Notes to Condensed Consolidated Financial Statements

For the Periods Ended March 31, 2016 and 2015

(Unaudited)

Note 1 – Nature of Business

Foundation Healthcare, Inc. (the “Company”) is organized under the laws of the state of Oklahoma and owns controlling and noncontrolling interests in surgical hospitals located in Oklahoma and Texas. The Company also owns noncontrolling interests in ambulatory surgery centers (“ASCs”) located in Texas, Pennsylvania, New Jersey, Ohio, and Maryland. The Company provides management services to a majority of the facilities that it has noncontrolling interests (referred to as “Affiliates”) under the terms of various management agreements.

Note 2 – Summary of Significant Accounting Policies

For a complete list of the Company’s significant accounting policies, please see the Company’s Annual Report on Form 10-K for the year ended December 31, 2015.

Interim Financial Information – The condensed consolidated financial statements included herein are unaudited and have been prepared in accordance with generally accepted accounting principles for interim financial statements and in accordance with Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America (“GAAP”) for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three months ended March 31, 2016 are not necessarily indicative of results that may be expected for the year ended December 31, 2016. The consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Form 10-K for the year ended December 31, 2015. The December 31, 2015 consolidated balance sheet was derived from audited financial statements.

Consolidation – The accompanying consolidated financial statements include the accounts of the Company and its wholly owned, majority owned and controlled subsidiaries. All significant inter-company accounts and transactions have been eliminated in consolidation.

The Company accounts for its investments in Affiliates in which the Company exhibits significant influence, but does not control, in accordance with the equity method of accounting. The Company does not consolidate its equity method investments, but rather measures them at their initial costs and then subsequently adjusts their carrying values through income for their respective shares of the earnings or losses during the period. The Company monitors its investments for other-than-temporary impairment by considering factors such as current economic and market conditions and the operating performance of the companies and records reductions in carrying values when necessary.

Use of estimates – The preparation of financial statements in conformity with generally accepted accounting principles requires management of the Company to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.

Reclassifications – Certain amounts presented in prior years have been reclassified to conform to the current year’s presentation.  Such reclassifications had no effect on net income.

Revenue recognition and accounts receivable – The Company recognizes revenues in the period in which services are performed and billed. Accounts receivable primarily consist of amounts due from third-party payors and patients. The Company’s ability to collect outstanding receivables is critical to its results of operations and cash flows. Amounts the Company receives for treatment of patients covered by governmental programs such as Medicare and Medicaid and other third-party payors such as health maintenance organizations, preferred provider organizations and other private insurers are generally less than the Company’s established billing rates. Additionally, to provide for accounts receivable that could become uncollectible in the future, the Company establishes an allowance for doubtful accounts to reduce the carrying value of such receivables to their estimated net realizable value. Accordingly, the revenues and accounts receivable reported in the Company’s consolidated financial statements are recorded at the net amount expected to be received.

Contractual Discounts and Cost Report Settlements – The Company derives a significant portion of its revenues from Medicare, Medicaid and other payors that receive discounts from its established billing rates. The Company must estimate the total amount of

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these discounts to prepare its consolidated financial statements. The Medicare and Medicaid regulations and various managed care contracts under which these discounts must be calculated are complex and are subject to int erpretation and adjustment. The Company estimates the allowance for contractual discounts on a payor-specific basis given its interpretation of the applicable regulations or contract terms. These interpretations sometimes result in payments that differ fro m the Company’s estimates. Additionally, updated regulations and contract renegotiations occur frequently, necessitating regular review and assessment of the estimation process by management. Changes in estimates related to the allowance for contractual di scounts affect revenues reported in the Company’s accompanying consolidated statements of operations.

Cost report settlements under reimbursement agreements with Medicare, Medicaid and Tricare are estimated and recorded in the period the related services are rendered and are adjusted in future periods as final settlements are determined. There is a reasonable possibility that recorded estimates will change by a material amount in the near term. The estimated net cost report settlements due to the Company were $2,112,000 and $500,000 as of March 31, 2016 and December 31, 2015 respectively, and are included in prepaid and other current assets in the accompanying consolidated balance sheets. We increased our cost report estimate by $1,612,000 during the three months ended March 31, 2016 based on settlements from our final filed cost report for 2014 and an estimate of the 2015 cost report.  The Company’s management believes that adequate provisions have been made for adjustments that may result from final determination of amounts earned under these programs.

