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EX-10.3 - EXHIBIT 10.3 - CLARIENT, INCc07536exv10w3.htm
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EX-31.1 - EXHIBIT 31.1 - CLARIENT, INCc07536exv31w1.htm
EX-32.2 - EXHIBIT 32.2 - CLARIENT, INCc07536exv32w2.htm
EX-10.2 - EXHIBIT 10.2 - CLARIENT, INCc07536exv10w2.htm
EX-32.1 - EXHIBIT 32.1 - CLARIENT, INCc07536exv32w1.htm
EX-31.2 - EXHIBIT 31.2 - CLARIENT, INCc07536exv31w2.htm
Table of Contents

 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
Mark One
     
þ   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For The Quarterly Period Ended September 30, 2010
OR
     
o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Transition Period from                      to                     
Commission File Number 000-22677
(CLARIENT LOGO)
CLARIENT, INC.
(Exact name of registrant as specified in its charter)
     
Delaware   75-2649072
(State or other jurisdiction of incorporation   (IRS Employer Identification Number)
or organization)    
     
31 Columbia    
Aliso Viejo, California   92656-1460
(Address of principal executive offices)   (Zip code)
(949) 425-5700
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
             
Large accelerated filer o   Accelerated filer þ   Non-accelerated filer o   Smaller reporting company o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ
The number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date:
     
Class   Outstanding at October 29, 2010
Common Stock, $0.01 par value per share   88,700,606 shares
 
 

 

 


 

CLARIENT, INC. AND SUBSIDIARIES
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 Exhibit 10.1
 Exhibit 10.2
 Exhibit 10.3
 Exhibit 31.1
 Exhibit 31.2
 Exhibit 32.1
 Exhibit 32.2

 

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PART I — FINANCIAL INFORMATION
Item 1.   Financial Statements.
CLARIENT, INC. AND SUBSIDIARIES
Condensed Consolidated Balance Sheets
(in thousands, except par values)
(Unaudited)
                 
    September 30,     December 31,  
    2010     2009  
 
               
ASSETS
               
 
               
Current assets:
               
Cash and cash equivalents
  $ 12,757     $ 10,903  
Restricted cash
    772       765  
Accounts receivable, net of allowance for doubtful accounts of $13,097 and $8,747 at September 30, 2010 and December 31, 2009, respectively
    26,664       21,568  
Supplies inventory
    1,420       1,291  
Prepaid expenses and other current assets
    1,145       935  
 
           
Total current assets
    42,758       35,462  
Restricted cash
    1,314       1,314  
Property and equipment, net
    16,162       14,346  
Intangible assets, net
    10,741       11,639  
Goodwill
    3,959       3,959  
Other assets
    216       227  
 
           
Total assets
  $ 75,150     $ 66,947  
 
           
 
               
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
 
               
Current liabilities:
               
Revolving line of credit
  $     $ 2,678  
Accounts payable
    3,711       2,883  
Accrued payroll
    5,168       3,985  
Accrued expenses and other current liabilities
    4,064       3,984  
Income tax payable
    86        
Current maturities of capital lease obligations
    1,212       645  
 
           
Total current liabilities
    14,241       14,175  
Long-term portion of capital lease obligations
    1,999       604  
Deferred rent and other non-current liabilities
    2,627       3,055  
Contingently issuable common stock
          2,650  
 
               
Commitments and contingencies
               
 
               
Preferred stock subject to redemption requirements outside the control of the issuer:
               
Series A convertible preferred stock $0.01 par value, authorized 8,000 shares, issued and outstanding 5,263 shares at September 30, 2010 and December 31, 2009, respectively. Aggregate liquidation preference and redemption value: September 30, 2010 and December 31, 2009—$71,158 and $55,800, respectively
    38,586       38,586  
 
               
Stockholders’ equity:
               
Common stock $0.01 par value, authorized 150,000 shares, issued and outstanding 88,664 and 84,092 at September 30, 2010 and December 31, 2009, respectively
    887       841  
Additional paid-in capital
    179,060       172,200  
Accumulated deficit
    (162,250 )     (165,164 )
 
           
Total stockholders’ equity
    17,697       7,877  
 
           
Total liabilities and stockholders’ equity
  $ 75,150     $ 66,947  
 
           
See accompanying Notes to Condensed Consolidated Financial Statements.

 

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CLARIENT, INC. AND SUBSIDIARIES
Condensed Consolidated Statements of Operations
(in thousands, except per share amounts)
(Unaudited)
                                 
    Three Months Ended     Nine Months Ended  
    September 30,     September 30,  
    2010     2009     2010     2009  
 
                               
Net revenue
  $ 31,441     $ 21,425     $ 86,803     $ 68,347  
Cost of services
    12,479       9,796       35,821       28,675  
 
                       
Gross profit
    18,962       11,629       50,982       39,672  
Operating expenses:
                               
Sales and marketing
    5,225       4,194       14,628       13,116  
General and administrative
    6,451       6,030       19,033       17,074  
Bad debt
    3,161       4,214       9,875       9,483  
Research and development
    1,455       282       3,882       805  
 
                       
Total operating expenses
    16,292       14,720       47,418       40,478  
 
                       
Income (loss) from operations
    2,670       (3,091 )     3,564       (806 )
Interest expense, net of interest income
    147       144       352       499  
Interest expense to related party
                      3,557  
Other expense
                31        
 
                       
Income (loss) from continuing operations before income taxes
    2,523       (3,235 )     3,181       (4,862 )
Income tax (expense) benefit
    (181 )           (267 )     599  
 
                       
Income (loss) from continuing operations
    2,342       (3,235 )     2,914       (4,263 )
Income from discontinued operations, net of income taxes
                      901  
 
                       
 
                               
Net income (loss)
  $ 2,342     $ (3,235 )   $ 2,914     $ (3,362 )
 
                       
 
                               
Series A preferred stock beneficial conversion feature
                      (4,290 )
 
                               
Undistributed earnings allocated to participating securities
    (504 )           (606 )      
 
                       
 
                               
Net income (loss) applicable to common stockholders
  $ 1,838     $ (3,325 )   $ 2,308     $ (7,652 )
 
                       
 
                               
Net income (loss) per share applicable to common stockholders – basic and diluted:
                               
Income (loss) from continuing operations
  $ 0.02     $ (0.04 )   $ 0.03     $ (0.11 )
Income from discontinued operations
                      0.01  
 
                       
Net income (loss) applicable to common stockholders
  $ 0.02     $ (0.04 )   $ 0.03     $ (0.10 )
 
                       
 
                               
Weighted–average shares used to compute net income (loss) per common share:
                               
Basic
    85,461       77,583       84,855       77,257  
 
                       
Diluted
    88,672       77,583       87,654       77,257  
 
                       
 
                               
See accompanying Notes to Condensed Consolidated Financial Statements.

 

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CLARIENT, INC. AND SUBSIDIARIES
Condensed Consolidated Statements of Cash Flows
(in thousands)
(Unaudited)
                 
    Nine Months Ended  
    September 30,  
    2010     2009  
Cash flows from operating activities:
               
Net income (loss)
  $ 2,914     $ (3,362 )
Income from discontinued operations, net of income taxes
          (901 )
Adjustments to reconcile net loss to net cash used in operating activities:
               
Depreciation and amortization
    3,408       2,820  
Bad debt expense
    9,875       9,483  
Amortization of warrants to related party interest expense
          2,506  
Amortization of deferred financing and offering costs
    4       423  
Amortization of intangible assets
    898        
Stock-based compensation
    2,536       1,640  
Issuance of common stock in consideration for research and development services
    75        
Income tax benefit related to discontinued operations
          (599 )
Mark to market adjustment for contingently issuable shares
    31        
Changes in operating assets and liabilities:
               
Interest on restricted cash
    (5 )      
Accounts receivable, net of allowance for doubtful accounts
    (14,971 )     (13,773 )
Supplies inventory
    (446 )     (271 )
Prepaid expenses and other assets
    (19 )     (758 )
Income tax payable
    267        
Accounts payable
    332       (1,745 )
Accrued payroll
    1,183       (846 )
Accrued interest on related party debt
          (1,259 )
Accrued expenses and other current liabilities
    191       664  
Deferred rent and other non-current liabilities
    (428 )     (793 )
 
           
Net cash provided by (used in) operating activities
    5,845       (6,771 )
 
           
Cash flows from investing activities:
               
Purchases of property and equipment
    (2,166 )     (3,280 )
Increase in restricted cash
    (2 )     (2,825 )
Proceeds from sale of discontinued operations, net of selling costs
          1,500  
 
           
Net cash used in investing activities
    (2,168 )     (4,605 )
 
           
Cash flows from financing activities:
               
Proceeds from sale of preferred stock
          40,000  
Offering costs from sale of preferred stock
          (1,414 )
Proceeds from exercise of stock options and warrants
    1,433       464  
Repayments on capital lease obligations
    (394 )     (195 )
Borrowings on revolving lines of credit
    69,338       55,426  
Repayments on revolving lines of credit
    (72,200 )     (64,478 )
Borrowings on related party debt
          5,800  
Repayments on related party debt
          (17,908 )
 
           
Net cash (used in) provided by financing activities
    (1,823 )     17,695  
 
           
Effect of exchange rate changes on cash and cash equivalents
          (8 )
 
           
Net increase in cash and cash equivalents
    1,854       6,311  
Cash and cash equivalents at beginning of period
    10,903       1,838  
 
           
Cash and cash equivalents at end of period
  $ 12,757     $ 8,149  
 
           
Supplemental disclosure of cash flow information:
               
Cash paid for interest
  $ 320     $ 2,729  
Cash paid for income taxes
           
Non cash investing and financing activities:
               
Property and equipment financed by capital leases
  $ 2,673     $ 1,069  
Property and equipment additions included in accounts payable and accrued expenses
    909       79  
Issuance of common stock and stock options in connection with acquisition of ownership interest
    2,650        
Issuance of warrants in connection with borrowings from related party
          600  
Beneficial conversion feature
          4,290  
See accompanying Notes to Condensed Consolidated Financial Statements.

 

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CLARIENT, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(all tabular amounts presented in thousands, except per share amounts)
(Unaudited)
(1) Description of Business, Basis of Presentation, and Operating Segment
(a) Description of Business
Clarient, Inc. and its wholly-owned subsidiaries (the “Company”) comprise an advanced oncology diagnostic services company, headquartered in Aliso Viejo, California. The Company’s mission is to help improve the lives of those affected by cancer through translating cancer discoveries into better patient care. The Company combines innovative technologies, clinically meaningful diagnostic tests, and world-class pathology expertise to provide services that assess and characterize cancer for physicians treating their patients. The Company also provides a complete complement of commercial services to biopharmaceutical companies and other research organizations, including diagnostic testing services, development of companion diagnostics, and clinical trial support. The Company’s physician customers are connected to its Internet-based portal, PATHSiTE®, delivering high resolution images and interpretative reports resulting from the Company’s services.
California state law prohibits general corporations from engaging in the practice of medicine, pursuant to both statutory and common law principles commonly known as the Corporate Practice of Medicine Doctrine (“CPMD”). The CPMD prohibits non-professional corporations from employing physicians and certain other healthcare professionals who provide professional medical services. All of the Company’s pathology services are provided by, or are under the supervision of, Clarient Pathology Services, Inc. (“CPS”) within the state of California, under a long-term and exclusive professional services agreement, as amended on September 1, 2009, by and between the Company and CPS (the “Professional Services Agreement”). Kenneth J. Bloom, M.D. is the president and sole stockholder of CPS. Dr. Bloom also serves as the Company’s Chief Medical Officer, a senior management function primarily involving the technical oversight of the Company’s diagnostic services laboratory.
The Company is responsible for performing a variety of non-medical administrative services for CPS, as required under the Professional Services Agreement. The Company bills and collects for the pathology services provided by CPS. The Company, in turn, pays CPS a monthly professional services fee. The fee is equal to the aggregate of CPS’ estimated physician salaries and benefits, and all of its other operating costs.
(bPending Acquisition by General Electric
On October 22, 2010, the Company entered into a definitive Agreement and Plan of Merger (the “Merger Agreement”) with General Electric Company, a New York corporation (“General Electric”), and Crane Merger Sub, Inc., a Delaware corporation and an indirect wholly-owned subsidiary of General Electric (“Purchaser”), pursuant to which General Electric, through the Purchaser, will commence an offer (the “Offer”) to acquire all of the outstanding shares of the Company’s common stock, par value $0.01 per share (the “Common Shares”), and all of the outstanding shares of the Company’s Series A Convertible Preferred Stock, par value $0.01 per share (the “Preferred Shares,” and together with the Common Shares, the “Shares”), at a price per Common Share of $5.00 (the “Common Offer Price”) and a price per Preferred Share of $20.00 (together with the Common Offer Price, the “Merger Consideration”).
Completion of the Offer is subject to several conditions, including (i) that a majority of the outstanding Common Shares (determined on a fully diluted basis) must be tendered and not validly withdrawn prior to the expiration of the Offer; (ii) that a majority of any Preferred Shares then outstanding must be tendered and not validly withdrawn prior to the expiration of the Offer, (iii) the expiration of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended (the “HSR Act”); (iv) the absence of a material adverse effect on the Company; and (v) other customary closing conditions.
Following consummation of the Offer, Purchaser will be merged with and into the Company (the “Merger”), with the Company surviving as a wholly-owned indirect subsidiary of General Electric. Upon completion of the Merger, each Share outstanding immediately prior to the effective time of the Merger (excluding those Shares that are held by General Electric, Purchaser, the Company or their wholly-owned subsidiaries, or by stockholders who properly exercise their appraisal rights under the Delaware General Corporation Law) will be canceled and converted into the right to receive the applicable Merger Consideration. Consummation of the Merger is subject to completion of the Offer, the absence of any legal prohibition and, if necessary, approval of the Company stockholders.

 

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(c) Basis of Presentation
The accompanying interim Condensed Consolidated Financial Statements of the Company were prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and the interim financial statements rules and regulations of the United States Securities and Exchange Commission (“SEC”). These financial statements include the financial position, results of operations, and cash flows of the Company, and the consolidated accounts of CPS, as required by applicable GAAP. All inter-company accounts and transactions have been eliminated in consolidation.
The preparation of the accompanying Condensed Consolidated Financial Statements in conformity with GAAP requires management to make estimates and assumptions. Such estimates and assumptions affect the amounts reported in the Condensed Consolidated Financial Statements and accompanying notes thereto. The Company’s most significant estimates relate to revenue recognition, allowance for doubtful accounts, stock-based compensation expense, and income tax valuation allowance. Actual results could differ from those estimates. As part of the interim financial statement preparation process, the Company also has evaluated whether any significant events have occurred after the balance sheet date of September 30, 2010 through November 2, 2010, representing the date this Quarterly Report on Form 10-Q was filed with the SEC, and concluded that no additional disclosures or adjustments were required.
The interim operating results are not necessarily indicative of the results for a full year. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to SEC rules and regulations relating to interim financial statements. The Condensed Consolidated Financial Statements included in this Form 10-Q should be read in conjunction with the Company’s audited Consolidated Financial Statements and Notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009.
(d) Operating Segment
The Company has one reportable operating segment that delivers advanced cancer diagnostic services to community pathologists, oncologists, and biopharmaceutical companies. As of September 30, 2010, all of the Company’s services were provided within the United States, and all of the Company’s assets were located within the United States.
(2) Summary of Significant Accounting Policies
(a) Revenue Recognition
Net revenue for the Company’s services is recognized on an accrual basis at the time discreet diagnostic tests are completed. Each test performed relates to a specimen encounter derived from a patient, and received by the Company on a specific date (such specimen encounter is commonly referred to as an “accession”). The Company’s services are billed to various payors, including Medicare, private health insurance companies, healthcare institutions, biopharmaceutical companies, and patients. The Company reports net revenue from contracted payors, including certain private health insurance companies, healthcare institutions, and biopharmaceutical companies, based on the contracted rate, or in certain instances, the Company’s estimate of the amount expected to be collected for the services provided. For billing to Medicare, the Company uses the published fee schedules, net of standard discounts (commonly referred to as “contractual allowances”). The Company reports net revenue from non-contracted payors, including certain private health insurance companies, based on the amount expected to be collected for the services provided. Recognized net revenue from patient payors is based on a multiple of the Centers for Medicare & Medicaid Services (CMS) reimbursement schedule, or as applicable, the patients’ co-pay or deductible obligations.
(b) Allowance for Doubtful Accounts and Bad Debt Expense
An allowance for doubtful accounts is recorded for estimated uncollectible amounts due from the Company’s various payor groups. The process for estimating the allowance for doubtful accounts involves significant assumptions and judgments. The allowance for doubtful accounts is adjusted periodically, and is principally based upon an evaluation of historical collection experience of aged accounts receivable among the Company’s various payor classes. After appropriate collection efforts, accounts receivable are written off and deducted from the allowance for doubtful accounts. Additions to the allowance for doubtful accounts are charged to bad debt expense.
The payment realization cycle for certain governmental and managed care payors can be lengthy. The collection cycle often involves payor denial of the Company’s billed amounts, requiring the Company to appeal and follow an adjudication process. Resulting periodic adjustments to bad debt expense may be significant.

