, including finance and accounting, sales and marketing and corporate development. Other significant costs include depreciation and amortization, professional fees for accounting and legal services, consulting fees and facilities costs. After completion of this offering, we anticipate our general and administrative expense will increase due to increased costs for directors and officers’ insurance, independent directors’ fees, professional fees, external reporting requirements, Sarbanes-Oxley compliance, investor relations and other costs associated with operating as a publicly-traded company, as well as the expenses associated with the businesses we acquired during the first half of 2005. As a result of the acquisitions, we acquired approximately $10.5 million of intangible assets with definite lives ranging from four to ten years, which are being amortized on a straight-line basis as selling, general and administrative expense. These increases will also likely include the hiring of additional personnel, including an expanded sales force for our healthcare segment, and other costs associated with building out the infrastructure and marketing our VeriMed patient identification system to the healthcare industry.

 

Historically, selling, general and administrative expense has also included certain services provided to us by Applied Digital, including accounting, finance and legal services, and telephone, rent and other items. The cost of these services was determined based on use, and management believes that the fees charged for these services have been reasonable. On December 27, 2005, we and Applied Digital entered into a transition services agreement. During the two-year term of this agreement, we will be obligated to reimburse Applied Digital for providing us with certain administrative transition services and related expenses, including payroll, legal, finance, accounting, information technology, and tax services, and services related to this offering. We anticipate that the aggregate cost of such services will be approximately $0.7 million per year for fixed costs, such as legal and accounting services, plus reasonable out of pocket direct expenses for the other direct transition services. On or prior to the end of the term of the agreement in December 2007, we will be responsible for providing these services internally or engaging third parties, which may result in an increase in selling, general and administrative expense. Going forward, we expect that our selling, general and administrative expense will remain relatively constant as a percentage of revenue.

 

Critical Accounting Policies and Estimates

 

The following is a description of the accounting policies that our management believes involves a high degree of judgment and complexity, and that, in turn, could materially affect our consolidated financial statements if various estimates and assumptions were changed significantly. The preparation of our consolidated financial statements requires that we make certain estimates and judgments that affect the

 

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amounts reported and disclosed in our consolidated financial statements and related notes. We base our estimates on historical experience and on other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates. For more detailed information on our significant accounting policies, see Note 1 to our audited financial statements and Note 1 to our unaudited interim condensed consolidated financial statements included elsewhere in this prospectus.

 

Revenue Recognition

 

Revenue Recognition Policy for VeriMed and VeriGuard Systems

 

Revenues from the sale of systems using the implantable VeriChip are recorded at gross amounts with a corresponding entry for cost of sales. As we have had a limited marketing period for these systems, the level of returns cannot yet be reasonably estimated. Accordingly, we do not recognize revenues until after the systems are shipped and title has transferred, provided that a purchase order has been received or a contract has been executed, the price is fixed or determinable, there are no uncertainties regarding customer acceptance, the period of time in which the distributor or customer has to return the product has elapsed and collection of the sales proceeds is reasonably assured. Once the level of returns can be reasonably estimated, revenues (net of expected returns) will be recognized at the time of shipment and the passage of title, assuming there are no uncertainties regarding customer acceptance. If uncertainties regarding customer acceptance exist, revenues will not be recognized until such uncertainties are resolved. We intend to recognize revenues from consignment sales to our GPOs after receipt of notification of product sales to their customers provided that a purchase order has been received or a contract has been executed with the GPO, the sales price is fixed or determinable, the period of time the GPO has to return the products as provided in its distributor agreement has elapsed and collectibility is reasonably assured. The products are sold to the GPOs and distributors with a limited warranty period.

 

Revenue Recognition Policy for VeriMed and VeriGuard Services

 

When offered, the services for maintaining subscriber information on our database registry will be sold as a stand-alone contract and treated according to the terms of the contractual arrangements then in effect as a separate earnings process. Revenues from this service generally will be recognized over the term of the subscription period or the term of the contractual arrangements then in effect.

 

Revenue Recognition Policy for Wander Prevention, Infant Protection and Asset Location and Tracking and Vibration Monitoring Systems

 

Hardware and software revenues are recognized when persuasive evidence of an arrangement exists, the goods are shipped and title passes, the price is fixed or determinable and collection of the sales proceeds is reasonably assured. Revenue from the sales of calibration and third party installation services is recognized as the services are performed. Revenue from post-contract support services is recognized over the term of the agreement. When software arrangements include multiple elements to which contract accounting does not apply, the individual elements are accounted for separately if vendor specific objective evidence, or VSOE, of fair value exists for the undelivered elements. Generally, the residual method is applied in allocating revenue between delivered and undelivered elements. If VSOE does not exist, the revenue on the completed arrangement is deferred until the earlier of VSOE being established or all of the undelivered elements are delivered or performed with the following exceptions: if the only undelivered element is post contract support, the deferred amount is recognized ratably over the post contract support period, and if the only undelivered element is services that do not require significant production, modification or customization of the software, the deferred amount is recognized as the services are performed. Maintenance revenue is deferred and recognized ratably over the terms of the maintenance agreements.

 

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Inventory Obsolescence

 

Estimates are used in determining the likelihood that inventory on hand can be sold. Historical inventory usage and current revenue trends are considered in estimating both obsolescence and slow-moving inventory. Inventory is stated at the lower of cost or market, determined by the first-in, first-out method, net of any reserves for obsolete or slow-moving inventory. As of September 30, 2005 and December 31, 2004, inventory reserves were $0.5 million and $0.1 million, respectively. We did not have any inventory reserves as of December 31, 2003 and 2002.

 

Goodwill and Other Intangible Assets

 

On January 1, 2002, we adopted Statement of Financial Accounting Standard No. 142, Goodwill and Other Intangible Assets, or FAS 142. FAS 142 eliminated the amortization of goodwill and other intangible assets with indefinite lives and instead requires that goodwill and other intangible assets with indefinite lives be tested for impairment at least annually. Intangible assets with finite lives are amortized over their useful lives.

 

In accordance with FAS 142, we are required to test our goodwill and intangible assets with indefinite lives for impairment annually. We test our goodwill and intangible assists with indefinite lives annually as part of our business planning cycle during the fourth quarter of each fiscal year. As of December 31, 2004, we did not have goodwill or other intangible assets. However, as a result of the acquisitions of two businesses during the first half of 2005, as of September 30, 2005, our consolidated goodwill was $18.1 million and the value of our intangible assets with indefinite lives totaled $4.9 million. Future events, such as market conditions or operational performance of our acquired businesses, could cause us to conclude that impairment exists relating to these assets, which would result in our having to record impairment charges.

 

Stock-Based Compensation

 

We account for our employee stock-based compensation plans in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, or APB 25, and Financial Accounting Standards Board Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation – an Interpretation of APB Opinion No. 25, and the disclosure provisions of FAS 123. In accordance with this accounting literature, no compensation cost is recognized for any of our fixed stock options granted to employees and directors when the exercise price of each option equals or exceeds the fair value of the underlying common stock as of the option grant date. When options are granted to employees and directors at a price less than fair market value on the date of the grant, compensation expense is required to be calculated based on the intrinsic value (i.e., the difference between the exercise price and the fair value on the date of the grant), and the compensation is recognized over the vesting period of the options. If the options are fully vested, the expense is recognized immediately. Changes in the terms of stock option grants, such as extending the vesting period of the options or changes in the exercise price, result in variable accounting in accordance with APB 25, such that compensation expense is measured and recognized over the vesting period. If the modified grant is fully vested, any additional compensation costs are recognized immediately.

 

We granted to certain of our employees options to purchase shares of our common stock. The options were granted at exercise prices equal to the value of the underlying common stock on the date of each grant, as determined by our management. Our management determined these values principally based upon internal valuation estimates as well as arms-length transactions involving the fair value of the businesses we acquired. The assumptions used by our management included:

 

    our projected operating performance;

 

    risk and the non-liquid nature of our common stock;

 

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    the purchase prices of the two businesses acquired during the first half of 2005; and

 

    trends and comparable valuations in the broad market for privately-held and publicly-traded technology and medical device companies.

 

There are inherent uncertainties in making estimates about forecasts of future operating results and identifying comparable companies and transactions that may be indicative of the fair value of our securities. We believe that the estimates of the fair value of our common stock at each option grant date are reasonable under the circumstances.

 

We have also granted nonqualified stock options to employees of Applied Digital and other non-employees who have provided services to us. For these options, we recognized the stock-based expense as the options vested based on an estimate of their fair value on the date of grant using the Black-Scholes option pricing model, which requires us to make several key judgments including:

 

    the estimated value of our common stock;

 

    the expected life of issued stock options;

 

    the expected volatility of our stock price; and

 

    the expected dividend yield to be realized over the life of the stock option.

 

We prepared these estimates based upon our historical experience, the stock price volatility of comparable publicly-traded companies, including Applied Digital, and our best estimation of future conditions.

 

On December 12, 2005, our board of directors approved a proposal which provides for vesting on December 30, 2005 of all of our outstanding and unvested stock options previously awarded to employees, and directors and to one employee of Applied Digital (to the extent not already vested on that date), provided, however, that the grantee that acquires any shares pursuant to such an option (the vesting of which has been accelerated) shall not be permitted to sell such shares until the earlier of: (i) the original vesting date applicable to such option or (ii) the date on which such grantee’s employment terminates for any reason.

 

The purpose of the accelerated vesting was to enable us to avoid recognizing in our statement of operations non-cash compensation expense associated with the options in future periods. As a result of the acceleration, we expect to avoid recognition of up to approximately $0.6 million of compensation expense in our statement of operations over the course of the original vesting period. Such expense will be included in our pro forma stock-based footnote disclosure for the quarter ended December 31, 2005. The majority of such compensation expense is expected to be avoided in 2006. FASB Financial Interpretation No. 44 requires us to recognize compensation expense under certain circumstances, such as a change in the vesting schedule when such options are in the money on the date of acceleration, that would allow an employee to vest an option that would have otherwise been forfeited based on the award’s original terms. We would be required to begin to recognize compensation expense over the new expected vesting period based on estimates of the number of options that employees ultimately will retain that otherwise would have been forfeited, absent the modifications. The majority of the accelerated options, absent the acceleration, would have been vested over the next six months, with a smaller percentage vesting over the next thirty-three months. Such estimates of compensation expense would be based on such factors as historical and expected employee turnover rates and similar statistics. Of the 1.0 million stock options that were affected by the acceleration of vesting, substantially all of the $4.4 million of intrinsic value of the newly vested options is attributable to our executive officers and directors. We are unable to estimate the number of options that our employees and directors will ultimately retain that otherwise would have been forfeited, absent the acceleration. Based on the current circumstance, the high concentration of options awarded to officers and directors and our historical turnover rates, no compensation expense resulting from the new

 

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measurement date will be recognized by us on December 30, 2005. We will recognize compensation expense in future periods, should a benefit be realized by the holders of the aforementioned options, which they would not otherwise have been entitled to receive.

 

In December 2004, the Financial Accounting Standards Board, or FASB, issued FAS 123R. FAS 123R is more fully described below under “Impact of Recently Issued Accounting Standards.” The provisions of FAS 123R will become effective for us beginning January 1, 2006. As discussed above, all of our outstanding employee stock options will be vested upon adoption on January 1, 2006, and, therefore, we do not expect that the initial adoption of FAS 123R will have a material impact on our consolidated results of operations and earnings (loss) per share. However, going forward, as we grant more options, we expect that the impact may be material. We have not yet determined the method of adoption, and we have not determined whether the adoption will result in amounts that are similar to the current pro forma disclosures required under FAS 123, although we anticipate that the amounts may be greater due to increases in personnel during 2005. In addition, we have not yet determined the impact of FAS 123R on our compensation policies or plans, if any.

 

Accounting for Income Taxes

 

As part of the process of preparing our consolidated financial statements, we are required to estimate our income tax liability in each of the jurisdictions in which we do business. This process involves estimating our actual current tax expense together with assessing temporary differences resulting from differing treatment of items, such as deferred revenues, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in our consolidated balance sheet. We must then assess the likelihood that our net deferred tax assets in each tax jurisdiction will be recovered from future taxable income in the applicable jurisdiction and, to the extent we believe that recovery is not more likely than not or is unknown, we must establish a valuation allowance.

 

Significant management judgment is required in determining the provision for income taxes, deferred tax assets and liabilities and any valuation allowance recorded against the deferred tax assets. As of September 30, 2005, we had $6.0 million in net deferred tax liabilities and net deferred tax assets of $0.1 million, associated with our Canadian operations. As of September 30, 2005 and December 31, 2004, 2003 and 2002, we had recorded a full valuation allowance against our U.S. net deferred tax assets due to uncertainties related to our ability to utilize these deferred tax assets, primarily consisting of net operating losses carried forward. The valuation allowance is based on our historical operating performance and estimates of taxable income in the United States and the period over which our deferred tax assets will be recoverable. As of September 30, 2005, we have not provided a valuation allowance against our Canadian deferred tax assets as we have deemed it more likely than not that these assets will be realized.

 

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Results of Operations

 

The table below sets forth data from our statements of operations for the nine months ended September 30, 2005 and 2004 and the years ended December 31, 2004 and 2003, expressed as a percentage of total revenue. We did not generate any revenue during 2002. Almost all of our revenue to date has come from our recent business acquisitions. Prior to these acquisitions, we had minimal revenues and, therefore, period to period results are not comparable and our historical results are not necessary indicative of our future results. In addition, in October 2004, FDA clearance was obtained to market VeriMed for its medical applications. Through September 30, 2005, we have not recorded any revenue from sales of our VeriMed patient identification system. For future periods, we expect that sales of our VeriMed patient identification system will become a major part of our revenue, although there can be no assurance that they will.

 

     Nine Months Ended
September 30,


   Year Ended
December 31,


 
         2005    

       2004    

       2004    

       2003    

 
     (Unaudited)            

Product revenue

   93.5%    100.0%    100.0%    100.0%  

Service revenue

   6.5%           
    
  
  
  

Total revenue

   100.0%    100.0%    100.0%    100.0%  
    
  
  
  

Cost of products sold

   35.1%    46.9%    80.6%    36.7%  

Cost of services sold

   4.5%           
    
  
  
  

Gross profit

   60.4%    53.1%    19.4%    63.3%  

Selling, general and administrative expense

   76.8%    762.6%    781.4%    362.8%  

Research and development

   11.6%           

Interest and other income

   (0.4)%    (8.4)%    (6.1)%     

Interest and other expense

   2.5%    54.8%    58.3%    14.3%  
    
  
  
  

Loss before benefit for income taxes

   30.1%    (755.9)%    (814.2)%    (313.8)%  

Benefit for income taxes

   (0.6)%           
    
  
  
  

Net loss

   29.5%    (755.9)%    (814.2)%    (313.8)%  
    
  
  
  

 

Our profitability and liquidity depend on many factors, including the success of our marketing programs, the maintenance and reduction of expenses and our ability to successfully develop and bring to market our new products and technologies.

 

Nine Months Ended September 30, 2005 Compared to Nine Months Ended September 30, 2004

 

Revenue

 

Revenue for the nine months ended September 30, 2005 increased $8.9 million to $9.1 million from $0.2 million for the nine months ended September 30, 2004.

 

Our healthcare segment’s revenue was $6.9 million for the nine months ended September 30, 2005 as a result of sales of our infant protection, wander prevention and asset location and identification systems following our acquisitions of VCI and Instantel during the first half of 2005. Our healthcare segment did not generate any revenue during the nine months ended September 30, 2004.

 

Our security and industrial segment’s revenue was $2.2 million for the nine months ended September 30, 2005 compared to $0.2 million for the nine months ended September 30, 2004. The $2.0 million increase was due to sales of $2.2 million from our asset location and identification and vibration monitoring systems following our acquisitions of VCI and Instantel during the first half of 2005, partially offset by a $0.2 million decrease in sales of VeriGuard.

 

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Gross Profit and Gross Profit Margin

 

Gross profit for the nine months ended September 30, 2005 was $5.5 million, an increase of $5.4 million from $0.1 million for the nine months ended September 30, 2004. As a percentage of revenue, our gross profit margin increased to 60.4% for the nine months ended September 30, 2005 from 53.1% for the nine months ended September 30, 2004.

 

During the nine months ended September 30, 2005, our healthcare segment’s gross profit was $4.2 million and its gross profit margin was 60.5%. Our healthcare segment did not generate any revenue or gross profit margin during the nine months ended September 30, 2004. The increase in gross profit was due to the sales of our infant protection, wander prevention and asset location and tracking systems to healthcare providers. We expect our healthcare segment’s gross profit margins to remain relatively constant in the future.

 

Our security and industrial segment’s gross profit increased $1.2 million to $1.3 million in the nine months ended September 30, 2005 from $0.1 million in the nine months ended September 30, 2004. The gross profit margin was 60.3% in the nine months ended September 30, 2005 as compared to 53.1% in the nine months ended September 30, 2004. The increases in gross profit and margin were attributable to sales of our asset location and tracking and vibration monitoring systems to security and industrial customers. We expect our security and industrial segment’s gross profit margins to remain relatively constant in the future.

 

Selling, General and Administrative Expense

 

Selling, general and administrative expense increased $5.6 million, or 412.9%, to $7.0 million in the nine months ended September 30, 2005 as compared to $1.4 million the nine months ended September 30, 2004. As a percentage of revenue, selling, general and administrative expense was 76.8% and 762.6% for the nine months ended September 30, 2005 and 2004, respectively.

 

Included in selling, general and administrative expense for the nine months ended September 30, 2005 and 2004 was $0.4 million and $0.3 million, respectively, of certain general and administrative services provided to us by Applied Digital, including, accounting, finance and legal services, telephone, rent and other miscellaneous items. We also expect the cost of the services being provided by Applied Digital under the terms of the transition services agreement to increase going forward as the transition services agreement has expanded the scope of the services to be provided.

 

Also, included in selling, general and administrative expense for the nine months ended September 30, 2005 and 2004 was $1.1 million and $0.2 million of compensation expense, respectively, associated with stock options granted to employees of Applied Digital and consultants.

 

Included in selling, general and administrative expense for the nine months ended September 30, 2005 and 2004 was approximately $0.7 million and $36,000, respectively, of depreciation and amortization expense. The increase is associated with equipment and intangible assets acquired as a result of acquisitions during the first half of 2005.

 

Our healthcare segment’s selling, general and administrative expense increased $4.3 million to approximately $5.1 million in the nine months ended September 30, 2005 from $0.8 million in the nine months ended September 30, 2004 due primarily to our acquisitions during the first half of 2005 of our infant protection, wander prevention and asset location and tracking systems businesses. As a percentage of revenue, selling general and administrative expense was 73.1% in the nine months ended September 30, 2005. Our healthcare segment did not generate any revenue in the nine months ended September 30, 2004.

 

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Our security and industrial segment’s selling, general and administrative expenses increased $1.3 million to $1.9 million in the nine months ended September 30, 2005 from $0.6 million in the nine months ended September 30, 2004 due primarily to our acquisitions during the first half of 2005 of our asset location and tracking and vibration monitoring systems businesses. As a percentage of revenue, selling, general and administrative expense decreased to 88.6% in the nine months ended September 30, 2005 from 342.5% in the nine months ended September 30, 2004, due primarily to the increase in sales in the 2005 period.

 

Research and Development

 

Research and development expense was approximately $1.1 million in the nine months ended September 30, 2005. We did not incur any research and development expense during the nine months ended September 30, 2004. As a percentage of revenue, research and development expense was 11.6% for the nine months ended September 30, 2005.

 

During the nine months ended September 30, 2005, research and development was $0.8 million for our healthcare segment and $0.3 million for our security and industrial segment. Our research and development expense related primarily to salaries and other employee expenses.

 

Interest Expense

 

Interest expense was $0.2 million and $0.1 million for the nine months ended September 30, 2005 and 2004, respectively. The interest expense was due to our level of outstanding borrowings owed to Applied Digital. We intend to use a portion of the proceeds from this offering to repay outstanding indebtedness owed to Applied Digital.

 

Income Taxes

 

We had an effective income tax benefit rate of 0.2% for the nine months ended September 30, 2005 related to our Canadian operations, which we acquired during the first half of 2005. We incurred a loss before taxes for the nine months ended September 30, 2005 and 2004 and we have not recorded a tax benefit for the resulting U.S. net operating loss carryforwards, as we have determined that a valuation allowance against our net U.S. deferred tax assets was appropriate based primarily on our historical operating performance.

 

Years Ended December 31, 2004, 2003 and 2002

 

From our inception through December 31, 2004, the majority of our efforts were focused on developing the markets for our VeriGuard product and obtaining FDA clearance for the VeriMed patient identification system. In October 2004, FDA clearance was obtained for the VeriMed patient identification system for its medical applications. As a result, we generated minimal revenue during the years ended December 31, 2004, 2003 and no revenues during 2002. We did not incur research and development expense during these years, as all development of these products was performed by Digital Angel. We have rights to these products from Digital Angel under an exclusive amended and restated supply, license and development agreement.

 

Revenue

 

Revenue for the years ended December 31, 2004 and 2003 was $0.2 million and $0.5 million, respectively. We did not generate any revenue during 2002. The revenue for 2004 and 2003 was comprised of sales of our VeriGuard system sold primarily to distributors. The decrease in revenue in 2004 as compared to 2003 was primarily due to a shift in focus to VeriMed and our decision to change from selling to small exclusive distributors to working with potential strategic alliances in the development of full scale security systems for our VeriGuard system.

 

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Gross Profit and Gross Profit Margin

 

Gross profit for the years ended December 31, 2004 and 2003 was $48,000 and $0.3 million, respectively. We did not generate any gross profit during 2002. The decrease in gross profit in 2004 as compared to 2003 was primarily a function of the decrease in sales. Our gross profit margin was 19.4% and 63.3% in 2004 and 2003, respectively. The decrease in gross profit margin for 2004 was due primarily to an allowance for slow moving inventory of approximately $0.1 million.

 

Selling, General and Administrative Expense

 

Also included in selling, general and administrative expense from the years ended December 31, 2005, was $0.3 million, $0.7 million and $0.1 million of compensation expense, respectively, associated with options granted to employees of Applied Digital and Consultants.

 

Included in selling, general and administrative expense for the years ended December 31, 2004, 2003 and 2002 was $0.4 million, $0.3 million and $0.2 million, respectively, of certain general and administrative services provided to us by Applied Digital including, accounting, finance and legal services, telephone, rent and other miscellaneous items. The cost of these services was determined based on use and management believes such cost to be reasonable.

 

Our healthcare segment’s selling, general and administrative expense increased $0.4 million to $0.9 million for the year ended December 31, 2004 from $0.5 million for the year ended December 31, 2003, primarily as a result of increased marketing efforts for our VeriMed patient identification system. Our healthcare segment’s selling, general and administrative expenses were $0.5 million and $0.3 million for the years ended December 31, 2003 and 2002, respectively.

