Ontrak, Inc. - Quarter Report: 2018 September (Form 10-Q)

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

____________________________

 

FORM 10-Q

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2018

 

Commission File Number 001-31932     

_______________________

 

CATASYS, INC.

(Exact name of registrant as specified in its charter)

_______________________

 

Delaware	88-0464853
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

 

11601 Wilshire Boulevard, Suite 1100, Los Angeles, California 90025

(Address of principal executive offices, including zip code)

 

(310) 444-4300

(Registrant's telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

 

Yes    ☑          No    ☐

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    

 

Yes    ☑          No    ☐

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See definitions of “large accelerated filer,” “accelerated filer,’’ “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer ☐      Accelerated filer  ☐      Non-accelerated filer  ☐      Smaller reporting company  ☑    Emerging growth company ☐

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

 

Yes    ☐            No    ☑

 

As of November 13, 2018, there were 16,135,956 shares of the registrant's common stock, $0.0001 par value per share, outstanding.

 

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TABLE OF CONTENTS

 

 

PART I - FINANCIAL INFORMATION			3
	ITEM 1. Financial Statements		3
		Condensed Consolidated Balance Sheets as of September 30, 2018 (unaudited) and December 31, 2017	3
		Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2018 and 2017 (unaudited)	4
		Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2018 and 2017 (unaudited)	5
		Condensed Consolidated Statements of Stockholders’ (Deficit) Equity for the Nine Months ended September 30, 2018 (unaudited)	6
		Notes to Condensed Consolidated Financial Statements	7
	ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations		19
	ITEM 3. Quantitative and Qualitative Disclosures About Market Risk		28
	ITEM 4. Controls and Procedures		28
PART II – OTHER INFORMATION			29
	ITEM 1. Legal Proceedings		29
	ITEM 1A. Risk Factors		29
	ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds		29
	ITEM 3. Defaults Upon Senior Securities		29
	ITEM 4. Mine Safety Disclosures		29
	ITEM 5. Other Information		29
	ITEM 6. Exhibits		29

 

 

 

In this Quarterly Report on Form 10-Q, except as otherwise stated or the context otherwise requires, the terms “the Company,” “Our Company,” “we,” “us,” or “our” refer to Catasys, Inc. and our wholly-owned subsidiaries. Our common stock, par value $0.0001 per share, is referred to as “common stock.”

 

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		(unaudited)
(In thousands, except for number of shares)		September 30,				December 31,
		2018				2017
ASSETS
Current assets
Cash and cash equivalents		$	4,855			$	4,779
Receivables, net of allowance for doubtful accounts of $0 and $476, respectively			2,391				511
Prepaids and other current assets			628				366
Total current assets			7,874				5,656
Long-term assets
Property and equipment, net of accumulated depreciation of $1,747 and $1,542, respectively			314				612
Deposits and other assets			291				336
Total Assets		$	8,479			$	6,604
LIABILITIES AND STOCKHOLDERS' (DEFICIT)/EQUITY
Current liabilities
Accounts payable		$	441			$	980
Accrued compensation and benefits			1,205				1,177
Deferred revenue			5,031				2,914
Other accrued liabilities			1,973				578
Total current liabilities			8,650				5,649
Long-term liabilities
Long term debt, net of discount of $535 and $0, respectively			7,415				-
Deferred rent and other long-term liabilities			-				25
Capital leases			-				2
Warrant liabilities			124				30
Total Liabilities			16,189				5,706
Stockholders' (deficit)/equity
Preferred stock, $0.0001 par value; 50,000,000 shares authorized; no shares issued and outstanding			-				-
Common stock, $0.0001 par value; 500,000,000 shares authorized; 16,087,186 and 15,889,171 shares issued and outstanding at September 30, 2018 and December 31, 2017, respectively			2				2
Additional paid-in-capital			296,506				294,220
Accumulated deficit			(304,218	)			(293,324	)
Total Stockholders' (Deficit)/Equity			(7,710	)			898
Total Liabilities and Stockholders' (Deficit)/Equity		$	8,479			$	6,604

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		Three Months Ended								Nine Months Ended
(In thousands, except per share amounts)		September 30,								September 30,
		2018				2017				2018				2017
Revenues
Healthcare services revenues		$	4,369			$	1,195			$	9,553			$	4,682
Operating expenses
Cost of healthcare services			3,237				1,664				8,465				4,361
General and administrative			5,120				2,575				13,298				8,144
Depreciation and amortization			59				47				229				131
Total operating expenses			8,416				4,286				21,992				12,636
Loss from operations			(4,047	)			(3,091	)			(12,439	)			(7,954	)
Other Income			-				16				40				44
Interest expense			(241	)			(1	)			(278	)			(3,408	)
Loss on conversion of note			-				-				-				(1,356	)
Loss on issuance of common stock			-				-				-				(145	)
Change in fair value of derivative liability			-				-				-				132
Change in fair value of warrant liability			(65	)			(2	)			(94	)			1,767
Loss from operations before provision for income taxes			(4,353	)			(3,078	)			(12,771	)			(10,920	)
Provision for income taxes			-				2				-				4
Net Loss		$	(4,353	)		$	(3,080	)		$	(12,771	)		$	(10,924	)
Basic and diluted net loss from operations per share:		$	(0.27	)		$	(0.06	)		$	(0.80	)		$	(0.30	)
Basic and diluted weighted number of shares outstanding			15,917				47,638				15,909				36,181

