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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K/A
(AMENDMENT NO. 1)
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ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997
COMMISSION FILE NUMBER: 001-12977
APPLE ORTHODONTIX, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 74-2795193
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
2777 ALLEN PARKWAY, SUITE 700
HOUSTON, TEXAS 77019
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (713) 852-2500
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
NAME OF EACH EXCHANGE
TITLE OF EACH CLASS ON WHICH REGISTERED
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Class A Common Stock, American Stock Exchange
$.001 Par Value Per Share
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. YES [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
At March 25, 1998, the aggregate market value of the registrant's Common
Stock held by non-affiliates of the registrant was approximately $121,492,575
based on the closing price of such stock on such date of $12 1/2.
At March 25, 1998, the number of shares outstanding of registrant's Class A
Common Stock was 10,129,991.
DOCUMENTS INCORPORATED BY REFERENCE: NONE
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Apple Orthodontix, Inc., a Delaware corporation (the "Company"), hereby
amends its Annual Report on Form 10-K originally filed with the Securities and
Exchange Commission on March 31, 1998, pursuant to Instruction G (3) to Form
10-K by completing Items 10 through 13 of Part III thereof. In addition to this
information, the Annual Report on Form 10-K/A (Amendment No. 1) includes all
information required by Parts I, II and IV of Form 10-K that the Company
included in its original Form 10-K filed on March 31, 1998.
TABLE OF CONTENTS
PAGE
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PART I
Items 1 1
and 2. Business and Properties..............
Item 3. Legal Proceedings.................... 11
Item 4. Submission of Matters to a Vote of 12
Security Holders.....................
PART II
Item 5. Market for Registrant's Common Stock 13
and Related Shareholder Matters......
Item 6. Selected Financial Data.............. 15
Item 7. Management's Discussion and Analysis 16
of Financial Condition and Results of
Operations...........................
Item 7A. Quantitative and Qualitative 20
Disclosures About Market Risk........
Item 8. Financial Statements and 21
Supplementary Data...................
Item 9. Changes In and Disagreements With 36
Accountants on Accounting and
Financial Disclosure.................
PART III
Item 10. Directors and Executive Officers of 36
the Registrant.......................
Item 11. Executive Compensation............... 38
Item 12. Security Ownership of Certain 42
Beneficial Owners and Management.....
Item 13. Certain Relationships and Related 42
Party Transactions...................
PART IV
Item 14. Exhibits, Financial Statement 44
Schedules, and Reports on Form 8-K...
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FORWARD LOOKING STATEMENTS
This Annual Report on Form 10-K includes certain statements that may be
deemed to be "forward-looking statements" within the meaning of Section 27A of
the Securities Act of 1933, as amended (the "Securities Act"), and Section 21E
of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). All
statements, other than statements of historical facts, included in this Annual
Report on Form 10-K that address activities, events or developments that the
Company expects, projects, believes or anticipates will or may occur in the
future, including such matters as business strategy, plans and objectives of
management of the Company for future operations and future industry conditions
are forward-looking statements. These statements are based on certain
assumptions and analyses made by management of the Company in light of its
experience and its perception of historical trends, current conditions, expected
future developments and other factors it believes are appropriate in the
circumstances. Such statements are subject to a number of assumptions, risks and
uncertainties, including the risk factors discussed herein, general economic and
business conditions, changes in laws or regulations and other factors, many of
which are beyond the control of the Company. Prospective investors are cautioned
that any such statements are not guarantees of future performance and that
actual results or developments may differ materially from those projected in the
forward-looking statements.
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PART I
ITEMS 1 AND 2. BUSINESS AND PROPERTIES
OVERVIEW
Apple Orthodontix, Inc., a Delaware corporation (the "Company"), provides
practice management services (which exclude the management and delivery of
orthodontic services) to orthodontic practices in the United States and Canada.
The Company offers the orthodontic practices with which it has affiliated (the
"Affiliated Practices") a full range of such services designed to facilitate the
delivery of high-quality, affordable orthodontic treatment to consumers. The
Company's Affiliated Practices benefit from the Company's practice operating
approach designed to (i) stimulate demand in their local markets by increasing
consumer awareness of the benefits, availability and affordability of
orthodontic treatment, (ii) improve the productivity and profitability of their
practices and (iii) leverage the benefits of orthodontist affiliation by
providing basic services that include clinical and financial information
management, access to capital and sophisticated technology, group purchasing and
comprehensive marketing techniques. The Company seeks to grow through
affiliations with additional orthodontic practices and the development of new
offices that complement geographic areas served by the Affiliated Practices. The
Company earns revenue by providing management, administrative, development and
other services to its Affiliated Practices.
In connection with its initial public offering ("IPO") in May 1997, the
Company acquired substantially all the tangible and intangible assets and
assumed certain liabilities of, and began providing long-term management
services to, 31 orthodontists operating in 58 offices located in 13 states in
the United States and in Alberta, Canada (the "Founding Affiliated Practices").
During 1997, the Company affiliated with an additional 20 practices with
aggregate historical gross patient revenues of $23.2 million for their most
recently completed fiscal year. As of December 31, 1997, the Company provided
services to 51 orthodontic practices representing 66 orthodontists operating in
15 states in the United States and three provinces in Canada.
Affiliated Practices are selected based on a variety of factors, including
competitive and financial strengths and historical growth of their practices and
the potential for future growth in their markets. The Company also considers the
local and national reputations of the Affiliated Practices within the
orthodontic services industry, their ability to manage multi-location practices
providing high levels of quality care and their desire to grow and improve the
operating efficiency of their respective practices. The Company selects its
Affiliated Practices based on the recommendations of its affiliated
orthodontists and management's extensive experience with orthodontic practices
in the United States and Canada.
INDUSTRY
OVERVIEW. The orthodontic services industry is highly fragmented, with over
90% of the approximately 9,000 orthodontists in the United States operating as
sole practitioners and approximately 3% being affiliated with public orthodontic
practice management companies. The industry currently generates approximately
$3.5 billion in annual gross revenues, which have grown steadily at an average
rate of 7.5% per year in recent years. Seventy percent of orthodontic services
are performed on a private pay, fee-for-service basis, 25% are covered by
traditional dental insurance (generally with a 50% or greater copayment by the
patient), and less than 5% are reimbursed from managed care payor sources due to
the elective nature of the service. Most orthodontic practices (including all
the existing Affiliated Practices) do not accept payment by Medicare or
Medicaid. According to the most recent statistics available from studies by the
Journal of Clinical Orthodontists ("JCO"), the median orthodontic practice in
the United States generated $518,800 in revenues, started 180 new cases and
experienced a case acceptance rate of 67% in 1996.
Orthodontic treatments are principally provided by orthodontists who have
completed two years of post-graduate studies following graduation from dental
school. The number of orthodontists in the United States has grown slowly since
1990, which the Company believes can be attributed to the limited number of
schools offering post-graduate orthodontic programs and the small class size at
each of those schools. In
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addition to orthodontists, a number of dentists provide various orthodontic
services. The industry information set forth herein does not include orthodontic
treatments provided by dentists.
The table below summarizes certain information from the 1997 JCO
Orthodontic Practice Study (the "1997 JCO Study") (the most recent available
with respect to average fee per case) concerning the United States orthodontic
services industry for each of the years presented:
<TABLE>
<CAPTION>
1990 1991 1992 1993 1994 1995
----------- ----------- ----------- ----------- ----------- -----------
<S> <C> <C> <C> <C> <C> <C>
Number of orthodontists.............. 8,720 8,760 8,856 8,958 9,060 9,115
Number of new cases.................. 1,308,000 1,314,000 1,416,690 1,478,070 1,540,200 1,640,700
Average fee per case................. $3,050 $3,221 $3,401 $3,447 $3,492 $3,645
</TABLE>
THE TRADITIONAL ORTHODONTIC PRACTICE. The traditional orthodontic practice
typically involves a single orthodontist, practicing at one primary location or
with an average of less than one satellite office, with a small number of
orthodontic assistants and business office personnel and, in some cases, an
orthodontic associate. On an individual practice basis, the 1997 JCO Study
reported median annual revenues of $518,800 and median operating income of
$224,000 in 1996. Median overhead as a percentage of revenues was 55%, resulting
in a 42% median operating margin before orthodontist compensation, interest and
taxes. Median down payments were equal to approximately 25% of the total
treatment cost. In 1996, median case starts and active treatment cases were 180
and 400 per practice, respectively, and the median case acceptance rate was 67%.
In the traditional practice, the orthodontist manages all business aspects of
the practice; the use of third-party management services is not typical.
The 1997 JCO Study reports that individual practices, on average, generated
over one-half of their referrals from dentists and less than 8% of the practices
utilized commercial advertising (and 1.8% utilized television advertising).
According to the 1997 JCO Study, orthodontists believed they had the ability to
increase case starts by 28%, but the median case starts have not increased
significantly since 1981, the first year of data presented in the study.
THE APPLE ORTHODONTIX APPROACH
The Company believes the traditional orthodontic practice is inefficient
and administratively burdensome to orthodontists and can be financially
burdensome to patients, who traditionally pay approximately 25% of the total
contract amount as a down payment.
The Company has developed a comprehensive operating strategy designed to
improve efficiency, increase the number of new case starts and active cases
handled by each orthodontist and relieve orthodontists associated with
Affiliated Practices of time-consuming administrative responsibilities. As part
of its practice operating approach, the Company assists its Affiliated Practices
in developing and implementing payment programs designed to make orthodontic
services more affordable to prospective patients, thereby making their services
available to a larger segment of the population in their respective markets. The
Company also assists the Affiliated Practices in developing satellite offices to
expand the scope of the geographic areas they serve.
The Company believes its approach provides benefits to orthodontists who
choose to affiliate with it by providing opportunities to: (i) drive internal
growth by implementing the Company's operating strategy; (ii) share in the
increased profitability resulting from internal growth; (iii) lower costs
through economies of scale; (iv) participate in a cost-effective national
advertising program; (v) focus on patient care; and (vi) enhance liquidity and
diversification.
OPERATING STRATEGY
Through its practice operating approach, the Company seeks to stimulate
increased productivity and internal growth in its Affiliated Practices. To
accomplish this objective, the Company has developed an operating approach
consisting primarily of (i) implementing practice-building and external
marketing programs designed to generate new case starts through increased
referrals from existing and former patients and the use of multimedia
advertising to stimulate demand for treatment services, (ii) offering more
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affordable payment plans to patients to broaden the market for orthodontic
services, (iii) increasing the operating efficiency of the Affiliated Practices
by relieving the orthodontists from various time-consuming administrative
responsibilities and realizing economies of scale, (iv) providing a
systems-oriented approach to training and education of clinic personnel to
improve communications with patients and prospective patients and increase
productivity, (v) developing satellite offices to expand the geographic markets
served by Affiliated Practices and (vi) utilizing customized management
information systems to provide detailed financial and operating data and related
analyses to Affiliated Practices and management. The Company believes that its
approach has resulted in local market expansion, increased new case starts and
practice profitability, increased orthodontist productivity and heightened
patient satisfaction in its existing Affiliated Practices.
Over time, the Company plans to implement a regional management structure
aligned with the locations of its Affiliated Practices. The Company believes a
regional structure will allow it to respond to the management and operational
issues within a particular region in a more timely and focused manner. In
addition, a regional structure will allow management to compare the operating
results of its Affiliated Practices to regularly published regional industry
statistics.
EXPANSION STRATEGY
The Company is pursuing an aggressive expansion strategy designed to
strengthen its position in its current markets and expand its network of
existing Affiliated Practices into markets it does not currently serve. The
Company believes that, because of the highly fragmented nature of the industry,
there are numerous orthodontic practices that are attractive candidates to
become Affiliated Practices. The Company focuses on candidates that have
favorable reputations in their local markets and the desire to implement the
Company's practice operating approach. The Company leverages the reputations and
relationships of the orthodontists associated with the existing Affiliated
Practices to identify and develop candidates to become future Affiliated
Practices. Many of these orthodontists hold, or have previously held, leadership
roles in various state, regional and national associations or are affiliated
with or teach at graduate orthodontic programs at dental schools. The Company
believes the visibility and reputation of these individuals, combined with the
acquisition experience of management, provides the Company with certain
advantages in identifying, negotiating and consummating future affiliations. As
consideration for future affiliations, the Company intends to use various
combinations of its Class A Common Stock, par value $.001 per share (the "Common
Stock"), cash and notes. The Company anticipates that the agreements entered
into in connection with its future affiliations will contractually restrict the
resale of all or a portion of the shares issued in those transactions for
varying periods of time.
The Company is developing new offices within selected markets served by the
existing Affiliated Practices. The Company believes that the new offices will
increase the geographic area served by the existing Affiliated Practices,
thereby increasing the potential market and leveraging the advertising budget of
the existing Affiliated Practices. The Company expects that these offices
generally will be located in high traffic areas.
Satellite offices (branch locations of existing Affiliated Practices)
developed by the Company generally will be staffed on a part-time basis by an
orthodontist from an Affiliated Practice. The Company's other new offices
generally will be staffed on a full-time basis by a newly recruited
orthodontist. The average cost of developing a new office varies by geographic
market and the square footage of the office and is estimated to range from
$250,000 to $400,000, including initial working capital requirements. The
Company provides management services and capital to develop these new offices.
The Company is responsible for selecting the site, negotiating the lease,
designing the office layout and furnishing the new office. The Company also
assists the Affiliated Practices in recruiting orthodontists and support staff
for these new offices, which generally will be open full-time.
The success of the Company's expansion strategy depends on a number of
factors, including the Company's ability to (i) identify attractive candidates
to become Affiliated Practices, (ii) affiliate with Affiliated Practices on
favorable terms, (iii) adapt the Company's structure to comply with present or
future
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legal requirements affecting the Company's arrangements with Affiliated
Practices and comply with regulatory and licensing requirements applicable to
orthodontists and facilities operated and services offered by orthodontists,
(iv) expand the Company's infrastructure and management to accommodate expansion
and (v) obtain suitable financing to facilitate its expansion program.
Identifying candidates to become Affiliated Practices and proposing, negotiating
and implementing advantageous affiliations with such groups can be a lengthy,
complex and costly process. There can be no assurance that the Company's
expansion strategy will be successful, that modifications to the Company's
strategy will not be required, that the Company will be able to provide services
effectively and enhance the profitability of additional Affiliated Practices or
that the Company will be able to obtain adequate financing on reasonable terms
to support its expansion program. Furthermore, using shares of Common Stock as
consideration for (or in order to provide financing for) future affiliations
could result in significant dilution to then-existing stockholders. In addition,
future affiliations accounted for as purchases may result in substantial noncash
amortization charges for intangible assets in the Company's statements of
operations.
The Company was incorporated in July 1996 and conducted no operations
before its IPO in May 1997 other than in connection with the IPO and affiliation
with the Founding Affiliated Practices. Although each of the existing Affiliated
Practices operated independently before affiliation with the Company, the
Company has a limited combined operating history. As a result, there can be no
assurance that the process of integrating the management and administrative
functions of the Affiliated Practices will be successful or that the Company's
management will be able to effectively or profitably manage these operations or
successfully implement the Company's operating or expansion strategies. Failure
by the Company to successfully implement its operating or expansion strategies
would have a material adverse effect on the Company's business, financial
condition and results of operations.
SERVICES AND OPERATIONS
The Company generally provides services with respect to all aspects of the
operations of its Affiliated Practices other than the provision of orthodontic
treatment. Except in Canada, the Company employs all business personnel at the
offices of the Affiliated Practices and, where permitted by applicable law and
governmental regulations, also employs the orthodontic assistants.
ADMINISTRATIVE. The Company earns revenue by providing services to the
Affiliated Practices, including staffing, education and training, billing and
collections, cash management, group purchasing, inventory management, payroll
processing, employee benefits administration, advertising production and other
marketing support, patient scheduling, financial reporting and analysis,
productivity reporting and analysis, associate recruiting and support for
acquisitions, new site development and other capital requirements. The Company
believes the orthodontists at the Affiliated Practices benefit from the support
provided by the Company and that these services substantially reduce the amount
of time the orthodontists are required to spend on administrative matters,
thereby enabling them to dedicate more time to the growth of their professional
practices. Through economies of scale, the Company is able to provide these
services at a lower cost than could be obtained by any of the Affiliated
Practices individually. In addition, because of its size and purchasing power,
the Company has been able to negotiate discounts on, among other things,
orthodontic and office supplies, health and malpractice insurance and equipment.