Laws and regulations governing Medicare and Medicaid programs are complex and subject to interpretation. The Company believes that it is in compliance with all applicable laws and regulations and is not aware of any pending or threatened investigations involving allegations of potential wrongdoing that would have a material effect on the Company’s financial statements. Compliance with such laws and regulations can be subject to future government review and interpretation as well as significant regulatory action including fines, penalties and exclusion from the Medicare and Medicaid programs.

Provision and Allowance for Doubtful Accounts – To provide for accounts receivable that could become uncollectible in the future, the Company establishes an allowance for doubtful accounts to reduce the carrying value of such receivables to their estimated net realizable value. The primary uncertainty lies with uninsured patient receivables and deductibles, co-payments or other amounts due from individual patients.

The Company has an established process to determine the adequacy of the allowance for doubtful accounts that relies on a number of analytical tools and benchmarks to arrive at a reasonable allowance. No single statistic or measurement determines the adequacy of the allowance for doubtful accounts. Some of the analytical tools that the Company utilizes include, but are not limited to, the aging of accounts receivable, historical cash collection experience, revenue trends by payor classification, revenue days in accounts receivable, the status of claims submitted to third party payors, reason codes for declined claims and an assessment of the Company’s ability to address the issue and resubmit the claim and whether a patient is on a payment plan and making payments consistent with that plan. Accounts receivable are written off after collection efforts have been followed in accordance with the Company’s policies.

Due to the nature of the healthcare industry and the reimbursement environment in which the Company operates, certain estimates are required to record net revenues and accounts receivable at their net realizable values at the time products or services are provided. Inherent in these estimates is the risk that they will have to be revised or updated as additional information becomes available, which could have a material impact on the Company’s operating results and cash flows in subsequent periods. Specifically, the complexity of many third-party billing arrangements and the uncertainty of reimbursement amounts for certain services from certain payors may result in adjustments to amounts originally recorded.

The patient and their third party insurance provider typically share in the payment for the Company’s products and services. The amount patients are responsible for includes co-payments, deductibles, and amounts not covered due to the provider being out-of-network. Due to uncertainties surrounding deductible levels and the number of out-of-network patients, the Company is not certain of the full amount of patient responsibility at the time of service. The Company estimates amounts due from patients prior to service and generally collects those amounts prior to service. Remaining amounts due from patients are then billed following completion of service.

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The activity in the allowance for doubtful accounts for the three months ending March 31, 2016 follows :

Cash and cash equivalents – The Company considers all highly liquid temporary cash investments with an original maturity of three months or less to be cash equivalents. Certificates of deposit with original maturities of more than three months are also considered cash equivalents if there are no restrictions on withdrawing funds from the account.

Restricted Cash – As of March 31, 2016 and December 31, 2015, the Company had restricted cash of approximately $0.1 million and $0.2 million respectively, included in cash in the accompanying consolidated balance sheets.  The restricted cash is pledged as collateral against certain debt of the Company.

Goodwill and Intangible Assets – The Company evaluates goodwill for impairment at least on an annual basis and more frequently if certain indicators are encountered. Goodwill is to be tested at the reporting unit level, defined as an ASC or hospital (referred to as a component), with the fair value of the reporting unit being compared to its carrying amount, including goodwill. If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is not considered to be impaired. The Company will complete its annual impairment test in December 2016.

Intangible assets other than goodwill which include physician membership interests, service contracts and covenants not to compete are amortized over their estimated useful lives using the straight line method. The remaining lives range from two to twenty years. The Company evaluates the recoverability of identifiable intangible asset whenever events or changes in circumstances indicate that an intangible asset’s carrying amount may not be recoverable.

Net income (loss) per share – Basic net income (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding for the period. Diluted income (loss) per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted during the period. Dilutive securities having an anti-dilutive effect on diluted loss per share are excluded from the calculation.

Recently Adopted and Recently Issued Accounting Guidance

Adopted Guidance

In January 2015, the FASB issued changes to the presentation of extraordinary items. Such items are defined as transactions or events that are both unusual in nature and infrequent in occurrence, and, currently, are required to be presented separately in an entity’s income statement, net of income tax, after income from continuing operations. The changes eliminate the concept of an extraordinary item and, therefore, the presentation of such items will no longer be required. Notwithstanding this change, an entity will still be required to present and disclose a transaction or event that is both unusual in nature and infrequent in occurrence in the notes to the financial statements. The Company adopted these changes on January 1, 2016. The adoption of these changes had no impact on the Company’s consolidated financial statements.

