<PAGE>
AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON NOVEMBER 16, 1998
REGISTRATION NO. 333-63801
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------
AMENDMENT NO. 1
TO
FORM S-1
REGISTRATION STATEMENT
UNDER
THE SECURITIES ACT OF 1933
------------------------
PROSPECT MEDICAL HOLDINGS, INC.
(Exact name of registrant as specified in its charter)
<TABLE>
<S> <C> <C>
DELAWARE 8011 330564370
(State or other jurisdiction of (Primary Standard Industrial (IRS Employer
incorporation or organization) Classification Code Number) Identification No.)
</TABLE>
515 SOUTH FLOWER STREET, SUITE 1640
LOS ANGELES, CALIFORNIA 90071
(213) 629-2185
(Address, including zip code, and telephone number, including area code, of
registrant's principal executive offices)
JACOB Y. TERNER, M.D.
515 SOUTH FLOWER STREET, SUITE 1640
LOS ANGELES, CALIFORNIA 90071
(213) 629-2185
(Name, address, including zip code, and telephone number, including area code,
of agent for service)
------------------------------
COPIES OF COMMUNICATIONS TO:
DALE S. MILLER, ESQ.
HOWARD J. UNTERBERGER, ESQ. STEVEN DREYER, ESQ.
SHAUNA ROTHKOPF, ESQ. Hall Dickler Kent Friedman & Wood, LLP
Miller & Holguin 909 Third Avenue
1801 Century Park East, Seventh Floor New York, New York 10022
Los Angeles, California 90067 (212) 339-5400
(310) 556-1990
------------------------------
APPROXIMATE DATE OF COMMENCEMENT OF PROPOSED SALE TO THE PUBLIC:
AS SOON AS PRACTICABLE AFTER THE EFFECTIVE DATE OF THIS REGISTRATION STATEMENT.
------------------------------
If any of the securities being registered on this Form are to be offered on
a delayed or continuous basis pursuant to Rule 415 under the Securities Act of
1933, check the following box. /X/
If this Form is filed to register additional securities for an offering
pursuant to Rule 462(b) under the Securities Act, check the following box and
list the Securities Act registration statement number of the earlier effective
registration statement for the same offering. / /
If this Form is a post-effective amendment filed pursuant to Rule 462(c)
under the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering. / /
If this Form is a post-effective amendment filed pursuant to Rule 462(d)
under the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering. / /
If delivery of the prospectus is expected to be made pursuant to Rule 434,
check the following box. / /
------------------------------
CALCULATION OF REGISTRATION FEE
<TABLE>
<CAPTION>
TITLE OF EACH PROPOSED MAXIMUM PROPOSED MAXIMUM
CLASS OF SECURITIES AMOUNT TO OFFERING PRICE PER AGGREGATE OFFERING AMOUNT OF
TO BE REGISTERED BE REGISTERED UNIT PRICE REGISTRATION FEE(6)
- -------------------------------------- --------------------- --------------------- --------------------- ---------------------
<S> <C> <C> <C> <C>
Common Stock.......................... 3,450,000 shares(1) $6.00 per share(5) $20,700,000 $6,106.50
Warrants for the purchase of Common
Stock............................... 3,450,000 warrants(2) $.10 per warrant(5) $345,000 $101.78
Common Stock underlying Warrants...... 3,450,000 shares(3) $8.40 per share(5) $28,980,000 $8,549.10
Representative's Warrants............. 300,000 warrants $.0001 per warrant $30 $.01
Common Stock underlying
Representative's Warrants........... 300,000 shares(4) $7.20 per share(5) $2,160,000 $637.20
Warrants underlying Representative's
Warrants............................ 300,000 warrants(4) $.12 per warrant(5) $36,000 $10.62
Common Stock underlying Warrants which
underlie Representative's
Warrants............................ 300,000 shares(4) $8.40 per share(5) $2,520,000 $743.40
Total Registration Fee................ $16,148.61
</TABLE>
(1) Includes 450,000 shares that the Underwriters may purchase from the
Registrant to cover over-allotments, if any.
(2) Includes 450,000 Warrants that the Underwriters may purchase from the
Registrant to cover over-allotments, if any.
(3) Includes 450,000 shares underlying Warrants that the Underwriters may
purchase from the Registrant to cover over-allotments, if any. Also
registered hereunder are an indeterminate number of additional shares of
Common Stock which may become issuable by virtue of anti-dilution provisions
of the Warrants.
(4) Also registered hereunder are an indeterminate number of additional shares
of Common Stock and Warrants which may become issuable by virtue of
anti-dilution provisions of the Representative's Warrants and an
indeterminate number of additional shares of Common Stock which may become
issuable by virtue of anti-dilution provisions of the Warrants which
underlie the Representative's Warrants.
(5) Estimated solely for the purpose of calculating the registration fee
pursuant to Rule 457(a) promulgated under the Securities Act of 1933.
(6) The registration fee was paid by the Registrant in connection with the
filing of its Registration Statement on Form S-1 with the Securities and
Exchange Commission on September 18, 1998.
------------------------------
THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR
DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT SHALL
FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION
STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(a) OF
THE SECURITIES ACT OF 1933 OR UNTIL THE REGISTRATION STATEMENT SHALL BECOME
EFFECTIVE ON SUCH DATE AS THE COMMISSION, ACTING PURSUANT TO SAID SECTION 8(a),
MAY DETERMINE.
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
<PAGE>
SUBJECT TO COMPLETION, DATED NOVEMBER 16, 1998
Information contained herein is subject to completion or amendment. A
registration statement relating to these securities has been filed with the
Securities and Exchange Commission. These securities may not be sold nor may
offers to buy be accepted prior to the time the registration statement becomes
effective. This prospectus shall not constitute an offer to sell or the
solicitation of an offer to buy, nor shall there be any sale of these securities
in any state in which such offer, solicitation or sale would be unlawful prior
to registration or qualification under the securities laws of any such state.
<PAGE>
PROSPECTUS
PROSPECT MEDICAL HOLDINGS, INC.
3,000,000 SHARES OF COMMON STOCK
AND 3,000,000 REDEEMABLE COMMON STOCK PURCHASE WARRANTS
This Prospectus relates to the offering (the "Offering") of 3,000,000 shares
(the "Shares") of common stock, $.01 par value per share (the "Common Stock"),
and 3,000,000 Redeemable Common Stock Purchase Warrants (the "Warrants") of
Prospect Medical Holdings, Inc., a Delaware corporation (the "Company"). The
Shares and Warrants are sometimes hereinafter collectively referred to as the
"Securities." The Shares and the Warrants may be purchased separately and will
be transferable separately immediately following completion of this Offering.
Each Warrant entitles the registered holder thereof to purchase one share of
Common Stock at an initial exercise price of $8.40 per share at any time during
the period commencing , 1999 [the first anniversary of the effective
date of the registration statement filed with respect to the Securities] and
terminating on , 2003 [the day immediately preceding the fifth anniversary
of said effective date]. The Warrant exercise price is subject to adjustment
under certain circumstances. Commencing , 1999 [the first anniversary
of said effective date], the Company may redeem the Warrants, in whole but not
in part, at $.10 per Warrant on thirty (30) days' prior written notice to the
Warrant holders, provided that the average closing sales price of the Common
Stock as reported on the American Stock Exchange, Inc. (the "American Stock
Exchange") equals or exceeds $18.00 per share for any twenty (20) trading days
within a period of thirty (30) consecutive trading days ending on the fifth
trading day prior to the date of the notice of redemption. See "Description of
Capital Stock."
Prior to this Offering, there has been no active trading market for the
Common Stock or the Warrants, and there can be no assurance that such a market
will develop after the completion of this Offering or, if such a market does
develop, that it will be sustained. It is currently anticipated that the initial
public offering prices of the Common Stock and the Warrants will be $6.00 per
share and $.10 per Warrant, respectively. For information regarding the factors
considered in determining the initial public offering prices of the Securities
and the terms of the Warrants, see "Risk Factors" and "Underwriting." The
Company intends to apply to list the Shares and the Warrants on the American
Stock Exchange, Inc. under the symbols "PXX" and "PXX.W," respectively. No
assurance can be given that such application will be granted or, if granted,
that an active trading market will develop.
THE SECURITIES OFFERED HEREBY INVOLVE A HIGH DEGREE OF RISK AND IMMEDIATE
AND SUBSTANTIAL DILUTION. SEE "RISK FACTORS" BEGINNING ON
PAGE 9 AND "DILUTION."
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS THE SECURITIES
AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION PASSED UPON THE
ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE
CONTRARY IS A CRIMINAL OFFENSE.
<TABLE>
<CAPTION>
UNDERWRITING
DISCOUNTS PROCEEDS TO
PRICE TO PUBLIC AND COMMISSIONS(1) COMPANY(2)
--------------------- --------------------- ---------------------
<S> <C> <C> <C>
Per Share......................................... $6.00 $0.54 $5.46
Per Warrant....................................... $0.10 $0.009 $0.091
Total(3).......................................... $18,300,000 $1,647,000 $16,653,000
</TABLE>
(1) THE COMPANY HAS AGREED TO INDEMNIFY THE SEVERAL UNDERWRITERS (THE
"UNDERWRITERS") AGAINST CERTAIN LIABILITIES, INCLUDING LIABILITIES UNDER THE
SECURITIES ACT OF 1933, AS AMENDED (THE "SECURITIES ACT"). DOES NOT INCLUDE
ADDITIONAL COMPENSATION PAYABLE TO SECURITY CAPITAL TRADING, INC., THE
REPRESENTATIVE (THE "REPRESENTATIVE") OF THE UNDERWRITERS, IN THE FORM OF A
NON-ACCOUNTABLE EXPENSE ALLOWANCE. SEE "UNDERWRITING" FOR INFORMATION
CONCERNING INDEMNIFICATION AND CONTRIBUTION ARRANGEMENTS WITH THE
UNDERWRITERS AND OTHER COMPENSATION PAYABLE TO THE REPRESENTATIVE.
(2) BEFORE DEDUCTING OFFERING EXPENSES PAYABLE BY THE COMPANY ESTIMATED AT
$ , EXCLUDING THE NON-ACCOUNTABLE EXPENSE ALLOWANCE PAYABLE TO THE
REPRESENTATIVE.
(3) THE COMPANY HAS GRANTED THE UNDERWRITERS A 45-DAY OPTION TO PURCHASE UP TO
AN ADDITIONAL 450,000 SHARES OF COMMON STOCK AND/OR 450,000 WARRANTS ON THE
SAME TERMS AS SET FORTH ABOVE, SOLELY TO COVER OVER-ALLOTMENTS, IF ANY. IF
SUCH OPTION IS EXERCISED IN FULL, THE TOTAL PRICE TO PUBLIC, UNDERWRITING
DISCOUNTS AND COMMISSIONS, AND PROCEEDS TO COMPANY WILL BE $21,045,000,
$1,894,050 AND $19,150,950, RESPECTIVELY. SEE "UNDERWRITING."
The Securities are offered by the Underwriters, subject to prior sale, when,
as, and if delivered to and accepted by the Underwriters and subject to approval
of certain legal matters by their counsel and subject to certain other
conditions. The Underwriters reserve the right to withdraw, cancel or modify
this Offering and to reject any order in whole or in part. It is expected that
delivery of the Securities offered hereby will be made against payment therefor
on or about , 1998 at the offices of Security Capital Trading, Inc.,
in New York, New York or in book-entry form through the facilities of The
Depository Trust Company.
SECURITY CAPITAL TRADING, INC.
The date of this Prospectus is , 1998
<PAGE>
[Map inserted here showing location of the Company's affiliated physician
organizations]
THIS PROSPECTUS CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND
UNCERTAINTIES, SUCH AS STATEMENTS OF THE COMPANY'S OR ITS MANAGEMENT'S PLANS,
OBJECTIVES, EXPECTATIONS, INTENTIONS, BELIEFS AND ESTIMATES. THE CAUTIONARY
STATEMENTS MADE IN THIS PROSPECTUS SHOULD BE READ AS BEING APPLICABLE TO ALL
FORWARD-LOOKING STATEMENTS WHEREVER THEY APPEAR IN THIS PROSPECTUS. THE
COMPANY'S ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE DISCUSSED HEREIN.
FACTORS THAT COULD CAUSE OR CONTRIBUTE TO SUCH DIFFERENCES INCLUDE THOSE
DISCUSSED IN "RISK FACTORS" AND "MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS," AS WELL AS THOSE DISCUSSED
ELSEWHERE IN THIS PROSPECTUS.
CERTAIN PERSONS PARTICIPATING IN THIS OFFERING MAY ENGAGE IN TRANSACTIONS
THAT STABILIZE, MAINTAIN, OR OTHERWISE AFFECT THE PRICE OF THE COMMON STOCK AND
WARRANTS, INCLUDING OVER-ALLOTTING, ENTERING STABILIZING BIDS, EFFECTING
SYNDICATE COVERING TRANSACTIONS AND IMPOSING PENALTY BIDS. FOR A DESCRIPTION OF
THESE ACTIVITIES, SEE "UNDERWRITING."
<PAGE>
PROSPECTUS SUMMARY
THE FOLLOWING SUMMARY INFORMATION IS QUALIFIED IN ITS ENTIRETY BY THE
DETAILED INFORMATION AND CONSOLIDATED FINANCIAL STATEMENTS, INCLUDING THE NOTES
THERETO, APPEARING ELSEWHERE IN THIS PROSPECTUS AND, ACCORDINGLY, SHOULD BE READ
IN CONJUNCTION WITH THAT INFORMATION AND THOSE FINANCIAL STATEMENTS AND NOTES.
PROSPECT MEDICAL HOLDINGS, INC., A DELAWARE CORPORATION ("PROSPECT MEDICAL
HOLDINGS" OR THE "COMPANY"), CONDUCTS ITS OPERATIONS THROUGH ITS TWO
WHOLLY-OWNED SUBSIDIARIES, PROSPECT MEDICAL SYSTEMS, INC., A DELAWARE
CORPORATION ("PROSPECT MEDICAL SYSTEMS"), AND SIERRA MEDICAL MANAGEMENT, INC., A
DELAWARE CORPORATION ("SIERRA MEDICAL MANAGEMENT"). EXCEPT AS OTHERWISE REQUIRED
BY THE CONTEXT, ALL REFERENCES HEREIN TO THE COMPANY SHALL BE DEEMED TO INCLUDE
PROSPECT MEDICAL SYSTEMS AND SIERRA MEDICAL MANAGEMENT. EXCEPT AS OTHERWISE
REQUIRED BY THE CONTEXT, ALL INFORMATION IN THIS PROSPECTUS ASSUMES THAT (I) THE
OVER-ALLOTMENT OPTION GRANTED TO THE UNDERWRITERS OF THIS OFFERING (THE
"UNDERWRITERS") IS NOT EXERCISED AND (II) THE REDEEMABLE COMMON STOCK PURCHASE
WARRANTS OFFERED HEREBY (THE "WARRANTS") AND THE WARRANTS GRANTED TO SECURITY
CAPITAL TRADING, INC. (THE "REPRESENTATIVE'S WARRANTS") AND ANY UNDERLYING
WARRANTS ARE NOT EXERCISED AND ANY UNDERLYING COMMON STOCK IS NOT ISSUED.
THE COMPANY
The Company primarily manages physician organizations that specialize in
providing medical services to individuals enrolled in managed care programs
offered by health maintenance organizations ("HMOs"). The Company's affiliated
physician organizations have entered into agreements with HMOs. Under these
agreements, the affiliated physician organizations provide medical services to
an HMO's enrollees in consideration for its payment of prepaid monthly fees
known as "capitation" payments. Physician organizations include medical groups
that employ physicians and independent practice associations that contract with
physicians.
Physician organizations increasingly are viewing managed care
administrators, such as the Company, as a means to increase their bargaining
power in response to the growth of HMOs. Additionally, physician organizations
are increasingly responding to cost-containment pressures within the managed
care industry by affiliating with managed care administrators, such as the
Company, to manage the non-medical aspects of their practices of medicine, and
as a means to achieve greater operating efficiencies and provide access to
greater capital resources.
The Company's growth strategy has thus far focused on the acquisition by its
affiliated physician organizations of other medical groups and independent
practice associations. These organizations provide services in Orange, Los
Angeles, Ventura and Santa Barbara Counties of the State of California. As of
June 30, 1998, the Company had approximately 350 primary care physicians and
approximately 1,390 specialists within its provider network. More specifically,
the Company has grown principally through four strategic acquisitions (Santa
Ana/Tustin Physicians Group, Sierra Medical Group, Western Medical Group and
Antelope Valley Medical Group (as such terms are defined herein)) and through
internal growth by the addition of new enrollees to its existing affiliated
physician organizations. The Company currently has four affiliated physician
organizations, Prospect Medical Group (as defined herein), Santa Ana/Tustin
Physicians Group, Sierra Medical Group and Pegasus Medical Group (as defined
herein). As of June 30, 1998, the affiliated physician organizations provided
services pursuant to agreements with 17 HMOs. The table set forth below shows
the increase since July 31, 1996, when current management assumed control of the
Company, in the number of commercial, Medicare and Medicaid enrollees served by
the Company's affiliated physician organizations.
1
<PAGE>
NUMBER OF ENROLLEES
<TABLE>
<CAPTION>
JUNE 30,
JULY 31, 1996(1) 1998(2)
----------------- ---------------
<S> <C> <C>
Enrollees
Commercial................................................ 4,900 81,480
Medicare.................................................. 1,900 8,587
Medicaid.................................................. -- 6,679
----- ------
Total 6,800 96,746
----- ------
----- ------
</TABLE>
- ------------------------
(1) Approximate. Does not include enrollees of Prospect Medical Group that were
added to the Company's service network on July 31, 1996 when current
management assumed control of the Company.
(2) Includes enrollment increases as a result of the Antelope Valley Medical
Group acquisition. Does not reflect the estimated potential loss of a
maximum of 13,000 enrollees commencing as of July 1, 1998, as a result of
the Yorba Linda Settlement Agreement (as defined herein). See "Risk
Factors--Recent Settlement Agreement with Yorba Linda Medical Group,"
"Unaudited Pro Forma Financial Information" and "Business of the
Company--Legal Proceedings."
The Company has selected the candidates for acquisition by its affiliated
physician organizations based on criteria that include (i) either a history of
profitable operation or a compelling synergy with opportunities for economies of
scale through combining operations; (ii) either geographic proximity to the
current operations of the Company's affiliated physician organizations or a
material share of the acquisition candidate's own local marketplace; (iii) a
favorable hospital relationship in which the interests of the hospital and the
acquisition candidate are aligned so as to discourage overutilization of
hospital services, thereby increasing the amount of HMO bonus pool monies
potentially available to the acquisition candidate; and/or (iv) willingness of
the acquisition candidate's management to continue in a management role with the
acquired entity following its acquisition.
In effecting an acquisition, the Company's affiliated physician
organizations generally acquire certain medical assets, including HMO contracts,
provider contracts and patient records, from an acquisition candidate in
consideration for cash, promissory notes and/or equity securities of the
Company. If related non-medical assets, such as management contracts, furniture,
fixtures or equipment, non-medical personnel or real property leases, are to be
acquired from a management company affiliated with the acquisition candidate,
these assets are acquired by the Company in consideration for cash, promissory
notes and/or equity securities of the Company. In some cases the affiliated
physician organizations may acquire the outstanding stock of an acquisition
candidate in consideration for cash, promissory notes and/or equity securities
of the Company. With respect to any acquisition by an affiliated physician
organization of the assets or stock of an acquisition candidate, the Company may
advance to the affiliated physician organization all or a portion of the cash
consideration or cash to repay the promissory notes, which advance may not be
repaid, or the affiliated physician organization may apply cash generated by
operations to pay the purchase price.
Under applicable California law, the Company's affiliated physician
organizations can accept risk under their contracts with HMOs only with respect
to services which are within the scope of their licensure, such as physician and
ancillary health care services. The affiliated physician organizations cannot
accept risk from an HMO with respect to services which are currently outside of
the scope of their licensure, such as hospital services. Currently, the
non-physician components of hospitalization and hospital facilities are
generally provided to the enrollees by hospitals that contract with and are paid
by the HMOs. The future strategy of the Company is to provide and manage all
health care services, including hospital health care services. To implement this
strategy, the Company, either directly or through an affiliated physician
organization, intends to seek a license pursuant to California law which will
allow the licensed entity to contract with HMOs to manage and provide health
care services on a full-risk basis.
2
<PAGE>
Southern California is a highly developed managed care market. Management
believes that there is more economic opportunity in developed markets because
(i) physicians and hospitals in developed markets have established practice and
referral patterns that are consistent with providing services within a managed
care framework and (ii) there is generally a higher concentration of physicians
and hospitals in a developed market, creating a more competitive environment
with greater opportunities for the Company and its affiliated physician
organizations to negotiate more favorable provider contracts. The Company
believes that the managed care industry operates most effectively on a regional
basis, and is affected most by provider competition, physician referral
patterns, custom and practice and local hospital relationships. Management also
believes that developing a significant local market presence permits economies
of scale and greater efficiencies through centralization of operations.
The Company believes that physician management fosters better relationships
with providers. The Chief Executive Officer, Jacob Y. Terner, M.D., and
President, Gregg DeNicola, M.D., have been practicing physicians. More recently
Dr. Terner served as Chairman of the Board and Chief Executive Officer of
Century MediCorp, Inc. ("Century MediCorp"), a publicly-traded corporation
operating through three wholly-owned HMO subsidiaries, hospitals and an
affiliated independent practice association, until its October 1992 merger with
a major publicly-traded HMO. The Company typically retains senior management of
the entities that it or its affiliated physician organizations acquire.
The Company provides management and other administrative services to
physician organizations that specialize in managed care, including personnel,
claims administration, utilization management and quality assurance, case
management and data collection and management information systems. The Company
also assists these physician organizations by negotiating capitation rates and
incentive payment arrangements with HMOs. The Company assists physician
organizations that accept full financial risk for all physician services to be
provided under an HMO agreement. The Company and its direct subsidiaries are
prohibited by California law from engaging in the corporate practice of medicine
and, therefore, do not practice medicine or employ physicians. The physician
organizations affiliated with the Company hire and contract with physicians and
ancillary health care service providers for the provision of medical services.
The Company has entered into a long-term management services agreement with
each affiliated physician organization. Under the long-term management services
agreements, the Company provides the physician organizations with certain
management and administrative support services as described above in return for
a fee calculated with reference to certain components of the physician
organization's revenues and the Company's costs of providing its services. The
Company's management fee fluctuates based on the profitability of the affiliated
physician organizations as the Company is also entitled to a residual interest
in the profits and losses of the affiliated physician organizations. The
Company's fee arrangements are structured so that, by enabling its affiliated
physician organizations to deliver required medical services in a more
cost-effective manner, the Company will benefit from the savings so obtained.
Prospect Medical Holdings, formerly known as Med-Search, Inc., was
incorporated in Delaware on May 12, 1993. The principal corporate executive
offices of the Company are located at 515 South Flower St., Suite 1640, Los
Angeles, California 90071, and its telephone number is (213) 629-2185.
3
<PAGE>
THE OFFERING
<TABLE>
<S> <C>
Securities Offered by the
Company......................... 3,000,000 shares of Common Stock and 3,000,000 Warrants
(collectively, the "Securities"). The shares of Common
Stock and Warrants may be purchased separately and will
be separately transferable immediately following
completion of this Offering. See "Description of Capital
Stock."
Terms of Warrants................. Each Warrant entitles the registered holder thereof to
purchase, at any time during the period commencing
, 1999 [the first anniversary of the effective
date of the registration statement filed with respect to
the Securities], and terminating on , 2003 [the
day immediately preceding the fifth anniversary of said
effective date], one share of Common Stock at an initial
exercise price of $8.40 per share, subject to
adjustment. Commencing , 1999 [the first
anniversary of said effective date], the Warrants are
subject to redemption by the Company, in whole but not
in part, at $.10 per Warrant on thirty (30) days' prior
written notice to the Warrant holders, provided that the
average closing sales price of the Common Stock as
reported on the American Stock Exchange equals or
exceeds $18.00 per share, subject to adjustment, for any
twenty (20) trading days within a period of thirty (30)
consecutive trading days ending on the fifth trading day
prior to the date of the notice of redemption. See
"Description of Capital Stock-- Warrants."
Common Stock Outstanding Prior to
the Offering(1)................. 4,449,395 shares of Common Stock
Securities to Be Outstanding
After Completion of the
Offering(1)..................... 7,449,395 shares of Common Stock and 3,000,000 Warrants
Risk Factors and Dilution......... An investment in the Common Stock and the Warrants
offered hereby involves a high degree of risk and
immediate and substantial dilution and should be
considered only by persons who can afford the loss of
their entire investment. See "Risk Factors" and
"Dilution."
Use of Proceeds................... The Company intends to apply a portion of the proceeds
of the Offering to pay down the outstanding balance
under the Company's credit facility provided by Imperial
Bank. Draws under such facility were used by the Company
(i) in connection with certain acquisitions, and (ii)
for working capital. The Company intends to apply
additional proceeds of the Offering (i) to repay certain
outstanding promissory notes made in connection with
certain completed acquisitions, (ii) to pay a portion of
the costs to establish a health plan with a limited
license pursuant to California law, in order to assume
full risk for the provision of health care services
under contracts with HMOs, and (iii) for working
capital.
</TABLE>
4
<PAGE>
<TABLE>
<S> <C>
Proposed American Stock Exchange
Symbols:
Common Stock.................... "PXX"
Warrants........................ "PXX.W"
</TABLE>
- ------------------------
(1) Calculated after deduction of the shares of Common Stock that were returned
to the Company in exchange for a release from certain agreements pursuant to
the Yorba Linda Settlement Agreement effective as of July 1, 1998. See "Risk
Factors--Recent Settlement Agreement with Yorba Linda Medical Group" and
"Business of the Company--History of the Company" for a further description
of the Yorba Linda Settlement Agreement. Does not include (i) any shares of
Common Stock that may be issued pursuant to the Underwriters' over-allotment
option or any shares of Common Stock that may be issued pursuant to the
exercise of Warrants offered hereby or the Representative's Warrants or
warrants underlying the Representative's Warrants, (ii) 176,000 shares of
Common Stock reserved for issuance pursuant to grants that may be made under
the Company's 1998 Stock Option Plan (the "Stock Option Plan"), including
but not limited to 55,000 shares of Common Stock reserved for issuance upon
exercise of options granted to two officers of the Company at an exercise
price equal to $5.00 per share, and 10,000 shares of Common Stock reserved
for issuance upon exercise of options granted to a recently elected director
at an exercise price equal to $5.00 per share, (iii) 477,119 shares of
Common Stock in the aggregate reserved for issuance upon exercise of options
granted to three current directors and a former director of the Company at
an exercise price equal to $1.25 per share, (iv) 35,000 shares of Common
Stock reserved for issuance upon exercise of options granted to the sellers
of Sierra Primary Care Medical Group, A Medical Corporation and Sierra
Medical Management, Inc. at an exercise price equal to $5.00 per share, (v)
13,635 shares of Common Stock reserved for issuance upon exercise of
warrants granted to certain finders in connection with the 1996 Merger (as
defined herein) and related transactions at an exercise price equal to
$1.375 per share, (vi) 192,725 shares of Common Stock reserved for issuance
upon exercise of warrants granted to the Company's commercial lender at an
exercise price of $5.00 per share and (vii) 10,080 shares of Common Stock
that may be issued to a physician whose assets were acquired by an
affiliated physician organization. See "Management of the Company--Stock
Option Plan," "Management's Discussion and Analysis of Financial Condition
and Results of Operations--Liquidity and Capital Resources-- CREDIT
FACILITY," and "Business of the Company--History of the Company."
5
<PAGE>
SELECTED CONSOLIDATED FINANCIAL DATA
The following selected financial data with respect to the Company's
statement of operations for the year ended September 30, 1993 and the balance
sheet data at September 30, 1993 have been derived from the financial statements
of Prospect Medical Group, the Company's predecessor for financial statement
reporting purposes. These financial statements have not been audited and are not
included herein. The following selected financial data with respect to the
Company's statements of operations for the years ended September 30, 1994, 1995
and 1996 and the balance sheet data at September 30, 1994, 1995 and 1996 have
been derived from the financial statements of the Company or its predecessor as
applicable which have been audited by BDO Seidman, LLP, independent certified
public accountants. The following selected financial data with respect to the
Company's statement of operations for the year ended September 30, 1997 and the
balance sheet data at September 30, 1997 have been derived from the financial
statements of the Company which have been audited by Ernst & Young LLP,
independent auditors. The selected financial data presented below for the nine
months ended June 30, 1997 and the nine months ended June 30, 1998 have not been
audited and were prepared by management of the Company on the same basis as the
audited financial statements appearing elsewhere in this Prospectus and, in the
opinion of management of the Company, include all adjustments necessary to
present fairly the information set forth therein. The results for the nine
months ended June 30, 1998 are not necessarily indicative of the results to be
expected for the year ending September 30, 1998 or future periods. The following
data should be read in conjunction with "Management's Discussion and Analysis of
Financial Condition and Results of Operations" and the financial statements of
the Company and the related notes thereto included elsewhere in this Prospectus.
<TABLE>
<CAPTION>
YEAR ENDED
SEPTEMBER 30, NINE MONTHS
1997 ENDED
YEARS ENDED SEPTEMBER 30, ------------- JUNE 30,
----------------------------------------------------------------- -----------
PRO FORMA
(UNAUDITED) AS ADJUSTED (UNAUDITED)
------------- (UNAUDITED) -----------
1993(1)(6) 1994(1)(6) 1995(1)(6) 1996(6) 1997(6) (2)(4)(5) 1997(6)
------------- ----------- ----------- ----------- ----------- ------------- -----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Revenues:
Net Patient Service Revenues.... $ 6,403 $ 9,495 $ 13,603 $ 22,518 $ 28,303 $ 47,530 $ 18,722
Management Fees................. 180 669 886 945 1,429 1,112 924
Other Revenues.................. -- 68 168 972 223 87 331
------ ----------- ----------- ----------- ----------- ------------- -----------
Total Operating Revenues.... 6,583 10,232 14,657 24,435 29,955 48,729 19,977
------ ----------- ----------- ----------- ----------- ------------- -----------
Expenses:
Cost of Medical Services........ 4,645 6,496 10,660 19,492 23,202 36,506 16,107
General and Administrative...... 1,669 2,741 3,545 4,291 7,236 12,516 4,330
Depreciation and Amortization... 7 50 125 102 244 1,578 114
------ ----------- ----------- ----------- ----------- ------------- -----------
Total Cost of Operations.... 6,321 9,287 14,330 23,885 30,682 50,600 20,551
Provision for Impairment of
Goodwill...................... -- -- -- -- (2,197) (5,053) (2,197)
------ ----------- ----------- ----------- ----------- ------------- -----------
Income (Loss) before Provision
for Income Taxes.............. 262 945 327 550 (2,924) (6,924) (2,771)
Income Tax Expense (Benefit).... 104 384 139 (5) (285) (449) 173
------ ----------- ----------- ----------- ----------- ------------- -----------
Net Income (Loss)........... $ 158 $ 561 $ 188 $ 555 $ (2,639) $ (6,475) $ (2,944)
------ ----------- ----------- ----------- ----------- ------------- -----------
------ ----------- ----------- ----------- ----------- ------------- -----------
Net Income (Loss) Per Common Share
Basic:
Basic Income (Loss) Per
Share....................... $ 0.10 $ 0.32 $ 0.10 $ 0.22 $ (0.55) $ (0.87) $ (0.62)
Weighted Average Number of
Common Shares Outstanding... 1,525 1,742 1,976 2,487 4,801 7,465 4,767
Diluted:
Diluted Income (Loss) Per
Share....................... $ 0.10 $ 0.32 $ 0.10 $ 0.22 $ (0.55) $ (0.87) $ (0.62)
Weighted Average Number of
Common and Common Dilutive
Shares Outstanding.......... 1,525 1,742 1,976 2,487 4,801 7,465 4,767
<CAPTION>
NINE MONTHS
ENDED
JUNE 30, 1998
-------------
PRO FORMA
AS ADJUSTED
(UNAUDITED)
1998(6) (3)(4)(5)
----------- -------------
<S> <C> <C>
STATEMENT OF OPERATIONS DATA:
Revenues:
Net Patient Service Revenues.... $ 38,592 $ 38,375
Management Fees................. 1,467 836
Other Revenues.................. 255 125
----------- -------------
Total Operating Revenues.... 40,314 39,336
----------- -------------
Expenses:
Cost of Medical Services........ 26,854 27,406
General and Administrative...... 12,294 11,112
Depreciation and Amortization... 786 1,041
----------- -------------
Total Cost of Operations.... 39,934 39,559
Provision for Impairment of
Goodwill...................... -- (312)
----------- -------------
Income (Loss) before Provision
for Income Taxes.............. 380 (535)
Income Tax Expense (Benefit).... 4 4
----------- -------------
Net Income (Loss)........... $ 376 $ (539)
----------- -------------
----------- -------------
Net Income (Loss) Per Common Sha
Basic:
Basic Income (Loss) Per
Share....................... $ 0.07 $ (0.07)
Weighted Average Number of
Common Shares Outstanding... 5,398 7,449
Diluted:
Diluted Income (Loss) Per
Share....................... $ 0.07 $ (0.07)
Weighted Average Number of
Common and Common Dilutive
Shares Outstanding.......... 5,765 7,449
</TABLE>
See accompanying notes to the audited historical and unaudited pro forma
consolidated
statement of operations data.
6
<PAGE>
<TABLE>
<CAPTION>
SEPTEMBER 30, JUNE 30, 1998
------------------------------------------------------- --------------------------
PRO FORMA
(UNAUDITED) AS ADJUSTED
1993(1) 1994(1) 1995(1) 1996 1997 (UNAUDITED) (UNAUDITED)(5)
----------- --------- --------- --------- --------- ----------- -------------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C>
BALANCE SHEET DATA:
Assets:
Cash and Cash Equivalents... $ 217 $ 278 $ 822 $ 5,333 $ 2,822 $ 1,765 $ 2,997
Other Current Assets........ 1,914 2,592 2,856 1,651 3,743 5,361 5,361
Intangible and Other
Assets.................... 119 541 583 2,947 17,946 21,377 21,057
----------- --------- --------- --------- --------- ----------- -------------
Total Assets.............. $ 2,250 $ 3,411 $ 4,261 $ 9,931 $ 24,511 $ 28,503 $ 29,415
----------- --------- --------- --------- --------- ----------- -------------
----------- --------- --------- --------- --------- ----------- -------------
Liabilities:
Accrued Medical Claims...... $ 447 $ 833 $ 1,278 $ 3,063 $ 5,918 $ 6,025 $ 6,025
Other Current Liabilities... 766 932 1,157 792 2,650 3,671 1,851
Other Liabilities........... -- 291 222 778 12,064 13,462 614
----------- --------- --------- --------- --------- ----------- -------------
Total Liabilities......... 1,213 2,056 2,657 4,633 20,632 23,158 8,490
Shareholders' Equity:......... 1,037 1,355 1,604 5,298 3,879 5,345 20,925
----------- --------- --------- --------- --------- ----------- -------------
Total Liabilities and
Shareholders' Equity...... $ 2,250 $ 3,411 $ 4,261 $ 9,931 $ 24,511 $ 28,503 $ 29,415
----------- --------- --------- --------- --------- ----------- -------------
----------- --------- --------- --------- --------- ----------- -------------
</TABLE>
<TABLE>
<CAPTION>
JUNE 30, 1998 (UNAUDITED)
----------------------------------------
PRO PRO FORMA
ACTUAL FORMA(4) AS ADJUSTED(5)
--------- ------------- --------------
(IN THOUSANDS)
<S> <C> <C> <C>
PRO FORMA BALANCE SHEET DATA:
Cash and Cash Equivalents............................................. $ 1,765 $ 1,822 $ 2,997
Working Capital (Deficit)............................................. (2,569) (2,513) 482
Total Assets.......................................................... 28,503 28,560 29,415
Long-Term Debt........................................................ 13,231 13,231 381
Total Shareholders' Equity............................................ 5,343 5,400 20,925
</TABLE>
- ------------------------
(1) On July 31, 1996, a wholly-owned subsidiary of the Company (at that time
named "Med-Search, Inc.") merged into Prospect Medical Systems (the "1996
Merger"), with Prospect Medical Systems being the surviving corporation and
a wholly-owned subsidiary of the Company. Prospect Medical Systems was
incorporated in November 1995 for the purpose of acquiring all of Prospect
Medical Group's non-professional assets and assuming all of its
administrative and management functions. It had nominal operations prior to
the 1996 Merger and all of its shares were held by the former shareholders
and the current sole shareholder of Prospect Medical Group. Through separate
transactions effected at or around the time of the 1996 Merger, the
shareholders of Prospect Medical Group received shares in the newly formed
Prospect Medical Systems, which were ultimately exchanged for a majority of
the shares in the Company. The exchange of shares was treated as a
reorganization of companies under common control. As the shareholders of
Prospect Medical Group became the majority stockholders in the merged
company through these transactions, under applicable financial reporting
requirements, Prospect Medical Group is considered the predecessor entity to
the Company for periods prior to July 31, 1996 for financial statement
reporting purposes. Accordingly, the historical predecessor financial
statements prior to July 31, 1996 are those of Prospect Medical Group, and
not those of the predecessor legal entity. Prospect Medical Group did not
engage an independent public accountant to audit its financial statements at
September 30, 1993 and for the year then ended.
(2) Gives effect to the acquisitions of Sierra Medical Group, Santa Ana/Tustin
Physicians Group and certain assets of Antelope Valley Medical Group as if
they had occurred on October 1, 1996. See
7
<PAGE>
"Business of the Company--History of the Company," "Unaudited Pro Forma
Financial Information" and "Management's Discussion and Analysis of
Financial Condition and Results of Operations."
(3) Gives effect to the acquisition of certain assets of Antelope Valley Medical
Group as if it had occurred on October 1, 1996. See "Business of the
Company--History of the Company," "Unaudited Pro Forma Financial
Information" and "Management's Discussion and Analysis of Financial
Condition and Results of Operations."
(4) Gives effect to the Yorba Linda Settlement Agreement. See "Risk
Factors--Recent Settlement Agreement with Yorba Linda Medical Group,"
"Unaudited Pro Forma Financial Information" and "Business of the
Company--Legal Proceedings" for further discussion of the Yorba Linda
Settlement Agreement.
(5) Gives effect to the completion of this Offering at an assumed initial public
offering price of $6.00 per share and $.10 per Warrant and the receipt and
application of the estimated net proceeds therefrom as if such transaction
had occurred on October 1, 1996 and October 1, 1997 for the statement of
operations data for fiscal year 1997 and the nine months ended June 30,
1998, respectively, and on June 30, 1998 for balance sheet data. See "Use of
Proceeds" and "Capitalization."
(6) During the year ended September 30, 1997, the Company's affiliated physician
organizations acquired Santa Ana/Tustin Physicians Group and Sierra Medical
Group and the Company acquired Sierra Medical Management, Inc., which added
an aggregate of approximately 27,000 enrollees. During the nine month period
ended June 30, 1998, Sierra Medical Group, an affiliated physician
organization, acquired certain assets of Antelope Valley Medical Group and
the Company acquired its affiliated management company, which added
approximately 12,000 enrollees. During this same period, the Company
acquired other entities, although immaterial in the aggregate, which added
additional enrollees. Comparison of the Company's historical results of
operations, particularly for the fiscal years ended September 30, 1997, 1996
and 1995 and for the nine month periods ended June 30, 1998 and 1997, will
not, in the view of management of the Company, prove meaningful because of
the rapid growth of the Company during such periods and because the
affiliation relationships entered into by the Company during those periods
are not reflected in the Company's historical results of operations for
prior periods.
8
<PAGE>
RISK FACTORS
AN INVESTMENT IN THE COMMON STOCK AND WARRANTS OFFERED HEREBY INVOLVES A
HIGH DEGREE OF RISK. PROSPECTIVE INVESTORS SHOULD CAREFULLY CONSIDER THE
FOLLOWING RISK FACTORS, IN ADDITION TO THE OTHER INFORMATION CONTAINED IN THIS
PROSPECTUS, BEFORE PURCHASING THE SECURITIES OFFERED HEREBY. THIS PROSPECTUS
CONTAINS FORWARD-LOOKING STATEMENTS. DISCUSSIONS CONTAINING SUCH FORWARD-LOOKING
STATEMENTS MAY BE FOUND IN THE MATERIAL SET FORTH BELOW AND UNDER "MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" AND
"BUSINESS OF THE COMPANY--STRATEGY OF THE COMPANY," AS WELL AS IN THE PROSPECTUS
GENERALLY. PROSPECTIVE INVESTORS ARE CAUTIONED THAT ANY SUCH FORWARD-LOOKING
STATEMENTS ARE NOT GUARANTEES OF FUTURE PERFORMANCE AND INVOLVE RISKS AND
UNCERTAINTIES. ACTUAL EVENTS OR RESULTS MAY DIFFER MATERIALLY FROM THOSE
DISCUSSED IN THE FORWARD-LOOKING STATEMENTS AS A RESULT OF VARIOUS FACTORS,
INCLUDING, WITHOUT LIMITATION, THE RISK FACTORS SET FORTH BELOW AND THE MATTERS
SET FORTH IN THIS PROSPECTUS GENERALLY.
LACK OF PROFITABLE HISTORY AND NEGATIVE WORKING CAPITAL. The Company has a
limited history of operations and earnings following implementation of the
Company's current growth strategy in mid-1996. The Company's audited
consolidated financial statements for the fiscal years ended September 30, 1995,
1996 and 1997 reflect net income (loss) of $188,250, $555,428, and $(2,639,415),
respectively, and the Company's unaudited consolidated financial statements for
the nine months ended June 30, 1998 reflect net income of $375,516. As described
more fully in this Prospectus, the Company consolidates its financial statements
with those of its affiliated physician organizations. See "Management's
Discussion and Analysis of Financial Condition and Results of
Operations--General." There can be no assurance that the Company will be able to
integrate and manage profitably the physician organizations with which it
affiliates, or that the Company will be able to successfully and profitably
manage HMO and other payor contracts on behalf of these physician organizations.
See "Selected Consolidated Financial Data" and "Management's Discussion and
Analysis of Financial Condition and Results of Operations." In addition, the
Company had negative working capital of $2,569,000 and $2,003,000 at June 30,
1998 and September 30, 1997, respectively.
DIFFICULTY IN CONTROLLING HEALTH CARE COSTS; CAPITATED NATURE OF
REVENUE. For the nine-month period ended June 30, 1998, the Company received
approximately 89% of its revenues on a consolidated basis from agreements with
HMOs. The Company's continuing profitability primarily depends upon the ability
of its affiliated physician organizations to pay out less in medical and
administrative costs than the capitation revenue received by them from HMOs.
HMOs are increasingly overseeing the provision of and the prices charged for
medical services with the goal of reducing costs and lowering capitation
payments. The Company's success therefore depends in large part on the effective
management of health care costs, including controlling utilization of specialty
care and other ancillary care and purchasing services at competitive prices. Any
adjustment downward in capitation payments caused by the increasing efforts by
HMOs to reduce costs could have a material adverse effect on the Company's
operating results and financial position. In addition, employer groups are
becoming increasingly successful in negotiating reductions in the growth of
premiums paid for their employees' health insurance, which tends to depress the
payments for health care services. At the same time, employer groups are
demanding higher accountability from payors and providers of health care
services with respect to measurable accessibility, quality and service. If these
trends continue, the cost of providing physician services could increase while
the level of payment could grow at a lower rate or could decrease. There can be
no assurance that these pricing pressures will not have a material adverse
effect on the operating results and financial condition of the Company.
Agreements with HMOs may also contain shared-risk arrangements under which
additional compensation can be earned based on the provision of high quality,
cost-effective health care to enrollees, but which may require that a portion of
any loss in connection with such shared-risk arrangements, including losses
resulting from the provision of hospital services, be assumed by the Company's
affiliated physician organizations, thereby reducing the Company's consolidated
net income. The amount of non-capitated and hospital costs in any period could
be affected by factors beyond the control of the Company or its affiliates,
9
<PAGE>
such as changes in treatment protocols, new technologies and inflation. To the
extent that such non-capitated and hospital costs are higher than anticipated,
revenue paid to the Company's affiliated physician organizations may not be
sufficient to cover the costs such organizations are responsible for paying. Any
such insufficiency could have a material adverse effect on the consolidated
operating results and financial condition of the Company.
RISKS ASSOCIATED WITH GROWTH STRATEGY. The Company's strategy primarily
involves growth through acquisition by the Company's affiliated physician
organizations of additional physician organizations that specialize in managed
care and the expansion of its affiliated physician organizations through
internal growth. Several of the acquisitions by the Company's affiliated
physician organizations were large transactions which involve significant risks
and uncertainties for the Company. The Company anticipates continuing to pursue
growth through acquisitions by the Company's affiliated physician organizations
and expansion of its affiliated physician organizations through internal growth.
The success of past and future acquisitions is largely dependent on the ability
of the Company to integrate the operations of the acquired physician
organizations into the operations of the Company's existing affiliated physician
organizations in an efficient and effective manner. The histories, business
models and cultures of acquired physician organizations may differ from those of
the Company and its affiliated physician organizations. The process of
integrating management services, which includes management information systems,
claims administration and billing services, utilization management of medical
services, care coordination and case management, quality and cost monitoring and
physician recruitment, as well as administrative functions, facilities and other
aspects of operations, while managing a larger entity with differing constituent
histories, business models and cultures, presents a significant challenge to the
Company's management. In addition, integration must be carried out so that the
Company is able to control medical and administrative costs. The ability to
control such costs is key to the successful future operations of the Company and
its affiliated physician organizations. There can be no assurance that any
acquisition will be successfully integrated on a timely basis, if at all, or
that the anticipated benefits of any such acquisition, including cost savings,
will be realized. Furthermore, there can be no assurance that any cost savings
which are realized will not be offset by increases in other expenses or
operating losses. The Company will encounter similar uncertainties and risks
with respect to any future acquisitions its affiliated physician organizations
may make. Failure to effectively accomplish the integration of acquired
companies could have a material adverse effect on the Company's results of
operations and financial condition. Further, there can be no assurance that the
Company will be able to successfully expand and manage the physician
organizations with which it affiliates. The Company's growth is dependent on its
ability to affiliate with physician organizations, to manage and control costs,
and to realize economies of scale.
Certain of the companies whose assets were recently acquired by affiliated
physician organizations have recently or historically operated at a loss. Other
acquired companies have experienced fluctuations in quarter-to-quarter operating
results. See "--Fluctuations in Quarterly Results." The Company has commenced
the institution of certain measures intended to reduce any operating losses and
to cause the acquired businesses to be operated profitably. However, there can
be no assurance that the Company will reverse these trends or cause these assets
to be operated profitably. If there are continuing operating losses from the
acquired assets, the Company may need additional capital to fund the related
businesses, and there can be no assurance that such additional capital can be
obtained at all or, if obtained, that it will be on terms acceptable to the
Company.
The Company and its affiliated physician organizations are regularly in
discussions with potential acquisition candidates and may from time to time
enter into letters of intent or definitive agreements with respect to the
acquisition of such businesses. No assurance can be given as to the Company's or
the affiliated physician organizations' ability to identify suitable acquisition
candidates, to compete successfully at favorable prices for available
acquisition candidates or to complete future acquisitions, or as to the
financial effect on the Company of any acquired business. Future acquisitions by
the Company or its affiliated physician organizations may involve the issuance
of additional shares of common stock of the Company, which could have a dilutive
effect on earnings per share, or could involve significant cash
10
<PAGE>
expenditures and may result in increased indebtedness and interest and
amortization expenses or decreased operating income, which could have a material
adverse impact on the Company's future operating results.
There can be no assurance that the Company and/or its affiliated physician
organizations will be able to achieve and manage its planned growth or that
suitable physician organizations will continue to be available for affiliation
upon terms satisfactory to the Company, if at all. In addition, there can be no
assurance that the Company's affiliated physician organizations will be able to
continue to attract and retain a sufficient number of qualified physicians and
other health care professionals to continue to expand their operations or
otherwise to maintain an adequate infrastructure to support continued growth.
Any failure of the Company or the Company's affiliated physician organizations
to consummate economically feasible acquisitions, effectively integrate
acquisitions or price services appropriately could have a material adverse
effect on the Company's growth, financial condition and results of operations.
The integration of acquired entities also requires the dedication of
management resources, which may distract the attention of management from the
day-to-day business of the combined companies. Furthermore, new acquisitions may
expose the Company's service network to new payors and providers with which it
has had no previous business experience. The Company cannot predict whether it
will be able to enroll into the Company's service network all members currently
served by physicians affiliated with newly acquired entities. Also, there can be
no assurance that there will not be substantial unanticipated costs or other
material adverse effects associated with acquisition and integration activities,
any of which could result in significant one-time charges to earnings or
otherwise materially adversely affect the Company's operating results.
RISKS ASSOCIATED WITH ESTABLISHING A FULL RISK HEALTH PLAN. The Company's
strategy also involves establishing a health plan with a limited license under
Knox-Keene (as defined below) to provide hospital, ancillary health care and
physician services to commercial and Medicare enrollees within the Company's
service network. To establish a health plan to provide hospital, physician and
ancillary health care services to commercial and Medicare enrollees and thereby
accept full financial risk for the provision of hospital as well as physician
and ancillary health care services, the Company or an affiliated physician
organization will need to obtain a license under the State of California
Knox-Keene Health Care Service Plan Act of 1975 ("Knox-Keene"), which Act is
administered by the State of California Department of Corporations ("DOC").
There can be no assurance that the Company and/or its affiliated physician
organizations will be able to obtain the necessary license to operate as a
health plan with a limited license. The application process to obtain such
license is also time-consuming and expensive.
Even if the Company or an affiliate obtains a limited license under
Knox-Keene to operate as a health plan, the Company or its affiliate will need
to enter into agreements with fully-licensed HMOs to provide hospital, physician
and ancillary health care services to commercial and/or Medicare enrollees. The
Company cannot predict which, if any, HMOs will be willing or able to enter into
agreements with the Company or an affiliated physician organization pursuant to
which the Company or such organization would assume full risk for all hospital,
physician and ancillary health care services or if any such agreements will be
available on terms acceptable to the Company. There can be no assurance that the
Company or an affiliate, as the case may be, will be able to implement or
operate as a health plan with a limited license. There also can be no assurance
that, even if the Company or an affiliate satisfies all of the conditions stated
above to assume full risk for all health care services, the Company will earn a
profit or not incur losses from such operations.
NEED FOR ADDITIONAL CAPITAL. Implementation of the Company's growth
strategy requires substantial capital resources to permit its affiliated
physician organizations to acquire the assets or stock of additional physician
organizations that specialize in managed care, for the effective integration,
operation, and expansion of affiliated physician organizations, and/or for the
acquisition of related management companies and for the effective integration
and operation of such management companies. Such resources will also be needed
to obtain a limited Knox-Keene license. A portion of the Company's consolidated
revenues
11
<PAGE>
is derived from incentive payments under HMO agreements that are accrued monthly
but are not received until approximately the third quarter of the calendar year.
These payments are not always made in a timely manner. For this and other
reasons, the Company may also require additional working capital infusions in
connection with its ongoing operations.
Subsequent to this Offering, the Company anticipates that a renewal or
replacement of its credit facility, including any additional amounts available
thereunder, and cash flows from operations will be sufficient to meet the
Company's currently anticipated acquisition, health plan formation and
development, expansion and working capital needs through September 30, 1999;
subsequent to September 30, 1999, the Company anticipates that the capital
needed to implement its business plan may exceed the capital sources described
above. To finance its ongoing capital requirements, the Company may from time to
time need to issue additional equity securities or incur additional debt. A
greater amount of debt or additional equity financing could be required to the
extent that the Common Stock fails to maintain a market value sufficient to
warrant its use in future acquisitions or to the extent that physician
organizations are unwilling to accept Common Stock in exchange for their
operating assets or common stock. Pursuant to the Company's agreements with the
Representative, the Company's ability to issue any securities is restricted for
a period commencing in March 1998 and ending twelve months following the
effective date of the Registration Statement of which this Prospectus forms a
part (the "Effective Date"), except for certain specified purposes, which
purposes include acquisitions. See "--Shares Eligible for Future Sale." The
Company's ability to issue any convertible debt or equity securities in a public
or private sale may also be restricted under certain circumstances pursuant to
contractual restrictions in the Company's agreements with its commercial lender.
There can be no assurance that the Company will be able to obtain additional
required capital on terms acceptable to the Company, if at all. Any additional
capital could result in increased indebtedness and interest and financing
expense, decreased operating income to fund future expansion and dilution of the
existing equity owners. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Liquidity and Capital Resources."
CURRENT FINANCING ARRANGEMENTS. The Company currently has a revolving
credit facility with Imperial Bank, a California banking corporation (the
"Bank"). The maximum amount available to the Company under the credit facility
is $12,500,000. The credit facility matures on July 3, 1999. The Company
currently intends to extend the maturity date to October 3, 1999 and to
renegotiate the terms of or replace its credit facility upon maturity. There can
be no assurance that the Company will be able to extend the maturity date or to
renegotiate the terms of or replace the credit facility or that any renegotiated
or replacement financing can be obtained on terms acceptable to the Company.
HIGH CONCENTRATION OF HMO CONTRACTS; SHORT-TERM NATURE OF HMO CONTRACTS. In
the current fiscal year, based on consolidated revenues for the nine-month
period ended June 30, 1998, the Company anticipates that contracts with three
HMOs will account for approximately 70% of the Company's consolidated total
operating revenue, of which the contracts with PacifiCare of California/FHP,
Inc. will account for approximately 50% of the Company's consolidated revenue,
the contracts with Blue Cross of California will account for slightly more than
10% of the Company's consolidated revenue and the contracts with Cigna
Healthcare of California, Inc. will account for slightly less than 10% of the
Company's consolidated revenue. HMO contracts generally are for one-year terms,
may be terminated earlier without cause upon notice and upon renewal and are
subject to annual negotiation of capitation rates, covered benefits and other
terms and conditions. At times, HMO contracts may be continued on a
month-to-month basis while the parties renegotiate the terms of the contracts.
The contracts with PacifiCare of California/FHP, Inc. expire on December 31,
1998, the contracts with Blue Cross of California expire on December 31, 1998
and the contracts with Cigna Healthcare of California, Inc. expire on December
31, 1998 and May 31, 1999; these contracts are generally renewed each year.
There can be no assurance that any of such contracts will not be terminated,
will be renewed or, if renewed, that they will contain favorable terms. The loss
of any such HMO contract and the failure to regain or retain such HMO's members
or the related revenues could have a material adverse effect on the Company, its
financial condition or results of operations.
12
<PAGE>
RELIANCE ON GOVERNMENT-SPONSORED HEALTH CARE PROGRAMS. Substantially all of
the Company's revenues on a stand-alone basis are derived from its management
services agreements with its affiliated physician organizations, which provide
for the Company to receive compensation thereunder in part based on the revenues
of such organizations. The Company estimates that approximately 35% of the
revenues of its affiliated physician organizations are derived from payments
made to their contracting HMOs under Medicare, Medicaid and other
government-sponsored health care programs. Consequently, any future reduction in
payments or any change in the regulations, policies, practices, interpretations
or statutes adversely affecting payments made to HMOs under these
government-sponsored health care programs could materially adversely affect the
results of operations of the Company. More specifically, the health industry is
experiencing a trend toward cost containment as government-sponsored payors seek
to impose lower reimbursement rates. The Federal Balanced Budget Act of 1997
(the "Budget Act") includes revisions to existing payment rates for health care
services, including health care services provided by the Company's affiliated
physician organizations. Although the payment rates for most of the services
provided by the Company's affiliated physician organizations have not been
reduced under such legislation, there can be no assurance that payment rates for
such services will not be reduced by future legislation or by the United States
Department of Health and Human Services pursuant to authority granted to it
under the Budget Act. This legislation also provides for an increase in state
discretion over the funding of Medicaid which, in light of the fact that
Medicaid-related expenditures comprise a substantial and growing share of state
budgets, could also lead to significant reductions in reimbursement to
providers.
DEPENDENCE ON HMO MEMBER GROWTH. The Company is also largely dependent on
the continued increase in the number of HMO members who use its service
networks. This growth may come from affiliation with additional physician
organizations, increased membership in HMOs currently contracting with the
Company through its affiliated physician organizations, additional agreements
between HMOs and the Company's affiliated physician organizations and
development or acquisition of other management companies. There can be no
assurance that the Company and its affiliated physician organizations will be
successful in identifying, acquiring and integrating additional physician
organizations or other management companies or in increasing the number of
enrollees. A decline in membership in HMOs could have a material adverse effect
on the operating results and financial condition of the Company.
DEPENDENCE ON AFFILIATED PHYSICIAN ORGANIZATIONS. Substantially all of the
Company's revenues on a stand-alone basis are derived from management services
agreements with its affiliated physician organizations. The Company's management
services agreements are for a term of 30 years with additional renewal terms of
10 years and may be terminated only for cause. Physicians are employed by the
affiliated medical groups (and not by the Company) pursuant to employment
agreements with initial terms ranging from three to seven years. The Company's
affiliated independent practice associations generally contract with independent
physicians pursuant to provider agreements with a term of one year, terminable
by either party upon 30 days' (for primary care physicians) or 90 days' (for
specialty care physicians) notice. Key members of a physician organization could
retire, become disabled, terminate their employment agreements or provider
contracts, or otherwise become unable or unwilling to continue generating
revenues at the current level or practicing medicine within such physician
organization. There can be no assurance that (i) physicians presently in the
Company's affiliated physician organizations will not leave such physician
organizations and that enrollees served by such physicians will not enroll in an
unaffiliated physician organization, (ii) the Company will be able to attract
additional physicians into its affiliated physician organizations, or (iii) the
amount of capitation and risk-sharing payments to such physicians will not have
to be increased. In addition, each of the Company's affiliated physician
organizations operates within a limited geographic area, and a deterioration of
economic or other conditions within such area could have a material adverse
impact upon the Company, its results of operations or cash flows. Any material
decline in revenue of the Company's affiliated physician organizations, whether
as a result of physicians leaving the affiliated physician organizations or
otherwise, could have a material adverse effect on the Company.
The Company's affiliated independent practice associations seek to include
exclusivity and non-diversion arrangements with contracting physicians in their
agreements. In an exclusivity agreement
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generally, a contracting physician agrees to refrain from providing physician
services to members of HMOs except through Company-affiliated physician
organizations. Under a non-diversion agreement, a physician is required to
refrain from diverting enrollees in a Company-affiliated independent practice
association to an independent practice association unaffiliated with the
Company. Although the affiliated independent practice associations have entered
into exclusivity and/or non-diversion agreements of varying degrees with certain
physicians, there can be no assurance as to the enforceability of such
restrictive agreements. There can also be no assurance that the affiliated
independent practice associations will be able to enter into additional
exclusivity and/or non-diversion arrangements. In addition, the affiliated
independent practice associations do not have exclusivity and/or non-diversion
agreements with a substantial number of the contracting physicians.
RECENT SETTLEMENT AGREEMENT WITH YORBA LINDA MEDICAL GROUP. Certain
physicians who are employed by Yorba Linda Medical Group have provided medical
services to enrollees of a Company-affiliated physician organization, Prospect
Medical Group, under separate provider agreements. Under the agreements between
these physicians and Prospect Medical Group, these physicians had agreed to be
exclusive providers for Prospect Medical Group. In October 1997, these
physicians sought release from the exclusivity and other noncompetition
provisions in their agreements with Prospect Medical Group in order to join
another physician organization. As described under "Business of the
Company--History of the Company," the Company and Prospect Medical Group have
agreed to the release in exchange for the return of 1,126,323 shares of Common
Stock pursuant to a settlement agreement (the "Yorba Linda Settlement
Agreement"). The Board of Directors of the Company believed that the return of
the Common Stock constituted adequate consideration for the release of such
physicians from their agreements. The Company estimates that no more than
approximately 13,000 of the Company's enrollees who were served by these
physicians as of June 30, 1998 may enroll with an unaffiliated physician
organization, and that the loss of these enrollees could reduce the Company's
capitation revenues by no more than 16%, or total revenues by no more than 15%,
based on the results of operations for the nine months ended June 30, 1998.
Management of the Company believes these reductions in revenue will not
materially adversely affect the Company's business, operations, financial
condition or cash flows because the costs associated with this revenue were
relatively higher than the costs associated with the Company's other revenue.
The Company believes that more than 50% of any such change in enrollment would
have occurred by October 1, 1998; as of such date approximately 6,000 of such
enrollees had enrolled with unaffiliated physician organizations. See "Unaudited
Pro Forma Financial Information" and "Management's Discussion and Analysis of
Financial Condition and Results of Operations" for a description of the
anticipated effect of the Yorba Linda Settlement Agreement on the results of
operations, financial condition and cash flows of the Company.
HIGHLY COMPETITIVE MARKET. The managed care industry is highly competitive
and is subject to continuing changes with respect to the manner in which
services are provided and how providers are selected and compensated. The
Company competes with any entity that contracts with HMOs and other payors for
the provision of prepaid health services, including but not limited to: (i)
other companies that provide management services to health care providers; (ii)
hospitals that affiliate with one or more medical groups; (iii) HMOs that employ
or contract directly with physicians; and (iv) other physician organizations.
Additionally, the physician organizations with which the Company is affiliated
compete with other medical groups and independent practice associations in the
areas in which such physician organizations do business, or are expected to do
business in the future. Pressures to reduce the cost of medical care, through
legal reform of the health care system or through market forces such as the
continued expansion of managed care, could materially adversely impact the
Company's revenues. Further, increased enrollment in prepaid plans because of
health care reform or for other reasons, increased participation by physicians
in group practices and other factors may attract new entrants into the managed
care industry and result in increased competition for the Company. Certain of
the Company's and its affiliated physician organizations' competitors are
significantly larger and better capitalized, provide a wider variety of
services, may have more experience in providing health care management services
and may have longer established
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relationships with HMOs. There can be no assurance that the Company or its
affiliated physician organizations will be able to compete effectively with such
competitors, that additional competitors will not enter the market or that such
competition will not make it more difficult to enter into affiliations with
physician organizations on terms beneficial to the Company, if at all. See
"Business of the Company-- Competition."
DEPENDENCE ON INFORMATION SYSTEMS. New systems are critical to developing
and implementing operational, financial and disease management information. To
develop its network, the Company has invested in a sophisticated management
information system. See "--Year 2000 Risks" and "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Liquidity and Capital
Resources-- YEAR 2000." The Company may experience unanticipated delays,
complications and expenses in implementing, integrating and operating such
systems. Furthermore, such systems may require modifications, improvements or
replacements as the Company expands and as new technologies become available.
See "Management's Discussion and Analysis of Financial Condition and Results of
Operations--Liquidity and Capital Resources--YEAR 2000" for a discussion of the
effects of the year 2000 on the Company's management information systems. Such
modifications, improvements or replacements may require substantial expenditures
and may require interruptions in operations during periods of implementation.
Moreover, implementation of such systems is subject to the availability of
information technology and skilled personnel to assist the Company in creating
and implementing the systems. No assurance can be given that the Company will be
able to enhance existing and/or implement new information systems. The failure
to successfully implement and maintain operational, financial and clinical
information systems would have a material adverse effect on the Company. See
"Business of the Company--Strategy of the Company."
DEPENDENCE ON KEY PERSONNEL. The Company's future success depends on the
services of its key management personnel, who include Jacob Y. Terner, M.D. and
Gregg DeNicola, M.D. The loss of either of these individuals, or the inability
to attract and retain a sufficient number of qualified management personnel,
could have a material adverse effect on the Company's results of operations.
Each of Dr. Terner and Dr. DeNicola has an employment agreement with the Company
that expires on July 30, 1999. See "Management of the Company--Employment
Arrangements" for a discussion of the terms of each of these employment
agreements. Currently, the Company maintains no life insurance on its key
management personnel.
RISKS INHERENT IN PROVISION OF MEDICAL SERVICES. Each of the Company's
affiliated physician organizations is involved in the delivery of health care
services to the public and, therefore, is exposed to the risk of professional
liability claims. Each of the affiliated physician organizations' contracts with
HMOs generally require such physician organizations to indemnify the HMO for
losses resulting from the negligence of physicians who were employed by or
contracted with the physician organization. Claims of this nature, if
successful, could result in substantial damage awards to the claimants, which
may exceed the limits of any applicable insurance coverage. Insurance against
losses related to claims of this type can be expensive. Moreover, in recent
years, physicians, hospitals and other participants in the health care industry
have become subject to an increasing number of lawsuits alleging medical
malpractice and related claims based on the withholding of approval for or
reimbursement of necessary medical services. Many of these lawsuits involve
large claims and substantial defense costs. Although the Company does not engage
in the practice of medicine or the provision of medical services, there can be
no assurance that the Company will not become involved in such litigation in the
future. The Company and its affiliated physician organizations are currently
insured under policies which cover general and professional liability (including
malpractice for the physician organizations only) and directors' and officers'
liability insurance on a "claims made" basis in
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amounts deemed appropriate by management, based upon historical claims and the
nature and risks of its business. In addition, the affiliated independent
practice association provider contracts with physicians typically require each
physician to maintain professional liability insurance coverage of the physician
and of each employee, servant and agent of the physician. There can be no
assurance, however, that future claims will not exceed the limits of available
insurance coverage, that existing insurers will remain solvent and able to meet
their obligations to provide coverage for any such claims, or that such coverage
will continue to be available or available with sufficient limits and at
reasonable cost to adequately and economically insure the Company's and
affiliated physician organizations' operations in the future. A judgment against
the Company or any of its affiliated physician organizations could have a
material adverse effect on the Company.
FULL RISK CAPITATION. Under all current HMO contracts, the Company's
affiliated physician organizations accept the financial risk for the provision
of physician (including certain specialty care physician) services and certain
ancillary (e.g., laboratory, physical therapy, etc.) health care services.
Pursuant to the Company's future growth strategy, the Company or an affiliated
entity may also accept the financial risk for hospital services. In the event
that (i) the Company is unable to negotiate favorable prices or rates in
contracts with providers of these services on behalf of itself or its affiliate,
or (ii) the affiliated physician organizations are unable to effectively control
the utilization of these services, the Company's costs could increase and as a
result the Company could experience material adverse effects on its results of
operations or cash flows.
