Item 1. Business
Overview
We provide specialized technology-based solutions to manage the business transactions between the employer-buyer and the carrier-supplier of health and welfare benefit programs. We use the Internet, proprietary technology and strategic support resources to simplify and automate the sharing of data and the completion of complex, multiple and ongoing financial and administrative transactions necessary to administer and pay for health and welfare benefits. Utilizing our services results in more choice and reduced costs for employers; improved efficiencies and strengthened client relationships for brokers and other benefit advisors; reduced costs and the ability to offer new products for health plans and other benefit suppliers; and more choice, convenience and improved service for employees and their dependents.
Group Health & Welfare Benefits
General Industry Background
With new capabilities, changing demographics and our society's ongoing commitment to health and well being, costs associated with health care continue to grow at a rate above other economic sectors. In 2000, it is estimated that the United States spent approximately $1.3 trillion on health care services and benefits. Aside from the federal government, which accounts for roughly half of all health care expenses, employers are the most significant purchasers of health and welfare benefits for employees, retirees and their dependents. Currently, more than half of the U.S. population receives group health insurance benefits through their employers, representing more than $600 billion annually in services and payments between employers and carriers, the two primary participants in the health and welfare benefits supply chain. Approximately three percent of that $600 billion, or $18 billion, is estimated to have been spent on the selection and administration of employee health and welfare benefits.
Health and welfare benefits represent the single largest benefit expense for employers. In 2002, the average annual cost of providing coverage for active and retired workers is estimated to be approximately $5,420 per employee. We expect this average cost to increase 9% to 19% annually over the next five years. In 2002, on average, each active employee is expected to contribute 19% of this amount through payroll deductions and co-payments.
Health and welfare benefits generally include health care, life, dental, short-term disability, long-term disability, and vision.
Employers, the primary benefit purchasers, can be segmented into three categories:
. Large employers: Those with more than 5,000 employees with complex benefit structures such as the Fortune 1000 companies and federal, state and local governments;
. Mid-sized employers: Generally defined as those with 250 to 5,000 employees; and
. Small employers: Under 250 employees.
We provide services today primarily to large and mid-sized employers.
Broadly characterized, carriers consist of any organization that reimburses physicians, hospitals, pharmacies and other direct providers of health care. These organizations include:
. Health maintenance organizations;
. Preferred provider organizations;
. Point of service plans;
. Self-directed health plans;
. Indemnity carriers;
. Third party administrators; and
. Pharmacy benefit managers.
Prior to the 1980s, employers typically purchased health benefits through a single third-party administrator or national indemnity insurance carrier. However, with the growth of managed care in the 1980s and 1990s, employers began to purchase coverage through an increasing number of health plans because the managed care system is comprised of numerous provider networks, each with a limited geographic services range. Among HMOs alone, there are over 550 licensed local health plans in the United States. Reflecting this proliferation of new types of plans and payers, we estimate that each Fortune 500 employer today contracts with an average of 30 different plans.
Administration of Health & Welfare Benefits
The administrative and financial processes that connect employers and carriers are complex, expensive and inefficient. Large and mid-sized employers generally purchase from multiple carriers. Carriers generally charge employers based on the number of enrolled employees and their projected actuarial risk or, alternatively, pay providers on behalf of the employer and then are reimbursed by the employer. Therefore, an individual employer is subject to multiple administrative and financing arrangements.
The administrative and financial processes consist of two basic components commonly referred to as the "front-end" and "back-end."
Front-end
The front-end process refers to the selection of various carriers by an employer, the provision of information to employees so they can make individual benefits selections, and the collection and ongoing maintenance of enrollment and eligibility data.
Carrier selection. Employers annually solicit rate quotes from health plans and other carriers in order to select which plans will be made available to their employees. Employers may choose as few as one or as many as 150 or more health plans depending on the employers' geographic locations and the desire to offer health plan choices. Large and mid-sized employers usually offer multiple health plans to provide greater choice, geographic coverage and access to specialized services for their employees. Employers choose various financing mechanisms depending on the level of risk they wish to retain, including self funded, fully insured, partially insured, or a combination of all three financing mechanisms. To make these decisions, consultants usually support large employers while mid-sized employers generally use brokers.
Communication of benefits information to employees. Employers annually provide information to employees regarding the availability and material features of each benefit plan offered for that year. This process entails distribution of printed materials, mailings and other manual, paper-based communications. Increasingly, employers and carriers are using electronic means to present, distribute and allow access to this information. Due to continuous changes in benefit information, materials must be regularly updated.
Collection of enrollment and eligibility information. Employees enroll in one or more of the available benefit plans during an annual open enrollment period. Employers collect enrollment and eligibility data using a wide variety of methods, including paper forms, telephone-based systems and Web-based self-service enrollment systems. Enrollment data includes information on the employee's benefit plan choices and primary care provider.
Eligibility information is basic information about the employee and his or her dependent(s), such as name, address, date of birth, Social Security number, employment code, benefit status, coverage level and eligibility period.
Life & work event management. In addition to collecting annual enrollment and eligibility information, employers need to obtain and communicate daily life event changes that affect coverage status. These changes include employee marriage, divorce, childbirth and address changes, as well as career events such as new hires, terminations and movements from hourly to salaried status. Health and welfare benefits are the only benefits that must maintain and store precise family history. No other benefits offered by employers require as high a level of information collection and continuous monitoring and modification.
Back-end
While the front-end process focuses on communication and collection of information between employers and employees, the back-end process focuses on managing and sharing eligibility and financial data with carriers and using this data to reconcile payments.
Post enrollment data management. Once enrollment and eligibility data is collected, employers undertake a cumbersome process to authenticate, edit, categorize and organize the data. This process also requires the ongoing classification of employees by employment status, such as active, retired, surviving spouse, student, union status and those eligible to receive benefits under the Consolidated Omnibus Budget Reconciliation Act of 1985 (COBRA), in order to accommodate diverse collection and payment processes for each category. This data management is critical to accurate billing, internal accounting and reconciling of payments between an employer and its carriers.
Eligibility data distribution. At a minimum, eligibility data should be transferred on a weekly basis from employers to carriers and in a manner that assures it will be correctly recorded. In many cases, however, this data is transferred far less frequently and with little assurance that it will be correctly interpreted by the carrier. At best, the data is communicated electronically between legacy systems and, at worst, via hard copy and updated through data entry. Ultimately, this eligibility data is required when employees and dependents present themselves to physicians and other providers for health care services. Providers obtain patient eligibility information via telephone or computer from patients' health plans prior to rendering services.
Billing, reconciliation and settlement. Carriers bill employers on a weekly or monthly basis based on either enrollment numbers and quoted rates, or on claims paid. It is our belief, based on our experience, that employers initially pay these multiple paper bills without completely auditing them. Employers then manually reconcile the number of enrolled employees and their eligibility status using their own internal data. Because of data discrepancies and delays in transfer and billing cycles, the carriers' data and the employers' data are rarely the same, and thus ongoing payment disputes are common.
Factors Influencing the Marketplace and Related Issues
The benefits procurement, administration and payment process is encumbered by inefficient procedures for rate setting, gathering and transferring data and executing payment transactions. These inefficiencies, together with other factors unique to health care delivery, result in the following significant challenges:
Fragmented employers and health plans. There are more than 17,000 large and mid-sized employers in the United States, many of which have a broadly dispersed employee base often located in multiple sites across the United States. In contrast, there are over 550 independent HMOs in the United States today, which may operate in a single or limited geographic service area. As a result, employers contract with multiple health plans to provide complete geographic coverage and choice for all of their employees.
Increasing group health insurance benefit costs. The average cost of employee and retiree health care is expected to increase 9% to 19% annually over the next five years. As these costs rise, we believe employers will
seek more cost-effective health insurance benefits solutions, will be more critical in their selection of carriers and will demand a more competitive bidding process. In addition, we believe employers will be looking for different solutions, which could include changing employee premium contribution schemes, demands for more employee choice, inclusion of employee self-directed health plans, and new creative pricing structures between employers and health plans. These changes will increase the complexity of benefit administration.
Complex data management. Carriers collect complex, detailed and dynamic data in varying formats from multiple employers. Conversely, employers must distribute this data in varying formats to multiple carriers. A failure to accurately update eligibility and financial data in a timely fashion may result in additional administrative costs and financial reconciliation problems, and can lead to employees and their dependents being wrongfully denied health care services or result in an inaccurate payment to physicians, hospitals or other health care providers.
Eligibility and financial data formats vary considerably throughout the health and welfare benefits supply chain and typically are unique to each particular employer and carrier. The collection, storage and transmission of this data remains a labor-intensive and error-prone process. As a result, most carriers are unable to frequently update this data. Some efforts have been made to develop a common standard. However, these standards do not meet the complex needs of multiple purchasers and have not been widely accepted or adopted. Further, the standards that do exist deal mostly with syntax (the form) and not with the semantics (the meaning) of the data.
Most employers to whom we market our services use their own unique human resource information systems and other benefit and payroll related systems to communicate with multiple carriers. These carriers, in turn, rely on their own unique legacy systems to manage customer premium billing and collections as well as provider claim adjudication and payment processing. Often, within a single employer or carrier, there are several systems in place for collecting and storing this data that are unable to easily communicate with one another.
Archaic pricing and financing processes. Employers must obtain rate quotes from carriers based on the estimated risk of the employers' employee population for that geographic market. Rates between plans are difficult to compare because of differing plan designs and underwriting methodologies. Today, a three-tier premium pricing standard (employee, employee + dependent, and family) is common. This pricing standard, which dates back to the 1960s, is based on the general risk of an employer group for a specific geographic area, not the risk of an individual employee or family. Health plans agree to cover all employees regardless of their health risk profiles or pre-existing conditions and, consequently, are paid a fixed fee per month that is the same for all employees within a tier. In many cases this results in plans bidding only on the entire employer group for that specific geographic market, therefore limiting employee choice.
Inefficient and inaccurate billing, reconciliation and settlement processes. Employers receive bills from each of their carriers in different formats and, in some cases, for different coverage periods. These bills are calculated using the data from carriers. If a carrier is late in recognizing an employee's termination, for example, the bill will be wrong and only an employer audit will catch the error. Regularly auditing carrier bills can be an arduous task depending on the number of carriers and the diversity of the payment arrangements. Inaccurate payments require significant manual intervention by employers and carriers to reconcile accounts.
Brokers have limited transaction processing capability. In the mid-sized employer market, employers and carriers conduct business through brokers. Many brokers want to focus on strategic advisory services, and act as a trusted business partner with their employer clients rather than a paper processor. Brokers generally do not have access to the capital needed to develop Web-based benefits administration systems. Consequently, this mid-market process is largely labor-intensive, paper-based and highly inefficient.
Added complexity caused by government regulation. Numerous federal, state and local laws and regulations govern the health care and insurance industries. These laws and regulations change frequently. In recent years, the responsibilities of employers that provide their employees with access to health care have increased significantly. In particular, COBRA and the Health Insurance Portability and Accountability Act of
1996 (HIPAA) have added substantial burdens to employers in the administration of employee health insurance benefits. The proposed legislation covering a patients' bill of rights includes a provision that may put carriers and employers at more risk of litigation. We believe this may have the effect of pushing employers toward a new pricing and financing system that may include such things as a defined contribution or self-directed approach to employee health insurance benefits.
Opportunity for Technology-Based Services
Health and welfare benefit transactions are well suited for technology-based service solutions. Most of these transactions are information-based and do not require delivery of durable goods at the point of payment. However, unlike other e-commerce services, such as purchasing tangible goods or services such as individual insurance online, health and welfare benefits transactions involve complex group insurance pricing, complex product presentation, and ongoing data management between multiple organizations.
We believe that technology-based solutions for the health and welfare benefits supply chain can simplify the sharing of data and completion of financial and administrative transactions. The solutions require the following components:
Front-end benefits administration:
. Systems and services that enable large employers to present requests for bids to carriers, and for carriers to respond with proposals; and
. Annual and ongoing enrollment systems or supporting services that accommodate enrollment in numerous plans, and content engines that provide plan descriptions, provider networks and rate information.
Back-end benefits administration:
. Systems that transfer eligibility and financial data files between participants in the supply chain and execute payment transactions with all applicable parties; and
. Systems that eventually enable carriers to present standardized offerings and processes to the employer buyer.
We provide technology and services for both front-end and back-end administration, though we do not provide all services to all market segments. For example, we do not provide carrier selection services directly to employers in the mid-market segment because that service is provided by the same brokers who act as our distribution system to that market.
Regardless of whether a customer uses our front-end enrollment system and services, we believe we can produce efficiencies with a more seamless integration of the front and back-end processes. We believe that linking our proprietary back-end technology and financial data management services with front-end solutions such as our ChoiceOne Link system and other non-proprietary solutions provides a fully integrated end-to-end solution for group health and welfare benefits administration.
Opportunity to Create a Business Service Category
Just like many employers turn to specialists for assistance in administering their payroll and 401(k) programs, we believe employers will turn increasingly to a specialist for help in administering their health and welfare benefits programs. A health and welfare benefits specialist is able to provide the technology and strategic support resources to help an employer simplify and automate the complex, ongoing and multiple transactions associated with the administration and exchange of data and dollars between participants in the health and welfare benefits supply chain.
We see a new category of employee benefits administrators--the health and welfare benefits specialist--emerging in the marketplace. We believe that we are well positioned to define and lead this new category.
Our Solution
We provide technology-based services that simplify and automate the management of group health and welfare benefits. Our services address the requirements of both the front and back-end processes. During the first eight years of our operations, we focused on data and financial management systems and on building electronic connections between customers, such as PepsiCo, Inc., Northwest Airlines Corporation, Target Corporation, GE Capital Services, Hilton Hotels Corporation and RR Donnelley & Sons Company, and the United States' largest regional and local health plans and other carriers, such as Aetna, CIGNA, Humana, and United Health Group, to name a few. We now also offer a fully integrated, real time enrollment and eligibility database platform, ChoiceOne Link, which integrates with payroll providers and expands our suite of services.