 

Our security and industrial segment’s selling, general and administrative expense decreased $0.5 million to $1.0 million for the year ended December 31, 2004 from $1.5 million for the year ended December 31, 2003, primarily as a result of a shift in the focus of our marketing efforts to the medical applications of the implantable VeriChip as a result of FDA’s clearance during the fourth quarter of 2004. Our security and industrial segment’s selling, general and administrative expense increased to $1.5 million for the year ended December 31, 2003 from $1.0 million for the year ended December 31, 2002, primarily as a result of increased marketing efforts. As a percentage of revenue, the security and industrial segment’s selling general and administrative expense increased to 350.3% in 2004 from 266.1% in 2003 primarily as a result of the decrease in revenue. Our security and industrial segment did not generate revenue during the year ended December 31, 2002.

 

Interest Expense

 

Applied Digital has funded our operations since our inception in November 2001 through loans. Interest expense for the years ended December 31, 2004, 2003 and 2002 was $0.1 million, $0.1 million and $21,000, respectively, and represented the interest charged to us by Applied Digital. The interest rate used to compute such interest was based upon the prevailing prime rate as published by The Wall Street Journal in effect during the applicable periods.

 

Income Taxes

 

We incurred losses before taxes for each of the years ended December 31, 2004, 2003 and 2002, and we have not recorded a tax benefit for any of these years. As a result of the losses, we have determined that a valuation allowance against our net deferred tax assets in each of these years was appropriate because, based on our historical performance and our estimates of future U.S. taxable income, it was deemed to be more likely than not that a tax benefit would not be realized.

 

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Liquidity and Capital Resources

 

As of September 30, 2005, cash and cash equivalents totaled $2.1 million compared to cash and cash equivalents of approximately $23,000 at December 31, 2004.

 

Cash Flows Used in Operating Activities

 

Net cash used in operating activities totaled $1.3 million, $0.7 million, $1.0 million, $1.0 million and $0.9 million during the nine months ended September 30, 2005 and 2004 and during the years ended December 31, 2004, 2003 and 2002, respectively. In the nine months ended September 30, 2005, cash was used primarily to fund operating losses and accounts receivable and for payments of accounts payable and accrued expenses, partially offset by an increase in deferred revenue. In the nine months ended September 30, 2004 and in each of the years ended December 2004, 2003 and 2002, cash was used primarily to fund operating losses.

 

Cash Flows from Investing Activities

 

Investing activities provided (used) cash of $1.6 million, $(29,000), $(32,000), $(6,000) and $(0.2) million during the nine months ended September 30, 2005 and 2004 and during the years ended December 31, 2004, 2003 and 2002, respectively. In the nine months ended September 30, 2005, cash of $1.8 million was provided by business acquisitions and cash of $0.2 million was used to purchase equipment. In the nine months ended September 30, 2004 and during each of the years ended December 31, 2004, 2003 and 2002, cash was used to purchase equipment.

 

Cash Flows from Financing Activities

 

Financing activities provided cash of $1.9 million, $0.5 million, $0.8 million, $1.3 million and $1.1 million during the nine months ended September 30, 2005 and 2004 and during the years ended December 31, 2004, 2003 and 2002, respectively. In each of the periods, cash was provided primarily by borrowings from Applied Digital.

 

Applied Digital contributed the shares of VCI that it acquired to us in exchange for 3.3 million shares of our common stock. It also funded our acquisition of Instantel in the amount of $22.3 million.

 

Credit Facilities

 

To date, we have financed a significant portion of our operations and investing activities primarily through funds from our founder and sole stockholder, Applied Digital. As of September 30, 2005, we were indebted to Applied Digital in the amount of $6.7 million, including $0.4 million of accrued interest. Our loan with Applied Digital bears interest at the prevailing prime rate of interest as published by The Wall Street Journal, which as of September 30, 2005 was 6.5% per annum. We intend to use a portion of the proceeds from this offering to repay all outstanding indebtedness owed to Applied Digital.

 

We have a credit agreement with the Royal Bank of Canada. The credit facility provides for borrowings up to Canadian or, CDN$1.5 million, or approximately $1.2 million based on the exchange rate as of September 30, 2005 (no amount was outstanding under the credit agreement as of September 30, 2005). The annual interest rate on the facility is the Bank of Canada prime rate plus 1%.

 

Financial Condition

 

We believe that with the net proceeds we expect to raise from this offering, the cash we have on hand and operating cash flows we expect to generate, we will have sufficient funds available to cover our cash requirements for more than the next 12 months. We intend to use approximately $                 million of the net proceeds from this offering to repay our outstanding indebtedness owed to Applied Digital at the time of the consummation of this offering and approximately $1.0 million to reimburse Applied Digital for a

 

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portion of the purchase price paid to acquire Instantel, with the remaining proceeds to be used for general corporate purposes, which may include research and development, capital expenditures and sales and marketing, including marketing of our VeriMed patient identification system to hospitals and physicians. Our goal is to achieve profitability and to generate positive cash flows from operations. During 2006, our focus will be to generate significant revenue and cash flow from sales of our VeriMed and VeriGuard systems. Although there can be no assurance, we hope to realize positive cash flow from sales of our VeriMed and VeriGuard systems in the next twelve months as these systems gain customer awareness and acceptance.

 

Our capital requirements depend on a variety of factors, including, but not limited to, the rate of increase or decrease in our existing business base, the success, timing, and amount of investment required to bring new products to market, revenue growth or decline, and potential acquisitions. Failure to generate positive cash flow from operations will have a material adverse effect on our business, financial condition and results of operations.

 

Contractual Obligations

 

The following table summarizes our significant contractual obligations as of September 30, 2005 and assuming the completion of this offering, and the effect such obligations are expected to have on our liquidity and cash flows in future periods:

 

     Payments Due By Period

     Total

   Less Than
1 Year


   1-3 Years

   4-5 Years

  

More Than

5 Years


     (amounts in thousands)

Contractual Obligations

                                  

Amount due to our parent company

   $ 6,709    $   6,709    $    $    $

Reimbursement to parent company under purchase price obligation

     1,000      1,000               

Operating lease obligations

     906      211      513      182     

Purchase commitments(1)

     17,041           2,625      6,250      8,166

Employment related contracts

     181      181               
    

  

  

  

  

Total

   $ 25,837    $ 8,101    $ 3,138    $ 6,432    $ 8,166
    

  

  

  

  


(1) Our exclusivity rights under the amended and restated supply, license and development agreement between Digital Angel and us can be terminated if we do not purchase certain prescribed minimum quantities as disclosed in this table.

 

The expected timing or payment of obligations discussed above is estimated based on current information. Timing of payments and actual amounts paid may be different depending on changes to agreed-upon amounts for some obligations.

 

Impact of Recently Issued Accounting Standards

 

In December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment, or FAS 123R, which replaces FAS 123 and supersedes APB No. 25. FAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. The provision of FAS 123R will become effective for us beginning January 1, 2006. The pro forma disclosures previously permitted under FAS 123 no longer will be an alternative to financial statement recognition. Under FAS 123R, we must determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at the date of adoption. The transition methods include prospective and retrospective options. We are currently evaluating the requirements of FAS 123R. As discussed below, all of our outstanding

 

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employee stock options will be vested upon adoption on January 1, 2006, and, therefore, we do not expect that the initial adoption of FAS 123R will have a material impact on our consolidated results of operations and earnings (loss) per share. However, going forward, as we grant more options, we expect that the impact may be material. We have not yet determined the method of adoption, and we have not determined whether the adoption will result in amounts that are similar to the current pro forma disclosures required under FAS 123, although we anticipate that the amounts may be greater due to increases in personnel during 2005. In addition, we have not yet determined the impact of FAS 123R on our compensation policies or plans, if any.

 

On December 12, 2005, our board of directors approved a proposal which provided for vesting on December 30, 2005 of all of our outstanding and unvested stock options previously awarded to employees and directors and to one employee of Applied Digital (to the extent not already vested on that date), provided, however, that the grantee that acquires any shares pursuant to such an option (the vesting of which has been accelerated) shall not be permitted to sell such shares until the earlier of: (i) the original vesting date applicable to such option or (ii) the date on which such grantee’s employment terminates for any reason.

 

The purpose of the accelerated vesting was to enable us to avoid recognizing in our statement of operations non-cash compensation expense associated with the options in future periods. As a result of the acceleration, we expect to avoid recognition of up to approximately $0.6 million of compensation expense in our statement of operations over the course of the original vesting period. Such expense will be included in our pro forma stock-based footnote disclosures in the quarter ended December 31, 2005. The majority of such compensation expense is expected to be avoided in 2006. FASB Financial Interpretation No. 44 requires us to recognize compensation expense under certain circumstances, such as a change in the vesting schedule when such options are in the money on the date of acceleration, that would allow an employee to vest in an option that would otherwise been forfeited based on the awards’ original terms. We would be required to begin to recognize compensation expense over the new expected vesting period based on estimates of the number of options that employees ultimately will retain that otherwise would have been forfeited, absent the modifications. The majority of the accelerated options, absent the acceleration, would have been vested over the next six months, with a smaller percentage vesting over the next thirty-three months. Such estimates of compensation expense would be based on such factors as historical and expected employee turnover rates and similar statistics. Of the 1.0 million stock options that were affected by the acceleration of vesting, substantially all of the $4.4 million of intrinsic value of the newly vested options is attributable to our executive officers and directors. We are unable to estimate the number of options that our employees and directors will ultimately retain that otherwise would have been forfeited, absent the acceleration. Based on the current circumstance, the high concentration of options awarded to officers and directors and our historical turnover rates, no compensation expense resulting from the new measurement date will be recognized by us on December 30, 2005. We will recognize compensation expense in future periods, should a benefit be realized by the holders of the aforementioned options, which they would not otherwise have been entitled to receive.

 

In November 2004, the FASB issued SFAS No. 151, Inventory Costs, an amendment of ARB No. 43, Chapter 4, or FAS 151. FAS No. 151 amends Accounting Research Bulletin No. 43, Chapter 4, to clarify that abnormal amounts of idle facility expense, freight, handling costs and wasted materials (spoilage) should be recognized as current-period charges. In addition, FAS No. 151 requires that allocation of fixed production overhead to inventory be based on the normal capacity of the production facilities. We are required to adopt FAS 151 beginning January 1, 2006. We believe the adoption of FAS 151 will not have a material impact on the results of our operations, financial position or cash flows.

 

In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets, or FAS 153. This Statement amends Opinion 29 to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it will a general exception for exchanges of nonmonetary assets that do not

 

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have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. FAS 153 for effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. We believe the adoption of FAS 153 will not have a material impact on the results of our operations or financial position.

 

In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections – a replacement of APB Opinion No. 20 and FASB Statement No. 3, or FAS 154. FAS 154 replaces APB Opinion No. 20 and FASB Statement No. 3 and changes the requirements for the accounting for and reporting of a change in accounting principle. FAS 154 also applies to all voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. When a pronouncement includes specific transition provisions, those provisions should be followed. FAS 154 is effective for all accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. We have not yet adopted the provisions of FAS 154 and we have not yet determined the impact on our financial statements, if any.

 

Qualitative and Quantitative Disclosures about Market Risk

 

We presently do not use any derivative financial instruments to hedge our exposure to adverse fluctuations in interest rates, foreign exchange rates, fluctuations in commodity prices or other market risks, nor do we invest in speculative financial instruments. Amounts due to our parent, Applied Digital, bear interest at the prevailing prime rate of interest as published by The Wall Street Journal. Our line of credit with the Royal Bank of Canada bears interest at the Bank of Canada prime rate plus 1%. Our interest income is sensitive to changes in the general level of U.S. interest rates, particularly since our investments are short-term.

 

Due to the nature of our short-term investments, we have concluded that there is no material market risk exposure and, therefore, no quantitative tabular disclosures are required. Due to the de minimus amounts of foreign currency exchange gains and losses and translation adjustments during the nine months ended September 30, 2005, a sensitivity analysis of fluctuations in foreign currency exchange rates is not required.

 

The table below presents the principal amount and weighted-average interest rate for our debt portfolio:

 

     Fair Value at
September 30, 2005


     (dollars in thousands)

Loan due to parent company

   $6,709

Weighted-average interest rate for the nine months ended September 30, 2005

   4.25%

 

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OUR BUSINESS

 

Overview

 

We develop, market and sell RFID systems used to identify, locate and protect people and assets. Our goal is to become the leading provider of RFID systems for people in the healthcare industry. We sell passive RFID systems for identification purposes and active RFID systems for location and identification purposes. We have recently begun to market our VeriMed patient identification system which is used to rapidly and accurately identify people who arrive in an emergency room and are unable to communicate. Our VeriMed patient identification system uses the first human-implantable passive RFID microchip, the VeriChip, cleared for medical use in October 2004 by FDA.

 

We believe that our patient identification solution is compelling for emergency room physicians as well as for patients who have cognitive impairment, chronic diseases or implanted medical devices. Using our scanners, an emergency room physician can rapidly obtain the patient’s name, primary care physician, emergency contact and other pertinent pre-approved data, such as personal health records. We expect that this rapid and accurate identification process will reduce the risk of a patient being improperly treated and the potential liability associated with medical errors.

 

Our active RFID systems have been installed in over 4,000 healthcare locations throughout North America. We intend to leverage our domain expertise in marketing and selling RFID systems to healthcare institutions to market and sell our VeriMed patient identification system to our existing customers as well as to new customers. As of December 15, 2005, 66 hospitals have agreed to implement our VeriMed patient identification system in their emergency rooms.

 

In addition to our VeriMed patient identification system, we market and sell other RFID systems for other applications in the healthcare industry as well as for security and industrial applications. These RFID systems include:

 

    infant protection systems used to prevent mother-baby mismatching and infant abduction;

 

    wander prevention systems used for protection and location of residents in long-term care facilities;

 

    asset location and identification systems used to locate and identify medical equipment;

 

    asset management systems that also incorporate bar code technology used to track mobile assets, equipment and inventory; and

 

    other systems incorporating the implantable VeriChip used for security purposes such as access control, payment verification and military applications.

 

In addition to our RFID systems, we market and sell systems providing engineering, construction and mining professionals with an accurate and efficient means to monitor and document the effects of human-induced vibrations on neighboring structures in an area where blasting occurs.

 

Industry Overview

 

RFID has become an important technology widely adopted and used in the auto identification, or Auto-ID, market, an industry characterized by identifying and locating objects electronically. RFID systems identify objects using radio frequency transmissions, typically achieved with communication between a microchip or tag and a scanner or reader. Historically, RFID has been used to identify objects in retail, transportation and logistics industries, as well as to identify and locate livestock and companion pets. Prior to the adoption of RFID, users identified and tracked objects manually as well as through the use of bar code technology. These solutions were limited because of the need for ongoing human intervention and the lack of instantaneous location capabilities. RFID technology possesses greater range, accuracy, speed and lower line-of-sight requirements than bar code technology.

 

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Healthcare

 

Healthcare is well positioned to benefit from RFID technology because of the inefficiencies in the existing methods of identifying, locating and protecting people and assets. According to the RFID Journal, Fast Track Technologies issued a report in April 2005, stating that the market for RFID technologies in the hospital and healthcare sectors is estimated to grow to $8.8 billion by 2010.

 

Patient Identification

 

In a November 1999 study, To Err is Human: Building a Safer Health System, the Institute of Medicine stated that as many as 98,000 people die each year in hospitals in the United States because of medical errors, in part due to mistaken patient identification and lack of information on a patient’s medical history. In addition, the study estimates that such preventable errors result in losses, other than the loss of human life, of $17 billion to $29 billion per year. These losses include the expense of additional care needed because of mistakes made, disability, and lost productivity and income.

Physicians in hospital emergency rooms require rapid and accurate access to basic patient information, including name, primary care physician and emergency contact information, to provide proper care. Physicians unable to properly identify patients in an emergency room are at a higher risk of providing improper treatment to patients. The identification problem is particularly acute when patients are unable to communicate basic information. According to a study we commissioned by Fletcher Spaght in October 2005, there are approximately 45 million at-risk patients living with:

 

    cognitive impairment, including Alzheimer’s disease and senile dementia;

 

    chronic diseases and related conditions, including seizure disorders, diabetes, cardiac conditions, chronic pulmonary disorders and severe allergies; and

 

    implanted medical devices, including pacemakers, defibrillators, coronary stents, artificial joints and organ transplants.

 

There are a number of competing products currently in the market designed to enhance patient identification for these at-risk patients. Identification bracelets, health information wallet cards, and data-embedded personal tokens, or key fobs, are currently used to identify people in a medical emergency. A significant problem with these solutions is that the identification bracelet, wallet card or key fob may not be with the patient at a time of emergency. Biometric technologies, such as finger printing and retina scanning, are another potential solution, but we believe that at this time their use in patient identification is limited because of high false positive rates.

 

Medical Records

 

In addition to identifying patients and their basic information, healthcare providers require access to a patient’s pertinent data in a timely manner to provide optimal care. Currently, there is no easy way to access this information as no universal centralized medical database exists to allow all physicians to access any particular patient’s records. Recognizing the problem of patient identification and access to medical records, the United States federal government is currently attempting to address certain inefficiencies in the healthcare system related to information technology. In particular, the current administration has developed a National Health Information Technology Plan which features as one of its main initiatives a plan to establish electronic health records for a majority of Americans within the next ten years.

 

Infant Protection

 

In addition to identification issues associated with emergency room patients, hospitals may face problems in dealing with mother-baby mismatching and infant abduction. According to a study we commissioned by Fletcher Spaght in October 2005, there are 3,488 birthing centers or hospital maternity

 

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wards in the United States. Furthermore, according to the National Center for Health Statistics, there were 4.1 million babies born in the United States in 2004. Birthing centers and hospitals are encouraged to implement and maintain security measures to prevent instances of mismatching and abduction by the Joint Commission on Accreditation of Healthcare Organizations. Hospitals may feel pressure from a marketing, liability or regulatory standpoint, to take the necessary steps to prevent mismatchings and abductions and may seek out new technologies to provide efficient solutions.

 

Wander Prevention

 

Many individuals residing in long-term care facilities, including nursing homes and assisted living facilities as well as hospital psychiatric wards and trauma units, are at a high risk of wandering away from their care facility. This can result in danger to the individual and subsequent liability to the healthcare providers and insurance companies. According to the National Institute on Aging of the U.S. National Institute of Health, in 2005 there were approximately 37 million persons over the age of 65 in the United States alone, and that number is expected to grow to approximately 58 million by 2025. Furthermore, according to the National Nursing Home Survey, published by the Center for Disease Control in June 2002, as of 1999 there were 18,000 nursing homes in the United States in which approximately 27% of the residents suffered from Alzheimer’s disease, dementia or related disorders.

 

Asset Location and Identification

 

Hospitals and other healthcare facilities can face significant financial consequences because of inefficiencies in identifying and locating hospital equipment and other assets. Inefficient equipment tracking measures can lead to inadvertent use of contaminated equipment which can lead to potentially life-threatening patient infections. We believe that there is a need for the healthcare industry to address the problem of real time asset location and identification.

 

Security and Industrial

 

The security, industrial, and government sectors also stand to benefit from the implementation of RFID technology. Many high security facilities such as government and industrial facilities have a need for access monitoring. For example, nuclear power plants, national research laboratories and correctional facilities require the means to accurately and securely monitor activity.

 

Industrial companies, such as construction, oil and gas, and power companies, face increased costs related to inefficiencies in locating mobile assets and tools. For example, according to a study conducted by the National Equipment Register in January 2005, the construction industry alone loses between $300 million and $1 billion annually from equipment and tool theft. Industrial companies frequently experience problems and incur costs related to managing inventory.

 

Our Solutions

 

We develop, market and sell passive and active RFID systems. The VeriMed patient identification system, which incorporates the implantable VeriChip, provides patients with a rapid and accurate identification solution. Our active RFID solutions provide users with the ability to locate and identify objects for healthcare and other applications. All of our systems are designed to enhance operating efficiencies and reduce costs and potential liability.

 

Healthcare

 

Patient Identification

 

In hospital emergency rooms, physicians require rapid access to basic patient information to properly treat and care for a patient. We believe that our solution is compelling for emergency room physicians and patients who have cognitive impairment, chronic diseases or implanted medical devices.

 

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Our VeriMed patient identification system, which incorporates the implantable VeriChip, rapidly and accurately provides physicians with a patient’s pre-approved data which can include a patient’s name, primary care physician, emergency contact and other pertinent pre-approved data, such as personal health records.

 

Our VeriMed patient identification system benefits patients by providing:

 

    rapid and accurate identification, reducing the risk of erroneous treatment by a physician;

 

    privacy protection; and

 

    an identification solution that is always with the patient and cannot be forgotten or lost.

 

Our VeriMed patient identification system benefits hospitals and physicians by providing:

 

    rapid and accurate identification, reducing the risk of cost and liability associated with potential medical errors; and

 

    immediate access to a patient’s basic information and personal health records.

 

In addition to these patient identification solutions, we believe the adoption of the implantable VeriChip may be beneficial in industries other than healthcare. For example, identification tags, commonly known as dog tags, used to identify military personnel have drawbacks similar to identification bracelets, wallet cards and key fobs as they can be forgotten, lost or stolen. Our technology can also be used for corpse identification in disaster recovery situations. We believe that the implantable VeriChip can provide a better, more rapid, secure and accurate identification solution in these circumstances.

 

Infant Protection

 

We believe that we are the leading provider of wearable, active RFID infant protection systems. Our system reduces the risk of mother-baby mismatchings, infant abductions and enables healthcare professionals to accurately identify and locate infants. Our system protects infants from mismatching and abductions by sounding alarms, locking doors and disabling elevators. While mismatching and infant abductions are rare, the impact of a single case can create a severe negative impact on hospitals, birthing centers and families.

 

The benefits of our infant protection system include:

 

    a reliable and accurate security system using RFID technology;

 

    a proprietary skin-sensing and cut band technology that sounds an alarm if the tag is removed or tampered with;

 

    a reduction of potential liability to hospitals; and

 

    an enhanced marketability of a hospital or birthing center.

 

Wander Prevention

 

We believe that we are a leading provider of wearable, active RFID wander prevention systems. Our system allows healthcare professionals to accurately identify and locate residents of long-term care facilities, including nursing homes and assisted living facilities, as well as hospital psychiatric wards and trauma units. Our system protects residents from wandering by sounding alarms, locking doors and disabling elevators. Residents wearing our tags are typically individuals who suffer from a dementia related disorder, such as Alzheimer’s disease. In addition, hospitals can use our wander prevention system in their pediatric wards to help protect their patients and reduce potential liability.