 

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(c) Stock-Based Compensation
The Company values stock-based awards, including stock options and restricted stock, as of the date of grant. The Company uses the Black-Scholes option-pricing model in valuing granted stock options. The fair value of granted restricted stock awards is equal to the Company’s closing stock price on the date of grant. The Company recognizes stock-based compensation expense, net of estimated forfeitures, using the straight-line method over the requisite service period. Forfeitures are estimated at the time of grant, and prospectively revised if actual forfeitures differ from those estimates. The Company classifies compensation expense related to these awards in the Condensed Consolidated Statements of Operations, based on the department to which the recipient reports.
(d) Long-Lived Assets
The Company evaluates the possible impairment of its long-lived assets when events or changes in circumstances occur that indicate that the carrying value of its assets may not be recoverable. Recoverability of assets to be held and used is measured through a comparison of the carrying value of such assets to the Company’s pretax cash flows (undiscounted and without interest charges) expected to be generated from their use in operations. If such assets are considered to be impaired, the impairment charge is measured as the amount by which the carrying amount of the assets exceeds fair value. Assets held for sale, when applicable, are reported at the lower of their carrying amount or fair value, less costs to sell.
One potential impairment indicator is current-period operating and/or cash flow loss, combined with a history of operating and/or cash flow losses. Because this condition has historically been applicable to the Company, management evaluates the Company’s asset group for impairment at the end of each reporting period. The asset group tested for impairment comprises the Company’s entire laboratory operation, representing the lowest level of its separately identifiable cash flows. The undiscounted cash flow projections for the asset group, which are derived from the Company’s operating plan, are used in evaluating the existence of impairment.
The undiscounted net cash flows expected to be generated by the Company’s asset group exceeded the carrying amount of the asset group as of September 30, 2010 and December 31, 2009; therefore, the Company’s asset group is not considered to be impaired. This conclusion is based upon judgments and estimates, made by the Company’s management, that are inherently uncertain. Such assumptions pertain to net revenue growth, cash collection trends, expense trends, and working capital management. Any number of changes in the Company’s business could adversely impact the aforementioned assumptions, and thus, adversely affect the results of the Company’s long-lived asset impairment test.
(e) Income Taxes
The Company uses the asset and liability method of accounting for income taxes. Under such method, deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis, and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Deferred taxes are reduced by a valuation allowance to an amount which is more likely than not to be realized. The effect on deferred tax assets and liabilities of a change in tax rates is recognized through income in the period of enactment.
(f) Cash and Cash Equivalents and Restricted Cash
Cash and cash equivalents consist of amounts held as unrestricted bank deposits or highly liquid investments — consisting of money market funds as of September 30, 2010, though from time to time may also include highly liquid debt instruments, time deposits, and certificates of deposit with an original maturity of three months or less at the date of purchase.
Restricted cash is held as bank deposits, serving as security deposits for the Company’s Aliso Viejo, California facility lease and a capital lease of computer hardware. Interest accrues to the Company on both accounts. The classification of restricted cash as current or non-current is dependent upon whether contractual terms provide for the restriction to be released within one year of the balance sheet date.
The Company’s unrestricted and restricted cash balances on deposit that exceeded the Federal Deposit Insurance Corporation (FDIC) limits were approximately $13.9 million at September 30, 2010.
(g) Supplies Inventory
Supplies inventory consists of laboratory and research and development supplies, and are stated at the lower of cost or market. Supplies inventory is accounted for under the first-in, first-out method (FIFO).

 

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(h) Property and Equipment and Depreciation
Property and equipment are depreciated using the straight-line method over the following estimated useful lives:
     
Office furniture, computer, software, and laboratory equipment
  Three to five years
 
   
Leasehold improvements
  Shorter of useful life or remaining term of lease, including expected extensions
Expenditures for maintenance, repairs, and minor improvements are charged to expense as incurred. Depreciation expense is recognized on the first day of the month subsequent to being placed into service. Leasehold improvements are capitalized and amortized over the shorter of their estimated useful lives or the remaining lease term, including expected extensions. The Company’s reimbursed expenditures for leasehold improvements that are received from its landlord are recorded to deferred rent and recovered ratably through a reduction of rent expense over the remaining term of the lease, including expected extensions.
(i) Capitalized Internal-Use Software Costs
The Company capitalizes eligible internal-use computer software costs. Amortization begins when the internal-use computer software is ready for its intended use, and is amortized over a three to five-year period using the straight-line method.
(j) Research and Development
Research and development costs are expensed as incurred. Research and development expenses consist of compensation and benefits for research and development personnel, license fees, supplies cost, costs of accessing clinical cohorts for ongoing studies, research and development arrangements with consultants and other third parties, allocated information technology personnel, and allocated facility-related costs.
(k) Intangible Assets, net
Intangible assets, net, primarily consist of intellectual property represented by proprietary biomarkers in development, substantially ready, or ready for diagnostic testing use. These intangible assets generally have associated patents or patents in process, and are amortized on a straight-line basis over estimated useful lives of seven years.
(l) Goodwill
Goodwill is recorded when the purchase price paid for an acquisition exceeds the estimated fair value of the net identified tangible and intangible assets acquired. The Company, on an annual basis, or more frequently if necessary, determines (i) whether the fair value of the relevant reporting unit exceeds carrying value, and (ii) the amount of an impairment loss, if any. The “reporting unit” tested for goodwill impairment comprises the Company’s entire laboratory operation, representing its single operating segment. The fair value of the Company’s “reporting unit” is represented by its total market capitalization on the NASDAQ Capital Market as of the close of the business day on December 1, which represents the Company’s annual impairment testing date. The Company’s management was not aware of any indicators of goodwill impairment as of September 30, 2010 and through the date this Quarterly Report on Form 10-Q was filed with the SEC.
(m) Fair Value Measurements
The Company applied relevant GAAP in measuring the fair value of its Variable Shares (see Note 14). Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants on the fair value measurement date. GAAP establishes a fair value hierarchy that distinguishes between (i) market participant assumptions developed based on market data obtained from independent sources (observable inputs) and (ii) an entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The fair value hierarchy consists of three broad levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The three levels of the fair value hierarchy are described below:
Level 1 — Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities.

 

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Level 2 — Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly, including quoted prices for similar assets or liabilities in active markets and quoted prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted prices that are observable for the asset or liability (e.g. interest rates); and inputs that are derived principally from or corroborated by observable market data by correlation or other means.
Level 3 — Inputs that are both significant to the fair value measurement and unobservable.
(3) Balance Sheet Detail
(a) Allowance for Doubtful Accounts
The following is a summary of activity for the Company’s allowance for doubtful accounts for the year ended December 31, 2009, and the nine months ended September 30, 2010:
         
Ending balance, December 31, 2008
  $ 8,045  
Bad debt expense
    12,927  
Write-offs
    (12,225 )
 
     
Ending balance, December 31, 2009
    8,747  
Bad debt expense
    9,875  
Write-offs
    (5,525 )
 
     
Ending balance, September 30, 2010
  $ 13,097  
 
     
(b) Property and Equipment
The following is a summary of the Company’s property and equipment:
                 
    September 30,     December 31,  
    2010     2009  
Office furniture, computer software, and laboratory equipment
  $ 26,385     $ 21,480  
Leasehold improvements
    9,966       9,650  
 
           
Total
    36,351       31,130  
Accumulated depreciation and amortization
    (20,189 )     (16,784 )
 
           
Property and equipment, net
  $ 16,162     $ 14,346  
 
           
As of September 30, 2010 and December 31, 2009, the Company’s associated capital lease obligations were $3.2 million and $1.2 million, respectively.
(c) Intangible assets
The following is a summary of the Company’s intangible assets:
                 
    September 30,     December 31,  
    2010     2009  
Biomarkers
  $ 11,349     $ 11,349  
In-process research and development
    76       76  
Issued patents
    26       26  
Patent applications
    123       123  
Non-compete agreements
    110       110  
Accumulated amortization
    (943 )     (45 )
 
           
Intangible assets, net
  $ 10,741     $ 11,639  
 
           

 

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The following is a summary of the estimated useful lives, estimated annual amortization expense, and expense classification of the Company’s intangible assets:
                         
    Estimated              
    Useful Life     Estimated Annual     Condensed Consolidated Statement of
    (years)     Amortization     Operations Classification
Biomarkers*
    7     $ 1,621     Cost of services or research and development
In-process research and development
    7       11     Research and development
Issued patents
    7       4     Cost of services
Patent applications
    7       18     Cost of services
Non-competition agreements
    3       37     Research and development
 
                     
Total
          $ 1,691          
 
                     
     
*   Upon the commercial launch of the associated biomarker, the related amortization is recorded to cost of services on a per sales unit convention. Until such time, the related amortization is recorded to research and development on a straight-line basis. The above estimated annual amortization for biomarkers assumes an even recognition over seven years, however, actual amortization will vary by year, based upon (i) the date of the commercial launch, and (ii) the number of units (i.e. diagnostic tests) sold which utilize the associated biomarker.
(4) Discontinued Operations
On March 8, 2007, the Company sold its instrument systems business (the “ACIS Business”), consisting of certain tangible assets, inventory, intellectual property (including the Company’s former patent portfolio and the ACIS and ChromaVision trademarks), contracts, and related assets to Carl Zeiss MicroImaging, Inc. and one of its subsidiaries (collectively, “Zeiss”) for an aggregate purchase price of $12.5 million. The $12.5 million consisted of $11.0 million in cash and an additional $1.5 million in contingent purchase price, subject to the satisfaction of certain post-closing conditions through March 8, 2009 relating to transferred intellectual property (the “ACIS Sale”). As part of the ACIS Sale, the Company entered into a license agreement with Zeiss that granted the Company a non-exclusive, perpetual and royalty-free license to certain of the transferred patents, copyrights, and software code for use in connection with imaging applications (excluding sales of imaging instruments) and the Company’s oncology diagnostic services business.
In March 2009, Zeiss’ management acknowledged the satisfaction of the post-closing conditions of the ACIS Sale and the associated $1.5 million payment due, which the Company subsequently received on April 8, 2009. The Company recorded the $0.9 million as income from discontinued operations, net of $0.6 million income tax benefit, within the accompanying Condensed Consolidated Statements of Operations for the nine months ended September 30, 2009.
The Company retains certain indemnification obligations to Zeiss for any third party claims surviving through the applicable statute of limitations. The Company believes the likelihood of a raised claim(s) is remote and, in any case, would be immaterial in value.
(5) Recent Accounting Pronouncements
FASB Codification
The Financial Accounting Standards Board (“FASB”) Accounting Standards CodificationTM (“FASB Codification”) became the single source of authoritative nongovernmental GAAP on July 1, 2009. The FASB Codification became effective for financial statements that cover interim and annual periods ending after September 15, 2009. Other than resolving certain minor inconsistencies in current GAAP, the FASB Codification does not affect GAAP, but rather organizes historical accounting pronouncements by approximately 90 accounting topics. Accordingly, in this Quarterly Report on Form 10-Q, the Company describes, in general, pertinent GAAP where applicable and/or cites the associated FASB Codification reference, rather than the historical GAAP reference.
Earnings Per Share
In June 2008, GAAP guidance was released for determining whether instruments granted in share-based payment transactions are participating securities. Under such guidance, unvested share-based payment awards that contain non-forfeitable rights to dividends or dividend equivalents, whether they are paid or unpaid, are considered participating securities and should be included in the computation of earnings per share pursuant to the two-class method. As required, the Company adopted such guidance retrospectively effective January 1, 2009, though it did not affect the Company’s consolidated financial position, results of operations, cash flows, or loss per common share in prior periods, as disclosed in Note 9.

 

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Variable Interest Entities
In December 2009, the FASB issued guidance on how a reporting entity determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a reporting entity is required to consolidate another entity is based on, among other things, the other entity’s purpose and design and the reporting entity’s ability to direct the activities of the other entity that most significantly impact the other entity’s economic performance. Such guidance requires a reporting entity to provide additional disclosures about its involvement with variable interest entities and any significant changes in risk exposure due to that involvement. A reporting entity is required to disclose how its involvement with a variable interest entity affects the reporting entity’s financial statements. The Company adopted the guidance as of January 1, 2010, and its application had no impact on its Condensed Consolidated Financial Statements. The Company currently consolidates the accounts of CPS, which it does not control through voting or similar rights, as disclosed in Note 1(a) and (b).
(6) Significant Risks and Uncertainties
Credit risk with respect to the Company’s accounts receivable is generally diversified due to the large number of payors that comprise its customer base. The Company has significant receivable balances with government payors, health insurance carriers, health care institutions, biopharmaceutical companies, and patients. The Company’s accounts receivable balances are not supported by collateral.
The laboratory services industry faces challenging billing and collection procedures. The cash realization cycle for certain governmental and managed care payors can be lengthy and may involve denial, appeal, and adjudication processes. Collection of governmental and private health insurer receivables is generally a function of providing these payors with complete and accurate billing information within various filing deadlines, though is subject to their approval of the underlying completed services. Collection of client receivables is generally a function of providing complete and accurate billing information to the client within the various filing deadlines, as the underlying services have been approved prior to completion. Receivables due from clients and patients, in particular, are generally subject to increased credit risk as compared to the Company’s other payor classes, due to the clients’ and patients’ credit worthiness or inability to pay.
The percentage of the Company’s gross accounts receivable of $39.8 million and $30.3 million as of September 30, 2010 and December 31, 2009, respectively, by primary payor class, is as follows:
                 
    September 30, 2010     December 31, 2009  
Governmental (Medicare and Medicaid)
    20 %     20 %
Private health insurers
    41 %     43 %
Clients (pathologists, hospitals, clinics)
    17 %     18 %
Patients (indirect bill)
    12 %     10 %
Patients (direct bill)
    10 %     9 %
 
           
Total
    100 %     100 %
The Company’s aged gross accounts receivable in total, and by payor class, as of September 30, 2010 and December 31, 2009 is as follows:
                                 
    September 30, 2010     %     December 31, 2009     %  
 
                               
All payor classes
                               
Total
  $ 39,761       100 %   $ 30,315       100 %
Unbilled
    5,410       14 %     4,819       16 %
Current
    7,002       18 %     5,817       19 %
31-60 days past due
    5,198       13 %     4,341       14 %
61-90 days past due
    3,054       8 %     2,799       9 %
91-120 days past due
    2,469       6 %     1,963       6 %
121-150 days past due
    2,408       6 %     1,299       4 %
Greater than 150 days past due
    14,220       35 %     9,277       32 %

 

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    September 30, 2010     %     December 31, 2009     %  
 
                               
Governmental payors (Medicare and Medicaid)
                               
Total
  $ 7,799       100 %   $ 5,989       100 %
Unbilled
    1,481       19 %     1,508       25 %
Current
    2,070       27 %     1,332       22 %
31-60 days past due
    566       7 %     517       9 %
61-90 days past due
    354       5 %     335       6 %
91-120 days past due
    319       4 %     228       4 %
121-150 days past due
    267       3 %     204       3 %
Greater than 150 days past due
    2,742       35 %     1,865       31 %
                                 
    September 30, 2010     %     December 31, 2009     %  
 
                               
Private health insurer payors
                               
Total
  $ 16,817       100 %   $ 13,009       100 %
Unbilled
    3,175       19 %     2,391       18 %
Current
    1,345       8 %     1,988       15 %
31-60 days past due
    1,604       9 %     1,395       11 %
61-90 days past due
    1,025       6 %     1,069       8 %
91-120 days past due
    973       6 %     729       6 %
121-150 days past due
    946       6 %     580       5 %
Greater than 150 days past due
    7,749       46 %     4,857       37 %
                                 
    September 30, 2010     %     December 31, 2009     %  
 
                               
Client (pathologists, hospitals, clinics, and biopharmaceutical) payors
                               
Total
  $ 6,673       100 %   $ 5,433       100 %
Unbilled
    454       7 %     585       11 %
Current
    2,618       39 %     1,791       33 %
31-60 days past due
    1,773       27 %     1,570       29 %
61-90 days past due
    566       8 %     530       10 %
91-120 days past due
    238       4 %     299       5 %
121-150 days past due
    166       2 %     164       3 %
Greater than 150 days past due
    858       13 %     494       9 %
                                 
    September 30, 2010     %     December 31, 2009     %  
 
                               
Patient payors (indirect bill)
                               
Total
  $ 3,894       100 %   $ 2,992       100 %
Unbilled
                       
Current
    163       4 %     137       5 %
31-60 days past due
    552       14 %     343       11 %
61-90 days past due
    497       13 %     337       11 %
91-120 days past due
    408       10 %     302       10 %
121-150 days past due
    402       10 %     275       9 %
Greater than 150 days past due
    1,872       49 %     1,598       54 %

 

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    September 30, 2010     %     December 31, 2009     %  
 
                               
Patient payors (direct bill)
                               
Total
  $ 4,578       100 %   $ 2,892       100 %
Unbilled
    300       7 %     335       12 %
Current
    806       18 %     569       19 %
31-60 days past due
    703       15 %     516       18 %
61-90 days past due
    612       13 %     528       18 %
91-120 days past due
    531       12 %     405       14 %
121-150 days past due
    627       14 %     76       3 %
Greater than 150 days past due
    999       21 %     463       16 %
As of September 30, 2010, the Company maintained a $13.1 million allowance for doubtful accounts in order to carry accounts receivable at the estimated net realizable value of $26.7 million, as presented within the accompanying Condensed Consolidated Balance Sheets. The allowance for doubtful accounts is an estimate that involves considerable professional judgment. As such, the Company’s actual collection of its September 30, 2010 accounts receivable may materially differ from management’s estimate for reasons including, but not limited to: customer mix, concentration of customers within the healthcare sector, and the general downturn in the United States economy.
(7) Lines of Credit
The following table summarizes the Company’s outstanding debt at its carrying value at September 30, 2010 and December 31, 2009. The Company believes the carrying amount of its outstanding debt approximates fair value due to its short-term nature and associated interest rate.
                 
    September 30, 2010     December 31, 2009  
 
               
Gemino Facility
  $     $ 2,678  
 
           
The following table summarizes the Company’s interest expense on its lines of credit, including interest expense to related party, for the three and nine months ended September 30, 2010 and 2009 within the accompanying Condensed Consolidated Statements of Operations:
                                 
    Three Months Ended     Nine Months Ended  
    September 30,     September 30,  
    2010     2009     2010     2009  
Gemino Facility
  $ 73     $ 120     $ 233     $ 361  
Comerica Facility
                      57  
Safeguard Facility
                      3,556  
 
                       
Total interest expense, including interest expense to Safeguard, a related party (excludes interest expense associated with capital leases)
  $ 73     $ 120     $ 233     $ 3,974  
 
                       
Gemino Facility
On July 31, 2008, the Company entered into a secured credit agreement (the “Gemino Facility”) with Gemino Healthcare Finance, LLC (“Gemino”), which was amended on February 27, 2009 (the “February 2009 Gemino Amendment”), November 13, 2009 (the “November 2009 Gemino Amendment”), and December 21, 2009 (the “December 2009 Gemino Amendment”). The Gemino Facility is a revolving facility under which the Company may borrow up to $8.0 million, secured by the Company’s accounts receivable and related assets. The November 2009 Gemino Amendment extended the Gemino Facility’s maturity date to January 31, 2011. The December 2009 Gemino Amendment joined AGI as a borrower under the Gemino Facility.

