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Positiveid Corp · IPO:  S-1/A · On 2/9/07

Filed On 2/9/07, 7:53am ET   ·   Accession Number 1193125-7-24937   ·   SEC File 333-130754

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  As Of                Filer                Filing    For/On/As Docs:Size              Issuer               Agent

 2/09/07  Positiveid Corp                   S-1/A                 10:4.0M                                   RR Donnelley/FA

Initial Public Offering (IPO):  Pre-Effective Amendment to Registration Statement (General Form)   —   Form S-1
Filing Table of Contents

Document/Exhibit                   Description                      Pages   Size 

 1: S-1/A       Amendment No. 7 to Form S-1                         HTML   3.14M 
 2: EX-5.1      Opinion of Holland & Knight LLP                     HTML     14K 
 3: EX-5.2      Opinion of Steptoe & Johnson LLP                    HTML     16K 
 4: EX-10.49    Third Amendment to Commercial Loan Agreement        HTML     17K 
 5: EX-10.50    Third Amendment and Restated Revolving Line of      HTML     21K 
                          Credit Note                                            
 6: EX-10.51    Third Amendment to Security Agreement               HTML     15K 
 7: EX-23.1     Consent of Eisner LLP                               HTML      7K 
 8: EX-23.2     Consent of Deloitte & Touche LLP                    HTML      7K 
 9: EX-23.3     Consent of Meyers Norris Penny LLP                  HTML      7K 
10: EX-23.4     Consent of Kpmg LLP                                 HTML      8K 


S-1/A   —   Amendment No. 7 to Form S-1
Document Table of Contents

Page (sequential) | (alphabetic) Top
 
11st Page   -   Filing Submission
"Table of Contents
"Prospectus Summary
"Risk Factors
"Special Note Regarding Forward-Looking Statements
"Use of Proceeds
"Dividend Policy
"Capitalization
"Dilution
"Selected Consolidated Financial Data
"Unaudited Pro Forma Condensed Combined Financial Information
"Management's Discussion and Analysis of Financial Condition and Results of Operations
"Our Business
"Management
"Certain Relationships and Related Party Transactions
"Principal and Selling Stockholders
"Description of Capital Stock
"Shares Eligible for Future Sale
"Material United States Tax Considerations for Non-United States Holders
"Underwriting
"Legal Matters
"Experts
"Where You Can Find More Information
"Index to Financial Statements
"Report of Independent Registered Public Accounting Firm
"Consolidated Balance Sheets as of December 31, 2005 and 2004
"Consolidated Statements of Operations for each of the years in the three-year period ended December 31, 2005
"Consolidated Statements of Stockholder's Equity (Capital Deficit) for each of the years in the three-year period ended December 31, 2005
"Consolidated Statements of Cash Flows for each of the years in the three-year period ended December 31, 2005
"Notes to Consolidated Financial Statements
"Condensed Consolidated Balance Sheets as of September 30, 2006 (unaudited) and December 31, 2005 (historical)
"Condensed Consolidated Statements of Operations for the nine months ended September 30, 2006 and 2005 (unaudited)
"Condensed Consolidated Statement of Stockholder's Equity as of September 30, 2006 (unaudited)
"Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2006 and 2005 (unaudited)
"Notes to Condensed Consolidated Financial Statements
"Consolidated Balance Sheets as of December 31, 2004 and 2003
"Consolidated Statements of Operations for the years ended December 31, 2004 and 2003
"Consolidated Statements of Stockholders' Equity for the years ended December 31, 2004 and 2003
"Consolidated Statements of Cash Flows for the years ended December 31, 2004 and 2003
"Consolidated Balance Sheets as of March 31, 2005 and December 31, 2004
"Consolidated Statements of Operations for the three-month periods ended March 31, 2005 (audited) and 2004 (unaudited)
"Consolidated Statements of Stockholders' Equity for the three-month periods ended March 31, 2005 (audited) and 2004 (unaudited)
"Consolidated Statements of Cash Flows for the three-month period periods ended March 31, 2005 (audited) and 2004 (unaudited)
"Report of Independent Registered Chartered Accountants
"Balance Sheets as of December 31, 2004 and 2003
"Statements of Operations for each of the years ended December 31, 2004 and 2003
"Statements of Shareholder's Equity for the years ended December 31, 2004 and 2003
"Statements of Cash Flows for the years ended December 31, 2004 and 2003
"Notes to Financial Statements
"Balance Sheets at June 9, 2005 and December 31, 2004
"Statements of Operations for the periods beginning January 1, 2005 and ending June 9, 2005 (audited) and beginning January 1, 2004 and ending June 9, 2004 (unaudited)
"Statements of Shareholder's Equity (Deficit) for the period ended June 9, 2005 and the year December 31, 2004
"Statements of Cash Flows for the periods beginning January 1, 2005 and ending June 9, 2005 (audited) and beginning January 1, 2004 and ending June 9, 2004 (unaudited)

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  Amendment No. 7 to Form S-1  
Table of Contents

As filed with the Securities and Exchange Commission on February 9, 2007

 

Registration No. 333-130754

 


 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 


 

Amendment No. 7 to

FORM S-1

REGISTRATION STATEMENT

UNDER

THE SECURITIES ACT OF 1933

 


 

VERICHIP CORPORATION

(Exact name of registrant as specified in its charter)

 


 

Delaware   3669   06-1637809

(State or other jurisdiction of

incorporation or organization)

 

(Primary Standard Industrial

Classification Code Number)

 

(I.R.S. Employer

Identification Number)

 

1690 South Congress Avenue, Suite 200

Delray Beach, Florida 33445

(561) 805-8008

(Address, including zip code, and telephone number, including area code, of registrant’s principal executive offices)

 

Scott R. Silverman

Chief Executive Officer

VeriChip Corporation

1690 South Congress Avenue, Suite 200

Delray Beach, Florida 33445

(561) 805-8008

(Name, address, including zip code, and telephone number, including area code, of agent for service)

 


 

Copies to:

 

 

Harvey A. Goldman, Esq.
Holland & Knight LLP
701 Brickell Avenue
Miami, Florida 33131
(305) 374-8500
  James M. Lurie, Esq.
Holland & Knight LLP
195 Broadway
New York, NY 10007
(212) 513-3200
  Donald H. Meiers, Esq.
Steptoe & Johnson LLP
1330 Connecticut
Avenue, N.W.

Washington, D.C. 20036
(202) 429-3000
  Selim Day, Esq.
Wilson Sonsini Goodrich & Rosati
Professional Corporation
1301 Avenue of the Americas
New York, New York 10019
(212) 999-5800
  Donna M. Petkanics, Esq.
Wilson Sonsini Goodrich &
Rosati

Professional Corporation
650 Page Mill Road
Palo AltoCalifornia 94304
(650) 493-9300

 

Approximate date of commencement of proposed sale to the public: As soon as practicable after the effective date of this Registration Statement.

 


 

If any of the securities being registered on this form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933 check the following box.  ¨

 

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

 

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

 

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

 

The registrant hereby amends this registration statement on such date or dates as may be necessary to delay its effective date until the registrant shall file a further amendment which specifically states that this registration statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the registration statement shall become effective on such date as the Securities and Exchange Commission, acting pursuant to said Section 8(a), may determine.

 



Table of Contents

The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any state or other jurisdiction where the offer or sale is not permitted.

 

SUBJECT TO COMPLETION, DATED FEBRUARY 9, 2007

 

3,100,000 Shares

 

LOGO

 

VERICHIP CORPORATION

 

Common Stock

 

This is our initial public offering of shares of our common stock. We are offering 3,100,000 shares. We expect the initial public offering price to be $6.50 per share.

 

Currently no public trading market exists for shares of our common stock. We have applied to have our common stock quoted on the Nasdaq Global Market under the symbol “CHIP.”

 


 

Investing in our common stock involves risks.

See “ Risk Factors” beginning on page 11 of this prospectus.

 


 

Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved of these securities or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense.

 

     Per Share

   Total

Public offering price

   $                                $                            

Underwriting discounts and commissions

   $                                $                            

Proceeds to VeriChip Corporation

   $                                $                            

 

Applied Digital Solutions, Inc., which currently holds a controlling interest in our common stock, has granted the underwriters a 30-day option to purchase up to an additional 465,000 shares of our common stock to cover over-allotments. We will not receive any of the proceeds received upon the sale of any shares offered upon exercise of the over-allotment option. Any shares purchased by the underwriters to cover over-allotments will be purchased at the initial public offering price, less underwriting discounts and commissions.

 

Merriman Curhan Ford & Co.

 

C.E. Unterberg, Towbin

 

Kaufman Bros., L.P.

 

The date of this Prospectus is                     , 2007


Table of Contents

LOGO


Table of Contents

You should rely only on the information contained in this prospectus. We have not authorized anyone to provide you with information different from that contained in this prospectus. We are offering to sell, and seeking offers to buy, shares of common stock only in jurisdictions where offers and sales are permitted. The information contained in this prospectus is accurate only as of the date of this prospectus regardless of the time of delivery of this prospectus or of any sale of our common stock. Our business, financial condition, results of operations and prospects may have changed since that date. Unless the context otherwise requires, in this prospectus, “VeriChip,” the “Company,” “we,” “us,” and “our” refer to VeriChip Corporation, a Delaware corporation, and its subsidiaries.

 


 

TABLE OF CONTENTS

 

     Page

Prospectus Summary

   1

Risk Factors

   11

Special Note Regarding Forward-Looking Statements

   29

Use of Proceeds

   31

Dividend Policy

   32

Capitalization

   33

Dilution

   34

Selected Consolidated Financial Data

   36

Unaudited Pro Forma Condensed Combined Financial Information

   39

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   43

Our Business

   79

Management

   108

Certain Relationships and Related Party Transactions

   142

Principal and Selling Stockholders

   149

Description of Capital Stock

   151

Shares Eligible for Future Sale

   155

Material United States Tax Considerations for Non-United States Holders

   158

Underwriting

   162

Legal Matters

   165

Experts

   165

Where You Can Find More Information

   166

Index to Financial Statements

   F-1

 


 

Hugs, Kisses, Roam Alert, Assetrac, Blastmate, Minimate, and BioBond are our registered trademarks and HALO, VeriMed, VeriChip, VeriGuard, VeriTrace and ToolHound are our trademarks. This prospectus contains trademarks and tradenames of other corporations and organizations.

 

i


Table of Contents

PROSPECTUS SUMMARY

 

This summary provides an overview of selected information contained elsewhere in this prospectus and does not contain all of the information you should consider before investing in our common stock . You should carefully read the entire prospectus, including the section entitled “Risk Factors” beginning on page 11 and our consolidated financial statements and the related notes included elsewhere in this prospectus, before making an investment decision.

 

Our Company

 

We are primarily engaged in the development, marketing and sale of radio frequency identification, or RFID, systems used to identify, locate and protect people and assets. The healthcare industry represents the principal market for our radio frequency identification systems. Our goal is to become the leading provider of radio frequency identification systems in the healthcare industry.

 

Through our acquisitions in the first half of 2005 of two Canadian-based businesses, each of which has been engaged in the design, marketing and sale of radio frequency identification systems for more than 20 years, we have become one of the leading providers of:

 

   

infant protection systems that help to prevent mother-baby mismatching and infant abduction; and

 

   

wander prevention systems that help to protect and locate residents in nursing homes and assisted living facilities.

 

As of December 31, 2006, our radio frequency identification systems for one or the other of these applications have been installed in over 4,000 healthcare locations, primarily located in North America. Sales of these systems currently represent a majority of our revenue.

 

We are in early stages of marketing an asset/staff location and identification system to hospitals and other healthcare facilities. This system is designed to efficiently identify, locate and protect medical staff, patients, visitors and medical equipment. We are seeking to leverage our established brand reputation, reseller network and extensive end-use customer base for our infant protection and wander prevention systems to gain inroads in the developing market for radio frequency identification real-time location systems in hospitals and other healthcare facilities. The healthcare market for these systems is just emerging, but several market research firms predict that these types of systems will develop into the second-largest application for radio frequency identification technology in the healthcare industry over the next decade.

 

Radio frequency identification technology involves the use of radio frequency, or RF, transmissions, typically achieved through communication between a microchip-equipped transponder and a receiver, for identification, location and other purposes. The basic components of a radio frequency identification system consist of:

 

   

a “tag,” containing a microchip-equipped transponder, an antenna and a capacitor, attached to the item to be identified, located or tracked, which wirelessly transmits stored information to a receiver;

 

   

one or more receivers, also referred to as “readers,” which are devices that read the tag by sending out a radio frequency signal to which a tag, in the range of the signal, responds;

 

   

the equipment, cabling, computer network and software applications to use the processed data for one or more applications.

 

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Table of Contents

Most radio frequency identification systems use either “active” or “passive” tags, with the choice reflecting the different characteristics of the tags and the nature of the radio frequency identification system application. The key difference in the technology is that active radio frequency identification systems deploy tags with battery-powered microchips that emit a signal at regular intervals or continuously, and do not rely on power from the reader to operate, while passive radio frequency identification systems deploy tags with microchips that have no attached power supply and receive an activating charge from the reader’s signal. Applications that require receipt of signals between the tag and the reader beyond approximately 10 meters in range usually need a battery in the tags. Our infant protection, wander prevention and asset/staff location and identification systems all make use of active radio frequency identification tags which are worn by the people or attached to the objects these systems are designed to identify, locate or protect.

 

We are also in the process of attempting to create a market within the healthcare sector for the first, and, to date, we believe the only, human-implantable radio frequency transponder system cleared for use for patient identification and health information purposes by the U.S. Food and Drug Administration, or FDA – our VeriMed patient identification system. To date, we have generated nominal revenue from sales of our VeriMed system. The key components of the VeriMed system are a passive microchip, which is approximately the size of a grain of rice, a fixed location or a wireless handheld scanner used to read the 16-digit identification number contained on the microchip, and a secure, web-enabled database containing information appropriate for the specific application. The implantable microchip is not worn or attached as are the tags used in our infant protection, wander prevention and asset/staff location and identification systems but rather is implanted under the skin in a person’s upper right arm utilizing a different technology.

 

We are also engaged in the development, marketing and sale of products with applications outside the healthcare sector that do not make use of radio frequency identification technology. Specifically, we offer:

 

   

a wide range of vibration monitoring instruments used by engineering, construction and mining professionals to monitor and document the effects of human-induced vibrations on neighboring structures in an area where blasting activity occurs. We believe we are the leading provider of vibration monitoring instruments. Sales of such instruments currently represent the second-largest source of our revenue.

 

   

an asset management system used by industrial companies to manage and track their mobile equipment and tools for purposes of, among other things, reducing theft and the hoarding of assets. Our asset management system provides broad functionality, including multi-facility management, usage tracking by cost center, remote requisition, employee certification, third-party enterprise resource planning integration, and time and attendance capability.

 

Our Strategy

 

For the foreseeable future, we expect that our revenue will continue to be derived primarily from sales of our infant protection and wander prevention systems, which along with our asset/staff location and identification system, make up our healthcare security system offerings, and sales of our vibration monitoring instruments.

 

Healthcare Security System Offerings

 

We believe that the global market for infant protection systems, including components of such systems that are consumable items, is currently growing at a rate of approximately 10-15% per year, although we consider the market relatively mature. The United States currently accounts for more than 95% of the global market for infant protection systems. There are approximately 3,400 birthing hospitals in the United States. We estimate that infant security systems have been implemented in approximately half of these facilities. Approximately 1,100 U.S. hospitals and birthing centers use our infant protection

 

2


Table of Contents

systems. We believe that growth opportunities exist among the remaining facilities that do not yet have infant protection systems in place, as well as through replacement of legacy systems. Currently, approximately half of our infant protection system sales are replacement system sales.

 

We estimate that, within the United States, radio frequency identification-type wander prevention systems are currently installed in approximately 30% of the more than 52,000 nursing homes and assisted living facilities. While the nursing home segment is considered fairly well penetrated, we believe that existing and future state regulations applicable to long-term facilities, which include security and wander prevention requirements, will continue to drive growth in demand for wander prevention systems for the next several years.

 

In view of the relative maturity of the markets for our infant protection and wander prevention systems – at least in the United States – our growth strategy for these businesses encompasses the following:

 

   

Market and sell these systems internationally through distribution relationships. We are only just beginning to penetrate geographic markets outside of North America for our infant protection and wander prevention systems. In an effort to accelerate this process, we intend to enter into distribution agreements with a combination of both local distributors who have an in-depth knowledge of the relevant geographic region, as well as larger distributors with a global or near-global reach.

 

   

Leverage our established brand recognition, reseller network and extensive end-use customer base for our infant protection and wander prevention systems to gain inroads in the emerging market for asset/staff location and identification systems. According to a report prepared by IDTechEx, a United Kingdom-based consulting firm, entitled “RFID in Healthcare 2006-2016,” over the next ten years the second-largest radio frequency identification application, by value, within the healthcare industry will be real-time location systems for staff, patients, visitors and assets. The largest radio frequency identification application is anticipated to be item-level tagging of pharmaceuticals. IDTechEx predicts that these two applications, on a combined basis, will represent an $800 million market by 2016. We are in the process of building out our distribution network for our asset/staff location and identification system and providing the requisite training to certain dealers in an effort to be on the forefront of the emerging market for these systems in the healthcare sector. We anticipate commercially launching our asset/staff location and identification system through our dealer channel for this system in the first quarter of 2007.

 

   

Offer healthcare security applications that are flexible, scalable and expandable. Our current product development efforts for our infant protection, wander prevention and asset/staff location and identification systems include having all of these systems share a common technology platform. This platform consists of a networked hardware infrastructure and a software-based server running on an industry standard computing platform, thereby allowing it to be integrated with a customer’s existing technology platform. On top of this common hardware and software platform, each of the applications, such as infant protection, augments the platform with specific radio frequency identification tags designed for that application and a software module that provides the application-specific graphical user interface. We believe that a common technology platform for our healthcare security system offerings will help us to migrate our existing end-use customers into deployment of asset/staff location and identification systems. In addition, we are in the process of interfacing our technology platform with other location technologies. The first interface we have completed is with WiFi. This has been done to illustrate the platform’s flexibility to interface to other wireless air interfaces and perform an even higher level of system integration that collects location-based information. This capability will make the platform more flexible, scalable and expandable.

 

3


Table of Contents

Security and Industrial System Offerings

 

We perceive the market for vibration monitoring instruments, like that for our healthcare security system offerings, to be of limited size and growth potential. In contrast to our healthcare security systems business, our vibration monitoring business is international in scope. We have a strong market presence in North America, Southeast Asia, India and Scandinavia, and a growing market presence in South Africa, Europe and Australia. Our primary strategy to grow this business is through the introduction of a new instrumentation platform. We believe that the new platform, which we anticipate will be completed in 2007, will better integrate with contemporary data communications protocols so as to improve our products’ remote monitoring capabilities. In addition, we expect the new platform will entail the addition of several sensors and peripherals that will enhance the ability to monitor additional environmental and structural parameters related to vibration and overpressure monitoring.

 

The VeriMed System and Other Applications for Our Implantable Microchip

 

We believe that our VeriMed system, which is one of our systems that utilizes our implantable microchip, may make a significant contribution to our revenue in the future. As part of our growth strategy, we intend to dedicate a portion of the operating cash flows generated by our healthcare security systems and security and industrial products, as well as a significant portion of the proceeds of this offering, to our efforts to create markets for the VeriMed system, as well as our other systems that utilize the implantable microchip.

 

Healthcare Application

 

We believe our VeriMed system will prove of use to emergency room personnel and other first responder medical practitioners in identifying uncommunicative patients and rapidly accessing their personal health records at the time of initial treatment. The primary target market for our VeriMed system consists of people who are more likely to require emergency medical care, persons with cognitive impairment, persons with chronic diseases and related conditions, and persons with implanted medical devices. According to a study we commissioned by Fletcher Spaght, Inc., there are approximately 45 million patients in the United States alone who fit this profile. Through use of our VeriMed system, a person can be scanned for the unique, 16-digit identification number on the implanted microchip, enabling access from our or a third party’s database to that person’s pre-approved information, including the person’s name, primary care physician, emergency contact information, advance directives, and, if the person elects, other pertinent data, such as personal health records.

 

Other Applications

 

We have also developed two other systems that utilize the implantable microchip, our VeriGuard and VeriTrace systems.

 

Our VeriGuard system uses our implantable microchip and/or active radio frequency identification tags to provide secure access control into restricted areas, map/track visitors throughout a facility, and track assets. We believe these applications will be of value to high security facilities, such as government facilities, nuclear power plants, national research laboratories and correction facilities, by providing secure ingress and egress and local area location. In 2003-2004, we derived minimal revenue from sales of the VeriGuard system.

 

Our VeriTrace system was conceived of in the wake of Hurricane Katrina, when we donated implantable microchips to FEMA’s Department of Mortuary Services in Mississippi and Louisiana to help

 

4


Table of Contents

with FEMA’s efforts to identify corpses. Our implantable microchips were used to provide an end-to-end tagging solution for the accurate tracking and identification of human remains and associated evidentiary items. We have not, as yet, taken any steps to market our VeriTrace system.

 

We obtain the implantable microchip used in our VeriMed, VeriGuard and VeriTrace systems from Digital Angel Corporation, a majority-owned subsidiary of our parent company, Applied Digital Solutions, Inc., under the terms of a supply agreement. Digital Angel, in turn, obtains the implantable microchip from a subsidiary of Raytheon Company under a separate supply agreement. The technology underlying these systems is covered, in part, by U.S. Patent No. 5,211,129, “Syringe-Implantable Identification Transponders.” In 1994, Destron/IDI, Inc., a predecessor company to Digital Angel, granted a co-exclusive license under this patent, other than for certain specified fields of use retained by the predecessor company, to Hughes Aircraft Company, or Hughes, and its then wholly-owned subsidiary, Hughes Identification Devices, Inc., or HID. The specified fields of use retained by the predecessor company do not include human identification or security applications. The rights licensed to Hughes and HID were freely assignable, and we do not know which party or parties currently have these rights or whether these rights have been assigned, conveyed or transferred to any third party. We source the implantable microchip indirectly from a subsidiary of Raytheon Company, with which Hughes, then known as HE Holdings, Inc. was merged in 1997. However, we have no documentation that establishes our right to use the patented technology for human identification or security applications. We do not anticipate generating more than nominal revenue from the sale of the VeriMed, VeriGuard or VeriTrace systems prior to the expiration of the patent in April 2008. Hughes, HID, any of their respective successors in interest, or any party to whom any of the foregoing parties may have assigned its rights under the 1994 license agreement may commence a claim against us asserting that we are violating its rights. If such a claim is successful, sales of our VeriMed, VeriGuard and VeriTrace systems could be enjoined, and we could be required to cease our efforts to create a market for these systems, until the patent expires in April 2008. In addition, we could be required to pay damages, which may be substantial. Regardless of whether any claimant is successful, we would face the prospect of the expenditure of funds in litigation, the diversion of management time and resources, damage to our reputation and the potential impairment in the marketability of our systems even after the expiration of the patent, which could harm our business and negatively affect our prospects.

 

Corporate Information

 

We were formed as a Delaware corporation by our parent company, Applied Digital Solutions, Inc., or Applied Digital, in November 2001. In January 2002, we began our efforts to create a market for radio frequency identification systems that utilize our human implantable microchip.

 

In March 2005, we acquired EXI Wireless Inc., a Canadian corporation engaged through its subsidiaries in the business of developing and marketing radio frequency identification systems for infant protection, wander prevention and asset/staff location and identification for use within the healthcare industry and asset management systems used by industrial companies to manage and track their mobile equipment and tools. Subsequent to the acquisition, EXI Wireless was renamed VeriChip Holdings Inc., or VHI.

 

In June 2005, we acquired Instantel Inc., a Canadian corporation engaged in the business of developing and marketing radio frequency identification systems for infant protection, wander prevention, emergency response and asset tracking within the healthcare industry, as well as vibration monitoring instruments for the construction, mining and blasting industries.

 

In January 2006, we effected an amalgamation of Instantel and the former EXI Wireless subsidiaries under Canadian law. The combined entities now operate as a wholly-owned subsidiary of VHI.

 

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Table of Contents

Risks Affecting Us

 

We are subject to a number of risks that you should be aware of before you decide to buy our common stock.

 

The principal risks associated with our Company and its existing revenue-generating businesses include:

 

   

uncertainty as to whether we will be able to successfully implement our business strategy;

 

   

our expectation that we will incur operating losses, on a consolidated basis, for the foreseeable future;

 

   

the relative maturity in the United States and limited size of the markets for our infant protection and wander prevention systems and vibration monitoring instruments;

 

   

uncertainty as to whether we will be able to increase our sales of infant protection and wander prevention systems outside the United States;

 

   

uncertainty as to whether we will be able to successfully sell our asset/staff location and identification system in the emerging market for radio frequency identification real-time location systems in the healthcare industry; and

 

   

the potential for other technologies to prove better or more cost-effective solutions than our radio frequency identification systems for customers in our target markets.

 

The principal risks associated with our efforts to create markets for our systems that utilize our implantable microchip include:

 

   

uncertainty as to whether a market for any of these systems will develop and whether we will be able to generate more than a nominal level of revenue from the sale of such systems;

 

   

with respect to our VeriMed system, the uncertainty as to the future availability of insurance reimbursement for the microchip implant procedure from government and private insurers;

 

   

a potential disruption in our operations, loss of sales and higher expense in the event we are unable to obtain the implantable microchip from Digital Angel, our sole supplier of the microchip, or have to make alternative arrangements for the manufacture of the microchip;

 

   

our obligation to meet annual minimum purchase requirements beginning in 2007 under our supply agreement with Digital Angel, as a condition to maintaining the exclusivity of our supply arrangement, that may exceed our sales of the microchip; and

 

   

possible third-party claims asserting that we hold no rights for the use of the implantable microchip technology and are violating the third party’s intellectual property rights. If such a claim were successful, we could be enjoined from marketing this technology and could be required to pay substantial damages.

 

Investors are urged to carefully review the “Risk Factors” section of this prospectus beginning on page 11.

 

Our Address

 

Our principal executive offices are located at 1690 South Congress Avenue, Suite 200, Delray Beach, Florida 33445. Our telephone number is (561) 805-8008. Our web site is http://www.verichipcorp.com. The information found on our web site is not part of this prospectus.

 

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Table of Contents

The Offering

 

Common stock to be offered

3,100,000 shares

 

Common stock outstanding after this offering

9,155,556 shares

 

Use of proceeds

We intend to use $3.5 million of the net proceeds from this offering to repay a portion of our outstanding indebtedness, including accrued interest, to Applied Digital at the time of the consummation of this offering.

 

 

We expect that approximately $8 million to $10 million of the net proceeds of this offering will be used over the next 24 months to continue the development of the market for our VeriMed system, principally through an increase in our sales and marketing efforts related to our VeriMed system.

 

 

The remaining net proceeds will be used for working capital and general corporate purposes, which may include research and development, capital expenditures and other sales and marketing expenses.

 

 

You should read the discussion in the “Use of Proceeds” section of this prospectus for more information.

 

Offer Price

Estimated at $6.50 per share.

 

Over-Allotment Option

In connection with the offering, Applied Digital Solutions, Inc., which currently holds a controlling interest in our common stock, has granted to the underwriters an option to purchase up to 465,000 shares of our common stock, which option is exercisable for a period of 30 days, to cover over-allotments, if any, made in connection with this offering. Any such shares will be sold by Applied Digital on the same terms and conditions as the other shares being sold in this offering.

 

Risk factors

You should read the “Risk Factors” section beginning on page 11 and the other information in this prospectus for a discussion of the factors that you should carefully consider before deciding to invest in our shares of common stock.

 

Proposed Nasdaq Global Market symbol

CHIP

 

Unless otherwise indicated, the number of shares of our common stock outstanding after the offering is based on shares outstanding as of February 8, 2007. This information excludes:

 

   

1,744,892 shares of our common stock issuable upon the exercise of outstanding options under our stock plans at a weighted average exercise price of $1.31 per share;

 

   

499,553 additional shares of our common stock reserved for future grant under our stock plans;

 

   

357,566 shares of our common stock issuable upon the exercise of outstanding options that were issued outside of our stock plans at a weighted average exercise price of $6.01 per share;

 

   

444,222 shares of our common stock issuable upon the exercise of outstanding warrants at a weighted average exercise price of $2.91 per share.

 

 

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Except as otherwise indicated in this prospectus, information in this prospectus:

 

   

gives effect to a 2-for-3 reverse stock split effected on December 20, 2005 and a 1-for-3 reverse stock split effected on December 18, 2006; and

 

   

assumes that the underwriters do not exercise their over-allotment option to purchase shares of our common stock from Applied Digital in the offering.

 

As used in this prospectus, all references to “$” or “dollars” are to U.S. dollars and all references to “CDN$” are to Canadian dollars.

 

 

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SUMMARY CONSOLIDATED FINANCIAL DATA

 

You should read the following summary consolidated financial data in conjunction with our consolidated financial statements and related notes, “Selected Consolidated Financial Data,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the “Unaudited Pro Forma Condensed Combined Financial Information” appearing elsewhere in this prospectus. The consolidated statements of operations data for the nine months ended September 30, 2006 and 2005, and the consolidated balance sheet data as of September 30, 2006, are derived from our unaudited interim consolidated financial statements. The consolidated statements of operations data for the years ended December 31, 2005, 2004 and 2003 are derived from our audited consolidated financial statements. The historical results are not necessarily indicative of results to be expected for future periods, and the results for the nine months ended September 30, 2006 are not necessarily indicative of results that may be expected for the entire year ending December 31, 2006. We acquired two Canadian-based businesses during the first half of 2005 and, accordingly, our historical results only include their results of operations since their respective dates of acquisition. The pro forma results reflected below give effect to the acquisitions of these two businesses as if they had occurred on January 1, 2005.

 

    

Nine Months

Ended

September 30,


    Year Ended December 31,

 
     2006

    2005

   

2005

Pro forma(1)


   

2005

Historical


   

2004

Historical


   

2003

Historical


 
     (Unaudited)     (Unaudited)                    
     (in thousands, except per share data)  

Consolidated Statements of Operations Data:

                                                

Total revenue

   $ 20,344     $ 9,115     $ 24,554     $ 15,869     $ 247     $ 545  

Loss before income taxes

     (3,992 )     (2,740 )     (6,254 )     (5,206 )     (2,011 )     (1,710 )

Net loss attributable to common stockholder

     (3,451 )     (2,688 )     (5,528 )     (5,263 )     (2,011 )     (1,710 )

Net loss per common share attributable to common stockholder-basic and diluted

   $ (0.62 )   $ (0.52 )   $ (0.99 )   $ (1.00 )   $ (0.45 )   $ (0.38 )

(1) See Unaudited Pro Forma Condensed Combined Financial Information appearing elsewhere in this prospectus.

 

     At September 30, 2006

     Actual

    As adjusted(1)

     (in thousands)

Consolidated Balance Sheet Data:

              

Cash

   $ 879     $ 13,904

Working capital

     (954 )     12,071

Total assets

     49,739       59,213

Total debt

     10,027       6,527

Total stockholders’ equity

     25,195       37,880

(1) The consolidated balance sheet data at September 30, 2006, as adjusted, is unaudited and gives effect to (i) our receipt of the net proceeds from the sale of 3.1 million shares of common stock in this offering at an assumed initial public offering price of $6.50 per share, after deducting estimated underwriting discounts and commissions and estimated offering expenses and (ii) the use of the net proceeds of this offering as set forth in the “Use of Proceeds” section of this prospectus.

 

 

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Recent Developments

 

In June 2005, we acquired Instantel Inc. for approximately $22.3 million in cash, including $0.3 million in acquisition costs, which was funded by Applied Digital. In October 2006, we paid the second installment of the purchase price for the acquisition of Instantel. The payment was in the amount of $2.0 million, which amount reflected a holdback of $0.5 million for an indemnification claim we have asserted against the sellers of Instantel. A final payment of up to $0.5 million may be due upon resolution of the indemnification claim. We funded the $2.0 million payment through a borrowing under our loan agreement with Applied Digital.

 

Effective December 5, 2006, Scott R. Silverman, the chairman of our board of directors, was appointed as our chief executive officer. Kevin H. McLaughlin resigned as our chief executive officer and as a member of our board of directors effective December 2, 2006. In connection with his appointment as chief executive officer, Mr. Silverman was granted 500,000 restricted shares of common stock.

 

We entered into an employment and non-compete agreement with Mr. Silverman on December 5, 2006. The agreement provides for, among other things, an initial base salary of $420,000 per year plus discretionary incentive compensation which could be significant and could exceed, by a substantial amount, 100% of his base salary. If Mr. Silverman’s employment is terminated prior to the expiration of the term of the agreement or if a change of control occurs, certain significant payments become due to Mr. Silverman. In the case of a termination of employment, the amount of such payments depends on the nature of the termination. See “Management—Executive Employment Arrangements” for a more detailed description of Mr. Silverman’s employment and non-compete agreement.

 

Our revenue for the nine month period ended September 30, 2006 was $20.3 million. We expect our revenue for the three month period ended December 31, 2006 will be between $6.7 million and $6.9 million. This revenue amount is preliminary and has not been audited or reviewed, and, accordingly, may be subject to adjustment.

 

We expect that our operating results for the three months ended December 31, 2006 will include charges related to our decision in October 2006 to consolidate our Canadian operations into an existing facility located in Ottawa, Ontario. The consolidation, expected to be completed in the first quarter of 2007, will entail the closing of our operations in Vancouver, British Columbia. This will eliminate duplicative functions and, we believe, improve operating efficiencies, positioning us to better execute on strategic initiatives to become the leading provider of RFID systems for the healthcare industry. We believe the consolidation will result in annual savings, of which a significant portion will be cash savings, and will have no effect on revenue. As a result of the consolidation, we expect to record aggregate charges in the range of $0.8 million to $1.4 million during the last quarter of 2006 and the first quarter of 2007, consisting of charges relating to termination benefits, fixed asset reserves and our Canadian tax assets.

 

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RISK FACTORS

 

An investment in our common stock involves a high degree of risk. You should carefully consider the following risks described below together with all of the other information in this prospectus, including our consolidated financial statements and the related notes, before making a decision to invest in our common stock. The following risks and the risks described elsewhere in this prospectus, including the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” could materially affect our business, prospects, financial condition, operating results and cash flows. If any these risks materialize, the trading price of our common stock could decline, and you may lose all or part of your investment.

 

Risks Related to Our Business

 

If we cannot successfully implement our business strategy, we expect that our business, results of operations and potential for growth will be adversely affected.

 

If our market assessments, or the assumptions, estimates and judgments underlying such assessments, on which we have charted our course for our business, prove to be incorrect, we may not be successful in implementing our strategy or achieving our objectives. In that case, we would expect that our business, results of operations, financial condition and potential for growth will be adversely affected.

 

Our business strategy for our Canadian-based businesses, from which we are currently generating substantially all of our revenue, includes:

 

   

endeavoring to market and sell, through international distributors, an increasing number of our infant protection, wander prevention and asset/staff location and identification systems outside of North America, where the market for these products is largely undeveloped;

 

   

leveraging our established brand recognition, reseller network and extensive end-use customer base for our infant protection and wander prevention systems to gain inroads in the emerging market for asset/staff location and identification systems;

 

   

working to complete our efforts to integrate our infant protection, wander prevention and asset/staff location and identification systems on one technology platform to enhance the flexibility, scalability and expandability of our system offerings; and

 

   

introducing a new vibration monitoring instrumentation platform that better integrates with contemporary data communications protocols so as to improve our vibration monitoring instruments’ remote monitoring capabilities.

 

Our business strategy also includes dedicating a portion of the operating cash flows derived from our healthcare security, and security and industrial, businesses, as well as a portion of the net proceeds from this offering, to funding our efforts to create markets for our systems that utilize our implantable microchip, principally our VeriMed system, from which, to date, we have generated only nominal revenue. We do not expect to generate more than nominal revenue from these systems over the next 12 to 18 months and possibly for a longer period of time.

 

We may decide to alter or discontinue aspects of our business strategy and may adopt alternative or additional strategies because of business or competitive factors or factors not currently foreseen, such as the introduction of new products by our competitors or the emergence of new technologies that would make our products and systems obsolete. If we are unable to successfully implement our current or future business strategy, our business, results of operations, financial condition and potential for growth may be adversely affected.

 

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We have a history of losses, and expect to incur additional losses in the future. We are unable to predict the extent of future losses or when we will become profitable.

 

We were formed by Applied Digital in November 2001 and have incurred operating losses since that time. Our accumulated deficit was $13.8 million as of September 30, 2006. Our net losses for the nine months ended September 30, 2006 and 2005 and the years ended December 31, 2005, 2004 and 2003 were $3.5 million, $2.7 million, $5.3 million, $2.0 million and $1.7 million, respectively. We expect to continue to incur operating losses for the foreseeable future.

 

Our ability in the future to achieve or sustain profitability is based on a number of factors, many of which are beyond our control, including the future demand for our active RFID systems targeted at the healthcare sector and the development of the market for our VeriMed system. If demand for our RFID systems generally, and the VeriMed system in particular, does not reach anticipated levels, or if we fail to manage our cost structure, we may not achieve or be able to sustain profitability.

 

Our expense levels will increase over the next several years, contributing to our expectation that we will incur losses for the foreseeable future.

 

We expect our operating expenses to increase over the next several years. For example, we expect our operating expenses for the year ending December 31, 2006 to be slightly higher than our pro forma combined operating expenses for the year ended December 31, 2005 (see “Unaudited Pro Forma Condensed Combined Financial Information”), and to increase by an estimated 10% to 12% in 2007. The 2006 increase is due, in part, to the restructuring charges to be taken in the fourth quarter of 2006 relating to the consolidation of our Canadian operations. The increase in future operating expenses will result from, among other things:

 

   

the expansion of our sales and marketing efforts to create a market for our VeriMed system; we estimate that approximately 22% of our consolidated operating expenses in 2007 will relate to our VeriMed business; and

 

   

our becoming a Securities and Exchange Commission-reporting and Nasdaq-listed company and, as such, being subject to the requirements of the Sarbanes-Oxley Act of 2002, Securities and Exchange Commission rules and regulations to implement certain of the Act’s provisions, including the requirement to have in place, and evaluate, internal control over financial reporting, and Nasdaq listing standards.

 

In addition, we will incur significant amortization expense associated with intangible assets that we acquired as a result of the acquisition of our Canadian-based businesses in the first half of 2005. Specifically, we expect to incur approximately $1.8 million in amortization expense associated with these intangible assets in the year ending December 31, 2006.

 

VHI’s existing bank credit facility may be terminated, or the lender may limit the availability of borrowings under that facility, at any time without notice. Further, all borrowings under the facility are repayable upon the lender’s demand. A demand for repayment or any restriction on the availability of borrowings under the facility would adversely affect our liquidity and financial condition.

 

Our wholly-owned subsidiary, VHI, is a party to loan agreements providing it with a bank credit facility of up to CDN$1.5 million, or approximately $1.3 million based on the exchange rate as of September 30, 2006, in revolving credit loans. The facility is not a committed facility, as it provides that loans are made available at the sole discretion of the lender. The lender may cancel or restrict the availability of the facility, or any unutilized portion of the facility, at any time or from time to time. Borrowings under the facility are repayable on demand, as a result of which outstanding borrowings are

 

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reflected as current liabilities in our consolidated financial statements. In addition, the payment and other obligations under the loan agreements are secured by all of the assets of VHI and its subsidiary. If the lender demands repayment of the borrowings under the facility, we may not have sufficient funds, or may be required to use a portion of any then remaining proceeds of this offering, to honor such demand. In such event, the lender would have the right to foreclose on the assets securing such borrowings. In addition, if the lender cancels or restricts our available borrowings under the facility, our ability to fund our operations may be materially and adversely affected and our prospects for growth would be harmed.

