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SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
 FORM 10-K (MARK ONE) þ
    
    ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE
FISCAL YEAR ENDED DECEMBER 31, 2004 OR
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE
TRANSITION PERIOD FROM ___TO ___
 Commission file number 0-22019 HEALTH GRADES, INC.  DELAWARE
(State or other jurisdiction
of incorporation or organization)
    
    62-1623449
(I.R.S. Employer Identification No.)500 GOLDEN RIDGE ROAD
GOLDEN, CO
(Address of principal executive offices)
    
    80401
(Zip Code)
 Registrants telephone number, including area code: (303) 716-0041 SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: None SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: None Indicate by check mark whether the registrant (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for
such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes þ No o Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is
not contained herein, and will not be contained, to the best of registrants knowledge, in the
definitive proxy statement incorporated by reference in Part III of this annual report on Form 10-K
or any amendment to this annual report on Form 10-K. þ Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of
the Act). Yes o No þ As of June 30, 2004, the aggregate market value of the Common Stock held by non-affiliates of the
registrant was $16,369,405. Such aggregate market value was computed by reference to the closing
sale price of the Common Stock as reported on the OTC Bulletin Board on such date. For purposes of
making this calculation only, the registrant has defined affiliates as including all executive officers, directors
and beneficial owners of more than five percent of the Common Stock of the Company. As of March 1, 2005
there were 26,036,858 shares of the registrants Common Stock outstanding.   1




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DOCUMENTS INCORPORATED BY REFERENCE  
 TABLE OF CONTENTS PART IItem 1. Business
    
    
    2Item 2. Properties
    
    
    19Item 3. Legal Proceedings
    
    
    19Item 4. Submission of Matters to a Vote of Security Holders
    
    
    20PART IIItem 5. Market for the Registrants Common Equity and Related Stockholder Matters
    
    
    21Item 6. Selected Financial Data
    
    
    21Item 7. Managements Discussion and Analysis of Financial Condition And Results of Operations
    
    
    21Item 7A. Quantitative and Qualitative Disclosures About Market Risk
    
    
    27Item 8. Financial Statements and Supplementary Data
    
    
    28Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
    
    
    28Item 9A. Controls and Procedures
    
    
    28PART IIIItem 10. Directors and Executive Officers of the Registrant
    
    
    28Item 11. Executive Compensation
    
    
    28Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
    
    
    28Item 13. Certain Relationships and Related Transactions
    
    
    29Item 14. Principal Accountant Fees and Services
    
    
    29PART IVItem 15. Exhibits and Financial Statement Schedules
    
    
    29Loan Modification AgreementBuilding LeaseConsent of Grant Thornton LLPCertification of CEO Pursuant to Rule 15d-14(a)Certification of CFO Pursuant to Rule 15d-14(a)Certification of CEO Pursuant to Rule 15d-14(b)Certification of CFO Pursuant to Rule 15d-14(b)
  This Report contains forward-looking statements that address, among other things, the
availability of healthcare data, expansion of our revenue base,
addition of personnel, 2005
cash incentive program, continued company expansion and anticipated capital expenditures.
These statements may be found under Item 1-Business, Item 1-Risk
Factors, and Item 7-Managements Discussion and Analysis of Financial Condition and Results of
Operations as well as in this Report generally. We generally identify forward-looking statements
in this report using words like believe, intend, expect, may, will, should, plan,
project, contemplate, anticipate or similar statements. Actual events or results may differ
materially from those discussed in forward-looking statements as a result of various factors,
including: the failure of the Company to generate increased revenues
or unanticipated capital expenditures. In addition, other factors that could cause actual events or
results to differ materially from those discussed in the forward looking statements are addressed
in Risk Factors in Item 1 and matters set forth in the Report generally. We undertake no
obligation to update publicly any forward-looking statements. 
 PART I 
 Item 1. Business. BUSINESS Overview Health Grades, Inc. (HealthGrades) provides proprietary, objective healthcare provider
ratings and advisory services. We provide our clients with healthcare information, including
information relating to quality of service and detailed profile information on physicians, that
enables them to measure, assess, enhance and market healthcare quality. Our clients include
hospitals, employers, benefits consulting firms, payers, insurance companies and consumers. We currently provide ratings or profile information relating to the following healthcare
providers: 2




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
    Over 5,000 hospitals with risk-adjusted ratings on twenty-eight procedures/diagnoses
and programmatic ratings for obstetrics and womens health (as further described below).
For twenty-six procedures/diagnoses, the risk adjustment was based upon the HealthGrades
methodology. For Gastrointestinal Procedures and Surgeries and Respiratory Failure, the
risk adjustment was based upon APR-DRG methodology developed by 3M Corporation. APR-DRG
stands for All Patient Refined Diagnosis Related Group.
    Over 620,000 physicians in over 120 specialties; and
    Over 16,000 nursing homes. We offer services to hospitals that are either attempting to build a reputation based upon
quality of care or are working to identify areas to improve quality. For hospitals that have
received high ratings, we offer the opportunity to license our ratings and trademarks and provide
assistance in their marketing programs at an institutional level (e.g., hospital clinical
excellence and exceptional experience regarding the overall number and type of patient safety
incidents within a hospital) at a service line level (e.g. cardiac, pulmonary, vascular, etc.) and
at a procedure/diagnosis level (e.g., within the cardiac service line-coronary bypass surgery, heart attack, heart failure, etc.). We also offer physician-led quality improvement consulting engagements
and other quality improvement analysis and services for any hospitals that are seeking to enhance
quality. In addition, we provide basic and detailed profile information on a variety of providers and
facilities. We make this information available to consumers, employers, benefits consulting firms
and payers to assist them in selecting healthcare providers. Basic profile information for certain
providers is available free of charge on our website, www.healthgrades.com. For a fee, we offer
healthcare quality reports with respect to hospitals, nursing homes and physicians. These reports
provide more detailed information than is available free of charge on our website. Report pricing
and content varies based upon the type of provider and whether the user is a consumer or a
healthcare professional (for example, a medical professional underwriter). We also provide detailed online healthcare quality information for employers, benefits
consulting firms, payers and other organizations that license our Quality Ratings Suite of
products  Hospital Quality Guide, Physician Quality Guide, Nursing Home Quality Guide and Home
Health Quality Guide. This information can be customized so that, for example, an employee can be
provided with online access to quality data relating to healthcare providers within the provider
network available under the employees health plan. We have entered into strategic arrangements with other service providers, including Ingenix
and J.D. Power and Associates, in an effort to increase our name recognition and market presence,
enhance our service offerings and increase the distribution of our products. Healthcare Provider Quality Information We compile comprehensive information regarding various healthcare providers and distill the
information to meet the requirements of consumers, employers, payers and other customers. While we
provide certain information for no charge on our website, we charge users for more detailed
information. Our revenues are generated, in part, through the provision of healthcare information
derived from our database in a manner that can be useful to consumers, employers, benefits
consulting firms, payers and others. The www.healthgrades.com website is a comprehensive healthcare information website that
provides rating and other profile information regarding a variety of providers and facilities. Our
goal is to provide comprehensive and objective healthcare ratings and profiles to assist consumers
in making informed decisions regarding their familys health. Hospital Specialty and Programmatic Ratings We currently provide risk-adjusted hospital
quality ratings in twenty-eight procedures/diagnoses. For twenty-six procedures/diagnoses,
including, among others, coronary bypass surgery, acute myocardial infarction (heart attack),
stroke, total knee or hip replacement and back and neck surgery, the risk adjustment is based upon
our methodology. For Gastrointestinal Procedures and Surgeries and Respiratory Failure, the risk
adjustment is based upon methodology developed by 3M Corporation. In addition, users can compare
hospitals utilizing our programmatic ratings for obstetrics and womens health. We have termed
these programmatic ratings as our obstetrics ratings, and our womens health ratings, which include our obstetrics ratings, are also based upon the presence or absence in a hospitals obstetric program, of certain features
as further described below, and not solely on 3




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mortality or complication
rates at a discrete procedure/diagnosis level as our other ratings are. Our
programmatic ratings are currently available in the sixteen states that provide us with all-payer
data, as further described below. In general, all ratings are updated each fall other than our
programmatic ratings, which typically are updated every spring. For each particular diagnosis or procedure chosen by the user, other than those relating to
obstetrics and womens health, we provide a rating system of five stars, three stars or one star
(five stars is the highest rating; one star is the lowest) for virtually every hospital in the
United States. We base all of our ratings, except ratings on obstetrics and womens health, on
three years of MedPAR (Medicare Provider Analysis and Review) data that we purchase from the
Centers for Medicare and Medicaid Services (formerly Health Care Financing Administration), known
as CMS. The MedPAR database contains the inpatient records of all Medicare patients. We apply
proprietary algorithms to the MedPAR data to account for variations in risk in order to make the
data comparable from hospital to hospital. In the initial analysis of the data, a separate data set
is created for each group of patients having a specific procedure or diagnosis (e.g., coronary
bypass surgery, total hip replacement), based on ICD-9-CM coding. The ICD-9-CM (International
Classification of Diseases, Clinical Modification) is the official system of assigning codes to
diagnoses and procedures associated with hospital utilization in the United States. The ICD-9 is
used to code and classify mortality data from death certificates. Each group of patients is
defined by using the information on diagnoses and procedures coded in the patient records. The
quality measure for some procedures or diagnoses is mortality, while the quality measure for others
is major complications. Generally, approximately 75% to 80% of hospitals studied are classified as three stars. The
three star rating is applied when there is no difference, statistically speaking, between a
hospitals predicted and actual performance. Approximately 10% to 15% of hospitals are rated five
stars, which means that their performance is statistically better than expected. Approximately 10%
to 15% of hospitals are rated one star, meaning that their performance was statistically worse than
expected. For our obstetrics ratings, which also are subject to the five star rating system, we use
state all-payer files from 16 individual states derived from the inpatient records of persons who
utilize hospitals in those states. The 16 states represented on the site are:
California, Florida, Iowa, Maine, Maryland, Massachusetts, Nevada, New Jersey, New York, North
Carolina, Pennsylvania, Texas, Utah, Virginia, Washington, and Wisconsin. This data represents all
discharges for the 16 states over a three-year period set from 2000-2002. We analyzed several
factors, such as volume of vaginal and cesarean delivery complications, for each hospital within
the 16 all-payer states. We then developed a system that assigned a weight to each factor based on
its importance to the quality of obstetric care. Based upon the application of this system, the
top 15% of hospitals (in the 16 states) receive five stars, the middle 70% receive three stars and
the bottom 15% receive one star. For the womens health ratings, which are also subject to the five star rating system, we use
state all-payer files from the same 16 individual states referenced for our obstetrics ratings.
These ratings are based upon outcomes in obstetric services and cardiac/stroke mortality outcomes
for women. The top 15% of hospitals (in the 16 states) receive five stars, the middle 70% receive
three stars and the bottom 15% receive one star. Institutional and Service Line Hospital Awards- We recognize exceptional quality outcomes at
an institutional level (e.g. hospital clinical excellence and patient safety) as well as at service
line level. Hospitals that achieve distinction from us for their exceptional quality outcomes
receive our Distinguished Hospital Award for Clinical Excellence(DHA-CE). This is an annual
distinction that is typically announced at the beginning of each calendar year. For our 2005 award
year, we segregated hospitals between teaching and non-teaching. For a teaching hospital to be
considered for the DHA-CE, a hospital is required to have an average overall star rating of at
least 3.3, total number of cases for HealthGrades related procedures of at least 5,000 and
inhospital mortality or major complication rating in at least 23 of the 28 procedures/diagnoses
that we rate using MedPAR data. For a non-teaching hospital to be considered for the DHA-CE, a
hospital is required to have an average overall star rating of at least 3.3, total number of cases
for HealthGrades related procedures of at least 4,000 and inhospital mortality or major
complication rating in at least 21 of the 28 procedures/diagnoses that we rate using MedPAR data. Nationwide, 229 hospitals received the DHA-CE designation in 2005. In 2004 we also released our first annual Distinguished Hospital Award for Patient Safety
(DHA-PS). This distinction is based on thirteen of the Agency for Healthcare Research and
Qualitys Patient Safety Indicators (including, among others, post-operative hip fracture,
post-operative hemorrhage or hematoma and post-operative sepsis) and recognizes exceptional
experience regarding the number and type of patient safety incidents within a hospital. In order
to achieve distinction, hospitals had to meet the following additional criteria:  
    Have an average overall HealthGrades star rating of at least 2.5; and 4




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
    Have a HealthGrades star rating in a minimum number of procedures/diagnoses as follows:  
    21 out of 26 procedures/diagnoses for teaching hospitals
    20 out of 26 procedures/diagnoses for non-teaching hospitals Recipients of the DHP-PS are in the top 7.5% of all hospitals considered. Nationwide, 48 teaching hospitals and 40 non-teaching hospitals received the DHA-PS designation in
2004. In January 2005 we released our first annual Specialty Excellence Awards. Hospitals with
specialty practices in cardiac, orthopedic, vascular, pulmonary, stroke, gastrointestinal care or
critical care ranked in the top ten percent in the nation received this distinction. Physician Quality Information- We provide quality information on over 620,000 physicians.
This information includes, to the extent available through our data sources, primary and secondary
specialty areas, medical school attended, years since medical school, address, telephone number,
board certification, hospital affiliation and federal or state medical board sanction information.
This data is compiled from a variety of public and private data sources. As not all physician
information is identified by a specific physician identifier (e.g. Unique Physician Identification
Number, or UPIN), we have developed an extensive matching process to ensure that we properly match
the various data elements that we compile from numerous data sources to the appropriate physician. Nursing Home Ratings- We provide ratings of the performance of nursing homes across the
United States that are Medicare or Medicaid certified and active in these programs. These ratings
are typically updated on a monthly basis. In preparing the ratings, we analyze licensing survey
data from CMSs Online Survey Certification and Reporting (OSCAR) database and complaint data from
CMSs Skilled Nursing Facility (SNF) Complaint database. Licensing surveys are inspections that
assess compliance with standards of patient care such as staffing, quality of care and cleanliness.
Complaint surveys are investigations of complaints and serious problems. Nursing homes whose most
recent survey date was more than 20 months prior to the date the data was received by HealthGrades
are not included in the analysis. Stand-alone Medicare and/or Medicaid nursing homes are analyzed
apart from Medicare, hospital-based nursing homes. We do not rate Medicare, hospital-based nursing
homes because these facilities are designed for short-term patient care. In addition, nursing homes
with only one licensing survey are not included in our analysis. The ratings are assigned on a
state by state basis, rather than nationally, because the surveys from which information is derived
are conducted by state agencies, and there may be variations between the states survey processes
and results. The best 30% of nursing homes receive five stars, and the middle 40% of nursing homes
receive three stars. Information and Related Services for Hospitals, Employers, Consumers, Benefits Consulting Firms,
Payers and Professionals The information provided on our www.healthgrades.com website, and the database from which this
information is derived, forms the basis of our marketing efforts. While certain information is
provided free of charge on our website, we seek to generate revenues from hospitals, as well as
employers, consumers and others as described below: Services for Hospitals- We offer programs that provide business development tools and marketing
assistance for hospitals seeking to distinguish themselves with respect to their clinical quality.
We also provide client-focused consulting services and analytical products for hospitals seeking to
understand and improve their quality. Our programs primarily cover the following clinical service
lines:  
    Cardiac;
    Orthopedics;
    Vascular;
    Pulmonary;
    Neurosciences;
    Gastrointestinal;
    Critical care;
    Obstetrics; and
    Womens health. 5




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SQI Program. We offer our SQI (Strategic Quality Initiative) program to highly rated
providers only after our ratings are completed; we do not adjust our ratings based on whether a
provider is willing to license with us. The SQI program provides business development tools to hospitals that are highly rated by us.
Under our SQI program, we license the commercial use of the HealthGrades corporate mark, applicable
data and multiple marketing messages that may be used by hospitals to demonstrate third party
validation of excellence, including:  
    HealthGrades name, logo, stars and current ratings data including performance score
    National designation (e.g., Top 5% in the Nation, Top 10% in the Nation) as applicable;
    Specialty Excellence Award for a licensed service line as applicable;
    State rank (i.e., Best in State, Best in Region) as applicable (not available for obstetrics or womens health);
    Marketing messages developed and approved by HealthGrades; and
    Ratings comparisons developed and approved by HealthGrades. The license may be in a single service line (for example, Cardiac) or multiple service lines
(for example, Cardiac, Neurosciences and Orthopedics). In addition, the SQI program provides
ongoing access to HealthGrades marketing service and resources, including our in-house healthcare
consultants, tailored to the hospitals specific needs. In addition, our QAI (Quality Assessment and Improvement)-I program, described below, is made
available to a hospital that has purchased our SQI program with respect to the areas covered by the
SQI program. Our in-house healthcare consultants also provide certain onsite consulting services. QAI-I Program. We also assist hospitals in measuring the success of their quality
efforts generally utilizing our in-house healthcare consultants. Whether purchased as a stand-alone
product, or as part of the SQI program, the QAI-I program involves our provision of an on-site
presentation to administrative, physician and quality improvement staff, including a detailed,
quality analysis and report of the last three years of clients Medicare data within the service
areas licensed by the hospital. This analysis includes:  
    National and Five Star performer benchmarks;
    Analysis of the hospitals annual actual and predicted outcome data;
    Risk adjusted analysis and comparison of hospitals documented and coded risk factors;
    Risk adjusted analysis and comparison of hospitals documented and coded complications; and
    Summary analysis presenting key observations and recommendations for overall improvement. Quality Report for Hospital Professionals  Clinical Service Line. We provide
hospitals with a comprehensive report that enables them to improve quality of care by benchmarking
their outcomes against national five-star hospitals and local competitors, detailing the strengths
and weaknesses of their public quality profile and analyzing their quality data underlying their
specific star ratings. Quality Report for Hospital Professionals  Patient Safety. We analyze hospitals
performance within thirteen patient safety indicators established by the Agency of Healthcare
Research and Quality (AHRQ), compares their performance against the best practice benchmark, the
national average and their state average and details the strengths and weaknesses of their public
safety profile. QAI-II Program. Our QAI-II program is principally designed to help a hospital improve
the quality of its care in particular service lines. Using our database and on-site interviews, we
can measure how well the hospital performs relative to national and regional best practices and
help identify measures to improve quality. Detailed quality comparisons are also available at the
hospital, physician group and individual physician level. Our physician-led consultants work
on-site with the hospital staff and physicians to present the data and assist in the quality
analysis and quality improvement. Under our QAI-II program, with respect to the areas licensed by
the hospital, we will provide services including, but not limited to, the following: periodic
onsite visits; detailed analysis of the last 2 years of clients all-payer data; and individual
quality profiles for high volume physicians. Distinguished Hospital Award Program for Clinical Excellence (DHP-CE). The DHP-CE
recognizes clinical excellence in hospitals across our range of service lines. Hospitals that
contract with us for DHP-CE services receive all of the SQI features described above with respect
to their licensed service areas. In addition, hospitals can reference the additional Distinguished
Hospital Award designation. Hospital clients are provided with additional marketing and planning
assistance with respect to the Distinguished Hospital Award designation as well as a trophy for
display at the hospital. This program was initially developed in conjunction with J.D. Power and
Associates, as described below under, Arrangements with Other Service Providers. 6




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During 2003 and prior years, as part of our DHP-CE and SQI programs, we provided certain
exclusivity rights for client hospitals. In most cases, for the particular service lines subject
to license by our hospital clients, we agreed not to provide similar marketing services to a
maximum of three hospitals selected by the client. However, we did not remove ratings of an
excluded hospital from our website or change the ratings in any way. Beginning in January 2004,
we no longer offer exclusivity under our contracts. For hospitals that signed agreements with us
during 2003 and prior years, we will continue to honor the exclusivity provisions in their
contracts solely for the remaining term of the agreement. As our agreements are typically three
years (with the ability to terminate on an annual basis), we anticipate that all exclusivity
provisions will expire by the end of 2006. Distinguished Hospital Award Program for Patient Safety (DHP-PS). The DHP-PS
recognizes hospitals with the best patient safety records in the nation. This award recognizes
exceptional outcomes based on thirteen patient safety indicators from the AHRQ. Under our DHP-PS
program, we license the commercial use of the HealthGrades corporate mark, applicable data and
marketing messages that may be used by hospitals to demonstrate third party validation of
excellence, including:  
    HealthGrades name
    HealthGrades logo
    Distinguished Hospital Award for Patient Safety (DHA-PS) designation and trophy for that year.
    Marketing messages developed by HealthGrades Additional Services for Employers, Benefits Consulting Firms, Payers and OthersWe license access to, and
customize our database for, employers, benefits consulting firms, payers and others. Modules
currently available for license are as follows:  
    Hospital Quality Guide
    Physician Quality Guide
    Nursing Home Quality Guide
    Home Health Quality Guide We offer our customers these modules in a standard format without customization for specific
geographic areas or provider networks, through our SmartChoice product. Customers can integrate
our modules within their online provider directories and we can customize our database for specific
geographic areas and provider networks as well as modify the look and feel of the modules through
our Quality Ratings Suite (QRS) product. As noted below, we have entered into an arrangement
with Ingenix, which provides for the marketing of our QRS product to managed care organizations,
payers, employers and benefit management companies. Through this arrangement, our provider quality
data can be combined with in- or out-of-network indicators so that users can search for healthcare
providers within the provider networks available under their current health plans. Depending on
the clients needs, we can customize our content for the intended users. Some of the healthcare
quality information available to our customers and their users within our modules are as follows: Hospital Quality Guide  
    Easy-to-understand star ratings by procedure or diagnosis and by service line based on risk-adjusted outcome measures;
    Consumer-friendly navigation and terminology;
    Cost, length of stay, procedure volume and distance to facility;
    Hospital profile information; and
    The Leapfrog Group (described below) safety measures. Physician Quality Guide  
    Addresses and phone numbers;
    State and federal sanction information (if any) within the last 5 years;
    Board certification;
    Years since medical school;
    Gender;
    Foreign languages; and
    Ratings of affiliated hospitals (hospitals for which the physician has privilages). 7