 

The benefits of our wander prevention system include:

 

    the protection of residents without physical restraint, providing them freedom to move throughout their place of residence;

 

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    the reduction of staff and the increased ability to focus on care rather than protection; and

 

    the reduction of potential liability to long-term care and related facilities.

 

Asset Location and Identification

 

Our asset location and identification system provides a reliable and efficient method to track and locate medical equipment. By using RFID technology, our system enables hospital staff to locate the equipment they require on demand and reduces the likelihood of unnecessary equipment purchases or rentals. This system locates equipment that may be lost or misplaced and can also provide information on the equipment’s condition. This helps to ensure that patients are treated with sterile and safe equipment and reduces the risk of infection or disease.

 

Security and Industrial

 

The implantable VeriChip and our active RFID tags are used in our VeriGuard system to offer access control, payment verification and other government and military applications. These applications can be used in high security facilities, such as government facilities, nuclear power plants, national research laboratories and correctional facilities to provide secure ingress and egress and local area location. In addition, our technology platform is compatible with other security identification technologies.

 

We also offer a management system for mobile industrial assets based on bar code and RFID technology. Our systems serve an important need in industrial environments by providing an accurate and efficient checkout and return system for tools, equipment and supplies. This automated system assigns mobile assets to specific employees, reducing theft and hoarding of assets.

 

Our Strategy

 

Our objective is to become the leading provider of RFID systems for people in healthcare. To achieve this goal, we intend to pursue the following strategies:

 

  Establish our VeriMed patient identification system as the leading patient identification solution in the healthcare industry. The implantable VeriChip, which is used in our VeriMed patient identification system, is the first FDA-cleared, human-implantable RFID microchip. We intend to capitalize on our first-mover advantage by leveraging our domain expertise in marketing and selling RFID systems to healthcare institutions to market and sell our VeriMed patient identification system to our existing customers as well as to new customers. This strategy includes:

 

  providing our proprietary scanners, which scan the implantable VeriChip, to strategically located hospital emergency rooms in targeted regional areas;

 

  educating and training physicians and other healthcare professionals of the benefits of our VeriMed patient identification system so that they will recommend our solutions to their patients; and

 

  marketing to at-risk patients directly as well as indirectly through their physicians.

 

  Leverage our proprietary technology platform to increase a barrier to entry for our competitors. Our active RFID technology platform, the VeriChip Auto-ID platform, is a scalable software platform designed to operate our proprietary applications as well as third party applications. Our goal is to make this technology platform widespread in hospitals in North America. This strategy includes:

 

  completing the integration of all of our RFID systems into our VeriChip Auto-ID platform;

 

  enabling our customers to centralize all of their identification and location processing of data, wherever derived, on our VeriChip Auto-ID platform; and

 

  targeting our existing customers to sell them our asset location and tracking systems and upgrade to our VeriChip Auto-ID platform.

 

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  Market and sell our systems internationally through distribution relationships. We are actively seeking to enter into global distribution agreements with systems integrators to provide us with access to international system sales. Our initial expansion is focused on English speaking countries outside of North America. We believe that the demographic trends that may have contributed to our success in North America also exist in other western countries.

 

  Address additional strategic markets for the implantable VeriChip. We believe that there is an opportunity for us to commercialize the implantable VeriChip in industries other than healthcare. For example, in the wake of Hurricane Katrina, we donated implantable VeriChips in Missouri and Texas in conjunction with FEMA’s department of mortuary services to help identify corpses. In the future, we plan to market the implantable VeriChip to FEMA for future disaster recovery efforts as well as to the military as a replacement for traditional dog tags.

 

  Pursue complementary acquisitions. We acquired two businesses in 2005. These acquisitions have enhanced our technology as well our product offerings. We intend to continue to seek to identify similarly situated companies that we believe could broaden the functionality and strength of our existing solutions.

 

Our Systems

 

Our systems, substantially all of which incorporate RFID technology, enable professionals to more effectively identify, locate and protect people and assets. Our systems include patient identification systems, infant protection systems, wander prevention systems, asset location and identification systems as well as other systems.

 

All of our RFID systems include the following three components:

 

    active or passive RFID tags or microchips;

 

    fixed location readers or handheld scanners with a built in antenna; and

 

    application software that either includes or connects to a database.

 

Our VeriMed Patient Identification System

 

Our VeriMed patient identification system provides physicians with rapid and accurate pertinent pre-approved patient data. The components of our system include:

 

    the only FDA-cleared human implantable RFID microchip;

 

    a hand-held scanner with a built in antenna; and

 

    a secure database containing patient-approved information.

 

The implantable VeriChip is a passive RFID microchip, approximately the size of a grain of rice, that is inserted under the skin in a patient’s arm by the patient’s physician or other authorized healthcare professional. Each implantable VeriChip contains a unique identification number. The implantable VeriChip is read when it is scanned by our scanner. Our scanner then sends the identification number to a secure information database that contains the individual’s personal contact information, emergency contact information and primary care physician contact information. In addition, to enhance the quality of care that they would receive in an emergency, patients can store their personal healthcare information on our data base registry. In addition, patients can store this information on a third-party database registry, which generally can be easily integrated with our VeriMed patient identification system.

 

Our Infant Protection Systems

 

Our infant protection systems, which we market and sell under the Hugs and HALO names, are designed to help hospitals lower the risk of mother-baby mismatching and infant abductions. The Hugs

 

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system uses a proprietary bracelet containing an active RFID tag intended to go around the infant’s wrist or ankle. If the bracelet is cut, a signal is emitted to a reader. The HALO system uses a generic bracelet containing an active RFID tag incorporating our proprietary skin-sensing technology also intended to go around an infant’s wrist or ankle. If the skin-sensing tag is removed from the infant’s skin, a signal is emitted to a reader. In each case, a corresponding tag is placed on the mother to ensure proper matching of mother and child.

 

When the tag is initially attached to an infant, it emits a beacon with a unique identification number and becomes automatically registered in our system’s software. Unlike the implantable VeriChip, which does not emit a signal or a beacon, the infant tag continues to emit a beacon every 10 seconds. The beacon is received by readers positioned above the ceiling or by a door that continuously monitor the tag’s location. Once a signal is emitted to a reader, the reader then sends the signal to a server containing our application software.

 

Our application software allows perimeter monitoring, continuous location monitoring of the infant, historical location monitoring and mother-baby matching. Once our infant protection system is installed and activated in a facility, staff and visitors can move infants freely within a protected zone, but infants cannot be removed from a designated area without a staff member being alerted. If an abductor takes an infant to an exit point, our software is capable of executing a variety of precautionary measures, such as triggering an alarm, alerting a nurse, identifying and locating particular infants, locking doors and shutting down elevators.

 

Our Wander Prevention Systems

 

Our wander prevention systems, which we market and sell under our RoamAlert and WatchMate names, are designed to prevent residents of long-term care facilities from wandering away from the facility or entering harmful or restricted areas. These systems consist of an active RFID bracelet, readers discretely positioned at points of exit along an identified perimeter and application software. Residents prone to wandering wear RFID bracelets approximately the size of a sports watch. The readers are similar to those used in our infant protection system. The wander prevention software can provide perimeter security. If a resident wearing a bracelet attempts to wander through a restricted door, the wander prevention systems may, among other things, activate a magnetic lock or sound an alarm at the nurse’s station.

 

Our Asset Location and Identification Systems

 

Assetrac

 

Our Assetrac system enables hospitals to efficiently identify, locate and protect medical equipment. Active RFID tags, affixed to hospital equipment, periodically transmit a beacon which includes a unique identification number. A signal is also emitted if the tag is removed from a piece of equipment. These signals are transmitted to readers which in turn send the signals to the server containing the VeriChip Auto ID platform. This software can continuously locate and track the tag as well as monitor equipment condition.

 

HOUNDware

 

Our HOUNDware asset management system is used by industrial companies to manage and track their mobile equipment and tools. HOUNDware is a turnkey system consisting of bar codes, passive RFID tags, durable scanners, wireless access points and management application software which includes a check-out and return system for mobile equipment and tools. The information relating to the equipment is maintained in a database enabling a company to monitor inventory, equipment maintenance status and job activity status.

 

 

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Our Other Systems

 

VeriGuard

 

Our VeriGuard system uses both the implantable VeriChip and active RFID tags to identify individuals and permit access into restricted areas. In the case of active tags, users have the ability to identify and locate individuals in restricted areas, similar to Assetrac, using the same reader technology. Alternatively, in the case of a VeriGuard system using an implantable VeriChip, users can be identified by a scanner to provide access to restricted areas although individuals who have an implanted VeriChip cannot be tracked or located.

 

Blastmate and MiniMate

 

Our non-RFID vibration monitoring systems provide engineering, construction and mining professionals with an accurate and efficient means to monitor and document the effects of human-induced vibrations on neighboring structures in an area where blasting occurs. Government regulations relating to vibration monitoring require compliance with specified standards to limit the potential for damage to neighboring structures and to minimize human annoyance that may result from commercial blasting or heavy construction. Our system assists in evaluating the peak vibration level, which is a key statistic in the prevention of structural damage.

 

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Addressable Markets and Applications

 

The following table identifies our current system offerings, addressable markets, current applications and representative users and customers that have deployed or beta tested our systems:

 

System   Market(s)   Applications  

Representative

Users and Customers

       

VeriMed

  Hospitals and Medical Facilities (Emergency Department)  

Patient identification

 

Patient admission

 

Patient record retrieval

 

Patient treatment

 

Reduction in medical errors

 

Hackensack University Medical Center

 

 

Providence Hospital

       

Hugs and HALO

 

 

 

Hospitals

 

Prevention of infant abduction

 

Mother/baby matching

 

Staff distress alerting

 

Controlled access to authorized areas

 

Stanford University Medical Center

 

Harvard Medical School

     
       

Roam Alert and WatchMate

 

 

 

Long Term Care Facilities

 

 

Assisted Living Facilities

Hospitals

 

Wander prevention

 

Patient location

 

Emergency response

 

Folsom Convalescent Hospital

 

 

Minnesota Veterans Home - Fergus Falls

     
       

Assetrac

 

Hospitals

 

Asset location

 

Asset protection

 

Maintenance scheduling

 

Perimeter protection

 

Asset identification

 

Legacy Hospital

 

Capital Regional Medical Center

       

HOUNDware

 

Construction

 

Power Generation

 

Oil & Gas

 

Forest Fire Management

 

Mobile asset location and identification

 

Return/checkout

 

Maintenance scheduling

 

Inventory Control

 

Bechtel Corporation

 

Hertz Equipment Rental Corporation

       

VeriGuard

 

Government

 

Commercial

 

Access control

 

Asset location

 

Personnel security

 

Visitor management

 

Attorney General

Office (Mexico)

 

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System   Market(s)   Applications  

Representative

Users and Customers

       
Other Systems Incorporating the VeriChip  

Emergency Response

 

Military

 

Medical Examiners/Coroners

 

Corpse tracking and identification

 

 

Dog tag replacement

 

DMORT (Disaster

Mortuary Operational

Recovery Team)

       

Blastmate and Minimate

 

 

 

Construction

 

Mining

 

Geotechnical

 

Vibration monitoring

 

Overpressure monitoring

 

Yangtze River Three

Gorges Dam Project,

 

Boston Artery Project (Big Dig)

 

Technology

 

A basic RFID system allows information to be collected quickly, does not require contact or line-of-sight and consists of tags and microchips as well as readers and scanners. RFID tags vary in shape and size and contain a miniature receiver/transmitter with an antenna controlled by a microchip. They can be either active or passive. Active RFID tags are powered by an internal battery. Passive RFID microchips such as the implantable VeriChip, on the other hand, are not powered by a battery and do not emit a beacon.

 

Passive Microchips and Scanners

 

Our VeriMed patient identification system incorporates a passive RFID microchip, the implantable VeriChip. The components of our implantable VeriChip include a semiconductor and an antenna, encased in a polymer-coated glass that binds our implantable VeriChip to human tissue. We refer to this bonding as bio-bonding. The implantable VeriChip can only be used for identification purposes and cannot be used to locate or track people. These passive implantable chips do not have a power supply and do not transmit a beacon. The implantable VeriChip can only be read by our proprietary scanner placed within approximately two to four inches of the implantable VeriChip. Our scanners receive a signal, transmitting a unique number to the scanner which is then sent to a computer. This enables healthcare providers to access a particular patient’s personal information stored in a database.

 

Active Tags and Readers

 

Our infant protection, wander prevention and asset location and identification systems incorporate an active RFID tag. This technology differs from the implantable VeriChip technology, as our active tags are designed for identification, location and tracking purposes. These active tags include an internal lithium battery enabling them to transmit a uniquely coded beacon on a continual or intermittent basis. The beacon has a range of approximately 40 to 60 feet indoors and 100 to 150 feet outdoors. Multiple readers embedded with antennas are strategically placed in selected locations throughout a facility to receive uniquely coded beacon signals from these active tags. All readers in range of a particular tag’s beacon send the received information to a server configured with our VeriChip Auto-ID platform. Using triangulation and other location algorithms, our technology platform can plot the location and identity of a particular active tag, regardless of the number of RFID tags in a given area.

 

In addition, our active tags include a tamper detection feature to prevent unauthorized removal, enhancing the security features of our systems. This includes our proprietary skin-sensing and cut band technologies used in our infant protection tags as well as our proprietary tamper proof asset tag used in our asset location and identification systems.

 

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Application Software

 

Our solutions are supported by our proprietary technology platform, which we refer to as our VeriChip Auto-ID platform, an intelligent event data collection software that provides location information. The software serves as a platform that has the ability to make intelligent decisions based on the data collected to assist users to identify, locate and protect key assets or individuals. Also, the VeriChip Auto-ID platform can receive and process data from third parties as well as collect location-based information and provide that information to a third party’s application software.

 

We have also developed application software that provides graphical end-user interfaces for our infant protection, wander prevention and asset location and identification systems. The graphical user interfaces allow users to monitor the system and be alerted to, among other things, security alarms, identification and location information, beeper notification or doors locking.

 

Research and Development

 

Our research and development group consists of 34 staff members based in Vancouver and Ottawa, Canada, who have an average of approximately 14 years of research and development experience. These employees are responsible for the development of hardware, software and the mechanical design of our systems. Further enhancements to our current systems and the development of new systems are important components of our ability to remain competitive in our marketplace.

 

One of our research and development efforts is targeted at completing the integration of our Hugs, HALO, RoamAlert and Assetrac systems with our VeriChip Auto-ID platform. We have developed our VeriChip Auto-ID platform to be compatible with all of these RFID systems. We intend to offer a “plug-and-play” solution for infant protection, wander prevention and asset location and identification to hospitals and other healthcare providers. We are also focused on developing a wireless infrastructure to connect all of our RFID readers eliminating the need to link the readers with a network of cables.

 

In addition, we are in the process of developing a wireless handheld scanner for our VeriMed patient identification system. This will enable our system to be used outside of an emergency room, such as in ambulances, other emergency rescue vehicles and remote locations.

 

Sales, Marketing and Distribution

 

Our customers consist of healthcare organizations, such as hospitals and long-term care facilities, healthcare professionals, such as physicians, and other customers that purchase our systems for non-healthcare applications, such as construction, oil and gas and power companies. We sell and market our systems generally through our direct sales force and through distributors. As of December 15, 2005, we had 15 sales and marketing representatives. Our sales and marketing group is based in Ottawa and Florida and includes sales representatives strategically located in North America. Our sales and marketing strategy is to sell our systems through multiple channels. We have built and will continue to increase our direct sales force. We also sell systems through distributors. We market our systems by attending trade shows and medical conferences and by advertising in publications.

 

Our VeriMed Patient Identification System

 

Our sales and marketing strategy for our VeriMed patient identification system is to contemporaneously market our system to hospitals and physicians. This dual sales and marketing approach is intended to accelerate the adoption of the VeriMed patient identification system by healthcare organizations as well as by physicians and patients.

 

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Our sales and marketing strategy for hospitals includes educating hospitals as to the benefits in adopting our VeriMed patient identification system. As of December 15, 2005, 66 hospitals registered to adopt the VeriMed patient identification system. Once registered, we install our scanner in the hospital emergency room and educate hospital personnel.

 

Our sales and marketing strategy for physicians includes using our sales force to directly market to and educate physicians in those geographic regions surrounding VeriMed-registered hospitals. Our strategy is for physicians to purchase our VeriMed patient identification kits and subsequently market them to their patients.

 

As our systems become widely adopted in our targeted geographic regions, we plan to leverage our relationship with Henry Schein Inc., a major supplier of pharmaceuticals and medical supplies, through a two-year consignment contract formed in November 2004. We believe that Henry Schein’s extensive distribution network will facilitate the sale of our VeriMed patient identification system to the physician community outside of our direct sales force’s customer base.

 

Our Other Healthcare Systems

 

We currently sell our infant protection and wander prevention systems through more than 200 distributors in North America and ten distributors outside of North America. These distributors are typically assigned a specific geographic sales territory. Additionally, we are a listed vendor to over 1,000 hospitals through our supply contracts with two major group purchasing organizations, or GPOs. Through these contracts, we sell our systems either directly to hospitals, in which case we use a local distributor for installation, or, through a distributor in which case the terms and conditions of the distributor’s sale are subject to the terms and conditions of our GPO contracts. To ensure that our systems are installed in accordance with our standards, we have established a distribution technical training and certification program.

 

We sell and market our Assetrac systems through a third party which markets our systems under their name using their sales force as well as through some of our distributors that also sell our infant protection systems.

 

Our Security and Industrial Systems

 

We sell and market our HOUNDware system solely through our direct sales force based in Canada. We market our HOUNDware system predominately in North America to approximately 150 accounts which include construction companies and other industrial organizations.

 

We sell our VeriGuard system through international distributors. We intend to seek additional distributors to sell our VeriGuard system in North America, and initially, in Europe. Our existing distributors market this system for security purposes to control access to restricted areas in government and industrial facilities.

 

We distribute our BlastMate and MiniMate systems to engineering, construction and mining professionals through an independent network consisting of approximately 75 distributors, approximately half of which operate in North America. In addition to these distributors, we also sell these systems through our direct sales force.

 

Competition

 

We face significant competition across all of our product lines from a wide variety of companies. Many of our current and future competitors have significantly greater financial, marketing and product development resources than we do. In addition, low barriers to entry across our product lines may result in new competitors entering the markets we serve. Increased competition may result in reduced prices, reduced gross margins and loss of market share.

 

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Generally, our solutions use RFID technologies. While many of our competitors also sell products that use RFID technologies, many sell products that incorporate alternative technologies, such as high frequency radio signals, or WiFi, bar code technology and biometric technology. Some of these technologies may prove to be a better or more cost effective solution than RFID technologies for customers in our target markets. In addition, our competitors may be able to respond more quickly to new or improved technologies by devoting greater resources to the development, promotion and sale of products. We expect our competitors to continue to improve the performance of and support for their current products and to introduce new products, technologies or services that could adversely affect sales of our current and future products.

 

With respect to our VeriMed patient identification system, we do not believe any other company currently offers a human implantable microchip-based identification system. However, various alternative patient identification solutions are currently available, such as bracelets sold by MedicAlert, health information wallet cards, biometric systems and key fobs that store personal health records. VeriMed is currently in its initial phase of deployment, and our competitive position will depend on whether hospitals and other healthcare providers accept this new technology and incorporate it into their standard operating procedure. Our competitive position will also depend on whether patients prefer our VeriMed patient identification system to existing or future identification systems.

 

With respect to our infant protection and wander prevention systems, we believe several other companies offer solutions for these markets. We believe that competition in these markets is mainly based on reputation and brand awareness. Given the fifteen years of experience of our subsidiary, Instantel, in these markets, we believe we compete favorably against our competitors. Based on a study we commissioned by Fletcher Spaght in October 2005, we believe we possess the leading market share of infant protection and a leading market share of wander prevention systems in North America.

 

With respect to the other systems we offer, we believe that competition is mainly based on product performance and ease of use, purchase price and operating cost. We believe that our systems are designed and manufactured to compete favorably based on these criteria with competitive systems currently in the market.

 

Manufacturing

 

Historically, our subsidiary VCI outsourced the manufacturing of all of its products to third parties, and our subsidiary Instantel outsourced the manufacturing of product components to third parties, but conducted final assembly, testing and quality control functions internally. We currently use the historical manufacturing processes of each of our subsidiaries for their respective products. As we continue to integrate our acquisitions, we intend to reevaluate our manufacturing procedures and determine whether to maintain our existing processes or to consolidate all or a portion of our manufacturing functions either with third parties or internally. Through December 15, 2005, we have not had material difficulties with respect to our ability to obtain our products manufactured by third parties or our supply of components for the products that we assemble. We believe that if any of our manufacturers or suppliers is unable or unwilling to provide us with our products or components, we would be able to procure alternative sources without material disruption to our business.

 

The supply of the implantable VeriChip is provided for under the terms of an amended and restated license agreement we have in place with Digital Angel. Digital Angel is majority owned by our parent, Applied Digital. Under the terms of the license agreement, we receive all of our supply of VeriChips from Digital Angel. Digital Angel relies solely on a production arrangement with Raytheon Microelectronics Espana, SA for the manufacture and assembly of VeriChips. The loss of our license with Digital Angel, or the loss of Digital Angel’s agreement with Raytheon, would adversely impact our supply of VeriChips and our ability to sell our VeriMed product until such time as we secure additional manufacturing capability. We cannot assure you that we will be able to procure additional manufacturing capability timely or on acceptable terms.

 

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Government Regulation

 

The VeriMed patient identification system is a medical device subject to extensive regulation by FDA, as well as other federal and state regulatory bodies in the United States and comparable authorities in other countries. We currently have FDA clearance to market our product in the United States for patient identification and health information. FDA regulations govern the following activities that we perform, or that are performed on our behalf, to ensure that medical products distributed domestically or exported internationally are safe and effective for their intended uses:

 

    product design, development and manufacture;

 

    product safety, testing, labeling and storage;

 

    premarketing clearance or approval;

 

    record keeping procedures;

 

    product marketing, sales and distribution; and

 

    post-marketing surveillance, reporting of deaths or serious injuries and medical device reporting.

 

FDA Premarket Clearance and Approval Requirements. Generally speaking, unless an exemption applies, each medical device we wish to distribute commercially in the United States will require either prior clearance under Section 510(k) of the Federal Food, Drug, and Cosmetic Act or a premarket approval application, or PMA, from FDA. Medical devices are classified into one of three classes—Class I, Class II, or Class III—depending on the degree or risk associated with each medical device and the extent of control needed to ensure safety and effectiveness. Devices deemed to pose lower risks are placed in either Class I or II. The manufacturer of a Class II device is typically required to submit to FDA a premarket notification requesting permission to commercially distribute the device and demonstrating that the proposed device is substantially equivalent to a previously cleared and legally marketed 510(k) device or a device that was in commercial distribution before May 28, 1976 for which FDA has not yet called for the submission of a PMA. This process is known as 510(k) clearance. Devices deemed by FDA to pose the greatest risk, such as life-sustaining, life-supporting or implantable devices, or devices deemed not substantially equivalent to a previously cleared 510(k) device, are generally placed in Class III, requiring premarket approval.