 

Following this offering and to support the expected increase in our working capital requirements, we will seek to obtain a larger, committed bank credit facility. However, no assurance can be given that we will be successful in obtaining such a facility. If we are unable to do so, our ability to grow our business and our prospects may be adversely affected.

 

We may need additional funding and may be unable to raise capital when needed, which would force us to delay, reduce or eliminate our product development programs or efforts to create a market for our VeriMed system.

 

We expect to require funding in future years, in addition to the proceeds from this offering, to create a market for our VeriMed system and any additional technologies or systems that we may license or develop. To the extent we raise additional capital by issuing equity securities, our stockholders may experience substantial dilution. In addition, our business and operations may change in a manner that would consume available resources at a greater rate than we anticipated. In such event, we may need to raise substantial additional capital.

 

We may seek to raise necessary funds through public or private equity offerings, debt financings or strategic alliance and licensing arrangements. If adequate funds are not available, we may be required to delay, reduce the scope of or eliminate one or more of our development programs, and our business, financial performance and stock price may be materially and adversely affected. To raise additional funds through strategic alliance or licensing arrangements, we may be required to relinquish rights to our technologies or systems, or grant licenses on terms that are not favorable to us.

 

The markets for our infant protection and wander prevention systems, and our vibration monitoring instruments, in the United States are relatively mature markets of limited size, which may limit our ability to increase our sales of these systems.

 

In the near term, we expect that our revenue will continue to be derived primarily from sales of our infant protection and wander prevention systems, and our vibration monitoring instruments. The markets for these systems—at least in the United States, where historically we have sold the substantial majority of our sales of these systems—can all be characterized as being of limited size and relatively mature. In the event we are not able to develop new markets, our future growth prospects will be modest. We cannot assure you that our historical revenue growth rates from these systems will continue.

 

To date, we have sold and had installed a limited number of our asset/staff location and identification systems. There are a number of factors beyond our control that may limit future sales of these systems.

 

To date, we have sold and had installed three of our asset/staff location and identification systems. These systems were sold through a single distributor on a private label basis. While we believe that the potential for RFID real-time location systems, such as our asset/staff location and identification system, to improve the quality and decrease the cost of healthcare is significant, the market for such systems in the healthcare sector is just emerging. The pace at which healthcare facilities have implemented RFID systems has been slower than many who follow the industry have anticipated. Market analysts have cited a number

 

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of factors that may be constraining the rate and extent of the U.S. healthcare industry’s adoption of RFID asset/staff location and identification systems, including:

 

   

the cost of deployment, coupled with the limited budgets of many hospitals;

 

   

the uncertainty or unquantifiable nature of the return on investment;

 

   

system compatibility issues;

 

   

the low level of awareness; and

 

   

privacy concerns.

 

We believe that our asset/staff location and identification system will need to capture market share in this emerging market within the next 12-24 months, as we expect that a significant factor in hospitals’ choice of system vendors will be referrals to other healthcare facilities that have deployed, and are pleased with, such systems. To achieve this, we will need to be on the forefront of the effort to educate healthcare industry personnel regarding the benefits, including the return on investment, achievable through implementation of RFID location and identification systems.

 

We may be unable to increase our sales of infant protection and wander prevention systems outside of North America.

 

We currently sell substantially all of our infant protection and wander prevention systems in North America. Part of our growth strategy is to increase our penetration of markets outside of North America for these systems. Conducting business internationally entails numerous risks, which could disrupt or otherwise adversely affect our business, including:

 

   

unexpected changes in regulatory requirements, taxes, trade laws, tariffs, import and export controls, customs duties and other trade restrictions or barriers;

 

   

more stringent regulations relating to data privacy and the unauthorized use of, or access to, commercial and personal information, particularly in Europe;

 

   

regulations, such as with respect to radio frequency bands, that require us to redesign our existing systems or develop new systems to comply;

 

   

restrictions on the transfer of funds;

 

   

changes in governmental policies and regulations;

 

   

limitations on the level of intellectual property protections; and

 

   

political unrest, terrorism and war.

 

If we are unable to expand our international distribution network in a timely and cost-effective manner, we could miss sales opportunities, which could constrain our growth.

 

Sales of our vibration monitoring instruments will be adversely affected if the introduction of our new instrumentation platform for these instruments is delayed or if the new platform does not achieve market acceptance.

 

If the introduction of our new vibration monitoring instrumentation platform is delayed or if the new platform does not achieve market acceptance, sales of our vibration monitoring instruments, which currently represent the primary source of revenue in our security and industrial segment, will be adversely affected. The new platform will replace our existing platform for vibration monitoring instruments for which we are facing certain manufacturing challenges due to the discontinuation and unavailability of key components. The introduction of the new platform represents our primary strategy to grow our vibration monitoring business. If we fail to timely introduce the new platform or if the new platform does not achieve market acceptance, our ability to grow this business will be materially and adversely affected.

 

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Our competitors, including those who have greater resources and experience than we do, may commercialize technologies that make ours obsolete or noncompetitive.

 

There are many public and private companies, universities, governmental agencies and research organizations actively engaged in research and development of RFID and other competing technologies with the same or similar functionality as our systems and that target the same markets that we target.

 

Our active RFID systems, such as our infant protection, wander prevention and asset/staff location and identification systems, utilize a zonal, also known as cell ID, system in which a network of readers are positioned to cover a defined area, including points of ingress or egress, to read tagged persons or objects within the defined area. There are a number of other technologies, such as UHF-based active RFID technologies, lower power Ultra Wide Band-based location technologies, 802.11 and Zigbee-based location and wireless networking technologies, and advanced, long range, encrypted passive RFID technology, that are being developed and sold that can be employed for our target applications. One or more of these technologies may prove to be a better or more cost-effective solution than our RFID systems for customers in our target markets and thus achieve greater market acceptance than the technologies used in our systems. If this were to occur, our ability to sell our systems, as well as our results of operations, financial condition and business prospects, would be adversely affected.

 

Some of our current competitors, as well as companies who utilize RFID technologies in applications outside of our target markets, have significantly greater financial, marketing and product development resources than we do. Low barriers to entry across most of our product lines may result in new competitors entering the markets we serve. If a current or future competitor were to successfully develop or acquire rights to more effective or lower cost systems for applications targeted by our systems, then sales of our systems could suffer and our business, results of operations and financial condition could be materially and adversely affected.

 

If we are unable to successfully integrate the operations, systems and personnel of the two Canadian-based businesses we acquired in the first half of 2005, our management team may be distracted or ineffective and our sales efforts may be impaired.

 

In the first half of 2005, we acquired two Canadian-based businesses that currently account for essentially all of our revenue. The acquired companies significantly expanded the scope of our operations in a rapid manner, and the integration of their operations, systems and personnel is ongoing and continues to present us with challenges, including:

 

   

the consolidation of the acquired companies’ respective facilities, scheduled to be completed in the first half of 2007;

 

   

managing our relationships with the acquired companies’ dealers and end-use customers;

 

   

entering markets or types of businesses in which certain members of our management team (who were not affiliated with either of the acquired companies) have little or no prior experience; and

 

   

integrating different and complex accounting and financial reporting systems.

 

As part of our integration of the acquired companies, we are in the process of integrating virtually all of our infant protection, wander prevention and asset/staff location and identification systems onto a common technology platform, capable of being integrated with other wireless technologies to enhance the flexibility, scalability and expandability of these system offerings. A key element of our growth strategy is to demonstrate the advantages of this common platform and cross-market to our customers our full portfolio of systems. If we are unable to successfully integrate these systems onto a single platform, our sales efforts and ability to cross-market our systems may be impaired, and our revenue may be adversely affected.

 

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We rely upon third-party dealers to market and sell, as well as install, service and maintain, our infant protection, wander prevention and asset/staff location and identification systems, and to market and sell our vibration monitoring instruments. As such, our revenue from sales of these products significantly depends on their efforts, as does the level of end-use customer satisfaction.

 

We currently have a limited sales, marketing and distribution infrastructure. We market and sell our infant protection, wander prevention and asset/staff location and identification systems, as well as vibration monitoring instruments, through third-party dealers. We currently derive substantially all of our revenue from these systems and instruments. In general, our dealer agreements impose no minimum purchase requirements.

 

By virtue of our reliance on dealers, our revenue significantly depends on the efforts of others. In addition, we are at risk that an end-use customer may have an unfavorable view of one of our systems based on a dealer’s improper installation, support or maintenance of that system.

 

Our dealers of our infant protection, wander prevention and asset/staff location and identification systems also have responsibility for the installation and after-sale servicing and maintenance of such systems. System installation requires relationships with cable companies, knowledge of the other products that need to be integrated with our hardware and knowledge of local codes. After-market customer service and maintenance is an important aspect of overall end-use customer satisfaction.

 

We may be subject to costly product liability claims from the use of our systems, which could damage our reputation, impair the marketability of our systems and force us to pay costs and damages that may not be covered by adequate insurance.

 

Manufacturing, marketing, selling, testing and operation of our systems entail a risk of product liability. We could be subject to product liability claims in the event our systems fail to perform as intended. Even unsuccessful claims against us could result in the expenditure of funds in litigation, the diversion of management time and resources, damage to our reputation and impairment in the marketability of our systems. While we maintain liability insurance, it is possible that a successful claim could be made against us, that the amount of our insurance coverage would not be adequate to cover the costs of defending against or paying such a claim, or that damages payable by us would harm our business.

 

If others assert that our products infringe their intellectual property rights, including rights to the patent covering our implantable microchip, we may be drawn into costly disputes and risk paying substantial damages or losing the right to sell our products.

 

We face the risk of adverse claims and litigation alleging our infringement of the intellectual property rights of others. If infringement claims are brought against us or our suppliers, including, in the case of our implantable microchip, Digital Angel, these assertions could distract management and necessitate our expending potentially significant funds and resources to defend or settle such claims. We cannot be certain that we will have the financial resources to defend ourselves against any patent or other intellectual property litigation.

 

If we or our suppliers are unsuccessful in any challenge to our rights to market and sell our products, we may, among other things, be required to:

 

   

pay actual damages, royalties, lost profits and/or increased damages and the third party’s attorneys’ fees, which may be substantial;

 

   

cease the development, manufacture, use and/or sale of products that use the intellectual property in question through a court-imposed sanction called an injunction;

 

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expend significant resources to modify or redesign our products, manufacturing processes or other technology so that it does not infringe others’ intellectual property rights or to develop or acquire non-infringing technology, which may not be possible; or

 

   

obtain licenses to the disputed rights, which could require us to pay substantial upfront fees and future royalty payments and may not be available to us on acceptable terms, if at all, or to cease marketing the challenged products.

 

Ultimately, we could be prevented from selling a product or otherwise forced to cease some aspect of our business operations as a result of any intellectual property litigation. Even if we or our suppliers are successful in defending an infringement claim, the expense, time delay, and burden on management of litigation and negative publicity could have a material adverse effect on our business. See also “Risks Related to Our Businesses Which Utilize the Implantable Microchip—Our sales of systems that incorporate our implantable microchip may be enjoined by third parties who have rights to the intellectual property used in these systems and we may be required to pay damages which could have an adverse effect on our business.”

 

Our inability to safeguard our intellectual property may adversely affect our business by causing us to lose a competitive advantage or by forcing us to engage in costly and time-consuming litigation to defend or enforce our rights.

 

We rely on copyrights, trademarks, trade secret protections, know-how and contractual safeguards to protect our non-patented intellectual property, including our software technologies. Our employees, consultants and advisors are required to enter into confidentiality agreements that prohibit the disclosure or use of our confidential information. We also have entered into confidentiality agreements to protect our confidential information delivered to third parties for research and other purposes. There can be no assurance that we will be able to effectively enforce these agreements, the confidential information will not be disclosed, others will not independently develop substantially equivalent confidential information and techniques or otherwise gain access to our confidential information, or that we can meaningfully protect our confidential information. Costly and time-consuming litigation could be necessary to enforce and determine the scope of our confidential information, and failure to maintain the confidentiality of our confidential information could adversely affect our business by causing us to lose a competitive advantage maintained through such confidential information.

 

Disputes may arise in the future with respect to the ownership of rights to any technology developed with third parties. These and other possible disagreements could lead to delays in the collaborative research, development or commercialization of our systems, or could require or result in costly and time-consuming litigation that may not be decided in our favor. Any such event could have a material adverse effect on our business, financial condition and results of operations by delaying our ability to commercialize innovations or by diverting our resources away from revenue-generating projects.

 

Our efforts to protect our intellectual property may be less effective in some foreign countries where intellectual property rights are not as well protected as in the United States.

 

The laws of some foreign countries do not protect intellectual property to as great an extent as do the laws of the United States. Policing unauthorized use of the intellectual property utilized in our systems and system components is difficult, and there is a risk that our means of protecting our intellectual property may prove inadequate in these countries. Our competitors in these countries may independently develop similar technology or duplicate our systems, which would likely reduce our sales in these countries. Furthermore, some of our patent rights may be limited in enforceability to the United States or certain other select countries, which may limit our intellectual property rights abroad.

 

We may not be successful in our efforts to obtain federal registration of our trademarks containing the “Veri” prefix with the U.S. Patent and Trademark Office.

 

In June 2004, VeriSign, Inc. filed oppositions with the U.S. Patent and Trademark Office, objecting to our registration of the VeriChip trade name and our trademarks that begin with the “Veri” prefix. If

 

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VeriSign is successful in the opposition proceedings, our applications to register VeriChip and our other “Veri-” marks will be refused. It is also possible that VeriSign could bring a court action seeking to enjoin our use of VeriChip and the other “Veri-” marks and/or seek monetary damages from our use of these marks. If VeriSign were to bring a court action and prevail in that action, we may required to re-name our company and re-brand some of our products, such as VeriMed, VeriGuard and VeriTrace, as well as to possibly pay damages to VeriSign for our use of any trademarks found to have been confusingly similar to those of VeriSign.

 

We depend on key personnel to manage our business effectively, and, if we are unable to hire, retain or motivate qualified personnel, our ability to design, develop, market and sell our systems could be harmed.

 

Our future success depends, in part, on certain key employees, including Scott R. Silverman, our chief executive officer and the chairman of our board of directors, and key technical and operations personnel, and on our ability to attract and retain highly skilled personnel. The loss of the services of any of our key personnel may seriously harm our business, financial condition and results of operations. In this regard, only five of the 15 people who served as vice presidents of the Company in June 2005, the time we completed the second of our two acquisitions in the first half of 2005, remain as our employees as of December 2006. In addition, the inability to attract or retain qualified personnel, or delays in hiring required personnel, particularly engineering, operations, finance, accounting, sales and marketing personnel, may also seriously harm our business, financial condition and results of operations. Our ability to attract and retain highly skilled personnel will be a critical factor in determining whether we will be successful in the future.

 

We are subject to various environmental laws and regulations that could impose substantial costs upon us.

 

We must comply with local, state, federal, and international environmental laws and regulations in the countries in which we do business, including those governing the management and disposal of hazardous substances and wastes. If we were to violate or become liable under environmental laws, we could incur costs or fines, or be subject to third-party property damage or personal injury claims, or be required to incur investigation or remediation costs. Our operations and products will be affected by future environmental laws and regulations, but we cannot predict the ultimate impact of any such future laws and regulations at this time. Our distributors who place our products on the market in the European Union, or EU, are required to comply with EU Directive 2002/96/EC on waste electrical and electronic equipment, known as the WEEE Directive. Noncompliance by our distributors may adversely affect the success of our business in that market. Additionally, we are investigating the applicability of EU Directive 2002/95/EC on the restriction of the use of certain hazardous substances in electrical and electronic equipment, known as the RoHS Directive. We do not expect the RoHS Directive will have a significant impact on our business.

 

Risks Related to Our Businesses Which Utilize the Implantable Microchip

 

We are endeavoring to create a market for our VeriMed system. We may never achieve market acceptance or significant sales of this system.

 

We have been in the process of endeavoring to create a market for our VeriMed system since the FDA cleared the VeriMed system for use for patient identification and health information purposes in October 2004. To date, we have only generated approximately $0.1 million in revenue from sales of the microchip inserter kits, significantly less than we had projected at the beginning of 2006. We may never achieve market acceptance or more than nominal or modest sales of this system.

 

We attribute the modest number of people who, through the date of this prospectus, have undergone the microchip implant procedure to the following factors:

 

   

Many people who fit the profile for which the VeriMed system was designed may not be willing to have a microchip implanted in their upper right arm.

 

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Physicians may be reluctant to discuss the implant procedure with their patients until a greater number of hospital emergency rooms have adopted the VeriMed system as part of their standard protocol.

 

   

The media has from time to time reported, and may continue to report, on the VeriMed system in an unfavorable and, on occasion, an inaccurate manner. For example, there have been articles published asserting, despite at least one study to the contrary, that the implanted microchip is not magnetic resonance imaging, or MRI, compatible.

 

   

Privacy concerns may influence individuals to refrain from undergoing the implant procedure or dissuade physicians from recommending the VeriMed system to their patients. Misperceptions that a microchip-implanted person can be “tracked” and that the microchip itself contains a person’s basic information, such as name, contact information, and personal health records, may contribute to such concerns.

 

   

Misperceptions and/or negative publicity may prompt legislative or administrative efforts by politicians or groups opposed to the development and use of human-implantable RFID microchips. In 2006, a number of states have introduced, and at least one state, Wisconsin, has enacted, legislation that would prohibit any requirement that an individual undergo a microchip-implant procedure. While we support all pending and enacted legislation that would preclude anything other than voluntary implantation, legislative bodies or government agencies may determine to go further, and their actions may have the effect, directly or indirectly, of delaying, limiting or preventing the use of human-implantable RFID microchips or the sale, manufacture or use of RFID systems utilizing such microchips.

 

   

At present, the cost of the microchip implant procedure is not covered by Medicare, Medicaid or private health insurance.

 

   

At present, no clinical studies to assess the impact of the VeriMed system on the quality of emergency department care have been completed.

 

In light of these and perhaps other factors, it is difficult to predict whether our VeriMed system will achieve market acceptance, how widespread that market acceptance will be, and the timing of such acceptance. Accordingly, we are uncertain as to whether we will generate the level of future revenue and revenue growth we have forecast from sales of the VeriMed system.

 

We believe that sales of our implantable microchip, and the extent to which our VeriMed system achieves market acceptance, will depend, in part, on the availability of insurance reimbursement from third-party payers, including federal and state governments under programs, such as Medicare and Medicaid, and private insurance plans. Insurers may not determine to cover the cost of the implant procedure, or it may take a considerable period of time for this to occur.

 

We believe that sales of our implantable microchip, and the extent to which our VeriMed system achieves market acceptance, will depend, in part, on the availability of insurance reimbursement from third-party payers, including federal and state government programs, such as Medicare and Medicaid, private health insurers, managed care organizations and other healthcare providers. Both governmental and private third-party payers are increasingly challenging the coverage and prices of medical products and services, and require proven efficacy and cost effectiveness for reimbursement. If patients undergoing the microchip implant procedure, or health institutions and doctors using the VeriMed system, are not able to obtain adequate reimbursement for the cost of using these products and services, they may forego or reduce their use. While we are in the process of facilitating and, in one case, funding clinical studies that may demonstrate the efficacy of the VeriMed system, which we believe will make it more likely that government and private insurers will cover the cost of the microchip implant process, it may take a considerable period of time for this to occur, if, in fact, it does occur. If government and private insurers do not determine to reimburse the cost of the implant process, we would not expect to realize the anticipated level of future sales of our implantable microchip and the database subscription fees.

 

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Our sales of systems that incorporate our implantable microchip may be enjoined by third parties who have rights to the intellectual property used in these systems and we may be required to pay damages which would have an adverse effect on our business.

 

We may face a claim that we are violating the intellectual property rights of one or more third parties with respect to U.S. Patent No. 5,211,129, “Syringe-Implantable Identification Transponders.” If such a claim is successful, we could be required to cease engaging in activities to market our systems that utilize the implantable microchip and to pay damages, which may be substantial.

 

We obtain the implantable microchip used in our VeriMed, VeriGuard and VeriTrace systems from Digital Angel, a majority-owned subsidiary of our parent company, Applied Digital, under the terms of a supply agreement. Digital Angel, in turn, obtains the implantable microchip from a subsidiary of Raytheon Company under a separate supply agreement. The technology underlying our VeriMed, VeriGuard and VeriTrace systems is covered, in part, by U.S. Patent No. 5,211,129. In 1994, Destron/IDI, Inc., a predecessor company to Digital Angel Corporation, granted a co-exclusive license under this patent, other than for certain specified fields of use retained by the predecessor company, to Hughes Aircraft Company, or Hughes, and its then wholly-owned subsidiary, Hughes Identification Devices, Inc., or HID. The specified fields of use retained by the predecessor company do not include human identification and security applications. The rights licensed in 1994 to Hughes and HID were freely assignable, and we do not know which party or parties currently have these rights or whether these rights have been assigned, transferred or conveyed to any third party. We source the implantable microchip indirectly from a subsidiary of Raytheon Company, with which Hughes, then known as HE Holdings, Inc. was merged in 1997. However, we have no documentation that establishes our right to use the patented technology for human identification and security applications. Hughes, HID, any of their respective successors in interest, or any party to whom any of the foregoing parties may have assigned its rights under the 1994 license agreement may commence a claim against us asserting that we are violating its rights. If such a claim is successful, sales of our VeriMed, VeriGuard and VeriTrace systems could be enjoined, and we could be required to cease our efforts to create a market for these systems, until the patent expires in April 2008. In addition, we could be required to pay damages, which may be substantial. Regardless of whether any claimant is successful, we would face the prospect of the expenditure of funds in litigation, the diversion of management time and resources, damage to our reputation and the potential impairment in the marketability of our systems even after the expiration of the patent, which could harm our business and negatively affect our prospects.

 

Even if our VeriMed system achieves some level of market acceptance, the anticipated significant and growing recurrent revenue from microchip-implanted persons’ subscribing to our database may not be realized.

 

Our business model envisages that our VeriMed system will achieve some level of penetration within our target market for such system: the approximately 45 million at-risk people in the United States with cognitive impairment, chronic diseases and related conditions, or implanted medical devices. The model also anticipates our deriving significant and growing recurrent revenue from subscriptions to our database by persons implanted with our microchip. However, a person implanted with our microchip may decide not to subscribe to our database if, for example, the hospital emergency room where he or she would most likely be taken in an emergency maintains its own database. We do not currently anticipate that a significant percentage of VeriMed-adopting hospitals and other healthcare facilities will choose to provide databases for this purpose. However, future regulatory changes, such as in connection with the U.S. government’s efforts to address inefficiencies in the U.S. healthcare system related to information technology, could spur hospitals and other healthcare facilities to establish systems to maintain electronic health records. This might have the effect of reducing the number of people implanted with our microchip who might otherwise subscribe to our database which could, in turn, negatively affect the future revenue that we anticipate we will derive from the VeriMed system.

 

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We intend to offer two annual subscription levels to our database: basic, which will allow an individual to include personal identification and contact information, physician and emergency contact information, blood type and advance directives, and full-featured, which will allow an individual to include all information permitted by the basic subscription as well as personal health records. Initially, we anticipate that individuals implanted with our microchip will take responsibility for inputting all of their information into our database, including personal health records, as physicians currently have little interest in being involved in this process – primarily because of liability concerns and because they are generally not paid for this service. Over time, we envision that persons implanted with our microchip may prevail upon their physicians to assist them with the inputting of information for which, by virtue of their medical training, physicians are better equipped to handle. If this does not occur, emergency room personnel and emergency medical technicians may lack confidence in the accuracy and completeness of implanted persons’ personal health records in the database. This may prompt some persons implanted with our microchip to choose to subscribe to our database only at the basic level, for which we plan to charge a lower annual fee. This could also negatively affect the revenue we anticipate we will derive in the future from the VeriMed system.

 

We obtain the implantable microchip used in our VeriMed, VeriGuard and VeriTrace systems from a single supplier, making us vulnerable to supply disruptions that could constrain our sales of such systems and/or increase our per-unit cost of production of the microchip.

 

At present, Digital Angel is our sole supplier of our implantable microchip under the terms of an agreement we entered into with Digital Angel in December 2005. Digital Angel, in turn, sources the microchip from Raytheon Microelectronics España, or RME, the actual manufacturer, under a supply agreement between Digital Angel and RME. The term of that agreement expires on June 30, 2010, subject to earlier termination by either party if, among other things, the other party breaches the agreement and does not remedy the breach within 30 days of receiving notice. Digital Angel and RME each own certain of the automated equipment and tooling used in the manufacture of the microchip. Accordingly, it would be difficult for Digital Angel to arrange for a third party other than RME to manufacture the implantable microchip if for any reason RME was unable to manufacture the implantable microchip or RME did not manufacture sufficient implantable microchips for Digital Angel to satisfy our requirements. Even if Digital Angel were able to arrange to have the implantable microchip manufactured in another facility, we currently believe making such arrangements and commencement of production could take at least three to six months. A supply disruption of this length could cause customers to cancel orders, negatively affect future sales and damage our business reputation. In addition, the per-unit cost of production at another facility could be more than the price per unit we pay to Digital Angel.

 

If we do not meet the minimum purchase requirements under our agreement with Digital Angel, Digital Angel may sell implantable microchips for secure human identification applications to third parties. Our loss of this exclusive supply arrangement may result in our facing competition with respect to our implantable microchip-based systems, which could have a material adverse effect on the expected growth of our business.

 

Our agreement with Digital Angel, under which we source our implantable microchip, includes a provision that Digital Angel may not sell to parties other than us and our resellers the implantable microchips, as well as the reader equipment, for secure human identification applications, provided we meet specified minimum purchase requirements. If we do not meet the minimum purchase requirements, Digital Angel is free to sell to other parties implantable microchips for secure human identification applications.

 

The minimum purchase requirements for implantable microchips under the agreement are as follows:

Year


   Minimum
Purchase
Requirement


2007

   $875,000

2008

   $1,750,000

2009

   $2,500,000

2010

   $3,750,000

2011 and thereafter

   $3,750,000

 

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For the nine months ended September 30, 2006 and the year ended December 31, 2005, the aggregate amount of our purchases under our agreement with Digital Angel were $0.2 million and $0.7 million, respectively.

 

If we lose the benefit of the exclusivity provision under our agreement with Digital Angel, we may face competition in the various target markets for our systems that use our implantable microchip, such as VeriMed, VeriGuard and VeriTrace, or face such competition at an earlier point in time than might otherwise have been the case, which could negatively affect our revenue, cash flows from operations, operating margins and profitability, as well as our growth prospects.

 

If Digital Angel were to terminate its agreement with us, we would not be able to obtain our implantable microchip. This would make it difficult to fulfill our expectations for future revenue and revenue growth from the sale of systems that use the implantable microchip.

 

Provided we meet our minimum purchase requirements, our agreement with Digital Angel is scheduled to remain in force until the last of the patents covering the supplied products expire. However, Digital Angel can terminate the agreement upon the occurrence of any of the following events:

 

   

our default in the performance of any of our obligations under the agreement (e.g., our failure to take delivery and pay for products) that is not cured within 90 days of receiving written notice of the default;

 

   

either party to the agreement filing a petition in bankruptcy; or

 

   

a petition in bankruptcy is filed against us and is not discharged within 30 days.

 

If the agreement were to be terminated, we would not be able to purchase our implantable microchip from Digital Angel. Further, if the termination occurred while the patents covering our implantable microchip remain in force, we could not obtain implantable microchips for secure human identification applications from any other source. As a result, we would not be able to sell our VeriMed system or any other products that incorporate our implantable microchip, such as our VeriGuard and VeriTrace systems. This would make it difficult for us to fulfill our expectations of future revenue and revenue growth from sales of such systems.

 

Implantation of our implantable microchip may be found to cause risks to a person’s health, which could adversely affect sales of our systems which incorporate the implantable microchip.

 

The implantation of our implantable microchip may be found, or be perceived, to cause risks to a person’s health. Potential or perceived risks include adverse tissue reactions, migration of the microchip and infection from implantation. As more people are implanted with our implantable microchip, it is possible that these and other risks to health will manifest themselves. Actual or perceived risks to a person’s health associated with the microchip implantation process could constrain our sales of the VeriMed system or result in costly and expensive litigation. Further, the potential resultant negative publicity could damage our business reputation, leading to loss in sales of our other systems targeted at the healthcare market which would harm our business and negatively affect our prospects.

 

If we are required to effect a recall of our implantable microchip, our reputation could be materially and adversely affected and the cost of any such recall could be substantial, which could adversely affect our results of operations and financial condition.

 

From time to time, implanted devices have become subject to recall due to safety, efficacy, product failures or other concerns. To date, we have not had to recall any of our implantable microchips. However, if, in the future, we are required to effect such a recall, the cost of the recall, and the likely related loss of system sales, could be substantial and could materially and adversely affect our results of operations and financial condition. In addition, any such recall could materially adversely affect our reputation and our ability to sell our systems that make use of the implantable microchip which would harm our business and negatively affect our prospects.

 

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Interruptions in access to, or the hacking into, our VeriMed patient information database may have a negative impact on our revenue, damage our reputation and expose us to litigation.

 

Reliable access to the VeriMed patient information database is a key component of the functionality of our VeriMed system. Our ability to provide uninterrupted access to the database, whether operated by us or one or more third parties with whom we contract, will depend on the efficient and uninterrupted operation of the computer and communications systems involved. Although certain elements of technological, power, communications, personnel and site redundancy are maintained, the database may not be fully redundant. Further, the database may not function properly if certain necessary third-party systems fail, or if some other unforeseen act or natural disaster should occur. In the past, we have experienced short periods during which the database was inaccessible as a result of development work, system maintenance and power outages. Any disruption of the database services, computer systems or communications networks, or those of third parties that we rely on, could result in the inability of users to access the database for an indeterminate period of time. This, in turn, could cause us to lose the confidence of the healthcare community and persons who have undergone the microchip implant procedure, resulting in a loss of revenue and possible litigation.

 

In addition, if the firewall software protecting the information contained in our database fails or someone is successful in hacking into the database, we could face damage to our business reputation and litigation.

 

Regulation of products and services that collect personally-identifiable information or otherwise monitor an individual’s activities may make the provision of our services more difficult or expensive and could jeopardize our growth prospects.

 

Certain technologies that we currently, or may in the future, support are capable of collecting personally-identifiable information. A growing body of laws designed to protect the privacy of personally- identifiable information, as well as to protect against its misuse, and the judicial interpretations of such laws, may adversely affect the growth of our business. In the United States, these laws include the Health Insurance Portability and Accountability Act, or HIPAA, the Federal Trade Commission Act, the Electronic Communications Privacy Act, the Fair Credit Reporting Act, and the Gramm-Leach-Bliley Act, as well as various state laws and related regulations. Although we are not a covered entity under HIPAA, we have entered into agreements with certain covered entities in which we are considered to be a “business associate” under HIPAA. As a business associate, we are required to implement policies, procedures and reasonable and appropriate security measures to protect individually identifiable health information we receive from covered entities. Our failure to protect health information received from customers could subject us to liability and adverse publicity, and could harm our business and impair our ability to attract new customers.

 

In addition, certain governmental agencies, like the U.S. Department of Health and Human Services and the Federal Trade Commission, have the authority to protect against the misuse of consumer information by targeting companies that collect, disseminate or maintain personal information in an unfair or deceptive manner. We are also subject to the laws of those foreign jurisdictions in which we operate, some of which currently have more protective privacy laws. If we fail to comply with applicable regulations in this area, our business and prospects could be harmed.

 

Certain regulatory approvals generally must be obtained from the governments of the countries in which our foreign distributors sell our systems. However, any such approval may be subject to significant delays or may not be obtained. Any actions by regulatory agencies could materially and adversely affect our growth plans and the success of our business.

 

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If we fail to comply with anti-kickback and false claims laws, we could be subject to costly and time-consuming litigation and possible fines or other penalties.

 

We are, or may become subject to, various federal and state laws designed to address healthcare fraud and abuse, including anti-kickback laws and false claims laws. The federal anti-kickback statute prohibits the offer, payment, solicitation or receipt of any form of remuneration in return for referring items or services payable by Medicare, Medicaid or any other federally-funded healthcare program. This statute also prohibits remuneration in return for purchasing, leasing or ordering or arranging, or recommending the purchasing, leasing or ordering, of items or services payable by Medicare, Medicaid or any other federally-funded healthcare program. The anti-kickback laws of various states apply more broadly to prohibit remuneration in return for referrals of business payable by payers other than federal healthcare programs.

 

False claims laws prohibit anyone from knowingly presenting, or causing to be presented, for payment to third-party payers, including Medicare and Medicaid, which currently do not provide reimbursement for our microchip implant procedure, claims for reimbursed drugs or services that are false or fraudulent, claims for items or services not provided as claimed, or claims for medically unnecessary items or services. Our activities relating to the reporting of wholesale or estimated retail prices of our VeriMed system, the reporting of Medicaid rebate information, and other information affecting federal, state and third-party payment for the VeriMed system, will be subject to scrutiny under these laws.

 

The anti-kickback statute and other fraud and abuse laws are very broad in scope, and many of their provisions have not been uniformly or definitively interpreted by existing case law or regulations. Violations of the anti-kickback statute and other fraud and abuse laws may be punishable by criminal and/or civil sanctions, including fines and civil monetary penalties, as well as the possibility of exclusion from federal healthcare programs, including Medicare and Medicaid, which currently do not provide reimbursement for our microchip implant procedure. We have not been challenged by a governmental authority under any of these laws and believe that our operations are in compliance with such laws. However, because of the far-reaching nature of these laws, we may be required to alter one or more of our practices to be in compliance with these laws. Healthcare fraud and abuse regulations are complex and even minor, inadvertent irregularities in submissions can potentially give rise to claims that the statute has been violated. If we are found to have violated these laws, or are charged with violating them, our business, financial condition and results of operations could suffer, and our management team could be required to dedicate significant time addressing the actual or alleged violations.

 

Risks Related to Our Continued Affiliation with Applied Digital and Digital Angel

 

After completion of this offering, Applied Digital will retain significant voting control over us. This may delay, prevent or deter corporate actions that may be in the best interest of our stockholders.

 

After the completion of this offering, Applied Digital will control approximately 60.7% of our outstanding common stock and 47.5% of our common stock on a fully-diluted basis (55.6% and 43.5%, respectively, if the underwriters’ over-allotment option is exercised in full). As a result, Applied Digital will be able either to control or exercise significant influence over all matters requiring approval of our stockholders, including the election of directors and approval of significant corporate transactions. This concentration of ownership may have the effect of delaying, preventing or deterring a change in control of our Company even when such a change may be in the best interests of all our stockholders. It could also have the effect of depriving stockholders of an opportunity to receive a premium for their common stock as part of a sale of our Company or assets and might affect the prevailing market price of our common stock.

 

Conflicts of interest may arise among Applied Digital, Digital Angel and us that could be resolved in a manner unfavorable to us.

 

Questions relating to conflicts of interest may arise between Applied Digital, our parent company, and/or Digital Angel, a subsidiary of Applied Digital, on the one hand, and us, on the other, in a number of

 

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areas relating to our past and ongoing relationships. After this offering, three of our five directors will continue to serve as directors of Applied Digital. This includes Scott R. Silverman, our new chief executive officer and the chairman of our board of directors, who serves as the chairman of the board of Applied Digital and also as a director of Digital Angel.

 

Areas in which conflicts of interest between or among Applied Digital, Digital Angel and us could arise include, but are not limited to, the following:

 

Cross directorships and stock ownership. The equity interests of our directors in Applied Digital or service as a director of both Applied Digital and us could create, or appear to create, conflicts of interest when directors are faced with decisions that could have different implications for the two companies. For example, these decisions could relate to, among other matters:

 

   

the nature, quality and cost of services rendered to us by Applied Digital;

 

   

the desirability of a potential acquisition or joint venture opportunity;

 

   

employee retention or recruiting; or

 

   

our dividend policy.

 

Intercompany transactions. From time to time, Applied Digital or its affiliates, including Digital Angel, may enter into transactions with us or our subsidiaries or other affiliates. Although the terms of any such transactions will be established based upon negotiations between employees of Applied Digital and/or the applicable affiliate and us and, when appropriate, subject to the approval of the independent directors on our board or a committee of disinterested directors, there can be no assurance that the terms of any such transactions will be as favorable to us or our subsidiaries or affiliates as may otherwise be obtained in arm’s-length negotiations with an unaffiliated third party.

 

Intercompany agreements. We have entered several agreements with Applied Digital, including:

 

   

a transition services agreement under which Applied Digital will provide us certain management, administrative, accounting, tax, legal and other services;

 

   

a loan agreement; and

 

   

a tax allocation agreement setting forth Applied Digital’s and our rights and obligations with respect to the handling and allocation of taxes and related matters for all periods prior to the consummation of this offering.

 

The terms of these agreements were established while we have been controlled by Applied Digital and were not the result of arm’s-length negotiations. In addition, conflicts could arise in the interpretation, or in connection with any extension or renegotiation, of these existing agreements after this offering. See “Certain Relationships and Related Party Transactions.”

 

Risks Related to the Offering

 

An active trading market for our common stock may not develop, and we expect that our stock price will fluctuate significantly due to events and developments unique to our business or the healthcare industry generally.

 

Prior to the offering, you could not buy or sell our common stock publicly. We have applied to have our common stock listed on the Nasdaq Global Market, but an active trading market for our shares may never develop or be sustained following the offering. The initial public offering price for our common stock will be determined through negotiations with the underwriters. This initial public offering price may vary from the market price of the common stock after the offering and you may not be able to sell your

 

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common stock at or above the initial public offering price. The stock market has from time to time experienced significant volatility. Factors that could cause volatility in the market price of our common stock include:

 

   

failure of any of our products, particularly our asset/staff location and identification system and our VeriMed system, to achieve commercial success;

 

   

FDA or international regulatory actions;

 

   

announcements of new products by our competitors;

 

   

market conditions in the healthcare sector;

 

   

litigation or public concern about the efficacy or safety of existing, new or potential products or technologies;

 

   

comments by securities analysts; and

 

   

rumors relating to us or our competitors.

 

These and other factors may cause the market price and demand for our common stock to fluctuate substantially, which may limit or prevent investors from readily selling their shares of our common stock and may otherwise negatively affect the liquidity of our common stock. In addition, in the past, when the market price of a stock has been volatile, holders of that stock have instituted securities class action litigation against the company that issued the stock. If any of our stockholders brought a lawsuit against us, we could incur substantial costs defending the lawsuit and the time and attention of our management may be diverted.

 

Future sales of our common stock, including sales of our common stock acquired upon the exercise of outstanding options and warrants, may cause our stock price to fall and you could lose all or part of your investment.

 

The market price of our common stock could decline as a result of sales by Applied Digital of shares of common stock in the market after the offering, or sales of our common stock acquired upon the exercise of outstanding options and warrants, or the perception that these sales could occur. These sales might also make it more difficult for us to sell equity securities at a time and price that we deem appropriate. The lock-up agreements delivered by certain of our current and former officers and directors, as well as Applied Digital, covering 7,920,069 shares of our common stock, including shares underlying outstanding options, provide that Merriman Curhan Ford & Co., at any time or from time to time and without notice, may release those parties from their obligation not to dispose of shares of our common stock for a period of 180 days after the date of this prospectus. In addition, IBM Credit Corporation, which holds a warrant exercisable for 410,889 shares of our common stock, has entered into a similar lock-up agreement covering such shares. Merriman Curhan Ford & Co. has no pre-established conditions to waiving the terms of the lock-up agreements, and any decision by it to waive those conditions would depend on a number of factors, which may include market conditions, the performance of our common stock in the market and our financial condition at that time.

 

After the offering, we will have 9,155,556 shares outstanding and 2,546,680 shares will be issuable upon exercise of outstanding options and warrants. Of these 11,702,236 shares, 944,222 shares will be subject to registration rights. See “Description of Capital Stock.”

