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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 THEFISCAL YEAR ENDED DECEMBER 31, 2005****OR**   o **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934****FOR THETRANSITION PERIOD FROM                     TO                     ****Commissionfile number 0-22019****HEALTH GRADES, INC.**(Exact name of registrant as specified in its charter)   DELAWARE 62-1623449(State or other jurisdiction (I.R.S. Employer Identification No.)of incorporation or organization)     500 Golden Ridge Road, Suite 100  GOLDEN, CO 80401(Address of principal executive offices) (Zip Code)Registrant’s telephone number, including area code: (303) 716-0041SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:NoneSECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:NoneIndicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act. Yes o No þIndicate by check mark if the registrant is not required to file reports pursuant to Section 13 orSection 15(d) of the Act. Yes o No þIndicate by check mark whether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days. Yes þ No oIndicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K isnot contained herein, and will not be contained, to the best of registrant’s knowledge, in thedefinitive proxy statement incorporated by reference in Part III of this annual report on Form 10-Kor any amendment to this annual report on Form 10-K. þIndicate by check mark whether the registrant is a large accelerated filer, an accelerated filer ora non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” inRule 12b-2 under the Exchange Act (check one).Large Accelerated Filer o Accelerated Filer o Non-Accelerated Filer þIndicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 underthe Exchange Act. Yes o No þAs of June 30, 2005, the aggregate market value of the Common Stock held by non-affiliates of theregistrant was $71,108,818. Such aggregate market value was computed by reference to the closingsale price of the Common Stock as reported on the NASDAQ Capital Market on such date. For purposesof making this calculation only, the registrant has defined “affiliates” as including all executiveofficers, directors and beneficial owners of more than five percent of the Common Stock of theCompany.As ofMarch 1, 2006 there were 28,309,905 shares of the registrant’s Common Stock outstanding.  
 

 
DOCUMENTS INCORPORATED BY REFERENCETABLE OF CONTENTS         PART I           Item 1. Business  2 Item 1A. Risk Factors  15 Item 1B. Unresolved StaffComments  20 Item 2. Properties  20 Item 3. Legal Proceedings  20 Item 4. Submission of Matters to a Vote of Security Holders  21          PART II           Item 5. Market for theRegistrant’s Common Equity and Related Stockholder Matters  22 Item 6. Selected Financial Data  22 Item 7. Management’s Discussion and Analysis of Financial Condition And Results of Operations  23 Item 7A. Quantitative and Qualitative Disclosures About Market Risk  31 Item 8. Financial Statements and Supplementary Data  31 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure  52 Item 9A. Controls and Procedures  52 Item 9B. Other Information  53          PART III           Item 10. Directors and Executive Officers of the Registrant  53 Item 11. Executive Compensation  53 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters  53 Item 13. Certain Relationships and Related Transactions  53 Item 14. Principal Accountant Fees and Services  54          PART IV           Item 15. Exhibits and Financial Statement Schedules  54 Directors' Compensation Consent of Grant Thornton LLP Certification 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, theavailability of healthcare data, expected 2006 income tax rate andgrowth in new sales. Thesestatements may be found under “Item 1-Business,” “Item 1A-Risk Factors,” and “Item 7-Management’sDiscussion and Analysis of Financial Condition and Results of Operations” as well as in this Reportgenerally. 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 thosediscussed in forward-looking statements as a result of variousfactors, including: unanticipated change in our valuation allowanceor slower than anticipated growth in new sales. In addition,other factors that could cause actual events or results to differ materially from those discussedin the forward looking statements are addressed in “Risk Factors” in Item 1A and matters set forthin the Report generally. We undertake no obligation to update publicly any forward-lookingstatements.PART I     Item 1. Business.**BUSINESS****Overview**     Health Grades, Inc. (“HealthGrades”) provides proprietary, objective ratings of hospitals,nursing homes and home health agencies. We also provide detailed information on physicians,including name, address, phone number, years in practice, information on whether they are boardcertified, whether they are free of state and federal sanctions and many other items. We provideour clients with healthcare information, including information relating to quality of service anddetailed profile information on physicians, that
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enables them to measure, assess, enhance and market healthcare quality. Our clients includehospitals, employers, benefits consulting firms, payers, insurance companies and consumers.     Onour website at www.healthgrades.com, we currently provide ratings or profile informationrelating to the following healthcare providers: **•** Over 5,000 hospitals with risk-adjusted ratings on 29 medical “issues” (which wedefine below) and programmatic ratings for maternity care and women’s health (as furtherdescribed below). For 27 medical issues, the risk adjustment was based upon ourmethodology. For Gastrointestinal Procedures and Surgeries and Respiratory Failure, therisk adjustment was based upon the APR-DRG methodology developed by 3M Corporation.APR-DRG is an acronym for All Patient Refined Diagnosis Related Group. The APR-DRGmethodology is a widely used severity-of-illness and risk of mortality adjustment tool.  **•** Over 620,000 physicians in over 120 specialties; and  **•** Over 16,000 nursing homes.     We offer services to hospitals that are either attempting to communicate their clinicalexcellence to their internal staff, consumers, and physicians or are working to improve quality.For hospitals that have received high ratings, we offer the opportunity to license our ratings andtrademarks 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 ofpatient safety incidents within a hospital) at a service line level (e.g. cardiac, pulmonary,vascular, etc.) and at a medical issue level (e.g., within the cardiac service line-coronary bypasssurgery, heart attack, heart failure, etc.). We also offer physician-led quality improvementengagements and other quality improvement analysis and services for any hospitals that are seekingto understand why they have quality issues compared to other, higher-rated hospitals and how theycan improve quality.     In addition, we provide basic and detailed profile information on a variety of providers andfacilities. We make this information available to consumers, employers, benefits consulting firmsand payers to assist them in selecting healthcare providers. Basic profile information for certainproviders is available free of charge on our website, www.healthgrades.com. For a fee, we offerhealthcare quality reports with respect to hospitals, nursing homes and physicians. These reportsprovide more detailed information than is available free of charge on our website. Report pricingand content varies based upon the type of provider and whether the user is a consumer or ahealthcare professional (for example, a medical professional underwriter).     We also provide detailed online healthcare quality information for employers, benefitsconsulting firms, payers and other organizations that license our Quality Ratings SuiteTM ofproducts – Hospital Quality GuideTM, Physician Quality GuideTM, Nursing Home Quality GuideTM and HomeHealth Quality GuideTM. This information can be customized so that, for example, an employee can beprovided with online access to quality data relating to healthcare providers within the providernetwork available under the employee’s health plan.**Recent Developments**SeeItem 3. Legal Proceedings, Demand for Arbitration-Agreement withHewitt Associates LLC, for information regarding a demand forarbitration we filed before the American Arbitration Associationagainst Hewitt Associates LLC.**Healthcare Provider Quality Information**     We compile comprehensive information regarding various healthcare providers and distill theinformation to meet the requirements of consumers, employers, payers and other customers. While weprovide certain information without charge on our website, we charge users for more detailedinformation. Our revenues are generated, in part, through the provision of healthcare informationderived from our databases in a manner that can be useful to consumers, employers, benefitsconsulting firms, payers and others.     The www.healthgrades.com website is a healthcare information website that provides rating andother profile information regarding a variety of providers and facilities. Our goal is to providehealthcare information that enables consumers to locate the right provider at their time of need.     *Hospital Specialty and Programmatic Ratings*– We currently provide risk-adjusted hospitalquality ratings for 29 medical issues. For 27 medical issues, including, among others, coronarybypass surgery, acute myocardial infarction (heart attack), stroke, total knee or hip replacementand back and neck surgery, the risk adjustment is based upon our methodology. For GastrointestinalProcedures and Surgeries and Respiratory Failure, the risk adjustment is based upon methodologydeveloped by 3M Corporation. In addition,
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users can compare hospitals utilizing our programmatic ratings for maternity care and women’shealth. We have termed these “programmatic ratings” because our maternity care ratings and ourwomen’s health ratings, which include our maternity care ratings, are based in part upon thepresence or absence in a hospital’s maternity care program, of specified attributes, describedbelow, and not solely on mortality or complication rates at a discrete medical issue level as ourother ratings are. Our programmatic ratings are currently available in 17 states that provide uswith all-payer data, as further described below. In general, all ratings are updated each fall,except for our programmatic ratings, which typically are updated every spring.     For each particular medical issue chosen by the user, other than those relating to maternitycare and women’s health, we provide a rating system of five stars, three stars or one star (fivestars is the highest rating; one star is the lowest) for virtually every hospital in the UnitedStates. We base all of our ratings, except ratings on maternity care and women’s health, on threeyears of MedPAR (Medicare Provider Analysis and Review) data that we purchase from the Centers forMedicare and Medicaid Services (formerly the Health Care Financing Administration), known as CMS.The MedPAR database contains the inpatient records of all Medicare patients. We apply proprietaryalgorithms to the MedPAR data to account for variations in risk in order to make the datacomparable from hospital to hospital. In the initial analysis of the data, a separate data set iscreated for each group of patients having a specific procedure or diagnosis (e.g., coronary bypasssurgery, total hip replacement), based on ICD-9-CM coding. The ICD-9-CM (InternationalClassification of Diseases, Clinical Modification) is the widely adopted system of assigning codesto diagnoses and procedures associated with hospital utilization in the United States. TheICD-9-CM is used to code and classify mortality data from death certificates. Each group ofpatients is defined by using the information on diagnoses and procedures coded in the patientrecords. The quality measure for some procedures or diagnoses is mortality, while the qualitymeasure for others is major complications.     