Amendment No. 2 to Form S-1
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As filed with the Securities and Exchange Commission on May 25, 2006

Registration No. 333-130754


UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 


 

Amendment No. 2 to

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

1301 Avenue of the Americas, 40th Floor

New York, New York 10019

(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.  ¨

 


 

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 MAY 25, 2006

 

                     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 have applied 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 6 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.

 

C.E. Unterberg, Towbin

 

Kaufman Bros., L.P.

 

The date of this Prospectus is                     , 2006


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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

   6

Special Note Regarding Forward-Looking Statements

   19

Use of Proceeds

   20

Dividend Policy

   20

Capitalization

   21

Dilution

   22

Selected Consolidated Financial Data

   24

Unaudited Pro Forma Condensed Combined Financial Information

   27

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

   31

Our Business

   62

Management

   82

Certain Relationships and Related Party Transactions

   95

Principal Stockholders

   100

Description of Capital Stock

   101

Shares Eligible for Future Sale

   106

Material United States Tax Considerations for Non-United States Holders

   109

Underwriting

   113

Legal Matters

   118

Experts

   118

Where You Can Find More Information

   119

 


 

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 radio frequency identification systems for people in the healthcare industry. We sell both passive and active radio frequency identification systems. Our passive radio frequency identification systems are used for identification purposes and our active systems are used for location and identification purposes. The key difference in the technology is that active radio frequency identification systems contain tags with battery powered microchips and emit a beacon while passive systems do not contain tags with battery powered microchips and cannot emit a beacon.

 

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 radio frequency identification microchip, the VeriChip, cleared for medical use in October 2004 by the United States Food and Drug Administration, or FDA. We obtain the implantable VeriChip and related scanners from Digital Angel Corporation, a majority-owned subsidiary of our parent company, Applied Digital Solutions, Inc., under the terms of a supply agreement. See “Risks Related to our Business - Because a predecessor of Digital Angel licensed the exclusive right to use the patent for the identification of human beings to other parties, our sales of systems that incorporate the implantable VeriChip may be enjoined by third parties who have the rights to the intellectual property” on page 6.

 

We believe that our VeriMed 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.

 

We market our VeriMed patient identification system to both hospitals and physicians. Initially, our marketing strategy for hospitals is to educate emergency room physicians and staff as to the benefits in adopting our VeriMed patient identification system. We are currently providing hospitals with our scanners at no charge. As of May 1, 2006, 97 hospitals and medical facilities had agreed to implement our VeriMed patient identification system in their emergency rooms. After this initial seeding phase which we expect to be completed during the first half of 2007, we intend to sell our scanners directly to hospitals. We currently use our sales force to directly market to and educate physicians in the geographic regions surrounding VeriMed-registered hospitals. We intend to sell VeriMed patient identification kits directly to physicians and anticipate that they will subsequently market them to their patients. As of May 1, 2006, 232 physicians had registered to provide the VeriMed patient identification system to select patients. In addition to the marketing efforts of physicians, we intend to increase the awareness as to the benefits of our implantable VeriChip through a direct marketing campaign to patients.

 

In addition to our VeriMed patient identification system, we market and sell other radio frequency identification systems for other applications in the healthcare industry as well as for security and industrial

 

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applications. These radio frequency identification systems, which have been installed in over 4,000 healthcare locations throughout North America, 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 radio frequency identification 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.

 

Our Strategy

 

Our objective is to become the leading provider of radio frequency identification 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;

 

    identify and develop 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 Holdings Inc., or VHI. VHI 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, VHI acquired Instantel Inc., an Ontario corporation, for total consideration of approximately $25 million, of which Applied Digital contributed $22.3 million. Instantel was formed in 1982. Instantel provides infant protection and wander prevention systems to the healthcare industry and offers vibration monitoring systems to industrial customers.

 

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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 March 31, 2006 were approximately $11.3 million. We have not generated any revenue from our VeriMed patient identification system. To date, approximately 50 people have been implanted with the implantable VeriChip as part of the 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. Our ability to sell the VeriMed patient identification system and our other systems that incorporate the implantable VeriChip may be enjoined by third parties who have rights to the intellectual property used in our systems. 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 these and other risks.

 

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 May 15, 2006. This information excludes:

 

    6,086,502 shares of our common stock issuable upon the exercise of outstanding options under our stock plans at a weighted average exercise price of $0.63 per share;

 

    646,831 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, pursuant to the terms of a share purchase agreement by which we acquired Instantel 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 three months ended March 31, 2006 and 2005, and the balance sheet data as of March 31, 2006, are derived from our unaudited interim consolidated financial statements. The statements of operations data for the years ended December 31, 2005, 2004 and 2003 and the balance sheet data at December 31, 2005 and 2004 are derived from our audited financial statements. The historical results are not necessarily indicative of results to be expected for future periods and the results for the three months ended March 31, 2006, are not necessarily indicative of results that may be expected for the entire year ending December 31, 2006. 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 on January 1, 2005.

 

    

Three Months

Ended

March 31,


    Year Ended December 31,

 
    

2006


   

2005


   

2005

Pro forma(1)


   

2005

Historical


   

2004

Historical


   

2003

Historical


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

Consolidated Statements of Operations Data:

                                                

Net revenue

   $ 6,550     $ 15     $     24,554     $     15,869     $ 247     $ 545  

Loss before income taxes

     (1,021 )     (1,075 )     (6,254 )     (5,206 )     (2,011 )     (1,710 )

Net loss attributable to common stockholder

     (1,021 )     (1,075 )     (5,505 )     (5,263 )     (2,011 )     (1,710 )

Net loss per common share attributable to common stockholder-basic and diluted

     (0.06 )     (0.08 )   $ (0.33 )   $ (0.33 )   $ (0.15 )   $ (0.13 )

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

 

     At March 31, 2006

     Actual

    Pro forma(1)

  

Pro forma

as adjusted(2)


     (in thousands)           

Consolidated Balance Sheet Data:

                 

Cash

   $ 594           

Working capital

     (6,703 )         

Total assets

     48,662           

Total debt

     7,521           

Total stockholder’s equity

     27,537           

(1) Pursuant to the terms of a share purchase agreement by which we acquired Instantel, upon the closing of this offering we will be required to issue a number of shares of our common stock with an aggregate market value of $2.0 million to Perceptis, the former parent company of Instantel. The balance sheet data as of March 31, 2006 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 March 31, 2006 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

 

Because a predecessor of Digital Angel licensed the exclusive right to use the patent for the identification of human beings to other parties, our sales of systems that incorporate the implantable VeriChip may be enjoined by third parties who have rights to the intellectual property.

 

Although the implantable VeriChip used in our VeriMed patient identification system and our VeriGuard and VeriTrace systems uses a technology related to a patent owned by our affiliate, Digital Angel Corporation, the exclusive rights to use the patented technology in applications involving the identification of human beings were licensed to Hughes Aircraft Company and Hughes Identification Devices, Inc. by Destron/IDI, Inc., a predecessor of Digital Angel, in 1994. Hughes Aircraft Company subsequently changed its name and is now known as Raytheon Company.

 

Raytheon Microelectronics España, or RME, entered into an agreement with Digital Angel, effective April 26, 2006, for the manufacture and assembly of glass encapsulated, syringe-implantable transponders, including the implantable VeriChip. We have been advised that RME is a wholly-owned subsidiary of Raytheon Company. The RME supply agreement grants Digital Angel a non-exclusive license to any and all intellectual property held by RME or its affiliates related to the manufacture, distribution or use of the microchip for use in human beings. However, because the 2006 agreement was with RME and not Raytheon Company, it is possible that RME lacks the authority or intellectual property to grant a license that would support our use of the patented technology for human identification. In addition, while RME represents that it and its affiliates have not assigned or granted any rights in the intellectual property to third parties, RME does not represent in the supply agreement that RME or its affiliates have any rights to use the patented technology in applications involving the identification of human beings or that RME has the authority to grant such a license. Because rights to use the patented technology granted in 1994 were freely assignable, we do not know which parties currently hold those rights. Therefore, we cannot assure you that the license granted by RME under the supply agreement with Digital Angel grants any rights that would support our use of the patented technology for human identification. The license granted by RME is part of each individual product sold under the supply agreement to Digital Angel and may not be conveyed separately from such products. Thus, any rights to the patented technology outside of products supplied to Digital Angel through RME are not available and we are at further risk should we engage a third party supplier even if we have the right to do so through our agreement with Digital Angel. In addition, the rights under the supply agreement between RME and Digital Angel will not prevent other parties from competing with us.

 

Digital Angel has sent a proposed letter agreement to RME for it to send to Raytheon Company in an effort to clarify the validity and scope of the license granted by RME under the supply agreement. However, we have been advised by Digital Angel that Raytheon Company has not executed the proposed letter agreement and that it may take several months for Raytheon Company to do so. We cannot assure you that the proposed letter agreement between Digital Angel and Raytheon will ever be executed by Raytheon.

 

Among other terms, our supply agreement with Digital Angel purports to license to us the right to use the implantable VeriChip technology. However, based on the 1994 license and the limitations

 

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associated with the supply agreement between RME and Digital Angel described above, certain rights relating to the license under our supply agreement with Digital Angel are broader than the license rights that Digital Angel has under its supply agreement with RME, most notably the rights to independently enforce the patent and to independently manufacture the products. Accordingly, such rights may be rendered inoperative by the previously granted right to use the patented technology for human identification. While we have been publicly marketing and selling the implantable VeriChip in applications involving the identification of human beings, including obtaining FDA clearance to market and sell the implantable VeriChip in the United States for patient identification, our use of the technology could be enjoined based on the claim that the sale and use of our products conflicts with the scope of the exclusive license previously granted to others for the use of the technology for the identification of human beings. Digital Angel is our sole supplier of implantable VeriChips. Digital Angel relies solely on the supply agreement with RME for the manufacture and assembly of implantable VeriChips. Our ability to successfully commercialize products incorporating the implantable VeriChip will depend in part on any third parties, including prior licensees or their successors in interest, not obtaining an injunction against us, Digital Angel or our suppliers or otherwise requiring us to pay additional royalties or other damages for the remaining life of the patent, which expires on May 18, 2010.

 

Costly and time-consuming litigation could result from our marketing, use and sale of the implantable VeriChip for the identification of human beings. If we or Digital Angel are denied use of the patented technology in applications involving the identification of human beings, we will not be able to purchase or sell the VeriMed patient identification system, or any other products that incorporate the implantable VeriChip before the patent expires, and we will not be able to fulfill our expectations for significant revenue growth from sales of our VeriMed patient identification system or our other systems incorporating the implantable VeriChip. Further, we may be required to pay royalties and other damages to third parties on products we have already purchased or will purchase from Digital Angel.

 

We lack the right to prevent third parties from making or selling products that incorporate the patented technology used in the implantable VeriChip.

 

Our ability to successfully commercialize products incorporating the implantable VeriChip will depend in part on our ability to enforce the patent purportedly licensed to us by Digital Angel relating to the implantable VeriChip for the remaining life of the patent in both the United States and in other countries. Because a predecessor of Digital Angel licensed the right to use the patent related to the implantable VeriChip in applications involving the identification of human beings to other parties in 1994, we do not have the right to exclude third parties from making or selling products that use the patented technology in applications involving the identification of human beings that may compete with our VeriMed patient identification system or our other systems incorporating the implantable VeriChip. In addition, the rights under the supply agreement between RME and Digital Angel will not prevent other parties from competing with us.

 

In addition, even if we obtain the rights to enforce the above patent, it is possible that the claims issued for this and other patents may not be sufficiently broad to protect the systems we intend to protect with the patents, and may not provide protection against competitive products or otherwise be commercially valuable. In addition, 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. Our inability to exclude third parties from making or selling competing products may result in our facing competition that could have a material adverse effect on our business prospects.

 

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

 

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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 will 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. To date, while over 4,000 health care locations have installed our active radio frequency identification, or RFID, systems, only 97 hospitals and medical facilities as of May 1, 2006 have agreed to implement our VeriMed patient identification system and less than ten of these are actually using the system currently. In addition, as of May 1, 2006, only 232 physicians have registered to provide the VeriMed patient identification system to their patients. To date, approximately 50 people have been implanted with the implantable VeriChip as part of the VeriMed patient identification system. If we are not successful in educating hospitals and physicians, they may not adopt our system and our ability to generate revenue from the VeriMed patient identification system will 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 adversely 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.

 

If we lose our exclusivity under our supply agreement with Digital Angel, Digital Angel may sell human implantable microchips to third parties causing an increase in competition, which could have a material adverse effect on the expected growth of our business.

 

Our agreement with Digital Angel to purchase the implantable VeriChip for identification of humans includes a provision that Digital Angel will be permitted to sell implantible microchips to other parties if we fail to meet specified minimum purchase requirements. If we fail to meet these minimum purchase requirements and Digital Angel sells implantable microchips to one or more third parties, our competition may increase which could have a material adverse effect on the 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.

 

If we lose our rights under our supply agreement with Digital Angel, we will not be able to purchase the implantable VeriChip and we may not be able to fulfill our expectations for significant revenue growth.

 

Our supply agreement with Digital Angel could be prematurely terminated upon the occurrence of specified events, including as a result of a bankruptcy event of the other party or an uncured default by us

 

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in the performance of any of our obligations under the agreement, including the payment of money. If we lose our rights under our supply agreement with Digital Angel, we will not be able to purchase the implantable VeriChip from Digital Angel 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 with concerns about privacy issues relating to the use and storage of personally-identifiable data, such as patient medical information, may influence healthcare professionals to refrain from adopting our systems.

 

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.

 

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 $11.3 million as of March 31, 2006 and our net losses attributable to the common stockholder for the three months ended March 31, 2006 and 2005 and the years ended December 31, 2005, 2004 and 2003 were $1.0 million, $1.1 million, $5.3 million, $2.0 million and $1.7 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 VHI 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. We expect to incur approximately $1.8 million in amortization expense associated with intangible assets in the year ending December 31, 2006. In addition, we expect our operating expenses for the year ending December 31, 2006 to be between 22% to 28% higher than our operating expenses for the year ended December 31, 2005.

 

If we are unable to successfully integrate the operations, systems and personnel of our recent acquisitions, our management team may be distracted or ineffective and our sales efforts will be impaired.