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		Nine Months Ended
(In thousands)		September 30,
		2018				2017
Operating activities:
Net loss		$	(12,771	)		$	(10,924	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization			229				131
Amortization of debt discount and issuance costs included in interest expense			95				3,335
Warrants issued for services			86				-
Loss on disposal of fixed assets			69				-
Provision for doubtful accounts			-				307
Deferred rent			(67	)			(60	)
Share-based compensation expense			2,024				191
Common stock issued for consulting services			112				181
Loss on conversion of convertible debenture			-				1,356
Loss on issuance of common stock			-				145
Fair value adjustment on warrant liability			94				(1,767	)
Fair value adjustment on derivative liability			-				(132	)
Changes in current assets and liabilities:
Receivables			(1,880	)			36
Prepaids and other current assets			3				113
Deferred revenue			3,994				1,655
Accounts payable and other accrued liabilities			949				85
Net cash used by operating activities		$	(7,063	)		$	(5,348	)
Investing activities:
Purchases of property and equipment		$	-			$	(274	)
Net cash used by investing activities		$	-			$	(274	)
Financing activities:
Proceeds from the issuance of common stock and warrants		$	-			$	16,458
Proceeds from the issuance of bridge loans			-				1,300
Payments on convertible debenture			-				(4,363	)
Transactions costs			-				(1,667	)
Proceeds from secured promissory note			7,500				-
Debt issuance costs			(336	)			-
Capital lease obligations			(25	)			(31	)
Net cash provided by financing activities		$	7,139			$	11,697
Net increase in cash and cash equivalents		$	76			$	6,075
Cash and cash equivalents at beginning of period			4,779				851
Cash and cash equivalents at end of period		$	4,855			$	6,926
Supplemental disclosure of cash paid
Interest		$	-			$	-
Income taxes		$	-			$	40
Supplemental disclosure of non-cash activity
Common stock issued for conversion of debt and accrued interest		$	-			$	7,163
Common stock issued upon settlement of deferred compensation to officer		$	-			$	1,122
Warrants issued in connection with A/R Facility		$	64			$	-

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										Additional
(Amounts in thousands, except for number of shares)		Common Stock								Paid-In				Accumulated
		Shares				Amount				Capital				Deficit				Total
Balance at December 31, 2017			15,889,171			$	2			$	294,220			$	(293,324	)		$	898
Adoption of accounting standard			-				-				-				1,877			$	1,877
Balance at January 1, 2018			15,889,171				2				294,220				(291,447	)			2,775
Common stock issued for outside services			24,000				-				112				-				112
Warrants issued for services			-				-				86				-				86
Warrants issued in connection with A/R facility			-				-				64				-				64
Cashless warrant exercise			174,015				-				-				-				-
Share-based compensation expense			-				-				2,024				-				2,024
Net loss			-				-				-				(12,771	)			(12,771	)
Balance at September 30, 2018			16,087,186			$	2			$	296,506			$	(304,218	)		$	(7,710	)

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Note 1.   Basis of Consolidation and Presentation

 

We harness proprietary big data predictive analytics, artificial intelligence and telehealth, combined with human intervention, to deliver improved member health and cost savings to health plans through integrated technology enabled treatment solutions. It is our mission to provide access to affordable and effective care, thereby improving health and reducing cost of care for people who suffer from the medical consequences of behavioral health conditions; helping these people and their families achieve and maintain better lives.

 

The accompanying unaudited condensed consolidated financial statements for Catasys, Inc. and its subsidiaries have been prepared in accordance with generally accepted accounting principles in the United States of America (“U.S. GAAP”) and instructions to Form 10-Q and, therefore, do not include all disclosures necessary for a complete presentation of financial position, results of operations, and cash flows in conformity with U.S. GAAP. In our opinion, all adjustments, consisting of normal recurring adjustments, considered necessary for a fair presentation have been included.  Interim results are not necessarily indicative of the results that may be expected for the entire fiscal year. The accompanying financial information should be read in conjunction with the financial statements and the notes thereto included in our most recent Annual Report on Form 10-K for the year-ended December 31, 2017, from which the balance sheet, as of December 31, 2017, has been derived.

 

Our ability to fund our ongoing operations is dependent on increasing the number of members that are eligible for our solutions by signing new contracts, identifying more eligible members in existing contracts, and generating fees from existing and new contracts and the success of management’s plan to increase revenue and continue to control expenses. We currently operate our OnTrak solutions in twenty-two states. We provide services to commercial (employer funded), managed Medicare Advantage, and managed Medicaid and duel eligible (Medicare and Medicaid) populations. We have generated fees from our launched programs and expect to increase enrollment and fees throughout 2018.