 

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The amount which the Company is entitled to borrow under the Gemino Facility at a particular time ($8.0 million availability as of September 30, 2010) is based on the amount of the Company’s qualified accounts receivable and certain liquidity factors.
Borrowings under the Gemino Facility bear interest at an annual rate equal to 30-day LIBOR (subject to a minimum annual rate of 2.50% at all times), plus an applicable margin of 6.0% (prior to the February 2009 Gemino Amendment, the applicable margin was 5.25%). The Company is required to pay a commitment fee of 0.50% per year on the daily average of unused credit availability (prior to the November 2009 Gemino Amendment, the commitment fee was 0.75%) and a collateral monitoring fee of 0.40% per year on the daily average of outstanding borrowings.
The February 2009 Gemino Amendment increased the Company’s capital expenditure limit to $7.5 million in each fiscal year. For the nine months ending September 30, 2010, the Company’s aggregate capital expenditures were $2.2 million. The February 2009 Gemino Amendment also modified the minimum level of “excess liquidity” covenant, increasing its threshold from $2.0 million to $3.0 million, though such covenant was subsequently eliminated with the November 2009 Gemino Amendment.
The November 2009 Gemino Amendment (i) extended the maturity date of the Gemino Facility from January 31, 2010 to January 31, 2011; (ii) removed the “excess liquidity” covenant; (iii) increased the facility’s “advance rate” from 75% to 85%; (iv) eliminated the minimum “fixed charge coverage ratio” covenant through December 31, 2009; (v) includes a “maximum loan turnover ratio” covenant (defined as the average monthly loan balance divided by average monthly cash collections multiplied by 30 days) of 35 days only for the three months ended December 31, 2009 (for the three months ended December 31, 2009 the Company’s calculated “maximum loan turnover ratio” was 18 days); (vi) requires a minimum annualized “fixed charge coverage ratio” (defined below) covenant of 1.00 for the three months ending March 31, 2010, 1.10 for six months ending June 30, 2010, 1.20 for the nine months ending September 30, 2010, and 1.20 for the twelve months ending December 31, 2010 and thereafter; and (vii) reduced the commitment fee from 0.75% to 0.50% per year on the daily average of unused credit availability.
The “fixed charge coverage ratio” is defined as the ratio of EBITDA (net income plus interest expense, tax expense, depreciation/amortization expense, and stock-based compensation expense), to the sum of (i) interest expense paid in cash on the Gemino Facility, (ii) payments made under capital leases, (iii) unfinanced capital expenditures, and (iv) taxes paid. For the three months ended September 30, 2010, the Company’s calculated “fixed charge coverage ratio” was 3.67, which exceeded the requirement of 1.00.
The Gemino Facility also contains a “material adverse change” clause (“MAC”) clause. If the Company encountered difficulties that would qualify as a MAC in its (i) operations, (ii) condition (financial or otherwise), or (iii) ability to repay amounts outstanding under the Gemino Facility, it could be cancelled at Gemino’s sole discretion. Also, in connection with the pending acquisition of the Company by General Electric, Gemino has the right to terminate the Gemino Facility upon completion of the Merger, unless Gemino consents to the Merger. In either case, if Gemino elects to terminate the Gemino Facility, it could then elect to declare the indebtedness, together with accrued interest and other fees, to be immediately due and payable and proceed against any collateral securing such indebtedness.
Comerica Facility
On March 26, 2009, the Company fully repaid the $9.8 million outstanding balance under its $12.0 million revolving credit agreement with Comerica Bank (the “Comerica Facility”), using a portion of the proceeds from the initial closing of the Oak Private Placement. The Comerica Facility was terminated at such time, as was Safeguard’s guarantee of the Comerica Facility (as described below). The Company maintains a $1.5 million standby letter of credit with Comerica Bank which is fully supported by a restricted cash account for the same amount. The letter of credit is for the benefit of the Company’s landlord for its leased corporate and laboratory facility in Aliso Viejo, California.
Borrowings under the Comerica Facility bore interest through February 27, 2009 at Comerica’s prime rate minus 0.5%, or at the Company’s option, at a rate equal to 30-day LIBOR plus 2.45%. The Comerica Facility was amended on February 27, 2009, and as a result, until its retirement on March 26, 2009, borrowings under the Comerica Facility bore interest at the Company’s option of: (i) 0.5% plus the greater of Comerica’s prime rate or 1.75%, or (ii) 30-day LIBOR plus 2.40%.
Safeguard Delaware, Inc., a wholly-owned subsidiary of Safeguard Scientifics, Inc. (“Safeguard”), the Company’s largest single stockholder, guaranteed the Company’s borrowings under the Comerica Facility in exchange for 0.5% per year of the total amount guaranteed plus 4.5% per year of the daily-weighted average principal balance outstanding. Additionally, the Company was required to pay Safeguard a quarterly usage fee of 0.875% of the amount by which the daily average outstanding principal balance under the Comerica Facility exceeded $5.5 million.

 

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Safeguard Facility
On March 7, 2007, the Company entered into a senior subordinated revolving credit facility with Safeguard (the “Initial Mezzanine Facility”). The Initial Mezzanine Facility provided the Company with up to $12.0 million in working capital funding, but was reduced by $6.0 million as a result of the ACIS Sale discussed in Note 4. The Initial Mezzanine Facility’s annual interest rate was 12.0%. In connection with the Initial Mezzanine Facility, the Company issued Safeguard 0.3 million common stock warrants to satisfy Safeguard’s commitment fees and maintenance and usage fees. The fair value of these common stock warrants was determined using the Black-Scholes option pricing model, and was initially expensed over the term of the Initial Mezzanine Facility, though the term was subsequently extended to coincide with the term of the New Mezzanine Facility (defined below).
On March 14, 2008, the Company entered into an amended and restated senior subordinated revolving credit facility with Safeguard (the “New Mezzanine Facility”) to refinance, renew, and expand the Initial Mezzanine Facility. The New Mezzanine Facility, which had a stated maturity date of April 15, 2009, provided the Company with up to $21.0 million in working capital funding. Borrowings under the New Mezzanine Facility bore interest at an annual rate of 12.0% through September 30, 2008 and 13.0% thereafter. Proceeds from the New Mezzanine Facility were used to refinance indebtedness under the Initial Mezzanine Facility, for working capital purposes, and to repay in full and terminate the Company’s former GE Capital Facility, which included certain equipment lease obligations.
In connection with the New Mezzanine Facility, the Company issued Safeguard 1.6 million common stock warrants upon its signing. The Company was also required to issue Safeguard an additional 2.2 million common stock warrants, in four equal tranches of 0.55 million common stock warrants if the balance of the New Mezzanine Facility had not been reduced to $6.0 million or less on or prior to May 1, 2008, July 1, 2008, September 1, 2008, and November 1, 2008, respectively. Such reduction was not accomplished and as a result, 0.55 million common stock warrants were issued on each of June 10, 2008, July 2, 2008, September 2, 2008, and November 6, 2008.
The fair value of the 1.6 million common stock warrants issued on March 14, 2008 and the 2.2 million common stock warrants issued from June 2008 through December 2008 was measured on March 14, 2008, the date of the New Mezzanine Facility commitment. The fair value of any unissued common stock warrants associated with the New Mezzanine Facility was measured and adjusted at each subsequent quarter end. The fair value of all such common stock warrants has been treated for accounting purposes as a debt discount of the New Mezzanine Facility and additional paid-in-capital. The Company began accreting the debt discount in the first quarter of 2008 (as adjusted for the change in fair value of any contingent warrants at each quarter-end) over the term of the New Mezzanine Facility through recording interest expense to related party on a straight-line basis.
The fair value of the common stock warrants issued to Safeguard in connection with the Initial Mezzanine Facility and New Mezzanine Facility was determined using the Black-Scholes option pricing model with the following inputs: zero dividends, a risk-free interest rate ranging from 3.4% to 4.5% (equal to the U.S. Treasury yield curve for the warrants’ term on the date of issuance), and expected stock volatility of 66% to 85% (measured using weekly price observations for a period equal to the warrants’ term).
On February 27, 2009, the Company entered into an amended and restated senior subordinated revolving credit facility with Safeguard (the “Third Mezzanine Facility”) to refinance, renew, and expand the New Mezzanine Facility. The Third Mezzanine Facility had a stated maturity date of April 1, 2010 and provided the Company with up to $30.0 million in working capital funding through March 25, 2009. Borrowings under the Third Mezzanine Facility bore interest at an annual rate of 14.0%, capitalized monthly to the principal balance. Upon the signing of the Third Mezzanine Facility, the Company issued Safeguard 0.5 million fully vested common stock warrants with a five year term and an exercise price equal to $1.376.
In connection with the Initial Oak Closing on March 26, 2009, the Company repaid $14.0 million of the outstanding balance under the Third Mezzanine Facility. Also on March 26, 2009, the Company and Safeguard amended the Third Mezzanine Facility, which resulted in the reduction of its total availability from $30.0 million to $10.0 million. The Second Oak Closing occurred on May 14, 2009, and at such time, the Company repaid the remaining outstanding balance (including accrued interest) of the Third Mezzanine Facility of $5.7 million, which was cancelled upon such repayment.
In connection with the $20.0 million reduction in availability of the Third Mezzanine Facility on March 26, 2009, the Company assessed the associated unamortized debt issuance costs of $1.7 million as of such date (which included unamortized warrant expense). The 67% reduction in borrowing capacity ($20.0 million divided by $30.0 million) resulted in the expensing of debt issuance costs in such proportion, totaling $1.1 million. Such amount was recorded to interest expense to related party for the three months ended March 31, 2009 within the accompanying Condensed Consolidated Statements of Operations. As of March 31, 2009, remaining unamortized debt issuance costs totaled $0.5 million, and were fully amortized through May 14, 2009, the date the Company fully repaid and cancelled the Third Mezzanine Facility.

 

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The interest expense on the outstanding balance under the Mezzanine Facilities, including the amortization of the fair value of issued warrants (see tables below), for the three and nine months ended September 30, 2009, was $-0- and $3.6 million, respectively. Such amount is included in interest expense to related parties within the accompanying Condensed Consolidated Statements of Operations.
The below table summarizes the common stock warrant activity associated with the Initial Mezzanine Facility for the nine months ended September 30, 2009. There was no comparable expense in 2010, due to the full repayment of the Mezzanine Facilities in May 2009.
                                                 
                                            Interest Expense  
                    Warrant   Warrant           Recognized  
  Exercise     Warrant   Issuance   Expiration           Nine Months Ended  
Number of warrants   Price     Term   Date   Date   Fair Value     September 30, 2009  
 
                                               
125,000*.
  $ 0.01     4 years   March 7, 2007   March 7, 2011   $ 204     $ 23  
62,500
    1.39     4 years   March 7, 2007   March 7, 2011     69       8  
31,250*
    0.01     4 years   November 14, 2007   November 14, 2011     62       11  
31,250*
    0.01     4 years   December 17, 2007   December 17, 2011     61       13  
31,250*
    0.01     4 years   March 5, 2008   March 5, 2012     62       16  
 
                                           
 
                                               
Total
                                  $ 458     $ 71  
 
                                           
The below table summarizes the common stock warrant activity associated with the New Mezzanine Facility:
                                                 
                                            Interest Expense  
                            Warrant           Recognized  
    Exercise     Warrant   Warrant   Expiration           Nine Months Ended  
Number of warrants   Price     Term   Issuance Date   Date   Fair Value     September 30, 2009  
 
                                               
1,643,750*
  $ 0.01     5 years   March 14, 2008   March 14, 2013   $ 2,666     $ 703  
550,000*
    0.01     5 years   June 10, 2008   June 11, 2013     1,140       300  
550,000*
    0.01     5 years   July 2, 2008   July 2, 2013     1,095       289  
550,000*
    0.01     5 years   September 2, 2008   September 2, 2013     1,167       308  
550,000*
    0.01     5 years   November 6, 2008   November 6, 2013     890       235  
 
                                           
Total
                                  $ 6,958     $ 1,835  
 
                                           
     
*   On November 20, 2008 Safeguard exercised the indicated common stock warrants.

 

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The below table summarizes the common stock warrant activity associated with the Third Mezzanine Facility:
                                                 
                                            Interest Expense  
                            Warrant             Recognized  
    Exercise     Warrant     Warrant     Expiration             Nine Months Ended  
Number of Warrants Issued   Price     Term     Issuance Date     Date     Fair Value     September 30, 2009  
 
                                               
500,000
  $ 1.376     5 years     February 27, 2009     February 27, 2014     $ 600     $ 600  
 
                                           
(8) Equipment Financing
On March 31, 2009, the Company entered into a three-year capital lease with Hitachi Data Systems Credit Corporation for computer equipment and related software with a fair value on such date of $1.2 million, associated with the Company’s initiative to upgrade its information technology infrastructure. The Company also has a number of active laboratory equipment and office equipment leases (capital and operating) with various providers as of September 30, 2010.
The Company’s capital lease obligations as of September 30, 2010 are as follows:
         
Remainder of 2010
  $ 388  
2011
    1,376  
2012
    967  
2013
    645  
2014
    236  
 
     
Subtotal
    3,612  
Less: interest
    (401 )
 
     
Total
    3,211  
Less: current portion
    (1,212 )
 
     
Capital lease obligations, long-term portion
  $ 1,999  
 
     
(9) Net Income (Loss) Per Share Information
The Company calculates earnings per share (“EPS”) under the two-class method. Under the two-class method, all earnings during the period are allocated to common stock and participating securities (defined below), based on their respective rights to receive dividends, assuming all earnings during the period were distributed.
The Company grants restricted stock awards from time to time under its 2007 Plan (see Note 11), generally entitling recipients to voting rights and non-forfeitable rights to dividends, if and when declared. The Company’s Series A convertible preferred stock (see Note 13) also carries voting rights and non-forfeitable dividend rights. The Company’s unvested restricted stock awards and its Series A convertible preferred stock, therefore, are deemed participating securities.
Participating securities are included in the computation of EPS under the two-class method in periods of net income, but are not included in the computation of EPS in periods of net loss, since the contractual terms of the participating securities do not require the holders’ funding of the Company’s losses. Additionally, participating securities are not included in the computation of EPS when distributions, or their accounting equivalents — such as an amortized beneficial conversion feature, are in excess of net income in the same period.
Basic EPS for the three and nine months ended September 30, 2010 and 2009, was computed by dividing net income attributable to common stockholders by the weighted average number of Common Shares outstanding during the period. Diluted EPS was computed by dividing net income attributable to common stockholders by the weighted average number of Common Shares outstanding during the period increased to include, if dilutive, the number of additional Common Shares that would be outstanding if the dilutive potential Common Shares had been issued. The dilutive effect of outstanding warrants, stock options, and restricted stock awards is reflected in diluted net income (loss) per share by application of the treasury stock method.

