================================================================================
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-KSB
|X| Annual Report Under Section 13 or 15(d) of the Securities Exchange Act
of 1934
FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 2007
|_| Transition Report Under Section 13 or 15(d) of the Securities Exchange
Act of 1934
Commission file number 000-26285
CNS RESPONSE, INC.
(Name of Small Business Issuer in Its Charter)
DELAWARE 87-0419387
(State or Other Jurisdiction (I.R.S. Employer
of Incorporation or Organization) Identification No.)
2755 Bristol St., Suite 285
Costa Mesa, CA 92626
(Address of Principal Executive Offices and Zip Code)
(714) 545-3288
(Issuer's telephone Number)
Securities registered under Section 12(b) of the Exchange Act:
None
Securities registered under Section 12(g) of the Exchange Act:
Common Stock, $0.001 par value
(Title of Class)
Check whether the issuer is not required to file reports pursuant to Section 13
or 15(d) of the Exchange Act. |_|
Check whether the issuer (1) filed all reports required to be filed by Section
13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter
period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes |X| No |_|
Check if there is no disclosure of delinquent filers in response to Item 405 of
Regulation S-B contained in this form, and no disclosure will be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-KSB or any
amendment to this Form 10-KSB. |_|
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act.) Yes |_| No |X|
The issuer's revenues for the fiscal year ended September 30, 2007 were
$238,400.
At December 5, 2007, the aggregate market value of the voting stock held by
non-affiliates of the issuer was $14,072,920.
At December 5, 2007, the issuer had 25,299,547 shares of Common Stock, $0.001
par value, issued and outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's Proxy Statement to be filed with the Securities and
Exchange Commission are incorporated by reference into Part III, Items 9, 10,
11, 12 and 14 of this Form 10-KSB.
Transitional Small Business Disclosure Format (check one): Yes |_| No |X|
================================================================================
CNS RESPONSE, INC.
2007 FORM 10-KSB ANNUAL REPORT
TABLE OF CONTENTS
PART I .....................................................................3
ITEM 1. DESCRIPTION OF BUSINESS..............................................4
ITEM 2. DESCRIPTION OF PROPERTY.............................................24
ITEM 3. LEGAL PROCEEDINGS...................................................24
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.................24
PART II ....................................................................25
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS AND
SMALL BUSINESS ISSUER PURCHASES OF EQUITY SECURITIES................25
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS...............................................26
ITEM 7. FINANCIAL STATEMENTS................................................55
ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE................................................79
ITEM 8A. CONTROLS AND PROCEDURES.............................................79
ITEM 8B. OTHER INFORMATION...................................................79
PART III ....................................................................80
ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS, CONTROL PERSONS AND
CORPORATE GOVERNANCE; COMPLIANCE WITH SECTION 16(A) OF THE
EXCHANGE ACT........................................................80
ITEM 10. EXECUTIVE COMPENSATION..............................................80
ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
AND RELATED STOCKHOLDER MATTERS.....................................80
ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
INDEPENDENCE........................................................80
ITEM 13. EXHIBITS............................................................80
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES..............................80
2
PART I
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
This 2007 Annual Report on Form 10-KSB, including the sections entitled
"Risk Factors," "Management's Discussion and Analysis of Financial Condition and
Results of Operations" and "Description of Business," contains "forward-looking
statements" that include information relating to future events, future financial
performance, strategies, expectations, competitive environment, regulation and
availability of resources. These forward-looking statements include, without
limitation, statements regarding: proposed new products or services; our
statements concerning litigation or other matters; statements concerning
projections, predictions, expectations, estimates or forecasts for our business,
financial and operating results and future economic performance; statements of
management's goals and objectives; trends affecting our financial condition,
results of operations or future prospects; our financing plans or growth
strategies; and other similar expressions concerning matters that are not
historical facts. Words such as "may," "will," "should," "could," "would,"
"predicts," "potential," "continue," "expects," "anticipates," "future,"
"intends," "plans," "believes" and "estimates," and similar expressions, as well
as statements in future tense, identify forward-looking statements.
Forward-looking statements should not be read as a guarantee of future
performance or results, and will not necessarily be accurate indications of the
times at, or by which, that performance or those results will be achieved.
Forward-looking statements are based on information available at the time they
are made and/or management's good faith belief as of that time with respect to
future events, and are subject to risks and uncertainties that could cause
actual performance or results to differ materially from those expressed in or
suggested by the forward-looking statements. Important factors that could cause
these differences include, but are not limited to:
o our inability to raise additional funds to support operations
and capital expenditures;
o our inability to achieve greater and broader market acceptance
of our products and services in existing and new market
segments;
o our inability to successfully compete against existing and
future competitors;
o our inability to manage and maintain the growth of our
business;
o our inability to protect our intellectual property rights; and
o other factors discussed under the headings "Risk Factors,"
"Management's Discussion and Analysis of Financial Condition
and Results of Operations" and "Business."
Forward-looking statements speak only as of the date they are made. You
should not put undue reliance on any forward-looking statements. We assume no
obligation to update forward-looking statements to reflect actual results,
changes in assumptions or changes in other factors affecting forward-looking
information, except to the extent required by applicable securities laws. If we
do update one or more forward-looking statements, no inference should be drawn
that we will make additional updates with respect to those or other
forward-looking statements.
3
ITEM 1. DESCRIPTION OF BUSINESS
WITH RESPECT TO THIS DISCUSSION, THE TERMS "WE" "US" "OUR" "CNS" AND
THE "COMPANY" REFER TO CNS RESPONSE, INC., A DELAWARE CORPORATION AND ITS
WHOLLY-OWNED SUBSIDIARY CNS RESPONSE, INC., A CALIFORNIA CORPORATION ("CNSR").
GENERAL
Prior to January 16, 2007, CNS Response, Inc. (then called
Strativation, Inc.) existed as a "shell company" with nominal assets whose sole
business was to identify, evaluate and investigate various companies to acquire
or with which to merge. On January 16, 2007, we entered into an Agreement and
Plan of Merger (the "Merger Agreement") with CNS Response, Inc., a California
corporation ("CNS California"), and CNS Merger Corporation, a California
corporation and our wholly-owned subsidiary ("MergerCo") pursuant to which we
agreed to acquire CNS California in a merger transaction wherein MergerCo would
merge with and into CNS California, with CNS California being the surviving
corporation (the "Merger"). On March 7, 2007, the Merger closed, CNS California
became our wholly-owned subsidiary, and on the same date we changed our
corporate name from Strativation, Inc. to CNS Response, Inc. We have nine
employees including eight full-time employees.
Founded in 2000, and located in Costa Mesa, California, our business is
focused on the commercialization of a patented system that aids physicians in
the identification and determination of appropriate and effective medications
for patients with certain behavioral (mental or addictive) disorders. Our
technology provides medical professionals with medication sensitivity data for a
subject patient based upon the identification and correlation of treatment
outcome information from other patients with similar neurophysiologic
characteristics which are contained in a proprietary outcomes database. This
methodology, called "Referenced-EEG" or "rEEG" represents an innovative approach
to identifying effective medications for patients suffering from debilitating
behavioral disorders. Referenced-EEG and rEEG are registered trademarks of CNSR.
Traditionally, prescription of medication for the treatment of
behavioral disorders (such as depression, bipolar disorders, eating disorders,
addiction, anxiety disorders, ADHD and schizophrenia) has been primarily based
on symptomatic factors, while the underlying physiology and pathology of the
disorder is rarely able to be analyzed, often resulting in multiple ineffective,
costly, and often lengthy, courses of treatment before effective medications are
identified. Some patients never find effective medications. We believe that rEEG
offers an improvement upon traditional methods for determining an effective
course of medication because rEEG is designed to correlate the success of
courses of medication and medication combinations, with the neurophysiological
characteristics of a particular patient.
In addition to its utility in providing psychiatrists and other
physicians with medication sensitivity guidance, rEEG provides us with
significant opportunities in the area of pharmaceutical development. rEEG, in
combination with the information contained in the rEEG database, has the
potential to be able to identify novel uses for, and novel combinations of,
neuropsychiatric medications currently on the market and in late stages of
clinical development, as well as aid in the identification of neurophysiologic
characteristics of clinical subjects that may be successfully treated with
neuropsychiatric medications in the clinical testing stage. We intend to enter
into relationships with established drug and biotechnology companies to further
explore these opportunities.
The initial technology, upon which rEEG is based, was originally
developed by an M.D. Pathologist/ Psychiatrist as well as a clinical
Psychiatrist in response to observations within their practice. They partnered
and formalized their activities into NuPharm Database, LLC, for the purpose of
4
facilitating investment in 1999. At the time of its formation, these founding
physicians assigned all of their rights in the technology to NuPharm.
CNSR was incorporated in California on January 11, 2000, for the
purpose of acquiring and commercializing the rEEG technology. The patent
application for the primary technology was acquired from Mill City/CNSR, LLC, a
Minnesota limited liability Company in January 2000 pursuant to the terms of a
Contribution and Subscription Agreement which provided for the issuance of
1,000,000 shares of CNSR's common stock to Mill City in exchange for all of its
assets. Mill City had previously acquired all of NuPharm's assets pursuant to an
Asset Purchase Agreement.
THE CHALLENGE AND THE OPPORTUNITY
The "CNS" in CNS Response, Inc. refers to the central nervous system,
the largest part of the nervous system and includes the brain and spinal cord -
organs fundamental to behavioral control. Often referred to as mental illness,
behavioral disorders have accounted for 7.4% of the total increase in health
care spending from 1987-2000, and they are second among the 15 conditions that
contributed the most to rising health care spending over this period (behind
only heart disease at 8.1%).(1)
More than one out of five adolescents, adults or senior adults,
representing more than 60 million people collectively, have mental or addictive
illness, an epidemic by any measure.(2) In any given year, only half of this
population receives some care for their problem.(3) The market for
pharmaceuticals to treat central nervous system disorders in the United States
is measured at more than $44 billion ($68 billion worldwide) or 23% of total
annual pharmaceutical sales.(4) Unfortunately, the vast majority of these
expenditures are not based on blood tests, CT scans, or any objective
measurement of the system being treated. Dr. Steven Hyman, Director of the
National Institute of Mental Health from 1996 to 2002 stated:
"IN MOST BRANCHES OF MEDICINE, PHYSICIANS CAN BASE THEIR DIAGNOSIS ON
OBJECTIVE TESTS: A DOCTOR CAN EXAMINE X-RAYS TO SEE IF A BONE IS
BROKEN, FOR EXAMPLE, OR CAN EXTRACT TISSUE SAMPLES TO SEARCH FOR CANCER
CELLS. BUT FOR SOME COMMON AND SERIOUS PSYCHIATRIC DISORDERS, DIAGNOSES
ARE STILL BASED ENTIRELY ON THE PATIENT'S OWN REPORT OF SYMPTOMS AND
THE DOCTOR'S OBSERVATIONS OF THE PATIENT'S BEHAVIOR." (5)
Collectively, the industry has been waiting to understand the
physiology of behavioral disorders, with the hope of finding an approach that
utilized objective patient data with prescriptive therapy.
Fueling the increase in spending are patients deemed to be
"Treatment-Resistant," typically defined as failing two or more trials of
standard of care therapies of adequate dose and duration. Treatment costs for
such patients are exceedingly high. For example, those in treatment-resistant
depression reach $10,000 annually for patients treated on an outpatient basis
only, and more than $40,000 annually for those treated on an inpatient basis.(6)
Based on conversations with managed behavioral health care organization (MBHO)
- ----------
(1) Moran, Mark, MANY MORE PEOPLE SEEKING MH TREATMENT SINCE 1980S. Psychiatric
News 39-19 at 15 (October 1, 2004).
(2) See SUPRA note 4 at xii.
(3) Id. at viii.
(4) See SUPRA note 2.
(5) Hyman, Steven. E., DIAGNOSING DISORDERS:PSYCHIATRIC ILLNESSES ARE OFTEN HARD
TO RECOGNIZE, BUT GENETIC TESTING AND NEUROIMAGING COULD SOMEDAY BE USED TO
IMPROVE DETECTION, Scientific American, (3): 96-103 (September 2003).
(6) Crown, W.H., Finkelstein, S., Berndt, E.R., Ling, D., Poret, A.W., Rush,
A.J., and Russell, J.M.. THE IMPACT OF TREATMENT-RESISTANT DEPRESSION ON HEALTH
CARE UTILIZATION AND COSTS, 63(11):963-71 (November 2002).
5
executives, the Company estimates that approximately 10% of patients represent
35-40% of MBHOs' patient costs, with the overwhelming majority deemed
treatment-resistant cases. MBHOs manage an estimated 210 million lives in the
U.S. alone, with 115 million covered by four organizations: Magellan, Value
Options, United Behavioral Health and CIGNA Behavioral Health.(7)
Historically, the practice of psychiatric medicine has been operated
subjectively, with treatment decisions involving powerful neuropsychiatric
medications being prescribed with little or no understanding of the underlying
physiology of each patient.(8) Modern medicine has been successful in
establishing etiology and finding effective therapy for only a relatively small
group of mental abnormalities(9) and has, therefore, necessarily had to rely on
symptomatic diagnoses to make course of treatment decisions. The prevalence of
the prescription of multiple courses of ineffective medications for patients
suffering from mental disorders, coupled with the attendant economic
inefficiencies of the practice of Psychiatry in this manner demands a logical
alternative.
Behavioral disorders are common in the United States and
internationally. An estimated 26.2 percent of Americans ages 18 and older --
about one in four adults -- suffer from a diagnosable mental disorder in a given
year.(10) The market for pharmaceuticals to treat central nervous system
disorders is more than $42 billion in the United States and is the largest
market segment of pharmaceutical sales, surpassing pharmaceuticals to treat
cardiac disease, cancer and diabetes.(11) Traditionally, prescription of
medication for the treatment of these disorders has been based on symptoms,
while the underlying physiology and pathology of the disease has rarely been
addressed. This can result in multiple ineffective, costly and often lengthy
courses of treatment before effective medications are identified, if at all.
OUR SOLUTION
rEEG is a historical outcomes-based information treatment tool
personalized to the functional imbalance of a patient's brain. We believe rEEG
to be the first broad-based objective, quantitative, neurophysiologic biomarker
system for facilitating appropriate and effective treatment for patients
suffering from behavioral (mental or addictive) disorders. In the past year,
physicians in sixteen states have used this system to guide treatment of their
treatment-resistant patients.
With a rEEG report, a physician (a "Client-Physician") can obtain
neuropsychiatric medication sensitivity and resistance data for individuals that
have brain abnormalities (abnormalities of electrical power distribution in the
brain) similar to that of their patient. The compelling clinical results and
economics demonstrated in multiple studies completed by either CNSR or
independent parties provide the basis from which, we believe, rEEG will become a
standard for guidance of psychiatric treatment of treatment-resistant patients.
See Section captioned "OUR BUSINESS -CLINICAL VALIDATION" for a review of
existing clinical data.
- ----------
(7) Open Minds Yearbook of Managed Behavioral Health Market Share in the United
States, 1998-1999, at 10-12 (Gettysburg, PA. 1999).
(8) Gardner, R., SOCIOPHYSIOLOGY AS THE BASIC SCIENCE OF PSYCHIATRY, Journal
Theoretical Medicine and Bioethics, 18-4 at 335-356 (December, 1997).
(9) Breggin, P., R., M.D., Toxic Psychiatry: Why Therapy, Empathy and Love Must
Replace the Drugs, Electroshock, and Biochemical Theories of the "New
Psychiatry", at 291 (St. Martin's Press, 1991).
(10) National Institute of Mental Health, The Numbers Count: Mental Disorders In
America (2006), http://www.nimh.nih.gov/publicat/numbers.cfm#Intro.
(11) IMS Health (NYSE: RX), IMS Retail Drug Monitor April 2006,
http://www.imshealth.com/vgn/images/portal/cit_40000873/56/43/78335031IMS%20
Retail%20Drug%20Monitor%20April2006.pdf.
6
Over the course of the last twenty years the Company and its scientific
founders have collected treatment outcomes for patients using various
medications where the patients' brain function was first measured with an EEG.
CNSR has correlated the EEG features with courses of treatment and outcomes
information provided by Client-Physicians. This information has been
subsequently assembled and organized into a proprietary database that we refer
to as the "rEEG Outcomes Database". The rEEG Outcomes Database contained
outcomes for over 2000 patients and more than 13,000 treatment trials of
medications on these patients.
Using the rEEG analysis method and the information contained in the
rEEG Outcomes Database, CNSR can provide a report (an "rEEG Report") to a
Client-Physician identifying medication groups (such as antidepressants,
stimulants, anticonvulsants and beta blockers), medication subgroups such as
antidepressant subgroups of SSRI's (selective serotonin reuptake inhibitors, an
example of which is Prozac), TCA's (tricyclic antidepressants, an example of
which is Desipramine), SNRI's (serotonin-norepinephrine reuptake inhibitors, an
example of which is Cymbalta). Further, and most importantly, CNSR's statistical
models in combination with the rEEG Outcomes Database indicates which specific
medications within these subgroups (such as Zoloft, Prozac, Elavil, Wellbutrin,
Effexor) are the most effective for patients whose EEGs evidence similar
characteristics to that of the subject patient.
Psychiatric treatment guided by rEEG has been shown, in independent
studies, to be significantly more efficacious than previous treatment practices.
See Section captioned "OUR BUSINESS - CLINICAL VALIDATION." Physicians that have
utilized such reports to inform their treatment strategies identify such reports
as `essential' or `significantly helpful' in approximately 75% of patients
treated based upon the information contained in the rEEG Report. The vast
majority of subject patients for whom we have created rEEG Reports have been
identified by their physicians as "treatment-resistant," generally understood to
be the most challenging, high-risk and expensive category of patients to
treat.(12) Typically, less than 25% of such patients find success in their next
treatment efforts.(13) Management believes that rEEG provides Client-Physicians
with a unique tool that can dramatically improve treatment outcome based on a
patient's own neurophysiology.
rEEG METHOD
CNSR's rEEG method consists of the following four integrated
components:
Quantitative Quantitative
Digital EEG + Normative + rEEG Outcomes + EEG / Medication
Analysis Analysis Correlations
1. Digital Electrocephalogram ("EEG")
The first step in the rEEG process is a standard digital EEG recording.
An EEG is a non-invasive, painless procedure where a cap of twenty
electrodes records the electrical output of the brain while the patient
is awake, but resting with their eyes closed. The recording normally
takes between 20 and 45 minutes. An EEG is a common, standardized
procedure in neurology, often used in diagnosis of epilepsy or other
neurological disorders such as brain tumor, stroke, encephalopathy etc.
- ----------
(12) Dewan, M.J., and Pies, R.W., The Difficult-to-Treat Psychiatric Patient, at
37, American Psychiatric Publishing, Inc. (September 2002).
(13) Rush, A.J., Trivedi, M.H., Wisniewski, S.R., Nierenberg, A.A., Stewart,
J.W., Wadren, D., Niederehe, G., Thase, M.E., Labori, P.W., Lebowitz, B.D.,
McGrath, P.J., Rosenbaum, J.F., Sackheim, H.A., Kupfer, D.J., Luther, J., and
Fava, M., ACUTE AND LONGER-TERM OUTCOMES IN DEPRESSED OUTPATIENTS REQUIRING ONE
OR SEVERAL TREATMENT steps: A STAR*D REPORT. Am. J. Psychiatry; 163: 11,
1905-1917.
7
2. Quantitative Normative Analysis
The electrical output at each of the twenty leads is "Fast Fourier"
transformed (a mathematical technique useful in wave analysis) into a
spectrum of electrical power output at various frequency ranges. One
standard approach transforms these waves into defined frequency ranges,
or bands, labeled Delta, Theta, Alpha and Beta. Output of these four
levels of frequency can be compared among the twenty leads. Standard
comparisons include electrical power of each of these bands on an
absolute and relative power basis (% of the total power output). Also,
comparison of various leads can be made for symmetry and coherence (a
measure of the phase of the energy output). Each of these measurements
(or groups of measurements) in a patient can be compared to values for
asymptomatic people (norms) of the same age and noted when they are
outside of standard normal ranges.
Analysis of the rEEG outcomes database has shown that certain abnormal
indications identifiable in an EEG (individually or in combination) are
indicators of probable response to different medication classes and
individual medications. We refer to these as "biomarkers". We have
identified a significant group of biomarkers that have shown relevance
and we calculate their value for each patient. We then examine the
history of treatment response to specific medications for patients with
similar patterns of abnormality in these biomarkers and compute a
projected sensitivity analysis for the current patient using any of the
specific medications or medication classes where we have sufficient
statistical power.
3. Quantitative rEEG Outcomes Analysis
A core element of rEEG is the rEEG Outcomes Database. This proprietary
database consists primarily of patient digital EEGs, medication
histories and outcomes collected over a 20 year period. An "outcome"
can be defined as a specific measure of change in behavior obtained
while taking specific medications. The rEEG Outcomes Database allows
for statistical correlation of more than 1,100 individual QEEG measures
against medication success, and includes more than 13,000 treatment
episodes with outcomes.
4. EEG / Medication Correlations - Computation of Proprietary
Variables and application of Correlation Engine
Currently, the rEEG Outcomes Database allows the Company to analyze
outcomes related to twenty-seven different medications from the classes
of antidepressants, stimulants, anticonvulsants, beta-blockers and food
supplements. The Company is continually growing the database and adding
additional medications as they become statistically relevant. There are
currently seventy-eight medications marketed in the U.S. for
depression, anxiety disorders, bipolar disorder, schizophrenia,
obsessive-compulsive disorder (OCD), attention-deficit hyperactivity
disorder (ADHD), post-traumatic stress disorder (PTSD), panic disorder,
and insomnia. This does not include sixty-one medications now marketed
in the United States for the treatment of Alzheimer's, Parkinson's
Disease, migraines and Epilepsy.(14)
- ----------
(14) Drug Reference for FDA Approved Psychiatric Drugs,
http://neurotransmitter.net/drug_reference.html.
8
TREATMENT DECISIONS MADE BY LICENSED PROFESSIONALS
We do not currently operate our own healthcare facilities, employ our
own treating physicians or provide medical advice or treatment to patients. The
Client-Physicians that contract for our rEEG Reports own their own facilities or
professional licenses, and control and are responsible for the clinical
activities provided on their premises. Patients receive medical care in
accordance with orders from their attending physicians. Physicians who contract
for rEEG Reports are responsible for exercising their independent medical
judgment in determining the specific application of the information contained in
the rEEG Reports, and the appropriate course of care for each patient. Following
the prescription of any medication, the Client-Physicians are presumed to
administer and provide continuing care treatment.
PROCESS FLOW
The flow chart below details the process of inception to rEEG Report
delivery. Currently, upon receipt of the EEG, a rEEG Report is generally
delivered to the referring physician 3-4 days. We expect that through efficiency
improvements, turnaround will be reduced to next day.
PATIENT/PHYSICIAN CNS RESPONSE NEUROLOGIST
________________________ _______________________
| EEG Recording in Field |_\| Transfer to CNS |
| | /| (Secure) |______________
|________________________| |_______________________| |
| |
___________V___________ _________ V__________
| Artifacting | | Neurologist Review |
| (remove eye blinks, | | (confirming that |
| muscle twitches, etc.)|/__| Patient is suitable |
| |\ | for rEEG) |
|_______________________| |_____________________|
|
___________V___________
| Quantitative |
| Normative |
| Analysis |
|_______________________|
|
___________V___________
| Computation of |
| Proprietary Variables |
|_______________________|
|
___________V___________
| |
| Correlation Engine |
|_______________________|
|
________________________ ___________V___________
| Receive rEEG Report | | rEEG Report |
| (Utilize for |/_| Generation |
| Treatment) |\ | and Review |
|________________________| |_______________________|
The chart above shows that the first step in the process is collection
of a digital EEG from the patient. This may be done at the physician's office or
off-site at a testing center. Some physicians own their own equipment for
testing while others arrange for technicians to visit their offices for patient
appointments. This data is then typically transferred to a secure Health
Insurance Portability and Accountability Act ("HIPPA") compliant FTP (File
Transfer Protocol) Internet site, although it can also be sent via overnight
delivery service. Another early step in the process is artifacting. This is the
process of selecting segments of the QEEG record for analysis that are free of
electrical distortions caused by muscle movement. Also, early in the process is
a conventional review of the EEG by a neurologist or neurophysiologist. This
serves as a quality control step to review the overall quality of the recording
and determine whether it is acceptable for rEEG processing. Also at this time,
the neurologist/neurophysiologist will author a review of the conventional EEG.
This will appear on CNSR's Type I rEEG Report.
9
OUR TECHNOLOGY AND INTELLECTUAL PROPERTY
rEEG PATENTS
We have two issued U.S. Patents which together provide CNSR with the
right to exclude others from using the rEEG technology. In addition, these
patents cover the analytical methodology utilized by CNSR with any form of
neurophysiology measurement including SPECT (Single Photon Emission Computed
Tomography), fMRI (Functional Magnetic Resonance Imaging), PET (Positron
Emission Tomography), CAT (Computerized Axial Tomography), and MEG
(Magnetoencephalography)). We do not currently have data on the utility of such
alternate measurements, but we believe they may, in the future, prove to be
useful to guide therapy in a manner similar to rEEG. We have also filed patent
applications for our technology in various foreign jurisdictions.
rEEG TRADEMARKS
We have filed trademark applications in the United States for the
following marks: "Referenced-EEG" and "rEEG". We will continue to expand our
brand names and our proprietary trademarks worldwide as our operations expand.
rEEG OUTCOMES DATABASE
The rEEG Outcomes Database consists of approximately 13,000 clinical
outcomes across 2,000 patients who had psychiatric or addictive problems. The
CNSR Outcomes database is maintained in two parts:
1. The QEEG Database
The QEEG Database includes EEG recordings and neurometric data derived
from analysis of these recordings. This data is collectively known as
the QEEG Data. QEEG or "Quantitative EEG" is a standard measure that
adds modern computer and statistical analyses to traditional EEG
studies.
2. The Clinical Outcomes Database
The Clinical Outcomes Database consists of physician provided
assessments of the clinical outcomes of patients and their associated
medications. The clinical outcomes of patients are generally recorded
using an industry-standard outcome rating scale, such as the Clinical
Global Impression Global Improvement scale ("CGI-I"). The CGI-I
requires a clinician to rate how much the patient's illness has
improved or worsened relative to a baseline state. A patient's illness
is compared to change over time and rated as: very much improved, much
improved, minimally improved, no change, minimally worse, much worse,
or very much worse. In addition, CNSR may utilize specialized scales
applicable to specific disorders, including the Beck Depression
Inventory and Ham-D scales (Hamilton Depression Rating Scale) for
depression and anxiety.
