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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-QSB
[X] Quarterly Report Under Section 13 or 15(d) of the Securities Exchange
Act of 1934
For the quarterly period ended June 30, 2008
[_] Transition Report Under Section 13 or 15(d) of the Securities Exchange
Act of 1934
For the transition period from ______________ to __________________.
Commission file number 0-26285
CNS RESPONSE, INC.
(Exact Name of Small Business Issuer as Specified in its Charter)
DELAWARE 87-0419387
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
2755 BRISTOL STREET, SUITE 285
COSTA MESA, CA 92626
(Address of principal executive offices)
(714) 545-3288
(Issuer's telephone number)
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 [_]
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act). Yes [_] No [X]
As of August 14, 2008, the issuer had 25,299,547 shares of common
stock, par value $.001 per share, issued and outstanding.
Transitional Small Business Disclosure Format: Yes [_] No [X]
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CNS RESPONSE, INC.
INDEX TO FORM 10-QSB
PAGE
----
PART I FINANCIAL INFORMATION................................................3
Item 1. Consolidated Financial Statements....................................3
Unaudited Condensed Consolidated Statements of Operations
for the three and nine months ended June 30, 2008 and 2007...........3
Condensed Consolidated Balance Sheets as of June 30, 2008
(unaudited) and September 30, 2007...................................4
Unaudited Condensed Consolidated Statements of Cash Flows
for the nine months ended June 30, 2008 and 2007.....................5
Unaudited Condensed Consolidated Statements of Stockholders'
Equity and Comprehensive Income (Loss) for the nine months
ended June 30, 2008 and 2007.........................................6
Notes to Unaudited Condensed Consolidated Financial Statements.......7
Item 2. Management's Discussion and Analysis or Plan of Operation...........20
Item 3. Controls and Procedures.............................................51
PART II OTHER INFORMATION...................................................52
Item 5. Other Information...................................................52
Item 6. Exhibits............................................................52
2
PART I
FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CNS RESPONSE, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
THREE MONTHS ENDED JUNE 30, NINE MONTHS ENDED JUNE 30,
------------ ------------ ------------ ------------
2008 2007 2008 2007
------------ ------------ ------------ ------------
REVENUES:
Referenced Laboratory .................. $ 36,500 $ 69,800 $ 131,000 $ 182,500
Clinic ................................. 196,400 -- 377,000 --
------------ ------------ ------------ ------------
Total revenues ....................... 232,900 69,800 508,000 182,500
------------ ------------ ------------ ------------
OPERATING EXPENSES:
Cost of revenues- Referenced Laboratory
(including amortization expense of $0
for the three months ended June 30,
2008 and 2007, and $0 and $19,900 for
the nine months ended June 30, 2008 and
2007, respectively) ................... 34,200 38,200 131,600 114,800
Research and development ................ 682,400 322,100 1,589,000 773,300
Sales and marketing ..................... 348,200 33,700 595,000 81,200
General and administrative .............. 776,400 233,700 2,200,800 1,108,400
------------ ------------ ------------ ------------
Total operating expenses .............. 1,841,200 627,700 4,516,400 2,077,700
------------ ------------ ------------ ------------
OPERATING LOSS ............................ (1,608,300) (557,900) (4,008,400) (1,895,200)
------------ ------------ ------------ ------------
OTHER INCOME (EXPENSE):
Interest income (expense), net .......... 13,000 22,600 97,200 (170,600)
Other ................................... -- 32,600 -- 94,300
------------ ------------ ------------ ------------
Total other income (expense) ............ 13,000 55,200 97,200 (76,300)
------------ ------------ ------------ ------------
(LOSS) BEFORE PROVISION FOR INCOME TAXES .. (1,595,300) (502,700) (3,911,200) (1,971,500)
PROVISION FOR INCOME TAXES ................ 600 -- 1,400 800
------------ ------------ ------------ ------------
NET (LOSS) ................................ $ (1,595,900) $ (502,700) $ (3,912,600) $ (1,972,300)
============ ============ ============ ============
BASIC NET (LOSS) PER SHARE ................ $ (0.06) $ (0.02) $ (0.15) $ (0.09)
============ ============ ============ ============
DILUTED NET (LOSS) PER SHARE .............. $ (0.06) $ (0.02) $ (0.15) $ (0.09)
============ ============ ============ ============
WEIGHTED AVERAGE SHARES
OUTSTANDING:
Basic ................................... 25,299,547 24,960,554 25,299,547 21,049,101
============ ============ ============ ============
Diluted ................................. 25,299,547 24,960,554 25,299,547 21,049,101
============ ============ ============ ============
See accompanying Notes to Consolidated Financial Statements.
3
CNS RESPONSE, INC.
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
JUNE 30, SEPTEMBER 30,
2008 2007
------------ ------------
(unaudited)
ASSETS
CURRENT ASSETS:
Cash .................................................. $ 3,118,600 $ 5,790,100
Accounts receivable (net of allowance for doubtful
accounts of $30,700 (unaudited) in 2008 and $17,200
in 2007) ............................................ 83,600 59,200
Prepaids and other .................................... 180,900 159,000
------------ ------------
Total current assets ................................ 3,383,100 6,008,300
OTHER ASSETS:
Goodwill .............................................. 320,200 --
Other assets .......................................... 30,900 4,100
------------ ------------
TOTAL ASSETS ............................................ $ 3,734,200 $ 6,012,400
============ ============
LIABILITIES AND STOCKHOLDERS'
EQUITY
CURRENT LIABILITIES:
Accounts payable (including $5,000 (unaudited) in 2008
and $5,000 in 2007 to related parties) .............. $ 287,700 $ 219,400
Accrued clinical costs ................................ 317,600 --
Accrued liabilities ................................... 207,500 207,500
Accrued compensation .................................. 266,600 73,400
Accrued consulting fees ............................... 50,100 73,200
Accrued interest ...................................... 40,900 35,800
Convertible promissory notes .......................... 50,000 50,000
Current portion of long-term liabilities (including
$85,000 in 2008 to officer) ......................... 86,800 --
------------ ------------
Total current liabilities ........................... 1,307,200 659,300
LONG-TERM LIABILITIES:
Note payable to officer ............................... 140,900 --
Other ................................................. 8,100 --
------------ ------------
Total liabilities ....................................... 1,456,200 659,300
------------ ------------
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY :
Common stock, $0.001 par value; authorized
750,000,000 shares; 25,299,547 outstanding
in 2008 and 2007 .................................... 25,300 25,300
Additional paid-in capital ............................ 17,467,500 16,630,000
Accumulated deficit ................................... (15,214,800) (11,302,200)
------------ ------------
Total stockholders' equity .......................... 2,278,000 5,353,100
------------ ------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY .............. $ 3,734,200 $ 6,012,400
============ ============
See accompanying Notes to Consolidated Financial Statements.
