Document
 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 
FORM 10‑Q

 
(Mark One)
x    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2017  
OR
o    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Transition Period From                 to                
Commission file number: 001-37792

 
NantHealth, Inc.
(Exact name of registrant as specified in its charter)

 
 
Delaware
 
27-3019889
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)

9920 Jefferson Blvd
Culver City, California
 
90232
(Address of principal executive offices)
 
(Zip Code)
(310) 883-1300
(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
 
Title of each class
 
Name of each exchange on which registered
Common Stock, $0.0001 par value
 
NASDAQ Global Select Market

Securities registered pursuant to Section 12(g) of the Act: None

 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer”, “smaller reporting company”, and "emerging growth company" in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer
o
Accelerated filer
o
 
 
 
 
Non-accelerated filer
x (Do not check if a smaller reporting company)
Smaller reporting company
o
 
 
Emerging growth company
x

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.   x
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  o    No  x
As of May 10, 2017 the registrant had 121,667,852 shares of common stock, par value $0.0001 per share, outstanding.
 


NantHealth, Inc.

Form 10-Q
As of and for the quarterly period ended March 31, 2017
Table of contents



 
 
Page
PART I.
 
 
 
 
Item 1.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Item 2.
 
 
 
Item 3.
 
 
 
Item 4.
 
 
 
 
 
 
PART II.
 
 
 
 
Item 1.
 
 
 
Item 1A.
 
 
 
Item 2.
 
 
 
Item 3.
 
 
 
Item 4.
 
 
 
Item 5.
 
 
 
Item 6.
 
 
 

We own or have rights to trademarks and service marks that we use in connection with the operation of our business. NantHealth, Inc. and our logo as well as other brands such as CareFx, our clinical operating system, cOS or NantOS, DeviceConX, FusionFX, GPS Cancer, HBox, Vitality, VitalsConX, NaviNet, eviti, eviti | Connect, and other marks relating to our eviti product line are used in this Quarterly Report on Form 10-Q. Solely for convenience, the trademarks and service marks referred to in this Quarterly Report on Form 10-Q are listed without the (sm) and (TM) symbols, but we will assert, to the fullest extent under applicable law, our rights or the rights of the applicable licensors to these trademarks, service marks and trade names. Additionally, we do not intend for our use or display of other companies’ trade names, trademarks, or service marks to imply a relationship with, or endorsement or sponsorship of us by, these other companies.

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SPECIAL NOTE REGARDING FORWARD LOOKING STATEMENTS
This Quarterly Report on Form 10-Q, including without limitation the sections entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Risk Factors,” contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. In some cases you can identify these statements by forward-looking words such as “believe,” “may,” “will,” “might,” “estimate,” “continue,” “anticipate,” “intend,” “could,” “should,” “would,” “project,” “plan,” “outlook,” “target,” “expect,” or similar expressions, or the negative or plural of these words or expressions. These forward-looking statements include, but are not limited to, statements concerning the following:
the structural change in the market for healthcare in the United States, including uncertainty in the healthcare regulatory framework and regulatory developments in the United States and foreign countries;
the evolving treatment paradigm for cancer, including physicians’ use of molecular information and targeted oncology therapeutics and the market size for molecular information products;
physicians’ need for precision medicine products and any perceived advantage of our solutions over those of our competitors, including the ability of our comprehensive platform to help physicians treat their patients’ cancers;
our ability to generate revenue from sales of products enabled by our molecular and biometric information platforms to physicians in clinical settings;
our ability to increase the commercial success of our sequencing and molecular analysis solution;
our plans or ability to obtain reimbursement for our sequencing and molecular analysis solution, including expectations as to our ability or the amount of time it will take to achieve successful reimbursement from third-party payors, such as commercial insurance companies and health maintenance organizations, and government insurance programs, such as Medicare and Medicaid;
our ability to effectively manage our growth, including the rate and degree of market acceptance of our solutions;
our ability to offer new and innovative products and services;
our ability to attract new partners and clients;
our ability to estimate the size of our target market;
our ability to maintain and enhance our reputation and brand recognition;
consolidation in the healthcare industry;
competition which could limit our ability to maintain or expand market share within our industry;
restrictions and penalties as a result of privacy and data protection laws;
our use of “open source” software;
our ability to use, disclose, de-identify or license data and to integrate third-party technologies;
data loss or corruption due to failures or errors in our systems and service disruptions at our data centers;
breaches or failures of our security measures;
our reliance on Internet infrastructure, bandwidth providers, data center providers, other third parties and our own systems for providing services to our users;
risks related to future acquisition opportunities;
the requirements of being a public company;
our ability to attract and retain key personnel;
our ability to obtain and maintain intellectual property protection for our solutions and not infringe upon the intellectual property of others; and
our financial performance expectations, including our expectations regarding our revenue, cost of revenue, gross profit or gross margin, operating expenses, including changes in research and development, sales and marketing and general and administrative expenses, and our ability to achieve and maintain future profitability.
We caution you that the foregoing list does not contain all of the forward-looking statements made in this Quarterly Report on Form 10-Q.
These forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties, which could cause our actual results to differ materially from those reflected in the forward-looking statements. These statements appear throughout this Quarterly Report on Form 10-Q and are statements regarding our intent, belief, or current expectations, primarily based on our current assumptions, expectations and projections about future events and trends that we may affect our business, financial conditions, operations results, cash flows or prospects, as well as related industry developments. You should not place undue reliance on these forward-looking statements, which apply only as of the date of this Quarterly Report on Form 10-Q. Our actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including the risks faced by us and described in Part II, Item 1A, entitled “Risk Factors,” and in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part I, Item 2 of this Quarterly Report on Form 10-Q. We undertake no obligation to update any forward-looking statements for any reason, or to conform these statements to actual results or to changes in our expectations.

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PART I — FINANCIAL INFORMATION
Item 1. Financial Statements
NantHealth, Inc.
Condensed Consolidated Balance Sheets
(Dollars in thousands, except per share amounts)
 
March 31,
2017
 
December 31,
2016
 
(Unaudited)
 
 
Assets
 
 
 
Current assets
 
 
 
Cash and cash equivalents
$
124,894

 
$
160,353

Accounts receivable, net
8,924

 
13,728

Inventories
2,175

 
2,217

Deferred implementation costs
3,469

 
3,336

Related party receivables, net
910

 
899

Prepaid expenses and other current assets
5,760

 
5,046

Total current assets
146,132

 
185,579

Property, plant, and equipment, net
33,072

 
29,139

Deferred implementation costs, net of current
8,470

 
7,910

Goodwill
131,068

 
131,068

Intangible assets, net
113,906

 
119,126

Investment in related party
202,671

 
207,197

Related party receivable, net of current
1,964

 
1,971

Other assets
2,259

 
2,317

Total assets
$
639,542

 
$
684,307

 
 
 
 
Liabilities and Stockholders' Equity
 
 
 
Current liabilities
 
 
 
Accounts payable
$
3,729

 
$
6,720

Accrued and other current liabilities
21,277

 
25,231

Deferred revenue
16,537

 
17,216

Related party payables, net
9,451

 
8,082

Total current liabilities
50,994

 
57,249

Deferred revenue, net of current
18,279

 
17,238

Related party liabilities
7,048

 
5,612

Related party promissory note
112,666

 
112,666

Related party convertible note, net
7,655

 
7,564

Convertible notes, net
71,770

 
70,810

Deferred income taxes, net
986

 
754

Other liabilities
625

 
820

Total liabilities
270,023

 
272,713

 
 
 
 
Stockholders' equity
 
 
 
Common stock, $0.0001 par value per share, 750,000,000 shares authorized; 121,626,567 and 121,250,437 shares issued and outstanding at March 31, 2017 and December 31, 2016, respectively (Including 6,976 shares of restricted stock)
12

 
12

Additional paid-in capital
885,355

 
886,334

Accumulated deficit
(516,388
)
 
(475,273
)
Accumulated other comprehensive income
540

 
521

Total stockholders' equity
369,519

 
411,594

Total liabilities and stockholders' equity
$
639,542

 
$
684,307

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

- 4 -

NantHealth, Inc.
Condensed Consolidated Statements of Operations
(Dollars in thousands, except per share amounts)
(Unaudited)

 
Three Months Ended 
 March 31,
 
2017
 
2016
 
 
 
 
Revenue:
 
 
 
Software and hardware
$
645

 
$
674

Software–as-a-service
15,231

 
13,701

Total software-related revenue
15,876

 
14,375

Maintenance
3,162

 
3,138

Sequencing and molecular analysis
510

 

Other services
2,961

 
1,938

Total net revenue
22,509

 
19,451

 
 
 
 
Cost of Revenue:
 
 
 
Software and hardware
312

 
239

Software-as-a-service
7,233

 
4,423

Total software-related cost of revenue
7,545

 
4,662

Maintenance
862

 
530

Sequencing and molecular analysis
1,538

 

Other services
5,678

 
3,565

Amortization of developed technologies
3,406

 
4,281

Total cost of revenue
19,029

 
13,038

 
 
 
 
Gross profit
3,480

 
6,413

 
 
 
 
Operating Expenses:
 
 
 
Selling, general and administrative
20,878

 
27,373

Research and development
13,399

 
10,694

Amortization of software license and acquisition-related assets
1,814

 
1,815

Total operating expenses
36,091

 
39,882

Loss from operations
(32,611
)
 
(33,469
)
Interest expense, net
(3,969
)
 
(1,498
)
Other income, net
273

 
338

Loss from related party equity method investment
(4,526
)
 
(2,914
)
Loss before income taxes
(40,833
)
 
(37,543
)
Provision for (benefit from) income taxes
282

 
(4,398
)
Net loss
$
(41,115
)
 
$
(33,145
)
 
 
 
 
Net income (loss) per share (1):
 
 
 
Basic and diluted - common stock
$
(0.34
)
 
$
(0.36
)
 Basic and diluted - redeemable common stock
N/A

 
$
0.25

 
 
 
 
Weighted average shares outstanding (1):
 
 
 
Basic and diluted - common stock
121,618,039

 
99,651,444

 Basic and diluted - redeemable common stock
N/A

 
10,714,285


The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

- 5 -

NantHealth, Inc.
Condensed Consolidated Statements of Operations
(Dollars in thousands, except per share amounts)
(Unaudited)

(1)
The net income (loss) per share and weighted average shares outstanding for the three months ended March 31, 2016, have been computed to give effect to the LLC Conversion (See Note 15) that occurred on June 1, 2016, prior to the Company’s initial public offering ("IPO").  In conjunction with the LLC Conversion, (a) all of the Company’s outstanding units automatically converted into shares of common stock, based on the relative rights of the Company's pre-IPO equityholders as set forth in the Company's limited liability company agreement and (b) the Company adopted and filed a certificate of incorporation with the Secretary of State of the state of Delaware and adopted bylaws. The Company adopted and filed an amendment to its certificate of incorporation with the Secretary of State of the state of Delaware to effect a 1-for-5.5 reverse stock split of its common stock on June 1, 2016.

The net loss per share for the common stock for the three months ended March 31, 2016 reflects $2,625 in accretion value allocated to the redeemable common stock. The redeemable common stock contained a put right, which expired unexercised on June 20, 2016. As a result of and as of that date, the shares were no longer redeemable and were included in common stock. See Note 17 for the calculation of net loss per share for common stock and redeemable common stock for the three months ended March 31, 2016.


The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

- 6 -

NantHealth, Inc.
Condensed Consolidated Statements of Comprehensive Loss
(Dollars in thousands)
(Unaudited)


 
Three Months Ended 
 March 31,
 
2017
 
2016
 
 
 
 
Net loss
$
(41,115
)
 
$
(33,145
)
Other comprehensive income (loss), net of reclassification adjustments and taxes -
 
 
 
Foreign currency translation gains (losses)
19

 
303

Comprehensive loss
$
(41,096
)
 
$
(32,842
)
The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

- 7 -

 NantHealth, Inc.
Condensed Consolidated Statements of Cash Flows
(Dollars in thousands)
(Unaudited)

 
Three Months Ended 
 March 31,
 
2017
 
2016
Cash flows from operating activities:
 
 
 
Net loss
$
(41,115
)
 
$
(33,145
)
Adjustments to reconcile net loss to net cash used in operating activities:
 
 
 
Depreciation and amortization
8,331

 
7,809

Amortization of debt discounts and deferred financing offering cost
1,051

 

Change in fair value of derivatives liability
(215
)
 

Unrealized changes in fair value of marketable securities

 
(53
)
Realized changes in fair value of marketable securities

 
53

Stock-based compensation
250

 
98

Deferred income taxes, net
233

 
(4,885
)
Provision for bad debt expense
187

 
110

Loss from related party equity method investment
4,526

 
2,914

Changes in operating assets and liabilities, net of business combinations:
 
 
 
Accounts receivable, net
4,626

 
4,762

Inventories
42

 
(51
)
Related party receivables, net
(4
)
 
1

Prepaid expenses and other current assets
(708
)
 
(731
)
Deferred implementation costs
(478
)
 
(3,402
)
Accounts payable
(2,352
)
 
(5,717
)
Accrued and other current liabilities
(3,631
)
 
(1,477
)
Deferred revenue
354

 
4,484

Related party payables, net
2,823

 
(2,718
)
Other assets and liabilities
58

 
450

Net cash used in operating activities
(26,022
)
 
(31,498
)
Cash flows from investing activities:
 
 
 
Purchase of property and equipment
(7,370
)
 
(4,170
)
Purchases of marketable securities

 
(31
)
Proceeds from sales of marketable securities

 
1,204

Acquisitions of businesses, net of cash acquired

 
(79,423
)
Deferred consideration for acquisition

 
2,404

Net cash used in investing activities
(7,370
)
 
(80,016
)
Cash flows from financing activities:
 
 
 
Deemed capital contribution from Chairman and CEO

 
440

Payment of short-term notes payable

 
(23,324
)
Proceeds from (payment of) related party promissory notes

 
152,666

Tax payments related to stock issued, net of stock withheld, for vested phantom units
(2,106
)
 

 
(2,106
)
 
129,782

Effect of exchange rate changes on cash and cash equivalents
39

 
303

Net increase in cash and cash equivalents
(35,459
)
 
18,571

Cash and cash equivalents, beginning of period
160,353

 
5,989

Cash and cash equivalents, end of period
$
124,894

 
$
24,560


- 8 -

NantHealth, Inc.
Condensed Consolidated Statements of Cash Flows
(Dollars in thousands)
(Unaudited)

 
Three Months Ended 
 March 31,
 
2017
 
2016
Supplemental disclosure of cash flow information:
 
 
 
Interest paid
$
(1
)
 
$

Interest received
9

 
1

Non-cash transactions:
 
 
 
Purchase of property and equipment (including internal use software)
1,642

 

NaviNet escrow receivable

 
1,678

Accretion to redemption value of Series F / redeemable common stock

 
2,625

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.