The format of the data is standardized and that standard is enforced at
the time of capture by a software application. Outcome data is input
into the database by the treating physician or in some cases, their
office staff. Each Client-Physician has access to his/her own patient
data through the software tool that captures clinical outcome data.
10
We consider the rEEG Outcomes Database to be a valuable trade secret
and are diligent about protecting such information. The rEEG Outcomes Database
is stored on a secure server and only a limited number of employees have access
to it. Any individual that is provided with access to the database is required
to enter into a strict confidentiality agreement.
OUR CURRENT OPERATIONS -- LABORATORY INFORMATION SERVICES
We provide rEEG analysis in a relationship analogous to the support
other physicians have from a reference laboratory or radiology center.
Physicians send us the QEEG data, and we return an analytical report for a
standard charge. This revenue model requires minimal training or impact on their
current operation and is one that physicians readily understand. In some cases,
we also provide the actual patient testing for acquisition of the QEEG data.
Our revenues are currently derived primarily from our Laboratory
Information Services business.
We currently offer rEEG Reports produced by our laboratory based on
QEEG data supplied by the physician or an independent testing service. There are
two primary types of analysis available.
TYPE I ANALYSIS
Type I analysis provides medication sensitivity information based on
statistical probability of improved outcomes against
neurophyisiologically similar patients. It is considered the baseline
measurement where the patient is preferably tested in an unmedicated
state, which means the patient abstains from taking neuropsychiatric
medications that cross the blood-brain barrier and act on the brain for
5 half-lives (can vary from 1 day for Ambien to 5 weeks for Prozac).
TYPE II ANALYSIS
Type II analysis provides medication sensitivity information based on
the changes to the patient's neurophysiology presumed to be from the
intervening treatment. It is, therefore, measured while the patient is
medicated.
Laboratory Information Services are either: 1) billed to the
Client-Physician or 2) billed to the Patient directly. Currently, all of the
rEEG Reports produced are billed to the Client-Physician. We bill our
Client-Physicians on a monthly basis.
Typically, after a 90 day medication regime guided by the Type I rEEG,
a Type II rEEG will be ordered if the desired outcome has not been achieved.
This follow-up analyzes changes post-medication in the patient's physiology, and
facilitates the preparation of an rEEG Report with data useful for determining
medication dose adjustment, alternative medicine selection or additional
medication augmentation. Because our Type I analysis has shown strong efficacy
in guiding successful medication of subject patient's disorders, we expect that
requests for Type II analysis will remain at their current levels.
11
OUR CURRENT MARKETS
CURRENT APPLIED DISORDERS
In the last 12 months, physicians in sixteen states have used rEEG in
their practice. A series of eight studies involving rEEG have been conducted
over the last several years cumulating 500 patients. See Section captioned
"CLINICAL VALIDATION." All studies, which involved most major categories of
psychiatric disorders (except for schizophrenia), have shown rEEG to be
demonstrably effective in guiding treatment. To date, these studies have
addressed the efficacy of rEEG with respect to the following behavioral
disorders:
o Attentional disorders (including Attention Deficit Disorder
("ADD")/Attention Deficit Hyperactivity Disorder ("ADHD"));
o Anxiety disorders;
o Depressive disorders;
o Bipolar disorders;
o Impulse control disorders;
o Post Traumatic stress disorder;
o Compulsive and obsessive disorders;
o Eating Disorders (including anorexia nervosa and bulimia
nervosa); and
o Addictive Disorders (including drug and alcohol abuse).
PRIVATE PAYERS
Currently, a large majority of our rEEG Reports are paid for directly
by patients.
Insurance coverage for treatment of behavioral disorders varies
significantly. Many health plans limit coverage for mental health benefits by
imposing co-payments, deductibles or limits on outpatient visits that are more
restrictive than those placed on physical illness. Many times these benefits do
not extend to addiction treatment. Lack of or limitations on insurance coverage
or exhaustion of insurance coverage often result in patients needing to pay
privately for treatment of behavioral disorders.
Another reason patients pay privately is that access to plan
psychiatrists may be limited, requiring patients to seek non-plan psychiatrists
that only accept direct patient payment. Occasionally, a patient receiving care
from a health plan psychiatrist may become disappointed with the amount of time
they are able to spend with that physician. They may prefer to pay privately in
order to obtain more physician time and attention.
Because of the nature of a behavioral disorder, many patients seek out
private pay psychiatrists as a result of a desire for greater anonymity. Some
patients are concerned about filing reimbursement claims with their employer's
health benefit program, especially in cases where they may not want their
employer to know of their affliction (e.g. addiction, Attention Deficit
Disorder, Obsessive-compulsive Disorder, Impulse Control Disorder).
12
Still other patients are seeking the best quality of care without
concern for reimbursement. Psychiatrists that accept private pay generally are
able to receive a higher hourly rate from private pay patients than most health
plan provide. As a psychiatrist develops a reputation for quality service they
may be able to focus their practice on private pay patients to a greater degree.
It is this reputation for quality service that may attract some of the patients
seeking best quality of care.
For these reasons and more there are a large number of psychiatrists
that accept only patients paying privately for their services. CNSR has
estimated that these psychiatrists treat approximately 40% of the treatment
resistant patients, which comprises 2 million people in any given year or a
potential annual market of $1.2 billion with present pricing.
MANAGED BEHAVIORAL HEALTH ORGANIZATIONS/MANAGED CARE PAYERS
Currently, only a small portion of our rEEG Reports are paid for by
insurers or managed healthcare companies.
Many insurance/managed health care companies and many self-insuring
employers providing behavioral health benefits seek to manage these services and
expenditures through separate entities (MBHOs) that focus exclusively on
managing the mental health benefit. MBHOs are separate entities such as Magellan
Health Services or ValueOptions, Inc. or subsidiaries of larger healthcare
management organizations such as United Behavioral Health or CIGNA Behavioral
Health.
MBHOs have developed contracted networks of behavioral health
specialists to service the needs of their insured members. Various policies for
patients and providers help to efficiently deliver the behavioral health
benefit. Employers that contract with MBHOs don't necessarily seek the lowest
cost of care. Often, the employer's goals are to minimize absenteeism,
disruption to their processes or time lost as a result of employee disabilities
and prefer to contract with MBHO's that can deliver a better quality of care,
accomplishing these goals. Employers may contract directly with an MBHO or
utilize MBHO's as part of the total health care managed care contract.
Based on our conversations with MBHO managers, we estimate that a small
subset (10%-15%) of those that seek treatment in any year account for a
disproportionately high percentage (30%-45%) of the total medical costs paid out
by MBHOs. These are typically the treatment resistant patients. In addition to
being burdensome on the MBHO's, these patients are also typically more expensive
to their primary health insurer as compared to other patients because of their
higher use of emergency room services, pharmaceuticals (which are often not
managed by the MBHO), and use of medical services associated with physical
ailments.
We estimate over 1 million patients covered by MBHOs in any given year
are candidates for rEEG Report guidance. At present pricing this represents an
annual market opportunity of $600 million.
TOTAL MARKET PERSPECTIVE
A 2004 Harris Interactive Poll stated that "an estimated 59 million
people, or more than one in four U.S. adults, have received some form of mental
health treatment in the past two years. The vast majority of these people -- an
estimated 48 million -- are being treated with prescription medication.
Medications are clearly the dominant form of mental health treatment in America,
the survey found" (as reported in Health Day News, May 5, 2004). The poll also
estimated another 24 million people needed but were not getting help because
they had given up on treatment or never pursued treatment. We estimate our
market opportunity for our Laboratory Information Services with respect to
central nervous system disorders to be in excess of $1.5 billion.
13
PRICING
We typically charge $400.00 to physicians for a Type I rEEG Report, our
standard report, which reflects EEG data obtained while a patient is off of
medications. Occasionally, physicians encounter patients that cannot tolerate
the discontinuation of their current medications to have a standard Type I test.
For these patients, we have a special report, Type I(m), which reflects EEG data
obtained while the patient is medicated with a medication that is in the rEEG
Outcomes Database. By estimating the likely EEG effect from the medication, we
can estimate the rEEG parameters of an unmedicated brain and issue a report
based on such estimation. Pricing to the physician for Type I(m) reports are
$800.
Type II testing is for patients that have a baseline Type I test on
record and have been medicated. A Type II rEEG Report compares changes in
neurophysiology from the Type I test data. We currently charge $200.00 for a
Type II rEEG Report.
Because the primary tasks of rEEG analysis are computer automated,
direct costs of processing are relatively low. Currently, CNSR contracts with a
neurophysiologist to supply a conventional review of and commentary on a
patient's EEG test. CNSR also contracts with outside services to select
artifact-free (an eye-blink and the corresponding electrical signal from same is
an example of an artifact) sections of the recording suitable for rEEG analysis.
These services constitute the majority of the direct costs associated with
processing a rEEG Type I analysis. We are evaluating bringing both of these
functions in-house during 2008, thereby reducing our costs per test, and
improving our margins.
CLINICAL VALIDATION
As summarized in a 2005 American Psychiatric Association Poster,
reviewing results of rEEG guided treatment in prospective, retrospective,
comparative studies and independent physician case series, fairly consistent
results were reported. Generally, rEEG guided therapy, when used in conjunction
with other standard clinical information has shown the ability to guide
physicians to successful outcomes in 70% or more of mostly treatment resistant
patients. Various studies in the literature would suggest the current standard
of care for treatment success with treatment resistant patients is less than
half that rate, and in some cases only 10-15%.(15)
COMPLETED INDEPENDENT STUDIES AND TRIALS
- -------------------- ----------------------- -------------------- ----------------------
Veterans Association CIGNA Treatment- Davis-Atlanta
ADD/Depression Study Blind Prospective Major Resistnat Field Trial Case Study
100 Patients Depression Study 56 Patients 15 Patients
13 Patients
- -------------------- ----------------------- -------------------- ----------------------
rEEG-Guided Efficacy rEEG-Guided Efficacy rEEG-Guided Efficacy rEEG-Guided Efficacy
>80% 83% 70% 100%
- -------------------- ----------------------- -------------------- ----------------------
Monte Nido Hamilton-Newport Beach Hoffman-Denver L'Abri Dual Diagnosis
Eating Disorder Case Case Series Case Series San Diego Case Series
Series 34 Patients 15 Patients 58 Patients
81 Patients
- -------------------- ----------------------- -------------------- ----------------------
rEEG-Guided Efficacy rEEG-Guided Efficacy rEEG-Guided Efficacy rEEG-Guided Efficacy
83% 78% 73% 93%
- -------------------- ----------------------- -------------------- ----------------------
- ----------
(15) DUNNER, D.L., RUSH, A.J., RUSSELL, J.M., BURKE, M., WOODARD, S., WINGARD,
P., and ALLEN, J., PROSPECTIVE, LONG-TERM, MULTICENTER STUDY OF THE NATURALISTIC
OUTCOMES OF PATIENTS WITH TREATMENT-RESISTANT DEPRESSION. J CLIN PSYCHIATRY.
67(5):688-95 (May 2006).
14
ADD/DEPRESSION STUDY
-----------------------------------------------------------------------
Prospective study with retrospective analysis.
EFFICACY: >80%
Date: 1995. The initial formalized trial consisted of 100 patients of
which 46 were diagnosed with ADD and 54 with depression. Conventional
thought would have anticipated that the ADD patients would have
responded to the stimulants and the depressed patients would have
responded to the antidepressants. In this study, those that failed to
respond to conventional treatment were treated with non-conventional
medications. rEEG correctly identified which patients would respond to
which medications over 80% of the time. This study was published in
Clinical Electroencephalography.(16)
VETERANS ADMINISTRATION BLINDED PROSPECTIVE MAJOR DEPRESSION STUDY
-----------------------------------------------------------------------
Randomized, Prospective, Double-Blind Study
Date: 1997-1999. A pilot prospective study of severe and long-term
Veterans Administration patients diagnosed with major depressive
disorders was conducted under the direction of Dr Art Kling, former
Vice-Chairman of the Department of Psychiatry at UCLA. The trial
consisted of 13 patients, all diagnosed with depression with average
illness duration of 16 years. As measured by all indices used, all
patients but one in the rEEG guided treatment group showed significant
improvement (86%). In the control group, where patients were treated
without the benefit of rEEG, only one of the patients significantly
improved based upon physician-guided medication selection (17%), and as
it turned out, this patient received the class of medication that rEEG
predicted would most benefit the patient need even though this
knowledge was not available to the physicians in the control group.
This study has been submitted for publication.
TREATMENT-RESISTANT PATIENT FIELD TRIAL - CIGNA CO-SPONSORSHIP
-----------------------------------------------------------------------
A pilot study conducted between 2000 and 2002 with CIGNA Behavioral
Health and its network of Atlanta psychiatrists included 56
treatment-resistant patients. All patients had previously failed at
least two trials of medication treatments. Utilizing rEEG guidance, 69%
of patients were reportedly responsive to identified treatments.
PHYSICIAN CASE SERIES
-----------------------------------------------------------------------
Six physicians in five different clinical settings covering a wide
variety of diagnoses and ages have now reported on treatment results
aided by the use of rEEG in their clinics. The physicians received no
remuneration of any kind from CNSR and, in most cases, paid or had
their patients pay for the test and rEEG analysis. After reporting on
their results, a number of these physicians developed a strong desire
to instruct other physicians in the use of rEEG, and they have now
become regional medical directors with responsibility for training
other physicians. These physicians generally reported patient outcomes
on the seven-point scale, Clinical Global Improvement Index. Most also
reported their subjective assessment of the helpfulness of rEEG in
- ----------
(16) Suffin, S. C. and Emory, W. H., CLINICAL ELECTROENCEPHALOGRAPHY, 26(2),
1995.
15
treatment of each patient on a seven-point scale, Clinical Helpfulness
Index. These patients had a wide variety of disorders but were
generally unresponsive to previous treatment efforts. We are pleased
that virtually all reported case series have shown compelling treatment
results with 70% to 90% of patients achieving much improved or very
much improved rankings. Equally important, similar levels were reported
in the rEEG Helpfulness Index (SIGNIFICANTLY HELPFUL OR ESSENTIAL).
MONTE NIDO RESIDENTIAL TREATMENT CENTER
-----------------------------------------------------------------------
Monte Nido is a small in-patient treatment clinic in Malibu,
California, treating patients suffering from significant eating
disorders, primarily anorexia nervosa or bulimia. Dr. W. Hamlin Emory
is Medical Director of this facility. An initial analysis of treatment
results of 81 patients with pharmacotherapy based on rEEG was compared
to 10 patients treated by physicians without rEEG and 13 patients who
had rEEG testing but decided against medication. 83% of the rEEG guided
patient achieved SIGNIFICANT OR MARKED improvement. None of the
patients in the other two groups achieved this level of improvement.
These results were published in a Scientific Poster at the National
Institute of Mental Health annual meeting, New Clinical Drug Evaluation
Unit Symposium of 2004. The Monte Nido Residential Treatment Center is
now seeking long term outcome data through patient surveys. We are
looking forward to learning of these results. The initial study was
described in a report in 2001.
HAMILTON-NEWPORT BEACH CASE SERIES
-----------------------------------------------------------------------
Conducted by Dr. Jim Hamilton, a Physician in Newport Beach, CA. In
this study, 34 treatment-resistant patients medicated based on
information provided in rEEG Reports were followed and rated. 19 of the
34 patients had addictive disorders. Only 28 of the 34 cases were
analyzed due to the fact that the balance were not available for
follow-up. Of the 28 analyzed, in 22 of these 28 cases rEEG was judged
to be essential or very helpful in their treatment. In 14 out of these
28 cases, where the rEEG was judged essential, Dr. Hamilton reported
that rEEG had directed him "to combinations of medicines that one would
never find, or would take years to find after nothing else had worked."
In the 19 addiction cases, 4 were lost to follow-up, but in the 15 that
were followed, rEEG was judged essential or very helpful in 14 (79%) of
the cases.
HOFFMAN-DENVER CASE SERIES
-----------------------------------------------------------------------
Conducted by Daniel Hoffman, M.D., now a Company Medical Director, with
a practice in Denver, CO. This study was conducted prior to Dr. Hoffman
becoming the National Medical Director for the Company. In this study,
rEEG Reports were provided for 74 treatment-resistant patients who were
then followed, and were rated on both the CGI scale and the
"Helpfulness" Index. In 56 (74%) of these cases, rEEG was judged to be
essential or very helpful in their treatment. A like percentage
reported a much improved or very much improved on the Clinical Global
Improvement index.
16
DAVIS-ATLANTA CASE SERIES
-----------------------------------------------------------------------
Conducted by T. Albert Davis, M.D., Medical Director at the Florence
McDonnell Center in Atlanta. This was Dr. Davis's initial study of 15
patients that he treated with the aid of rEEG Reports. All 15 patients
were reported as having successful outcomes with 7 rated as Very Much
Improved and 8 rated Much Improved on the CGI scale. In Helpfulness,
rEEG was rated essential for 9 of these patients and moderately helpful
for six of these patients.
RANCHO L'ABRI DUAL DIAGNOSIS
-----------------------------------------------------------------------
In this study, 58 "dual diagnosis" (addiction and co-morbid mental
illness) patients were treated at Rancho L'Abri, San Diego, one of the
most respected in-patient treatment facilities in Southern California.
The physicians of Rancho L'Abri described their experience with rEEG in
a scientific poster at the 2005 American Psychiatry Association annual
meeting. The poster described both CGI rating of Very Much Improved or
Much Improved and Helpfulness rating of Essential or Very Helpful in
over 90% of the patients for whom it was used.
OUR BUSINESS PLAN - LABORATORY INFORMATION SERVICES
OUR STRATEGY
Our strategy is to provide rEEG analysis in a relationship with a
physician that is analogous to that of a reference laboratory. In each
geographic market, we plan to support this service with a full-time market
manager, identified EEG testing sites and a part-time Regional Medical Director.
The Regional Medical Director will provide local medical leadership and
training, local market communications, a site for physicians to refer
particularly challenging cases and support of family physicians needing
specialty consults.
In the next year, we plan to execute initiatives designed to allow for
dramatic introduction of rEEG to both treating physicians and their patients in
calendar year 2008. We envision this introduction will have elements of pushing
demand for rEEG via physician education and pulling demand for rEEG through
consumer education. The physician introduction will be accomplished through
development of an in-house direct sales force along with professional journal
and trade show introduction. The consumer introduction will utilize the major
broadcast, print and electronic news media.
Certain initiatives which are being considered for 2008 include:
1. EXPAND OUR GROUP OF CLIENT-PHYSICIANS TO INCLUDE MOST MAJOR US
CITIES. This key infrastructure development is one element
necessary for rapid penetration. rEEG Reports often stimulate
the identification of treatment strategies that most
physicians would not typically consider. Physicians often are
inexperienced in these treatment strategies, and they also may
be unfamiliar with combinations of medicines that may be
suggested by our rEEG Reports. It is valuable for physicians
who are not familiar with our rEEG Reports to have an
experienced colleague guide them through initial treatments
that are facilitated by the use of our rEEG Reports. For
physicians that are unfamiliar with our rEEG Reports, their
success is dependent on their ability to understand our rEEG
Reports and integrate them as another tool of insight to be
used in conjunction with their existing training.
17
2. CONDUCT PILOT PROGRAMS WITH MANAGED CARE PAYERS. We believe
that adoption of rEEG for reimbursement is best accomplished
through demonstration of its clinical and economic impact with
patients in a health plan. In at least one of these pilot
programs, CNSR will seek to pay for independent economic and
outcome analysis that CNSR will have the right to publish.
3. COMPLETE CURRENT MULTI-SITE AND CONDUCT ADDITIONAL ACADEMIC
TRIALS. CNSR is conducting a nine site, 120 patient, academic
controlled, blinded, and randomized study of patients
suffering from treatment resistant depression. The study will
be conducted at Stanford, Cambridge Hospital-Harvard,
University of California - Irvine, University of California -
San Diego and University of Texas - San Antonio. This study
has been designed with significant care by many academicians
including members of our advisory board. Because of the
involvement of respected academic centers, we believe that the
results of the study will be published, and widely
disseminated.
4. IMPROVE SYSTEM TURN-AROUND TO NEXT DAY AND ADD CAPACITY TO
COVER PROJECTED VOLUME. We plan to increase the usefulness of
our service by returning reports to physicians one day after
patient data is submitted to us. To accomplish this task, we
will need to improve the coordination of functions related to
rEEG analysis that we currently outsource. Our longer term
goal is to advance rEEG turn-around time to be
"while-you-wait."
5. ENHANCE REPORTS TO PROVIDE QUANTITATIVE BIOMARKER DATA AND
DEVELOP PHYSICIAN TRAINING AND CERTIFICATION PROCESS. We plan
to advance our training programs this year with the aid of a
training CD-ROM which is currently in development. In
addition, our next generation rEEG report is anticipated to
provide technical data on the set of rEEG biomarkers in a
manner that will allow trained physicians to better consider
treatment options and integrate their knowledge of clinical
assessment and historical treatment experience with the rEEG
biomarker data. Our training program will aid physicians' use
and understanding of our rEEG Reports. The training process
will have the added advantage of communicating to patients and
their families that a participating physician has completed
rEEG training, and is competent in the use of rEEG Reports to
guide treatment.
6. EXPAND REPORTED MEDICATIONS TO INCLUDE ANTIPSYCHOTICS.
Antipsychotics are the only significant class of psychotropic
medications for which rEEG does not currently offer treatment
guidance. Psychosis is one of the most severe mental illness
and is also one of the most difficult to treat. We plan to
conduct studies to determine if our rEEG Reports are useful in
guiding the treatment of psychosis, especially schizophrenia.
We have an initiative to accomplish this objective with a
group in China.
7. ADD KEY LEADERSHIP IN MEDICINE AND MARKETING. We plan to
continue to hire, train, retain and motivate additional
skilled personnel, particularly managers with experience in
growing healthcare companies, sales representatives who are
responsible for customer education and training and customer
support, as well as personnel with experience in clinical
testing and matters relating to obtaining regulatory
approvals.
MARKET INTRODUCTION
After accomplishing our immediate goals of building the regional
medical leadership and reaching agreement for pilot trials with MBHOs,
aggressive national introduction will occur with establishment of that regional
leadership, establishment of an introductory sales force, and prepublication
release of our treatment-resistant depression or other key study data.
18
PUSH: By accessing thought leaders in psychiatry at the national and
community level, publicizing the clinical benefits in professional and consumer
media, and relying on our own dedicated sales force to educate psychiatrists we
believe that the compelling benefits and economic efficiency of rEEG guidance
will provide large scale physician trial.
Our main promotional strategy with physicians will continue to be "try
it, you'll like it - no charge". Because of the low variable cost of producing
rEEG Reports, we can offer free trials to physicians to encourage them to begin
to experience the benefits of rEEG. Our current program offers Physicians five
(5) free Type I reports with their only commitment being the completion of a
consultative review with one of our regional medical directors for each report.
We encourage physicians to select their most hard to treat patients for these
free trials. It is our expectation that no matter how well conducted our
academic trials, physicians need to experience rEEG for themselves. One
physician has written a letter to CNSR stating, "I DON'T KNOW THAT I COULD GO
BACK TO PRACTICING BLINDED PSYCHIATRY. UNTIL YOU EXPERIENCE HOW DIFFERENT IT
FEELS TO PRACTICE THIS WAY, I COULD SEE SKEPTICISM FROM OTHERS." We believe
physician trial is the key to adoption of rEEG.
PULL: We intend to utilize major print, broadcast and electronic news
media to explain the benefits of rEEG directly to patients. We believe that
these media are the most effective and cost-efficient means to pull-in consumer
demand for rEEG and that we have an unusual opportunity to develop a large reach
at an early stage that can stimulate dynamic demand.
This demand will also encourage physicians to seek early understanding
of rEEG and our goal of trial. Assisting patients to find early adopting
physicians by providing identification of trained physicians on our web site
will likely provide another win- win for patients, physicians and CNSR.
NEW MARKETS
ADDITIONAL APPLICABLE DISORDERS
While physicians have historically classified central nervous system
disorders as psychiatric or neurological, the diseases themselves could be
characterized as disorders of the same organ system, primarily the brain. The
utility of using of neurophysiological data to guide treatment of the brain in
connection with psychiatric disorders may well extend to neurological disorders.
For example, we currently have significant information in our rEEG
Outcomes Database with respect to the effectiveness of anticonvulsants for
patients with certain biomarkers. We intend to explore the utility of our
biomarkers for guiding use of medications, including anticonvulsants, for their
primary indication of seizure disorders, as well as their utility in pain
management for which they are also often prescribed.
ADDITIONAL APPLICATIONS BEYOND TREATMENT-RESISTANCE
Due to the success of rEEG with treatment-resistant patients, we
believe that rEEG has the potential to become a useful tool for psychiatrists in
treating patients that do not qualify as treatment resistant. For example, it is
generally acknowledged that children have a wide range of reactions to
anti-depressants and, in fact, anti-depressants in many cases actually harm
instead of help them. The ability to avoid prescribing anti-depressants for
children that may have a physiological predisposition to react negatively would
reduce suffering for both the children, and their families, and facilitate the
identification of a successful strategy earlier in the process. In addition,
adolescents, who are typically intolerant of the long process of medication,
would be especially good candidates for rEEG guided therapy.
19
CENTERS OF EXCELLENCE
It is our intention to work with our Client-Physicians, and our medical
advisors to support, possibly with financial resources, the establishment of
practices and/or clinics that specialize in the use of rEEG guided therapy. We
believe that a network of such practices, which we call "Centers of Excellence,"
will provide opportunities for physician training and additional clinical trials
and demonstrations of the value of rEEG technology. It is our goal to make these
Centers of Excellence a destination for treatment-resistant patients and a
resource for care managers of the MBHOs, and, in time, a network of such Centers
may be in a position to contract for a disease management program with the
managed care industry.
GOVERNMENT
The market for our Laboratory Information Services potentially includes
state hospitals, wards of the state in specialty care homes for persistently and
seriously ill and jails. 2,186,230 prisoners were held in Federal or State
prisons or in local jails as of mid 2005.(17) Rates of severe mental illness in
this population are reportedly as high as 24%.(18) We are not currently pursuing
this market, in part because there is a substantial incidence of Schizophrenia
in this population and we do not yet have sufficient data to provide treatment
guidance for Schizophrenic patients.
We believe the incarcerated population returning to society may be a
particularly good market for rEEG. We have not yet explored the opportunity to
address this population but are interested in studying whether rEEG guided
treatment might add enough improvement in efficiency and effectiveness to alter
the recidivism rate.