Generally, approximately 75% to 80% of hospitals studied are classified as three stars. Thethree star rating is applied when there is no difference, statistically speaking, between ahospital’s predicted and actual performance. Approximately 10% to 15% of hospitals are rated fivestars, 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 thanexpected.     For our maternity care ratings, which also are subject to the five star rating system, we usestate all-payer files from 17 individual states derived from the inpatient records of persons whoutilize hospitals in those states. The 17 states represented on the site are:Arizona, California, Florida, Iowa, Maine, Maryland, Massachusetts, Nevada, New Jersey, New York,North Carolina, Pennsylvania, Texas, Utah, Virginia, Washington, and Wisconsin. This datarepresents all discharges for the 17 states over a three-year period set from 2001-2003. Weanalyzed several factors, such as volume of vaginal and cesarean delivery complications, for eachhospital within the 17 all-payer states. We then developed a system that assigned a weight to eachfactor based on its importance to the quality of maternity care. Based upon the application ofthis system, the top 15% of hospitals (in the 17 states) receive five stars, the middle 70% receivethree 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 usestate all-payer files from the same 17 individual states referenced for our obstetrics ratings.These ratings are based upon outcomes in maternity care services and cardiac/stroke mortalityoutcomes for women. The top 15% of hospitals (in the 17 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 atan institutional level (e.g. hospital clinical excellence and patient safety) as well as at serviceline level. Hospitals that achieve distinction from us for their exceptional quality outcomesreceive our Distinguished Hospital Award for Clinical Excellence*TM*(DHA-CE). This is an annualdistinction that is typically announced at the beginning of each calendar year. For our 2006 awardyear, we segregated hospitals between teaching, non-teaching and community hospitals. Communityhospitals were defined as non-teaching hospitals with fewer than 200 beds. For a hospital to beconsidered for the DHA-CE, a hospital was required to have an average overall star rating of atleast 3.3 and inhospital mortality or major complication rating in at least 21 of the 28 medicalissues that we rate using MedPAR data. The top twenty percent of hospitals that met this criteria,ranked in descending order by their average star rating derived from averaging all of theirHealthGrades’ ratings, from each of the groups (teaching, non-teaching and community) were awardedthe DHA-CE designation.Nationwide, 277 hospitals received the DHA-CE designation in 2006.     Hospitals that achieve distinction from us for their exceptional patient safety performancereceive our annual Distinguished Hospital Award for Patient SafetyTM (DHA-PS). This distinction isbased on thirteen of the Agency for Healthcare Research and Quality’s (AHRQ) Patient SafetyIndicators (PSI’s) (including, among others, post-operative hip fracture, post-operative hemorrhageor hematoma and post-operative sepsis) and recognizes exceptional experience regarding the numberand type of patient safety
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incidents within a hospital. We utilized the PSI software developed by AHRQ to determine thepatient safety rates for each individual PSI. We then created an overall patient safety score forevery hospital utilizing the PSI software developed by AHRQ. For our 2005 award year, we segregatedhospitals between teaching and non-teaching. In order to achieve distinction, hospitals had to havean average overall HealthGrades star rating of at least 2.5 and have a HealthGrades star rating ina minimum number of 20 of the 28 medical issues we rate using MedPAR data. The top ten percent ofthe hospitals that met these criteria, ranked in descending order by their average overall patientsafety score, from each of the groups (teaching and non-teaching)were awarded the DHA-PSdesignation.In 2005, recipients of the DHP-PS were in the top 3% of all hospitals evaluated.Nationwide, 71 teaching hospitals and 64 non-teaching hospitals received the DHA-PS designation in2005.     In January 2005 we released our first annual Specialty Excellence AwardsTM. Hospitals withspecialty practices in cardiac, orthopedic, vascular, pulmonary, stroke, gastrointestinal care orcritical care ranked in the top ten percent in the nation received this distinction.     *Physician Quality ReportsTM*- We provide quality information on over 620,000 physicians. Thisinformation includes, to the extent available through our data sources, primary and secondaryspecialty 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 physicianinformation is identified by a specific physician identifier (e.g. Unique Physician IdentificationNumber, or UPIN), we have developed an extensive matching process designed to properly match thevarious data elements that we compile from numerous data sources to the appropriate physician. Inmost cases, our Physician Quality Reports are available to consumers for a fee. We utilize onlinemedia to attract a significant percentage of the visitors to our website. Currently, the majorityof the traffic to our website is derived through major search enginesand is displayed as part of the “free” search results. However, we also pay for certain keywords that enableHealthGrades to be displayed in certain banner or “paid” search results as well.     Wehave also recently launched a program entitled, “Patient - Provider GatewayTM”, under whicha physician can sponsor his or her own profile as, described below. Physician Quality Reports forphysicians that are participating in our Patient - Provider Gateway program are made available toconsumers without charge.     *Patient- Provider GatewayTM -*This program is designed to increase the efficiency andprofitability of participating physicians through marketing and patient education. Under thisprograms we design a premium profile for the physician that incorporates HealthGrades’source-verified information (e.g., board certification, years in practice, etc.) as well asinformation provided directly from the physician (e.g., practice philosophy, office hours, etc.).This premium profile is then made available, without charge, to all consumers searching theHealthGrades website. The Patient - Provider Gateway is designed to give physicians anopportunity to engage in a cost-effective complement to other traditional marketing mediums (e.g.,telephone directories, newspapers, radio, billboards, etc.). In addition, unlike many of thetraditional marketing mediums, we provide the ability to measure the success of these onlinemarketing efforts through our performance reporting which tracks, among other things, the number ofconsumers that view the physician’s premium profile.     *Nursing Home Ratings*- We provide ratings of the performance of nursing homes across theUnited States that are Medicare or Medicaid certified and active in these programs. These ratingsare typically updated on a monthly basis. In preparing the ratings, we analyze licensing surveydata from CMS’s Online Survey Certification and Reporting (OSCAR) database and complaint data fromCMS’s Skilled Nursing Facility (SNF) Complaint database. Licensing surveys are inspections thatassess 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 mostrecent survey date was more than 20 months prior to the date the data was received by HealthGradesare not included in the analysis. Stand-alone Medicare and/or Medicaid nursing homes are analyzedapart from Medicare, hospital-based nursing homes. We do not rate Medicare, hospital-based nursinghomes because these facilities are designed for short-term patient care. In addition, nursing homeswith only one licensing survey are not included in our analysis. The ratings are assigned on astate by state basis, rather than nationally, because the surveys from which information is derivedare conducted by state agencies, and there may be variations between the states’ survey processesand results. The highest rated 30% of nursing homes receive five stars, and the middle 40% ofnursing homes receive three stars.
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**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 thisinformation is derived, forms the basis of our marketing efforts. While some information isprovided free of charge on our website, we seek to generate revenues from hospitals, as well asemployers, consumers and others as described below:**Services for Hospitals**- We offer programs that provide business development tools and marketingassistance for hospitals seeking to distinguish themselves with respect to their clinical quality.We also provide consulting services and analytical products for hospitals seeking to understand andimprove their quality. Our programs, described in more detail below, primarily cover the followingclinical service lines:**•** Cardiac;**•** Orthopedics;**•** Vascular;**•** Pulmonary;**•** Neurosciences;**•** Gastrointestinal;**•** Critical care;**•** General surgery;**•** Maternity care; and**•** Women’s health.     Strategic Quality Initiative (SQI). We offer our SQI (Strategic Quality Initiative)program to highly rated providers only after our ratings are completed; we do not adjust ourratings based on whether a provider is willing to license with us.     The SQI program provides business development and marketing tools to hospitals that are highlyrated by us. Under our SQI program, we license the commercial use of the HealthGrades corporatemark, applicable data and multiple marketing messages that may be used by hospitals to demonstratethird party validation of excellence, and HealthGrades’ online marketing services, including, amongother things: **•** 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 maternity care or women’s health);  **•** Marketing messages developed and approved by HealthGrades;  **•** Premium placement of Enhanced Hospital Profile on the HealthGrades’ website in thephysician search section for the Patient-Provider Gateway (PPG) Service Line(s) licensed;  **•** Search engine optimization for the PPG Service Line(s) licensed with Client’s marketarea(s) as defined by the U.S. Census Bureau by county;  **•** Client password-protected access to a template in which Client can input and update itsprofile information at Client’s convenience; 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 providesongoing access to HealthGrades’ marketing service and resources, including our in-house healthcareconsultants, tailored to the hospital’s specific needs.     Strategic Quality Partnership (SQP). The SQP program (formerly, Distinguished HospitalProgram or, “DHP”) recognizes clinical excellence in hospitals across our range of service lines.Hospitals that contract with us for the SQP program receive all of the SQI features described abovewith respect to their licensed service areas. In addition, hospitals can reference the additionalDistinguished Hospital AwardTM for Clinical Excellence designation. Hospital clients are provided with additional marketingand planning assistance with respect to the Distinguished Hospital Award designation as well as atrophy for display at the hospital. This program also includes a quality analysis module to helphospitals understand their ratings and what they can do to continue to improve their quality.