 

Management’s Plans

 

In June 2018 we entered into a venture loan and security agreement (the “Loan Agreement”) with Horizon Technology Finance Corporation (the “Lender”), which provides for up to $7.5 million in loans to the Company, including initial loans in the amount of $5.0 million funded upon signing of the Loan Agreement.  An additional $2.5 million loan was subject to the Company’s achievement of billings of not less than $5.0 million during any three consecutive month period on or prior to November 30, 2018.  In August 2018, we incurred the additional $2.5 million loan as a result of our achievement of the trailing three month billings exceeding $5.0 million on or prior to November 30, 2018. In addition, in June 2018, we entered into a loan and security agreement in connection with a $2.5 million receivables financing facility with Corporate Finance, a division of Heritage Bank of Commerce (the “A/R Facility”). The A/R Facility provides for the borrower entities to borrow up to 85% of the Company’s eligible accounts receivable, as defined in the A/R Facility. We have not borrowed on the A/R Facility.

 

Historically we have seen and continue to see net losses, net loss from operations, negative cash flow from operating activities, and historical working capital deficits as we continue through a period of rapid growth. These conditions raise substantial doubt about our ability to continue as a going concern.  The accompanying financial statements do not reflect any adjustments that might result if we were unable to continue as a going concern. We have entered into new contracts, expanded with existing health plan contracts, and identified more eligible members.  To support this increased demand for services, we invested in the additional headcount needed to support these customers launching during the first nine months of 2018.  We have had a growing customer base and are able to fully scale our operations to service the contracts and future enrollment providing leverage in these investments that is expected to result in positive cash flow during the second quarter of 2019. Based upon this expected positive cash flow, we believe we will have enough capital to cover expenses through at least the next twelve months. We will continue to monitor liquidity carefully and in the event we do not have enough capital to cover expense we will make the necessary and appropriate reductions in spending to remain cash flow positive.  However, if we were to add more health plans than budgeted, increase the size of the outreach pool by more than we anticipate, decide to invest in new products or seek out additional growth opportunities, we would need to finance these options via a debt or equity financing, subject to complying with certain restrictions on the incurrence of indebtedness in our current lending facilities.

 

 

All inter-company transactions have been eliminated in consolidation.

 

Note 2.   Summary of Significant Accounting Policies

 

Revenue Recognition

 

Revenue from contracts with customers is recognized when, or as, we satisfy our performance obligations by transferring the promised goods or services to the customers. A good or service is transferred to a customer when, or as, the customer obtains control of that good or service. A performance obligation may be satisfied over time or at a point in time. Revenue from a performance obligation satisfied over time is recognized by measuring our progress in satisfying the performance obligation in a manner that depicts the transfer of the goods or services to the customer. Revenue from a performance obligation satisfied at a point in time is recognized at the point in time that we determine the customer obtains control over the promised good or service. The amount of revenue recognized reflects the consideration we expect to be entitled to in exchange for those promised goods or services (i.e., the “transaction price”). In determining the transaction price, we consider multiple factors, including the effects of variable consideration. Variable consideration is included in the transaction price only to the extent it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainties with respect to the amount are resolved. In determining when to include variable consideration in the transaction price, we consider the range of possible outcomes, the predictive value of our past experiences, the time period of when uncertainties expect to be resolved and the amount of consideration that is susceptible to factors outside of our influence, such as the judgment and actions of third parties.

 

The following table disaggregates our revenue by contract:

 

 

 

        Our Catasys contracts are generally designed to provide cash fees to us on a monthly basis, an upfront case rate, or fee for service based on enrolled members. The Company’s performance obligation is satisfied over time as the OnTrak service is provided continuously throughout the service period. The Company recognizes revenue evenly over the service period using a time-based measure because the Company is providing a continuous service to the customer. Contracts with minimum performance guarantees or price concessions include variable consideration and are subject to the revenue constraint. The Company uses an expected value method to estimate variable consideration for minimum performance guarantees and price concessions. The Company has constrained revenue for expected price concessions during the period ending September 30, 2018.

 

Cost of Services

 

Cost of healthcare services consists primarily of salaries related to our care coaches, outreach specialists and other staff directly involved in member care, healthcare provider claims payments, and fees charged by our third party administrators for processing these claims. Salaries and fees charged by our third party administrators for processing claims are expensed when incurred and healthcare provider claims payments are recognized in the period in which an eligible member receives services. We contract with doctors and licensed behavioral healthcare professionals, on a fee-for-service basis. We determine that a member has received services when we receive a claim or in the absence of a claim, by utilizing member data recorded in the OnTrakTM database within the contracted timeframe, with all required billing elements correctly completed by the service provider. 

 

 

Cash Equivalents and Concentration of Credit Risk 

 

We consider all highly liquid investments with an original maturity of three months or less to be cash equivalents. Financial instruments that potentially subject us to a concentration of credit risk consist of cash and cash equivalents. Cash is deposited with what we believe are highly credited, quality financial institutions. The deposited cash may exceed Federal Deposit Insurance Corporation (“FDIC”) insured limits. As of September 30, 2018, we had $4.4 million in cash and cash equivalents exceeding federally insured limits.

 

For the nine months ended September 30, 2018, five customers accounted for approximately 86% of revenues (26%, 23%, 15%, 11%, and 11%) and three customers accounted for approximately 66% of accounts receivable (27%, 22%, and 17%).