- 9 -

NantHealth, Inc.
Notes to Condensed Consolidated Financial Statements
(Dollars in thousands, except per share amounts)
(Unaudited)


Note 1. Description of Business and Basis of Presentation
Nature of Business
Nant Health, LLC was formed on July 7, 2010, as a Delaware limited liability company. On June 1, 2016, Nant Health, LLC converted into a Delaware corporation (the “LLC Conversion”) and changed its name to NantHealth, Inc. (“NantHealth”). NantHealth, together with its subsidiaries (the “Company”), is a healthcare IT company converging science and technology through a single integrated clinical platform, to provide actionable health information at the point of care, in the time of need, anywhere, anytime. NantHealth works to transform clinical delivery with actionable clinical intelligence at the moment of decision, enabling clinical discovery through real-time machine learning systems. The company’s technology empowers physicians, patients, payers and researchers to transcend genomics into the world of proteomics and the traditional barriers of today’s healthcare system. By converging molecular science, computer science and big data technology, the Nant Operating System ("NantOS") platform allows physicians, patients and payers to coordinate care, monitor outcomes and control cost in real time. NantHealth is a majority-owned subsidiary of NantWorks, LLC (“NantWorks”), which is a subsidiary of California Capital Equity, LLC (“Cal Cap”). The three companies were founded by and are led by Dr. Patrick Soon-Shiong.
As of March 31, 2017, the Company conducted the majority of its operations in the United States, Canada, the United Kingdom, Singapore and India.
LLC Conversion and Initial Public Offering
On June 1, 2016, immediately prior to the pricing of its initial public offering (“IPO”) and in conjunction with the LLC Conversion, all outstanding units of Nant Health, LLC were automatically converted into shares of the Company’s common stock. Immediately following the LLC Conversion, the Company effected a 1-for-5.5 reverse stock split of its common stock. All share and per share amounts in the Condensed Consolidated Financial Statements and notes thereto have been retroactively adjusted, where necessary, to give effect to this reverse stock split.

On June 7, 2016, the Company completed its IPO, whereby it sold 6,500,000 shares of common stock at a public offering price of $14.00 per share. Additionally, on June 9, 2016, the underwriters partially exercised their over allotment option to purchase an additional 400,000 shares of common stock at $14.00 per share.

The Company received a total of $83,566 in proceeds from its IPO, after deducting underwriting discounts and commissions and offering costs of $13,034. The offering was registered under the Securities Act of 1933, as amended, on a registration statement on Form S-1 (Registration No. 333-211196), as amended (the “Registration Statement”).
Basis of Presentation
The accompanying unaudited Condensed Consolidated Financial Statements include the accounts of NantHealth and its subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation. These interim Condensed Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). These Financial Statements have been prepared on the same basis as the audited Consolidated Financial Statements for the fiscal year ended December 31, 2016 and, in the opinion of management, include all adjustments, which are normal and recurring in nature, necessary for a fair presentation of the Company's financial position and results of operation. Operating results for interim periods are not necessarily indicative of the results that may be expected for a full fiscal year. Certain reclassifications have been made to prior period amounts to conform to the current year presentation. Operating results for interim periods are not necessarily indicative of the results that may be expected for a full fiscal year. The accompanying Condensed Consolidated Balance Sheet as of December 31, 2016 has been derived from the audited Consolidated Financial Statements at that date but does not include all of the disclosures required by GAAP.
Principles of Consolidation
The accompanying Condensed Consolidated Financial Statements include the financial statements of all wholly owned subsidiaries. All intercompany balances and transactions with the Company’s subsidiaries have been eliminated.

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NantHealth, Inc.
Notes to Condensed Consolidated Financial Statements
(Dollars in thousands, except per share amounts)
(Unaudited)

Note 2. Summary of Significant Accounting Policies
There have been no significant changes to the accounting policies as disclosed in the Company's Annual Report on Form 10-K. The accounting policies are described in the Company’s Annual Report on Form 10-K.
Use of Estimates
The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the Condensed Consolidated Financial Statements and accompanying notes. Actual results may differ from those estimates.
Segment Reporting
The chief operating decision maker for the Company is its Chief Executive Officer. The Chief Executive Officer reviews financial information presented on a Condensed Consolidated basis for purposes of allocating resources and evaluating financial performance. The Company has one business activity and there are no segment managers who are held accountable for operations, operating results, or plans for levels or components below the Condensed Consolidated unit level. Accordingly, management has determined that the Company operates in one reportable segment.
Recent Accounting Pronouncements
Revenue from Contracts with Customers

The new FASB Topic 606 standards commencing with Accounting Standard Update ("ASU") No. 2014-09 ("Topic 606"), Revenue from Contracts with Customers replace existing revenue recognition rules including industry-specific guidance. Topic 606 outlines a five-step process for revenue recognition that focuses on transfer of control, as opposed to transfer of risk and rewards, and also requires enhanced disclosures regarding the nature, amount, timing and uncertainty of revenues and cash flows from contracts with customers. Major provisions include determining which goods and services are distinct and require separate accounting (performance obligations), how variable consideration (which may include change orders and claims) is recognized, whether revenue should be recognized at a point in time or over time and ensuring the time value of money is considered in the transaction price. Revenue is recognized in an amount that reflects the consideration which the entity expects to receive in exchange for goods or services. The provisions of Topic 606 will become effective for annual reporting periods beginning after December 15, 2017, at which point the Company plan to adopt the standard. The FASB allows two adoption methods under Topic 606 standards. Under one method, a company will apply the rules to contracts in all reporting periods presented, subject to certain allowable exceptions. Under the other method, a company will apply the rules to all contracts existing as of January 1, 2018, recognizing in beginning retained earnings an adjustment for the cumulative effect of the change and providing additional disclosures comparing results to previous rules.

The initial assessment of the impact of the new revenue standard on the current business processes, systems and controls is expected to be completed during fiscal 2017. Additionally, the Company is currently evaluating the potential impact that the implementation of this new revenue standard will have on the Company's Consolidated Financial Statements as well as selection of the method of adoption. The FASB has issued, and may issue in the future, interpretive guidance which may cause the evaluation to change.
The Company will not implement this new standard prior to the required effective date. Upon initial evaluation, the Company expects that the most significant impact will likely be to its software arrangements due to the requirement to estimate of selling price for deliverables. Under current revenue accounting guidance, if VSOE did not exist for license and implementation fees, the Company recognizes those revenues over the post contract support period. Also, the principal versus agent analysis under ASC 606 focuses on whether the entity controls each specified good or service in an arrangement and the company is currently evaluating whether the guidance will have an impact on how the Company reports its sequencing and molecular analysis revenue.

- 11 -

NantHealth, Inc.
Notes to Condensed Consolidated Financial Statements
(Dollars in thousands, except per share amounts)
(Unaudited)

Other accounting pronouncements

In January 2017, the FASB issued ASU No. 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business. This standard clarifies the definition of a business and provides a screen to determine if a set of inputs, processes and outputs is a business. The screen requires that when substantially all of the fair value of gross assets acquired (or disposed of) is concentrated in a single identifiable asset or a group of similar identifiable assets, the assets acquired would not be a business. Under the new guidance, in order to be considered a business, an acquisition must include, at a minimum, an input and a substantive process that together significantly contribute to the ability to create output. In addition, the standard narrows the definition of the term “output” so that it is consistent with how it is described in Topic 606 standards. This standard will be effective for annual periods beginning after December 15, 2017, including interim periods within that reporting period. The Company is currently evaluating the impact this guidance may have on its Condensed Consolidated Financial Statements.

In January 2017, the FASB issued ASU 2017-04, Intangibles – Goodwill and Other (Topic 350) to simplify the accounting for goodwill impairment. This guidance, among other things, removes step 2 of the goodwill impairment test thus eliminating the need to determine the fair value of individual assets and liabilities of the reporting unit. Upon adoption of this ASU, goodwill impairment will be the amount by which a reporting unit’s carrying value exceeds its fair value, not to exceed the carrying amount of goodwill. This may result in more or less impairment being recognized than under current guidance. This update will become effective for the Corporation’s annual and interim goodwill impairment tests beginning in the first quarter of 2020, and early adoption is permitted. The Company is still evaluating the impact of this standard update.

Other recent accounting pronouncements issued by the FASB (including its Emerging Issues Task Force), the American Institute of Certified Public Accountants, and the Securities and Exchange Commission ("SEC") did not have, or are not believed by management to have, a material impact on the Company's present or future Condensed Consolidated Financial Statements.
Note 3. Business Combinations
NaviNet, Inc. Acquisition in 2016
On November 30, 2015, NantHealth entered into a definitive agreement with 3BE Holdings, LLC (“3BE”) to acquire 100% of the outstanding equity interest of NaviNet, Inc. (“NaviNet”) in exchange for $83,529 in cash, subject to working capital adjustments, 15,513,726 newly issued Series H units with a fair value of $52,500 and contingent arrangements or earnouts of up to $12,250, which was effective on January 1, 2016 (See Note 6). The contingent arrangements or earnouts require the Company to pay up to a total of $12,250 to certain of NaviNet’s former shareholders if NaviNet’s revenues to those former shareholders exceed certain thresholds during the years ended December 31, 2016 and 2017. These contingent amounts or earnouts have been excluded from the purchase price consideration and are accounted for as sales incentives as certain predefined targets are met and are reflected as contra revenue. The cash portion of the acquisition was financed through a promissory note with NantCapital, LLC (“NantCapital”), an affiliate of the Company (See Note 18). In June 2016, the Company paid an additional $455 to 3BE as a working capital adjustment and accounted for the payment as an increase to the purchase price of NaviNet. In December 2016, and in accordance with the definitive agreements, the Company received $2,409 out of the escrow account for the settlement of the final net working capital adjustment.
 
The following table summarizes the total purchase consideration for the acquisition:
 
 Amounts
Cash paid to 3BE at closing
$
74,823

Cash paid to option holders after closing
2,580

Cash paid to escrow account
6,126

Working capital settlement payment
455

Fair value of Series H units
52,500

Total consideration
$
136,484


- 12 -

NantHealth, Inc.
Notes to Condensed Consolidated Financial Statements
(Dollars in thousands, except per share amounts)
(Unaudited)


The total consideration was allocated to the net assets acquired based upon their estimated fair values:
 
 Amounts
Cash and restricted cash
$
4,804

Accounts receivable, net
10,693

Property, plant and equipment
5,044

Other assets and liabilities, net
4,561

Accounts payable
(4,585
)
Accrued and other current liabilities
(3,674
)
Deferred revenue
(2,603
)
Deferred tax liability
(15,508
)
Assumed indebtedness
(23,324
)
Trade names
3,000

Developed technology
32,000

Customer relationships
52,000

Goodwill
74,076

Total fair value of net assets acquired
$
136,484

 The estimated life of the acquired trade names is four years, the estimated life of customer relationships is fifteen years and the estimated life of the developed technology is seven years, with these intangibles amortized on a straight-line basis. The excess of the purchase price over the net tangible and intangible assets of $74,076 was recorded as goodwill, and considered non-deductible for income tax purpose.
At the closing of the acquisition, the Company repaid all $23,324 of assumed indebtedness presented in the table above.
During the year ended December 31, 2016, the Company recognized $300 measurement period adjustments, which reduced goodwill. The measurement period adjustments included a $2,909 increase to goodwill related to a decrease in property and equipment, a $697 decrease to goodwill related to an increase in research and development grant receivable, a $955 decrease to goodwill related to a decrease in deferred revenue, a $209 increase to goodwill related to a deferred tax liability increase due to various allocation adjustments, $455 increase to goodwill for working capital adjustments, a $188 increase to goodwill related to an accrued sales tax liability increase and a $2,409 decrease to goodwill, representing the Company’s right to be reimbursed from 3BE for severance benefits if their employment is terminated by the Company without cause or by the employee for good reason within 12 months after the closing date, which was settled through the escrow account in December 2016, of which $1,678 recorded during three months ended March 31, 2016.
Note 4. Accounts Receivable, net
Accounts receivable, net excludes amounts related to PCS and other services that were billed but not yet delivered at each period end. These undelivered services are also excluded from the deferred revenue balances on the accompanying Condensed Consolidated Balance Sheets. The amount of outstanding and unpaid invoices excluded from both the accounts receivable and deferred revenue balances as of March 31, 2017 and December 31, 2016 was $6,506 and $5,325, respectively.
 
Accounts receivable are included on the Condensed Consolidated Balance Sheets, net of the allowance for doubtful accounts. The allowance for doubtful accounts at March 31, 2017 and December 31, 2016 was $598 and $452, respectively.

- 13 -

NantHealth, Inc.
Notes to Condensed Consolidated Financial Statements
(Dollars in thousands, except per share amounts)
(Unaudited)

Note 5. Inventories
Inventories as of March 31, 2017 and December 31, 2016 consisted of the following:
 
March 31,
2017
 
December 31,
2016
 
 
 
 
Finished goods
$
1,799

 
$
1,840

Raw materials
376

 
377

Inventories
$
2,175

 
$
2,217


Note 6. Prepaid Expenses and Other Current Assets and Accrued and Other Current Liabilities
Prepaid expenses and other current assets as of March 31, 2017 and December 31, 2016 consisted of the following:
 
March 31,
2017
 
December 31,
2016
 
 
 
 
Prepaid expenses
$
5,422

 
$
4,685

Restricted cash (1)
100

 
100

Other current assets
238

 
261

Prepaid expenses and other current assets
$
5,760

 
$
5,046


(1)
Additional $250 of non-current restricted cash is included in the Company’s Condensed Consolidated Balance Sheets as part of other assets.