RESEARCH AND DEVELOPMENT
We will continue to enhance, refine and improve the accuracy of our
CNSR Database and rEEG through expansion of the number of medications covered by
our rEEG Reports, expansion of our biomarkers, refinement of our biomarker
system, and by reducing the time to turnaround a report to the physician. We
spent $1,442,600 and $519,800 on research and development for each of the fiscal
years ended September 30, 2007 and 2006, respectively. Other specific research
and development goals consist of:
o Developing enhanced Type II Analyses that have increased value
and content;
o Addition of other CNSR agents, and possibly cardiac agents;
o Developing an automated Type I (m) for patients on a single
well characterized medication;
o Advancing our research to understand the total balance
analysis that can be used for monitoring or a more global
scale; and
o Improved graphical presentation of results.
- ----------
(17) U.S. Dept. of Justice- Bureau of Justice Statistics,
http://www.ojp.usdoj.gov/bjs/prisons.htm.
(18) Daly, R., PRISON MENTAL HEALTH CRISIS CONTINUES TO GROW, Psychiatry News,
40-20 at 1 (October 20, 2006).
20
OUR BUSINESS PLAN - PHARMACEUTICAL DEVELOPMENT AND ADVANCEMENT
Although we intend to emphasize our Laboratory Information Services
during the next twelve (12) months, we plan to increase our involvement with the
pharmaceutical industry in the future.
OUR STRATEGY
Our strategy in the next year is the initiation of marketing of rEEG to
selected potential pharmaceutical development partners. Evaluation of such
opportunities by potential partners is complicated by many issues including
state of intellectual property, regulatory approval for marketing and the
trial(s) necessary, medication delivery and packaging requirements of the
medications, therapeutic synergy of the combination, market needs in selected
indications and related competitive advantage, estimated market size, production
costs, current physician familiarity with the individual agents and other
considerations.
A secondary goal is to explore the business opportunity in aiding in
resuscitating opportunities for psychiatric medications that are no longer being
pursued by their developers despite the fact that such medications demonstrated
significant efficacy for subgroups of patients in clinical trials. We believe
that, by using our system of rEEG biomarkers, we can aid in identifying patient
populations that are more likely to respond to a particular medication based on
their common physiological characteristics. We are interested in exploring
cooperative relationships, which utilize our technology and rEEG Outcomes
Database to aid in the development and clinical trials of efficacious
medications that previously had failed to adequately demonstrate that efficacy
in late stage trials.
We intend to leverage our capabilities and technology to develop a
pharmaceutical business from four sources:
COMBINATION OF OFF-PATENT AGENTS FORMULATED INTO SINGLE PILL FIXED-DOSE
COMBINATIONS.
Our data has demonstrated that some patient electrophysiological
abnormalities are more frequently observed than others. Most of the frequent
abnormalities take more than one agent to bring the patient to an
electrophysiological normal state. This is not surprising, as the individual
agents were never developed from an electrophysiological normalizing
perspective. We have identified a number of high frequency abnormalities that
appear to be most effectively addressed by a combination of medications. We have
filed patent applications on two categories of combinations and expect to file
more. Our current focus is for opportunities in bulimia, treatment-resistant
depression and addiction.
PARTNERING WITH PHARMACEUTICAL DEVELOPERS TO "RESCUE" NEW AGENTS IN
DEVELOPMENT.
New Chemical Entities (NCEs) that have been shown to be safe, but not
efficacious in late stage clinical trials present opportunities to partner or
acquire and re-license. Specifically, our interest is focused on a group of
agents that can generally be described as having (a) completed pre-clinical
formulation, toxicology, pilot production development, and all required animal
studies, (b) completed Phase I human safety studies, (c) completed Phase II
human dosing studies and possibly conducted initial Phase III pivotal efficacy
studies. These agents will have shown themselves to be generally safe without
debilitating adverse affects but have been discontinued in development due to
their failure to show compelling efficacy in either Phase II or Phase III
studies.
21
We estimate that there are approximately 200 central nervous system
compounds which are sitting idle at large pharmaceutical companies after failing
Phase II or Phase III trial.(19) We have completed a review of 53 such agents
that fit the described criteria and initially has focused on eight which are
thought to be worthy of consideration for licensing. Five other agents have been
identified as to be worth in-licensing pursuit for United States development.
These are agents that have been approved in overseas markets but not in the
United States. While they may not have been adequately differentiated, or the
regulatory expense may not have seemed justifiable for the potential market
opportunity, we believe that these agents belong to classes that have been
generally under utilized for additional significant indications. We believe that
for some medications, our rEEG biomarker system will be able to identify
patients with a high likelihood of responding well to these medications based on
the presence of rEEG-defined biomarkers.
We believe our rEEG biomarker system can be used to effect:
o Reduction of placebo responders in a clinical trial by
focusing on treatment resistant patients or eliminating
patients demonstrating normal neurophysiologic function and
balance;
o An increase in treatment group responders by selecting
patients for trial inclusion based on the presence of specific
rEEG defined neurophysiology.
AMELIORATING THE CNSR SIDE EFFECTS OF MEDICATIONS USED FOR OTHER MEDICAL
PURPOSES.
"Cancer fog" is a colloquial term used to describe the response of a
patient or care-givers response to the stresses and perhaps the medications
associated with cancer therapeutics. For patients, these effects appear to be
particularly specific to certain chemotherapeutic agents.
To the extent these agents cause a specific common alteration in
neurophysiological function, rEEG should be able to note and identify this. This
should allow the creation of a counteracting medication antidote for people
suffering from a neuropsychiatric condition following primary therapy.
COMPARABLE COMPANIES, COMPETITION AND INDUSTRY DEVELOPMENTS
INDUSTRY DEVELOPMENTS
We are not aware of any reference laboratories that service Psychiatry
with tools or information to direct therapy, although the following firms are
using neurophysiological data in an attempt to diagnose certain disorders and,
in some cases, monitor or confirm therapy:
o LEXICOR INC. (www.lexicor.com) - uses EEG to diagnose ADHD
o NEURONETIX (www.neuronetix.com) - uses tools to diagnose
Autism, Dyslexia and Alzheimer's
o AMEN CLINIC - uses SPECT for diagnosis and monitoring of
therapy
o NEUROGNOSTICS - uses FMRI for confirmation of therapeutic
efficacy
We are not aware of any companies using neurophysiological data to
guide therapy in conjunction with a neurophysiology outcomes database.
- ----------
(19) Jarvis, L. M. TEACHING AN OLD DRUG NEW TRICKS: GENE LOGIC IS CONVINCING BIG
PHARMA TO TAKE ANOTHER LOOK AT ABANDONED DRUGS. Chemical and Engineering News,
84-7 at 52,54-55 (February 13, 2006).
22
COMPARABLE COMPANIES
Although there are no companies offering a service similar to that
offered by CNSR, the following companies might be noted as comparable through
some commonalities:
o ASPECT MEDICAL SYSTEMS, INC. (Nasdaq: ASPM), an EEG anesthesia
monitoring company, is developing a specific EEG measurement
system that indicates a patient's likely response to some
antidepressant medications. Patients must be measured prior to
and after taking medication. Publicly available knowledge
suggests that the technology may validate a patient's
treatment but does not guide specific treatment. Initial
trials have shown efficacy in correlating a patient's ultimate
response to antidepressants. The revenue model appears to
involve sale of equipment and a per-patient charge. The
company is now conducting trials.
o HYTHIAM, INC. (Nasdaq: HYTM). Though perhaps more of an
analogous company than a competitor, Hythiam is a public
company introducing a proprietary addiction detoxification
procedure that purports to address physiologic needs of
addicts and impact on-going recovery. The company charges a
$15,000 fee for stimulant abusers and $12,000 for alcohol
abusers. Since CNSR does not provide guidance regarding
detoxification of addictions (only their post-detoxification
treatment), Hythiam is not a direct competitor.
o BRAIN RESOURCE COMPANY (www.brainresource.com), an Australian
public company developing EEG and other physiology data on
patients with behavioral illness through a network of
physician data relationships. Their revenue model includes
physician services and sale of systems and services to
pharmaceutical development companies in the CNSR field.
o GENOMIC HEALTH, INC. (NasdaqGM: GHDX). This public company
provides analogous services to those of CNSR for patients
suffering from cancer.
EMERGING TECHNOLOGIES
The entire field of neuropsychiatry is undergoing dramatic changes as a
result of the introduction of new technologies. Many of these changes are driven
by medical device companies including:
o CYBERONICS, INC. (Nasdaq: CYBX). Cyberonics has developed an
implantable Vagus Nerve Stimulation device approved for
treatment-resistant depression. This device has received
pre-marketing approval from the Food and Drug Agency for
patients and is believed to be under reimbursement review by
insurance payers.
o MEDTRONIC, INC. (NYSE: MDT). Medtronic has an implantable deep
brain stimulation device (DBS) in development which is similar
to their device approved for Parkinson's treatment.
o NEURONETICS (www.neuronetics.com). Neuronetics has developed a
trans-cranial magnetic stimulation (rTMS) device which is
designed to be applied externally in a series of treatments
over several weeks. The company is expected to file FDA
registration soon.
We view these developing treatment options as expensive augmentations
to existing therapies for treatment-resistant patients. From this perspective,
these devices can be considered as competitive therapeutic treatment options to
medications. To the best of our knowledge, rEEG-guided therapy provides a higher
probability of treatment success at a significantly lower cost than device-based
solutions, which gives us a competitive advantage in the marketplace.
23
GOVERNMENT REGULATION
Currently, we do not believe that sales of our Laboratory Information
Services, including our rEEG Reports, are subject to regulatory approval.
However, federal and state laws and regulations relating to the sale of our
Laboratory Information Services are subject to future changes, as are
administrative interpretations of regulatory agencies. In the event that federal
and state laws and regulations change, we may need to incur additional costs to
seek government approvals for the sale of our Laboratory Information Services.
In the future, we intend to seek approval for medications or
combinations of medications for new indications, either with corporate partners,
or potentially, on our own. The development and commercialization of medications
for new indications is subject to extensive regulation by the U.S. Federal
government, principally through the FDA and other federal, state and
governmental authorities elsewhere. Prior to marketing any central nervous
system medication, and in many cases prior to being able to successfully partner
a central nervous system medication, we will have to conduct extensive clinical
trials at our own expense to determine safety and efficacy of the indication
that we are pursuing.
ITEM 2. DESCRIPTION OF PROPERTY
We currently lease our office space under a lease agreement which
expires in November of 2008. The facility is approximately 1900 sq. ft, and is
located in Costa Mesa, California. It is from this facility that we conduct all
of our executive and administrative functions. We believe our space is adequate
for our current needs and that suitable additional or substitute space will be
available to accommodate the foreseeable expansion of our operations.
ITEM 3. LEGAL PROCEEDINGS
From time to time, we may be involved in litigation relating to claims
arising out of our operations in the normal course of business. We are not
currently party to any legal proceedings, the adverse outcome of which, in our
management's opinion, individually or in the aggregate, would have a material
adverse effect on our results of operations or financial position.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of our stockholders in the quarter
ended September 30, 2007.
24
PART II
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS AND SMALL
BUSINESS ISSUER PURCHASES OF EQUITY SECURITIES
COMMON STOCK
Our common stock is currently listed for trading on the OTC Bulletin
Board under the symbol CNSO.OB. The following table sets forth, for the periods
indicated, the high and low bid information for Common Stock as determined from
sporadic quotations on the OTC Bulletin Board. The following quotations reflect
inter-dealer prices, without retail mark-up, mark-down or commission and may not
represent actual transactions.
HIGH* LOW*
----- ----
YEAR ENDED SEPTEMBER 30, 2006
First Quarter.......................... $4.50 $1.80
Second Quarter......................... $4.00 $3.00
Third Quarter.......................... $4.00 $3.00
Fourth Quarter......................... $8.50 $3.50
YEAR ENDED SEPTEMBER 30, 2007
First Quarter.......................... $8.50 $0.55
Second Quarter......................... $4.50 $0.55
Third Quarter.......................... $2.50 $1.05
Fourth Quarter......................... $1.40 $0.70
* Adjusted price reflecting the 1:50 reverse stock split that became
effective January 10, 2007
On December 5, 2007, the closing sales price of our common stock as
reported on the OTC Bulletin Board was $0.80 per share. As of December 5, 2007,
there were 369 record holders of our common stock. The number of holders of
record is based on the actual number of holders registered on the books of our
transfer agent and does not reflect holders of shares in "street name" or
persons, partnerships, associations, corporations or other entities identified
in security position listings maintained by depository trust companies.
DIVIDEND RIGHTS
We have not paid or declared cash distributions or dividends on our
common stock. CNSR has never paid dividends on its common stock. We do not
intend to pay cash dividends on our common stock in the foreseeable future. We
currently intend to retain all earnings, if and when generated, to finance our
operations. The declaration of cash dividends in the future will be determined
by the board of directors based upon our earnings, financial condition, capital
requirements and other relevant factors.
25
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH THE
CONSOLIDATED FINANCIAL STATEMENTS AND ACCOMPANYING NOTES PROVIDED UNDER PART II,
ITEM 7 OF THIS ANNUAL REPORT ON FORM 10-KSB. THIS DISCUSSION SUMMARIZES THE
SIGNIFICANT FACTORS AFFECTING THE CONDENSED CONSOLIDATED OPERATING RESULTS,
FINANCIAL CONDITION AND LIQUIDITY AND CASH FLOWS OF CNS RESPONSE, INC. FOR THE
FISCAL YEARS ENDED SEPTEMBER 30, 2007 AND 2006. EXCEPT FOR HISTORICAL
INFORMATION, THE MATTERS DISCUSSED IN THIS MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ARE "FORWARD-LOOKING
STATEMENTS" WITHIN THE MEANING OF THE PRIVATE SECURITIES LITIGATION REFORM ACT
OF 1995. THESE STATEMENTS ARE SUBJECT TO RISKS AND UNCERTAINTIES AND ARE BASED
ON THE BELIEFS AND ASSUMPTIONS OF OUR MANAGEMENT AS OF THE DATE HEREOF BASED ON
INFORMATION CURRENTLY AVAILABLE TO OUR MANAGEMENT. USE OF WORDS SUCH AS
"BELIEVES," "EXPECTS," "ANTICIPATES," "INTENDS," "PLANS," "ESTIMATES," "SHOULD,"
"FORECASTS," "GOAL," "LIKELY" OR SIMILAR EXPRESSIONS, INDICATE A FORWARD-LOOKING
STATEMENT. FORWARD-LOOKING STATEMENTS ARE NOT GUARANTEES OF FUTURE PERFORMANCE
AND INVOLVE RISKS, UNCERTAINTIES AND ASSUMPTIONS. ACTUAL RESULTS MAY DIFFER
MATERIALLY FROM THE FORWARD-LOOKING STATEMENTS WE MAKE. SEE "RISK FACTORS"
ELSEWHERE IN THIS ANNUAL REPORT ON FORM 10-KSB FOR A DISCUSSION OF CERTAIN RISKS
ASSOCIATED WITH OUR BUSINESS. WE DISCLAIM ANY OBLIGATION TO UPDATE
FORWARD-LOOKING STATEMENTS FOR ANY REASON.
OVERVIEW
We are a life sciences company focused on the commercialization of a
patented system that guides psychiatrists and other physicians to determine a
proper treatment for patients with behavioral (psychiatric and/or addictive)
disorders.
We have developed an extensive proprietary database (the "CNS
Database") consisting of approximately 13,000 clinical outcomes across 2,000
patients who had psychiatric or addictive problems. For each patient, we have
compiled electrocephalographic ("EEG") scans, symptoms, course of treatment and
outcomes often across multiple treatments from multiple psychiatrists and
physicians. Using this database, our technology compares a patient's EEG scan to
the outcomes in the database and ranks treatment options based on treatment
success of patients having similar neurophysiology.
Trademarked as Referenced-EEGSM ("rEEGSM"), this patented technology
allows CNSR to create and provide simple reports ("rEEG Reports") that
specifically guide physicians to treatment strategies based on the patient's own
physiology. The vast majority of these patients were considered long-term
"treatment-resistant", the most challenging, high-risk and expensive category to
treat.
rEEG identifies relevant neurophysiology that is variant from the norm
and identifies medications that have successfully treated database patients
having similar aberrant physiology. It does this by comparing a patient's
standard digital EEG to a normative database. This identifies the presence of
abnormalities. The rEEG process then identifies a set of patients having similar
abnormalities as recorded in our CNS Database and reports on historical relative
medication success for this stratified group. Upon completion, the physician is
provided the analysis in a report detailing and ranking classes of agents (and
specific agents within the class) by treatment success for patients having
similar abnormal electrophysiology.
We believe the key factors that will drive broader adoption of rEEG
will be acceptance by healthcare providers of its clinical benefits,
demonstration of the cost-effectiveness of using our test, reimbursement by
third-party payors, expansion of our sales force and increased marketing
efforts.
26
Since our inception, we have generated significant net losses. As of
September 30, 2007, we had an accumulated deficit of $11.3 million. We incurred
operating losses of $3.3 million and $1.8 million for the fiscal years ended
September 30, 2007 and 2006, respectively. We expect our net losses to continue
for at least the next several years. We anticipate that a substantial portion of
our capital resources and efforts will be focused on research and development,
scale up of our commercial organization, and other general corporate purposes.
Research and development projects include the completion of clinical trials
which are essential to validate the efficacy of our products and services across
different type of behavioral disorders, the enhancement of the CNS Database and
the identification of new medication that are often combinations of approved
drugs.
RECENT EVENTS
Prior to January 16, 2007, CNS Response, Inc. (then called
Strativation, Inc.) existed as a "shell company" with nominal assets whose sole
business was to identify, evaluate and investigate various companies to acquire
or with which to merge. On January 16, 2007, we entered into an Agreement and
Plan of Merger (the "Merger Agreement") with CNS Response, Inc., a California
corporation ("CNS California"), and CNS Merger Corporation, a California
corporation and our wholly-owned subsidiary ("MergerCo") pursuant to which we
agreed to acquire CNS California in a merger transaction wherein MergerCo would
merge with and into CNS California, with CNS California being the surviving
corporation (the "Merger"). On March 7, 2007, the Merger closed, CNS California
became our wholly-owned subsidiary, and on the same date we changed our
corporate name from Strativation, Inc. to CNS Response, Inc.
PRINCIPAL TERMS OF THE MERGER
At the Effective Time of the Merger (as defined in the Merger
Agreement, as amended on February 23, 2007), MergerCo was merged with and into
CNS California, the separate existence of MergerCo ceased, and CNS California
continued as the surviving corporation at the subsidiary level. We issued an
aggregate of 17,827,958 shares of our common stock to the stockholders of CNS
California in exchange for 100% ownership of CNS California. Additionally, we
assumed an aggregate of 8,407,517 options to purchase shares of common stock and
warrants to purchase shares of common stock on the same terms and conditions as
previously issued by CNS California.
Immediately prior to the closing of the Merger, we had outstanding
868,990 shares of common stock. Immediately after the closing of the Merger, and
without taking into consideration the Private Placement offering described
below, we had 18,696,948 outstanding shares of common stock, and options and
warrants to purchase 8,407,517 shares of common stock.
PRIVATE PLACEMENT TRANSACTION
On March 7, 2007, simultaneous with the closing of the Merger, we
received gross proceeds of approximately $7,008,450 in a private placement
transaction (the "Private Placement") with institutional investors and other
high net worth individuals ("Investors"). On May 16, 2007, the Company received
additional gross proceeds of $797,300 from the second closing of the Private
Placement. Pursuant to Subscription Agreements entered into with these
Investors, we sold 6,504,758 Investment Units, at $1.20 per Investment Unit.
Each "Investment Unit" consists of one share of our common stock, and a five
year non-callable warrant to purchase three-tenths of one share of our common
Stock, at an exercise price of $1.80 per share (the "Investor Warrants"). After
commissions and expenses, we received net proceeds of approximately $6,748,400
in the Private Placement.
27
Brean Murray Carret & Co. ("Brean Murray") acted as placement agent and
corporate finance advisor in connection with the Private Placement. For their
services as placement agent and financial advisor, pursuant to the terms of an
Engagement Agreement between CNSR and Brean Murray, Brean Murray received a
retainer in the form of 83,333 shares of our common stock (having a deemed value
of $100,000) upon the closing of the Private Placement. We also paid Brean
Murray a fee equal to 8% of the funds raised in the Private Placement, or
approximately $624,500 of the gross proceeds from the financing. In addition,
Brean Murray received warrants (the "Placement Agent Warrants") to purchase
shares of our common stock in amounts equal to (i) 8% of the shares of common
stock sold by Brean Murray in the Private Placement (520,380 warrants at an
exercise price of $1.44 per share), and (ii) 8% of the shares underlying the
Investor Warrants sold by Brean Murray in the Private Placement (156,114
warrants at an exercise price of $1.80 per share). The Placement Agent Warrants
are fully vested and have a term of 5 years. We also paid $88,000 in costs, fees
and expenses incurred by Brean Murray in connection with the Private Placement.
We expressly assumed CNS California's agreement with Brean Murray upon the
closing of the Merger. Pursuant to this agreement, Brean Murray has a right of
first refusal to represent us in certain corporate finance transactions for a
period of one year following the closing of the Private Placement.
REGISTRATION RIGHTS AGREEMENTS
Under the terms of the Subscription Agreements between us and the
Investors in the Private Placement, we were obligated to file a Registration
Statement on Form SB-2 with the Securities and Exchange Commission (the "SEC")
within 45 days following the closing (the "Registration Statement") to permit
the resale of the shares of common stock sold in the Private Placement and
purchasable under the warrants sold in the Private Placement. The Company's
Registration Statement on Form SB-2 was filed on May 22, 2007 with the
Securities and Exchange Commission.
The Subscription Agreements also require us to use our reasonable best
efforts to obtain the effectiveness of the Registration Statement not later than
150 days after the closing of the Private Placement, subject to certain
exceptions. After obtaining the effectiveness of the Registration Statement, we
are further obligated to use our reasonable best efforts to maintain the
effectiveness of the Registration Statement until all such shares registered
thereby may be sold without restriction pursuant to Rule 144(k) promulgated
under the Securities Act of 1933, except that investors may not be able to sell
their shares under the Registration Statement during periods when we may be
required to update the information contained in that Registration Statement
under applicable securities laws. If we fail to satisfy our obligations for
obtaining effectiveness of the Registration Statement within 150 days after the
closing of the Private Placement we must pay liquidated cash damages to the
investors in the offering in an aggregate amount equal to 1% of the Investment
Unit purchase price for each share registered, per month that elapses after such
failure until the earlier of (a) the date the Registration Statement is filed or
becomes effective, as applicable, or (b) the date that is one year from the
closing of the Private Placement. The Company's Registration Statement on Form
SB-2 became effective on June 22, 2007.
Under the terms of a Registration Rights Agreement entered into between
us and the majority stockholders of our common stock immediately prior to the
Merger, we were also obligated to include up to 767,103 shares of our common
stock on the Registration Statement described above. The registration rights
attaching to the shares held by these stockholders are not transferable with
such shares. Our former majority stockholders have identical registration rights
to those provided to the investors, except they do not have the right to
liquidated damages as provided in the Subscription Agreements. A total of
484,250 shares of our Common Stock held by one of our former majority
shareholder were registered for resale on our registration statement on Form
SB-2.
28
In addition to the registration rights described above, the holders of
the shares (i) sold in the Private Placement, (ii) issuable upon exercise of the
Investor Warrants, (iii) held by the our majority stockholders prior to the
Merger, (iv) issuable upon exercise of the Placement Agent Warrants or otherwise
under the Engagement Agreement with the Placement Agent, and (v) issued upon
conversion of CNSR Series A Preferred Stock, CNSR Series B Preferred Stock and
certain shares of CNSR Common Stock under the terms of the Merger Agreement,
each have piggy-back registration rights with respect to such shares effective
September 7, 2007, and demand registration rights with respect to such shares
effective March 7, 2008.
After the completion of the Private Placement and the Merger, we had an
aggregate of 25,303,462 shares of common stock outstanding, with the former CNS
California shareholders and the investors in the Private Placement owning in the
aggregate 24,351,139 shares of our common stock, which represented approximately
96.2% of our issued and then outstanding shares of common stock. Our
stockholders immediately prior to the Merger and Private Placement owned
approximately 3.4% of our outstanding common stock (or, 868,990 shares of our
common stock) immediately after completion of these transactions.
FINANCIAL OPERATIONS OVERVIEW
REVENUES
We derive our revenues from the sale of rEEG Reports to physicians and
operate in one industry segment. Physicians are generally billed upon delivery
of an rEEG Report. The list prices of our rEEG Reports to physicians range from
$200 to $800 with $400 being the most frequent charge.
COST OF REVENUES
Cost of revenues represents the cost of direct labor, the amortization
of the purchased database and costs associated with external processing,
analysis and consulting review necessary to render an individualized test
result. Costs associated with performing our tests are expensed as the tests are
performed. We are currently evaluating the feasibility of hiring our own
personnel to perform most of the processing and analysis necessary to render a
report.
RESEARCH AND DEVELOPMENT
Research and development expenses primarily represent costs incurred to
design and conduct clinical studies, improve rEEG processing, add data to our
database, improve analytical techniques and advance application of the
methodology to additional clinical diagnosis. We charge all research and
development expenses to operations as they are incurred.
SALES AND MARKETING
Our selling and marketing expenses consist primarily of personnel costs
and the costs of educating physicians, laboratory personnel and other healthcare
professionals regarding our product.
GENERAL AND ADMINISTRATIVE
Our general and administrative expenses consist primarily of personnel
related costs, legal costs, accounting costs and other professional and
administrative costs.
29
CRITICAL ACCOUNTING POLICIES AND SIGNIFICANT JUDGMENTS AND ESTIMATES
This discussion and analysis of our financial condition and results of
operations is based on our financial statements, which have been prepared in
accordance with U.S. generally accepted accounting principles. The preparation
of these consolidated financial statements requires management to make estimates
and judgments that affect the reported amounts of assets, liabilities and
expenses and the disclosure of contingent assets and liabilities at the date of
the financial statements, as well as revenues and expenses during the reporting
periods. We evaluate our estimates and judgments on an ongoing basis. We base
our estimates on historical experience and on various other factors we believe
are reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying value of assets and liabilities that are not
readily apparent from other sources. Actual results could therefore differ
materially from those estimates under different assumptions or conditions.