 

For the three months ended September 30, 2018, one customer accounted for approximately 12% of revenues.

 

Basic and Diluted Income (Loss) per Share

 

Basic income (loss) per share is computed by dividing the net income (loss) to common stockholders for the period by the weighted average number of shares of common stock outstanding during the period. Diluted income (loss) per share is computed by dividing the net income (loss) for the period by the weighted average number of shares of common stock and dilutive common equivalent shares outstanding during the period.

 

Common equivalent shares, consisting of 3,641,785 and 1,795,246 shares for the nine months ended September 30, 2018 and 2017, respectively, issuable upon the exercise of stock options and warrants have been excluded from the diluted earnings per share calculation as their effect is anti-dilutive.

 

Share-Based Compensation

 

Our 2017 Stock Incentive Plan (the “2017 Plan”), provides for the issuance of up to 2,333,334 shares of our common stock and an additional 243,853 shares of our common stock that are represented by awards granted under our 2010 Stock Incentive Plan (the “2010 Plan”). In August 2018, at our Annual Stockholders Meeting, Stockholders approved an amendment to the Company's 2017 Plan, among other things, to provide for an additional 1,400,000 shares to be issued in connection with awards granted thereunder (the “2017 Amended Plan”). Incentive stock options (ISOs) under Section 422A of the Internal Revenue Code and non-qualified options (NSOs) are authorized under the 2017 Amended Plan. We have granted stock options to executive officers, employees, members of our board of directors, and certain outside consultants. The terms and conditions upon which options become exercisable vary among grants, but option rights expire no later than ten years from the date of grant and employee and board of director awards generally vest over three to five years. As of September 30, 2018, we had 3,641,785 stock options outstanding of which 390,880 are vested and 335,402 shares available for future awards under the 2017 Amended Plan.

 

Share-based compensation expense was $1.1 million and $2.0 million for the three and nine months ended September 30, 2018, compared with $32,000 and $191,000 for the same periods in 2017, respectively.

 

Stock Options – Employees and Directors

 

We measure and recognize compensation expense for all share-based payment awards made to employees and directors based on estimated fair values on the date of grant. We estimate the fair value of share-based payment awards using the Black-Scholes option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the consolidated statements of operations.

 

For share-based awards issued to employees and directors, share-based compensation is attributed to expense using the straight-line single option method. Share-based compensation expense recognized in our consolidated statements of operations for the three and nine months ended September 30, 2018 and 2017 is based on awards ultimately expected to vest, reduced for estimated forfeitures. Accounting rules for stock options require forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

 

 

There were 1,167,957 and 1,810,264 options granted to employees and directors during the three and nine months ended September 30, 2018 compared with no options granted during the same periods in 2017. Employee and director stock option activity for the nine months ended September 30, 2018 are as follows:

 

 

 

The expected volatility assumptions have been based on the historical and expected volatility of our stock, measured over a period generally commensurate with the expected term. The weighted average expected option term for the three and nine months ended September 30, 2018 and 2017, reflects the application of the simplified method prescribed in Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin (“SAB”) No. 107 (as amended by SAB 110), which defines the life as the average of the contractual term of the options and the weighted average vesting period for all option tranches.

 

As of September 30, 2018, there was $6.3 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the 2017 Amended Plan. That cost is expected to be recognized over a weighted-average period of approximately 3.94 years.          

 

Stock Options and Warrants – Non-employees

 

We account for the issuance of options and warrants for services from non-employees by estimating the fair value of warrants issued using the Black-Scholes pricing model. This model’s calculations include the option or warrant exercise price, the market price of shares on grant date, the weighted average risk-free interest rate, the expected life of the option or warrant, and the expected volatility of our stock and the expected dividends.

 

For options and warrants issued as compensation to non-employees for services that are fully vested and non-forfeitable at the time of issuance, the estimated value is recorded in equity and expensed when the services are performed and benefit is received. For unvested shares, the change in fair value during the period is recognized in expense using the graded vesting method.

 

There were no options issued to non-employees for the three and nine months ended September 30, 2018 or during the same periods in 2017.

 

There was no share based compensation expense relating to stock options and warrants recognized for the non-employees for the three and nine months ended September 30, 2018 or during the same periods in 2017.

 

There were 0 and 24,000 warrants issued in exchange for services during the three months and nine months ended September 30, 2018, compared with 90,000 warrants issued in exchange for services during the same periods in 2017. Generally, the costs associated with warrants issued for services are amortized to the related expense on a straight-line basis over the related service periods.

 

There were 9,720 warrants issued in connection with the June 2018 A/R Facility financing (see Footnote 4).

 

In September 2018, there was a cashless exercise of 250,002 warrants and 174,015 shares of common stock, par value $0.0001, were issued.

 

There were 1,795,246 and 2,011,528 warrants outstanding as of September 30, 2018 and 2017, respectively.

 

 

Common Stock

 

There were 0 and 24,000 shares of common stock issued in exchange for investor relations services during the three and nine months ended September 30, 2018, respectively, compared with 0 and 28,985 for the same periods in 2017. Generally, the costs associated with shares issued for services are amortized to the related expense on a straight-line basis over the related service periods.