In 2001, we integrated our proprietary back-end technology with front-end enrollment applications, including ChoiceOne Link and those offered by PeopleSoft, Inc. and CitiStreet LLC. We intend to increase volume through these arrangements, and add additional such arrangements.
Value Proposition
We believe our solution provides value to all participants through the collection, management and storage of employee enrollment, eligibility and financial data and the ongoing transmission of this data to carriers.
Additionally, we manage and execute the reconciling of payments between the purchasers and suppliers of health and welfare benefits.
For employers, our technology-based solution:
. streamlines the enrollment process;
. leverages existing relationships with human resource information systems and services companies such as PeopleSoft, Inc. and CitiStreet LLC;
. reduces administrative costs associated with the distribution of benefit plan information to employees, the enrollment transaction, and the management and transfer of data among parties;
. reduces employee benefits expense by reducing or eliminating premium payments for terminated employees that are no longer eligible to be covered under the employer's benefit plan;
. shifts the employer's responsibility to us for transmitting accurate enrollment and eligibility information to a variety of carriers and gives purchasers and suppliers access to real time eligibility via Web-enabled tools;
. eliminates the traditional paper-based and labor-intensive payment reconciling process used by purchasers and suppliers, and delivers a single, consolidated bill to employers and automates accurate and retroactively adjusted payments to carriers;
. allows more choice of plans and reduces the cost of switching between competing health plans;
. reduces the cost of procuring health and welfare benefits by increasing carrier competition in the bidding process and eventually offering preferred carrier relationships to the employer purchasers; and
. increases the ability to attract and retain employees through more diverse benefit offerings.
For carriers, our technology-based solution:
. improves timeliness and accuracy and lowers the cost of receiving eligibility and financial data;
. reduces the administrative burden associated with receiving eligibility and financial data as well as the costs and distraction related to the follow up and collection of late and unpaid premiums;
. provides improved customer service and provider satisfaction by improving the accuracy and timeliness of claims adjudication through Web-enabled access to employers' eligibility and financial data; and
. opens channels for them to create and distribute new products and services.
For brokers and other benefit advisors, our technology-based solution:
. allows access to technology without significant capital expenditures;
. moves services from a paper process to a more efficient Web-based solution;
. allows brokers to more easily offer multiple health plans to their employer clients; and
. provides significant differentiation from competing brokers.
For employees, our technology-based solution:
. provides more opportunity for choice of plans and, through more competitive pricing, lower costs;
. provides access to interactive voice response (IVR)/Web-based enrollment and plan information; and
. improves quality of services by reducing eligibility data errors through the more timely and accurate transmission of eligibility data to carriers.
Health and Welfare Benefits Administration Services
We manage complex and dynamic data and dollar transactions between the buyers of health and welfare benefits, employees and employers, and their carrier suppliers. Our core technology incorporates the business rules of each of the relevant participants in the supply chain, as well as the format translations needed to automatically reconcile and pay carriers. Our solution creates a standard for connectivity without causing employers or carriers to make major changes to their systems. Employers can use our services to manage their enrollment process, or they can manage it independently. We enable the employer to send data in the format and media of their choice. After enrollment, our system edits and translates the data into a standard format. To facilitate connectivity to carriers, our system then translates that data into the format that is compatible with the computer systems of the individual carriers utilized by our employer customers. This translated information is then transmitted in the medium acceptable to the carrier. The eligibility data stored in our system is more current than the data held by the carriers, allowing us to accurately bill and pay the parties concerned.
Our primary services are:
. Enrollment: streamlined, self-service health and welfare benefits enrollment for human resource managers and employee populations via the Web or IVR. We have proprietary enrollment tools or can leverage the self-service enrollment tools of human resource system and service companies such as PeopleSoft, Inc. and CitiStreet LLC.
. Administration: the input, processing and output of enrollment data, customer service support, financial services and carrier management.
. Billing, payment and collection: creation of the invoice from the data, eligibility rules, and rates housed in our system. This allows the employer to obtain a consolidated bill for all of their carriers and allows the carriers to discontinue direct billing to employers by using our services. After billing, the employer pays us and we pay the carriers on their behalf. The carriers accept our payment as payment in full because we have tied the dollars to the eligibility data rules. Our bill automatically incorporates the retroactive adjustments caused by late adds, deletes and other eligibility changes.
Our suite of services also includes flexible spending account administration, COBRA and HIPAA compliance services and individual billing services for inactive employee populations, and enhanced
administration services, such as primary care physician selection, over-age dependent verification, enhanced carrier audits, and employee/customer service support.
Revenues generated from our administration or "exchange" services were $31,057,000, $23,172,000 and $13,823,000, for the years ended December 31, 2001, 2000 and 1999, respectively.
Health & Welfare Benefits Procurement Consulting Services
We provide health and welfare benefits procurement consulting services to large employers, primarily our Fortune 1000 customers. We undertake these services on a project basis. We assist and advise our customers on their selection of potential carriers and other benefit suppliers, preparation of requests for proposals, evaluation of proposals, rate negotiations, actuarial services and the preparation of benefit plan communication materials for employees. Approximately 42 of our employees engage in delivering these services. Our principal customers for these services are General Electric Company, Nabisco, Inc., and Federated Department Stores Inc. We view these activities as a complement to our health and welfare benefits administration services. In addition, we gain valuable knowledge regarding market conditions and processes from providing these services. Revenues generated from our procurement consulting services were $5,806,000, $5,829,000 and $3,703,000, for the years ended December 31, 2001, 2000 and 1999, respectively. We expect these revenues to increase due to our November 2001 acquisition of the health and welfare assets of Howard Johnson, and through direct sales to large employers.
Our Strategy
Our objective is to be the leading provider of technology-based services that manage the health and welfare benefits supply chain. Key elements to our strategy include the following:
Create a new category. Much like large employers turn to specialists to administer payroll and their 401(k) programs, we believe employers will turn to a specialist for the administration of their health and welfare benefits, as a significant amount of an employer's money is involved, and the associated transactions are multiple, ongoing and extremely complex. "Health and welfare benefits supply chain management" is a new and emerging category that we are striving to define and lead. We will develop marketing programs to build awareness of this new category and the value of working with a specialist.
Increase penetration of the large employer market. We will continue to focus on marketing our services to large employers with geographically dispersed employee populations and complex benefit plans where we can best demonstrate administrative efficiencies, cost savings and participant satisfaction. There are approximately 1,800 employers in the United States with 5,000 employees or more. With the acquisition of the health and welfare assets of Howard Johnson, we now provide services to more than 60 of these employers, including Eastman Kodak Company, General Electric Company, Georgia-Pacific, Intel Corporation, Kellogg Company, KPMG LLP, Northwest Airlines Corporation, PepsiCo, Inc., Safeway, Inc., TRW, Inc., and Target Corporation. The remaining companies in the large employer market provide us with substantial growth opportunities.
Expand large employer customer base through relationships with aggregators of employees. We intend to continue to aggressively sell through select relationships with aggregators such as human resource information systems and service companies. Human resource information systems and service companies include those involved with payroll, record keeping, and enterprise-wide systems. These key strategic relationships with human resource information systems and service companies such as PeopleSoft, Inc. and CitiStreet LLC, enhance our service offering and provide an opportunity to expand our customer base.
Expand presence in the mid-size employer market. There are approximately 16,000 mid-sized employers in the United States who buy group health insurance primarily through brokers. Our mid-market activities remain focused on selling our services to and through brokers who act as distribution partners to mid-sized employers. Our solution for the mid-market utilizes a more standardized approach to the administration of health and welfare benefits.
Develop new products and services. We intend to use our market knowledge and experience to develop new products and services to fully leverage our technology-based services and consulting expertise. In February 2002, we entered into an agreement with Emerge HealthCare, Inc. (Emerge) to develop and deliver new risk-adjusted pricing health and welfare benefit products that we believe will improve employee choice of carriers, benefit plan design, price and provider networks. As a part of this relationship, Emerge will provide services such as health plan relations, risk management, and broker distribution and sales. We will provide the technology and services to this new developing product and license our proprietary platform to Emerge. As the product and market develops, we believe that additional companies such as Emerge will develop and we will be in a strong strategic position to provide additional technology and services to these developing companies.
Pursue key strategic relationships to further enhance our service offering and client base. We intend to pursue key strategic relationships, including partnerships and acquisitions. These partnership and acquisition candidates could include companies that provide benefits administration services similar to eBenX or additional strategic services such as payroll, voluntary benefits, carrier support or other strategic services. We believe that making strategic acquisitions and developing strategic relationships will enable us to enhance our service offerings and expand our client base.
Customers
As of December 31, 2001, we had approximately 63 large employer customers and 185 mid-market customers. In 2001, approximately 55% of our consolidated revenues came from 16 customers.
In 2001, Verizon Communications Inc. and PepsiCo, Inc., accounted for 12.5% and 9.8%, respectively, of our consolidated revenue. In 2000, Verizon Communications Inc. and PepsiCo, Inc. accounted for 19.2% and 13.2%, respectively, of our consolidated revenue. We discontinued providing the majority of services to Verizon Communications Inc. as of December 31, 2001, and anticipate the discontinuance of remaining services as of March 31, 2002.
Sales and Marketing
Our sales, marketing and business development staff is organized according to our key targeted customer segments: large employers and mid-sized employers. Executive management plays an active role in our sales, marketing and business development efforts.
Large Employers. We sell directly to large employers, and partner with human resource information systems and service companies, such as PeopleSoft, Inc. and CitiStreet LLC. We employ a senior vice president in charge of sales who is supported by a dedicated large market sales force. Additional employees are dedicated to supporting our partnership efforts. We will consider adding personnel to this area as other strategic relationships are developed in the future. In addition, we augment the sales effort with dedicated strategic procurement consultants who spend a portion of their time cross selling administrative services to the large employer market. In addition, our Client Relationship Management staff is responsible for selling additional services to existing customers.
Due to the technical nature of our products and services, our typical sales cycle in the large employer market is six to nine months and usually involves a competitive bidding process, which starts with a request for proposal (RFP) from the employer. The employer often indicates that this RFP has been sent to other benefits administration service companies, which may or may not submit a proposal to the employer. Our sales process also is seasonal in nature because most large employers undergo the open enrollment process in the fall of each year. We obtain approximately 75% of our customer commitments during the months of May through August. The mutual intent is that our services will become operational prior to the next annual enrollment period.
Mid-sized Employers. We utilize existing brokerage distribution systems to penetrate the mid-sized employer market. We employ a dedicated mid-market sales force that is specifically focused on developing our sales and marketing efforts to mid-sized employers through brokers.
Customer Support
We believe a high level of customer support is necessary to support and enhance the services we provide. We provide a wide range of customer support services through our call service center, account managers, customer service staff and an e-mail help desk. By providing consolidated customer service through our service center, we allow employers, employees and their dependents, brokers, carriers and other participants in the supply chain to resolve enrollment, eligibility and billing issues. We also assist individual participants with enrollment choices, grievances and benefit plan clarification. Our service center is available 24 hours a day, seven days a week through a combination of an Internet-based support service, voice mail, electronic mail, and call center staff operating during normal business hours. We use a proprietary automated tracking system to ensure resolution of all inquiries. As of December 31, 2001, we had more than 140 employees in customer support functions.
Competition
The market for health and welfare benefits administration services is intensely competitive, rapidly evolving and subject to continual change. We believe that the principal competitive factors in this market are expertise in benefits administration, managed care and relevant government regulations, data integration and transfer technology, health and welfare benefits processing technology, customer service and support, price, and the breadth of services offered in addition to health and welfare benefits administration. We believe our products and services are competitive with respect to these factors.
In the large employer market we compete with total benefits outsourcers who offer retirement administration services such as 401(k) or pension administration in addition to benefits administration, and benefits consultants with administration services capabilities. We believe our major competititors are Hewitt Associates LLC, Automatic Data Processing, Inc., and Towers Perrin Forster & Crosby. We also compete with the internal information systems departments of employers and carriers that may choose to perform their own health and welfare benefits administration services. In the mid-sized employer market, we compete with other start up and independent companies that provide technology solutions that serve the automation and benefits administration needs of employers, brokers and other benefit advisors. However, as the economy experienced a downturn in 2001, many of these start up and independent companies merged, sold their businesses or went out of business due to a shortage of capital. Currently, none of these start up and independent companies have a significant market share. In addition, many human resource service and systems companies have the health care expertise and financial strength to develop the technology necessary to compete with us. As the market evolves, we expect increasing competition from Internet-based service providers in both the health care connectivity market and the online insurance market. We believe that our established technology and our knowledge of the health care market provide us with the necessary capabilities to adapt to the evolving market and to increasing competition.
Systems and Technology
Primary Systems Information
Historically, our services have been delivered using our proprietary BEN-NET(R) technology as the core eligibility and financial exchange platform. BEN-NET was originally designed and implemented in 1994 to serve two distinct customer bases: Fortune 1000 employers and health insurance purchasing coalitions. Though the latter market never fully developed, the business requirements and attendant system capabilities, such as our ability to update, transmit and permanently store eligibility data at both the employee and dependent level, have provided additional benefit to our large employer clients. We have incorporated a number of enhancements to BEN-NET in three subsequent major releases.
In 2000, as a result of our acquisition of Arbor, we also acquired its processing technology referred to as ChoiceOne Link. The ChoiceOne Link system is the platform for our mid-market activities, and provides front-end enrollment and eligibility capabilities via Web, IVR, and paper as well as back-end integration with payroll,
human resource information service systems and insurance carriers. In 2001, work was completed on the first phase of the integration between ChoiceOne Link and BEN-NET. This integration will be completed in 2002.