Accrued and other current liabilities of March 31, 2017 and December 31, 2016 consisted of the following:
 
March 31,
2017
 
December 31,
2016
 
 
 
 
Payroll and related costs
$
10,109

 
$
13,248

NaviNet acquisition accrued earnout (See Note 3)
3,338

 
2,675

Other accrued and other current liabilities
7,830

 
9,308

Accrued and other current liabilities
$
21,277

 
$
25,231



- 14 -

NantHealth, Inc.
Notes to Condensed Consolidated Financial Statements
(Dollars in thousands, except per share amounts)
(Unaudited)

Note 7. Property, Plant and Equipment, net
Property, plant and equipment, net as of March 31, 2017 and December 31, 2016 consisted of the following:
 
March 31,
2017
 
December 31,
2016
 
 
 
 
Computer equipment and software
$
20,773

 
$
16,080

Furniture and equipment
7,533

 
7,533

Leasehold and building improvements
4,089

 
4,051

Internal use software
16,638

 
15,600

Construction in progress
2,371

 
1,090

 
51,404

 
44,354

Less: accumulated depreciation and amortization
(18,332
)
 
(15,215
)
Property, plant and equipment, net
$
33,072

 
$
29,139

 
Depreciation and amortization expense was $3,111 for the three months ended March 31, 2017, of which $1,330 related to internal use software costs. Depreciation and amortization expense was $1,713 for the three months ended March 31, 2016, of which none related to internal use software costs. Amounts capitalized to internal use software for the three months ended March 31, 2017 and 2016 were $1,038 and $3,100, respectively.

Note 8. Intangible Assets, net
The Company’s definite-lived intangible assets as of March 31, 2017 and December 31, 2016 consisted of the following:
 
March 31,
2017
 
December 31,
2016
 
 
 
 
Customer relationships
$
65,200

 
$
65,200

Developed technologies
98,930

 
98,930

Software license
5,000

 
5,000

Intellectual property
2,400

 
2,400

Trade name
3,000

 
3,000

 
174,530

 
174,530

Less: accumulated amortization
(60,624
)
 
(55,404
)
Intangible assets, net
$
113,906

 
$
119,126



Amortization of finite-lived intangible assets is provided over their estimated useful lives on a straight-line basis or the pattern in which economic benefits are consumed, if reliably determinable. The Company reviews its finite-lived intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Amortization expense was $5,220 and $6,096 for the three months ended March 31, 2017 and 2016, respectively.
During the three months ended March 31, 2016, the Company recorded $87,000 of definite-lived intangible assets related to the acquisition of NaviNet (See Note 3). These intangibles are amortized over a period of four to fifteen years.

- 15 -

NantHealth, Inc.
Notes to Condensed Consolidated Financial Statements
(Dollars in thousands, except per share amounts)
(Unaudited)

The estimated future amortization expense over the next five years and thereafter for the intangible assets that exist as of March 31, 2017 is as follows:
 
Amounts
Remainder of 2017
$
13,858

2018
18,478

2019
18,166

2020
14,958

2021
11,646

Thereafter
36,800

Total future intangible amortization expense
$
113,906

Note 9. Goodwill
Goodwill as of March 31, 2017 and December 31, 2016 was $131,068.
On January 1, 2016 the Company added $74,076 of goodwill related to the acquisition of NaviNet (See Note 3).
Measurement period adjustments during three months ended March 31, 2016 resulted in an increase of $1,531 to goodwill, including an increase of $1,678 related to the NaviNet acquisition (See Note 3), partially offset by a reduction of $147 related to the asset acquisition of Healthcare Solutions from Harris Corporation from 2015.
Goodwill acquired in a business combination and determined to have an indefinite useful life is not amortized but is tested for impairment annually as of October 1 or between annual tests when an impairment indicator exists.
Note 10. Investments
Equity method investment
Investment in NantOmics
In 2015 the Company purchased a total of 169,074,539 Series A-2 units of NantOmics, LLC (“NantOmics”), a related party of the Company, for an aggregate purchase price of $250,774. The Series A-2 units do not have any voting rights and represent approximately 14.28% of NantOmics’ issued and outstanding membership interests. NantOmics is majority owned by NantWorks and delivers molecular diagnostic capabilities with the intent of providing actionable intelligence and molecularly driven decision support for cancer patients and their providers at the point of care.
 
The Company applies the equity method to account for its investment in NantOmics as the interest in the equity is similar to a partnership interest. Further, the Company has the ability to exert significant influence over the operating and financial policies of the entity since NantWorks controls both NantHealth and NantOmics. The difference between the carrying amount of the investment in NantOmics and the Company’s underlying equity in NantOmics’ net assets relate to both definite and indefinite-lived intangible assets. The Company attributed $28,195 and $14,382 of these differences to NantOmics’ developed technologies and its reseller agreement with the Company, respectively, prior to the application of developed technology intangibles included in NantOmics net assets, and the remaining basis differences were attributed to goodwill. The Company amortizes the basis differences related to the definite-lived intangible assets over the assets’ estimated useful lives and records these amounts as a reduction in the carrying amount of its investment and an increase in its equity method loss.

The investment in related party is assessed for possible impairment when events indicate that the fair value of the investment may be below the carrying value. When such a condition is deemed to be other than temporary, the carrying value of the investment is written down to its fair value, and the amount of the write-down is included in net loss. In making the determination as to whether a decline is other than temporary, the Company considers such factors as the duration and extent of the decline, the investee’s financial performance, and our ability and intention to retain the investment for a period that will be sufficient to allow for any anticipated recovery in the investment’s market value. The new cost basis of the investment is not changed for subsequent recoveries in fair value.


- 16 -

NantHealth, Inc.
Notes to Condensed Consolidated Financial Statements
(Dollars in thousands, except per share amounts)
(Unaudited)

The fair value of its equity method investment is determined using the income approach. The income approach utilizes a discounted cash flow model incorporating management’s expectations for future revenue, operating expenses, and earnings before interest, taxes, depreciation and amortization, capital expenditures and an anticipated tax rate. The related cash flow forecasts are discounted using an estimated weighted-average cost of capital at the date of valuation.  Differences between the carrying value of an equity investment and its underlying equity in the net assets of the related party are assigned to the extent practicable to specific assets and liabilities based on our analysis of the various factors giving rise to the difference. When appropriate, our share of the related party’s reported earnings is adjusted quarterly to reflect the difference between these allocated values and the related party’s historical book values.

During the year ended December 31, 2016, the Company determined that an other than temporary impairment of $29,816 in the value of the investment in NantOmics had occurred, predominantly attributed to a decline in the value of goodwill. The decline in the fair value was primarily caused by a change in the risk profile of the financial projections for NantOmics resulting from the delay in the Company’s GPS revenue growth. The Company based its financial projections based on information that the Company believes is reasonable; however, actual results may differ materially from those projections. The other than temporary impairment was based on judgments and estimates that are forward looking in nature and include risks and uncertainties related to assumptions regarding the Company’s future financial performance, commercial acceptance of the Company’s product and service offerings, risk of reimbursement for the Company’s sequencing and molecular analysis solution, developments in the healthcare and molecular diagnostics industry, the Company’s ability to integrate its business acquisitions, regulatory risks, and other general business risks including unanticipated adverse changes in NantOmics' operating environment.

The Company believes that there is no additional other than temporary impairment required to be recorded as of March 31, 2017.

The Company reports its share of NantOmics’ income or loss and the amortization of basis differences using a one quarter lag. For the three months ended March 31, 2017 and 2016, the Company recognized loss of $4,526 and $2,914, respectively related to this investment.

The Company used the following summarized financial information for NantOmics for the three months ended December 31, 2016 and 2015, respectively to record its equity method losses for the three months ended March 31, 2017 and 2016, respectively.

 
Three months ended December 31,
 
2016
 
2015
Sales
$
2,415

 
$
1,250

Gross loss
(2,217
)
 
(784
)
Loss from operations
(7,770
)
 
(8,566
)
Net loss
(21,766
)
 
(9,332
)
Net loss attributable to NantOmics
(20,513
)
 
(8,667
)
Cost method Investment
Investment in IOBS
On June 16, 2015, the Company invested $1,750 in Innovative Oncology Business Solutions, Inc. (“IOBS”) in exchange for 1,750,000 shares of IOBS’s Series A preferred stock. IOBS offers community oncology practices an alternative medical home model for oncology patients that improves health outcomes, enhances patient care experiences and significantly reduces costs of care. The shares of preferred stock represent 35.0% of the outstanding equity of IOBS on an as-converted basis. The Company applied the cost method to account for its investment because the preferred stock is not considered in-substance common stock, is not considered a debt instrument as the Company cannot unilaterally demand redemption of the preferred stock and the preferred stock does not have a readily determinable fair value.

As of March 31, 2017 and December 31, 2016, IOBS was considered a variable interest entity. The Company is not the primary beneficiary of IOBS because it only has the right to elect two of five directors. All major decisions of IOBS require the majority vote by the members of the board of directors, including decisions made to manage the business including hiring and firing of officers and other critical management functions. Therefore, the Company does not consolidate IOBS.

- 17 -

NantHealth, Inc.
Notes to Condensed Consolidated Financial Statements
(Dollars in thousands, except per share amounts)
(Unaudited)

Note 11. Convertible Notes
In December 2016, the Company entered into the Purchase Agreement with J.P. Morgan Securities LLC and Jefferies LLC, as representatives of the several initial purchasers named therein (collectively, the “Initial Purchasers”), to issue and sell $90,000 in aggregate principal amount of its 5.50% senior convertible notes due 2021 ("Convertible Notes") in a private placement to qualified institutional buyers pursuant to Rule 144A under the Securities Act of 1933, as amended (the “Securities Act”) and to non-U.S. persons pursuant to Regulation S under the Securities Act. In December 2016, the Company entered into a purchase agreement (the “Cambridge Purchase Agreement”) with Cambridge Equities, L.P., an entity affiliated with Dr. Patrick Soon-Shiong, the Company’s Chairman and Chief Executive Officer (“Cambridge”), to issue and sell $10,000 in aggregate principal amount of the Convertible Notes in a private placement pursuant to an exemption from the registration requirements of the Securities Act afforded by Section 4(a)(2) of the Securities Act. In December 2016, pursuant to the exercise of the overallotment by the Initial Purchasers, the Company issued an additional $7,000 principal amount of the Convertible Notes. The total net proceeds from this offering were approximately $102,714, $9,917 from Cambridge and $92,797 from the initial purchasers, after deducting of initial purchasers’ discount and debt issuance costs of $4,286 in connection with the Convertible Notes offering.
On December 21, 2016, the Company entered into an Indenture, relating to the issuance of the Convertible Notes (the “Indenture”), by and between the Company and U.S. Bank National Association, as trustee (the “Trustee”). The interest rates are fixed at 5.50% per year, payable semi-annually on June 15 and December 15 of each year, beginning on June 15, 2017. The Convertible Notes will mature on December 15, 2021, unless earlier repurchased by the Company or converted pursuant to their terms.
In connection with the offering of the Convertible Notes, on December 15, 2016, the Company entered into a Second Amended and Restated Promissory Note which amends and restates the Amended and Restated Promissory Note, dated May 9, 2016, between the Company and NantCapital, to, among other things, extend the maturity date of the promissory note to June 30, 2022 and to subordinate such promissory note in right of payment to the Convertible Notes (See Note 18).
The initial conversion rate of the Convertible Notes is 82.3893 shares of common stock per $1 principal amount of Convertible Notes (which is equivalent to an initial conversion price of approximately $12.14 per share). Prior to the close of business on the business day immediately preceding September 15, 2021, the Convertible Notes will be convertible only under the following circumstances:
(1) during any calendar quarter commencing after March 31, 2017 (and only during such calendar quarter), if, for at least 20 trading days (whether or not consecutive) during the 30 consecutive trading day period ending on the last trading day of the immediately preceding calendar quarter, the last reported sale price of the Company’s common stock on such trading day is greater than or equal to 120% of the conversion price on such trading day;
(2) during the five business day period after any five consecutive trading day period in which, for each day of that period, the trading price per $1 principal amount of the Convertible Notes for such trading day was less than 98% of the product of the last reported sale price of the Company’s common stock and the conversion rate on such trading day; or
(3) upon the occurrence of specified corporate transactions as described in the Indenture agreement.
Upon conversion, the Convertible Notes will be settled in cash, shares of the Company’s common stock or any combination thereof at the Company’s option.
Upon the occurrence of a fundamental change (as defined in the Indenture), holders may require the Company to purchase all or a portion of the Convertible Notes in principal amounts of $1 or an integral multiple thereof, for cash at a price equal to 100% of the principal amount of the Convertible Notes to be purchased plus any accrued and unpaid interest to, but excluding, the fundamental change purchase date. The conversion rate will be subject to adjustment upon the occurrence of certain specified events.

- 18 -

NantHealth, Inc.
Notes to Condensed Consolidated Financial Statements
(Dollars in thousands, except per share amounts)
(Unaudited)

On or after the date that is one year after the last date of original issuance of the Convertible Notes, if the last reported sale price of the Company’s common stock for at least 20 trading days (whether or not consecutive) during the period of 30 consecutive trading days ending within the five trading days immediately preceding a conversion date is greater than or equal to 120% of the conversion price on each applicable trading day, the Company will make an interest make-whole payment to a converting holder (other than a conversion in connection with a make-whole fundamental change in which the conversion rate is adjusted) equal to the sum of the present values of the scheduled payments of interest that would have been made on the Convertible Notes to be converted had such Convertible Notes remained outstanding from the conversion date through the earlier of (i) the date that is three years after the conversion date and (ii) the maturity date if the Convertible Notes had not been so converted. The present values of the remaining interest payments will be computed using a discount rate equal to 2.0%. The Company may pay any interest make-whole payment either in cash or in shares of its common stock, at the Company’s election as described in the Indenture.

The Company accounts for convertible debt instruments that may be settled in cash upon conversion (including partial cash settlement) by recording the liability and equity components of the convertible debt separately. The liability component is computed based on the fair value of a similar liability that does not include the conversion option. The liability component includes both the value of the embedded interest make-whole derivative and the carrying value of the Convertible Notes.  The equity component is computed based on the total debt proceeds less the fair value of the liability component. The equity component is also recorded as debt discount and amortized as interest expense over the expected term of the Convertible Notes.
The liability component of the Convertible Notes on the date of issuance was computed as $83,079, consisting of the value of the embedded interest make-whole derivative of $1,499 and the carrying value of the Convertible Notes of $81,580. Accordingly, the equity component on the date of issuance was $23,921. If the debt will be considered current at the balance sheet date, the liability component of the convertible notes will be classified as current liabilities and presented in current portion of convertible notes debt and the equity component of the convertible debt will be considered a redeemable security and presented as redeemable equity on the Company's Condensed Consolidated Balance Sheet.
Offering costs of $4,286 related to the issuance of the Convertible Notes are allocated to the liability and equity components in proportion to the allocation of the proceeds and accounted for as deferred financing offering costs and equity issuance costs, respectively. Approximately $972 of this amount was allocated to equity and the remaining $3,314 were capitalized as deferred financing offering costs.
The debt discounts and deferred financing offering costs on the Convertible Notes are being amortized to interest expense over the contractual terms of the Convertible Notes, using the effective interest method at an effective interest rate of 12.82%.
As of March 31, 2017, the remaining life of the Convertible Notes is approximately 57 months.

