**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-K**

(Mark One)

**x**                                ANNUAL REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**Forthe fiscal year ended December 31, 2006**

**OR**

**o**                                   TRANSITION REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**Forthe transition period from                to                **

**CommissionFile Number**001-33191

**MEDecision, Inc.**

(Exact Name of Registrant as Specified in Its Charter)

| Pennsylvania                             |   | 23-2530889          |
|------------------------------------------|--------|---------------------|
| (State or Other Jurisdiction of          |   | (I.R.S. Employer    |
| Incorporation or Organization)           |   | Identification No.) |
| 601 Lee Road                             |   |                |
| Chesterbrook Corporate Center            |   |                |
| Wayne, Pennsylvania                      |   | 19087               |
| (Address of Principal Executive Offices) |   | (Zip Code)          |

 

Registrant’s telephone number, including area code:(610) 540-0202

Securities registered pursuant to Section 12(b) ofthe Exchange Act:

|                        | **Title of each class** | ** **                   |   | ** ** | **Name of each exchange on which registered** | ** ** |
|------------------------|-------------------------|------------------------------|--------|------------|-----------------------------------------------|------------|
| Common Stock,          |                    | The NASDAQ Stock Market  LLC |
| no par value per share |                    |                         |

 

Securities registeredpursuant to Section 12(g) of the Exchange Act:

|                | **Title of each class** | ** **     |   | ** ** | **Name of each exchange on which registered** | ** ** |
|----------------|-------------------------|----------------|--------|------------|-----------------------------------------------|------------|
| Not applicable |                    | Not applicable |

 

Indicate by check mark if the registrant is awell-known seasoned issuer, as defined in Rule 405 of the Securities Act.Yes o  No x

Indicate by check mark if the registrant is notrequired to file reports pursuant to Section 13 or Section 15(d) ofthe Act. Yes o  No x

Indicate by check mark whether the registrant: (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days. Yes x  No o

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, and willnot be contained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K:  x

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filed, or anon-accelerated filer. See definition of “accelerated filed and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

| Large accelerated filer o |   | Accelerated filer o |   | Non-accelerated  filer x |
|---------------------------|--------|---------------------|--------|--------------------------|

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act). Yes o  No x

As of March 27, 2007, 15,247,638 shares of theregistrant’s common stock, no par value per share, were outstanding. As of suchdate, the aggregate market value of the voting stock held by non-affiliates ofthe registrant was approximately $44,053,000. Such aggregate market value wascomputed by reference to the closing price of the common stock as reported onthe NASDAQ Global Market on March 27, 2007. For purposes of determiningthis amount only, the registrant has defined affiliates as including theexecutive officers and directors of the registrant on March 27, 2007.

**DOCUMENTSINCORPORATED BY REFERENCE**

|                                      | **Document** | ** **    |   | ** ** | **Form 10-K Reference** | ** ** |
|--------------------------------------|--------------|---------------|--------|------------|------------------------------|------------|
| Portions of Proxy Statement for      |         | Part III |
| 2007  Annual Meeting of Shareholders |         |          |

 

 

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**TABLEOF CONTENTS**

|               | ** ** | ** **                                                                                                          | ** ** | **Page** | ** ** |
|---------------|------------|---------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| PART I   |       | 1                                                                                                                   |       |
| Item  1.      |       | Business                                                                                                            |       | 1        |       |
| Item  1A.     |       | Risk Factors                                                                                                        |       | 16       |       |
| Item 1B.      |       | Unresolved Staff  Comments                                                                                          |       | 32       |       |
| Item  2.      |       | Properties                                                                                                          |       | 32       |       |
| Item 3.       |       | Legal Proceedings                                                                                                   |       | 32       |       |
| Item 4.       |       | Submission of  Matters to a Vote of Security Holders                                                                |       | 32       |       |
| PART II  |       | 33                                                                                                                  |       |
| Item 5.       |       | Market for  Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases  of Equity Securities |       | 33       |       |
| Item 6.       |       | Selected Financial  Data                                                                                            |       | 38       |       |
| Item 7.       |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                         |       | 39       |       |
| Item 7A.      |       | Quantitative  and Qualitative Disclosures about Market Risk                                                         |       | 69       |       |
| Item 8.       |       | Financial  Statements and Supplementary Data                                                                        |       | 70       |       |
| Item 9.       |       | Changes In and Disagreements with Accountants on  Accounting and Financial Disclosure                               |       | 102      |       |
| Item 9A.      |       | Controls and Procedures                                                                                             |       | 106      |       |
| Item  9B.     |       | Other  Information                                                                                                  |       | 106      |       |
| PART III |       | 107                                                                                                                 |       |
| Item 10.      |       | Directors, Executive Officers and Corporate Governance  of the Registrant                                           |       | 107      |       |
| Item 11.      |       | Executive Compensation                                                                                              |       | 107      |       |
| Item 12.      |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters                     |       | 107      |       |
| Item 13.      |       | Certain Relationships and Related Transactions, and  Director Independence                                          |       | 107      |       |
| Item 14.      |       | Principal Accountant Fees and Services                                                                              |       | 107      |       |
| PART IV  |       | 108                                                                                                                 |       |
| Item 15.      |       | Exhibits and Financial Statement Schedules                                                                          |       | 108      |       |

 

*This Annual Reporton Form 10-K, including the sections labeled Management’s Discussionand Analysis of Financial Condition and Results of Operations, containsforward-looking statements that you should read in conjunction with thefinancial statements and notes to financial statements that we have includedelsewhere in this Annual Report on Form 10-K. These statements arebased on our current expectations, assumptions, estimates and projections aboutour business and our industry, and involve known and unknown risks,uncertainties, and other factors that may cause our or our industry’s results,levels of activity, performance or achievements to be materially different fromany future results, levels of activity, performance or achievements expressedor implied in, or contemplated by, the forward-looking statements. We generallyidentify these statements by words or phases such as “believe,” “anticipate,” “expect,”“intend,” “plan,” “will,” “may,” “should,” “estimate,” “predict,” “potential,” “continue,”or the negative of such terms or other similar expressions. Our actual resultsand the timing of events may differ significantly from the results discussed inthe forward-looking statements, and you should not place undue reliance onthese statements. Factors that might cause such a difference include thosediscussed below under the heading “Risk Factors,” as well as those discussedelsewhere in this Annual Report on Form 10-K. We disclaim any intentor obligation to update any forward-looking statements as a result ofdevelopments occurring after the period covered by this report or otherwise.*

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**PART I**

**Item 1.**                        Business.

**Company Overview**

MEDecision, Inc., which was incorporated in October1988 under the laws of Pennsylvania, is referred to throughout this report as“MEDecision,” the “Company,” the “registrant,” “we,” “us,” or through similarexpressions. These terms are used on the basis of consolidation described innote 1 to the consolidated financial statements that are set forth in Part II,Item 8 of this 10-K Report.

We are a provider of software, services and clinicalcontent to healthcare payers that allow them to improve the quality andaffordability of healthcare provided to their members and increase theiradministrative efficiency. Our Collaborative Care Management suite analyzesdata, automates payer workflow processes and electronically connects payers,providers and patients, providing them with a common view of the patient’shealth that helps to foster better clinical decision making. Our solution isbuilt around a suite of modular and easily configurable software applicationsand utilizes the Internet to link our payer customers to their members andtheir members’ chosen healthcare providers.

In order to streamline our product positioning andmore clearly represent product functionalities, we renamed and reorganized ourproduct offerings during the first quarter of 2007. As a result, the IntegratedMedical Management and Collaborative Data Exchange product suites were combinedto be a part of our Collaborative Care Management suite umbrella. The name ofour Analytics and Disease Management product was changed to Data Gathering andAnalytics, while our Transactions and Information Exchange product was renamedCollaborative Data Exchange.

Our Collaborative Care Management suite is comprisedof four related product modules—(i) Data Gathering and Analytics; (ii) ClinicalRules and Processes; (iii) Advanced Medical Management; and (iv) CollaborativeData Exchange. Data Gathering and Analytics is a data engine with an analyticscomponent that enables a payer to process, summarize and evaluate informationfrom both internal and external sources. Clinical Rules and Processes is aclinical content and process management solution featuring embedded,state-of-the-art clinical best practices that have been validated byevidence-based medicine. Advanced Medical Management is a care managementsolution consisting of workflow and detection tools that address the continuumof care management processes, such as specialized case and disease management,admission and outpatient certification, referral management, concurrent reviewand discharge planning. Collaborative Data Exchange is a communication servicethat facilitates the mutual transmission of information between the variousstakeholders in the healthcare process. Collaborative Data Exchange addresses theentire spectrum of clinical data exchange: from basic service requests(referrals, authorizations and extensions) to simple clinical informationtransfer (questionnaire fulfillment) to complex electronic health record-basedtransactions. The Collaborative Data Exchange module allows our customers tosecurely transmit health records containing critical patient information in aneasily understood format to patients and providers at the time they are makingtreatment decisions. We refer to these health records as Patient ClinicalSummaries, and believe that they are a critical first step to developingElectronic Health Records. In the future, we expect our Patient ClinicalSummaries to integrate additional information provided by patients and a broadrange of providers, thereby increasing their value to all constituents.

As of December 31,2006, our customers included approximately 56 regional and national managedcare organizations, including the largest organizations in more than 27regional markets. Based on our review of publicly available information and ourcustomers’ enrollment data, we believe that, in the aggregate, our customersinsure or manage care for approximately one out of every six insured persons inthe United States. Depending on the application, we provide our solutions on anannual subscription basis, on a per-transaction basis or under limited termlicenses, all of which provide us with recurring revenue. 

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Weprimarily license our solutions through direct sales to customers in the UnitedStates. Our revenue has increased at a compound annual growth rate of 28.1%since 2002, to $44.2 million for the year ended December 31, 2006, from$16.4 million for the year ended December 31, 2002.

**Our Initial PublicOffering**

On December 18, 2006,we completed our initial public offering in which we and certain sellingshareholders sold an aggregate of 4,700,000 shares of our common stock at aprice to the public of $10.00 per share. The net proceeds to us from the saleof 3,300,000 of those shares were approximately $26.4 million after deductingunderwriting commissions and offering expenses. We have used approximately $9.5million of the net proceeds to pay the accrued and unpaid cash dividends to theformer holders of our Series B and Series C preferred stock whoseshares automatically converted into common stock upon the consummation of theinitial public offering and approximately $0.6 million of the net proceeds torepay the balance outstanding on our working capital credit facility prior tothe initial public offering. We intend to use the balance of the net proceedsfrom our initial public offering for general corporate purposes includingworking capital needs.

**Industry Overview**

The Centers for Medicare & Medicaid Services,or CMS, projected that more than $2.0 trillion was spent on healthcare in 2005,representing 16% of U.S. Gross Domestic Product, or GDP. CMS estimates thatspending will grow to $4.0 trillion by 2015, or 20% of GDP, representing 7.2%annual growth since 2004. Healthcare costs are increasing in part due toimprovements in medical technology and medical treatments, but also because ofincreases in general utilization of healthcare products and services. Risinghealthcare costs negatively impact a wide array of constituencies, including federaland state governments, employers, consumers and healthcare providers. However,we believe that the broad array of healthcare payers is the most directlyimpacted. Payers include federal and state government programs like Medicare,Medicaid and public employee health benefit plans, large commercial insurersand numerous other national, regional and local health plans and administratorsand self-insured corporations. Rising healthcare costs consistently threaten tonegatively impact these payers.

We believe that payershave two options if they are to maintain their viability. First, payers canproactively manage the delivery of healthcare services and products to theirmembers to improve the quality and cost of care. Second, they can offset risinghealthcare costs by reducing their internal administrative costs throughefficiency gains. To the extent they are not successful at proactively managingcare more effectively and reducing their internal administrative costs, payersmust pass the rising cost of healthcare on to their customers and their members.Passing on these costs ultimately threatens the payers’ relationships withtheir customers and/or members as enterprises and consumers also seek to lowertheir healthcare-related expenditures. Accordingly, payers are consistentlyseeking new strategies to more effectively manage the care delivery process fortheir members and reduce their internal operating costs. Based on our research,we believe that the market for care management solutions is currently in excessof $1 billion per year and is growing at a compound annual growth rate inexcess of 15.8%.

***Overuse, underuse and misuse of medical services andtreatments is widespread.***

We believe that one of the material contributors torising healthcare costs is overuse, underuse and misuse of medical services andtreatments caused by providers lacking timely access to necessary patientinformation and providers consistently failing to apply clinical bestpractices, which we refer to as poor-quality care. We believe that thiscombination has led to avoidable medical errors, injuries and fatalities. Forexample, The Institute of Medicine reported in November 1999 that as manyas 98,000 people die in hospitals each year as a result of preventable medicalerrors. Additionally, an article in the *WallStreet Journal* dated May 23, 2006 reported that the Institutefor Healthcare Improvement found that poor 

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communication isresponsible for as many as 50% of all medication errors and up to 20% ofadverse drug events in hospitals.

*Providers Generally LackNecessary Patient Information.*   We believe that a primary contributor to medicalerrors is generally the lack of information exchange among different providerstreating the same patients. Generally, providers have access to only thepatient information contained in their own files and systems. For providersseeing a patient for the first time, the information is often limited toinformation provided by the patient, which is generally rudimentary, incompleteor inaccurate. We believe that this issue is particularly acute in emergencyroom situations where physicians need to make quick decisions about how totreat a patient, and generally lack the critical information that they need toprovide the patient with optimal care. We believe that this absence of completepatient information has a negative impact on the quality and cost of care bycausing providers to misdiagnose medical conditions, prescribe medications thatnegatively interact with each other, and order duplicative or medicallyunnecessary tests and procedures.

In an effort to address this critical roadblock toimproving quality of care, in 2004 President Bush appointed a NationalCoordinator for Health Information Technology to develop a strategy for anational health information infrastructure. Largely as a consequence, webelieve that electronic health information networks are gaining popularity as apotential means for fostering the exchange of healthcare data by linkingpayers, providers and patients to the same network. Both the Nationwide HealthInformation Network and its regional counterparts, the Regional Health InformationOrganizations, depend on the existence of Electronic Health Records, or EHRs,for their success. EHRs are intended to provide a comprehensive view of apatient’s health status and care history compiled from an individual patient’sinformation across the healthcare system. We believe that EHRs will eventuallyconsolidate information supplied by payers (Payer Based Health Records), providers(Electronic Medical Records, or EMRs) and patients (Personal Health Records, or PHRs).

However, an impediment to creating EHRs in the nearterm is the relative scarcity of detailed electronic patient data. According toa U.S. Department of Health and Human Services study published by the Centersfor Disease Control in March 2005, only 17% of physicians were utilizingEMR systems in their practices in 2003, and under a third of hospitals wereutilizing EMRs in 2002. In terms of patient-supplied data, we believe that PHRsare in their infancy. Based on our analysis of industry reports and ourcustomers’ experience with Internet applications they provide to their members,we believe that fewer than 1% of the population of the United States hascreated and maintains an electronic PHR for themselves and/or their families.As a result, we believe that today’s only reliable source of comprehensivepatient data comes from payers, which have vast amounts of member datacontained in their legacy claims processing and care management systems.

*Clinical Best Practices AreNot Universally Applied by Providers.*   Even whenphysicians have a reasonably complete picture of a patient’s status, physiciansoften do not have all of the medical information that would help them treat thepatient, thereby putting the patient’s health at unnecessary risk. A wide arrayof medical organizations, such as the American Medical Association, AmericanDiabetes Association and American Heart Association, consistently updateclinical best practices for treatment of medical conditions and chronicdiseases. Although providers have access to this information, based on a RANDstudy published in the New England Journal of Medicine in June 2003, webelieve that clinical best practices are not employed approximately 45% of thetime. Failure to apply clinical best practices can raise healthcare costs bydecreasing the quality and cost effectiveness of the treatment. We believe thatthese failures occur for a variety of reasons, including provider inability tokeep up with clinical best practices due to the volume of medical conditionsand diseases and the frequency with which clinical best practices change.

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Given the magnitude of the challenges facing thehealthcare system, the need for payers to respond to rapid increases in medicalcosts, and the capital requirements for information systems to address thechallenges, we believe that payers are the logical drivers of change. Payers,however, face their own challenges.

***Payers generally lack systems to effectively andefficiently address poor-quality care.***

Due to their role in the healthcare system, payers areuniquely positioned to identify poor-quality care and have an interest inimproving outcomes for their members to reduce the cost of care. As thefinancial intermediary between the provider and patient, payers have theopportunity to monitor the care provided to their members through active caremanagement programs. Payers have a large volume of patient information inelectronic format contained in their legacy claims processing and caremanagement systems. However, we believe that payers generally lack theinformation technology systems to play these roles effectively and efficiently.Based on our experience, we believe that payers generally rely on a combinationof manual processes, third-party point solutions and proprietary systems formany components of the care management process. As a result, we believe thatthese processes generally suffer from the following critical weaknesses:

*Payers Cannot Effectivelyand Efficiently Identify High-Risk Patients.*   In order forpayers to identify poor-quality care, they must monitor the care provided totheir members. Payers widely rely on manual processes, third-party providers ortheir own proprietary systems with limited functionality and scalability toidentify high-risk members. The administrative cost of using clinical staff toclosely monitor every member is prohibitively expensive and materiallyoutweighs the financial benefits. For payers to have a positive influence onquality and cost of care at an acceptable administrative cost, we believe thatthey must have the technology to identify members with a high risk ofsubstantial healthcare costs, including members with chronic diseases such asdiabetes, or severe medical conditions such as breast cancer. While identifyingpatients whose historical costs have been high is relatively easy, the challengeis to identify those patients who will incur high costs in the next 12 to 18months. We believe that less than 20% of payers’ most seriously ill members areresponsible for a majority of the payers’ healthcare costs.

*Payers Lack Information Systems to Optimally Manage Member Care.*   Payers employteams of doctors and nurses—who are in short supply and highly compensated—tomonitor the care provided to high-risk members and often intervene wherenecessary. These professionals review each patient’s treatment plan againstclinical best practices and intervene with the treating provider and patient tothe extent poor-quality care exists. This process is referred to as caremanagement. In our experience, these care management professionals lackcomprehensive information technology systems to support their workflowprocesses. Furthermore, they often rely on manual, ad-hoc processes tointerject clinical best practices into their workflow. As a result, we believethat the traditional care management process suffers from the followingweaknesses:

·       caremanagers fail to consistently identify poor-quality care;

·       caremanagers’ intervention processes have a high risk of manual error;

·       caremanagers cannot consistently apply the most recent clinical best practices;

·       payersfail to capture and analyze valuable historical data; and

·       payerscan only apply care management to the most obvious, highest cost members.

*Payers Lack Systems Necessary to Share Critical Patient InformationInternally and With Providers.*   We believe that payers have the most comprehensivebase of patient information in electronic format. Their legacy claims and caremanagement systems contain basic member identification information as well asraw data on the member’s historical medical conditions, inpatient facilityadmissions, emergency room visits, tests and procedures, medications andproviders. This information, once processed and validated, can be 

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*utilizedthroughout a payer’s organization to help to improve the quality of care.However, this generally does not occur, because many payers’ legacy systems arenot integrated with other systems. Therefore, data housed in one system cannotbe leveraged by other functional departments without direct access to thatsystem. The information contained in payers’ legacy systems can be even morevaluable at the point of care. For example, we believe that this basicinformation would increase an emergency room doctor’s ability to provide highquality care when presented with an unconscious patient. However, in order forthis information to positively influence care decisions, providers must haveon-demand access to this information in an easily understood format. To date,payers have lacked the systems necessary to automatically assemble the data,review the data for inconsistencies, analyze and summarize the data anddisseminate the data internally and to providers in real time.*

**Benefits of OurSolutions**

Our Collaborative Care Management suite is comprisedof four related product modules—(i) Data Gathering and Analytics; (ii) ClinicalRules and Processes; (iii) Advanced Medical Management; and (iv) CollaborativeData Exchange. Data Gathering and Analytics is a data engine with an analyticscomponent that enables a payer to process, summarize and evaluate informationfrom both internal and external sources. Clinical Rules and Processes is aclinical content and process management solution featuring embedded,state-of-the-art clinical best practices that have been validated byevidence-based medicine. Advanced Medical Management is a care managementsolution consisting of workflow and detection tools that address the continuumof care management processes, such as specialized case and disease management,admission and outpatient certification, referral management, concurrent reviewand discharge planning. Collaborative Data Exchange is a communication servicethat facilitates the mutual transmission of information between the variousstakeholders in the healthcare process. Collaborative Data Exchange addressesthe entire spectrum of clinical data exchange: from basic service requests(referrals, authorizations and extensions) to simple clinical informationtransfer (questionnaire fulfillment), to complex electronic health record-basedtransactions. We believe that these solutions promote collaborative health caremanagement where all healthcare stakeholders—the payer, the provider and thepatient—participate in helping to obtain the best outcome at the best cost.

We believe oursolutions allow our payer customers to improve the quality of care and reducecosts by enabling payers to:

·       **Identify high-risk members.**   Oursolutions automatically organize the data contained in our customers’ legacyclaims processing and care management systems and apply proprietary algorithmsto that data to classify their members based on their risk of incurringmaterial medical costs. We believe that these solutions increase theeffectiveness of our customers’ care management programs by more accurately andefficiently identifying members that would benefit from active disease or casemanagement, thereby helping to improve the quality and reduce the cost of care.

·       **Promote consistency and reduce manual errors andadministrative costs through automation.**   Our solutionsautomate the workflow process for utilization management, case management anddisease management. With respect to utilization management, our solutionsautomate workflow processes to enable our customers to adjudicate approximately85% of providers’ healthcare authorization requests without manual interventionand guide utilization management specialists through the workflow process forthe remaining, more complex cases. By doing so, these solutions allow ourcustomers’ specialists to handle more cases and focus on more complexvalue-added tasks, thereby reducing administrative costs. With respect to casemanagement and disease management, our solutions guide care managementspecialists through a systematic intervention process specifically tailored tothe member’s medical condition or disease based on clinical best practices andour customers’ internal rules and guidelines. By doing so, we believe oursolutions promote 

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consistent utilization andcare management processes that are less prone to manual error, thereby helpingto improve the quality and reduce the cost of care.

·       **Promote the consistent application of clinical bestpractices.**   Our solutions enable care management professionalsto apply clinical best practices and best processes when adjudicating themedical appropriateness of requested services, evaluating treatment plans andcreating intervention plans. Accordingly, adjudications are more accurate,while care management intervention plans are more consistently based onclinical best practices helping to improve the quality of care and to reducethe cost of care.

·       **Utilize analytics to improve processes.**   Thereporting tools contained in our solutions allow our customers to analyzehistorical results to determine which care management interventions weregenerally the most effective in improving the quality of care and costefficiency. These tools allow our customers to continually refine and improvetheir internal care management rules and guidelines.

·       **Enable enhanced information access.**   Our solutionsestablish a single source of clinical information that supports integrationwith our customers’ other operational systems to ensure that care managers haveaccess to the most current information. By providing access to all relevantdata, we allow more effective care management programs. Our solutions alsoallow patients and providers to obtain a Patient Clinical Summary, whichincludes patient demographic information, medical conditions, providers andtreatment opportunities in an on-demand, easy to use format. By providing thiscritical patient information to patients and providers in an easily understoodformat in real time, we believe that we improve the quality and reduce the costof care. For example, in a study dated July 24, 2006 that we commissionedto be conducted on our behalf by HealthCore, Inc., a data analysis companyowned by Wellpoint, the sharing of Patient Clinical Summaries by BlueCrossBlueShield of Delaware with the staff at the emergency department forChristiana Care Health System greatly reduced the cost of care for patientsseen in the emergency room. The study compared the costs of services deliveredin the emergency department, and for those patients admitted to the hospitalduring their first day of hospitalization. HealthCore included data on 918emergency room visits where Patient Clinical Summaries were retrieved and 3,590matched “control” visits where no Patient Clinical Summaries were used. The conclusionwas that overall costs paid by the health plan and the patient dropped by anaverage of approximately $545 per emergency department visit, or 19.7% of theaverage cost of the control visits that did not utilize this information.

***Our Strategy***

Our goal is to bethe leading provider of care management solutions and to encourage market-wideadoption of our Patient Clinical Summary. Key elements of our strategy include:

·       **Continue to expand our relationships with customers.**   Wehave developed strong customer relationships, which we believe provide us withboth recurring revenue streams from those customers and cross-sellingopportunities. During 2006, we renewed approximately 89% of our customercontracts which were subject to renewal. Historically, our revenue per customerhas increased as we have expanded our penetration within those customers byincluding more members and increasing the number of solutions purchased bythose customers. We will further strengthen relationships with our existingcustomers to ensure a consistent renewal rate in the future. We also intend todevelop innovative cross-selling programs to continue to increase our revenueper customer.

·       **Innovate new solutions and lead the next generation ofCollaborative Care Management.**   Over the past five years, wehave introduced several new solutions and expanded our clinical content in 

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response to the uniqueneeds of our customers. We have accomplished this expansion through internaldevelopment, as well as acquisitions. We intend to further develop innovativesolutions, both internally and through acquisitions, to improve the quality andcost of care and increase administrative efficiency. In particular, we intendto lead the market in the development of the next generation of ourCollaborative Care Management suite. To that end, we are currently developingtwo new software modules, called MEDeWeaver and MEDePathway, which will allowproviders and patients to populate Patient Clinical Summaries with additionalinformation. We expect these expanded solutions to serve as the foundation forElectronic Health Records by aggregating payer, provider andpatient-contributed information.

·       **Apply resources to ensure provider adoption of PatientClinical Summary.**   We released our Collaborative Data Exchangesuite in 2005 and are currently deploying it for eight managed care organizations.We will generate a transaction fee for each Patient Clinical Summary deliveredto a provider. Therefore, the growth in revenue for our Collaborative DataExchange module will be contingent upon provider adoption of the PatientClinical Summary. In January 2007, in order to cultivate this adoption, wecreated a specialized marketing and training team and are working with ourcustomers’ provider relations departments to strengthen our ability to increaseusage of our Patient Clinical Summary. We intend to continue to creativelyapply resources in order to encourage provider adoption of Patient ClinicalSummary.

·       **Expand our customer base.**   We havegrown our annual revenue to $44.2 million in 2006 by licensing our solutions toapproximately 56 customers. We estimate that there are at least 300 additionalmanaged care organizations in the United States that could benefit from oursolutions. Because they share the same challenges as our existing customers, webelieve that self-insured companies and Medicare and Medicaid organizations arealso attractive target customers. Our strategy also includes committing resourcesto license our solutions into smaller payers in markets where our largercustomers have rolled out our principal connectivity module, Collaborative DataExchange. We believe these smaller payers can achieve high productivity gainsfrom the already established provider adoption of our self-service tools.Furthermore, we anticipate the emerging Regional Health Information Organizationsto provide us with a new market opportunity. We intend to continue to invest insales and marketing to increase awareness of our solutions within the payermarket and obtain additional payer customers.

·       **Continue to build recurring and predictable revenue streams.**   Historically,we derived most of our revenue from our Advanced Medical Management module, forwhich our customers purchase five-year term licenses. Although this moduleprovides us with a recurring revenue stream, the size of the license fee andthe fact that we recognize the license fee at the time we enter into thecontract has caused this revenue stream to fluctuate, sometimes significantly,from quarter to quarter. In 1999, we began offering our customers additionalsolutions and clinical content for which they pay annual subscription fees ortransaction fees. These revenue streams provide us with greater quarterly revenuevisibility as we recognize the revenue from annual subscription fees ratablyover the term of the license and from transactions as they occur. We intend tocontinue to develop new solutions for which our customers will pay annualsubscription fees or transaction fees.

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**Our CollaborativeCare Management Solution**

***Our Integrated Medical Management Suite***

Our Collaborative Care Management suite consists offour related product modules—(i) Data Gathering and Analytics; (ii) ClinicalRules and Processes; (iii) Advanced Medical Management; and (iv) CollaborativeData Exchange.

*Data Gathering and Analytics.*   OurData Gathering and Analytics module is a data engine with an analyticscomponent that enables a payer to process, summarize and evaluate informationfrom both internal and external sources. This module creates a thorough patientclinical view and enables the identification of patients and populations thatwould benefit from care management and health and wellness intervention.

·       **Payer Based Health Record.**   Our DataGathering and Analytics module automates the creation of an electronic PayerBased Health Record for each of a payer’s members. It does so by aggregatingthe data contained in the payer’s legacy claims processing systems, capturingall of the raw data related to a specific member and combining that informationwith the care management data that exists in the Advanced Medical Managementmodule. After gathering the data, our Data Gathering and Analytics moduleapplies proprietary algorithms and embedded clinical content to analyze thedata for inconsistencies. For example, the existence of one test for diabeteswithout corresponding evidence of treatment for diabetes does not result in thelisting of diabetes on the member’s list of medical conditions. Once the PayerBased Health Record has been created, it is available for use in all of ourother solutions, as well as for reporting and further analysis.

·       **Risk stratification.**   Leveraging thesame data utilized to create the Payer Based Health Record, our Data Gatheringand Analytics module automatically identifies members who could immediately benefitfrom active disease or case management to help improve clinical or cost outcomes.After patients have been identified and their clinical information analyzed,proprietary algorithms and, in some cases, third-party applications containedin our module classify members, enabling our customers to match the intensityof the case or disease management resources with the patient’s 

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need. In conjunction withthe stratification methodology, our Data Gathering and Analytics moduleestablishes a set of triggers for specific events that indicate whether amember is likely to become a cost or utilization outlier. These triggers can becustomized to match the specific clinical criteria used by our customers, orprovided as part of the Clinical Rules and Processes module.

·       **Integration with Advanced Medical Management andreporting.**   When integrated with our Advanced MedicalManagement module, the data derived by our Data Gathering and Analytics moduleis then electronically integrated with our customers’ care management workflowsystem. After a care management program has been established, the reportingtools provided in Data Gathering and Analytics allow our customers to determinewhich interventions were the most efficient in meeting the plan’s goals, whichwere the most cost effective and which led to the best health outcomes fortheir members. This information allows the payers’ medical directors to beginto develop best practice models, monitor their effectiveness and then modifythe best practice models as necessary.

*ClinicalRules and Processes.*   Our Clinical Rules andProcesses module is a clinical content and process management solutionfeaturing embedded, state-of-the-art clinical best practices that have beenvalidated by evidence-based medicine. It delivers reliable and accurateclinical rules throughout our Collaborative Care Management suite,establishing the consistency necessary for optimal diagnostics and treatmentrecommendations. We continually update our Clinical Rules and Processesmodule based on evolving clinical best practices and best processes anddistribute the updated content to our customers both annually for lowerpriority changes and more frequently for higher priority changes.

Our Clinical Rules andProcesses module consists of two primary content categories:

·       **Medical Appropriateness Criteria.**   Thiscategory consists of clinical content for utilization management regarding themedical appropriateness of a proposed healthcare service or treatment. These rules areused to manually or automatically adjudicate requests for authorizations andreferrals.

·       **Clinical Care Pathways.**   This categoryconsists of content for case and disease management that automaticallypopulates questionnaires, goal templates and other correspondence to patientsand providers. This information is integrated with the Advanced MedicalManagement module and is exposed to the payer care manager when they bring up acase in their workflow. We support clinical care pathways for 28 medicalconditions that we believe address the majority ofhealthcare expenditures.

*AdvancedMedical Management.*   Our Advanced MedicalManagement module is a care management solution consisting of workflow anddetection tools that address the continuum of care management processes, suchas specialized case and disease management, admission and outpatientcertification, referral management, concurrent review and discharge planning.It allows care management staff to automatically and intelligently administer,manage and evaluate both individual and population-wide healthcare programs,which improves healthcare quality and reduces administrative and medical costs.It also assists our customers with meeting regulatory and accreditationrequirements for consistent care management processes.

·       **Workflow automation.**   Leveraging thiscomprehensive data repository, our Advanced Medical Management module automatesworkflow across the continuum of the care management process including:

·        *Utilization management.*   This qualityassurance process allows payers to confirm the medical necessity of healthcareservices and products. Utilization management generally includes the clinicalreview of hospital admissions, organ transplants, elective surgeries, high-techdiagnostic tests and expensive medications, often before the service or productis delivered to the patient.

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·        *Case management.*   This care andfinancial benefits coordination process supports patients with multipleconditions and/or traumatic injuries by ensuring that the patient receives theappropriate care from different members of their care team at the appropriatetime and in the appropriate setting, even when the patient’s health benefitplan might require modification to provide coverage for such treatment.

·        *Disease management.*   These coachingand care coordination processes support patients with chronic conditions byhelping to ensure that the patient understands the nature of the condition andthe best ways to minimize its impact, and that the patient complies with theestablished treatment regimen. The disease manager also helps coordinate thepatient’s interaction with the healthcare system to ensure that the patientreceives the appropriate care from different members of their care team at themost appropriate time and in the most appropriate setting.

·       **Interoperability with Data Gathering and Analytics.**   Whenpayers utilize our Advanced Medical Management module in combination with ourData Gathering and Analytics module, workflows are automatically populated withcare management data generated by the Data Gathering and Analytics module.Additionally, since the same data also is used to create the Patient ClinicalSummary for the provider, everyone on the care management team is working withconsistent data.

·       **Interoperability with Collaborative Data Exchange.**   Whenpayers utilize our Advanced Medical Management module with our CollaborativeData Exchange module, most authorizations and referrals that wouldtraditionally be handled by a payer care manager for approval over thetelephone are automatically clinically adjudicated with the same rules thatthe payer care manager would have used. Only the referrals and authorizationsthat are considered too complicated or questionable are presented to a payercare manager, having automatically populated their work queue, when theexception occurs. The case is then presented with all of the pertinent historyand relevant clinical guidelines to help the payer care manager adjudicate therequest manually.

We license a database module from InterSystemsCorporation that is material to our Advanced Medical Management module. Thelicense that originally expired on December 31, 2006 has been extended bythe parties through May 15, 2007, and its renewal is currently undernegotiation. In addition, the license may be terminated if we breach the termsof the license and fail to cure the breach within a specified period of time.If we fail to license the InterSystems Corporation database module, it couldadversely affect our ability to sell our solutions and lead to a decline inrevenue and the future growth of our business.

*CollaborativeData Exchange.*   Our Collaborative Data Exchangemodule is a communication service that facilitates the mutual transmission ofinformation between the various stakeholders in the healthcare process.Collaborative Data Exchange addresses the entire spectrum of clinical dataexchange: from basic service requests (referrals, authorizations andextensions) to simple clinical information transfer (questionnairefulfillment), to complex electronic health record-based transactions.Additionally, Collaborative Data Exchange is the resource through which we areable to deliver the Patient Clinical Summary (PCS).

With Collaborative Data Exchange, providers canelectronically submit referrals, authorizations and extensions requests throughmultiple communication sources including the Internet, interactive voiceresponse and electronic data interchange. As a result, payers can reach theirentire provider community regardless of the provider’s technologyinfrastructure. When combined with the Clinical Rules and Processesmodule, it enables payers to automatically process requests from physicians andhospitals, which significantly reduces a payer’s administrative costs becauserequests are initiated, processed and completed without human intervention.Payers using the Internet and interactive voice response paths have been able 

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to automate and approve upto 85% of their referral requests. Requests that require human intervention areflagged for further review and immediately routed to a payer care manager forresolution.

***Our Collaborative Care Management Suite***

Our Collaborative CareManagement suite leverages the connectivity of our Collaborative Data Exchangemodule to deliver the Patient Clinical Summary electronically and on-demand toproviders at the point of care.

*Patient ClinicalSummary*

Our PatientClinical Summary is an Electronic Health Record that is currently built fromthe data contained in the Payer Based Heath Record. In an easily understandableformat, the Patient Clinical Summary presents:

·       patientdemographic information, including name, date of birth, contact information andthe name of the patient’s primary care physician;

·       asummary of the patient’s medical conditions categorized by severity;

·       acomplete log of the patient’s facility admissions and emergency room visits;

·       asummary of historical tests and healthcare services provided to the patient;

·       asummary of medications taken by the patient;

·       alist of the patient’s historical providers, their specialty and contactinformation;

·       aschedule of early detection flags and potential treatment opportunities; and

·       an evaluation of thepatients’ risk of needing treatment for a serious medical condition in the next12  months.

*Future Solutions*

We are currently developing two additional components thatwe believe will increase the value of our Collaborative Data Exchange suite.

**MEDeWeaver.  **We believe that our MEDeWeaver module will enablethe next generation of the Electronic Health Record by weaving together allavailable sources of patient information, including the Payer Based HealthRecord, the Electronic Medical Record and the Personal Health Record.MEDeWeaver is a module that gathers patient data stored in several differentdatabases, analyzes this data for inconsistencies and combines it into onereport. This product will be completed and released by development at the endof the first quarter 2007 and will be installed for a customer during thesecond quarter of 2007.

**MEDePathway.**   We believe that our MEDePathwaymodule will allow our payer customers to leverage the data contained in thePatient Clinical Summary for other uses. For example, if a payer has a memberportal through which they allow their members to access information,MEDePathway would allow the payer to expose the data contained in the PatientClinical Summary to the patient through the portal. The data is providedas a standardized transmission allowing the payer to decide how to present itwithin the portal. In effect, MEDePathway will manage incoming requests forinformation and outgoing responses. It will validate the requestor, manage thecommunications and security for accepting the request from outside sources andthen deliver the data to the recipient. The data sent is based on thereceiver’s needs and complies with the relevant state and federal data privacyrequirements. This product is currently in development and we expect it to begenerally available for release to customers in the second quarter of 2007.

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**ProfessionalServices**

Our professional servicespersonnel have extensive domain expertise and use our proprietary technologyand content to provide implementation and consulting services and training.Many of our professional service personnel have held positions at healthcareorganizations or senior level consulting positions at major consulting firmsand other enterprise software companies.

***Implementation and Consulting Services***

Our implementationservices begin with an evaluation of a customer’s current informationtechnology infrastructure, which includes process engineering to optimize theconfiguration of our solutions and integration with existing applications tofit each organization’s dynamic business requirements. We support a consultingcertification program and have a project management office that equips ourconsultants with a library of toolkits, forms, training documentation andworkshop templates. We also oversee the management of customer deployments tohelp enable smooth, systematic and on-time implementations and maximize successand financial returns for our customers. After the initial deployment of oursolutions, we provide ongoing strategic consulting services to help ourcustomers achieve desired results in quality improvement, increasedproductivity, cost savings and operational effectiveness. We collaborate withcustomer project leaders to establish an ongoing process for continualevolution and solution optimization so that our customers can promote bestpractice usage and end user adoption long after we deploy our solutions.

***Training***

We offer a full range ofeducational services including pre-deployment classroom training,train-the-trainer programs, system administrator training, post-deploymentspecialty training, upgrade training and eLearning/web-based training. We alsooffer a variety of training tools to drive user adoption, including solutionuser manuals, process user guides, feature training exercises, a self-servicewebsite for training scheduling and registration, post-training assessments andsynchronous, web-based training tools for remote users.

***Technology, Development and Operations***

***Technology***

Our Collaborative Care Management suite is built on amulti-tier, independent Java 2 Platform, Enterprise Edition, or J2EE, architectureusing a standards-based Struts (Model-View-Controller) Framework that consistsof open source components, commercially available products and our own proprietarytools. This framework incorporates a fully defined services-orientedarchitecture that allows for the continued extension and adaptability of ourCollaborative Care Management suite through an underlying collection of highlycohesive, loosely coupled components. We use this programming model to abstractinterfaces, standardize messaging and increase the versatility and the value ofour solutions. This approach allows for platform independence coupled with highscalability and availability.

We have implementedthe following guiding principles into our development methodology:

·       flexiblearchitecture to accommodate customer change requests built upon solid businessdomain models and solution architecture;

·       modularsolution architecture to facilitate reuse and enhance marketability;

·       databaseindependence achieved through integration and resource tiers with no dependencyon encapsulated and loosely coupled business logic;

·       leverageopen community standards; and

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·       incremental migration fromlegacy to new architecture to preserve the customer experience.

***Development***

We believe that three primary factors drive ourinnovation: our clients, our domain experts and our research and developmentemployees. We use the feedback gained through our customer interactions andfrom all of our employees to add value added enhancements to the modelproducts. We also leverage the experience of our domain experts, who producewhite papers, case studies and thought pieces, which form the foundation forour innovation. Our research and development team maintains a repository ofideas, and selected ideas are presented to the market validation team. Marketvalidated ideas progress to the prototype stage. The executive team reviewsprototypes and selects those with the highest potential, which then enter theproduct development phase. Once in the product development stage, our team ofinternal software engineers develops, tests and implements the applicable codefor stand-alone deployment or integration into our existing solutions, asapplicable.

Total research anddevelopment expenditures were $9.4 million, $5.0 million and $4.4 millionfor the years ended December 31, 2006, 2005 and 2004, respectively. Totalresearch and development expenditures included capitalized software developmentcosts of $1.4 million, $2.4 million and $1.2 million for the years ended December 31,2006, 2005 and 2004, respectively.

***Operations***

Our primary service delivery datacenter is managed byMEDecision within a SunGard hardened datacenter facility in Philadelphia,Pennsylvania. This datacenter serves as the primary facility for ourtransaction based solutions and also for delivery of Patient Clinical Summariesto payers, providers and patients. A physically separate segment of thisfacility is used to deliver our hosted solutions for customers who subscribe tothis service offering. We also have a secondary datacenter in Wayne,Pennsylvania for our Data Gathering and Analytics module service bureauoffering and a disaster recovery site located within another SunGard facilityin Carlstadt, New Jersey. We adhere to industry standards and best practices inour domestic operations. The transaction environment is shared across clientsto reduce costs for each individual client. Each client’s network connectivityis highly secured. Data backups are completed over the wide area network to ourdisaster recovery facility in Carlstadt, New Jersey.

Our datacenters arecontinuously monitored by a comprehensive set of tools and personnel, 24 hoursa day, seven days a week. Our datacenters have built-in power redundancy,with two uninterrupted power supplies backed up by an industrial strengthgenerator to provide uninterrupted service to our clients. We have documentedour network, server and database management procedures including backup andrecovery.

***Customer Support***

We believe that superiorcustomer support is critical to our customers. Our customer support groupassists our customers by answering questions and troubleshooting our solutions.Customer support is available 24 hours a day, seven days a week by telephone,email and over the Internet from a member of our customer support team. Eachmember of our customer support team receives comprehensive training andorientation to ensure that our customers receive high-quality support andservice. Each of our customers is assigned a single point of contact. When anissue is reported to us, our customer support personnel follow a clearlydefined escalation process to ensure that mission-critical issues are resolvedto the satisfaction of the client. We believe that our customer service modelhas materially contributed to our client retention rate. As of December 31,2006, our customer support group consisted of 21 employees located in Wayne,Pennsylvania.

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**Customers**

As of December 31, 2006, we had contracts with 44entities that represented approximately 56 regional and national managed careplans. Our customers include the largest managed care organizations in morethan 27 regional markets.

Our sales to Health CareService Corporation, or HCSC, and Horizon Blue Cross Blue Shield accounted forapproximately 27% and 20%, respectively, of our revenue for the year ended December 31,2006. In late 2005, HCSC selected our Collaborative Care Management solutionfor use by its enterprise. As part of that contract, HCSC consolidated threeseparate agreements with us: BlueCross BlueShield of Illinois, Texas, NewMexico and Oklahoma. On an aggregated basis, the healthcare plans covered bythe HCSC agreement accounted for 25% of our revenue in 2005, and included afive-year term license fee that accounted for 13% of revenue. If the healthcareplans currently covered by the HCSC agreement are aggregated in similar fashionfor the purpose of comparison with prior years, the plans also accounted for10% of our revenue in 2004. In addition, in 2004, PacifiCare and BCBS ofMassachusetts each accounted for 14% of our total revenue. No othercustomer accounted for more than 10% of our revenue in the years 2006, 2005 or2004. We have described in more detail our contractual relationships with HCSCand Horizon Blue Cross Blue Shield in “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations—Significant Customer Contracts.”

**Sales and Marketing**

Our target customers include the leading regionalhealth insurance companies and national health insurance companies. We licenseour solutions to new and existing customers primarily through our direct salesforce. We manage our relationships with our existing customers, includingcross-selling and up-selling activities, through client relationship managers.Our sales office is located in Wayne, Pennsylvania.

Our marketing initiativesare generally targeted toward increasing awareness of our solutions within thehealthcare payer market. In order to do so, we participate in conferences,trade shows and healthcare industry events, conduct direct mail and emailcampaigns, advertise in industry-specific trade magazines and Internetwebsites, distribute white papers, case studies and thought pieces, and use ourwebsite to provide product and company information.

**Intellectual Property**

Our intellectualproperty rights are important to our business. We rely on a combination ofcopyright, trade secret, trademark and other common laws in the United Statesand other jurisdictions, as well as confidentiality procedures and contractualprovisions to protect our proprietary technology, processes and otherintellectual property. However, we believe that the following factors are moreessential to our ability to maintain a competitive advantage:

·       ourdomain expertise;

·       frequentenhancements to our solutions;

·       continuedexpansion of our healthcare content; and

·       thetechnological skills of our research and development personnel.