Our significant accounting policies are described in Note 3 to our
consolidated financial statements included elsewhere in this report. We believe
the following critical accounting policies reflect our more significant
estimates and assumptions used in the preparation of our consolidated financial
statements.
REVENUE RECOGNITION
We have generated limited revenues since our inception. Revenues for
our product are recognized when an rEEG Report is delivered to a
Client-Physician.
STOCK-BASED COMPENSATION EXPENSE
Stock-based compensation expense, which is a non-cash charge, results
from stock option grants. Compensation cost is measured at the grant date based
on the calculated fair value of the award. We recognize stock-based compensation
expense on a straight-line basis over the vesting period of the underlying
option. The amount of stock-based compensation expense expected to be amortized
in future periods may decrease if unvested options are subsequently cancelled or
may increase if future option grants are made.
30
RESULTS OF OPERATIONS FOR THE YEARS ENDED SEPTEMBER 30, 2007 AND 2006
The following table presents consolidated statement of operations data
for each of the periods indicated as a percentage of revenues.
YEAR YEAR MONTHS
ENDED ENDED
SEPTEMBER 30, SEPTEMBER 30,
2007 2006
------------- -------------
Revenues .................................... 100% 100%
Cost of revenues ............................ 70 113
------------- -------------
Gross profit ................................ 30 (13)
Research and development .................... 605 296
Sales and marketing ......................... 52 62
General and administrative expenses ......... 745 643
------------- -------------
Operating loss .............................. (1,372) (1,014)
Other income (expense), net ................. (4) 1,061
------------- -------------
Net income (loss) ........................... (1,376)% 47%
============= =============
REVENUES
YEAR ENDED YEAR ENDED
SEPTEMBER 30, SEPTEMBER 30, PERCENT
2007 2006 CHANGE
------------- ------------- -------------
Revenues ...................... $ 238,400 $ 175,500 36%
The number of rEEG Reports delivered for the fiscal year increased from
440 in 2006 to 630 in 2007 while the price per report decreased from
approximately $400 in 2006 to $378 in 2007. The increase in the number of
reports is attributable to the purchase of rEEG Reports by 22 doctors in fiscal
2007 as compared to 13 doctors in fiscal 2006. The decrease in the average price
of the reports is attributable to a change in the types of reports (Type 1 vs
Type 2) purchased by physicians. We recently hired a new president whose main
focus is the commercialization of our product, and accordingly, we expect to
begin to scale up our sales and marketing efforts in fiscal 2008. However, we do
not expect to drive broader adoption of reports based on our rEEG technology
until the completion in late 2008 of our multi-site clinical study to validate
the efficacy of our product. Accordingly, we anticipate that revenues will not
increase materially until fiscal 2009.
31
COST OF REVENUES
YEAR ENDED YEAR ENDED
SEPTEMBER 30, SEPTEMBER 30, PERCENT
2007 2006 CHANGE
------------- ------------- -------------
Cost of revenues .............. $ 166,200 $ 197,900 (16%)
Cost of revenues consists of payroll costs, consulting costs, charges
relating to the amortization of the CNS Database and other miscellaneous
charges. For the year ended September 30, 2007, cost of revenues was $166,200
consisting primarily of direct labor costs of $64,600, consulting fees of
$52,800, amortization of the purchased database of $19,900 and stock-based
compensation of $20,100. For the year ended September 30, 2006, cost of revenues
was $197,900 consisting primarily of direct labor costs of $50,200, consulting
fees of $41,500, amortization of the purchased database of $79,800 and
stock-based compensation of $22,000. We expect costs of revenues will increase
as an absolute number as the volume of rEEGs processed increases; however, cost
of revenues will decrease as a percentage of revenues due to operating
efficiencies and as a result of the cost of the purchased database being fully
amortized in the first quarter of our fiscal year ended September 30, 2007.
RESEARCH AND DEVELOPMENT
YEAR ENDED YEAR ENDED
SEPTEMBER 30, SEPTEMBER 30, PERCENT
2007 2006 CHANGE
------------- ------------- -------------
Research and development ...... $ 1,442,600 $ 519,800 178%
Research and development expenses consist of clinical studies, costs to
identify indications of approved drugs and drug candidates, projects for
training doctors in the use of rEEG, patents costs, consulting fees, payroll
costs (including stock-based compensation), expenses related to database
enhancements, and other miscellaneous costs. Research and development costs
increased for fiscal year ended September 30, 2007 from the fiscal year ended
September 30, 2006 primarily as a result of increases in (i) expenses associated
with clinical studies, (ii) costs incurred to identify indications of approved
drugs and drug candidates, (iii) expenses in relation to projects for training
doctors in the use of rEEG technology, (iv) patent costs and (v) costs relating
to the acquisition of new data for our database. The increase in expenses
relating to clinical studies is attributable to our expansion of a clinical
study with the goal of driving market acceptance of our rEEG technology.
Training costs increased as we undertook projects to train doctors in the use of
rEEG reports. The increase in patent costs is attributable primarily to legal
costs incurred for the expansion and protection of our intellectual property.
The increase in database costs relates to the acquisition of data for
anti-psychotic drugs. We expect research and development expenses to continue to
increase as we, among other things, complete the multi-site study to validate
the efficacy of our product, acquire new data for our database, enhance our
system and hire additional employees.
32
SALES AND MARKETING
YEAR ENDED YEAR ENDED
SEPTEMBER 30, SEPTEMBER 30, PERCENT
2007 2006 CHANGE
------------- ------------- -------------
Sales and marketing ........... $ 123,600 $ 109,600 13%
Sales and marketing expenses were $123,600 for fiscal 2007 as compared
to $109,600 for fiscal 2006. Sales and marketing expenses for fiscal 2007
consisted of primarily of payroll costs of $75,400, production of marketing
materials of $21,000 and consulting expenses of $18,100. Sales and marketing
expenses for fiscal 2006 consisted primarily of payroll costs. The increase in
sales and marketing expenses is attributable to production of collateral
marketing material and the hiring of consultants to commence to expand our sales
and marketing efforts. We expect sales and marketing costs to increase
significantly in fiscal 2008 as we start to expand our sales force.
GENERAL AND ADMINISTRATIVE
YEAR ENDED YEAR ENDED
SEPTEMBER 30, SEPTEMBER 30, PERCENT
2007 2006 CHANGE
------------- ------------- -------------
General and administrative .... $ 1,775,600 $ 1,132,400 57%
General and administrative expenses for the fiscal year ended September
30, 2007 primarily related to salaries (including stock-based compensation),
costs associated with being a public company and professional fees. General and
administrative expenses for the fiscal year ended September 30, 2006 primarily
related to salaries (including stock-based compensation), professional fees and
costs incurred in connection with unsuccessful capital raising activities. The
increase in general and administrative expenses for the fiscal year ended
September 30, 2007 is primarily related to (i) a $475,000 advisory fee paid to
Richardson & Patel, LLP in connection with our merger transaction that will not
recur, (ii) increased costs associated with being a public company offset by
(iv) decreased legal costs and travel and entertainment incurred in connection
with unsuccessful capital raising activities and (v) decreased consulting fees
as we outsourced fewer tasks in the period. We expect general and administrative
costs to continue to increase as we expand our staff and incur costs associated
with being a public reporting company.
33
INTEREST EXPENSE
YEAR ENDED YEAR ENDED
SEPTEMBER 30, SEPTEMBER 30, PERCENT
2007 2006 CHANGE
------------- ------------- -------------
Interest Expense, net ........ $ 115,600 $ 390,600 (70%)
For the fiscal year ended September 30, 2007, net interest expense was
$115,600 and consisted of $189,800 relating to interest expense from the
ascribed value of a warrant issued to NuPharm Database, LLC, interest expense
from promissory notes and other interest bearing accounts of $16,500 offset by
interest income of $90,700. For the fiscal year ended September 30, 2006
interest expense was $390,600 and consisted of interest expense form promissory
notes and other interest bearing accounts of $391,100 offset by interest income
of $500. Interest expense relating to the warrant will not recur as the entire
balance of unamortized prepaid interest was expensed in connection with our
merger. We expect interest expense relating to convertible debt and other
interest bearing accounts to continue to decrease as substantially all
convertible debt and other interest bearing accounts have either been repaid or
converted into the Company's stock. We expect interest income to increase due to
funds available from the private placement.
GAIN ON DERIVATIVE INSTRUMENTS
YEAR ENDED YEAR ENDED
SEPTEMBER 30, SEPTEMBER 30, PERCENT
2007 2006 CHANGE
------------- ------------- -------------
Gain on derivative instruments . $ 0 $ 1,178,500 *
* Not meaningful
Gain on derivative instruments was $1,178,500 for the fiscal year ended
September 30, 2006 as compared to zero for the fiscal year ended September 30,
2007. In accordance with generally accepted accounting principles, we treated
the beneficial conversion feature associated with the convertible promissory
notes and all non-employee warrants exercisable during the period the notes were
potentially convertible into an unlimited number of common shares as liabilities
at their fair value. The fair value of the beneficial conversion feature and the
warrants were estimated using the Black-Scholes option pricing model. The fair
value of the beneficial conversion feature and the warrants and options was
recomputed each reporting period with the change in fair value recorded as a
gain or loss on derivative instruments. As of September 30, 2006, we
reclassified the derivative instrument liability into equity as the number of
authorized shares was sufficient to accommodate the conversion of all notes,
related accrued interest and outstanding warrants. Thus no gain or loss on
derivative instruments were generated or incurred in fiscal year ended September
30, 2007.
34
GAIN ON TROUBLED DEBT RESTRUCTURING
YEAR ENDED YEAR ENDED
SEPTEMBER 30, SEPTEMBER 30, PERCENT
2007 2006 CHANGE
------------- ------------- -------------
Gain on troubled-debt
restructuring ................ $ 0 $ 1,079,700 *
* Not meaningful
Gain on troubled debt restructuring was $1,079,700 for the year ended
September 30, 2006 as compared to zero in for the fiscal year ended September
30, 2007. At September 30, 2005, we owed certain employees and consultants
deferred compensation, accrued consulting fees, other compensation-related
liabilities and accrued interest thereon aggregating $2,480,900. Due to
financial difficulties experienced by the company, in August and September 2006,
certain employees and consultants to whom the company owed an aggregate of
$3,199,400 accepted 5,834,117 shares of CNSR's common stock (of which 182,952
were restricted), and warrants and options to purchase an aggregate of 270,638
shares of CNSR's common stock at $0.59 per share in full settlement of our
obligations. On the date of transfer, the amounts due to employees and
consultants exceeded the aggregate fair value of the shares, warrants and
options transferred by $2,467,700. The gain attributable to employees considered
related parties of $1,388,000 has been treated as a capital transaction and
included in additional paid-in capital in the accompanying financial statements.
The remaining gain of $1,079,700 has been included in operations in the
accompanying financial statements.
OTHER INCOME
YEAR ENDED YEAR ENDED
SEPTEMBER 30, SEPTEMBER 30, PERCENT
2007 2006 CHANGE
------------- ------------- -------------
Other Income ................... $ 106,900 $ 0 *
* Not meaningful
Other income for the fiscal year ended September 30, 2007 was $196,900
and consisted of gains from settlement of payables. Other income for the fiscal
year ended September 30, 2006 was zero. The increase in other income is
attributable to the settlement of accounts payable at a discount to the recorded
amounts.
LIQUIDITY AND CAPITAL RESOURCES
Since our inception, we have incurred significant losses and, as of
September 30, 2007, we had an accumulated deficit of approximately $11.3
million. We have not yet achieved profitability and anticipate that we will
continue to incur net losses for the foreseeable future. We expect that our
research and development, selling and marketing and general and administrative
expenses will continue to grow and, as a result, we will need to generate
significant product revenues to achieve profitability. We may never achieve
profitability.
35
SOURCES OF LIQUIDITY
Since our inception substantially all of our operations have been
financed primarily from equity and debt financings. Through September 30, 2007,
we had received proceeds of $8.6 million from the sale of stock, $3,116,000 from
the issuance of convertible promissory notes and $220,400 for the issuance of
common stock to employees in connection with expenses paid by such employees on
behalf of the company. As of September 30, 2007, we had cash of $5.8 million and
debt of $659,300.
CASH FLOWS
As of September 30, 2007 we had $5.8 million in cash compared to
$204,900 at September 30, 2006. The increase of $5.6 million was due to cash
received in connection with the sale of common stock of $8.5 million offset by
used cash in operating activities of $3 million.
Net cash used in operating activities was $3 million for the fiscal
year ended September 30, 2007 compared to $597,600 for fiscal year ended
September 30, 2006. The increased in cash used of $2.4 million was primarily
attributable to an increase in research and development expenses, the payment of
the advisory fee of $475,000 to Richardson & Patel, LLP and the repayment of
certain operating liabilities due to availability of cash.
Net cash used in investing activities was $7,200 for the fiscal year
ended September 30, 2007 compared to $175,900 for the fiscal year ended
September 30, 2006. Our investing activities for 2007 consisted of loans made to
employees and deposits. We expect amounts used in investing activities to
increase for the purchase of property and equipment.
Net cash provided by financing activities was $8.6 million for the year
ended September 30, 2007 compared to $500,000 for the fiscal year ended
September 30, 2006. Financing activities in fiscal 2007 consisted of the sale of
stock. Financing activities in fiscal 2006 consisted of the issuance of
convertible promissory notes.
CONTRACTUAL OBLIGATIONS
As of September 30, 2007, we had no significant contractual
obligations.
OPERATING CAPITAL AND CAPITAL EXPENDITURE REQUIREMENTS
We expect to continue to incur substantial operating losses in the
future and to make capital expenditures to keep pace with the expansion of our
research and development programs and to scale up our commercial operations. We
expect that our existing cash will be used to fund working capital and for
capital expenditures and other general corporate purposes. The amount and timing
of actual expenditures may vary significantly depending upon a number of
factors, such as the progress of our product development, regulatory
requirements, commercialization efforts and the amount of cash used by
operations.
We currently anticipate that our cash and collections from sale of our
services, together with the proceeds of completed financings, will be sufficient
to fund our operations for at least the next 12 months.
36
Our future funding requirements will depend on many factors, including
the following:
a. the cost of expanding our commercial operations, including our
selling and marketing efforts;
b. the rate of progress and cost of research and development
activities associated with our products;
c. the rate of progress and cost of research and development
activities associated with the identification, development and
commercialization of new indications of approved medications
and medication candidates;
d. the cost of filing, prosecuting, defending and enforcing any
patent claims and other intellectual property rights; and
e. the effect of technological and market developments.
Until we can generate a sufficient amount of revenues to finance our
cash requirements, which we may never do, we expect to finance future cash needs
primarily through public or private equity offerings, debt financings,
borrowings or strategic collaborations. The issuance of equity securities may
result in dilution to stockholders. We do not know whether additional funding
will be available on acceptable terms, or at all. If we are not able to secure
additional funding when needed, we may have to delay, reduce the scope of or
eliminate one or more research and development programs or selling and marketing
initiatives. In addition, we may have to work with a partner on one or more of
our technology development programs or market development programs, which may
lower the economic value of those programs to our company.
INCOME TAXES
Since inception, we have incurred operating losses and, accordingly,
have not recorded a provision for federal income taxes for any periods
presented. As of September 30, 2007, we had net operating loss carryforwards for
federal income tax purposes of $8.1 million. If not utilized, the federal net
operating loss carryforwards will expire beginning in 2021. Utilization of net
operating loss and credit carryforwards may be subject to a substantial annual
limitation due to restrictions contained in the Internal Revenue Code that are
applicable if we experience an "ownership change" that may occur, for example,
as a result of the Private Placement being aggregated with certain other sales
of our stock before or after this offering. The annual limitation may result in
the expiration of our net operating loss and tax credit carryforwards before
they can be used.
OFF-BALANCE SHEET ARRANGEMENTS
We have no off-balance sheet arrangements or financing activities with
special purpose entities.
37
RISK FACTORS
INVESTING IN OUR COMMON STOCK INVOLVES A HIGH DEGREE OF RISK. YOU
SHOULD CAREFULLY CONSIDER THE FOLLOWING RISK FACTORS AND ALL OTHER INFORMATION
CONTAINED IN THIS REPORT BEFORE PURCHASING OUR COMMON STOCK. THE RISKS AND
UNCERTAINTIES DESCRIBED BELOW ARE NOT THE ONLY ONES FACING US. ADDITIONAL RISKS
AND UNCERTAINTIES THAT WE ARE UNAWARE OF, OR THAT WE CURRENTLY DEEM IMMATERIAL,
ALSO MAY BECOME IMPORTANT FACTORS THAT AFFECT US. IF ANY OF THE FOLLOWING RISKS
OCCUR, OUR BUSINESS, FINANCIAL CONDITION OR RESULTS OF OPERATIONS COULD BE
MATERIALLY AND ADVERSELY AFFECTED. IN THAT CASE, THE TRADING PRICE OF OUR COMMON
STOCK COULD DECLINE, AND YOU MAY LOSE SOME OR ALL OF THE MONEY YOU PAID TO
PURCHASE OUR COMMON STOCK.
RISKS RELATED TO OUR COMPANY
OUR OPERATING RESULTS MAY FLUCTUATE SIGNIFICANTLY BASED ON CUSTOMER ACCEPTANCE
OF OUR PRODUCTS.
Management expects that we will experience substantial variations in
our net sales and operating results from quarter to quarter due to customer
acceptance of our products. We rely on sales by our affiliates to generate
significant revenues for us. If customers don't accept our products, our sales
and revenues would decline, resulting in a reduction in our operating income.
WE HAVE A LIMITED OPERATING HISTORY, MAKING IT DIFFICULT TO EVALUATE OUR FUTURE
PERFORMANCE.
We were incorporated in 2000 and therefore have a limited operating
history. Investors have limited substantive financial information on prior
operations to evaluate the company as an investment. Our potential must be
viewed in light of the problems, expenses, difficulties, delays and
complications often encountered in the operation of a new business. We will be
subject to the risks inherent in the ownership and operation of a company with a
limited operating history such as fluctuations in expenses, competition, the
general strength of regional and national economies, and governmental
regulation. Any failure to successfully address these risks and uncertainties
would seriously harm our business and prospects.
WE CURRENTLY DEPEND ON SALES OF OUR REEG REPORTS FOR SUBSTANTIALLY ALL OF OUR
REVENUE, AND IF OUR REPORTS DO NOT GAIN WIDESPREAD MARKET ACCEPTANCE, THEN OUR
REVENUES MAY NOT EXCEED OUR EXPENSES.
We have developed a methodology that aids psychiatrists and other
physicians in selecting appropriate and effective medications for patients with
certain behavioral or addictive disorders based on physiological traits of the
patient's brain and information contained in a proprietary database that has
been developed over the last twenty years. We began selling reports, referred to
as rEEG Reports, based on our methodology in 2000. To date, we have not received
widespread market acceptance of the usefulness of our rEEG Reports in helping
psychiatrists and physicians inform their treatment strategies for patients
suffering from behavioral and/or addictive disorders. Because we currently
depend on the sale of rEEG Reports for substantially all or our revenue, and we
have no other significant products or services, if we fail to achieve widespread
market acceptance for our rEEG Reports, we will not be able to sustain or grow
our revenues.
38
OUR OPERATING RESULTS MAY FLUCTUATE SIGNIFICANTLY AND OUR STOCK PRICE COULD
DECLINE OR FLUCTUATE IF OUR RESULTS DO NOT MEET THE EXPECTATION OF ANALYSTS OR
INVESTORS.
Management expects that we will experience substantial variations in
our operating results from quarter to quarter. We believe that the factors which
influence this variability of quarterly results include:
o the use of and demand for rEEG Reports and other products
and/or services that we may offer in the future that are based
on our patented methodology;
o the effectiveness of new marketing and sales programs;
o turnover in our direct sales force;
o changes in management;
o the introduction of products or services that are viewed in
the marketplace as substitutes for the services we provide;
o communications published by industry organizations or other
professional entities in the psychiatric and physician
community that are unfavorable to our business;
o the introduction of regulations which impose additional costs
on or impede our business; and
o the timing and amount of our expenses, particularly expenses
associated with the marketing and promotion of our services,
the training of physicians and psychiatrists in the use of our
rEEG Reports, and research and development.
As a result of fluctuations in our revenue and operating expenses that
may occur, management believes that period-to-period comparisons of our results
of operations are not a good indication of our future performance. It is
possible that in some future quarter or quarters, our operating results will be
below the expectations of securities analysts or investors. In that case, our
common stock price could fluctuate significantly or decline.
IF THE ESTIMATES WE MAKE, AND THE ASSUMPTIONS ON WHICH WE RELY IN PREPARING OUR
FINANCIAL STATEMENTS PROVE INACCURATE, OUR ACTUAL RESULTS MAY VARY FROM THOSE
REFLECTED IN OUR FINANCIAL STATEMENTS.
Our financial statements have been prepared in accordance with
accounting principles generally accepted in the United States. The preparation
of these financial statements requires us to make estimates and judgments that
affect the reported amounts of our assets, liabilities, revenues and expenses,
the amounts of charges accrued by us and related disclosure of contingent assets
and liabilities. This includes estimates and judgments regarding revenue
recognition, allowances for doubtful accounts, valuation of derivatives,
warrants and other equity transactions. We base our estimates and judgments on
historical experience and on various other assumptions that we believe to be
reasonable under the circumstances at the time such estimates and judgments were
made. There can be no assurance, however, that our estimates and judgments, or
the assumptions underlying them, will be correct.
WE MAY NEED ADDITIONAL FUNDING TO SUPPORT OUR OPERATIONS AND CAPITAL
EXPENDITURES, WHICH MAY NOT BE AVAILABLE TO US AND WHICH LACK OF AVAILABILITY
COULD ADVERSELY AFFECT OUR BUSINESS.
We have not generated significant revenues or become profitable, may
never do so, and may not generate sufficient working capital to cover costs of
operations. We intend to fund our operations and capital expenditures from
revenues, our cash on hand and the net proceeds of our private placement that we
concluded in May of 2007. As a result of our private placement, we believe that
39
we will have sufficient funds to finance the cost of our operations, our
operating and management infrastructure, and planned expansion for the next 9
months. However, in the event we expand our operations more aggressively then we
currently anticipate, we may need to raise additional cash through private
equity offerings, debt financings, borrowings or strategic collaborations until
we can generate a sufficient amount of product revenues to finance our cash
requirements. In addition, we may need to raise additional funds to pursue
business opportunities (such as acquisitions of complementary businesses), to
react to unforeseen difficulties, such as the need to defend or enforce our
intellectual property rights, to respond to competitive pressures, or to obtain
regulatory approvals needed to market our services and/or products.
We currently have no committed sources of additional capital, and there
can be no assurance that any financing arrangements will be available in amounts
or on terms acceptable to us, if at all. Furthermore, the sale of additional
equity or convertible debt securities may result in additional dilution to
existing stockholders. If adequate additional funds are not available, we may be
required to delay, reduce the scope of or eliminate material parts of the
implementation of our business strategy. This limitation could substantially
harm our business, results of operations and financial condition.
OUR INDUSTRY IS HIGHLY COMPETITIVE, AND WE MAY NOT BE ABLE TO COMPETE
SUCCESSFULLY, WHICH COULD RESULT IN PRICE REDUCTIONS AND DECREASED DEMAND FOR
OUR PRODUCTS.
The healthcare business in general, and the behavioral health treatment
business in particular, are highly competitive. In the event that we are unable
to convince physicians, psychiatrists and patients of the efficacy of our
products and services, individuals seeking treatment for behavioral health
disorders may seek alternative treatment methods, which could negatively impact
our sales and profitability.
OUR rEEG REPORTS MAY NOT BE AS EFFECTIVE AS WE BELIEVE THEM TO BE, WHICH COULD
LIMIT OR PREVENT US FROM GROWING OUR REVENUES.
Our belief in the efficacy of our rEEG technology is based on a limited
number of studies. Such results may not be statistically significant, and may
not be indicative of the long-term future efficacy of the information we
provide. Controlled scientific studies, including those that have been announced
and that are planned for the future, may yield results that are unfavorable or
demonstrate that our services, including our rEEG Reports, are not clinically
useful. While we have not experienced such problems to date, if the initially
indicated results cannot be successfully replicated or maintained over time,
utilization of services based on our rEEG technology, including the delivery of
our rEEG Reports, could decline substantially and therefore harm our operating
results and stock price.
IF WE DO NOT MAINTAIN AND EXPAND OUR RELATIONSHIPS IN THE PSYCHIATRIC AND
PHYSICIAN COMMUNITY, OUR GROWTH WILL BE LIMITED AND OUR BUSINESS COULD BE
HARMED. IF PSYCHIATRISTS AND OTHER PHYSICIANS DO NOT RECOMMEND AND ENDORSE OUR
PRODUCTS AND SERVICES, OUR SALES MAY DECLINE OR WE MAY BE UNABLE TO INCREASE OUR
SALES, AND IN SUCH INSTANCES OUR PROFITABILITY WOULD BE HARMED.
Purchases by psychiatrists and physicians of our rEEG Reports currently
account for substantially all of our revenue. Consequently, our relationships
with psychiatrists and physicians are critical to our continued growth. We
believe that these relationships are based on the quality and ease of use of our
rEEG Reports, our commitment to the behavioral health market, our marketing
efforts, and our presence at tradeshows such as the American Psychiatric
Association annual meeting. Any actual or perceived diminution in our reputation
or the quality of our rEEG Reports, or our failure or inability to maintain our
commitment to the behavioral health market and our other marketing and product
promotion efforts could damage our current relationships, or prevent us from
forming new relationships, with psychiatrists and other physicians and cause our
growth to be limited and our business to be harmed.
40
To sell our rEEG Reports, psychiatric professionals must recommend and
endorse them. We may not obtain the necessary recommendations or endorsements
from this community. Acceptance of our rEEG Reports depends on educating
psychiatrists and physicians as to the benefits, clinical efficacy, ease of use,
revenue opportunity, and cost-effectiveness of our rEEG Reports and on training
the medical community to properly understand and utilize our rEEG Reports. If we
are not successful in obtaining the recommendations or endorsements of
psychiatrists and other physicians for our rEEG Reports, we may be unable to
increase our sales and profitability.
NEGATIVE PUBLICITY OR UNFAVORABLE MEDIA COVERAGE COULD DAMAGE OUR REPUTATION AND
HARM OUR OPERATIONS.