The following table summarizes how the issuance of the Convertible Notes is reflected in the Company's Condensed Consolidated Balance Sheets as of March 31, 2017 and December 31, 2016.
 
Related party
 
Others
 
Total
Balance as of March 31, 2017
 
 
 
 
 
Gross proceeds
$
10,000

 
$
97,000

 
$
107,000

 
 
 
 
 
 
Interest make-whole derivative fair value at issuance
(148
)
 
(1,351
)
 
(1,499
)
Conversion option reported in equity as additional paid-in capital
(2,233
)
 
(21,688
)
 
(23,921
)
Deferred financing offering costs
(65
)
 
(3,249
)
 
(3,314
)
Amortization of debt discounts and deferred financing offering costs
101

 
1,058

 
1,159

Unamortized debt discounts and deferred financing offering costs
(2,345
)
 
(25,230
)
 
(27,575
)
 
 
 
 
 
 
Net carrying amount
$
7,655

 
$
71,770

 
$
79,425

 
 
 
 
 
 
Balance as of December 31, 2016
 
 
 
 
 
Gross proceeds
$
10,000

 
$
97,000

 
$
107,000

Unamortized debt discounts and deferred financing offering costs
(2,436
)
 
(26,190
)
 
(28,626
)
Net carrying amount
$
7,564

 
$
70,810

 
$
78,374

 

- 19 -

NantHealth, Inc.
Notes to Condensed Consolidated Financial Statements
(Dollars in thousands, except per share amounts)
(Unaudited)

The following table sets forth the Company's interest expense incurred for the three months ended March 31, 2017:
 
Related party
 
Others
 
Total
Accrued coupon interest expense
$
138

 
$
1,334

 
$
1,472

Amortization of debt discounts
89

 
841

 
930

Amortization of deferred financing offering costs
2

 
119

 
121

Total convertible notes interest expense
$
229

 
$
2,294

 
$
2,523



Note 12. Fair Value Measurements
Assets and liabilities measured at fair value on a recurring basis as of March 31, 2017 and December 31, 2016 consisted of the following:
 
March 31, 2017
 
Total
 fair value
 
Quoted price in active markets for identical assets
 (Level 1)
 
Significant other observable inputs
(Level 2)
 
Significant unobservable inputs
 (Level 3)
Assets - Cash equivalents
$
116,159

 
$
116,159

 
$

 
$

Liabilities - Interest make-whole derivative
56

 

 

 
56

 
December 31, 2016
 
Total
 fair value
 
Quoted price in active markets for identical assets
 (Level 1)
 
Significant other observable inputs
(Level 2)
 
Significant unobservable inputs
 (Level 3)
Assets - Cash equivalents
$
149,067

 
$
149,067

 
$

 
$

Liabilities - Interest make-whole derivative
271

 

 

 
271


The Company’s intangible assets and goodwill are initially measured at fair value and any subsequent adjustment to the initial fair value occurs only if an impairment charge is recognized. The fair values of the Company’s marketable securities and cash equivalents (consisting of mainly money market accounts) are based on quoted market prices in active markets with no valuation adjustment (See Note 8).

Level 3 Inputs
In December 2016, the Company issued $107,000 in aggregate principal amount of Convertible Notes due December 15, 2021, of which $10,000 issued to a related party (See Note 11). The Convertible Notes include an interest make-whole feature whereby if a noteholder converts any of the Convertible Notes one year after the last date of original issuance of the Convertible Notes, they are entitled, in addition to the other consideration payable or deliverable in connection with such conversion, to an interest make-whole payment equal to the sum of the present values of the scheduled payments, computed using a discount rate equal to 2.0%, of interest that would have been made on the Convertible Notes to be converted had such Convertible Notes remained outstanding from the conversion date through the earlier of (i) the date that is three years after the conversion date and (ii) the maturity date if the Convertible Notes had not been so converted. The Company may pay any interest make-whole payment either in cash or in shares of its common stock, at the Company’s election as described in the Indenture. The Company has determined that this feature is an embedded derivative and have recognized the fair value of this derivative as a liability in the Company's Condensed Consolidated Balance Sheets, with subsequent changes to fair value recorded through earnings at each reporting period as part of other income, net on the Company's Condensed Consolidated Statements of Operations as change in fair value of derivative liability.  

- 20 -

NantHealth, Inc.
Notes to Condensed Consolidated Financial Statements
(Dollars in thousands, except per share amounts)
(Unaudited)

The following tables set forth a summary of changes in the fair value of Level 3 liabilities for the three months ended March 31, 2017:
 
 
December 31, 2016
 
Additions
 
Change in fair value
 
March 31, 2017
Interest make-whole derivative liability:
 
 
 
 
 
 
 
 
Related party
 
$
25

    
$

    
$
(20
)
 
$
5

Others
 
246

    

    
(195
)
 
51

 
 
$
271

 
$

 
$
(215
)
 
$
56

As of March 31, 2017 and December 31, 2016, the fair value and carrying value of the Company's Convertible Notes were:
 
 
 
Fair value
 
Carrying value
 
Face value
 
 
 

 
 

 
 

5.5% convertible senior notes due December 15, 2021:
 
 
 
 
 
 
Balance as of March 31, 2017
 
 
 
 
 
 
Related party
 
$
7,759

    
$
7,655

    
$
10,000

Others
 
75,265

 
71,770

 
97,000

 
 
$
83,024

 
$
79,425

 
$
107,000

Balance as of December 31, 2016
 
 
 
 
 
 
Related party
 
$
11,081

    
$
7,564

    
$
10,000

Others
 
107,491

 
70,810

 
97,000

 
 
$
118,572

 
$
78,374

 
$
107,000


The fair value shown above represents the fair value of the debt instrument, inclusive of both the debt and equity components, but excluding the derivative liability. The carrying value represents only the carrying value of the debt component.

Note 13. Commitments and Contingencies
The Company's principal commitments consist of obligations under its outstanding debt obligations, non-cancelable leases for its office space and certain equipment and vendor contracts to provide research services, and purchase obligations under license agreements and reseller agreements.
Lease Arrangements
The Company leases both real estate and equipment used in its operations and classifies those leases as either operating or capital leases for accounting purposes. As of March 31, 2017 and December 31, 2016, the Company had no material capital leases and the remaining lives of its operating leases ranged from one to five years.
Rental expense associated with operating leases is charged to expense in the year incurred and is included in the Condensed Consolidated Statements of Operations. For the three months ended March 31, 2017 and 2016, the rental expense was charged to selling, general and administrative expense in the amount of $1,254 and $1,110, respectively.
Related Party Promissory Note
On January 4, 2016, the Company executed a $112,666 demand promissory note in favor of NantCapital to fund the acquisition of NaviNet, On May 9, 2016, the promissory note with NantCapital was amended to provide that all outstanding principal and accrued interest is due and payable on June 30, 2021, and not on demand (See Note 18).

- 21 -

NantHealth, Inc.
Notes to Condensed Consolidated Financial Statements
(Dollars in thousands, except per share amounts)
(Unaudited)

Indenture obligations under Convertible Notes
On December 21, 2016, the Company entered into the Indenture relating to the issuance of the $107,000 Convertible Notes, by and between the Company and U.S. Bank National Association the Trustee. The interest rates are fixed at 5.50% per year, payable semi-annually on June 15 and December 15 of each year, beginning on June 15, 2017. The Convertible Notes will mature on December 15, 2021, unless earlier repurchased by the Company or converted pursuant to their terms (See Note 11).
Purchase obligations Under License Agreements and Reseller Agreements
In September 2016, the Company entered into a Second Amended and Restated Reseller Agreement for genomic and proteomic sequencing services and related bioinformatics and analysis services with NantOmics, with an effective date of June 19, 2015 (See Note 18).
Obligations Under Exclusive License Agreement with Northshore
On September 29, 2015, the Company entered into an exclusive license agreement with NorthShore to further develop their Health Heritage software platform ("Health Heritage"), and to license the software to customers.
Regulatory Matters
The Company is subject to regulatory oversight by the U.S. Food and Drug Administration and other regulatory authorities with respect to the development, manufacturing, and sale of some of the solutions. In addition, the Company is subject to the Health Insurance Portability and Accountability Act (“HIPAA”), the Health Information Technology for Economic and Clinical Health Act and related patient confidentiality laws and regulations with respect to patient information. The Company reviews the applicable laws and regulations regarding effects of such laws and regulations on its operations on an on-going basis and modifies operations as appropriate. The Company believes it is in substantial compliance with all applicable laws and regulations. Failure to comply with regulatory requirements could have a significant adverse effect on the Company’s business and operations.
Legal Matters
The Company is, from time to time, subject to claims and litigation that arise in the ordinary course of its business. The Company intends to defend vigorously any such litigation that may arise under all defenses that would be available. Except as discussed below, in the opinion of management, the ultimate outcome of proceedings of which management is aware, even if adverse to them, would not have a material adverse effect on the Company’s Condensed Consolidated Financial Condition or Results Of Operations. Regardless of the outcome, litigation can have an adverse impact on the Company because of defense and settlement costs, diversion of management resources and other factors.
Securities Litigation
In March 2017, a number of putative class action securities complaints were filed in U.S. District Court for the Central District of California, naming as defendants the Company and certain of the Company's executive officers and directors.  The pending complaints are captioned Deora v. NantHealth, Inc., 2:17-cv-01825, Di Rienzo v. NantHealth, Inc., 2:17-cv-01912, and Shafik v. NantHealth, Inc., 2:17-cv-01940.  Some of the complaints also name as defendants investment banks who were underwriters in the Company's initial public offering.  The complaints generally allege that defendants violated the federal securities laws by making material misstatements and omissions concerning NantHealth’s business, operations, and results.  In particular, the complaints refer to an article in alleging that defendants misrepresented NantHealth’s business with the University of Utah and donations to the university by non-profit entities associated with the Company's founder Dr. Soon-Shiong.  The complaints seek unspecified damages and other relief on behalf of putative classes of persons who purchased or acquired NantHealth securities in the IPO or on the open market from the time of the initial public offering through early March 2017.  The Company believes that the claims lack merit and intend to vigorously defend the litigation.  The monetary and other impact of this action may remain unknown for substantial periods of time. The cost to defend, settle or otherwise resolve this matter may be significant and divert management's attention. The Company cannot assure you that it will prevail in this lawsuit. If the Company is ultimately unsuccessful in this matter, it could be required to pay substantial amounts which might materially adversely affect the Company's business, operating results and financial condition.

- 22 -

NantHealth, Inc.
Notes to Condensed Consolidated Financial Statements
(Dollars in thousands, except per share amounts)
(Unaudited)

Note 14. Income Taxes
The provision for income taxes for the three months ended March 31, 2017 was $282 and the benefit from income taxes for three months ended March 31, 2016 was $4,398. The tax provision for income taxes for the three months ended March 31, 2017 included an income tax provision for the consolidated group based on an estimated annual effective tax rate. Prior to June 1, 2016 the provision for income taxes consisted of income tax provision for the corporate subsidiaries of NantHealth. For the three months ended March 31, 2016, the tax benefit was mostly attributed to the reduction of deferred tax liability as a result of the amortization of NaviNet’s purchase accounting intangibles.

The effective tax rates for the three months ended March 31, 2017 and 2016 were a provision of 0.70% and a benefit of 11.7%, respectively. The effective tax rate for the three months ended March 31, 2017 differed from the U.S. federal statutory rate of 34% primarily as a result of nondeductible expenses, state income taxes, foreign income taxes, and the impact of a full valuation allowance on its net deferred tax assets. The effective tax rate for the three months ended March 31, 2016 differed from the federal statutory rate primarily due to the fact that Nant Health, LLC was a limited liability company during that period. It converted from a pass-through entity to a C corporation, NantHealth, Inc., on June 1, 2016. Prior to the LLC Conversion, the tax provision represented that of Nant Health, LLC’s corporate subsidiaries. As mentioned above the major change in the Company's effective tax rates for the three months ended March 31, 2017 as compared to the three months ended March 31, 2016 was also attributable to the LLC Conversion on June 1, 2016 (See Note 15). 
The Company has evaluated the available evidence supporting the realization of its deferred tax assets, including the amount and timing of future taxable income, and has determined that it is more likely than not that its net deferred tax assets will not be realized in the U.S. and certain foreign jurisdictions. Due to uncertainties surrounding the realization of the deferred tax assets, the Company maintains a full valuation allowance against substantially all deferred tax assets. If/when the Company determines that it will be able to realize some portion or all of its deferred tax assets, an adjustment to its valuation allowance on its deferred tax assets would have the effect of increasing net income in the period(s) such determination is made.The Company files income tax returns in the U.S. Federal jurisdiction, various U.S. state jurisdictions and certain foreign jurisdictions. One of the Company’s corporate subsidiary, Assisteo Holding, Inc, is currently under an IRS audit for the tax year 2014. The Company is no longer subject to income tax examination by the U.S. federal, state or local tax authorities for years ended December 31, 2011 or prior, however, its tax attributes, such as net operating loss (“NOL”) carryforwards and tax credits, are still subject to examination in the year they are used.
Note 15. Stockholders’ Equity
Initial Public Offering
On June 7, 2016, the Company completed its IPO of 6,500,000 shares of common stock at a public offering price of $14.00 per share. Additionally, on June 9, 2016, the underwriters partially exercised their overallotment option to purchase an additional 400,000 shares of the common stock at $14.00 per share. The Company received $83,566 in proceeds from its IPO, after deducting underwriting discounts and commissions and offering costs of $13,034.

In connection with the pricing of the Company’s IPO on June 1, 2016, $40,590 of principal and accrued interest on the Company’s related party promissory notes with NantOmics was converted into 2,899,297 shares of the Company’s common stock.

On July 25, 2016, the Company issued 1,056,689 shares of common stock, after withholding approximately 538,794 shares to satisfy tax withholding obligations, to participants of the Phantom Unit Plan based in the United States whose phantom units vested as a result of the IPO. The Company made a cash payment of $5,738 to cover employee withholding taxes upon the settlement of these vested phantom units.  The Company also paid $235 on August 9, 2016 to cash-settle 16,818 vested phantom units held by participants of the Phantom Unit Plan at the time of the IPO who were based outside of the United States.
LLC Conversion and Reverse Split
Upon completion of the LLC Conversion on June 1, 2016, (a) all of the Company’s outstanding units automatically converted into shares of common stock, based on the relative rights of the Company's pre-IPO equityholders as set forth in the Company's limited liability company agreement (the "LLC Agreement") and (b) the Company adopted and filed a certificate of incorporation with the Secretary of State of the state of Delaware and adopted bylaws. The Company adopted and filed an amendment to its certificate of incorporation (the "Amended Certificate of Incorporation") with the Secretary of State of the state of Delaware to effect a 1-for-5.5 reverse stock split of its common stock on June 1, 2016.