Others may develop products that are similar to andthat compete with our technology. We generally enter into confidentiality andother written agreements with our employees and third-party partners, wherebywe attempt to control access to and distribution of our software, documentationand other proprietary technology. Despite our efforts to protect ourproprietary technology, third-parties may, in an unauthorized manner, attemptto use, copy or otherwise obtain and market or distribute our intellectualproperty or proprietary technology or may otherwise develop a product withsimilar functionality as our 

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solutions and services.Policing unauthorized use of our intellectual property and proprietarytechnology is difficult, and nearly impossible on a worldwide basis. Therefore,we cannot be certain that the steps we have taken or will take in the futurewill prevent misappropriation of our technology or intellectual property.

Litigation regardingintellectual property is prevalent in the software industry. From time to time,in the ordinary course of our business, we may be subject to claims relating toour intellectual property rights or those of others, and we expect thatthird-parties may commence legal proceedings or otherwise assert intellectualproperty claims against us in the future, particularly if we expand the scopeof our business, increase the number of products we offer that compete withthird-parties in the industry or the functionality of our solutions or servicesoverlap with those of third-parties. We cannot be certain that a third-partydoes not have a patent or other intellectual property rights that could resultin a future claim against us. These actual and potential claims and anyresulting litigation could subject us to significant liability for damages. Inaddition, even if we prevail, litigation could be expensive, time consuming andrequire additional resources of ours to defend and could affect our businessmaterially and adversely. Any third-party claims or litigation may also limitour ability to use various business processes, software and hardware, othersystems, technologies or intellectual property, unless we are able to enterinto a license agreement with such third-party, which may not be available oncommercially reasonable terms, if at all.

**Competition**

We haveexperienced, and expect to continue to experience, intense competition from anumber of companies. Our Collaborative Care Management suite competes withLandacorp, Inc., McKesson Corporation and The TriZetto Group, Inc.,each of which offer products that compete with one or more modules in our suiteof solutions. The principal competitive factors in our industry include:

·       solutionbreadth and functionality;

·       easeof deployment, integration and configuration;

·       domainexpertise;

·       depthof clinical content;

·       servicesupport;

·       solutionprice;

·       breadthof sales infrastructure; and

·       breadthof customer support.

We believe that we generally compete favorably withrespect to all of these factors.

We may face futurecompetition from large, established healthcare information technologycompanies, as well as from emerging companies. Barriers to entry into ourindustry are relatively low, new software products are frequently introducedand existing products are continually enhanced. In addition, we expect thatthere is likely to be consolidation in our industry, which would lead toincreased price competition and other forms of competition. Establishedcompanies not only may develop their own competitive products, but also mayacquire or establish cooperative relationships with current or futurecompetitors, including cooperative relationships between both larger,established and smaller public and private companies. In addition, our abilityto license our solutions will depend, in part, on the compatibility of oursoftware with software provided by our competitors. Our competitors could altertheir products so that they will no longer be compatible with our software orthey could deny or delay access by us to advance software releases, which wouldlimit our ability to adapt our software to these new releases. If our competitorswere to bundle their products in this manner or make their productsnon-compatible with 

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ours,our ability to license our solutions might be harmed and could reduce our grossmargins and operating income.

**Employees**

As of December 31,2006, we had 243 employees, consisting of 37 employees in sales and marketing,104 employees in research and development, 75 employees in delivery andsupport of our solutions and 27 employees in general and administrativepositions. None of our employees are represented by a union. We consider ourrelationship with our employees to be good and have not experienced anyinterruptions of our operations as a result of labor disagreements.

**Item 1A.**                RiskFactors.

*Our future resultsmay be affected by industry trends and specific risks in our business. Some ofthe factors that could materially affect our future results include thosedescribed below. Operating results for future periods are difficult to predictand, therefore, prior results are not necessarily indicative of results to beexpected in future periods. Factors that could have a material adverse effecton our business, results of operations, and financial condition include, butare not limited to, the following:*

***Our business may not continue togrow if the size of the market for care management solutions and marketacceptance of our solutions does not continue to grow.***

Our growth is dependentupon the overall growth of the market for care management solutions, which isin the early stages of development and is rapidly evolving. In addition, ourgrowth is dependent on the continued adoption of new software and technologies,including electronic health records, by managed care organizations. In new andrapidly evolving industries such as ours, there is significant uncertainty andrisk as to the demand for, and market acceptance of, recently introducedsolutions and services. Achieving and maintaining market acceptance for new orupdated solutions and services is likely to require substantial marketingefforts and the expenditure of significant funds to create awareness and demandby potential customers. There can be no assurance that the revenue opportunitiesfrom new or updated solutions and services will allow us to recover amounts wespend for their development, marketing and roll-out. If the market refuses toadopt our solutions or if a competitor develops a solution or service that ispreferred by the market, the demand for our solutions will decrease, and we maynot be able to sustain or increase our levels of revenue or profitability inthe future.

***If the reliance andadoption of electronic Patient Clinical Summaries by healthcare providers isnot widespread or competing solutions prove more attractive to healthcareproviders, then our future revenue growth will be materially adversely affected.***

Although our success in marketing our Patient ClinicalSummaries will be measured by sales to healthcare payers, the growth of ourrevenue is reliant on the adoption of electronic Patient Clinical Summaries bydoctors and other healthcare providers. In the future, there may be moreeffective alternatives to our Patient Clinical Summaries for patient records,including solutions marketed by our competitors, physician sponsored electronichealth records and other more traditional means of medical record storage. Thefuture success of our business model is, in large part, linked to the adoptionby healthcare professionals of our Patient Clinical Summaries. If theseprofessionals ultimately prefer a different method by which to gain medicalinformation about their patients, then our results of operations and financialcondition could be adversely affected.

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***If Regional HealthInformation Organizations do not gain widespread acceptance, our future growthand revenue may suffer.***

Our growth prospects aredependent, in part, on the implementation of Regional Health InformationOrganizations as a facility for the retrieval of patient data and delivery ofPatient Clinical Summaries. If federal, state and other regional legislativeand regulatory authorities delay or oppose implementing these clinical dataexchanges, it will be more difficult for us to incorporate data from healthcareproviders into our Patient Clinical Summaries. This limitation could negativelyaffect the usefulness of our products and could significantly limit the growthof our market. In addition, this limitation could lead to greater competition forwhat would become a smaller market in which to license our current solutions,resulting in additional expenses in marketing our solutions and adverse effectson our results from operations and our ability to provide Patient ClinicalSummary based products. Furthermore, our solutions may not be well suited forthe type of organization, if any, that ultimately gains widespread acceptancefor the dissemination of patient health information. This situation could causeus to incur additional expenses to customize our solutions to be acceptable tothese new market participants without any short-term revenue, or futureprospect of revenue, to cover these costs. As a result, we may not achieve ourexpected growth or sustain or increase our revenue or profitability in thefuture.

***The ability of someof our customers to compete with us, and other customers to provide solutionsthat are similar to those we offer may adversely affect our market and lowerour revenue and profits.***

Some of our customers sellor license care management solutions that compete with ours or have currentintentions to develop them. For example, some payer customers currently offerelectronic data transmission services to healthcare providers that allow themto download patient health information in a format similar to the formatoffered by our solutions through affiliated clearinghouses, Internet portalsand other means of communications. In addition, some of our customers haveextensive internal development resources and provide their organizations withsolutions similar to ours. For example, some of our customers internallydevelop functions such as patient analytics and data warehousing. The abilityof payers to implement competing technology or to provide services similar toours may adversely affect our ability to sell our solutions to these entitiesor the terms and conditions we are able to negotiate in our agreements withthem, which may lower the revenue and profits that we currently realize fromthese transactions.

***If we fail tocomply with broad patient privacy and medical information security laws andregulations, we could be subject to fines and civil and criminal penalties thatcould negatively impact our business and operating results.***

As part of the operation of our business, our customersprovide us, or our solutions interface, with patient-identifiable medicalinformation. Government legislation and industry rulemaking, particularly theHealth Insurance Portability and Accountability Act of 1996, or HIPAA, andstandards and requirements published by industry groups such as the JointCommission on Accreditation of Healthcare Organizations, require the use and implementationof security, privacy and other standards and requirements for the receipt,creation, maintenance and transmission of certain electronic protected healthinformation. Generally, HIPAA regulations directly affect what are referred toas Covered Entities. Most of our customers are Covered Entities, and wefunction in many of our relationships as a business associate, under businessassociate agreements with those customers. The federal agencies charged withenforcement authority under HIPAA have taken the position that a Covered Entitycan be subject to HIPAA penalties and sanctions for certain material breachesof a business associate agreement. The penalties for a violation of HIPAA by aCovered Entity can be significant and include both civil and criminal penaltiesand fines and could have an adverse impact on our business, financial conditionand results of operations, if such penalties ever were imposed on customers ofours due to a defect in one of our solutions or the 

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unauthorized release ofpatient-identifiable medical information. We have policies and procedures thatwe believe assure material compliance with all federal and stateconfidentiality requirements for the handling of protected health informationthat we receive from Covered Entities and with our obligations under businessassociate agreements. If, however, we do not follow those policies and procedures,or if they are not sufficient to prevent the unauthorized disclosure ofprotected health information, we could be subject to liability and lawsuits,termination of our customer contracts or our operations could be shut down.

Moreover, because all HIPAA regulations are subject tochange or interpretation and because certain other HIPAA standards are not yetpublished, we cannot predict the full future impact of HIPAA on our businessand operations. In the event that the HIPAA regulations and compliance requirementsmaterially change or are interpreted in a way that requires any material changeto the way in which we do business, our business, financial condition andresults of operations could be adversely affected.

Furthermore, states maypass legislation regulating how a patient’s medical information may be sharedamong payers and providers that are more stringent than the equivalent federallaws. The passage of state laws that affect information sharing may affect theability of our customers to use our solutions, therefore reducing demand forour solutions, which would negatively impact our revenue and financialcondition. We may need to incur significant costs to monitor active statelegislation and to lobby legislators to prevent the passage of statelegislation that would adversely affect our ability to sell our solutions.

***If HIPAAregulations are changed to require patients to provide written consent to thesharing of their information for treatment and health care operations, ourfuture growth and revenue may suffer.***

Currently under HIPAA,written consent from patients is not required when sharing patient healthinformation among Covered Entities and business associates for “treatment”purposes and “healthcare operations.” Patients may choose to “opt out” of aninformation sharing process, if desired, to protect their privacy. However, iffederal or state legislation modifies existing privacy regulations to require apatient to provide written consent prior to any provider’s or payer’s retrievalof a patient’s health care information from certain sources for treatment orhealthcare operations, it may significantly decrease the amount of informationthat we could gather in our Patient Clinical Summaries. This situation woulddecrease the usefulness of our Patient Clinical Summaries and the demand forsuch products. Any decreased demand would reduce our future revenue andnegatively impact our business and future growth.

***Initiativesencouraging increased use of information technology in the healthcare sectormay result in increased competition.***

There are currentlynumerous federal, state and private initiatives and studies seeking ways toincrease the use of information technology in healthcare to improve care whilereducing costs. These and other initiatives may encourage more competitors todevelop, sell or license solutions and services to our current and potential customers.In addition, competition from information technology solutions and servicesmade available to healthcare payers on a not-for-profit or other low-cost basisby or on behalf of governmental entities could have an adverse impact on salesof our solutions and services. The effect that these initiatives may have onour business is difficult to predict, and we can provide no assurances that wewill adequately respond to the increased competition resulting from these initiativesor that we will be able to take advantage of any resulting opportunities.

***Increasedgovernment involvement in the healthcare sector may limit the ability ofpotential customers to purchase and use our solutions, which could reducerevenue and materially affect future growth.***

Healthcare system reformin the United States under the Medicare Prescription Drug, Improvement and ModernizationAct of 2003 and other federal and state initiatives, such as a nationalhealthcare system, could increase government involvement in healthcare, lowerreimbursement rates and otherwise 

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changethe business environment of our customers and the other entities with which wehave a business relationship and may limit their ability to purchase and useour solutions and services. We cannot predict whether or when future healthcarereform initiatives at the federal or state level or other initiatives affectingour business will be proposed, enacted or implemented or the impact thoseinitiatives may have on our business, financial condition or results of operations.Our customers and the other entities with which we have a business relationshipcould react to these initiatives by curtailing or deferring purchases of oursolutions and/or services. Additionally, government regulation could alter themanner in which physicians and other healthcare providers, hospitals,healthcare payers and other healthcare participants provide care to patients,maintain patient medical information and interact with one another, therebylimiting the utility of our solutions and services to existing and potentialcustomers and curtailing broad acceptance of our solutions and services.

***Increasedgovernmental regulation of the Internet could require us to modify ourproducts, which could result in a reduction in our revenue and profitability.***

The Internet and its associated technologies aresubject to significant government regulation. Given our use of the Internet todeliver our solutions and services, our failure, or the failure of our payercustomers and business partners, to accurately anticipate the application oflaws and regulations affecting how we deliver our solutions and services, orany other failure to comply with such applicable laws and regulations, couldcreate legal liability for us. This situation could result in adverse publicityor decreased revenue, each of which could materially and adversely affect ourbusiness. In addition, new laws and regulations, or new interpretations of existinglaws and regulations, may be adopted or implemented with respect to theInternet or other online services that may materially affect the way we and ourcustomers handle user privacy, patient confidentiality, consumer protection andother similar issues. Such adoption or implementation could cause our currentsolutions or services to fail to comply with then applicable laws orregulations, and would require the revision of our current solutions orservices or the development of new solutions or services in compliance withsuch laws or regulations. Such revision or new development could be costly andtake a significant amount of time which could reduce our revenue andprofitability and otherwise materially adversely affect our financialcondition.

New laws and regulationsor new interpretations of existing laws and regulations could impact the ratescharged by Internet service providers to companies such as ours. Such laws andregulations could result in increased costs to provide our solutions to ourcustomers, which could reduce our profitability and otherwise materially adverselyaffect our financial condition.

***We may be liablefor the misdiagnoses, mistreatment, injury or other harm to patients resultingfrom the use of data that we provide to healthcare providers, and any resultingclaims could negatively impact our operating results and result in a decline inour stock price.***

We provide, and facilitateproviding, information for use by healthcare providers in treating patients.Our healthcare payer customers’ data is the primary source of a majority ofthis information. If this data is incorrect or incomplete, the patient could bemisdiagnosed or mistreated resulting in adverse consequences, including death,giving rise to claims against us. In addition, certain of our solutions relateto patient health information, and a court or government agency may take theposition that our delivery of this information, including through licensedphysicians or other healthcare providers, exposes us to personal injuryliability or other liability for wrongful delivery or handling of healthcareservices or erroneous health information. While we maintain liability insurancecoverage in an amount that we believe is sufficient for the risks associatedwith our business, we cannot assure you that this coverage will prove to beadequate or will continue to be available on acceptable terms, if at all. Aclaim brought against us that is uninsured or under-insured could harm ourbusiness, financial condition and results of operations. Even 

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unsuccessfulclaims could result in substantial costs and diversion of management resourcesand could cause the trading price of our common stock to decline.

***Consolidation inthe healthcare industry could lead to a decrease in revenue and profitability.***

Many healthcare industry participants are combining orconsidering combining with other participants to create fewer and largercustomers and potential customers, each of which would likely have greatermarket power and leverage in negotiating contracts for our solutions andservices. Moreover, as provider networks and managed care organizationsconsolidate and the number of market participants decreases, competition toprovide solutions and services such as ours will become more intense, and theimportance of establishing relationships with key industry participants willincrease. These industry participants may try to use their market power to negotiateprice reductions for our solutions and services. If we are forced to reduce ourprices, our revenue would decrease and our profitability would decline.

Although some of ourcustomers have been parties to consolidations in the past, our revenue andcustomer base have not been materially affected by such consolidations duringthe past five years. We cannot assure, however, that we will not be materiallyaffected by such consolidations in the future.

***We operate in amarket with limited potential clients, derive a significant portion of ourrevenue from a limited number of customers, and if we are unable to maintainthese customer relationships or attract additional customers, our revenue willbe adversely affected.***

Our sales to Health Care Service Corporation andHorizon Blue Cross Blue Shield accounted for approximately 27% and 20%,respectively, of our revenue for the years ended December 31, 2006 and2005, respectively. Our sales to Health Care Service Corporation and itsaffiliates, on an aggregate basis, accounted for approximately 25% of ourrevenue for 2005. Collectively, our top five customers accounted forapproximately 63% and 50% of our revenue for 2006 and 2005, respectively.Although we are seeking to broaden our customer base, we anticipate that asmall number of customers will continue to account for a large percentage ofour revenue. The loss of one or more of our key customers, or fewer or smallerorders from them, would adversely affect our revenue.

In addition, the number ofpotential customers in the electronic healthcare information market is limited,and therefore, our total customer base is limited. We believe that there areapproximately 300 additional potential customers in our market. As of December 31,2006, we had contracts with 44 entities that represented approximately 56 regionaland national managed care organizations. If we lose one contract, we may losemore than one entity as a customer. Our contracts with our customers aretypically five-year agreements. We do, however, enter into contracts with ourcustomers that do not require long-term commitments, such as annual maintenancecontracts or contracts for our transactional solutions. If we are not able toattract additional customers, license new solutions to our existing customersor obtain contract renewals from our customers, our revenue could decline.

***We derive asignificant portion of our revenue from recurring revenue streams, and if weare unable to maintain these customer relationships, our revenue will beadversely affected.***

Each of our licenseagreements with third-party customers provides us with a revenue stream thatgenerally recurs. Historically, a substantial portion of our customers haverenewed their licenses at the end of each license term, which is typically fiveyears. During the year ended December 31, 2006, our customers renewed 89%of the contracts the stated terms of which were to expire during that period.The combination of recurring revenue and high renewal rates has provided uswith a substantial annual revenue base. However, our customers may not continueto renew at this rate, and if they do renew, the value of the contracts may beless. Thus, there is no assurance we will be able to sustain these renewalrates, and if we are unable to sustain them, our revenue and profits could beadversely affected.

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***We have grownrapidly, and if we fail to manage our growth, our reputation, revenue andresults of operations may be negatively impacted.***

Although we commencedoperations 18 years ago, recently we have experienced, and continue to experience,significant growth in our operations. This growth has entailed hiring keypersonnel, developing and introducing several new products into the market andestablishing new customer and licensing relationships. We anticipate furtherexpansion of our operations to address our potential growth as we continue toaddress market opportunities. This expansion has placed, and we expect willcontinue to place, a substantial strain on our management, operational andfinancial resources. In order to manage future growth, we will be required toimprove existing, and to implement new, operating and management systems,procedures and controls. We also need to hire, train and manage additionalqualified personnel. A significant factor in our growth has been a substantialincrease in consumer demand for our products. If we do not effectively manageour growth, we may not adequately satisfy this demand. In addition, the qualityof our offerings or our ability to develop and bring our offerings to market ona timely or cost effective basis could suffer. This could negatively impact ourreputation, revenue and results of operations.

***We have a historyof losses and cannot assure you that we will remain profitable, and as aresult, we may have to cease operations and liquidate our business.***

Our expenses have exceededour revenue in four of the last five years, and no net income has beenavailable to common shareholders in four of the last five years. As of December 31,2006, our shareholders’ equity was $18.5 million which amount takes into considerationour net proceeds from our initial public offering which closed on December 18,2006. Our future profitability depends on revenue exceeding expenses, but wecannot ensure that this will continue. If it does not continue, we could beforced to curtail operations and sell or liquidate our business, and you couldlose some or all of your investment.

***We have a historyof quarterly fluctuations in our revenue and operating results and expect thesefluctuations to continue, which may result in volatility in our stock price.***

As a result offluctuations in our revenue and operating expenses, our quarterly operatingresults may vary significantly. We may not be able to curtail our spendingquickly enough if our revenue falls short of our expectations. We expect thatour operating expenses will increase substantially in the future as we expandour selling and marketing activities, increase our new product developmentefforts and hire additional personnel. Our operating results may fluctuate inthe future as a result of the factors described below and elsewhere in thisAnnual Report on Form 10-K:

·       customers’budgetary constraints and the procedures that they must follow in order topurchase solutions and services;

·       theexistence and growth of markets for our solutions and services;

·       potentialreductions in the funds available to pay for our solutions;

·       thesize and timing of orders from customers;

·       thespecific mix of software and services in customer orders;

·       theperiod of time necessary for a customer to select and purchase our solutions;

·       changesin pricing policies by us or our competitors;

·       thetiming of new solution announcements and solution introductions by us or ourcompetitors;

·       changesin revenue recognition or other accounting guidelines employed by us and/orestablished by the Financial Accounting Standards Board or other rule makingbodies;

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·       thefinancial stability of our customers;

·       ourability to develop, introduce and market new solutions, applications andsolution enhancements;

·       marketacceptance of new solutions, applications and solution enhancements;

·       oursuccess in expanding our sales and marketing programs;

·       deferralsof customer orders in anticipation of new solutions;

·       executionof, or changes to, our strategy; and

·       general market and economicconditions affecting businesses generally.

***Lengthy salescycles for some of our solutions and the adoption of transaction-basedsolutions may result in unanticipated fluctuations in the revenue that wereceive from such solutions.***

The duration of the salescycle for our solutions and services is difficult to predict and depends on anumber of factors, including the nature and size of the potential customer andthe size of the purchase contemplated by the potential customer. Our sales andmarketing efforts with respect to healthcare payers generally involve a lengthysales cycle due to these organizations’ complex decision-making processes.Additionally, in light of increased governmental involvement in the healthcareindustry and related changes in the operating environment for healthcareorganizations, our current and potential customers may react to these changesby curtailing or deferring investments, including those for our products andservices. If potential customers take longer than we expect to decide whetherto purchase our solutions or to adopt our transaction-based solution, theexpenses we incur in attempting to market our solutions could increase and ourrevenue could decrease, which could harm our business, financial condition andresults of operations and the trading price of our common stock could decline.

***If our informationsystems or the Internet experience security breaches or are otherwise perceivedto be insecure, our business could suffer, and our revenue could decline.***

The difficulty of securely transmitting confidentialinformation and patient-related personal health information over the Internethas been a significant barrier to existing or potential customers’ willingnessto engage in communications over the Internet. Our business model relies on ourcustomers’ ability and willingness to use the Internet to transmit confidentialpatient health information. Any compromise of Internet security may detercustomers from using the Internet for these purposes and from using oursolutions or services.

We may be required toexpend significant capital and other resources to protect against securitybreaches and hackers or to alleviate problems caused by breaches. Despite theimplementation of security measures, it also is possible that third-partiescould penetrate the network security of our solutions or otherwisemisappropriate confidential patient health information and other data that maybe stored on or transmitted using our solutions. In that event, our operationscould be interrupted, and we could be subject to allegations of liability andthe effects of regulatory action. We may need to devote significant financialand other resources to defend ourselves from such allegations, to protectagainst security breaches and to alleviate problems caused by such breaches,whether or not such breaches were a result of a deficiency in our solutions orservices.

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***Consumer groupswith concerns about privacy issues relating to the use and storage ofpersonally-identifiable data, such as patient medical information, mayinfluence healthcare professionals to refrain from adopting our solutions.***

Consumer sentimentregarding healthcare privacy issues is constantly evolving. Such consumersentiment may affect our customers’ interest in our current or future products.In some cases, consumer groups and individual consumers already have begun toexpress concern over the storage and/or use of personally-identifiable patientinformation. Accordingly, privacy concerns of consumers may influence healthcareprofessionals to refrain from adopting our solutions, which could in turn harmour prospects. Moreover, strong consumer attitudes may precipitate significantadverse opinions, which may lead to new regulations. If we fail to successfullymonitor and address the privacy concerns of consumers, our business andprospects would be harmed.

***If we do notdevelop and implement new or updated solutions and services in order togenerate revenue from existing and new customers and compete effectivelyagainst our competitors, our revenue could decline, and our future growth couldbe adversely affected.***

We must introduce andlicense new solutions and improve the functionality of our existing coresolutions and services in a timely manner in order to retain existing customersand attract new customers. The pace of change in the markets we serve is rapid,and there are frequent new solution and service introductions by ourcompetitors and by vendors whose solutions and services we use in providing ourown solutions and services. If we do not successfully identify and respond totechnological and regulatory changes and evolving industry standards in atimely manner, our core solutions and services may become obsolete orunattractive to potential or existing customers. Technological changes also mayresult in the offering of competitive solutions and services at prices lowerthan we are charging for ours, which could result in our losing sales unless welower our prices. Furthermore, our development and implementation of proposedsolutions and services may take longer and cost more than originally expected,requiring more testing than anticipated and the addition of personnel and otherresources. Any such failure or delay could adversely affect our competitiveposition and our profitability or could make our current solutions obsolete orunattractive to potential or existing customers.

***Competition for ouremployees is intense, and we may not be able to attract and retain the highlyskilled employees that we need to support our business.***

The industry in which weoperate is characterized by a high level of employee mobility and aggressiverecruiting of skilled personnel. There can be no assurance that our currentemployees will continue to work for us. Our ability to provide high-qualitysolutions to our customers depends in large part upon our employees’ experienceand expertise. We must attract and retain highly qualified personnel, includingdoctors and nurses, with a deep understanding of the healthcare and healthcareinformation technology industries. We compete with a number of companies forexperienced personnel and many of these companies, including customers andcompetitors, have greater resources than we have and may be able to offer moreattractive terms of employment. In addition, we invest significant time andexpense in training our employees, which increases their value to customers andcompetitors who may seek to recruit them and increases the costs of replacingthem. If we fail to retain our employees, the quality of our products andservices and our ability to provide such products and services could diminishand this could have a material adverse effect on our business, financialcondition and results of operations and as a result, the trading price of ourcommon stock may decline.

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***If we lose theservices of our key personnel, we may be unable to replace them, and ourbusiness, financial condition and results of operations could be adverselyaffected.***

Our success largelydepends on the continued skills, experience, efforts and policies of ourmanagement and other key personnel and our ability to continue to attract,motivate and retain highly qualified employees. In particular, the services ofDavid St.Clair, our Chairman of the Board of Directors and Chief ExecutiveOfficer; John H. Capobianco, our President and Chief Operating Officer; andCarl E. Smith, our Executive Vice President and Chief Financial Officer areintegral to the execution of our business strategy. If one or more of our key employeesleaves our employment, we will have to find a replacement with the combinationof skills and attributes necessary to execute our strategy. Because competitionfor skilled employees is intense, and the process of finding qualified individualscan be lengthy and expensive, we believe that the loss of the services of keypersonnel could adversely affect our business, financial condition and resultsof operations. We cannot assure you that we will continue to retain suchpersonnel.

***Our failure to compete successfully could cause ourrevenue or market share to decline.***

The market for oursolutions and services is intensely competitive and is characterized by rapidlyevolving industry standards, technology and user needs and the frequentintroduction of new solutions and services. Some of our competitors may be moreestablished, benefit from greater name recognition and have substantiallygreater financial, technical and marketing resources than we do. In addition, anumber of companies new to our market have introduced or developed solutionsand services that are competitive with one or more components of the solutionsthat we offer. We expect that additional competitors will continue to enterthis market. Moreover, we expect that competition will continue to increase asa result of consolidation in both the information technology and healthcaretechnology industries. If one or more of our competitors or potentialcompetitors were to merge or partner with one of our competitors, the change inthe competitive landscape could adversely affect our ability to competeeffectively. Furthermore, our potential customer base is composed of a limitednumber of healthcare insurance payers. This limited number of potentialcustomers, and the fact that many of our competitors already may have anexisting relationship with many of them, is likely to further increase thelevel of competition within our industry and may lead to increased pricecompetition. We compete on the basis of several factors, including:

·       solutiondepth and functionality;

·       easeof deployment, integration and configuration;

·       domainexpertise;

·       depthof clinical content;

·       servicesupport;

·       solutionprice;

·       breadthof sales infrastructure; and

·       breadthof customer support.

There can be no assurancethat we will be able to compete successfully against current and future competitorsor that the competitive pressures that we face will not materially adverselyaffect our business, financial condition and results of operations.

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***Acquisitions,business combinations and other transactions may be difficult to complete and,if completed, may have a negative effect on our operating results, financialcondition and the prospects of our business.***

We may pursue acquisitionsof existing companies in order to grow our business and to diversify our solutionsand services if we determine that such acquisitions are likely to serve ourstrategic goals. We cannot assure you that we will be able to locate anysuitable acquisition opportunities. Further, even if we find suchopportunities, we cannot assure you that we will be able to integratesuccessfully any future acquisitions, that these acquired companies willoperate profitably or that we will realize the potential benefits from theseacquisitions. To date, we and our management have had limited experience withthe integration of acquired businesses. If we do not successfully integrateacquired companies, the attention of our management may be diverted and ourbusiness, financial condition and results of operations could be adverselyaffected.

***Complex softwaresuch as ours often contains undetected defects or errors, which could lead toan increase in our costs or a reduction in our revenue.***

It is possible that errors may be found in oursolutions after the introduction of new software or enhancements to existingsoftware have been made. We continually introduce new solutions andenhancements to our solutions, and despite testing by us, it is possible thaterrors might occur in our software. If we detect any errors before we introducea solution, we might have to delay deployment for an extended period of timewhile we address the problem. If we do not discover software errors that affectour new or current solutions or enhancements until after they are deployed, wewould need to provide enhancements to correct such errors. Errors in our softwarecould result in:

·       harmto our reputation;

·       lostsales;

·       delaysin commercial release;

·       solutionliability claims;

·       delaysin or loss of market acceptance of our solutions;

·       license terminations orrenegotiations; and

·       expensesand diversion of resources to remedy errors.

Furthermore, our customersmight use our software solutions together with solutions from other companies.As a result, when problems occur, it might be difficult to identify the softwaresolution that is the source of the problem. Even when our software solutions donot cause these problems, the existence of these errors might cause us to incursignificant costs, divert the attention of our technical personnel from oursolution development efforts, impact our reputation and cause significantcustomer relations problems.

***If we are deemed toinfringe on the proprietary rights of third-parties, we could incurunanticipated expenses and be prevented from providing our solutions and services.***

Many participants in our industry have an increasingnumber of patents and patent applications, as well as copyrights and tradesecrets, and have frequently demonstrated a readiness to take legal actionbased on allegations of patent and other intellectual property infringement. Wecould face an adverse claim and litigation alleging infringement by us of theintellectual property rights of others.

We could be subject to intellectual propertyinfringement claims for our current or future solutions and services if oursolutions’ functionality overlaps with competitive solutions. While we do notbelieve that we have infringed or are infringing on any proprietary rights ofthird-parties, we cannot assure you that infringement claims will not beasserted against us or that those claims will be unsuccessful.

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If infringement claims arebrought against us, we would likely incur substantial costs and suffer thediversion of management resources defending any infringement claims. We cannotbe certain that we will have the financial resources to defend ourselves againstany patent or other intellectual property litigation. If we were found toinfringe on the intellectual property rights of others, we might be forced topay significant license fees or royalties or damages for infringement,including, if the claimant successfully claims willful infringement, potentialtreble damages. Moreover, we cannot assure you that a license for anyintellectual property of third-parties that might be required for the operationof our solutions or services will be available on commercially reasonableterms, or at all. In addition, we could be forced to stop providing certainsolutions and services or using certain technology or trademarks if we areenjoined or face an injunction from a court, or our use of such items could berestricted on terms that we find unacceptable. Even the mere announcement ofintellectual property litigation against us could cause our stock price todrop, regardless of the ultimate outcome of the dispute. We would likely incursubstantial costs and suffer the diversion of management resources defendingany infringement claims. Furthermore, a party making a claim against us couldsecure a judgment awarding substantial damages, as well as injunctive or otherequitable relief that could effectively block our ability to provide solutionsor services. In addition, we cannot assure you that licenses for anyintellectual property of third-parties that might be required for the operationof our solutions or services will be available on commercially reasonableterms, or at all.

***Our failure tolicense and effectively integrate third-party technologies could adverselyaffect our ability to sell our solutions and lead to a decline in revenue andthe future growth of our business.***

For some of the technology that is used in oursolutions and in providing our services, we depend upon licenses fromthird-party vendors. For example, we license a database module that is materialto our Advanced Medical Management module from InterSystems Corporation. Wemust continue licensing these technologies to operate and license our solutionsand to service our customers. These technologies might not continue to beavailable to us on commercially reasonable terms, if at all. Most of theselicenses are for a limited duration and can be renewed only by mutual consent,including the InterSystems license the expiration of which was originally December 31,2006 but has been extended until May 15, 2007 while we negotiate a renewal. Inaddition, most of these licenses, including the InterSystems license, may beterminated if we breach the terms of the license and fail to cure the breachwithin a specified period of time. Our inability to obtain any of theselicenses could delay development of new solutions and services or cause us tocease operating one or more solutions or services until equivalent replacementtechnology can be identified, licensed and integrated. There is no assurancethat we would be able to find an equivalent replacement technology, and if wedid, the resources required to obtain and implement an equivalent replacementtechnology could be significant and could harm our business, financialcondition and results of operations.

Most of the technologythat we license from third-parties is licensed pursuant to agreements that arenon-exclusive. Therefore, our competitors may obtain the right to use thetechnology covered by such licenses and use the technology to compete directlywith us. Our use of third-party technologies exposes us to increased risks,including, but not limited to, risks associated with the integration of suchtechnology into our solutions and services, the diversion of our resources fromthe development of our own proprietary technology and our inability to generaterevenue from such licensed third-party technology sufficient to offsetassociated acquisition and maintenance costs. In addition, if our vendorschoose to cease providing any of our licensed third-party technology ordiscontinue support of the licensed third-party technology in the future, wemight not be able to offer our related modules and services. Furthermore, ifthese third-parties are unsuccessful in their continued research and developmentefforts or we are unsuccessful in our internal technology development efforts,we might not be able to modify or adapt our own solutions to effectivelycompete in our industry.

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***We have limitedintellectual property protection and may be unable to adequately protect orenforce our intellectual property rights. This could substantially impair ourability to compete and achieve our business goals.***

Our success and business plan are predicated on ourproprietary systems and technology. Accordingly, protecting our intellectualproperty rights related to our systems and technology is critical to ourcontinued success and our ability to maintain our competitive position. Weprotect our proprietary systems through a combination of trademark, tradesecret and copyright law, confidentiality agreements and technical measures. Wecurrently have one pending patent application and we also filed an applicationunder the Patent Cooperation Treaty, which preserves our rights to seek acorresponding patent in certain foreign countries should we determine thatforeign patent protection is desirable. However, we can give no assurance thatsuch patents will ever be issued or, if such patents are issued, that theirclaims will have sufficient scope to ensure protection of any of our solutionsor services or to offer a competitive advantage. We cannot be sure that thesteps we have taken will prevent misappropriation of our technology orinfringement of our intellectual property rights. We cannot ensure that otherswill not independently develop similar or alternative technologies or duplicateany of our or our licensors’ technologies, or that we will develop additionalproprietary technologies that are patentable or protectable intellectualproperty. In addition, the process of completing patents could divert ourresources away from designing new solutions or otherwise developing our solutions.

To protect our intellectual property rights, we may inthe future need to assert claims of infringement or misappropriation of suchrights against third-parties. The outcome of litigation to enforce ourintellectual property rights is highly unpredictable, could result insubstantial costs and diversion of resources and could have a material adverseeffect on our financial condition and results of operations regardless of thefinal outcome of such litigation. Such infringement or misappropriation of ourintellectual property would have an adverse effect on our competitive position.We also may have to engage in litigation in the future to enforce or protectour intellectual property rights or to defend against claims of invalidity, andwe may likely incur substantial out of pocket costs and the diversion of management’stime and attention in so doing.

Despite our efforts toprotect our unpatented and unregistered intellectual property rights, we maynot be successful or the safeguards may not be adequate to detect or determisappropriation of our technology or to prevent an unauthorized third-partyfrom copying or otherwise obtaining and using our products, technology or otherinformation that we regard as proprietary. Policing unauthorized use of oursolutions, services and proprietary technology is very difficult, and nearlyimpossible on a worldwide basis. If we are not able to protect our intellectualproperty rights or if our intellectual property is otherwise impaired, it couldresult in significant harm to our future growth plans and the success of ourbusiness could be materially and adversely affected.

***Factors beyond ourcontrol could cause interruptions in our operations, which would adverselyaffect our reputation in the marketplace and our business, financial conditionand results of operations.***

To succeed, we mustbe able to operate our systems without interruption. Certain of ourcommunications and information services are provided through our third-partyservice providers, which we do not control. Our operations are vulnerable tointerruption by damage from a variety of sources, many of which are not withinour control, including without limitation:

·       powerloss and telecommunications failures;

·       softwareand hardware errors, failures or crashes;

·       lossor interruption of Internet access;

·       computerviruses and similar disruptive problems; and

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·       fire,flood and other natural disasters.

Any significantinterruptions in our services or operations would damage our reputation in themarketplace, may result in liability to our customers and have a negativeimpact on our business, financial condition and results of operations.

***Performanceproblems with our solutions or services or our customers’ system failures,whether caused by hardware, software or other problems, could cause us to losebusiness or incur liabilities.***

Our customer satisfaction and our business could beharmed if our customers experience transmission delays or failures or loss ofdata in their systems as a result of our solutions or services. These systems,and the software used in these systems, are complex, and despite testing andquality control, we cannot be certain that problems will not occur or that theywill be detected and corrected promptly and permanently when they do occur.

We have developedcontingency plans for handling customer system failures and other customeremergencies; however, we have limited backup facilities if these systems arenot functioning. The occurrence of a major catastrophic event or other systemfailure at any of our facilities or at one of our third-party facilities couldinterrupt our services or result in the loss of stored data, which could have amaterial adverse impact on our business or cause us to incur materialliabilities. If we are unable to deliver our solutions to our customers as aresult of the failure of a customer’s system, our inability to deliver willnegatively impact our financial condition. Although we maintain insurance forour business, we cannot assure that our insurance will be adequate tocompensate us for all losses that may occur or that this coverage will continueto be available on acceptable terms or in sufficient amounts.

***We may not generate sufficient future taxable incometo allow us to realize our deferred tax assets.***

We have a significantamount of tax loss carryforwards that will be available to reduce the taxes wewould otherwise owe in the future. We have not recognized any portion of thesefuture tax deductions in our consolidated balance sheet as of December 31,2006. The realization of our deferred tax assets is dependent upon our generationof future taxable income during the periods in which we are permitted, by law,to use those assets. We exercise judgment in evaluating our ability to realizethe recorded value of these assets, and consider a variety of factors, includingthe scheduled reversal of deferred tax liabilities, projected future taxableincome and tax planning strategies in making this assessment. Our evaluation ofthe realizability of deferred tax assets must consider both positive andnegative evidence, and the weight given to the potential effects of positiveand negative evidence is based on the extent to which the evidence can be verifiedobjectively. We cannot assure you that we will have profitable operations inthe future that will allow us to realize our deferred tax assets.

***If we fail todevelop or maintain an effective system of internal controls, we may not beable to accurately report our financial results or prevent fraud. As a result,current and potential shareholders could lose confidence in our financialreporting, which would harm our business and the trading price of our commonstock.***

Effective internal controls are necessary for us toprovide reliable financial reports and effectively prevent fraud and to operatesuccessfully as a public company. If we cannot provide reliable financialreports or prevent fraud, our reputation and operating results would be harmed.We have in the past discovered, and may in the future discover, areas of ourinternal controls that need improvement.

During the audit of our financial statements as of andfor the year ended December 31, 2006, no material weaknesses werediscovered. In connection with the audit of our financial statements as of andfor the year ended December 31, 2005 and re-audits of our financialstatements as of and for the years ended December 31, 2004 and 2003 (ofwhich, financial statements for the year ended December 31, 2003 are not 

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included in the “ConsolidatedFinancial Statements” as set forth under Item 8 of this Annual Report on Form 10-K),our independent auditors reported to our audit committee on July 28, 2006that we had material weaknesses in our internal controls (as defined under thestandards established by the Public Company Accounting Oversight Board—U.S.)with respect to our accounting and reporting of certain complex transactions.In addition, on December 16, 2005, in connection with their audit of our financialstatements as of and for the year ended December 31, 2004, our previousindependent auditors reported to our audit committee and informed us that wehad material weaknesses in our internal controls as defined under auditingstandards generally accepted in the United States of America. A materialweakness is a significant deficiency, or a combination of significantdeficiencies, that results in more than a remote likelihood that a materialmisstatement of the annual or interim financial statements will not beprevented or detected.

The followingmaterial weaknesses were reported by our independent auditors in connectionwith their audit of our financial statements as of and for the year ended December 31,2005 and re-audit of our financial statements as of and for the years ended December 31,2004 and 2003:

·       Wedid not have adequate controls to provide reasonable assurance that allelements of contractual arrangements with customers were being recorded inaccordance with generally accepted accounting principles. Specifically, we didnot have adequate controls to properly determine that persuasive evidence ofcontractual arrangements with customers existed before recording revenue.Errors in determining that contracts had been signed by customers resulted inthe premature recognition of revenue that should have been deferred to laterperiods, in accordance with Statement of Position 97-2 (SOP 97-2), “SoftwareRevenue Recognition,” and related interpretations. As a result of theseidentified deficiencies, material revenue-related audit adjustments wererecorded to our financial statements to defer revenue from the periods in whichthey were originally recorded until such time as the appropriate revenue recognitioncriteria were met.

·       Wedid not have appropriate accounting personnel who possessed an appropriatelevel of experience in the selection and application of generally acceptedaccounting principles with respect to the accounting for our previouslyoutstanding Series A convertible preferred stock and our previouslyoutstanding Series B and C redeemable convertible preferred stock (whichconverted into common stock upon the closing of our initial public offering on December 18,2006) to provide reasonable assurance that all transactions were being appropriatelyrecorded and summarized in our financial statements. Specifically, we did notproperly identify and record the beneficial conversion option relating to theaccrued and unpaid dividends on our previously outstanding Series Aconvertible preferred stock. We did not identify and record the embeddedderivative conversion option on our previously outstanding Series B and Credeemable convertible preferred stock and reflect the changes in the fairvalue of those conversion options in earnings. We did not accrete the carryingvalue of our previously outstanding Series C redeemable convertiblepreferred stock to liquidation value, which was three times the stated value.As a result of these identified deficiencies, we recorded material post-closingaudit adjustments to our financial statements for the years ended December 31,2005, 2004 and 2003 (of which, financial statements for the year ended December 31,2003 are not included in the “Consolidated Financial Statements” as set forthin Item 8 of this Annual Report on Form 10-K).

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The followingmaterial weaknesses were reported by our previous independent auditors inconnection with their audit of our financial statements as of and for the yearsended December 31, 2004 and 2003 (of which, financial statements for theyear ended December 31, 2003 are not included in the “ConsolidatedFinancial Statements” as set forth under Item 8 of this Annual Report on Form 10-K):

·       Errorsin revenue recognition were identified that resulted primarily from a lack ofsecondary review over the application of accounting principles to specificcontract terms as well as the analysis and estimates supporting the amountsrecorded. These errors resulted from the lack of a systematic process foraccumulating information supporting VSOE and underlying recorded revenue aswell as the lack of appropriate levels of review. As a result, we recordedmaterial post-closing audit adjustments to our financial statements for theyear ended December 31, 2003, which financial statements are not includedin the “Consolidated Financial Statements” as set forth under Item 8 of thisAnnual Report on Form 10-K.

·       Wedid not have appropriate accounting personnel who possessed an appropriatelevel of experience in the selection and application of generally acceptedaccounting principles with respect to the accounting for our previouslyoutstanding Series A convertible preferred stock and our previouslyoutstanding Series B and C redeemable convertible preferred stock toprovide reasonable assurance that all transactions were being appropriatelyrecorded and summarized in the financial statements. Specifically, we did notaccrete the carrying value to redemption value at the earliest redemption dateand did not properly record the accrued and unpaid dividends on our previouslyoutstanding Series A convertible preferred stock and our previouslyoutstanding Series B and C redeemable convertible preferred stock. As aresult of these identified deficiencies, we recorded material post-closingaudit adjustments to our financial statements for the year ended December 31,2003, which financial statements are not included in the “ConsolidatedFinancial Statements” as set forth under Item 8 of this Annual Report on Form 10-K.

·       Wedid not have appropriate accounting personnel who possessed an appropriatelevel of experience in the selection and application of generally acceptedaccounting principles with respect to the accounting for income taxes,specifically the appropriate valuation allowance for deferred tax assets. As aresult of this material weakness, we recorded material post-closing auditadjustments to our financial statements for the year ended December 31,2003, which financial statements are not included in the “ConsolidatedFinancial Statements” as set forth under Item 8 of this Annual Report on Form 10-K.

We have begun ourremediation efforts and we believe that our actions in this regard havestrengthened our internal controls over financial reporting. Our efforts todate have included the following:

·       Wehave expanded our accounting staff to add additional skills and experience,specifically experience in revenue recognition for software sales and services,and will continue the expansion of our accounting staff, as well as the use ofqualified outside professionals as necessary to enhance and maintain ourinternal accounting controls.