In the event that the marketplace perceives our rEEG Reports as not
offering the benefits which we believe they offer, we may receive significant
negative publicity. This publicity may result in litigation and increased
regulation and governmental review. If we were to receive such negative
publicity or unfavorable media attention, whether warranted or unwarranted, our
ability to market our rEEG Reports would be adversely affected, pharmaceutical
companies may be reluctant to pursue strategic initiatives with us relating to
the development of new products and services based on our rEEG technology, we
may be required to change our products and services and become subject to
increased regulatory burdens, and we may be required to pay large judgments or
fines. Any combination of these factors could further increase our cost of doing
business and adversely affect our financial position, results of operations and
cash flows.
IF WE DO NOT SUCCESSFULLY GENERATE ADDITIONAL PRODUCTS AND SERVICES FROM OUR
PATENTED METHODOLOGY AND PROPRIETARY DATABASE, OR IF SUCH PRODUCTS AND SERVICES
ARE DEVELOPED BUT NOT SUCCESSFULLY COMMERCIALIZED, THEN WE COULD LOSE REVENUE
OPPORTUNITIES.
Currently, our primary business is the sale of rEEG Reports to
psychiatrists and physicians based on our rEEG methodology and proprietary
database. In the future, we may utilize our patented methodology and proprietary
database to produce pharmaceutical advancements and developments. For instance,
we may use our patented methodology and proprietary database to identify new
medications that are promising in the treatment of behavioral health disorders,
identify new uses of medications which have been previously approved, and
identify new patient populations that are responsive to medications in clinical
trials that have previously failed to show efficacy in United States Food & Drug
Administration (FDA) approved clinical trials. The development of new
pharmaceutical applications that are based on our patented methodology and
proprietary database will be costly, since we will be subject to additional
regulations, including the need to conduct expensive and time consuming clinical
trials.
In addition, to successfully monetize our pharmaceutical opportunity,
we will need to enter into strategic alliances with biotechnology or
pharmaceutical companies that have the ability to bring to market a medication,
an ability which we currently do not have. We maintain no pharmaceutical
manufacturing, marketing or sales organization, nor do we plan to build one in
the foreseeable future. Therefore, we are reliant upon approaching and
successfully negotiating attractive terms with a partner who has these
capabilities. No guarantee can be made that we can do this on attractive terms.
If we are unable to find strategic partners for our pharmaceutical opportunity,
our revenues may not grow as quickly as we desire, which could lower our stock
price.
41
IN THE EVENT THAT WE PURSUE OUR PHARMACEUTICAL OPPORTUNITIES, WE OR ANY
DEVELOPMENT PARTNERS THAT WE PARTNER WITH WILL LIKELY NEED TO CONDUCT CLINICAL
TRIALS. IF SUCH CLINICAL TRIALS ARE DELAYED OR UNSUCCESSFUL, IT COULD HAVE AN
ADVERSE EFFECT ON OUR BUSINESS.
We have no experience conducting clinical trials of psychiatric
medications and in the event we conduct clinical trials, we will rely on outside
parties, including academic investigators, outside consultants and contract
research organizations to conduct these trials on our behalf. We will rely on
these parties to assist in the recruitment of sites for participation in
clinical trials, to maintain positive relations with these sites, and to ensure
that these sites conduct the trials in accordance with the protocol and our
instructions. If these parties renege on their obligations to us, our clinical
trials may be delayed or unsuccessful.
In the event we conduct clinical trials, we cannot predict whether we
will encounter problems that will cause us or regulatory authorities to delay or
suspend our clinical trials or delay the analysis of data from our completed or
ongoing clinical trials. In addition, we cannot assure you that we will be
successful in reaching the endpoints in these trials, or if we do, that the FDA
or other regulatory agencies will accept the results.
Any of the following could delay the completion of clinical trials, or
result in a failure of these trials to support our business, which would have an
adverse effect on our business:
o delays or the inability to obtain required approvals from
institutional review boards or other governing entities at
clinical sites selected for participation in our clinical
trials;
o delays in enrolling patients and volunteers into clinical
trials;
o lower than anticipated retention rates of patients and
volunteers in clinical trials;
o negative results from clinical trials for any of our potential
products; and
o failure of our clinical trials to demonstrate the efficacy or
clinical utility of our potential products.
If we determine that the costs associated with attaining regulatory
approval of a product exceed the potential financial benefits or if the
projected development timeline is inconsistent with our determination of when we
need to get the product to market, we may chose to stop a clinical trial and/or
development of a product.
IF WE DO NOT DEVELOP AND IMPLEMENT A SUCCESSFUL SALES AND MARKETING STRATEGY, WE
MAY NOT EXPAND OUR BUSINESS SUFFICIENTLY TO COVER OUR EXPENSES.
We currently rely on our direct sales force to market and promote our
rEEG Reports. In the event that we experience high turnover in our direct sales
force, and new sales representatives do not acquire the skills to sell our rEEG
Reports in a timely and successful manner, we may not be able to sustain and
grow our revenue.
In addition, in order to grow our business, we will need to develop and
introduce new sales and marketing programs and clinical education programs to
promote the use of our rEEG Reports by psychiatrists and physicians. If we do
not implement these new sales and marketing and education programs in a timely
and successful manner, we may not be able to achieve the level of market
awareness and sales required to expand our business.
42
WE MAY FAIL TO SUCCESSFULLY MANAGE AND MAINTAIN THE GROWTH OF OUR BUSINESS,
WHICH COULD ADVERSELY AFFECT OUR RESULTS OF OPERATIONS.
As we continue expanding our commercial operations, this expansion
could place significant strain on our management, operational, and financial
resources. To manage future growth, we will need to continue to hire, train, and
manage additional employees, particularly a specially trained sales force to
market our rEEG Reports.
In addition, we have maintained a small financial and accounting staff,
and our reporting obligations as a public company, as well as our need to comply
with the requirements of the Sarbanes-Oxley Act of 2002, and the rules and
regulations of the SEC will continue to place significant demands on our
financial and accounting staff, on our financial, accounting and information
systems and on our internal controls. As we grow, we will need to add additional
accounting staff and continue to improve our financial, accounting and
information systems and internal controls in order to fulfill our reporting
responsibilities and to support expected growth in our business. Our current and
planned personnel, systems, procedures and controls may not be adequate to
support our anticipated growth or management may not be able to effectively
hire, train, retain, motivate and manage required personnel. Our failure to
manage growth effectively could limit our ability to achieve our marketing and
commercialization goals or to satisfy our reporting and other obligations as a
public company.
WE MAY INCUR SIGNIFICANT EXPENSES OR BE PREVENTED FROM COMMERCIALIZING OR
DEVELOPING PRODUCTS AS A RESULT OF AN INTELLECTUAL PROPERTY INFRINGEMENT CLAIM.
Our commercial success depends, in part, on our ability to operate
without infringing the patents and proprietary rights of third parties.
Infringement proceedings are long, costly and time-consuming and their outcome
is uncertain.
If we become involved in any patent infringement litigation,
interference or other administrative proceedings related to our products, we
will incur substantial expenses and the time and effort of our management and
scientific personnel, will be significantly diverted. As a result of such
litigation or proceedings, we could lose our proprietary position, and be
restricted from selling, manufacturing or distributing the affected product(s),
incur substantial damage awards, including punitive damages, or be required to
seek third party licenses at terms that may be unattractive, or we may fail to
acquire the license.
WE MAY NOT BE ABLE TO ADEQUATELY PROTECT OUR INTELLECTUAL PROPERTY, WHICH IS THE
CORE OF OUR BUSINESS.
We consider the protection of our intellectual property to be critical
to our business prospects. We currently have two issued U.S. patents, and we
have filed separate patent applications in multiple foreign jurisdictions.
In the future, if we fail to file patent applications in a timely
manner, or in the event we elect not to file a patent application because of the
costs associated with patent prosecution, we may lose patent protection that we
may have otherwise obtained. The loss of any proprietary rights which are
obtainable under patent laws may result in the loss of a competitive advantage
over present or potential competitors, with a resulting decrease in revenues and
profitability for us.
With respect to the applications we have filed, there is no guarantee
that the applications will result in issued patents, and further, any patents
that do issue may be too narrow in scope to adequately protect our intellectual
property and provide us with a competitive advantage. Competitors and others may
43
design around aspects of our technology, or alternatively may independently
develop similar or more advanced technologies that fall outside the scope of our
claimed subject matter but that can be used in the treatment of behavioral
health disorders.
In addition, even if we are issued additional patents covering our
products, we cannot predict with certainty whether or not we will be able to
enforce our proprietary rights, and whether our patents will provide us with
adequate protection against competitors. We may be forced to engage in costly
and time consuming litigation or reexamination proceedings to protect our
intellectual property rights, and our opponents in such proceedings may have and
be willing to expend, substantially greater resources than we are able to. In
addition, the results of such proceedings may result in our patents being
invalidated or reduced in scope. These developments could cause a decrease in
our operating income and reduce our available cash flow, which could harm our
business and cause our stock price to decline.
We also utilize processes and technology that constitute trade secrets,
such as our outcomes database, and we must implement appropriate levels of
security for those trade secrets to secure the protection of applicable laws,
which we may not do effectively. In addition, the laws of many foreign countries
do not protect proprietary rights as fully as the laws of the United States.
While we have not had any significant issues to date, the loss of any
of our trade secrets or proprietary rights which may be protected under the
foregoing intellectual property safeguards may result in the loss of our
competitive advantage over present and potential competitors.
CONFIDENTIALITY AGREEMENTS WITH EMPLOYEES, LICENSEES AND OTHERS MAY NOT
ADEQUATELY PREVENT DISCLOSURE OF TRADE SECRETS AND OTHER PROPRIETARY
INFORMATION.
In order to protect our proprietary technology and processes, we rely
in part on confidentiality provisions in our agreements with employees,
licensees, treating physicians and psychiatrists and others. These agreements
may not effectively prevent disclosure of confidential information and may not
provide an adequate remedy in the event of unauthorized disclosure of
confidential information. Moreover, policing compliance with our confidentiality
agreements and non-disclosure agreements, and detecting unauthorized use of our
technology is difficult, and we may be unable to determine whether piracy of our
technology has occurred. In addition, others may independently discover our
trade secrets and proprietary information. Costly and time-consuming litigation
could be necessary to enforce and determine the scope of our proprietary rights,
and failure to obtain or maintain trade secret protection could adversely affect
our competitive business position.
ALTHOUGH WE BELIEVE WE ARE NOT CURRENTLY SUBJECT TO REGULATORY APPROVAL FOR THE
SALE OF OUR REEG REPORTS, REGULATIONS ARE CONSTANTLY CHANGING, AND IN THE FUTURE
OUR BUSINESS MAY BE SUBJECT TO REGULATION.
Currently, we do not believe that sales of our rEEG Reports are subject
to regulatory approval. However, federal, state and foreign laws and regulations
relating to the sale of our rEEG Reports are subject to future changes, as are
administrative interpretations of regulatory agencies. If we fail to comply with
applicable federal, state or foreign laws or regulations, we could be subject to
enforcement actions, including injunctions preventing us from conducting our
business, withdrawal of clearances or approvals and civil and criminal
penalties. In the event that federal, state, and foreign laws and regulations
change, we may need to incur additional costs to seek government approvals in
order to sell our rEEG Reports. There is no guarantee that we will be able to
obtain such approvals in a timely manner or at all, and as a result, our
revenues from our rEEG Reports may be reduced, or potentially eliminated.
44
IN THE FUTURE, WE INTEND TO SEEK REGULATORY APPROVAL FOR MEDICATIONS OR
COMBINATIONS OF MEDICATIONS FOR NEW INDICATIONS, AND THERE IS NO GUARANTEE THAT
WE WILL RECEIVE SUCH APPROVALS.
We intend to seek approval for medications or combinations of
medications for new indications, either with corporate partners, or potentially,
on our own. We are currently not authorized to market such medications in any
jurisdiction, and we may never receive such authorization. The development and
commercialization of medications for new indications is subject to extensive
regulation by the U.S. Federal government, principally through the FDA and other
federal, state and governmental authorities elsewhere. Prior to marketing any
central nervous system medication, and in many cases prior to being able to
successfully partner a central nervous system medication, we will have to
conduct extensive clinical trials at our own expense to determine safety and
efficacy of the indication that we are pursuing. We have no prior experience, as
a company, in conducting clinical trials. Clinical trials are expensive and can
take years to complete, and have uncertain outcomes. In addition, the regulatory
and approval procedures vary from country to country, and additional testing may
be required in some jurisdictions. It may take several years to complete the
clinical trials, and a product may fail at any stage of testing. Difficulties
and risks associated with clinical trials may result in our, or our partners'
inability to achieve regulatory approval to market medications for central
nervous system disorders. The FDA, other regulatory agencies, our collaborators,
or we may suspend or terminate clinical trials at any time.
Delays or failures in obtaining regulatory approval may delay or
prevent the commercialization of any product that we may develop for new
indications, diminish any competitive advantage, reduce or eliminate revenues,
milestone payments or royalties from collaborators, and adversely affect our
ability to attract new collaborators. The results of earlier clinical trials do
not necessarily predict the results of later clinical trials. Medications in
later clinical trials may fail to show desired safety and efficacy traits in the
indication we are seeking approval for, despite prior success in clinical trials
for other indications. Even if we and/or our collaborators and partners believe
the data collected from such clinical trials are promising, such data may not
support approval by the FDA or any other regulatory authorities. In addition,
the FDA or other regulatory authority may interpret the data differently than we
do, which could delay, limit or prevent regulatory approval. We expect to rely,
in part, on clinical trials that were performed by third-party physicians. These
trial results may not be predictive of the results of clinical trials we intend
to perform for new indications. In addition, the results of prior clinical
trials may not now be acceptable to the FDA or other regulatory authorities
because the data may be incomplete, outdated, or otherwise unacceptable for
inclusions in ours or our partners' regulatory submissions for approval of
medications for new indications.
IN THE EVENT WE OBTAIN REGULATORY APPROVAL FOR NEW INDICATIONS FOR EXISTING
MEDICATIONS, WE WILL STILL BE SUBJECT TO EXTENSIVE REGULATION BY THE FDA AND
OTHER AGENCIES, AND IF WE FAIL TO COMPLY WITH SUCH REGULATIONS, THE SALE OF OUR
PRODUCTS MAY BE RESTRICTED.
If we, or our collaborators, obtain regulatory approval for new
indications for existing medications, we will still be subject to extensive
regulation by the FDA and/or other regulatory agencies. We and our collaborators
will be required to conduct extensive post-market surveillance of products. Our,
or our collaborators', failure to comply with applicable FDA and other
regulatory requirements, or the later discovery of unknown problems, may result
in restrictions on the marketing or sale of such products that will negatively
impact sales and/or collaboration revenue, and may result in denial of authority
to market the medication product(s).
45
IF WE DO NOT RETAIN OUR SENIOR MANAGEMENT AND OTHER KEY EMPLOYEES, WE MAY NOT BE
ABLE TO SUCCESSFULLY IMPLEMENT OUR BUSINESS STRATEGY.
Our future success depends on the ability, experience and performance
of our senior management and our key professional personnel. Our success
therefore depends to a significant extent on retaining the services of Leonard
Brandt, our President, Chief Executive Officer, and Secretary, Horace Hertz, our
Chief Financial Officer, and others. Because of their ability and experience, if
we lose one or more of the members of our senior management or other key
employees, our ability to successfully implement our business strategy could be
seriously harmed.
We intend to carry key man life insurance on Leonard Brandt in an
amount of $2.0 million, payable to the company. We do not carry key man life
insurance on any of our other key employees. We do not have employment
agreements in place with most of our executives and key employees, and each may
terminate their employment upon notice and without cause or good reason. While
we believe our relationships with our executives are good and do not anticipate
any of them leaving in the near future, the loss of the services of Leonard
Brandt or any other key member of management could have a material adverse
effect on our ability to manage our business.
IF WE DO NOT ATTRACT AND RETAIN SKILLED PERSONNEL OR IF WE DO NOT MAINTAIN GOOD
RELATIONSHIPS WITH OUR EMPLOYEES, WE MAY NOT BE ABLE TO EXPAND OUR BUSINESS.
Our products and services are based on a complex database of
information. Accordingly, we require skilled medical, scientific and
administrative personnel to sell and support our products and services. Our
future success will depend largely on our ability to continue to hire, train,
retain and motivate additional skilled personnel, particularly sales
representatives who are responsible for customer education and training and
customer support, as well as personnel with experience in clinical testing and
matters relating to obtaining regulatory approvals. If we are not able to
attract and retain skilled personnel, we will not be able to continue our
development and commercialization activities.
In addition, we may be subject to claims that we engage in
discriminatory or inappropriate practices with respect to our hiring,
termination, promotion and compensation processes for our employees. Such
claims, with or without merit, could be time consuming, distracting and
expensive to defend, could divert attention of our management from other tasks
important to the success of our business and could adversely affect our
reputation as an employer.
IN THE FUTURE WE COULD BE SUBJECT TO PERSONAL INJURY CLAIMS, WHICH COULD RESULT
IN SUBSTANTIAL LIABILITIES THAT MAY EXCEED OUR INSURANCE COVERAGE.
All significant medical treatments and procedures, including treatment
that is facilitated through the use of our rEEG Reports, involve the risk of
serious injury or death. While we do not treat patients or determine whether
treatment that is guided by rEEG Reports that we provide is appropriate for any
particular patient, and have not been the subject of any personal injury claims
for patients treated by providers using our rEEG Reports, our business entails
an inherent risk of claims for personal injuries, which are subject to the
attendant risk of substantial damage awards. We cannot control whether
individual physicians and psychiatrists will properly select patients, apply the
appropriate standard of care, or conform to our procedures in determining how to
treat their patients. A significant source of potential liability is negligence
or alleged negligence by physicians treating patients with the aid of the rEEG
Reports that we provide. There can be no assurance that a future claim or claims
will not be successful or, including the cost of legal defense, will not exceed
the limits of available insurance coverage.
46
We currently have general liability and medical professional liability
insurance coverage for up to $5 million per year for personal injury claims. We
may not be able to maintain adequate liability insurance, in accordance with
standard industry practice, with appropriate coverage based on the nature and
risks of our business, at acceptable costs and on favorable terms. Insurance
carriers are often reluctant to provide liability insurance for new healthcare
services companies and products due to the limited claims history for such
companies and products. In addition, based on current insurance markets, we
expect that liability insurance will be more difficult to obtain and that
premiums will increase over time and as the volume of patients treated by
physicians that are guided by our rEEG Reports increases. In the event of
litigation, regardless of its merit or eventual outcome, or an award against us
during a time when we have no available insurance or insufficient insurance, we
may sustain significant losses of our operating capital which may substantially
reduce stockholder equity in the company.
IF GOVERNMENT AND THIRD-PARTY PAYERS FAIL TO PROVIDE COVERAGE AND ADEQUATE
PAYMENT RATES FOR TREATMENTS THAT ARE GUIDED BY OUR REEG REPORTS, OUR REVENUE
AND PROSPECTS FOR PROFITABILITY MAY BE HARMED.
Our future revenue growth will depend in part upon the availability of
reimbursement from third-party payers for psychiatrists and physicians who use
our rEEG Reports to guide the treatment of their patients. Such third-party
payers include government health programs such as Medicare and Medicaid, managed
care providers, private health insurers and other organizations. These
third-party payers are increasingly attempting to contain healthcare costs by
demanding price discounts or rebates and limiting both coverage on which
procedures they will pay for and the amounts that they will pay for new
procedures. As a result, they may not cover or provide adequate payment for
treatments that are guided by our rEEG Reports, which will discourage
psychiatrists and physicians from utilizing the information services we provide.
We may need to conduct studies to demonstrate the cost-effectiveness of
treatments that are guided by our products and services to such payers'
satisfaction. Such studies might require us to commit a significant amount of
management time and financial and other resources. Adequate third-party
reimbursement might not be available to enable us to realize an appropriate
return on investment in research and product development, and the lack of such
reimbursement could have a material adverse effect on our operations and could
adversely affect our revenues and earnings.
OUR BUSINESS PROSPECTS AND PROFITABILITY COULD BE NEGATIVELY IMPACTED IF WE HAVE
OVER-ESTIMATED THE DEMAND FOR OUR REEG REPORTS.
We are focused on the market for behavioral health disorders. The
projected demand for our rEEG Reports could materially differ from actual demand
if our assumptions regarding this market and its trends and acceptance of our
rEEG Reports by the psychiatric community prove to be incorrect or do not
materialize or if other products or services gain more widespread acceptance,
which in each case would adversely affect our business prospects and
profitability.
WE ARE SUBJECT TO EVOLVING AND EXPENSIVE CORPORATE GOVERNANCE REGULATIONS AND
REQUIREMENTS. OUR FAILURE TO ADEQUATELY ADHERE TO THESE REQUIREMENTS OR THE
FAILURE OR CIRCUMVENTION OF OUR CONTROLS AND PROCEDURES COULD SERIOUSLY HARM OUR
BUSINESS.
Because we are a publicly traded company we are subject to certain
federal, state and other rules and regulations, including applicable
requirements of the Sarbanes-Oxley Act of 2002. Compliance with these evolving
regulations is costly and requires a significant diversion of management time
and attention, particularly with regard to our disclosure controls and
procedures and our internal control over financial reporting. Although we have
reviewed our disclosure and internal controls and procedures in order to
determine whether they are effective, our controls and procedures may not be
able to prevent errors or frauds in the future. Faulty judgments, simple errors
or mistakes, or the failure of our personnel to adhere to established controls
47
and procedures may make it difficult for us to ensure that the objectives of the
control system are met. A failure of our controls and procedures to detect other
than inconsequential errors or fraud could seriously harm our business and
results of operations.
OUR SENIOR MANAGEMENT'S LIMITED RECENT EXPERIENCE MANAGING A PUBLICLY TRADED
COMPANY MAY DIVERT MANAGEMENT'S ATTENTION FROM OPERATIONS AND HARM OUR BUSINESS.
Our management team has relatively limited recent experience managing a
publicly traded company and complying with federal securities laws, including
compliance with recently adopted disclosure requirements on a timely basis. Our
management will be required to design and implement appropriate programs and
policies in responding to increased legal, regulatory compliance and reporting
requirements, and any failure to do so could lead to the imposition of fines and
penalties and harm our business.
RISKS RELATED TO OUR INDUSTRY
THE HEALTHCARE INDUSTRY IN WHICH WE OPERATE IS SUBJECT TO SUBSTANTIAL REGULATION
BY STATE AND FEDERAL AUTHORITIES, WHICH COULD HINDER, DELAY OR PREVENT US FROM
COMMERCIALIZING OUR PRODUCTS AND SERVICES.
Healthcare companies are subject to extensive and complex federal,
state and local laws, regulations and judicial decisions governing various
matters such as the licensing and certification of facilities and personnel, the
conduct of operations, billing policies and practices, policies and practices
with regard to patient privacy and confidentiality, and prohibitions on payments
for the referral of business and self-referrals. There are federal and state
laws, regulations and judicial decisions that govern patient referrals,
physician financial relationships, submission of healthcare claims and
inducement to beneficiaries of federal healthcare programs. Many states prohibit
business corporations from practicing medicine, employing or maintaining control
over physicians who practice medicine, or engaging in certain business
practices, such as splitting fees with healthcare providers. Many healthcare
laws and regulations applicable to our business are complex, applied broadly and
subject to interpretation by courts and government agencies. Our failure, or the
failure of physicians and psychiatrists to whom we sell our rEEG Reports, to
comply with these healthcare laws and regulations could create liability for us
and negatively impact our business.
In addition, the FDA, regulates development, testing, labeling,
manufacturing, marketing, promotion, distribution, record-keeping and reporting
requirements for prescription drugs. Compliance with laws and regulations
enforced by the FDA and other regulatory agencies may be required in relation to
future products or services developed or used by us. Failure to comply with
applicable laws and regulations may result in various adverse consequences,
including withdrawal of our products and services from the market, or the
imposition of civil or criminal sanctions.
We believe that this industry will continue to be subject to increasing
regulation, political and legal action and pricing pressures, the scope and
effect of which we cannot predict. Legislation is continuously being proposed,
enacted and interpreted at the federal, state and local levels to regulate
healthcare delivery and relationships between and among participants in the
healthcare industry. Any such changes could prevent us from marketing some or
all of our products and services for a period of time or permanently.
48
WE MAY BE SUBJECT TO REGULATORY AND INVESTIGATIVE PROCEEDINGS, WHICH MAY FIND
THAT OUR POLICIES AND PROCEDURES DO NOT FULLY COMPLY WITH COMPLEX AND CHANGING
HEALTHCARE REGULATIONS.
While we have established policies and procedures that we believe will
be sufficient to ensure that we operate in substantial compliance with
applicable laws, regulations and requirements, the criteria are often vague and
subject to change and interpretation. We may become the subject of regulatory or
other investigations or proceedings, and our interpretations of applicable laws
and regulations may be challenged. The defense of any such challenge could
result in substantial cost and a diversion of management's time and attention.
Thus, any such challenge could have a material adverse effect on our business,
regardless of whether it ultimately is successful. If we fail to comply with any
applicable laws, or a determination is made that we have failed to comply with
these laws, our financial condition and results of operations could be adversely
affected.
FAILURE TO COMPLY WITH THE FEDERAL TRADE COMMISSION ACT OR SIMILAR STATE LAWS
COULD RESULT IN SANCTIONS OR LIMIT THE CLAIMS WE CAN MAKE.
The Company's promotional activities and materials, including
advertising to consumers and physicians, and materials provided to third parties
for their use in promoting our products and services, are regulated by the
Federal Trade Commission (FTC) under the FTC Act, which prohibits unfair and
deceptive acts and practices, including claims which are false, misleading or
inadequately substantiated. The FTC typically requires competent and reliable
scientific tests or studies to substantiate express or implied claims that a
product or service is effective. If the FTC were to interpret our promotional
materials as making express or implied claims that our products and services are
effective for the treatment of mental illness, it may find that we do not have
adequate substantiation for such claims. Failure to comply with the FTC Act or
similar laws enforced by state attorneys general and other state and local
officials could result in administrative or judicial orders limiting or
eliminating the claims we can make about our products and services, and other
sanctions including fines.
OUR BUSINESS PRACTICES MAY BE FOUND TO CONSTITUTE ILLEGAL FEE-SPLITTING OR
CORPORATE PRACTICE OF MEDICINE, WHICH MAY LEAD TO PENALTIES AND ADVERSELY AFFECT
OUR BUSINESS.