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Nursing Home Quality Guide  
    Overall star rating based on comparison to other facilities within the state;
    Details of the last four licensing surveys;
    Complaint investigations;
    Repeat violations; and
    State averages for violations and inspections. Home Health Quality Guide  
    Overall star rating based on comparison to other home health agencies within an individual state;
    Licensing survey deficiencies;
    Complaint investigations; and
    Repeat violations. Healthcare Quality Reports for Professionals- We offer comprehensive quality information to
organizations in need of current and historical quality information on nursing homes and hospitals.
In addition, we offer reports on physicians that contain detailed information with respect to
education, professional licensing history and other items. Nursing Home Quality Reports for Professionals- Our primary customers for our Nursing Home
Quality Reports for professionals are medical professional liability underwriters and other
organizations. We currently offer the following three categories of reports on nursing homes:
Nursing Home Quality Report; Executive Summary Reports and Risk Assessment Report. Our Nursing
Home Quality Report for Professionals contains detailed information on ownership, certification
history, staffing and patient demographics as well as performance and ranking data from health,
state complaint and licensing surveys. Our Executive Summary Report is a three-page report, which
summarizes this information. Our Risk Assessment Report is a two to three page textual analysis of
the Nursing Home Quality Report that highlights potential problem areas within a facility that
require risk management. Hospital Reports for Professionals- Our Hospital Reports contain detailed information on
ownership, services provided and clinical performance outcomes. Some of the features of our reports
include:  
    Risk and severity-adjusted performance measures for cardiac, neurosciences, stroke,
vascular, orthopedics and pulmonary service lines (as well as the underlying
procedures/diagnoses for each service line);
    Programmatic ratings for womens health and obstetrics;
    Comparative statistics and state/national benchmarks;
    Infections, complication and mortality rates; and
    Cases At Risk analysis, which projects how many cases are likely to have adverse
outcomes based upon our proprietary mortality or complication rate analysis. Physician Reports for Professionals  Our Physician Reports contain detailed information on a
physicians demographics, which include:  
    Education history;
    Professional licensing history;
    Board certifications;
    State medical board and Medicare sanction history;
    Hospital and health plan affiliations; and
    Our quality ratings for each hospital with which the physician is affiliated. We also offer credit reports and civil and criminal records checks in separate reports. Healthcare Quality Reports for Consumers- We offer comprehensive quality information to consumers
that provides current and historical quality information on hospitals and nursing homes. In
addition, we offer reports on physicians that contain detailed information with respect to
education, professional licensing history and other items. 8




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Hospital Quality Reports for Consumers- Our Hospital Quality Reports for Consumers include:  
    Ratings for all procedures and diagnoses rated by HealthGrades for the hospital;
    Survey data prepared in connection with the Leapfrog Group; and
    HealthGrades methodology and helpful hints for choosing a hospital. Nursing Home Quality Reports for Consumers- Our Nursing Home Quality Reports for Consumers include:  
    Our rating for the particular nursing home;
    Health survey history with descriptions and severity of the deficiencies for the last four licensing surveys;
    Instances of repeated deficiencies;
    How the nursing home compares to others in the state; and
    Our methodology and helpful hints for choosing a nursing home. Physician Quality Reports for Consumers- Our Physician Quality Reports for Consumers include:  
    Addresses and phone numbers;
    Board certification information;
    Education information;
    State and federal sanction information (if any) within the last 5 years;
    Name and address of area hospitals;
    Gender and age;
    National comparative statistics in board certification and sanction activity regarding
physicians in the same specialty field; and
    Information on how to choose a physician with a checklist and guide. Arrangements with Other Service Providers We have entered into arrangements with other service providers in an effort to increase our
name recognition and market presence, as well as enhance our service offerings. The following is a
summary of our current arrangements for the provision of joint product offerings. Distinguished Hospital Program with J.D. Power and Associates. In August 2002, we entered
into an agreement with J.D. Power and Associates to offer a Distinguished Hospital Program, which
is designed to validate and recognize hospitals that perform at notably high levels utilizing J.D.
Power and Associates customer satisfaction data and HealthGrades clinical quality data. Under
this program, hospitals may be concurrently or separately recognized and awarded for exceptional
clinical performance and for the provision of an outstanding patient experience. The first
component of this program, clinical excellence recognition, is provided by HealthGrades and
developed thorough detailed, risk-adjusted analysis of patient outcomes (described above under,
Information and Related Services for Hospitals, Employers, Consumers, Benefits Consulting Firms,
Payers, and Professionals  Distinguished Hospital Award Program for Clinical Excellence (DHP-CE). The second component of the program, service excellence recognition, is provided by J.D. Power and
Associates and is obtained by surveying a random sample of patients who have recently experienced a
hospital stay and comparing the results with those from a nationally representative patient
experience study. The Distinguished Hospital Program offers hospitals that receive recognition the
ability to enter into a license agreement to reference the awards in future advertising and
marketing efforts. To enhance the visibility, understanding and appreciation of the available
awards, HealthGrades and J.D. Power and Associates provide the following support:  
    onsite strategic marketing and communication consulting;
    advertising and press release samples; and
    electronic artwork; Ingenix/HealthGrades Quality Rating Suite. We have entered into an arrangement with Ingenix,
Inc., to market our Quality Ratings Suite (described above under Additional Services for
Employers, Benefits Consulting Firms, Payers and Others) to managed care organizations, payers,
employers and benefits consulting firms through Ingenix sales and marketing teams. Ingenix 9




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provides much of the physician data included in our Quality Ratings Suite, which combines
access to HealthGrades quality ratings and The LeapFrog Group Patient Safety Survey information.
(The Leapfrog Group, a consortium of more than 90 Fortune 500 companies and other large private and
public healthcare purchasers, began a national effort in November 2000 to reward hospitals for
advances in patient safety and to educate employees, retirees, and families about the importance of
hospitals efforts in this area. The Leapfrog Groups Survey assesses the extent to which urban,
acute care hospitals in selected regions of the U.S. currently meet or are striving to implement
three patient safety practices: Computer Physician Order Entry, Evidence-Based Hospital Referral
and ICU Physician Staffing.) In addition, under the Ingenix/HealthGrades Quality Rating Suite,
customers are offered project management, information technology, user support and communications
services (for example, information for users of the Ingenix/HealthGrades Quality Rating Suite and
instructions on how to access the information). The Quality Rating Suite also includes the
following features:  
    links to HealthGrades Hospital Quality Guide from Ingenix online physician and hospital directories;
    risk severity adjusted mortality/complication rates by procedures/diagnoses;
    hospital comparison tools;
    search by geography, procedure/diagnoses and consumer preference (e.g., the consumer can
place more importance on the distance to travel if desired);
    downloadable hospital quality reports;
    nursing home ratings;
    physician profiles and sanction information; and
    additional customization (client designed user interface or additional data, such as state hospital data) Typically, Ingenix will add the HealthGrades QRS functionality to services available to its
existing clients who license Ingenix provider lookup online application. An additional licensing
fee is charged, of which a portion is payable to us, with Ingenix retaining the remaining part of
the fee. We only recognize the fees that will ultimately be paid to us as revenue from Ingenix,
and not the entire amount of the licensing fee. We recognize revenues related to these agreements
in a straight-line manner over the term of the agreement. Competition With respect to our quality services for hospitals, we face competition from data providers,
such as Solucient and healthcare consulting companies such as GE Medical Systems and Premier that
offer certain consulting services to hospitals. We believe that the ability to demonstrate the
value of marketing and consulting programs, name brand recognition and cost are the principal
factors that affect competition. We face competition with respect to our service offerings to employers, benefits consulting
firms, payers, consumers and others from companies that provide online information and decision
support tools regarding healthcare providers and physicians. There are several companies that
currently offer online healthcare information and support tools such as Subimo and HealthShare
Technologies (recently acquired by WebMD). We believe that the ability to provide accurate and
comprehensive healthcare information in a manner that is cost-effective to the client is the
principal factor that affects competition in this area. We face competition on our nursing home quality reports with companies such as CareScout,
which provide ratings of nursing homes and charge professionals and consumers for this information. Company History We were incorporated in Delaware in December 1995 under the name Specialty Care Network, Inc.
Upon commencement of operations in 1996, we were principally engaged in the management of physician
practices engaged in musculoskeletal care, which is the treatment of conditions relating to bones,
joints, muscles and connective tissues. Due to difficulties in the physician practice management
industry in general, and with respect to our affiliated physician practices in particular, we
terminated or restructured our arrangements with various physician practices. As a result, the
scope of our physician practice management business became increasingly limited in subsequent
years, particularly after a restructuring of our arrangements with nine practices in June 1999, and
ceased entirely in September 2002. 10




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During 1998, we began to focus on the provision of healthcare information through the
establishment of our healthcare provider quality ratings and profile information, which we first
introduced on our website. Since that time, we have expanded the scope of our healthcare
information services to encompass the additional services described above. In January 2000, we changed our name to Healthgrades.com, Inc. In November 2000, we changed
our name to Health Grades, Inc. Government Regulation The delivery of healthcare services has become one of the most highly regulated of
professional and business endeavors in the United States. Both the federal government and the
individual state governments are responsible for overseeing the activities of individuals and
businesses engaged in the delivery of healthcare services. The focus of Federal regulation of
healthcare businesses and professionals is based primarily upon their participation in the Medicare
and Medicaid programs. Each of these programs is financed, at least in part, with Federal funds.
State jurisdiction is based upon its financing of healthcare as well as the states authority to
regulate and protect the health and welfare of its citizens. A provision of the federal Social Security Act, commonly known as the Medicare/Medicaid
Anti-Kickback Law, prohibits kickbacks, rebates and bribes in return for referrals. This law
provides an extremely broad base for finding violations. Indeed, any remuneration, direct or
indirect, offered, paid, solicited, or received, in return for referrals of patients or business
for which payment may be made in whole or in part under Medicare, or a state healthcare program
(Medicaid) could be considered a violation of law. The language of the Anti-Kickback Law also
prohibits payments made to anyone to induce them to recommend purchasing, leasing, or ordering any
good, facility, service, or item for which payment may be made in whole or in part by Medicare.
Criminal penalties under the Anti-Kickback Law include fines up to $25,000, imprisonment for up to
5 years, or both. In addition, acts constituting a violation of the Anti-Kickback Law may also lead to civil penalties,
such as fines, assessments and exclusion from participation in the Medicare and Medicaid programs. To provide more direct guidance on the interpretation of the Anti-Kickback Law, the Office of
Inspector General, or OIG, of the Department of Health and Human Services (DHHS) has developed
regulations regarding what types of business arrangements are not to be considered violative of the
law and to develop criteria to be applied to any new arrangement to determine whether it is
acceptable under the law. The regulations are known as Safe Harbors and address activities that
may technically violate the Anti-Kickback Law, but are not to be considered as illegal when carried
on in conformance with the proposed regulation. The OIG has also set forth specific procedures by
which the DHHS, through the OIG, in consultation with the Department of Justice (DOJ), will issue
advisory opinions to outside parties regarding the interpretation and applicability of
anti-kickback and certain other statutes relating to Federal and State healthcare programs. Whenever an arrangement exists with an entity capable of providing services reimbursed by
Medicare or Medicaid, the arrangement must be analyzed to determine if the Anti-Kickback Law is
implicated (i.e., can the arrangement be characterized as involving remuneration intended to induce
referrals for the provision of covered services). Because our customers will, in some instances,
be healthcare providers, we must be mindful of state and federal anti-kickback laws; that is, we
want to be sure that any payments to us will not be considered a payment for a referral of patients
or business that HealthGrades controls. The only payments made to us by providers and practitioners will be for access to information,
evaluation and consulting services, not to induce referrals. Federal courts have interpreted the
anti-kickback provisions very broadly to prohibit even those payments made in return for legitimate
services, if the intent to induce referrals can be inferred from the arrangement. However, where
the payments made under an agreement represent fair market value or reasonable remuneration for the
goods, services or other consideration being received, there should be less factual support for any
inference that payments are in exchange for referrals. Moreover, HealthGrades does not control
patients, doctors, or others in a position to refer patients or other business covered under
Medicare or Medicaid. There is a potential that our arrangements could be brought within the personal services and
management agreement safe harbor regulation. The personal services and management agreement safe
harbors provide that payments under such agreements will not constitute remuneration under the
Anti-Kickback Law if the payments meet seven criteria, including that the agreement is set out in
writing and is signed by the parties, and that aggregate compensation is set in advance, is
consistent with fair market value and does not take into account the volume or value of any
referrals or business generated between the parties. Unless an arrangement meets all of the terms
of a safe harbor, the government could attempt to draw an inference that payments made constitute
remuneration and that at least one purpose of the remuneration is to induce referrals. However,
failure to meet the safe harbors does not render an arrangement per se unlawful. We believe that
our operations comply with applicable legal regulatory requirements of the Anti-Kickback Law.
However, some of these laws have been applied to payments by physicians for marketing and referral
services and 11




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could constrain our relationships, including financial and marketing relationships with
customers such as hospitals. It is possible that additional or changed laws, regulations or
guidelines could be adopted in the future that could affect our business. Many state have laws that prohibit payment of kickbacks or other payment of remuneration to
those in a position to control the referral of patients. Therefore, it is possible that our
activities may be found not to comply with these laws. Noncompliance with such laws could subject
us to penalties and sanctions. Nonetheless, to our knowledge, we are not in violation of any legal
requirements under such state laws. In addition to the anti-kickback laws, false claims are prohibited pursuant to federal
criminal and civil statutes. Criminal provisions prohibit knowingly filing false claims, making
false statements or claims to be made by others. Civil provisions prohibit the filing of claims or
causing the filing of claims that the person filing knew were false. Criminal penalties include
fines and imprisonment. Civil penalties include fines up to $10,000 per claim, plus treble
damages, for each claim filed. Although we are not filing claims ourselves, liability under the statutes can extend to those
who cause the filings of claims. To the extent that consulting advice provided to our customers
could be construed as aiding or abetting the presentation of false claims by our customers, there
could be false claims liability, although we endeavor to provide advice that cannot be so
construed. Healthcare Legislation. It is our belief that the Medicare Prescription Drug Improvement and
Modernization Act of 2003 has not had a major impact on our
arrangements with providers. Future legislation may be introduced and considered by Congress and
state legislatures that is designed to change access to and payment for healthcare services in the
United States. We can make no prediction as to whether future legislation will be enacted or, if
enacted, the effect that such legislation will have on us. Privacy of Information and HIPAA Consumers sometimes enter private information about themselves or their family members when
using our services. Also, our systems record use patterns when consumers access our databases that
may reveal health related information or other private information about their user. In addition,
information regarding employee usage of healthcare providers and facilities can also be compiled by
our systems in connection with services we offer to employers and other payers. Numerous federal
and state laws and regulations govern collection, dissemination, use and confidentiality of
patient-identifiable health information, including:  
    state privacy and confidentiality laws;
    state laws regulating healthcare professionals, such as physicians, pharmacists and nurse practitioners;
    Medicaid laws;
    the U.S. Health Insurance Portability and Accountability Act of 1996, or HIPAA, as
described in detail below, and related rules proposed by the Health Care Financing
Administration; and
    CMS standards for electronic transmission of health data Under HIPAA, Congress set national standards for the protection of health information. Under
the law, and regulations known collectively as the Privacy Rule, covered entities must implement
standards to protect and guard against the misuse of individually identifiable health information. We believe that we have
complied with the applicable standards. Failure to timely implement these standards may, under
certain circumstances, trigger the imposition of civil or criminal penalties. The Privacy Rule does not replace federal, state, or other law that grants individuals even
greater privacy protections, and covered entities are free to retain or adopt more protective
policies or practices. By law, the Privacy Rule applies only to covered entities  healthcare plans, clearinghouses,
and providers. As such, we are not a covered entity. However, most healthcare providers and payers
do not carry out all of their healthcare activities and functions by themselves. Instead, they
often use the services of a variety of other persons or businesses. The Privacy Rule allows covered
entities to disclose protected health information to business associates if the covered entities
obtain satisfactory assurances that the business associate will use the information only for the
purposes for which it was engaged, will safeguard the information from misuse, and will comply
with certain other requirements under the Privacy Rule. Although HealthGrades is not a covered
entity, it may be asked to enter into business associate agreements with covered entities. 12




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Covered entities may disclose protected health information to an entity in its role as a
business associate onlyto help the covered entity carry out its healthcare functions  not for the
business associates independent use or purposes, except as needed for the proper management and
administration of the business associate. If a covered entity finds out about a material breach or violation of the privacy related
provisions of the contract by the business associate, it must take reasonable steps to cure the
breach or end the violation, and, if unsuccessful, terminate the contract with the business
associate. If termination is not feasible (e.g., where there are no other viable business
alternatives for the covered entity), the covered entity must report the problem to the Department
of Health and Human Services Office for Civil Rights. Government Regulation of the Internet Any new or revised law or regulation pertaining to the Internet, or the application or
interpretation of existing laws and regulations, could decrease demand for our services, increase
our cost of doing business, decrease the availability of the data we obtain and use from third
parties, increase the costs of online marketing, or otherwise cause our business to suffer. Laws and regulations have been adopted in the United States and throughout the world, and
additional laws and regulations may be adopted in the future, that address Internet-related issues,
including online content, privacy, online marketing, unsolicited commercial e-mail, pricing and
quality of products and services. This legislation could increase our cost of doing business and
negatively affect our business. Moreover, it likely will take many years to determine the extent to
which older laws and regulations governing issues like property ownership, libel, negligence taxes,
and personal privacy are applicable to the Internet. Currently, U.S. privacy law consists of numerous disparate state and federal statutes
regulating specific industries that collect personal data, or particular types or uses of personal
data. For example, HIPAA consists of a large body of statutory provisions and regulations that
control the disclosure, use, and transfer of personal health information in digital form by
providers and others. Several other privacy laws and regulations predate and therefore do not
specifically address online activities. In addition, a number of comprehensive legislative and
regulatory privacy proposals have taken effect or are now under consideration by federal, state and
local governments in the United States. All such privacy laws may decrease access to the raw data
that we use, and may increase our costs of compliance with such laws and regulations in the conduct
of our business. Intellectual Property We regard the protection of our intellectual property rights to be important. We rely on a
combination of copyright, trademark and trade secret restrictions and contractual provisions to
protect our intellectual property rights. We require selected employees to enter into
confidentiality and invention assignment agreements as well as non-competition agreements. The
contractual provisions and other steps we have taken to protect our intellectual property may not
prevent misappropriation of our technology or deter third parties from developing similar or
competing technologies. We own federal trademark registrations for the marks HEALTHGRADES and THE HEALTHCARE QUALITY
EXPERTS. There is also significant uncertainty regarding the applicability to the Internet of existing
laws regarding matters such as property ownership and other intellectual property rights. The vast
majority of these laws were adopted prior to the advent of the Internet and, as a result, do not
contemplate or address the unique issues of the Internet and related technologies. In addition,
new laws that regulate activities on the Internet have been passed and may be passed, which may
have unanticipated effects. For further information, see Risk Factors  Our propriety rights may not be fully protected,
and we may be subject to intellectual property infringement claims by others. Employees As of December 31, 2004 we had 67 employees, most of whom were located at our corporate
offices in Denver, Colorado. Of these employees, 25 were engaged in sales and marketing, client
consulting or client administrative support, 27 in product development (including information
technology/web development) and 15 in general and administrative (including finance, accounting, IT
infrastructure, etc.). We are not subject to any collective bargaining agreements. 13




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RISK FACTORS Risks Related to Our Business OUR HEALTHCARE INFORMATION BUSINESS DOES NOT HAVE A SUBSTANTIAL HISTORY OF PROFITABILITY AND MAY
NOT CONTINUE TO BE PROFITABLE. We began developing our healthcare information business in 1998. For the year ended December
31, 2004, all of our operations related to this business. Our income from operations was
approximately $1.8 million for the year ended December 31, 2004, which was our first year of
profitability for our healthcare information business. Our business model assumes that consumers
will be attracted to and use the healthcare ratings and profile information and related content
available on our website, which will, in turn, enable us to license access to our quality
information to hospitals and other providers. In addition, our business model assumes that
employers, payers, insurance plans, consumers and other potential customers will seek our
healthcare information to help increase the quality and reduce the cost of healthcare. While we are
encouraged by our recent performance, our business model is not yet proven, and we cannot assure
you that we will sustain profitability. OUR BUSINESS WILL SUFFER IF WE ARE NOT ABLE TO OBTAIN RELIABLE DATA AS A BASIS FOR OUR HEALTHCARE
INFORMATION. To provide our healthcare information, we must be able to receive comprehensive, reliable
data. We currently obtain this data from a number of public and private sources. Currently, the
information we utilize to compile our hospital ratings is acquired from CMS. For the year ended
December 31, 2004, revenues derived from DHP, SQI, and QAI products accounted for approximately 76%
of our total ratings and advisory revenue. These products are based exclusively on our hospital
ratings. Moreover, some of our SmartChoice and QRS modules are based on information acquired from
CMS. Our business could suffer if some of our data sources, particularly, CMS, were to begin
charging for use or access to this data, or cease to make such information available, and suitable
alternative sources are not identified on a timely basis. Moreover, our ability to attract and
retain customers is dependent on the reliability of the information that we use and purchase. If
our information is inaccurate or otherwise erroneous, our reputation and customer following could
be damaged. In the past, we have had disputes with two providers of information who sought to
terminate our arrangements based on allegations, which we denied, that our use of the information
violated the terms of our agreements with the providers. We have located alternate sources of
information or modified the scope of information provided in response to these disputes.
Nevertheless, our failure to obtain suitable information, if needed to use in place of information
provided by a source that determines to stop providing information, or which charges substantially
more for such data, could hurt our business. FAILURE TO EFFECTIVELY MANAGE THE GROWTH OF OUR OPERATIONS AND INFRASTRUCTURE COULD DISRUPT OUR
OPERATIONS AND PREVENT US FROM MAINTAINING OR INCREASING PROFITABLITY We are currently in an expansion mode and are seeking to increase our sales efforts, attract
new clients, maintain existing clients and develop new products. To manage our growth, we must
successfully attract qualified personnel to serve all areas of our business and successfully
integrate new personnel into our operations. Our failure to manage personnel and otherwise
appropriately manage expansion of our business could adversely affect our business and future
growth. WE MAY BE SUED FOR INFORMATION WE OBTAIN OR INFORMATION RETRIEVED FROM OUR WEBSITES OR OTHERWISE
PROVIDED TO EMPLOYERS AND OTHERS. We may be subjected to claims for defamation, negligence, copyright or trademark or patent
infringement, personal injury or other legal theories relating to the information we publish on our
websites or otherwise provide to customers. These types of claims have been brought, sometimes
successfully, against online services as well as print publications in the past. We have received
threats from some providers that they will assert defamation and other claims in connection with
the information posted on our healthgrades.com website. We have had disputes with certain physicians with respect to the accuracy of their data that
is included in reports we sell to consumers and professionals, and have settled litigation with
some of these physicians. Continuing to improve the accuracy of our
data by both internal process measures and by obtaining data from various sources for
comparative purposes will continue to be important for us. 14




