Notes to Financial Statements (unaudited)
Note A - BASIS OF PRESENTATION
Health Discovery Corporation
(the “Company”) is a biotechnology-oriented company that has acquired patents and has patent pending applications for
certain machine learning tools, primarily pattern recognition techniques using advanced mathematical algorithms to analyze large
amounts of data thereby uncovering patterns that might otherwise be undetectable. Such machine learning tools are currently
in use for diagnostics and drug discovery, but are also marketed for other applications. The Company licenses the use
of its patent protected technology and may provide services to develop specific learning tools under development agreements or
to sell to third parties.
The accounting principles
followed by the Company and the methods of applying these principles conform with accounting principles generally accepted in the
United States of America (GAAP). In preparing financial statements in conformity with GAAP, management is required to make estimates
and assumptions that affect the reported amounts in the financial statements. Actual results could differ significantly from those
estimates.
The interim financial
statements included in this report are unaudited but reflect all adjustments which, in the opinion of management, are necessary
for a fair presentation of the financial position and results of operations for the interim periods presented. All such adjustments
are of a normal recurring nature. The results of operations for the three month period ended March 31, 2016 are not necessarily
indicative of the results of a full year’s operations and should be read in conjunction with the financial statements and
footnotes included in the Company’s annual report on Form 10-K for the year ended December 31, 2015.
Note B – REVENUE RECOGNITION
Revenue is generated
through the sale or license of patented technology and processes and from services provided through development agreements. These
arrangements are generally governed by contracts that dictate responsibilities and payment terms. The Company recognizes
revenues as they are earned over the duration of a license agreement or upon the sale of any owned patent once all contractual
obligations have been fulfilled. If a license agreement has an undetermined or unlimited life, the revenue is recognized
over the remaining expected life of the patents. Revenue is recognized under development agreements in the period the services
are performed.
The Company treats
the incremental direct cost of revenue arrangements, which consists principally of employee bonuses, as deferred charges and these
incremental direct costs are amortized to expense using the straight-line method over the same term as the related deferred revenue
recognition.
Deferred revenue represents
the unearned portion of payments received in advance for licensing and development agreements. The Company had total unearned revenue
of $137,393 as of March 31, 2016. Unearned revenue of $43,388 is recorded as current and $94,005 is classified as long-term.
Note C - NET LOSS PER SHARE
Basic Earnings
Per Share (“EPS”) includes no dilution and is computed by dividing income or loss available to common
stockholders by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential
dilution of securities that could share in the earnings or losses of the entity. Due to the net loss in all periods
presented, potentially dilutive shares are not included in the calculation of diluted EPS as those shares would create an
anti-dilutive result.
Note D - STOCK-BASED COMPENSATION
and
other EQUITY BASED PAYMENTS
Stock-based expense
included in our net loss for the three months ended March 31, 2016 consisted of $21,642 for stock options granted to employees,
directors, and consultants. Stock-based expense included in our net loss for the three months ended March 31, 2015 was $17,071
for stock options granted to directors, officers and consultants.
As of March 31, 2016,
there was $139,971 of unrecognized cost related to stock option grants. The cost is to be recognized over the remaining
vesting periods that average approximately 1.5 years.
HEALTH DISCOVERY CORPORATION
Notes to Financial Statements (unaudited), continued
Note D - STOCK-BASED COMPENSATION
and
other EQUITY BASED PAYMENTS,
continued
On February 8, 2016,
the Company granted options to purchase 5,000,000 shares of the Company’s common stock to a group of employees and consultants
in recognition of their efforts to lower the Company’s monthly expenditures and compensation and their continuing contributions
to the Company. The options vest over a two-year period, have an exercise price of $.03, and expire on February 8, 2026. Within
the group of 5,000,000 options, the Company’s Vice President, Mark A. Moore, Ph.D., received an option to purchase 500,000
shares of the Company’s common stock and the Company’s Senior Vice President, Hong Zhang, Ph.D., received an option
to purchase 1,250,000 shares of the Company’s common stock. The fair value of each option granted is $0.0219 and was estimated
on the date of grant using the Black-Scholes pricing model with the following assumptions: dividend yield at 0%, risk-free interest
rate of 1.99%, an expected life of 5 years, and volatility of 96%. The aggregate computed value of these options is $109,271,
and this amount will be charged as an expense over the two-year vesting period. Because these options exceed the amount
of common shares available if the holders exercise the previously issued outstanding options and warrants, the Company will need
to increase the authorized shares of common stock in order to satisfy these options.