 

We acquired VHI 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 VHI 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;

 

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    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 the implantable VeriChip, making us vulnerable to supply disruptions that could delay our product delivery to our customers.

 

Digital Angel is our sole supplier of the implantable VeriChip under the terms of an amended and restated supply agreement between us and Digital Angel. Under our agreement with Digital Angel, Digital Angel purports to license us the right to manufacture the implantable VeriChip. However, in 1994, the exclusive rights to use certain patented technology involved in the manufacture of the implantable VeriChip for use in applications involving the identification of human beings were licensed to Hughes Aircraft Company and Hughes Identification Devices, Inc. by Destron/IDI, Inc., a predecessor of Digital Angel. Hughes Aircraft Company subsequently changed its name to Raytheon Company. Consequently, the right to independently manufacture the implantable VeriChip under our supply agreement with Digital Angel may conflict with and be rendered inoperative by the previously granted right to use the patented technology for human identification.

 

The implantable VeriChip is manufactured for Digital Angel by Raytheon Microelectronics España, or RME, under a supply agreement with Digital Angel that expires June 30, 2010. We have been advised that RME is a wholly-owned subsidiary of Raytheon Company. The RME supply agreement grants Digital Angel a non-exclusive license to any and all intellectual property held by RME or its affiliates related to the manufacture, distribution or use of glass encapsulated, syringe-implantable transponders, including the implantable VeriChip. However, because the supply agreement is with RME and not Raytheon Company, it is possible that RME lacks the authority or intellectual property to grant a license that would support the use of the patented technology in the manufacture of the implantable Verichip used in application involving the identification of human beings.

 

If we are unable to obtain the implantable VeriChip from Digital Angel or if Digital Angel is unable to obtain it from RME or another supplier under the terms of the supply agreement with RME, we may not be able to manufacture it in another facility. If we are unable to obtain adequate supplies of the implantable VeriChip, we may 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. Even if we were able to have the implantable VeriChip manufactured in another facility, we currently believe establishing such an arrangement could take three to six months for us to locate another facility to manufacture the implantable VeriChip and for production to commence. The cost of production at another facility could be more than we are paying to Digital Angel. A supply disruption could negatively impact our expectations for significant revenue growth.

 

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

 

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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. In the past, we have experienced short periods of unaccessability to the patient information database as a result of development work, system maintenance and power outages. While there were no reported problems by end users in those situations, 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. The database system may still be vulnerable to disruptions in the event the building housing the computer system is destroyed, the computer server fails or the firewall software protecting the data fails. Any disruptions to the patient information database could irreparably harm our business and prospects.

 

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 the FDA’s jurisdiction. The FDA clearance for the implantable 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, 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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If we fail or allegedly fail to comply with anti-kickback and false claims laws, we could be subject to costly and time-consuming litigation and possible fines or other penalties.

 

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 because we may suffer fines or other penalties as a result of such violations and because our management team could be distracted.

 

We may be subject to costly product liability claims from the use of our systems which could damage our reputation, impair the marketability of our systems, and force us to pay costs and damages that may not be covered by adequate insurance.

 

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, then sales of our systems could suffer and 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

 

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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.

 

If others assert that our products infringe their intellectual property rights, we may be drawn into costly disputes and risk paying substantial damages or losing the right to sell our products.

 

We face the risk of adverse claims and litigation alleging infringement by VeriChip of the intellectual property rights of others, including the rights to technology previously licensed by Digital Angel’s predecessor used in the implantable VeriChip, as described above. If infringement claims are brought against us or our suppliers, these assertions could distract management and we may have to expend potentially significant funds and resources to defend or settle such claims. We cannot be certain that we will have the financial resources or substantive arguments to defend ourselves against any patent or other intellectual property litigation.

 

If we or our suppliers are unsuccessful in any challenge to our rights to market and sell our products, we may, among other things, be required to:

 

    pay actual damages, royalties, lost profits and/or increased damages and the third party’s attorneys’ fees, which may be substantial;

 

    cease the development, manufacture, use and/or sale of products that use the intellectual property in question through a court-imposed sanction called an injunction;

 

    expend significant resources to modify or redesign our products, manufacturing processes or other technology so that it does not infringe others’ intellectual property rights or to develop or acquire non-infringing technology, which may not be possible; or

 

    obtain licenses to the disputed rights, which could require us to pay substantial upfront fees and future royalty payments and may not be available to us on acceptable terms, if at all, or to cease marketing the challenged products.

 

Ultimately, we could be prevented from selling a product or otherwise forced to cease some aspect of our business operations as a result of any intellectual property litigation. Even if we or our suppliers are successful in defending an infringement claim, the expense, time delay, and burden on management of litigation and negative publicity could have a material adverse effect on our business.

 

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 by causing us to lose a competitive advantage or by forcing us to engage in costly and time-consuming litigation to defend or enforce our rights.

 

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 by causing us to lose a competitive advantage maintained through such confidential information.

 

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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 by delaying our ability to commercialize innovations or by diverting our resources away from revenue-generating projects.

 

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 additional funding and may be unable to raise capital when needed, which would force us to delay, reduce or eliminate our product development programs or commercialization efforts.

 

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.

 

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,

 

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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 by reducing the revenue we could otherwise receive from sales of the implantable VeriChip.

 

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 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

 

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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. This includes Scott Silverman, the chairman of our board of directors, who serves as the chairman of the board of Applied Digital and also as a director of Digital Angel. 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.”

 

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

 

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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;

 

    a denial of our or Digital Angel’s use of the patented technology used in the implantable VeriChip or a requirement that we pay additional royalties or other damages in connection with our use of the implantable VeriChip;

 

    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 and stockholder covering 18,754,657 shares of our common stock, 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. In addition, our warrant holders have agreed to enter into similar lockup agreements covering 1,332,667 shares of our common stock upon 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.

 

After the offering, we will have 6,153,169 and 1,332,667 shares issuable upon exercise of outstanding options and warrants, respectively. Of these 7,485,836 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.”

 

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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);

 

    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,” “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.

 

On December 27, 2005, we entered into an agreement with Applied Digital providing for a revolving loan facility to us in principal amount of up to $8.5 million, of which $7.3 million was drawn on March 31, 2006. 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 March 31, 2006:

 

    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 March 31, 2006(1)(2)

     Actual

    Pro forma

   Pro forma
as adjusted


     (Unaudited)
    

(in thousands, except

share and per share data)

Debt, including current portion

   $ 7,521     $    $

Stockholder’s equity:

                     

Preferred stock: $0.001 par value, 5,000,000 shares authorized, none issued or outstanding, actual, pro forma and as adjusted

               

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

     25               

Additional paid-in capital

     38,894               

Accumulated other comprehensive loss

     (37 )             

Accumulated deficit

     (11,345 )             
    


 

  

Total stockholder’s equity

     27,537               
    


 

  

Total capitalization

   $ 35,058               
    


 

  


(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 March 31, 2006 have been retroactively adjusted to reflect the reverse stock split.

 

(2) Pursuant to the terms of a share purchase agreement by which we acquired Instantel, upon the closing of this offering we will be required to issue a number of shares of our common stock with an aggregate market value of $2.0 million to Perceptis, the former parent company of Instantel.

 

The table above does not include the following as of March 31, 2006:

 

    6,086,502 shares of our common stock issuable upon the exercise of outstanding options under our stock plans at a weighted average exercise price of $0.63 per share;

 

    646,831 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 December 31, 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, goodwill and deferred offering costs) 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 December 31, 2008 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 December 31, 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 March 31, 2006 and gives effect to the 2-for-3 reverse stock split that was effectuated on December 20, 2005, and excludes, as of March 31, 2006:

 

    6,086,502 shares of our common stock issuable upon the exercise of outstanding options under our stock plans at a weighted average exercise price of $0.63 per share;

 

    646,831 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

 

VeriChip Corporation

 

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 Information” appearing elsewhere in this prospectus data for the three months ended March 31, 2006 and 2005, and the balance sheet data as of March 31, 2006, 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, 2005, 2004 and 2003 are derived from our audited financial statements. The historical results are not necessarily indicative of results to be expected for future periods and the results for the three months ended March 31, 2006, are not necessarily indicative of results that may be expected for the entire year ending December 31, 2006. 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 on January 1, 2005.

 

    Three Months
Ended March 31,


    Year Ended December 31,

 
    2006

    2005

   

2005

Pro forma(1)


   

2005

Historical


   

2004

Historical


   

2003

Historical


   

2002

Historical


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

Consolidated Statements of Operations Data:

                                                       

Net revenue

  $ 6,550     $ 15     $     24,554     $     15,869     $ 247     $ 545     $  

Cost of products and services sold

    2,569       10       10,332       6,395       199       200        
   


 


 


 


 


 


 


Gross profit

    3,981       5       14,222       9,474       48       345        

Selling, general and administrative expense

    4,007       1,023       16,956       12,442       1,930       1,977       1,320  

Research and development

    885             3,260       1,958                    

Interest and other income

    (18 )           (83 )     (63 )     (15 )            

Interest expense

    128       57       343       343       144       78       21  
   


 


 


 


 


 


 


Loss before income taxes

    (1,021 )     (1,075 )     (6,254 )     (5,206 )     (2,011 )     (1,710 )     (1,341 )

Provision for (benefit from) income taxes

                (750 )     56                    
   


 


 


 


 


 


 


Net loss

    (1,021 )     (1,075 )     (5,504 )     (5,262 )     (2,011 )     (1,710 )     (1,341 )

Deemed dividends

                (1 )     (1 )                 (44 )
   


 


 


 


 


 


 


Net loss attributable to common stockholder

    (1,021 )     (1,075 )   $ (5,505 )   $ (5,263 )   $ (2,011 )   $ (1,710 )   $ (1,385 )
   


 


 


 


 


 


 


Net loss attributable to common stockholder per common
share-basic and diluted

  $ (0.06 )   $ (0.08 )   $ (0.33 )   $ (0.33 )   $ (0.15 )   $ (0.13 )   $ (0.10 )
   


 


 


 


 


 


 


Average common shares outstanding: Basic and diluted

    16,667       13,333       16,667       15,836       13,333       13,333       13,333  

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

 

    At March 31,

  At December 31,

 
    2006

  2005

  2004

    2003

    2002

 
    (Unaudited)   (in thousands)  

Consolidated Balance Sheet Data:

                                   

Cash

  $ 594   $     1,440   $ 23     $ 269     $  

Property and equipment

    895     890     131       147       184  

Goodwill

    17,008     16,982                  

Total assets

    48,662     48,438     283       782       245  

Long-term debt

    7,264     6,881                  

Total debt

    7,521     6,975         4,221           2,864           1,236  

Stockholder’s equity (deficit)

    27,537     28,527     (4,012 )     (2,258 )     (1,264 )

 

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VeriChip Holdings Inc., formerly eXI Wireless Inc.

 

We have presented the following selected financial data for VHI because VHI is considered to be a predecessor of ours. The information presented is for periods prior to our acquisition of VHI. We acquired VHI effective March 31, 2005.

 

You should read the following selected consolidated financial data in conjunction with eXI Wireless’ consolidated financial statements and related notes appearing elsewhere in this prospectus. The consolidated statement of operations and balance sheet data for the years ended and as of December 31, 2004, 2003, 2002 and 2001, and for the three months ending March 31, 2005, are derived from eXI Wireless’ audited financial statements.

 

     Three
months
ended
March 31,


    Year Ended December 31,

 
    

2005

Historical


   

2004

Historical


   

2003

Historical


   

2002

Historical


   

2001

Historical


 
     (in thousands, except per share data)  

Consolidated Statements of Operations Data:

                                        

Net revenue

   $     1,986     $     6,004     $     6,118     $     6,383     $     4,956  

Cost of products and services sold

     575       1,763       1,735       1,754       1,419  
    


 


 


 


 


Gross profit

     1,411       4,241       4,383       4,629       3,537  

Selling, general and administrative expense and depreciation and amortization

     1,355       3,524       3,222       3,276       3,011  

Research and development

     262       918       741       728       1,517  

Interest and other income

     (2 )     (17 )     (4 )     (7 )     (5 )

Foreign exchange loss (gain)

     (18 )     169       334       36       (45 )
    


 


 


 


 


Earnings (loss) before income taxes

     (186 )     (353 )     90       596       (941 )

Benefit from income taxes

           (24 )     (55 )     (75 )     (152 )

Loss from discontinued operations net of tax

                       (512 )     (189 )
    


 


 


 


 


Net income (loss)

   $ (186 )   $ (329 )   $ 145     $ 159     $ (978 )
    


 


 


 


 


     March 31,

    December 31,

 
     2005

    2004

    2003

    2002

    2001

 
     (in thousands)  

Consolidated Balance Sheet Data:

                                        

Cash

   $     554     $     1,127     $ 1,025     $ 1,296     $ 719  

Property, plant and equipment

     191       189       294       318       369  

Goodwill

     1,441       1,450       1,348       1,103       1,179  

Total assets

     4,975       5,338       5,203       4,847       4,062  

Long-term debt

                              

Total debt

                              

Stockholder’s equity

     3,971       4,025       4,070       3,184       2,983  

 

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Table of Contents

Instantel Inc.

 

We have presented the following selected financial data for Instantel because Instantel is considered to be a predecessor of ours. The information presented is for periods prior to our acquisition of Instantel. We acquired Instantel effective June 10, 2005.

 

You should read the following selected consolidated financial data in conjunction with Instantel’s consolidated financial statements and related notes appearing elsewhere in this prospectus, the statement of operations and balance sheet data for the years ended and as of December 31, 2004, 2003, 2002, and 2001, and for the period ending June 9, 2005, are derived from Instantel’s audited financial statements.