- 23 -

NantHealth, Inc.
Notes to Condensed Consolidated Financial Statements
(Dollars in thousands, except per share amounts)
(Unaudited)

Below is a summary of the number of member units pre LLC Conversion as converted into common shares:
 
Pre Conversion
(Units)
Former Series A Unit Holders
420,255,676

Former Series B Unit Holders
19,109,603

Former Series C Unit Holders
3,470,254

Former Series D Unit Holders
3,572,066

Former Series E Unit Holders
35,720,664

Former Series G Unit Holders
59,099,908

Former Series H Unit Holders
15,513,726

Total Member Units
556,741,897


The units in the table above were converted to 99,661,906 shares of common stock, of which 10,462 shares of restricted stock. The members’ equity balance of $525,388 was reclassified into common stock and additional paid-in capital in the Condensed Consolidated Balance Sheet as of June 1, 2016.
LLC Agreement and Amended Certificate of Incorporation
Prior to the LLC Conversion, the Company’s operations were governed by its LLC Agreement. Upon the consummation of the LLC Conversion, the Company converted into a corporation, and the LLC Agreement no longer governs the Company's operations or the rights of its equityholders.
The LLC Agreement provided that the board of directors had the power and discretion to manage and control the business, property and affairs of the company, but that certain actions required the consent of certain of the Company's former members. Under the LLC Agreement, the Company had units authorized, including Series A through H units. Each equityholder holding Series A, B, D, E, F, G or H units had one vote for each unit held. Profits interests units awarded under the Nant Health, LLC Profits Interests Plan (the "Profits Interests Plan") took the form of Series C units of the Company. Holders of Series C units did not have the right to vote. The LLC Agreement also set forth the rights of and restrictions on unitholders, including certain rights of first refusal and preemptive and co-sale rights. The LLC Agreement also provided that, upon the LLC Conversion, the allocation of shares of the Company's common stock among the pre-IPO equityholders was dependent upon the IPO price of its common stock, based on the relative rights of the pre-IPO equityholders as set forth in the LLC Agreement. As a result, as part of the LLC Conversion, the Company set the actual allocation of shares among its pre-IPO equityholders based upon the IPO price of its common stock.
Concurrently with the consummation of the LLC Conversion, the LLC Agreement was terminated, other than certain provisions relating to certain pre-termination tax matters and certain liabilities.

In accordance with the Company’s amended and restated certificate of incorporation, which was filed immediately following the closing of its IPO, the Company is authorized to issue 750,000,000 shares of common stock, with a par value of $0.0001 per share, and 20,000,000 shares of undesignated preferred stock, with a par value of $0.0001 per share. Holders of the Company’s common stock are entitled to one vote for each share held on all matters submitted to a vote of its stockholders. Holders of the Company’s common stock have no cumulative voting rights. Further, as of March 31, 2017 and December 31, 2016, holders of the Company’s common stock have no preemptive, conversion, redemption or subscription rights and there are no sinking fund provisions applicable to the Company’s common stock. Upon liquidation, dissolution or winding-up of the Company, holders of the Company’s common stock are entitled to share ratably in all assets remaining after payment of all liabilities and the liquidation preferences of any outstanding shares of preferred stock. Subject to preferences that may be applicable to any outstanding shares of preferred stock, holders of the Company’s common stock are entitled to receive dividends, if any, as may be declared from time to time by the Company’s board of directors. As of March 31, 2017 and December 31, 2016, there were no outstanding shares of preferred stock.

- 24 -

NantHealth, Inc.
Notes to Condensed Consolidated Financial Statements
(Dollars in thousands, except per share amounts)
(Unaudited)

2016 NaviNet Equity Issuances

On January 1, 2016, the Company issued 15,513,726 Series H units to 3BE Holdings, LLC for the acquisition of NaviNet at a purchase price of $3.3841 per unit for an aggregate amount of $52,500. The Series H units had substantially the same rights and preferences as the former Series B, D, E, F and G units that were outstanding at the time. On June 1, 2016, the Series H units issued to 3BE Holdings, LLC were converted into 3,749,998 shares of the Company’s common stock.
Other Equity Contributions

In January 2015, the Company entered into an agreement to provide certain research related sequencing services to a research institution. The agreement provides that the institution pay the Company $10,000 in exchange for the Company providing sequencing services. Certain public and private charitable 501(c)(3) non-profit organizations provided partial funding for the sequencing and related bioinformatics costs associated with the project. The Company’s Chairman and CEO serves as the CEO and a member of the board of directors of each of the non-profit organizations and by virtue of these positions he may have influence or control over these organizations. The institution was not contractually or otherwise required to use the Company’s molecular profiling solutions or any of the Company’s other products or services as part of the charitable gift, however, the institution did not have a requirement to order or pay for the services unless it first received private donor funding for the project. As a result, the Company does not classify the fees related to this project as revenue but instead classifies the amounts as deemed capital contributions from the Company's Chairman and CEO. During the three months ended March 31, 2016, $440 was recorded as a deemed capital contribution within members' equity or stockholders' equity, and through December 31, 2016 the total $10,000 amount was recorded as a deemed capital contribution within members' equity or stockholders' equity. During the three months ended March 31, 2016 $264 of costs were recorded as other services cost of revenue related to the service performed.

In December 2016, the Company entered into an agreement to provide genomic and proteomic sequencing and related bioinformatics services to an institution related to cancer research. The agreement provides that the institution pay the Company a fixed per-test fee in exchange for the services to be provided by the Company. A private charitable 501(c)(3) non-profit organization controlled by the Company’s Chairman and CEO also made a charitable gift to the institution in December 2016. The gift does not contractually or otherwise require the institution to use the Company’s molecular profiling solutions or any of the Company’s other products or services. No amounts related to this arrangement have been recognized in the Company’s Condensed Consolidated Balance Sheets or Statements of Operations as of or for the three months ended March 31, 2017.
Redeemable Series F Units / Common Stock

On June 20, 2014, the Kuwait Investment Office (“KIO”) purchased 53,580,996 Series F units of the Company through a Delaware blocker corporation, KHealth Holdings, Inc. (“KHealth”), at a purchase price of $2.7995 per unit for an aggregate amount of $150,000. KIO is the London Office of the Kuwait Investment Authority (“KIA”). As part of the investment, KIO had the right and option, but not the obligation, to require NantHealth to redeem 100% of the outstanding shares of KHealth at an amount equal to the original purchase price of $150,000 plus accrued annual interest of 7.0% if the Company had not (i) filed a registration statement on Form S-1 with the Securities and Exchange Commission on or before December 20, 2015 or (ii) had not completed a qualified initial public offering on or before June 20, 2016 (the “Put Right”). KIO did not exercise the Put Right, and it expired as of June 20, 2016.
As of December 31, 2015, the Company determined that the redemption of the Series F units was probable due to the uncertainty of completing a qualified initial public offering under prong (ii) and, as such, accrued $16,042 of interest as a reduction to members’ equity. Prior to December 31, 2015, the Company had concluded that redemption was not probable and had not adjusted the carrying value of such units to redemption value. The Series F units were classified in the Condensed Consolidated balance sheet as of December 31, 2015 as temporary equity as a result of the contingent redemption feature.
As part of the LLC Conversion, the Series F units converted to 10,714,285 shares of redeemable common stock as of June 1, 2016. Since the Put Right expired unexercised on June 20, 2016, the shares of common stock owned by KIO are no longer redeemable and are included in Stockholders’ equity.


- 25 -

NantHealth, Inc.
Notes to Condensed Consolidated Financial Statements
(Dollars in thousands, except per share amounts)
(Unaudited)

Letter Agreement with NantWorks
On May 22, 2016, the Company signed a letter agreement with NantWorks whereby NantWorks agreed to purchase directly from KIO all of the outstanding shares of KHealth if KIO had elected to exercise its Put Right. KIO did not exercise its Put Right (which expired by its terms on June 20, 2016) and NantWorks, therefore did not purchase these shares.

The change in net carrying amount of the Series F units and common stock owned by KIO through June 20, 2016 consisted of the following:
 
Redeemable Series F Units
 
Redeemable Common Stock
 
Common Stock and Additional-Paid-in-Capital
Balance at December 31, 2015
$
166,042

 
$

 
$

Accretion to redemption value
2,625

 

 

Balance at March 31, 2016
168,667

 

 

Accretion to redemption value
1,750

 

 

Balance at June 1, 2016 pre-LLC Conversion
170,417

 

 

LLC Conversion
(170,417
)
 
170,417

 

Balance at June 1, 2016 post-LLC Conversion

 
170,417

 

Accretion to redemption value

 
583

 

Balance at June 20, 2016 pre expiration of Put Right

 
171,000

 

Expiration of Put Right at June 20, 2016

 
(171,000
)
 
171,000

Balance at June 20, 2016 post expiration of Put Right
$

 
$

 
$
171,000

Note 16. Stock Based Compensation
The following table reflects the components of stock-based compensation expense recognized in the Company's Condensed Consolidated Statements of Operations:
 
Three Months Ended 
 March 31,
 
2017
 
2016
Series C / Restricted Stock -
 
 
 
Research and development
$
15

 
$
98

 
 
 
 
Phantom units:
 
 
 
Cost of revenue
708

 

Selling, general and administrative
(1,352
)
 

Research and development
914

 

Total phantom units stock-based compensation expense
270

 

 
 
 
 
Stock options -
 
 
 
Selling, general and administrative
(35
)
 

 
 
 
 
Total stock based compensation expense
250

 
98

Amount capitalized to internal-use software and deferred implementation costs
524

 

Total stock-based compensation cost
$
774

 
$
98


- 26 -

NantHealth, Inc.
Notes to Condensed Consolidated Financial Statements
(Dollars in thousands, except per share amounts)
(Unaudited)

Retired Profits Interests Plan
On December 3, 2013, the Company adopted the Profits Interests Plan under which it had reserved an aggregate of 63,750,000 Series C units for issuance to associates, consultants and contractors of the Company in consideration for bona fide services provided to the Company.
The Series C units were considered profits interests of the Company and did not entitle their holders (the “Series C Members”) to receive distributions if the Company were liquidated immediately after the grant. Instead, the Series C Members were entitled to receive an allocation of a portion of the profit and loss of the Company arising after the date of the grant and, subject to vesting conditions, distributions made out of a portion of the profits of the Company arising after the grant date of the Series C units. Grants of the Series C units were either fully vested, partially vested, or entirely unvested at the time of the grant as determined by the Board.
Series C Members were not entitled to receive any distributions until the aggregate distributions made by the Company exceeded a hurdle amount applicable to those Series C units. The hurdle amount for each grant was determined by the Board at the date of issuance of such units. After all other members received their applicable hurdle amount, the Series C Members were entitled to receive their percentage interest of such excess distributions.
As of December 31, 2015 and through the date of the LLC Conversion, the Company had 3,470,254 Series C units outstanding.
Upon the LLC Conversion (See Note 15) on June 1, 2016, the Company issued 28,973 shares of common stock to holders of vested Series C units and 10,462 shares of restricted stock to holders of unvested Series C units. The shares of restricted stock issued to holders of unvested profits interests are subject to forfeiture until becoming fully vested in accordance with the terms of the original Series C unit grant agreements (See Restricted Stock below).
Phantom Unit Plan
On March 31, 2015, the Company approved the Nant Health, LLC Phantom Unit Plan (the “Phantom Unit Plan”). The maximum number of phantom units that may be issued under the Phantom Plan is equal to 11,590,909 minus the number of issued and outstanding Series C units of the Company. As of March 31, 2017, there were 3,515,718 phantom units outstanding under the Phantom Unit Plan, after giving effect to the 1-for-5.5 reverse stock split. Each grant of phantom units made to a participant under the Phantom Unit Plan vests over a defined service period, subject to completion of a liquidity event. The Company’s IPO satisfied the liquidity event condition and the phantom units now entitle their holders to cash or non-cash payments in an amount equal to the number of vested units held by that participant multiplied by the fair market value of one share of the Company’s common stock on the date each phantom unit vests. After the Company’s IPO, the Company will no longer issue any units under the Phantom Unit Plan.

The Company intends to settle all vested phantom unit payments held by United States-based participants in shares of the Company’s common stock and classifies these awards as equity awards in its Condensed Consolidated Balance Sheet. Awards held by participants who are based outside of the United States will be settled in cash and are classified within accrued and other current liabilities on the Condensed Consolidated Balance Sheet as of March 31, 2017 and December 31, 2016.

The following table summarizes the activity related to the unvested phantom units during the three months ended March 31, 2017:
 
Number of Units
 
Weighted
Average Grant
date value per
phantom unit
Unvested phantom units outstanding - December 31, 2016
4,322,080

 
$14.95
   Granted
113,656

 
$4.75
   Vested
(602,271
)
 
$15.78
   Forfeited
(317,747
)
 
$15.27
Unvested phantom units outstanding - March 31, 2017
3,515,718

 
$14.44


- 27 -

NantHealth, Inc.
Notes to Condensed Consolidated Financial Statements
(Dollars in thousands, except per share amounts)
(Unaudited)

During the year ended December 31, 2016, the Company granted 995,364 phantom units to employees of related companies who are providing services to the Company under the shared services agreement with NantWorks (See Note 18) as well as certain consultants of the Company, none of which were issued during the three months ended March 31, 2016. Stock compensation expense for the phantom units issued to these participants is re-measured at the end of each reporting period until the awards vest. All other grants of phantom units have been made to employees of the Company. The Company uses the accelerated attribution method to recognize expense for all phantom units since the awards’ vesting was subject to the completion of a liquidity event. The grant date fair value of the phantom units granted prior to LLC Conversion was estimated using both an option pricing method and a probability weighted expected return method.
 
As of March 31, 2017, the Company had $20,453 of unrecognized stock based compensation expense related to phantom units which will be recognized over a weighted-average period of 1.9 years. Of that amount, $19,142 of unrecognized expense is related to employee grants with a weighted-average period of 1.9 years and $1,311 of unrecognized expense is related to non-employee grants with a weighted-average period of 2.0 years.