 

Investors in the offering will pay a much higher price than the book value of our common stock and will incur immediate and substantial dilution and may incur additional dilution in the future.

 

If you purchase our common stock in the offering, you will pay more for your shares than the amount Applied Digital paid for our shares. You will incur immediate and substantial dilution of $6.19 per share, representing the difference between our pro forma net tangible book value per share after giving effect to the offering and an assumed initial public offering price of $6.50 per share. In the past, we have

 

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issued options and warrants to acquire common stock at prices significantly below the assumed initial public offering price. To the extent these options or warrants are ultimately exercised, you will sustain further dilution. Moreover, we may require additional funds to support our working capital requirements or for other purposes, and may seek to raise additional funds through public or private equity financing. We also may acquire other companies or technologies or finance strategic alliances by issuing equity. Any of these or other capital raising transactions may result in additional dilution to our stockholders.

 

We will have broad discretion in how we use the net proceeds of this offering, and we may not use these proceeds effectively, which could negatively impact our results of operations and cause our stock price to decline.

 

Our management will have considerable discretion in the application of a portion of the net proceeds of this offering, and you will not have the opportunity, as part of your investment decision, to assess whether we are using the net proceeds effectively. We intend to use the net proceeds from this offering as follows:

 

   

$3.5 million will be used to repay a portion of our outstanding indebtedness, including accrued interest, owed to Applied Digital at the time of the consummation of this offering;

 

   

approximately $8.0 million to $10.0 million will be used over the next 24 months to continue the development of the market for our VeriMed system, principally through an increase in our sales and marketing efforts related to our VeriMed system; and

 

   

the remaining net proceeds will be used for working capital and general corporate purposes, which may include research and development, capital expenditures and other sales and marketing expenses.

 

There can be no assurance that the net proceeds used to continue the development of the market for the VeriMed system will, in fact, result in the development of that market and, in fact, may provide little or no return to investors. In addition, our management will have broad discretion in applying the net proceeds of this offering remaining after repayment of the amount owed to Applied Digital, and may determine to apply these remaining net proceeds for other purposes.

 

Provisions of our second amended and restated certificate of incorporation or our amended and restated bylaws could delay or prevent an acquisition of our company, even if the acquisition would be beneficial to our stockholders, and could make it more difficult for you to change management.

 

Provisions of our second amended and restated certificate of incorporation and our amended and restated bylaws may discourage, delay or prevent a merger, acquisition or other change in control that stockholders may consider favorable, including transactions in which stockholders might otherwise receive a premium for their shares. This is because these provisions may prevent or frustrate attempts by stockholders to replace or remove our current management or members of our board of directors. These provisions, among other things:

 

   

prohibit cumulative voting in the election of directors, which might otherwise allow holders of less than a majority of our outstanding shares of voting stock to elect one or more director candidates;

 

   

permit our board of directors to issue, without further action by our stockholders, up to 5,000,000 shares of “blank check” preferred stock, with any rights, preferences and privileges as they may designate (including the right to approve an acquisition or other change in control);

 

   

establish advance notice procedures with respect to stockholder proposals and the nomination of candidates for election as directors, other than nominations made by or at the direction of our board of directors;

 

   

prohibit stockholders from calling special meetings of stockholders;

 

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prohibit stockholder action by written consent, thereby requiring all actions to be taken at a meeting of the stockholders; and

 

 

 

provide that members of our board of directors may only be removed for cause by the affirmative vote of holders of at least a majority of the voting power of all then outstanding shares of capital stock entitled to vote generally in the election of directors, voting together as a single class.

 

As a result, these provisions and others available under Delaware’s General Corporation Law could limit the price that investors are willing to pay in the future for shares of our common stock.

 

As a public company, we will need to dedicate significant time and expense to enhancing, documenting, testing and certifying our internal control over financial reporting.

 

As a publicly-traded company, we will be required to file annual and quarterly reports containing our financial statements within specified time periods. Securities and Exchange Commission rules will require that our chief executive officer and chief financial officer periodically provide certifications as to, among other things, the existence and effectiveness of our internal control over financial reporting and disclosure controls and procedures. Furthermore, our independent registered public accounting firm will be required, beginning with our annual report on Form 10-K for our fiscal year ending December 31, 2007, to attest to management’s assessment of our internal control over financial reporting. In general, this process requires significant documentation of policies, procedures and controls, review of that documentation by our internal accounting staff and our outside auditors, and testing of our internal controls by our internal accounting staff and our outside independent registered public accounting firm. Documentation and testing of our internal controls will involve considerable time and expense and may strain our internal resources. Ensuring that we have adequate internal financial and accounting controls and procedures in place to help ensure that we can produce accurate financial statements on a timely basis is a costly and time-consuming effort that needs to be re-evaluated on a periodic basis.

 

If we fail to maintain proper and effective internal controls, our ability to produce accurate financial statements could be impaired, which could adversely affect our operating results, our ability to operate our business and our stock price.

 

During the course of our testing of our internal controls, we may identify, and have to disclose, material weaknesses or significant deficiencies in our internal controls that will have to be remediated. Implementing any appropriate changes to our internal controls may require specific compliance training of our directors, officers and employees, entail substantial costs in order to modify our existing accounting systems, and take a significant period of time to complete. Such changes may not, however, be effective in maintaining the adequacy of our internal controls, and any failure to maintain that adequacy, or consequent inability to produce accurate financial statements on a timely basis, could increase our operating costs and could materially impair our ability to operate our business. In addition, investors’ perceptions that our internal controls are inadequate or that we are unable to produce accurate financial statements may negatively affect our stock price.

 

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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

This prospectus contains forward-looking statements that involve risks and uncertainties. Forward-looking statements include all statements that are not historical facts. These forward-looking statements, which are usually accompanied by words such as “may,” “might,” “should,” “could,” “intends,” “estimates,” “predicts,” “potential,” “continue,” “believes,” “anticipates,” “plans,” “expects” and similar expressions, relate to, without limitation, statements about our market opportunities, our strategy, our projected revenue and expense levels and the adequacy of our available cash resources. This prospectus also contains forward-looking statements attributed to third parties relating to their estimates regarding the size of the future market for products and systems such as our products and systems, and the assumptions underlying such estimates. These statements are only predictions based on our current expectations and projections, or those of third parties, about future events.

 

Although we believe that the expectations reflected in the forward-looking statements contained in this prospectus are based upon reasonable assumptions, no assurance can be given that such expectations will be attained or that any deviations will not be material. In light of these risks, uncertainties and assumptions, the forward-looking statements, events and circumstances discussed in this prospectus may not occur and actual results could differ materially and adversely from those anticipated or implied in the forward-looking statements. Important factors that could cause our actual results, level of performance or achievements to differ materially from those expressed or forecasted in, or implied by, the forward-looking statements we make in this prospectus include:

 

   

our ability to successfully implement our business strategy;

 

   

our expectation that we will incur losses, on a consolidated basis, for the foreseeable future;

 

   

our ability to fund our operations;

 

   

borrowings under our existing bank facility are payable on demand and the facility could be terminated at any time without notice;

 

   

the relative maturity in the United States and limited size of the markets for our infant protection and wander prevention systems and vibration monitoring instruments;

 

   

the degree of success we have in leveraging our brand reputation, reseller network and end-use customer base for our infant protection and wander prevention systems to gain inroads in the emerging market for asset/staff location and identification systems;

 

   

the rate and extent of the U.S. healthcare industry’s adoption of RFID asset/staff location and identification systems;

 

   

the relative degree of market acceptance of our zonal, or cell ID, active RFID systems compared to competing technologies, such as lower power Ultra Wide Band-based location technologies, 802.11 and Zigbee-based location and wireless networking technologies;

 

   

our ability to complete our efforts to integrate our infant protection, wander prevention and asset/staff location and identification systems on one technology platform;

 

   

our ability to complete our efforts to introduce a new vibration monitoring instrumentation platform;

 

   

uncertainty as to whether we will be able to increase our sales of infant protection and wander prevention systems outside of North America;

 

   

our success in integrating our Canadian-based businesses;

 

   

our reliance on third-party dealers to successfully market and sell our products;

 

   

we may become subject to costly product liability claims and claims that our products infringe the intellectual property rights of others;

 

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our ability to comply with current and future regulations relating to our businesses;

 

   

uncertainty as to whether a market for our VeriMed, VeriGuard and VeriTrace systems will develop and whether we will be able to generate more than a nominal level of revenue from the sale of these systems;

 

   

the potential for patent infringement claims to be brought against us asserting that we hold no rights for the use of the implantable microchip technology and that we are violating another party’s intellectual property rights. If such a claim is successful, we could be enjoined from engaging in activities to market the systems that utilize the implantable microchip and be required to pay substantial damages;

 

   

market acceptance of our VeriMed system, which will depend in large part on the future availability of insurance reimbursement for the VeriMed system microchip implant procedure from government and private insurers, and the timing of such reimbursement, if it, in fact, occurs;

 

   

a potential disruption to our business, loss of sales and higher expense if we are unable to obtain the implantable microchip used in our VeriMed, VeriGuard and VeriTrace systems from Digital Angel and other risks related to our supply agreement with Digital Angel;

 

   

our ability to provide uninterrupted, secure access to the VeriMed database;

 

   

conflict of interest risks related to our continued affiliation with Digital Angel and our parent company, Applied Digital;

 

   

our ability to establish and maintain proper and effective internal accounting and financial controls; and

 

   

the other factors discussed under “Risk Factors.”

 

You should not place undue reliance on any forward-looking statements. Except as otherwise required by federal securities laws, we disclaim any obligation or undertaking to disseminate any updates or revisions to any forward-looking statement contained in this prospectus to reflect any change in our expectations or any change in events, conditions or circumstances on which any such statement is based.

 

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USE OF PROCEEDS

 

We estimate that the net proceeds we will receive from the sale of our common stock in this offering will be approximately $16.5 million, based on an assumed initial public offering price of $6.50 per share and after deducting estimated underwriting discounts and commissions and estimated offering expenses which we have not previously paid. We will not receive any proceeds from the sale of shares subject to the over-allotment option granted by Applied Digital to the underwriters.

 

We intend to use $3.5 million of the net proceeds we receive from this offering to repay a portion of our indebtedness to Applied Digital, in accordance with the terms of amended loan documents between, Applied Digital, as lender, and us, as borrower. For more information on our indebtedness to Applied Digital and the terms of the loan documents, see “Certain Relationships and Related Party Transaction—Transactions with Applied Digital—Loan from Applied Digital.”

 

We expect that approximately $8.0 million to $10.0 million of the net proceeds of this offering will be used over the next 24 months to continue our efforts to create a market for our VeriMed system, principally through an increase in our sales and marketing efforts.

 

We intend to use the remaining net proceeds for working capital and general corporate purposes, which may include research and development, capital expenditures and other sales and marketing expenses. We have not determined the amounts to be used for any of these purposes and may find it necessary or advisable to use this portion of the net proceeds for other purposes.

 

The amount and timing of what we actually spend for any of these or other purposes will depend on a number of factors, including our future revenue and cash generated by operations and the other factors described under “Risk Factors.” Accordingly, our management will have broad discretion in applying this portion of the net proceeds of the offering remaining after repayment of a portion of the amount owed to Applied Digital. Pending these uses, we intend to invest the net proceeds that are not dedicated to repayment of our outstanding indebtedness, and accrued interest, owed to Applied Digital in short-term interest-bearing, investment grade securities. We cannot predict whether such securities will yield a favorable return.

 

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DIVIDEND POLICY

 

We have never declared or paid any cash dividends on our capital stock. We presently intend to retain future earnings, if any, to finance the development and growth of our business, and we do not expect to pay any cash dividends in the foreseeable future. Any future determination with respect to the payment of dividends will be at the discretion of our board of directors and will be dependent upon our financial condition, results of operations, capital requirements, general business conditions, terms of financing arrangements and other factors that our board of directors may deem relevant.

 

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CAPITALIZATION

 

The following table sets forth our capitalization as of September 30, 2006:

 

   

on an actual basis; and

 

   

on an as adjusted basis to give effect to (i) our receipt of the net proceeds from the sale of 3,100,000 shares of our common stock we are offering in this offering at an assumed initial public offering price of $6.50 per share, after deducting estimated underwriting discounts and commissions and estimated offering expenses, and (ii) the use of the net proceeds we will receive as set forth in the “Use of Proceeds” section of this prospectus.

 

You should read this table in conjunction with the information under the captions “Use of Proceeds,” “Selected Consolidated Financial Data” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the related notes, included elsewhere in this prospectus.

 

     September 30, 2006(1)

 
     Actual

     As adjusted

 
     (Unaudited)  
     (in thousands, except
share and per share data)
 

Debt, including current portion

   $ 10,027      $ 6,527  

Stockholders’ equity:

                 

Preferred stock: $0.001 par value, 5,000,000 shares authorized, none issued or outstanding, actual and as adjusted

             

Common stock: $0.01 par value; 70,000,000 shares authorized (40,000,000 shares effective December 2006); 5,555,556 shares issued and outstanding, actual; 9,155,556 issued and outstanding, as adjusted

     55        92  

Additional paid-in capital

     38,952        51,600  

Accumulated other comprehensive loss

     (37 )      (37 )

Accumulated deficit

     (13,775 )      (13,775 )
    


  


Total stockholders’ equity

     25,195        37,880  
    


  


Total capitalization

   $ 35,222      $ 44,407  
    


  



(1) On December 18, 2006, we amended and restated our certificate of incorporation to decrease the authorized number of shares of our common stock from 70,000,000 to 40,000,000 shares and to change the par value of our common stock to $0.01 per share. In addition, we effected a 1-for-3 reverse stock split. The shares issued and outstanding as of September 30, 2006 have been retroactively adjusted to reflect the reverse stock split. In December 2006, we also issued 500,000 restricted shares of common stock to Scott R. Silverman in connection with his appointment as our chief executive officer. The issuance of such restricted shares is reflected as issued and outstanding in the as adjusted column of the table.

 

The table above does not include the following as of September 30, 2006:

 

   

1,741,559 shares of our common stock issuable upon the exercise of outstanding options under our stock plans at a weighted average exercise price of $1.30 per share;

 

   

502,886 additional shares of our common stock reserved for future grant under our stock plans;

 

   

357,566 shares of our common stock issuable upon the exercise of outstanding options that were issued outside of our stock plans at a weighted average exercise price of $6.01 per share; and

 

   

444,222 shares of our common stock issuable upon the exercise of outstanding warrants at a weighted average exercise price of $2.91 per share.

 

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DILUTION

 

Investors participating in the offering will incur immediate and substantial dilution. On a pro forma basis to reflect the issuance of 500,000 restricted shares of common stock to our chief executive officer in December 2006, as of September 30, 2006, we had a deficit net tangible book value of $13.4 million, or $(2.21) per share of our common stock. Net tangible book value per share represents the amount of our total tangible assets (total assets less intangible assets, goodwill and deferred offering costs) less total liabilities, divided by the pro forma number of shares of our outstanding common stock at September 30, 2006. After giving effect to the sale of 3.1 million shares of our common stock in this offering at an assumed initial public offering price of $6.50 per share, and after deducting estimated underwriting discounts commissions and estimated offering expenses payable by us, our adjusted net tangible book value as of September 30, 2006 would have been approximately $2.8 million, or approximately $0.31 per share of our common stock. This represents an immediate increase in net tangible book value of $2.52 per share to our existing stockholder and an immediate dilution of $6.19 per share to investors purchasing shares of our common stock in this offering.

 

The following table illustrates this per share dilution to the investors in this offering without giving effect to the over-allotment option granted by Applied Digital to the underwriters:

 

Assumed initial public offering price per share

            $ 6.50

Deficit net tangible book value per share as of September 30, 2006

   $ (2.21 )       

Increase per share attributable to investors in this offering

   $ 2.52         
    


      

As adjusted net tangible book value per share after the offering

            $ 0.31
             

Dilution in net tangible book value per share to investors in this offering

            $ 6.19
             

 

The following table summarizes, on a pro forma basis as of September 30, 2006 to reflect the issuance of 500,000 shares of restricted common stock to our chief executive officer in December 2006, the differences between the number of shares of common stock purchased from us, the total consideration paid, and the average price per share paid by our existing stockholders and by investors in this offering. We have used an assumed initial public offering price of $6.50 per share, and have not deducted the estimated underwriting discounts and commissions and other estimated expenses of the offering payable by us.

 

     Shares Purchased

    Total Consideration

   

Average Price

Per Share


     Number

   Percent

    Amount

    Percent

   

Existing stockholders

   6,055,556    66.1 %   $35,539,570 (1)   63.8 %   $5.87

New investors

   3,100,000    33.9 %   $20,150,000     36.2 %   $6.50
    
  

 

 

 

Total

   9,155,556    100.00 %   $55,689,570     100.00 %   $6.08
    
  

 

 

 

(1) The amount includes the consideration paid for EXI Wireless, which was contributed to us by Applied Digital in exchange for 1,111,111 shares of our common stock, and the purchase price consideration paid by Applied Digital, on our behalf, at the time of the closing of the acquisition of Instantel (which excludes a purchase price installment of $2.5 million borne by us). With respect to the 500,000 restricted shares of common stock issued to Scott R. Silverman upon his becoming our chief executive officer in December 2006, no cash consideration was paid for such shares.

 

The discussion and tables above are based on 6,055,556 shares of common stock outstanding on September 30, 2006 on a pro forma basis to give effect to the issuance of 500,000 restricted shares of

 

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common stock to Mr. Silverman in December 2006, and exclude as of September 30, 2006 an aggregate of 3,046,233 shares of common stock that are reserved for future issuance, consisting of:

 

   

1,741,559 shares of our common stock issuable upon the exercise of outstanding options under our stock plans at a weighted average exercise price of $1.30 per share;

 

   

502,886 additional shares of our common stock reserved for future grant under our stock plans;

 

   

357,566 shares of our common stock issuable upon the exercise of outstanding options that were issued outside of our stock plans at a weighted average exercise price of $6.01 per share; and

 

   

444,222 shares of our common stock issuable upon the exercise of outstanding warrants at a weighted average exercise price of $2.91 per share.

 

To the extent that these options and warrants are exercised, there will be further dilution to investors in this offering. In addition, we may choose to raise additional capital due to market conditions or strategic considerations even if we believe we have sufficient funds for our current or future operating plans. To the extent that additional capital is raised through the sale of equity or convertible debt securities, the issuance of these securities could result in further dilution to our stockholders.

 

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SELECTED CONSOLIDATED FINANCIAL DATA

 

VeriChip Corporation

 

You should read the following selected consolidated financial data in conjunction with our consolidated financial statements and related notes, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the “Unaudited Pro Forma Condensed Combined Financial Information” appearing elsewhere in this prospectus. Data for the nine months ended September 30, 2006 and 2005, and the balance sheet data as of September 30, 2006, are derived from our unaudited interim condensed consolidated financial statements included elsewhere in this prospectus. The balance sheet data as of September 30, 2005 is derived from our unaudited interim condensed consolidated financial statements which are not included in this prospectus. The consolidated statements of operations data for the years ended December 31, 2005, 2004 and 2003 and the consolidated balance sheet data at December 31, 2005 and 2004 are derived from our audited consolidated financial statements included elsewhere in this prospectus. The consolidated statements of operations data for the year ended December 31, 2002 and the consolidated balance sheet data at December 31, 2003 and 2002 are derived from our audited consolidated financial statements which are not included in this prospectus. The historical results are not necessarily indicative of results to be expected for future periods, and the results for the nine months ended September 30, 2006 are not necessarily indicative of results that may be expected for the entire year ending December 31, 2006. We acquired two Canadian-based businesses during the first half of 2005 and, accordingly, our historical results only include their results of operations since their respective dates of acquisition. The pro forma results reflected below give effect to the acquisitions of these two businesses as if they had occurred on January 1, 2005.

 

    

Nine Months
Ended

September 30,


    Year Ended December 31,

 
     2006

    2005

   

2005

Pro forma(1)


   

2005

Historical


   

2004

Historical


   

2003

Historical


   

2002

Historical


 
     (Unaudited)     (Unaudited)                          
                 (in thousands, except per share data)  

Consolidated Statements of Operations Data:

                                                        

Total revenue

   $ 20,344     $ 9,115     $     24,554     $     15,869     $ 247     $ 545     $  

Total cost of products and services

     8,494       3,606       10,332       6,395       199       200        
    


 


 


 


 


 


 


Gross profit

     11,850       5,509       14,222       9,474       48       345        

Selling, general and administrative expense

     12,580       7,001       16,990       12,442       1,930       1,977       1,320  

Research and development

     2,700       1,057       3,260       1,958                    

Interest and other expense (income)

     61       (39 )     (83 )     (63 )     (15 )            

Interest expense

     501       230       343       343       144       78       21  
    


 


 


 


 


 


 


Loss before benefit for income taxes

     (3,992 )     (2,740 )     (6,288 )     (5,206 )     (2,011 )     (1,710 )     (1,341 )

Benefit from (provision for) income taxes

     541       53       761       56                    
    


 


 


 


 


 


 


Net loss

     (3,451 )     (2,687 )     (5,527 )     (5,262 )     (2,011 )     (1,710 )     (1,341 )

Deemed dividends

           (1 )     (1 )     (1 )                 (44 )
    


 


 


 


 


 


 


Net loss attributable to common stockholder

     (3,451 )     (2,688 )   $ (5,528 )   $ (5,263 )   $ (2,011 )   $ (1,710 )   $ (1,385 )
    


 


 


 


 


 


 


Net loss attributable to common stockholder per common share- basic and diluted

   $ (0.62 )   $ (0.52 )   $ (0.99 )   $ (1.00 )   $ (0.45 )   $ (0.38 )   $ (0.31 )
    


 


 


 


 


 


 


Weighted average number of common shares outstanding: Basic and diluted

     5,556       5,185       5,556       5,279       4,444       4,444       4,444  

(1) See Unaudited Pro Forma Condensed Combined Financial Information appearing elsewhere in this prospectus.

 

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     At September 30,

   At December 31,

 
     2006

   2005

   2004

    2003

    2002

 
     (Unaudited)    (in thousands)  

Consolidated Balance Sheet Data:

                                      

Cash

   $ 879    $ 1,440    $ 23     $ 269     $  

Equipment, net of accumulated depreciation and amortization

     1,100      890      131       147       184  

Goodwill

     16,025      16,982                   

Total assets

     49,739      48,438      283       782       245  

Long-term debt

     8,947                        

Total debt

     10,027      6,975      4,221       2,864       1,236  

Stockholder’s equity (deficit)

     25,195      28,527      (4,012 )     (2,258 )     (1,264 )

 

EXI Wireless Inc.

 

We have presented the following selected consolidated financial data for EXI Wireless Inc. because EXI Wireless is considered to be a predecessor of ours. The information presented is for periods prior to our acquisition of EXI Wireless. We acquired EXI Wireless effective March 31, 2005.

 

You should read the following selected consolidated financial data in conjunction with the EXI Wireless consolidated financial statements and related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing elsewhere in this prospectus. The consolidated statements of operations and balance sheet data at and for the years ended December 31, 2004, 2003, 2002 and 2001, and at and for the three months ended March 31, 2005, are derived from the EXI Wireless audited consolidated financial statements.

 

     Three
months
ended
March 31,


    Year Ended December 31,

 
    

2005

Historical


   

2004

Historical


   

2003

Historical


   

2002

Historical


   

2001

Historical


 
     (in thousands, except per share data)  

Consolidated Statements of Operations Data:

                                        

Sales

   $ 1,986     $ 6,004     $ 6,118     $ 6,383     $ 4,956  

Cost of sales

     575       1,763       1,735       1,754       1,419  
    


 


 


 


 


Gross profit

     1,411       4,241       4,383       4,629       3,537  

Selling, general and administrative expense and depreciation and amortization

     1,355       3,524       3,222       3,276       3,011  

Research and development

     262       918       741       728       1,517  

Interest and other income

     (2 )     (17 )     (4 )     (7 )     (5 )

Foreign exchange loss (gain)

     (18 )     169       334       36       (45 )
    


 


 


 


 


Earnings (loss) before income taxes

     (186 )     (353 )     90       596       (941 )

Benefit from income taxes

           (24 )     (55 )     (75 )     (152 )

Loss from discontinued operations net of tax

                       (512 )     (189 )
    


 


 


 


 


Net income (loss)

     $(186 )   $ (329 )   $ 145     $ 159     $ (978 )
    


 


 


 


 


     At March 31,

    At December 31,

 
     2005

    2004

    2003

    2002

    2001

 
     (in thousands)  

Consolidated Balance Sheet Data:

                                        

Cash

   $ 554     $ 1,127     $ 1,025     $ 1,296     $ 719  

Property, plant and equipment

     191       189       294       318       369  

Goodwill

     1,441       1,450       1,348       1,103       1,179  

Total assets

     4,975       5,338       5,203       4,847       4,062  

Long-term debt

                              

Total debt

                              

Stockholder’s equity

     3,971       4,025       4,070       3,184       2,983  

 

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Instantel Inc.

 

We have presented the following selected consolidated financial data for Instantel Inc. because Instantel is considered to be a predecessor of ours. The information presented is for periods prior to our acquisition of Instantel. We acquired Instantel effective June 10, 2005.

 

You should read the following selected consolidated financial data in conjunction with Instantel’s consolidated financial statements and related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing elsewhere in this prospectus. The consolidated statements of operations and balance sheet data at and for the years ended December 31, 2004, 2003, 2002 and 2001, and at and for the period ended June 9, 2005, are derived from Instantel’s audited financial statements.

 

    

Period
ended

June 9,


    Year Ended December 31,

    

2005

Historical


   

2004

Historical


   

2003

Historical


   

2002

Historical


   

2001

Historical


     (in thousands, except per share data)

Consolidated Statements of Operations Data:

                                      

Revenue

   $ 6,759     $ 13,595     $ 11,382     $ 11,344     $ 10,470

Cost of goods sold

     3,226       5,450       4,645       4,430       4,322
    


 


 


 


 

Gross margin

     3,533       8,145       6,737       6,914       6,148

Selling, general and administrative expense

     4,205       6,928       6,281       6,447       3,538

Research and development

     1,040       1,688       1,397       1,138       1,297

Interest and other income

                            

Interest expense

     367       943       1,055       1,265       230
    


 


 


 


 

Earnings (loss) before income taxes

     (2,079 )     (1,414 )     (1,996 )     (1,935 )     1,083

Provision for (benefit from) income taxes

     (1,221 )     (660 )     (795 )     (697 )     732
    


 


 


 


 

Net loss

   $ (858 )   $ (754 )   $ (1,201 )   $ (1,238 )   $ 351
    


 


 


 


 

     At June 9,

    At December 31,

     2005

    2004

    2003

    2002

    2001

     (in thousands)

Balance Sheet Data:

                                      

Cash and cash equivalents

   $ 4     $ 46     $ 167     $ 659     $

Property and Equipment

     493       474       278       273       277

Goodwill

     593       593       593       593       593

Total Assets

     10,280       11,593       14,418       17,925       21,389

Long-term debt

           5,500       5,500       8,633       9,892

Total debt

     6,214       6,087       8,133       9,892       10,500

Stockholder’s (deficit) equity

     (222 )     634       1,382       2,463       3,827

 

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UNAUDITED PRO FORMA CONDENSED COMBINED FINANCIAL INFORMATION

 

The accompanying unaudited pro forma condensed combined statement of operations reflects our condensed consolidated results of operations for the year ended December 31, 2005, after giving effect to our acquisitions of EXI Wireless Inc. and Instantel Inc. as if such acquisitions had occurred on January 1, 2005.

 

The pro forma adjustments do not reflect any adjustments associated with potential operating efficiencies and cost savings associated with combining the companies. The pro forma adjustments do not include any adjustments to historical prices for any future price changes, any adjustments to selling and marketing expenses for any future operating changes or any additional costs associated with becoming a publicly-held company.

 

The pro forma adjustments reflecting the consummation of the acquisitions are based upon the purchase method of accounting and upon the assumptions set forth in the footnotes to the unaudited pro forma condensed combined statement of operations. The required purchase accounting adjustments, including the allocation of the purchase price to the assets acquired and liabilities assumed based on their respective fair values, is based upon final valuations for EXI Wireless and Instantel.

 

On March 31, 2005, Applied Digital acquired EXI Wireless through a plan of arrangement under which Applied Digital issued 3,388,407 shares of its common stock valued at approximately $11.7 million to EXI Wireless’ shareholders. In addition, all outstanding EXI Wireless options and warrants were converted into options or warrants exercisable for shares of Applied Digital’s common stock. The value of the options and warrants exchanged was approximately $0.7 million. Included in the aggregate $13.3 million purchase price was approximately $0.9 million of acquisition costs consisting primarily of a finder’s fee and legal and accounting related services that were direct costs of the acquisition. Applied Digital contributed EXI Wireless to us effective March 31, 2005 under the terms of an exchange agreement dated June 9, 2005, in consideration for approximately 1.1 million shares of our common stock.

 

On June 10, 2005, we acquired Instantel under the terms of a share purchase agreement. The purchase price for Instantel was $25.0 million, if the sellers elected to receive the second installment of the purchase price in some combination of our common stock and Applied Digital’s common stock, or $24.5 million, if the sellers elected to receive the second installment of the purchase price in cash. Applied Digital funded the initial purchase price payment of $22.0 million with such funding being recorded as a capital contribution to us. In September 2006, the sellers elected to receive the second purchase price payment in cash. Accordingly, on October 10, 2006, we paid the sellers $2.0 million, which amount reflected a holdback of $0.5 million for an indemnification claim we have asserted against the sellers of Instantel. We funded this payment through borrowings under our loan agreement with Applied Digital. A final payment of up to $0.5 million may be due upon resolution of the indemnification claim. In addition, we incurred approximately $0.3 million in acquisition costs. Under the terms of the share purchase agreement, Instantel became a wholly-owned subsidiary of VHI.

 

In January 2006, we effected an amalgamation of Instantel and the former EXI Wireless subsidiaries under Canadian law. The combined entities now operate as a wholly-owned subsidiary of VHI.

 

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UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF OPERATIONS

For the Year Ended December 31, 2005

 

   

VeriChip

Corporation

Historical

Year Ended

December 31, 2005


   

EXI

Historical

Three Months
Ended

March 31, 2005


   

Instantel

Historical

Period Beginning

January 1, 2005

and Ending

June 9, 2005


   

Pro forma

Adjustments


   

Pro forma

Combined

Year Ended

December 31,
2005


 
    (in thousands, except per share data)  

Total revenue

  $ 15,869     $   1,986     $ 6,759     $ (60 )(A)   $ 24,554  

Total cost of products and services

    6,395       575       3,226       136  (B)     10,332  
   


 


 


 


 


Gross profit

    9,474       1,411       3,533       (196 )     14,222  

Selling, general and administrative expense

    12,442       1,355       4,205       (1,012 )(B)     16,990  

Research and development

    1,958       262       1,040             3,260  

Interest and other income

    (63 )     (20 )                 (83 )

Interest expense

    343             367       (367 )(C)     343  
   


 


 


 


 


Loss before provision (benefit) for income taxes

    (5,206 )     (186 )     (2,079 )     1,183       (6,288 )

Provision (benefit) for income taxes

    56             (1,221 )     404  (D)     (761 )
   


 


 


 


 


Net loss

    (5,262 )     (186 )     (858 )     779       (5,527 )

Deemed dividend

    (1 )                       (1 )
   


 


 


 


 


Net loss attributable to common stockholder

  $ (5,263 )   $ (186 )   $ (858 )   $ 779     $ (5,528 )
   


 


 


 


 


Loss per common share attributable to common stockholder – basic and diluted

  $ (1.00 )                           $ (0.99 )(E),(F)
   


 


 


 


 


Weighted average number of common shares outstanding – basic and diluted

    5,279                       277  (E)     5,556  (E),(F)

 

The following table describes the acquisitions of EXI Wireless and Instantel during the year ended December 31, 2005 (in thousands). The purchase price allocations were finalized in 2006.

 

Company Acquired


  

Effective

Date

Acquired


  

Acquisition

Price


  

Goodwill

and

Other

Intangibles

Acquired


  

Other Net

Assets and

Liabilities


 

Business Description


EXI Wireless

   3/31/05    $ 13,283    $ 11,541    $1,742   Provider of infant protection, wander prevention and asset location and identification systems.

Instantel

   6/10/05    $ 24,737    $ 25,936    $(1,199)   Manufacturer of remote monitoring products including infant protection and wander prevention systems and vibration monitoring instruments.

 

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The total purchase price of the businesses acquired was allocated as follows:

 

     EXI Wireless

  

Estimated

Useful

Life


   Instantel

  

Estimated

Useful

Life


     (in thousands)         (in thousands)     

Intangibles:

                   

Patented and non-patented proprietary technology

   $3,710    12.3    $1,720    11.8

Trademarks(1)

   1,131       3,790   

Customer relationships

   895    4.0    3,390    10.0

Distribution network

   816    6.6    6,000    8.4

Goodwill(1)

   4,989       11,036   

(1) Trademarks and goodwill have indefinite lives.

 

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PRO FORMA ADJUSTMENTS FOR THE UNAUDITED PRO FORMA

CONDENSED COMBINED STATEMENT OF OPERATIONS FOR THE YEAR ENDED

DECEMBER 31, 2005 ARE AS FOLLOWS:

 

(A) To eliminate deferred revenue not recognizable under purchase accounting.

 

(B) To adjust amortization expense for acquired intangible assets with definite lives. The following table presents the pre-acquisition amortization expense as compared to the post-acquisition amortization expense for VHI and Instantel:

 

                  Adjustment to:

 
    Pre-Acquisition

  Post-Acquisition

  Pro forma Adjustment

    Cost of Products
and Services
Sold


  Selling, General
and
Administrative
Expense


 
    (in thousands)  

EXI Wireless

  $        30   $      163   $      133                

Instantel

    1,511     502     (1,009 )              
   

 

 


 

 


    $   1,541   $ 665   $ (876 )   $ 136   $ (1,012 )
   

 

 


 

 


 

   The decrease in amortization expense relates primarily to the decrease in the carrying value of Instantel’s intangible assets with finite lives, which decreased from approximately $17.1 million, as reflected in the Instantel financial statements, to approximately $11.1 million, as well as to an increase in the expected lives of Instantel’s intangible assets with finite lives. The intangible assets acquired in the Instantel acquisition were determined to have estimated lives ranging from 8.4 to 11.8 years versus estimated lives of five years in the Instantel financial statements. The expected lives of these intangible assets were determined based upon the expected use of the assets, our ability to extend or renew patents and other contractual provisions associated with the assets, the estimated average life of the associated products, the stability of the industry, expected changes in or the costs we are likely to incur in finding alternative distribution networks or channels, and other factors deemed appropriate.

 

(C) To eliminate interest expense for Instantel’s debt not assumed by us under the terms of the share purchase agreement with respect to the acquisition of Instantel.

 

(D) To adjust income taxes for the tax effects of the pro forma adjustments.

 

(E) Represents the number of shares of our common stock that were issued in exchange for the EXI Wireless stock under the terms of the share exchange agreement between us and Applied Digital. For purposes of this pro forma presentation, the common stock issued was deemed to be outstanding for the entire period presented.

 

(F) Potentially diluted common shares were not included in the computation of diluted loss per share because to do so would have been anti-dilutive. The potentially dilutive incremental, underlying common shares consist of approximately 1.7 million weighted average options and approximately 0.4 million weighted average warrants.

 

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

 

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the “Selected Consolidated Financial Data” and our unaudited interim and audited annual financial statements and the notes to those financial statements included elsewhere in this prospectus. Our discussion contains forward-looking statements based upon current expectations that involve risks and uncertainties. Our actual results and the timing of events could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth under “Risk Factors,” “Our Business” and elsewhere in this prospectus. Due to our limited operating history and our acquisition of two Canadian-based businesses in the first half of 2005 which significantly expanded our operations and product offerings, period to period comparisons of or changes in financial data are not necessarily indicative of, and you should not rely upon them as an indicator of, our future financial performance.

 

Overview

 

Our History

 

We were formed as a Delaware corporation by our parent company, Applied Digital, in November 2001. In January 2002, we began our efforts to create a market for our RFID systems that utilize our human-implantable microchip. These efforts included obtaining FDA approval, which occurred in October 2004, of our VeriMed system for use for patient identification and health information purposes, and creating our direct and indirect sales channels for our VeriGuard system.

 

On March 31, 2005, Applied Digital acquired EXI Wireless through a plan of arrangement under which Applied Digital issued 3,388,407 shares of its common stock valued at approximately $11.7 million to EXI Wireless’ shareholders. In addition, all outstanding EXI Wireless options and warrants were converted into options or warrants exercisable for shares of Applied Digital’s common stock. The value of the options and warrants exchanged was approximately $0.7 million. Included in the aggregate $13.3 million purchase price was approximately $0.9 million of acquisition costs consisting primarily of a finder’s fee and legal and accounting related services that were direct costs of the acquisition. Applied Digital contributed EXI Wireless to us effective March 31, 2005 under the terms of an exchange agreement dated June 9, 2005, in consideration for approximately 1.1 million shares of our common stock.

 

On June 10, 2005, we acquired Instantel under the terms of a share purchase agreement. The purchase price for Instantel was $25.0 million, if the sellers elected to receive the second installment of the purchase price in some combination of our common stock and Applied Digital’s common stock, or $24.5 million, if the sellers elected to receive the second installment of the purchase price in cash. Applied Digital funded the initial purchase price payment of $22.0 million with such funding being recorded as a capital contribution to us. In September 2006, the sellers elected to receive the second purchase price payment in cash. Accordingly, on October 10, 2006, we paid the sellers $2.0 million, which amount reflected a holdback of $0.5 million for an indemnification claim we have asserted against the sellers of Instantel. We funded this payment through borrowings under our loan agreement with Applied Digital. A final payment of up to $0.5 million may be due upon resolution of the indemnification claim. In addition, we incurred approximately $0.3 million in acquisition costs. Under the terms of the share purchase agreement, Instantel became a wholly-owned subsidiary of VHI.

 

In January 2006, we effected an amalgamation of Instantel and the former EXI Wireless subsidiaries under Canadian law. The combined entities now operate as a wholly-owned subsidiary of VHI.

 

Our Business

 

We have two reportable operating segments: healthcare, and security and industrial.

 

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Healthcare Segment

 

Our healthcare segment encompasses the development, marketing and sale of our healthcare and patient identification systems, specifically:

 

   

infant protection systems used in hospital maternity wards and birthing centers to prevent infant abduction and mother-baby mismatching;

 

   

wander prevention systems used by long-term care facilities to locate and protect their residents; and

 

   

an asset/staff location and identification system used by hospitals and other healthcare facilities to identify, locate and protect medical staff, patients, visitors and medical equipment.

 

Our healthcare segment also includes the VeriMed system, from which, to date, we have derived only nominal revenues.

 

Healthcare Security Systems

 

Our healthcare security systems consist of our infant protection, wander prevention and asset/staff location and identification systems. Sales of our infant protection systems and wander prevention systems currently represent a majority of our revenues. To date, a limited number of our asset/staff location and identification systems have been sold and installed.

 

Infant Protection Systems

 

Our infant protection systems are sold through dealers. Under the terms of our dealer agreements, our dealers are responsible for system installation and post-sale customer service and system maintenance. We derive revenue from the sale of the systems, specifically the tags, bracelets, anklets and wristbands, receivers, the computer hardware and application software. The average sales price of our infant protection systems generally ranges from $30,000 to $40,000. However, system prices can vary widely depending on the hardware and software requirements of the particular system installation, the number of RFID transponders or tags needed in a particular installation, the desired level of integration with a facility’s existing communication and security systems, the size and general layout or floor plan of the facility and the number of egress points in the facility that need to be covered by the system. The RFID tags, bracelets, anklets, wristbands and receivers that are component parts of our infant protection systems are consumable items. During the first nine months of 2006, revenue from consumables represented approximately 39% of our aggregate infant protection revenue.