BEN-NET
BEN-NET and its fully integrated attendant applications are delivered using a multi-tier information system comprised of multiple midrange servers, PCs and workstations. The midrange servers, Sun Enterprise servers running Sun's Solaris UNIX operating system, are used to provide middle-tier application component logic and as a platform for our relational database management system. Batch and end-user local and Internet applications employ a number of different languages, primarily PowerBuilder, C/C++, and Java.
Our BEN-NET production processing environment, maintained at two redundant sites in the Minneapolis area, is composed of multiple servers, permitting maximum flexibility in organizing and protecting client data. The environment, in which our database runs, UNIX, is a highly scalable platform. Given this platform, we are able to add capacity relatively easily; we can also physically organize our databases on different servers to optimize the processing performed on each server. For example, an entire production server can be dedicated to a single large client if this client has extensive processing requirements. Within this processing environment, we establish separate physical production databases for each of our large employer customers to ensure that customer data remains confidential and secure while maintaining its integrity. This enables us to provide secure, real time Internet-based employer, broker and carrier access to consistent, specified user group data, resulting in reduced support costs and improved timeliness and quality.
We believe our proprietary data import and export management application is a key differentiator for our services. Electronic Vendor Interface Management (EVIM) delivers the ability and flexibility to receive and transmit data between participants in the benefit supply chain. This application incorporates a library of health plan data maps as well as a deep knowledge of the business rules required for the complex managed care market.
Electronic imports and exports (an average of 1,000 files per week with each file ranging from 500-130,000 records) are managed via EVIM, ensuring automated, timely distribution of data, payments, and reports to employers, brokers and carriers. The precise management of this flow of data also supports a key function of BEN-NET, the dynamic application of customer-related business rules to customer-delivered eligibility data, streamlining health plan delivery of both service and payment.
ChoiceOne Link
ChoiceOne Link is delivered using a multi-tier information system comprising multiple NT servers and workstations. The NT servers host proprietary application logic, Microsoft SQL Server databases, MS Internet Information Servers, as well as firewall and intrusion detection applications. The workstations control ChoiceOne Link setup, maintenance, and batch processes. ChoiceOne Link was developed in Visual Basic, Java and C++.
Redundancy, System Backup, Security and Disaster Recovery
We believe our facilities and operations include sufficient redundancy, back-up and security to ensure minimal exposure to systems failure or unauthorized access. The preparations in this area include the use of two data processing sites in Minnesota and two data processing sites in Pennsylvania in order to help provide redundancy for data and processes should one site be completely disabled. As part of our ongoing efforts, we simulate the loss of one of our data sites and enact our disaster recovery plan on a periodic basis.
In addition to real-time replication of data between the sites, incremental backups of both software and databases are performed on a daily basis and a full system backup is performed weekly. Backup tapes are stored at an offsite location along with copies of schedules and production control procedures, procedures for recovery using an off-site data center, documentation and other critical information necessary for recovery and continued
operation. Our primary Minnesota data processing facility has two separate power feeds, uninterruptible power supply (UPS) and back-up generators, that provide a level of redundancy should a power outage or interruption occur.
We employ rigorous physical and electronic security to protect customer data. Our data centers have restricted card key access and appropriate additional physical security measures. Electronic protections include encryption, firewalls, multi-level access controls and separate customer databases.
Proprietary Rights
We rely upon a combination of contractual rights, trade secrets, copyrights, technical measures, nondisclosure agreements, patents and trademarks to establish and protect proprietary rights in our products and technologies. However, we believe that intellectual property protection is less important than our ability to continue to develop new applications and services that meet the requirements of our industry. As a result, we have invested heavily in the research and development of our products and services, spending approximately $8,704,000, $7,883,000 and $4,012,000 in 2001, 2000 and 1999, respectively. We typically enter into nondisclosure and confidentiality agreements with our employees and consultants with access to sensitive information. However, these agreements may be breached and we may not have adequate remedies for any breach. Others may acquire substantially equivalent proprietary technologies or otherwise gain access to our proprietary technologies. In addition, any particular technology may not be regarded as a trade secret under applicable law. As a result of the reliance that we place on our trade secrets, loss of our trade secret protection could harm our business and results of operations. Arbor has patented its health and welfare benefit systems. The patent will expire in March 2016.
Although we have taken steps to protect our technology, the steps taken by us to protect our proprietary rights may not be adequate to prevent misappropriation of our technology or independent development or sale by others of software products with features based upon, or otherwise similar to, our products. While we believe our technology has been independently developed and that none of our technology or intellectual property infringes on the rights of others, third parties may assert infringement claims against us in the future. If infringement were established, we might be required to modify our products or technologies or obtain a license to permit our continued use of those rights. We may not be able to do either in a timely manner or upon acceptable terms and conditions, and any failure to do so could harm our business and results of operations. In addition, any future litigation necessary to protect our trade secrets, know-how or other proprietary rights, to defend ourselves against claimed infringement of the rights of others or to determine the scope and validity of the proprietary rights of others could result in substantial cost to us and diversion of our resources. Adverse determinations in any litigation or proceedings also could subject us to significant liabilities to third parties and could prevent us from producing, selling or using our products or technologies. We may not have the resources to defend or prosecute a proprietary rights infringement claim or other action.
Government Regulation
The health care industry is highly regulated by state, federal and local laws and regulations, which are subject to change. Currently, few of these laws and regulations apply directly to our business but rather apply primarily to employers, health plans and health providers. For example, the confidentiality of individual health information and the circumstances under which such data may be released for inclusion in our databases may be subject to regulation under state and federal laws, including HIPAA, which governs the disclosure and the use of personal health information. Although compliance with these laws and regulations currently is principally the responsibility of health plans and providers, and we typically do not include confidential patient medical information in our databases, newly finalized regulations may extend to our business and some data that we include in our databases. In addition, we anticipate the issuance of federal standards that will require the implementation of security measures that apply to the maintenance and transmission of health information. Changes to these and other federal and state laws, as well as enactment of new legislation at the federal or state level, may materially restrict employers' and health plans' ability to store and transmit personal health information and may affect the use of our products and services.
Laws and regulations may be adopted with respect to the Internet or other online services covering issues such as user privacy, pricing, content, copyrights, distribution and characteristics and quality of products and services. The adoption of any additional laws or regulations may impede the growth of the Internet or other online services. This could decrease the demand for our products and services and/or increase our cost of doing business. Moreover, the applicability to the Internet of existing laws in various jurisdictions governing property ownership, sales taxes and other forms of taxation, libel and personal privacy is uncertain and may remain uncertain for a considerable length of time.
Finally, our function as a conduit for payment by employers to health plans may subject us to the provisions of the Employee Retirement Income Security Act (ERISA). ERISA imposes fiduciary duties on employers and health plans with respect to payments made on behalf of participants. Although we believe our role in the payment process is purely ministerial, it is possible that these fiduciary duties could be deemed to apply to us. In that event, we may become subject to greater liability with respect to these payments and may experience higher operating costs in order to comply with these regulations.
Employees
As of December 31, 2001, we had 495 full-time employees, including 170 in information technology, 142 in operations, 67 in account relations, 34 in sales and marketing, 42 in consulting, and 40 in administration and executive management. We have never had a work stoppage and none of our employees currently are represented under collective bargaining agreements. We consider our relations with our employees to be good. We believe that our future success will depend in part on the continued service of our senior management and key technical personnel and our ability to attract, integrate, retain and motivate highly qualified technical and managerial personnel. Competition for qualified personnel in our industry and geographic locations is intense.
Item 2.
Item 2. Properties
Our corporate headquarters are located at 605 North Highway 169, Suite LL, Minneapolis, Minnesota, 55441-6465, where we lease approximately 109,000 square feet of office space. This operating lease expires in 2005. Our telephone number is 763-614-2000 and our Web site address is www.ebenx.com.
Our subsidiary, Arbor Associates, Inc., has its main office at 325 Chestnut Street, Suite 1010, Philadelphia, Pennsylvania, 19106, for our mid-market division. It leases approximately 14,000 square feet of office space under a lease that expires in 2006.
We license office space in three locations in Seattle, Washington, totaling approximately 25,000 square feet, and we sublease office space of approximately 7,500 square feet in Chicago, Illinois, for operations supporting the administration of clients acquired from Howard Johnson. The license expires in 2002 and the sublease expires in 2003. We are currently negotiating a sublease agreement to be effective through 2003 that will consolidate the Seattle locations.
We also maintain approximately 5,600 square feet of office space for our primary data processing production facility in Minneapolis, Minnesota. The term of this operating lease is ten years, through 2009, with the right to renew for two additional five-year terms. In addition, we provide office space of approximately 6,800 square feet in Atlanta, Georgia, under an operating lease that expires in 2005, for 8 professionals focused on providing procurement services.
Item 3.
Item 3. Legal Proceedings
A class action lawsuit was filed on October 25, 2001 on behalf of purchasers of our securities between December 9, 1999 and December 6, 2000, inclusive. The lawsuit was filed in United States District Court,
Southern District of New York, against eBenX, BancBoston Robertson Stephens, Inc., Warburg Dillon Read LLC, Thomas Weisel Partners LLC, and our Chairman, Mark W. Tierney, Chief Executive Officer, John J. Davis, and Executive Vice President & General Manager-Corporate Solutions, Scott P. Halstead. The complaint alleges violations of Sections 11, 12(a)(2) and 15 of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. The complaint alleges that our prospectus, filed in connection with our initial public offering, was materially false and misleading because it failed to disclose certain commissions and agreements between the aforementioned parties and certain investors and customers. The complaint seeks unspecified damages plus attorneys' fees and rescission. We intend to vigorously defend against this lawsuit.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of security holders during the fourth quarter of 2001.
PART II
Item 5.
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
Our common stock, $.01 par value, is traded on the Nasdaq National Market tier of The Nasdaq Stock Market under the symbol "EBNX". Prior to December 10, 1999, there was no public market for our common stock. The following table sets forth the high and low bid quotations for the periods indicated as reported by the Nasdaq National Market.
National Market
The closing sales price of our common stock on March 1, 2002 was $4.08. As of March 1, 2002, we had 20,004,621 shares of common stock held by 354 shareholders of record. This does not reflect persons or entities that hold their stock in a nominee or a "street" name through various brokerage firms.
Dividend Policy
We have never declared or paid any cash dividends on our capital stock and do not anticipate paying any cash dividends in the foreseeable future. We currently intend to retain future earnings to fund the development and growth of our business.
Use of Proceeds from Initial Public Offering
On December 15, 1999, we closed our initial public offering of 5,000,000 shares of common stock. In January 2000, the underwriters exercised their over-allotment option to purchase 750,000 shares at the initial offering price of $20.00 per share. The shares of the common stock sold in the offering were registered under the Securities Act of 1933 on a registration statement on Form S-1 (No. 333-87985), the effective date of which was
December 9, 1999. With the over-allotment option, the aggregate initial public offering proceeds totaled $115 million. After deducting underwriting discounts and commissions and other offering expenses of $9.5 million, we received net proceeds of approximately $105.5 million from the offering.
Through December 31, 2001, we have used the net offering proceeds for the following purposes in the approximate amounts set forth below (in millions):
In connection with our acquisition of Arbor, the President of Mid-Market, formerly President of Arbor, received approximately $11.4 million in his capacity as the majority shareholder of Arbor. He was not affiliated with eBenX prior to the acquisition. Otherwise, none of the net proceeds were paid, directly or indirectly to (i) officers or directors of eBenX or its affiliates, (ii) persons owning 10% or more of our equity securities or (iii) affiliates.
Recent Sales of Unregistered Securities
Not applicable.
Item 6.
Item 6. Selected Consolidated Financial Data
The following selected financial data should be read together with the financial statements and related notes and "Management's Discussion and Analysis of Financial Condition and Results of Operations," appearing elsewhere in this document. The selected statement of operations data shown below for the years ended December 31, 2001, 2000 and 1999 and the balance sheet data as of December 31, 2001 and 2000 are derived from our audited financial statements included elsewhere in this document. The selected statement of operations data shown below for the years ended December 31, 1998 and 1997 and the balance sheet data as of December 31, 1999, 1998 and 1997 are derived from our audited financial statements not included elsewhere in this document.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of the financial condition and results of operations of eBenX should be read in conjunction with "Selected Consolidated Financial Data" and our consolidated financial statements and related notes appearing elsewhere in this report. This discussion and analysis contains forward-looking statements that involve risks, uncertainties, and assumptions. The actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including but not limited to the risks discussed in this report.
Overview
We provide specialized technology-based solutions to employers, brokers, employee benefit advisors, and health plans and other carriers for the purchase, administration, and payment of group health and welfare benefits. We apply the Internet and other technology to simplify and automate the complex, ongoing and multiple transactions associated with the exchange of health and welfare benefits data and dollars.
On November 5, 2001, we acquired the health and welfare assets of Howard Johnson & Company, a wholly owned subsidiary of Merrill Lynch & Company, Inc., for a purchase price of $12.6 million, consisting of approximately $11.5 million in cash and the assumption of $1.1 million of liabilities. The acquisition was accounted for under the purchase method of accounting. Under this method, the purchase price is allocated to the assets acquired and liabilities assumed based on their determined fair market values. The assets acquired primarily consist of customer contracts and arrangements for the provision of health and welfare benefits administration services. This acquisition resulted in significant increases in accounts receivable, accrued compensation, and accrued expenses.
Revenue is derived primarily from providing ongoing annual enrollment and health and welfare eligibility administration and premium billing and payment exchange services. Administrative or exchange services revenue typically is priced on a per employee per month basis with adjustments made to accommodate the number of health plans and other carriers required by the customer. We typically enter into multi-year contracts with our large employer customers and often provide fixed and variable fee structures to permit volume-adjusted pricing.
