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 nine month period ended September 30, 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 $115,700 as of September 30, 2016. Unearned revenue of $43,388 is recorded as current and $72,312 is classified as long-term.
Note C - NET (LOSS) INCOME 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 compensation
expense included in our net loss for the three months and nine months ended September 30, 2016 was $35,163 and $175,931,
respectively, for stock options granted to employees, directors, and consultants. Stock-based compensation expense included in
our net loss for the three months and nine months ended September 30, 2015 was $17,071 and $51,212, respectively.
As of September 30,
2016, there was $192,993 of unrecognized cost related to stock option grants. The cost is to be recognized over the
remaining vesting periods that average approximately 2.25 years.
HEALTH DISCOVERY CORPORATION
Notes to Financial Statements (unaudited), continued
Note D - STOCK-BASED COMPENSATION
and
other EQUITY BASED PAYMENTS,
continued
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. 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 fair value of these options is $158,756, 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. 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 fair value of these options is $79,519, and this amount
was charged as an expense during the second quarter of 2016.
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 fair value of these options is
$109,271, and this amount will be charged as an expense over the two-year vesting period. Because at the time of issuance, these
options exceeded the amount of common shares available if the holders exercised the previously issued outstanding options
and warrants, the Company needed to increase the authorized shares of common stock in order to satisfy these options. The shareholders
of the Company approved this increase in authorized shares on May 17, 2016.
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 at the time of issuance, these warrants exceeded the amount of common shares
available if the holders exercised the previously issued outstanding options and warrants, the Company needed to increase the
authorized shares of common stock in order to satisfy these options. The shareholders of the Company approved this increase in
authorized shares on May 17, 2016. The fair value of each warrant granted was $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%.
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 and six month periods
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 at the time of issuance,
these warrants exceeded the amount of common shares available if the holders exercised the previously issued outstanding options
and warrants, the Company needed to increase the authorized shares of common stock in order to satisfy these options. The shareholders
of the Company approved this increase in authorized shares on May 17, 2016. The fair value of each warrant granted was
$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%.
HEALTH DISCOVERY CORPORATION
Notes to Financial Statements (unaudited)
, continued
Note D - STOCK-BASED COMPENSATION
and
other EQUITY BASED PAYMENTS,
continued
Furthermore, as a result
of the Company issuing options and warrants which exceeded the amount of common shares available if the holders exercised the previously
issued outstanding options and warrants, the Company recorded an increase in the common stock warrants liability during the first
quarter of 2016 of $940,812 and $255,800 during the second quarter of 2016.
As previously disclosed
above, the Company had issued options and warrants which exceeded the amount of common shares available if the holders exercised
all of the previously issued outstanding options and warrants. This created a common stock warrant liability for the Company.
During the first quarter, based upon the trading price of the Company’s common stock, this liability increased by
$940,812 and during the second quarter of 2016 increased by $1,196,612. At the Annual Shareholder Meeting of the Company
held on May 17, 2016, the shareholders approved an increase to the authorized shares of common and preferred stock. As a result,
the Company has enough common stock available if the holders exercised all of the previously issued outstanding options and warrants.
This resulted in there no longer being a common stock warrant liability for the Company. With the reduction in the common
stock warrant liability, the Company increased the common stock value within the balance sheet.
As of September 30,
2016, there were 100,750,000 option and warrant shares outstanding with a weighted average exercise price of $0.033. The following
schedule summarizes combined stock option and warrant information as of September 30, 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
|
|
|
|
6.75
|
|
|
|
3,000,000
|
|
|
|
6.75
|
|
$0.030
|
|
|
72,000,000
|
|
|
|
9.25
|
|
|
|
68,250,000
|
|
|
|
9.25
|
|
$0.035
|
|
|
9,000,000
|
|
|
|
9.75
|
|
|
|
3,000,000
|
|
|
|
9.75
|
|
$0.036
|
|
|
7,750,000
|
|
|
|
7.00
|
|
|
|
6,833,335
|
|
|
|
7.00
|
|
$0.040
|
|
|
1,000,000
|
|
|
|
1.25
|
|
|
|
1,000,000
|
|
|
|
1.25
|
|
$0.050
|
|
|
1,000,000
|
|
|
|
1.25
|
|
|
|
1,000,000
|
|
|
|
1.25
|
|
$0.060
|
|
|
7,000,000
|
|
|
|
9.50
|
|
|
|
7,000,000
|
|
|
|
9.50
|
|
Total
|
|
|
100,750,000
|
|
|
|
|
|
|
|
90,083,335
|
|
|
|
|
|
The weighted average
remaining life of all outstanding warrants and options at September 30, 2016 are 9.35 years. The aggregate intrinsic value
of all options and warrants outstanding and exercisable as of September 30, 2016 was $392,400, based on the market closing
price of $0.0351 on September 30, 2016, less exercise prices.