Many states, including California, in which our principal executive
offices are located, have laws that prohibit business corporations, such as us,
from practicing medicine, exercising control over medical judgments or decisions
of physicians, or engaging in certain arrangements, such as employment or
fee-splitting, with physicians. Courts, regulatory authorities or other parties,
including physicians, may assert that we are engaged in the unlawful corporate
practice of medicine by providing administrative and ancillary services in
connection with our rEEG Reports, or that selling our rEEG Reports for a portion
of the patient fees constitutes improper fee-splitting, in which case we could
be subject to civil and criminal penalties, our contracts could be found legally
invalid and unenforceable, in whole or in part, or we could be required to
restructure our contractual arrangements. There can be no assurance that this
will not occur or, if it does, that we would be able to restructure our
contractual arrangements on favorable terms.
OUR BUSINESS PRACTICES MAY BE FOUND TO VIOLATE ANTI-KICKBACK, SELF-REFERRAL OR
FALSE CLAIMS LAWS, WHICH MAY LEAD TO PENALTIES AND ADVERSELY AFFECT OUR
BUSINESS.
The healthcare industry is subject to extensive federal and state
regulation with respect to financial relationships and "kickbacks" involving
healthcare providers, physician self-referral arrangements, filing of false
claims and other fraud and abuse issues. Federal anti-kickback laws and
regulations prohibit certain offers, payments or receipts of remuneration in
return for (i) referring patients covered by Medicare, Medicaid or other federal
health care program, or (ii) purchasing, leasing, ordering or arranging for or
recommending any service, good, item or facility for which payment may be made
49
by a federal health care program. In addition, federal physician self-referral
legislation, commonly known as the Stark law, generally prohibits a physician
from ordering certain services reimbursable by Medicare, Medicaid or other
federal healthcare program from any entity with which the physician has a
financial relationship. In addition, many states have similar laws, some of
which are not limited to services reimbursed by federal healthcare programs.
Other federal and state laws govern the submission of claims for reimbursement,
or false claims laws. One of the most prominent of these laws is the federal
False Claims Act, and violations of other laws, such as the anti-kickback laws
or the FDA prohibitions against promotion of off-label uses of medications, may
also be prosecuted as violations of the False Claims Act.
While we believe we have structured our relationships to comply with
all applicable requirements, federal or state authorities may claim that our fee
arrangements, agreements and relationships with contractors and physicians
violate these anti-kickback, self-referral or false claims laws and regulations.
These laws are broadly worded and have been broadly interpreted by courts. It is
often difficult to predict how these laws will be applied, and they potentially
subject many typical business arrangements to government investigation and
prosecution, which can be costly and time consuming. Violations of these laws
are punishable by monetary fines, civil and criminal penalties, exclusion from
participation in government-sponsored health care programs and forfeiture of
amounts collected in violation of such laws. Some states also have similar
anti-kickback and self-referral laws, imposing substantial penalties for
violations. If our business practices are found to violate any of these
provisions, we may be unable to continue with our relationships or implement our
business plans, which would have an adverse effect on our business and results
of operations.
WE MAY BE SUBJECT TO HEALTHCARE ANTI-FRAUD INITIATIVES, WHICH MAY LEAD TO
PENALTIES AND ADVERSELY AFFECT OUR BUSINESS.
State and federal governments are devoting increased attention and
resources to anti-fraud initiatives against healthcare providers, taking an
expansive definition of fraud that includes receiving fees in connection with a
healthcare business that is found to violate any of the complex regulations
described above. While to our knowledge we have not been the subject of any
anti-fraud investigations, if such a claim were made defending our business
practices could be time consuming and expensive, and an adverse finding could
result in substantial penalties or require us to restructure our operations,
which we may not be able to do successfully.
OUR USE AND DISCLOSURE OF PATIENT INFORMATION IS SUBJECT TO PRIVACY AND SECURITY
REGULATIONS, WHICH MAY RESULT IN INCREASED COSTS.
In conducting research or providing administrative services to
healthcare providers in connection with the use of our rEEG Reports, we may
collect, use, maintain and transmit patient information in ways that will be
subject to many of the numerous state, federal and international laws and
regulations governing the collection, dissemination, use and confidentiality of
patient-identifiable health information, including the federal Health Insurance
Portability and Accountability Act (HIPAA) and related rules. The three rules
that were promulgated pursuant to HIPAA that could most significantly affect our
business are the Standards for Electronic Transactions, or Transactions Rule;
the Standards for Privacy of Individually Identifiable Health Information, or
Privacy Rule; and the Health Insurance Reform: Security Standards, or Security
Rule. HIPAA applies to covered entities, which include most healthcare
facilities and health plans that may contract for the use of our services. The
HIPAA rules require covered entities to bind contractors like us to compliance
with certain burdensome HIPAA rule requirements.
The HIPAA Transactions Rule establishes format and data content
standards for eight of the most common healthcare transactions. If we perform
billing and collection services on behalf of psychiatrists and physicians, we
may be engaging in one of more of these standard transactions and will be
50
required to conduct those transactions in compliance with the required
standards. The HIPAA Privacy Rule restricts the use and disclosure of patient
information, requires entities to safeguard that information and to provide
certain rights to individuals with respect to that information. The HIPAA
Security Rule establishes elaborate requirements for safeguarding patient
information transmitted or stored electronically. We may be required to make
costly system purchases and modifications to comply with the HIPAA rule
requirements that are imposed on us and our failure to comply may result in
liability and adversely affect our business.
Numerous other federal and state laws protect the confidentiality of
personal and patient information. These laws in many cases are not preempted by
the HIPAA rules and may be subject to varying interpretations by courts and
government agencies, creating complex compliance issues for us and the
psychiatrists and physicians who purchase our services, and potentially exposing
us to additional expense, adverse publicity and liability.
RISKS RELATING TO INVESTMENT IN OUR COMMON STOCK
WE HAVE A LIMITED TRADING VOLUME AND SHARES ELIGIBLE FOR FUTURE SALE BY OUR
CURRENT STOCKHOLDERS MAY ADVERSELY AFFECT OUR STOCK PRICE.
Bid and ask prices for shares of our Common Stock are quoted on NASD's
OTC Bulletin Board under the symbol CNSO.OB. There is currently no broadly
followed, established trading market for our Common Stock. While we are hopeful
that following the merger, the Company will command the interest of a greater
number of investors, an established trading market for our shares of Common
Stock may never develop or be maintained. Active trading markets generally
result in lower price volatility and more efficient execution of buy and sell
orders. The absence of an active trading market reduces the liquidity of our
Common Stock. Before commencement of the private placement, we had little or no
trading volume in our Common Stock. As a result of this lack of trading
activity, the quoted price for our Common Stock on NASD's OTC Bulletin Board is
not necessarily a reliable indicator of its fair market value. Further, if we
cease to be quoted, holders would find it more difficult to dispose of, or to
obtain accurate quotations as to the market value of, our Common Stock, and the
market value of our Common Stock would likely decline.
IF AND WHEN A TRADING MARKET FOR OUR COMMON STOCK DEVELOPS, THE MARKET PRICE OF
OUR COMMON STOCK IS LIKELY TO BE HIGHLY VOLATILE AND SUBJECT TO WIDE
FLUCTUATIONS, AND YOU MAY BE UNABLE TO RESELL YOUR SHARES AT OR ABOVE THE PRICE
AT WHICH YOU ACQUIRED THEM.
The market price of our Common Stock is likely to be highly volatile
and could be subject to wide fluctuations in response to a number of factors
that are beyond our control, including:
o quarterly variations in our revenues and operating expenses;
o developments in the financial markets and worldwide or
regional economies;
o announcements of innovations or new products or services by us
or our competitors;
o announcements by the government relating to regulations that
govern our industry;
o significant sales of our Common Stock or other securities in
the open market;
o variations in interest rates;
o changes in the market valuations of other comparable
companies; and
o changes in accounting principles.
51
In the past, stockholders have often instituted securities class action
litigation after periods of volatility in the market price of a company's
securities. If a stockholder were to file any such class action suit against us,
we would incur substantial legal fees and our management's attention and
resources would be diverted from operating our business to respond to the
litigation, which could harm our business.
SUBSTANTIAL FUTURE SALES OF OUR COMMON STOCK IN THE PUBLIC MARKET COULD CAUSE
OUR STOCK PRICE TO FALL.
Our registration statement on Form SB-2 as filed with the Securities
and Exchange Commission became effective in the third quarter of 2007. As a
result, 9,938,138 shares of our Common Stock became eligible for sale, including
2,627,939 shares of our Common Stock issuable upon the exercise of certain
warrants. The sale of these shares could depress the market price of our Common
Stock. A reduced market price for our shares could make it more difficult to
raise funds through future offerings of Common Stock.
Other holders of our Common Stock have piggy-back registration rights
with respect to such shares effective September 7, 2007, and demand registration
rights with respect to such shares effective March 7, 2008.
Moreover, as additional shares of Common Stock become available for
resale in the open market (including shares issuable upon the exercise of the
Company's outstanding options and warrants), the supply of our publicly traded
shares will increase. This could decrease their price.
Some of our shares may also be offered from time to time in the open
market pursuant to Rule 144, and these sales may have a depressive effect on the
market for our shares. In general, a person who has held restricted shares for a
period of one year may, upon filing with the Securities & Exchange Commission
(the "SEC") a notification on Form 144, sell into the market shares up to an
amount equal to 1% of the outstanding shares. The SEC has recently adopted
revisions to Rule 144 which will, among other things, reduce the holding period
for non-affiliates to six months. Upon the effectiveness of the revisions to
Rule 144, a substantial majority of the outstanding shares of our common stock
will become eligible for resale under Rule 144.
THE SALE OF SECURITIES BY US IN ANY EQUITY OR DEBT FINANCING COULD RESULT IN
DILUTION TO OUR EXISTING STOCKHOLDERS AND HAVE A MATERIAL ADVERSE EFFECT ON OUR
EARNINGS.
Any sale of Common Stock by us in a future private placement could
result in dilution to our existing stockholders as a direct result of our
issuance of additional shares of our capital stock. In addition, our business
strategy may include expansion through internal growth, by acquiring
complementary businesses, by acquiring or licensing additional products and
services, or by establishing strategic relationships with targeted customers and
suppliers. In order to do so, or to finance the cost of our other activities, we
may issue additional equity securities that could dilute our stockholders' stock
ownership. We may also assume additional debt and incur impairment losses
related to goodwill and other tangible assets if we acquire another company and
this could negatively impact our earnings and results of operations.
52
THE TRADING OF OUR COMMON STOCK ON THE OVER-THE-COUNTER BULLETIN BOARD AND THE
POTENTIAL DESIGNATION OF OUR COMMON STOCK AS A "PENNY STOCK" COULD IMPACT THE
TRADING MARKET FOR OUR COMMON STOCK.
Our securities, as traded on the Over-the-Counter Bulletin Board, may
be subject to SEC rules that impose special sales practice requirements on
broker-dealers who sell these securities to persons other than established
customers or accredited investors. For the purposes of the rule, the phrase
"accredited investors" means, in general terms, institutions with assets in
excess of $5,000,000, or individuals having a net worth in excess of $1,000,000
or having an annual income that exceeds $200,000 (or that, when combined with a
spouse's income, exceeds $300,000). For transactions covered by the rule, the
broker-dealer must make a special suitability determination for the purchaser
and receive the purchaser's written agreement to the transaction before the
sale. Consequently, the rule may affect the ability of broker-dealers to sell
our securities and also may affect the ability of purchasers to sell their
securities in any market that might develop therefor.
In addition, the SEC has adopted a number of rules to regulate "penny
stock" that restrict transactions involving these securities. Such rules include
Rules 3a51-1, 15g-1, 15g-2, 15g-3, 15g-4, 15g-5, 15g-6, 15g-7, and 15g-9 under
the Securities and Exchange Act of 1934, as amended. These rules may have the
effect of reducing the liquidity of penny stocks. "Penny stocks" generally are
equity securities with a price of less than $5.00 per share (other than
securities registered on certain national securities exchanges or quoted on the
NASDAQ Stock Market if current price and volume information with respect to
transactions in such securities is provided by the exchange or system). Because
our securities may constitute "penny stock" within the meaning of the rules, the
rules would apply to us and to our securities. If our securities become subject
to the penny stock rules, our stockholders may find it more difficult to sell
their securities.
Stockholders should be aware that, according to SEC, the market for
penny stocks has suffered in recent years from patterns of fraud and abuse. Such
patterns include (i) control of the market for the security by one or a few
broker-dealers that are often related to the promoter or issuer; (ii)
manipulation of prices through prearranged matching of purchases and sales and
false and misleading press releases; (iii) "boiler room" practices involving
high-pressure sales tactics and unrealistic price projections by inexperienced
sales persons; (iv) excessive and undisclosed bid-ask differentials and markups
by selling broker-dealers; and (v) the wholesale dumping of the same securities
by promoters and broker-dealers after prices have been manipulated to a desired
level, resulting in investor losses. Our management is aware of the abuses that
have occurred historically in the penny stock market. Although we do not expect
to be in a position to dictate the behavior of the market or of broker-dealers
who participate in the market, management will strive within the confines of
practical limitations to prevent the described patterns from being established
with respect to our securities.
WE HAVE NOT PAID DIVIDENDS IN THE PAST AND DO NOT EXPECT TO PAY DIVIDENDS FOR
THE FORESEEABLE FUTURE, AND ANY RETURN ON INVESTMENT MAY BE LIMITED TO POTENTIAL
FUTURE APPRECIATION ON THE VALUE OF OUR COMMON STOCK.
We currently intend to retain any future earnings to support the
development and expansion of our business and do not anticipate paying cash
dividends in the foreseeable future. Our payment of any future dividends will be
at the discretion of our Board of Directors after taking into account various
factors, including without limitation, our financial condition, operating
results, cash needs, growth plans and the terms of any credit agreements that we
may be a party to at the time. To the extent we do not pay dividends, our stock
may be less valuable because a return on investment will only occur if and to
the extent our stock price appreciates, which may never occur. In addition,
53
investors must rely on sales of their Common Stock after price appreciation as
the only way to realize their investment, and if the price of our stock does not
appreciate, then there will be no return on investment. Investors seeking cash
dividends should not purchase our Common Stock.
OUR OFFICERS, DIRECTORS AND PRINCIPAL STOCKHOLDERS CAN EXERT SIGNIFICANT
INFLUENCE OVER US AND MAY MAKE DECISIONS THAT ARE NOT IN THE BEST INTERESTS OF
ALL STOCKHOLDERS.
After the closing of the merger and private placement in May 2007, our
officers, directors and principal stockholders (greater than 5% stockholders)
collectively control approximately 33% of our issued and outstanding Common
Stock. As a result, these stockholders are able to affect the outcome of, or
exert significant influence over, all matters requiring stockholder approval,
including the election and removal of directors and any change in control. In
particular, this concentration of ownership of our Common Stock could have the
effect of delaying or preventing a change of control of us or otherwise
discouraging or preventing a potential acquirer from attempting to obtain
control of us. This, in turn, could have a negative effect on the market price
of our Common Stock. It could also prevent our stockholders from realizing a
premium over the market prices for their shares of Common Stock. Moreover, the
interests of this concentration of ownership may not always coincide with our
interests or the interests of other stockholders, and accordingly, they could
cause us to enter into transactions or agreements that we would not otherwise
consider.
TRANSACTIONS ENGAGED IN BY OUR LARGEST STOCKHOLDERS, OUR DIRECTORS OR EXECUTIVES
INVOLVING OUR COMMON STOCK MAY HAVE AN ADVERSE EFFECT ON THE PRICE OF OUR STOCK.
After the closing of the merger and private placement in May 2007, our
officers, directors and principal stockholders (greater than 5% stockholders)
collectively control approximately 33% of our issued and outstanding Common
Stock. Subsequent sales of our shares by these stockholders could have the
effect of lowering our stock price. The perceived risk associated with the
possible sale of a large number of shares by these stockholders, or the adoption
of significant short positions by hedge funds or other significant investors,
could cause some of our stockholders to sell their stock, thus causing the price
of our stock to decline. In addition, actual or anticipated downward pressure on
our stock price due to actual or anticipated sales of stock by our directors or
officers could cause other institutions or individuals to engage in short sales
of our Common Stock, which may further cause the price of our stock to decline.
From time to time our directors and executive officers may sell shares
of our common stock on the open market. These sales will be publicly disclosed
in filings made with the SEC. In the future, our directors and executive
officers may sell a significant number of shares for a variety of reasons
unrelated to the performance of our business. Our stockholders may perceive
these sales as a reflection on management's view of the business and result in
some stockholders selling their shares of our common stock. These sales could
cause the price of our stock to drop.
ANTI-TAKEOVER PROVISIONS MAY LIMIT THE ABILITY OF ANOTHER PARTY TO ACQUIRE US,
WHICH COULD CAUSE OUR STOCK PRICE TO DECLINE.
Delaware law contains provisions that could discourage, delay or
prevent a third party from acquiring us, even if doing so may be beneficial to
our stockholders, which could cause our stock price to decline. In addition,
these provisions could limit the price investors would be willing to pay in the
future for shares of our Common Stock.
54
ITEM 7. FINANCIAL STATEMENTS
Index to financial statements
PAGE
----
Report of Independent Registered Public Accounting Firm................. 56
Consolidated Balance Sheet as of September 30, 2007..................... 57
Consolidated Statements of Operations for the Years Ended
September 30, 2007 and 2006............................................. 58
Consolidated Statement of Changes in Stockholders' Equity (Deficit)
for the Years Ended September 30, 2007 and 2006......................... 59
Consolidated Statements of Cash Flows for the Years Ended
September 30, 2007 and 2006............................................. 60
Notes to Consolidated Financial Statements for the Years Ended
September 30, 2007 and 2006............................................. 62
55
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors
CNS Response, Inc.
We have audited the accompanying consolidated balance sheet of CNS Response,
Inc. (the "Company") and its subsidiary as of September 30, 2007, and the
related consolidated statements of operations and comprehensive loss, changes in
stockholders' equity and cash flows for each of the years in the two-year period
ended September 30, 2007. 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 the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of CNS Response, Inc.
at September 30, 2007, and the results of its operations and it cash flows for
each of the years in the two-year period ended September 30, 2007 in conformity
with accounting principles generally accepted in the United States of America.
The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. As discussed in Note 1 to the
financial statements, the Company's continued operating losses and limited
capital raise substantial doubt about its ability to continue as a going
concern. Management's plans in regard to this matter are also described in Note
1. The accompanying financial statements do not include any adjustments that
might result from the outcome of this uncertainty.
/s/ Cacciamatta Accountancy Corporation
Irvine, California
December 7, 2007
56
CNS RESPONSE, INC.
CONSOLIDATED BALANCE SHEET AT SEPTEMBER 30, 2007
ASSETS
CURRENT ASSETS:
Cash ...................................................... $ 5,790,100
Accounts receivable (net of allowance for doubtful
accounts of $17,200) ................................... 59,200
Prepaids and other ........................................ 159,000
------------
Total current assets .................................... 6,008,300
OTHER ASSETS ................................................. 4,100
------------
TOTAL ASSETS ................................................. $ 6,012,400
============
LIABILITIES AND STOCKHOLDERS'
EQUITY
CURRENT LIABILITIES:
Accounts payable (including $5,000 to related party) ...... $ 219,400
Accrued liabilities ....................................... 207,500
Deferred compensation (including $56,700
to related party) ....................................... 73,400
Accrued consulting fees ................................... 73,200
Accrued interest .......................................... 35,800
Convertible promissory notes .............................. 50,000
------------
Total current liabilities ............................... 659,300
------------
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY:
Common stock, $0.001 par value; authorized
750,000,000 shares; 25,299,547 outstanding .............. 25,300
Additional paid-in capital ................................ 16,630,000
Accumulated deficit ....................................... (11,302,200)
------------
Total stockholders' equity .............................. 5,353,100
------------
TOTAL LIABILITIES AND STOCKHOLDERS'
EQUITY .................................................... $ 6,012,400
============
See accompanying Notes to Consolidated Financial Statements
57
CNS RESPONSE, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE YEARS ENDED
SEPTEMBER 30, 2007 AND 2006
YEARS ENDED
SEPTEMBER 30,
----------------------------
2007 2006
------------ ------------
REVENUES ....................................... $ 238,400 $ 175,500
------------ ------------
OPERATING EXPENSES:
Cost of revenues (including amortization
expense of $19,900 and $79,800 for the
years ended September 30, 2007 and 2006,
respectively) .............................. 166,200 197,900
Research and development .................... 1,442,600 519,800
Sales and marketing ......................... 123,600 109,600
General and administrative .................. 1,775,600 1,132,400
------------ ------------
Total operating expenses .................. 3,508,000 1,959,700
------------ ------------
OPERATING LOSS ................................. (3,269,600) (1,784,200)
------------ ------------
OTHER INCOME (EXPENSE):
Interest expense, net ....................... (115,600) (390,600)
Gain on derivative instruments .............. -- 1,178,500
Gain on troubled debt restructuring ......... -- 1,079,700
Other ....................................... 106,900
------------ ------------
Total other income (expense) ................ (8,700) 1,867,600
------------ ------------
INCOME (LOSS) BEFORE PROVISION FOR INCOME TAXES (3,278,300) 83,400
PROVISION FOR INCOME TAXES ..................... 800 800
------------ ------------
NET INCOME (LOSS) .............................. $ (3,279,100) $ 82,600
============ ============
BASIC NET INCOME (LOSS) PER SHARE .............. $ (0.17) $ 0.03
============ ============
DILUTED NET INCOME (LOSS) PER SHARE ............ $ (0.17) $ 0.00
============ ============
WEIGHTED AVERAGE SHARES OUTSTANDING:
Basic ....................................... 18,778,077 2,836,216
============ ============
Diluted ..................................... 18,778,077 33,369,915
============ ============
See accompanying Notes to Consolidated Financial Statements
58
CNS RESPONSE, INC.
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (DEFICIT) FOR THE YEARS ENDED
SEPTEMBER 30, 2007 AND 2006
Common Stock Additional
---------------------------- Paid-in Accumulated
Shares Amount Capital Deficit Total
------------ ------------ ------------ ------------ ------------
Balance at October 1, 2005 ........................ 2,068,990 $ 2,100 $ 26,100 $ (8,105,700) $ (8,077,500)
Reclassification of derivative instrument ......... -- -- 343,100 -- 343,100
Issuance of stock for settlement of debt .......... 5,834,117 5,800 695,000 -- 700,800
Troubled debt restructuring with related parties .. -- -- 1,388,000 -- 1,388,000
Stock-based compensation .......................... -- -- 369,900 -- 369,900
Net income for the year ended September 30, 2006 .. -- -- -- 82,600 82,600
------------ ------------ ------------ ------------ ------------
Balance at September 30, 2006 ..................... 7,903,107 7,900 2,822,100 (8,023,100) (5,193,100)
Forgiveness of accrued interest from NuPharm and
issuance and exercise of warrants by NuPharm . 2,800,000 2,800 334,800 -- 337,600
Conversion of convertible promissory notes and
accrued interest ............................. 5,993,515 6,000 4,061,100 -- 4,067,100
Issuance of stock in connection with mezzanine
financing, net of offering costs of $47,600 .. 1,905,978 1,900 1,875,500 -- 1,877,400
Issuance of stock for settlement of debt .......... 11,015 -- 1,300 -- 1,300
Issuance of options in settlement of accrued
consulting fees .............................. -- -- 27,000 -- 27,000
Issuance of stock in connection with private
placement, net of offering costs of
$1,057,300 ................................... 6,504,758 6,500 6,741,900 -- 6,748,400
Issuance of stock as payment of placement agent fee 83,333 100 (100) -- --
Issuance of stock to repay note to NuPharm and
related accrued interest ..................... 244,509 200 293,200 -- 293,400
Collection of loans receivable through the
receipt of stock ............................. (146,668) (100) (175,900) -- (176,000)
Stock- based compensation ......................... -- -- 649,100 -- 649,100
Derivative instrument liability ................... -- -- (2,273,700) -- (2,273,700)
Reclassify fair value of derivative instrument
liability .................................... -- -- 2,273,700 -- 2,273,700
Net loss for the year ended September 30, 2007 .... -- -- -- (3,279,100) (3,279,100)
- --------------------------------------------------- ------------ ------------ ------------ ------------ ------------
Balance at September 30, 2007 ..................... 25,299,547 $ 25,300 $ 16,630,000 $(11,302,200) $ 5,353,100
============ ============ ============ ============ ============
See accompanying Notes to Consolidated Financial Statements
59
CNS RESPONSE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS FOR YEARS ENDED
SEPTEMBER 30, 2007 AND 2006
YEAR ENDED SEPTEMBER 30,
--------------------------
2007 2006
----------- -----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) .............................................. $(3,279,100) $ 82,600
Adjustments to reconcile net income (loss) to net cash
used in operating activities:
Amortization of intangibles .................................. 19,900 79,800
Allowance for doubtful accounts .............................. -- 4,800
Gain on derivative instruments ............................... -- (1,178,500)
Gain on troubled debt restructuring .......................... -- (1,079,700)
Other ........................................................ (106,900) --
Stock based compensation ..................................... 649,100 369,900
Non-cash interest expense .................................... 189,800 --
Changes in operating assets and liabilities:
Accounts receivable ........................................ (32,900) (1,700)
Prepaids and other ......................................... (87,900) (67,000)
Accounts payable ........................................... (271,200) 202,700
Accrued liabilities ........................................ (59,400) 5,900
Deferred compensation ...................................... 2,100 298,800
Accrued consulting ......................................... 7,400 301,300
Accrued interest ........................................... 10,200 383,500
----------- -----------
Net cash used in operating activities ...................... (2,958,900) (597,600)
----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Increase in deposits ............................................ (3,000) --
Loans to employees .............................................. (4,200) (175,900)
----------- -----------
Net cash used in investing activities ....................... (7,200) (175,900)
----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Repayment of debt ............................................... (5,000) --
Proceeds from issuance of convertible promissory notes, net of
offering costs ................................................ -- 500,000
Proceeds from the sale of preferred stock, net of offering costs 1,779,900 --
Proceeds from the sale of common stock, net of offering costs ... 6,748,400 --
Proceeds from exercise of warrants .............................. 28,000 --
----------- -----------
Net cash provided by financing activities ................... 8,551,300 500,000
----------- -----------
NET INCREASE (DECREASE) IN CASH ................................... 5,585,200 (273,500)
CASH- BEGINNING OF YEAR ........................................... 204,900 478,400
----------- -----------
CASH- END OF YEAR ................................................. $ 5,790,100 $ 204,900
=========== ===========
60
SUPPLEMENTAL DISCLOSURE OF CASH FLOW
INFORMATION:
Cash paid during the period for:
Interest ...................................................... $ 2,300 --
=========== ===========
Income taxes .................................................. $ 800 $ 800
=========== ===========
Common stock issued for settlement of troubled debt ............. -- $ 700,800
=========== ===========
Conversion of preferred stock into common stock ................. 5,958,200 --
=========== ===========
Conversion of promissory notes and related accrued interest
into preferred stock .......................................... 4,067,100 --
=========== ===========
Common stock received as collection of loans receivable ......... 176,000 --
=========== ===========
Derivative instrument liability ................................. 2,273,700 --
=========== ===========
See accompanying Notes to Consolidated Financial Statements
61
CNS RESPONSE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED
SEPTEMBER 30, 2007 AND 2006
1. NATURE OF OPERATIONS
ORGANIZATION AND NATURE OF OPERATIONS
CNS Response, Inc. (the "Company") was incorporated in Delaware on July
10, 1984. The Company utilizes a patented system that guides psychiatrists and
other physicians to determine a proper treatment for patients with mental,
behavioral and/or addictive disorders. The Company also intends to identify,
develop and commercialize new indications of approved drugs and drug candidates
for this patient population.