 

510(k) Clearance Pathway. By law, FDA is required to clear or deny a 510(k) premarket notification within 90 days of submission of the application. As a practical matter, clearance often takes significantly longer. FDA may require further information, including clinical data, to make a determination regarding substantial equivalence. If FDA determines that the device, or its intended use, is not substantially equivalent to a previously-cleared device or use, FDA will place the device, or the particular use, into Class III. Notwithstanding, a manufacturer of such device may request FDA to classify and clear the device as a Class II device if the device does not pose a great risk, and thereby eliminate the need for a PMA. FDA determined that our VeriMed patient identification system is not substantially equivalent to a previously cleared device or use. However, we subsequently requested, and in October 2004 received, classification and clearance for VeriMed as a Class II device. In granting this clearance, FDA created a new device classification for “implantable radiofrequency transponder systems for patient identification and health information.” FDA also determined that devices that meet this description will be exempt from 510(k) premarket clearance so long as they comply with the provisions of an FDA guidance document that establishes special controls for this type of device. Therefore, a company that wishes to market products that will compete with the VeriMed patient identification system will not be required to submit a 510(k) premarket clearance application to the FDA if they comply with the special controls guidance document.

 

Premarket Approval Pathway. Generally, a PMA must be submitted to FDA if the device cannot be cleared through the 510(k) process. The PMA process is much more demanding than the 510(k) premarket notification process. A PMA must be supported by extensive data, including but not limited to technical,

 

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preclinical, clinical trials, manufacturing and labeling to demonstrate to FDA’s satisfaction the safety and effectiveness of the device. Our current systems have not been, and we do not anticipate that any of our future systems will be, subject to PMA requirements.

 

Pervasive and Continuing Regulation. After a device is placed on the market, numerous regulatory requirements continue to apply. These include:

 

    quality system regulation, or QSR, which require manufacturers, including third-party manufacturers, to follow stringent design, testing, control, documentation and other quality assurance procedures during all aspects of the manufacturing process;

 

    labeling regulations and FDA prohibitions against the promotion of products for uncleared, unapproved or off-label uses;

 

    clearance or approval of product modifications that could significantly affect safety or effectiveness or that would constitute a major change in intended use;

 

    medical device reporting, or MDR, regulations, which require that manufacturers report to FDA if their device may have caused or contributed to a death or serious injury or malfunctioned in a way that would likely cause or contribute to a death or serious injury if the malfunction were to recur; and

 

    post-market surveillance regulations, which apply when necessary to protect the public health or to provide additional safety and effectiveness data for the device.

 

The VeriMed patient identification system is subject to special controls, including controls on biocompatibility, information security procedures, software validation, performance testing, electromagnetic compatibility and sterility testing, among other things.

 

We have registered with FDA as a medical device manufacturer. FDA has broad post-market and regulatory enforcement powers. We are subject to unannounced inspections by FDA, to determine our compliance with the QSR and other regulations, and these inspections may include the manufacturing facilities of our suppliers. Our current manufacturing facility has not yet been inspected by FDA.

 

Failure to comply with applicable regulatory requirements can result in enforcement action by FDA, which may include any of the following sanctions:

 

    warning letters, fines, injunctions, consent decrees and civil penalties;

 

    repair, replacement, refunds, recall or seizure of our products;

 

    operating restrictions, partial suspension or total shutdown of production;

 

    refusing our requests for 510(k) clearance or premarket approval of new products, new intended uses or modifications to existing products;

 

    withdrawing 510(k) clearance or premarket approvals that have already been granted; and

 

    criminal prosecution.

 

Fraud and Abuse. We may directly or indirectly be subject to various federal and state laws pertaining to healthcare fraud and abuse, including anti-kickback laws. In particular, the federal healthcare program Anti-Kickback Statute prohibits persons from knowingly and willfully soliciting, offering, receiving or providing remuneration, directly or indirectly, in exchange for or to induce either the referral of an individual, or the furnishing, arranging for or recommending a good or service, for which payment may be made in whole or part under federal healthcare programs, such as the Medicare and Medicaid programs. Penalties for violations include criminal penalties and civil sanctions such as fines, imprisonment and possible exclusion from Medicare, Medicaid and other federal healthcare programs. The Anti-Kickback Statute is broad and prohibits many arrangements and practices that are lawful in businesses outside of the

 

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healthcare industry. In implementing the statute, the Office of Inspector General, or OIG, has issued a series of regulations, known as the safe harbors. These safe harbors set forth provisions that, if all their applicable requirements are met, will assure healthcare providers and other parties that they will not be prosecuted under the Anti-Kickback Statute. The failure of a transaction or arrangement to fit precisely within one or more safe harbors does not necessarily mean that it is illegal or that prosecution will be pursued. However, conduct and business arrangements that do not fully satisfy each applicable element of a safe harbor may result in increased scrutiny by government enforcement authorities, such as the OIG.

 

Employees

 

As of December 15, 2005, we had 139 employees, of whom 40 were in our sales and marketing group, 23 in technical support, 35 in research and development, 23 in manufacturing and 18 in finance and administration. We consider our relationship with our employees to be good and have not experienced any interruptions of our operations as a result of labor disagreements. None of our employees are represented by labor unions or covered by collective bargaining agreements.

 

Properties

 

Our corporate headquarters is located in Delray Beach, Florida, where we occupy approximately 2,200 square feet of office space pursuant to a transition services agreement with Applied Digital. The transition services agreement expires December 27, 2007. See “Certain Relationships and Related Party Transactions” for more information regarding the transition services agreement. We also occupy approximately 11,500 square feet of office space in Vancouver, Canada pursuant to a lease that expires June 1, 2009 where research and development, business development and a portion of our sales and administration functions are performed, and approximately 15,000 square feet of office space in Ottawa, Canada pursuant to a lease that expires May 31, 2009 where our manufacturing, assembly, customer service, product support and engineering functions are performed. In addition, a portion of our sales functions are currently performed in Edmonton, Canada, where we occupy approximately 3,000 square feet of office space. We are in the process of relocating the Edmonton operations to our facility in Ottawa. We expect to complete this relocation in the first quarter of 2006.

 

Legal Proceedings

 

On January 10, 2005, we commenced an action in the Circuit Court for Palm Beach County, Florida, against Metro Risk Management Group, LLC, or Metro Risk. In this suit, we have claimed that Metro Risk breached the parties’ three international distribution agreements by failing to meet required minimum purchase obligations. On July 1, 2005, Metro Risk asserted a counterclaim against us for breach of contract and fraud. Metro Risk seeks unspecified damages, lost profits, and attorneys’ fees. Currently, we have pending a motion to strike Metro Risk’s answer, affirmative defenses, allegations within the counterclaim, and other claims. Given the early stage of the matter and because discovery has not yet begun, counsel is currently unable to assess our risk.

 

We are a party to various legal actions, as either plaintiff or defendant, including the matter identified above, which arise in the ordinary course of business. We do not believe that these actions will result in any loss to us, and accordingly, no provision has been made in the financial statements to this prospectus. However, litigation is inherently unpredictable, and the costs and other effects of pending or future litigation, governmental investigations, legal and administrative cases and proceedings, whether civil or criminal, settlements, judgments and investigations, claims or charges in any such matters, and developments or assertions by or against us relating to us or to our intellectual property rights and intellectual property licenses could have a material adverse effect on our business, financial condition and operating results.

 

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MANAGEMENT

 

Executive Officers and Directors of the Registrant

 

Our executive officers and directors and their ages as of December 15, 2005, are:

 

Name


   Age

  

Position


Kevin H. McLaughlin

   63    Chief Executive Officer and Director

Daniel A. Gunther

   44    President

Malik Talib

   38    Executive Vice President

Nurez Khimji

   37    Chief Financial Officer

Scott R. Silverman(1)(3)

   41    Chairman of the Board of Directors

Daniel E. Penni(1)(2)

   58    Director

Tommy G. Thompson(1)

   64    Director

Constance K. Weaver(2)(3)

   53    Director

Paul C. Green(2) (3)

   55    Director

(1) Member of the compensation committee
(2) Member of the audit committee
(3) Member of the nominating and governance committee

 

Mr. McLaughlin was appointed our Chief Executive Officer in November 2004 and has served as a member of our board of directors since November 2005. Mr. McLaughlin previously served as Chief Operating Officer of our parent company, Applied Digital, from April 2003 to April 2005 and as its President from May 2003 to April 2005. From April 2002 to March 2003, Mr. McLaughlin served as Chief Executive Officer, President and Chief Operating Officer of InfoTech USA, Inc., Applied Digital’s 52.5% owned subsidiary. Prior to April 2002, he served as Chief Executive Officer of Computer Equity Corporation, Applied Digital’s wholly-owned subsidiary. Mr. McLaughlin served as Applied Digital’s Vice President of Sales from June 2000 to July 2001. Mr. McLaughlin served as a director of Applied Digital’s majority-owned subsidiary, Digital Angel, from September 2003 to November 2005. He is currently the Chairman of the Board of Government Telecommunications Inc., a wholly-owned subsidiary of Applied Digital.

 

Mr. Gunther was appointed our President in June 2005. From 1987 until that time, Mr. Gunther held a series of senior management positions at Instantel in operations, product management, manufacturing, quality, sales and finance. In 1993, he was appointed Instantel’s Chief Financial Officer, in 2001 he was appointed its Chief Operating Officer and in 2003 he was appointed its President and Chief Executive Officer. In addition to these responsibilities, he was a member of Instantel’s board of directors from April 2003 to June 2005.

 

Mr. Talib was appointed our Executive Vice President in April 2005. Previously, he was President of VCI, which he founded, from July 1996 to March 2005 and Chief Executive Officer of VCI from January 1998 to May 2000 and January 2002 to March 2005. Mr. Talib has been the President of the Ismaili Council for British Columbia since 2002.

 

Mr. Khimji was appointed our Chief Financial Officer in April 2005. Prior to that time, he served as the Chief Financial Officer of VCI from January 2002 to March 2005. Mr. Khimji served as the Chief Financial Officer of Marine BioProducts from August 2001 to December 2001. From September 1997 to August 2001, Mr. Khimji served as a senior associate for KPMG LLP. He holds the designation of Chartered Accountant.

 

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Directors

 

Mr. Silverman has served as the Chairman of our board of directors since March 2003 and as a member of our board of directors since February 2002. He has served as the Chairman of the board of directors of Applied Digital and as its Chief Executive Officer since March 2003. From August 2001 to March 2002, he served as a special advisor to Applied Digital’s board of directors and from March 2002 to March 2003, he served as Applied Digital’s President and as a member of its board of directors. From September 1999 to March 2002, Mr. Silverman operated his own private investment banking firm, and from October 1996 to September 1999, he served in various capacities for Applied Digital, including positions related to business development, corporate development and legal affairs. Mr. Silverman also currently serves on the board of directors of Applied Digital’s majority-owned subsidiary, Digital Angel. Mr. Silverman is an attorney licensed to practice in New Jersey and Pennsylvania.

 

Mr. Green has served as a member of our board of directors since December 2005. Since September 2002, Mr. Green has served as the President of Paul C. Green Consulting, a financial services consulting firm. From 1990 to September 2002, he was Chairman of the board of directors, Chief Executive Officer and President of Massachusetts Finncorp., Inc. and President of Massachusetts Cooperative Bank. Since January 2005, Mr. Green has also served as trustee of the 32 Brazeo Lane Realty Trust.

 

Mr. Penni has served as a member of our board of directors since June 2004. Presently, he is an Area Executive Vice President for Arthur J. Gallagher & Co., or AJG. Since 1988 he has held several positions for AJG, including Area Chief Operating Officer. He has worked in various sales and administrative roles in the insurance business since 1969. Mr. Penni has been a member of the board of directors of Applied Digital since 1994 and serves as the Chairman of Applied Digital’s compensation committee. He also currently serves as Treasurer and Chairman of the Finance Committee of the Board of Trustees of the Massachusetts College of Pharmacy and Health Sciences in Boston.

 

Mr. Thompson has served as a member of our board of directors since July 2005. Mr. Thompson is currently a partner at Akin Gump Strauss Hauer & Feld LLP and is a senior advisor to Deloitte & Touche LLP, serving as the independent chair of the Deloitte Center for Health Care Management and Transformation. He also has served as President of Logistics Health, Inc. since March 2005. He served as the Secretary of the U.S. Department of Health and Human Services from January 2001 to January 2005. He previously served as governor of Wisconsin from 1987 through 2001. He also serves on the board of directors of Centene Corporation, a multi-line managed care organization that provides Medicaid and Medicaid-related programs to organizations and individuals through government subsidized programs. He has been a director of C. R. Bard, Inc., a designer and seller of medical, surgical, diagnostic and patient care devices, since August 2005 and is a member of its science and technology committee and regulatory compliance committee.

 

Ms. Weaver has served as a member of our board of directors since February 2005. Since July 2005, Ms. Weaver has served as the Executive Vice President and Chief Marketing Officer for Bearing Point, Inc. From October 2002 to February 2005, Ms. Weaver served as Executive Vice President, Public Relations, Marketing Communications and Brand Management for AT&T Corporation, or AT&T. From 1996 to October 2002, Ms. Weaver served as Vice President, Investor Relations and Financial Communications for AT&T. From 1995 through 1996, she was Senior Director, Investor Relations and Financial Communications for Microsoft Corporation. From 1993 to 1995, she was Vice President, Investor Relations, and from 1991 to 1993 she was Director of Investor Relations, for MCI Communications, Inc. Ms. Weaver has been a member of the board of directors of Applied Digital since July 1998 and serves as a member of Applied Digital’s compensation, nominating and technology committee and as Chairman of Applied Digital’s compliance committee.

 

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Board Composition

 

Our board of directors currently consists of six members: Scott R. Silverman, Kevin H. McLaughlin, Daniel E. Penni, Tommy G. Thompson, Constance K. Weaver and Paul C. Green. Our board of directors is divided into three classes, with each director serving a three-year term and one class being elected at each year’s annual meeting of stockholders. The classes of the directors are as follows:

 

    Class I, whose term will expire at the annual meeting of stockholders to be held in 2007. The Class I directors are Paul C. Green and Tommy G. Thompson.

 

    Class II, whose term will expire at the annual meeting of stockholders to be held in 2008. The Class II directors are Kevin H. McLaughlin and Constance K. Weaver.

 

    Class III, whose term will expire at the annual meeting of stockholders to be held in 2009. The Class III directors are Daniel E. Penni and Scott R. Silverman.

 

The classification of the board of directors may have the effect of delaying or preventing changes in the control or management of our company. Our directors hold office until their successors have been elected or qualified or until the earlier of their death, resignation, disqualification or removal.

 

There are no family relationships among our directors and executive officers. Subject to certain exceptions, under the listing standards of the Nasdaq National Market, within one year of the effectiveness of a registration statement filed with the Commission in connection with a public offering of securities, boards of directors must consist of a majority of independent directors. Although we are considered a “controlled” company under such listing standards and therefore are not required to comply with such listing standards, we have nevertheless determined to comply with them. Our board of directors has determined that four of our six directors are independent under such standards.

 

Director Compensation

 

Our directors who are also our employees do not receive any additional compensation for their services as our directors. Following the offering, we will pay each of our non-employee directors, other than Mr. Silverman, a quarterly fee of $5,000 for serving on our board of directors. We will pay an additional $1,000 quarterly fee to the chairperson of our audit committee. Our non-employee directors are also reimbursed for out-of-pocket expenses incurred in attending board and committee meetings. As of December 15, 2005, each non-employee director, except Mr. Green who was appointed on December 12, 2005, had been issued stock options under our flexible stock plans.

 

During 2004, Messrs. Penni and Silverman and Ms. Weaver were granted annual option awards of 133,333, 300,000 and 33,333 options, respectively, to purchase shares of our common stock, at an exercise price of $0.375 per share. Except with respect to our flexible stock plans, non-employee directors are not eligible to participate in any of our other benefit plans.

 

We currently have a medical advisory board consisting of Dr. Sameer Mehta, Mr. Howard Weintraub and Dr. Jonathan Musher. During 2005, Dr. Sameer Mehta, Mr. Howard Weintraub and Dr. Jonathan Musher were each granted options to purchase 66,667 shares of our common stock, at a weighted average exercise price of $1.71 per share.

 

Board Committees

 

Our board of directors has the authority to appoint committees to perform certain management and administrative functions. Our board of directors currently has an audit committee, compensation committee and nominating and governance committee.

 

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Audit Committee

 

Our audit committee is responsible for the oversight of our accounting, reporting and financial control practices. Among other functions, the audit committee is responsible for:

 

    overseeing and monitoring our accounting, financial reporting processes, audits and the integrity of our financial statements;

 

    appointing and overseeing the work of our independent accountants and reviewing the adequacy of our system of overseeing the independent accountant’s qualifications, independence and performance;

 

    assisting our board of directors in the oversight and monitoring of our compliance with legal and regulatory requirements;

 

    reviewing our internal accounting and financial controls; and

 

    reviewing our audited financial statements and reports and discussing the statement and reports with management, including any significant adjustments, management judgments and estimates, new accounting polices and disagreements with management.

 

The members of our audit committee are Paul C. Green, Daniel E. Penni and Constance K. Weaver. Mr. Green chairs the audit committee. Our board of directors has determined that each of the members of our audit committee is “independent” as defined under, and required by, the federal securities laws and the rules of the Nasdaq National Market, including Rule 10A-3(b)(i) under the Securities and Exchange Act of 1934. Our board of directors has determined that Mr. Green qualifies as an “audit committee financial expert” under the federal securities laws and has the “financial sophistication” required under the rules of the Nasdaq National Market.

 

Compensation Committee

 

Our compensation committee is primarily responsible for reviewing and approving the compensation, benefits, corporate goals and objectives of our chief executive officer and our other executive officers, evaluating the performance for our key executive officers, administering our employee benefit plans and making recommendations to our board of directors regarding these matters.

 

Our compensation committee currently consists of Scott R. Silverman, Daniel E. Penni and Tommy G. Thompson. Mr. Silverman chairs the compensation committee.

 

Nominating and Governance Committee

 

The members of our nominating and governance committee are Scott R. Silverman, Paul C. Green and Constance K. Weaver. Ms. Weaver chairs the committee. Our nominating and corporate governance committee identifies, evaluates and recommends nominees to our board of directors and its committees, conducts searches for appropriate directors and evaluates the performance of our board of directors and of individual directors. It is also responsible for ensuring that we and our employees maintain the highest standards of compliance with both external and internal rules, regulations and good practices. Further, the nominating and governance committee is responsible for reviewing developments in corporate governance practices, evaluating the adequacy of our corporate governance practices and reporting and making recommendations to our board of directors concerning corporate governance matters.

 

Compensation Committee Interlocks and Insider Participation

 

No member of the compensation committee has been an officer or employee of ours at any time. None of our executive officers serves as a member of the board of directors or the compensation committee

 

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of any other company that has one or more executive officers serving as a member of our board of directors or compensation committee. Prior to the formation of the compensation committee in December 2005, our board of directors as a whole made decisions relating to compensation of our executive officers.

 

Code of Business Conduct and Ethics

 

Our board of directors has approved and we have adopted a Code of Conduct and Corporate Ethics General Policy Statement, or the Code of Conduct, that applies to all of our directors, officers and employees. This Code of Conduct is available upon written request to VeriChip Corporation, Attention: Secretary, 1690 South Congress Avenue, Suite 200, Delray Beach, Florida 33445. The Audit Committee of the board of directors is responsible for overseeing the Code of Conduct. Our board of directors must approve any waivers of the Code of Conduct for directors and executive officers.

 

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EXECUTIVE COMPENSATION AND OTHER MATTERS

 

Summary Compensation Table

 

The following table sets forth summary information concerning compensation of our Chief Executive Officer and each of the next four most highly compensated executive officers whose total annual salary and bonus exceeded $100,000 during our fiscal year ended December 31, 2004. We refer to these persons as our named executive officers.

 

         

Annual Compensation


   Long-Term
Compensation


             Shares
Underlying
Options(2)


Name and Principal

Position


   Year

   Salary

    Bonus(1)

  

Kevin H. McLaughlin
Chief Executive Officer

   2004              

Kevin J. Wiley(3)
Former Chief Executive Officer

   2004    $ 22,154          666,667

Keith I. Bolton(4)
Former President

   2004    $ 112,612 (5)   $ 25,000   

(1) The amount in the Bonus column was a discretionary award granted in consideration of the contribution of the named executive officer.
(2) Indicates the number of securities underlying the options.
(3) Mr. Wiley was employed with us from June 2004 to August 2004. His options were forfeited when he resigned.
(4) Mr. Bolton is no longer serving as an officer. From June 2005 to December 2005, he served as our Vice President of Government & International Affairs, and from April 2003 to June 2005, he served as our President. Prior to that time, from February 2002 to April 2003, he served as Vice President. Mr. Bolton was elected to our board of directors in February 2002 and served as a director until July 2005.
(5) Includes $852 of earned income that was contributed to Mr. Bolton’s flexible spending plan.

 

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Stock Options Granted in Fiscal 2004

 

The following table sets forth information concerning stock options granted to each of our named executive officers during the fiscal year ended December 31, 2004 and all individuals serving as the chief executive officer during 2004. The percentage of total options granted to employees set forth below is based on an aggregate of 1,433,333 shares of our common stock underlying options granted in 2004.

 

Name                                             


   Individual Grants

  

Expiration

Date


   Potential Realizable
Value at Assumed
Annual Rates of
Stock Price
Appreciation for
Option Term(1)


  

Number of
Shares
Underlying
Options

Granted (#)


  

% of Total
Options
Granted to
Employees
in Fiscal

Year


   

Exercise

or Base

Price

($/share)(2)


     
              5%

   10%

Kevin H. McLaughlin(3)

   166,667    11.6 %   $0.375    5/26/2012    $29,841    $71,474

Kevin J. Wiley(4)

   666,667    46.5 %   $0.975    6/14/2012      

Keith I. Bolton

   0    0             

(1) Potential realizable values are net of exercise price, but before any taxes associated with exercise. The assumed rates of stock appreciation are provided in accordance with SEC rules based upon an assumed initial public offering price of $           per share, and do not represent our estimate or projection of the future stock price.
(2) Represents the estimated fair value of the common stock on the date of grant as determined by our management and approved by our board of directors.
(3) Represents options issued to Mr. McLaughlin in his capacity as President and Chief Operating Officer of our parent company, Applied Digital under our 2002 Flexible Stock Plan.
(4) Options granted to Mr. Wiley under our 2002 Flexible Stock Plan were forfeited upon his resignation of employment.