The Company does not employ orthodontists or control the practice of
orthodontics by the orthodontists employed the Affiliated Practices, and its
services revenue generally depends on revenue generated by the Affiliated
Practices. In some cases, the fees are based on the costs and expenses the
Company incurs in connection with providing services. The profitability of the
Affiliated Practices, as well as the performance of the individual orthodontists
employed by the Affiliated Practices, affect the Company's profitability.
PRACTICE-BUILDING PROGRAM. The Company believes patient satisfaction
levels, practice productivity and profitability can be substantially enhanced
through a consistent training program emphasizing practice-building techniques.
The Company implements programs designed to generate growth in case starts by
increasing (i) referrals from existing and former patients and (ii) case
acceptance rates. These programs include a full complement of training,
operating and monitoring techniques emphasizing improvements in communications
with patients and patient satisfaction levels in all facets of operations,
including initial
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telephone contacts with prospective patients, initial consultations and case
presentations and written or telephonic follow-ups after office visits. The
Company's programs are designed to result in clear, concise and consistent
communications between the patient and the orthodontist and his or her staff.
The Company believes that these programs have a positive effect on the patients'
experience and therefore positively affect the number of patient referrals and
case acceptance rates of Affiliated Practices.
EXTERNAL MARKETING. The Company and its Affiliated Practices utilize
multimedia advertising in certain local markets to stimulate demand for
treatment and promote name recognition for the Company and the Affiliated
Practices. The general public traditionally has had little information about the
availability of orthodontic services or orthodontic fees prior to an initial
consultation with an orthodontist. The advertisements address the two primary
barriers to receiving orthodontic treatment, availability and affordability, by
focusing on the availability of orthodontic services and the more affordable
payment plans offered by the Affiliated Practices. The advertisements also
stress the quality of care available at the Affiliated Practices and the
advantages of receiving orthodontic treatment from a professionally trained
orthodontist as opposed to a general dentist. The advertisements also promote a
toll-free number for ease of scheduling an appointment with the local Affiliated
Practice.
Generally, it is anticipated that an Affiliated Practice will spend an
amount equal to between 5% and 7% of its net revenues for advertising and
marketing, which the Company believes is significantly higher than the industry
average for traditional orthodontic practices. The Company is responsible for
subcontracting the production of all broadcast advertising, which is tailored to
meet local requirements. The frequency and airing times for any television
advertisements are determined by regional media consultants retained by the
Company and the Affiliated Practice in order to optimize penetration to target
market segments.
AFFORDABLE PAYMENT PLANS. Orthodontic services primarily involve private
pay, fee-for-service treatments. As part of its overall marketing strategy for
the Affiliated Practices, the Company encourages the Affiliated Practices to
make orthodontic services available to a larger portion of the population in
their respective markets by offering more affordable payment plans. Many of the
existing Affiliated Practices have historically received a down payment equal to
25% of the total cost of services, with the remaining amount paid equally over
the term of treatment. The typical payment plan recommended by the Company
consists of a modest initial down payment and monthly payments thereafter for
the duration of the treatment period, generally between 26 and 34 months.
Existing Affiliated Practices using such payment plans have experienced an
initial decrease in working capital; however, the Company believes that the
decrease in working capital generally will be offset by an increase in the
number of patients receiving orthodontic treatment because of the combined
effect of advertising, offering more affordable payment plans and the use of the
Company's practice-building program. The Company believes that offering more
affordable payment plans combined with the use of advertising has resulted in an
increase in the number of patients inquiring about orthodontic treatment. The
Company also believes that this increase, combined with the use of its internal
marketing programs, has resulted in an increase in the number of patients
receiving orthodontic treatment at the existing Affiliated Practices.
TRAINING AND EDUCATION. Staff and practice development programs are an
integral part of the Company's operating strategy. The Company believes its
programs (i) increase the motivation and overall performance of the staff, (ii)
improve the level of patient satisfaction achieved by the Affiliated Practices
and (iii) improve the Company's ability to attract and retain qualified
personnel, which collectively result in increased referrals from existing and
former patients and increased case acceptance rates for the Affiliated
Practices. The Company provides each Affiliated Practice with consulting and
educational services. These services include a full training program covering
all non-orthodontic aspects of the practice and specific training designed for
the efficient and effective use of the Company's management information system.
Specifically, the Company's training program provides each member of the
Affiliated Practice, from the receptionist to the orthodontist, with guidelines
for addressing questions and concerns of prospective and existing patients,
techniques for explaining treatment procedures and length of treatment,
parameters for establishing appropriate financial arrangements with each patient
and a systematic approach to monitoring
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the success of each area of training. Training is conducted both at individual
clinics and in group sessions and includes proprietary manuals, tapes and role
playing activities.
MANAGEMENT INFORMATION SYSTEM. The Company believes that access to
accurate, relevant and timely financial and operating information is a key
element to providing practice management services to orthodontic practices. The
Company offers a fully integrated financial reporting, productivity measurement
and patient management system to each existing Affiliated Practice. This system
is designed to increase the productivity of the Affiliated Practices by enabling
the Company and the Affiliated Practices to cost-effectively monitor the
productivity of the Affiliated Practices, identify problem areas and
opportunities for improvement and take corrective action in a timely manner.
Productivity measures that are monitored include case acceptance rates,
treatment times and case starts. In addition, the management information system
facilitates optimization of the orthodontists' time through computerized
scheduling and diagnostic and treatment recordkeeping systems. The Company
believes this system has improved the productivity of the existing Affiliated
Practices that have implemented it through benchmarking programs that identify
and help to establish the most efficient operational procedures.
LOCATIONS
As of December 31, 1997, the Company provided management services in the
following locations:
NUMBER OF
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STATE/PROVINCE PRACTICES OFFICES ORTHODONTISTS
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Alberta................................. 5 6 5
Arizona................................. 2 5 2
British Columbia........................ 2 4 2
California.............................. 11 15 11
Colorado................................ 6 12 6
Connecticut............................. 5 7 6
Georgia................................. 1 1 1
Illinois................................ 1 4 1
Montana................................. 1 3 1
Nevada.................................. 1 1 2
New Mexico.............................. 1 2 1
New York................................ 1 2 1
Ontario................................. 3 4 6
Pennsylvania............................ 2 4 2
South Carolina.......................... 1 1 1
Texas................................... 5 18 13
Utah.................................... 2 5 2
Virginia................................ 1 2 3
-- --
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Totals............................. 51 96 66
== ======= ==
SERVICE AGREEMENTS
The Company enters into a long-term service agreement ("Service Agreement")
with each Affiliated Practice and such practice's orthodontist employees under
which the Company is the exclusive administrator of non-orthodontic services
relating to the operation of the Affiliated Practice. The following is intended
to be a brief summary of the typical form of Service Agreement the Company has
entered into and expects to enter into with Affiliated Practices. The actual
terms of the various Service Agreements may vary from the description below on a
case-by-case basis, depending on negotiations with the individual Affiliated
Practices and the requirements of applicable law and governmental regulations.
The service fees payable to the Company by the Affiliated Practices under
the Service Agreements are calculated in accordance with the Company's three
general types of Service Agreements -- the standard
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form of the Service Agreement (the "Standard Contract"), the alternative form of
the Service Agreement (the "Alternative Contract") and a Service Agreement based
upon a flat fee (the "Flat Fee Contract"). The Standard Contract calls for a
calculation of the monthly service fee based on the total revenues earned by the
Affiliated Practices, which is defined by the agreement to represent 24% of the
total contract value in the initial month of a patient's treatment, with the
remainder of the contract balance earned evenly over the balance of the contract
term. From total revenues, the Company retains a percentage of the Affiliated
Practices' cash collections. The Alternative Contract is used in certain
jurisdictions where use of the Standard Contract is not permitted. It is a
cost-plus fee arrangement, whereby the service fee includes the reimbursement of
defined expenses incurred by the Company in the course of providing services to
the Affiliated Practice plus a percentage of revenues. The Flat Fee Contract is
based on a flat fee that is subject to adjustment on an annual basis. It is used
when local jurisdictions do not allow use of the Standard Contract or the
Alternative Contract. The Company believes the fees generated by each of these
formulas are reflective of the fair market value of the service provided and are
comparable to the fees earned by other management service companies in the
respective jurisdictions where these arrangements exist. See "Item 7.
Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Overview".
Pursuant to each Service Agreement, the Company, among other matters, (i)
acts as the exclusive manager and administrator of non-orthodontist services
relating to the operation of the Affiliated Practice, subject to matters
reserved to the Affiliated Practice, (ii) administers the billing of patients,
insurance companies and other third-party payors and collects on behalf of the
Affiliated Practice the fees for professional orthodontic and other services and
products rendered or sold by the Affiliated Practice, (iii) provides, as
necessary, clerical, accounting, payroll, legal, bookkeeping and computer
services and personnel, information management, tax return information,
printing, postage and duplication services and transcribing services, (iv)
supervises and maintains custody of substantially all files and records, (v)
provides facilities, equipment and furnishings for the Affiliated Practice, (vi)
prepares, in consultation with the Affiliated Practice, all annual capital and
operating budgets, (vii) orders and purchases inventory and supplies as
reasonably requested by the Affiliated Practice and (viii) implements, in
consultation with the Affiliated Practice, advertising programs.
Under each Service Agreement, the applicable Affiliated Practice retains
the responsibility for, among other things, (i) hiring, compensating and
supervising orthodontist employees and other licensed dental professionals, (ii)
ensuring that orthodontists have the required licenses, credentials, approvals
and other certifications appropriate to the performance of their duties and
(iii) complying with federal and state laws, regulations and ethical standards
applicable to the practice of orthodontics. In addition, the Affiliated are
exclusively in control of all aspects of the practice of orthodontics and the
provision of orthodontic services.
During the term of the Service Agreement (generally 20 to 40 years) and,
subject to certain exceptions and limitations, for a period of two years
thereafter, the existing Affiliated Practices have agreed not to compete with
the Company or the other Affiliated Practices within a specified geographic
area. In addition, each orthodontist employee has agreed, subject to certain
exceptions and limitations, not to compete with the Company or the other
Affiliated Practices within a specified geographic area until the later of (i)
the fifth anniversary date of the Service Agreement or (ii) five years from the
date the employee becomes a stockholder of the Affiliated Practice, and for a
period of two years after the earlier of his or her termination of employment
with the Affiliated Practice or termination of the applicable Service Agreement.
The existing Affiliated Practices also have agreed not to disclose certain
confidential and proprietary information relating to the Company and the
Affiliated Practices.
Each Affiliated Practice is responsible for obtaining professional
liability insurance for the employees of the Affiliated Practice (which names
the Company as an additional insured).
ORTHODONDIST EMPLOYMENT AGREEMENTS
The revenues of the Affiliated Practices (and, therefore, the success of
the Company) are dependent on fees generated by the orthodontists the Affiliated
Practices employ. Each Affiliated Practice is a party to an employment agreement
with each orthodontist associated with its practice (the "Orthodontist
Employment
7
<PAGE>
Agreements"). The Orthodontist Employment Agreements are generally for an
initial term ranging from five to seven years and continue thereafter on a
year-to-year basis until terminated under the terms of the agreements. The
Orthodontist Employment Agreements generally provide that the orthodontist will
not compete with the Company within a specified geographic area for a period of
two years following termination of the agreement. The Company does not employ
orthodontists and, where prohibited by applicable law, does not employ
orthodontic hygienists or orthodontic assistants. A substantial reduction in the
number of orthodontists employed by or associated with the Affiliated Practices
could have a material adverse effect on the financial performance of the
Company. The ability of the Affiliated Practices to replace existing
orthodontists by attracting new orthodontists may be constrained by the limited
number of new orthodontists completing post-graduate orthodontic programs each
year. In addition, a shortage of available orthodontists with the skills and
experience sought by the Company would have a material adverse effect on the
Company's expansion opportunities. Failure by the Affiliated Practices to employ
a sufficient number of orthodontists (whether by renewals of existing employment
agreements or otherwise) would have a material adverse effect on the Company's
business, financial condition and results of operations.
COMPETITION
The Company faces substantial competition from other companies to establish
affiliations with additional orthodontic practices. A number of other public and
private practice management companies focus on orthodontics, and several
companies are pursuing similar strategies in dentistry and other segments of the
health care industry. The Company is aware that general dental practice
management companies have provided, or intend to provide, orthodontic services
and have sought, or intend to seek, to affiliate with or employ orthodontists.
Certain of these competitors have greater financial and other resources than the
Company. Additional companies with similar objectives may enter the Company's
markets and compete with the Company. In addition, the business of providing
orthodontic services is highly competitive in each market in which the Company
operates. The Affiliated Practices face local competition from other
orthodontists, general dentists and pedodontists (dentists specializing in the
care of children's teeth), some of whom have more established practices.
Dentists are not restricted by law or any governmental authority from providing
orthodontic services. The Company believes the increase in recent years in
dentists providing orthodontic services has limited the growth of patient case
starts performed by orthodontists. There can be no assurance that the Company or
the Affiliated Practices will be able to compete effectively, that additional
competitors will not enter their markets or that additional competition will not
have a material adverse effect on the Company.
EMPLOYEES
As of December 31, 1997, the Company had 481 employees, of which 40 are
employed at the Company's headquarters and 441 are employed at the locations of
the existing Affiliated Practices. None of the Company's employees is
represented by collective bargaining agreements. The Company has not experienced
any work stoppages as a result of labor disputes and the Company considers its
employee relations to be good.
The Company's future performance depends in significant part on the
continued service of its senior management, including Dr. Vondrak and other key
personnel. There can be no assurance that Dr. Vondrak, the Company's senior
management and other key employees will continue to work for the Company. Loss
of services of those employees could have a material adverse effect on the
Company's business, results of operations and financial condition. The success
of the Company's growth strategy also depends on the Company's ability to
attract and retain additional high-quality personnel.
INSURANCE
The Affiliated Practices provide orthodontic services to the public and are
exposed to the risks of professional liability and other claims. Such claims, if
successful, could result in substantial damage awards to the claimants that may
exceed the limits of any applicable insurance coverage. Although the Company
does not control the practice of orthodontics by the Affiliated Practices, it
could be asserted that the
8
<PAGE>
Company should be held liable for malpractice of an orthodontist employed by an
Affiliated Practice. Each of the existing Affiliated Practices has undertaken to
comply with all applicable regulations and legal requirements, and the Company
maintains liability insurance for itself and is named as an additional insured
party on the liability insurance policies of the existing Affiliated Practices.
The existing Affiliated Practices maintain comprehensive professional liability
insurance, generally with limits of not less than $1.0 million per claim and
with aggregate policy limits of not less than $3.0 million per orthodontist. The
Company expects that it will require future Affiliated Practices to maintain
comparable insurance coverage. In the event an Affiliated Practice employs more
than one orthodontist, that practice will maintain insurance with a separate
limit for claims against that practice in an amount acceptable to the Company.
There can be no assurance that a future claim or claims will not be successful
or, if successful, will not exceed the limits of available insurance coverage or
that such coverage will continue to be available at acceptable costs.
The Company and the existing Affiliated Practices maintain professional
liability insurance coverage on a claims-made basis. Such insurance provides
coverage for claims asserted when the policy is in effect regardless of when the
events that caused the claim occurred.
GOVERNMENT REGULATION
The orthodontic services industry in the U.S. and Canada is regulated
extensively at both the state, provincial and federal levels. Regulatory
oversight includes, but is not limited to, considerations of fee-splitting,
corporate practice of orthodontics and state insurance regulation.
CORPORATE PRACTICE OF ORTHODONTICS; FEE-SPLITTING
The laws of many states in the U.S. and provinces of Canada prohibit
business corporations such as the Company from engaging in the practice of
orthodontics or employing orthodontists to practice orthodontics. The specific
restrictions against the corporate practice of orthodontics, as well as the
interpretation of those restrictions by state regulatory authorities, vary from
jurisdiction to jurisdiction. The restrictions are generally designed to
prohibit an entity not wholly owned by orthodontists (such as the Company) from
controlling the professional assets of an orthodontic practice (such as patient
records and payor contracts), employing orthodontists to practice orthodontics
(or, in certain jurisdictions, employing dental hygienists or orthodontic
assistants), or controlling the content of an orthodontist's advertising or
professional practice. The Company does not acquire any professional assets and,
as provided in the Service Agreements, does not control the practice of
orthodontics or employ orthodontists to practice orthodontics at any of the
Affiliated Practices' locations. Moreover, in jurisdictions in which it is
prohibited, the Company does not employ orthodontic hygienists or orthodontic
assistants. The Company provides management services to the Affiliated
Practices, and believes that the fees the Company charges for those services are
consistent with the laws and regulations of the jurisdictions in which it
operates. Therefore, the Company believes it would not be regarded as "owner,"
"operator" or "manager" of the Affiliated Practices within the meaning of those
terms under applicable orthodontic practice acts and believes that its
operations comply with the above-described laws to which it is subject. The laws
of many jurisdictions also prohibit orthodontists from sharing professional fees
with non-orthodontic entities.