GOING CONCERN UNCERTAINTY
The Company has a limited operating history and its operations are
subject to certain risks and uncertainties frequently encountered by rapidly
evolving markets. These risks include the failure to develop or supply
technology or services, the ability to obtain adequate financing, competition
within the industry and technology trends.
To date, the Company has financed its cash requirements primarily from
debt and equity financings. It will be necessary for the Company to raise
additional funds. The Company's liquidity and capital requirements depend on
several factors, including the rate of market acceptance of its services, the
ability to expand and retain its customer base, its ability to execute its
current business plan and other factors. The Company is currently exploring
additional sources of capital but there can be no assurances that any financing
arrangement will be available in amounts and terms acceptable to the Company.
2. REVERSE MERGER AND FINANCING
COMPLETION OF MERGER
On January 16, 2007, CNS Response, Inc. (formerly Strativation, Inc), a
Delaware corporation (the "Company"), along with CNS Merger Corporation, a
California corporation and the Company's wholly-owned subsidiary ("Merger Sub")
entered into an Agreement and Plan of Merger (the "Merger Agreement") with CNS
Response, Inc, a privately held California corporation ("CNS California"),
pursuant to which CNS California would be acquired by the Company in a merger
transaction wherein Merger Sub would merge with and into CNS California, with
CNS California being the surviving corporation (the "Merger"). On March 7, 2007,
the Merger closed and CNS California became a wholly-owned subsidiary of the
Company. At the closing, the Company changed its name to CNS Response, Inc.
From a historical perspective, CNS California was deemed to have been
the acquirer in the reverse merger and CNS California is deemed the survivor of
the reorganization. As a result, the consolidated financial statements of the
Company presented reflect the historical results of CNS California prior to the
Merger, and of the combined entities following the merger, and do not include
the historical financial results of the entity formerly known as Strativation,
Inc. Common stock has been retroactively restated to reflect the number of
shares received by CNS California equity holders in the Merger after giving
effect to the difference in par value, with the offset to additional paid-in
capital. The equity of the Company survives the reorganization. Upon the closing
of the reorganization, the Company changed its fiscal year to September 30. All
costs associated with the Merger were expensed as incurred.
62
CNS RESPONSE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED
SEPTEMBER 30, 2007 AND 2006
PRINCIPAL TERMS OF THE MERGER
On March 7, 2007, Merger Sub was merged with and into CNS California,
the separate existence of Merger Sub ceased, and CNS California continued as the
surviving corporation at the subsidiary level. Pursuant to the Merger, the
issued and outstanding shares of common stock of CNS California were converted
into an aggregate of 9,845,132 shares of Company Common Stock, and the issued
and outstanding shares of Series A and B preferred stock of CNS California were
converted into 5,993,515 and 1,905,978 shares of Company Common Stock,
respectively. In addition warrants and options to purchase shares of common
stock of CNS California were converted into warrants and options to purchase
4,271,414 and 4,136,103 shares of Company Common Stock, respectively. Following
the Merger, the business conducted by the Company is the business conducted by
CNS California.
Pursuant to the terms of the Merger Agreement, CNS Response, Inc.
(formerly Strativation, Inc.) paid an advisory fee of $475,000 to Richardson &
Patel, LLP, the Company's former legal counsel and a principal shareholder,
immediately upon the closing of the Merger. The fee has been expensed as a cost
of the merger.
Immediately after the closing of the Merger, and without taking into
consideration the Private Placement Offering, the issuance of shares of common
stock to repay the note to NuPharm Database, LLC and the tendering to the
Company of shares of common stock by an officer and certain employees to repay
their loans to CNS California described below, the Company had outstanding
18,696,948 shares of common stock, options to purchase 4,136,103 shares of
common stock and warrants to purchase 4,271,414 shares of common stock.
ACCOUNTING TREATMENT OF THE MERGER AND FINANCIAL STATEMENT PRESENTATION
The Company accounted for the Merger as a reverse merger under
generally accepted accounting principles, and accordingly, the consolidated
financial statements of the Company for the periods before March 7, 2007,
reflect only the operations of CNS California. No goodwill or other intangible
asset was recorded as a result of the Merger. Immediately prior to the reverse
merger on March 7, 2007, the Company had no material operations, assets, or
liabilities. Therefore, pro forma financial statements are not presented.
THE PRIVATE PLACEMENT
Immediately following the closing of the Merger, the Company received
gross proceeds of approximately $7.0 million from the first closing of a private
placement transaction (the "Private Placement") with institutional investors and
other high net worth individuals ("Investors"). On May 15, 2007, the Company
received additional gross proceeds of $797,300 from the second closing of the
Private Placement. Pursuant to Subscription Agreements entered into with these
Investors, the Company sold 6,504,758 Investment Units, at $1.20 per Investment
Unit. Each Investment Unit consists of one share of Company common stock, and a
five year non-callable warrant to purchase three-tenths of one share of the
Company common stock at an exercise price of $1.80 per share. The value of the
warrants was determined to be $1,674,600 using the Black-Scholes option pricing
model with the following assumptions: a volatility rate of 100%, risk free
interest rate of 5%, an expected life of five years and zero dividends. The
value of the warrants was recorded as a liability in accordance with SFAS No.
133 and EITF 00-19. As of June 22, 2007, the common shares underlying the
warrants were registered satisfying the warrant liability. As of such date, the
value of the warrants had not changed and thus the recorded amount was
reclassified to Stockholders' Equity.
63
CNS RESPONSE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED
SEPTEMBER 30, 2007 AND 2006
As partial consideration for services rendered further to the Private
Placement, the Company's placement agent was issued 83,333 shares of common
stock, warrants to purchase 520,380 shares of Company common stock at an
exercise price of $1.44 per share and warrants to purchase 156,114 shares of
Company's common stock at exercise price of $1.80 per share . The value of the
warrants was determined to be $599,100 using the Black-Scholes option pricing
model with the following assumptions: a volatility rate of 100%, risk free
interest rate of 5%, an expected life of five years and zero dividends. The
value of the warrants was recorded as a liability in accordance with SFAS No.
133 and EITF 00-19. As of June 22, 2007, the common shares underlying the
warrants were registered satisfying the warrant liability. As of such date, the
value of the warrants had not changed and thus the recorded amount was
reclassified to Stockholders' Equity.
See Notes 4, 6, 7 and 8 for description of other transactions completed
concurrently with the completion of the private placement.
3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF CONSOLIDATION
The consolidated financial statements include the accounts of CNS
Response, Inc., an inactive parent company, and its wholly owned subsidiary CNS
California. All significant intercompany transactions have been eliminated in
consolidation.
USE OF ESTIMATES
The preparation of the consolidated financial statements requires
management to make estimates and judgments that affect the reported amounts of
assets, liabilities, revenue and expense, and related disclosure of contingent
assets and liabilities. On an ongoing basis, the Company evaluates its
estimates, including those related to revenue recognition, doubtful accounts,
intangible assets, income taxes, valuation of equity instruments, contingencies
and litigation. The Company bases its estimates on historical experience and on
various other assumptions that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent from
other sources. Actual results may differ materially from these estimates.
CASH
The Company deposits its cash with major financial institutions and may
at times exceed federally insured limits. The Company believes that the risk of
loss is minimal. To date, the Company has not experienced any losses related to
cash deposits with financial institutions.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The Company's short-term financial instruments, including cash,
accounts receivable and accounts payable are carried at cost. The cost of the
short-term financial instruments approximates fair value due to their relatively
short maturities. The carrying value of long-term financial instruments,
including notes payable, approximates fair value as the interest rates
approximate current market rates of similar debt obligations.
64
CNS RESPONSE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED
SEPTEMBER 30, 2007 AND 2006
ACCOUNTS RECEIVABLE
The Company estimates the collectibility of customer receivables on an
ongoing basis by reviewing past-due invoices and assessing the current
creditworthiness of each customer. Allowances are provided for specific
receivables deemed to be at risk for collection.
INTANGIBLE ASSETS
Intangible assets consisted of a purchased database recorded at cost
and were amortized over an estimated useful life of seven years.
LONG-LIVED ASSETS
As required by Statement of Financial Accounting Standards ("SFAS") No.
144, ACCOUNTING FOR THE IMPAIRMENT OR DISPOSAL OF LONG-LIVED ASSETS, the Company
reviews the carrying value of its long-lived assets whenever events or changes
in circumstances indicate that the historical cost-carrying value of an asset
may no longer be appropriate. The Company assesses recoverability of the
carrying value of the asset by estimating the future net cash flows expected to
result from the asset, including eventual disposition. If the future net cash
flows are less than the carrying value of the asset, an impairment loss is
recorded equal to the difference between the asset's carrying value and fair
value. No impairment loss was recorded for the years ended September 30, 2007
and 2006.
REVENUES
The Company recognizes revenue as the related services are delivered.
RESEARCH AND DEVELOPMENT EXPENSES
The Company charges all research and development expenses to operations
as incurred.
ADVERTISING EXPENSES
The Company charges all advertising expenses to operations as incurred.
STOCK-BASED COMPENSATION
The Company has adopted SFAS No. 123R, SHARE-BASED PAYMENT (revised
2004) and related interpretations which establish the accounting for equity
instruments exchanged for employee services. Under SFAS No. 123R, share-based
compensation cost is measured at the grant date based on the calculated fair
value of the award. The expense is recognized over the employees' requisite
service period, generally the vesting period of the award.
INCOME TAXES
The Company accounts for income taxes to conform to the requirements of
SFAS No. 109, ACCOUNTING FOR INCOME TAXES. Under the provisions of SFAS 109, an
entity recognizes deferred tax assets and liabilities for future tax
consequences of events that have already been recognized in the Company's
financial statements or tax returns. The measurement of deferred tax assets and
liabilities is based on provisions of the enacted tax law. The effects of future
65
CNS RESPONSE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED
SEPTEMBER 30, 2007 AND 2006
changes in tax laws or rates are not anticipated. Valuation allowances are
established when necessary to reduce deferred tax assets to the amount expected
to be realized.
COMPREHENSIVE INCOME (LOSS)
SFAS No. 130, REPORTING COMPREHENSIVE INCOME, requires disclosure of
all components of comprehensive income (loss) on an annual and interim basis.
Comprehensive income (loss) is defined as the change in equity of a business
enterprise during a period from transactions and other events and circumstances
from non-owner sources. The Company's comprehensive income (loss) is the same as
its reported net income (loss) for the years ended September 30, 2007 and 2006.
INCOME (LOSS) PER SHARE
Basic and diluted net income (loss) per share has been computed using
the weighted average number of shares of common stock outstanding during the
period.
SEGMENT INFORMATION
The Company uses the management approach for determining which, if any,
of its products and services, locations, customers or management structures
constitute a reportable business segment. The management approach designates the
internal organization that is used by management for making operating decisions
and assessing performance as the source of any reportable segments. Management
uses one measurement of profitability and does not disaggregate its business for
internal reporting and therefore operates in a single business segment.
RECLASSIFICATIONS
Certain amounts in prior years have been reclassified to conform to
current year presentation. These reclassifications had no effect on previously
reported operating loss or net income.
RECENT ACCOUNTING PRONOUNCEMENTS
In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain
Hybrid Financial Instruments--an amendment of FASB Statements No. 133 and 140."
SFAS No. 155 eliminates the exemption from applying SFAS No. 133, "Accounting
for Derivative Instruments and Hedging Activities," to interests in securitized
financial assets so that similar instruments are accounted for similarly
regardless of the form of the instruments. SFAS No. 155 also allows issuers of
financial statements to elect fair value measurement at acquisition, at
issuance, or when a previously recognized financial instrument is subject to a
remeasurement (new basis) event, on an instrument-by-instrument basis, in cases
in which a derivative would otherwise have to be bifurcated. SFAS No. 155 is
effective for all financial instruments acquired or issued after the first
fiscal year beginning after September 15, 2006. The adoption of SFAS No. 155 did
not have a material impact on our consolidated financial statements.
In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing
of Financial Assets--an amendment of FASB Statement No. 140." SFAS No. 156
requires that all separately recognized servicing assets and servicing
liabilities be initially measured at fair value, if practicable. It also
permits, but does not require, the subsequent measurement of servicing assets
and servicing liabilities at fair value. An entity that uses derivative
instruments to mitigate the risks inherent in servicing assets and servicing
liabilities is required to account for those derivative instruments at fair
value. Under SFAS No. 156, an entity can elect subsequent fair value measurement
66
CNS RESPONSE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED
SEPTEMBER 30, 2007 AND 2006
of its servicing assets and servicing liabilities by class, thus simplifying its
accounting and providing for income statement recognition of the potential
offsetting changes in fair value of the servicing assets, servicing liabilities,
and related derivative instruments. An entity that elects to subsequently
measure servicing assets and servicing liabilities at fair value is expected to
recognize declines in fair value of the servicing assets and servicing
liabilities more consistently than by reporting other-than-temporary
impairments. SFAS No. 156 is effective for fiscal years beginning after
September 15, 2006. The adoption of SFAS No. 156 did not have a material impact
on our consolidated financial statements.
In June 2006, the FASB issued FASB Interpretation No. 48, or FIN 48,
"Accounting for Uncertainty in Income Taxes--an interpretation of FASB Statement
No. 109, Accounting for Income Taxes," which clarifies the accounting for
uncertainty in income taxes. FIN 48 prescribes a recognition threshold and
measurement attribute for the financial statement recognition and measurement of
a tax position taken or expected to be taken in a tax return. The Interpretation
requires that the Company recognize in the financial statements, the impact of a
tax position, if that position is more likely than not of being sustained on
audit, based on the technical merits of the position. FIN 48 also provides
guidance on derecognition, classification, interest and penalties, accounting in
interim periods and disclosure. The provisions of FIN 48 are effective beginning
in the fiscal year ending September 30, 2008 with the cumulative effect of the
change in accounting principle recorded as an adjustment to opening retained
earnings. We do not expect the adoption of FIN 48 to have a material impact on
our consolidated financial statements.
In September 2006, the SEC released Staff Accounting Bulletin No. 108,
"Considering the Effects of Prior Year Misstatements When Quantifying
Misstatements in Current Year Financial Statements" (SAB 108). SAB 108 provides
guidance on how the effects of the carryover or reversal of prior year financial
statement misstatements should be considered in quantifying a current year
misstatement. Prior practice allowed the evaluation of materiality on the basis
of the error quantified as the amount by which the current year income statement
was misstated (rollover method) or the cumulative error quantified as the
cumulative amount by which the current year balance sheet was misstated (iron
curtain method). The guidance provided in SAB 108 requires both methods to be
used in evaluating materiality. Immaterial prior year errors may be corrected
with the first filing of prior year financial statements after adoption. The
cumulative effect of the correction would be reflected in the opening balance
sheet with appropriate disclosure of the nature and amount of each individual
error corrected in the cumulative adjustment, as well as a disclosure of the
cause of the error and that the error had been deemed to be immaterial in the
past. The adoption of SAB 108 did not have a material impact on our consolidated
financial statements.
In September 2006, the FASB issued Statement of Financial Accounting
Standards No. 157, "Fair Value Measurements," or SFAS No. 157. This Statement
defines fair value as used in numerous accounting pronouncements, establishes a
framework for measuring fair value in generally accepted accounting principles,
or GAAP, and expands disclosure related to the use of fair value measures in
financial statements. SFAS No. 157 does not expand the use of fair value
measures in financial statements, but standardizes its definition and guidance
in GAAP. The Standard emphasizes that fair value is a market-based measurement
and not an entity-specific measurement based on an exchange transaction in which
the entity sells an asset or transfers a liability (exit price). SFAS No. 157
establishes a fair value hierarchy from observable market data as the highest
level to fair value based on an entity's own fair value assumptions as the
lowest level. The Statement is to be effective for our financial statements
issued in 2008; however, earlier application is encouraged. We believe that SFAS
No. 157 will not have a material impact on our consolidated financial
statements.
67
CNS RESPONSE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED
SEPTEMBER 30, 2007 AND 2006
In September 2006, the FASB issued SFAS No. 158, "Employers' Accounting
for Defined Benefit Pension and Other Postretirement Plans-an amendment of FASB
Statements No. 87, 88, 106, and 132(R)," which requires the recognition of the
over-funded or under-funded status of a defined benefit postretirement plan in a
company's balance sheet. This portion of the new guidance is effective on
December 31, 2006. Additionally, the pronouncement eliminates the option for
companies to use a measurement date prior to their fiscal year-end effective
December 31, 2008. SFAS No. 158 provides two approaches to transition to a
fiscal year-end measurement date, both of which are to be applied prospectively.
Under the first approach, plan assets are measured on September 30, 2007 and
then remeasured on January 1, 2008. Under the alternative approach, a 15-month
measurement will be determined on September 30, 2007 that will cover the period
until the fiscal year-end measurement is required on December 31, 2008. We do
not have any defined benefit pension or postretirement plans that are subject to
SFAS No. 158. As such, we do not expect the pronouncement to have a material
impact on our consolidated financial statements.
In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option
for Financial Assets and Financial Liabilities Including an Amendment of FASB
Statement No. 115," which permits companies to measure many financial
instruments and certain other assets and liabilities at fair value on an
instrument-by-instrument basis (the fair value option). Adoption of the standard
is optional and may be adopted beginning in the first quarter of 2007. We are
currently evaluating the possible impact of adopting SFAS No. 159 on our
consolidated financial statements.
In May 2007, Emerging Issues Task Force Issue No.07-4, "Application of
the Two-Class Method under FASB Statement No. 128, EARNINGS PER SHARE, to Master
Limited Partnerships" or EITF 07-4, was issued. The provisions of this standard
are effective for interim and annual reporting periods beginning after December
15, 2007. We do not expect the adoption of EITF 07-4 to have a material impact
on our consolidated financial statements.
4. LOANS TO RELATED PARTIES
From September 2006 through February 2007, CNS California loaned
certain officer, employees and a consultant $171,800 under notes bearing
interest at 5.26% per annum, compounded annually, and requiring payment on or
after the earlier of (i) the date that is two years following the date of the
note, and (ii) a demand by CNS California following the date on which CNS
California has received an aggregate of $5,000,000 from the sale(s) of its
capital stock provided the assigned value (as defined) of the stock at the time
of the demand is more than $1. The notes provided that repayment of the notes
could be made in one of the following ways, or in combination of both:
(a) in cash, or
(b) by tendering Common Stock of CNS California owned by
the borrower, with an aggregate Assigned Value (as
defined) equal to the principal and accrued interest
on the notes.
Pursuant to the abovementioned terms and the terms of the merger
described in Note 2 above, the Company demanded payment of all such notes upon
the completion of the merger and private placement in which the Company raised
approximately $7,805,000. The officer who owed the Company $93,900, including
interest, repaid the loan by tendering 78,219 shares of the Company's Common
Stock to the Company. Certain other employees and consultant repaid their loans
by tendering an aggregate of 68,449 shares of the Company's common stock to the
Company. None of the aforementioned notes remained outstanding as of September
30, 2007.
68
CNS RESPONSE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED
SEPTEMBER 30, 2007 AND 2006
5. TROUBLED DEBT RESTRUCTURING--DEFERRED COMPENSATION AND ACCRUED
CONSULTING FEES
At September 30, 2005, CNS California owed certain employees and
consultants deferred compensation, accrued consulting fees, other
compensation-related liabilities and accrued interest thereon aggregating
$2,480,900. Due to financial difficulties experienced by CNS California, in
August and September 2006, certain employees and consultants to whom CNS
California owed an aggregate of $3,199,400 forgave approximately 80% of the debt
and accepted 5,834,117 shares of the Company's common stock (of which 182,952
were restricted), and warrants and options to purchase an aggregate of 270,638
shares of CNS California's common stock at an exercise price of $0.59 per share
in full settlement of CNS California's remaining obligations. On the date of
transfer, the amounts due to employees and consultants exceeded the aggregate
estimated fair value (based on an estimate of $0.12 per share) of the shares,
warrants and options transferred by $2,467,700. The gain attributable to
employees considered related parties of $1,388,000 has been treated as a capital
transaction and included in additional paid-in capital in the accompanying
consolidated financial statements. The remaining gain of $1,079,700 has been
recorded as a gain on troubled debt restructuring in the accompanying
consolidated financial statements.
6. CONVERTIBLE PROMISSORY NOTES
CNS California has issued convertible promissory notes with detachable
warrants from time to time to fund its operations. The notes bear interest at 8%
per year, compounded annually, and are payable on demand. The terms of the notes
provide for the (i) conversion of principal and accrued interest into the same
type of securities issued by CNS California upon a qualified institutional
financing, the amount of which financing varies between notes and ranges from $1
to $4 million, and (ii) conversion price to be equal to the same price as the
shares sold in the financing. The notes provide for an aggregate of $2,196,000
in principal to convert automatically and $920,700 to convert at the note
holders' options based upon certain financing requirements (as defined).
Due to the variable conversion price, the notes were potentially
convertible into an unlimited number of common shares. Accordingly, CNS
California has accounted for the notes under SFAS 133 and EITF 00-19 which
require the beneficial conversion feature to be treated as an embedded
derivative, recording a liability equal to the estimated fair value of the
conversion option. In addition, all non-employee warrants that are exercisable
during the period the notes were potentially convertible into an unlimited
number of common shares are required to be recorded as liabilities at their fair
value. The fair value of the beneficial conversion feature and the warrants were
estimated using the Black-Scholes option pricing model. The fair value of the
beneficial conversion feature and the warrants and options was recomputed each
reporting period with the change in fair value recorded as a gain or loss on
derivative instruments.
In August 2006, CNS California amended its Articles of Incorporation
whereby the number of authorized shares was increased to 100,000,000, of which
80,000,000 were designated as common shares and 20,000,000 were designated as
preferred shares.
Since at September 30, 2006, the number of authorized shares was
sufficient to accommodate the conversion of all notes, related accrued interest
and outstanding warrants, CNS California has reclassified the derivative
instrument liability with an estimated fair value of $343,100 to equity in the
accompanying consolidated financial statements.
69
CNS RESPONSE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED
SEPTEMBER 30, 2007 AND 2006
In October 2006, CNS California and the note holders of certain of the
convertible promissory notes converted promissory notes with an aggregate
outstanding balance of $3,061,700 and related accrued and unpaid interest of
$1,005,400 at September 30, 2006 into 5,993,515 shares of CNS California's
Series A Preferred Stock. In addition, the exercise price of warrants to
purchase 1,062,116 shares of the Company's common stock was changed to $0.59 per
share. The preferred shares were converted into 5,993,515 shares of the
Company's common stock upon the completion of the merger described in Note 2.
7. NOTE PAYABLE TO NUPHARM DATABASE, LLC
In connection with the January 2000 Asset Purchase Agreement between
CNS California and NuPharm Database, LLC (NuPharm) providing for the purchase of
a database and the assumption of certain NuPharm liabilities, CNS California
issued a subordinated note payable to NuPharm in the amount of $299,900 bearing
interest at 8% per year and due on March 15, 2004 and a warrant to purchase
2,800,000 shares of CNS California's common stock at $0.01 per share. The
warrant was not exercised before expiring in 2005.
In October 2006, CNS California and NuPharm agreed to exchange the note
and the related accrued interest for a 5% note in the principal amount of
$287,400, representing the outstanding principal at September 30, 2006, and
warrants to purchase 2,800,000 shares of the CNS California's common stock at
$0.01 per share. The note was due and payable on demand five years from the date
of issuance, could be prepaid by the Company at any time without penalties and
was convertible into shares of common stock of CNS California upon the
completion of a financing (as defined) at a price per share of the common stock
issued in such financing. The warrant was exercised in October 2006. CNS
California valued the warrant at $309,500 using the Black-Scholes model and
recorded the excess of the value of the warrant over the forgiven accrued
interest of $119,800 as a prepaid asset. The excess was being amortized as
interest expense over a period of one year, the expected term of the note when
it was issued.
Pursuant to the abovementioned terms, the note payable to NuPharm and
accrued interest thereon were converted into 244,509 shares of the Company's
Common Stock upon the completion of the merger and private placement described
in Note 2 above. Upon conversion, the entire balance of the unamortized prepaid
interest was charged to interest expense.
8. STOCKHOLDERS' EQUITY
COMMON AND PREFERRED STOCK
The Company is authorized to issue 750,000,000 shares of common stock.
CNS California is authorized to issue 100,000,000 shares of two classes
of stock, 80,000,000 of which was designated as common shares and 20,000,000 of
which was designated as preferred shares.
As described in Note 5 above, during August and September 2006, CNS
California issued 5,834,117 shares of its common stock with a fair value of
$700,800 in connection with the restructuring of certain debt. These common
shares were converted into 5,834,117 shares of the Company's common stock upon
the completion of the merger described in Note 2 above.
70
CNS RESPONSE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED
SEPTEMBER 30, 2007 AND 2006
As described in Note 7 above, in October 2006, NuPharm exercised the
warrant to purchase 2,800,000 shares of CNS California's common stock at a price
of $0.01 per share. These common shares were converted into 2,800,000 shares of
the Company's common stock upon the completion of the merger described in Note 2
above.
As described in Note 6 above, in October 2006, CNS California and the
note holders of certain of the convertible promissory notes converted promissory
notes with an aggregate outstanding balance of $3,061,700 and related accrued
and unpaid interest of $1,005,400 at September 30, 2006 into 5,993,515 shares of
the CNS California's Series A Preferred Stock. These preferred shares were
converted into 5,993,515 shares of the Company's common stock upon the
completion of the merger described in Note 2 above.