Customers may purchase some or all of our services, and the customer relationship may evolve from utilizing procurement services to utilizing implementation and enrollment services and per employee-based administrative services.
Cost of services consists primarily of personnel costs for account management, operations, production and procurement and information technology costs for both ongoing procurement and administrative services and for customer implementation expense. The information technology costs relate to personnel costs for implementing and maintaining customer and health plan computer interfaces and computer hardware and software expenses related to computer processing. A portion of cost of services consists of new customer implementation expenses. Therefore, as a short-term effect of growth, increasing numbers of new customers will cause the cost of services as a percentage of net revenue to increase.
Selling, general and administrative expenses consist primarily of payroll and payroll-related expenses associated with sales and marketing, executive management and corporate administrative personnel, as well as professional fees and expenditures for advertising, public relations and promotional efforts.
Research and development expenses consist primarily of development personnel and external contractor costs related to the development of new products and services, enhancement of existing products and services, quality assurance and testing. The Company follows AICPA Statement of Position No. 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use", in accounting for internally developed software. To date, we have not capitalized any of our software development costs as a majority of our in-house development efforts related to determining specific software requirements and evaluating alternatives related to specific performance criteria for our products. As a result, all research and development costs have been expensed as incurred.
Since our inception, we have incurred losses. As of December 31, 2001, we had an accumulated deficit of $91.6 million. These losses and this accumulated deficit have resulted from the significant costs incurred in the development of our technology platform, the establishment of relationships with our customers, the development and maintenance of our customer and carrier interfaces, amortization of stock-based compensation and goodwill and other intangibles and a $30.4 million impairment charge to the carrying value of goodwill associated with the September 2000 acquisition of Arbor. Although we have experienced significant revenue growth in recent periods, our operating results for future periods are subject to numerous uncertainties. In view of the rapidly evolving nature of our business and our limited operating history, we believe that period-to-period comparisons of our operating results are not necessarily meaningful and should not be relied upon as an indication of future performance.
Critical Accounting Policies and Estimates
General
Management's discussion and analysis of its financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an on-going basis, management evaluates its estimates, including those related to customer receivables, short-term investments, intangible assets, income taxes, and contingencies and litigation. Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
Management believes the following critical accounting policies affect its more significant judgments and estimates used in the preparation of its consolidated financial statements.
Revenue Recognition
We recognize revenue for administrative, enrollment, and procurement consulting services as the services are performed. Implementation fees associated with our administrative services are recognized as revenue over the life of the contract.
Short-term Investments
We classify our short-term investments as available-for-sale securities. Pursuant to SFAS No. 115 such securities are measured at fair market value in the financial statements with unrealized gains or losses recorded in other comprehensive income until the securities are sold or otherwise disposed of. However, in accordance with SFAS No. 115, a decline in fair market value below cost that is other than temporary is accounted for as a realized loss.
Bad Debts
We maintain allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.
Note Receivable
In conjunction with the formation of a strategic alliance, we provided a line of credit of $1.5 million (see Note 5 to the Audited Financial Statements). We will evaluate recoverability of the carrying amount of this line of credit on a periodic basis. If we determine that the carrying value is not fully recoverable, we will have to record an impairment charge not previously recognized.
Goodwill and Intangible Impairment
In assessing the recoverability of our goodwill and other intangibles, we must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. If these estimates or their related assumptions change in the future, then we may be required to record impairment charges for these assets not previously recorded. Effective January 1, 2002, we adopted Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets," and are required to analyze our goodwill and other intangible assets for impairment issues during the first six months of 2002, and then on a periodic basis thereafter.
Results of Operations
The following table sets forth for the periods indicated selected statement of operations data expressed as a percentage of net revenues.
In addition to our operating results, we also track and provide enrollment statistics. Enrollment is defined as the number of employees or retirees to whom we currently provide administration services. Enrollment commitments include the number of employees currently in enrollment, plus the number of new customer employees that will be implemented in the foreseeable future, and reduced by further known and anticipated customer dis-enrollments (if any). The following table sets forth our enrollment statistics for the periods indicated:
Years ended December 31, 2001 and 2000
Enrollment and enrollment commitments. Enrollment increased 31% to 1.023 million as of December 31, 2001 from 780,000 as of December 31, 2000. Enrollment commitments increased 24% to 1.06 million as of December 31, 2001 from 852,000 as of December 31, 2000. These increases were the result of the best new sales year in our history and the acquisition of the health and welfare assets of Howard Johnson. We sold employers representing over 285,000 covered employees during 2001. Approximately two-thirds of these new sales came through strategic partnerships. The acquisition of the health and welfare assets of Howard Johnson contributed 270,000 enrolled employees and 210,000 employee commitments as of December 31, 2001. The difference of 60,000 employees is due to three employers who notified Howard Johnson prior to the close of the transaction of their intent to discontinue service before January 1, 2003. We contemplated this in the agreement and adjusted the purchase price accordingly.
Net revenue. Net revenue increased to $36.9 million in 2001 from $29.0 million in 2000, representing an increase of $7.9 million, or 27.2%. This increase was the result of additional revenue earned from our subsidiary, Arbor Associates Inc., which was acquired in September 2000, additional revenue derived from the acquisition of the health and welfare clients of Howard Johnson in November 2001, and internal revenue growth from the sale of new business in 2000 and 2001. These increases were partially offset by the loss of several unprofitable clients during 2001 and decreased revenue from consulting services provided to Verizon Communications, Inc.
Cost of services. Cost of services increased to $28.5 million in 2001, from $21.2 million in 2000, representing an increase of $7.3 million, or 34.4%. Cost of services, as a percentage of net revenues, increased to 77.3% in 2001 from 73.0% in 2000. This increase is primarily due to costs related to integrating Arbor operations and systems; higher rent, equipment lease costs, maintenance costs and depreciation related to our new Minnesota production site; higher rent costs related to new company headquarters; and reserves established for terminated clients. We anticipate that cost of service as a percentage of revenue will decrease as a result of actions taken during first quarter 2002 to eliminate excess space at our corporate headquarters, and to reduce the workforce.
Selling, general and administrative. Selling, general and administrative expenses increased to $16.7 million in 2001, from $12.0 million in 2000. The $4.7 million increase, or 39.2%, primarily was due to additions in the sales and marketing staff, an increase in rent and depreciation of leasehold improvements related to our corporate headquarters move in mid-2000, adding an additional corporate headquarters floor in mid-2001, additions to bad debt reserves, and a full year of expenses for Arbor. Selling, general and administrative expenses, as a percentage of net revenues, increased to 45.2% in 2001, from 41.4% in 2000, primarily due to the above factors. We anticipate that selling, general, and administrative expenses will decrease as a percentage of revenue in the future as a result of leveraging existing resources across a larger revenue base and due to actions taken during the first quarter of 2002 to eliminate excess headquarters office space and to reduce the general and administrative workforce.
Research and development. Research and development expenses increased to $8.7 million in 2001, from $7.9 million in 2000, representing an increase of $0.8 million, or 10.1%. This increase is primarily due to research and development expenses incurred during 2001 by Arbor. Research and development expenses, as a percentage of net revenues, decreased to 23.6% in 2001, from 27.2% in 2000. We anticipate that research and development expenses will decrease as a percentage of net revenue in the future because we are leveraging existing resources across a larger revenue base, and from technologies gained through the Arbor acquisition.
Amortization of stock-based compensation. In connection with the granting of stock options to employees prior to our initial public offering, we recorded deferred stock-based compensation in 1999 with an additional amount recorded in 2000 related to our acquisition of Arbor. We recorded $2.5 million in amortization expense related to the deferred stock-based compensation in 2001, a decrease of 7.4% from the $2.7 million recorded in 2000. The amortization of deferred stock-based compensation will result in an additional $3.1 million of total charges to operations through 2004.
Goodwill and other intangibles charges. Goodwill and other intangibles charges increased to $53.0 million in 2001, from $7.2 million in 2000. In the fourth quarter of 2001, we recorded a $30.4 million impairment charge to the carrying value of goodwill associated with the September 2000 acquisition of Arbor. In the fourth quarter of 2001, management believed that the carrying value of the Arbor goodwill exceeded its fair market value. As a result, we performed an impairment test by using a current market valuation approach to calculate the amount of the impairment charge. Prior to this one-time charge, goodwill and other intangibles of $67.8 million related to this acquisition were being amortized over a 36-month period. Under SFAS No. 142, Goodwill and Other Intangible Assets, goodwill and intangible assets deemed to have indefinite lives will no longer be amortized but will be subject to annual impairment tests. Other intangible assets will be amortized over their useful lives. During the first six months of 2002, the Company will perform the first of the required impairment tests of goodwill and indefinite lived intangible assets as of January 1, 2002. Management has not yet determined what the effect of these tests will be on our earnings and financial position.
Interest income and other, net. Net interest income includes income earned from our invested cash and short-term investments, and income earned from facilitating our customers' payments to their health plans and other carriers. Net interest income decreased to $3.7 million in 2001, from $6.5 million in 2000, representing a decrease of $2.8 million, or 43.1%. This decrease is primarily a result of the decrease in our short-term investment portfolio as a result of the acquisition of the health and welfare business assets of Howard Johnson, operating losses, and a decrease in the return on investment of the securities that are held in our short-term investment portfolio due to a general decline in market interest rates.
Income taxes. As of December 31, 2001, we had unused federal and state research and development tax credit carryforwards of approximately $250,000 which begin to expire in 2009. In addition, we had unused federal net operating loss carryforwards at December 31, 2001, of approximately $23.1 million which begin to expire in 2009. These net operating loss carryforwards are not recognized as an asset on the Company's balance sheet because the utilization of these carryforwards is dependent upon our ability to generate sufficient taxable income during future periods.
Years Ended December 31, 2000 and 1999
Enrollment and enrollment commitments. Enrollment increased 46% to 780,000 as of December 31, 2000 from 535,000 as of December 31, 1999. Enrollment commitments increased 42% to 852,000 as of December 31, 2000 from 600,000 as of December 31, 1999. These increases were the result of internal sales and the acquisition of Arbor.
Net revenue. Net revenue increased to $29.0 million in 2000 from $17.5 million in 1999, representing an increase of $11.5 million, or 65.5%. This increase was due primarily to our success in direct sales of both our administrative and procurement services to new customers, as well as through the expansion of administrative services to our existing customers. In addition, revenue in 2000 includes approximately four months of revenue resulting from our September 2000 acquisition of Arbor.
Cost of services. Cost of services increased to $21.2 million in 2000, from $13.4 million in 1999, representing an increase of $7.8 million, or 58.4%. The increase can be attributed to additional personnel and computer-related costs required to service our new clients. Cost of services, as a percentage of net revenues, decreased to 73.0% in 2000 from 76.3% in 1999, primarily due to efficiencies gained from our efforts to standardize and streamline our rules-based interfaces with customers and health plans and other carriers.
Selling, general and administrative. Selling, general and administrative expenses increased to $12.0 million in 2000, from $5.1 million in 1999. The $6.9 million increase, or 134.5%, primarily was due to additions to management infrastructure and sales and marketing staff and a one-time write-off of property and equipment of $210,000 relating to the relocation of our corporate headquarters. Selling, general and administrative expenses, as a percentage of net revenues, increased to 41.4% in 2000, from 29.2% in 1999.
Research and development. Research and development expenses increased to $7.9 million in 2000, from $4.0 million in 1999, representing an increase of $3.9 million, or 96.5%. This increase primarily was due to additions to our research and development staff and external contractors to enhance product offerings and expand services to the mid-sized employer market. Research and development expenses, as a percentage of net revenues, increased to 27.2% in 2000, from 22.9% in 1999.
Amortization of stock-based compensation. In connection with the granting of stock options to employees, we recorded deferred stock-based compensation in 1999, with an additional amount recorded in 2000 related to our acquisition of Arbor. We recorded $2.7 million in amortization expense related to the deferred stock-based compensation in 2000, an increase of 254.5% from the $767,000 recorded in 1999. The amortization of deferred stock-based compensation will result in an additional $6.2 million of charges to operations through 2004.
Goodwill and other intangibles charges. Related to our acquisition of Arbor, goodwill and other intangibles of $67.8 million were recorded. Prior to December 31, 2001, goodwill and other intangibles were being amortized over 36 months. We recorded $7.2 million in amortization expense related to these assets in 2000.
Interest income and other, net. Net interest income includes income earned from our invested cash and short-term investments and income earned from facilitating our customers' payments to their health plans and other carriers. Net interest income increased to $6.5 million in 2000, from $716,000 in 1999. The increase in interest income is a result of the income earned on the proceeds received from the completion of our initial public offering on December 10, 1999, and increased income earned from customer payments to health plans and other carriers. Net interest income in 1999 also included interest expenses related to outstanding debt obligations under our bank credit facility, which was repaid during 1999.
Income taxes. As of December 31, 2000, we had unused federal and state research and development tax credit carryforwards of approximately $250,000 which begin to expire in 2009. In addition, we had unused federal net operating loss carryforwards at December 31, 2000 of approximately $11.4 million which begin to expire in 2009.
Liquidity and Capital Resources
Our initial public offering on December 10, 1999, and the January 2000 exercise of the underwriter's over allotment, generated gross proceeds of $115 million in cash. After underwriting discounts and commissions and other costs, the net proceeds from the offering totaled $105.5 million. Approximately $20.4 million of these proceeds were used in connection with our acquisition of Arbor in September 2000 and approximately $11.5 million were used in connection with our November 2001 acquisition of the health and welfare assets of Howard Johnson. We intend to use the remaining proceeds from the offering for general corporate purposes, including working capital, sales and marketing expenditures, development of new products and services, and investment in technology infrastructure. In addition, a portion of the net proceeds may be used for other acquisitions of businesses, products and technologies that are complementary to ours. Pending use of the net proceeds for the above purposes, we intend to invest the net proceeds from this offering in short-term, interest-bearing, investment-grade securities.