 

We believe that the global market for infant protection products, including consumables, is currently growing at approximately 10-15% per year, although we consider the market relatively mature. The United States currently accounts for more than 95% of the global market for infant protection systems. There are approximately 3,400 birthing hospitals in the United States. We estimate that infant security systems have been implemented in approximately half of these facilities. Approximately 1,100 U.S. hospitals and birthing centers use our infant protection systems. We believe that growth opportunities exist among the remaining facilities that do not yet have infant protection systems in place, as well as through replacement of legacy systems. Presently, approximately half of our infant protection system sales are replacement system sales.

 

The Joint Commission on Accreditation of Healthcare Organizations, or JCAHO, has begun to recommend the installation of electronic security systems in hospitals’ pediatric departments. Although this is a largely untapped market, we believe that we can leverage our existing end-use customer base and expand such customers’ infant protection systems into pediatrics.

 

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Wander Prevention Systems

 

We sell our wander prevention systems through dealers. As with our dealer agreements for our infant protection systems, our dealer agreements for our wander prevention systems provide that our dealers are responsible for system installation and post-sale customer service and system maintenance. We derive revenues from the sale of the systems, specifically the tags, bracelets, anklets and wristbands, receivers, the computer hardware and application software. The average sales price of our wander prevention systems generally ranges from $8,000 to $10,000. However, as with our infant protection systems, system prices can vary. The RFID tags and wristbands that are component parts of our wander prevention systems are consumable items. During the first nine months of 2006, revenue from consumables represented approximately 44% of our aggregate wander prevention revenue.

 

We estimate that within the United States RFID-type wander prevention systems are currently installed in approximately 30% of the more than 52,000 nursing homes and assisted living facilities. While the nursing home segment is fairly well penetrated, we believe that existing and future state regulations applicable to long-term facilities, which include security and wander prevention requirements, will continue to drive growth in demand for wander prevention systems for the next several years. We also believe that our wander prevention business will benefit from key demographic trends. In that regard, the U.S. Census Bureau has estimated that the 65 and older population in the United States will reach 70 million people by the year 2030. An estimated half of all elderly people now require nursing home care in their lifetime, with the highest use occurring after age 85. We believe the aging of the U.S. population, combined with the increased prevalence of Alzheimer’s (nearly half of all nursing home residents have Alzheimer’s or a related disorder), we believe has caused nursing homes and assisted living facilities to place increased emphasis on wander prevention systems. In light of the problems that exist in controlling residents suffering from dementia or Alzheimer’s, a number of assisted living facilities are building special wings to accommodate such residents’ special needs.

 

Asset/Staff Location and Identification Systems

 

To date, a limited number of our asset/staff location and identification systems have been sold and installed. Those systems were sold through a dealer on a private label basis. We are in the process of building out our distribution network for our asset/staff location and identification system and providing the requisite training to certain dealers in an effort to be at the forefront of the emerging market for such systems in the healthcare sector. We anticipate the commercial launch of our asset/staff location and identification system through the dealer channel for this system in the first quarter of 2007.

 

We expect the sales price for our asset/staff location and identification system will vary widely based on the level of system implementation and specific application of each system. For instance, the number of departments within a healthcare facility, the desired resolution, such as the degree of precision in location, and the number of asset/staff tags required will have a significant impact on the price of a system. Based on our system sales to date, we expect the average system sales price will be between $175,000 to $225,000.

 

According to a report prepared by IDTechEx, a United Kingdom-based consulting firm, over the next ten years the second-largest RFID application, by value, within the healthcare industry will be real-time location systems for staff, patients, visitors and assets. The largest RFID application is anticipated to be item-level tagging of pharmaceuticals. IDTechEx predicts that these two applications, on a combined basis, will represent an $800 million market by 2016. We believe that it is important for our asset/staff location and identification system to capture market share in the emerging market for real-time location and identification systems in the healthcare industry within the next 12-24 months, as we expect that a significant factor in hospitals’ choice of system vendors will be referrals to other healthcare facilities that

 

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have deployed, and are pleased with, such systems. To achieve this, we will need to be on the forefront of the effort to educate healthcare industry professionals regarding the benefits, including the return on investment, we believe can be achieved through implementation of RFID location and identification systems.

 

We intend to leverage our established brand, reseller network and extensive end-use customer base for our infant protection and wander prevention systems to gain inroads in the emerging market for asset/staff location and identification systems. We believe that our efforts to develop a common technology platform for our infant protection, wander prevention and asset/staff location and identification systems will help us to migrate our existing end-use customers into deployment of our asset/staff location and identification systems. See “Our Business – Technology – Technology Platform/Application Software.” We believe that a common technology platform will allow us to provide our end-use customers with an enhanced value proposition through the ability to maximize their return on investment from deployment of an RFID system, and distribute the infrastructure and installation costs, across multiple applications.

 

Historically, we have sold each of our healthcare security systems separately. However, through our efforts to develop a common technology platform for our healthcare security systems, we have the ability to offer customers an integrated security solution comprising two or more of our applications on a common hardware and software platform. A common technology platform will allow us to provide our end-use customers with an enhanced value proposition through the ability to maximize their return on investment from deployment of an RFID system, and distribute the infrastructure and installation costs, across multiple applications. We anticipate that, if we are successful in migrating our end-use customers to deployment of our asset/staff location and identification systems in conjunction with our other healthcare security system applications, application software will represent a greater proportion of the purchase price of such systems. In addition, we expect that competitive forces will result in reductions in the prices of system hardware components. We believe that the ability to offer current and prospective end-use customers an integrated RFID solution is a key competitive advantage that should contribute to future growth.

 

VeriMed Patient Identification System

 

As of September 30, 2006, we have only generated approximately $0.1 million in revenue from our VeriMed system, significantly less than we projected at the beginning of 2006, primarily from the sale of the implantable microchip inserter kits.

 

Currently, we are providing scanners to hospitals and third party emergency room management companies at no charge in order to build out the geographic footprint of the healthcare facilities that can and will use our VeriMed system as part of their standard protocol. The cost of the scanners, which was approximately $7,000 in 2005 and $32,000 for the nine months ended September 30, 2006, is included as selling, general and administrative expense in our consolidated statements of operations included elsewhere in this prospectus. We expect to continue this “seeding” process for the foreseeable future as we endeavor to build out our network across the United States and overseas. Ultimately, we intend to sell our scanners directly to hospitals, third-party emergency room management companies and other potential users of our VeriMed system, such as emergency medical technicians and other emergency personnel outside the hospital emergency room setting, and to sell our implantable microchips and scanners to doctors, primarily through distributors. At the time that we begin selling scanners, the cost of the scanners will be reflected in cost of products sold in our consolidated statements of operations.

 

There are a number of risks associated with our VeriMed business including:

 

   

uncertainty as to whether a market for the VeriMed system will develop and whether we will be able to generate more than a nominal level of revenue from the sale of such systems;

 

   

uncertainty as to the future availability of insurance reimbursement for the microchip implant procedure from government and private insurers;

 

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a potential disruption in our operations, loss of sales and higher expense in the event we are unable to obtain the implantable microchip from Digital Angel, our sole supplier of the microchip, or have to make alternative arrangements for the manufacture of the microchip;

 

   

our obligation to meet annual minimum purchase requirements beginning in 2007 under our supply agreement with Digital Angel, as a condition to maintaining the exclusivity of our supply arrangement, that may exceed our sales of the microchip; and

 

   

possible third-party claims asserting that we hold no rights for the use of the implantable microchip technology and are violating the third party’s intellectual property rights. If such a claim were successful, we could be enjoined from marketing this technology and could be required to pay substantial damages.

 

For additional information relating to the risks associated with our VeriMed business, see “Risk Factors—Risks Related to Our Businesses Which Utilize the Implantable Microchip” beginning on page 18 of this prospectus.

 

Security and Industrial Segment

 

Our security and industrial segment encompasses the sale of:

 

   

vibration monitoring instruments used by engineering, construction and mining professionals to monitor the effects of human induced vibrations, such as blasting activity;

 

   

asset management systems used by industrial companies to manage and track their mobile equipment and tools; and

 

   

systems incorporating our implantable microchip for security applications.

 

Vibration Monitoring Instruments

 

Sales of vibration monitoring instruments currently represent the primary source of revenue in our security and industrial segment. We sell our vibration monitoring instruments through an independent network of approximately 75 dealers, approximately half of which operate in North America. The average sales price of our vibration monitoring instruments ranges from $4,500 to $5,000. We also generate revenues from rendering post-sale calibration services. On a historical basis, revenues from these services have represented approximately 20% of our instrument sales.

 

Our vibration monitoring business is currently the most international of our business activities. We have a strong market presence in North America, Southeast Asia, India and Scandinavia, and a growing market presence in South Africa, Europe and Australia. We believe the greater geographical diversity of this business serves as a buffer against declines in construction and mining activity in any one geographic area or region, though this business continues to be influenced by changes in global economic activity.

 

We are in the process of developing and introducing a new instrumentation platform. The new platform will replace our existing platforms for our vibration monitoring instruments, for which we are facing certain manufacturing challenges due to the discontinuation and unavailability of key components. We believe the new platform, when completed, will better integrate with contemporary data communications protocols so as to improve our products’ remote monitoring capabilities. In addition, we expect the new platform will entail the addition of several sensors and peripherals that will enhance the ability to monitor additional environmental and structural parameters related to vibration and overpressure monitoring.

 

Asset Management Systems

 

We sell our entry-level asset management systems through our direct sales force at price points that vary widely based on the size and scope of the system. We are currently in the process of seeking to

 

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sell our ToolHound systems through an indirect distribution channels. We believe that creating indirect distribution channels for these systems will provide a basis for increased sales and operating profit for these systems through at a lower overall gross margin which will reflect the cost of the dealer discounts.

 

Based on feedback from our customers obtained in connection with the studies we commissioned by Fletcher Spaght, Inc., we believe that the return on investment from deployment of industrial asset tracking solutions, such as our ToolHound asset management system, can be attractive (reflecting the significant savings associated with reducing the amount of theft of tracked assets), but implementation of such solutions is often a low priority for our target customers: companies in asset-intensive industries (e.g., construction, mining, utilities) which tend to have higher-value mobile assets and are thus more likely to invest in more comprehensive solutions such as our ToolHound system. These customers are generally affected by the same macroeconomic drivers, making this business vulnerable to changes in those drivers.

 

Systems Incorporating the Implantable Microchip for Security Applications

 

To date, we have derived limited revenue from sales of our VeriGuard system, which uses our implantable microchip and/or active RFID tags to provide secure access control into restricted areas, map/track visitors throughout a facility, and track assets, in part reflecting our recent focus on commercializing our VeriMed system. We have not yet begun to market our VeriTrace system which uses our implantable microchip and wirelessly integrates with a Ricoh® digital camera for accurate tagging and identification of human remains and associated evidentiary items.

 

Since our VeriGuard and VeriTrace systems, like our VeriMed system, incorporate our implantable microchip, many of the risks associated with the VeriMed system apply to the VeriGuard and VeriTrace systems, including the risk of possible third-party claims asserting we are violating rights with respect to certain patented intellectual property underlying each of these systems. We do not anticipate generating more than nominal revenues from the sale of the VeriGuard and VeriTrace systems prior to the expiration of the patent in April 2008.

 

Basis of Presentation

 

For the reasons discussed below, our historical consolidated financial statements included elsewhere in this prospectus, and those of the Canadian-based businesses acquired in the first half of 2005, are not necessarily indicative of our future operating results or financial condition. You should not rely upon such financial statements as an indicator of our future financial performance.

 

Our Acquisition of the Canadian-Based Businesses

 

On March 31, 2005 and June 10, 2005, we acquired two Canadian-based businesses that were primarily engaged in the development, marketing and sale of healthcare security systems utilizing RFID technology. Prior to that time, our operations were comprised of efforts to create markets for our human-implantable microchip. As a result of these acquisitions, we acquired approximately $21.5 million of intangible assets and recorded approximately $16.0 million of goodwill. Of the intangible assets acquired, approximately $5.4 million represents patented and non-patented proprietary technology that is being amortized in cost of products sold on a straight line basis over finite lives ranging from 11.8 to 12.3 years. Approximately $11.1 million represents customer relationships and distribution networks with finite lives ranging from 4-10 years. These intangible assets are being amortized on a straight line basis as selling, general and administrative expense. The remaining $4.9 million of intangible assets acquired represents trademarks with indefinite lives.

 

Efforts to Create Markets for Our Systems that Utilize the Implantable Microchip

 

For the foreseeable future, we expect that we will generate significant operating losses in connection with our efforts to create markets for our systems that utilize the implantable microchip. Our

 

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expectations in this regard reflect our belief that revenue derived from sales of such systems will remain at a nominal level or show only modest growth. In the case of our VeriMed system, we do not expect to experience any significant growth in revenue from the sale of the system prior to government and private insurers’ determinations to reimburse the cost of the microchip implant procedure. However, we can provide no assurance as to when or if government or private insurers will decide to take such action The expected significant operating losses from our systems which utilize the implantable microchip, and in particular, the VeriMed system, also reflect an anticipated increase in our selling, general and administrative expenses as we augment our direct sales force, seek to develop a distribution network for the VeriMed system, enhance our marketing efforts directed toward physicians and patients, and fund or otherwise facilitate clinical studies of the VeriMed system that we hope prove successful in demonstrating the efficacy of the system to fulfill its intended functions. While we anticipate that we will continue to generate operating profits from our Canadian-based businesses, on a consolidated basis we expect to incur operating losses for at least the next 12-24 months.

 

Transition Services Agreement with Applied Digital

 

Applied Digital currently provides certain general and administrative support to us. We and Applied Digital have entered into an amended and restated transition services agreement, to be effective upon the consummation of this offering, under which Applied Digital will provide this support for twenty-four months subsequent to the effective date, subject to earlier termination of the agreement. Under the agreement, we are obligated to reimburse Applied Digital for providing us with certain administrative transition services and related expenses, including payroll, legal, finance, accounting, information technology, and tax services, and services related to this offering. We anticipate that the aggregate cost of such services in 2007 and subsequent years during the term of the agreement will be approximately $0.9 million per year for fixed costs, such as legal and accounting services, plus reasonable out-of-pocket expenses. On or, if we elect, prior to the end of the term of the agreement, we will be responsible for providing these services internally or engaging third parties, which may result in an increase in selling, general and administrative expense. We believe that the cost of these services reflects an amount consistent with what we would have to pay to independent parties.

 

Additional Expenses Associated with Being a Public Company

 

After completion of this offering, we anticipate our selling, general and administrative expense will increase by approximately $1.3 million due to increased costs for directors and officers’ insurance, independent directors’ fees, professional fees, external reporting requirements, Sarbanes-Oxley compliance, investor relations and other costs associated with operating as a publicly-traded company.

 

Research and Development

 

We expect that our research and development expenses will increase for at least the next year due to the additional research staff associated with the Canadian-based operations that we acquired during the first half of 2005, our efforts to complete the integration of our software and hardware platforms underlying our RFID systems during 2006 and early 2007, and development efforts related to potential new applications for our implantable microchip. We expect our research and development expenses for the year ending December 31, 2006 to be approximately 85% to 90% higher than our research and development expenses for the year ended December 31, 2005, and to remain approximately at the 2006 level in 2007.

 

Critical Accounting Policies and Estimates

 

The following is a description of the accounting policies that our management believes involve a high degree of judgment and complexity, and that, in turn, could materially affect our consolidated financial statements if various estimates and assumptions made in connection with the application of such policies were changed significantly. The preparation of our consolidated financial statements requires that

 

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we make certain estimates and judgments that affect the amounts reported and disclosed in our consolidated financial statements and related notes. We base our estimates on historical experience and on other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates. For more detailed information on our significant accounting policies, see Note 1 to our audited consolidated financial statements as of and for the year ended December 31, 2005, included elsewhere in this prospectus.

 

Revenue Recognition

 

Our revenue recognition policies provide very specific and detailed guidelines in measuring revenue; however, certain estimates and judgments affect the application of our revenue recognition policies. The complexity of the estimation process and all issues related to the assumptions, risks and uncertainties inherent in our revenue recognition policies affect the amounts reported in our financial statements. A number of internal and external factors affect the timing of our revenue recognition, including estimates of customer returns and the timing of customer acceptance.

 

Revenue Recognition Policy for

 

Our Healthcare Security and Asset Management Systems, and Our Vibration Monitoring Instruments

 

We recognize revenue from the sale of the hardware and software components of our healthcare security and asset management systems, as well as our vibration monitoring instruments, when the following criteria are met:

 

   

persuasive evidence of an arrangement exists (e.g., a purchase order has been received or a contract has been executed);

 

   

the system components are shipped;

 

   

title has transferred;

 

   

the price is fixed or determinable; and

 

   

collection of the sales proceeds is reasonably assured.

 

Revenue from software implementation and consulting services is recognized as the services are performed. Revenue from post-contract support services is recognized over the term of the service agreement.

 

When software arrangements include multiple elements to which contract accounting does not apply, the individual elements are accounted for separately if vendor specific objective evidence, or VSOE, of fair value exists for the undelivered elements. Generally, the residual method is applied in allocating revenue between delivered and undelivered elements. If VSOE does not exist, the revenue associated with the entire agreement is deferred until the earlier of VSOE being established or all of the undelivered elements are delivered or performed with the following exceptions:

 

   

If the only undelivered element is post-contract support, the deferred amount is recognized ratably over the post-contract support period.

 

   

If the only undelivered element is services that do not require significant production, modification or customization of the software, the deferred amount is recognized as the services are performed.

 

Maintenance revenue is deferred and recognized ratably over the terms of the maintenance agreements.

 

Revenue Recognition Policy for Systems Using Our Implantable Microchip

 

Revenue from the sale of systems using our implantable microchip (VeriMed and VeriGuard) are recorded at gross amounts with a corresponding entry for cost of sales. As we are in the initial process of

 

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commercializing these systems, the level of distributor or physician returns cannot yet be reasonably estimated. Accordingly, we do not recognize revenues until the following criteria are met:

 

   

a purchase order has been received or a contract has been executed;

 

   

the system is shipped;

 

   

title has transferred;

 

   

the price is fixed or determinable;

 

   

there are no uncertainties regarding customer acceptance;

 

   

collection of the sales proceeds is reasonably assured; and

 

   

the period during which the distributor or physician has a right to return the product has elapsed.

 

We intend to recognize revenue from consignment sales, if any, when all of the criteria listed above have been met and after the receipt of notification of such product sales from the distributor’s customers (e.g., physicians). Once the level of returns can be reasonably estimated, revenues (net of expected returns) will be recognized when all of the criteria above are met for either direct or consignment sales.

 

Revenue Recognition Policy for VeriMed Services

 

The services for maintaining subscriber information on our VeriMed database will be sold on a stand-alone contract basis, separate and apart from the implant procedure itself, and treated according to the terms of the contractual arrangements then in effect. Revenue from the database service will be recognized over the term of the subscription period or the terms of the contractual arrangements then in effect.

 

Notwithstanding the above descriptions of our VeriMed revenue recognition policies, with respect to the sales of products and services sold in tandem, our revenue recognition policy will be determined by the ultimate arrangements negotiated with independent third parties.

 

Inventory Obsolescence

 

Estimates are used in determining the likelihood that inventory on hand can be sold. Historical inventory usage and current revenue trends are considered in estimating both obsolescence and slow-moving inventory. Inventory is stated at the lower of cost or market, determined by the first-in, first-out method, net of any reserves for obsolete or slow-moving inventory. As of September 30, 2006 and December 31, 2005 and 2004, inventory reserves were $0.1 million, $0.1 million and $0.1 million, respectively. We did not have any inventory reserves as of December 31, 2003. The estimated market value of our inventory is based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required, which could have a material effect on our financial condition and results of operations.

 

Goodwill and Other Intangible Assets

 

On January 1, 2002, we adopted Statement of Financial Accounting Standard No. 142, Goodwill and Other Intangible Assets, or FAS 142. FAS 142 eliminated the amortization of goodwill and other intangible assets with indefinite lives and instead requires that goodwill and other intangible assets with indefinite lives be tested for impairment at least annually. Intangible assets with finite lives are amortized over their useful lives.

 

In accordance with FAS 142, we are required to test our goodwill and intangible assets with indefinite lives for impairment annually. We test our goodwill and intangible assists with indefinite lives annually as part of our business planning cycle during the fourth quarter of each fiscal year. The determination of the value of our intangible assets requires management to make estimates and assumptions about the future operating results of our “reporting units,” as that term is defined in FAS 142.

 

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Our reporting units are those businesses for which discrete financial information is available and upon which segment management makes operating decisions. As of September 30, 2006, we operated in two reporting units: healthcare, and security and industrial. As of December 31, 2004, we did not have goodwill or other intangible assets. However, as a result of the acquisitions of the two Canadian-based businesses during the first half of 2005, as of September 30, 2006, our consolidated goodwill was $16.0 million and the value of our intangible assets with indefinite lives totaled $4.9 million.

 

Our intangible assets with indefinite lives consist of trademarks, acquired in connection with the acquisition of our Canadian-based businesses. In determining the value of these trademarks, we employed the income approach. We used the discounted cash flow method to calculate the present value of the projected income from the product lines to which the EXI Wireless and Instantel trademarks relate. In our valuation model, we considered the “relief from royalty” concept, which assumes that if a company owns a trademark it does not have to “rent” one and therefore is “relieved” from paying a royalty. The amount of the phantom payment (after-tax) is used as a surrogate for income attributable to the trademark.

 

In valuing these trademarks, we applied a market-based royalty rate to projections of revenue for the various product lines to which the trademarks relate. The projected royalty cash flows, on an after-tax basis, were discounted to present value using a discount rate that adequately reflected the inherent risks of such cash flows. We applied what we believe to be appropriate discount rates, ranging from 17.0% to 23.7%, and used a terminal revenue growth rate of 5%.

 

Future events, such as market conditions or operational performance of our acquired businesses, could cause us to conclude that impairment exists relating to our goodwill and trademarks. In such event, we would record impairment charges, which could have a material impact on our financial condition and results of operations. Specifically, our annual test of the estimated fair value of our trademarks is subject to assumptions regarding:

 

   

the future level of royalty cash flows related to the trademarks;

 

   

the “relief from royalty” rate applied to the future revenue;

 

   

the discount rate used to bring the future cash flows to present value; and

 

   

any changes in our determination regarding the estimated useful life of the trademarks.

 

The acquisition date valuations for the EXI Wireless and Instantel trademarks were $1,131,000 and $3,790,000, respectively. We have evaluated the sensitivity of our trademark valuations to variations in our estimated useful life assumptions for these trademarks. We concluded that our valuations would not change significantly due to variations in the estimated useful life assumptions. Approximately 86.0% of the present value of the trademark cash flows is contributed by the cash flows generated between year 1 (2005) and year 20 (2025). Therefore, a sensitivity analysis based on variations of the estimated useful lives of the trademarks would not significantly change our valuations.

 

We evaluated the sensitivity of the trademark valuations to variations in the projected revenue estimates for fiscal years 2005 through 2009 and variations in the 5.0% terminal revenue growth rate for fiscal years 2010 and beyond. A summary of the valuation scenarios is as follows:

 

Scenario 1: A 10.0% increase in the projected annual revenue for 2005 through 2009 and a 10.0% increase in the terminal revenue growth rate from 5.0% to 5.5%. The Scenario 1 assumptions result in the following valuations:

 

EXI Wireless Trademarks:

   $1,266,000 (11.9% greater than acquisition date valuation)

Instantel Trademarks:

   $4,290,000 (13.2% greater than acquisition date valuation)

 

Scenario 2: A 10.0% decrease in the projected annual revenue for 2005 through 2009 and a 10.0% decrease in the terminal revenue growth rate from 5.0% to 4.5%. The Scenario 2 assumptions result in the following valuations:

 

EXI Wireless Trademarks:

   $1,001,000 (11.5% less than acquisition date valuation)

Instantel Trademarks:

   $3,310,000 (12.7% less than acquisition date valuation)

 

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Based on our analysis of the uncertainties associated with the assumptions used in our trademark valuations, we concluded that, when performing our annual tests for impairment, variations in the level of projected revenue represent the most significant variable affecting the future estimated fair value of our trademarks.

 

Stock-Based Compensation

 

Effective January 1, 2006, we adopted FAS 123R, using the modified prospective transition method. Under this method, stock-based compensation expense is recognized using the fair-value based method for all awards granted on or after the date of adoption. Compensation expense for new awards granted after January 1, 2006 is recognized over the requisite service period based on the grant-date fair value of those options.

 

Prior to the adoption of FAS 123R, we used the intrinsic value method under APB 25 and Financial Accounting Standards Board Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation—an Interpretation of APB Opinion No. 25, and provided the pro forma and disclosure information required by FAS 123. Under the intrinsic value method, no stock-based compensation was recognized in our consolidated statements of operations for options granted to our employees and directors because the exercise price of such stock options granted to employees and directors equaled or exceeded the fair value of the underlying stock on the dates of grant.

 

FAS 123R requires forfeitures of stock-based grants to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. In our pro forma information required under FAS 123 for the periods prior to January 1, 2006, we accounted for forfeitures as they occurred.

 

In the nine months ended September 30, 2006, we incurred stock-based compensation expense of approximately $40,000 as a result of our adoption of FAS 123R on January 1, 2006. This expense resulted from the issuance of 52,012 stock options during the nine months ended September 30, 2006, which were granted with a weighted average exercise price of $9.88 per share. The weighted-average fair market value of the options was determined to be $5.97 per share. This stock-based compensation expense was reflected in the unaudited condensed consolidated statement of operations in selling, general and administrative expense.

 

During the period January 1, 2005 to August 11, 2005, we granted to certain of our employees and directors options exercisable for approximately 0.3 million shares of our common stock. These options have exercise prices ranging from $6.93 to $8.55 per share. These exercise prices were equal to or greater than the estimated fair value, as determined by our management, of the underlying common stock on the date of each grant. We did not grant any options to employees subsequent to August 11, 2005 through December 31, 2005.

 

Our management determined the value of our common stock principally based upon internal valuation estimates, as well as arm’s-length transactions involving the fair value of the businesses we acquired. Due to management’s familiarity with discounted cash flow analyses and the readily available values of the businesses we acquired during the first half of 2005, management chose not to obtain contemporaneous valuations by an unrelated valuation specialist. The assumptions used by management related to:

 

   

our projected operating performance;

 

   

risk of non-achievement of projected operating performance;

 

   

the purchase prices of the two businesses acquired during the first half of 2005, including the risk that the acquisitions might not have been completed at certain interim valuation dates; and

 

   

trends and comparable valuations in the broad market for privately-held and publicly-traded technology and medical device companies.

 

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Management’s valuation methodology, including terminal and enterprise values, was based on the following factors:

 

   

Unlevered free cash flows for the Company’s implantable microchip business were projected for five years, which was deemed to be the appropriate valuation period.

 

   

Earnings before interest, taxes, depreciation and amortization, or EBITDA, was used to estimate terminal value.

 

   

Management considered the relevant multiples for RFID and medical device companies to determine the appropriate terminal value multiple.

 

   

A discount rate was applied to the net free cash flows and terminal value. The rate was determined based on the risk-free rate of the 10-year U.S. Treasury Bond plus an applicable market risk premium and the specific risk premium associated with our facts and circumstances. The discount rate utilized by us was the rate of return expected from the market or the rate of return for a similar investment with similar risks.

 

   

The purchase prices of the acquired businesses, adjusted for the risk that the acquisitions might not have been completed at certain interim valuation dates, were added to the value of the implantable microchip business to determine enterprise value.

 

   

Management computed the fully diluted value of each share of our common stock in order to factor in the dilutive effect of reflecting in-the-money stock options and warrants at each valuation date.

 

There are inherent uncertainties in forecasting future operating results and identifying comparable companies and transactions that may be indicative of the fair value of our common stock. We believe that the estimates of the fair value of our common stock at each option grant date are reasonable under the circumstances.

 

During 2005, we granted to consultants and employees of Applied Digital and Digital Angel options exercisable for approximately 0.1 million shares of our common stock. In accordance with FAS 123, we recorded compensation expense associated with these options based on an estimate of the fair value, as determined by our management (using the methodology discussed above), of our common stock on each date of grant and using the Black-Scholes valuation model. We were required to re-measure the stock-based compensation expense associated with these options on December 30, 2005, the date of acceleration of the vesting of all of these options, as more fully discussed below. This re-measurement was based on the estimated fair value of our common stock on December 30, 2005, which was assumed to be the then estimated initial public offering price, and using the Black-Scholes valuation model. This re-measurement resulted in stock-based compensation expense being recorded in 2005 based upon the fair value of these stock options on the accelerated vesting date.

 

During 2005, 2004 and 2003, we granted to employees of Applied Digital, and other non-employees who had provided services to us, options exercisable for approximately 1.1 million shares of our common stock. We recognized compensation expense related to these option grants using the same methodology as was used for the 2005 option grants, as discussed above. We recorded aggregate compensation expense of approximately $2.3 million, $0.3 million and $0.7 million during the years ended December 31, 2005, 2004 and 2003, respectively, in connection with these stock options.

 

The Black-Scholes option pricing model, which we used to value our stock options, requires us to make several key judgments including:

 

   

the estimated value of our common stock;

 

   

the expected life of issued stock options;

 

   

the expected volatility of our stock price;

 

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the expected dividend yield to be realized over the life of the stock options; and

 

   

the risk-free interest rate over the expected life of the stock options.

 

Our computation of the expected life of issued stock options was determined based on historical experience of similar awards giving consideration to the contractual terms of the stock-based awards, vesting schedules and expectations about employees’ future length of service. The interest rate was based on the U.S. Treasury yield curve in effect at the time of grant. Our computation of expected volatility was based on the historical volatility of Applied Digital’s common stock.

 

The significant factors contributing to the difference between the fair value of the stock options granted during the period January 1, 2005 to August 11, 2005 and the estimated initial public offering price of shares of our common stock as of December 30, 2005 include, among others:

 

   

Certain hospital emergency rooms adopted our VeriMed system beginning in the latter part of the third quarter of 2005. Specifically, as of August 1, 2005, five hospitals had agreed to adopt our VeriMed system in their emergency departments and we had a goal of having 20 to 25 hospitals agree to adopt our VeriMed system by December 31, 2005. Having an infrastructure of hospitals that have adopted the VeriMed system as part of their standard protocol is considered a necessary step in the commercialization of the VeriMed system, because, without that infrastructure, those persons who fit the profile for which the VeriMed system was designed have little or no reason to undergo the microchip implant procedure. After our attendance at the American College of Emergency Physicians’ Scientific Assembly, which took place in Washington D.C. from September 26 to 29, 2005, 49 hospitals had agreed to adopt our VeriMed system in their emergency rooms. As of December 15, 2005, 66 hospitals had agreed to do so.

 

   

During the latter part of 2005, we began the groundwork for the integration of all of our RFID healthcare security systems onto a single technology platform, which we expected to have completed by late 2006. We believe that an integrated platform and infrastructure for our portfolio of RFID healthcare security systems will provide us with a significant competitive advantage.

 

   

We came to the view that there is a significant market opportunity for our asset/staff location and identification system. Today, our asset/staff location and identification system is essentially a new product. It was the first healthcare security application adapted to our technology platform. The new platform has expanded the deployment options for our asset/staff location and identification system, which can range from a portal-based system to a full, real-time location system.

 

   

We identified additional strategic markets for the implantable microchip. For example, during the second half of 2005 and specifically in the wake of Hurricane Katrina, we donated implantable microchips to FEMA’s Department of Mortuary Services in Mississippi and Louisiana to help with FEMA’s efforts to identify corpses. The acceptance of this new use for the implantable microchip has led to the development of VeriTrace, the only end-to-end implantable tagging solution for the accurate tracking and identification of human remains and associated evidentiary items.

 

   

We expanded our sales of certain of our healthcare security systems into international markets. On October 19, 2005, we shipped our first Hugs infant protection system for use in the United Kingdom, and in early January 2006 we completed the negotiations of an agreement with Ingersoll Rand Security Technologies, a sector of Ingersoll-Rand Company Limited. Under the terms of the agreement, Ingersoll Rand Security Technologies has the non-exclusive right to promote, sell, install and maintain certain of our infant protection, wander prevention and asset/staff location and identification systems, as well as the related technology platform and application development interface, in healthcare, commercial and industrial markets in North and South America, including the Caribbean and Hawaii.

 

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We used the enterprise value to forward-looking revenue valuation approach to determine the estimated IPO value on December 30, 2005. Under this approach, fair value was determined based upon a range of multiples of projected future revenue. The multiples used represented those multiples of revenue that our peers’ common stock were trading for in the public

 

markets. This approach was deemed appropriate because revenue multiples for publicly traded companies provide the highest correlation of public company trading values. Specifically, publicly-traded companies in comparable industries tend to have similar revenue multiples, whereas their EBITDA and net income multiples are not deemed to be as consistent in part because certain companies in comparable industries are not EBITDA positive or do not earn net income.

 

On December 12, 2005, our board of directors approved a proposal which provided for vesting on December 30, 2005 of all of our then outstanding and unvested stock options previously awarded to employees, directors, one employee of Applied Digital, one employee of Digital Angel and consultants. In connection with the acceleration of these options, we stipulated that a grantee that acquires any shares

through exercise of any of such options shall not be permitted to sell such shares until the earlier of (i) the original vesting date applicable to such option or (ii) the date on which such grantee’s employment terminates for any reason.

 

The purpose of accelerating the vesting of the options granted to our directors and employees was to enable us to avoid recognizing in future periods non-cash compensation expense associated with such options in our consolidated statements of operations, which would have otherwise been required upon our adoption of FAS 123R on January 1, 2006. As a result of the acceleration, we avoided recognition of up to approximately $0.6 million of compensation expense in our consolidated statements of operations over the course of the original vesting period, substantially all of which was expected to be avoided in 2006. Such expense is included in our pro forma stock-based compensation footnote disclosure for the year ended December 31, 2005. FASB Financial Interpretation No. 44 requires us to recognize compensation expense under certain circumstances, such as a change in the vesting schedule when the options whose vesting schedule was changed are in-the-money on the date of change, which would allow an employee to vest in an option that would have otherwise been forfeited based on the award’s original terms. We would be required to begin to recognize compensation expense over the new expected vesting period based on estimates of the number of options that employees ultimately will retain that otherwise would have been forfeited, absent the modifications. The majority of the accelerated options, absent the acceleration, would have vested during the first half of 2006, with a smaller percentage vesting over 30 months. Such estimates of compensation expense would be based on such factors as historical and expected employee turnover rates and similar statistics. Of options exercisable for approximately 0.3 million shares of our common stock that were affected by the acceleration of vesting, substantially all of the $4.4 million of intrinsic value of these options is attributable to our executive officers and directors at that time. We are unable to estimate the number of options that our employees and directors will ultimately retain that otherwise would have been forfeited, absent our acceleration of the vesting of these options. Based on the then current circumstances, the high concentration of such options awarded to officers and directors and our historical turnover rates, no compensation expense resulting from the new measurement date was recognized by us upon acceleration of vesting on December 30, 2005. We will recognize compensation expense in future periods, should a benefit be realized by the holders of the aforementioned options, which they would not otherwise have been entitled to receive. During the nine months ended September 30, 2006, we recognized approximately $0.1 million of compensation expense as a result of a terminated employee receiving a benefit related to the accelerated vesting of his options that he would not otherwise have received. If we are required to recognize additional compensation expense in connection with the accelerated vesting of in-the-money stock options, it could have a material impact on our future results of operations.

 

Accounting for Income Taxes

 

As part of the process of preparing our consolidated financial statements, we are required to estimate our income tax liability in each of the jurisdictions in which we do business. This process involves

 

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estimating our actual current tax expense together with assessing temporary differences resulting from differing treatment of items, such as deferred revenues, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in our consolidated balance sheet. We must then assess the likelihood that our net deferred tax assets in each tax jurisdiction will be recovered from future taxable income in the applicable jurisdiction and, to the extent we believe that recovery is not more likely than not or is unknown, we must establish a valuation allowance.

 

Significant management judgment is required in determining the provision for income taxes, deferred tax assets and liabilities and any valuation allowance recorded against the deferred tax assets. As of September 30, 2006, we had $4.4 million in net deferred tax liabilities, associated with our Canadian-based operations. As of September 31, 2006 and December 31, 2005, 2004 and 2003, we had recorded a full valuation allowance against our U.S. net deferred tax assets due to uncertainties related to our ability to utilize these deferred tax assets, primarily consisting of net operating loss carryforwards. The valuation allowance was based on our historical operating performance and estimates of taxable income in the United States and the period over which our deferred tax assets will be recoverable. As of September 30, 2006, we have not provided a valuation allowance against our Canadian deferred tax assets as we have deemed it more likely than not that these assets will be realized.

 

If we continue to incur U.S. operating losses we will continue to provide a full valuation allowance against our U.S. net deferred tax assets. Conversely, if our U.S. operations become profitable in the future, we may reduce some or all of our valuation allowance, which could result in a significant tax benefit and a favorable impact on our financial condition and operating results.

 

If for Canadian tax purposes we incur operating losses in the future or if we are unable to generate sufficient future Canadian taxable income, or if there is a material change in the actual effective tax rates or time period within which the underlying temporary differences become taxable or deductible, and we were to establish a valuation allowance against all or a significant portion of our Canadian deferred tax assets, it could result in a material adverse impact on our operating results.

 

Recent Developments

 

Our revenue for the nine month period ended September 30, 2006 was $20.3 million. We expect our revenue for the three month period ended December 31, 2006 will be between $6.7 million and $6.9 million. This revenue amount is preliminary and has not been audited or reviewed, and, accordingly, may be subject to adjustment.

 

We expect that our operating results for the three months ended December 31, 2006, will include charges related to our decision in October 2006 to consolidate our Canadian operations into an existing facility located in Ottawa, Ontario. The consolidation, expected to be completed in the first quarter of 2007, will entail the closing of our operations in Vancouver, British Columbia. This will eliminate duplicative functions and, we believe, improve operating efficiencies, positioning us to better execute on strategic initiatives to become the leading provider of RFID systems for the healthcare industry. We believe the consolidation will result in annual savings, of which a significant portion will be cash savings, and will have no effect on revenue. As a result of the consolidation, we expect to record charges in the range of $0.8 million to $1.4 million during the last quarter of 2006 and the first quarter of 2007, consisting of charges relating to termination benefits, fixed asset reserves and our Canadian tax assets.

 

Results of Operations

 

The table below sets forth data from our consolidated statements of operations for the nine months ended September 30, 2006 and 2005 and the years ended December 31, 2005, 2004 and 2003, expressed as a percentage of total revenue. To date, substantially all of our revenue consists of revenue from our Canadian-based businesses, which were acquired in the first half of 2005. Prior to the acquisitions of these

 

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businesses, we had minimal revenue and, therefore, period-to-period results are not comparable. Accordingly, our historical results are not necessarily indicative of our future results.

 

Through September 30, 2006, we have recorded nominal revenue from sales of our VeriMed system. Over time, we expect that sales of our VeriMed system will become a significant part of our revenue, although there can be no assurance that they will.

 

All pro forma revenue information discussed in this Management’s Discussion and Analysis of Financial Condition and Results of Operations concerning our 2005 or 2004 fiscal year assumes that the acquisitions of EXI Wireless and Instantel occurred on January 1, 2005 and January 1, 2004, respectively. The discussion also assumes that these companies’ segment reporting was consistent with our current segment reporting. Such pro forma information is not necessarily indicative of what our results of operations would have been had EXI Wireless and Instantel been owned and operated by us as of January 1, 2005 or 2004, nor does it purport to represent our results of operations for future periods.