4
CNS RESPONSE, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
NINE MONTHS ENDED JUNE 30,
----------------------------
2008 2007
------------ ------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net (loss) ..................................................... $ (3,912,600) $ (1,972,300)
Adjustments to reconcile net (loss) to net cash
used in operating activities:
Depreciation and amortization ................................ 90,600 19,900
Other ........................................................ -- (84,600)
Stock based compensation ..................................... 837,500 7,100
Non-cash interest expense .................................... -- 189,800
Write-off of Deferred offering costs ......................... 42,900 --
Changes in operating assets and liabilities:
Accounts receivable ........................................ 17,000 (35,000)
Prepaids and other ......................................... (137,400) (84,300)
Accounts payable ........................................... 20,800 (381,300)
Accrued clinical costs ..................................... 317,600 --
Accrued liabilities ........................................ -- (41,300)
Deferred compensation ...................................... 185,800 2,100
Accrued consulting ......................................... (23,200) 6,400
Accrued interest ........................................... 4,900 8,900
------------ ------------
Net cash used in operating activities ...................... (2,556,100) (2,364,600)
------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Increase in other assets ....................................... (40,200) (3,000)
Cash for acquisition, including transaction costs of $43,700 ... (11,600) --
Loans to employees ............................................. -- (4,200)
------------ ------------
Net cash used in investing activities ...................... (51,800) (7,200)
------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Repayment of debt .............................................. (40,700) (5,000)
Deferred offering costs ........................................ (22,900) --
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 (used in) provided by financing activities ........ (63,600) 8,551,300
------------ ------------
NET INCREASE (DECREASE) IN CASH ................................... (2,671,500) 6,179,500
CASH- BEGINNING OF PERIOD ......................................... 5,790,100 204,900
------------ ------------
CASH- END OF PERIOD ............................................... $ 3,118,600 $ 6,384,400
============ ============
SUPPLEMENTAL DISCLOSURE OF CASH FLOW
INFORMATION:
Cash paid during the period for:
Interest ...................................................... $ 10,300 $ 2,300
============ ============
Income taxes .................................................. $ 1,400 $ 800
============ ============
Fair value of note payable to officer issued for acquisition .... $ 265,900 --
============ ============
Fair value of equipment acquired through a lease ................ $ 10,500 --
============ ============
Conversion of preferred stock into common stock ................. -- $ 5,958,200
============ ============
Common stock received as collection of loans receivable ......... -- $ 171,300
============ ============
Derivative instrument liability ................................. -- $ 2,273,700
============ ============
See accompanying Notes to Consolidated Financial Statements.
5
CNS RESPONSE, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
AND COMPREHENSIVE INCOME (LOSS)
Additional
For the nine months ended June 30, 2008 Common Stock Paid-in Accumulated
Shares Amount Capital Deficit Total
------------ ------------ ------------ ------------ ------------
BALANCE - September 30, 2007 ...................... 25,299,247 $ 25,300 $ 16,630,000 $(11,302,200) $ 5,353,100
Stock-based compensation .......................... -- -- 837,500 -- 837,500
Net loss for the nine months ended June 30, 2008 .. -- -- -- (3,912,600) (3,912,600)
------------ ------------ ------------ ------------ ------------
Balance at June 30, 2008 .......................... 25,299,547 $ 25,300 $ 17,467,500 $(15,214,800) $ 2,278,000
============ ============ ============ ============ ============
For the nine months ended June 30, 2007
BALANCE - 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 ...................................... (142,753) (100) (171,200) -- (171,300)
Stock-based compensation .......................... -- -- 7,100 -- 7,100
Derivative instrument liability ................... -- -- (2,273,700) -- (2,273,700)
Reclassify fair value of derivate instrument
liability ..................................... -- -- 2,273,700 -- 2,273,700
Net loss for the nine months ended June 30, 2007 .. -- -- -- (1,972,300) (1,972,300)
------------ ------------ ------------ ------------ ------------
BALANCE at June 30, 2007 .......................... 25,303,462 $ 25,300 $ 15,992,700 $ (9,995,400) $ 6,022,600
============ ============ ============ ============ ============
See accompanying Notes to Consolidated Financial Statements.
6
CNS RESPONSE, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. NATURE OF OPERATIONS AND BASIS OF PRESENTATION
The unaudited condensed consolidated financial statements of CNS
Response, Inc. ("CNS," "we," "us," "our" or the "Company") have been prepared
pursuant to the rules and regulations of the Securities and Exchange Commission
and include all the accounts of CNS and its wholly owned subsidiaries, CNS
California (see Note 2) and NeuroTherapy Clinic, P.C. (see Note 10). Certain
information and note disclosures, normally included in financial statements
prepared in accordance with accounting principles generally accepted in the
United States, have been condensed or omitted pursuant to such rules and
regulations. The unaudited condensed consolidated financial statements reflect
all adjustments, consisting only of normal recurring adjustments, necessary for
a fair statement of our financial position as of June 30, 2008 and our operating
results, cash flows, and changes in stockholders' equity for the interim periods
presented. The September 30, 2007 balance sheet was derived from our audited
financial statements but does not include all disclosures required by accounting
principles generally accepted in the United States of America. These
consolidated financial statements and the related notes should be read in
conjunction with our financial statements and notes for the year ended September
30, 2007 which are included in our current report on Form 10-KSB, filed with the
Securities and Exchange Commission on December 7, 2007.
The preparation of financial statements in accordance with accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities and revenues and
expenses in the financial statements. Examples of estimates subject to possible
revision based upon the outcome of future events include, among others,
recoverability of long-lived assets and goodwill, stock-based compensation, the
allowance for doubtful accounts, the valuation of equity instruments, use and
other taxes. Actual results could differ from those estimates.
The results of operations for the three and nine months ended June 30,
2008 are not necessarily indicative of the results that may be expected for
future periods or for the year ending September 30, 2008.
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
7
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.
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 (see
Notes 4 and 6) 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. 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 (see Note 6) and the tendering
to the Company of shares of common stock by an officer and certain employees to
repay their loans to CNS California (see Note 4), 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
8
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.
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 has been 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. 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
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
9
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. The adoption of SFAS
No. 157 did not have a material impact on our consolidated financial statements.
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.
10
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. The
adoption of SFAS No. 159 did not have a material impact 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. The adoption of EITF 07-4 did not have a material impact on our
consolidated financial statements.
In December 2007, the FASB issued SFAS No. 141 (revised 2007),
"Business Combinations," or SFAS No. 141R. SFAS No. 141R replaces SFAS No. 141,
"Business Combinations." SFAS No. 141R establishes principles and requirements
for how an acquiror recognizes and measures in its financial statements the
identifiable assets acquired, the liabilities assumed, any noncontrolling
interest in the acquiree, and the goodwill acquired or a gain from a bargain
purchase. SFAS No. 141R also determines disclosure requirements to enable the
evaluation of the nature and financial effects of the business combination. SFAS
No. 141R applies prospectively to business combinations for which the
acquisition date is on or after the beginning of a fiscal year that begins on or
after December 15, 2008 and has implications for acquisitions that occur prior
to this date. We are currently in the process of evaluating the impact that the
adoption of SFAS No. 141R will have on our financial position, results of
operations and cash flows.
In December 2007, the FASB issued SFAS No. 160, "Noncontrolling
Interests in Consolidated Financial Statements," or SFAS No. 160. SFAS No. 160
amends Accounting Research Bulletin 51, "Consolidated Financial Statements," or
ARB 51, and requires all entities to report noncontrolling (minority) interests
in subsidiaries within equity in the consolidated financial statements, but
separate from the parent shareholders' equity. SFAS No. 160 also requires any
acquisitions or dispositions of noncontrolling interests that do not result in a
change of control to be accounted for as equity transactions. Further, SFAS No.