During the three months ended March 31, 2017, the Company issued 376,130 shares of common stock to participants of the Phantom Unit Plan based in the United States, after withholding approximately 212,402 shares to satisfy tax withholding obligations. The Company made a cash payment of $2,106 to cover employee withholding taxes taxes upon the settlement of these vested phantom units. During the three months ended March 31, 2017 the Company also paid $137 to cash-settle 13,739 vested phantom units held by participants of the Phantom Unit Plan based outside of the United States, and fractional shares remaining of vested units held by participants based in the United States.
2016 Equity Incentive Plan
In May and June of 2016, the Company’s Board of Directors adopted and the Company’s stockholders approved the 2016 Equity Incentive Plan (“the 2016 Plan”) in connection with the Company’s IPO. The 2016 Plan provides for the grant of incentive stock options, non-statutory stock options, restricted stock, restricted stock units, stock appreciation rights, performance units and performance shares to employees, directors and consultants. A total of 6,000,000 shares of common stock were reserved for issuance pursuant to the 2016 Plan.
Restricted Stock
The Company issued 10,462 shares of restricted stock under the 2016 Plan on June 1, 2016, in connection with the conversion of the Series C units, of which 3,486 were vested and converted into unrestricted common stock during 2016, and as of March 31, 2017 and December 31, 2016 there were 6,976 shares of restricted stock.
Total stock-based compensation expense of $216 is expected to be recognized on a straight-line basis over approximately the next 1.6 years for the unvested restricted stock outstanding as of March 31, 2017. The unrecognized stock compensation relates to nonemployees and the awards are being accounted for pursuant to ASC 505-50. Stock compensation expense for the Series C units/restricted stock issued to the nonemployees is calculated based on the fair value of the award on each balance sheet date and the attribution of that cost is being recognized ratably over the vesting period.

Stock Options

During the year ended December 31, 2016, the Company issued 500,000 stock options under the 2016 equity incentive plan to Mark Burnett, who is a non-employee member of the Company’s Board of Directors, with exercise price of $14.00. The award is being accounted for pursuant to ASC 505-50. Stock compensation expense issued to the nonemployees is calculated based on the fair value of the award on each balance sheet date and the attribution of that cost is being recognized ratably over the vesting period. The Company has utilized the Black-Scholes option-pricing model to determine the fair value of the stock options.

As of March 31, 2017, the Company had $84 of unrecognized stock based compensation expense related to the stock options. This cost is expected to be recognized over a weighted-average period of 3.15 years.


- 28 -

NantHealth, Inc.
Notes to Condensed Consolidated Financial Statements
(Dollars in thousands, except per share amounts)
(Unaudited)

Note 17. Net Income (Loss) Per Share
The following table sets forth reconciliations of the numerators and denominators used to compute basic and diluted net income (loss) per share of common stock and redeemable common stock for the three months ended March 31, 2017 and 2016:
 
Three Months Ended 
 March 31,
 
2017
 
2016
 
Common Stock
 
Common Stock
 
Redeemable Common Stock
Net income (loss) per share numerator:
 
 
 
 
 
Net loss
$
(41,115
)
 
$
(33,145
)
 
$

Accretion to redemption value of series F/redeemable common stock

 
(2,625
)
 
2,625

Net income (loss) for basic and diluted net income (loss) per share
$
(41,115
)
 
$
(35,770
)
 
$
2,625

 
 
 
 
 
 
Net income (loss) per share denominator:
 
 
 
 
 
Weighted-average shares for basic net loss per share
121,618,039

 
99,651,444

 
10,714,285

Effect of dilutive securities

 

 

Weighted-average shares for dilutive net income (loss) per share
121,618,039

 
99,651,444

 
10,714,285

 
 
 
 
 
 
Basic and diluted net income (loss) per share
$
(0.34
)
 
$
(0.36
)
 
$
0.25

The net income (loss) per share and weighted-average shares outstanding have been computed to give effect to the LLC Conversion (See Note 15) that occurred June 1, 2016 prior to the Company’s initial public offering.  In conjunction with the LLC Conversion, (a) all of the Company’s outstanding units automatically converted into shares of common stock, based on the relative rights of the Company's pre-IPO equityholders as set forth in the limited liability company agreement and (b) the Company adopted and filed a certificate of incorporation with the Secretary of State of the state of Delaware and adopted bylaws. The Company filed an amended certificate of incorporation to effect a 1-for-5.5 reverse stock split of its common stock on June 1, 2016.

As of December 31, 2015, the Company determined that the redemption of the Series F units was probable due to the uncertainty of completing a qualified initial public offering and, as such, accrued interest as a reduction to members’ equity. Prior to December 31, 2015, the Company had concluded that redemption was not probable and had not adjusted the carrying value of such units to redemption value. As of June 1, 2016 as part of the LLC Conversion, the Series F units converted to shares of redeemable common stock. The Put Right on redeemable common stock expired unexercised on June 20, 2016, and as of that date, the shares of common stock owned by KIO are no longer redeemable and are included in common shares (See Note 15).

The following number of potential common shares at the end of each period were excluded from the calculation of diluted net loss per share attributable to common stockholders because their effect would have been anti-dilutive for the periods presented:
 
Three Months Ended 
 March 31,
 
2017
 
2016
Unvested restricted stock
6,976

 
10,462

Unvested phantom units
3,515,718

 
3,722,914

Stock options
500,000

 

Convertible notes
8,815,655

 


- 29 -

NantHealth, Inc.
Notes to Condensed Consolidated Financial Statements
(Dollars in thousands, except per share amounts)
(Unaudited)

Note 18. Related Party Transactions
NantWorks Shared Services Agreement
In October 2012, the Company entered into a shared services agreement with NantWorks that provides for ongoing services from NantWorks in areas such as public relations, information technology and cloud services, human resources and administration management, finance and risk management, environmental health and safety, sales and marketing services, facilities, procurement and travel, and corporate development and strategy (the "Shared Services Agreement"). The Company was billed quarterly for such services at cost, without mark-up or profit for NantWorks, but including reasonable allocations of employee benefits, facilities and other direct or fairly allocated indirect costs that relate to the associates providing the services. During the three months ended March 31, 2017 and 2016, the Company incurred $1,385 and $2,429 of expenses, respectively, related to selling, general and administrative services provided to the Company by NantWorks and affiliates, net of services provided to NantWorks and affiliates. Additionally, the Company incurred $210 of expenses during the three months ended March 31, 2016, related to research and development services provided by NantWorks and its subsidiaries.
Related Party Receivables and Payables
As of March 31, 2017 and December 31, 2016, the Company had related party receivables, net of related party payables of $2,874 and $2,870, respectively. The related party receivables, net of related party payables as of March 31, 2017 and December 31, 2016 primarily consisted of a receivable from Ziosoft KK of $2,126, which was related to the sale of Qi Imaging. As of March 31, 2017 and December 31, 2016 the Company had related party payables, net of receivables balances including related party liabilities of $16,499 and $13,694, respectively. The related party payables, net of receivables balances primarily relate to amounts owed to NantWorks pursuant to the Shared Services Agreement, amounts owed to NantOmics under the Second Amended Reseller Agreement (defined below) and interest payable. The balance of the related party receivables and payables represent amounts paid by affiliates on behalf of the Company or vice versa.
Amended Reseller Agreement
On June 19, 2015, the Company entered into a five and a half year exclusive Reseller Agreement with NantOmics for sequencing and bioinformatics services (the "Original Reseller Agreement"). NantOmics is a majority owned subsidiary of NantWorks and is controlled by the Company's Chairman and CEO. On May 9, 2016, the Company and NantOmics executed an Amended and Restated Reseller Agreement (the “Amended Reseller Agreement”), pursuant to which the Company received the worldwide, exclusive right to resell NantOmics’ quantitative proteomic analysis services, as well as related consulting and other professional services, to institutional customers (including insurers and self-insured healthcare providers) throughout the world. The Company retained its existing rights to resell NantOmics’ genomic sequencing and bioinformatics services. Under the Amended Reseller Agreement, the Company is responsible for various aspects of delivering its sequencing and molecular analysis solutions, including patient engagement and communications with providers such as providing interpretations of the reports delivered to the physicians and resolving any disputes, ensuring customer satisfaction, and managing billing and collections. On September 20, 2016, the Company and NantOmics further amended the Reseller Agreement (the "Second Amended Reseller Agreement"). The Second Amended Reseller Agreement permits the Company to use vendors other than NantOmics to provide any or all of the services that are currently being provided by NantOmics and clarifies that the Company is responsible for order fulfillment and branding.

The Second Amended Reseller Agreement grants to the Company the right to renew the agreement (with exclusivity) for up to three renewal terms, each lasting three years, if the Company achieves projected volume thresholds, as follows: (i) the first renewal option can be exercised if the Company completes at least 300,000 tests between June 19, 2015 and June 30, 2020; (ii) the second renewal option can be exercised if the Company completes at least 570,000 tests between July 1, 2020 and June 30, 2023; and (iii) the third renewal option can be exercised if the Company completes at least 760,000 tests between July 1, 2023 and June 30, 2026. If the Company does not meet the applicable volume threshold during the initial term or the first or second exclusive renewal terms, the Company can renew for a single additional three year term, but only on a non-exclusive basis.
The Company agreed to pay NantOmics non-cancellable annual minimum fees of $2,000 per year for each of the calendar years from 2016 through 2020 and, subject to the Company exercising at least one of its renewal options described above, the Company is required to pay annual minimum fees to NantOmics of at least $25,000 per year for each of the calendar years from 2021 through 2023 and $50,000 per year for each of the calendar years from 2024 through 2029.
As of March 31, 2017 and December 31, 2016, the Company has $1,856 and $1,950, respectively, of outstanding related party payables under the Second Amended Reseller Agreement.

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NantHealth, Inc.
Notes to Condensed Consolidated Financial Statements
(Dollars in thousands, except per share amounts)
(Unaudited)

Master Services and License Agreement with the Chan Soon-Shiong Medical Center at Windber
On December 29, 2016, the Company entered into a master services and license agreement with the Chan Soon-Shiong Medical Center at Windber (“CSSMCW”) whereby the Company will provide CSSMCW with access to certain of its hosted, software-as-a-service solutions and associated products and services. The initial order form under the agreement has a service period of three years and may be terminated for cause by either party in the case of material breach by the other party. Upon expiration of the initial term, the agreement automatically renews for successive one-year periods, unless either party provides the other party with at least 120 days’ prior written notice of its intent not to renew. Amounts invoiced to CSSMCW by the Company are payable within 30 days of receipt. No amounts have been recognized under this agreement during the three months ended March 31, 2017.
Cambridge Purchase Agreement
On December 15, 2016, the Company entered into a purchase agreement (the “Cambridge Purchase Agreement”) with Cambridge Equities, L.P., an entity affiliated with the Company's Chairman and CEO Dr. Patrick Soon-Shiong (“Cambridge”), to issue and sell $10,000 in aggregate principal amount of the Convertible Notes in a private placement pursuant to an exemption from the registration requirements of the Securities Act afforded by Section 4(a)(2) of the Securities Act. The Cambridge Purchase Agreement includes customary representations, warranties and covenants by the Company and customary closing conditions (See Note 11). The accrued and unpaid interest on the convertible notes was $153 and $15 at March 31, 2017 and December 31, 2016, as part of current related party liabilities on the Condensed Consolidated Balance Sheet.
Related Party Promissory Notes
On January 4, 2016, the Company executed a $112,666 demand promissory note in favor of NantCapital to fund the acquisition of NaviNet. The note bears interest at a per annum rate of 5.0%, compounded annually and computed on the basis of the actual number of days elapsed and a year of 365 or 366 days, as the case may be. The unpaid principal and any accrued and unpaid interest on the note was originally due and payable on demand in either (i) cash, (ii) shares of the Company's common stock based on per share price of $18.6126, (iii) Series A-2 units of NantOmics based on a per unit price of $1.484 to the extent such equity is owned by the Company or (iv) any combination of the foregoing, all at the option of NantCapital. Subject to the preceding sentence, the Company may prepay the outstanding amount at any time, either in whole or in part, without premium or penalty and without the prior consent of NantCapital. On May 9, 2016, the promissory note with NantCapital was amended to provide that all outstanding principal and accrued interest is due and payable on June 30, 2021, and not on demand. On December 15, 2016, in connection with the offering of the Convertible Notes, the Company entered into a Second Amended and Restated Promissory Note which amends and restates the Amended and Restated Promissory Note, dated May 9, 2016, between the Company and NantCapital, to, among other things, extend the maturity date of the Promissory Note to June 30, 2022 and to subordinate the Promissory Note in right of payment to the Convertible Notes (See Note 11). No other terms of the promissory note were changed. As of March 31, 2017 and December 31, 2016, the total principal and interest outstanding on the note amounted to $119,709 and $118,253, respectively. The accrued and unpaid interest on the note was $7,043 and $5,587, respectively as of March 31, 2017 and December 31, 2016, as part of non current related party liabilities on the Condensed Consolidated Balance Sheets. The Company can request additional advances subject to NantCapital approval. The NantCapital Note bears interest at a per annum rate of 5.0% compounded annually and computed on the basis of the actual number of days in the year. NantCapital has the option, but not the obligation, to require us to repay any such amount in cash, Series A-2 units of NantOmics (based on a per unit price of $1.484) held by us, shares of the Company's common stock based on a per share price of $18.6126 (if such equity exists at the time of repayment), or any combination of the foregoing at the sole discretion of NantCapital.
On January 22, 2016, the Company executed a demand promissory note in favor of NantOmics. The principal amount of the initial advance totaled $20,000. On March 8, 2016, NantOmics made a second advance to the Company for $20,000. The note bears interest at a per annum rate is 5.0% and is compounded annually. In May and June of 2016, the Company executed amendments to the demand promissory note with NantOmics, which provide that all unpaid principal of each advance owed to NantOmics and any accrued and unpaid interest would convert automatically into shares of the Company’s common stock after pricing of the Company’s IPO and immediately after conversion of the Company from a limited liability company to a corporation. On June 1, 2016, approximately $40,590 of principal and accrued interest under the promissory note with NantOmics was converted into 2,899,297 shares of the Company’s common stock in connection with the IPO. The Company can request additional advances subject to NantOmics approval, and as of March 31, 2017, there was no outstanding balance on the promissory note.