FLUCTUATIONS IN QUARTERLY RESULTS. The Company's financial statements
(including interim financial statements) contain accruals which are calculated
quarterly for estimates of incentive payments to be made by the HMOs to the
Company's affiliated physician organizations based upon a comparison of
specialist and hospital utilization to budgeted costs. Quarterly results have in
the past and may in the future be affected by adjustments to such estimates for
actual costs incurred. Historically, the affiliated physician organizations and
HMOs generally reconcile differences between actual and estimated amounts
receivable or payable relating to HMO incentive payment arrangements by the
third quarter of each calendar year. In the event that the affiliated physician
organizations and HMOs are unable to reconcile such differences, extensive
negotiation, arbitration or litigation relating to the final settlement of these
amounts may occur. Any delay in the settlement of these amounts may result in an
inability of the Company to record anticipated income. As the Company's network
expands to include additional HMOs, the timing of these reconciliations may
vary; this variation in timing may cause the Company's results not to be
directly comparable to corresponding quarters in other years. The Company's
financial statements also include estimates of costs for covered medical
benefits incurred by enrollees, which costs have not yet been reported by the
providers. While these estimates are based on information available to the
Company at the time of calculation, actual costs may differ from the Company's
estimates of such amounts. If the actual costs differ significantly from the
amounts estimated by the Company, adjustments will be required and quarterly
results may be affected. Quarterly results may also be affected by movements of
HMO members from one HMO to another, particularly during periods of open
enrollment for HMOs. Additionally, the Company, through its affiliated physician
organizations, anticipates making acquisitions in the future. Such acquisitions
could cause fluctuations in the Company's quarterly results. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations."
YEAR 2000 RISKS. The Company is seeking to ensure that its electronic data
processing systems, including any embedded systems that control equipment, will
recognize the year 2000 and will not treat any date after December 31, 1999 as a
date during the twentieth century. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations--Liquidity and Capital
Resources--YEAR 2000." However, no assurances can be given that the Company will
be able to avoid all year 2000 problems, especially those that could originate
with third parties with whom the Company engages in electronic transactions or
otherwise does business. If the Company or any third party with whom the Company
does
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business were to have a year 2000 problem, the Company's business could be
seriously disrupted and the Company's financial condition and results of
operations could be materially adversely affected.
RISK RELATED TO INTANGIBLE ASSETS AND AMORTIZATION OF GOODWILL. The Company
has a significant amount of intangible assets. Primarily as a result of
acquisitions by the Company's affiliated physician organizations, intangible
assets (net of accumulated amortization) of approximately $18,588,000 have been
recorded in the Company's consolidated balance sheet as of June 30, 1998.
Additional acquisitions will result in the recordation of additional intangible
assets which will cause a further increase in amortization expense and a
corresponding decrease in operating income. Further, any future determination
that a significant impairment of the value of acquired intangible assets has
occurred would require the write-down of the impaired portion of unamortized
goodwill to fair value, which would have a material adverse effect on the
Company's consolidated results of operations. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations."
GOVERNMENT REGULATION. The activities currently conducted by the Company
and its affiliated physician organizations are subject to extensive regulation
at the local, state, and federal levels. The Company believes its operations and
those of its affiliates are in material compliance with applicable laws.
However, the assortment of laws and regulations affecting the business of the
Company and its affiliates are complex, in many cases ambiguous and many
provisions have not been the subject of regulatory or judicial interpretation.
There can be no assurance that a review of the business of the Company and its
affiliates by courts or regulatory authorities will not result in a
determination that the Company or an affiliate has not complied fully with all
applicable laws and regulations in one or more aspects of its business, which
could adversely affect the operations of the Company or such affiliate. Further,
there can be no assurance that the health care regulatory environment will not
change so as to restrict the existing operations of the Company and its
affiliates or their expansion. See "Business of the Company--Governmental
Regulation."
In California, and in certain other states in which the Company may attempt
to conduct business in the future, general business corporations are not
permitted to practice medicine, exercise control over physicians who practice
medicine or engage in certain practices such as fee-splitting with physicians.
The statutory prohibitions against the corporate practice of medicine generally
proscribe lay entities from employing or hiring health care practitioners, or
from otherwise interfering directly or indirectly with a health care
practitioner's practice of medicine. The Company believes that it is not engaged
in the corporate practice of medicine as it neither represents to the public
that it offers medical services nor purports to control the practice of
medicine. Further, although the Company provides the affiliated physician
organizations with administrative, management and support services, the
affiliated physician organizations continue to be exclusively in control of and
responsible for all aspects of the practice of medicine and delivery of medical
services. The Company's agreements with its affiliated physician organizations
specifically reserve to the physicians exclusive authority to make all decisions
regarding medical care, including the right to employ physicians or enter into
contracts for the provision of medical services or make other financial
commitments relating thereto. See "Business of the Company--The Affiliated
Physician Organizations." There can be no assurance, however, that regulatory
authorities, courts or parties with which the Company does business will not
assert that the Company is engaged in the corporate practice of medicine and
seek relief prohibiting the Company from carrying on business or voiding
existing contractual relationships. If such assertions are made, the Company
might be required to restructure its contracts with its affiliated physician
organizations. Any such restructuring could have a material adverse effect on
the Company.
The Company and its affiliated physician organizations are subject to
federal legislation that prohibits activities and arrangements that provide
kickbacks or other economic inducements for the referral of business under the
Medicare and Medicaid programs. "Safe harbor" regulations have been promulgated
to identify certain business and payment practices which are deemed not to
violate this legislation. In addition, federal legislation (known as Stark II)
currently restricts the ability of physicians to refer Medicare/Medicaid
patients to entities providing certain designated health services if the
physician has an
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ownership interest or compensation arrangement in such entity. Non-compliance
with either the federal anti-kickback legislation or the federal self-referral
prohibition can result in exclusion from the Medicare and Medicaid programs and
civil and criminal penalties. In addition, with respect to the self-referral
prohibition, the entity and the referring physician are prohibited from
receiving reimbursement for services rendered. Many states, including
California, have similar anti-kickback and self-referral laws which provide for
similar penalties. Although the Company believes that its operations and the
operations of its affiliated physician organizations comply with all federal and
state anti-kickback and self-referral laws, no assurances can be given that
their operations fall outside the scope of these prohibitions. Further, there
can be no assurance that the Company or its affiliated physician organizations
will be able to comply with any prospective legislation which may be enacted to
regulate the health care industry. See "Business of the Company--Governmental
Regulation."
In April 1998, the Office of the Inspector General of the United States
Department of Health and Human Services (the "OIG") issued an advisory opinion
under the federal anti-kickback statute which raised questions with respect to
compensation arrangements that included a fee based on a percentage of the
physician organization's net revenues in a proposed management services
agreement between a management company and a primary care physician
organization. The Company continues to receive a percentage of gross revenues of
each affiliated physician organization under its management services agreements,
in addition to payment for costs and expenses incurred thereunder; based upon
such advisory opinion, the Company has revised its standard management services
agreement with its affiliated physician organizations to specify as a portion of
its compensation a flat fee payable on a monthly basis as compensation for
marketing services. However, no assurance can be given that the OIG or any other
health care regulatory agency will not interpret the Company's compensation
arrangements to be in violation of the prohibitions of the anti-kickback
statute. See "Business of the Company--Governmental Regulation."
There are also state and federal civil and criminal statutes imposing
substantial penalties, including civil and criminal fines and imprisonment, on
health care providers that fraudulently or wrongfully bill governmental or other
third-party payors for health care services. The federal law prohibiting false
billings allows a private person to bring a civil action in the name of the
United States government for violations of its provisions. The Company believes
it and its affiliated physician organizations are in material compliance with
such laws, but no assurance can be given that their activities will not be
challenged or scrutinized by governmental authorities. Moreover, technical
Medicare and other reimbursement rules affect the structure of physician billing
arrangements. The Company believes it and its affiliated physician organizations
are in material compliance with such regulations, but regulatory authorities may
differ and in such event the Company may have to modify its physician billing
arrangements. Non-compliance with such regulations may adversely affect the
operation of the Company and subject it to penalties and additional costs.
INACTIVE PRIOR MARKET FOR THE COMMON STOCK; NO ASSURANCE OF AMERICAN STOCK
EXCHANGE LISTING. Prior to the Offering, the Common Stock has been the subject
of limited and sporadic trading on the OTC Bulletin Board operated by the
National Association of Securities Dealers, Inc. (the "Bulletin Board"). The
Company intends to apply to list the Shares and the Warrants on the American
Stock Exchange under the proposed symbols "PXX" and "PXX.W," respectively. No
assurance can be given that such application will be granted or, if granted,
that an active trading market will develop. See "Price Range of Common Stock and
Dividend Policy." There can be no assurance that an active trading market, if
developed, will be sustained.
The Board of Governors of the American Stock Exchange, Inc. has established
certain standards for the initial listing and continued listing of a security on
the American Stock Exchange. The standards for initial listing require, among
other things, that an issuer have a three-year history of operations; minimum
public distribution of 500,000 shares together with a minimum of 800 public
holders or 1,000,000 shares together with a minimum of 400 public holders, and
stockholders' equity of at least $4,000,000; the minimum bid price for the
listed securities be $3.00 per share; and the minimum market value of the public
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float (the shares held by non-insiders) be at least $15,000,000. The maintenance
standards require, among other things, that an issuer maintain a minimum market
value of its public float of at least $1,000,000, a minimum public distribution
of 200,000 shares and a minimum of 300 holders and comply with certain filing
requirements of the American Stock Exchange. There can be no assurance that the
Company will continue to satisfy the requirements for maintaining an American
Stock Exchange listing. If the Company's securities were to be de-listed from
the American Stock Exchange, it would adversely affect the prices of such
securities and the ability of holders to sell them, and the Company would be
required to comply with the initial listing requirements to be relisted on the
American Stock Exchange.
DETERMINATION OF OFFERING PRICE; POSSIBLE VOLATILITY OF STOCK PRICE. The
initial public offering price of the Common Stock and the Warrants (in each
case, the "Offering Price") has been established by negotiation between the
Company and the Representative and may not be indicative of the prices that will
prevail in the public market. See "Underwriting." There has been a history of
significant volatility in the market prices for shares of health care companies
and smaller capitalization companies generally, and it is likely that the market
price of the Common Stock will be highly volatile. There can be no assurance
that shares of Common Stock or the Warrants may be resold at or above the
Offering Price after this Offering. Prices for the Common Stock and the Warrants
following this Offering may be influenced by many factors, including
announcements of legislation or regulation affecting the health care industry in
general and reimbursement for health care services in particular, the depth and
liquidity of the market for the Common Stock and the Warrants, investor
perceptions of the Company and fluctuations in the Company's operating results
and market conditions.
RISK OF LOW-PRICED SECURITIES; RISK OF APPLICATION OF PENNY STOCK RULES. If
the Company is unable to satisfy the American Stock Exchange's listing and/or
maintenance requirements, the Common Stock would remain on, or return to, as the
case may be, the Bulletin Board, a screen-based electronic bulletin board
maintained by the National Association of Securities Dealers, Inc. If the price
per share were to drop below $5.00, then, unless the Company satisfied certain
net asset tests, the Company's securities would become subject to certain penny
stock rules promulgated by the Securities and Exchange Commission (the
"Commission"). At June 30, 1998, the Company did not satisfy these net asset
tests. The penny stock rules require a broker-dealer, prior to a transaction in
a penny stock not otherwise exempt from the rules, to deliver a standardized
risk disclosure document prepared by the Commission that provides information
about penny stocks and the nature and level of risks in the penny stock market.
The broker-dealer also must provide the customer with current bid and offer
quotations for the penny stock, the compensation of the broker-dealer and its
salesperson in the transaction and monthly account statements showing the market
value of each penny stock held in the customer's account. In addition, the penny
stock rules require that prior to a transaction in a penny stock not otherwise
exempt from such rules, the broker-dealer must make a special written
determination that the penny stock is a suitable investment for the purchaser
and receive the purchaser's written agreement to the transaction. These
disclosure requirements may have the effect of reducing the level of trading
activity in the secondary market for a stock that becomes subject to the penny
stock rules. If the Common Stock becomes subject to the penny stock rules,
investors in the Offering may find it more difficult to sell their shares, which
may cause a decrease in the value of such shares.
SPECULATIVE NATURE OF WARRANTS. The Warrants do not confer any rights of
Common Stock ownership on their holders, such as voting rights or the right to
receive dividends, but rather merely represent the right to acquire shares of
Common Stock at a fixed price for a limited period of time. Following the
completion of this Offering, the market value of the Warrants will be uncertain
and there can be no assurance that the market value of the Warrants will equal
or exceed their initial public offering price. There can be no assurance that
the market price of the Common Stock will ever equal or exceed the exercise
price of the Warrants, and consequently, whether it will ever be profitable for
holders of the Warrants to exercise the Warrants.
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POTENTIAL ADVERSE EFFECT OF REDEMPTION OF WARRANTS. Commencing , 1999
[the first anniversary of the Effective Date], the Warrants are subject to
redemption by the Company at $.10 per Warrant on thirty (30) days' prior written
notice to the Warrant holders if the average closing sales price of the Common
Stock as reported on the American Stock Exchange equals or exceeds $18.00 per
share for any twenty (20) trading days within a period of thirty (30)
consecutive trading days ending on the fifth trading day prior to the date of
the notice of redemption. If the Warrants are redeemed, holders of the Warrants
will lose their rights to exercise the Warrants after the expiration of the
thirty (30)-day notice of redemption period. Upon receipt of a notice of
redemption, holders would be required to: (i) exercise the Warrants and pay the
exercise price at a time when it may be disadvantageous for them to do so; (ii)
sell the Warrants at the current market price, if any, when they might otherwise
wish to hold the Warrants; or (iii) accept the redemption price, which is likely
to be substantially less than the market value of the Warrants at the time of
redemption. See "Description of Capital Stock--Warrants."
POTENTIAL ADVERSE EFFECT OF SUBSTANTIAL SHARES OF COMMON STOCK
RESERVED. The Company has reserved a total of 4,954,559 shares of Common Stock
for issuance as follows: (i) 3,450,000 shares for issuance upon exercise of the
3,450,000 Warrants (including those covered by the Underwriters' over-allotment
option); (ii) 300,000 shares for issuance upon exercise of the Representative's
Warrants; (iii) 300,000 shares for issuance upon exercise of the Warrants
issuable upon exercise of the Representative's Warrants; (iv) 176,000 shares of
Common Stock reserved for issuance pursuant to grants that may be made under the
Stock Option Plan, including but not limited to 55,000 shares of Common Stock
reserved for issuance upon exercise of options granted to two officers of the
Company at an exercise price equal to $5.00 per share, and 10,000 shares of
Common Stock reserved for issuance upon exercise of options granted to a
recently elected director at an exercise price equal to $5.00 per share; (v)
477,119 shares of Common Stock in the aggregate reserved for issuance upon
exercise of options granted to three current directors and a former director of
the Company at an exercise price equal to $1.25 per share; (vi) 35,000 shares of
Common Stock reserved for issuance upon exercise of options granted to the
sellers of stock of Sierra Primary Care Medical Group, A Medical Corporation and
Sierra Medical Management, Inc. at an exercise price equal to $5.00 per share;
(vii) 13,635 shares of Common Stock reserved for issuance upon exercise of
warrants granted to certain finders in connection with the 1996 Merger and
related transactions at an exercise price equal to $1.375 per share; (viii)
192,725 shares of Common Stock reserved for issuance upon exercise of warrants
granted to the Bank at an exercise price of $5.00 per share; and (ix) 10,080
shares that may be issued to a physician whose assets were acquired by an
affiliated physician organization. The existence of the Warrants, the
Representative's Warrants and any other options or warrants may adversely affect
the Company's ability to consummate future equity financings. Further, the
holders of such warrants and options may exercise them at a time when the
Company would otherwise be able to obtain additional equity capital on terms
more favorable to the Company. See "Shares Eligible for Future Sale."
LEGAL RESTRICTIONS ON SALES OF SHARES UNDERLYING THE WARRANTS. The Warrants
are not exercisable for one year and will not then be exercisable unless, at the
time of the exercise, the Company has a current prospectus (included in an
effective registration statement under the Securities Act of 1933, as amended
(the "Securities Act")) covering the shares of Common Stock issuable upon
exercise of the Warrants, and such shares have been registered, qualified or
deemed to be exempt under the securities laws of the state of residence of the
exercising holder of the Warrants.
LACK OF EXPERIENCE OF REPRESENTATIVE. Securities Capital Trading, Inc., the
Representative, commenced operations in June 1995. The Representative has
co-managed and participated as an underwriter in only two previous public
offerings of securities. Accordingly, the Representative has limited experience
as a co-manager or underwriter of public offerings of securities. In addition,
the Representative is a relatively small firm and no assurance can be given that
the Representative will be able to participate effectively as a market maker of
the Securities. No assurance can be given that any broker-dealer will be a
market maker in any of the Securities. See "Underwriting."
REPRESENTATIVE'S POTENTIAL INFLUENCE ON THE MARKET AND THE COMPANY. A
significant amount of the Securities offered hereby may be sold to customers of
the Representative. Such customers subsequently may
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engage in transactions for the sale or purchase of such Securities through or
with the Representative. If the Representative participates in the market, as a
market maker or otherwise, the Representative may exert a dominating influence
on the market, if one develops, for the Securities. Such market making activity
may be discontinued at any time. The price and liquidity of the Common Stock and
the Warrants may be significantly affected by the degree, if any, of the
Representative's participation in such market. In addition, the Representative
may have a continuing influence on the Company through exercise of the
Representative's Warrants. See "Underwriting."
DILUTION. The Offering Price per share of Common Stock is substantially
higher than the book value per share of Common Stock. Investors purchasing
shares of Common Stock in this Offering will, therefore, incur immediate,
substantial dilution in net tangible book value of their shares. See "Dilution."
Substantial additional dilution could result from the anticipated issuance of
other equity securities of the Company, including shares issued upon the
exercise of currently outstanding options and warrants. See "Shares Eligible for
Future Sale." In addition, the Company's expansion strategy includes
acquisitions by its affiliated physician organizations of, and affiliations by
the Company with, additional physician organizations and acquisition by the
Company of related management companies. Such acquisitions and affiliations may
be consummated using newly-issued shares of Common Stock as consideration. The
issuance of additional shares of Common Stock may have a dilutive effect on the
Company's net tangible book value or earnings per share following such issuance.
SHARES ELIGIBLE FOR FUTURE SALE. Sales of substantial amounts of Common
Stock in the public market following this Offering could have an adverse effect
on the market price of the Common Stock. Upon completion of the Offering and
after giving effect to the Yorba Linda Settlement Agreement (see "Business of
the Company--History of the Company"), the Company will have outstanding
approximately 7,449,395 shares of Common Stock (7,899,395 shares if the
Underwriters' over-allotment option is exercised in full), of which 3,000,000
shares offered hereby (3,450,000 shares if the Underwriters' over-allotment
option is exercised in full) will be freely tradeable without restriction or
further registration under the Securities Act to the extent they are not held by
"affiliates" of the Company, as that term is defined in Rule 144 ("Rule 144")
promulgated under the Securities Act. The remaining 4,449,395 shares of Common
Stock outstanding upon completion of the Offering will be "restricted
securities" as that term is defined in Rule 144, of which 2,597,083 shares will
be eligible for resale without restriction in compliance with Rule 144(k),
1,025,039 shares will be eligible for resale subject to the manner of sale,
volume, notice and current public information requirements of Rule 144, and
827,273 shares will subsequently become eligible for resale under Rule 144 upon
expiration of their respective one-year holding periods. Additionally, upon
completion of the Offering the Company will have outstanding Warrants,
Representative's Warrants and other options and warrants for the purchase of up
to approximately 4,504,559 shares of Common Stock (4,954,559 shares if the
Underwriters' over-allotment option is exercised in full). The existence of a
large number of shares eligible for future sale could have an adverse effect on
the Company's ability to raise additional equity capital or on the price at
which such equity capital could be raised. See "Shares Eligible for Future
Sale."
The officers, directors and certain other stockholders of the Company, who
upon completion of the Offering will own in the aggregate 1,649,039 shares of
Common Stock (including all of the shares that will be eligible for resale under
Rule 144 (other than pursuant to paragraph (k) thereof) and 624,000 of the
shares that will not yet be eligible for resale under Rule 144 following the
Offering) and options and/or warrants to purchase up to 460,000 shares of Common
Stock, are required to agree that they will not, without the consent of the
Underwriters, directly or indirectly, offer, sell, transfer, pledge, assign,
hypothecate or otherwise encumber any of such shares or securities exercisable
or exchangeable for or convertible into shares of Common Stock, whether or not
owned, or otherwise dispose of any interest therein under Rule 144 or otherwise,
for a period of not less than twelve months following the effective date (the
"Effective Date") of the Registration Statement filed with respect to this
Offering (the "Registration Statement"). In addition, without the consent of the
Underwriters, the Company will not sell or offer for sale any of its securities
for a period commencing on March 24, 1998 through a date twelve months following
the Effective Date, except pursuant to or in connection with (i) the exercise of
options
21
<PAGE>
granted by the Company under any incentive stock ownership plan (a "Plan")
authorized by the Company's stockholders, (ii) the exercise of non-Plan options
and warrants granted by the Company prior to March 24, 1998 and/or (iii) the
issuance of shares of Common Stock in transactions involving acquisitions by the
Company or its affiliated physician organizations of the assets or equity
ownership of unrelated business entities.
In connection with obtaining its credit facility, the Company issued to the
Bank warrants to purchase shares of Common Stock (the "Bank Warrants"). In the
event the Company offers to the Company's stockholders rights to purchase any
securities of the Company, then the holders of the Bank Warrants are entitled to
participate in such rights offering.
Certain holders of warrants to purchase shares of Common Stock have certain
registration rights with respect to such shares and additional shares that may
be issued to such persons upon certain dilutive events (subject to certain
limitations on the numbers of shares such holders are entitled to have
registered under any registration statement).
NO DIVIDENDS. The Company has never paid cash dividends on the Common Stock
and anticipates that for the foreseeable future, all earnings, if any, will be
retained for the operation and expansion of the Company's business. In addition,
under the Company's credit facility, the Company is currently prohibited from
declaring or paying any dividends or distributions of earnings to its
stockholders. See "Price Range of Common Stock and Dividend Policy."
ANTI-TAKEOVER EFFECT OF CERTAIN CHARTER AND OTHER PROVISIONS. The Company's
Certificate of Incorporation and Bylaws contain certain provisions that could
have the effect of making it more difficult for a person to acquire, or of
discouraging a third party from attempting to acquire, control of the Company,
including transactions in which stockholders might receive a substantial premium
for their shares over then current market prices, and may limit the ability of
stockholders to approve transactions that they deem to be in their best
interest. The Company's Certificate of Incorporation authorizes the Board of
Directors of the Company (the "Board of Directors") to issue preferred stock
("Preferred Stock") without stockholder approval and upon such terms as the
Board of Directors may determine. The rights of the holders of Common Stock will
be subject to, and may be adversely affected by, the rights of the holders of
any Preferred Stock that may be issued in the future. The issuance of Preferred
Stock, while providing desirable flexibility in connection with possible
acquisitions and other corporate purposes, could have the effect of discouraging
a person from acquiring a majority of the outstanding Common Stock. There are no
shares of Preferred Stock presently outstanding and the Company has no present
plans to issue any shares of Preferred Stock. See "Description of Capital
Stock--Preferred Stock." The Company's Certificate of Incorporation further
provides for the classification of its Board of Directors into three classes,
with each class of directors serving staggered terms of three years. In
addition, stockholders do not have the right (i) to take action by written
consent without authorization by a resolution of the Board of Directors or (ii)
to call special meetings of stockholders. Any amendment to the Company's Bylaws
or certain provisions of the Company's Certificate of Incorporation requires the
affirmative vote of the holders of at least 75% of the outstanding shares of the
Company. In addition, the Company will, upon consummation of this Offering, be
subject to the anti-takeover provision of Section 203 of the Delaware General
Corporation Law. In general, this statute prohibits a publicly held Delaware
corporation from engaging in a "business combination" with an "interested
stockholder" for a period of three years after the date of the transaction in
which the person became an interested stockholder unless such business
combination is approved in the prescribed manner. See "Description of Capital
Stock--Transactions with Interested Persons."
Provisions in Dr. DeNicola's employment agreement provide for
post-termination compensation, including payment of his salary for two years,
following a merger or consolidation in which the Company is not the consolidated
or surviving corporation or a transfer of substantially all of the assets of the
Company. See "Management of the Company--Employment Arrangements." A change in
control of the Company also constitutes an event of default under the Company's
credit facility. The foregoing matters may, together or separately, have the
effect of discouraging or making more difficult an acquisition or change of
control of the Company.
22
<PAGE>
THE COMPANY
The Company manages and administers physician organizations (i.e., medical
groups and independent practice associations) that have entered into agreements
with HMOs to provide physician and certain ancillary health care services to HMO
members under capitated or prepaid fee arrangements. Management services are
provided by the Company to each affiliated physician organization pursuant to a
long-term management services agreement. Under this long-term management
services agreement, the Company provides the physician organization with certain
management and administrative support services, such as claims administration,
utilization management and quality assurance, case management, data collection
and management information systems and payor and provider contracting. The
Company also provides its affiliated medical groups with leased premises,
furniture, fixtures, equipment and personnel (which the Company does not provide
to its affiliated independent practice associations, as such associations are
operated as separate businesses with respect to these items). In order to
provide the Company with financial security under its management services
agreements, the Company enters into an assignable option agreement with each of
its affiliated physician organizations which gives the Company the right at any
time to designate the physician or physicians who will own such physician
organization. See "Business of the Company--The Affiliated Physician
Organizations--ASSIGNABLE OPTION AGREEMENTS."
Physician organizations increasingly are responding to the cost-containment
pressures within the managed care industry by affiliating with managed care
administrators such as the Company. The Company's management services are
intended to allow affiliated physician organizations to deliver required medical
services in a more cost-effective manner. Management believes that cost savings
can be generated without adversely affecting the quality of care provided by the
physician organizations by, for example, managing the risk for hospital services
as well as physician and ancillary health care services, negotiating favorable
HMO and provider contracts, and generating operating efficiencies. The Company's
fee arrangements with affiliated physician organizations are structured so as to
allow the Company to benefit from the savings so obtained.
The Company believes that the managed care industry operates most
effectively on a regional basis, and is affected most by provider competition,
physician referral patterns, custom and practice and local hospital
relationships. Management believes that developing a significant local market
presence permits economies of scale and greater efficiencies through
centralization of operations. Management believes there is more economic
opportunity in developed rather than in undeveloped managed care markets because
(i) physicians and hospitals in developed markets have established practice and
referral patterns that are consistent with providing services within a managed
care framework and (ii) there is generally a higher concentration of physicians
and hospitals in a developed market, creating a more competitive environment
with greater opportunities for the Company and its affiliated physician
organizations to negotiate more favorable provider contracts. The Company has
selected certain counties in Southern California as the initial primary service
area for its operations because management believes that Southern California is
a highly-developed managed care market.
The Company's primary strategy is to grow through acquisition by its
affiliated physician organizations of other medical groups and independent
practice associations. The criteria which the Company has developed to assess
potential acquisition candidates for its affiliated physician organizations
include (i) either a history of profitable operation or a compelling synergy
with opportunities for economies of scale through combining operations; (ii)
either geographic proximity to the current operations of the Company's
affiliated physician organizations or a material share of the potential
acquisition candidate's own local marketplace; (iii) a favorable hospital
relationship in which the interests of the hospital and the acquisition
candidate are aligned so as to discourage overutilization of hospital services,
thereby increasing the amount of HMO bonus pool monies potentially available to
the acquisition candidate; and/or (iv) willingness of the acquisition
candidate's management to continue in a management role with the acquired entity
following its acquisition. The Company is continuously seeking new acquisition
and
23
<PAGE>
affiliation candidates as part of its growth strategy. There can be no assurance
that any definitive agreements will be executed or that any such acquisitions or
affiliations will be consummated.
As part of the Company's future growth strategy, the Company intends to seek
to provide and manage all hospital health care services as well as physician and
ancillary health care services for enrollees within the Company's service
network in exchange for a monthly per member capitation payment from the
respective payor. To implement this strategy the Company intends, either
directly or through an affiliated physician organization, to seek to obtain a
license pursuant to California law to contract with HMOs on a full-risk basis.
The ability of the Company and/or any affiliated physician organization to
assume the financial and managerial responsibility for hospital as well as
physician and ancillary health care services will also require the Company to
obtain contracts with fully-licensed HMOs. There can be no assurance that any
such license or contract can be obtained. See "Risk Factors--Risks Associated
with Establishing a Full Risk Health Plan."
Since July 1997, Prospect Medical Group, a physician organization affiliated
with the Company, has acquired four physician organizations for the aggregate
consideration of approximately $12,700,000 in cash, plus promissory notes in the
aggregate principal amount of $3,000,000 and the issuance of 800,000 shares of
Common Stock and options to purchase 35,000 shares of Common Stock. These
acquisitions increased the Company's service network in Central Orange County
and significantly increased the Company's share of the managed care market in
the Antelope Valley region of Southern California.
The Company has entered into a long-term management services agreement with
Prospect Medical Group and has entered into an assignable option agreement with
Prospect Medical Group and Dr. DeNicola, the sole shareholder of Prospect
Medical Group, to establish its affiliation relationship.
USE OF PROCEEDS
The estimated net proceeds to the Company from the sale of the 3,000,000
shares of Common Stock and Warrants to purchase 3,000,000 shares of Common Stock
offered hereby are $15,524,000 ($17,954,000 if the Underwriters' over-allotment
option is exercised in full), based on an assumed initial public offering price
of $6.00 per share and $0.10 per Warrant and after deducting underwriting
discounts and commissions and costs of the Offering. The Company intends to use
such net proceeds as follows:
<TABLE>
<S> <C>
ANTICIPATED APPLICATION
- ---------------------------------------------------------------
Repayment of acquisition financing(1).......................... $10,000,000
Repayment of Sierra Medical Group notes and other debt(2)...... 3,250,000
Repayment of additional draw down on credit facility(3)........ 1,100,000
Formation of health plan(4).................................... 500,000
Working capital................................................ 674,000
----------
TOTAL FUNDS APPLIED............................................ $15,524,000
----------
----------
</TABLE>
- ------------------------
(1) The Company intends to use a portion of the proceeds of the Offering to pay
the outstanding debt under the Company's credit facility provided by the
Bank. Approximately $10,000,000 was drawn under this facility by the Company
as of June 30, 1998 in connection with the acquisitions of Santa Ana/Tustin
Physicians Group, Inc., a California professional corporation ("Santa
Ana/Tustin Physicians Group") and Sierra Primary Care Medical Group, A
Medical Corporation ("Sierra Medical Group"). See "Business of the
Company--History of the Company" and "Management's Discussion and Analysis
of Financial Condition and Results of Operations--Liquidity and Capital
Resources." Application of proceeds to pay the outstanding balance will make
funds available under the Company's credit facility for future acquisitions.
See "Risk Factors--Need for Additional Capital" and "Business of the
Company--Strategy of the Company." The interest rate on the Company's credit
24
<PAGE>
facility varies based upon the Bank's prime rate plus an applicable margin
ranging from 50 to 150 basis points. The credit facility matures on July 3,
1999.
(2) The Company intends to apply approximately $2,250,000 (outstanding balance
at June 30, 1998) of proceeds of the Offering to pay off the outstanding
principal of two promissory notes issued by Prospect Medical Group to
acquire Sierra Medical Group and one promissory note issued by the Company
to acquire Sierra Medical Management, Inc., and approximately $1,000,000 of
proceeds of the Offering to pay the cash portion of the purchase price and
to pay off the principal of a promissory note that the Company issued in
connection with the acquisition of certain assets of PrimeCare Medical Group
of Antelope Valley, Inc., a California professional corporation ("Antelope
Valley Medical Group").
(3) The Company intends to use approximately $1,100,000 of proceeds of the
Offering to pay an additional draw under the Company's credit facility that
was used for working capital.
(4) The Company intends to apply approximately $500,000 of proceeds of the
Offering to pay certain costs associated with the formation and development
of a health plan. See "Business of the Company--Strategy of the
Company--EXPANDING SCOPE OF LICENSURE; ESTABLISHING A FULL-RISK HEALTH PLAN"
and "Management's Discussion and Analysis of Financial Condition and Results
of Operations-- Liquidity and Capital Resources--ADDITIONAL FINANCING." Such
costs include organizational expenses and initial operating expenses and
making a reserve fund deposit with a federally insured bank for purposes of
satisfying regulatory tangible net equity and working capital requirements
for Knox-Keene license purposes. See "Business of the Company--Governmental
Regulation--REGULATORY REQUIREMENTS FOR A LIMITED LICENSE KNOX-KEENE HEALTH
PLAN." The Company intends to use a draw on its credit facility to pay for
any additional costs associated therewith, which the Company currently
estimates will total approximately $2,500,000.
Allocation of the net proceeds of this Offering by the Company, as set forth
above, represents the Company's best estimate, based upon its present plans and
certain assumptions regarding general economic and industry conditions. If any
of such plans or assumptions should change, the Company may find it necessary or
advisable to reallocate some of the Offering proceeds within the above-described
categories, or to other purposes.
Pending any of the other uses described above, the Company intends to apply
the net proceeds of the Offering to pay off any outstanding balances under the
Company's credit facility and then to invest any remaining net proceeds in
short-term, investment grade, interest-bearing securities, certificates of
deposit or direct or guaranteed obligations of the United States.
PRICE RANGE OF COMMON STOCK AND DIVIDEND POLICY
Prior to this Offering, the Common Stock has been the subject of limited and
sporadic trading on the Bulletin Board, a screen-based electronic bulletin board
maintained by the National Association of Securities Dealers, Inc. There is no
established public trading market for the Common Stock. See "Risk
Factors--Inactive Prior Market for the Common Stock; No Assurance of American
Stock Exchange Listing" and "Description of Capital Stock--Listing on American
Stock Exchange."
As of July 1, 1998, the estimated number of beneficial owners of the Common
Stock was approximately 695 and the number of stockholders of record was 459.
No cash dividends have been paid by the Company to date and none is expected
to be paid in the near future. In the event the Company becomes profitable,
management currently is of the view that all earnings will be retained for the
operation and expansion of the Company's business. The future dividend policy of
the Company will be subject to the discretion of the Board of Directors and will
depend upon a number of factors, including future earnings, financial
conditions, cash needs and general business conditions. In addition, under the
Company's credit facility, the Company is currently prohibited from declaring or
paying any dividends or distributions of earnings to its stockholders. See "Risk
Factors--No Dividends."
25
<PAGE>
CAPITALIZATION
The following table sets forth, as of June 30, 1998, the actual
capitalization and pro forma capitalization of the Company (i) giving effect to
the Yorba Linda Settlement Agreement (see "Risk Factors-- Recent Settlement
Agreement with Yorba Linda Medical Group" and "Business of the Company--History
of the Company") and (ii) as adjusted to reflect the Offering and use of
proceeds therefrom. The capitalization information set forth in the table below
is unaudited and is qualified by and should be read in conjunction with
"Unaudited Pro Forma Financial Information," "Selected Consolidated Financial
Data," "Management's Discussion and Analysis of Financial Condition and Results
of Operations" and the Company's Consolidated Financial Statements and the Notes
thereto included elsewhere in this Prospectus.
<TABLE>
<CAPTION>
JUNE 30, 1998
-------------------------------------------
<S> <C> <C> <C>
PRO FORMA AS
ACTUAL PRO FORMA(1) ADJUSTED
------------- ------------- -------------
Short-term debt..................................................... $ 1,630,582 $ 1,630,582 $ 130,582
------------- ------------- -------------
------------- ------------- -------------
Long-term debt...................................................... $ 13,230,774 $ 13,230,774 380,774
------------- ------------- -------------
Shareholders' equity:
Preferred Stock, $.01 par value per share; 1,000,000 shares
authorized; no shares issued.................................... -- -- --
Common Stock, $.01 par value per share; 40,000,000 shares
authorized, 5,575,718 shares issued and outstanding (actual),
4,449,395 shares issued and outstanding (pro forma); 7,449,395
shares issued and outstanding (as adjusted)..................... 55,757 44,494 74,494
Additional paid-in-capital........................................ 5,554,195 5,622,220 21,117,097
Accumulated deficit............................................... (266,632) (266,632) (266,632)
------------- ------------- -------------
Total shareholders' equity...................................... 5,343,320 5,400,082 20,924,959
------------- ------------- -------------
Total capitalization.......................................... $ 18,574,094 $ 18,630,856 $ 21,305,733
------------- ------------- -------------
------------- ------------- -------------
</TABLE>
- ------------------------
(1) Reflects the reduction of 1,126,323 shares of Common Stock which become
unissued and authorized shares.
26
<PAGE>
DILUTION
The difference between the initial public offering price per share of Common
Stock and the adjusted pro forma net tangible book value per share of Common
Stock after this Offering constitutes the dilution to investors in this
Offering. Net tangible book value per share is determined by dividing the net
tangible book value of the Company (total tangible assets reduced by the amount
of total liabilities) by the number of outstanding shares of Common Stock. The
following discussion allocates no value to the Warrants.
The historical net negative tangible book value of the Company at June 30,
1998 was approximately $(13,939,504), or $(2.50) per share of Common Stock
($(13,882,742) or $(3.12) per share of Common Stock after giving effect to the
Yorba Linda Settlement Agreement (see "Risk Factors--Recent Settlement Agreement
with Yorba Linda Medical Group" and "Business of the Company--History of the
Company")). See "Management's Discussion and Analysis of Financial Condition and
Results of Operations-- Liquidity and Capital Resources." After giving effect to
the Yorba Linda Settlement Agreement, the Offering and the application of the
net proceeds from the Offering (with an initial public offering price of $6.00
per share), the Company's net tangible book value at June 30, 1998 would have
been approximately $1,962,000, or $0.26 per share. This represents an immediate
increase in net tangible book value of $3.38 per share to existing stockholders,
and an immediate dilution in net tangible book value of $5.74 per share to new
investors purchasing shares of Common Stock in the Offering. The following table
illustrates this per share dilution:
<TABLE>
<S> <C> <C> <C> <C>
Initial public offering price per share of Common Stock........... $ 6.00
<CAPTION>
BEFORE AFTER
YORBA LINDA YORBA LINDA
SETTLEMENT SETTLEMENT
AGREEMENT AGREEMENT
----------- -----------
<S> <C> <C> <C> <C>
Historical net negative tangible book value per share at June 30,
1998............................................................ (2.50) (3.12)
Increase in net tangible book value per share attributable to
existing investors............................................ 2.73 3.38
----------- -----------
Adjusted pro forma net tangible book value per share after the
Offering........................................................ 0.23 0.26
--------- ---------
Dilution per share to new investors............................... $ 5.77 $ 5.74
--------- ---------
--------- ---------
</TABLE>
The following table summarizes, on an adjusted pro forma basis as of June
30, 1998, the number of shares of Common Stock purchased from the Company, the
total consideration paid and the average price paid per share by the existing
stockholders and by new investors at an initial public offering price of $6.00
per share:
<TABLE>
<CAPTION>
SHARES PURCHASED(1)(2) TOTAL CONSIDERATION(1)(2)
----------------------- -------------------------- AVERAGE PRICE
NUMBER PERCENT AMOUNT PERCENT PER SHARE
---------- ----------- ------------- ----------- ---------------
<S> <C> <C> <C> <C> <C>
Existing stockholders(2)(3)......................... 4,449,395 59.7% $ 5,666,714 23.9% $ 1.27
New investors....................................... 3,000,000 40.3 18,000,000 76.1 6.00
---------- ----- ------------- -----
Total............................................. 7,449,395 100.0% $ 23,666,714 100.0%
---------- ----- ------------- -----
---------- ----- ------------- -----
</TABLE>
- ------------------------
(1) Assuming the Underwriters' over-allotment option is exercised in full, sales
of Common Stock by the Company in the Offering will reduce the number of
shares of Common Stock held by existing stockholders to 56.3% of the total
number of shares of Common Stock to be outstanding after the Offering, and
will increase the number of shares held by new investors to 43.7% of the
total number of shares of Common Stock to be outstanding after the Offering.
See "Beneficial Ownership of Capital Stock."
(2) After giving effect to the reduction of 1,126,323 shares of Common Stock
outstanding in conjunction with the Yorba Linda Settlement Agreement.
(3) The above computations assume no exercise after June 30, 1998 of any of the
outstanding options and warrants to purchase shares of the Common Stock. As
of June 30, 1998, there were options and warrants outstanding to purchase a
total of 783,479 shares of Common Stock at a weighted average exercise price
of $2.65 per share, all of which were exercisable on such date. To the
extent that these options and warrants are exercised, there will be further
dilution to new investors.
27
<PAGE>
UNAUDITED PRO FORMA FINANCIAL INFORMATION
The following unaudited pro forma consolidated balance sheet at June 30,
1998 and the unaudited pro forma consolidated statements of operations for the
year ended September 30, 1997 and the nine months ended June 30, 1998 have been
prepared to reflect adjustments to the Company's historical consolidated
financial position and results of operations to give effect to the following
completed transactions as if such transactions had been consummated at earlier
dates.
Effective July 14, 1997, Prospect Medical Group (an affiliate of the
Company) acquired Santa Ana/ Tustin Physicians Group for cash consideration of
$5,000,000. Effective September 25, 1997, Prospect Medical Group and the Company
acquired Sierra Medical Group and Sierra Medical Management, Inc., respectively,
for consideration totaling $9,000,000 in cash and notes and 600,000 shares of
the Common Stock and options to purchase 35,000 shares of the Common Stock.
These two acquisitions resulted in goodwill and other intangible assets of
$5,081,343 and $11,134,128, respectively.
Effective as of June 1, 1998, Sierra Medical Group acquired certain assets
(primarily provider contracts and the responsibility to provide medical services
to enrollees) of Antelope Valley Medical Group and the Company acquired certain
assets (primarily management rights) of its affiliated management company for
$1,000,000 in cash and notes and 200,000 shares of the Common Stock. This
acquisition resulted in goodwill and other intangible assets of $2,082,619. None
of the personnel or facilities of Antelope Valley Medical Group or its related
management company were acquired by Sierra Medical Group or the Company. The
general and administrative costs shown in the unaudited pro forma consolidated
statements of operations for the year ended September 30, 1997 and the nine
months ended June 30, 1998 for Antelope Valley Medical Group reflect historical
costs incurred by or on behalf of Antelope Valley Medical Group for the year
ended September 30, 1997 and eight months ended May 31, 1998, respectively. The
Company believes that it will be able to integrate the acquired assets into the
existing operations of its affiliated physician organizations utilizing
personnel and facilities already located and operating in the Antelope Valley
and thereby significantly reduce the general and administrative costs associated
with the operations of the assets acquired from Antelope Valley Medical Group.
Therefore, the Company does not believe that the historical general and
administrative costs of Antelope Valley Medical Group are indicative of the
costs likely to be incurred in future periods. In addition, prior to
acquisition, the former management of Antelope Valley Medical Group had
determined that it could not operate Antelope Valley Medical Group profitably,
and therefore a non-recurring expense totaling $3,168,260 was recorded by the
former management of Antelope Valley Medical Group in the twelve-month period
ended December 31, 1997.
The unaudited pro forma financial information also gives effect to the Yorba
Linda Settlement Agreement. Yorba Linda Medical Group is a separate professional
corporation not owned or controlled by Prospect Medical Group. The physician
shareholders of Yorba Linda Medical Group provide services primarily to
fee-for-service patients. In October 1986 the shareholders of Yorba Linda
Medical Group formed Prospect Medical Group, a separate professional
corporation, to focus on managed care. Prospect Medical Group obtained contracts
with HMOs pursuant to which it was responsible for providing services to the
HMOs' members. Prior to the 1996 Merger, the shares of Prospect Medical Group
owned by all of the Yorba Linda Medical Group physicians (other than Dr.
DeNicola) were redeemed; these physicians were then issued shares of common
stock of Prospect Medical Systems. In connection with the 1996 Merger, these
physicians (who were also shareholders of Yorba Linda Medical Group) exchanged
their shares of common stock of Prospect Medical Systems for Common Stock. The
Yorba Linda Medical Group physicians had entered into contracts with Prospect
Medical Group to provide services to its enrollees under its HMO contracts. In
return for higher capitation payments to these physicians, Prospect Medical
Group included in its agreements with these physicians certain exclusivity,
nonsolicitation and other protective covenants. Prospect Medical Group also
entered into a management services agreement with Yorba Linda Medical Group to
provide administrative and management services. Ten of the physicians employed
by Yorba Linda Medical Group who had also become stockholders of the Company
28
<PAGE>
and who had provided physician services to enrollees of Prospect Medical Group
sought release in 1997 from the exclusivity and other noncompetition provisions
in their agreements with Prospect Medical Group. Effective July 1, 1998, the
Company and Prospect Medical Group entered into the Yorba Linda Settlement
Agreement with these physicians (the "Departing YL Physicians"). Pursuant to the
Yorba Linda Settlement Agreement, the Departing YL Physicians returned to the
Company an aggregate of 1,126,323 shares of the Common Stock that had been
issued to them in connection with the 1996 Merger in exchange for a release by
Prospect Medical Group from the non-competition and exclusivity provisions
contained in their agreements. Since the Departing YL Physicians were interested
in joining another physician organization and the enrollees who were assigned to
them either enrolled with a physician organization not affiliated with the
Company or were assigned to another physician employed by or contracting with
Prospect Medical Group, the Company believes that it is unlikely that these
physicians will continue to provide services to enrollees of Prospect Medical
Group. However, six physicians previously affiliated with Yorba Linda Medical
Group did not seek release from their agreements with Prospect Medical Group,
have formed another physician organization and will continue to provide services
to enrollees of Prospect Medical Group on an exclusive basis. The Company
estimates that a maximum of approximately 13,000 enrollees who were served by
the Departing YL Physicians may be transferred from Prospect Medical Group.
Through October 1, 1998, approximately 6,000 such enrollees have transferred
from Prospect Medical Group to a physician organization not affiliated with the
Company. The effect of the Yorba Linda Settlement Agreement was to reduce
operating revenues on the pro forma consolidated statements of operations as
compared to the historical consolidated statements of operations. Likewise, the
cost of medical services was reduced on the pro forma consolidated statements of
operations as compared to the historical statements of operations because the
costs associated with providing the medical services to the Yorba Linda Medical
Group enrollees would not have been incurred; however, no other adjustments to
reduce operating expenses which might have resulted from the reduction in the
number of enrollees have been made, except for the reduction of historical
general and administrative costs incurred attributable to the generation of
management fee revenues which will no longer be earned. See "Risk
Factors--Recent Settlement Agreement with Yorba Linda Medical Group."
The unaudited pro forma consolidated statements of operations for the year
ended September 30, 1997 and the nine months ended June 30, 1998 reflect the pro
forma results of operations of all entities acquired described above and the
impact from the Yorba Linda Settlement Agreement as if such acquisitions and
Settlement Agreement had been effected as of October 1, 1996.
During the period ended June 30, 1998 the Company through its affiliated
physician organizations made other acquisitions, including the purchase of
substantially all of the assets of Western Medical Group, which in the aggregate
were not deemed material. The unaudited pro forma financial information does not
give effect to these immaterial transactions.
The pro forma financial information has been prepared by management based on
the historical consolidated audited and unaudited financial statements of the
Company and the affiliated physician organizations as of and for the year ended
September 30, 1997 and as of and for the nine months ended June 30, 1998.
Additional general and administrative expenses, which may have been required to
support the operations of the acquired entities, are not included in the
consolidated pro forma results of operations. The Company and its affiliated
physician organizations have not had any experience prior to June 1, 1998
operating or managing the assets acquired from Antelope Valley Medical Group and
its affiliated management company. These assets will need to be integrated with
those assets currently managed by the Company. Consequently, the Company's
actual results of operations or financial condition may differ from the
information presented in the pro forma financial information as a result of this
acquisition. Similarly, the effect of the Yorba Linda Settlement Agreement on
the Company's actual results of operations or financial condition may differ
from the pro forma financial information since the Company has historically
included the revenues and related expenses derived from the enrollees of Yorba
Linda Medical Group within its affiliated physician organizations' service
network and such enrollees may
29
<PAGE>
be transferred from the Company's affiliated physician organizations in the
future. The pro forma financial information is presented for illustrative
purposes only and does not purport to represent what the results of operations
or financial condition of the Company for the periods or at the dates presented
would have been if such transactions had been consummated as of such dates and
is not indicative of the results that may be obtained in the future.
The pro forma statement of operations for the year ended September 30, 1997
also reflects the proposed offering of Common Stock and Warrants in the
Offering, at an assumed initial public offering price of $6.00 per share and
$.10 per Warrant, and gives effect to the receipt and application of the
estimated net proceeds from the Offering, as if such transaction had occurred on
October 1, 1996. The pro forma statement of operations for the nine months ended
June 30, 1998 also reflects the proposed Offering and gives effect to the
receipt and application of the estimated net proceeds from the Offering,
including the repayment of certain indebtedness, as if such transactions had
occurred on October 1, 1997. The pro forma balance sheet as of June 30, 1998
also reflects the Offering and gives effect to the receipt and application of
the estimated net proceeds from the Offering, as if such transaction had
occurred on June 30, 1998.
The pro forma financial information is based on the financial statements of
the Company, after giving effect to the assumptions and adjustments in the
accompanying notes to the pro forma financial information.
30
<PAGE>
UNAUDITED PRO FORMA CONSOLIDATED STATEMENT
OF OPERATIONS DATA
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30, 1997
------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
SANTA ANA/ SIERRA
TUSTIN MEDICAL
PHYSICIANS GROUP
GROUP FOR FOR THE
THE PERIOD ANTELOPE
PROSPECT PERIOD 10/1/96 VALLEY YORBA LINDA PRO FORMA
MEDICAL 10/1/96 TO MEDICAL SETTLEMENT PRO FORMA OFFERING AS
HOLDINGS TO 7/13/97 9/24/97 GROUP AGREEMENT(1) ADJUSTMENTS TOTAL ADJUSTMENTS(5) ADJUSTED
-------- ---------- ------- -------- ------------ ----------- ------- -------------- ----------
<CAPTION>
(IN THOUSANDS EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Total Operating
Revenues..... $ 29,955 $7,539 $12,899 $ 6,614 $(8,278) $-- $48,729 $-- $48,729
-------- ---------- ------- -------- ------------ ----------- ------- -------------- ----------
Cost of Medical
Services..... 23,202 5,151 7,773 6,246 (5,866) -- 36,506 -- 36,506
General and
Administrative... 7,236 2,507 5,272 1,181 (891) 1,206(2) 16,511 (1,347)(5) 15,164
(2,648)(3) (2,648) -- (2,648)
Depreciation
and
Amortization... 244 34 45 398 -- 857(4) 1,578 -- 1,578
-------- ---------- ------- -------- ------------ ----------- ------- -------------- ----------
Total Cost of
Operations... 30,682 7,692 13,090 7,825 (6,757) (585) 51,947 (1,347) 50,600
Provision for
Impairment of
Goodwill..... (2,197) -- -- (2,856) -- -- (5,053) -- (5,053)
-------- ---------- ------- -------- ------------ ----------- ------- -------------- ----------
Income (Loss)
Before
Provision for
Income
Taxes........ (2,924) (153) (191) (4,067) (1,521) 585 (8,271) 1,347 (6,924)
Income Tax
Benefit...... (285) (123) (41) -- -- -- (449) -- (449)
-------- ---------- ------- -------- ------------ ----------- ------- -------------- ----------
Net Income
(Loss)..... $ (2,639) $ (30) $ (150) $(4,067) $(1,521) $ 585 $(7,822) $ 1,347 $(6,475)
-------- ---------- ------- -------- ------------ ----------- -------------- ----------
-------- ---------- ------- -------- ------------ ----------- ------- -------------- ----------
-------
Basic and
Diluted
Weighted
Average
Number of
Common
Shares(6).... 4,801 4,801 4,801
Pro Forma
Adjustments... -- (336) 2,664
-------- ------- ----------
4,801 4,465 7,465
-------- ----------
-------- ------- ----------
-------
Basic and
Diluted Loss
Per
Share........ $ (0.55) $ (1.75) $ (0.87)
-------- ----------
-------- ------- ----------
-------
</TABLE>
See accompanying notes to the unaudited pro forma consolidated statement of
operations data.
31
<PAGE>
(1) The reduction in revenues related to the Yorba Linda Settlement Agreement
includes primarily lost capitation and shared risk revenues based on the
number of enrollees serviced by the Departing YL Physicians at their
historical capitated rates and revenues under the management services
agreement with Yorba Linda Medical Group. Medical costs and operating
expenses are reduced based upon (i) an allocation of the cost of medical
services derived from the medical loss ratio calculated with respect to the
related capitation revenue and (ii) an allocation of general and
administrative costs related to the provision of management services for
these enrollees and physicians. The medical loss ratio was determined from
the historical capitation revenues and capitation and claims expenses for
the period.
(2) Assumed aggregate interest costs of $1,206,000 with respect to debt incurred
related to the three acquisitions made are as follows:
(i) The $5,000,000 debt incurred related to Santa Ana/Tustin Physicians
Group is for nine and one-half months at an interest rate of 9% per
annum.
(ii) The $9,000,000 debt incurred related to Sierra Medical Group and its
related management company is for 12 months at an average interest
rate of approximately 8.4% per annum.
(iii) The $1,000,000 debt incurred related to Antelope Valley Medical Group
and its related management company is for 12 months at an interest
rate of 9% per annum.
(3) Reductions in certain general and administrative expenses of $2,648,000
relate to reductions in certain officer salaries and rent of Santa
Ana/Tustin Physicians Group and Sierra Medical Group and its related
management company due to new employment and rental agreements entered into
concurrent with the closing of the acquisitions. No significant reductions
resulted from the acquisition of the assets of Antelope Valley Medical Group
and its related management company.
(4) Additional amortization of goodwill resulting from acquisitions is as
follows:
The goodwill acquired in the acquisitions of Santa Ana/Tustin Physicians
Group, Sierra Medical Group and its related management company and certain
assets of Antelope Valley Medical Group and its related management company
totaled $5,081,343, $11,134,128 and $2,082,619, respectively. The Company is
amortizing such goodwill over 20 years.
Consequently, pro forma amortization with respect to the acquisition of
Santa Ana/Tustin Physicians Group from October 1, 1996 to July 13, 1997 was
approximately $201,000, for Sierra Medical Group and its related management
company was approximately $556,000 and for certain assets of Antelope Valley
Medical Group and its related management company was approximately $100,000.
(5) Reduction of $1,347,000 of interest resulting from repayment of all
interest-bearing, acquisition-related debt utilizing the Offering proceeds
after increasing historical interest expenses by the pro forma adjustments
referenced in footnote (2) above. The Offering proceeds are assumed to be
adequate to reduce all historical and pro forma interest expenses.
(6) The weighted average number of Common Shares outstanding is impacted as
follows:
(i) Reduction of 1,126,323 shares which represent the shares returned
pursuant to the Yorba Linda Settlement Agreement;
(ii) Increase of 600,000 shares related to the acquisition of Sierra
Medical Group and Sierra Medical Management, Inc.;
(iii) Increase of 200,000 shares related to the acquisition of certain
assets of Antelope Valley Medical Group and its related management
company; and
(iv) Increase of 3,000,000 shares related to this Offering.
32
<PAGE>
UNAUDITED PRO FORMA CONSOLIDATED STATEMENT OF OPERATIONS DATA
<TABLE>
<CAPTION>
NINE MONTHS ENDED JUNE 30, 1998
---------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<CAPTION>
ANTELOPE VALLEY
MEDICAL
PROSPECT GROUP
MEDICAL (EIGHT MONTHS YORBA LINDA PRO FORMA
HOLDINGS ENDED SETTLEMENT PRO FORMA OFFERING PRO FORMA AS
(HISTORICAL) MAY 31, 1998) AGREEMENT(4) ADJUSTMENTS TOTAL ADJUSTMENTS(3) ADJUSTED
----------- --------------- ------------- ----------- --------- --------------- -------------
<S> <C> <C> <C> <C> <C> <C> <C>
Total Operating
Revenues............ $ 40,314 $ 5,235 $ (6,213) $ -- $ 39,336 $ -- $ 39,336
----------- ------ ------------- ----------- --------- ------- -------------
Cost of Medical
Services............ 26,854 4,992 (4,440) -- 27,406 -- 27,406
General and
Administrative...... 12,294 477 (631) 60(1) 12,200 (1,088) 11,112
Depreciation and
Amortization........ 786 188 -- 67(2) 1,041 -- 1,041
----------- ------ ------------- ----------- --------- ------- -------------
Total Cost of
Operations........ 39,934 5,657 (5,071) 127 40,647 (1,088) 39,559
Provision for
Impairment of
Goodwill............ -- 312 -- -- 312 -- 312
----------- ------ ------------- ----------- --------- ------- -------------
Income (loss) before
Provision for Income
Taxes............... 380 (734) (1,142) (127) (1,623) 1,088 (535)
Income Tax Expense.... 4 -- -- -- 4 -- 4
----------- ------ ------------- ----------- --------- ------- -------------
Net Income (Loss)... $ 376 $ (734) $ (1,142) $ (127) $ (1,627) $ 1,088 $ (539)
----------- ------ ------------- ----------- --------- ------- -------------
----------- ------ ------------- ----------- --------- ------- -------------
Weighted Average
Number of Common
Shares(5)........... 5,398 5,398 5,398
Pro Forma
Adjustments......... -- (948) 2,051
----------- --------- -------------
5,398 4,450 7,449
----------- --------- -------------
----------- --------- -------------
Basic and Diluted Net
Loss Per Share...... $ 0.07 $ (0.37) $ (0.07)
----------- --------- -------------
----------- --------- -------------
</TABLE>
- ------------------------
(1) Assumed aggregate interest costs of $60,000 with respect to debt of
$1,000,000 incurred related to the acquisition of certain assets of Antelope
Valley Medical Group and its related management company are based upon 8
months interest at a rate of 9% per annum.
(2) Additional amortization of goodwill resulting from acquisitions is as
follows:
The goodwill acquired in the acquisition of certain assets of Antelope
Valley Medical Group and its related management company totaled
$2,082,619. The Company is amortizing such goodwill over 20 years.
Consequently, pro forma amortization with respect to the acquisition of
these assets was approximately $67,000.
(3) Reduction of $1,088,000 of interest resulting from the repayment of all
interest-bearing, acquisition-related debt utilizing the Offering proceeds
after increasing pro forma interest as referenced in footnote (1) above. The
Offering proceeds are assumed to be adequate to reduce all historical and
pro forma interest expense.
(4) The reduction in revenues related to the Yorba Linda Settlement Agreement
includes primarily lost capitation and shared risk revenues based on the
number of enrollees serviced by the Departing YL Physicians at their
historical capitated rates and revenues under the management services
agreement with Yorba Linda Medical Group. Medical costs and operating
expenses are reduced based upon
33
<PAGE>
(i) an allocation of the cost of medical services derived from the medical
loss ratio calculated with respect to the related capitation revenue and
(ii) an allocation of general and administrative costs related to the
provision of management services for these enrollees and physicians. The
medical loss ratio was determined from the historical capitation revenues
and capitation and claims expenses for the period.
(5) The weighted average number of common shares outstanding is impacted as
follows:
(i) Reduction of 1,126,323 shares which represent the shares returned
pursuant to the Yorba Linda Settlement Agreement;
(ii) Increase of 200,000 shares related to the acquisition of certain
assets of Antelope Valley Medical Group and its related management
company (adjusted for eight months of the nine-month period); and
(iii) Increase of 3,000,000 shares related to this Offering.
34
<PAGE>
UNAUDITED PRO FORMA CONSOLIDATED BALANCE SHEET DATA AS OF JUNE 30,
1998
<TABLE>
<CAPTION>
PRO FORMA
ADJUSTMENTS
PROSPECT MEDICAL YORBA LINDA PRO FORMA
HOLDINGS SETTLEMENT OFFERING PRO FORMA
(HISTORICAL) AGREEMENT(1) ADJUSTMENTS(2) AS ADJUSTED
---------------- ------------ ----------------- ------------
<S> <C> <C> <C> <C>
ASSETS
Current Assets:
Cash and cash equivalents.................... $ 1,765,408 $ 56,762 $ 1,174,877 $ 2,997,047
Accounts receivable, net of allowance........ 4,864,892 -- -- 4,864,892
Prepaid expenses and other expenses.......... 341,425 -- -- 341,425
Recoverable income taxes..................... 154,655 -- -- 154,655
---------------- ------------ ----------------- ------------
Total current assets........................... 7,126,380 56,762 1,174,877 8,358,019
Property, improvements and equipment:
Land......................................... 40,620 -- -- 40,620
Leasehold improvements....................... 120,000 -- -- 120,000
Equipment.................................... 1,810,460 -- -- 1,810,460
Furniture and fixtures....................... 153,537 -- -- 153,537
---------------- ------------
2,124,617 -- -- 2,124,617
Less: accumulated depreciation and
amortization............................... (501,563) -- -- (501,563)
---------------- ------------ ----------------- ------------
1,623,054 -- -- 1,623,054
Deposits and other assets...................... 109,971 -- -- 109,971
Deferred tax assets............................ 361,121 -- -- 361,121
Deferred financing costs....................... 374,378 -- -- 374,378
Deferred offering costs........................ 320,121 -- (320,121) 0
Goodwill and other intangible assets, net...... 18,588,325 -- -- 18,588,325
---------------- ------------ ----------------- ------------
Total assets................................... $ 28,503,350 $ 56,762 $ 854,756 $ 29,414,868
---------------- ------------ ----------------- ------------
---------------- ------------ ----------------- ------------
Liabilities and Shareholders' Equity
Current Liabilities:
Accrued medical claims....................... $ 6,024,959 $ -- $ -- $ 6,024,959
Accounts payable............................. 2,040,225 -- (320,121) 1,720,104
Notes payable and capital lease obligations,
current portion............................ 1,630,582 -- (1,500,000) 130,582
---------------- ------------ ----------------- ------------
Total current liabilities...................... 9,695,766 -- (1,820,121) 7,875,645
Notes payable to related parties............... 1,750,000 -- (1,750,000) 0
Other notes payable and capital lease
obligations.................................. 11,480,774 -- (11,100,000) 380,774
Deferred income taxes.......................... 233,490 -- -- 233,490
---------------- ------------ ----------------- ------------
Total liabilities.............................. 23,160,030 -- (14,670,121) 8,489,909
Shareholders' equity:
Common stock................................. 55,757 (11,263) 30,000 74,494
Additional paid-in capital................... 5,554,195 68,025 15,494,877 21,117,097
Accumulated deficit.......................... (266,632) -- -- (266,632)
---------------- ------------ ----------------- ------------
Total shareholders' equity..................... 5,343,320 56,762 15,524,877 20,924,959
---------------- ------------ ----------------- ------------
Total liabilities and shareholders' equity..... $ 28,503,350 $ 56,762 $ 854,756 $ 29,414,868
---------------- ------------ ----------------- ------------
---------------- ------------ ----------------- ------------
</TABLE>
- ------------------------
(1) Pro forma adjustments to reflect the Yorba Linda Settlement Agreement
pursuant to which 1,126,323 shares of the Common Stock are to be surrendered
to the Company plus $56,762 is to be paid by certain physician stockholders
of the Company and a contracting physician in return for a release from
certain noncompetition provisions in agreements entered into during the 1996
Merger.
(2) Pro forma adjustments to reflect the closing of the Offering are as follows:
(a) Estimated proceeds from the Offering of $18,300,000, less
underwriting discounts and transactions costs of $2,775,123 (assumes
no over-allotment).
(b) Utilization of proceeds from the Offering to pay down certain
borrowings.
35
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
THE FOLLOWING DISCUSSION AND ANALYSIS SHOULD BE READ IN CONJUNCTION WITH THE
COMPANY'S CONSOLIDATED FINANCIAL STATEMENTS (INCLUDING THE NOTES THERETO) AND
THE OTHER FINANCIAL INFORMATION APPEARING ELSEWHERE IN THIS PROSPECTUS. EXCEPT
FOR THE HISTORICAL INFORMATION CONTAINED HEREIN, THE DISCUSSIONS IN THIS
PROSPECTUS CONTAIN FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND
UNCERTAINTIES. THE COMPANY'S ACTUAL RESULTS MAY DIFFER SIGNIFICANTLY FROM THE
RESULTS DISCUSSED IN THE FORWARD-LOOKING STATEMENTS. FACTORS THAT MIGHT CAUSE OR
CONTRIBUTE TO SUCH A DIFFERENCE INCLUDE, BUT ARE NOT LIMITED TO, THOSE DISCUSSED
BELOW AND IN "RISK FACTORS" AND ELSEWHERE IN THE PROSPECTUS.
GENERAL
The Company manages and administers medical groups and independent practice
associations that have entered into agreements with HMOs to provide medical
services to enrollees under a capitated or prepaid fee arrangement.
As discussed further in Note 1 to the Company's consolidated financial
statements, under applicable financial reporting requirements the financial
statements of the affiliated physician organizations with which the Company has
long term management services agreements are consolidated with those of the
Company. The Emerging Issues Task Force ("EITF"), an advisory committee of the
Financial Accounting Standards Board, has recently evaluated certain matters
relating to accounting practices for management companies, including
consolidation of the financial statements of management companies and
professional associations with which such companies have management agreements.
As promulgated in EITF Issue No. 97-2, consolidation is appropriate where the
management company establishes a "controlling financial interest" in a physician
organization. The EITF concluded that such a controlling financial interest can
be established through contractual arrangements. Specifically, a controlling
financial interest exists, if, for a requisite period of time and subject to
limitations derived from federal and state laws, the management company has
control over the physician organization and has a "financial interest" in the
physician organization that meets specific criteria set forth in EITF Issue No.
97-2. According to the EITF, a rebuttable presumption of financial control
exists if a majority of the outstanding voting equity interests of the physician
organization is owned by a nominee shareholder of the management company. To the
extent permissible under federal and state law, the Company's management
services agreements provide the Company with control over all of the non-medical
aspects and operations of the business of its affiliated physician
organizations. Further, the Company, through its wholly-owned subsidiary,
Prospect Medical Systems, under the terms of its assignable option agreements
with Prospect Medical Group and its sole nominee shareholder, has the assignable
right, at will and on an unlimited basis, to designate a successor physician or
physicians to purchase for nominal consideration all of the stock of Prospect
Medical Group from the nominee shareholder. There is no limitation on who may be
named by the Company as a nominee shareholder except that such person must be a
licensed physician or otherwise permitted by law to hold shares in a
professional corporation. Dr. DeNicola is currently the sole nominee shareholder
as well as a director and an officer of Prospect Medical Group. In addition, Dr.