160 requires that a parent recognize a gain or loss in net income when a
subsidiary is deconsolidated. SFAS No. 160 is effective for fiscal years
beginning on or after December 15, 2008. We do not expect the adoption of SFAS
No. 160 will have a significant, if any, impact on our financial position,
results of operations and cash flows.
4. LOANS TO RELATED PARTIES
From September 2006 through February 2007, CNS California loaned
certain officer, employees and a consultant $171,300 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.
11
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 June 30,
2008.
5. CONVERTIBLE PROMISSORY NOTES
In October 2006, CNS California and the note holders of certain
convertible promissory notes converted notes with an aggregate outstanding
balance of $3,061,700 and related accrued and unpaid interest of $1,005,300 at
September 30, 2006 into 5,993,515 shares of CNS California Series A Preferred
Stock. In addition, the exercise price of warrants to purchase 1,062,116 shares
of the CNS California common stock issued to such note holders was changed to
$0.59 per share. As described in Note 2, upon the merger with Strativation, the
preferred shares were converted into 5,993,515 shares of the Company's common
stock and the warrants were converted into warrants to purchase 1,062,116 shares
of the Company's common stock at $0.59 per share. The consolidated financial
statements of the Company presented reflect the issuance of these shares as
common stock.
6. 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 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.
7. PRIVATE PLACEMENT-SERIES B PREFERRED STOCK
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
12
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 4) 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
described in Note 2. The consolidated financial statements of the Company
presented reflect the issuance of these shares as common stock.
8. STOCKHOLDERS' EQUITY
COMMON AND PREFERRED STOCK
As of June 30, 2008, the Company was authorized to issue 750,000,000
shares of common stock.
As of June 30, 2008, CNS California was 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.
In October 2006, CNS California issued 5,993,515 shares of its
preferred stock in connection with the conversion of notes payable described in
Note 5. All of these shares of preferred stock were converted into 5,993,515
shares of the Company's common stock concurrently with the completion of the
Merger described in Note 2.
In October and November 2006, CNS California issued 1,905,978 shares of
its preferred stock in connection with the private placement described in Note
7. All of these shares of preferred stock were converted into 1,905,978 shares
of the Company's common stock concurrently with the completion of the Merger
described in Note 2.
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
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 June 30, 2008, 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.
13
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 June 30,
2008, there were 9,042,324 options and 183,937 restricted shares outstanding
under the 2006 Plan and 773,739 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:
Risk-free
Dividend interest Expected Expected
Options granted in: Yield rate volatility life
- ------------------------ ------------ ------------ ------------ ------------
Fiscal 2006 ............ 0% 5.46% 100% 5 years
November 2006 .......... 0% 5.00% 100% 10 years
August 2007 ............ 0% 4.72% 91% 5 years
October 2007 ........... 0% 4.60% 105% 5 years
December 2007 .......... 0% 4.00% 113% 5 years
April 2008 ............. 0% 3.78% 172% 5 years
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 three and nine
months ended June 30, 2008 is as follows:
14
For the three months
ended June 30,
-------------------------
2008 2007
-------- --------
Operations ................... $ 4,000 $ 0
Research and development ................... 68,900 1,400
Sales and marketing ................... 46,300 0
General and administrative ................... 136,000 1,500
-------- --------
Total ................... $255,200 $ 2,900
======== ========
For the nine months
ended June 30,
-------------------------
2008 2007
-------- --------
Operations ................... $ 12,000 $ 0
Research and development ................... 255,500 4,100
Sales and marketing ................... 46,300 0
General and administrative ................... 523,700 3,000
-------- --------
Total ................... $837,500 $ 7,100
======== ========
Total unrecognized compensation as of June 30, 2008 amounted to
$1,963,800.
15
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
Granted .......................................... 1,605,621 $ 0.90
Exercised ........................................ -- --
Forfeited ........................................ -- --
Outstanding at June 30, 2008 .......................... 9,042,324 $ 0.63
Weighted average fair value of options granted during:
Year ended September 30, 2006 .................... $ 0.09
Year ended September 30, 2007 .................... $ 0.77
Nine months ended June 30, 2008 .................. $ 0.76
Following is a summary of the status of options outstanding at June 30,
2008:
Weighted Average 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
$0.80 140,000 10 years $0.80
$0.89 968,875 10 years $0.89
$0.96 496,746 10 years $0.96
$1.09 2,966,989 10 years $1.09
$1.20 333,611 5 years $1.20
---------------- ---------------
Total 9,042,324 $0.63
================ ===============
16
Following is a summary of the status of options exercisable at June 30,
2008:
Weighted Average
Remaining Weighted Average
Exercise Price Number of Shares Contractual Life Exercise Price
- -------------- ---------------- ---------------- ---------------
$0.12 854,270 9 years $0.12
$0.132 3,112,545 6 years $0.132
$0.30 115,075 9 years $0.30
$0.59 28,588 9 years $0.59
$0.80 25,000 10 years $0.80
$0.89 181,661 10 years $0.89
$0.96 50,787 10 years $0.96
$1.09 1,380,887 10 years $1.09
$1.20 125,103 5 years $1.20
---------------- ---------------
5,873,916 $0.42
================ ===============
WARRANTS TO PURCHASE COMMON STOCK
All warrants described below were issued by CNS California and assumed
by the company under the terms of the Merger Agreement described in Note 2.
At September 30, 2007, there were warrants outstanding to purchase
6,899,353 shares of the Company's common stock at exercise prices ranging from
$0.01 to $1.812 with a weighted average exercise price of $1.04. The warrants
expire at various times through 2017. No warrants were issued or exercised
during the nine months ended June 30, 2008. Accordingly, all warrants are
outstanding at June 30, 2008.
9. NET LOSS 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 three and nine months ended June 30, 2008 and 2007,
the Company has excluded all common equivalent shares from the calculation of
diluted net loss per share as such securities are anti-dilutive.
17
Anti-dilutive common equivalent shares not included in the computation
of dilutive net loss per share are as follows:
Three months ended June 30,
-----------------------------
2008 2007
--------- ---------
Convertible debt ....................... 4,995,000 4,995,000
Warrants ............................... 6,899,353 6,765,133
Options ................................ 8,959,533 4,136,103
Nine months ended June 30,
-----------------------------
2008 2007
--------- ---------
Convertible debt ....................... 4,995,000 6,713,653
Warrants ............................... 6,899,353 5,253,803
Options ................................ 8,510,578 4,113,486
Preferred stock ........................ -- 4,445,282
10. ACQUISITION OF NEURO THERAPY CLINIC, PC
On January 15, 2008, the Company acquired all of the outstanding common
stock of Neuro-Therapy Clinic, PC ("NTC") in exchange for a non-interest bearing
note payable of $300,000 payable in equal monthly installments over 36 months.
Upon the completion of the acquisition, the sole shareholder of NTC was
appointed Chief Medical Officer of the Company.
