**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-QSB**

 

| **ý**                                        | ** ** | **QUARTERLY  REPORT UNDER SECION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|---------------------------------------------------|------------|---------------------------------------------------------------------------------------|
|                                              |       |                                                                                  |
| **For the quarterly period ended March 31, 2006** |
|                                              |       |                                                                                  |
| **o**                                             | ** ** | **TRANSITION  REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT**                  |

 

**Commission file number: 0-31152**

 

**CRDENTIA CORP.**

(Exact name of small business issuer as specified in its charter)

 

| **Delaware**                                                    | ** ** | **76-0585701**                    |
|-----------------------------------------------------------------|------------|-----------------------------------|
| (State or other jurisdiction of incorporation or  organization) |       | (IRS Employer Identification No.) |

 

**5001 LBJ Freeway, Suite 850, Dallas, Texas 75244**

(Address of principal executive offices)

 

**(972) 850-0780**

(Issuer’s telephone number)

 

Checkwhether the issuer (1) filed all reports required to be filed by Section 13 or15(d) of the Exchange Act during the past 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days. Yes ý No o

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act). Yes o No ý

 

Statethe number of shares outstanding of each of the issuer’s classes of commonequity, as of the latest practicable date. At May 12, 2006, 14,415,293 sharesof common stock, $.0001 par value, were outstanding.

 

TransitionalSmall Business Disclosure Format (check one): Yes o No ý

 

 

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**CRDENTIA CORP.**

 

Form 10-QSB Quarterly Report

For the Quarterly Period Ended March 31, 2006

 

**Table of Contents**

 
| ** **                              | **Page** |
|-----------------------------------------|----------|
| ** **                              |     |
| **PART I – FINANCIAL INFORMATION** |     |
|                                    |     |   |   |
| Item 1.                                 |     | Financial Statements | 3 |
|                                    |     |   |   |
|                                    |     | Condensed Consolidated  Balance Sheets at March 31, 2006 (unaudited) and December 31, 2005 | 3 |
|                                    |     |   |   |
|                                    |     | Unaudited Condensed  Consolidated Statements of Operations for the Three Months Ended March 31,  2006 and 2005 | 4 |
|                                    |     |   |   |
|                                    |     | Unaudited Condensed  Consolidated Statements of Cash Flows for the Three Months Ended March 31,  2006 and 2005 | 5 |
|                                    |     |   |   |
|                                    |     | Notes to Unaudited Condensed  Consolidated Financial Statements | 6 |
|                                    |     |   |   |
| Item 2.                                 |     | Management’s Discussion and  Analysis or Plan of Operation | 18 |
|                                    |     |   |   |
| Item 3.                                 |     | Controls and Procedures | 33 |
|                                    |     |   |   |
| **PART II – OTHER INFORMATION**    |     |
|                                    |     |   |   |
| Item 1.                                 |     | Legal Proceedings | 34 |
|                                    |     |   |   |
| Item 2.                                 |     | Unregistered Sales of Equity  Securities and Use of Proceeds | 34 |
|                                    |     |   |   |
| Item 3.                                 |     | Defaults Upon Senior  Securities | 35 |
|                                    |     |   |   |
| Item 4.                                 |     | Submission of Matters to a  Vote of Security Holders | 35 |
|                                    |     |   |   |
| Item 5.                                 |     | Other Information | 35 |
|                                    |     |   |   |
| Item 6.                                 |     | Exhibits | 35 |
|                                    |     |   |   |
| **SIGNATURES**                          |     |

 

2

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**PART I– FINANCIAL INFORMATION**

 

**Item 1.    Financial Statements**

 

Crdentia Corp.

Condensed Consolidated Balance Sheets

 
| ** **                                                                                                                                                                                                                              | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                              | ** ** | **2006**           | ** ** | **2005**              | ** ** |
| ** **                                                                                                                                                                                                                              | ** ** | **(unaudited)**    | ** ** | ** **            | ** ** |
| Current assets:                                                                                                                                                                                                                         |       |               |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                                                               |       | $                  | 148,678    |                  | $          | 434,921 |   |
| Accounts receivable, net of allowance for  doubtful accounts of $200,000 at March 31, 2006 and $275,000 at December 31,  2005                                                                                                           |       | 4,432,648          |       | 4,566,975             |       |
| Unbilled receivables                                                                                                                                                                                                                    |       | 614,043            |       | 625,899               |       |
| Other current assets                                                                                                                                                                                                                    |       | 603,341            |       | 464,865               |       |
| Total current assets                                                                                                                                                                                                                    |       | 5,798,710          |       | 6,092,660             |       |
|                                                                                                                                                                                                                                    |       |               |       |                  |       |
| Property and equipment, net                                                                                                                                                                                                             |       | 394,874            |       | 418,837               |       |
| Goodwill                                                                                                                                                                                                                                |       | 22,977,377         |       | 22,977,377            |       |
| Intangible assets, net                                                                                                                                                                                                                  |       | 1,804,161          |       | 1,985,585             |       |
| Other assets                                                                                                                                                                                                                            |       | 930,409            |       | 518,001               |       |
| Total assets                                                                                                                                                                                                                            |       | $                  | 31,905,531 |                  | $          | 31,992,460 |   |
|                                                                                                                                                                                                                                    |       |               |       |                  |       |
| Current liabilities:                                                                                                                                                                                                                    |       |               |       |                  |       |
| Revolving lines of credit                                                                                                                                                                                                               |       | $                  | 3,848,827  |                  | $          | 4,672,096 |   |
| Accounts payable and accrued expenses                                                                                                                                                                                                   |       | 1,370,864          |       | 1,447,905             |       |
| Accrued dividends on convertible preferred  stock                                                                                                                                                                                       |       | —             |       | 800,748               |       |
| Accrued employee compensation and benefits                                                                                                                                                                                              |       | 1,014,680          |       | 980,005               |       |
| Debentures, net of discount of $1,595,002                                                                                                                                                                                               |       | 144,998            |       | —                |       |
| Note payable to seller                                                                                                                                                                                                                  |       | 3,215,490          |       | 3,215,490             |       |
| Current portion of note payable to lender,  net of discount                                                                                                                                                                             |       | 1,177,651          |       | 1,147,634             |       |
| Other current liabilities                                                                                                                                                                                                               |       | 331,139            |       | 321,963               |       |
| Total current liabilities                                                                                                                                                                                                               |       | 11,103,649         |       | 12,585,841            |       |
|                                                                                                                                                                                                                                    |       |               |       |                  |       |
| Notes payable to lender, less current  portion, net of discount                                                                                                                                                                         |       | —             |       | 1,149,833             |       |
| Long-term bonus payable                                                                                                                                                                                                                 |       | 825,730            |       | 801,084               |       |
| Other long-term liabilities                                                                                                                                                                                                             |       | 7,032              |       | 7,032                 |       |
| Total liabilities                                                                                                                                                                                                                       |       | 11,936,411         |       | 14,543,790            |       |
|                                                                                                                                                                                                                                    |       |               |       |                  |       |
| Commitments and contingencies                                                                                                                                                                                                           |       |               |       |                  |       |
|                                                                                                                                                                                                                                    |       |               |       |                  |       |
| Convertible preferred stock, 10,000,000  shares authorized:                                                                                                                                                                             |       |               |       |                  |       |
| Series C Convertible Preferred Stock $0.0001  par value, 183,028 shares issued and outstanding at March 31, 2006 and  December 31, 2005 (liquidation preference of $54,908,400 at March 31, 2006  and December 31, 2005)                |       | 10,020,048         |       | 10,020,048            |       |
| Series C preferred stock warrants                                                                                                                                                                                                       |       | 839,555            |       | 839,555               |       |
|                                                                                                                                                                                                                                    |       |               |       |                  |       |
| Stockholders’ equity:                                                                                                                                                                                                              |       |               |       |                  |       |
| Common stock, par value $0.0001,  150,000,000 shares authorized at 2005; 3,870,701 shares issued and 3,763,060  shares outstanding at March 31, 2006 and 3,515,766 shares issued and  3,408,125 shares outstanding at December 31, 2005 |       | 387                |       | 352                   |       |
| Additional paid in capital                                                                                                                                                                                                              |       | 113,681,176        |       | 109,802,174           |       |
| Treasury stock, 107,641 shares at cost                                                                                                                                                                                                  |       | —             |       | —                |       |
| Accumulated deficit                                                                                                                                                                                                                     |       | (104,572,046       | )          | (103,213,459          | )          |
| Total stockholders’ equity                                                                                                                                                                                                         |       | 9,109,517          |       | 6,589,067             |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                                         |       | $                  | 31,905,531 |                  | $          | 31,992,460 |   |

 

The accompanying notes are an integral part of these condensedconsolidated financial statements.

 

3

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Crdentia Corp.

Unaudited Condensed Consolidated Statementsof Operations

 
| ** **                                                                   | ** ** | **Three months ended March 31,** | ** ** |
|------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
|                                                                         |       |                                                 |       |   |   |
| Revenue from services                                                        |       | $                                                    | 8,984,823  |   | $ | 5,122,313 |   |
| Direct operating expenses                                                    |       | 7,235,519                                            |       | 4,048,820 |   |
| Gross profit                                                                 |       | 1,749,304                                            |       | 1,073,493 |   |
|                                                                         |       |                                                 |       |   |   |
| Operating expenses:                                                          |       |                                                 |       |   |   |
| Selling, general, and administrative  expenses                               |       | 2,600,785                                            |       | 1,715,880 |   |
| Gain from settlement of acquisition claim                                    |       | (1,064,693                                           | )          | — |   |
| Non-cash stock based compensation                                            |       | 378,260                                              |       | 78,846 |   |
| Total operating expenses                                                     |       | 1,914,352                                            |       | 1,794,726 |   |
|                                                                         |       |                                                 |       |   |   |
| Loss from operations                                                         |       | (165,048                                             | )          | (721,233 | ) |
|                                                                         |       |                                                 |       |   |   |
| Interest expense, net                                                        |       | (1,193,539                                           | )          | (524,034 | ) |
|                                                                         |       |                                                 |       |   |   |
| Loss before income taxes                                                     |       | (1,358,587                                           | )          | (1,245,267 | ) |
|                                                                         |       |                                                 |       |   |   |
| Income tax expense                                                           |       | —                                               |       | — |   |
|                                                                         |       |                                                 |       |   |   |
| Net loss                                                                     |       | (1,358,587                                           | )          | (1,245,267 | ) |
|                                                                         |       |                                                 |       |   |   |
| Non-cash preferred stock dividends                                           |       | —                                               |       | (2,162,187 | ) |
|                                                                         |       |                                                 |       |   |   |
| Net loss attributable to common  stockholders                                |       | $                                                    | (1,358,587 | ) | $ | (3,407,454 | ) |
|                                                                         |       |                                                 |       |   |   |
| Basic and diluted loss per common share attributable  to common stockholders |       | $                                                    | (0.42      | ) | $ | (2.50 | ) |
|                                                                         |       |                                                 |       |   |   |
| Weighted average number of common shares  outstanding                        |       | 3,214,729                                            |       | 1,363,496 |   |

 

The accompanying notes are an integral partof these unaudited condensed consolidated financial statements.

 

4

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Crdentia Corp.

Unaudited Condensed Consolidated Statementsof Cash Flows

 
| ** **                                                                    | ** ** | **Three months ended March 31,** | ** ** |
|-------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                    | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
|                                                                          |       |                                                 |       |   |   |
| Operating activities:                                                         |       |                                                 |       |   |   |
| Net loss                                                                      |       | $                                                    | (1,358,587 | ) | $ | (1,245,267 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities:  |       |                                                 |       |   |   |
| Amortization of long-term bonus payable                                       |       | 24,645                                               |       | 22,309 |   |
| Non-cash interest expense                                                     |       | 831,813                                              |       | 286,510 |   |
| Depreciation and amortization                                                 |       | 219,177                                              |       | 173,218 |   |
| Gain on disposal of fixed assets                                              |       | (500                                                 | )          | — |   |
| Gain on settlement of acquisition claim                                       |       | (1,064,693                                           | )          | — |   |
| Bad debt expense                                                              |       | 6,548                                                |       | — |   |
| Non-cash stock based compensation                                             |       | 378,260                                              |       | 78,846 |   |
| Changes in operating assets and  liabilities, net of effects of acquisitions: |       |                                                 |       |   |   |
| Accounts receivable                                                           |       | 127,778                                              |       | 10,123 |   |
| Unbilled receivables                                                          |       | 11,856                                               |       | (152,932 | ) |
| Other current assets and liabilities                                          |       | (135,952                                             | )          | 380,771 |   |
| Accounts payable and accrued expenses                                         |       | (312,041                                             | )          | (120,204 | ) |
| Accrued employee compensation and benefits                                    |       | 34,674                                               |       | 82,000 |   |
| Net cash used in operating activities                                         |       | (1,237,022                                           | )          | (484,626 | ) |
|                                                                          |       |                                                 |       |   |   |
| Investing activities:                                                         |       |                                                 |       |   |   |
| Purchases of property and equipment                                           |       | (13,952                                              | )          | (3,724 | ) |
| Proceeds from sale of property and  equipment                                 |       | 500                                                  |       | — |   |
| Cash paid for acquisition of subsidiaries,  net of cash received              |       | —                                               |       | (4,753,994 | ) |
| Other                                                                         |       | —                                               |       | (28,473 | ) |
| Net cash used in investing activities                                         |       | (13,452                                              | )          | (4,786,191 | ) |
|                                                                          |       |                                                 |       |   |   |
| Financing activities:                                                         |       |                                                 |       |   |   |
| Exercise of warrants for Series C preferred  stock, net of expenses           |       | —                                               |       | 6,435,687 |   |
| Issuance of common stock for cash                                             |       | 1,150,000                                            |       | — |   |
| Net decrease in revolving lines of credit                                     |       | (823,269                                             | )          | (849,934 | ) |
| Proceeds from notes payable to majority  stockholder                          |       | —                                               |       | 1,050,000 |   |
| Proceeds from debentures and warrants                                         |       | 2,000,000                                            |       | — |   |
| Repayment of notes payable to majority  stockholder                           |       | —                                               |       | (1,450,000 | ) |
| Repayment of subordinated convertible notes                                   |       | (12,500                                              | )          | — |   |
| Repayment of note payable to lender                                           |       | (1,350,000                                           | )          | — |   |
| Repayment of notes payable to sellers                                         |       | —                                               |       | (68,695 | ) |
| Net cash provided by financing activities                                     |       | 964,231                                              |       | 5,117,058 |   |
|                                                                          |       |                                                 |       |   |   |
| Net decrease in cash and cash equivalents                                     |       | (286,243                                             | )          | (153,759 | ) |
| Cash and cash equivalents at beginning of  period                             |       | 434,921                                              |       | 362,472 |   |
| Cash and cash equivalents at end of period                                    |       | $                                                    | 148,678    |   | $ | 208,713 |   |

 

The accompanying notes are an integral partof these unaudited condensed consolidated financial statements.