In February 2015, the FASB issued changes to the analysis that an entity must perform to determine whether it should consolidate certain types of legal entities. These changes (i) modify the evaluation of whether limited partnerships and similar legal entities are variable interest entities or voting interest entities, (ii) eliminate the presumption that a general partner should consolidate a limited partnership, (iii) affect the consolidation analysis of reporting entities that are involved with variable interest entities, particularly those that have fee arrangements and related party relationships, and (iv) provide a scope exception from consolidation guidance for reporting entities with interests in legal entities that are required to comply with or operate in accordance with requirements that are similar to those in Rule 2a-7 of the Investment Company Act of 1940 for registered money market funds. The Company adopted these changes on January 1, 2016. The adoption of these changes had no impact on the Company’s consolidated financial statements.

In April 2015, the FASB issued changes to the presentation of debt issuance costs.  Currently, such costs are required to be presented as a noncurrent asset in an entity’s balance sheet and amortized into interest expense over the term of the related debt

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instrument.  The changes require that debt issuance costs be presented in an entity’s balance sheet as a direct deduction from the carrying value of the related debt liability.  The amortization of debt issuance costs remains unchanged.  The Company adopted the se changes on January 1, 2016.   T he adoption of these changes result ed in a decrease of approximately $ 612 ,000 , to other assets and lon g-term debt, net of current portion , respectively, debt included in the accompanying consolidated balance sheet.

In August 2014, the FASB issued changes to the disclosure of uncertainties about an entity’s ability to continue as a going concern. Under GAAP, continuation of a reporting entity as a going concern is presumed as the basis for preparing financial statements unless and until the entity’s liquidation becomes imminent. Even if an entity’s liquidation is not imminent, there may be conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern. Because there is no guidance in GAAP about management’s responsibility to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern or to provide related note disclosures, there is diversity in practice with respect to whether, when, and how an entity discloses the relevant conditions and events in its financial statements. As a result, these changes require an entity’s management to evaluate whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date that financial statements are issued. Substantial doubt is defined as an indication that it is probable that an entity will be unable to meet its obligations as they become due within one year after the date that financial statements are issued. If management has concluded that substantial doubt exists, then the following disclosures should be made in the financial statements: (i) principal conditions or events that raised the substantial doubt, (ii) management’s evaluation of the significance of those conditions or events in relation to the entity’s ability to meet its obligations, (iii) management’s plans that alleviated the initial substantial doubt or, if substantial doubt was not alleviated, management’s plans that are intended to at least mitigate the conditions or events that raise substantial doubt, and (iv) if the latter in (iii) is disclosed, an explicit statement that there is substantial doubt about the entity’s ability to continue as a going concern. The Company adopted these changes on January 1, 2016. The adoption of these changes had no impact on the Company’s consolidated financial statements. This guidance will need to be applied by management at the end of each annual period and interim period therein to determine what, if any, impact there will be on the consolidated financial statements in a given reporting period.

In September 2015, the FASB issued changes to the accounting for business combinations simplifying the accounting for measurement period Adjustments. The update eliminates the requirement for an acquirer to retrospectively adjust its financial statements for changes to provisional amounts that are identified during the measurement-period following the consummation of a business combination. Instead, the update requires these types of adjustments to be made during the reporting period in which they are identified and would require additional disclosure or separate presentation of the portion of the adjustment that would have been recorded in the previously reported periods as if the adjustment to the provisional amounts had been recognized as of the acquisition date. The Company adopted these changes on January 1, 2016. The adoption of these changes had no impact on the Company’s consolidated financial statements.

Issued Guidance

In July 2015, the FASB issued changes to the subsequent measurement of inventory. Currently, an entity is required to measure its inventory at the lower of cost or market, whereby market can be replacement cost, net realizable value, or net realizable value less an approximately normal profit margin. The changes require that inventory be measured at the lower of cost and net realizable value, thereby eliminating the use of the other two market methodologies. Net realizable value is defined as the estimated selling prices in the ordinary course of business less reasonably predictable costs of completion, disposal, and transportation. These changes do not apply to inventories measured using LIFO (last-in, first-out) or the retail inventory method. Currently, the Company applies the net realizable value market option to measure its inventories at the lower of cost or market. These changes become effective for the Company on January 1, 2017. Management has determined that the adoption of these changes will not have an impact on the Company’s consolidated financial statements.