DeNicola is also a director and an officer of the Company. As a director and
officer of the Company, Dr. DeNicola has a fiduciary duty to protect the
interests of the Company and its stockholders. Prospect Medical Group is the
sole nominee shareholder of each of the Company's other affiliated physician
organizations. See "Business of the Company--The Affiliated Physician
Organizations--MANAGEMENT SERVICES" and "Business of the Company--The Affiliated
Physician Organizations--ASSIGNABLE OPTION AGREEMENTS" for a description of the
management services agreements and assignable option agreements. The Company
believes that its management services agreements and assignable option
agreements contain provisions which require the Company to report the financial
condition and results of operations of its affiliated physician organizations on
a consolidated basis. As a consequence of this consolidation, the operations of
the Company's affiliated physician organizations have, and will continue to
have, a significant impact upon the Company's financial statements.
36
<PAGE>
The Company primarily provides management and administrative services to its
affiliated physician organizations; its affiliated physician organizations
contract with or employ the physicians who provide medical services to enrollees
within the Company's service network. The Company also provides certain
management and administrative services to unaffiliated physician organizations.
Management believes that the Company's relationships with its affiliated
physician organizations and the physicians employed by or contracting with such
organizations are good. While acknowledging that any of these physicians could
terminate his or her relationship with the Company's affiliated physician
organizations, and that any such termination could have an adverse impact on the
Company's business, results of operations or financial condition, management
anticipates generally maintaining these relationships for the indefinite future.
Management believes that any deterioration in the relationship between the
Company and its unaffiliated physician organizations would not have a material
adverse effect on the Company's business, results of operations or financial
condition.
On July 31, 1996, a wholly-owned subsidiary of the Company merged into
Prospect Medical Systems in the 1996 Merger, with Prospect Medical Systems being
the surviving corporation and a wholly-owned subsidiary of the Company.
Concurrently with the 1996 Merger, the name of the Company was changed from
"Med-Search, Inc." to its current name, "Prospect Medical Holdings, Inc."
Prospect Medical Systems was incorporated in November 1995 for the purpose of
acquiring all of Prospect Medical Group's non-professional assets and assuming
all of its administrative and management functions. It had nominal operations
prior to the 1996 Merger and all of its shares were held by the former
shareholders and the current sole shareholder of Prospect Medical Group. Through
separate transactions effected at or around the time of the 1996 Merger, the
shareholders of Prospect Medical Group, certain of whom were physician providers
to Prospect Medical Group employed by Yorba Linda Medical Group, received shares
in the newly formed Prospect Medical Systems, which were ultimately exchanged
for a majority of the shares in the Company. The exchange of shares was treated
as a reorganization of companies under common control. As the shareholders of
Prospect Medical Group became the majority stockholders in the merged company
through these transactions, under applicable financial reporting requirements,
Prospect Medical Group is considered the predecessor entity to the Company for
periods prior to July 31, 1996 for financial statement reporting purposes.
Accordingly, the historical predecessor financial statements prior to July 31,
1996 are those of Prospect Medical Group, not those of the predecessor legal
entity.
Prospect Medical Group's subsidiaries, Santa Ana/Tustin Physicians Group and
Sierra Medical Group, were acquired on July 14, 1997, and September 25, 1997,
respectively. As of the dates of acquisition by Prospect Medical Group, Santa
Ana/Tustin Physicians Group and Sierra Medical Group had approximately 12,000
and 15,000 covered lives, respectively. Pegasus Medical Group, Inc., a
wholly-owned subsidiary of Prospect Medical Group that was formed on November 7,
1996 ("Pegasus Medical Group"), had no medical operations until its acquisition
of certain assets of Marvin L. Ginsburg, M.D., a Medical Corporation, dba A.V.
Western Medical Group, Inc. ("Western Medical Group") on October 31, 1997. Based
upon the number of lives served by Western Medical Group on October 31, 1997,
this acquisition provided Pegasus Medical Group with approximately 5,300 covered
lives. Sierra Medical Group acquired certain assets of Antelope Valley Medical
Group effective as of June 1, 1998, including responsibility for approximately
12,000 covered lives. Such acquisitions have been accounted for under the
purchase method of accounting and the operations of such acquired physician
organizations have been included on a consolidated basis in the Company's
financial statements for periods after the respective effective dates of such
acquisitions. Consequently, the Company's financial statements for the fiscal
year ending September 30, 1997 reflect only 2.5 months of the operations of
Santa Ana/Tustin Physicians Group and no operations for either Sierra Medical
Group or Pegasus Medical Group. In addition, the Company's balance sheet as of
September 30, 1997 does not reflect the acquisition of any assets of Western
Medical Group by Pegasus Medical Group or any assets of Antelope Valley Medical
Group and its related management company. The Western Medical Group acquisition
was not considered material when the determination was made for inclusion of
separate historical financial statements.
37
<PAGE>
The Company's consolidated revenues are composed primarily of (1) monthly
payments (capitation payments) made by HMOs to the Company's affiliated
physician organizations on behalf of the HMOs' members who have chosen or been
assigned to one of these organizations to provide for the HMOs' members' medical
needs under managed care arrangements, (2) fee-for-service collections generated
by the affiliated physician organizations for medical services provided and (3)
incentive payments made under risk-sharing agreements with HMOs utilizing funds
(i.e., "risk pools" or "bonus pools") withheld or paid by the HMOs to promote
and reward savings obtained through the efficient utilization of medical
services. See "Business of the Company--Managed Care Industry Overview" for a
brief description of such payments. Additional revenues are received by the
Company in the form of management fees from non-affiliated physician
organizations.
The Company's consolidated cost of medical services consists largely of (1)
monthly capitation payments to those primary care physicians and specialists
contracting with the Company's affiliated independent practice associations who
have elected that means of compensation, (2) mostly discounted fee-for-service
payments made to non-capitated specialists and other providers of medical
services who are not employed by Prospect Medical Group or its medical group
subsidiaries and (3) salaries, benefits and other compensation paid to
physicians and other medical professionals who are employees of Prospect Medical
Group or its medical group subsidiaries.
In order for the Company to implement its growth strategy, the Company has
been required to invest in the expansion of its operating infrastructure.
Approximately 68 additional persons were hired during the period from April 1,
1997 to March 31, 1998, in part to establish separate departments to manage the
areas of (i) clinical operations, including case management and quality control,
(ii) claims and management information systems operations, (iii) contracting,
and (iv) independent practice association/medical management, including billing
and collecting, practice management, medical staff and provider relations. Each
of these departments operates under the supervision of a vice president; since
March 31, 1998 the Company has not significantly increased the number of its
permanent employees.
Other general and administrative expenses incurred in preparation for
implementation of the Company's growth strategy included investment in advanced
management information systems equipment and increased legal and accounting
costs in connection with the Company's acquisition program. In fiscal year 1998,
Prospect Medical Systems acquired the hardware and software for a sophisticated
management information system at an initial investment of approximately
$1,100,000. The Company currently estimates that the total cost will be expended
in fiscal year 1998. The Company commenced using the new system on September 1,
1998. The Company borrowed approximately $600,000 of the total cost from an
unaffiliated lender under a long-term loan agreement at an interest rate of
10.25% per annum. The Company anticipates that any additional costs that are
incurred to install and implement this system will be paid from cash generated
from operations.
RESULTS OF OPERATIONS
Comparison of the Company's historical results of operations for the fiscal
years ended September 30, 1997, 1996 and 1995 and for the nine month periods
ended June 30, 1998 and 1997 will not, in the view of management of the Company,
prove meaningful because of the rapid growth of the Company during such periods
and because the affiliation relationships entered into by the Company during
those periods are not reflected in the Company's historical results of
operations for prior periods. Instead, a summary of the elements which
management of the Company believes essential to an analysis of the results of
operations for such periods is presented below.
FISCAL YEAR ENDED SEPTEMBER 30, 1997 COMPARED WITH FISCAL YEAR ENDED SEPTEMBER
30, 1996
The Company's total operating revenues increased to $29,955,000 in the
fiscal year ended September 30, 1997 from $24,435,000 in the fiscal year ended
September 30, 1996, representing an increase of $5,520,000. Of this increase,
$4,355,000 resulted from an increase in capitation revenue to $24,606,000 in
38
<PAGE>
the fiscal year ended September 30, 1997 from $20,251,000 in the fiscal year
ended September 30, 1996. The increase of $4,355,000 in capitation revenues from
1996 resulted from the addition of 13,000 enrollees or approximately $2,555,000
from internal growth, and approximately 27,000 enrollees or approximately
$1,800,000 as a result of acquisitions by the affiliated physician
organizations. As of September 30, 1997, the number of managed care patients
enrolled in the Company's networks totaled approximately 75,000 as compared to
approximately 35,000 at the same date in 1996.
Fee-for-service revenues increased to $1,188,000 during the fiscal year
ended September 30, 1997 from $705,000 during the fiscal year ended September
30, 1996. This increase is primarily the result of an increase in co-payments
made by enrollees under HMO agreements and fees from non-capitated patients.
Fee-for-service revenues as a percentage of operating revenues increased to
approximately 4.0% during the fiscal year ended September 30, 1997 from
approximately 2.9% during the fiscal year ended September 30, 1996. The Company
believes that this percentage will not increase significantly as the Company and
its affiliated physician organizations undertake additional acquisitions.
Incentive payments consist of bonus pool revenue that is paid to affiliated
physician organizations. Bonus pool revenue increased to $2,509,000 during the
fiscal year ended September 30, 1997 from $1,562,000 during the fiscal year
ended September 30, 1996. This increase was due to increased enrollees and to
lower hospital utilization rates by enrollees.
Revenue from management services provided to unaffiliated physician
organizations ("MSO Revenue") increased to $1,429,000 for the fiscal year ended
September 30, 1997 from $945,000 for the fiscal year ended September 30, 1996.
The increase resulted from the Company managing additional unaffiliated
physician organizations during the year ended September 30, 1997. For the fiscal
year ended September 30, 1997, $891,000 of the MSO Revenue and for the fiscal
year ended September 30, 1996, $901,000 of the MSO Revenue was derived from
management services provided to Yorba Linda Medical Group. A portion of such
revenue terminated as of July 1, 1998. The Company has determined that MSO
Revenue derived from the Yorba Linda Medical Group was at a break-even level
relative to net income during these periods; accordingly, the Company does not
believe that the termination of such revenue will have a material adverse effect
on the Company's results of operations. See "Risk Factors--Recent Settlement
Agreement with Yorba Linda Medical Group."
The cost of medical services for the fiscal year ended September 30, 1997
was $23,202,000, representing an increase of $3,710,000 from $19,492,000 in the
prior fiscal year. The total cost of medical services increased from fiscal year
1996 to fiscal year 1997 as a result of the increase in the number of enrollees
from the Company's acquisition program and internal growth. The medical loss
ratio (the ratio of the cost of medical services to net patient service
revenues) was 82.0% and 86.6% for the fiscal years ended September 30, 1997 and
1996, respectively. The decrease in the medical loss ratio from fiscal year 1996
to fiscal year 1997 resulted from lower medical costs per enrollee at the
acquired physician organizations.
The Company and its affiliates have taken several additional actions since
October 1, 1997 in an attempt to continue to reduce their respective costs.
These actions include closer monitoring of claims authorizations, renegotiation
of contracts for certain specialty and ancillary health care services, including
obstetrics and gynecology, orthopedics, general surgery, outpatient radiology
and physical therapy and entering into new agreements for certain hospital
services and hospital-based physicians. The Company has entered into a lease to
consolidate the operations of Santa Ana/Tustin Physicians Group with certain
operations of Prospect Medical Group. The Company has also entered into a lease
to consolidate the management and administrative functions performed by Prospect
Medical Systems for Prospect Medical Group and Santa Ana/Tustin Physicians Group
into a single location in November, 1998.
Gross margin for the fiscal year ended September 30, 1997 increased to
$6,753,000 from $4,943,000 for the prior fiscal year, representing 22.5% and
20.2% of total operating revenues for the fiscal years ended September 30, 1997
and 1996, respectively. The increase in gross margin resulted from a larger
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increase in total operating revenues than the increase in the cost of medical
services as a function of lower medical costs per enrollee at the acquired
physician organizations.
General and administrative expenses for the fiscal year ended September 30,
1997 rose to $7,300,000 from $4,212,000 for the preceding fiscal year,
representing 24% and 17% of total operating revenues for the respective year.
The largest component of such costs is non-physician salaries and benefits.
Salaries and benefits increased to $4,318,000 during the fiscal year ended
September 30, 1997 from $2,559,000 during the fiscal year ended September 30,
1996, an increase of 69%. This increase resulted from the increase in the number
of management personnel hired in preparation for implementation of the Company's
growth strategy and cost containment programs.
Other general and administrative expenses incurred in preparation for
implementation of the Company's growth strategy included employee training in
connection with investment in advanced management information systems equipment,
and increased legal and accounting costs. Physician office expenses increased to
$869,000 during the fiscal year ended September 30, 1997 from $696,000 during
the fiscal year ended September 30, 1996. This increase is primarily the result
of additional offices for the medical groups acquired pursuant to the Company's
acquisition program. Other operating expenses increased to $2,113,000 during the
fiscal year ended September 30, 1997 from $957,000 during the fiscal year ended
September 30, 1996, an increase of 121%. This increase is primarily the result
of the Company's acquisition program and an increase in personnel support.
Depreciation and amortization rose to $244,000 for the fiscal year ended
September 30, 1997 as compared to $102,000 for the fiscal year ended September
30, 1996. The increase in depreciation and amortization is attributable to the
amortization of a portion of the goodwill related to acquisitions effected in
1997 and an increase in fixed assets in 1997.
The differential in the income tax rate of (10%) for the year ended
September 30, 1997, as compared to the income tax rate of (1%) for the year
ended September 30, 1996, resulted from a change in accounting methods adopted
in 1996 and the non-deductibility of the goodwill impairment charge and goodwill
amortization in 1997.
The acquisition of the stock of Santa Ana/Tustin Physicians Group, Sierra
Medical Group and Sierra Medical Management, Inc. (and certain assets of Western
Medical Group and Antelope Valley Medical Group) and related entities have been
accounted for by the Company using the purchase method of accounting, under
which the Company records as goodwill the excess of the purchase price over the
fair value of the net tangible assets of the acquired businesses. As of
September 30, 1997, the Company's total consolidated assets were approximately
$24,511,000, of which approximately $16,530,000, or 67.4%, was goodwill and
other intangible assets. Goodwill is being amortized on a straight-line basis
over a 20 year period.
Substantially all of the goodwill on the Company's consolidated balance
sheet as of September 30, 1997 is related to acquiring the stock of Santa
Ana/Tustin Physicians Group, Sierra Medical Group and Sierra Medical Management,
Inc. The Company evaluates each acquisition and establishes an appropriate
amortization period based on the underlying facts and circumstances. Currently,
the Company uses 20 years based on an allocation of the estimated fair values of
the net assets acquired. Subsequent to each acquisition, the Company reevaluates
such facts and circumstances to determine if the related goodwill continues to
be realizable and if the amortization period continues to be appropriate.
Amortization of goodwill for the fiscal year ended September 30, 1997 was
$49,000. In addition, during the fiscal year ended September 30, 1997 the
Company voluntarily terminated one HMO contract related to the provider network
acquired in the 1996 Merger because the capitation payments made under this
contract were not sufficient to cover the cost of medical services provided
thereunder. This HMO contract was the primary asset acquired in that
transaction. Consequently, all intangible assets acquired from the Company (then
named "Med-Search, Inc.") in that transaction were considered impaired and of
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no continuing value. To reflect this asset impairment, a loss totaling
$2,197,000 was recorded in the fiscal year ended September 30, 1997.
Affiliations with additional physician organizations which result in the
recognition of additional goodwill would cause amortization expense to increase
further. Any future determination that a significant impairment has occurred
would require the write-down of the impaired portion of unamortized goodwill to
fair value, which would have a material adverse effect on the Company's results
of operations. See "Risk Factors--Risk Related to Intangible Assets and
Amortization of Goodwill."
Interest expense was $152,000 during the fiscal year ended September 30,
1997, as compared to none in the prior year, and was attributable to two and one
half months of interest on funds drawn on the Company's revolving credit
agreement for acquisition purposes.
As a consequence of incurring the foregoing expenses, the Company suffered a
net loss of $2,639,000 for the fiscal year ended September 30, 1997 as compared
to net income of $555,000 for the prior fiscal year.
FISCAL YEAR ENDED SEPTEMBER 30, 1996 COMPARED WITH FISCAL YEAR ENDED SEPTEMBER
30, 1995
The Company's total operating revenues increased to $24,435,000 in the
fiscal year ended September 30, 1996 from $14,657,000 in the fiscal year ended
September 30, 1995, representing an increase of $9,778,000, as a result of
internal growth. As of September 30, 1996 the number of managed care patients
enrolled in the Company's service networks totaled approximately 35,000 as
compared to approximately 27,000 at the same date in 1995.
The cost of medical services in the fiscal year ended September 30, 1996 was
$19,492,000, representing an increase of $8,832,000 from $10,660,000 in the
prior fiscal year. During the fiscal year ended September 30, 1996, the increase
in total operating revenues was slightly higher than the increase in the cost of
medical services, resulting in a $946,000 increase in gross profit (from
$3,997,000 to $4,943,000). The gross margin for the fiscal year ended September
30, 1996 was 20.2% of total operating revenues as compared to 27.3% for the
prior fiscal year. Medical costs as a percentage of net patient service revenues
increased from 78.4% in 1995 to 86.6% in 1996. The increase in the medical loss
ratio and the decrease in gross margin is attributable to higher costs in the
fiscal year ended September 30, 1996 relating to patient services and treatment,
including higher utilization of specialists that the Company had to provide.
Subsequent to the 1996 fiscal year, the Company instituted a program to control
such costs by converting a significant number of specialists in its network from
fee-for-service to capitated compensation arrangements.
General and administrative expenses for the fiscal year ended September 30,
1996 increased to $4,212,000 from $3,545,000 for the preceding fiscal year,
representing 17% and 24%, respectively, of total operating revenues for such
years. This resulted primarily from an increase in non-physician salaries and
benefits to support the increase in enrollees.
Depreciation and amortization was approximately $102,000 for the fiscal year
ended September 30, 1996 as compared to $125,000 in the prior fiscal year.
During 1996 approximately $240,000 of property and equipment was sold to an
affiliate at nominal value, which resulted in a loss of $240,000 to the Company.
As a result the average depreciable base was reduced during the year.
Investment income was $175,000 for the fiscal year ended September 30, 1996,
as compared to none in the prior year, and was attributed to the ability of the
Company to invest the surplus cash balances generated by the sale of shares of
Common Stock in a private placement.
Income taxes decreased from $139,000 to $(6,000) between 1995 and 1996 as a
result of the adjustment of certain deferred tax liabilities in connection with
an accounting method change adopted in 1996 which decreased the tax rate by 36
percentage points from the prior year.
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As a result of an increase in gross margin and reduced general and
administrative expenses as a percentage of total operating revenues the Company
experienced an increase in net income to $555,000 for the fiscal year ended
September 30, 1996 as compared to $188,000 in the fiscal year ended September
30, 1995.
NINE MONTHS ENDED JUNE 30, 1998 COMPARED WITH NINE MONTHS ENDED JUNE 30, 1997
The Company's total operating revenues increased to $40,314,000 in the nine
months ended June 30, 1998 from $19,977,000 in the nine months ended June 30,
1997, representing an increase of $20,337,000 or 101.8%. The majority of this
increase resulted from the increase in capitation revenues during the nine
months ended June 30, 1998 to $33,860,000 from $16,165,000 during the nine
months ended June 30, 1997. Approximately 90% of the increase in the capitation
revenues from the nine months ended June 30, 1997 when compared to the nine
months ended June 30, 1998 resulted from the increase in the number of managed
care patients served by the Company's affiliated physician organizations as a
result of the Company's acquisition program and approximately 10% of the
increase resulted from internal growth of 9,000 enrollees during periods of open
enrollment for HMO plans under contract with the Company's affiliated physician
organizations.
Fee-for-service revenues increased to $2,610,000 during the nine months
ended June 30, 1998 from $762,000 during the nine months ended June 30, 1997.
This increase is largely the result of the Company's acquisition program.
Fee-for-service revenues as a percentage of total operating revenues increased
to approximately 6.5% during the nine months ended June 30, 1998 from
approximately 3.8% during the nine months ended June 30, 1997. This percentage
increase was primarily the result of the acquisitions of the Sierra Medical
Group and the Santa Ana/Tustin Physicians Group, both of which operate at least
in part on a medical group model which provides for a higher percentage of
fee-for-service revenues.
Incentive payments consist of bonus pool revenue that is paid to affiliated
physician organizations. Bonus pool revenue increased to $2,122,000 during the
nine months ended June 30, 1998 from $1,795,000 during the nine months ended
June 30, 1997. This increase was due to additional bonus pools for which
physician organizations that became affiliated with the Company during fiscal
year 1997 and the first quarter of fiscal year 1998 were eligible.
MSO Revenue increased to $1,467,000 for the nine months ended June 30, 1998
from $924,000 for the nine months ended June 30, 1997. The increase in MSO
Revenue resulted from managing additional unaffiliated physician organizations
when compared to the comparable prior period. For the nine months ended June 30,
1998, $631,000 of the MSO Revenue, and for the nine months ended June 30, 1997,
$668,000 of the MSO Revenue, was derived from management services provided to
Yorba Linda Medical Group. As of July 1, 1998, a portion of such revenue was
terminated. The Company has determined that MSO Revenue derived from the Yorba
Linda Medical Group was at a break-even level relative to net income during
these periods; accordingly, the Company does not believe that the termination of
such revenue will have a material adverse effect on the Company's results of
operations. See "Risk Factors-- Recent Settlement Agreement with Yorba Linda
Medical Group."
The cost of medical services increased to $26,854,000 during the nine months
ended June 30, 1998 from $16,107,000 during the nine months ended June 30, 1997.
Of such cost, monthly capitation payments to primary care physicians and
specialists increased to $8,656,000 during the nine months ended June 30, 1998
from $5,635,000 during the nine months ended June 30, 1997. This increase was
largely attributable to an increase in the number of physicians receiving
capitation payments as a result of the Company's acquisition program. The
reduction in medical costs as a percentage of net patient service revenues from
86.0% for the nine months ended June 30, 1997 as compared to 69.6% for the nine
months ended June 30, 1998 results from the acquirees operating at significantly
lower medical costs and the Company implementing new contracts with specialists
and ancillary health care providers. The acquired physician organizations have
lower medical costs because they have more control over the utilization of
medical services as a result of employing primary care physicians rather than
paying monthly capitation payments to independent primary care physicians.
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During the nine months ended June 30, 1998, total operating revenues rose at
a faster rate than the cost of medical services, resulting in an $9,591,000
increase in gross margin (from $3,869,000 during the nine months ended June 30,
1997 to $13,460,000 during the nine months ended June 30, 1998). The gross
margin was 33.4% of total operating revenues during the nine month period ended
June 30, 1998, as compared to 19.4% for the nine month period ended June 30,
1997. The increase in gross margin is a result of the lower medical cost per
enrollee at the acquired physician organizations and the implementation of new
contracts with specialists and ancillary health care providers.
General and administrative expenses for the nine months ended June 30, 1998
rose to $11,299,000 from $4,503,000 for the nine months ended June 30, 1997,
representing 28.0% and 22.5% of total operating revenues for such periods. The
largest component of such costs is salaries and benefits. Salaries and benefits
increased to $6,580,000 during the nine months ended June 30, 1998 from
$2,513,000 during the nine months ended June 30, 1997, an increase of more than
162%. This increase resulted from the increase in the number of management and
other personnel hired in preparation for implementation of the Company's growth
strategy and cost containment programs and the increase in personnel
incorporated from the Company's acquisition program.
Physician office expenses increased to $1,097,000 during the nine months
ended June 30, 1998 from $535,000 during the nine months ended June 30, 1997.
This increase is primarily the result of additional offices for the medical
groups acquired pursuant to the Company's acquisition program. Other operating
expenses increased as a result of the implementation of the Company's growth
strategy to $3,622,000 during the nine months ended June 30, 1998 from
$1,455,000 during the nine months ended June 30, 1997, an increase of 149%.
Depreciation and amortization rose to $786,000 for the nine months ended
June 30, 1998 as compared to $114,000 for the nine months ended June 30, 1997,
an increase of 589%. Depreciation and amortization increased primarily because
of the amortization of goodwill associated with the acquisitions of Sierra
Medical Group and its related management company and Santa Ana/Tustin Physicians
Group over a nine month period in 1998 as compared to two and one-half months
for Santa Ana/Tustin Physicians Group only in the comparable period in 1997.
Interest expense was $1,028,000 during the nine months ended June 30, 1998,
as compared to none in the prior year. Interest expense during the nine months
ended June 30, 1998 was attributable to nine months of interest on funds drawn
on the Company's credit facility for acquisition purposes, and interest due on
promissory notes made by Prospect Medical Group and the Company to the sellers
of Sierra Medical Group and its related management company.
Investment income decreased from $173,000 for the nine months ended June 30,
1997 to $32,000 for the nine months ended June 30, 1998 because of reduced
average cash balances available to invest in 1998.
The income tax rates for the nine month period ending June 30, 1997 when
compared to the same period in 1998 vary because the goodwill amortization and
impairment charge in fiscal year 1997 was not deductible, other timing
differences were operative and during 1998 the Company was able to utilize its
net operating loss carryforward. As a consequence of the foregoing, the Company
earned a net income of $376,000 for the nine months ended June 30, 1998 as
compared to a net loss of $2,944,000 for the nine months ended June 30, 1997.
PRO FORMA NINE MONTHS ENDED JUNE 30, 1998 COMPARED WITH HISTORICAL NINE MONTHS
ENDED JUNE 30, 1998
The pro forma consolidated statement of operations gives effect to the
acquisition of assets of Antelope Valley Medical Group, the Yorba Linda
Settlement Agreement in which shares of Common Stock were returned to the
Company and the utilization of proceeds of this Offering to repay debt. During
June 1998, Sierra Medical Group acquired certain assets of Antelope Valley
Medical Group and the
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Company acquired certain assets of its related management company. None of the
personnel or facilities of Antelope Valley Medical Group or its related
management company were acquired by Sierra Medical Group or the Company. The
Company believes that it will be able to integrate the acquired assets into the
existing operations of its affiliated physician organizations, thereby reducing
the costs associated with the operations of the assets acquired from Antelope
Valley Medical Group in future periods. The pro forma statement of operations
data has not been adjusted to reflect any reduction in the historical operating
costs of Antelope Valley Medical Group.
The pro forma financial information for the period also gives effect to the
Yorba Linda Settlement Agreement. Certain physicians employed by Yorba Linda
Medical Group who had provided physician services to enrollees of Prospect
Medical Group sought release from the exclusivity and other noncompetition
provisions in their agreements with Prospect Medical Group. Effective July 1,
1998, the Company and Prospect Medical Group entered into the Yorba Linda
Settlement Agreement pursuant to which these physicians who were also
stockholders of the Company have returned to the Company an aggregate of
1,126,323 shares of Common Stock in exchange for their release from the
exclusivity and other noncompetition provisions in their agreements with
Prospect Medical Group. See "Unaudited Pro Forma Financial Information."
The Company's pro forma total operating revenues decreased by $978,000 as
compared to the historical total operating revenues as a result of including the
historical unaudited revenues of Antelope Valley Medical Group and the reduction
in revenues related to the Yorba Linda Settlement Agreement as if they had been
effected at the beginning of the period. These two events resulted in a net
enrollee decrease of approximately 1,000. The increase in the cost of medical
services of $552,000 can be attributed to the higher historical medical cost per
enrollee of Antelope Valley Medical Group as compared to Yorba Linda Medical
Group. The decrease in general and administrative costs results from cost
savings derived from services no longer provided to Yorba Linda Medical Group
physicians, including a reduction in rent expense. In addition, prior to
acquisition, the former management of Antelope Valley Medical Group had
determined that it could not operate Antelope Valley Medical Group profitably,
and therefore a non-recurring expense totaling $312,000 was recorded by such
management in the eight-month period ended May 31, 1998 in addition to a charge
of $2,856,000 recorded prior to September 30, 1997. Lastly, the pro forma
consolidated statement of operations has also been adjusted to give effect to
the utilization of proceeds of the Offering to pay down debt and thereby reduce
interest expense.
LIQUIDITY AND CAPITAL RESOURCES
GENERAL. The Company requires capital primarily to facilitate its
acquisition strategy and to develop the infrastructure necessary to effectively
manage its affiliated physician organizations. Prior to or concurrent with
establishment of an affiliation relationship with a physician organization,
Prospect Medical Holdings may advance funds to one of its wholly-owned
subsidiaries to acquire the non-medical assets used to operate and manage the
physician organization. Prospect Medical Holdings may also advance funds to an
affiliated physician organization to acquire the medical assets or, in some
cases, the stock of another physician organization.
While the affiliated physician organization is obligated under its
management services agreement to repay such advances of funds to the Company,
the Company does not anticipate that such advances will be repaid unless there
is a sale of all or substantially all of the assets of such physician
organization. Any such advance to an affiliated physician organization is
collateralized by the accounts and rights to payment of the affiliated physician
organization pursuant to the terms of the general security agreement between the
Company and such organization. In addition, in the event of a default, the
Company could, pursuant to its assignable option agreement with such
organization and its nominee shareholder, exercise its option (which may be
exercised at any time) (i) to acquire the assets of the affiliated physician
organization, or (ii) to designate a successor nominee physician shareholder,
thereby causing a change in the ownership or management of the assets of the
affiliated physician organization. Of a total of $10,725,000 loaned by the
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Company to its affiliates for acquisition-related purposes, $8,700,000 is
required to be repaid on or before July 3, 1999. These loans were financed by
the Company through draws on the Company's credit facility. The Bank has a
first-priority lien on substantially all of the assets of the Company and its
subsidiaries as security for amounts outstanding under the credit facility. The
Company has also granted to the Bank a security interest in and to its rights
and remedies under each of the management services agreements with the
affiliated physician organizations, the related assignable option agreements and
the security agreements with the affiliated physician organizations. The Bank
may also exercise the Company's rights under its assignable option agreements in
the event of a default by the Company under its credit facility and, pursuant to
its credit succession agreement, the Bank may select the new shareholder(s) and,
to the extent permitted by law, elect (a) new director(s) of the affiliated
physician organizations.
Under the Company's credit facility, the Company is required to satisfy
certain conditions before the Bank becomes obligated to lend money to the
Company in connection with an acquisition. The Company is required to submit a
written description of the proposed acquisition, including financial
information, and copies of the proposed acquisition documents, to the Bank. If
the total consideration to be paid is (i) more than $3,000,000 or (ii)
$1,000,000 or more but less than $3,000,000 and the consideration to be paid
exceeds certain income tests, the Company is required to obtain the Bank's prior
written consent to the acquisition.
Generally, contractual payments for capitation tend to be received by the
Company's affiliated physician organizations from the HMOs before the dates when
capitation and claim payments to the affiliated physician organizations'
providers are due, improving cash flow. However, the portion of the Company's
consolidated revenues that is derived from the affiliated physician
organizations' share of HMO bonus pools may be settled quarterly, semi-annually
or annually, well after the revenue has been accrued. Generally, bonus pools are
settled after the end of the contract year, which, with respect to the contracts
between the Company's affiliated physician organizations and contracting HMOs,
is generally December 31. Settlement is the process of adjusting budgeted
amounts against actual amounts in order to calculate the correct incentives or
penalties. Once payments have been made by an HMO from a bonus pool, such monies
generally are not required to be repaid. Historically, amounts payable to the
Company's affiliated physician organizations that are derived from bonus pools
are generally paid in the third quarter of each calendar year. These payments
generally result in higher cash flows in the third calendar quarter (the last
quarter of the Company's fiscal year) than in other quarters. See "Risk
Factors--Fluctuations in Quarterly Results".
The Company's primary sources of cash since 1996 have been funds provided by
borrowing under the Company's credit facility, by the issuance of equity
securities and by operating activities. Upon consummation of the 1996 Merger in
the fiscal year ended September 30, 1996 the Company raised a net of $2,359,000
through a sale of shares of Common Stock in a private transaction. During fiscal
year 1997 the Company began to implement its growth strategy through a series of
acquisitions, including acquisitions by its affiliated physician organizations,
and affiliations in exchange for cash, debt and equity securities. Through June
30, 1998, the Company paid or committed to pay consideration in an aggregate
amount of approximately $15,950,000 in connection with such acquisitions in
addition to the issuance of approximately 800,000 shares of Common Stock and
options to purchase 35,000 shares of Common Stock.
In July 1997, the Company (through Prospect Medical Group) acquired all of
the stock of Santa Ana/ Tustin Physicians Group for $5,000,000. In September
1997, the Company acquired all of the stock of Sierra Medical Management, Inc.
and (through Prospect Medical Group) acquired all of the stock of Sierra Medical
Group for an aggregate purchase price of $6,500,000 in cash, plus $2,500,000
payable pursuant to notes issued by Prospect Medical Group to the sellers,
600,000 shares of Common Stock valued at $2.00 per share and options to purchase
35,000 shares of Common Stock at an exercise price of $5.00 per share. Such
notes bear interest at the rate of 7% per annum, require interest to be paid
monthly, with $125,000 of principal payable quarterly, plus annual principal
payments of $250,000 until March 1999, when the unpaid principal balance then
outstanding, and all accrued but unpaid interest, are due and
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payable in full. The notes to the former shareholders of Sierra Medical Group
provide that Prospect Medical Group will prepay the principal of such notes in
full from the proceeds of this Offering; the interest on such notes will be paid
from internally generated funds. See "Use of Proceeds."
ACQUISITIONS DURING THE CURRENT FISCAL YEAR. In October 1997 the Company
(through Pegasus Medical Group) acquired certain assets (primarily consisting of
HMO contracts, certain equipment and furniture and rights under certain leases)
of Western Medical Group for $700,000. The Company (through Prospect Medical
Group) also acquired substantially all of the assets of two medical practices
for a total consideration of approximately $200,000 plus the issuance of up to
approximately 10,000 shares of Common Stock valued at a price of $5.00 per
share. As of June 1998 Sierra Medical Group acquired certain assets (primarily
consisting of provider contracts and the responsibility to provide medical
services to enrollees) of the Antelope Valley Medical Group and the Company
acquired certain assets (primarily consisting of management rights) of a related
entity for consideration consisting of $500,000 in cash, $500,000 in promissory
notes and 200,000 shares of Common Stock valued at a price of $5.00 per share.
WORKING CAPITAL. The Company had negative working capital of $2,569,000 and
$2,003,000 at June 30, 1998 and September 30, 1997, respectively. The negative
working capital at September 30, 1997 resulted primarily from current
liabilities incurred in connection with acquisitions and the use of cash in
operations. At June 30, 1998, the negative working capital resulted primarily
from current liabilities incurred in connection with acquisitions. At June 30,
1998, the Company had cash and cash equivalents of $1,765,000 and a working
capital ratio (currents assets to current liabilities) of .73, compared to cash
and cash equivalents of $2,822,000 and a working capital ratio of .77 at
September 30, 1997 and cash and cash equivalents of $693,000 and a working
capital ratio of .78 at June 30, 1997. The increase in cash and cash equivalents
of approximately $2,129,000 from June 30, 1997 to September 30, 1997 resulted
primarily from the receipt of risk pool monies, cash received from the
acquisition of Santa Ana/Tustin Physicians Group and an increase in capitation
revenues received as a result of the Santa Ana/Tustin Physician Group
acquisition. The decrease in cash from $2,822,000 at September 30, 1997 to
$1,765,000 at June 30, 1998 resulted from the Company's and its affiliated
physician organizations' acquisitions, capital expenditures and costs incurred
in connection with the Offering. At September 30, 1997, the Company had cash and
cash equivalents of $2,822,000 and a working capital ratio of .77, compared to
cash and cash equivalents of $5,333,000 and a working capital ratio of 1.81 at
September 30, 1996 and cash and cash equivalents of $822,000 and a working
capital ratio of 1.51 at September 30, 1995. The decrease in cash and cash
equivalents of approximately $2,511,000 from September 30, 1996 to September 30,
1997 resulted primarily from the use of $2,200,000 for the Company's acquisition
activities (net of borrowings under the Company's credit facility) and from
operating losses. The increase in cash and cash equivalents of approximately
$4,511,000 from September 30, 1995 to September 30, 1996 resulted primarily from
proceeds from the private placement and from operations. The only significant
current asset of the Company other than cash comprises accounts receivable.
Accounts receivable consist primarily of the Company's interest in risk sharing
pools, accrued management fees due from managed physician practices which are
not consolidated, and fee-for-service amounts due from patients and third party
payors. These receivable balances increased from $1,328,000 at September 30,
1996 to $3,247,000 at September 30, 1997 to $4,865,000 at June 30, 1998,
increases of $1,919,000 and $1,618,000, respectively, primarily due to (a) the
increase in fee-for-service revenues as a result primarily of the Company's
acquisition program, the most significant portion of which arose as a result of
the July 1997 acquisition of Santa/Ana Tustin Physicians Group by Prospect
Medical Group, the September 1997 acquisition of Sierra Medical Group by
Prospect Medical Group and Sierra Medical Management, Inc. by the Company and
the June 1998 acquisition of certain assets of Antelope Valley Medical Group by
Sierra Medical Group and certain assets of a related entity by the Company; and
(b) the increase in shared risk receivables of $1,947,000 related to Prospect
Medical Group's acquisitions and internal growth in enrollment. The differences
in the receivable balances are also affected by the timing of the receipt of
payments under the shared risk programs with HMOs, which are typically made
during the second and third quarter of the calendar year.
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The Company's current liabilities consist of (i) accrued medical claims,
which are amounts accrued as payable by its affiliated physician organizations
to specialty care physicians and ancillary health care service providers, (ii)
accounts payable and (iii) the current portion of notes payable and capital
lease obligations. The Company's accrued medical claims include claims received
by its affiliated physician organizations, together with amounts accrued as
estimated costs for covered medical benefits incurred by the enrollees in the
Company's service network but not yet reported to the Company's affiliated
physician organizations by providers ("IBNR"). Claims that are not disputed by
the Company are typically paid within 30 days of their receipt. The increase in
accrued medical claims from $2,953,000 at June 30, 1997 to $5,918,000 at
September 30, 1997 and to $6,025,000 at June 30, 1998 resulted primarily from
the increased number of enrollees as a result of the Company's acquisition
program. The increase in accrued medical claims from $1,278,000 at September 30,
1995 to $3,063,000 at September 30, 1996 resulted from internal growth. The
increase in accrued medical claims from $3,063,000 at September 30, 1996 to
$5,918,000 at September 30, 1997 resulted primarily from the increased number of
enrollees as a result of the Company's acquisition program.
CREDIT FACILITY. In July 1997, the Company obtained a credit facility of
$10,000,000 from the Bank in the form of a revolving credit agreement (the
"Facility"). The full Facility was utilized by the Company in connection with
the acquisitions of Santa Ana/Tustin Physicians Group, Sierra Medical Group and
Sierra Medical Management, Inc. In February 1998, the Company obtained an
increase in the Facility to $12,500,000. Interest on the unpaid principal
balance of loans under the Facility is calculated at the Bank's prime rate plus
an applicable margin ranging from one-half percent (.5%) to one and one-half
percent (1.5%). The applicable margin depends upon the Company's leverage ratio,
which in general is calculated by dividing consolidated debt by consolidated
earnings. The applicable margin for the Company has been and, as of November 1,
1998, was 1.5%. The Bank's prime rate as of that date was 8%, resulting in an
interest rate of 9.5% for loans under the Facility. The Facility matures on July
3, 1999 and is secured by a first-priority lien on substantially all of the
assets of the Company and its subsidiaries. The Facility is also subject to both
affirmative and negative covenants, including financial covenants. The financial
covenants include maintaining certain financial ratios, such as a minimum
current ratio, maximum leverage ratio and minimum coverage ratio, as well as
satisfying a net worth test. As of September 30, 1997, the Company did not meet
certain financial ratios. The Bank has waived compliance with these ratios as of
September 30, 1997, and December 31, 1997, made the waivers effective
retroactive to September 1, 1997, and has revised the ratios for periods
thereafter. As of March 31, 1998, the Company did not meet its minimum current
ratio, maximum leverage ratio or minimum coverage ratio. As of June 30, 1998,
the Company did not meet its minimum current ratio or its minimum coverage ratio
and had exceeded its limit on total annual capital expenditures. The Bank has
permanently waived compliance with these ratios and negative covenants at those
dates. If the Bank did not waive compliance by the Company with its covenants to
maintain the financial ratios and its other financial covenants contained in the
Facility, the Company would be in default under the Facility and the Bank could
pursue the legal remedies provided to it thereunder. Any such default could have
a material adverse effect upon the Company, its results of operations, and its
financial condition. As of October 1, 1998, the Company is required to maintain
a minimum current ratio of 1 to 1, a maximum leverage ratio of 3.5 to 1 and a
minimum coverage ratio of 1.25 to 1. The Company is also required to meet a
minimum net worth test, which it has always met. In connection with the
establishment of the Facility and the increase in the amount available under the
Facility, the Company granted seven year warrants to the Bank for the purchase
of up to 192,725 shares of Common Stock at $5.00 per share. The Company intends
to renegotiate the terms of or replace the Facility upon expiration.
As described above, the Company has primarily funded its acquisition program
with draws on the Facility. The assets acquired by the Company and its
affiliated physician organizations have largely been intangible assets. The
result of acquiring such intangible assets with draws on the Facility is
reflected in the significant negative net tangible book value of the Company.
See "Dilution."
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EQUIPMENT LOAN. The Company entered into a loan agreement in September 1997
to finance a portion of the cost of a management information system. The loan
agreement had an original principal balance of approximately $600,000, with an
interest rate of 10.25% per annum and a term of seven years.
ADDITIONAL FINANCING. As the Company continues to aggressively pursue its
business strategy, additional financing, specifically in connection with the
Company's and its affiliated physician organizations' acquisitions, will be
required. Establishing a health plan with a limited license under California law
will also require additional financing. In addition, the operation and expansion
of affiliated physician organizations will require ongoing capital expenditures.
The Company anticipates repaying the outstanding balance under the Facility with
proceeds of this Offering. The Company anticipates applying approximately
$500,000 of proceeds of this Offering to pay a portion of the cost to establish
a limited license Knox-Keene health plan. The Company anticipates using a draw
on the Facility to pay for any additional costs to establish such a plan which
the Company currently estimates will total approximately $2,500,000. The Company
anticipates financing future acquisitions and potential business expansion with
a combination of the proceeds of this Offering, draws under the Facility, and
cash flows from operations. Subsequent to this Offering, the Company believes
that a renewal or replacement of the Facility, including any additional amounts
thereunder, and cash flow from operations will be sufficient to meet the
Company's currently anticipated acquisition, health plan establishment,
expansion and working capital needs through September 30, 1999. In addition, in
order to meet its long-term liquidity needs, the Company may incur, from time to
time, additional short and long term bank indebtedness and may issue additional
equity and debt securities, the availability and terms of which will depend upon
market and other conditions. Pursuant to the Company's agreements with the
Representative, the Company's ability to issue any securities is restricted for
a period commencing in March 1998 and ending twelve months following the
Effective Date, except for certain specified purposes, which purposes include
acquisitions. See "Risk Factors--Shares Eligible for Future Sale". The Company's
ability to issue any convertible debt or equity securities in a public or
private sale may also be restricted under certain circumstances pursuant to
contractual restrictions in the Company's agreements with the Bank. There can be
no assurance that such additional financing will be available upon terms
acceptable to the Company, if at all. The failure to raise the funds necessary
to finance its future cash requirements could adversely affect the Company's
ability to pursue its strategy and could adversely affect its results of
operations for future periods.
The Company may require additional financing to the extent the Company
identifies new candidates that meet its criteria for potential acquisitions and
it or an affiliated physician organization is able to enter into acquisition
agreements with such candidates. The Company may issue shares of Common Stock
for all or a portion of the consideration to be paid for any such acquisition.
There can be no assurances that the Company will be able to identify any such
acquisition candidates, that the Company or an affiliated physician organization
will be able to enter into any acquisition agreements on acceptable terms or
that the Company will be able to obtain sufficient financing to consummate any
such future acquisitions.
YORBA LINDA SETTLEMENT AGREEMENT. The management of the Company does not
anticipate that the Yorba Linda Settlement Agreement will have a material impact
on the Company's liquidity and cash flows.
YEAR 2000. Many existing computer systems and programs process transactions
using two digits rather than four digits for the year of a transaction. Unless
the hardware and/or the software have been or will be modified, a significant
number of those computer systems and programs may process a transaction with a
date of the year 2000 as the year "00", which could cause the system or the
program to fail or create erroneous results before, on or after January 1, 2000
(the "Year 2000 Issue"). The Company has recently explored the effect of the
Year 2000 Issue in connection with its management information systems,
computerized accounting system, computerized telephone system and all of the
Company's personal computers.
The Company has formed a Year 2000 project team that includes members of its
management information systems department, finance department, senior management
and a computer consultant to
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continue evaluating and analyzing all systems. An inventory of all systems and
programs that could be affected by the Year 2000 date change has been developed
and categorized as to importance.
The Company has recently purchased a sophisticated management information
system (including software, licensing, training and support) for approximately
$1,100,000. The management information system is specifically designed for the
managed care segment of the Company's business, which accounts for approximately
89% of the Company's consolidated revenue. The vendor of this system is
obligated under the purchase contract to provide and install a Year 2000 module
designed to address the Year 2000 Issue. The Company commenced using the system
on September 1, 1998. The Company anticipates that the Year 2000 module will be
installed in February 1999, and will be tested within 90 days thereafter. No
assurances can be given that the Year 2000 module will resolve the Year 2000
Issue. The Company does not expect any additional costs associated with the
installation of its Year 2000 module.
The Company also uses a computer system which was leased commencing in 1996
for billing and collection of fee-for-service accounts receivable, which
accounts for less than 7.5% of the Company's revenues. This system is not
currently Year 2000 compliant; however, the vendor has provided a software
upgrade to enable the computer system to become Year 2000 compliant. The Company
anticipates commencing to test the software upgrade on or about December 1, 1998
and to complete testing by January 31, 1999 to confirm that the upgrade will
resolve the Year 2000 Issue. No assurance can be made at this time that the
upgrade will resolve the Year 2000 Issue. The vendor has agreed to provide the
upgrade and any technical support required at no cost to the Company, and has
assured the Company that the upgrade has been fully tested to resolve the Year
2000 Issue. In the event the software upgrade will not resolve the Year 2000
Issue, the Company intends to terminate the lease for the computer system and
the Company anticipates that it will purchase another computer system which is
Year 2000 compliant at a cost of approximately $100,000 to perform these
services. The Company anticipates that any such cost, if incurred, would be paid
from cash flow generated by operations.
The Company's financial and general ledger systems use a licensed software
program. The licensor has provided a software upgrade to address the Year 2000
Issue at a negligible cost. The Company has tested the upgrade and has concluded
that the financial and general ledger systems are now Year 2000 compliant.
In connection with the anticipated relocation of the administrative offices
of Prospect Medical Systems to its new facilities in Santa Ana, California (on
or about November 13, 1998), management will be entering into a contract for a
new state-of-the-art telephone interconnect system. The software in connection
with the operation and management of the telephone system is operated through
Microsoft Windows NT technology, and the Year 2000 module included with the
telephone interconnect software has already been tested by the manufacturer who
reports that the software is Year 2000 compliant. The telephone interconnect
system will be leased directly from the manufacturer and the lease will provide
for a full service guarantee for the life of the lease (8 years). The cost of
the telephone interconnect system will be approximately $130,000, plus lease
charges which include full service of the equipment by the manufacturer for the
8 year term. The Company anticipates that any such cost will be paid from cash
flow generated by operations.
The Company utilizes personal computers that are connected to a network for
all of its employee workstations. These personal computers all utilize Microsoft
Windows NT as their operating system. The Company believes that the Windows NT
operating system is Year 2000 compliant. Management replaces personal computers
after five years, and the Company anticipates replacing a portion of its
personal computers in 1999 and 2000. The cost anticipated is approximately
$75,000 per year. This cost is generally paid from cash flow generated by
operations.
The Company also has facilities in other parts of Orange County, California,
Santa Barbara, California and the Antelope Valley region of Los Angeles County
(Palmdale, California and Lancaster, California). The data and information
relating to the assets acquired from Antelope Valley Medical Group
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have been connected to the management information system and the computer system
for billing and collections; management anticipates that the facilities for
Santa Ana/Tustin Physicians Group will be connected by December 1, 1998 and
those of Sierra Medical Group and Pegasus Medical Group will be connected by
January 1, 1999. These facilities also operate with personal computers, which
use the Microsoft Windows NT operating system. Telephone systems at each
location are currently being analyzed to determine if they meet the Year 2000
Issue, or whether they will require replacement. The cost associated with
replacement of telephone systems at these offices is negligible.
The medical equipment at the medical offices managed by the Company has all
been tested and the Company has verified that this equipment is Year 2000
compliant, based on testing of the medical equipment and its related software.
The Company and its affiliated physician organizations primarily do business
with hospitals and HMOs. The Company has contacted all of the hospitals and HMOs
with which they do business and has verified that the hospitals and HMOs are in
the process of preparing for the Year 2000. The Company has been provided
assurances that the hospitals and HMOs will be Year 2000 compliant by March
1999, although no assurances can be given by the Company with respect to these
other parties.
Any failure of the HMOs and third-party payors to become prepared for the
Year 2000 could result in substantial adverse difficulties for the Company and
its business. The most reasonably likely worst case scenario for the Company is
the failure of the HMOs to become Year 2000 compliant. In the event the HMOs
that contract with the Company's affiliated physician organizations do not
become Year 2000 compliant in a timely manner, the impact could severely and
adversely affect the Company's results of operations and financial condition.
Additionally, all information between the Company and its HMOs would have to be
prepared and processed manually, at substantial cost to the Company.
In the case of third-party payors (Medicare, Medicaid, and indemnity
insurance companies) not becoming Year 2000 compliant in a timely manner, there
would be some impact on the Company's revenues and additional cost to manually
prepare and process claims. However, this segment of the Company's business
accounts for less than 7.5% of its revenues, and is not a primary source of the
Company's business.
In the case of the affiliated physician organizations' hospital
relationships, in the event the hospitals are not Year 2000 compliant, all
claims, authorizations, and in-patient hospital days would have to be processed
manually, which could delay patients from obtaining needed medical care
promptly, and potentially expose the Company and its affiliated physician
organizations to possible liability from the patients. The Company does not
anticipate, however, that a failure of the hospitals to become Year 2000
compliant would materially adversely affect its business, results of operations
or financial condition.
The Company's project team is in the process of developing a contingency
plan, which will be completed by March 31, 1999, to prepare for the possibility
a) that any of the Company's systems or programs will fail to be Year 2000
compliant; or b) that any of the parties with which the Company or its
affiliated physician organizations have significant business relationships
(hospitals, HMOs or third-party payors as described above) will fail to be Year
2000 compliant. See "Risk Factors--Year 2000 Risks."
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BUSINESS OF THE COMPANY
GENERAL
The Company manages and administers physician organizations (i.e., medical
groups and independent practice associations) that have entered into agreements
with HMOs to provide physician and certain ancillary health care services to HMO
members under capitated or prepaid fee arrangements. Management services are
provided by the Company to each affiliated physician organization pursuant to a
long-term management services agreement. Under this long-term management
services agreement, the Company provides the physician organization with certain
management and administrative support services, such as claims administration,
utilization management and quality assurance, case management, data collection
and management information systems and payor and provider contracting. The
Company also provides its affiliated medical groups with leased premises,
furniture, fixtures, equipment and personnel (which the Company does not provide
its affiliated independent practice associations, as such associations are
operated as separate businesses with respect to these items). In order to
provide the Company with financial security under its management services
agreements, the Company enters into an assignable option agreement with each of
its affiliated physician organizations which gives the Company the right at any
time to designate the physician or physicians who will own the physician
organization. See "--The Affiliated Physician Organizations--MANAGEMENT
SERVICES" and "--ASSIGNABLE OPTION AGREEMENTS."
Physician organizations increasingly are responding to the cost-containment
pressures within the managed care industry (see "--Managed Care Industry
Overview") by affiliating with organizations such as the Company. The Company's
management services are intended to allow affiliated physician organizations to
deliver required medical services in a more cost-effective manner. Management
believes that cost savings can be generated without adversely affecting the
quality of care provided by the physician organizations by, for example,
managing the risk for hospital services as well as physician and ancillary
health care services, negotiating favorable HMO and provider contracts, and
generating operating efficiencies. See "--Strategy of the Company." The
Company's fee arrangements with affiliated physician organizations are
structured so as to allow the Company to benefit from the savings so obtained.
See "--The Affiliated Physician Organizations--MANAGEMENT SERVICES".
The Company's management and administrative functions are performed by its
wholly-owned subsidiaries, Prospect Medical Systems and Sierra Medical
Management. Prospect Medical Systems conducts its operations in Orange, Los
Angeles, Ventura and Santa Barbara Counties of Southern California and currently
manages Prospect Medical Group and Santa Ana/Tustin Physicians Group. Sierra
Medical Management conducts its operations in the Antelope Valley region of Los
Angeles County and currently manages Sierra Medical Group (including the assets
acquired from Antelope Valley Medical Group) and Pegasus Medical Group. Under
California law, the Company and its subsidiaries are prohibited both from
engaging in the corporate practice of medicine and from contracting directly
with HMOs. Therefore, the physician organizations with which the Company
affiliates (see "--The Affiliated Physician Organizations") enter into all HMO
contracts and hire and contract with physicians and ancillary health care
service providers in order to provide the medical services which such physician
organizations are obligated to provide under their HMO contracts. See "--The
Affiliated Physician Organizations--PROVIDER AGREEMENTS." The non-physician
components of hospitalization are provided to the enrollees by hospitals that
contract with and are paid by the HMOs. Currently, the Company's affiliated
physician organizations have contracts with approximately 17 HMOs, from which
the Company's consolidated revenue is primarily derived.
The Company's primary growth strategy includes the acquisition by its
affiliated physician organizations of other medical groups and independent
practice associations. See "--Strategy of the Company." Since July 31, 1996,
when current management assumed control of the Company, the number of enrollees
served by the Company's affiliated physician organizations has increased from
approximately 6,800 to approximately 97,000 as of June 30, 1998, and over
100,000 as of July 31, 1998, principally through four
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strategic acquisitions. As of June 30, 1998, the affiliated physician
organizations provided services through approximately 350 primary care
physicians and 1,390 specialists in the Company's provider network. See
"--History of the Company."
In effecting an acquisition, the Company's affiliated physician
organizations generally acquire certain medical assets, including HMO contracts,
provider contracts and patient records, from an acquisition candidate in
consideration for cash, promissory notes and/or equity securities of the
Company. If related non-medical assets, such as management contracts, furniture,
fixtures or equipment, non-medical personnel or real property leases, are to be
acquired from a management company affiliated with the acquisition candidate,
these assets are acquired by the Company in consideration for cash, promissory
notes and/or equity securities of the Company. In some cases the affiliated
physician organizations may acquire the outstanding stock of an acquisition
candidate in consideration for cash, promissory notes and/or equity securities
of the Company. With respect to an acquisition by an affiliated physician
organization of the assets or stock of an acquisition candidate, the Company may
advance to the affiliated physician organization all or a portion of the cash
consideration or cash to repay the promissory notes, which advance may not be
repaid, or the affiliated physician organization may apply cash generated by
operations to pay the purchase price.When the Company issues its equity
securities in connection with an acquisition, it does so (i) to limit the amount
of cash expended therefor and/or (ii) to increase the strength of the post-
acquisition ties between the physician owners of the acquisition candidate and
the Company. Upon consummation of an acquisition, the Company enters into a
long-term management services agreement with the newly-acquired physician
organization.
The Company believes that one of its strengths is its experienced
management, which has provided a foundation from which to develop and manage the
Company's current operations and future growth. See "Management of the Company."
Management believes that the Company is viewed more favorably by potential
acquisition candidates because its Chief Executive Officer and President have
been practicing physicians. Its Chief Executive Officer, Jacob Y. Terner, M.D.,
previously served as Chairman of the Board and Chief Executive Officer of
Century MediCorp, a publicly-traded corporation operating through three
wholly-owned HMO subsidiaries, hospitals and an affiliated independent practice
association, until its October 1992 merger with a major publicly-traded HMO. The
Company believes that physician management fosters better relationships with
providers, thereby enhancing existing operations as well as appealing to
potential acquisition candidates. In keeping with the Company's strategy of
"corporate clout/local control," the Company typically retains senior management
of the entities which it acquires.
MANAGED CARE INDUSTRY OVERVIEW
Medical services have traditionally been provided on a fee-for-service basis
with insurance companies assuming responsibility for paying all or a portion of
such fees. Over the past decade, however, the costs of medical services have
generally risen at a higher rate than the consumer price index. As a result,
insurers, employers, state and federal governments and other health insurance
payors have been seeking to reduce or control the sustained increases in health
care costs. The response to these cost increases has been a shift away from the
traditional fee-for-service method of paying for health care, and the resultant
emergence of HMOs and other managed health care organizations which rely on the
concept that prepayment based on prior negotiation is an effective way of
controlling health care costs.
HMOs offer a comprehensive health care benefits package in exchange for a
fixed, prepaid monthly fee or premium per enrollee that does not vary through
the contract period regardless of the quantity or quality of medical services
used. HMOs enroll members by entering into contracts with employer groups or
directly with individuals to provide a broad range of health care services for a
prepaid charge, with minimal or no deductibles or co-payments required of the
members. HMOs, in turn, contract directly with physicians, physician groups,
hospitals and other health care providers to administer medical care to HMO
members. These contracts provide for payment to the provider on either a
discounted fee-for-service or per diem basis, or through a fixed monthly payment
(also referred to as a capitation payment) based on the
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number of members covered, regardless of the actual need for and utilization of
covered services. Under these contracts the provider assumes the financial risk
that all necessary health care services can be provided at a cost less than the
amount paid to the provider by the HMO. These contracts may also include
incentive arrangements from HMOs for efficient utilization of hospital services
or specialist services. Such arrangements include incentive payments to be made
by the HMO or amounts withheld by the HMO from the contracted payment amounts.
These payments or amounts are distributed to the physician organization and
other participants (e.g., the hospital) following a reconciliation of budgeted
expenses against actual expenses. To the extent actual expenses exceed budgeted
expenses, the physician organization and other participants may be required to
contribute additional amounts to pay such expenses.
In states such as California, a provider can only accept risk from an HMO
for those services which the provider is authorized to perform within the scope
of its licensure. Thus, a physician or physician group cannot accept risk for
the provision of hospital services, and a hospital cannot accept risk for
physician or certain ancillary health care services. A provider in California,
however, may obtain a license under Knox-Keene, the same California law that
governs HMOs, and thereby accept risk for both physician and certain ancillary
health care and hospital services.
Practitioners in small to mid-sized physician organizations find themselves
at a competitive disadvantage in the managed care environment. They generally do
not have the market presence, expertise, or sophisticated cost accounting and
quality management systems required for capitated risk-sharing arrangements. In
addition, they often lack the capital required to purchase new medical equipment
and information systems to enhance the efficiency and quality of their
practices. Administrative burdens have been exacerbated by the proliferation of
HMOs, which require physicians to comply with multiple formats for claims
processing, credentialing and other administrative reporting requirements. As a
result, physicians' operating expenses and the number of hours devoted to
non-medical activities have increased.
Physician organizations increasingly are responding to the cost-containment
pressures within the managed care industry by affiliating with organizations,
such as the Company, to control economic risk and perform the non-medical
management and administrative tasks that arise from the practice of medicine in
a managed care setting. These organizations provide management and other
administrative services to physician organizations, including with respect to
personnel, utilization management and quality assurance, case management and
data collection and management information systems. These organizations also
assist physician organizations by negotiating capitation rates and incentive
payment arrangements with HMOs and other payors. These organizations may manage
a portion of the economic risks involved in providing health care or assist
physician organizations that accept full financial risk for all physician and
ancillary health care services to be provided under HMO agreements.
HISTORY OF THE COMPANY
The Company was formed on May 12, 1993 as a Delaware corporation. Following
its formation, the Company (then named Med-Search, Inc.) provided managed care
and medical practice management services to a California professional
corporation doing business as Interstate Care Providers ("ICP"). As of July 31,
1996, ICP had managed care contracts with four HMOs, through which it managed
approximately 6,800 capitated lives, primarily in Ventura County, California.
On July 31, 1996, control of the Company was transferred in a series of
private transactions to certain investors (including Jacob Y. Terner, M.D.) and
to former physician stockholders of Prospect Medical Systems (including Gregg
DeNicola, M.D.). A new Board of Directors was elected and the new Board of
Directors appointed Dr. Terner as the Chairman of the Board and Chief Executive
Officer and Dr. DeNicola as the President. Concurrently with the change of
control, the 1996 Merger was completed. Upon consummation of the 1996 Merger,
the Company's name was changed from "Med-Search, Inc." to "Prospect Medical
Holdings, Inc." The Company raised $2,500,000 in a private transaction to
finance short-term working capital needs immediately after the 1996 Merger.
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Following the 1996 Merger, management began to implement the Company's
growth strategy through a series of acquisitions and affiliations. On July 14,
1997, Prospect Medical Group acquired all of the outstanding shares of stock of
Santa Ana/Tustin Physicians Group for cash consideration of $5,000,000. The
founder and former sole shareholder of Santa Ana/Tustin Physicians Group
continues to serve as its president pursuant to the terms of a two-year
employment agreement. Concurrently, Santa Ana/Tustin Physicians Group signed a
long-term management services agreement with Prospect Medical Systems.
On September 25, 1997, Prospect Medical Group acquired all of the
outstanding shares of stock of Sierra Medical Group. Sierra Medical Management,
Inc. ("Old Sierra") concurrently merged into a wholly-owned subsidiary of
Prospect Medical Holdings, Inc., which subsidiary signed an amended and restated
management services agreement with Sierra Medical Group. The aggregate
consideration paid was $6,500,000 plus promissory notes in the aggregate
principal amount of $2,500,000 and the issuance of 600,000 shares of the
Company's common stock valued at a price of $2.00 per share and options to
purchase 35,000 shares of the Company's common stock at an exercise price of
$5.00 per share. The founders and former shareholders of Sierra Medical Group,
Sinnadurai E. Moorthy, M.D. and Karunyan Arulanantham, M.D., executed three-year
consulting and employment agreements, respectively, with Sierra Medical Group
subsequent to the acquisition. Jayaratnam Jayakumar, the administrator of Sierra
Medical Group, executed a three-year employment agreement with Sierra Medical
Management and has primary responsibility for the day-to-day management of
Sierra Medical Management.
On October 31, 1997, Pegasus Medical Group acquired certain assets of
Western Medical Group located in the same service area as Sierra Medical Group
for aggregate cash consideration of $700,000. Concurrently, Pegasus Medical
Group signed a long-term management services agreement with Sierra Medical
Management.
During June 1998, Sierra Medical Group acquired certain assets of Antelope
Valley Medical Group and the Company acquired certain assets of its related
management company for the aggregate consideration of $500,000 in cash and
$500,000 payable pursuant to promissory notes issued by the Company plus the
issuance of 200,000 shares of Common Stock valued at a price of $5.00 per share.
Antelope Valley Medical Group is located in the same service area as Sierra
Medical Group.
As of July 1, 1998, the Company and Prospect Medical Group entered into the
Yorba Linda Settlement Agreement. Pursuant to the Yorba Linda Settlement
Agreement the physicians who were released from their exclusivity and
noncompetition agreements with Prospect Medical Group returned to the Company an
aggregate of 1,126,323 shares of Common Stock that was previously issued to them
and repaid to Prospect Medical Group approximately $60,000. See "Risk
Factors--Recent Settlement Agreement with Yorba Linda Medical Group," "Unaudited
Pro Forma Financial Information" and "Management's Discussion and Analysis of
Financial Condition and Results of Operations" for a description of the
anticipated effect of the Yorba Linda Settlement Agreement on the results of
operations, financial condition and cash flows of the Company.
STRATEGY OF THE COMPANY
The Company believes that the managed care industry operates most
effectively on a regional basis, and is affected most by provider competition,
physician referral patterns, custom and practice and local hospital
relationships. Management believes that developing a significant local market
presence permits economies of scale and greater efficiencies through
centralization of operations. Management believes there is more economic
opportunity in developed rather than in undeveloped managed care markets because
(i) physicians and hospitals in developed markets have established practice and
referral patterns that are consistent with providing services within a managed
care framework and (ii) there is generally a higher concentration of physicians
and hospitals in a developed market, creating a more competitive environment
with greater opportunities for the Company and its affiliated physician
organizations to negotiate more favorable provider contracts. The Company has
selected Southern California as the initial
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primary service area for its operations because management believes that
Southern California is a highly-developed managed care market.
Management of the Company intends to focus on the following factors in
seeking to achieve its business strategy. These factors relate primarily to the
expansion of the Company's business through acquisitions by its affiliated
physician organizations and establishment of a licensed health plan as well as
increasing operating efficiencies.
ACQUISITIONS. The Company views the acquisition and incorporation of
additional physician organizations with a concentration of managed care patients
into its provider network as the most direct route to size and stability. The
Company is focusing on physician organizations with approximately 10,000 or more
capitated HMO enrollees as possible acquisition candidates. The criteria which
the Company has developed to assess potential acquisitions for its affiliated
physician organizations include (i) either a history of profitable operation or
a compelling synergy with opportunities for economies of scale through combining
operations; (ii) either geographic proximity to the current operations of the
Company's affiliated physician organizations or a material share of the
acquisition candidate's own local marketplace; (iii) a favorable hospital
relationship in which the interests of the hospital and the acquisition
candidate are aligned so as to discourage overutilization of hospital services,
thereby increasing the amount of HMO bonus pool monies potentially available to
the acquisition candidate; and/or (iv) willingness of the acquisition
candidate's management to continue in a management role with the acquired entity
following its acquisition. The Company also intends to increase its operations
through the acquisition of additional management companies in order to create a
regional network to provide management services to additional physician
organizations. However, there can be no assurance that any definitive agreements
will be executed or that any such acquisitions or affiliations will be
consummated.
The Company believes that it will be able to continue to attract physician
organizations by (i) offering the affiliated physicians of the incorporated
entities the benefits of payor contracts negotiated by the Company on behalf of
one of the Company's affiliated physician organizations, together with the
opportunity to build a larger patient base; (ii) allowing physicians who are
otherwise reluctant to associate with management companies an opportunity to
retain more substantial control over the non-medical aspects of the operations
and management of their practice of medicine than afforded to physicians by
other management companies; and (iii) relieving physicians from the
administrative burden imposed by compliance with a variety of HMO contracts. At
the same time, the Company can offer to these physicians the benefits of
improved information resulting from its centralized management information
systems, accounting and other financial services.