 

     Nine Months Ended
September 30,


   Year Ended December 31,

     2006

   2005

   2005

   2004

   2003

Product revenue

   93.8%    93.5%    91.5%    100.0%    100.0%

Service revenue

   6.2%    6.5%    8.5%      
    
  
  
  
  

Total revenue

   100.0%    100.0%    100.0%    100.0%    100.0%
    
  
  
  
  

Cost of products sold

   38.6%    35.1%    34.4%    80.6%    36.7%

Cost of services sold

   3.2%    4.5%    5.9%      
    
  
  
  
  

Gross profit

   58.2%    60.4%    59.7%    19.4%    63.3%

Selling, general and administrative expense

   61.8%    76.8%    78.4%    781.4%    362.8%

Research and development

   13.3%    11.6%    12.3%      

Interest and other (income)

   0.3%    (0.4)%    (0.4)%    (6.1)%   

Interest and other expense

   2.5%    2.5%    2.2%    58.3%    14.3%
    
  
  
  
  

Loss before provision for income taxes

   (19.7)%    (30.1)%    (32.8)%    (814.2)%    (313.8)%

Benefit (provision) for income taxes

   2.7%    0.6%    (0.4)%      
    
  
  
  
  

Net loss attributable to common stockholder

   (17.0)%    (29.5)%    (33.2)%    (814.2)%    (313.8)%
    
  
  
  
  

 

Nine Months Ended September 30, 2006 Compared to Nine Months Ended September 30, 2005

 

The table below presents statement of operations data by segment and in total for the nine months ended September 30, 2006 and 2005.

 

     2006

    2005

 
     Healthcare

    Security
and
Industrial


    Total

    Healthcare

    Security
and
Industrial


    Total

 
     (in thousands)

    (in thousands

 

Product revenue

   $ 14,774     $ 4,300     $ 19,074     $  6,618     $ 1,902     $ 8,520  

Service revenue

     282       988       1,270       305       290       595  
    


 


 


 


 


 


Total revenue

     15,056       5,288       20,344       6,923       2,192       9,115  

Gross profit

     8,657       3,193       11,850       4,187       1,322       5,509  

Selling, general and administrative

     9,752       2,828       12,580       5,061       1,940       7,001  

Research and development

     1,807       893       2,700       758       299       1,057  
    


 


 


 


 


 


Total operating expenses

     11,559       3,721       15,280       5,819       2,239       8,058  
    


 


 


 


 


 


Operating loss

   $ (2,902 )   $ (528 )   $ (3,430 )   $ (1,632 )   $ (917 )   $ (2,549 )
    


 


 


 


 


 


 

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Revenue

 

Revenue for the nine months ended September 30, 2006 was $20.3 million, an increase of $11.2 million compared to the comparable period of the prior year. Revenue for the nine months ended September 30, 2005 includes only six months of revenue from VHI (formerly EXI Wireless), which we acquired on March 31, 2005, and revenue from Instantel for the period from June 10, 2005 (the date of acquisition) to September 30, 2005.

 

On a pro forma basis, revenue for the nine months ended September 30, 2006 increased $2.5 million, or 14.0%, to $20.3 million compared to pro forma revenue of $17.8 million for the nine months ended September 30, 2005.

 

Our healthcare segment’s revenue was $15.1 million for the nine months ended September 30, 2006 compared to $6.9 million for the nine months ended September 30, 2005. The $8.2 million increase in revenue in our healthcare segment reflects a full nine months of revenue from our Canadian-based businesses in 2006 compared to only a portion of the 2005 period.

 

On a pro forma basis, our healthcare segment’s revenue increased $1.9 million, or 14.4%, to $15.1 million for the nine months ended September 30, 2006 compared to $13.2 million for the nine months ended September 30, 2005. The increase is the result of a $2.2 million increase in sales of our infant protection systems, partially offset by a $0.3 million decrease in the sales of asset/staff location and identification systems. We attribute the increase in sales of infant protection systems primarily to our efforts in 2006 to consolidate and rationalize our dealer network so as to increase our sales volumes generated by our key dealers. Infant protection system sales reflected sales to healthcare facilities that had not previously deployed an infant protection system, as well as to healthcare facilities that were replacing existing systems. Additionally, we experienced revenue growth associated with our sale of RFID tags and other consumables of $0.4 million, or approximately 20%, relating to our Hugs infant protection system. This increase in consumable sales was driven by our installed base of healthcare facilities. In 2005, we continued the development of our new asset/staff location and identification RFID system, and sold three of these systems in 2005. The decrease in revenue from asset/staff location and identification systems in 2006 principally reflects the absence of additional system sales as the systems sold in 2005 were installed and implemented during 2006. We anticipate the commercial launch of our asset/staff location and identification system through the dealer channel for this system in the first quarter of 2007.

 

Our security and industrial segment’s revenue was $5.3 million for the nine months ended September 30, 2006 compared to $2.2 million for the nine months ended September 30, 2005. The $3.1 million increase in revenue in our security and industrial segment reflects a full nine months of revenue from our Canadian-based businesses in 2006 compared to only a portion of the 2005 period. Segment sales consist principally of sales of our vibration monitoring instruments.

 

On a pro forma basis, our safety and industrial segment’s revenue increased $0.7 million, or 15.2%, to $5.3 million for the nine months ended September 30, 2006 compared to $4.6 million for the nine months ended September 30, 2005. The increase was the result of a $0.7 million increase in revenue from our vibration monitoring instruments due to continued strong demand in the worldwide construction market. The strength or weakness of the worldwide construction market has historically had a significant influence on the sales volumes of our vibration monitoring instruments.

 

Gross Profit and Gross Profit Margin

 

Our cost of products consists of component parts, direct labor and finished goods. Component parts and finished goods are purchased from contract manufacturers, including our implantable microchip and scanners used in our VeriMed system, which are purchased as finished goods under the terms of our agreement with Digital Angel. As discussed above under “Basis of Presentation – Our Acquisition of the Canadian-Based Businesses,” included in our cost of products is amortization of intangible assets acquired in

 

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the acquisitions of our Canadian-based businesses during the first half of 2005. Such amortization amounted to $0.3 million and $0.1 million in the nine months ended September 30, 2006 and 2005, respectively.

 

Cost of services consists primarily of third-party installation services in connection with direct sales to healthcare customers. In addition, cost of services sold in our security and industrial segment consists of servicing our existing systems, principally the calibration services we provide with respect to our vibration monitoring instruments.

 

Gross profit for the nine months ended September 30, 2006 was $11.9 million compared to $5.5 million for the nine months ended September 30, 2005. As a percentage of revenue, our gross profit margin was 58.2% and 60.4% for the nine months ended September 30, 2006 and 2005, respectively.

 

Our healthcare segment’s gross profit for the nine months ended September 30, 2006 was $8.7 million compared to $4.2 million for the nine months ended September 30, 2005. The increase in gross profit of $4.5 million was primarily the result of the 2006 period including a full nine months of operations from our Canadian-based businesses as compared to the 2005 period. Our healthcare segment’s gross profit margin decreased to 57.5% in the nine months ended September 30, 2006 compared to 60.5% in the nine months ended September 30, 2005. The decline in gross profit margin reflected an increase in warranty and inventory reserves of $0.2 million resulting from the consolidation of the operations of our Canadian-based businesses and changes in product mix.

 

Our security and industrial segment’s gross profit for the nine months ended September 30, 2006 was $3.2 million compared to $1.3 million for the nine months ended September 30, 2005. The increase in gross profit of $1.9 million was attributable to sales of our vibration monitoring instruments as a result of our acquisition of Instantel on June 10, 2005. Our security and industrial segment’s gross profit margin was 60.4% and 60.3% for the nine months ended September 30, 2006 and 2005, respectively.

 

Selling, General and Administrative Expense

 

Selling, general and administrative expense consists primarily of compensation for employees in executive and operational functions, including finance and accounting, sales and marketing and corporate development. Other significant costs include depreciation and amortization, professional fees for accounting and legal services, consulting fees and facilities costs.

 

Selling, general and administrative expense increased $5.6 million to $12.6 million for the nine months ended September 30, 2006 as compared to $7.0 million for the nine months ended September 30, 2005. As a percentage of revenue, selling, general and administrative expense was 61.8% and 76.8% for the nine months ended September 30, 2006 and 2005, respectively. During the nine months ended September 30, 2006, we recorded $0.3 million for severance costs related to the consolidation of the operations of our Canadian-based businesses in Ottawa, Ontario.

 

Included in selling, general and administrative expense for the nine months ended September 30, 2006 and 2005 was $0.6 million and $0.4 million, respectively, of certain general and administrative services provided to us by Applied Digital, including accounting, finance and legal services, telephone, rent and other miscellaneous items. We expect the annual cost of the services being provided by Applied Digital under the terms of the amended and restated transition services agreement will be approximately $0.9 million in 2007 and thereafter, reflecting that the scope of the services provided by Applied Digital under the agreement was expanded at the end of 2005.

 

Selling, general and administrative expense for the nine months ended September 30, 2006 and 2005 included approximately $1.5 million and $0.7 million, respectively, of depreciation and amortization

 

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expense. The increase was due to increased amortization of intangible assets as a result of the acquisition of the Canadian-based businesses in the first half of 2005.

 

Included in selling, general and administrative expense for the nine months ended September 30, 2005 was $1.1 million of compensation expense associated with stock options granted to employees of Applied Digital and consultants. Our board of directors accelerated the vesting of all of our then unvested employee and director stock options on December 30, 2005. This, coupled with our grant of a minimal number of stock options during the nine months ended September 30, 2006, resulted in significantly lower stock-based compensation expense during the nine months ended September 30, 2006. As a result of the termination of an employee whose options were in-the-money at the time his options were accelerated, we incurred equity based compensation of approximately $0.1 million during the nine months ended September 30, 2006.

 

Our healthcare segment’s selling, general and administrative expense was $9.8 million in the nine months ended September 30, 2006, an increase of $4.7 million compared to the corresponding period of the prior year. The increase was primarily a result of a full nine months of operations from our Canadian-based businesses as compared to the 2005 period. In addition, approximately $1.4 million of the period-over-period increase resulted from the addition of sales and marketing staff, consultants and other marketing services related to our efforts to create a market for our VeriMed system. As a percentage of our healthcare segment’s revenue, selling, general and administrative expense was 64.8% and 73.1% for the nine months ended September 30, 2006 and 2005, respectively. We attribute the decrease in selling, general, and administrative expense as a percentage of revenue primarily to the inclusion of the results of our Canadian-based businesses for the full nine months in 2006.

 

Our security and industrial segment’s selling, general and administrative expense increased $0.9 million to $2.8 million for the nine months ended September 30, 2006 compared to the corresponding period of the prior year. The increase was primarily the result of our acquisition of Instantel in June 2005. As a percentage of our security and industrial segment’s revenue, this segment’s selling, general and administrative expense was 53.5% and 88.5% for the nine months ended September 30, 2006 and 2005, respectively. We attribute the decrease in selling, general, and administrative expense as a percentage of segment revenue primarily to the inclusion of the results of Instantel for the full nine months in 2006.

 

We expect selling, general and administrative expense to increase in the future due to contemplated additions of sales and marketing staff related to our marketing and sale of our VeriMed system and database services, as well as the additional costs resulting from our being a publicly held company. See “Basis of Presentation – Additional Expenses Associated with Being a Public Company” above.

 

Research and Development

 

Our research and development expense consists primarily of payroll costs for engineering personnel and costs associated with various projects, including testing, developing prototypes and related expenses.

 

Research and development expense was $2.7 million for the nine months ended September 30, 2006 compared to $1.1 million for the nine months ended September 30, 2005. As a percentage of revenue, research and development expense was 13.3% and 11.6% for the nine months ended September 30, 2006 and 2005, respectively.

 

Our healthcare segment’s research and development expense increased $1.0 million to approximately $1.8 million for the nine months ended September 30, 2006 compared to the corresponding period of the prior year. The increase in our healthcare segment’s research and development expense was

 

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primarily due to the acquisitions of our Canadian-based businesses during the first half of 2005, the continued development of our asset/staff location and identification system, and our initiative to integrate virtually all of our healthcare security systems on to a common technology platform.

 

Our security and industrial segment’s research and development expense increased $0.6 million to approximately $0.9 million for the nine months ended September 30, 2006 compared to the corresponding period of the prior year. The increase in our security and industrial segment’s research and development expense was primarily due to the acquisition of Instantel on June 10, 2005. The period-over-period increase also reflected costs associated with the development efforts for our next generation vibration monitoring instruments.

 

Interest Expense

 

Interest expense was $0.5 million and $0.2 million for the nine months ended September 30, 2006 and 2005, respectively. The increase in interest expense was primarily due to our increased level of outstanding borrowings owed to Applied Digital and our increased borrowings under our revolving credit facility with the Royal Bank of Canada. We intend to use a portion of the proceeds from this offering to repay all outstanding indebtedness owed to Applied Digital. Through October 5, 2006, the interest rate under our loan agreement with Applied Digital was based upon the prevailing prime rate as published by The Wall Street Journal in effect during the applicable periods. Since that date, the interest rate on our loan was fixed at 12% per annum.

 

Income Taxes

 

We had an effective tax rate of (13.6%) and (1.9%) for the nine months ended September 30, 2006 and 2005, respectively, related to our Canadian-based businesses. We incurred consolidated losses before taxes for the nine months ended September 30, 2006 and 2005. However, we have not recorded a tax benefit for the resulting U.S. net operating loss carryforwards, as we have determined that a valuation allowance against our net U.S. deferred tax assets was appropriate based primarily on our historical operating results. The benefit recorded in the nine months ended September 30, 2006 was primarily the result of the effect of a decrease in Canadian tax rates resulting from the change in future enacted income tax rates on our net deferred tax liabilities.

 

Year Ended December 31, 2005 Compared to Year Ended December 31, 2004

 

The table below presents statement of operations data by segment and in total for the years ended December 31, 2005 and 2004.

 

     2005

    2004

 
     Healthcare

    Security
and
Industrial


    Total

    Healthcare

    Security
and
Industrial


    Total

 
     (in thousands)

    (in thousands)

 

Product revenue

   $ 11,200     $ 3,320     $ 14,520     $     $ 247     $ 247  

Service revenue

     849       500       1,349                    
    


 


 


 


 


 


Total revenue

     12,049       3,820       15,869             247       247  

Gross profit

     7,115       2,359       9,474             48       48  

Selling, general and administrative

     9,207       3,235       12,442       1,041       889       1,930  

Research and development

     1,313       645       1,958                    
    


 


 


 


 


 


Total operating expenses

     10,520       3,880       14,400       1,041       889       1,930  
    


 


 


 


 


 


Operating loss

   $ (3,405 )   $ (1,521 )   $ (4,926 )   $ (1,041 )   $ (841 )   $ (1,882 )
    


 


 


 


 


 


 

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Revenue

 

Revenue for the year ended December 31, 2005 increased $15.7 million to $15.9 million compared to the prior year. The increase was entirely attributable to the acquisition of our Canadian-based businesses in the first half of 2005. On a pro forma basis, our revenues were $24.6 million for the year ended December 31, 2005.

 

Our healthcare segment’s revenue was $12.0 million for the year ended December 31, 2005, reflecting sales of our healthcare security systems following the acquisition of our Canadian-based businesses in the first half of 2005. Our healthcare segment did not generate any revenue during the year ended December 31, 2004. On a pro forma basis, our healthcare segment’s revenue was $18.4 million for the year ended December 31, 2005 compared to $14.7 million for the year ended December 31, 2004. The increase of $3.7 million, or 25%, was primarily a result of $2.2 million of increased revenue from our infant protection systems due to sales during 2005 to new and existing customers, and sales of $1.3 million related to our asset/staff location and identification system, principally as a result of several sales during 2005. During 2006, these asset/staff location and identification systems were installed and implemented.

 

Our security and industrial segment’s revenue was $3.8 million for the year ended December 31, 2005 compared to $0.2 million for the year ended December 31, 2004. The $3.6 million increase was due to sales of our asset management systems and vibration monitoring instruments following the acquisition of our Canadian-based businesses during the first half of 2005, partially offset by a $0.2 million decrease in sales of our VeriGuard system. On a pro forma basis, our security and industrial segment’s revenue was $6.2 million for the year ended December 31, 2005 compared to $5.1 million for the year ended December 31, 2004. The majority of the $1.1 million increase was attributable to an increase in sales of our vibration monitoring instruments as a result of strong demand in the worldwide construction market.

 

Gross Profit and Gross Profit Margin

 

Gross profit for the year ended December 31, 2005 was $9.5 million, an increase of $9.4 million compared to the prior year. As a percentage of revenue, our gross profit margin increased to 59.7% for the year ended December 31, 2005, compared to 19.4% in the prior year.

 

During the year ended December 31, 2005, our healthcare segment’s gross profit was $7.1 million and its gross profit margin was 59.1%. Our healthcare segment did not generate any revenue or gross profit margin during the year ended December 31, 2004. The gross profit of $7.1 million was due to the acquisition of our Canadian-based businesses in the first half of 2005 and, specifically, sales of our healthcare security systems. We expect our healthcare segment’s gross profit margins to continue at historical levels in the future.

 

Our security and industrial segment’s gross profit increased $2.3 million to $2.4 million in the year ended December 31, 2005 compared to the prior year. The gross profit margin was 61.8% in the year ended December 31, 2005 as compared to 19.4% in the year ended December 31, 2004. The increases in gross profit and margin were attributable to sales of our asset management systems and vibration monitoring instruments to security and industrial customers. We expect our security and industrial segment’s gross profit margins to continue at historical levels in the future.

 

Selling, General and Administrative Expense

 

Selling, general and administrative expense increased $10.5 million to $12.4 million in the year ended December 31, 2005 as compared to $1.9 million in the year ended December 31, 2004. As a percentage of revenue, selling, general and administrative expense was 78.4% for the year ended December 31, 2005. As we generated nominal revenue in 2004, the comparative 2004 percentage is not meaningful.

 

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Included in selling, general and administrative expense for the year ended December 31, 2005 and 2004 was:

 

   

$0.5 million and $0.4 million, respectively, of certain general and administrative services provided to us by Applied Digital, including accounting, finance and legal services, telephone, rent and other miscellaneous items;

 

   

$2.3 million and $0.3 million, respectively, of compensation expense associated with stock options granted to employees of Applied Digital and consultants; and

 

   

approximately $1.1 million and $48,000, respectively, of depreciation and amortization expense, with the increase in 2005 resulting from the amortization of intangible assets acquired in connection with the acquisition of our Canadian-based businesses during the first half of 2005.

 

Our healthcare segment’s selling, general and administrative expense increased $8.2 million to approximately $9.2 million in the year ended December 31, 2005 from $1.0 million in the year ended December 31, 2004. The increase was due to a $4.3 million increase in selling, general and administrative expense related to our VeriMed business and to the acquisition of our Canadian-based businesses during the first half of 2005. As a percentage of the healthcare segment’s revenue, segment selling, general and administrative expense was 76.4% in the year ended December 31, 2005. Our healthcare segment did not generate any revenue in the year ended December 31, 2004. We received FDA clearance for use of our VeriMed system for patient identification and health information purposes in October 2004. Prior to that time, we had undertaken only a limited degree of sales and marketing efforts to create a market for our VeriMed system. Subsequent to receiving FDA clearance, in 2005, we increased our sales and marketing efforts for our VeriMed system, specifically through additions of sales and marketing employees and consultants, and other associated market development costs.

 

Our security and industrial segment’s selling, general and administrative expenses increased $2.3 million to $3.2 million in the year ended December 31, 2005 from $0.9 million in the year ended December 31, 2004, due primarily to the acquisitions of our Canadian-based businesses in the first half of 2005. As a percentage of the security and industrial segment’s revenue, segment selling, general and administrative expense decreased to 84.7% in the year ended December 31, 2005 from 359.9% in the year ended December 31, 2004, due primarily to the increase in segment revenue in the 2005 period.

 

Research and Development

 

Research and development expense was approximately $2.0 million in the year ended December 31, 2005. We did not incur any research and development expense during the year ended December 31, 2004. As a percentage of revenue, research and development expense was 12.3% for the year ended December 31, 2005.

 

During the year ended December 31, 2005, research and development expense was approximately $1.4 million for our healthcare segment and approximately $0.6 million for our security and industrial segment. Our research and development expense related primarily to salaries and other employee expenses incurred in the development of our asset/staff location and identification system and the development of our common healthcare security technology platform.

 

Interest Expense

 

Interest expense was $0.3 million and $0.1 million for the year ended December 31, 2005 and 2004, respectively. The interest expense was due to our level of outstanding borrowings owed to Applied Digital. We intend to use a portion of the proceeds from this offering to repay all outstanding indebtedness owed to

 

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Applied Digital and interest expense is expected to be reduced accordingly. The interest rate used to compute such interest was based upon the prevailing prime rate as published by The Wall Street Journal in effect during the applicable periods.

 

Income Taxes

 

We had an effective income tax expense rate of 1.1% for the year ended December 31, 2005 related to our Canadian operations. We incurred a consolidated loss before taxes for the year ended December 31, 2005 and 2004. We have not recorded a tax benefit for the resulting U.S. net operating loss carryforwards, as we have determined that a valuation allowance against our net U.S. deferred tax assets was appropriate based primarily on our historical operating results.

 

Year Ended December 31, 2004 Compared to Year Ended December 31, 2003

 

The table below presents statement of operations data by segment and in total for the years ended December 31, 2004 and 2003 was as follows:

 

     2004

    2003

 
     Healthcare

    Security
and
Industrial


    Total

    Healthcare

    Security
and
Industrial


    Total

 
     (in thousands)

    (in thousands)

 

Product revenue

   $     $ 247     $ 247     $     $ 545     $ 545  

Service revenue

                                    
    


 


 


 


 


 


Total revenue

           247       247             545       545  

Gross profit

           48       48             345       345  

Selling, general and administrative

     1,041       889       1,930       505       1,472       1,977  

Research and development

                                    
    


 


 


 


 


 


Total operating expenses

     1,041       889       1,930       505       1,472       1,977  
    


 


 


 


 


 


Operating loss

   $ (1,041 )   $ (841 )   $ (1,882 )   $ (505 )   $ (1,127 )   $ (1,632 )
    


 


 


 


 


 


 

From the inception of our operations through December 31, 2004, the majority of our efforts were focused on developing the markets for our VeriGuard system and obtaining FDA clearance of our VeriMed system for use for patient identification and health information purposes, which occurred in October 2004. We generated minimal revenue during the years ended December 31, 2004 and 2003. We did not incur research and development expense during these years, as development of these systems was performed by Digital Angel.

 

Revenue

 

Revenue for the years ended December 31, 2004 and 2003 was $0.2 million and $0.5 million, respectively. The revenue for 2004 and 2003 was comprised of sales of our VeriGuard system, sold primarily to dealers. The decrease in revenue in 2004 as compared to 2003 was primarily due to a shift in our focus to efforts to create a market for our VeriMed system and database services.

 

Gross Profit and Gross Profit Margin

 

Gross profit for the years ended December 31, 2004 and 2003 was $48,000 and $0.3 million, respectively. The decrease in gross profit in 2004 as compared to 2003 was primarily a function of the decrease in sales. Our gross profit margin was 19.4% and 63.3% in 2004 and 2003, respectively. The

 

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decrease in gross profit margin for 2004 was due primarily to an allowance for slow moving inventory of approximately $0.1 million.

 

Selling, General and Administrative Expense

 

Selling, general and administrative expense was $1.9 million and $2.0 million in 2004 and 2003, respectively. Included in selling, general and administrative expense for the years ended December 31, 2004 and 2003 was:

 

   

$0.3 million and $0.7 million, respectively, of compensation expense associated with options granted to employees of Applied Digital and consultants; and

 

   

$0.4 million and $0.3 million, respectively, of certain general and administrative services provided to us by Applied Digital, including accounting, finance and legal services, telephone, rent and other miscellaneous items. The cost of these services was determined based on use and management believes such cost to have been reasonable.

 

Our healthcare segment’s selling, general and administrative expense increased $0.5 million to $1.0 million for the year ended December 31, 2004 from $0.5 million for the year ended December 31, 2003, primarily as a result of increased marketing efforts for our VeriMed system.

 

Our security and industrial segment’s selling, general and administrative expense decreased $0.6 million to $0.9 million for the year ended December 31, 2004 from $1.5 million for the year ended December 31, 2003, primarily as a result of a shift in the focus of our marketing efforts to the medical applications of our implantable microchip as a result of FDA’s clearance of our VeriMed system for use for patient identification and health information purposes in October 2004. As a percentage of segment revenue, the security and industrial segment’s selling general and administrative expense increased to 359.9% in 2004 from 270.1% in 2003, primarily as a result of the decrease in revenue generated by sales of our VeriGuard system.

 

Interest Expense

 

Applied Digital has funded our operations since our inception in November 2001 through loans. Interest expense on these loans for the years ended December 31, 2004 and 2003 was $0.1 million and $0.1 million, respectively. The interest rate used to compute such interest was based upon the prevailing prime rate as published by The Wall Street Journal in effect during the applicable periods.

 

Income Taxes

 

We incurred losses before taxes for each of the years ended December 31, 2004 and 2003, and we have not recorded a tax benefit for any of these years. As a result of the losses, we have determined that a valuation allowance against our net deferred tax assets in each of these years was appropriate because, based on our historical performance and our estimates of future U.S. taxable income, it was deemed to be more likely than not that a tax benefit would not be realized.

 

EXI Wireless Inc.

 

Three Months Ended March 31, 2005 Compared to Three Months Ended March 31, 2004 (unaudited)

 

Revenue

 

Revenue for the three-month period ended March 31, 2005 increased $0.5 million, to $2.0 million, from $1.5 million for the three-month period ended March 31, 2004.

 

The healthcare segment’s revenue was $1.7 million for the three-month period ended March 31, 2005, compared to $1.4 million for the three-month period ended March 31, 2004. The increase was due to increased sales of EXI Wireless’ asset location, infant protection and wander prevention products to new and existing customers.

 

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The security and industrial segment’s revenue was $0.3 million for the three-month period ended March 31, 2005, compared to $0.1 million for the three-month period ended March 31, 2004. The increase was due to increased sales of asset management systems.

 

Gross Profit and Gross Profit Margin

 

Gross profit for the three-month period ended March 31, 2005 was $1.4 million, an increase of $0.3 million from $1.1 million for the three-month period ended March 31, 2004. As a percentage of revenue, the gross profit margin decreased slightly to 71.1% for the three-month period ended March 31, 2005 from 72.3% for the three-month period ended March 31, 2004. The decrease in percentage was due to differences in the product mix with less of the revenue generated by higher margin software sales in 2005 than the same period in 2004.

 

Selling, General and Administrative Expense

 

Selling, general and administrative expense for the three-month period ended March 31, 2005 was $1.4 million, an increase of $0.6 million, or 69.4%, from $0.8 million for the three-month period ended March 31, 2004. Selling, general and administrative expense, as a percentage of revenue, increased to 68.3% in the three-month period ended March 31, 2005, compared to 52.2% in the three-month period ended March 31, 2004. The increase was due to increased sales and marketing initiatives related to EXI Wireless’ asset/staff location systems.

 

Included in EXI Wireless’ selling, general and administrative expense for the three-month period ended March 31, 2005 was $0.1 million of depreciation and amortization expense, compared to $0.1 million for the three-month period ended March 31, 2004. Such amounts are based on EXI Wireless’ historical cost basis and do not reflect the amount of our depreciation and amortization expense following our acquisition of EXI Wireless as a result of purchase accounting treatment for its amortizable and depreciable assets.

 

Research and Development

 

Research and development expense was approximately $0.3 million in the three-month period ended March 31, 2005, compared to $0.2 million the three-month period ended March 31, 2004. Research and development expenditures primarily consisted of salaries for technical personnel, cost of related engineering materials, information technology infrastructure support, and subcontracted costs. As a percentage of revenue, research and development expense was 13.2% for the three-month period ended March 31, 2005 compared to 14.6% for the three-month period ended March 31, 2004. The increase for the period was primarily due to salaries and other employee expenses related to the development of EXI Wireless’ asset/staff location systems.

 

Income Taxes

 

Income tax recovery was $0 for the three months ended March 31, 2005 and 2004. EXI Wireless utilized $0.1 million of investment tax credits during the three-month period ended March 31, 2005 compared to $0 during the three-month period ended March 31, 2004 to reduce its current taxes payable. After utilizing the credits, EXI Wireless continued to have federal and provincial investment tax credits totaling $1.1 million at March 31, 2005 that may be applied to taxes payable in the future.

 

Year Ended December 31, 2004 Compared to Year Ended December 31, 2003

 

Revenue

 

Revenue for the year ended December 31, 2004 decreased $0.1 million to $6.0 million from $6.1 million for the year ended December 31, 2003.

 

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EXI Wireless’ healthcare segment’s revenue was $5.2 million for the year ended December 31, 2004 compared to $5.3 million for the year ended December 31, 2003.

 

EXI Wireless’ security and industrial segment’s revenue remained constant at $0.8 million for the year ended December 31, 2004 and 2003, respectively.

 

EXI Wireless generated the majority of its revenue from sales into the United States. The rise of the Canadian dollar versus the U.S. dollar had a negative impact on revenues during the year. The Canadian dollar increased 7.0% against the U.S. dollar during the year.

 

Gross Profit and Gross Profit Margin

 

Gross profit for the year ended December 31, 2004 was $4.2 million, a decrease of $0.2 million, from $4.4 million for the year ended December 31, 2003. As a percentage of revenue, EXI Wireless’ gross profit margin decreased to 70.6% for the year ended December 31, 2004 from 71.6% for the year ended December 31, 2003.

 

During 2004, EXI Wireless’ gross margin was negatively affected by foreign exchange differences between the Canadian and U.S. dollar. Moreover, contracts that required EXI Wireless to provide an installed system or a turnkey system reduced gross margin percentages as EXI Wireless used third-party subcontractors to install these systems. The gross margins from the installation portion of a turnkey system are lower than product gross margins.

 

Selling, General and Administrative Expense

 

Selling, general and administrative expense increased $0.3 million, or 9.4%, to $3.5 million in the year ended December 31, 2004 as compared to $3.2 million for the year ended December 31, 2003. Selling, general and administrative expense, as a percentage of revenue, increased to 58.7% in 2004, compared to 52.7% in 2003. The increase was due to increased sales and marketing initiatives related to EXI Wireless’ asset management systems.

 

Included in selling, general and administrative expense for each of the years ended December 31, 2004 and 2003 was approximately $0.3 million of depreciation and amortization expense. Such amounts are based on EXI Wireless’ historical cost basis and do not reflect the amount of our depreciation and amortization expense following our acquisition of EXI Wireless as a result of purchase accounting treatment for its amortizable and depreciable assets.

 

Research and Development

 

Research and development expense was approximately $0.9 million in the year ended December 31, 2004 compared to $0.7 million for the year ended December 31, 2003. Research and development expenditures primarily consisted of salaries for technical personnel, cost of related engineering materials, information technology infrastructure support, and subcontracted costs. As a percentage of revenue, research and development expense was 15.3% for the year ended December 31, 2004 compared to 12.1% the year ended December 31, 2003. The increase for the year was primarily due to an increase in salaries and other employee expenses.

 

Other Expenses

 

Other expenses were $0.2 million in the year ended December 31, 2004, compared to $0.3 million in the year ended December 31, 2003. Other expenses include interest income, interest expense and foreign exchange gains and losses. The decrease in other expenses in the year ended December 31, 2004 was due primarily to a decrease of $0.1 million in foreign exchange losses compared to the year ended December 31, 2003.

 

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Income Taxes

 

Income tax recovery was $0.1 million in the year ended December 31, 2004, compared to $0.1 million in the year ended December 31, 2003. EXI Wireless utilized $0.3 million of investment tax credits during the year compared to $0.2 million in 2003 to reduce its current taxes payable. After utilizing the credits, EXI Wireless continued to have federal and provincial investment tax credits totaling $1.2 million at December 31, 2004 that may be applied to taxes payable in the future.

 

Instantel Inc.

 

January 1, 2005 to June 9, 2005 Compared to January 1, 2004 to June 9, 2004 (unaudited)

 

Revenue

 

Revenue for the period ended June 9, 2005 increased $1.3 million to $6.8 million from $5.5 million for the period ended June 9, 2004. The increase was primarily a result of increased revenues derived from the sale of Instantel’s infant protection systems. During the period ended June 9, 2005, Instantel introduced new products into the market that helped increase revenues.

 

Gross Profit and Gross Profit Margin

 

Gross profit for the period ended June 9, 2005 was $3.5 million, an increase of $0.3 million, from $3.2 million for the period ended June 9, 2004. As a percentage of revenue, gross profit margin decreased to 52.3% for the period ended June 9, 2005 from 58.2% for the period ended June 9, 2004. The decrease in gross profit margin was due to a $0.2 million bonus paid out as a result of our acquisition of Instantel on June 10, 2005. The decrease in the gross margin percentage was also due to differences in the product mix, with less high margin software sales in 2005 compared to 2004.

 

Selling, Marketing, General and Administrative Expense

 

Selling, marketing, general and administrative expense increased $1.3 million, to $4.2 million in the period ended June 9, 2005 as compared to $2.9 million in the period ended June 9, 2004. Selling, marketing, general and administrative expense, as a percentage of revenue, increased to 62.2% in 2005, compared to 51.8% in 2004. The increase was primarily due to a $0.7 million bonus paid out as a result of our acquisition of Instantel on June 10, 2005. The remaining increase was due to increased sales and marketing initiatives related to Instantel’s infant protection and wander prevention systems, and vibration monitoring instruments.

 

Included in selling, marketing, general and administrative expense for the periods ended June 9, 2005 and 2004 was approximately $1.5 million of depreciation and amortization expense. Such amounts are based on Instantel’s historical cost basis and do not reflect the amount of our depreciation and amortization expense following our acquisition of Instantel as a result of purchase accounting treatment for Instantel’s amortizable and depreciable assets.

 

Research and Development

 

Research and development expenses were approximately $1.0 million in the period ended June 9, 2005, compared to $0.7 million in the period ended June 9, 2004. Research and development expenditures primarily consisted of salaries for technical personnel, cost of related engineering materials, information technology infrastructure support, and subcontracted costs. As a percentage of revenue, research and development expense was 15.4% for the period ended June 9, 2005 compared to 12.2% for the period ended June 9, 2004. The increase for the period was primarily due to a $0.3 million bonus paid out as a result of our acquisition of Instantel on June 10, 2005.

 

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Interest expense

 

Interest expense was $0.4 million in each of the periods ended June 9, 2005 and 2004. The interest expense was due to Instantel’s level of debt outstanding.

 

Income Taxes

 

Income tax recovery was $1.2 million in the period ended June 9, 2005, compared to a recovery of $0.4 million in the period ended June 9, 2004. The increase in the income tax recovery was primarily due to reversal of temporary differences related to intangible assets as the amortization for accounting purposes was higher than the tax basis resulting in a reduction of the deferred income tax liability.

 

Year Ended December 31, 2004 Compared to Year Ended December 31, 2003

 

Revenue

 

Revenue for the year ended December 31, 2004 increased $2.2 million to $13.6 million from $11.4 million for the year ended December 31, 2003. The increase was primarily due to increased demand for infant protection systems. Instantel also experienced revenue growth for its vibration monitoring instruments as a result of continued demand in Asian construction markets compared to 2003.

 

Gross Profit and Gross Profit Margin

 

Gross profit for the year ended December 31, 2004 was $8.1 million, an increase of $1.4 million, from $6.7 million for the year ended December 31, 2003. As a percentage of revenue, gross profit margin increased slightly to 59.9% for the year ended December 31, 2004 from 59.2% for the year ended December 31, 2003.

 

Selling, Marketing, General and Administrative Expense

 

Selling, marketing, general and administrative expense increased $0.6 million, or 10.3%, to $6.9 million in the year ended December 31, 2004 as compared to $6.3 million the year ended December 31, 2003. The increase for the year was due to increased sales and marketing initiatives related to asset location and identification systems and infant protection systems. Selling, marketing, general and administrative expense, as a percentage of revenue, decreased to 51.0% in 2004 compared to 55.2% in 2003.

 

Included in selling, marketing, general and administrative expense for the years ended December 31, 2004 and 2003 was approximately $3.4 million of depreciation and amortization expense. Such amounts were based on Instantel’s historical cost basis and do not reflect the amount of our depreciation and amortization expense following our acquisition of Instantel as a result of purchase accounting treatment for Instantel’s amortizable and depreciable assets.

 

Research and Development

 

Research and development expense was approximately $1.7 million in the year ended December 31, 2004, compared to $1.4 million in the year ended December 31, 2003. Research and development expenditures primarily consisted of salaries for technical personnel, cost of related engineering materials, information technology infrastructure support, and subcontracted costs. The increase in 2004 compared to the prior year was primarily due to salaries and other employee expenses. As a percentage of revenue, research and development expense was 12.4% for the year ended December 31, 2004 compared to 12.3% the year ended December 31, 2003.

 

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Interest expense

 

Interest expense was $0.9 million in the year ended December 31, 2004 compared to $1.1 million in the year ended December 31, 2003. The decrease was primarily due to repayments of debt during 2004.

 

Income Taxes

 

Income tax recovery was $0.7 million in the year ended December 31, 2004 compared to a recovery of $0.8 million in the year ended December 31, 2003. The decrease in income tax recovery of $0.1 million was due to current income tax expense increasing $0.8 million in 2004, offset by an increase in the recovery of deferred income tax expense of $0.6 million.

 

Liquidity and Capital Resources

 

As of September 30, 2006, cash totaled $0.9 million compared to cash of approximately $1.4 million at December 31, 2005.

 

Cash Flows Used in Operating Activities

 

Net cash used in operating activities totaled $1.8 million, $2.0 million, $2.2 million, $1.6 million, and $1.4 million during the nine months ended September 30, 2006 and 2005 and the years ended December 31, 2005, 2004 and 2003, respectively. For each of the periods presented, cash was used primarily to fund operating losses, accounts receivable and for purchases of inventory, partially offset by an increase in accounts payable and accrued expenses.

 

Since our acquisitions of our Canadian-based businesses in the first half of 2005, we have generated operating cash flows from such operations that have partially funded our efforts to create a market for our VeriMed system. We expect to continue to generate significant net cash operating outflows for the foreseeable future in our VeriMed business as a result of our continuing investment in marketing and sales efforts related to our VeriMed business. We expect that these net cash operating outflows will continue to be funded through cash flows generated by our Canadian-based operations, as well as from the net proceeds of this offering. As a result, we expect that our consolidated statements of cash flows will reflect significant cash flows used in operating activities for at least the next 12-24 months.

 

The components of our VeriMed system (i.e., scanners, insertion kits and the implantable microchips) are purchased as finished goods under the terms of our agreement with Digital Angel. The agreement imposes minimum purchase requirements as follows: $0 in 2006; $875,000 in 2007; $1,750,000 in 2008; $2,500,000 in 2009; $3,750,000 in 2010; and $3,750,000 in each year thereafter, subject to the parties reaching agreement on a different amount. Under the terms of the agreement, Digital Angel may not supply human implantable microchips to other parties if we meet the minimum purchase requirements. If sales of the implantable microchip do not materialize or do not reach the level of the applicable minimum purchase requirement in any year, we intend to satisfy the minimum purchase requirements nonetheless. In such event, our inventory of implantable microchips will increase. We believe that, following consummation of this offering, we will have sufficient liquidity to meet the minimum purchase requirements under the agreement for the next few years.