·       Weinstituted new internal accounting controls, including a detailed review of newcontracts by qualified accounting personnel to appropriately recognize andrecord revenue from term license sales as well as the sales from professionalservices and subscription and maintenance.

·       Weinstituted new internal accounting controls over the pricing of our separatesoftware and service offerings.

·       Weinstituted new accounting procedures to accrete the value of our previouslyoutstanding preferred stock to its redemption value at the earliest redemptiondate, and to accrete the value of our previously outstanding preferred stockfor accrued but unpaid dividends.

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·       Wehave engaged qualified outside professionals to assist our accounting staff inanalyzing and recording current and deferred income tax provisions andbenefits, assets, and liabilities, and will continue to do so as necessary toimprove, enhance and maintain our system of internal accounting controls.

As of December 31, 2006, we have incurredapproximately $0.3 million of costs related to our efforts to remediate ourmaterial weaknesses. The costs associated with our remediation efforts to datehave not been material. We will continue to evaluate the effectiveness of thecontrol environment and will continue to refine existing controls. We believethat the material weaknesses identified by our independent auditors have beenaddressed. However, it is possible that additional deficiencies in our internalcontrols may be discovered in the future. Any failure to maintain effectivecontrols, or any difficulties encountered in their improvement, could harm ouroperating results or cause us to fail to meet our reporting obligations and mayresult in a restatement of our prior period financial statements. Ineffectiveinternal controls could also cause investors to lose confidence in our reportedfinancial information, which would likely have a negative effect on the tradingprice of our common stock.

In addition, anydeficiencies in internal controls that we identify in the future will need tobe addressed as part of the evaluation of our internal controls over financialreporting pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 andmay impair our ability to comply with Section 404. See the immediatelyfollowing risk factor in this Annual Report on Form 10-K regardingour reporting obligations and internal controls over financial reporting.

***If we fail tocomply with the reporting obligations of the Securities Exchange Act of 1934and Section 404 of the Sarbanes-Oxley Act of 2002, or if we fail toachieve and maintain adequate internal controls over financial reporting, ourbusiness results of operations and financial condition, and investors’confidence in us, could be materially adversely affected.***

As a public company, we are required to comply withthe periodic reporting obligations of the Exchange Act including preparingannual reports, quarterly reports and current reports. Our failure to prepareand disclose this information in a timely manner could subject us to penaltiesunder federal securities laws, expose us to lawsuits and restrict our abilityto access financing. In addition, we are required under applicable law and regulationsto integrate our systems of internal controls over financial reporting. We areevaluating our existing internal controls with respect to the standards adoptedby the Public Company Accounting Oversight Board. During the course of ourevaluation, we have identified areas requiring improvement and have begun todesign enhanced processes and controls to address issues identified throughthis review. This could result in significant delays and costs to us andrequire us to divert substantial resources, including management time fromother activities.

We expect to dedicate significant management,financial and other resources in 2007 in connection with our compliance with Section 404of the Sarbanes-Oxley Act of 2002. We expect these efforts to include a reviewof our existing internal control structure. As a result of this review, we mayeither hire or outsource additional personnel to expand and strengthen ourfinance function. We cannot be certain at this time that we will be able tocomply with all of our reporting obligations and successfully complete theprocedures, certification and attestation requirements of Section 404 ofthe Sarbanes-Oxley Act of 2002 by the time that we are required to file ourannual report on Form 10-K for the fiscal year ended December 31,2007. If we fail to achieve and maintain the adequacy of our internal controls,we may not be able to ensure that we can conclude on an ongoing basis that wehave effective internal controls over financial reporting in accordance withthe Sarbanes-Oxley Act of 2002. Moreover, effective internal controls arenecessary for us to produce reliable financial reports and are important tohelp prevent fraud. As a result, our failure to satisfy the requirements of Section 404of the Sarbanes-Oxley Act of 2002 on a timely basis could result in the loss ofinvestor confidence in the reliability of our financial statements, which inturn could harm our business and negatively impact the trading price of ourcommon stock.

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**Item 1B.**               UnresolvedStaff Comments.

None.

**Item 2.**                        Properties.

We lease our headquartersin Wayne, Pennsylvania, which consists of approximately 90,000 square feet. Theleases for our headquarters expire in August 2016. We believe that ourfacilities are in good operating condition and will adequately serve our needsfor at least the next 18 months. We also anticipate that, if required, suitableadditional or alternative space will be available on commercially reasonableterms, in office buildings we currently occupy or in space nearby, toaccommodate expansion of our operations.

**Item 3.**                        LegalProceedings.

There are no materiallegal proceedings to which we are a party or to which any of our property issubject. We may, however, become subject to lawsuits in the ordinary course ofbusiness.

**Item 4.**                        Submissionof Matters to a Vote of Security Holders.

On October 18,2006, certain holders of our capital stock executed a written consent ofshareholders in lieu of a special meeting approving the following actions:

·       amendmentof our articles of incorporation to effectuate a one-for-two reverse stocksplit of our common stock to be effective prior to the closing of our initialpublic offering;

·       amendmentand restatement of our articles of incorporation to be effective upon theclosing of our initial public offering;

·       secondamendment and restatement of our bylaws to be effective upon the closing of ourinitial public offering; and

·       adoptionof our 2006 Equity Incentive Plan.

This written consent ofshareholders in lieu of a special meeting regarding the foregoing actions wasexecuted by the holders of at least 60% of our then-outstanding shares of Series Apreferred stock, Series B preferred stock and Series C preferredstock (each voting as a separate class) and of at least a majority of ourthen-outstanding shares of common stock, and was executed prior to the closingof our initial public offering. No meeting of shareholders was held inconnection with the submission of the foregoing matters to our shareholders. Incompliance with Section 1766(c) of the Pennsylvania BusinessCorporation of Law of 1988, as amended, notice of the approval and adoption ofeach of the foregoing actions was mailed to all of our shareholders who did notexecute a counterpart to the written consent of shareholders in lieu of aspecial meeting regarding the foregoing actions.

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**PART II**

**Item 5.**                        Marketfor Registrant’s Common Equity, Related Stockholder Matters and IssuerPurchases of Equity Securities.

**Market Informationof Common Stock**

Our common stock istraded on the NASDAQ Global Market under the symbol “MEDE” since December 13,2006. Prior to that date, there was no public market for our common stock. Forthe period from December 13, 2006 through December 31, 2006, the highand low sale prices per share of our common stock as reported on the NASDAQGlobal Market were $10.24 and $9.04, respectively.

As of March 27,2007, we had approximately 128 holders of record of our common stock.

**Securities Authorized for Issuance Under Equity CompensationPlans**

| **Plan category**                                      | ** ** | ** ** | ** ** | **Number of  securities to be  issued upon  exercise of  outstanding  options,  warrants,  and rights** | ** ** | **Weighted  average  exercise price  of outstanding  options,  warrants and  rights** | ** ** | **Number of securities  remaining available for  future issuance under  equity compensation  plans (excluding  securities reflected  in column (a))** | ** ** |
|-------------------------------------------------------------|------------|------------|------------|---------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                  | ** ** | **(a)**    | ** ** | **(b)**                                                                                                                               | ** ** | **(c)**                                                                                              | ** ** |
| Equity  compensation plans approved by security holders     |       |       | 2,937,082  |                                                                                                                                  |       |                                                                                                 | 4.27       |                                                                                                                                                                                                         |       |   | 1,500,000 |   |   |
| Equity compensation  plans not approved by security holders |       |       | 409,558    |                                                                                                                                  |       |                                                                                                 | 2.76       |                                                                                                                                                                                                         |       |   | — |   |   |

 

**Stock PerformanceGraph and Cumulative Total Return**

*The following StockPerformance Graph shall not be deemed incorporated by reference into any of ourfilings under the Securities Act of 1933 or the Securities Exchange Act of1934, except to the extent we specifically incorporate it by reference therein.*

Prior to December 13,2006, shares of our common stock were not publicly traded and there was nopublic market for our common stock. The graph below compares the cumulative totalshareholder return of our common stock with that of the NASDAQ Global MarketComposite Index and the NASDAQ Computer Index from December 13, 2006 (thedate shares of our common stock began to trade publicly) through December 31,2006. The graph assumes an investment of $100 in shares of our common stock andin both of the other indices on December 13, 2006 and reinvestment of alldividends. The comparisons in this graph are provided in accordance withSecurities and Exchange Commission disclosure requirements and are not intendedto forecast or be indicative of the future performance of shares of our commonstock.

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**Cumulative TotalStockholder Return**

We chose the foregoing indexesfor comparison with our stock price because we believe the NASDAQ Global MarketComposite index is a broad equity market index of all companies whose stock istraded on the NASDAQ market, as ours is, and because the NASDAQ Computer Indexis representative of companies in the same line-of-business as that in which weoperate.

**Dividend Policy**

We have never declared orpaid cash dividends on our common stock. We do not anticipate declaring orpaying any cash dividends on our common stock in the foreseeable future. Wecurrently intend to retain all available funds and any future earnings tofinance the development and growth of our business. Consequently, shareholderswill need to sell their shares of our common stock to realize a return on theirinvestment, if any.

**Sales ofUnregistered Securities**

On January 3, 2006, we granted options to 15 ofour employees to purchase an aggregate of 28,750 shares of our common stockunder our Amended and Restated Stock Option Plan at an exercise price of $2.50per share.

On March 7, 2006, we issued 250 shares of ourcommon stock upon the exercise of options granted under our Amended andRestated Stock Option Plan at an exercise price of $0.50 per share.

On April 10, 2006, we issued 1,000 shares of ourcommon stock upon the exercise of options granted under our Amended andRestated Stock Option Plan at an exercise price of $2.00 per share.

On April 26, 2006, we granted options to 38 ofour employees to purchase an aggregate of 353,375 shares of our common stockunder our Amended and Restated Stock Option Plan at an exercise price of $22.00per share.

On May 24, 2006, we issued 625 shares of ourcommon stock upon the exercise of options granted under our Amended andRestated Stock Option Plan at an exercise price of $0.50 per share.

On June 9, 2006, we issued 500 shares of ourcommon stock upon the exercise of options granted under our Amended andRestated Stock Option Plan at an exercise price of $0.50 per share.

On July 13, 2006, we issued 1,500 shares of ourcommon stock upon the exercise of options granted under our Amended andRestated Stock Option Plan at an exercise price of $2.00 per share.

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On July 18, 2006, we granted options to two ofour employees to purchase an aggregate of 126,000 shares of our common stockunder our Amended and Restated Stock Option Plan at an exercise price of $22.00per share.

On August 11, 2006, we issued 1,240,448 shares ofour common stock upon the conversion of 1,266,991 shares of our Series Bpreferred stock pursuant to the terms of certain conversion agreements that weentered into with certain of the holders of our then-outstanding Series Bpreferred stock.

On August 11, 2006, we issued 1,122,134 shares ofour common stock upon the conversion of 1,528,199 shares of our Series Cpreferred stock pursuant to the terms of certain conversion agreements that weentered into with certain of the holders of our then-outstanding Series Cpreferred stock.

On September 15, 2006, we issued 1,000 shares,1,500 shares and 1,250 shares of our common stock upon the exercise of optionsgranted under our Amended and Restated Stock Option Plan at an exercise priceof $0.50 per share, $2.00 per share and $4.00 per share, respectively.

On September 20, 2006, we issued 625 shares ofour common stock upon the exercise of options granted under our Amended andRestated Stock Option Plan at an exercise price of $0.50 per share.

On October 30, 2006, we issued 1,000 shares ofour common stock upon the exercise of options granted under our Amended andRestated Stock Option Plan at an exercise price of $22.00 per share.

On November 2, 2006, we issued 1,000 shares ofour common stock upon the exercise of options granted under our Amended andRestated Stock Option Plan at an exercise price of $0.50 per share.

On November 3, 2006, we issued 1,500 shares ofour common stock upon the exercise of options granted under our Amended andRestated Stock Option Plan at an exercise price of $2.00 per share.

On November 8, 2006, we issued 1,500 shares of ourcommon stock upon the exercise of options granted under our Amended andRestated Stock Option Plan at an exercise price of $2.00 per share.

On November 10, 2006, we issued 750 shares and1,500 shares of our common stock upon the exercise of options granted under ourAmended and Restated Stock Option Plan at an exercise price of $0.50 per shareand $2.00 per share, respectively.

On November 15, 2006, we issued 1,500 shares ofour common stock upon the exercise of options granted under our Amended andRestated Stock Option Plan at an exercise price of $2.00 per share.

On November 16, 2006, we issued 2,500 shares ofour common stock upon the exercise of options granted under our Amended andRestated Stock Option Plan at an exercise price of $2.00 per share.

On November 20, 2006, we issued 1,000 shares ofour common stock upon the exercise of options granted under our Amended andRestated Stock Option Plan at an exercise price of $2.00 per share.

On November 25, 2006, we issued 1,500 shares ofour common stock upon the exercise of options granted under our Amended andRestated Stock Option Plan at an exercise price of $2.00 per share.

On November 27, 2006, we issued 1,500 shares ofour common stock upon the exercise of options granted under our Amended andRestated Stock Option Plan at an exercise price of $2.00 per share.

On November 29, 2006, we issued 3,000 shares ofour common stock upon the exercise of options granted under our Amended andRestated Stock Option Plan at an exercise price of $2.00 per share.

On November 30, 2006, we issued 3,000 shares ofour common stock upon the exercise of options granted under our Amended andRestated Stock Option Plan at an exercise price of $2.00 per share.

On December 18, 2006, we issued 2,358,123 sharesof our common stock upon the automatic conversion of all of the outstandingshares of our Series A preferred stock, including the accrued and 

35

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unpaid dividends thereon,upon the closing of our initial public offering pursuant to the terms of ourarticles of incorporation which was then in effect.

On December 18, 2006, we issued 1,737,638 sharesof our common stock upon the automatic conversion of all of the outstandingshares of our Series B preferred stock upon the closing of our initialpublic offering pursuant to the terms of our articles of incorporation whichwas then in effect.

On December 18, 2006, we issued 1,661,664 sharesof our common stock upon the automatic conversion of all of the outstandingshares of our Series C preferred stock upon the closing of our initialpublic offering pursuant to the terms of our articles of incorporation whichwas then in effect.

On December 18, 2006, we issued 124,344 shares ofour common stock upon the “cashless exercise” of warrants held by certainpersons who are beneficial owners of at least 10% percent of our common stock. Theterm “cashless exercise” refers to the surrender of a portion of the shares ofour common stock underlying the exercised warrant as payment for the exerciseprice of the warrant exercised. We did not receive any cash proceeds from theexercise of any of these warrants.

On December 18, 2006, we issued 37,500 shares ofour common stock upon the exercise of warrants held by David St.Clair, ourChairman of the Board of Directors and Chief Executive Officer. Each share ofcommon stock was issued at an exercise price of $1.80 per share. We receivedcash proceeds in the aggregate amount of $67,500 from the exercise of thesewarrants.

The foregoing securities were offered and sold by usin reliance upon exemptions from the registration requirements provided by Section 4(2) ofthe Securities Act of 1933, as amended, and Regulation D promulgated thereunderrelating to sales not involving any public offering and/or Rule 701promulgated under the Securities Act of 1933, as amended, relating totransactions occurring under compensatory benefit plans. For each offering andsale for which we relied on Section 4(2) of the Securities Act of1933, as amended, and Regulation D promulgated thereunder, the purchasers wereaccredited investors and were provided with the appropriate access toinformation about us.

No underwriters wereinvolved in any of the foregoing grants, conversions and exercises. Nounderwriting discounts or commissions were applicable to any of the foregoinggrants, conversions and exercises.

**Use of Proceedsfrom Initial Public Offering**

Our registration statement on Form S-1(Commission File No. 333-136532) covering the initial publicoffering of 4,700,000 shares of our common stock, including 1,400,000 sold by certainselling shareholders, was declared effective by the SEC on December 13,2006. The offering closed on December 18, 2006 and did not terminatebefore any securities were sold. As of the date of the filing this report, theoffering has terminated and all of the securities registered pursuant to theregistration statement have been sold.

The offering was managed by Cowen and Company, LLC andCIBC World Markets Corp. Cowen and Company, LLC, CIBC World Markets Corp. andPacific Growth Equities, LLC were representatives of the underwriters withrespect to our initial public offering.

The aggregate proceeds to us from the sale of all3,300,000 shares of common stock registered for sale by us based on the initialpublic offering price of $10.00 per share (prior to underwriting commissions)was $33 million. The aggregate proceeds to the selling shareholders namedin the registration statement from the sale of all 1,400,000 shares of commonstock registered for sale by them based on the initial public offering price of$10.00 per share (prior to underwriting commissions) was $14 million.

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ThroughDecember 31, 2006, we incurred the following expenses in connection withour initial public offering in the following amounts (as approximated, inthousands):

| Underwriting  discounts and commissions   |   | $      | 2,310  |   |
|-------------------------------------------|--------|--------|--------|--------|
| Finders’ fees                        |   | — |   |
| Expenses paid to  or for our underwriters |   | — |   |
| Other expenses                            |   | $      | 4,282  |   |
| Total expenses                            |   | $      | 6,592  |   |

 

No payments for any of the foregoing expenses weremade directly or indirectly to (i) any of our directors, officers or theirassociates, (ii) any person(s) owning 10% or more of any class of ourequity securities or (iii) any of our affiliates.

Net proceeds from the sale of all 3,300,000 shares ofcommon stock registered for sale by us based on the initial public offeringprice of $9.30 per share (net of underwriting commissions) and estimatedoffering expenses of approximately $4.3 million payable by us, wereapproximately $26.4 million.

BetweenDecember 13, 2006 and December 31, 2006, the net proceeds have beenused for the following purposes in the following amounts (as approximated, inthousands):

| Construction of plant,  building and facilities                                                                                                      |   | $       | — |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------|--------|--------|
| Purchase and  installation of machinery and equipment                                                                                                |   | —  |   |
| Purchase of real estate                                                                                                                              |   | —  |   |
| Acquisition of  other business                                                                                                                       |   | —  |   |
| Repayment of indebtedness                                                                                                                            |   | $       | 572    |   |
| Working capital                                                                                                                                      |   | —  |   |
| Temporary investments                                                                                                                                |   | —  |   |
| Other purposes (total)  (for which at least $100,000 has been used):                                                                                 |   | $  | 9,505  |   |
| *(1)   Payment  of accrued and unpaid dividends to the former holders of our Series B  and Series C preferred stock—$9,500* |   |    |   |
| Total                                                                                                                                                |   | $       | 10,077 |   |

 

As disclosed in the table immediately above, we haveused approximately $9.5 million of the net proceeds to pay the accrued andunpaid dividends to the former holders of our Series B and Series Cpreferred stock whose shares automatically converted into common stock upon theconsummation of our initial public offering. Of this amount, approximately $7.7million of accrued and unpaid dividends were directly or indirectly paid tocertain of our directors and officers and to certain persons beneficiallyowning 10% or more of any class of our equity securities on account of theirprevious record or beneficial ownership of shares of our Series B and Series Cpreferred stock.

We intend to use thebalance of the net proceeds from our initial public offering for generalcorporate purposes, including working capital needs.

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**Item6.**                        SelectedFinancial Data.

Thefollowing table sets forth our selected financial data for the periodsindicated. The data set forth should be read in conjunction with ourConsolidated Financial Statements together with the related notes theretoincluded elsewhere herein and in conjunction with our “Management’s Discussionand Analysis of Financial Condition and Results of Operations” under Item 7herein. As further explained in Notes 2 and 6 of the Consolidated FinancialStatements, all of our Preferred Stock was converted to common stock upon thecompletion of our initial public offering, which will affect the comparabilityof the amounts shown for 2006 with earlier periods.

| ** **                                                                                                         | ** ** | **Year Ended December 31,**                                             | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|
| ** **                                                                                                         | ** ** | **2006**                                                                               | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                                                         | ** ** | **(in thousands, except share and per share data)** | ** ** |
| **Consolidated Statement of Operations Data:**                                                                     |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Revenue                                                                                                            |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Subscription, maintenance  and transaction fees                                                                    |       | $                                                                                      | 22,090     |   | $ | 17,187 |   | $ | 14,666 |   | $ | 12,600 |   | $ | 9,456 |   |
| Term license revenue                                                                                               |       | 8,778                                                                                  |       | 9,729 |   | 6,260 |   | 2,439 |   | 2,119 |   |
| Professional services                                                                                              |       | 13,341                                                                                 |       | 11,680 |   | 7,102 |   | 5,488 |   | 4,844 |   |
| Total revenue                                                                                                      |       | 44,209                                                                                 |       | 38,596 |   | 28,028 |   | 20,527 |   | 16,419 |   |
| Cost of revenue                                                                                                    |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Subscription, maintenance  and transaction fees                                                                    |       | 7,641                                                                                  |       | 8,163 |   | 6,774 |   | 4,837 |   | 4,047 |   |
| Term licenses                                                                                                      |       | 1,722                                                                                  |       | 1,653 |   | 1,455 |   | 872 |   | 764 |   |
| Professional services                                                                                              |       | 5,806                                                                                  |       | 5,499 |   | 4,843 |   | 3,622 |   | 3,348 |   |
| Total cost of revenue                                                                                              |       | 15,169                                                                                 |       | 15,315 |   | 13,072 |   | 9,331 |   | 8,159 |   |
| Gross margin                                                                                                       |       | 29,040                                                                                 |       | 23,281 |   | 14,956 |   | 11,196 |   | 8,260 |   |
| Operating expenses                                                                                                 |       |                                                                                   |       |   |   |   |   |   |   |   |   |
| Sales and marketing                                                                                                |       | 10,534                                                                                 |       | 7,778 |   | 4,668 |   | 3,211 |   | 2,159 |   |
| Research and development                                                                                           |       | 8,045                                                                                  |       | 2,627 |   | 3,243 |   | 3,903 |   | 4,787 |   |
| General and  administrative                                                                                        |       | 12,520                                                                                 |       | 9,707 |   | 6,320 |   | 4,343 |   | 4,626 |   |
| Total operating expenses                                                                                           |       | 31,099                                                                                 |       | 20,112 |   | 14,231 |   | 11,457 |   | 11,572 |   |
| (Loss) income from  operations                                                                                     |       | (2,059                                                                                 | )          | 3,169 |   | 725 |   | (261 | ) | (3,312 | ) |
| Loss (gain) on  change in fair value of redeemable convertible preferred stock conversion  options                 |       | 8,615                                                                                  |       | 694 |   | 576 |   | (38 | ) | (127 | ) |
| Interest expense,  net                                                                                             |       | 466                                                                                    |       | 274 |   | 175 |   | 249 |   | 209 |   |
| (Loss) income  before (provision) benefit for income taxes                                                         |       | (11,140                                                                                | )          | 2,201 |   | (26 | ) | (472 | ) | (3,394 | ) |
| (Provision)  benefit for income taxes                                                                              |       | (6,677                                                                                 | )          | 6,491 |   | — |   | — |   | — |   |
| Net (loss) income                                                                                                  |       | $                                                                                      | (17,817    | ) | $ | 8,692 |   | $ | (26 | ) | $ | (472 | ) | $ | (3,394 | ) |
| Accretion of  convertible preferred shares and redeemable convertible preferred shares                             |       | (8,068                                                                                 | )          | (3,994 | ) | (6,113 | ) | (7,958 | ) | (5,799 | ) |
| (Loss) income  available to common shareholders                                                                    |       | $                                                                                      | (25,885    | ) | $ | 4,698 |   | $ | (6,139 | ) | $ | (8,430 | ) | $ | (9,193 | ) |
| (Loss) income per  share available to common shareholders, basic                                                   |       | $                                                                                      | (5.62      | ) | $ | 1.45 |   | $ | (1.92 | ) | $ | (2.71 | ) | $ | (2.97 | ) |
| (Loss) income per  share available to common shareholders, diluted                                                 |       | $                                                                                      | (5.62      | ) | $ | (0.66 | ) | $ | (1.92 | ) | $ | (2.71 | ) | $ | (2.97 | ) |
| Weighted average  shares used to compute (loss) income available to common shareholders per  common share, basic   |       | 4,605,318                                                                              |       | 3,229,064 |   | 3,189,366 |   | 3,107,920 |   | 3,090,193 |   |
| Weighted average  shares used to compute (loss) income available to common shareholders per  common share, diluted |       | 4,605,318                                                                              |       | 14,143,586 |   | 3,189,366 |   | 3,107,920 |   | 3,090,193 |   |

 

| ** **                                   | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                   | ** ** | **(in thousands)**                    | ** ** |
| **Consolidated Balance Sheet  Data:**        |       |                                       |       |   |   |   |   |   |   |   |   |
| Cash and cash equivalents                    |       | $                                          | 17,408     |   | $ | 2,447 |   | $ | 431 |   | $ | 764 |   | $ | — |   |
| Total current assets                         |       | 28,584                                     |       | 16,366 |   | 5,836 |   | 4,028 |   | 3,147 |   |
| Total assets                                 |       | 41,380                                     |       | 32,283 |   | 12,219 |   | 7,150 |   | 7,402 |   |
| Short-term debt                              |       | 2,161                                      |       | 1,262 |   | 552 |   | 699 |   | 2,143 |   |
| Deferred revenue, current                    |       | 9,662                                      |       | 8,951 |   | 5,639 |   | 3,861 |   | 1,823 |   |
| Total current liabilities                    |       | 17,287                                     |       | 17,137 |   | 10,016 |   | 7,077 |   | 6,979 |   |
| Long-term debt                               |       | 2,557                                      |       | 2,515 |   | 1,180 |   | 174 |   | 309 |   |
| Deferred revenue, net of  current            |       | 691                                        |       | 666 |   | 246 |   | — |   | — |   |
| Preferred stock                              |       | —                                     |       | 47,115 |   | 50,837 |   | 44,724 |   | 36,414 |   |
| Total shareholders’ equity (deficiency) |       | 18,465                                     |       | (38,402 | ) | (51,082 | ) | (44,980 | ) | (36,561 | ) |
|                                              |            |                                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**Item 7.**                        Management’sDiscussion and Analysis of Financial Condition and Results of Operations.

*The following discussion of our financial conditionand results of operations should be read in conjunction with the “SelectedFinancial Data” and our consolidated financial statements and the notes tothose statements appearing elsewhere in this report. The following discussioncontains forward-looking statements that reflect our plans, estimates andbeliefs. Our actual results could differ materially from those discussed inthese forward-looking statements. Factors that could cause or contribute to suchdifferences include, but are not limited to, those discussed below andelsewhere in this report, particularly under the caption “Risk Factors.”*

**Overview**

We are a provider of software, services and clinicalcontent to healthcare payers that allow them to improve the quality andaffordability of healthcare provided to their members and increase theiradministrative efficiency. Our Collaborative Care Management suite analyzesdata, automates payer workflow processes and electronically connects payers,healthcare providers and patients, providing them with a common view of thepatient’s health that helps to foster better clinical decision making. Oursolution is built around a suite of modular and easily configurable softwareapplications and utilizes the Internet to link our payer customers to theirmembers and their members’ chosen healthcare providers.

Our Collaborative Care Management suite is comprisedof four related product modules—(i) Data Gathering and Analytics; (ii) ClinicalRules and Processes; (iii) Advanced Medical Management; and (iv) CollaborativeData Exchange. Data Gathering and Analytics is a data engine with an analyticscomponent that enables a payer to process, summarize and evaluate informationfrom both internal and external sources. Clinical Rules and Processes is aclinical content and process management solution featuring embedded,state-of-the-art clinical best practices that have been validated byevidence-based medicine. Advanced Medical Management is a care managementsolution consisting of workflow and detection tools that address the continuumof care management processes, such as specialized case and disease management,admission and outpatient certification, referral management, concurrent reviewand discharge planning. Collaborative Data Exchange is a communication servicethat facilitates the mutual transmission of information between the variousstakeholders in the healthcare process. Collaborative Data Exchange addressesthe entire spectrum of clinical data exchange: from basic service requests(referrals, authorizations and extensions) to simple clinical informationtransfer (questionnaire fulfillment), to complex electronic health record-basedtransactions. The Collaborative Data Exchange module allows our customers tosecurely transmit health records containing critical patient information in aneasily understood format to patients and providers at the time they are makingtreatment decisions. We refer to these health records as Patient ClinicalSummaries and believe that they are a critical first step to developingElectronic Health Records. In the future, we expect our Patient ClinicalSummaries to integrate additional information provided by patients and a broadrange of providers, thereby increasing their value to all constituents.

Since 1999, we have focused on broadening our solutionportfolio in order to respond to the evolving needs of our customers. In 1999,we began offering our Data Gathering and Analytics module; in 2001, we beganoffering our Collaborative Data Exchange module; in 2003, we began offeringOptiCareCert; in 2004, we began offering OptiCarePath; and in 2005, we beganoffering our customers the ability to electronically transmit Patient ClinicalSummaries via our Collaborative Data Exchange module.

We operate in a relatively small market, where we have56 of approximately 350 potential customers. This presents our management withthe challenge of expanding our revenue within a limited potential customerbase, and the attendant risk of our inability to grow revenue if we are unableto do so. Our strategy is to develop new customers, sell additional solutionsto existing customers, and introduce new products such as MEDeWeaver andMEDePathway. However, not every potential customer is in the market for softwareat all times. Because of the cost, time and effort involved in implementing asoftware 

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solution like the productswe sell, once a potential customer chooses a solution from a competitor overMEDecision’s Collaborative Care Management solutions, they may not be in themarket to buy a complete software solution for a number of years, althoughthere may be opportunities to provide them with specific modules from ourIntegrated Medical Management suite to address particular needs they may have.

In the past, our non-recurring revenue, whichprimarily consists of term license fees for our software products andprofessional service fees associated with implementation of these softwareproducts, has constituted a significant portion of our revenue. This non-recurringrevenue is generally paid in lump sums, thereby decreasing the predictabilityof our revenue. As a result of these risks and challenges, we have focused, andanticipate that we will continue to focus, on the growth of our business,expanding existing customer relationships, developing innovative new solutions,expanding our customer base within our market and continuing to build recurringand predictable revenue through new products like our Patient Clinical Summary.While we anticipate funding our growth primarily from operating cash flow, wemay utilize a portion of the net proceeds from our initial public offeringwhich closed on December 18, 2006 for one or more of the components of ourgrowth strategy.

Prior to 2006, we experienced our fastest growth interm licenses and professional services revenue, thereby increasing those itemsas a percentage of our revenue. Consequently we realized a decreasingpercentage of subscription, maintenance and transaction fee revenue even thoughthat revenue grew as well. For the year ended December 31, 2006,subscription, maintenance and transaction fee revenue increased as a percentageof total revenue due to increased sales of our Data Gathering and Analytics andCollaborative Data Exchange modules. In the future, we anticipate the marketwill have an increased focus on Electronic Health Records and what we refer toas our Patient Clinical Summary. For these solutions, our customers pay anannual subscription fee and pay a transaction fee each time they utilize thesolution. In addition, once adopted by a customer, there are less sales andadministrative efforts required to increase the transaction volume with acustomer as compared to the efforts required to sell a new term license for oneof our other solutions. We anticipate that the growth of this portion of ourbusiness will continue to outpace our traditional software licenses and, as aresult, subscription and transaction revenue will become a larger portion ofour overall revenue. We anticipate that this strategy will continue to lead tomore recurring and predictable overall revenue. In addition, given the loweradministrative and sales costs associated with this revenue, we anticipate thatthis will increase our margins, especially as transaction volume with a givencustomer increases.

We evaluate and monitor our business based on ourresults from operations, including our percentage of revenue growth, ourrevenue by category, operating expenses as a percent of total revenue and ouroverall financial position. In doing so, we monitor margins for our existingbusiness and evaluate the potential margin contributions for each type ofrevenue that we generate. In addition, we monitor our Earnings Before Interest,Depreciation and Amortization, or EBITDA, as a measure of operating performancein addition to net income and the other measures included in our financialstatements. We operate in one reportable segment.

We license our solutionsprimarily to large regional healthcare insurance companies. As of December 31,2006, our customers included approximately 56 regional and national managedcare organizations, including the largest organizations in more than 27regional markets. Our revenue has increased at a compound annual growth rate of28.1% since 2002, to $44.2 million for the year ended December 31, 2006.Our overall increase in revenue is attributable to increased emphasis by ourcustomers on active management of their total insured population and the expansionof our solutions to meet their evolving needs.

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**Background**

We began operations in 1988 by licensing an automatedmedical management solution to large regional healthcare insurance companies.This solution was the predecessor to our current Advanced Medical Managementmodule. In 1999, we acquired the assets of an analytical software company thatbecame the basis of our current Data Gathering and Analytics module. In 2000,we expended a significant amount of capital to begin the development of ourCollaborative Data Exchange module, completing the initial development of themodule in the third quarter of 2001. In December 2002, we acquired assetsthat were the foundation for clinical decision support content, which enabledus to create our Clinical Rules and Processes module. In 2005, we began tooffer our customers the ability to electronically transmit Patient ClinicalSummaries to providers at the point of care.

From inception until 1997, our operations were fundedprimarily through internally generated cash flows and bank borrowings. In 1997,we issued approximately $3.5 million of Series A convertible preferredstock in order to raise capital for marketing our products. In 1999, we made astrategic decision to develop new products. To fund this initiative, in thefourth quarter of 1999 and in the first half of 2000, certain existinginvestors, including our Chief Executive Officer and Liberty Ventures I, L.P.,which is an affiliate of ours as a result of their ownership of our outstandingcapital stock, provided bridge financing until the closing of our Series Bconvertible preferred financing. To those investors who participated in thebridge financing, we issued seven-year warrants to purchase an aggregate of435,000 shares of common stock, 375,000 of which had an exercise price of $2.00per share and 60,000 of which had an exercise price of $5.00 per share. InJune, July and August of 2000, we issued in the aggregateapproximately $30.0 million of Series B convertible preferred stock,primarily to fund the research and development of new products. In September 2001and March 2002, we issued in the aggregate approximately $4.9 million of Series Cconvertible preferred stock in order to fund our working capital requirements.

In 1997, we entered into a borrowing arrangement witha third-party lender pursuant to which we issued warrants to purchase 200,000shares of common stock at an exercise price of $2.00 per share. In 1999, weissued additional warrants to purchase 100,000 shares of common stock at anexercise price of $2.00 per share to the same lender. We entered into anarrangement with a different lender in 2001 pursuant to which we issuedwarrants to purchase 283,185 shares of common stock at an exercise price of$1.13 per share. In 2002, we entered into a borrowing arrangement with ourcurrent lender to provide working capital financing up to $4.0 million basedupon eligible receivables. In connection with that arrangement, we issuedwarrants to purchase an aggregate 235,929 shares of common stock at an exerciseprice of $0.90 per share.

On December 18, 2006,we raised approximately $26.4 million from our initial public offering, net offees and expenses. In connection with the closing of our initial publicoffering, all of our outstanding shares of Series A preferred stock, Series Bpreferred stock and Series C preferred stock were converted into commonstock under the terms of each of the respective preferred stock designations. Alldividends on the Series A preferred stock that were accrued but unpaid asof the date of the offering were converted into common stock pursuant to anelection of each holder of such shares as provided under the terms of the Series Apreferred stock designation. All dividends on the Series B preferred stockand Series C preferred stock that were accrued but unpaid as of the dateof the offering (approximately $9.5 million) were paid in cash from theproceeds of the offering. We currently have no shares of preferred stockoutstanding.

**Sources of Revenue**

We derive revenue from thefollowing sources: (i) subscription, maintenance and transaction fees; (ii) termlicense fees for our solutions; and (iii) fees for discrete professionalservices.

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***Subscription, Maintenance and Transaction Fees***

Our customers pay an annual subscription fee toprocess data through MEDecision’s service bureau and access reports using ourData Gathering and Analytics module and to transmit clinical data and decisionsthrough our Collaborative Data Exchange module. Customers also pay a fee foreach transaction transmitted over our network. We recognize subscription feesratably over the term of the subscription agreement and include this in thesubscription, maintenance and transaction fee revenue on our consolidatedstatements of operations. We also offer our customers a hosted solution andreceive monthly fees for those services. We recognize hosting revenue ratablyover the term of the related agreement, which is typically five years induration. Hosting revenue is included in subscription, maintenance andtransaction fee revenue on our consolidated statements of operations.

Our customers pay an annual maintenance and supportfee equal to approximately 22% of the annualized Advanced Medical Managementlicense fee, which entitles our customers to unspecified software updates andupgrades and basic product support. For clinical content, our customers pay anadditional 13% of the annualized license fee for maintenance and support. Werecognize maintenance and support fees ratably over the term of the maintenanceand support agreement.

Our customers paytransaction fees for each member eligibility verification, for clinicaladjudication of treatment requests and for access to on-demand member healthinformation, including Patient Clinical Summaries. We recognize transactionfees at the time of the transaction.

***Term License Fee***

Our customers pay a termlicense fee to utilize our Advanced Medical Management and ClinicalRules and Processes modules, typically for five years. We recognizerevenue for term license fees upon delivery of the software.

***Professional Services***

In conjunction with our solutions, we provide servicesto assist our customers in the installation and implementation of the softwareand the integration of our solutions with other systems within the healthcareinsurance company. We sell these services on either a fixed price or atime-and-materials basis and recognize revenue when the services are performed.Services revenue also includes reimbursable billable travel, lodging and otherout-of-pocket expenses incurred as part of delivering services to ourcustomers.

Each of our license modelsprovides us with a recurring revenue stream. Historically, a substantial portionof our clients have renewed their licenses each year. During the year ended December 31,2006, our clients renewed 89% of the contracts which were to expire during thatperiod. The combination of recurring revenue and high renewal rates provide uswith substantial annual revenue predictability. Although in general our revenueis consistent throughout the year, sales of certain modules that have aninitial term license can cause revenue volatility from quarter to quarter. Thesales cycle for our Advanced Medical Management module is typically eightmonths or longer. As a result, it is difficult for us to predict the quarter inwhich a particular sale may occur. In addition, in a small portion of oursales, the license fee is material relative to our total revenue during thequarter. Accordingly, our revenue may vary significantly from quarter toquarter depending on the quarter during which a large sale occurs.

***Strategy for Growth***

Our strategy for revenue growth is to (1) increaserecurring and transaction-based revenue streams as a percentage of totalrevenue, primarily through Patient Clinical Summary transactions; (2) expandour customer base into additional managed care organizations in the UnitedStates that could benefit from our 

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entire Collaborative CareManagement suite or its related product modules; (3) expand relationshipswith our existing customers; and (4) develop the next generation of ourCollaborative Care Management suite.

Historically, we derived most of our revenue from ourAdvanced Medical Management module, for which our customers purchase five-yearterm licenses and which we recognize as revenue at the time we enter into thecontract. In 1999, we began licensing modules that provide transaction orannual recurring revenue that are recorded ratably over the contract term. In2005, we began delivering a Patient Clinical Summary for eight managed careorganizations. We intend to emphasize modules with transaction oriented andannual recurring revenue, as these streams provide us with greater revenuevisibility and higher gross margins and operating margins. We have developed ascalable network infrastructure to deliver a high volume of transactions (suchas authorizations, referrals and Patient Clinical Summaries) to providers andpatients. An increase in transaction volume will require some additional technologyinfrastructure, but we believe the cost of network expansion will besubstantially lower than the increase in revenue. In addition, we expect someinvestment initially in sales and marketing to educate and assist in theinitial deployment of transaction-based modules, but less, as a percentage ofrevenue, than the increase in revenue.

Prior to 2003, we licensed our software moduleseparately to payer organizations. Beginning in 2003, we began marketing andlicensing our modules as an integrated solution, providing the payer an abilityto license the entire Collaborative Care Management suite, or certaincomponents initially, based upon the payer’s business needs at that time. Webelieve there are at least 350 additional managed care organizations in theUnited States, self-insured companies and Medicare and Medicaid organizationsthat could benefit from licensing and deploying our entire Collaborative CareManagement suite, or selected modules. We license our solutions to newcustomers through our direct sales force, and our marketing initiativesgenerally have included conferences, trade shows, healthcare industry eventsand direct mail campaigns. We will continue to invest in additional salespersonnel and marketing programs to increase awareness of our integratedsolution, but not at the same rate of our revenue growth.

Through our customer sales operation, we have expandedour penetration within our customer base by including more members and byincreasing the number of modules licensed by our customers. We intend todevelop additional cross-selling programs to aid our customer relationshipstaff to continue to increase the number of modules utilized by our customersin the provision of care to their membership. The large cross-sellingopportunity is based on the adoption of the Patient Clinical Summarytransactions, which benefit the payer, patient and provider. This adoption willrequire some investment in marketing, but we expect it to be less than thedirect sales costs associated with the sales of our historical softwaresolutions.

***Trends in Sales of our Solutions***

Our Collaborative Care Management suite consists offour related product modules: (i) Data Gathering and Analytics; (ii) ClinicalRules and Processes; (iii) Advanced Medical Management; and (iv) CollaborativeData Exchange. As discussed above, prior to 2003, we marketed and sold thesemodules individually rather than as a suite of products. Since that time, wehave marketed these modules as the Collaborative Care Management suite,although we continue to license the modules individually in order to offer ourcustomers an individualized solution. In general, customers license theAdvanced Medical Management module as the core of their solution. Prior to2004, our customers generally initiated their relationships with us bylicensing just that one module. However, since 2004, we believe that ourcustomers have focused more on implementing integrated multi-functional systemsand have looked for products that offer more than a claims management system.As a result, a significant number of our new customers now license one or twomodules in addition to our Advanced Medical Management module. We anticipatethat this will remain the case for the foreseeable future.

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As a result of the shiftin market focus to more integrated software solutions, we anticipate that newcustomers will license an increasing number of modules and existing customerswill continue to expand their product suites by licensing additional modules.However, given that most of our customers initially license our AdvancedMedical Management module, revenue related to that module is a significantportion of our overall revenue. We anticipate that this significance willdiminish as customers license additional modules and our transaction feerevenue increases as a percentage of overall revenue.

**Cost of Revenue**

Our costs of revenue are broken down into cost of termlicenses, cost of subscription, maintenance and transaction fees and cost ofprofessional services.

Our cost ofsubscription, maintenance and transaction fees consist of:

·       amortizationof internally developed and purchased capitalized software;

·       compensationand related employee benefits of our product support, product maintenance andproduct hosting staff;

·       third-partymaintenance fees associated with the third-party software incorporated into ourAdvanced Medical Management module;

·       solutionhosting costs associated with a third-party secured facility;

·       royaltiesrelated to software licenses; and

·       communicationcosts associated with our hosting network.

Our cost of termlicenses primarily consists of:

·       amortizationof internally developed and purchased capitalized software; and

·       third-partylicense fees for the third-party software incorporated in our Advanced MedicalManagement module.

Our cost ofprofessional services consists of:

·       compensationand related employee benefits for our professional services staff;

·       costsof independent contractors that provide consulting and professional services toour customers; and

·       travel,lodging and other out-of-pocket expenses for our staff and independentconsultants to perform work at a customer’s site for which we receivereimbursement.

The costs associated witheach of our modules, as a percentage of revenue, is different. Therefore,changes in the mix of modules and services will result in fluctuations in grossmargin. We expect the percentage of our revenue derived from our Data Gatheringand Analytics module, Clinical Rules and Processes module, CollaborativeData Exchange module and Collaborative Care Management suite to increase in thefuture. As a result, we expect our gross margins to increase in the future.

**Operating Expenses**

We classify our operatingexpenses as follows:

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***Sales and Marketing***

Sales and marketingexpenses primarily consist of:

·       personneland related costs for employees engaged in sales, corporate marketing, productmarketing and product management, including salaries, commissions, other incentivecompensation and related employee benefit costs;

·       travelrelated expenses to meet with existing and potential customers, and for othersales and marketing related purposes;

·       costsassociated with trade shows and industry conventions;

·       feesand other expenses related to public relations consultants; and

·       costsassociated with our annual user conference and other marketing relatedactivities.

We expense our salescommissions proportionately over the same period that the related revenue isrecognized. We expect our sales and marketing expense to increase in the futureas we increase the number of direct sales professionals and invest in marketingprograms to encourage provider adoption of our Collaborative Care Managementsuite and its related product modules. However, we expect sales and marketingexpenses to remain relatively constant as a percentage of revenue for theforeseeable future.

***Research and Development***

Research anddevelopment expenses consist primarily of:

·       personneland related costs, including salaries and employee benefits for softwareengineers, software quality assurance engineers and clinical systems engineers;

·       consultingfees paid to independent consultants who provide software or qualityengineering services to us; and

·       costsof medical panels and research for annual clinical updates to our solutions.

To date, our research and development efforts havebeen devoted to new product offerings and increases in features andfunctionality of our existing suites. We expect research and developmentexpenses to increase in the future as we continue to develop innovative newsolutions for our customers. However, we expect research and developmentexpenses to remain consistent as a percentage of revenue, fluctuating slightlydepending on our product development initiatives.

Historically, we havecapitalized a portion of our research and development expenses related topurchased and internally developed software. Capitalized research anddevelopment expenses totaled $1.4 million, $2.0 million and $0.9 millionfor the years ended December 31, 2006, 2005 and 2004, respectively.Otherwise, we expense research and development as those costs are incurred.