In the fourth quarter
of 2013, the Board of Directors authorized the issuance of Series C Preferred Shares in private placement transactions. As of
December 31, 2015, the Company had issued a total of 30,000,000 preferred shares. The Series C Preferred Shares were fully subscribed
in the third quarter 2015. The Series C Preferred Shares are accompanied by $0.03 warrants and $0.03 contingency warrants. The
contingency warrants were issued during the three months ended March 31, 2016 as a result of the Company not attaining
profitability by the end of the first quarter 2016. Because these contingency warrants exceed the amount of common shares available
if the holders exercise the previously issued outstanding options and warrants, the Company will need to increase the authorized
shares of common stock in order to satisfy these options. Furthermore, the Company has recorded an increase in the common stock
warrants liability during the first quarter of 2016. The fair value of each warrant granted is $0.0219 and was estimated on
the date of grant using the Black-Scholes pricing model with the following assumptions: dividend yield at 0%, risk-free interest
rate of 1.67%, an expected life of 5 years, and volatility of 96%. The aggregate computed value of these warrants is $656,380.
During the third quarter
of 2015, the Board of Directors authorized the issuance of Common Stock in a private placement of 7,000,000 Common Shares with
certain warrant features. As of March 31, 2016, 7,000,000 shares of this offering were sold. During the three month period
ended March 31, 2016, the Company sold 3,000,000 of these shares and received $90,000 in proceeds. The Common Shares are accompanied
by $0.03 warrants and $0.06 contingency warrants. The contingency warrants were issued during the three months ended March
31, 2016 as a result of the Company not attaining profitability by the end of the first quarter 2016. Because these warrants
exceed the amount of common shares available if the holders exercise the previously issued outstanding options and warrants, the
Company will need to increase the authorized shares of common stock in order to satisfy these options. Furthermore, the Company
has recorded an increase in the common stock warrants liability during the first quarter of 2016. The fair value of each warrant
granted is $0.0219 and was estimated on the date of grant using the Black-Scholes pricing model with the following assumptions:
dividend yield at 0%, risk-free interest rate of 1.67%, an expected life of 5 years, and volatility of 96%. The aggregate computed
value of these warrants is $284,432.
As of March 31, 2016,
there were 91,750,000 option and warrant shares outstanding with a weighted average exercise price of $0.032.
The following schedule
summarizes combined stock option and warrant information as of March 31, 2016:
Exercise Prices
|
|
Number
Outstanding
|
|
|
Weighted-
Average
Remaining
Contractual
Life (years)
|
|
Number
Exercisable
|
|
|
Weighted
Average
Remaining
Contractual Life
(years) of
Exercisable
Options
and
Warrants
|
$0.027
|
|
|
3,000,000
|
|
|
7.25
|
|
|
2,500,000
|
|
|
7.25
|
$0.030
|
|
|
72,000,000
|
|
|
9.75
|
|
|
67,000,000
|
|
|
9.75
|
$0.036
|
|
|
7,750,000
|
|
|
7.50
|
|
|
5,916,668
|
|
|
7.50
|
$0.040
|
|
|
1,000,000
|
|
|
1.75
|
|
|
1,000,000
|
|
|
1.75
|
$0.050
|
|
|
1,000,000
|
|
|
1.75
|
|
|
1,000,000
|
|
|
1.75
|
$0.060
|
|
|
7,000,000
|
|
|
10.00
|
|
|
7,000,000
|
|
|
10.00
|
Total
|
|
|
91,750,000
|
|
|
|
|
|
84,416,668
|
|
|
|
The weighted average
remaining life of all outstanding warrants and options at March 31, 2016 are 9.75 years. The aggregate intrinsic value of all options
and warrants outstanding and exercisable as of March 31, 2016 was $7,500, based on the market closing price of $0.03 on March 31,
2016, less exercise prices.
HEALTH DISCOVERY CORPORATION
Notes to Financial Statements (unaudited), continued
Note E - PATENTS
The Company has acquired
and developed a group of patents related to biotechnology and certain machine learning tools used for diagnostic and drug discovery.
Legal costs associated with patent acquisitions
and the application processes for new patents are capitalized as patent
assets. The Company has recorded as other assets $875,386 in patents and patent related costs, net of $3,110,408 in accumulated
amortization, at March 31, 2016.
Amortization charged
to operations for the three months ended March 31, 2016 and 2015 was $65,680 in both years. Estimated amortization expense for
the next three years is $262,720 per year. Estimated amortization expense for the fourth year is $152,906 and no amortization
expense for the fifth year.