 

Cash Flows from Investing Activities

 

Investing activities (used) provided cash of $(0.6) million, $1.6 million, $1.4 million, $(32,000) and $(6,000) during the nine months ended September 30, 2006 and 2005 and the years ended December 31, 2005, 2004 and 2003, respectively. In the nine months ended September 30, 2006, $0.6 million was used to purchase equipment. In the nine months ended September 30, 2005, $0.2 million was used to purchase

 

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equipment. In the nine months ended September 30, 2005 and the year ended December 31, 2005, net cash acquired in business acquisitions contributed by Applied Digital was $1.8 million. During the year ended December 31, 2005, $0.4 million was used to purchase equipment.

 

Cash Flows from Financing Activities

 

Financing activities provided cash of $1.9 million, $2.5 million, $2.2 million, $1.4 million and $1.6 million during the nine months ended September 30, 2006 and 2005 and the years ended December 31, 2005, 2004 and 2003, respectively. In the nine months ended September 30, 2006, cash of $1.0 million was provided from net borrowings under our credit agreement with the Royal Bank of Canada and cash of $2.1 million was provided by borrowings from Applied Digital. In each of the other periods presented, cash was provided primarily by borrowings from Applied Digital. In the nine months ended September 30, 2006, cash of $1.1 million was used to pay professional fees related to our contemplated initial public offering.

 

Applied Digital contributed to us the shares of EXI Wireless that it acquired in exchange for approximately 1.1 million shares of our common stock. It also funded the initial purchase price of our acquisition of Instantel in the amount of $22.3 million which was treated as a capital contribution to us under generally accepted accounting principles.

 

Credit Facilities

 

To date, we have financed a significant portion of our operations and investing activities primarily through funds provided by Applied Digital. As of September 30, 2006, we were indebted to Applied Digital in the amount of $8.9 million, including $0.4 million of accrued interest. Through October 5, 2006, our loan with Applied Digital bore interest at the prevailing prime rate of interest as published by The Wall Street Journal, which as of September 30, 2006 was 8.25% per annum. On October 6, 2006, we entered into an amendment to the loan agreement which increased the principal amount available thereunder to $13.0 million and we borrowed an additional $2.0 million under the agreement to make the second purchase price payment with respect to our acquisition of Instantel. In connection with that amendment, the interest rate was also changed to a fixed rate of 12% per annum. Previously, our indebtedness to Applied Digital bore interest at the prevailing prime rate of interest as published from time to time by The Wall Street Journal. That amendment further provided that the loan matured on July 1, 2008, but could be extended at the option of Applied Digital through December 27, 2010.

 

On January 19, 2007, and again on February 8, 2007, we entered into further amendments to the loan documents which increased the maximum principal amount of indebtedness that we may incur to $14.5 million. A portion of this increase was used to cover approximately $0.7 million of intercompany advances made to us by Applied Digital during the first week of January 2007. Upon the consummation of this offering, the loan will cease to be a revolving line of credit, and we will have no ability to incur additional indebtedness under the loan documents. The interest continues to accrue on the outstanding indebtedness at a rate of 12% per annum. Under the terms of the loan agreement as most recently amended on February 8, 2007, we are required to repay Applied Digital $3.5 million of principal and accrued interest upon the consummation of this offering. We are not obligated to repay an additional amount of our indebtedness until January 1, 2008. Effective with the payment of the $3.5 million, all interest which has accrued on the loan as of the last day of each month, commencing with the month in which such payment is made, shall be added to the principal amount. Commencing January 1, 2008 through January 1, 2010, we are obligated to repay $300,000 on the first day of each month. A final balloon payment equal to the outstanding principal amount then due under the loan plus all accrued and unpaid interest will be due and payable on February 1, 2010. We amended the repayment terms of the loan to allow us to retain a greater portion of the net proceeds of this offering for use in our business, thereby improving our liquidity for at least the next 12 to 18 months. However, in the event this offering is not consummated on or before July 1, 2008, the loan will mature on July 1, 2008, but could be extended on an annual basis at the option of Applied Digital through December 27, 2010. Pending completion of this offering, the remaining principal amount available under the loan agreement with Applied Digital is intended to fund the Company’s working capital requirements and costs related to this offering.

 

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Our subsidiary, VHI, has entered into a credit facility dated March 15, 2006 with the Royal Bank of Canada, or RBC, providing for up to CDN$1.5 million, or approximately $1.3 million based on the exchange rate as of September 30, 2006, of revolving credit loans, provided that outstanding borrowings under the facility may not exceed at any time an amount determined by reference to eligible accounts receivable plus eligible inventory, in each case as defined in the agreement, of VHI, or CDN$1.2 million at September 30, 2006. At September 30, 2006, $1.1 million was outstanding under the facility. The facility is not a committed facility as it provides that loans are made available to VHI at the sole discretion of RBC and that RBC may cancel or restrict the availability or any unutilized portion thereof at any time or from time to time. Borrowings may be made in either Canadian or U.S. dollars, are repayable on demand, as a result of which outstanding borrowings under the facility are reflected as current liabilities in our consolidated financial statements, and bear interest at a floating rate per annum equal to the Canadian or U.S. dollar prime rate, as applicable, announced by RBC from time to time, plus in each case 1%. The facility also provides for letters of credit and letters of guarantee denominated in Canadian dollars. Borrowings, letters of credit and letters of guarantee under the facility are secured by all of the assets of VHI and its subsidiary, and is guaranteed by VHI’s subsidiary in the amount of CDN$2.0 million. The loan agreements contain customary representations and warranties and events of default for loan arrangements of this type. In addition, the loan agreements contain customary covenants restricting VHI’s ability to, among other things, merge or enter into business combinations, create liens, or sell or otherwise transfer assets. The foregoing is a summary of the material terms of the credit facility and related agreements, and is qualified in its entirety by reference to the terms and provisions of those agreements which are filed as exhibits to the registration statement of which this prospectus is a part.

 

Following this offering, and in order to support the expected growth in our working capital requirements as our business expands, we will seek to obtain a larger, committed bank credit facility. However, no assurance can be given that we will be successful in this regard.

 

Financial Condition

 

As of September 30, 2006, the Company had a working capital deficit of approximately $1.0 million and an accumulated deficit of $13.8 million.

 

After giving effect to the repayment of borrowings under our loan agreement with Applied Digital from the proceeds of this offering, we believe that with the remaining net proceeds from this offering, together with the cash we have on hand, our expected borrowing capacity under current and new bank facilities and operating cash flows we expect to generate, we will have sufficient funds available to cover our cash requirements, including capital expenditures, debt service requirements and the minimum purchase obligations under our supply agreement with Digital Angel, through at least the end of 2008. We intend to use $3.5 million of the net proceeds from this offering to repay a portion of our outstanding indebtedness owed to Applied Digital at the time of the consummation of this offering. Approximately $8.0 million to $10.0 million of the net proceeds will be used over the next 24 months to continue the development of the market for our VeriMed system, principally through an increase in our sales and marketing expenses related to our VeriMed system. The remaining proceeds will be used for working capital and for general corporate purposes, which may include research and development, capital expenditures and other sales and marketing expenses. See “Use of Proceeds.” However, a decrease in operating cash flows from our Canadian-based businesses, or our inability to enter into a larger, committed bank credit facility, or failure to control or, as necessary, reduce costs related to our continuing investment in our VeriMed business, would have a material adverse effect on our planned business operations, financial condition, results of operations and liquidity.

 

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Contractual Obligations

 

The following table summarizes our significant contractual obligations as of September 30, 2006 and, assuming the completion of this offering, the effect such obligations are expected to have on our liquidity and cash flows in future periods:

 

     Payments Due By Period

     Total

  

Three Months
Ended

December 31,
2006


   2007

  

2008-2009


   

2010-2011


   After
2011


     (amounts in thousands)

Contractual Obligations

                                          

Amount due Applied Digital(1)

   $ 8,947    $    $ 3,500    $ 5,447 (1)   $    $

Other debt(2)

     1.080      1,080                     

Purchase price obligation(3)

     2,500      2,500                     

Operating lease obligations

     1,965      149      623      1,193           

Purchase commitments(4)

     54,601           1,569      5,875       9,288      37,869
    

  

  

  


 

  

Total

   $ 69,093    $ 3,729    $ 5,692    $ 12,515     $ 9,288    $ 37,869
    

  

  

  


 

  


(1) The approximately $9.0 million reflected in the table represents the amount owed to Applied Digital as of September 30, 2006. Since that date, the total principal amount available under the loan agreement was increased to $14.5 million, and we borrowed additional amounts to fund our operations, to pay costs of this offering and to make the payment referred to in note (3) below. We estimate that approximately $15.0 million, including accrued interest of $1.0 million, will be outstanding under the loan agreement upon completion of this offering. Under the terms of the loan agreement, as most recently amended on February 8, 2007, we are obligated to pay $3.5 million of our indebtedness to Applied Digital upon consummation of this offering, which amount is reflected in the table under the 2007 column. We are not required to make any additional payments of our indebtedness in 2007 and interest on the outstanding principal amount of the loan will continue to accrue at the rate of 12% per annum. During each of 2008 and 2009, we are obligated to pay Applied Digital monthly payments aggregating $3.6 million per year. An additional $300,000 payment is due January 1, 2010 and on February 1, 2010 a balloon payment equal to the outstanding principal amount then due under the loan plus all accrued and unpaid interest is due. Accordingly, the amount to be due during the 2008-2009 period, will be approximately $7.2 million and the amount to be due during the 2010-2011 period, including the balloon payment, will be approximately $8.1 million. For a description of the material terms of the loan agreement with Applied Digital, see “Credit Facilities” above.
(2) Represents borrowings under our revolving credit facility with Royal Bank of Canada. Such borrowings are repayable on demand and are thus reflected as a current liability in the above table and in our consolidated financial statements. The table assumes the accrual of interest through September 30, 2006. For a description of the terms of the loan agreement with Royal Bank of Canada, see “Credit Facilities” above.
(3) Amount relates to the second and final installment of the purchase price for Instantel Inc. The second installment of the purchase price in the amount of $2.0 million, which amount reflected a holdback of $0.5 million for an indemnification claim we have asserted against the sellers of Instantel, was paid in October 2006. We funded such payment through borrowings under our loan agreement with Applied Digital. A final payment of up to $0.5 million may be due upon resolution of the indemnification claim.
(4)

Includes the minimum purchase requirements for our implantable microchips under our supply agreement with Digital Angel and for our custom straps under our supply agreement with Emerson & Cuming Microwave Products. Our exclusivity rights under the supply agreement with Digital Angel can be terminated if we do not purchase the prescribed minimum quantities. Under the agreement with Digital Angel, if during any year we purchase in excess of the minimum

 

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purchase requirement for that year, the excess will be credited against the minimum purchase requirement for the following year or years. The agreement with Digital Angel ends in 2013, subject to earlier termination in the event of either party’s default or bankruptcy, except that, so long as we meet the minimum purchase obligations under the agreement, the term is automatically renewed on an annual basis until the expiration of the last patents covering any of the supplied products (currently in 2021). Accordingly, the amount shown in the After 2011 column includes the annual purchase commitment of $3,750,000 through 2021. See “Business – Manufacturing; Supply Arrangements.”

 

Impact of Recently Issued Accounting Standards

 

In December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment, or FAS 123R, which replaces FAS 123 and supersedes APB No. 25. FAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. We adopted FAS 123R, effective January 1, 2006. The pro forma disclosures previously permitted under FAS 123 are no longer an alternative to financial statement recognition. As discussed below, the vesting of all of our then outstanding employee stock options was accelerated as of December 30, 2005. As a result, our initial adoption of FAS 123R did not have a material impact on our consolidated results of operations and earnings (loss) per share. However, going forward, as we grant more options, we expect that the impact may be material.

 

On December 12, 2005, our board of directors approved a proposal which provided for vesting on December 30, 2005 of all of our then outstanding and unvested stock options previously awarded to our directors, employees and consultants, one employee of Applied Digital, and one employee of Digital Angel. In connection with the acceleration of these options, we stipulated that a grantee that acquires any shares through exercise of any of such options shall not be permitted to sell such shares until the earlier of: (i) the original vesting date applicable to such option or (ii) the date on which such grantee’s employment terminates for any reason.

 

The purpose of the accelerated vesting of the options granted to our directors and employees was to enable us to avoid recognizing in future periods non-cash compensation expense associated with such options in our consolidated statements of operations, which would have otherwise been required upon our adoption of FAS 123R on January 1, 2006. As a result of the acceleration, we avoided recognition of up to approximately $0.6 million of compensation expense in our consolidated statements of operations over the course of the original vesting period, substantially all of which was expected to be avoided in 2006. Such expense is included in our pro forma stock-based footnote disclosure for the year ended December 31, 2005. FASB Financial Interpretation No. 44 requires us to recognize compensation expense under certain circumstances, such as a change in the vesting schedule when the options whose vesting schedule was changed are in-the-money on the date of change, which would allow an employee to vest in an option that would have otherwise been forfeited based on the award’s original terms. We would be required to begin to recognize compensation expense over the new expected vesting period based on estimates of the number of options that employees ultimately will retain that otherwise would have been forfeited, absent the modifications. The majority of the accelerated options, absent the acceleration, would have vested during the first half of 2006, with a smaller percentage vesting over 30 months. Such estimates of compensation expense would be based on such factors as historical and expected employee turnover rates and similar statistics. Of options exercisable for approximately 0.3 million shares of our common stock that were affected by the acceleration of vesting, substantially all of the $4.4 million of intrinsic value of these options is attributable to our executive officers and directors at that time. We are unable to estimate the number of options that our employees and directors will ultimately retain that otherwise would have been forfeited, absent our acceleration of the vesting of these options. Based on the then current circumstances, the high concentration of such options awarded to officers and directors and our historical turnover rates, no compensation expense resulting from the new measurement date was recognized by us upon acceleration

 

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of the vesting on December 30, 2005. We will recognize compensation expense in future periods, should a benefit be realized by the holders of the aforementioned options, which they would not otherwise have been entitled to receive. During the nine months ended September 30 2006, we recognized approximately $0.1 million of compensation expense as a result of a terminated employee receiving a benefit related to the accelerated vesting of his options that he would not otherwise have received. If we are required to recognize additional compensation expense in connection with the accelerated vesting of in-the-money stock options, it could have a material impact on our future results of operations.

 

In November 2004, the FASB issued SFAS No. 151, Inventory Costs, or FAS 151, an amendment of Accounting Research Bulletin (ARB) No. 43, Chapter 4. FAS 151 amends ARB No. 43, Chapter 4, to clarify that abnormal amounts of idle facility expense, freight, handling costs and wasted materials (spoilage) should be recognized as current-period charges. In addition, FAS No. 151 requires that allocation of fixed production overhead to inventory be based on the normal capacity of the production facilities. Our adoption of FAS 151 on January 1, 2006 did not have a material impact on the results of our operations, financial position or cash flows.

 

In December 2004, the FASB issued SFAS No. 153, Exchanges of Non-monetary Assets, or FAS 153. This Statement amends APB Opinion 29 to eliminate the exception for non-monetary exchanges of similar productive assets and replaces it with a general exception for exchanges of non-monetary assets that do not have commercial substance. A non-monetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. FAS 153 is effective for non-monetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. We believe the adoption of FAS 153 will not have a material impact on the results of our operations or financial position.

 

In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections, or FAS 154. FAS 154 replaces APB Opinion No. 20 and FASB Statement No. 3 and changes the requirements for the accounting for, and reporting of, a change in accounting principle. FAS 154 also applies to all voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. When a pronouncement includes specific transition provisions, those provisions should be followed. FAS 154 is effective for all accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. We adopted the provisions of FAS 154 and will assess the impact of a retrospective application of a change in accounting principle in accordance with FAS 154 if the need for such a change arises after the effective date.

 

In February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial Instruments, or FAS 155. This Statement amends FASB Statements No. 133, Accounting for Derivative Instruments and Hedging Activities, and No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. FAS 155 resolves issues addressed in Statement 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.” FAS 155 permits fair value re-measurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, clarifies which interest-only strips and principal-only strips are not subject to the requirements of FASB Statement No. 133, and establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation. It also clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives and amends FASB Statement No. 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. FAS 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. We have not yet determined the impact of the adoption of FAS 155 on our financial statements, if any.

 

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In March 2006, the FASB issued Statement of Financial Accounting Standard 156 – Accounting for Servicing of Financial Assets, or FAS 156, which requires that all separately recognized servicing assets and servicing liabilities be initially measured at fair value. FAS 156 permits, but does not require, the subsequent measurement of servicing assets and servicing liabilities at fair value. Adoption is required as of the beginning of the first fiscal year that begins after September 15, 2006. Early adoption is permitted. The adoption of FAS 156 is not expected to have a material effect on our consolidated financial position, results of operations or cash flows.

 

In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes — an interpretation of FAS No. 109, or FIN 48, which clarifies the accounting for uncertainty in income taxes. Currently, the accounting for uncertainty in income taxes is subject to significant and varied interpretations that have resulted in diverse and inconsistent accounting practices and measurements. Addressing such diversity, FIN 48 prescribes a consistent recognition threshold and measurement attribute, as well as clear criteria for subsequently recognizing, derecognizing and measuring changes in such tax positions for financial statement purposes. FIN 48 also requires expanded disclosure with respect to the uncertainty in income taxes. FIN 48 is effective for fiscal years beginning after December 15, 2006. We have not yet determined the impact of FIN 48 on our consolidated financial position, results of operations, cash flows or financial statement disclosures.

 

In September 2006, the FASB issued Statement of Financial Accounting Standard 157 – Fair Value Measurements, or FAS 157. FAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. FAS 157 applies under other accounting pronouncements that require or permit fair value measurements. Accordingly, FAS 157 does not require any new fair value measurements. However, for some entities, the application of FAS 157 will change current practice. FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We have not yet determined the impact of FAS 157 on our consolidated financial position, results of operations, cash flows or financial statement disclosures.

 

In September 2006, the FASB issued Statement of Financial Accounting Standard 158 – Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, or FAS 158. FAS 158 amends of FASB Statements No. 87, 88, 106, and 132(R), or FAS 158. FAS 158 requires an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan (other than a multiemployer plan) as an asset or liability in its statement of financial position and to recognize changes in the funded status in the year in which the changes occur through comprehensive income. It also requires an employer to measure the funded status of a plan as of the date of its year-end statement of financial position, with limited exceptions. Under FAS 158, the requirement to initially recognize the funded status of a defined benefit postretirement plan and to provide the required disclosures is effective for us as of the end of our first fiscal year ending after December 15, 2006. The requirement to measure plan assets and benefit obligations as of the date of the employer’s fiscal year-end statement of financial position is effective for us for our first fiscal year ending after December 15, 2008. We have not yet determined the impact of FAS 158 on our consolidated financial position, results of operations, cash flows or financial statement disclosures.

 

In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements,” or SAB 108, that requires public companies to utilize a “dual approach” to assessing the quantitative effects of financial misstatements. This dual approach includes both an income statement focused assessment and a balance sheet focused assessment. SAB 108 is effective for annual financial statements covering the first fiscal year ending after November 15, 2006. We are currently assessing the impact of SAB 108 but do not expect that it will have a material effect on our results of operations or financial condition.

 

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Qualitative and Quantitative Disclosures about Market Risk

 

We presently do not use any derivative financial instruments to hedge our exposure to adverse fluctuations in interest rates, foreign exchange rates, fluctuations in commodity prices or other market risks, nor do we invest in speculative financial instruments. Our line of credit with the Royal Bank of Canada bears interest at the Bank of Canada prime rate plus 1%. Our interest income is sensitive to changes in the general level of U.S. interest rates, particularly since our investments are short-term.

 

Due to the nature of our short-term investments, we have concluded that there is no material market risk exposure and, therefore, no quantitative tabular disclosures are required. Due to the minimal amounts of foreign currency exchange gains and losses and translation adjustments during the year ended December 31, 2005, and the nine months ended September 30, 2006, a sensitivity analysis of fluctuations in foreign currency exchange rates is not required.

 

The table below presents the principal amount, including accrued interest, and weighted-average interest rate for our debt portfolio:

 

     September 30, 2006

 
     (dollars in thousands)  

Loan due Applied Digital

   $8,947  

Credit agreement with Royal Bank of Canada

   $1,080  

Weighted-average interest rate for the nine months ended September 30, 2006

   7.88 %

 

Based upon the average variable rate debt outstanding during the nine months ended September 30, 2006, a 1% change in our variable interest rates would have affected our loss before income taxes by approximately $0.1 million on an annual basis. Based upon the average variable rate debt outstanding during 2005, a 1% change in our variable interest rates would have affected our loss before income taxes by approximately $0.1 million.

 

The estimated fair value of our indebtedness to Applied Digital is not reasonably determinable due to the related party nature of the instrument.

 

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OUR BUSINESS

 

Overview

 

We are primarily engaged in the development, marketing and sale of radio frequency identification, or RFID, systems used to identify, locate and protect people and assets. The healthcare industry represents the principal market for our RFID systems. Our goal is to become the leading provider of RFID systems in the healthcare industry.

 

Through our acquisitions in the first half of 2005 of two Canadian-based businesses, each of which has been engaged in the design, marketing and sale of radio frequency identification systems for more than 20 years, we have become one of the leading providers of:

 

   

infant protection systems that help to prevent mother-baby mismatching and infant abduction; and

 

 

   

wander prevention systems that help to protect and locate residents in nursing homes and assisted living facilities.

 

As of December 31, 2006, our RFID systems for one or the other of these applications have been installed in over 4,000 healthcare locations, primarily located in North America. Sales of these systems currently represent a majority of our revenue.

 

We are in early stages of marketing an asset/staff location and identification system to hospitals and other healthcare facilities. This system is designed to efficiently identify, locate and protect medical staff, patients, visitors and medical equipment. We are seeking to leverage our established brand reputation, reseller network and extensive end-use customer base for our infant protection and wander prevention systems to gain inroads in the developing market for RFID real-time location systems in hospitals and other healthcare facilities. The healthcare market for these systems is just emerging, but several market research firms predict that these types of systems will develop into the second-largest application for RFID technology in the healthcare industry over the next decade.

 

RFID technology involves the use of radio frequency, or RF, transmissions, typically achieved through communication between a microchip-equipped transponder and a receiver, for identification, location and other purposes. The basic components of an RFID system consist of:

 

   

a “tag,” containing a microchip-equipped transponder, an antenna and a capacitor, attached to the item to be identified, located or tracked, which wirelessly transmits stored information to a receiver;

 

   

one or more receivers, also referred to as “readers,” which are devices that read the tag by sending out an RF signal to which a tag, in the range of the signal, responds;

 

   

the equipment, cabling, computer network and software applications to use the processed data for one or more applications.

 

Most RFID systems use either “active” or “passive” tags, with the choice reflecting the different characteristics of the tags and the nature of the RFID system application. The key difference in the technology is that active RFID systems deploy tags with battery-powered microchips that emit a signal at regular intervals or continuously and do not rely on power from the reader to operate, while passive RFID

 

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systems deploy tags with microchips that have no attached power supply and receive an activating charge from the reader’s signal. Applications that require receipt of signals between the tag and the reader beyond approximately 10 meters in range usually need a battery in the tags.

 

Our infant protection, wander prevention and asset/staff location and identification systems all make use of active RFID tags which are worn by the people or attached to the objects these systems are designed to identify, locate or protect, enabling the systems to be used for perimeter control, tamper notification, and location and tracking purposes. Multiple receivers with radio frequency antennas are placed in selected locations throughout a facility to receive coded beacon messages from these active tags. All receivers in range of a particular tag decode the message and send the received information to a central server. The received tag information is used for multiple purposes across the range of system applications, including to provide supervisory alerts when tag messages are absent and to provide tag positional location through triangulation or other context-sensing algorithms. In addition, many of our active tags include a tamper detection feature to prevent unauthorized removal, enhancing the security features of our systems. This includes our proprietary skin-sensing and cut band technologies used with our infant protection tags, as well as our proprietary tamper-proof asset tag used in our asset/staff location and identification system.

 

We are also in the process of attempting to create a market within the healthcare sector for the first, and, to date, we believe the only, human-implantable radio frequency transponder system cleared for use for patient identification and health information purposes by the U.S. Food and Drug Administration, or FDA – our VeriMed patient identification system. To date, we have generated nominal revenue from sales of our VeriMed system. The key components of the VeriMed system are a passive microchip, which is approximately the size of a grain of rice, a fixed location or a wireless handheld scanner used to read the 16-digit identification number contained on the microchip, and a secure, web-enabled database containing information appropriate for the specific application. The implantable microchip is not worn or attached as are the tags used in our infant protection, wander prevention and asset/staff location and identification systems but rather is implanted under the skin in a person’s upper right arm utilizing a different technology.

 

We are also engaged in the development, marketing and sale of products with applications outside the healthcare sector that do not make use of RFID technology. Specifically, we offer:

 

   

a wide range of vibration monitoring instruments used by engineering, construction and mining professionals to monitor and document the effects of human-induced vibrations on neighboring structures in an area where blasting activity occurs. We believe we are the leading provider of vibration monitoring instruments. Sales of such instruments currently represent the second-largest source of our revenue.

 

   

an asset management system used by industrial companies to manage and track their mobile equipment and tools for purposes of, among other things, reducing theft and the hoarding of assets. Our asset management system provides broad functionality, including multi-facility management, usage tracking by cost center, remote requisition, employee certification, third-party enterprise resource planning integration, and time and attendance capability.

 

Industry Overview

 

RFID and the Healthcare Industry

 

RFID technology has been widely adopted and used in a number of industries and for a number of different applications. Today, RFID is being used to identify objects in retail, transportation and logistics

 

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industries, as well as to identify and locate livestock and companion pets. RFID technology offers a number of advantages over other systems used to identify and track objects, such as barcode technology. RFID technology offers instantaneous location ability without the need for ongoing human intervention, and provides greater range, accuracy, speed and lower line-of-sight requirements than barcode technology.

 

According to a report prepared by IDTechEx, a United Kingdom-based consulting firm, entitled “RFID in Healthcare 2006-2016,” the market for RFID tags and systems in the healthcare industry in 2006 amounts to $90 million, representing approximately 3% of the total RFID market. IDTechEx has forecast that by 2016 the market for RFID tags and systems in the healthcare industry will grow to approximately

$2.1 billion, estimated to then represent 8% of the total market for RFID technology. The anticipated rapid growth in the healthcare industry’s adoption of RFID technology reflects the many healthcare-related applications envisioned and the benefits – for example, operational efficiencies, cost control and error prevention – to be derived from such applications.

 

Some of the major applications of RFID systems being deployed in the healthcare industry today include:

 

   

Infant Protection—At present, approximately 50% of maternity wards and other birthing facilities in the United States, and 65-75% of maternity wards with greater than 1,000 births per year, have some type of infant protection system – though not necessarily an RFID system. Based on our experience, we anticipate that hospital maternity wards and birthing centers will continue to upgrade their security measures, with RFID systems designed for these applications achieving greater market penetration. The adoption of security measures, such as the implementation of an RFID infant protection system, has been prompted by problems in dealing with mother-baby mismatching and infant abduction. The Journal of Healthcare Protection Management has reported that an estimated 20,000 mismatching incidents occur annually in the United States. Between 1983 and 2004, 223 infants were recorded as being abducted in the United States, with over 50% taken from healthcare facilities.

 

   

Wander Prevention—At present, we estimate that roughly 30% of the long-term care facilities in the United States have deployed an RFID-type wander prevention system. The level of system deployment varies by type of facility. Nursing homes reflect the highest level, followed by assisted living facilities. The implementation of RFID wander prevention systems has been prompted by the significant number of individuals residing in long-term care facilities, including nursing homes and assisted living facilities, who are at risk of wandering away from their care facility. This can result in danger to the individual and subsequent liability to the healthcare facility and its insurer. According to the National Institute on Aging of the U.S. National Institutes of Health, in 2005 there were approximately 37 million people over the age of 65 in the United States alone, and that number is expected to grow to approximately 58 million by 2025. Furthermore, according to the National Nursing Home Survey, published by the Center for Disease Control in June 2002, as of 1999, there were 18,000 nursing homes in the United States in which approximately 27% of the residents suffered from Alzheimer’s disease, dementia or related disorders. We believe that existing and future state regulations applicable to long-term facilities, which include security and wander prevention requirements, will drive the growth in demand for wander prevention systems.

 

IDTechEx expects that over the next ten years the second-largest RFID application, by value, within the healthcare industry will be real-time location systems for staff, patients, visitors and assets. Real-time location systems are designed to locate persons or objects from a distance within a defined physical space, such as an entire hospital, a care unit or a patient’s room. In this context, “real-time” means that the RFID system checks and updates the location of the persons and/or objects on a frequent basis, such as every few seconds. The IDTechEx report cites a number of factors underlying the expected growth in real-time location system applications, including: the increase in incidents of violence towards staff in hospitals

 

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and long-term care facilities; the increase in the dependent elderly as a percentage of the overall population, which is causing the ratio of patients to staff to increase, necessitating more efficient use of staff; and the excessive costs and inadequate level of service and safety resulting from the inability to locate assets and supplies. RFID real-time location systems can enhance the operational flow and productivity of medical staff, enable appropriate personnel to more quickly respond to incidents of patient violence against staff, locate patients and assets, and respond to patients’ needs for assistance.

 

Notwithstanding the predictions of significant growth for RFID real-time location systems in the healthcare sector, the pace at which healthcare facilities have implemented RFID systems has been slower

than many who follow the industry have anticipated. Market analysts have cited a number of factors that may be constraining the rate and extent of the U.S. healthcare industry’s adoption of RFID asset/staff location and identification systems, including:

 

   

the cost of deployment, coupled with the limited budgets of many hospitals;

 

   

the uncertainty or unquantifiable nature of the return on investment;

 

   

system compatibility issues;

 

   

the low level of awareness; and

 

   

privacy concerns.

 

To date, hospitals in the United States that have implemented real-time location systems have done so primarily on a departmental basis. This reflects, in part, the funding constraints of U.S. hospitals, nearly two-thirds of which operate at break-even level financially, as well as the difficulty of quantifying the return on investment derived from deployment of an RFID system. Most of the existing system installations represent early adopters of the technology, typically teaching hospitals. IDTechEx expects that the future rate of adoption of RFID real-time location systems will depend on the size of the hospital, with large and mid-sized hospitals more likely being early adopters. IDTechEx also expects that the average price of real-time location systems will rise as larger-scale and more sophisticated projects are undertaken, notwithstanding the expected reduction in the costs of tags and some degree of standardization of the software and modularity of hardware. In general, a real-time location system with a greater coverage area translates into greater potential for applications that improve productivity, increase revenues and reduce costs.

 

We believe that RFID technology may also be used to address the need of emergency room personnel and other first responder medical practitioners to identify uncommunicative patients and rapidly access their personal health records, and we believe that use of such technology has the potential to improve patient care, enhance productivity and lower costs. The IDTechEx report refers to a study performed by the U.S. Institute of Medicine that estimated that preventable medical errors in the United States cause between 44,000 and 98,000 deaths each year, due in part to mistaken patient identification and lack of information on a patient’s medical history, and results in losses, other than the loss of human life, of $17 billion to $29 billion annually. These losses include the expense of additional care needed because of mistakes, disability, and lost productivity and income. One factor that can contribute to the occurrence of preventable medical errors is the inability to identify a patient and/or access his or her health records. Recognizing the problem of patient identification and access to medical records, the United States government is currently attempting to address certain inefficiencies in the healthcare system related to information technology. In particular, the current administration has developed a National Health Information Technology Plan which features as one of its main initiatives a plan to establish electronic health records for a majority of Americans within the next ten years.

 

RFID and Security and Industrial Applications

 

The security, industrial and government sectors also stand to benefit from the implementation of RFID technology. Many high security facilities, such as government and industrial facilities, have a need for

 

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access monitoring. For example, nuclear power plants, national research laboratories and correctional facilities require the means to accurately and securely monitor activity. Line of sight identifiers, such as ID cards, suffer from problems that RFID technology readily overcome, such as reliance on human visual identification, loss, theft, tampering and slow speed.

 

Large industrial companies in higher-value asset-intensive industries, such as construction, oil and gas, and power companies, can face significant costs related to inefficiencies in locating mobile assets and tools. A January 2005 report by the National Equipment Register cites estimates of the total value of construction and farm equipment stolen annually in the United States ranging from $300 million and $1 billion. Companies in these industries frequently experience problems and incur costs related to managing inventory. To address these problems, companies such as SAP, Oracle and Peoplesoft offer enterprise resource planning, warehouse management, and manufacturing execution systems that include asset tracking modules and capabilities. To date, RFID solutions have achieved limited market penetration.

 

Vibration Monitoring

 

Government regulations relating to the monitoring of vibrations resulting from activities, such as mining, commercial blasting, pile driving and heavy construction, require compliance with specified standards. These standards serve to limit the potential for damage to neighboring structures and to minimize human annoyance. The demand for such monitoring, though affected by the level of economic activity, has, in general, increased over the last 20 years, reflecting the greater degree of blasting and vibration activities occurring closer to densely populated areas. In addition, the insurance industry requires monitoring to avoid claims for vibration-related damage.

 

Our Solutions

 

We are primarily engaged in the development, marketing and sale of RFID systems used to identify, locate and protect people and assets. The healthcare industry represents the principal market for our RFID systems. We also market and sell RFID and non-RFID systems with applications outside the healthcare sector, specifically for security and industrial applications. In addition, we market and sell vibration monitoring instruments used to monitor and document the effects of human-induced vibrations on neighboring structures in an area where blasting occurs. All of our systems are designed to enable our end-use customers to enhance operating efficiencies, reduce costs, and reduce the exposure to potential liability.

 

Our Healthcare Security Systems

 

Infant Protection

 

We are a leading provider of RFID infant protection systems, which we market and sell under the Hugs and HALO brand names. Our systems reduce the risk of infant abductions and mother-baby mismatching, and enable healthcare professionals to accurately identify infants. Our systems help protect infants from abductions by sounding alarms, locking doors and disabling elevators. While infant abductions are rare, the impact of a single case can create a severe negative impact on hospitals, birthing centers and families. With an additional optional component worn by the mother, one of our systems can be used to help prevent mother baby-mismatching through an audible signal to indicate a match or mismatch.

 

The benefits of our infant protection systems include:

 

   

a reliable and accurate security system using RFID technology, requiring no manual checking of infant tags or other devices to make sure they are working (as the system software continually monitors the status of all key system components, and generates an alarm if something goes wrong);

 

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automatic alerting of mother-baby mismatches (in the case of one of our systems);

 

   

a proprietary skin-sensing or cut band technology that sounds an alarm if the tag is removed or tampered with;

 

   

a reduction of potential liability to hospitals and birthing centers; and

 

   

an enhanced marketability of a hospital or birthing center.

 

The Hugs System

 

The Hugs system uses a proprietary anklet band containing an active RFID tag. If the band is cut or tampered with, a signal is emitted to a receiver. The Hugs system software continually monitors the status of all infant tags, and will generate an alarm if a tag does not send a status message every 12 seconds – and more frequently when within the range of a mounted receiver at a point of egress. The beacon is received by receivers positioned above the ceiling or by a door that monitor the tag’s location. Once a signal is emitted to a receiver, the receiver then sends the signal to a server containing our application software.

 

The Hugs system will alert the staff of a maternity ward or birthing center if:

 

   

someone tries to exit via a monitored door or elevator with a protected infant, without authorization;

 

   

the band is cut or tampered with;

 

   

the tag’s signal is not detected by the system for a specified period of time;

 

   

the tag’s battery power is low;

 

   

an authorized exit occurs but someone tries to “piggyback” through the protected exit with another infant; or

 

   

an authorized exit occurs, but the infant is not returned to the designated safe area in a specified time.

 

In the event of an alarm, the server indicates the tag ID number and the exact location on a floor plan map of the facility. The Hugs system can automatically activate magnetic door locks or hold an elevator. It can also integrate with and activate other security and access control systems, such as alpha-numeric pagers and cameras.

 

Through the use of simple password procedures, the Hugs system allows staff to sign tags out of the system, so infants can be moved, for example, from the maternity ward for testing or other medical procedures.

 

The optional Kisses component to the Hugs system is designed to ensure mother infant matching. With the Kisses option, each mother wears a small Kisses tag. Every time a mother and infant are brought together, an audible signal indicates a match or mismatch. In the event of a mismatch, the infant’s tag immediately alerts the maternity ward or birthing center

 

The Halo System

 

The HALO system is offered at a lower price point than our Hugs system. The HALO system uses a generic bracelet, which goes around an infant’s ankle, containing an active RFID tag incorporating our proprietary skin-sensing technology. If the skin-sensing tag is removed from the infant’s skin, a signal is emitted to a receiver. Any unauthorized attempt to remove the HALO tag, or to take the infant through a monitored exit, immediately results in an alarm at the HALO computer. The alarm identifies the infant and exact location.

 

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The HALO system supports easy, secure bypass of exits via a keypad or card-access system, recording the identity of the staff member and the baby being transported. With optional staff tags, this process becomes completely automatic.

 

The HALO system is modular in design and can be easily expanded to new areas of the medical facility – for example, the pediatrics wing – with the addition of more receivers and tags.

 

Wander Prevention

 

We believe that we are one of the leading providers of active, wearable tag RFID wander prevention systems, which we market and sell under the Roam Alert brand name. Our systems allow healthcare professionals to accurately identify and locate residents of long-term care facilities, including nursing homes and assisted living facilities, as well as hospital psychiatric wards and trauma units. Our systems help protect residents from wandering by sounding alarms, locking doors and disabling elevators. Residents wearing our tags are typically individuals who suffer from a dementia-related disorder, such as Alzheimer’s disease. In addition, hospitals can use our wander prevention systems in their pediatric wards to help protect their patients and reduce potential liability.

 

The benefits of our wander prevention systems include:

 

   

the protection of residents without physical restraint, providing them freedom to move throughout their place of residence;

 

   

the reduction of staffing requirements and the increased ability to focus on care rather than protection; and

 

   

the reduction of potential liability to long-term care and related facilities.

 

With the Roam Alert wander prevention system, an at-risk resident of a long-term care facility wears an active tag RFID bracelet, which we believe to be one of the smallest and lightest on the market. Exits are protected by door receivers. When the resident approaches an exit, the door controller locks the door to prevent the resident from leaving or, if the door is open, an alarm sounds. All alarm information is presented in an intuitive visual format: the name of the resident, his/her location and even a picture can be displayed on PCs installed at one or several nurse stations around the long-term care facility. For bypassing doors, staff members wear staff pendant tags. Doors will unlock automatically and the system will record the identity of the staff member, as well as the resident(s) the staff member is escorting.

 

The Roam Alert system allows for customization of resident care so as to give each resident the maximum possible freedom compatible with his/her safety. The system can be programmed to enable a resident to pass through certain exits, for example to reach a common area, while all other exits and residents remain protected.

 

The system provides not only wander prevention, but can also be expanded to include personal emergency response and resident locating. Residents and staff can call for help from anywhere in the facility at any time.

 

Our Roam Alert ECO product, which we sell at a lower price point, is targeted at facilities with only a few exits to monitor and/or only a few residents in need of protection. The Roam Alert ECO can cover elevators, and supports display of the resident tag ID number at the door with the optional ID display unit. It is easily integrated with nurse call, access control and fire safely systems. In addition, the ECO product can be upgraded to the fuller functionality of the Roam Alert system.

 

Asset/Staff Location and Identification

 

Our Assetrac asset/staff location and identification system provides a reliable and efficient method for hospitals and other healthcare facilities to locate high-value mobile medical equipment, which we

 

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believe can be of help in providing ready access to such equipment when needed and reducing losses due

to misplacement or theft. The location information provided by the system can also be used to establish whether that equipment has been sterilized since its last use. This information helps to ensure that patients are treated with sterile and safe equipment.

 

Our location and identification system can be utilized for other applications, such as:

 

   

tracking patients for identification purposes prior to the administration of medications or surgery;

 

   

tracking the location of caregivers in healthcare facilities to ensure timely response to emergencies; and

 

   

facilitating staff alarms in the event of patient violence.