The acquisition was accounted under the purchase method of accounting,
and accordingly, the purchase price was allocated to NTC's net tangible assets
based on their estimated fair values as of January 15, 2008. The excess purchase
price over the value of the net tangible assets was recorded as goodwill. The
purchase price and the allocation thereof are as follows:
Fair value of note payable issued .......................... $ 265,900
Direct transaction costs ................................... 43,700
Purchase price ............................................. 309,600
Allocated to net tangible liabilities,
including cash of $32,100 ............................... (10,600)
---------
Allocated to goodwill ...................................... $ 320,200
=========
The acquisition was not material, and accordingly, no pro forma results
are presented.
11. GOODWILL
In accordance with SFAS No. 142, Goodwill and Other Intangible Assets,
goodwill will not be amortized but instead will be tested for impairment at
least annually, or more frequently if certain indicators are present.
18
11. REPORTABLE SEGMENTS
The Company operates in two business segments: reference laboratory and
clinic. Reference laboratory provide reports ("rEEG Reports") that assist
physicians with treatment strategies for patients with behavioral (psychiatric
and/or addictive) disorders based on the patient's own physiology. Clinic
operates NTC, a full service psychiatric practice.
The following tables show operating results for our reportable
segments, along with reconciliation from segment gross profit to (loss) from
operations, the most directly comparable measure in accordance with generally
accepted accounting principles in the United States, or GAAP:
Three months ended June 30, 2008
------------------------------------------------------------
Reference
Laboratory Clinic Eliminations Total
------------ ------------ ------------ ------------
Revenues ................... $ 39,300 $ 196,400 $ (2,800) $ 232,900
------------ ------------ ------------ ------------
Operating expenses:
Cost of revenues ......... 34,200 2,800 (2,800) 34,200
Research and development . 682,400 -- -- 682,400
Sales and marketing ...... 330,500 17,700 -- 348,200
General and administrative 528,800 247,600 -- 776,400
------------ ------------ ------------ ------------
Total operating expenses . 1,575,900 268,100 (2,800) 1,841,200
------------ ------------ ------------ ------------
Loss from operations ....... $ (1,536,600) $ (71,700) $ 0 $ (1,608,300)
============ ============ ============ ============
Nine months ended June 30, 2008
------------------------------------------------------------
Reference
Laboratory Clinic Eliminations Total
------------ ------------ ------------ ------------
RRevenues ................... $ 140,800 $ 377,000 $ (9,800) $ 508,000
------------ ------------ ------------ ------------
Operating expenses:
Cost of revenues ......... 131,600 9,800 (9,800) 131,600
Research and development . 1,589,000 -- -- 1,589,000
Sales and marketing ...... 574,100 20,900 -- 595,000
General and administrative 1,756,000 444,800 -- 2,200,800
------------ ------------ ------------ ------------
Total operating expenses . 4,050,700 475,500 (9,800) 4,516,400
------------ ------------ ------------ ------------
Loss from operations ....... $ (3,909,900) $ (98,500) $ 0 $ (4,008,400)
============ ============ ============ ============
The following table includes selected segment financial information as of June
30, 2008, related to goodwill and total assets:
Reference
Laboratory Clinic Total
---------- ---------- ----------
Goodwill .......................... $ 320,200 -- $ 320,200
========== ========== ==========
Total assets ...................... $3,651,600 $ 82,600 $3,734,200
========== ========== ==========
19
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
THE INFORMATION CONTAINED IN THIS FORM 10-QSB IS INTENDED TO UPDATE THE
INFORMATION CONTAINED IN OUR ANNUAL REPORT ON FORM 10-KSB FOR THE YEAR ENDED
SEPTEMBER 30, 2007 AND PRESUMES THAT READERS HAVE ACCESS TO, AND WILL HAVE READ,
THE "MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION" AND OTHER
INFORMATION CONTAINED IN SUCH FORM 10-KSB. THE FOLLOWING DISCUSSION AND ANALYSIS
ALSO SHOULD BE READ TOGETHER WITH OUR CONSOLIDATED FINANCIAL STATEMENTS AND THE
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS INCLUDED ELSEWHERE IN THIS FORM
10-QSB.
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 THREE AND NINE MONTHS ENDED JUNE 30,
2008 AND 2007. EXCEPT FOR HISTORICAL INFORMATION, THE MATTERS DISCUSSED IN THIS
MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION ARE "FORWARD-LOOKING
STATEMENTS" THAT INVOLVE RISKS AND UNCERTAINTIES AND ARE BASED UPON JUDGMENTS
CONCERNING VARIOUS FACTORS THAT ARE BEYOND OUR CONTROL. ACTUAL RESULTS COULD
DIFFER MATERIALLY FROM THOSE PROJECTED IN THE FORWARD-LOOKING STATEMENTS AS A
RESULT OF, AMONG OTHER THINGS, THE FACTORS DESCRIBED BELOW UNDER THE CAPTION
"CAUTIONARY STATEMENTS AND RISK FACTORS."
BUSINESS OVERVIEW
We are a life sciences company primarily focused on the
commercialization of a patented system that assists psychiatrists and other
physicians to determine a proper treatment for patients with behavioral
(psychiatric and/or addictive) disorders. We intend to identify, develop and
commercialize new indications of approved drugs and drug candidates for this
patient population. We are also a provider of behavioral health care services
through Neuro-Therapy Clinic, P.C. ("NTC"), a wholly-owned subsidiary, acquired
on January 15, 2008.
We have developed an extensive proprietary database (the "CNS
Database") consisting of approximately 13,000 clinical outcomes across 1,600
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-EEG ("rEEG"), this patented technology allows
CNS to create and provide simple reports ("rEEG Reports") that specifically
assist 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, identifying the presence of any
pathophysiology. The rEEG process then compares the stratified set of patients
with similar pathophysiology to our CNS Database and reports on 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.
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.
20
Since our inception, we have generated significant net losses. As of
June 30, 2008, we had an accumulated deficit of $15.2 million and incurred
operating losses of $1.6 million and $3.9 million for the three and nine months
then ended. 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 necessary to
validate the efficacy of our products and services across different types of
behavioral disorders and the enhancement of the CNS Database.
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 17,744,625 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.
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
21
Engagement Agreement between CNS California 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 received 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 initially became effective on June 22, 2007. The Company filed a
Post-Effective amendment to its Registration Statement on March 10, 2008, which
became effective on March 13, 2008, to include its financial statements for the
year ended September 30, 2007 in the Registration Statement.
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
767,103 shares of our Common Stock held by our former majority shareholder were
registered for resale on our registration statement on Form SB-2.
22
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 CNS California Series A Preferred Stock, CNS California Series B
Preferred Stock and certain shares of CNS California 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.
ACQUISITION OF NEURO-THERAPY CLINIC, PC
On January 15, 2008, we acquired all of the outstanding common stock of
Neuro-Therapy Clinic, P.C. ("NTC") in exchange for a non-interest bearing note
payable of $300,000 payable in equal monthly installments over 36 months. Upon
the completion of the acquisition, the sole shareholder of NTC became our Chief
Medical Officer. We acquired NTC to advance neurophysiology data collection,
beta-test planned technological advances in rEEG, advance physician training in
rEEG and investigate practice development strategies associated with rEEG.
REVENUES
We derive our revenues from two sources: (i) the sale of rEEG Reports
to physicians and (ii) patient service revenue in our clinic.