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     During 2003 and prior years, as part of our SQP and SQI programs, we provided certainexclusivity rights for client hospitals. In most cases, for the particular service lines subjectto license by our hospital clients, we agreed not to provide similar marketing services to amaximum 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 ceased offering exclusivity under our contracts. For hospitals that signed agreements with usduring 2003 and prior years, we will continue to honor the exclusivity provisions in theircontracts solely for the remaining term of the agreement. As our agreements are typically threeyears (with the ability to terminate on an annual basis), we anticipate that all exclusivityprovisions will expire by the end of 2006.     Distinguished Hospital Program for Patient SafetyTM (DHP-PS). The DHP-PS recognizeshospitals with the best patient safety records in the nation. This award recognizes exceptionaloutcomes based on thirteen patient safety indicators from the AHRQ. Under our DHP-PS program, welicense the commercial use of the HealthGrades corporate mark, applicable data and marketingmessages that may be used by hospitals to demonstrate third party validation of excellence,including:**•** HealthGrades name and logo.**•** Distinguished Hospital Award for Patient Safety (“DHA-PS”) designation and trophy for that year.**•** Marketing messages developed by HealthGrades.     This program also includes a quality analysis module to assist hospitals in understandingtheir ratings and what they can do to continue to improve their quality.     Quality Assessment and Improvement (QAI). Our QAI program is principally designed tohelp a hospital improve the quality of its care in particular service lines. Using our database andon-site interviews, we can measure how well the hospital performs relative to national and regionalbest practices and help identify measures to improve quality. Detailed quality comparisons are alsoavailable at the hospital, physician group and individual physician level. Our physician-ledconsultants work on-site with the hospital staff and physicians to present the data and assist inthe quality analysis and quality improvement. Under our QAI program, with respect to the areaslicensed by the hospital, we will provide services including, but not limited to, the following:periodic onsite visits; detailed analysis of the last two years of client’s all-payer data; andindividual quality profiles for high volume physicians.     Quality Assessment (QA). The QA program involves our provision of an on-site presentation toadministrative, physician and quality improvement staff, including a detailed, quality analysis andreport of the last three years of client’s Medicare data within the service areas licensed by thehospital. 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.Upon completion of the QA program the client has the option, at a reduced fee, to participate in aQAI program for the licensed service line.     Quality Report for Hospital ProfessionalsTM — Clinical Service Line.  We providehospitals with a comprehensive report that enables them to improve quality of care by benchmarkingtheir outcomes against national five-star hospitals and local competitors, detailing the strengthsand weaknesses of their public quality profile and analyzing their quality data underlying theirspecific star ratings.     Quality Report for Hospital ProfessionalsTM — Patient Safety. We provide reports thatanalyze hospitals’ performance within thirteen patient safety indicators established by the Agencyof Healthcare Research and Quality (AHRQ), compares their performance against the best practicebenchmark, the national average and their state average and details the strengths and weaknesses oftheir public safety profile.**Additional Services for Employers, Benefits Consulting Firms, Payers and Others**–We license accessto, and customize our database for, employers, benefits consulting firms, payers and others.Modules currently available for license are as follows:
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**•** Hospital Quality GuideTM**•** Physician Quality GuideTM**•** Nursing Home Quality GuideTM**•** Home Health Quality GuideTMWe offer our customers these modules in a standard format without customization for specificgeographic areas or provider networks, through our Quality Ratings SuiteTM (QRS) product. For anadditional fee, customers can integrate our modules within their online provider directories, andwe can customize our database for specific geographic areas and provider networks as well as modifythe look and feel of the modules. Depending on the client’s needs, we can customize our contentfor the intended users. Some of the healthcare quality information available to our customers andtheir users within our modules are as follows:     Hospital Quality Guide **•** Easy-to-understand star ratings on over 100 medical issues (27 medical issues utilizingour methodology and over 73 medical issues utilizing 3M’s APR-DRG methodology) and byservice 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 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 privileges).     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***TM*- We offer comprehensive quality information toorganizations 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 toeducation, professional licensing history and other items.     *Nursing Home Quality Reports for ProfessionalsTM*- Our primary customers for our Nursing HomeQuality Reports for professionals are medical professional liability underwriters. We currently offer the following three categories of reports on nursing homes:Nursing Home Quality Report; Executive Summary Reports and Risk Assessment Report. Our NursingHome Quality Report for Professionals contains detailed information on ownership, certificationhistory, staffing and patient
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demographics as well as performance and ranking data from health, state complaint andlicensing surveys. Our Executive Summary Report is a three-page report, which summarizes thisinformation. Our Risk Assessment Report is a two to three page textual analysis of the Nursing HomeQuality Report that highlights potential problem areas within a facility that require riskmanagement.     *Hospital Reports for ProfessionalsTM*- Our Hospital Reports contain detailed information onownership, services provided and clinical performance outcomes. Some of the features of our reportsinclude: **•** Risk and severity-adjusted performance measures for cardiac, neurosciences, stroke,vascular, orthopedics and pulmonary service lines (as well as the underlying medical issuefor 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 adverseoutcomes based upon our proprietary mortality or complication rate analysis.     *Physician Reports for Professionals*TM — Our Physician Reports contain detailed information on aphysician’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.**Healthcare Quality Reports for Consumers***TM*- We offer comprehensive quality information to consumersthat provides current and historical quality information on hospitals and nursing homes. Inaddition, we offer reports on physicians that contain detailed information with respect toeducation, professional licensing history and other items.     *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 ConsumersTM*- 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 ConsumersTM*- 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;
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 **•** National comparative statistics in board certification and sanction activity regardingphysicians 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 ourname recognition and market presence, as well as enhance our service offerings. The following is asummary of our current arrangements for the provision of joint product offerings.     *Ingenix/HealthGrades Quality Rating Suite*. We previously entered into an arrangement withIngenix, Inc., to market our Quality Ratings Suite (described above under “Additional Services forEmployers, Benefits Consulting Firms, Payers and Others”) to managed care organizations, payers,employers and benefits consulting firms through Ingenix’ sales and marketing teams. Ingenixformerly provided some of the physician data that was included in our Quality Ratings Suite. InNovember 2005, we provided notice to Ingenix that we would not renew the agreement, and theagreement terminated on December 31, 2005. Under the terms of the agreement, we and Ingenix willcontinue to perform services under any ongoing customer license for joint HealthGrades/Ingenixcustomers until the expiration or termination of the initial term of the license. In accordancewith the agreement, we are now utilizing the physician data derived from Ingenix solely forexisting joint HealthGrades/Ingenix customers.     Under the Ingenix/HealthGrades Quality Rating Suite, customers were offered projectmanagement, information technology, user support and communications services (for example,information for users of the Ingenix/HealthGrades Quality Rating Suite and instructions on how toaccess the information).     Typically, Ingenix added the HealthGrades’ QRS functionality to services available to itsexisting clients who license Ingenix’ provider lookup online application. An additional licensingfee is charged, of which a portion is payable to us, with Ingenix retaining the remaining part ofthe 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 agreementsin 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 thatoffer certain consulting services to hospitals. We believe that the ability to demonstrate thevalue of marketing and consulting programs, name brand recognition and cost are the principalfactors that affect competition.     We face competition with respect to our service offerings to employers, benefits consultingfirms, payers, consumers and others from companies that provide online information and decisionsupport tools regarding healthcare providers and physicians. There are several companies thatcurrently offer online healthcare information and support tools such as Subimo and HealthShareTechnologies (recently acquired by WebMD). We believe that the ability to provide accurate andcomprehensive healthcare information in a manner that is cost-effective to the client is theprincipal factor that affects competition in this area.**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 physicianpractices 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 managementindustry in general, and with respect to our affiliated physician practices in particular, weterminated or restructured our arrangements with various physician practices. As a result, thescope of our physician practice management business became increasingly limited in subsequentyears, particularly after a restructuring of our arrangements with nine practices in June 1999, andceased entirely in September 2002.     During 1998, we began to focus on the provision of healthcare information through theestablishment of our healthcare provider quality ratings and profile information, which we firstintroduced on our website. Since that time, we have expanded the scope of our healthcareinformation services to encompass the additional services described above.