 

In September 2018, there was a cashless exercise of 250,002 warrants and 174,015 shares of common stock, par value $0.0001, were issued.

 

In April 2017, we entered into an underwriting agreement with Joseph Gunnar & Co., LLC (“Joseph Gunnar”), as underwriter in connection with a public offering of the Company’s securities. Pursuant to the underwriting agreement, we agreed to issue and sell an aggregate 3,125,000 shares of common stock at a public offering price of $4.80 per share, and the purchase price to the underwriter after discounts and commission was $4.464 per share. The closing of the offering occurred on April 28, 2017. We received $15.0 million in gross proceeds in connection with the offering.

 

Pursuant to the underwriting agreement with Joseph Gunnar, we granted the underwriters a 45 day over-allotment option to purchase up to 468,750 additional shares of common stock at the public offering price less the applicable underwriter discount. In May, the underwriter acquired an additional 303,750 shares pursuant to such over-allotment option. We received $1.5 million in gross proceeds in connection with the over-allotment option.

 

In connection with the public offering, our common stock began trading on the NASDAQ Capital Market (“NASDAQ”) under the symbol “CATS” beginning on April 26, 2017.

 

In April 2017, several investors, including Acuitas Group Holdings, LLC (“Acuitas”), one hundred percent (100%) of which is owned by Terren S. Peizer, Chairman and Chief Executive Officer of the Company, and Shamus, LLC (“Shamus”), a Company owned by David E. Smith, a member of our board of directors, exercised their option to convert their convertible debentures and received 2,982,994 shares of common stock. There was a loss on the conversion of the convertible debentures of $1.4 million for the six months ended June 30, 2017.

 

In April 2017, Terren S. Peizer agreed to settle his deferred salary balance of $1.1 million for 233,734 shares of common stock. As a result, the Company recognized a loss on settlement of liability totaling $83,807 which is recorded to loss on issuance of common stock.

 

In April 2017, we filed a certificate of amendment to our Certificate of Incorporation, as amended and in effect, with the Secretary of State of the State of Delaware, implementing a 1-for-6 reverse stock split of the Company's common stock, pursuant to which each six shares of issued and outstanding common stock converted into one share of common stock. Proportionate voting rights and other rights of common stock holders were not affected by the reverse stock split.  No fractional shares of common stock were issued as a result of the reverse stock split; stockholders were paid cash in lieu of any such fractional shares.

 

All stock options and warrants to purchase common stock outstanding and our Common Stock reserved for issuance under the Company's equity incentive plans immediately prior to the reverse stock split were appropriately adjusted by dividing the number of affected shares of common stock by six and, as applicable, multiplying the exercise price by six as a result of the reverse stock split.

 

Income Taxes

 

We have recorded a full valuation allowance against our otherwise recognizable deferred tax assets as of September 30, 2018.  As such, we have not recorded a provision for income tax for the period ended September 30, 2018.  We utilize the liability method of accounting for income taxes as set forth in ASC 740, Income Taxes. Under the liability method, deferred taxes are determined based on the temporary differences between the financial statement and tax basis of assets and liabilities using tax rates expected to be in effect during the years in which the basis differences reverse. A valuation allowance is recorded when it is more likely than not that some of the deferred tax assets will not be realized. 

 

 

We assess our income tax positions and record tax benefits for all years subject to examination based upon our evaluation of the facts, circumstances and information available at the reporting date. For those tax positions where there is greater than 50% likelihood that a tax benefit will be sustained, we have recorded the largest amount of tax benefit that may potentially be realized upon ultimate settlement with a taxing authority that has full knowledge of all relevant information. For those income tax positions where there is less than 50% likelihood that a tax benefit will be sustained, no tax benefit has been recognized in the financial statements.  Based on management's assessment of the facts, circumstances and information available, management has determined that all of the tax benefits for the period ended September 30, 2018 should be realized.   

 

Fair Value Measurements

 

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Assets and liabilities recorded at fair value in the consolidated balance sheets are categorized based upon the level of judgment associated with the inputs used to measure fair value. The fair value hierarchy distinguishes between (1) market participant assumptions developed based on market data obtained from independent sources (observable inputs) and (2) an entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The fair value hierarchy consists of three broad levels, which gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level I) and the lowest priority to unobservable inputs (Level III). The three levels of the fair value hierarchy are described below:

 

Level Input:		Input Definition:
Level I		Inputs are unadjusted, quoted prices for identical assets or liabilities in active markets at the measurement date.
Level II		Inputs, other than quoted prices included in Level I, that are observable for the asset or liability through corroboration with market data at the measurement date.
Level III		Unobservable inputs that reflect management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date.

 

The following table summarizes fair value measurements by level at September 30, 2018 for assets and liabilities measured at fair value:

 

 

 

Financial instruments classified as Level III in the fair value hierarchy as of September 30, 2018, represent our liabilities measured at market value on a recurring basis which include warrant liabilities resulting from recent debt financing. In accordance with current accounting rules, the warrant liabilities with anti-dilution protection are being marked-to-market each quarter-end until they are completely settled or expire. The warrants are valued using the Black-Scholes option-pricing model, using both observable and unobservable inputs and assumptions consistent with those used in our estimate of fair value of employee stock options. See Warrant Liabilities below.