***General and Administrative***

General andadministrative expenses represent the complete, unallocated costs and expensesof managing and supporting our entire operations. General and administrativeexpenses consist primarily of:

·       personneland related costs for our executives, finance, human resources, corporateinformation technology systems, strategic business, corporate quality,corporate training and administrative personnel;

·       legaland accounting professional fees;

·       facilitiesand related costs;

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·       recruitingand training costs;

·       depreciation;

·       travelrelated expenses for executives and other administrative personnel; and

·       computermaintenance and support for our internal information technology system.

We expect general andadministrative expenses to increase in the future as we absorb expenses relatedto being a publicly traded company and invest in an infrastructure to supportour continued growth.

**Critical AccountingPolicies and Estimates**

Our discussion and analysis of our financial conditionand consolidated results of operations are based upon our consolidatedfinancial statements, which have been prepared in accordance with generallyaccepted accounting principles in the United States. The preparation of ourconsolidated financial statements requires us to make estimates and assumptionsthat affect the reported amounts of assets, liabilities, revenue and expensesand related disclosure of contingent assets and liabilities. On an on-goingbasis, we evaluate our estimates based upon historical experience and variousother assumptions that we believe to be reasonable under the circumstances, theresults of which form the basis for making judgments about the carrying valuesof assets and liabilities that are not readily apparent from other sources. Ouractual results may differ from these estimates.

We believe that thefollowing critical accounting policies affect our more significant estimatesand judgments used in the preparation of our consolidated financial statements:

***Revenue Recognition***

We derive revenue primarily from three sources: (i) recurringrevenue consisting of annual recurring subscription fees for our Data Gatheringand Analytics and Collaborative Data Exchange modules, including PCS,transaction revenue associated with member eligibility verification, clinicaladjudication of treatment requests and access of on-demand member healthinformation and technical and clinical maintenance and support fees; (ii) initialterm and renewal license fees for our Advanced Medical Management and Clinical Rules andProcesses modules and (iii) fees for discrete professional services. Ourstandard license agreement typically provides a time-based license, which istypically five years in duration, to use our solutions. We may license oursoftware in multiple element arrangements if the customer purchases anycombination of maintenance, consulting, training, subscriptions or hostingservices in conjunction with the software product license.

We recognize revenue pursuant to the requirements ofAICPA Statement of Position, or SOP, 97-2, *Software Revenue Recognition*; as amended by SOP 98-9, *Software Revenue Recognition, With Respect to CertainTransactions*; SOP 81-1, *Accountingfor Performance of Construction-type and Certain Production-type Contracts*;the SEC’s Staff Accounting Bulletin, or SAB, No. 104, *Revenue Recognition*; Emerging Issues TaskForce, or EITF, Issue No. 00-21, *RevenueArrangements With Multiple Deliverables*; EITF Issue No. 00-03,*Application of AICPA Statement of Position*97-2 *to Arrangements That Include theRight to Use Software Stored on Another Entity’s Hardware*; EITFIssue No. 03-05, *Applicability ofAICPA Statements of Position* 97-2, *Software Revenue Recognition, to Non-Software Deliverables in anArrangement Containing More-Than-Incidental Software*; andother authoritative accounting guidance.

We enter intotransactions that represent multiple-element arrangements, which may include acombination of professional services, hosting, PCS and software. In instanceswhere certain arrangements include both software and non-software relatedelements, we apply the principles of SOP 97-2 to software elements. Ifthe elements of the arrangement fall outside the scope of SOP 97-2, thenwe apply the principles of EITF 00-21. In accordance with EITF 00-21,multiple-element arrangements are assessed to 

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determinewhether they can be separated into more than one unit of accounting. Amultiple-element arrangement is separated into more than one unit of accountingif all of the following criteria are met:

·       thedelivered item(s) has value to the client on a stand-alone basis.

·       thereis objective and reliable evidence of the fair value of the undelivereditem(s).

·       ifthe arrangement includes a general right of return relative to the delivereditem(s), delivery or performance of the undelivered item(s) is consideredprobable and substantially in the control of the company.

If these criteria are not met, then revenue isdeferred until such criteria are met or until the period(s) over which thelast undelivered element is delivered. If there is objective and reliableevidence of fair value for all units of accounting in an arrangement, thearrangement consideration is allocated to the separate units of accountingbased on each unit’s relative fair value. There may be cases, however, in whichthere is objective and reliable evidence of fair value of the undelivered item(s) butno such evidence for the delivered item(s). In those cases, the residual methodis used to allocate the arrangement consideration. Under the residual method,the amount of consideration allocated to the delivered item(s) equals thetotal arrangement consideration less the aggregate fair value of theundelivered item(s). We apply the revenue recognition policies discussed belowto each separate unit of accounting.

We recognize revenue using the residual method whenvendor-specific objective evidence, or VSOE, of fair value exists for all ofthe undelivered elements in the arrangement, but does not exist for one or moredelivered elements, and all revenue recognition criteria in SOP 97-2,other than the requirement for VSOE of fair value of each delivered element ofthe arrangement, are satisfied. We allocate revenue to each undelivered elementbased upon its respective fair value determined by either (a) the pricecharged when that element is sold separately, (b) the price established bymanagement if that element is not yet sold separately and it is probable thatthe price will not change before the element is sold separately or (c) substantiverenewal rates. We defer revenue for all undelivered elements and recognize theresidual amount of the arrangement fee, if any, when the basic criteria in SOP97-2 have been met.

Under SOP 97-2,provided that the customer’s contract does not require significant production,modification or customization of our basic software code, we recognize revenue whenthe following four criteria have been met:

·       persuasiveevidence of an arrangement exists;

·       deliveryof our basic software code has occurred;

·       thelicense fee is fixed or determinable; and

·       collectionof the license fee is probable.

For arrangementswhere we provide software hosting services, we record revenue in accordancewith SOP 97-2 unless:

·       thecustomer cannot take possession of the software at any time during the hostingperiod without significant penalty;

·       thecustomer cannot contract with another hosting provider without significanteffort or expenditure; or

·       thesoftware’s functionality is compromised by the termination of hosting services.

Under these circumstances, we record revenue ratablyover the longer of the contract period or the maintenance period under EITFIssue No. 00-03.

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For those arrangements that meet the criteria for SOP97-2 accounting, we establish fair value for all undelivered elements anduse the residual method to determine the fair value of the license fee that isrecorded upon achievement of the four revenue recognition criteria mentionedabove and included in term license revenue in the consolidated statement ofoperations. VSOE is established for hosting services under such arrangementsbased on the price charged when hosting services are sold separately as a renewal.Hosting revenue is included with subscription, maintenance and transaction feerevenue in the consolidated statements of operations.

If, at the outset of an arrangement, we determine thatthe arrangement fee is not fixed or determinable, then revenue is deferreduntil the arrangement fee becomes due and payable by the customer, assuming allother revenue recognition criteria have been met. If at the outset of anarrangement we determine that collectibility is not probable, then revenue isdeferred until payment is received. Our license agreements typically do notprovide for a right of return other than during the standard 90-daywarranty period. Historically, we have not incurred warranty expense orexperienced returns of its products. If an arrangement allows for customeracceptance of the software or services, then we defer revenue recognition untilthe earlier of customer acceptance or when the acceptance rights lapse.

We also offer subscriptions to access software whichis hosted at our ASP facility. We categorize these fees as subscriptions. Thefees related to these subscription arrangements are recognized as revenueratably over the subscription term, which is typically 12 months. Revenue formultiyear time-based licenses that include maintenance, whether separatelypriced or not, is recognized ratably over the license term and included insubscription, maintenance and transaction fee revenue unless a substantivemaintenance renewal rate exists, in which case the residual amount isrecognized as software revenue and included in term license fee revenue whenthe basic criteria in SOP 97-2 have been met.

Our initial maintenance term is generally in the rangeof one to five years, renewable by the customer on an annual basis thereafter.Our customers typically prepay maintenance for periods of one to 12 months.Maintenance revenue is deferred and recognized ratably over the term of themaintenance contract and is included in subscription, maintenance andtransaction fee revenue. Should a customer on maintenance be specificallyidentified as a bad debtor, then we would cease recognizing maintenance revenueexcept to the extent that maintenance fees have already been collected.

While the statements of work with our customers mayspecify multiple elements, we believe that the service elements included in ourcontractual arrangements with customers are not essential to the functionalityof our software, which can operate in a standalone fashion upon installation.These service elements do not include significant modification or customizationof our software, but may include configuring, designing and implementing simpleinterfaces with other customer software, installation and configuration ofthird-party software, and training in the use of both our software andthird-party software. The timing of payments for software is independent of thepayment terms for the service elements in our contractual arrangements withcustomers. In multi-element arrangements involving software and consulting,training or other services that are not essential to the functionality of thesoftware, the services revenue is accounted for separately from the softwarerevenue. VSOE for services did not exist during 2004 and prior. As a result,revenue attributable to all elements in a multi-element arrangement, includingsoftware and services, in 2004 was deferred until the related services werecompleted and only then recognized as revenue, assuming VSOE existed for allother undelivered elements. In situations when revenue is deferred as a resultof ongoing services, the costs associated with all delivered elements are alsodeferred and recognized as expense when the services are completed. In late2004, we introduced package pricing for the various service elements of ourcontractual arrangements with customers, and now recognize VSOE for serviceelements based on the prices of those packages, which are based on hourly ratesconsistent with those used in the separate sales of services.

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Consulting, training and other services are typicallysold under fixed-price arrangements and are recognized using the proportionalperformance method based on direct labor hours incurred to date as a percentageof total estimated project costs required to complete the project. Consultingservices primarily comprise implementation support related to the installationand configuration of our products and do not typically require significantproduction, modification or customization of the software. In arrangements thatrequire significant production, modification or customization of the softwareand where services are not available from third-party suppliers, the consultingand license fees are recognized concurrently. When total cost estimates exceedrevenue in a fixed-price arrangement, the estimated losses are recognizedimmediately in cost of revenue.

The assumptions, risks and uncertainties inherent withthe application of the proportional performance method affect the timing andamounts of revenue and expenses reported. Numerous internal and external factorscan affect estimates, including direct labor rates, utilization and efficiencyvariances.

Where contractual arrangements with customers includethe sale of third-party software, revenue is recognized for the sale of thethird-party software and the related expense is included in cost of revenue.

In accordance with EITF Issue No. 01-14, *Income Statement Characterization of ReimbursementsReceived for Out-of-Pocket Expenses Incurred*, we account forout-of-pocket expenses rebilled to customers as maintenance, consulting andtraining revenue with related costs included in cost of revenue. For the yearsended December 31, 2006, 2005 and 2004, reimbursement expenses totaled$0.4 million, $0.4 million, and $0.4 million, respectively.

We also generate revenue from transactions that areprocessed through our web portal. Fees from these transactions are billed tocustomers in arrears on a monthly basis and are recognized in the period inwhich the transactions occur. The Company establishes VSOE for these transactionfees based on the rates charged for transactions in separate sales.

We believe that ouraccounting estimates used in applying our revenue recognition are criticalbecause:

·       thedetermination that it is probable that the customer will pay for the productsand services purchased is inherently judgmental;

·       theallocation of proceeds to certain elements in multiple-element arrangements iscomplex;

·       thedetermination of whether a service is essential to the functionality of thesoftware is complex;

·       establishingcompany-specific fair values of elements in multiple-element arrangementsrequires adjustments from time-to-time to reflect recent prices charged wheneach element is sold separately; and

·       thedetermination of the stage of completion for certain consulting arrangements iscomplex.

Changes in the aforementioned items could have amaterial effect on the type and timing of revenue recognized.

In prior periods, our estimates of the total cost ofconsulting, training and other services, which are recognized on apercentage-of-completion basis have been reasonably accurate. As a result,there have been no significant changes in the amount of gross profit recognizedrelative to the revenue recognized in different periods.

If we were to change ourpricing approach in the future, this could affect our revenue recognitionestimates, in particular, if bundled pricing precludes establishment of VSOE.

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***Accounts Receivable and Allowance for DoubtfulAccounts***

The majority of our accounts receivable are due from tradecustomers. Credit is extended based on evaluation of each customer’s financialcondition. Collateral is not required. Accounts receivable payment terms aretypically 30 days and are stated in the financial statements at amounts duefrom customers net of an allowance for doubtful accounts. Accounts outstandinglonger than the payment terms are considered past due. We determine ourallowance by considering a number of factors including the length of time tradeaccounts receivable are past due, our previous loss history, customers’ currentability to pay their obligations to us and the condition of the general economyand the industry as a whole. We write off accounts receivable when they becomeuncollectible, and payments subsequently received on such receivables arecredited to the allowance for doubtful accounts.

We believe that ourestimate of our  allowance for doubtfulaccounts is critical because of the significance of our accounts receivablebalance relative to total assets.  If thegeneral economy deteriorated, or factors affecting the profitability orliquidity of the industry changed significantly, then this could affect theaccuracy of our allowance for doubtful accounts.

***Capitalized Software Research and Development Costs***

We record capitalized software costs on the balancesheet at the lower of unamortized capitalized costs or net realizable value. Wecapitalize purchased and internally developed software in accordance withStatement of Financial Accounting Standards, or SFAS, No. 86, *Accounting for the Costs of Computer Software to beSold, Leased or Otherwise Marketed*. We identify projects thattypically represent significant improvements in features and functionality. Thecosts incurred in the preliminary stages of development are expensed as researchand development costs as they are incurred. Once a solution has reached thedevelopment stage where technological feasibility has been established,internal and external costs will be capitalized based upon the developmenthours charged against the project. Amortization begins and capitalization endswhen the product is available for general release to our customers. Annualamortization of capitalized software costs is the greater of the amountcomputed using (i) the ratio that the current gross revenue for a productbears to the total of current and anticipated future gross revenue for thatproduct or  (ii)  on a straight-line basis over the estimatedeconomic life of the product, which ranges from three to five years. Weevaluate the useful lives of these assets quarterly and test for impairmentswhenever events or changes in circumstances occur that could impact therecoverability of these assets.

We believe that our estimate of our capitalizedsoftware costs and the period for their amortization is critical because of thesignificance of our balance of capitalized software costs relative to our totalassets.  Potential impairment isdetermined by comparing the balance of unamortized capitalized software coststo the sales revenue projected for a capitalized software project. If effortsto sell that software project are terminated, or if the projected sales revenuefrom that software project drops below a level that is less than theunamortized balance, then an impairment would be recognized.

Factors that could changethe amount of software capitalized in the future include greater use ofoffshore programming resources, which would reduce the amount of softwarecapitalized, or shorter product life cycles, which would require amortizationon a shorter time schedule.

***Stock-Based Compensation***

Prior to January 1, 2006, stock-basedcompensation was measured in accordance with the provisions of SFAS No. 123,*Accounting for Stock-Based Compensation,*and SFAS No. 148, *Accounting forStock-Based Compensation—Transition and Disclosure—An Amendment of FASBStatement No. 123,* which permitted companies to continue toapply the provisions of Accounting Principles Board Opinion, or APB, No. 25,*Accounting for Stock Issued to Employees*,and related interpretations including Financial Accounting Standards Board, orFASB, Interpretation No. 44, *Accountingfor Certain Transactions*

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*InvolvingStock Compensation, an Interpretation of APB Opinion No. 25*.Under this method, compensation expense is measured as the excess, if any, ofthe fair market value of our common stock at the date of the grant over theexercise price of the option. In accordance with the provisions of SFAS No. 123and SFAS No. 148, *Accounting forStock-Based Compensation—Transition and Disclosure*, we disclosed proforma results of operations as if the minimum value-based method had beenapplied in measuring compensation expense for stock-based incentive awards.

As required by FASB under SFAS No. 123R, *Share-Based Payment*, effective January 1,2006, we adopted the fair value recognition provisions of SFAS 123R whichrequires us to apply the provisions of SFAS 123R to new awards granted, and toawards modified, repurchased, or cancelled after the effective date. We beganrecognizing stock-based compensation expense under a calculated measurement valuecomputation effective January 1, 2006. The fair value of stock optionswill be recognized as expense in our financial statements over the remainingvesting period of the stock options. The adoption of SFAS No. 123Rresulted in $0.2 million of expense in 2006. In addition, the adoption of thisstandard will result in difficulties comparing our operating results for futureperiods to those of our prior periods, since prior periods through 2005 willnot reflect stock-based compensation expense under SFAS No. 123R.

At the time that optionswere granted during the years 2004, 2005 and in January and April of2006, the fair value of the common stock for the options was estimated by theboard of directors, with input from management. Given the absence of an activemarket for our common stock, our board of directors, the members of which webelieve had extensive business and finance experience, was required to estimatethe fair value of our common stock at the time of each option grant. In July 2006,we engaged an independent valuation specialist to perform a retrospectivevaluation of our common stock as of and for the years ended December 31,2004 and 2005. As a result of this retrospective valuation, it was determinedthat the exercise prices for the stock options granted in the first half of2004 and for April and July 2006 exceeded the fair value of our commonstock at those dates. The exercise prices for stock option grants in the secondhalf of 2004, all of 2005 and January 2006 were below the retrospectivefair values determined for those dates. Accordingly, as required by APB Opinion25, for the difference by which the fair value of the underlying common stockexceeded the option exercise price of the grants in 2004 and 2005, werecognized stock-based compensation expense in our consolidated statements ofoperations for the years ended December 31, 2006, 2005 and 2004 in the amountsof approximately $0.4 million, $0.3 million and $21,000, respectively.

*SignificantFactors, Assumptions and Methodologies Used in Determining Fair Value.*

We used the market approach (one of three generallyused valuation approaches) to estimate the value of the enterprise at each dateat which options were granted. The market approach uses direct comparisons toother enterprises and their equity securities to estimate the fair value ofprivately issued securities. The fair value measured by the market approach isbased on a comparison to similar enterprises or similar transactions. Our boardof directors considered the market values of comparable software companies inpublic and private sales, conducted discussions of value with outside equityinvestors (including those who had purchased shares of our Series A, Series Band Series C preferred stock) and potential strategic business partnersand considered our business trends in determining our market-based value. Ourboard of directors then deducted the liquidation preferences of the preferredstock, including accrued and unpaid dividends, to determine the value remainingfor the holders of our common stock. Given the objective and subjective factorsutilized in this valuation methodology, there is inherent uncertainty in theseestimates. Of the three generally accepted valuation methodologies, our boardof directors believed that the market approach was the most appropriateapproach to utilize because of its focus on value based on a sale or publicoffering liquidity events. At the time, it was more likely a liquidity eventwould involve the sale of us or an initial public offering of our common stock.

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The independent valuation specialist also used amarket approach to value our common stock. The specialist estimated theretrospective fair values of our common stock using a probability-weightedanalysis of the present value of returns afforded to common shareholders ineach of three possible future liquidity events—an initial public offering, saleor dissolution. Given the structure of our shareholder base, the valuationexpert did not analyze our value in a scenario where we continue as a privatecompany indefinitely with no liquidity transaction. For each of the threetransaction scenarios, estimated future and present values for the shares ofour common stock were calculated using assumptions, including: (i) theexpected pre-money valuation (pre-initial public offering, pre-sale orpre-dissolution); (ii) the expected probability distribution of valuesrelating to the expected pre-money valuation, which not only demonstrates thelevel of volatility of expected values, but is particularly important for ajunior security—such as the common stock in an enterprise that has preferredstock—which demonstrates an asymmetrical distribution of returns; and (iii) anappropriate risk-adjusted discount rate to the present rate.

The valuation expert’s initial public offeringvaluation was based primarily on the following: (i) an analysis ofcompanies comparable to us, including their valuation at a trailing yearmultiple and one-year forward revenue multiple; (ii) an analysis of abroader range of software companies, broken down into certain key criteria,including size, profitability and growth; and (iii) since detailed multi-yearprojections were available only for 2005 analysis, the valuation expertperformed a discounted cash flow analysis for the December 31, 2005valuation. Such projections were not available in prior years, and as a result,no discounted cash flow analysis was performed for those years. Using theforegoing, low, median and high values of the common equity were estimated andthe common equity per share value was calculated. A weighted-average estimateof values was calculated using weightings of 0% (for the low case), 50% (forthe median case) and 50% (for the high case) in the valuation analysis for 2005and 2004, as well as June 30, 2006.

The sale valuation was based primarily on thefollowing: (i) an analysis of merger and acquisition transactions involvingcompanies comparable to us, including their valuation as a trailing yearrevenue multiple; (ii) an analysis of a broader range of software companyacquisitions, segmented by certain key criteria, including size and profitability;(iii) an estimated calculation of the common equity per share value byutilizing the foregoing, low, median and high values of the common equity; and (iv) aweighted-average estimate of values was calculated using weightings of 25% (forthe low case), 50% (for the median case) and 25% (for the high case).

The dissolution valuation was based primarily on thefollowing: (i) the valuation expert’s estimate (with management input)regarding expected dissolution proceeds; (ii) upon subtracting ourliabilities from our assets, the net value to equity shareholders wasestimated; (iii) after deducting accrued dividends, liquidation andpreferences from the net equity value, the value to common shareholders wascalculated. Since our management has represented that the dissolution scenariois highly unlikely, but not impossible, the valuation expert only assigned a 5%probability weighting on this scenario in its calculations.

The valuation expert applied weightings to each of thethree indicated values based upon its estimate of the likelihood of the variousscenarios, as of the valuation date. Its estimate of the likelihood of anygiven scenario was based on: (i) the initial public offering and mergerand acquisition transaction market conditions; (ii) the relative size,based on trailing revenue, of the issuers which successfully completed initialpublic offerings during the relevant time period; (iii) our profitability;and (iv) the likelihood that an initial public offering would qualify as aQualified Initial Public Offering under the terms of our preferred stock.

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As aresult of the foregoing, the following weightings were assigned for theapplicable periods:

| ** **    | ** ** | ** **        | ** ** | **Year Ended**   | ** ** |
|---------------|------------|-------------------|------------|-----------------------|------------|
| ** **    | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
| ** **    | ** ** | **2006**          | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Sale / Merger |       |              | 25         | %                     |       |   | 70 | % |   |   | 85 | % |   |
| IPO           |       |              | 70         | %                     |       |   | 25 | % |   |   | 10 | % |   |
| Dissolution   |       |              | 5          | %                     |       |   | 5 | % |   |   | 5 | % |   |
| Total         |       |              | 100        | %                     |       |   | 100 | % |   |   | 100 | % |   |

 

*Significant Factors Contributing to the Differencebetween Fair Value as of the Date of Each Grant and the Estimated InitialPublic Offering Price.*

Wegranted stock options with exercise prices of $0.50 during the years endedDecember 31, 2005 and 2004, $2.50 in January 2006 and $22.00 inApril and July 2006. The independent valuation specialist determinedin its retrospective valuation that the fair value of our common stock was, asof each date indicated:

| ** **            | ** ** | **June 30,** | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
|-----------------------|------------|-------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **            | ** ** | **2006**          | ** ** | **2005**              | ** ** | **2004**              | ** ** |
| Fair value per  share |       |              | $          | 6.34                  |       |                  |       | $ | 4.52 |   |   |   | $ | 2.02 |   |   |
|                       |            |                   |            |                       |            |                       |            |  |  |  |  |  |  |  |  |  |

 

For the periods 2004 through 2005, the fair valuedetermined contemporaneously by our board of directors differs from theretrospective valuation by the valuation expert, which in turn differedsignificantly from the initial public offering price of our stock. The primaryreason for the difference between the market-based fair value determined by ourboard of directors and the retrospective valuation by the valuation expertrelates to the number and composition of the comparison companies used by ourboard of directors and the valuation expert, and the more comprehensiveapproach used by the valuation expert in that the valuation expert used aprobability-weighted estimate of the values from each of the three scenariosposed (sale of the company, IPO or dissolution). The primary reason for thedifference between the initial public offering price and the fair valuesdetermined by the independent valuation expert as of June 30, 2006 andDecember 31, 2005 and 2004  is thatduring these periods, the valuation expert and we determined that it was highlyunlikely that we could have completed an initial public offering due to(i) weak initial public offering conditions, (ii) our relative smallsize in terms of revenue compared to companies that completed initial publicofferings during such periods, and (iii) prior to 2005, our lack ofprofitability. As a result, a liquidity event in the form of a sale or merger wasdetermined to be most likely. Our sale or merger would trigger liquidationpayments of approximately $40.0 million to the holders of our Series A,Series B and Series C preferred stock plus accrued dividends, greatlydiminishing, or even eliminating, the value of our shares of common stock.

As of June 30, 2006, the independent valuationexpert determined that the fair value of our common stock was $6.34 per share.As disclosed elsewhere, the initial public offering price of our common stockwas $10.00. This increase in fair value between that determined by thevaluation expert and that determined by our underwriters is attributable to thefollowing factors: an increase in the valuation of comparable public companiesincluded in the independent valuation expert’s report; an increase in theprobability of completing our initial public offering; and, as our initialpublic offering became more likely, the removal of the discount related to theuncertainty associated with a shareholder liquidity event. In addition, therewas also a difference in the methodology utilized by the independent valuationexpert and our underwriters. The valuation expert used a broader group ofhealthcare software companies that, overall, had valuation multiples that werelower than the group included in the underwriters’ valuation. In addition, thevaluation expert included as comparable companies only those companies whoserevenue base is most closely 

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comparable to our currentbusiness model, despite the fact that we anticipate increased subscription,maintenance and transaction fee based revenues in the future from our PatientClinical Summary product.

We consider the estimates of expected term andvolatility used in calculating the Black-Scholes fair value of future awards tobe critical because of the amount of stock-based compensation to be recognizedin our financial statements. Because of the short time that our stock has beenpublicly traded, we cannot estimate how accurate our estimates may prove to becompared to the actual market behavior of our stock price and the futureexercise behavior of the participants in our equity incentive plans. As wedevelop historical data, these estimates may change in the future. Also, we mayfind that a different method to calculate fair value may be more accurate indetermining the actual economic impact of stock-based compensation.

We do not anticipate anysignificant changes in the number of stock option awards granted in the futureor the number of participants in our equity incentive plans.

***Accounting for Preferred Shares and Derivative Shares***

As of the closing of our initial public offering on December 18,2006, all of our preferred stock converted into common stock. We currently haveno shares of preferred stock outstanding.

Prior to the closing of our initial public offering,we accounted for our previously outstanding preferred stock and relatedinstruments in accordance with EITF Issue No. 00-19, *Accounting for Derivative Financial InstrumentsIndexed to, and Potentially Settled in, a Company’s Own Stock*; EITFIssue No. 98-5, *Accounting forConvertible Securities with Beneficial Conversion Features or Contingent AdjustableConversion Ratios*; EITF Issue No. 00-27, *Application of Issue No. 98-5 to CertainConvertible Instruments*; SFAS No. 133, *Accounting for Derivative Instruments and HedgingActivities*; and other applicable professional standards. Thecarrying value of our Series A, Series B and Series C preferredstock was increased, or accreted, using the interest method, to redemption value,from the date of issuance to the earliest redemption date. The carrying valueof our Series A, Series B and Series C preferred stock were alsoaccreted for the value of accrued and unpaid cumulative dividends.

In accordance with theprovisions of SFAS No. 133, we identified the conversion feature of our Series Band Series C preferred stock as an embedded derivative. Under the criteriaof EITF 00-19, these embedded derivatives were classified as a liability,with changes in fair value of the derivatives at each balance sheet datereflected in our results of operations. For our previously outstanding Series Apreferred stock, for which accrued and unpaid dividends could have been paid inadditional shares of Series A preferred stock at the option of the holderwhen such preferred stock was outstanding, when the fair value of our commonstock (into which the dividend shares could have been converted) exceeded theconversion price, a beneficial conversion option was recognized for thedifference between the fair value of the common stock and the conversion priceon the Series A preferred stock dividends, in accordance with EITF 00-27.Changes in the value of this beneficial conversion option were recorded inadditional paid in capital in our consolidated balance sheet.

***Accounting for Income Taxes***

We account for income taxes in accordance with SFAS No. 109,*Accounting for Income Taxes*,under the asset-and-liability method. Deferred tax assets and liabilities arerecognized for the future tax consequences attributable to differences betweenthe financial statement carrying amounts of existing assets and liabilities andtheir respective tax bases and operating loss and tax credit carryforwards.Deferred tax assets and liabilities are measured using enacted tax rates toapply to taxable income in the years in which those temporary differences areexpected to be recovered or settled. Any change in the enacted tax rate and itseffect on deferred assets and liabilities is recognized in the period thatincludes the 

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enactment date. Avaluation allowance is recorded against deferred tax assets if it is morelikely than not that such assets will not be realized.

The realization of deferred tax assets is evaluatedquarterly by assessing the valuation allowance and by adjusting the amount ofthe allowance, if necessary. We make estimates and judgments to calculate ourtax liabilities and determine the realization of our deferred tax assets, whicharise from temporary differences between the tax and financial statement recognitionof revenues and expenses. We also estimate a deferred tax asset valuationallowance if, based on the available evidence, it is more likely than not thatsome portion or all of the recorded deferred tax assets will not be realized infuture periods. These estimates and judgments are inherently subjective.

In evaluating our ability to realize deferred taxassets, we consider all available positive and negative evidence. Our positiveevidence includes our projections of future taxable income, the remaining lifeof the net operating loss carryforwards and cumulative taxable income over thethree most recent fiscal years. Our negative evidence includes operating lossesgenerated from 2000 through 2003 and the taxable losses generated in 2006. Indetermining future taxable income, we make assumptions for the amount oftaxable income, the reversal of temporary differences and the implementation offeasible and prudent tax planning strategies. These assumptions require us tomake judgments about our future taxable income and are consistent with theplans and estimates we use to manage our business.

Term license revenue of $1.4 million recorded duringthe fourth quarter of 2006 was below our expectations resulting in a net lossfor the year ended December 31, 2006 and reversing the trend of two consecutiveyears of book and three consecutive years of taxable income. This lower termlicense revenue was primarily the result of the delay in the execution ofcertain contracts which became known to us during the last two weeks of theyear. In addition, a new customer contract which the Company anticipatedobtaining and closing prior to December 31, 2006 was lost to a competitorin January 2007. As a result of the delay in the closing of contracts and thelost opportunity, the Company recorded a net loss in the fourth quarter of 2006and the full year 2006, and, reduced its revenue and net income guidance for2007. Accordingly, the Company fully reserved the deferred tax asset atDecember 31, 2006.

We operate within multiple state taxing jurisdictionsand are subject to audit in each jurisdiction. No tax audits have been made todate, and any tax audit may require an extended period of time to resolve. Inour opinion, adequate provisions for income taxes have been made for allperiods.

We believe that our estimate of our deferred taxassets and liabilities and our estimation of future tax benefits to be realizedin calculating the valuation allowance against those deferred tax assets arecritical because of the significance of our net deferred tax assets relative toour total assets and because of the effect that possible realization of pastnet operating losses may have upon our future net income. Because of thevariability of our revenue and expenses in the past and uncertainties about thefuture, we cannot estimate how accurate those estimates are without furtheroperating history. As our business continues to develop and our ability toforecast future income improves, we expect to be able to become accurate indetermining the amount of deferred tax assets and liabilities that we canexpect to utilize.

We have not had our taxreturns examined by any federal or state tax authorities in the past. As wegain experience with tax examinations in the future, our estimates of anyunrecognized tax benefits may change, which may affect the amount of netoperating losses that we may be able to utilize in the future.

***Recently Issued Accounting Standards***

In June 2006, the FASB issued FASB InterpretationNo. 48, *Accounting for Uncertainty in Income Taxes—aninterpretation of FASB Statement No. 109*, which clarifies theaccounting for uncertainty in tax positions. This interpretation requires the financialstatement recognition of a tax position taken or expected to be taken in a taxreturn, if that position is more likely than not of being sustained on audit, 

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based on the technicalmerits of the position. The provisions of FIN 48 became effective for us as of January 1,2007. We have evaluated the impact of this accounting interpretation anddetermined that there will not be a material impact on our financial statementsas a result of the adoption of this consensus opinion.

In June 2006, the Emerging Issues Task Forcereached a consensus on Issue 06-3, “How Sales Taxes Collected fromCustomers and Remitted to Governmental Authorities Should Be Presented in theIncome Statement (That Is, Gross Versus Net Presentation)”. The EITF determinedthat the presentation of taxes on a gross or net basis is an accounting policydecision that should be disclosed. This consensus becomes effective for us asof January 1, 2007. We do not anticipate any material impact from theeffectiveness of this consensus opinion.

In July 2006, the FASB issued FASB Statement No. 157,*Fair Value Measurements*. This newstandard provides guidance for using fair value to measure assets andliabilities. The statement clarifies that for items that are not activelytraded, fair value should reflect the price in a transaction with a marketparticipant, including an adjustment for risk, and establishes a fair valuehierarchy that prioritizes the information used to develop the assumptionsmarket participants would use when pricing the asset or liability. SFAS No. 157is effective for fiscal years beginning after November 15, 2007, andinterim periods within those fiscal years. This statement becomes effective forus as of January 1, 2007, and while expected to require us to makeadditional disclosures, is not expected to have a material impact on the ourresults of operations or financial condition.

In September 2006, the SEC staff issued StaffAccounting Bulletin No. 108, *Considering the Effects ofPrior Year Misstatements when Quantifying Misstatements in Current Year FinancialStatements*. SAB No. 108 provides interpretative guidance on theprocess of quantifying financial statement misstatements and is effective forfiscal years ending after November 15, 2006. The adoption of thisstatement in our fiscal year ended December 31, 2006 did not have anyeffect on our results of operations or financial condition.

In February 2007, theFASB issued FASB Statement No. 159, *The Fair Value Option forFinancial Assets and Financial Liabilities, Including an amendment of FASBStatement No. 115*. Under this statement, entities will bepermitted to measure many financial instruments and certain other assets andliabilities at fair value on an instrument-by-instrument basis (the fair valueoption). By electing the fair value measurement attribute for certain assetsand liabilities, entities will be able to mitigate potential “mismatches” thatarise under the current mixed measurement attribute model. Entities will alsobe able to offset changes in the fair values of a derivative instrument and itsrelated hedged item by selecting the fair value option for the hedged item. SFASNo. 159 will become effective for fiscal years beginning after November 15,2007. We are currently evaluating the effect that the adoption of thisstatement will have on our financial statements.

**SignificantCustomer Contracts**

Two of our customers,Health Care Service Corporation, or HCSC, and Horizon Blue Cross Blue Shield,or Horizon, accounted for 27% and 20%, respectively, of our revenue for theyear ended December 31, 2006. HCSC accounted for 25% of our revenue for2005. Each of these contracts contains a term license component, an annualsubscription and maintenance fee component. As is the case generally with allof our term license arrangements, a significant amount of the revenue of thecontract is recognized in the initial year of the contract, with the remainingyear revenue composed predominantly of annual subscription and maintenance feesand services relating primarily to implementation. See the discussion of “Sourcesof Revenue” contained under Item 7 of this Annual Report on Form 10-K.As a result, while these two contracts represent a material portion of ourrevenue for the year ended December 31, 2006, we can not determine at thistime whether these contracts will represent a material portion of our revenuein the future.

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***HCSC Agreement***

**On November 15, 2005, weentered into a Master Product Agreement with HCSC. This agreement, which werefer to as the HCSC Agreement, is a software license and support agreementpursuant to which we license certain software products to HCSC and providesoftware support and hosting services to HCSC in connection with these softwareproducts. The initial term of the license under the HCSC Agreement is for threeyears, with a yearly option for HCSC to renew for two additional years untilexpiration in November 15, 2010. The HCSC Agreement may only be terminatedby either party for a breach of the agreement, but the support services may beterminated by HCSC at any time with proper notice to us. Annual support feesand annual ASP hosting fees will not increase during the initial three yearterm, but may increase each year thereafter by no more than a fixedpre-negotiated rate. The agreement sets forth the support services to beprovided, including technical support, business support and product upgrades.**

The HCSC Agreementaccounted for a significant portion of our 2005 revenue primarily as a resultof the initial license fee that was recognized at the end of 2005. Theimplementation for the project began in late 2005 and continued through 2006.As a result, the revenue in connection with the implementation of the projectcombined with the recognition of annual license and support payments resultedin the HCSC Agreement accounting for a significant portion of our revenue forthe year ended December 31, 2006. Given that services are provided on anas requested basis, we cannot determine at this time whether the HCSC Agreementwill account for a material portion of our revenue in the future.

***Horizon Agreement***

**On June 30, 2005, we enteredinto a Master Product and Services Agreement with Horizon. This agreement,which we refer to as the Horizon Agreement, is a software license and supportagreement pursuant to which we license certain software products to Horizon andprovide software support services to Horizon in connection with these softwareproducts. The initial term of the license under the Horizon Agreement is forfive years. The Horizon Agreement may be terminated for convenience by Horizonunder certain circumstances or for breach of the agreement by either party.Horizon may choose to terminate the support services on a yearly basis bychoosing not to renew these services. The Horizon Agreement sets forth thesupport services to be provided, including technical support, business supportand product upgrades. These support services have specific performance targets,metrics and escalation levels for each of our support services.**

**The Horizon Agreement accounted forless than 10% of our 2005 revenue. The Horizon Agreement accounted for asignificant portion of our revenue for the year ended December 31, 2006 asa result of the initial license fees that were recognized in that period. Giventhat services are provided on an as requested basis, we cannot determine atthis time whether the Horizon Agreement will account for a material portion ofour revenue in the future.**

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**ConsolidatedResults of Operations**

Thefollowing table sets forth key components of our results of operations for theperiods indicated as a percentage of total revenue:

| ** **                                                                                 | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                 | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenue                                                                                    |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Subscription, maintenance and transaction fees                                             |       |                                       | 50         | % |   |   | 45 | % |   |   | 53 | % |   |
| Term license revenue                                                                       |       |                                       | 20         |   |   |   | 25 |   |   |   | 22 |   |   |
| Professional services                                                                      |       |                                       | 30         |   |   |   | 30 |   |   |   | 25 |   |   |
| Total revenue                                                                              |       |                                       | 100        |   |   |   | 100 |   |   |   | 100 |   |   |
| Cost of revenue                                                                            |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Subscription, maintenance and transaction fees                                             |       |                                       | 17         |   |   |   | 22 |   |   |   | 24 |   |   |
| Term licenses                                                                              |       |                                       | 4          |   |   |   | 4 |   |   |   | 5 |   |   |
| Professional services                                                                      |       |                                       | 13         |   |   |   | 14 |   |   |   | 18 |   |   |
| Total cost of revenue                                                                      |       |                                       | 34         |   |   |   | 40 |   |   |   | 47 |   |   |
| Gross margin                                                                               |       |                                       | 66         |   |   |   | 60 |   |   |   | 53 |   |   |
| Operating expenses                                                                         |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
| Sales and marketing                                                                        |       |                                       | 24         |   |   |   | 20 |   |   |   | 17 |   |   |
| Research and development                                                                   |       |                                       | 18         |   |   |   | 7 |   |   |   | 12 |   |   |
| General and administrative                                                                 |       |                                       | 28         |   |   |   | 25 |   |   |   | 22 |   |   |
| Total operating expenses                                                                   |       |                                       | 70         |   |   |   | 52 |   |   |   | 51 |   |   |
| (Loss) income from operations                                                              |       |                                       | (4         | ) |   |   | 8 |   |   |   | 2 |   |   |
| Loss on change in  fair value of redeemable convertible preferred stock conversion options |       |                                       | 20         |   |   |   | 2 |   |   |   | 2 |   |   |
| Interest expense,  net                                                                     |       |                                       | 1          |   |   |   | 1 |   |   |   | — |   |   |
| (Loss) income before (provision) benefit for income  taxes                                 |       |                                       | (25        | ) |   |   | 5 |   |   |   | — |   |   |
| (Provision) benefit  for income taxes                                                      |       |                                       | (15        | ) |   |   | 17 |   |   |   | — |   |   |
| Net (loss) income                                                                          |       |                                       | (40        | ) |   |   | 22 |   |   |   | — |   |   |
| Accretion of convertible preferred shares and redeemable  convertible preferred shares     |       |                                       | (18        | ) |   |   | (10 | ) |   |   | (22 | ) |   |
| (Loss) income available  to common shareholders                                            |       |                                       | (58        | )% |   |   | 12 | % |   |   | (22 | )% |   |

 

**Comparison of YearsEnded December 31, 2006 and 2005**

***Revenue***

Consolidated revenue increased 14.5% to $44.2 millionfor the year ended December 31, 2006 from $38.6 million for the year endedDecember 31, 2005. This increase resulted primarily from an increase insubscription, maintenance and transaction revenue and professional servicesrevenue. Subscription, maintenance and transaction revenue increased $4.9million to $22.1 million for the year ended December 31, 2006 from $17.2million for the year ended December 31, 2005. Professional servicesrevenue increased $1.6 million to $13.3 million for the year endedDecember 31, 2006 from $11.7 million for the year ended December 31,2005.

For the year ended December 31, 2006 we enteredinto a total of 20 contracts compared to 18 for the year endedDecember 31, 2005. In 2006, 2 contracts were with new customers wholicensed our Advanced 

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Medical Management moduleand at least one other module. The remaining 18 contracts were with existingcustomers that have already implemented our Advanced Medical Management moduleand were adding an additional module. In 2005, we entered into a total of 18contracts, of which four were with new customers who licensed our AdvancedMedical Management module. Three of these customers also licensed at least oneadditional module. During 2006, Horizon licensed our Clinical Care Pathwayssolution and expanded its utilization of our Advanced Medical Management moduleto an increased membership base. For the year ended December 31, 2006, Horizonrepresented approximately 20% of our total revenue.

The subscription,maintenance and transaction revenue increase reflects the revenue fromcontracts signed in late 2005 for our Clinical Care Pathways and Data Gatheringand Analytics modules (approximately $3.8 million of which was associatedwith our agreement with HCSC), hosting contracts signed in early 2005 for whichthe customers did not complete implementation until the fourth quarter of 2005and increased maintenance and support revenue associated with contracts executedin late 2005 and early 2006. The increase in professional services revenuereflects several implementation projects associated with HCSC in connectionwith their contract executed in the fourth quarter of 2005.

***Cost of Revenue***

Cost of revenue decreased 1% to $15.2 million for theyear ended December 31, 2006 from $15.3 million for the year endedDecember 31, 2005.

This net decrease resulted from a decrease in thecosts of subscription, maintenance and transaction fees of $0.5 million,partially offset by an increase in the cost of term licenses of $0.1 millionand an increase in the cost of professional services of $0.3 million.

The decrease in the cost of subscription, maintenanceand transaction fees of $0.5 million is primarily due to a decrease in theamortization of capitalized software costs of $0.5 million, a decrease inpersonnel and personnel related costs of $0.1 million resulting from thereallocation of personnel from product maintenance to product development, adecrease of $0.1 million in outside consultant costs and a decrease in $0.1million in hardware and software support and maintenance costs. These decreaseswere partially offset by increases in third-party secured facility costs andcommunications costs associated with our hosting network of $0.3 million.

The increase in cost of term licenses of $0.1 millionis principally due to an increase in the amortization of capitalized softwarecosts of $0.5 million, partially offset by a reduction in the cost ofthird-party license fees of $0.4 million

The increase in the costof professional services of $0.3 million is due to increased personnel andpersonnel related costs of $0.8 million to support our increasedprofessional services work, partially offset by a reduction in the use ofoutside consultants of $0.3 million.

***Gross Margin***

Gross margin increased 25% to $29.0 million for theyear ended December 31, 2006 from $23.3 million for the year endedDecember 31, 2005. As a percentage of revenue, gross margin increased to66% for the year ended December 31, 2006 from 60% for the year endedDecember 31, 2005.

Gross margin from subscription, maintenance andtransaction fee revenue increased 61% to $14.4 million for the year endedDecember 31, 2006 from $9.0 million for the year ended December 31, 2005.As a percentage of subscription, maintenance and transaction fee revenue, grossmargin from subscription, maintenance and transaction fee revenue increased to65% for the year ended December 31, 2006 from 52% for the year endedDecember 31, 2005. This increase is a result of revenue from contractssigned in late 2005 for Clinical Care Pathways, hosting contracts signed inearly 2005 for which customers did not 

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complete implementationuntil the fourth quarter of 2005 and increased maintenance and support revenueassociated with contracts signed in the late part of 2005. In addition, loweramortization of capitalized software related to products licensed on asubscription basis and a reallocation of personnel from product maintenance toproduct development contributed to the increased gross margin on subscription,maintenance and transaction fee revenue.

Gross margin from term license fee revenue decreased12% to $7.1 million for the year ended December 31, 2006 from $8.1 millionfor the year ended December 31, 2005. As a percentage of term license feerevenue, gross margin from term license fee revenue decreased to 80% for theyear ended December 31, 2006 from 83% for the year ended December 31,2005. This decrease is attributable to an increase in capitalized softwareamortization for our Advanced Medical Management module and third-partysoftware costs associated with new term license contracts.

Gross margin fromprofessional services revenue increased 21% to $7.5 million for the year ended December 31,2006 from $6.2 million for the year ended December 31, 2005. As apercentage of professional services revenue, gross margin from professionalservices revenue increased to 57% for the year ended December 31, 2006from 53% for the year ended December 31, 2005. This increase is a resultof continued operational efficiency in our professional services operationsfrom new project management methodologies which were implemented in late 2004.