Note F – STOCKHOLDERS’ EQUITY
Series C Preferred Stock
In the fourth quarter
of 2013, the Board of Directors authorized the issuance of Series C Preferred Shares in private placement transactions. As of
December 31, 2015, the Company had issued a total of 30,000,000 preferred shares. The Series C Preferred Shares were fully subscribed
in the third quarter of 2015. The Series C Preferred Shares are accompanied by $0.03 warrants and $0.03 contingency warrants.
The contingency warrants were issued during the three month period ended March 31, 2016 as a result of the Company not attaining
profitability by the end of the first quarter 2016. The holders must exercise fifty percent of the warrants if the market price
for the Company’s common stock is $0.20 for a period of thirty consecutive calendar days. The holders must also
exercise fifty percent of the warrants if the market price for the Company’s common stock is $0.30 for a period
of thirty consecutive calendar days. The fair value of each warrant granted is $0.0219 and was estimated on the date
of grant using the Black-Scholes pricing model with the following assumptions: dividend yield at 0%, risk-free interest rate of
1.67%, an expected life of 5 years, and volatility of 96%. The aggregate computed value of these warrants is $656,380.
The Series C Preferred
Stock has not been registered under either federal or state securities laws and must be held until a registration statement covering
such securities is declared effective by the Securities and Exchange Commission or an applicable exemption applies.
Each share
of Series C Preferred Stock may be converted into one share of Common Stock of the Company at the option of the holder,
without the payment of additional consideration by the holder, so long as the Company has a sufficient number of authorized
shares to allow for the exercise of all of its outstanding warrants and options. The Shares of Series C Preferred Stock must
be converted into Common Stock of the Company either by the demand by the shareholder or at the fifth anniversary of the date
of issuance. If the Company were to be dissolved, the Series C Preferred Stock receives preferential treatment over
Common Stock.
During the third quarter
of 2015, the Board of Directors authorized the issuance of Common Stock in a private placement of 7,000,000 Common Shares with
certain warrant features. As of March 31, 2016, 7,000,000 shares of this offering have been sold. The Common Shares are accompanied
by $0.03 warrants and $0.06 contingency warrants. The contingency warrants were issued during the three month period ended March
31, 2016 as a result of the Company not attaining profitability by the end of the first quarter 2016. The holders must exercise
fifty percent of the warrants if the market price for the Company’s common stock is $0.20 for a period of thirty consecutive
calendar days. The holders must also exercise fifty percent of the warrants if the market price for the Company’s
common stock is $0.30 for a period of thirty consecutive calendar days. The fair value of each warrant granted is $0.0219
and was estimated on the date of grant using the Black-Scholes pricing model with the following assumptions: dividend yield at
0%, risk-free interest rate of 1.67%, an expected life of 5 years, and volatility of 96%.
Due to the warrant
features that accompany the sale of the Company’s preferred and common shares, if all outstanding options and warrants were
exercised, the Company would not have sufficient shares of common stock to meet the exercised options. The aggregate intrinsic
value of all options and warrants outstanding and exercisable as of March 31, 2016 was $7,500, based on the market closing price
of $0.03 on March 31, 2016, less exercise prices. The Company will need to increase the authorized shares of common stock in order
to satisfy the options and warrants if the holders exercise the outstanding options and warrants.
HEALTH DISCOVERY CORPORATION
Notes to Financial Statements (unaudited),
continued
Note G – INVESTMENT IN AVAILABLE FOR SALE SECURITIES
The Company has elected
the fair value option in accordance with ASC 825,
Financial Instruments,
as it relates to its shares held in NeoGenomics’
common stock that were acquired resulting from the NeoGenomics Master License Agreement executed on January 6, 2012. Management
made the election for the fair value option related to this investment because it believes the fair value option for the NeoGenomics
common stock provides a better measurement from which to compare financial statements from reporting period to reporting period.
No other financial assets or liabilities are fair valued using the fair value option.