 

5

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**Crdentia Corp.**

**Notes to Unaudited Condensed ConsolidatedFinancial Statements**

**March 31, 2006**

 

**Note 1    Organization and Summary of SignificantAccounting Policies**

 

Organization

 

CrdentiaCorp (the “Company”), a Delaware corporation, is a provider of healthcarestaffing services in the United States. Such services include travel nursing,per diem staffing, contractual clinical services and private duty home healthcare. The Company considers these services to be one segment. Each of theseservices relate solely to providing healthcare staffing to customers and theCompany utilizes common systems, databases, procedures, processes and similarmethods of identifying and serving these customers.

 

Atthe beginning of 2003, the Company was a development stage company with nocommercial operations. During that year, the Company pursued its operationalplan of acquiring companies in the healthcare staffing field and completed theacquisition of four operating companies. The companies acquired in 2003 wereBaker Anderson Christie, Inc., New Age Nurses, Inc., Nurses Network, Inc., PSRNurse Recruiting, Inc. and PSR Nurses Holdings Corp., which holds the limitedpartner and general partner interests in PSR Nurses, Ltd. During 2004, theCompany completed the acquisitions of Arizona Home Health Care/Private Duty,Inc. and Care Pros Staffing, Inc. During 2005, the Company acquired TravMedUSA, Inc. and Health Industry Professionals, LLC, Prime Staff, LP and MintMedical Staffing Odessa.

 

Theaccompanying financial statements include the results of the wholly-ownedsubsidiaries discussed above from their respective dates of acquisition. Allintercompany transactions have been eliminated in consolidation.

 

OnApril 4, 2006 the Company executed a one-for-ten reverse stock split of theoutstanding shares of common stock. All common share and per share informationincluded in these financial statements have been retroactively adjusted toreflect the reverse stock split.

 

Basisof Presentation

 

Theaccompanying unaudited financial data as of and for the three months endedMarch 31, 2006 and 2005 have been prepared by the Company pursuant to the rulesand regulations of the Securities and Exchange Commission. Certain informationand footnote disclosures normally included in financial statements prepared inaccordance with accounting principles generally accepted in the United Statesof America have been condensed or omitted pursuant to such rules andregulations. These unaudited condensed consolidated financial statements shouldbe read in conjunction with the audited financial statements and the notesthereto included in the Company’s annual report on Form 10-KSB for the yearended December 31, 2005.

 

Inthe opinion of management, all adjustments (which include only normal recurringadjustments) necessary to present fairly the financial position, results ofoperations, and cash flows as of and for the three months ended March 31, 2006 and2005 have been made. The results of operations for the three months ended March31, 2006 are not necessarily indicative of the expected operating results forthe full year.

 

Certainreclassifications have been made to conform prior year data to the current yearpresentation.

 

6

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GoingConcern

 

TheCompany generated a net loss of $1,358,587 attributable to common stockholdersin the first three months of 2006 and used cash in operations of $1,237,022during this period. Additionally, although the Company ended the first quarterof 2006 with a significant working capital deficit of $5,304,939, it was ableto secure additional funding during this period to finance its operations as itcontinued to execute its business plan to acquire and grow companies involvedin healthcare staffing. The Company will need to raise $1,000,000 to $2,000,000during the next twelve months to satisfy debt service requirements and workingcapital needs. There is no assurance that the Company will be able to raise theamount of debt or equity capital required to meet its objectives. The Company’schallenging financial circumstances may make the terms, conditions and cost ofany available capital relatively unfavorable. If additional debt or equitycapital is not readily available, the Company will be forced to scale back itsacquisition activities and its operations. This would result in an overallslowdown of the Company’s development. The Company’s short-term need forcapital may force it to consider and potentially pursue other strategic optionssooner than it might otherwise have desired. These conditions raise substantialdoubt about the Company’s ability to continue as a going concern. The financialstatements do not include any adjustments to reflect the possible futureeffects on the recoverability and classification of assets, or the amounts andclassification of liabilities that may result from the outcome of thisuncertainty.

 

Managementhas taken a number of steps to address the financial performance of the Companyand to achieve positive cash flow during 2006. The Company replaced a portionof its debt with new debt that has a lower interest rate, restructured theoperating management team, and implemented programs to obtain expense savings. However,there can be no assurances that these programs will be successful.

 

Stock-BasedCompensation

 

OnJanuary 1, 2006 the Company adopted the Financial Accounting Standards BoardStatement of Financial Accounting Standards No. 123 (revised 2004), *Share-Based Payment*, (“SFAS 123R”), that addresses theaccounting for share-based payment transactions in which an enterprise receivesemployee services in exchange for either equity instruments of the enterpriseof liabilities that are based on the fair value of the enterprise’s equityinstruments or that may be settled by issuance of such equity instruments. Thestatement eliminates the ability to account for share-based compensationtransactions using the intrinsic value method as prescribed by AccountingPrinciples Board Opinion No. 25, “Accounting for Stock Issued to Employees,”and generally requires that such transactions be accounted for using afair-value-based method and recognized as expense in the Company’s condensedconsolidated statements of operations.

 

TheCompany adopted SFAS 123R using the modified prospective method which requiresthe application of the accounting standard as of January 1, 2006. The Company’sconsolidated interim financial statements for the three months ended March 31,2006 reflect the impact of adopting SFAS 123R. In accordance with the modifiedprospective method, the consolidated interim financial statements for priorperiods have not been restated to reflect, and do not include, the impact ofFAS 123R. See pro forma information below.

 

Stock-basedcompensation expense recognized during the period is based on the value of theportion of stock-based payment awards that is ultimately expected to vest. Stock-basedcompensation expense recognized in the condensed consolidated statement ofoperations for the three months ended March 31, 2006 included compensationexpense for stock-based payment awards granted prior to, but not yet vested, asof December 31, 2005 based on the grant date fair value estimated in accordancewith the pro forma provision of SFAS 148 and compensation expense for thestock-based payment awards granted subsequent to December 31, 2005, based onthe grant date fair value estimated in accordance with SFAS 123R. Asstock-based compensation expense recognized in the condensed consolidatedstatement of operations for the three months ended March 31, 2006 is based onawards ultimately expected to vest, it has been reduced for estimatedforfeitures. SFAS 123R requires forfeitures to be estimated at the time ofgrant and revised, if necessary, in subsequent periods if actual forfeituresdiffer form those estimates. In the pro forma

 

7

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informationrequired under SFAS 148 for the periods prior to January 1, 2006, forfeitureswere accounted for as they occurred.

 

Thetable below shows net loss per share attributable to common stockholders forthe three months ended March 31, 2005 as if the Company had elected the fairvalue method of accounting for stock options effective January 1, 2005.

 
| ** **                                                          | ** **                                                                                                        | **Three months ended** | ** ** |
|---------------------------------------------------------------------|-------------------------------------------------------------------------------------------------------------------|----------------------------------|------------|
| ** **                                                          | ** **                                                                                                        | **March 31, 2005**     | ** ** |
|                                                                |                                                                                                              |                             |       |
| Net loss attributable to common  stockholders as reported           |                                                                                                              | $                                | (3,407,454 | ) |
| Add:                                                                | stock-based  employee compensation in reported net loss, net of related tax effects                               |                             |       |   |
|                                                                |                                                                                                              | 78,846                           |       |
| Deduct:                                                             | stock-based  employee compensation determined under fair value method for all awards, net  of related tax effects |                             | (92,234    | ) |
|                                                                |                                                                                                              |                             |       |
| Proforma net loss attributable to common  stockholders, as adjusted |                                                                                                              | $                                | (3,420,842 | ) |
|                                                                |                                                                                                              |                             |       |
| Loss per share attributable to common  stockholders:                |                                                                                                              |                             |       |
| Basic and diluted, as reported                                      |                                                                                                              | $                                | (2.50      | ) |
| Basic and diluted, as adjusted                                      |                                                                                                              | $                                | (2.50      | ) |

 

EarningsPer Share

 

Basicper share data has been computed on the loss attributable to commonstockholders for each period divided by the weighted average number of sharesof common stock outstanding for each period (excluding restricted common stockissued to certain officers of the Company). Diluted earnings per common shareinclude both the weighted average number of common shares and any common shareequivalents such as convertible securities, options or warrants in thecalculation. As the Company recorded net losses for the three months endedMarch 31, 2006 and 2005, common share equivalents outstanding would beanti-dilutive, and as such, have not been included in diluted weighted averageshares outstanding. Common share equivalents that were excluded in the 2006calculations totaled 5,332,563 (3,652,230 in 2005).

 

**Note 2    Acquisitions**

 

TheCompany acquired TravMed USA, Inc. and Health Industry Professionals, LLC onMarch 29, 2005, and Prime Staff, LP and Mint Medical Staffing Odessa on May 4,2005.

 

UnauditedPro Forma Summary Information

 

The following unaudited pro forma summary approximatesthe consolidated results of operations as if all acquisitions had occurred asof January 1, 2005, after giving effect to certain adjustments, includingamortization of specifically identifiable intangibles and interest expense. Thepro forma financial information does not purport to be indicative of theresults of operations that would have occurred had the transactions taken placeat the beginning of the period presented or of future results of operations.

 

8

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| ** **                                                                   | ** ** | **March 31,** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------|------------|
| ** **                                                                   | ** ** | **2005**           | ** ** |
|                                                                         |       |               |       |
| Revenue from services                                                        |       | $                  | 11,239,000 |   |
|                                                                         |       |               |       |
| Loss from operations                                                         |       | (822,148           | )          |
|                                                                         |       |               |       |
| Net loss attributable to common  stockholders                                |       | (2,984,335         | )          |
|                                                                         |       |               |       |
| Basic and diluted loss per common share attributable  to common stockholders |       | (1.95              | )          |
|                                                                         |       |               |       |
| Weighted-average shares of common stock outstanding                          |       | 1,528,369          |       |
|                                                                              |            |                    |            |  |

 

**Note 3    Settlement of Acquisition Claim**

 

In2005, the Company asserted a claim against a seller of one of the Company’s2003 acquisitions. In January 2006, the Company and the seller settled with theseller returning 59,150 shares of the Company’s common stock that had beenissued in connection with the acquisition. The Company reported a gain onsettlement of acquisition claim of $1,064,693 representing the fair value ofthe stock returned on the date of the settlement. The offset to the gainrecorded was a reduction in common stock and additional paid-in capital. The returnedshares were immediately retired.

 

**Note 4    Accounts Payable and Accrued Expenses**

 

Accountspayable and accrued expenses consist of the following:

 
| ** **       | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|------------------|------------|--------------------|------------|-----------------------|------------|
| ** **       | ** ** | **2006**           | ** ** | **2005**              | ** ** |
|             |       |               |       |                  |       |
| Accounts payable |       | $                  | 701,684    |                  | $          | 825,986 |   |
| Accrued expenses |       | 669,180            |       | 621,919               |       |
|             |       | $                  | 1,370,864  |                  | $          | 1,447,905 |   |

 

**Note 5    Revolving Line of Credit**

 

OnJune 16, 2004, the Company entered into a Loan and Security Agreement withBridge Healthcare Finance, LLC (“Bridge Healthcare”), pursuant to which theCompany obtained a revolving credit facility that allowed for maximumborrowings of up to $15,000,000 (the “Loan”). During the first quarter of 2005,the maximum borrowings under the Loan was reduced to $10,000,000 permitting theCompany to lower its effective interest rate through lower unused line fees. TheLoan had an original term of three years and bears interest at a rate equal tothe greater of three percent (3.0%) per annum over the prime rate or nine andone-half percent (9.5%) per annum (10.75% at March 31, 2006) with interestpayable monthly. Accounts receivable serves as security for the Loan and theLoan is subject to certain financial and reporting covenants. Customer paymentsare used to repay the advances on the Loan after deducting charges for interestexpense, unused line and account management fees. Except in certain limitedcircumstances, the Loan cannot be prepaid in full without the Company incurringa significant prepayment penalty. The financial covenants are for themaintenance of minimum tangible net worth, minimum debt service coverageratios, minimum EBITDA, maximum capital expenditure limits and maximumoperating lease obligations. In May 2005 the Company renegotiated covenantsrelated to the Loan; however, at December 31, 2005 and March 31, 2006, theCompany was not in compliance with the revised covenants. Bridge Healthcarewaived compliance with the covenants for 2005. However, at March 31, 2006, theCompany had not obtained a waiver for non-compliance. Management is currentlyconsidering various alternatives to rectify covenant non-compliance, includingrenegotiating the covenants with Bridge

 

9

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Healthcareor negotiating a new facility with a new lender. The Company was charged feesby Bridge Healthcare for various compliance violations and related waiversgranted during 2005. During the third quarter of 2005, Bridge Healthcare made a$600,000 credit line available to the Company in the form of an over-advance onthe Company’s Loan. The line of credit was used as necessary to pay certainremaining amounts due on acquisitions completed in March 2005 and for workingcapital purposes. During the first quarter of 2006, the Company used proceedsfrom a private offering (as discussed in Notes 8 and 10) to repay the $600,000over-advance. The Loan includes events of default (with grace periods asapplicable) and provides that, upon the occurrence of certain events ofdefault, payment of all amounts payable under the Loan, including the principalamount of, and accrued interest on, the Loan may be accelerated. There are alsocross default provisions between the Loan and the Term Loan discussed in Note 6.The outstanding balance on the Loan is $3,848,827 at March 31, 2006, whichrepresents the total availability under the line relative to the amount ofreceivables outstanding at that date. The maturity date of the Loan wasextended for an additional year through June 2008. The prepayment penaltydiscussed above is applicable for the one-year extension period except theamount is reduced in the event of a change in control of the Company.

 

**Note 6    Notes Payable to Lender**

 

Pursuantto a loan agreement dated August 31, 2004, the Company obtained a term loancredit facility (“Term Loan”) in the amount up to $10,000,000 from BridgeOpportunity Finance, LLC, an affiliate of Bridge Healthcare. The Company mayobtain loans under the agreement to fund permitted acquisitions. Any loansobtained under the Term Loan are due and payable in full on August 31, 2007 andbear interest at the rate of fifteen and one-quarter percent (15.25%) per annumwith interest payable monthly. The Term Loan is secured by all assets of theCompany. On August 31, 2004, the Company received proceeds from the Term Loanof $2,697,802 for the acquisitions of Arizona Home Health Care/Private Duty,Inc. and Care Pros Staffing, Inc.