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     In January 2000, we changed our name to Healthgrades.com, Inc. In November 2000, we changedour name to Health Grades, Inc.**Government Regulation**     The delivery of healthcare services has become one of the most highly regulated ofprofessional and business endeavors in the United States. Both the federal government and theindividual state governments are responsible for overseeing the activities of individuals andbusinesses engaged in the delivery of healthcare services. The focus of Federal regulation ofhealthcare businesses and professionals is based primarily upon their participation in the Medicareand 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 toregulate and protect the health and welfare of its citizens.     A provision of the federal Social Security Act, commonly known as the Medicare/MedicaidAnti-Kickback Law, prohibits kickbacks, rebates and bribes in return for referrals. This lawprovides an extremely broad base for finding violations. Indeed, any remuneration, direct orindirect, offered, paid, solicited, or received, in return for referrals of patients or businessfor 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 alsoprohibits payments made to anyone to induce them to “recommend purchasing, leasing, or ordering anygood, 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 to5 years, or both. In addition, acts constituting a violation of the Anti-Kickback Law may alsolead to civil penalties, such as fines, assessments and exclusion from participation in theMedicare and Medicaid programs.     To provide more direct guidance on the interpretation of the Anti-Kickback Law, the Office ofInspector General, or OIG, of the Department of Health and Human Services (DHHS) has developedregulations regarding what types of business arrangements are not to be considered violative of thelaw and to develop criteria to be applied to any new arrangement to determine whether it isacceptable under the law. The regulations are known as “Safe Harbors” and address activities thatmay technically violate the Anti-Kickback Law, but are not to be considered as illegal when carriedon in conformance with the proposed regulation. The OIG has also set forth specific procedures bywhich the DHHS, through the OIG, in consultation with the Department of Justice (DOJ), will issueadvisory opinions to outside parties regarding the interpretation and applicability ofanti-kickback and certain other statutes relating to Federal and State healthcare programs.     Whenever an arrangement exists with an entity capable of providing services reimbursed byMedicare or Medicaid, the arrangement must be analyzed to determine if the Anti-Kickback Law isimplicated (i.e., can the arrangement be characterized as involving remuneration intended to inducereferrals 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, wewant to be sure that any payments to us will not be considered a payment for a referral of patientsor business that HealthGrades controls.     Theonly payments made to us by providers and practitioners will be for access to information,to make their HealthGrades’ profiles available to consumerswithout cost, or for evaluation and consultingservices — not to induce referrals. Federal courts have interpreted the anti-kickback provisionsvery broadly to prohibit even those payments made in return for legitimate services, if the intentto induce referrals can be inferred from the arrangement. However, where the payments made underan agreement represent fair market value or reasonable remuneration for the goods, services orother consideration being received, there should be less factual support for any inference thatpayments are in exchange for referrals. Moreover, we do not control patients, doctors, or othersin 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 andmanagement agreement safe harbor regulation. The personal services and management agreement safeharbors provide that payments under such agreements will not constitute remuneration under theAnti-Kickback Law if the payments meet seven criteria, including that the agreement is set out inwriting and is signed by the parties, and that aggregate compensation is set in advance, isconsistent with fair market value and does not take into account the volume or value of anyreferrals or business generated between the parties. Unless an arrangement meets all of the termsof a safe harbor, the government could attempt to draw an inference that payments made constituteremuneration 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 thatour 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 referralservices and
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could constrain our relationships, including financial and marketing relationships withcustomers such as hospitals. It is possible that additional or changed laws, regulations orguidelines could be adopted in the future that could affect our business.     Many states have laws that prohibit payment of kickbacks or other payment of remuneration tothose in a position to control the referral of patients. Therefore, it is possible that ouractivities may be found not to comply with these laws. Noncompliance with such laws could subjectus to penalties and sanctions. Nonetheless, to our knowledge, we are not in violation of any legalrequirements under such state laws.     In addition to the anti-kickback laws, false claims are prohibited pursuant to federalcriminal and civil statutes. Criminal provisions prohibit knowingly filing false claims, makingfalse statements or claims to be made by others. Civil provisions under the federal False ClaimsAct (FCA) prohibit the filing of claims or causing the filing of claims that the person filing knewwere false. Criminal penalties include fines and imprisonment. Civil penalties under the FCAinclude fines up to $10,000 per claim, plus treble damages, for each claim filed. In addition,under the Deficit Reduction Act of 2005, states are encouraged to enact their own false claimslaws, which could increase the number of false claims suits at the state level.     Although we are not filing claims ourselves, liability under the FCA can extend to those whocause the filings of claims. To the extent that consulting advice provided to our customers couldbe construed as aiding or abetting the presentation of false claims by our customers, there couldbe 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 andModernization Act of 2003 has not had a major impact on our arrangements with providers. Futurelegislation may be introduced and considered by Congress and state legislatures that is designed tochange access to and payment for healthcare services in the United States. We can make noprediction as to whether future legislation will be enacted or, if enacted, the effect that suchlegislation will have on us.*Privacy of Information and HIPAA*     Consumers sometimes enter private information about themselves or their family members whenusing our services. Also, our systems record use patterns when consumers access our databases thatmay 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 byour systems in connection with services we offer to employers and other payers. Numerous federaland state laws and regulations govern collection, dissemination, use and confidentiality ofpatient-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, asdescribed in detail below, and related rules proposed by the Health Care FinancingAdministration; and  **•** CMS standards for electronic transmission of health data     Under HIPAA, Congress set national standards for the protection of health information created,maintained or transmitted by health plans, health care clearinghouses and certain health careproviders (“covered entities”). Under the law and regulations known collectively as the Privacyand Security Rules, covered entities must implement standards to protect and guard against themisuse of individually identifiable health information. Although we are not a covered entity, webelieve that we have complied with the applicable standards. Failure to timely implement thesestandards may, under certain circumstances, trigger the imposition of civil or criminal penalties.     The Privacy and Security Rules do not replace federal, state, or other law that grantsindividuals even greater privacy protections, and covered entities are free to retain or adopt moreprotective policies or practices.     Most healthcare providers and payers do not carry out all of their healthcare activities andfunctions by themselves. Instead, they often use the services of a variety of other persons orbusinesses. The Privacy and Security Rules allow covered entities to disclose protected healthinformation to business associates if the covered entities obtain satisfactory assurances that thebusiness associate will use the information only for the purposes for which it was engaged, willsafeguard the information from misuse, and will comply with certain other requirements under thePrivacy and Security Rules. Although HealthGrades is not a covered entity, it may be asked to enterinto business associate agreements with covered entities.
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     Covered entities may disclose protected health information to an entity in its role as abusiness associate *only*to help the covered entity carry out its healthcare functions – not for thebusiness associate’s independent use or purposes, except as needed for the proper management andadministration of the business associate.     If a covered entity finds out about a material breach or violation of the privacy relatedprovisions of the contract by the business associate, it must take reasonable steps to cure thebreach or end the violation, and, if unsuccessful, terminate the contract with the businessassociate. If termination is not feasible (e.g., where there are no other viable businessalternatives for the covered entity), the covered entity must report the problem to the Departmentof Health and Human Services Office for Civil Rights.**Government Regulation of the Internet**     The Internet is currently the subject of a fair number of statues and regulations, and thetrend for the foreseeable future appears to be that of an increase in the quantity and thecomplexity of regulation. Any new or revised law or regulation pertaining to the Internet, or theapplication or interpretation of existing laws and regulations, could decrease demand for ourservices, increase our cost of doing business, decrease the availability of the data we obtain anduse from third parties, increase the costs of online marketing, or otherwise cause our business tosuffer.     Laws and regulations have been adopted in the United States and throughout the world, andadditional 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 andquality of products and services. This legislation could increase our cost of doing business andnegatively affect our business. Moreover, it will take many years to determine the full extent towhich 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 statutesregulating specific industries that collect personal data, or particular types or uses of personaldata. For example, HIPAA consists of a large body of statutory provisions and regulations thatcontrol the disclosure, use, and transfer of personal health information in digital form byproviders and others. One recent trend is the enactment of privacy and security statutes thatrequire the disclosure to authorities and to data subjects of any breach of security of a databaseof personal information. Several other privacy laws and regulations predate and therefore do notspecifically address online activities. In addition, a number of comprehensive legislative andregulatory privacy proposals have taken effect or are now under consideration by federal, state andlocal governments in the United States. All such privacy laws may decrease access to the raw datathat we use, and may increase our costs of compliance with such laws and regulations in the conductof our business.     In addition, the regulation of the Internet outside the United States may affect our cost ofdoing business, directly or indirectly, in the long run. For example, privacy law in the EuropeanUnion and in a number of other countries is far more restrictive then U.S. privacy law in terms ofhow personal information may be collected, stored, processed, transmitted, and shared with others.As a result, the Company may not be able to profitably expand its business to the European Union orother countries that have similar laws, and the Company may not be able to realize the benefits ofreducing costs by outsourcing any of its operations that involve the processing of personalinformation to such countries. Further, the more restrictive privacy and other Internet-relatedlaws and regulations in other countries have served as a model for newer and more restrictiveprivacy and other Internet-laws and regulations in the United States.**Intellectual Property**     We regard the protection of our intellectual property rights to be important. We rely on acombination of copyright, trademark, trade secret restrictions and contractual provisions toprotect our intellectual property rights. We require selected employees to enter intoconfidentiality and invention assignment agreements as well as non-competition agreements. Thecontractual provisions and other steps we have taken to protect our intellectual property may notprevent misappropriation of our technology or deter third parties from developing similar orcompeting technologies.     We own federal trademark registrations for the marks HealthGrades, The Healthcare QualityExperts and The Healthcare Rating Experts. We have also applied for registered trademarks for thephrase, “Guiding America to Better Healthcare” as well as the HealthGrades Checkmark & Star Logo.
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     We own registered copyrights for the following HealthGrades’ databases and reports:     Databases: **•** Hospital Ratings;  **•** Hospital Awards; and  **•** Hospital Patient Safety     Reports: **•** Hospital Quality ReportTM;  **•** Physician Quality ReportTM;  **•** Physician Quality Comparison Report TM;  **•** Nursing Home Quality ReportTM; and  **•** Nursing Home Quality Comparison ReportTM     There is also significant uncertainty regarding the applicability to the Internet of existinglaws regarding matters such as property ownership and other intellectual property rights. The vastmajority of these laws were adopted prior to the advent of the Internet and, as a result, do notcontemplate 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 mayhave 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, 2005 we had 106 employees, most of whom were located at our corporateoffices in Golden, Colorado. Of these employees, 46 were engaged in sales and marketing, clientconsulting or client administrative support, 47 in product development (including informationtechnology/web development) and 13 in general and administrative (including finance, accounting, ITinfrastructure, etc.). We are not subject to any collective bargaining agreements.