In May 2014, the FASB issued changes to the recognition of revenue from contracts with customers. These changes created a comprehensive framework for all entities in all industries to apply in the determination of when to recognize revenue, and, therefore, supersede virtually all existing revenue recognition requirements and guidance. This framework is expected to result in less complex guidance in application while providing a consistent and comparable methodology for revenue recognition. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To achieve this principle, an entity should apply the following steps: (i) identify the contract(s) with a customer, (ii) identify the performance obligations in the contract(s), (iii) determine the transaction price, (iv) allocate the transaction price to the performance obligations in the contract(s), and (v) recognize revenue when, or as, the entity satisfies a performance obligation. These changes become effective for the Company on January 1, 2018. Management is currently evaluating the potential impact of these changes on the Company’s consolidated financial statements.

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In February 2016, the FASB issued changes to the accounting for leases, which requires an entity that leases assets to recognize on the balance sheet the assets and liabilities for the rights and obligations created by those leases. The update is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018 and must be adopted using a modified retrospective approach. Mana gement is currently evaluating the impact of this update on the consolidated financial statements.

In March 2016, the FASB issued changes to employee share-based payment accounting, which simplifies several aspects of the accounting for employee share-based payment transactions, including the accounting for income taxes, forfeitures, and statutory tax withholding requirements, as well as classification on the statement of cash flows. For public companies, the new guidance is effective for annual reporting periods (including interim periods within those periods) beginning after December 15, 2016, with early adoption permitted. The Company is in the process of evaluating the impact of adoption of this guidance on its financial statements.

Note 3 – Acquisition

On December 31, 2015, the Company closed the acquisition comprising substantially all of the hospital assets and hospital operating entity of University General Health Systems, Inc. (“UGHS”), consisting primarily of a sixty-nine bed acute care hospital located in the Medical City area of Houston, Texas (referred to as University General Hospital, LP or “UGH” and collectively referred to as the “Acquisition”).  Subsequent to the Acquisition, UGH is being operated as Foundation Surgical Hospital of Houston.

The acquisition of UGH was based on management’s belief that UGH fits into the Company’s acquisition and development strategy and operating model that enables the Company to grow by taking advantage of highly-fragmented markets, an increasing demand for short stay surgery and a need by physicians to forge strategic alliances to meet the needs of the evolving healthcare landscape while also shaping the clinical environments in which they practice.  The Company expects the acquisition of UGH will generate positive earnings and cash flow that will be accretive to the earnings and cash flow of the Company.  The Company expects the goodwill attributable to UGH to be tax deductible.

The Company paid $25.1 million in cash for the net assets acquired from UGHS.

The fair value amounts have been initially recorded using preliminary estimates.  The Company has engaged a third-party valuation company to complete a valuation of the fair value of the assets acquired and liabilities assumed in the acquisition.  A portion of the valuation was completed in March 2016 and management believes the valuation will be fully completed by June 30, 2016.  The preliminary estimates will be revised in future periods and the revisions may materially affect the presentation of the Company’s consolidated financial results.  Any changes to the initial estimates of the fair value of the assets and liabilities will be recorded as adjustments to those assets and liabilities and residual amounts will be allocated to goodwill.  The preliminary purchase allocations for the Acquisition are as follows:

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During the three months ended March 31, 2016, the Company incurred approximately $167,000 in expenses related to the Acquisition.  The expenses incurred related primarily to legal fees related to the purchase agreement and structure of the transaction and professional fees related to the audits of the 2015 and 2014 financial statements of UGH.

Since the Acquisition occurred on December 31, 2015, there are no acquisition revenues and earnings included in the Company’s consolidated statements of operations for the year ended December 31, 2015.  The revenue and earnings of the combined entity had the Acquisition date been January 1, 2015 are as follows:

The pro forma information is presented for informational purposes only and is not necessarily indicative of the results of operations that actually would have been achieved had the acquisition been consummated as of that time, nor is it intended to be a projection of future results.

Note 4 – Divestitures

On July 15, 2015, we sold our 10% interest in the Kirby Glen Surgery, LLC, one of our Equity Owned ASCs located in Houston, Texas.  We received $0.2 million in combined proceeds for the sale of the equity interest and termination of our management agreement.