The Company’s
investment in NeoGenomics’ common stock is recorded on the accompanying balance sheets under the caption Investment in Available
for Sale Securities. The carrying value of this investment on the date of acquisition approximated $1,945,000. The change in fair
value from December 31, 2015 to March 31, 2016 is an unrecognized loss of $20,544 for the remaining 18,000 shares held and
is classified as other expense under the caption Unrealized Loss on Available for Sale Securities in the accompanying statements
of operations. There are three levels of investments in the fair value hierarchy that assesses a company’s assets based on the
degree of certainty around the asset’s underlying value. A Level 1 asset can be valued with certainty because they are
liquid and have clear market prices. At the other end of the spectrum, Level 3 assets are illiquid and estimating their value
requires inputs that are unobservable and reflect significant management assumptions. The Company classifies its investment
as an available for sale security presented as a trading security on the balance sheets and the fair value is considered
a Level 1 investment in the fair value hierarchy. The March 31, 2016 fair value of the investment of $121,434 is for the remaining
shares held and is calculated using the closing stock price of the NeoGenomics common stock at the end of the reporting period.
As of March 31, 2016
and December 31, 2015, the Company held 18,000 shares of NeoGenomics stock. The initial 1,360,000 shares were acquired in January
2012 as a result of the NeoGenomics Master License Agreement.
Note H – COMMITMENTS AND CONTINGENCIES
The Company is subject
to various claims primarily arising in the normal course of business. Although the outcome of these matters cannot be
determined, the Company does not believe it is probable that any such claims will result in material costs and expenses.
Note I – FINANCIAL CONDITION
AND GOING CONCERN
The Company has prepared
its financial statements on a “going concern” basis, which presumes that it will be able to realize our assets and
discharge our liabilities in the normal course of business for the foreseeable future.
The Company’s
ability to continue as a going concern is dependent upon our licensing arrangements with third parties, achieving profitable operations,
obtaining additional financing and successfully bringing the Company’s technologies to the market. The outcome of these
matters cannot be predicted at this time. The Company’s financial statements have been prepared on a going concern
basis and do not include any adjustments to the amounts and classifications of the assets and liabilities that might be necessary
should the Company be unable to continue in business.
If the going concern
assumption was not appropriate for the Company’s financial statements then adjustments would be necessary in the carrying
value of assets and liabilities, the reported expenses and the balance sheet classifications used. Such adjustments may be
material.
At March 31, 2016, the Company had $406,455 cash on hand along with its investment in NeoGenomics stock classified as available for sale
securities worth $121,434. As a result, the Company estimates cash will be depleted by the end of 2016 if the Company does not
generate sufficient cash to support operations.
HEALTH DISCOVERY CORPORATION
Notes to Financial Statements (unaudited),
continued
Note I – FINANCIAL CONDITION
AND GOING CONCERN, continued
The Company’s
plan to have sufficient cash to support operations is comprised of generating revenue through its relationship with NeoGenomics,
providing services related to those patents, selling its NeoGenomics stock, and obtaining additional equity or debt financing.
Specifically, the Company expects to begin receiving revenue by the end of 2016 from commercialization of the flow cytometry
service and prostate tests developed as a part of the NeoGenomics relationship.
As a result, the Company
focused its efforts to secure funds via licensing activity or other forms of fund raising either in the debt or equity markets. In
addition, prior to the beginning of this year, the Company began raising capital through the Series C Preferred Stock offering.
The Series C Preferred Stock offering was fully subscribed and completed in August 2015. As a result, the Company received $568,000
in 2015 in addition to the $332,000 received in prior years for a total of $900,000.
During the third
quarter of 2015, the Board of Directors authorized the issuance of Common Stock in a private placement of 7,000,000 Common Shares
with certain warrant features. As of March 31, 2016, 7,000,000 shares of this offering were sold. During the three month period
ended March 31, 2016, the Company sold 3,000,000 of these shares and received $90,000 in proceeds.
The Company believes
the funds received from the Series C Preferred Stock offering and private placement, along with disciplined expense management,
will allow the Company to maintain operations until the end of 2016. While the Company believes these efforts will create a profitable
future, there is no guarantee the Company will be successful in these efforts.
Note J – RECENT ACCOUNTING PRONOUNCEMENTS
In February 2016,
the Financial Accounting Standards Board (“FASB”) issued Accounting Standards (“ASU”)
2016-02, Leases. This standard update was issued to increase transparency and comparability among organizations by
recognizing lease assets and lease liabilities, including for operating leases, on the balance sheet and disclosing key information
about leasing arrangements. ASU 2016-02 is effective for fiscal years, and interim periods within those fiscal years, beginning
after December 15, 2018. The Company is currently evaluating the impact that adopting ASU 2016-02 will have on its financial statements.