 

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Basic and diluted EPS applicable to common stockholders for the three and nine months ended September 30, 2010 and 2009 is summarized in the table below:
                                 
    Three Months Ended September 30,     Nine Months Ended September 30,  
    2010     2009     2010     2009  
Net income (loss) per share applicable to common stockholders — basic and diluted:
                               
Income (loss) from continuing operations, net of income taxes
  $ 0.02     $ (0.04 )   $ 0.03     $ (0.11 )
Income from discontinued operations, net of income taxes
                      0.01  
 
                       
Net income (loss) applicable to common stockholders
  $ 0.02     $ (0.04 )   $ 0.03     $ (0.10 )
 
                       
Basic and diluted EPS was computed by dividing net loss applicable to common stockholders by the applicable weighted-average outstanding Common Shares during each period, as summarized in the table below:
                                 
    Three Months Ended September 30,     Nine Months Ended September 30,  
    2010     2009     2010     2009  
 
                               
Basic and diluted EPS numerator:
                               
Income (loss) from continuing operations, net of income taxes
  $ 2,342     $ (3,235 )   $ 2,914     $ (4,263 )
Income from discontinued operations, net of income taxes
                      901  
 
                       
Net income (loss)
  $ 2,342     $ (3,235 )   $ 2,914     $ (3,362 )
 
                       
 
                               
Less: Series A preferred stock beneficial conversion feature
                      (4,290 )
 
                               
Less: Undistributed earnings allocated to participating securities
    (504 )           (606 )      
 
                       
 
                               
Undistributed earnings (loss) allocated to common stockholders
  $ 1,838     $ (3,235 )   $ 2,308     $ (7,652 )
 
                       

 

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The following share amounts were used to compute basic and diluted EPS applicable to common stockholders (in periods of net loss, or when distributions or equivalents were in excess of net income, the anti dilutive effects of participating securities, stock options, and warrants, were properly excluded):
                 
    Three Months Ended September 30,  
    2010     2009  
Basic EPS denominator:
               
Weighted-average outstanding common shares
    85,461       77,583  
 
           
 
               
Diluted EPS denominator:
               
Weighted-average outstanding common shares
    88,672       77,583  
 
           
                 
    Nine Months Ended September 30,  
    2010     2009  
Basic EPS denominator:
               
Weighted-average outstanding common shares
    84,855       77,257  
 
           
 
               
Diluted EPS denominator:
               
Weighted-average outstanding common shares
    87,654       77,257  
 
           
The following outstanding Company securities were excluded from the above calculations of net income (loss) per share applicable to common stockholders because their impact would have been anti-dilutive:
                         
    Three     Nine        
    Months     Months        
    Ended     Ended        
    September 30,     September 30,     Total Outstanding at  
    2010     2010     September 30, 2009  
 
                       
Series A convertible preferred stock (as converted — see Note 13)
                21,053  
 
 
Common stock options (treasury stock method)
    5,603       5,971       7,486  
Common stock warrants (treasury stock method)
    315       360       3,033  
 
                 
Total
    5,918       6,331       31,572  
 
                 

 

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(10) Comprehensive Income (Loss)
Comprehensive income (loss) is defined as the change in equity from net income (loss) and other transactions from non-stockholder sources during the period. The following summarizes the components of the Company’s comprehensive income (loss):
                                 
    Three Months Ended     Nine Months Ended  
    September 30,     September 30,  
    2010     2009     2010     2009  
 
                               
Net income (loss)
  $ 2,342     $ (3,235 )   $ 2,914     $ (3,362 )
 
                               
Foreign currency translation adjustment
          (3 )           (8 )
 
                       
 
                               
Comprehensive income (loss)
  $ 2,342     $ (3,238 )   $ 2,914     $ (3,370 )
 
                       
(11) Stock-Based Compensation
2007 Incentive Award Plan
The Company has one active stockholder-approved stock plan, the 2007 Incentive Award Plan (the “2007 Plan”), which replaced the Company’s former stockholder-approved stock plan (the “1996 Plan”). The 2007 Plan provides for the grant of incentive stock options and nonqualified stock options, restricted stock awards and restricted stock units, stock appreciation rights, performance shares, performance stock units, dividend equivalents, stock payments, deferred stock, performance bonus awards, and performance-based awards.
The maximum number of shares of the Company’s common stock available for issuance under the 2007 Plan is 12.0 million shares (which increased by 7.0 million shares due to a stockholder-approved amendment of the 2007 Plan in June 2010), plus additional availability from forfeited shares under the 1996 Plan. As of September 30, 2010, 5.2 million shares were available for grant under the 2007 Plan. The Company does not hold treasury shares, and therefore all shares issued through exercised stock options are through unissued shares that are authorized and reserved under the 2007 Plan. It is the Company’s policy that before stock is issued through the exercise of stock options, the Company must first receive all required cash payment for such shares.
Stock-based awards are governed by agreements between the Company and the recipients. Incentive stock options and nonqualified stock options may be granted under the 2007 Plan at an exercise price of not less than the closing fair market value of the Company’s common stock on the respective date of grant. The grant date is generally the date the award is approved by the Company’s Board of Directors, though for aggregate awards of 50,000 or less in each calendar quarter, the grant date is generally the date the award is approved by the Company’s chief executive officer on the first business date of a calendar month.
The Company’s standard stock-based award vests 25 percent on the first anniversary of the date of grant, or for new hires, the first anniversary of their initial date of employment with the Company. Awards vest either monthly or quarterly thereafter on a straight-line basis over 36 months. Stock options must be exercised, if at all, no later than 10 years from the date of grant. Upon termination of employment with the Company, vested stock options may be exercised within 90 days from the last date of employment. In the event of an optionee’s death, disability, or retirement, the exercise period is 365 days from the last date of employment.

 

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Stock-based Compensation Expense
Stock-based compensation, which includes stock options and restricted stock awards, is recognized in the Condensed Consolidated Statements of Operations as follows:
                                 
    Three Months Ended     Nine Months Ended  
    September 30,     September 30,  
    2010     2009     2010     2009  
Cost of services
  $ 189     $ 83     $ 436     $ 155  
Operating expenses
    1,028       418       2,175       1,485  
 
                       
Total stock-based compensation expense
  $ 1,217     $ 501     $ 2,611     $ 1,640  
 
                       
(12) Outstanding Equity Securities and Stock Transactions
The following table presents the Company’s outstanding equity securities as of September 30, 2010:
         
    Shares  
 
       
Common stock (includes unvested restricted stock awards)
    88,664  
Series A preferred stock (as-converted)
    21,053  
Options outstanding (vested and unvested)
    8,401  
Warrants outstanding (all of which are vested)
    729  
 
     
Total
    118,847  
 
     
The below summarizes recent significant transactions involving the Company’s equity securities.
Acquisition of Applied Genomics, Inc.
On December 21, 2009, the Company completed its acquisition of Applied Genomics, Inc. (“AGI”) in accordance with the terms and conditions of the Agreement and Plan of Merger and Reorganization, dated as of December 21, 2009, as amended March 17, 2010, by and between the Company and AGI. The purchase price for AGI consisted of 4.4 million of the Company’s Common Shares issued to the former AGI stockholders at the closing of the acquisition (inclusive of exchanged stock option awards with an exercise price of $0.40 per share), and a maximum of an additional 3.2 million of the Company’s Common Shares to the former AGI stockholders (inclusive of exchanged stock option awards with an exercise price of $0.40 per share), upon the achievement of three milestones by December 31, 2012. As of September 30, 2010, two of the three milestones had been achieved, resulting in the issuance of 1.5 million shares (inclusive of exchanged stock option awards with an exercise price of $0.40 per share). See Note 14 for further discussion of the AGI acquisition.
Stock Purchase Agreement with Oak Investment Partners XII, Limited Partnership
On March 25, 2009, the Company entered into a stock purchase agreement (“Oak Purchase Agreement”) with Oak Investment Partners XII, Limited Partnership (“Oak”). In reliance on Section 4(2) of the Securities Act of 1933, as amended (the “Securities Act”), the Company agreed to sell Oak up to an aggregate of 6.6 million shares of its Series A convertible preferred stock, $0.01 par value (the “Preferred Shares”), in two or more tranches (the “Oak Private Placement”) for aggregate consideration of up to $50.0 million. The initial closing of the Oak Private Placement occurred on March 26, 2009, at which time the Company issued and sold an aggregate of 3.8 million Preferred Shares (the “Initial Oak Closing Shares”) for aggregate consideration of $29.1 million. The second closing of the Oak Private Placement occurred on May 14, 2009, at which time the Company issued and sold an aggregate of 1.4 million Preferred Shares (the “Second Oak Closing Shares”) for aggregate consideration of $10.9 million. Oak’s Preferred Shares represented 19.2% of the total voting power of the Company’s issued and outstanding voting securities as of September 30, 2010.
Sale by Safeguard Scientifics, Inc.
In August and September 2009, Safeguard, through its wholly owned subsidiaries, completed the sale of an aggregate of 18.4 million shares of the Company’s common stock held by Safeguard in an underwritten public offering which was pursuant to an effective registration statement filed with the SEC. The Company did not, and will not, receive any proceeds from the sale of such shares. Safeguard’s holdings of the Company’s common stock represented 27.5% of the total voting power of the Company’s issued and outstanding voting securities as of September 30, 2010.

 

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Share Registration Obligations of the Company
As required by the terms of the Oak Purchase Agreement, the Company entered into a Registration Rights Agreement with Oak on March 26, 2009. The Registration Rights Agreement obligated the Company to register for resale, on a Form S-3 registration statement, the shares of common stock issuable upon the conversion of the Preferred Shares. Such From S-3 was filed with the SEC on December 22, 2009. From time to time in the past, the Company completed several other private placements of its equity securities. In connection therewith, the Company has entered into certain agreements which require the Company to register, for resale, such investors’ securities under the Securities Act. The Company has concluded that under applicable GAAP, an accrual of the estimated costs of preparing and filing such future registration statements is not required.
Stock Warrant Activity
The Company has issued stock warrants to various parties in connection with entering and maintaining certain credit facilities, as consideration for various licensing arrangements with other companies, and in conducting other corporate business. The Company had 0.7 million outstanding stock warrants as of September 30, 2010, all of which were exercisable. The warrants have expiration dates ranging from January 2011 through February 2014. Stock warrant activity in 2010 is summarized below:
                 
            Weighted Average  
    Shares     Exercise Price  
 
               
Stock warrants outstanding, December 31, 2009
    1,413     $ 1.26  
Granted
             
Exercised
    674          
Canceled
    10          
 
             
Warrants outstanding, September 30, 2010
    729     $ 1.44  
 
             
(13) Redeemable Preferred Stock
General Features
In March and May 2009, the Company issued and sold an aggregate of 5.3 million Preferred Shares to Oak for aggregate gross consideration of $40.0 million. In connection with the issuance of the Initial and Second Oak Closing Shares, the Company incurred expenses of $1.4 million. These expenses were related to legal fees and investment banker fees which were recorded as a reduction of additional paid in capital, rather than expense. Accordingly, the Preferred Shares are presented at $38.6 million in the accompanying Condensed Consolidated Balance Sheets at September 30, 2010 and December 31, 2009, respectively ($40.0 million of aggregate Oak proceeds less $1.4 million of legal fees and investment banker fees).
Each Preferred Share will be voted with Common Shares on an as-converted basis and is initially convertible, at any time, into four shares of the Company’s common stock, though is subject to broad-based weighted-average anti-dilution protection in the event that the Company issues additional shares at or below the then-applicable conversion price for such share (initially $1.90 per share). This provision will not be triggered, however, unless and until the Company issues shares that, when aggregated with all shares issued after the initial closing, have an aggregate offer or issue price exceeding $5.0 million. The Preferred Shares will automatically convert if, at any time beginning after March 26, 2010, the Company’s common stock price is above $4.75 per share (as adjusted for stock splits, combinations, recapitalizations and the like) for 20 consecutive trading days over a 30-day trading period.
The Preferred Shares are senior to the Company’s common stock with respect to liquidation preference and dividends (in the event declared) in proportion to the relative number of Common Shares on an as-converted basis. The Preferred Shares do not accrue dividends. Upon any liquidation of the Company, before any distribution or payment is made to any other stockholders, each Preferred Share holder is entitled to receive a liquidation payment. The liquidation payment is the greater of (1) the initial purchase price of $7.60 per Preferred Share (equal to $1.90 per common share on an if-converted basis, and subject to adjustment for any stock splits, stock dividends or other recapitalizations) plus any declared and unpaid dividends thereon or (2) such amount per Preferred Share as would have been payable had each Preferred Share been converted into common stock immediately prior to such liquidation. At any time after March 26, 2013, the Company may, at its option, redeem all Preferred Shares for an amount equal to its full liquidation preference.

 

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Redemption and Liquidation Rights
The redemption rights of the Preferred Shares are immediately triggered by the occurrence of certain business events enumerated in the Stock Purchase Agreement with Oak. All such business events are deemed to be within the Company’s control, except beginning in the third quarter of 2009, an event of a change in control of the Company, whether by acquisition or merger. As of August 21, 2009, an event of a change of control of the Company became possible with the effective registration of Safeguard’s holdings in the Company through a registration statement on Form S-3 filed with the SEC (the “Safeguard S-3”). The Safeguard S-3 resulted in the ability of a third-party to acquire over 50% of registered shares of the Company on the open market (see Note 15). Accordingly, the Preferred Shares have been classified as temporary equity (rather than permanent equity) within the accompanying Condensed Consolidated Balance Sheets, as required under applicable GAAP, since all redemption events are not solely within the Company’s control as of September 30, 2010 and December 31, 2009.
The Company’s stock price on the NASDAQ Capital Market closed at $3.38 and $2.65 per common share on September 30, 2010 and December 31, 2009, respectively, which exceeded the Preferred Shares’ $1.90 liquidation value per common share, on an as-converted basis. In accordance with GAAP, Company determined that the liquidation preference for the Preferred Shares was $71.2 million and $55.8 million as of September 30, 2010 and December 31, 2009, respectively, as disclosed in the accompanying Condensed Consolidated Balance Sheets. The liquidation preference was determined by multiplying 21.1 million Common Shares that the Preferred Shares could be converted into by the NASDAQ Capital Market closing price of $3.38 and $2.65 per common share on each date, respectively. As of the date this Quarterly Report was filed with the SEC, the Company believes that the Merger with General Electric is likely to occur. If the Merger is completed, the liquidation preference on the Preferred Shares will be $5.00 per Common Share, and one Preferred Share converts to four Common Shares.
Beneficial Conversion Feature
The Oak Purchase Agreement’s Material Adverse Effect (“MAE”) clause could have allowed Oak, at their sole discretion, to have never completed the Second Oak Closing on May 14, 2009 due to their rights under the Oak Purchase Agreement. Oak’s discretion in completing the Second Oak Closing allowed by the MAE clause, combined with the in-the-money non-detachable conversion feature of the Preferred Shares, resulted in a $4.3 million beneficial conversion feature (the “BCF”) associated with the Second Oak Closing Shares.
The Company recorded the BCF as an increase to accumulated deficit and a coinciding increase of additional paid-in capital as of May 14, 2009, reflected within the accompanying Condensed Balance Sheets as of September 30, 2010 and December 31, 2009. The BCF also served to increase net loss applicable to common stockholders by $4.3 million for the nine months ended September 30, 2009, reflected within the accompanying Condensed Consolidated Statement of Operations. The BCF was calculated using the Company’s $2.65 per common share closing price on May 14, 2009 (the date of the Second Oak Closing), less Oak’s $1.90 contractual purchase price of the Company’s common stock on an if-converted basis. The resulting $0.75 value per share was multiplied by the Second Oak Closing Shares on an if-converted basis, equal to 5.7 million Common Shares.
(14) Contingently Issuable Common Stock
AGI Acquisition Summary
On December 21, 2009 (the “AGI Closing Date”), the Company completed the acquisition of AGI (the “AGI Acquisition”) in accordance with the terms and conditions of the Agreement and Plan of Merger and Reorganization, dated as of December 21, 2009, as amended March 17, 2010, among the Company, AGI, and the other parties named therein (the “AGI Agreement”). As of the AGI Closing Date, AGI had developed 10 prognostic and predictive multivariate immunohistochemistry-based (IHC) biomarkers for use in assessing the recurrence rates of certain cancer types, and the likelihood of a favorable patient response to various treatment options.
The AGI purchase price consisted of 4.4 million of the Company’s Common Shares, inclusive of exchanged stock option awards with an exercise price of $0.40 per share, which were issuable on the Closing Date, and a maximum of an additional 3.2 million shares, inclusive of exchanged stock option awards with an exercise price of $0.40 per share (the “Contingent Shares”) upon the achievement of certain revenue and scientific milestones (the “AGI Milestones”) by December 31, 2012.
The AGI acquisition was accounted for as a business combination under applicable GAAP, requiring the use of the acquisition method of accounting. Accordingly, the purchase price was allocated to the assets acquired and liabilities assumed, based on their estimated fair values on the AGI Closing Date.

 

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Liability Accounting for Variable Shares
As of December 31, 2009, an aggregate 1.4 million of the Contingent Shares met the requirements for liability accounting under applicable GAAP (the “Variable Shares”). The Variable Shares were variable with respect to the number of Common Shares that, depending on the sequence of AGI Milestone achievements, are issuable through December 31, 2012, though limited to an aggregate issuance of the 3.2 million shares, inclusive of exchanged stock option awards. The Company, therefore, recorded a $2.7 million long term liability reported as “contingently issuable common shares” on its Consolidated Balance Sheets as of December 31, 2009. The $2.7 million value was derived from a calculation performed by the Company that involved the estimated probability and timing of Variable Share achievement into a single, present-valued amount, utilizing (i) certain liquidity restrictions on the Variable Shares; (ii) the contingency associated with the Variable Shares; and (iii) the volatility associated with the Company’s stock.
During the three months ended March 31, 2010, 1.5 million of the Contingent Shares became immediately issuable to the former AGI shareholders, based upon the achievement in February and March 2010 of two milestones under the AGI Agreement. As a result of these two milestones being achieved, the Variable Shares no longer met the requirement for liability accounting as of March 17, 2010.
The Company recorded a mark-to-market adjustment for the Variable Shares through March 17, 2010. The adjustment involved comparing the value of the Variable Shares as of December 31, 2009, to their value as of March 17, 2010. The Company recorded $31,000 of expense within “other expense” on its Condensed Consolidated Statements of Operations for the nine months ended September 30, 2010 for this mark to market adjustment. The fair value of the Variable Shares as of March 17, 2010 was derived from a calculation performed by the Company that involved the (i) the Company’s closing stock price on the NASDAQ Capital Market on each of the two milestone achievement dates in February and March 2010 multiplied by the related number of Variable Shares on each of such dates, less (ii) an estimated discount for certain liquidity restrictions on the Variable Shares, incorporating Level 3 inputs (see Note 2(m)).
The Company reclassified the $2.7 million contingently issuable common shares liability reported on its December 31, 2009 Consolidated Balance Sheet to additional paid in capital during the nine months ended September 30, 2010. Accordingly, the contingently issuable common shares liability was $-0- at September 30, 2010, as summarized in the table below.
         
    Contingently Issuable  
    Common Stock  
December 31, 2009
  $ 2,650  
Mark to market adjustment of Variable Shares (non-cash)
    31  
Reclassification of Variable Shares to additional paid in capital
    (2,681 )
 
     
September 30, 2010
  $  
 
     
(15) Subsequent Event
Pending Acquisition by General Electric
On October 22, 2010, the Company entered into the Merger Agreement with General Electric, and the Purchaser, pursuant to which General Electric, through the Purchaser, will commence the Offer to acquire all of the outstanding shares of the Company’s Common Shares, and all of the outstanding shares of the Company’s Preferred Shares at a price per Common Share of $5.00 and a price per Preferred Share of $20.00.
Completion of the Offer is subject to several conditions, including (i) that a majority of the outstanding Common Shares (determined on a fully diluted basis) must be tendered and not validly withdrawn prior to the expiration of the Offer; (ii) that a majority of any Preferred Shares then outstanding must be tendered and not validly withdrawn prior to the expiration of the Offer;, (iii) the expiration of the applicable waiting period under the HSR Act; (iv) the absence of a material adverse effect on the Company; and (v) other customary closing conditions.