Prior to our public offering we funded operations primarily through private sales of preferred stock and limited bank borrowings. Computer and communications equipment was funded primarily through operating leases.
At December 31, 2001, we had $49.5 million in short-term investments and cash and cash equivalents. Short-term investments consisted primarily of commercial paper and corporate and government bonds. Cash equivalents consisted primarily of money market funds.
Our operating activities used cash of $12.3 million in 2001, $8.5 million in 2000 and $3.8 million in 1999. The use of cash from operations in 2001 was due primarily to our net loss and an increase in accounts receivable, principally offset by non-cash charges for depreciation and amortization. The use of cash from operations in 2000 was due primarily to our net loss, an increase in other current assets and a decrease in accounts payable, partially offset by non-cash charges for depreciation and amortization. The use of cash from operations in 1999 was due primarily to our net loss and an increase in accounts receivable, partially offset by an increase in depreciation and accrued expenses.
Our investing activities provided cash of $14.3 million in 2001, and used cash of $104.1 million in 2000 and $1.6 million in 1999. In 2001, sales of investments, net of purchases, provided cash of $30.7 million. Other 2001 investing activities included the acquisition of the health and welfare assets of Howard Johnson of $11.5 million, and additions to property and equipment of $4.1 million. In 2000, our investing activities used cash of $20.4 million for the acquisition of Arbor and $6.9 million for additions to property and equipment. In
2000, purchases of investments, net of sales, used cash of $76.8 million. In 1999, our investing activities used cash of $1.6 million for additions to equipment.
Our financing activities provided cash of $503,000 in 2001, $14.7 million in 2000, and $102.4 million in 1999. In 2001, financing activities provided $161,000 in cash through sales of common stock and $342,000 from the exercise of stock options and warrants. In 2000, financing activities provided $13.8 million in cash through the sale of common stock, primarily from the exercise of the underwriter's over-allotment option to purchase shares and our Employee Stock Purchase Plan. The exercise of stock options and warrants added $879,000 in cash. In 1999, financing activities provided cash from the sale of $10.4 million in preferred stock and $92.6 million in common stock, partially offset by the repayment of bank borrowings.
Our equipment additions consist primarily of computer hardware and software, office furniture and equipment, and leasehold improvements. We fund equipment additions either through the use of working capital or with operating leases. We expect to fund future equipment additions in the same manner.
We believe that the net proceeds from the sale of the common stock in our public offering and cash from operations will be sufficient to meet our working capital and operating resource expenditure requirements for the foreseeable future. However, to the extent that cash is used to fund acquisitions or investments in complementary businesses, technologies or service lines, we may find it necessary to obtain additional equity or debt financing.
Risks Related to Our Business
We have had net losses over the past several years and while our goal is to achieve operating profitability in the fourth quarter of 2002, we may not be able to achieve or maintain profitability in the future.
Our business strategy may be unsuccessful and we may never achieve or maintain significant revenues or profitability. With the exception of fiscal 1995, we have incurred net losses each year since we began operations in 1993. We had net losses of approximately $68.8 million, $15.5 million and $5.0 million for the years ended December 31, 2001, 2000 and 1999, respectively. At December 31, 2001, we had an accumulated deficit of $91.6 million. We expect to continue to incur development, sales and marketing and other operational expenses in connection with our business. We may also incur expenses in connection with acquisitions or other strategic relationships.
We rely significantly on a limited number of customers and the loss of any material customer could harm our business and operating results.
The loss of a material customer would significantly reduce our revenue and harm our business and operating results. In 2001, sixteen customers accounted for approximately 55% of our total revenue. Further, because increased employee participation from existing customers has contributed to our revenue growth, the loss of any material customer would harm our prospects for future growth. We may continue to depend upon a small number of customers for a substantial percentage of our revenue in the future.
The failure of the industry to accept our services could limit our revenue growth.
The failure of industry participants to accept our services as a replacement for traditional methods of operation could limit our revenue growth. Our success depends on our ability to provide services to a large number of employers with a substantial base of participating employees and to efficiently and accurately collect and process eligibility data and execute payment transactions with numerous health plans. The acceptance by employers of our services will require that all participants in the group health insurance market adopt new methods of administering benefits, exchanging eligibility information and executing payment transactions.
Further, our services facilitate competition among health plans at the employer level by creating an infrastructure that allows multiple health plans to service a single employer. Health plans have in the past resisted servicing smaller companies on a non-exclusive basis. This resistance may inhibit our growth, especially in the mid-sized employer market.
We face intense competition in our industry and, if we are unable to compete successfully, our business and operating results will be seriously harmed.
Increased competition in our industry could result in price reductions, reduced gross margins or loss of market share, which could seriously harm our business and operating results. The health and welfare benefits administration industry is intensely competitive, rapidly evolving and subject to sudden technological change. We believe that the principal competitive factors in this market are health and managed care expertise, data integration and transfer technology, benefits processing technology, customer service and support, price, and the breadth of services offered in addition to health and welfare benefits administration. We expect competition to increase in the future.
We compete with administrative service providers, total benefits outsourcers and benefits consultants with administrative capabilities. We also compete with the human resource and information systems departments of carriers and employers that perform their own health and welfare benefit administration services. In the mid-sized employer market we compete with administrative service providers including health benefit brokerages with administrative arms. In addition, total benefits outsourcers and many human resource service and systems companies have the health care expertise and financial strength to develop the technology necessary to compete with us. As the market evolves we expect increased competition from Internet-based service providers in both the health care connectivity market between suppliers and providers (e.g., physicians, hospitals and pharmacies) and the online insurance market.
Many of our current and potential competitors have longer operating histories, significantly greater financial, technical, marketing and other resources, significantly greater name recognition and a larger installed base of customers than we do. In addition, many of our competitors have well-established relationships with our current and potential customers and have extensive knowledge of our industry. Current and potential competitors have established or may establish strategic relationships among themselves or with third parties to increase the ability of their products and services to address employer needs. They may develop similar services to ours and we may not be able to successfully market our services or develop and introduce new services that are less costly than or superior to those of our competitors. Accordingly, it is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share.
Failure to manage our growth effectively could harm our business and operating results.
Failure to manage our growth effectively could harm our business and operating results. Continued growth will place significant strain upon our management and operational systems and resources. We will need to expand our existing information systems or acquire new systems to meet the requirements of our future operations. Any expansion or replacement of our information systems may not be sufficient to meet our needs. In addition, we may experience interruptions of service as we expand these systems.
We recently have added a significant number of new employees both as a result of organic growth and acquisitions. We will continue to add personnel to maintain our ability to grow in the future. We must integrate our new employees into a cohesive team. At the same time, we must increase the total number of employees and train and manage our employee work force in a timely and effective manner to expand our business. We may not be able to do so successfully, which would limit expansion of our business and harm our operating results.
Unsuccessful efforts or incurrence of unanticipated expenses in selling our services could harm our business and operating results.
The time, expense and effort of securing customers may exceed our expectations and may harm our business and operating results. The decision to implement our services requires a substantial and technical analysis of an employer's health and welfare benefits offerings and requirements, and time-intensive education of the advantages of our services. Due to the length of our sales cycle, which ranges from six to nine months, we often devote significant resources and incur costs without any assurance that a prospective employer will purchase our services. In the event that a prospective employer does not purchase our services, we may have incurred substantial costs that cannot be recovered and which will not result in future revenues.
Our failure to establish and maintain successful relationships with strategic partners could limit our revenue growth.
We believe that our future revenue growth depends in part upon the successful creation and maintenance of relationships with strategic partners such as front-end health care information collection companies, human resource information services firms, benefits consultants and brokers and other industry participants. To date, we have established a limited number of strategic relationships. Strategic partners may offer products or services of several different companies, including products and services that compete with our services. Strategic partners and potential strategic partners may be influenced by our competitors to scale back or end their relationships with us. We may not establish additional strategic relationships and these relationships may not be ultimately successful. Our strategic partners may not devote adequate resources to selling our services.
If we are unable to establish and maintain successful strategic relationships, we may have to devote substantially more resources to the sales and marketing of our services, which will increase our costs and harm our operating results.
Our quarterly results likely will fluctuate which could cause the value of our common stock to rapidly decline.
Any quarterly fluctuations in our operating results could subject the market price of our common stock to rapid and unpredictable change. Historically, we obtain a significant portion of each year's new customer commitments during the months of May through August because most employers have open enrollment periods for the selection of health plans by their employees in the fall. We expect this seasonality in our business to continue. Our expenses are relatively fixed in the short term and are based in part on our expectations of future revenues, which may vary significantly. If we do not achieve expected revenue targets, we may be unable to adjust our spending quickly enough to offset any revenue shortfall, which could harm our business and operating results.
Factors that may cause these quarterly fluctuations include:
. the number and size of new customers starting services;
. the decision of one or more employers to delay implementation or cancel ongoing services;
. our ability to design, develop and introduce new services and features for existing services on a timely basis;
. costs associated with strategic acquisitions and alliances or investments in technology;
. expenses incurred for geographic and service expansion;
. a reduction in the number of employees of our customers; and
. mergers or acquisitions of our customers by other companies.
Further, our agreements with customers generally do not have penalties for cancellation. As a result, any decision by a customer to cancel our services may cause significant variations in operating results in a particular quarter and could result in losses for that quarter. As we secure larger customers, any cancellation of services by a larger customer likely would result in greater fluctuations in operating results than historically experienced.
Failure to retain our key executives or attract and retain qualified technical personnel could harm our business and operating results.
The loss of one or more of our executive officers could inhibit the development of our business and, accordingly, harm our business and operating results. While we generally enter into employment agreements with our key executive officers, we may not be able to retain them.
Qualified personnel are in great demand throughout the health care industry. Our future growth and our ability to achieve our financial and operational objectives will depend in large part upon our ability to attract and
retain highly skilled technical, engineering, sales and marketing and customer support personnel. Our failure to attract and retain personnel may limit the rate at which we can expand our business, including the development of new products and services and the retention of additional customers, which could harm our business and operating results.
We could be subject to potential liability claims related to our services that could harm our financial condition and results of operations.
Any liability claim brought against us, even if not successful, would likely be time consuming and costly and could seriously harm our business and operating results. Errors in the performance of our services on behalf of an employer could result in the delay of processing of health care eligibility information or execution of payment transactions or could otherwise result in financial or other damages to our customers. These errors also may result in the improper denial of health care benefits to employees. A liability claim brought against us by an employer or an employee could seriously harm our business and reputation.
Our customer agreements generally require that we indemnify our customers for various losses and liabilities incurred by them that are caused by us. Any indemnification payments required under these agreements may harm our business and operating results.
We also may become party to litigation brought by a participating employee against an employer or health plan. We may not successfully avoid liability for problems related to the provision of health care benefits even though we do not make medical determinations or coverage decisions. Any claims or litigation also could require expenditures in terms of management time and other resources to defend us. This could require us to implement measures to reduce our exposure to this liability, which may require us, among other things, to expend substantial resources or to discontinue service offerings or to take other precautions. Liability of this type could harm our business and operating results.
Expected benefits of our recent acquisition of the health and welfare assets of Howard Johnson & Company may not be realized.
Achieving the expected benefits of our acquisition of the health and welfare assets of Howard Johnson will depend in part on the timely and efficient integration of the operations and personnel of the two companies and conversion of customers to our core systems. Among the challenges involved in this integration are demonstrating to customers that the acquisition will not result in adverse changes to service or customer service standards, persuading personnel and customers that our business cultures are compatible and addressing any perceived adverse changes in business focus. An unsuccessful integration may result in the loss of customers and key employees, and divert the attention of management that may adversely affect our business, financial condition and operating results.
The failure to successfully integrate any future acquisitions could harm our business and operating results.
If we acquire businesses in the future and are unable to successfully integrate these businesses into our own, it could harm our business and operating results. In order to remain competitive or to expand our business, we may find it necessary or desirable to acquire other businesses, products or technologies. If we identify an appropriate acquisition candidate, we may not be able to negotiate the terms of the acquisition successfully, to finance the acquisition or to integrate the acquired businesses, products or technologies into our existing business and operations. Further, completing a potential acquisition and integrating an acquired business may strain our resources and require significant management time. In addition, we may be required to expense significant amounts of goodwill and other intangible assets in connection with future acquisitions that would harm our operating results.
Changes in the health care industry could harm our future operating results and opportunities for growth.
Our services are, in large part, beneficial to employers because we are able to coordinate the exchange of eligibility and financial data and execute payment transactions between an employer and its numerous carriers.
Changes in the health care industry may require us to reconfigure our services and systems to accommodate a change in data formats and codes utilized by recently acquired or consolidated health plans. Further, the consolidation of health plans operating in the same geographic market may substantially reduce the number of competitive health plans in that market. Existing and potential customers, especially mid-sized employers operating in only one geographic market, may not find our services beneficial if there is limited competition among health plans. In addition, the health care landscape could change such that an employer would no longer find it beneficial to contract with multiple carriers, limiting the need for our services.
Although there is not currently any single payer or government sponsored health care legislation being proposed, such legislation has been introduced in the past. Should such legislation be made into law, it could dramatically change the health care industry and may adversely affect our business.
Our revenues could decrease if our systems or processes are inadequate.
Any failure of our systems or processes could harm our business and operating results. We process vast amounts of enrollment, eligibility and financial data and execute many payment transactions. Any delay or failure in our system, in our ability to communicate electronically with employers and health plans, or in our ability to collect, store, analyze or process accurate enrollment, eligibility and financial data may result in the denial of health care benefits, or in the delay or failure to execute payment transactions accurately. This type of denial or failure would harm our business and operating results.