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Patients who file lawsuits against providers often name as defendants all persons or companies
with any nexus to the providers. As a result, patients may file lawsuits against us based on, among
other things, treatment provided by hospitals or other facilities that are highly rated by us, or
by doctors who are identified on our website. In addition, a court or government agency may take
the position that our delivery of health information directly, or information delivered by a
third-party website that a consumer accesses through our website, exposes us to malpractice or
other personal injury liability for wrongful delivery of healthcare services or erroneous health
information. Such exposure may adversely affect our business. Moreover, the amount of insurance
we maintain with insurance carriers may not be sufficient to cover all of the losses we might incur
from these claims and legal actions. In addition, insurance for some risks is difficult, impossible
or too costly to obtain, and as a result, we may not be able to purchase insurance for some types
of risks. IF WE DO NOT STRENGTHEN RECOGNITION OF OUR BRAND NAME, OUR ABILITY TO EXPAND OUR BUSINESS WILL BE
IMPAIRED. To expand our audience of online users and increase our online traffic and increase interest
in our other healthcare information services, we must strengthen recognition of our brand name. To
be successful in this effort, consumers must perceive us as a trusted source of healthcare
information; hospitals and other providers must perceive us as an effective marketing and sales
channel for their services and products; and employees, payers, insurers, consumers and others must
perceive us as a source of valuable information that can be used to enhance the quality and
cost-effectiveness of healthcare. We may be required to increase substantially our marketing budget
in our efforts to strengthen brand name recognition. Our business will suffer if our efforts are
not productive. OUR BUSINESS WILL SUFFER IF WE ARE UNABLE TO ATTRACT, RETAIN AND MOTIVATE HIGHLY SKILLED EMPLOYEES. Our ability to execute our business plan and be successful depends upon our ability to
attract, retain and motivate highly skilled employees when needed. We rely on the continued
services of our senior management and other personnel. As we expand our business, we need to hire
additional personnel to support our operations. We may be unable to retain our key employees or
attract or retain other highly qualified employees in the future. If we do not succeed in
attracting new personnel as needed and retaining and motivating our current personnel, our business
will suffer. WE MAY EXPERIENCE SYSTEM FAILURES THAT COULD INTERRUPT OUR SERVICES. The success of our healthgrades.com website and activities related to the website will depend
on the capacity, reliability and security of our network infrastructure. We rely on telephone
communication providers to provide the external telecommunications infrastructure necessary for
Internet communications. We will also depend on providers of online content and services for some
of the content and applications that we make available through healthgrades.com. Any significant
interruptions in our services or increase in response time could result in the loss of potential or
existing users or customers. Although we maintain insurance for our business, we cannot guarantee
that our insurance will be adequate to compensate us for losses that may occur or to provide for
costs associated with business interruptions. We must be able to operate our website 24 hours a day, 7 days a week, without material
interruption. To operate without interruption, we and our content providers must guard against:  
    damage from fire, power loss and other natural disasters;
    communications failures;
    software and hardware errors, failures or crashes;
    security breaches, computer viruses and similar disruptive problems; and
    other potential interruptions. Our website may be required to accommodate a high volume of traffic and deliver frequently
updated information. Our website
users may experience slower response times or system failures due to increased traffic on our
website or for a variety of other reasons. We could experience disruptions or interruptions in
service due to the failure or delay in the transmission or receipt of this information. Any
significant interruption of our operations could damage our business. 15




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OUR PROPRIETARY RIGHTS MAY NOT BE FULLY PROTECTED, AND WE MAY BE SUBJECT TO INTELLECTUAL PROPERTY
INFRINGEMENT CLAIMS BY OTHERS. Our failure to adequately protect our intellectual property rights could harm our business by
making it easier for our competitors to duplicate our services. We have two trademarks that have
been registered with the U.S. Patent and Trademark Office. In addition, we require some of our
employees to enter into confidentiality and invention assignment agreements and, in more limited
cases, non-competition agreements. Nevertheless, our efforts to establish and protect our
proprietary rights may be inadequate to prevent imitation of our services or branding by others or
may be subject to challenge by others. Furthermore, our ability to protect some of our proprietary
rights is uncertain since legal standards relating to the validity, enforceability and scope of
intellectual property rights in Internet related industries are uncertain and are still evolving. In addition to the risk of failing to adequately protect our proprietary rights, there is a
risk that we may become subject to a claim that we infringe upon the proprietary rights of others.
Although we do not believe that we are infringing upon the rights of others, third parties may
claim that we are doing so. The possibility of inadvertently infringing upon the proprietary rights
of another is increased for businesses such as ours because there is significant uncertainty
regarding the applicability to the Internet of existing laws regarding matters such as copyrights
and other intellectual property rights. A claim of intellectual property infringement may cause us
to incur significant expenses in defending against the claim. If we are not successful in defending
against an infringement claim, we could be liable for substantial damages or may be prevented from
offering some aspects of our services. We may be required to make royalty payments, which could be
substantial, to a party claiming that we have infringed their rights. These events could damage our
business. WE MAY LOSE BUSINESS IF HOSPITALS AND OTHERS UTILIZE OUR NAME AND RATINGS WITHOUT OUR PERMISSION In order for a hospital to use our name and ratings information, we require them to enter into
a marketing agreement with us. However, hospitals, the media and others may take the position that
certain use of our ratings is fair use and not proprietary. We will need to continue to enforce
the protection of our proprietary information and aggressively pursue hospitals and others that
utilize our name and ratings information without our permission. If our enforcement efforts are
unsuccessful, our business may be adversely affected. WE MAY LOSE BUSINESS IF WE ARE UNABLE TO KEEP UP WITH RAPID TECHNOLOGICAL OR OTHER CHANGES. If we are unable to keep up with changing technology and other factors related to our market,
we may be unable to attract and retain users or customers, which would reduce or limit our
revenues. The markets in which we compete are characterized by rapidly changing technology,
evolving technological standards in the industry, frequent new service and product announcements
and changing consumer demand. Our future success will depend on our ability to adapt to these
changes, and to continuously improve the content, features and reliability of our services in
response to competitive service and product offerings and the evolving demands of the marketplace.
In addition, the widespread adoption of new Internet networking or telecommunications technologies
or other technological changes could require us to incur substantial expenditures to modify or
adapt our website or infrastructure, which might negatively affect our ability to become or remain
profitable. WE RELY LARGELY ON ADVERTISING AND SEARCH ENGINE PLACEMENT TO GENERATE TRAFFIC TO OUR WEBSITE We rely on online media to attract a significant percentage of the visitors to our web site.
Prices for online advertising could increase as a result of increased demand for advertising
inventory, which would cause our expenses to increase and could result in lower margins. Our
advertising contracts with online search engines are typically short-term. If one or more search
engines on which we rely for advertising modifies or terminates its relationship with us, our
expenses could increase, the number of visitors we generate could decrease and our revenues or
margins could decline. Additionally, changes to our position within search engine search results
could cause visits to our website and the amount of reports ordered from our website to decline. OUR BUSINESS WILL SUFFER IF WE ARE NOT ABLE TO COMPETE SUCCESSFULLY. The market for healthcare information is new, rapidly evolving and competitive. We expect
competition to increase significantly, and our business will be adversely affected if we are unable
to compete successfully. We currently compete, or potentially compete, with many providers of
healthcare information services and products, both online and through traditional means. We
compete, directly 16




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and indirectly, for users and customers principally with:  
    data providers that provide detailed utilization and outcomes information to hospitals;
    healthcare consulting companies;
    companies or organizations providing or maintaining online healthcare information;
    vendors of healthcare information, products and services distributed through other means, including direct sales, mail and
fax messaging;
    companies and organizations providing or maintaining general purpose consumer online services that provide access to
healthcare content and services;
    companies and organizations providing or maintaining public sector and non-profit websites that provide healthcare
information and services without advertising or commercial sponsorships;
    companies and organizations providing or maintaining web search and retrieval services and other high-traffic websites; and
    publishers and distributors of traditional media, some of which have established or may establish websites Some of these competitors are larger, have greater resources and have more experience in providing
healthcare information than us. RISKS RELATED TO HEALTHCARE INFORMATION AND THE INTERNET HEALTHCARE REFORMS AND THE COST OF REGULATORY COMPLIANCE COULD NEGATIVELY AFFECT OUR BUSINESS. The healthcare industry is heavily regulated. In the ordinary course of business, healthcare
entities and companies that do business with them are subject to state and federal regulatory
scrutiny, supervision, oversight and control. These various laws, regulations and guidelines
affect, among other matters, the provision, licensing, labeling, marketing, promotion and
reimbursement of healthcare services and products. Our failure or the failure of our customers to
comply with any applicable legal or regulatory requirements, or any investigation or audit of our
or our customers practices could:  
    result in limitation or prohibition of business activities;
    subject us or our customers to legal fees and expenses and adverse publicity; or
    increase the costs of regulatory compliance and, if found by a court of competent jurisdiction to have engaged in
improper practices, subject us or our customers to criminal or civil monetary fines or other penalties A federal law commonly known as the Medicare/Medicaid Anti-Kickback Law, prohibits kickbacks,
rebates and bribes in return for referrals. This law provides an extremely broad base for finding
violations. Indeed, any remuneration, direct or indirect, offered, paid, solicited or received in
return for referrals of patients or business for which payment may be made in whole or in part
under Medicare or Medicaid could be considered a violation of law. The statute also prohibits
payments made to anyone to induce them to recommend purchasing, leasing or ordering any good,
facility, service or item for which payment may be made in whole or in part by Medicare. Similar
laws exist in some states. We believe that our operations comply with applicable legal regulatory requirements of the
anti-kickback laws. Nevertheless, some of these laws have been applied to payments by physicians
for marketing and referral services and could constrain our relationships, including financial and
marketing relationships with customers such as hospitals. It is possible that additional or more
restricted laws, regulations or guidelines could be adopted in the future. Criminal provisions prohibit knowingly filing false claims or making false statements or
causing false statements to be made by others, and civil provisions prohibit the filing of claims
or causing the filing of claims that one knows were false. Criminal penalties 17




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include fines and
imprisonment. Civil penalties include fines of up to $10,000 per claim plus treble damages, for
each filed claim. Although we are not filing claims ourselves, liability under the statutes can
extend to those who cause claims to be filed. To the extent that consulting advice provided to our
customers could be construed as aiding or abetting the presentation of false claims by the
customers, we could be subject to false claims liability. THE INTERNET IS SUBJECT TO MANY LEGAL UNCERTAINTIES AND POTENTIAL GOVERNMENT REGULATIONS THAT MAY
DECREASE USAGE OF OUR WEBSITE, INCREASE OUR COST OF DOING BUSINESS OR OTHERWISE HAVE A DAMAGING
EFFECT ON OUR BUSINESS Laws and regulations may be adopted in the future that address Internet-related issues,
including online content, user privacy, pricing and quality of products and services. This
legislation could increase our cost of doing business and negatively affect our business. Moreover,
it may take years to determine the extent to which existing laws governing issues like property
ownership, libel, negligence and personal privacy are applicable to the Internet. Currently, U.S.
privacy law consists of disparate state and federal statutes regulating specific industries that
collect personal data. Most of them predate and therefore do not specifically address online
activities. In addition, a number of comprehensive legislative and regulatory privacy proposals are
now under consideration by federal, state and local governments in the United States. Any new law or regulation pertaining to the Internet, or the application or interpretation of
existing laws, could decrease usage for our website, increase our cost of doing business or
otherwise cause our business to suffer. OUR BUSINESS COULD BE IMPAIRED BY STATE AND FEDERAL LAWS DESIGNED TO PROTECT INDIVIDUAL HEALTH
INFORMATION. If we fail to comply with current or future laws or regulations governing the collection,
dissemination, use and confidentiality of patient health information, our business could suffer. Consumers sometimes enter private information about themselves or their family members when
using our services. Also, our systems record use patterns when consumers access our databases that
may reveal health-related information or other private information about the user. In addition,
information regarding employee usage of healthcare providers and facilities can also be compiled by
our systems in connection with services we offer to employers and other payers. Numerous federal
and state laws and regulations govern collection, dissemination, use and confidentiality of
patient-identifiable health information, including:  
    state privacy and confidentiality laws;
    state laws regulating healthcare professionals, such as physicians, pharmacists and nurse practitioners;
    Medicaid laws;
    the Health Insurance Portability and Accountability Act of 1996 and related rules proposed by the Health Care Financing
Administration; and
    CMS standards for electronic transmission of health data Congress may consider future legislation that would establish more strict standards for
protection and use of health information. While we are not gathering patient health information at
this time and we are not a covered entity under HIPAA, other third-party websites that consumers
access through our website and employees, payers and other customers may not maintain systems to
safeguard any health information they may be collecting. In some cases, we may place our content on
computers that are under the physical control of others, which may increase the risk of an
inappropriate disclosure of information. For example, we contract out the hosting of our website to
a third party. In addition, future laws or changes in current laws may necessitate costly
adaptations to our systems. ONLINE SECURITY BREACHES COULD HARM OUR BUSINESS. Our security measures may not prevent security breaches. Substantial or ongoing security
breaches on our system or other Internet-based systems could reduce user confidence in our website,
causing reduced usage that adversely affects our business. The secure transmission of confidential
information over the Internet is essential to maintain confidence in our websites. We believe that 18




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consumers generally are concerned with security and privacy on the Internet, and any publicized
security problems could inhibit the growth of our provision of healthcare information on the
Internet. We will need to incur significant expense to protect and remedy against security breaches when
we identify a significant business risk. Currently, we do not store sensitive information, such as
patient information or credit card information, on our websites. If we launch services that require
us to gather sensitive information, our security expenditures will increase significantly. A party that is able to circumvent our security systems could steal proprietary information or
cause interruptions in our operations. Security breaches could also damage our reputation and
expose us to a risk of loss or litigation and possible liability. Our insurance policies may not be
adequate to reimburse us for losses caused by security breaches. We also face risks associated with
security breaches affecting third parties conducting business over the Internet or customers and
others who license our data. OTHER RISKS OUR OFFICERS AND DIRECTORS MAINTAIN SIGNIFICANT CONTROL OF HEALTH GRADES, INC. As of December 31, 2004, our current executive officers and directors and entities with which
they are affiliated beneficially own approximately 30.9% of our outstanding common stock. In
addition, Essex Woodlands Health Ventures Fund IV, L.P. holds
approximately 37.2% of our
outstanding common stock. If our officers, directors and Essex Woodlands act together, they will
be able to control the management and affairs of Health Grades, Inc. and will have the ability to
control all matters requiring stockholder approval, including the election of directors and
approval of significant corporate transactions. This concentration of ownership may have the effect
of delaying, deferring or preventing an acquisition of us, impair the ability of existing
stockholders to remove and replace our management and/or Board of Directors, and may adversely
affect the market price for our common stock. OUR CERTIFICATE OF INCORPORATION AND BYLAWS INCLUDE ANTI-TAKEOVER PROVISIONS THAT MAY DETER OR
PREVENT A CHANGE OF CONTROL. Some provisions of our certificate of incorporation and bylaws and provisions of Delaware law
may deter or prevent a takeover attempt, including an attempt that might result in a premium over
the market price for our common stock. Our certificate of incorporation requires the vote of 66
2/3% of the outstanding voting securities in order to effect certain actions, including a sale of
substantially all of our assets, certain mergers and consolidations and our dissolution or
liquidation, unless these actions have been approved by a majority of the directors. Our
certificate of incorporation also authorizes our Board of Directors to issue up to 2,000,000 shares
of preferred stock having such rights as may be designated by our Board of Directors, without
stockholder approval. Our bylaws provide that stockholders must follow an advance notification
procedure for certain nominations of candidates for the Board of Directors and for certain other
stockholder business to be conducted at a stockholders meeting. The General Corporation Law of
Delaware restricts certain business combinations with interested stockholders upon their
acquisition of 15% or more of our common stock. All of these provisions could make it more difficult for a third party to acquire, or could
discourage a third party from attempting to acquire, control of us, and thereby could prevent our
stockholders from receiving a premium for their shares. In addition, the foregoing provisions
could impair the ability of existing stockholders to remove and replace our management and/or our
Board of Directors. WE HAVE NO INTENTION TO PAY DIVIDENDS ON OUR COMMON STOCK. We have never declared or paid any cash dividends on our common stock. We currently intend to
retain all future earnings to finance the expansion of our business. 
 Item 2. Properties We have a lease for our approximately 28,700 square foot headquarters facility in Golden,
Colorado, which expires on May 31, 2010. 
 Item 3. Legal Proceedings On or about October 10, 2002, Strategic Performance Fund  II (SPF-II) commenced an action in the
Circuit Court of the 17th Judicial Circuit in and for Broward County, Florida against us, alleging
breach of two leases. These leases relate to two buildings in which one of our former affiliated
practices, Orthopaedic Associates, P.A. d/b/a Park Place Therapeutic Center (Park Place) leased
office space. Park Place ceased the payment of its rental obligations with respect to the two
leases in May 2000, and subsequently filed a petition for bankruptcy, under Chapter 11 of the
Bankruptcy Code, in the United States Bankruptcy Court, Southern District of Florida, Ft.
Lauderdale Division. SPF-II sought damages against us in the amount of approximately $4.7 million. The basis of the allegation against us was that while under the corporate name of Specialty Care
Network, Inc., we entered into an Assignment, Assumption and Release Agreement dated July 8, 1997,
under which we assumed the obligations of Orthopaedic Management Services, Inc., as lessee, under
its Lease Agreement with the owner and lessor, Park Place Orthopaedic Center II, Ltd. The
agreement was executed in connection with our acquisition of most of the non-medical assets of the
Park Place practice. On October 1, 1997, the owner of the leased property sold its interests in
the leasehold estates to SPF-II. On June 10, 1999, we sold the assets of the Park Place practice,
including the leasehold interests, back to Park Place and entered into an Absolute Assignment and
Assumption Agreement with Park Place, under which Park Place agreed to indemnify us in connection
with the leasehold obligations. In addition, we entered into an Indemnification Agreement with
Park Place and its individual physician owners, under which the individual physician owners
(severally up to their ownership interest in the practice) agreed to indemnify us in connection
with the leasehold obligations. SPF-II alleged that, notwithstanding the assignment of our
leasehold interests to Park Place, HealthGrades remains liable for all lessee obligations under the
leases. We filed a response to the initial complaint instituted by SPF-II, denying all liability with
respect to the subject leases. In addition, we filed a third-party complaint against the
individual physician owners seeking indemnification from each of these individuals under the terms
of the Indemnification Agreement. The physician owners filed a response to our complaint denying
their liability under the Indemnification Agreement, and asserting several affirmative defenses,
including, among others, our failure to mitigate damages, lack of consideration, our assertion of a
premature claim as liability and damages have not been established by SPF-II, rejection of the
leases by the bankruptcy court, and, in the case of one physician owner, a claim that an agent of
ours (who was, in fact, an employee of Park Place both before and after our affiliation with the
practice) fraudulently induced the purchase of the Park Place practices assets from us. The
physician owners also filed a motion to enjoin further prosecution of the action instituted against
them by HealthGrades and Bank of America, the lender in connection with their repurchase of the
assets of the Park Place practice, pending resolution of the bankruptcy proceeding. In November 2003, we executed a Settlement Agreement and Mutual Release (the Settlement
Agreement) with SPF-II, Orthopaedic Associates, P.A. d/b/a Park Place Therapeutic Center (Park
Place) and four of the physician owners of Park Place, in connection with a legal proceeding
concerning an alleged breach by us of two leases. In consideration for the dismissal of all claims
and mutual releases, we paid approximately $441,000 into an escrow account to be released to SPF-II
upon the satisfaction of certain conditions of the Settlement Agreement. In addition, we agreed to
pay an additional $50,000 to SPF-II on or before September 25, 2004. The aggregate payment amount
of $491,000 was recorded as an expense in our statement of operations in the third quarter of 2003.
As the $441,000 payment was made into escrow prior to year end, this cash was removed from our
balance sheet as of December 31, 2003. Payment out of escrow was contingent upon the occurrence,
on or before September 25, 2004 of (i) bankruptcy court approval of Chapter 11 plans relating to
Park Place and the four physician owners and (ii) the payment of a specified amount to SPF-II
pursuant to the Chapter 11 plans. In April 2004, upon satisfaction of the conditions described
above, the $441,000 in the above mentioned escrow account was released to SPF-II. In July 2004, we
made the final $50,000 payment to SPF-II, and an order of dismissal was entered on July 30, 2004. In 2004, we provided indemnification to our Chief Executive Officer, Kerry R. Hicks, for legal fees
totaling $272,000 relating to litigation involving Mr. Hicks. The litigation arose from loans that
Mr. Hicks and three other executive officers provided to us in December 1999 in the amount of $3,350,000 (including $2,000,000 individually loaned by Mr. Hicks).
These loans enabled us to purchase a minority interest in an internet healthcare rating business
that has become our current healthcare provider rating and advisory services business. We were the
majority owner of the business, but had agreed with the holder of the minority interest that if we
failed to purchase the holders interest by December 31, 1999, we would relinquish control and
majority ownership to the holder. In March 2000, the executive officers were compelled to convert
our obligations to them (including the $2,000,000 owed to Mr. Hicks) into our equity securities in
order to induce several private investors to invest an aggregate of $14,800,000 in our equity
securities. The executive officers personally borrowed money from our principal lending bank in order to fund
their loans to us. In early 2001, the bank claimed that Mr. Hicks was obligated to pay amounts
owed to the bank by a former executive who was unable to fully repay his loan; Mr. Hicks denied
this obligation. In October 2002, the bank sold the note to an affiliate of a collection agency
(the collection agency and the affiliate are collectively referred to as the collection agency).
Although the bank informed the collection agency in July 2003 of the banks conclusion that Mr.
Hicks was not obligated under the former executives promissory note issued to the bank, the
collection agency commenced litigation in September 2003 in federal court in Tennessee to collect
the remaining balance of approximately $350,000 on the note and named Mr. Hicks as a defendant. On
motion by Mr. Hicks, the court action was stayed, and Mr. Hicks commenced an arbitration proceeding
against the collection agency in October 2003, seeking an order that he had no liability under the
note and asserting claims for damages. The bank was added as a party in March 2004. The bank repurchased the note from the collection agency in December 2003 and resold the note to
another third party in February 2004, so that Mr. Hicks obligation to repay the note was no longer
at issue. The remaining claims included, among others, claims by the bank against Mr. Hicks for
costs and expenses of collection of the loan, claims by the collection agency against Mr. Hicks for
costs relating to this matter and claims by Mr. Hicks against the bank for breach of fiduciary duty
and fraud, and against the collection agency for abuse of process and defamation. Mr. Hicks also
commenced litigation against the other parties in Colorado state court based on similar claims. An
arbitration hearing was held from February 1-4, 2005, and a determination by the arbitrator is pending. Our determination to indemnify Mr. Hicks was based on, among other things, the fact that the
dispute related to Mr. Hicks efforts and personal financial commitment to provide funds to us in
December 1999, without which we likely would not have remained viable. Although we expect to
indemnify Mr. Hicks for additional legal expenses incurred in 2005, we do not expect these expenses
to be material in relation to our total operating expenses in 2005. We are subject to other legal proceedings and claims that arise in the ordinary course of our
business. In the opinion of management, these actions are unlikely to materially affect our
financial position. 19