 

Option Exercises and Fiscal 2004 Year End Value

 

The following table shows information concerning the number and value of unexercised options held by each of the named executive officers as of December 31, 2004 and all individuals serving as the chief executive officer during 2004. There were no options exercised by the named executive officers in 2004. There was no public trading market for the common stock as of December 31, 2004. Accordingly, the value of unexercised in-the-money options listed below has been calculated on the basis of an assumed initial public offering price of $             per share, less the applicable exercise price per share, multiplied by the number of shares underlying such options.

 

     Number of Shares of
Common Stock Underlying
Unexercised Options at
Year End (#)


    Value of Unexercised
In-the-Money Options at
Year End ($)


Name


   Exercisable

   Unexercisable

    Exercisable

   Unexercisable

Kevin H. McLaughlin

   66,667    166,667           

Kevin J. Wiley

      (1)         

Keith I. Bolton

   400,000    0           

(1) All of Mr. Wiley’s options to purchase shares of our common stock were terminated in August 2004.

 

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Employment Contracts

 

We have entered into an employment arrangement with our President, Daniel A. Gunther, effective as of June 10, 2005. Under the terms of the arrangement, Mr. Gunther receives an initial base salary of CDN$210,000 and is eligible for an annual incentive compensation of up to CDN$300,000, which will be calculated based upon the achievement of certain corporate objectives, including our revenue, the number of hospitals equipped with our VeriMed patient identification system in 2005 and minimum EBITDA objectives. Mr. Gunther has also been granted an option to acquire 166,667 shares of our common stock, at a price per share equal to US$2.475. Under the terms of the arrangement, Mr. Gunther has agreed, during the course of his engagement and for a period of one year following the termination thereof, not to, directly or indirectly, attempt to solicit or in any other way disturb or service any person, firm or corporation that has been a customer, employee or vendor of the Company, or any of its current or future affiliates, at any time within one year prior to Mr. Gunther’s termination.

 

Through our subsidiary VCI, we have entered into an executive agreement effective as of April 1, 2005 with Malik Talib, who serves as our Executive Vice President. Pursuant to the agreement, Mr. Talib receives an annual base salary of CDN$210,000, a quarterly bonus of CDN$2,500, contingent on the attainment of certain financial objectives and integration goals determined by our President and CEO, and an annual bonus of up to 50% of his base salary, contingent upon certain financial, strategic and integration objectives being met. Mr. Talib has also been granted an option to acquire 77,050 shares of our common stock, at an exercise price per share equal to US$2.31. On or prior to January 15, 2006, Mr. Talib will be granted an additional option to acquire 3,831 shares of our common stock, at an exercise price per share equal to US$2.31. Mr. Talib has agreed that if he is no longer employed by us, he will not, for a period of two years, engage in any aspect of the wireless technology business in North America or solicit any of our customers or employees. We may terminate the executive agreement upon one year’s written notice or the payment of one year’s salary, based on salary level for the previous 12 months.

 

Through our subsidiary VCI, we have entered into an executive agreement effective as of April 1, 2005 with Nurez Khimji, who serves as our Chief Financial Officer. Pursuant to the agreement, Mr. Khimji receives an annual base salary of CDN$150,000, a discretionary quarterly bonus, and an annual bonus of up to 50% of his base salary, contingent upon certain financial, strategic and integration objectives being met. Mr. Khimji has also been granted an option to acquire 38,525 shares of our common stock, at an exercise price per share equal to US$2.31. On or prior to January 15, 2006, Mr. Khimji will be granted an additional option to acquire 1,919 shares of our common stock, at an exercise price per share equal to US$2.31. Mr. Khimji has agreed that if he is no longer employed by us, he will not, for a period of two years, engage in any aspect of the wireless technology business in North America or solicit any of our customers or employees. We may terminate the executive agreement and Mr. Khimji’s employment upon 12 months written notice.

 

Stock Option and Other Compensation Plans

 

VeriChip Corporation 2002 Flexible Stock Plan and 2005 Flexible Stock Plan

 

The Company sponsors and maintains two separate flexible stock plans, the 2002 Flexible Stock Plan and the 2005 Flexible Stock Plan. The 2002 Flexible Stock Plan, as amended, was approved by our stockholder on February 7, 2002, and the 2005 Flexible Stock Plan was adopted by our board of directors on April, 27, 2005, approved by our stockholder on May 6, 2005 and approved by the stockholders of our parent company, Applied Digital, on June 11, 2005. The purpose of our Flexible Stock Plans is to attract, motivate and reward service providers and other individuals eligible for such awards of our common stock and/or cash, or a Benefit, and to encourage ownership of our common stock. The 2002 Flexible Stock Plan and the 2005 Flexible Stock Plan are substantially similar in form, types of awards and other material provisions, except with respect to the eligibility provisions under each respective plan and the total number of shares reserved for issuance under each plan.

 

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The 2002 Flexible Stock Plan’s eligibility provision provides that we may grant Benefits under the plan to those employees and directors of our company and or its affiliates who are selected by our company to participate in the Plan. The total number of shares reserved for issuance under the 2002 Flexible Stock Plan is 5,900,000.

 

The 2005 Flexible Stock Plan’s eligibility provisions are more expansive than the 2002 Flexible Stock Plan’s eligibility provisions. Under the 2005 Flexible Stock Plan, we may grant Benefits to employees, members of our board of directors (including former employees and members of our board in connection with their separation from our company) and other individuals who are not affiliates but have a direct or indirect ownership interest in our company or its affiliates or in which our company has a direct or indirect ownership interest, individuals who, and employees and owners of entities which are, customers and suppliers of our company or its affiliates, individuals who, and employees and owners of entities which, render services to our company or its affiliates, and individuals who, and employees and owners of entities which have an ownership or business affiliation with any such individuals or entities described above. The total number of shares reserved for issuance under the 2005 Flexible Stock Plan is 833,333.

 

Shares Issued under the Flexible Stock Plans

 

Shares issued under the 2002 Flexible Stock Plan and the 2005 Flexible Stock Plan may be authorized but unissued shares, shares held in treasury, or both. If an option or SAR expires or is terminated, surrendered or canceled, without having been fully exercised, if restricted stock or performance shares are forfeited, or if any other grant results in shares of our common stock not being issued, the shares covered by such option or SAR, grant of shares of restricted stock, performance shares or other grant, as the case may be, shall again be available for use under the Flexible Stock Plans.

 

The Flexible Stock Plans contain provisions for equitable adjustments of awards granted under the plans if there is any change in our common stock by reason of any stock dividend, spin-off, split-up, spin-out, recapitalization, merger, consolidation, reorganization, combination or exchange of shares.

 

Administration

 

Each Flexible Stock Plan is administered by a committee, referred to as the Committee. The Committee shall consist of our board of directors, unless the board appoints a Committee of two or more but less than all of the board. If the Committee does not include the entire board, it shall serve at the pleasure of the board, which may from time to time appoint members in substitution for members previously appointed.

 

Subject to the provisions of each Flexible Stock Plan, the Committee has complete authority to:

 

    determine when and to whom benefits are granted and the type and amounts of such benefits;

 

    determine the terms, conditions and provisions of, and restrictions relating to each benefit granted;

 

    interpret and construe the Flexible Stock Plans and all agreements granting benefits under the plans;

 

    prescribe, amend and rescind rules and regulations relating to the plans;

 

    determine all questions relating to benefits under the plans;

 

    maintain accounts, records and legends relating to benefits;

 

    employ agents, attorneys or accountants or other persons for such purposes as the Committee considers necessary or desirable.

 

    take, at any time, any action required or permitted by the Flexible Stock Plans in the case of a change of control, irrespective of whether a change of control has occurred or is imminent;

 

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    determine, except to the extent otherwise provided in the Flexible Stock Plans, whether and to which extent benefits will be structured to conform to the requirements applicable to performance-based compensation, and to take such action, establish such procedures, and impose such restrictions at the time such benefits are granted as the Committee determines to be necessary or appropriate to conform to such requirements; and

 

    do and perform all acts which it may deem necessary or appropriate for the administration of the Flexible Stock Plans and carry out the purposes of the Flexible Stock Plans.

 

Amendment, Termination and Change in Control

 

Our board of directors may amend either Flexible Stock Plan at any time. However, our board of directors may not amend the Flexible Stock Plans without stockholder approval if such amendment:

 

    would cause options, which are intended to qualify as incentive stock options to fail to qualify as such;

 

    would cause the Flexible Stock Plans to fail to meet the requirements of Rule 16b-3 of the Securities Exchange Act of 1934; or

 

    would violate applicable law.

 

The amendment or termination of either Flexible Stock Plan will not adversely affect any Benefit granted prior to such amendment or termination. However, any Benefit may be modified or canceled by the Committee if and to the extent permitted by the Flexible Stock Plans or benefit agreement or with the consent of the participant to whom such Benefit was granted.

 

The Flexible Stock Plans have no fixed termination date and shall continue in effect until terminated by our board of directors.

 

In the event of a change of control, all incentive stock options and non-qualified stock options shall become fully exercisable, except to the extant that the right to exercise the option is subject to restrictions established in connection with an SAR that is issued in tandem with the option; all SARs shall become immediately payable, except to the extant that the right to exercise the SAR is subject to restrictions established in connection with an option that is issued in tandem with the SAR; all restricted stock shall become vested; all performance shares shall be deemed fully earned; and all cash awards, other stock based awards, and other benefits shall become fully vested, exercisable or payable. In addition, the Committee may, to the extent not inconsistent with the above, provide such protection as it deems necessary to maintain a participant’s rights, including, without limitation:

 

    providing for purchase of a benefit for an amount in cash equal to the amount which could have been attained upon the exercise or realization of such benefit;

 

    making such adjustment to the outstanding benefits as the Committee deems appropriate; and/or

 

    causing the outstanding benefits to be assumed, or new benefits substituted therefor, by the surviving corporation.

 

Eligibility for Benefits

 

The 2002 Flexible Stock Plan and the 2005 Flexible Stock Plan have different eligibility provisions.

 

The 2002 Flexible Stock Plan’s eligibility provision provides that benefits may be awarded to individuals selected by the Committee who are employees of, or members of the board of directors of, our company or its affiliates. Only employees will be eligible for incentive stock options under the plan.

 

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The 2005 Flexible Stock Plan’s eligibility provisions are more expansive and provide that Benefits may be awarded to individuals selected by the Committee who are employees of, or members of the board of directors of, our company or its affiliate (including former employees and former members of the board of directors if in connection with their separation from our company), employees and owners of entities which are not affiliates but which have a director or indirect ownership interest in our company or its affiliates or in which our company or its affiliate has a direct or indirect ownership interest, individuals who, and employees and owners of entities which, are entities which render services to our company and its affiliates and individuals who, and employees and owners of entities, which have ownership or business affiliations with any individual or entity described above. Only employees will be eligible for incentive stock options under the plan.

 

Types of Benefits

 

Under the Flexible Stock Plans, the Committee may grant a number of different types of benefits. A summary of the principal characteristics of various types of benefits which may be granted is set forth below. The Flexible Stock Plans provide that the total number of shares that may be covered by a stock option where the purchase price is no less than the fair market value of the shares on the grant date plus SARs which may be granted to any participant in any fiscal year shall not exceed $25,000,000.

 

Stock Options.  Two types of stock options may be granted under each Flexible Stock Plan. Stock options intended to qualify for special tax treatment under Section 422 of the Code are referred to as “incentive stock options,” and options not intended to so qualify are referred to as “non-qualified stock Options.” In the case of non-qualified stock options, the option price shall be determined by the Committee but shall be no less than 85% of the fair market value of the shares of our common stock on the date the option is granted, and, in the case of incentive stock options, the price shall be determined by the Committee but shall be no less than the fair market value of the shares of our common stock on the date the option is granted.

 

The other terms of options shall be determined by the Committee and set forth in any agreement evidencing the terms of benefits granted under each Flexible Stock Plan. However, no holder of any stock option may exercise such stock option if our common stock is not then traded publicly on a stock exchange or stock market except in connection with a sale of our company or part of our common stock or within two months prior to the expiration of the stock option as provided in the agreement (or as may be extended by the Committee). However, in the case of options intended to qualify as incentive stock options, such terms must meet all requirements of Section 422 of the Code.

 

SARs.  A SAR is the right to receive an amount equal to the appreciation in value of one share of common stock from the time the SAR is granted until the time the grantee elects to receive payment. Participants who elect to receive payment of SARs shall receive payment in cash, common stock or a combination of both, as the Committee shall determine. When SARs are granted in tandem with an incentive stock option, the SARs must contain such terms and conditions as are necessary for the related option to qualify as an incentive stock option. In addition, if SARs are granted in tandem with a stock option, the exercise of the option shall cause a correlative reduction in the SARs and the payment of SARs shall cause a correlative reduction in the shares under the stock option.

 

Restricted Stock.  Restricted stock is common stock which is subject to forfeiture until a period of time has elapsed or certain conditions have been fulfilled. Unless the Committee determines otherwise, shares of restricted stock shall be granted at a cost equal to par value (presently $0.0015 per share). Certificates representing shares of restricted stock shall bear a legend referring to the applicable Flexible Stock Plan, noting the risk of forfeiture of the shares and stating that such shares are non-transferable until all restrictions have been satisfied and the legend has been removed. At the discretion of the Committee, the grantee may or may not be entitled to full voting and dividend rights with respect to all shares of restricted stock from the date of grant.

 

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Performance Shares.  Performance shares are the right to receive our common stock or cash equal to the fair market value of our common stock at a future date in accordance with the terms of the grant. The terms and conditions of such performance shares shall be determined by the Committee, in its sole discretion, but generally are expected to be based substantially upon the attainment of targeted profit and/or performance objectives.

 

Cash Awards.  A cash award is a benefit payable in cash. The Committee may grant a cash award at such time and such amounts it deems appropriate. The amount of any cash award in any fiscal year to any participant who is subject to Section 16 of the Exchange Act shall not exceed the greater of $100,000 or 100% of his or her cash compensation for such fiscal year.

 

Other Stock Based Awards.  An other stock based award is an award that is valued in whole or in part by reference to, or is otherwise based on, our common stock. Other stock based awards may include, without limitation, the grant of shares based on certain conditions, the payment of cash based on the performance of the common stock, and the grant of securities convertible into shares. The Committee shall have the right to grant shares in lieu of the payment of cash compensation pursuant to the mutual agreement of the participant and us.

 

Other Benefits.  The Committee shall have the right to provide types of benefits under the Flexible Stock Plans in addition to those specifically listed, if the Committee believes that such benefits would further the purposes for which the Flexible Stock Plans were established.

 

Transferability.  Unless otherwise specified in an agreement or permitted by the Committee, each Benefit shall be non-transferable other than by will or the laws of descent and distribution and shall be exercisable during a participant’s lifetime only by him/her.

 

Tandem Awards.  Awards may be granted by the Committee in tandem. However, no benefit may be granted in tandem with an incentive stock option except SARs.

 

Payment.  Upon the exercise of an option or in the case of any other benefit that requires a payment to us, payment may be made either in cash, including a so-called “cashless exercise” or such other method as the Committee or agreement may provide.

 

Limitation on Benefits.  The number of shares covered by stock options where the purchase price is no less than fair market value of the shares on the grant date and SARs that may be granted in any fiscal year shall not exceed $25,000,000. The cash awards in any fiscal year to any participant who is subject to Section 16 of the Securities Exchange Act of 1934, as amended, shall not exceed the greater of $100,000 or 100% of his or her cash compensation for such fiscal year.

 

Effect of Termination for Cause.  If a participant is an employee and he or she is “terminated for cause,” or violates any of the terms of such participant’s employment after such participant has become vested in any of such participant’s rights under the Flexible Stock Plans, the participant’s full interest in such rights shall terminate on the date of such termination of employment and all rights thereunder shall cease. Whether a participant’s employment is terminated for cause shall be determined by our board. Cause shall include, but not be limited to gross negligence, willful misconduct, flagrant or repeated violations of our policies, rules or ethics, a material breach by the participant of any employment agreement between the participant and the employer, intoxication, substance abuse, sexual or other unlawful harassment, disclosure of confidential or proprietary information, engaging in a business competitive with us or our affiliates, or dishonest, illegal or immoral conduct.

 

Incentive Compensation Plans

 

We have adopted a Sales Incentive Compensation Plan and a Senior Management Incentive Compensation Plan that provide monetary incentives for meeting and exceeding revenue targets.

 

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Employees that are eligible to participate in the Sales Incentive Compensation Plan are identified each fiscal year, and are not assured continued participation. Participating employees receive pre-determined compensation for achieving specified revenue targets.

 

Employees that are eligible to participate in the Senior Management Incentive Compensation Plan are identified each fiscal quarter or fiscal year, and are not assured continued participation. Participating employees receive pre-determined compensation for achieving specified revenue targets, subject to a minimum earnings requirement. If the EBITDA target or minimum earnings in the fiscal quarter or fiscal year is not achieved, incentive compensation for that fiscal quarter or fiscal year for all participants is reduced to achieve the minimum EBITDA or minimum earnings.

 

401(k) Retirement Plan

 

VCI maintains and contributes to and has certain obligations under a defined contribution pension plan for eligible Canadian employees. Applied Digital has a retirement savings plan under section 401(k) of the Internal Revenue Code for the benefit of eligible United States employees, including our eligible U.S. employees. Applied Digital has made no matching contributions to the 401(k) Plan.

 

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CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS

 

Since our incorporation in November 2001, there has not been, and there is not currently proposed any transaction or series of similar transactions in which the amount involved exceeded or will exceed $60,000 and in which any current director, executive officer, holder of more than 5% of our capital stock, or entities affiliated with them, had a material interest, other than as described in the “Management” section of this prospectus and in the transactions described below.

 

Transactions with Applied Digital

 

Loan from Applied Digital

 

As of September 30, 2005, we owed our parent company, Applied Digital, approximately $6.7 million in principal and accrued interest. To evidence that indebtedness, on December 27, 2005 we entered into an agreement with Applied Digital providing for a revolving loan to us in principal amount of up to $8.5 million. The loan bears interest at the prime rate of interest as published from time to time in The Wall Street Journal. The revolving loan and all other obligations of any kind owed by us to Applied Digital are secured by a lien on all of our assets. Upon the closing of our offering, we will use a portion of the proceeds to repay our loan. After we repay our loan, the lien on our assets will be released.

 

Transition Services Agreement

 

On December 27, 2005, we entered into a transition services agreement with our parent, Applied Digital, in which Applied Digital agreed to provide us with certain administrative transition services and payment of expenses requested from time to time by us, including payroll, legal, finance, accounting, information technology and tax services and services related to this offering. As compensation for these services, we have agreed to pay Applied Digital (i) approximately $62,000 per month for fixed costs allocable to these services, (ii) Applied Digital’s reasonable out-of-pocket direct expenses incurred in connection with providing these services, (iii) Applied Digital’s expenses incurred in connection with services provided to us in connection with this offering and (iv) any charges by third party service providers that may or may not be incurred as part of this offering and that are attributable to transition services provided to or for us.

 

The term of the agreement continues until such time as we request Applied Digital to cease performing such services, provided that Applied Digital is not obligated to continue to provide the transition services for more than two years. Except for any request by us that Applied Digital cease to perform transition services, the agreement may not be terminated by either party except in the event of a material default in Applied Digital’s delivery of the transition services or in our payment for those services.

 

Instantel Acquisition

 

On June 10, 2005, we and our subsidiary, VCI, entered into a share purchase agreement with Instantel, Instantel Holding Company, Perceptis, L.P., and our parent, Applied Digital, to acquire 100% of the common stock of Instantel. Under the terms of the share purchase agreement, Instantel became a wholly-owned subsidiary of VCI.

 

Under the share purchase agreement, the $25.0 million purchase price for the Instantel stock was payable in two installments. Applied Digital funded the first $22.0 million installment upon the closing of the acquisition on June 10, 2005. The second payment is required to be made on the earlier of the closing of this offering or September 30, 2006, subject to extension until December 31, 2006. If this offering is completed prior to September 30, 2006 (or December 31, 2006, if extended), then the second payment may be satisfied by issuing to Perceptis a number of shares of our common stock with a market value of $2.0 million and by transferring a number of shares of Applied Digital common stock with a market value of $1.0 million that are currently being held in escrow. If this offering is not completed prior to September 30,

 

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2006 (or December 31, 2006, if extended), then Perceptis may elect, at its option, to receive either a cash payment from us equal to $2.5 million or a number of shares of Applied Digital common stock with an aggregate market value equal to $3.0 million on the date of payment.

 

The second payment is our obligation, but our obligation has been guaranteed by Applied Digital and secured by shares of Applied Digital common stock with a market value of $3.0 million which have been placed in escrow for the benefit of Perceptis. Upon the closing of this offering prior to September 30, 2006 (or December 31, 2006, if extended), we will exchange a number of shares of our common stock with an aggregate market value of $2.0 million on the date of exchange for a number of shares of Applied Digital common stock currently held in the escrow account with an aggregate market value of $2.0 million on the date of exchange. Following this exchange of shares, Perceptis will receive the shares of our common stock and also the remaining shares of Applied Digital common stock held in the escrow account. Pursuant to a letter agreement between us, VCI and Applied Digital, we will be required to deliver the shares of Applied Digital common stock we receive in the exchange along with cash in the amount of $1.0 million in order to reimburse Applied Digital for the Applied Digital stock issued to the escrow account to secure Applied Digital’s guarantee of our obligation to make the second payment under the share purchase agreement.

 

Transactions with Digital Angel

 

Amended and Restated Supply, License and Development Agreement

 

Digital Angel Corporation, which is a majority-owned subsidiary of our parent, Applied Digital, owns the products, technology and intellectual property rights underlying our human-implantable microchip business. This technology is used in our VeriMed and VeriGuard systems. We have entered into an amended and restated supply, license and development agreement with Digital Angel.

 

Under this agreement, Digital Angel is our sole supplier of microchips relating to this business. Under this agreement, Digital Angel has granted us exclusive rights to Digital Angel’s implantable microchip and RFID technology for the primary purpose of secure, human identification. We must reach agreement on additional, reasonable terms with Digital Angel if we want such rights to extend to additional products. In addition, our exclusivity only applies as long as we meet certain minimum purchase requirements. Specifically, the minimum purchase requirements are currently $0, $875,000, $1,750,000 and $2,500,000 for each of 2006, 2007, 2008 and 2009, respectively, and $3,750,000 for 2010 and each year thereafter. Under this agreement, Digital Angel also currently manages the database used to store patient information in connection with our VeriMed system.