INTERNAL GROWTH. Management of the Company also intends to grow through the
addition of new enrollees to its service network. The Company provides marketing
services to its affiliated physician organizations to promote such growth. With
respect to Prospect Medical Group, the Company seeks to increase its enrollment
through the development of relationships with sales representatives and
marketing directors of HMOs and marketing directors and administrators of
hospitals. Representatives of Prospect Medical Group attend health fairs and
community and other events directed at commercial and Medicare enrollees and
seek to attend these fairs and events as representatives of the sole physician
organization whenever possible. The Company has also established a speakers
bureau to make the physicians of Prospect Medical Group available to speak at
public events. In addition, the Company has set up a Web page for Prospect
Medical Group and is in the process of expanding its Web page. The Company
intends to develop similar marketing programs for Sierra Medical Group, Santa
Ana/Tustin Physicians Group and Pegasus Medical Group.
EXPANDING SCOPE OF LICENSURE; ESTABLISHING A FULL-RISK HEALTH PLAN. Under
applicable California law, the Company's affiliated physician organizations can
accept risk under their contracts with HMOs only with respect to services which
are within the scope of their licensure, such as physician and ancillary health
care services. The affiliated physician organizations cannot accept risk from an
HMO with respect to
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services which are currently outside of the scope of their licensure, such as
hospital services. The HMOs which now contract with the Company's affiliated
physician organizations for physician services must contract directly with
hospitals for hospital services, which deprives the Company and its affiliated
physician organizations of control over the way in which such services are
provided and managed.
As part of its future strategy, the Company intends, either directly or
through an affiliated physician organization, to seek to obtain the state
regulatory approvals necessary to establish a licensed health plan in order to
provide and manage both hospital and physician and ancillary health care
services. As a health plan, the Company or its affiliate would receive a fixed
payment in return for full responsibility to provide and pay for all hospital,
physician and ancillary health care services. By managing full risk the Company
believes that it can achieve greater control over patient care through its
utilization management and quality assurance protocols.
The Company intends as a health plan to seek to allocate the risk for
hospital services to the hospitals within its inpatient provider network by
entering into fixed fee or capitated payment arrangements. All other services
not provided directly by an affiliated physician organization would be
subcontracted out to other providers; the Company intends to seek to use fixed
fee schedules that include per diems, case rates and other favorable
arrangements. The profitability of any licensed health plan established by the
Company will be dependent upon the ability of the Company to negotiate favorable
arrangements with hospitals and other subcontractors. There can be no assurance,
however, that any hospital or other subcontractor will agree to provide such
services on a fixed fee or capitated payment basis or upon terms otherwise
favorable to the Company.
In order to be able to provide hospital, physician and ancillary health care
services on a full-risk basis under California law, the Company expects to seek
a form of Knox-Keene HMO licensure known as a "limited license" or a "license
with waivers." The holder of a limited license under Knox-Keene may provide
services on a full-risk basis to commercial, Medicare and/or Medicaid members of
other (fully-licensed) plans and is precluded from contracting directly with
subscribers. A limited Knox-Keene health care service plan license, unlike a
full Knox-Keene health care service plan license, would not permit the Company
to market directly to employer groups to promote its health plan. With such a
license, the Company must enter into contracts with fully-licensed health plans
and can provide services only to the members of the plans with which it
contracts. The fully-licensed HMO performs all advertising and marketing
functions, collects all premiums from the purchasers of plan services and
performs certain administrative services that vary by HMO. The Company expects
that such a limited license would be easier to obtain than a full license,
although no assurances can be given that even the limited license is obtainable
by the Company or an affiliated physician organization, and would forestall
direct competition between the Company and the HMOs with which it contracts.
Upon obtaining the required licensure, the Company believes that it or its
affiliate will be able to obtain full-risk contracts with HMOs, although no
assurances can be given.
Subsequent to the current year, the Company might seek a full Knox-Keene
license in order to market directly to, and collect premiums from, Medicare
enrollees (but not commercial enrollees). It is expected that this form of
license would permit the Company to both operate as a Medicare Health Plan (as
defined below) certified by the United States Department of Health and Human
Services, Health Care Financing Administration ("HCFA") and to accept full risk
from other fully-licensed plans as if it held a limited license as described
above. To date, however, no health plan has received such a license, and no
assurance can be given that such a license can be obtained. While such a license
may be harder to obtain, it would enable the Company's health plan to contract
directly with HCFA (the federal governmental agency responsible for
administering and overseeing the Medicare program) to serve Medicare
beneficiaries under the Medicare+Choice program established under the Budget Act
to give Medicare beneficiaries health plan options in addition to the original
Medicare fee-for-service program and already existing Medicare HMOs.
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One of the plan categories available to members under the Medicare+Choice
program is the Coordinated Care Plan, which includes HMO plans,
provider-sponsored organization ("PSO") plans, and preferred-provider
organization plans. A PSO is an entity that is established or organized and
operated by a provider or group of affiliated health care providers and must be
majority-owned by affiliated health care providers. A Medicare+Choice
Coordinated Care Plan (a "Medicare Health Plan") contracts directly with HCFA to
provide hospital, physician and ancillary health care services to Medicare
beneficiaries. A Medicare Health Plan is allowed to provide services on behalf
of only one payor (HCFA) and only one enrollee population (Medicare
beneficiaries). A Medicare Health Plan performs all advertising and marketing
functions and collects all premiums from enrollees. As a result, the formation
of a Medicare Health Plan could potentially place the Company in competition for
Medicare beneficiaries with the HMOs now contracting with the Company's
affiliated physician organizations. The Company is continuing to evaluate
whether to form and develop a Medicare Health Plan, as the Company does not
intend to operate a Medicare Health Plan in a manner that would interfere with
the established relationships of its affiliated physician organizations with
their contracting HMOs.
A Medicare Health Plan is required to obtain certification from HCFA. The
Company or an affiliated physician organization may apply for licensure as a
Medicare Health Plan to serve Medicare beneficiaries within its service area who
currently are not served by providers within its network. In addition, in
California, Medicare Health Plans which are HMO plans or PSO plans must be
licensed as Knox-Keene health care service plans. To date, however, no PSO has
been licensed under Knox-Keene, and no assurances can be given that such a
license can be obtained.
As described under "--Governmental Regulation," once the Company or its
affiliate has obtained a license under Knox-Keene, whatever its form, the
Company or its affiliate will be subject to continuing regulation by the DOC and
must continue to meet certain operating requirements. The Company believes that
the management information system that it is currently implementing and the
infrastructure that it has developed will satisfy a substantial portion of the
data reporting and organizational and administrative capacity requirements to
assume full risk as a limited license Knox-Keene plan, or to assist an
affiliated physician organization to meet such requirements. There can be no
assurance, however, that the Company or its affiliate will be able to obtain the
required license or to satisfy any other regulatory requirements. See
"--Governmental Regulation."
Management of the Company anticipates that state licensure for a health plan
under Knox-Keene could occur in six to twelve months. To finance all or a
portion of the cost of formation and development of a licensed health plan, the
Company intends to apply, or loan to an affiliated physician organization, a
portion of the proceeds from this Offering; the Company intends to finance the
remainder of such cost from borrowings under the Facility. No assurance can be
given that the Company or an affiliated physician organization will be able to
obtain a Knox-Keene license or that sufficient funds will be available to
finance the associated costs, including amounts required to satisfy regulatory
reserve and working capital requirements. See "--Governmental
Regulation--REGULATORY REQUIREMENTS FOR A LIMITED LICENSE KNOX-KEENE HEALTH
PLAN."
ENHANCED ABILITY TO NEGOTIATE FAVORABLE HMO AND PROVIDER
CONTRACTS. Management believes that the most significant benefit of increased
size of its affiliated physician organizations may be the ability to negotiate
HMO and specialist contracts on a more favorable basis. The Company believes
that as its affiliated physician organizations provide services to a larger
number of members of each of their contracting HMOs, the Company's bargaining
power will increase and, as a result, the Company may be able to negotiate more
favorable contract terms, including capitation rates. The Company believes that
the ability to offer a larger number of enrollees to specialist physicians may
also enable its affiliated independent practice associations to contract with
specialist physicians at more competitive rates.
STRENGTHEN PROVIDER NETWORK. Management of the Company also recognizes the
importance of contractual arrangements that strengthen relationships with the
providers. The Company assists its
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affiliated independent practice associations in negotiating agreements with
contracting physicians and other medical providers. The Company seeks to include
in these agreements provisions under which (i) a contracting physician agrees to
refrain from providing physician services to members of HMOs except through
Company-affiliated physician organizations (an exclusivity provision), and (ii)
a contracting physician is required to refrain from soliciting or diverting an
enrollee of a Company-affiliated physician organization to enroll with a
physician organization unaffiliated with the Company (a non-solicitation or
non-diversion provision). Providers are offered higher capitation rates as an
incentive to become an exclusive provider. The Company believes that as of June
30, 1998 approximately 9 of the physicians within its provider network had
exclusivity provisions in their contracts with an affiliated independent
practice association (see "--The Affiliated Physician Organizations"). Certain
other physicians have non-diversion or non-solicitation provisions in their
contracts with an affiliated independent practice association. The Company
believes the inclusion of these provisions strengthens and differentiates its
provider network. No assurances can be given as to the enforceability of these
provisions.
OPERATING EFFICIENCIES. The Company believes that consolidating additional
physician organizations that are acquired by the Company's affiliates will
enable the Company to provide improved management services to the affiliated
physician organizations on a more cost-effective basis. To integrate the newly
acquired physician organizations, the Company intends to centralize the
functions of credentialing, claims, finance, utilization management, quality
assurance and management information systems with the assistance of an on-site
person for quality assurance and utilization review. The Company will evaluate
each acquired physician organization on a case-by-case basis in order to
determine which, if any, administrative and management functions are most
efficiently handled locally.
Since August 1996, the Company has taken several significant steps to
develop its management and operations infrastructure and improve its operating
efficiencies. Infrastructure development has included creation of distinct
departments with specific responsibilities for clinical operations, including
quality management and case management; claims and management information
systems operations; contracting; and independent practice association/medical
management and the appointment of experienced managers for each such department.
DECENTRALIZED MANAGEMENT STRUCTURE. In keeping with the Company's strategy
of "corporate clout/ local control," the Company believes that each physician
organization presents unique management issues and therefore is best served by
decentralized management. As described above, the Company typically retains
senior management of the entities which it acquires or with which it affiliates,
adding additional management personnel as the entity expands. Each physician
organization's physicians continue to maintain full professional control of the
practice of medicine.
ALIGNMENT OF ECONOMIC INTERESTS. The Company intends to issue shares of
Common Stock as all or a portion of the consideration for most future
acquisitions as part of its strategy to give management of entities acquired by
the Company or its affiliates a stake in the Company's future. No assurances can
be given, however, that potential future acquisition candidates will accept
shares of Common Stock.
THE AFFILIATED PHYSICIAN ORGANIZATIONS
The Company provides management and administrative services to the
affiliated physician organizations under long-term management services
agreements that, together with the assignable option agreements, establish an
affiliation relationship. See "--Management Services" for a description of the
management services agreements and "--Assignable Option Agreements" for a
description of the assignable option agreements. The affiliated physician
organizations include medical groups that employ physicians and independent
practice associations that contract with physicians and other medical providers.
As of June 30, 1998, the affiliated physician organizations employed
approximately 28 primary care physicians and 1 specialist and contracted with
approximately 326 primary care physicians and 1,389 specialists.
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Currently, the Company provides management and administrative services to
the four affiliated physician organizations described below (the "Physician
Organizations"). Dr. DeNicola is currently the sole shareholder, a director and
officer of Prospect Medical Group and Prospect Medical Group is the sole
shareholder of the three remaining Physician Organizations.
PROSPECT MEDICAL GROUP. Prospect Medical Group, which includes a medical
group and independent practice association, operates substantially in Orange
County, with smaller operations in Ventura, Santa Barbara and Los Angeles
Counties. As of June 30, 1998, Prospect Medical Group provided professional
medical services to approximately 54,000 enrollees through capitated contracts
with 15 HMOs. If the Yorba Linda Settlement Agreement had been entered into on
or before June 30, 1998, the Company estimates that Prospect Medical Group would
have provided medical services to at least 40,600 enrollees as of June 30, 1998.
In addition, Prospect Medical Group provides limited services on a traditional
fee-for-service basis. See "Management of the Company."
SANTA ANA/TUSTIN PHYSICIANS GROUP. Santa Ana/Tustin Physicians Group is
located in Central Orange County, California. Santa Ana/Tustin Physicians Group
includes a medical group practice composed of primary care physicians located in
Santa Ana, California as well as a physician delivery network consisting of
multiple independent physician practices. As of June 30, 1998, Santa Ana/Tustin
Physicians Group provided professional medical services to approximately 10,400
enrollees through capitated contracts with three HMOs.
SIERRA MEDICAL GROUP. Sierra Medical Group is located in the Antelope
Valley region of Los Angeles County, California. As of June 30, 1998, Sierra
Medical Group provided professional medical services at three offices, located
in the cities of Palmdale and Lancaster, to approximately 27,000 individuals,
including individuals who previously were enrollees of Antelope Valley Medical
Group, assigned to it under contracts with thirteen HMOs as well as other health
care programs. As of June 30, 1998, Sierra Medical Group received approximately
90% of its revenues from managed care contracts with HMOs. The remaining 10% was
made up from fee-for-service revenues.
PEGASUS MEDICAL GROUP. Pegasus Medical Group is located in the Antelope
Valley region of Los Angeles County, California. As of June 30, 1998, Pegasus
Medical Group provided professional medical services to approximately 5,600
persons through capitated contracts with four HMOs.
Set forth below is a chart showing each of the HMOs contracting with the
affiliated Physician Organizations, the number of enrollees of the Physician
Organizations served pursuant to each HMO's contracts and the percentage of the
total number of enrollees of the Physician Organizations served pursuant to each
HMO's contracts as of June 30, 1998. The chart below shows the contracts
covering commercial members, Medicare beneficiaries and Medicaid beneficiaries
as separate contracts although the contracts may be held by the same HMO.
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HMO ENROLLMENT
AS OF JUNE 30, 1998(1)
<TABLE>
<CAPTION>
NUMBER % OF TOTAL NUMBER
HMO CONTRACTS OF ENROLLEES OF ENROLLEES
- -------------------------------------------------------------------------------- ------------- -----------------
<S> <C> <C>
COMMERCIAL
Aetna U.S. Healthcare of California, Inc...................................... 1,834 1.90
California Physicians' Service dba Blue Shield of California/Care America
Southern California, Inc.................................................... 8,815 9.11
Vivahealth, Inc., dba BPS HMO................................................. 364 0.38
Blue Cross of California...................................................... 16,890 17.46
Cigna Healthcare of California, Inc........................................... 10,556 10.91
Foundation Health/Health Net.................................................. 7,291 7.54
Inter Valley Health Plan...................................................... 144 0.15
Maxicare of California, Inc................................................... 2,407 2.49
United Healthcare of California, Inc., formerly known as Metrahealth.......... 3,392 3.51
PacifiCare of California/FHP, Inc............................................. 21,522 22.24
Prudential Health Care Plan of California, Inc................................ 6,967 7.20
Universal Care................................................................ 1,057 1.09
One Health Plan............................................................... 198 .20
Other(2)...................................................................... 43 .04
------ ------
SUBTOTAL...................................................................... 81,480 84.22
MEDICARE
Aetna U.S. Healthcare of California, Inc. Senior.............................. 1,013 1.05
Blue Shield of California/CareAmerica Southern California Inc. Sr............. 374 0.39
Cigna Healthcare of California, Inc. Sr....................................... 371 0.38
FHP, Inc. Sr./PacificCare (Secure Horizons)................................... 6,790 7.02
Other(3)...................................................................... 39 .04
------ ------
SUBTOTAL...................................................................... 8,587 8.88
MEDICAID
California Physicians Service dba Blue Shield of California................... 848 .88
Cal Optima.................................................................... 3,100 3.20
Molina Medical Centers........................................................ 2,731 2.82
------ ------
SUBTOTAL........................................................................ 6,679 6.90
------ ------
GRAND TOTAL..................................................................... 96,746(1) 100.00
------ ------
------ ------
</TABLE>
- ------------------------
(1) Does not reflect the potential loss of an estimated maximum of approximately
13,000 enrollees as a result of the Yorba Linda Settlement Agreement.
(2) Other includes members under Greater Pacific HMO, Inc., HMO California and
UHP Healthcare.
(3) Other includes members under Foundation Health Sr./Health Net Sr., United
Healthcare of California, Inc. Sr., formerly known as Metrahealth Sr., and
Prudential Health Care Plan of California, Inc. Sr.
PROVIDER AGREEMENTS
Decisions regarding patient health care are made exclusively by physicians
who are employees of or contract with the Physician Organizations and are
rendered in connection with guidelines and policies developed and administered
by the medical director of the affiliated medical group. Each independent
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practice association enters into the following types of contracts for the
provision of physician and ancillary health care services:
PRIMARY CARE PHYSICIAN AGREEMENT. This agreement provides that primary care
physicians contracting with an independent practice association are responsible
both for the provision of primary care services to enrollees and for the
decision to refer enrollees to specialists when appropriate. Primary care
physicians receive monthly capitation or reduced fee-for-service payments for
the provision of primary care services to enrollees. An independent practice
association can terminate the primary care physician agreement immediately upon
the occurrence of certain specified events, including suspension, restriction or
revocation of the physician's license to practice medicine in California,
denial, restriction or revocation of medical staff privileges at any hospital
for medical disciplinary reasons, and loss of professional liability insurance,
among others. Either party may terminate the agreement, with cause, upon 30
days' prior written notice. During the term of the agreement, neither party may
terminate the agreement without cause.
SPECIALIST AGREEMENT. This agreement provides that specialty care
physicians contracting with an independent practice association receive either
(i) discounted fee-for-service or case rate payments, or (ii) subcapitated
payments for the provision of specialty services to those enrollees referred to
them by the independent practice association. An independent practice
association can terminate the specialist agreement immediately upon the
occurrence of certain specified events, including suspension, restriction or
revocation of the physician's license to practice medicine in California,
denial, restriction or revocation of medical staff privileges at any hospital
for medical disciplinary reasons, and loss of professional liability insurance,
among others. Generally, either party may terminate the agreement, with or
without cause, upon 90 days' prior written notice.
ANCILLARY PROVIDER AGREEMENT. This agreement provides that ancillary
service providers (generally non-physician providers such as physical
therapists, laboratories, etc.) contracting with an independent practice
association receive monthly capitation or discounted fee-for-service payments
for the provision of services to enrollees on an as-needed basis. Generally,
either party can terminate the ancillary provider agreement, with or without
cause, upon 60 to 90 days' prior written notice.
MANAGEMENT SERVICES
Prospect Medical Systems has executed separate long-term management services
agreements with each of Prospect Medical Group and Santa Ana/Tustin Physicians
Group. Sierra Medical Management has executed separate long-term management
services agreements with Sierra Medical Group and Pegasus Medical Group. Each of
the management services agreements contains terms substantially similar to those
summarized below.
Pursuant to the management services agreements, each Physician Organization
has delegated to the Company the non-physician administrative, management and
support functions that are required by the Physician Organization in the
practice of medicine. As compensation for the services provided to each
Physician Organization pursuant to its respective management services agreement,
the Company receives from the revenues of each Physician Organization (i) the
costs of the Company in providing services and satisfying its obligations
thereunder, plus (ii) an additional percentage of the gross revenues of the
Physician Organization, a fixed fee for marketing and public relations services
and a portion of net pre-tax income or loss of the Physician Organization. If,
after paying the costs of the Company described in clause (i), the Physician
Organization has insufficient working capital to meet its liabilities or other
obligations, then the Company may defer the amount of gross revenues to be paid
to the Company until the Physician Organization is able to meet its obligations
or all or substantially all of the assets of the Physician Organization are
sold.
To secure the payment of all accrued management fees, each Physician
Organization has granted to the Company a security interest in its accounts and
rights to payment. The management services agreements have a thirty (30)-year
term and will renew automatically for successive ten (10)-year terms unless
either party elects to terminate them. The management services agreements are
terminable by the
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unilateral action of the applicable Physician Organization prior to their normal
expiration only for the breach by the Company of its obligations thereunder or
for certain bankruptcy events.
The management services agreements specifically obligate the Company to
provide suitable facilities, fixtures and equipment and non-physician support
personnel (including marketing, clerical, administrative and maintenance
personnel) to each of its affiliated medical groups so that the affiliated
medical groups can adequately provide for all medical services. The Company is
further obligated to provide to the Physician Organizations (including
affiliated independent practice associations) administrative, accounting and
billing services and to assist in all phases of contract administration and
marketing. Under the management services agreements, the Physician Organizations
continue to be solely and exclusively in control of and responsible for all
aspects of the practice of medicine.
The management and administrative services provided under the management
services agreements to the Physician Organizations include the following:
UTILIZATION MANAGEMENT/QUALITY ASSURANCE. Pursuant to the management
services agreements, the Company assists the Physician Organizations with
development and implementation of a utilization and quality management plan. The
Company further implements systems, programs and procedures necessary for the
Physician Organizations and participating providers to perform utilization and
quality management; organizes procedures for prior authorization of elective,
urgent and emergent out-patient ambulatory surgery and hospital procedures;
assists the Physician Organizations with prospective, concurrent and
retrospective review of medical procedures in accordance with their policies and
HMO health plan requirements; provides data regarding the use of outpatient and
inpatient services by the provider to the Physician Organizations and the use of
noncontracting providers; and assists the medical director and the utilization
review/quality assurance committee of each affiliated medical group in
responding to HMO plan member grievances based on the instructions of such
medical director. The protocols followed by the Company in performing its
utilization management and quality assurance functions are derived from the
Milliman and Robertson Ambulatory guidelines and the Inpatient and Surgical Care
guidelines, and the standards established for managed care organizations by the
National Committee for Quality Assurance, respectively.
CASE MANAGEMENT. Case management is a division of the clinical operations
department. The purpose of case management is to coordinate the non-medical
aspects of patient care and facilitate access to specialty care throughout the
continuum of chronic or terminal illness. Patients are referred to case
management by falling into specific disease categories that are high-risk and
require intensive clinical management and coordination. Many such cases also
have potential for consuming a disproportionate amount of resources and
therefore require a collaborative effort from the healthcare team. Case
management develops the non-treatment aspects of the patient's total plan of
care and continuously monitors and reassesses the implementation of such plan.
Services include but are not limited to: coordination of out-of-network care,
coordination of tertiary care, community resource referrals, monitoring of
ongoing rehabilitation, patient education, coordination of access to
family/caregiver support and patient advocacy. The case management staff works
under the pre-established guidelines developed and approved by the governing
board of the Physician Organization under the direction of its medical director.
PHYSICIAN CREDENTIALING. The Company's physician credentialing program
seeks to monitor the physicians within the network. The physician credentialing
program includes the investigation and verification of physicians'
qualifications, credentials and medical staff privileges at the time they are
brought into the network, as well as periodically reviewing competency and
continuing medical education.
MANAGED CARE CONTRACTING. The Company's services are aimed at evaluating,
negotiating and administering agreements with payors, such as prepaid health
plans; negotiating agreements with specialist and ancillary service providers;
negotiating agreements with out-of-area hospital and ancillary providers;
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and coordinating each Physician Organization's network and, with respect to
affiliated medical groups, their office operations.
CLAIMS ADMINISTRATION. The Company possesses complete medical claims
processing capabilities. These capabilities include determining enrollee
eligibility, identifying appropriate benefits, issuing payments to providers,
processing hospital and outpatient facility charges for the payment of claims
and providing and analyzing encounter data.
FINANCIAL SERVICES. The Company has exclusive decision-making authority
with respect to the establishment and preparation of annual budgets for the
practice of each affiliated medical group that reflect in reasonable detail
anticipated revenues and expenses. In consultation with each affiliated medical
group the Company establishes bank accounts for the deposit of all sums received
by each affiliated medical group for services provided to enrollees. In addition
the Company may endorse all checks made payable to each affiliated medical group
and deposit checks and funds; prepare financial statements on a monthly basis;
receive and deposit capitation and other payments received by the Physician
Organizations; calculate primary care capitation and specialty, ancillary and
other payable claims based on the records provided by the participating plans
and prepare checks to pay the amounts due; monitor subscribers or enrollees
exceeding stop loss deductibles and communicate with HMOs orally or in writing
to seek reimbursement on behalf of the Physician Organizations; bill other
payors for coordination of benefits and other third party liability payments;
administer capitation and other distributions from HMOs including auditing and
monitoring of HMO incentive payments; negotiate and settle the Physician
Organizations' share of such payments; establish and maintain IBNR reserves for
the Physician Organizations; and assist the Physician Organizations in
establishing and administering a physician incentive system and a system to
establish and adjust reserves for medical expenses.
BILLING SERVICES. The Company also provides bookkeeping and accounting
services including the preparation, distribution and recording of all bills and
statements for fee-for-service professional services rendered by the Physician
Organizations as well as all reports and forms required by applicable third
party payors; collection of accounts receivable; and submission, processing and
collection of all claims for payment to, and receipt of payments from,
third-party payors. The Physician Organizations at all times have the ultimate
responsibility for setting all fees for professional services provided on a
fee-for-service basis to patients of the practice, as well as establishing the
terms of each managed care contract.
PROVIDER RELATIONS. The Company's services include the preparation,
negotiation and renewal of agreements with each Physician Organization's
providers, and the maintenance of eligibility data in a computerized database.
The Company provides resources to train providers in each Physician
Organization's policies and procedures and assist each Physician Organization in
developing and updating manuals.
MANAGEMENT INFORMATION SYSTEMS. The Company's management information
systems, which support both practice-oriented and administrative functions,
assist management in maintaining control over the significant growth experienced
during the last two years and are critical to the growth which is anticipated in
the future. The Company's newly acquired management information system is a
sophisticated software system specifically designed for managed care. The
Company commenced using the new system on September 1, 1998. Further, the
Company maintains an on-line database that provides inpatient and outpatient
utilization statistics, and patient encounter reporting. The Company believes
that the availability of timely information on utilization patterns improves
physician productivity and effectiveness. This data also plays an integral role
in the physician utilization control process by enabling the medical directors
and utilization control nurses of the affiliated medical groups to monitor case
management decisions, evaluate patient outcomes and monitor utilization trends.
In addition, the Company's management information systems are capable of
performing various administrative functions including insurance verification,
billing, accounts payable and receivable, outside service referrals and
verification, and all third party claims processing. See "Risk
Factors--Dependence on Information Systems."
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PATIENT ELIGIBILITY AND SERVICES. The Company provides a variety of
services related to patient eligibility, including obtaining eligibility lists
from health plans, assisting with the determination of eligibility of patients
for health care coverage prior to the provision of medical services, maintaining
a computerized eligibility database, distributing eligibility reports to and
coordinating health education and wellness programs for enrollees of each
Physician Organization.
PATIENT AND PHYSICIAN RELATIONS. The Company employs staff to aid patients
and physicians in understanding managed care and the nature and extent of
coverages, assist patients in making informed decisions concerning their medical
care and treatment alternatives, and provide support in resolving financial
questions.
MARKETING AND PUBLIC RELATIONS SERVICES. The Company assists each Physician
Organization in the Physician Organization's marketing, public relations and
advertising of the health care services provided by the Physician Organization.
The Company provides and is principally responsible for marketing and
advertising services for each Physician Organization. In providing its marketing
services, the Company is acting solely in its capacity as administrator for the
Physician Organization. All such marketing services are to be conducted in
accordance with the laws, rules, regulations and guidelines of all applicable
governmental and quasi-governmental agencies, including but not limited to the
Medical Board of California.
The Company has the right to decline to manage new medical facilities which
a Physician Organization desires to establish or acquire. Consistent with a
Physician Organization's exclusive control of all aspects of patient medicine,
the Physician Organization retains the right to purchase from outside providers
any equipment, facilities or services not provided by the Company. The Company
is obligated to provide all medical and non-medical supplies reasonably
requested by the Physician Organization.
ASSIGNABLE OPTION AGREEMENTS
In order to provide the Company with financial security under its management
services agreements, the Company enters into an assignable option agreement with
each affiliated physician organization. The assignable option agreement
restricts the affiliated physician organization from transferring or encumbering
its assets and provides the Company, through its wholly-owned subsidiaries,
Prospect Medical Systems and Sierra Medical Management, with the assignable
option to purchase such assets at any time for nominal consideration. Moreover,
the physician organizations are required to affirmatively covenant to conduct
their business and to maintain, protect and use their assets in a manner which
prevents their diminution in value. In addition, the Company, under the terms of
the assignable option agreements, has the assignable right, at all times, to
designate a successor physician or physicians to purchase for nominal
consideration all of the stock of each affiliated physician organization from
its sole nominee shareholder. There is no limitation on who may be named by the
Company as a nominee shareholder except that such person must be a licensed
physician or otherwise permitted by law to hold shares in a professional
corporation. Dr. DeNicola is currently the nominee shareholder, a director and
an officer of Prospect Medical Group and a director and an officer of the
Company. Prospect Medical Group is the nominee shareholder of each of the other
three Physician Organizations. The Company believes that the cumulative effect
of these provisions of the assignable option agreements is to safeguard the
Company's rights under the management services agreements by conferring on the
Company the ultimate power to control all business decisions of the affiliated
physician organizations.
COMPETITION
The managed care industry is highly competitive and is subject to continuing
changes with respect to the manner in which services are provided and how
providers are selected and paid. The Company is subject to significant
competition both in affiliating with physician organizations and in seeking
managed care contracts on behalf of its affiliated physician organizations.
Generally, the Company and its affiliated physician organizations compete with
any entity that contracts with payors for the provision of prepaid
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health care services, including but not limited to (i) other companies that
provide management services to health care providers, (ii) hospitals that
affiliate with one or more physician organizations, (iii) HMOs that employ or
contract directly with physicians and (iv) other physician organizations.
Additionally, the physician organizations with which the Company is affiliated
compete with other medical practices in the areas in which the Company does
business, or is expected to do business in the future. Pressures to reduce the
cost of medical care, through legal reform of the health care system or through
market forces such as the continued expansion of managed care, could adversely
impact the Company's revenues. Further, increased enrollment in prepaid plans
because of health care reform or for other reasons, increased participation by
physicians in group practices and other factors may attract new entrants into
the managed care industry and result in increased competition for the Company.
Certain competitors, including but not limited to MedPartners, Inc., and PhyCor,
Inc. and certain of its subsidiaries are significantly larger and better
capitalized than the Company, provide a wider variety of services, have greater
experience in providing health care management services and have
longer-established relationships with buyers of such services than does the
Company. There can be no assurance that the Company will be able to compete
effectively with such competitors, that additional competitors will not enter
the market, or that such competition will not make it more difficult to enter
into affiliations with physician organizations on terms beneficial to the
Company.
The Company also experiences competition in the recruitment and retention of
qualified physicians and other health care professionals on behalf of its
affiliated physician organizations. There can be no assurance that the Company
will be able to recruit or retain a sufficient number of qualified physicians
and other health care professionals to continue to expand the operation of its
affiliated physician organizations. See "Risk Factors--Highly Competitive
Market."
The Company believes that the principal competitive factors applicable to
all areas of its business are: (i) the number of enrollees in the management
company's network, with a larger number generally enabling the management
company to negotiate with HMOs and other payors for higher capitation rates and
with specialists and ancillary health care service providers for more favorable
contract terms; (ii) the degree of competition among primary care physicians,
specialists, ancillary health care service providers and hospitals in the areas
in which the affiliated physician organizations of the management company
conduct business, with a higher degree of competition enhancing the ability of
the management company to obtain on behalf of its affiliated physician
organizations lower negotiated costs of medical services from such care
providers; (iii) the degree to which the affiliated physician organizations of
the management company are present in the regions they service, as evidenced by,
e.g., the number of local hospitals at which its primary care physicians and
specialists are accorded staff privileges, with a higher degree of presence
generally making such physician organizations more attractive to potential
enrollees; (iv) as a function of the importance of the number of enrollees in
the management company's network, the ability of the management company, on
behalf of its affiliated physician organizations, to identify suitably
synergistic acquisition candidates and to consummate such acquisitions at
reasonable prices and on terms otherwise favorable to its affiliated physician
organizations; and (v) the quality of the management company's management
information systems, technological infrastructure generally and the platform
into which its affiliated physician organizations are rolled upon acquisition.
The Company believes that it is, and will continue to be, able to compete
favorably on the basis of these factors.
GOVERNMENTAL REGULATION
GENERAL HEALTH CARE REGULATIONS. The health care industry is highly
regulated, and there can be no assurance that the regulatory environment in
which the Company operates will not change significantly in the future.
Generally, regulation of health care companies is increasing and health care
transactions continue to be subject to substantial scrutiny by regulatory
authorities. The federal Health Insurance Portability and Accountability Act of
1996 is among the most significant and comprehensive anti-fraud laws to be
enacted. Its provisions create new anti-fraud programs, amend existing
anti-fraud statutes to cover
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more health care providers and to impose greater penalties for violations, and
create new crimes to combat health care fraud and abuse. In addition to
increased scrutiny of fraud and abuse activity, legislation has been introduced,
and in some cases enacted, which may significantly affect the reimbursement of
health care services under certain health care programs. The recently enacted
Budget Act will reduce funds available to the Medicare program by $115 billion
over five years. Federal, state and local officials and legislators continue to
propose a variety of reforms to the health care system. Certain reforms could,
if adopted, have a material adverse effect on the Company.
Both federal and state law, including California law, generally specify who
may practice medicine and limit the scope of relationships between medical
practitioners and other parties. Under these laws, the Company is prohibited
from practicing medicine or exercising control over the provision of medical
services. To comply with such laws, the provider network is organized so that
all physician services are offered by the physicians who are employed by or
contract with a Physician Organization. The Company does not employ physicians
to provide medical services, exert control over medical decision-making or
represent to the public that it offers medical services. The Company has entered
into a separate management services agreement with each of the Physician
Organizations which delegates to the Company the performance of administrative,
management and support functions. These agreements specifically reserve
exclusive control and responsibility for all aspects of the practice of medicine
and the delivery of medical services to the Physician Organizations. See "--The
Affiliated Physician Organizations--MANAGEMENT SERVICES." Further, the Company
has entered into an assignable option agreement with each of the Physician
Organizations which provides the Company with the assignable option to designate
a successor physician or physicians, which person or persons must be permitted
by law to be a shareholder in a professional corporation, to purchase for
nominal consideration all or any portion of the stock of such Physician
Organization. The Company believes that its rights under the assignable option
agreements do not run counter to the prohibitions of the corporate practice of
medicine as (i) the successor designee must be a licensed professional qualified
to own shares of a California professional corporation and (ii) the licensed
professionals engaged by the Physician Organizations retain exclusive control
under the Company's management services agreements over all aspects of the
practice of medicine and delivery of health care services. However, there can be
no assurances that any health care regulatory agency will not interpret the
Company's arrangements under its management services agreements or assignable
option agreements with the Physician Organizations to be in violation of the
prohibition of the corporate practice of medicine.
Further, state law imposes licensing requirements on individual physicians
and on facilities operated by physicians. In addition, federal and state laws
regulate HMOs and other managed care organizations with which the Physician
Organizations may have contracts. Some states also require licensing of third-
party administrators and collection agencies. This may affect the Company's
operations in states in which the Company may seek to do business in the future.
In connection with the existing operations of the Physician Organizations and
their expansion into new markets, the Company believes they are in compliance
with all such laws and regulations and current interpretations thereof, but
there can be no assurance that such laws, regulations or interpretations will
not change in the future or that additional laws and regulations will not be
enacted. The ability of the Company to operate profitably will depend in part
upon the Company and the Physician Organizations obtaining and maintaining all
necessary licenses and other approvals and operating in compliance with
applicable health care regulations.
Subject to limited exceptions, federal anti-kickback legislation prohibits
the offer, payment, solicitation or receipt of any form of remuneration, whether
direct or indirect, in return for, or in order to induce: (i) the referral of a
person for services; (ii) the furnishing or arranging for the furnishing of
items or services; or (iii) the purchase, lease or order of, arranging or
recommending purchasing, leasing or ordering of, any item or service, in each
case, reimbursable under any federally funded health care programs, including
the Medicare or Medicaid programs. A violation of the federal anti-kickback
statute generally requires several elements: (i) the offer, payment,
solicitation, or receipt of remuneration; (ii) the intent to induce referrals;
and (iii) the ability of the parties to make or influence referrals of patients
for
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services reimbursable under federally funded health care programs or to provide
items reimbursable under such programs. Noncompliance with, or violation of, the
federal anti-kickback legislation can result in exclusion from the Medicare and
Medicaid programs and civil and criminal penalties. Many states, including
California, have similar anti-kickback prohibitions with similar penalties.
The Company believes that the fees received for management and
administrative services rendered under its management services agreements are
consistent with the fair market value of such services as established in arms'
length transactions of a similar nature. The Company does not believe that such
fees may be viewed as remuneration for referring or influencing referrals of
patients or services under federally funded health care programs as prohibited
by statute. Further, the Company believes that the methods used by it or its
affiliated physician organizations to acquire the assets or stock of physician
organizations do not violate anti-kickback laws as the consideration paid in
connection therewith is consistent with fair market value in arms' length
transactions of a similar nature and is not designed to induce the referral of
patients. For these reasons, the Company believes that its activities are not in
violation of the anti-kickback legislation. If, however, the Company is deemed
to be in a position to make, influence or receive referrals from or to
physicians, or the Company is deemed to be a provider under such federally
funded health care programs, the operations of the Company could be subject to
scrutiny under the federal and state anti-kickback laws and the Company's
operations could be materially and adversely affected.
The Company also believes that the business operations of its affiliated
physician organizations do not involve the offer, payment, solicitation or
receipt of remuneration to induce referrals of patients. The financial
arrangements between the physician organizations and the primary care physicians
who make referrals do not take into account any referrals between the parties,
are consistent with fair market value as established in arms' length
transactions of a similar nature and are structured to meet safe harbors to the
anti-kickback laws where applicable.
Upon written request, the OIG is authorized to issue advisory opinions,
which clarify whether a proposed arrangement implicates the federal
anti-kickback statute and, if so, whether it fits within a statutory exception
or safe harbor. In April 1998, the OIG issued an advisory opinion under the
federal anti-kickback statute regarding a proposed management services contract
between a management company and a primary care physician organization. Pursuant
to the agreement, the management company would provide facilities, equipment,
billing services, and marketing services to the physician organization, as well
as negotiate on behalf of the physician organization with managed care plans and
establish specialty physician networks to which referrals may be made by the
primary care physicians. The compensation paid to the management company
included a fee based on a percentage of the physician organization's net
revenues, including revenues from business derived from managed care contracts
arranged by the management company. The OIG concluded that the proposed
arrangement was problematic because: (1) percentage of revenue compensation
arrangements may include financial incentives to increase patient referrals
since the revenue includes revenue from business derived from managed care
contracts arranged by the management company and the management company would be
establishing networks of specialist physicians to whom the primary care
physicians would be required to make referrals in some circumstances; (2) the
proposed arrangement contained no safeguards against overutilization, which is
particularly problematic in light of the proposed establishment of provider
networks with required referral arrangements; and (3) percentage of revenue
compensation arrangements may include financial incentives that encourage
abusive billing practices as the management company has an incentive to maximize
the physician organization's revenue. However, the OIG did not rule that the
proposed contract was illegal, noting that it had not received any information
on the proposed arrangement from the management company and that the legality of
the arrangement might depend on the intent of the parties. After studying the
legal implications of the advisory opinion, the Company has revised its standard
management agreement with its affiliated physician organizations to specify a
flat fee payable on a monthly basis as compensation for marketing services.
Further, the capitated compensation arrangements of the Company's
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affiliated physician organizations contain inherent safeguards against
overutilization as they are economically designed to discourage referrals to the
extent medically unnecessary. The Company is also in the process of adopting a
corporate compliance program for it and its affiliated physician organizations
designed to prevent violation of the anti-kickback statute in both acquisitions
and day-to-day operations. Although the Company continues to receive percentage
of revenue remuneration under its management services agreements in
consideration of its provision of management services, the Company believes
that, by providing for flat fee compensation in consideration of its marketing
services, its financial arrangements do not include financial incentives to
increase patient referrals and, further, the compensation arrangements of the
Company's affiliated physician organizations contain inherent safeguards against
and preventatives of overutilization. Accordingly, the Company believes that
such financial and compensation arrangements do not violate the anti-kickback
statutes. However, there can be no assurances that the OIG or any other health
care regulatory agency will not interpret such arrangements to be in violation
of the prohibitions of the anti-kickback statutes.
Federal legislation also restricts the ability of physicians to refer
patients to entities in which or with which they or one of their immediate
family members has an ownership interest or compensation arrangement for the
provision of certain designated health services reimbursable under federally
funded health plans. Further, the entity providing health care services is also
prohibited from presenting, or causing to be presented, a claim or bill for the
designated services furnished pursuant to a prohibited referral. Penalties for
violations include, without limitation, denial of reimbursement, forfeiture of
amounts collected in violation of the provision, civil monetary penalties and
exclusion from the Medicare and Medicaid programs. Many states, including
California, have similar self-referral laws which provide for similar penalties.
The Company does not currently provide any designated health care services
under the self-referral laws and therefore believes that its business
arrangements do not fall within the ambit of the self-referral prohibitions.
Although the Company believes that its operations are in compliance with the
self-referral laws, because the Company provides management services related to
designated health care services provided by its affiliated physician
organizations, there can be no assurance that judicial or administrative
authorities will not find these provisions applicable to the Company's
operations or that the regulatory environment will not change, requiring the
Company to alter its current business relationships. Any such change could have
a material adverse effect on the business, financial condition and results of
operations of the Company. The Company further believes that its affiliated
physician organizations' financial arrangements with physicians are not
violative of the state and federal self-referral laws as: (i) the Company's
affiliated physician organizations do not have a financial interest in any
provider of designated health services, except to the extent that the provision
of such services qualifies for the group practice exception to the self-referral
laws; (ii) physicians engaged by the Company's affiliated independent practice
associations do not control to whom their patient referrals go, as the
independent practice association contracts directly with the providers; and
(iii) the Company's affiliated physician organizations generally contract with
providers of designated health services on a capitated basis and there is
therefore no incentive for the provision of services related to prohibited
referrals.
The federal government continues to engage in increased scrutiny of joint
ventures and other transactions among health care providers in an effort to
reduce potential fraud and abuse relating to patients of federal health care
programs, and no assurances can be given that the Company's operations will not
fall within the ambit of the anti-kickback or self-referral prohibitions or that
other laws or regulations will not be enacted that will have a material adverse
effect on the Company. The application of the anti-kickback and self-referral
laws and regulations to many kinds of business transactions in the health care
industry has not been subject to regulatory or judicial interpretation. Should
any of the Company's business arrangements be deemed to constitute arrangements
designed to induce the referral of Medicare or Medicaid patients or to involve
referrals to entities in which or with which the referring physician has an
ownership interest or compensation arrangement, then such arrangements could be
viewed as violating
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anti-kickback or self-referral laws and regulations. A determination of
liability under any such law could have a material adverse effect on the
Company's business, financial condition and results of operations.
Federal and state laws prohibit anti-competitive conduct among health care
providers within the same or overlapping markets, such as price-fixing
agreements between competitors, agreements allocating or dividing geographic
market areas in which competitors will separately operate, or agreements to
boycott or refuse to deal with another competitor. Such antitrust laws also
prohibit the monopolization of markets, or mergers and other agreements among
competitors intended to monopolize markets. Because the Physician Organizations
remain separate legal entities, they may be deemed to be competitors, and
therefore may be subject to these antitrust laws. In such case, their
activities, including the coordination of their contracting efforts, could
violate antitrust prohibitions. The Company intends to comply with state and
federal antitrust laws, but there is no assurance that the review of the
Company's operations by courts or regulatory authorities will not result in a
determination of anti-competitive conduct that could adversely affect the
operations of the Company and its affiliated physician organizations.
Certain states have enacted statutes or adopted regulations affecting risk
assumption in the health care industry, including statutes and regulations that
subject any physician or physician network engaged in risk-based contracting to
applicable insurance laws and regulations, which may include, among other
things, laws and regulations providing for minimum capital requirements and
other safety and soundness requirements. Managed care arrangements typically
shift some of the economic risk of providing patient care from the person who
pays for the care to the provider of the care by capping fees, requiring reduced
fees, or paying a set fee per patient irrespective of the amount of care
delivered. Under capitated managed care contracts, the physician is typically
paid a predetermined monthly capitation payment amount per patient, per month,
from the payor in exchange for providing all necessary covered services to the
patients covered under the arrangement. This arrangement shifts the risks of
utilization of such services to the physician organization that provides the
health care services. The Company believes that it is in compliance with the
insurance laws and regulations in California where it conducts its business.
Specifically, the Company believes that the negotiation and administration of
managed care contracts and the acceptance of capitation payments by a health
care provider does not constitute the conduct of the business of insurance under
the laws and regulations of that state. However, the application of state
insurance laws to such reimbursement arrangements is an unsettled area of law
and is subject to interpretation by regulators with broad discretion. In the
event the Company or its affiliated physician organizations are determined to be
engaged in the business of insurance, the Company or the affected physician
organizations could be required to either seek licensure as an insurance company
under Knox-Keene or to change the form of their relationships with third-party
payors and may become subject to enforcement actions. Any such event could have
a material adverse effect on the Company's business, financial condition and
results of operations. See "--REGULATORY REQUIREMENTS FOR A LIMITED LICENSE
KNOX-KEENE HEALTH PLAN."
REGULATORY REQUIREMENTS FOR A LIMITED LICENSE KNOX-KEENE HEALTH PLAN. To
operate a health plan in the State of California, an organization must apply for
a license under Knox-Keene from the DOC. All Knox-Keene health care service plan
applicants must demonstrate the projected financial viability of the plan in the
marketplace, and that the proposed business will "break even" within a
reasonable period of time. Traditionally, this is accomplished through market
feasibility studies and letters of interest that support enrollment projections,
actuarial studies that justify medical utilization costs, and comprehensive
financial projections. The DOC requires all plans to demonstrate fiscal
soundness and full assumption of financial risk, which includes (i)
demonstrating that health care rates and charges are financially sound and will
provide for achievement and maintenance of a positive cash flow; (ii) showing
that adequate working capital will be available, including provisions for
contingencies; (iii) providing adequate insurance for extraordinary losses; (iv)
substantiating enrollment projections; (v) projecting financial viability; (vi)
listing the entity's sources of tangible net equity; and (vii) demonstrating
that the overall business plan has been validated by feasibility studies and
actuarial reports.
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The organization must also meet certain quality assurance and utilization
review standards and will be subject to audit by its contracting HMOs. These
audits may be performed by the individual HMOs or by an independent auditor on
behalf of the HMOs. The organization must also implement grievance and complaint
procedures to identify, evaluate and remedy problems relating to access,
continuity and quality of care, and utilization management, and to document that
provider reimbursement exceeds the costs of services expected to be provided.
The organization must also continually demonstrate sufficient organizational and
administrative capacity.
Newly licensed plans are required to maintain a minimum tangible net equity
of $1,000,000. The DOC also expects that a plan will have at least another
$2,000,000 to $3,000,000 available for working capital and expansion needs,
including an amount sufficient to pay for all obligations incurred through a
projected break even date. After the plan becomes operational, tangible net
equity requirements may exceed the above-listed amounts if the annualized
revenues or enrollment of the plan exceed certain criteria.
Once an entity has obtained a license under Knox-Keene, it will be subject
to continuing regulation by the DOC; to assume full risk for the provision of
hospital, physician and ancillary health care services to enrollees, it must
continue to meet certain operating requirements. These requirements include
significant data reporting specifications, particularly regarding financial
viability, quality management and general organizational and administrative
capacity. These requirements may involve significant investment in management
information systems and organizational and administrative capacity.
GENERAL REGULATORY REQUIREMENTS. In addition to the regulations referred to
above, significant aspects of the Company's and its affiliated physician
organizations' operations are subject to state and federal statutes and
regulations governing workplace health and safety, dispensing of controlled
substances and the disposal of medical waste. The operations of the Company and
its affiliated physician organizations may also be affected by changes in
ethical guidelines and operating standards of professional and trade
associations such as the American Medical Association. Accordingly, changes in
existing laws and regulations, adverse judicial or administrative
interpretations of such laws and regulations or enactment of new legislation
could have a material adverse effect on the operating results and financial
condition of the Company.
MALPRACTICE INSURANCE
The Company currently is not covered by malpractice insurance but does carry
general liability insurance. Each of the Company's affiliated medical groups
maintains malpractice insurance as well as managed care professional liability
insurance for the corporate entity and its employees. The Company requires all
physicians who contract with an affiliated independent practice association to
carry malpractice insurance coverage.
EMPLOYEES
At June 30, 1998, Prospect Medical Holdings had approximately 10 full-time
employees. Prospect Medical Systems had approximately 134 full-time and 17
part-time employees. Sierra Medical Management had approximately 95 full-time
and 5 part-time employees. None of such employees is subject to a collective
bargaining agreement. Management believes that its employee relations are good.
PROPERTIES
The Company does not own any real property. The Company or the Physician
Organizations currently lease space for medical and administrative offices as
described in the following charts. The space described below may be shared space
used for medical and administrative office purposes or separate space used for
medical and/or administrative offices located at the same address and may be
leased under the same or separate leases.
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MEDICAL OFFICES
<TABLE>
<CAPTION>
AGGREGATE
SQUARE
FOOTAGE
PRACTICE GROUP (APPX) LOCATION EXPIRATION CURRENT RENT PER MONTH
- ------------------------------------ ----------- -------------------------- ---------- -----------------------
<S> <C> <C> <C> <C>
Prospect Medical Group.............. 10,596 Yorba Linda, California (6 Between Between $1,094 and
Offices) 10/31/98 $5,046 (aggregating
and $16,099 per month)
08/30/01
1,688 Dana Point, California 06/01/01 $3,101
2,800 Mission Viejo, California 06/01/03 $5,320
2,303 Laguna Hills, California 07/31/00 $4,162
4,490 Santa Barbara, California 11/30/97 (1) --
Santa Ana/Tustin Physicians Group... 6,005 Santa Ana, California 07/31/03 $9,608
Sierra Medical Group................ 7,500(2) Lancaster, California 09/24/02 $6,412
3,500 Lancaster, California 09/24/02 $3,600
12,542 Palmdale, California 11/30/01 $12,291
Pegasus Medical Group............... 4,200 Lancaster, California 10/31/02 $3,360
6,500 Palmdale, California 10/30/00 $7,800
</TABLE>
- ------------------------
(1) Landlord is paying Prospect Medical Systems $70,000 to vacate the premises
by March 31, 1998. There is no rent due and payable under this lease.
Prospect Medical Systems is currently seeking comparable medical office
space in Santa Barbara.
(2) The total square footage of the premises is 10,000, of which 7,500 square
feet is used for medical office space and 2,500 square feet is used for
administrative office space. The rent for the entire premises is $8,550,
which amount is apportioned $6,412 for medical office space and $2,137 for
administrative office space for purposes of this chart.
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ADMINISTRATIVE OFFICES
<TABLE>
<CAPTION>
AGGREGATE
SQUARE
FOOTAGE
(APPX) LOCATION EXPIRATION RENT PER MONTH
----------- -------------------------- ---------- -----------------------
<S> <C> <C> <C> <C>
Prospect Medical Holdings........... 2,546 Los Angeles, California 09/30/00 $3,910
(headquarters)
Prospect Medical Systems............ 1,973 Yorba Linda, California (1 11/30/01 $2,664
office)
19,446 Santa Ana, California 11/30/05 $20,807
Sierra Medical Management........... 500 Lancaster, California 09/24/02 $567
2,500(3) Lancaster, California 09/24/02 $2,137
2,200 Lancaster, California 07/31/01 $1,500
</TABLE>
- ------------------------
(3) See footnote 2 above.
Sierra Medical Group owns an approximately 10,000 square foot undeveloped
lot located near its offices in Palmdale, California that is currently used as a
parking lot.
The Company believes that its existing and planned medical and
administrative offices are adequate to support the operations of the Company and
its affiliated physician organizations for the foreseeable future. As the
Company affiliates with, and its affiliated physician organizations acquire,
additional physician organizations, management expects that the Company will
enter into additional medical office space leases.
LEGAL PROCEEDINGS
The Company is a party to certain legal actions arising in the ordinary
course of business. In the opinion of the Company's management, liability, if
any, under these claims is adequately covered by insurance or will not have a
material effect on the Company's financial position or results of operations.
In 1996, 16 physician-shareholders of the Yorba Linda Medical Group became
stockholders of the Company. In connection with this transaction, each of the
physicians entered into written contracts with Prospect Medical Group which
contained certain restrictions upon their activities following the termination
of their relationship with Prospect Medical Group. Specifically, each contract
contained a covenant not to compete, and provisions which prohibited the
solicitation of Prospect Medical Group patients, the diversion of Prospect
Medical Group patients, and the disclosure of confidential trade secret
information. In 1997, the Departing YL Physicians sought to be released from
these restrictive covenants in order to form a new affiliation with one of
Prospect Medical Group's competitors (the "Competitor").
Effective July 1, 1998, a settlement agreement was entered into among the
Company, Prospect Medical Group, Yorba Linda Medical Group, and the Departing YL
Physicians and the other physician shareholders of Yorba Linda Medical Group
(the "Yorba Linda Settlement Agreement"). Prior to execution of the Yorba Linda
Settlement Agreement, an action was filed entitled DENICOLA V. MCGINTY, Orange
County Superior Court Case No. 795018. This was a petition for writ of mandate,
filed by the six physician-shareholders of Yorba Linda Medical Group who were
not seeking to terminate their relationship with Prospect Medical Group, against
Yorba Linda Medical Group and the four physician-shareholders of Yorba Linda
Medical Group who comprised the Yorba Linda Medical Group Board of Directors.
Petitioners sought disclosure of the terms and conditions negotiated between
Yorba Linda Medical Group and the Competitor. As part of the Yorba Linda
Settlement Agreement, the petitioners agreed not to further pursue, and
eventually dismissed, this litigation. On or about August 14, 1998, Yorba Linda
Medical Group and the Departing YL Physicians filed a lawsuit against the
Company, Prospect Medical
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Group, Prospect Medical Systems, Dr. DeNicola and certain other individual
physicians based upon allegations of breach of contract, fraud and certain
related claims with respect to the Yorba Linda Settlement Agreement (MCGINTY V.
PROSPECT MEDICAL GROUP, ET AL., Orange County Superior Court Case No. 798208
(the "MCGINTY Lawsuit")). The relief sought in the complaint in this action
included compensatory damages in an unspecified amount, punitive damages in an
unspecified amount, injunctive relief which would require Prospect Medical Group
to involuntarily transfer certain enrollees to the Competitor, interest, costs,
and attorneys' fees. The MCGINTY Lawsuit was voluntarily dismissed by the
plaintiffs on October 9, 1998. The Company believes that all disputed issues
concerning the Yorba Linda Settlement Agreement have been effectively resolved
as of the date of dismissal of the MCGINTY Lawsuit. See "Risk Factors--Recent
Settlement Agreement with Yorba Linda Medical Group" and "Business of the
Company--History of the Company" for further discussion of the recently executed
Yorba Linda Settlement Agreement.
73
<PAGE>
BENEFICIAL OWNERSHIP OF CAPITAL STOCK
The following table sets forth certain information regarding the beneficial
ownership of the Common Stock, as of July 1, 1998, after giving effect to the
Yorba Linda Settlement Agreement by: (i) each person or entity known by the
Company to own beneficially more than five percent of the Common Stock, (ii)
each of the Company's Directors who beneficially owns shares, (iii) each
executive officer identified in the Summary Compensation Table under "Management
of the Company--Executive Compensation" who beneficially owns shares, and (iv)
all executive officers and Directors as a group. The information presented in
the table is based upon information provided by such persons to the Company. The
share totals reflect a one-for-forty-four reverse stock split which was effected
on July 31, 1996.
<TABLE>
<CAPTION>
NAME AND ADDRESS OF SHARES PERCENTAGE
BENEFICIAL OWNER BENEFICIALLY OWNED(1) OWNED
- ---------------------------------------------- ---------------------------------- ----------
<S> <C> <C>
Paul Amir, Trustee, Herta and ................ 400,406 9.00
Paul Amir Family Trust
8730 Wilshire Blvd, Suite 300
Beverly Hills, California 90211
Karunyan Arulanantham, M.D. .................. 285,750(2) 6.40
44725 10th Street West, Suite 250
Lancaster, California 93534
Jacob Y. Terner, M.D. ........................ 441,295(3) 9.59
Gregg DeNicola, M.D. ......................... 275,127(4) 5.98
David A. Levinsohn ........................... 268,211(5) 5.95
Sinnadurai E. Moorthy, M.D. .................. 285,750(6) 6.40
Kenneth Schwartz ............................. 10,000(7) .22
Thomas A. Maloof(8) .......................... 222,238(9) 4.87
All Executive Officers and Directors ......... 1,708,633(2)(3)(4)(5)(6)(7)(10) 34.80
as a Group (9 persons)
</TABLE>
- ------------------------
(1) Beneficial ownership is determined in accordance with the rules of the
Securities and Exchange Commission and generally includes voting or
investment power with respect to securities. Shares of Common Stock subject
to options or warrants currently exercisable or exercisable within 60 days
are deemed outstanding for purposes of computing the percentage ownership of
the person holding such options or warrants but are not deemed outstanding
for purposes of computing the percentage ownership of any other person.
Except as may be indicated otherwise, and subject to community property laws
where applicable, the persons named in the table above have sole voting and
investment power with respect to all shares of Common Stock shown as
beneficially owned by them.
(2) Includes 15,750 shares of Common Stock issuable upon exercise of options.
Dr. Arulanantham is employed by and is a director of Sierra Medical Group
and is the President of Sierra Medical Management.
(3) Includes 150,000 shares of Common Stock issuable upon exercise of options.
(4) Includes 150,000 shares of Common Stock issuable upon exercise of options.
(5) Includes 60,000 shares of Common Stock issuable upon exercise of options.
(6) Includes 15,750 shares of Common Stock issuable upon exercise of options.
(7) Includes 10,000 shares of Common Stock issuable upon exercise of options.
(8) Thomas A. Maloof resigned as Chief Financial Officer of Prospect Medical
Holdings as of February 28, 1998.
(9) Includes 117,119 shares of Common Stock issuable upon exercise of options.
(10) Includes 58,500 shares of Common Stock issuable upon exercise of options
held by executive officers not named above.
74
<PAGE>
MANAGEMENT OF THE COMPANY
DIRECTORS AND EXECUTIVE OFFICERS
The Board of Directors is classified into three classes. The first class was
elected pursuant to stockholder written consent effective as of the 1996 Merger
to serve until the annual meeting of stockholders to be held in 1997 ("Class I
Directors"), the second class to serve until the annual meeting of stockholders
to be held in 1998 ("Class II Directors") and the third class to serve until the
annual meeting of stockholders to be held in 1996 ("Class III Directors").
Directors will be elected by the stockholders of the Company at each annual
meeting of stockholders and serve until the third annual meeting of stockholders
following their election and until their successors are elected and qualified or
until their earlier removal or resignation. The Company's Certificate of
Incorporation provides that the Board of Directors shall consist of not less
than three nor more than seven persons. David Levinsohn and Kenneth Schwartz
serve as Class I Directors, Dr. Terner and Dr. DeNicola serve as Class II
Directors and Sinnadurai E. Moorthy, M.D. serves as a Class III Director.
Officers of the Company are elected by the Board of Directors and hold office
until their successors are chosen and qualified, or until they resign or have
been removed from office. There are no family relationships between any
directors or current officers of the Company. Officers serve at the discretion
of the Board of Directors.
The following sets forth certain biographical information, the present
occupation and business experience for the past five years of each director and
executive officer:
<TABLE>
<CAPTION>
NAME AGE POSITION WITH THE COMPANY
- ---------------------------------------- --- ---------------------------------------------
<S> <C> <C>
Jacob Y. Terner, M.D.................... 64 Chairman of the Board and Director
Gregg DeNicola, M.D..................... 44 President and Director
R. Stewart Kahn......................... 47 Executive Vice President and Secretary
Donna Vigil............................. 50 Chief Financial Officer
Karunyan Arulanantham, M.D.............. 54 President of Sierra Medical Management
Jayaratnam Jayakumar.................... 49 Executive Vice President of Sierra Medical
Management
Sinnadurai E. Moorthy, M.D.............. 57 Director and Consultant
David Levinsohn......................... 64 Director
Kenneth Schwartz........................ 62 Director
</TABLE>
JACOB Y. TERNER, M.D. Jacob Y. Terner, M.D. is the Chairman of the Board,
Chief Executive Officer and a director of Prospect Medical Holdings. Dr. Terner
has served as a director of Prospect Medical Holdings since July 31, 1996. Dr.
Terner has held the position of Clinical Professor of Obstetrics and Gynecology
at the University of Southern California School of Medicine since 1972. Dr.
Terner also served as Chairman of the Board and Chief Executive Officer of
Century MediCorp, a publicly-traded corporation, until its October 1992 merger
with Foundation Health Corporation. Following such merger, Dr. Terner was named
to Foundation's Board of Directors and served as its Executive Vice President
and as a director, until his resignation in December 1992. Foundation Health
Corporation merged with Health Systems International, Inc. in April 1997.
In September 1992, Dr. Terner entered into an agreement relating to the
issuance of an order by the SEC concerning the late filing of reports of
transactions in the securities of Century MediCorp of which Dr. Terner was then
Chairman of the Board of Directors and Chief Executive Officer. The order found
that Dr. Terner filed reports on Form 4 under Section 16(a) of the Securities
Exchange Act of 1934, as amended (the "1934 Act"), in an untimely fashion
between 1987 and 1991 and required that Dr. Terner cease and desist from any
further late filings.
On June 30, 1997, Dr. Terner consented, without admitting or denying any of
the allegations in a complaint relating to an insider trading investigation by
the SEC, except as specifically set forth therein, to the entry of a final
judgment of permanent injunction and other relief. The SEC's investigation
involved
75
<PAGE>
the trading of Century MediCorp stock in June and/or July 1992 by persons other
than Dr. Terner prior to the public announcement of Century MediCorp's merger
with Foundation Health, a California Health Plan. The judgment permanently
restrained and enjoined Dr. Terner from employing any fraudulent device, scheme
or artifice, making material misstatements or omitting material statements of
fact or engaging in fraudulent or deceitful acts, practices or courses of
business in violation of Section 10(b) of the 1934 Act and Rule 10b-5
thereunder. No allegations were made that Dr. Terner had personally engaged in
the trading of Century MediCorp stock. Dr. Terner was further ordered to pay a
civil penalty in the amount of $225,750 under the Insider Trading and Securities
Fraud Enforcement Act of 1988.
GREGG DENICOLA, M.D. Gregg DeNicola, M.D. has served as President and as a
director of Prospect Medical Holdings since July 31, 1996. Dr. DeNicola is also
a director and the President of Prospect Medical Systems. Dr. DeNicola was one
of the founders of Prospect Medical Group in 1986, and is the sole shareholder
and serves as an officer and director of Prospect Medical Group. Dr. DeNicola
also serves as the Medical Director of Continuing Medical Education at
Placentia-Linda Hospital, is one of the Medical Directors of the Pain program at
St. Jude Hospital, is a clinical faculty volunteer at the University of Southern
California and is Assistant Professor of Medicine, Department of Family
Practice, at the University of California at Irvine.
R. STEWART KAHN. R. Stewart Kahn was appointed by the Board of Directors to
serve as the Executive Vice President of Prospect Medical Holdings effective as
of March 1, 1998 and as Secretary of Prospect Medical Holdings in July 1998.
From 1987 until his appointment as Executive Vice President of Prospect Medical
Holdings, Mr. Kahn was the President and Chief Executive Officer of Legend
Capital Corporation, a consulting firm specializing in financial, marketing and
accounting services in the health care industry.
DONNA VIGIL. Donna Vigil was appointed to serve as the Chief Financial
Officer of the Company effective July 15, 1998. Ms. Vigil served as Chief
Financial Officer of NetSoft from January 1989 to September 1997. She served as
Corporate Controller of Ready Temp Inc. from February 1986 to January 1989. Ms.
Vigil is a certified public accountant.
KARUNYAN ARULANANTHAM, M.D. Karunyan Arulanantham, M.D. currently serves as
the President of Sierra Medical Management and was appointed to this position as
of the closing of the merger of Old Sierra into Sierra Medical Management on
September 25, 1997. Dr. Arulanantham was a shareholder, practicing physician and
officer of Sierra Medical Group from its formation in 1984 to the date of its
acquisition by Prospect Medical Group. Dr. Arulanantham is Board-certified in
Pediatrics, Pediatric Endocrinology and Quality Assurance and Utilization
Review. Dr. Arulanantham is a Fellow of the American Academy of Pediatrics and
the American College of Endocrinologists. He currently serves as an Assistant
Clinical Professor of Pediatrics at the University of California at Los Angeles
and is a member of the Board of Trustees of Palmdale Hospital Medical Center. He
continues to practice medicine and is a provider for Sierra Medical Group.
JAYARATNAM JAYAKUMAR. Jayaratnam Jayakumar currently serves as Executive
Vice President of Sierra Medical Management. Mr. Jayakumar was appointed to
serve as Executive Vice President of Sierra Medical Management effective as of
the closing of the merger of Old Sierra into Sierra Medical Management on
September 25, 1997. Mr. Jayakumar received a Masters in Business Administration
from the University of California at Irvine. From May 15, 1987 to September 25,
1997, Mr. Jayakumar served as the administrator of Old Sierra.
SINNADURAI E. MOORTHY, M.D. Sinnadurai E. Moorthy, M.D. was elected to the
Board of Directors of the Company as of May 1998. Dr. Moorthy was a shareholder,
practicing physician and officer of Sierra Medical Group from its formation in
1984 to the date of its acquisition by Prospect Medical Group. Dr. Moorthy is
currently the Director of Gastroenterology at Lancaster Community Hospital. He
continues to practice medicine and is a provider for Sierra Medical Group.
76
<PAGE>
DAVID LEVINSOHN. David Levinsohn has served as a director of Prospect
Medical Holdings since July 31, 1996. Mr. Levinsohn has been the President and
Chief Executive Officer of Sherman Oaks Health Systems, Inc., d/b/a Sherman Oaks
Hospital and Medical Center ("Sherman Oaks Health Systems") since March 1995.
Prior to being named to such positions, Mr. Levinsohn served as the Chief
Operating Officer of Sherman Oaks Health Systems since May 1994. From November
1993 to May 1994, Mr. Levinsohn was the Vice President of Encino Tarzana Medical
Center. From 1989 until November 1993, Mr. Levinsohn was Executive Director of
Sherman Oaks Hospital. Mr. Levinsohn currently serves on the Board of Directors
of the Coalition of Burn Centers of America.