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Item 4. Submission of Matters to a Vote of Security Holders Not applicable. Executive Officers of the Registrant The following table sets forth certain information concerning the executive officers of the
Company. The executive officers are elected or appointed by the Board of Directors of the Company
to serve for one year or until their successors are duly elected and qualified. NAME
    
    AGE
    
    POSITIONKerry R. Hicks
    
    
    45
    
    
    President, Chief Executive OfficerJ.D. Kleinke
    
    
    42
    
    
    Vice Chairman of the Board of DirectorsDavid G. Hicks
    
    
    47
    
    
    Executive Vice President-Information TechnologySarah Loughran
    
    
    40
    
    
    Executive Vice President-Provider ServicesAllen Dodge
    
    
    37
    
    
    Senior Vice President-Finance, Chief Financial
Officer, Secretary and TreasurerMichael D. Phillips
    
    
    47
    
    
    Senior Vice President-Provider SalesJohn R. Morrow
    
    
    45
    
    
    Senior Vice President-Strategic Development
 KERRY R. HICKS, one of our founders, has served as our Chief Executive Officer and one of our
directors since our inception in 1995. He has served as Chairman of the Board since December 2004.
He also served as our President from our inception until November 1999 and since March 2002. J.D. KLEINKE has served as Vice Chairman of the Board of Directors since December 2004. He has
been one of our directors since April 2002. Mr. Kleinke is a part-time executive and, as Vice
Chairman, he is responsible for assisting in setting our strategic
direction and cultivating new strategic partnerships. DAVID G. HICKS has served as our Executive Vice President  Information Technology since November
1999. He was Senior Vice President of Information Technology from May 1999 to November 1999 and
Vice President of Management Information Systems from March 1996 until May 1999. SARAH LOUGHRAN has served us in several capacities since 1998, including as our Executive Vice
President  Provider Services since July 2004 and Senior Vice President  Provider Services from
December 2001 to July 2004. ALLEN DODGE has served as Senior Vice President  Finance and Chief Financial Officer since May
2001. He was Vice President  Finance/Controller from March 2000 to May 2001 and Corporate
Controller from September 1997 to March 2000. Mr. Dodge is a Certified Public Accountant. MICHAEL D. PHILLIPS has served as Senior Vice President  Provider Sales since December 2001. He
was our Vice President  Provider Sales from April 2000 until December 2001. Prior to joining
HealthGrades, Mr. Phillips was Vice President of Sales at HCIA-Sachs (later named Solucient LLC)
from January 1999 to February 2000 and Vice President of Sales for LBA Healthcare Management from
October 1986 to December 1998. JOHN R. MORROW has served as Senior Vice President  Strategic Development since February 2003.
From June 2000 to January 2003, he was a self-employed consultant. From November 1999 to May 2000,
Mr. Morrow served as Senior Vice President and Publisher for HCIA-Sachs LLC (later named Solucient
LLC). From August 1998 to November 1999 Mr. Morrow served as Senior
Vice President and Publisher for HCIA, Inc. During his term with HCIA and Solucient, Mr. Morrow
was responsible for the Syndicated Products business units and 100 Top Hospitals Programs and
Corporate Channel Relationships. Kerry R. Hicks and David G. Hicks are brothers. 20




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PART II 
 Item 5. Market for Registrants Common Equity and Related Stockholder Matters The following table sets forth the high and low sales prices for our Common Stock for the
quarters indicated as reported by the OTC Bulletin Board (OTCBB). HIGH
    
    
    LOWYear Ended December 31, 2003First Quarter
    
    $
    .06
    
    
    $
    .03Second Quarter
    
    
    .61
    
    
    
    .04Third Quarter
    
    
    .45
    
    
    
    .20Fourth Quarter
    
    
    .62
    
    
    
    .25Year Ended December 31, 2004First Quarter
    
    $
    1.80
    
    
    $
    .55Second Quarter
    
    
    1.75
    
    
    
    .86Third Quarter
    
    
    1.85
    
    
    
    1.12Fourth Quarter
    
    
    3.25
    
    
    
    1.50
 We have never paid or declared any cash dividends and do not anticipate
paying any cash dividends in the foreseeable future. We currently intend to retain any future
earnings for use in our business. 
 Item 6. Selected Financial Data Statement of Operations Data Year Ended December 31,2004
    
    
    2003
    
    
    2002
    
    
    2001
    
    
    2000Ratings and advisory revenue
    
    $
    14,536,304
    
    
    $
    8,803,929
    
    
    $
    5,091,891
    
    
    $
    3,088,451
    
    
    $
    1,578,979Physician practice service fees
    
    
    
    
    
    
    
    
    
    
    195,492
    
    
    
    551,925
    
    
    
    4,249,658Income (loss) from operations
    
    
    1,760,547
    
    
    
    (1,275,850
    )
    
    
    (1,770,555
    )
    
    
    (7,620,773
    )
    
    
    (7,355,737
    )Income (loss) before cumulative effect of a
change in accounting principle
    
    
    1,782,143
    
    
    
    (1,283,687
    )
    
    
    (562,482
    )
    
    
    (7,367,243
    )
    
    
    (7,544,746
    )Net income (loss)
    
    $
    1,782,143
    
    
    $
    (1,283,687
    )
    
    $
    (1,650,793
    )(1)
    
    $
    (7,367,243
    )
    
    $
    (7,544,746
    )Net income (loss) per common share (basic)
    
    $
    0.07
    
    
    $
    (0.05
    )
    
    $
    (0.05
    )(1)
    
    $
    (0.30
    )
    
    $
    (0.39
    )Weighted average number of common shares
used in computation (basic)
    
    
    25,058,173
    
    
    
    26,679,467
    
    
    
    36,189,748
    
    
    
    24,399,699
    
    
    
    19,535,841Net income (loss) per common share (diluted)
    
    $
    0.05
    
    
    $
    (0.05
    )
    
    $
    (0.05
    )(1)
    
    $
    (0.30
    )
    
    $
    (0.39
    )Weighted average number of common
shares and common share equivalents
used in computation (diluted)
    
    
    33,031,087
    
    
    
    26,679,467
    
    
    
    36,189,748
    
    
    
    24,399,699
    
    
    
    19,535,841
 (1)
    Net loss for the year ended December 31, 2002 includes an impairment charge of
approximately $1.1 million related to a cumulative effect of a change in accounting principle due
to our adoption of Statement of Financial Accounting Standards No. 142, Goodwill and Other
Intangible Assets. In addition, net loss also reflects an income tax benefit of approximately $1.0
million related to the carryback of our 2001 tax loss.
 Balance Sheet Data DECEMBER 31, 2004
    
    
    DECEMBER 31, 2003
    
    
    DECEMBER 31, 2002
    
    
    DECEMBER 31, 2001
    
    
    DECEMBER 31, 2000Working capital (deficit)
    
    
    96,190
    
    
    
    (1,820,137
    )
    
    
    44,207
    
    
    
    161,324
    
    
    
    4,292,698Total assets
    
    
    12,931,127
    
    
    
    8,821,239
    
    
    
    7,117,551
    
    
    
    7,747,904
    
    
    
    14,371,174Total long-term debt
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total short-term debt
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,559,213
 
 ITEM 7. Managements Discussion and Analysis of Financial Condition and Results of Operations Introductory Commentary 21




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In evaluating our financial results and financial condition, management has focused principally on
the following: Revenue Growth and Client Retention  We believe these are key factors affecting both our results
of operations and our liquidity. Revenue growth during 2004 reflects growth across all of our
product areas. In prior years, our revenue growth was principally due to increased sales of our
Strategic Quality Initiative (SQI) program to hospitals. Sales of our SQI programs to hospitals
are typically particularly strong in the period following our annual release of our new ratings,
which occurs during the fall for most of the procedures and diagnoses for which we rate hospitals.
This trend continued in 2004, as sales were particularly strong in September and December. We also
have added, and plan to continue to add, new service lines and awards to market to hospitals. For
example, in the second quarter of 2003, we announced the recipients of our first annual
Distinguished Hospital Award for Clinical Excellence (DHA-CE). Hospitals that were DHA-CE
recipients represent the highest-scoring of the nations full-service hospitals based on a
three-year, risk-adjusted analysis of procedures and diagnoses in six of our service lines. In the
fourth quarter of 2003, we identified the DHA-CE recipients for the 2004 year and began marketing
our services to those hospitals. Sales of both our SQI and DHA-CE programs during the third and
fourth quarter of 2003 contributed to our 2004 revenue growth, since
revenue from these programs is recognized throughout the twelve months following the execution of the contracts. Our
Distinguished Hospital Award for Patient Safety (DHA-PS) was launched during the latter part of
the second quarter of 2004. This award is based on thirteen of the Agency for Healthcare Research
and Qualitys Patient Safety Indicators. As part of our 2005 ratings release, which occurred in
October 2004, we added Gastrointestinal services to the seven service lines that we market to
hospitals. In addition, we developed a new Critical Care service line (which includes procedures
and diagnoses such as pulmonary embolism, sepsis and respiratory failure) which we began marketing
to hospitals during the fourth quarter of 2004. We also experienced meaningful growth from the sales of our quality information to employers,
benefits consulting firms, consumers and others through our Healthcare Quality Reports and our
Quality Ratings Suite (QRS). We have achieved this growth principally through the utilization of
our distribution channels for our quality information such as Hewitt Associates, which provides our
quality information to over 125 Fortune 1000 corporations throughout the United States, and the
increased sales of our information to consumers. In addition to our efforts to generate revenue from new sales, a principal objective for us is to
achieve a high rate of retention of our clients. This is particularly true for our hospital
clients, which typically sign agreements for three-year terms, subject to a cancellation right by
either the hospital or us on each annual anniversary date. We believe one of the obstacles to
maintaining high retention rates is that clients who signed hospital contracts with us several
years ago, when we were developing our provider services business and charging significantly lower
fees than we do today, may be unwilling to accept our current pricing structure. In addition,
beginning in January 2004, we no longer offer exclusivity under our hospital contracts. Under the
exclusivity provisions of these contracts, we generally agreed not to provide marketing services to
a maximum of three hospitals designated by the hospital client. For hospitals that signed
agreements with us during 2003 and prior years, we will continue to honor the exclusivity
provisions in their contracts solely for the remaining term of the agreement. As our agreements
are typically three years (subject to the ability of a client or us to terminate on each
anniversary date), we anticipate that all exclusivity provisions will expire by the end of 2006.
While the termination of exclusivity provisions may serve as a disincentive for some hospitals to
renew agreements with us, we believe we will benefit from the ability to market our services to
hospitals that we were previously precluded from approaching under exclusivity arrangements.
During the year ended December 31, 2004, we retained contracts representing approximately 77% of
the annual revenue associated with all contracts that had first or second year anniversaries during
this period. We typically receive a non-refundable payment from hospital clients for the first year of the
contract term upon contract execution. If we are unable to attract new hospital clients and retain
a significant portion of our current clients, our liquidity could be adversely affected. Variable Expense Considerations  During 2004, we added product development personnel and
additional personnel to provide client consulting and support for our DHA-CE, SQI and QAI programs.
We anticipate that we will continue to add sales personnel, client consultants, product
development personnel, information technology personnel and, possibly, additional administrative
support personnel as we continue to expand our revenue base. As of March 2005, we have increased
our employee base to over 80 employees.
In addition, we believe the quality of our information is of the utmost importance and we will
continue to pursue ways to enhance both the quantity and quality of our information. We also
expect to put in place a cash incentive program for 2005 for our personnel who do not receive other
variable compensation such as commissions on sales. The amount of the cash incentive program will
be dependent upon our performance. Based on company performance during 2004, we recorded an
expense of approximately $642,000 related to our 2004 cash incentive program. Management
recognizes that any increases in expenses to accommodate future growth must be applied in a
disciplined fashion so as to enable us to obtain meaningful benefits from the standpoint of our
operations and cash flows. 22




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Distribution and Other Collaborative Arrangements  As part of our revenue growth strategy, we seek
to enter into arrangements with well recognized businesses to develop new products such as our
Distinguished Hospital Award Program, which we developed with J.D. Power and Associates, and expand
upon distribution channels through relationships with companies such as Hewitt Associates. We
expect to continue to seek arrangements such as these to increase the exposure and market
penetration of our product offerings. In June 2004, we announced an arrangement with 3M Health
Information Systems (3M) under which we will offer, pursuant to a Quality Excellence Program,
3Ms coding expertise and process improvement services in conjunction with our clinical quality
improvement services. This program is designed to assist hospitals in assessing and improving their
performance in the quality of care delivered and the accuracy of the patient data that is publicly
available and utilized by employers, payers, and consumers to identify the best hospitals. To
date, our arrangement with 3M has not produced any meaningful financial results. We believe our cash resources
are sufficient to support ongoing operations at least through March
31, 2006. Nevertheless, we confront the risk that our inability to generate revenues as expected
could compel us to seek additional financing, which may not be available at satisfactory terms. Critical Accounting Estimates In preparing our financial statements, management is required to make estimates and
assumptions that, among other things, affect the reported amounts of assets, revenues and expenses.
These estimates and assumptions are most significant where they involve levels of subjectivity and
judgment necessary to account for highly uncertain matters or matters susceptible to change, and
where they can have a material impact on our financial condition and operating performance. We
discuss below the most significant estimates and related assumptions used in the preparation of our
financial statements, namely those relating to our income tax valuation allowance and goodwill. If actual
results were to differ materially from the estimates made, the reported results could be materially
affected. Our senior management has discussed the application of these estimates with our Audit
Committee. Income Tax Valuation Allowance We currently maintain a full valuation allowance against our net deferred tax asset of
approximately $1.5 million. The valuation allowance results from uncertainty regarding our ability
to produce sufficient taxable income in future periods necessary to realize the benefits of the
related deferred tax assets. During 2004, the valuation allowance was decreased by approximately
$673,000 principally due to our 2004 operating income. In accordance with Statement of Financial
Accounting Standards No. 109, Accounting for Income Taxes, we assessed the continuing need for the
valuation allowance and concluded that until we have at least six quarters of net income before tax and cumulative net
income before tax during the most recent twelve quarters, our net
deferred tax assets should remain subject to a full valuation
allowance. Goodwill As a result of the adoption of SFAS 142, we discontinued the amortization of goodwill effective
January 1, 2002. SFAS 142 also requires companies to perform a transitional test of goodwill for
impairment as of January 1, 2002, and we completed this test during the second quarter of 2002.
Based upon the results of the test, we recorded a charge of approximately $1.1 million in our
statement of operations for the quarter ended June 30, 2002, as a cumulative effect of a change in
accounting principle. Goodwill, net in the accompanying balance sheets, as of December 31, 2004
and 2003, is shown net of the impairment charge described above. SFAS 142 describes various potential methodologies for determining fair value, including market
capitalization (if a public company has one reporting unit), discounted cash flow analysis (present
value technique) and techniques based on multiples of earnings, revenue, earnings before income
tax, depreciation and amortization, and/or other financial measures. SFAS 142 also states that if
a valuation technique is used that considers multiple sources of information, such as an average of
the quoted market prices of the reporting unit over a specific time period and the results of a
present value technique, the company should apply that technique consistently period to period
(i.e., in the required annual impairment analysis in subsequent years). As HealthGrades consists of only one reporting unit, and is publicly traded, management began its
fair value analysis with an evaluation of our market capitalization. We applied a market
capitalization approach by multiplying the number of actual shares outstanding by an average market
price. We applied an additional premium of 30% to this valuation to give effect to managements
best estimate of a control premium. As the majority of our outstanding shares were then owned by
management and two venture capitalist investors, management believed a premium of 30% was
reasonable to give effect to additional benefits a purchaser would derive from control of
HealthGrades. Beginning with the impairment test completed in the fourth quarter of 2003, we
reduced the control premium to 20%. This change was made due to the fact that in the first quarter
of 2003, we repurchased 12,004,333 shares of common stock owned by one of the venture capital
investors. As a result, management believed that a reduction in the control premium was
appropriate. As our shares are thinly traded, management believes that any analysis of HealthGrades fair value
should include valuation techniques in addition to overall market capitalization. We contemplated
utilizing cost, market or income approaches. However, utilization of cost or market approaches was
not feasible, particularly given the fact that HealthGrades does not fall into an easily
identifiable peer group of companies from which to compare valuations in the form of
price/earnings ratios, sales of similar companies, etc. Therefore, management determined to
utilize an approach using the present value of expected future cash flows as an additional
valuation technique. Due to the inherent uncertainty involved in projecting cash flows, in
particular for a growth company, management developed a range of possible cash flows and derived a
probability-weighted average of the range of possible amounts to determine the expected cash flow. After deriving the market capitalization and expected cash flow valuations as described above, we
then applied an equal weighting to each model to derive an overall fair value estimate of
HealthGrades. For our transitional impairment test in 2002, the carrying value of our net assets
exceeded the fair value estimate. We then compared the implied fair value of goodwill to the
carrying amount of goodwill to arrive at the impairment loss calculation of approximately $1.1
million during the quarter ended June 30, 2002, in connection with the transitional test for
impairment. As required under SFAS 142, we performed our annual test for impairment of our goodwill
during the fourth quarters of 2002, 2003 and 2004. These tests resulted in no additional
impairment to our goodwill balance. We will perform the annual impairment test in the fourth quarter of subsequent years, or sooner, if
indicators of impairment arise at an interim date. Any impairment identified during the annual
impairment tests will be recorded as an operating expense in our consolidated statement of
operations. We expect to continue to utilize the combined market capitalization and expected cash
flow approach described above to perform our annual impairment analysis and interim tests if
necessary. REVENUE AND EXPENSE COMPONENTS The following descriptions of the components of revenues and expenses apply to the comparison of
results of operations. Ratings and advisory revenue.We currently operate in one business segment. We provide
proprietary, objective healthcare provider ratings and advisory services to our clients. We
generate revenue by providing our clients with information and other assistance that enables them
to measure, assess, enhance and market healthcare quality. Our target clients include hospitals,
employers, benefits consulting firms, payers, insurance companies and consumers. Physician practice service fees.Physician practice service fees include services fees and other
revenue derived from our physician practice management business. We have not provided physician
practice management services since September 2002. Cost of ratings and advisory revenue.Cost of ratings and advisory revenue consists primarily of
the costs associated with the delivery of services related to our SQI, Distinguished Hospital Award
and QAI programs, as well as the costs incurred to acquire the data
utilized in connection with these and other services such as our SmartChoice and QRS products. The
cost of delivery of services relates primarily to the client consultants and support staff that
provide our services. Cost of physician practice management revenue. In 2002, cost of physician practice management
revenue primarily consisted of consulting costs related to the delivery of limited services to
physician practices under agreements that expired at various times through September 2002. Sales and marketing costs. Sales and marketing costs include salaries, wages and commission
expenses related to our sales efforts, as 23




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##### Table of Contents



well as other direct sales and marketing costs. For our
SQI, Distinguished Hospital Award and QAI agreements, we pay our sales personnel commissions as we
receive payment from our hospital clients. We typically receive a non-refundable payment for the
first year (and subsequent years on each anniversary date) of the three-year contract term. In
addition, we record the commission expense in the period it is earned, which is typically upon
contract execution for the first year of the agreement and on each anniversary date for clients
that do not cancel in the second or third year of the contract term. We record the commission
expense in this manner because once a contract is signed, the salesperson has no remaining
obligations to perform in order to earn the commission. Product development costs.We incur product development costs related to the development and
support of our website and the development of applications to support data compilation and
extraction for our consulting services. These costs (which consist primarily of salaries and
benefits, consulting fees and other costs related to software development, application development
and operations expense) are expensed as incurred. General and administrative expenses.General and administrative expenses consist primarily of
salaries, employee benefits and other expenses for employees that support our infrastructure such
as finance and accounting personnel, certain information technology employees and some of our
support staff, facility costs, professional fees and insurance costs. RESULTS OF OPERATIONS Ratings and Advisory Revenue Overview Year ended
    
    
    
    Year ended
    
    
    
    Year endedProduct Area
    
    
    December 31, 2004
    
    
    
    December 31, 2003
    
    
    
    December 31, 2002Marketing services
to hospitals
(SQI and
Distinguished
Hospital Award
products)
    
    
    $
    8,763,218
    
    
    
    $
    6,366,530
    
    
    
    $
    3,997,300Quality improvement
services to
hospitals
(QAI products)
    
    
    
    2,043,619
    
    
    
    
    964,674
    
    
    
    
    514,329Sales of quality
information to
employers,
consumers and
others
(QRS and Healthcare
Quality Reports)
    
    
    
    3,516,450
    
    
    
    
    1,262,255
    
    
    
    
    406,290Consultant
reimbursed travel
    
    
    
    213,017
    
    
    
    
    170,220
    
    
    
    
    173,972Other
    
    
    
    
    
    
    
    
    40,250
    
    
    
    
    Total
    
    
    $
    14,536,304
    
    
    
    $
    8,803,929
    
    
    