On June 12, 2015, the Company executed an agreement pursuant to which the Company sold a portion of its 20% equity investment in Grayson County Physician Property, LLC (“GCPP”) through a series of transactions.  In conjunction with the sale, the management agreement under which the Company provided certain services including billing and collections, general management services, legal support, and accounting services was terminated.  The Company’s decision to sell the assets of GCPP was part of the Company’s strategic plan to focus on the growth of its majority owned surgical hospital businesses.  The Company received $7.8 million of proceeds as a result of the sale and $0.5 million for the termination of the management agreement.  The Company used $7.0 million of these proceeds to reduce the Company’s principal balance of the note held by the Company’s senior lender. The remainder of the proceeds will be used for working capital needs and possible future acquisitions.  See Note 5 – Discontinued Operations for additional information.

On March 31, 2015, Houston Orthopedic Surgical Hospital, L.L.C. (“HOSH”), our Equity Owned hospital in Houston, Texas, sold substantially all of its assets under an asset purchase agreement.  Given that the Company does not exhibit control with the 20% investment in HOSH, the Company accounts for the investment on a cost or cash basis.  As a result of the HOSH sale, the Company received a distribution on May 12, 2015 $1.8 million, of which $0.6 million is being held in escrow until October 2016.

Note 5 – Discontinued Operations

The partial sale of GCPP in June 2015 was part of the Company’s strategic plan to focus on majority owned investments. As a result, the proceeds from the sale, the remaining equity ownership, and the results of operations and cash flows related to the equity investment in GCPP for all periods presented have been classified as discontinued operations.  Therefore, the Company reclassified $0.1 million from equity in earnings from affiliates to income from discontinued operations, net of tax, for the three months ending March 31, 2016 and 2015, respectively.   

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T he operating results for the Company’s discontinued operations for the three month s ended March 31 , 201 6 and 201 5 are summarized below:  

The balance sheet items for the Company’s discontinued operations are summarized below:

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The results of operations for the three months ended March 31, 2016 and 201 5 , of the Company’s equity investments in Affiliates are as follows:

The results of financial position as of March 31, 2016 and December 31, 2015, of the Company’s equity investments in Affiliates are as follows:

Goodwill and intangible assets with indefinite lives must be tested for impairment at least once a year. Carrying values are compared with fair values, and when the carrying value exceeds the fair value, the carrying value of the impaired asset is reduced to its fair value. The Company tests goodwill for impairment on an annual basis in the fourth quarter or more frequently if management believes indicators of impairment exist. The performance of the test involves a two-step process. The first step of the impairment test involves comparing the fair values of the applicable reporting units with their aggregate carrying values, including goodwill. The Company generally determines the fair value of its reporting units using the income approach methodology of valuation that includes the discounted cash flow method as well as other generally accepted valuation methodologies. If the carrying amount of a reporting unit exceeds the reporting unit’s fair value, the Company performs the second step of the goodwill impairment test to determine the amount of impairment loss. The second step of the goodwill impairment test involves comparing the implied fair value of the affected reporting unit’s goodwill with the carrying value of that goodwill.

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Changes in the carrying a mount of intangible assets during the three months ended March 31, 2016 were as follows:

Intangible assets as of March 31, 2016 and December 31, 2015 include the following:

         Amortization expense for the three months ended March 31, 2016 and 2015 was $562,816 and $514,556, respectively.  

Amortization expense for the next five years related to these intangible assets is expected to be as follows:

The Company has various insurance premium financing notes payable that bear interest rates ranging from 4.8% to 5.0%.  The insurance notes mature from June 2016 to October 2016 and the Company is required to make monthly principal and interest payments totaling $134,051.

The Company’s long-term debt obligations at March 31, 2016 and December 31, 2015 are as follows:

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Texas Capital Bank Credit Facility

Effective December 31, 2015, the Company entered into a Credit Agreement (the “TCB Credit Facility”) with Texas Capital Bank, National Association (“TCB”).  The TCB Credit Facility replaced and consolidates all of the Company’s and the Company’s subsidiaries’ debt in the principal amount of $28.4 million, which is referred to as the Term Loan, and provides for an additional revolving loan in the amount of $12.5 million, which is referred to as the Revolving Loan.  The Company has also entered into a number of ancillary agreements in connection with the TCB Credit Facility, including deposit account control agreements, subsidiary guarantees, security agreements and promissory notes.

Maturity Dates.   The Term Loan matures on December 30, 2020 and the Revolving Loan matures on December 30, 2018.