 

The primary Digital Angel patent under our license agreement with Digital Angel related to the implantable VeriChip will expire on May 18, 2010. This agreement continues until March 2013, and, as long as we continue to meet the minimum purchase requirements, will automatically renew on an annual basis until the expiration of Digital Angel’s patents covering the supplied products (if applicable). The agreement may be terminated earlier prior to its stated term under specified events, such as a bankruptcy of the other party or an uncured default under the agreement.

 

We cannot be certain that a court would find a competing product of the implantable VeriChip to infringe the patent, nor can we assure you that a court would affirm the patent’s validity in an enforcement action. In addition, we cannot assure you that Digital Angel has sufficient rights to exclude, or would ultimately prevail in an action to exclude, third parties from making or selling competing products. A termination of our supply, license and development agreement by Digital Angel or the loss of our exclusive rights due to our failure to meet our minimum commitment, the inability of Digital Angel to exclude third parties from making or selling competing products, the expiration or earlier termination of the primary Digital Angel patent or for any other reason could have a material adverse effect on our business. Furthermore, there are important limitations and risks associated with this agreement. Therefore, we encourage you to see the description of the agreement in “Risk Factors”.

 

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Under a predecessor supply, license and development agreement with Digital Angel, we paid Digital Angel approximately $0.5 million, $0.1 million, $0.1 million, $0.6 million and $0.1 million during the nine months ended September 30, 2005 and 2004 and the years ended December 31, 2004, 2003 and 2002, respectively.

 

Relationship with Deloitte & Touche LLP

 

The financial statements of Instantel as of December 31, 2004 and 2003 and for the two years in the period ended December 31, 2004, included in this prospectus have been audited by Deloitte & Touche LLP, an independent registered public accounting firm, as stated in their reports appearing herein and elsewhere in the registration statement. Work on Instantel’s 2004 financial statements was completed prior to January 2005. Tommy G. Thompson has been a senior advisor to Deloitte & Touche LLP since March 2005, but was not involved in the preparation of the audits of Instantel. On June 10, 2005, VCI, our direct wholly owned subsidiary, entered into a share purchase agreement by and among Instantel, Perceptis, L.P., VCI, Applied Digital and us, pursuant to which VCI acquired Instantel. Subsequently, on July 7, 2005, we appointed Mr. Thompson to our board of directors.

 

Limitation of Liability and Indemnification of Officers and Directors

 

Our amended and restated certificate of incorporation and our amended and restated bylaws provide that our directors and officers shall be indemnified by us to the fullest extent authorized by Delaware law, as it now exists or may in the future be amended, against all expenses and liabilities reasonably incurred in connection with their service for or on our behalf. In addition, our amended and restated certificate of incorporation provides that our directors will not be personally liable for monetary damages to us for breaches of their fiduciary duty as directors, unless they violated their duty of loyalty to us or to our stockholders, acted in bad faith, knowingly or intentionally violated the law, authorized illegal dividends or redemptions or derived an improper personal benefit from their action as directors.

 

Our parent company, Applied Digital, has obtained insurance that currently insures our directors and officers against specified losses and that currently insures us against specific obligations to indemnify our directors and officers. Under the terms of the transition services agreement, our officers and directors will continue to be covered by Applied Digital’s insurance policy for the next two years, after which time we will be required to obtain our own policy.

 

Currently, there is no pending litigation or proceeding involving any of our directors, officers or employees in which indemnification is sought, required or permitted, nor are we aware of any threatened litigation or proceeding that may result in a claim for indemnification.

 

 

 

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PRINCIPAL STOCKHOLDERS

 

The following table sets forth certain information known to us regarding beneficial ownership of shares of our common stock as of December 15, 2005:

 

    each of our directors;

 

    each of our named executive officers;

 

    all of our named executive officers and directors as a group; and

 

    each person, or group of affiliated persons, known to us to be the beneficial owner of more than 5% of our outstanding shares of common stock.

 

Beneficial ownership is determined in accordance with the rules and regulations of the Commission and includes voting and investment power with respect to the securities. In computing the number of shares beneficially owned by a person and the percentage ownership of that person, shares of common stock subject to options or warrants held by that person that are currently exercisable or exercisable within 60 days of the date of this prospectus are deemed outstanding. Such shares, however, are not deemed outstanding for the purposes of computing the percentage ownership of any other person. To our knowledge, except as indicated in the footnotes to this table and subject to community property laws where applicable, the persons named in the table have sole voting and investment power with respect to all shares of our common stock shown opposite such person’s name. The percentage of beneficial ownership is based on 16,666,667 shares of our common stock outstanding as of December 15, 2005 and                      shares of our common stock outstanding immediately after the offering. The numbers shown in the table assume no exercise by the underwriters of their over-allotment option.

 

 

    

Number of Shares

Beneficially Owned(#)


  

Percentage of Shares Beneficially Owned


Name and Address of Beneficial Owner


     

Before This

Offering(%)


  

After This

Offering(%)(1)


   After This
Offering if
Over-Allotment
Option is Exercised
in Full(%)(1)


Five percent stockholders:

                   

Applied Digital Solutions, Inc.

    1690 South Congress Avenue
Suite 200, Delray Breach,
Florida 33445

   16,666,667    100.0          

IBM Credit Corporation(2)

    North Castle Drive
Armonk, NY 10504

   1,232,667    6.9          

Named Executive Officers and Directors:

                   

Kevin H. McLaughlin(3)

  

666,667

  

3.8

         

Daniel A. Gunther(3)

  

166,667

  

*

         

Malik Talib(3)

  

77,050

  

*

         

Nurez Khimji(3)

  

38,525

  

*

         

Scott R. Silverman(3)

  

933,333

  

5.3

         

Paul C. Green(3)

  

  

*

         

Daniel E. Penni(3)

  

200,000

  

1.2

         

Tommy G. Thompson(3)

  

166,667

  

*

         

Constance K. Weaver(3)

  

233,333

  

1.4

         

Executive Officers and Directors as a group (9 persons)

  

2,482,242

  

13.0

         

* Less than 1%
(1) Excludes                      shares of our common stock issuable to Perceptis, L.P., the former indirect beneficial owner of all of Instantel’s ordinary shares, upon the consummation of this offering.
(2) Represents shares issuable upon the exercise of a warrant that is currently exercisable.
(3) Represents shares issuable upon the exercise of stock options that are currently exercisable or exercisable within 60 days of the date of this prospectus.

 

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DESCRIPTION OF CAPITAL STOCK

 

The following information describes our common stock, as well as options and warrants to purchase our common stock, and provisions of our amended and restated certificate of incorporation and our bylaws, as will be in effect upon the closing of the offering.

 

Our authorized capital stock consists of 70,000,000 shares of our common stock, par value $0.0015 per share, and 5,000,000 shares of preferred stock, par value $0.001 per share, that may be issued in one or more series. On December 20, 2005, we effectuated a 2-for-3 reverse stock split.

 

The following description of our capital stock is only a summary and is qualified by reference to our amended and restated certificate of incorporation and amended and restated bylaws and by the provisions of applicable Delaware law. Our amended and restated certificate of incorporation and amended and restated bylaws have been filed with the Commission as exhibits to the registration statement of which this prospectus forms a part.

 

Common Stock

 

As of December 15, 2005, there were 16,666,667 shares of our common stock outstanding and held of record by Applied Digital. In addition, as of December 15, 2005, there were 6,163,800 shares of our common stock subject to outstanding options. There will be                      shares of common stock outstanding upon the closing of the offering, which gives effect to the issuance of                      shares of our common stock offered by us under this prospectus but does not give effect to the exercise of the underwriters’ over-allotment option.

 

Each share of common stock has identical rights and privileges in every respect. The holders of our common stock are entitled to vote upon all matters submitted to a vote of our stockholders and are entitled to one vote for each share of common stock held. The holders of common stock are entitled to receive such dividends, payable in cash, stock or otherwise, as may be declared by our board of directors out of any funds legally available for the payment of dividends. If we voluntarily or involuntarily liquidate, dissolve or wind-up, the holders of common stock will be entitled to receive after distribution in full of the preferential amounts, if any, all of the remaining assets available for distribution ratably in proportion to the number of shares of common stock held by them. Holders of common stock have no preferences or any preemptive, conversion or exchange rights. There are no redemption or sinking fund provisions applicable to our common stock. All outstanding shares of our common stock are fully paid and non-assessable, and the shares of our common stock to be issued in the offering will be fully paid and non-assessable. The rights, preferences and privileges of the holders of our common stock are subject to, and may be adversely affected by, the rights of the holders of any shares of any series of preferred stock that we may designate in the future.

 

Preferred Stock

 

Our board of directors has the authority, without further stockholder action, to issue up to 5,000,000 shares of preferred stock in one or more series and to fix the designations, powers, preferences, privileges of the preferred stock, including dividend rights, conversion rights, voting rights terms of redemption, liquidation preference, sinking fund terms and number of shares constituting any series or the designation of any series. Our board of directors, without stockholder approval, can issue preferred stock with voting, conversion or other rights that could adversely affect the voting power and other rights of the holders of common stock. Preferred stock could thus be issued quickly with terms calculated to delay or prevent a change of control or make removal of management more difficult and/or impair the liquidation rights of our common stock. Additionally, the issuance of preferred stock may have the effect of decreasing the market price of the common stock. We currently have no preferred stock outstanding and have no plans to issue any preferred stock.

 

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Warrants

 

Pursuant to a warrant agreement dated as of August 21, 2002, we issued to IBM Credit Corporation, or IBM, a warrant to purchase 1,232,667 shares of our common stock at an exercise price of $0.075 per share. The warrant is immediately exercisable, contains a “cashless” exercise provision and expires on August 21, 2007.

 

In connection with our acquisition of Instantel, on June 10, 2005, we issued warrants to Satellite Strategic Finance Associates, LLC, or SSFA, and Satellite Strategic Finance Partners, Ltd., or SSFP, to purchase, respectively, 37,120 and 62,880 shares of our common stock at an exercise price of $12.00 per share. The warrants expire on the one year anniversary of the consummation of this offering. Each warrant contains provisions for the adjustment of the exercise price and number of shares issuable upon the exercise of the warrant in the event of stock dividends, stock splits, reorganizations, reclassifications, merger and consolidations.

 

Perceptis Exchange Right

 

In connection with our acquisition of Instantel, if this offering is completed prior to September 30, 2006 (or December 31, 2006, if the deadline is extended), the terms of the share purchase agreement require us to issue to Perceptis, the former ultimate parent company of Instantel, a number of shares of our common stock with an aggregate market value of $2.0 million.

 

Registration Rights

 

Both SSFA and SSFP have been granted registration rights in connection with their respective warrants. Pursuant to the terms of warrants issued to SSFA and SSFP, they will be entitled to certain rights with respect to the registration of their shares under the Securities Act of our common stock issued upon the exercise of their warrants. Their warrants provide that if, at any time after the completion of an initial public offering, we propose to register any of our common stock under the Securities Act of 1933, as amended, or Securities Act, in connection with the public offering of such shares for cash other than a registration statement on Form S-8 or Form S-4, SSFA and SSFP are entitled to written notice of the registration and are entitled to include their shares of our common stock in such registration.

 

Pursuant to a registration rights agreement between Perceptis and us, in the event that we consummate an initial public offering, we are required to include in the registration statement filed with respect to the initial public offering provisions regarding the registration, pursuant to Rule 415 under the Securities Act of Perceptis’ shares of our common stock. However, if the managing underwriter of the initial public offering advises us in writing that the registration of Perceptis’ shares of our common stock in such a manner would adversely affect that initial public offering, then we may file the registration statement pursuant to Rule 415 under the Securities Act with respect to Perceptis’ shares as promptly as practicable after the consummation of the initial public offering. In connection with this offering, our managing underwriter, Merriman Curhan Ford & Co., has delivered a letter to us advising that the registration of Perceptis’ shares of our common stock would adversely affect the offering. Accordingly, we have not included such shares in this offering.

 

Pursuant to the warrant agreement we entered into with IBM, IBM will be entitled to certain rights with respect to the registration under the Securities Act of their shares of our common stock issued upon the exercise of the warrant. The warrant provides that if at any time we propose to register any of our common stock under the Securities Act in connection with a public offering of such shares for cash, other than a registration statement on Form S-8 or Form S-4, IBM is entitled to written notice of the registration and is entitled to include its shares of our common stock in such registration. Additionally, IBM may make a one time demand that we file a registration statement under the Securities Act covering its shares of our common stock; provided that IBM cannot make such demand unless the reasonably anticipated aggregate price to the public, net of underwriting discounts and commissions, is in excess of $500,000.

 

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Notwithstanding the foregoing, pursuant to the terms of the warrant agreement IBM has agreed not to exercise any of its registration rights at any time that it is able to sell its shares of our common stock under Rule 144 of the Securities Act in a single transaction not exceeding the volume limitations thereunder.

 

Certain Provisions of our Amended and Restated Certificate of Incorporation and Amended and Restated Bylaws and Delaware Anti-Takeover Law

 

Amended and Restated Certificate of Incorporation and Amended and Restated Bylaws

 

Some provisions of our certificate of incorporation and our bylaws contain provisions that could make it more difficult to acquire us by means of a merger, tender offer, proxy contest or otherwise, or to remove our incumbent officers and directors. These provisions, summarized below, are expected to discourage coercive takeover practices and inadequate takeover bids. These provisions are also designed to encourage persons seeking to acquire control of us to first negotiate with our board of directors. We believe that the benefits of increased protection of our potential ability to negotiate with the proponent of an unfriendly or unsolicited proposal to acquire or restructure us outweigh the disadvantages of discouraging such proposals because negotiation of such proposals could result in an improvement of their terms.

 

Undesignated Preferred Stock

 

The ability to authorize and issue undesignated preferred stock may enable our board of directors to render more difficult or discourage an attempt to change control of us by means of a merger, tender offer, proxy contest or otherwise. For example, if in the due exercise of its fiduciary obligations, the board of directors were to determine that a takeover proposal is not in our best interest, the board of directors could cause shares of preferred stock to be issued without stockholder approval in one or more private offerings or other transactions that might dilute the voting or other rights of the proposed acquirer or insurgent stockholder or stockholder group.

 

Board of Directors

 

Our certificate of incorporation provides that our board of directors be divided into three classes, with each director serving a three-year term and one class being elected at each annual meeting of stockholders.

 

Stockholder Meetings

 

Our certificate of incorporation and bylaws provide that a special meeting of stockholders may be called only by the Chairman of our board of directors, our Chief Executive Officer, our President or by a resolution adopted by a majority of our board of directors.

 

Requirements for Advance Notification of Stockholder Nominations and Proposals

 

Our bylaws establish advance notice procedures with respect to stockholder proposals and the nomination of candidates for election as directors, other than nominations made by or at the direction of the board of directors.

 

Stockholder Action by Written Consent

 

Our certificate of incorporation and bylaws provide that, except as may otherwise be provided with respect to the rights of the holders of preferred stock, no action that is required or permitted to be taken by our stockholders at any annual or special meeting may be effected by written consent of stockholders in

 

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lieu of a meeting of stockholders, unless the action to be effected by written consent of stockholders and the taking of such action by such written consent have expressly been approved in advance by our board. This provision, which may not be amended except by the affirmative vote of holders of at least 66 2/3% of the voting power of all then outstanding shares of capital stock entitled to vote generally in the election of directors, voting together as a single class, makes it difficult for stockholders to initiate or effect an action by written consent that is opposed by our board.

 

Amendment of the Bylaws

 

Under Delaware law, the power to adopt, amend or repeal bylaws is conferred upon the stockholders. A corporation may, however, in its certificate of incorporation also confer upon the board of directors the power to adopt, amend or repeal its bylaws. Our charter and bylaws grant our board the power to adopt, amend and repeal our bylaws at any regular or special meeting of the board on the affirmative vote of a majority of the directors then in office. Our stockholders may adopt, amend or repeal our bylaws but only at any regular or special meeting of stockholders by an affirmative vote of holders of at least 66 2/3% of the voting power of all then outstanding shares of capital stock entitled to vote generally in the election of directors, voting together as a single class.

 

Removal of Directors

 

Our certificate of incorporation and bylaws provide that members of our board of directors may only be removed for cause and only by the affirmative vote of holders of at least 66 2/3% of the voting power of all then outstanding shares of capital stock entitled to vote generally in the election of directors, voting together as a single class.

 

Amendment of the Certificate of Incorporation

 

Our certificate of incorporation provides that, in addition to any other vote that may be required by law or any preferred stock designation, the affirmative vote of the holders of at least 66 2/3% of the voting power of all then outstanding shares of capital stock entitled to vote generally in the election of directors, voting together as a single class, is required to amend, alter or repeal, or adopt any provision as part of our certificate of incorporation inconsistent with the provisions of our certificate of incorporation dealing with distributions on our common stock, our board of directors, our bylaws, meetings of our stockholders or amendment of our certificate of incorporation.

 

The provisions of our certificate of incorporation and bylaws could have the effect of discouraging others from attempting hostile takeovers and, as a consequence, they may also inhibit temporary fluctuations in the market price of our common stock that often result from actual or rumored hostile takeover attempts. These provisions may also have the effect of preventing changes in our management. It is possible that these provisions could make it more difficult to accomplish transactions which stockholders may otherwise deem to be in their best interests.

 

Delaware Anti-Takeover Law

 

Pursuant to our amended and restated certificate of incorporation, we have elected not to be governed by Section 203 of the Delaware General Corporation Law. Section 203 prohibits a publicly held Delaware corporation from engaging in a “business combination” with an “interested stockholder” for a period of three years after the date of the transaction in which the person became an interested stockholder, unless the business combination is approved in a prescribed manner. The term “business combination” includes mergers, asset sales and other transactions resulting in a financial benefit to the interested stockholder. Subject to limited exceptions, an “interested stockholder” is a person who, together with affiliates and associates, owns, or within three years did own, 15% or more of our voting stock.

 

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Transfer Agent and Registrar

 

The transfer agent and registrar for our common stock is                     . The transfer agent’s address is                     .

 

Exchange Listing

 

We intend to apply to have our common stock approved for quotation on the Nasdaq National Market under the symbol “CHIP.” We do not intend to apply to list our common stock on any other exchange or quotation system.

 

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SHARES ELIGIBLE FOR FUTURE SALE

 

Prior to the offering, there has been no public market for our common stock. Future sales of substantial amounts of our common stock in the public market, or the perception that such sales may occur, could adversely affect prevailing market prices of our common stock. Furthermore, since some shares will not be available for public resale shortly after the offering because of contractual and legal restrictions as described below, sales of substantial amounts of our common stock in the public market after these restrictions lapse could adversely affect the prevailing market price and our ability to raise equity capital in the future.

 

Upon completion of the offering, we will have outstanding an aggregate of                      shares of our common stock, assuming the issuance of                      shares of our common stock in the offering and no exercise of outstanding options and warrants. Of these shares, all of the shares sold in the offering will be freely tradable without restriction or further registration under the Securities Act, unless these shares are purchased by our “affiliates” as that term is defined in Rule 144 under the Securities Act or by persons who are subject to the lock-up agreements described below, which shares would be subject to the terms of such lock-up agreements. The remaining                      outstanding shares of common stock held by existing stockholders are “restricted securities” within the meaning of Rule 144 of the Securities Act. Restricted securities may be sold in the public market only if registered or if they qualify for an exemption from registration described below under Rules 144 or 701 promulgated under the Securities Act, or another exemption.

 

As a result of the contractual restrictions described below and the provisions of Rules 144 and 701 under the Securities Act, the restricted securities will be available for sale in the public market as follows:

 

    no such shares will be eligible for sale upon completion of the offering; and

 

                         shares will be eligible for sale upon the expiration of the lock-up agreements, described below, beginning 180 days after the date of this prospectus, subject to Rule 144 volume limitations.

 

Lock-Up Agreements

 

We and our directors, officers and stockholder, holding an aggregate             shares of our common stock outstanding before this offering representing approximately     % of our common stock, have entered into lock-up agreements with the underwriters generally providing that they will not offer, sell, contract to sell or grant any option to purchase or otherwise dispose of our shares of common stock or any securities exercisable for or convertible into our common stock owned by them prior to the offering for a period of 180 days after the date of this prospectus without the prior written consent of Merriman Curhan Ford & Co. on behalf of our underwriters. In addition, if we issue an earnings release or material news or a material event relating to us occurs during the last 18 days of the 180 day lock-up period or if, prior to the expiration of the 180 day lock-up period, we announce that we will release earnings during the 16-day period beginning on the last day of the 180 day lock-up period, the restrictions imposed by the underwriters’ lock-up agreements will continue to apply until the expiration of the 19-day period beginning on the issuance of the earnings release or the occurrence of the material news or material event, as applicable, unless Merriman Curhan Ford & Co. waives, in writing, such extension. Merriman Curhan Ford & Co. has advised us that it has no current intention to shorten or release any of the shares subject to the lock-up agreements prior to the expiration of the lock-up period. Merriman Curhan Ford & Co., in its sole discretion, may release the shares subject to the lock-up agreements in whole or in part at anytime with or without notice.

 

Rule 144

 

In general, under Rule 144 as currently in effect, beginning 90 days after the effective date of this offering, a person who has beneficially owned restricted securities for at least one year prior to the proposed sale, including the holding period of any prior owner except one of our affiliates, would be

 

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entitled to sell (upon expiration of the lock-up described above) within any three-month period a number of shares that does not exceed the greater of:

 

    1% of the number of shares of our common stock then outstanding, which will equal approximately                      shares immediately after the offering; or

 

    the average weekly trading volume of our common stock on the Nasdaq National Market during the four calendar weeks preceding the filing of a notice on Form 144 with respect to the sale.

 

Sales under Rule 144 are also subject to manner of sale provisions and notice requirements and to the availability of current public information about us. Rule 144 also provides that our affiliates who sell shares of our common stock that are not restricted shares must nonetheless comply with the same restrictions applicable to restricted shares with the exception of the holding period requirement.

 

Rule 144(k)

 

Under Rule 144(k) as currently in effect, a person who is not deemed to have been one of our affiliates at any time during the 90 days preceding a sale, and who has beneficially owned the shares proposed to be sold for at least two years, including the holding period of any prior owner except an affiliate of ours, is entitled to sell these shares without complying with the manner of sale, public information, volume limitation or notice provisions of Rule 144.

 

Rule 701

 

Under Rule 701 as currently in effect, shares of our common stock acquired upon the exercise of currently outstanding options or pursuant to other rights granted under our compensatory stock purchase plan or option plan or other written agreement may be resold, to the extent not subject to lock-up agreements:

 

    by persons other than affiliates, beginning 90 days after the effective date of the offering, subject only to the manner of sale provisions of Rule 144; and

 

    by affiliates, subject to the manner of sale, current public information, and filing requirements of Rule 144, in each case, without compliance with the one-year holding period requirement of Rule 144.