 

TheTerm Loan provides that the Company shall issue warrants to purchase shares of commonstock to the lender up to 12% of the Company’s overall capitalization on thedate of borrowing. On August 31, 2004, the Company issued warrants to purchase 90,578shares of common stock at a price of $31.50 per share in connection with thefirst borrowing under the credit facility. As a result, the Term Loan has beenrecorded net of a discount of $810,000 which represents the estimated fairmarket value related to the warrants at the date of issuance. The discount isbeing amortized to interest expense over the life of the Term Loan. During thefirst quarter of 2006, the Company used proceeds from a private offering (asdiscussed in Notes 8 and 10) to repay $1,350,000 of the Term Loan. As a resultof this repayment, the Company recorded $200,168 of additional interest relatingto the proportionate amount of unamortized discount associated with therepayment. Amortization of the remaining discount totaled $30,017 during thefirst quarter of 2006. The outstanding balance of the Term Loan is $1,347,802at March 31, 2006, which is before an unamortized discount of $170,151.

 

Exceptin certain limited circumstances, the Term Loan cannot be prepaid in fullwithout the Company incurring a significant prepayment penalty. The Term Loanalso contains certain financial covenants, including the maintenance of minimumtangible net worth, minimum debt service coverage ratios, minimum EBITDA,maximum capital expenditure limits and maximum operating lease obligations. AtMarch 31, 2005, the Company was out of compliance with certain financialcovenants of the Term Loan, for which a waiver was received from the lender. InMay 2005 the Company renegotiated covenants related to the term loan; however,at December 31, 2005 and March 31, 2006, the Company was not in compliance withthe revised covenants. Bridge Healthcare waived compliance with the covenantsfor 2005. However, at March 31, 2006, the Company had not obtained a waiver fornon-compliance. Management is currently considering various alternatives torectify this covenant non-compliance, including renegotiating the covenantswith Bridge Healthcare or negotiating a new facility with a new lender. Accordingly,the Term Loan has been classified as a current liability on the accompanyingbalance sheet as of March 31, 2006. The Company was charged fees by Bridge forvarious compliance violations and related waivers granted during 2005. The TermLoan includes events of default (with grace periods as applicable) and providesthat, upon the occurrence of certain events of default, payment of all amounts

 

10

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payableunder the Term Loan, including the principal amount of, and accrued intereston, the Term Loan may be accelerated. There are also cross default provisionsbetween the Term Loan and the Loan.

 

**Note 7    Notes Payable to Sellers**

 

Aspartial consideration for the acquisition of TravMed USA, Inc. (“TravMed”) onMarch 29, 2005, the Company issued unsecured subordinated notes to the formerTravMed stockholders in the total amount of $3,215,490. The notes werethree-year convertible notes bearing interest at 7.75%. Monthly interestpayments were required for the first six months followed by principal andinterest payments the next thirty months to fully repay the debt. Since October31, 2005, the Company had not made debt service payments required by terms ofthese notes payable to sellers as claims were asserted in State District Courtin Dallas, Texas against the sellers of TravMed for breach of non-competition/solicitationagreements, breach of fiduciary duty, tortious interference with existing andprospective contracts and business relations, and declaratory relief. TheCompany received a notice of default in early November 2005 and the due date ofthe notes was accelerated such that the entire balance of the notes payable tosellers was due. The default under the notes payable to sellers triggereddefaults under the Loan and Term Loan discussed in Notes 5 and 6, as well asthe Debentures discussed in Note 8. Also, as a result of this default, BridgeHealthcare had an option to discontinue making revolving credit loans to theCompany on receivables of TravMed. Because of the uncertainty surroundingrepayment of these notes, the Company classified all of the balance as acurrent liability on the accompanying balance sheets.

 

OnMay 9, 2006, under terms of agreements to acquire TravMed, the Company returnedto the sellers the shares in TravMed that it had acquired on March 29, 2005. Uponreturn of the shares to the sellers, the Company was permitted to retainTravMed receivables existing on May 9, 2006, and the $3,215,490 of seller notespayable are extinguished. Following the return of the shares, the sellers arereleased from covenants not to compete, and the Company and the sellers arefree to compete for the customer contracts existing on May 9, 2006. Managementbelieves that substantially all customers will elect to contract directly withthe Company. In addition, the Company expects to report a gain on extinguishmentof seller debt of $3,215,490. To the extent of any loss of customers, there maybe an offset to the foregoing gain due to the write-off of intangibles relatedto customer contracts recorded at the time of acquiring TravMed and for thevalue of any furniture and equipment returned to the sellers.

 

**Note 8    Debentures**

 

InJanuary 2006, the Company completed a private placement totaling $4 million. Thefirst phase was completed on December 30, 2005 and consisted of $2 million, or333,333 shares of common stock and the second phase consisted of $2 million of8% convertible debentures. The convertible debentures have a term of threeyears and bear interest at a rate of 8% per year, payable semi-annually in cashor registered stock at the Company’s option. The debentures are convertibleinto common stock at a price of $6.00 per share. The sale of convertibledebentures included common stock warrant coverage allowing debenture holders toexercise warrants to purchase 500,000 common shares. Warrants to purchase166,667 common shares have a five year term and an exercise price of $7.50 pershare. Warrants to purchase 333,333 common shares expire on June 14, 2006 andhave an exercise price of $6.00 per share. The Company computed the relativefair value of the warrants at $1,443,265 and the beneficial conversion feature relatedto the debentures at $556,735, and recorded these amounts as a discount to thedebentures which will be amortized over the term of the debentures.

 

Termsof an agreement with the placement agent representing the Company required placementfees upon a private placement of at least $5 million. Although the minimum wasnot achieved, fees have been accrued and warrants recorded based on the loweramount of funding. Per the terms of the agreement, $589,722 was recorded asdeferred financing costs associated with the debentures and $294,867 wasrecorded as an offset to proceeds from the equity portion of the funding. The$589,722 will be amortized over the three year term of the debentures. A portionof the placement fees were warrants to purchase 50,000 shares of common stockat $6.00 per share. The warrants have a five year life and were valued at $629,589($419,722 recorded as deferred financing costs and $209,867 recorded as anoffset to proceeds from the equity offering). The remaining portion of the feetotaling $255,000 is to be paid in cash.

 

11

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OnFebruary 16, 2006, a holder of the debentures converted $260,000 of thedebentures into 43,333 shares of the Company’s common stock. The Companyrecognized expense in the amount of $72,117 relating to the deferred financingfees associated with the converted debentures and expense in the amount of$238,333 related to the proportionate share of the unamortized discount on theconverted debentures.

 

Thedebentures have cross-default provisions with the Company’s revolving line ofcredit and notes payable to lender. Since the Company is in default on itsrevolving line of credit and notes payable to lender, it is also in default onthe debentures. Accordingly, the amount of the debentures ($1,740,000 facevalue outstanding and $144,998 after a discount of $1,595,002) has beenclassified as a current obligation on the accompanying balance sheet as of March31, 2006.

 

TheCompany was obligated to register the shares (including the shares issuableupon conversion of the debentures and exercise of the warrants) for resale on aregistration statement. The Company has used the proceeds from the privateplacement for working capital and the retirement of 50% of its outstanding $2.7million Term Loan (discussed in Note 6) as well as retirement of the $600,000over-advance facility (discussed in Note 5).

 

**Note 9    Convertible Preferred Stock**

 

ConvertiblePreferred Stock Issued and Outstanding

 

The Company is authorized to issue 10,000,000 shares of preferred stockat a par value of $0.0001. The holders of the convertible preferred stock havethe right to require the Company to redeem any or all of its outstanding preferredshares upon a change of control or certain other contingent events that couldbe outside the control of the Company. Thus, convertible preferred stock iscarried outside of permanent equity in the mezzanine section of the Company’sbalance sheet. At March 31, 2006 there are shares issued and outstandingconsisting of the following:

 
| ** **                           | ** ** | **March 31, 2006** | ** ** |
|--------------------------------------|------------|------------------------------|------------|
| ** **                           | ** ** | **Shares**                   | ** ** | **Shares** | ** ** |
| ** **                           | ** ** | **Issued**                   | ** ** | **Outstanding** | ** ** |
|                                 |       |                         |       |   |   |
| Series C Convertible Preferred Stock |       | 183,028                      |       | 183,028 |   |

 

Theconversion price of all convertible preferred stock is subject to appropriateadjustment in the event of stock splits, stock dividends, reverse stock splits,capital reorganizations, recapitalizations, reclassifications, and similaroccurrences as well as the issuance of common stock in consideration of anamount less than the then–effective conversion price.

 

Allconvertible preferred shares issued and outstanding are convertible currentlyat the option of the holder. The Company has evaluated the potential effect ofany beneficial conversion terms related to convertible instruments. As aresult, the convertible instruments may have a carrying amount that differssignificantly from its redemption amount. In such cases, the difference betweenthe carrying amount and the redemption amount (limited to the actual proceedsreceived) is recorded as a beneficial conversion feature and deducted as adeemed dividend in determining net loss attributable to common stockholders. Thetable below summarizes the redemption requirements and beneficial conversion ofthe convertible preferred shares outstanding at March 31, 2006:

 
| ** **               | ** ** | ** **      | ** ** | ** **   | ** ** | **Common Shares** | ** ** | **Beneficial**       | ** ** |
|--------------------------|------------|-----------------|------------|--------------|------------|------------------------|------------|----------------------|------------|
| **Shares of**       | ** ** | ** **      | ** ** | ** **   | ** ** | **Issuable**           | ** ** | **Conversion**       | ** ** |
| **Convertible**          | ** ** | **Shares**      | ** ** | **Carrying** | ** ** | **Upon**               | ** ** | **Recorded at** | ** ** |
| **Preferred Stock** | ** ** | **Outstanding** | ** ** | **Amount**   | ** ** | **Conversion**         | ** ** | **Issuance**         | ** ** |
|                     |       |            |       |         |       |                   |       |                 |       |
| C                        |       | 183,028         |       | $            | 10,020,048 |                   | 1,830,280  |                 | $          | 1,070,510 |   |
|                          |            |                 |            |              |            |                        |            |                      |            |  |  |

 

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SeriesC Convertible Preferred Stock (“Series C”)

 

Theholders of Series C are entitled to receive, when declared by the Board of Directors,a dividend on each quarter end beginning September 30, 2004 and ending December31, 2005 in an amount equal to 2.5 shares of common stock (.25 shares of commonstock post-split) for each share of outstanding Series C held by them. In theevent of any liquidation or winding up of the Company, the holders of theSeries C will be entitled to receive in preference to the holders of common stockan amount equal to five times their initial purchase price plus any declaredbut unpaid dividends and any remaining liquidation proceeds will thereafter bedistributed on a pro rata basis to the holders of the Company’s common stockand any other series of preferred stock expressly entitled to participate insuch distribution. The Series C is convertible at the option of the holder intocommon shares at an initial conversion ratio of 100 shares of common stock (10share of common stock post-split) for each share of Series C. The conversionratio upon voluntary conversion is subject to adjustment under certain circumstances.Unless previously voluntarily converted prior to such time, the Series C willbe automatically converted into common stock at an initial conversion ratio of 100shares of common stock (10 shares of common stock post-split) for each share ofSeries C upon the earlier of (i) the closing of an underwritten public offeringof our common stock pursuant to a registration statement under the SecuritiesAct of 1933, as amended, with aggregate net proceeds of at least $25 million,or (ii) the date specified by written consent or agreement of the holders of amajority of the then outstanding shares of Series C. The description of theforegoing rights, preferences and privileges of the Series C is qualified inits entirety by the Certificate of Designations, Preferences and Rights ofSeries C filed with the Secretary of State of the State of Delaware on August31, 2004.

 

OnMarch 1, 2006, the Board of Directors declared a dividend to the Series Cholders payable on December 31, 2005 which had an estimated fair value of$800,748 and was paid through the issuance of 45,757 shares of common stockduring March 2006.

 

Asof March 31, 2006, warrants to purchase Convertible Preferred Stock areoutstanding as follows:

 
| **Series of Convertible** | ** ** | ** **   | ** ** | **Exercise Price** | ** ** |
|-------------------------------------|------------|--------------|------------|-------------------------|------------|
| **Preferred Stock**            | ** ** | **Warrants** | ** ** | **Per share**      | ** ** |
|                                |       |         |       |                    |       |
| B-1                                 |       |         | 6,000      |                    | $          | 60 |   |
| C                                   |       |         | 124,086    |                    | $          | 60 |   |

 

**Note 10  Common Stock and Stock Options**

 

Inthe first quarter of 2006 the Company completed further equity financings withMedCap Partners L.P., the majority stockholder, for $1,150,000 at per shareprices ranging from $6.00 to $8.00. The proceeds were used for working capitalpurposes.

 

EmployeeStock Options and Restricted Stock Grants

 

TheCompany entered into a Restricted Stock Bonus Agreement with James D. Durham,its Chief Executive Officer dated effective March 24, 2006. Pursuant to theagreement, the Company issued Mr. Durham 150,000 shares of its common stockwith an aggregate fair market value of $675,000. The shares of restricted stockvest in accordance with the following schedule: 1/4 of the total shares vest onMarch 24, 2007 and 1/48 of the total shares vest monthly thereafter. In theevent of a “Corporate Transaction” (as defined in the agreement), the sharesshall immediately become fully vested if, within five years after the CorporateTransaction, Mr. Durham’s service is terminated by the successor company, theCompany or a related entity without “Cause” or voluntarily by Mr. Durham with “GoodReason.”

 

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OnMarch 24, 2006 the Company granted James J. TerBeest, its Chief FinancialOfficer an option to purchase 150,000 shares of common stock at a per shareexercise price of $4.50. The shares of common stock subject to the option vestin accordance with the following schedule: 1/4 of the total shares vest onMarch 24, 2007 and 1/48 of the total shares vest monthly thereafter.

 

Impactof the Adoption of SFAS 123R

 

TheCompany adopted SFAS 123R using the modified prospective transition methodbeginning January 1, 2006. The Company’s consolidated interim financialstatements for the three months ended March 31, 2006 reflect the impact ofadopting SFAS 123R. In accordance with the modified prospective method, theconsolidated interim financial statements for prior periods have not beenrestated to reflect, and do not include, the impact of FAS 123R.

 

Stock-basedcompensation expense recognized during the period is based on the value of theportion of stock-based payment awards that is ultimately expected to vest. Stock-basedcompensation expense recognized in the condensed consolidated statement ofoperations during the three months ended March 31, 2006 included compensationexpense for stock-based payment awards granted prior to, but not yet vested, asof December 31, 2005 based on the grant date fair value estimated in accordancewith the pro forma provision of SFAS 148 and compensation expense for thestock-based payment awards granted subsequent to December 31, 2005, based onthe grant date fair value estimated in accordance with SFAS 123R. Asstock-based compensation expense recognized in the condensed consolidatedstatement of operations for the three months ended March 31, 2006 is based onawards ultimately expected to vest, it has been reduced for estimated forfeitures.SFAS 123R requires forfeitures to be estimated at the time of grant andrevised, if necessary, in subsequent periods if actual forfeitures differ formthose estimates. In the pro forma information required under SFAS 148 for theperiods prior to January 1, 2006, forfeitures were accounted for as theyoccurred. The impact on the Company’s results of operations of recordingstock-based compensation for the three month period ended March 31, 2006 wasapproximately $52,000 and was recorded in selling, general, and administrativeexpenses.