KENNETH SCHWARTZ. Kenneth Schwartz was elected to the Board of Directors of
the Company in June 1998. Mr. Schwartz served as a director of Deloitte & Touche
LLP from December 1990 to June 1998. He previously served as a member of the
National Management Committee and Managing Partner of the Los Angeles office of
Spicer & Oppenheimer CPA.
The Board may increase the number of its members and appoint one or two
additional independent directors upon consummation of the Offering. The Company
has adopted an Insider Trading Policy to establish guidelines relating to
purchases and sales of the Company's Common Stock.
COMPENSATION OF DIRECTORS
Prospect Medical Holdings compensates its non-employee Directors for their
attendance at Board and committee meetings at $500 per Board meeting and $250
per committee meeting. Employees of the Company who serve on the Board receive
no compensation for attending Board or Board committee meetings.
During the fiscal year ended September 30, 1997, Prospect Medical Holdings
awarded options to purchase 60,000 shares of the Common Stock of Prospect
Medical Holdings at an exercise price of $1.25 per share exercisable for six
years to Mr. Levinsohn in consideration for his services as a director.
During the fiscal year ended September 30, 1998, Prospect Medical Holdings
awarded options to purchase 10,000 shares of the Common Stock of Prospect
Medical Holdings at an exercise price of $5.00 per share exercisable for five
years to Mr. Schwartz in consideration for his services as a director.
COMMITTEES OF THE BOARD OF DIRECTORS
AUDIT COMMITTEE. The Board of Directors has recently established an audit
committee (the "Audit Committee") to make recommendations to management
concerning the engagement of independent public accountants, review with the
independent public accountants the plans and results of the audit engagement,
approve professional services provided by the independent public accountants,
review independence of the independent public accountants, consider the range of
audit and non-audit fees and review the adequacy of the Company's internal
accounting controls. The Board of Directors has appointed Mr. Levinsohn and Mr.
Schwartz to serve on the Audit Committee.
COMPENSATION COMMITTEE. The Board of Directors has established a
compensation committee (the "Compensation Committee") to determine salaries and
incentive compensation of the Company's executive officers and to administer the
Stock Option Plan. The current executive officer salaries were set by the Board
of Directors. The Board of Directors has appointed Mr. Levinsohn and Mr.
Schwartz to serve on the Compensation Committee.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
Prior to July 1, 1998, the Board of Directors, consisting of Dr. Terner and
Dr. DeNicola who are also each officers of the Company, Mr. Maloof (who, until
his resignation on February 28, 1998, was also an officer of the Company) and
Mr. Levinsohn, together acted as the Compensation Committee of the Board.
77
<PAGE>
Certain of the physician executive officers of the Company and its
subsidiaries are the sole stockholder and officers and directors of Prospect
Medical Group, Santa Ana/Tustin Physicians Group, Sierra Medical Group and
Pegasus Medical Group, all of which are Physician Organizations.
The ownership, control and continuous management of the Physician
Organizations are governed in part by agreements (the "Assignable Option
Agreements") entered into by the Company's subsidiaries, the nominee stockholder
of the Physician Organization and each such Physician Organization. The
Assignable Option Agreements prohibit the transfer of stock of the applicable
Physician Organization without the prior written consent of the Company's
subsidiary. Each Assignable Option Agreement terminates upon termination of the
management services agreement between the Physician Organization and the
Company's subsidiary that are parties to such Assignable Option Agreement. See
"Business of the Company-- The Affiliated Physician Organizations--ASSIGNABLE
OPTION AGREEMENTS."
Each Assignable Option Agreement grants to the Company's subsidiary party
thereto an assignable right to designate a successor physician(s), which
person(s) must be duly licensed physicians in the State of California or
otherwise permitted by law to be a shareholder in a professional corporation, to
purchase all or part of the stock of the Physician Organization in its sole
discretion. Gregg DeNicola, M.D., who is a stockholder, director and President
of the Company, is the sole shareholder, President, Chief Financial Officer and
Secretary of Prospect Medical Group. Jacob Y. Terner, M.D., who is a
stockholder, director, Chairman of the Board and Chief Executive Officer of the
Company, is a Vice President of Prospect Medical Group. Prospect Medical Group
is the sole shareholder of the other three Physician Organizations.
During July and September 1997, the Company made two loans of $5,000,000
each to Prospect Medical Group in connection with the acquisitions of Santa
Ana/Tustin Physicians Group and Sierra Medical Group. In October 1997, the
Company made a loan of $700,000 to Pegasus Medical Group in connection with the
acquisition of Western Medical Group. In June 1998, the Company made a loan of
$25,000 to Sierra Medical Group in connection with the acquisition of assets of
Antelope Valley Medical Group. None of such amounts have been repaid. Of these
loans, a loan for a portion of one $5,000,000 loan (in the principal amount of
$3,000,000), the other loan for $5,000,000 and the loan for $700,000 are
required to be repaid on or before July 3, 1999. These loans were structured to
require repayment on July 3, 1999 in accordance with the terms of the Facility.
The maturity of these loans would be extended in connection with an extension of
the maturity of the Facility, which the Company is seeking and which will be
subject to the consent of the Bank. Each of these three loans bears interest at
the rate of 6% per annum. The remaining loans currently bear interest at the
rate of 10% per annum and are repayable on demand. Since these loans are payable
from revenues of the affiliated physician organizations, the Company does not
anticipate that sufficient funds will available to repay such loans or that such
organizations will be able to obtain financing to repay these loans, except in
the event that any such organization or all or substantially all of its assets
are sold. As the Company prepares its financial statements on a consolidated
basis for financial statement reporting purposes, these loans are eliminated in
the consolidation. See "Risk Factors--Need for Additional Capital." All of the
loans are collateralized by the accounts and rights to payment of the applicable
Physician Organization.
EXECUTIVE COMPENSATION
The tables and discussion below set forth information about the compensation
awarded to, earned by, or paid to the Company's Chief Executive Officer and all
of its other executive officers during the fiscal year ended September 30, 1997.
No other compensation was paid to the executive officers of the Company during
the fiscal year ended September 30, 1997.
78
<PAGE>
SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
LONG-TERM COMPENSATION AWARDS
ANNUAL COMPENSATION SHARES UNDERLYING
NAME AND PRINCIPAL POSITION FISCAL YEAR ENDED SALARY BONUS OPTIONS
- ---------------------------------- ---------------------- ---------- --------- ------------------------------
<S> <C> <C> <C> <C>
Jacob Y. Terner, M.D.
Chief Executive Officer......... September 30, 1997 $ -- (1) $ -- 150,000
Gregg DeNicola, M.D. (2)
President and Secretary......... September 30, 1997 $ 300,000 $ -- 150,000
Thomas A. Maloof (3)
Chief Financial Officer......... September 30, 1997 $ 127,000 $ -- 117,119
</TABLE>
- ------------------------
(1) Dr. Terner received an expense reimbursement of $600 per month commencing in
April 1997.
(2) R. Stewart Kahn was appointed to serve as Executive Vice President of
Prospect Medical Holdings effective as of March 1, 1998 and as Secretary of
Prospect Medical Holdings in July 1998.
(3) Thomas A. Maloof resigned as Chief Financial Officer of Prospect Medical
Holdings as of February 28, 1998. Donna Vigil was appointed to serve as
Chief Financial Officer of Prospect Medical Holdings in July 1998.
OPTION GRANTS IN FISCAL YEAR ENDED SEPTEMBER 30, 1997
The following table sets forth information with respect to grants of stock
options to certain executive officers during fiscal year 1997.
<TABLE>
<CAPTION>
POTENTIAL REALIZABLE
PERCENT OF VALUE AT ASSUMED
TOTAL ANNUAL RATES OF
NUMBER OPTIONS STOCK PRICE
OF SHARES GRANTED TO APPRECIATION FOR
UNDERLYING EMPLOYEES EXERCISE PRICE MARKET PRICE OPTION TERM
OPTIONS IN FISCAL PER SHARE ON DATE OF --------------------
NAME GRANTED(1) YEAR ($/SH) GRANT(3) 0% 5%
- --------------------------------------- ----------- --------------- --------------- ------------- --------- ---------
<S> <C> <C> <C> <C> <C> <C>
Jacob Y. Terner, M.D................... 150,000 31 $ 1.25 $ 1.25 $ -0- $ 64,500
Gregg DeNicola, M.D.................... 150,000 31 $ 1.25 $ 1.25 $ -0- $ 64,500
Thomas A. Maloof(2).................... 117,119 25 $ 1.25 $ 1.25 $ -0- $ 50,361
<CAPTION>
NAME 10%
- --------------------------------------- ----------
<S> <C>
Jacob Y. Terner, M.D................... $ 144,000
Gregg DeNicola, M.D.................... $ 144,000
Thomas A. Maloof(2).................... $ 112,434
</TABLE>
- ------------------------
(1) All options were exercisable on October 15, 1996, the date of grant.
(2) Thomas A. Maloof resigned as Chief Financial Officer of Prospect Medical
Holdings as of February 28, 1998.
(3) On the date of grant of the options, there was no active trading market for
the Common Stock. The options were granted with an exercise price which was
determined to be equal to fair market value on the date of grant based on
the per share price in a recent private sale of the Common Stock.
79
<PAGE>
AGGREGATE OPTION EXERCISES AND FISCAL YEAR-END OPTION VALUES
The following table sets forth certain information regarding the year-end
value of options held by certain executive officers. No options were exercised
by such officers during fiscal year 1997.
<TABLE>
<CAPTION>
NUMBER OF VALUE OF UNEXERCISED
UNEXERCISED IN-THE-MONEY
OPTIONS AT FISCAL YEAR OPTIONS AT FISCAL YEAR
END END
SEPTEMBER 30, 1997 SEPTEMBER 30, 1997
NAME (ALL EXERCISABLE) (ALL EXERCISABLE)(2)
- ---------------------------------------------------------------- ------------------------ ------------------------
<S> <C> <C>
Jacob Y. Terner, M.D............................................ 150,000 $ 112,500
Gregg DeNicola, M.D............................................. 150,000 $ 112,500
Thomas A. Maloof(1)............................................. 117,119 $ 87,839
</TABLE>
- ------------------------
(1) Thomas A. Maloof resigned as Chief Financial Officer of Prospect Medical
Holdings as of February 28, 1998.
(2) At September 30, 1997, there was no active trading market for the Common
Stock. Therefore, for illustrative purposes, valuations at that date have
been based on the $2.00 per share price in a recent private sale of the
Common Stock.
STOCK OPTION PLAN
The Board of Directors has recently approved the Stock Option Plan. A total
of 176,000 shares of the Common Stock has been reserved for issuance upon the
exercise of options pursuant to the Stock Option Plan. Such shares may be either
authorized but unissued shares or shares acquired by the Company and held in its
treasury. The Stock Option Plan will be administered by a committee of at least
two members of the Board of Directors, who are not officers or employees of the
Company and who are appointed by the Board of Directors, or by the entire Board
of Directors (the "Committee").
Each option granted under the Stock Option Plan will be either an incentive
stock option intended to qualify under Section 422 of the Internal Revenue Code
of 1986, as amended, or a non-qualified stock option, and will be evidenced by a
Stock Option Agreement between the Company and the optionee. The price to be
paid for shares of stock upon exercise of each option will be determined by the
Committee at the time such option is granted, but shall be not less than the
fair market value of the stock, as determined in accordance with the Stock
Option Plan, on the date the option is granted. The maximum term of each option
will be ten years. The aggregate fair market value of the Common Stock with
respect to which incentive stock options are first exercisable by any single
optionee in any calendar year will be limited to $100,000.
An option under the Stock Option Plan will terminate in the event the holder
ceases to be employed by the Company, except in the case of death or disability.
In the case of death or disability, the option will be permitted to be exercised
within 12 months by the holder, holder's legal representative, executor,
administrator, legatee or heirs, as the case may be. The Board has approved the
grant of options to purchase 111,000 shares of Common Stock under the Stock
Option Plan. The Company may issue options to Mr. Kahn, Ms. Vigil and Mr.
Schwartz under the Stock Option Plan in replacement for the options previously
granted to him or her.
EMPLOYMENT ARRANGEMENTS
Dr. Terner is compensated pursuant to an Employment Agreement with the
Company effective upon the change of control of management on July 31, 1996 and
expiring on July 30, 1999. Under the terms of this agreement, as amended, Dr.
Terner received no compensation until September 30, 1997, after which time he is
to be compensated at the discretion of the Board. On April 17, 1997, the Board
(with Dr. Terner abstaining) approved an expense reimbursement of $600 per month
to Dr. Terner. In September, 1997 the
80
<PAGE>
Board (with Dr. Terner abstaining) approved compensation of $100,000 per annum
effective as of October 1, 1997. Dr. Terner's compensation may be increased at
the discretion of the Company based on performance criteria established by the
Company.
Dr. DeNicola is compensated pursuant to an Employment Agreement with the
Company effective upon the change of control of management on July 31, 1996 and
expiring on July 30, 1999. Under the terms of this agreement, as amended, Dr.
DeNicola receives base compensation of $300,000 per annum. Dr. DeNicola's
compensation may be increased at the discretion of the Company based on
performance criteria established by the Company. In addition, in the event of a
merger or consolidation in which the Company is not the consolidated or
surviving corporation or a transfer of substantially all of the assets of the
Company, Dr. DeNicola may decide to terminate his Employment Agreement with the
Company. In such event, the Company is obligated to pay Dr. DeNicola an amount
equal to two (2) years salary at the
then current rate of compensation.
Mr. Kahn is compensated at an annual salary of $100,000. Mr. Kahn was
granted options to purchase 30,000 shares of common stock of Prospect Medical
Holdings at an exercise price of $5.00 per share. Options to purchase 10,000
shares vest on each of October 1, 1998, October 1, 1999 and October 1, 2000.
All options are exercisable for five years from the date of grant. Mr. Kahn owns
24,000 shares of common stock of Prospect Medical Holdings.
Ms. Vigil is compensated at an annual salary of $100,000. Ms. Vigil was
granted options to purchase 25,000 shares of common stock of Prospect Medical
Holdings at an exercise price of $5.00 per share. Options to purchase 8,333
shares vest on each of October 1, 1998 and October 1, 1999 and options to
purchase 8,334 shares vest on October 1, 2000. All options are exercisable for
five years from the date of grant.
Dr. Arulanantham is compensated pursuant to an Employment Agreement with
Sierra Medical Group executed on September 25, 1997 which provides for base
compensation of $200,000 per annum. Dr. Arulanantham's compensation may be
increased at the discretion of Sierra Medical Group based on performance
criteria established by Sierra Medical Group.
CONSULTING AGREEMENTS
Dr. Moorthy is compensated pursuant to a Consulting Agreement with Sierra
Medical Group effective March 1, 1998 which provides for base compensation of
$84,400 per annum. Dr. Moorthy's compensation may be increased at the discretion
of Sierra Medical Group based on performance criteria established by Sierra
Medical Group.
CERTAIN TRANSACTIONS
Dr. Moorthy is the sole shareholder and officer and director of S.E.
Moorthy, M.D., Inc., a California professional corporation that provides medical
services, including gastroenterology services, to Sierra Medical Group. During
the period from January 1, 1998 to June 1, 1998, Sierra Medical Group paid
approximately $80,000 to S.E. Moorthy, M.D., Inc., a portion of which was paid
to Dr. Moorthy.
81
<PAGE>
DESCRIPTION OF CAPITAL STOCK
GENERAL
Prospect Medical Holdings is a Delaware corporation. The Company has two
classes of stock: Common Stock and Preferred Stock.
COMMON STOCK
The Company's Certificate of Incorporation currently authorizes the issuance
of 40,000,000 shares of $.01 par value Common Stock, of which 4,449,395 are
currently issued and outstanding, and 904,559 are reserved for issuance (i) upon
the exercise of outstanding options and warrants, (ii) pursuant to the Stock
Option Plan and (iii) in connection with completed acquisitions. Holders of
Common Stock are entitled to one vote, either in person or by proxy, for each
share held of record on all matters submitted to a vote of stockholders.
Except as otherwise provided by law and by the Company's Certificate of
Incorporation, action can be taken by a majority of shares entitled to vote at a
meeting. Holders of Common Stock are entitled to dividends when and as may be
declared by the Board of Directors out of funds legally available therefor, and,
in the event of liquidation or dissolution of the Company, are entitled to share
ratably in the assets of the Company remaining after payment of liabilities and
payment in respect of any preferred stock. Holders of Common Stock have no
conversion, preemptive or other subscription rights, and there are no redemption
or sinking fund provisions with respect to the Common Stock. The outstanding
shares of Common Stock of the Company are fully paid and nonassessable.
PREFERRED STOCK
The Company's Certificate of Incorporation currently authorizes the issuance
of 1,000,000 shares of preferred stock, $.01 par value ("Preferred Stock"),
which may be issued from time to time in one or more series as determined by the
Board of Directors without stockholder approval. The Board of Directors has been
authorized to fix the designation, powers, preferences, and rights of the shares
of each such series and any qualifications, limitations or restrictions thereon.
Preferred Stock could be given voting and conversion rights which would dilute
the voting power and equity of holders of Common Stock and could rank prior to
the Common Stock or a newly created series of Preferred Stock with respect to
dividend rights, rights on liquidation or other rights. The Company has no
current plans for the issuance of any of the shares of authorized Preferred
Stock, and as of the date of this Prospectus, no shares of Preferred Stock are
outstanding.
Such Preferred Stock could create impediments to persons seeking to gain
control of the Company, although there is no present intention to do so. The
issuance of such shares could prevent holders of the Common Stock from receiving
a premium for their shares from a potential third-party acquiror. See "Risk
Factors--Anti-Takeover Effect of Certain Charter and Other Provisions."
WARRANTS
The following summary description of certain provisions of the Warrants is
believed to reflect the material provisions of the Warrants but is not
necessarily complete and is qualified in all respects by reference to the actual
text of the Warrant Agreement between the Company and American Stock Transfer &
Trust Company (the "Warrant Agent"), a copy of which has been filed as an
exhibit to the Registration Statement of which this Prospectus is a part. See
"Available Information."
EXERCISE PRICE AND TERMS. Each Warrant entitles the registered holder
thereof to purchase, at any time commencing , 1999 [the first anniversary
of the Effective Date] until , 2003 [the day immediately preceding the
fifth anniversary of the Effective Date], one share of Common Stock at a price
of $8.40 per share, subject to adjustment in accordance with the anti-dilution
and other provisions referred
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to below. The holder of any Warrant may exercise such Warrant by surrendering
the certificate representing the Warrant to the Warrant Agent, with the
subscription form thereon properly completed and executed, together with payment
of the exercise price. No fractional shares will be issued upon the exercise of
the Warrants. The exercise price of the Warrants bears no relationship to any
objective criteria of value and should in no event be regarded as an indication
of any future market price of the Securities offered hereby.
ADJUSTMENTS. The exercise price and the number of shares of Common Stock
purchasable upon the exercise of the Warrants are subject to adjustment upon the
occurrence of certain events, including stock dividends, stock splits,
combinations or reclassifications of the Common Stock or the sale by the Company
of Common Stock or other securities convertible into Common Stock at a price
below the exercise price of the Warrants. Additionally, an adjustment would be
made in the case of a reclassification or exchange of Common Stock,
consolidation or merger of the Company with or into another corporation (other
than a consolidation or merger in which the Company is the surviving
corporation) or sale of all or substantially all of the assets of the Company,
in order to enable warrantholders to acquire the kind and number of shares of
stock or other securities or property receivable in such event by a holder of
the number of shares of Common Stock that might otherwise have been purchased
upon the exercise of the Warrant.
REDEMPTION PROVISIONS. Commencing , 1999 [the first anniversary of
the Effective Date], the Warrants are subject to redemption by the Company, in
whole but not in part, at $.10 per Warrant on not less than thirty (30) days'
prior written notice to the warrantholders, if the average closing sales price
of the Common Stock as reported on the American Stock Exchange equals or exceeds
$18.00 per share for any twenty (20) trading days within a period of thirty (30)
consecutive trading days ending on the fifth trading day prior to the date of
the notice of redemption. In the event the Company exercises the right to redeem
the Warrants, such Warrants will be exercisable until 5:00 p.m. (New York time)
on the business day immediately preceding the date for redemption fixed in such
notice. If any Warrant called for redemption is not exercised by such time, it
will cease to be exercisable and the holder will be entitled only to the
redemption price.
TRANSFER, EXCHANGE AND EXERCISE. The Warrants are in registered form and
may be presented to the Warrant Agent for transfer, exchange or exercise at any
time on or prior to their expiration date, which is the day immediately
preceding the fifth anniversary of the date of this Prospectus, at which time
the Warrants will become wholly void and of no value. If a market for the
Warrants develops, the holder may sell the Warrants instead of exercising them.
There can be no assurance, however, that a market for the Warrants will develop
or continue.
WARRANTHOLDER NOT A STOCKHOLDER. The Warrants do not confer upon holders
thereof any voting, dividend, or other rights as stockholders of the Company.
MODIFICATION OF WARRANTS. The Company and the Warrant Agent may make such
modifications to the Warrants as they deem appropriate to cure ambiguities or to
make certain corrections or as they deem necessary or desirable that do not
adversely affect the interests of the warrantholders; any other modifications,
supplements or alterations can only be made with the consent in writing of the
warrantholders representing not less than 66 2/3% of the Warrants then
outstanding. The Company may, in its sole discretion, lower the exercise price
of the Warrants for a period of not less than thirty (30) days on not less than
thirty (30) days' prior written notice to the warrantholders and the
Representative. Modification of the number of securities purchasable upon the
exercise of any Warrant, an increase in the exercise price or acceleration of
the expiration date with respect to any Warrant requires the consent of the
applicable warrantholder.
The Warrants are not exercisable unless, at the time of the exercise, the
Company has a current prospectus covering the shares of Common Stock issuable
upon exercise of the Warrants, and such shares
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have been registered, qualified or deemed to be exempt under the securities or
"blue sky" laws of the state of residence of the exercising holder of the
Warrants.
LISTING ON AMERICAN STOCK EXCHANGE
There is no established public trading market for the Common Stock. See
"Risk Factors--Inactive Prior Market for the Common Stock; No Assurance of
American Stock Exchange Listing." The Company intends to make an application for
a listing on the American Stock Exchange. As of the date of this Prospectus, to
obtain an American Stock Exchange listing a company must have a three-year
history of operations; and minimum public distribution of 500,000 shares
together with a minimum of 800 public holders or 1,000,000 shares together with
a minimum of 400 public holders; the minimum bid price for the listed securities
must be $3.00 per share; the minimum market value of the public float (the
shares held by non-insiders) must be at least $15,000,000; and stockholders'
equity must be at least $4,000,000. In the event that the Company is able to
sell all 3,000,000 Shares being offered hereby, it is hoped that the Company
will (on a pro forma basis) satisfy all American Stock Exchange requirements for
a new listing. There can be no assurances however, as to when, if ever, such a
listing may be obtained or if obtained, that an active trading market will
develop. See "Risk Factors--Inactive Prior Market for the Common Stock; No
Assurance of American Stock Exchange Listing."
CERTAIN PROVISIONS OF THE COMPANY'S CERTIFICATE OF INCORPORATION AND BYLAWS
Under the Company's Certificate of Incorporation, the Board of Directors is
divided into three classes which are to be as nearly equal in number as
reasonably possible. The initial term of office of the first class expired at
the 1994 annual meeting of stockholders, the initial term of office of the
second class expired at the 1995 annual meeting of stockholders and the initial
term of office of the third class expired at the 1996 annual meeting of
stockholders. At each annual meeting of stockholders coinciding with the
expiration of the term of office of a class of directors, successor directors
are elected for a term of office to expire at the third succeeding annual
meeting of stockholders after their election. Under the Company's Certificate of
Incorporation, a director holds office until the annual meeting of stockholders
for the year in which his term expires and until his successor shall be elected
and shall qualify. The Company has not held an annual meeting of its
stockholders to elect members to the Board of Directors since the 1996 Merger
that was consummated on July 31, 1996. Under the Delaware General Corporation
Law, or under the California General Corporation Law, to the extent that such
law is applicable, if an annual meeting has not been held to elect directors,
for a period of 13 months (15 months under California law), upon application of
any stockholder or director (a director may apply only under Delaware law), the
Court of Chancery in the State of Delaware or the Superior Court in the State of
California may summarily order a meeting to be held to elect directors. The
directors elected at the 1996 Merger have continued to serve as directors, other
than Thomas A. Maloof who has since resigned. Having a classified Board of
Directors may make it more difficult to effect a change in control of the
Company than if the Board of Directors were not classified with staggered terms.
See "Risk Factors--Anti-Takeover Effect of Certain Charter and Other
Provisions."
Under the Company's Certificate of Incorporation special meetings of the
stockholders for any purpose or purposes may be called at any time only by the
Board of Directors, the Chairman of the Board, or by the Chief Executive Officer
or President of the Company. The Company's Certificate of Incorporation further
provides that any action required or permitted to be taken at any annual or
special meeting of stockholders may not be taken by a written consent of the
stockholders pursuant to the Delaware General Corporation Law, unless such
action by written consent is authorized by resolution of the Board of Directors
of the Company. Since the stockholders of the Company do not have the right to
call a special stockholders' meeting, this requirement in the Company's
Certificate of Incorporation for Board of Directors' authorization of
stockholders' action by written consent eliminates the ability of stockholders
of the Company to take any actions independently of the Board of Directors of
the Company. See "Risk Factors--Anti-Takeover Effect of Certain Charter and
Other Provisions."
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The Company's Certificate of Incorporation also provides that certain
provisions thereof may not be amended, altered, changed or repealed without the
affirmative vote of the holders of not less than 75% of the outstanding shares
of Company stock entitled to vote. Under the Company's Certificate of
Incorporation and the Company's Bylaws, the Company's Bylaws may be adopted,
amended or repealed by the affirmative vote of the holders of 75% of the
outstanding shares and, subject to the rights of the Company's stockholders to
adopt, amend or repeal bylaws pursuant to the Delaware General Corporation Law,
the Board of Directors may adopt, amend or repeal the Company's Bylaws.
LIMITATION OF LIABILITY OF DIRECTORS
Under the Delaware General Corporation Law, a director's liability cannot be
eliminated or limited: (i) for breaches of duty of loyalty, (ii) for acts or
omissions not in good faith or which involve intentional misconduct or a knowing
violation of law, (iii) for the payment of unlawful dividends or expenditure of
funds for unlawful stock purchases or redemptions, or (iv) for transactions from
which the director derived an improper personal benefit. Under the Company's
Certificate of Incorporation no director of the Company shall be personally
liable to the Company or its stockholders for monetary damages for any breach of
fiduciary duty by such director as a director. The Company's Certificate of
Incorporation further provides that notwithstanding the foregoing a director
shall be liable to the extent provided by applicable law as described in clauses
(i) through (iv) above. This provision, in effect, eliminates the rights of the
Company and its stockholders (through stockholders' derivative suits on behalf
of the Company) to recover monetary damages from a director for breach of his or
her fiduciary duty of care as a director, except in the situations set forth in
clauses (i) through (iv) above. In addition, the Certificate of Incorporation
does not alter the liability of directors under federal securities laws, and
does not limit or eliminate the rights of the Company or any stockholder to seek
non-monetary relief, such as an injunction or rescission, in the event of a
breach in a director's duty of care. The Certificate of Incorporation requires
the Company to indemnify all directors and officers of the Company to the
fullest extent permitted by law, provided, however, that, with certain limited
exceptions, the Company will only indemnify an officer or director in connection
with a proceeding that was authorized by the Board of Directors. The Bylaws also
authorize the Company to indemnify and advance indemnification expenses to the
Company's officers and directors.
The Company's Certificate of Incorporation further provides that if and to
the extent final legal determination is ever made that and for so long as
Section 204(a)(10) or Section 317 of the California Corporations Code are
applicable to the Company, the provision of the Company's Certificate of
Incorporation relating to limitation of a director's liability for monetary
damages and the provisions relating to indemnification set forth therein will
apply only to the extent permissible under Sections 204(a)(10) and 317 of the
California Corporations Code.
TRANSACTIONS WITH INTERESTED PERSONS
Section 203 of the Delaware General Corporation Law regulates certain
"business combinations" involving Delaware corporations. Generally, Section 203
of the Delaware General Corporation Law prohibits a publicly held Delaware
corporation from engaging in a broad range of "business combinations" with an
"interested stockholder" (defined generally as a person owning 15% or more of
the corporation's outstanding voting stock) for three years following the date
such person became an interested stockholder unless (i) before the person
becomes an interested stockholder, the transaction resulting in such person
becoming an interested stockholder or the business combination is approved by
the board of directors of the corporation, (ii) upon consummation of the
transaction which resulted in the stockholder becoming an interested
stockholder, the interested stockholder owned at least 85% of the outstanding
voting stock of the corporation (excluding shares owned by directors who are
also officers of the corporation or shares held by employee stock plans that do
not provide employees with the right to determine confidentially
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whether shares held subject to the plan will be tendered in a tender offer or
exchange offer) or (iii) on or after such date on which such person became an
interested stockholder the business combination is approved by the board of
directors and authorized at an annual or special meeting, and not by written
consent, by the affirmative vote of at least 66 2/3% of the outstanding voting
stock excluding shares owned by the interested stockholder. The restrictions of
Section 203 do not apply, among other reasons, if a corporation, by action of
its stockholders, adopts an amendment to its certificate of incorporation or
bylaws expressly electing not to be governed by Section 203, provided that, in
addition to any other vote required by law, such amendment to the certificate of
incorporation or bylaws must be approved by the affirmative vote of a majority
of the shares entitled to vote. Moreover, an amendment so adopted generally is
not effective until twelve months after its adoption and does not apply to any
business combination between the corporation and any person who became an
interested stockholder of such corporation on or prior to such adoption. The
Company's Certificate of Incorporation and Bylaws do not currently contain any
provisions electing not to be governed by Section 203 of the Delaware General
Corporation Law.
These provisions are intended to make unsolicited takeover bids more
difficult, even if desired by holders of a majority of the outstanding shares.
However, these provisions also make it more difficult to remove incumbent
directors.
Section 203 applies only to Delaware corporations that have a class of
voting stock that is listed on a national securities exchange, are quoted on an
inter-dealer quotation system such as Nasdaq or are held of record by more than
2,000 stockholders. Since the Company currently does not have a class of voting
stock that is listed on a national securities exchange or is quoted on an
inter-dealer quotation system such as Nasdaq, and has fewer than 2,000
stockholders of record, Section 203 does not currently apply to the Company.
Following the Offering, however, if the Company's application for listing on the
American Stock Exchange is granted or the Company has 2,000 or more stockholders
of record, Section 203 would apply to the Company in the absence of an amendment
to the Company's Certificate of Incorporation or Bylaws as described above.
Section 203 is subject to possible challenge in takeover disputes, and it is
not yet clear whether and to what extent its constitutionality will be upheld by
the courts. Although the United States District Court for the District of
Delaware has consistently upheld the constitutionality of Section 203, the
Delaware Supreme Court has not yet considered the issue. The Company believes
that so long as the constitutionality of Section 203 is upheld, Section 203 will
(if applicable to the Company) encourage any potential acquiror to negotiate
with the Company's Board of Directors. Section 203 would also have the effect of
limiting the ability of a potential acquiror to make a two-step bid for the
Company in which all stockholders are not treated equally. The application of
Section 203 to the Company would confer upon the Board of Directors the power to
reject a proposed business combination, even though a potential acquiror may be
offering a substantial premium for the Company's shares over the then current
market price. Section 203 could also discourage certain potential acquirors
unwilling to comply with its provisions.
Apart from the restrictions set forth in Section 203 of the Delaware General
Corporation Law, the Company's Certificate of Incorporation includes
restrictions on transactions between "Interested Persons" (as described below)
and the Company. In general, these provisions prevent an "Interested Person"
from engaging in these business combinations with the Company, unless certain
stockholder approvals, including approval by stockholders other than the
interested stockholders, have been obtained.
Under the Company's Certificate of Incorporation, an "Interested Person" is
any person, firm or corporation, or any group thereof, acting or intending to
act in concert, including any person directly or indirectly controlling or
controlled by or under direct or indirect common control with such person, firm,
or corporation or group, which owns of record or beneficially, directly or
indirectly, five percent (5%) or more of the shares of any class of voting
securities of the Company.
Under the Company's Certificate of Incorporation, except as set forth in the
following paragraph, the affirmative vote of the holders of 75% of the
outstanding shares of the Company entitled to vote on the
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applicable record date is required for: (i) any merger or consolidation to which
the Company, or any of its subsidiaries, and an Interested Person are parties;
(ii) any sale, lease, exchange or other disposition by the Company, or any of
its subsidiaries, of all or substantially all of the Company's or its
subsidiaries' assets to an Interested Person; (iii) any purchase or other
acquisition by the Company, or any of its subsidiaries, of assets or stock of an
Interested Person, the aggregate purchase price of which exceeds $20,000,000;
and (iv) any other transaction with an Interested Person which requires the
approval of the stockholders of the Company under the Delaware General
Corporation Law, as in effect from time to time.
The provisions of the preceding paragraph are not applicable to any
transaction described therein if the transaction is approved by resolution of
the Board of Directors, provided that a majority of the members of the Board of
Directors voting for the approval of such transaction are duly elected and
acting members of the Board of Directors prior to the time that the person, firm
or corporation, or any group thereof, with whom such transaction is proposed,
became an Interested Person.
CERTAIN PROVISIONS OF CALIFORNIA LAW
The Company is a corporation organized under the laws of Delaware and
generally the laws of the state of incorporation govern the corporate operations
of a corporation and the rights of its stockholders. Certain provisions of the
California Corporations Code may become applicable to a corporation incorporated
outside of California, however, if (i) the corporation transacts intrastate
business in California and the average of its California property, payroll and
sales factors (as defined in the California Revenue and Taxation Code) with
respect to it is more than 50% during its latest fiscal year, (ii) more than
one-half of its outstanding voting securities are held of record by persons
having addresses in California and (iii) the corporation is not otherwise
exempt. An exemption is provided if the corporation has outstanding securities
listed on the American Stock Exchange (a "Listed Corporation").
The Company intends to apply to list its Common Stock on the American Stock
Exchange. However, no assurances can be given that the Company's application
will be granted. If granted, the Company would be exempt as a Listed
Corporation.
Except as discussed herein, provisions of California law which could be
applicable to the Company if the Company meets these tests and is not exempt as
a Listed Corporation include, without limitation, those provisions relating to
the stockholders' right to cumulative votes in elections of directors
(cumulative voting is mandatory under California law), and the Company's ability
to indemnify its officers, directors and employees (which is more limited in
California than in Delaware). Notwithstanding the foregoing, a corporation may
provide for a classified board of directors, or eliminate cumulative voting, or
both if it is a Listed Corporation.
TRANSFER AGENT, REGISTRAR AND WARRANT AGENT
The transfer agent and registrar for the Common Stock and the warrant agent
for the Warrants is American Stock Transfer & Trust Company, New York, New York.
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SHARES ELIGIBLE FOR FUTURE SALE
Upon completion of the Offering, the Company will have approximately
7,449,395 shares of Common Stock outstanding (7,899,395 shares if the
Underwriters' over-allotment option is exercised in full), as well as Warrants,
Representative's Warrants and other options and warrants for the purchase of up
to approximately 4,504,559 additional shares of Common Stock (4,954,559 shares
if the Underwriters' over-allotment option is exercised in full).
Of the shares that will then be outstanding, the 3,000,000 shares sold in
the Offering (3,450,000 shares if the Underwriters' over-allotment option is
exercised in full) will be freely tradable without restriction under the
Securities Act, unless they are held by an "affiliate" of the Company, as that
term is defined in Rule 144, in which case resales would be subject to certain
limitations and restrictions described below.
The remaining 4,449,395 shares of Common Stock outstanding upon completion
of the Offering will be "restricted securities" as defined in Rule 144 and may
be sold in the public market only if registered under the Securities Act or sold
in accordance with an applicable exemption from registration, such as Rule 144.
Of these restricted shares, 2,597,083 shares will be eligible for resale without
restriction under the Securities Act in compliance with Rule 144(k) as described
below, 1,025,039 shares (the "Rule 144 Shares") will be eligible for resale
subject to the other provisions of Rule 144 described below, and 827,273 shares
(the "Non-Rule 144 Shares") will subsequently become eligible for resale under
Rule 144 upon expiration of their respective one-year holding periods. However,
all of the Rule 144 Shares and 624,000 of the Non-Rule 144 Shares will be
subject to contractual lock-up agreements between the holders of such shares and
the Company or the Underwriters. The lock-up agreements will prohibit the
Company's officers, directors and beneficial owners of 5% or more of the Common
Stock from directly or indirectly offering, selling or otherwise transferring a
beneficial interest in securities of the Company without the prior written
consent of the Company and the Representative for a period of twelve months
after the Effective Date. The Company has also agreed, with limited exceptions,
not to sell or offer for sale any of its securities without the consent of the
Underwriters until twelve months after the Effective Date.
In general, under Rule 144 as currently in effect, a person (or persons
whose shares are aggregated) who has beneficially owned restricted shares for at
least one year is entitled to sell, within any three-month period, a number of
such shares that does not exceed the greater of (i) 1% of the then-outstanding
shares of Common Stock (approximately 74,494 shares immediately after the
Offering) and (ii) the average weekly trading volume of such shares during the
four calendar weeks preceding the sale. Sales under Rule 144 are also currently
subject to certain requirements as to the manner of sale, the filing of a notice
of proposed sale, and the availability of current public information about the
Company. Rule 144 also provides that affiliates who own securities that are not
restricted shares must nonetheless comply with the same restrictions applicable
thereunder to restricted shares, with the exception of the one-year holding
period requirement. A person who has not been an affiliate of the Company at any
time within three months prior to the sale and has beneficially owned the
restricted shares for at least two years is entitled to sell such shares under
Rule 144(k) without regard to the volume limitations or any of the other
requirements described above.
Prior to the Offering, there has been no established public trading market
for the Company's Common Stock. See "Price Range of Common Stock and Dividend
Policy." Any sale of substantial amounts of Common Stock, or the perception that
such sales could occur, could adversely affect the prevailing market price for
the Common Stock and could impair the Company's future ability to raise capital
through an offering of its equity securities. See "Risk Factors--Shares Eligible
for Future Sale."
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UNDERWRITING
The Underwriters named below (the "Underwriters"), for whom Security Capital
Trading, Inc., is acting as representative (in such capacity, the
"Representative"), have severally agreed, subject to the terms and conditions of
the Underwriting Agreement with the Company (the "Underwriting Agreement") to
purchase from the Company and the Company has agreed to sell to the
Underwriters, on a firm commitment basis, the respective numbers of Shares and
Warrants set forth opposite their names:
<TABLE>
<CAPTION>
NUMBER OF NUMBER OF
UNDERWRITERS SHARES WARRANTS
- -------------------------------------------------------------------- ---------- ----------
<S> <C> <C>
Security Capital Trading, Inc.......................................
Total............................................................. 3,000,000 3,000,000
</TABLE>
The Underwriters are committed to purchase all the Shares of Common Stock
and Warrants offered hereby, if any of such securities are purchased. The
Underwriting Agreement provides that the obligations of the several Underwriters
are subject to conditions precedent specified therein.
The Company has been advised by the Representative that the Underwriters
propose initially to offer the Securities to the public at the initial public
offering prices set forth on the cover page of this Prospectus and to certain
dealers at such prices less concessions not in excess of $ per Share and
$ per Warrant. Such dealers may reallow a concession not in excess of
$ per Share and $ per Warrant to certain other dealers. After
the initial public offering, the offering prices, concessions and reallowances
to dealers may be changed by the Representative. No such change, however, shall
change the amount of proceeds to be received by the Company as set forth on the
cover page of this Prospectus.
The Representative has informed the Company that it does not expect sales to
discretionary accounts by the Underwriters to exceed five percent of the
Securities offered hereby.
The Company has agreed to indemnify the Underwriters against certain
liabilities, including liabilities under the Securities Act, or to contribute to
payments that the Underwriters may be required to make. The Company has been
advised that in the opinion of the Securities and Exchange Commission such
indemnification is against public policy as expressed in the Securities Act and
is, therefore, unenforceable. The Company has also agreed to pay to the
Representative a non-accountable expense allowance equal to 2.5% of the gross
proceeds derived from the sale of the Securities underwritten, of which $50,000
has been paid to date.
The Company has granted to the Underwriters an over-allotment option,
exercisable during the forty-five (45) day period from the date of this
Prospectus, to purchase up to an additional 450,000 shares of Common Stock
and/or 450,000 Warrants at the initial public offering price per Share and
Warrant, respectively, offered hereby, less underwriting discounts and the
non-accountable expense allowance. Such option may be exercised only for the
purpose of covering over-allotments, if any, incurred in the sale of the
Securities offered hereby. To the extent such option is exercised in whole or in
part, each Underwriter will have a firm commitment, subject to certain
conditions, to purchase the number of the additional Securities proportionate to
its initial commitment.
In connection with this Offering, the Company has agreed to sell to the
Representative, for nominal consideration, warrants (the "Representative's
Warrants") to purchase from the Company up to 300,000 shares of Common Stock
and/or 300,000 Warrants (the "Underlying Warrants"). The Representative's
Warrants are initially exercisable at a price of $7.20 per share of Common Stock
and $.12 per Warrant for a period of four (4) years, commencing at the beginning
of the second year after their issuance and sale and are restricted from sale,
transfer, assignment or hypothecation for a period of twelve (12) months from
the date hereof, except to officers of the Representative. The Representative's
Warrants provide for adjustment in the number of shares of Common Stock and
Warrants issuable upon the exercise thereof and in
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the exercise price of the Representative's Warrants as a result of certain
events, including subdivisions and combinations of the Common Stock. The
Representative's Warrants grant to the holders thereof certain rights of
registration for the securities issuable upon exercise thereof. The Underlying
Warrants are initially exercisable at a price of $8.40 per share of Common Stock
for a period of four (4) years, commencing at the beginning of the second year
after their issuance and sale and otherwise have substantially the same terms
and provisions as the Warrants.
In connection with this Offering, certain Underwriters and selling group
members and their respective affiliates may engage in transactions that
stabilize, maintain or otherwise affect the market prices of the Securities.
Such transactions may include stabilization transactions effected in accordance
with Rule 104 of Regulation M, pursuant to which such persons may bid for or
purchase the Common Stock and/or Warrants for the purpose of stabilizing their
respective market prices. The Underwriters also may create a short position for
the account of the Underwriters by selling more Securities in connection with
the Offering than they are committed to purchase from the Company, and in such
case may purchase Securities in the open market following completion of the
Offering to cover all or a portion of such short position. The Underwriters may
also cover all or a portion of such short position, up to 450,000 shares of
Common Stock and/or 450,000 Warrants, by exercising the over-allotment option
referred to above. In addition, the Representative may impose "penalty bids"
under contractual arrangements with the Underwriters whereby it may reclaim from
an Underwriter (or dealer participating in the Offering) for the account of
other Underwriters, the selling concession with respect to the Securities that
are distributed in the Offering but subsequently purchased for the account of
the Underwriters in the open market. Any of the transactions described in this
paragraph may result in the maintenance of the prices of the Securities at a
level above which might otherwise prevail in the open market. None of the
transactions described in this paragraph is required, and, if they are
undertaken, they may be discontinued at any time.
Prior to this Offering, there has been no active trading market for the
Common Stock or the Warrants. Consequently, the initial public offering prices
of the Securities and the exercise price of the Warrants have been determined
arbitrarily by negotiations between the Company and the Representative and do
not necessarily bear any relationship to the Company's asset value, net worth,
or other established criteria of value. The factors considered in such
negotiations, in addition to prevailing market conditions, included the history
of and prospects for the industry in which the Company competes, an assessment
of the Company's management, the prospects of the Company, its capital structure
and the market for initial public offerings.
Securities Capital Trading, Inc., the Representative, commenced operations
in June 1995. The Representative has co-managed and participated as an
underwriter in only two previous public offerings of securities. Accordingly,
the Representative has limited experience as a co-manager or underwriter of
public offerings of securities. In addition, the Representative is a relatively
small firm and no assurance can be given that the Representative will be able to
participate effectively as a market maker of the Securities. No assurance can be
given that any broker-dealer will be a market maker in any of the Securities.
See "Risk Factors--Lack of Experience of Representative."
LEGAL MATTERS
Certain legal matters with respect to the Common Stock offered hereby will
be passed upon for the Company by Miller & Holguin, Los Angeles, California.
Miller & Holguin owns 160,162 shares of the Company's outstanding Common Stock.
Certain legal matters in connection with the Offering will be passed upon for
the Underwriters by Hall Dickler Kent Friedman & Wood, LLP, New York, New York.
90
<PAGE>
EXPERTS
The consolidated financial statements of the Company at September 30, 1997
and for the year then ended appearing in this Prospectus and Registration
Statement have been audited by Ernst & Young LLP, independent auditors, as set
forth in their report thereon appearing elsewhere herein, and are included in
reliance upon such report given on the authority of such firm as experts in
accounting and auditing. No adverse opinion, disclaimer of opinion,
qualification or modification as to uncertainty, audit scope or accounting
principles was contained in said report.
The consolidated financial statements of the Company at September 30, 1996
and for each of the two years in the period ended September 30, 1996 appearing
in this Prospectus and Registration Statement have been audited by BDO Seidman,
LLP, independent certified public accountants and are included in reliance upon
such report given on the authority of such firm as experts in accounting and
auditing. No adverse opinion, disclaimer of opinion, qualification or
modification as to uncertainty, audit scope or accounting principles was
contained in said report.
The financial statements of Antelope Valley Medical Group at December 31,
1997 and 1996 and for each of the years ended December 31, 1997 and 1996
appearing in this Prospectus and Registration Statement have been audited by
Ernst & Young LLP, independent auditors, as set forth in their report thereon
appearing elsewhere herein, and are included in reliance upon such report given
on the authority of such firm as experts in accounting and auditing.
The statements of operations and accumulated deficit and cash flows of
Sierra Medical Group at December 31, 1996 and for the year ended December 31,
1996 and for the period from January 1, 1997 through September 30, 1997
appearing in this Prospectus and Registration Statement have been audited by
Ernst & Young LLP, independent auditors, as set forth in their report thereon
appearing elsewhere herein, and are included in reliance upon such report given
on the authority of such firm as experts in accounting and auditing.
The statements of operations and cash flows of Santa Ana/Tustin Physicians
Group for the ten month period ended December 31, 1996 and for the year ended
February 29, 1996 have been audited by BDO Seidman, LLP, independent certified
public accountants, as set forth in their report thereon appearing elsewhere
herein, and are included in reliance upon such report given on the authority of
such firm as experts in accounting and auditing. A statement of operations of
Santa Ana/Tustin Physicians Group for the period from January 1, 1997 through
July 13, 1997 appearing in this Prospectus and Registration Statement has been
audited by Ernst & Young LLP, independent auditors, as set forth in their report
thereon appearing elsewhere herein, and is included in reliance upon such report
given on the authority of such firm as experts in accounting and auditing.
In September 1997, the Board appointed Ernst & Young LLP as the Company's
independent certified public accounts. Prior thereto, BDO Seidman, LLP,
independent certified public accountants, served as the Company's independent
certified public accountants. BDO Seidman, LLP, independent certified public
accountants, was dismissed as the Company's independent certified public
accountants in August 1997. The change in accountants from BDO Seidman, LLP,
independent certified public accountants, to Ernst & Young LLP was effective for
fiscal 1997, was unanimously approved by the Board and was not due to any
disagreements between the Company and BDO Seidman, LLP, independent certified
public accountants, on any matter of accounting principles or practices,
financial statement disclosure or auditing scope or procedures.
91
<PAGE>
AVAILABLE INFORMATION
The Company has filed with the Securities and Exchange Commission (the
"Commission") the Registration Statement (on Form S-1) under the Securities Act
with respect to the Common Stock and Warrants offered hereby. This Prospectus
does not contain all of the information set forth in the Registration Statement
and the exhibits and schedules thereto. For further information with respect to
the Company and the Common Stock and Warrants offered hereby, reference is made
to the Registration Statement and the schedules and exhibits filed therewith.
Statements contained in this Prospectus concerning the contents of contracts or
other documents are summaries of the material provisions thereof. A copy of the
Registration Statement, including exhibits and schedules thereto, may be
inspected without charge at the public reference facilities maintained by the
Commission at Room 1024, 450 5th Street, N.W., Washington, D.C. 20549, and at
the Commission's regional offices located at 7 World Trade Center, Suite 1300,
New York, New York 10048 and Citicorp Center, 500 West Madison Street, Suite
1400, Chicago, Illinois 60661. Copies of all or any part of the Registration
Statement may be obtained from such offices after payment of fees prescribed by
the Commission. The Commission maintains a Web site (http:// www.sec.gov) that
contains registration statements, reports, proxy and information statements and
other information regarding registrants that file electronically with the
Commission.
92
<PAGE>
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
PAGE
---------
<S> <C>
Index to Audited Consolidated Financial Statements of Prospect Medical Holdings, Inc. included in this
Prospectus:
Reports of Independent Auditors.......................................................................... F-2
Consolidated Balance Sheets as of September 30, 1996 and 1997 and June 30, 1998.......................... F-4
Consolidated Statements of Operations for the Years Ended September 30, 1995, 1996 and 1997 and the Nine
Months Ended June 30, 1997 and 1998.................................................................... F-5
Consolidated Statements of Shareholders' Equity.......................................................... F-6
Consolidated Statements of Cash Flows for the Years Ended September 30, 1995, 1996 and 1997 and the Nine
Months Ended June 30, 1997 and 1998.................................................................... F-7
Notes to Consolidated Financial Statements............................................................... F-9
Index to Audited Financial Statements of Antelope Valley Medical Group, Inc. included in this Prospectus:
Report of Independent Auditors........................................................................... F-27
Balance Sheets as of December 31, 1996 and 1997 and March 31, 1998....................................... F-28
Statements of Operations for the Years Ended December 31, 1996 and 1997, and the Three Months Ended March
31, 1997 and 1998...................................................................................... F-29
Statements of Shareholder's Equity (Deficit)............................................................. F-30
Statements of Cash Flows for the Years Ended December 31, 1996 and 1997 and the Three Months Ended March
31, 1997 and 1998...................................................................................... F-31
Notes to Financial Statements............................................................................ F-32
Index to Audited Combined Financial Statements of Sierra Primary Care Medical Group, a Medical Corporation
and Sierra Medical Management, Inc. included in this Prospectus:
Report of Independent Auditors........................................................................... F-40
Combined Statements of Operations and Accumulated Deficit for the Nine Months Ended September 30, 1997
and the Year Ended December 31, 1996................................................................... F-41
Combined Statements of Cash Flows for the Nine Months Ended September 30, 1997 and the Year Ended
December 31, 1996...................................................................................... F-42
Notes to Combined Financial Statements................................................................... F-43
Index to Audited Financial Statements of Santa Ana-Tustin Physicians Group, Inc. included in this
Prospectus:
Reports of Independent Auditors.......................................................................... F-48
Statements of Operations and Retained Earning for the Period from January 1 to July 13, 1997, for the Ten
Months Ended December 31, 1996 and the Year Ended February 29, 1996.................................... F-50
Statements of Cash Flows for the Period from January 1 to July 13, 1997, for the Ten Months Ended
December 31, 1996 and the Year Ended February 29, 1996................................................. F-51
Notes to Financial Statements............................................................................ F-52
</TABLE>
F-1
<PAGE>
REPORT OF INDEPENDENT AUDITORS
Board of Directors
Prospect Medical Holdings, Inc.
We have audited the consolidated balance sheet of Prospect Medical Holdings,
Inc., as of September 30, 1997, and the related consolidated statements of
operations, shareholders' equity and cash flows for the year then ended. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audit. The financial statements of Prospect Medical
Holdings, Inc. for the years ended September 30, 1996 and 1995, were audited by
other auditors whose report dated November 20, 1996, expressed an unqualified
opinion on those statements.
We conducted our audit 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 audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
Prospect Medical Holdings, Inc., at September 30, 1997, and the consolidated
results of their operations and their cash flows for the year then ended, in
conformity with generally accepted accounting principles.
/s/ ERNST & YOUNG LLP
Los Angeles, California
December 8, 1997,
except for Note 4, as to
which the date is February 6, 1998,
and Note 7, as to which the date is July 1, 1998
F-2
<PAGE>
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
To the Board of Directors and Stockholders
Prospect Medical Holdings, Inc.
Yorba Linda, California
We have audited the accompanying combined balance sheet of Prospect Medical
Holdings, Inc. (a Delaware corporation) and Prospect Medical Group, Inc.
(predecessor business) as of September 30, 1996, and the related combined
statements of operations, stockholders' equity and cash flows for each of the
two years then ended. These financial statements are the responsibility of the
respective Company's manage-ment. 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 ac-counting 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 combined financial statements referred to above present
fairly, in all material respects, the financial position of Prospect Medical
Holdings, Inc. and Prospect Medical Group, Inc. (predecessor business) at
September 30, 1996, and the results of their operations and their cash flows for
each of the two years then ended, in conformity with generally accepted
accounting principles.
<TABLE>
<S> <C> <C>
By: /s/ BDO SEIDMAN, LLP
------------------------
BDO Seidman, LLP
</TABLE>
Los Angeles, California
November 20, 1996
F-3
<PAGE>
PROSPECT MEDICAL HOLDINGS, INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
SEPTEMBER 30
----------------------- JUNE 30
1996 1997 1998
---------- ----------- -----------
(UNAUDITED)
<S> <C> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents............... $5,333,144 $ 2,821,700 $ 1,765,408
Accounts receivable, net of allowance of
$128,000, $640,000 and $802,680 at
September 30, 1996 and 1997, and at
June 30, 1998, respectively........... 1,327,863 3,246,901 4,864,892
Prepaid expenses and other.............. 78,896 341,842 341,425
Recoverable income taxes................ 243,967 154,655 154,655
---------- ----------- -----------
Total current assets...................... 6,983,870 6,565,098 7,126,380
Property, improvements and equipment:
Land.................................... -- 40,620 40,620
Leasehold improvements.................. -- 120,000 120,000
Equipment............................... 665,762 1,010,601 1,810,460
Furniture and fixtures.................. -- 141,113 153,537
---------- ----------- -----------
665,762 1,312,334 2,124,617
Less accumulated depreciation and
amortization.......................... (157,799) (330,309) (501,563)
---------- ----------- -----------
507,963 982,025 1,623,054
Deposits and other assets................. 50,000 58,750 109,971
Deferred tax assets....................... 192,583 374,967 361,121
Goodwill and other intangible assets,
net..................................... 2,196,612 16,530,207 19,282,824
---------- ----------- -----------
Total assets.............................. $9,931,028 $24,511,047 $28,503,350
---------- ----------- -----------
---------- ----------- -----------
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accrued medical claims.................. $3,063,461 $ 5,917,716 $ 6,024,959
Accounts payable........................ 517,405 1,676,927 2,040,225
Notes payable and capital lease
obligations, current portion.......... 274,962 972,965 1,630,582
---------- ----------- -----------
Total current liabilities................. 3,855,828 8,567,608 9,695,766
Notes payable to related parties.......... 159,890 1,750,000 1,750,000
Other notes payable and capital lease
obligations............................. 147,726 10,080,000 11,480,774
Deferred income taxes..................... 469,630 233,490 233,490
---------- ----------- -----------
4,633,074 20,631,898 23,160,030
Shareholders' equity:
Preferred stock, $.01 par value,
1,000,000 shares authorized, none
issued................................ -- -- --
Common stock, $.01 par value, 40,000,000
shares authorized, 4,767,079,
5,367,079 and 5,575,718 issued and
outstanding at September 30, 1996 and
1997 and June 30, 1998,
respectively.......................... 47,670 53,670 55,757
Additional paid-in capital.............. 3,253,017 4,467,627 5,554,195
Retained earnings (deficit)............. 1,997,267 (642,148) (266,632)
---------- ----------- -----------
5,297,954 3,879,149 5,343,320
---------- ----------- -----------
Total liabilities and shareholders'
equity.................................. $9,931,028 $24,511,047 $28,503,350
---------- ----------- -----------
---------- ----------- -----------
</TABLE>
See accompanying notes.
F-4
<PAGE>
PROSPECT MEDICAL HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30 NINE MONTHS ENDED JUNE 30
------------------------------------------- ----------------------------
1995 1996 1997 1997 1998
------------- ------------- ------------- ------------- -------------
(UNAUDITED)
<S> <C> <C> <C> <C> <C>
Net patient service revenues......... $ 13,603,452 $ 22,518,478 $ 28,302,504 $ 18,722,263 $ 38,592,161
Management fees...................... 885,558 944,506 1,429,080 923,607 1,466,997
Other revenues....................... 168,322 971,996 223,489 330,839 254,879
------------- ------------- ------------- ------------- -------------
Total operating revenues............. 14,657,332 24,434,980 29,955,073 19,976,709 40,314,037
Cost of medical services............. 10,660,160 19,492,159 23,202,223 16,107,412 26,853,785
------------- ------------- ------------- ------------- -------------
Medical profit margin................ 3,997,172 4,942,821 6,752,850 3,869,297 13,460,252
Operating expenses:
General and administrative......... 3,544,512 4,212,449 7,299,696 4,502,583 11,299,200
Depreciation and
amortization..................... 124,993 101,541 243,937 114,019 785,842
------------- ------------- ------------- ------------- -------------
3,669,505 4,313,990 7,543,633 4,616,602 12,085,042
------------- ------------- ------------- ------------- -------------
Operating income (loss).............. 327,667 628,831 (790,783) (747,305) 1,375,210
Interest expense..................... -- -- (151,654) -- (1,027,888)
Investment income.................... -- 174,792 215,110 172,761 32,410
Loss on sale of property and
equipment to affiliate............. -- (240,000) -- -- --
Other income (expense)............... -- (13,951) -- -- --
Provision for impairment of goodwill
and other intangible assets........ -- -- (2,196,612) (2,196,612) --
------------- ------------- ------------- ------------- -------------
-- (79,159) (2,133,156) (2,023,851) (995,478)
------------- ------------- ------------- ------------- -------------
Income (loss) before income taxes.... 327,667 549,672 (2,923,939) (2,771,156) 379,732
Income tax provision (benefit)....... 139,417 (5,756) (284,524) 173,241 4,216
------------- ------------- ------------- ------------- -------------
Net income (loss).................... $ 188,250 $ 555,428 $ (2,639,415) $ (2,944,397) $ 375,516
------------- ------------- ------------- ------------- -------------
------------- ------------- ------------- ------------- -------------
Net income (loss) per common share
(NOTE 1)
Basic:
Basic income (loss) per share.... $ .10 $ 0.22 $ (0.55) $ (0.62) $ 0.07
Weighted average number of common
shares outstanding............. 1,975,835 2,486,866 4,800,942 4,767,079 5,397,696
Diluted:
Diluted income (loss) per
share.......................... $ .10 $ 0.22 $ (0.55) $ (0.62) $ 0.07
Weighted average number of common
and common dilutive shares
outstanding.................... 1,975,835 2,486,907 4,800,942 4,767,079 5,765,421
</TABLE>
See accompanying notes.
F-5
<PAGE>
PROSPECT MEDICAL HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
<TABLE>
<CAPTION>
ADDITIONAL
NUMBER OF COMMON PAID-IN RETAINED
SHARES STOCK CAPITAL EARNINGS TOTAL
---------- --------- ------------ ------------ ------------
<S> <C> <C> <C> <C> <C>
Balance at September 30, 1994................... 70,000 $ 17,500 $ 84,926 $ 1,253,589 $ 1,356,015
Issuance of common stock...................... 10,000 2,500 57,993 -- 60,493
Net income.................................... -- -- -- 188,250 188,250
---------- --------- ------------ ------------ ------------
Balance at September 30, 1995................... 80,000 20,000 142,919 1,441,839 1,604,758
Repurchase and cancellation of stock.......... (80,000) (20,000) (206,688) -- (226,688)
Issuance of common stock to former PMG
shareholders................................ 2,002,023 20,020 -- -- 20,020
Purchase of Med-Search in reverse
acquisition................................. 763,033 7,630 946,161 -- 953,791
Shares issued in connection with private
placement................................... 2,002,023 20,020 2,339,123 -- 2,359,143
Other......................................... 31,502 -- 31,502
Net income.................................... -- -- -- 555,428 555,428
---------- --------- ------------ ------------ ------------
Balance at September 30, 1996................... 4,767,079 47,670 3,253,017 1,997,267 5,297,954
Issuance of stock............................. 600,000 6,000 1,214,610 -- 1,220,610
Net loss...................................... -- -- -- (2,639,415) (2,639,415)
---------- --------- ------------ ------------ ------------
Balance at September 30, 1997................... 5,367,079 53,670 4,467,627 (642,148) 3,879,149
Issuance of stock............................. 208,639 2,087 1,045,913 -- 1,048,000
Other......................................... -- -- 40,655 -- 40,655
Net income.................................... -- -- -- 375,516 375,516
---------- --------- ------------ ------------ ------------
Balance at June 30, 1998 (UNAUDITED)............ 5,575,718 $ 55,757 $ 5,554,195 $ (266,632) $ 5,343,320
---------- --------- ------------ ------------ ------------
---------- --------- ------------ ------------ ------------
</TABLE>
See accompanying notes.
F-6
<PAGE>
PROSPECT MEDICAL HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30 NINE MONTHS ENDED JUNE 30
--------------------------------------- --------------------------
1995 1996 1997 1997 1998
----------- ------------ ------------ ------------ ------------
(UNAUDITED)
<S> <C> <C> <C> <C> <C>
OPERATING ACTIVITIES
Net income (loss)......................... $ 188,250 $ 555,428 $ (2,639,415) $ (2,944,397) $ 375,516
Adjustments to reconcile net income (loss)
to net cash provided by operating
activities:
Depreciation and amortization........... 124,993 101,541 243,937 114,019 785,842
Provision for bad debts................. 9,000 32,000 512,000 135,427 186,890
Loss on disposal of assets.............. -- 240,000 -- -- --
Noncash impairment charge............... -- -- 2,196,612 2,196,612 --
Changes in assets and liabilities:
Accounts receivable................... (343,811) 1,306,152 (1,039,410) (1,520,311) (1,804,881)
Prepaid expenses and other............ 70,217 47,703 (225,380) (179,974) (50,804)
Recoverable income taxes.............. -- -- 237,158 89,312 --
Deferred income taxes................. (174,398) (662,800) (429,759) (418,524) 13,846
Accrued medical claims................ 445,857 1,645,587 (152,018) (110,178) 107,243
Accounts payable...................... 168,751 276,897 273,698 800,259 363,298
Income taxes.......................... 221,388 86,581 -- -- --
----------- ------------ ------------ ------------ ------------
Net cash provided by (used in) operating
activities.............................. 710,247 3,629,089 (1,022,577) (1,837,755) (23,050)
INVESTING ACTIVITIES
Purchase of property, improvements and
equipment............................... (166,737) (266,249) (329,352) (258,557) (812,283)
Acquisition of subsidiaries (net of cash
acquired)............................... -- (1,036,086) (10,549,539) (2,335,735) (1,041,374)
Deferred offering costs................... -- -- -- -- (320,121)
Other investment activities............... -- -- -- -- (29,460)
----------- ------------ ------------ ------------ ------------
Net cash used in investing
activities.............................. (166,737) (1,302,335) (10,878,891) (2,594,292) (2,203,238)
FINANCING ACTIVITIES
Proceeds from issuance of notes payable... -- -- 9,648,227 -- 1,649,539
Principal payments on notes payable and
capital lease obligation................ (60,253) (92,628) (278,813) (208,158) (568,198)
Issuances of common stock, net of
repurchases............................. 60,493 2,277,301 20,610 -- 88,655
----------- ------------ ------------ ------------ ------------
Net cash provided by (used in) financing
activities.............................. 240 2,184,673 9,390,024 (208,158) 1,169,996
----------- ------------ ------------ ------------ ------------
Increase (decrease) in cash and cash
equivalents............................. 543,750 4,511,427 (2,511,444) (4,640,205) (1,056,292)
Cash and cash equivalents at beginning of
period.................................. 277,967 821,717 5,333,144 5,333,144 2,821,700
----------- ------------ ------------ ------------ ------------
Cash and cash equivalents at end of
period.................................. $ 821,717 $ 5,333,144 $ 2,821,700 $ 692,939 $ 1,765,408
----------- ------------ ------------ ------------ ------------
----------- ------------ ------------ ------------ ------------
</TABLE>
See accompanying notes.
F-7
<PAGE>
PROSPECT MEDICAL HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30 NINE MONTHS
--------------------------- ENDED JUNE 30
1996 1997 1998
------------ ------------- -------------
<S> <C> <C> <C>
Supplemental schedule of noncash investing and financing activities:
Issuance of promissory note for repurchase and cancellation of
stock............................................................ $ 113,344 $ -- $ --
Details of businesses acquired in purchase transactions:
Fair value of assets acquired...................................... 2,484,612 19,560,691 3,017,624
Less:
Issuance of promissory notes..................................... (288,000) (2,500,000) (976,250)
Other liabilities assumed........................................ (206,735) (3,903,332) --
Common stock issued.............................................. (953,791) (1,200,000) (1,000,000)
------------ ------------- -------------
Cash paid for acquisitions........................................... 1,036,086 11,957,359 1,041,374
Cash of acquired businesses.......................................... -- (1,407,820) --
------------ ------------- -------------
Net cash paid........................................................ $ 1,036,086 $ 10,549,539 $ 1,041,374
------------ ------------- -------------
------------ ------------- -------------
</TABLE>
There were no noncash activities in fiscal 1995 and for the nine months ended
June 30, 1997.
See accompanying notes.
F-8
<PAGE>
PROSPECT MEDICAL HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 1997
1. OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES
BUSINESS AND BASIS OF PRESENTATION
Prospect Medical Holdings, Inc., a Delaware corporation (the Company or
Prospect), was incorporated on May 12, 1993. Prospect is a health care
management services organization which develops integrated delivery systems, and
provides medical management systems and services to affiliated and unaffiliated
medical organizations. The affiliated medical organizations employ and/or
contract with physicians and professional medical corporations, and contract
with managed care payors.
Prospect currently manages the provision of prepaid health care services for
its affiliated medical organizations in Southern California. The Network
consists of the following related medical organizations as of September 30,
1997:
Prospect Medical Group, Inc. (PMG)
Sierra Primary Care Medical Group, a Medical Corporation (SPCMG)
Santa Ana-Tustin Physicians Group, Inc. (SATPG)
Each of the medical organizations listed above is owned by a nominee
physician shareholder who is also an employee, member of management and a
shareholder of Prospect. The management company subsidiaries of the Company have
entered into an assignable option agreement with each Affiliate (as defined
below) and its nominee shareholder. Under the assignable option agreements,
Prospect acquired an assignable option for a nominal amount from each Affiliate
and its nominee shareholder to purchase all or part of the Affiliate's assets
(the Asset Option) and the right to designate the purchaser (successor
physician) for all or part of the Affiliate's issued and outstanding stock held
by the nominee physician shareholder (the Stock Option) in its sole discretion.