***Sales and Marketing***

Sales and marketingexpenses increased 35% to $10.5 million for the year ended December 31,2006 from $7.8 million for the year ended December 31, 2005. This $2.7million increase is due to increased sales and product marketing personnel andpersonnel-related costs that increased sales and marketing expense $1.4million, increased commission expense of $1.1 million attributable to theincreased revenue and increased corporate marketing expenses of $0.4 millionfor public relations, user conference and tradeshows.

***Research and Development***

Research and developmentexpenses increased 206% to $8.0 million for the year ended December 31,2006 from $2.6 million for the year ended December 31, 2005. The change ofthe $5.4 million increase reflects increased personnel andpersonnel-related costs and increased independent contractor costs of$4.4 million. For the year ended December 31, 2006, we capitalized$1.4 million of software development costs related to specific projectswhich will add new product features and functionality, a decrease of 42% from$2.4 million capitalized for the year ended December 31, 2005. Totalresearch and development expenditures increased 88% to $9.4 million (includingcapitalized software development costs of $1.4 million) for the year endedDecember 31, 2006 from $5.0 million (including capitalized softwaredevelopment costs of $2.4 million) for the year ended December 31,2005.

***General and Administrative***

General and administrativeexpenses increased 29% to $12.5 million for the year ended December 31, 2006from $9.7 million for the year ended December 31, 2005 or $2.9 million.This increase is due to an increase of $0.8 million in personnel andpersonnel related costs within the corporate operations, increased depreciationexpense of $0.9 million, an increase in legal and consultant costs of$0.6 million associated with the development of our Collaborative DataExchange module, $0.3 million related to recruiting costs for new personnel anda $0.5 million increase in facility costs resulting from the additionalspace leased in the year ended December 31, 2006 compared to the yearended December 31, 2005. In addition, approximately $0.4 million ofthe increase is related to stock compensation expense and the adoption of SFAS No. 123R,*Share-Based Payment*, as of January 1,2006.

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***Loss on Change inFair Value of Previously Outstanding Redeemable Convertible Preferred StockConversion Options***

The fair value of ourpreviously outstanding conversion options changed by $7.9 million to an$8.6 million loss for the year ended December 31, 2006 from a $0.7 millionloss for the year ended December 31, 2005. The change resulted from the increasein the fair value of the conversion options calculated using the Black-Scholesmodel.

***Interest Expense, Net***

Interest expense, netincreased 70% to $0.5 million for the year ended December 31, 2006 from$0.3 million for the year ended December 31, 2005. This $0.2 millionincrease is attributable to higher overall average borrowings outstanding aswell as higher average costs of borrowing for the year ended December 31, 2006compared to the year ended December 31, 2005.

***Provision for Income Taxes***

We recorded an income tax provision of $6.7 millionfor the year ended December 31, 2006 as compared to a benefit of $6.5million for the year ended December 31, 2005. The change resulted from management’sevaluation of our positive and negative evidence bearing upon the ability torealize our deferred tax assets. Management’s assessment at December 31,2006 was that the weight of the negative evidence outweighed the positive evidencethat a portion of the deferred tax assets would be realized, and accordingly,the valuation allowance was increased, and the net deferred tax asset wasdecreased by $6.7 million.

Term license revenue of$1.4 million recorded during the fourth quarter of 2006 was below ourexpectations resulting in a net loss for the year ended December 31, 2006 andreversing the trend of two consecutive years of book and three consecutiveyears of taxable income. This lower term license revenue was primarily the resultof the delay in the execution of certain contracts which became known to usduring the last two weeks of the year. In addition, a new customer contractwhich the Company anticipated obtaining and closing prior to December 31,2006 was lost to a competitor in January 2007. As a result of the delay inclosing of contracts and the lost opportunity, the Company recorded a net lossin the fourth quarter of 2006 and the full year 2006, and, reduced its revenueand net income guidance for 2007. Accordingly, the Company fully reserved thedeferred tax asset at December 31, 2006.

***Net (Loss) Income***

We recorded a net loss of$17.8 million for the year ended December 31, 2006 compared to netincome of $8.7 million for the year ended December 31, 2005. Theincrease in term license and subscription, maintenance and transaction revenueand improving efficiency in professional services all contributed to anincrease in gross margin of $5.8 million. Increases in expenses for the yearended December 31, 2006 of $11.0 million over the year ended December 31,2005 offset the improved margin. We had a $2.1 million loss from operations forthe year ended December 31, 2006 compared to $3.2 million in income fromoperations for the year ended December 31, 2005. An increase in interestexpense combined with an increase in the provision for income taxes furtherincreased the loss from operations, thereby resulting in a net loss of$17.8 million for the year ended December 31, 2006 compared to netincome of $8.7 million the year ended December 31, 2005.

***Accretion of Previously Outstanding ConvertiblePreferred Shares and Redeemable Preferred Shares***

The accretion of ourpreviously outstanding convertible and redeemable convertible preferred sharesfor the year ended December 31, 2006 increased $4.1 million to$8.1 million from $4.0 million for the year ended December 31, 2005.This increase is attributable to the increase in the fair value of our common 

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stockand the associated value of the embedded conversion feature of the preferredshares. Under accounting rules, this accretion of value to the preferred stockreduces the net income available to common shareholders.

***(Loss) Income Available to Common Shareholders***

For the reasons describedabove, the loss available to common shareholders was $25.9 million for the yearended December 31, 2006 compared to income available to commonshareholders of $4.7 million for the year ended December 31, 2005. Thisresulted from a net loss of $17.8 million for the year ended December 31,2006 compared to net income of $8.7 million for the year ended December 31,2005 and from the $4.0 million increase in the year ended December 31,2006 compared to year ended December 31, 2005 in the accretion to the preferredshares which reduced net income available to common shareholders

**Comparison of YearsEnded December 31, 2005 and 2004**

***Revenue***

Consolidated revenue increased 38% to $38.6 millionfor the year ended December 31, 2005 from $28.0 million for the yearended December 31, 2004. The $10.6 million increase in consolidatedrevenue was attributable to an increase in the number and average size of salesof our Collaborative Care Management suite during 2005 compared to 2004, anincrease of $4.6 million in professional services fees attributable toincreased volume of services work for existing customers and an increase intransaction fees and hosting revenue. Term license revenue increased 55% forthe year ended December 31, 2005 over the year ended December 31,2004 resulting from the sale of our Collaborative Care Management suite to alarge healthcare insurance company. Revenue derived from transaction fees andhosting fees increased 76%, or $2.2 million, for the year ended December 31,2005 over the year ended December 31, 2004 due to the licensing in late2004 of our solutions to several customers on a hosted basis, resulting in 2005revenue of $1.7 million, and an increase in the volume of authorizationsand referrals transmitted over the Collaborative Data Exchange module resultingin $0.3 million revenue in 2005.

For the year ended December 31, 2005, we enteredinto a total of 18 product contracts compared to 12 contracts executed in theyear ended December 31, 2004. In the 2005 period, four contracts were withnew customers who licensed our Advanced Medical Management module, and three ofwhom licensed at least one other module. For the year ended December 31,2004, we signed contracts with seven new customers, five of whom licensed ourAdvanced Medical Management module and one of whom also licensed at least oneadditional module.

Beginning in the secondquarter of 2003, we began to market our Collaborative Care Management suite.Prior to that time, we marketed and licensed modules individually. Our customershave historically licensed our Advanced Medical Management module. However,since 2003, new customers have licensed one or two additional product modulesin addition to licensing our Advanced Medical Management module. For the yearended December 31, 2005, we entered into a total of 19 product contracts.Six contracts were for new customers that licensed multiple product modules.The existing customer contracts contain a license for one additional productmodule.

***Cost of Revenue***

Cost of revenue increased 17% to $15.3 million for theyear ended December 31, 2005 from $13.1 million for the year ended December 31,2004. This increase resulted from an increase in the cost of subscription,maintenance and transaction fees of $1.4  million to $8.2 million forthe year ended December  31, 2005 from $6.8 million for the year ended December 31,2004, an increase in cost of term licenses of $0.2 million to$1.7 million for the year ended December  31, 2005 from$1.5 million for the year 

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ended December  31,2004 and an increase of $0.7 million to $5.5 million for the yearended December 31, 2005 from $4.8 million for the year ended December 31,2004.

The increase in the cost of subscription, maintenanceand transaction fees is largely attributable to increased personnel andpersonnel related costs and increased temporary consultants for product supportof $0.5 million and $0.4 million, respectively, and increased cost ofnetwork support and maintenance associated with the hosted operations of$0.2 million.

The increase of$0.6 million in cost of professional services results from increasedpersonnel and personnel related costs.

***Gross Margin***

Gross margin increased 55% to $23.3 million for theyear ended December 31, 2005 from $15.0 million for the year ended December 31,2004. As a percentage of revenue, gross margin increased to 60% for the yearended December 31, 2005 from 53% for the year ended December 31,2004.

Gross margin from subscription, maintenance andtransaction fee revenue increased 14% to $9.0 million for the year ended December 31,2005 from $7.9 million for the year ended December 31, 2004. As apercentage of subscription, maintenance and transaction fee revenue, grossmargin from subscription, maintenance and transaction fee revenue decreased to52% for the year ended December 31, 2005 from 54% for the year ended December 31,2004. This decrease is a result of increased personnel and personnel relatedcosts related to product support and increased cost of network support andmaintenance associated with our hosting operations offset by highersubscription fees and hosting fees from customers who signed contracts in thelate part of 2004.

Gross margin from term license revenue increased 67%to $8.0 million for the year ended December 31, 2005 from $4.8 million forthe year ended December 31, 2004. As a percentage of term license revenue,gross margin from term license revenue increased to 82% for the year ended December 31,2005 from 76% for the year ended December 31, 2004. This increase is aresult of the licensing of our Collaborative Care Management suite to HCSC.

Gross margin fromprofessional services revenue increased 170% to $6.2 million for the year endedDecember 31, 2005 from $2.3 million for the year ended December 31,2004. As a percentage of professional services revenue, gross margin fromprofessional services revenue increased to 53% for the year ended December 31,2005 from 32% for the year ended December 31, 2004. This increase is dueto increased utilization of personnel from reduced turnover and new projectmanagement methodologies which we began implementing in late 2004.

***Sales and Marketing***

Sales and marketingexpenses increased 66% to $7.8 million for the year ended December 31,2005 from $4.7 million for the year ended December 31, 2004. The materialcomponents of the $3.1 million increase include increased commission expensedue to the increase in consolidated revenue in 2005 over 2004 of$1.0 million, increased sales personnel and personnel-related costs of$1.4 million resulting from the reorganization of our sales organizationand creation of a sales team focused on cross-selling, increased travel-relatedexpenditures of $0.2 million and increased trade show expenses and othermarketing-related costs of $0.4 million.

***Research and Development***

Research and development expenses decreased 19% to$2.6 million for the year ended December 31, 2005 from $3.2 millionfor the year ended December 31, 2004. The net decrease of $0.6 millionreflects an increase in capitalization of software development partially offsetby increased 

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development efforts addingnew product features and functionality prior to establishing technologicalfeasibility, which required increased personnel and personnel-related costs aswell as increased use of independent contractors. For the year ended December 31,2005, we capitalized $2.4 million of software development costs, an increase of$1.2 million over the $1.2 million of software development costs capitalizedfor the year ended December 31, 2004. Total research and developmentexpenditures for the year ended December 31, 2005 were $5.0 million(including capitalized software development costs of $2.4 million) inaggregate, a 14%, or $0.6 million increase over total research and developmentexpenditures of $4.4 million (including capitalized software development costsof $1.2 million) for the year ended December 31, 2004.

***General and Administrative***

General and administrativeexpenses increased 54% to $9.7 million for the year endedDecember 31, 2005 from $6.3 million for the year endedDecember 31, 2004. The $3.4 million increase is primarily attributable tothe accrual of a special incentive pool of $1.1 million based upon our resultsof operations for the year ended December 31, 2005, the creation of a strategicbusiness development operation focused on developing our Collaborative Care Managementsuite increasing costs $0.5 million in 2005 compared to 2004, increasedtravel-related expenses of $0.2  million (primarily attributable to thestrategic business development operation), increased facilities and facilities-relatedexpenses of $0.4  million relating to increased office space, increaseddepreciation of $0.2  million related to increased capital expenditures,increased recruiting and retention costs of $0.3  million and increasedlegal and consulting costs of $0.3  million.

***Loss on Change inFair Value of Previously Outstanding Redeemable Convertible Preferred StockConversion Options***

The fair value of ourpreviously outstanding conversion options changed by $0.1 million to a $0.7million loss for the year ended December 31, 2005 from a $0.6 million lossfor the year ended December 31, 2004. The change resulted from the changein the fair value of the conversion options calculated using the Black-Scholesmodel.

***Interest Expense, Net***

Interest expense, netincreased 50% to $0.3 million for the year ended December 31, 2005 from$0.2 million for the year ended December 31, 2004. The $0.1 millionincrease is attributable to increased average borrowings for capital expenditures,primarily through capital leases, offset by lower average borrowings forworking capital and secondarily to increased average interest rates onborrowings in 2005 compared to 2004.

***Provision for Income Taxes***

We realized an income taxbenefit of $6.5 million for the year ended December 31, 2005 as comparedto no provision or benefit for the year ended December 31, 2004. The $6.5million increase was primarily attributable to the utilization of our netoperating loss carryforward and the reduction in our tax valuation allowance ofapproximately $7.5 million with a consequent increase in our net deferred taxasset of $6.5 million. These changes resulted from management’s evaluationof our positive and negative evidence bearing upon the ability to realize ourdeferred tax assets and we believe that it is more likely than not that we willrealize a portion of the benefits of federal and state tax assets.

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***Net (Loss) Income***

We recorded net income of$8.7 million for the year ended December 31, 2005 compared to a netloss of $26,000 for the year ended December 31, 2004. The increase in termlicense and subscription, maintenance and transaction revenue, as well as anincrease in the volume of professional services work performed for customers,contributed to an increase in gross margin of $8.3 million. Increases inexpenses for the year ended December 31, 2005 of $5.9 million overthe year ended December 31, 2004 partially offset the improved margin. Ourincome from operations for the year ended December 31, 2005 increased$2.4 million over the year ended December 31, 2004. An increase of$0.1 million in the valuation of the embedded conversion feature of the preferredshares for the year ended December 31, 2005 over the year endedDecember 31, 2004 and an increase in interest expense resulted in a changein pre-tax income of $2.2 million for the year ended December 31,2005 over the year ended December 31, 2004. For the year endedDecember 31, 2005, we had pre-tax income of $2.2 million compared toa pre-tax loss of $26,000 for the year ended December 31, 2004. In 2005,we realized an income tax benefit of $6.5 million from the utilization ofnet operating loss carryforwards and a reduction in the tax valuationallowance. This resulted in net income for the year ended December 31,2005 of $8.7 million compared to a net loss of $26,000 for the year endedDecember 31, 2004.

***Accretion of Previously Outstanding ConvertiblePreferred Shares and Redeemable Preferred Shares***

The accretion of ourpreviously outstanding convertible and redeemable convertible preferred sharesfor the year ended December 31, 2005 decreased $2.1 million to$4.0 million from $6.1 million for the year ended December 31,2004. This increase is attributable to the increase in the fair value of theCompany’s common stock and the associated value of the beneficial conversionfeature of the preferred shares. Under accounting rules, this accretion of valueto the preferred stock reduces the net income available to our commonshareholders.

***(Loss) Income Available to Common Shareholders***

For the reasons describedabove, for the year ended December 31, 2005, we recorded income availableto common shareholders of $4.7 million compared to a loss available to commonshareholders for the year ended December 31, 2004 of $6.1 million. This$10.8 million change resulted from an increase in net income of $8.7 millionplus a reduction in the accretion of preferred stock conversion value of $2.1million.

**Liquidity andCapital Resources**

Since our inception and until our initial publicoffering which closed on December 18, 2006, we financed our operationsprimarily through internally generated cash flows, borrowings from banks andthe issuance of preferred stock. On December 18, 2006, we raisedapproximately $26.4 million, net of fees and expenses, through the closing ofour initial public offering. As of December 31, 2006 and December 31,2005, we had cash of $17.4 million and $2.4 million, respectively, andreceivables of $10.0 million and $10.4 million, respectively. As ofDecember 31, 2006 and December 31, 2005, we had no borrowings underour bank working capital facility. As of December 31, 2006 andDecember 31, 2005, we had $4.4 million and $3.8 million, respectively, intotal capital equipment financing, primarily capital leases, outstanding. As ofDecember 31, 2006 and 2005, we had $0.3 million and $0, respectively, ofinsurance premium financing outstanding. As of December 31, 2005, we hadaccumulated dividends on our preferred stock of $14.5 million.

In connection with the closing of our initial publicoffering on December 18, 2006, all of our outstanding shares ofSeries A preferred stock, Series B preferred stock and Series Cpreferred stock converted into common stock under the terms of each of therespective preferred stock designations. All 

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dividends on theSeries A preferred stock that were accrued but unpaid as of the date ofthe offering were converted into common stock pursuant to an election of eachholder of such shares as provided under the terms of the Series Apreferred stock designation. All dividends on the Series B preferred stockand Series C preferred stock that were accrued but unpaid as of the dateof the offering (approximately $9.5 million) were paid in cash from theproceeds of the offering. Thus, as of December 31, 2006, we had noaccumulated dividends on our preferred stock.

We have a working capital facility with Silicon ValleyBank that is collateralized by all our assets. Our borrowings under thisfacility can be no more than the lesser of $8.0 million or 80% of eligiblereceivables, as such term is defined in the bank agreement, minus the totalamounts then undrawn on all outstanding letters of credit, or any otheraccommodations issued or incurred by Silicon Valley Bank for our benefit. Theworking capital facility terminates on September 29, 2007. As of December 31,2006, we had no outstanding borrowings outstanding under the working capitalfacility and remaining availability of $4.2 million. We also have a$1.0 million equipment line of credit with Silicon Valley Bank that iscollateralized by our assets. As of December 31, 2006, we haveapproximately $0.1 million outstanding under this equipment line. Additionalborrowings under this facility will convert to a 30-month term note as ofthe first day of the subsequent calendar quarter.

As of December 31,2006, we were out of compliance with one of the financial covenants under therevolving line of credit agreement with Silicon Valley Bank. On March 26,2007, we executed an amendment and waiver to the underlying loan and securityagreement to (i) waive the existing default; (ii) increase the amountto be borrowed under the equipment line of credit to $1.75 million; (iii) extendthe equipment line maturity date to the earlier of the date 30 months after thecalendar quarter subsequent to each equipment advance but no later than December 1,2009; and (iv) replace the liquidity and net income covenants withtangible net worth and adjusted quick ratio covenants. Under the amendment andwaiver to the loan agreement, which is attached hereto as Exhibit 10.16(iv),we are required to maintain certain quarterly minimum tangible net worth andmonthly adjusted quick ratio covenants, as defined.

**OperatingActivities**

Net cash provided by operating activities was $1.9million and $5.7 million for the year ended December 31, 2006 and 2005,respectively. Net cash used in operating activities for the year ended December 31,2006 consisted of a net loss of $17.8 million, offset by non-cashdepreciation and amortization of $3.2 million, a non-cash reversal ofdeferred tax assets of $6.7 million, a non-cash loss on change in fair value ofredeemable convertible preferred stock conversion options of $8.6 million,stock compensation expense of $0.7 million, a decrease in accounts receivableof $0.4 million and by other changes in working capital of $0.4 million. Deferredrevenue increased $0.7 million to $10.3 million at December 31, 2006from $9.6 million at December 31, 2005. Deferred revenue consists of (i) annualmaintenance and subscription fees for the software solutions that are paid inadvance and recorded over the service period, and (ii) advance billingsfor professional services projects that are recorded using the proportionalperformance method based upon labor hours expended compared to estimated laborhours to complete the project. The increase was attributable to an increase inadvance payments for professional services projects of $1.6 millionpartially offset by the amortization of prepaid annual maintenance andsubscription fees of $0.9 million. Net cash used in operating activitiesfor the year ended December 31, 2005 consisted of a net income of $8.7million, non-cash depreciation and amortization of $2.1 million, an increase indeferred revenue of $3.7 million, an increase in accounts receivable of$5.9 million and an increase in other working capital of $2.0 million.

Net cash provided byoperating activities was $5.7 million and $2.5 million for the years ended December 31,2005 and 2004, respectively. Net cash provided from operating activities forthe year ended December 31, 2005 primarily resulted from net income of$5.1 million, plus non-cash depreciation and amortization of $2.1 million andan increase in deferred revenue of $3.7 million, which was partially offset 

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bychanges in working capital of $5.2 million. Net cash provided from operationsfor the year ended December 31, 2004 consisted of a net loss of $1.3million, offset by non-cash depreciation and amortization of $1.9 millionand an increase in deferred revenue of $2.0 million, which was partially offsetby changes in working capital of $0.1 million.

**InvestingActivities**

Net cash used in investing activities was $2.5 millionand $3.2 million for the year ended December 31, 2006 and 2005,respectively. The net change in investing activities resulted from a slightlylower investment in the development of new product features and functionalityas the Company focused on the implementation of software products for contractsthat were closed. Net cash used in investing activities for the year ended December 31,2006 related to development activities to enhance our product offering and thecapitalization of the cost associated with those projects of $1.4 million andthe purchase of office equipment and computer equipment of $1.1 million. Netcash used in investing activities for the year ended December 31, 2005related to development activities to enhance our product offering and thecapitalization of the cost associated with those projects of $2.0 million, thecapitalization of contingent payments of $0.1 million related to theacquisition of clinical decision support software at the end of 2002, thecapitalization of software developed by an independent firm of $0.8 million andthe purchase of office equipment and computer equipment of $0.8 million.

Net cash used in investingactivities was $3.2 million and $2.0 million for the years ended December 31, 2005and 2004, respectively. Net cash used in investing activities for the yearended December  31, 2005 related to development activities to enhanceour product offering and the capitalization of the cost associated with thoseprojects of $2.0 million, the capitalization of contingent payments of$0.1 million related to the acquisition of clinical decision supportsoftware at the end of 2002, the capitalization of software developed by anindependent firm of $0.8 million and the purchase of office equipment andcomputer equipment of $0.8 million. Net cash used in investing activities forthe year ended December 31, 2004 related to development activities toenhance our product offering and the capitalization of the cost associated withthose projects of $0.9 million, the capitalization of contingent paymentsrelated to the acquisition of clinical decision support software at the end of2002 of $0.3 million and the purchase of office equipment and computerequipment of $0.9 million.

**FinancingActivities**

Net cash provided by financing activities was $15.6million for the year ended December 31, 2006 compared to net cash used infinancing activities of $0.5 million for the year ended December 31, 2005.The net change in financing activities resulted from the net proceeds of ourinitial public offering which closed on December 18, 2006 partially offsetby the payment of preferred stock dividends and higher capital lease paymentsin 2006. Net cash provided by financing activities for the year ended December 31,2006 consisted of net proceeds from our initial public offering of $26.4million partially offset by the payment of accrued and unpaid dividends to theformer holders of our Series B and Series C preferred stock of $9.5million, repayments against our capital leases outstanding of $1.4 million andrepayments against our equipment line of credit of $0.1 million. Net cash usedin financing activities for the year ended December 31, 2005consisted of borrowings against our equipment line of credit of $0.2 millionand repayments against our capital leases outstanding.

Net cash used in financing activities was $0.5 millionand $0.8 million for the years ended December 31, 2005 and 2004,respectively. Net cash used in financing activities for the year ended December 31, 2005consisted of borrowings against our equipment line of credit of $0.2 millionand repayments against our capital leases outstanding. Net cash used infinancing activities for the year ended December 31, 2004 consisted ofrepayments on our capital leases outstanding and repayment of borrowings on ourworking capital facility.

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We believe that our cashbalances, cash flows from operations and available borrowings under our workingcapital line of credit, equipment line of credit and capital leases will besufficient to satisfy our working capital and capital expenditure requirementsfor at least the next 12 months. We used approximately $9.5 million of the$26.4 million net proceeds from our initial public offering which closed on December 18,2006 to pay the accrued and unpaid dividends to the former holders of our Series Band Series C preferred stock upon the automatic conversion of such sharesinto common stock upon the consummation of the offering. We intend to use thebalance of the net proceeds of the offering for general corporate purposes, includingworking capital needs. We believe opportunities may exist to expand our currentbusiness through strategic acquisitions and investments in technology, and wemay use a portion of the proceeds for these purposes. Changes in our operatingplans, lower than anticipated revenue, increased expenses or other events,including those described in “Risk Factors” may cause us to seekadditional debt or equity financing on an accelerated basis. Financing may notbe available on acceptable terms, or at all, and our failure to raise capitalwhen needed could negatively impact our growth plans, our financial conditionand results of operations. Additional equity financing would be dilutive to theholders of common stock, and debt financing, if available, may involvesignificant cash payment obligations and covenants or financial ratiorequirements that restrict our ability to operate our business. We do not,however, have any current plans to issue additional equity, including preferredstock, in the near future.

**ContractualObligations and Commitments**

Thefollowing table summarizes our contractual arrangements at December 31,2006 and the timing and effect that such commitments are expected to have onour liquidity and cash flows in future periods after giving effect to thecompletion of our initial public offering on December 18, 2006 and ourapplication of the net proceeds from our initial public offering.

| ** **                      | ** ** | **Payments Due By Period** | ** ** |
|---------------------------------|------------|-------------------------------------------|------------|
| ** **                      | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Thereafter,** | ** ** |
| ** **                      | ** ** | **2007**                                  | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** | **through 2016** | ** ** |
| ** **                      | ** ** | **(in thousands)**                   | ** ** |
| Contractual Obligations:        |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Capital leases                  |       | $                                         | 2,159      |   | $ | 1,794 |   | $ | 779 |   | $ | 202 |   | $ | 59 |   |   | $ | — |   |   |
| Operating leases                |       | 1,932                                     |       | 1,838 |   | 1,878 |   | 1,931 |   | 1,999 |   |   | 10,258 |   |   |
| Note payable(1)                 |       | 75                                        |       | — |   | — |   | — |   | — |   |   | — |   |   |
| Insurance premium financing(2)  |       | 313                                       |       | — |   | — |   | — |   | — |   |   | — |   |   |
| Third-party software agreements |       | 508                                       |       | — |   | — |   | — |   | — |   |   | — |   |   |
| Total                           |       | $                                         | 4,987      |   | 3,632 |   | 2,657 |   | 2,133 |   | 2,058 |   |   | 10,258 |   |   |
|                                 |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)          Excludes interest whichis calculated at prime (8.25% at December 31, 2006) plus 1.75%.

(2)          Excludes interest whichis calculated at 7.5%.

The amounts listed above for capital leases representpayments that we are required to make for equipment. If we fail to remaincurrent with our obligations for any of these capital leases, we would be indefault, and our continued failure to cure such default would cause ourremaining obligations under the defaulted capital lease to become immediatelydue.

The amounts listed above for operating leasesrepresent base monthly rent on leases for office space and copier and faxequipment, and do not include required variable facility operating expensereimbursements to the landlord. If we fail to make payments on our officespace, we will be required to pay all remaining lease payments immediately.

We are party to an Amended and Restated Loan andSecurity Agreement with Silicon Valley Bank dated September 28, 2006 andamended March 26, 2007 pursuant to which Silicon Valley Bank provides 

68

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senior debt financing tous. Our obligations under the Amended and Restated Loan and Security Agreementare secured by a lien on all of our assets. The Amended and Restated Loan andSecurity Agreement includes covenants requiring us to maintain a minimum tangiblenet worth and minimum adjusted quick ratio, as defined. In the event that wemake a misrepresentation, breach a warranty or fail to perform a covenant setforth in the Amended and Restated Loan and Security Agreement or if there is amaterial adverse change in our business, operations or condition (each of whichis defined in the agreement as an event of default), Silicon Valley Bank may,among other things, cease making loans to us, accelerate the date for paymentof all of our outstanding obligations to the bank and/or take possession of andsell all of our assets. Additionally, from and after the occurrence and duringthe continuance of an event of default, the then-current interest rate on theoutstanding loans under the Amended and Restated Loan and Security Agreementwill increase by 5%.

We are party to a contract to purchase third-partylicenses from a software vendor. The agreement expired on December 31,2005; however, the agreement automatically renews on an annual basis, unlessterminated by either party. Expense of $0.5 million was incurred under thisagreement in each of the years ended December 31, 2006, 2005 and 2004 andis included in cost of subscription, maintenance and transaction fees revenuein the accompanying financial statements. Scheduled future minimum payments asof December 31, 2006 under this contract are $0.5 million in 2007.

We are party to a contractwhereby we are obligated to make minimum royalty payments on an annual basis.Total minimum royalty payments under this agreement aggregate $0.5 million andare recorded ratably over the four year term of the agreement. We recorded $0.2million, $0.1 million and $0.1 million of expense under this agreement for eachof the years ended December 31, 2006, 2005 and 2004, respectively, and isincluded in cost of subscription, maintenance and transaction fees revenue inthe accompanying financial statements  There are no scheduled future minimum paymentsas of December 31, 2006 under this contract.

**Item 7A.**                Quantitativeand Qualitative Disclosures about Market Risk.

Market risk represents therisk of loss that may impact our financial position due to adverse changes in financialmarket prices and rates. Our market risk exposure is primarily a result offluctuations in interest rates. We do not hold financial instruments fortrading purposes.

**Interest Rate Risk**

The primary objective of our investment activities isto preserve principal while maximizing income without significantly increasingrisk. Some of the securities in which we may invest may be subject to marketrisk. This means that a change in prevailing interest rates may cause theprincipal amount of the investment to fluctuate. To minimize this risk in thefuture, we intend to maintain our portfolio of cash equivalents and short-terminvestments in a variety of securities, including commercial paper, governmentand non-government debt securities, certificates of deposit and money marketfunds. Money market funds are not subject to market risk because the interestpaid on these funds fluctuates with the prevailing interest rate. However, adecline in interest rates would result in reduced future investment income tous.

Our interest expense, generally, is not sensitive tochanges in prevailing interest rates since the majority of our borrowings thatare outstanding and our capital leases are at a fixed interest rate. Borrowingsunder our working capital and equipment lines of credit are subject toadjustments in prevailing interest rates. Future increases in prevailinginterest rates will increase future interest expense payable by us. However, wedo not believe a 10% increase in prevailing interest rates will have a materialeffect on our interest expense.

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**Item 8.**                        FinancialStatements and Supplementary Data.

**INDEX**

**TO**

**CONSOLIDATEDFINANCIAL STATEMENTS**

Asrequired under Item 8. Financial Statements and Supplementary Data, theconsolidated financial statements of the Company are provided under this Item8. The consolidated financial statements included under this Item 8 are asfollows:
|                                                                                                                                                                                                       | ** ** | Page   | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------|------------|
| Report of Independent Registered Public Accounting  Firm                                                                                                                                              |       | 71     |       |
| Consolidated  Balance Sheets as of December 31, 2006 and 2005                                                                                                                                    |       | 72     |       |
| Consolidated  Statements of Operations for the years ended December 31, 2006, 2005 and  2004                                                                                                     |       | 73     |       |
| Consolidated Statements of Convertible Preferred  Stock, Redeemable Convertible Preferred Stock and Stockholders’ Equity  (Deficiency) for the years ended December 31, 2006, 2005 and 2004 |       | 74     |       |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2006, 2005 and  2004                                                                                                     |       | 75     |       |
| Notes to Consolidated Financial Statements                                                                                                                                                            |       | 76-101 |       |

 

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**Reportof Independent Registered Public Accounting Firm**

The Board of DirectorsMEDecision, Inc.:

We have audited the accompanying consolidated balancesheets of MEDecision, Inc. and Subsidiaries as of December 31, 2006 and 2005,and the related consolidated statements of operations, convertible preferredstock, redeemable convertible preferred stock and stockholders’ equity (deficiency)and cash flows for each of the three years in the period ended December 31,2006. These consolidated financial statements are the responsibility of theCompany’s management. Our responsibility is to express an opinion on theseconsolidated financial statements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes consideration of internal control over financialreporting as a basis for designing audit procedures that are appropriate in thecircumstances, but not for the purpose of expressing an opinion on theeffectiveness of the Company’s internal control over financial reporting.Accordingly, we express no such opinion. An audit also includes examining, on atest basis, evidence supporting the amounts and disclosures in the financialstatements, assessing the accounting principles used and significant estimatesmade by management, as well as evaluating the overall financial statementpresentation. We believe that our audits provide a reasonable basis for ouropinion.

In our opinion, the financial statements referred toabove present fairly, in all material respects, the consolidated financialposition of MEDecision, Inc. and Subsidiaries as of December 31, 2006 and 2005,and the consolidated results of their operations and their cash flows for eachof the three years in the period ended December 31, 2006, in conformity withaccounting principles generally accepted in the United States of America.

As discussed in footnote 2to the consolidated financial statements, the Company adopted Statement ofFinancial Accounting Standards No. 123(R), Share-Based Payment, on January 1,2006.

/s/ Grant Thornton LLPPhiladelphia, Pennsylvania

March 23, 2007 (except for paragraph 3 in footnote 3,Financing Arrangements, as to which the date is March 26, 2007)

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**MEDECISION, INC.CONSOLIDATED BALANCE SHEETS(in thousands, except share and per share data)**

| ** **                                                                                                                                                                                                                                                                                            | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                                                                            | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **Assets**                                                                                                                                                                                                                                                                                            |       |                  |       |   |   |
| Current assets                                                                                                                                                                                                                                                                                        |       |                  |       |   |   |
| Cash and cash  equivalents                                                                                                                                                                                                                                                                            |       | $                     | 17,408     |   | $ | 2,447 |   |
| Accounts  receivable, net of allowance for doubtful accounts of $52 and $55,  respectively                                                                                                                                                                                                            |       | 9,975                 |       | 10,363 |   |
| Prepaid expenses                                                                                                                                                                                                                                                                                      |       | 1,085                 |       | 630 |   |
| Other current  assets                                                                                                                                                                                                                                                                                 |       | 116                   |       | 150 |   |
| Deferred income  taxes                                                                                                                                                                                                                                                                                |       | —                |       | 2,776 |   |
| Total current  assets                                                                                                                                                                                                                                                                                 |       | 28,584                |       | 16,366 |   |
| Property and equipment                                                                                                                                                                                                                                                                                |       |                  |       |   |   |
| Computer equipment  and software                                                                                                                                                                                                                                                                      |       | 7,384                 |       | 10,434 |   |
| Leasehold  improvements                                                                                                                                                                                                                                                                               |       | 3,324                 |       | 2,032 |   |
| Office equipment  and furniture                                                                                                                                                                                                                                                                       |       | 1,887                 |       | 1,363 |   |
|                                                                                                                                                                                                                                                                                                  |       | 12,595                |       | 13,829 |   |
| Less accumulated  depreciation and amortization                                                                                                                                                                                                                                                       |       | (4,116                | )          | (7,216 | ) |
| Net property and  equipment                                                                                                                                                                                                                                                                           |       | 8,479                 |       | 6,613 |   |
| Capitalized software,  net of accumulated amortization of $6,909 and $6,091, respectively                                                                                                                                                                                                             |       | 3,857                 |       | 3,274 |   |
| Other assets                                                                                                                                                                                                                                                                                          |       | 460                   |       | 341 |   |
| Deferred income  taxes                                                                                                                                                                                                                                                                                |       | —                |       | 5,689 |   |
| Total assets                                                                                                                                                                                                                                                                                          |       | $                     | 41,380     |   | $ | 32,283 |   |
| **Liabilities,  Convertible Preferred Stock,  Redeemable Convertible Preferred Stock and Stockholders’ Equity (Deficiency)**                                                                                                                                                                     |       |                  |       |   |   |
| Current liabilities                                                                                                                                                                                                                                                                                   |       |                  |       |   |   |
| Current portion of  capital lease obligations                                                                                                                                                                                                                                                         |       | $                     | 1,773      |   | $ | 1,162 |   |
| Note payable and  current portion of long-term note payable                                                                                                                                                                                                                                           |       | 388                   |       | 100 |   |
| Accounts payable                                                                                                                                                                                                                                                                                      |       | 2,554                 |       | 2,006 |   |
| Accrued payroll  and related costs                                                                                                                                                                                                                                                                    |       | 1,111                 |       | 1,803 |   |
| Other accrued  expenses                                                                                                                                                                                                                                                                               |       | 1,799                 |       | 1,826 |   |
| Conversion option  on the convertible preferred stock and the convertible redeemable preferred  stock                                                                                                                                                                                                 |       | —                |       | 1,289 |   |
| Deferred license  and maintenance revenue                                                                                                                                                                                                                                                             |       | 7,482                 |       | 8,407 |   |
| Deferred  professional services revenue                                                                                                                                                                                                                                                               |       | 2,180                 |       | 544 |   |
| Total current  liabilities                                                                                                                                                                                                                                                                            |       | 17,287                |       | 17,137 |   |
| Long-term liabilities                                                                                                                                                                                                                                                                                 |       |                  |       |   |   |
| Capital lease  obligations                                                                                                                                                                                                                                                                            |       | 2,557                 |       | 2,440 |   |
| Note payable                                                                                                                                                                                                                                                                                          |       | —                |       | 75 |   |
| Deferred rent                                                                                                                                                                                                                                                                                         |       | 2,380                 |       | 1,510 |   |
| Deferred tax  liability                                                                                                                                                                                                                                                                               |       | —                |       | 1,720 |   |
| Deferred license  and maintenance revenue, net of current                                                                                                                                                                                                                                             |       | 691                   |       | 666 |   |
| Other long-term  liabilities                                                                                                                                                                                                                                                                          |       | —                |       | 22 |   |
| Total long-term  liabilities                                                                                                                                                                                                                                                                          |       | 5,628                 |       | 6,433 |   |
| Commitments and  contingencies                                                                                                                                                                                                                                                                        |       | —                |       | — |   |
| Series B  redeemable convertible preferred stock, no par value; authorized 7,500,000  shares; issued and outstanding 0 and 4,022,252 shares at December 31,  2006 and 2005, respectively; liquidation and redemption value $0 and $28,625  at December 31, 2006 and 2005, respectively |       | —                |       | 28,545 |   |
| Series C  redeemable convertible preferred stock, no par value; authorized 7,500,000  shares; issued and outstanding 0 and 4,851,549 shares at December 31,  2006 and 2005, respectively; liquidation and redemption value $0 and $19,053  at December 31, 2006 and 2005, respectively |       | —                |       | 18,570 |   |
| Stockholders’ equity (deficiency)                                                                                                                                                                                                                                                                |       |                  |       |   |   |
| Series A  convertible preferred stock, no par value; authorized 2,333,333 shares;  issued and outstanding 0 and 2,333,333 shares at December 31, 2006 and  2005, respectively; liquidation value $0 and $6,298 at December 31, 2006  and 2005, respectively                            |       | —                |       | 6,298 |   |
| Common stock, no  par value; authorized 100,000,000 shares; issued and outstanding 14,886,073  and 3,274,727 at December 31, 2006 and 2005, respectively                                                                                                                                         |       | 104,099               |       | 13,631 |   |
| Additional paid in  capital—beneficial conversion feature                                                                                                                                                                                                                                        |       | —                |       | 1,418 |   |
| Accumulated  deficit                                                                                                                                                                                                                                                                                  |       | (85,634               | )          | (59,749 | ) |
| Total  stockholders’ equity (deficiency)                                                                                                                                                                                                                                                         |       | 18,465                |       | (38,402 | ) |
| Total liabilities,  convertible preferred stock, redeemable convertible preferred stock and  stockholders’ equity (deficiency)                                                                                                                                                                   |       | $                     | 41,380     |   | $ | 32,283 |   |

 

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

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**MEDECISION, INC.CONSOLIDATED STATEMENTS OF OPERATIONS(in thousands, except share and per share data)**

| ** **                                                                                                         | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                         | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenue                                                                                                            |       |                                       |       |   |   |   |   |
| Subscription, maintenance and transaction fees                                                                     |       | $                                          | 22,090     |   | $ | 17,187 |   | $ | 14,666 |   |
| Term license revenue                                                                                               |       | 8,778                                      |       | 9,729 |   | 6,260 |   |
| Professional services                                                                                              |       | 13,341                                     |       | 11,680 |   | 7,102 |   |
| Total revenue                                                                                                      |       | 44,209                                     |       | 38,596 |   | 28,028 |   |
| Cost of revenue                                                                                                    |       |                                       |       |   |   |   |   |
| Subscription, maintenance and transaction fees                                                                     |       | 7,641                                      |       | 8,163 |   | 6,774 |   |
| Term licenses                                                                                                      |       | 1,722                                      |       | 1,653 |   | 1,455 |   |
| Professional services                                                                                              |       | 5,806                                      |       | 5,499 |   | 4,843 |   |
| Total cost of revenue                                                                                              |       | 15,169                                     |       | 15,315 |   | 13,072 |   |
| Gross margin                                                                                                       |       | 29,040                                     |       | 23,281 |   | 14,956 |   |
| Operating  expenses                                                                                                |       |                                       |       |   |   |   |   |
| Sales and marketing                                                                                                |       | 10,534                                     |       | 7,778 |   | 4,668 |   |
| Research and development                                                                                           |       | 8,045                                      |       | 2,627 |   | 3,243 |   |
| General and administrative                                                                                         |       | 12,520                                     |       | 9,707 |   | 6,320 |   |
| Total operating expenses                                                                                           |       | 31,099                                     |       | 20,112 |   | 14,231 |   |
| (Loss) income from operations                                                                                      |       | (2,059                                     | )          | 3,169 |   | 725 |   |
| Loss on change in  fair value of redeemable convertible preferred stock conversion options                         |       | 8,615                                      |       | 694 |   | 576 |   |
| Interest expense,  net                                                                                             |       | 466                                        |       | 274 |   | 175 |   |
| (Loss) income before (provision) benefit for income  taxes                                                         |       | (11,140                                    | )          | 2,201 |   | (26 | ) |
| (Provision)  benefit for income taxes                                                                              |       | (6,677                                     | )          | 6,491 |   | — |   |
| Net (loss) income                                                                                                  |       | $                                          | (17,817    | ) | $ | 8,692 |   | $ | (26 | ) |
| Accretion of convertible preferred shares and redeemable  convertible preferred shares                             |       | (8,068                                     | )          | (3,994 | ) | (6,113 | ) |
| (Loss) income  available to common shareholders                                                                    |       | $                                          | (25,885    | ) | $ | 4,698 |   | $ | (6,139 | ) |
| (Loss) income per  share available to common shareholders, basic                                                   |       | $                                          | (5.62      | ) | $ | 1.45 |   | $ | (1.92 | ) |
| (Loss) income per  share available to common shareholders, diluted                                                 |       | $                                          | (5.62      | ) | $ | 0.66 |   | $ | (1.92 | ) |
| Weighted average shares used to compute (loss) income  available to common shareholders per common share, basic    |       | 4,605,318                                  |       | 3,229,064 |   | 3,189,366 |   |
| Weighted average shares  used to compute (loss) income available to common shareholders per common  share, diluted |       | 4,605,318                                  |       | 14,143,586 |   | 3,189,366 |   |

 

*The accompanying notes are an integral part of these consolidated financial statements*

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**MEDECISION, INC.**

**CONSOLIDATEDSTATEMENTS OF CONVERTIBLE PREFERRED STOCK, REDEEMABLE CONVERTIBLE PREFERREDSTOCK AND STOCKHOLDERS’ EQUITY (DEFICIENCY)**