 

SFAS123R requires cash flows resulting from excess tax benefits to be classified asa part of cash flows from financing activities. Excess tax benefits arerealized tax benefits from tax deductions for exercised options in excess ofthe deferred tax asset attributable to stock compensation costs for suchoptions. There were no stock options exercised in the three months ended March31, 2006 and 2005.

 

ValuationAssumptions

 

TheCompany calculated the fair value of each option award on the date of grantusing the Black-Scholes option pricing model. The following assumptions wereused for the three months ended March 31, 2006. There were no options grantedduring the three months ended March 31, 2005.

 
| ** **                | ** ** | **Three Months Ended** | ** ** |
|---------------------------|------------|----------------------------------|------------|
| ** **                | ** ** | **March 31, 2006**     | ** ** |
|                      |       |                             |       |
| Risk-free interest rate   |       | 4.66                             | %          |
| Expected lives (in years) |       | 4                                |       |
| Dividend yield            |       | 0.00                             | %          |
| Expected volatility       |       | 103.36                           | %          |

 

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Stockoption activity is summarized as follows:

 
| ** **                                              | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                              | ** ** | **March 31, 2006**     | ** ** |
|                                                    |       |                             |       |
| Outstanding, January 1                                  |       | 500,666                          |       |
| Granted                                                 |       | 150,000                          |       |
| Exercised                                               |       | —                           |       |
| Forfeited                                               |       | (13,875                          | )          |
| Outstanding, March 31                                   |       | 636,791                          |       |
|                                                    |       |                             |       |
| Exercisable                                             |       | 328,587                          |       |
| Non-vested, January 1                                   |       | 349,517                          |       |
| Non-vested, March 31                                    |       | 308,204                          |       |
| Vested, Net of forfeitures                              |       | 41,313                           |       |
|                                                    |       |                             |       |
| Average exercise price per share:                       |       |                             |       |
|                                                    |       |                             |       |
| Outstanding, January 1                                  |       | $                                | 10.21      |   |
| Granted                                                 |       | 4.50                             |       |
| Exercised                                               |       | —                           |       |
| Forfeited                                               |       | 2.37                             |       |
| Outstanding, March 31                                   |       | 8.60                             |       |
| Exercisable                                             |       | 7.10                             |       |
| Non-vested, January 1                                   |       | 9.50                             |       |
| Non-vested, March 31                                    |       | 9.78                             |       |
|                                                    |       |                             |       |
| Weighted-average remaining term of  outstanding options |       | 8.49 years                       |       |
| Weighted-average remaining term of  exercisable options |       | 7.89 years                       |       |
|                                                         |            |                                  |            |  |

 

**Note 11  Supplemental Disclosure to the Statements ofCash Flows**

 
| ** **                                                                                          | ** ** | **Three months ended March 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                          | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
|                                                                                                |       |                                                 |       |   |   |
| Supplemental cash flow disclosures:                                                                 |       |                                                 |       |   |   |
| Cash paid for interest                                                                              |       | $                                                    | 171,233    |   | $ | 157,913 |   |
| Cash paid for income taxes                                                                          |       | —                                               |       | — |   |
| Non-cash investing and financing  activities:                                                       |       |                                                 |       |   |   |
| Conversion of preferred stock into common  stock                                                    |       | —                                               |       | 30,873,400 |   |
| Conversion of debentures into common stock                                                          |       | 260,000                                              |       | — |   |
| Issuance of the following in connection  with a merger                                              |       |                                                 |       |   |   |
| Common stock issued                                                                                 |       | —                                               |       | 2,601,600 |   |
| Revolving credit line assumed                                                                       |       | —                                               |       | 941,390 |   |
| Notes payable issued                                                                                |       | —                                               |       | 3,215,490 |   |
| Common stock issued as payment of preferred  stock dividends                                        |       | 800,748                                              |       | 3,189,441 |   |
| Common stock issued associated with working  capital loans from majority stockholder                |       | —                                               |       | 162,500 |   |
| Placement fees payable related to sale of common  stock                                             |       | 65,000                                               |       | — |   |
| Value of debentures allocated to attached  common stock warrants and beneficial conversion features |       | 2,000,000                                            |       | — |   |
| Fair value of warrants issued as placement  fee related to debentures                               |       | 419,722                                              |       | — |   |
|                                                                                                     |            |                                                      |            |  |  |  |  |

 

**Note 12  Legal Proceedings**

 

OnJanuary 27, 2006, the Company filed suit against the sellers of TravMed USA,Inc. asserting claims for breach of non-competition/solicitation agreements,breach of fiduciary duty, tortious interference with existing and prospectivecontracts and business relations, and declaratory relief arising out of the

 

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acquisitionagreement. The Company will be seeking damages related to the above claims.

 

OnJanuary 31, 2006, the Company filed suit against the sellers of Arizona HomeHealth/Private Duty, Inc. asserting claims for fraud, indemnity, anddeclaratory relief arising out of the acquisition agreement. On February 23,2006, the sellers filed a counter suit.

 

Fromtime to time, the Company may become involved in various lawsuits and legalproceedings which arise in the ordinary course of business. However, litigationis subject to inherent uncertainties, and an adverse result in these or othermatters may arise from time to time that may harm the Company’s business. TheCompany is not currently aware of any such legal proceedings or claims that areexpected to have, individually or in the aggregate, a material adverse affecton the Company’s business, financial condition or operating results.

 

**Note 13  Subsequent Events**

 

OnApril 18, 2006 the Company acquired the assets of Staff Search Ltd. for $2,476,208,including preliminary acquisition costs. The Company issued a promissory notein the principal amount of $1,410,000 and issued 229,128 shares of its commonstock valued at $1,066,208 (determined by the average of $4.65 per share whichapproximates the average trading value as quoted on the OTC Bulletin Board forthe three days before and three days after the acquisition date). Thepromissory note accrues interest at a rate equal to 8.00% per annum. Theprincipal amount of the note, plus all accrued interest, is payable upon demandof the holder. The note includes events of default (with grace periods, asapplicable) and provides that, upon the occurrence of certain events ofdefault, payment of all amounts due under the note shall become immediatelypayable.

 

OnApril 4, 2006, the Company implemented a one-for-ten reverse split of itsoutstanding shares of common stock. At the Company’s Annual Meeting of Stockholdersheld on November 8, 2005, its stockholders approved a proposal to amend itsAmended and Restated Certificate of Incorporation to effect a reverse stocksplit of all of its outstanding shares of common stock at an exchange ratioranging from one-to-two to one-to-ten, with the final ratio to be determined bythe Board of Directors following stockholder approval. Pursuant to a resolutionof the Board of Directors effective March 1, 2006, the directors approved areverse stock split at an exchange ratio of one-to-ten. No fractional shareswill be issued in connection with the reverse stock split. In lieu offractional shares, stockholders will receive a cash payment based on the marketprice, after adjustment for the effect of the stock split, of the Company’scommon stock on the effective date of the stock split. The cash payment forfractional shares was nominal. The reverse stock split also affects options,warrants and other securities convertible into or exchangeable for shares ofthe Company’s common stock that were issued and outstanding immediately priorto the effective time of the stock split. All common and per share informationincluded in these financial statements have been retroactively adjusted toreflect the reverse stock split.

 

OnApril 3, 2006 a special committee of the Board of Directors recommended, theBoard of Directors approved and holders of the Preferred Stock and Warrantsagreed to the exchange of all outstanding Series C Convertible Preferred Stock,Series C warrants and Series B-1 warrants into common stock as follows:

 
| ** **                            | ** ** | **Shares**    | ** ** | **Common stock** | ** ** |
|---------------------------------------|------------|---------------|------------|-----------------------|------------|
| **Description of security** | ** ** | **exchanged** | ** ** | **issued**            | ** ** |
| Series C Convertible Preferred Stock  |       | 183,028       |       | 9,151,400             |       |
| Series C Warrants                     |       | 124,086       |       | 1,054,731             |       |
| Series B-1 Warrants                   |       | 6,000         |       | 51,000                |       |

 

Theexchange as approved by the Board of Directors varied from existing PreferredStock conversion ratios and was based on recommendations from the specialcommittee of the Board of Directors after they sought

 

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valuationguidance from an outside firm. The effect of this exchange will transfer thecarrying value of the Convertible Preferred Stock and the Series C preferredstock warrants on the Company’s balance sheet to stockholders’ equity resultingin an increase in stockholders’ equity of $10,859,603.

 

OnApril 3, 2006 MedCap Partners L.P. purchased 58,333 shares of common stock at aprice per share of $6.00. Proceeds of $350,000 were used for working capitalpurposes.

 

OnMay 2, 2006, the Board of Directors granted 177,318 options to purchase theCompany’s common stock to employees of the Company.

 

17

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**Item 2.    Management’s Discussion and Analysis or Planof Operation**

 

**OVERVIEW**

 

Weare a provider of healthcare staffing services, focusing on the areas of travelnursing, per diem staffing, contractual clinical services, and private dutyhome care. Our travel nurses are recruited domestically as well asinternationally, and placed on temporary assignments at healthcare facilitiesacross the United States. Our per diem nurses are local nurses placed athealthcare facilities on short-term assignments. Our contractual clinicalservices group provides complete clinical management and staffing forhealthcare facilities and our private duty home care group provides nursingcase management and staffing for skilled and non-skilled care in the home. Weconsider the different services described above to be one segment as each ofthese services relate solely to providing healthcare staffing to customers thatare healthcare providers and utilize similar distribution methods, commonsystems, databases, procedures, processes and similar methods of identifyingand serving these customers.

 

Wedid not have any revenue in 2003 until we completed our first acquisition inAugust 2003. During 2003, we pursued our operational plan of acquiringcompanies in the healthcare staffing field and completed acquisitions of fourcompanies. In 2004, we purchased two companies, in 2005 purchased three morecompanies and on April 18, 2006 we purchased one company. We have contractedwith more than 1,500 healthcare facilities across 49 U.S. states and theDistrict of Columbia. We anticipate continuing our plan to acquire specializedcompanies in the healthcare staffing field for the foreseeable future.

 

Thecompanies we acquired in 2003 — Baker Anderson Christie, Inc., New Age Nurses,Inc., Nurses Network, Inc., and PSR Nurse Recruiting, Inc. and PSR NursesHoldings Corp., which hold the limited partner and general partner interests inPSR Nurses, Ltd. — provide the foundation for our continued growth. During 2003we began operating the acquired companies, combining the various back officesand support staff into a central location and began streamlining the operations.We continued our acquisition program in 2004 and acquired Care Pros Staffing,Inc. and Arizona Home Health Care/Private Duty, Inc. On March 28, 2005, weacquired TravMed USA, Inc. and Health Industry Professionals, LLC. On May 4,2005, we acquired PrimeStaff, LP and Mint Medical Staffing Odessa. On April 18,2006, we acquired Staff Search Ltd.

 

Somekey factors we are focusing on to improve performance are as follows:

 

•                  We are identifying innovative ways to attractand retain nurses.

 

•                  We are vigorously managing professionalliability insurance costs, workers compensation insurance costs, and healthcare costs to enhance gross margins.

 

•                  We are expanding our home health business inan effort to improve gross margins through a better mix of the servicesprovided.

 

•                  We are devoting constant attention towardachieving growth both organically and through acquisitions so that we canspread our corporate overhead over a larger base of business and achieveeconomies of scale.

 

•                  During the first quarter of 2006, we raisedapproximately $2,000,000 in debentures and $1,150,000 in equity. These proceedswere used to repay a $600,000 over-advance on the revolving line of credit, arepayment of $1,350,000 on the term loan and the balance was used for workingcapital purposes. We are currently working to raise another $1 million to $4million of debt and equity for working capital needs, for debt retirement andfor acquisitions.

 

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•                  We are seeking to list our common stock onthe Nasdaq Market or another national exchange (our common stock is currentlyquoted on the OTC Bulletin Board).

 

**LIQUIDITYAND CAPITAL RESOURCES**

 

Duringthe first quarter of 2006, we raised approximately $2,000,000 in debentures and$1,150,000 in equity. These proceeds were used to repay a $600,000 over-advanceon the revolving line of credit, a repayment of $1,350,000 on the term loan andthe balance was used for working capital purposes. We are currently working toraise another $1 million to $4 million of debt and equity for working capitalneeds, for debt retirement and for acquisitions.

 

OnJune 16, 2004, the Company entered into a Loan and Security Agreement withBridge Healthcare Finance, LLC (“Bridge Healthcare”), pursuant to which theCompany obtained a revolving credit facility up to $15,000,000 (the “Loan”). Duringthe first quarter of 2005, the Loan was reduced to $10,000,000 permitting theCompany to lower its effective interest rate through lower unused line fees. TheLoan had an original term of three years and bears interest at a rate equal tothe greater of three percent (3.0%) per annum over the prime rate or nine andone-half percent (9.5%) per annum (10.75% at March 31, 2006). Interest ispayable monthly. Accounts receivable serves as security for the Loan and theLoan is subject to certain financial and reporting covenants. Customer paymentsare used to repay the advances on the Loan after deducting charges for interestexpense, unused line and account management fees. Except in certain limitedcircumstances, the Loan cannot be prepaid in full without the Company incurringa significant prepayment penalty. The financial covenants are for themaintenance of minimum tangible net worth, minimum debt service coverage ratios,minimum EBITDA, maximum capital expenditure limits and maximum operating leaseobligations. In May 2005 the Company renegotiated covenants related to theLoan; however, at December 31, 2005 and March 31, 2006, the Company was not incompliance with the revised covenants. Bridge Healthcare waived compliance withthe covenants for 2005. However, at March 31, 2006, the Company had notobtained a waiver for non-compliance. Management is currently consideringvarious alternatives to rectify covenant non-compliance, includingrenegotiating the covenants with Bridge Healthcare or negotiating a newfacility with a new lender. The Company was charged fees by Bridge Healthcarefor various compliance violations and related waivers granted during 2005. Duringthe third quarter of 2005, Bridge Healthcare made a $600,000 credit lineavailable to the Company in the form of an over-advance on the Company’s Loan. Theline of credit was used as necessary to pay certain remaining amounts due onacquisitions completed in March 2005 and for working capital purposes. Duringthe first quarter of 2006, the Company used proceeds from a private offering(as discussed in Notes 8 and 10) to repay the $600,000 over-advance. The Loanincludes events of default (with grace periods as applicable) and providesthat, upon the occurrence of certain events of default, payment of all amountspayable under the Loan, including the principal amount of, and accrued intereston, the Loan may be accelerated. There are also cross default provisions betweenthe Loan and the Term Loan discussed in Note 6. The outstanding balance on theLoan is $3,848,827 at March 31, 2006, which represents the total availabilityunder the line relative to the amount of receivables outstanding at that date. Thematurity date of the Loan was extended for an additional year through June 2008.The prepayment penalty discussed above is applicable for the one-year extensionperiod except the amount is reduced in the event of a change in control of theCompany.