The Company may also assign the assignable option agreements to any person. The
assignable option agreements have initial terms of 30 years and are
automatically extended for additional terms of 10 years each, so long as the
terms of the related management services agreements described below (the
Management Agreements) are automatically extended. Upon termination of each
Management Agreement, the related Asset Option and Stock Option are
automatically and immediately exercised. The Asset and Stock Options may be
exercised separately or simultaneously for a purchase price of $1,000 each.
Under these nominee shareholder agreements, Prospect has the unilateral right to
establish or effect change of the nominee, at will, and without consent of the
nominee, on an unlimited basis and at nominal cost throughout the term of the
Management Agreements. Prospect has an employment agreement with the current
nominee shareholder of PMG in his capacity as the President of the Company. The
employment agreement, which is for a term of three years and cannot be
terminated without cause, provides for a base compensation and certain customary
benefits. Since the agreement is only for the employment of the nominee
shareholder as the President of Prospect and not in his capacity as the nominee
shareholder of PMG, the agreement does not affect Prospect's ability to change
the nominee shareholder at will. PMG is the nominee shareholder of SPCMG and
SATPG.
Effective June 5, 1996, for PMG, and upon acquisition, the remaining related
medical organizations (collectively, the Affiliates), each entered into a
Management Agreement whereby the Affiliate has agreed to pay a management fee to
Prospect Medical Systems, Inc. or Sierra Medical Management, Inc., as applicable
(each of which is a wholly-owned subsidiary of Prospect). The fee is based in
part on the costs to the management company and on a percentage of revenues the
Affiliate receives (i) for the performance of medical services by the
Affiliate's employees and independent contractor physicians and physician
F-9
<PAGE>
PROSPECT MEDICAL HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
1. OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
extenders, (ii) for all other services performed by the Affiliates, and (iii) as
proceeds from the sale of assets or the merger or other business combination of
the Affiliate. The managment fee also includes a fixed fee for marketing and
public relations services. The revenue from which this fee is determined
includes medical capitation, all sums earned from participation in any risk
pools and all fee-for-service revenue earned. The Management Agreements have
initial terms of 30 years renewable for successive 10-year periods thereafter
unless terminated by either party for cause. In return for payment of the
management fee, Prospect has agreed to provide financial management, information
systems, marketing, advertising and public relations, risk management, and
administrative support for utilization review and quality of care. The Company
has exclusive decision-making authority with respect to the establishment and
preparation of operating and capital budgets and the establishment of policies
and procedures for the Affiliates and makes recommendations for the development
of guidelines for selection and hiring of health care professionals,
compensation payable to such personnel, scope of services to be provided,
patient acceptance policies, pricing of services, and contract negotiation and
execution. At its cost, Prospect has assumed the obligations for all facilities,
medical and nonmedical supplies, and employment of nonphysician personnel for
its affiliated medical groups. All remaining funds are remitted to the
Affiliate, from which the Affiliate pays for the cost of all medical services.
The management fee earned by Prospect fluctuates based on the profitability of
each Affiliate, as Prospect is allocated a 50% residual interest in the profits
or losses of the Affiliate, after deduction for costs to the management company
and physician compensation. The remaining 50% is retained by the Affiliate.
The Management Agreements are not terminable by the Affiliates except in the
case of gross negligence, fraud or other illegal acts of Prospect, or bankruptcy
of the Company. Through the Management Agreements and the Company's relationship
with the nominee shareholder of each Affiliate, Prospect has exclusive authority
over all decision-making related to the ongoing major or central operations of
the physician practices. The Company, however, does not engage in the practice
of medicine.
Further, Prospect's rights under the Management Agreements are unilaterally
salable or transferable. Based on the provisions of the Management Agreements
and the assignable option agreements, Prospect has determined that it has a
controlling financial interest in the Affiliates. Consequently, under applicable
accounting principles, Prospect consolidates the revenue and expenses of the
Affiliates from the respective dates of execution of the Management Agreements.
All significant inter-entity balances have been eliminated in consolidation. The
Company has also entered into management services agreements with other medical
organizations for the provision of non-medical administrative and practice
support services whereby the Company receives a percentage of the organization's
gross revenues or a predetermined fee as compensation. Prospect does not have a
controlling financial interest in these other medical organizations and,
consequently, records the management fee revenue associated with the management
services provided.
The Company consolidates all controlled subsidiaries, which control is
effectuated through ownership of voting common stock or by other means. All
significant intercompany transactions have been eliminated in consolidation.
As of September 30, 1997, Prospect managed health care services to
approximately 62,000 commercial, 7,300 senior and 6,000 Medicaid enrollees under
contracts with various health plans.
F-10
<PAGE>
PROSPECT MEDICAL HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
1. OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
REVERSE ACQUISITION
In July 1996, Prospect changed its name from Med-Search, Inc. (Med-Search)
in connection with an Agreement and Plan of Reorganization (the Merger
Agreement). Under the Merger Agreement, Med-Search Acquisition Corporation, a
wholly-owned subsidiary of Med-Search, a physician practice management company,
was merged with and into Prospect Medical Systems (PMS), with PMS being the
surviving corporation (the Merger). PMS was incorporated in November 1995 for
the purpose of assuming all of the non-professional assets and administrative
and management functions of PMG. PMS had nominal operations prior to the Merger
and its shares were held by the shareholders of PMG.
Through separate transactions effected at or around the time of the Merger,
the former physician shareholders and the current sole shareholder of PMG
received shares in the newly formed PMS. In the Merger, the PMG holders
exchanged 1,600 shares of PMS common stock for 2,002,023 shares of Med-Search
common stock and became the majority shareholders in the Company. The Merger has
been accounted for as a reverse acquisition as the shareholders of PMS became
the majority shareholders of Med-Search after the combination of the companies.
Therefore, the assets acquired and liabilities assumed of Med-Search were
recorded at fair value as of the acquisition date. Concurrent with the Merger,
Prospect completed a private placement offering raising $2,500,000 in cash
($2,359,143 net of costs) in exchange for 2,002,023 shares of Prospect's common
stock. Med-Search shareholders, who held 33,573,452 shares immediately prior to
the Merger, were issued 763,033 shares of Prospect common stock in connection
with the Merger (reflecting a 1:44 reverse stock split) which, based on the
share price of the private placement, were valued at $1.25 per share or
$953,791.
In addition to the issuance of shares, in connection with the Merger,
Prospect incurred costs totaling $489,784 in attorneys' fees and other costs,
and incurred $526,327 of other costs, including costs to settle litigation and
costs related to former shareholders/officers of Med-Search. The excess of costs
over the fair value of Med-Search's net assets totaled $2,196,612, and has been
reflected in goodwill and other intangible assets as of September 30, 1996.
Under applicable financial reporting requirements, PMG is considered the
predecessor entity to the Company for periods prior to July 31, 1996 for
financial statement reporting purposes. Accordingly, the historical financial
statements prior to July 31, 1996 are those of PMG, not those of the predecessor
legal entity.
MEDICAL REVENUES AND COST RECOGNITION
Operating revenue of the Company consists primarily of fees for medical
services provided by the Affiliates under capitated contracts with various
managed care payors including health maintenance organizations (HMOs) or under
fee-for-service arrangements. Capitation revenue under HMO contracts is prepaid
monthly to the Affiliates based on the number of enrollees electing any one of
the Affiliates as their health care provider. HMO contracts also include
provisions to share in the risk for hospitalization whereby the Affiliate can
earn additional incentive revenue or incur penalties based upon the utilization
of hospital services. Estimated shared-risk amounts receivable from the HMOs are
recorded based upon estimated hospital utilization and estimated associated
costs incurred by assigned HMO enrollees, compared to budgeted costs.
Differences between actual contract settlements and estimated receivables
relating to HMO risk-sharing arrangements are recorded in the year of final
settlement.
F-11
<PAGE>
PROSPECT MEDICAL HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
1. OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Capitation revenue under HMO contracts is recognized in the month in which
the Affiliates are obligated to provide services. Fee-for-service revenues are
recognized when the services have been performed. Management fee revenue is
earned in the month the services have been delivered. The Affiliates accrue
estimated shared-risk revenues or expenses in the period in which the Affiliates
are contracted to provide services.
The Company provides management services to several independent physician
providers not owned or controlled by the Company under one year (with 90 days'
cancellation notice provisions) management fee arrangements providing for
compensation ranging from 6.6% of revenues to 10% of revenues. The Company also
provides management services to affiliated providers whose results are
consolidated in the Company's financial statements under management fee
arrangements based on cost, a fixed marketing fee, a percentage of revenues and
a percentage of net income or loss. Revenues and expenses relating to these
inter-entity agreements have been eliminated in consolidation.
In connection with providing services to HMO enrollees, the Affiliates are
responsible for the medical services their affiliated physicians provide to
assigned HMO enrollees. The cost of health services is recognized in the period
in which it is provided and includes an estimate of the cost of services which
have been incurred but not yet reported. The estimate for accrued medical costs
is based on actuarial projections of costs using historical studies of claims
paid. Estimates are continually monitored and reviewed and, as settlements are
made or estimates adjusted, differences are reflected in current operations.
Management of the Company is not aware of any material disputes, unsettled
matters or other claims between the Affiliates and their contracted HMOs. There
have been no material settlements involving disputes between the Affiliates and
their contracted HMOs.
The Affiliates participate in reinsurance protection programs which limit
the amount of risk they ultimately bear by providing reimbursement payments once
medical services provided to an individual enrollee exceed an agreed-upon
deductible amount. Estimates of reinsurance recoveries are included in accounts
receivable in the accompanying financial statements and, in the opinion of
management, adjustments, if any, would not have a material effect on the
consolidated financial position of the Company. The Company's reinsurance
programs have not had a material impact on its operations. The Company is not
relieved of its primary obligation under any claims incurred as result of its
reinsurance program.
PROPERTY, IMPROVEMENTS AND EQUIPMENT
Property, improvements and equipment are stated on the basis of cost.
Depreciation of equipment is provided using the straight-line method over the
estimated useful lives of the assets, and amortization of leasehold improvements
is provided using the straight-line basis over the shorter of the lease period
or the estimated useful lives of the leasehold improvements. Capitalized lease
obligations are amortized over the life of the lease. Lease amortization is
included in depreciation expense.
GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill and other intangible assets totaling $16,215,471 at September 30,
1997 ($19,233,095 at June 30, 1998--see tables below under this heading) arose
as the result of the acquisition of Sierra Medical Management, Inc., Sierra
Primary Care Medical Group and Santa Ana-Tustin Physicians Group, Inc. Related
intangible assets consist of the fair value of acquired HMO contracts, covenants
not to compete
F-12
<PAGE>
PROSPECT MEDICAL HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
1. OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
and workforce in place. Goodwill represents the excess of the consideration paid
and liabilities assumed over the fair value of the assets acquired including
identifiable intangible assets. In conjunction with these acquisitions,
management of the Company has reviewed the allocation of the excess of costs
(including costs incurred related to the acquisitions) over net assets acquired
and has determined, to date, that these costs (goodwill) are allocable to the
operating platforms acquired which allowed the Company to expand its
geographical territory through the addition of the existing renewable HMO
contracts included in the acquisitions. These HMO contracts have historically
been renewed each year with the acquired physician organizations over the last
decade and the HMOs are currently not offering additional contracts to similarly
situated physician organizations in the same territories. Only immaterial
amounts are allocable to identifiable intangible assets such as physician
agreements which include non-competition terms. Such acquisitions are discussed
in Note 2 below.
Goodwill has been recorded at cost and is being amortized on the
straight-line method over an average life of 20 years based on the estimated
fair values of the net assets acquired. Accumulated amortization was $49,292 at
September 30, 1997 ($644,770 at June 30, 1998).
During each period the Company reviews the carrying value of goodwill to
determine if facts and circumstances exist which would suggest that goodwill may
be impaired, or that the amortization period needs to be modified. Among the
factors considered by the Company in making the evaluation are changes in the
Company's payor contracts, local market developments, changes in regulations,
national health care trends, changes in third party payment patterns and other
factors. Using these factors, if indications are present which may indicate
impairment is probable, the Company will prepare a projection of undiscounted
cash flows. If impairment is indicated, then an adjustment will be made. Based
on the factors considered above, the Company does not believe that there are any
current factors indicating any impairment of goodwill as of September 30, 1997
and June 30, 1998, which would require an adjustment.
The Company periodically evaluates the realization of the assets acquired
and they are written down to estimated fair value when appropriate. During
fiscal 1997, Prospect terminated the HMO contract supporting the network
acquired in the Med-Search combination discussed above. Consequently, all
intangible assets acquired from Med-Search were considered impaired and of no
continuing value. An impairment loss totaling $2,196,612 has been recorded in
fiscal 1997 related to this circumstance.
F-13
<PAGE>
PROSPECT MEDICAL HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
1. OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
A summary schedule of the Company's acquisition costs and accumulated
amortization of goodwill at September 30, 1997 is as follows:
<TABLE>
<CAPTION>
TOTAL
PURCHASE
CONSIDERATION
(NET IN EXCESS OF
ASSETS)/ NET TANGIBLE PROFESSIONAL
PURCHASE LIABILITIES ASSETS FEES AND OTHER
PRICE ASSUMED ACQUIRED RELATED COSTS TOTAL
------------- ------------ ------------- -------------- -------------
<S> <C> <C> <C> <C> <C>
Santa Ana/Tustin Physicians Group.... $ 5,000,000 $ (116,473) $ 4,883,527 $ 197,816 $ 5,081,343
Sierra Medical Group................. 10,200,000 717,544 10,917,544 216,584 11,134,128
------------- ------------ ------------- -------------- -------------
$ 15,200,000 $ 601,071 $ 15,801,071 $ 414,400 16,215,471
------------- ------------ ------------- --------------
------------- ------------ ------------- --------------
Accumulated amortization............. (49,292)
-------------
$ 16,166,179
-------------
-------------
</TABLE>
A summary schedule of the Company's acquisition costs and accumulated
amortization of goodwill at June 30, 1998 is as follows (unaudited):
<TABLE>
<CAPTION>
TOTAL
PURCHASE
CONSIDERATION
(NET IN EXCESS OF
ASSETS)/ NET TANGIBLE PROFESSIONAL
PURCHASE LIABILITIES ASSETS FEES AND OTHER
PRICE ASSUMED ACQUIRED RELATED COSTS TOTAL
------------- ------------ ------------- -------------- -------------
<S> <C> <C> <C> <C> <C>
Santa Ana/Tustin Physicians Group.... $ 5,000,000 $ (116,473) $ 4,883,527 $ 197,816 $ 5,081,343
Sierra Medical Group................. 10,200,000 717,544 10,917,544 216,584 11,134,128
AV Western Medical Group............. 700,000 -- 700,000 53,310 753,310
Antelope Valley Medical Group........ 2,000,000 -- 2,000,000 82,619 2,082,619
Other................................ 165,400 -- 165,400 16,295 181,695
------------- ------------ ------------- -------------- -------------
$ 18,065,400 $ 601,071 $ 18,666,471 $ 566,624 19,233,095
------------- ------------ ------------- --------------
------------- ------------ ------------- --------------
Accumulated amortization............. (644,770)
-------------
$ 18,588,325
-------------
-------------
</TABLE>
As of September 30, 1997 and June 30, 1998 other intangible assets consisted
primarily of deferred offering costs and deferred financing costs aggregating
$364,028 and $694,499, respectively.
MEDICAL MALPRACTICE LIABILITY INSURANCE
Certain of the Affiliates maintain claims-made basis medical malpractice
insurance coverage of up to $2,000,000 per incident and $4,000,000 in the
aggregate on an annual basis. Claims-made coverage covers only those claims
reported during the policy period. An estimate of losses, if any, for incurred
but unreported claims is recorded based upon historical experience. In 1997,
Prospect caused the Affiliates to
F-14
<PAGE>
PROSPECT MEDICAL HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
1. OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
renew their existing policies and expects to be able to continue to obtain
coverage in future years. Further, it has been the Company's experience that
substantially all claims are reported within a year of the incident date.
The individual physicians who contract with the Affiliates carry their own
medical malpractice insurance.
EARNINGS (LOSS) PER SHARE
Effective December 15, 1997, the Company was required to adopt Statement of
Financial Accounting Standards (SFAS) No. 128 "Earnings per Share." SFAS No. 128
requires the presentation of "basic earnings per share" (which excludes
dilution) and "diluted earnings per share." All earnings per share calculations
presented in the financial statements have been presented in accordance with
SFAS No. 128.
Basic earnings (loss) per share is computed by dividing net income (loss) by
the weighted average number of common shares outstanding. Diluted earnings
(loss) per share is computed by dividing net income (loss) by the weighted
average number of common shares outstanding, after giving effect to potentially
dilutive shares computed using the treasury stock method. Such shares are
excluded if determined to be anti-dilutive. Common stock issued at below
estimated fair value on the issuance date is included in weighted average number
of common shares as if such shares have been outstanding for all periods
presented.
F-15
<PAGE>
PROSPECT MEDICAL HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
1. OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
The following is a reconciliation of the numerators and denominators used in
the calculation of basic and diluted earnings per share for each period
presented in the financial statements.
<TABLE>
<CAPTION>
YEARS ENDED SEPTEMBER 30 NINE MONTHS ENDED JUNE 30
----------------------------------------- ---------------------------
1995(1) 1996(1) 1997(2) 1997(2) 1998
------------ ------------ ------------- ------------- ------------
(UNAUDITED)
<S> <C> <C> <C> <C> <C>
Basic earnings (loss) per common share:
Numerator--Net income (loss)........... $ 188,250 $ 555,428 $ (2,639,415) $ (2,944,397) $ 375,516
------------ ------------ ------------- ------------- ------------
------------ ------------ ------------- ------------- ------------
Denominator--
Weighted average number of common
shares outstanding................. 1,975,835 2,486,866 4,800,942 4,767,079 5,397,696
------------ ------------ ------------- ------------- ------------
------------ ------------ ------------- ------------- ------------
Basic earnings (loss) per common
share.............................. $ 0.10 $ 0.22 $ (0.55) $ (0.62) $ 0.07
------------ ------------ ------------- ------------- ------------
------------ ------------ ------------- ------------- ------------
Diluted earnings (loss) per common share:
Numerator--Net income (loss)........... $ 188,250 $ 555,428 $ (2,639,415) $ (2,944,397) $ 375,516
------------ ------------ ------------- ------------- ------------
------------ ------------ ------------- ------------- ------------
Denominator--
Weighted average number of common
shares outstanding................. 1,975,835 2,486,866 4,800,942 4,767,079 5,397,696
Dilutive stock options and
warrants........................... -- 41 -- -- 367,725
------------ ------------ ------------- ------------- ------------
1,975,835 2,486,907 4,800,942 4,767,079 5,765,421
------------ ------------ ------------- ------------- ------------
------------ ------------ ------------- ------------- ------------
Diluted earnings (loss) per common
share.............................. $ 0.10 $ 0.22 $ (0.55) $ (0.62) $ 0.07
------------ ------------ ------------- ------------- ------------
------------ ------------ ------------- ------------- ------------
</TABLE>
- ------------------------
(1) The shares outstanding with respect to periods prior to July 1996 have been
adjusted to reflect the approximate 25:1 dilution of shares as a result of
the exchange of stock by holders of PMG with the Company.
(2) Stock options and warrants are excluded from the calculation of diluted loss
per share for the fiscal year ended September 30, 1997, and the nine months
ended June 30, 1997, because the inclusion of stock options and warrants
would have an anti-dilutive effect.
F-16
<PAGE>
PROSPECT MEDICAL HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
1. OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
STOCK OPTIONS
In October 1995, SFAS No. 123 "Accounting for Stock-Based Compensation" was
issued, which provides an alternative to Accounting Principles Board (APB)
Opinion 25 "Accounting for Stock Issued to Employees." SFAS No. 123 encourages,
but does not require, that compensation expense for grants of stock, stock
options and other equity instruments to employees be based on the fair value of
such instruments. The statement also allows companies to continue to measure
compensation expense using the intrinsic value method prescribed by APB Opinion
No. 25. The Company has elected to continue using the intrinsic value based
method.
With respect to stock options granted at an exercise price which is less
than the fair market value on the date of grant, the difference between the
option exercise price and market value at date of grant is charged to operations
over the period the options vest. Income tax benefits attributable to stock
options are credited to additional paid-in capital when exercised.
CASH AND CASH EQUIVALENTS
Cash equivalents are considered to be all liquid investments with a maturity
of three months or less when purchased.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The financial instruments reported in the accompanying consolidated balance
sheets consist primarily of cash and cash equivalents, accounts receivable,
notes payable and capital lease obligations and all other liabilities. The
carrying amounts of current assets and liabilities approximate their fair value
due to the relatively short period of time between the origination of the
instruments and their expected realization.
The carrying amounts of notes payable and capital lease obligations
approximate fair value since the outstanding debt relates primarily to revolving
bank loans which bear interest at the prime rate plus applicable margin. The
carrying amounts of the remaining notes payable approximate their fair value as
interest rates used in valuing these instruments approximate interest rates
currently available to the Company.
CONCENTRATIONS OF CREDIT RISK
Financial instruments which potentially subject the Company to
concentrations of credit risk consist of shared-risk and stop-loss receivables.
The Company's credit risk with respect to shared-risk and stop-loss receivables
is limited since amounts are generally due from large HMOs.
During the year ended September 30, 1997 the Company received approximately
33%, 16% and 11% of its total operating revenues from contracts with three HMOs.
During the year ended September 30, 1996 the Company received approximately 28%
and 11% of its total operating revenues from contracts with two HMOs. During the
year ended September 30, 1995 the Company received approximately 41%, 24% and
16% of its total operating revenues from contracts with three HMOs.
F-17
<PAGE>
PROSPECT MEDICAL HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
1. OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) (CONTINUED)
USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets, liabilities, revenues
and expenses at the date and for the periods that the financial statements are
prepared. Actual results could differ from those estimates.
NEW ACCOUNTING PRONOUNCEMENTS
The Financial Accounting Standards Board (FASB) has issued the following
pronouncements regarding disclosure that the Company will adopt in fiscal 1998:
SFAS No. 129, "Disclosure of Information about Capital Structure,"
consolidates the existing guidance relating to an entity's capital structure.
The required capital structure disclosures include liquidation preferences of
preferred stock, information about pertinent rights and privileges of the
outstanding equity securities and the redemption amount of all issues of capital
stock that are redeemable at fixed or determinable prices on fixed or
determinable dates.
SFAS No. 130, "Reporting Comprehensive Income," establishes new rules for
the reporting and display of comprehensive income and its components in a
complete set of general-purpose financial statements as well as in interim
period financial statements.
SFAS No. 131, "Disclosures about Segments of an Enterprise and Related
Information," significantly changes the way public companies report segment
information in annual financial statements and also requires those companies to
report selected segment information in interim financial reports. Under
Statement 131, public companies will report financial and descriptive
information about their operating segments. Operating segments are
revenue-producing components of the enterprise for which separate financial
information is produced internally and are subject to evaluation by the chief
operating decision-maker in deciding how to allocate resources to segments.
2. ACQUISITIONS
SANTA ANA--TUSTIN PHYSICIAN GROUP, INC.
Effective July 14, 1997, PMG purchased SATPG for a cash consideration
totaling $5,000,000. Simultaneous with this purchase transaction, PMS entered
into a Management Agreement with SATPG with an initial 30-year term, renewable
for additional 10 year terms thereafter, unless terminated by either party. The
acquisition resulted in goodwill of $5,081,343.
SIERRA MEDICAL GROUP, INC. AND SIERRA MEDICAL MANAGEMENT, INC.
Effective September 25, 1997, Prospect, together with a physician
shareholder, purchased SPCMG and Sierra Medical Management, Inc. (SMM) for
consideration totaling $10,200,000 consisting of $6,500,000 in cash, promissory
notes of $2,500,000 in principal amount bearing interest at 7%, and 600,000
shares valued at $2 per share of Prospect common stock. Principal on the notes
is due in quarterly installments of $125,000 and an annual payment of $250,000
(see Note 5). Simultaneous with this purchase transaction, SMM entered into a
Management Agreement with SPCMG with an initial 30-year term,
F-18
<PAGE>
PROSPECT MEDICAL HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. ACQUISITIONS (CONTINUED)
renewable for successive 10-year periods thereafter, unless terminated by either
party. The acquisition resulted in goodwill of $11,134,128.
Summarized below are the unaudited pro forma consolidated results of
operations for Prospect as if the acquisitions of SATPG, SPCMG and SMM had taken
place as of October 1, 1995 (amounts in thousands, except per share data).
<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER
30
--------------------
1996 1997
--------- ---------
<S> <C> <C>
Operating revenues...................................................... $ 45,120 $ 50,393
Net income (loss)....................................................... 617 (2,044)
Basic income (loss) per share........................................... .20 (.38)
Diluted income (loss) per share......................................... .20 (.38)
</TABLE>
3. INCOME TAXES
The Company accounts for income taxes under Statement of Financial
Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109),
under which deferred income tax assets and liabilities are recognized for the
differences between financial and income tax reporting bases of assets and
liabilities based on enacted tax rates and laws.
The components of the provision (benefit) for income tax are as follows:
<TABLE>
<CAPTION>
1995 1996 1997
----------- ---------- -----------
<S> <C> <C> <C>
Current:
Federal................................................................... $ 243,235 $ 37,663 $ --
State..................................................................... 68,696 37,468 --
----------- ---------- -----------
311,931 75,131 --
Deferred:
Federal................................................................... (132,404) (49,633) (246,164)
State..................................................................... (40,110) (31,254) (38,360)
----------- ---------- -----------
(172,514) (80,887) (284,524)
----------- ---------- -----------
Total:
Federal................................................................... 110,831 (11,970) (246,164)
State..................................................................... 28,586 6,214 (38,360)
----------- ---------- -----------
$ 139,417 $ (5,756) $ (284,524)
----------- ---------- -----------
----------- ---------- -----------
</TABLE>
F-19
<PAGE>
PROSPECT MEDICAL HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
3. INCOME TAXES (CONTINUED)
Temporary differences and carryforwards that result in deferred income tax
balance as of September 30, are as follows:
<TABLE>
<CAPTION>
1996 1997
----------- -----------
<S> <C> <C>
Deferred income tax assets:
State taxes....................................................... $ 12,739 $ --
Allowances for bad debts.......................................... 26,800 94,849
Net operating loss................................................ 61,732 151,841
Depreciation...................................................... 91,312 128,277
----------- -----------
192,583 374,967
Deferred income tax liabilities:
Section 481 adjustment for cash to accrual reporting.............. (469,630) (233,490)
----------- -----------
(277,047) 141,477
Valuation allowance............................................... -- --
----------- -----------
Net deferred income taxes........................................... $ (277,047) $ 141,477
----------- -----------
----------- -----------
</TABLE>
The differences between the provision for income tax expense at the federal
statutory rate of 34% and that reflected in the consolidated statements of
operations are summarized as follows for the years ended September 30:
<TABLE>
<CAPTION>
1995 1996 1997
--------- --------- ---------
<S> <C> <C> <C>
Tax provision (credit) at statutory rate................................................. 34% 34% (34%)
State taxes, net of federal benefit...................................................... 6% 1% (1%)
Goodwill................................................................................. -- -- 25%
Accounting method change................................................................. -- (36%) --
Other.................................................................................... 3% -- --
--- --------- ---------
43% (1%) (10%)
--- --------- ---------
--- --------- ---------
</TABLE>
During 1996, the Company changed from cash to accrual basis for tax return
reporting under Section 481 of the Internal Revenue Code of 1986, as amended. In
the process of the conversion from cash to accrual basis, the Company identified
an overstatement of accounts receivable in the prior year tax returns. The
overstatement resulted in the recording of a deferred tax liability in the prior
years, which was reversed in 1996. The combined effect of these items resulted
in a reduction of the Company's tax provision in fiscal 1996.
Taxes paid totaled approximately $538,737, $208,000 and $502,000 in 1995,
1996 and 1997, respectively.
F-20
<PAGE>
PROSPECT MEDICAL HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
4. NOTES PAYABLE
Related party and other notes payable consist of the following:
<TABLE>
<CAPTION>
SEPTEMBER 30
------------------------- JUNE 30
1996 1997 1998
---------- ------------- -------------
(UNAUDITED)
<S> <C> <C> <C>
Notes payable to related parties consist of the following:
Note payable to former shareholder, interest at 9% payable monthly,
maturing in July 1998.............................................. $ 264,000 $ 120,000 $ 57,946
Note payable to former shareholder, interest at 5.05% payable
monthly, maturing in May 1998...................................... 96,563 39,890 --
Note payable to former shareholders for the acquisition of Sierra
Primary Care Medical Group, interest at 7% per annum, $112,500
payable quarterly plus annual payments of $225,000 until March
1999............................................................... -- 2,250,000 2,025,000
Note payable to former shareholder of Sierra Medical Management,
interest at 7% per annum ($12,500 payable quarterly plus annual
payments of $25,000 until March 1999).............................. -- 250,000 225,000
Notes payable to former shareholder for the acquisition of Antelope
Valley Medical Group, interest at 8% per year, final maturity in
180 days........................................................... -- -- 976,250
---------- ------------- -------------
360,563 2,659,890 3,284,196
Less current maturities.............................................. 200,673 909,890 1,534,196
---------- ------------- -------------
$ 159,890 $ 1,750,000 $ 1,750,000
---------- ------------- -------------
---------- ------------- -------------
Other notes payable consist of the following:
Revolving loan to bank, interest per annum at prime rate plus
applicable margin.................................................. $ -- $ 10,000,000 $ 11,100,000
Capital lease obligations and equipment loans........................ 222,015 143,875 477,160
---------- ------------- -------------
222,015 10,143,875 11,577,160
Less current maturities.............................................. 74,289 63,075 96,386
---------- ------------- -------------
$ 147,726 $ 10,080,000 $ 11,480,774
---------- ------------- -------------
---------- ------------- -------------
</TABLE>
At September 30, 1997, the Company has a revolving credit agreement with a
bank for $10,000,000 with interest at the bank's prime rate (8.50% at September
30, 1997), plus an applicable margin (ranging from .50% to 1.50%; .50% at
September 30, 1997). As of February 6, 1998, the Company increased the principal
available under the revolving credit agreement to $12,500,000. Interest is
payable monthly on a 360-day basis. The line expires July 3, 1999. The line is
collateralized by the stock of Prospect's subsidiaries and the Company's
accounts receivable, inventory and unencumbered equipment. The line is also
subject to financial covenants, including maintaining certain financial ratios.
As of September 30, 1997, the Company did not meet certain financial ratios. The
bank has waived compliance with these ratios as of September 30, 1997, and
December 31, 1997, made the waivers effective retroactive to September 1, 1997,
and has revised the ratios for periods thereafter (see Note 8). The Company
expects to be able to meet the revised ratios in the future. The line has a
facility fee of 0.5% per year on the unused balance of the line. In
F-21
<PAGE>
PROSPECT MEDICAL HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
4. NOTES PAYABLE (CONTINUED)
connection with the revolving credit agreement, Prospect granted a warrant to
the bank to purchase 192,725 (132,375 as of September 30, 1997) shares of common
stock at $5.00 per share (see Note 5). The fair value of notes payable
approximates the carrying value due either to the short-term nature of such
notes or the fact that the notes bear interest at rates currently available to
the Company under similar terms.
Interest paid totaled $36,850, $36,313, and $151,654 in 1995, 1996 and 1997,
respectively.
Payments under long-term notes as of September 30, 1997, follow:
<TABLE>
<S> <C>
1998................................................... $ 972,965
1999................................................... 11,830,800
2000................................................... --
2001................................................... --
2002................................................... --
Thereafter............................................. --
----------
$12,803,765
----------
----------
</TABLE>
5. STOCK TRANSACTIONS AND OPTION PLANS
STOCK TRANSACTIONS
All Prospect capital stock transactions discussed below have been adjusted
to reflect the July 1996 reverse stock split of 1:44.
STOCK OPTIONS
The Company has stock option agreements with certain directors and officers.
The exercise price of the options granted approximated or exceeded the fair
market value of the underlying common stock at the date of grant. A summary of
the option agreements which exist at September 30, 1997, is as follows:
<TABLE>
<CAPTION>
WEIGHTED AVERAGE
OPTIONS EXERCISE PRICE
-------------- -----------------
<S> <C> <C>
Outstanding, beginning of year................................................. --
Granted...................................................................... 512,119 $ 1.51
Exercised.................................................................... -- --
Forfeited.................................................................... -- --
-------------- -----
Outstanding, end of year....................................................... 512,119 $ 1.51
-------------- -----
-------------- -----
Exercisable, end of year....................................................... 512,119 $ 1.51
-------------- -----
-------------- -----
Price.......................................................................... $ 1.25 - $5.00
--------------
--------------
Weighted average fair value of options granted during the year................. $ .30
--------------
--------------
</TABLE>
F-22
<PAGE>
PROSPECT MEDICAL HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
5. STOCK TRANSACTIONS AND OPTION PLANS (CONTINUED)
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING
-----------------------------------------
WEIGHTED OPTIONS EXERCISABLE
AVERAGE ------------------------
REMAINING WEIGHTED WEIGHTED
NUMBER CONTRACTUAL AVERAGE NUMBER AVERAGE
OUTSTANDING LIFE (# OF EXERCISE EXERCISABLE EXERCISE
RANGE OF EXERCISE PRICE AT 9/30/97 MONTHS) PRICE AT 9/30/97 PRICE
- ---------------------------------------------------- ----------- --------------- ----------- ----------- -----------
<S> <C> <C> <C> <C> <C>
$1.25-$5.00 512,119 60 $ 1.51 512,119 $ 1.51
</TABLE>
The Company has elected to follow APB Opinion No. 25 and related
interpretations in accounting for its stock options because, as discussed below,
the alternative fair value accounting provided for under SFAS No. 123 requires
use of option valuation models that were not developed for use in valuing stock
options. Under APB No. 25, because the exercise price of the Company's stock
options equals or exceeds the market price of the underlying stock on the date
of grant, no compensation expense is recognized.
Pro forma information regarding net loss and loss per share is required by
SFAS No. 123, and has been determined as if the Company had accounted for its
stock options under the fair value method of that Statement. The fair value of
these options was estimated at the date of grant using a Minimum Value option
pricing model with the following weighted average assumptions for 1997: expected
market price of the Company's common stock at $1.25 for 477,119 option shares
and $2 for 35,000 option shares on the respective dates of grant, a weighted
average expected life of the options of five years, risk-free interest rate of
6%, and dividend yield of 0%.
The Minimum Value option valuation model was developed for use in estimating
the fair value of traded options which have no vesting restrictions and are
fully transferable. In addition, option valuation models require the input of
highly subjective assumptions including the expected stock price volatility.
Because the Company's stock options have characteristics significantly different
from those of traded options, and because changes in the subjective input
assumptions can materially affect the fair value estimate, in management's
opinion, the existing models do not necessarily provide a reliable single
measure of the fair value of its stock options.
Pro forma disclosures required by SFAS No. 123 include the effects of all
stock option awards granted by the Company in fiscal 1997. During the initial
phase-in period, the effects of applying this Statement for generating pro forma
disclosures are not likely to be representative of the effects on pro forma net
income or loss for future years, for example, because options may vest over
several years and additional awards generally are made for each year. For
purposes of pro forma disclosures, the estimated fair value of the options is
amortized to expense over the options' vesting period. The Company's pro forma
information is as follows for the year ended September 30, 1997.
<TABLE>
<S> <C>
Pro forma net loss.............................................. $(2,792,000)
Pro forma basic and diluted loss per share...................... $ (.58)
</TABLE>
The Company has reserved 512,119 shares in connection with the stock option
agreements.
WARRANTS
As of July 31, 1996, warrants to purchase 13,635 shares of the Company's
common stock at $1.375 per share were issued to finders in connection with the
Med-Search merger. The warrants are exercisable at the date of grant and expire
in July 2001. In connection with the $10 million revolving line of credit,
Prospect granted a warrant in July 1997 to the bank to purchase 132,375 shares
of common stock at $5.00 per share. An additional warrant to purchase 60,350
shares of common stock at $5.00 per share was
F-23
<PAGE>
PROSPECT MEDICAL HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
5. STOCK TRANSACTIONS AND OPTION PLANS (CONTINUED)
granted in February 1998 upon the amendment of the Company's credit line (see
Note 4). The warrants are immediately exercisable. The warrant to purchase
132,375 common shares expires in July 2004 and the warrant to purchase 60,350
common shares expires in February 2005. No value was assigned to the issuance of
these warrants as the exercise price exceeded the fair value of the underlying
stock, estimated at $1.25 to $2.00 per share during this period, and there was
either no or only nominal trading activity in the stock. Consequently, the
Company determined that the fair value of the warrants was de minimis.
6. COMMITMENTS AND CONTINGENCIES
LEASES
The Company leases certain buildings and equipment under operating leases.
Leases with related parties had future obligations totaling $1,500,000 as of
September 30, 1997. Certain building leases contain renewal options for two
consecutive five-year periods at the then market rent. Future minimum rental
payments required under operating leases that have initial or remaining
noncancelable lease terms in excess of one year as of September 30, 1997, are as
follows:
<TABLE>
<S> <C>
1998............................................................ $ 988,563
1999............................................................ 635,309
2000............................................................ 583,248
2001............................................................ 300,096
2002............................................................ 300,096
Thereafter...................................................... --
---------
$2,807,312
---------
---------
</TABLE>
Consolidated rent expense for 1995, 1996 and 1997, was approximately $261,000,
$396,000, and $529,000, respectively.
REGULATORY MATTERS
Laws and regulations governing the Medicare program and health care
generally are complex and subject to interpretation. Prospect and its affiliates
believe that they are in compliance with all applicable laws and regulations and
are not aware of any pending or threatened investigations involving allegations
of potential wrongdoing. While no such regulatory inquiries have been made,
compliance with such laws and regulations can be subject to future government
review and interpretation as well as significant regulatory action including
fines, penalties, and exclusion from the Medicare and Medicaid programs.
LITIGATION
Prospect is involved in various legal proceedings in the ordinary course of
business. Management believes that the ultimate resolution of such legal
proceedings will not have a material adverse effect on the financial position
and results of operations of the Company.
YEAR 2000 - UNAUDITED
The Company has formed a Year 2000 project team which has completed an
inventory of all systems and programs, categorized as to importance, which could
be affected by the Year 2000 date change.
F-24
<PAGE>
PROSPECT MEDICAL HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
6. COMMITMENTS AND CONTINGENCIES (CONTINUED)
The Company has recently purchased a sophisticated management information
system for approximately $1,100,000 for its managed care segment, which accounts
for 89% of the Company's revenue. The purchase agreement requires the vendor to
install a Year 2000 module to handle the Year 2000 issue at no additional cost.
The Company expects to install this module in February 1999 and complete testing
within 90 days. The billing and collection system currently leased by the
Company for its fee-for-service segment, which accounts for less than 7.5% of
its revenues, is not Year 2000 compliant. A Year 2000 software upgrade has been
provided at no additional cost by the vendor with testing to be completed by
January 31, 1999. In addition, the Company has obtained a Year 2000 software
upgrade for its financial and general ledger systems at negligible cost, which
has been successfully tested by the Company. The Company tested and determined
all medical equipment to be Year 2000 compliant. Management believes that its
personal computers which utilize the Microsoft Windows NT operating system are
capable of handling the Year 2000 date change. In addition to replacing or
modifying its programs and systems, the Company has also contacted all hospitals
and health plans with which it transacts business and has been provided
assurance that they will be Year 2000 compliant by March 1999.
Since no assurance can be provided that the Year 2000 issue will be
successfully resolved, the Company's project team will complete a contingency
plan by March 31, 1999 to address potential problems in the event the Company's
systems or programs or principal business partners fail to be Year 2000
compliant. Costs of modifying the software to remediate Year 2000 problems are
charged to expense as incurred.
7. SUBSEQUENT EVENTS
COMPLETED AND PENDING ACQUISITIONS
In October 1997, Pegasus Medical Group Inc., an affiliate of Prospect,
purchased substantially all the assets of Western Medical Group, Inc. The
acquisition price of $700,000 and related acquisition costs of $53,310 were
allocated to goodwill.
On December 17, 1997, the Company executed a binding commitment letter to
purchase certain assets of Antelope Valley Medical Group, Inc. for consideration
totaling $500,000 in cash and $500,000 in a short-term promissory note bearing
interest at 8% per year and 200,000 shares of the Company's common stock valued
at $5.00 per share. The acquisition was completed effective as of June 1, 1998.
The acquisition price of $2,000,000 and $82,619 in acquisition costs were
allocated to goodwill.
SHAREHOLDER SETTLEMENT
Yorba Linda Medical Group (YLMG) is a primary care physician practice in
Orange County, California. In October 1986, the shareholders of YLMG formed PMG
as a separate California professional medical corporation, to engage in the
managed care healthcare practice. The YLMG shareholders were also shareholders
of PMG. Through a series of transactions effected at or around the time of the
1996 Merger (see Note 1), the YLMG shareholders redeemed their shares in PMG and
received shares in the newly formed Prospect Medical Systems, Inc., which were
ultimately exchanged for a majority of the shares in the Company. The Company
formerly maintained an administrative service agreement with YLMG under which
the Company provided administrative and operational services such as contract
management, utilization review, case management, claims processing and payment
and quality assurance. Pursuant to this agreement, YLMG agreed to pay to the
Company a management fee for its services. Since Prospect did not have a nominee
shareholder agreement with YLMG and did not have a controlling
F-25
<PAGE>
PROSPECT MEDICAL HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
7. SUBSEQUENT EVENTS (CONTINUED)
financial interest in YLMG through ownership of voting common stock or by other
means, the accounts of YLMG are not consolidated in the accompanying financial
statements for the relevant periods.
Effective July 1, 1998, the Company entered into a settlement agreement with
certain YLMG physician-shareholders, PMG and YLMG (the "Yorba Linda Settlement
Agreement") whereby the physicians surrendered 1,126,323 shares of the Company's
common stock previously issued to them, at no cost to Prospect, in return for a
release from noncompetition and nondiversion provisions contained in certain
agreements. The remaining YLMG physicians elected to remain in the Prospect
network and continued to contract with the Company through a new professional
corporation. This transaction did not result in a gain or loss to the Company
since the return of the shares (at no cost to the Company) was accounted for as
a treasury stock transaction and, as the YLMG physicians who voluntarily
withdrew were in the original PMG network, this transaction did not result in an
adjustment to goodwill. Prospect estimates that a maximum of approximately
13,000 PMG enrollees who were served by these physicians could elect to transfer
to a medical organization that is not affiliated with the Company. As of October
1, 1998, approximately 6,000 PMG enrollees have transferred to an unaffiliated
medical organization. Revenues, medical costs and operating expenses related to
the 13,000 enrollees in fiscal 1997 were approximately $8,278,000, $5,866,000
and $891,000, respectively.
8. NOTE TO UNAUDITED INTERIM FINANCIAL STATEMENTS
The unaudited financial information for the nine-month periods ended June
30, 1997, and June 30, 1998, has been prepared in accordance with generally
accepted accounting principles for interim financial information. In the opinion
of management, all adjustments considered necessary for a fair presentation,
which consist solely of normal recurring adjustments, have been included. The
interim information should be read in conjunction with the financial statements
for the years ended September 30, 1995, 1996, and 1997. Operating results for
interim periods are not necessarily indicative of the results which may be
expected for the entire year.
The Company was not in compliance with certain financial covenants at March
31, 1998 and June 30, 1998, respectively. The Company has received waivers from
its lender with respect to compliance with those covenants as of those dates.
The waiver permanently waives the events of non-compliance which existed as of
March 31, 1998 and June 30, 1998.
The YLMG physicians who have not sought to terminate their relationship with
the Company filed an action relating to certain matters which were the subject
of the negotiations leading to the Yorba Linda Settlement Agreement, entitled
DENICOLA V. MCGINTY, Orange County Superior Court Case No. 795018. This action
was subsequently dismissed by the plaintiffs in connection with the Yorba Linda
Settlement Agreement. On or about August 14, 1998, YLMG and its
physician-shareholders who had terminated their relationship with PMG pursuant
to said Settlement Agreement, filed a separate lawsuit against the Company, PMG,
PMS, Dr. DeNicola and certain other individual physicians seeking damages and
injunctive relief based upon allegations of breach of contract, fraud and
certain related claims with respect to the Yorba Linda Settlement Agreement
(MCGINTY V. PROSPECT MEDICAL GROUP, ET AL., Orange County Superior Court Case
No. 798208 (the "MCGINTY Lawsuit")). The MCGINTY Lawsuit was voluntarily
dismissed by the plaintiffs on October 9, 1998.
F-26
<PAGE>
REPORT OF INDEPENDENT AUDITORS
Board of Directors
Prospect Medical Holdings, Inc.
We have audited the accompanying balance sheets of Antelope Valley Medical
Group, Inc. as of December 31, 1997 and 1996, and the related statements of
operations, changes in shareholder's equity (deficit) and cash flows for the
years then ended. 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 financial statements referred to above present fairly,
in all material respects, the financial position of Antelope Valley Medical
Group, Inc. as of December 31, 1997 and 1996, and the results of its operations
and its cash flows for the years then ended in conformity with generally
accepted accounting principles.
/s/ ERNST & YOUNG LLP
Los Angeles, California
June 26, 1998
F-27
<PAGE>
ANTELOPE VALLEY MEDICAL GROUP, INC.
BALANCE SHEETS
<TABLE>
<CAPTION>
DECEMBER 31
----------------------- MARCH 31
1996 1997 1998
----------- ---------- -----------
(UNAUDITED)
<S> <C> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents..................................... $ 604,659 $ 159,241 $ --
Accounts receivable, net...................................... 210,437 572,006 725,034
Prepaid expenses.............................................. 3,335 -- 7,000
----------- ---------- -----------
Total current assets............................................ 818,431 731,247 732,034
Property and equipment, net..................................... 44,318 -- --
Due from affiliates (NOTE 5).................................... -- 162,159 --
Deposits and other assets....................................... 42,631 -- --
Goodwill, net................................................... 4,413,821 1,400,000 1,400,000
----------- ---------- -----------
Total assets.................................................... $ 5,319,201 $2,293,406 $ 2,132,034
----------- ---------- -----------
----------- ---------- -----------
LIABILITIES AND SHAREHOLDER'S EQUITY
Current liabilities:
Bank overdraft................................................ $ -- $ 509,938 $ 23,931
Accrued medical claims........................................ 730,364 1,299,750 1,617,980
Accounts payable and accrued expenses......................... 77,138 1,786 --
Due to former shareholders (NOTES 1 AND 5).................... 2,300,000 -- --
Due to affiliates (NOTE 5).................................... -- -- 723,731
Other liabilities (NOTE 6).................................... 800,000 1,128,257 397,558
----------- ---------- -----------
Total current liabilities....................................... 3,907,502 2,939,731 2,763,200
Due to affiliates (NOTE 5)...................................... 293,000 634,391 755,574
Medical malpractice liability................................... 148,000 24,000 24,000
----------- ---------- -----------
4,348,502 3,598,122 3,542,774
Shareholder's equity (deficit):
Common stock, Class A (voting), no par value: 750,000 shares
authorized, issued and outstanding at December 31, 1997 and
1996........................................................ 500,000 1,500,000 1,500,000
Common stock, Class B (voting), no par value: 750,000 shares
authorized, issued and outstanding at December 31, 1997 and
1996........................................................ 500,000 1,500,000 1,500,000
Accumulated deficit........................................... (29,301) (4,304,716) (4,410,740)
----------- ---------- -----------
Total shareholder's equity (deficit)............................ 970,699 (1,304,716) (1,410,740)
----------- ---------- -----------
Total liabilities and shareholder's equity (deficit)............ $ 5,319,201 $2,293,406 $ 2,132,034
----------- ---------- -----------
----------- ---------- -----------
</TABLE>
See accompanying notes.
F-28
<PAGE>
ANTELOPE VALLEY MEDICAL GROUP, INC.
STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
THREE MONTHS ENDED
YEAR ENDED DECEMBER 31 MARCH 31
--------------------------- --------------------------
1996 1997 1997 1998
------------ ------------- ------------ ------------
(UNAUDITED)
<S> <C> <C> <C> <C>
Revenues:
Net patient service revenue........................... $ 6,023,732 $ 6,556,139 $ 1,591,976 $ 1,948,434
Shared risk and stop-loss revenue..................... 421,105 436,964 41,091 157,428
------------ ------------- ------------ ------------
Total revenues.......................................... 6,444,837 6,993,103 1,633,067 2,105,862
Expenses:
Medical provider expense.............................. 5,435,702 6,806,957 1,335,008 1,959,695
Non-physician compensation and benefits............... 349,522 385,548 128,540 66,577
Occupancy............................................. 70,914 74,795 16,768 16,560
Supplies.............................................. 24,919 19,680 9,469 12,441
Purchased services and other.......................... 614,134 392,595 134,839 156,613
Provision for impairment of goodwill (NOTE 2)......... -- 3,168,260 -- --
Depreciation and amortization......................... 171,268 420,683 80,999 --
------------ ------------- ------------ ------------
Total expenses.......................................... 6,666,459 11,268,518 1,750,623 2,211,886
------------ ------------- ------------ ------------
Net loss................................................ $ (221,622) $ (4,275,415) $ (72,556) $ (106,024)
------------ ------------- ------------ ------------
------------ ------------- ------------ ------------
</TABLE>
See accompanying notes.
F-29
<PAGE>
ANTELOPE VALLEY MEDICAL GROUP, INC.
STATEMENTS OF SHAREHOLDER'S EQUITY (DEFICIT)
<TABLE>
<CAPTION>
COMMON STOCK
------------------------- ACCUMULATED
SHARES AMOUNT DEFICIT TOTAL
---------- ------------- ------------- -------------
<S> <C> <C> <C> <C>
Balance at December 31, 1995............................ 1,500,000 $ 1,450,000 $ (735,162) $ 714,838
Capital transactions with former shareholders (NOTE
5).................................................. -- (1,300,000) -- (1,300,000)
Application of push-down accounting upon acquisition
by PCAV (NOTES 1 AND 5)............................. -- 850,000 927,483 1,777,483
Net loss.............................................. -- -- (221,622) (221,622)
---------- ------------- ------------- -------------
Balance at December 31, 1996............................ 1,500,000 1,000,000 (29,301) 970,699
Capital contribution from PCAV (NOTE 5)............... -- 2,000,000 -- 2,000,000
Net loss.............................................. -- -- (4,275,415) (4,275,415)
---------- ------------- ------------- -------------
Balance at December 31, 1997............................ 1,500,000 3,000,000 (4,304,716) (1,304,716)
Net loss.............................................. -- -- (106,024) (106,024)
---------- ------------- ------------- -------------
Balance at March 31, 1998 (unaudited)................... 1,500,000 $ 3,000,000 $ (4,410,740) $ (1,410,740)
---------- ------------- ------------- -------------
---------- ------------- ------------- -------------
</TABLE>
See accompanying notes.
F-30
<PAGE>
ANTELOPE VALLEY MEDICAL GROUP, INC.
STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
THREE MONTHS ENDED
YEAR ENDED DECEMBER 31 MARCH 31
------------------------ ------------------------
1996 1997 1997 1998
----------- ----------- ----------- -----------
(UNAUDITED)
<S> <C> <C> <C> <C>
OPERATING ACTIVITIES
Net loss.................................................... $ (221,622) $(4,275,415) $ (72,556) $ (106,024)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization............................. 171,268 420,683 80,999 --
Provision for impairment of goodwill...................... -- 3,168,260 -- --
Write-off of other assets................................. -- 43,461 -- --
Cancellation of note to former shareholders............... -- (150,000) -- --
Changes in operating assets and liabilities:
Accounts receivable..................................... 172,920 (361,569) (200,497) (153,028)
Prepaid expenses and other.............................. 140 2,504 3,335 (7,000)
Accrued medical claims.................................. (169,546) 569,386 225,000 318,230
Accounts payable and other liabilities.................. 35,338 (243,720) 223,792 (732,485)
Due to affiliates....................................... 293,000 179,232 (135,596) 1,007,073
Medical malpractice liability........................... -- (124,000) -- --
----------- ----------- ----------- -----------
Net cash provided by (used in) operating activities......... 281,498 (771,178) 124,477 326,766
INVESTING ACTIVITIES
Purchases of property and equipment......................... (2,088) (34,178) (3,459) --
----------- ----------- ----------- -----------
Net cash used in investing activities....................... (2,088) (34,178) (3,459) --
FINANCING ACTIVITIES
Bank overdraft.............................................. -- 509,938 -- (486,007)
Payment of note to former shareholders...................... -- (150,000) -- --
Distributions to former shareholders........................ (615,000) -- -- --
----------- ----------- ----------- -----------
Net cash used in financing activities....................... (615,000) 359,938 -- (486,007)
----------- ----------- ----------- -----------
Decrease in cash and cash equivalents....................... (335,590) (445,418) 121,018 (159,241)
Cash and cash equivalents at beginning of period............ 940,249 604,659 604,659 159,241
----------- ----------- ----------- -----------
Cash and cash equivalents at end of period.................. $ 604,659 $ 159,241 $ 725,677 $ --
----------- ----------- ----------- -----------
----------- ----------- ----------- -----------
SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING
ACTIVITIES
Payment of acquisition debt by PCAV reflected as a capital
contribution.............................................. -- $ 2,000,000 $ 2,000,000 --
Capital transactions with former shareholders:
Distribution of non-cash assets........................... $ 385,000 -- -- --
Distribution declared payable to shareholders............. 300,000 -- -- --
PURCHASE PRICE ADJUSTMENTS
Litigation liability........................................ -- $ 312,143 -- --
Other liabilities........................................... -- 185,236 -- --
-----------
Total increase to goodwill.................................. -- $ 497,379 -- --
-----------
-----------
PURCHASE ACCOUNTING
Acquisition debt............................................ $ 2,000,000 -- -- --
Employee severance arising from acquisition................. 800,000 -- -- --
Application of push-down accounting......................... 1,777,483 -- -- --
-----------
Goodwill recorded at acquisition............................ $ 4,577,483 -- -- --
-----------
-----------
</TABLE>
See accompanying notes.
F-31
<PAGE>
ANTELOPE VALLEY MEDICAL GROUP, INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1997
1. BACKGROUND AND ORGANIZATION
Antelope Valley Medical Group, Inc. (AVMG or the Group) was incorporated as
a not-for-profit organization in 1985 as Antelope Valley Group (AVG). In 1987,
AVG reorganized as a mutual benefit organization. In June 1995, AVG became a
for-profit corporation through a statutory merger with a for-profit entity and
was renamed Antelope Valley Medical Group, Inc. The Group is a primary care
physicians group which services patients in the communities of Lancaster and
Palmdale, California. AVMG is organized as a professional corporation under the
Internal Revenue Code.
In June 1996, the outstanding common stock of the Group was purchased by
PrimeCare Medical Group of Antelope Valley, Inc. (PCAV), which is solely owned
by the controlling physician shareholder of PrimeCare International, Inc. (PCI).
Concurrent with the acquisition, AVMG entered into a management services
agreement (MSA) with PCI.
The MSA has an initial term of 30 years renewable for successive 15-year
periods unless terminated by either party for cause. Under the agreement, PCI
provides centralized non-medical administrative and operational services such as
accounting, information systems, quality assurance, billing and collections,
claims processing and payment, utilization and review, contract management,
provider and member services, marketing, financial reporting, and case
management. As compensation for services rendered, PCI receives a management fee
equal to the Group's capitation and incentive program revenues less provider
expenses.
At December 31, 1997, AVMG provides health services to approximately 11,100
commercial and 1,000 Medicare enrollees under contracts with various health
plans.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PUSH-DOWN ACCOUNTING
As discussed further in Note 6, all of the common stock of AVMG was acquired
by PCAV as of June 30, 1996, for total consideration of $3 million including $1
million in cash and a non-interest bearing note for $2 million. The purchase
consideration and resulting goodwill has been recorded on the books of AVMG. The
push-down entries resulted in an increase in shareholder's equity of $1,777,000,
notes payable of $2 million, $800,000 liability associated with an employee
termination and goodwill of $4,577,000 as of the acquisition date. In January
1997, the $2 million note was paid to the former shareholders and recorded by
PCI as a capital contribution to AVMG in the accompanying financial statements.
The financial statements reflect the combined operating results of the Group
as well as non-medical expenses incurred by PCI in the management of the Group's
operations (see Note 5).
MEDICAL REVENUE AND COST RECOGNITION
Net patient service revenue consists primarily of fees for medical services
provided by the Group under capitated contracts with health maintenance
organizations (HMOs). Capitation revenue is prepaid monthly to the Group based
on the number of enrollees electing the Group as their health care provider.
Capitation revenue under HMO contracts is recognized during the period in which
the Group is obligated to provide services. In 1997, the Group received 32%, 24%
and 14% of its net patient service revenue from three health plans. In 1996, the
Group received 31%, 26%, 17% and 12% of its net patient service revenue from
four health plans.
F-32
<PAGE>
ANTELOPE VALLEY MEDICAL GROUP, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
HMO contracts include provisions to share in the risk for hospitalization
whereby the Company can earn additional incentive revenue or incur penalties
based upon the utilization of hospital services. The Group accrues its estimated
shared risk revenue or expenses in the period in which the Group is contracted
to provide services. Shared-risk amounts receivable from the HMOs or hospitals
are recorded based upon estimated hospital utilization and associated costs
incurred by assigned HMO enrollees, compared to budgeted costs. Differences
between actual contract settlements and estimated receivables relating to HMO
risk-sharing arrangements are recorded in the year of final settlement. In 1997
and 1996, the Group recorded shared-risk revenue from HMOs and unaffiliated
hospitals totaling $99,000 and $155,000, respectively.
Included in net patient service revenue in 1997 was net institutional
revenue of $317,000, relating to Desert Valley Hospital (DVH), an affiliated
medical facility owned by PCI. The institutional revenue represents capitation
payments received by DVH relating to the Group's enrollees less medical expenses
for institutional services rendered. Such net revenues are allocated to the
Group under an intercompany risk sharing agreement.
In connection with providing services to HMO enrollees, the Group is
responsible for all covered medical services provided to assigned HMO enrollees.
The cost of medical services is recognized in the period in which it is provided
and includes an estimate of the cost of services which have been incurred but
not yet reported. The estimate for accrued medical costs is based on actuarial
projections of costs using historical studies of claims payments. Estimates are
continually monitored and reviewed and, as settlements are made or estimates
adjusted, differences are reflected in current operations.
The Group participates in reinsurance protection programs which limit the
amount of risk it ultimately bears by providing reimbursement payments once
medical services provided to an individual enrollee exceed an agreed-upon
amount. Estimates of reinsurance recoveries are included in accounts receivable
and are reflected as a reduction of medical provider expense in the accompanying
financial statements. Reinsurance recoveries for 1997 and 1996 were not
significant.
CASH AND CASH EQUIVALENTS
The Company considers all highly liquid investments with a maturity of three
months or less when purchased to be cash equivalents.
ACCOUNTS RECEIVABLE, NET
A summary of accounts receivable at December 31 is as follows:
<TABLE>
<CAPTION>
1996 1997
---------- ----------
<S> <C> <C>
Shared risk receivables............................................... $ 138,163 $ 102,148
Full risk receivables................................................. -- 316,926
Stop-loss and other receivables....................................... 72,274 152,932
---------- ----------
$ 210,437 $ 572,006
---------- ----------
---------- ----------
</TABLE>
F-33
<PAGE>
ANTELOPE VALLEY MEDICAL GROUP, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost, and are depreciated using the
straight-line method over the useful lives of the assets which range from five
to seven years. Leasehold improvements are amortized using the straight-line
method over the shorter of the lease period or the estimated useful lives of the
leasehold improvements.
MEDICAL MALPRACTICE LIABILITY INSURANCE
The Group purchases claims-made basis professional liability coverage of up
to $1,000,000 per incident and $3,000,000 in the aggregate on an annual basis,
with a $25,000 deductible per case. Claims-made coverage covers only those
claims reported during the policy period. The recorded liability for claim
losses not covered by insurance, including losses incurred but not reported, is
estimated by an independent actuary based on the Group's claims experience using
a discount rate of 9% for both 1997 and 1996. There is no assurance that the
amount accrued will be adequate to cover actual claims settled.
GOODWILL
Goodwill totaling $5,074,000 arose as the result of the acquisition of the
Group by PCAV. The amount represents the excess of the consideration paid and
liabilities assumed over the fair value of the assets acquired. Included in
total goodwill was an adjustment in 1997 of $497,000 to reflect the resolution
of an acquisition contingency which was primarily related to the resolution of
litigation arising from the Group's acquisition (see Note 6). Goodwill is being
amortized over 15 years.
At each reporting period, management reviews the carrying value of goodwill
to determine if facts and circumstances exist which would suggest that goodwill
may be impaired or that the amortization period needs to be modified. Among the
factors considered in making the evaluation are changes in the payor or
physician contracts, local market developments, changes in regulations, national
health care trends, changes in third-party payment patterns and other factors.
In December 1997, PCI adopted a formal plan to exit the Lancaster market and
subsequently entered into an agreement in June 1998 to sell certain assets to
Prospect Medical Holdings, Inc. (Prospect--see Note 7).
The sale of AVMG was based on PCI's assessment that it could not operate
AVMG profitably. Consequently, as a result of these factors, PCI determined that
the goodwill of AVMG was impaired and a write-down was necessary. Since PCI
entered into an agreement with Prospect to sell AVMG's management services
agreement and physician contracts of AVMG, PCI has determined that the sale
price represents the fair value of AVMG's goodwill as of December 31, 1997.
Therefore, an impairment adjustment of $3,168,000 was recorded as of December
31, 1997, and has been reflected in the accompanying statements of operations.
Amortization expense totaled $343,000 and $163,000 for 1997 and 1996,
respectively. Accumulated amortization, exclusive of the impairment charge, was
$506,000 and $163,000 at December 31, 1997 and 1996, respectively.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying amounts of financial instruments reported in the accompanying
balance sheets (consisting primarily of cash and cash equivalents, accounts
receivable, and all liabilities) approximate their fair value due to the
relatively short period of time between the origination of the instruments and
their expected realization.
F-34
<PAGE>
ANTELOPE VALLEY MEDICAL GROUP, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
CONCENTRATION OF CREDIT RISK
Financial instruments which potentially subject AVMG to concentrations of
credit risk consist primarily of cash and cash equivalents, accounts receivable
shared risk and reinsurance receivable. Concentration of credit risk with
respect to accounts receivable is limited, due to the large number of payors
comprising AVMG's customer base. Concentration of credit risk with respect to
shared risk and reinsurance receivable is limited since amounts are generally
due from large HMOs.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities as of the date of the financial
statements. Estimates also affect the reported amounts of revenues and expenses
during the reporting period. Estimates made by the Group relate primarily to
valuation of receivables and deferred tax assets, recoverability of intangibles,
accrued medical claims and medical malpractice liability. Actual results could
differ from these estimates.
3. PROPERTY AND EQUIPMENT
A summary of property and equipment at December 31 follows:
<TABLE>
<CAPTION>
1996 1997
---------- ----------
<S> <C> <C>
Medical equipment..................................................... $ 3,610 $ --
Computer equipment.................................................... 112,048 --
Furniture and equipment............................................... 28,152 --
Leasehold improvements................................................ 12,085 --
---------- ----------
155,895 --
Less accumulated depreciation......................................... 111,577 --
---------- ----------
Property and equipment, net........................................... $ 44,318 $ --
---------- ----------
---------- ----------
</TABLE>
Depreciation expense totaled $21,000 and $19,000 for 1997 and 1996,
respectively. In 1997, the Group recorded a charge of $57,000 to write off the
net carrying value of its property and equipment due to impairment of such
assets. The amount is included in depreciation and amortization expense.
4. INCOME TAXES
The Group accounts for income taxes using the liability method as required
by Statement of Financial Accounting Standards No. 109, "Accounting for Income
Taxes" (SFAS No. 109). SFAS No. 109 is an asset and liability method which
requires the recognition of deferred tax assets and liabilities for the expected
future tax consequences of events that have been recognized in the Group's
financial statements or tax returns. Deferred income taxes reflect the net tax
effects of the temporary differences between the carrying amounts of assets and
liabilities for financial reporting purposes and the amounts used for income tax
return purposes. Deferred income taxes may also be recognized for operating
losses incurred that will be available to offset future federal and state
taxable income. In estimating future tax consequences, SFAS
F-35
<PAGE>
ANTELOPE VALLEY MEDICAL GROUP, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
4. INCOME TAXES (CONTINUED)
No. 109 generally considers all expected future events other than enactments of
changes in the tax law or rates.
The Group did not record a provision for income taxes for the years ended
December 31, 1997 and 1996, due to operating losses incurred.
The differences between the provision for income taxes at the federal
statutory rate of 35% and that shown in the statements of operations are
summarized as follows:
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31
-------------------------
1996 1997
---------- -------------
<S> <C> <C>
Federal benefit at statutory rate.................................. $ 78,000 $ 1,496,000
State tax benefit.................................................. 13,000 258,000
Goodwill........................................................... (62,000) (1,440,000)
Management fee in excess of (less than) manager cost............... 57,000 (264,000)
Other.............................................................. (12,000) (19,000)
Valuation allowance................................................ (74,000) (31,000)
---------- -------------
Provision for income taxes......................................... $ -- $ --
---------- -------------
---------- -------------
</TABLE>
Significant components of the Group's federal and state deferred tax assets
are as follows:
<TABLE>
<CAPTION>
DECEMBER 31
------------------------
1996 1997
----------- -----------
<S> <C> <C>
Deferred tax assets:
Allowance for doubtful accounts................................... $ 143,000 $ --
Employee severance................................................ 328,000 456,000
Net operating losses.............................................. 376,000 376,000
Depreciation...................................................... -- 5,000
Other............................................................. -- 41,000
----------- -----------
847,000 878,000
Valuation allowance................................................. (847,000) (878,000)
----------- -----------
$ -- $ --
----------- -----------
----------- -----------
</TABLE>
At December 31, 1997, the Group has net operating losses (NOLs) for income
tax purposes of approximately $917,000. The federal and state carryforwards,
unless utilized, will expire at various dates through 2011. The Tax Reform Act
of 1986 includes provisions which may limit the net operating loss carryforwards
available for use in any given year if certain events, including changes in
stock ownership could occur. Management believes that a portion of the NOLs may
be subject to an annual limitation under the provisions of Section 382 of the
Internal Revenue Code and may not be available during the 15-year carryforward
period. As such, a valuation allowance is provided for all deferred tax assets.