**(inthousands)**

| ** **                                                                                          | ** ** | ** **        | ** ** | ** **        | ** ** | ** **        | ** ** | **Stockholders’ Equity (Deficiency)** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-------------------|------------|-------------------|------------|-------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                          | ** ** | ** **        | ** ** | ** **        | ** ** | ** **        | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** | **Additional** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                          | ** ** | **Series A** | ** ** | **Series B** | ** ** | **Series C** | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** | **Paid-in** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                          | ** ** | **redeemable**    | ** ** | **redeemable**    | ** ** | **redeemable**    | ** ** | **Series A**                                    | ** ** | ** ** | ** ** | ** ** | ** ** | **Capital -** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                          | ** ** | **convertible**   | ** ** | **convertible**   | ** ** | **convertible**   | ** ** | **convertible**                                      | ** ** | ** ** | ** ** | ** ** | ** ** | **Beneficial** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                          | ** ** | **preferred**     | ** ** | **preferred**     | ** ** | **preferred**     | ** ** | **preferred**                                        | ** ** | **Common Stock** | ** ** | **Conversion** | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
| ** **                                                                                          | ** ** | **stock**         | ** ** | **stock**         | ** ** | **stock**         | ** ** | **stock**                                            | ** ** | **Shares** | ** ** | **Amount** | ** ** | **Feature** | ** ** | **Deficit** | ** ** | **Total** | ** ** |
| Balance at December 31, 2003                                                                   |       |              | $          | 5,668             |       |              |       | $                                                    | 24,739     |   |   |   | $ | 14,317 |   |   |   | $ | — |   |   | 3,111 |   | $ | 13,328 |   |   | $ | — |   |   |   | $ | (58,308 | ) |   | $ | (44,980 | ) |
| Net loss                                                                                            |       |              | —     |              |       |              | —     |                                                 |       |   | — |   |   |   | — |   |   | — |   | — |   |   | — |   |   |   | (26 | ) |   | (26 | ) |
| Accretion of convertible preferred stock and  redeemable convertible preferred stock issuance costs |       |              | —     |              |       |              | 382        |                                                 |       |   | 25 |   |   |   | — |   |   | — |   | — |   |   | — |   |   |   | (407 | ) |   | (407 | ) |
| Accretion of convertible preferred stock and  redeemable convertible preferred stock dividends      |       |              | 315        |              |       |              | 1,712      |                                                 |       |   | 549 |   |   |   | — |   |   | — |   | — |   |   | — |   |   |   | (2,576 | ) |   | (2,576 | ) |
| Accretion to redemption value                                                                       |       |              | —     |              |       |              | —     |                                                 |       |   | 3,130 |   |   |   | — |   |   | — |   | — |   |   | — |   |   |   | (3,130 | ) |   | (3,130 | ) |
| Issuance of stock options                                                                           |       |              | —     |              |       |              | —     |                                                 |       |   | — |   |   |   | — |   |   | — |   | 21 |   |   | — |   |   |   | — |   |   | 21 |   |
| Exercise of stock options                                                                           |       |              | —     |              |       |              | —     |                                                 |       |   | — |   |   |   | — |   |   | 108 |   | 16 |   |   | — |   |   |   | — |   |   | 16 |   |
| Balance at December 31, 2004                                                                   |       |              | 5,983      |              |       |              | 26,833     |                                                 |       |   | 18,021 |   |   |   | — |   |   | 3,219 |   | 13,365 |   |   | — |   |   |   | (64,447 | ) |   | (51,082 | ) |
| Net income                                                                                          |       |              | —     |              |       |              | —     |                                                 |       |   | — |   |   |   | — |   |   | — |   | — |   |   | — |   |   |   | 8,692 |   |   | 8,692 |   |
| Accretion of convertible preferred stock and redeemable  convertible preferred stock dividends      |       |              | 36         |              |       |              | 1,712      |                                                 |       |   | 549 |   |   |   | 279 |   |   | — |   | — |   |   | 1,418 |   |   |   | (3,994 | ) |   | (2,297 | ) |
| Reclassification                                                                                    |       |              | (6,019     | )                 |       |              | —     |                                                 |       |   | — |   |   |   | 6,019 |   |   | — |   | — |   |   | — |   |   |   | — |   |   | 6,019 |   |
| Issuance of stock options                                                                           |       |              | —     |              |       |              | —     |                                                 |       |   | — |   |   |   | — |   |   | — |   | 256 |   |   | — |   |   |   | — |   |   | 256 |   |
| Exercise of stock options                                                                           |       |              | —     |              |       |              | —     |                                                 |       |   | — |   |   |   | — |   |   | 55 |   | 10 |   |   | — |   |   |   | — |   |   | 10 |   |
| Balance at December 31, 2005                                                                   |       |              | —     |              |       |              | 28,545     |                                                 |       |   | 18,570 |   |   |   | 6,298 |   |   | 3,274 |   | 13,631 |   |   | 1,418 |   |   |   | (59,749 | ) |   | (38,402 | ) |
| Net loss                                                                                            |       |              | —     |              |       |              | —     |                                                 |       |   | — |   |   |   | — |   |   | — |   | — |   |   | — |   |   |   | (17,817 | ) |   | (17,817 | ) |
| Accretion of convertible preferred stock and  redeemable convertible preferred stock dividends      |       |              | —     |              |       |              | 1,464      |                                                 |       |   | 476 |   |   |   | 305 |   |   | — |   | — |   |   | 5,822 |   |   |   | (8,068 | ) |   | (1,941 | ) |
| Conversion to common stock                                                                          |       |              | —     |              |       |              | (22,396    | )                                                    |       |   | (17,154 | ) |   |   | (6,603 | ) |   | 8,120 |   | 63,298 |   |   | (7,240 | ) |   |   | — |   |   | 49,455 |   |
| Initial public offering of common stock                                                             |       |              | —     |              |       |              | —     |                                                 |       |   | — |   |   |   | — |   |   | 3,300 |   | 30,690 |   |   | — |   |   |   | — |   |   | 30,690 |   |
| Offering issuance costs                                                                             |       |              | —     |              |       |              | —     |                                                 |       |   | — |   |   |   | — |   |   | — |   | (4,282 | ) |   | — |   |   |   | — |   |   | (4,282 | ) |
| Payment of preferred stock dividends                                                                |       |              | —     |              |       |              | (7,613     | )                                                    |       |   | (1,892 | ) |   |   | — |   |   | — |   | — |   |   | — |   |   |   | — |   |   | — |   |
| Issuance of stock options                                                                           |       |              | —     |              |       |              | —     |                                                 |       |   | — |   |   |   | — |   |   | — |   | 621 |   |   | — |   |   |   | — |   |   | 621 |   |
| Exercise of warrants                                                                                |       |              | —     |              |       |              | —     |                                                 |       |   | — |   |   |   | — |   |   | 162 |   | 67 |   |   | — |   |   |   | — |   |   | 67 |   |
| Exercise of stock options                                                                           |       |              | —     |              |       |              | —     |                                                 |       |   | — |   |   |   | — |   |   | 30 |   | 74 |   |   | — |   |   |   | — |   |   | 74 |   |
| Balance at  December 31, 2006                                                                  |       |              | $          | —            |       |              |       | $                                                    | —     |   |   |   | $ | — |   |   |   | $ | — |   |   | 14,886 |   | $ | 104,099 |   |   | $ | — |   |   |   | $ | (85,634 | ) |   | $ | 18,465 |   |

 

*The accompanying notes are an integral part of these consolidated financial statements*

74

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**MEDECISION, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS(in thousands)**

| ** **                                                                                 | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                 | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| *Cash  flows from operating activities*                                                    |       |                                       |       |   |   |   |   |
| Net (loss) income                                                                          |       | $                                          | (17,817    | ) | $ | 8,692 |   | $ | (26 | ) |
| Adjustments  to reconcile net (loss) income to net cash provided by operating activities:  |       |                                       |       |   |   |   |   |
| Depreciation and amortization                                                              |       | 2,295                                      |       | 1,324 |   | 1,173 |   |
| Loss on change in fair value of redeemable  convertible preferred stock conversion options |       | 8,615                                      |       | 694 |   | 576 |   |
| Amortization of capitalized software                                                       |       | 818                                        |       | 793 |   | 701 |   |
| Stock compensation expense                                                                 |       | 621                                        |       | 256 |   | 21 |   |
| Amortization of deferred financing cost                                                    |       | 37                                         |       | 20 |   | 22 |   |
| (Recovery of) provision for doubtful accounts                                              |       | (3                                         | )          | (43 | ) | 5 |   |
| Loss on disposal of asset                                                                  |       | 17                                         |       | — |   | — |   |
| Deferred income tax provision (benefit)                                                    |       | 6,677                                      |       | (6,491 | ) | — |   |
| Decrease  (increase) in assets:                                                            |       |                                       |       |   |   |   |   |
| Accounts receivable                                                                        |       | 391                                        |       | (5,919 | ) | (2,393 | ) |
| Prepaid expenses and other assets                                                          |       | (264                                       | )          | 329 |   | (214 | ) |
| Increase  (decrease) in liabilities:                                                       |       |                                       |       |   |   |   |   |
| Accounts payable                                                                           |       | 548                                        |       | 769 |   | (85 | ) |
| Accrued payroll and related costs                                                          |       | (692                                       | )          | 1,269 |   | (158 | ) |
| Other accrued expenses                                                                     |       | (10                                        | )          | 252 |   | 859 |   |
| Deferred revenue                                                                           |       | 736                                        |       | 3,732 |   | 2,024 |   |
| Net cash provided by operating activities                                                  |       | 1,969                                      |       | 5,677 |   | 2,505 |   |
| *Cash  flows from investing activities*                                                    |       |                                       |       |   |   |   |   |
| Capitalized software                                                                       |       | (1,402                                     | )          | (2,403 | ) | (1,158 | ) |
| Purchase of property and equipment                                                         |       | (1,136                                     | )          | (764 | ) | (860 | ) |
| Net cash used in investing activities                                                      |       | (2,538                                     | )          | (3,167 | ) | (2,018 | ) |
| *Cash  flows from financing activities*                                                    |       |                                       |       |   |   |   |   |
| Proceeds from sale of common stock in initial public  offering                             |       | 30,690                                     |       | — |   | — |   |
| Offering issuance costs                                                                    |       | (4,282                                     | )          |   |   |   |   |
| Proceeds from exercise of common stock options                                             |       | 74                                         |       | 10 |   | 16 |   |
| Proceeds from exercise of warrants                                                         |       | 67                                         |       | — |   | — |   |
| Payment of preferred stock dividends                                                       |       | (9,505                                     | )          |   |   |   |   |
| Repayment of capital lease obligations                                                     |       | (1,414                                     | )          | (679 | ) | (412 | ) |
| Net borrowings on line of credit                                                           |       | —                                     |       | — |   | (424 | ) |
| Borrowings on equipment note payable, bank                                                 |       | —                                     |       | 250 |   | — |   |
| Repayment on equipment note payable, bank                                                  |       | (100                                       | )          | (75 | ) | — |   |
| Net cash provided by (used in) financing activities                                        |       | 15,530                                     |       | (494 | ) | (820 | ) |
| Net increase (decrease) in cash and cash equivalents                                       |       | 14,961                                     |       | 2,016 |   | (333 | ) |
| Cash and cash equivalents, beginning of period                                             |       | 2,447                                      |       | 431 |   | 764 |   |
| Cash and cash equivalents, end of period                                                   |       | $                                          | 17,408     |   | $ | 2,447 |   | $ | 431 |   |
| Supplemental  disclosures of cash flow information:                                        |       |                                       |       |   |   |   |   |
| Cash paid during the period for interest                                                   |       | $                                          | 533        |   | $ | 253 |   | $ | 155 |   |
| Supplemental  disclosures of noncash investing and financing activities:                   |       |                                       |       |   |   |   |   |
| Property and equipment acquired under capital leases                                       |       | $                                          | 2,142      |   | $ | 2,549 |   | $ | 1,695 |   |
| Tenant improvement allowance received under operating  lease                               |       | $                                          | 901        |   | $ | 371 |   | $ | 982 |   |
| Financed insurance  policy                                                                 |       | $                                          | 313        |   | $ | — |   | $ | — |   |

 

*The accompanying notes are an integral part of these consolidated financial statements*

75

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**MEDECISION, INC. Notes to Consolidated Financial Statements (in thousands, except share and per share data)**

**(1)   Business**

MEDecision, Inc. (Parent) and its wholly-ownedsubsidiaries, Optimed Medical Systems, LLC (Optimed), Collaborative CareConsortium (C3), and MEDecision Investments, Inc. (MEDecision Investments)collectively, the Company, provide technology-based clinical decision supportand transaction management solutions to managed care payers in the healthcareindustry located in the United States. The Parent began operations in 1988,Optimed began operations in 2003, C3 began operations in 2005, and MEDecisionInvestments began operations in 2006. The Parent, Optimed and C3 are allincorporated in the Commonwealth of Pennsylvania. MEDecision Investments isincorporated in the State of Delaware.

The Company operates inone reportable segment. All of the Company assets are located in the UnitedStates.

**(2)**          Summary of SignificantAccounting Policies and Practices

*(a) Basis of Presentation*

The consolidated financial statements include theaccounts of the Company and its wholly-owned subsidiaries. All significantintercompany transactions and balances have been eliminated in consolidation

On December 18, 2006, the Company completed aninitial public offering in which certain selling shareholders sold an aggregateof 4,700,000 shares the Company’s stock at a price of $10 per share. The netproceeds to the Company were $26,400, net of underwriting commissions andoffering expenses. The Company used approximately $9,500 of the net proceeds topay the accrued and unpaid cash dividends to the former holders ofSeries B and C Preferred stock and approximately $600 of the net proceedsto repay a balance outstanding on the working capital credit facility.

On October 18, 2006,the Company’s Board of Directors approved a 1-for-2 reverse stocksplit with an effective date of December 13, 2006. All share and per shareamounts in the accompanying consolidated financial statements have beenretroactively adjusted for all periods presented to give effect to the reversestock split.

*(b) Reclassification*

Certain prior yearbalances have been reclassified to conform to the current year presentation.Such reclassifications did not affect total revenues, operating income or netincome.

*(c) Use ofEstimates*

The consolidated financialstatements are prepared in accordance with accounting principles generallyaccepted in the United States of America, which require management to makeassumptions and estimates that affect the reported amounts of assets andliabilities in the financial statements, disclosure of contingent assets andliabilities at the date of the consolidated financial statements and reportedamounts of revenue and expenses during the reporting periods. Managementbelieves that the estimates used are reasonable, although actual amounts coulddiffer from those estimates and the differences could have a material impact onthe consolidated financial statements.

76

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**MEDECISION, INC. Notes to Consolidated Financial Statements (Continued) (in thousands, except share and per share data)**

*(d) RevenueRecognition*

The Company derives its revenue primarily from threesources: (i) recurring revenue consisting of annual recurring subscriptionfees for its Analytics and Disease Management and Transactions and InformationExchange modules, transaction revenue associated with member eligibilityverification, clinical adjudication of treatment requests and access ofon-demand member health information and technical and clinical maintenance andsupport fees; (ii) initial term and renewal license fees for its AdvancedMedical Management and Clinical Rules and Processes modules; and (iii) feesfor discrete professional services. The Company’s standard license agreementtypically provides a time-based license, five years in duration, to use itssolutions. The Company may license its software in multiple elementarrangements if the customer purchases any combination of maintenance,consulting, training, subscriptions or hosting services in conjunction with thesoftware product license.

The Company recognizes revenue pursuant to therequirements of AICPA Statement of Position (SOP) 97-2, *Software Revenue Recognition*; as amendedby SOP 98-9, *Software RevenueRecognition*, With Respect to Certain Transactions; SOP 81-1, *Accounting for Performance of Construction-type andCertain Production-type Contracts*; the Securities and ExchangeCommission’s (SEC) Staff Accounting Bulletin (SAB) No. 104, *Revenue Recognition*; Emerging Issues TaskForce (EITF) Issue No. 00-21, *RevenueArrangements with Multiple Deliverables*; EITF Issue No. 00-03,*Application of AICPA Statement of Position 97-2,*to *Arrangements That Include the Right toUse Software Stored on Another Entity’s Hardware*; EITF Issue No. 03-05,*Applicability of AICPA Statement of Position97-2, Software Revenue Recognition, to Non-Software Deliverables in anArrangement Containing More-Than Incidental Software*; and otherauthoritative accounting guidance.

The Company entersinto transactions that represent multiple-element arrangements, which mayinclude a combination of professional services, hosting, PCS and software. Ininstances where certain arrangements include both software and non-softwarerelated elements, the Company applies the principles of SOP 97-2 tosoftware elements. If the elements of the arrangement fall outside the scope ofSOP 97-2, then the Company applies the principles of EITF 00-21. Inaccordance with EITF 00-21, multiple-element arrangements are assessed todetermine whether they can be separated into more than one unit of accounting.A multiple-element arrangement is separated into more than one unit ofaccounting if all of the following criteria are met:

·       the delivered item(s) hasvalue to the client on a stand-alone basis.

·       there is objective andreliable evidence of the fair value of the undelivered item(s).

·       if the arrangement includesa general right of return relative to the delivered item(s), delivery orperformance of the undelivered item(s) is considered probable andsubstantially in the control of the company.

If these criteria are not met, then revenue isdeferred until such criteria are met or until the period(s) over which thelast undelivered element is delivered. If there is objective and reliableevidence of fair value for all units of accounting in an arrangement, thearrangement consideration is allocated to the separate units of accountingbased on each unit’s relative fair value. There may be cases, however, in whichthere is objective and reliable evidence of fair value of the undelivered item(s) butno such evidence for the delivered item(s). In those cases, the residual methodis used to allocate the arrangement consideration. Under the residual method,the amount of consideration allocated to the delivered item(s) equals thetotal 

77

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**MEDECISION, INC. Notes to Consolidated Financial Statements (Continued) (in thousands, except share and per share data)**

arrangement considerationless the aggregate fair value of the undelivered item(s). The Company appliesthe revenue recognition policies discussed below to each separate unit of accounting.

The Company recognizes revenue using the residualmethod when vendor-specific objective evidence (VSOE) of fair value exists forall of the undelivered elements in the arrangement, but does not exist for oneor more delivered elements and all revenue recognition criteria in SOP 97-2other than the requirement for VSOE of fair value of each delivered element ofthe arrangement are satisfied. The Company allocates revenue to eachundelivered element based on its respective fair value determined by either (a) theprice charged when that element is sold separately, (b) the priceestablished by management if that element is not yet sold separately and it isprobable that the price will not change before the element is sold separatelyor (c) substantive renewal rates. The Company defers revenue for theundelivered elements and recognizes the residual amount of the arrangement fee,if any, when the basic criteria in SOP 97-2 have been met.

Provided that thecustomer’s contract does not require significant production, modification orcustomization of the software under SOP 97-2, the Company recognizesrevenue when the following four criteria have been met:

·       persuasive evidence of anarrangement exists;

·       delivery of its basicsoftware code has occurred;

·       the license fee is fixed ordeterminable; and

·       collection of the licensefee is probable.

For arrangementswhere the Company provides software hosting services, it records revenue inaccordance with SOP 97-2 unless:

·       the customer cannot takepossession of the software at any time during the hosting period withoutsignificant penalty;

·       the customer cannotcontract with another hosting provider without significant effort orexpenditure; or

·       the software’sfunctionality is compromised by the termination of hosting services.

Under these circumstances, the Company records revenueratably over the longer of the contract period or the maintenance period.

For those arrangements that meet the criteria for SOP97-2 accounting, the Company has fair value for all undelivered elementsand uses the residual method to determine the fair value of the license feethat is recorded upon achievement of the four revenue recognition criteriamentioned above and is included in term license revenue in the consolidatedstatement of operations. VSOE is established for hosting services under sucharrangements based on the price charged when hosting services are soldseparately as a renewal. Hosting revenue is included with subscription,maintenance and transaction fee revenue in the consolidated statement ofoperations.

If at the outset of an arrangement the Companydetermines that the arrangement fee is not fixed or determinable, then revenueis deferred until the arrangement fee becomes due and payable by the 

78

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**MEDECISION, INC. Notes to Consolidated Financial Statements (Continued) (in thousands, except share and per share data)**

customer, assuming all otherrevenue recognition criteria have been met. If at the outset of an arrangementthe Company determines that collectibility is not probable, then revenue isdeferred until payment is received. The Company’s license agreements typicallydo not provide for a right of return other than during the standard warrantyperiod of 90 days. Historically, the Company has not incurred warranty expenseor experienced returns of its products. If an arrangement allows for customeracceptance of the software or services, then the Company defers revenuerecognition until the earlier of customer acceptance or when the acceptancerights lapse.

The Company also offers subscriptions to accesssoftware which is hosted at its ASP facility. These fees are categorized assubscriptions by the Company. The fees related to these subscriptionarrangements are recognized as revenue ratably over the subscription term,which is typically 12 months. Revenue for multiyear time-based licenses and theprovision of maintenance, whether separately priced or not, is recognizedratably over the license term and included in subscription, maintenance andtransaction fee revenue unless a substantive maintenance renewal rate exists,in which case the residual amount is recognized as software revenue andincluded in term license fee revenue when the basic criteria in SOP 97-2have been met.

The Company’s initial maintenance term is generally inthe range of one to five years, renewable by the customer on an annual basisthereafter. The Company’s customers typically prepay maintenance for periods ofone to 12 months. Maintenance revenue is deferred and recognized ratably overthe term of the maintenance contract and is included in subscription,maintenance and transaction fee revenue. If a customer on maintenance isspecifically identified as a bad debtor, then the Company would ceaserecognizing maintenance revenue except to the extent that maintenance fees havealready been collected.

While the statements of work with customers mayspecify multiple elements, the Company believes that the services elementsincluded in its contractual arrangements with customers are not essential tothe functionality of its software, which can operate in a standalone fashionupon installation. These services elements do not include significantmodification or customization of its software, but may include configuring,designing and implementing simple interfaces with other customer software,installation and configuration of third-party software, and training in the useof Company and third-party software. The timing of payments for software isindependent of the payment terms for the services elements in its contractualarrangements with customers. In multiple element arrangements involvingsoftware and consulting, training or other services that are not essential tothe functionality of the software, the services revenue is accounted forseparately from the software revenue. VSOE for services did not exist during2004 and prior years. As a result, revenue attributable to all elements in amultiple element arrangement, including services, in 2004 were deferred untilthe related services were completed and only then recognized as revenue,assuming VSOE exists for all other undelivered elements. In situations whenrevenue is deferred as a result of ongoing services, the costs associated withall delivered elements are also deferred and recognized as expense when theservices are completed. In late 2004, the Company introduced package pricingfor the various service elements of its contractual arrangements withcustomers, and now recognizes VSOE for services elements based on the prices ofthose packs which are based on hourly rates consistent with those used in theseparate sales of services. Accordingly, beginning in 2005, the Companyrecognized revenue for delivered elements and undelivered elements in amultiple element arrangement based on VSOE.

79

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**MEDECISION, INC. Notes to Consolidated Financial Statements (Continued) (in thousands, except share and per share data)**

Consulting, training and other services are typicallysold under fixed-price arrangements and are recognized using the proportional performancemethod based on direct labor costs incurred to date as a percentage of totalestimated project costs required to complete the project. Consulting servicesprimarily comprise implementation support related to the installation andconfiguration of the Company’s products and do not typically requiresignificant production, modification or customization of the software. Inarrangements that require significant production, modification or customizationof the software and where services are not available from third-partysuppliers, the consulting and license fees are recognized concurrently. Whentotal cost estimates exceed revenue in a fixed-price arrangement, the estimatedlosses are recognized immediately in cost of revenue.

The assumptions, risks and uncertainties inherent withthe application of the proportional performance method affect the timing andamounts of revenue and expenses reported. Numerous internal and externalfactors can affect estimates, including direct labor rates, utilization andefficiency variances.

Where contractual arrangements with customers includethe sale of third-party software, revenue is recognized for the sale of thethird-party software, and the related expense is included in cost of revenue.

In accordance with EITF Issue No. 01-14, *Income Statement Characterization of ReimbursementsReceived for**“Out of PocketExpenses Incurred,”* the Company accounts for out-of-pocket expensesrebilled to customers as maintenance, consulting and training revenue, with therelated costs included in cost of revenue. For the years ended December 31,2006, 2005 and 2004, reimbursed expenses totaled $438, $427 and $367,respectively.

The Company also generatesrevenue from transactions that flow through its Web portal. Fees from thesetransactions are billed to customers in arrears on a monthly basis and arerecognized in the period in which the transactions occur. The Companyestablishes VSOE for these transaction fees based on the rates charged fortransactions in separate sales.

*(e) Cost of Revenue*

The Company’s costs of revenue are broken down intocost of term licenses, cost of subscription, maintenance and transaction feesand cost of professional services.

The Company’s costof subscription, maintenance and transaction fees consists of:

·       amortization of internallydeveloped and purchased capitalized software;

·       compensation and relatedemployee benefits of the Company’s product support, product maintenance andproduct hosting staff;

·       third-party maintenancefees associated with the third-party software incorporated into the Company’sAdvanced Medical Management module;

·       solution hosting costsassociated with a third-party secured facility;

·       royalties related tosoftware licenses; and

·       communication costsassociated with the Company’s hosting network.

80

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**MEDECISION, INC. Notes to Consolidated Financial Statements (Continued) (in thousands, except share and per share data)**

The Company’s costof term licenses consists of:

·       amortization of internallydeveloped and purchased capitalized software; and

·       third-party license feesfor the third-party software incorporated in the Company’s Advanced MedicalManagement module.

The Company’s costof professional services consists of:

·       compensation and relatedemployee benefits for the Company’s professional services staff;

·       costs of independentcontractors that provide consulting and professional services to the Company’scustomers; and

·  travel,lodging and other out-of-pocket expenses for the Company’s staff andindependent consultants to perform work at a customer’s site for which theCompany receives reimbursement.

*(f) Cash and cashequivalents*

Cash equivalents arehighly liquid investments with original maturities of 90 days or less. Suchinvestments are stated at cost, which approximates for value.

*(g) AccountsReceivable*

Trade accounts receivable are recorded at the invoicedamount and do not bear interest. The majority of the Company’s accountsreceivable are due from trade customers. Credit is extended based on evaluationof the customer’s financial condition. Collateral is not required. Accountsreceivable payment terms are typically 30 days and are stated in the financialstatements at amounts due from customers net of an allowance for doubtfulaccounts. Accounts outstanding longer than the payment terms are consideredpast due. The Company determines the allowance by considering a number offactors, including the length of time trade accounts receivable are past due,previous loss history, the customer’s current ability to pay its obligationsand the condition of the general economy and the industry as a whole. Theallowance for doubtful accounts is the Company’s best estimate of the amount ofprobable credit losses in the Company’s existing accounts receivable. Accountbalances are written off against the allowance after all means of collectionhave been exhausted and the potential for recovery is considered remote.Payments subsequently received on such receivables are credited to theallowance for doubtful accounts. The Company does not have anyoff-balance-sheet credit exposure related to its customers.

Activity in the allowancefor doubtful accounts for the years ended December 31, 2006, 2005 and 2004is as follows:

| **Period Ended**   | ** ** | ** ** | ** ** | **Balance at  Beginning of  Period** | ** ** | **Provision** | ** ** | **Recoveries** | ** ** | **Write-offs** | ** ** | **Balance at  End of  Period** | ** ** |
|-------------------------|------------|------------|------------|------------------------------------------------|------------|---------------|------------|----------------|------------|----------------|------------|------------------------------------------|------------|
| December 31,  2006 |       |       | $          | 55                                             |       |          |       | $              | 7          |           |       |                                     | $          | — |   |   |   | (10 | ) |   |   | $ | 52 |   |   |
| December 31,  2005 |       |       | 98         |                                           |       |          | (25        | )              |       |           | —     |                                     |       |   | (18 | ) |   |   | 55 |   |   |
| December 31, 2004  |       |       | 93         |                                           |       |          | 16         |           |       |           | 6          |                                     |       |   | (17 | ) |   |   | 98 |   |   |

 

Accounts receivable include unbilled revenue forproducts delivered and services performed but not billed. Unbilled revenue asof December 31, 2006 and 2005 was $4,167 and $1,324, respectively.

81

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**MEDECISION, INC. Notes to Consolidated Financial Statements (Continued) (in thousands, except share and per share data)**

*(h) Prepaidexpenses*

Prepaid expenses consistprimarily of amounts paid for insurance and annual software maintenancecontracts.

*(i) Property andEquipment*

Property and equipment are stated at cost. Propertyand equipment under capital leases are stated at the present value of futureminimum lease payments at the inception of the lease.

In 2006, 2005 and 2004, the Company received leaseincentives of $901, $371 and $982, respectively, relating to tenant improvementallowances in conjunction with entering into an operating lease for itscorporate headquarters. Such tenant improvement allowances have been recordedas leasehold improvements and are being amortized over the life of the lease.These tenant improvement allowances are not included as collateral under theCompany’s borrowing agreement with a bank since title to such asset is deemedto be held by the landlord. See also Note 2(q) below.

Depreciation andamortization on property and equipment are calculated on the straight-linemethod over the estimated useful lives of the assets. The estimated useful lifeof computer equipment and software is three to five years, while officeequipment and furniture is four to seven years. Property and equipment heldunder capital leases and leasehold improvements are amortized on astraight-line basis over the shorter of the lease term or estimated useful lifeof the asset. Total depreciation and amortization expense for the years ended December 31,2006, 2005 and 2004 was $2,295, $1,324 and $1,173, respectively, which isincluded in general and administrative expense in the accompanying statementsof operations.

*(j) CapitalizedSoftware Costs*

Capitalized software costs are stated on the balancesheet at the lower of net book value or net realizable value of the capitalizedcosts.

The Company capitalizes purchased and internallydeveloped software in accordance with Statement of Financial AccountingStandards (SFAS) No. 86, *Accounting forthe Costs of Computer Software to be Sold*,*Leased or Otherwise Marketed*. The capitalization of costsof internally developed software begins when technological feasibility isestablished. Amortization begins and capitalization ends when the product isavailable for general release to customers. Annual amortization of capitalizedsoftware costs is the greater of the amount computed using (a) the ratiothat the current gross revenue for a product bears to the total of current andanticipated future gross revenue for that product or (b) on astraight-line basis over the estimated economic life of the product, whichranges from three to five years. The Company performs quarterly reviews toensure that the estimated future gross revenue from each product exceeds theunamortized costs.

During the years ended December 31,2006, 2005 and 2004, the Company capitalized $1,026, $2,002 and $869,respectively, related to internally developed software costs and $376, $401 and$289, respectively, related to payments to third-parties for the development ofsoftware. Amortization of capitalized software costs amounted to $818, $793 and$701 for the years ended December 31, 2006, 2005 and 2004, respectively,which was recorded in cost of revenue.

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**MEDECISION, INC. Notes to Consolidated Financial Statements (Continued) (in thousands, except share and per share data)**

*(k) Other Assets*

Othercurrent assets consist of deferred financing costs, deferred rent,miscellaneous receivables and interest receivable. Deferred financing costs areamortized over the life of the borrowing. Other assets include refundabledeposits and the long-term portion of prepaid expenses.

| ** **                             | ** ** | **December 31,** | ** ** |
|----------------------------------------|------------|-----------------------|------------|
| ** **                             | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Other current assets:                  |       |                  |       |   |   |
| Deferred financing  costs, net         |       | 68                    |       | 60 |   |
| Deferred rent, net                     |       | —                |       | 64 |   |
| Miscellaneous  receivables             |       | 25                    |       | 26 |   |
| Interest receivable                    |       | 23                    |       | — |   |
|                                   |       | $                     | 116        |   | $ | 150 |   |
| Other assets:                          |       |                  |       |   |   |
| Refundable deposits                    |       | $                     | 367        |   | $ | 214 |   |
| Long-term portion of  prepaid expenses |       | 93                    |       | 127 |   |
|                                   |       | $                     | 460        |   | $ | 341 |   |

 

*(l) Research andDevelopment*

Research and developmentcosts, other than software costs capitalized, are expensed when incurred inaccordance with SFAS No. 86. Research and development costs expensed were$8,045, $2,627 and $3,243 in the years ended December 31, 2006, 2005 and2004, respectively.

*(m) Advertising*

Advertising costs areexpensed as incurred and amounted to $339, $356 and $144 in the years ended December 31,2006, 2005 and 2004, respectively. These costs are included in sales and marketingexpense in the accompanying statements of operations.

*(n) Income Taxes*

Income taxes are accountedfor in accordance with SFAS No. 109, *Accountingfor Income Taxes*, under the asset-and-liability method. Deferred taxassets and liabilities are recognized for the future tax consequencesattributable to differences between the financial statement carrying amounts ofexisting assets and liabilities and their respective tax bases and operatingloss and tax credit carryforwards. Deferred tax assets and liabilities aremeasured using enacted tax rates expected to apply to taxable income in theyears in which those temporary differences are expected to be recovered orsettled. The effect on deferred tax assets and liabilities of a change in taxrates is recognized in income in the period that includes the enactment date. Avaluation allowance is recorded against deferred tax assets if it is morelikely than not that such assets will not be realized. The factors used toassess the likelihood of realization are the forecast of future taxable income,the remaining time period to utilize any tax operating losses and tax creditsand available tax planning strategies that could be implemented to realizedeferred tax assets.

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**MEDECISION, INC. Notes to Consolidated Financial Statements (Continued) (in thousands, except share and per share data)**

*(o) Stock-BasedCompensation*

Through the end of 2005, the Company measuredstock-based compensation arrangements in accordance with the provisions of SFASNo. 123, *Accounting for Stock-BasedCompensation*, which permitted companies to continue to apply theprovisions of Accounting Principles Board (APB) Opinion No. 25, *Accounting for Stock Issued to Employees*,and related interpretations. Under APB Opinion No. 25, the Company did notrecord compensation expense when stock options were granted to eligibleparticipants as long as the exercise price was not less that the fair marketvalue of the stock when the option was granted. In accordance with, SFAS No. 123and SFAS No. 148, *Accounting forStock-Based Compensation—Transition and Disclosure*, the Companydisclosed pro forma results of operations, including per share data as if theminimum value-based method had been applied in measuring compensation expensefor stock-based incentive awards. Although the Company’s board of directorsused its best estimate of the fair value of the Company’s stock price and madegrants of stock options in 2004 and 2005 with exercise prices equal to thoseestimates of fair value, a subsequent independent appraisal of the common stock’svalue on the grant dates resulted in recognizing stock-based compensationexpense in the Consolidated Statement of Operations for the years ended December 31,2005 and 2004 in the amounts of $256 and $21, respectively, for the differencebetween the fair market value of the underlying common stock on the date ofgrant and the option exercise price for options granted under the Company’sstock option plan.

The Company accounts for equity instruments issued tonon-employees in accordance with the provisions of SFAS No. 123, EITFIssue No. 96-18, *Accounting forEquity Instruments that are Issued to Other than Employees for Acquiring*,*or in Conjunction with Selling, Goods or Services*and FASB Interpretation No. 28, *Accountingfor Stock Appreciation Rights and Other Variable Stock Option or Award Plans—aninterpretation of APB Opinions No. 15 and 25.*

Thefollowing table illustrates the effect on the results of operations if thefair-value-based method had been applied to all outstanding and unvested awardsin each period.

| ** **                                                                                                                | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                                | ** ** | **2005**                                   | ** ** | **2004** | ** ** |
| Net income (loss), as  reported                                                                                           |       | $                                          | 8,692      |   | $ | (26 | ) |
| Add: stock based  compensation in reported net income (loss), net income                                                  |       | 161                                        |       | 21 |   |
| Deduct: total  stock-based employee compensation expense determined under fair-value-method  for all awards, net of taxes |       | (303                                       | )          | (23 | ) |
| Pro forma net (loss) income                                                                                               |       | $                                          | 8,550      |   | $ | (28 | ) |
| Add: Accretion of  convertible preferred shares and redeemable convertible preferred shares                               |       | (3,994                                     | )          | (6,113 | ) |
| Proforma income (loss)  available to common shareholders, basic and diluted                                               |       | $                                          | 4,556      |   | $ | (6,141 | ) |
| Pro forma income (loss)  per share available to common shareholders, basic                                                |       | $                                          | 1.42       |   | $ | (1.92 | ) |
| Pro forma income (loss) per share available to  common shareholders, diluted                                              |       | $                                          | 0.34       |   | $ | (1.92 | ) |

 

In December 2004, the Financial AccountingStandards Board (FASB) issued SFAS No. 123R, *Share Based Payment: An Amendment of FASB Statements No. 123 and95*. This statement requires that the cost resulting from allshare-based payment transactions be recognized in the Company’s consolidatedfinancial statements. In addition, in March 2005 the Securities andExchange Commission (SEC) released SEC Staff 

84

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**MEDECISION, INC. Notes to Consolidated Financial Statements (Continued) (in thousands, except share and per share data)**

Accounting Bulletin (SAB) No. 107,*Share-Based Payment*. SAB No. 107provides the SEC staff’s position regarding the application of SFAS No. 123Rand certain SEC rules and regulations, and also provides the staff’s viewsregarding the valuation of share-based payment arrangements for publiccompanies. Generally, the approach in SFAS No. 123R is similar to theapproach described in SFAS No. 123. However, SFAS No. 123R requiresall share-based payments to employees, including grants of employee stockoptions, to be recognized in the statement of operations based on their fairvalues. Pro forma disclosure of fair value recognition, as prescribedunder SFAS No. 123, is no longer an alternative.

Effective January 1, 2006, the Company adoptedthe calculated value recognition provisions of SFAS No. 123R utilizing theprospective-transition method, as permitted by SFAS No. 123R. Under thistransition method, compensation cost was recognized during the year ended December 31,2006 for the portion of outstanding vested awards, based on the grant-datecalculated value of those awards.

During the year ended December 31, 2006, optionsto purchase 508,125 shares of common stock were granted to employees. For the yearended December 31, 2006, the Company recognized stock-based compensationexpense of $621 ($0.13 per share) of which $397 pertained to the intrinsicvalue of options issued below fair market value in 2005 and 2004. No taxbenefit was recognized on this expense because of the non-deductibility ofincentive stock options.

The options were valued using a Black-Scholes model. TheCompany expects to continue to utilize the Black-Scholes model to estimate thecalculated value related to employee stock options.

As of December 31, 2006, there was $2,153 oftotal unrecognized compensation cost related to nonvested share-basedcompensation arrangements granted under existing stock option plans, which willbe recognized over the weighted average period of  6.15 years. The total calculated measurementvalue of options vested during the year ended December 31, 2006 was $397.

TheBlack-Scholes model is used by the Company to determine the weighted averagefair value of options. The calculated value of options at date of grant and theassumptions utilized to determine such values are indicated in the followingtable:

| ** **                                                                          | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                          | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Weighted average fair  value at date of grant for options granted during the period |       | $                                          | 4.97       |   | $ | 3.16 |   | $ | 2.02 |   |
| Weighted average  risk-free interest rates                                          |       | 5.0                                        | %          | 4.0 | % | 4.0 | % |
| Weighted average  expected life of option (in years)                                |       | 7.8                                        |       | 7.3 |   | 6.9 |   |
| Expected stock price  volatility                                                    |       | 84.6                                       | %          | — |   | — |   |
| Weighted average  forfeiture rate assumed                                           |       | 11.5                                       | %          | — |   | — |   |
| Expected dividend yield                                                             |       | —                                     |       | — |   | — |   |
|                                                                                     |            |                                            |            |  |  |  |  |  |  |  |

 

The Company determined its volatility factor throughan analysis of peer companies in terms of market capitalization and totalassets. The Company cannot compute expected volatility due to its lack ofhistorical stock prices. The Company uses historical data to estimate optionexercise and employee termination within the valuation model. Separate groupsof employees and non-employees that have similar historical exercise behaviorare considered separately for valuation purposes. The Company calculated theexpected term by analyzing for each group cumulative share exercise andexpiration data 

85

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**MEDECISION, INC. Notes to Consolidated Financial Statements (Continued) (in thousands, except share and per share data)**

and post-vestingemployment termination behavior as of the grant date. The weighted average lifeas of each grant date was then calculated and used in determining the fairvalue at each grant date. The risk-free interest rate for periods within thecontractual life of the option is based on the U.S. Treasury yield curve ineffect at the time of the grant. The expected dividend yield is zero based onthe Company’s historical experience. In 2006, the fair value of the commonstock at the date of grant was based on an independent appraisal of the commonstock’s value at January 1, 2006 and June 30, 2006.

Ourpre-tax compensation cost for stock-based employee compensation was $621 and$254 for the years ended December 31, 2006 and 2005, respectively. As aresult of the adoption of Statement 123R, our financial results were lowerthan under our previous accounting method for share-based compensation by thefollowing amounts:

| ** **                              | ** ** | **Year Ended  December 31,  2006** | ** ** |
|-----------------------------------------|------------|----------------------------------------------|------------|
| Loss before provision  for income taxes |       |                                         | $          | 224 |   |   |
| Net Loss                                |       |                                         | $          | 224 |   |   |

 

*(p) Impairment ofLong-Lived Assets*

In accordance with SFAS No. 144, *Accounting for the Impairment or Disposal of Long Lived Assets*,long-lived assets, such as property and equipment, and other assets subject toamortization, are reviewed for impairment whenever events or changes incircumstances indicate that the carrying amount of an asset may not berecoverable. Recoverability of assets to be held and used is measured by acomparison of the carrying amount of an asset to estimated undiscounted futurecash flows expected to be generated by the asset. If the carrying amount of anasset exceeds its estimated future cash flows, then an impairment charge isrecognized by the amount by which the carrying amount of the asset exceeds thefair value of the asset.

*(q) Deferred Rentand Lease Incentives*

The Company’s operatingleases contain predetermined fixed escalations of minimum rentals during theoriginal lease terms. For these leases, the Company recognizes the related rentexpense on a straight-line basis over the life of the lease and records thedifference between the amounts charged to operations and amounts paid asdeferred rent. The Company also received certain lease incentives when itentered into operating lease arrangements in 2006, 2005 and 2004, including$901, $371 and $982, respectively, of tenant improvement allowances. Theselease incentives were recorded as deferred rent at the beginning of the leaseterm and recognized as a reduction of rent expense over the lease term. SeeNote 2(i) above. As a result of the above, as of December 31, 2006and 2005, there is a deferred rent balance of $2,404 and $1,446, respectively,of which $24 is included in accrued expenses at December 31, 2006 and $64is included in other current assets at December 31, 2005.

*(r) Accounting forConvertible Preferred Stock, Redeemable Convertible Preferred Stock andDerivative Shares*

The Company accounted for the preferred stock andrelated instruments in accordance with EITF Issue No. 00-19,Accounting for Derivative Financial Instruments Indexed to, and PotentiallySettled in, a Company’s Own Stock; EITF Issue No. 98-5, Accountingfor Convertible Securities with Beneficial Conversion features or ContingentAdjustable Conversion Ratios; EITF Issue No. 00-27, Application of 

86

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**MEDECISION, INC. Notes to Consolidated Financial Statements (Continued) (in thousands, except share and per share data)**

Issue No. 98-5to Certain Convertible Instruments; SFAS No. 133, Accounting forDerivative Instruments and Hedging Activities and other applicable professionalstandards. The carrying value of the Company’s Series  A convertiblepreferred stock and Series  B and Series  C redeemable convertiblepreferred stock was increased, or accreted, using the interest method, to redemptionor liquidation value, from the date of issuance to the earliest redemptiondate. The carrying value of the Company’s Series A convertible preferredstock and Series B and Series C redeemable convertible preferredstock was also accreted for the value of accrued and unpaid cumulativedividends.

In accordance with the provisions of SFASNo. 133, the Company identified the conversion feature of the Company’sSeries B and Series C redeemable convertible preferred stock as anembedded derivative. Under the criteria of EITF 00-19, these embeddedderivatives were classified as a liability, with changes in fair value of thederivatives at each balance sheet date reflected in the Company’s results ofoperations. For the Company’s Series  A convertible preferred stock, forwhich accrued and unpaid dividends may, at the option of the holder, be paid inadditional shares of Series  A convertible preferred stock, when the fairvalue of the Company’s common stock (into which the dividend shares may beconverted) exceeded the conversion price, a beneficial conversion option wasrecognized for the difference between the fair value of the common stock andthe conversion price on the Series  A convertible preferred stockdividends, in accordance with EITF 00-27. Changes in the value of thisbeneficial conversion option were recorded in additional paid in capital in theCompany’s Consolidated Balance Sheet.

Asfurther explained in Note 6, all of the outstanding Series A,Series B, and Series C preferred stock was converted into common stockon December 18, 2006 in connection with the initial public offering of theCompany’s common stock. The carrying values of the Series A,Series B, and Series C preferred stock, less $9.5 million inaccrued dividends on the Series B and Series C preferred stock whichwere paid in cash on December 18, 2006, and including the value ofembedded derivatives and beneficial conversion options, were converted tocommon stock. No gain or loss was recognized on this transaction.

*(s) Commitments andContingencies*

In accordance with SFASNo. 5, *Accounting for Contingencies*,the Company records liabilities for loss contingencies when it is probable thata liability has been incurred and the amount of the liability can be reasonablyestimated.

*(t) Fair Value ofFinancial Instruments*

As of December 31,2006 and 2005, the Company has the following financial instruments: accountsreceivable, accounts payable, accrued expenses, capital lease obligations anddebt. The carrying value of these financial instruments approximated fairvalue. Accrued expenses are stated at the amounts expected to be paid withinthe next 12 months, and capital lease obligations are stated at the net presentvalue of future minimum payments.

87

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**MEDECISION, INC. Notes to Consolidated Financial Statements (Continued) (in thousands, except share and per share data)**

*(u) Concentrationof Credit Risk*

Financial instruments that potentially expose theCompany to concentration of credit risk consist primarily of trade accountsreceivable. All of the Company’s sales and related accounts receivable are fromcustomers in the health care industry located in the United States. Sales totwo customers for the year ended December 31, 2006 were 47%; sales to onecustomer for the year ended December 31, 2005 were 25%; sales to threecustomers for the year ended December 31, 2004 were 38%. AtDecember 31, 2006 and 2005, trade receivables related to two customerswere 46% and 61%, respectively, of total net accounts receivable. The Companydoes not require collateral or other security to support credit sales, butprovides an allowance for bad debts based on historical experience andspecifically identified risks.

Cash balances aremaintained at one bank. Accounts located in the United States are insured bythe Federal Deposit Insurance Corporation (FDIC) up to $100,000. Certainoperating cash accounts may exceed the FDIC insurance limits.