 

    

Period
ended

June 9,


   

Year Ended December 31,


    

2005

Historical


   

2004

Historical


   

2003

Historical


   

2002

Historical


   

2001

Historical


     (in thousands, except per share data)

Consolidated Statements of Operations Data:

                                      

Net revenue

   $ 6,759     $ 13,595     $ 11,382     $ 11,344     $ 10,470

Cost of products and services sold

     3,226       5,450       4,645       4,430       4,322
    


 


 


 


 

Gross profit

     3,533       8,145       6,737       6,914       6,148

Selling, general and administrative expense

     4,205       6,928       6,281       6,447       3,538

Research and development

     1,040       1,688       1,397       1,138       1,297

Interest and other income

                            

Interest expense

     367       943       1,055       1,265       230
    


 


 


 


 

Earnings (loss) before income taxes

     (2,079 )     (1,414 )     (1,996 )     (1,935 )     1,083

Provision for (benefit from) income taxes

     (1,221 )     (660 )     (795 )     (697 )     732
    


 


 


 


 

Net loss

   $ (858 )   $ (754 )   $ (1,201 )   $ (1,238 )   $ 351
    


 


 


 


 

 

     At June 9,

    At December 31,

     2005

    2004

   2003

   2002

   2001

     (in thousands)

Balance Sheet Data:

                                   

Cash and cash equivalents

   $ 4     $ 46    $ 167    $ 659    $

Property and Equipment

     493       474      278      273      277

Goodwill

     593       593      593      593      593

Total Assets

     10,280       11,593      14,418      17,925      21,389

Long-term debt

           5,500      5,500      8,633      9,892

Total debt

     6,214       6,087      8,133      9,892      10,500

Stockholder’s (deficit) equity

     (222 )     634      1,382      2,463      3,827

 

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UNAUDITED PRO FORMA CONDENSED COMBINED FINANCIAL INFORMATION

 

The accompanying unaudited pro forma condensed combined statements of operations reflect our condensed consolidated results of operations for the year ended December 31, 2005, after giving effect to the acquisitions of VHI and Instantel during the first half of 2005. The unaudited pro forma condensed combined statements of operations give effect to the acquisitions of VHI 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 associated with 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 final valuations for VHI and preliminary valuations for Instantel.

 

On March 31, 2005, Applied Digital acquired VHI 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 VHI’s shareholders. In addition, all existing VHI 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 VHI 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, VHI 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 $2.5 million to $3.0 million to be paid in the future in some combination of cash, 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 VHI.

 

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Table of Contents

UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF OPERATIONS

For the Year Ended December 31, 2005

 

   

VeriChip

Corporation

Historical

Year Ended

December 31, 2005


   

VHI

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

Year Ended

December 31,
2005


 
    (in thousands, except per share data)  

Total revenue

  $ 15,869     $   1,986     $ 6,759     $ (60 )(A)   $ 24,554  

Cost of products and services sold

    6,395       575       3,226       136  (B)     10,332  
   


 


 


 


 


Gross profit

    9,474       1,411       3,533       (196 )     14,222  

Selling, general and administrative expense

    12,442       1,355       4,205       (1,046 )(B)     16,956  

Research and development

    1,958       262       1,040             3,260  

Interest and other income

    (63 )     (20 )                 (83 )

Interest expense

    343             367       (367 )(C)     343  
   


 


 


 


 


Loss before provision (benefit) for income taxes

    (5,206 )     (186 )     (2,079 )     1,217       (6,254 )

Provision (benefit) for income taxes

    56             (1,221 )     415  (D)     (750 )
   


 


 


 


 


Net loss

    (5,262 )     (186 )     (858 )     802       (5,504 )

Deemed dividend

    (1 )                       (1 )
   


 


 


 


 


Net loss attributable to common stockholder

  $ (5,263 )   $ (186 )   $ (858 )   $ 802     $ (5,505 )
   


 


 


 


 


Loss per common share attributable to common stockholder – basic and diluted

  $ (0.33 )                           $ (0.33 )
   


 


 


 


 


Weighted average number of common shares outstanding – basic and diluted

    15,836                       831  (E)     16,667  (F)(G)

 

The following table describes the acquisitions of VHI and Instantel during the year ended December 31, 2005 (in thousands):

 

Company Acquired


  

Effective

Date

Acquired


  

Acquisition

Price


  

Goodwill

and

Other

Intangibles

Acquired


  

Other Net

Assets and

Liabilities


   

Business Description


VHI

   3/31/05    $ 13,283    $ 11,555    $ 1,728     Provider of infant protection, wander prevention and asset location and identification systems combining automated RFID identification and real-time location technologies.

Instantel Inc.

   6/10/05    $ 25,272    $ 26,239    $ (967 )   Manufacturer of remote monitoring products including wander prevention and maternity ward infant protection systems and vibration monitors.

 

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The total purchase price of the businesses acquired was allocated as follows (the required purchase accounting adjustments, including the allocation of the purchase price to the assets acquired and liabilities assumed based on their respective fair values, have been made based upon preliminary valuations. Accordingly, the purchase price allocations are still in review and are subject to change. We currently believe that we have identified all significant liabilities and tangible and intangible assets acquired, however, based upon our final valuation and review we may determine that additional liabilities or tangible assets exist or we may determine that the preliminary value ascribed to the intangible assets or the estimated useful lives require revision. Any adjustments to the purchase price allocation will be recorded as increases or decreases in goodwill):

 

     VHI

  

Estimated

Useful

Life


   Instantel Inc.

  

Estimated

Useful

Life


     (in thousands)         (in thousands)     

Intangibles:

                   

Patented and non-patented proprietary technology

   $3,710    12.3    $1,720    11.8

Trademarks(1)

   1,131       3,790   

Customer relationships

   895    4.0    3,390    10.0

Distribution network

   856    6.6    5,320    8.4

Goodwill(1)

   4,963       12,019   

(1) Trademarks and goodwill have indefinite lives.

 

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PRO FORMA ADJUSTMENTS FOR THE UNAUDITED PRO FORMA

CONDENSED COMBINED STATEMENT OF OPERATIONS FOR THE YEAR ENDED

DECEMBER 31, 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 VHI and Instantel:

 

 

                  Adjustment to:

 
    Pre-Acquisition

  Post-Acquisition

  Pro forma Adjustment

    Cost of Products
and Services
Sold


  Selling, General
and
Administrative
Expense


 
    (in thousands)  

VHI

  $        30   $      165   $      135                

Instantel

    1,511     466     (1,045 )              
   

 

 


 

 


    $ 1,541   $ 631   $ (910 )   $ 136   $ (1,046 )
   

 

 


 

 


 

   The decrease in amortization expense relates primarily to the decrease in the amount of Instantel’s intangible assets with definite lives, which decreased from approximately $17.1 million to approximately $10.4 million, as well as to an increase in the expected lives of Instantel’s intangible assets. The intangible assets acquired have lives ranging from 8.4 to 11.8 years versus the pre-acquisition intangible assets which had estimated lives of five years. The expected economic lives of these intangible assets were determined based upon the expected use of the assets, our ability to extend or renew patents and other contractual provisions associated with the assets, the estimated average life of the associated products, the stability of the industry, expected changes in or the costs we are likely to incur in finding alternative distribution networks or channels, and other factors deemed appropriate.

 

(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 tax effects of the pro forma adjustments.

 

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

 

(F) The potentially diluted common shares were not included in the computation of diluted loss per share because to do so would have been anti-dilutive. The potentially dilutive common shares consist of 5,018,000 weighted average options and 1,202,000 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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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 sell both passive and active RFID systems. Our passive RFID systems are used for identification purposes and our active systems are used for location and identification purposes. The key difference in the technology is that active RFID systems contain tags with battery powered microchips and emit a beacon while passive systems do not contain tags with battery powered microchips and cannot emit a beacon.

 

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 VHI and contributed VHI to us under the terms of an exchange agreement in consideration for 3.3 million shares of our common stock. VHI 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, VHI 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 and as of December 31, 2005, we had not generated any revenue from sales of this product.

 

Going forward, in order to achieve significant revenue growth, we intend to focus the majority of our marketing efforts on generating sales from our VeriMed patient identification system. Given our plans, we anticipate that our revenue mix will differ significantly from our historical revenue mix. 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 an increase in our sales and marketing costs 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.

 

As of March 31, 2006, we have only generated approximately $0.1 million in 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 approximately $7,469 as of March 31, 2006, is included in our statement of operations for the three months ended March 31, 2006, 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. We expect the initial seeding phase to be completed during the first half of 2007. We have an agreement with Henry Schein Inc., a major supplier of pharmaceuticals and medical supplies, to offer our VeriMed patient identification kits, which include a scanner and ten implantable VeriChips for a catalog price of $1,410. We anticipate that physicians will offer the implantable VeriChip to patients at a retail cost of between $250 to $300, including the cost of implantation. Patients will be offered a choice of subscribing to our database registry and/or the database registry of others. We intend to offer patients two subscription levels to our database registry. We intend to charge an annual subscription fee of $20.00 for a basic database registry subscription and an annual subscription fee of $79.95 for a full-featured database registry subscription. 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.

 

Our growth strategy with respect to sales of our VeriMed patient identification system has a broad geographic scope. Our large distribution partners such as Henry Schein, Inc. and Ingersoll Rand have an extensive domestic and international presence. We also have distribution agreements with smaller local distributors in the countries of Germany, Colombia, Guatemala, Puerto Rico, Ecuador, and Honduras. These agreements are for both our passive and active RFID systems. We also have signed local distribution agreements in Spain for our passive RFID systems. We expect that we will continue to pursue expansion of our distribution relationships within the European Union.

 

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

 

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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 supply agreement with Digital Angel. We expect to have sufficient liquidity to meet the minimum purchase requirements of implantable VeriChips during the first few years of the term of our supply and development agreement with Digital Angel. If our projected sales of our implantable VeriChip do not materialize and we desire to maintain our exclusivity under our supply and development agreement with Digital Angel, we intend to increase our implantable microchip inventory levels in order to satisfy our minimum purchase requirements. We expect that our cost of products on sales of the VeriMed and VeriGuard systems will be consistent with the cost as a percent of revenue we have historically realized on sales of our infant protection, wander prevention and asset location and identification systems. 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 basis over lives ranging from 11.8 to 12.11 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 payroll costs 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. We expect that our research and development expenses will be between 9% and 11% of our expected sales revenue for the year ending December 31, 2006.

 

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 by approximately $1.3 million 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. These additional expenses are expected to be paid for from cash flows from our operations.

 

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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 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 at December 31, 2005, included elsewhere in this prospectus.

 

Revenue Recognition

 

Our revenue recognition policy provides very specific and detailed guidelines in measuring revenue; however, certain judgments affect the application of our revenue recognition policy. The complexity of the estimation process and all issues related to the assumptions, risks and uncertainties inherent with our revenue recognition policies affect the amounts reported in our financial statements. A number of internal and external factors affect the timing of our revenue recognition, including estimates of customer returns and the timing of customer acceptance. Our cost of sales may vary based upon estimates of warranty costs, and customer specification and testing requirement changes. To the extent we experience increased warranty claim activity or increased costs associated with servicing those claims, or meeting customer specification and testing requirement changes, our cost will increase resulting in decreased gross profit. Future revenues are difficult to predict, and any shortfall in revenue or delay in recognizing revenue could cause our operating results to vary significantly from quarter to quarter and could result in future operating losses.

 

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

 

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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. We generally indemnify our distributors against third party claims of intellectual property infringement.

 

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.

 

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 March 31, 2006, December 31, 2005 and 2004, inventory reserves were $0.1 million, $0.1 million and $0.1 million, respectively. We did not have any inventory reserves as of December 31, 2003. The estimated market value of our inventory is based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required, which could have a material affect on our financial condition and results of operations.

 

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.

 

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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. The determination of the value of our intangible assets requires management to make estimates and assumptions about the future operating results of our reporting units. 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 March 31, 2006, our consolidated goodwill was $17.0 million and the value of our intangible assets with indefinite lives totaled $4.9 million.

 

Our intangible assets with indefinite lives consisted of trademarks. In determining the value of our trademarks, we employed the income approach. We used the discounted cash flow method to calculate the present value of VHI’s and Instantel’s trademark cash flows. In our valuation model we considered the “relief from royalty” concept which assumes that if a company owns a trademark it does not have to “rent” one and therefore is “relieved” from paying a royalty. The amount of the phantom payment (after-tax) is used as a surrogate for income attributable to the trademark.

 

In valuing the VHI and Instantel trademarks, we applied a market-based royalty rate to projections of revenue for the various product lines of VHI and Instantel. The royalty cash flows, on an after-tax basis, were discounted to present value using a discount rate that adequately reflected the inherent risks of the trademark cash flows. In valuing the trademarks, we applied what we believe to be the appropriate discount rates, ranging from 17.0% to 23.7% to the projected trademark cash flows and we used a terminal growth rate of 5%.

 

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, which could have a material impact on our financial condition and results of operations.

 

Stock-Based Compensation

 

Effective January 1, 2006, the Company adopted FAS 123R, using the modified prospective transition method. Under this method, stock-based compensation expense is recognized using the fair-value based method for all awards granted on or after the date of adoption. Compensation expense for new awards granted after January 1, 2006 will be recognized over the requisite service period based on the grant-date fair value of those options. Prior to adoption, the Company used the intrinsic value method under APB 25, and related interpretations and provided the disclosure-only provisions of FAS 123. Under the intrinsic value method, no stock-based compensation had been recognized in our consolidated statement of operations for options granted to our employees and directors because the exercise price of such stock options granted to employees and directors equaled or exceeded the fair market value of the underlying stock on the dates of grant.

 

FAS 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. In our pro forma information required under FAS 123 for the periods prior to January 1, 2006, the Company accounted for forfeitures as they occurred.

 

The adoption of this standard resulted in compensation expense of $31,000 in the first quarter of 2006 as 6,036 options were granted with a weighted-average fair market value of $5.26. Stock-based compensation expense was reflected in the condensed consolidated statement of operations and deficit in selling, general and administrative expense.

 

We granted to certain of our employees options to purchase 6,036 shares of our common stock during the three months ended March 31, 2006 that were granted at an exercise price of $2.31 per share and were less than the value of the underlying common stock on the date of the grant, as determined by our management.

 

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We granted to certain of our employees and directors options to purchase approximately 1.0 million shares of our common stock during the period January 1, 2005 to August 11, 2005 that were granted at exercise prices ranging from $2.31 to $2.85 per share and were equal to or greater than the value of the underlying common stock on the date of each grant, as determined by our management. We did not grant any options to employees subsequent to August 11, 2005 through December 31, 2005.