- 31 -


Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following is a discussion and analysis of our financial condition and the results of operations as of and for the periods presented below. The following discussion and analysis should be read in conjunction with the “Condensed Consolidated Financial Statements” and notes thereto included elsewhere in this Quarterly Report on Form 10-Q, or Quarterly Report. This discussion contains forward-looking statements that are based on the beliefs, assumptions, and information currently available to our management, and are subject to known and unknown risks, uncertainties, and other factors that may cause our actual results to differ materially from those expressed or implied by such forward-looking statements. These risks, uncertainties, and other factors include, among others, those described in greater detail elsewhere in this Quarterly Report and in our Annual Report on Form 10-K, particularly in Item 1A, “Risk Factors”.
Overview
We are a leading next-generation, evidence-based, personalized healthcare company focused on enabling our clients to fundamentally change the diagnosis, treatment and pharmacoeconomics of cancer and other critical illnesses. We believe a molecular-driven, systems-based approach to making clinical treatment decisions based on large-scale, real time biometric and phenotypical data will become the standard of care initially for patients with cancer and, ultimately, other critical illnesses. We derive revenue from selling GPS Cancer (our Genomic Proteomic Spectrometry Cancer test, a unique, comprehensive molecular test and decision support solution that measures the proteins present in the patient's tumor tissue, combined with whole genomic and transcriptomic sequencing of tumor & normal samples), to which we obtained exclusive access from an affiliate, and NantOS and NantOS apps to healthcare providers and payors, self-insured employers and biopharmaceutical companies. NantOS and NantOS apps include proprietary methods and algorithms for enabling healthcare providers to make better treatment decisions to improve patient outcomes and lower the cost of care, and allow healthcare payors to ensure that their dependents receive high quality care in a cost-effective manner. We believe that as healthcare providers and payors migrate to value-based reimbursement models and implement advances in precision medicine, our offerings position us at the forefront of multiple significant market opportunities.
We market NantHealth solutions (which was originally introduced to the market as CLINICS) as a comprehensive integrated solution that includes GPS Cancer, NantOS and the NantOS apps. We also market our GPS Cancer, NantOS, individual NantOS apps and suites of NantOS apps as stand-alone solutions. To accelerate our commercial growth and enhance our competitive advantage, we continue to:
introduce new marketing, education and engagement efforts and foster relationships across the oncology community to drive adoption of GPS Cancer;
pursue reimbursement of GPS Cancer from regional and national third-party payors and government payors;
publish scientific and medical advances;
strengthen our commercial organization to increase our NantHealth solutions client base and to broaden usage of our solutions by existing clients who currently use only NantOS, specific NantOS apps or suites of NantOS apps; and
develop new features and functionality for NantHealth solutions to address the needs of current and future healthcare provider and payor, self-insured employer and biopharmaceutical company clients.
Since our inception, we have devoted substantially all of our resources to the development and commercialization of NantHealth solutions, including NantOS and the NantOS apps, as well as the commercial launch of our GPS Cancer business. To complement our internal growth and expertise, we have made several strategic acquisitions of companies, products and technologies. We have incurred significant losses since our inception, and as of March 31, 2017 our accumulated deficit was approximately $516.4 million. We expect to continue to incur operating losses over the near term as we drive adoption of GPS Cancer, expand our commercial operations, and invest further in NantHealth solutions.


- 32 -


We plan to (i) continue investing in our infrastructure, including but not limited to solution development, sales and marketing, implementation and support, (ii) continue efforts to make infrastructure investments within an overall context of maintaining reasonable expense discipline, (iii) add new clients through maintaining and expanding sales, marketing and solution development activities, (iv) expand our relationships with existing clients through delivery of add-on and complementary solutions and services and (v) continue our commitment of service in support of our client satisfaction programs. We believe that our growing client base using our NantOS and NantOS apps on a daily basis is a strategic asset, and we intend to expand sales of NantHealth solutions offerings towards this client base in order to attempt to leverage this strategic asset.
Recent Developments and Acquisition
On June 7, 2016, we completed our IPO, whereby we sold 6,500,000 shares of our common stock at a public offering price of $14.00 per share. Additionally, on June 9, 2016, the underwriters partially exercised their overallotment option to purchase an additional 400,000 shares of our common stock at $14.00 per share.

We received a total of $83.6 million in net proceeds from our IPO, after deducting underwriting discounts and commissions and offering costs of $13.0 million. The offering was registered under the Securities Act of 1933, as amended, on a registration statement on Form S-1 (Registration No. 333-211196), as amended.

In December 2016, we issued convertible notes to a related party and others for net proceeds of $9.9 million and $92.8 million, respectively, after deducting underwriting discounts and commissions and other offering costs of $4.3 million. Please see Note 11 of the Notes to accompanying Condensed Consolidated Financial Statements for further discussion of these convertible notes.
We made a significant acquisition in 2016, which has expanded the features and functionality of NantHealth solutions. In January 2016 we acquired NaviNet, which provides a secure collaboration network connecting approximately 36 health plans and which is estimated to be utilized in more than 70% of the nation’s physicians’ offices during the fourth quarter of 2016. NaviNet Open will serve as a nationwide scalable and secure web-based portal for patients and providers.
Non-GAAP Net Loss and Non-GAAP Net Loss Per Share
Adjusted net loss and adjusted net loss per share are financial measures that are not prepared in conformity with United States generally accepted accounting principles (U.S. GAAP). Our management believes that the presentation of Non-GAAP financial measures provides useful supplementary information regarding operational performance, because it enhances an investor’s overall understanding of the financial results for our core business. Additionally, it provides a basis for the comparison of the financial results for our core business between current, past and future periods. Other companies may define these measures in different ways. Non-GAAP financial measures should be considered only as a supplement to, and not as a substitute for or as a superior measure to, financial measures prepared in accordance with U.S. GAAP.

Net loss Non-GAAP excludes the effects of (1) loss from equity method investments, (2) stock based compensation expense, (3) intangible amortization, (4) corporate restructuring expenses, (5) acquisition related compensation expense (6) acquisition related sales incentives, which have been recorded as contra revenue, (7) change in fair value of derivatives liability, (8) non-cash interest expense related to convertible notes, and (9) the impact of intangibles amortization on provision for (benefit from) income taxes.
 
Adjusted shares outstanding include Series F redeemable units as if converted to common stock on January 1, 2016. These units were converted to common stock in conjunction with the LLC conversion on June 1, 2016. The Put Right held by KIO expired on June 20, 2016, and the shares of common stock owned by KIO are no longer redeemable. See Note 15 to the accompanying Condensed Consolidated Financial Statements for further discussion of the Put Right.


- 33 -


The following table reconciles Net loss to Net loss - Non-GAAP and Shares outstanding to Shares outstanding - Non-GAAP for the three months ended March 31, 2017 and 2016 (Unaudited):
(Dollars in thousands, except per share amounts)
Three Months Ended 
 March 31,
 
2017
 
2016
Net loss
$
(41,115
)
 
$
(33,145
)
Adjustments to GAAP net loss:


 


Loss from related party equity method investment
4,526

 
2,914

Stock-based compensation expense
250

 
98

Corporate restructuring
220

 
1,966

Acquisition related compensation expense

 
4,814

Acquisition related sales incentive
662

 
1,420

Change in fair value of derivatives liability
(215
)
 

Non-cash interest expense related to convertible notes
1,051

 

Intangible amortization
5,220

 
6,096

Impact of intangibles amortization on provision for (benefit from) income taxes
233

 
(4,528
)
Total adjustments to GAAP net loss
11,947

 
12,780

Net loss - Non-GAAP
$
(29,168
)
 
$
(20,365
)
 
 
 
 
Weighted average shares outstanding (1)
121,618,039

 
99,651,444

Weighted average Series F/redeemable stock (1)(2)

 
10,714,285

Shares outstanding - Non-GAAP (1)
121,618,039

 
110,365,729

 
 
 
 
Net loss per share - Non-GAAP (1)
$
(0.24
)
 
$
(0.18
)

The following table reconciles Net loss per share to Net loss per share Non-GAAP for the three months ended March 31, 2017 and 2016 (Unaudited):
 
Three Months Ended 
 March 31,
 
2017
 
2016
Net loss per common share - GAAP
$
(0.34
)
 
$
(0.36
)
Adjustments to GAAP net loss per common share:
 
 
 
Loss from related party equity method investment
0.04


0.03

Stock-based compensation expense

 

Corporate restructuring

 
0.02

Acquisition related compensation expense

 
0.05

Acquisition related sales incentive
0.01

 
0.01

Change in fair value of derivatives liability

 

Non-cash interest expense related to convertible notes
0.01

 

Intangible amortization
0.04

 
0.07

Impact of intangibles amortization on provision for (benefit from) income taxes

 
(0.05
)
Accretion to redemption value of Series F/redeemable common stock

 
0.03

Dilution from Series F/redeemable common stock

 
0.02

Total adjustments to GAAP net loss per common share
0.10

 
0.18

Net loss per share - Non-GAAP (1)
$
(0.24
)
 
$
(0.18
)





- 34 -



(1)
The net loss per share - non-GAAP, weighted average shares outstanding, weighted average Series F units/redeemable stock and shares outstanding - non-GAAP have been computed to give effect to the LLC conversion that occurred June 1, 2016 prior to our IPO. In conjunction with the LLC Conversion, (a) all of our outstanding units automatically converted into shares of common stock, based on the relative rights of our pre-IPO equityholders as set forth in the limited liability company agreement and (b) we adopted and filed a certificate of incorporation with the Secretary of State of the state of Delaware and adopted bylaws. We filed an amended certificate of incorporation to effect a 1-for-5.5 reverse stock split of our common stock on June 1, 2016.

(2)
The weighted average shares outstanding have been further adjusted to account for the redeemable Series F units (converted to common stock in conjunction with the LLC conversion), whose Put Right expired on June 20, 2016.  Prior to June 20, 2016, these units/shares of common stock were classified as redeemable members’/stockholders’ equity in the balance sheet, and as such, were not included in the weighted-average shares outstanding prior to June 20, 2016. The Put Right expired June 20, 2016, and the shares were no longer redeemable and are included in shareholders’ equity following that day. The weighted-average shares are adjusted to include the redeemable common stock in the weighted average shares outstanding for the entire period.
Components of Our Results of Operations
Revenue
We generate our revenue from the sale of licensed software, maintenance, software-as-a-service, hardware and services. Our systems infrastructure and platforms support the delivery of both personalized comprehensive sequencing and molecular analysis and the implementation of value-based care models across the healthcare continuum. We generate revenue from the following sources:
Software, middleware and hardware - Software, middleware and hardware revenue is generated from the sale of NantOS and NantOS apps software on either a perpetual or term license basis, and the sale of our hardware. The software is installed on the client’s site or the client’s designated vendor’s site and is not hosted by us or by a vendor contracted by us. We also generate revenue from the resale of third-party software and hardware to our clients. Our software and hardware solutions sold include components of our NantOS, including FusionFX, cOS, DeviceConX and HBox.

Software-as-a-service - Software-as-a-service, or SaaS, revenue is generated from our clients’ access to and usage of our hosted software solutions on a subscription basis for a specified contract term, which is typically annually. In our SaaS arrangements, the client cannot take possession of the software during the term of the contract and generally only has the right to access and use the software and receive any software upgrades published during the subscription period. Solutions sold under a SaaS model include our eviti platform solutions, NantOS and NantOS apps.

Maintenance - Maintenance revenue includes ongoing post-contract client support, or PCS, or maintenance during the paid PCS term. Additionally, PCS includes ongoing development of software updates and upgrades provided to the client on a when and if available basis. We sell NantOS, including DeviceConX and FusionFX, with maintenance contracts.

Sequencing and molecular analysis - Sequencing and molecular analysis revenue is generated by the process of performing sequencing and analysis of whole genome DNA, RNA and proteomic results, including GPS Cancer. We recognize revenue upon the delivery of the analysis and reporting of the results to the client or on a cash basis when it cannot conclude that the fees are fixed and determinable and collectability is reasonably assured.

Other services - Other services revenue includes revenue from professional services we provide that are generally complementary to our software solutions and may or may not be required for the solution to function as desired by the client. When associated with software, there services are generally provided in the form of training and implementation services during the software license period and do not include PCS. Other services revenue also includes revenue related to nursing and therapy services provided to patients in a home care setting and any other services not included in the preceding revenue sources.

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We have established VSOE for PCS on certain of our software solutions. We have not yet established VSOE of fair value for any element other than PCS for a portion of our arrangements. In situations where VSOE of fair value exists for PCS but not a delivered element, the residual method is used to allocate revenue to the undelivered element equal to our VSOE value with the remainder allocated to the delivered elements. In situations where our services are essential to the functionality of our software and VSOE of fair value for PCS does not exist, we defer revenue and costs until we have delivered all elements of the arrangement and amortize revenue and costs over the initial PCS period. For our contracts with multiple elements, we defer revenue until only one undelivered element remains and then recognize the revenue following the pattern of delivery of the final undelivered element. The timing and pattern of this revenue recognition can cause variations in revenue from period-to-period.
Cost of Revenue
Cost of revenue consists primarily of personnel-related costs for associates providing services to our clients and supporting our revenue-generating platform infrastructure, including salaries, benefits and bonuses. Additional expenses include consultant costs, direct reimbursable travel expenses and other direct engagement costs associated with the design, development, sale and installation of our solutions, including system support and maintenance services. Our cost of revenue associated with each of our revenue sources is as follows:

Software, middleware and hardware - Software and hardware cost of revenue includes third-party software and hardware costs directly associated with our solutions.

Software-as-a-service - SaaS cost of revenue includes personnel-related, amortization of deferred implementation costs, depreciation of internal use software and other direct costs associated with the delivery and hosting of NantOS and NantOS apps, including eviti, our cancer-decision support solution, and NaviNet on a subscription basis.

Maintenance - Maintenance cost of revenue includes personnel-related and other direct costs associated with the ongoing support or maintenance we provide for our clients.

Sequencing and molecular analysis - Sequencing and molecular analysis cost of revenue includes internal costs associated with these services and amounts due to NantOmics under our Reseller Agreement for the sequencing and analysis of whole genome, DNA, RNA and proteomic results.

Other services - Other services cost of revenue includes personnel-related costs, amortization of deferred implementation costs, depreciation of internal use software and other direct costs associated with software training and implementation services provided to our clients as well as direct expenses relating to our nursing and therapy services provided to patients in a home care setting.
Cost of revenue also includes amortization of our developed technologies used to generate revenue. We plan to continue to expand our capacity to support our growth, which will result in higher cost of revenue in absolute dollars. We expect cost of revenue to decrease as a percentage of revenue over time as we expand NantHealth solutions and realize economies of scale.
Operating Expenses
Our operating expenses consist of selling, general and administrative, research and development, and amortization of software license and acquisition-related assets.

Selling, general and administrative

Selling, general and administrative expense consists primarily of shared service fees from NantWorks, personnel-related expenses for our sales and marketing, finance, legal, human resources, and administrative associates, stock based compensation, and advertising and marketing promotions of NantHealth solutions. It also includes trade show and event costs, sponsorship costs, point of purchase display expenses and related amortization as well as legal costs, consulting and professional fees, insurance and other corporate and administrative costs.