Dental boards do not generally interpret these prohibitions as preventing a
non-orthodontic entity from owning non-professional assets used by an
orthodontist in an orthodontic practice or providing management services to an
orthodontist for a fee provided that the following conditions are met: (i) a
licensed dentist or orthodontist has complete control and custody over the
professional assets; (ii) the non-orthodontic entity does not employ or control
the orthodontists (or, in some states, orthodontic hygienists or orthodontic
assistants); (iii) all orthodontic services are provided by a licensed dentist
or orthodontist; and (iv) licensed dentists or orthodontists have control over
the manner in which orthodontic care is provided and all decisions affecting the
provision of orthodontic care. Applicable laws generally require that the amount
of a management fee be reflective of the fair market value of the services
provided by the management company and in certain states require that any
management fee be a flat fee or cost-plus fee based on the cost of services
performed by the Company. In general, the orthodontic practice acts do not
address or provide any restrictions concerning the manner in which companies
account for revenues from an orthodontic practice,
9
<PAGE>
subject to the above-noted restrictions relating to control over the
professional activities of the orthodontic practice, ownership of the
professional assets of an orthodontic practice and payments for management
services.
There can be no assurance that a review of the Company's business
relationships by courts or regulatory authorities will not result in
determinations that could prohibit or otherwise adversely affect the operations
of the Company or that the regulatory environment will not change, requiring the
Company to reorganize or restrict its existing or future operations. The laws
regarding fee-splitting and the corporate practice of orthodontics and their
interpretation are enforced by regulatory authorities with broad discretion.
There can be no assurance that the legality of the Company's business or its
relationship with the Affiliated Practices will not be successfully challenged
or that the enforceability of the provisions of any Service Agreement will not
be limited.
STATE INSURANCE REGULATION
Although the Company does not anticipate entering into managed care
contracts, there are certain regulatory risks associated with the Company's role
in negotiating and administering managed care contracts. The application of
state insurance laws to other than various types of fee-for-service arrangements
is an unsettled area of law and is subject to interpretation by regulators with
broad discretion. As the Company or the Affiliated Practices contract with
third-party payors, including self-insured plans, for certain
non-fee-for-service basis arrangements, the Company may become subject to state
insurance laws. Specifically, in some states, state insurance regulators may
determine that the Company or an Affiliated Practice is engaged in the business
of insurance because some of the managed care contracts to which an Affiliated
Practice may become a party may contain capitation features. In the event that
the Company or an Affiliated Practice is determined to be engaged in the
business of insurance, it could be required either to seek licensure as an
insurance company or to change the form of the relationships with third-party
payors and, as a result, the Company's revenues may be adversely affected.
HEALTH CARE REFORM PROPOSALS
The U.S. Congress has considered various types of health care reform,
including comprehensive revisions to the current health care system. It is
uncertain what, if any, legislative proposals will be adopted in the future or
what actions federal or state legislatures or third-party payors may take in
anticipation of or in response to any health care reform proposals or
legislation. Health care reform legislation could have a material adverse effect
the operations of the Company, and changes in the health care industry, such as
the growth of managed care organizations and provider networks, may result in
lower payment levels for the services of orthodontic practitioners and lower
profitability for Affiliated Practices, which would reduce the service fees
payable to the Company.
EXTENT OF PROTECTION OF PROPRIETARY RIGHTS
The Company relies in part on trademark, service mark, trade dress, trade
secret, unfair competition and copyright laws to protect its intellectual
property rights. There can be no assurance that actions taken by the Company
will be adequate to protect its intellectual property rights from
misappropriation by others, that the Company's proprietary information will not
become known to competitors, that others will not independently develop
substantially equivalent or better intellectual properties that do not infringe
on the Company's intellectual property rights or that others will not assert
rights in, and ownership of, proprietary rights of the Company. Furthermore, the
Company's rights to its "APPLE ORTHODONTIX" common law service mark may be
limited in market areas where a similar trademark or service mark may already be
in use. The Company has not applied for or obtained any registrations of its
trademarks or service marks. The Company is aware of several other businesses
that utilize an "APPLE" service mark in connection with the provision of general
dental services, some of which have obtained federal or state trademark
registrations. The Company is aware of one other orthodontic practice in the
United States that utilizes a service mark similar to the Company's, which
practice is not located in a market where any of the existing Affiliated
Practices' offices are located.
10
<PAGE>
ITEM 3. LEGAL PROCEEDINGS
On December 10, 1996, Orthodontic Centers of America, Inc. ("OCA") filed a
complaint in the United States District Court for the Eastern District of
Louisiana against the Company, Dr. Vondrak, John G. Vondrak, P.C. and John G.
Vondrak Apple Orthodontix, Inc. ("JGVAOI"), alleging, among other things,
misappropriation of trade secrets and certain breaches of a confidentiality
agreement executed by Dr. Vondrak, on behalf of John G. Vondrak, P.C., in favor
of OCA. While the Company is not a party to the confidentiality agreement, OCA
alleged that the Company should be bound by its terms as a result of the
relationship between Dr. Vondrak and the Company (specifically, OCA alleged that
Dr. Vondrak and Apple are alter egos and, alternatively, that Dr. Vondrak was
acting as the Company's agent when he executed the confidentiality agreement).
OCA's complaint stated that OCA was seeking monetary damages in excess of
$75,000. In August 1997, the court dismissed OCA's claims without prejudice on
the grounds that the court lacked jurisdiction. There can be no assurance that
OCA will not seek to overturn the court's decision or file a similar suit in
another jurisdiction.
In August 1997, the Company filed a declaratory judgment action in the
District Court of Harris County, Texas (164th Judicial District) seeking a
finding by the court that neither the Company nor Dr. Vondrak has violated the
terms of the confidentiality agreement, otherwise used confidential information
supplied by OCA or unfairly competed against OCA. In October 1997, OCA filed an
answer generally denying the Company's allegations, as well as asserting a
counterclaim against the Company, JGVAOI, Apple Orthodontix of Texas, Inc.,
Apple Acquisition of Texas, Inc., Dr. Vondrak, John G. Vondrak, P.C., one of the
Founding Affiliated Practices and the orthodontist associated with such
practice. OCA's counterclaim alleges, among other things, unfair competition,
misappropriation of trade secrets, tortious interference with prospective
contractual arrangements and certain breaches of confidentiality agreements
executed by each of Dr. Vondrak, on behalf of John G. Vondrak, P.C., and the
affiliated orthodontist, on behalf of the Founding Affiliated Practice referred
to above, in favor of OCA. While the Company is not a party to these
confidentiality agreements, OCA alleged that the Company should be bound by
their terms as a result of the relationships between Dr. Vondrak, the affiliated
orthodontist and the Company (specifically, OCA alleged that Dr. Vondrak and the
Company are alter egos and that the Company and abetted or conspired with Dr.
Vondrak and the affiliated orthodontist in their wrongful conduct). OCA's
complaint states that it is seeking monetary damages in excess of the minimum
jurisdictional limits of the court, punitive damages, injunctive relief,
prejudgment interest and attorneys' fees. The Company intends to vigorously
defend the claims made by OCA, which the Company believes are without merit.
This lawsuit is still pending, and the Company cannot predict whether it will
succeed in obtaining the declarations sought from the court or, if it is not
successful, what effect this may have on the Company.
In November 1997, the Company received notice that an acquaintance of Dr.
Vondrak, Mr. Donald Rose, was threatening to sue the Company, JGVAOI, Dr.
Vondrak and John G. Vondrak, P.C., alleging, among other things, certain
breaches of an alleged oral agreement with Dr. Vondrak pursuant to which Dr.
Vondrak was to award Mr. Rose 10% of any stock issued to Dr. Vondrak in the IPO
in exchange for Mr. Rose's effort to obtain venture capital for the Company. On
January 8, 1998, Dr. Vondrak filed a declaratory judgement action in the
District Court of Harris County, Texas (269th Judicial District) seeking a
finding by the court that Mr. Rose was not entitled to any of Dr. Vondrak's
stock or any other remuneration. Mr. Rose has filed a special appearance
challenging jurisdiction and a general denial. The Company is not a party to the
declaratory judgement action filed by Dr. Vondrak. While the Company was not a
party to the alleged oral agreement, Mr. Rose maintains that the Company should
be bound by its terms as a result of the relationship between Dr. Vondrak and
the Company. Although the Company believes that these allegations are without
merit, there can be no assurance that a lawsuit will not be filed and, if filed,
that the Company will obtain a successful outcome.
The Company is not currently a party to any other claims, suits or
complaints relating to services and products provided by the Company or the
existing Affiliated Practices, although there can be no assurance that such
claims will not be asserted against the Company in the future. The Company is
subject to certain pending claims as a result of successor liability in
connection with its affiliations with existing Affiliated
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<PAGE>
Practices; however, the Company believes that the ultimate resolution of those
claims will not have a material adverse effect on the financial position or
operating results of the Company.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Prior to the closing of the IPO, the stockholders of the Company approved a
number of matters during the period covered by this Annual Report on Form 10-K.
On April 24, 1997, the stockholders approved by unanimous written consent (i)
the amendment and restatement of the Company's Certificate of Incorporation to,
among other things, (A) increase the number of authorized shares of capital
stock to 39,106,852 shares, consisting of 25,000,000 shares of Common Stock,
4,106,852 shares of Class B Common Stock, par value $.001 per share (the "Class
B Stock") and 10,000,000 shares of Preferred Stock, (B) change the par value of
Common Stock to $.001 per share and (C) reclassify each outstanding share of
Common Stock into 4,012.556913 shares of Class B Stock; and (ii) the adoption of
the Company's 1996 Stock Option Plan. On May 18, 1997, the stockholders approved
by unanimous written consent a certificate of amendment to the Company's
Restated Certificate of Incorporation providing for the reclassification of each
issued and outstanding share of Class B Stock into 0.815 shares of Class B
Stock.
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<PAGE>
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS
(a) The Company's authorized common stock consists of 25,000,000 shares of
Common Stock and 4,106,852 shares of Class B Stock.
The Company's Common Stock has been publicly traded on the American Stock
Exchange under the symbol AOI since the Company's IPO offering on May 22, 1997.
The following table sets forth the quarterly high and low sales prices for the
indicated quarter of fiscal 1997:
QUARTER ENDED HIGH LOW
- ------------------------------------- ---- ----
June 30, 1997 (partial quarter
commencing May 22, 1997)........... $12 15/16 $ 7 3/8
September 30, 1997................... 16 1/4 9
December 31, 1997.................... 16 1/16 10
The Company's Class B Stock is not publicly traded.
There were approximately 106 shareholders of record (including brokerage
firms and other nominees) of the Company's Common Stock as of March 24, 1998.
The number of record holders does not bear any relationship to the number of
beneficial owners of Common Stock.
The Company has never paid any cash dividends and does not anticipate
paying cash dividends on its Common Stock or Class B Stock in the foreseeable
future. The Company currently intends to retain earnings to support operations
and finance expansion. In addition, the Company's existing credit facility
prohibits the payment of dividends.
RECENT SALES OF UNREGISTERED SECURITIES
The following information relates to securities of the Company issued or
sold during 1997 which were not registered under the Securities Act:
In April 1997, each outstanding share of Common Stock was reclassified
into 4,012.5569 shares of Class B Stock (the "Stock Split"), which was
subsequently readjusted in May 1997 with the net effect of a 3,270-for-one
split. The Stock Split and adjustment were exempt from the registration
requirements of the Securities Act as they did not involve a "sale," as
defined in Section 2(3) of the Securities Act.
Simultaneously with the completion of its IPO, the Company issued
3,682,554 shares of Common Stock in connection with the acquisitions of the
Founding Affiliated Practices. These issuances were exempt from the
registration requirements of the Securities Act by virtue of Section 4(2)
thereof as transactions not involving any public offering.
Each share of Class B Stock will automatically convert to Common Stock
on a share-for-share basis (i) in the event of a disposition of such share
of Class B Stock by the holder thereof (excluding dispositions to such
holder's affiliates), (ii) in the event any person not affiliated with the
Company acquires beneficial ownership of 15% or more of the outstanding
shares of capital stock of the Company, (iii) in the event any person not
affiliated with the Company offers to acquire beneficial ownership of 15%
or more of the outstanding shares of capital stock of the Company, (iv) in
the event the holder of such share elects to so convert at any time after
the second anniversary of the date of the IPO, (v) on the fifth anniversary
of the date of the IPO or (vi) in the event the holders of a majority of
the outstanding shares of Common Stock approve such conversion. In
addition, the Company may elect to convert any outstanding shares of Class
B Stock into shares of Common Stock in the event 80% or more of the
outstanding shares of Class B Stock as of the date of the IPO have
previously been converted into shares of Common Stock.
(b) Use of Proceeds.
The Company's Registration Statement on Form S-1 (Registration No.
333-22785), as amended, with respect to the offering of shares in the IPO was
declared effective by the Securities and Exchange
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Commission (the "Commission") on May 14, 1997. The IPO commenced on May 22,
1997, and has since terminated, resulting in (i) the sale by the Company of
2,350,000 shares of Common Stock on May 22, 1997 and (ii) the sale by the
Company of 352,500 shares of Common Stock pursuant to the exercise of the
underwriters' over-allotment option on May 27, 1997. The shares sold constituted
all the shares of Common Stock covered by the Registration Statement. The
managing underwriters for the IPO were Bear, Stearns & Co. Inc. and Equitable
Securities Corporation. The aggregate price to the public for the shares sold in
the IPO was $18.9 million. The Company incurred total expenses of $6.8 million
with respect to the IPO, including $1.3 million in underwriting discounts and
commissions paid by the Company and $5.5 million in other expenses. The amount
of other expenses is a reasonable estimate of such amount. None of such payments
was a direct or indirect payment to directors or officers of the Company or
their associates, to persons owning 10% or more of any class of equity
securities of the Company or to affiliates of the Company, other than $3.0
million to repay certain transaction costs advanced by TriCap Funding I, L.L.C
and approximately $500,000 in consulting fees paid to TriCap Partners, an
affiliate of TriCap Funding I, L.L.C., which was co-owned by Mr. William W.
Sherrill, a director of the Company.
The net proceeds to the Company from the IPO were $12.1 million. The
Company used such net proceeds as follows: (i) $6.6 million for a special
dividend to the Founding Affiliated Practices and (ii) $5.5 million for
affiliations with additional orthodontic practices. None of such payments was a
direct or indirect payment to directors or officers of the Company or their
associates, to persons owning 10% or more of any class of equity securities of
the Company or to affiliates of the Company, other than approximately $525,000
paid to Dr. John G. Vondrak, Chairman of the Board and Chief Executive Officer
of the Company, for the affiliation of Dr. Vondrak's orthodontic practice with
the Company and the reimbursement of certain organizational expenses of the
Company incurred by such practice.
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ITEM 6. SELECTED FINANCIAL DATA
The information set forth below for the year ended December 31, 1997 and
for the period from inception of operations (July 15, 1996) through December 31,
1996 is derived from the audited consolidated financial statements of the
Company included elsewhere in this Report. The Company believes that comparison
of results for 1997 periods to those for 1996 periods is not meaningful because
the Company was effectively not in operation in 1996.
<TABLE>
<CAPTION>
PERIOD FROM INCEPTION
YEAR ENDED (JULY 15, 1996) THROUGH
DECEMBER 31, 1997 DECEMBER 31, 1996
----------------- -----------------------
(IN THOUSANDS, EXCEPT
PER SHARE AMOUNTS)
<S> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Management service fee revenues(1)...... $19,186 $--
Costs and expenses(2):
Salaries and benefits.............. 8,411 627
Orthodontic supplies............... 2,352 --
Rent............................... 2,156 20
Advertising and marketing.......... 484 --
General and administrative......... 3,617 232
Depreciation and amortization...... 943 5
Special compensation expense
related to issuance of
stock(3)......................... -- 13,812
Special consulting expense related
to issuance of stock(3).......... -- 9,613
----------------- -----------------------
Total costs and expenses........... 17,963 24,309
----------------- -----------------------
Operating income (loss)................. 1,223 (24,309)
Interest expense........................ 274 --
Interest and other income............... (207) --
----------------- -----------------------
Income (loss) before income tax
provision............................. 1,156 (24,309)
Income tax provision.................... 439 --
----------------- -----------------------
Net income (loss)....................... $ 717 $ (24,309)
================= =======================
Earnings (loss) per common and common equivalent share:
Basic.............................. $ 0.09 $ (7.24)
Diluted............................ 0.09 (7.24)
Weighted average shares outstanding:
Basic.............................. 8,132 3,359
Diluted............................ 8,344 3,359
DECEMBER 31,
---------------------
1997 1996
--------- ----------
BALANCE SHEET DATA:
Working capital......................... $ 2,645 $ (2,324)
Total assets............................ 55,180 1,461
Long-term debt, net of current
portion............................... 248 --
Stockholders' equity.................... 35,493 (884)
</TABLE>
- ------------
(1) Reflects management service fees for the Founding Affiliated Practices since
June 1, 1997. Management service fees related to affiliations subsequent to
the IPO are included from the date of such affiliation.