 

Hospitals have the ability to deploy asset/staff location and identification systems of varying scale, ranging from a system covering a single department, such as the emergency room or the operating room, to one covering the entire facility. The system can provide a combination of portal-based tracking and true real-time tracking. To date, three of our asset/staff location and identification systems have been sold and installed. These systems were sold through a single distributor on a private label basis.

 

We expect that a hospital’s purchase of our asset/staff location and identification system, which, in general, will have a higher price, ranging from $100,000 to $1.5 million or more, than an infant protection or wander prevention system, will involve a fairly lengthy sales cycle requiring the approval of senior level hospital executives and, because the market for such systems in the healthcare sector is just emerging, a significant educational process.

 

Our VeriMed System

 

Our VeriMed system is designed to rapidly and accurately identify people who are unconscious, confused or unable to communicate at the time of medical treatment, for example, upon arrival at a hospital emergency room. Our VeriMed system provides emergency room physicians and staff who have access to our scanner and either our or a third-party database with rapid access to patient pre-approved information, including the patient’s name, primary care physician, emergency contact information, advance directives and, if the patient elects, other pertinent data, such as personal health records. In addition, we believe that our recent introduction of our wireless handheld scanner will make the VeriMed system an important identification tool for EMTs and other emergency personnel outside the hospital emergency room setting. The components of our system include:

 

   

a glass-encapsulated microchip-equipped transponder, antenna, and capacitor;

 

   

a fixed location, and now a wireless handheld, scanner; and

 

   

a secure, web-enabled database containing patient-approved information.

 

The microchip used in the VeriMed system is a passive RFID microchip, approximately the size of a grain of rice, which is implanted under the skin in a patient’s upper right arm by the patient’s physician. The capsule is coated with a polymer, BioBondTM to form adherence to human tissue, thereby preventing migration in the body. Each microchip contains a unique 16-digit identification number. The identification number can be read by one of our handheld scanners. When the scanner is placed within a few inches of the microchip, a small amount of radio frequency energy passes from the scanner, energizing the dormant microchip, which then emits a radio frequency signal transmitting the identification number. With that identification number, emergency room personnel or EMTs can securely obtain from our or a third party’s database the patient’s pre-approved information, including the patient’s name, primary care physician, emergency contact information, advance directives and, if the patient elects, other pertinent data, such as personal health records.

 

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We currently envision offering patients two annual subscription levels to our database, basic and full-featured. The following table sets forth the type of information that a patient can store on our database at each subscription level.

 

Type of Information


   Basic
Subscription Level


   Full-Featured
Subscription Level


Personal identification and contact information    ü    ü

Physician and emergency contact information

   ü    ü

Blood type and allergies

   ü    ü

Information about medical facilities where additional information is stored

   ü    ü

Advance directives:

   ü    ü

• living will

         

power of attorney

         

• health care agent

         

• do-not-resuscitate order

         

• organ/tissue donor card

         

Personal health records:

        ü

• medical conditions

         

• medications and over-the-counter drugs and supplements

         

• medical device implants

         

• previous surgeries and recent hospital admissions and medical tests

         

• specialty physicians

         

 

An individual implanted with our microchip is under no obligation to subscribe to our database and, instead, may have his or her information stored solely on a third-party database, such as that maintained by a nearby hospital. In such case, we would not derive the recurrent revenue associated with the subscription to our database. Alternatively, a patient may decide to store his or her information in both our database and a third-party database. If a hospital or other healthcare facility desires, we will, in general, seek to integrate our database with its own database.

 

Initially, we anticipate that a microchip-implanted individual will take responsibility for inputting all of his or her information into our database, including personal health records, as physicians currently have little interest in being involved in this process – primarily because of liability concerns and because they are not generally paid for this service. However, in time we envision that persons with our microchip may prevail upon their physicians to assist them with the inputting of information for which, by virtue of their medical training, physicians are better equipped to provide. This, in turn, should provide emergency room personnel and EMTs with greater confidence in the accuracy and completeness of patients’ personal health records in the database.

 

An individual implanted with our microchip whose information is included in our database may grant access to such information to any of the following categories of persons, at the sole discretion of the patient:

 

   

public safety personnel, including local police, fire and rescue workers;

 

   

emergency medical personnel, including EMTs and paramedics;

 

   

medical facilities, including hospitals, urgent care centers and physician offices; and

 

   

law enforcement personnel, including sheriff’s departments, state police and the FBI.

 

Unless a patient decides otherwise, such persons will have read-only access to a patient’s information.

 

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There are a number of risks associated with our VeriMed business including:

 

   

uncertainty as to whether a market for the VeriMed system will develop and whether we will be able to generate more than a nominal level of revenue from the sale of such systems;

 

   

uncertainty as to the future availability of insurance reimbursement for the microchip implant procedure from government and private insurers;

 

   

a potential disruption in our operations, loss of sales and higher expense in the event we are unable to obtain the implantable microchip from Digital Angel, our sole supplier of the microchip, or have to make alternative arrangements for the manufacture of the microchip;

 

   

our obligation to meet annual minimum purchase requirements beginning in 2007 under our supply agreement with Digital Angel, as a condition to maintaining the exclusivity of our supply arrangement, that may exceed our sales of the microchip; and

 

   

possible third-party claims asserting that we hold no rights for the use of the implantable microchip technology and are violating the third party’s intellectual property rights. If such a claim were successful, we could be enjoined from marketing this technology and could be required to pay substantial damages.

 

For additional information relating to the risks associated with our VeriMed business, see “Risk Factors—Risks Related to Our Businesses Which Utilize the Implantable Microchip” beginning on page 18 of this prospectus.

 

Our Security and Industrial Systems

 

Vibration Monitoring Instruments

 

Our Blastmate and Minimate vibration monitoring instruments provide engineering, construction and mining professionals with an accurate and efficient means to monitor and document the effects of human-induced vibrations on neighboring structures in an area where blasting occurs. Government regulations relating to vibration monitoring require compliance with specified standards to limit the potential for damage to neighboring structures and to minimize human annoyance that may result from commercial blasting or heavy construction. Our instruments assist in evaluating the peak vibration level, which is a key statistic in the prevention of structural damage.

 

We are in the process of developing and introducing a new instrumentation platform. The new platform will replace our existing platforms for our vibration monitoring instruments, for which we are facing certain manufacturing challenges due to the discontinuation and unavailability of key components. We believe the new platform, when completed, will better integrate with contemporary data communications protocols so as to improve our products’ remote monitoring capabilities. In addition, we expect the new platform will entail the addition of several sensors and peripherals that will enhance the ability to monitor additional environmental and structural parameters related to vibration and overpressure monitoring.

 

Asset Management System

 

Our asset management system, ToolHound, is used by industrial companies to manage and track their mobile equipment and tools. Our primary markets for the ToolHound system are the heavy construction, power generation and petrochemical processing industries. ToolHound is a turnkey system consisting of barcodes, durable scanners, wireless access points and management application software that includes a check-out and return system for mobile equipment and tools. The information relating to the equipment is maintained in a database enabling a company to monitor inventory, equipment maintenance status and job activity status. The ToolHound system provides broad functionality relative to competitive products, including multi-facility management, usage tracking by cost center, remote requisition, employee certification, third-party enterprise resource planning integration, and time and attendance capability. In addition, our core competency in RFID technology provides us with expanded product development possibilities, such as the ability to read data from RFID tags.

 

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VeriGuard

 

Our VeriGuard system uses our implantable microchip and/or active RFID tags to provide secure access control into restricted areas, map/track visitors throughout a facility, and track assets. These applications can be used in high security facilities, such as government facilities, nuclear power plants, national research laboratories and correctional facilities, to provide secure ingress and egress and local area location. In the case of our active RFID systems, users have the ability to identify and locate individuals in restricted areas, similar to our asset/staff location and identification system targeted at the healthcare sector, using the same reader technology. With systems using our implantable microchip, individuals are identified

by a scanner. Per-user price considerations are such that the VeriGuard system competes primarily with high-end biometric access control methodologies, such as retina scanning.

 

Since our VeriGuard and VeriTrace systems, like our VeriMed system, incorporate our implantable microchip, many of the risks associated with the VeriMed system apply to the VeriGuard and VeriTrace systems, including the risk of possible third-party claims asserting we are violating rights with respect to certain patented intellectual property underlying each of these systems. We do not anticipate generating more than nominal revenues from the sale of the VeriGuard and VeriTrace systems prior to the expiration of the patent in April 2008.

 

Our Strategy

 

For the foreseeable future, we expect that our revenue will continue to be derived primarily from sales of our infant protection and wander prevention systems, which along with out asset/staff location and identification system, make up our healthcare security system offerings, and sales of our vibration monitoring instruments.

 

Healthcare Security System Offerings

 

We believe that the global market for infant protection systems, including components of such systems that are consumable items, is currently growing at a rate of approximately 10-15% per year,

although we consider the market relative mature. The United States currently accounts for more than 95% of the global market for infant protection systems. There are approximately 3,400 birthing hospitals in the United States. We estimate that infant security systems have been implemented in approximately half of these facilities. Approximately 1,100 U.S. hospitals and birthing centers use our infant protection systems. We believe that growth opportunities exist among the remaining facilities that do not yet have infant protection systems in place, as well as through replacement of legacy systems. Presently, approximately half of our infant protection system sales are replacement system sales.

 

We estimate that within the United States RFID-type wander prevention systems are currently installed in approximately 30% of the more than 52,000 nursing homes and assisted living facilities. While the nursing home segment is considered fairly well penetrated, we believe that existing and future state regulations applicable to long-term facilities, which include security and wander prevention requirements, will continue to drive growth in demand for wander prevention systems for the next several years.

 

In view of the relative maturity of the markets for our infant protection and wander prevention systems – at least in the United States – our growth strategy for these businesses encompasses the following:

 

   

Market and sell these systems internationally through distribution relationships. We are only just beginning to penetrate geographic markets outside of North America for our infant protection and wander prevention systems. In an effort to accelerate this process, we intend to enter into distribution agreements with a combination of both local distributors who have an in-depth knowledge of the relevant geographic region, as well as larger distributors with a global or near-global reach.

 

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Leverage our established brand recognition, reseller network and extensive end-use customer base for our infant protection and wander prevention systems to gain inroads in the emerging market for asset/staff location and identification systems. We intend to leverage our established brand reputation, reseller network and extensive end-use customer base for our infant protection and wander prevention systems to gain inroads in the emerging market for RFID location and identification systems in the healthcare industry. We are in the process of building out our distribution network for our asset/staff location and identification system and providing the requisite training to certain dealers in an effort to be on the forefront of the emerging market for these systems in the healthcare sector. We anticipate commercially launching our asset/staff location and identification system through our dealer channel for this system in the first quarter of 2007. We believe that it is important for our asset/staff location and identification system to capture market share in this emerging market within the next 12-24 months, as we expect that a significant factor in hospitals’ choice of system vendors will be referrals to other healthcare facilities that have deployed, and are pleased with, such systems. To achieve this, we will need to be on the forefront of the effort to educate the healthcare industry regarding the benefits, including the return on investment, achievable through implementation of RFID location and identification systems.

 

   

Offer healthcare security applications that are flexible, scalable and expandable. Our current product development efforts for our infant protection, wander prevention and asset/staff location and identification systems include having all of these systems share a common technology platform. This platform consists of a networked hardware infrastructure and a software-based server running on an industry standard computing platform thereby allowing it to be integrated with a customer’s existing technology platform. On top of this common hardware and software platform, each of the applications, such as infant protection, augments the platform with specific RFID tags designed for that application and a software module that provides the application-specific graphical user interface. We believe that a common technology platform for our healthcare security system offerings will help us to migrate our existing end-use customers into deployment of asset/staff location and identification systems. A common technology platform will also allow us to provide our end-use customers with an enhanced value proposition through the ability to maximize their return on investment from deployment of an RFID system, and distribute the infrastructure and installation costs, across multiple applications. We are also in the process of interfacing our technology platform with other location technologies. The first interface we have completed is with WiFi. This has been done to illustrate the platform’s flexibility to interface to other wireless air interfaces and perform an even higher level of system integration that collects location-based information. This capability will make the platform more flexible, scalable and expandable.

 

Security and Industrial System Offerings

 

We perceive the market for vibration monitoring instruments, like that for our healthcare security system offerings, to be of limited size and growth potential. Our primary strategy to grow this business is through the introduction of a new instrumentation platform. We believe that the new platform, which we anticipate will be completed in 2007, will better integrate with contemporary data communications protocols so as to improve our products’ remote monitoring capabilities. In addition, we expect the new platform will entail the addition of several sensors and peripherals that will enhance the ability to monitor additional environmental and structural parameters related to vibration and overpressure monitoring.

 

The VeriMed System and Other Applications for Our Implantable Microchip

 

We believe that our VeriMed system, which is one of our systems that utilizes our implantable microchip, may make a significant contribution to our revenue in the future. As part of our growth strategy, we intend to dedicate a portion of the operating cash flows generated by our healthcare security systems

 

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and security and industrial products, as well as a significant portion of the proceeds of this offering, to our efforts to create markets for the VeriMed system, as well as our other systems that utilize the implantable microchip.

 

Healthcare Application

 

We believe our VeriMed system will prove of use to emergency room personnel and other first responder medical practitioners in identifying uncommunicative patients and rapidly accessing their personal health records at the time of initial treatment. The primary target market for our VeriMed system consists of people who are more likely to require emergency medical care, persons with cognitive impairment, persons with chronic diseases and related conditions, and persons with implanted medical devices. According to a study we commissioned by Fletcher Spaght, Inc., there are approximately 45 million patients in the United States alone who fit this profile. Through use of our VeriMed system, a person can be scanned for the unique, 16-digit identification number on the implanted microchip, enabling access from our or a third party’s database to that person’s pre-approved information, including the person’s name, primary care physician, emergency contact information, advance directives, and if the person elects, other pertinent data, such as personal health records. See “Risk Factors—Risks Related to Our Businesses Which Utilize the Implantable Microchip.”

 

Our sales and marketing strategy for our VeriMed system is to contemporaneously market our system to hospitals, hospital networks, third-party emergency department management companies and nursing homes, as well as to physicians who treat at-risk patients: persons with diabetes, cancer, coronary heart disease, chronic obstructive pulmonary disease, cerebrovascular disease (stroke), congestive heart failure, Alzheimer’s, epilepsy and other diseases or conditions, including persons with implanted devices. This sales and marketing approach is intended to accelerate the adoption of the VeriMed system by healthcare facilities, as well as by physicians and patients.

 

In the initial phase of our efforts to create a market for the VeriMed system, we have focused on getting hospitals and third-party emergency room management companies to adopt the VeriMed system in their emergency rooms. This focus reflects our recognition that physicians who treat patients within our target market may be disinclined to discuss with their patients, and patients may not be persuaded by, the benefits of the VeriMed system in the absence of some or all of the hospital emergency rooms in their immediate geographic area having become part of our network. To build out our network, we have been providing our scanners, at no charge, to hospitals and third-party emergency room companies. As of December 31, 2006, 392 hospitals and other medical facilities have agreed to adopt our VeriMed system in their emergency rooms. Approximately 20% of these facilities have received training in the use of our system and, as part of their standard protocol, are scanning patients who arrive in their emergency rooms unconscious, confused or unable to communicate. We expect to continue this “seeding” process for the foreseeable future, as we endeavor to build out the network across the United States and overseas.

 

Physicians whose patients fit within our target market are the focus of the second phase of our commercialization efforts. At present, our sales and marketing strategy for physicians who treat patients who fit the profile for which our VeriMed system is intended to benefit includes using our sales force to directly market to and educate such physicians in those geographic regions surrounding hospitals that have adopted the VeriMed system as part of their standard protocol. We are distributing marketing materials, such as brochures and posters, intended to be displayed in physicians’ offices. Our focus on physicians reflects our belief that, as with all medical treatments and procedures, it is the physician who is responsible for discussing and recommending a particular course of action, knowing the particular circumstances of the individual patient. Our plan is to sell VeriMed kits directly to physicians, who will charge their patients for the cost of the implant process on a fee for service basis.

 

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As of December 31, 2006, over 1,200 physicians have registered in our VeriMed physician network and, as such, have agreed to make the VeriMed system available to their patients. To date, these physicians have implanted 222 people, from which we have generated nominal revenues. We attribute the modest number of people who have undergone the microchip implant procedure to a number of factors:

 

   

Many people who fit the profile for which the VeriMed system was designed may not be willing to have a microchip implanted in their upper right arms.

 

   

Physicians may be reluctant to discuss the implant procedure with their patients until a greater number of hospital emergency rooms have adopted the VeriMed system as part of their standard protocol.

 

   

The media has from time to time reported, and may continue to report, on the VeriMed system in an unfavorable and, on occasion, an inaccurate manner. For example, there have been articles published asserting, despite at least one study to the contrary, that the implanted microchip is not MRI compatible.

 

   

Privacy concerns may influence individuals to refrain from undergoing the implant procedure or dissuade physicians from recommending the VeriMed system to their patients. Misperceptions that a microchip-implanted person can be “tracked” and that the microchip itself contains a person’s basic information and personal health records may contribute to such concerns.

 

   

Misperceptions and/or negative publicity may prompt legislative or administrative efforts by politicians or groups opposed to the development and use of human-implantable RFID microchips. In that regard, in 2006, a number of states have introduced, and at least one state has enacted, legislation that would prohibit any requirement that an individual undergo a microchip-implant procedure. While we support all pending and enacted legislation that would preclude anything other than voluntary implantation, legislative bodies or government agencies may determine to go further, and their actions may have the effect, directly or indirectly, of delaying, limiting or preventing the use of human-implantable RFID microchips or the sale, manufacture or use of RFID systems utilizing such microchips.

 

   

At present, the cost of the microchip implant procedure is not covered by Medicare, Medicaid or private health insurance.

 

   

At present, no clinical studies to assess the impact of the VeriMed system on the quality of emergency department care have been completed.

 

With respect to the last two factors listed above, we are in the process of facilitating and, in one case, funding clinical studies that we believe may demonstrate the efficacy of the VeriMed system. We believe that once this is established, government and private insurers may be more likely to cover the cost of the microchip implant process. In any event, these studies are likely to be of considerable interest to physicians who treat at-risk patients.

 

In June 2006, we entered into a memorandum of understanding with Horizon Blue Cross Blue Shield of New Jersey, the largest health insurer in the State of New Jersey (Horizon BCBSNJ), the Hackensack University Medical Center Independent Physicians Association (IPA) and the Hackensack University Medical Center, under which Hackensack University Medical Center and its physicians have the right to test the VeriMed system over a period of approximately two years. We have been advised that Horizon BCBSNJ has recently initiated efforts to enroll in a pilot program 250 members of Horizon BCBSNJ who were treated for an episode of care by a Hackensack IPA physician between January 1, 2004 and December 31, 2006. Each participant in the program is to be tested for a period of two years after receiving the microchip implant. The objective of this clinical study is to assess the impact of the VeriMed system on emergency department care provided to patients with specified chronic medical conditions. This will include an assessment of: the insertion technique; patient data selection and input; staff acceptance and use

 

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of the technology; frequency of database access; the time involved for information gathering with current methods compared to the VeriMed System; the impact of the VeriMed system on clinical presentation and treatment; and the functionality of the VeriMed system in an application environment. The memorandum of understanding contemplates that Horizon BCBSNJ, as the sponsor of the program, will prepare a report no less than six months after the program has ended. To facilitate this clinical study, we have agreed, among other things, to enter Horizon BCBSNJ-furnished patient data in each program participant’s personal health record, such that the information can be passed through to Horizon BCBSNJ or its designee in an automated manner. We are also supplying our handheld scanners at no cost, as is typical for clinical studies. No patient or third party will be billed for use of the VeriMed system during the study. The study has been reviewed by the Horizon BCBSNJ privacy board and will be managed by the Horizon BCBSNJ clinical innovations department At the end of the study, implanted patients will have the option of subscribing to our database or the database of Hackensack University Medical Center, or having the microchip removed.

 

We are currently in discussions with the American Medical Directors Association (AMDA) regarding a proposed study to assess the efficacy of the VeriMed system in improving patient outcomes and improving access to patient medical information while patients are in route to emergency rooms from long-term care facilities, both skilled nursing facilities and assisted living facilities. The proposed study would involve 10 facilities, either skilled nursing facilities or assisted living facilities, with an estimated study population of 225 people. The inclusion criteria for the study participants would include being age 65 or above and having two or more of the following conditions: dementia, stroke, diabetes, chronic obstructive pulmonary disease, congestive heart failure, coronary heart disease and epilepsy. No patient or third party will be billed for use of the VeriMed system during the study. At the end of the study, implanted patients will have the option of subscribing to our database or having the microchip removed.

 

We believe that if the results of these and other clinical studies that may be undertaken are sufficiently compelling, the Center for Medicare and Medicaid Services may determine that the VeriMed microchip implant procedure is reimbursable under Medicare and Medicaid. If this were to occur, we believe many private insurers would follow suit. We can provide no assurance as to if and when government or private insurers will decide to take such action. It may take a considerable period of time for this to occur, if, in fact, it does occur. If government and private insurers do not determine to reimburse the cost of the implant procedure, we would not expect to realize the currently anticipated level of sales of our implantable microchip and the database subscription fees.

 

We are also in the process of seeking endorsements of the VeriMed system from patient advocacy groups, which we believe would greatly enhance our efforts to reach out directly to at-risk patients. To date, we have engaged in very limited direct marketing to at-risk patients. We are also seeking to develop physician “champions” to serve as spokespersons for the VeriMed system.

 

Other Applications

 

We have also developed two other systems that utilize the implantable microchip, our VeriGuard and VeriTrace systems. See “Risk Factors—Risks Related to Our Businesses Which Utilize the Implantable Microchip.”

 

Our VeriGuard system uses our implantable microchip and/or active RFID tags to provide secure access control into restricted areas, map/track visitors throughout a facility, and track assets. We believe these applications will be of value to high security facilities, such as government facilities, nuclear power plants, national research laboratories and correction facilities, by providing secure ingress and egress and local area location. In 2003-2004, we derived minimal revenue from sales of the VeriGuard system. We have focused most of our efforts on creating a market for our VeriMed system since receipt of the FDA’s clearance of the human-implantable radio frequency transponder system for patient identification and health information purposes in October 2004.

 

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Our VeriTrace system was conceived of in the wake of Hurricane Katrina, when we donated implantable microchips to FEMA’s Department of Mortuary Services in Mississippi and Louisiana to help with FEMA’s efforts to identify corpses. Our implantable microchips were used to provide an end-to-end tagging solution for the accurate tracking and identification of human remains and associated evidentiary items. We have not, as yet, taken any steps to market our VeriTrace system.

 

Technology

 

Active Tags and Readers

 

Our infant protection, wander prevention and asset/staff location and identification systems all make use of active RFID tags, enabling the systems to be used for perimeter control, tamper notification, location and tracking purposes. These active tags include an internal lithium battery enabling them to transmit a coded radio frequency beacon on a continual or intermittent basis. The beacon has a reliable range of approximately 30 to 50 feet indoors and up to 100 feet outdoors. Multiple receivers with radio frequency antennas are placed in selected locations throughout a facility to receive coded beacon messages from these active tags. All receivers in range of a particular tag decode the message and send the received information to a central server. The received tag information is used for multiple purposes across the range of applications, including to provide supervisory alerts when tag messages are missing and to provide tag positional location by triangulation and other context sensing algorithms.

 

In addition, many of our active tags include a tamper detection feature to prevent unauthorized removal, enhancing the security features of our systems. This includes our proprietary skin-sensing and cut band technologies used with our infant protection tags, as well as our proprietary tamper-proof asset tag used in our asset/staff location and identification system.

 

Technology Platform/Application Software

 

Our current product development efforts for our infant protection, wander prevention and asset/staff location and identification systems include having all of these systems share a common technology platform. This platform consists of a networked hardware infrastructure and a software-based server running on an industry standard computing platform. On top of this common hardware and software platform, each of the applications, such as infant protection, augments the platform with specific RFID tags optimally designed for that application and a software module that presents the application-specific graphical user interface. We have already developed application software that provides graphical user interfaces for our Hugs infant protection, patient identification and asset/staff location and identification systems on the platform. We will be completing the wander prevention and our Halo infant protection system application software in the coming months. The graphical user interfaces allow users to monitor the system and be alerted to, among other things, security alarms, identification and location information, tag associations, activity reports, tamper alarms, pager notifications and doors locking.

 

We are in the process of interfacing our technology platform with other location technologies. The first interface we have completed is with WiFi. This has been done to illustrate the platform’s flexibility to interface to other wireless air interfaces and perform an even higher level of system integration that collects location-based information. In addition, the platform can interface with other vertically integrated systems for work flow management within the healthcare industry. In such cases, the platform serves as the RFID engine, processing data from third-party software applications. This capability makes the platform more flexible, scalable and expandable.

 

Research and Development

 

Our research and development group consists of 43 staff members, currently based in Ottawa and Vancouver, Canada, who have an average of approximately 18 years of research and development experience. These employees are responsible for the development of hardware, software and the

 

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mechanical design of our systems. Further enhancements to our current systems and the development of new systems are important components of our ability to remain competitive in our marketplace. In November 2006, we decided to consolidate our Canadian operations into our existing facility in Ottawa. The consolidation will entail the closing of our Vancouver facility, expected to be completed in mid-2007.

 

Intellectual Property

 

We rely on a combination of patents, copyrights, trade secrets (including know-how), employee intellectual property agreements and third-party agreements to establish and protect proprietary rights in our products.

 

Our patent portfolio consists of patents issued in the United States and patents issued in Canada, including the following:

 

   

U.S. Patent No. 6,144,303, “Tag and System for Patient Safety Monitoring,” applies to infant protection tags that sense when they are in contact with the skin. The tag can generate an alarm when it is removed. The U.S. patent expires in 2019. The corresponding issued patent in Canada is Canadian Patent No. 2,260,577, which expires in 2019.

 

   

U.S. Patent No. 5,977,877, “Multiple Conductor Security Tag,” applies to tags attached with bands that can detect unauthorized cutting of a band attached to a person or object. This patent expires in 2018.

 

   

U.S. Patent No. 5,374,921, “Fiber Optic Security and Communications Link” applies to security tags with an optical fiber in the band to detect unauthorized removal. This patent expires in 2011. The corresponding issued patent in Canada is Canadian Patent No. 2,055,266, which expires in 2011.

 

   

U.S. Patent No. 6,137,414, “Asset Security Tag,” applies to asset protection tags that can generate an alarm if the asset to which it is attached (such as a piece of hospital equipment) is moved to an unauthorized area or if the tag is removed without authorization. This patent expires in 2019.

 

   

U.S. Patent No. 6,456,191, “Tag System with Anti-Collision Features,” applies to RFID tags with communication features that allow communications with multiple tags in close proximity to one another. The U.S. patent expires in 2019. The corresponding issued patent in Canada is Canadian Patent No. 2,266,337, which expires in 2019.

 

   

U.S. Patent No. 7,116,230, “Asset Location System, applies to an RFID tagging system that utilizes a portable receiver, instead of a network of fixed receivers, to track, analyze and prioritize information on the location of tagged assets within a building or warehouse. This patent expires in 2025.

 

The technology covered by the above-listed patents is widely used in our healthcare security systems. We also have patents relating to our seismic monitoring business, including U.S. Patent No. 4,935,748, “Blast Recorder and Method of Displaying Blast Energy,” which applies to devices for displaying seismic signals detected from a blast and expires June 19, 2007.

 

In addition to the patents described above, we have a license from Digital Angel Corporation under U.S. Patent No. 5,952,935, “Programmable Channel Search Reader,” which applies to RFID tag readers that are capable of reading different kinds of RFID tags with differing communications protocols. The patent expires on May 3, 2016. We also have a license from BI Incorporated under U.S. Patent No. 4,952,913, “Tag for Use with Personnel Monitoring System,” which applies to tags, for individuals, that sense and report tampering. The patent expires in 2007. This patented technology is used in our Hugs infant protection system.

 

We obtain the implantable microchip used in our VeriMed, VeriGuard and VeriTrace systems from Digital Angel Corporation, a majority-owned subsidiary of our parent company, Applied Digital, under the

 

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terms of a supply agreement. Digital Angel, in turn, obtains the implantable microchip from a subsidiary of Raytheon Company under a separate supply agreement. The technology underlying these systems is covered, in part, by U.S. Patent No. 5,211,129, “Syringe-Implantable Identification Transponders.” In 1994, Destron/IDI, Inc., a predecessor company to Digital Angel, granted a co-exclusive license under this patent, other than for certain specified fields of use retained by the predecessor company, to Hughes Aircraft Company, or Hughes, and its then wholly-owned subsidiary, Hughes Identification Devices, Inc., or HID. The specified fields of use retained by the predecessor company do not include human identification applications. The rights licensed to Hughes and HID were freely assignable, and we do not know which party or parties currently have these rights or whether these rights have been assigned, conveyed or transferred to any third party. We source the implantable microchip indirectly from a subsidiary of Raytheon Company, with which Hughes, then known as HE Holdings, Inc. was merged in 1997. However, we have no documentation that establishes our right to use the patented technology for human identification applications. We do not anticipate generating more than nominal revenue from the sale of the VeriMed, VeriGuard or VeriTrace systems prior to the expiration of the patent in April 2008. Hughes, HID, any of their respective successors in interest, or any party to whom one of the foregoing parties may have assigned its rights under the 1994 license agreement may commence a claim against us asserting that we are violating its rights. If such a claim is successful, sales of our VeriMed, VeriGuard and VeriTrace systems could be enjoined, and we could be required to cease our efforts to create a market for these systems, until the patent expires in April 2008. In addition, we could be required to pay damages, which may be substantial. Regardless of whether any claimant is successful, we would face the prospect of the expenditure of funds in litigation, the diversion of management time and resources, damage to our reputation and the potential impairment in the marketability of our systems even after the expiration of the patent, which could harm our business and negatively affect our prospects.

 

Our employees, consultants and advisors are required to enter into confidentiality agreements that prohibit the disclosure or use of our confidential and proprietary information. We also have entered into confidentiality agreements to protect our confidential information delivered to third parties. Our RFID tag designs benefit from confidential know how we have developed through experience. Our middleware product that is a component of our technology platform for our healthcare security applications, as well as other software products, are protected by copyright and trade secret rights.

 

We are seeking registration of our VeriChip trade name in various product markets in the United States and elsewhere in the world. However, in June 2004, VeriSign, Inc. filed oppositions with the U.S. Patent and Trademark Office, objecting to our registration of the VeriChip trade name and our trademarks that begin with the “Veri” prefix. If VeriSign is successful in the opposition proceedings, our applications to register VeriChip and other “Veri-” marks will be refused. It is also possible that VeriSign could bring a court action seeking to enjoin our use of VeriChip and the other “Veri-” marks and/or seek monetary damages from our use of these marks. If VeriSign were to bring a court action and prevail in that action, we may be required to re-name our company and re-brand some of our products, such as VeriMed, VeriGuard and VeriTrace, as well as to possibly pay damages to VeriSign for our use of any trademarks found to have been confusingly similar to those of VeriSign.

 

Despite our efforts to protect our intellectual property rights, it may be possible for unauthorized third parties to copy portions of our products or to reverse engineer or otherwise obtain and use some technology and information that we regard as proprietary. Our reliance on intellectual property rights is subject to a number of risks. See “Risk Factors.”

 

Sales, Marketing and Distribution

 

Our end-use customers consist of healthcare facilities, such as hospitals and long-term care facilities, healthcare professionals, such as physicians, individual patients, and other customers that purchase our systems for non-healthcare applications, such as construction, oil and gas companies and power companies.

 

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Our sales and marketing strategy is to sell our systems through multiple channels. However, to date we have sold essentially all of our active RFID systems through dealers. Most of our largest dealers, by volume of systems sold, are focused exclusively or primarily on the healthcare industry. As of December 31, 2006, our sales and marketing staff consists of a total of 47 people, based primarily in Ottawa, Canada and at our corporate headquarters in Florida. We have a limited number of sales representatives strategically located in other places in North America, where we have a number of hospitals that have adopted our VeriMed system.

 

In general, the terms of our dealer agreements for our healthcare security systems obligate our dealers to provide us with reports, on a monthly basis, regarding information such as:

 

   

sales and inventory levels for the preceding month;

 

   

sales analyses within the dealers’ territories;

 

   

forecasts for future sales on a rolling one month, three month and annual basis; and

 

   

service and support activity.

 

We use these reports, among other things, to effectively plan our inventory levels, manage dealer performance against sales targets, identify and resolve channel conflicts, and manage our customer support.

 

We market our systems primarily by attending trade shows and medical conferences and by advertising in publications.

 

Our Healthcare Security Systems

 

Infant Protection/Wander Prevention

 

We currently sell our infant protection and wander prevention systems through dealers. These dealers are typically appointed, on a non-exclusive basis, to cover a specific geographic sales territory. The term of such appointment is generally for one year, but subject to automatic renewal from year-to-year in the absence of a termination by us or the dealer. In general, our agreements with our dealers impose no minimum purchase requirements. Some of our dealer agreements include price protection provisions, under which we undertake not to charge the dealer prices higher than the best price we are offering our systems to any of our other dealers.

 

Our dealers of our infant protection and wander prevention systems have responsibility for the installation and after-sale servicing and maintenance of such systems. System installation requires relationships with cable companies, knowledge of the other products that need to be integrated with our hardware and knowledge of local codes. To ensure that our systems are installed in accordance with our standards, we have established a distribution technical training and certification program. In addition to system installation, our dealers provide end-use customers with post-sale customer service and system maintenance.

 

Asset/Staff Location and Identification System

 

The three asset/staff location and identification systems that have been sold and installed were sold through Agility Healthcare Solutions LLC, a company engaged in logistical management of mobile assets for the healthcare provider industry. These systems were sold on a private label basis. Agility Healthcare markets our systems under its name using its sales force, as well as through some of our dealers that also sell our infant protection systems.

 

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We are in the process of building out our distribution network for our asset/staff location and identification system and providing the requisite training to certain dealers. We anticipate that the optimal size of our dealer network for this system will be smaller than that for our infant protection and wander prevention systems, given the higher price points for asset/staff location and identification systems, the need to reach senior level executives of targeted healthcare facilities and the anticipated longer sales cycle.

 

Our VeriMed System

 

To date, our marketing efforts with respect to our VeriMed system have been to provide our scanners to hospitals and third-party emergency room management companies at no charge in order to build out the geographic footprint of the healthcare facilities that can and will use our VeriMed system as part of their standard protocol. We expect to continue this “seeding” process for the foreseeable future as we endeavor to build out our network across the United States and overseas. In addition, we have been marketing our VeriMed system to physicians, who treat patients who fit the profile for which our VeriMed system is intended to benefit, in those geographic areas surrounding hospitals that have adopted the VeriMed system. In the near future, we expect to enter into dealer arrangements to distribute the VeriMed starter kit sets and the microchip insertion kits.

 

Our Security and Industrial Systems

 

Vibration Monitoring Instruments

 

We distribute our Blastmate and Minimate systems to engineering, construction and mining professionals through an independent network consisting of approximately 75 dealers, approximately half of which operate in North America.

 

ToolHound

 

We market and sell our ToolHound system primarily through our direct sales force based in Ottawa, Canada. We market our ToolHound system predominately in North America to approximately 150 accounts, which include construction companies and other industrial organizations.

 

VeriGuard

 

We sell our VeriGuard system through international distributors. We intend to seek additional distributors to sell our VeriGuard system in North America, and initially, in Europe. Our existing distributors market this system for security purposes to control access to restricted areas in government and industrial facilities.

 

Competition

 

Most of our systems utilize RFID technologies. While certain of our competitors in certain of our system applications also sell products that use RFID technologies, some sell products that incorporate other technologies, such as high frequency radio signals, or WiFi, barcode technology and biometric technology. With respect to the healthcare industry in particular, we are unable to predict which technology will be most widely adopted in the future. In addition, some of our current competitors, as well as companies who utilize RFID technologies in applications outside of our target markets, have significantly greater financial, marketing and product development resources than we do. Low barriers to entry across most of our product lines may result in new competitors entering the markets we serve. Also, our competitors may be able to respond more quickly to new or improved technologies by devoting greater resources to the development, promotion and sale of products. We expect our competitors to continue to improve the performance of and support for their current products. We also expect that, like us, they will introduce new products, technologies or services. Our competitors’ new or upgraded products could adversely affect sales of our current and future products.

 

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With respect to our infant protection and wander prevention systems, several other companies offer solutions for these applications, including Visonic Technologies, RF Technologies, Innovative Control Systems and Senior Technologies. We believe that competition in these markets is mainly based on product features, reputation, including endorsements by other healthcare facilities, and brand awareness. Based on the Fletcher Spaght study, we believe we possess a leading market share in infant protection systems and are one of the leading providers of wander prevention systems in North America.

 

With respect to our VeriMed system, we do not believe any other company currently offers a human implantable microchip-based patient identification system. However, various media sources have reported on people who have been implanted with RFID chips obtained over the Internet for as little as $2.00. We do not know if the RFID microchips obtained over the Internet are in compliance with the Federal Food, Drug and Cosmetic Act, its regulations or the FDA special controls guidance document applicable to this technology. See “Our Business – Government Regulation.” In addition, various alternative patient identification solutions are currently available, such as bracelets sold by MedicAlert, health information wallet cards, biometric systems and key fobs that store personal health records. We are currently in the process of seeking to create a market for our VeriMed system, and our competitive position in this market will depend on whether hospitals and other healthcare providers accept this new technology and incorporate it into their standard protocol. Our competitive position will also depend on whether patients prefer our VeriMed system to existing or future identification systems , as well as whether the implant process becomes subject to reimbursement by government and private insurers.

 

With respect to the other systems we offer, we believe that competition is mainly based on product performance and ease of use, purchase price and operating cost. We believe that our systems are designed and manufactured to compete favorably based on these criteria with competitive systems currently in the market.

 

Manufacturing; Supply Arrangements

 

We outsource the manufacturing of all the hardware components of our active RFID systems to third-party contractors, but conduct final assembly, testing and quality control functions internally. To date, we have not had material difficulties obtaining system components. Except as discussed below, we believe that if any of our manufacturers or suppliers were to cease supplying us with system components, we would be able to procure alternative sources without material disruption to our business.

 

We source the custom straps used with our Hugs infant protection systems from a sole supplier, Emerson & Cuming Microwave Products. Emerson & Cuming manufactures the straps at a single facility located in New England, although it operates another facility in Belgium from which the straps could be manufactured. While we and our dealers maintain excess inventory to ensure that we maintain an adequate supply of the straps, we believe it would take several months to make alternative arrangements should we be unable to source these custom straps from Emerson & Cuming. Under the agreement with Emerson & Cuming, we are subject to minimum purchase requirements, with the aggregate amount of our minimum purchase requirements being $4 million over the next five years.

 

Digital Angel Corporation is our sole supplier of the implantable microchip used in our VeriMed system, and our VeriGuard and VeriTrace systems, under the terms of an agreement we entered into with Digital Angel in December 2005. The following is a summary of the principal terms of that agreement:

 

   

Digital Angel has agreed to sell to us and our resellers, on an exclusive basis, the transponders and reader equipment for our VeriMed system, as well any upgrades, enhancements and improvements, which are to be used for the primary purpose of secure human identification. Digital Angel has committed not to sell these products to any other party if Digital Angel knows or should know that such products are to be used principally for secure identification applications.

 

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Digital Angel has committed to use it best efforts to supply all of our requirements for the transponders and reader equipment as and when required. However, if Digital Angel is unable or unwilling to meet our requirements, we may obtain additional suppliers and Digital Angel is obligated to permit the use of the underlying intellectual property for that purpose. We also have the right to design and build, or cause to be designed and built, and sell, our own readers, to be used for human applications only, and Digital Angel has granted to us a fully-paid, royalty-free, non-exclusive license to utilize one of its patents for that purpose.