The occurrence of a catastrophic event or other system failure at our facilities could interrupt our operations or result in the loss or corruption of stored data. In addition, we depend on the efficient operation of Internet and network connections among our system, employers and carriers. These connections depend on the efficient operation of data exchange tools, Web browsers, Internet service providers and Internet and network backbone service providers. In the past, Internet users have occasionally experienced difficulties with Internet and online services due to system failures. Any disruption in Internet or network access provided by third parties could harm our business and operating results. Further, we are dependent on hardware suppliers for prompt delivery, installation and service of equipment used to deliver our services. The failure of these suppliers to promptly deliver, install or service equipment could harm our business and operating results.
Furthermore, our business depends upon products, services and technology provided by third parties, such as health care providers and insurers, insurance and health care brokers, information technology consultants, network support providers, telecommunication companies, Internet service and access providers, third-party service providers, vendors, business partners and others outside our control. A prolonged Internet or communications failure also could prevent us from performing services on behalf of customers. Also, a systemic failure could require potential customers to dedicate substantial resources towards fixing or resolving problems and may make the sales and marketing of our services more difficult.
Our business and reputation may be harmed if we are unable to protect the privacy of our information.
Our information systems and Internet communications may be vulnerable to damage from physical break-ins, computer viruses, programming errors, attacks by computer hackers or similar disruptive problems. A user who is able to access our computer or communication systems could gain access to confidential employer, employee or carrier information or our own confidential information. A material security breach could harm our business and our reputation or could result in liability to us. Therefore, it is critical that our facilities and infrastructure remain secure. The occurrence of any of these events could result in the interruption, delay or cessation of our services, which could harm our business or operating results. Further, our reputation may suffer if third parties were to obtain this information and we may be liable for this disclosure. Any effect on our reputation or any liability for any disclosure could harm our business and operating results.
If we are unable to adequately protect our intellectual property rights or if we infringe upon the intellectual property rights of third parties, our results may be harmed.
Our success depends in part upon our intellectual property rights to products and services that we develop. We rely on a combination of contractual, statutory and common law rights including non-disclosure agreements,
trade secrets, copyrights, patents and trademarks to establish and protect our intellectual property rights in our names, products, services and related technology. While our subsidiary, Arbor Associates, Inc., has patented its health and welfare benefit systems, we currently have no other registered patents or pending patent applications covering any of our technology. Loss of intellectual property protection or inability to secure intellectual property protection on any of our names, confidential information or technology could harm our business and operating results.
We have received a U.S. trademark registration for BEN-NET and a U.S. service mark registration for WebElect(R). In addition, we have applied for trademark and service mark protection for benX, eBenX, and The Benefit Exchange Network under the classification of computer hardware and software, employee benefits consulting services and computer consulting services. Our subsidiary, Arbor Associates, Inc., has not applied for any trademark or service mark protections. These applications may not be granted. Our current trademark and service mark registrations and any future granted registrations may not be enforceable or effective in protecting the marks, and the lack of registered trademark or service mark protection for our subsidiary's marks and name could require it to stop using the marks or to change its name. Any failure to protect our marks or our subsidiary's marks could result in the loss of any goodwill created in providing our services. We typically enter into non-disclosure and confidentiality agreements with our employees and consultants with access to sensitive information. These agreements may not be adequate to protect our intellectual property rights or prevent misappropriation of our technology. Products and services with features similar to our services may be independently developed.
Although we believe that our core technology has been independently developed and that none of our technology or intellectual property infringes on the rights of others, third parties may assert infringement claims against us in the future. We may be required to modify our products, services, internal systems or technologies or to obtain a license to permit our continued use of those rights. We may not be able to do either in a timely manner or upon reasonable terms and conditions. Failure to do so could harm our business and operating results. In addition, future litigation relating to these matters could result in substantial cost diversion of resources by us. Adverse determinations in any litigation or proceedings of this type also could subject us to significant liabilities to third parties and could prevent us from using some of our products, services, internal systems or technologies.
Rapidly changing technology may impair our financial performance.
We may encounter difficulties responding to technological changes that could delay our introduction of products and services and we may not be able to respond to these changes in a timely and cost-effective manner. Our business depends upon the use of software, hardware, networking and Internet technology and systems. These technologies and systems are rapidly evolving and are subject to rapid change and obsolescence. As these technologies mature, we must be able to quickly and successfully modify our products and services to adapt to this change. We may encounter difficulties that could delay or harm the performance of our products or services. We may not be able to respond to technological changes in a timely and cost-effective manner. In addition, our competitors may develop technologically superior products and services. Further, data formatting and eligibility rules within a particular employer or health plan, or within the group health benefits industry as a whole, may change and may require substantial and expensive re-engineering of eligibility data and adjustment of the tools we use to process this eligibility data.
Federal, state and local laws could harm our business and operating results.
Federal, state or local laws could harm our business and operating results by requiring us to change the way we provide services and increase our cost of performing services. Further, these laws could restrict our ability to continue to develop our business as currently planned. The health care industry is highly regulated by federal, state and local laws. The application of existing laws, or the implementation of new laws applicable to our business could harm our business and operating results. For example, the confidentiality of patient records and the circumstances under which records may be released for inclusion in our databases may be subject to substantial regulation. Although compliance with current laws is principally the responsibility of health care
providers and carriers, these regulations may be extended to cover our business and the eligibility data and other information included in our databases. If these laws are extended to cover our business, we may be required to expend additional resources in order to comply with these laws, including changes to our security practices, and may be exposed to greater liability in the event we fail to comply with these laws.
HIPAA mandates that health plans use standard transactions, identifiers, security and other provisions. We have designed our products and services to comply with HIPAA, but any change in federal standards would require us to expend additional resources to comply with the new standards. In addition, under HIPAA, the U.S. Department of Health and Human Services has issued proposed rules that, if adopted, would impose significant restrictions on the disclosure of electronic personal health information.
Further, our ministerial role in facilitating payments by employers to health plans may subject us to ERISA. This act imposes fiduciary duties on employers and health plans with respect to payments made on behalf of participating employees and it is possible that these fiduciary duties could be deemed to apply to us. In that event, we may become subject to greater liability and constraints with respect to these payments and may experience higher operating costs in order to comply with this regulation. These increases in operating costs may harm our business and operating results.
Laws and regulations concerning the sale, marketing or distribution of insurance over the Internet could harm our business and operating results.
The impact of current or future insurance laws and regulations on our business is difficult to anticipate because the application of e-commerce to the insurance market is relatively new. The insurance industry is subject to extensive regulation under state laws. Insurance laws and regulations cover all aspects of the insurance process, including sales techniques, underwriting for eligibility, rates, claim payments, and record keeping by licensed insurance companies and insurance agents. A company that does business as an insurance agent is generally required to be licensed in each state in which it conducts that business. In the future, aspects of our business or other activities may be considered by insurance regulatory authorities to fall under their licensing jurisdiction which might increase our cost of providing services and/or make it more difficult to market and provide services in those jurisdictions.
Future sales of our common stock in the public market could cause the price of our common stock to decline.
We cannot predict the timing or amount of future sales of shares of our stock or the effect, if any, that market sales of shares, or the availability of shares for sale, will have on the prevailing market price of our common stock. Our shareholders could sell substantial amounts of our common stock in the public market. Currently approximately 240,499 shares are subject to certain lock-up agreements. Upon the expiration of these agreements, these shares will be available for public trading. Consequently, the price of our common stock could fall.
Concentration of ownership may give some shareholders substantial influence and may prevent or delay a change in control.
Some shareholders, including officers and directors of the company, beneficially own a substantial portion of our outstanding common stock. These shareholders may be able to exercise substantial influence over all matters requiring shareholder approval, including the election of directors and approval of significant corporate transactions. This concentration of ownership may also have the effect of discouraging third party offers to acquire our company or of delaying or preventing a change in control of our company.
Our charter documents and Minnesota law may discourage unsolicited takeover offers which could deprive our shareholders of opportunities to sell their shares of common stock at prices higher than prevailing market prices.
Provisions of our articles of incorporation, bylaws and Minnesota law could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our shareholders. For instance, our bylaws
provide for a classified board of directors with each class of directors subject to re-election every three years. This will make it more difficult for third parties to insert their representatives on our board of directors and gain control of our company. These provisions also could discourage proxy contests and make it more difficult for shareholders to elect directors and take other corporate actions. Further, the Minnesota Control Share Acquisition Act and the Minnesota Business Combination Act may make it more difficult for third parties to secure control of us or to complete an acquisition. These acts may discourage unsolicited takeover offers that could deprive our shareholders of opportunities to sell their shares of common stock at prices higher than prevailing market prices.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
Interest Rate Sensitivity
Our exposure to market risk for changes in interest rates relate primarily to our short-term investments. We do not use derivative financial instruments. The primary objective of our investment activities is to preserve principal while maximizing yields without significantly increasing risk. Due to the nature of our investments, we believe that there is no material risk exposure. All investments are held at market value, with unrealized gains and losses included in other comprehensive income.
The table below represents principal (or notional) amounts and related weighted-average interest rates by year of maturity for our investments at December 31, 2001 (in thousands):
Exchange Rate and Commodity Price Sensitivity
We do not conduct business outside of the United States and do not invest in foreign instruments or commodities and, therefore, have no direct exposure related to either foreign currency exchange rate fluctuation or commodity price fluctuation.
Item 8.
Item 8. Financial Statements and Supplementary Data
Selected Quarterly Operating Results
The following table shows unaudited statement of operations data for each quarter in the years ended December 31, 2001 and 2000. In management's opinion, this unaudited quarterly information has been prepared on the same basis as the audited financial statements and related notes and includes all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the information for the quarters presented, when read in conjunction with the audited financial statements and related notes included elsewhere in this annual report. We believe that quarter-to-quarter comparisons of our financial results are not necessarily meaningful and should not be relied upon as an indication of future performance.
EBENX, INC.
FINANCIAL STATEMENTS
Years Ended December 31, 2001, 2000 and 1999
Report of Independent Auditors
Board of Directors and Shareholders eBenX, Inc.
We have audited the accompanying consolidated balance sheets of eBenX, Inc. as of December 31, 2001 and 2000, and the related consolidated statements of operations, changes in shareholders' equity (deficit), and cash flows for each of the three years in the period ended December 31, 2001. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of eBenX, Inc. at December 31, 2001 and 2000, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2001, in conformity with accounting principles generally accepted in the United States.
/s/ Ernst & Young LLP
Minneapolis, Minnesota February 8, 2002
EBENX, INC.
CONSOLIDATED BALANCE SHEETS (Amounts in thousands, except share and per share data)
See accompanying notes to consolidated financial statements.
EBENX, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS (Amounts in thousands, except per share data)
See accompanying notes to consolidated financial statements.
EBENX, INC.
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY (DEFICIT) (Amounts in thousands)
See accompanying notes to consolidated financial statements.
EBENX, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (Amounts in thousands)
See accompanying notes to consolidated financial statements.
EBENX, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2001, 2000, and 1999
1. Business Description and Summary of Significant Accounting Policies
Business Description
eBenX, Inc., a Minnesota corporation incorporated in September 1993 (the "Company"), provides technology-based solutions for the purchase, administration and payment of group health and welfare benefits. The Company currently operates in a single business segment providing services to employers, brokers, and other employee benefit advisors, and health plans and other carriers. The Company's customers are located throughout the United States.
Principles of Consolidation
The consolidated financial statements include the Company and its wholly owned subsidiaries, Arbor Associates, Inc. and Managed Care Buyer's Group, Inc. All intercompany accounts and transactions have been eliminated in consolidation.
Cash and Cash Equivalents
The Company considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents. Cash equivalents are stated at cost, which approximates market value.
Short-term investments
Short-term investments consist of commercial paper, U.S. government and agency securities and corporate notes and bonds. All short-term investments are classified as available-for-sale securities under the provisions of Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." Available-for-sale securities are carried at fair value, with the unrealized gains and losses, net of tax, reported as a separate component of shareholders' equity.
The amortized cost of debt securities is adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization and accretion as well as interest and realized gains and losses are included in interest income and other.
Property and Equipment
Property and equipment, including purchased software, is stated at cost for items purchased and at estimated fair value for items contributed by the founding shareholders. Depreciation is computed using the straight-line method over the estimated useful lives of the assets of five to seven years. Leasehold improvements are amortized on a straight-line basis over the estimated useful life of the assets or the related lease term, whichever is less.
Income Taxes
Income taxes are accounted for under the liability method. Deferred income taxes are provided for temporary differences between financial reporting and tax bases of assets and liabilities.
Revenue Recognition
The Company generates revenue from providing exchange and procurement services. Administrative or exchange services represent technology-based solutions to employers and health plans for the purchase,
EBENX, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
administration, and payment of group health and welfare benefits. Fees related to these services are generally billed on a per employee per month basis. Revenue is recognized as services are performed. The Company also records revenue related to implementation fees associated with its exchange services. These fees are recognized as revenue over the life of the contract. In addition, the Company receives fees for providing enrollment services. These fees are recognized over the enrollment period as services are provided. Procurement consulting services consist of the Company assisting and advising customers on the selection of potential health care suppliers, preparation of requests for proposals, evaluation of proposals, rate negotiations, actuarial services and preparation of benefit plan communication materials for employees. The Company's ongoing exchange contracts range in duration from one to five years. Procurement services agreements do not exceed five years in duration. The Company recognizes revenue under the contracts and agreements as services are performed. Revenues generated from administrative or exchange services for the years ended December 31, 2001, 2000 and 1999 were $31,057,000, $23,172,000, and $13,823,000, respectively. Revenues generated from procurement consulting services for the years ended December 31, 2001, 2000, and 1999 were $5,806,000, $5,829,000, and $3,703,000, respectively.