 

 

The following table summarizes our fair value measurements using significant Level III inputs, and changes therein, for the three and nine months ended September 30, 2018:

 

 

 

 Property and Equipment

 

Property and equipment are stated at cost, less accumulated depreciation. Additions and improvements to property and equipment are capitalized at cost. Expenditures for maintenance and repairs are charged to expense as incurred. Depreciation is computed using the straight-line method over the estimated useful lives of the related assets, which range from two to seven years for furniture and equipment. Leasehold improvements are amortized over the lesser of the estimated useful lives of the assets or the related lease term, which is typically five to seven years.

 

Variable Interest Entities

 

Generally, an entity is defined as a Variable Interest Entity (“VIE”) under current accounting rules if it has (a) equity that is insufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, or (b) equity investors that cannot make significant decisions about the entity’s operations, or that do not absorb the expected losses or receive the expected returns of the entity. When determining whether an entity that is a business qualifies as a VIE, we also consider whether (i) we participated significantly in the design of the entity, (ii) we provided more than half of the total financial support to the entity, and (iii) substantially all of the activities of the VIE either involve us or are conducted on our behalf. A VIE is consolidated by its primary beneficiary, which is the party that absorbs or receives a majority of the entity’s expected losses or expected residual returns.

 

As discussed under the heading Management Services Agreement (“MSA”) below, we have an MSA with a Texas nonprofit health organization (“TIH”) and a California Professional Corporation (“CIH”). Under this MSA, the equity owners of TIH and CIH has only a nominal equity investment at risk, and we absorb or receive a majority of the entity’s expected losses or expected residual returns. We participate significantly in the design of this MSA. We also agree to provide working capital loans to allow for TIH and CIH to pay for their obligations. Substantially all of the activities of TIH and CIH either involve us or are conducted for our benefit, as evidenced by the facts that (i) the operations of TIH and CIH are conducted primarily using our licensed network of providers and (ii) under the MSA, we agree to provide and perform all non-medical management and administrative services for the entities. Payment of our management fee is subordinate to payments of the obligations of TIH and CIH, and repayment of the working capital loans is not guaranteed by the equity owner of the affiliated medical group or other third party. Creditors of TIH and CIH do not have recourse to our general credit.

 

Based on the design and provisions of this MSA and the working capital loans provided to the entities, we have determined that TIH and CIH are a VIE’s, and that we are the primary beneficiary as defined in the current accounting rules. Accordingly, we are required to consolidate the revenues and expenses of the managed medical corporation.

 

Management Services Agreement

 

In April 2018, we executed an MSA with TIH and in July 2018, we executed an MSA with CIH. Under the MSA’s, we license to TIH and CIH the right to use our proprietary treatment programs and related trademarks and provide all required day-to-day business management services, including, but not limited to:

 

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general administrative support services;

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information systems;

 

 

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recordkeeping;

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billing and collection;

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obtaining and maintaining all federal, state and local licenses, certifications and regulatory permits.

 

All clinical matters relating to the operation of TIH and CIH and the performance of clinical services through the network of providers shall be the sole and exclusive responsibility of the TIH and CIH Board free of any control or direction by Catasys.

 

TIH and CIH pay us a monthly fee equal to the aggregate amount of (a) our costs of providing management services (including reasonable overhead allocable to the delivery of our services and including salaries, rent, equipment, and tenant improvements incurred for the benefit of the medical group, provided that any capitalized costs will be amortized over a five-year period), (b) 10%-15% of the foregoing costs, and (c) any performance bonus amount, as determined by the TIH and CIH at its sole discretion. The payment of our fee is subordinate to payment of the entities’ obligations.

 

Under the MSA’s, the equity owner of the affiliated treatment center has only a nominal equity investment at risk, and we absorb or receive a majority of the entity’s expected losses or expected residual returns. We also agree to provide working capital loans to allow for TIH and CIH to pay for their obligations. Substantially all of the activities of TIH and CIH either involves us or are conducted for our benefit, as evidenced by the facts that (i) the operations of TIH is conducted primarily using our licensed protocols and (ii) under the MSA, we agree to provide and perform all non-medical management and administrative services for the treatment center. Payment of our management fee is subordinate to payments of the obligations of TIH and CIH, and repayment of the working capital loans is not guaranteed by the equity owner of TIH and CIH or other third party. Creditors of TIH and CIH do not have recourse to our general credit. Based on these facts, we have determined that TIH and CIH are VIE’s and that we are the primary beneficiary as defined in current accounting rules.  Accordingly, we are required to consolidate the assets, liabilities, revenues and expenses of the managed treatment center.

 

The amounts and classification of assets and liabilities of the VIE included in our consolidated balance sheets at September 30, 2018 are as follows:

 

 

 

Warrant Liabilities

 

The warrant liabilities were calculated using the Black-Scholes model based upon the following assumptions:

 

 

 

 

We issued 11,049 warrants to purchase common stock in April 2015 which are being accounted for as liabilities in accordance with Financial Accounting Standards Board (“FASB”) accounting rules, due to anti-dilution provisions in the warrants that protect the holders from declines in our stock price, which is considered outside our control.  These warrants are marked-to-market each reporting period, using the Black-Scholes pricing model, until they are completely settled or expire.