    $
    5,091,891
 YEAR ENDED DECEMBER 31, 2004 COMPARED TO YEAR ENDED DECEMBER 31, 2003 Ratings and advisory revenue. For the year ended December 31, 2004, ratings and advisory revenue
was approximately $14.5 million, an increase of $5.7 million from ratings and advisory revenue of
$8.8 million for the year ended December 31, 2003. For the year ended December 31, 2004 and 2003,
approximately 60% and 72% of our ratings and advisory revenue was derived from our marketing
services to hospitals. Although revenue from our marketing services declined as a percentage of
total revenue from 2003 to
2004, revenues from this product area increased by approximately $2.4 million to $8.8 million for
the year ended December 31, 2004. This increase is principally due to the addition of new clients
in 2004. We continued to add clients for our existing service lines as well as our Distinguished
Hospital Awards for Clinical Excellence and Patient Safety. In addition, approximately 14% of our
ratings and advisory revenue was derived from the sale of our quality improvement services to
hospitals for the year ended December 31, 2004 compared to 11% for the same period of 2003. Sales
of our quality information totaled 24% of our ratings and advisory revenue for the year ended
December 31, 2004 compared to 14% for the same period of 2003. Strong growth in our direct sales
of quality reports to consumers via our website and our relationship with Hewitt Associates,
through whom we provide our quality information to over 125 of the Fortune 1000 companies, was a
principal reason for the increase in sales of our quality information. 24




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Cost of ratings and advisory revenue. For the years ended December 31, 2004 and 2003, cost of
ratings and advisory revenue was approximately $2.5 million and $2.0 million, respectively, or
approximately 17% and 22% of ratings and advisory revenue. The decrease in cost of ratings and
advisory revenue as a percentage of ratings and advisory revenue is due to the fact that our
revenue growth was principally from our marketing services to hospitals and sales of quality
information, and increased sales of these items do not entail a substantial amount of incremental
cost. In addition, one of the significant components of cost of ratings and advisory revenue is
our cost to acquire data, which has remained relatively fixed for the last year. Moreover, our
sales of our healthcare quality reports do not require any commission costs as these are sold
online directly to consumers. Costs related to our healthcare quality reports are principally
related to payments to internet search engines for placement on the internet, as well as fees paid
to a consultant. The fees we pay to a consultant are variable based upon the revenue generated
from the sale of our healthcare quality reports to consumers, less certain expenses, and are
subject to a monthly cap. These costs are included in sales and marketing expense in our
consolidated statements of operations. Sales and marketing costs for the year ended December 31, 2004 increased to approximately $4.9
million from $3.4 million for the same period of 2003. As a percentage of ratings and advisory
revenue, sales and marketing costs were 34% and 38%, respectively. The decrease as a percentage of
ratings and advisory revenue is primarily due to our increased existing base of business. We pay a
lesser percentage of commissions to our sales group upon renewals of contracts with hospitals than
we pay with respect to new contracts. General and administrative expenses. For the year ended December 31, 2004, general and
administrative expenses were approximately $3.3 million, an increase of approximately $505,000 from
general and administrative expenses of approximately $2.8 million for the same period of 2003.
The increase in general and administrative expenses is due to various items including an increase
in professional fees related to our internal control efforts with respect to Sarbanes-Oxley, an
increase in legal fees, indemnification expenses (described in Note 12 to the financial
statements), additional office rent related to an increase in office space of approximately 3,000
square feet during 2004 and other items related to our growth during 2004. YEAR ENDED DECEMBER 31, 2003 COMPARED TO YEAR ENDED DECEMBER 31, 2002 REVENUE: Ratings and advisory revenue Ratings and advisory revenue was approximately $8.8 million for the year ended December 31,
2003, an increase of approximately $3.7 million or 73% from the year ended December 31, 2002. This
increase reflects strong sales of our Distinguished Hospital Award and SQI programs during 2003.
The revenue growth reflects both new clients as well as the sale of additional services to current
clients. Of the total amount of additional business added during 2003 for the Distinguished
Hospital Award, SQI and QAI products, approximately 70% reflected sales to new clients and
approximately 30% related to sales of additional services to our existing clients. Our retention
of existing clients also contributed to our increased revenues. For our Distinguished Hospital
Award, SQI and QAI agreements that had first or second year anniversary dates during 2003, we
retained approximately 79% of these clients. Also contributing to our revenue growth in 2003 was
our sale of Healthcare Quality Reports. We began selling these reports at the end of 2002. For the year ended December 31, 2003, approximately 72% of our ratings and advisory revenue
was derived from our Distinguished Hospital Award and SQI programs. For the same period of 2002,
approximately 79% of our ratings and advisory revenue was derived from our SQI programs. We had no
Distinguished Hospital Award sales in 2002 as the program did not begin until early 2003. Sales
of our Quality Ratings Suite, Healthcare Quality Reports for Consumers and Healthcare Quality
Reports for Professionals accounted for approximately 14% of revenues during 2003, compared to
approximately 8% for the same period of 2002. In addition,
approximately 11% of our ratings and advisory revenue for the year ended December 31, 2003 was
derived from our QAI services, compared to 10% for the same period in 2002. Cost of ratings and advisory revenue For the year ended December 31, 2003, cost of ratings and advisory revenue was approximately
$2.0 million, or approximately 22% of ratings and advisory revenue, compared to $1.5 million, or
29% of revenue for the same period of 2002. The decrease is primarily due to a reduction in costs
to acquire data. During 2002, we renegotiated a data purchase agreement with a vendor, which 25




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substantially reduced our cost to acquire certain physician data. In addition, during 2003, as
described above, we had strong sales of our Distinguished Hospital Award and SQI programs. These
programs do not have significant cost of sales as they are primarily licensing and marketing
arrangements. The costs incurred related to these programs principally relate to the sales
efforts, which are included in sales and marketing costs. Sales and marketing costs Sales and marketing costs increased from approximately $2.1 million for the year ended
December 31, 2002 to $3.4 million for the year ended December 31, 2003, an increase of
approximately 62%. As a percentage of ratings and advisory revenue, sales and marketing costs
decreased from approximately 41% for the year ended December 31, 2002 to 38% for the same period of
2003. Sales and marketing costs as a percentage of ratings and advisory revenue has decreased over
the prior year due to an increase of retained clients. We pay a lower percentage of contract
payments as commissions to our sales group upon the retention of contracts (i.e., non-cancellation
of contracts on their anniversary date and signing of new contracts at the end of their term) than
we pay with respect to new contracts. Therefore, as our business expands, we anticipate that the
overall commission cost as a percentage of ratings and advisory revenue will decline. General and administrative expenses For the year ended December 31, 2003, general and administrative expenses were approximately
$2.8 million, an increase of approximately $712,000 or 34% over general and administrative expenses
of approximately $2.1 million for the same period of 2002. The increase relates to legal fees
incurred during 2003 due to the SPF-II litigation described in Note 12 to our consolidated
financial statements included in this report. General and administrative expenses do not include
the amount we paid to settle this litigation, which is reported in the litigation settlement line
item. Also contributing to the increase in general and administrative expenses were 2003 cash
bonuses. Interest expense For the year ended December 31, 2003, we incurred interest expense of approximately $15,000
with respect to interest paid on a loan payable of $500,000 that was outstanding for part of 2003.
This note was completely repaid in 2003. LIQUIDITY AND CAPITAL RESOURCES As of December 31, 2004, we had working capital of approximately $96,000, an increase of $1.9
million from our working capital deficit of approximately $1.8 million as of December 31, 2003.
Included in current liabilities as of December 31, 2004 is $7.7 million in deferred income,
representing principally contract payments for future marketing and quality improvement services to
hospitals. These amounts will be reflected in revenue upon provision of the related services. For
the year ended December 31, 2004, cash flow provided by operations was approximately $2.8 million
compared to cash provided by operations of approximately $1.3 million for the same period of 2003.
Our 2004 net income has favorably affected our working capital deficit as well as our cash flow
from operations. We have a line of credit arrangement (the Agreement) with Silicon Valley Bank. Under the terms
of the Agreement, we may request advances not to exceed an aggregate amount of $1.0 million over
the term of the Agreement, subject to a maximum borrowing equal to 75% of Eligible Accounts (as
defined in the Agreement) plus 50% of our cash invested with Silicon Valley Bank. Our ability to
request advances is also limited by any outstanding letters of credit. In connection with a lease
we executed on our new headquarters in Golden, Colorado, in December 2004, we executed a standby
letter of credit with Silicon Valley Bank for $500,000 in January 2005. Such amount reduces the
amount we can request as an advance under the Agreement. Therefore, subsequent to the issuance of
the standby letter of credit in January 2005, approximately $500,000 was available to us. Advances
under the Agreement bear interest at Silicon Valley Banks prime rate plus .5% and are secured by
substantially all of our assets. Interest is due monthly on
advances outstanding, and the principal balance of any advances taken by us are due on February 13,
2006. Our ability to request advances under the Agreement is subject to certain financial and
other covenants. As of December 31, 2004, we were in compliance with these covenants. In February 2004, we added approximately 2,900 square feet of office space to our existing lease of
12,200 square feet relating to our former headquarters. Total annual lease costs for our
full-service lease on the 15,100 square feet were approximately $270,000. This lease expired in
February 2005. In December 2004, we executed a lease agreement on an office building at a new
location in Golden, Colorado for approximately 28,700 square feet. Our lease began in February
2005. 26




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The term of the lease is 63 months. In addition to our annual lease expense, we are
incurring approximately $300,000 in other capital costs for modifications to the current building,
additional furniture purchases, audio-video equipment and other items. In addition to the capital expenditures related to our new facility, we anticipate incurring
certain capital expenditures during 2005 primarily to upgrade some of our information technology
hardware and software. We expect that capital expenditures for items in addition to our new
facility costs noted above will be approximately $100,000. Although we anticipate that we have sufficient funds available to support ongoing operations
through at least March 31, 2006, if our revenues fall short of our expectations or our expenses
exceed our expectations, we may need to raise additional capital through public or private debt or
equity financing. We may not be able to secure sufficient funds on terms acceptable to us. If
equity securities are issued to raise funds, our stockholders equity may be diluted. If additional
funds are raised through debt financing, we may be subject to significant restrictions.
Furthermore, as noted above, upon execution of our SQI, Distinguished Hospital Award and QAI
agreements, we typically receive a non-refundable payment for the first year of the contract term
(which is typically three years, subject to a cancellation right by either the client or us on each
annual anniversary date). We record the cash payment as deferred revenue, which is a current
liability on our balance sheet, and is then amortized to revenue over the first year
of the term. Subsequent annual renewal payments, which are made in advance of the year to which
the payment relates, are treated in the same manner. As a result, our operating cash flow is
substantially dependent upon our ability to continue to sign new agreements, as well as continue to
maintain a high rate of client retention. Our current operating plan includes growth in new
agreements. A significant failure to achieve sales targets in the plan or a significant decline in
our renewal rate would have a material negative impact on our financial position and cash flow. The following table sets forth our contractual obligations as of December 31, 2004: Payments Due by PeriodLess than
    
    
    
    
    
    
    
    
    
    
    More thenTotal
    
    
    1 year
    
    
    2-3 years
    
    
    4-5 years
    
    
    5 yearsContractual ObligationsOperating Lease Obligations
    
    
    1,662,765
    
    
    
    260,428
    
    
    
    664,710
    
    
    
    610,199
    
    
    
    127,428Total
    
    
    1,662,765
    
    
    
    260,428
    
    
    
    664,710
    
    
    
    610,199
    
    
    
    127,428
 Operating lease obligations relate principally to our office space lease. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS Share-Based Payments In December 2004, the FASB issued SFAS No. 123, (Revised 2004): Share-Based Payment(SFAS 123R),
which replaces SFAS No. 123, Accounting for Stock-Based Compensation, (SFAS 123) and supersedes APB
Opinion No. 25, Accounting for Stock Issued to Employees. SFAS 123R requires all share-based
payments to employees, including grants of employee stock options, to be recognized in the
financial statements based on their fair values beginning with the first interim or annual period
after June 15, 2005. The pro forma disclosures previously permitted under SFAS 123 no longer will
be an alternative to financial statement recognition. We are required to adopt SFAS 123R in the
third quarter of fiscal 2005, beginning July 1, 2005. Under SFAS 123R, we must determine the
appropriate fair value model to be used for valuing share-based payments, the amortization method
for compensation cost and the transition method to be used at date of adoption. The transition
methods include prospective and retroactive adoption
options. Under the retroactive option, prior periods may be restated either as of the beginning of
the year of adoption or for all periods presented. The prospective method requires that
compensation expense be recorded for all unvested stock options and restricted stock at the
beginning of the first quarter of adoption of SFAS 123R. We are evaluating the requirements of SFAS
123R and expect that the adoption of SFAS 123R will have a material impact on our results of
operations and earnings per share. We have not yet determined the method of adoption or the effect
of adopting SFAS 123R. 
 Item 7a. Quantitative and Qualitative Disclosure about Market Risk 27




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We have certain investments in a treasury obligation fund maintained by Silicon Valley Bank. As of
December 31, 2004, our investment in this fund amounted to approximately $5.1 million. This amount
is included within the cash and cash equivalents line item of our balance sheet and consists of
investments in highly liquid U.S. treasury securities with original maturities of 90 days or less.
For the year ended December 31, 2004, interest earned on this balance was approximately $22,000.
Any decrease in interest rates in this investment account would not have a material impact on our
financial position. 
 Item 8. Financial Statements and Supplementary Data See pages 33-53 of this document. 
 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Not applicable. 
 Item 9A. Controls and Procedures Evaluation of Disclosure Controls and Procedures Our management, with the participation of our Chief Executive Officer and Chief Financial Officer,
evaluated the effectiveness of our disclosure controls and procedures as of the end of the period
covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial
Officer concluded that our disclosure controls and procedures as of the end of the period covered
by this report are functioning effectively to provide reasonable assurance that the information
required to be disclosed by us in reports filed under the Securities Exchange Act of 1934 is (i)
recorded, processed, summarized and reported within the time periods specified in the SECs rules
and forms and (ii) accumulated and communicated to our management, including the Chief Executive
Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding disclosure.
A controls system cannot provide absolute assurance, however, that the objectives of the controls
system are met, and no evaluation of controls can provide absolute assurance that all control
issues and instances of fraud, if any, within a company have been detected. Change in Internal Control over Financial Reporting No change in our internal
control over financial reporting occurred during our most
recent fiscal quarter that has materially affected, or is reasonably likely to materially affect,
our internal control over financial reporting. 
 PART III 
 Item 10. Directors and Executive Officers of the Registrant This information (other than the information relating to executive officers included in Part I)
will be included in an amendment to this Form 10-K, which will be filed within 120 days after the
close of our fiscal year covered by this report 
 Item 11. Executive Compensation This information will be included in an amendment to this Form 10-K, which will be filed within 120
days after the close of our fiscal year covered by this report. 
 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder
Matters Equity Compensation Plan Information The following table provides information, as of December 31, 2004, regarding securities issuable
under our stock based compensation plans. 28




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##### Table of Contents



Number of securitiesremaining availableNumber of securities
    
    
    
    
    
    
    
    
    for future issuanceto be issued upon
    
    
    
    Weighted-average
    
    
    
    under equityexercise of
    
    
    
    exercise price of
    
    
    
    compensation plansoutstanding options,
    
    
    
    outstanding options,
    
    
    
    (excluding securitieswarrants and rights
    
    
    
    warrants and rights
    
    
    
    reflected in column(a))Plan category
    
    
    (a)
    
    
    
    (b)
    
    
    
    (c)Equity compensation
plans approved
by security holders
    
    
    
    9,778,384
    
    
    
    $
    0.41
    
    
    
    
    2,019,685Equity compensation
plans not approved
by security holders
    
    
    
    20,000
    (1)
    
    
    $
    2.00
    
    
    
    
    N/ATotal
    
    
    
    9,798,384
    
    
    
    
    
    
    
    
    
    2,019,685
 (1)  Represents warrants issued to a company with respect to certain financial advisory services
provided to us.
 Other information required to be included in this item will be included in an amendment to this
Form 10-K, which will be filed within 120 days after the close of our fiscal year covered by this
report. 
 Item 13. Certain Relationships and Related Transactions This information will be included in an amendment to this Form 10-K, which will be filed within 120
days after the close of our fiscal year covered by this report. 
 Item 14. Principal Accountant Fees and Services This information will be included in an amendment to this Form 10-K, which will be filed within 120
days after the close of our fiscal year covered by this report. 
 PART IV 
 ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES. (a) 1. Financial Statements. The financial statements listed in the accompanying Index to Financial Statements and Financial
Statement Schedule at page F-1 are filed as part of this Form 10-K. 2. Financial Statement Schedules. The following financial statement schedule is filed as part of this Form 10-K: Schedule II  Valuation and Qualifying Accounts. All other schedules have been omitted because they are not applicable, or not required, or the
information is shown in the Financial Statements or notes thereto. (b) Exhibits. 29




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##### Table of Contents



The following is a list of exhibits filed as part of this annual report on Form 10-K. Unless
otherwise indicated, the file number of each document incorporated by
reference is 000-22019. EXHIBITNUMBER
        
        DESCRIPTION3.1
        
        Form of Amended and Restated Certificate
          of Incorporation (incorporated by reference to Exhibit 3.1 to our
          Annual Report on Form 10-K for the year ended December 31,
          2001.)3.2
        
        Amended and Restated Bylaws (incorporated
          by reference to Exhibit 3.2 to our Annual Report on Form 10-K
          for the year ended December 31, 2001.)10.1*
        
        1996 Equity Compensation Plan, as amended
          (incorporated by reference to Exhibit 10.1 to our Annual Report
          on Form 10-K for the year ended December 31, 2002.)10.2.1
        
        Loan and Security Agreement dated May 10,
          2002 by and between Health Grades, Inc., Healthcare Ratings, Inc., ProviderWeb.net,
          Inc., and Silicon Valley Bank (incorporated by reference to Exhibit 10.1
          to our Quarterly Report on Form 10-Q for the quarter ended June 30,
          2002.)10.2.2
        
        Loan Modification Agreement dated March 11,
          2003 by and between Health Grades, Inc. and Silicon Valley Bank (incorporated
          by reference to Exhibit 10.2.2 to our Annual Report on Form 10-K
          for the year ended December 31, 2002.)10.2.3
        
        Loan Modification Agreement dated February
          20, 2004 by and between Health Grades, Inc. and Silicon Valley Bank
          (incorporated by reference to Exhibit 10.2 to our Quarterly Report on
          Form 10-Q for the quarter ended March 31, 2004)10.2.4
        
        Loan Modification Agreement dated February
          22, 2005 by and between Health Grades, Inc. and Silicon Valley Bank10.3
        
        Stock and Warrant Repurchase Agreement dated
          March 11, 2003 (incorporated by reference to Exhibit 10.3
          to our Annual Report on Form 10-K for the year ended December 31,
          2002.)10.4*
        
        Employment Agreement dated as of April 1,
          1996 by and between Specialty Care Network, Inc. and Kerry R. Hicks
          (incorporated by reference to Exhibit 10.3 to our Registration
          Statement on Form S-1 (File No. 333-17627))10.5.1*
        
        Employment Agreement between Specialty Care
          Network, Inc. and David Hicks, dated March 1, 1996 (incorporated
          by reference to Exhibit 10.8 to our Registration Statement of Form S-1
          (File No. 333-17627))10.5.2*
        
        Amendment to Employment Agreement between
          Specialty Care Network, Inc. and David Hicks, dated December 2,
          1997. (incorporated by reference to Exhibit 10.8.1 to our Annual
          Report on Form 10-K for the fiscal year ended December 31,
          1997)10.6
        
        Building Lease between GR Development One,
          LLC, Landlord and Health Grades, Inc. Tenant.23.1
        
        Consent of Grant Thornton LLP31.1
        
        Certification of the Chief Executive Officer
          pursuant to Rule 15d-14(a) under the Securities Exchange Act.31.2
        
        Certification of the Chief Financial Officer
          pursuant to Rule 15d-14(a) under the Securities Exchange Act.32.1
        
        Certification of the Chief Executive Officer
          pursuant to Rule 15d-14(b) under the Securities Exchange Act.32.2
        
        Certification of the Chief Financial Officer
          pursuant to Rule 15d-14(b) under the Securities Exchange Act.
   *
    
    - Constitutes a management contract, compensatory plan or arrangement required to be filed
as an exhibit to this report. 30




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##### Table of Contents



SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934,
the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized. HEALTH GRADES, INC. Date: March 31, 2005
    
    /s/ Kerry R. HicksKerry R. HicksChief Executive Officer
 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the Registrant and in the capacities and on the
dates indicated. NAME
    
    TITLE
    
    DATE/s/ Kerry R. Hicks
    
    Chief Executive Officer
    
    March 31, 2005(Principal Executive Officer)Kerry R. Hicks/s/ Allen Dodge
    
    Chief Financial Officer andTreasurer (Principal Financial andAllen Dodge
    
    Accounting Officer)
    
    March 31, 2005/s/ Peter H. Cheesbrough
    
    Director
    
    March 31, 2005Peter H. Cheesbrough/s/ Leslie S. Matthews, M.D.
    