(2) Corporate office expenses are included for all periods presented.
(3) Reflects non-recurring charges related to shares issued to management and
advisors of the Company in October and December 1996, at $7.00 per share.
15
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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following is management's discussion and analysis of certain
significant factors that have affected certain aspects of the Company's
financial position and results of operations during the periods included in the
accompanying consolidated financial statements. This discussion should be read
in conjunction with the Company's Consolidated Financial Statements and Notes
thereto presented elsewhere in this Report.
OVERVIEW
The Company conducted no significant operations before its IPO in May 1997
when the Company acquired the tangible and intangible assets and liabilities of,
and entered into Service Agreements with, the 31 Founding Affiliated Practices.
Since that time, through December 31, 1997, the Company has affiliated with an
additional 20 practices and 35 orthodontists operating in 39 offices. The
Company expects that its future growth will come from (i) implementing a
comprehensive practice operating approach designed to drive internal growth of
the Affiliated Practices, (ii) entering into Service Agreements with new
Affiliated Practices and (iii) developing new orthodontic centers, including
satellite offices (branch locations of existing Affiliated Practices), with
existing and future Affiliated Practices.
Through its Service Agreements, the Company provides a full complement of
practice management services to Affiliated Practices in return for management
service fees. The management service fees earned by the Company are in
accordance with three general types of Service Agreements -- the Standard
Contract, the Alternative Contract and the Flat Fee Contract. The Standard
Contract calls for a calculation of the monthly service fee based on the total
patient revenues earned by the Affiliated Practice, which is defined by the
agreement to represent 24% of the total contract value in the initial month of a
patient's treatment, with the remainder of the contract balance earned evenly
over the balance of the contract term. From total patient revenues, the
practices retain a percentage of the Affiliated Practices' cash collections.
The Alternative Contract is used in certain jurisdictions where use of the
Standard Contract is not permitted. It is a cost-plus fee arrangement, whereby
the service fee includes the reimbursement of defined expenses incurred by the
Company in the course of providing services to the Affiliated Practice plus a
percentage of revenues. The Flat Fee Contract is based on a flat fee that is
subject to adjustment on an annual basis. It is used when local jurisdictions do
not allow use of the Standard Contract or the Alternative Contract. The Company
believes the fees generated by each of these formulas reflect the fair market
value of the services provided and are comparable to the fees earned by other
practice management service companies in the respective jurisdictions where
these arrangements exist. See "Items 1 and 2. Business and Properties -- Service
Agreements."
The expenses incurred by the Company in fulfilling its obligations under
the Service Agreements are generally of the same nature as the operating costs
and expenses that would have otherwise been incurred by the Affiliated
Practices, including salaries, wages and benefits of practice personnel
(excluding orthodontists and, in some cases, orthodontic assistants and other
professional personnel), orthodontic supplies and office supplies used in
administering their clinic practices, the office (general and administrative)
expenses of the practices and depreciation and amortization of assets acquired
from the existing Affiliated Practices. In addition to the operating costs and
expenses discussed above, the Company incurs personnel and administrative
expenses in connection with establishing and maintaining a corporate office,
which provides management, administrative, marketing and business development
services.
The Company's results of operations may fluctuate significantly from
quarter to quarter or year to year. Results may fluctuate due to a number of
factors, including the timing of future affiliations and new office openings,
seasonal fluctuations in the demand for orthodontic services and competitive
factors. Accordingly, quarterly comparisons of the Company's revenues and
operating results should not be relied on as an indication of future
performance, and the results of any quarterly period may not be indicative of
results to be expected for a full year.
The securities markets have, from time to time, experienced significant
price and volume fluctuations that may be unrelated to the operating performance
of particular companies. These fluctuations often substantially affect the
market price of a company's common stock. The market prices for securities of
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<PAGE>
physician practice management companies have been, and can in the future be to
be, particularly volatile. The market price of the Common Stock may be subject
to volatility from quarter to quarter depending on announcements regarding the
Affiliated Practices and the Company's ability to open new offices, affiliations
by the Company or its competitors, government relations, developments or
disputes concerning proprietary rights, changes in health care policy in the
United States and Canada, the issuance of stock market analyst reports and
recommendations, and economic and other external factors beyond the control of
the Company, as well as operating results of the Company and fluctuations in the
Company's financial results.
In accordance with Staff Accounting Bulletin ("SAB") No. 48, "Transfers of
Nonmonetary Assets by Promoters or Shareholders," published by the Commission,
the acquisition of the assets and assumption of certain liabilities for all the
Founding Affiliated Practices has been accounted for by the Company at the
transferors' historical cost basis, with the shares of Common Stock issued in
those transactions being valued at the historical cost of the nonmonetary assets
acquired net of liabilities assumed. The cash consideration paid at closing on
May 29, 1997 is reflected as a dividend by the Company to the owners of the
Founding Affiliated Practices in the quarter ended June 30, 1997. SAB No. 48 is
not applicable to affiliations made by the Company subsequent to the IPO. The
Company's subsequent acquisitions of certain of the assets and liabilities of
Affiliated Practices has resulted and will continue to result in substantial
noncash amortization charges for intangible assets in the Company's statements
of operations.
RESULTS OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, 1997 AND THE PERIOD FROM
INCEPTION
(JULY 15, 1996) THROUGH DECEMBER 31, 1996
MANAGEMENT SERVICE FEE REVENUES
The Company generated management service fee revenues of $19.2 million for
the year ended December 31, 1997. The Company conducted no significant
operations during 1996 through the date of the IPO. Following completion of the
IPO and the affiliations with the Founding Affiliated Practices on May 29, 1997,
the Company began operations effective June 1, 1997. Therefore, management
service fee revenues reflect only seven months of operations during the year
ended December 31, 1997 and there were no management service fee revenues during
the year ended December 31, 1996.
COSTS AND EXPENSES
The Company incurred costs and expenses of $18.0 million (93.6% of service
fee revenues) for the year ended December 31, 1997. The Company's costs and
expenses consisted primarily of salaries and benefits, orthodontic supplies,
rent, advertising and marketing, general and administrative and depreciation and
amortization. Costs and expenses of $24.3 million for 1996 represented corporate
office expenses for the period from inception (July 15, 1996) through December
31, 1996. Of the $24.3 million of costs and expenses for the period ended
December 31, 1996, $23.4 million related to the valuing of stock issued to
founders, management and advisors of the Company in October and December 1996 at
the initial public offering price of $7.00 per share. This valuation resulted in
special compensation expense of $13.8 million and special consulting expense of
$9.6 million, with a corresponding increase in additional paid-in capital of
$23.4 million. There was no net effect on stockholders' equity. The Company also
incurred various legal, accounting, travel, personnel and marketing costs during
the period from inception (July 15, 1996) through December 31, 1996 in
connection with the IPO and the affiliations with the Founding Affiliated
Practices.
OPERATING INCOME
The Company generated operating income of $1.2 million for the year ended
December 31, 1997. This operating income amount comprised 6.4% of service fee
revenues for the period. The Company generated an operating loss of $24.3
million for the year ended December 31, 1996, which was primarily attributable
to the compensation and consulting charges described above. As stated above,
these results reflect the impact of the Company's Service Agreements only for
the period from June 1, 1997 through December 31, 1997 (i.e., the period
subsequent to the IPO) for the Founding Affiliated Practices and from the date
of affiliation through December 31, 1997 for all subsequent affiliations.
General and administrative expenses
17
<PAGE>
were incurred during the entire period from inception (July 15, 1996) through
May 29, 1997 in connection with the IPO and the affiliation with the Founding
Affiliated Practices.
INTEREST EXPENSE
Interest expense of $273,506 for the year ended December 31, 1997 reflected
the cost of borrowings under the Company's revolving credit facility entered
into on July 28, 1997, certain indebtedness of the Founding Affiliated Practices
that was assumed by the Company and certain capital lease obligations for
computer and office equipment. There was no interest expense incurred during the
year ended December 31, 1996.
INTEREST INCOME
Interest income of $190,669 for the year ended December 31, 1997 reflected
interest earned on the Company's net proceeds from the IPO and on notes
receivable from certain of the Founding Affiliated Practices. There was no
interest income generated during the year ended December 31, 1996.
INCOME TAX PROVISION
The Company incurred an income tax provision of $439,282 for the year ended
December 31, 1997, representing an effective tax rate of 38%. The Company
incurred no income taxes for the period ended December 31, 1996. The benefit of
the net operating loss generated during 1996 was fully reserved.
NET INCOME (LOSS)
As a result of the foregoing factors, the Company generated net income of
$716,725 for the year ended December 31, 1997, or earnings per share of $0.09.
This net income amount comprised 3.7% of service fee revenues for the period.
The net loss of $24.3 million for 1996 represented a loss per share of $7.24.
YEAR 2000 IMPACT ON INFORMATION TECHNOLOGY INFRASTRUCTURE
During 1997, the Company completed a comprehensive evaluation of its
information technology infrastructure to analyze the impact of the technical
problems anticipated for the year 2000. Following its evaluation, the Company
determined that substantially all its information technology infrastructure
would be unaffected by such problems and that the financial impact of the year
2000 on the Company's information technology infrastructure would be negligible.
LIQUIDITY AND CAPITAL RESOURCES
FINANCING ACTIVITIES
The Company has financed its capital requirements to date with borrowings
from banks and issuances of equity securities. To date, it has been able to
obtain satisfactory financing for its operations and believes that it will be
able to obtain such financing as it requires in the future. On July 28, 1997,
the Company entered into a three-year, $15.0 million revolving credit facility
with Chase Bank of Texas, N.A. (the "Chase Facility"). Availability under the
Chase Facility is tied to the Company's cash flow and liquidity. Advances under
the Chase Facility bear interest, at the Company's option, at prime rate or
LIBOR, in each case plus a margin calculated based on the Company's ratio of
indebtedness to cash flow. At December 31, 1997, the Company had no borrowings
drawn under this facility.
In May 1997, the Company issued and sold 2,702,500 shares of Common Stock
in its IPO. The IPO provided the Company with net proceeds of $12.1 million. The
Company used the net proceeds from the IPO to fund cash paid for affiliations
with the Founding Affiliated Practices of $6.6 million with the remainder
funding affiliations with additional practices. In November 1997, the Company
issued and sold 1,490,014 shares of Common Stock in a public offering (the
"Offering"). The Offering provided the Company with net proceeds of $15.3
million. The Company has used the proceeds of the Offering to repay $12.2
million under the Chase Facility, to affiliate with additional orthodontists, to
develop new offices, for capital expenditures and for general corporate
purposes.
18
<PAGE>
Total long-term debt increased from zero at December 31, 1996, to $247,624
at December 31, 1997. The increase is attributable to borrowings for
affiliations with new orthodontic practices, the purchase of property and
equipment and general working capital needs, net of repayment of borrowings
under the Chase Facility out of the proceeds of the Offering. The Company's
weighted average cost of indebtedness was 8.7% per annum for the year ended
December 31, 1997.
WORKING CAPITAL MANAGEMENT
The Company's strategy in managing its working capital is to maintain
sufficient availability under its bank credit facility to finance short-term
capital needs in excess of internally generated funds and minimize excess cash
on its balance sheet.
The cash and cash equivalents balance of $2.1 million at December 31, 1997
consisted primarily of net proceeds remaining from the Offering.
The restricted cash balance of $2.1 million at December 31, 1997 consisted
of borrowings under the Company's revolving credit facility which were placed
into escrow pending the resolution of certain post-closing contingencies related
to a new affiliation completed during the third quarter of 1997. A favorable
resolution of these post-closing contingencies would result in payment of the
$2.1 million to the sellers in January 1999. The Company has the right to post a
letter of credit in order to have the $2.1 million released from escrow to the
Company prior to January 1999.
CAPITAL EXPENDITURES
The Company made capital expenditures for the Affiliated Practices during
1997 of approximately $3.6 million to fund, among other things, the development
of new offices. The average cost of developing a new office (which may vary by
geographic market) is estimated to be approximately $250,000 to $400,000,
including initial working capital requirements. The Service Agreements provide
for advances by the Company to the Affiliated Practices for working capital
requirements (including any deficits in cash flows of Affiliated Practices
resulting from, among other factors, development of satellite offices) and other
purposes. Such loans bear interest at prime plus 1% and are repayable over
varying periods of time not to exceed five years. Total notes receivable from
Affiliated Practices were $1.6 million at December 31, 1997. It is anticipated
that capital expenditures in 1998 will be funded from the Company's cash flow
from operations, the net proceeds from the Offering and borrowings under the
Chase Facility.
The Company's expansion strategy requires substantial capital resources.
Capital is needed not only for the affiliation with future Affiliated Practices,
but also for the effective integration, operation and expansion of the existing
and future Affiliated Practices. In addition, the Affiliated Practices may from
time to time require capital for renovation and expansion and for the addition
of equipment and technology. The extent to which the Company is able or willing
to use shares of Common Stock to enter into future affiliations or provide
future financing will depend on the market value of the Common Stock from time
to time and, in the case of affiliations, the willingness of owners of potential
Affiliated Practices to accept Common Stock as full or partial payment of
consideration for their affiliations. Using shares of Common Stock for these
purposes may result in significant dilution to then-existing stockholders. The
Company will require additional capital from outside financing sources in order
to continue its expansion program. There can be no assurance that the Company
will be able to obtain additional funds when needed on satisfactory terms or at
all. Any limitation on the Company's ability to obtain additional financing
could have a material adverse effect on the Company's business, financial
condition and results of operations.
BUSINESS DEVELOPMENT
The Company's business development program also requires significant
amounts of capital. The amount of cash to be used in attracting the affiliation
of new Affiliated Practices, particularly the amount to be used in any given
period, depends on a number of factors, many of which are beyond the Company's
control. The Company anticipates the use of a combination of cash, notes and
shares of its Common Stock to fund the cost of additional affiliations. In order
to fund such additional affiliations, the Company will use cash flow from
operations, net proceeds from the Offering and borrowings under the Chase
Facility and will
19
<PAGE>
seek to raise capital through additional bank borrowings and public or private
debt or equity issuances. The availability of these capital sources will depend
on prevailing market conditions, interest rates and the then existing financial
condition of the Company. During the year ended December 31, 1997, the Company
spent $8.7 million of cash (including $321,000 in deferred payments and $1.5
million in related out-of-pocket costs) and issued 1.9 million shares of Common
Stock in connection with affiliations with new Affiliated Practices.
AFFORDABLE PAYMENT PLANS
A part of the Company's business strategy is to encourage Affiliated
Practices to offer more affordable payment plans to patients. The Company does
not expect the affordable payment plans, or any potential increase in bad debt
expense resulting from these plans, to have any significant negative impact on
the working capital or liquidity of the Affiliated Practices. Existing
Affiliated Practices using such payment plans have experienced an initial
decrease in working capital; however, the Company believes that the decrease in
working capital generally will be offset by an increase in the number of
patients receiving orthodontic treatment because of the combined effect of
advertising, offering more affordable payment plans and the use of the Company's
practice-building program. Moreover, the Company believes the existing
Affiliated Practices have the financial wherewithal to sustain any negative
impact that may result from these payment plans. Therefore, the Company does not
anticipate that the offering by the Affiliated Practices of more affordable
payment plans will impair the Company's ability to collect service fees from the
Affiliated Practices.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Not applicable.
20
<PAGE>
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors and Stockholders of
Apple Orthodontix, Inc.:
We have audited the accompanying consolidated balance sheets of Apple
Orthodontix, Inc., a Delaware corporation, and subsidiaries as of December 31,
1997 and 1996, and the related consolidated statements of operations, changes in
stockholders' equity (deficit) and cash flows for the year ended December 31,
1997 and the period from inception, July 15, 1996, through December 31, 1996.
These financial statements are the responsibility of the Company's management.
Our responsibility is to express an opinion on these financial statements based
on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Apple
Orthodontix, Inc. and subsidiaries as of December 31, 1997 and 1996, and the
results of its operations and its cash flows for the year ended December 31,
1997 and the period from inception, July 15, 1996, through December 31, 1996, in
conformity with generally accepted accounting principles.