In October, 2006, CNS California sold 1,905,978 Units in a private
financing resulting in net proceeds of $1,877,400. Each Unit consists of one
share of Series B Preferred Stock and 5-year warrants to purchase .6 shares of
the CNS California's common stock at $1.51 per share. Holders of the Series B
Preferred Stock were entitled to receive non-cumulative dividends at an annual
rate of 4% when, as and if declared by the Board. Each share of the Series B
Preferred Stock initially converts into one share of the Company's Common Stock
at any time at the option of the holder. However, each share of Series B
Preferred Stock will automatically convert into Common Stock at the then
applicable conversion rate in the event of (i) the sale of $5,000,000 or more of
Common Stock or units consisting of Common Stock and warrants in one or more
related transactions; (ii) the closing of an underwritten public offering with a
price equal or greater than $1.21 per share and net proceeds to CNS California
of not less than $5,000,000, or (iii) upon the written consent of the holders of
the majority of the Series A Preferred (see Note 6) in the case of conversion of
the Series A Preferred or the Series B Preferred in the case of conversion of
the Series B Preferred. All shares of preferred stock were converted into
1,905,978 shares of common stock concurrently with the completion of the Merger.
As described in Note 2 above, in March and May 2007, the Company sold
6,504,758 Investment Units, at $1.20 per Investment Unit. Each Investment Unit
consists of one share of Company common stock, and a five year non-callable
warrant to purchase three-tenths of one share of the Company common stock at an
exercise price of $1.80 per share.
As described in Note 2 above, as partial consideration for services
rendered further to the private placement, the Company's placement agent was
issued 83,333 shares of the Company's common stock.
As described in Note 7 above, the note payable to NuPharm and accrued
interest thereon were converted into 244,509 shares of the Company's Common
Stock upon the completion of the merger and private placement described in Note
2 above.
As described in Note 4 above, an officer and certain employees and
consultants repaid their loans to the Company by tendering 146,668 shares of the
Company's common stock.
STOCK-OPTION PLAN
On September 27, 2004, the Company adopted the 2004 Stock Option Plan
pursuant to which there were 15,000,000 shares of common stock reserved for
issuance and under which the Company may issue incentive stock options,
nonqualified stock options, stock awards and stock bonuses to officers,
directors and employees. The option price for each share of stock subject to an
option was to be (i) no less than the fair market value of a share of stock on
the date the option is granted, if the option is an ISO, or (ii) no less than
85% of the fair market value of the stock on the date the option is granted, if
71
CNS RESPONSE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED
SEPTEMBER 30, 2007 AND 2006
the option is a NSO ; provided, however, if the option was an ISO granted to an
eligible employee who is a 10% shareholder, the option price for each share of
stock subject to such ISO was to be no less than 110% of the fair market value
of a share of stock on the date such ISO is granted. Stock options were to have
a maximum term of ten years from the date of grant, except for ISOs granted to
an eligible employee who is a 10% shareholder, in which case the maximum term
was to be five years from the date of grant. ISOs could be granted only to
eligible employees. At September 30, 2007, there were no options outstanding
under this plan.
In connection with the Merger described in Note 2, the Company assumed
the CNS California stock option plan described below and all of the options
granted thereunder at the same price and terms.
On August 3, 2006, CNS California adopted the CNS California 2006 Stock
Incentive Plan (the "2006 Plan"). The 2006 Plan provides for the issuance of
awards in the form of restricted shares, stock options (which may constitute
incentive stock options(ISO) or nonstatutory stock options (NSO)), stock
appreciation rights and stock unit grants to eligible employees, directors and
consultants and is administered by the board of directors. A total of 10 million
shares of stock are reserved for issuance under the 2006 Plan. As of September
30, 2007, there were 7,436,703 options and 183,937 restricted shares outstanding
under the 2006 Plan and 2,379,360 shares available for issuance of awards.
The 2006 Plan provides that in any calendar year, no eligible employee
or director shall be granted an award to purchase more than 3 million shares of
stock. The option price for each share of stock subject to an option shall be
(i) no less than the fair market value of a share of stock on the date the
option is granted, if the option is an ISO, or (ii) no less than 85% of the fair
market value of the stock on the date the option is granted, if the option is a
NSO ; provided, however, if the option is an ISO granted to an eligible employee
who is a 10% shareholder, the option price for each share of stock subject to
such ISO shall be no less than 110% of the fair market value of a share of stock
on the date such ISO is granted. Stock options have a maximum term of ten years
from the date of grant, except for ISOs granted to an eligible employee who is a
10% shareholder, in which case the maximum term is five years from the date of
grant. ISOs may be granted only to eligible employees.
The Company has adopted SFAS No. 123R (revised 2004), "Share-Based
Payment", and related interpretations. Under SFAS No. 123R, share-based
compensation cost is measured at the grant date based on the calculated fair
value of the award. The Company estimates the fair value of each option on the
grant date using the Black-Scholes model. The following assumptions were made in
estimating the fair value:
Options granted in Options granted in Options granted in
fiscal 2006 November 2006 August 2007
- ------------------------ ------------------ ------------------ ------------------
Dividend yield 0% 0% 0%
- ------------------------ ------------------ ------------------ ------------------
Risk-free interest rate 5.46% 5.00% 4.72%
- ------------------------ ------------------ ------------------ ------------------
Expected volatility 100% 100% 91%
- ------------------------ ------------------ ------------------ ------------------
Expected life 5 years 10 years 5 years
- ------------------------ ------------------ ------------------ ------------------
72
CNS RESPONSE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED
SEPTEMBER 30, 2007 AND 2006
The expense is recognized over the employees' requisite service period,
generally the vesting period of the award. Stock-based compensation expense
included in the accompanying statements of operations for the years ended
September 30, 2007 and 2006 is as follows:
For the fiscal year
ended September 30,
------------------------
2007 2006
- ---------------------------------------------------- ---------- ----------
Operations ......................................... $ 20,100 $ 22,000
Research and development ........................... 212,000 141,000
Sales and marketing ................................ -- 8,300
General and administrative ......................... 417,000 198,600
---------- ----------
Total ......................... $ 649,100 $ 369,900
========== ==========
Total unrecognized compensation as of September 30, 2007 amounted to
$1,980,300.
A summary of stock option activity is as follows:
Weighted
Average
Number of Exercise
Shares Price
--------- ----------
Outstanding at October 1, 2005
Granted .......................................... 4,000,403 $ 0.13
Exercised ........................................ -- --
Forfeited ........................................ -- --
Outstanding at September 30, 2006 ..................... 4,000,403 $ 0.13
Granted .......................................... 3,436,300 $ 1.07
Exercised ........................................ -- --
Forfeited ........................................ -- --
Outstanding at September 30,2007 ...................... 7,436,703 $ 0.57
Weighted average fair value of options granted during:
Year ended September 30, 2006 .................... $ 0.09
Year ended September 30, 2007 .................... $ 0.77
Following is a summary of the status of options outstanding at
September 30, 2007:
Weighted Average
Remaining Weighted Average
Exercise Price Number of Shares Contractual Life Exercise Price
$0.12 859,270 10 years $0.12
$0.132 3,112,545 7 years $0.132
$0.30 135,700 10 years $0.30
$0.59 28,588 10 years $0.59
$1.09 2,966,989 10 years $1.09
$1.20 333,611 5 years $1.20
--------- ------
Total 7,436,703 $0.57
========= ======
73
CNS RESPONSE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED
SEPTEMBER 30, 2007 AND 2006
Following is a summary of the status of options exercisable at
September 30, 2007:
Weighted Average
Remaining Weighted Average
Exercise Price Number of Shares Contractual Life Exercise Price
$0.12 849,270 9 years $0.12
$0.132 3,112,545 6 years $0.132
$0.30 73,825 9 years $0.30
$0.59 28,588 9 years $0.59
$1.09 560,583 10 years $1.09
$1.20 83,403 5 years $1.20
--------- -----
4,708,214 $0.27
========= =====
WARRANTS TO PURCHASE COMMON STOCK
At September 30, 2006, there were warrants outstanding to purchase
3,115,154 shares of the Company's common stock at exercise prices ranging from
$0.01 to $0.59 with a weighted average exercise price of $0.28. The warrants
expire at various times through 2016 and are still outstanding as of September
30, 2007.
As described in Note 6, these warrants were initially recorded as a
liability at their fair value. Fair value was computed using the Black-Scholes
pricing model at each reporting period with the change in fair value recorded as
a gain or loss on derivative instruments. For the year ended September 30, 2006,
the Company recorded a gain on derivative instruments amounting to $1,178,500.
As of September 30, 2006, the warrants were reclassified to equity since the
number of authorized shares was increased to accommodate the exercise of all
warrants and settlement of warrants was within the control of the Company.
During the year ended September 30, 2007, the following additional
3,784,199 warrants were granted and are outstanding as of such date:
Warrants to Purchase Exercise Price Issued in Connection With:
1,143,587 shares $1.51 Private placement described in Note 2
7,921 shares $1.01 To placement agent for private placement
described in Note 2
4,752 shares $1.812 To placement agent for private placement
described in Note 2
1,951,445 shares $1.80 Private placement completed immediately
after the merger and described in Note 2
520,380 shares $1.44 To placement agent for private placement
completed immediately after the merger
and described in Note 2
156,114 shares $1.80 To placement agent for private placement
completed immediately after the merger
and described in Note 2
74
CNS RESPONSE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED
SEPTEMBER 30, 2007 AND 2006
As described in Note 2, the warrants to purchase 2,107,559 shares of
common stock at $1.80 per share and the warrants to purchase 520,380 shares at
$1.44 per share were initially recorded as a liability at their fair value. Fair
value was computed using the Black-Scholes pricing model. As of June 22, 2007,
the common shares underlying the warrants were registered satisfying the warrant
liability. As of such date, the value of the warrants had not changed and thus
the recorded amount was reclassified to Stockholders' Equity.
9. INCOME TAXES
The Company accounts for income taxes under the liability method.
Deferred tax assets and liabilities are determined based on differences between
financial reporting and tax bases of assets and liabilities, and are measured
using the enacted tax rates and laws that will be in effect when the differences
are expected to reverse. We provide a valuation allowance to reduce our deferred
tax assets to their estimated realizable value.
Reconciliations of the provision (benefit) for income taxes to the
amount compiled by applying the statutory federal income tax rate to profit
(loss) before income taxes is as follows for each of the years ended September
30:
2007 2006
------ ------
Federal income tax (benefit) at statutory rates ........... (34)% 34%
Non-recognizable (gains) losses from derivative instruments 0% (483)%
Gain from troubled debt restructured with related parties . 0% 566%
Stock-based compensation .................................. 17% 447%
Non deductible interest expense ........................... 6% --
Change in valuation allowance ............................. 11% (564)%
State income taxes ........................................ 0% 1%
Income tax provision ...................................... 0% 1%
Temporary differences between the financial statement carrying amounts
and tax bases of assets and liabilities that give rise to significant portions
of deferred taxes relate to the following at September 30, 2007 and 2006:
2007 2006
----------- -----------
Deferred income tax assets:
Net operating loss carryforward .......... $ 3,257,800 $ 1,851,000
Deferred interest, consulting and
compensation liabilities .............. 14,300 462,500
Amortization ............................. 223,300 215,400
----------- -----------
3,495,400 2,528,900
Deferred income tax liabilities--other ....... (12,100) (34,600)
----------- -----------
Deferred income tax asset--net before
valuation allowance ....................... 3,483,300 2,494,300
Valuation allowance .......................... (3,483,300) (2,494,300)
----------- -----------
Deferred income tax asset--net ............... $ -- $ --
=========== ===========
75
CNS RESPONSE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED
SEPTEMBER 30, 2007 AND 2006
Current and non-current deferred taxes have been recorded on a net
basis in the accompanying balance sheet. As of September 30, 2007 we have net
operating loss carryforwards of approximately $8.1 million. The net operating
loss carryforwards expire by 2027. Utilization of net operating losses and
capital loss carryforwards may be subject to the limitations imposed by Section
382 of the Internal Revenue Code. The Company has placed a valuation allowance
against the deferred tax assets in excess of deferred tax liabilities due to the
uncertainty surrounding the realization of such excess tax assets. Management
periodically evaluates the recoverability of the deferred tax assets and the
level of the valuation allowance. At such time as it is determined that it is
more likely than not that the deferred tax assets are realizable, the valuation
allowance will be reduced accordingly.
10. EARNINGS PER SHARE
In accordance with SFAS 128, "Computation of Earnings Per Share," basic
net income (loss) per share is computed by dividing the net income (loss) to
common stockholders for the period by the weighted average number of common
shares outstanding during the period. Diluted net income (loss) per share is
computed by dividing the net income (loss) for the period by the weighted
average number of common and dilutive common equivalent shares outstanding
during the period. For the year ended September 30, 2007, the Company has
excluded all common equivalent shares from the calculation of diluted net loss
per share as such securities are anti-dilutive. The number of dilutive common
equivalent shares for the year ended September 30, 2006 has been determined in
accordance with the treasury-stock method.
A summary of the net income (loss) and shares used to compute net
income (loss) per share for the years ended September 30, 2007 and 2006 is as
follows:
2007 2006
------------ ------------
Net income (loss) for computation of
basic net income (loss) per share ......... $ (3,279,100) $ 82,600
Add interest expense relating to
convertible debt ........................... -- 297,800
------------ ------------
Net income (loss) for computation of
dilutive net income (loss) per share ....... $ (3,279,100) $ 380,400
============ ============
Basic net income (loss) per share ............. $ (0.17) $ 0.03
============ ============
Diluted net income (loss) per share ........... $ (0.17) $ 0.00
============ ============
Basic weighted average shares outstanding ..... 18,778,077 2,836,216
Dilutive common equivalent shares ............. -- 30,533,699
------------ ------------
Diluted weighted average common shares ........ 18,778,077 33,369,915
============ ============
Anti-dilutive common equivalent shares
not included in the computation of
dilutive net loss per share:
Convertible debt ...................... 6,283,989 323,086,919
Warrants .............................. 5,372,566 2,496,063
Options ............................... 4,598,260 --
Preferred Stock ....................... 767,324 --
76
CNS RESPONSE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED
SEPTEMBER 30, 2007 AND 2006
11. COMMITMENTS AND CONTINGENT LIABILITIES
LITIGATION
From time to time the Company is subject to legal proceedings and
claims, which arise in the ordinary course of its business. The Company believes
that although there can be no assurances as to the disposition of the
proceedings, based upon information available to the Company at this time, the
expected outcome of these matters would not have a material impact on the
Company's results of operations or financial condition.
RENT EXPENSE
The Company leases its headquarters under an operating lease expiring
in November 2007 and requiring monthly rentals of $3,500. Total rental expense
for the years ended September 30, 2007 and 2006 was $39,100 and $8,300,
respectively.
In November 2007, the Company entered into a new one-year lease for its
headquarters at the same location expiring in November 2008 and requiring
monthly rentals of $3,600.
12. SIGNIFICANT CUSTOMERS
For the year ended September 30, 2007, four customers accounted for 58%
of the Company's revenue and 48% of accounts receivable at September 30, 2007.
For the year ended September 30, 2006, five customers accounted for 75%
of the Company's revenue and 29% of accounts receivable at September 30, 2006.
13. RELATED PARTY TRANSACTIONS
Convertible promissory notes and accrued interest to related parties
amounted to $1,768,300 and $414,300, respectively, at September 30, 2006 and
were repaid in October 2006 as described in Note 6 above. Interest expense to
related parties amounted to $112,900 for the year ended September 30, 2006.
Consulting expenses to a director amounted to $10,000 for the year
ended September 30, 2006.
As described in Note 4, in August 2006 CNS California and two of its
employees, who were significant shareholders, entered into an agreement whereby
the two employees received 4,362,652 shares of the Company's common stock,
warrants to purchase 242,050 shares of the Company's common stock at $0.59 per
share and options to purchase 28,588 shares of the Company's common stock at
$0.59 per share in full settlement of debt aggregating $1,943,100. On the date
of transfer, the amounts due to these employees exceeded the aggregate fair
value (based on an estimate of $0.12 per share) of the shares, warrants and
options transferred by $1,388,000. The gain has been treated as a capital
transaction and included in additional paid-in capital in the accompanying
consolidated financial statements.
77
CNS RESPONSE, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED
SEPTEMBER 30, 2007 AND 2006
14. SUBSEQUENT EVENTS
On October 1, 2007, the Company entered into an employment agreement
with George Carpenter pursuant to which Mr. Carpenter will serve as our
President commencing on October 1, 2007. During the period of his employment,
Mr. Carpenter will receive a base salary of no less than $180,000 per annum,
which is subject to upward adjustment at the discretion of the Chief Executive
Officer or the Board of Directors of our Company. In addition, Mr. Carpenter was
granted an option to purchase 968,875 shares of our common stock at an exercise
price of $0.89 per share pursuant to the Company's 2006 Stock Incentive Plan,
which will vest as follows: 121,109 shares will vest on the grant date and the
remaining 847,766 shares will vest in equal monthly installments of
approximately 20,185 shares over forty-two months beginning seven months after
the commencement of Mr. Carpenter's employment.
On October 24, 2007, the Company signed a letter of intent to acquire
the NeuroTherapy Clinic (NTC), a psychiatric clinic in Denver, Colorado. NTC is
a center for highly-advanced testing and treatment of neuropsychiatric problems,
including learning, attentional and behavior challenges, mild head injuries, as
well as depression, anxiety, bipolar and all other common psychiatric disorders.
78
ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
ITEM 8A. CONTROLS AND PROCEDURES
As of September 30, 2007, the end of the period covered by this Report,
we conducted an evaluation, under the supervision and with the participation of
our Chief Executive Officer and Chief Financial Officer, of our disclosure
controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e)) under the
Securities Exchange Act of 1934, as amended (the "Exchange Act"). Based on this
evaluation, our Chief Executive Officer and Chief Financial Officer concluded
that, as of September 30, 2007, our disclosure controls and procedures were
effective.
During the quarter ended September 30, 2007, there were no changes in
our internal control over financial reporting (as defined in Rule 13a-15(f)
under the Exchange Act) that have materially affected, or are reasonably likely
to materially affect, our internal control over financial reporting.
ITEM 8B. OTHER INFORMATION
None.
79
PART III
ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS, CONTROL PERSONS AND CORPORATE
GOVERNANCE; COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT
The information required by this item is incorporated by reference from
the information contained in our Definitive Proxy Statement to be filed with the
Securities and Exchange Commission ("SEC") no later than January 28, 2008.
ITEM 10. EXECUTIVE COMPENSATION
The information required by this item is incorporated by reference from
the information contained in our Definitive Proxy Statement to be filed with the
Securities and Exchange Commission ("SEC") no later than January 28, 2008.
ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
The information required by this item is incorporated by reference from
the information contained in our Definitive Proxy Statement to be filed with the
Securities and Exchange Commission ("SEC") no later than January 28, 2008.
ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
INDEPENDENCE
The information required by this item is incorporated by reference from
the information contained in our Definitive Proxy Statement to be filed with the
Securities and Exchange Commission ("SEC") no later than January 28, 2008.
ITEM 13. EXHIBITS
See attached Exhibit Index.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by this item is incorporated by reference from
the information contained in our Definitive Proxy Statement to be filed with the
Securities and Exchange Commission ("SEC") no later than January 28, 2008.
80
SIGNATURES
In accordance with Section 13 or 15(d) of the Exchange Act, the
Registrant caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.
CNS RESPONSE, INC.
By: /s/ Leonard J. Brandt
--------------------------------
Leonard J. Brandt
Chief Executive Officer
Date: December 7, 2007
POWER OF ATTORNEY
The undersigned directors and officers of CNS Response, Inc. do hereby
constitute and appoint Leonard J. Brandt and Horace Hertz with full power of
substitution and resubstitution, as their true and lawful attorney and agent, to
do any and all acts and things in their name and behalf in their capacities as
directors and officers and to execute any and all instruments for them and in
their names in the capacities indicated below, which said attorney and agent,
may deem necessary or advisable to enable said corporation to comply with the
Securities Exchange Act of 1934, as amended and any rules, regulations and
requirements of the Securities and Exchange Commission, in connection with this
Annual Report on Form 10-KSB, including specifically but without limitation,
power and authority to sign for them or any of them in their names in the
capacities indicated below, any and all amendments (including post-effective
amendments) hereto, and they do hereby ratify and confirm all that said
attorneys and agents, or either of them, shall do or cause to be done by virtue
hereof.
In accordance with the Exchange Act, this report has been signed below
by the following persons on behalf of the Registrant and in the capacities and
on the dates indicated..
SIGNATURE TITLE DATE
--------- ----- ----
/s/ Leonard J. Brandt Chief Executive Officer December 7, 2007
- -------------------------- (Principal Executive Officer)
Leonard J. Brandt
/s/ George Carpenter President December 7, 2007
- --------------------------
George Carpenter
/s/ Horace Hertz Chief Financial Officer December 7, 2007
- -------------------------- (Principal Financial and
Horace Hertz Accounting Officer)
Director December _, 2007
- --------------------------
David B. Jones
/s/ Jerome Vaccaro, M.D. Director December 7, 2007
- --------------------------
Jerome Vaccaro, M.D.
/s/ Kevin R. Keating Director December 7, 2007
- --------------------------
Kevin R. Keating
/s/ Henry T. Harbin, M.D. Director December 7, 2007
- --------------------------
Henry T. Harbin, M. D.
81
EXHIBIT INDEX
EXHIBIT NUMBER EXHIBIT TITLE
2.1 Agreement and Plan of Merger between Strativation, Inc., CNS
Merger Corporation and CNS Response, Inc. dated as of January 16,
2007. Incorporated by reference to Exhibit No. 10.1 to the
Registrant's Current Report on Form 8-K (File No. 000-26285) filed
with the Commission on January 22, 2007.
2.2 Amendment No. 1 to Agreement and Plan of Merger by and among
Strativation, Inc., CNS Merger Corporation, and CNS Response, Inc.
dated as of February 28, 2007. Incorporated by reference to
Exhibit No. 10.1 to the Registrant's Current Report on Form 8-K
(File No. 000-26285) filed with the Commission on March 1, 2007.
3.1.1 Certificate of Incorporation, dated March 17, 1987. Incorporated
by reference to Exhibit No. 3(i) to the Registrant's Form 10-SB
(File No. 000-26285) filed with the Commission on June 7, 1999.
3.1.2 Certificate of Amendment of Certificate of Incorporation, dated
June 1, 2004. Incorporated by reference to Exhibit 16 to the
Registrant's Current Report on Form 8-K (File No. 000-26285) filed
with the Commission on June 8, 2004.
3.1.3 Certificate of Amendment of Certificate of Incorporation, dated
August 2, 2004. Incorporated by reference to Exhibit 16 to the
Registrant's Current Report on Form 8-K (File No. 000-26285) filed
with the Commission on August 5, 2004.
3.1.4 Certificate of Ownership and Merger Merging CNS Response, Inc., a
Delaware corporation, with and into Strativation, Inc., a Delaware
corporation, dated March 7, 2007. Incorporated by reference to the
Registrant's Current Report on Form 8-K (File No. 000-26285) filed
with the Commission on March 13, 2007.
3.2 Bylaws. Incorporated by reference to Exhibit No. 3(ii) to the
Registrant's Form 10-SB (File No. 000-26285) filed with the
Commission on June 7, 1999.
4.1 2006 CNS Response, Inc. Option Plan. Incorporated by reference to
Exhibit 4.1 to the Registrant's Current Report on Form 10-QSB
(File No. 000-26285) filed with the Commission on May 15, 2007. *
4.2 Form of Warrant issued to Investors in Private Placement.
Incorporated by reference to Exhibit 4.1 to the Registrant's
Current Report on Form 8-K (File No. 000-26285) filed with the
Commission on March 13, 2007.
10.1 Stock Purchase Agreement by and among the Registrant and George
LeFevre, Scott Absher, and the purchasers signatory thereto dated
July 18, 2006. Incorporated by reference from the Registrant's
Current Report on Form 8-K (File No. 000-26285) filed with the
Commission on July 24, 2006.
10.2 Amended and Restated Shares for Debt Agreement, dated January 16,
2007 by and between the Registrant and Richardson & Patel LLP
2007. Incorporated by reference to Exhibit No. 10.1 to the
Registrant's Current Report on Form 8-K (File No. 000-26285) filed
with the Commission on January 16, 2007.
10.3 Amended and Restated Registration Rights Agreement, dated January
16, 2007 by and among the Registrant and the stockholders
signatory thereto. Incorporated by reference to Exhibit No. 10.2
to the Registrant's Current Report on Form 8-K (File No.
000-26285) filed with the Commission on January 16, 2007.
82
10.4 Form of Subscription Agreement between the Registrant and certain
investors, dated March 7, 2007. Incorporated by reference to
Exhibit 10.4 to the Registrant's Current Report on Form 8-K (File
No. 000-26285) filed with the Commission on March 13, 2007.
10.5 Form of Indemnification Agreement by and among the Registrant, CNS
Response, Inc., a California corporation, and certain individuals,
dated March 7, 2007. Incorporated by reference to Exhibit 10.5 to
the Registrant's Current Report on Form 8-K (File No. 000-26285)
filed with the Commission on March 13, 2007.
10.6 Form of Registration Rights Agreement by and among the Registrant
and certain Investors signatory thereto dated March 7, 2007.
Incorporated by reference to Exhibit 10.6 to the Registrant's
Current Report on Form 8-K (File No. 000-26285) filed with the
Commission on March 13, 2007.
10.7 Form of Registration Rights Agreement by and among the Registrant
and certain stockholders of the Company signatory thereto dated
March 7, 2007. Incorporated by reference to Exhibit 10.7 to the
Registrant's Current Report on Form 8-K (File No. 000-26285) filed
with the Commission on March 13, 2007.
10.8 Employment Agreement by and between the Registrant and George
Carpenter dated October 1, 2007. Incorporated by reference to
Exhibit 10.1 to the Registrant's Current Report on Form 8-K (File
No. 000-26285) filed with the Commission on October 3, 2007.*
21.1 Subsidiaries of the Registrant. Incorporated by reference to
Exhibit 21 to the Registrant's Current Report on Form 8-K (File
No. 000-26285) filed with the Commission on March 13, 2007.
24.1 Power of Attorney (included as part of the Signature Page).
31.1 Certification by Chief Executive Officer pursuant to Rule
13a-14(a) or 15d-14(a) under the Securities Exchange Act of 1934,
as amended.
31.2 Certification by Chief Financial Officer pursuant to Rule
13a-14(a) or 15d-14(a) under the Securities Exchange Act of 1934,
as amended.
32.1 Certification of Chief Executive Officer and Chief Financial
Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
* Management contract or compensatory plan or arrangement.
83