 

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. Due to management’s familiarity with discounted cash flow analyses and the readily available values contributed by the businesses acquired, management chose not to obtain contemporaneous valuations by an unrelated valuation specialist. The assumptions used by management included:

 

    our projected operating performance;

 

    risk of non achievement of projected operating performance;

 

    the purchase prices of the two businesses acquired during the first half of 2005, including the risk that the acquisitions may not have been completed at certain interim valuation dates; and

 

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

 

Management’s valuation methodology including terminal and enterprise value was based on the following factors:

 

    Unlevered free cash flows for the Company’s implantable microchips business were projected for five years, which was deemed to be the appropriate valuation period;

 

    Earnings before interest, taxes, depreciation and amortization, or EBITDA, were used to estimate terminal value;

 

    A terminal value was calculated (management considered the relevant multiples for RFID and medical device companies in determining the appropriate terminal value multiple);

 

    A discount rate was applied to the net free cash flows and terminal value. The rate was determined based on the risk free rate of the 10-year U.S. Treasury Bond plus an applicable market risk premium and the specific risk premium associated with the company’s facts and circumstances (the discount rate utilized by the Company was the rate of return expected from the market or the rate of return for a similar investment with similar risks);

 

    The purchase prices of VHI and Instantel adjusted for the risk that the acquisitions may not have been completed at certain interim valuation dates, were added to the value of the implantable microchip business to determine enterprise value; and

 

    Management computed the fully diluted value of each share of VeriChip’s common stock in order to factor in the dilutive effect of reflecting in-the-money stock options and warrants at each valuation date.

 

There are inherent uncertainties in forecasting 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 granted a total of approximately 0.3 million stock options during 2005 to consultants and employees of Applied Digital and Digital Angel. In accordance with FAS 123, we recorded compensation expense associated with these options based on an estimate of the fair value on each date of grant (with the fair value of our common stock for grants from January 1, 2005 to August 11, 2005 being determined by management as discussed above) and using the Black-Scholes valuation model. We were required to re-measure the compensation expense associated with these options on December 30, 2005, the date all that these options vested. (We accelerated the vesting of these options as more fully discussed below.) This re-measurement was based on the estimated fair value of our common stock on December 30, 2005, which

 

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was assumed to be the estimated initial public offering price, and using the Black-Scholes valuation model. This re-measurement resulted in compensation expense being recorded in 2005 based upon the fair value of these stock options on the vesting date. In addition, during 2004, 2003 and 2002, we granted stock options to employees of Applied Digital and other non-employees who had provided services to us. For these options, we recognized compensation expense using the same methodology as was used for the comparable 2005 grants discussed above. The Company recorded aggregate compensation expense of approximately $2.3 million, $0.3 million and $0.7 million during the years ended December 31, 2005, 2004 and 2003, respectively, in connection with these stock options. The significant factors contributing to the difference between the fair value of the stock options granted during the period January 1, 2005 to August 11, 2005 and the estimated initial public offering price include, among others:

 

    The acceptance of our VeriMed patient identification system beginning in the latter part of the third quarter of 2005. As of August 1, 2005, five hospitals had agreed to adopt our VeriChip patient identification system in their emergency departments and we had a goal of having 20 to 25 hospitals agree to adopt our VeriMed patient identification system by December 31, 2005. Having an infrastructure of hospitals is a necessary step to developing the VeriMed patient identification system because without that infrastructure the patients have no reason to obtain the microchip. After our attendance at the American College of Emergency Physicians’ Scientific Assembly, which took place in Washington D.C. from September 26 to 29, 2005, 49 hospitals agreed to adopt our VeriMed patient identification systems and as of December 15, 2005, 66 hospitals had agreed to implement our VeriMed patient identification system in their emergency rooms (as of May 1, 2006, 97 hospitals and medical facilities had agreed to implement the system);

 

    During the latter part of 2005, we began the ground work for the integration of all of our RFID systems into our VeriChip Auto-ID platform, which we expected to have completed by late 2006. We believe that a truly integrated platform and infrastructure for our complete healthcare product portfolio will provide us with significant point of competitive differentiation;

 

    The expanded market opportunities for our asset location and tracking system to our existing Instantel customers. Today, our AssetTrac system is essentially a new product. It is our first end-user application utilizing our VeriChip Auto-ID platform. The new platform has expanded the deployment options which can range from entry-level portal only coverage to full RFID coverage as well as a mix of resolutions in between;

 

    The identification of additional strategic markets for the implantable VeriChip. For example, in the wake of Hurricane Katrina, we donated implantable VeriChips in Missouri and Texas during the last half of September 2005 in conjunction with FEMA’s department of mortuary services to help identify corpses. The success of this new use for the implantable VeriChip has led to the development of VeriTrace, the only end-to-end implantable tagging solution for the accurate tracking and identification of human remains and associated evidentiary items;

 

    The expansion of our systems into international markets. On October 19, 2005, we shipped our first Hug infant protection system for use in the United Kingdom, and in early January 2006, we completed the negotiations of our agreement with Ingersoll Rand Security Technologies, a sector of Ingersoll-Rand Company Limited. Under the terms of the agreement, Ingersoll Rand Security Technologies has the non-exclusive right to promote, sell, install and maintain certain of our infant protection, wander prevention and asset tracking products, as well as the related Auto-ID platform and application development interface, in healthcare, commercial and industrial markets in North and South America, including the Caribbean and Hawaii; and

 

   

The enterprise value to forward looking revenue valuation approach used in determining the estimated IPO value. Under this approach, fair value was determined based upon a range of multiples of projected future revenue. The multiples used represented those multiples of

 

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revenue that our peers’ common stock were trading for in the public markets. This approach was deemed appropriate because revenue multiples for publicly traded companies provide the highest correlation of public company trading values (i.e., companies in comparable industries tend to have similar revenue multiples, whereas publicly traded companies’ EBITDA and new income multiples are not deemed to be as consistent in part because certain companies in comparable industries are not EBITDA positive or do not earn net income).

 

The Black-Scholes option pricing model, which we used to value these options 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 provided for vesting on December 30, 2005 of all of our outstanding and unvested stock options previously awarded to employees, and directors and consultants (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 of the director and employee options 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 avoided 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 is included in our pro forma stock-based footnote disclosure for the year 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 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. If we are required to recognize such compensation expense, it could have a material impact on our results of operations.

 

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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 March 31, 2006, we had $4.8 million in net deferred tax liabilities, associated with our Canadian operations. As of March 31, 2006, December 31, 2005, 2004 and 2003, 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 March 31, 2006, 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.

 

If we continue to operate at a loss or are unable to generate sufficient future Canadian taxable income, or if there is a material change in the actual effective tax rates or time period within which the underlying temporary differences become taxable or deductible, we will be required to increase our valuation allowance against our U.S. net deferred tax assets or to establish a valuation allowance against all or a significant portion of our Canadian deferred tax assets, which could result in a material adverse impact on our operating results. Conversely, if we become profitable in the future, we may reduce some or all of our valuation allowance, which could result in a significant tax benefit and a favorable impact on our financial condition and operating results.

 

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Results of Operations

 

The table below sets forth data from our statements of operations for the three months ended March 31, 2006 and 2005 and the years ended December 31, 2005, 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 necessarily indicative of our future results. In addition, in October 2004, FDA clearance was obtained to market VeriMed for its medical applications. Through March 31, 2006, 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.

 

    

Three Months Ended
March 31,


  

Year Ended December 31,


 
     2006

   2005

       2005    

       2004    

       2003    

 

Product revenue

   94.0%    100.0%    91.5%    100.0%    100.0%  

Service revenue

   6.0%       8.5%        
    
  
  
  
  

Total revenue

   100.0%    100.0%    100.0%    100.0%    100.0%  
    
  
  
  
  

Cost of products sold

   36.2%    66.7%    34.4%    80.6%    36.7%  

Cost of services sold

   3.1%       5.9%        
    
  
  
  
  

Gross profit

   60.8%    33.3%    59.7%    19.4%    63.3%  

Selling, general and administrative expense

   61.2%    6,820.0%    78.4%    781.4%    362.8%  

Research and development

   13.5%       12.3%        

Interest and other income

   (0.3)%       (0.4)%    (6.1)%     

Interest and other expense

   19.5%    380.0%    2.2%    58.3%    14.3%  
    
  
  
  
  

Loss before provision for income taxes

   (15.6)%    (7,166.7)%    (32.8)%    (814.2)%    (313.8)%  

Provision for income taxes

         0.4%        
    
  
  
  
  

Net loss attributable to common stockholder

   (15.6)%    (7,166.7)%    (33.2)%    (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.

 

Three months ended March 31, 2006 Compared to Three Months ended March 31, 2005

 

Operating loss by segment for the three months ended March 31, was as follows:

 

    

2006


  

2005


     Healthcare

   Security
and
Industrial


   Total

   Healthcare

   Security
and
Industrial


   Total

     (in thousands)

   (in thousands

Product revenue

   $ 4,777    $ 1,380    $ 6,157    $    $ 15    $ 15

Service revenue

     69      324      393               
    

  

  

  

  

  

Total revenue

     4,846      1,704      6,550           15      15

Gross profit

     2,942      1,039      3,981           5      5

Selling, general and administrative

     2,989      1,018      4,007      665      358      1,023

Research and development

     581      304      885               
    

  

  

  

  

  

Total operating expenses

     3,570      1,322      4,892      665      358      1,023
    

  

  

  

  

  

Operating loss

   $ (628)    $ (283)    $ (911)    $ (665)    $ (353)    $ (1,018)
    

  

  

  

  

  

 

 

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Revenue

 

Revenue for the three months ended March 31, 2006 was $6.6 million compared to $15,000 in the three-months ended March 31, 2005. This revenue increase is due to our acquisitions of VHI and Instantel during the first half of 2005.

 

Our healthcare segment’s revenue was $4.8 million for the three months ended March 31, 2006. Our healthcare segment’s revenue resulted from sales of our infant protection, wander prevention and asset location and identification systems, which we acquired as a result of the acquisitions of VHI and Instantel during the first half of 2005. Our healthcare segment did not generate any revenue for the three months ended March 31, 2005. We expect that our revenues from this segment will increase going forward as the markets for our VeriMed Patient Identification systems and our asset location and identification system expand.

 

Our security and industrial segment’s revenue was $1.7 million for the three months ended March 31, 2006 compared to $15,000 in the three months ended March 31, 2005. The majority of the $1.7 million was due to $1.5 million in revenues from our vibration monitoring systems as there was strong demand in world-wide construction. We acquired our vibration monitoring systems as a result of our acquisition of Instantel on June 9, 2005.

 

Gross Profit and Gross Profit Margin

 

Gross profit for the three months ended March 31, 2006 was $4.0 million. As a percentage of revenue, our gross profit margin was 60.8% for the three months ended March 31, 2006. Since we reported minimal revenues for the three months ended March 31, 2005, our gross profit and gross profit margin is not a meaningful number.

 

Our healthcare segment’s gross profit was $2.9 million for the three months ended March 31, 2006 and its gross profit margin was 60.7%. Our gross profit was due to the sales of our infant protection, wander prevention and asset location and tracking systems to healthcare providers. These systems were acquired as result of the acquisitions of VHI and Instantel during the first half of 2005.

 

Our security and industrial segment’s gross profit was $1.1 million for the three months ended March 31, 2006 and its gross profit margin was 61.0%. Our gross profit was attributable to sales of our asset management and vibration monitoring systems to security and industrial customers. In addition, service revenues for calibration services that positively impacted gross margins. Almost all of the gross profit from this segment was the result of the acquisitions of VHI and Instantel during the first half of 2005.

 

Selling, General and Administrative Expense

 

Selling, general and administrative expense increased $3.0 million, or 291.7%, to $4.0 million in the three months ended March 31, 2006 as compared to $1.0 million for the three months ended March 31, 2005. As a percentage of revenue, selling, general and administrative expense was 61.2% for the three months ended March 31, 2006. Since we reported minimal revenue for the three months ended March 31, 2005, our selling, general and administrative expense as a percentage of revenue for the three months ended March 31, 2005 is not a meaningful number.

 

Included in selling, general and administrative expense for the three months ended March 31, 2006 and 2005 was $0.2 million and $0.1 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.

 

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Also included in selling, general and administrative expense for the three months ended March 31, 2006 and 2005 was approximately $0.5 million and $13,000, respectively, of depreciation and amortization expense. The increase is due to the acquisition of intangible and fixed assets during 2005 as a result of the acquisitions of VHI and Instantel.

 

All of our unvested employee and director stock options were vested on December 30, 2005 and a minimal number of stock options were granted in the first quarter of 2006, therefore equity based compensation expense related to our unvested stock options was immaterial in the three months ended March 31, 2006.

 

Our healthcare segment’s selling, general and administrative expense increased $2.3 million to approximately $3.0 million for the three months ended March 31, 2006 from $0.7 million for the three months ended March 31, 2005. As a percentage of our healthcare segment revenue, this segment’s selling general and administrative expense was 61.7 % for the three months ended March 31, 2006. Our healthcare segment did not generate any revenue for the three months ended March 31, 2005. The increase was primarily due to increased sales and marketing initiatives related to infant protection, wander prevention, asset location and identification systems, and VeriMed products by approximately $1.9 million during the three months ended March 31, 2006.

 

Our security and industrial segment’s selling, general and administrative expense increased $0.7 million to $1.0 million for the three months ended March 31, 2006 from $0.3 million in the three months ended March 31, 2005. As a percentage of our security and industrial segment revenue, this segment’s selling, general and administrative expense was 59.8% in the three months ended March 31, 2006. The increase in selling, general and administrative expense was primarily due the selling, general and administrative expenses associated with VHI and Instantel, which we acquired during the first half of 2005. Also contributing to the increase were sales and marketing initiatives during the three months ended March 31, 2006 related to our vibration monitoring systems and our VeriGuard product.

 

Research and Development

 

Research and development expense was $0.9 million for the three months ended March 31, 2006. We did not incur any research and development costs during the three months ended March 31, 2005. As a percentage of revenue, research and development expense was 13.5% for the three months ended March 31, 2006.

 

Our healthcare segment’s research and development expense was $0.6 million for the three months ended March 31, 2006. As a percentage of our healthcare segment revenue, research and development expense was 12.0% for the three months ended March 31, 2006. Research and development expenses for the three months ended March 31, 2006 was primarily due to salaries and the continued development of our asset location and identification systems.

 

Our security and industrial segment’s research and development expense was $0.3 million for the three months ended March 31, 2006. As a percentage of our security and industrial segment revenue, research and development expense was 17.9% for the three months ended March 31, 2006. Research and development expense for the three months ended March 31, 2006 was primarily due to salaries and other employee expenses.