Interest Rates.   Borrowings under the TCB Credit Facility are made, at the Company’s option, as either Base Rate loans or LIBOR loans.  “Base Rate” for any day is the highest of (i) the Prime Rate, (ii) the Federal Funds Rate plus one half of one percent (0.5%), and (iii) Adjusted LIBOR plus one percent (1.00%).  LIBOR loans are based on either the one month, two month or three month LIBOR rate at the Company’s option.  The interest rate is either a Base Rate or LIBOR plus the Applicable Margins based on our Senior Debt to EBITDA Ratio, as defined.

The Applicable Margins are as follows:

The Applicable Margin in effect will be adjusted within 45 days following the end of each quarter based on the Company’s Senior Debt to EBITDA ratio.  The Senior Debt to EBITDA Ratio is calculated by dividing all of our senior indebtedness (excluding capital lease obligations for Foundation Surgical Hospital of Houston), that is by the Company’s EBITDA for the preceding four fiscal quarters.  EBITDA is defined in the TCB Credit Facility as the Company’s net income plus (b) the sum of the following: interest expense; income taxes; depreciation; amortization; extraordinary losses determined in accordance with GAAP; cash and noncash stock compensation expense; and other non‑recurring expenses reducing such net income which do not represent a cash item in such period or any future period, minus (c) the sum of the following: income tax credits; extraordinary gains determined in accordance with GAAP; and all non‑recurring, non‑cash items increasing net income.

Interest and Principal Payments.   The Company is required to make quarterly payments of principal and interest on the Term Loan.  The first four quarterly payments on the Term Loan will be $1,013,393, on the first day of each April, July, October, and January during the term hereof, commencing April 1, 2016.  The Company is required to make quarterly payments on the Revolving Loan equal to the accrued and unpaid interest.  All unpaid principal and interest on the Term Loan and Revolving Loan must be paid on the respective maturity dates of each Loan.

Borrowing Base .  The Company’s ability to borrow money under the Revolving Loan is limited to the Company’s Borrowing Base.  The Company’s Borrowing Base is equal to the sum of (i) 80% of the eligible account of Foundation Surgical Hospital of San

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Antonio, no t to exceed the outstanding principal balance of the intercompany note payable by the San Antonio Hospital to the Company, (ii) 80% of the eligible account of Foundation Surgical Hospital of El Paso, not to exceed the outstanding principal balance of the i ntercompany note payable by the El Paso Hospital to the Company, and (iii) 80% of the eligible account of Foundation Surgical Hospital of Houston, not to exceed the outstanding principal balance of the intercompany note payable by the Houston Hospital to t he Company.

Mandatory Prepayments.   The Company must make mandatory prepayments of the Term Loans in the following situations, among others:

Voluntary Prepayments.   The Company may prepay amounts under the Term Loan or Revolving Loan at any time provided that the Company is required to pay a prepayment fee of 2% of the amount prepaid if payment is made prior to the first anniversary, 1.5% if the prepayment is made after the first anniversary but prior to the second anniversary and 1% if the prepayment is made after the second anniversary but prior to the third anniversary.  

Guaranties.   Each of the Company’s direct or indirect wholly-owned subsidiaries jointly and severally and unconditionally guaranty payment of the Company’s obligations owed to Lenders.

Financial Covenants:

Debt to EBITDA Ratio.   As of December 31, 2015, the Company must maintain a Debt to EBITDA Ratio, not in excess of 3.50 to 1.00.  Thereafter, the Company must maintain a Debt to EBITDA Ratio as of the last day of any fiscal quarter, not in excess of (a) 3.25 to 1.00 for the fiscal quarters ending December 31, 2015, March 31, 2016, June 30, 2016 and September 30, 2016; (b) 2.75 to 1.00 for the fiscal quarters ending December 31, 2016, March 31, 2017, June 30, 2017 and September 30, 2017; (c) 2.50 to 1.00 for the fiscal quarters ending December 31, 2017, March 31, 2018, June 30, 2018 and September 30, 2018; and (d) 2.25 to 1.00 for the fiscal quarter ending December 31, 2018 and at the end of each fiscal quarter thereafter.  As of March 31, 2016, the Company’s Debt to EBITDA Ratio was 3.12.