    Director
    
    March 31, 2005Leslie S. Matthews, M.D./s/ J.D. Kleinke
    
    Director
    
    March 31, 2005J.D. Kleinke/s/ John Quattrone
    
    Director
    
    March 31, 2005John Quattrone/s/ Mark Pacala
    
    Director
    
    March 31, 2005Mark Pacala
 31




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SUPPLEMENTAL INFORMATION TO BE FURNISHED
WITH REPORTS FILED PURSUANT TO
SECTION 15(d) OF THE ACT BY
REGISTRANTS WHICH HAVE NOT REGISTERED
SECURITIES PURSUANT TO SECTION 12 OF THE ACT No annual report covering the Registrants last fiscal year and no proxy statement, form of
proxy or other soliciting material relating to the Registrants 2004 annual meeting of stockholders
has been sent to the Registrants stockholders. The Registrant intends to send a report to
stockholders for the period covered by this report and a proxy statement and proxy with respect to
the Registrants next annual meeting of stockholders. The Registrant will furnish copies of such
material when such material is sent to its stockholders. Such material shall not be deemed to be
filed with the Commission or otherwise subject to the liabilities of Section 18 of the Securities
Exchange Act of 1934. 32




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##### Table of Contents



INDEX TO FINANCIAL STATEMENTS HEALTH GRADES, INC.:Report
of Independent Registered Public Accounting Firm
    
    
    34Balance Sheets
    
    
    35Statements of Operations
    
    
    36Statements of Stockholders Equity
    
    
    37Statements of Cash Flows
    
    
    38Notes to Financial Statements
    
    
    39
 33




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##### Table of Contents



Report of Independent Registered Public Accounting Firm Board of Directors and Stockholders of Health Grades, Inc. We have audited the accompanying balance sheets of Health Grades, Inc. as of December 31, 2004 and
2003, and the related statements of operations, stockholders equity, and cash flows for each
of the three years in the period ended December 31, 2004. These financial statements are the
responsibility of the Companys management. Our responsibility is to express an opinion on these
financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight
Board (United States). Those standards require that we plan and perform the audits to obtain
reasonable assurance about whether the financial statements are free of material misstatement. The
Company is not required to have, nor were we engaged to perform an audit of its internal control
over financial reporting. Our audit included consideration of internal control over financial
reporting as a basis for designing audit procedures that are appropriate in the circumstances, but
not for the purpose of expressing an opinion on the effectiveness of the Companys internal control
over financial reporting. Accordingly, we express no such opinion. An audit also includes
examining, on a test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial
statements referred to above present fairly, in all material
respects, the financial position of Health Grades, Inc. as of December 31, 2004 and 2003, and the
results of its operations and its cash flows for each of the three years in the period ended
December 31, 2004, in conformity with accounting principles generally accepted in the United States
of America. Our audit was conducted for the purpose of forming an opinion on the basic financial statements
taken as a whole. Schedule II is presented for purposes of additional analysis and is not a
required part of the basic financial statements. This schedule has been subjected to the auditing
procedures applied in the audit of the basic financial statements and, in our opinion, is fairly
stated in all material respects in relation to the basic financial statements taken as a whole. /s/ GRANT THORNTON LLP
 Denver, Colorado
February 4, 2005 (except for Note 16, as to which the date is
February 22, 2005) 34




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##### Table of Contents



Health Grades, Inc. 
 Balance Sheets DECEMBER 312004
    
    
    2003ASSETSCash and cash equivalents
    
    $
    6,153,862
    
    
    $
    3,559,125Accounts receivable, net
    
    
    3,034,375
    
    
    
    1,688,336Prepaid expenses and other
    
    
    253,839
    
    
    
    230,840Total current assets
    
    
    9,442,076
    
    
    
    5,478,301Property and equipment, net
    
    
    382,870
    
    
    
    236,757Goodwill, net
    
    
    3,106,181
    
    
    
    3,106,181Total assets
    
    $
    12,931,127
    
    
    $
    8,821,239LIABILITIES AND STOCKHOLDERS EQUITYAccounts payable
    
    $
    44,035
    
    
    $
    116,117Accrued payroll, incentive compensation and related
expenses
    
    
    1,178,581
    
    
    
    1,148,161Accrued expenses
    
    
    322,777
    
    
    
    175,380Deferred income
    
    
    7,729,195
    
    
    
    5,785,437Income taxes payable
    
    
    71,298
    
    
    
    73,343Total current liabilities
    
    
    9,345,886
    
    
    
    7,298,438Long-term liabilities
    
    
    
    
    
    
    Total liabilities
    
    
    9,345,886
    
    
    
    7,298,438Commitments and contingenciesStockholders equity:Preferred stock, $0.001 par value, 2,000,000
shares authorized, no shares issued or outstanding
    
    
    
    
    
    
    Common stock, $0.001 par value, 100,000,000 shares authorized,
and 44,880,176 and 44,052,153 shares issued in 2004 and
2003, respectively
    
    
    44,880
    
    
    
    44,052Additional paid-in capital
    
    
    90,094,408
    
    
    
    89,814,939Accumulated deficit
    
    
    (72,786,467
    )
    
    
    (74,568,610
    )Treasury stock, 19,563,390 shares in 2004 and 2003
    
    
    (13,767,580
    )
    
    
    (13,767,580
    )Total stockholders equity
    
    
    3,585,241
    
    
    
    1,522,801Total liabilities and stockholders equity
    
    $
    12,931,127
    
    
    $
    8,821,239
 See accompanying notes to financial statements. 35




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##### Table of Contents



Health Grades, Inc. 
 Statements of Operations Years ended December 31, 2004
    
    
    2003
    
    
    2002Revenue:Ratings and advisory revenue
    
    $
    14,536,304
    
    
    $
    8,803,929
    
    
    $
    5,091,891Physician practice service fees
    
    
    
    
    
    
    
    
    
    
    195,492Other
    
    
    1,447
    
    
    
    1,551
    
    
    
    20,00014,537,751
    
    
    
    8,805,480
    
    
    
    5,307,383Expenses:Cost of ratings and advisory revenue
    
    
    2,488,202
    
    
    
    1,963,949
    
    
    
    1,468,097Cost of physician practice management revenue
    
    
    
    
    
    
    
    
    
    
    91,051Gross margin
    
    
    12,049,549
    
    
    
    6,841,531
    
    
    
    3,748,235Operating expenses:Sales and marketing
    
    
    4,932,210
    
    
    
    3,357,874
    
    
    
    2,074,425Product development
    
    
    2,017,441
    
    
    
    1,433,965
    
    
    
    1,321,511Litigation settlement
    
    
    
    
    
    
    491,000
    
    
    
    General and administrative
    
    
    3,339,298
    
    
    
    2,834,467
    
    
    
    1,975,086Income (loss) from operations
    
    
    1,760,600
    
    
    
    (1,275,775
    )
    
    
    (1,622,787
    )Other:Interest income
    
    
    21,543
    
    
    
    7,393
    
    
    
    14,009Interest expense
    
    
    
    
    
    
    (15,305
    )
    
    
    Income (loss) before income taxes and cumulative
effect of a change in accounting principle
    
    
    1,782,143
    
    
    
    (1,283,687
    )
    
    
    (1,608,778
    )Income tax benefit
    
    
    
    
    
    
    
    
    
    
    1,046,296Income (loss) before cumulative effect of a change in
accounting principle
    
    
    1,782,143
    
    
    
    (1,283,687
    )
    
    
    (562,482
    )Cumulative effect of a change in accounting
principle
    
    
    
    
    
    
    
    
    
    
    (1,088,311
    )Net income (loss)
    
    $
    1,782,143
    
    
    $
    (1,283,687
    )
    
    $
    (1,650,793
    )Net income (loss) per common share (basic)Income (loss) before cumulative effect of a
change in accounting principle
    
    $
    0.07
    
    
    $
    (0.05
    )
    
    $
    (0.02
    )Cumulative effect of a change in accounting
principle
    
    
    
    
    
    
    
    
    
    
    (0.03
    )Net income (loss) per common share
    
    $
    0.07
    
    
    $
    (0.05
    )
    
    $
    (0.05
    )Weighted average number of common shares
used in computation (basic)
    
    
    25,058,173
    
    
    
    26,679,467
    
    
    
    36,189,748Net income (loss) per common share (diluted)Income (loss) before cumulative effect of a
change in accounting principle
    
    $
    0.05
    
    
    $
    (0.05
    )
    
    $
    (0.02
    )Cumulative effect of a change in accounting
principle
    
    
    
    
    
    
    
    
    
    
    (0.03
    )Net income (loss) per common share
    
    $
    0.05
    
    
    $
    (0.05
    )
    
    $
    (0.05
    )Weighted average number of common shares
used in computation (diluted)
    
    
    33,031,087
    
    
    
    26,679,467
    
    
    
    36,189,748
 See accompanying notes to financial statements. 36




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##### Table of Contents



Health Grades, Inc. 
 Statements of Stockholders Equity
Years ended
December 31, 2004, 2003 and 2002 STOCKCOMMON STOCK
    
    
    ADDITIONAL
    
    
    PURCHASE$0.001 PAR VALUE
    
    
    PAID-IN
    
    
    PLAN
    
    
    ACCUMULATED
    
    
    TREASURYSHARES
    
    
    AMOUNT
    
    
    CAPITAL
    
    
    RECEIVABLE
    
    
    DEFICIT
    
    
    STOCK
    
    
    TOTALBalance at January 1, 2002
    
    
    42,165,733
    
    
    $
    42,166
    
    
    $
    89,549,538
    
    
    $
    
    
    
    $
    (71,634,130
    )
    
    $
    (13,267,580
    )
    
    $
    4,689,994Common stock issued
    
    
    1,799,973
    
    
    
    1,800
    
    
    
    213,298
    
    
    
    (215,098
    )
    
    
    
    
    
    
    
    
    
    
    Payments made under stock purchase
plan
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    215,098
    
    
    
    
    
    
    
    
    
    
    
    215,098Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,650,793
    )
    
    
    
    
    
    
    (1,650,793
    )Balance at December 31, 2002
    
    
    43,965,706
    
    
    
    43,966
    
    
    
    89,762,836
    
    
    
    
    
    
    
    (73,284,923
    )
    
    
    (13,267,580
    )
    
    
    3,254,29912,004,333 shares acquired as treasury
stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (500,000
    )
    
    
    (500,000
    )Option grants to consultant
    
    
    
    
    
    
    
    
    
    
    42,499
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    42,499Employee stock option exercise
    
    
    86,447
    
    
    
    86
    
    
    
    9,604
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    9,690Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,283,687
    )
    
    
    
    
    
    
    (1,283,687
    )Balance at December 31, 2003
    
    
    44,052,153
    
    
    
    44,052
    
    
    
    89,814,939
    
    
    
    
    
    
    
    (74,568,610
    )
    
    
    (13,767,580
    )
    
    
    1,522,801Option grants to consultant
    
    
    
    
    
    
    
    
    
    
    157,500
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    157,500Employee stock option exercise
    
    
    828,023
    
    
    
    828
    
    
    
    121,969
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    122,797Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,782,143
    
    
    
    
    
    
    
    1,782,143Balance at December 31, 2004
    
    
    44,880,176
    
    
    $
    44,880
    
    
    $
    90,094,408
    
    
    $
    
    
    
    $
    (72,786,467
    )
    
    $
    (13,767,580
    )
    
    $
    3,585,241
 See accompanying notes to financial statements. 37




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##### Table of Contents



Health Grades, Inc. 
 Statements of Cash Flows Years ended December 31, 2004
    
    
    2003
    
    
    2002OPERATING ACTIVITIESNet income (loss)
    
    $
    1,782,143
    
    
    $
    (1,283,687
    )
    
    $
    (1,650,793
    )Adjustments to reconcile net income (loss) to net
cash provided by operating activities:Cumulative effect of a change in accounting principle
    
    
    
    
    
    
    
    
    
    
    1,088,311Non-cash consulting expense related to
non-employee stock options
    
    
    157,500
    
    
    
    42,499
    
    
    
    Depreciation expense
    
    
    146,051
    
    
    
    98,006
    
    
    
    249,802Bad debt expense
    
    
    3,569
    
    
    
    11,667
    
    
    
    6,500Loss (gain) on sale of assets and other
    
    
    7,146
    
    
    
    (75
    )
    
    
    446Changes in operating assets and liabilities:Accounts receivable, net
    
    
    (1,349,609
    )
    

    
    (1,024,489
    )
    
    
    96,356Prepaid expenses and other assets
    
    
    (22,999
    )
    
    
    54,058
    
    
    
    (152,317
    )Prepaid and recoverable income taxes
    
    
    (2,045
    )
    
    
    (3,380
    )
    
    
    (207
    )Accounts payable and accrued expenses
    
    
    75,315
    
    
    
    153,367
    
    
    
    (142,185
    )Accrued payroll, incentive compensation
and related expenses
    
    
    30,420
    
    
    
    751,387
    
    
    
    (167,716
    )Deferred income
    
    
    1,943,758
    
    
    
    2,533,812
    
    
    
    1,115,450Net cash provided by operating activities
    
    
    2,771,249
    
    
    
    1,333,165
    
    
    
    443,647INVESTING ACTIVITIESPurchases of property and equipment
    
    
    (300,156
    )
    
    
    (230,852
    )
    
    
    (19,981
    )Sale of property, plant and equipment
    
    
    847
    
    
    
    75
    
    
    
    Net cash used in investing activities
    
    
    (299,309
    )
    
    
    (230,777
    )
    
    
    (19,981
    )FINANCING ACTIVITIESProceeds from stock purchases
    
    
    
    
    
    
    
    
    
    
    215,098Principal repayments on note payable
    
    
    
    
    
    
    (500,000
    )
    
    
    Purchases of treasury stock
    
    
    
    
    
    
    (500,000
    )
    
    
    Exercise of employee stock options
    
    
    122,797
    
    
    
    9,690
    
    
    
    Repayments of notes receivable
    
    
    
    
    
    
    
    
    
    
    12,726Proceeds from note payable
    
    
    
    
    
    
    500,000
    
    
    
    Net cash provided by (used in) financing activities
    
    
    122,797
    
    
    
    (490,310
    )
    
    
    227,824Net increase in cash and cash equivalents
    
    
    2,594,737
    
    
    
    612,078
    
    
    
    651,490Cash and cash equivalents at beginning of period
    
    
    3,559,125
    
    
    
    2,947,047
    
    
    
    2,295,557Cash and cash equivalents at end of period
    
    $
    6,153,862
    
    
    $
    3,559,125
    
    
    $
    2,947,047SUPPLEMENTAL CASH FLOW INFORMATIONInterest paid
    
    $
    
    
    
    $
    15,305
    
    
    $
    Income taxes paid
    
    $
    2,045
    
    
    $
    3,380
    
    
    $
    207
 See accompanying notes to financial statements. 38




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Health Grades, Inc. 
 Notes to Financial Statements December 31, 2004 and 2003 1. DESCRIPTION OF BUSINESS Health Grades, Inc. (HealthGrades) provides proprietary, objective healthcare provider ratings
and advisory services. We provide our clients with healthcare information, including information
relating to quality of service and detailed profile information on physicians, that enables them to
measure, assess, enhance and market healthcare quality. Our clients include hospitals, employers,
benefits consulting firms, payers, insurance companies and consumers. We offer services to hospitals that are either attempting to build a reputation based upon quality
of care or are working to identify areas to improve quality. For hospitals that have received high
ratings, we offer the opportunity to license our ratings and trademarks and provide assistance in
their marketing programs at an institutional level (e.g., hospital clinical excellence and
exceptional experience regarding the overall number and type of patient safety incidents within a
hospital) at a service line level (e.g. cardiac, pulmonary, vascular, etc.) and at a
procedure/diagnosis level (e.g., coronary bypass surgery, community acquired pneumonia, valve
replacement surgery, etc.). We also offer physician-led quality improvement consulting engagements
and other quality improvement analysis and services for any hospitals that are seeking to enhance
quality. In addition, we provide basic and detailed profile information on a variety of providers and
facilities. We make this information available to consumers, employers, benefits consulting firms
and payers to assist them in selecting healthcare providers. Basic profile information for certain
providers is available free of charge on our website, www.healthgrades.com. For a fee, we offer
healthcare quality reports with respect to hospitals, nursing homes and physicians. These reports
provide more detailed information than is available free of charge on our website. Report pricing
and content varies based upon the type of provider and whether the user is a consumer or a
healthcare professional (for example, a medical professional underwriter). We provide detailed online healthcare quality information for employers, benefits consulting firms,
payers and other organizations that license our Quality Ratings Suite of products  Hospital
Quality Guide, Physician Quality Guide, Nursing Home Quality Guide and Home Health Quality
Guide. We have also entered into strategic arrangements with other service providers, including Ingenix
and J.D. Power and Associates, in an effort to increase our name recognition and market presence,
enhance our service offerings and increase the distribution of our products. In addition to the services noted above, which constitute our ratings and advisory business, we
also provided, through September 2002, limited physician practice management services to
musculoskeletal practices under management services agreements. As of December 31, 2002, all of
these agreements had expired or had been terminated. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION Effective December 31, 2002, we liquidated our Healthcare Ratings and Providerweb.net subsidiaries.
This liquidation had no impact on our financial position or operations. As of and for the years
ended December 31, 2003 and 2004, Health Grades, Inc. had no subsidiaries. All significant
intercompany balances and transactions for the years ended December 31, 2002 have been eliminated
in consolidation. USE OF ESTIMATES The preparation of financial statements in conformity with accounting principles generally accepted
in the United States of America requires management to make estimates and assumptions that affect
the amounts reported in the financial statements and footnotes. These estimates are based on
managements current knowledge of events and actions they may undertake in the future, and actual
results could differ from those estimates. 39




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RECLASSIFICATIONS Certain reclassifications have been made to the 2003 and 2002 financial statements to conform to
the 2004 presentation. REVENUE RECOGNITION Ratings and advisory revenue Strategic Quality Initiative, Distinguished Hospital and Quality Assessment and Improvement
Programs: Our ratings and advisory revenue is generated principally from annual fees paid by hospitals that
participate in our Strategic Quality Initiative (SQI), Distinguished Hospital (DHP) and Quality
Assessment and Improvement (QAI) programs. The SQI program provides business development tools to
hospitals that are highly rated on our website. Under the SQI program, we license the HealthGrades
name and our report card ratings to hospitals. The license may be in a single service line (for
example, Cardiac) or multiple service lines (for example, Cardiac, Neuroscience and Orthopedics.)
We also assist hospitals in promoting their ratings and measuring the success of their efforts
utilizing our team of in-house healthcare consultants. Our SQI and DHP programs provide a license to highly rated hospitals, enabling them to utilize our
name and certain ratings information for an annual period. Another feature of the SQI and DHP
programs is a detailed comparison of the data underlying a hospitals rating to local and national
benchmarks. DHP-CE (Distinguished Hospital Award Program for Clinical Excellence) recognizes
clinical excellence in hospitals among a range of service lines. Hospitals that contract with us
for DHP services receive all of the SQI features described above with respect to their licensed
service lines. In addition, hospitals can reference the additional DHA (Distinguished Hospital
Award) designation. Hospital clients are provided with additional marketing and planning
assistance related to the DHA designation as well as trophies for display at the hospital. DHP-PS
(Distinguished Hospital Award Program for Patient Safety) recognizes hospitals with the best
patient safety records in the nation. This award recognizes exceptional outcomes based on thirteen
patient safety indicators from the Agency for Healthcare Research on Quality. Under our DHP-PS program, we license the commercial use
of the HealthGrades corporate mark, applicable data and marketing messages that may be used by
hospitals to demonstrate third party validation of excellence. Our QAI program is principally designed to help hospitals measure and improve the quality of their
care in particular areas where they have lower ratings. Using our database and focusing on a
particular hospitals information and ratings we can help identify areas to improve quality and
measure how well the hospital performs relative to national and regional best practices. Our
consultants work on-site with the hospital staff and physicians to present the data and assist in
the quality analysis. We typically receive a non-refundable payment at the beginning of each year of the contract term
(which is typically three years, subject to a cancellation right by either the client or us, on
each annual anniversary date). We record the cash payment as deferred revenue that is then
amortized to revenue on a straight-line basis over the respective year of the term. Certain of
our products represent a one-time delivery of data. For these arrangements, we recognize revenue
at the point that the data is delivered. SmartChoice and Quality Ratings Suite: Through our SmartChoice and Quality Ratings Suite (QRS), we license access to, and customize our
database for employers, benefits consulting firms, payers and others. Modules currently available
for license are the Hospital Quality Guide, Physician Quality Guide, Nursing Home Quality Guide and
Home Health Quality Guide. Some of our revenue for this product is derived through a relationship
with Ingenix. Typically, Ingenix will add the HealthGrades QRS functionality to services
available to its existing clients who license Ingenix provider lookup online application. An
additional licensing fee is charged, of which a portion is payable to us, with Ingenix retaining
the remaining part of the fee. We only recognize the fees that will ultimately be paid to us as
revenue from Ingenix, and not the entire amount of the licensing fee. We recognize revenues
related to these agreements in a straight-line manner over the term of the agreement. Healthcare Quality Reports: We offer comprehensive quality information to professionals and consumers that provides current and
historical quality information on hospitals and nursing homes in more detail than is available on
our website. In addition, we offer reports on physicians that contain detailed information with
respect to education, professional licensing history and other items. As pricing is usually on a
per report basis, we recognize revenue as reports are ordered and delivered to the customer. 40




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Physician practice service fees: Physician practice service fees include services fees and other revenue derived from our former
physician practice management business. Physician practice service fee revenue is recognized
based upon the contractual arrangements of the underlying service agreements with physician
practices that we were formerly affiliated with. PRODUCT DEVELOPMENT COSTS We incur product development costs related to the development and support of our website and the
development of applications to support data compilation and extraction for our consulting services
and modification of our quality guides. These costs (which consist primarily of salaries and
benefits, consulting fees and other costs related to software development, application development
and operations expense) are expensed as incurred. CASH AND CASH EQUIVALENTS Cash and cash equivalents generally consist of cash and overnight investment accounts that include
short-term government obligations. These instruments have original maturity dates not exceeding
three months. Such investments are stated at fair value (which includes accrued interest on our
short-term government obligations) and are considered cash equivalents for purposes of reporting
cash flows. FINANCIAL INSTRUMENTS The carrying amounts of financial instruments, as reported in the accompanying balance sheets,
approximate their fair value primarily due to the short-term and/or variable-rate nature of such
financial instruments. PROPERTY AND EQUIPMENT Property and equipment are stated at cost. Costs of repairs and maintenance are expensed as
incurred. Depreciation is computed using the straight-line method over the estimated useful lives
of the underlying assets. Amortization of leasehold improvements are computed using the
straight-line method over the shorter of the initial lease term or the estimated useful lives of
the underlying assets. The estimated useful lives used are as follows: Computer equipment and software
    
    3-5 yearsFurniture and fixtures
    
    5-7 yearsLeasehold improvements
    
    5 years
 GOODWILL Goodwill, which is stated at cost, is evaluated annually for impairment in accordance with the
provisions of Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible
Assets(SFAS 142). As a result of the adoption of SFAS 142, we discontinued the amortization of
goodwill effective January 1, 2002. SFAS 142 also requires companies to perform a transitional
test of goodwill for impairment as of January 1, 2002, and we completed this test during the second
quarter of 2002. Based upon the results of the test, we recorded a charge of approximately $1.1
million in our consolidated statement of operations for the quarter ended June 30, 2002, as a
cumulative effect of a change in accounting principle. See Note 5 for further discussion of our
adoption of SFAS 142. NET INCOME (LOSS) PER COMMON SHARE We compute net income (loss) per common share in accordance with Statement of Financial Accounting
Standards No. 128, Earnings Per share(SFAS 128). Under the provisions of SFAS 128, basic net
income (loss) per common share is computed by dividing the net income (loss) for the period by the
weighted average number of common shares outstanding during the period. Diluted net income (loss)
per common share is computed by dividing the net income (loss) for the period by the weighted
average number of common shares and common share equivalents outstanding during the period. Common
share equivalents, (composed of incremental common shares issuable upon the exercise of common
stock options and warrants) are included in diluted net income (loss) per share to the extent these
shares are dilutive, utilizing the treasury stock method. The treasury stock method utilizes the
weighted average number of shares outstanding during each year and the assumed exercise of dilutive
stock options and warrants, less the number of treasury shares assumed to be purchased from the
proceeds using the average market price of our common stock. Common share equivalents are not
included in our computation of diluted net loss per common share for the years ended December 31,
2003 and 2002 because 41