Research and Development and Software Development
Research and development expenses consist primarily of development personnel and external contractor costs related to the development of new products and services, enhancement of existing products and services, quality assurance and testing. The Company follows AICPA Statement of Position No. 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use", in accounting for internally developed software. To date, the Company has not capitalized any software development costs as a majority of in-house development efforts are related to determining specific software requirements and evaluating alternatives related to specific performance criteria for its products. As a result, all research and development costs have been expensed as incurred.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
Advertising Costs
The Company expenses advertising costs as incurred. The amount of advertising expensed during 2001, 2000 and 1999 was approximately $418,000, $357,000, and $71,000, respectively.
Impairment of Long-Lived Assets
The Company records impairment losses on long-lived assets used in operations when indicators of impairment are present and the undiscounted cash flows estimated to be generated by those assets are less than the assets' carrying amount.
Stock-Based Compensation
The Company follows Accounting Principles Board Opinion (APB) No. 25, "Accounting for Stock Issued to Employees", and related interpretations in accounting for its employee stock options. Under APB No. 25, expense is recognized for the excess of the market price of the underlying stock on the date of grant over the exercise price of the Company's employee stock options.
Net Loss Per Share
Basic net loss per share is based on the weighted-average shares outstanding during the period. Diluted net loss per share increases the shares used in the per share calculation by the dilutive effects of options, warrants,
EBENX, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
and convertible securities. The Company's common stock equivalent shares outstanding from stock options and warrants are excluded from the diluted net loss per share computation for all periods because their effect would be antidilutive.
Fair Value of Financial Instruments
SFAS No. 107, "Disclosure About Fair Value of Financial Instruments," requires certain disclosures regarding the fair value of financial instruments. Cash and cash equivalents, accounts receivable, accounts payable, and accrued liabilities are reflected in the consolidated financial statements at fair value due to the short-term maturity of these instruments.
Comprehensive Loss
SFAS No. 130, "Reporting Comprehensive Income," establishes standards for the reporting and display of comprehensive income and its components. Adjustments to comprehensive loss for the years ended December 31, 2001 and 2000 consisted solely of unrealized gains on available-for-sale securities of $196,000 and $8,000, respectively, resulting in total comprehensive losses of $68,617,000 and $15,482,000, respectively.
Reclassification
Certain prior year items have been reclassified to conform to the current year presentation.
Recent Accounting Pronouncements
In June 2001, the Financial Accounting Standards Board issued SFAS No. 141, "Business Combinations", and No. 142, "Goodwill and Other Intangible Assets", effective for fiscal years beginning after December 15, 2001. Under the new rules, goodwill and intangible assets deemed to have indefinite lives will no longer be amortized but will be subject to annual impairment tests in accordance with the Statement. Other intangible assets will continue to be amortized over their useful lives.
The Company will apply the new rules on accounting for goodwill and other intangible assets beginning in the first quarter of 2002. Application of the nonamortization provisions of SFAS No. 142 is expected to result in an increase in net income of $8.8 million, $7.3 million and $3.5 million for 2002, 2003 and 2004, respectively. During the first six months of 2002, the Company will perform the first of the required impairment tests of goodwill and indefinite lived intangible assets as of January 1, 2002. The Company has not yet determined what the effect of these tests will be on the earnings and financial position of the Company. The provisions of SFAS No. 142 do not allow for amortization of goodwill associated with acquisitions that closed after July 1, 2001. As a result, the 2001 net loss was $702,000 lower than it would have been had the goodwill associated with the acquisition of the health and welfare assets of Howard Johnson been amortized through December 31, 2001.
In August 2001, the Financial Accounting Standards Board issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets", which addresses financial accounting and reporting for the impairment or disposal of long-lived assets and supersedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of", and the accounting and reporting provision of APB Opinion No. 30, "Reporting the Results of Operations" for a disposal of a segment of a business. SFAS No. 144 is effective for fiscal years beginning after December 15, 2001, with earlier application encouraged. The Company expects to adopt SFAS No. 144 as of January 1, 2002, and it has not determined the effect, if any, the adoption will have on the Company's financial position and results of operations.
2. Acquisitions
On November 5, 2001, the Company completed the acquisition of the health and welfare assets of Howard Johnson & Company, ("Howard Johnson"), a wholly owned subsidiary of Merrill Lynch & Company, Inc., for a
EBENX, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
final purchase price of approximately $12.6 million, including approximately $11.5 million paid in cash at closing and approximately $1.1 million in assumed obligations to employees, pursuant to the terms of an Asset Purchase Agreement between Howard Johnson and the Company dated as of October 19, 2001 (the "Asset Purchase Agreement"). The purchase price was funded from the Company's existing cash.
In connection with the consummation of this acquisition, the Company entered into a Shared Services Agreement with Howard Johnson pursuant to which Howard Johnson will provide agreed upon services to the Company in connection with the Company's health and welfare business for up to 24 months. The Company is obligated to pay Howard Johnson a monthly fee of $187,500, subject to reduction as responsibility for providing these services to each client is transferred to the Company. The Company also entered into a Marketing Agreement with Howard Johnson pursuant to which Howard Johnson may refer potential and existing clients seeking health and welfare benefits services to the Company in exchange for a percentage of revenues from such referrals.
On September 6, 2000, the Company completed its acquisition of Arbor Administrative Services, Inc. ("Arbor"). Arbor provides benefits administration and related Web-based services to mid-sized employers. Arbor distributes its services primarily through brokers and employee benefit advisors. The Company paid $17 million in cash and exchanged approximately 2,596,000 shares of eBenX stock with a fair value of $44.6 million for all of the outstanding common stock of Arbor. The common stock was valued using eBenX's average closing stock price on the date prior to and the date of the announcement. The Company also assumed all of the outstanding restricted stock, stock options and warrants of Arbor at a fair value of $4.8 million. The options and warrants were valued using the Black-Scholes option-pricing model with inputs of .90 for volatility, two years for expected life, 6.35% for the risk-free interest rate, and a market value of $17.19. The restricted stock was valued at a market value of $17.19 per share. In connection with the acquisition, the Company incurred transaction costs consisting primarily of professional fees of $1.4 million, bringing the total purchase price for the acquisition to $67.8 million.
Each of the above acquisitions was accounted for using the purchase method of accounting. The excess of the consideration provided over the relative fair value of the assets acquired was allocated to goodwill. The allocation of purchase price related to the acquisition of the health and welfare assets of Howard Johnson is subject to change pending a final analysis of the value of the assets acquired and the liabilities assumed.
The total purchase price paid for the Arbor and Howard Johnson acquisitions was allocated as follows (in thousands):
In the fourth quarter of 2001, the Company recorded a $30.4 million impairment charge to the carrying value of goodwill associated with the 2000 acquisition of Arbor. In the fourth quarter of 2001, management believed that the carrying value of the Arbor goodwill exceeded its fair market value. As a result, the Company performed an impairment test by using a current market valuation approach to calculate the amount of the impairment charge.
Prior to the impairment charge of $30.4 million in fourth quarter 2001, goodwill and other intangible assets related to the Arbor acquisition were being amortized over a three year period, however, in accordance with SFAS No. 142, no amortization was recorded for goodwill associated with the acquisition of the health and welfare assets of Howard Johnson in 2001. At December 31, 2001, accumulated goodwill charges and amortization related to goodwill and other intangible assets acquired in the Arbor acquisition totaled $60.2 million.
EBENX, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The following summary, prepared on an unaudited pro forma basis, reflects the condensed consolidated results of operations for the years ended December 31, 2001, 2000 and 1999, assuming Arbor had been acquired at the beginning of 2000 and 1999, and assuming the health and welfare assets of Howard Johnson had been acquired at the beginning of 2001and 2000 (in thousands, except per share data):
The pro forma results are not necessarily indicative of what would have occurred if the acquisitions had been in effect for the periods presented. They are not intended to be a projection of future results and do not reflect any synergies that might be affected from combined operations.
3. Short-term Investments
The following is a summary of short-term investments at December 31, 2001 (in thousands):
The contractual maturities of the Company's available-for-sale securities at December 31, 2001 were as follows (in thousands):
Actual maturities may differ from contractual maturities because some borrowers have the right to call or prepay obligations. Realized gains or losses from the sales of marketable securities are based on the specific identification method. Gross realized gains and losses on sales of available for sale securities were immaterial in 2001.
EBENX, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
4. Property and Equipment, net
Property and equipment as of December 31 are as follows (in thousands):
5. Note Receivable
In conjunction with the formation of a strategic alliance to develop, promote, distribute and support an integrated Web-based benefits administration and communications product for mid-sized employers, the Company entered into a joint development agreement and a related loan agreement on August 31, 2001, granting a line of credit of $1.5 million to Online Benefits, Inc, a privately held Delaware corporation. The outstanding principal balance under the line of credit bears interest at a rate of 8% per annum. Interest is due annually on the anniversary date of the loan agreement. On August 31, 2004, the third anniversary date of the loan agreement, payment of the lesser of the outstanding principal balance under the line of credit or the total gross revenues received by the strategic alliance through such date is due. If less than the entire principal balance under the line of credit is paid on August 31, 2004, then the lesser of the remaining principal balance or the total gross revenues of the strategic alliance for the preceding year is due on the next and each succeeding anniversary date of the loan agreement. Any remaining outstanding principal balance under the line of credit is due on August 31, 2006. At December 31, 2001, $800,000 has been advanced and remains outstanding under the line of credit.
As a condition of the loan agreement, the Company received warrants to purchase common stock of Online Benefits at an exercise price of $1.644 per share. The warrants entitle the Company to purchase shares equal to 15% of the total advances on the line of credit, divided by the per share exercise price. The warrants expire August 31, 2006. Warrants for the purchase of 72,992 shares of common stock were outstanding at December 31, 2001.
6. Redeemable Preferred Stock
In May and June 1999, the Company sold a total of 1,075,820 shares of Series C preferred stock resulting in net proceeds to the Company of $10.4 million. Prior to the closing of the Company's initial public offering in December 1999, all of the Company's preferred stock converted into 6,248,922 shares of common stock.
7. Shareholders' Equity
Common Stock
On December 8, 1999, the Company effected a three-for-one stock split whereby each shareholder received two additional shares for each share owned. Accordingly, all share, per share, and weighted average share information have been restated to reflect the split.
On December 15, 1999, the Company closed its initial public offering of 5,000,000 shares of common stock sold at $20.00 per share. The Company received $91.5 million in proceeds from the offering, net of underwriting
EBENX, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
discounts, commissions, and other costs. An additional 750,000 shares were sold under the exercise of the underwriter's over-allotment option in January 2000, resulting in additional net proceeds to the Company of $14 million.
Employee Stock Purchase Plan
The Company's board of directors approved the 1999 Employee Stock Purchase Plan, effective December 10, 1999, under which 900,000 shares of common stock have been reserved for issuance. The Plan permits an eligible employee to purchase common stock at a price equal to 85% of the lesser of the fair market value of the common stock at the beginning of the purchase period and the fair market value of the common stock at the end of the purchase period. Under the Plan, employees may purchase stock at a maximum amount of 15% of their compensation per annum, not to exceed $21,250. Shares purchased under this plan were 56,244 and 79,500 in 2001 and 2000, respectively.
8. Income Taxes
At December 31, 2001 and 2000, the Company's deferred taxes are as follows (in thousands):
The Company has established a valuation allowance to fully reserve for the net deferred tax assets at December 31, 2001 and 2000. The valuation allowance was established due to the available evidence indicating that it is not more than likely that the deferred tax assets will be realized.
As of December 31, 2001, the Company has unused federal and state research and development tax credit carryforwards of approximately $250,000 which begin to expire in 2009. In addition, the Company has unused federal net operating loss carryforwards at December 31, 2001 of approximately $23.1 million, which begin to expire in 2009. The utilization of these carryforwards is dependent upon the Company's ability to generate sufficient taxable income during the carryforward periods, and is subject to limitations imposed under Section 382 of the Internal Revenue Code.
EBENX, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
9. Operating Leases
The Company leases or subleases its office space and certain equipment under terms of noncancelable operating lease agreements, which expire through November 2009. Future lease payments for all operating leases, excluding executor costs, such as management and maintenance fees are as follows (in thousands):
Rent expense, including the Company's pro rata share of certain operating costs, was $6,993,000, $5,457,000, and $2,096,000 in 2001, 2000 and 1999 respectively.
On August 29, 2001, the Company secured an irrevocable letter of credit for approximately $1.8 million. The letter was required under the operating lease of the Company's corporate headquarters, and as such, the lessor is assigned as the beneficiary of the funds in the event of default on the lease. The letter of credit expires July 31, 2005, and is collateralized by securities restricted for that purpose.
10. Significant Customers
Significant customer activity as a percent of the Company's net revenue in 2001, 2000 and 1999 is as follows:
11. Stock Options, Restricted Stock and Warrants
In 1993, the Company adopted the 1993 Stock Option Plan (the "1993 Plan") to encourage stock ownership by employees, directors and other individuals as determined by the board of directors. The Plan provides that options granted there under may be either incentive stock options (ISOs), as defined by the Internal Revenue Code, or nonqualified stock options. A maximum of 3,900,000 shares may be granted under the 1993 Plan. At December 31, 2001, there were no shares available for grant under the 1993 Plan. The 1993 Plan expires in 2003.
In 1999, the Company adopted the 1999 Stock Incentive Plan (the "1999 Plan"). The 1999 Plan provides for the granting of incentive stock options and nonqualified stock options, stock appreciation rights, restricted stock, performance awards, and other stock-based awards. The Company has reserved 3,000,000 shares for issuance under the 1999 Plan. At December 31, 2001, 583,850 shares were available for grant under the 1999 Plan. The 1999 Plan expires in 2009.