Benefits of deferred tax assets will be recognized when realized. Taxes paid in
1997 and 1996 were not significant.
F-36
<PAGE>
ANTELOPE VALLEY MEDICAL GROUP, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
5. RELATED PARTY TRANSACTIONS
ACQUISITION DEBT
In June 1996, PCAV acquired all of the outstanding common stock of AVMG for
$3 million. $1 million was paid upon closing and recorded as paid in capital at
December 31, 1996. The remaining $2 million in a non-interest bearing note was
paid in January 1997. Prior to the acquisition, AVMG made distributions of cash
and other assets to the shareholders totaling $1.3 million. $1 million was
distributed prior to closing and the remaining $300,000 was held pending the
outcome of the Group's litigation with a former officer (see Note 6). $150,000
was paid in October 1997, and the remaining $150,000 was canceled due to the
adverse outcome of such legal matter. Total amounts due to former shareholders
at December 31, 1996, of $2,300,000 were included in current liabilities in the
accompanying balance sheet. All amounts due were paid or canceled as of December
31, 1997.
MANAGEMENT COST
PCI incurs certain expenses for the provision of management services to the
Group. Pursuant to the MSA, these costs are not separately reimbursable and are
included in the management fee. As discussed in Note 1, manager costs are
included in the accompanying financial statements to reflect the operating
results of the Group on a stand-alone basis. Direct expenses are recorded as
non-medical operating costs and general expenses of PCI allocable to the Group
are included in purchased services in the statements of operations. General
expenses primarily include corporate overhead costs and costs of centralized
administrative and support departments, including claims processing, physician
credentialing, accounting, human resources and other services. Claims processing
costs are allocated to the Group based on the number of claims processed.
Credentialing costs are allocated based on physicians credentialed and human
resources costs are allocated based on the number of full-time equivalents.
Accounting and other general expenses are allocated based on member months.
Management believes that these allocation methods are reasonable. Total direct
and allocable expenses of PCI (excluding depreciation and amortization), were
$873,000 for 1997 and $448,000 for the six-month period from the acquisition
date to December 31, 1996. Payables to PCI for costs incurred in the amount of
$634,000 and $293,000 are included in due to affiliates (non-current) at
December 31, 1997 and 1996, respectively. Management fees computed in accordance
with the MSA were $186,000 and $587,000 for 1997 and the six months ended
December 31, 1996, respectively.
FULL RISK INCOME
AVMG shares certain institutional revenue with Desert Valley Hospital (DVH),
a wholly owned subsidiary of PCI. Under an intercompany agreement, capitation
revenue received by DVH attributable to the Group's enrollees, net of the
related cost of institutional services, is allocated to the Group. Net revenues
totaled $317,000 in 1997, all of which were outstanding at year end. No amounts
were allocated to the Group in 1996.
OTHER
Due to/from affiliates included in current assets (liabilities) arise from
the ordinary course of business and relates primarily to cash transfers between
the Group and PCI as the Group is included in PCI's centralized cash management
system.
F-37
<PAGE>
ANTELOPE VALLEY MEDICAL GROUP, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
6. COMMITMENTS AND CONTINGENCIES
LEASES
The Company leases certain office space and equipment under operating leases
which expire through
1998. Minimum rental payments required in 1998 under the operating leases that
have initial or remaining noncancelable lease terms in excess of one year at
December 31, 1997, totaled $43,000. Rental expense for 1997 and 1996 was $40,000
and $71,000, respectively.
LITIGATION
In June 1996, the Group terminated a former officer upon acquisition by PCAV
and recorded a liability of $800,000 for certain obligations pursuant to the
officer's employment agreement, although PCI had disputed its obligation to pay
such amount. This amount was included in goodwill recorded upon the acquisition
of the Group by PCI. In February 1998, the dispute was settled and the Group
received an adverse ruling totaling $1,112,000 in binding arbitration. The award
in excess of the amount accrued was included in the impairment charge recorded
in 1997. Outstanding amounts due to the former officer included in other current
liabilities were $398,000, $1,112,000, and $800,000 at March 31, 1998, December
31, 1997 and December 31, 1996, respectively.
ASSETS PLEDGED
In May 1997, PCI obtained a $75 million senior secured credit facility from
a commercial bank. At December 31, 1997, $55 million principal amount was
outstanding under this facility. To secure this facility, PCI, its subsidiaries
and affiliated professional corporations, including AVMG, provided to the bank a
first priority perfected security interest in all real and personal assets.
AVMG's outstanding common stock was also pledged to the bank. On May 19, 1998,
this credit facility was fully repaid, and all security interests and stock
pledges, including those of AVMG, were fully released.
REGULATORY MATTERS
Laws and regulations governing the Medicare program and health care
generally are complex and subject to interpretation. The Company believes that
it is in compliance with all applicable laws and regulations and is not aware of
any pending or threatened investigations involving allegations of potential
wrongdoing. While no such regulatory inquiries have been made, compliance with
such laws and regulations can be subject to future government review and
interpretation as well as significant regulatory action including fines,
penalties, and exclusion from the Medicare program.
YEAR 2000--UNAUDITED
The Group processes its financial and operating data using PCI's centralized
computer systems. As certain assets of the Group were acquired on June 1, 1998
(see Note 7), and the operations of the Group's business were assumed by
Prospect Medical Holdings, Inc. (Prospect) on such date, subsequent financial
and operational transaction processing will be performed using separate computer
systems implemented for the Group by Prospect.
Prospect's accounting software is currently capable of processing
transactions in the year 2000 and beyond. Prospect is implementing a purchase
contract for its management information system which provides for a software
upgrade to be installed in February 1999 to address year 2000 matters.
Implementation costs are not expected to be significant.
F-38
<PAGE>
ANTELOPE VALLEY MEDICAL GROUP, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
7. SUBSEQUENT EVENT AND CURRENT LIQUIDITY ISSUES
On June 1, 1998, Prospect acquired certain assets of AVMG (primarily
goodwill and management rights to the Group). Of the total purchase price,
$500,000 is payable in cash, $500,000 in a short-term promissory note at an
annual interest rate of 8% and the balance in 200,000 shares of Prospect common
stock. Prospect intends to provide necessary funds to finance the Group's
working capital deficiency.
8. NOTE TO UNAUDITED INTERIM FINANCIAL STATEMENTS
The unaudited financial information for the three-month periods ended March
31, 1998 and 1997, has been prepared in accordance with generally accepted
accounting principles for interim financial information. In the opinion of
management, all adjustments considered necessary for a fair presentation, which
consist solely of normal recurring adjustments, have been included. The interim
information should be read in conjunction with the financial statements for the
years ended December 31, 1997 and 1996. Operating results for interim periods
are not necessarily indicative of the results which may be expected for the
entire year.
F-39
<PAGE>
REPORT OF INDEPENDENT AUDITORS
The Boards of Directors of
Sierra Primary Care Medical Group, a Medical Corporation
Sierra Medical Management, Inc.
Prospect Medical Group, Inc.
We have audited the accompanying combined statements of operations and
accumulated deficit, and cash flows of Sierra Primary Care Medical Group, a
Medical Corporation and Sierra Medical Management, Inc. for the nine months
ended September 30, 1997, and the year ended 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 financial statements referred to above present fairly,
in all material respects, the combined results of operations and cash flows of
Sierra Primary Care Medical Group, a Medical Corporation and Sierra Medical
Management, Inc. for the nine months ended September 30, 1997, and the year
ended December 31, 1996, in conformity with generally accepted accounting
principles.
/s/ ERNST & YOUNG LLP
Los Angeles, California
March 2, 1998
F-40
<PAGE>
SIERRA PRIMARY CARE MEDICAL GROUP,
A MEDICAL CORPORATION
AND SIERRA MEDICAL MANAGEMENT, INC.
COMBINED STATEMENTS OF OPERATIONS AND ACCUMULATED DEFICIT
<TABLE>
<CAPTION>
NINE MONTHS
YEAR ENDED ENDED
DECEMBER 31 SEPTEMBER 30
1996 1997
------------- -------------
<S> <C> <C>
Revenues:
Net patient service revenue...................................................... $ 11,996,995 $ 9,247,655
Risk-share and stop loss revenue................................................. 716,544 408,175
------------- -------------
Total revenues..................................................................... 12,713,539 9,655,830
Expenses:
Medical provider expense:
Physician shareholders......................................................... 1,776,000 1,380,533
Other.......................................................................... 6,587,298 4,936,293
Non-physician compensation and benefits.......................................... 2,533,820 2,041,874
Occupancy........................................................................ 627,386 483,040
Supplies......................................................................... 266,294 283,426
Purchased services and other..................................................... 812,877 1,094,962
Depreciation and amortization.................................................... 58,298 32,976
Loss on sale of property and equipment........................................... -- 26,710
------------- -------------
Total expenses..................................................................... 12,661,973 10,279,814
------------- -------------
Income (loss) before income taxes.................................................. 51,566 (623,984)
Income tax expense (benefit)....................................................... 52,407 (244,360)
------------- -------------
Net loss........................................................................... (841) (379,624)
Accumulated deficit at beginning of period......................................... (212,373) (213,214)
------------- -------------
Accumulated deficit at end of period............................................... $ (213,214) $ (592,838)
------------- -------------
------------- -------------
</TABLE>
See accompanying notes.
F-41
<PAGE>
SIERRA PRIMARY CARE MEDICAL GROUP,
A MEDICAL CORPORATION
AND SIERRA MEDICAL MANAGEMENT, INC.
COMBINED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
NINE MONTHS
YEAR ENDED ENDED
DECEMBER 31 SEPTEMBER 30
1996 1997
------------ ------------
<S> <C> <C>
OPERATING ACTIVITIES
Net loss............................................................................. $ (841) $ (379,624)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization...................................................... 58,298 32,976
Loss on sale of property and equipment............................................. -- 26,710
Changes in operating assets and liabilities:
Accounts receivable.............................................................. 39,046 (25,973)
Shared risk receivable........................................................... 25,000 200,000
Other receivables................................................................ -- (10,916)
Refundable income taxes.......................................................... (94,279) 95,429
Deferred tax asset............................................................... -- (203,776)
Claims payable................................................................... (41,911) 297,439
Accounts payable and other....................................................... 15,240 45,096
Salaries and benefits payable.................................................... 35,115 29,955
------------ ------------
Net cash provided by operating activities............................................ 35,668 107,316
INVESTING ACTIVITIES
Purchases of property and equipment.................................................. (22,996) --
Proceeds from sale of property and equipment......................................... -- 105,706
------------ ------------
Net cash provided by (used in) investing activities.................................. (22,996) 105,706
FINANCING ACTIVITIES
Issuance of common stock of Sierra Medical Management, Inc........................... -- 10,000
Proceeds from borrowings............................................................. 54,135 --
Principal payments on long-term debt................................................. (2,225) (51,910)
------------ ------------
Net cash (used in) provided by financing activities.................................. 51,910 (41,910)
------------ ------------
Net increase in cash and cash equivalents............................................ 64,582 171,112
Cash and cash equivalents at beginning of period..................................... 324,071 388,653
------------ ------------
Cash and cash equivalents at end of period........................................... $ 388,653 $ 559,765
------------ ------------
------------ ------------
</TABLE>
See accompanying notes.
F-42
<PAGE>
SIERRA PRIMARY CARE MEDICAL GROUP,
A MEDICAL CORPORATION
AND SIERRA MEDICAL MANAGEMENT, INC.
NOTES TO COMBINED FINANCIAL STATEMENTS
SEPTEMBER 30, 1997
1. BACKGROUND AND ORGANIZATION
Sierra Primary Care Medical Group, a Medical Corporation (SPCMG) was
incorporated in 1984 as a primary care physician group which serves patients in
the communities of Lancaster and Palmdale, California. SPCMG is organized as a
C-corporation under the Internal Revenue Code.
Sierra Medical Management, Inc. (SMM) was incorporated in April 1997, as a
healthcare management services organization which provides comprehensive medical
management services, organizational development and contracting support to
SPCMG. SMM is organized as a C-corporation under the Internal Revenue Code and
it commenced operations on June 1, 1997.
SPCMG and SMM are owned and managed by two physician shareholders. Effective
May 21, 1997, SPCMG and SMM (collectively the Company) entered into a management
services agreement with an initial term of 30 years renewable for successive
10-year periods thereafter, unless terminated by either party with advance
written notice.
Under the management services agreement, SMM agrees to provide
administrative and operational services such as contract management, network
development, provider and member services, marketing, financial reporting,
utilization review, case management, claims processing and payment, and quality
assurance for a fee, based upon a contractual formula.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The combined financial statements include the accounts of SPCMG and SMM from
commencement of operations in April 1997. SPCMG and SMM are under common
ownership and management for all periods presented and these financial
statements represent the results of a single business enterprise. All
significant intercompany transactions and balances have been eliminated in
combination.
MEDICAL REVENUE AND COST RECOGNITION
Net patient service revenue consists primarily of fees for medical services
provided by the Company under capitated contracts with health maintenance
organizations (HMOs). Capitation revenue under HMO contracts is prepaid monthly
to the Company based on the number of enrollees electing the Company as their
health care provider. Capitation revenue is recognized during the period in
which the Company is obligated to provide services. The Company received
approximately 92% of its net patient service revenue under capitated
arrangements for the nine months ended September 30, 1997, and the year ended
December 31, 1996. The remainder of the Company's revenue is derived under
fee-for-service arrangements which is recorded in the period the services are
rendered. For the nine months ended September 30, 1997, and the year ended
December 31, 1996, the Company received 43%, 34% and 12% of its net patient
service revenue from three health plans. HMO contracts include provisions to
share in the risk for hospitalization whereby the Company can earn additional
revenue or incur penalties based upon the utilization of hospital services. The
Company accrues its estimated shared risk revenue or expenses in the period in
which the Company is contracted to provide services. Shared-risk revenues are
estimated based upon hospital utilization and associated costs incurred by
assigned HMO enrollees, compared to
F-43
<PAGE>
SIERRA PRIMARY CARE MEDICAL GROUP,
A MEDICAL CORPORATION
AND SIERRA MEDICAL MANAGEMENT, INC.
NOTES TO COMBINED FINANCIAL STATEMENTS (CONTINUED)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
budgeted costs. Differences between actual contract settlements and estimated
amounts relating to HMO risk-sharing arrangements are recorded in the year of
final settlement.
In connection with providing services to HMO enrollees, the Company is
responsible for all covered medical services provided to assigned HMO enrollees.
The cost of medical services is recognized in the period in which it is provided
and includes an estimate of the cost of services which have been incurred but
not yet reported. The estimate for accrued medical costs is based on actuarial
projections of costs using historical studies of claims paid. Estimates are
continually monitored and reviewed and, as settlements are made or estimates
adjusted, differences are reflected in current operations.
The Company participates in reinsurance protection programs with the HMOs
which limit the amount of risk the Company ultimately bears by providing
reimbursement payments once medical services provided to an individual enrollee
exceed an agreed-upon amount. Reinsurance recoveries are recorded once the
attachment point is achieved and the amounts are collected from the HMOs.
Reinsurance recoveries for the nine months ended September 30, 1997 and the year
ended December 31, 1996 were not significant.
DEPRECIATION
Property and equipment are depreciated using the straight-line method over
the useful lives of the assets which range from five to seven years. Leasehold
improvements are amortized over the shorter of the useful lives or the lease
period.
MEDICAL MALPRACTICE LIABILITY INSURANCE
The Company procures professional liability coverage on behalf of its
physicians on a claims-made basis of up to $1,000,000 per claim and a $3,000,000
annual aggregate. The insurance contract specifies that coverage is available
only during the term of each insurance contract and covers only those claims
reported while the policies are in force. The Company has renewed its policy
through September 30, 1998. Based on a review of prior claims experience,
including reporting patterns and the number and severity of claims, and in
consideration of the cost of available tail coverage, the Company has recorded
an estimate for incurred but not reported claims at September 30, 1997. There is
no assurance that the amount accrued will be adequate to cover actual claims
settled.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from these estimates.
REGULATORY MATTERS
Laws and regulations governing the Medicare program and health care
generally are complex and subject to interpretation. The Company believes that
it is in compliance with all applicable laws and regulations and is not aware of
any pending or threatened investigations involving allegations of potential
wrongdoing. Compliance with such laws and regulations can be subject to future
government review and
F-44
<PAGE>
SIERRA PRIMARY CARE MEDICAL GROUP,
A MEDICAL CORPORATION
AND SIERRA MEDICAL MANAGEMENT, INC.
NOTES TO COMBINED FINANCIAL STATEMENTS (CONTINUED)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
interpretation as well as significant regulatory action including fines,
penalties, and exclusion from the Medicare and Medicaid programs.
3. BENEFIT PLANS
The Company sponsors a defined contribution plan (the Plan) for employees
who meet the minimum length of service and age requirements. The plan was
adopted in 1990. Eligible employees may contribute up to the statutory limit in
the Plan year. The Company may, at its discretion, match up to 25% of employee
contributions not to exceed 4% of an employee's compensation. The Company is
responsible for the administration of the Plan as the Plan administrator and
trustee.
The Company's contributions totaled $8,742 for the nine months ended
September 30, 1997, and $11,377 for the year ended December 31, 1996.
4. INCOME TAXES
The Company accounts for income taxes using the liability method as required
by Statement of Financial Accounting Standards No. 109, "Accounting for Income
Taxes" (SFAS No. 109). SFAS No. 109 is an asset and liability method which
requires the recognition of deferred tax assets and liabilities for the expected
future tax consequences of events that have been recognized in the Company's
financial statements or tax returns. In estimating future tax consequences, SFAS
No. 109 generally considers all expected future events other than enactments of
changes in the tax law or rates.
The provision for income taxes is as follows:
<TABLE>
<CAPTION>
NINE MONTHS
YEAR ENDED ENDED
DECEMBER 31 SEPTEMBER 30
1996 1997
------------ ------------
<S> <C> <C>
Current:
Federal........................................................ $ 157,090 $
State.......................................................... 38,960 --
------------ ------------
196,050 --
------------ ------------
Deferred:
Federal........................................................ (143,643) (195,565)
State.......................................................... -- (48,795)
------------ ------------
(143,643) (244,360)
------------ ------------
Provision for income taxes (benefits)............................ $ 52,407 $ (244,360)
------------ ------------
------------ ------------
</TABLE>
Deferred income taxes represent the net effects of the temporary differences
between the carrying amount of assets and liabilities for financial reporting
purposes, and the amounts used for income tax purposes. Deferred tax assets and
liabilities were not significant at December 31, 1996 and September 30, 1997.
F-45
<PAGE>
SIERRA PRIMARY CARE MEDICAL GROUP,
A MEDICAL CORPORATION
AND SIERRA MEDICAL MANAGEMENT, INC.
NOTES TO COMBINED FINANCIAL STATEMENTS (CONTINUED)
4. INCOME TAXES (CONTINUED)
The differences between the provision for income taxes at the federal
statutory rate of 34% and that shown in the statements of operations and
accumulated deficit are summarized as follows:
<TABLE>
<CAPTION>
NINE MONTHS
YEAR ENDED ENDED
DECEMBER 31 SEPTEMBER 30
1996 1997
------------ ------------
<S> <C> <C>
Federal provision (benefit) at statutory rate.................... $ 18,048 $ (212,155)
State income taxes............................................... 7,695 (36,241)
IRS audit assessment............................................. 131,690 --
Additional state franchise taxes for 1995 and 1994............... 31,265 --
Other............................................................ 7,352 4,036
Benefit from net operating loss carryback........................ (143,643) --
------------ ------------
Provision (benefit) for income taxes............................. $ 52,407 $ (244,360)
------------ ------------
------------ ------------
</TABLE>
During fiscal 1996, the Internal Revenue Service (IRS) assessed additional
taxes of $131,690 and interest of $26,704 in the course of an audit of the
Company's tax returns for the years ended June 30, 1995 and 1994. These
assessments were paid in 1996. In fiscal 1997, the Company utilized its net
operating loss (NOL) carrybacks to reduce the additional taxable income in 1995
and 1994 as a result of the audit, and consequently received a refund of
$143,643. In January 1997, the Company also amended its 1995 and 1994 state
franchise tax returns to reflect the federal tax adjustments and paid additional
taxes of $31,265. Total assessments and additional taxes, net of the NOL
benefit, of $19,312 have been included in the provision for income taxes for
1996.
5. RELATED PARTY TRANSACTIONS
The shareholders of the Company are partners in Sierra Medical Group
Partnership (the Partnership), an affiliated medical group which comprises
primary care and specialist physicians. The Partnership's sole contract is a
provider services agreement with the Company to provide medical services to its
HMO enrollees. As consideration for its services, the Partnership receives a
percentage of the Company's total capitation revenue, which is determined at the
discretion of the Company's board of directors and is adjusted periodically
(13.5% for the nine months ended September 30, 1997, and the year ended December
31, 1996). Payments to the Partnership totaled $1,152,943 for the nine months
ended September 30, 1997, and $1,419,526 for the year ended December 31, 1996.
The Company also contracts with other non-affiliated specialists, who are
reimbursed on a discounted fee-for-service basis.
One physician shareholder also provides specialty services to the Company's
patients. Fees paid to the physician shareholder totaled $142,296 for the nine
months ended September 30, 1997, and $218,415 for the year ended December 31,
1996.
The Company leases medical facilities and office space from companies owned
by the physician shareholders. The leases expire between 1998 and 2001 at total
monthly payments of $52,124. Total rental expense under these leases for the
nine months ended September 30, 1997, was $469,116 and $625,488 for the year
ended December 31, 1996.
F-46
<PAGE>
SIERRA PRIMARY CARE MEDICAL GROUP,
A MEDICAL CORPORATION
AND SIERRA MEDICAL MANAGEMENT, INC.
NOTES TO COMBINED FINANCIAL STATEMENTS (CONTINUED)
6. SUBSEQUENT EVENT
Effective September 25, 1997, Prospect Medical Holdings, Inc. (Prospect),
together with a physician shareholder, purchased the outstanding common stock of
SPCMG and SMM for total consideration of $10,200,000 consisting of $6,500,000 in
cash, promissory notes of $2,500,000 bearing interest at 7%, and 600,000 shares
valued at $2 per share of Prospect common stock. Principal on the notes is due
in quarterly installments of $125,000 and an annual payment of $250,000.
Simultaneous with this purchase transaction, Prospect Medical Systems, Inc.
(Systems), a subsidiary of Prospect, entered into a long-term management and
assignment of revenues agreement with SPCMG with an initial 30-year term,
renewable for successive 10-year periods thereafter. All revenues for the
performance of medical services are assigned to Systems. In exchange, Systems
has agreed to provide financial, management, information systems, marketing,
advertising and public relations, risk management, and administrative support
for utilization review and quality care. Additionally, Systems at its cost, has
assumed the obligations of the facilities, medical and non-medical supplies, and
employment of non-physician personnel. All remaining funds are remitted to the
Company, from which the costs of all medical services are paid. The management
fee earned by Systems fluctuates based on the profitability of the Company as
Systems retains a 50% residual interest in the net profits of the Company.
F-47
<PAGE>
REPORT OF INDEPENDENT AUDITORS
Board of Directors of
Santa Ana-Tustin Physicians Group, Inc.
Prospect Medical Group, Inc.
We have audited the accompanying statements of operations and retained
earnings, and cash flows of Santa Ana-Tustin Physicians Group, Inc. for the
period January 1, 1997 to July 13, 1997. 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 audit. The financial
statements of Santa Ana-Tustin Physicians Group, Inc. for the ten months ended
December 31, 1996 and the year ended February 29, 1996, were audited by other
auditors whose report dated February 11, 1997, expressed an unqualified opinion
on those statements.
We conducted our audit 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 audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the results of operations and cash flows of Santa
Ana-Tustin Physicians Group, Inc. for the period January 1, 1997 to July 13,
1997, in conformity with generally accepted accounting principles.
/s/ ERNST & YOUNG LLP
Los Angeles, California
March 23, 1998
F-48
<PAGE>
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
Santa Ana-Tustin Physicians Group, Inc.
Santa Ana, California
We have audited the accompanying related statements of income, changes in
stockholder's equity and cash flows of Santa Ana-Tustin Physicians Group, Inc.
(the "Company") for the ten month period ended December 31, 1996 and year ended
February 29, 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 financial statements referred to present fairly, in all
material respects, the results of operations, changes in stockholders equity and
cash flows of Santa Ana-Tustin Physicians Group, Inc. for the ten month period
ended December 31, 1996 and year ended February 29, 1996, in conformity with
generally accepted accounting principles.
<TABLE>
<S> <C> <C>
By: /s/ BDO SEIDMAN, LLP
------------------------
BDO Seidman, LLP
</TABLE>
Los Angeles, California
February 11, 1997
F-49
<PAGE>
SANTA ANA-TUSTIN PHYSICIANS GROUP, INC.
STATEMENTS OF OPERATIONS AND RETAINED EARNINGS
<TABLE>
<CAPTION>
PERIOD
YEAR TEN MONTHS FROM
ENDED ENDED JANUARY 1 TO
FEBRUARY 29 DECEMBER 31 JULY 13,
1996 1996 1997
------------ ------------ ------------
<S> <C> <C> <C>
Revenues:
Net patient service revenue.......................................... $ 5,398,822 $5,428,784 $4,722,264
Management fee revenue............................................... 16,412 537,999 352,347
Shared-risk revenue.................................................. 596,139 510,015 233,654
Other revenues....................................................... 524,821 174,667 82,114
------------ ------------ ------------
Total revenues......................................................... 6,536,194 6,651,465 5,390,379
Expenses:
Medical provider
Physician shareholder.............................................. 791,500 830,609 180,000
Other.............................................................. 3,410,752 3,648,893 3,691,939
Non-physician compensation and benefits.............................. 1,115,050 1,209,257 930,513
Occupancy............................................................ 154,872 117,619 96,394
Supplies............................................................. 64,773 49,649 42,992
Purchased services and others........................................ 689,943 673,485 751,022
Depreciation and amortization........................................ 38,224 35,085 23,009
------------ ------------ ------------
Total expenses......................................................... 6,265,114 6,564,597 5,715,869
------------ ------------ ------------
Income (loss) before income tax expense (benefit)...................... 271,080 86,868 (325,490)
Income tax expense (benefit) (NOTE 2).................................. 108,794 35,100 (122,520)
------------ ------------ ------------
Net income (loss)...................................................... 162,286 51,768 (202,970)
Retained earnings at beginning of period............................... 245,109 407,395 459,163
------------ ------------ ------------
Retained earnings at end of period..................................... $ 407,395 $ 459,163 $ 256,193
------------ ------------ ------------
------------ ------------ ------------
</TABLE>
See accompanying notes.
F-50
<PAGE>
SANTA ANA-TUSTIN PHYSICIANS GROUP, INC.
STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
PERIOD
YEAR TEN MONTHS FROM
ENDED ENDED JANUARY 1 TO
FEBRUARY 29 DECEMBER 31 JULY 13,
1996 1996 1997
----------- ------------ ------------
<S> <C> <C> <C>
OPERATING ACTIVITIES
Net income (loss)....................................................... $ 162,286 $ 51,768 $ (202,970)
Adjustments to reconcile net income (loss) to net cash provided by
operating activities:
Depreciation and amortization......................................... 38,224 35,085 23,009
Change in operating assets and liabilities:
Shared-risk receivable.............................................. -- (5,753) (176,658)
Other receivables................................................... (46,188) (119,035) (154,830)
Prepaid expenses.................................................... -- -- (21,244)
Deferred tax asset.................................................. 48,000 (81,000) (160,720)
Other assets........................................................ 84,348 11,018 (333)
Claims payable...................................................... (95,000) 240,000 553,240
Accounts payable and accrued expenses............................... 10,327 51,514 228,331
Deferred revenue.................................................... -- -- 263,785
Income taxes payable................................................ (36,099) 90,964 (109,333)
----------- ------------ ------------
Net cash provided by operating activities............................... 165,898 274,561 242,277
INVESTING ACTIVITIES
Purchases of property and equipment..................................... (39,147) (46,438) (13,338)
----------- ------------ ------------
Net cash used in investing activities................................... (39,147) (46,438) (13,338)
FINANCING ACTIVITIES
Capital lease payments.................................................. (12,158) -- --
----------- ------------ ------------
Net cash used in financing activities................................... (12,158) -- --
----------- ------------ ------------
Increase in cash and cash equivalents................................... 114,593 228,123 228,939
Cash and cash equivalents at beginning of period........................ 276,400 390,993 619,116
----------- ------------ ------------
Cash and cash equivalents at end of period.............................. $ 390,993 $ 619,116 $ 848,055
----------- ------------ ------------
----------- ------------ ------------
</TABLE>
See accompanying notes.
F-51
<PAGE>
SANTA ANA-TUSTIN PHYSICIANS GROUP, INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1997
1. OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES
BUSINESS DESCRIPTION
Santa Ana-Tustin Physicians Group, Inc. (the Company) is an independent
physicians association (IPA) incorporated in 1981 which operates in Orange
County, California, and provides medical services primarily through capitated
contracts with health maintenance organizations (HMOs). The Company's healthcare
services are performed by employed physicians, independent providers and by IPAs
under contract with the Company. In addition, the Company provides management
services to various unaffiliated medical groups and IPAs. The Company is
organized as a C-corporation under the Internal Revenue Code.
MEDICAL REVENUES AND COST RECOGNITION
Net patient service revenue consists primarily of fees for medical services
provided by the Company under capitated contracts with HMOs. Capitated revenue
under HMO contracts is prepaid monthly to the Company based on the number of
enrollees electing the Company as their health care provider. The Company
received approximately 97% of its net patient service revenue under capitated
arrangements for the period January 1, 1997 to July 13, 1997, and the ten months
ended December 31, 1996. The remainder of the Company's revenue is derived under
fee-for-service arrangements. Three contracts accounted for 97% and 95% of the
Company's revenue for the period January 1, 1997 to July 13, 1997, and for the
ten months ended December 31, 1996, respectively. HMO contracts include
provisions to share in the risk for hospitalization whereby the Company can earn
additional revenue or incur penalties based upon the utilization of hospital
services. Estimated shared-risk amounts due from the HMOs are estimated based
upon hospital utilization and associated costs incurred by the assigned HMO
enrollees, compared to budgeted costs. Differences between actual contract
settlements and estimated amounts relating to HMO risk-sharing arrangements are
recorded in the year of final settlement.
In connection with providing services to HMO enrollees, the Company is
responsible for all covered medical services provided to assigned HMO enrollees.
The costs of medical services are recognized in the period in which they are
provided and include an estimate of the costs of services which have been
incurred but not yet reported. The estimate for accrued medical costs is based
on actuarial projections of costs using historical studies for claims paid.
Estimates are continually monitored and reviewed and, as settlements are made or
estimates adjusted, differences are reflected in current operations.
The Company participates in reinsurance protection programs with the HMOs
which limit the amount of risk the Company ultimately bears by providing
reimbursement payments once the medical services provided to an individual
enrollee exceed an agreed-upon amount. Reinsurance recoveries are recorded once
the attachment point is achieved and the amounts are collected from the HMOs.
MANAGEMENT FEE REVENUE
Management fee revenue consists of management fees from Western Individual
Practice Association and Premier Medical Group for provision of non-medical
practice support services. Management fees are recorded in the period the
services are rendered.
F-52
<PAGE>
SANTA ANA-TUSTIN PHYSICIANS GROUP, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
1. OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
DEPRECIATION
Property and equipment are depreciated using the Modified Cost Recovery
System (MACRS) method, which method is similar to an accelerated method of
depreciation, over the estimated useful life of each class of depreciable
assets.
MEDICAL MALPRACTICE LIABILITY INSURANCE
The Company procures professional liability coverage on behalf of its
physicians on a claims-made basis of up to $2,000,000 per claim and a $4,000,000
annual aggregate with no deductible. The insurance contract specifies that
coverage is available only during the term of each insurance contract and covers
only those claims reported while the policies are in force. The Company has
renewed its policy through June 1, 1998. Based on a review of prior claims
experience, including reporting patterns and the number and severity of claims,
and in consideration of the cost of available tail coverage, the Company
determined that incurred but not reported claims were not significant at
September 30, 1997. There is no assurance that actual claims will not exceed
management's estimate.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities as of the date of the financial
statements. Estimates also affect the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.
REGULATORY MATTERS
Laws and regulations governing the Medicare program and health care
generally are complex and subject to interpretation. The Company believes that
it is in compliance with all applicable laws and regulations and is not aware of
any pending or threatened investigations involving allegations of potential
wrongdoing. Compliance with such laws and regulations can be subject to future
government review and interpretation as well as significant regulatory action
including fines, penalties, and exclusion from the Medicare and Medicaid
programs.
RECLASSIFICATIONS
Certain prior period account balances have been reclassified to conform with
the 1997 financial statements presentation.
2. INCOME TAXES
The Company accounts for income taxes using the liability method as required
by Statement of Financial Accounting Standards No. 109, "Accounting for Income
Taxes" (SFAS No. 109). SFAS No. 109 is an asset and liability method which
requires the recognition of deferred tax assets and liabilities for the expected
future tax consequences of events that have been recognized in the Company's
financial statements or tax returns. In estimating future tax consequences, SFAS
No. 109 generally considers all expected future events other than enactments of
changes in the tax law or rates.
F-53
<PAGE>
SANTA ANA-TUSTIN PHYSICIANS GROUP, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
2. INCOME TAXES (CONTINUED)
The provision for income taxes (benefits) is as follows:
<TABLE>
<CAPTION>
PERIOD FROM
YEAR TEN MONTHS JANUARY 1
ENDED ENDED 1997 TO
FEBRUARY 29 DECEMBER 31 JULY 13,
1996 1996 1997
----------- ------------ ------------
<S> <C> <C> <C>
Current:
Federal........................................... $ 46,991 $ 90,400 $ --
State............................................. 13,803 25,700 --
----------- ------------ ------------
60,794 116,100
----------- ------------ ------------
Deferred:
Federal........................................... 38,000 (64,000) (96,920)
State............................................. 10,000 (17,000) (25,600)
----------- ------------ ------------
48,000 (81,000) (122,520)
----------- ------------ ------------
Provision for income taxes (benefits)............... $ 108,794 $ 35,000 $ (122,520)
----------- ------------ ------------
----------- ------------ ------------
</TABLE>
The differences between the provision for income taxes at the federal
statutory rate of 34% and that shown in the statements of operations and
retained earnings are summarized as follows:
<TABLE>
<CAPTION>
PERIOD FROM
YEAR TEN MONTHS JANUARY 1
ENDED ENDED 1997 TO
FEBRUARY 29 DECEMBER 31 JULY 13,
1996 1996 1997
----------- ------------ ------------
<S> <C> <C> <C>
Federal provision (benefit) at statutory rate....... $ 92,167 $ 29,535 $ (110,667)
State income taxes.................................. 15,744 5,045 (18,904)
Other............................................... 883 520 7,051
----------- ------------ ------------
Provision (benefit) for income taxes................ $ 108,794 $ 35,100 $ (122,520)
----------- ------------ ------------
----------- ------------ ------------
</TABLE>
3. RELATED PARTY TRANSACTIONS
Salaries paid to the sole physician shareholder totaled $180,000 for the
period January 1, 1997 to July 13, 1997, and $830,609 for the ten months ended
December 31, 1996.
4. COMMITMENTS
The Company leases medical and office space under an operating lease. The
lease is for a three-year period expiring on February 28, 1998. Rental expense
totaled $96,394 for the period January 1, 1997 to July 13, 1997, and $135,564
for the ten months ended December 31, 1996.
5. SUBSEQUENT EVENT
Effective July 14, 1997, Prospect Medical Group, Inc. (Prospect) purchased
the outstanding common stock of the Company for cash consideration of
$5,000,000. Concurrent with this purchase transaction, Prospect Medical Systems,
Inc. (Systems), an affiliate of Prospect, entered into a long-term management
and assignment of revenues agreement with the Company with an initial 30-year
term, renewable for 10 years thereafter. All revenues for the performance of
medical services are assigned to Systems. In
F-54
<PAGE>
SANTA ANA-TUSTIN PHYSICIANS GROUP, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
5. SUBSEQUENT EVENT (CONTINUED)
exchange, Systems has agreed to provide financial, management, information
systems, marketing, advertising and public relations, risk management, and
administrative support for utilization review and quality care. Additionally,
Systems, at its cost, has assumed the obligations of the facilities, medical and
non-medical supplies, and employment of non-physician personnel. All remaining
funds are remitted to the Company, from which the costs of all medical services
are paid. The management fee earned by Systems fluctuates based on the
profitability of the Company as Systems retains a 50% residual interest in the
net profits of the Company.
F-55
<PAGE>
- -------------------------------------------
-------------------------------------------
- -------------------------------------------
-------------------------------------------
NO DEALER, SALESPERSON OR ANY OTHER PERSON IS AUTHORIZED TO GIVE ANY
INFORMATION OR TO MAKE ANY REPRESENTATIONS NOT CONTAINED IN THIS PROSPECTUS,
AND, IF GIVEN OR MADE, SUCH INFORMATION OR REPRESENTATIONS MUST NOT BE RELIED
UPON AS HAVING BEEN AUTHORIZED BY THE COMPANY OR ANY OF THE UNDERWRITERS. THIS
PROSPECTUS DOES NOT CONSTITUTE AN OFFER TO SELL OR A SOLICITATION OF AN OFFER TO
BUY TO ANY PERSON IN ANY JURISDICTION WHERE SUCH AN OFFER OR SOLICITATION WOULD
BE UNLAWFUL. NEITHER THE DELIVERY OF THIS PROSPECTUS NOR ANY SALE MADE HEREUNDER
SHALL, UNDER ANY CIRCUMSTANCES, CREATE ANY IMPLICATION THAT THE INFORMATION
CONTAINED HEREIN IS CORRECT AS OF ANY TIME SUBSEQUENT TO THE DATE HEREOF.
-------------------
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Prospectus Summary........................................................ 1
Risk Factors.............................................................. 9
The Company............................................................... 23
Use of Proceeds........................................................... 24
Price Range of Common Stock and Dividend Policy........................... 25
Capitalization............................................................ 26
Dilution.................................................................. 27
Unaudited Pro Forma Financial Information................................. 28
Management's Discussion and Analysis of Financial Condition and Results of
Operations.............................................................. 36
Business of the Company................................................... 51
Beneficial Ownership of Capital Stock..................................... 74
Management of the Company................................................. 75
Certain Transactions...................................................... 81
Description of Capital Stock.............................................. 82
Shares Eligible for Future Sale........................................... 88
Underwriting.............................................................. 89
Legal Matters............................................................. 90
Experts................................................................... 91
Available Information..................................................... 92
Index to Financial Statements............................................. F-1
</TABLE>
-------------------
UNTIL , 1998 (25 DAYS AFTER THE COMMENCEMENT OF THE OFFERING),
ALL DEALERS EFFECTING TRANSACTIONS IN THE COMMON STOCK AND WARRANTS, WHETHER OR
NOT PARTICIPATING IN THIS DISTRIBUTION, MAY BE REQUIRED TO DELIVER A PROSPECTUS.
THIS IS IN ADDITION TO THE OBLIGATION OF DEALERS TO DELIVER A PROSPECTUS WHEN
ACTING AS UNDERWRITERS AND WITH RESPECT TO THEIR UNSOLD ALLOTMENTS OR
SUBSCRIPTIONS.
PROSPECT MEDICAL HOLDINGS, INC.
3,000,000 SHARES OF
COMMON STOCK
3,000,000 WARRANTS
--------------
PROSPECTUS
--------------
SECURITY CAPITAL TRADING, INC.
, 1998
- -------------------------------------------
-------------------------------------------
- -------------------------------------------
-------------------------------------------
<PAGE>
PART II
INFORMATION NOT REQUIRED IN PROSPECTUS
ITEM 13. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION.
The Registrant estimates that expenses in connection with the distribution
described in this Registration Statement will be as shown below. All expenses
incurred with respect to the distribution will be paid by the Registrant. See
"Underwriting."
<TABLE>
<S> <C>
SEC registration fee.............................................. $ 16,149
NASD filing fee................................................... 5,974
American Stock Exchange listing fee............................... 60,000
Printing and engraving expenses................................... 100,000
Transfer and warrant agent and registrar fees..................... 3,500
Accounting fees and expenses...................................... 160,000
Legal fees and expenses........................................... 275,000
Other expenses.................................................... 50,000
---------
Total......................................................... $ 670,623
---------
---------
</TABLE>
ITEM 14. INDEMNIFICATION OF DIRECTORS AND OFFICERS.
The Registrant is a Delaware corporation. Section 145 of the Delaware
General Corporation Law ("DGCL") provides that a corporation may indemnify any
person who was or is a party or is threatened to be made a party to any
threatened, pending or completed action, suit or proceeding, whether civil,
criminal, administrative or investigative (other than an action by or in the
right of the corporation) by reason of the fact that such person is or was a
director, officer, employee or agent of the corporation, or is or was serving at
the request of the corporation as a director, officer, employee or agent of
another corporation, partnership, joint venture, trust or other enterprise,
against expenses (including attorneys' fees), judgments, fines and amounts paid
in settlement actually and reasonably incurred by such person in connection with
such action, suit or proceeding if such person acted in good faith and in a
manner such person reasonably believed to be in or not opposed to the best
interests of the corporation, and, with respect to any criminal action or
proceeding, had no reasonable cause to believe such person's conduct was
unlawful.
Section 145 further provides that a corporation may indemnify any person who
was or is a party or is threatened to be made a party to any threatened, pending
or completed action or suit by or in the right of the corporation to procure a
judgment in its favor by reason of the fact that such person is or was a
director, officer, employee or agent of the corporation, or is or was serving at
the request of the corporation as a director, officer, employee or agent of
another corporation, partnership, joint venture, trust or other enterprise,
against expenses (including attorneys' fees) actually and reasonably incurred by
such person in connection with the defense or settlement of such action or suit
if such person acted in good faith and in a manner such person reasonably
believed to be in or not opposed to the best interests of the corporation and
except that no indemnification shall be made in respect of any claim, issue or
matter as to which such person shall have been adjudged to be liable to the
corporation unless and only to the extent that the Delaware Court of Chancery or
the court in which such action or suit was brought shall determine that, despite
an adjudication of liability but in view of all the circumstances of the case,
such person is fairly and reasonably entitled to indemnity for such expenses
which the Court of Chancery or such other court shall deem proper.
Additionally, Section 145 provides that indemnification pursuant to its
provisions ("permissive indemnification") shall not be deemed exclusive of any
other rights to which a person seeking indemnification may be entitled under any
bylaw, agreement, vote of stockholders or disinterested directors or
II-1
<PAGE>
otherwise, both as to action in such person's official capacity and as to action
in another capacity while holding such office.
The indemnification provisions in Article V of the Registrant's Bylaws are
substantially consistent with the permissive indemnification provisions of
Section 145 of the DGCL.
Paragraph 8 of the Registrant's Certificate of Incorporation provides
generally that each person who was or is made a party or is threatened to be
made a party to or is otherwise involved in any action, suit or proceeding by
reason of the fact that he or she is or was a director or officer of the
Registrant or, while a director or officer of the Registrant, is or was serving
at the request of the Registrant as a director, officer, employee or agent of
another entity or enterprise, shall be indemnified and held harmless by the
Registrant to the fullest extent authorized by the DGCL against all expense,
liability and loss reasonably incurred or suffered in connection therewith. Such
right to indemnification is deemed a contract right and is not exclusive of any
right which any person may have or acquire under any statute, provision of the
Certificate of Incorporation, Bylaw, agreement, vote of stockholders or
disinterested directors or otherwise. In any suit brought against the Registrant
to enforce such indemnification right, it shall be a defense that the person
seeking indemnification has not met the applicable standard of conduct set forth
in the DGCL. Further, no person who is entitled to indemnification under
Paragraph 8 shall be entitled to payment of consequential damages, including,
without limitation, damages for inconvenience, emotional distress, lost profits,
injury to privacy, publicity or reputation, or punitive damages.
Paragraph 7 of the Registrant's Certificate of Incorporation provides that
no director of the Registrant shall be personally liable to the Registrant or
its stockholders for monetary damages for any breach of fiduciary duty by such
director as a director. Notwithstanding the foregoing sentence, a director shall
be liable to the extent provided by applicable law (i) for any breach of the
director's duty of loyalty to the Registrant or its stockholders, (ii) for acts
or omissions not in good faith or which involve intentional misconduct or a
knowing violation of law, (iii) pursuant to Section 174 of the DGCL, or (iv) for
any transaction from which the director derived an improper personal benefit.
The Registrant also has purchased a liability insurance policy which insures
its directors and officers against certain liabilities, including liabilities
under the Securities Act of 1933, as amended ("Securities Act").
ITEM 15. RECENT SALES OF UNREGISTERED SECURITIES.
Except as otherwise indicated, the Registrant believes that each of the
transactions described in the table below was exempt from the registration
requirements of the Securities Act pursuant to Section 4(2) as a transaction not
involving any public offering. In each case, the number of investors was
limited, the investors were either accredited or otherwise qualified and had
access to material information about the Registrant, and restrictions were
placed on the resale of the securities sold. Where appropriate, the numbers of
securities shown in the table have been adjusted to reflect the 1:44 reverse
stock split which became effective on July 31, 1996.
<TABLE>
<CAPTION>
DATE TITLE AMOUNT CONSIDERATION RECIPIENT(S)
- --------- ------------------------ --------------------- --------------------------- ---------------------------
<C> <S> <C> <C> <C>
2/96 Common Stock 2,273 shares Services rendered to James Howatt, M.D.
associated medical group
3/96 Common Stock 45,455 shares Settlement of claims Earl F. Jordan, M.D.
3/96 Common Stock 68,864 shares(1)(2) Services rendered and Terry Worthylake
settlement of claims
3/96 Common Stock 68,864 shares(1)(2) Services rendered and James Crowell
settlement of claims
7/96 Common Stock 68,864 shares(2) Settlement of claims John Raffeto
</TABLE>
II-2
<PAGE>
<TABLE>
<CAPTION>
DATE TITLE AMOUNT CONSIDERATION RECIPIENT(S)
- --------- ------------------------ --------------------- --------------------------- ---------------------------
<C> <S> <C> <C> <C>
7/96 Common Stock 68,864 shares(2) Settlement of claims Roger L. Rothrock
7/96 Common Stock 160,162 shares Services rendered Miller & Holguin, counsel
to Registrant
7/96 Common Stock 1,534,488 shares $1,916,166 Private investors
7/96 Common Stock 307,379 shares Reimbursement of expenses Certain directors and
totaling $383,834 officers of the Registrant
7/96 Common Stock 2,002,023(3) shares Shares of Prospect Medical Former stockholders of
Systems, Inc. Prospect Medical Systems,
Inc.
7/96 Warrants to purchase 13,635 warrants Services in connection with Finders
Common Stock merger of
Prospect Medical Systems,
Inc.
10/96 Options to purchase 477,119 options Services rendered Certain directors of the
Common Stock Registrant
7/97 Warrants to purchase 132,375 warrants Extension of credit Imperial Bank
Common Stock
9/97 Common Stock and Options 600,000 shares and Shares of Sierra Medical Former stockholders of
to purchase Common Stock 35,000 options Management, Inc. Sierra Medical Management,
Inc.
1/98 Common Stock 50,000 shares(4) Sale of assets of Suncrest Barbara Noble
Medical Group, Inc.
1/98 Common Stock 1,000 shares(4) Services rendered Legal counsel
1/98 Common Stock 24,000 shares $3,000 R. Stewart Kahn
2/98 Warrants to purchase 60,350 warrants Modification of terms of Imperial Bank
Common Stock credit agreement
4/98 to Options to purchase 55,000 options Services rendered Certain officers of the
7/98 Common Stock Registrant
6/98 Common Stock 200,000 Shares Assets of PrimeCare PrimeCare International,
International, Inc. Inc.
7/98 Options to purchase 10,000 options Services rendered A director of the
common stock Registrant
</TABLE>
- ------------------------
(1) 34,091 of such shares were issued in reliance on the exemption provided by
Rule 701 under the Securities Act pursuant to a written compensation
agreement between the Registrant and the recipient.
(2) Shares issued in connection with transactions related to the merger of a
subsidiary of the Registrant into Prospect Medical Systems, Inc., a Delaware
corporation, in a reverse triangular merger (the "1996 Merger").
(3) Approximately 1,126,323 of these shares were returned to the Company
pursuant to the Yorba Linda Settlement Agreement.
(4) The obligation to issue these shares arose on or about the time of the 1996
Merger.
II-3
<PAGE>
ITEM 16. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.
(A) EXHIBITS
The following exhibits are filed as part of this Registration Statement:
1.1 Form of Underwriting Agreement by and between Security Capital Trading,
Inc. and Prospect Medical Holdings, Inc.*
2.1 Agreement and Plan of Reorganization, dated as of June 10, 1996, among
Med- Search, Inc., Med-Search Acquisition Corporation and Prospect Medical
Systems, Inc.*
2.2 Agreement for the Purchase and Sale of Stock of Santa Ana/Tustin
Physicians Group, Inc., made and entered into as of June 23, 1997, among
Prospect Medical Group, Inc., Melvin L. Reich, D.O. and Santa Ana/Tustin
Physicians Group, Inc.*
2.3 Agreement for the Purchase and Sale of Stock of Sierra Primary Care
Medical Group, Inc., made and entered into as of September 23, 1997, among
Prospect Medical Group, Inc., Sierra Primary Care Medical Group, Inc.,
Sinnadurai E. Moorthy, M.D., Karunyan Arulanantham, M.D. and the Arulanantham
Charitable Remainder Trust.*
2.4 Agreement and Plan of Reorganization made and entered into as of
September 23, 1997, among Prospect Medical Holdings, Inc., Sierra Medical
Management, Inc. and Sinnadurai E. Moorthy, M.D., Karunyan Arulanantham, M.D.
and Jayaratnam Jayakumar.*
2.5 Asset Purchase Agreement made and entered into as of October 29, 1997,
among Pegasus Medical Group, Inc., Marvin L. Ginsburg, M.D. Medical Corporation
d/b/a A.V. Western Medical Group, Inc., and J. Robert West.*
2.6 Agreement for the Purchase and Sale of Assets/Transfer of Member
Responsibility, entered into as of May 13, 1998, by and among PrimeCare
International, Inc., PrimeCare Medical Group of Antelope Valley, Inc., Prospect
Medical Holdings, Inc. and Sierra Primary Care Medical Group, A Medical
Corporation.*
2.7 First Amendment to Agreement for Purchase and Sale of Assets/Transfer
of Member Responsibility, dated, for reference purposes only, June 5, 1998, by
and among PrimeCare International, Inc., PrimeCare Medical Group of Antelope
Valley, Inc., Prospect Medical Holdings, Inc. and Sierra Primary Care Medical
Group, A Medical Corporation.*
3.1 Certificate of Incorporation of Prospect Medical Holdings, Inc. as
amended to date.*
3.2 Bylaws of Prospect Medical Holdings, Inc.*
4.1 Specimen Common Stock Certificate(1)
4.2 Form of Warrant Agreement between Prospect Medical Holdings, Inc. and
American Stock Transfer & Trust Company, Inc., including form of Warrant.*
4.3 Form of Representative's Warrant.*
5.1 Opinion of Miller and Holguin(1)
10.1 Form of Amended and Restated Management Services Agreement, made as of
September 15, 1998 and deemed to have been effective as of June 4, 1996, between
Prospect Medical Systems, Inc. and Prospect Medical Group, Inc.(2)*
10.2 Amended and Restated Assignable Option Agreement, made as of September
2, 1998 and deemed to have been effective as of June 5, 1996, among Prospect
Medical Systems, Inc., Prospect Medical Group, Inc. and Gregg DeNicola.*
10.3 Individual Non-Competition Agreement, dated as of June 5, 1996,
between Prospect Medical Group, Inc. and Gregg DeNicola, M.D.*
II-4
<PAGE>
10.4 Employment Agreement dated as of July 31, 1996 between Med-Search,
Inc. and Gregg A. DeNicola, M.D., as amended.*
10.5 Employment Agreement dated as of July 31, 1996 between Med Search,
Inc. and Jacob Y. Terner, M.D.*
10.6 Investment Agreement dated as of July 31, 1996 between Jacob Y. Terner
and Med-Search, Inc.*
10.7 Agreement dated as of July 31, 1996 among Jacob Y. Terner and Barbara
Noble, both individually and as representative of Joseph W. Noble, M.D.,
deceased, and the Noble 1992 Family Trust.*
10.8 Intentionally Omitted.
10.9 Intentionally Omitted.
10.10 Revolving Credit Agreement, dated as of July 3, 1997, between
Prospect Medical Holdings, Inc. and Imperial Bank.*
10.11 Security Agreement, dated as of July 3, 1997, between Prospect
Medical Holdings, Inc. and Imperial Bank.*
10.12 Continuing Guaranty, dated as of July 3, 1997, executed by Prospect
Medical Systems, Inc. in favor of Imperial Bank.*
10.13 Security Agreement, dated as of July 3, 1997, between Prospect
Medical Systems and Imperial Bank.*
10.14 Security Agreement - Stock Pledge, dated as of July 3, 1997, between
Prospect Medical Holdings, Inc. and Imperial Bank.*
10.15 Collateral Assignment of Transaction Documents, dated as of July 3,
1997, between Prospect Medical Systems, Inc. and Imperial Bank.*
10.16 Security Agreement (Physician Group), dated as of July 3, 1997,
between Prospect Medical Systems, Inc. and Prospect Medical Group, Inc.*
10.17 Credit Succession Agreement, dated as of July 3, 1997, among Prospect
Medical Holdings, Inc., Prospect Medical Systems, Inc., Prospect Medical Group,
Inc., Imperial Bank and Gregg DeNicola.*
10.18 Amended and Restated Warrant, dated as of July 3, 1997, issued by
Prospect Medical Holdings, Inc. to Imperial Bank.*
10.19 Amended and Restated Assignable Option Agreement made as of September
2, 1998 and deemed to have been effective as of July 14, 1997, among Prospect
Medical Systems, Inc., Prospect Medical Group, Inc. and Santa Ana/Tustin
Physicians Group, Inc.*
10.20 Non-Competition Agreement effective as of July 14, 1997 between
Prospect Medical Group, Inc. and Melvin L. Reich, D.O.
10.21 Personal Guaranty of Payment and Performance by Melvin L. Reich,
D.O., dated as of July 14, 1997, made in favor of Prospect Medical Group, Inc.*
10.22 Personal Guaranty of Payment and Performance by Jacob Y. Terner,
M.D., dated as of June 23, 1997, made in favor of Melvin L. Reich, D.O. and
Santa Ana/Tustin Physicians Group, Inc.*
10.23 Form of Amended and Restated Management Services Agreement, made as
of September 15, 1998 and deemed to have been effective as of July 14, 1997,
between Prospect Medical Systems, Inc. and Santa Ana/Tustin Physicians Group,
Inc.(2)*
10.24 Amendment Number One to Revolving Credit Agreement, dated as of July
14, 1997, between Prospect Medical Holdings, Inc. and Imperial Bank.*
II-5
<PAGE>
10.25 Amendment Number One to Security Agreement, dated as of July 14,
1997, between Prospect Medical Systems, Inc. and Imperial Bank.*
10.26 Intentionally Omitted.
10.27 Secured Promissory Note, dated as of July 14, 1997, in the original
amount of $3,000,000, executed by Prospect Medical Systems, Inc., made payable
to Prospect Medical Holdings, Inc., together with Endorsement Allonge in favor
of Imperial Bank executed by Prospect Medical Holdings, Inc.*
10.28 Inter-Company Security Agreement, dated as of July 14, 1997, between
Prospect Medical Holdings, Inc. and Prospect Medical Systems, Inc.*
10.29 Collateral Assignment of Transaction Documents, dated as of July 14,
1997, between Prospect Medical Systems, Inc. and Imperial Bank.*
10.30 Security Agreement (Physician Group), dated as of July 14, 1997,
between Prospect Medical Systems, Inc. and Santa Ana/Tustin Physicians Group,
Inc.*
10.31 Promissory Note, dated as of July 14, 1997, in the original amount of
$3,000,000, executed by Prospect Medical Group, Inc., made payable to Prospect
Medical Systems, Inc., together with Endorsement Allonge in favor of Imperial
Bank executed by Prospect Medical Systems, Inc.*
10.32 Amended and Restated Credit Succession Agreement, dated as of July
14, 1997, among Prospect Medical Holdings, Inc., Gregg DeNicola, M.D., Santa
Ana/Tustin Physicians Group, Inc., Prospect Medical Systems, Inc., Prospect
Medical Group, Inc. and Imperial Bank.*
10.33 Amended and Restated Assignable Option Agreement, made as of
September 2, 1998 and deemed to have been effective as of September 25, 1997, by
and among Sierra Primary Care Medical Group, Inc., Sierra Medical Management,
Inc. and Prospect Medical Group, Inc.*
10.34 $1,125,000 Contingent Promissory Note, dated September 25, 1997,
payable to Karunyan Arulanantham, M.D. by Prospect Medical Group, Inc.*
10.35 $1,125,000 Contingent Promissory Note, dated September 25, 1997,
payable to Sinnadurai E. Moorthy, M.D. by Prospect Medical Group, Inc.*
10.36 Option to Purchase Common Stock, dated September 25, 1997, issued by
Prospect Medical Holdings, Inc. to Sinnadurai E. Moorthy, M.D.*
10.37 Option to Purchase Common Stock, dated September 25, 1997, issued by
Prospect Medical Holdings, Inc. to Karunyan Arulanantham, M.D.*
10.38 Security Agreement (Guarantor), dated as of September 25, 1997,
entered into between Prospect Medical Holdings, Inc. and Karunyan Arulanantham,
M.D.*
10.39 Form of Second Amended and Restated Management Services Agreement,
made as of September 15, 1998 and deemed to have been effective as of September
25, 1997, between Sierra Medical Management, Inc. and Sierra Primary Care
Medical Group, Inc.(2)*
10.40 Subordinate Guaranty, dated as of September 25, 1997, executed by
Prospect Medical Holdings, Inc. in favor of Karunyan Arulanantham, M.D.*
10.41 Subordinate Guaranty, dated as of September 25, 1997, executed by
Prospect Medical Holdings, Inc. in favor of Sinnadurai E. Moorthy, M.D.*
10.42 Employment Agreement, dated September 25, 1997, between Sierra
Primary Care Medical Group, Inc. and Karunyan Arulanantham, M.D.*
10.43 Employment Agreement, dated September 25, 1997, between Sierra
Primary Care Medical Group, Inc. and Sinnadurai E. Moorthy, M.D.*
II-6
<PAGE>
10.44 Non-Competition Agreement, effective as of September 25, 1997,
between Prospect Medical Group, Inc. and Karunyan Arulanantham, M.D.*
10.45 Non-Competition Agreement, effective as of September 25, 1997,
between Prospect Medical Group, Inc. and Sinnadurai E. Moorthy, M.D.*
10.46 Employment Agreement, dated as of September 25, 1997, between Sierra
Medical Management, Inc. and Jayaratnam Jayakumar.*
10.47 Non-Competition Agreement, effective as of September 25, 1997,
between Sierra Medical Management, Inc. and Jayaratnam Jayakumar.*
10.48 $250,000 Subordinated Promissory Note, dated September 25, 1997,
payable to Jayaratnam Jayakumar by Prospect Medical Holdings, Inc.*
10.49 Option to Purchase Common Stock, dated September 25, 1997, issued by
Prospect Medical Holdings, Inc. to Jayaratnam Jayakumar.*
10.50 Security Agreement, dated September 25, 1997, entered into between
Prospect Medical Holdings, Inc. and Jayaratnam Jayakumar.*
10.51 Amendment Number Two to Revolving Credit Agreement, dated as of
September 25, 1997, between Prospect Medical Holdings, Inc. and Imperial Bank.*
10.52 Secured Promissory Note, dated as of September 25, 1997, in the
original amount of $5,000,000 executed by Prospect Medical Systems, Inc. and
made payable to Prospect Medical Holdings, Inc., together with Endorsement
Allonge in favor of Imperial Bank executed by Prospect Medical Holdings, Inc.*
10.53 Amendment Number One to Inter-Company Security Agreement, dated as of
September 25, 1997, between Prospect Medical Holdings, Inc. and Prospect Medical
Systems, Inc.*
10.54 Continuing Guaranty, dated as of September 25, 1997, delivered by
Sierra Medical Management, Inc. to Imperial Bank.*
10.55 Security Agreement, dated as of September 25, 1997, between Sierra
Medical Management, Inc. and Imperial Bank.*
10.56 Security Agreement - Stock Pledge, dated as of September 25, 1997,
between Prospect Medical Holdings, Inc. and Imperial Bank.*
10.57 Promissory Note, dated as of September 25, 1997, in the original
amount of $5,000,000, executed by Prospect Medical Group, Inc. and made payable
to Prospect Medical Systems, Inc., together with Endorsement Allonge in favor of
Imperial Bank executed by Prospect Medical Systems, Inc.*
10.58 Collateral Assignment of Transaction Documents, dated as of September
25, 1997, between Sierra Medical Management, Inc. and Imperial Bank.*
10.59 Security Agreement, dated as of September 25, 1997, between Sierra
Primary Care Medical Group, Inc. and Sierra Medical Management, Inc.*
10.60 Joinder Agreement, dated as of September 25, 1997, among Sierra
Medical Management, Inc., Sierra Primary Care Medical Group, Inc., Gregg
DeNicola, M.D., Prospect Medical Systems, Inc. Prospect Medical Group, Inc.,
Santa Ana/Tustin Physicians Group, Inc., Prospect Medical Holdings, Inc. and
Imperial Bank.*
10.61 Subordination and Note Cancellation Agreement, dated as of September
25, 1997, among Karunyan Arulanantham, M.D., Sinnadurai E. Moorthy, M.D.,
Prospect Medical Systems, Inc., Prospect Medical Group, Inc., Prospect Medical
Holdings, Inc. and Imperial Bank.*
II-7
<PAGE>
10.62 Subordination Agreement, dated as of September 25, 1997, among
Jayaratnam Jayakumar, Prospect Medical Holdings, Inc. and Imperial Bank.*
10.63 Intentionally Omitted.
10.64 Form of Amended and Restated Management Services Agreement, made as
of September 15, 1998 and deemed to have been effective as of October 31, 1997,
by and between Sierra Medical Management, Inc. and Pegasus Medical Group,
Inc.(2)*
10.65 Amended and Restated Assignable Option Agreement, made as of
September 2, 1998 and deemed to have been effective as of October 31, 1997,
among Sierra Medical Management, Inc., Pegasus Medical Group, Inc. and Prospect
Medical Group, Inc.*
10.66 Assignment and Assumption Agreement, by Marvin L. Ginsburg, M.D.
Medical Corporation d/b/a A.V. Western Medical Group, Inc. to Pegasus Medical
Group, Inc.*
10.67 Collateral Assignment of Transaction Documents, dated as of October
31, 1997, between Sierra Medical Management, Inc. and Imperial Bank.*
10.68 Security Agreement (Physician Group), dated as of October 31, 1997,
between Pegasus Medical Group, Inc. and Sierra Medical Management, Inc.*
10.69 $700,000 Secured Promissory Note, dated October 31, 1997, executed by
Prospect Medical Systems, Inc. and made payable to Prospect Medical Holdings,
Inc., together with Endorsement Allonge in favor of Imperial Bank by Prospect
Medical Holdings, Inc.*
10.70 $700,000 Promissory Note, dated October 31, 1997, executed by
Prospect Medical Group, Inc. and made payable to Prospect Medical Systems, Inc.,
together with Endorsement Allonge in favor of Imperial Bank executed by Prospect
Medical Systems, Inc.*
10.71 $700,000 Promissory Note, dated October 31, 1997, executed by Pegasus
Medical Group, Inc., made payable to Prospect Medical Group, Inc., together with
Endorsement Allonge in favor of Prospect Medical Systems, Inc. executed by
Prospect Medical Group, Inc., together with Endorsement Allonge in favor of
Imperial Bank executed by Prospect Medical Systems, Inc.*
10.72 Joinder Agreement, dated as of October 31, 1997, among Pegasus
Medical Group, Inc., Sierra Medical Management, Inc., Sierra Primary Care
Medical Group, Inc., Gregg DeNicola, M.D., Prospect Medical Holdings, Inc.,
Prospect Medical Systems, Inc., Prospect Medical Group, Inc., Santa Ana/Tustin
Physicians Group, Inc. and Imperial Bank.*
10.73 Amended and Restated Amendment Number Three to Revolving Credit
Agreement, dated as of February 6, 1998, between Prospect Medical Holdings, Inc.
and Imperial Bank, together with consent of Prospect Medical Systems, Inc. and
Sierra Medical Management, Inc. as guarantors.*
10.74 $12,500,000 Replacement Secured Revolving Note, dated February 6,
1998, executed by Prospect Medical Holdings, Inc. and made payable to Imperial
Bank.*
10.75 Amended and Restated Warrant, issued as of February 6, 1998, by
Prospect Medical Holdings, Inc. to Imperial Bank.*
10.76 Intentionally Omitted.
10.77 Consulting Agreement, dated as of March 1, 1998, between Sierra
Primary Care Medical Group, Inc. and Sinnadurai E. Moorthy, M.D.*
10.78 Prospect Medical Holdings, Inc. 1998 Stock Option Plan(1)
10.79 Intentionally Omitted.
II-8
<PAGE>
10.80 Non-Competition Agreement, made as of June 1, 1998, by and between
Sierra Primary Care Medical Group and Prospect Medical Holdings, Inc., on the
one hand, and PrimeCare Medical Group of Antelope Valley, Inc. and PrimeCare
International, on the other hand.*
10.81 IPA Medicare Shared Risk Services Agreement effective on September 1,
1989, by and between PacifiCare of California and Santa Ana-Tustin Physicians
Group, Inc.(2)*
10.82 Point-of-Service Amendment to IPA Medicare Shared Risk Services
Agreement, effective on January 1, 1996 by and between PacifiCare of California
and Santa Ana-Tustin Physicians Group, Inc.(2)*
10.83 Amendment to IPA Medicare Shared Risk Services Agreement, effective
on January 1, 1996 by and between PacifiCare of California and Santa Ana-Tustin
Physicians Group, Inc.(2)*
10.84 1995 Amendment to IPA Medicare Shared Risk Services Agreement,
effective on January 1, 1995, by and between PacifiCare of California and Santa
Ana-Tustin Physicians Group, Inc.(2)*
10.85 1994 Amendment to IPA Medicare Shared Risk Services Agreement,
effective on January 1, 1994, by and between PacifiCare of California and Santa
Ana-Tustin Physicians Group, Inc.(2)*
10.86 1993 Amendment to IPA Medicare Shared Risk Services Agreement,
effective on January 1, 1993, by and between PacifiCare of California and Santa
Ana-Tustin Physicians Group, Inc.(2)*
10.87 1992 Amendment to IPA Medicare Shared Risk Services Agreement,
effective on January 1, 1992, by and between PacifiCare of California and Santa
Ana-Tustin Physicians Group, Inc.(2)*
10.88 Amendment to IPA Medicare Shared Risk Services Agreement, effective
on January 1, 1991, by and between PacifiCare of California and Santa Ana-Tustin
Physicians Group, Inc.(2)*
10.89 Amendment to PacificCare IPA Medicare Shared Risk Services Agreement,
effective on January 1, 1990, by and between PacifiCare, Inc. and Santa
Ana-Tustin Physicians Group, Inc.(2)*
10.90 Amendment to PacifiCare IPA Medicare Shared Risk Services Agreement,
effective on August 31, 1990, by and between PacifiCare of California and Santa
Ana-Tustin Physicians Group, Inc.*
10.91 PacifiCare IPA Commercial Services Agreement, made and entered into
on January 1, 1990, by and between PacifiCare of California and Santa Ana-Tustin
Physicians Group, Inc.(2)*
10.92 Amendment to IPA Commercial Services Agreement, effective on January
1, 1996, between PacifiCare of California and Santa Ana-Tustin Physicians Group,
Inc.*
10.93 1995 Amendment to IPA Commercial Services Agreement, effective on
January 1, 1995, between PacifiCare of California, Inc. and Santa Ana-Tustin
Physicians Group, Inc.(2)*
10.94 1994 Amendment to IPA Commercial Services Agreement, effective on
January 1, 1994, between PacifiCare of California and Santa Ana-Tustin
Physicians Group, Inc.(2)*
10.95 1993 Amendment to IPA Commercial Services Agreement, effective on
January 1, 1993, between PacifiCare of California and Santa Ana-Tustin
Physicians Group, Inc.(2)*
10.96 1993 Amendment to IPA Commercial Services Agreement, effective on
January 1, 1993, between between PacifiCare of California, Inc. and Santa
Ana-Tustin Physicians Group, Inc.(2)*
10.97 PacifiCare Choice Amendment to PacifiCare IPA Commercial Services
Agreement, effective on January 1, 1993, between PacifiCare of California, Inc.
and Santa Ana-Tustin Physicians Group, Inc.(2)*
10.98 1992 Amendment to IPA Commercial Services Agreement, effective on
January 1, 1992, between PacifiCare of California and Santa Ana-Tustin
Physicians Group, Inc.(2)*
10.99 Amendment to IPA Commercial Services Agreement, effective on January
1, 1991, between PacifiCare of California and Santa Ana-Tustin Physicians Group,
Inc.(2)*
II-9
<PAGE>
10.100 IPA Medicare Partial Risk Services Agreement, made and entered into
August 1, 1993, between PacifiCare of California and Prospect Medical Group,
Inc.(2)*
10.101 Amendment to IPA Medicare Partial Risk Services Agreement, effective
November 1, 1993, between PacifiCare of California and Prospect Medical Group,
Inc.(2)*
10.102 IPA Medicare Shared Risk Services Agreement, made and entered into
July 1, 1996, between PacifiCare, Inc. and Prospect Medical Group, Inc.(2)*
10.103 Point-of-Service Amendment to IPA Medicare Shared Risk Services
Agreement, made effective July 1, 1996, by and between PacifiCare of California
and Prospect Medical Group, Inc.(2)*
10.104 CaliforniaCare Medical Services Agreement, effective January 1,
1997, between Blue Cross of California and Prospect Medical Group.(2)*
10.105 Amendment to CaliforniaCare Medical Services Agreement, effective as
of May 1, 1997, between Blue Cross of California and affiliates and Prospect
Medical Group.*
10.106 Letter of Agreement Serving as Addendum to the 1997 Medical Services
Agreement Between Blue Cross of California and Prospect Medical Group for
CaliforniaCare, Blue Cross Plus and Personal CaliforniaCare, effective January
1, 1997, between Blue Cross of California and Prospect Medical Group.(2)*
10.107 Letter of Agreement Serving as Addendum to the 1997 Medical Services
Agreement Between Blue Cross of California and Prospect Medical Group for
CaliforniaCare, Blue Cross Plus and Personal CaliforniaCare, effective January
1, 1997, between Blue Cross of California and Prospect Medical Group.(2)*
10.108 PacifiCare of California Medical Group/IPA Services Agreement (Split
Capitation), entered into March 1, 1998, between PacifiCare of California, Inc.
and Sierra Medical Group.(2)*
10.109 PacifiCare IPA Commercial Risk Services Agreement, made and entered
into as of January 1, 1996, by and between PacifiCare of California and Prospect
Medical Group, Inc.(1)
10.110 Settlement Agreement, effective as of July 1, 1998, by and among the
senior shareholders of Yorba Linda Medical Group identified therein, the junior
shareholders of Yorba Linda Medical Group identified therein, Prospect Medical
Holdings, Inc., Prospect Medical Group, Inc. and certain other parties.