Senior Debt to EBITDA Ratio .  As of December 31, 2015, the Company must maintain a Senior Debt to EBITDA Ratio not in excess of 3.00 to 1.00.  Thereafter, the Company must maintain a Senior Debt to EBITDA Ratio as of the last day of any fiscal quarter, not in excess of (a) 3.00 to 1.00 for the fiscal quarters ending December 31, 2015, March 31, 2016, June 30, 2016 and September 30, 2016; (b) 2.50 to 1.00 for the fiscal quarters ending December 31, 2016, March 31, 2017, June 30, 2017 and September 30, 2017; (c) 2.25 to 1.00 for the fiscal quarters ending December 31, 2017, March 31, 2018, June 30, 2018 and September 30, 2018; and (d) 2.00 to 1.00 for the fiscal quarter ending December 31, 2018 and at the end of each fiscal quarter thereafter.  As of March 31, 2016, the Company’s Senior Debt to EBITDA Ratio was 2.69.

Pre-Distribution Fixed Charge Coverage Ratio .  The Company must maintain as of the last day of any fiscal quarter a Pre-Distribution Fixed Charge Coverage Ratio in excess of 1.30 to 1.00.  As of March 31, 2016, the Company’s Pre-Distribution Fixed Charge Coverage Ratio was 1.82.

Post-Distribution Fixed Charge Coverage Ratio.   The Company must maintain as of the last day of any fiscal quarter, a Post-Distribution Fixed Charge Coverage Ratio in excess of 1.05 to 1.00.  As of March 31, 2016, the Company’s Post-Distribution Fixed Charge Coverage Ratio was 1.30.

Capital Expenditures.   The Company shall not make capital expenditures in excess of $5,000,000 during any fiscal year.

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As of March 31, 2016, the Company is in compliance with all of the TCB Credit Facility financial covenants.

Collateral.   Payment and performance of the Company’s obligations under the TCB Credit Facility are secured in general by all of the Company and the Company’s guarantors’ assets.

Negative Covenants .  The TCB Credit Facility has restrictive covenants that, among other things, limits or restricts the Company’s ability to do the following without the consent of TCB:

Defaults and Remedies.   In addition to the general defaults of failure to perform our obligations under the Loan Agreement, events of default also include the occurrence of a change in control, as defined, and the loss of our Medicare or Medicaid certification, collateral casualties, entry of a uninsured judgment of $500,000 or more, failure of first liens on collateral and the termination of any of the Company’s management agreements that represent more than 10% of the Company’s management fees for the preceding 18 month period.  In the event of a monetary default, all of the Company’s obligations due under the TCB Credit Facility shall become immediately due and payable.  In the event of a non-monetary default, the Company has 10 days or in some cases three days to cure before Texas Capital Bank has the right to declare the Company’s obligations due under the TCB Credit Facility immediately due and payable.

At March 31, 2016, future maturities of long-term debt were as follows:

The Company’s capital lease obligations as of March 31, 2016 and December 31, 2015 are as follows:

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The Company has entered into a capital lease covering the FSH Houston hospital facility, see Note 3 - Acquisition.  The capital lease bears an interest at fixed rate of 7.5%.  The Company is required to make monthly principal and inter est payments under the capital lease totaling $193,611.

The Company has entered into various capital leases that are collateralized by certain computer and medical equipment used by the Company.  The capital leases bear interest at fixed rates ranging from 5.6% to 9.0%.  The Company is required to monthly principal and interest payments under the capital leases totaling $300,084.

At March 31, 2016, future maturities of capital lease obligations were as follows:

Note 9 – Preferred Noncontrolling Interests

During 2013, the Company’s wholly-owned subsidiary, Foundation Health Enterprises, LLC (“FHE”) completed a private placement offering of $9,135,000. The offering was comprised of 87 units (“FHE Unit” or “preferred noncontrolling interest”). Each FHE Unit was offered at $105,000 and entitled the purchaser to one (1) Class B membership interest in FHE, valued at $100,000, and 1,000 shares of the Company’s common stock, valued at $5,000. The total consideration of $9,135,000 was comprised of $8,700,000 attributable to the preferred noncontrolling interest and $435,000 attributable to the 87,000 shares of the Company’s common stock.

The FHE Units provide for a cumulative preferred annual return of 9% on the amount allocated to the Class B membership interests. The FHE Units will be redeemed by FHE in four annual installments beginning in July 2014. The FHE Unit holders agreed to defer the first installment payment until March 2015.  The first installment was paid on April 1, 2015. The first three installments shall be in the amount of $10,000 per FHE Unit and the fourth installment will be in the amount of the unreturned capital contribution and any undistributed preferred distributions. The FHE Units are convertible at the election of the holder at any time prior to the complete redemption into restricted common shares of the Company at a conversion price of $20.00 per share. Since the FHE Units have a redemption feature and a conversion feature which the Company determined to be substantive, the preferred noncontrolling interests has been recorded at the mezzanine level in the accompanying consolidated balance sheets and the corresponding dividends are recorded as a reduction of accumulated deficit.