- 36 -


We expect to continue to grow our investment in selling and other related expenses supporting future growth in GPS as well as expanding our brand.  We are reviewing our other selling, general and administrative investments and expect to drive cost savings through greater efficiencies and synergies across our company. Additionally, we expect to incur additional costs for legal, accounting, insurance, investor relations and other costs associated with operating as a public company. These increases include additional costs we expect to incur associated with compliance with the Sarbanes-Oxley Act and other regulations governing public companies as well as increased costs for directors’ and officers’ liability insurance and an enhanced investor relations function. However, we expect our selling, general and administrative expense to decrease as a percentage of revenue over the long term as our revenue increases and we realize economies of scale.

Research and development

Research and development expenses consist primarily of personnel-related costs for associates working on development of solutions, including salaries, benefits and stock based compensation. Also included are non-personnel costs such as consulting and professional fees to third-party development resources.
Substantially all of our research and development expenses are related to developing new software solutions and improving our existing software solutions. To date, research and development expenses have been expensed as incurred as the period between achieving technological feasibility and the release of software solutions for sale has been short and development costs qualifying for capitalization have been insignificant.
With the exception of stock based compensation, we expect our research and development expenses to continue to increase in absolute dollars and as a percentage of revenue in the short term as we continue to make significant investments in developing new solutions and enhancing the functionality of our existing solutions. However, we expect our research and development expenses to decrease as a percentage of revenue over the long term as we realize economies of scale from our developed technology.
Amortization of Software License and Acquisition Related Assets
Amortization of software license and acquisition related assets consists of non-cash amortization expense related to our non-revenue generating technology as well as amortization expense that we recognize on intangible assets that we acquired through our investments.
Interest Expense, net
Interest expense, net primarily consists of interest expense associated with our outstanding borrowings, including coupon interest expense, amortization of debt discounts and amortization of deferred financing offering cost, offset by interest income earned on our cash and cash equivalents and marketable securities.
Other Income, net
Other income, net consists primarily of unrealized and realized gains (losses), dividends received from our marketable securities, change in fair value of derivative liability and other non-recurring items.
Loss from Equity Method Investment
Loss from equity method investment consists of our pro rata share of losses of a company that we own an ownership interest in and account for under the equity method of accounting.
We regularly evaluate our investments, which are not carried at fair value, for other than temporary impairment in accordance with U.S. GAAP.
Provision for (Benefit from) Income Taxes
Provision for income taxes consists of U.S. federal and state and foreign income taxes. To date, we have no significant U.S. federal, state and foreign cash income taxes because of our LLC status prior to June 1, 2016 and current and accumulated net operating losses.
We record a valuation allowance when it is more likely than not that some portion or all of a deferred tax asset will not be realized. In making such a determination, we consider all the available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, and ongoing prudent and feasible tax planning strategies in assessing the amount of the valuation allowance. When we establish or reduce the valuation allowance against the deferred tax assets, our provision for income taxes will increase or decrease, respectively, in the period such determination is made.

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Results of Operations
The following table sets forth our Condensed Consolidated Statements of Operations data for each of the periods indicated (Unaudited):
(Dollars in thousands, except per share amounts)
Three Months Ended 
 March 31,
 
2017
 
2016
Revenue:
 
 
 
Software and hardware
$
645

 
$
674

Software–as-a-service
15,231

 
13,701

Total software-related revenue
15,876

 
14,375

Maintenance
3,162

 
3,138

Sequencing and molecular analysis
510

 

Other services
2,961

 
1,938

Total net revenue
22,509

 
19,451

 
 
 
 
Cost of Revenue:
 
 
 
Software and hardware
312

 
239

Software-as-a-service
7,233

 
4,423

Total software-related cost of revenue
7,545

 
4,662

Maintenance
862

 
530

Sequencing and molecular analysis
1,538

 

Other services
5,678

 
3,565

Amortization of developed technologies
3,406

 
4,281

Total cost of revenue
19,029

 
13,038

 
 
 
 
Gross profit
3,480

 
6,413

 
 
 
 
Operating Expenses:
 
 
 
Selling, general and administrative
20,878

 
27,373

Research and development
13,399

 
10,694

Amortization of software license and acquisition-related assets
1,814

 
1,815

Total operating expenses
36,091

 
39,882

Loss from operations
(32,611
)
 
(33,469
)
Interest expense, net
(3,969
)
 
(1,498
)
Other income, net
273

 
338

Loss from related party equity method investment
(4,526
)
 
(2,914
)
Loss before income taxes
(40,833
)
 
(37,543
)
Provision for (benefit from) income taxes
282

 
(4,398
)
Net loss
$
(41,115
)
 
$
(33,145
)
 
 
 
 
Net income (loss) per share (1):
 
 
 
Basic and diluted - common stock
$
(0.34
)
 
$
(0.36
)
 Basic and diluted - redeemable common stock
N/A

 
$
0.25

 
 
 
 
Weighted average shares outstanding (1):
 
 
 
Basic and diluted - common stock
121,618,039

 
99,651,444

Basic and diluted - redeemable common shares
N/A

 
10,714,285


- 38 -


(1)
The net income (loss) per share and weighted average shares outstanding for the three months ended March 31, 2016, have been computed to give effect to the LLC Conversion (See Note 15 of the accompanying Condensed Consolidated Financial Statements) that occurred on June 1, 2016, prior to our IPO. In conjunction with the LLC Conversion, (a) all of our outstanding units automatically converted into shares of common stock, based on the relative rights of our pre-IPO equityholders as set forth in our limited liability company agreement and (b) we adopted and filed a certificate of incorporation with the Secretary of State of the state of Delaware and adopted bylaws. The Company adopted and filed an amendment to its certificate of incorporation with the Secretary of State of the state of Delaware to effect a 1-for-5.5 reverse stock split of its common stock on June 1, 2016.

The net loss per share for the common stock for the three months ended March 31, 2016 reflects $2,625 in accretion value allocated to the redeemable common stock. The redeemable common stock contained a put right, which expired unexercised on June 20, 2016. As a result of and as of that date, the shares were no longer redeemable and were included in common stock. See Note 17 of the accompanying Condensed Consolidated Financial Statements for the calculation of net loss per share for common stock and redeemable common stock for the three months ended March 31, 2016.
The following table sets forth our Condensed Consolidated Statements of Operations data as a percentage of revenue for each of the periods indicated (Unaudited):

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Three Months Ended 
 March 31,
 
2017
 
2016
Revenue:
 
 
 
Software and hardware
2.9
%
 
3.5
%
Software–as-a-service
67.6
%
 
70.4
%
Total software-related revenue
70.5
%
 
73.9
%
Maintenance
14.0
%
 
16.1
%
Sequencing and molecular analysis
2.3
%
 
0.0
%
Other services
13.2
%
 
10.0
%
Total net revenue
100.0
%
 
100.0
%
 
 
 
 
Cost of Revenue:
 
 
 
Software and hardware
1.4
%
 
1.2
%
Software-as-a-service
32.1
%
 
22.8
%
Total software-related cost of revenue
33.5
%
 
24.0
%
Maintenance
3.8
%
 
2.7
%
Sequencing and molecular analysis
6.8
%
 
0.0
%
Other services
25.2
%
 
18.3
%
Amortization of developed technologies
15.2
%
 
22.0
%
Total cost of revenue
84.5
%
 
67.0
%
 
 
 
 
Gross profit
15.5
%
 
33.0
%
 
 
 
 
Operating Expenses:
 
 
 
Selling, general and administrative
92.8
%
 
140.8
%
Research and development
59.5
%
 
55.0
%
Amortization of software license and acquisition-related assets
8.1
%
 
9.3
%
Total operating expenses
160.4
%
 
205.1
%
Loss from operations
(144.9
%)
 
(172.1
%)
Interest expense, net
(17.6
%)
 
(7.7
%)
Other income, net
1.2
%
 
1.7
%
Loss from equity method investment
(20.1
%)
 
(14.9
%)
Loss before income taxes
(181.4
%)
 
(193.0
%)
Provision for (benefit from) income taxes
1.3
%
 
(22.6
%)
Net loss
(182.7
%)
 
(170.4
%)

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Comparison of Three Months Ended March 31, 2016 and 2017 (Unaudited)
Revenue
 
Three Months Ended 
 March 31,
 
Period-To-Period Change
 
2017
 
2016
 
 
 
 
 
Amount
 
Amount
 
Amount
 
Percentage
Software and hardware
$
645

 
$
674

 
$
(29
)
 
-4.3
 %
Software–as-a-service
15,231

 
13,701

 
1,530

 
11.2
 %
Total software-related revenues
15,876

 
14,375

 
1,501

 
10.4
 %
Maintenance
3,162

 
3,138

 
24

 
0.8
 %
Sequencing and molecular analysis
510

 

 
510

 
0.0
 %
Other services
2,961

 
1,938

 
1,023

 
52.8
 %
Total net revenue
$
22,509

 
$
19,451

 
$
3,058

 
15.7
 %
Comparison of the three month periods ended March 31, 2016 versus 2017
Total revenue increased $3.1 million or 15.7% from $19.5 million to $22.5 million for the three months ended March 31, 2016 and March 31, 2017, respectively. Our total revenue growth was driven primarily by a $1.5 million increase in software-as-a-service (SaaS), as well as a $1.0 million increase in other services.
Our total software-related revenues (including software and hardware and SaaS) was $15.9 million for the three months ended March 31, 2017 compared to $14.4 million for the three months ended March 31, 2016, an increase of $1.5 million or 10.4% The growth in software-related revenue was primarily driven by SaaS revenue from our NaviNet and eviti solutions. The increase in SaaS revenue was offset by a flat performance from our software and hardware line of business due to the timing of completed implementations as compared to the same period in the prior year.
Software and hardware revenue remained flat as revenue decreased slightly from $0.7 million to $0.6 million for the three months ended March 31, 2016 and March 31, 2017, respectively. The primary driver of the decrease was related to $0.3 million lower revenue from completed implementations of DeviceConX compared to the same period in the prior year. Our software and hardware revenue results experience fluctuations due to the timing of implementation completions for our DeviceConX customers and our revenue recognition for DeviceConX arrangements.
SaaS revenue increased $1.5 million or 11.2% from $13.7 million to $15.2 million for the three months ended March 31, 2016 and March 31, 2017, respectively. This increase was primarily driven by a $1.4 million increase of Payer engagement revenue attributed to reductions in estimated sales incentives recorded as contra revenue, as well as organic growth with existing customer base.
Maintenance revenue increased from $3.1 million to $3.2 million for the three months ended March 31, 2016 and March 31, 2017, respectively. This increase was primarily driven by a growth in Fusion FX maintenance.
Sequencing and molecular analysis revenue of $0.5 million was limited to primarily what could be recognized on a cash basis given the uncertainty over reimbursement for a substantial majority of the GPS profiles delivered in the quarter. As the Company gains additional insurance coverage and reimbursement experience, we expect to be able to reduce the portion of GPS revenue which is recognized on a cash basis.


- 41 -


We are significantly expanding our sales efforts by adding seasoned sales and account management professionals in 2017. In our first quarter of 2017 we grew our GPS field sales team from 5 to 11 professionals. We expect to continue to grow our sales teams in 2017 with additions during the second quarter of 2017. The commercial team's efforts are focused around expanding the reimbursement coverage of the GPS test through the development of pilot partnerships with commercial insurance payers, expanding the offering, and enhancing operational performance and efficiencies. The pilot partnerships supports an alignment with designated provider/oncology groups within the health plan payors network who will have the capability to order the profile for patients based on coverage criteria. Reimbursement is recognized for each test order throughout the pilot agreement. Profile value will be assessed by the Plan with the goal of full medical policy adoption at pilot end. We have grown the number of payers and self-insured employers covering our GPS test to nine and expect this number to continue to grow with the aggressive efforts in place. Our pipeline of self-insured employers includes opportunities with many companies listed on Fortune's 100, as well as an alliance of 50 of the largest employers in the US. Most recently, we announced a partnership with the International Association of Firefighters - a group with a significantly higher incidence rate of cancer than the normal population. This Union, made of first responders, currently has a membership of approximately 300,000 with more than 1,500 local organization. Through this important partnership we have added contracts with self-insured groups across the US and we have created an option to aggregate groups that are not self-insured to support a coverage options for them.
In January 2015, we entered into an agreement to provide certain research related sequencing services to a research institution. The agreement provides that the institution pay us $10.0 million in exchange for our providing sequencing services through our reseller agreement with NantOmics. In 2016 and 2015, we completed $3.8 million and $6.2 million, respectively in services, which was recorded as deemed capital contributions. As a result, through December 31, 2016 we have completed all of our obligation for a total of $10.0 million, all of which was recorded as deemed capital contributions. At the institution's request, certain non-profit organizations provided partial funding for the sequencing and related bioinformatics costs associated with the project. Our Chairman and Chief Executive Officer serves as a member of the board of directors of, and may have significant influence or control over, these organizations. The institution was not contractually or otherwise required to use our molecular profiling solution or any of our other products or services as part of the charitable gift.
Other services revenue increased $1.0 million or 52.8% from $1.9 million to $3.0 million for the three months ended March 31, 2016 and March 31, 2017, respectively. This was primarily driven by a $1.3 million increase in Fusion services as a result of an implementation of a large contract. This growth was offset by a decrease of $0.4 million in our home health care services.
We continue to believe that significant opportunities exist for expanded cross-sell opportunities of our suite of solutions across our existing customer base, including the recently acquired FusionFX and NaviNet customer bases. We are also integrating the cOS, FusionFX and NaviNet product solutions within our NantOS platform and believe that opportunities exist to cross-sell this combination of solutions to existing former FusionFX and NaviNet customers as well as to new customers. We also believe that our customer base and our product solutions provide unique opportunities to expand the volume of GPS sequencing analysis reporting to our customer base. Maintaining our current customer base will be important to our future maintenance and SaaS recurring revenue streams.

- 42 -


Cost of Revenue
 
Three Months Ended 
 March 31,
 
Period-To-Period Change
 
2017
 
2016
 
 
 
 
 
Amount
 
Amount
 
Amount
 
Percentage
Software and hardware
$
312

 
$
239

 
$
73

 
30.5
 %
Software–as-a-service
7,233

 
4,423

 
2,810

 
63.5
 %
Total software-related cost of revenue
7,545

 
4,662

 
2,883

 
61.8
 %
Maintenance
862

 
530

 
332

 
62.6
 %
Sequencing and molecular analysis
1,538