 

Interest Expense

 

Interest expense was $0.1 million and $0.1 million for the three months ended March 31, 2006 and 2005, 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 and interest expense is expected to be reduced accordingly.

 

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Unaudited Results of Operations for the Three Months Ended March 31, 2006 Compared to Unaudited Pro Forma Results of Operations for the Three Months Ended March 31, 2005

 

Basis of Presentation

 

The following discussion and analysis assumes that the acquisitions of VHI and Instantel occurred as of January 1, 2005 and revenue is presented in accordance with our accounting policies. The results presented below are not necessarily indicative of what our results of operations would have been had VHI and Instantel been combined as of January 1, 2005, nor does it purport to represent results of operations for any future periods.

 

Operating loss by segment for the three months ended March 31, 2006 and pro forma three months ended March 31, 2005:

 

     2006

    2005

 
     Healthcare

    Security
and
Industrial


    Total

    Healthcare

    Security
and
Industrial


    Total

 
     (in thousands)     (in thousands)  

Product revenue

   $ 4,777     $ 1,380     $ 6,157     $ 3,956     $ 1,509     $ 5,465  

Service revenue

     69       324       393       —         —         —    
    


 


 


 


 


 


Total revenue

     4,846       1,704       6,550       3,956       1,509       5,465  

Gross profit

     2,942       1,039       3,981       2,383       887       3,270  

Selling, general and administrative

     2,989       1,018       4,007       2,709       951       3,660  

Research and development

     581       304       885       569       185       754  
    


 


 


 


 


 


Total operating expenses

     3,570       1,322       4,892       3,278       1,136       4,414  
    


 


 


 


 


 


Operating loss

   $ (628 )   $ (283 )   $ (911 )   $ (895 )   $ (249 )   $ (1,144 )
    


 


 


 


 


 


 

Revenue

 

Revenue for the three months ended March 31, 2006 increased $1.1 million to $6.6 million compared to pro forma revenue of $5.5 million for the three months ended March 31, 2005.

 

Our healthcare segment’s revenue was $4.8 million for the three months ended March 31, 2006 compared to $4.0 million on a pro forma basis for the three months ended March 31, 2005. The $0.8 million increase was primarily a result of increased sales of our infant protection products due to significant contracts entered into during the latter half of 2005 with new and existing customers, and increased sales related to our asset location and identification systems due to the introduction of new products during the latter half of 2005.

 

Our security and industrial segment’s revenue was $1.7 million for the three months ended March 31, 2006 compared to $1.5 million on a pro forma basis for the three months ended March 31, 2006. The majority of the $0.2 million increase was due to increase in revenues of our vibration monitoring systems. The increase in revenues was primarily due to continued strong demand in world-wide construction.

 

Gross Profit and Gross Profit Margin

 

Gross profit for the three months ended March 31, 2006 was $4.0 million, an increase of $0.7 million from $3.3 million on a pro forma basis for the three months ended March 31, 2005. As a percentage of revenue, our gross profit margin increased to 60.8% for the three months ended March 31, 2006 from 59.8% on a pro forma basis for the three months ended March 31, 2005. Changes in the product mix resulted in an increase in gross margin on a pro forma basis.

 

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Our healthcare segment’s gross profit on a pro forma basis increased $0.5 million to $2.9 million for the three months ended March 31, 2006 as compared to $2.4 million on a pro forma basis for the three months ended March 31, 2005. Our gross profit margin was 60.7% for the three months ended March 31, 2006 as compared to 60.3% on a pro forma basis for the three months ended March 31, 2005.

 

Our security and industrial segment’s gross profit on a pro forma basis increased $0.1 million to $1.0 million for the three months ended March 31, 2006 from $0.9 million on a pro forma basis for the three months ended March 31, 2005. Our gross profit margin on a pro forma basis was 61.0% for the three months ended March 31, 2006 as compared to 58.8 % on a pro forma basis for the three months ended March 31, 2005. The increase in gross profit was attributable to sales of our asset management and vibration monitoring systems to security and industrial customers.

 

Selling, General and Administrative Expense

 

Selling, general and administrative expense on a pro forma basis increased $0.3 million, or 9.5%, to $4.0 million for the three months ended March 31, 2006 as compared to $3.7 million on a pro forma basis for the three months ended March 31, 2005. As a percentage of revenue, selling, general and administrative expense for the three months ended March 31, 2006 was 61.2% compared to 67.0% on a pro forma basis for the three months ended March 31, 2005.

 

Included in selling, general and administrative expense for the three months ended March 31, 2006 and on a pro forma basis for the three months ended March 31, 2005 was $0.2 million and $0.1, 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.

 

Included in selling, general and administrative expense for the three months ended March 31, 2006 and on a pro forma basis for the three months ended March 31, 2005 was approximately $0.5 million and $0.4, respectively, of depreciation and amortization expense.

 

Our healthcare segment’s selling, general and administrative expense on a pro forma basis increased $0.3 million to approximately $3.0 million for the three months ended March 31, 2006 from $2.7 million on a pro-forma basis for the three months ended March 31, 2005. As a percentage of our healthcare segment revenue, selling general and administrative expense was 61.7% and 68.5% for the three months ended March 31, 2006 and on a pro forma basis for the three months ended March 31, 2005, respectively. The increase was primarily due increased sales and marketing initiatives related to infant protection, wander prevention, asset location and identification systems, and VeriMed products during the three months ended March 31, 2006.

 

Our security and industrial segment’s selling, general and administrative expense was $1.0 million and $1.0 million for the three months ended March 31, 2006 and on a pro forma basis for the three months ended March 31, 2005, respectively. As a percentage of our security and industrial segment revenue, selling, general and administrative expense decreased to 59.7% in the three months ended March 31, 2006 from 63.0% on a pro form basis for the three months ended March 31, 2005.

 

Research and Development

 

Research and development expense on a pro forma basis increased $0.1 million, or 17.5%, to $0.9 million for the three months ended March 31, 2006 as compared to $0.8 million on a pro forma basis for the three months ended March 31, 2005. As a percentage of revenue, research and development expense was 13.5% and 13.8% for the three months ended March 31, 2006 and on a pro forma basis for the three months ended March 31, 2005, respectively.

 

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Our healthcare segment’s research and development expense for the three months ended March 31, 2006 and on a pro forma basis for the three months ended March 31, 2005 was $0.6 million and $0.6, respectively. As a percentage of our healthcare segment revenue, research and development expense was 12.0% for the three months ended March 31, 2006 compared to 14.4% on a pro forma basis for the three months ended March 31, 2005.

 

Our security and industrial segment’s research and development expense on a pro forma basis increased $0.1 million to $0.3 million for the three months ended March 31, 2006 from $0.2 million on a pro forma basis for the three months ended March 31, 2005. As a percentage of our security and industrial segment revenue, research and development expense was 17.9% and 12.2% for the three months ended March 31, 2006 and on a pro forma basis for the three months ended March 31, 2005, respectively. Research and development expenses increased due to the addition of research and development staff and other employee related costs.

 

Interest Expense

 

Interest expense was $0.1 million for the three months ended March 31, 2006 as compared to $36,000 on a pro forma basis for the three months ended March 31, 2005. The interest expense was due to our level of outstanding borrowings owed to Applied Digital. We intend to use a portion of our proceeds from this offering to repay outstanding indebtedness owed to Applied Digital and interest expense is expected to be reduced accordingly.

 

Year Ended December 31, 2005 Compared to Year Ended December 31, 2004

 

Operating loss by segment for the years ended December 31, was as follows:

 

     2005

    2004

 
     Healthcare

    Security
and
Industrial


    Total

    Healthcare

    Security
and
Industrial


    Total

 
     (in thousands)

    (in thousands)

 

Product revenue

   $ 11,200     $ 3,320     $ 14,520     $ —       $ 247     $ 247  

Service revenue

     849       500       1,349       —         —         —    
    


 


 


 


 


 


Total revenue

     12,049       3,820       15,869       —         247       247  

Gross profit

     7,115       2,359       9,474       —         48       48  

Selling, general and administrative

     9,207       3,235       12,442       1,041       889       1,930  

Research and development

     1,313       645       1,958       —         —         —    
    


 


 


 


 


 


Total operating expenses

     10,520       3,880       14,400       1,041       889       1,930  
    


 


 


 


 


 


Operating loss

   $ (3,405 )   $ (1,521 )   $ (4,926 )   $ (1,041 )   $ (841 )   $ (1,882 )
    


 


 


 


 


 


 

Revenue

 

Revenue for the year ended December 31, 2005 increased $15.7 million to $15.9 million from $0.2 million for the year ended December 31, 2004.

 

Our healthcare segment’s revenue was $12.1 million for the year ended December 31, 2005 as a result of sales of our infant protection, wander prevention and asset location and identification systems following our acquisitions of VHI and Instantel during the first half of 2005. Our healthcare segment did not generate any revenue during the year ended December 31, 2004.

 

Our security and industrial segment’s revenue was $3.8 million for the year ended December 31, 2005 compared to $0.2 million for the year ended December 31, 2004. The $3.6 million increase was due to

 

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sales of $3.8 million from our asset location and identification and vibration monitoring systems following our acquisitions of VHI and Instantel during the first half of 2005, partially offset by a $0.2 million decrease in sales of VeriGuard.

 

Gross Profit and Gross Profit Margin

 

Gross profit for the year ended December 31, 2005 was $9.5 million, an increase of $9.4 million from $48,000 for the year ended December 31, 2004. As a percentage of revenue, our gross profit margin increased to 59.7% for the year ended December 31, 2005 from 19.4% for the year ended December 31, 2004.

 

During the year ended December 31, 2005, our healthcare segment’s gross profit was $7.1 million and its gross profit margin was 59.1%. Our healthcare segment did not generate any revenue or gross profit margin during the year ended December 31, 2004. The gross profit of $7.1 million was due to the product line sales and revenues of the acquired companies, specifically 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 $2.1 million to $2.4 million in the year ended December 31, 2005 from $48,000 in the year ended December 31, 2004. The gross profit margin was 61.8% in the year ended December 31, 2005 as compared to 19.4% in the year ended December 31, 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 $10.5 million, or 544.6%, to $12.4 million in the year ended December 31, 2005 as compared to $1.9 million the year ended December 31, 2004. As a percentage of revenue, selling, general and administrative expense was 78.3% and 781.4% for the year ended December 31, 2005 and 2004, respectively.

 

Included in selling, general and administrative expense for the year ended December 31, 2005 and 2004 was $0.5 million and $0.4 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 annual cost of the services being provided by Applied Digital under the terms of the transition services agreement to increase to a range of between approximately $0.7 million to $0.8 million 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 year ended December 31, 2005 and 2004 was $2.3 million and $0.3 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 year ended December 31, 2005 and 2004 was approximately $1.1 million and $48,000, 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 $8.1 million to approximately $9.2 million in the year ended December 31, 2005 from $1.1 million in the year ended December 31, 2004 due primarily to our acquisitions during the first half of 2005 of our infant protection,

 

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wander prevention and asset location and tracking systems businesses. As a percentage of revenue, selling general and administrative expense was 76.4% in the year ended December 31, 2005. Our healthcare segment did not generate any revenue in the year ended December 31, 2004.

 

Our security and industrial segment’s selling, general and administrative expenses increased $2.4 million to $3.2 million in the year ended December 31, 2005 from $0.8 million in the year ended December 31, 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 84.7% in the year ended December 31, 2005 from 350.3% in the year ended December 31, 2004, due primarily to the increase in sales in the 2005 period.

 

Research and Development

 

Research and development expense was approximately $2.0 million in the year ended December 31, 2005. We did not incur any research and development expense during the year ended December 31, 2004. As a percentage of revenue, research and development expense was 12.3% for the year ended December 31, 2005.

 

During the year ended December 31, 2005, research and development was $1.3 million for our healthcare segment and $0.6 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 $0.3 million and $0.1 million for the year ended December 31, 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 and interest expense is expected to be reduced accordingly.

 

Income Taxes

 

We had an effective income tax expense rate of 1.1% for the year ended December 31, 2005 related to our Canadian operations, which we acquired during the first half of 2005. We incurred a loss before taxes for the year ended December 31, 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 and 2003

 

Operating loss by segment for the years ended December 31, was as follows:

 

     2004

    2003

 
     Healthcare

    Security
and
Industrial


    Total

    Healthcare

    Security
and
Industrial


    Total

 
     (in thousands)

    (in thousands)

 

Product revenue

   $ —       $ 247     $ 247     $ —       $ 545     $ 545  

Service revenue

     —         —         —         —         —         —    
    


 


 


 


 


 


Total revenue

     —         247       247       —         545       545  

Gross profit

     —         48       48       —         345       345  

Selling, general and administrative

     1,041       889       1,930       505       1,472       1,977  

Research and development

     —         —         —         —         —         —    
    


 


 


 


 


 


Total operating expenses

     1,041       889       1,930       505       1,472       1,977  
    


 


 


 


 


 


Operating loss

   $ (1,041 )   $ (841 )   $ (1,882 )   $ (505 )   $ (1,127 )   $ (1,632 )
    


 


 


 


 


 


 

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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 and 2003. We did not incur research and development expense during these years, as all development of these products was performed by Digital Angel.

 

Revenue

 

Revenue for the years ended December 31, 2004 and 2003 was $0.2 million and $0.5 million, respectively. 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.

 

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. 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, 2004 and 2003, was $0.3 million and $0.7 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 and 2003 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. 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 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. 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.

 

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 and 2003 was $0.1 million and $0.1 million, 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.

 

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Income Taxes

 

We incurred losses before taxes for each of the years ended December 31, 2004 and 2003, 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.

 

VeriChip Holdings, Inc. (formerly eXI Wireless)

 

Three Month Ended March 31, 2005 Compared to Three Month Ended March 31, 2004 (unaudited)

 

Revenue

 

Revenue for the three month period ended March 31, 2005 increased $0.5 million, to $2.0 million, from $1.5 million for the three month period ended March 31, 2004.

 

Our healthcare segment’s revenue was $1.7 million for the three month period ended March 31, 2005, compared to $1.4 million for the three month period ended March 31, 2004. The increase was due to increased sales in our asset location, infant protection and wander prevention products.

 

Our security and industrial segment’s revenue was $0.3 million for the three month period ended March 31, 2005, compared to $0.1 million for the three month period ended March 31, 2004. The increase was due to increased sales in our asset management products.