Note 10 – Commitments and Contingencies

Legal claims – The Company is exposed to asserted and unasserted legal claims encountered in the normal course of business, including claims for damages for personal injuries, medical malpractice, breach of contracts, wrongful restriction of or interference with physicians’ staff privileges and employment related claims. In certain of these actions, plaintiffs request payment for damages, including punitive damages that may not be covered by insurance. Management believes that the ultimate resolution of these matters will not have a material adverse effect on the operating results or the financial position of the Company. There were no settlement expenses during the three months ended March 31, 2016 and 2015 related to the Company’s ongoing unasserted legal claims.

Self-insurance – Effective January 1, 2014, the Company began using a combination of insurance and self-insurance for employee-related healthcare benefits. The self-insurance liability is determined actuarially, based on the actual claims filed and an estimate of incurred but not reported claims. Self-insurance reserves as of March 31, 2016 and December 31, 2015 were $567,197 and $424,593, respectively, and are included in accrued liabilities in the accompanying consolidated balance sheets.

Note 11 – Fair Value Measurements

Fair value is the price that would be received from the sale of an asset or paid to transfer a liability (i.e., an exit price) in the principal or most advantageous market in an orderly transaction between market participants. In determining fair value, the accounting standards established a three-level hierarchy that distinguishes between (i) market data obtained or developed from independent sources (i.e., observable data inputs) and (ii) a reporting entity’s own data and assumptions that market participants would use in

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pricing an asset or liability (i.e., unobservable data inputs). Financial assets and financial liabilities measured and reported at fair value are classified in one of the following categories, in order of priority of observability and objectivity of pricing inputs:

The fair value measurement level for an asset or liability is based on the lowest level of any input that is significant to the fair value measurement. Valuation techniques should maximize the use of observable inputs and minimize the use of unobservable inputs.

Recurring Fair Value Measurements: The carrying value of the Company’s financial assets and financial liabilities is their cost, which may differ from fair value. The carrying value of cash held as demand deposits, money market and certificates of deposit, accounts receivable, short-term borrowings, accounts payable and accrued liabilities approximated their fair value. At March 31, 2016, the fair value of the Company’s long-term debt, including the current portion was determined to be approximately equal to its carrying value.

Nonrecurring Fair Value Measurements: During 2015, the Company completed the University General Hospital, LP acquisition; see Note 3 – Acquisition for additional information.  The assets acquired and liabilities assumed in the acquisition were recorded at their fair values on the date of the acquisition.  For the acquisition, the nonrecurring fair value measurements were developed using significant unobservable inputs (Level 3) using discounted cash flow calculations based upon the Company’s weighted average cost of capital and third-party valuation services.  Assumptions used were similar to those that would be used by market participants performing valuations of these business units and were based on analysis of current and expected future economic conditions and the updated strategic plan for each business unit.  The assets acquired were valued at $59,808,000 and the liabilities assumed were $34,708,000.  

Note 12 – Related Party Transactions

Effective June 1, 2014, the Company’s hospital subsidiary located in El Paso, Texas entered into a sublease agreement with The New Sleep Lab International, Ltd., referred to as New Sleep. New Sleep is controlled by Dr. Robert Moreno, one of our Directors. The sublease with New Sleep calls for monthly rent payments of $8,767 and the sublease expires on November 30, 2018. The space subleased from New Sleep will be sublet to physician partners and casual uses of our hospital and is located in a building that also houses one of our imaging facilities. During the three months ended March 31, 2016, the Company incurred approximately $23,600 in lease expense under the terms of the lease.

As of March 31, 2016, the Company had $0.1 million on deposit at Valliance Bank. Valliance Bank is controlled by Mr. Roy T. Oliver, one of our greater than 5% shareholders. A noncontrolling interest in Valliance Bank is held by Mr. Joseph Harroz, Jr., a director of the Company. Mr. Stanton Nelson, the Company’s Chief Executive Officer and Mr. Harroz also serve as directors of Valliance Bank.

The Company has entered into agreements with certain of its Affiliate ASCs and hospitals to provide management services. As compensation for these services, the surgery centers and hospitals are charged management fees which are either fixed or are based on a percentage of the Affiliates cash collected or the Affiliates net revenue. The percentages range from 2.25% to 6.0%.