 

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Following consummation of the Offer, Purchaser will be merged with and into the Company (the “Merger”), with the Company surviving as a wholly-owned indirect subsidiary of General Electric. Upon completion of the Merger, each Share outstanding immediately prior to the effective time of the Merger (excluding those Shares that are held by General Electric, Purchaser, the Company or their wholly-owned subsidiaries, or by stockholders who properly exercise their appraisal rights under the Delaware General Corporation Law) will be canceled and converted into the right to receive the applicable Merger Consideration. Consummation of the Merger is subject to completion of the Offer, the absence of any legal prohibition and, if necessary, approval of the Company stockholders.
The Merger Agreement may be terminated under certain customary circumstances, including by General Electric if the Company’s Board of Directors withdraws or changes its recommendation in support of the Offer, or by the Company if the Company’s Board of Directors decides to accept a Superior Proposal (as defined in the Merger Agreement). In each of these cases, the Company may be required to pay General Electric a termination fee of $18.0 million (the “Breakup Fee”).
In addition, if the Offer expires or terminates without any Shares being purchased or is not completed before April 22, 2011, either General Electric or the Company may terminate the Merger Agreement. If prior to the date of any such termination, a competing acquisition proposal is publicly disclosed and the Company enters into an agreement to consummate, or actually consummates, a competing acquisition proposal within six months after such termination, then the Company may also be required to pay General Electric the Breakup Fee upon completion of such competing acquisition proposal.
In connection with the Merger, all outstanding stock options, whether vested or unvested, will be deemed to be exercised and terminated in exchange for a payment in cash of the excess, if any, of the Common Offer Price over the exercise price per share of such stock option; all vesting restrictions applicable to shares of restricted common stock shall be fully accelerated, and such shares of restricted common stock shall be cancelled and converted into the right to receive the. Common Offer Price in the Merger; and all outstanding warrants will be converted into the right to receive the excess, if any, of the Common Offer Price over the exercise price per share of such warrant.

Stockholder Letters

On October 22, 2010, Oak and Safeguard the (“Supporting Stockholders”) entered into a separate letter agreement with the Company (collectively, the “Stockholder Letters”), pursuant to which Oak and Safeguard each committed to pay a cash retention bonus to certain eligible officers of the Company upon the consummation of a Change in Control (as defined in the Stockholder Letters). The consummation of the transactions contemplated by the Merger Agreement will be considered a Change in Control for purposes of the Stockholder Letters. The terms and conditions of each Stockholder Letter are materially identical to each other, as summarized below.

Each Stockholder Letter provides that a total of at least eight officers of the Company are eligible to receive a retention bonus, including the following named executive officers of the Company: Ronald A. Andrews, the Company’s Chief Executive Officer and Vice Chairman; Michael R. Rodriguez, the Company’s Chief Financial Officer; Michael J. Pellini, the Company’s President and Chief Operating Officer; and David J. Daly, the Company’s Senior Vice President of Commercial Operations. The aggregate amount of retention bonuses that may become payable to all eligible officers under the Shareholder Letters will not exceed $12.0 million. The named executive officers have been allocated the following amount of retention bonuses, any payment of which is subject to the terms and conditions of the Shareholder Letter: $3.7 million to Mr. Andrews, $1.1 million to Mr. Rodriguez, $2.2 million to Dr. Pellini, and $2.1 million to Mr. Daly. These allocations may be modified by mutual agreement of the Supporting Stockholders and the Company (subject to approval of a majority of the members of the Compensation Committee of the Board not affiliated with either Supporting Stockholder). An officer will be eligible to receive payment of the allocated amount of retention bonus if a Change in Control occurs prior to the termination of the Stockholder Letter, and either (i) the officer is employed by the Company on the date on which a Change in Control occurs, or (ii) the officer’s employment is terminated by the Company without “Cause” or by the officer for “Good Reason” (each as defined in the Stockholder Letters) following the effective date of the Stockholder Letter and prior to the date of such Change in Control. Subject to the officer’s execution of a release of claims against the applicable Supporting Stockholder and the Company, approval by the Compensation Committee of the Board, and payment of applicable taxes, any retention bonus that becomes payable under the Stockholder Letter will be paid on the date on which a Change in Control occurs. The Company has agreed to pay up to $1.3 million of excise taxes under Internal Revenue Code Section 4999 that directly or indirectly result from payments of retention bonuses under the Stockholder Letters (grossed up to cover any additional taxes that result from the payment of such excise taxes by the Company).

Each Stockholder Letter may be terminated, amended or modified by mutual agreement of the Company (subject to approval of a majority of the members of the Audit Committee of the Board) and the Supporting Stockholder at any time prior to the consummation of a Change in Control. In addition, each Stockholder Letter will automatically terminate, unless extended in writing by the Company and the Supporting Stockholder, if (i) the Company is not a party to a definitive agreement providing for a Change in Control for a period of at least 15 consecutive business days following the effective date of the Stockholder Letter and prior to the consummation of a Change in Control, or (ii) the other Stockholder Letter is terminated or materially amended to reduce the amount of the commitment of the other Supporting Stockholder to pay retention bonuses thereunder without the consent of the Supporting Stockholder.

Litigation
Following announcement of the Merger Agreement on October 22, 2010, several lawsuits were filed by plaintiffs who allegedly hold Common Shares, suing on behalf of themselves and on behalf of an alleged class of the Company’s public stockholders. Five suits have been filed in the Superior Court of California, County of Orange: on October 25, 2010 a suit was filed by plaintiff Herbert Silverberg (“Silverberg Complaint”) naming the Company, each member of the Company’s Board of Directors, Safeguard, Oak and Purchaser; on October 26, 2010 a suit was filed by plaintiff Southwest Ohio Regional Council of Carpenters Pension Plan (“Southwest Ohio Complaint”) naming the Company, each member of the Company’s Board of Directors, Purchaser, General Electric and 25 unidentified “Does”; and on October 28, 2010 three suits were filed; by plaintiff Dolph Haege naming the Company, each member of the Company’s Board of Directors, Purchaser and General Electric, by plaintiff Michael Sassone (“Sassone Complaint”) naming the same defendants as the Southwest Ohio Complaint and by Frank Sigl (“Sigl Complaint”) also naming the same defendants as the Southwest Ohio Complaint. In addition, a suit was filed in Delaware Court of Chancery on October 27, 2010 by plaintiff Bette Kurzweil naming the Company, each member of the Company’s Board of Directors, General Electric, GE Healthcare, and Purchaser. The Company has been notified that two additional cases have been filed, but, as of the date this quarterly report on Form 10–Q was filed with the SEC, the Company has not received the related complaints.
Plaintiffs in each case allege that the Company’s Board of Directors breached their fiduciary duties to the Company’s stockholders, and that the Merger Agreement between the Company and General Electric involves an unfair price, an inadequate sales process, unreasonable deal protection devices, and that defendants agreed to the Merger to benefit themselves personally. Several of the Complaints also allege that Safeguard and Oak together control the Company and breached fiduciary duties allegedly owed by controlling shareholders to the Company’s stockholders. In addition, in each case, the plaintiffs allege that either the Company, General Electric, GE Healthcare, and/or the Purchaser, aided and abetted the alleged breach of fiduciary duty by the other defendants.
The complaints seek to enjoin the transaction or in the alternative award the respective plaintiffs and alleged class damages plus pre- and post-judgment interest, as well as other unspecified attorney’s and other fees and costs, and other relief. The Southwest Ohio Complaint, Sassone Complaint, and Sigl Complaint also seek to impose a constructive trust in favor of plaintiff and the alleged class upon any benefits improperly received by defendants.
The Company believes that these actions have no merit and intends to defend vigorously against them. The Company has not recorded any accrual for these claims within the accompanying Condensed Consolidated Financial Statements.

 

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Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking Statements
This Quarterly Report on Form 10-Q contains forward-looking statements that are based on current expectations, estimates, forecasts and projections about us, the industries in which we operate and other matters, as well as management’s beliefs and assumptions and other statements regarding matters that are not historical facts. These statements include, in particular, statements about our plans, strategies and prospects. For example, when we use words such as “projects,” “expects,” “forecasts,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “should,” “would,” “could,” “will,” “opportunity,” “potential” or “may,” variations of such words or other words that convey uncertainty of future events or outcomes, we are making forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”) and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”).
Our forward-looking statements are subject to risks and uncertainties. Factors that might cause actual results to differ materially, include, but are not limited to: delays in completing, or the failure to complete, the proposed Merger with General Electric due to a failure to satisfy closing conditions or other reasons, our ability to continue to develop and expand our diagnostic services business, uncertainties inherent in our product development programs, our ability to attract and retain highly qualified managerial, technical, and sales and marketing personnel, our ability to maintain compliance with financial and other covenants under our credit facility, our ability to successfully manage our in-house billing and collection processes, the continuation of favorable third-party payor reimbursement for laboratory tests, changes in federal payor regulations or policies, including adjustments to Medicare reimbursement rates, that may affect coverage and reimbursement for our laboratory diagnostics services, our ability to obtain additional financing on acceptable terms or at all, unanticipated expenses or liabilities or other adverse events affecting cash flow, uncertainty of success in identifying and developing new diagnostic tests or novel markers, our ability to fund development of new diagnostic tests and novel markers, and to obtain adequate patent protection covering our use of these tests and markers, and the amount of resources we determine to apply to novel marker development and commercialization, the risk to us of infringement claims and the possibility of the need to license intellectual property from third parties to avoid or settle such claims, FDA initiatives to regulate the development, validation and commercialization of laboratory developed tests, failure to obtain regulatory approvals and clearances required to conduct clinical trials if/when required and/or to commercialize our services and underlying diagnostic applications, our ability to compete with other technologies and with emerging competitors in novel cancer diagnostics and our dependence on third parties for collaboration in developing new tests, and those factors set forth under the captions “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Risk Factors” in this Quarterly Report on Form 10-Q and disclosures made under the captions “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Risk Factors” and “Financial Statements and Supplementary Data” included in our Annual Report on Form 10-K for the year ended December 31, 2009. Many of these factors are beyond our ability to predict or control. In addition, as a result of these and other factors, our past financial performance should not be relied upon as an indication of future performance. All forward-looking statements attributable to us, or to persons acting on our behalf, are expressly qualified in their entirety by this cautionary statement.
We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. In light of these risks and uncertainties, the forward-looking events and circumstances discussed in this Quarterly Report on Form 10-Q might not occur.
Pending Acquisition by General Electric
On October 22, 2010, the Company entered into a definitive Agreement and Plan of Merger (the “Merger Agreement”) with General Electric Company, a New York corporation (“General Electric”), and Crane Merger Sub, Inc., a Delaware corporation and an indirect wholly-owned subsidiary of General Electric (“Purchaser”), pursuant to which General Electric, through the Purchaser, will commence an offer (the “Offer”) to acquire all of the outstanding shares of the Company’s common stock, par value $0.01 per share (the “Common Shares”), and all of the outstanding shares of the Company’s Series A Convertible Preferred Stock, par value $0.01 per share (the “Preferred Shares,” and together with the Common Shares, the “Shares”), at a price per Common Share of $5.00 (the “Common Offer Price”) and a price per Preferred Share of $20.00 (together with the Common Offer Price, the “Merger Consideration”).
Completion of the Offer is subject to several conditions, including (i) that a majority of the outstanding Common Shares (determined on a fully diluted basis) must be tendered and not validly withdrawn prior to the expiration of the Offer; (ii) that a majority of any Preferred Shares then outstanding must be tendered and not validly withdrawn prior to the expiration of the Offer;, (iii) the expiration of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended (the “HSR Act”); (iv) the absence of a material adverse effect on the Company; and (v) other customary closing conditions.

 

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Following consummation of the Offer, Purchaser will be merged with and into the Company (the “Merger”), with the Company surviving as a wholly-owned indirect subsidiary of General Electric. Upon completion of the Merger, each Share outstanding immediately prior to the effective time of the Merger (excluding those Shares that are held by General Electric, Purchaser, the Company or their wholly-owned subsidiaries, or by stockholders who properly exercise their appraisal rights under the Delaware General Corporation Law) will be canceled and converted into the right to receive the applicable Merger Consideration. Consummation of the Merger is subject to completion of the Offer, the absence of any legal prohibition and, if necessary, approval of the Company stockholders.
Overview and Outlook
We are an advanced oncology diagnostics services company, headquartered in Aliso Viejo, California, and incorporated in 1993. Our mission is to help improve the lives of those affected by cancer through translating cancer discoveries into better patient care. We combine innovative technologies, clinically meaningful diagnostic tests, and world-class pathology expertise to provide advanced diagnostic services that assess and characterize cancer for physicians in the course of treating their patients. We also provide a complete complement of commercial services to biopharmaceutical companies and other research organizations, including diagnostic testing services, development of companion diagnostics, and clinical trial support. Our physician customers are connected to our Internet-based portal, PATHSiTE®, that delivers high resolution images and critical interpretative reports resulting from our diagnostic testing services.
Our strategic focus is centered on identifying high-value opportunities that enable the expansion and differentiation of our cancer diagnostic services within the highly competitive medical laboratories sector in which we operate. We commercialize our services through our highly developed commercial channels with community pathologists, oncologists, universities, hospitals, and pharmaceutical researchers. An important aspect of our strategy is to develop and expand our diagnostic offerings by applying our technical and medical expertise in combination with available intellectual property. Our diagnostic tests utilize “biomarkers” which are present in human tissues, cells, or fluids to aid in understanding a cancer patient’s diagnosis, prognosis, and expected outcome from the use of specific therapeutics. We believe that diagnostic tests which utilize biomarkers may help bring clarity to critical decision making points related to cancer treatment for healthcare providers and the biopharmaceutical industry.
In 2010, we are focused on four primary areas:
    Maintain net revenue growth by reaching new customers and increasing “same store sales” to our existing customers with our new services;
    Maintain financial discipline to achieve profitability;
    Leverage our industry-leading commercial channel and successfully launch new proprietary diagnostic tests into this channel; and
    Maximize the effectiveness of our billing and collection function.
Our Services
Overview
We provide a wide range of cancer diagnostic testing and consultative services that include technical laboratory services and professional interpretation of cancer diagnostic reports by licensed physicians that specialize in anatomic pathology and hematopathology. Our reports and analyses are provided to customers through PATHSiTE®, our Internet-based portal.
Our anatomic pathology services assess and evaluate the most common types of solid tumors: breast, colon, lung, and prostate, representing over 80 percent of tumor biopsies in the United States. We also offer an extensive menu of hematopathology testing for leukemia and lymphoma. Our laboratory continues to expand its service offerings as new biomarkers emerge. We also provide a complete complement of commercial services to biopharmaceutical companies and other research organizations, including diagnostic testing services, development of companion diagnostics, and clinical trial support.

 

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New Tests Launched in 2010
Clarient Insight®Dx Pulmotype®
In February 2010, we launched Clarient Insight®Dx Pulmotype® (“Pulmotype”), a five antibody immunohistochemistry (IHC) test that can be used to aid in the histological distinction between adenocarcinoma and squamous cell carcinoma in non-small cell lung cancer tumor specimens. The histologic classification of non-small cell lung tumors has gained clinical relevance because newly developed targeted therapies show different clinical effectiveness or toxicity dependent upon the histology of the tumor. Non-small cell lung cancer accounts for approximately 85% of the more than 200,000 lung cancer cases diagnosed each year. There is currently no other widely accepted molecular-based tool to help distinguish these different histological types. Pulmotype can, therefore, assist pathologists through complementing their morphological assessment of lung types, resulting in better diagnostic precision for more targeted therapeutic decisions for patients.
Methodologies Employed in Our Laboratory Services
Our extensive menu of over 350 diagnostic tests used to assess and characterize cancer includes various methodologies which incorporate the latest laboratory technologies: IHC, flow cytometry, polymerase chain reaction (“PCR”), fluorescent in situ hybridization (“FISH”), cytogenetics, and histology, which are briefly described below:
    IHC refers to the process of localizing proteins in cells of a tissue section and relies on the principle of antibodies binding specifically to antigens in biological tissues. IHC is widely used in the diagnosis of abnormal cells such as those found in cancerous tumors. Specific molecular markers are characteristic of particular cellular events such as proliferation or cell death (apoptosis). IHC is also used to understand the distribution and localization of biomarkers and differentially expressed proteins in various parts of biological tissue.
    Flow cytometry is a technology that measures and analyzes multiple physical characteristics of single particles, usually cells, as they flow in a fluid stream through a beam of light. The properties measured include a particle’s relative size, relative granularity or internal complexity, and relative fluorescence intensity. The use of flow cytometry assists a pathologist in diagnosing a wide variety of leukemia and lymphoma neoplasms. Flow cytometry is also used to monitor patients through therapy to determine whether the disease burden is increasing or decreasing, otherwise known as minimal residual disease monitoring.
    PCR is a molecular biology technique that uses small DNA probes to target and amplify specific gene sequences for further analysis. The amplification occurs through the use of the polymerase chain reaction which consists of repeated cycles of heating and cooling the specimen in the presence of specific reagents. The technique is extremely sensitive and rapid, and offers direct detection and visualization of gene sequences.
    FISH is a molecular technique that can be used to detect and localize the presence or absence of specific DNA sequences on chromosomes. The technique uses fluorescent probes that bind to only those parts of the chromosome with which they show a high degree of sequence similarity. Fluorescence microscopy is used to visualize the fluorescent probes bound to the chromosomes. FISH is often used for finding specific features of the genome for use in genetic counseling, medicine, and species identification. FISH can be used to help identify a number of gene alternations, such as amplification, deletions, and translocations.
    Histology is the study of the microscopic structure of tissues. Through histology services, a pathologist attempts to determine the diagnosis of disease. Through structural and other changes in cells, tissues, and organs, pathologists can use a number of tools to establish a diagnosis of the type of disease suffered by the patient, a prognosis on the likely progression of the disease, and a determination as to which therapies are most likely to be effective in treating the patient. In addition to histology service, a number of molecular studies can now be run on these samples to gain further insight on prognostic and predictive indicators.
    Cytogenetics involves genetic testing in cancer to assess a variety of genetic disorders and hematologic malignancies. It involves looking at the chromosome structure to identify changes from patterns seen in normal chromosomes.