In November 2015, the FASB issued ASU No. 2015-17, Balance Sheet Classification of Deferred Taxes. This standard
update provides guidance for balance sheet classification of deferred taxes. This standard requires that deferred tax assets and
liabilities be classified as non-current on the balance sheet, and eliminates the prior guidance which required an entity to separate
deferred tax liabilities and assets into a current amount and a noncurrent amount on the balance sheet. ASU 2015-17 is effective
for fiscal years, and interim periods within those years, beginning after December 15, 2016. Earlier application is permitted
as of the beginning of an interim or annual period. The Company is currently evaluating the impact that adopting ASU
2015-17 will have on its financial statements.
Note K – ACCOUNTING POLICIES
Patents
Initial costs paid
to purchase patents are capitalized and amortized using the straight line method over the remaining life of the patent. The Company
capitalizes the external costs and filing fees associated with obtaining patents on its new discoveries and amortizes these costs
using the straight-line method over the shorter of the legal life of the patent or its economic life, generally 17 years, beginning
on the date the patent is issued. Annual patent maintenance costs and annual license and renewal registration fees are expensed
as period costs. If the applied for patents are abandoned or are not issued, the Company will expense the costs capitalized to
date in the period of abandonment or earlier if abandonment appears probable. The carrying value of patents is reviewed
for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. As of March
31, 2016, the Company does not believe there has been any impairment of its patents.
HEALTH DISCOVERY CORPORATION
Notes to Financial Statements (unaudited),
continued
Note K – ACCOUNTING POLICIES
,
continued
Stock-based Compensation
Stock-based compensation
cost is measured at grant date, based on the fair value of the award, and is recognized as expense over the requisite service
period.
Valuation and
Amortization Method
– The fair value awards of stock that do not contain a market condition target are estimated on
the grant date using the Black-Scholes option-pricing model. The fair value of options that contain a market condition, such as
a specified hurdle price, is estimated on the grant date using a probability weighted fair value model similar to a lattice valuation
model. Both the Black-Scholes and the probability weighted valuation models require assumptions and estimates of expected
volatility, expected life, expected dividend yield and expected risk-free interest rates.
Expected Term
– The expected term of the award represents the period that the Company’s stock-based awards are expected to be
outstanding and was determined based on historical experience, giving consideration to the contractual terms of the stock-based
awards, vesting schedules, and forfeitures due to departure prior to the end of the vesting schedule.
Expected Volatility
–
Volatility is a measure of the amounts by which a financial variable such as stock price has fluctuated (historical
volatility) or is expected to fluctuate (expected volatility) during a period. The Company uses the historical volatility, employing
a prior period equivalent to the expected term to estimate expected volatility.
Risk-Free Interest
Rate
– The Company bases the risk-free interest rate used in the Black-Scholes valuation method on the implied yield
currently available on U.S. Treasury zero-coupon issues with a remaining term equivalent to the expected term of a stock
award.
Note L – SUBSEQUENT
EVENTS
On May 17, 2016, the
Company held its Annual Shareholder’s Meeting. One of the proposals presented by the Company in its proxy statement was
an approval to amend the Company’s Articles of Incorporation to increase the number of authorized shares of common stock
from 300,000,000 to 450,000,000. This proposal received a majority of votes.
In connection with
their election to the Board of Directors, on May 17, 2016, the Company granted to Mr. Henry Kaplan, Mr. Kevin Kowbel, Mr. George
McGovern, and Mr. William Quirk each an option to purchase 1,500,000 shares of the Company’s common stock. As a result, the
options for Messrs. Kaplan, Kowbel, McGovern and Quirk vest 250,000 shares every six months, have an exercise price of $0.035,
and expire on May 17, 2026. The fair value of each option granted is $0.0265 and was estimated on the date of grant using the Black-Scholes
pricing model with the following assumptions: dividend yield at 0%, risk-free interest rate of 1.89%, an expected life of 5 years,
and volatility of 102%. The aggregate computed value of these options is $159,038, and this amount will be charged as an expense
over the three-year vesting period.
Additionally, in recognition
of his leadership as Chairman of the Board of Directors and CEO, on May 17, 2016, the Company granted to Mr. Kevin Kowbel an option
to purchase 3,000,000 shares of the Company’s common stock. As a result, the options for Mr. Kowbel vest immediately, have
an exercise price of $0.035, and expire on May 17, 2026. The fair value of each option granted is $0.0265 and was estimated on
the date of grant using the Black-Scholes pricing model with the following assumptions: dividend yield at 0%, risk-free interest
rate of 1.89%, an expected life of 5 years, and volatility of 102%. The aggregate computed value of these options is $79,519, and
this amount will be charged as an expense during the second quarter of 2016.
HEALTH DISCOVERY
CORPORATION