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Item 1A. Risk Factors.Risks Related to Our BusinessOUR BUSINESS WILL SUFFER IF WE ARE NOT ABLE TO OBTAIN RELIABLE DATA AS A BASIS FOR OUR HEALTHCAREINFORMATION.     To provide our healthcare information, we must be able to receive comprehensive, reliabledata. We currently obtain this data from a number of public and private sources. Currently, theinformation we utilize to compile our hospital ratings is acquired from the Centers for Medicareand Medicaid Services (“CMS”). For the year ended December 31, 2005, revenues derived from SQP,SQI, and QAI products accounted for approximately 72% of our total ratings and advisory revenue.These products are based exclusively on our hospital ratings. Moreover, some of our QRS modulesare 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 suchinformation available, and suitable alternative sources were not identified on a timely basis.Moreover, our ability to attract and retain customers is dependent on the reliability of theinformation that we use and purchase. If our information is inaccurate or otherwise erroneous, ourreputation and customer following could be damaged. In the past, we have had disputes with twoproviders of information who sought to terminate our arrangements based on allegations, which wedenied, that our use of the information violated the terms of our agreements with the providers. Wehave located alternate sources of information or modified the scope of information provided inresponse to these disputes. Nevertheless, our failure to obtain suitable information, if needed touse in place of information provided by a source that determines to stop providing information, orwhich charges substantially more for such data, could hurt our business.FAILURE TO EFFECTIVELY MANAGE THE GROWTH OF OUR OPERATIONS AND INFRASTRUCTURE COULD DISRUPT OUROPERATIONS AND PREVENT US FROM MAINTAINING OR INCREASING PROFITABLITY     We have expanded meaningfully in the past few years and are seeking to increase our salesefforts, attract new clients, maintain existing clients and develop new products. To manage ourgrowth, we must successfully attract qualified personnel and successfully integrate new personnelinto our operations. Our failure to manage personnel and otherwise appropriately manage expansionof 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 OTHERWISEPROVIDED TO EMPLOYERS AND OTHERS.     We may be subjected to claims for defamation, negligence, copyright or trademark or patentinfringement, personal injury or other legal theories relating to the information we publish on ourwebsites or otherwise provide to customers. These types of claims have been brought, sometimessuccessfully, against online services as well as print publications in the past. We have receivedthreats from some providers that they will assert defamation and other claims in connection withthe information posted on our healthgrades.com website.     We have had disputes with certain physicians with respect to the accuracy of their data thatis included in reports we sell to consumers and professionals, and have settled litigation withsome of these physicians. Continuing to improve the accuracy of our data by both internal processmeasures and by obtaining data from various sources for comparative purposes will continue to beimportant for us.     Patients who file lawsuits against providers often name as defendants all persons or companieswith any nexus to the providers. As a result, patients may file lawsuits against us based on, amongother things, treatment provided by hospitals or other facilities that are highly rated by us, orby doctors who are identified on our website. In addition, a court or government agency may takethe position that our delivery of health information directly, or information delivered by athird-party website that a consumer accesses through our website, exposes us to malpractice orother personal injury liability for wrongful delivery of healthcare services or erroneous healthinformation. Such exposure may adversely affect our business. Moreover, the amount of insurancewe maintain may not be sufficient to cover all of the losses we might incur from these claims andlegal actions. In addition, insurance for some risks is difficult, impossible or too costly toobtain, 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 BEIMPAIRED.
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     To expand our audience of online users, increase our online traffic and increase interest inour other healthcare information services, we must strengthen recognition of our brand name. To besuccessful in this effort, consumers must perceive us as a trusted source of healthcareinformation; hospitals and other providers must perceive us as an effective marketing and saleschannel for their services and products; and employees, payers, insurers, consumers and others mustperceive us as a source of valuable information that can be used to enhance the quality andcost-effectiveness of healthcare. We may be required to increase substantially our marketing budgetin our efforts to strengthen brand name recognition. Our business will suffer if our efforts arenot 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 toattract, retain and motivate highly skilled employees when needed. As we expand our business, weneed to hire additional personnel to support our operations. We may be unable to retain our keyemployees or attract or retain other highly qualified employees in the future. If we do not succeedin attracting new personnel as needed and retaining and motivating our current personnel, ourbusiness 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 dependon the capacity, reliability and security of our network infrastructure. We rely on telephonecommunication providers to provide the external telecommunications infrastructure necessary forInternet communications. We will also depend on providers of online content and services for someof the content and applications that we make available through healthgrades.com. Any significantinterruptions in our services or increase in response time could result in the loss of potential orexisting users or customers. Although we maintain insurance for our business, we cannot guaranteethat our insurance will be adequate to compensate us for losses that may occur or to provide forcosts associated with business interruptions.     We must be able to operate our website 24 hours a day, 7 days a week, without materialinterruption. 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 frequentlyupdated information. Our website users may experience slower response times or system failures dueto increased traffic on our website or for a variety of other reasons. We could experiencedisruptions or interruptions in service due to the failure or delay in the transmission or receiptof this information. Any significant interruption of our operations could damage our business.OUR PROPRIETARY RIGHTS MAY NOT BE FULLY PROTECTED, AND WE MAY BE SUBJECT TO INTELLECTUAL PROPERTYINFRINGEMENT CLAIMS BY OTHERS.     If we fail to adequately protect our intellectual property rights, our business could beharmed by making it easier for our competitors to duplicate our services. We have certaintrademarks and copyrights that have been registered with the U.S. Patent and Trademark Office andthe U.S. Copyright Office, respectively. In addition, we require some of our employees to enterinto confidentiality and invention assignment agreements and, in more limited cases,non-competition agreements. Nevertheless, our efforts to establish and protect our proprietaryrights may be inadequate to prevent imitation of our services or branding by others or may besubject to challenge by others. Furthermore, our ability to protect some of our proprietary rightsis uncertain since legal standards relating to the validity, enforceability and scope ofintellectual property rights in Internet related industries are uncertain and are still evolving.
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     In addition to the risk of failing to adequately protect our proprietary rights, there is arisk 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 mayclaim that we are doing so. The possibility of inadvertently infringing upon the proprietary rightsof another is increased for businesses such as ours because there is significant uncertaintyregarding the applicability to the Internet of existing laws regarding matters such as copyrightsand other intellectual property rights. A claim of intellectual property infringement may cause usto incur significant expenses in defending against the claim. If we are not successful in defendingagainst an infringement claim, we could be liable for substantial damages or may be prevented fromoffering some aspects of our services. We may be required to make royalty payments, which could besubstantial, to a party claiming that we have infringed their rights. These events could damage ourbusiness.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 intoa marketing agreement with us. However, hospitals, the media and others may take the position thatcertain use of our ratings is “fair use” and not proprietary. We will need to continue to enforcethe protection of our proprietary information and aggressively pursue selected hospitals and othersthat utilize our name and ratings information without our permission. If our enforcement effortsare 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 ourrevenues. The markets in which we compete are characterized by rapidly changing technology,evolving technological standards in the industry, frequent new service and product announcementsand changing consumer demand. Our future success will depend on our ability to adapt to thesechanges, and to continuously improve the content, features and reliability of our services inresponse to competitive service and product offerings and the evolving demands of the marketplace.In addition, the widespread adoption of new Internet networking or telecommunications technologiesor other technological changes could require us to incur substantial expenditures to modify oradapt our website or infrastructure, which might negatively affect our ability to remainprofitable.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 advertisinginventory, which would cause our expenses to increase and could result in lower margins. Ouradvertising contracts with online search engines are typically short-term. If one or more searchengines on which we rely for advertising modifies or terminates its relationship with us, ourexpenses could increase, the number of visitors we generate could decrease and our revenues ormargins could decline. Additionally, changes to our position within search engine search resultscould cause visits to our website and the number 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 expectcompetition to increase significantly, and our business will be adversely affected if we are unableto compete successfully. We currently compete, or potentially compete, with many providers ofhealthcare information services and products, both online and through traditional means. Wecompete, directly 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 andfax messaging;**•** companies and organizations providing or maintaining general purpose consumer online services that provide access tohealthcare
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  content and services;**•** companies and organizations providing or maintaining public sector and non-profit websites that provide healthcareinformation 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 websitesSome of these competitors are larger, have greater resources and have more experience in providinghealthcare information than us.RISKS RELATED TO HEALTHCARE INFORMATION AND THE INTERNETHEALTHCARE REFORMS AND THE COST OF REGULATORY COMPLIANCE COULD NEGATIVELY AFFECT OUR BUSINESS.     The healthcare industry is heavily regulated. In the ordinary course of business, healthcareentities and companies that do business with them are subject to state and federal regulatoryscrutiny, supervision, oversight and control. These various laws, regulations and guidelinesaffect, among other matters, the provision, licensing, labeling, marketing, promotion andreimbursement of healthcare services and products. Our failure or the failure of our customers tocomply with any applicable legal or regulatory requirements, or any investigation or audit of ouror 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 inimproper 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 findingviolations. Indeed, any remuneration, direct or indirect, offered, paid, solicited or received inreturn for referrals of patients or business for which payment may be made in whole or in partunder Medicare or Medicaid could be considered a violation of law. The statute also prohibitspayments 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. Similarlaws exist in some states.     We believe that our operations comply with applicable legal regulatory requirements of theanti-kickback laws. Nevertheless, some of these laws have been applied to payments by physiciansfor marketing and referral services and could constrain our relationships, including financial andmarketing relationships with customers such as hospitals. It is possible that additional or morerestrictive laws, regulations or guidelines could be adopted in the future.     Criminal provisions prohibit knowingly filing false claims or making false statements orcausing false statements to be made by others, and civil provisions prohibit the filing of claimsor causing the filing of claims that one knows were false. Criminal penalties include fines andimprisonment. Civil penalties under the federal False Claims Act (“FCA”) include fines of up to$10,000 per claim plus treble damages, for each filed claim. Although we are not filing claimsourselves, liability under the FCA can extend to those who cause claims to be filed. In addition,under the Deficit Reduction Act of 2005, states are encouraged to enact their own false claimslaws, which could increase the number of false claims suits at the state level. To the extent thatconsulting advice provided to our customers could be construed as aiding or abetting thepresentation 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 LAWS AND REGULATIONSTHAT MAY DECREASE USAGE OF OUR WEBSITE, INCREASE OUR COST OF DOING BUSINESS OR OTHERWISE HAVE ADAMAGING EFFECT ON OUR BUSINESS     Laws and regulations have been adopted and will likely continue to be adopted in the futurethat address Internet-related issues,