 

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Employees
As of September 30, 2010, we, inclusive of CPS (defined in Note 1(a) to the Condensed Consolidated Financial Statements), had 405 employees: 236 in laboratory diagnostics, research and development, and related support positions; 112 in executive, finance, information technology, billing, and administrative positions; and 57 in sales and marketing positions. We are not subject to any collective bargaining agreements, and we believe that our relationship with our employees is good. In addition to full-time employees, we use various independent contractors, primarily for certain of our service development and administrative activities.
Billing
Overview
Our net revenue is predominately derived from performing oncology diagnostic testing services which are billed to third parties (Medicare and private health insurers), clients (pathologists, hospitals, clinics, and biopharmaceutical companies), and patients. Our laboratory diagnostic services are eligible for third-party reimbursement under well-established medical billing codes. These billing codes are known as Healthcare Common Procedure Coding Systems and incorporate Medicare’s Common Procedural Terminology (“CPT”) codes, providing the means by which Medicare/Medicaid and private health insurers identify medical services that are eligible for reimbursement. The Medicare/Medicaid reimbursement amounts are based on the relative value of medical services with associated CPT codes, as established by the Centers for Medicare & Medicaid Services (“CMS”) with recommendations from the American Medical Association’s Relative Value Update Committee.
CMS reimbursement rates, which provide the basis for substantially all of our billings, are dictated by CPT codes under two distinct reimbursement schedules: a Physician Fee Schedule and a Clinical Fee Schedule. We have the requisite provider numbers for both schedules, though the vast majority of our billings fall under the Physician Fee Schedule. The relevant CPT billing codes under the Physician Fee Schedule further distinguishes between “Technical” diagnostic services (the performance of a diagnostic test), “Professional” services (the professional interpretation of a diagnostic test, typically performed by a licensed physician), and “Global” services (the combination of Technical and Professional services).
The amount that we are able to be reimbursed from private health insurers is based on several factors, including the type of health insurance coverage (for example, health maintenance organization or preferred provider organization), whether the services are considered to be in network or out of network by the health insurance provider, and the amount of any co-pays or deductibles for which the patient is responsible.
Payor Classes
Third-party billing. The majority of our net revenue is generated from patients who use health insurance coverage through Medicare or private health insurers.
Client billing. We generally establish arrangements with our clients that allow us to bill them an agreed-upon amount for each type of service provided, though our client pricing is generally based upon the effective CPT code rate. It is generally our clients’ responsibility to seek reimbursement from their patients’ health insurance companies and/or the patients themselves.
Patient billing. We bill patients with health insurance co-payment obligations and deductibles (indirect billings), as well as patients without health insurance coverage (direct billings).
We do not rely on any single customer, or subset of customers, for a significant portion of our net revenue and we therefore have minimal risk of customer concentration. We, however, are dependent upon reimbursement from Medicare and its designated administrator for a substantial portion of our services. Any significant delay in payment from Medicare, or any reduction in the published Medicare fee schedules could impact our operating results, cash flows, and/or financial condition.

 

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CPT Code Summary — 2010 and 2009
The following table summarizes the Medicare reimbursement rates under the Physician Fee Schedule and Clinical Laboratory Fee Schedule for the most common CPT codes used in our laboratory services (“Fees”). The “TC” modifier denotes Technical services, “26” modifier denotes Professional services, and no modifier denotes Global services (except CPT codes 83891, 83896, 83898, 83907, and 83914 which are Technical). The below CPT codes, which provide the basis for our reimbursement rates per test, are associated with a substantial portion of our net revenue:
                                     
                                2010 Fees  
                                (6/1/10 – 11/30/10)  
        2010 Fees     2010 Fees*     2009 Fees     Change  
CPT Code   General Description of Service   (1/1/10 – 5/31/10)     (6/1/10 – 11/30/10)     (1/1/09 – 12/31/09)     From 2009  
88185
  Flow cytometry (cell surface, cytoplasmic, or nuclear marker)   $ 58     $ 60     $ 59       1.7 %
 
                                   
88342 — TC
  IHC (including tissue immunoperoxidase)   $ 72     $ 74     $ 72       2.8 %
88342 — 26
  IHC (including tissue immunoperoxidase)   $ 45     $ 46     $ 44       4.5 %
88342
  IHC (including tissue immunoperoxidase)   $ 117     $ 119     $ 116       2.6 %
 
                                   
88361 — TC
  IHC (computer assisted)   $ 112     $ 114     $ 116       (1.7 )%
88361 — 26
  IHC (computer assisted)   $ 60     $ 62     $ 62        
88361
  IHC (computer assisted)   $ 173     $ 176     $ 178       (1.1 )%
 
                                   
88368 — TC
  FISH (manual)   $ 181     $ 184     $ 182       1.1 %
88368 — 26
  FISH (manual)   $ 68     $ 70     $ 70        
88368
  FISH (manual)   $ 249     $ 254     $ 251       1.2 %
 
                                   
88367 — TC
  FISH (computer assisted)   $ 221     $ 225     $ 222       1.4 %
88367 — 26
  FISH (computer assisted)   $ 66     $ 67     $ 66       1.5 %
88367
  FISH (computer assisted)   $ 286     $ 292     $ 288       1.4 %
 
                                   
83891
  PCR — Isolation or extraction of highly purified NA   $ 6     $ 6     $ 6        
83896
  PCR- NA probe   $ 6     $ 6     $ 6        
83898
  PCR — Amp of patient NA, each NA sequence   $ 24     $ 24     $ 24        
83907
  PCR — Lysis of cells prior to NA extraction (FFPE Only)   $ 19     $ 19     $ 20       (5.0 )%
83914
  PCR — Mutation identification   $ 24     $ 24     $ 24        
83912 — 26
  PCR — Interpretation and report   $ 20     $ 20     $ 19       5.3 %
88381
  PCR — Microdissection, manual   $ 234     $ 238     $ 257       (7.4 )%
     
*   The presented 2010 rates are through November 30, 2010 only, as the Medicare reimbursement rates under the Physician Fee Schedule for December 2010 and beyond, continue to be the subject of ongoing deliberations in U.S. Congress as of the date this Quarterly Report on Form 10-Q was filed with the SEC.

 

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Characteristics of Our Net Revenue and Expenses
Net revenue
Net revenue is derived from billing governmental and private health insurers, clients, and patients for the services that we provide. We report revenue net of “contractual allowances” which is defined and discussed within the “Critical Accounting Policies and Estimates” section below. Bad debt expense is recorded as an operating expense, and is a key component of our overall operating performance.
Cost of services
Cost of services includes compensation (including stock-based compensation) and benefits of laboratory personnel, laboratory support personnel, and pathology personnel. Cost of services also includes depreciation expense of laboratory equipment, laboratory supplies expense, allocated facilities-related expenses, and certain direct costs related to the performance of our services, such as shipping.
Sales and marketing
Sales and marketing expenses primarily consist of the compensation and benefits of our sales force, sales support personnel, and marketing personnel. Sales and marketing expenses also include those costs attributable to marketing our services to community pathology practices, oncology practices, hospitals, and clinics.
General and administrative
General and administrative expenses primarily include compensation (including stock-based compensation) and benefits for personnel that support our general operations such as: information technology, executive management, billing and collection, client services, financial accounting, purchasing, and human resources. General and administrative expenses also include allocated facilities-related expenses, insurance, recruiting, legal, audit, and other professional services.
Bad debt
Bad debt consists of estimated uncollectible accounts, or portions thereof, recorded during the period. The process of evaluating the required allowance for doubtful accounts, and resulting bad debt expense, at each period end involves an evaluation of historical collection experience to aged receivable balances by payor class, and also involves our significant assumptions and judgment for those receivables we believe are unlikely for collection.
Research and development
Research and development costs are expensed as incurred. Research and development expenses consist of compensation and benefits for research and development personnel, license fees, supplies cost, costs of accessing clinical cohorts for ongoing studies, research and development arrangements with consultants and other third parties, allocated information technology personnel, and allocated facility-related costs. Our research and development activities primarily relate to the development and validation of diagnostic tests in connection with our diagnostic services, as well as the development of technology to electronically deliver such services to our customers.
Critical Accounting Policies and Estimates
Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). The preparation of financial statements requires us to make estimates and assumptions that effect the reported amounts of assets, liabilities, and the disclosure of contingent assets and liabilities as of the dates of the accompanying Condensed Consolidated Balance Sheets, and net revenue and expenses for the periods presented within the accompanying Condensed Consolidated Statements of Operations.
Management believes that the following estimates are the most critical to understand and evaluate our reported financial results, which require management’s most difficult, subjective, or complex judgments, resulting from the need to make estimates that are inherently uncertain.

 

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Revenue recognition
Net revenue for our diagnostic services is recognized at the time of completion of discreet diagnostic tests which comprise a patient encounter at a specific date of service (commonly referred to as an “accession”). Our services are billed to various payors, including Medicare/Medicaid, private health insurance companies, healthcare institutions, and patients. We utilize published fee schedules from CMS for amounts we bill to Medicare/Medicaid for our services and recognize as net revenue. We report net revenue for our services from contracted payors, including certain private health insurance companies and healthcare institutions, based on the contracted rate (which is generally based on the CMS published fee schedule) or in certain instances, our estimate of such rate.
We report net revenue from non-contracted payors, including certain private health insurance companies, based on the amount expected to be approved for payment for our services, which are net of standard discounts, commonly referred to as “contractual allowances” in our sector. Any subsequent revenue adjustments for non-contracted payors are recognized in the period realized. Patient revenue is divided into two classes: direct bill and indirect bill. The amount recognized as net revenue for direct bill patients is based on a standard multiple of the CMS published fee schedule. The amount recognized as net revenue for indirect bill patients is based on their co-pay or deductible obligation with their primary insurance payor.
Allowance for doubtful accounts and bad debt expense
An allowance for doubtful accounts is recorded for estimated uncollectible amounts due from our various payor groups. The process for estimating the allowance for doubtful accounts involves significant assumptions and judgments. The allowance for doubtful accounts is adjusted periodically, and is principally based upon an evaluation of our historical collection experience of aged accounts receivable, among various payor classes. After appropriate collection efforts, accounts receivable are written off and deducted from the allowance for doubtful accounts. Additions to the allowance for doubtful accounts are charged to bad debt expense.
The payment realization cycle for certain governmental and managed care payors can be lengthy. The collection cycle often involves payor denial of our billed amounts, requiring us to appeal and follow an adjudication process. Resulting periodic adjustments to bad debt expense may be significant.
Stock-based compensation
We value stock-based awards, including stock options and restricted stock, as of the date of grant. We use the Black-Scholes option-pricing model in valuing granted stock options. The fair value of granted restricted stock awards is equal to our closing stock price on the date of grant. We recognize stock-based compensation expense, net of estimated forfeitures, using the straight-line method over the requisite service period. Forfeitures are estimated at the time of grant, and prospectively revised if actual forfeitures differ from those estimates. We classify compensation expense related to these awards in the Condensed Consolidated Statements of Operations based on the department to which the recipient reports.

 

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Results of Operations
Continuing Operations Overview — Three Months Ended September 30, 2010 and 2009
The following table presents our results of continuing operations and the percentage of net revenue for each line item for the three months ended September 30, 2010 and 2009 (in thousands):
                                 
    Three Months Ended  
    September 30, 2010     September 30, 2009  
Net revenue
  $ 31,441       100.0 %   $ 21,425       100.0 %
Cost of services
    12,479       39.7 %     9,796       45.7 %
 
                       
Gross profit
    18,962       60.3 %     11,629       54.3 %
Operating expenses:
                               
Sales and marketing
    5,225       16.6 %     4,194       19.6 %
General and administrative
    6,451       20.5 %     6,030       28.1 %
Bad debt
    3,161       10.1 %     4,214       19.7 %
Research and development
    1,455       4.6 %     282       1.3 %
 
                       
Total operating expenses
    16,292       51.8 %     14,720       68.7 %
 
                       
Income from operations
    2,670       8.5 %     (3,091 )     (14.4 )%
Interest expense, net of interest income
    147       0.5 %     144       0.7 %
Income tax expense
    181       0.6 %            
 
                       
Income from continuing operations, net of income taxes
  $ 2,342       7.4 %   $ (3,235 )     (15.1 )%
 
                       
Total Accessions
Each test we perform relates to a specimen encounter derived from a patient, and received by us on a specific date. Such specimen encounter is commonly referred to as an “accession” in the laboratory sector. The following table presents the total number of our accessions:
                         
    Three Months Ended September 30,        
    2010     2009     Percent change  
    (in thousands)        
 
                       
Total Accessions
    43       35       22.9 %
 
                 
Test Volumes by General Test Type
Our diagnostic services incorporate a variety of testing methodologies for each of the below categories, as discussed in Item 2, Our Services. The following table presents our test volumes by general test type:
                         
    Three Months Ended September 30,        
    2010     2009     Percent change  
    (in thousands)        
 
                       
Solid tumor, including breast prognostics
    96       84       14.2 %
Leukemia / Lymphoma
    201       150       34.0 %
Molecular diagnostics
    9       6       50.0 %
 
                 
Total test volume
    306       240       27.5 %
 
                 

 

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Average Net Revenue and Average Cost of Services Per Accession
The following table presents our average net revenue and average cost of services per accession:
                         
    Three Months Ended September 30,        
    2010     2009     Percent change  
Average net revenue per accession
  $ 731     $ 612       19.4 %
Average cost of services per accession
    290       280       3.6 %
 
                 
 
 
Gross profit per accession
  $ 441     $ 332       32.8 %
 
                 
Average Net Revenue and Average Cost of Services Per Test
The following table presents our average net revenue and average cost of services per test:
                         
    Three Months Ended September 30,        
    2010     2009     Percent change  
Average net revenue per test
  $ 103     $ 89       15.7 %
Average cost of services per test
    41       41        
 
                 
Gross profit per test
  $ 62     $ 48       29.2 %
 
                 
Net Revenue by Payor Class
The following table presents our net revenue by payor class:
                                 
    Three Months Ended September 30,  
    2010     2009  
    (in thousands)  
 
                               
Governmental health insurance (Medicare, Medicaid)
  $ 10,762       34 %   $ 8,210       39 %
 
                               
Private health insurance
    11,959       38 %     7,792       36 %
 
                               
Clients (pathologists, hospitals, clinics, and biopharmaceutical companies)
    6,825       22 %     4,279       20 %
 
                               
Patients
    1,895       6 %     1,144       5 %
 
                       
 
                               
Total
  $ 31,441       100 %   $ 21,425       100 %
 
                           

 

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Active Customers
The following table presents our estimated active customer count. We consider an active customer to be any customer that has ordered our services within the six months prior to September 30, 2010 and 2009, respectively:
                         
    As of September 30,        
    2010     2009     Percent change  
 
                       
Active customers
    1,444       1,150       25.6 %
 
                 
Net Revenue per Full Time Equivalent Employee
The following table presents average net revenue per full time equivalent (“FTE”) employee(a), including the employees of CPS:
                         
    Three Months Ended        
    September 30,        
    2010     2009     Percent change  
    (in thousands)        
 
                       
Net revenue per FTE employee
  $ 80     $ 65       23.1 %
 
                 
     
(a)   Represents our average number of company-wide employees during the respective period, as adjusted for part-time personnel, utilizing a typical 40 hour work week.
Three Months Ended September 30, 2010 versus September 30, 2009
Net Revenue
                                 
    Three Months Ended                
    September 30,             Percent  
    2010     2009     Variance     change  
    (in thousands)              
 
                               
Net revenue
  $ 31,441     $ 21,425     $ 10,016       46.7 %
Our 46.7% net revenue increase resulted from a 27.5% increase in diagnostic services test volume, and a 19.4% increase in average net revenue per accession in the three months ended September 30, 2010, as compared to the prior year period. See the above Billing section for a table of Medicare reimbursement rates under the Physician Fee Schedule and Clinical Fee Schedule for the most common CPT codes associated with our laboratory services in 2010 and 2009.
Our net revenue growth was enabled by our expanded capabilities and service offerings which utilize the test methodologies of IHC, flow cytometry, FISH, and molecular/PCR, and our accompanying sales and marketing efforts. We anticipate that net revenue will continue to increase as we further execute our strategy of expanding our diagnostic service offerings, and further execute our associated sales and marketing plan.
Cost of Services, Gross Profit, and Gross Margin
                                 
    Three Months Ended                
    September 30,             Percent  
    2010     2009     Variance     change  
    (in thousands)              
Cost of services
  $ 12,479     $ 9,796     $ 2,683       27.4 %
Gross profit
    18,962       11,629       7,333       63.1 %
Gross margin percentage (gross profit as a percent of net revenue)
    60.3 %     54.3 %                

 

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The $2.7 million increase in cost of services was driven by a 27.5% increase in test volume, and was primarily related to: additional laboratory personnel costs of $0.9 million; increased laboratory supplies of $0.5 million; additional courier expenses of $0.6 million; and increased cost of tests performed on our behalf by other laboratories of $0.6 million.
Our gross margin percentage (gross profit divided by net revenue) for the three months ended September 30, 2010 of 60.3%, increased by 6.0%, as compared to the prior year period. The gross margin increase was primarily driven by our 46.7% increase in net revenue. A significant portion of our service costs are fixed, or only partially variable in nature. Accordingly, as our testing volumes grow, we realize improved economies of scale and improved productivity, as measured by the metric of specimens prepared and tested by month, per FTE laboratory employee. Gross margins could be adversely affected, however, if Medicare reimbursement rates are decreased effective November 30, 2010, or beyond.
Operating Expenses and Interest Expense, net
                                 
    Three Months Ended                
    September 30,             Percent  
    2010     2009     Variance     change  
    (in thousands)              
Sales and marketing
  $ 5,225     $ 4,194     $ 1,031       24.6 %
 
                               
General and administrative
    6,451       6,030       421       7.0 %
Bad debt
    3,161       4,214       (1,053 )     (25.0 )%
Research and development
    1,455       282       1,173       416 %
Interest expense, net of interest income
    147       144       3       2.1 %
Sales and marketing. The $1.0 million increase for the three months ended September 30, 2010 as compared to 2009 was primarily related to $0.9 million of additional sales and marketing personnel related costs, including sales commissions. The remaining $0.1 million increase was related to our expanded advertising and promotion campaign costs.
General and administrative. The $0.4 million increase is related to several factors which include: (i) a $0.4 million increase in personnel expenses (including relocation and recruiting expenses, and stock-based compensation). The increased expenses, to support our growth, were principally associated with our billing and collection and information technology functions, (ii) a $0.1 million increase in legal expenses associated with corporate development activity, (iii) a $0.1 million increase in facility expenses associated with the continued expansion of our Aliso Viejo, California facility, and (iv) a $0.1 million increase in general insurance expenses. Such increases were partially offset by a $0.3 million reduction in consulting fees.
Bad debt. Bad debt expense decreased by 25.0% for the three months ended September 30, 2010 as compared to 2009. The bad debt expense we recorded for the three months ended September 30, 2010 was based upon an evaluation of our historical collection experience of aged accounts receivable, for our various payor classes.
In September 2008, our in-house billing and collection department began operations, using licensed third-party billing and collection software. As of September 30, 2009 and for the three months then ended, a substantial portion of our accounts receivable balance that was billed by our former outsourced billing and collection provider had either been written off, or fully-reserved within our total allowance for doubtful accounts, through the recording of bad debt expense.
We expect that bad debt expense as a percentage of net revenue will gradually decrease to the high single digit level over the next four to five quarters, as we more effectively manage our billing and collection function and continue to improve our billing and collection processes.
Research and development. The $1.2 million increase in research and development expenses was primarily driven by $0.2 million of intangible asset amortization for the three months ended September 30, 2010. The intangible assets were associated with our December 2009 acquisition of AGI (see Note 14 to the Condensed Consolidated Financial Statements). We also incurred $0.7 million of increased compensation and benefits costs for research and development personnel, primarily related to personnel hired in connection with the AGI acquisition; $0.1 million of increased costs associated with third parties who assist us in developing novel diagnostic tests; and $0.1 million of increased cost allocation in connection with our physical facilities (including depreciation expense) associated with our Aliso Viejo, California facility, and our Huntsville, Alabama facility.
Interest expense, net. Interest expense of $0.1 million for the three months ended September 30, 2010 remained consistent with the prior year period. All such interest expense is associated with our Gemino credit facility (see Note 7 to our Condensed Consolidated Financial Statements).