*(v) Earnings (Loss)Per Share*

The Company follows SFAS No. 128, *Earnings Per Share*. Under SFAS No. 128,companies that are publicly held or have complex capital structures arerequired to present basic and diluted earnings per share on the face of thestatement of operations. Earnings (loss) per share are based on the weightedaverage number of shares and common stock equivalents outstanding during theperiod. Preferred stock issuance costs are accreted to the convertiblepreferred stock and reduce (increase) the net income (loss) available to commonshareholders. Costs directly attributable to the offering of the convertiblepreferred and redeemable convertible preferred stock were accreted to the valueof the stock. In the calculation of diluted earnings per share, sharesoutstanding are adjusted to assume conversion of the Company’s preferredconvertible stock using the if-converted method in accordance withSFAS 128. In doing so, shares outstanding are adjusted for the dilutiveeffect of the assumed exercise of outstanding options and warrants using thetreasury stock method. In the calculation of basic earnings per share, weightedaverage numbers of shares outstanding are used as the denominator. The Companyhad a net loss available to common shareholders for the years ended December 31,2006 and 2004. As a result, the common stock equivalents of stock options,warrants and convertible securities issued and outstanding at those dates werenot included in the computation of diluted earnings per share for the yearsthen ended as they were antidilutive. The Company has reflected on a pro formabasis the effect on historical basic and diluted earnings per share of the 1-for-2reverse stock split of its common stock effective as of December 13, 2006.

88

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**MEDECISION, INC. Notes to Consolidated Financial Statements (Continued) (in thousands, except share and per share data)**

Net(loss) income per share is computed as follows:

| ** **                                                                                                         | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                         | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Numerator:                                                                                                         |       |                                       |       |   |   |   |   |
| (Loss) income  available to common shareholders                                                                    |       | $                                          | (25,885    | ) | $ | 4,698 |   | $ | (6,139 | ) |
| Accretion of  convertible preferred shares and redeemable convertible preferred shares                             |       | 8,068                                      |       | 3,994 |   | 6,113 |   |
| Net (loss) income                                                                                                  |       | $                                          | (17,817    | ) | $ | 8,692 |   | $ | (26 | ) |
| Denominator:                                                                                                       |       |                                       |       |   |   |   |   |
| Weighted average  shares used to compute (loss) income available to common shareholders per  common share,  basic  |       | 4,605,318                                  |       | 3,229,064 |   | 3,189,366 |   |
| Incremental  shares required for diluted earnings per share:                                                       |       |                                       |       |   |   |   |   |
| Effect of nominal shares                                                                                           |       | —                                     |       | 547,474 |   | — |   |
| As if converted effect of assumed conversion of  preference shares                                                 |       | —                                     |       | 9,001,902 |   | — |   |
| Diluted effect of assumed exercise of outstanding  options and warrants, net                                       |       | —                                     |       | 1,365,147 |   | — |   |
| Weighted average  shares used to compute (loss) income available to common shareholders per  common share, diluted |       | 4,605,318                                  |       | 14,143,586 |   | 3,189,366 |   |
| (Loss) income per  share available to common shareholders, basic                                                   |       | $                                          | (5.62      | ) | $ | 1.45 |   | $ | (1.92 | ) |
| (Loss) income per share  available to common shareholders, diluted                                                 |       | $                                          | (5.62      | ) | $ | 0.66 |   | $ | (1.92 | ) |

 

For the years ended December 31,2005, weighted average shares of common stock issuable in connection with stockoptions and warrants of 202,303 shares were not included in the dilutedearnings per share calculation because doing so would have been antidilutive.

*(w) SegmentReporting*

SFAS No. 131, *Disclosures about Segments of an Enterprise and Related Information*,establishes annual and interim reporting standards for operating segments of acompany. It also requires entity-wide disclosures about the products andservices an entity provides, the material countries in which it holds assetsand reports revenue, and its major customers. We report our financial resultsas a single business segment.

*(x) Recently IssuedAccounting Standards*

In June 2006, the FASB issued FASB InterpretationNo. 48, *Accounting for Uncertainty inIncome Taxes—an interpretation of FASB Statement No. 109* (FIN48), which clarifies the accounting for uncertainty in tax positions. Thisinterpretation requires the financial statement recognition of a tax positiontaken or expected to be taken in a tax return, if that position is more likelythan not of being sustained on audit, 

89

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**MEDECISION, INC. Notes to Consolidated Financial Statements (Continued) (in thousands, except share and per share data)**

based on the technicalmerits of the position. The provisions of FIN 48 are effective for fiscal yearsbeginning after December 15, 2006. The Company is currently evaluating theimpact the adoption of FIN 48 will have on its financial condition andresults of operations.

In June 2006, the Emerging Issues Task Forcereached a consensus on Issue 06-3, How Sales Taxes Collected fromCustomers and Remitted to Governmental Authorities Should Be Presented in theIncome Statement (That Is, Gross Versus Net Presentation). The EITF determinedthat the presentation of taxes on a gross or net basis is an accounting policydecision that should be disclosed. The consensus is effective for periodsbeginning after December 15, 2006. The Company does not expect a materialeffect to result from its adoption of this consensus opinion.

In September 2006, the SEC staff issued StaffAccounting Bulletin No. 108, *Considering the Effects ofPrior Year Misstatements when Quantifying Misstatements in Current YearFinancial Statements*. SAB No. 108 provides interpretativeguidance on the process of quantifying financial statement misstatements and iseffective for fiscal years ending after November 15, 2006. The adoption ofthis statement in our fiscal year ended December 31, 2006 did not have anyeffect on the Company’s results of operations or financial condition.

In September, 2006, the FASB issued SFAS No. 157,*Fair Value Measurement*. This newstandard provides guidance for using fair value to measure assets andliabilities. The statement clarifies that for items that are not activelytraded, fair value should reflect the price in a transaction with a marketparticipant, including an adjustment for risk, and establishes a fair valuehierarchy that prioritizes the information used to develop the assumptionsmarket participants would use when pricing the asset or liability. SFAS No. 157is effective for fiscal years beginning after November 15, 2007, andinterim periods within those fiscal years. The Company does not expect torecord any material adjustments upon the adoption of this statement.

In February, 2007, theFASB issued FASB Statement No. 159, *The Fair Value Option forFinancial Assets and Financial Liabilities, Including an amendment of FASBStatement No. 115*. Under this statement, entities will bepermitted to measure many financial instruments and certain other assets andliabilities at fair value on an instrument-by-instrument basis (the fair valueoption). By electing the fair value measurement attribute for certain assetsand liabilities, entities will be able to mitigate potential “mismatches” thatarise under the current mixed measurement attribute model. Entities will alsobe able to offset changes in the fair values of a derivative instrument and itsrelated hedged item by selecting the fair value option for the hedged item. SFASNo. 159 will become effective for fiscal years beginning after November 15,2007. We are currently evaluating the effect that the adoption of thisstatement will have on our financial statements.

**(3)**          FinancingArrangements

As of December 31, 2006 and 2005, the Company hada revolving line of credit for a maximum borrowing limit of $8,000. As ofDecember 31, 2006 and 2005, the revolving line of credit bore interest atthe bank’s prime rate (8.25% and 7.25% as of December 31, 2006 and 2005,respectively) plus 1.25%. As of December 31, 2006 and December 31,2005, there were no outstanding borrowings under the agreement, and the maximumamount outstanding during each period was $4,913 and $3,211, respectively.Pursuant to the agreement, the Company’s borrowings under this facility arelimited to the lesser of $8,000 or 80% of qualified accounts receivable. Theagreement included covenants requiring the Company to maintain a 

90

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**MEDECISION, INC. Notes to Consolidated Financial Statements (Continued) (in thousands, except share and per share data)**

minimum amount of liquidityand net income. From and after completion of our initial public offering onDecember 18, 2006, the Company was required to maintain cash and cashequivalents of at least $2.0 million. The Company was also required tohave a minimum net income of $750,000 for the quarter ended December 31,2006, $1,250,000 for the quarter ended March 31, 2007, $1,600,000 for thequarter ended June 30, 2007 and $2,000,000 for each quarter thereafter.The line of credit facility expires on September 29, 2007. Borrowingsunder the credit facility are collateralized by substantially all of the assetsof the Company.

As of December 31, 2006 and December 31,2005, the Company also had an equipment line of credit for a maximum borrowinglimit of $1,000 and $500, respectively. As of December 31, 2006 andDecember 31, 2005, the outstanding balances were $75 and $175,respectively, under the equipment line of credit. Borrowings under thisfacility convert to a 30-month term note as of the first day of the calendar quartersubsequent to borrowing. Under the terms of the agreement, the line bearsinterest at the bank’s prime rate plus 1.5% (8.50% and 7.50% as ofDecember 31, 2006 and 2005, respectively).

As of December 31, 2006, the Company was not incompliance with one of the financial covenants under the revolving line ofcredit agreement. On March 26, 2007, the Company and the bank executed anamendment and waiver to the loan and security agreement to (i) waive theexisting default; (ii) increase the amount to be borrowed under theequipment line of credit to $1.75 million; (iii) extend the equipmentline maturity date to the earlier of the date 30 days after the calendarquarter subsequent to each equipment advance but no later than December 1,2009; and (iv) replace the liquidity and net income covenants withtangible net worth and adjusted quick ratio covenants. Under the amendment andwaiver to the loan agreement, the Company is required to maintain certainquarterly minimum tangible net worth and monthly adjusted quick ratiocovenants, as defined.

As of December 31, 2006 and 2005, the Company hadoutstanding insurance premium financing of $313 and $0, respectively. Theinsurance premium financing bears interest at the rate of 7.5%.

The Company incurredinterest expense of $570, $274 and $175 for the years ended December 31,2006, 2005 and 2004, respectively.

**(4)**          Leases

TheCompany is obligated under capital leases covering office furniture andcomputer hardware and software that expire at various dates throughAugust 2011. At December 31, 2006 and 2005, the gross amount ofproperty and equipment and related accumulated amortization recorded under capitalleases were as follows:

| ** **                       | ** ** | **December 31,** | ** ** |
|----------------------------------|------------|-----------------------|------------|
| ** **                       | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Computer  equipment and software |       | $                     | 5,570      |   | $ | 4,369 |   |
| Leasehold  improvements          |       | 15                    |       | 15 |   |
| Office equipment  and furniture  |       | 1,797                 |       | 856 |   |
|                             |       | 7,382                 |       | 5,240 |   |
| Less: accumulated  amortization  |       | (3,110                | )          | (1,623 | ) |
|                             |       | $                     | 4,272      |   | $ | 3,617 |   |

 

91

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**MEDECISION, INC. Notes to Consolidated Financial Statements (Continued) (in thousands, except share and per share data)**

Amortization of assets held under capital leases isincluded with depreciation and amortization expense in the accompanyingstatement of operations.

The Company leases office space, equipment and avehicle under various cancelable and noncancelable operating lease agreementsthat expire on various dates through August 2016. The Company’s operatinglease for office space allows the Company to terminate the lease after sevenyears, provided 12 months’ written notice is provided. Upon such termination, theCompany must pay a penalty of $1,800, reduced by $30 each month subsequent tothe 84th month of the lease. Rental expense foroperating leases was approximately $1,509, $970 and $688 for the years endedDecember 31, 2006, 2005 and 2004, respectively.

Futureminimum lease payments under noncancelable operating leases and future minimumcapital lease payments as of December 31, 2006 are:

| **Year ending December 31,**                               | ** ** | ** ** | ** ** | **Capital  Leases** | ** ** | **Operating  Leases** | ** ** |
|---------------------------------------------------------------------------|------------|------------|------------|---------------------|------------|-----------------------|------------|
| 2007                                                                      |       | $          | 2,159      |                |       | $                     | 1,932      |   |   |
| 2008                                                                      |       | 1,794      |       |                | 1,838      |                  |       |
| 2009                                                                      |       | 779        |       |                | 1,878      |                  |       |
| 2010                                                                      |       | 202        |       |                | 1,931      |                  |       |
| 2011                                                                      |       | 59         |       |                | 1,999      |                  |       |
| Thereafter  through 2016                                                  |       | —     |       |                | 10,258     |                  |       |
| Total minimum  lease payments                                             |       | 4,993      |       |                | $          | 19,836                |       |   |
| Less: amount  representing interest (at rates ranging from 2.0% to 18.9%) |       | (663       | )          |                |       |                  |       |
| Present value of  net minimum capital lease payments                      |       | 4,330      |       |                |       |                  |       |
| Less: current  installments of obligations under capital leases           |       | 1,773      |       |                |       |                  |       |
| Obligations under  capital leases, excluding current installments         |       | $          | 2,557      |                |       |                  |       |   |

 

**(5)**          IncomeTaxes

The income tax provision(benefit) for the years ended December 31, 2006, 2005 and 2004 consistedof the following:

|  

** **                    | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------|------------|--------------------------------------------|------------|
| ** **                            | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Current:                              |       |                                       |       |   |   |   |   |   |   |
| Federal                               |       | $                                          | (859       | ) | $ | 958 |   |   | $ | — |   |   |
| State and local                       |       | (20                                        | )          | 139 |   |   | — |   |   |
| Total current                         |       | (879                                       | )          | 1,097 |   |   | — |   |   |
| Deferred:                             |       |                                       |       |   |   |   |   |   |   |
| Federal                               |       | 7,382                                      |       | (6,627 | ) |   | — |   |   |
| State and local                       |       | 174                                        |       | (961 | ) |   | — |   |   |
| Total deferred                        |       | 7,556                                      |       | (7,588 | ) |   | — |   |   |
| Total income tax  provision (benefit) |       | $                                          | 6,677      |   | $ | (6,491 | ) |   | $ | — |   |   |

 

92

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**MEDECISION, INC. Notes to Consolidated Financial Statements (Continued) (in thousands, except share and per share data)**

Areconciliation of the Company’s effective income tax rate to the statutoryfederal income tax rate of 34% for the years ended December 31, 2006, 2005and 2004 is as follows:

| ** **                  | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------|------------|--------------------------------------------|------------|
| ** **                  | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Statutory federal  rate     |       | 34.0                                       | %          | 34.0 | % | 34.0 | % |
| State income  taxes         |       | 0.8                                        |       | 4.8 |   | 5.6 |   |
| Permanent  differences      |       | (27.0                                      | )          | 1.3 |   | 3.6 |   |
| Tax credits                 |       | 4.5                                        |       | (6.7 | ) | (28.5 | ) |
| Adjustments to  book income |       | 1.4                                        |       | 3.6 |   | 128.0 |   |
| Valuation  allowance        |       | (74.0                                      | )          | (268.0 | ) | (142.5 | ) |
| Total income tax  provision |       | (60.3                                      | )%         | (231.0 | )% | 0.2 | % |

 

Thetax effect of significant temporary differences by component as of December 31,2006 and 2005 are as follows:

| ** **                                           | ** ** | **December 31,** | ** ** |
|------------------------------------------------------|------------|-----------------------|------------|
| ** **                                           | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Deferred tax  assets, current:                       |       |                  |       |   |   |
| Net operating loss carryforwards                     |       | $                     | —     |   | $ | 1,013 |   |
| Deferred revenue                                     |       | 3,911                 |       | 3,983 |   |
| Other accruals                                       |       | 392                   |       | 306 |   |
| Total gross deferred tax asset, current              |       | 4,303                 |       | 5,302 |   |
| Less: valuation allowance                            |       | (4,303                | )          | (2,526 | ) |
| Net deferred tax asset, current                      |       | —                |       | 2,776 |   |
| Deferred tax  assets, long term:                     |       |                  |       |   |   |
| Net operating loss carryforwards                     |       | 11,135                |       | 9,120 |   |
| Goodwill amortization                                |       | 51                    |       | 51 |   |
| Tax credits                                          |       | 2,195                 |       | 1,696 |   |
| Total gross deferred tax asset, long-term            |       | 13,381                |       | 10,867 |   |
| Less: valuation allowance                            |       | (11,371               | )          | (5,178 | ) |
| Net deferred tax asset, long term                    |       | 2,010                 |       | 5,689 |   |
| Deferred tax  liabilities, long-term:                |       |                  |       |   |   |
| Plant and equipment, principally due to depreciation |       | 620                   |       | 498 |   |
| Deferred rent                                        |       | 163                   |       | 84 |   |
| Capitalized software                                 |       | 1,227                 |       | 1,138 |   |
| Total gross deferred tax liability, long term        |       | 2,010                 |       | 1,720 |   |
| Net deferred tax asset                               |       | $                     | —     |   | $ | 6,745 |   |

 

At December 31, 2006, the Company had netoperating loss carryforwards for federal and state income tax purposes ofapproximately $46.1 million that begin to expire in 2015 and 2007 forfederal and state income taxes, respectively. Pursuant to income taxregulations, the annual utilization of this carryforward, as well as a portionof the carryforward may be limited or impaired in certain circumstances.

93

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**MEDECISION, INC. Notes to Consolidated Financial Statements (Continued) (in thousands, except share and per share data)**

In assessing therealizability of deferred tax assets, management considers whether it is morelikely than not that some portion or all of the deferred tax assets will not berealized. The ultimate realization of deferred tax assets is dependent upon thegeneration of future taxable income during the periods in which those temporarydifferences become deductible. Management considers the scheduled reversal ofdeferred tax liabilities, projected future taxable income and tax planningstrategies in making this assessment. Accordingly, management’s assessment atDecember 31, 2006 was that the weight of the negative evidence outweighedthe positive evidence that all of the deferred tax assets would be realized,and accordingly, the valuation allowance was increased, and the net deferredtax asset was decreased, by $6.7 million at that time.

**(6)**          ConvertiblePreferred Stock and Redeemable Convertible Preferred Stock

Arollforward of shares for the years ended December 31, 2006, 2005 and 2004is as follows:

| ** **                             | ** ** | **Series A** | ** ** | **Series B** | ** ** | **Series C** | ** ** |
|----------------------------------------|------------|-------------------|------------|-------------------|------------|-------------------|------------|
| Balance,  December 31, 2003       |       | 2,333,333         |       | 4,022,252         |       | 4,851,549         |       |
| Balance,  December 31, 2004       |       | 2,333,333         |       | 4,022,252         |       | 4,851,549         |       |
| Balance,  December 31, 2005       |       | 2,333,333         |       | 4,022,252         |       | 4,851,549         |       |
| Conversion into shares of common stock |       | (2,333,333        | )          | (4,022,252        | )          | (4,851,549        | )          |
| Balance,  December 31, 2006       |       | —            |       | —            |       | —            |       |

 

All of the outstanding Series A, Series B,and Series C preferred stock was converted into common stock onDecember 18, 2006 in connection with the initial public offering of theCompany’s common stock. The carrying values of the Series A,Series B, and Series C preferred stock, less $9.5 million in accrueddividends on the Series B and Series C preferred stock which werepaid in cash on December 18, 2006, and including the value of embeddedderivatives and beneficial conversion options, were converted to common stock.No gain or loss was recognized on this transaction.

The terms of the Series B and C redeemableconvertible preferred stock include certain embedded conversion options thatrepresent derivative financial instruments under the provisions of SFASNo. 133. Thus the conversion options were separated from the Series Band C redeemable convertible preferred stock and valued using the Black-Scholesmodel. The Series C redeemable convertible preferred stock andSeries B redeemable convertible preferred stock contained redemption featuresthat would result in the holder receiving cash that is based on the value ofthe common stock. The Series C redeemable convertible preferred stock andSeries B redeemable convertible preferred stock redemption features alsoinclude a clause that the holder can put the shares back at the greater ofaccreted value or fair value (including the value of the conversion option).Consistent with the model in EITF Issue No. 00-19, this featuremeets the definition of net cash settlement associated with the conversionoption. Therefore, the Company separated the conversion option from thepreferred instrument and determined the fair value. The Company accounted forthe conversion options using the fair value method at the end of each quarterwith the change in fair value being recorded against earnings. Actual periodclose common stock prices, applicable volatility rates, and the period closerisk-free interest rate for the instrument’s expected remaining life, are thekey assumptions used in the valuation calculation. The change in fair value forthe years ended December 31, 2006, 2005 and 2004 were $(8,615), ($694) and($576), respectively.

94

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**MEDECISION, INC. Notes to Consolidated Financial Statements (Continued) (in thousands, except share and per share data)**

In accordance with the provisions of EITF IssueNo. 98-5 and EITF Issue No. 00-27, the Company reviewedthe value of the conversion option for the Series A convertible preferredstock accrued and unpaid dividends and determined that it was “in-the-money” atthe conversion date and through December 18, 2006 and for the year endedDecember 31, 2005. The Company accounted for the beneficial conversionoptions using the intrinsic value method at the end of each quarter, with theresultant gain or loss recognition recorded against accumulated deficit inaccordance with EITF Issue No. 00-27.

Information about thesignificant provisions, conversion and redemption features and liquidationpreferences of each series of convertible preferred stock follows:

*Series C*

The holders of Series C redeemable convertiblepreferred stock were entitled to dividends at a rate of 10% per year. Dividendswere due and payable semiannually and accumulated if not paid. Dividends werepayable in cash, or, under certain conditions, may have been payable in cash oradditional shares of Series C preferred stock, or a combination of both.As of December 31, 2005 undeclared unpaid dividends of $2,225 hadaccumulated.

Each share of Series C preferred stock wasconvertible into one share of common stock, subject to adjustment in certaincircumstances, and had a liquidation preference equal to three times its statedvalue, as defined, plus all accrued and unpaid dividends thereon.

The liquidation and redemption value of theoutstanding Series C preferred stock at December 31, 2005 was$19,053. The liquidation and redemption value included $373 as ofDecember 31, 2005 related to outstanding but unexercised Series Cstock options. In addition, the liquidation and redemption values include $110as of December 31, 2005 related to the conversion option liability.

All of the outstandingSeries C preferred stock was converted into common stock onDecember 18, 2006 in connection with the initial public offering of theCompany’s common stock. The carrying value of the Series C preferredstock, less $1.9 million in accrued dividends which were paid in cash onDecember 18, 2006, and including the value of embedded derivatives andbeneficial conversion options, was converted to common stock. No gain or losswas recognized on this transaction.

*Series B*

The holders of Series B redeemable convertiblepreferred stock were entitled to dividends at a rate of 9% per year.Series B dividends were due and payable semiannually after Series Cdividends had been declared and paid and accumulated if not paid. Dividendswere payable in cash or, under certain conditions, may have been be payable incash or additional shares of Series B preferred stock, or a combination ofboth. As of December 31, 2005, $9,460 of undeclared, unpaid dividends hadaccumulated.

Each share of Series B preferred stock wasconvertible into one share of common stock, subject to adjustment in certaincircumstances, and had a liquidation preference equal to its stated value, asdefined, plus all accrued and unpaid dividends thereon.

The liquidation and redemption value of Series Bpreferred stock at December 31, 2005 was $28,625. The liquidation andredemption value included $80 as of December 31, 2005 related to theconversion option liability.

95

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**MEDECISION, INC. Notes to Consolidated Financial Statements (Continued) (in thousands, except share and per share data)**

All of the outstanding Series Bpreferred stock was converted into common stock on December 18, 2006 inconnection with the initial public offering of the Company’s common stock. Thecarrying value of the Series B preferred stock, less $7.6 million in accrueddividends which were paid in cash on December 18, 2006, and including thevalue of embedded derivatives and beneficial conversion options, was convertedto common stock. No gain or loss was recognized on this transaction.

*Series A*

The holders of Series A convertible preferredstock were entitled to dividends at a rate of 9% per year. Series Aaccumulated dividends were due and payable after Series C and B dividendswere paid. Dividends were payable in cash unless the Series A shareholderexercised the option to receive the dividend in shares of common stock based onthe “dividend conversion price,” as defined, which was determined annually. Asof December 31, 2005, $2,796 of undeclared, unpaid dividends hadaccumulated.

Each share of Series A preferred stock wasconvertible into one share of common stock, subject to adjustment in certaincircumstances, and had a liquidation preference equal to its stated value, asdefined, plus all accrued and unpaid dividends thereon.

The liquidation value of Series A preferred stockat December 31, 2005 was $6,298. As of December 31, 2005, the2,333,333 shares of Series A preferred would have been convertible into4,497,364 shares of common stock, if the holders of Series A preferredshares had elected to receive all accumulated undeclared, unpaid dividends inshares of common stock.

All of the outstanding Series Apreferred stock was converted into common stock on December 18, 2006 inconnection with the initial public offering of the Company’s common stock. Thecarrying value of the Series A preferred stock, and including the value ofembedded derivatives and beneficial conversion options, was converted to commonstock. No gain or loss was recognized on this transaction.

**(7)**          Warrantsand Options

*(a) Warrants*

Inconnection with various financing activities, the Company issued warrants topurchase common stock. As of December 31, 2006, warrants to purchase theCompany’s common stock were outstanding as follows:

| **Date Issued**     | ** ** | ** ** | ** ** | **Warrants** | ** ** | **Exercise  Price** | ** ** | **Expiration  Date** | ** ** |
|--------------------------|------------|------------|------------|--------------|------------|---------------------|------------|----------------------|------------|
| February 12,  1997  |       |       | 100,000    |         |       |                | $          | 4.00                 |       |   | February 11,  2007 |   |
| June 1, 1999        |       |       | 50,000     |         |       |                | 4.00       |                 |       | May 31,  2009 |   |
| June 15,  2000      |       |       | 141,593    |         |       |                | 2.26       |                 |       | May 31,  2008 |   |
| July 2, 2002        |       |       | 82,965     |         |       |                | 1.80       |                 |       | July 2,  2009 |   |
| September 26,  2002 |       |       | 35,000     |         |       |                | 1.80       |                 |       | September 26,  2009 |   |
|                     |       |       | 409,558    |         |       |                |       |                 |       |   |   |

 

In connection with theCompany’s initial public offering for its common stock, on December 18,2006, warrants for 193,500 shares of the company’s stock were exercised. $67,500in cash was received for 37,500 

96

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**MEDECISION, INC. Notes to Consolidated Financial Statements (Continued) (in thousands, except share and per share data)**

shares. Warrantsfor the remaining 156,000 shares were exercised in a cashless exercisetransaction, in which a net of 124,344 shares of common stock were issued.

*(b) Stock Options*

In October, 2006, the Company’s shareholders approvedthe 2006 Equity Incentive Plan, which became effective upon the Company’sinitial public offering. The 2006 Plan provides for the award of incentivestock options, non-qualified stock options, stock appreciation rights,restricted stock, restricted stock units, performance awards and other stock-basedawards.  Employees, directors,consultants, and other individuals who provide services to the Company areeligible to be granted awards under the 2006 Plan; however, only employees areeligible to be granted incentive stock options, and not beyond 10 years fromthe adoption of the 2006 Plan. The exercise price of any option granted underthe plan will not be less than 100% of the fair market value of the commonstock on the date of grant (110% for incentive stock options issued to a morethan 10% shareholder). No incentive stock option award may be awarded in anamount that would vest more than $100,000 of fair value in any calendar year. Themaximum term of any award is 10 years from the grant date (5 years for morethan 10% shareholder). The board of directors may determine the vesting periodfor each award under the 2006 Plan.

The Company has reserved 1,500,000 shares for futureissuance under the plan plus any shares which were subject to awards but notissued under the Company’s previous plan. The maximum number of shares that maybe issued under the 2006 plan will be 4,437,082. At December 31, 2006,there were 1,500,000 shares available for grant under the 2006 Plan.

The Company previously had a stock option plan, theAmended and Restated Stock Option Plan, whereby the Company may grant eitherincentive or nonqualified stock options to purchase shares of the Company’scommon stock. The board of directors may determine the vesting period for eachaward under the plan, but the maximum term of any award is 10 years from thedate of grant. The Company had authorized 8,000,000 shares to be issued underthe plan. Stock options may be granted at no less than the fair market value ofthe shares at the date of the grant, as determined by the Company. Although theCompany’s board of directors used its best estimate of the fair value of theCompany’s stock price and made grants of stock options in 2004 and 2005 withexercise prices equal to those estimates of fair value, a subsequent independentappraisal of the common stock’s value on the grant dates conducted by MufsonHowe Hunter & Company, LLC resulted in recognizing stock-basedcompensation expense in the Consolidated Statement of Operations for the yearsended December 31, 2006, 2005 and 2004 and in the amounts of $397, $256and $21, respectively, for the difference between the fair market value of theunderlying common stock on the date of grant and the option exercise price foroptions granted under the Company’s stock option plan.

For the year ended December 31, 2006, 508,125options were granted at a weighted average price of $20.90, with a contractlife of 10 years.

97

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**MEDECISION, INC. Notes to Consolidated Financial Statements (Continued) (in thousands, except share and per share data)**

Stockoption activity for the three years ended December 31, 2006 is as follows:

| ** **                         | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|------------------------------------|------------|----------------------------|------------|----------------------------------------|------------|
| Balance at  December 31, 2003 |       | 2,365,289                  |       |                                   | $          | 0.94 |   |   |
| Granted                            |       | 516,125                    |       |                                   | 0.52       |   |   |
| Exercised                          |       | (108,281                   | )          |                                   | 0.14       |   |   |
| Canceled &  forfeited     |       | (548,001                   | )          |                                   | 0.44       |   |   |
| Balance at  December 31, 2004 |       | 2,225,133                  |       |                                   | 0.96       |   |   |
| Granted                            |       | 548,500                    |       |                                   | 0.50       |   |   |
| Exercised                          |       | (55,606                    | )          |                                   | 0.18       |   |   |
| Canceled &  forfeited     |       | (201,320                   | )          |                                   | 1.88       |   |   |
| Balance at  December 31, 2005 |       | 2,516,707                  |       |                                   | 0.80       |   |   |
| Granted                            |       | 508,125                    |       |                                   | 20.90      |   |   |
| Exercised                          |       | (29,500                    | )          |                                   | 2.52       |   |   |
| Canceled &  forfeited     |       | (58,250                    | )          |                                   | 2.36       |   |   |
| Balance at  December 31, 2006 |       | 2,937,082                  |       |                                   | $          | 4.27 |   |   |

 

At December 31, 2006, weighted average exerciseprices, aggregate intrinsic value and weighted average remaining contractuallife of outstanding options were $4.27, $22,560 and 6.15 years, respectively.Options for 1,904,610 shares were exercisable at December 31, 2006. Theweighted average exercise price of exercisable options, aggregate intrinsicvalue and weighted-average remaining contractual term of exercisable optionswas $0.91, $17,320, and 5.10 years, respectively.

As of December 31, 2006, there was $2,141 ofunrecognized compensation expense related to unvested option awards. Thisunrecognized compensation expense will be recognized over a weighted averageperiod of 2.76 years.

The total intrinsic value of options exercised during2006, 2005, and 2004 was $123, $233, and $6, respectively, and the total fairvalue of shares vested during each of those years was $182, $242, and $16,respectively. During the year ended December 31, 2006, the Companyreceived $74 in cash payments related to option exercises.

Duringthe year ended December 31, 2006, the Company granted stock options asfollows:

| **Date of Grant** | ** ** | ** ** | ** ** | **Number of  Options Granted** | ** ** | **Exercise Price  Per Share** | ** ** | **Fair Value  Per Share** | ** ** |
|-----------------------------|------------|------------|------------|------------------------------------------|------------|-----------------------------------------|------------|-------------------------------------|------------|
| January 3,  2006       |       |       | 28,750     |                                     |       |                                    | $          | 2.50                                |       |   |   | $ | 4.52 |   |   |
| April 26,  2006        |       |       | 353,375    |                                     |       |                                    | 22.00      |                                |       |   | 4.52 |   |   |
| July 18, 2006          |       |       | 126,000    |                                     |       |                                    | 22.00      |                                |       |   | 6.34 |   |   |

 

The calculated measurementvalue of each grant is being recognized as compensation expense over theapplicable vesting period, in accordance with SFAS 123R. The fair values shownfor the grants were based on a contemporaneous valuation by an independentvaluation specialist.

98

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**MEDECISION, INC. Notes to Consolidated Financial Statements (Continued) (in thousands, except share and per share data)**

**(8)**          PostretirementBenefits

The Company maintains a401(k) defined contribution retirement plan that covers substantially allemployees. Under this plan, participants may contribute up to 15% of theirpretax compensation, subject to current limitations under the Internal RevenueCode. The Company may elect to make matching contributions at the discretion ofthe board of directors. The Company currently matches 30% of the participant’sdeferral, limited to 4% of each participant’s pretax compensation. Totalemployer contributions to the plan were approximately $160, $128 and $110 forthe years ended December 31, 2006, 2005 and 2004, respectively.

**(9)**          Commitmentsand Contingencies

The Company has entered into employment agreementswith two officers of the Company, each of which was amended on July 18,2006. The agreements expire in September 2007 and January 2007 andinclude an annual base salary and other discretionary cash and stock optionbonuses. Scheduled future base compensation under these agreements for the yearending December 31, 2007 total approximately $499.

The Company is party to a contract to purchasethird-party licenses from a software vendor. The agreement expired on December 31,2005; however, the agreement automatically renews on an annual basis, unlessterminated by either party. $493, $451 and $451 of expense was incurred underthis agreement in 2006, 2005 and 2004, respectively, and is included in cost ofrevenue in the accompanying financial statements. Scheduled future minimumpayments as of December 31, 2006 under this contract are $508 in 2007.

The Company is party to a contract whereby it isobligated to make minimum royalty payments on an annual basis. Total minimumroyalty payments under this agreement aggregate $500 and are recorded ratablyover the four year term of the agreement. The Company recorded $235, $125 and$63 of expense under this agreement for the years ended December 31, 2006,2005 and 2004, respectively. There are no scheduled future minimum payments asof December 31, 2006 under this contract.

The Company’s contracts with its customers providethat customers are responsible for payment of sales and use taxes on theCompany’s licensing and maintenance fees, and where applicable, professionalservices. Prior to 2006, the Company did not collect sales taxes. During theyear ended December 31, 2006, the Company began to collect and remit salestaxes from its customers. In the event that a customer has not paid use taxwhere and when due, or is otherwise unable to pay, the Company may have acontingent liability for unpaid taxes, interest and penalties. A liability of$229 and $644 has been accrued at December 31, 2006 and 2005,respectively, against such contingencies.

The Company, in the normalcourse of business, may be party to various claims. Management believes thatthe ultimate resolution of any such claims would not have a material impact onthe Company’s financial position or operating results.

**(10)**   RelatedParties

An executive of the Company is the owner of aconsulting firm that, during the years ended December 31, 2005 and 2004provided certain professional services to the Company. During the years 

99

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**MEDECISION, INC. Notes to Consolidated Financial Statements (Continued) (in thousands, except share and per share data)**

ended December 31,2005 and 2004, $25 and $35, respectively, was paid to this firm for servicesrendered. There were no services provided after 2005.

A member of the board ofdirectors is the owner of a consulting company that, during the year ended December 31,2004, provided web design services to the Company. During the year ended December 31,2004, approximately $33 was paid to the firm for services rendered. No serviceswere received by the Company from this consulting company after 2004.

**(11)**   Industryand Geographic Segment Information

The Company derived all of its revenue from thehealthcare industry in the years ended December 31, 2006, 2005 and 2004.All of the Company’s revenue in those periods was derived from United Statescustomers and all of its assets during these periods were in the United States.

100

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**MEDECISION, INC. Notes to Consolidated Financial Statements (Continued) (in thousands, except share and per share data)**

**(12)**   QuarterlyResults of Operations (Unaudited)

| ** **                                                                                                         | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                         | ** ** | **Dec. 31,  2006**          | ** ** | **Sept. 30  2006** | ** ** | **June 30,  2006** | ** ** | **March 31,  2006** | ** ** | **Dec. 31,  2005** | ** ** | **Sept. 30,  2005** | ** ** | **June 30,  2005** | ** ** | **March 31,  2005** | ** ** |
| ** **                                                                                                         | ** ** | **(unaudited)**                  | ** ** |
| Revenue                                                                                                            |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Subscription, maintenance  and transaction fees                                                                    |       | $                                | 5,779      |   | $ | 5,502 |   | $ | 5,501 |   | $ | 5,308 |   | $ | 6,226 |   | $ | 3,926 |   | $ | 3,493 |   | $ | 3,542 |   |
| Term license  revenue                                                                                              |       | 1,375                            |       | 3,479 |   | 3,509 |   | 415 |   | 2,862 |   | 5,032 |   | 1,183 |   | 652 |   |
| Professional  services                                                                                             |       | 3,516                            |       | 3,046 |   | 3,676 |   | 3,103 |   | 5,235 |   | 2,646 |   | 2,013 |   | 1,786 |   |
| Total revenue                                                                                                      |       | 10,670                           |       | 12,027 |   | 12,686 |   | 8,826 |   | 14,323 |   | 11,604 |   | 6,689 |   | 5,980 |   |
| Cost of revenue                                                                                                    |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Subscription,  maintenance and transaction fees                                                                    |       | 2,081                            |       | 1,959 |   | 1,879 |   | 1,722 |   | 2,117 |   | 2,366 |   | 1,895 |   | 1,785 |   |
| Term licenses                                                                                                      |       | 518                              |       | 519 |   | 473 |   | 212 |   | 878 |   | 502 |   | 180 |   | 93 |   |
| Professional  services                                                                                             |       | 1,371                            |       | 1,341 |   | 1,473 |   | 1,621 |   | 1,588 |   | 1,208 |   | 1,313 |   | 1,390 |   |
| Total cost of  revenue                                                                                             |       | 3,970                            |       | 3,819 |   | 3,825 |   | 3,555 |   | 4,583 |   | 4,076 |   | 3,388 |   | 3,268 |   |
| Gross margin                                                                                                       |       | 6,700                            |       | 8,208 |   | 8,861 |   | 5,271 |   | 9,740 |   | 7,528 |   | 3,301 |   | 2,712 |   |
| Operating expenses                                                                                                 |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Sales and  marketing                                                                                               |       | 2,842                            |       | 2,873 |   | 2,614 |   | 2,205 |   | 2,444 |   | 2,238 |   | 1,846 |   | 1,250 |   |
| Research and  development                                                                                          |       | 2,217                            |       | 2,118 |   | 2,149 |   | 1,561 |   | 676 |   | 580 |   | 771 |   | 600 |   |
| General and  administrative                                                                                        |       | 3,616                            |       | 3,262 |   | 3,167 |   | 2,475 |   | 3,980 |   | 2,005 |   | 1,918 |   | 1,804 |   |
| Total operating  expenses                                                                                          |       | 8,675                            |       | 8,253 |   | 7,930 |   | 6,241 |   | 7,100 |   | 4,823 |   | 4,535 |   | 3,654 |   |
| (Loss) income from    operations                                                                                   |       | (1,975                           | )          | (45 | ) | 931 |   | (970 | ) | 2,640 |   | 2,705 |   | (1,234 | ) | (942 | ) |
| Loss (gain) on  change in fair value of redeemable convertible preferred stock conversion  options                 |       | 6,202                            |       | 2,979 |   | (281 | ) | (285 | ) | (299 | ) | 1,213 |   | (116 | ) | (104 | ) |
| Interest expense,  net                                                                                             |       | 179                              |       | 147 |   | 80 |   | 60 |   | 100 |   | 78 |   | 55 |   | 41 |   |
| (Loss) income  before (provision) benefit for income taxes                                                         |       | (8,356                           | )          | (3,171 | ) | 1,132 |   | (745 | ) | 2,839 |   | 1,414 |   | (1,173 | ) | (879 | ) |
| (Provision) benefit  for income taxes                                                                              |       | (6,825                           | )          | 75 |   | (343 | ) | 416 |   | 6,630 |   | (1,032 | ) | 507 |   | 386 |   |
| Net (loss) income                                                                                                  |       | $                                | (15,181    | ) | $ | (3,096 | ) | $ | 789 |   | $ | (329 | ) | $ | 9,469 |   | $ | 382 |   | $ | (666 | ) | $ | (493 | ) |
| Accretion of  convertible preferred shares and redeemable convertible preferred shares                             |       | (4,269                           | )          | (2,431 | ) | (684 | ) | (684 | ) | (684 | ) | (2,022 | ) | (644 | ) | (644 | ) |
| (Loss) income  available to common shareholders                                                                    |       | $                                | (19,450    | ) | $ | (5,527 | ) | $ | 105 |   | $ | (1,013 | ) | $ | 8,785 |   | $ | (1,640 | ) | $ | (1,310 | ) | $ | (1,137 | ) |
| (Loss) income per  share available to common shareholders, basic                                                   |       | $                                | (2.69      | ) | $ | (1.20 | ) | $ | 0.03 |   | $ | (0.31 | ) | $ | 2.70 |   | $ | (0.51 | ) | $ | (0.41 | ) | $ | (0.35 | ) |
| (Loss) income per  share available to common shareholders, diluted                                                 |       | $                                | (2.69      | ) | $ | (1.20 | ) | $ | 0.03 |   | $ | (0.31 | ) | $ | 0.63 |   | $ | (0.41 | ) | $ | (0.41 | ) | $ | (0.35 | ) |
| Weighted average  shares used to compute (loss) income available to common shareholders per common  share, basic   |       | 7,238,054                        |       | 4,588,521 |   | 3,276,479 |   | 3,274,850 |   | 3,249,415 |   | 3,222,843 |   | 3,222,822 |   | 3,220,934 |   |
| Weighted average  shares used to compute (loss) income available to common shareholders per common  share, diluted |       | 7,238,054                        |       | 4,588,521 |   | 3,475,777 |   | 3,274,850 |   | 14,603,454 |   | 4,035,133 |   | 3,222,822 |   | 3,220,934 |   |

 

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**Item9.**                        Changes Inand Disagreements with Accountants on Accounting and Financial Disclosure.

On March 14, 2006,upon the authorization of our board of directors acting on the recommendationof the audit committee of the board of directors, we selected Grant ThorntonLLP as our independent registered public accounting firm. We did not consultwith Grant Thornton on any financial or accounting reporting matters before itsappointment. All of the audited financial statements included in this AnnualReport on Form 10-K have been audited by Grant Thornton.

In connection with the audit of our financialstatements as of and for the year ended December 31, 2005 and re-audit ofour financial statements as of and for the years ended December 31, 2004and 2003 (of which, financial statements for the year ended December 31,2003 are not included in the “Consolidated Financial Statements” as set forthunder Item 8 of this Annual Report on Form 10-K), Grant Thorntonidentified and informed us that we had material weaknesses (as defined underthe standards established by the Public Company Accounting Oversight Board—U.S.)with respect to our accounting and reporting of certain complex transactions,as more specifically described below. As a result of these material weaknesses,we restated our financial statements as of and for the years endedDecember 31, 2005, 2004 and 2003 (of which, financial statements for theyear ended December 31, 2003 are not included in the “ConsolidatedFinancial Statements” as set forth in Item 8 of this Annual Report onForm 10-K).Our selected financial data as of and for the years endedDecember 31, 2003 and 2002 were derived from financial statements, whichwe restated as a result of these material weaknesses and which were audited byGrant Thornton.

KPMG LLP (KPMG) was previously the principalaccountants for the Company. On March 14, 2006, upon the authorization ofour board of directors acting on the recommendation of our audit committee, wedismissed KPMG as our independent registered public accounting firm. The auditreport of KPMG on our consolidated financial statements as of and for the yearended December 31, 2004 did not contain any adverse opinion or disclaimerof opinion, nor was it qualified or modified as to uncertainty, audit scope, oraccounting principles, except that such report contained a separate paragraphstated as follows: “We also audited the adjustments described in Note 3 to theaccompanying consolidated financial statements that were applied to restate the2003 financial statements. The consolidated financial statements of the Companyas of December 31, 2003 were audited by other auditors whose reportthereon dated February 25, 2004, expressed an unqualified opinion on thosestatements, before the restatement described in Note 3 to the consolidatedfinancial statements.”

In connection with the audit of the year ended December 31,2004, and the subsequent interim period through March 14, 2006, there were(i) no disagreements with KPMG on any matter of accounting principles orpractices, financial statement disclosure, or auditing scope or procedures,which disagreements, if not resolved to the satisfaction of KPMG, would havecaused KPMG to make reference in connection with its report to the subjectmatter of the disagreements, and (ii) no reportable events of the typelisted in paragraphs  (A) through (D) of Item 304(a)(1)(v) ofRegulation S-K, except that KPMG reported orally to and discussed with ouraudit committee on December 16, 2005 that during its audit of the consolidatedfinancial statements as of and for the year ended December 31, 2004, itnoted material weaknesses in internal controls related to accounting forrevenue recognition, accounting for the accretion of costs and dividendsrelated to preferred stock and accounting for income taxes, as morespecifically described below. We have authorized KPMG to respond fully to anyinquiries by our successor independent registered accounting firm, GrantThornton, regarding these material weaknesses.

On May 27, 2005, upon the authorization of ourboard of directors, acting on the recommendation of our audit committee, wedismissed Goldenberg Rosenthal, LLP and engaged KPMG as our independentregistered public accounting firm. We did not consult with KPMG on anyfinancial or accounting reporting matters before its appointment.