 

As of December 15, 2005, options to purchase a total 6,163,799 shares of our common stock were outstanding.

 

Registration of Shares in Connection with Compensatory Benefit Plan

 

Immediately after the completion of the offering, we intend to file a registration statement or Form S-8 under the Securities Act covering shares of common stock issued or reserved for issuance under our stock option and employee stock purchase plans. This registration statement is expected to be filed and become effective as soon as practicable after the date of this prospectus. Accordingly, shares registered under this registration statement will, subject to vesting provisions and Rule 144 volume limitations, manner of sale, notice and public information requirements applicable to our affiliates, be available for sale in the open market subject to the lock-up agreements.

 

Registration Rights

 

After this offering, and subject to the lock-up agreements, SSFA, SSFP and Perceptis, L.P., who will collectively hold     % of our common stock after the completion of this offering, will be entitled to certain rights with respect to the registration of those shares under the Securities Act. For more information, see “Description of Capital Stock—Registration Rights.” After such registration, these shares of our common stock will become freely tradeable without restriction under the Securities Act. These sales could have a material adverse effect on the prevailing market price of our common stock.

 

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MATERIAL UNITED STATES TAX CONSIDERATIONS FOR NON-UNITED STATES HOLDERS

 

The following is a general discussion of material U.S. federal income and estate tax considerations with respect to the acquisition, ownership and disposition of shares of our common stock applicable to non-U.S. holders as of the date hereof. In general, a “non-U.S. holder” is any holder other than:

 

    a citizen or resident of the United States;

 

    a corporation created or organized in or under the laws of the United States or any political subdivision thereof;

 

    an estate, the income of which is includible in gross income for U.S. federal income tax purposes regardless of its source; or

 

    a trust if (a) a court within the United States is able to exercise primary supervision over the administration of the trust and one or more U.S. persons have the authority to control all substantial decisions of the trust or (b) it has a valid election in effect under applicable Treasury regulations to be treated as a United States person.

 

Generally, an individual may be treated as a resident of the United States in any calendar year for U.S. federal income tax purposes by, among other ways, being present in the United States for at least 31 days in that calendar year and for an aggregate of at least 183 days during a three-year period ending in the current calendar year. For purposes of this calculation, such individual would count all of the days in which he or she was present in the current year, one-third of the days present in the immediately preceding year, and one-sixth of the days present in the second preceding year. Residents are taxed for U.S. federal income tax purposes as if they were citizens of the United States.

 

This discussion is based on current provisions of the Internal Revenue Code of 1986, as amended, or the Code, final, temporary or proposed Treasury regulations promulgated thereunder, judicial opinions, published positions of the Internal Revenue Service and all other applicable authorities, all of which are subject to change (possibly with retroactive effect). We assume in this discussion that a non-U.S. holder holds shares of our common stock as a capital asset (generally property held for investment).

 

This discussion does not address all aspects of U.S. federal income and estate taxation that may be important to a particular non-U.S. holder in light of that non-U.S. holder’s individual circumstances, nor does it address any aspects of U.S. state, local or non-U.S. taxes. Special rules that may apply to certain non-U.S. holders, such as “controlled foreign corporations,” “passive foreign investment companies,” “foreign personal holding companies,” individuals who are U.S. expatriates, partnerships or other pass-through entities, and corporations that accumulate earnings to avoid U.S. federal income tax, that are subject to special treatment under the Code are not described herein. Those individuals or entities should consult their own tax advisors to determine the U.S. federal, state, local and other tax consequences that may be relevant to them. This discussion also does not consider any specific facts or circumstances that may apply to a non-U.S. holder subject to special treatment under the U.S. federal income tax laws, including without limitation:

 

    banks, insurance companies or other financial institutions;

 

    partnerships;

 

    tax-exempt organizations;

 

    tax-qualified retirement plans;

 

    dealers in securities or currencies;

 

    traders in securities that elect to use a mark-to-market method of accounting for their securities holdings;

 

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    certain U.S. expatriates; and

 

    persons that will hold common stock as a position in a hedging transaction, “straddle” or “conversion transaction” for tax purposes.

 

Accordingly, we urge prospective investors to consult with their own tax advisors regarding the U.S. federal, state, local and non-U.S. income and other tax considerations of acquiring, holding and disposing of shares of our common stock.

 

If a partnership holds shares of our common stock, the tax treatment of a partner will generally depend upon the status of the partner and the activities of the partnership. Any partner in a partnership holding shares of our common stock should consult his, her or its own tax advisors.

 

Dividends

 

In general, dividends we pay, if any, to a non-U.S. holder will be subject to U.S. withholding tax at a 30% rate of the gross amount. The withholding tax might not apply or might apply at a reduced rate under the terms of an applicable income tax treaty between the United States and the non-U.S. holder’s country of residence. A non-U.S. holder must demonstrate its entitlement to treaty benefits by certifying, among other things, its nonresident status. A non-U.S. holder generally can meet this certification requirement by providing an Internal Revenue Service Form W-8BEN or appropriate substitute form to us or our paying agent. Also, special rules apply if the dividends are effectively connected with a trade or business carried on by the non-U.S. holder within the United States and, if a treaty applies, are attributable to a permanent establishment of the non-U.S. holder within the United States. Dividends effectively connected with this U.S. trade or business, and, if a treaty applies, attributable to such a permanent establishment of a non-U.S. holder, generally will not be subject to U.S. withholding tax if the non-U.S. holder files certain forms, including Internal Revenue Service Form W-8ECI (or any successor form), with the payor of the dividend, and generally will be subject to U.S. federal income tax on a net income basis, in the same manner as if the non-U.S. holder were a resident of the United States. A non-U.S. holder that is a corporation may be subject to an additional “branch profits tax” at a rate of 30% (or a reduced rate as may be specified by an applicable income tax treaty) on the repatriation from the United States of its “effectively connected earnings and profits,” subject to certain adjustments. A non-U.S. holder of shares of our common stock eligible for a reduced rate of U.S. withholding tax pursuant to an income tax treaty may obtain a refund of any excess amounts withheld by filing an appropriate claim for refund with the Internal Revenue Service.

 

Gain on Sale or Other Disposition of Common Stock

 

In general, a non-U.S. holder will not be subject to U.S. federal income tax on any gain realized upon the sale or other disposition of the holder’s shares of our common stock unless:

 

    the gain is effectively connected with a trade or business carried on by the non-U.S. holder within the United States and, if required by an applicable income tax treaty as a condition to subjecting a non-U.S. holder to United States income tax on a net basis, the gain is attributable to a permanent establishment of the non-U.S. holder maintained in the United States, in which case a non-U.S. holder will be subject to U.S. federal income tax on any gain realized upon the sale or other disposition on a net income basis, in the same manner as if the non-U.S. holder were a resident of the United States. Furthermore, the branch profits tax discussed above may also apply if the non-U.S. holder is a corporation;

 

    the non-U.S. holder is an individual and is present in the United States for 183 days or more in the taxable year of disposition and certain other tests are met, in which case a non-U.S. holder will be subject to a flat 30% tax on any gain realized upon the sale or other disposition, which tax may be offset by United States source capital losses (even though the individual is not considered a resident of the United States);

 

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    the non-U.S. holder is subject to tax pursuant to the provisions of the Internal Revenue Code regarding the taxation of U.S. expatriates; or

 

    we are or have been a U.S. real property holding corporation (a USRPHC) for U.S. federal income tax purposes at any time within the shorter of the five-year period preceding the disposition and the non-U.S. holder’s holding period. We do not believe that we are or have been a USRPHC, and we do not anticipate becoming a USRPHC. If we have in the past or were to become a USRPHC at any time during this period, generally gains realized upon a disposition of shares of our common stock by a non-U.S. holder that did not directly or indirectly own more than 5% of our common stock during this period would not be subject to U.S. federal income tax, provided that our common stock is “regularly traded on an established securities market” (within the meaning of Section 897(c)(3) of the Code). Our common stock will be treated as regularly traded on an established securities market during any period in which it is listed on a registered national securities exchange or any over-the-counter market, including the Nasdaq National Market.

 

U.S. Federal Estate Tax

 

Shares of our common stock that are owned or treated as owned by an individual who is not a citizen or resident (as defined for U.S. federal estate tax purposes) of the United States at the time of death will be includible in the individual’s gross estate for U.S. federal estate tax purposes, unless an applicable estate tax treaty provides otherwise, and therefore may be subject to U.S. federal estate tax.

 

Backup Withholding, Information Reporting and Other Reporting Requirements

 

Generally, we must report annually to the Internal Revenue Service and to each non-U.S. holder the amount of dividends paid to, and the tax withheld with respect to, each non-U.S. holder. These reporting requirements apply regardless of whether withholding was reduced or eliminated by an applicable tax treaty. Copies of this information also may be made available under the provisions of a specific treaty or agreement with the tax authorities in the country in which the non-U.S. holder resides or is established.

 

U.S. backup withholding tax is imposed (at a current rate of 28%) on certain payments to persons that fail to furnish the information required under the U.S. information reporting requirements. A non-U.S. holder of shares of our common stock will be subject to this backup withholding tax on dividends we pay unless the holder certifies, under penalties of perjury, among other things, its status as a non-U.S. holder (and we or our paying agent do not have actual knowledge or reason to know the holder is a United States person) or otherwise establishes an exemption.

 

Under the Treasury regulations, the payment of proceeds from the disposition of shares of our common stock by a non-U.S. holder made to or through a U.S. office of a broker generally will be subject to information reporting and backup withholding unless the beneficial owner certifies, under penalties of perjury, among other things, its status as a non-U.S. holder (and we or our paying agent do not have actual knowledge or reason to know the holder is a United States person) or otherwise establishes an exemption. The payment of proceeds from the disposition of shares of our common stock by a non-U.S. holder made to or through a non-U.S. office of a broker generally will not be subject to backup withholding and information reporting, except as noted below. In the case of proceeds from a disposition of shares of our common stock by a non-U.S. holder made to or through a non-U.S. office of a broker that is:

 

    a U.S. person;

 

    a “controlled foreign corporation” for U.S. federal income tax purposes;

 

    a foreign person 50% or more of whose gross income from certain periods is effectively connected with a U.S. trade or business; or

 

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    a foreign partnership if at any time during its tax year (a) one or more of its partners are U.S. persons who, in the aggregate, hold more than 50% of the income or capital interests of the partnership or (b) the foreign partnership is engaged in a U.S. trade or business;

 

information reporting (but not backup withholding) will apply unless the broker has documentary evidence in its files that the owner is a non-U.S. holder and certain other conditions are satisfied, or the beneficial owner otherwise establishes an exemption (and the broker has no actual knowledge or reason to know to the contrary).

 

Backup withholding is not an additional tax. Any amounts withheld under the backup withholding rules from a payment to a non-U.S. holder can be refunded or credited against the non-U.S. holder’s U.S. federal income tax liability, if any, provided that the required information is furnished to the Internal Revenue Service in a timely manner.

 

THE FOREGOING DISCUSSION OF CERTAIN U.S. FEDERAL INCOME TAX CONSIDERATIONS IS FOR GENERAL INFORMATION ONLY AND IS NOT TAX ADVICE. ACCORDINGLY, EACH PROSPECTIVE HOLDER OF SHARES OF OUR COMMON STOCK SHOULD CONSULT HIS, HER OR ITS OWN TAX ADVISER WITH RESPECT TO THE FEDERAL, STATE, LOCAL AND FOREIGN TAX CONSEQUENCES OF THE ACQUISITION, OWNERSHIP AND DISPOSITION OF COMMON STOCK.

 

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UNDERWRITING

 

Merriman Curhan Ford & Co. and Kaufman Bros., L.P. are acting as the representatives of the underwriters. We and the underwriters named below have entered into an underwriting agreement with respect to the common stock being offered by this prospectus. In connection with this offering and subject to certain conditions, each of the underwriters named below has severally agreed to purchase, and we have agreed to sell, the number of shares of common stock set forth opposite the name of each underwriter.

 

Underwriters


  

Number of Shares of

Common Stock


Merriman Curhan Ford & Co.

    

Kaufman Bros., L.P.

    
    

Total

    
    

 

The underwriting agreement is subject to a number of terms and conditions and provides that the underwriters must buy all of the common stock if they buy any of it (other than those shares covered by the over-allotment option described below).

 

The underwriters have advised us that they do not intend to confirm sales of the common stock to any account over which they exercise discretionary authority in an aggregate amount in excess of 5% of the total securities offered by this prospectus.

 

We have granted to the underwriters an option, exercisable as provided in the underwriting agreement and expiring 30 days after the effective date of this offering, to purchase up to an additional                      shares of common stock at the public offering price set forth on the cover page of this prospectus, less underwriting discounts and commissions. The underwriters may exercise this option only to cover over-allotments made in connection with the sale of the common stock offered by this prospectus, if any. To the extent that the underwriters exercise this option, each of the underwriters will become obligated, subject to conditions, to purchase approximately the same percentage of these additional shares of common stock as the number of shares of common stock to be purchased by it in the above table bears to the total number of shares of common stock offered by this prospectus. We will be obligated, pursuant to the option, to sell these additional shares of common stock to the underwriters to the extent the option is exercised. If any additional shares of common stock are so purchased, the underwriters will offer the additional shares on the same terms as those on which the                      shares are being offered.

 

The underwriting agreement provides that we will reimburse the representative for its expenses on a non-accountable basis in the amount equal to         % of the aggregate public offering price of the offered common stock, including any over-allotment, of which $             has been paid to date, and the balance of which will be paid on the closing of this offering.

 

The representative has advised us that the underwriters propose initially to offer the shares to the public at the initial public offering price set forth on the cover page of this prospectus and to dealers at that price less a concession not in excess of $             per share. The underwriters may allow, and the dealers may reallow, a discount not in excess of $             per share to other dealers. After the initial public offering, the public offering price, concession and discount may be changed.

 

We intend to apply to have our common stock included for quotation on the Nasdaq National Market under the symbol “CHIP.”

 

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The following table shows the public offering price, underwriting discount and proceeds before expenses to us. The information assumes either no exercise or full exercise by the underwriters of their over-allotment option.

 

     Per Share

   Without Option

   With Option

Public offering price

   $                $                $            

Underwriting discount

   $                $                $            

Proceeds, before expenses, to VeriChip Corporation

   $                $                $            

 

In addition, we estimate that our share of the total expenses of this offering, excluding underwriting discounts and commissions, will be approximately $            .

 

Each of our directors and executive officers, certain other employees, and certain holders of our common stock (and securities exchangeable for, or convertible into or exercisable for, our common stock), have agreed with the underwriters not to offer, pledge, sell, contract to sell, sell any option or contract to purchase, purchase any option or contract to sell, grant any option, right or warrant to purchase, lend, or otherwise transfer or dispose of, directly or indirectly, any shares of our common stock or any securities convertible into or exercisable or exchangeable for our common stock, or enter into any swap or other arrangement that transfers to another, in whole or in part, any of the economic consequences of ownership of our common stock, for a period of at least 180 days after the date of the final prospectus relating to this public offering, without the prior written consent of Merriman Curhan Ford & Co. on behalf of the underwriters. This consent may be given at any time without public notice. In addition, if we issue an earnings release or material news or a material event relating to us occurs during the last 18 days of 180-day lock-up period or if prior to the expiration of the 180-day lock-up period, we announce that we will release earnings results during the 16-day period beginning on the last day of the 180-day lock-up period, the restrictions imposed by underwriters’ lock-up agreements will continue to apply until the expiration of the 19-day period beginning on the issuance of the earnings release or the occurrence of the material news or material event, as applicable, unless Merriman Curhan Ford & Co. waives, in writing, such extension. The agreement does not apply to the exercise of options or warrants or the conversion of a security outstanding on the date of this prospectus and which is described in this prospectus, nor does it apply to transfers or dispositions made as bona fide gifts or to trusts for estate planning purposes where the donee/transferee signs a lock-up agreement. There are no agreements between the underwriters and any of our stockholders or affiliates releasing them from these lock-up agreements prior to the expiration of the 180-day period. In addition, we have agreed with the underwriters not to make certain issuances or sales of our securities for a period of at least 180 days after the date of the final prospectus relating to this public offering, without the prior written consent of Merriman Curhan Ford & Co. on behalf of the underwriters.

 

At our request, the underwriters intend to reserve up to          shares, or         % of the shares of our common stock offered hereby, for sale at the initial public offering price to persons who are stockholders of our parent company, Applied Digital, through a directed share program. The number of shares of our common stock available for sale to the general public will be reduced by the number of directed shares purchased by participants in the program. Any directed shares not purchased will be offered by the underwriters to the general public on the same basis as all other shares of common stock offered. The directed share program is being arranged by                     .

 

The underwriting agreement provides that we will indemnify the underwriters against specified liabilities, including liabilities under the Securities Act. We have been advised that, in the opinion of the Commission, indemnification for liabilities under the Securities Act is against public policy as expressed in the Securities Act and is therefore unenforceable.

 

In connection with the offering, Merriman Curhan Ford & Co. on behalf of the underwriters, may purchase and sell shares of our common stock in the open market. These transactions may include short sales, syndicate covering transactions and stabilizing transactions. Short sales involve syndicate sales of

 

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common stock in excess of the number of shares to be purchased by the underwriters in the offering, which creates a syndicate short position. “Covered” short sales are sales of shares made in an amount up to the number of shares represented by the underwriters’ over-allotment option. In determining the source of shares to close out the covered syndicate short position, the underwriters will consider, among other things, the price of shares available for purchase in the open market as compared to the price at which they may purchase shares through the over-allotment option. Transactions to close out the covered syndicate short involve either purchases of the common stock in the open market after the distribution has been completed or the exercise of the over-allotment option. The underwriters may also make “naked” short sales of shares in excess of the over-allotment option. The underwriters must close out any naked short position by purchasing shares of common stock in the open market. A naked short position is more likely to be created if the underwriters are concerned that there may be downward pressure on the price of the shares in the open market after pricing that could adversely affect investors who purchase in the offering. Stabilizing transactions consist of bids for or purchases of shares in the open market while the offering is in progress.

 

The underwriters also may impose a penalty bid. Penalty bids permit the underwriters to reclaim a selling concession from a syndicate member when Merriman Curhan Ford & Co. repurchases shares originally sold by that syndicate member in order to cover syndicate short positions or make stabilizing purchases.

 

Any of these activities may have the effect of preventing or retarding a decline in the market price of the common stock. They may also cause the price of the common stock to be higher than the price that would otherwise exist in the open market in the absence of these transactions. The underwriters may conduct these transactions on the Nasdaq National Market or in the over-the-counter market, or otherwise. If the underwriters commence any of these transactions, they may discontinue them at any time.

 

A prospectus in electronic format may be made available on Internet sites or through other online services maintained by one or more of the underwriters and/or selling group members participating in this offering, or by their affiliates. In those cases, prospective investors may view offering terms online and, depending upon the particular underwriter or selling group member, prospective investors may be allowed to place orders online. The underwriters may agree with us to allocate a specific number of shares for sale to online brokerage account holders. Any such allocation for online distributions will be made by the underwriters on the same basis as other allocations.

 

Prior to the offering, there has been no public market for our common stock. Consequently, the initial public offering price of the common stock offered by this prospectus will be determined by negotiation between us and the underwriters. Among the factors to be considered in determining the initial public offering price of the common stock are:

 

    our history and our prospects;

 

    the industry in which we operate;

 

    the present stage of our development, including the status of, and development prospects for, our proposed products and services;

 

    our past and present operating results;

 

    the market capitalizations and stages of development of other companies that we and the underwriters believe to be comparable to our business;

 

    the previous experience of our executive officers; and

 

    the general condition of the securities markets at the time of this offering.

 

The offering price stated on the cover page of this prospectus should not be considered an indication of the actual value of our common stock. That price is subject to change as a result of market conditions and other factors, and we cannot assure you that our common stock can be resold at or above the initial public offering price.

 

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INFORMATION REGARDING MERRIMAN CURHAN FORD & CO.

 

Merriman Curhan Ford & Co., the lead managing underwriter of the offering, was organized and registered as a broker-dealer in 2002. Since 2002, Merriman Curhan Ford & Co. has co-managed and underwritten 17 public offerings of equity securities. From time to time, Merriman Curhan Ford &Co. has provided, and continues to provide, investment banking and other services to us for which it receives customary fees and commissions. Other than the foregoing, Merriman Curhan Ford & Co. does not have any material relationship with us or any of our officers, directors or controlling persons, except with respect to its contractual relationship with us under the underwriting agreement entered into in connection with this offering.

 

LEGAL MATTERS

 

The validity of our common stock offered by this prospectus is being passed upon for us by Akin Gump Strauss Hauer & Feld LLP. Wilson Sonsini Goodrich & Rosati, Professional Corporation, Palo Alto, California, is acting as counsel to the underwriters in connection with certain legal matters in connection with this offering. Tommy G. Thompson, a partner in Akin Gump Strauss Hauer & Feld LLP, and one of our directors since July 2005, holds options to purchase 166,667 shares of our common stock. Akin Gump Strauss Hauer & Feld LLP has provided legal services to us since September 2005.

 

EXPERTS

 

The financial statements of VeriChip Corporation at December 31, 2004 and 2003 and for each of the years in the three year period ended December 31, 2004, and the financial statement schedules included in this prospectus have been so included in reliance on the report of Eisner LLP, independent registered public accounting firm, given on the authority of said firm as experts in auditing and accounting.

 

The financial statements of Instantel as of December 31, 2004 and 2003 and for the two years in the period ended December 31, 2004, included in this prospectus have been audited by Deloitte & Touche LLP, an independent registered public accounting firm, as stated in their reports appearing herein and elsewhere in the registration statement, which report includes an explanatory paragraph regarding a restatement of 2004 and 2003 financial statements, and are included in reliance upon the reports of such firm given upon their authority as experts in auditing and accounting.

 

The financial statements of Instantel as of June 9, 2005 and for the period January 1, 2005 to June 9, 2005, included in this prospectus have been so included in reliance on the report of Meyers Norris Penny LLP, independent registered public accounting firm, given on the authority of said firm as experts in auditing and accounting.

 

The consolidated financial statements of eXI Wireless, Inc. and subsidiaries as of March 31, 2005, December 31, 2004 and 2003 and for the three-months ended March 31, 2005 and for each of the years in two year period ended December 31, 2004, included in this prospectus have been so included in reliance upon the reports of KPMG LLP, independent registered public accounting firm, appearing elsewhere herein, and upon the authority of said firm as experts in accounting and auditing.