 

 

For the three and nine months ended September 30, 2018, we recognized a loss of $65,000 and $94,000, respectively, compared with a loss of $2,000 and a gain of $1.8 million for the same periods in 2017, respectively, related to the revaluation of our warrant liabilities.

 

Recently Issued or Newly Adopted Accounting Standards

 

In August 2018, the FASB issued Accounting Standard Update (“ASU”) No. 2018-13, Fair Value Measurement (Topic 820), which modifies the disclosure requirements on fair value measurements in Topic 820, Fair Value Measurement, including, among other changes, the consideration of costs and benefits when evaluating disclosure requirements. For public companies, the amendments are effective for annual reporting periods beginning after December 15, 2019, including interim periods within those annual periods. Early adoption is permitted. We are currently assessing the impact that adopting this new accounting guidance will have on its financial statements and footnote disclosures.

 

In June 2018, the FASB issued ASU 2018-07, Improvements to Nonemployee Share-Based Payment Accounting (“ASU 2018-07”), which supersedes ASC 505-50 and expands the scope of ASC 718 to include all share-based payments arrangements related to the acquisition of goods and services from both employees and nonemployees. For public companies, the amendments are effective for annual reporting periods beginning after December 15, 2018, including interim periods within those annual periods. Early adoption is permitted, but no earlier than a company's adoption date of ASC 606. We do not believe that the adoption of ASU 2018-07 will have a material impact on our condensed consolidated financial statements.

 

In April 2016, the FASB issued ASU 2016-10, Revenue from Contracts with Customers (Topic 606) (“ASU 2016-10”), which amends certain aspects of the Board’s new revenue standard, ASU 2014-09, Revenue from Contracts with Customers. The standard should be adopted concurrently with adoption of ASU 2014-09, which is effective for annual and interim periods beginning after December 15, 2017. Early adoption is permitted. We have selected the modified retrospective approach as our transition method under ASU 2016-10 and the financial impact to the financial statements was to decrease retained earnings and deferred revenue by $1.9 million effective January 1, 2018 (Please see footnote 3).

 

In February 2016, the FASB ASU No. 2016-02, Leases (Topic 842) (“ASU 2016-02”). Under the new guidance, lessees will be required to recognize the following for all leases (with the exception of short-term leases) at the lease commencement date: a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis; and a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. Under the new guidance, lessor accounting is largely unchanged. Certain targeted improvements were made to align, where necessary, lessor accounting with the lessee accounting model and Topic 606, Revenue from Contracts with Customers. The new lease guidance simplified the accounting for sale and leaseback transactions primarily because lessees must recognize lease assets and lease liabilities. Lessees will no longer be provided with a source of off-balance sheet financing. Public business entities should apply the amendments in ASU 2016-02 for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years (i.e., January 1, 2019, for a calendar year entity). Early application is permitted.  Lessees (for capital and operating leases) and lessors (for sales-type, direct financing, and operating leases) must apply a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. The modified retrospective approach would not require any transition accounting for leases that expired before the earliest comparative period presented. Lessees and lessors may not apply a full retrospective transition approach. We are currently evaluating the expected impact that the standard could have on our condensed consolidated financial statements and related disclosures.  We plan on having this analysis completed during the fourth quarter of 2018.

 

In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses (“ASU 2016-13”). The amendment revises the impairment model to utilize an expected loss methodology in place of the currently used incurred loss methodology, which will result in more timely recognition of losses on financial instruments, including, but not limited to, available for sale debt securities and accounts receivable. The Company is required to adopt this standard starting in the first quarter of fiscal year 2021. Early adoption is permitted. We are currently evaluating the impact of the adoption of this standard on our condensed consolidated financial statements and related disclosures.

 

 

In July 2017, the FASB issued ASU 2017-11, Earnings Per Share (Topic 260); Distinguishing Liabilities from Equity (Topic 480); Derivatives and Hedging (Topic 815): (Part I) Accounting for Certain Financial Instruments with Down Round Features, (Part II) Replacement of the Indefinite Deferral for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests with a Scope Exception (“ASU 2017-11”). The amendments in this update are intended to simplify the accounting for certain equity linked financial instruments and embedded features with down round features that result in the strike price being reduced on the basis of the pricing of future equity offerings. Under the new guidance, a down round feature will no longer need to be considered when determining whether certain financial instruments or embedded features should be classified as liabilities or equity instruments. That is, a down round feature will no longer preclude equity classification when assessing whether an instrument or embedded feature is indexed to an entity's own stock. In addition, the amendments clarify existing disclosure requirements for equity-classified instruments. These amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2018, with early adoption permitted. We do not believe that the adoption of ASU 2017-11 will have a material impact on our condensed consolidated financial statements.

 

Note 3. ASC 606

 

        In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606), (“ASU 2014-09”). ASU 2014-09 supersedes the revenue recognition requirements in ASC 605 - Revenue Recognition (“ASC 605”) and most industry-specific guidance throughout ASC 605. The FASB has issued numerous updates that provide clarification on a number of specific issues as well as requiring additional disclosures. The core principle of ASC 606 requires that an entity recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services.