 

Pursuantto a loan agreement dated August 31, 2004, the Company obtained a term loancredit facility (“Term Loan”) in the amount up to $10,000,000 from BridgeOpportunity Finance, LLC, an affiliate of Bridge Healthcare. The Company mayobtain loans under the agreement to fund permitted acquisitions. Any loansobtained under the Term Loan are due and payable in full on August 31, 2007 andbear interest at the rate of fifteen and one-quarter percent (15.25%) per annum.Interest is payable monthly. The Term Loan is secured by all assets of theCompany. On August 31, 2004, the Company received proceeds from the Term Loanof $2,697,802 for the acquisitions of Arizona Home Health Care/Private Duty,Inc. and Care Pros Staffing, Inc.

 

TheTerm Loan provides that the Company shall issue warrants to purchase shares of commonstock to the lender up to 12% of the Company’s overall capitalization on thedate of borrowing. On August 31, 2004,

 

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theCompany issued warrants to purchase 90,578 shares of common stock at a price of$31.50 per share in connection with the first borrowing under the creditfacility. As a result, the Term Loan has been recorded net of a discount of$810,000 which represents the estimated fair market value related to thewarrants at the date of issuance. The discount is being amortized to interestexpense over the life of the Term Loan. During the first quarter of 2006, theCompany used proceeds from a private offering to repay $1,350,000 of the TermLoan. As a result of this repayment, the Company recorded $200,168 ofadditional interest relating to the unamortized discount associated with therepayment. Amortization of the remaining discount totaled $30,017 during thefirst quarter of 2006. The outstanding balance of the Term Loan is $1,347,802at March 31, 2006, which is before an unamortized discount of $170,151.

 

Exceptin certain limited circumstances, the Term Loan cannot be prepaid in fullwithout the Company incurring a significant prepayment penalty. The Term Loanalso contains certain financial covenants, including the maintenance of minimumtangible net worth, minimum debt service coverage ratios, minimum EBITDA,maximum capital expenditure limits and maximum operating lease obligations. AtMarch 31, 2005, the Company was out of compliance with certain financialcovenants of the Term Loan, for which a waiver was received from the lender. InMay 2005 the Company renegotiated covenants related to the term loan; however,at December 31, 2005 and March 31, 2006, the Company was not in compliance withthe revised covenants. However, at March 31, 2006, the Company had not obtaineda waiver for non-compliance. Bridge Healthcare waived compliance with thecovenants for 2005. Management is currently considering various alternatives torectify this non-compliance, including renegotiating the covenants with BridgeHealthcare or negotiating a new facility with a new lender. The Company wascharged fees by Bridge for various compliance violations and related waiversgranted during 2005. The Term Loan includes events of default (with graceperiods as applicable) and provides that, upon the occurrence of certain eventsof default, payment of all amounts payable under the Term Loan, including theprincipal amount of, and accrued interest on, the Term Loan may be accelerated.There are also cross default provisions between the Term Loan and the Loan.

 

Aspartial consideration for the acquisition of TravMed USA, Inc. (“TravMed”) onMarch 29, 2005, we issued unsecured subordinated notes to the former TravMedstockholders in the total amount of $3,215,490. The notes were three-yearconvertible notes bearing interest at 7.75%. Monthly interest payments wererequired for the first six months followed by principal and interest paymentsthe next thirty months to fully repay the debt. Since October 31, 2005, we hadnot made debt service payments required by terms of these notes payable tosellers as claims were asserted in State District Court in Dallas, Texas againstthe sellers of TravMed for breach of non-competition/solicitation agreements,breach of fiduciary duty, tortious interference with existing and prospectivecontracts and business relations, and declaratory relief. We received a noticeof default in early November 2005 and the due date of the notes was acceleratedsuch that the entire balance of the notes payable to sellers was due. Thedefault under the notes payable to sellers triggered defaults under the Loan andTerm Loan discussed above, as well as the Debentures discussed below. Also, asa result of this default, Bridge Healthcare had an option to discontinue makingrevolving credit loans to us on receivables of TravMed. Because of theuncertainty surrounding repayment of these notes, we classified all of thebalance as a current liability on the accompanying balance sheets.

 

OnMay 9, 2006, under terms of agreements to acquire TravMed, we returned to thesellers the shares in TravMed that it had acquired on March 29, 2005. Uponreturn of the shares to the sellers, the Company was permitted to retainTravMed receivables existing on May 9, 2006, and the $3,215,490 of seller notespayable are extinguished. Following the return of the shares, the sellers arereleased from covenants not to compete, and we and the sellers are free tocompete for the customer contracts existing on May 9, 2006. Management believesthat substantially all customers will elect to contract directly with us. Inaddition, we expect to report a gain on extinguishment of seller debt of$3,215,490. To the extent of any loss of customers, there may be an offset tothe foregoing gain due to the write-off of intangibles related to customercontracts recorded at the time of acquiring TravMed and for the value of anyfurniture and equipment returned to the sellers.

 

InJanuary 2006, we completed a private placement totaling $4 million. The firstphase was completed on December 30, 2005 and consisted of $2 million, or333,333 shares of common stock and the second phase consisted of $2 million of8% convertible debentures. The convertible debentures have a term of three

 

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yearsand bear interest at a rate of 8% per year, payable semi-annually in cash orregistered stock at our option. The debentures are convertible into commonstock at a price of $6.00 per share. The sale of convertible debenturesincluded common stock warrant coverage allowing debenture holders to exercisewarrants to purchase 500,000 common shares. Warrants to purchase 166,667 commonshares have a five year term and an exercise price of $7.50 per share. Warrantsto purchase 333,333 common shares expire on June 14, 2006 and have an exerciseprice of $6.00 per share. We computed the relative fair value the warrants at$1,443,265 and the beneficial conversion feature at $556,735, and recordedthese amounts as a discount to the debentures.

 

Termsof an agreement with the broker representing us required broker fees upon aprivate placement of at least $5 million. Although the minimum was notachieved, fees have been accrued and warrants recorded based on the loweramount of funding. Accordingly, $589,722 was recorded as deferred financingcosts and $294,867 was recorded as an offset to proceeds from the equityportion of the funding. The $589,722 will be amortized over the three yearperiod the debentures will be outstanding. A portion of the broker fees werewarrants to purchase 50,000 shares of common stock at $6.00 per share. Thewarrants have a five year life and were valued at $629,589 ($419,722 recordedas deferred financing costs and $209,867 recorded as an offset to proceeds fromthe equity offering).

 

OnFebruary 16, 2006, a holder of the debentures converted $260,000 of thedebentures into 43,333 shares of our common stock. We recognized expense in theamount of $72,117 relating to the deferred financing fees associated with theconverted debentures and expense in the amount of $238,333 related to theproportionate share of the unamortized discount on the converted debentures.

 

Thedebentures have cross-default provisions with our revolving line of credit andnotes payable to lender. Since we are in default on our revolving line ofcredit and notes payable to lender, we are also in default on the debentures. Accordingly,the amount of the debentures ($1,740,000 face value outstanding and $144,998after a discount of $1,595,002) has been classified as a current obligation onthe accompanying balance sheet as of March 31, 2006.

 

Weare obligated to register the shares (including the shares issuable upon conversionof the debentures and exercise of the warrants) for resale on a registrationstatement. We have used the proceeds from the private placement for workingcapital and the retirement of 50% of our outstanding $2.7 million Term Loan(discussed above) as well as retirement of the $600,000 over-advance facility(discussed above).

 

Inthe first quarter of 2006 we completed further equity financings with ourmajority stockholder for $1,150,000 at per share prices ranging from $6.00 to$8.00. The proceeds were used for working capital purposes. Our capitalcommitments for the next twelve months are minimal as our business does notrequire the purchase of plants, factories, extensive capital equipment orinventory.

 

We generated a net loss of $1,358,587 attributableto common stockholders in the first three months of 2006 and used cash inoperations of $1,237,022 during this period. Additionally, although we endedthe first quarter of 2006 with a significant working capital deficit of $5,304,939,we were able to secure additional funding during this period to finance ouroperations as we continued to execute our business plan to acquire and growcompanies involved in healthcare staffing. We will need to raise $1,000,000 to$2,000,000 during the next twelve months to satisfy debt service requirementsand working capital needs. There is no assurance that we will be able to raisethe amount of debt or equity capital required to meet our objectives. Our challengingfinancial circumstances may make the terms, conditions and cost of anyavailable capital relatively unfavorable. If additional debt or equity capitalis not readily available, we will be forced to scale back our acquisitionactivities and our operations. This would result in an overall slowdown of ourdevelopment. Our short-term need for capital may force us to consider andpotentially pursue other strategic options sooner than we might otherwise havedesired. These conditions raise substantial doubt about our ability to continueas a going concern. The financial statements do not include any adjustments toreflect the possible future effects on the recoverability and classification ofassets, or the amounts and classification of liabilities that may result fromthe outcome of this uncertainty.

 

Managementhas taken a number of steps to address our financial performance and to achievepositive cash flow during 2006. We replaced a portion of our debt with new debtthat has a lower interest rate,

 

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restructuredthe operating management team, and implemented programs to obtain cash expensesavings. However, there can be no assurances that these programs will besuccessful.

 

**CRITICALACCOUNTING POLICIES AND MANAGEMENT JUDGEMENT**

 

Thepreparation of the financial statements in accordance with accountingprinciples generally accepted in the United States of America requires us tomake judgments, estimates, and assumptions regarding uncertainties that affectthe reported amounts of assets and liabilities, disclosure of contingent assetsand liabilities, and the reported amounts of revenues and expenses. Areas thatrequire significant judgments, estimates, and assumptions include theassignment of fair values upon acquisition of goodwill and other intangibleassets, testing for impairment of long-lived assets and valuation of the stockused to consummate our acquisitions. We use historical experience, qualifiedindependent consultants and all available information to make these judgmentsand estimates, and actual results will inevitably differ from those estimatesand assumptions that are used to prepare the Company’s financial statements atany given time.

 

**AccountsReceivable**

 

Accountsreceivable are reduced by an allowance for doubtful accounts that provides areserve with respect to those accounts for which revenue was recognized butwith respect to which management subsequently determines that payment is notexpected to be received. We analyze the balances of accounts receivable toensure that the recorded amounts properly reflect the amounts expected to becollected. This analysis involves the application of varying percentages toeach accounts receivable category based on the age of the uncollectibleaccounts receivable. The amount ultimately recorded as the reserve isdetermined after management also analyzes the collectibility of specific largeor problematic accounts on an individual basis, as well as the overall businessclimate and other factors. Our estimate of the percentage of uncollectibleaccounts may change from time to time and any such change could have a materialimpact on our financial condition and results of operations.

 

**PurchaseAccounting, Goodwill and Intangible Assets**

 

Allbusiness acquisitions have been accounted for using the purchase method of accountingand, accordingly, the statements of operations include the results of eachacquired business since the date of acquisition. The assets acquired andliabilities assumed are recorded at their estimated fair value as determined bymanagement and supported in some cases by an independent third-party valuation.We finalize the allocation of the purchase price to the fair value of theassets acquired and liabilities assumed when we obtain information sufficientto complete the allocation, but in any case, within one year after acquisition.

 

Goodwillarising from the acquisitions of businesses is recorded as the excess of thepurchase price over the estimated fair value of the net assets of thebusinesses acquired. Statement of Financial Accounting Standards No. 142 (“Goodwilland Other Intangible Assets”) provides that goodwill is to be tested forimpairment annually or more frequently if circumstances indicate potentialimpairment. Consistent with this standard, we will review goodwill, as well asother intangible assets and long-term assets, for impairment annually or morefrequently as warranted, and if circumstances indicate that the recorded valueof any such other asset is impaired, such asset is written down to its new,lower fair value. If any item of goodwill or such other asset is determined tobe impaired, an impairment loss would be recognized equal to the amount bywhich the recorded value exceeds the estimated fair market value.

 

**Stock-BasedCompensation**

 

OnJanuary 1, 2006, the Company adopted the modified prospective method of SFASNo. 123 (Revised 2004), *Shared-Based Payment*(“SFAS No. 123R”), which is a revision of SFAS No. 123, *Accountingfor Stock-Based Compensation* (“SFAS No. 123”). SFAS No. 123Rsupersedes APB Opinion No. 25, and amends SFAS No. 95, *Statement ofCash Flows*. SFAS No. 123R requires all share-based payments to

 

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employees,including grants of employee stock options, to be recognized in the incomestatement based on their fair values. Pro forma disclosure is no longer analternative. Under the modified prospective application, SFAS No. 123R isapplied to new awards and to awards modified, repurchased or cancelled afterthe effective date. Compensation cost for the portion of awards for whichrequisite service has not been rendered that are outstanding as of theeffective date is recognized as the service is rendered on or after theeffective date. The compensation cost for that portion of awards is based onthe grant date fair value of those awards as calculated for pro formadisclosures under SFAS No. 123. In accordance with the modified prospectivemethod, the consolidated financial statements for the prior periods have notbeen restated to reflect, and do not include, the impact of SFAS No. 123R.

 

Theadoption of SFAS No. 123R will require the Company to record substantialnon-cash compensation expenses. While the adoption of SFAS No. 123R is notexpected to have a significant effect on the Company’s financial condition orcash flows, it is expected to have a significant effect on the Company’sresults of operations. The future impact of the adoption of SFAS No. 123Rcannot be predicted at this time because it will depend on the levels ofshare-based payments granted by the Company in the future. However, had theCompany adopted SFAS No. 123R in prior periods, the impact of the standardwould have approximated the impact of SFAS No. 123 as described in the proforma net loss attributable to common shareholders.

 

Priorto January 1, 2006, the Company accounted for stock-based employee compensationarrangements in accordance with provisions of Accounting Principles Board (“APB”)Opinion No. 25, *Accounting for Stock Issued to Employees,*and complied with the disclosure provisions of SFAS No. 123 as amended by SFASNo. 148. Under APB Opinion No. 25, compensation expense for employees is basedon the excess, if any, on the date of grant, of the fair value of the Company’sstock over the exercise price and is recognized on a straight-line basis overthe vesting term of the option.