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 also capitalized as patent assets.
The Company has recorded as other assets $744,026 in patents and patent related costs, net of $ 3,241,769 in accumulated
amortization, at September 30, 2016.
Amortization charged
to operations for the three months and nine months ended September 30, 2016 and 2015 was $65,680 and $197,039 in both years. Estimated
amortization expense for the next three years, including 2016, is $262,720 per year. Estimated amortization expense for
the fourth year is $152,906 and no amortization expense for the fifth year.
HEALTH DISCOVERY CORPORATION
Notes to Financial Statements (unaudited),
continued
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 or the warrants will expire. 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 or the warrants will expire. 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 fair 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 September 30, 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 or the warrants will expire. 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 or the warrants
will expire. 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%.
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 September 30, 2016 is an unrealized gain of $6,096 for the remaining 18,000 shares held
and is classified as other expense under the caption Unrealized Gain (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 September 30, 2016 fair value of the investment of $148,074 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.
HEALTH DISCOVERY CORPORATION
Notes to Financial Statements (unaudited)
, continued
Note G – INVESTMENT IN AVAILABLE FOR SALE SECURITIES,
continued
As of September 30,
2016 and December 31, 2015, the Company held 18,000 shares of NeoGenomics stock.
Note H – COMMITMENTS AND CONTINGENCIES
On July 17, 2013,
the Company received a Civil Investigative Demand (the "Demand") from the Federal Trade Commission of the United States
of America (the "FTC") relating to the Company's MelApp software application. In the Demand, the FTC requested information
relating to potentially unfair or deceptive acts or practices related to (i) false advertising and (ii) consumer privacy and data
security, in violation of Trade Commission Act, 15 U.S.C. Sections 45 and 42.
On February 23,
2015, the FTC notified the Company of its approval, by a vote of 4-1, to accept an Agreement Containing Consent Order (“Agreement”).
This Agreement was for settlement purposes only. The Company neither admitted nor denied any of the allegations, except as specifically
stated in the Agreement. The Company believed the effort to contest this matter with the FTC would require funds greater than
the Company had at its disposal.
The Agreement does,
among other things, bar the Company from claiming that any device detects or diagnoses melanoma or its risk factors, or increases
users’ chances of early detection, unless the representation is not misleading and supported by competent and reliable scientific
evidence in the form of human clinical testing of the device. The Agreement also prohibits the Company from making any other misleading
or unsubstantiated claims about a device’s health benefits or efficacy, unless the representation is not misleading and
supported by competent and reliable scientific evidence in the form of human clinical testing of the device. Finally, the Company
was required to pay $17,693 to the FTC, which was accrued during the three month period ended March 31, 2015. This amount is included
as Settlement Expense in the accompanying statements of operations for the nine-month period ended September 30, 2015.
The Company’s
balance sheet for the year ended December 31, 2014 reflected an accrued liability of approximately $239,910 for professional services.
In an effort to conserve cash, the Company worked with several of the vendors regarding a portion of this amount by negotiating
with the service providers regarding potential reduction of the amount billed. During the quarter ended September 30,
2015, the Company and the service providers negotiated the amounts owed and as a result, the Company recorded a decrease in accounts
payables of $121,503. During the period ended September 30, 2016 there was no forgiveness on payables.
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 its assets and
discharge its 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 September 30,
2016, the Company had $183,451 of cash on hand along with its investment in NeoGenomics stock classified as available for
sale securities worth $148,074. Also, at September 30, 2016, the Company had $390,191 in current liabilities. As a result,
the Company estimates cash will be depleted by the end of first quarter 2017 if the Company does not generate sufficient
cash to support operations.
The Company’s
plan to have sufficient cash to support operations is comprised of generating revenue through finding new opportunities to license
its technology, providing services related to those patents, selling its NeoGenomics stock, and obtaining additional equity or
debt financing.
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 September 30, 2016, 7,000,000 shares of this offering had been sold. During the first quarter of
2016, the Company sold 3,000,000 of these shares and received $90,000 in proceeds.
The Company is
currently in discussions with NeoGenomics to modify the current agreement between the two companies. One of the goals for these
discussions is to obtain quarterly payments from NeoGenomics that would help cover monthly expenses.
Additionally, the
Company is attempting to encourage the Series C Preferred Stockholders to exercise some or all of their warrants in order to help
fund the operations of the Company.
While the Company believes these efforts will create a profitable
future, there is no guarantee the Company will be successful in these efforts.
HEALTH DISCOVERY CORPORATION
Notes to Financial Statements (unaudited),
continued
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 September
30, 2016, the Company does not believe there has been any impairment of its patents.
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.
HEALTH DISCOVERY CORPORATION