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including online content, user privacy, pricing, and quality of products and services. Thislegislation could increase our cost of doing business and negatively affect our business. Moreover,it may take many more years to determine the extent to which laws and regulations passed prior tothe popular use of the Internet govern issues like property ownership, libel, negligence andpersonal privacy are applicable to the Internet. Currently, U.S. privacy law consists of disparatestate and federal statutes regulating specific industries that collect personal data. Most of thempredate and therefore do not specifically address online activities. In addition, a number ofcomprehensive legislative and regulatory privacy proposals are now under consideration by federal,state and local governments in the United States. Laws and regulations in countries outside theUnited States restrict the availability of new markets in other countries where those markets wouldotherwise be available for expansion, and reduce any potential savings in relocating any operationsof the Company to those countries. Moreover, restrictive privacy and other laws outside the UnitedStates serve as a model for new and more restrictive laws inside the United States at both theFederal and the State levels.     Any new law or regulation pertaining to the Internet, or the application or interpretation ofexisting laws, could decrease usage for our website, increase our cost of doing business orotherwise cause our business to suffer.OUR BUSINESS COULD BE IMPAIRED BY STATE AND FEDERAL LAWS DESIGNED TO PROTECT INDIVIDUAL HEALTHINFORMATION.     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 whenusing our services. Also, our systems record use patterns when consumers access our databases thatmay 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 byour systems in connection with services we offer to employers and other payers. Numerous federaland state laws and regulations govern collection, dissemination, use and confidentiality ofpatient-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 (“HIPAA”) and related rules proposed by the Health CareFinancing Administration; and**•** CMS standards for electronic transmission of health data     Congress may consider future legislation that would establish more strict standards forprotection and use of health information. While we are not gathering patient health information atthis time and we are not a covered entity under HIPAA, other third-party websites that consumersaccess through our website and employees, payers and other customers may not maintain systems tosafeguard any health information they may be collecting. In some cases, we may place our content oncomputers that are under the physical control of others, which may increase the risk of aninappropriate disclosure of information. For example, we contract out the hosting of our website toa third party. In addition, future laws or changes in current laws may necessitate costlyadaptations to our systems.ONLINE SECURITY BREACHES COULD HARM OUR BUSINESS.     Our security measures may not prevent security breaches. Substantial or ongoing securitybreaches 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 confidentialinformation over the Internet is essential to maintain confidence in our websites. We believe thatconsumers generally are concerned with security and privacy on the Internet, and any publicizedsecurity problems could inhibit the growth of our provision of healthcare information on theInternet.     We will need to incur significant expense to protect and remedy against security breaches whenwe identify a significant business risk. Currently, we do not store sensitive information, such aspatient information or credit card information, on our websites. If we launch services that requireus to gather sensitive information, our security expenditures will increase significantly.
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     A party that is able to circumvent our security systems could steal proprietary information orcause interruptions in our operations. Security breaches could also damage our reputation andexpose us to a risk of loss or litigation and possible liability. Our insurance policies may not beadequate to reimburse us for losses caused by security breaches. We also face risks associated withsecurity breaches affecting third parties conducting business over the Internet or customers andothers who license our data.OTHER RISKSOUR CERTIFICATE OF INCORPORATION AND BYLAWS INCLUDE ANTI-TAKEOVER PROVISIONS THAT MAY DETER ORPREVENT A CHANGE OF CONTROL.     Some provisions of our certificate of incorporation and bylaws and provisions of Delaware lawmay deter or prevent a takeover attempt, including an attempt that might result in a premium overthe market price for our common stock. Our certificate of incorporation requires the vote of 662/3% of the outstanding voting securities in order to effect certain actions, including a sale ofsubstantially all of our assets, certain mergers and consolidations and our dissolution orliquidation, unless these actions have been approved by a majority of the directors. Ourcertificate of incorporation also authorizes our Board of Directors to issue up to 2,000,000 sharesof preferred stock having such rights as may be designated by our Board of Directors, withoutstockholder approval. Our bylaws provide that stockholders must follow an advance notificationprocedure for certain nominations of candidates for the Board of Directors and for certain otherstockholder business to be conducted at a stockholders meeting. The General Corporation Law ofDelaware restricts certain business combinations with interested stockholders upon theiracquisition of 15% or more of our common stock.     All of these provisions could make it more difficult for a third party to acquire, or coulddiscourage a third party from attempting to acquire, control of us, and thereby could prevent ourstockholders from receiving a premium for their shares. In addition, the foregoing provisionscould impair the ability of existing stockholders to remove and replace our management and/or ourBoard 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 toretain all future earnings to finance the expansion of our business.Item 1B.Unresolved Staff CommentsNoneItem 2. Properties     We have a lease for our approximately 28,700 square foot headquarters facility in Golden,Colorado, which expires on May 31, 2010. These facilities are suitable to accommodate ouroperations at their current level.Item 3. Legal ProceedingsDemand for Arbitration-Agreement with Hewitt Associates LLCOn March 28, 2006, we filed a Demand for Arbitration before the American ArbitrationAssociation against Hewitt Associates LLC (“Hewitt”). The Demand for Arbitration relates to aDevelopment and Services Agreement with Hewitt that we entered into effective June 30, 2005, (asamended, the “Agreement”). Under the Agreement, we were to develop and host applications thatwould enable Hewitt’s clients to make available to their employees and other participants enhancedHealth Grades’ health care quality information as well as other information regarding providers ina particular health plan’s network. Such information was to include our hospital and physicianquality information along with health plan supplied data.Under the Agreement, during an initial evaluation period that ended on December 31, 2005, weprovided pilot services to one Hewitt client. The Agreement provided that, at the end of theevaluation period, Hewitt would determine whether we were successful in providing the pilotservices. In addition, during the evaluation period, Hewitt was to evaluate our capacity tocollect, process, integrate, deploy, maintain and update provider-specific data received fromhealth plans that would enable a Hewitt client participant to determine the identity of providersin a health plan’s network (“Network Tag Services”). If Hewitt determined that the pilot serviceswere not successful or otherwise did not warrant continuation of the Agreement, or if Hewittdetermined that we are not suitable to provide the Network Tag Services, Hewitt could terminatethe Agreement. The Agreement provided that notice of such termination must be sent to us no laterthan December 31, 2005.If Hewitt’s evaluations were favorable, Hewitt would pay to us a fee based upon the total number ofHewitt clients’ participants with access to our websites, and the type of services to which theparticipants have access, in accordance with a fee schedule attached to the Agreement, subject tominimum payments of $3 million per annum in 2007, 2008 and 2009.The Demand for Arbitration alleges, among other things, that on December 31, 2005, Hewitt sent us aletter in which Hewitt concluded that the provision of the pilot services was “successful,” andthat, with regard to the Network Tag Services, the health plans have been slow to respond to theHewitt/Health Grades request for data. Moreover, the Demand for Arbitration alleges that Hewittdid not terminate the Agreement on December 31, 2005 and that follow up e-mails from Hewitt madereference to Hewitt’s desire to “amend the existing Agreement . . .” . The Demand for Arbitrationfurther alleges that our response to Hewitt’s December 31, letter, while committing us to therelationship, reminded Hewitt that bringing the health plan information to us is one of theprincipal responsibilities Hewitt has under the Agreement. In addition, the Demand for Arbitrationstates that, on March 10, 2006, Hewitt claimed that the December 31, 2005 letter invoked the rightto terminate the Agreement, even though the December 31 letter makes no reference to terminatingthe Agreement; moreover, on March 15, 2006, Hewitt administrators refused to continue to performHewitt’s obligations under the Agreement.In the Demand for Arbitration, we claim, among other things, that Hewitt has willfully repudiatedand breached the terms of the Agreement by falsely contending that it had the right to terminatethe Agreement based on our performance of the pilot services and the Network Tag Services; byrefusing to continue to perform under the Hewitt Agreement; and by falsely contending that we hadmaterially breached the Agreement when Hewitt had precluded us from providing services under the Agreement and our performance had at all times been commendable. Weare seeking $21 million in damages, plus costs.Hewitt has not yet responded to the Demand for Arbitration.Indemnificationof our Chief Executive OfficerIn 2004, we provided indemnification to our Chief Executive Officer, Kerry R. Hicks, for legal feestotaling approximately $272,000 relating to litigation involving Mr. Hicks. We provided additionalindemnification of approximately $461,000 during 2005. 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 topurchase a minority interest in an internet healthcare rating business that has become our currenthealthcare provider rating and advisory services business. Although we were the majority owner ofthe business, we had agreed with the principal minority interest holder that if we failed topurchase the holder’s interest by December 31, 1999, we would relinquish control and majorityownership to the holder. In March 2000, the executive officers converted our obligations to them(including the $2,000,000 owed to Mr. Hicks) into our equity securities in order to induce severalprivate 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 fundtheir loans to us. In early 2001, the bank claimed that Mr. Hicks was obligated to pay amountsowed to the bank by a former executive who was unable to fully repay his loan; Mr. Hicks deniedthis 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, thecollection agency commenced litigation in September 2003 in federal court in Tennessee to collectthe remaining balance of