ARTHUR ANDERSEN LLP
Houston, Texas
February 25, 1998
21
<PAGE>
APPLE ORTHODONTIX, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31,
-------------------------------
1997 1996
-------------- ---------------
ASSETS
Current assets:
Cash and cash equivalents....... $ 2,114,449 $ 21,254
Restricted cash................. 2,140,146 --
Receivable from orthodontic
practices, net of allowances
of $69,163 and $0,
respectively.................. 2,361,627 --
Prepaid expenses................ 250,205 --
Other current assets............ 644,557 --
-------------- ---------------
Total current assets....... 7,510,984 21,254
-------------- ---------------
Property and equipment, net.......... 6,025,430 --
Intangible assets, net............... 39,146,371 44,687
Receivable from orthodontic
practices, net of current
portion............................ 1,641,633 --
Deferred issuance costs.............. 34,325 1,395,350
Other assets......................... 821,508 --
-------------- ---------------
Total assets............... $ 55,180,251 $ 1,461,291
============== ===============
LIABILITIES AND STOCKHOLDERS' EQUITY
(DEFICIT)
Current liabilities:
Current maturities of long-term
debt.......................... $ 1,022,710 $ --
Accounts payable and accrued
expenses...................... 3,242,000 1,830,009
Payable to orthodontic
practices..................... 250,649 --
Income tax payable.............. 351,013 --
Amounts due to venture capital
investors..................... -- 515,000
-------------- ---------------
Total current
liabilities............. 4,866,372 2,345,009
-------------- ---------------
Long-term debt, net of current
maturities......................... 247,624 --
Deferred income taxes................ 14,544,383 --
Other long-term obligations.......... 29,099 --
-------------- ---------------
Total liabilities.......... 19,687,478 2,345,009
-------------- ---------------
Commitments and contingencies
Stockholders' equity (deficit)
Class A common stock , $0.001 par value, 25,000,000 shares authorized,
9,980,192 and 0 shares issued and
outstanding................... 9,980 --
Class B common stock, $0.001 par
value, 4,106,852 shares
authorized, 3,176,774 and
3,347,084 shares issued and
outstanding................... 3,177 3,347
Additional paid-in capital...... 58,295,163 23,422,313
Warrants........................ 777,106 --
Retained deficit................ (23,592,653) (24,309,378)
-------------- ---------------
Total stockholders' equity
(deficit)............... 35,492,773 (883,718)
-------------- ---------------
Total liabilities and
stockholders' equity
(deficit)............... $ 55,180,251 $ 1,461,291
============== ===============
The accompanying notes are an integral part of these consolidated financial
statements.
22
<PAGE>
APPLE ORTHODONTIX, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
PERIOD FROM
INCEPTION
(JULY 15,
YEAR ENDED 1996) THROUGH
DECEMBER 31, DECEMBER 31,
1997 1996
------------- -------------
Management service fee revenues...... $ 19,185,550 $ --
Costs and expenses:
Salaries and benefits.............. 8,411,032 627,476
Orthodontic supplies............... 2,351,786 --
Rent............................... 2,155,876 19,676
Advertising and marketing.......... 483,973 --
General and administrative......... 3,616,596 232,232
Depreciation and amortization...... 943,437 4,510
Special compensation expense
related to issuance of stock.... -- 13,812,681
Special consulting expense related
to issuance of stock............ -- 9,612,803
------------- -------------
Total costs and expenses... 17,962,700 24,309,378
------------- -------------
Operating income (loss).... 1,222,850 (24,309,378)
Interest expense..................... 273,506 --
Interest income...................... (190,669) --
Other expense (income), net.......... (15,994) --
------------- -------------
Income (loss) before income
tax provision........... 1,156,007 (24,309,378)
Income tax provision................. 439,282 --
------------- -------------
Net income (loss).......... $ 716,725 $ (24,309,378)
============= =============
Earnings (loss) per common and common equivalent share:
Basic...................... $ 0.09 $ (7.24)
============= =============
Diluted.................... $ 0.09 $ (7.24)
============= =============
Number of shares used in calculating earnings (loss) per common and common
equivalent share:
Basic...................... 8,131,905 3,358,513
============= =============
Diluted.................... 8,344,398 3,358,513
============= =============
The accompanying notes are an integral part of
these consolidated financial statements.
23
<PAGE>
APPLE ORTHODONTIX, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (DEFICIT)
<TABLE>
<CAPTION>
CLASS A AND B TOTAL
COMMON STOCK ADDITIONAL STOCKHOLDERS'
------------------------- PAID-IN RETAINED EQUITY
SHARES AMOUNT CAPITAL WARRANTS DEFICIT (DEFICIT)
-------------- --------- ----------- -------- ------------ -------------
<S> <C> <C> <C> <C> <C>
BALANCE, July 15, 1996.................. -- $ -- $ -- $ -- $ -- $ --
Issuance of stock.................. 3,347,084 3,347 23,422,313 -- -- 23,425,660
Net loss........................... -- -- -- -- (24,309,378) (24,309,378)
-------------- --------- ----------- -------- ------------ -------------
BALANCE, December 31, 1996.............. 3,347,084 3,347 23,422,313 -- (24,309,378) (883,718)
Issuances of common stock.......... 4,196,800 4,197 27,428,872 -- -- 27,433,069
Transfers of certain assets and
liabilities by founders.......... 3,682,554 3,683 495,274 -- -- 498,957
Special dividend to founders....... -- -- (6,591,711) -- -- (6,591,711)
Issuance of warrants............... -- -- (777,106) 777,106 -- --
Issuance of stock to new affiliated
practices........................ 1,930,528 1,930 14,112,622 -- -- 14,114,552
Issuances of options to
non-employees.................... -- -- 204,899 -- -- 204,899
Net income......................... -- -- -- -- 716,725 716,725
-------------- --------- ----------- -------- ------------ -------------
BALANCE, December 31, 1997.............. 13,156,966 $ 13,157 $58,295,163 $777,106 $(23,592,653) $ 35,492,773
============== ========= =========== ======== ============ =============
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
24
<PAGE>
APPLE ORTHODONTIX, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
PERIOD FROM
INCEPTION
(JULY 15, 1996)
YEAR ENDED THROUGH
DECEMBER 31, 1997 DECEMBER 31, 1996
----------------- -----------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)............... $ 716,725 $ (24,309,378)
Adjustments to reconcile net
income (loss) to net cash used
in operating activities:
Depreciation and
amortization............ 943,437 4,510
Deferred income tax
expense................. 88,270 --
Special compensation and
consulting expense paid
in stock................ -- 23,425,484
Provision for doubtful
accounts................ 69,163 --
Changes in assets and
liabilities, excluding effects
of acquisitions:
Receivable from orthodontic
practices............... (2,322,907) --
Prepaid expenses........... (285,888) --
Other assets............... (683,073) --
Payables and other accrued
liabilities............. (1,766,379) 404,215
----------------- -----------------
Net cash used in
operating
activities......... (3,240,652) (475,169)
----------------- -----------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures............ (3,631,962) --
Payments for new affiliated
practices..................... (6,815,963) --
Payments of costs associated
with entering into new
affiliations.................. (1,548,751)
Payment into escrow for a new
affiliated practice........... (2,140,146) --
Advances to affiliates.......... (1,868,446) --
Repayment of advances by
affiliates.................... 123,142 --
----------------- -----------------
Net cash used in
investing
activities......... (15,882,126) --
----------------- -----------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from borrowings........ 14,934,130 798,744
Repayments of borrowings........ (15,353,817) (253,300)
Proceeds from issuances of
common stock.................. 33,723,540 176
Cash paid related to common
stock issuance costs.......... (5,496,169) (49,197)
Special dividend to founders.... (6,591,711) --
----------------- -----------------
Net cash provided by
financing
activities......... 21,215,973 496,423
----------------- -----------------
NET INCREASE IN CASH AND CASH
EQUIVALENTS........................ 2,093,195 21,254
CASH AND CASH EQUIVALENTS AT
BEGINNING OF PERIOD................ 21,254 --
----------------- -----------------
CASH AND CASH EQUIVALENTS AT END OF
PERIOD............................. $ 2,114,449 $ 21,254
================= =================
The accompanying notes are an integral part of these consolidated financial
statements.
25
<PAGE>
APPLE ORTHODONTIX, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. BUSINESS AND ORGANIZATION
Apple Orthodontix, Inc. ("Apple" or the "Company") was founded in July 1996
to provide practice management services to orthodontic practices in the United
States and Canada. On May 29, 1997, Apple acquired substantially all of the
tangible and intangible assets and assumed certain of the liabilities of 31
orthodontic practices (collectively, the "Founding Affiliated Practices") in
exchange for 3.7 million shares of its class A common stock, par value $.001 per
share (the "Common Stock"), and $6.6 million (the "Acquisitions"). Simultaneous
with the Acquisitions, Apple closed its initial public offering (the "IPO") of
2.7 million shares of Common Stock. The net proceeds of the Common Stock issued
in the IPO (after deducting the underwriting discounts and commissions) were
$17.6 million. Total related offering costs were $5.5 million.
Apple effectively began operations with the Founding Affiliated Practices
on June 1, 1997. Apple has subsequently acquired the assets and assumed the
liabilities of additional practices (the "New Orthodontist Affiliations"). The
New Orthodontist Affiliations together with the Founding Affiliated Practices
are collectively referred to as the "Affiliated Practices."
The acquisitions of the Founding Affiliated Practices have been accounted
for in accordance with the Securities and Exchange Commission's Staff Accounting
Bulletin ("SAB") No. 48. In accordance with SAB No. 48, the acquisition of the
assets and assumption of certain liabilities for all of the Founding Affiliated
Practices has been accounted for by the Company at the transferors' historical
cost basis, with the shares of Common Stock issued in those transactions being
valued at the historical cost of the nonmonetary assets acquired net of
liabilities assumed. The cash consideration paid at closing on May 29, 1997, is
reflected as a dividend by the Company to the owners of the Founding Affiliated
Practices in the quarter ended June 30, 1997. SAB No. 48 is not applicable to
affiliations made by the Company subsequent to the IPO.
The acquisitions of assets and liabilities of the New Orthodontist
Affiliations are accounted for by allocating the fair market value of the
consideration paid by Apple to the assets acquired, net of liabilities assumed,
including intangible assets. As a result of this allocation process, the Company
records a significant portion of the consideration as a service fee intangible.
The service fee intangible has resulted and will continue to result in
substantial noncash amortization charges for intangible assets in the Company's
consolidated statements of operations.
2. SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The consolidated financial statements include the accounts of the Company
and its wholly-owned subsidiaries. All intercompany transactions and balances
have been eliminated.
CASH AND CASH EQUIVALENTS
For purposes of the consolidated statements of cash flows, the Company
considers all time deposits and certificates of deposit with original maturities
of three months or less to be cash equivalents.
RECEIVABLE FROM ORTHODONTIC PRACTICES, NET
The Company grants credit to its customers (i.e. the Affiliated Practices),
which are located in various geographic regions throughout the United States and
Canada. The Company performs ongoing credit evaluations of its customers and
generally does not require collateral. The Company maintains an allowance for
doubtful accounts at a level which management believes is sufficient to cover
potential credit losses.
26
<PAGE>
APPLE ORTHODONTIX, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
PROPERTY AND EQUIPMENT, NET
Property and equipment is stated at cost. Equipment under capital leases is
stated at the net present value of the future minimum lease payments at the
inception of the related leases. Depreciation of property and equipment is
calculated using the straight-line method over the estimated useful lives of the
assets. Routine maintenance and repairs are charged to expense as incurred,
while costs of betterment and renewals are capitalized.
INTANGIBLE ASSETS, NET
Intangible assets consist primarily of service fee intangibles which are
amortized over the life of the service agreement (ranging from 20 to 40 years)
with the respective Affiliated Practice. Service fee intangibles represent the
excess of the costs of affiliation over the fair value of the net assets
acquired. The costs of affiliation include the consideration paid to the owners
of the Affiliated Practices, the incremental out-of-pocket costs incurred in
connection with the affiliation and the direct costs related to the Apple
employees who identify, evaluate, negotiate and close the affiliation. Such
costs are recorded as other noncurrent assets until consummation of the
affiliation. If an affiliation is not consummated, all such costs are expensed
in the period in which the affiliation is abandoned. The Company's management
periodically evaluates the realizability of the intangible assets on a practice
by practice basis considering such factors as profitability and net cash flow.
Should this evaluation result in an assessment that the value of the intangible
asset is overstated, an adjustment will be made in the period that the
adjustment is identified. If it is determined that the estimated remaining
service period requires revision, that revision will be made on a prospective
basis.
REVENUE RECOGNITION
The management service fee revenues (the "Service Fees") payable to the
Company by the Founding Affiliated Practices under their Service Agreements with
the Company (the "Service Agreements") vary based on the fair market value, as
determined in arm's-length negotiations, for the nature and amount of services
provided. Except with respect to Service Agreements providing for the payment of
flat fees, the Service Fees earned by the Company are in accordance with the
Company's two general types of Service Agreements. The Standard Contract calls
for a calculation of the monthly Service Fee based on the total revenues earned
by the Founding Affiliated Practices, which is defined by the agreement to
represent 24% of the total contract value in the initial month of a patient's
treatment with the remainder of the contract balance earned evenly over the
balance of the contract term. From total revenues, the practices retain a
percentage of the Founding Affiliated Practices' cash collections. There are
adjustments to the service fee designed to both provide incentives for the
orthodontists to provide efficient patient treatment and to increase the number
of patients treated, as well as to ensure that the orthodontists retain a
minimum amount for payment of their compensation from their respective practices
on a monthly basis. The Alternative Contract is used in California. It is a cost
plus fee arrangement, whereby the service fee includes the reimbursement of
expenses incurred by Apple in the course of providing services to the Founding
Affiliated Practice plus a percentage based on revenues.
GENERAL AND ADMINISTRATIVE COSTS
General and administrative costs include office expenses, professional
fees, clerical and other administrative overhead.
INCOME TAXES
The Company recognizes deferred tax assets and liabilities for expected
future tax consequences of events that have been recognized in the financial
statements or tax returns. Deferred tax assets and liabilities are determined
based on the differences between the financial statement carrying amounts and
the tax bases
27
<PAGE>
APPLE ORTHODONTIX, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
of assets and liabilities using enacted tax rates and laws in effect in the
years in which the differences are expected to reverse.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The Company's financial instruments consist primarily of cash and cash
equivalents, trade receivables, trade payables and debt instruments. The book
values of each of these items are considered to be representative of their
respective fair values.
NEW ACCOUNTING STANDARDS
In February 1997, the Financial Accounting Standards Board issued SFAS No.
128, "Earnings Per Share." This statement establishes new standards for
computing and presenting earnings per share requiring the presentation of
"basic" and "diluted" earnings per share as compared to "primary" and "fully
diluted" earnings per share. The Company adopted SFAS No. 128 for the year ended
December 31, 1997 and restated its prior period earnings per share data.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires the use of estimates and assumptions by
management in determining the reported amounts of liabilities and disclosures of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of expenses during the reporting period. Actual results
could differ from those estimates.
3. NEW ORTHODONTIST AFFILIATIONS
During the period from commencement of operations (June 1, 1997) through
December 31, 1997, the Company completed New Orthodontist Affiliations with 21
practices representing 27 orthodontists and 37 office locations. In addition,
eight orthodontists joined existing Affiliated Practices. The New Orthodontist
Affiliations generated patient revenue of $23.2 million (unaudited) for their
most recently completed fiscal year. Prior patient revenue is not necessarily
indicative. of the level of patient revenue that these practices may be expected
to generate in the future and is not necessarily indicative of the future
Service Fees that the Company will receive in conjunction with these
affiliations.
Total consideration related to the New Orthodontist Affiliations is
summarized as follows:
Cash................................. $ 6,815,963
Deferred payments.................... 321,054
Debt assumed......................... 650,000
Common stock......................... 14,114,552
--------------
Total consideration........ $ 21,901,569
==============
In addition to the above consideration, the Company incurred out-of-pocket
costs of $1.5 million related to entering into service agreements with the New
Orthodontist Affiliations. The Company also placed $2.1 million into an escrow
account pending the resolution of certain post-closing contingencies related to
one of the New Orthodontist Affiliations closed during the third quarter of
1997. This $2.1 million is reflected as restricted cash on the accompanying
consolidated balance sheet. A favorable resolution of these post-closing
contingencies would result in payment of the $2.1 million to the sellers in
January 1999. The Company has the right to post a letter of credit in order to
have the $2.1 million released from escrow to the Company prior to January 1999.