 

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Income Taxes
                     
    Three Months Ended    
    September 30,    
    2010   2009   Variance
    (in thousands)    
 
                   
Income tax expense
  $   181     $   181
The $0.2 million tax expense for the three months ended September 30, 2010 represents our estimate of income tax expense applicable to our taxable income for the same period, and is primarily related to the federal and California alternative minimum tax (“AMT”) schemes, notwithstanding our substantial net operating loss carryforward. The deferred tax asset derived from the current period’s AMT has been fully reserved through a valuation allowance, thus resulting in income tax expense recognition in the same amount. Our tax expense also includes the effects of excess tax benefits from stock option deductions that were realized during the three months ended September 30, 2010. The Company’s policy is to use tax law ordering for determining when excess tax benefits are realized. The excess tax benefit was recorded as a component of additional paid in capital with a corresponding tax expense due to the Company’s valuation allowance on its net deferred tax assets.
Continuing Operations Overview — Nine Months Ended September 30, 2010 and 2009
The following table presents our results of continuing operations and the percentage of net revenue for each line item for the first nine months of 2010 and 2009 (in thousands):
                                 
    Nine Months Ended  
    September 30, 2010     September 30, 2009  
Net revenue
  $ 86,803       100.0 %   $ 68,347       100.0 %
Cost of services
    35,821       41.3 %     28,675       42.0 %
 
                       
Gross profit
    50,982       58.7 %     39,672       58.0 %
Operating expenses:
                               
Sales and marketing
    14,628       16.9 %     13,116       19.2 %
General and administrative
    19,033       21.9 %     17,074       25.0 %
Bad debt
    9,875       11.4 %     9,483       13.9 %
Research and development
    3,882       4.5 %     805       1.2 %
 
                       
Total operating expenses
    47,418       54.6 %     40,478       59.2 %
 
                       
Income from operations
    3,564       4.1 %     (806 )     (1.2 )%
Interest expense, net of interest income
    352       0.4 %     4,056       5.9 %
Other expense
    31       0.0 %            
Income tax expense (benefit)
    267       0.3 %     (599 )     (0.9 )%
 
                       
Income (loss) from continuing operations, net of income taxes
  $ 2,914       3.4 %   $ (4,263 )     (6.2 )%
 
                       

 

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Total Accessions
The following table presents the total number of our accessions for the nine months ended September 30, 2010 and 2009.
                         
    Nine Months Ended September 30,        
    2010     2009     Percent change  
    (in thousands)        
 
                       
Total Accessions
    121       101       19.8 %
 
                 
Test Volumes by General Test Type
The following table presents our test volumes by general test type for the nine months ended September 30, 2010 and 2009.
                         
    Nine Months Ended September 30,        
    2010     2009     Percent change  
    (in thousands)        
 
                       
Solid tumor, including breast prognostics
    276       249       10.8 %
Leukemia / Lymphoma
    556       436       27.5 %
Molecular diagnostics
    25       16       56.3 %
 
                 
Total test volume
    857       701       22.3 %
 
                 
Average Net Revenue and Average Cost of Services Per Accession
The following table presents our average net revenue and average cost of services per accession in the nine months ended September 30, 2010 and 2009:
                         
    Nine Months Ended September 30,        
    2010     2009     Percent change  
Average net revenue per accession
  $ 717     $ 677       5.9 %
Average cost of services per accession
    296       284       4.2 %
 
                 
Gross profit per accession
  $ 421     $ 393       7.1 %
 
                 
Average Net Revenue and Average Cost of Services Per Test
The following table presents our average net revenue and average cost of services per test in the nine months ended September 30, 2010 and 2009:
                         
    Nine Months Ended September 30,        
    2010     2009     Percent change  
Average net revenue per test
  $ 101     $ 98       3.1 %
Average cost of services per test
    42       41       2.4 %
 
                 
Gross profit per test
  $ 59     $ 57       3.5 %
 
                 

 

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Net Revenue by Payor Class
The following table presents our net revenue by payor class in the nine months ended September 30, 2010 and 2009:
                                 
    Nine Months Ended September 30,  
    2010     2009  
    (in thousands)  
 
                               
Governmental health insurance (Medicare, Medicaid)
  $ 29,612       34 %   $ 25,290       37 %
 
                               
Private health insurance
    33,915       39 %     29,008       42 %
 
                               
Clients (pathologists, hospitals, clinics, and biopharmaceutical companies)
    17,955       21 %     10,770       16 %
 
 
Patients
    5,321       6 %     3,279       5 %
 
                       
 
                               
Total
  $ 86,803       100 %   $ 68,347       100 %
 
                           
Net Revenue per Full Time Equivalent Employee
The following table presents average net revenue per full time equivalent (“FTE”) employee(a), including the employees of CPS, for the nine months ended September 30, 2010 and 2009:
                         
    Nine Months Ended September 30,        
    2010     2009     Percent change  
    (in thousands)        
 
                       
Net revenue per FTE employee
  $ 231     $ 218       6.0 %
 
                 
     
(a)   Represents our average number of company-wide employees during the respective period, as adjusted for part-time personnel, utilizing a typical 40 hour work week.
Nine Months Ended September 30, 2010 versus September 30, 2009
Net Revenue
                                 
    Nine Months Ended                
    September 30,             Percent  
    2010     2009     Variance     change  
    (in thousands)              
 
                               
Net revenue
  $ 86,803     $ 68,347     $ 18,456       27.0 %
Our 27.0% net revenue increase resulted from a 22.3% increase in diagnostic services test volume in the nine months ended September 30, 2010, and a 5.9% increase in average net revenue per accession, as compared to the prior year period. See the above Billing section for a table of Medicare reimbursement rates under the Physician Fee Schedule and Clinical Fee Schedule for the most common CPT codes associated with our laboratory services in 2010 and 2009.
Our net revenue growth was enabled by our expanded capabilities and service offerings which utilize the test methodologies of IHC, flow cytometry, FISH, and molecular/PCR, and our accompanying sales and marketing efforts.

 

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Cost of Services, Gross Profit, and Gross Margin
                                 
    Nine Months Ended                
    September 30,             Percent  
    2010     2009     Variance     change  
    (in thousands)              
Cost of services
  $ 35,821     $ 28,675     $ 7,146       24.9 %
Gross profit
    50,982       39,672       11,310       28.5 %
Gross margin percentage (gross profit as a percent of net revenue)
    58.7 %     58.0 %                
The $7.1 million increase in cost of services was driven by a 22.3% increase in test volume, and was primarily related to: (i) additional laboratory personnel costs of $2.9 million; (ii) increased laboratory supplies of $1.6 million; (iii) additional courier expenses of $1.4 million; (iv) increased cost of tests performed on our behalf by other laboratories of $0.8 million; (v) increased facilities costs of $0.2 million; (vi) additional consulting fees of $0.2 million; and (vii) additional amortization of patent expense of $0.1 million.
Our gross margin percentage for the nine months ended September 30, 2010 of 58.7%, slightly increased from 58.0%, as compared to the prior year period. Despite the 27.0% increase in net revenue for the nine months ended September 30, 2010, as compared to the prior year period, gross margins only marginally increased. During late 2009 and early 2010, we made certain strategic laboratory investments to support our operations, and hired of additional laboratory personnel to support our anticipated test volume growth, though it initially adversely impacted our current year gross profit percentage.
Operating Expenses and Interest Expense, net
                                 
    Nine Months Ended                
    September 30,             Percent  
    2010     2009     Variance     change  
    (in thousands)              
Sales and marketing
  $ 14,628     $ 13,116     $ 1,512       11.5 %
 
                               
General and administrative
    19,033       17,074       1,959       11.5 %
Bad debt
    9,875       9,483       392       4.1 %
Research and development
    3,882       805       3,077       382.2 %
Interest expense, net of interest income
    352       4,056       (3,704 )     (91.3 )%
Other expense
    31             31          
Sales and marketing. The $1.5 million increase for the nine months ended September 30, 2010, as compared to the prior year period, was primarily related to $1.3 million of additional sales and marketing personnel related costs, including sales commissions. The remaining $0.2 million increase was primarily related to an additional $0.1 million of travel expenses of our sales and marketing personnel. The remaining $0.1 million increase was related to our expanded advertising and promotion campaign costs.
General and administrative. The $2.0 million increase is related to several factors which include: (i) a $1.6 million increase in personnel expenses (including relocation and recruiting expenses, and stock-based compensation). The increased expenses, to support our growth, were principally associated with our billing and collection and information technology functions; (ii) a $0.1 million increase in insurance expense, (iii) a $0.3 million increase in depreciation expense on recently deployed capital assets; (iv) a $0.4 million net decrease in consulting expenses related to certain corporate initiatives; (v) a $0.5 million increase in facility expenses associated with the continued expansion of our Aliso Viejo, California facility, (vi) increased collection expenses of $0.1 million due to our overall testing volume and revenue increase, and (vii) $0.2 million of additional supplies and postage expense. Such increases were partially offset by a $0.5 million reduction in legal and accounting fees.
Bad debt. Despite revenue growth of 27.0% for the nine months ended September 30, 2010, as compared to the prior year period, bad debt expense only increased by 4.1%. The bad debt expense we recorded for the nine months ended September 30, 2010 was based upon an evaluation of our historical collection experience of aged accounts receivable for our various payor classes.
In September 2008, our in-house billing and collection department began operations, using licensed third-party billing and collection software. As of September 30, 2009 and for the nine months then ended, a substantial portion of our accounts receivable balance that was billed by our former outsourced billing and collection provider had either been written off, or fully-reserved within our total allowance for doubtful accounts, through the recording of bad debt expense.

 

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Research and development. The $3.1 million increase in research and development expenses was primarily driven by $0.8 million of amortization of intangible assets acquired through our acquisition of AGI in December 2009 (see Note 14 to the Condensed Consolidated Financial Statements); $1.5 million of increased compensation and benefits costs for research and development personnel, primarily related to personnel hired in connection with our December 2009 acquisition of AGI; $0.4 million of increased costs associated with third parties who assist us in developing novel diagnostic tests; and $0.3 million of increased costs related to physical facilities and depreciation due to expansion of our Aliso Viejo, California facility, as well as the addition of our Huntsville, Alabama facility in connection with the AGI acquisition.
Interest expense, net. Interest expense includes stated interest and fees on our credit facility(s), plus the amortization of the fair value of issued common stock warrants in connection with borrowings under our former credit facility with Safeguard. The $3.7 million decrease in interest expense is primarily related to $2.5 million of recognized warrant expense for the nine months ended September 30, 2009 associated with the retired Safeguard facilities, which did not recur in 2010. In addition, we had lower average outstanding borrowings in the nine months ended September 30, 2010 as compared to 2009, due to the repayment and retirement of our revolving credit facilities with Comerica and Safeguard, as discussed in Note 7 to the Condensed Consolidated Financial Statements.
Other expense. Other expense represents our mark-to-market of Variable Shares in connection with our acquisition of AGI (as defined and described in Note 14 to the Condensed Consolidated Financial Statements).
Income Taxes
                         
    Nine Months Ended        
    September 30,        
    2010     2009     Variance  
    (in thousands)        
 
                       
Income tax expense (benefit)
  $ 267     $ (599 )   $ 866  
The $0.3 million tax expense for the nine months ended September 30, 2010 represents our estimate of income tax expense applicable to our taxable income for the same period, and is primarily related to federal and California AMT, notwithstanding our substantial net operating loss carryforward. The deferred tax asset derived from the current period’s AMT has been fully reserved through a valuation allowance, thus resulting in income tax expense recognition in the same amount. Our tax expense also includes the effects of excess tax benefits from stock option deductions that were realized during the nine months ended September 30, 2010. The Company’s policy is to use tax law ordering for determining when excess tax benefits are realized. The excess tax benefit was recorded as a component of additional paid in capital with a corresponding tax expense due to the Company’s valuation allowance on its net deferred tax assets.
The $0.6 million tax benefit in 2009 relates to the tax effect, through continuing operations, of a $1.5 million payment received in April 2009 from Zeiss, the acquirer in the ACIS Sale (see Note 4 to the Condensed Consolidated Financial Statements). The proceeds were in connection with the satisfaction of certain post-closing conditions from the ACIS Sale in 2007.
Liquidity and Capital Resources
The chart below summarizes selected liquidity data and metrics as of September 30, 2010, December 31, 2009, and September 30, 2009:
                         
    September 30,     December 31,     September 30,  
    2010     2009     2009  
    (in thousands, except financial metrics data)  
Cash and cash equivalents
  $ 12,757     $ 10,903     $ 8,149  
Accounts receivable, net
    26,664       21,568       24,605  
Total current liabilities
    14,241       14,175       14,153  
Working capital surplus (a)
    28,517       21,287       21,171  
Days sales outstanding (“DSO”) (b)
  78 days     86 days     103 days  
Current ratio (c)
    3.00       2.50       2.50  
     
(a)   total current assets minus total current liabilities.
 
(b)   net accounts receivable divided by a rolling three-month average of net revenue multiplied by 31 days.
 
(c)   total current assets divided by total current liabilities.
Management believes that the Company’s liquidity and capital resources are sufficient to meet its operational needs at least through September 30, 2011.

 

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Operating Activities
Cash provided by operating activities was $5.8 million for the nine months ended September 30, 2010, as compared to cash used in operating activities of $6.8 million in the prior year period. The increase in cash provided by operating activities is primarily a function of increased net revenue and associated general improvements in our billing and collection processes, specifically within the area of monitoring and follow-up of significant accounts receivable balances. We hired additional billing and collection personnel throughout 2009 in order to improve the completeness and accuracy of the bills we send, and to minimize the time between our completed service date and our billing date. During the nine months ended September 30, 2010 and 2009, our cash collections from customers totaled $72.3 million and $54.1 million, respectively, representing 83.3% and 79.2% of reported net revenue for the same periods, respectively.
Investing Activities
Cash used in investing activities for the nine months ended September 30, 2010 of $2.2 million primarily consisted of capital expenditures related to purchases of new laboratory equipment and certain information technology system enhancements.
Financing Activities
Net cash used in financing activities for the nine months ended September 30, 2010 was $1.8 million, as compared to $17.7 million of net cash provided by financing activities during the same period in 2009. During nine months ended 2010, our repayments on our revolving credit facility with Gemino exceeded our borrowings by $2.9 million. In March and May 2009, we received an aggregate $38.6 million in proceeds, net of offering costs, from the sale of our Series A convertible preferred stock to Oak (see Note 13 to the Condensed Consolidated Financial Statements). Such proceeds were used to repay our now-retired revolving credit facilities with Safeguard and Comerica, and our active Gemino Facility (see Note 7 to the Condensed Consolidated Financial Statements).
Credit Arrangements
The following table summarizes our outstanding balance under our credit arrangement (excluding capital lease obligations) and our remaining credit availability as of September 30, 2010 (in thousands):
                         
    Outstanding     Credit Availability        
    September 30, 2010     September 30, 2010     Earliest Stated Maturity  
Gemino Facility
  $     $ 8,000     January 31, 2011
 
                   
As discussed in Note 7 to the Condensed Consolidated Financial Statements, on March 25, 2009 we entered into a Stock Purchase Agreement with Oak (the “Oak Purchase Agreement”), pursuant to which we agreed to sell and issue to Oak, up to an aggregate of 6.6 million shares of our Series A convertible preferred stock in two or more tranches for aggregate consideration of up to $50.0 million (the “Oak Private Placement”). The initial closing of the Oak Private Placement occurred on March 26, 2009, at which time we issued and sold Oak an aggregate of 3.8 million preferred shares for aggregate consideration of $29.1 million. After paying investment banking fees and legal expenses, we used the remaining proceeds to repay in full the outstanding balance of $9.8 million on our retired revolving credit facility with Comerica Bank, to support a $2.3 million standby letter of credit with Comerica Bank (subsequently reduced to $1.5 million in December 2009) through opening a restricted cash account with Comerica Bank in the same amount, and to repay $14.0 million of our retired mezzanine facility with Safeguard.
The second closing of the Oak Private Placement occurred on May 14, 2009, at which time we issued and sold Oak an aggregate of 1.4 million Series A preferred shares (the “Second Oak Closing Shares”) for aggregate consideration of $10.9 million. Of the $10.9 million of proceeds from the second closing of the Oak Private Placement, $5.7 million was used to repay in full and terminate the mezzanine facility with Safeguard. The remaining amount of $4.8 million, net of legal fees and investment banking fees, was used to support our working capital requirements. Though our Comerica and Safeguard facilities have been repaid and retired, we continue to maintain our credit facility (the “Gemino Facility”) with Gemino Healthcare Finance, LLC (“Gemino”).