 

   

Digital Angel may not supply human implantable microchips to other parties if we meet certain minimum purchase requirements, specifically: $875,000 in 2007; $1,750,000 in 2008; $2,500,000 in 2009; $3,750,000 in 2010; and $3,750,000 in each year thereafter, subject to the parties reaching agreement on a different amount. If during any year we purchase in excess of the minimum purchase requirement for that year, the excess will be credited against the minimum purchase requirement for the following year or years.

 

   

In the event a competitor makes, uses, sells or offers any similar product or service, the price we are required to pay for products is subject to downward adjustment to enable us to more effectively compete.

 

   

The term of the agreement ends on March 4, 2013, subject to earlier termination in the event of either party’s default or bankruptcy. However, so long as we meet the minimum purchase obligations under the agreement, the term is to be automatically renewed on an annual basis until the expiration of the last of the patents covering any of the supplied products.

 

   

If we desire to have a third party manufacture any of the products, product upgrades, enhancements or improvements, or any New Products – for reasons other than Digital Angel’s inability or unwillingness to supply us – we have the right to do so. In such event, we are obligated to pay Digital Angel a royalty on each product manufactured by third parties that would otherwise infringe Digital Angel’s underlying intellectual property rights.

 

For additional information regarding the agreement with Digital Angel, see “Certain Relationships and Related Party Transactions – Transactions with Digital Angel.”

 

Our implantable microchip is manufactured for Digital Angel by Raytheon Microelectronics España, a subsidiary of Raytheon Company, or RME, under the terms of a supply agreement between Digital Angel and RME. The term of that agreement ends on June 30, 2010, subject to earlier termination by either party if, among other things, the other party breaches the agreement and does not remedy the breach within 30 days of receiving notice. Under the agreement, RME is Digital Angel’s preferred supplier of the glass encapsulated, syringe-implantable transponders, provided that RME’s pricing remains market competitive. Certain of the automated equipment and tooling used in the production of the transponders is owned by Digital Angel; other automated equipment and tooling is owned by RME. It would be difficult and time-consuming for Digital Angel to arrange for production of the transponders by a third party. Accordingly, we cannot assure you that we will be able to procure alternative manufacturing capability if we are unable to obtain the implantable microchip from Digital Angel or if Digital Angel is unable to obtain it from RME or another supplier.

 

Environmental Regulation

 

We must comply with local, state, federal, and international environmental laws and regulations in the countries in which we do business, including laws and regulations governing the management and disposal of hazardous substances and wastes. We expect our operations and products will be affected by future environmental laws and regulations, but we cannot predict the effects of any such future laws and regulations at this time. Our distributors who place our products on the market in the European Union are required to comply with EU Directive 2002/96/EC on waste electrical and electronic equipment, known as

 

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the WEEE Directive. Noncompliance by our distributors with EU Directive 2002/96/EC may adversely affect the success of our business in that market. Additionally, we are investigating the applicability of EU Directive 2002/95/EC on the restriction of the use of certain hazardous substances in electrical and electronic equipment, known as the RoHS Directive which took effect on July 1, 2006. We do not expect the RoHS Directive will have a significant impact on our business.

 

Government Regulation

 

Laws and Regulations Pertaining to RFID Technologies

 

Our active RFID systems, as well as our RFID systems that use our implantable microchip, rely on low-power, localized use of radio frequency spectrum to operate. As a result, we must comply with U.S. Federal Communications Commission, or FCC, and Industry Canada regulations, as well as the laws and regulations of other jurisdictions that we sell our products, governing the design, testing, marketing, operation and sale of RFID devices. Accordingly, all of our products and systems have a paired FCC and Industry Canada equipment authorization.

 

U.S. Federal Communications Commission Regulations

 

Under FCC regulations and Section 302 of the Communications Act, RFID devices, including those we market and sell, must be authorized and comply with all applicable technical standards and labeling requirements prior to being marketed in the United States. The FCC’s rules prescribe technical, operational and design requirements for devices that operate on the electromagnetic spectrum at very low powers. The rules ensure that such devices do not cause interference to licensed spectrum services, mislead consumers regarding their operational capabilities or produce emissions that are harmful to human health. Our RFID devices are intentional radiators, as defined in the FCC’s rules. As such, our devices may not cause harmful interference to licensed services and must accept any interference received. We must construct all equipment in accordance with good engineering design as well as manufacturers’ practices.

 

Manufacturers of RFID devices must submit testing results and/or other technical information demonstrating compliance with the FCC’s rules in the form of an application for equipment authorization. The FCC processes each application when it is in a form acceptable for filing and, upon grant, issues an equipment identification number. Each of our RFID devices must bear a label which displays the equipment authorization number, as well as specific language set forth in the FCC’s rules. In addition, each device must include a user manual cautioning users that changes or modifications not expressly approved by the manufacturer could void the equipment authorization. As a condition of each FCC equipment authorization, we warrant that each of our devices marked under the grant and bearing the grant identifier will conform to all the technical and operational measurements submitted with the application. RFID devices used and/or sold in interstate commerce must meet these requirements or the equipment authorization may be revoked, the devices may be seized and a forfeiture may be assessed against the equipment authorization grantee. The FCC requires all holders of equipment authorizations to maintain a copy of each authorization together with all supporting documentation and make these records available for FCC inspection upon request. The FCC may also conduct periodic sampling tests of equipment to ensure compliance. We believe we are in substantial compliance with all FCC requirements applicable to our products and systems.

 

Industry Canada Regulations

 

Industry Canada regulates the design, sale and use of radio communications devices in accordance with its Radio Standards Specifications, or RSS, and Radio Standards Procedures, or RSP. As intentional emitters, our RFID devices are subject to Industry Canada’s RSP-100, which establishes the procedures by which RFID communications equipment receives certification by Industry Canada. The RSP-100 certification procedure and RSS standards ensure that RFID radio devices do not cause interference to licensed spectrum services and that the devices do not produce emissions that are harmful to human health.

 

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Manufacturers of RFID devices must demonstrate compliance with RSP-100 and RSS-210. Industry Canada requires manufacturers of RFID devices to file an application and agreement for certification of services. A manufacturer of active RFID equipment must submit testing results and/or other technical information demonstrating compliance with RSS-210 along with the manufacturer’s application. Industry Canada’s Certification and Engineering Bureau processes the application and, upon grant, issues a unique certification/registration number, which is required to be displayed on each certified piece of equipment. In addition, in accordance with RSS-Gen, the following information must appear on any radio frequency device: the certification/registration number; the manufacturer’s name, trade name or brand name; and the model name or number.

 

Each RFID device must include a user manual. The user manual must identify that the radio frequency device operates on a no interference, no protection basis, meaning that the device may not cause radio interference and cannot claim protection from interference. Radio frequency devices that do not meet the certification, labeling and user manual provision requirements and are sold within or between the Canadian territories/provinces are subject to penalty by Industry Canada, which may include seizure of the devices and/or assessment of forfeitures. Industry Canada will also conduct audit checks, from time to time, to ensure compliance. We believe we are in substantial compliance with all Industry Canada requirements applicable to our products and systems.

 

Regulation by the FDA

 

Our VeriMed patient identification system is a medical device subject to extensive regulation by the FDA, as well as other federal and state regulatory bodies in the United States and comparable authorities in other countries. In October 2004, the VeriMed system received classification as a Class II medical device by the FDA for patient identification and health information purposes. This allows us to market the VeriMed system in the United States.

 

FDA Premarket Clearance and Approval Requirements. Generally speaking, unless an exemption applies, each medical device we wish to distribute commercially in the United States will require either prior clearance under Section 510(k) of the Federal Food, Drug, and Cosmetic Act, or FFDCA, or a premarket approval application, or PMA, from the FDA. Medical devices are classified into one of three classes – Class I, Class II or Class III – depending on the degree of risk to the patient associated with the medical device and the extent of control needed to ensure safety and effectiveness. Devices deemed to pose lower risks are placed in either Class I or II. The manufacturer of a Class II device is typically required to submit to the FDA a premarket notification requesting permission to commercially distribute the device and demonstrating that the proposed device is substantially equivalent to a previously cleared and legally marketed 510(k) device or a device that was in commercial distribution before May 28, 1976 for which the FDA has not yet called for the submission of a PMA. This process is known as 510(k) clearance. Devices deemed by the FDA to pose the greatest risk, such as life-sustaining, life-supporting or implantable devices, or devices deemed not substantially equivalent to a previously cleared 510(k) device, are generally placed in Class III, requiring premarket approval.

 

In October 2004, we received classification of our VeriMed system as a Class II device. In granting this clearance, the FDA created a new device category for “implantable radiofrequency transponder systems for patient identification and health information.” The FDA also determined that devices that meet this description will be exempt from 510(k) premarket clearance so long as they comply with the FFDCA, its implementing regulations and the provisions of an FDA guidance document issued by the FDA in December 2004, entitled Guidance for Industry and FDA Staff, Class II Special Controls Guidance Document: Implantable Radiofrequency Transponder System for Patient Identification and Health Information,” that establishes special controls for this type of device. The special controls, which are intended to ensure that the device is safe and effective for its intended use, include the following: biocompatibility testing, information security procedures, performance standard verification, software validation, electro-magnetic

 

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compatibility and sterility testing. We believe that we are in compliance with FFDCA, its implementing regulations and the December 2004 guidance document. A company that wishes to market products that will compete with the VeriMed system will not be required to submit a 510(k) premarket clearance application to the FDA if the company complies with the requirements of the special controls guidance document.

 

In January, 2007, the FDA published a Draft Guidance entitled Radio-Frequency Wireless Technology in Medical Devices.” This document includes the FDA’s current recommendations regarding specific risks and limitations to be considered when developing and implementing a Quality System for medical devices using radio frequency wireless technology, as well as additional information to be included in the labeling for such devices. We believe our Quality System and labeling for our VeriMed System substantially meet the recommendations outlined in the draft guidance.

 

Pervasive and Continuing Regulation. After a device is placed on the market, numerous regulatory requirements continue to apply. These include:

 

   

quality system regulations, or QSR, which require manufacturers, including third-party manufacturers, to follow stringent design, testing, control, documentation and other quality assurance procedures during all aspects of the manufacturing process;

 

   

labeling regulations and FDA prohibitions against the promotion of products for uncleared, unapproved or off-label uses;

 

   

clearance or approval of product modifications that could significantly affect safety or effectiveness or that would constitute a major change in intended use;

 

   

medical device reporting, or MDR, regulations, which require that a manufacturer report to the FDA if the manufacturer’s device may have caused or contributed to a death or serious injury or malfunctioned in a way that would likely cause or contribute to a death or serious injury if the malfunction were to recur; and

 

   

post-market surveillance regulations, which apply when necessary to protect the public health or to provide additional safety and effectiveness data for the device.

 

We have registered with the FDA as a medical device manufacturer. The FDA has broad post-market and regulatory enforcement powers. We are subject to unannounced inspections by the FDA to determine our compliance with the QSR and other regulations, and these inspections may include the manufacturing facilities of our suppliers. The Digital Angel manufacturing facility located in St. Paul, Minnesota, was inspected by the FDA in late May and early June 2006, during which the FDA inspector conducted a routine Level II Quality System Inspectional Technique inspection. During the inspection, the FDA inspector made three verbal observations regarding deviations in Digital Angel’s quality system unrelated to our implantable microchip. It is our understanding that Digital Angel has corrected the three deviations. To our knowledge, the Raytheon Microelectronics España facility has not yet been inspected by the FDA.

 

Failure to comply with applicable regulatory requirements can result in enforcement action by the FDA, which may include any of the following sanctions:

 

   

warning letters, fines, injunctions, consent decrees and civil penalties;

 

   

repair, replacement, refunds, recall or seizure of products;

 

   

operating restrictions, partial suspension or total shutdown of production;

 

   

refusing requests for 510(k) clearance or premarket approval of new products, new intended uses or modifications to existing products;

 

   

withdrawing 510(k) clearance or premarket approvals that have already been granted; and

 

   

criminal prosecution.

 

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Fraud and Abuse

 

We are subject to various federal and state laws pertaining to healthcare fraud and abuse, including anti-kickback laws and false claims laws. Violations of these laws are punishable by criminal and/or civil sanctions, including, in some instances, imprisonment and exclusion from participation in federal and state healthcare programs, including Medicare, Medicaid and Veterans Affairs health programs. We have never been challenged by a government authority under any of these laws and believe that our operations are in material compliance with such laws. However, because of the far-reaching nature of these laws, there can be no assurance that we would not be required to alter one or more of our practices to be in compliance with these laws. In addition, there can be no assurance that the occurrence of one or more violations of these laws would not result in a material adverse effect on our financial condition and results of operations.

 

Anti-Kickback Laws

 

We may directly or indirectly be subject to various federal and state laws pertaining to healthcare fraud and abuse, including anti-kickback laws. In particular, the federal healthcare program Anti-Kickback Statute prohibits persons from knowingly and willfully soliciting, offering, receiving or providing remuneration, directly or indirectly, in exchange for or to induce either the referral of an individual, or the furnishing, arranging for or recommending a good or service, for which payment may be made in whole or part under federal healthcare programs, such as the Medicare and Medicaid programs. Penalties for violations include criminal penalties and civil sanctions such as fines, imprisonment and possible exclusion from Medicare, Medicaid and other federal healthcare programs.

 

Federal False Claims Act

 

We may become subject to the Federal False Claims Act, or FCA. The FCA imposes civil fines and penalties against anyone who knowingly submits or causes to be submitted to a government agency a false claim for payment. The FCA contains so-called “whistle-blower” provisions that permit a private individual to bring a claim on behalf of the government to recover payments made as a result of a false claim. The statute provides that the whistle-blower may be paid a portion of any funds recovered as a result of the lawsuit. Even though the VeriMed system is not reimbursed by federal healthcare programs, it is still

possible that we may be liable for violations of the FCA, for instance, if a sales representative were to assist or instruct a physician to bill a government program for microchip implantation by listing on the claim form some other service that is reimbursable.

 

State Laws and Regulations

 

Many states have enacted laws similar to the federal Anti-Kickback Statute and FCA. The Deficit Reduction Act of 2005 contains provisions that give monetary incentives to states to enact new state false claims acts. The state Attorneys General are actively engaged in promoting the passage and enforcement of these laws. While the Federal Anti-Kickback Statute and FCA apply only to federal programs, many similar state laws apply both to state funded and to commercial health care programs. In addition to these laws, all states have passed various consumer protection statutes. These statutes generally prohibit deceptive and unfair marketing practices, including making untrue or exaggerated claims regarding consumer products. There are potentially a wide variety of other state laws, including state privacy laws, to which we might be subject. We have not conducted an exhaustive examination of these state laws.

 

Privacy Laws and Regulations

 

Our VeriMed business is subject to various federal and state laws regulating the protection of consumer privacy. We have never been challenged by a governmental authority under any of these laws and believe that out operations are in material compliance with such laws. However, because of the

 

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far-reaching nature of these laws, there can be no assurance that we would not be required to alter one or more of our systems and data security procedures to be in compliance with these laws. Our failure to protect health information received from customers could subject us to liability and adverse publicity and could harm our business and impair our ability to attract new customers.

 

U.S. Federal Trade Commission Oversight

 

An increasing focus of the United States Federal Trade Commission’s (FTC’s) consumer protection regulation is the impact of technological change on protection of consumer privacy. Under the FTC’s statutory authority to prosecute unfair and deceptive advertising practices, the FTC vigorously enforces promises a business makes about how personal information is collected, used and secured. More recently, the FTC has found that failure to take reasonable and appropriate security measures to protect sensitive personal information is an unfair practice violating federal law. In the consent decree context, offenders are routinely required to adopt very specific cybersecurity and internal compliance mechanisms, as well as submit to twenty years of independent compliance audits. Businesses that do not adopt reasonable and appropriate data security controls have been found liable for as much as $10 million in civil penalties and $5 million in consumer redress. To date, the FTC has concluded nine prosecutions for failure to adopt reasonable and appropriate data security controls.

 

Recent events demonstrate that the FTC continues to actively consider the potential impact of RFID on consumer protection issues. This year, the FTC launched a new initiative, “Protecting Consumers in the Next Tech-ade” and convened public hearings on November 6-8, 2006 that brought together experts from the business, government and technology sectors as well as consumer advocates, academics and law enforcement officials to explore ways in which convergence and the globalization of commerce impact consumer protection. Panelists examined changes in marketing and technology over the past decade and challenges facing consumers, business and government. One of the panels, entitled “RFID Technology in the Next Tech-ade,” focused on the role of RFID in the healthcare and retail sectors.

 

State Legislation

 

During 2006, a number of state legislatures have considered legislation addressing RFID and consumer privacy concerns. Among the laws passed was a Wisconsin bill prohibiting any requirement that

an individual undergo implantation of a microchip, with violators subject to a forfeiture of not more than $10,000. Other state legislatures have introduced similar legislation, such as Ohio, which introduced a bill prohibiting employers from requiring an employee to insert a “radio frequency identification tag” into the employee’s body, and South Dakota, which introduced a bill declaring that no person may require implantation of an RFID microchip in another person. The States of Georgia and New Hampshire have recently passed laws convening an expert study committee to consider the impact of RFID technology on consumer privacy, including providing healthcare and issue recommendations. A number of states also have introduced legislation focusing on the consumer privacy implications of RFID use in government identification documents, prescription drug tracking and retail sales. To date, none of this legislative activity restricts our current or planned operations.

 

Many states have privacy laws relating specifically to the use and disclosure of healthcare information. Federal healthcare privacy laws preempt state laws that are less restrictive than the federal law, but more restrictive state laws still may apply to us. Therefore, we may be required to comply with one or more of these multiple state privacy laws. Statutory penalties for violation of these state privacy laws varies widely. Violations also may subject us to lawsuits for invasion of privacy claims.

 

The European Union

 

In the European Union (EU), promotion of RFID technology is viewed as a critical economic issue. It is established that insofar as RFID is a technology involving collection, sharing and storage of personally

 

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identifiable information, the mandates of Directive 95/46/EC of the European Parliament and of the Council of 24 October 1995 on the Protection of Individuals With Regard to the Processing of Personal Data and On the Free Movement of Such Data (“EU Data Directive”) applies. All 25 EU member countries have implemented the EU data directive. At issue today is whether additional privacy protection laws beyond those prescribed by the EU data directive and its country-specific laws are needed for privacy issues raised by RFID technology. On January 19, 2005, the EU’s Working Party 29, charged with interpretation and expansion of EU data protection law and policy, adopted Working Document 105, addressing data protection issues related to RFID technology. That document reinforced the need to comply with the basic principles of the EU data directive and related documents whenever personal data is collected via RFID technology. Guidance to RFID manufacturers was also provided regarding responsibilities to design privacy compliant technology.

 

The EU recently completed a six-month consultation with public and industry stakeholders on the use of RFID tags. At a conference held on October 16, 2006, the Commissioner for Information Society and Media, the top official leading the RFID consultation, announced that the EU must consider adopting a specialized legal framework to ensure that RFID technology does not infringe on privacy. The consultation results indicated that while the EU was prepared to be convinced of the benefits of RFID, the public expressed great concerns about ensuring that privacy is not compromised.

 

Health Insurance Portability and Accountability Act of 1996

 

We are not a health care provider, health plan or health care clearinghouse. Therefore, we are not subject to the Health Insurance Portability and Accountability Act of 1996, or HIPAA. To the extent required by HIPAA, we have entered into business associate agreements with certain health care providers and health plans relating to the privacy and security of protected health information. We have implemented policies and procedures to enable us to comply with these HIPAA business associate agreements.

 

Employees

 

As of December 31, 2006, we had 172 employees, of whom 47 were in our sales and marketing group, 33 in project management/technical support, 43 in research and development, 28 in operations and 21 in finance and administration. We consider our relationship with our employees to be satisfactory and have not experienced any interruptions of our operations as a result of labor disagreements. None of our employees are represented by labor unions or covered by collective bargaining agreements.

 

Properties

 

Our corporate headquarters is located in Delray Beach, Florida, where we occupy approximately 2,200 square feet of office space pursuant to a transition services agreement with Applied Digital. The transition services agreement expires December 27, 2007. See “Certain Relationships and Related Party Transactions” for more information regarding the transition services agreement.

 

We occupy approximately 21,000 square feet of office space in Ottawa, Canada, at an annual rental rate of Canadian $11.00 per square foot, under the terms of a lease that expires May 31, 2009. We have an option to renew the lease for a further five-year term. At the Ottawa facility, we engage in final assembly of certain of our active RFID systems and our vibration monitoring equipment. In addition, we provide customer service, product support and engineering functions from this facility. The operations conducted at our Ottawa facility are certified to the ISO 9001 international quality standard.

 

We currently lease approximately 11,500 square feet of office space in Vancouver, Canada. The lease expires May 31, 2009. We are in the process of shifting our operations in Vancouver, which have included research and development, business development and a portion of our sales and administration functions, to our Ottawa facility. We expect to complete the relocation of the Vancouver activities to Ottawa in mid-2007. We are in the process of exploring various arrangements with respect to the lease.

 

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Legal Proceedings

 

On January 10, 2005, we commenced an action in the Circuit Court for Palm Beach County, Florida, against Metro Risk Management Group, LLC, or Metro Risk. In this suit, we have claimed that Metro Risk breached the parties’ three international distribution agreements by failing to meet required minimum purchase obligations. On July 1, 2005, Metro Risk asserted a counterclaim against us for breach of contract and fraud in the inducement. Specifically, in its claim for breach of contract, Metro Risk alleged that we breached the exclusivity provision of the parties’ distribution agreements by later signing a different distribution agreement with a large distributor of medical supplies. Metro Risk asserted that the distribution agreement with this other distributor included areas in Europe. Moreover, regarding its claim for fraud in the inducement, Metro Risk alleged that we fraudulently induced Metro Risk into signing the distribution agreements by promising millions of dollars in profits. By virtue of its counterclaim, Metro Risk seeks reliance damages in the amount of $155,000, which represents the amount of money advanced by Metro Risk for the project, lost profits, and attorneys’ fees. Currently, we are preparing a motion for summary judgment on our claim for breach of contract based on Metro Risk’s anticipatory repudiation of the three agreements. Given the early stage of the matter and because discovery has recently begun, counsel is currently unable to assess our risk.

 

We are a party to various legal actions, as either plaintiff or defendant, including the matter identified above, arising in the ordinary course of business, none of which is expected to have a material adverse effect on our business, financial condition or results of operations. However, litigation is inherently unpredictable, and the costs and other effects of pending or future litigation, governmental investigations, legal and administrative cases and proceedings, whether civil or criminal, settlements, judgments and investigations, claims or charges in any such matters, and developments or assertions by or against us relating to us or to our intellectual property rights and intellectual property licenses could have a material adverse effect on our business, financial condition and operating results.

 

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MANAGEMENT

 

Executive Officers and Directors

 

Our executive officers and directors, and their ages and positions, as of February 8, 2007, are set forth below:

 

Name


   Age

  

Position


Scott R. Silverman

   43    Chairman of the Board of Directors and Chief Executive Officer

Daniel A. Gunther

   46    President

William J. Caragol

   39    Chief Financial Officer

Daniel E. Penni(1)(2)

   59    Director

Tommy G. Thompson(1)

   65    Director

Constance K. Weaver(2)(3)

   54    Director

Paul C. Green(2) (3)

   57    Director

(1) Member of the compensation committee
(2) Member of the audit committee
(3) Member of the nominating and governance committee

 

Scott R. Silverman has served as our chief executive officer since December 5, 2006, as the chairman of our board of directors since March 2003 and as a member of our board of directors since February 2002. He also served as our chief executive officer from April 2003 to June 2004. He has served as the chairman of the board of directors of Applied Digital since March 2003, and served as chief executive officer of Applied Digital from March 2003 to December 5, 2006, and as acting president of Applied Digital from April 2005 to December 5, 2006. From March 2002 to March 2003, he served as Applied Digital’s president and as a member of its board of directors. From August 2001 to March 2002, he served as a special advisor to Applied Digital’s board of directors. From September 1999 to March 2002, Mr. Silverman operated his own private investment banking firm. From October 1996 to September 1999, he served in various capacities with Applied Digital, including positions related to business development, corporate development and legal affairs. Mr. Silverman has served as the chairman of the board of Applied Digital’s wholly-owned subsidiary, InfoTech USA. Inc., since January 2006. He has also served as a director of Applied Digital’s majority-owned subsidiary, Digital Angel, since July 2003, and as chairman of the Digital Angel board since February 2004. Mr. Silverman is an attorney licensed to practice in New Jersey and Pennsylvania.

 

Daniel A. Gunther has served as our president since June 2005. From 1987 to June 2005, Mr. Gunther held a series of senior management positions at Instantel in operations, product management, manufacturing, quality, sales and finance. In 1987, he was appointed Instantel’s chief financial officer and vice president of operations. In 2001, he was appointed Instantel’s chief operating officer. In 2003, he was appointed Instantel’s president and chief executive officer. Mr. Gunther served as a member of Instantel’s board of directors from April 2003 to June 2005. He is a certified management accountant and holds a master’s degree in business administration.

 

William J. Caragol has served as our chief financial officer since August 2006. From July 2005 to August 2006, he served as the chief financial officer of Government Telecommunications, Inc., a subsidiary of Applied Digital. From December 2003 to June 2005, Mr. Caragol was the vice president of business development and chief financial officer of Millivision Technologies, a technology company. From August 2001 to December 2003, Mr. Caragol was a consulting partner with East Wind Partners LLP, a communications business development company, in Washington, D.C. He is a member of the American

 

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Institute of Certified Public Accountants and graduated from the Washington & Lee University with a bachelor of science in Administration and Accounting.

 

Daniel E. Penni has served as a member of our board of directors since June 2004. Presently, he is a principal with the Endowment for the 21st Century. From September 1988 until December 2005, Mr. Penni was employed by Arthur J. Gallagher & Co., an insurance brokerage and risk management services firm, where he served in several positions, including most recently as an area executive vice president. He has worked in various sales and administrative roles in the insurance business since 1969. Mr. Penni has been a member of the board of directors of Applied Digital since 1994 and serves as the chairman of the compensation committee, as well as a member of the audit, nominating, and compliance and governance committees, of Applied Digital’s board of directors. He also served as treasurer and chairman of the finance committee of the board of trustees of the Massachusetts College of Pharmacy and Health Sciences in Boston through June 2006.

 

Tommy G. Thompson has served as a member of our board of directors since July 2005. Mr. Thompson is currently a partner at the law firm of Akin Gump Strauss Hauer & Feld LLP. He is also a senior advisor to Deloitte & Touche LLP in the United States, serving as the independent chair of the Deloitte Center for Health Solutions. He has also served as president of Logistics Health, Inc. since March 2005. From January 2001 to January 2005, Mr. Thompson served as the Secretary of the U.S. Department of Health and Human Services. From January 1987 to January 2001, he served as Governor of the State of Wisconsin. Mr. Thompson currently serves as a director of Centene Corporation, a multi-line managed care organization that provides Medicaid and Medicaid-related programs to organizations and individuals through government subsidized programs. He also serves as a director of C. R. Bard, Inc., a designer and seller of medical, surgical, diagnostic and patient care devices, and is a member of its science and technology, and regulatory compliance, committees.

 

Constance K. Weaver has served as a member of our board of directors since February 2005. Since July 2005, Ms. Weaver has served as the executive vice president and chief marketing officer for BearingPoint, Inc., a management and technology consulting firm. From October 2002 to February 2005, Ms. Weaver served as executive vice president of Public Relations, Marketing Communications and Brand Management for AT&T Corporation, or AT&T. From 1996 to October 2002, Ms. Weaver served as vice president of Investor Relations and Financial Communications for AT&T. From 1995 through 1996, she served as senior director of Investor Relations and Financial Communications for Microsoft Corporation. From 1993 to 1995, she served as vice president of Investor Relations, and from 1991 to 1993 she was director of Investor Relations, for MCI Communications, Inc. Ms. Weaver has been a member of the board of directors of Applied Digital since July 1998 and serves as chairman of the compliance and governance committee, and as a member of the compensation, nominating and technology committees, of Applied Digital’s board of directors.

 

Paul C. Green has served as a member of our board of directors since December 2005. Since September 2002, Mr. Green has served as the president of Paul C. Green Consulting, a financial services consulting firm. From 1990 to September 2002, he was chairman of the board of directors, chief executive officer and president of Massachusetts Finncorp., Inc. and president of Massachusetts Cooperative Bank. Since September 2002, Mr. Green has served as trustee of the 32 Brazao Lane Realty Trust.

 

Board Composition

 

Our board of directors currently consists of five members: Scott R. Silverman, Daniel E. Penni, Tommy G. Thompson, Constance K. Weaver and Paul C. Green.

 

Subject to certain exceptions, under the listing standards of the Nasdaq Global Market, within one year of the effectiveness of a registration statement filed with the Securities and Exchange Commission in

 

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connection with a public offering of securities, a listed company’s board of directors must consist of a majority of independent directors. As a “controlled” company under such listing standards, we are not required to comply with this requirement. However, we have determined to do so. Our board of directors has determined that four of our five directors are independent under such standards.

 

Our directors are elected annually and hold office until their successors have been elected or qualified or until the earlier of their death, resignation, retirement, disqualification or removal. Our directors may be removed only for cause by the affirmative vote of holders of a majority of the outstanding shares of capital stock entitled to vote generally in the election of directors, voting together as a single class.

 

There are no family relationships among our directors and executive officers.

 

Board Committees

 

Our board of directors has the authority to appoint board committees to perform certain management and administrative functions. Our board of directors currently has an audit committee, a compensation committee, and a nominating and governance committee. The members of each committee are appointed annually by the board of directors.

 

Audit Committee

 

Our audit committee currently consists of Paul C. Green, Daniel E. Penni and Constance K. Weaver. Mr. Green chairs the audit committee. Our board of directors has determined that each of the members of our audit committee is “independent,” as defined under, and required by, the federal securities laws and the rules of the Securities and Exchange Commission, including Rule 10A-3(b)(i) under the Securities and Exchange Act of 1934, as well as the listing standards of the Nasdaq Global Market. Our board of directors has determined that Mr. Green qualifies as an “audit committee financial expert” under applicable federal securities laws and regulations, and has the “financial sophistication” required under the listing standards of the Nasdaq Global Market.

 

The audit committee assists our board of directors in its oversight of:

 

   

our accounting, financial reporting processes, audits and the integrity of our financial statements;

 

   

our independent auditor’s qualifications, independence and performance;

 

   

our compliance with legal and regulatory requirements;

 

   

our internal accounting and financial controls; and

 

   

our audited financial statements and reports, and the discussion of the statements and reports with management, including any significant adjustments, management judgments and estimates, new accounting polices and disagreements with management.

 

The audit committee has the sole and direct responsibility for appointing, evaluating and retaining our independent auditors and for overseeing their work. All audit and non-audit services to be provided to us by our independent auditors must be approved in advance by our audit committee, other than de minimis non-audit services that may instead be approved in accordance with applicable Securities and Exchange Commission rules.

 

Compensation Committee

 

Our compensation committee currently consists of Daniel E. Penni and Tommy G. Thompson. Mr. Penni chairs the compensation committee. Our board of directors has determined that each of the

 

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members of our compensation committee is “independent,” as defined under, and required by, the rules of the Nasdaq Global Market. So long as we remain a “controlled company,” as defined by the Nasdaq rules, we are not required to comply with the Nasdaq rules requiring that all members of the compensation committee be “independent” and in the future we may determine to appoint a director who is not independent within the meaning of, and to the extent permitted in, such rules. Prior to his appointment as our chief executive officer, Mr. Silverman served as the chairman of the compensation committee.

 

Our compensation committee assists our board of directors in the discharge of its responsibilities relating to compensation of our executive officers. Specific responsibilities of our compensation committee include:

 

   

reviewing and recommending to our board approval of the compensation, benefits, corporate goals and objectives of our chief executive officer and our other executive officers;

 

   

evaluating the performance of our executive officers; and

 

   

administering our employee benefit plans and making recommendations to our board of directors regarding these matters.

 

Nominating and Governance Committee

 

Our nominating and governance committee currently consists of Constance K. Weaver and Paul C. Green. Ms. Weaver chairs the nominating and governance committee. Our board of directors has determined that each of the members of our nominating and governance committee is “independent,” as defined under, and required by, the rules of the Nasdaq Global Market. So long as we remain a “controlled company,” as defined by the Nasdaq rules, we are not required to comply with the Nasdaq rules requiring that all members of the nominating and governance committee be “independent” and in the future we may determine to appoint a director who is not independent within the meaning of, and to the extent permitted in, such rules. Prior to his appointment as our chief executive officer, Mr. Silverman served as a member of the nominating and governance committee.

 

The primary responsibilities of our nominating and corporate governance committee include:

 

   

identifying, evaluating and recommending nominees to our board of directors and its committees;

 

   

evaluating the performance of our board of directors and of individual directors;

 

   

ensuring that we and our employees maintain the highest standards of compliance with both external and internal rules, regulations and good practices; and

 

   

reviewing developments in corporate governance practices, evaluating the adequacy of our corporate governance practices and reporting and making recommendations to our board of directors concerning corporate governance matters.

 

Medical Advisory Board

 

We currently have a medical advisory board consisting of Dr. Sameer Mehta, Mr. Howard Weintraub, Dr. Jonathan Musher and Nick Minicucci, Jr. In February 2005, Dr. Sameer Mehta and Mr. Howard Weintraub were each granted options to purchase 22,222 shares of our common stock, with the exercise price of such options being $4.95 per share. In May 2005, Dr. Musher was granted options to purchase 22,222 shares of our common stock, with the exercise price of such options being $5.45 per share. All of the options granted to members of our medical advisory board were granted outside of our 2002 Flexible Stock Plan and 2005 Flexible Stock Plan. At the time of grant, the exercise prices of these options were equal to or greater than the estimated fair market value of our common stock at such time. The grants of these options provided for a two-year vesting period. However, on December 12, 2005, our board of directors adopted resolutions vesting, as of December 30, 2005, all then outstanding and unvested stock options that had been awarded to our directors, employees, consultants, one employee of Applied Digital and one employee of Digital Angel, to the extent not already vested on that date. No awards of stock options were made in 2006 to members of our medical advisory board.

 

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Compensation Committee Interlocks and Insider Participation

 

No member of the compensation committee simultaneously served both as a member of the compensation committee and as an officer or employee of ours during 2006. None of our executive officers serves as a member of the board of directors or the compensation committee, or committee performing an equivalent function, of any other entity that has one or more of its executive officers serving as a member of our board of directors or compensation committee. Prior to the formation of the compensation committee in December 2005, our board of directors as a whole made decisions relating to the compensation of our executive officers.

 

Code of Business Conduct and Ethics

 

Our board of directors has approved and we have adopted a Code of Conduct and Corporate Ethics General Policy Statement, or the Code of Conduct, which applies to all of our directors, officers and employees. Our board of directors has also approved and we have adopted a Code of Ethics for Senior Financial Officers, or the Code for SFO, which applies to our chief executive officer, chief financial officer, and controller. The Code of Conduct and Code for SFO are available upon written request to VeriChip Corporation, Attention: Secretary, 1690 South Congress Avenue, Suite 200, Delray Beach, Florida 33445. The audit committee of our board of directors is responsible for overseeing the Code of Conduct and the Code for SFO. Our audit committee must approve any waivers of the Code of Conduct for directors and executive officers and any waivers of the Code for SFO.

 

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Executive Compensation

 

Compensation Discussion and Analysis

 

General

 

Our compensation arrangements with those persons who served as our executive officers for all or part of 2006 reflect the individual circumstances surrounding the applicable executive officer’s hiring or appointment. For example, several individuals who became our executive officers at the time of the acquisition of our Canadian-based businesses in the first half of 2005 – specifically, Messrs. Daniel A. Gunther, Malik Talib and Nurez Khimji – were parties to employment agreements with either EXI Wireless or Instantel at the time these companies were acquired. Although we subsequently entered into new or amended employment agreements with each of Messrs. Gunther, Talib and Khimji, the material terms of such agreements, such as base salary levels, were influenced by those prior agreements. Similarly, the compensation arrangements in place for Scott R. Silverman, who was serving as the chief executive officer of our parent company, Applied Digital, before agreeing to become our chief executive officer in early December 2006, closely parallel the terms of his former employment agreement with Applied Digital.

 

Until June 2004, our board of directors was comprised, essentially at all times, primarily, if not exclusively, of representatives of Applied Digital’s or our management. As a wholly-owned subsidiary of Applied Digital, we were not subject to the corporate governance requirements applicable to SEC-reporting companies or the corporate governance listing standards of any stock exchange. Our board did not establish separate board committees, including a compensation committee, until December 2005, when we began to take steps to complete an initial public offering of our securities. Until Mr. Silverman’s appointment as our chief executive officer in December 2006, Mr. Silverman served as chairman of our compensation committee.

 

The foregoing information is intended to provide context for the discussion that follows regarding our existing compensation arrangements with those persons who served as our executive officers for all or part of 2006.

 

Principal Components of Compensation of Our Executive Officers

 

The principal components of the compensation we have historically paid to our executive officers have consisted of:

 

   

base salary;

 

   

signing or retention bonuses, paid in cash;

 

   

cash incentive compensation under the terms of individual senior management incentive compensation plans established for our executive officers; and

 

   

equity compensation, generally in the form of grants of stock options.

 

Our chief executive officer has historically played a significant role in the determination of the amounts of base salary, signing or retention bonuses and other forms of cash and equity-based compensation to be paid other members of senior management. We expect that the compensation committee of our board of directors will continue to solicit input from our chief executive officer with respect to compensation decisions affecting other members of our senior management.

 

Allocation of Compensation Among Principal Components

 

The compensation committee of our board of directors has not yet established any policies or guidelines with respect to the mix of base salary, bonus, cash incentive compensation and equity awards to be paid or awarded to our executive officers. In general, the compensation committee believes that a greater percentage of the compensation of the most senior members of our management should be performance-based. Following the completion of our initial public offering, the compensation committee of our board of

 

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directors anticipates adopting more formal and structured compensation policies and programs. The compensation committee will endeavor to implement policies designed to attract, retain and motivate

individuals with the skills and experience necessary for us to achieve our business objectives. These policies will also serve to link pay with measurable performance, which, in turn, should help to align the interests of our executive officers with our shareholders.

 

Base Salary

 

Our Chief Executive Officer

 

We appointed Scott R. Silverman as our chief executive officer in early December 2006. In April 2006, our board of directors, together with a member of the board of directors of Applied Digital, initiated a search for a new chief executive officer, mindful that Kevin H. McLaughlin, who was then serving as our chief executive officer, was approaching retirement age. In connection with this search, an executive search firm was initially consulted, but was not formally retained. While the search firm advised as to the backgrounds of several potential candidates, our board recognized that key qualities our new chief executive officer would need to possess included a clear, in-depth understanding of the benefits of our VeriMed patient identification system, and the skills, energy level and zeal to lead our efforts to create a market for the VeriMed system – a significant component of our growth strategy. After considering the backgrounds and qualifications of the candidates presented by the search firm, our board realized that Mr. Silverman was the ideal candidate for the position given his support, as Applied Digital’s chief executive officer, of our efforts to create a market for the VeriMed system.

 

When our board broached the subject with Mr. Silverman of his becoming our chief executive officer, he indicated a willingness to accept the challenge and perceived reduction in status, provided it did not entail a financial sacrifice relative to his compensation arrangements as the chief executive officer of Applied Digital. Based on information provided to our board by the search firm at the outset of the search for a chief executive officer, our board had developed a sense of the compensation package – in terms of base salary, guaranteed bonus, additional at-risk incentive compensation and equity interest – that would need to be provided to a candidate for the position. Mr. Silverman’s compensation arrangements with Applied Digital were in line with the parameters identified in our board’s discussions