 

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WHERE YOU CAN FIND MORE INFORMATION

 

We have filed with the Commission a registration statement on Form S-1 (including exhibits, schedules and amendments) under the Securities Act of 1933 with respect to the shares of our common stock to be sold in the offering. This prospectus does not contain all the information set forth in the registration statement. For further information with respect to us and the shares of our common stock to be sold in the offering, reference is made to the registration statement. Statements contained in this prospectus as to the contents of any contract, agreement or other document referred to are not necessarily complete. Whenever a reference is made in this prospectus to any contract, agreement or other document of ours, the reference may not be complete, and you should refer to the exhibits that are a part of the registration statement for a copy of the contract, agreement or document.

 

You may read and copy all or any portion of the registration statement or any other information we file at the Commission’s public reference room at 100 F Street, N.E., Room 1580, Washington, D.C. 20549. You can request copies of these documents, upon payment of a duplicating fee, by writing to the Commission. Please call the Commission at 1-800-SEC-0330 for further information on the operation of the public reference rooms. The Commission also maintains a web site (http://www.sec.gov) that contains reports, proxy and information statements and other information regarding issuers that file electronically with the Commission.

 

Upon completion of the offering, we will become subject to the information and periodic reporting requirements of the Securities Exchange Act of 1934 and, in accordance therewith, will file periodic reports, proxy statements and other information with the Commission. Such periodic reports, proxy statements and other information will be available for inspection and copying at the public reference room and web site of the Commission referred to above.

 

This prospectus includes statistical data that were obtained from industry publications. These industry publications generally indicate that the authors of these publications have obtained information from sources believed to be reliable, but do not guarantee the accuracy and completeness of their information. While we believe these industry publications to be reliable, we have not independently verified their data.

 

WE HAVE NOT AUTHORIZED ANYONE TO GIVE ANY INFORMATION OR TO MAKE ANY REPRESENTATION CONCERNING THIS OFFERING EXCEPT THE INFORMATION AND REPRESENTATIONS WHICH ARE CONTAINED IN THIS PROSPECTUS. IF ANYONE GIVES OR MAKES ANY OTHER INFORMATION OR REPRESENTATION, YOU SHOULD NOT RELY ON IT. THIS PROSPECTUS IS NOT AN OFFER TO SELL, OR A SOLICITATION OF AN OFFER TO PURCHASE, ANY SECURITIES OTHER THAN THOSE TO WHICH IT RELATES, NOR DOES IT CONSTITUTE AN OFFER TO SELL OR A SOLICITATION OF AN OFFER TO PURCHASE BY ANY PERSON IN ANY CIRCUMSTANCES IN WHICH AN OFFER OR SOLICITATION IS UNLAWFUL. YOU SHOULD NOT INTERPRET THE DELIVERY OF THIS PROSPECTUS OR ANY SALE MADE HEREUNDER AS AN INDICATION THAT THERE HAS BEEN NO CHANGE IN OUR AFFAIRS SINCE THE DATE OF THIS PROSPECTUS. YOU SHOULD ALSO BE AWARE THAT THE INFORMATION IN THIS PROSPECTUS MAY CHANGE AFTER THIS DATE.

 

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INDEX TO FINANCIAL STATEMENTS

 

CONTENTS

 

    

Page


VERICHIP CORPORATION

    

Report of Independent Registered Public Accounting Firm

  

F-3

Balance Sheets as of December 31, 2004 and 2003

  

F-4

Statements of Operations for each of the years in the three-year period ended December 31, 2004

  

F-5

Statements of Capital Deficit for each of the years in the three-year period ended December 31, 2004

  

F-6

Statements of Cash Flows for each of the years in the three-year period ended December 31, 2004

  

F-7

Notes to Financial Statements

  

F-8

Condensed Consolidated Balance Sheets as of September 30, 2005 (unaudited) and December 31, 2004 (historical)

  

F-24

Condensed Consolidated Statements of Operations for the nine-months ended September 30, 2005 and 2004 (unaudited)

  

F-25

Condensed Consolidated Statement of Stockholder’s Equity for the nine-months ended September 30, 2005 (unaudited)

  

F-26

Condensed Consolidated Statements of Cash Flows for nine-months ended September 30, 2005 and 2004 (unaudited)

  

F-27

Notes to Condensed Consolidated Financial Statements (unaudited)

  

F-28

Financial Statement Schedules, Valuation and Qualifying Accounts

  

F-49

EXI WIRELESS INC.

    

Independent Auditors’ Report

  

F-50

Consolidated Balance Sheets as of December 31, 2004 and 2003

  

F-51

Consolidated Statements of Operations for the years ended December 31, 2004 and 2003

  

F-52

Consolidated Statements of Stockholders’ Equity for the years ended December 31, 2004 and 2003

  

F-53

Consolidated Statements of Cash Flows for the years ended December 31, 2004 and 2003

  

F-54

Notes to Consolidated Financial Statements

  

F-55

Independent Auditors’ Report

  

F-65

Consolidated Balance Sheets as of March 31, 2005 and December 31, 2004

  

F-66

Consolidated Statements of Operations and Deficit for the three-month periods ended March 31, 2005 (audited) and 2004 (unaudited)

  

F-67

Consolidated Statements of Stockholders’ Equity for the three-month periods ended March 31, 2005 (audited) and 2004 (unaudited)

  

F-68

Consolidated Statements of Cash Flows for the three-month period periods ended March 31, 2005 (audited) and 2004 (unaudited)

  

F-69

Notes to Consolidated Financial Statements

  

F-70

 

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     Page

INSTANTEL INC.

    

Report of Independent Registered Chartered Accountants

   F-80

Balance Sheets as of December 31, 2004 and 2003

   F-81

Statements of Operations for each of the years ended December 31, 2004 and 2003

   F-82

Statements of Shareholder’s Equity for the years ended December 31, 2004 and 2003

   F-83

Statements of Cash Flows for the years ended December 31, 2004 and 2003

   F-84

Notes to Financial Statements

   F-85

Report of Independent Registered Public Accounting Firm

   F-93

Balance Sheets at June 9, 2005 and December 31, 2004

   F-94

Statements of Operations for the periods beginning January 1, 2005 and ending June 9, 2005 (audited) and beginning January 1, 2004 and ending June 9, 2004 (unaudited)

  

F-95

Statements of Shareholder’s Equity (Deficit) for the period ended June 9, 2005 and the year December 31, 2004

  

F-96

Statements of Cash Flows for the periods beginning January 1, 2005 and ending June 9, 2005 (audited) and beginning January 1, 2004 and ending June 9, 2004 (unaudited)

  

F-97

Notes to Financial Statements

   F-98

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

Board of Directors and Stockholder

 

VeriChip Corporation,

 

We have audited the accompanying balance sheets of VeriChip Corporation (the “Company”), a wholly owned subsidiary of Applied Digital Solutions, Inc., as of December 31, 2004 and 2003, and the related statements of operations, capital deficit and cash flows for each of the years in the three-year period ended December 31, 2004. Our audits also included the financial statement schedules listed in Item 16(b). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the financial statements enumerated above present fairly, in all material respects, the financial position of VeriChip Corporation as of December 31, 2004 and 2003, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.

 

Eisner LLP

 

New York, New York

November 23, 2005,

With respect to the eighth and twentieth paragraphs of Note 1.

December 20, 2005,

With respect to Notes 3, 8 and 11

December 27, 2005.

 

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VERICHIP CORPORATION

 

BALANCE SHEETS

(In thousands, except par value)

 

     December 31,

 
     2004

    2003

 

ASSETS

                

Note 11

                

CURRENT ASSETS

                

Cash

   $ 23     $ 269  

Accounts receivable (net of allowance for doubtful accounts of $– in 2004 and $13 in 2003)

           33  

Inventories, net of allowance for slow moving inventory

     89       292  

Prepaid expenses

     40       41  
    


 


TOTAL CURRENT ASSETS

     152       635  

EQUIPMENT, NET

     131       147  
    


 


     $ 283     $ 782  
    


 


LIABILITIES AND CAPITAL DEFICIT

                

CURRENT LIABILITIES

                

Accounts payable and other accrued expenses

   $ 34     $ 44  

Distributor deposits

     23       87  

Deferred revenue

     17       45  

Due to Parent Company

     4,221       2,864  
    


 


TOTAL LIABILITIES

     4,295       3,040  

COMMITMENTS AND CONTINGENCIES

                

CAPITAL DEFICIT

                

Preferred stock (Note 1)

     —         —    

Common stock: Authorized 35,000 shares in 2004 and 30,000 shares in 2003, of $.0015 par value; 13,333 shares issued and outstanding in 2004 and 2003

     20       20  

Additional paid-in-capital

     1,030       773  

Accumulated deficit

     (5,062 )     (3,051 )
    


 


TOTAL CAPITAL DEFICIT

     (4,012 )     (2,258 )
    


 


     $ 283     $ 782  
    


 


 

 

See the accompanying notes to financial statements.

 

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VERICHIP CORPORATION

 

STATEMENTS OF OPERATIONS

(In thousands, except per share data)

 

     For the Years Ended
December 31,


 
     2004

    2003

    2002

 

PRODUCT REVENUE

   $ 247     $ 545     $ –    
    


 


 


COST OF PRODUCTS SOLD

     199       200       –    
    


 


 


GROSS PROFIT

     48       345       –    

SELLING, GENERAL AND ADMINISTRATIVE EXPENSE

     1,930       1,977       1,320  

OTHER INCOME

     (15 )     –         –    

INTEREST EXPENSE

     144       78       21  
    


 


 


LOSS BEFORE PROVISION FOR INCOME TAXES

     (2,011 )     (1,710 )     (1,341 )
    


 


 


PROVISION FOR INCOME TAXES

     –         –         –    
    


 


 


NET LOSS

   $ (2,011 )   $ (1,710 )   $ (1,341 )

DEEMED DIVIDEND

     –         –         (44 )
    


 


 


NET LOSS AVAILABLE TO COMMON STOCKHOLDER

   $ (2,011 )   $ (1,710 )   $ (1,385 )
    


 


 


NET LOSS PER COMMON SHARE – BASIC AND DILUTED

   $ (0.15 )   $ (0.13 )   $ (0.10 )
    


 


 


WEIGHTED AVERAGE NUMBER OF COMMON SHARES
OUTSTANDING – BASIC AND DILUTED

     13,333       13,333       13,333  
    


 


 


 

 

See the accompanying notes to financial statements.

 

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VERICHIP CORPORATION

 

STATEMENTS OF CAPITAL DEFICIT

For the Years Ended December 31, 2004, 2003 and 2002

(In thousands)

 

     Common Stock

   Additional
Paid-in-
Capital


    Accumulated
Deficit


    Total
Capital
Deficit


 
     Number

   Amount

      

BALANCE – DECEMBER 31, 2001

      $    $     $     $  

Net loss

                   (1,341 )     (1,341 )

Issuance of common stock to Parent Company

   13,333      20                  20  

Issuance of warrant to IBM at fair value

             44             44  

Deemed dividend (value of warrant issued to IBM)

                 (44 )           (44 )

Issuance of options for services

             57             57  
    
  

  


 


 


BALANCE – DECEMBER 31, 2002

   13,333      20      57       (1,341 )     (1,264 )

Net loss

                   (1,710 )     (1,710 )

Issuance of options for services

             716             716  
    
  

  


 


 


BALANCE – DECEMBER 31, 2003

   13,333      20      773       (3,051 )     (2,258 )

Net loss

                   (2,011 )     (2,011 )

Issuance of options for services

             257             257  
    
  

  


 


 


BALANCE – DECEMBER 31, 2004

   13,333    $      20    $     1,030     $     (5,062 )   $ (4,012 )
    
  

  


 


 


 

 

See the accompanying notes to financial statements.

 

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VERICHIP CORPORATION

 

STATEMENTS OF CASH FLOWS

(In thousands)

 

     For the Years Ended December 31,

 
     2004

    2003

    2002

 

CASH FLOWS FROM OPERATING ACTIVITIES

                        

Net loss

   $ (2,011)     $ (1,710)     $ (1,341)  

Adjustments to reconcile net loss to net cash used in operating activities:

                        

Depreciation

     48       44       33  

Non-employee stock option compensation

     257       716       57  

Costs and expenditures funded by the Parent Company

     543       352       180  

Allowance for slow moving inventory

     79              

Decrease (increase) in accounts receivable

     33       (15 )     (18 )

Decrease (increase) in inventories

     124       (292 )      

Decrease (increase) in prepaid expense

     1       1       (42 )

(Decrease) increase in accounts payable and accrued expenses

     (10 )     28       16  

(Decrease) increase in distributor deposits

     (64 )     (156 )     242  

(Decrease) increase in deferred revenue

     (28 )     31       14  
    


 


 


NET CASH USED IN OPERATING ACTIVITIES

     (1,028 )     (1,001 )     (859 )
    


 


 


CASH FLOWS FROM INVESTING ACTIVITIES

                        

Payments for equipment

     (32 )     (6 )     (217 )
    


 


 


NET CASH USED IN INVESTING ACTIVITIES

     (32 )     (6 )     (217 )
    


 


 


CASH FLOWS FROM FINANCING ACTIVITIES

                        

Borrowings from Parent Company, net of repayments

     814       1,276       1,056  

Issuance of common shares

                 20  
    


 


 


NET CASH PROVIDED BY FINANCING ACTIVITIES

     814       1,276       1,076  
    


 


 


NET (DECREASE) INCREASE IN CASH

     (246 )     269        

CASH – BEGINNING OF YEAR

     269              
    


 


 


CASH – END OF YEAR

   $ 23     $ 269     $  
    


 


 


 

See the accompanying notes to financial statements.

 

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VERICHIP CORPORATION

 

Notes to Financial Statements

 

1. Organization and Significant Accounting Policies

 

Organization

 

VeriChip Corporation (the “Company”) is a Delaware corporation formed in November 2001. The Company’s operations began in January 2002. The Company issued 13,333,333 shares of its common stock to its parent company, Applied Digital Solutions, Inc., referred to as Applied Digital or Parent Company, upon the commencement of its operations. Applied Digital owns 100% of the outstanding shares of the Company’s common stock. Prior to the expansion of the Company’s business through two acquisitions during the first half of 2005, as discussed in Note 13, the Company’s activities consisted primarily of developing the markets for its radio frequency identification, or RFID, systems using the implantable VeriChip.

 

The implantable VeriChip is a human-implantable microchip that uses RFID technology and that can be used in a variety of patient identification and security applications. Each implantable VeriChip contains a unique identification number that is read by the Company’s scanner. In October 2004, the U.S. Food and Drug Administration, or FDA, cleared the Company’s VeriMed patient identification system for medical use in the United States. The Company’s VeriMed patient identification system is used to rapidly and accurately provide physicians with a patient’s pre-approved data which can include a patient’s name, primary care physician, emergency contact and other pertinent pre-approved data, such as personal health records.

 

VeriChip is not an FDA-regulated medical device with regard to its use in security applications. The security applications for VeriChip are marketed under the VeriGuard brand name. The Company’s VeriGuard system is used to identify individuals and permit access into restricted areas.

 

Through December 31, 2004, the Company has been dependent upon the financial support of Applied Digital. See Note 11 for information concerning the amount due to Parent Company and the conversion of such borrowing into a line of credit with Applied Digital.

 

The Company obtains the implantable VeriChip and related scanners from Digital Angel Corporation, or Digital Angel, under the terms of an exclusive supply and license agreement. The terms of the supply and license agreement are discussed in Note 11. Digital Angel is a majority-owned subsidiary of Applied Digital and it owns the patents related to the implantable VeriChip. Through December 31, 2004, all research and development efforts related to the implantable VeriChip have been performed by Digital Angel.

 

Through December 31, 2004, the Company’s revenues, which were minimal, were derived solely from the Company’s VeriGuard system, and the Company operated in one segment. As a result of the two acquisitions during the first half of 2005, which are more fully discussed in Note 13, on July 1, 2005, the Company began operating in two business segments: (i) Healthcare and (ii) Security and Industrial. Accordingly, the Company’s operations for all periods have been presented in the Company’s two business segments.

 

Revenues, when generated, and operating costs associated with the Company’s VeriMed patient identification system are included in the Company’s Healthcare segment. Revenue and operating costs associated with the Company’s VeriGuard system are included in the Company’s Security and Industrial segment.

 

On December 12, 2005, the Company’s board of directors proposed and the Company’s shareholder approved a 2-for-3 reverse stock split, which was effectuated on December 20, 2005. All share

 

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amounts reflected in these financial statements have been adjusted for the reverse stock split. In addition, on December 12, 2005, the Company’s board of directors proposed and the Company’s shareholder approved the authorization of 5.0 million shares of blank check preferred stock and an increase in the Company’s authorized shares of its common stock from 50.0 million to 70.0 million shares. These changes were also effectuated on December 20, 2005.

 

Significant Accounting Policies

 

Use Of Estimates

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make certain estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Included in these estimates are assumptions about allowances for inventory obsolescence, bad debt reserves and equipment lives, among others. Although these estimates are based on the knowledge of current events and actions the Company may undertake in the future, they may ultimately differ from actual results.

 

Inventories

 

Inventories consist of human implantable microchips and scanners (finished goods). Inventories are valued at the lower of cost or market, determined by the first-in, first-out method. The Company monitors and analyzes inventory for potential obsolescence and slow-moving items based upon the aging of the inventory and the inventory turns by product. Inventory items designated as slow moving are written down to reflect their estimated net realizable value. Inventory items designated as obsolete are written off. Allowance for slow moving inventory was approximately $0.1 million, $0 and $0 as of December 31, 2004, 2003 and 2002, respectively.

 

Equipment

 

Equipment is carried at cost less accumulated depreciation computed using straight-line methods. Equipment is depreciated over periods ranging from 3 to 5 years. Repairs and maintenance, which do not extend the useful life of the asset, are charged to expense as incurred.

 

Advertising Costs

 

The Company expenses production costs of print advertisements on the first date the advertisements take place. Advertising expense included in selling, general and administrative expense was approximately $0.1 million, $19,000 and $1,000 in 2004, 2003 and 2002, respectively.

 

Revenue Recognition

 

In general the Company recognizes revenue after products are shipped to customers and title has transferred, provided that a purchase order has been received or a contract has been executed, there are no uncertainties regarding customer acceptance, the sales price is fixed and determinable and collectability is reasonably assured. If uncertainties regarding customer acceptance exist, revenue is recognized when such uncertainties are resolved.

 

Revenues from the sale of VeriChip microchips and scanners are recorded in the statement of operations at the gross amounts, with a separate corresponding entry for the cost of sales. Because of minimal sales volumes to date (all of which have been to distributors), the Company’s management cannot, as yet, reasonably estimate the amount of returns. Accordingly, the Company does not at this time recognize revenues from direct sales to its distributors until the products are shipped and title has transferred, all the above mentioned conditions have been satisfied, and the period of time the distributor

 

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has to return products (as provided in the applicable agreement) has expired. Once the amount of returns can be reasonably estimated, revenues (net of expected returns) will be recognized in accordance with the Company’s general accounting policy for product sales. When the Company commences consignment sales of its VeriChip microchips and scanners, the Company intends to recognize revenues from such sales after receipt of notification from the distributor that a product sale has been made to its customer, provided that a purchase order has been received or a contract has been executed with the customer, the sales price is fixed and determinable and the period of time the customer has to return the products (as provided in the applicable agreement) has expired and collectability is reasonably assured. As of December 31, 2004, deferred VeriChip product revenue was de minimus.

 

Originally, the Company entered into distributorship agreements whereby the distributor would pay an up-front fee in exchange for the exclusive right to market, promote and sell VeriChip products within the agreed upon territory. Under this arrangement, the distribution fee was not creditable against or applied towards amounts due for any products subsequently ordered by the distributor. During 2003, the Company amended its existing contracts to stipulate that $1.00 of up-front money would be allocated to a distribution fee, and the remaining amounts were customer deposits, which could be applied against future purchases of VeriChip microchips and scanners. Therefore, distributor fees were never recognized as revenue.

 

Stock-Based Compensation

 

The Company accounts for its employee stock-based compensation plans in accordance with the Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, or APB 25, and Financial Accounting Standards Board Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation—an Interpretation of APB Opinion No. 25, or FIN 44. In accordance with this accounting literature, no compensation cost is recognized for any of the Company’s fixed stock options granted to directors and employees when the exercise price of each option equals or exceeds the fair value of the underlying common stock on the grant date. As of December 31, 2004, the Company has not granted any options to employees at a price less than fair value on the date of grant. When options are granted to officers and directors at a price less than the fair market value on the date of grant, compensation expense is required to be calculated based on the intrinsic value (i.e., the difference between the exercise price and the fair market value on the date of grant), and the compensation expense must be recognized over the vesting period of the options. If the options are fully vested, the expense is recognized immediately. Changes in the terms of stock option grants, such as extending the vesting period of the options or changes in the exercise price generally have an accounting consequence. Accordingly, compensation expense is measured in accordance with APB 25, such that compensation expense is measured and recognized over the vesting period. If the modified grant is fully vested, any additional compensation cost is recognized immediately. The Company accounts for equity instruments issued to non-employees and non-directors, including employees of Applied Digital, in accordance with the provisions of Statement of Financial Accounting Standard, or SFAS, No. 123, Accounting for Stock-based Compensation, or FAS 123. The Company recognized $0.3 million, $0.7 million and $0.1 million of expense during 2004, 2003 and 2002, respectively, associated with such options, including $12,000 and $0.2 million during 2004 and 2003, respectively, related to a severance agreement.

 

In December 2004, the Financial Accounting Standards Board, or FASB, issued SFAS No. 123 (revised 2004), Share-Based Payment, or FAS 123R, which replaces FAS 123 and supersedes APB 25. The impact of FAS 123R is more fully described under the section titled Impact of Recently Issued Accounting Standards.

 

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As of December 31, 2004, the Company had one stock option plan. The following table illustrates the effect on net loss and loss per share if the Company had applied the fair value recognition provisions of FAS 123 to stock-based employee compensation for options granted under its plan:

 

     Year Ended December 31,

 
     2004

    2003

    2002

 
     (in thousands, except per
share amounts)
 

Net loss available to common stockholder, as reported

   $(2,011 )   $(1,710 )   $(1385 )

Deduct: Total stock-based employee compensation expense determined under fair value-based method for all awards, net of related tax effects

   (134 )   (56 )   (90 )
    

 

 

Pro forma net loss available to common stockholder

   $(2,145 )   $(1,766 )   $(1,475 )
    

 

 

Loss per share:

                  

Basic and Diluted—as reported

   $(0.15 )   $(0.13 )   $(0.10 )

Basic and Diluted—pro forma

   $(0.16 )   $(0.13 )   $(0.11 )

 

The weighted average per share fair value of grants made in 2004, 2003 and 2002 for the Company’s stock options was $0.22, $0.23, and $0.05, respectively. The fair values of the options granted were estimated on the grant date using the Black-Scholes valuation model based on the following weighted-average assumptions:

 

     2004

    2003

    2002

 

Estimated option life