Upon the resolution of these contingencies beyond a reasonable doubt, the
Company will record a liability for the consideration and allocate the
consideration to the assets to be acquired, primarily intangibles.
28
<PAGE>
APPLE ORTHODONTIX, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The cost of each of the above New Orthodontist Affiliations has been
allocated on the basis of the estimated fair market value of the assets acquired
and liabilities assumed, resulting in gross service fee intangibles of $39.5
million. These allocations may be adjusted to the extent that management becomes
aware of additional information within one reporting year of the affiliation
date which results in a material change in the amount of any contingency or
changes in the estimated fair market value of assets acquired and liabilities
assumed.
4. PROPERTY AND EQUIPMENT
A summary of property and equipment is as follows:
USEFUL DECEMBER 31,
LIVES IN -----------------------
YEARS 1997 1996
-------- ------------ ---------
Equipment............................ 5 $ 1,440,889 $ --
Furniture and fixtures............... 7 1,371,330 --
Computer software.................... 5 1,310,521 --
Leasehold improvements............... 5 1,073,448 --
Construction in progress............. -- 831,250 --
Computer hardware.................... 3 487,460 --
------------ ---------
6,514,898 --
Less: accumulated depreciation....... (489,468) --
------------ ---------
$ 6,025,430 $ --
============ =========
5. INTANGIBLE ASSETS
A summary of intangible assets is as follows:
DECEMBER 31,
-------------------------
1997 1996
-------------- ---------
Service fee intangible............... $ 39,482,835 $ --
Other................................ 122,015 49,197
-------------- ---------
39,604,850 49,197
Less: accumulated amortization....... (458,479) (4,510)
-------------- ---------
$ 39,146,371 $ 44,687
============== =========
6. LONG-TERM DEBT
A summary of long-term debt is as follows:
DECEMBER 31,
--------------------------
1997 1996
------------ ------------
Unsecured revolving credit
facility........................... $ -- $ --
Notes payable, maturing in varying
amounts through October 2002, with
interest ranging from 7.5% to
9.25%.............................. 1,076,020 --
Capitalized lease obligations, due in
monthly installments through April
2001, with interest ranging from
9.5% to 24.66%..................... 194,314 --
------------ ------------
1,270,334 --
Less: current maturities........ 1,022,710 --
------------ ------------
Long-term debt, net of current
maturities........................... $ 247,624 $ --
============ ============
29
<PAGE>
APPLE ORTHODONTIX, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
On July 28, 1997, the Company entered into a three-year, $15 million
unsecured revolving credit facility with Chase Manhattan Bank. Advances under
this facility bear interest, at the Company's option, at prime rate or LIBOR, in
each case plus a margin which is calculated based upon the Company's ratio of
indebtedness to cashflow. The Company is required to maintain certain financial
covenants regarding net worth, coverage ratios and additional indebtedness.
The notes payable primarily relate to debts of the Affiliated Practices
that were assumed by the Company.
Total assets recorded under capital leases and the accumulated depreciation
thereon were $263,781 and $76,958 as of December 31, 1997, respectively. There
were no capital leases at December 31, 1996.
Aggregate maturities of the notes payable and the future minimum payments
under leases are as follow:
Year Ended December 31,
1998............................ $ 1,022,710
1999............................ 142,252
2000............................ 54,303
2001............................ 34,383
2002............................ 16,686
Thereafter...................... --
------------
$ 1,270,334
============
7. STOCKHOLDERS' EQUITY
COMMON STOCK
Holders of the Company's Class A common stock (the "Class A Stock") are
entitled to one vote per share. Holders of the Company's Class B common stock
(the "Class B Stock") are entitled to three-tenths ( 3/10ths) of a vote per
share. The Class B Stock is convertible into Class A Stock in certain
circumstances, including the disposition of shares of Class B Stock by the
holder thereof (excluding dispositions to such holder's affiliates). During the
year ended December 31, 1997, 170,310 shares of Class B Stock were converted
into Class A Stock. Included in the 9,980,192 shares of Class A Stock at
December 31, 1997 were 1,027,354 nonvoting exchangeable shares issued in
connection with Canadian affiliations during 1997 which are exchangeable into
shares of Class A Stock.
DIVIDENDS
With the exception of a special dividend paid to the Founding Affiliated
Practices in connection with the Acquisitions (see Note 1), the Company has
never paid cash dividends on its common stock and has no present intention to
pay cash dividends. In addition, the Company's unsecured revolving credit
facility prohibits the payment of cash dividends on its common stock. It is the
Company's intention to retain earnings to finance the expansion of its business.
WARRANTS
In May 1997, the Company granted stock purchase warrants that entitled
certain venture capital investors to purchase 180,000 shares of the Company's
common stock at a price of $7.00 per share through May 2002. All of the warrant
shares were vested at issuance. The warrants were recorded at their estimated
value of $777,106 by applying the Black-Scholes option pricing model at the date
of grant.
30
<PAGE>
APPLE ORTHODONTIX, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
STOCK OPTION PLAN
The Company maintains an incentive compensation plan (the "Incentive Plan")
which provides the ability to grant non-qualified options, restricted stock,
deferred stock, incentive stock options, stock appreciation rights and other
long-term incentive awards. Stock options are typically granted under the
Incentive Plan at an exercise price which equals the fair market value of the
stock on the date of the grant. The number of shares available for issuance
under the Incentive Plan at any time is limited to the greater of 1.0 million
shares of common stock or 12% of the number of shares of common stock
outstanding on the last day of the preceding calendar quarter.
The Company issued options to purchase 922,550 shares and 0 shares during
the years ended December 31, 1997 and 1996, respectively. No options were
exercised during either of the two years ended December 31, 1997 or 1996. At
December 31, 1997, options were outstanding at prices ranging from $3.00 to
$15.25 per share, of which 225,925 were exercisable. All of the Company's
options were issued at fair market value.
As allowed by SFAS No. 123, "Accounting for Stock-Based Compensation," the
Company accounts for awards under its 1997 Stock Option Plan under Accounting
Principles Board Opinion No. 25, under which no compensation cost has been
recognized for stock options issued with exercise prices greater than or equal
to the fair market value at the date of grant. Had compensation cost for these
plans been determined consistent with SFAS No. 123, the Company's net loss and
loss per share would have been reduced to the following pro forma amounts:
YEAR ENDED DECEMBER 31,
---------------------------
1997 1996
---------- ---------------
Net income (loss)
As reported........................ $ 716,725 $ (24,309,378)
========== ===============
Pro forma.......................... $ 591,637 $ (24,309,378)
========== ===============
Income (loss) per share
As reported........................ $ 0.09 $ (7.24)
========== ===============
Pro forma.......................... $ 0.07 $ (7.24)
========== ===============
During the year ended December 31, 1997, the Company issued options to
purchase 28,000 shares to individuals other than employees and directors of the
Company as consideration for the closing of New Orthodontist Affiliations. The
fair value of these options was determined using the Black-Scholes option
pricing model at the date of grant and capitalized as a cost of affiliation.
PROFIT SHARING PLAN
In 1997, the Company established a defined contribution 401(k) profit
sharing plan for employees meeting certain employment requirements. Eligible
employees may contribute amounts up to the lesser of 15% of their annual
compensation or the maximum amount permitted under IRS regulations to their
401(k) account. The Company does not match any portion of employee
contributions.
31
<PAGE>
APPLE ORTHODONTIX, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
8. INCOME TAXES
The Company and its subsidiaries file a consolidated federal income tax
return. Affiliated Practices file "short-period" federal returns through their
respective acquisition dates and thereafter are included in the Company's
consolidated return. The new practices established by the affiliating
orthodontists file separate federal returns and are solely responsible for their
tax liabilities on an ongoing basis.
The amounts of consolidated federal and state income tax expense are as
follows:
YEAR ENDED DECEMBER
31,
----------------------
1997 1996
---------- ----------
Current:
Federal......................... $ 298,361 $ --
State........................... 52,652 --
---------- ----------
351,013 --
---------- ----------
Deferred:
Federal......................... 79,782 --
State........................... 8,487 --
---------- ----------
88,269 --
---------- ----------
$ 439,282 $ --
========== ==========
A reconciliation of total income tax expense to the amounts calculated by
applying the federal statutory tax rate is as follows:
YEAR ENDED DECEMBER 31,
------------------------
1997 1996
---------- ------------
Tax at statutory rate................ $ 393,382 $ (300,524)
Add (deduct):
State income taxes.............. 45,774 (26,516)
Nondeductible expenses.......... 27,166 --
Valuation allowance............. (27,040) 327,040
---------- ------------
Income tax expense................... $ 439,282 $ --
========== ============
32
<PAGE>
APPLE ORTHODONTIX, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The components of deferred income tax liabilities and assets are as
follows:
YEAR ENDED DECEMBER 31,
-------------------------------
1997 1996
--------------- --------------
Deferred income tax liabilities:
Property and equipment.......... $ (38,000) $ --
Intangibles..................... (14,718,642) --
--------------- --------------
Total deferred income tax
liabilities............. (14,756,642) --
--------------- --------------
Deferred income tax assets:
Estimated tax basis resulting
from affiliation with founding
practices..................... 300,000 --
Bad debt reserves............... 26,220 --
Accrued expenses................ 186,039 --
Net operating loss.............. -- 327,040
Less: valuation allowance....... (300,000) (327,040)
--------------- --------------
Total deferred income tax
assets..................... 212,259 --
--------------- --------------
Net deferred income tax
liabilities................ $ (14,544,383) $ --
=============== ==============
9. EARNINGS PER SHARE
Earnings per common and common equivalent share have been computed based on
the weighted average number of shares outstanding. The following table
reconciles the number of common shares outstanding with the number of common
shares used in computing earnings per share:
YEAR ENDED DECEMBER 31,
-------------------------
1997 1996
------------ -----------
Common shares outstanding............ 13,156,966 3,347,084
Effect of using weighted average
common shares outstanding during
the period......................... (5,025,061) 11,429
------------ -----------
Shares used in calculating basic
earnings per share................. 8,131,905 3,358,513
Effect of shares issuable under stock
option plans and warrant agreements
based on the treasury stock
method............................. 212,493 --
------------ -----------
Shares used in calculating diluted
earnings per share................. 8,344,398 3,358,513
============ ===========
10. SUPPLEMENTAL CASH FLOW INFORMATION
Supplemental disclosures of cash flow information are as follows:
YEAR ENDED DECEMBER
31,
---------------------
1997 1996
---------- ---------
Interest paid during the period, net
of capitalized interest............ $ 279,313 $ --
Income taxes paid during the
period............................. -- $ --
The Company acquired assets in capital lease transactions for $263,781 and
$0 in 1997 and 1996, respectively.
33
<PAGE>
APPLE ORTHODONTIX, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
11. COMMITMENTS AND CONTINGENCIES
The Company has entered into various non-cancelable operating lease
agreements, primarily for facilities and equipment utilized for operations.
Rental expense under operating leases was $1,801,944 and $19,676 in 1997 and
1996, respectively. Minimum future annual lease payments under these agreements
are as follows:
Year Ended December 31,
1998............................ $ 2,086,462
1999............................ 1,731,841
2000............................ 1,480,489
2001............................ 1,185,844
2002............................ 743,002
Thereafter...................... 1,215,345
------------
$ 8,442,983
============
The Company has secured employment agreements with various officers and
certain key employees of the Company. The agreements generally provide for the
employee's annual base salary and bonus participation. The agreements also
generally provide for one year non-competition agreements and severance payments
of between one and three year's salary in the event the employee is terminated
without cause.
The Company carries a broad range of insurance coverage, including general
liability, comprehensive property damage, workers' compensation, employers'
liability, directors' and officers' liability and other coverage customary in
the industry. The Company and the existing Affiliated Practices maintain
professional liability insurance coverage on a claims-made basis. Such insurance
provides coverage for claims asserted when the policy is in effect, regardless
of when the events that caused the claim occurred.
12. RELATED PARTY TRANSACTIONS
In 1996, the Company entered into an agreement with TriCap Funding I,
L.L.C. ("TriCap"), which is co-owned by a director of the Company, whereby
TriCap agreed to provide $3 million to finance costs related to the IPO. The $3
million, to the extent expended, was repaid out of proceeds from the IPO,
including interest at a rate of prime plus 25 basis points. The Company also
entered into an agreement with TriCap during 1996 that provided for the payment
to TriCap of a $500,000 financial advisory fee and the issuance to TriCap of
warrants to purchase 180,000 shares of common stock with an exercise price of
$7.00 per share, each upon the consummation of the IPO.
The practice of a founding stockholder of the Company (the "Founding
Stockholder") paid for certain costs and expenses on behalf of the Company prior
to the consummation of the IPO. The amount payable to the Founding Stockholder's
practice at December 31, 1996 was $30,444 and was included in accounts payable
and accrued expenses in the accompanying balance sheet. This amount was repaid
with the proceeds from the IPO.
13. CONCENTRATIONS OF SERVICE FEE REVENUE
For the year ended December 31, 1997, 14% of the Company's revenues were
derived from one Affiliated Practice, which was the only Affiliated Practice
that provided 10% or more of revenues. For the year ended December 31, 1997, 25%
of the Company's revenues were derived from Affiliated Practices in Canada.
34
<PAGE>
APPLE ORTHODONTIX, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
14. COMBINED PATIENT DATA
Combined operating data for the Affiliated Practices for the period from
initial affiliation through December 31, 1997 is as follows:
PATIENT CASH
REVENUES COLLECTIONS
----------- ------------
Practices participating under the
Standard Contract.................. $14,891,945 $ 13,617,373
Practices participating under the
Alternative Contract............... 4,095,918 3,982,313
Practices participating under flat
fee agreements..................... 6,054,841 6,054,841
----------- ------------
$25,042,704 $ 23,654,527
=========== ============
Combined patient receivables, net of the Affiliated Practices as of
December 31, 1997 is as follows:
Patient receivables.................. $ 3,471,028
Unbilled patient receivables......... 3,443,896
Patient prepayments.................. (2,410,327)
------------
Patient receivables, net of
prepayments............. $ 4,504,597
============
15. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
<TABLE>
<CAPTION>
FIRST SECOND THIRD FOURTH
QUARTER QUARTER QUARTER QUARTER
------------ ------------ ------------ --------------
<S> <C> <C> <C> <C>
1997
Management service fee
revenues...................... $ -- $ 1,685,957 $ 7,479,653 $ 10,019,940
Operating income (loss)......... (475,322) (609,521) 873,995 1,433,698
Net income (loss)............... (475,322) (192,962) 512,763 872,246
Basic earnings (loss) per
share......................... (0.14) (0.03) 0.05 0.07
Diluted earnings (loss) per
share......................... (0.14) (0.03) 0.05 0.07
1996
Management service fee
revenues...................... $ -- $ -- $ -- $ --
Operating income (loss)......... -- -- (172,395) (24,136,983)
Net income (loss)............... -- -- (172,395) (24,136,983)
Basic earnings (loss) per
share......................... -- -- (0.05) (7.19)
Diluted earnings (loss) per
share......................... -- -- (0.05) (7.19)
</TABLE>
16. SUBSEQUENT EVENTS
Since December 31, 1997, nine additional orthodontists have affiliated with
the Company. Five of these orthodontists had established practices, and four
agreed to join Affiliated Practices. The additional orthodontists in established
practices operate four locations and generated historical patient revenue of
$1.9 million for their most recently completed fiscal year. Prior patient
revenue is not necessarily indicative of the level of patient revenue that these
practices may be expected to generate in the future and is not necessarily
indicative of the future Service Fees that the Company will receive in
conjunction with these affiliations. Total consideration to these new
orthodontists consisted of 149,799 shares of common stock and $819,490 of cash,
assumed debt and deferred purchase price.
35
<PAGE>
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth the names, ages (as of April 13, 1998) and
positions of the Company's executive officers and key employees:
NAME AGE POSITION
- ----------------------------------- --- --------------------------------
John G. Vondrak, D.D.S............. 57 Chairman of the Board and Chief
Executive Officer
Robert J. Syverson................. 49 President and Chief Operating
Officer
Michael W. Harlan.................. 37 Vice President and Chief
Financial Officer
H. Steven Walton................... 40 Vice President of Business
Development
W. Daniel Cook..................... 43 Chief Administrative Officer and
a Director
LeeAnn Peniche(1).................. 37 Vice President of Training and
Marketing
- ------------
(1) Key Employee.
The executive officers of the Company are elected annually by the Board of
Directors of the Company and serve at the discretion of the Board.