SALE OF REEG REPORTS
Physicians are generally billed upon delivery of the rEEG Report. The
list prices of our rEEG Reports range from $200 to $800, with $400 being the
most frequent charge.
REVENUE FROM CLINIC
Patient service revenue is generated as a result of providing services
to patients on an outpatient basis. Patient service revenue is recorded at our
established billing rates less contractual adjustments. Generally, collection in
full is not expected on our established billing rates. Contractual adjustments
are recorded to state our patient service revenue at the amount we expect to
collect for the services provided based on amounts due from third-party payors
at contractually determined rates.
COST OF REVENUES
Cost of revenues represents the cost of direct labor, and costs
associated with external processing, analysis and consulting review necessary to
render an individualized test result. Costs associated with performing our test
are recorded as tests are processed. We continually evaluate the feasibility of
hiring our own personnel to perform most of the processing and analysis
necessary to render a rEEG Report.
23
RESEARCH AND DEVELOPMENT
Research and development expenses primarily represent costs incurred to
design and conduct clinical studies, improve rEEG processing, add data to the
CNS 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 products and services.
GENERAL AND ADMINISTRATIVE
Our general and administrative expenses consist primarily of personnel
related costs, legal costs, accounting costs and other professional and
administrative costs.
CRITICAL ACCOUNTING POLICIES, 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.
The following represents a summary of our critical accounting policies,
defined as those policies that we believe are the most important to the
portrayal of our financial condition and results of operations and that require
management's most difficult, subjective or complex judgments, often as a result
of the need to make estimates about the effects of matters that are inherently
uncertain.
REVENUE RECOGNITION- We have generated limited revenues since our
inception. Revenues for our product are recognized when an rEEG Report is
delivered to the physician. Patient service revenues are recognized when the
services are performed.
24
STOCK-BASED COMPENSATION EXPENSE- Stock-based compensation expense,
which is a non-cash charge, results from stock option grants. Pursuant to SFAS
No. 123(R), 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.
RECENT ACCOUNTING PRONOUNCEMENTS
See Note 3 to Notes to Condensed Consolidated Financial Statements for
a full description of recent accounting pronouncements including the respective
expected dates of adoption and effects on results of operations and financial
condition.
RESULTS OF OPERATIONS
We operate in two business segments: reference laboratory and clinic.
Reference laboratory provide reports ("rEEG Reports") that assist physicians
with treatment strategies for patients with behavioral (psychiatric and/or
addictive) disorders based on the patient's own physiology. Clinic operates
Neuro-Therapy Clinic, PC ("NTC"), a full service psychiatric practice.
The following tables show operating results for our reportable
segments, along with reconciliation from segment gross profit to (loss) from
operations.
Three months ended June 30, 2008
------------------------------------------------------------
Reference
Laboratory Clinic Eliminations Total
------------ ------------ ------------ ------------
Revenues ................... $ 39,300 $ 196,400 $ (2,800) $ 232,900
------------ ------------ ------------ ------------
Operating expenses:
Cost of revenues ......... 34,200 2,800 (2,800) 34,200
Research and development . 682,400 -- -- 682,400
Sales and marketing ...... 330,500 17,700 -- 348,200
General and administrative 528,800 247,600 -- 776,400
------------ ------------ ------------ ------------
Total operating expenses . 1,575,900 268,100 (2,800) 1,841,200
------------ ------------ ------------ ------------
Loss from operations ....... $ (1,536,600) $ (71,700) $ 0 $ (1,608,300)
============ ============ ============ ============
Nine months ended June 30, 2008
------------------------------------------------------------
Reference
Laboratory Clinic Eliminations Total
------------ ------------ ------------ ------------
Revenues ................... $ 140,800 $ 377,000 $ (9,800) $ 508,000
------------ ------------ ------------ ------------
Operating expenses:
Cost of revenues ......... 131,600 9,800 (9,800) 131,600
Research and development . 1,589,000 -- -- 1,589,000
Sales and marketing ...... 574,100 20,900 -- 595,000
General and administrative 1,756,000 444,800 -- 2,200,800
------------ ------------ ------------ ------------
Total operating expenses . 4,050,700 475,500 (9,800) 4,516,400
------------ ------------ ------------ ------------
Loss from operations ....... $ (3,909,900) $ (98,500) $ 0 $ (4,008,400)
============ ============ ============ ============
The acquisition of NTC was effected on January 15, 2008 and accounted
under the purchase method of accounting; accordingly, our consolidated financial
statements include the operations of NTC from January 16, 2008. Therefore,
unless otherwise indicated, the following comparisons of the results of
operations for the three and nine months ended June 30, 2008 and the three and
nine months ended June 30, 2007 pertain only to our reference laboratory
segment.
25
NTC is a center for highly-advanced testing and treatment of
neuropsychiatric problems, including learning, attentional and behavioral
challenges, mild head injuries, as well as depression, anxiety, bipolar and all
other common psychiatric disorders. Through this acquisition, CNS expects to
advance neurophysiology data collection, beta-test planned technological
advances in rEEG, advance physician training in rEEG and investigate practice
development strategies associated with rEEG.
COMPARISON OF THREE MONTHS ENDED JUNE 30, 2008
AND THREE MONTHS ENDED JUNE 30, 2007
The following table presents statement of operations data for each of
the periods indicated as a percentage of revenues.
THREE MONTHS THREE MONTHS
ENDED ENDED
JUNE 30, 2008 JUNE 30, 2007
------------- -------------
Revenues ................................... 100% 100%
Cost of revenues ........................... 87 55
------------- -------------
Gross profit ............................... 13 45
Research and development ................... 1,736 461
Sales and marketing ........................ 841 48
General and administrative expenses ........ 1,346 335
------------- -------------
Operating loss ............................. (3,910) (799)
Other income, net .......................... 32 79
------------- -------------
Net loss ................................... (3,878)% (720)%
============= =============
REVENUES
THREE MONTHS THREE MONTHS
ENDED ENDED PERCENT
JUNE 30, 2008 JUNE 30, 2007 CHANGE
------------- ------------- -------------
Revenues ...................... $ 39,300 $ 69,800 (44)%
The number of rEEG Reports delivered for the period decreased from 179
in 2007 to 103 in 2008 while the price per report decreased from approximately
$390 to $350. We hired a president in October of 2007 whose main focus is the
commercialization of our products, and accordingly, we have begun to scale up
our sales and marketing efforts. However, we do not expect to drive broader
adoption of reports based on our rEEG technology until the completion in 2009 of
our multi-site clinical study to validate the efficacy of our products.
Accordingly, we anticipate that revenues will not increase materially until
fiscal 2009.
26
COST OF REVENUES
THREE MONTHS THREE MONTHS
ENDED ENDED PERCENT
JUNE 30, 2008 JUNE 30, 2007 CHANGE
------------- ------------- -------------
Cost of revenues .............. $ 34,200 $ 38,200 (10)%
Cost of revenues consists of payroll costs, consulting costs, and other
miscellaneous charges. Consulting costs primarily represent external costs
associated with the processing and analysis of rEEG Reports and range between
$75 and $100 per rEEG Report. Cost of revenues for the three months ended June
30, 2008 decreased from the comparable period for 2007 as a result of decreases
in the number of tests performed for the comparable periods as explained above.