 

TheCompany accounts for equity instruments issued to non-employees in accordancewith the provisions of SFAS No. 123 and SFAS No. 148 and Emerging Issues TaskForce Issue No. 96-18, *Accounting for Equity InstrumentsThat Are Issued to Other Than Employees for Acquiring, or in Conjunction withSelling, Goods or Services*. All transactions in which goods orservices are the consideration received for the issuance of equity instrumentsare accounted for based on the fair value of the consideration received or thefair value of the equity instrument issued, whichever is more reliablymeasurable. The measurement date of the fair value of the equity instrumentissued is the earlier of the date on which the counterparty’s performance iscomplete or the date on which it is probable that performance will occur.

 

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**RESULTSOF OPERATIONS**

 

Thefollowing condensed consolidated statement of operations includes CrdentiaCorp. plus the results of operations of all companies acquired from theirrespective dates of acquisition.

 

Crdentia Corp.

UnauditedCondensed Consolidated Statements of Operations

** **
| ** **                                     | ** ** | **Three months ended March 31,** | ** ** |
|------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                     | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
|                                           |       |                                                 |       |   |   |
| Revenue from services                          |       | $                                                    | 8,984,823  |   | $ | 5,122,313 |   |
| Direct operating expenses                      |       | 7,235,519                                            |       | 4,048,820 |   |
| Gross profit                                   |       | 1,749,304                                            |       | 1,073,493 |   |
|                                           |       |                                                 |       |   |   |
| Operating expenses:                            |       |                                                 |       |   |   |
| Selling, general, and administrative  expenses |       | 2,600,785                                            |       | 1,715,880 |   |
| Gain from settlement of acquisition claim      |       | (1,064,693                                           | )          | — |   |
| Non-cash stock based compensation              |       | 378,260                                              |       | 78,846 |   |
| Total operating expenses                       |       | 1,914,352                                            |       | 1,794,726 |   |
|                                           |       |                                                 |       |   |   |
| Loss from operations                           |       | (165,048                                             | )          | (721,233 | ) |
|                                           |       |                                                 |       |   |   |
| Interest expense, net                          |       | (1,193,539                                           | )          | (524,034 | ) |
|                                           |       |                                                 |       |   |   |
| Loss before income taxes                       |       | (1,358,587                                           | )          | (1,245,267 | ) |
|                                           |       |                                                 |       |   |   |
| Income tax expense                             |       | —                                               |       | — |   |
|                                           |       |                                                 |       |   |   |
| Net loss                                       |       | (1,358,587                                           | )          | (1,245,267 | ) |
|                                           |       |                                                 |       |   |   |
| Non-cash preferred stock dividends             |       | —                                               |       | (2,162,187 | ) |
|                                           |       |                                                 |       |   |   |
| Net loss attributable to common  stockholders  |       | $                                                    | (1,358,587 | ) | $ | (3,407,454 | ) |

 

***Three months ended March 31, 2006 compared to the three months endedMarch 31, 2005***

 

Revenuesfor the three months ended March 31, 2006 were $8,984,823 compared to revenuesof $5,122,313 for the same period in 2005. Revenues increased in 2006 comparedto 2005 due to the acquisitions in March and May of 2005. In 2006 approximately36% (27% in 2005) of our revenue was derived from the placement of travelnurses on assignment, typically 13 weeks in length. Such assignments generallyinvolve temporary relocation to the geographic area of the assignment. In 2006,we also provided per diem nurses to satisfy the short-term needs of healthcarefacilities. Per diem services provided 56% of our revenue for 2006 (63% in2005). The change in travel/per diem mix from 2005 to 2006 resulted from ouracquisition of the TravMedtravel business on May 29, 2005which increased the relative amount of our travel business. The remainingamount of our revenue in 2006 and 2005 came from providing clinical managementand staffing services to healthcare facilities and private duty homecare. During2006 and 2005, most of our customers were acute care hospitals locatedthroughout the continental United States.

 

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Ouroverall gross profit in 2006 was $1,749,304 or 19.5% of revenues compared to $1,073,493or 21.0% of revenues in 2005. Our gross profit is the difference between therevenue we realize when we bill our customers for the services of our healthcareprofessionals and our direct operating costs, which include the cost of thehealthcare professionals and the related housing and travel costs, certainemployment related taxes and workers compensation insurance coverage. Thedecrease in gross profit margin is primarily due to increased housing andtravel costs associated with our travel nurses. We are currently consideringvarious alternatives to control these costs in the future.

 

Ourselling, general and administrative costs were $2,600,785******or 29% of revenuesin 2006 compared to $1,715,880 or 34%******of revenues in 2005. Selling, general andadministrative expenses are comprised primarily of personnel costs, professionalfees related to being a public company and various other office andadministrative expenses. Selling, general and administrative costs as apercentage of revenue were lower in 2006 due to cost cutting measures.

 

In2005, the Company asserted a claim against a seller of one of the Company’s2003 acquisitions. In January 2006, the Company and the seller settled with theseller returning 59,150 shares of the Company’s stock that had been issued inconnection with the acquisition. The Company reported a gain on this settlementof $1,064,693 representing the fair value of the stock returned on the date ofthe settlement.

 

Non-cashstock based compensation expense increased from $78,846 in 2005 to $378,260 in2006. This increase resulted from the Company’s adoption of SFAS 123R requiringexpensing of the fair value of options granted which amounted to approximately$52,000 for the first quarter of 2006 and amortization related to 280,000shares of restricted stock to officers of the Company which amounted to$238,000 in the first quarter of 2006. Of the 370,000 shares granted in May2005, 90,000 were incentive based and forfeited in December 2005 when targetedoperating goals were not achieved.

 

Interestcosts increased from $524,034 in 2005 to $1,193,539 in 2006. This increaseresulted from the $2,000,000 debenture financing which occurred in January 2006,interest rate increases since the first quarter of 2005 and the write-off of $438,501in unamortized debt discounts and $72,117 in deferred financing costs resulting from the retirement of 50% of ouroutstanding $2.7 million Term Loan (as discussed above), and the conversion of$260,000 of the debentures (as discussed above).

 

Thenon-cash preferred stock dividends in the first quarter of 2005 relate tocommon stock dividends declared by the Board of Directors on our Series B,Series B-1 and Series C convertible preferred stock as well as cumulativecommon stock dividends declared on September 30, 2004, December 31, 2004 andMarch 31, 2005 related to the warrants exercised on March 29, 2005 for 108,333shares of Series C convertible preferred stock. The common stock dividends onthe warrants are payable once the warrants are exercised.

 

**RISKFACTORS**

 

Wewere formed in November 1997, and commenced operations on August 7, 2003following our acquisition of Baker Anderson Christie, Inc. Any investment in ourcommon stock involves a high degree of risk. You should consider carefully thefollowing information about these risks, together with the other informationcontained in this report, before you decide to buy our common stock. The risksand uncertainties described below are not the only ones we face. Additionalrisks and uncertainties not presently known to us or that we currently deemimmaterial may also impair our operations. If any of the following risksactually occur, our business would likely suffer and our results could differmaterially from those expressed in any forward-looking statements contained inthis report. In such case, the trading price of our common stock could decline,and you may lose all or part of the money you paid to buy our common stock.

 

**Our independent registered public accounting firm issued a going concern opinion on our financial statements, questioning our ability to continue as a going concern.**

 

Our independent registered public accounting firm’s opinion on our 2005 financial statements included an explanatory paragraph indicating substantial doubt about our ability to continue as a going concern. Since our inception, we have operated with limited operating capital, and we continue to face immediate and substantial cash needs.

 

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Wehave limited cash resources and will need to raise additional capital throughpublic or private financings or other arrangements in order to meet currentcommitments and continue development of our business. We cannot assure you thatadditional capital will be available to us when needed, if at all, or, ifavailable, will be obtained on terms attractive to us. Our failure to raiseadditional capital when needed could cause us to cease our operations.

 

Wehave financed our operations since inception primarily through the privateplacement of equity and debt securities and loan facilities. Although ourmanagement recognizes the need to raise funds in the near future, there can beno assurance that we will be successful in consummating any fundraisingtransaction, or if we do consummate such a transaction, that its terms andconditions will not require us to give investors warrants or other valuablerights to purchase additional interest in our company, or be otherwiseunfavorable to us. Among other things, the agreements under which we issuedsome of our existing securities include, and any securities that we may issuein the future may also include, terms that could impede our ability to raiseadditional funding. The issuance of additional securities could imposeadditional restrictions on how we operate and finance our business. Inaddition, our current debt financing arrangements involve significant interestexpense and restrictive covenants that limit our operations.

 

There can be no assurance that management’s plans to become cash flow positive during 2006 will be successful. We have been successful raising capital in the past; however, if we are unsuccessful in raising additional capital, we may need to reduce the level of our operations, resulting in a material adverse effect on our business and operations and charges that could be material to our business and results of operations.

 

**We mayface difficulties identifying acquisitions and integrating these acquisitionsinto our operations. These acquisitions may be unsuccessful, involvesignificant cash expenditures or expose us to unforeseen liabilities.**

 

We continually evaluate opportunities to acquirehealthcare staffing companies that complement or enhance our business andfrequently have preliminary acquisition discussions with such companies. Since2003, we have acquired nine businesses. These acquisitions involve numerousrisks, including:

 

•       potential loss of revenues following theacquisition;

 

•       difficulties integrating acquired personneland distinct cultures into our business;

 

•       difficulties integrating acquired companiesinto our operating, financial planning and financial reporting systems;

 

•       diversion of management attention fromexisting operations; and

 

•       assumption of liabilities and exposure tounforeseen liabilities of acquired companies, including liabilities for theirfailure to comply with healthcare regulations.

 

Theseacquisitions may also involve significant cash expenditures, debt incurrenceand integration expenses that could seriously harm our financial condition andresults of operations. We may fail to achieve expected efficiencies andsynergies. Any acquisition may ultimately have a negative impact on ourbusiness and financial condition.

 

**There is not an active public market for our common stock,and the trading price of our common stock is subject to volatility.**

 

Thequotation of shares of our common stock on the OTC Bulletin Board began onFebruary 24, 2003. There can be no assurances, however, that a market willdevelop or continue for our common stock. Our common stock may be thinlytraded, if traded at all, even if we achieve full operation and generatesignificant revenue and is likely to experience significant price fluctuations.In addition, our stock may be

 

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definedas a “penny stock” under Rule 3a51-1 adopted by the Securities and ExchangeCommission under the Securities Exchange Act of 1934, as amended. In general, a“penny stock” includes securities of companies which are not listed on theprincipal stock exchanges or the National Association of Securities DealersAutomated Quotation System (“Nasdaq”) or National Market System (“Nasdaq NMS”)and have a bid price in the market of less than $5.00; and companies with nettangible assets of less than $2,000,000 ($5,000,000 if the issuer has been incontinuous operation for less than three years), or which have recordedrevenues of less than $6,000,000 in the last three years. “Penny stocks” aresubject to Rule 15g-9, which imposes additional sales practice requirements onbroker-dealers that sell such securities to persons other than establishedcustomers and “accredited investors” (generally, individuals with net worth inexcess of $1,000,000 or annual incomes exceeding $200,000, or $300,000 togetherwith their spouses, or individuals who are officers or directors of the issuerof the securities). For transactions covered by Rule 15g-9, a broker-dealermust make a special suitability determination for the purchaser and havereceived the purchaser’s written consent to the transaction prior to sale. Consequently,this rule may adversely affect the ability of broker-dealers to sell our commonstock, and therefore, may adversely affect the ability of our stockholders tosell common stock in the public market.

 

Thetrading price of our common stock is likely to be subject to wide fluctuations.Factors affecting the trading price of our common stock may include:

 

•                  Variations in our financial results;

 

•                  Announcements of innovations, new solutions,strategic alliances or significant agreements by us or by our competitors;

 

•                  Recruitment or departure of key personnel;

 

•                  Changes in estimates of our financial resultsor changes in the recommendations of any securities analysts that elect tofollow our common stock;

 

•                  Market conditions in our industry, theindustries of our customers and the economy as a whole; and

 

•                  Sales of substantial amounts of our commonstock, or the perception that substantial amounts of our common stock will besold, by our existing stockholders in the public market.

 

**Ourneed to raise additional capital in the future could have a dilutive effect onyour investment.**

 

Wewill need to raise additional capital.  One possibility for raisingadditional capital is the public or private sale of our Common Stock orsecurities convertible into or exercisable for our common stock. Such salescould be consummated at a significant discount to the trading price of our stock.

 

Ifwe sell additional shares of our common stock, such sales will further dilutethe percentage of our equity that our existing stockholders own. In addition,our recent private placement financings have involved the issuance ofsecurities at a price per share that represented a discount to the tradingprices listed for our Common Stock on the OTC Bulletin Board and it is possiblethat we will close future private placements involving the issuance ofsecurities at a discount to prevailing trading prices. Depending upon the priceper share of securities that we sell in the future, a stockholder’s interest inus will be further diluted by any adjustments to the number of shares and theapplicable exercise price required pursuant to the terms of the agreementsunder which we previously issued securities. No assurance can be given thatprevious or future investors, finders or placement agents will not claim thatthey are entitled to additional anti-dilution adjustments or dispute ourcalculation of any such adjustments.  Any such claim or dispute couldrequire us to incur material costs and expenses regardless of the resolutionand, if resolved unfavorably to us, to affect dilutive securities issuances oradjustments to previously issued securities. In addition, future financings mayinclude provisions requiring us to make additional payments to the investors ifwe fail to obtain or maintain the effectiveness of SEC registration statementsby specified dates or take other specified action.

 

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Ourability to meet these requirements may depend on actions by regulators andother third parties, over which we will have no control. These provisions mayrequire us to make payments or issue additional dilutive securities, or couldlead to costly and disruptive disputes. In addition, these provisions couldrequire us to record additional non-cash expenses.

 

**Ourcredit facility imposes significant expenses and restrictive covenants upon us.**

 

InJune 2004 we obtained a $15 million revolving credit facility, which wasreduced in 2005 to $10 million, (the “Revolving Facility”) from BridgeHealthcare Finance, LLC.  In August 2004 we obtained a $10 million termloan credit facility from Bridge Opportunity Finance, LLC (the “Term Facility”and together with the Revolving Facility, the “Credit Facility”).  BridgeOpportunity Finance, LLC is an affiliate of Bridge Healthcare Finance, LLC.

 

TheCredit Facility involves significant interest expenses and other fees.  Inaddition, except in certain limited circumstances, the Revolving Facilitycannot be pre-paid in full without us incurring a significant pre-paymentpenalty.