In connection with the acquisition of Arbor, the Company adopted the eBenX, Inc./Arbor Administrative Services, Inc. 2000 Equity Compensation Plan (the "2000 Plan", collectively, with the 1993 Plan and the 1999
EBENX, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Plan, the "Plans") effective September 6, 2000. The 2000 Plan provides for the granting of incentive stock options, nonqualified stock options and restricted stock to employees and directors of the Company. The Company has reserved 667,944 shares for issuance under the 2000 Plan. At the time of the Arbor acquisition, the Company issued 318,745 shares of restricted stock, including 22,053 vested shares, and options to purchase 349,199 shares. At December 31, 2001, 183,733 shares of restricted stock were vested, and there were 66,208 shares available for grant under the 2000 Plan. The 2000 Plan expires in 2010.
The compensation committee of the board of directors determines who will receive options under the Plans and sets the terms, including vesting dates. Options may have a maximum term of no more than ten years except in the case of a shareholder possessing more than 10% of the total voting power of all classes of stock (a 10% shareholder) in which case the maximum term is five years. The exercise price of ISOs granted under the Plans must be at least equal to the fair market value (or in the case of a 10% shareholder, 110% of the fair market value) of the common stock on the date of grant. The board of directors determines the exercise price of nonqualified options granted under the Plans.
The exercise price may be paid in cash, shares of previously owned common stock, or by issuance of a promissory note. In addition, the Plans also contain a provision allowing the Company to permit option holders to pay their withholding obligation through share redirection. If an option expires, terminates or is canceled, the shares not purchased there under may become available for additional option awards under the Plans.
In connection with the granting of stock options to employees prior to the Company's initial public offering, the Company recorded deferred stock-based compensation of approximately $5.5 million in the year ended December 31, 1999. This amount represents the difference between the exercise price and the deemed fair value of the Company's common stock for accounting purposes on the date these stock options were granted. In connection with the acquisition of Arbor in September 2000, the Company recorded deferred stock-based compensation of $5.2 million. This amount represents the difference between the exercise price and the deemed fair value of the Company's common stock for accounting purposes on the date all outstanding unvested options and restricted stock of Arbor were converted to Company options and restricted stock. The deferred stock-based compensation is included as a component of stockholders' equity and is being amortized over the vesting period of the options. Amortization expense of approximately $2.5 million and $2.7 million was recognized in 2001 and 2000, respectively. The amortization of the remaining deferred stock-based compensation will result in additional charges to operations through 2004.
EBENX, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Option activity is summarized as follows:
Summary information about the Company's stock options outstanding at December 31, 2001 is as follows:
EBENX, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Exercise prices for grants are equal to the market price of common stock on the date of grant. Prior to the Company's public offering, the board of directors established exercise prices for grants based on the board's estimation of the fair value of the common stock on the date of grant. Options vest over periods of one to ten years, and expire five to ten years after the date of grant.
Pro forma information regarding net loss and loss per share is required by SFAS No. 123, "Accounting for Stock-Based Compensation", and has been determined as if the Company had accounted for its employee stock options under the fair value method of SFAS No. 123. The fair value for these options was calculated as of the date of grant using the Black-Scholes multiple option-pricing model for options granted in 2001 and 2000, and the minimum value option-pricing model for options granted in 1999. The fair value calculation for 1999 does not include a volatility factor, because the options were granted prior to the Company's initial public offering.
Had the Company recorded compensation cost in accordance with SFAS No. 123, the net loss and net loss per share would have been as follows:
During 1995, the Company entered into a line of credit agreement to borrow up to $550,000, which expired in 1996. In connection with the agreement, the Company issued a warrant to purchase 6,000 shares of the Company's Series A Convertible Preferred Stock at $2.701 per share. These warrants are convertible into 18,000 shares of common stock, and are exercisable over ten years.
During 1995, the Company granted three employees warrants to purchase 65,415 shares of common stock at $.0333 per share. The warrants, which were immediately exercisable and expired at various times between June 30, 2000 and August 31, 2000, were granted in lieu of cash compensation. All remaining warrants were exercised during 2000.
In connection with the acquisition of Arbor and the conversion of all outstanding equity securities to those of the Company, the Company issued a warrant to purchase 53,520 shares of common stock at $10.15 per share to a former investor of Arbor. The warrant is exercisable over ten years and expires June 2010.
EBENX, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
12. Employee Benefit Plans
The Company has a 401(k) plan covering substantially all employees. Under the terms of the plan, participants may contribute 2% to 20% of their salary to the plan. Employees are eligible after one day of service and upon attainment of age 21. The Company may make matching contributions based on a discretionary formula or may contribute a discretionary amount. The Company did not make any contributions in 2001, 2000 or 1999.
13. Contingencies
A class action lawsuit was filed on October 25, 2001 on behalf of purchasers of our securities between December 9, 1999 and December 6, 2000, inclusive. The lawsuit was filed in United States District Court, Southern District of New York, against eBenX, BancBoston Robertson Stephens, Inc., Warburg Dillon Read LLC, Thomas Weisel Partners LLC, and our Chairman, Mark W. Tierney, Chief Executive Officer, John J. Davis, and Executive Vice President & General Manager-Corporate Solutions, Scott P. Halstead. The complaint alleges violations of Sections 11, 12(a)(2) and 15 of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. The complaint alleges that our prospectus, filed in connection with our initial public offering, was materially false and misleading because it failed to disclose certain commissions and agreements between the aforementioned parties and certain investors and customers. The complaint seeks unspecified damages plus attorneys' fees and rescission. We intend to vigorously defend against this lawsuit.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
Incorporated herein by reference to portions of the Proxy Statement for Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission within 120 days of the close of the fiscal year ended December 31, 2001.
Item 11.
Item 11. Executive Compensation
Incorporated herein by reference to portions of the Proxy Statement for Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission within 120 days of the close of the fiscal year ended December 31, 2001.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
Incorporated herein by reference to portions of the Proxy Statement for Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission within 120 days of the close of the fiscal year ended December 31,
For purposes of computing the market value of eBenX Common Stock held by non-affiliates of eBenX on the cover page of this report, all executive officers, directors, and shareholders affiliated with directors of eBenX are considered to be affiliates of eBenX. This does not represent an admission by eBenX or any such person as to the affiliate status of such person.
Item 13.
Item 13. Certain Relationships and Related Transactions
Incorporated herein by reference to portions of the Proxy Statement for Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission within 120 days of the close of the fiscal year ended December 31, 2001.
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
(a)(1) The following financial statements are filed herewith in Item 8:
(i) Consolidated Balance Sheets as of December 31, 2001 and 2000.
(ii) Consolidated Statements of Operations for the years ended December 31, 2001, 2000 and 1999.
(iii) Consolidated Statement of Shareholders' Equity (Deficit) for the years ended December 31, 2001, 2000 and 1999.
(iv) Consolidated Statements of Cash Flows for the years ended December 31, 2001, 2000 and 1999.
(v) Notes to consolidated financial statements at December 31, 2001.
(a)(2) Financial Statement Schedule.
(i) Schedule II--Valuation and Qualifying Accounts. Such schedules should be read in conjunction with the consolidated financial statements. All other supporting schedules are omitted because of absence of conditions under which they are required.
(a)(3) Exhibits
The following exhibits are filed or incorporated by reference:
3.1 Fifth Amended and Restated Articles of Incorporation of the Company (incorporated by reference to Exhibit 3.1 of Registrant's Registration Statement on Form S-1, Registration Number 333-87985).
3.2 Amended and Restated Bylaws of the Company (incorporated by reference to Exhibit 3.2 of Registrant's Registration Statement on Form S-1, Registration Number 333-87985).
4.1 Specimen of Common Stock Certificate (incorporated by reference to Exhibit 4.1 of Registrant's Registration Statement on Form S-1, Registration Number 333-87985).
10.1 1993 Stock Option Plan (incorporated by reference to Exhibit 4.4 of Registrant's Registration Statement on Form S-8, Registration Number 333-94081).
10.2 1999 Stock Incentive Plan (incorporated by reference to Exhibit 4.5 of Registrant's Registration Statement on Form S-8, Registration Number 333-94081).
10.3 1999 Employee Stock Purchase Plan (incorporated by reference to Exhibit 4.6 of Registrant's Registration Statement on Form S-8, Registration Number 333-94081).
10.4 eBenX, Inc./Arbor Administrative Services, Inc. 2000 Equity Compensation Plan (incorporated by reference to Exhibit 10.4 of Registrant's Annual Report on Form 10-K, filed on March 23, 2001).
10.5 Agreement and Plan of Merger by and among Arbor Administrative Services, Inc., a Delaware corporation, the principal stockholder of Arbor, eBenX, Inc., a Minnesota corporation, and Arbor Acquisition Corp., a Minnesota corporation, dated August 28, 2000 (incorporated by reference to Exhibit 2.1 of Registrant's Form 8-K, filed on September 14, 2000).
10.6 Services Agreement by and between the Company and PepsiCo, Inc. dated June 1, 1997 (incorporated by reference to Exhibit 10.4 of Registrant's Registration Statement on Form S-1, Registration Number 333-87985).
10.7 Services Agreement by and between the Company and Bell Atlantic Corporation, dated July 1, 1998 (incorporated by reference to Exhibit 10.5 of Registrant's Registration Statement on Form S-1, Registration Number 333-87985).
10.8 Employment Agreement by and between the Company and Mark Tierney, dated as of April 22, 1999, and amended and restated on September 28, 1999 (incorporated by reference to Exhibit 10.9 of Registrant's Registration Statement on Form S-1, Registration Number 333-87985).
10.9 Employment Agreement by and between the Company and John Davis, dated as of April 12, 1999 (incorporated by reference to Exhibit 10.10 of Registrant's Registration Statement on Form S-1, Registration Number 333-87985).
10.10 Employment Agreement by and between the Company and Scott Halstead, dated as of April 22, 1999 (incorporated by reference to Exhibit 10.11 of Registrant's Registration Statement on Form S-1, Registration Number 333-87985).
10.11 Employment Agreement by and between the Company and Jeff Rosenblum, dated as of September 6, 2000 (incorporated by reference to Exhibit 10.11 of Registrant's Annual Report on Form 10-K, filed on March 23, 2001).
10.12 Multi-Tenant Office Lease Agreement by and between the Company and Utah State Retirement Investment Fund, dated January 21, 2000 (incorporated by reference to Exhibit 10.5 of Registrant's Form 10-Q, filed on August 11, 2000).
10.13 Registration Rights Agreement, dated September 6, 2000 (relating to the registration rights of the previous shareholders of Arbor Administrative Services, Inc.) (incorporated by reference to Exhibit 10.15 of Registrant's Annual Report on Form 10-K, filed on March 23, 2001).
10.14 Employment Agreement by and between the Company and Thomas E. Kelly, dated as of February 23, 2001 (incorporated by reference to Exhibit 10.8 of Registrant's Quarterly Report on Form 10-Q, filed on May 14, 2001).
10.15 Separation Agreement and Release by and between the Company and Michael C. Bingham, dated as of March 5, 2001 (incorporated by reference to Exhibit 10.9 of Registrant's Quarterly Report on Form 10-Q, filed on May 14, 2001).
10.16 Asset Purchase Agreement between Howard Johnson & Company and eBenX, Inc. dated as of October 19, 2001 (incorporated by reference to Exhibit 10.1 of Registrant's Current Report on Form 8-K, filed on November 20, 2001).
10.17 Shared Services Agreement by and between Howard Johnson & Company and eBenX, Inc. dated as of November 1, 2001 (incorporated by reference to Exhibit 10.2 of Registrant's Current Report on Form 8-K, filed on November 20, 2001).
10.18 Transaction Services Agreement by and between Howard Johnson & Company and eBenX, Inc. dated as of November 1, 2001 (incorporated by reference to Exhibit 10.3 of Registrant's Current Report on Form 8-K, filed on November 20, 2001).
10.19 Marketing Agreement by and between Howard Johnson & Company and eBenX, Inc. dated as of November 5, 2001 (incorporated by reference to Exhibit 10.4 of Registrant's Current Report on Form 8-K, filed on November 20, 2001).
21.1 Subsidiaries of the Company(1)
23.1 Consent of Ernst & Young LLP(1)
24.1 Power of Attorney(1) - -------- (1) Filed herewith.
(b) The registrant filed reports on Form 8-K during its fourth fiscal quarter ended December 31, 2001. The reports filed on November 6 and 20, 2001, pertained to the acquisition of the assets of the health and welfare business unit of Howard Johnson & Company, a wholly owned subsidiary of Merrill Lynch & Company, Inc.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
EBENX, INC. Dated: March 27, 2002 By /S/ JOHN J. DAVIS ------------------------------------ John J. Davis Chief Executive Officer and President
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons in the capacities and on the dates indicated.
Signature Title Date --------- ----- ----
/S/ MARK W. TIERNEY Chairman and Director March 27, 2002 - ---------------------- Mark W. Tierney
/S/ JOHN J. DAVIS President, Chief Executive March 27, 2002 - ---------------------- Officer and Director John J. Davis (principal executive officer)
/S/ RANDALL J. SCHMIDT acting Chief Financial March 27, 2002 - ---------------------- Officer and Secretary Randall J. Schmidt (principal financial officer and principal accounting officer)
/S/ PAUL V. BARBER Director March 27, 2002 - ---------------------- Paul V. Barber
/S/ JAMES P. BRADLEY Director March 27, 2002 - ---------------------- James P. Bradley
/S/ DANIEL M. CAIN Director March 27, 2002 - ---------------------- Daniel M. Cain
/S/ ALAIN C. ENTHOVEN Director March 27, 2002 - ---------------------- Alain C. Enthoven
/S/ FRANK C. WITTHUN Director March 27, 2002 - ---------------------- Frank C. Witthun
EBENX, INC.
SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS
- -------- (1) Amounts written off against the reserve.