 

Gross Profit and Gross Profit Margin

 

Gross profit for the three month period ended March 31, 2005 was $1.4 million, an increase of $0.3 million from $1.1 million for the three month period ended March 31, 2004. As a percentage of revenue, our gross profit margin decreased slightly to 71.1% for the three month period ended March 31, 2005 from 72.3% for the three month period ended March 31, 2004. The decrease in percentage was due to differences in the product mix with less higher margin software sales in 2005.

 

Selling, General and Administrative Expense

 

Selling, general and administrative expense for the three month period ended March 31, 2005 was $1.4 million, an increase of $0.6 million, or 69.4% from $0.8 for the three month period ended March 31, 2004. Sales, general and administrative expense, as a percentage of revenue, increased to 68.3% in the three month period ended March 31, 2005, compared to 52.2% in the three month period ended March 31, 2004. The increase was due to increased sales and marketing initiatives related to our asset management and tracking software systems.

 

Included in selling, general and administrative expense for the three month period ended March 31, 2005 was $0.1 million of depreciation and amortization expense, compared to $0.1 million for the three month period ended March 31, 2004.

 

Research and Development

 

Research and development expense was approximately $0.3 million in the three month period ended March 31, 2005, compared to $0.2 million the three month period ended March 31, 2004. Research and development expenditures were primarily composed of salaries for technical personnel, cost of related engineering materials, information technology infrastructure support, and subcontracted costs. As a percentage of revenue, research and development expense was 13.2% for the three month period ended March 31, 2005 compared to 14.6% the three month period ended March 31, 2004. The increase for the period was primarily due to salaries and other employee expenses.

 

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Income Taxes

 

Income tax recovery was nil for the three months ended March 31, 2005 and 2004. We utilized $0.1 million of investment tax credits during the three month period ended March 31, 2005 compared to nil during the three month period ended March 31, 2004 to reduce our current taxes payable. After utilizing the credits, the Company continues to have federal and provincial investment tax credits totaling $1.0 million at March 31, 2005 that may be applied to taxes payable in the future.

 

VeriChip Holdings, Inc. (formerly eXI Wireless)

 

Year Ended December 31, 2004 Compared to Year Ended December 31, 2003

 

Revenue

 

Revenue for the year ended December 31, 2004 decreased $0.1 million to $6.0 million from $6.1 million for the year ended December 31, 2003.

 

Our healthcare segment’s revenue was $5.2 million for the year ended December 31, 2004 compared to $5.3 million for the year ended December 31, 2003.

 

Our security and industrial segment’s revenue remained constant at $0.8 million for the year ended December 31, 2004 and 2003, respectively.

 

We generated the majority of its revenues from sales into the United States. The rise of the Canadian dollar versus the U.S. dollar had a negative impact on revenues during the year. The Canadian dollar increased 7.0% against the U.S. dollar during the year.

 

Gross Profit and Gross Profit Margin

 

Gross profit for the year ended December 31, 2004 was $4.2 million, a decrease of $0.2 million, from $4.4 million for the year ended December 31, 2003. As a percentage of revenue, our gross profit margin decreased to 70.6% for the year ended December 31, 2004 from 71.6% for the year ended December 31, 2003.

 

During 2004, our gross margin was negatively affected by foreign exchange differences between the Canadian and U.S. dollar. Moreover, contracts that required us to provide an installed system or a turn key system reduced gross margin percentages as we used third party sub-contractors to install these systems.

 

Selling, General and Administrative Expense

 

Selling, general and administrative expense increased $0.3 million, or 9.4%, to $3.5 million in the year ended December 31, 2004 as compared to $3.2 million the year ended December 31, 2003. Sales, general and administrative expense, as a percentage of revenue, increased to 58.7% in 2004, compared to 52.7% in 2003. The increase was due to increased sales and marketing initiatives related to our asset management and tracking software systems.

 

Included in selling, general and administrative expense for the year ended December 31, 2004 and 2003 was approximately $0.3 million of depreciation and amortization expense for each year.

 

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Research and Development

 

Research and development expense was approximately $0.9 million in the year ended December 31, 2004, compared to $0.7 million the year ended December 31, 2003. Research and development expenditures were primarily composed of salaries for technical personnel, cost of related engineering materials, information technology infrastructure support, and subcontracted costs. As a percentage of revenue, research and development expense was 15.3% for the year ended December 31, 2004 compared to 12.1% the year ended December 31, 2003. The increase for the year was primarily due to increase in salaries and other employee expenses.

 

Other Expenses

 

Other expenses was $0.2 million in the year ended December 31, 2004, compared to $0.3 million the year ended December 31, 2003. Other expenses include interest income, interest expense and foreign exchange gains and losses. The decrease in other expenses in the year ended December 31, 2004 was due primarily to a decrease of $0.1 million in foreign exchange losses compared to the year ended December 31, 2003.

 

Income Taxes

 

Income tax recovery was $0.1 million in the year ended December 31, 2004, compared to $0.1 million the year ended December 31, 2003. We utilized $0.3 million of investment tax credits during the year compared to $0.2 million to reduce our current taxes payable. After utilizing the credits, the Company continues to have federal and provincial investment tax credits totaling $1.2 million at December 31, 2004 that may be applied to taxes payable in the future.

 

Instantel Inc.

 

Results of Operations—For the period ended June 9, 2005 compared to the period ended June 9, 2004 (unaudited)

 

Revenue

 

Revenue for the period ended June 9, 2005 increased $1.3 million to $6.8 million from $5.5 million for the period ended June 9, 2004. The increase was primarily a result of increased revenues of our infant protection products. During the period, we introduced new products into the market that helped increase revenues.

 

Gross Profit and Gross Profit Margin

 

Gross profit for the period ended June 9, 2005 was $3.5 million, an increase of $0.3 million, from $3.2 million for the period ended June 9, 2004. As a percentage of revenue, our gross profit margin decreased to 52.3% for the period ended June 9, 2005 from 58.2% for the period ended June 9, 2004. The decrease in gross profit margin was due to a $0.2 million bonus paid out as a result of our acquisition by VeriChip Incorporated on June 10, 2005. The decrease in percentage was also due to differences in the product mix with less higher margin software sales in 2005 compared to 2004.

 

Selling, Marketing, General and Administrative Expense

 

Selling, marketing, general and administrative expenses increased $1.3 million, to $4.2 million in the period ended June 9, 2005 as compared to $2.9 million the period ended June 9, 2004. Selling, marketing, general and administrative expense, as a percentage of revenue, increased to 62.2% in 2005, compared to 51.8% in 2004. The increase was primarily due to a $0.7 million bonus paid out as a result of

 

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our acquisition by VeriChip Incorporated on June 10, 2005. The remaining increase was due to increased sales and marketing initiatives related to our asset location and identification systems and infant protection products.

 

Included in selling, marketing, general and administrative expense for the period ended June 9, 2005 and 2004 was approximately $1.6 million of depreciation and amortization expense.

 

Research and Development

 

Research and development expenses were approximately $1.0 million in the period ended June 9, 2005, compared to $0.7 million the period ended June 9, 2004. Research and development expenditures were primarily composed on salaries for technical personnel, cost of related engineering materials, information technology infrastructure support, and subcontracted costs. As a percentage of revenue, research and development expense was 15.4% for the period ended June 9, 2005 compared to 12.2% the period ended June 9, 2004. The increase for the period was primarily due to a $0.3 million bonus paid out as a result of our acquisition by VeriChip Incorporated on June 10, 2005.

 

Interest expense

 

Interest expense was $0.4 million in the period ended June 9, 2005 and 2004. The interest expense was due to our level of debt outstanding.

 

Income Taxes

 

Income tax recovery was $1.2 in the period ended June 9, 2005, compared to a recovery of $0.4 million the period ended June 9, 2004. The increase in the income tax recovery was primarily due to reversal of temporary differences related to intangible assets as the amortization for accounting purposes was higher than the tax basis resulting in a reduction of the deferred income tax liability.

 

Instantel Inc.

 

Results of Operations—Year Ended December 31, 2004 Compared to Year Ended December 31, 2003

 

Revenue

 

Revenue for the year ended December 31, 2004 increased $2.2 million to $13.6 million from $11.4 million for the year ended December 31, 2003. The increase is primarily due to increased growth and demand of our infant protection products. We also experienced revenue growth for our instrumentation products as a result of continued demand in Asian markets compared to 2003.

 

Gross Profit and Gross Profit Margin

 

Gross profit for the year ended December 31, 2004 was $8.1 million, an increase of $1.4 million, from $6.7 million for the year ended December 31, 2003. As a percentage of revenue, our gross profit margin increased slightly to 59.9% for the year ended December 31, 2004 from 59.2% for the year ended December 31, 2003.

 

Selling, Marketing, General and Administrative Expense

 

Selling, marketing, general and administrative expenses increased $0.6 million, or 10.3%, to $6.9 million in the year ended December 31, 2004 as compared to $6.3 million the year ended December 31, 2003. Selling, marketing, general and administrative expense, as a percentage of revenue, decreased to 51.0% in 2004, compared to 55.2% in 2003. The increase for the year was due to increased sales and marketing initiatives related to our asset location and identification systems and infant protection products.

 

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Included in selling, marketing, general and administrative expense for the year ended December 31, 2004 and 2003 was approximately $3.6 million of depreciation and amortization expense.

 

Research and Development

 

Research and development expense was approximately $1.7 million in the year ended December 31, 2004, compared to $1.4 million the year ended December 31, 2003. Research and development expenditures were primarily composed on salaries for technical personnel, cost of related engineering materials, information technology infrastructure support, and subcontracted costs. The increase for the year was primarily due to salaries and other employee expenses. As a percentage of revenue, research and development expense was 12.4% for the year ended December 31, 2004 compared to 12.3% the year ended December 31, 2003.

 

Interest expense

 

Interest expense was $0.9 million in the year ended December 31, 2004, compared to $1.1 million the year ended December 31, 2003. The decrease was primarily due to repayments of debt during 2004 which resulted in lower interest expense compared to 2003.

 

Income Taxes

 

Income tax recovery was $0.7 in the year ended December 31, 2004, compared to a recovery of $0.8 million the year ended December 31, 2003. The decrease in income tax recovery of $0.1 million was due to current income tax expense increasing $0.8 million during the year which was offset by an increase in the recovery of deferred income tax expense of $0.6 million.

 

Unaudited Pro Forma Results of Operations for the Year Ended December 31, 2005 Compared to Unaudited Pro Forma Results of Operations for the Year Ended December 31, 2004

 

Basis of Presentation

 

The results of VHI and Instantel have been included in our statement of operations for 2005 since their respective dates of acquisition. The following discussion and analysis assumes that the acquisitions of VHI and Instantel occurred as of January 1, 2004 and revenue is presented in accordance with our accounting policies. The results presented below are not necessarily indicative of what our results of operations would have been had VHI and Instantel been combined entities during such periods, nor does it purport to represent results of operations for any future periods.

 

Pro forma operating loss by segment for the years ended December 31, was as follows:

 

     2005

    2004

 
     Healthcare

    Security
and
Industrial


    Total

    Healthcare

    Security
and
Industrial


   Total

 
     (in thousands)     (in thousands)  

Product revenue

   $ 17,469     $ 5,220     $ 22,689     $ 14,498     $ 4,305    $ 18,803  

Service revenue

     928       937       1,865       219       824      1,043  
    


 


 


 


 

  


Total revenue

     18,397       6,157       24,554       14,717       5,129      19,846  

Gross profit

     10,625       3,597       14,222       9,229       2,756      11.985  

Selling, general and administrative

     12,254       4,702       16,956       8,864       1,310      10,174  

Research and development

     2,303       957       3,260       1,911       695      2,606  
    


 


 


 


 

  


Total operating expenses

   $ 14,557     $ 5,659     $ 20,216       10,775       2,005      12,780  
    


 


 


 


 

  


Operating profit / (loss)

   $ (3,932 )   $ (2,062 )   $ (5,994 )   $ (1,546 )   $ 751    $ (795 )
    


 


 


 


 

  


 

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Revenue

 

Revenue on a pro forma basis for the year ended December 31, 2005 increased $4.7 million to $24.6 million compared to pro forma revenue of $19.9 million for the year ended December 31, 2004.

 

Our healthcare segment’s revenue was $18.4 million on a pro forma basis for the year ended December 31, 2005 compared to $14.7 million on a pro forma basis for the year ended December 31, 2004. The $3.7 million increase was primarily a result of increased sales of $2.2 million of our infant protection products due to significant contracts entered into during 2005 with new and existing customers, and increased sales of $1.3 million related to our asset location and identification systems due to the introduction of new products during 2005.

 

Our security and industrial segment’s revenue was $6.2 million on a pro forma basis for the year ended December 31, 2005 compared to $5.1 million on a pro forma basis for the year ended December 31, 2004. The majority of the $1.1 million increase was due to a $0.7 million increase in revenues of our vibration monitoring systems. The increase in revenues was primarily due to continued strong demand in world-wide construction.

 

Gross Profit and Gross Profit Margin

 

Gross profit on a pro forma basis for the year ended December 31, 2005 was $14.2 million, an increase of $2.2 million from $12.0 million on a pro forma basis for the year ended December 31, 2004. As a percentage of revenue, our gross profit margin on a pro forma basis decreased to 57.9% for the year ended December 31, 2005 from 60.4% on a pro forma basis for the year ended December 31, 2004. Changes in the product mix resulted in a decline in gross margin on a pro forma basis.

 

During the year ended December 31, 2005, our healthcare segment’s gross profit on a pro forma basis was $10.6 million and its gross profit margin on a pro forma basis was 57.8% compared to gross profit on a pro forma basis of $9.3 million and gross profit margin on a pro forma basis of 62.9% for the year ended December 31, 2004. The increase in gross profit was due to the increased sales of our infant protection, wander prevention and asset location and tracking systems to healthcare providers. The decrease in gross margin percentage was due to increased salaries and bonuses for production staff paid out during the year. The decrease in percentage was also due to differences in the product mix with less higher margin software sales in 2005 compared to 2004.

 

Our security and industrial segment’s gross profit on a pro forma basis increased $0.9 million to $3.6 million in the year ended December 31, 2005 from $2.7 million on a pro forma basis in the year ended December 31, 2004. Gross profit margin on a pro forma basis was 58.4 % in the year ended December 31, 2005 as compared to 53.7 % on a pro forma basis in the year ended December 31, 2004. The increases in gross profit and margin were attributable to sales of our asset management and vibration monitoring systems to security and industrial customers. Moreover, there were increased service revenues for calibration services that positively impacted gross margins.