 

TheCredit Facility imposes various restrictions on our activities without theconsent of the lenders, including a prohibition on fundamental changes to us orour direct or indirect subsidiaries (including certain consolidations, mergersand sales and transfer of assets, and limitations on our ability or any of ourdirect or indirect subsidiaries to grant liens upon our property orassets).  In addition, under the Credit Facility we must meet certain networth, earnings and debt service coverage requirements.  The CreditFacility includes events of default (with grace periods, as applicable) andprovides that, upon the occurrence of certain events of default, payment of allamounts payable under the Credit Facility, including the principal amount of,and accrued interest on, the Credit Facility may be accelerated.  Inaddition, upon the occurrence of certain insolvency or bankruptcy relatedevents of default, all amounts payable under the Credit Facility, including theprincipal amount of, and accrued interest on, the Credit Facility shallautomatically become immediately due and payable. We are currently in defaultof certain covenants and requirements contained in the Credit Facility.

 

Theexpenses and restrictions associated with the Credit Facility have the effectof limiting our operations.  In addition, our failure to pay requiredinterest expenses and other fees or to meet restrictions under the CreditFacility would have a material adverse affect on us.

 

**Theagreements governing the convertible debentures contain covenants andrestrictions that may limit our ability to operate our business.**

 

Theterms of our 2006 convertible debentures limit our ability to, among otherthings: declare or pay dividends or distributions on any equity securities,create or incur additional indebtedness, create additional liens on our assetsand repurchase common stock. These restrictions could adversely affect ourability to borrow additional funds or raise additional equity to fund ourfuture operations. In addition, if we fail to comply with any of the covenantscontained in the agreements or otherwise default on the convertible debentures,the holders may accelerate the indebtedness, and we may not have sufficientfunds available to make the required payments. We are currently in default ofcertain covenants contained in the convertible debentures.

 

**MedCapPartners L.P. controls a majority of our outstanding capital stock and this maydelay or prevent change of control of our company or adversely affect our stockprice.**

 

MedCapPartners L.P. controls approximately 77% of our outstanding capital stock, afterthe April 3, 2006 preferred stock and warrant exchange. As a result, MedCap isable to exercise control over matters requiring stockholder approval, such asthe election of directors and the approval of significant corporatetransactions. These types of transactions include transactions involving anactual or potential change of control of our company or other transactions thatthe non-controlling stockholders may deem to be in their best interests and inwhich such stockholders could receive a premium for their shares. C. Fred Toney,a

 

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memberor our Board of Directors, is the managing member of MedCap Management &Research LLC, the general partner of MedCap Partners L.P.

 

**Theability to attract and retain highly qualified personnel to operate and manageour operations is extremely important and our failure to do so could adverselyaffect us.**

 

Presently,we are dependent upon the personal efforts of our management team. The loss ofany of our officers or directors could have a material adverse effect upon ourbusiness and future prospects. We do not presently have key-person lifeinsurance upon the life of any of our officers or directors. Additionally, aswe continue our planned expansion of commercial operations, we will require theservices of additional skilled personnel. There can be no assurance that we canattract persons with the requisite skills and training to meet our future needsor, even if such persons are available, that they can be hired on termsfavorable to us.

 

**We havehad a short operating history.**

 

Wewere formed in November 1997 and commenced operations on August 7, 2003 withour acquisition of Baker Anderson Christie, Inc. We are a “start-up” operationand subject to all the risks inherent in a new business venture, many of whichare beyond our control, including the ability to implement successfuloperations, lack of capital to finance acquisitions and failure to achievemarket acceptance. In addition, as a start-up venture we will face significantcompetition from many companies virtually all of which are larger, betterfinanced and have significantly greater market recognition than us.

 

**Thesuccessful implementation of our business strategy depends upon the ability ofour management to monitor and control costs.**

 

Withrespect to our planned operations, management cannot accurately project or giveany assurance with respect to our ability to control development and operatingcosts and/or expenses in the future. Consequently, as we expand our commercialoperations, management may not be able to control costs and expensesadequately, and such operations may generate losses.

 

**We maybecome subject to governmental regulations and oversight, which could adverselyaffect our ability to continue or expand our business strategy.**

 

Althoughour operations are currently not subject to any significant governmentregulations, it is possible that, in the future, such regulations may belegislated. Although we cannot predict the extent of any such futureregulations, a possibility exists that future or unforeseen changes may have anadverse impact upon our ability to continue or expand our operations aspresently planned.

 

**If weare unable to attract qualified nurses and healthcare professionals for ourhealthcare staffing business, our business could be negatively impacted.**

 

Werely significantly on our ability to attract and retain nurses and healthcareprofessionals who possess the skills, experience and licenses necessary to meetthe requirements of our hospital and healthcare facility clients. We competefor healthcare staffing personnel with other temporary healthcare staffingcompanies and with hospitals and healthcare facilities. We must continuallyevaluate and expand our temporary healthcare professional network to keep pacewith our hospital and healthcare facility clients’ needs. Currently, there is ashortage of qualified nurses in most areas of the United States, competitionfor nursing personnel is increasing, and salaries and benefits have risen. Wemay be unable to continue to increase the number of temporary healthcareprofessionals that we recruit, decreasing the potential for growth of ourbusiness. Our ability to attract and retain temporary healthcare professionalsdepends on several factors, including our ability to provide temporaryhealthcare professionals with assignments that they view as attractive and toprovide them with competitive benefits and wages. We cannot assure you that wewill be successful in any of these areas. The cost of attracting temporary healthcareprofessionals and providing them with attractive benefit packages may be higherthan we anticipate and, as a result, if we are unable to

 

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passthese costs on to our hospital and healthcare facility clients, our lossescould increase. Moreover, if we are unable to attract and retain temporaryhealthcare professionals, the quality of our services to our hospital andhealthcare facility clients may decline and, as a result, we could loseclients.

 

**Thetemporary staffing industry is highly competitive and the success and futuregrowth of our business depend upon our ability to remain competitive inobtaining and retaining temporary staffing clients.**

 

Thetemporary staffing industry is highly competitive and fragmented, with limitedbarriers to entry. We compete in national, regional and local markets withfull-service agencies and in regional and local markets with specializedtemporary staffing agencies. Some of our competitors include AMN Healthcare Services,Inc., Cross Country, Inc., Medical Staffing Network Holdings, Inc. and OnAssignment, Inc. All of these companies have significantly greater marketingand financial resources than we do. Our ability to attract and retain clientsis based on the value of the service we deliver, which in turn dependsprincipally on the speed with which we fill assignments and the appropriatenessof the match based on clients’ requirements and the skills and experience ofour temporary employees. Our ability to attract skilled, experienced temporaryprofessionals is based on our ability to pay competitive wages, to providecompetitive benefits, to provide multiple, continuous assignments and therebyincrease the retention rate of these employees. To the extent that competitorsseek to gain or retain market share by reducing prices or increasing marketingexpenditures, we could lose revenues and our margins could decline, which couldseriously harm our operating results and cause the trading price of our stockto decline. As we expand into new geographic markets, our success will dependin part on our ability to gain market share from competitors. We expectcompetition for clients to increase in the future, and the success and growthof our business depend on our ability to remain competitive.

 

**Ourbusiness depends upon our continued ability to secure and fill new orders fromour hospital and healthcare facility clients, because we do not have long-termagreements or exclusive contracts with them.**

 

Wegenerally do not have long-term agreements or exclusive guaranteed ordercontracts with our hospital and healthcare facility clients. The success of ourbusiness depends upon our ability to continually secure new orders fromhospitals and other healthcare facilities and to fill those orders with ourtemporary healthcare professionals. Our hospital and healthcare facilityclients are free to place orders with our competitors and may choose to usetemporary healthcare professionals that our competitors offer them. Therefore,we must maintain positive relationships with our hospital and healthcarefacility clients. If we fail to maintain positive relationships with ourhospital and healthcare facility clients, we may be unable to generate newtemporary healthcare professional orders and our business may be adverselyaffected.

 

**Fluctuationsin patient occupancy at our clients’ hospitals and healthcare facilities mayadversely affect the demand for our services and therefore the profitability ofour business.**

 

Demandfor our temporary healthcare staffing services is significantly affected by thegeneral level of patient occupancy at our hospital and healthcare clients’facilities. When occupancy increases, hospitals and other healthcare facilitiesoften add temporary employees before full-time employees are hired. Asoccupancy decreases, hospitals and other healthcare facilities typically reducetheir use of temporary employees before undertaking layoffs of their regularemployees. In addition, we may experience more competitive pricing pressureduring periods of occupancy downturn. Occupancy at our clients’ hospitals andhealthcare facilities also fluctuates due to the seasonality of some electiveprocedures. We are unable to predict the level of patient occupancy at anyparticular time and its effect on our revenues and earnings.

 

**Healthcarereform could negatively impact our business opportunities, revenues andmargins.**

 

TheU.S. government has undertaken efforts to control increasing healthcare coststhrough legislation, regulation and voluntary agreements with medical careproviders and drug companies. In the recent past, the U.S. Congress hasconsidered several comprehensive healthcare reform proposals. The proposalswere generally intended to expand healthcare coverage for the uninsured andreduce the growth of total

 

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healthcareexpenditures. While the U.S. Congress did not adopt any comprehensive reformproposals, members of Congress may raise similar proposals in the future. Ifany of these proposals are approved, hospitals and other healthcare facilitiesmay react by spending less on healthcare staffing, including nurses. If thiswere to occur, we would have fewer business opportunities, which couldseriously harm our business.

 

Stategovernments have also attempted to control increasing healthcare costs. Forexample, the state of Massachusetts has recently implemented a regulation thatlimits the hourly rate payable to temporary nursing agencies for registerednurses, licensed practical nurses and certified nurses’ aides. The state ofMinnesota has also implemented a statute that limits the amount that nursingagencies may charge nursing homes. Other states have also proposed legislationthat would limit the amounts that temporary staffing companies may charge. Anysuch current or proposed laws could seriously harm our business, revenues andmargins.

 

Furthermore,third party payers, such as health maintenance organizations, increasinglychallenge the prices charged for medical care. Failure by hospitals and otherhealthcare facilities to obtain full reimbursement from those third partypayers could reduce the demand or the price paid for our staffing services.

 

**Weoperate in a regulated industry and changes in regulations or violations ofregulations may result in increased costs or sanctions that could reduce ourrevenues and profitability.**

 

Thehealthcare industry is subject to extensive and complex federal and state lawsand regulations related to professional licensure, conduct of operations,payment for services and payment for referrals. If we fail to comply with thelaws and regulations that are directly applicable to our business, we couldsuffer civil and/or criminal penalties or be subject to injunctions or ceaseand desist orders.

 

Ourbusiness is generally not subject to the extensive and complex laws that applyto our hospital and healthcare facility clients, including laws related toMedicare, Medicaid and other federal and state healthcare programs. However,these laws and regulations could indirectly affect the demand or the pricespaid for our services. For example, our hospital and healthcare facilityclients could suffer civil or criminal penalties or be excluded fromparticipating in Medicare, Medicaid and other healthcare programs if they failto comply with the laws and regulations applicable to their businesses. Inaddition, our hospital and healthcare facility clients could receive reducedreimbursements, or be excluded from coverage, because of a change in the ratesor conditions set by federal or state governments. In turn, violations of orchanges to these laws and regulations that adversely affect our hospital andhealthcare facility clients could also adversely affect the prices that theseclients are willing or able to pay for our services.

 

Inaddition, improper actions by our employees and other service providers maysubject us to regulatory and litigation risk.

 

**Competitionfor acquisition opportunities may restrict our future growth by limiting ourability to make acquisitions at reasonable valuations.**

 

Ourbusiness strategy includes increasing our market share and presence in thetemporary healthcare staffing industry through strategic acquisitions ofcompanies that complement or enhance our business. We have historically facedcompetition for acquisitions. In the future, such competition could limit ourability to grow by acquisitions or could raise the prices of acquisitions andmake them less attractive to us.

 

**Significantlegal actions could subject us to substantial uninsured liabilities.**

 

Inrecent years, healthcare providers have become subject to an increasing numberof legal actions alleging malpractice, product liability or related legaltheories. Many of these actions involve large claims and significant defensecosts. In addition, we may be subject to claims related to torts or crimescommitted by our employees or temporary healthcare professionals. In someinstances, we are required to indemnify our clients against some or all ofthese risks. A failure of any of our employees or healthcare professionals toobserve our policies and guidelines intended to reduce these risks, relevantclient policies and guidelines or

 

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applicablefederal, state or local laws, rules and regulations could result in negativepublicity, payment of fines or other damages. Our professional malpracticeliability insurance and general liability insurance coverage may not cover allclaims against us or continue to be available to us at a reasonable cost. If weare unable to maintain adequate insurance coverage or if our insurers denycoverage we may be exposed to substantial liabilities.

 

**We maybe legally liable for damages resulting from our hospital and healthcarefacility clients’ mistreatment of our healthcare personnel.**

 

Becausewe are in the business of placing our temporary healthcare professionals in theworkplaces of other companies, we are subject to possible claims by ourtemporary healthcare professionals alleging discrimination, sexual harassment,negligence and other similar activities by our hospital and healthcare facilityclients. The cost of defending such claims, even if groundless, could besubstantial and the associated negative publicity could adversely affect ourability to attract and retain qualified healthcare professionals in the future.

 

**Executionof our business strategy and growth of our business are substantially dependentupon our ability to attract, develop and retain qualified and skilled sales personnel.**

 

Executionof our business strategy and continued growth of our business are substantiallydependent upon our ability to attract, develop and retain qualified and skilledsales personnel who engage in selling and business development for our services.The available pool of qualified sales personnel candidates is limited. Wecommit substantial resources to the recruitment, training, development andoperational support of our sales personnel. There can be no assurance that wewill be able to recruit, develop and retain qualified sales personnel insufficient numbers or that our sales personnel will achieve productivity levelssufficient to enable growth of our business. Failure to attract and retainproductive sales personnel could adversely affect our business, financialcondition and results of operations.

 

**We havea substantial amount of goodwill and other intangible assets on our balancesheet. Our level of goodwill and other intangible assets may have the effect ofdecreasing our earnings or increasing our losses.**

 

Asof March 31, 2006, we had $24.8 million of goodwill and other unamortizedintangible assets on our balance sheet, which represents the excess of thetotal purchase price of our acquisitions over the fair value of the net assetsacquired. At March 31, 2006, goodwill and other intangible assets represented 79%of our total assets.

 

InJuly 2001, the Financial Accounting Standards Board issued SFAS No. 141, *Business Combinations*, and SFAS No. 142, *Goodwill and Other Intangible Assets*. SFASNo. 141 requires that the purchase method of accounting be used for allbusiness combinations initiated after June 30, 2001, as well as all purchasemethod business combinations completed after June 30, 2001. SFAS No. 142requires that, subsequent to January 1, 2002, goodwill not be amortized butrather that it be reviewed annually for impairment. In the event impairment isidentified, a charge to earnings would be recorded. We have adopted theprovisions of SFAS No. 141 and SFAS No. 142. Although it does not affect ourcash flow, an impairment charge of goodwill to earnings has the effect ofdecreasing our earnings or increasing our losses, as the case may be. If we arerequired to write down a substantial amount of goodwill, our stock price couldbe adversely affected.