We expect costs of revenues will increase as an absolute number as we deliver
more rEEG Reports. However, we expect cost of revenues to decrease as a
percentage of revenues as we improve our operating efficiency.
RESEARCH AND DEVELOPMENT
THREE MONTHS THREE MONTHS
ENDED ENDED PERCENT
JUNE 30, 2008 JUNE 30, 2007 CHANGE
------------- ------------- -------------
Research and development ...... $ 682,400 $ 322,100 112%
Research and development expenses consist of clinical studies, costs to
identify indications of approved drugs and drug candidates, patent costs,
consulting fees, payroll costs, expenses related to database enhancements, and
other miscellaneous costs. Research and development costs increased for the
three months ended June 30, 2008 from the comparable period for 2007 as a result
of increases in: (i) expenses relating to clinical studies, and (ii) payroll
costs; offset by decreases in (iii) the cost of identifying indications of
approved drugs and drug candidates, (iv) expenses relating to database
enhancements and (v) patent costs. The increase in expenses relating to clinical
studies is attributable to our expansion and acceleration of a clinical study
with the goal of driving market acceptance of our rEEG technology. The increase
in payroll costs is attributable to the hiring of our Chief Medical Officer and
of increases in stock-based compensation. The cost of identifying indications of
approved drugs and drug candidates decreased as we deferred these projects to
concentrate our efforts in the clinical study and the commercialization of our
product. Expenses relating to database enhancements decreased as in 2007 we
undertook a project to enhance our database for antipsychotic drugs and no
similar project was deemed necessary in 2008. Patent costs decreased as the
result of a decrease in the number of filings. Notwithstanding the deferral of
projects to identify indications of approved drugs and drug candidates, we
expect research and development expenses to continue to increase as we
accelerate our clinical study to validate the efficacy of our product and hire
additional employees.
SALES AND MARKETING
THREE MONTHS THREE MONTHS
ENDED ENDED PERCENT
JUNE 30, 2008 JUNE 30, 2007 CHANGE
------------- ------------- -------------
Sales and marketing ........... $ 330,500 $ 33,700 881%
27
Sales and marketing expenses consists primarily of consulting fees,
payroll costs, marketing costs and travel costs. Sales and marketing expenses
increased for the three months ended June 30, 2008 from the comparable period
for 2007 as a result of the hiring of consultants to expand our sales and
marketing efforts, increases in marketing activities, such as attendance at
conferences, increased travel and the hiring of (i) a Vice President for
commercial operations, (ii) an additional salesperson and (iii) a marketing
assistant. We expect sales and marketing costs to increase in as we continue to
expand our sales and marketing efforts.
GENERAL AND ADMINISTRATIVE
THREE MONTHS THREE MONTHS
ENDED ENDED PERCENT
JUNE 30, 2008 JUNE 30, 2007 CHANGE
------------- ------------- -------------
General and administrative
expenses ................... $ 528,800 $ 233,700 126%
The increase in general and administrative expenses for the three
months ended June 30, 2008 as compared to the comparable period for 2007 is
primarily attributable to increases in payroll due to the hiring of a new
president and stock-based compensation costs, increases in the costs associated
with being a public company and the write-off in 2008 of offering costs related
to a capital raising effort that was terminated unsuccessfully. Costs associated
with being a public company include certain legal and accounting costs, premiums
for directors and officers insurance and costs for investor relations. 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.
INTEREST INCOME
THREE MONTHS THREE MONTHS
ENDED ENDED PERCENT
JUNE 30, 2008 JUNE 30, 2007 CHANGE
------------- ------------- -------------
Interest Income, net .......... $ 13,000 $ 22,600 (42)%
For the three months ended June 30, 2008, net interest income was
$13,000 and consisted of interest income of $19,800 offset by interest expense
of $6,800. For the three months ended June 30, 2007, net interest income was
$22,600 and consisted primarily of interest income of $24,200 offset by interest
expense of $1,600. The decrease in interest income is attributable to less cash
available for investments as well as lower interest rates. The increase in
interest expense is due to the interest expense on the note payable to our Chief
Medical Officer issued in connection with the acquisition of Neuro-Therapy
Clinic, PC in January 2008. We expect net interest income to decrease as
available cash decreases due to expected operating losses.
28
OTHER INCOME
THREE MONTHS THREE MONTHS
ENDED ENDED PERCENT
JUNE 30, 2008 JUNE 30, 2007 CHANGE
------------- ------------- -------------
Other Income .................. $ 0 $ 32,600 *
* Not meaningful
Other income for the three months ended June 30, 2007 was $32,600 and
consisted of gains from settlement of payables. Other income for the three
months ended June 30, 2008 was zero. The decrease in other income is
attributable to the settlement of accounts payable at a discount to the recorded
amounts in 2007.
NET LOSS
THREE MONTHS THREE MONTHS
ENDED ENDED PERCENT
JUNE 30, 2008 JUNE 30, 2007 CHANGE
------------- ------------- -------------
Net Loss ...................... $ (1,524,200) $ (502,700) 203%
The increase in net loss of $1,021,500 is due primarily to an increase in
stock-based compensation and increases in the cost of clinical studies. We
expect to incur net losses for the next few years as we continue to improve our
rEEG technology and reaffirm its validity through clinical studies, increase the
penetration of our products in the marketplace, and hire additional personnel.
COMPARISON OF NINE MONTHS ENDED JUNE 30, 2008
AND NINE MONTHS ENDED JUNE 30, 2007
The following table presents consolidated statement of operations data
for each of the periods indicated as a percentage of revenues.
NINE MONTHS NINE MONTHS
ENDED ENDED
JUNE 30, JUNE 30,
2008 2007
----------- -----------
Revenues ....................................... 100% 100%
Cost of revenues ............................... 93 63
----------- -----------
Gross profit ................................... 7 37
Research and development ....................... 1,129 424
Sales and marketing ............................ 408 44
General and administrative expenses ............ 1,247 607
----------- -----------
Operating loss ................................. (2,777) (1,038)
Other income (expense), net .................... 68 (42)
----------- -----------
Net loss ....................................... (2,709)% (1,080)%
=========== ===========
29
REVENUES
NINE MONTHS NINE MONTHS
ENDED ENDED PERCENT
JUNE 30, 2008 JUNE 30, 2007 CHANGE
------------- ------------- -------------
Revenues....................... $ 140,800 $ 182,500 (23)%
The number of rEEG Reports delivered for the period decreased from 479
in 2007 to 396 in 2008 while the price per report decreased from approximately
$380 to $350. We hired a president in October of 2007 whose main focus is the
commercialization of our product, and accordingly, we have begun to scale up our
sales and marketing efforts. However, we do not expect to drive broader adoption
of reports based on our rEEG technology until the completion in 2009 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.