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In connection with the audit of the year ended December 31,2003 and the subsequent interim period through May 27, 2005, there were nodisagreements with Goldenberg Rosenthal on any matter of accounting principlesor practices, financial statement disclosure or auditing scope or procedure,which disagreements, if not resolved to the satisfaction of GoldenbergRosenthal, would have caused them to make reference thereto in their report onour financial statements for such years. The audit report of GoldenbergRosenthal on our consolidated financial statements as of and for the year endedDecember 31, 2003 did not contain an adverse opinion or disclaimer ofopinion, and was not qualified or modified as to uncertainty, audit scope oraccounting principle.

During the audit of our financial statements as of andfor the year ended December 31, 2006, no material weaknesses werediscovered. In connection with the audit of our financial statements as of andfor the year ended December 31, 2005 and re-audit of our financialstatements as of and for the years ended December 31, 2004 and 2003 (ofwhich, financial statements for the year ended December 31, 2003 are notincluded in the “Consolidated Financial Statements” as set forth in Item 8 ofthis Annual Report on Form 10-K), in July 2006, our independentauditors reported to our audit committee and informed us that we had materialweaknesses (as defined under the standards established by the Public CompanyAccounting Oversight Board—U.S.) with respect to our accounting and reportingof certain complex transactions. In addition, in December 2005, inconnection with their audit of our financial statements as of and for the yearended December 31, 2004, our previous independent auditors reportedmaterial weaknesses in our internal controls as defined under auditingstandards generally accepted in the United States of America. A materialweakness is a significant deficiency, or a combination of significantdeficiencies, that results in more than a remote likelihood that a materialmisstatement of the annual or interim financial statements will not beprevented or detected.

As aresult of the material weakness reported by our independent auditors, werestated our financial statements as of and for the years ended December 31,2005, 2004 and 2003 as summarized in the following table:

| **Change in:**                                                             | ** ** | ** **                                  | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** | **December 31,  2003** | ** ** |
|---------------------------------------------------------------------------------|------------|---------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                                                      | ** ** | **(amounts in $ millions):** | ** ** |
| Total assets                                                                    |       |                                        | —     |                        |       |                        | (0.9       | )                           |       |   | (1.1 | ) |   |
| Liability for  fair value of conversion options                                 |       |                                        | (4.9       | )                           |       |                        | 0.6        |                        |       |   | 0.02 |   |   |
| Additional  paid-in capital—beneficial conversion feature                  |       |                                        | (2.2       | )                           |       |                        | —     |                        |       |   | — |   |   |
| Shareholders’  deficiency                                                  |       |                                        | (6.1       | )                           |       |                        | (51.7      | )                           |       |   | (12.5 | ) |   |
| Net revenue                                                                     |       |                                        | —     |                        |       |                        | (0.5       | )                           |       |   | 1.6 |   |   |
| Income from operations                                                          |       |                                        | —     |                        |       |                        | (0.09      | )                           |       |   | 1.7 |   |   |
| Change in fair  value of conversion option                                      |       |                                        | (3.6       | )                           |       |                        | 0.6        |                        |       |   | (0.04 | ) |   |
| Net income or  loss                                                             |       |                                        | 3.6        |                        |       |                        | (0.7       | )                           |       |   | 1.7 |   |   |
| Accretion of  convertible preferred and redeemable convertible preferred shares |       |                                        | (2.2       | )                           |       |                        | 6.1        |                        |       |   | 8.0 |   |   |
| Increase (decrease) in  net income available to common shareholders             |       |                                        | 5.8        |                        |       |                        | (6.8       | )                           |       |   | (6.2 | ) |   |

 

The followingmaterial weaknesses were reported by our independent auditors in connectionwith their audit of our financial statements as of and for the year ended December 31,2005 and re-audit of our financial statements as of and for the years ended December 31,2004 and 2003:

·       We did not have adequatecontrols to provide reasonable assurance that all elements of contractual arrangementswith customers were being recorded in accordance with generally acceptedaccounting principles. Specifically, we did not have adequate controls toproperly determine that persuasive evidence of contractual arrangements withcustomers existed before recording revenue. 

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Errors in determining thatcontracts had been signed by customers resulted in the premature recognition ofrevenue that should have been deferred to later periods, in accordance withStatement of Position 97-2 (SOP 97-2), “Software RevenueRecognition,” and related interpretations. As a result of these identifieddeficiencies, material revenue-related audit adjustments were recorded to ourfinancial statements to defer revenue from the periods in which they wereoriginally recorded until such time as the appropriate revenue recognitioncriteria were met.

·       We did not have appropriateaccounting personnel who possessed an appropriate level of experience in theselection and application of generally accepted accounting principles withrespect to the accounting for our previously outstanding Series Aconvertible preferred stock and our previously outstanding Series B and Credeemable convertible preferred stock (which converted into common stock uponthe closing of our initial public offering on December 18, 2006) toprovide reasonable assurance that all transactions were being appropriatelyrecorded and summarized in our financial statements. Specifically, we did notproperly identify and record the beneficial conversion option relating to theaccrued and unpaid dividends on our previously outstanding Series Aconvertible preferred stock. We did not identify and record the embeddedderivative conversion option on our previously outstanding Series B and Credeemable convertible preferred stock and reflect the changes in the fairvalue of those conversion options in earnings. We did not accrete the carryingvalue of our previously outstanding Series C redeemable convertiblepreferred stock to liquidation value, which was three times the stated value.As a result of these identified deficiencies, we recorded material post-closingaudit adjustments to our financial statements for the years ended December 31,2005, 2004 and 2003 (of which, financial statements for the year ended December 31,2003 are not included in the “Consolidated Financial Statements” as set forthin Item 8 of this Annual Report on Form 10-K).

As a result of the material weakness reported by ourprevious independent auditors, we restated our financial statements as of andfor the year ended December 31, 2003, which resulted in a $8.1 milliondecrease in total assets, a $43.3 million increase in shareholders’ deficiency,a $2.8 million decrease in income from operations, a $10.8 million decrease innet income before and after taxes and a $2.0 million decrease in net incomeavailable to common shareholders.

The followingmaterial weaknesses were reported by our previous independent auditors inconnection with their audit of our financial statements as of and for the yearsended December 31, 2004 and 2003 (of which, financial statements for theyear ended December 31, 2003 are not included in the “ConsolidatedFinancial Statements” as set forth in Item 8 of this Annual Report on Form 10-K):

·       Errors in revenuerecognition were identified that resulted primarily from a lack of secondaryreview over the application of accounting principles to specific contract termsas well as the analysis and estimates supporting the amounts recorded. Theseerrors resulted from the lack of a systematic process for accumulatinginformation supporting VSOE and underlying recorded revenue as well as the lackof appropriate levels of review. As a result, we recorded material post-closingaudit adjustments to our financial statements for the year ended December 31,2003, which financial statements are not included in the “ConsolidatedFinancial Statements” as set forth under Item 8 of this Annual Report on Form 10-K.

·       We did not have appropriateaccounting personnel who possessed an appropriate level of experience in theselection and application of generally accepted accounting principles withrespect to the accounting for our previously outstanding Series Aconvertible preferred stock and our previously outstanding Series B and Credeemable convertible preferred stock to provide reasonable assurance that alltransactions were being appropriately recorded and summarized in the financialstatements. Specifically, we did not accrete the carrying value to redemptionvalue at 

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the earliest redemptiondate and did not properly record the accrued and unpaid dividends on ourpreviously outstanding Series A convertible preferred stock and ourpreviously outstanding Series B and C redeemable convertible preferredstock. As a result of these identified deficiencies, we recorded materialpost-closing audit adjustments to our financial statements for the year ended December 31,2003, which financial statements are not included in the “ConsolidatedFinancial Statements” as set forth under Item 8 of this Annual Report on Form 10-K.

·       We did not have appropriateaccounting personnel who possessed an appropriate level of experience in theselection and application of generally accepted accounting principles withrespect to the accounting for income taxes, specifically the appropriatevaluation allowance for deferred tax assets. As a result of this materialweakness, we recorded material post-closing audit adjustments to our financialstatements for the year ended December 31, 2003, which financialstatements are not included in the “Consolidated Financial Statements” as setforth under Item 8 of this Annual Report on Form 10-K.

These material weaknesses may have contributed to theerrors corrected in the restatement of our financial statements as of and forthe years ended December 31, 2005, 2004 and 2003 (of which, financialstatements for the year ended December 31, 2003 are not included in the “ConsolidatedFinancial Statements” as set forth in Item 8 of this Annual Report on Form 10-K).

We have begun ourremediation efforts and we believe that our actions in this regard havestrengthened our internal controls over financial reporting. Our efforts todate have included the following:

·       We have expanded ouraccounting staff to add additional skills and experience, specificallyexperience in revenue recognition for software sales and services, and willcontinue the expansion of our accounting staff, as well as the use of qualifiedoutside professionals as necessary to enhance and maintain our internal accountingcontrols.

·       We instituted new internalaccounting controls, including a detailed review of new contracts by qualifiedaccounting personnel to appropriately recognize and record revenue from termlicense sales as well as the sales from professional services and subscriptionand maintenance.

·       We instituted new internalaccounting controls over the pricing of our separate software and service offerings.

·       We instituted newaccounting procedures to accrete the value of our previously outstandingpreferred stock to its redemption value at the earliest redemption date, and toaccrete the value of our previously outstanding preferred stock for accrued butunpaid dividends.

·       We have engaged qualifiedoutside professionals to assist our accounting staff in analyzing and recordingcurrent and deferred income tax provisions and benefits, assets, andliabilities, and will continue to do so as necessary to improve, enhance andmaintain our system of internal accounting controls.

As of December 31, 2006, we have incurredapproximately $0.3 million of costs related to our efforts to remediate ourmaterial weaknesses. The costs associated with our remediation efforts to datehave not been material. We will continue to evaluate the effectiveness of thecontrol environment and will continue to refine existing controls. We believe thatthe material weaknesses identified by our independent auditors have beenaddressed. Additional deficiencies in our internal controls may be discoveredin the future. Any failure to maintain effective controls, or any difficultiesencountered in their improvement, could harm our operating results or cause usto fail to meet our reporting obligations and may result in a restatement ofour prior period financial statements. Ineffective internal controls could alsocause investors to lose 

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confidence in our reportedfinancial information, which would likely have a negative effect on the tradingprice of our common stock.

For a description of risks associated with ourinternal controls, please see “Risk Factors—If we fail to develop or maintainan effective system of internal controls, we may not be able to accuratelyreport our financial results or prevent fraud. As a result, current andpotential shareholders could lose confidence in our financial reporting, whichwould harm our business and the trading price of our common stock.”

**Item 9A.**                Controlsand Procedures.

**Evaluation ofDisclosure Controls and Procedures**

We maintain disclosure controls and procedures (asdefined in Rules 13a-15(e) and 15d-15(e) promulgatedunder the Exchange Act) that are designed to ensure that information that wouldbe required to be disclosed in Exchange Act reports is recorded, processed,summarized and reported within the time periods specified in the SEC’s rules andforms, and that such information is accumulated and communicated to ourmanagement, including the Chief Executive Officer, Chief Operating Officer andChief Financial Officer, as appropriate, to allow timely decisions regardingrequired disclosure.

As of December 31, 2006, our management,including the Chief Executive Officer, Chief Operating Officer and ChiefFinancial Officer, evaluated the effectiveness of the design and operation ofthe Company’s disclosure controls and procedures. Based on such evaluation, ourmanagement concluded that our disclosure controls and procedures were effectiveas of the end of the period covered by this annual report.

This annual report doesnot include a report of management’s assessment regarding internal control overfinancial reporting or an attestation report of the company’s registered publicaccounting firm due to a transition period established by rules of theSecurities and Exchange Commission for newly public companies.

**Item 9B.**               OtherInformation.

On March 26, 2007, we and our wholly-ownedsubsidiary, MEDecision Investments, Inc., entered into a First Amendmentand Waiver to Loan and Security Agreement with Silicon Valley Bank (the “*First Amendment and Waiver*”) pursuant to which(A) certain provisions of the Amended and Restated Loan and SecurityAgreement dated September 28, 2006 among us, MEDecisionInvestments, Inc. and Silicon Valley Bank (the “*LoanAgreement*”), were amended and (B) Silicon Valley Bank waivedour failure to comply with a financial covenant requiring us to maintain aminimum amount of net income that was set forth in the Loan Agreement for thequarter ended December 31, 2006, which failure would otherwise haveconstituted an event of default under the Loan Agreement.

Among the provisions of the Loan Agreement that wereamended, the First Amendment and Waiver increases the maximum amount that wemay borrow under our equipment line of credit, extends the maturity date foreach advance made to us under that line of credit and replaces financialcovenants requiring us to maintain a minimum amount of liquidity and net incomethat were set forth under the Loan Agreement with financial covenants requiringus to maintain a minimum ratio of liquidity and a minimum amount of tangiblenet worth.

A copy of the FirstAmendment and Waiver is attached hereto as Exhibit 10.16(iv) and isincorporated herein by reference. The foregoing description of the FirstAmendment and Waiver is qualified in its entirety by reference to the full textof the First Amendment and Waiver.

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**PART III**

**Item 10.**                 Directors,Executive Officers and Corporate Governance of the Registrant.

We incorporate herein by reference theinformation contained under the captions “Election of Directors”, “Section 16(a) BeneficialOwnership Reporting Compliance”, “Election of Directors—Board of Directors andCommittees—Audit Committee”, “Election of Directors—Code of Ethics” and “Electionof Directors—Board of Directors and Committees—Nominating and Corporate GovernanceCommittee” in our proxy statement pursuant to Regulation 14A under the ExchangeAct to be filed by us in connection with our 2007 Annual Meeting of Shareholderswith the SEC within 120 days after the end of the fiscal year covered by thisAnnual Report (the “Proxy Statement”).

**Item 11.**                 ExecutiveCompensation.

We incorporate herein byreference the information contained under the captions “Executive Compensation”,“Compensation Committee Interlocks and Insider Participation” and “CompensationCommittee Report” in the Proxy Statement.

**Item12.**                 SecurityOwnership of Certain Beneficial Owners and Management and Related Stockholder Matters.

We incorporate herein byreference the information contained under the captions “Security Ownership ofCertain Beneficial Owners and Management” and “Equity Compensation PlanInformation” in the Proxy Statement.

**Item 13.**                 CertainRelationships and Related Transactions, and Director Independence.

We incorporate herein byreference the information contained under the captions “Transactions withRelated Persons, Promoters and Certain Control Persons” and “Electionof Directors—Board of Directors and Committees” in the Proxy Statement.

**Item 14.**                 PrincipalAccountant Fees and Services.

We incorporate herein by reference the informationcontained under the caption “Proposal to Ratify Independent Registered PublicAccounting Firm” in the Proxy Statement.

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**PART IV**

**Item 15. Exhibitsand Financial Statement Schedules.**

(a)   Documentsfiled as a part of this report:

(1)   FinancialStatements. The “Consolidated Financial Statements” as set forth under Item 8of this Annual Report on Form 10-K are incorporated herein.

(2)   FinancialStatement Schedules. All financial statement schedules have been omittedbecause they are not applicable, not required, or the information is shown inthe “Consolidated Financial Statements” as set forth under Item 8 of thisAnnual Report on Form 10-K or the related notes thereto.

(3)   Exhibits. See(b) below.

(b)   Exhibits:

| Exhibit    | ** ** | ** **                                                                                                                                                                                                                                                                                  |
|------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Number** | ** ** | ** **                                                                                                                                                                                                                                                                                  | ** ** | **Description of Document** |
| 3.1        |       | Amended  and Restated Articles of Incorporation of MEDecision, Inc. (incorporated  by reference to Exhibit 3.3 filed with Amendment No. 4 to the  Company’s Registration Statement on Form S-1 on November 17,  2006, Registration No. 333-136532)       |
| 3.2        |       | Second Amended and Restated Bylaws of  MEDecision, Inc. (incorporated by reference to Exhibit 3.4 filed with  Amendment No. 4 to the Company’s Registration Statement on Form S-1  on November 17, 2006, Registration No. 333-136532)                    |
| 4.1        |       | Specimen Common Stock Certificate (incorporated by  reference to Exhibit 4.1 filed with Amendment No. 4 to the  Company’s Registration Statement on Form S-1 on November 17,  2006, Registration No. 333-136532)                                              |
| 4.2(i)     |       | Warrant for the Purchase of Common Stock issued to  Commerce Bank, N.A. on February 12, 1997 (incorporated by reference to  Exhibit 4.2(i) filed with the Company’s Registration Statement on  Form S-1 on August 11, 2006, Registration No. 333-136532) |
| 4.2(ii)    |       | Amendment to Warrant for the Purchase of Common  Stock dated August 1, 2006 (incorporated by reference to  Exhibit 4.2(ii) filed with the Company’s Registration Statement on  Form S-1 on August 11, 2006, Registration No. 333-136532)                 |
| 4.3(i)     |       | Warrant for the Purchase of Common Stock issued to  Commerce Bank, N.A. on June 1, 1999 (incorporated by reference to  Exhibit 4.3(i) filed with the Company’s Registration Statement on  Form S-1 on August 11, 2006, Registration No. 333-136532)      |
| 4.3(ii)    |       | Amendment to Warrant for the Purchase of Common  Stock dated August 1, 2006 (incorporated by reference to  Exhibit 4.3(ii) filed with the Company’s Registration Statement on  Form S-1 on August 11, 2006, Registration No. 333-136532)                 |
| 4.4        |       | Warrant Purchase Agreement dated June 15, 2001  in favor of PNC Bank, National Association (incorporated by reference to  Exhibit 4.4 filed with the Company’s Registration Statement on  Form S-1 on August 11, 2006, Registration No. 333-136532)           |
| 4.5        |       | Warrant to Purchase Stock dated July 2, 2002 in  favor of Silicon Valley Bank (incorporated by reference to Exhibit 4.5  filed with the Company’s Registration Statement on Form S-1 on  August 11, 2006, Registration No. 333-136532)                        |
| 4.6        |       | Warrant to Purchase Stock dated September 26,  2002 in favor of Silicon Valley Bank (incorporated by reference to  Exhibit 4.6 filed with the Company’s Registration Statement on  Form S-1 on August 11, 2006, Registration No. 333-136532)                  |
|            |            |                                                                                                                                                                                                                                                                                             |  |  |

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| 10.1*     |   | MEDecision, Inc. Amended and Restated Stock  Option Plan (incorporated by reference to Exhibit 10.1 filed with  Amendment No. 5 to the Company’s Registration Statement on Form S-1  on November 22, 2006, Registration No. 333-136532)                                                                                                                     |
|-----------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.2*     |   | Form of Notice of Grant of Incentive Stock  Options under the Amended and Restated Stock Option Plan (incorporated by  reference to Exhibit 10.2 filed with the Company’s Registration  Statement on Form S-1 on August 11, 2006, Registration  No. 333-136532)                                                                                                  |
| 10.3*     |   | Form of Notice of Grant of Non-Qualified Stock  Options under the Amended and Restated Stock Option Plan (incorporated by  reference to Exhibit 10.3 filed with the Company’s Registration  Statement on Form S-1 on August 11, 2006, Registration  No. 333-136532)                                                                                              |
| 10.4(i)*  |   | Employment Agreement dated January 1, 2003  between MEDecision, Inc. and David St.Clair (incorporated by reference  to Exhibit 10.4(i) filed with the Company’s Registration Statement  on Form S-1 on August 11, 2006, Registration No. 333-136532)                                                                                                   |
| 10.4(ii)* |   | Amendment to Employment Agreement dated  July 18, 2006 between MEDecision, Inc. and David St.Clair  (incorporated by reference to Exhibit 10.4(ii) filed with the  Company’s Registration Statement on Form S-1 on August 11,  2006, Registration No. 333-136532)                                                                                      |
| 10.5(i)*  |   | Employment Agreement dated September 4, 2002  between MEDecision, Inc. and John H. Capobianco (incorporated by  reference to Exhibit 10.5(i) filed with the Company’s Registration  Statement on Form S-1 on August 11, 2006, Registration  No. 333-136532)                                                                                       |
| 10.5(ii)* |   | Amendment to Employment Agreement dated  July 18, 2006 between MEDecision, Inc. and John H. Capobianco  (incorporated by reference to Exhibit 10.5(ii) filed with the  Company’s Registration Statement on Form S-1 on August 11,  2006, Registration No. 333-136532)                                                                             |
| 10.6+     |   | Agreement of Lease, made March 5, 2004 by and  between FV Office Partners, L.P. and MEDecision, Inc. (incorporated by  reference to Exhibit 10.6 filed with the Company’s Registration  Statement on Form S-1 on August 11, 2006, Registration No. 333-136532)                                                                                              |
| 10.7+     |   | Agreement of Lease, made April 19, 2005 by and  between FV Office Partners, L.P. and MEDecision, Inc. (incorporated by  reference to Exhibit 10.7 filed with the Company’s Registration  Statement on Form S-1 on August 11, 2006, Registration  No. 333-136532)                                                                                            |
| 10.8+     |   | Agreement of Lease, made May 31, 2006 by and  between Chesterbrook Partners, LP and MEDecision, Inc. (incorporated by  reference to Exhibit 10.8 filed with the Company’s Registration  Statement on Form S-1 on August 11, 2006, Registration  No. 333-136532)                                                                                             |
| 10.9(i)   |   | Second Amended and Restated Registration Rights  Agreement dated as of September 25, 2001 by and among  MEDecision, Inc. and the Holders party thereto (as such term is defined  therein) (incorporated by reference to Exhibit 10.9(i) filed with  the Company’s Registration Statement on Form S-1 on  August 11, 2006, Registration No. 333-136532) |
| 10.9(ii)  |   | Amendment to Second Amended and Restated  Registration Rights Agreement dated as of July 6, 2006 (incorporated by  reference to Exhibit 10.9(ii) filed with the Company’s Registration  Statement on Form S-1 on August 11, 2006, Registration  No. 333-136532)                                                                                             |
| 10.9(iii) |   | Second Amendment to Second Amended and Restated  Registration Rights Agreement dated as of August 2, 2006 (incorporated  by reference to Exhibit 10.9(iii) filed with the Company’s  Registration Statement on Form S-1 on August 11, 2006,  Registration No. 333-136532)                                                                                   |

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| 10.10*      |   | Description of Danielle Russella Bantivoglio’s  Commission Plan (incorporated by reference to Exhibit 10.12 filed with  Amendment No. 1 to the Company’s Registration Statement on Form S-1  on September 28, 2006, Registration No. 333-136532)                                                                           |
|-------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.11#      |   | Master Product Agreement dated November 15,  2005 between MEDecision, Inc. and Health Care Service Corporation  (incorporated by reference to Exhibit 10.13 filed with Amendment  No. 6 to the Company’s Registration Statement on Form S-1 on  December 11, 2006, Registration No. 333-136532)                       |
| 10.12(i)#   |   | Value Added Remarketing Agreement made  March 30, 1989 between MEDecision, Inc. and InterSystems  Corporation (incorporated by reference to Exhibit 10.14(i) filed  with Amendment No. 1 to the Company’s Registration Statement on  Form S-1 on September 28, 2006, Registration No. 333-136532)                |
| 10.12(ii)#  |   | 2006 Terms and Conditions and Partner Addendum to  Value Added Remarketing Agreement (incorporated by reference to  Exhibit 10.14(ii) filed with Amendment No. 1 to the Company’s  Registration Statement on Form S-1 on September 28, 2006,  Registration No. 333-136532)                                                 |
| 10.12(iii)# |   | 2006 Pricing Terms to Value Added Remarketing  Agreement (incorporated by reference to Exhibit 10.14(iii) filed  with Amendment No. 1 to the Company’s Registration Statement on  Form S-1 on September 28, 2006, Registration No. 333-136532)                                                                             |
| 10.12(iv)#  |   | Letter Amendment to Value Added Remarketing  Agreement dated September 19, 2006 (incorporated by reference to  Exhibit 10.14(iv) filed with Amendment No. 1 to the Company’s  Registration Statement on Form S-1 on September 28, 2006,  Registration No. 333-136532)                                                 |
| 10.13#      |   | Master Product and Services Agreement dated  June 30, 2005 between MEDecision, Inc. and Horizon Blue Cross Blue  Shield of New Jersey (incorporated by reference to Exhibit 10.15 filed  with Amendment No. 6 to the Company’s Registration Statement on  Form S-1 on December 11, 2006, Registration No. 333-136532) |
| 10.14*      |   | Form of Amended and Restated Indemnification  Agreement                                                                                                                                                                                                                                                                                                  |
| 10.15(i)    |   | Pledge Agreement dated June 30, 1998 between  David St.Clair and Fiona A. St.Clair (incorporated by reference to  Exhibit 10.18(i) filed with Amendment No. 3 to the Company’s  Registration Statement on Form S-1 on October 31, 2006,  Registration No. 333-136532)                                                 |
| 10.15(ii)   |   | Pledge Agreement dated June 30, 1998 between  David St.Clair and Fiona A. St.Clair, as custodian for William T. Serber  (incorporated by reference to Exhibit 10.18(ii) filed with  Amendment No. 3 to the Company’s Registration Statement on Form S-1  on October 31, 2006, Registration No. 333-136532)            |
| 10.15(iii)  |   | Pledge Agreement dated June 30, 1998 between  David St.Clair and Zachariah W. Serber (incorporated by reference to  Exhibit 10.18(iii) filed with Amendment No. 3 to the Company’s  Registration Statement on Form S-1 on October 31, 2006,  Registration No. 333-136532)                                             |
| 10.15(iv)   |   | Pledge Agreement dated June 30, 1998 between  David St.Clair and Kathryn S. Patterson (incorporated by reference to  Exhibit 10.18(iv) filed with Amendment No. 3 to the Company’s  Registration Statement on Form S-1 on October 31, 2006,  Registration No. 333-136532)                                             |

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| 10.16(i)   |   | Amended and Restated Loan and Security Agreement  dated September 28, 2006 between MEDecision, Inc. and Silicon  Valley Bank (incorporated by reference to Exhibit 10.19(i) filed  with Amendment No. 3 to the Company’s Registration Statement on  Form S-1 on October 31, 2006, Registration No. 333-136532)                        |
|------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.16(ii)  |   | Consent and Waiver dated November 14, 2006  between MEDecision, Inc. and Silicon Valley Bank (incorporated by  reference to Exhibit 10.19(ii) filed with Amendment No. 4 to  the Company’s Registration Statement on Form S-1 on  November 17, 2006, Registration No. 333-136532)                                                     |
| 10.16(iii) |   | Additional Borrower Joinder Supplement dated  November 22, 2006, between MEDecision Inc., MEDecision  Investments, Inc. and Silicon Valley Bank (incorporated by reference to  Exhibit 10.19(iii) filed with Amendment No. 6 to the Company’s  Registration Statement on Form S-1 on December 11, 2006,  Registration No. 333-136532) |
| 10.16(iv)  |   | First Amendment and Wavier to Loan and Security  Agreement dated March 26, 2007, between MEDecision Inc., MEDecision  Investments, Inc. and Silicon Valley Bank                                                                                                                                                                                                     |
| 10.17(i)*  |   | MEDecision, Inc. Series C Stock Equity  Incentive Plan (incorporated by reference to Exhibit 10.20(i) filed  with Amendment No. 4 to the Company’s Registration Statement on  Form S-1 on November 17, 2006, Registration No. 333-136532)                                                                                             |
| 10.17(ii)* |   | Form of Non-Qualified Stock Option Agreement  under the Series C Stock Equity Incentive Plan (incorporated by  reference to Exhibit 10.20(ii) filed with Amendment No. 4 to  the Company’s Registration Statement on Form S-1 on  November 17, 2006, Registration No. 333-136532)                                                     |
| 10.18(i)*  |   | MEDecision, Inc. 2006 Equity Incentive Plan  (incorporated by reference to Exhibit 10.21 filed with Amendment  No. 4 to the Company’s Registration Statement on Form S-1 on  November 17, 2006, Registration No. 333-136532)                                                                                                                    |
| 10.18(ii)* |   | Form of ISO Grant Award Agreement under  MEDecision, Inc. 2006 Equity Incentive Plan                                                                                                                                                                                                                                                                                     |
| 21.1       |   | Subsidiaries of MEDecision, Inc. (incorporated  by reference to Exhibit 21.1 filed with Amendment No. 4 to the  Company’s Registration Statement on Form S-1 on November 17,  2006, Registration No. 333-136532)                                                                                                                                |
| 23.1       |   | Consent of Grant Thornton LLP                                                                                                                                                                                                                                                                                                                                                      |
| 31.1       |   | Certification by Chief Executive Officer pursuant to  Rule 13a-14(a)/15d-14(a)                                                                                                                                                                                                                                                                                                |
| 31.2       |   | Certification by Chief Financial Officer pursuant to  Rule 13a-14(a)/15d-14(a)                                                                                                                                                                                                                                                                                                |
| 32.1       |   | Certification Furnished pursuant to 18 U.S.C.  Section 1350 as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002                                                                                                                                                                                                                                        |

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*                    Managementcontracts and compensatory plans and arrangements required to be filed asexhibits pursuant to Item 15(b) of this Annual Report on Form 10-K.

+                Exhibits andschedules have been omitted and will be provided to the Securities and ExchangeCommission upon request.

#                 An applicationhas been submitted to the Securities and Exchange Commission for confidentialtreatment, pursuant to Rule 406 of the Securities Act of 1933, of portionsof these exhibits. These portions have been omitted from these exhibits.

(c)   FinancialStatement Schedules. None

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized, in the City of Wayne,Commonwealth of Pennsylvania on March 28, 2007.

|          | **MEDECISION, INC.** |
|----------|----------------------|
|     | By:                  | /s/ DAVID ST.CLAIR |
|     |                 | David St.Clair |
| * * | * *             | *Chairman of the Board of Directors and  Chief Executive Officer* |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated.

|                         | **Signature** | ** **                                                            | ** ** | ** **          | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|-------------------------|---------------|-----------------------------------------------------------------------|------------|---------------------|-----------|------------|------------|------------|----------|------------|
| /s/ DAVID  ST.CLAIR     |          | Chairman of the  Board of                                             |       | March 28, 2007 |
| **David St.Clair**      |          | Directors and  Chief Executive Officer (Principal Executive Officer)  |       |                |
| /s/ JOHN H.  CAPOBIANCO |          | President and  Chief Operating                                        |       | March 28, 2007 |
| **John H. Capobianco**  |          | Officer                                                               |       |                |
| /s/ CARL E.  SMITH      |          | Executive Vice  President and                                         |       | March 28, 2007 |
| **Carl E. Smith**       |          | Chief Financial  Officer (Principal Financial and Accounting Officer) |       |                |
| /s/ TIMOTHY W.  WALLACE |          | Director                                                              |       | March 28, 2007 |
| **Timothy W. Wallace**  |          |                                                                  |       |                |
| /s/ THOMAS R.  MORSE    |          | Director                                                              |       | March 28, 2007 |
| **Thomas R. Morse**     |          |                                                                  |       |                |
| /s/ PAUL E. BLONDIN     |          | Director                                                              |       | March 28, 2007 |
| **Paul E. Blondin**     |          |                                                                  |       |                |
| /s/ ELIZABETH  A. DOW   |          | Director                                                              |       | March 28, 2007 |
| **Elizabeth  A. Dow**   |          |                                                                  |       |                |

 

112

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**EXHIBIT INDEX**

| Exhibit    | ** ** | ** **                                                                                                                                                                                                                                                                                       |
|------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Number** | ** ** | ** **                                                                                                                                                                                                                                                                                       | ** ** | **Description of Document** |
| 3.1        |       | Amended  and Restated Articles of Incorporation of MEDecision, Inc. (incorporated  by reference to Exhibit 3.3 filed with Amendment No. 4 to the  Company’s Registration Statement on Form S-1 on November 17,  2006, Registration No. 333-136532)            |
| 3.2        |       | Second Amended and Restated Bylaws of  MEDecision, Inc. (incorporated by reference to Exhibit 3.4 filed  with Amendment No. 4 to the Company’s Registration Statement on  Form S-1 on November 17, 2006, Registration No. 333-136532)                         |
| 4.1        |       | Specimen Common Stock Certificate (incorporated by  reference to Exhibit 4.1 filed with Amendment No. 4 to the  Company’s Registration Statement on Form S-1 on November 17,  2006, Registration No. 333-136532)                                                   |
| 4.2(i)     |       | Warrant for the Purchase of Common Stock issued to  Commerce Bank, N.A. on February 12, 1997 (incorporated by reference to  Exhibit 4.2(i) filed with the Company’s Registration Statement on  Form S-1 on August 11, 2006, Registration No. 333-136532)      |
| 4.2(ii)    |       | Amendment to Warrant for the Purchase of Common  Stock dated August 1, 2006 (incorporated by reference to  Exhibit 4.2(ii) filed with the Company’s Registration Statement on  Form S-1 on August 11, 2006, Registration No. 333-136532)                      |
| 4.3(i)     |       | Warrant for the Purchase of Common Stock issued to  Commerce Bank, N.A. on June 1, 1999 (incorporated by reference to  Exhibit 4.3(i) filed with the Company’s Registration Statement on  Form S-1 on August 11, 2006, Registration No. 333-136532)           |
| 4.3(ii)    |       | Amendment to Warrant for the Purchase of Common  Stock dated August 1, 2006 (incorporated by reference to Exhibit 4.3(ii) filed  with the Company’s Registration Statement on Form S-1 on  August 11, 2006, Registration No. 333-136532)                      |
| 4.4        |       | Warrant Purchase Agreement dated June 15, 2001  in favor of PNC Bank, National Association (incorporated by reference to  Exhibit 4.4 filed with the Company’s Registration Statement on  Form S-1 on August 11, 2006, Registration No. 333-136532)                |
| 4.5        |       | Warrant to Purchase Stock dated July 2, 2002 in  favor of Silicon Valley Bank (incorporated by reference to Exhibit 4.5  filed with the Company’s Registration Statement on Form S-1 on  August 11, 2006, Registration No. 333-136532)                             |
| 4.6        |       | Warrant to Purchase Stock dated September 26,  2002 in favor of Silicon Valley Bank (incorporated by reference to  Exhibit 4.6 filed with the Company’s Registration Statement on  Form S-1 on August 11, 2006, Registration No. 333-136532)                       |
| 10.1*      |       | MEDecision, Inc. Amended and Restated Stock  Option Plan (incorporated by reference to Exhibit 10.1 filed with  Amendment No. 5 to the Company’s Registration Statement on Form S-1  on November 22, 2006, Registration No. 333-136532)                       |
| 10.2*      |       | Form of Notice of Grant of Incentive Stock  Options under the Amended and Restated Stock Option Plan (incorporated by  reference to Exhibit 10.2 filed with the Company’s Registration  Statement on Form S-1 on August 11, 2006, Registration  No. 333-136532)    |
| 10.3*      |       | Form of Notice of Grant of Non-Qualified Stock  Options under the Amended and Restated Stock Option Plan (incorporated by  reference to Exhibit 10.3 filed with the Company’s Registration Statement  on Form S-1 on August 11, 2006, Registration No. 333-136532) |
| 10.4(i)*   |       | Employment Agreement dated January 1, 2003  between MEDecision, Inc. and David St.Clair (incorporated by reference  to Exhibit 10.4(i) filed with the Company’s Registration Statement  on Form S-1 on August 11, 2006, Registration No. 333-136532)     |
|            |            |                                                                                                                                                                                                                                                                                                  |  |  |

113

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| 10.4(ii)*  |   | Amendment to Employment Agreement dated  July 18, 2006 between MEDecision, Inc. and David St.Clair  (incorporated by reference to Exhibit 10.4(ii) filed with the  Company’s Registration Statement on Form S-1 on August 11,  2006, Registration No. 333-136532)                                                                                      |
|------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.5(i)*   |   | Employment Agreement dated September 4, 2002  between MEDecision, Inc. and John H. Capobianco (incorporated by  reference to Exhibit 10.5(i) filed with the Company’s Registration  Statement on Form S-1 on August 11, 2006, Registration  No. 333-136532)                                                                                       |
| 10.5(ii)*  |   | Amendment to Employment Agreement dated  July 18, 2006 between MEDecision, Inc. and John H. Capobianco  (incorporated by reference to Exhibit 10.5(ii) filed with the Company’s  Registration Statement on Form S-1 on August 11, 2006,  Registration No. 333-136532)                                                                             |
| 10.6+      |   | Agreement of Lease, made March 5, 2004 by and  between FV Office Partners, L.P. and MEDecision, Inc. (incorporated by  reference to Exhibit 10.6 filed with the Company’s Registration  Statement on Form S-1 on August 11, 2006, Registration  No. 333-136532)                                                                                             |
| 10.7+      |   | Agreement of Lease, made April 19, 2005 by and  between FV Office Partners, L.P. and MEDecision, Inc. (incorporated by  reference to Exhibit 10.7 filed with the Company’s Registration  Statement on Form S-1 on August 11, 2006, Registration  No. 333-136532)                                                                                            |
| 10.8+      |   | Agreement of Lease, made May 31, 2006 by and  between Chesterbrook Partners, LP and MEDecision, Inc. (incorporated by  reference to Exhibit 10.8 filed with the Company’s Registration  Statement on Form S-1 on August 11, 2006, Registration  No. 333-136532)                                                                                             |
| 10.9(i)    |   | Second Amended and Restated Registration Rights  Agreement dated as of September 25, 2001 by and among  MEDecision, Inc. and the Holders party thereto (as such term is defined  therein) (incorporated by reference to Exhibit 10.9(i) filed with  the Company’s Registration Statement on Form S-1 on  August 11, 2006, Registration No. 333-136532) |
| 10.9(ii)   |   | Amendment to Second Amended and Restated Registration  Rights Agreement dated as of July 6, 2006 (incorporated by reference to  Exhibit 10.9(ii) filed with the Company’s Registration Statement on  Form S-1 on August 11, 2006, Registration No. 333-136532)                                                                                              |
| 10.9(iii)  |   | Second Amendment to Second Amended and Restated  Registration Rights Agreement dated as of August 2, 2006 (incorporated  by reference to Exhibit 10.9(iii) filed with the Company’s  Registration Statement on Form S-1 on August 11, 2006,  Registration No. 333-136532)                                                                                   |
| 10.10*     |   | Description of Danielle Russella Bantivoglio’s  Commission Plan (incorporated by reference to Exhibit 10.12 filed with  Amendment No. 1 to the Company’s Registration Statement on Form S-1  on September 28, 2006, Registration No. 333-136532)                                                                                                            |
| 10.11#     |   | Master Product Agreement dated November 15,  2005 between MEDecision, Inc. and Health Care Service Corporation  (incorporated by reference to Exhibit 10.13 filed with Amendment  No. 6 to the Company’s Registration Statement on Form S-1 on  December 11, 2006, Registration No. 333-136532)                                                        |
| 10.12(i)#  |   | Value Added Remarketing Agreement made  March 30, 1989 between MEDecision, Inc. and InterSystems  Corporation (incorporated by reference to Exhibit 10.14(i) filed  with Amendment No. 1 to the Company’s Registration Statement on Form S-1  on September 28, 2006, Registration No. 333-136532)                                                 |
| 10.12(ii)# |   | 2006 Terms and Conditions and Partner Addendum to  Value Added Remarketing Agreement (incorporated by reference to  Exhibit 10.14(ii) filed with Amendment No. 1 to the Company’s  Registration Statement on Form S-1 on September 28, 2006,  Registration No. 333-136532)                                                                                  |

114

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| 10.12(iii)# |   | 2006 Pricing Terms to Value Added Remarketing  Agreement (incorporated by reference to Exhibit 10.14(iii) filed  with Amendment No. 1 to the Company’s Registration Statement on  Form S-1 on September 28, 2006, Registration No. 333-136532)                                                                                                  |
|-------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.12(iv)#  |   | Letter Amendment to Value Added Remarketing  Agreement dated September 19, 2006 (incorporated by reference to  Exhibit 10.14(iv) filed with Amendment No. 1 to the Company’s  Registration Statement on Form S-1 on September 28, 2006,  Registration No. 333-136532)                                                                      |
| 10.13#      |   | Master Product and Services Agreement dated  June 30, 2005 between MEDecision, Inc. and Horizon Blue Cross Blue  Shield of New Jersey (incorporated by reference to Exhibit 10.15 filed  with Amendment No. 6 to the Company’s Registration Statement on  Form S-1 on December 11, 2006, Registration No. 333-136532)                      |
| 10.14*      |   | Form of Amended and Restated Indemnification  Agreement                                                                                                                                                                                                                                                                                                                       |
| 10.15(i)    |   | Pledge Agreement dated June 30, 1998 between  David St.Clair and Fiona A. St.Clair (incorporated by reference to  Exhibit 10.18(i) filed with Amendment No. 3 to the Company’s  Registration Statement on Form S-1 on October 31, 2006,  Registration No. 333-136532)                                                                      |
| 10.15(ii)   |   | Pledge Agreement dated June 30, 1998 between David  St.Clair and Fiona A. St.Clair, as custodian for William T. Serber  (incorporated by reference to Exhibit 10.18(ii) filed with  Amendment No. 3 to the Company’s Registration Statement on Form S-1  on October 31, 2006, Registration No. 333-136532)                                 |
| 10.15(iii)  |   | Pledge Agreement dated June 30, 1998 between  David St.Clair and Zachariah W. Serber (incorporated by reference to  Exhibit 10.18(iii) filed with Amendment No. 3 to the Company’s  Registration Statement on Form S-1 on October 31, 2006,  Registration No. 333-136532)                                                                  |
| 10.15(iv)   |   | Pledge Agreement dated June 30, 1998 between  David St.Clair and Kathryn S. Patterson (incorporated by reference to  Exhibit 10.18(iv) filed with Amendment No. 3 to the Company’s  Registration Statement on Form S-1 on October 31, 2006,  Registration No. 333-136532)                                                                  |
| 10.16(i)    |   | Amended and Restated Loan and Security Agreement  dated September 28, 2006 between MEDecision, Inc. and Silicon  Valley Bank (incorporated by reference to Exhibit 10.19(i) filed  with Amendment No. 3 to the Company’s Registration Statement on  Form S-1 on October 31, 2006, Registration No. 333-136532)                        |
| 10.16(ii)   |   | Consent and Waiver dated November 14, 2006  between MEDecision, Inc. and Silicon Valley Bank (incorporated by  reference to Exhibit 10.19(ii) filed with Amendment No. 4 to  the Company’s Registration Statement on Form S-1 on  November 17, 2006, Registration No. 333-136532)                                                     |
| 10.16(iii)  |   | Additional Borrower Joinder Supplement dated  November 22, 2006, between MEDecision Inc., MEDecision  Investments, Inc. and Silicon Valley Bank (incorporated by reference to  Exhibit 10.19(iii) filed with Amendment No. 6 to the Company’s  Registration Statement on Form S-1 on December 11, 2006,  Registration No. 333-136532) |
| 10.16(iv)   |   | First Amendment and Wavier to Loan and Security  Agreement dated March 26, 2007, between MEDecision Inc., MEDecision  Investments, Inc. and Silicon Valley Bank                                                                                                                                                                                                     |
| 10.17(i)*   |   | MEDecision, Inc. Series C Stock Equity  Incentive Plan (incorporated by reference to Exhibit 10.20(i) filed  with Amendment No. 4 to the Company’s Registration Statement on  Form S-1 on November 17, 2006, Registration No. 333-136532)                                                                                             |

115

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| 10.17(ii)* |   | Form of Non-Qualified Stock Option Agreement  under the Series C Stock Equity Incentive Plan (incorporated by  reference to Exhibit 10.20(ii) filed with Amendment No. 4 to  the Company’s Registration Statement on Form S-1 on  November 17, 2006, Registration No. 333-136532) |
|------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.18(i)*  |   | MEDecision, Inc. 2006 Equity Incentive Plan  (incorporated by reference to Exhibit 10.21 filed with Amendment  No. 4 to the Company’s Registration Statement on Form S-1 on  November 17, 2006, Registration No. 333-136532)                                                                |
| 10.18(ii)* |   | Form of ISO Grant Award Agreement under  MEDecision, Inc. 2006 Equity Incentive Plan                                                                                                                                                                                                                                 |
| 21.1       |   | Subsidiaries of MEDecision, Inc. (incorporated  by reference to Exhibit 21.1 filed with Amendment No. 4 to the  Company’s Registration Statement on Form S-1 on November 17,  2006, Registration No. 333-136532)                                                                            |
| 23.1       |   | Consent of Grant Thornton LLP                                                                                                                                                                                                                                                                                                  |
| 31.1       |   | Certification by Chief Executive Officer pursuant to  Rule 13a-14(a)/15d-14(a)                                                                                                                                                                                                                                            |
| 31.2       |   | Certification by Chief Financial Officer pursuant to  Rule 13a-14(a)/15d-14(a)                                                                                                                                                                                                                                            |
| 32.1       |   | Certification Furnished pursuant to 18 U.S.C.  Section 1350 as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002                                                                                                                                                                                    |

----

*                    Managementcontracts and compensatory plans and arrangements required to be filed asexhibits pursuant to Item 15(b) of this Annual Report on Form 10-K.

+                Exhibits andschedules have been omitted and will be provided to the Securities and ExchangeCommission upon request.

#                 An applicationhas been submitted to the Securities and Exchange Commission for confidentialtreatment, pursuant to Rule 406 of the Securities Act of 1933, of portionsof these exhibits. These portions have been omitted from these exhibits.

116

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