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approximately $350,000 on the note and named Mr. Hicks as a defendant. On motion by Mr. Hicks, thecourt action was stayed, and Mr. Hicks commenced an arbitration proceeding against the collectionagency in October 2003, seeking an order that he had no liability under the note and assertingclaims 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 toanother third party in February 2004, so that Mr. Hicks’ obligation to repay the note was no longeran issue. The remaining claims included, among others, claims by the bank against Mr. Hicks forcosts and expenses of collection of the loan, claims by the collection agency against Mr. Hicks forabuse of process and tortious interference with the relationship between the bank and thecollection agency 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 commencedlitigation against the other parties, as well as two individuals affiliated with the collectionagency (together with the collection agency, the “collection agency parties”), based on similarclaims. That case was removed to federal court by the defendants. Mr. Hicks later filed an amendedcomplaint against the collection agency parties in federal district court for abuse of process,defamation and intentional infliction of emotional distress. The federal district court determinedthat Mr. Hicks’ claims should be submitted to the arbitration proceeding, but in January 2005, thearbitrator stayed Mr. Hicks’ federal court claims and the collection agency’s claims against Mr.Hicks for abuse of process and tortious interference until after consideration of the other pendingclaims. An arbitration hearing was held in February 2005 on the other claims submitted by theparties.In April 2005, the arbitrator announced his determination. The arbitrator ruled that thecollection agency was liable to Mr. Hicks in the amount of $400,000 for emotional distress andother maladies as well as attorneys’ fees in the amount of $15,587 with interest as a result of thecollection agency’s abuse of process in initiating the action in federal court in Tennessee. Thearbitrator determined that the bank had no liability.Mr. Hicks has not been paid the arbitration award. The collection agency sought reconsideration ofthe ruling by the arbitrator, who denied the request. Mr. Hicks filed a motion with the federaldistrict court to confirm the arbitration award, and the court confirmed the award on October 26,2005. The collection agency filed a notice of appeal in connection with the federal districtcourt’s confirmation of the arbitration award entered in favor of Mr. Hicks. Counsel for Mr. Hickshas advised us that Mr. Hicks has filed a motion to dismiss the notice of appeal because severalclaims remain unresolved by the court and the district court did not certify its ruling for appeal.The hearing on the remaining claims in the arbitration was held on February 28, 2006 through March3, 2006. The arbitrator who heard these claims died unexpectedly a few daysafter the arbitration hearing was complete and did not issue aruling. A new arbitrator has been appointed. It is anticipated that,during April 2006, the new arbitrator will set procedures under whichthe remaining claims will be decided.Our determination to indemnify Mr. Hicks was based on, among other things, the fact that thedispute related to Mr. Hicks’ efforts and personal financial commitment to provide funds to us inDecember 1999, without which we likely would not have remainedviable. Mr. Hicks has advised us that he intends to reimburse us forall indemnification expenses we have incurred and continue to incur,from the proceeds of any final award paid to him, net of any incometaxes payable by him resulting from the award.By a letter to our Board of Directors dated February 13, 2006, one of the collection agency partiesmade allegations directed at us, Mr. Hicks and the attorneys representing Mr. Hicks in thearbitration. The principal allegations appear to be that we, Mr. Hicks and the attorneys conspiredto enter into an illegal arrangement with an account officer of the bank whose loan was the initialsubject of the arbitration, without the bank’s knowledge, that enabled us to indirectly obtainfunds from the bank and, in conspiracy with the late Arbitrator, prevented the collection agency partiesfrom reporting the alleged conduct to government authorities. The collection agency partythreatened suit if it is not paid $10.3 million.We believe these allegations are absurd and completely without merit. To our knowledge, thecollection agency parties have not sought to assert any such “claims” against us in thearbitration. We will vigorously contest any litigation that may be brought against us by thecollection agency parties.We are subject to other legal proceedings and claims that arise in the ordinary course of ourbusiness. In the opinion of management, these actions are unlikely to materially affect ourfinancial position.Item 4. Submission of Matters to a Vote of Security Holders     Not applicable.Executive Officers of the Registrant
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The following table sets forth certain information concerning the executive officers of theCompany. The executive officers are elected by the Board of Directors of the Company to serve forone year or until their successors are duly elected and qualified.       **NAME** **AGE** **POSITION**Kerry R. Hicks  46  President, Chief Executive OfficerJ.D. Kleinke  44  Vice Chairman of the Board of DirectorsDavid G. Hicks  48  Executive Vice PresidentSarah Loughran  41  Executive Vice PresidentAllen Dodge  38  Senior Vice President-Finance, ChiefFinancial Officer, Secretary andTreasurerKERRY R. HICKS, one of our founders, has served as our Chief Executive Officer and one of ourdirectors 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 January 2005. He has beenone 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 strategicpartnerships. Mr. Kleinke has served as President and Chief Executive officer for HSN, a privatelyheld health information technology development company, since April 1998.DAVID G. HICKS has served as our Executive Vice President since November 1999. He was Senior VicePresident of Information Technology from May 1999 to November 1999 and Vice President of ManagementInformation Systems from March 1996 until May 1999.SARAH LOUGHRAN has served us in several capacities since 1998, including as our Executive VicePresident since July 2004 and Senior Vice President – Provider Services from December 2001 to July2004.ALLEN DODGE has served as Senior Vice President – Finance and Chief Financial Officer since May2001. He was Vice President – Finance/Controller from March 2000 to May 2001 and CorporateController from September 1997 to March 2000. Mr. Dodge is a Certified Public Accountant.Kerry R. Hicks and David G. Hicks are brothers.PART IIItem 5. Market for Registrant’s Common Equity and Related Stockholder MattersThe following table sets forth the high and low sales prices for our Common Stock for the quartersindicated as reported on the Nasdaq Capital Market (since June 16, 2005) and the OTC Bulletin Board(prior to June 16, 2005).           **HIGH** **LOW**Year Ended December 31, 2004        First Quarter $1.80  $.55 Second Quarter  1.75   .86 Third Quarter  1.85   1.12 Fourth Quarter  3.25   1.50          Year Ended December 31, 2005        First Quarter $5.10  $2.77 Second Quarter  5.95   3.72 Third Quarter  5.50   3.25 Fourth Quarter  6.48   3.20 We have never paid or declared any cash dividends and do not anticipate paying any cashdividends in the foreseeable future. We currently intend to retain any future earnings for use inour business.Item 6. Selected Financial DataStatement of Operations Data
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                       Year Ended December 31,   **2005**  **2004**  **2003**  **2002**  **2001** Ratings and advisory revenue $20,794,173  $14,536,304  $8,803,929  $5,091,891  $3,088,451                      Physician practice service fees  —   —   —   195,492   551,925                      Income (loss) from operations  3,942,424   1,760,600   (1,275,775)  (1,770,555)  (7,620,773)                     Income (loss) before cumulative effect of achange in accounting principle  4,139,853   1,782,143   (1,283,687)  (562,482)  (7,367,243)                     Net income (loss) $4,139,853  $1,782,143  $(1,283,687) $(1,650,793)(1) $(7,367,243)                                     Net income (loss) per common share (basic) $0.15  $0.07  $(0.05) $(0.05)(1) $(0.30)                                     Weighted average number of common sharesused in computation (basic)  27,039,057   25,058,173   26,679,467   36,189,748   24,399,699                                      Net income (loss) per common share (diluted) $0.12  $0.05  $(0.05) $(0.05)(1) $(0.30)                                     Weighted average number of commonshares and common share equivalentsused in computation (diluted)  34,833,521   33,031,087   26,679,467   36,189,748   24,399,699                  (1) – Net loss for the year ended December 31, 2002 includes an impairment charge ofapproximately $1.1 million related to a cumulative effect of a change in accounting principle dueto our adoption of Statement of Financial Accounting Standards No. 142, *Goodwill and OtherIntangible Assets*. In addition, net loss also reflects an income tax benefit of approximately $1.0million related to the carryback of our 2001 tax loss.Balance Sheet Data                       **DECEMBER 31, 2005** **DECEMBER 31, 2004** **DECEMBER 31, 2003** **DECEMBER 31, 2002** **DECEMBER 31, 2001**Working capital (deficit)  5,024,057   96,190   (1,820,137)  44,207   161,324 Total assets  23,844,473   12,931,127   8,821,239   7,117,551   7,747,904 Total long-term debt  5,254   —   —   —   — ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of OperationsIntroductory CommentaryIn evaluating our financial results and financial condition, management has focused principally onthe following:*Revenue Growth and Client Retention*– We believe these are key factors affecting both our resultsof operations and our cash flow from operations. For the year ended December 31, 2005, ourincreased revenues as compared to the same period of 2004 reflected our success in several productareas. We continued adding new hospital customers to our Strategic Quality Partnership (SQP)(formerly, Distinguished Hospital Program), Strategic Quality Initiative (SQI) and QualityAssessment and Improvement (QAI) programs. In addition, we continued to increase sales through thedistribution of our quality information in our Quality Ratings Suite and Healthcare Quality Reportsfor Consumers.As our base of hospital clients grows, one of our principal objectives is to achieve a high rate ofretention of these clients. We believe one of the obstacles to maintaining high retention ratesfor our marketing clients is the fact that clients may have lost their high ratings by a givencontract anniversary date. In addition, for our contracts with hospitals that have also beenawarded an overall hospital designation, such as our Distinguished Hospital Award for ClinicalExcellenceTM, we have found that in many cases, the hospitals terminate their contract with us ifthey lose the overall hospital designation. For example, hospitals that contract with us for theSQP program typically have been awarded our Distinguished Hospital Award for Clinical Excellence.In addition, the contracts give them the ability to utilize any additional marketing messages theyhave for our individual service lines as well. However, if the hospital does not achieve theDistinguished Hospital Award for Clinical Excellence each year of their agreement they may notplace as much value on the individual service line messages and, therefore, terminate theiragreement with us. We have continued to enhance the services provided in our agreements as well asadd service line awards that are designed to increase our ability to retain these clients.For the year ended December 31, 2005, we retained, or signed new agreements with, contractsrepresenting approximately 68% of the annual contract value of hospitals whose contracts had firstor second year anniversary dates. This percentage was substantially the same whether the hospitalscontracted with us for marketing services or quality improvement services. In general, our rate ofre-
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signing expired contracts is lower, especially with respectto our quality improvement clients, than our retention rate with respect to contracts that have acancellation option on the first or second anniversary dates. Some of our quality improvementclients view a three-year term as the culmination of their improvement efforts rather than astarting point. The increase in our contract prices over the last several years has caused somehospitals to decline renewal as well. Because we give our clients a fixed annual contract priceduring their three-year term, our price points for renewals may have increased significantly at theexpiration of the contract. In addition, prior to January 2004, for clients that signed SQIcontracts with us, we agreed not to sign similar agreements with a specified number of hospitals inclose proximity to the client hospital. Beginning in January 2004, we no longer offer this type ofexclusivity under our hospital contracts. For hospitals that signed agreements with us during2003, we will continue to honor the exclusivity provisions in their contracts solely for theremaining term of the agreement. As our agreements are typically three years (subject to acancellation right that may be exercised by either the client or us on each annual anniversarydate), we anticipate that all exclusivity provisions will expire by the end of 2006.We typically receive a non-refundable payment for the first year of the contract term (which asnoted above is typically three years, subject to a cancellation right that may be exercised byeither the client or us on each annual anniversary date) upon contract execution. Because wetypically receive payment in advance for each year of the term of these agreements, if we cannotcontinue to attract new hospital clients and retain a significant portion of our current clients,our cash flow from operations could be adversely affected.*Income Taxes*– During the six month period ended June 30, 2005, we reversed by $1.5 million, thevaluation allowance for deferred tax assets previously reflected in our financial statements. Thevaluation allowance resulted from uncertainty regarding our ability to realize the benefits of therelated deferred tax assets. In accordance with Statement of Financial Accounting Standards No.109, Accounting for Income Taxes, we assessed the continuing need for the valuation allowance andconcluded that, consistent with criteria we established in 2004, the valuation allowance was nolonger required. As a result, our effective income tax rate during 2005 was approximately .2%. Inaddition, cash provided by operations for the year ended December 31, 2005 includes a reduction inincome taxes payable of approximately $1.2 million related to certain employee stock optiontransactions. During 2006, we anticipate an effective income tax rate of approximately 42%.