 

**Demandfor medical staffing services is significantly affected by the general level ofeconomic activity and unemployment in the United States.**

 

Wheneconomic activity increases, temporary employees are often added beforefull-time employees are hired. However, as economic activity slows, manycompanies, including our hospital and healthcare facility clients, reduce theiruse of temporary employees before laying off full-time employees. In addition,we may experience more competitive pricing pressure during periods of economicdownturn. Therefore,

 

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anysignificant economic downturn could have a material adverse impact on ourfinancial position and results of operations.

 

**Item 3.    Controls and Procedures**

 

We maintain disclosure controls and proceduresthat are designed to ensure that information required to be disclosed in ourExchange Act reports is recorded, processed, summarized and reported within thetime periods specified in the SEC’s rules and forms and that such informationis accumulated and communicated to our management including our Chief ExecutiveOfficer and Chief Financial Officer, as appropriate, to allow for timelydecisions regarding required disclosure. In designing and evaluating thedisclosure controls and procedures, management recognizes that any controls andprocedures, no matter how well designed and operated can provide onlyreasonable assurance of achieving the desired control objectives and managementis required to apply its judgment in evaluating the cost-benefit relationshipof possible controls and procedures.

 

As required by Rule 13a-15(b) under the ExchangeAct, we conducted an evaluation under the supervision and with theparticipation of our management, including our Chief Executive Officer and ourChief Financial Officer, of the effectiveness of the design and operation ofour disclosure controls and procedures as of the end of the period covered bythis report. Based upon the foregoing evaluation, our principal executiveofficer and our principal financial officer concluded that our disclosurecontrols and procedures were effective at the reasonable assurance level as ofthe end of the fiscal period covered by this report.

 

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**PART II – OTHERINFORMATION**

 

**Item 1.    Legal Proceedings**

 

OnJanuary 27, 2006, we filed suit against the sellers of TravMed USA, Inc.asserting claims for breach of non-competition/solicitation agreements, breachof fiduciary duty, tortious interference with existing and prospectivecontracts and business relations, and declaratory relief arising out of theacquisition agreement. The Company is seeking damages related to the aboveclaims.

 

OnJanuary 31, 2006, the Company filed suit against the sellers of Arizona HomeHealth/Private Duty, Inc. asserting claims for fraud, indemnity, anddeclaratory relief arising out of the acquisition agreement. On February 23,2006, the sellers filed a counter suit.

 

Fromtime to time, we may become involved in various lawsuits and legal proceedingswhich arise in the ordinary course of business. However, litigation is subjectto inherent uncertainties, and an adverse result in these or other matters mayarise from time to time that may harm our business. We are not currently awareof any such legal proceedings or claims that we believe will have, individuallyor in the aggregate, a material adverse affect on our business, financialcondition or operating results.

 

**Item 2.    Unregistered Sales of Equity Securities andUse of Proceeds**

 

SinceJanuary 1, 2006, the Company has issued and sold the following unregisteredsecurities:

 

•                  On January 6, 2006, the Company issued toinvestors $2,000,000 aggregate principal amount of 8% Convertible SubordinatedDebentures, Short Term Warrants to purchase an aggregate of 333,333 shares ofcommon stock and Long Term Warrants to purchase an aggregate total of 166,666shares of common stock.

 

•                  On January 24, 2006, the Company issued125,000 shares of common stock to MedCap Partners LP for cash proceeds of$750,000.

 

•                  On March 3, 2006, the Company issued 25,000shares of common stock to MedCap Partners LP for cash proceeds of $200,000.

 

•                  On March 13, 2006, the Company issued 25,000shares of common stock to MedCap Partners LP and MedCap Master Fund L.P forcash proceeds of $200,000.

 

•                  On March 24, 2006, the Company issued 150,000shares of restricted common stock to its Chairman and Chief Executive Officer.

 

•                  On April 3, 2006 the Company issued 58,333shares of common stock to MedCap Partners LP for cash proceeds of $350,000

 

•                  On April 4, 2006 the Company issued10,257,131 shares of common stock to accredited investors, including MedCapPartners LP and James D. Durham, in exchange for all outstanding shares of theCompany’s Series C convertible Preferred stock and warrants to purchase SeriesC Convertible Preferred Stock and Series B-1 Convertible Preferred Stock.

 

•                  On April 18, 2006 the Company issued 229,128shares of common stock in connection with its acquisition of Staff Search Ltd.

 

Theissuances of the securities were made pursuant to an exemption fromregistration provided by the Securities Act of 1933, as amended.

 

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**Item 3.    Defaults Upon Senior Securities**

 

Thedisclosure set forth in Notes 5, 6, 7 and 8 to Crdentia Corp.’s UnauditedCondensed Consolidated Financial Statements dated March 31, 2006 included inItem 1 of Part I of this Quarterly Report, to the extent applicable, isincorporated herein by reference.

 

**Item 4.    Submission of Matters to a Vote of SecurityHolders**

 

None

 

**Item 5.    Other Information**

 

None

 

**Item 6.    Exhibits**

 

(a)                                  Exhibits

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                             |
|----------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1                  |       | Asset  Purchase Agreement dated April 10, 2006 by and among Crdentia Corp., CRDE  Corp., Staff Search Acquisition Corp., Staff Search, Ltd., SSL GP, LCC and  J.W. Iden.                    |
|                 |       |                                                                                                                                                                                        |
| 2.2                  |       | First  Amendment to Asset Purchase Agreement dated April 18, 2006 by and among  Crdentia Corp., CRDE Corp., Staff Search Acquisition Corp., Staff Search,  Ltd., SSL GP, LCC and J.W. Iden. |
|                 |       |                                                                                                                                                                                        |
| 3.1(2)               |       | Restated  Certificate of Incorporation.                                                                                                                                                     |
|                 |       |                                                                                                                                                                                        |
| 3.2(3)               |       | Certificate  of Amendment to Restated Certificate of Incorporation.                                                                                                                         |
|                 |       |                                                                                                                                                                                        |
| 3.3(4)               |       | Certificate  of Amendment to Restated Certificate of Incorporation.                                                                                                                         |
|                 |       |                                                                                                                                                                                        |
| 3.4(4)               |       | Certificate  of Correction of Certificate of Amendment to Restated Certificate of  Incorporation.                                                                                           |
|                 |       |                                                                                                                                                                                        |
| 3.5(4)               |       | Certificate  of Correction of Certificate of Amendment to Restated Certificate of  Incorporation.                                                                                           |
|                 |       |                                                                                                                                                                                        |
| 3.6(2)               |       | Restated  Bylaws.                                                                                                                                                                           |
|                 |       |                                                                                                                                                                                        |
| 3.7(5)               |       | Certificate  of Designations, Preferences and Rights of Series A Preferred Stock of  Crdentia Corp.                                                                                    |
|                 |       |                                                                                                                                                                                        |
| 3.8(6)               |       | Certificate  of Amendment of Certificate of Designations, Preferences and Rights of  Series A Preferred Stock of Crdentia Corp.                                                        |
|                 |       |                                                                                                                                                                                        |
| 3.9(7)               |       | Certificate  of Designations, Preferences and Rights of Series B Preferred Stock of  Crdentia Corp.                                                                                    |
|                 |       |                                                                                                                                                                                        |
| 3.10(8)              |       | Certificate  of Correction of Certificate of Designations, Preferences and Rights of  Series B Preferred Stock of Crdentia Corp.                                                       |
|                 |       |                                                                                                                                                                                        |
| 3.77(9)              |       | Certificate  of Designations, Preferences and Rights of Series B-1 Preferred Stock of  Crdentia Corp.                                                                                  |

 

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| 3.12(10)  |   | Certificate  of Correction of Certificate of Designations, Preferences and Rights of  Series B-1 Preferred Stock of Crdentia Corp.                                                                  |
|-----------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|      |   |                                                                                                                                                                                                     |
| 3.13(11)  |   | Certificate  of Designations, Preferences and Rights of Series C Preferred Stock of  Crdentia Corp.                                                                                                 |
|      |   |                                                                                                                                                                                                     |
| 3.14(10)  |   | Certificate  of Correction of Certificate of Designations, Preferences and Rights of  Series C Preferred Stock of Crdentia Corp.                                                                    |
| 3.15(12)  |   | Certificate  of Amendment to Amended and Restated Certificate of Incorporation of Crdentia  Corp.                                                                                                        |
|      |   |                                                                                                                                                                                                     |
| 3.16(14)  |   | Certificate of Amendment to Restated  Certificate of Incorporation.                                                                                                                                      |
|      |   |                                                                                                                                                                                                     |
| 3.17(14)  |   | Certificate of Correction of Certificate of  Amendment to Restated Certificate of Incorporation.                                                                                                         |
|      |   |                                                                                                                                                                                                     |
| 3.17(14)  |   | Certificate of Correction of Certificate of  Amendment to Restated Certificate of Incorporation.                                                                                                         |
|      |   |                                                                                                                                                                                                     |
| 3.18(13)  |   | Certificate  of Amendment of Certificate of Designations, Preferences and Rights of  Series C Preferred Stock of Crdentia Corp.                                                                     |
|      |   |                                                                                                                                                                                                     |
| 10.63(16) |   | Securities Purchase Agreement by and among the  Company and the investors identified on the signature pages thereto, dated as  of January 6, 2006.                                                  |
|      |   |                                                                                                                                                                                                     |
| 10.64(16) |   | Form of Convertible Debenture by and among the  Company and the investors identified on the signature pages thereto, dated as  of January 6, 2006.                                                       |
|      |   |                                                                                                                                                                                                     |
| 10.65(16) |   | Form of Long-Term Stock Purchase Warrant by  and among the Company and the investors identified on the signature pages  thereto, dated as of January 6, 2006.                                            |
|      |   |                                                                                                                                                                                                     |
| 10.66(16) |   | Form of Short-Term Stock Purchase Warrant by  and among the Company and the investors identified on the signature pages  thereto.                                                                        |
|      |   |                                                                                                                                                                                                     |
| 10.67(16) |   | Form of Registration Rights Agreement by and  among the Company and the investors identified on the signature pages  thereto, dated as of January 6, 2006.                                               |
|      |   |                                                                                                                                                                                                     |
| 10.68(17) |   | Separation Agreement by and between Crdentia  Corp. and Pamela Atherton, dated January 7, 2006.                                                                                                     |
|      |   |                                                                                                                                                                                                     |
| 10.69(17) |   | General Release of Claims by and between  Crdentia Corp. and Pamela Atherton, dated January 7, 2006.                                                                                                |
|      |   |                                                                                                                                                                                                     |
| 10.70(17) |   | Settlement Agreement, dated January 9,  2006, by and among Crdentia Corp., Nick Liuzza, Sr., Nick Liuzza, Jr.,  Christopher Liuzza and certain other former shareholders of New Age Staffing,  Inc. |
|      |   |                                                                                                                                                                                                     |
| 10.72(15) |   | Promissory  Note Issued by Crdentia to Staff Search Ltd.                                                                                                                                                 |
|      |   |                                                                                                                                                                                                     |
| 10.73     |   | Notice  of Restricted Stock Bonus Award and Restricted Stock Bonus Award Agreement  dated March 24, 2006 by and between Crdentia Corp. and James D. Durham.                                              |
|      |   |                                                                                                                                                                                                     |
| 10.74     |   | Notice  of Stock Option Award and Stock Option Award Agreement dated March 24, 2006  by and between Crdentia Corp. and James T. TerBeest.                                                                |

 

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| 31.1   |   | Certification  of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002. |
|--------|--------|------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                       |
| 31.2   |   | Certification  of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002. |
|   |   |                                                                                                       |
| 32.1   |   | Certification  of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley  act of 2002. |
|   |   |                                                                                                       |
| 32.2   |   | Certification  of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley  act of 2002. |

 

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| (2)  |   | Filed  with a Current Report on Form 8-K dated August 22, 2002.                                                                      |
|------|--------|------------------------------------------------------------------------------------------------------------------------------------------------|
| (3)  |   | Filed  with a Quarterly Report on Form 10-QSB dated August 12, 2003.                                                                 |
| (4)  |   | Filed  with an amended Current Report on Form 8-K/A dated June 28, 2004.                                                             |
| (5)  |   | Filed  with a Current Report on Form 8-K dated December 30, 2003.                                                                    |
| (6)  |   | Filed  with a Current Report on Form 8-K dated February 20, 2004.                                                                    |
| (7)  |   | Filed  with a Current Report on Form 8-K dated June 22, 2004.                                                                        |
| (8)  |   | Filed  with an amended Current Report on Form 8-K/A dated October 10,  2004.                                                         |
| (9)  |   | Filed  with a Current Report on Form 8-K dated August 24, 2004.                                                                      |
| (10) |   | Filed  with an amended Current Report on Form 8-K/A dated October 10,  2004.                                                         |
| (11) |   | Filed  with a Current Report on Form 8-K dated September 7, 2004.                                                                    |
| (12) |   | Filed  with a Current Report on Form 8-K dated January 1, 2005.                                                                      |
| (13) |   | Filed  with a Current Report on Form 8-K dated March 21, 2005.                                                                       |
| (14) |   | Filed on Post-Effective Amendment No. 1 to Registration  Statement on Form SB-2 with the Securities and Exchange Commission on April  4, 2006. |
| (15) |   | Filed with a Current Report on Form 8-K  dated April 18, 2006.                                                                            |
| (16) |   | Previously  filed on Form 8-K with the Securities and Exchange Commission on January 10,  2006 and incorporated herein by reference.      |
| (17) |   | Previously  filed on Form 8-K with the Securities and Exchange Commission on  January 12, 2006 and incorporated herein by reference.      |

 

37

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**SIGNATURES**

 

Pursuantto the requirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the Registrant has duly caused this Report to be signed on its behalf bythe undersigned, thereunto duly authorized.

 
|                 |   |    CRDENTIA  CORP. |
|----------------------|--------|-----------------------------------|
|                 |   |                              |
| Dated:  May 15, 2006 | By:    | /s/  James D. Durham              |   |
|                 |   |                              | James  D. Durham |
|                 |   |                              | Chief  Executive Officer and |
|                 |   |                              | Chairman  of the Board |
|                 |   |                              | (Principal  Executive Officer) |
|                 |   |                              |
|                 |   |                              |
| Dated:  May 15, 2006 | By:    | /s/  James J. TerBeest            |   |
|                 |   |                              | James J. TerBeest |
|                 |   |                              | Chief Financial Officer |
|                 |   |                              | (Principal Financial Officer) |
|                      |        |                                   |  |  |

 

38

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