 

Selling, General and Administrative Expense

 

Selling, general and administrative expense on a pro forma basis increased $6.8 million, or 69.4%, to $17.0 million in the year ended December 31, 2005 as compared to $10.2 million on a pro forma basis in the year ended December 31, 2004. As a percentage of revenue, selling, general and administrative expense on a pro forma basis was 69.3% and 51.3% for the years ended December 31, 2005 and 2004, respectively.

 

Included in selling, general and administrative expense on a pro forma basis for the year ended December 31, 2005 and 2004 was $0.5 million and $0.4 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.

 

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Also, included in selling, general and administrative expense on a pro forma basis for the year ended December 31, 2005 and 2004 was $ 2.3 million and $0.3 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 pro forma year ended December 31, 2005 and 2004 was approximately $1.8 million and $1.5, respectively, of depreciation and amortization expense. The increase is due to increased capital asset purchases during 2005 which resulted in a higher depreciable asset base.

 

Our healthcare segment’s selling, general and administrative expense on a pro forma basis increased $3.4 million to approximately $12.3 million for the year ended December 31, 2005 from $8.9 million on a pro-forma basis for the year ended December 31, 2004. As a percentage of revenue, selling general and administrative expense on a pro forma basis was 66.6% and 60.2% for the year ended December 31, 2005 and 2004 respectively. The increase was primarily due to increased compensation expense associated with stock options granted to employees of Applied Digital and consultants and an increase in professional fees related to the initial public offering. Moreover, we increased sales and marketing initiatives related to our VeriMed product during 2005.

 

Our security and industrial segment’s selling, general and administrative expense on a pro forma basis increased $3.4 million to $4.7 million for the year ended December 31, 2005 from $1.3 million on a pro forma basis year ended December 31, 2004. As a percentage of revenue, selling, general and administrative expense increased to 76.4% in the pro forma year ended December 31, 2005 from 25.5% in the pro forma year ended December 31, 2004. The increase was primarily due to increased compensation expense associated with stock options granted to employees of Applied Digital and consultants and an increase in professional fees related to the initial public offering. Moreover, we increased sales and marketing initiatives related to our VeriGuard product during 2005.

 

Research and Development

 

Research and development expense on a pro forma basis increased $0.7 million, or 25%, to $3.3 million in the year ended December 31, 2005 as compared to $2.6 million on a pro forma basis for the year ended December 31, 2004. As a percentage of revenue, research and development expense on a pro forma basis was 15.5% and 13.6% for the years ended December 31, 2005 and 2004, respectively.

 

Our healthcare segment’s research and development expense on a pro forma basis increased $0.4 million to approximately $2.3 million in the year ended December 31, 2005 from $1.9 million on a pro forma basis for the year ended December 31, 2004. As a percentage of revenue, research and development expense on a pro forma basis was 12.5% in the year ended December 31, 2005 compared to 13% in the year ended December 31, 2004. Research and development expenses increased due to the addition of staff and the continued development of our asset location and identification systems.

 

Our security and industrial segment’s research and development expense on a pro forma basis increased $0.3 million to $1.0 million in the year ended December 31, 2005 from $0.7 million on a pro forma basis for the year ended December 31, 2004. As a percentage of revenues, research and development expense on a pro forma basis was 15.5% and 13.6% for the years ended December 31, 2005 and 2004, respectively. Research and development expenses increased due to the addition of staff and the continued development of our VeriGuard product.

 

Income Taxes

 

We had effective (benefit) income tax rates of (12.0)% and 22.1% on a pro forma basis in 2005 and 2004, respectively. Differences in the effective income tax rates from the statutory federal income tax rate arise primarily from state taxes net of federal benefits, foreign income tax rate differences and the increase or reduction of valuation allowances related to net operating loss carry forwards.

 

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We incurred a loss before taxes on a pro forma basis for the years ended December 31, 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 and our estimates of future U.S taxable income.

 

Liquidity and Capital Resources

 

As of March 31, 2006, cash totaled $0.6 million compared to cash of approximately $1.4 million at December 31, 2005.

 

Cash Flows Used in Operating Activities

 

Net cash used in operating activities totaled $0.7 million, $0.9 million, $2.2 million, $1.6 million, and $1.4 million during the three months ended March 31, 2006 and 2005 and during the years ended December 31, 2005, 2004 and 2003, respectively. In the three months ended March 31, 2006, cash was used primarily to fund operating losses and accounts receivable and for purchases of inventory partially offset by an increase in deferred revenue. In the three months ended March 31, 2005 and during each of the years ended December 2005, 2004 and 2003, cash was used primarily to fund operating losses.

 

Cash Flows from Investing Activities

 

Investing activities provided (used) cash of $(0.1) million, $0.6 million, $1.4 million, $(32,000) and $(6,000) during the three months ended March 31, 2006 and 2005 and during the years ended December 31, 2005, 2004 and 2003, respectively. In the three months ended March 31, 2006, cash of $0.1 million was used to purchase equipment. In the three months ended March 31, 2005, cash of $0.1 million was used to purchase equipment. In the year ended December 31, 2005, net cash acquired in business acquisition was $1.8 million and cash of $0.4 million was used to purchase equipment. In each of the years ended December 31, 2005, 2004 and 2003, cash was used to purchase equipment.

 

Cash Flows from Financing Activities

 

Financing activities provided cash of $10,000, $0.9 million, $2.2 million, $1.4 million and $1.6 million during the three months ended March 31, 2006 and 2005 and during the years ended December 31, 2005, 2004 and 2003, respectively. In each of the periods, cash was provided primarily by borrowings from Applied Digital. In the three months ended March 31, 2006, cash of $0.5 million was used for our contemplated initial public offering.

 

Applied Digital contributed the shares of VHI 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 March 31, 2006, we were indebted to Applied Digital in the amount of $7.3 million, including $0.7 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 March 31, 2006 was 7.75% 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 $1.3 million based on the exchange rate as of March 31, 2006 ($0.3 million was outstanding under the credit agreement as of March 31, 2006). The annual interest rate on the facility is the Bank of Canada prime rate plus 1%.

 

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Financial Condition

 

We believe that with the net proceeds we expect to raise from this offering, the cash we have on hand, the borrowing capacity available to us under existing credit facilities, 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 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 revenue 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 systems in the next twelve months. We estimate that we would realize positive cash flow if we achieve a 50% increase in revenue in 2006 over the revenue reported for the year ended December 31, 2005, on a pro forma basis.

 

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 March 31, 2006 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

   $ 7,264    $ 7,264 (2)   $    $    $

Reimbursement to parent company under purchase price obligation

     1,000      1,000 (3)              

Operating lease obligations

     815      236       533      46     

Purchase commitments(1)

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

  


 

  

  

Total

   $ 26,120    $ 8,500     $ 3,158    $ 6,296    $ 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.
(2) This assumes completion of the IPO in 2006.
(3) Amount relates to reimbursement to parent company for the acquisition of Instantel Inc. and assumes completion of the IPO in 2006.

 

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.

 

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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 became effective for us beginning January 1, 2006. The pro forma disclosures previously permitted under FAS 123 no longer are an alternative to financial statement recognition. As discussed below, all of our outstanding employee stock options were vested upon adoption on January 1, 2006, and, therefore, the initial adoption of FAS 123R did not 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.

 

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 avoided recognition of approximately $0.6 million of compensation expense in our statement of operations over the course of the original vesting period. Such expense is included in our pro forma stock-based footnote disclosures in the year ended December 31, 2005. The majority of such compensation expense was 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 was 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 adopted FAS 151 and it did 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

 

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productive assets and replaces it will a general exception for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. FAS 153 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 adopted the provisions of FAS 154 and it did not have a material impact on the results of our operations, financial position or cash flow.

 

In February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial Instruments. This Statement amends FASB Statements No. 133, Accounting for Derivative Instruments and Hedging Activities, and No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. This Statement resolves issues addressed in Statement 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.” SFAS No. 155 permits fair value re-measurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, clarifies which interest-only strips and principal-only strips are not subject to the requirements of Statement 133, and establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation. It also clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives and amends Statement 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. This Statement is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. We have not yet determined the impact of the adoption of FAS 155 on our financial statements, if any.

 

In March 2006, the FASB issued Statement of Financial Accounting Standard 156 – Accounting for Servicing of Financial Assets (“FAS 156”), which requires all separately recognized servicing assets and servicing liabilities be initially measured at fair value. FAS 156 permits, but does not require, the subsequent measurement of servicing assets and servicing liabilities at fair value. Adoption is required as of the beginning of the first fiscal year that begins after September 15, 2006. Early adoption is permitted. The adoption of FAS 156 is not expected to have a material effect on our consolidated financial position, results of operations or cash flows.

 

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 highest 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.

 

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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 year ended December 31, 2005, and the three months ended March 31, 2006, 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:

 

     March 31, 2006

     (dollars in thousands)

Loan due to parent company

   $7,264

Weighted-average interest rate for the three months ended March 31, 2006

   7.0%

 

The estimated fair value of the debt to the parent company is not reasonably determinable due to the related party nature of the instrument.

 

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OUR BUSINESS

 

Overview

 

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 both passive and active RFID systems. Our passive RFID systems are used for identification purposes and our active systems for location and identification purposes. The key difference in the technology is that active RFID systems contain tags with battery powered microchips and emit a beacon while passive systems do not contain tags with battery powered microchips and cannot emit a beacon.

 

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 obtain the implantable VeriChip and related scanners from Digital Angel, a majority-owned subsidiary of our parent company, Applied Digital, under the terms of a supply agreement.

 

We believe that our VeriMed 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.

 

We market our VeriMed patient identification system to both hospitals and physicians. Initially, our marketing strategy for hospitals is to educate emergency room physicians and staff as to the benefits in adopting our VeriMed patient identification system. We are currently providing hospitals with our scanners at no charge. As of May 1, 2006, 97 hospitals and medical facilities had agreed to implement our VeriMed patient identification system in their emergency rooms. After this initial seeding phase which we expect to be completed during the first half of 2007, we intend to sell our scanners directly to hospitals. We currently use our sales force to directly market to and educate physicians in the geographic regions surrounding VeriMed-registered hospitals. We intend to sell VeriMed patient identification kits directly to physicians and anticipate that they will subsequently market them to their patients. As of May 1, 2006, 232 physicians had registered to provide the VeriMed patient identification system to select patients. In addition to the marketing efforts of physicians, we intend to increase the awareness as to the benefits of our implantable VeriChips through a direct marketing campaign to patients.

 

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, which have been installed in over 4,000 healthcare locations throughout North America, 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.

 

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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.

 

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 a report issued by Fast Track Technologies in April 2005 titled RFID and Emerging Technologies Guide to Healthcare, the market for RFID technologies in the hospital and healthcare sectors is estimated to grow from $1.3 billion in 2005 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, data-embedded personal tokens, or key fobs, and biometric technologies, such as finger printing and retina scanning, are currently used to identify people in a medical emergency. A significant problem with some of these solutions is that the identification bracelet, wallet card or key fob may not be with the patient at a time of emergency.

 

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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 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

 

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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. 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.

 

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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;

 

    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.

 

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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. 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.

 

  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.

 

  Identify and develop 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 February 2006, we announced a new system, VeriTrace, that integrates with Ricoh® digital cameras for forensic applications. In the future, we plan to market the VeriTrace system to FEMA for future disaster recovery efforts as well as medical examiners, forensic scientists, criminalists and related organizations.

 

  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.

 

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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 where the individual’s personal information is stored. Access to and control of a patient’s information stored in the database is limited to the patient. In addition, access to the patient’s information may also be granted to any of the following categories of persons, at the sole discretion of the patient:

 

    public safety personnel, including local police, fire and rescue workers;

 

    emergency medical personnel, including emergency medical technicians and paramedics;

 

    medical facilities, including hospitals, urgent care centers and physician offices; and

 

    law enforcement personnel, including sheriff’s departments, state police and FBI.

 

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We intend to offer patients two subscription levels to our database registry, basic and full-featured. The following table sets forth the type of information that a patient can store on our database registry with each subscription level.

 

Type of Information


  

Basic

Subscription Level


   Full-Featured
Subscription Level


Personal identification and contact information    ü    ü

Physician and emergency contact information

   ü    ü

Blood type and allergies

   ü    ü

Information about medical facilities where additional information is stored

   ü    ü

Advance directives:

   ü    ü

• living will

         

• power of attorney

         

• health care agent

         

• do-not-resuscitate order

         

• organ/tissue donor card

         

Personal health records:

        ü

• medical conditions

         

• medications and over-the-counter drugs and supplements

         

• medical device implants

         

• previous surgeries and recent hospital admissions and medical tests

         

• specialty physicians

         

 

In addition, patients can store their information on a third-party database registry, which generally can be 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 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.

 

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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 discreetly 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.

 

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.

 

VeriTrace

 

Our VeriTrace system uses the implantable VeriChip and wirelessly integrates with a Ricoh® digital camera for accurate tagging and identification of human remains and associated evidentiary items by medical examiners, forensic scientists, criminalists and disaster recovery personal. Our system allows these professionals to accurately tag and inventory data while capturing images of human remains and associated evidentiary items.

 

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

 

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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.

 

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

 

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System   Market(s)   Applications  

Representative

Users and Customers

VeriGuard

 

Government

 

Commercial

 

Access control

 

Asset location

 

Personnel security

 

Visitor management

 

Attorney General

Office (Mexico)

VeriTrace

 

 

Emergency Response

 

Medical Examiners/Coroners

  Corpse tracking and identification  

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

 

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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.

 

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.