JOHN G. VONDRAK, D.D.S. is the founder of the Company and has been Chairman
of the Board of Directors and Chief Executive Officer of the Company since
October 1996 and has served as a director of the Company since July 1996. Dr.
Vondrak has been the President and sole shareholder of JGVAOI, one of the
Founding Affiliated Practices, for more than the past five years. Dr. Vondrak is
a licensed dentist, a graduate of an American Dental Association accredited
orthodontic program and maintained a private orthodontic practice for over 24
years. He is a member of the American Association of Orthodontists and the
Southwest Society of Orthodontists and has served as President of the New Mexico
Orthodontic Society (1979).
ROBERT J. SYVERSON has been President of the Company since November 1996
and Chief Operating Officer of the Company since October 1996. From July 1996
through October 1996, Mr. Syverson served as a consultant to the Company on
operational and financial matters. From February 1979 through April 1996, Mr.
Syverson held various executive positions in the finance operations and sales
departments of "A" Company Orthodontics, a manufacturer and supplier of
orthodontic materials. Positions included Vice President of Finance, Vice
President of Operations, Vice President of International Sales and, most
recently, Executive Vice President of Sales.
MICHAEL W. HARLAN has been Vice President and Chief Financial Officer of
Company since March 1997. From December 1996 to February 1997, Mr. Harlan served
as a consultant to the Company on financial and accounting matters. From April
1991 through December 1996, Mr. Harlan held various positions in the finance and
acquisition departments of Sanifill, Inc., an international environmental
services company that was acquired by USA Waste Services, Inc. in 1996. He
served as the Treasurer of Sanifill, Inc. beginning in September 1993. While at
Sanifill, Inc., Mr. Harlan participated in numerous acquisitions and was
actively involved in raising public and private capital.
H. STEVEN WALTON has served as Vice President of Business Development since
June 1997 and served as Vice President of Acquisitions from March 1997 to June
1997. From June 1994 to February 1997, Mr. Walton served as Vice President --
Government Affairs and General Counsel of Sanifill, Inc., which was acquired by
USA Waste Services, Inc. in 1996, and then as Vice President of Business
Development of USA Waste Services, Inc. Before joining Sanifill, Mr.
Walton was Senior Vice President and General
36
<PAGE>
Counsel of Catalyst Energy Corporation, an independent power company, and then
Of Counsel to the law firm Blackwell, Sanders, Matheny, Weary & Lombardi, Kansas
City, Missouri.
W. DANIEL COOK has served as a director of the Company since October 1996
and as Chief Administrative Officer since February 1997. From December 1996 to
May 1997, Mr. Cook served as a consultant to the Company on various legal
matters. Prior thereto he was a partner at the law firm of Breard, Raines &
Cook, P.L.L.C. from March 1996 to May 1997 and was associated with the law firm
of Page, Mannio, Peresich, Dickinson & McDermott, P.L.L.C. from 1991 to 1995.
LEEANN PENICHE has been Vice President of Training and Marketing since June
1997. Prior to that time, she served as Director of Training of the Company
beginning in March 1997. From September 1996 to February 1997, Ms. Peniche
served as a consultant to the Company on various practice development matters.
In July 1989, Ms. Peniche founded Peniche & Associates, Inc., a consulting firm
specializing in the development and implementation of practice development
techniques for orthodontic practices throughout North America, where she has
served as its President from inception to the date of the IPO. From January 1985
until September 1991, Ms. Peniche was on the faculty of Paradigm Practice
Management Company, where she specialized in training orthodontists and their
staff in practice development activities. Ms. Peniche is a frequent lecturer
with the American Association of Orthodontics, the Pacific Coast Orthodontic
Society and numerous other private orthodontic societies. Ms. Peniche is a
Registered Dental Assistant, specializing in orthodontics.
DIRECTORS OF THE REGISTRANT
The following sets forth information concerning the Class I, Class II and
Class III directors of the Company whose present terms of office will expire at
the 1998, 1999 or 2000 annual meetings of stockholders, respectively, including
each director's age as of April 13, 1998, position with the Company, if any, and
business experience during the past five years.
CLASS I
ROD L. CROSBY, JR., age 59, has served as a director of the Company since
July 1997. Mr. Crosby has served as the Senior Vice President of Business
Development of Corporate Express, a supplier of office products and services,
since 1995. From 1994 to 1995, Mr. Crosby served as a director of U.S. Delivery
Systems, Inc., a delivery service company formed as a result of a combination in
November 1993 of a number of delivery companies, including ViaNet, Inc., a
company founded by Mr. Crosby. Prior to that time, Mr. Crosby served as Chairman
and Chief Executive Officer of ViaNet, Inc. from 1986 until 1993. Mr. Crosby
serves on the board of directors of e-CommLink, a software company serving the
banking and medical industries.
RICHARD J. MARXEN, age 51, has served as a director of the Company since
February 1998. Mr. Marxen is the founder of Connective Technologies, Inc., a
privately-held business solutions provider for systems integration, and has
served as its chairman, president and chief executive officer since 1990. Prior
to that time, Mr. Marxen founded a business consulting firm and a management
systems consulting firm.
CLASS II
W. DANIEL COOK. See "-- Executive Officers of the Registrant."
WILLIAM W. SHERRILL, age 71, has served as a director of the Company since
October 1996. He is an Executive Professor at the University of Houston College
of Business Administration and is the Director for the University of Houston's
Center for Entrepreneurship & Innovation. Mr. Sherrill was formerly the
principal of William W. Sherrill, Financial Consultants from 1974 to 1981. From
1971 to 1974, Mr. Sherrill served as the President of Associates Corporation of
North America and was a director of Gulf and Western Industries, Inc. Before
joining Associates Corporation, he was appointed by the President of the United
States in 1967 to fill an unexpired term as Governor of the Federal Reserve
Board in Washington, D.C. and was reappointed to a full 14-year term on the
Board of Governors. Prior to his Federal Reserve appointment, he was the
Director of the Federal Deposit Insurance Corporation. Mr. Sherrill initially
was appointed to the Company's Board of Directors pursuant to the provisions of
a funding agreement between The Company
37
<PAGE>
and TriCap Funding I, L.L.C. ("TriCap"). See "Certain Relationships and
Related Party Transactions" under Item 13.
ROBERT L. BREWTON, age 45, has served as a director of the Company since
February 1998. Since January 1996, Mr. Brewton has served as the Chief
Investment Officer of Residential Company of America, Ltd., a privately-held
real estate investment and management company. From 1987 until January 1996, Mr.
Brewton served as President of the multifamily division of the Transwestern
Property Company, the predecessor of Residential Company of America, Ltd.
CLASS III
JOHN G. VONDRAK, D.D.S. See "-- Executive Officers of the Registrant."
CLYDE C. WADDELL, JR., age 56, has served as a director of the Company
since July 1997. Mr. Waddell is the owner, President and Chief Executive Officer
of Hester's Office Center, Inc., an office supply company, and has served in
such capacity for more than the past five years. Mr. Waddell is a certified
public accountant.
COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT
Section 16(a) of the Exchange Act requires the Company's directors and
executive officers and persons who own more than 10% of a registered class of
the Company's equity securities, to file with the Commission and the American
Stock Exchange initial reports of ownership and reports of changes in ownership
of Common Stock. Officers, directors and greater than 10% stockholders are
required by SEC regulation to furnish the Company with copies of all such forms
they file. Based solely on a review of the copies of such reports furnished to
the Company and written representations that no other reports were required, the
Company believes that all its directors and executive officers during 1997
complied on a timely basis with all applicable filing requirements under Section
16(a) of the Exchange Act.
ITEM 11. EXECUTIVE COMPENSATION
DIRECTOR COMPENSATION
Each director who is not an employee of the Company receives a fee of
$2,000 for attendance at each Board of Directors meeting and $1,000 for each
committee meeting (unless held on the same day as a Board of Directors meeting).
All directors are reimbursed for their out-of-pocket expenses and other expenses
incurred in attending meetings of the Board or committees thereof and for other
expenses incurred in their capacity as directors. In addition, under the
Company's 1997 Stock Compensation Plan, each current nonemployee director has
been granted nonqualified options to purchase 10,000 shares of Common Stock. In
addition, each newly elected nonemployee director automatically will be granted
nonqualified options to purchase 10,000 shares of Common Stock on the date that
person first becomes a nonemployee director of the Company. Thereafter, each
nonemployee director automatically will be granted nonqualified options to
purchase 5,000 shares of Common Stock on the first business day of the month
following the date of the Company's annual meeting of stockholders. Each option
will have an exercise price per share equal to the fair market value of the
Company's Common Stock on the date of grant. On completion of the Company's IPO
in May 1998, Mr. Sherrill was granted an option to purchase 10,000 shares of
Common Stock at an exercise price per share equal to the initial public offering
price to the public. Each of Messrs. Crosby, Waddell, Brewton and Marxen
received an option to purchase 10,000 shares of Common Stock on his appointment
to the Board of Directors (July 1997 for Messrs. Crosby and Waddell and February
1998 for Messrs. Brewton and Marxen) at an exercise price per share equal to the
fair market value of the Common Stock on the date of grant. All the options
granted to the nonemployee directors have a term of ten years, and become
exercisable as to one-quarter on the date of grant, and thereafter in cumulative
annual installments of one-quarter beginning on the first anniversary of the
date of grant.
38
<PAGE>
COMPENSATION OF EXECUTIVE OFFICERS
The following table sets forth information regarding the compensation of
the Company's (i) Chief Executive Officer for the fiscal years ended December
31, 1996 and 1997 and (ii) other executive officers (together with the Chief
Executive Officer, the "Named Executive Officers") for the fiscal year ended
December 31, 1997.
SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
LONG-TERM COMPENSATION AWARDS
ANNUAL COMPENSATION(1) -----------------------------
------------------------------------ SHARES
OTHER ANNUAL RESTRICTED STOCK UNDERLYING
NAME AND PRINCIPAL POSITION YEAR SALARY(2) BONUS COMPENSATION AWARDS OPTIONS
- ------------------------------------- --------- ---------- --------- ------------- ---------------- ----------
<S> <C> <C> <C> <C> <C>
John G. Vondrak, D.D.S. ............. 1997 $ 176,763 $ -- $ 2,054(3) -- 135,000
Chairman of the Board 1996 75,000 52,000 -- -- --
and Chief Executive Officer
Robert J. Syverson................... 1997 159,455 -- -- -- 100,000
President and Chief 1996 56,000 48,000 -- (4) --
Operating Officer
Michael W. Harlan.................... 1997 135,049 -- -- -- --
Vice President and Chief 1996 7,688 48,000 -- (4) 90,000
Financial Officer
H. Steven Walton..................... 1997 404,447(5) 37,000 -- -- 161,850
Vice President of Business 1996 -- -- -- -- --
Development
W. Daniel Cook....................... 1997 117,564 -- -- -- 70,000
Chief Administrative 1996 10,000 48,000 -- (4) --
Officer
</TABLE>
- ------------
(1) Excludes any perquisites and other benefits that do not exceed the lesser of
$50,000 or 10% of the total of annual salary and bonus reported for any
Named Executive Officer.
(2) Amounts shown for 1996 consist of fees earned as a consultant to the
Company. Amounts shown for 1997 include (i) fees earned as a consultant to
the Company from January 1997 to April 1997 of $62,500, $62,500, $51,021 and
$40,000 for Dr. Vondrak, Mr. Syverson, Mr. Harlan and Mr. Cook,
respectively.
(3) Consists of moving expenses reimbursed by the Company in 1997. Does not
include amounts for shares of stock purchased by Dr. Vondrak in October 1996
in respect of which the Company recorded a special compensation expense of
$9,052,346 in 1996.
(4) Does not include amounts for shares of restricted stock purchased by Messrs.
Syverson and Cook in October 1996 and Mr. Harlan in December 1996. For
federal income tax purposes, the Company valued the shares purchased in
October 1996 at their purchase price ($1,030 for Mr. Syverson and $1,202 for
Mr. Cook) and the shares purchased by Mr. Harlan at $16,139. For financial
statement purposes, the Company recorded special compensation expense in
1996 for these purchases of $1,029,980 (Mr. Syverson), $537,873 (Mr. Harlan)
and $1,201,637 (Mr. Cook). See "Organization of the Company" in Item 13.
(5) Includes performance-based payment for successful completion of new
affiliations of orthodontists with the Company pursuant to Mr. Walton's
employment agreement with the Company. See "-- Employment Agreements."
39
<PAGE>
OPTION GRANTS. The following table sets forth certain information on grants
of stock options during 1997 to the Named Executive Officers reflected in the
Summary Compensation Table.
STOCK OPTIONS GRANTED IN 1997
<TABLE>
<CAPTION>
INDIVIDUAL GRANTS POTENTIAL REALIZABLE
---------------------------------------------------------- VALUE AT
PERCENT OF ASSUMED ANNUAL RATES
NUMBER OF TOTAL OF STOCK
SHARES OPTIONS PRICE APPRECIATION FOR
UNDERLYING GRANTED TO EXERCISE OPTION TERM(4)
OPTIONS EMPLOYEES PRICE (PER EXPIRATION ------------------------
GRANTED IN 1997 IN 1997 SHARE)(3) DATE 5% 10%
--------------- ---------- ----------- ---------- ---------- ------------
<S> <C> <C> <C> <C> <C> <C>
John G. Vondrak, D.D.S.................. 135,000(1) 14.6% $7.00 05/22/07 $ 594,305 $ 1,506,087
Robert J. Syverson...................... 100,000(1) 10.8 7.00 05/22/07 440,226 1,115,620
H. Steven Walton........................ 161,850(2) 17.5 7.00 05/22/07 712,506 1,805,631
W. Daniel Cook.......................... 70,000(1) 7.6 7.00 05/22/07 308,158 780,934
</TABLE>
- ------------
(1) These options were granted in April 1997 and became exercisable with respect
to 25% of the shares subject thereto on May 29, 1997. They become
exercisable in additional 25% increments on each May 29 in the period ended
May 29, 2000.
(2) Includes options to purchase 85,000 shares granted in April 1997 which have
the exercisability schedule described in Note (1) above. The remaining
options became exercisable with respect to 38,425 shares on May 29, 1997 and
will become exercisable with respect to the remaining 38,425 shares on May
29, 1998.
(3) The exercise price of the options granted was equal to the fair market value
of the Common Stock on the date of grant.
(4) The potential realizable value through the expiration date of the options
has been determined on the basis of the per share market price at the time
the options were granted, compounded annually over 10 years, net of the
exercise price. These values have been determined based on assumed rates of
appreciation and are not intended to forecast the possible future
appreciation, if any, of the price or value of the Company's Common Stock.
OPTION EXERCISES AND 1997 YEAR-END OPTION VALUES. The following table sets
forth certain information with respect to unexercised options to purchase Common
Stock held by the Named Executive Officers at December 31, 1997. None of the
Named Executive Officers exercised options in 1997.
YEAR-END 1997 OPTION VALUES
<TABLE>
<CAPTION>
NUMBER OF SHARES
UNDERLYING UNEXERCISED VALUE OF UNEXERCISED
OPTIONS HELD AT IN-THE-MONEY OPTIONS AT
DECEMBER 31, 1997 DECEMBER 31, 1997(1)
-------------------------------- --------------------------------
EXERCISABLE UNEXERCISABLE(2) EXERCISABLE UNEXERCISABLE(2)
----------- ----------------- ----------- -----------------
<S> <C> <C> <C> <C>
John G. Vondrak......................... 33,750 101,250 $ 164,531 $ 493,594
Robert J. Syverson...................... 25,000 75,000 121,875 365,625
Michael W. Harlan....................... 45,000 45,000 219,375 219,375
H. Steven Walton........................ 59,675 102,175 290,916 498,103
W. Daniel Cook.......................... 17,500 52,500 85,313 255,938
</TABLE>
(1) Value of unexercised in-the-money options is calculated based upon the
difference between the option price and the closing price of the Common
Stock at year end, multiplied by the number of shares underlying the
options. The closing price of the Common Stock as reported on the American
Stock Exchange on December 31, 1997 was $11.875.
(2) All these options become immediately exercisable on a change in control of
the Company.
EMPLOYMENT AGREEMENTS
The Company has employment agreements with Dr. Vondrak and Messrs. Harlan
and Cook. Each of these agreements provides for an annual base salary in an
amount not less than $180,000, $130,000 and
40
<PAGE>
$120,000 for Dr. Vondrak, Mr. Harlan and Mr. Cook, respectively, and entitles
the employee to participate in all the Company's compensation plans (as defined
in the agreements) in which other executive officers of the Company participate.