 

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The Gemino Facility contains certain financial and non-financial covenants which require our compliance, as described within Note 7 to the Consolidated Financial Statements. Failure to maintain compliance would constitute an event of default. The Gemino Facility also contains a material adverse change (“MAC”) clause. If we encountered difficulties that would qualify as a MAC in our (i) operations, (ii) condition (financial or otherwise), or (iii) ability to repay the amount outstanding, our credit agreement could be cancelled at Gemino’s sole discretion. Gemino could then elect to declare the indebtedness, together with accrued interest and other fees, to be immediately due and payable and proceed against any collateral securing such indebtedness. We believe, though we can provide no assurance, that we will continue to be able to meet the Gemino Facility’s financial covenants, as amended (see below), and will not encounter a MAC triggering event.
On November 13, 2009, we executed the November 2009 Gemino Amendment. The November 2009 Gemino Amendment (i) extended the maturity date of the Gemino Facility from January 31, 2010 to January 31, 2011, (ii) removed the “excess liquidity” covenant, (iii) increased the facility’s “advance rate” from 75% to 85%, (iv) eliminated the minimum “fixed charge coverage ratio” covenant through December 31, 2009, (v) includes a “maximum loan turnover ratio” (average monthly loan balance divided by average monthly cash collections multiplied by 30 days) of 35 days only for the three months ending December 31, 2009, (vi) requires a minimum annualized “fixed charge coverage ratio” covenant of 1.00 for the three months ending June 30, 2010, 1.10 for six months ending June 30, 2010, 1.20 for the nine months ending September 30, 2010, and 1.20 for the twelve months ending December 31, 2010 and thereafter, and (vii) reduced the commitment fee from 0.75% to 0.50% per year on the daily average of unused credit availability. We believe we were in compliance with the aforementioned financial covenants as of September 30, 2010, and for the period then ended.
In connection with the pending acquisition of the Company by General Electric, Gemino has the right to terminate the Gemino Facility upon completion of the Merger, unless Gemino consents to the Merger. If Gemino elects to terminate the Gemino Facility, it could then elect to declare the indebtedness, together with accrued interest and other fees, to be immediately due and payable and proceed against any collateral securing such indebtedness.
In-House Billing and Collection
On June 1, 2008, our in-house billing and collection department began operations, using licensed third-party billing and collection software. During the fourth quarter of 2008, we ceased utilizing the services of our former billing and collection service provider. We did not have adequate internal resources to resolve various unanticipated billing and collection process issues during this transition period. As a result, our cash collections in 2008 did not increase at the same rate as our net revenue increased. Several collection process issues persisted through early 2009, negatively affecting our collection results during such time.
Though the effectiveness of our billing and collection department has increased significantly since early 2009, we are actively seeking additional means to improve our performance in this area. We believe that this will remain an ongoing activity of critical importance in 2010 and beyond, as we rely on our cash collections to support our general working capital needs.
Contractual Obligations
The following table summarizes our contractual obligations and commercial commitments at September 30, 2010:
                                         
    Payment due by period at September 30, 2010  
            Less                        
            than 1                     After  
    Total     Year     1 - 3 Years     3 - 5 Years     5 Years  
    (in thousands)  
Gemino Facility
  $     $     $     $     $  
Capital lease obligations
    3,211       1,212       1,999              
Operating leases
    9,392       1,877       3,794       3,440       281  
Purchase commitments (reagent chemicals for laboratory services and software licenses)
    7,397       2,311       4,207       879        
 
                             
Total
  $ 20,000     $ 5,400     $ 10,000     $ 4,319     $ 281  
 
                             
The above table does not include potential severance benefits due under various employment agreements with certain employees if such employee(s) was terminated without cause, the timing and total amount of which are not practicable to estimate.

 

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Off-Balance Sheet Arrangements
We have no off-balance sheet arrangements that involve liquidity, hedging, or financing activities, except for operating lease arrangements. In addition, we are not aware of any matters that may expose us to liability that is not expressly reflected in the Condensed Consolidated Financial Statements, except for potential indemnification obligations associated with the ACIS Sale.
As of September 30, 2010, we did not have any relationships with unconsolidated entities or financial partnerships, often referred to as special purpose entities. Special purpose entities are generally established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. In connection with the provision of pathology services, we have a long-term and exclusive relationship with CPS, as described in Note 1 to the Condensed Consolidated Financial Statements. We are, therefore, not subject to any material financing, liquidity, market or credit risk that could arise if we had engaged in such off-balance sheet arrangements.
Recent Accounting Pronouncements
Several new accounting standards have been issued and adopted recently. None of these standards had, or are expected to have, a material impact on our financial position, results of operations, or liquidity. See Note 5 to the Condensed Consolidated Financial Statements.
Item 3.   Quantitative and Qualitative Disclosures About Market Risk
Our cash and cash equivalents, comprising of bank deposits and money market investments, are not subject to significant interest rate risk due to their short term nature. As of September 30, 2010, the carrying value of our cash and cash equivalents approximates fair value.
Borrowings under our Gemino Facility bear interest at an annual rate equal to 30-day LIBOR (subject to a minimum annual rate of 2.50% at all times) plus an applicable margin of 6.0% during 2009 and 2010. The variable interest rate applicable of our Gemino Facility may therefore expose us to market risk due to changes in interest rates of 30-day LIBOR. As of September 30, 2010, we had no outstanding borrowings under the Gemino Facility.
Item 4.   Controls and Procedures
Evaluation of disclosure controls and procedures
Our management, with the participation and under the supervision of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were effective as of the end of the period covered by this Quarterly Report on Form 10-Q to provide reasonable assurance that the information required to be disclosed by us in reports filed under the Exchange Act is (i) recorded, processed, summarized and reported within the time periods specified in the U.S. Securities and Exchange Commission’s rules and forms and (ii) accumulated and communicated to our management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding disclosure. A controls system, no matter how well designed and operated, cannot provide absolute assurance that the objectives of the controls system are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected.
Changes in internal control over financial reporting
There were no changes in our internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) that occurred during the quarter ended September 30, 2010 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II — OTHER INFORMATION
Item 1.   Legal Proceedings
Following announcement of the Merger Agreement on October 22, 2010, several lawsuits were filed by plaintiffs who allegedly hold Common Shares, suing on behalf of themselves and on behalf of an alleged class of the Company’s public stockholders. Five suits have been filed in the Superior Court of California, County of Orange: on October 25, 2010 a suit was filed by plaintiff Herbert Silverberg (“Silverberg Complaint”) naming the Company, each member of the Company’s Board of Directors, Safeguard, Oak and Purchaser; on October 26, 2010 a suit was filed by plaintiff Southwest Ohio Regional Council of Carpenters Pension Plan (“Southwest Ohio Complaint”) naming the Company, each member of the Company’s Board of Directors, Purchaser, General Electric and 25 unidentified “Does”; and on October 28, 2010 three suits were filed; by plaintiff Dolph Haege naming the Company, each member of the Company’s Board of Directors, Purchaser and General Electric, by plaintiff Michael Sassone (“Sassone Complaint”) naming the same defendants as the Southwest Ohio Complaint and by Frank Sigl (“Sigl Complaint”) also naming the same defendants as the Southwest Ohio Complaint. In addition, a suit was filed in Delaware Court of Chancery on October 27, 2010 by plaintiff Bette Kurzweil naming the Company, each member of the Company’s Board of Directors, General Electric, GE Healthcare, and Purchaser. We have been notified that two additional cases have been filed, but, as of the date this quarterly report on Form 10-Q was filed with the SEC, we have not received the related complaints.
Plaintiffs in each case allege that the Company’s Board of Directors breached their fiduciary duties to the Company’s stockholders, and that the Merger Agreement between the Company and General Electric involves an unfair price, an inadequate sales process, unreasonable deal protection devices, and that defendants agreed to the Merger to benefit themselves personally. Several of the Complaints also allege that Safeguard and Oak together control the Company and breached fiduciary duties allegedly owed by controlling shareholders to the Company’s stockholders. In addition, in each case, the plaintiffs allege that either the Company, General Electric, GE Healthcare, and/or the Purchaser, aided and abetted the alleged breach of fiduciary duty by the other defendants.
The complaints seek to enjoin the transaction or in the alternative award the respective plaintiffs and alleged class damages plus pre- and post-judgment interest, as well as other unspecified attorney’s and other fees and costs, and other relief. The Southwest Ohio Complaint, Sassone Complaint, and Sigl Complaint also seek to impose a constructive trust in favor of plaintiff and the alleged class upon any benefits improperly received by defendants.
The Company believes that these actions have no merit and intends to defend vigorously against them. The Company has not recorded any accrual for these claims within the accompanying Condensed Consolidated Financial Statements.
Item 1A.   Risk Factors
There have been no material changes in our risk factors from the information set forth in our Annual Report on Form 10-K for the year ended December 31, 2009, except for the following:
Failure to complete the Merger with General Electric could negatively impact our stock price and adversely affect our future financial condition, operations and prospects.
If the Offer or Merger with General Electric is not completed for any reason, we may be subject to a number of material risks, including the following:
    if the Merger Agreement is terminated, we may be required in specific circumstances, to pay a termination fee of $18 million to General Electric;
    the price of our common stock may decline to the extent that the current market price of our stock reflects an assumption that the Offer and Merger will be completed;
    we must pay significant transaction-related expenses related to the Offer and Merger, including substantial legal, accounting and financial advisory fees, and other expenses related to the Offer and Merger, even if the Offer and Merger are not completed; and
    our day-to-day operations may be disrupted due to the substantial time and effort our management must devote to completing the transaction.
These risks could negatively impact our stock price and adversely affect our future financial condition, operations and prospects.
In addition, our current and prospective employees may experience uncertainty about their future role with us or General Electric. This may adversely affect our ability to attract and retain key management, pathologists, sales and marketing and other personnel.

 

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If the Merger Agreement is terminated and our Board of Directors determines to seek another merger or business combination, it may not be able to find a party willing to pay an equivalent or more attractive price than that which would have been paid in the Offer or Merger with General Electric.
Changes in federal payor regulations or policies may adversely affect coverage and reimbursement for our services and may have a material adverse effect upon our business.
Government payors, such as Medicare and Medicaid, have increased their efforts to control the cost, utilization, and delivery of health care services. On March 1, 2010, a 21.2 percent reduction in Medicare payments under the Medicare Physician Fee Schedule was to take effect, however, the reduction has been stayed through November 30, 2010. We believe that the proposed cuts to the Physician Fee Schedule will ultimately not occur, though there can be no assurance of our expectation. If payment reductions to the Medicare Physician Fee Schedule eventually take effect, reductions in the reimbursement rates applicable to other third-party payors may also occur, since many third-party payors base their reimbursement rates on the published Medicare fee schedules. Accordingly, the 21.2 percent proposed reduction in Medicare payments under the Medicare Physician Fee Schedule would have a material adverse impact on our business, if enacted. From time to time, Congress may consider and implement other reductions to the Medicare Physician Fee Schedule in conjunction with budgetary legislation which would similarly have a negative impact on our business if/when implemented.
The technical component “grandfather clause” for Medicare billings was extended through December 31, 2010. The grandfather clause permits us to directly bill Medicare for the technical laboratory services we provide to hospital inpatients and outpatients. Hospitals generally receive a bundled payment from Medicare for all services provided to Medicare patients. Absent the grandfather clause, when a hospital subcontracts out a cancer diagnostic test to us, the hospital would be responsible for paying us out of the bundled fee it receives from Medicare, since we would not be able to directly bill Medicare for technical laboratory services. This form of reimbursement would subject us to increased administrative costs and slower collections and would likely result in reduced reimbursement levels and pricing pressure. We expect the grandfather clause will continue to be extended, though there can be no assurance of our expectation.
Our net revenue may be diminished by health care reform initiatives.
On March 23, 2010, President Obama signed comprehensive health reform, the Patient Protection and Affordable Care Act (“PPACA”) into law, which will (i) require most U.S. citizens and legal residents to have health insurance; (ii) assess monetary penalties upon employers with more than 50 employees that do not offer coverage; and (iii) expand Medicaid coverage. In order to pay for the PPACA, the Obama administration is considering cuts in Medicare payments, which might be significant. Our net revenue could be adversely affected by such potential adjustments to Medicare reimbursement rates for our laboratory diagnostic services, offsetting the potential benefit to our business of additional insured U.S. citizens and legal residents.
The FDA’s enforcement discretion over laboratory-developed tests may subject us to additional costs and delay launches of our proprietary diagnostic tests.
The U.S. Food and Drug Administration (“FDA”) has previously stated that clinical laboratories which develop tests in-house are considered to be manufacturers of medical devices and are subject to the FDA’s jurisdiction under the federal Food, Drug, and Cosmetic Act (“FD&C Act”). We develop assays and intend to validate new biomarkers as they become available to us. Many of the assays and new markers we intend to validate will be considered analyte specific reagents (“ASRs”), commonly referred to as “home brews.” ASRs are reagents composed of chemicals or antibodies which are the active ingredients of tests used to identify one specific disease or condition. The FDA confirmed previous announcements in July 2010 that it will exercise enforcement discretion over laboratory-developed ASRs, as well as laboratory-developed tests (“LDTs”) using commercially available and laboratory-developed ASRs. The scope of the FDA’s enforcement discretion is widely expected to be released by the FDA in the first half of 2011, with the potential of any and all regulations being immediately enforceable.
The FDA announced (in draft guidance in July 2007) that in vitro diagnostic multivariate index assays (“IVDMIAs”) do not fall within the scope of LDTs over which the FDA has generally exercised enforcement discretion. The guidance document defines IVDMIAs as gene or protein-based tests (which include tests for breast and prostate cancer) that combine assays and algorithms to produce results tailored to a specific patient. In the draft guidance, the FDA stated that IVDMIAs must meet pre-market and post-market device requirements under the FD&C Act and FDA regulations, including pre-market review of class II and III devices. We may decide to develop IVDMIAs in-house, which would then be subject to these regulations, should the FDA adopt these draft provisions. In such case, we would be required to obtain pre-market notification clearance, often referred to as a “510(k)” clearance or pre-market approval (“PMA”) of the test from the FDA. In order to market a device subject to the 510(k) clearance process, the FDA must determine that the proposed device is “substantially equivalent” to a device legally on the market, known as a “predicate” device. Clinical and non-clinical data may be required to demonstrate substantial equivalence. The 510(k) clearance process usually takes from three to twelve months from the time of submission to the time that a company can begin to market and distribute such product in the United States.

 

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The process can take significantly longer and there can be no assurance that the FDA will issue such clearance. The PMA approval pathway requires an applicant to demonstrate that the device is safe and effective and such determination is based, in part, on data obtained in clinical trials. The PMA approval process is much more costly, lengthy, and uncertain and generally takes between one and three years from submission to PMA approval, but may take significantly longer and such approval may never be obtained. Once clearance or approval is obtained, ongoing compliance with FDA regulations, including those related to manufacturing operations, recordkeeping, reporting, marketing, and promotion, would increase the cost, time and complexity of conducting our business.
Item 6.   Exhibits
The following is a list of exhibits required by Item 601 of Regulation S-K filed as part of this Quarterly Report on Form 10-Q.
               
        Incorporated Filing
        Reference
            Original
Exhibit     Form Type &   Exhibit
Number Description   Filing Date   Number
   
 
       
10. 1
Employment Agreement dated as of July 26, 2010, by and between Clarient, Inc. and Ronald A. Andrews.
   
   
 
       
10. 2
Employment Agreement dated as of July 26, 2010, by and between Clarient, Inc. and Dr. Michael J. Pellini.
   
   
 
       
10. 3
Employment Agreement dated as of July 26, 2010, by and between Clarient, Inc. and David J. Daly.
   
   
 
       
31. 1
Certification of Ronald A. Andrews Pursuant to Rule 13a-14(a) / 15d-14(a) of the Securities Exchange Act of 1934.
   
   
 
       
31. 2
Certification of Michael R. Rodriguez Pursuant to Rules 13a-14(a) / 15d-14(a) of the Securities Exchange Act of 1934.
   
   
 
       
32. 1
Certification of Ronald A. Andrews Pursuant to Rule 13a-14(b) / 15d-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350.
   
   
 
       
32. 2
Certification of Michael R. Rodriguez Pursuant to Rule 13a-14(b) / 15d-14(b) of the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350.
   
 
     
  Filed herewith

 

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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
         
  CLARIENT, INC.
 
 
DATE: November 2, 2010  BY:  /s/ RONALD A. ANDREWS    
    Ronald A. Andrews   
    Vice Chairman and Chief Executive Officer   
         
DATE: November 2, 2010  BY:  /s/ MICHAEL R. RODRIGUEZ    
    Michael R. Rodriguez   
    Senior Vice President and Chief Financial Officer   

 

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