 

We adopted ASC 606 effective January 1, 2018 using the modified retrospective method. We recognized the cumulative effect of initially applying the new revenue standard as an adjustment to the opening balance of retained earnings. The comparative information has not been restated and continues to be reported under the accounting standards in effect for those periods. The cumulative effect of the changes made to our consolidated January 1, 2018 balance sheet for the adoption of ASU 2014-09 were as follows (in thousands):

 

 

 

In accordance with the new revenue standard requirements, the disclosure of the impact of adoption on our consolidated income statement and balance sheet for the three and nine months ended September 30, 2018 was as follows (in thousands):

 

 

 

 

 

Note 4. Long-Term Debt

 

In June 2018 we entered into a venture loan and security agreement (the “Loan Agreement”) with Horizon Technology Finance Corporation (the “Lender”), which provides for up to $7.5 million in loans to us, including initial loans in the amount of $5.0 million funded upon signing of the Loan Agreement.  An additional $2.5 million loan was subject to us achieving billings of not less than $5.0 million during any three consecutive month period on or prior to November 30, 2018. In August 2018, we incurred the additional $2.5 million loan as a result of our achievement of the trailing three month billings exceeding $5.0 million on or prior to November 30, 2018.

 

Repayment of the loans is on an interest-only basis through September 1, 2019, followed by monthly payments of principal and accrued interest for the balance of the term, subject to extension in the event that our billings exceed $20.0 million during the six months period ended June 30, 2019. The loans bear interest at a floating coupon rate of 8.75% plus the amount by which one-month LIBOR exceeds 2.0%.  We have also agreed to make quarterly revenue based payments to the Lender in the amount of 0.2% of their consolidated revenue in accordance with GAAP, in any quarter in which our EBITDA is negative, or 0.4% of such consolidated revenue if our EBITDA is positive. We have recognized approximately $9,000 and $10,000 in interest expense for revenue based payments for the three and nine months ended September 30, 2018, respectively. A final payment equal to 6.0% of each loan tranche will be due on the scheduled maturity date of March 1, 2022 for each loan. In addition, if we repay all or a portion of the loan prior to the applicable maturity date, we will pay the Lender a prepayment penalty fee, based on a percentage of the then outstanding principal balance, equal to 3% if the prepayment occurs during the interest-only payment period, 2% thereafter, plus the amount by which the Revenue Based Payments received prior to such prepayment did not exceed certain minimum thresholds.  We recognized approximately $147,000 and 170,000 in interest expense for the three and nine months ended September 30, 2018.

 

Obligations under the Loan Agreement are secured by a first priority security interest in all of our respective assets, with the exception of intellectual property. We have agreed not to pledge or otherwise encumber our intellectual property assets, subject to certain exceptions.

 

The Loan Agreement includes customary affirmative and restrictive covenants, excluding any covenants to attain or maintain certain financial metrics, and also includes customary events of default, including for payment failures, breaches of covenants, change of control and material adverse changes.  Upon the occurrence of an event of default and following any applicable cure periods, a default interest rate of an additional 5% may be applied to the outstanding loan balances (and a late payment fee of 6% of the amount due incurred), and the Lender may declare all outstanding obligations immediately due and payable and take such other actions as set forth in the Loan Agreement.

 

 

In connection with the Loan Agreement, we were obligated to pay the Lender a $75,000 commitment fee.

 

We recognized approximately $588,000 of debt discount associated with this Loan Agreement, which is being amortized to interest expense using the effective interest method over the term of the Loan Agreement.  Amortization of the debt discount associated with the Loan Agreement was approximately $49,000 and $53,000 for the three and nine months ended September 30, 2018 and is included in interest expense in the accompanying condensed consolidated statements of operations.

 

Also in June 2018, we entered into a loan and security agreement in connection with a $2.5 million receivables financing facility with Corporate Finance, a division of Heritage Bank of Commerce (the “A/R Facility”). The A/R Facility provides for us to borrow up to 85% of our eligible accounts receivable, as defined in the A/R Facility. Interest on such borrowings accrues at the rate of the Wall Street Journal Prime Rate plus 3.0%. The lender under the A/R Facility is entitled to an annual facility fee of 1% and the initial term of the A/R Facility is two years. Obligations under the A/R Facility are secured by a first priority security interest in all of our personal property, with the exception of intellectual property, and are senior to all borrowings under the Loan Agreement pursuant to an intercreditor agreement. We have not borrowed on the A/R Facility.

 

In connection with the A/R Facility agreement, we issued Heritage Bank of Commerce warrants to purchase an aggregate of 9,720 shares of common stock (the “Heritage Warrants”), subject to a reduction in the event of early termination of the AR Facility agreement. These warrants were recorded as debt issuance costs as well as all fees associated with securing the A/R Facility and are being amortized to interest expense over the two-years term of the A/R Facility using the straight-line method. We recognized approximately $262,000 of debt issuance costs associated with the A/R Facility, and the amortization of the debt issuance costs associated with the A/R Facility was approximately $35,000 and $41,000 for the three and nine months ended September 30, 2018 and is included in interest expense in the accompanying condensed consolidated statements of operations.

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