Each of these agreements also has a continuous three-year term, subject to the
right of the Company and the employee to terminate the employee's employment at
any time. If the employee's employment is terminated by the Company without
cause (as defined in the agreements) or by the employee with good reason (as
defined in the agreements), the employee will be entitled, during each of the
years in the three-year period beginning on the termination date, to (i)
periodic payments equal to his average annual cash compensation (as defined in
the agreements) from the Company, including bonuses, if any, during the two
years (or the period of employment, if shorter) preceding the termination date,
and (ii) continued participation in all the Company's compensation plans (other
than the granting of new awards under the 1997 Stock Compensation Plan or any
other performance-based plan). Except in the case of a termination for cause,
any stock options previously granted to the employee under the 1997 Stock
Compensation Plan that have not been exercised and are outstanding as of the
time immediately prior to the date of his termination will remain outstanding
(and continue to become exercisable pursuant to their respective terms) until
exercised or the expiration of their term, whichever is earlier. If a change of
control (as defined in the agreements) of the Company occurs, the employee will
be entitled to terminate his employment at any time during the 365-day period
following that change of control and receive a lump-sum payment equal to three
times his highest annual base salary under the agreement (plus such amounts as
may be necessary to hold the employee harmless from the consequences of any
resulting excise or other similar purpose tax relating to "parachute payments"
under the Internal Revenue Code of 1986, as amended). Each employment agreement
contains a covenant limiting the employee's right to compete against the Company
for a period of one year following termination of employment.
The Company also has employment agreements with Messrs. Syverson and
Walton. Both agreements, as amended in February 1998, provide that if the
Company terminates the employee's employment or the employee resigns, the
employee will be entitled to a severance benefit keyed to his prior annual cash
compensation and payable ratably over the 12-month period beginning on the date
of termination. As of March 31, 1998, the severance benefit for Mr. Syverson
would have been $682,500. As of the same date, the severance benefit for Mr.
Walton, reflecting the commissions his employment agreement entitles him in
connection with the Company's new affiliations with orthodontists, would have
been a minimum of $1,600,000.
Mr. Walton's employment agreement obligates the Company to lend Mr. Walton,
on a nonrecourse unsecured basis, the amount necessary to enable him to exercise
options to purchase up to 76,850 shares of Common Stock at an exercise price of
$7.00 per share (a maximum of $537,950). The Company will treat this loan (or
loans) as compensation expense and ordinary income to Mr. Walton. In that event,
Mr. Walton's employment agreement would require the Company to reimburse Mr.
Walton in the amount necessary to place him in essentially the same position had
he purchased the optioned shares for a nominal amount in December 1996.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
In September 1997, the Company established a Compensation Committee to make
recommendations with respect to salaries and bonuses to be paid to officers and
other employees of the Company. The current members of the Compensation
Committee of the Board are Messrs. Brewton, Crosby, Marxen, Waddell and Sherrill
(chairman), each of whom is a nonemployee director. Prior to completion of the
Company's IPO, matters with respect to the compensation of executive officers
and other employees of the Company were determined by the members of the Board
of Directors as a whole. Messrs. Vondrak and Cook, who were members of the Board
of Directors, participated in deliberations concerning compensation.
41
<PAGE>
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth the shares of Common Stock and the Class B
Stock beneficially owned directly or indirectly as of April 13, 1998 (i) by each
person who is known to the Company to own beneficially more than 5% of the
Common Stock and the Class B Stock, (ii) each of the Company's directors and
Named Executive Officers and (iii) all executive officers and directors as a
group.
<TABLE>
<CAPTION>
NUMBER OF SHARES BENEFICIALLY OWNED
-----------------------------------------------------------
PERCENT PERCENT COMBINED
COMMON OF CLASS B OF VOTING
STOCK(2) CLASS STOCK CLASS POWER
------- -------- --------- -------- ---------
<S> <C> <C> <C> <C> <C>
John G. Vondrak, D.D.S.(1)........... 377,481 4.2% 1,293,377 38.6% 8.0%
Robert J. Syverson................... 50,000 * 130,809 3.9 *
Michael W. Harlan.................... 45,000 * 76,850(3) 2.3 *
H. Steven Walton..................... 120,850 * -- -- *
W. Daniel Cook(1).................... 60,198 * 171,687 5.1 *
Robert L. Brewton.................... 2,500 * -- -- *
Rod L. Crosby, Jr.................... 18,906 * 28,167 * *
Richard J. Marxen.................... 2,500 * -- -- *
William W. Sherrill.................. 66,250 * 137,350 4.1 1.1
Clyde C. Waddell, Jr................. 2,500 * -- -- *
All executive officers and directors
as a group (10 persons)............ 746,185 7.1 1,838,240 54.9 12.4
</TABLE>
- ------------
* less than 1%.
(1) The address of such person is 2777 Allen Parkway, Suite 700, Houston, Texas
77019.
(2) Includes shares subject to outstanding options that are or will become
exercisable within 60 days of April 13, 1998, as follows: Dr. Vondrak --
67,500; Mr. Syverson -- 50,000; Mr. Harlan -- 45,000; Mr. Walton -- 119,350;
Mr. Cook -- 35,000 shares; and Messrs. Brewton, Crosby, Marxen, Sherrill and
Waddell -- 2,500 each. In addition, the shares shown for Mr. Sherrill
include 60,000 shares subject to an outstanding exercisable warrant.
(3) Includes 16,350 shares held of record by the Michael and Bonnie Harlan 1996
Family Trust. Mr. Harlan disclaims beneficial ownership of those shares.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS
ORGANIZATION OF THE COMPANY
The following table provides certain information concerning the shares of
Class B Stock the Company issued and sold to certain affiliates of the Company
on October 11 and December 9, 1996:
DATE OF NUMBER PURCHASE PRICE
NAME ISSUANCE OF SHARES PER SHARE
- -------------------------------------- -------- --------- --------------
John G. Vondrak, D.D.S................ 10/11/96 1,358,782 $ .001
TriCap Funding I, L.L.C............... 10/11/96 1,373,498 .001
Robert J. Syverson.................... 10/11/96 130,809 .001
W. Daniel Cook........................ 10/11/96 171,687 .001
Michael W. Harlan..................... 12/09/96 76,850 .001
The number of shares of Class B Stock issued on October 11, 1996 to each of
the founding stockholders shown in the table was determined by negotiations
among the founding stockholders. The number of shares of Class B Stock issued to
Michael W. Harlan on December 9, 1996 was determined by negotiations between the
Board of Directors and Mr. Harlan. Class B Stock is convertible into Common
Stock on a share-for-share basis under certain circumstances.
42
<PAGE>
The shares of Class B Common Stock the Company sold to Messrs. Syverson and
Harlan, and 76% of the shares the Company sold to Mr. Cook, in 1996 were issued
subject to restrictions on transfer and risk of forfeiture if employment were to
be terminated in certain circumstances. When the IPO closed, these restrictions
and risk lapsed with respect to 50% of the restricted shares each employee owns.
The Company expects that these restrictions and risk will lapse on May 29, 1998
on the remaining restricted shares each employee owns.
In connection with the acquisition of the assets of JGVAOI, one of the
Founding Affiliated Practices, Dr. Vondrak received approximately 259,981 shares
of Common Stock and $455,000 and entered into a Service Agreement providing for
service fee payments to the Company. In July 1997, Dr. Vondrak transferred his
practice to another orthodontist affiliated with the Company. As a result, Dr.
Vondrak is no longer a party to a Service Agreement with the Company and paid no
fees to the Company pursuant to that Service Agreement. The Company used its
proceeds from the IPO and funds advanced by TriCap to reimburse JGVAOI for the
Company's organizational expenses JGVAOI had incurred on the Company's behalf.
TriCap Partners, an affiliate of TriCap that is co-owned by Mr. Sherrill, a
director, was the exclusive financial advisor to the Company pursuant to a
consulting agreement that expired May 29, 1997. Pursuant to that agreement and
when the IPO closed, the Company (i) paid to TriCap Partners $500,000 and (ii)
issued to TriCap Partners a warrant to purchase 180,000 shares of Common Stock
at an exercise price per share of $7.00. The Company granted TriCap Partners
certain demand and piggyback registration rights respecting the warrant shares.
TriCap Partners subsequently distributed this warrant to its investors,
including Mr. Sherrill.
Pursuant to a funding agreement between TriCap and the Company, TriCap
advanced to the Company approximately $2.6 million to fund transaction costs in
connection with the affiliation with the Founding Affiliated Practices and the
IPO. The Company used proceeds from the IPO to repay these advances, together
with expenses of approximately $400,000 incurred by TriCap on behalf of the
Company with interest. The funding agreement terminated pursuant to its terms on
May 29, 1997. In connection with the funding agreement, the Company granted
TriCap and Dr. Vondrak certain piggyback registration rights.
TriCap purchased 400,000 shares of Common Stock in the IPO. It subsequently
distributed all the shares of Company stock held by it, including these shares,
to its investors.
43
<PAGE>
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(A)(1) FINANCIAL STATEMENTS
Report of Independent Accountants
Consolidated Balance Sheets as of December 31, 1997 and 1996
Consolidated Statements of Operations for the Year Ended December 31, 1997
and the period from inception (July 15, 1996) through December 31, 1996
Consolidated Statements of Changes in Stockholders' Equity (Deficit) for
the Year Ended December 31, 1997 and the period from inception (July 15, 1996)
through December 31, 1996
Consolidated Statements of Cash Flows for the Year Ended December 31, 1997
and the period from inception (July 15, 1996) through December 31, 1996
Notes to Consolidated Financial Statements
(A)(2) FINANCIAL STATEMENT SCHEDULES
All schedules and other statements for which provision is made in the
applicable regulations of the Commission have been omitted because they are not
required under the relevant instructions or are inapplicable.
(A)(3) EXHIBITS
EXHIBIT DESCRIPTION
- -------------------------------------------------------------
*3.1 -- Restated Certificate of Incorporation
(Incorporated herein by reference to
Exhibit 3.1 of the Company's
Registration Statement on Form S-1
(Registration No. 333-22785)).
*3.2 -- Bylaws (Incorporated herein by reference to Exhibit
3.2 of the Company's Registration Statement on Form S-1
(Registration No.
333-22785)).
*4.1 -- Form of certificate evidencing
ownership of Common Stock of Apple
Orthodontix, Inc. (Incorporated
herein by reference to Exhibit 4.1 of
the Company's Registration Statement
on Form S-1 (Registration No.
333-22785)).
*4.2 -- Form of Registration Rights Agreement
(Incorporated herein by reference to
Exhibit 4.1 of the Company's
Registration Statement on Form S-1
(Registration No. 333-22785)).
*4.3 -- Registration Rights Agreement among
Apple Orthodontix, Inc., John G.
Vondrak, D.D.S. and TriCap Funding I,
L.L.C. (Incorporated herein by
reference to Exhibit 4.3 of the
Company's Registration Statement on
Form S-1 (Registration No. 333-
22785)).
*4.4 -- Registration Rights Agreement between
TriCap Partners, L.L.C. and Apple
Orthodontix, Inc. (Incorporated
herein by reference to Exhibit 4.4 of
the Company's Registration Statement
on Form S-1 (Registration No.
333-22785)).
*10.1 -- Revolving Credit Facility with Chase
Bank of Texas, N.A. (formerly named
"Texas Commerce Bank, N.A.")
(Incorporated herein by reference to
Exhibit 10.1 of the Company's
Registration Statement on Form S-1
(Registration No. 333-38817)).
`*10.2 -- Apple Orthodontix, Inc. 1997 Stock
Compensation Plan (Incorporated herein by reference to
Exhibit 10.2 of the Company's Registration Statement on
Form S-1 (Registration
No. 333-38817)).
*10.3 -- Form of Option Agreement for the
Apple Orthodontix, Inc. 1997 Stock
Compensation Plan (Incorporated herein by reference to
Exhibit 10.3 of the Company's Registration Statement on
Form S-1 (Registration
No. 333-38817)).
44
<PAGE>
EXHIBIT DESCRIPTION
- -------------------------------------------------------------
`*10.4 -- Employment Agreement between Apple
Orthodontix, Inc. and John G.
Vondrak, D.D.S. (Incorporated herein
by reference to Exhibit 10.2 of the
Company's Registration Statement on
Form S-1 (Registration No.
333-22785)).
`*10.5 -- Employment Agreement between Apple
Orthodontix, Inc. and Robert J.
Syverson (Incorporated herein by
reference to Exhibit 10.3 of the
Company's Registration Statement on
Form S-1 (Registration No.
333-22785)).
`*10.6 -- Employment Agreement between Apple
Orthodontix, Inc. and Michael W.
Harlan (Incorporated herein by
reference to Exhibit 10.4 of the
Company's Registration Statement on
Form S-1 (Registration No.
333-22785)).
`*10.7 -- Employment Agreement between Apple
Orthodontix, Inc. and W. Daniel Cook
(Incorporated herein by reference to
Exhibit 10.5 of the Company's
Registration Statement on Form S-1
(Registration No. 333-22785)).
`*10.8 -- Employment Agreement of H. Steven
Walton (Incorporated herein by reference to Exhibit 10.7
of the Company's Registration Statement on Form S-1
(Registration No.
333-22785)).
`*10.9 -- Amendment to Employment Agreement of
H. Steven Walton (Incorporated herein
by reference to Exhibit 10.9 of the
Company's Registration Statement on
Form S-1 (Registration No.
333-38817)).
`*10.10 -- Second Amendment to Employment
Agreement of H. Steven Walton (Incorporated herein by
reference to Exhibit 99.2 of the Company's Current
Report on Form 8-K dated February 24,
1998).
*10.11 -- Form of Service Agreement for
Founding Affiliated Practices
(Incorporated herein by reference to
Exhibit 10.8 of the Company's
Registration Statement on Form S-1
(Registration No. 333-22785)).
*10.12 -- Form of Alternative Service Agreement
for Founding Affiliated Practices
(Incorporated herein by reference to
Exhibit 10.6 of the Company's
Registration Statement on Form S-1
(Registration No. 333-22785)).
*10.13 -- Form of Flat Fee Service Agreement
for Founding Affiliated Practices
(Incorporated herein by reference to
Exhibit 10.11 of the Company's
Registration Statement on Form S-1
(Registration No. 333-22785)).
`*10.14 -- First Amendment to Employment
Agreement of Robert J. Syverson (Incorporated herein by
reference to Exhibit 99.1 of the Company's Current
Report on Form 8-K dated February 24,
1998).
21.1 -- Subsidiaries of the Registrant.
23.1 -- Consent of Arthur Andersen LLP.
27.1 -- Financial Data Schedule.
- ------------
* Incorporated herein by reference as indicated.
` Management contract or compensatory plan or arrangement required to be filed
as an exhibit pursuant to the requirements of Item 14(c) of Form 10-K.
(B) REPORTS ON FORM 8-K
None.
45
<PAGE>
SIGNATURES
PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON
ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED.
APPLE ORTHODONTIX, INC.
By: /s/ MICHAEL W. HARLAN
MICHAEL W. HARLAN
CHIEF FINANCIAL OFFICER
Date: April 30, 1998
46
EXHIBIT 21.1
SUBSIDIARIES OF APPLE ORTHODONTIX, INC.
Apple Orthodontix of Texas, Inc., a Texas corporation
Apple Orthodontix of Canada, Inc., an Alberta corporation
EXHIBIT 23.1
CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS
As independent public accountants, we hereby consent to the incorporation
of our reports included in this Form 10-K, into the Company's previously filed
Registration Statements on Form S-4, File No. 333-28937 and Form S-8, File No.
333-38077.
April 30, 1998
Houston, Texas
<TABLE> <S> <C>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-END> DEC-31-1997
<CASH> 2,114,449
<SECURITIES> 0
<RECEIVABLES> 2,430,790
<ALLOWANCES> (69,163)
<INVENTORY> 0
<CURRENT-ASSETS> 7,510,984
<PP&E> 6,514,898
<DEPRECIATION> (489,468)
<TOTAL-ASSETS> 55,180,251
<CURRENT-LIABILITIES> 4,866,372
<BONDS> 0
0
0
<COMMON> 13,157
<OTHER-SE> 35,479,616
<TOTAL-LIABILITY-AND-EQUITY> 55,180,251
<SALES> 0
<TOTAL-REVENUES> 19,254,713
<CGS> 0
<TOTAL-COSTS> 17,962,700
<OTHER-EXPENSES> 15,994
<LOSS-PROVISION> (69,163)
<INTEREST-EXPENSE> (82,837)
<INCOME-PRETAX> 1,156,007
<INCOME-TAX> (439,282)
<INCOME-CONTINUING> 716,725
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 716,725
<EPS-PRIMARY> 0.09
<EPS-DILUTED> 0.09
</TABLE>