 

Intellectual Property Rights Relating to the Implantable VeriChip

 

We have an amended and restated supply and development agreement with Digital Angel, a majority-owned subsidiary of our parent, Applied Digital, relating to the implantable VeriChip and to the technology underlying our implantable microchip business. This technology is used in our VeriMed, VeriGuard and VeriTrace systems. Digital Angel is our sole supplier of microchips relating to our implantable microchip business. Under our agreement with Digital Angel, Digital Angel purports to license to us the right to use the implantable VeriChip technology. However, in 1994, the exclusive rights to use the patented technology in applications involving the identification of human beings were licensed to Hughes Aircraft Company and Hughes Identification Devices, Inc. by Destron/IDI, Inc., a predecessor of Digital Angel. Hughes Aircraft Company subsequently changed its name and is now known as Raytheon Company. Raytheon Microelectronics España, or RME, entered into an agreement with Digital Angel effective as of April 26, 2006. We have been advised that RME is a wholly-owned subsidiary of Raytheon Company. The RME supply agreement grants Digital Angel a non-exclusive license to any and all intellectual property held by RME or its affiliates related to the manufacture, distribution or use of the microchip for use in human beings as more fully described below. However, because the 2006 agreement was with RME and not Raytheon Company, it is possible that RME lacks the authority or intellectual property to grant a license that would support our use of the patented technology for human identification. Based on the 1994 license and the limitations associated with the supply agreement between RME and Digital Angel, certain rights relating to the license under our supply agreement with Digital Angel are broader than the license rights that Digital Angel has under its supply agreement with RME, most notably the rights to independently enforce the patent and to independently manufacture the products. Accordingly, such rights may be rendered inoperative by the previously granted right to use the patented technology for human identification. As a result, our use of the technology might be enjoined and we could be required to pay damages, including enhanced damages, based on the claim that the sale and use of our products conflicts with the exclusive license previously granted to others for the use of the technology for the identification of human beings.

 

Digital Angel may supply human implantable microchips to other parties unless we meet certain minimum purchase requirements. In addition, our rights under our agreement with Digital Angel will not prevent other parties from competing with us. A holder or holders of the exclusive rights granted in 1994 may also compete with us or may license the patented technology to others who may compete with us.

 

 

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Our agreement with Digital Angel 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 in the performance of any obligation under the agreement, including the payment of money.

 

As described above, Digital Angel entered into a new supply agreement with RME effective as of April 26, 2006 for the manufacture and assembly of glass encapsulated, syringe-implantable transponders, including the implantable VeriChip. As part of the supply agreement, RME granted to Digital Angel, and to any person acquiring title to any glass encapsulated, syringe-implantable transponders purchased from Digital Angel, a license to all intellectual property held by RME or its affiliates related to the manufacture, distribution or use of such product. In addition, while RME represents that it and its affiliates have not assigned or granted any rights in the intellectual property to third parties, RME does not represent in the supply agreement that RME or its affiliates have any rights to use the patented technology in applications involving the identification of human beings or that RME has the authority to grant such a license. Because rights to use the patented technology granted in 1994 were freely assignable, we do not know which parties currently hold those rights. Therefore, we cannot assure you that the license granted by RME under the supply agreement with Digital Angel grants any rights that would support our use of the patented technology for human identification. The license granted by RME is part of each individual product sold under the supply agreement to Digital Angel and may not be conveyed separately from such products. Thus, any rights to the patented technology outside of products supplied to Digital Angel through RME are not available and we are at further risk should we engage a third party supplier even if we have the right to do so through our agreement with Digital Angel. In addition, the rights under the supply agreement between RME and Digital Angel will not prevent other parties from competing with us.

 

Digital Angel has sent a proposed letter agreement to RME for it to send to Raytheon Company in an effort to clarify the validity and scope of the license granted by RME under the supply agreement. However, we have been advised by Digital Angel that Raytheon Company has not executed the proposed letter agreement and that it may take several months for Raytheon Company to do so. We cannot assure you that the proposed letter agreement between Digital Angel and Raytheon will ever be executed by Raytheon.

 

The primary Digital Angel patent related to the implantable VeriChip will expire on May 18, 2010. However, we and Digital Angel do not have the right to enforce the patent in applications for the identification of human beings. A termination of our supply and development agreement by Digital Angel or the loss of our supply rights due to our failure to meet our minimum commitment, the inability of both us and Digital Angel to exclude third parties from making or selling competing products, or, if we obtain any rights to the patent, the expiration or earlier termination of the primary Digital Angel patent could have a material adverse effect on our business. There are important limitations and risks associated with this agreement and the related intellectual property rights. Therefore, we encourage you to see “Because a predecessor of Digital Angel licensed the exclusive right to use the patent for the identification of human beings to other parties, our sales of systems that incorporate the implantable VeriChip may be enjoined by third parties who have rights to the intellectual property” and other risk factors under Risk Factors for an additional discussion of our intellectual property issues.

 

Research and Development

 

Our research and development group consists of 35 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.

 

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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. The “plug-and-play” solution will provide a common application interface designed to enable users to add other applications and features to the same network infrastructure. 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 May 15 2006, we had 45 sales and marketing representatives. Our sales and marketing group is based in Ottawa, Vancouver 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.

 

Our sales and marketing strategy for hospitals includes educating hospitals as to the benefits in adopting our VeriMed patient identification system. As of May 1, 2006, 97 hospitals and medical facilities had agreed to implement the VeriMed patient identification system. Once registered, we install our scanner in the hospital emergency room and educate hospital personnel. In connection with the registration of a hospital, we provide the hospital with a recommended protocol describing the scanning process. Each registered hospital can choose to include this protocol in its clinical practices as it deems appropriate and as clinical circumstances warrant. In addition, we are not aware of any regulatory requirement defining how healthcare providers should obtain patient identification information prior to commencing treatment or requiring the healthcare provider to document how this information is to be obtained.

 

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 of May 1, 2006, 232 physicians had registered to provide the VeriMed patient identification system to select 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

 

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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.

 

Under the terms of the consignment contract, we have agreed to provide, and Henry Schein has agreed to distribute, our VeriMed patient identification system. Henry Schein has agreed to accept a quantity of the VeriMed patient identification systems mutually agreed to by the parties and to promote the system in its line of direct-to-physician marketing materials. Henry Schein has agreed to provide us with payment for the VeriMed patient identification systems shipped to healthcare professionals within 30 days after the close of each month. The consignment contract can be terminated by either party prior to the end of its two-year term in the event that the other party commits a noncurable default under the contract, or commits a curable default that is not remedied within 30 days after written notice thereof.

 

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.

 

In early January 2006, we entered into an authorized dealer agreement with IR Security & Safety Americas, or Ingersoll Rand. The term of this agreement is for three years and is automatically renewable for additional one year periods. Under the terms of the agreement, Ingersoll Rand has the non-exclusive right to promote, sell and market our HALO infant protection systems, our RoamAlert wander prevention systems, our Assetrac asset location and identification systems, and our HOUNDware asset management systems, as well as the related VeriChip Auto-ID platform, in healthcare, commercial and industrial markets in North and South America, including the Caribbean and Hawaii. Ingersoll Rand is required to pay for the systems it purchases under the agreement within 30 days after the date of shipment.

 

Our Security and Industrial Systems

 

We sell and market our HOUNDware system primarily 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 also sell and market our HOUNDware system through our authorized dealer agreement with Ingersoll Rand Security Technologies to commercial and industrial markets in North and South America, including the Caribbean and Hawaii.

 

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.

 

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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.

 

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 media sources have recently reported on people who have been implanted with RFID chips obtained over the Internet for as little as $2.00. We do not believe that the RFID chips obtained over the Internet are FDA-approved medical devices. In addition, 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, including Visonic Technologies, RF Technologies, Innovative Control Systems and Senior Technologies. 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 VHI 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

 

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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. To date, 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.

 

Digital Angel is our sole supplier of the implantable VeriChip under the terms of a supply agreement we have in place with Digital Angel. Digital Angel is majority owned by our parent company, Applied Digital. Under our agreement with Digital Angel, Digital Angel purports to license us the right to manufacture the implantable VeriChip. However, in 1994, the exclusive rights to use certain patented technology involved in the manufacture of the implantable VeriChip for use in applications involving the identification of human beings were licensed to Hughes Aircraft Company and Hughes Identification Devices, Inc. by Destron/IDI, Inc., a predecessor of Digital Angel. Hughes Aircraft Company subsequently changed its name to Raytheon Company. Consequently, the right to independently manufacture the implantable VeriChip under our supply agreement with Digital Angel may conflict with and be rendered inoperative by the previously granted right to use the patented technology for human identification.

 

The implantable VeriChip is manufactured for Digital Angel by Raytheon Microelectronics España or RME, under a supply agreement with Digital Angel that expires June 30, 2010. We have been advised that RME is a wholly-owned subsidiary of Raytheon Company. The RME supply agreement grants Digital Angel a non-exclusive license to any and all intellectual property held by RME or its affiliates related to the manufacture, distribution or use of glass encapsulated, syringe-implantable transponders, including the implantable VeriChip. However, because the supply agreement is with RME and not Raytheon Company, it is possible that RME lacks the authority or intellectual property to grant a license that would support the use of the patented technology in the manufacture of the implantable Verichip used in application involving the identification of human beings.

 

We cannot assure you that we will be able to procure alternative manufacturing capability, if we are unable to obtain the implantable VeriChip from Digital Angel or if Digital Angel is unable to obtain it from RME or another supplier under the terms of the supply agreement with RME. We encourage you to read the risk factor titled “We rely on third parties to supply and manufacture the implantable VeriChip, making us vulnerable to supply disruption which could delay our product delivery to our customers” and the other risk factors under the “Risk Factors” section of this document.

 

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.

 

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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, 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

 

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    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 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 May 15, 2005, we had 146 employees, of whom 45 were in our sales and marketing group, 25 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

 

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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 May 31, 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. In the first quarter of 2006, we relocated the Edmonton operations to our facility in Ottawa.

 

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 in the inducement. Specifically, in its claim for breach of contract, Metro Risk alleged that we breached the exclusivity provision of the parties’ distribution agreements by later signing a different distribution agreement with Henry Schein. Metro Risk asserted that the Henry Schein distribution agreement included areas in Europe. Moreover, regarding its claim for fraud in the inducement, Metro Risk alleged that we fraudulently induced Metro Risk into signing the distribution agreements by promising millions of dollars in profits. By virtue of its counterclaim, Metro Risk seeks reliance damages in the amount of $155,000, which represents the amount of money advanced by Metro Risk for the project, 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 May 15, 2006, are:

 

Name


   Age

  

Position


Kevin H. McLaughlin

   64    Chief Executive Officer and Director

Daniel A. Gunther

   45    President

Malik Talib

   39    Executive Vice President

Nurez Khimji

   38    Chief Financial Officer

Scott R. Silverman(1)(3)

   42    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)

   56    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 VHI, which he founded, from July 1996 to March 2005 and Chief Executive Officer of VHI 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 VHI 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 a principal with the Endowment for the 21st Century. From 1988 until March 2006, Mr. Penni was employed by Arthur J. Gallagher & Co., where he served in several positions, including most recently as an Area Executive Vice President. 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 except for the composition of our compensation committee, which will include one director who has not been determined to be independent. 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 2005, Mr. Thompson and Ms. Weaver were granted annual option awards of 166,667 and 133,333 options, respectively, to purchase shares of our common stock, at exercise prices of $2.85 and $2.31 per share, respectively. The exercise prices of these options were equal to or greater than the estimated fair market value of our common stock on the dates of grant. 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, Dr. Jonathan Musher and Nick Minicucci, Jr. 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 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.

 

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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 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, 2005. We refer to these persons as our named executive officers.

 

         

Annual Compensation


         Long-Term
Compensation


      
           

Other

Annual

Compensation(1)


   Shares
Underlying
Options


  

All Other

Compensation


 

Name and Principal

Position


   Year

   Salary

    Bonus

         

Kevin H. McLaughlin Chief Executive Officer

   2005
2004
   $
 
132,923
(2)
 
  $
 
150,500
 
 
  $
 
6,750
   433,333
    
 

 
 

Keith I. Bolton

Former President

   2005
2004
   $
$
101,092
112,612
 
(5)
  $
$
6,000
25,000
 
 
  $
 
3,850
  
   $
 
2,066
(3)
 

Daniel A. Gunther(4)
President

   2005    $ 96,821 (6)   $ 249,330          166,667       

Malik Talib(4)
Executive Vice President

   2005    $ 130,165 (2)   $ 112,603 (7)        77,050    $ 2,603 (8)

Nurez Khimji(4)
Chief Financial Officer

   2005    $ 92,975 (2)   $ 81,612 (9)        38,525    $ 1,860 (8)

(1) Represents car allowances paid to Messrs. McLaughlin and Bolton during 2005.
(2) Represents compensation paid to Messrs. McLaughlin, Talib and Khimji for the period April 1 to December 31, 2005.
(3) Represents the amount of commissions paid to Mr. Bolton in 2005.
(4) Messrs. Gunther, Talib and Khimji receive salary and bonus paid in Canadian dollars. The compensation amounts reported in this table have been converted from Canadian dollars to U.S. dollars using the average exchange rate for 2005.
(5) Includes $852 of earned income that was contributed to Mr. Bolton’s flexible spending plan
(6) Represents compensation paid to Mr. Gunther for the period June 1 to December 31, 2005.
(7) Includes a retention bonus paid to Mr. Talib in the amount of $50,000.
(8) Represents the amount of contributions paid by the Company on behalf of Messrs. Talib and Khimji to a defined pension plan.
(9) Includes a retention bonus paid to Mr. Khimji in the amount of $35,000.

 

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Stock Options Granted in Fiscal 2005

 

The following table sets forth information concerning stock options granted to each of our named executive officers during the fiscal year ended December 31, 2005 and all individuals serving as the president during 2005. The percentage of total options granted to employees set forth below is based on an aggregate of 1,283,799 shares of our common stock underlying options granted in 2005.

 

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

   433,333    33.8 %   $2.31    7/1/2013    $            $        

Keith I. Bolton

   0    0                 

Daniel A. Gunther

   166,667    13.0 %   $2.475    8/12/2013          

Malik Talib

   77,050    6.0 %   $2.31    7/1/2013          

Nurez Khimji

   38,525    3.0 %   $2.31    7/1/2013          

(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.

 

Option Exercises and Fiscal 2005 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, 2005 and all individuals serving as the president during 2005. There were no options exercised by the named executive officers in 2005. There was no public trading market for the common stock as of December 31, 2005. 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. On December 12, 2005, the Company’s board of directors approved a proposal which provides for the vesting on December 30, 2005, of all of our outstanding and unvested stock options previously awarded to employees and directors.

 

     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

   666,667       $                $            

Keith I. Bolton

   400,000             

Daniel A. Gunther

   166,667             

Malik Talib

   77,050             

Nurez Khimji

   38,525