16.1 Letter from BDO Seidman LLP.
21.1 List of Subsidiaries of Registrant.*
23.1 Consent of Ernst & Young LLP.
23.2 Consent of BDO Seidman LLP.
23.3 Consent of BDO Seidman LLP.
23.4 Consent of Miller & Holguin (included in Exhibit 5.1).(1)
27.1 Financial Data Schedule.*
- ------------------------
* Previously filed with the Company's Registration Statement filed on
September 18, 1998.
(1) To be filed by amendment
(2) Registrant has requested confidential treatment from the Securities and
Exchange Commission for portions of this exhibit, which confidential
portions have been filed separately.
(B) FINANCIAL STATEMENT SCHEDULES
All schedules have been omitted because they are not applicable or are not
required or the information required to be set forth therein is included in the
Registrant's Consolidated Financial Statements or the Notes thereto.
II-10
<PAGE>
ITEM 17. UNDERTAKINGS.
(a) The undersigned Registrant hereby undertakes:
(1) To file, during any period in which offers or sales are being made,
a post-effective amendment to this Registration Statement:
(i) To include any prospectus required by section 10(a)(3) of the
Securities Act;
(ii) To reflect in the prospectus any facts or events arising after
the effective date of the Registration Statement (or the most
recent post-effective amendment thereof) which, individually or
in the aggregate, represent a fundamental change in the
information set forth in the Registration Statement.
Notwithstanding the foregoing, any increase or decrease in volume
of securities offered (if the total dollar value of securities
offered would not exceed that which was registered) and any
deviation from the low or high end of the estimated maximum
offering range may be reflected in the form of prospectus filed
with the Securities and Exchange Commission pursuant to Rule
424(b) if, in the aggregate, the changes in volume and price
represent no more than 20% change in the maximum aggregate
offering price set forth in the "Calculation of Registration Fee"
table in the effective Registration Statement.
(iii) To include any material information with respect to the plan of
distribution not previously disclosed in the Registration
Statement or any material change to such information in the
registration statement;
(2) That, for the purpose of determining any liability under the
Securities Act, each such post-effective amendment shall be deemed to be a
new registration statement relating to the securities offered therein, and
the offering of such securities at that time shall be deemed to be the
initial bona fide offering thereof.
(3) To remove from registration by means of a post-effective amendment
any of the securities being registered which remain unsold at the
termination of the offering.
(f) The undersigned Registrant hereby undertakes to provide to the
Underwriters at the closing specified in the Underwriting Agreement
certificates in such denominations and registered in such names as
required by the Underwriters to permit prompt delivery to each purchaser.
(h) Insofar as indemnification for liabilities arising under the Securities
Act may be permitted to directors, officers and controlling persons of
the Registrant pursuant to the foregoing provisions, or otherwise, the
Registrant has been advised that in the opinion of the Securities and
Exchange Commission such indemnification is against public policy as
expressed in the Securities Act and is, therefore, unenforceable. In the
event that a claim for indemnification against such liabilities (other
than the payment by the Registrant of expenses incurred or paid by a
director, officer or controlling person of the Registrant in the
successful defense of any action, suit or proceeding) is asserted by such
director, officer or controlling person in connection with the securities
being registered, the Registrant will, unless in the opinion of its
counsel the matter has been settled by controlling precedent, submit to a
court of appropriate jurisdiction the question whether such
indemnification by it is against public policy as expressed in the
Securities Act and will be governed by the final adjudication of such
issue.
(i) The undersigned Registrant hereby undertakes that:
(1) For purposes of determining any liability under the Securities Act,
the information omitted from the form of prospectus filed as part of this
Registration Statement in reliance upon Rule 430A and contained in a form of
prospectus filed by the Registrant pursuant to Rule 424(b)(1) or (4) or
II-11
<PAGE>
Rule 497(h) under the Securities Act shall be deemed to be part of this
Registration Statement as of the time it was declared effective.
(2) For the purpose of determining any liability under the Securities
Act, each post-effective amendment that contains a form of prospectus shall
be deemed to be a new registration statement relating to the securities
offered therein, and the offering of such securities at that time shall be
deemed to be the initial bona fide offering thereof.
II-12
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Act of 1933, the Registrant
has duly caused this Registration Statement to be signed on its behalf by the
undersigned, thereunto duly authorized, in the City of Los Angeles, State of
California, on November 16, 1998.
<TABLE>
<S> <C> <C>
PROSPECT MEDICAL HOLDINGS, INC.
By: /s/ JACOB Y. TERNER, M.D.
-----------------------------------------
Jacob Y. Terner, M.D.
CHIEF EXECUTIVE OFFICER
</TABLE>
Pursuant to the requirements of the Securities Act of 1933, this
Registration Statement has been signed by the following persons in the
capacities and on the dates indicated.
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
- ------------------------------ -------------------------- -------------------
<C> <S> <C>
/s/ JACOB Y. TERNER, M.D. Chairman of the Board,
- ------------------------------ Chief Executive Officer November 16, 1998
Jacob Y. Terner, M.D. and Director
/s/ GREGG A. DENICOLA, M.D.
- ------------------------------ President and Director November 16, 1998
Gregg A. DeNicola, M.D.
/s/ SINNADURAI E. MOORTHY, M.D.
- ------------------------------ Director November 16, 1998
Sinnadurai E. Moorthy, M.D.
/s/ DAVID A. LEVINSOHN
- ------------------------------ Director November 16, 1998
David A. Levinsohn
/s/ KENNETH SCHWARTZ
- ------------------------------ Director November 16, 1998
Kenneth Schwartz
/s/ DONNA VIGIL Chief Financial Officer
- ------------------------------ (Principal Financial and November 16, 1998
Donna Vigil Accounting Officer)
</TABLE>
II-13
<PAGE>
INDEX TO EXHIBITS
1.1 Form of Underwriting Agreement by and between Security Capital Trading,
Inc. and Prospect Medical Holdings, Inc.*
2.1 Agreement and Plan of Reorganization, dated as of June 10, 1996, among
Med- Search, Inc., Med-Search Acquisition Corporation and Prospect Medical
Systems, Inc.*
2.2 Agreement for the Purchase and Sale of Stock of Santa Ana/Tustin
Physicians Group, Inc., made and entered into as of June 23, 1997, among
Prospect Medical Group, Inc., Melvin L. Reich, D.O. and Santa Ana/Tustin
Physicians Group, Inc.*
2.3 Agreement for the Purchase and Sale of Stock of Sierra Primary Care
Medical Group, Inc., made and entered into as of September 23, 1997, among
Prospect Medical Group, Inc., Sierra Primary Care Medical Group, Inc.,
Sinnadurai E. Moorthy, M.D., Karunyan Arulanantham, M.D. and the Arulanantham
Charitable Remainder Trust.*
2.4 Agreement and Plan of Reorganization made and entered into as of
September 23, 1997, among Prospect Medical Holdings, Inc., Sierra Medical
Management, Inc. and Sinnadurai E. Moorthy, M.D., Karunyan Arulanantham, M.D.
and Jayaratnam Jayakumar.*
2.5 Asset Purchase Agreement made and entered into as of October 29, 1997,
among Pegasus Medical Group, Inc., Marvin L. Ginsburg, M.D. Medical Corporation
d/b/a A.V. Western Medical Group, Inc., and J. Robert West.*
2.6 Agreement for the Purchase and Sale of Assets/Transfer of Member
Responsibility, entered into as of May 13, 1998, by and among PrimeCare
International, Inc., PrimeCare Medical Group of Antelope Valley, Inc., Prospect
Medical Holdings, Inc. and Sierra Primary Care Medical Group, A Medical
Corporation.*
2.7 First Amendment to Agreement for Purchase and Sale of Assets/Transfer
of Member Responsibility, dated, for reference purposes only, June 5, 1998, by
and among PrimeCare International, Inc., PrimeCare Medical Group of Antelope
Valley, Inc., Prospect Medical Holdings, Inc. and Sierra Primary Care Medical
Group, A Medical Corporation.*
3.1 Certificate of Incorporation of Prospect Medical Holdings, Inc. as
amended to date.*
3.2 Bylaws of Prospect Medical Holdings, Inc.*
4.1 Specimen Common Stock Certificate(1)
4.2 Form of Warrant Agreement between Prospect Medical Holdings, Inc. and
American Stock Transfer & Trust Company, Inc., including form of Warrant.*
4.3 Form of Representative's Warrant.*
5.1 Opinion of Miller and Holguin(1)
10.1 Form of Amended and Restated Management Services Agreement, made as of
September 15, 1998 and deemed to have been effective as of June 4, 1996, between
Prospect Medical Systems, Inc. and Prospect Medical Group, Inc.(2)*
10.2 Amended and Restated Assignable Option Agreement, made as of September
2, 1998 and deemed to have been effective as of June 5, 1996, among Prospect
Medical Systems, Inc., Prospect Medical Group, Inc. and Gregg DeNicola.*
10.3 Individual Non-Competition Agreement, dated as of June 5, 1996,
between Prospect Medical Group, Inc. and Gregg DeNicola, M.D.*
10.4 Employment Agreement dated as of July 31, 1996 between Med-Search,
Inc. and Gregg A. DeNicola, M.D., as amended.*
<PAGE>
10.5 Employment Agreement dated as of July 31, 1996 between Med Search,
Inc. and Jacob Y. Terner, M.D.*
10.6 Investment Agreement dated as of July 31, 1996 between Jacob Y. Terner
and Med-Search, Inc.*
10.7 Agreement dated as of July 31, 1996 among Jacob Y. Terner and Barbara
Noble, both individually and as representative of Joseph W. Noble, M.D.,
deceased, and the Noble 1992 Family Trust.*
10.8 Intentionally Omitted.
10.9 Intentionally Omitted.
10.10 Revolving Credit Agreement, dated as of July 3, 1997, between
Prospect Medical Holdings, Inc. and Imperial Bank.*
10.11 Security Agreement, dated as of July 3, 1997, between Prospect
Medical Holdings, Inc. and Imperial Bank.*
10.12 Continuing Guaranty, dated as of July 3, 1997, executed by Prospect
Medical Systems, Inc. in favor of Imperial Bank.*
10.13 Security Agreement, dated as of July 3, 1997, between Prospect
Medical Systems and Imperial Bank.*
10.14 Security Agreement - Stock Pledge, dated as of July 3, 1997, between
Prospect Medical Holdings, Inc. and Imperial Bank.*
10.15 Collateral Assignment of Transaction Documents, dated as of July 3,
1997, between Prospect Medical Systems, Inc. and Imperial Bank.*
10.16 Security Agreement (Physician Group), dated as of July 3, 1997,
between Prospect Medical Systems, Inc. and Prospect Medical Group, Inc.*
10.17 Credit Succession Agreement, dated as of July 3, 1997, among Prospect
Medical Holdings, Inc., Prospect Medical Systems, Inc., Prospect Medical Group,
Inc., Imperial Bank and Gregg DeNicola.*
10.18 Amended and Restated Warrant, dated as of July 3, 1997, issued by
Prospect Medical Holdings, Inc. to Imperial Bank.*
10.19 Amended and Restated Assignable Option Agreement made as of September
2, 1998 and deemed to have been effective as of July 14, 1997, among Prospect
Medical Systems, Inc., Prospect Medical Group, Inc. and Santa Ana/Tustin
Physicians Group, Inc.*
10.20 Non-Competition Agreement effective as of July 14, 1997 between
Prospect Medical Group, Inc. and Melvin L. Reich, D.O.
10.21 Personal Guaranty of Payment and Performance by Melvin L. Reich,
D.O., dated as of July 14, 1997, made in favor of Prospect Medical Group, Inc.*
10.22 Personal Guaranty of Payment and Performance by Jacob Y. Terner,
M.D., dated as of June 23, 1997, made in favor of Melvin L. Reich, D.O. and
Santa Ana/Tustin Physicians Group, Inc.*
10.23 Form of Amended and Restated Management Services Agreement, made as
of September 15, 1998 and deemed to have been effective as of July 14, 1997,
between Prospect Medical Systems, Inc. and Santa Ana/Tustin Physicians Group,
Inc.(2)*
10.24 Amendment Number One to Revolving Credit Agreement, dated as of July
14, 1997, between Prospect Medical Holdings, Inc. and Imperial Bank.*
10.25 Amendment Number One to Security Agreement, dated as of July 14,
1997, between Prospect Medical Systems, Inc. and Imperial Bank.*
10.26 Intentionally Omitted.
<PAGE>
10.27 Secured Promissory Note, dated as of July 14, 1997, in the original
amount of $3,000,000, executed by Prospect Medical Systems, Inc., made payable
to Prospect Medical Holdings, Inc., together with Endorsement Allonge in favor
of Imperial Bank executed by Prospect Medical Holdings, Inc.*
10.28 Inter-Company Security Agreement, dated as of July 14, 1997, between
Prospect Medical Holdings, Inc. and Prospect Medical Systems, Inc.*
10.29 Collateral Assignment of Transaction Documents, dated as of July 14,
1997, between Prospect Medical Systems, Inc. and Imperial Bank.*
10.30 Security Agreement (Physician Group), dated as of July 14, 1997,
between Prospect Medical Systems, Inc. and Santa Ana/Tustin Physicians Group,
Inc.*
10.31 Promissory Note, dated as of July 14, 1997, in the original amount of
$3,000,000, executed by Prospect Medical Group, Inc., made payable to Prospect
Medical Systems, Inc., together with Endorsement Allonge in favor of Imperial
Bank executed by Prospect Medical Systems, Inc.*
10.32 Amended and Restated Credit Succession Agreement, dated as of July
14, 1997, among Prospect Medical Holdings, Inc., Gregg DeNicola, M.D., Santa
Ana/Tustin Physicians Group, Inc., Prospect Medical Systems, Inc., Prospect
Medical Group, Inc. and Imperial Bank.*
10.33 Amended and Restated Assignable Option Agreement, made as of
September 2, 1998 and deemed to have been effective as of September 25, 1997, by
and among Sierra Primary Care Medical Group, Inc., Sierra Medical Management,
Inc. and Prospect Medical Group, Inc.*
10.34 $1,125,000 Contingent Promissory Note, dated September 25, 1997,
payable to Karunyan Arulanantham, M.D. by Prospect Medical Group, Inc.*
10.35 $1,125,000 Contingent Promissory Note, dated September 25, 1997,
payable to Sinnadurai E. Moorthy, M.D. by Prospect Medical Group, Inc.*
10.36 Option to Purchase Common Stock, dated September 25, 1997, issued by
Prospect Medical Holdings, Inc. to Sinnadurai E. Moorthy, M.D.*
10.37 Option to Purchase Common Stock, dated September 25, 1997, issued by
Prospect Medical Holdings, Inc. to Karunyan Arulanantham, M.D.*
10.38 Security Agreement (Guarantor), dated as of September 25, 1997,
entered into between Prospect Medical Holdings, Inc. and Karunyan Arulanantham,
M.D.*
10.39 Form of Second Amended and Restated Management Services Agreement,
made as of September 15, 1998 and deemed to have been effective as of September
25, 1997, between Sierra Medical Management, Inc. and Sierra Primary Care
Medical Group, Inc.(2)*
10.40 Subordinate Guaranty, dated as of September 25, 1997, executed by
Prospect Medical Holdings, Inc. in favor of Karunyan Arulanantham, M.D.*
10.41 Subordinate Guaranty, dated as of September 25, 1997, executed by
Prospect Medical Holdings, Inc. in favor of Sinnadurai E. Moorthy, M.D.*
10.42 Employment Agreement, dated September 25, 1997, between Sierra
Primary Care Medical Group, Inc. and Karunyan Arulanantham, M.D.*
10.43 Employment Agreement, dated September 25, 1997, between Sierra
Primary Care Medical Group, Inc. and Sinnadurai E. Moorthy, M.D.*
10.44 Non-Competition Agreement, effective as of September 25, 1997,
between Prospect Medical Group, Inc. and Karunyan Arulanantham, M.D.*
10.45 Non-Competition Agreement, effective as of September 25, 1997,
between Prospect Medical Group, Inc. and Sinnadurai E. Moorthy, M.D.*
<PAGE>
10.46 Employment Agreement, dated as of September 25, 1997, between Sierra
Medical Management, Inc. and Jayaratnam Jayakumar.*
10.47 Non-Competition Agreement, effective as of September 25, 1997,
between Sierra Medical Management, Inc. and Jayaratnam Jayakumar.*
10.48 $250,000 Subordinated Promissory Note, dated September 25, 1997,
payable to Jayaratnam Jayakumar by Prospect Medical Holdings, Inc.*
10.49 Option to Purchase Common Stock, dated September 25, 1997, issued by
Prospect Medical Holdings, Inc. to Jayaratnam Jayakumar.*
10.50 Security Agreement, dated September 25, 1997, entered into between
Prospect Medical Holdings, Inc. and Jayaratnam Jayakumar.*
10.51 Amendment Number Two to Revolving Credit Agreement, dated as of
September 25, 1997, between Prospect Medical Holdings, Inc. and Imperial Bank.*
10.52 Secured Promissory Note, dated as of September 25, 1997, in the
original amount of $5,000,000 executed by Prospect Medical Systems, Inc. and
made payable to Prospect Medical Holdings, Inc., together with Endorsement
Allonge in favor of Imperial Bank executed by Prospect Medical Holdings, Inc.*
10.53 Amendment Number One to Inter-Company Security Agreement, dated as of
September 25, 1997, between Prospect Medical Holdings, Inc. and Prospect Medical
Systems, Inc.*
10.54 Continuing Guaranty, dated as of September 25, 1997, delivered by
Sierra Medical Management, Inc. to Imperial Bank.*
10.55 Security Agreement, dated as of September 25, 1997, between Sierra
Medical Management, Inc. and Imperial Bank.*
10.56 Security Agreement - Stock Pledge, dated as of September 25, 1997,
between Prospect Medical Holdings, Inc. and Imperial Bank.*
10.57 Promissory Note, dated as of September 25, 1997, in the original
amount of $5,000,000, executed by Prospect Medical Group, Inc. and made payable
to Prospect Medical Systems, Inc., together with Endorsement Allonge in favor of
Imperial Bank executed by Prospect Medical Systems, Inc.*
10.58 Collateral Assignment of Transaction Documents, dated as of September
25, 1997, between Sierra Medical Management, Inc. and Imperial Bank.*
10.59 Security Agreement, dated as of September 25, 1997, between Sierra
Primary Care Medical Group, Inc. and Sierra Medical Management, Inc.*
10.60 Joinder Agreement, dated as of September 25, 1997, among Sierra
Medical Management, Inc., Sierra Primary Care Medical Group, Inc., Gregg
DeNicola, M.D., Prospect Medical Systems, Inc. Prospect Medical Group, Inc.,
Santa Ana/Tustin Physicians Group, Inc., Prospect Medical Holdings, Inc. and
Imperial Bank.*
10.61 Subordination and Note Cancellation Agreement, dated as of September
25, 1997, among Karunyan Arulanantham, M.D., Sinnadurai E. Moorthy, M.D.,
Prospect Medical Systems, Inc., Prospect Medical Group, Inc., Prospect Medical
Holdings, Inc. and Imperial Bank.*
10.62 Subordination Agreement, dated as of September 25, 1997, among
Jayaratnam Jayakumar, Prospect Medical Holdings, Inc. and Imperial Bank.*
10.63 Intentionally Omitted.
10.64 Form of Amended and Restated Management Services Agreement, made as
of September 15, 1998 and deemed to have been effective as of October 31, 1997,
by and between Sierra Medical Management, Inc. and Pegasus Medical Group,
Inc.(2)*
<PAGE>
10.65 Amended and Restated Assignable Option Agreement, made as of
September 2, 1998 and deemed to have been effective as of October 31, 1997,
among Sierra Medical Management, Inc., Pegasus Medical Group, Inc. and Prospect
Medical Group, Inc.*
10.66 Assignment and Assumption Agreement, by Marvin L. Ginsburg, M.D.
Medical Corporation
d/b/a A.V. Western Medical Group, Inc. to Pegasus Medical Group, Inc.*
10.67 Collateral Assignment of Transaction Documents, dated as of October
31, 1997, between Sierra Medical Management, Inc. and Imperial Bank.*
10.68 Security Agreement (Physician Group), dated as of October 31, 1997,
between Pegasus Medical Group, Inc. and Sierra Medical Management, Inc.*
10.69 $700,000 Secured Promissory Note, dated October 31, 1997, executed by
Prospect Medical Systems, Inc. and made payable to Prospect Medical Holdings,
Inc., together with Endorsement Allonge in favor of Imperial Bank by Prospect
Medical Holdings, Inc.*
10.70 $700,000 Promissory Note, dated October 31, 1997, executed by
Prospect Medical Group, Inc. and made payable to Prospect Medical Systems, Inc.,
together with Endorsement Allonge in favor of Imperial Bank executed by Prospect
Medical Systems, Inc.*
10.71 $700,000 Promissory Note, dated October 31, 1997, executed by Pegasus
Medical Group, Inc., made payable to Prospect Medical Group, Inc., together with
Endorsement Allonge in favor of Prospect Medical Systems, Inc. executed by
Prospect Medical Group, Inc., together with Endorsement Allonge in favor of
Imperial Bank executed by Prospect Medical Systems, Inc.*
10.72 Joinder Agreement, dated as of October 31, 1997, among Pegasus
Medical Group, Inc., Sierra Medical Management, Inc., Sierra Primary Care
Medical Group, Inc., Gregg DeNicola, M.D., Prospect Medical Holdings, Inc.,
Prospect Medical Systems, Inc., Prospect Medical Group, Inc., Santa Ana/Tustin
Physicians Group, Inc. and Imperial Bank.*
10.73 Amended and Restated Amendment Number Three to Revolving Credit
Agreement, dated as of February 6, 1998, between Prospect Medical Holdings, Inc.
and Imperial Bank, together with consent of Prospect Medical Systems, Inc. and
Sierra Medical Management, Inc. as guarantors.*
10.74 $12,500,000 Replacement Secured Revolving Note, dated February 6,
1998, executed by Prospect Medical Holdings, Inc. and made payable to Imperial
Bank.*
10.75 Amended and Restated Warrant, issued as of February 6, 1998, by
Prospect Medical Holdings, Inc. to Imperial Bank.*
10.76 Intentionally Omitted.
10.77 Consulting Agreement, dated as of March 1, 1998, between Sierra
Primary Care Medical Group, Inc. and Sinnadurai E. Moorthy, M.D.*
10.78 Prospect Medical Holdings, Inc. 1998 Stock Option Plan(1)
10.79 Intentionally Omitted.
10.80 Non-Competition Agreement, made as of June 1, 1998, by and between
Sierra Primary Care Medical Group and Prospect Medical Holdings, Inc., on the
one hand, and PrimeCare Medical Group of Antelope Valley, Inc. and PrimeCare
International, on the other hand.*
10.81 IPA Medicare Shared Risk Services Agreement effective on September 1,
1989, by and between PacifiCare of California and Santa Ana-Tustin Physicians
Group, Inc.(2)*
10.82 Point-of-Service Amendment to IPA Medicare Shared Risk Services
Agreement, effective on January 1, 1996 by and between PacifiCare of California
and Santa Ana-Tustin Physicians Group, Inc.(2)*
10.83 Amendment to IPA Medicare Shared Risk Services Agreement, effective
on January 1, 1996 by and between PacifiCare of California and Santa Ana-Tustin
Physicians Group, Inc.(2)*
<PAGE>
10.84 1995 Amendment to IPA Medicare Shared Risk Services Agreement,
effective on January 1, 1995, by and between PacifiCare of California and Santa
Ana-Tustin Physicians Group, Inc.(2)*
10.85 1994 Amendment to IPA Medicare Shared Risk Services Agreement,
effective on January 1, 1994, by and between PacifiCare of California and Santa
Ana-Tustin Physicians Group, Inc.(2)*
10.86 1993 Amendment to IPA Medicare Shared Risk Services Agreement,
effective on January 1, 1993, by and between PacifiCare of California and Santa
Ana-Tustin Physicians Group, Inc.(2)*
10.87 1992 Amendment to IPA Medicare Shared Risk Services Agreement,
effective on January 1, 1992, by and between PacifiCare of California and Santa
Ana-Tustin Physicians Group, Inc.(2)*
10.88 Amendment to IPA Medicare Shared Risk Services Agreement, effective
on January 1, 1991, by and between PacifiCare of California and Santa Ana-Tustin
Physicians Group, Inc.(2)*
10.89 Amendment to PacificCare IPA Medicare Shared Risk Services Agreement,
effective on January 1, 1990, by and between PacifiCare, Inc. and Santa Ana-
Tustin Physicians Group, Inc.(2)*
10.90 Amendment to PacifiCare IPA Medicare Shared Risk Services Agreement,
effective on August 31, 1990, by and between PacifiCare of California and Santa
Ana-Tustin Physicians Group, Inc.*
10.91 PacifiCare IPA Commercial Services Agreement, made and entered into
on January 1, 1990, by and between PacifiCare of California and Santa Ana-Tustin
Physicians Group, Inc.(2)*
10.92 Amendment to IPA Commercial Services Agreement, effective on January
1, 1996, between PacifiCare of California and Santa Ana-Tustin Physicians Group,
Inc.*
10.93 1995 Amendment to IPA Commercial Services Agreement, effective on
January 1, 1995, between PacifiCare of California, Inc. and Santa Ana-Tustin
Physicians Group, Inc.(2)*
10.94 1994 Amendment to IPA Commercial Services Agreement, effective on
January 1, 1994, between PacifiCare of California and Santa Ana-Tustin
Physicians Group, Inc.(2)*
10.95 1993 Amendment to IPA Commercial Services Agreement, effective on
January 1, 1993, between PacifiCare of California and Santa Ana-Tustin
Physicians Group, Inc.(2)*
10.96 1993 Amendment to IPA Commercial Services Agreement, effective on
January 1, 1993, between between PacifiCare of California, Inc. and Santa
Ana-Tustin Physicians Group, Inc.(2)*
10.97 PacifiCare Choice Amendment to PacifiCare IPA Commercial Services
Agreement, effective on January 1, 1993, between PacifiCare of California, Inc.
and Santa Ana-Tustin Physicians Group, Inc.(2)*
10.98 1992 Amendment to IPA Commercial Services Agreement, effective on
January 1, 1992, between PacifiCare of California and Santa Ana-Tustin
Physicians Group, Inc.(2)*
10.99 Amendment to IPA Commercial Services Agreement, effective on January
1, 1991, between PacifiCare of California and Santa Ana-Tustin Physicians Group,
Inc.(2)*
10.100 IPA Medicare Partial Risk Services Agreement, made and entered into
August 1, 1993, between PacifiCare of California and Prospect Medical Group,
Inc.(2)*
10.101 Amendment to IPA Medicare Partial Risk Services Agreement, effective
November 1, 1993, between PacifiCare of California and Prospect Medical Group,
Inc.(2)*
10.102 IPA Medicare Shared Risk Services Agreement, made and entered into
July 1, 1996, between PacifiCare, Inc. and Prospect Medical Group, Inc.(2)*
10.103 Point-of-Service Amendment to IPA Medicare Shared Risk Services
Agreement, made effective July 1, 1996, by and between PacifiCare of California
and Prospect Medical Group, Inc.(2)*
10.104 CaliforniaCare Medical Services Agreement, effective January 1,
1997, between Blue Cross of California and Prospect Medical Group.(2)*
<PAGE>
10.105 Amendment to CaliforniaCare Medical Services Agreement, effective as
of May 1, 1997, between Blue Cross of California and affiliates and Prospect
Medical Group.*
10.106 Letter of Agreement Serving as Addendum to the 1997 Medical Services
Agreement Between Blue Cross of California and Prospect Medical Group for
CaliforniaCare, Blue Cross Plus and Personal CaliforniaCare, effective January
1, 1997, between Blue Cross of California and Prospect Medical Group.(2)*
10.107 Letter of Agreement Serving as Addendum to the 1997 Medical Services
Agreement Between Blue Cross of California and Prospect Medical Group for
CaliforniaCare, Blue Cross Plus and Personal CaliforniaCare, effective January
1, 1997, between Blue Cross of California and Prospect Medical Group.(2)*
10.108 PacifiCare of California Medical Group/IPA Services Agreement (Split
Capitation), entered into March 1, 1998, between PacifiCare of California, Inc.
and Sierra Medical Group.(2)*
10.109 PacifiCare IPA Commercial Risk Services Agreement, made and entered
into as of January 1, 1996, by and between PacifiCare of California and Prospect
Medical Group, Inc.(1)
10.110 Settlement Agreement, effective as of July 1, 1998, by and among the
senior shareholders of Yorba Linda Medical Group identified therein, the junior
shareholders of Yorba Linda Medical Group identified therein, Prospect Medical
Holdings, Inc., Prospect Medical Group, Inc. and certain other parties.
16.1 Letter from BDO Seidman LLP.
21.1 List of Subsidiaries of Registrant.*
23.1 Consent of Ernst & Young LLP.
23.2 Consent of BDO Seidman LLP.
23.3 Consent of BDO Seidman LLP.
23.4 Consent of Miller & Holguin (included in Exhibit 5.1).(1)
27.1 Financial Data Schedule.*
- ------------------------
* Previously filed with the Company's Registration Statement filed on
September 18, 1998.
(1) To be filed by amendment
(2) Registrant has requested confidential treatment from the Securities and
Exchange Commission for portions of this exhibit, which confidential
portions have been filed separately.
<PAGE>
NON-COMPETITION AGREEMENT
THIS NON-COMPETITION AGREEMENT ("Agreement") is made effective as of the
14th day of July, 1997, by and between Prospect Medical Group, Inc., a
California professional corporation ("Purchaser"), and Melvin L. Reich, D.O.
("Physician"). All capitalized terms used herein and not otherwise expressly
defined shall have the same meanings set forth in the Stock Purchase Agreement.
R E C I T A L S
A. Purchaser is developing an integrated delivery system, a key
component of which is a strong network of physicians who can provide the
necessary professional medical services to payors in a designated geographic
area.
B. To build the physician component of its integrated delivery
systems, Purchaser provides a range of alternative services to and relationships
with physicians including the recruitment of physicians to a designated
geographic area, the management of physician practices, the acquisition of
assets and/or physician practices, the consolidation of physician practices, the
formation of medical groups, the establishment of outpatient clinics, etc.
C. Physician owns all of the issued and outstanding capital stock
of the Santa Ana/Tustin Physicians Group, Inc. ("Company").
D. Physician is selling to Purchaser and Purchaser is purchasing
from Physician all of Physician's stock in Company ("Stock") pursuant to that
certain Agreement for the Purchase and Sale of Stock ("Stock Purchase
Agreement") of even date herewith, by and among Purchaser, Company and
Physician.
E. Purchaser desires to purchase the Stock pursuant to
Purchaser's goal of developing an integrated delivery system.
F. Physician will benefit from the sale of the Stock to
Purchaser.
G. As conditions to the Closing of the Stock Purchase Agreement,
Physician shall have entered into an agreement in the form of this Agreement to
be delivered to Purchaser, and shall have entered into an Employment Agreement
with Purchaser.
<PAGE>
NOW, THEREFORE, in consideration of the foregoing premises and other good
and valuable consideration, the receipt and sufficiency of which are hereby
acknowledged, the parties hereto agree as follows.
1. PHYSICIAN'S COVENANTS.
1.1 As a material inducement to Purchaser to enter into the Stock
Purchase Agreement and except as set forth herein, or as permitted under the
Employment Agreement between Physician and Purchaser, Physician shall not
(directly or indirectly through any business, enterprise, venture, partnership,
corporation or any other entity controlled directly or indirectly by Physician
whether alone or as a partner, stockholder, creditor or otherwise) in the
Service Area described in Section 4 below:
A. During the term of Physician's employment with Company,
(i) practice medicine, or engage, participate, aid, assist,
or hold any interest in any business or provision of any service which is, or as
of Physician's engagement or participation, would become, competitive with any
aspect of Purchaser's or any of Purchaser's Affiliates' outpatient or other
healthcare services;
(ii) sell, transfer, assign or otherwise permit another
party to benefit from, any remaining goodwill attributable to Physician based
upon the provision of physician services by or through Physician;
(iii) engage or contract (other than with Purchaser or any of
Purchaser's Affiliates) for the provision of any management services to
Physician or any physician employed or under contract to Physician (as
applicable) which are the same as or substantially similar to any of the
services that Purchaser furnishes;
(iv) commit any other act or assist others to commit any
other act which might injure the business of Purchaser or Purchaser's
Affiliates;
B. During the term of Physician's employment with Company and for
a period of two (2) years thereafter,
(i) solicit or assist any other person to solicit any
business relating to a competing line of business (other than for Purchaser or
any of its affiliates) from any present or potential customer (including all
third party payors) of Physician, Seller, Purchaser, or any of their affiliates;
(ii) directly or indirectly employ, contract, solicit or
encourage any employee or other person under contract with Purchaser or any of
its Affiliates to leave the employ of any such entity, except pursuant to the
terms of the Stock Purchase Agreement; and
2
<PAGE>
(iii) directly or indirectly solicit, request, advise, or
encourage any present or future supplier, customer, patient or employee of
Purchaser or its Affiliates (including practices managed by Purchaser) to
withdraw, curtail, disenroll, or become enrolled with another provider of health
care, or cancel its business dealings with Purchaser or its affiliates, or take
any actions that might impair the relations of Purchaser or any of its
affiliates and their respective suppliers, customers, employees or others.
1.2 If any term or provision of this Section is determined to be illegal,
unenforceable or invalid in whole or in part for any reason, such illegal,
unenforceable or invalid provision or part thereof shall be stricken from this
Agreement, and such provision shall not affect the legality, enforceability or
validity of the remainder of this Agreement. If any provision or part thereof
of this Agreement is stricken from this Agreement, in accordance with the
provisions of this Section, then the stricken provision shall automatically be
replaced to the extent possible, with a legal, enforceable and valid provision
which is as similar in tenor to the stricken provision as is legally possible.
2. CONFIDENTIALITY. From and after the Closing Date, Physician shall keep
secret and retain in strictest confidence, and shall not use for the benefit of
any other party, except for Purchaser or any of Purchaser's Affiliates, trade
secrets known to Physician relating to the business and operations of Physician,
Seller, Purchaser or any of their affiliates, including without limitation,
customer lists, utilization data, patient records, business acquisition plans,
relating to the business and operations of Physician, Seller, Purchaser or any
of their affiliates learned by Physician before or after the date of this
Agreement, and shall not disclose them to anyone outside of Purchaser and its
Affiliates, provided however, that this section shall not apply to information
in the public domain or to information that is sought from Physician pursuant to
subpoena or court order (but Physician must provide notice to Purchaser or its
Affiliates in order for them to contest such subpoenas or court orders).
3. PHYSICIAN'S REPRESENTATION. Physician specifically acknowledges,
represents, and warrants that (i) Physician's covenants set forth in this
Agreement are being purchased in connection with the sale of the Stock to
Purchaser, (ii) such covenants are reasonable and necessary to protect the
legitimate interests of Purchaser, and (iii) Purchaser would not have entered
into the Stock Purchase Agreement in the absence of such restrictions.
Physician acknowledges that this Agreement is subject to all representations,
warranties and covenants in the Stock Purchase Agreement.
4. SERVICE AREA. The Service Area to which Physician's covenants in Section 1
applies is set forth in Exhibit A attached hereto.
5. TERM. Except for the provisions contained in Section 1.1.B, the term of
this Agreement commences as of the day and year first above written and
terminates upon the earlier to occur of:
(i) the termination of Physician's employment under the Employment
Agreement; or
3
<PAGE>
(ii) the date on which the Stock Purchase between Purchaser and
Physician is terminated due to a "Jeopardy Event" as defined in Section 10.1 of
the Stock Purchase Agreement; or
(iii) the date upon which Employer is in material default of any of
Employer's obligations under its Employment Agreement with Physician or the
Stock Purchase Agreement, and Physician terminates the Employment Agreement as a
result of such material breach. In the event of termination of Physician's
Employment Agreement by Physician for cause, as set forth therein, Employer
shall be required to pay to Physician the remaining compensation and benefits
owed under the Employment Agreement at such times as if the Employment Agreement
were still in full force and effect.
6. MISCELLANEOUS.
A. SUCCESSORS AND ASSIGNS. This Agreement shall be binding upon and
shall inure to the benefit of the parties and their respective heirs (as
applicable), legal representatives, and permitted successors and assigns. No
party may assign this Agreement or the rights, interests or obligations
hereunder. Any assignment or delegation in contravention of this Section shall
be null and void.
B. MEDICAL STAFF PRIVILEGES. Nothing in this Agreement is intended to
prohibit Physician from maintaining professional staff membership or clinical
privileges at any acute care hospital or other health facility licensed to
provide patient care for stays in excess of twenty-four (24) hours, so long as
maintaining such privileges does not in any manner result in Physician competing
with Employer in the Service Area.
C. COUNTERPARTS. This Agreement, and any amendments thereto, may be
executed in counterparts, each of which shall constitute an original document,
but which together shall constitute one and the same instrument.
D. HEADINGS. The section headings contained in this Agreement are
inserted for convenience only and shall not affect in any way the meaning or
interpretation of this Stock Purchase Agreement.
E. STOCKHOLDER IN PUBLIC COMPANY. Notwithstanding any provision to the
contrary, nothing contained herein shall prevent Physician from purchasing or
otherwise acquiring equity securities of a company that has a class of
securities traded on a national securities exchange whose business competes with
that of the Company, so long as Physician's ownership of such securities does
not exceed one percent (1%) of the total outstanding shares of such competitive
company.
F. AMENDMENT. This Agreement may not be amended except in writing and
as executed by all parties.
4
<PAGE>
G. TIME OF ESSENCE. Time is expressly made of the essence of this
Agreement and each and every provision hereof of which time of performance is a
factor.
H. NOTICES. Any notices required or permitted to be given hereunder by
any party to the other shall be in writing and shall be deemed delivered upon
personal delivery; twenty-four (24) hours following deposit with a courier for
overnight delivery; or seventy-two (72) hours following deposit in the U.S.
Mail, registered or certified mail, postage prepaid, return-receipt requested,
addressed to the parties at the following addresses or to such other addresses
as the parties may specify in writing:
If to Physician: Melvin L. Reich, D.O.
4603 Seashore Drive
Newport Beach, California 92663
With copy to: George Wall, Esq.
Palmieri, Tyler, Wiener, Wilhelm and Waldron
2603 Main Street, Suite 1300
Irvine, California 92714
If to Purchaser: Gregg DeNicola, M.D.
Prospect Medical Group, Inc.
18200 Yorba Linda Blvd., Suite 409
Yorba Linda, California 92686
With copy to: Dale S. Miller, Esq.
Miller & Holguin
1801 Century Park East, Suite 700
Los Angeles, CA 90067
I. GOVERNING LAW. This Agreement shall be governed by and construed in
accordance with the laws of the State of California.
J. SEVERABILITY. If any provision or portion of this Agreement is held
by a court of competent jurisdiction to be invalid or unenforceable, the
remainder of this Agreement will nevertheless continue in full force and effect
and shall not be invalidated or rendered unenforceable or otherwise adversely
affected, unless such invalidity or unenforceability would defeat an essential
business purpose of this Stock Purchase Agreement. Without limiting the
generality of the foregoing, if the provisions of this Agreement shall be deemed
to create a restriction which is unreasonable as to either duration or
geographical area, or both, the parties agree that the provisions of this
Agreement shall be enforced for such duration and in such geographical area as
any court of competent jurisdiction may determine to be reasonable.
K. ARBITRATION. The parties firmly desire to resolve all disputes
arising hereunder without resort to litigation in order to protect their
respective business reputations and the
5
<PAGE>
confidential nature of certain aspects of their relationship. Accordingly, any
controversy or claim arising out of or relating to this Agreement, or the breach
thereof, shall be settled by arbitration as set forth below.
(i) All disputes which in any manner arise out of or relate to
this Agreement or the subject matter thereof, shall be resolved exclusively by
arbitration in accordance with the provisions of this Section K. Either party
may commence arbitration by sending a written demand for arbitration to the
other party, setting forth the nature of the controversy, the dollar amount
involved, if any, and the remedies sought, and attaching a copy of this Section
to the demand.
(ii) The parties stipulate to arbitration before a single, mutually
agreed upon arbitrator sitting on the Los Angeles, California Judicial
Arbitration Mediation Services (JAMS) panel. In the event that the parties are
unable to agree upon the person chosen as arbitrator within 30 days of the
demand for arbitration, the arbitrator shall be selected in the sole discretion
of the JAMS administrator. The arbitrator shall be a member of the California
bar.
(iii) The parties shall share all costs of arbitration. The
prevailing party shall be entitled to reimbursement by the other party of such
party's attorneys' fees and costs and any arbitration fees and expenses incurred
in connection with the arbitration hereunder.
(iv) The substantive law of the State of California shall be
applied by the arbitrator. All proceedings in arbitration shall be in
accordance with the California Code of Civil Procedure, as amended, and the
parties shall have the right to legal discovery in any matter submitted to
arbitration in satisfaction of California Code of Civil Procedure Section
1283.05, as permitted by California Code of Civil Procedure Section 1283.1(b).
(v) Arbitration shall take place in Los Angeles, California unless
the parties otherwise agree. As soon as reasonably practicable, a hearing with
respect to the dispute or matter to be resolved shall be conducted by the
arbitrator. As soon as reasonably practicable thereafter, the arbitrator shall
arrive at a final decision, which shall be reduced to writing, signed by the
arbitrator and mailed to each of the parties and their legal counsel.
(vi) All decisions of the arbitrator shall be final, binding and
conclusive on the parties and shall constitute the only method of resolving
disputes or matters subject to arbitration pursuant to this Agreement. The
arbitrator or a court of appropriate jurisdiction may issue a writ of execution
to enforce the arbitrator's judgment. Judgment may be entered upon such a
decision in accordance with applicable law in any court having jurisdiction
thereof.
(vii) Notwithstanding the foregoing, because time is of the essence
of this Agreement, the parties specifically reserve the right to seek a judicial
temporary restraining order, preliminary injunction, or other similar equitable
relief.
(viii) The decision and award of the arbitrator shall be kept
confidential by the
6
<PAGE>
parties to the greatest extent possible. No disclosure of such decision or
award shall be made by the parties except as required by law or as necessary or
appropriate to effect the enforcement thereof.
(ix) Should either Employer or Physician institute any action or
procedure to enforce this Agreement or any provision hereof, or for damages by
reason of any alleged breach of this Agreement or of any provision hereof, or
for a declaration of rights hereunder (including without limitation
arbitration), the prevailing party in any such action or proceeding shall be
entitled to receive from the other party all costs and expenses, including
without limitation reasonable attorneys' fees, incurred by the prevailing party
in connection with such action or proceeding.
IN WITNESS WHEREOF, the parties hereto have executed this Agreement
of the day and year first written above.
"Purchaser"
PROSPECT MEDICAL GROUP, INC.
By: /s/ Gregg DeNicola
--------------------------------
Gregg DeNicola, M.D., President
"Physician"
By: /s/ Melvin L. Reich
--------------------------------
Melvin L. Reich, D.O.
7
<PAGE>
EXHIBIT A
TO NON-COMPETITION AGREEMENT
The Service Area referred to in Section 4 of the Non-Competition
Agreement shall be the fifteen (15) mile radius surrounding the following
facility addresses:
999 North Tustin Avenue,
Suite 120
Santa Ana, CA 92680
18200 Yorba Linda Blvd.,
Suites 102, 104, 108, 401, 409
Yorba Linda, CA 92686
23961 Calle De La Magdalena,
Suite 517
Laguna Hills, CA 92653-3656
1001 East Chapman Avenue,
Suite A
Fullerton, CA 92635
17021 Yorba Linda Boulevard,
Suite 70 and Suite 200
Yorba Linda, CA 92686
13372 Newport Avenue,
Suites H, I, J
Tustin, CA 92680
<PAGE>
SETTLEMENT AGREEMENT
This is an agreement to settle the dispute among Yorba Linda Medical
Group, Inc. ("YLMG"), the senior shareholders of YLMG as identified on the
signature page of this Agreement ("the Senior Shareholders"), the junior
shareholders of YLMG as identified on the signature page of this Agreement
("the Junior Shareholders") who intend to form Yorba Linda Family Physicians,
a Medical Group, Inc. ("YLFP") and Prospect Medical Holdings, Inc. ("PMH"),
its subsidiaries and affiliates (collectively referenced as "Prospect").
This document sets out the material terms of the agreement, which will be
memorialized in a long-form agreement to be drafted and signed by all parties.
The parties have agreed to the following material terms and conditions:
1. SENIOR SHAREHOLDERS NON-COMPETE AND PMH STOCK SURRENDER.
The Senior Shareholders will end their affiliation with
Prospect and surrender to PMH all of the PMH stock which was
previously issued to them plus the sum of $56,762.48. The
stock and funds will be transferred July 1, 1998, but the
service agreements between the Senior Shareholders and
Prospect may terminate at a later date at the Senior
Shareholders' option. Prospect will release the Senior
Shareholders from the non-competition covenants contained in
article X of the Stock Redemption Agreements previously
entered into by each such physician. In addition,
notwithstanding any provision contained in articles IX or X
of the Stock Redemption Agreements, each Senior Shareholder
may continue to treat those patients who have designated the
Senior Shareholder as his or her primary care physician.
2. JUNIOR STOCKHOLDERS NON-COMPETE AND YLMG STOCK SURRENDER.
YLMG will release the Junior Shareholders from any
restrictive covenant to which they may be bound under their
agreements with YLMG. The Junior Shareholders will
surrender to YLMG any and all of their ownership interest in
YLMG and its assets. YLMG shall pay the sum of $5,000 to
each Junior Shareholder in respect of the YLMG stock each is
surrendering.
3. NON-SOLICITATION OF PATIENTS. Notwithstanding the
provisions of paragraphs 1 and 2 above, the parties
acknowledge and agree that effective immediately and
continuing through and including January 1, 2000, the names,
addresses, and other data relating to the patients of the
physicians who are signatories to this agreement, including
but not limited to any list containing such information,
shall be deemed "trade secrets" as defined under Civil Code
Section 3426.1(d). The parties further agree that effective
immediately and continuing through and including
<PAGE>
January 1, 2000, no party may use any trade secret to
solicit, directly or indirectly, any patient of any other
physician signatory. However, nothing in this paragraph should
be construed to prevent any signatory to this agreement from
soliciting patients by general advertising, mass mailings, or
other similar means which do not use protected trade secrets, as
defined herein, as the basis for identifying the persons to whom
the mailing or advertising is directed.
4. JUNIOR SHAREHOLDERS ACCOUNTS RECEIVABLE. YLMG shall
transfer to the Junior Shareholders (or YLFP if so
designated by the Junior Shareholders) thirty percent (30%)
of the net amount collected from all YLMG medical services
rendered through June 30, 1998 which are collected after
that date. Prospect shall continue billing and collecting
for all YLMG medical services rendered prior to July 1, 1998
for a fee equal to eight percent (8%) of the amount
collected on and after such date, which fee shall be
retained by Prospect from said collections. Prospect shall
remit thirty percent (30%) of such net collections to the
Junior Shareholders and the balance to YLMG to be paid on
the business day after collection. Payments on all patient
accounts, including over-the-counter payments, shall be
credited to the oldest account receivables. Global
obstetrical fees for patients of the Junior Shareholders who
deliver on or after July 1, 1998 shall be the responsibility
and property of the Junior Shareholders. Prospect shall not
be obligated to prepare financial statements on or after
July 1, 1998, but shall continue to prepare the following
reports which currently are provided to YLMG: (1) physician
production report, (2) daily deposit report, and (3)
accounts receivable collection report. Following the close
of each month, Prospect shall deliver to YLMG a
reconciliation covering any overpayments or other required
adjustments.
5. JUNIOR SHAREHOLDERS BACK PAY. The Junior Shareholders shall
be entitled to all of their back pay accrued through May 31,
1998, together with interest at the rate of 8% from the
first day of January next following the date such
compensation became delinquent, with such payment to be made
on July 1, 1998. Such back pay shall include, but not be
limited to, task force stipends to be paid based upon
meeting attendance from June 1997 through June 1998 at $250
per month. Additionally, the Junior Shareholders shall
continue to be entitled to 40% of their collections through
June 30, 1998, to be paid to the Junior Shareholders on or
before July 31, 1998. All professional liability insurance
premiums, licensing fees and dues which are due through June
30, 1998, and have been historically paid by YLMG, shall be
paid by YLMG for all Junior Shareholders. However, YLFP
agrees to reimburse YLMG for its pro-rata share of the July
1998 malpractice insurance premium (due in June 1998) from
the joint signature account established pursuant to
paragraph 8 herein.
2
<PAGE>
6. SCPIE STOCK. YLMG shall release its claim and entitlement
to the SCPIE Holdings stock currently registered in the
names of the Junior Shareholders.
7. JUNIOR SHAREHOLDERS PRACTICE NAME AND LOCATION. The Junior
Shareholders will resign from employment with YLMG effective
July 1, 1998, provided that all payments upon closing which
are required by this Agreement have been made, and all other
conditions precedent which are required by this Agreement
have been satisfied, by that date. Thereafter, the Junior
Shareholders will be permitted to maintain an office in
their current building until November 30, 1998, under a
comprehensive full service lease with rent at $1.75 per
square foot and commercially reasonable terms under which
the Junior Shareholders will be responsible for insurance.
Rent for holding over from December 1, 1998 through December
15, 1998 shall be at 110% of base rent. Thereafter, rent
shall be at 200% of the base rate. The Junior Shareholders
will occupy the following three suites: Suites 130, 140 and
160 within the current building. The parties agree that
some or all of the Junior Shareholders will be required to
move their office location within the current building. The
cost of the move within the current building will be borne
by YLMG. Each physician will maintain custody of the
medical records for his or her patients. The Junior
Shareholders may use the name "Yorba Linda Family
Physicians, a Medical Group, Inc." but will not be entitled
to external signage at the current Yorba Linda building.
The Junior Shareholders may use an internal sign of similar
size and style as the existing YLMG Urgent Care sign. All
other current internal signage shall be modified to reflect
the change in affiliation of the Junior Shareholders from
YLMG to YLFP. The Junior Shareholders may use without
charge the furniture and medical equipment of YLMG in the
offices they occupy until they vacate the Yorba Linda
building. However, the Junior Shareholders shall pay thirty
(30%) of the current lease payment obligations of YLMG for
the telephone system and photocopiers. Payment shall be made
by YLFP no later than ten business days after presentment of
the approved invoice by YLMG. Upon vacating the Yorba Linda
building, the Junior Shareholders may take (1) the furniture
from their back office consultation rooms, (2) five (5) hand
held dopplers, and (3) the NST machine, but no other
furniture, equipment or supplies. The Junior Shareholders
will be responsible for all administration and management of
their practices on and after July 1, 1998.
8. JUNIOR SHAREHOLDERS START-UP EXPENSES. YLMG shall reimburse
the Junior Shareholders for their reasonable start-up
expenses of their new offices away from the current
building, including but not limited to, moving expenses and
tenant improvements. Such expenses shall not include
salaries or working capital. YLMG's maximum obligation for
such expenses is $150,000, and YLMG will pay that sum
($150,000) into a joint signature account established no
later than July 1, 1998. Each check on
3
<PAGE>
such account shall be co-signed by one authorized Senior
Shareholder and one authorized Junior Shareholder. Only one
distribution shall be made from the account each week, on
Friday, for expenses submitted for payment on or before the
close of business on the preceding business day. Interest, if
any, on the account shall accrue to YLMG.
9. ATTORNEY'S FEES. YLMG and the Senior Shareholders represent
to Prospect and the Junior Shareholders that none of the
attorneys' fees incurred in association with negotiations
with St. Jude Heritage Health Foundation, in connection with
the negotiation of this Agreement, or in connection with the
pending litigation between the parties have been borne by
YLMG.
10. COOPERATING ON TRANSFER. The parties will cooperate on any
patient transfer issues which arise from this Agreement.
Such cooperation will include, but not be limited to,
drafting a "neutral" announcement, the form of which will be
agreed upon prior to being sent to the patients of the
Senior Shareholders or Junior Shareholders. Prospect will
cooperate in transferring management and administrative
functions to YLMG and its agents or designees, and shall
authorize third party payors to release information on the
Senior Shareholders patients to the designee of YLMG. Such
designee shall be considered a successor in interest with
respect to enforcement of this provision.
11. COOPERATING ON PATIENT CARE. The parties will cooperate on
the continuing patient care of their respective patients on
and after July 1, 1998. Such cooperation shall include, but
not be limited to, properly directing patients presenting at
the YLMG or YLFP offices to the proper location for such
patients' designated physician, allowing YLFP use of the
flexible sigmoidoscopy, colposcopy and treadmill equipment
and facilities (for which YLMG will reimbursed at the rate
of $35 per case), and directing telephone inquiries from
patients to the appropriate designated physician or such
physician's staff.
12. TRANSITION TEAM. A transition team comprised of Kenneth K.
Tan, M.D., representing the Senior Shareholders, and Paul M.
Jordan, M.D., representing the Junior Shareholders, shall be
established effective immediately and shall continue in
existence until at least January 15, 1999. During its first
two months of operations, the transition team shall meet at
least twice a week to discuss and resolve operational and
other issues which arise in connection with the transition
of the Junior Shareholders and their patients from YLMG to
YLFP. Thereafter the transition team shall meet at least
once a week for that purpose. In the first instance, the
parties shall report to their designated representative any
and all issues which arise in connection with the
transition. In the event the transition team is not able to
effect a
4
<PAGE>
satisfactory resolution of an issue raised by a party, the party
shall submit the issue to mediation. YLMG and YLFP shall split
equally the fees of the mediator. However, nothing in this
paragraph shall be construed to require the parties to mediate
any dispute arising in connection with any alleged breach of
this Agreement. Mediation shall be required only for issues
arising in connection with the transition, as discussed herein.
13. PMH STOCK CERTIFICATES. Phillip J. Goldberg shall collect
and maintain custody of the PMH stock certificates from the
Senior Shareholders, so that they can be surrendered to PMH
upon the execution of the long form agreement.
14. MUTUAL RELEASE. Prospect and the Junior Shareholders, on
the one hand, and YLMG and the Senior Shareholders on the
other hand, will mutually release each other, and their
respective directors, officers, employees, and attorneys,
from any and all existing claims, whether known or unknown,
and also waive the provisions of California Civil Code
Section 1542 so that full effect can be given to this
release. Upon the signature by all parties of the long-form
agreement, the Junior Shareholders shall dismiss with
prejudice the action styled DENICOLA V. MCGINTY, Orange
County Superior Court Case No. 795018. In addition, the
Junior Shareholders shall request that the Court continue
for two (2) weeks the hearing presently scheduled for June
30, 1998, in connection with the Junior Shareholders'
petition for a writ of mandate requiring the disclosure of
certain documents, in order to permit the parties to prepare
and execute a long-form agreement.
15. CLOSING. Except as otherwise provided in this agreement,
the closing of the transaction between the parties and the
delivery of payments and other materials shall occur at 9:00
a.m. on Wednesday, July 1, 1998 at the offices of YLMG.
16. BINDING EFFECT. Although the parties anticipate drafting
and executing a more formal agreement, this letter
agreement, once fully executed, shall be binding upon the
parties and fully enforceable under the provisions of
California Code of Civil Procedure Section 664.6. This
Agreement may be executed in counterparts and shall be
deemed fully executed when each party has signed and
transmitted a counterpart to the other. All counterparts
taken together shall constitute a single agreement.
5
<PAGE>
The parties have indicated their acceptance of the terms of this agreement
by their signatures below.
/s/ Phillip J. Goldberg /s/ Lytton W. Smith, M.D.,
- ----------------------------------- -----------------------------------
Phillip J. Goldberg Lytton W. Smith, M.D.,
Attorney for Yorba Linda President, Yorba Linda Medical
Medical Group, Inc., and the Group, Inc.
Senior Shareholders
SENIOR SHAREHOLDERS /s/ R. Scott Hall, M.D.
-----------------------------------
R. Scott Hall, M.D., Secretary,
Yorba Linda Medical Group, Inc.
/s/ W. Ray McGinty, M.D. /s/ Lytton W. Smith, M.D.
- ----------------------------------- -----------------------------------
W. Ray McGinty, M.D. Lytton W. Smith, M.D.
/s/ John C. Schmidt, M.D. /s/ Fred M. Hurst, M.D.
- ----------------------------------- -----------------------------------
John C. Schmidt, M.D. Fred M. Hurst, M.D.
/s/ Richard A. Kenfield, M.D. /s/ R. Scott Hall, M.D.
- ----------------------------------- -----------------------------------
Richard A. Kenfield, M.D. R. Scott Hall, M.D.
/s/James R.W. Leonard, M.D. /s/ Kenneth K. Tan, M.D.
- ----------------------------------- -----------------------------------
James R.W. Leonard, M.D. Kenneth K. Tan, M.D.
/s/ Joanna K. Tan, M.D. /s/ Dean L. Okimoto, M.D.
- ----------------------------------- -----------------------------------
Joanna K. Tan, M.D. Dean L. Okimoto, M.D.
6
<PAGE>
JUNIOR SHAREHOLDERS
/s/ Charles H. Kanter, Esq.
- -----------------------------------
Charles H. Kanter, Esq.
Attorney for Junior
Shareholders
/s/ Gregg A. DeNicola, M.D. /s/ Michael D. Hall, M.D.
- ----------------------------------- -----------------------------------
Gregg A. DeNicola, M.D. Michael D. Hall, M.D.
/s/ Thomas C. Barker, M.D. /s/ Dennis J. Ponzio, M..D
- ----------------------------------- -----------------------------------
Thomas C. Barker, M.D. Dennis J. Ponzio, M..D
/s/ Daniel L. May, M.D. /s/ Paul M. Jordan, M.D.
- ----------------------------------- -----------------------------------
Daniel L. May, M.D. Paul M. Jordan, M.D.
PROSPECT
/s/ Kenneth E. Johnson, Esq. /s/ Jacob Y. Terner, M.D.
- ----------------------------------- -----------------------------------
Kenneth E. Johnson, Esq. Jacob Y. Terner, M.D., President,
Attorneys for Prospect Prospect Medical Holdings, Inc.
/s/ Gregg A. DeNicola, M.D. /s/ Gregg A. DeNicola, M.D.
- ----------------------------------- -----------------------------------
Gregg A. DeNicola, M.D., __________________, Secretary,
President, Prospect Medical Prospect Medical Holdings,
Group, Inc. Inc.
/s/ Gregg A. DeNicola, M.D.
- -----------------------------------
__________________, Secretary,
Prospect Medical Group, Inc.
7
<PAGE>
EXHIBIT 16.1
November 16, 1998
Securities and Exchange Commission
Washington, D.C. 20549
Re: Prospect Medical Holdings, Inc.
We have read the last paragraph under the caption "Experts" in the Prospectus
constituting a part of this Registration Statement on Form S-1 for Prospect
Medical Holdings, Inc., and are in agreement with the information contained
therein insofar as it relates to BDO Seidman, LLP.
Very truly yours,
/s/ BDO Seidman, LLP
--------------------------
BDO Seidman, LLP
<PAGE>
EXHIBIT 23.1
CONSENT OF INDEPENDENT AUDITORS
We consent to the reference to our firm under the caption "Experts" and to
the use of our report dated December 8, 1997, except for Note 4, as to which the
date is February 6, 1998 and Note 7, as to which the date is July 1, 1998, with
respect to the consolidated financial statements of Prospect Medical Holdings,
Inc. as of and for the year ended September 30, 1997; our report dated June 26,
1998 with respect to the financial statements of Antelope Valley Medical Group,
Inc. as of December 31, 1997 and 1996 and for the years then ended; our report
dated March 2, 1998 with respect to the combined financial statements of Sierra
Primary Care Medical Group, a Medical Corporation and Sierra Medical Management,
Inc. as of September 30, 1997, and December 31, 1996, and for the nine months
ended September 30, 1997 and the year ended December 31, 1996; our report dated
March 23, 1998 with respect to the financial statements of Santa Ana-Tustin
Physicians Group, Inc. as of July 13, 1997 and for the period from January 1,
1997 to July 13, 1997, included in the Registration Statement (Form S-1 No.
333-63801) and related Prospectus of Prospect Medical Holdings, Inc. for the
registration of 3,000,000 shares of its common stock.
/s/ ERNST & YOUNG LLP
Los Angeles, California
November 16, 1998
<PAGE>
EXHIBIT 23.2
CONSENT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
To the Board of Directors and Stockholders
Prospect Medical Holdings, Inc.
We hereby consent to the use in the Prospectus constituting a part of this
Registration Statement on Form S-1 of our report dated November 20, 1996,
relating to the combined balance sheet of Prospect Medical Holdings, Inc. and
Prospect Medical Group, Inc. (predecessor business) as of September 30, 1996 and
the related combined statements of operations, stockholders' equity and cash
flows for each of the two years then ended, which are contained in that
Prospectus.
We also consent to the reference to us under the caption "Experts" in the
Prospectus.
/s/ BDO SEIDMAN, LLP
Los Angeles, California
November 16, 1998
<PAGE>
EXHIBIT 23.3
CONSENT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
To the Board of Directors and Stockholders
Santa Ana-Tustin Physicians Group, Inc.
We hereby consent to the use in the Prospectus constituting a part of this
Registration Statement on Form S-1 of our report dated February 11, 1997,
relating to the statements of income, changes in stockholder's equity and cash
flows of Santa Ana-Tustin Physicians Group, Inc. for the ten month period ended
December 31, 1996 and year ended February 29, 1996, which are contained in that
Prospectus.
We also consent to the reference to us under the caption "Experts" in the
Prospectus.
/s/ BDO SEIDMAN, LLP
Los Angeles, California
November 16, 1998