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##### Table of Contents



the effect on net loss per common share would be antidilutive. Common share equivalents excluded
from our calculation of diluted net loss per common share because their effect would be
antidilutive totaled 2,017,064 and 15,732 for the years ended December 31, 2003 and 2002,
respectively. In addition, as of December 31, 2004, options and
warrants to purchase 2,054,356 shares of common stock were excluded
from our calculation of dilutive securities as the exercise prices
were above the market price for our common stock. The following table sets forth the computation of basic and diluted earnings per share for the
years ended December 31, 2004, 2003 and 2002. 2004
    
    
    2003
    
    
    2002Numerator for both basic and diluted earnings
per share:Income (loss) before cumulative effect of a
change in accounting principle
    
    $
    1,782,143
    
    
    $
    (1,283,687
    )
    
    $
    (562,482
    )Cumulative effect of a change in accounting
principle
    
    
    
    
    
    
    
    
    
    
    (1,088,311
    )Net income (loss)
    
    $
    1,782,143
    
    
    $
    (1,283,687
    )
    
    $
    (1,650,793
    )Denominator:Denominator for basic net income (loss) per
common shareweighted average shares
    
    
    25,058,173
    
    
    
    26,679,467
    
    
    
    36,189,748Effect of dilutive securities:Employee
stock options and outstanding warrants
    
    
    7,972,914
    
    
    
    
    
    
    
    Denominator for diluted net income (loss) per
common shareadjusted weighted average
shares and assumed conversion
    
    
    33,031,087
    
    
    
    26,679,467
    
    
    
    36,189,748
 STOCK-BASED COMPENSATION We account for our stock-based compensation arrangements using the intrinsic value method under the
provisions of Accounting Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to
Employees(APB No. 25), and related interpretations. Pro forma information regarding net income and earnings per share is required by Statement of
Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation(SFAS 123), and has
been determined as if we had accounted for our employee stock options under the fair value method
of that accounting pronouncement. The fair value for options awarded during the years ended
December 31, 2004, 2003 and 2002 were estimated at the date of grant using the Black Scholes option
pricing model with the following weighted-average assumptions: risk-free interest rate over the
life of the option of 1.32% to 3.25%; no dividend yield; and expected three year lives of the
options. Volatility factors used in 2004 were between 1.51 and 1.78. The volatility factors
utilized for the year ended December 31, 2003 were between 1.95 and 2.04. For the year ended
December 31, 2002, the volatility factor used was 1.91. The Black-Scholes option pricing model was developed for use in estimating the fair value of traded
options, which have no vesting restrictions and are fully transferable. In addition, option
valuation models require the input of highly subjective assumptions, including the expected stock
price volatility. For purposes of pro forma disclosure, the estimated fair value of the options is amortized to
expense over the options vesting period. Because compensation expense associated with an award is
recognized over the vesting period, the impact on pro forma net (loss) income as disclosed below
may not be representative of compensation expense in future years. The following table illustrates
the effect on net loss and loss per share if we had applied the fair value recognition provisions
of SFAS 123, using assumptions described above, to our stock-based compensation plan: 42




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##### Table of Contents



Year ended December 31,2004
    
    
    2003
    
    
    2002Net income (loss) as reported
    
    $
    1,782,143
    
    
    $
    (1,283,687
    )
    
    $
    (1,650,793
    )Add: Stock-based compensation expense included in
reported net income under APB No. 25
    
    
    
    
    
    
    
    
    
    
    Less: Total stock-based employee compensation expense determined
under
fair value based method for awards granted, modified or settled, net
of tax effect
    
    
    (223,150
    )
    
    
    (343,512
    )
    
    
    (870,374
    )Pro forma net income (loss)
    
    $
    1,558,993
    
    
    $
    (1,627,199
    )
    
    $
    (2,521,167
    )Income (loss) per share as reported:Basic
    
    $
    0.07
    
    
    $
    (0.05
    )
    
    $
    (0.05
    )Diluted
    
    $
    0.05
    
    
    $
    (0.05
    )
    
    $
    (0.05
    )Income (loss) per share pro forma:Basic
    
    $
    0.06
    
    
    $
    (0.06
    )
    
    $
    (0.07
    )Diluted
    
    $
    0.05
    
    
    $
    (0.06
    )
    
    $
    (0.07
    )
 RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS Share-Based Payments In December 2004, the FASB issued SFAS No. 123, (Revised 2004): Share-Based Payment(SFAS 123R),
which replaces SFAS No. 123, Accounting for Stock-Based Compensation, (SFAS 123) and supersedes APB
Opinion No. 25, Accounting for Stock Issued to Employees. SFAS 123R requires all share-based
payments to employees, including grants of employee stock options, to be recognized in the
financial statements based on their fair values beginning with the first interim or annual period
after June 15, 2005. The pro forma disclosures previously permitted under SFAS 123 no longer will
be an alternative to financial statement recognition. We are required to adopt SFAS 123R in the
third quarter of fiscal 2005, beginning July 1, 2005. Under SFAS 123R, we must determine the
appropriate fair value model to be used for valuing share-based payments, the amortization method
for compensation cost and the transition method to be used at date of adoption. The transition
methods include prospective and retroactive adoption options. Under the retroactive option, prior
periods may be restated either as of the beginning of the year of adoption or for all periods
presented. The prospective method requires that compensation expense be recorded for all unvested
stock options and restricted stock at the beginning of the first quarter of adoption of SFAS 123R.
We are evaluating the requirements of SFAS 123R and expect that the adoption of SFAS 123R will have
a material impact on our results of operations and earnings per share. We have not yet determined
the method of adoption or the effect of adopting SFAS 123R. 3. ACCOUNTS RECEIVABLE AND RATINGS AND ADVISORY SERVICES REVENUE Accounts receivable consisted of the following: DECEMBER 312004
    
    
    2003Trade accounts receivable
    
    $
    3,049,611
    
    
    $
    1,700,003Less allowance for doubtful accounts
    
    
    15,236
    
    
    
    11,667$
    3,034,375
    
    
    $
    1,688,336
 For the years ended December 31, 2004, 2003 and 2002, we derived substantially all of our
revenue from our ratings and advisory services. Furthermore, our marketing program services
accounted for 60%, 72% and 79% of total ratings and advisory revenue for the years ending December
31, 2004, 2003 and 2002, respectively. During 2004, 2003 and 2002, no individual customer
accounted for more the 10% of our revenues. The majority of our accounts
receivable are due from hospitals. Accounts receivable are due within
30 days and are stated at amounts due from customers net of an
allowance for doubtful accounts. Accounts outstanding longer than the
contractual payment terms are considered past due. We determine our
allowance by considering a number of factors, including the length of
time trade accounts receivables are past due, any previous loss
history and the customers ability to pay its obligations. We
write off accounts receivable when they become uncollectible, and
payments subsequently received on such receivables are credited to
the allowance for doubtful accounts. 43




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##### Table of Contents



4. PROPERTY AND EQUIPMENT Property and equipment consist of the following: DECEMBER 312004
    
    
    2003Furniture and fixtures
    
    $
    807,477
    
    
    $
    847,147Computer equipment and software
    
    
    2,213,413
    
    
    
    1,974,276Leasehold improvements and other
    
    
    13,217
    
    
    
    10,7843,034,107
    
    
    
    2,832,207Accumulated depreciation and amortization
    
    
    (2,651,237
    )
    
    
    (2,595,450
    )Net property and equipment
    
    $
    382,870
    
    
    $
    236,757
 For the years ended December 31, 2004, 2003, and 2002, depreciation expense was approximately
$146,000, $98,000, and $250,000 respectively. 5. GOODWILL As a result of the adoption of SFAS 142, we discontinued the amortization of goodwill effective
January 1, 2002. SFAS 142 also requires companies to perform a transitional test of goodwill for
impairment as of January 1, 2002, and we completed this test during the second quarter of 2002.
Based upon the results of the test, we recorded a charge of approximately $1.1 million in our
statement of operations for the quarter ended June 30, 2002, as a cumulative effect of a change in
accounting principle. Goodwill, net in the accompanying balance sheets, as of December 31, 2004
and 2003, is shown net of the impairment charge described above. SFAS 142 describes various potential methodologies for determining fair value, including market
capitalization (if a public company has one reporting unit), discounted cash flow analysis (present
value technique) and techniques based on multiples of earnings, revenue, earnings before income
tax, depreciation and amortization, and/or other financial measures. SFAS 142 also states that if
a valuation technique is used that considers multiple sources of information, such as an average of
the quoted market prices of the reporting unit over a specific time period and the results of a
present value technique, the company should apply that technique consistently period to period
(i.e., in the required annual impairment analysis in subsequent years). As HealthGrades consists of only one reporting unit, and is publicly traded, management began its
fair value analysis with an evaluation of our market capitalization. We applied a market
capitalization approach by multiplying the number of actual shares outstanding by an average market
price. We applied an additional premium of 30% to this valuation to give effect to managements
best estimate of a control premium. As the majority of our outstanding shares were then owned by
management and two venture capitalist investors, management believed a premium of 30% was
reasonable to give effect to additional benefits a purchaser would derive from control of
HealthGrades. Beginning with the impairment test completed in the fourth quarter of 2003, we
reduced the control premium to 20%. This change was made due to the fact that in the first quarter
of 2003, we repurchased 12,004,333 shares of common stock owned by one of the venture capital
investors. As a result, management believed that a reduction in the control premium was
appropriate. As our shares are thinly traded, management believes that any analysis of HealthGrades fair value
should include valuation techniques in addition to overall market capitalization. We contemplated
utilizing cost, market or income approaches. However, utilization of cost or market approaches was
not feasible, particularly given the fact that HealthGrades does not fall into an easily
identifiable peer group of companies from which to compare valuations in the form of
price/earnings ratios, sales of similar companies, etc. Therefore, management determined to
utilize an approach using the present value of expected future cash flows as an additional
valuation technique. Due to the inherent uncertainty involved in projecting cash flows, in
particular for a growth company, management developed a range of possible cash flows and derived a
probability-weighted average of the range of possible amounts to determine the expected cash flow. After deriving the market capitalization and expected cash flow valuations as described above, we
then applied an equal weighting to each model to derive an overall fair value estimate of
HealthGrades. For our transitional impairment test in 2002, the carrying value of our net assets
exceeded the fair value estimate. We then compared the implied fair value of goodwill to the
carrying amount of goodwill to arrive at the impairment loss calculation of approximately $1.1
million during the quarter ended June 30, 2002, in connection with the transitional test for
impairment. As required under SFAS 142, we performed our annual test for impairment of our goodwill
during the fourth quarters of 2002, 2003 and 2004. These tests resulted in no additional
impairment to our goodwill balance. 44




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##### Table of Contents



We will perform the annual impairment test in the fourth quarter of subsequent years, or sooner, if
indicators of impairment arise at an interim date. Any impairment identified during the annual
impairment tests will be recorded as an operating expense in our consolidated statement of
operations. We expect to continue to utilize the combined market capitalization and expected cash
flow approach described above to perform our annual impairment analysis and interim tests if
necessary. 6. STOCK AND WARRANT REPURCHASE Pursuant to a Stock and Warrant Repurchase Agreement, dated March 11, 2003, we paid a former
venture capital investor, Chancellor V., L.P. (Chancellor) $500,000 to repurchase all 12,004,333
shares of our common stock and warrants to purchase 1,971,820 shares of our common stock that
Chancellor had acquired through certain financing transactions in 2000 and 2001. Immediately prior
to the repurchase, Chancellors ownership of HealthGrades common stock represented 33% of our
outstanding common stock, and Chancellors ownership of HealthGrades common stock and warrants
represented 36% of our total outstanding common stock (assuming full exercise of the warrants held
by Chancellor, but assuming no exercise of any other warrants or options). See also note 8. 7. BANK LINE OF CREDIT AND TERM LOAN On May 13, 2002, we completed a line of credit arrangement (the Agreement) with Silicon Valley
Bank. Under the terms of the Agreement, we were entitled to request advances not to exceed an
aggregate amount of $1.0 million over the one-year term of the Agreement. Through subsequent
amendments, we extended the term of the Agreement to February 19, 2005. To date, we have not
borrowed any funds under the Agreement. In addition, advances under the Agreement are limited to
75% of Eligible Accounts (as defined in the Agreement) plus 50% of our cash invested with Silicon
Valley Bank. In addition, an amendment to the Agreement provided for a term loan of $500,000, which carried an
interest rate of 5.94% and was due on March 1, 2005. In October 2003, we repaid the balance of the
term loan. Advances under the Agreement bear interest at Silicon Valley Banks prime rate plus 0.75% and are
secured by substantially all of our assets. Interest is due monthly on advances outstanding and
the principal balance of any advances taken by us are due at the end of the Agreement term. Our
ability to request advances under the Agreement is subject to certain financial and other
covenants. As of December 31, 2004, we had no advances outstanding and we were in compliance with
the covenants. In connection with a lease we executed for our new
headquarters in Golden, Colorado, in December 2004, we executed a standby letter of credit with
Silicon Valley Bank in January 2005, for $500,000. Such amount reduces the amount we can request
as an advance under the Agreement. Therefore, as of January 2005, $500,000 of our line of credit
was available to us. See also Note 16 for recent developments relating to this Agreement. 8. COMMON STOCK AND WARRANTS For the year ended December 31, 2002, participants in our 2002 Stock Purchase Plan paid
approximately $215,000 for 1,799,973 shares purchased through payroll deductions. This amount was
included in cash received from financing activities in our consolidated statement of cash flows.
The 2002 Stock Purchase Plan enabled participating employees to purchase shares of our common stock
by electing to have payroll deductions in 2002 of up to 30 percent of their annual base rate of pay
(excluding bonuses, overtime pay, commissions and severance pay) as in effect on January 1, 2002.
The 2002 Stock Purchase Plan terminated on December 31, 2002. We record treasury stock at cost with regard to monetary transactions and at estimated fair value
with regard to non-monetary transactions. As of December 31, 2004, we had the following common shares reserved for future issuance: Awards under the 1996 Equity Compensation Plan
    
    
    9,774,884Awards under the 1996 Incentive and Non-Qualified Stock Option Plan
    
    
    3,500Total shares reserved for future issuance
    
    
    9,778,384
 As of December 31, 2004, we had the following warrants outstanding to purchase our common
stock: 45




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##### Table of Contents



Entity or Individual Holding Warrants
    
    
    Number of Warrants
    
    
    Warrant Price
    
    
    Expiration Date of WarrantsEssex Woodlands Health Ventures
    
    
    145,530
    
    
    $0.15
    
    
    10/9/2007207,900
    
    
    $0.26
    
    
    4/16/200741,580
    
    
    $0.26
    
    
    3/16/20051,008,420
    
    
    $4.00
    
    
    3/16/2005Kerry R. Hicks
    
    
    350,000
    
    
    $4.00
    
    
    3/16/2005David G. Hicks
    
    
    17,500
    
    
    $4.00
    
    
    3/16/2005Former Company Officers
    
    
    192,500
    
    
    $4.00
    
    
    3/16/2005Others
    
    
    64,750
    
    
    $4.00
    
    
    3/16/2005150,000
    
    
    $3.45
    
    
    3/16/200520,000
    
    
    $2.00
    
    
    6/5/2005
 9. STOCK OPTION PLANS On March 22, 1996, we adopted the 1996 Incentive and Non-Qualified Stock Option Plan (the Plan)
under which nontransferable options to purchase up to 5,000,000 shares of HealthGrades common stock
were available for award to eligible directors, officers, advisors, consultants and key employees.
On January 10, 1997, the Board of Directors voted to terminate the Plan. The exercise price for incentive stock options awarded during the year ended December 31, 1996 was
not less than the fair market value of each share at the date of the grant, and the options granted
under the Plan had a term of ten years. Options, which were generally contingent on continued
employment with HealthGrades, could be exercised only in accordance with a vesting schedule
established by our Board of Directors. Of the 553,500 shares underlying options granted during the
year ended December 31, 1996 at an exercise price of $1.00 per share, 3,500 shares underlying the
options remain outstanding and exercisable at December 31, 2004. The other 550,000 shares
underlying options were forfeited or exercised during 1997. On October 15, 1996, our Board of Directors approved the 1996 Equity Compensation Plan (the Equity
Plan), which initially provided for the grant of options to purchase up to 2,000,000 shares of
HealthGrades common stock. The total number of shares authorized for issuance under the Equity Plan
increased to 6,000,000 in 1998, 7,000,000 in 2000, 8,000,000 in 2001 and 13,000,000 in 2002. Our
stockholders approved the Equity Plan and each increase in shares authorized for issuance. Both
incentive stock options and non-qualified stock options may be issued under the provisions of the
Equity Plan. Employees of HealthGrades and any subsidiaries, members of the Board of Directors and
certain consultants and advisors are eligible to participate in the Equity Plan, which will
terminate no later than October 14, 2006. Our Board of Directors or a committee of the Board of
Directors authorizes the granting and vesting of options under the Equity Plan. As of December 31,
2004, there were 2,019,685 shares available for future granting under the Equity Plan. A summary of HealthGrades stock option activity and related information for the years ended
December 31 is as follows: 2004
    
    
    2003
    
    
    2002WEIGHTED-
    
    
    
    
    
    
    WEIGHTED-
    
    
    
    
    
    
    WEIGHTED-AVERAGE
    
    
    
    
    
    
    AVERAGE
    
    
    
    
    
    
    AVERAGEEXERCISE
    
    
    
    
    
    
    EXERCISE
    
    
    
    
    
    
    EXERCISEOPTIONS
    
    
    PRICE
    
    
    OPTIONS
    
    
    PRICE
    
    
    OPTIONS
    
    
    PRICEOutstanding at Beginning of Year
    
    
    9,831,408
    
    
    $
    0.31
    
    
    
    9,857,426
    
    
    $
    0.78
    
    
    
    4,814,278
    
    
    $
    3.68GrantedExercise price equal to
fair value of common stock
    
    
    919,004
    
    
    $
    1.32
    
    
    
    1,390,548
    
    
    $
    0.26
    
    
    
    6,640,759
    
    
    $
    0.09Exercised
    
    
    (828,023
    )
    
    $
    0.15
    
    
    
    (86,447
    )
    
    $
    0.11
    
    
    
    
    
    
    
    Forfeited
    
    
    (144,005
    )
    
    $
    0.99
    
    
    
    (1,330,119
    )
    
    $
    3.72
    
    
    
    (1,597,611
    )
    
    $
    6.68Outstanding at end of year
    
    
    9,778,384
    
    
    $
    0.41
    
    
    
    9,831,408
    
    
    $
    0.31
    
    
    
    9,857,426
    
    
    $
    0.78Exercisable at end of year
    
    
    8,062,638
    
    
    $
    0.36
    
    
    
    7,466,013
    
    
    $
    0.35
    
    
    
    6,601,970
    
    
    $
    1.07
 46




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##### Table of Contents



2004
    
    
    2003
    
    
    2002Weighted-Average Fair Value of Options:Granted During the YearExercise price equal to fair value of
common stock
    
    $
    1.14
    
    
    $
    0.24
    
    
    $
    0.08
 Exercise prices for options outstanding and the weighted-average remaining contractual lives
of those options at December 31, 2004 are as follows: OPTIONS OUTSTANDING
    
    
    OPTIONS EXERCISABLEWEIGHTEDAVERAGE
    
    
    WEIGHTED-
    
    
    
    
    
    
    WEIGHTEDREMAINING
    
    
    AVERAGE
    
    
    
    
    
    
    AVERAGERANGE OF
    
    NUMBER
    
    
    CONTRACTUAL
    
    
    EXERCISE
    
    
    NUMBER
    
    
    EXERCISEEXERCISE PRICES
    
    OUTSTANDING
    
    
    LIFE (YEARS)
    
    
    PRICE
    
    
    EXERCISABLE
    
    
    PRICE$0.04-$0.25
    
    
    6,079,459
    
    
    
    7.04
    
    
    $
    0.10
    
    
    
    5,669,462
    
    
    $
    0.10$0.30-$0.50
    
    
    928,216
    
    
    
    8.18
    
    
    
    0.32
    
    
    
    346,192
    
    
    
    0.33$0.53-$0.75
    
    
    1,420,298
    
    
    
    5.02
    
    
    
    0.60
    
    
    
    1,415,298
    
    
    
    0.60$0.78-$1.00
    
    
    304,500
    
    
    
    6.62
    
    
    
    0.86
    
    
    
    253,500
    
    
    
    0.87$1.01-$1.95
    
    
    865,540
    
    
    
    8.69
    
    
    
    1.36
    
    
    
    240,815
    
    
    
    1.57$2.00-$2.94
    
    
    95,000
    
    
    
    6.84
    
    
    
    2.63
    
    
    
    60,000
    
    
    
    2.74$3.10-$3.56
    
    
    23,000
    
    
    
    6.56
    
    
    
    3.40
    
    
    
    15,000
    
    
    
    3.56$6.00-$6.75
    
    
    35,900
    
    
    
    2.92
    
    
    
    6.51
    
    
    
    35,900
    
    
    
    6.51$9.75-$11.75
    
    
    26,471
    
    
    
    2.55
    
    
    
    11.48
    
    
    
    26,471
    
    
    
    11.48$0.04-$11.75
    
    
    9,778,384
    
    
    
    6.96
    
    
    $
    0.41
    
    
    
    8,062,638
    
    
    $
    0.36
 10. LEASES We are obligated under operating leases for our office space and certain office equipment. In
February 2004, we added approximately 2,900 square feet of office space to our lease for 12,200
square feet in Lakewood, Colorado. Total annual lease costs for our full-service lease on the
15,100 square feet were approximately $270,000. In December 2004, we executed a lease agreement on
an office building at a new location in Golden, Colorado for approximately 28,700 square feet. The
lease term under this new lease begins in February 2005. The term of the lease is sixty three
months. Future minimum payments under the operating leases with terms in excess of one year are summarized
as follows for the years ending December 31: 2005
    