COST OF REVENUES
NINE MONTHS NINE MONTHS
ENDED ENDED PERCENT
JUNE 30, 2008 JUNE 30, 2007 CHANGE
------------- ------------- -------------
Cost of revenues............... $ 131,600 $ 114,800 15%
Cost of revenues consists of payroll costs, consulting costs, and other
miscellaneous charges. Consulting costs primarily represent external costs
associated with the processing and analysis of rEEG Reports and range between
$75 and $100 per rEEG Report. Cost of revenues for the nine months ended June
30, 2008 increased from the comparable period for 2007 as a result of increases
in bonus expense, vacation expense and stock-based compensation. We expect costs
of revenues will increase as an absolute number as we deliver more rEEG Reports.
However, we expect cost of revenues to decrease as a percentage of revenues as
we improve our operating efficiency.
RESEARCH AND DEVELOPMENT
NINE MONTHS NINE MONTHS
ENDED ENDED PERCENT
JUNE 30, 2008 JUNE 30, 2007 CHANGE
------------- ------------- -------------
Research and development....... $ 1,589,000 $ 773,300 105%
Research and development expenses consist of clinical studies, costs to
identify indications of approved drugs and drug candidates, patent costs,
consulting fees, payroll costs, expenses related to database enhancements, and
other miscellaneous costs. Research and development costs increased for the nine
months ended June 30, 2008 from the comparable period for 2007 as a result of
increases in: (i) expenses relating to clinical studies, (ii) recruiting costs,
and (iii) payroll costs, including stock-based compensation; offset by a
30
decrease in the cost of identifying indications of approved drugs and drug
candidates. The increase in expenses relating to clinical studies is
attributable to our expansion and acceleration of a clinical study with the goal
of driving market acceptance of our rEEG technology. Recruiting costs increased
as we intensified our search for various employees. Payroll increased due to the
hiring of our Chief Medical Officer, and increases in bonus expense, vacation
expense and stock-based compensation. The cost of identifying indications of
approved drugs and drug candidates decreased as we deferred these projects to
concentrate our efforts in the clinical study and the commercialization of our
product. Notwithstanding the deferral of projects to identify indications of
approved drugs and drug candidates, we expect research and development expenses
to continue to increase as we accelerate our clinical study to validate the
efficacy of our product and hire additional employees.
SALES AND MARKETING
NINE MONTHS NINE MONTHS
ENDED ENDED PERCENT
JUNE 30, 2008 JUNE 30, 2007 CHANGE
------------- ------------- -------------
Sales and marketing............ $ 574,100 $ 81,200 607%
Sales and marketing expenses consists primarily of consulting fees,
payroll costs, marketing costs and travel costs. Sales and marketing expenses
increased for the nine months ended June 30, 2008 from the comparable period for
2007 as a result of the hiring of consultants to expand our sales and marketing
efforts, increases in marketing activities, such as attendance at conferences,
increased travel and the hiring of (i) a Vice President for commercial
operations, (ii) an additional salesperson and (iii) a marketing assistant, We
expect sales and marketing costs to increase in as we continue to expand our
sales and marketing efforts.
GENERAL AND ADMINISTRATIVE
NINE MONTHS NINE MONTHS
ENDED ENDED PERCENT
JUNE 30, 2008 JUNE 30, 2007 CHANGE
------------- ------------- -------------
General and administrative
expenses.................... $ 1,756,000 $ 1,108,400 58%
General and administrative expenses for the nine months ended June 30,
2008 primarily relate to salaries (including stock-based compensation), costs
associated with being a public company and professional fees. General and
administrative expenses for the nine months ended June 30, 2007 primarily relate
to salaries, fees paid to regulatory agencies and a $475,000 advisory fee paid
to Richardson & Pattel, LLP in connection with our merger transaction, that will
not recur. The increase in general and administrative expenses for the nine
months ended June 30, 2008 as compared to the comparable period for 2007 is
primarily attributable to increases in payroll due to the hiring of a new
president, increases in bonus expense, vacation expense and stock-based
compensation, increases in the costs associated with being a public company and
the write-off in 2008 of offering costs related to a capital raising effort that
was terminated unsuccessfully. Costs associated with being a public company
include certain legal and accounting costs, premiums for directors and officers
31
insurance and costs for investor relations. 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.
INTEREST INCOME (EXPENSE)
NINE MONTHS NINE MONTHS
ENDED ENDED PERCENT
JUNE 30, 2008 JUNE 30, 2007 CHANGE
------------- ------------- -------------
Interest Income (Expense)...... $ 97,200 $ (170,600) *
* Not meaningful
For the nine months ended June 30, 2008, net interest income was
$97,200 and consisted of interest income of $113,200 offset by interest expense
of $16,000. For the nine months ended June 30, 2007, interest expense was
$170,600 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 $14,900 offset by
interest income of $34,100. The increase in interest income is attributable to
cash available for investments for a longer period in 2008 since we completed
our private placement in March 2007. The increase in interest expense (after
excluding the ascribed value of the warrant) is due to the interest expense on
the note payable to our Chief Medical Officer issued in connection with the
acquisition of Neuro-Therapy Clinic, PC in January 2008. We expect net interest
income to decrease as available cash decreases due to expected operating losses.
OTHER INCOME
NINE MONTHS NINE MONTHS
ENDED ENDED PERCENT
JUNE 30, 2008 JUNE 30, 2007 CHANGE
------------- ------------- -------------
Other Income................... $ -- $ 94,300 *
* Not meaningful
Other income for the nine months ended June 30, 2007 was $94,300 and
consisted of gains from settlement of payables. Other income for the nine months
ended June 30, 2008 was zero. The decrease in other income is attributable to
the settlement of accounts payable at a discount to the recorded amounts in
2007.
NET LOSS
NINE MONTHS NINE MONTHS
ENDED ENDED PERCENT
JUNE 30, 2008 JUNE 30, 2007 CHANGE
------------- ------------- -------------
Net Loss....................... $ (3,814,100) $ (1,972,300) 93%
32
The increase in net loss of $1,841,800 is due primarily to an increase in
stock-based compensation, increases in the cost of clinical studies, increases
in sales and marketing costs and increases in payroll costs offset by a decrease
in an advisory fee of $475,000 paid in 2007 in connection with our merger
transaction. We expect to incur net losses for the next few years as we continue
to improve our rEEG technology and reaffirm its validity through clinical
studies, increase the penetration of our products in the marketplace, and hire
additional personnel.
LIQUIDITY AND CAPITAL RESOURCES
As of June 30, 2008, we had cash and cash equivalents of approximately
$3.1 million and a working capital balance of approximately $2.1 million. As of
June 30, 2007, we had cash and cash equivalents of approximately $6.4 million
and a working capital balance of approximately $6.0 million. Our positive cash
balance results primarily from funds received in connection with the Private
Placement of $7.8 million completed in May 2007.
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 believe that our existing cash and cash equivalents will be
sufficient to fund our minimum working capital and capital expenditure needs for
at least the next six months. However, if our working capital requirements or
capital expenditures are greater than we expect, or if we expand our business by
acquiring complementary businesses or assets, we may need to raise additional
debt or equity financing. We are continually evaluating various financing
strategies to be used to expand our business and fund future growth. There can
be no assurance that additional debt or equity financing will be available on
acceptable terms or at all. We currently do not have any material commitments
for capital expenditures.