    $
    260,4282006
    
    
    340,2762007
    
    
    324,4342008
    
    
    303,1632009
    
    
    307,036Thereafter
    
    
    127,428Total
    
    $
    1,662,765
 Rent expense for the years ended December 31, 2004, 2003 and 2002 under all operating leases
was approximately $327,000, $250,000 and $278,000, respectively. 11. INCOME TAXES We are a corporation subject to federal and certain state and local income taxes. The provision for
income taxes is made pursuant to the liability method as prescribed in Statement of Financial
Accounting Standards No. 109, Accounting for Income Taxes. This method requires recognition of
deferred income taxes based on temporary differences between the financial reporting and income tax
bases of assets and liabilities, using currently enacted income tax rates and regulations. Deferred income taxes reflect the net tax effects of temporary differences between the carrying
amounts of assets and liabilities for financial reporting purposes and the amounts used for income
tax purposes. Significant components of our deferred tax assets and liabilities at December 31,
2004 and 2003 are as follows: 47




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##### Table of Contents



2004
    
    
    2003Deferred tax assets:Accrued liabilities
    
    $
    49,741
    
    
    $
    213,716Allowance for doubtful accounts
    
    
    6,247
    
    
    
    4,783Property and equipment, net
    
    
    
    
    
    
    43,638Web development costs
    
    
    
    
    
    
    21,288Net operating loss carryforwards
    
    
    1,574,402
    
    
    
    1,981,6981,630,390
    
    
    
    2,265,123Valuation allowance for deferred
tax assets
    
    
    (1,500,550
    )
    
    
    (2,173,889
    )Gross deferred tax asset
    
    
    129,840
    
    
    
    91,234Deferred tax liabilities:Prepaid expenses
    
    
    104,075
    
    
    
    91,234Property and equipment, net
    
    
    25,765
    
    
    
    Gross deferred tax liability
    
    
    129,840
    
    
    
    91,234Net deferred tax liability
    
    $
    
    
    
    $
    
 The valuation allowance results from uncertainty regarding our ability to produce sufficient
taxable income in future periods necessary to realize the benefits of the related deferred tax
assets. During 2004, the valuation allowance was decreased by $673,339 principally due to our 2004
operating income. In accordance with Statement of Financial Accounting Standards No. 109,
Accounting for Income Taxes, we assessed the continuing need for the valuation allowance and
concluded that until
we have at least six quarters of net income before tax and cumulative
net income before tax
during the most recent twelve quarters, our net deferred tax assets
should remain subject to a full valuation allowance. The income tax (benefit) expense for the years ended December 31, 2004, 2003 and 2002 is summarized
as follows: 2004
    
    
    2003
    
    
    2002Current:Federal
    
    $
    
    
    
    $
    
    
    
    $
    (1,046,296
    )State
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,046,296
    )Deferred:Federal
    
    
    
    
    
    
    
    
    
    
    State
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total
    
    $
    
    
    
    $
    
    
    
    $
    (1,046,296
    )
 The income tax (benefit) expense differs from amounts currently payable because certain
revenues and expenses are reported in the statement of operations in periods that differ from those
in which they are subject to taxation. The principal differences relate to different methods of
calculating depreciation for financial statement and income tax purposes and currently
non-deductible book accruals and reserves. During 2002, the Job Creation and Worker Assistance Act of 2002 (JCWA Act) was signed into law.
One of the provisions of the JCWA Act extended the net operating loss carryback provisions of the
Internal Revenue Code from two years to five years for losses incurred in 2001 and 2002. Prior to
the passage of the JCWA Act, we did not have the ability to utilize our 2001 tax loss to reduce
prior year taxable income because we had no taxable income in 2000 or 1999. However, with the
passage of the JCWA Act, we were able to carryback our 2001 tax loss to reduce taxable income in
1997. As a result of the carryback, we received a tax refund of $1,046,296, which was recorded in
2002. A reconciliation between the statutory federal income tax rate of 34% and our 0.0%, 0.0% and
(38.8%) effective tax rates for the years ended December 31, 2004, 2003 and 2002, respectively, is
as follows: 2004
    
    
    2003
    
    
    2002Federal statutory income tax rate
    
    
    34.0
    %
    
    
    (34.0
    )%
    
    
    (34.0
    )%State income taxes, net of federal benefit
    
    
    6.4
    
    
    
    (5.0
    )
    
    
    (4.8
    )Non-deductible goodwill amortization
and impairment and other costs
    
    
    0.8
    
    
    
    2.3
    
    
    
    24.6Miscellaneous
    
    
    (3.4
    )
    
    
    (1.5
    )
    
    
    (1.7
    )Deferred tax asset valuation allowance
    
    
    (37.8
    )
    
    
    38.2
    
    
    
    (22.9
    )Effective income tax rate
    
    
    0.0
    %
    
    
    0.0
    %
    
    
    (38.8
    )%
 48




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We have approximately $3,800,000 in net operating loss carryforwards which may be used to
offset future taxable income. These loss carryforwards expire from 2019 through 2023. Certain
changes in our stock ownership during 2001 resulted in an ownership change pursuant to the tax laws
and, due to this change, approximately $900,000 of our net operating loss carryforwards are subject
to restrictions on the timing of their use. The remaining $2,900,000 of net operating loss
carryforwards are not subject to any use limitations. 12. LEGAL PROCEEDINGS On or about October 10, 2002, Strategic Performance Fund  II (SPF-II) commenced an action in the
Circuit Court of the 17th Judicial Circuit in and for Broward County, Florida against us, alleging
breach of two leases. These leases relate to two buildings in which one of our former affiliated
practices, Orthopaedic Associates, P.A. d/b/a Park Place Therapeutic Center (Park Place) leased
office space. Park Place ceased the payment of its rental obligations with respect to the two
leases in May 2000, and subsequently filed a petition for bankruptcy, under Chapter 11 of the
Bankruptcy Code, in the United States Bankruptcy Court, Southern District of Florida, Ft.
Lauderdale Division. SPF-II sought damages against us in the amount of approximately $4.7 million. The basis of the allegation against us was that while under the corporate name of Specialty Care
Network, Inc., we entered into an Assignment, Assumption and Release Agreement dated July 8, 1997,
under which we assumed the obligations of Orthopaedic Management Services, Inc., as lessee, under
its Lease Agreement with the owner and lessor, Park Place Orthopaedic Center II, Ltd. The
agreement was executed in connection with our acquisition of most of the non-medical assets of the
Park Place practice. On October 1, 1997, the owner of the leased property sold its interests in
the leasehold estates to SPF-II. On June 10, 1999, we sold the assets of the Park Place practice,
including the leasehold interests, back to Park Place and entered into an Absolute Assignment and
Assumption Agreement with Park Place, under which Park Place agreed to indemnify us in connection
with the leasehold obligations. In addition, we entered into an Indemnification Agreement with
Park Place and its individual physician owners, under which the individual physician owners
(severally up to their ownership interest in the practice) agreed to indemnify us in connection
with the leasehold obligations. SPF-II alleged that, notwithstanding the assignment of our
leasehold interests to Park Place, HealthGrades remains liable for all lessee obligations under the
leases. We filed a response to the initial complaint instituted by SPF-II, denying all liability with
respect to the subject leases. In addition, we filed a third-party complaint against the
individual physician owners seeking indemnification from each of these individuals under the terms
of the Indemnification Agreement. The physician owners filed a response to our complaint denying
their liability under the Indemnification Agreement, and asserting several affirmative defenses,
including, among others, our failure to mitigate damages, lack of consideration, our assertion of a
premature claim as liability and damages have not been established by SPF-II, rejection of the
leases by the bankruptcy court, and, in the case of one physician owner, a claim that an agent of
ours (who was, in fact, an employee of Park Place both before and after our affiliation with the
practice) fraudulently induced the purchase of the Park Place practices assets from us. The
physician owners also filed a motion to enjoin further prosecution of the action instituted against
them by HealthGrades and Bank of America, the lender in connection with their repurchase of the
assets of the Park Place practice, pending resolution of the bankruptcy proceeding. In November 2003, we executed a Settlement Agreement and Mutual Release (the Settlement
Agreement) with SPF-II, Orthopaedic Associates, P.A. d/b/a Park Place Therapeutic Center (Park
Place) and four of the physician owners of Park Place, in connection with a legal proceeding
concerning an alleged breach by us of two leases. In consideration for the dismissal of all claims
and mutual releases, we paid approximately $441,000 into an escrow account to be released to SPF-II
upon the satisfaction of certain conditions of the Settlement Agreement. In addition, we agreed to
pay an additional $50,000 to SPF-II on or before September 25, 2004. The aggregate payment amount
of $491,000 was recorded as an expense in our statement of operations in the third quarter of 2003.
As the $441,000 payment was made into escrow prior to year end, this cash was removed from our
balance sheet as of December 31, 2003. Payment out of escrow was contingent upon the occurrence,
on or before September 25, 2004 of (i) bankruptcy court approval of Chapter 11 plans relating to
Park Place and the four physician owners and (ii) the payment of a specified amount to SPF-II
pursuant to the Chapter 11 plans. In April 2004, upon satisfaction of the conditions described
above, the $441,000 in the above mentioned escrow account was released to SPF-II. In July 2004, we
made the final $50,000 payment to SPF-II, and an order of dismissal was entered on July 30, 2004. In 2004, we provided indemnification to our Chief Executive Officer, Kerry R. Hicks, for legal fees
totaling $272,000 relating to litigation involving Mr. Hicks. The litigation arose from loans that
Mr. Hicks and three other executive officers provided to us in 49




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December 1999 in the amount of $3,350,000 (including $2,000,000 individually loaned by Mr. Hicks).
These loans enabled us to purchase a minority interest in an internet healthcare rating business
that has become our current healthcare provider rating and advisory services business. We were the
majority owner of the business, but had agreed with the holder of the minority interest that if we
failed to purchase the holders interest by December 31, 1999, we would relinquish control and
majority ownership to the holder. In March 2000, the executive officers were compelled to convert
our obligations to them (including the $2,000,000 owed to Mr. Hicks) into our equity securities in
order to induce several private investors to invest an aggregate of $14,800,000 in our equity
securities. The executive officers personally borrowed money from our principal lending bank in order to fund
their loans to us. In early 2001, the bank claimed that Mr. Hicks was obligated to pay amounts
owed to the bank by a former executive who was unable to fully repay his loan; Mr. Hicks denied
this obligation. In October 2002, the bank sold the note to an affiliate of a collection agency
(the collection agency and the affiliate are collectively referred to as the collection agency).
Although the bank informed the collection agency in July 2003 of the banks conclusion that Mr.
Hicks was not obligated under the former executives promissory note issued to the bank, the
collection agency commenced litigation in September 2003 in federal court in Tennessee to collect
the remaining balance of approximately $350,000 on the note and named Mr. Hicks as a defendant. On
motion by Mr. Hicks, the court action was stayed, and Mr. Hicks commenced an arbitration proceeding
against the collection agency in October 2003, seeking an order that he had no liability under the
note and asserting claims for damages. The bank was added as a party in March 2004. The bank repurchased the note from the collection agency in December 2003 and resold the note to
another third party in February 2004, so that Mr. Hicks obligation to repay the note was no longer
at issue. The remaining claims included, among others, claims by the bank against Mr. Hicks for
costs and expenses of collection of the loan, claims by the collection agency against Mr. Hicks for
costs relating to this matter and claims by Mr. Hicks against the bank for breach of fiduciary duty
and fraud, and against the collection agency for abuse of process and defamation. Mr. Hicks also
commenced litigation against the other parties in Colorado state court based on similar claims. An
arbitration hearing was held from February 1-4, 2005, and a determination by the arbitrators is pending. Our determination to indemnify Mr. Hicks was based on, among other things, the fact that the
dispute related to Mr. Hicks efforts and personal financial commitment to provide funds to us in
December 1999, without which we likely would not have remained viable. Although we expect to
indemnify Mr. Hicks for additional legal expenses incurred in 2005, we do not expect these expenses
to be material in relation to our total operating expenses in 2005. We are subject to other legal proceedings and claims that arise in the ordinary course of our
business. In the opinion of management, these actions are unlikely to materially affect our
financial position. 13. COMMITMENTS We have entered into employment agreements that provide two executives with minimum base pay,
annual incentive awards and other fringe benefits. We expense all costs related to the agreements
in the period that the services are rendered by the employee. In the event of death, disability,
termination with or without cause, voluntary employee termination, or change in ownership of
HealthGrades, we may be partially or wholly relieved of our financial obligations to such
individuals. However, under certain circumstances, a change in control of HealthGrades may provide
significant and immediate enhanced compensation to the executives. At December 31, 2004, we were
contractually obligated to pay base pay compensation to these executives of approximately $508,000
through December 31, 2005. 14. EMPLOYEE BENEFIT PLAN We maintain a defined contribution employee benefit plan (the Benefit Plan). The Benefit Plan
covers substantially all HealthGrades employees and includes a Qualified Non-Elective Contribution
equal to 3% of annual compensation, applicable to all eligible participants, regardless of whether
or not the participant contributes to the Benefit Plan. Expense under the Benefit Plan, including the Qualified Non-Elective Contribution, aggregated
approximately $139,000, $116,000 and $114,000 for 2004, 2003 and 2002, respectively. 50




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15. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) The following is a summary of the quarterly results of operations for the years ended December 31,
2004 and 2003. Certain reclassifications have been made to previously reported amounts to conform
to the current period presentation. 2004
    
    March 31
    
    
    June 30
    
    
    September 30
    
    
    December 31Revenue:Ratings and advisory
    
    $
    3,217,423
    
    
    $
    3,500,314
    
    
    $
    3,673,293
    
    
    $
    4,145,274Other
    
    
    250
    
    
    
    867
    
    
    
    286
    
    
    
    44Total revenue
    
    
    3,217,673
    
    
    
    3,501,181
    
    
    
    3,673,579
    
    
    
    4,145,318Expenses:Cost of ratings and advisory revenue
    
    
    662,203
    
    
    
    548,103
    
    
    
    650,932
    
    
    
    626,964Gross margin
    
    
    2,555,470
    
    
    
    2,953,078
    
    
    
    3,022,647
    
    
    
    3,518,354Operating expenses:Sales and marketing
    
    
    1,091,450
    
    
    
    1,152,999
    
    
    
    1,296,566
    
    
    
    1,391,195Product development
    
    
    465,450
    
    
    
    445,232
    
    
    
    481,819
    
    
    
    624,940General and administrative
    
    
    803,209
    
    
    
    731,214
    
    
    
    805,894
    
    
    
    998,981Income (loss) from operations
    
    
    195,361
    
    
    
    623,633
    
    
    
    438,368
    
    
    
    503,238Other:Interest income
    
    
    1,850
    
    
    
    3,233
    
    
    
    4,351
    
    
    
    12,109Income (loss) before income taxes
    
    
    197,211
    
    
    
    626,866
    
    
    
    442,719
    
    
    
    515,347Income tax benefit
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net income (loss)
    
    
    197,211
    
    
    
    626,866
    
    
    
    442,719
    
    
    
    515,347Net income (loss) per share (basic)
    
    $
    0.01
    
    
    $
    0.03
    
    
    $
    0.02
    
    
    $
    0.02Weighted average shares outstanding
(basic)
    
    
    24,835,779
    
    
    
    25,030,159
    
    
    
    25,110,477
    
    
    
    25,253,553Net income (loss) per share (diluted)
    
    $
    0.01
    
    
    $
    0.02
    
    
    $
    0.01
    
    
    $
    0.02Weighted average shares outstanding
(diluted)
    
    
    32,063,695
    
    
    
    33,023,883
    
    
    
    33,192,577
    
    
    
    33,836,726
 2003
    
    March 31
    
    
    June 30
    
    
    September 30
    
    
    December 31Revenue:Ratings and advisory
    
    $
    1,737,741
    
    
    $
    2,009,311
    
    
    $
    2,289,669
    
    
    $
    2,767,208Other
    
    
    43
    
    
    
    1,444
    
    
    
    32
    
    
    
    32Total revenue
    
    
    1,737,784
    
    
    
    2,010,755
    
    
    
    2,289,701
    
    
    
    2,767,240Expenses:Cost of ratings and advisory revenue
    
    
    440,109
    
    
    
    464,998
    
    
    
    510,428
    
    
    
    548,414Gross margin
    
    
    1,297,675
    
    
    
    1,545,757
    
    
    
    1,779,273
    
    
    
    2,218,826Operating expenses:Sales and marketing
    
    
    642,522
    
    
    
    847,083
    
    
    
    817,061
    
    
    
    1,051,208Product development
    
    
    327,430
    
    
    
    332,748
    
    
    
    337,284
    
    
    
    436,503Litigation settlement
    
    
    
    
    
    
    
    
    
    
    491,000
    
    
    
    General and administrative
    
    
    589,892
    
    
    
    811,444
    
    
    
    655,709
    
    
    
    777,422Loss from operations
    
    
    (262,169
    )
    
    
    (445,518
    )
    
    
    (521,781
    )
    
    
    (46,307
    )Other:Interest income
    
    
    2,185
    
    
    
    1,830
    
    
    
    1,586
    
    
    
    1,792Interest expense
    
    
    (578
    )
    
    
    (6,888
    )
    
    
    (6,062
    )
    
    
    (1,777
    )Loss before income taxes
    
    
    (260,562
    )
    
    
    (450,576
    )
    
    
    (526,257
    )
    
    
    (46,292
    )Income tax benefit
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net loss
    
    
    (260,562
    )
    
    
    (450,576
    )
    
    
    (526,257
    )
    
    
    (46,292
    )Net income (loss) per share (basic
and diluted)
    
    $
    (0.01
    )
    
    $
    (0.02
    )
    
    $
    (0.02
    )
    
    $
    Weighted average shares outstanding
(basic and diluted)
    
    
    33,605,720
    
    
    
    24,402,398
    
    
    
    24,404,493
    
    
    
    24,431,077
 51




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16. SUBSEQUENT EVENTS On February 22, 2005, we extended the maturity date of our line of credit arrangement to February 13,
2006. In conjunction with our renewal, the interest rate on any advances under the line of credit
was reduced to Silicon Valley Banks prime rate plus .5%. Our ability to request advances is also
limited by any outstanding letters of credit. 52




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Health Grades, Inc. and Subsidiaries Schedule II  Valuation and Qualifying Accounts BALANCE AT
    
    
    CHARGED TO
    
    
    CHARGED TO
    
    
    
    
    
    
    BALANCE ATBEGINNING
    
    
    COSTS AND
    
    
    OTHER
    
    
    
    
    
    
    END OFDESCRIPTION
    
    OF PERIOD
    
    
    EXPENSES
    
    
    ACCOUNTS
    
    
    DEDUCTIONS
    
    
    PERIODYear ended December 31, 2004Allowance for doubtful
accounts on trade
receivables
    
    $
    11,667
    
    
    $
    3,569
    
    
    $
    

    
    
    $
    
    
    
    $
    15,236Year ended December 31, 2003Allowance for doubtful
accounts on trade
receivables
    
    $
    
    
    
    $
    11,667
    
    
    $
    
    
    
    $
    
    
    
    $
    11,667Year ended December 31, 2002Allowance for doubtful
accounts on trade
receivables
    
    $
    57,419
    
    
    $
    
    
    
    $
    
    
    
    $
    (57,419
    )(1)
    
    $
    
   (1)
    
    Represents actual amounts charged against the allowance for the periods presented. 53




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EXHIBIT ENDEX The following is a list of exhibits
    filed as part of this annual report on Form 10-K. Unless otherwise indicated,
    the file number of each document incorporated by reference is 000-22019. EXHIBITNUMBER
        
        DESCRIPTION3.1
        
        Form of Amended and Restated Certificate
          of Incorporation (incorporated by reference to Exhibit 3.1 to our
          Annual Report on Form 10-K for the year ended December 31,
          2001.)3.2
        
        Amended and Restated Bylaws (incorporated
          by reference to Exhibit 3.2 to our Annual Report on Form 10-K
          for the year ended December 31, 2001.)10.1*
        
        1996 Equity Compensation Plan, as amended
          (incorporated by reference to Exhibit 10.1 to our Annual Report
          on Form 10-K for the year ended December 31, 2002.)10.2.1
        
        Loan and Security Agreement dated May 10,
          2002 by and between Health Grades, Inc., Healthcare Ratings, Inc., ProviderWeb.net,
          Inc., and Silicon Valley Bank (incorporated by reference to Exhibit 10.1
          to our Quarterly Report on Form 10-Q for the quarter ended June 30,
          2002.)10.2.2
        
        Loan Modification Agreement dated March 11,
          2003 by and between Health Grades, Inc. and Silicon Valley Bank (incorporated
          by reference to Exhibit 10.2.2 to our Annual Report on Form 10-K
          for the year ended December 31, 2002.)10.2.3
        
        Loan Modification Agreement dated February
          20, 2004 by and between Health Grades, Inc. and Silicon Valley Bank
          (incorporated by reference to Exhibit 10.2 to our Quarterly Report on
          Form 10-Q for the quarter ended March 31, 2004)10.2.4
        
        Loan Modification Agreement dated February
          22, 2005 by and between Health Grades, Inc. and Silicon Valley Bank10.3
        
        Stock and Warrant Repurchase Agreement dated
          March 11, 2003 (incorporated by reference to Exhibit 10.3
          to our Annual Report on Form 10-K for the year ended December 31,
          2002.)10.4*
        
        Employment Agreement dated as of April 1,
          1996 by and between Specialty Care Network, Inc. and Kerry R. Hicks
          (incorporated by reference to Exhibit 10.3 to our Registration
          Statement on Form S-1 (File No. 333-17627))10.5.1*
        
        Employment Agreement between Specialty Care
          Network, Inc. and David Hicks, dated March 1, 1996 (incorporated
          by reference to Exhibit 10.8 to our Registration Statement of Form S-1
          (File No. 333-17627))10.5.2*
        
        Amendment to Employment Agreement between
          Specialty Care Network, Inc. and David Hicks, dated December 2,
          1997. (incorporated by reference to Exhibit 10.8.1 to our Annual
          Report on Form 10-K for the fiscal year ended December 31,
          1997)10.6
        
        Building Lease between GR Development One,
          LLC, Landlord and Health Grades, Inc. Tenant.23.1
        
        Consent of Grant Thornton LLP31.1
        
        Certification of the Chief Executive Officer
          pursuant to Rule 15d-14(a) under the Securities Exchange Act.31.2
        
        Certification of the Chief Financial Officer
          pursuant to Rule 15d-14(a) under the Securities Exchange Act.32.1
        
        Certification of the Chief Executive Officer
          pursuant to Rule 15d-14(b) under the Securities Exchange Act.32.2
        
        Certification of the Chief Financial Officer
          pursuant to Rule 15d-14(b) under the Securities Exchange Act.