CASH FLOWS
We have satisfied our working capital requirements primarily through
the sale of equity securities and through debt financings. For the nine months
ended June 30, 2008, we had a net decrease in cash of $2.7 million. Cash flows
from operating, financing and investing activities for the nine months ended
June 30, 2008 and 2007 are summarized in the following table:
NINE MONTHS
ENDED JUNE 30,
------------------------------
ACTIVITY: 2008 2007
- ------------------------------------------ ----------- -----------
Operating activities ..................... $(2,556,100) $(2,364,600)
Investing activities ..................... (51,800) (7,200)
Financing activities ..................... (63,600) 8,551,300
----------- -----------
Net (decrease) increase in cash .......... $(2,671,500) $ 6,179,500
=========== ===========
33
OPERATING ACTIVITIES
Net cash used in operating activities was approximately $2.6 million
and $2.4 million for the nine months ended June 30, 2008 and 2007, respectively.
The increase in net cash used of approximately $200,000 was primarily due to the
increase in net loss explained above offset by (i) an increase in stock-based
compensation and (ii) a decrease in the use of cash for operating assets and
liabilities.
INVESTING ACTIVITIES
Net cash used in investing activities was approximately $51,800 and
$7,200 for the nine months ended June 30, 2008 and 2007, respectively. Our
investing activities for the nine months ended June 30, 2008 consisted primarily
of the purchase of property and equipment. We expect amounts used in investing
activities to increase as we continue to purchase property and equipment.
FINANCING ACTIVITIES
Net cash used by financing activities was $63,600 for the nine months
ended June 30, 2008 and consisted primarily of payments on a note payable to an
officer and the incurrence of deferred offering costs. Cash provided by
financing activities was $8.6 million for the nine months ended June 30, 2007
and primarily reflects net proceeds received in private placement transactions.
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 2022. 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". The annual limitation may
result in the expiration of our net operating loss and tax credit carryforwards
before they can be used.
CONTRACTUAL OBLIGATIONS AND OFF-BALANCE SHEET ARRANGEMENTS
The following summarizes our contractual obligations at June 30, 2008
and the effects such obligations are expected to have on liquidity and cash
flows in the future periods
Payments Due by Period
---------------------------------------------
Less than
Contractual Obligations: Total 1 Year 1-3 Years 4-5 Years
- -------------------------------- --------- --------- --------- ---------
Note Payable to Chief
Medical Officer ............. $ 225,900 $ 85,000 $ 140,900 $ --
Lease Payable .................. 9,900 1,800 4,100 $ 4,000
--------- --------- --------- ---------
Total .......................... $ 235,800 $ 86,800 $ 145,000 $ 4,000
========= ========= ========= =========
34
At June 30, 2008 and June 30,2007, we did not have any relationships
with unconsolidated entities or financial partnerships, such as entities often
referred to as structured finance or special purpose entities, which would have
been established for the purpose of facilitating off-balance sheet arrangements
or other contractually narrow or limited purposes. As such, we are not exposed
to any financing, liquidity, market or credit risk that could arise if we had
engaged in such relationships.
CAUTIONARY STATEMENTS AND 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
WE HAVE A LIMITED OPERATING HISTORY, MAKING IT DIFFICULT TO EVALUATE OUR FUTURE
PERFORMANCE.
Our operating subsidiary, CNS California, which we acquired in the
merger, was incorporated in 2000 and therefore has a limited operating history.
Therefore, investors have limited substantive financial information on our prior
operations to evaluate our stock 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.
IF OUR REEG 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. If we fail to achieve
widespread market acceptance for our rEEG Reports, we will not be able to grow
our revenues.
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.
35
o turnover among our employees.
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.
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.
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
we will have sufficient funds to finance the cost of our operations, our
operating and management infrastructure, and planned expansion for the next 6
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
36
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.
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.
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.
37
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.
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;
38
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 choose 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 a limited number of employees to market and
promote our rEEG Reports. 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 and higher
additional employees for this purpose. 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.
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
39
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
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
40
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.
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
41
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.
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 Chief Executive Officer and Secretary, and George Carpenter, our
President, 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 do not carry key man life insurance on any of our key employees. We
do not have an employment agreement in place with Mr. Brandt, and he may
terminate his 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.
42
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.
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
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.
43
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.
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
44
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
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.
45
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
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.
46
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 the
Over-the-Counter Bulletin Board under the symbol CNSO.OB. There is currently no
broadly followed, established trading market for our Common Stock and 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. Also, as a result of
this lack of trading activity, the quoted price for our Common Stock on the
Over-the-Counter 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 LARGER 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.
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.
47
SUBSTANTIAL FUTURE SALES OF OUR COMMON STOCK IN THE PUBLIC MARKET COULD CAUSE
OUR STOCK PRICE TO FALL.
Upon the effectiveness of our post-effective amendment to our
Registration Statement on Form S-1, 9,978,676 shares of Common Stock became
eligible for resale, 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 offering 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. Such shares may also
be eligible for resale pursuant to Rule 144 of the Securities Act of 1933, as
amended.
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.
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.
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 therefore.
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
48
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,
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.
Our officers, directors and principal stockholders (greater than 5%
stockholders) collectively control approximately 60% 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.
49
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.
Our officers, directors and principal stockholders (greater than 5%
stockholders) collectively control approximately 60% 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. In addition, these provisions could limit the price investors
would be willing to pay in the future for shares of our Common Stock.
50
ITEM 3. CONTROLS AND PROCEDURES.
CONTROLS AND PROCEDURES
Members of the company's management, including our Chief Executive
Officer and President, Leonard J. Brandt, and Chief Financial Officer, Horace
Hertz, have evaluated the effectiveness of our disclosure controls and
procedures, as defined by paragraph (e) of Exchange Act Rules 13a-15 or 15d-15,
as of June 30, 2008, the end of the period covered by this report. Based upon
that evaluation, Messrs. Brandt and Hertz concluded that our disclosure controls
and procedures are effective.
INTERNAL CONTROL OVER FINANCIAL REPORTING
There were no changes in our internal control over financial reporting or
in other factors identified in connection with the evaluation required by
paragraph (d) of exchange act rules 13a-15 or 15d-15 that occurred during the
quarter ended June 30, 2008 that have materially affected, or are reasonably
likely to materially affect, our internal control over financial reporting.
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PART II
OTHER INFORMATION
ITEM 5. OTHER INFORMATION
Effective as of August 15, 2008, Horace Hertz will resign from his
position as Chief Financial Officer of the Company. Mr. Hertz will remain with
the Company in a consulting role until August 31, 2008.
ITEM 6. EXHIBITS
The following exhibits are filed as part of this report:
EXHIBIT
NUMBER EXHIBIT TITLE
- ------- -----------------------------------------------------------------
31.1 Certification of Principal Executive Officer pursuant to
Securities Exchange Act Rules 13a-14(a) and 15d-14(a) as adopted
pursuant to section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of Principal Financial Officer pursuant to
Securities Exchange Act Rules 13a-14(a) and 15d-14(a) as adopted
pursuant to section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of Principal Executive Officer and Principal
Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to section 906 of the Sarbanes-Oxley Act of 2002.
52
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, as amended, the Registrant caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized.
CNS RESPONSE, INC.
Date: August 14, 2008 /s/ Horace Hertz
-------------------------------------------
By: Horace Hertz
Its: Chief Financial Officer
(Principal Financial and
Accounting Officer)
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