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Critical Accounting Estimates     In preparing our financial statements, management is required to make estimates andassumptions 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 andjudgment necessary to account for highly uncertain matters or matters susceptible to change, andwhere they can have a material impact on our financial condition and operating performance. Wediscuss below the most significant estimates and related assumptions used in the preparation of ourfinancial statements, namely those relating to our income tax valuation allowance. If actualresults were to differ materially from the estimates made, the reported results could be materiallyaffected. Our senior management has discussed the application of these estimates with our AuditCommittee.Income Tax Valuation Allowance
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     Until June 30, 2005, we maintained a full valuation allowance against our net deferred taxasset of approximately $1.5 million. The valuation allowance resulted from uncertainty regardingour ability to produce sufficient taxable income in future periods necessary to realize thebenefits of the related deferred tax assets. In accordance with Statement of Financial AccountingStandards No. 109, *Accounting for Income Taxes*, we assessed the continuing need for the valuationallowance and concluded that once we had achieved at least six quarters of net income before taxand cumulative net income before tax during the most recent twelvequarters, we could reverse thevaluation allowance. During the second quarter of 2005, we met these criteria and determined thatthe valuation allowance was no longer required.REVENUE AND EXPENSE COMPONENTSThe following descriptions of the components of revenues and expenses apply to the comparison ofresults of operations.*Ratings and advisory revenue.*We currently operate in one business segment. We provideproprietary, objective healthcare provider ratings and advisory services to our clients. Wegenerate revenue by providing our clients with information and other assistance that enables themto measure, assess, enhance and market healthcare quality. Our target clients include hospitals,employers, benefits consulting firms, payers, insurance companies and consumers. We typicallyreceive a non-refundable payment at the beginning of each year of the contract term (which istypically three years, subject to a cancellation right by either the client or us, on each annualanniversary date). We record the cash payment as deferred revenue that is then amortized torevenue on a straight-line basis over the respective year of the term. Certain of our productsrepresent a one-time delivery of data. For these arrangements, we recognize revenue at the timethat the data is delivered.*Cost of ratings and advisory revenue.*Cost of ratings and advisory revenue consists primarily ofthe costs associated with the delivery of services related to our SQI, SQP and QAI programs, aswell as the costs incurred to acquire the data utilized in connection with these and other servicessuch as our Quality Ratings Suite products. The cost of delivery of services relates primarily tothe client consultants and support staff that provide our services.*Sales and marketing costs*. Sales and marketing costs include salaries, wages and commissionexpenses related to our sales efforts, as well as other direct sales and marketing costs. For ourSQP, SQI and QAI agreements, we pay our sales personnel commissions as we receive payment from ourhospital clients. We typically receive a non-refundable payment for the first year (and subsequentyears on each anniversary date) of the three-year contract term. In addition, we record thecommission expense in the period it is earned, which is typically upon contract execution for thefirst year of the agreement and on each anniversary date for clients that do not cancel in thesecond or third year of the contract term. We record the commission expense in this manner becauseonce a contract is signed, the salesperson has no remaining obligations to perform during theagreement in order to earn the commission.*Product development costs.*We incur product development costs related to the development andsupport of our website and the development of applications to support data compilation andextraction for our consulting services. These costs are expensed asincurred unless the criteria for capitalization under SOP 98-1are met.*General and administrative expenses.*General and administrative expenses consist primarily ofsalaries, employee benefits and other expenses for employees that support our infrastructure suchas finance and accounting personnel, certain information technology employees and some of oursupport staff, facility costs, professional fees and insurance costs.
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RESULTS OF OPERATIONSRatings and Advisory Revenue Overview               Year ended  Year ended  Year ended Product Area December 31, 2005  December 31, 2004  December 31, 2003 Marketing services tohospitals(SQP and SQI products) $12,341,196  $8,763,218  $6,366,530 Quality improvementservices to hospitals(QAI products)  2,442,338   2,043,619   964,674 Sales of qualityinformation toemployers,consumers and others(QRS and HealthcareQuality Reports)  5,741,471   3,516,450   1,262,255 Consultant reimbursedtravel  269,168   213,017   170,220 Other  —   —   40,250           Total $20,794,173  $14,536,304  $8,803,929           YEAR ENDED DECEMBER 31, 2005 COMPARED TO YEAR ENDED DECEMBER 31, 2004Ratings and advisory revenue. For the year ended December 31, 2005, ratings and advisory revenuewas approximately $20.8 million, an increase of $6.3 million from ratings and advisory revenue of$14.5 million for the year ended December 31, 2004. For the year ended December 31, 2005 and 2004,approximately 59% and 60% of our ratings and advisory revenue was derived from our marketingservices to hospitals. Revenues from this product area increased by approximately $3.6 million to$12.3 million for the year ended December 31, 2005. This increase is principally due to theaddition of new clients, as well as our continued success selling additional services to existinghospitals, or “upsells.” For 2005, upsells accounted for approximately 38% of total new contractedsales. The addition of two additional marketing services sales personnel contributed to our salesgrowth. In addition, individuals hired in recent years have continued to increase their salesproficiency. In addition, approximately 12% of our ratings and advisory revenue was derived fromthe sale of our quality improvement services to hospitals for the year ended December 31, 2005compared to 14% for the same period of 2004. Sales of our quality information totaled 28% of ourratings and advisory revenue for the year ended December 31, 2005 compared to 24% for the sameperiod of 2004. Strong growth in our direct sales of quality reports to consumers via our websiteand our relationship with Hewitt Associates, through whom we provide our quality information toover 125 of the Fortune 1000 companies, was a principal reason for the increase in sales of ourquality information.Cost of ratings and advisory revenue. For the years ended December 31, 2005 and 2004, cost ofratings and advisory revenue was approximately $3.2 million and $2.5 million, respectively, orapproximately 15% and 17% of ratings and advisory revenue. The slight decrease in cost of ratingsand advisory revenue as a percentage of ratings and advisory revenue is due to the fact that themajority of our revenue growth was from our marketing services to hospitals and sales of qualityinformation, and increased sales of these items do not entail a substantial amount of incrementalcost. In addition, one of the significant components of cost of ratings and advisory revenue isour cost to acquire data, which has remained relatively fixed for the last year. Moreover, salesof our healthcare quality reports do not require any commission costs as these are sold onlinedirectly to consumers. Costs related to our healthcare quality reports are principally related topayments to internet search engines for placement on the internet, as well as fees paid to aconsultant. The fees we pay to a consultant are variable based upon the revenue generated from thesale of our healthcare quality reports to consumers, less certain expenses, and are subject to amonthly cap. These costs are included in sales and marketing expense in our statements ofoperations.Salesand marketing costs. Sales and marketing costs for the year ended December 31, 2005 increased to approximately $5.8million from $4.9 million for the same period of 2004. As a percentage of ratings and advisoryrevenue, sales and marketing costs were 28% and 34%, in 2005 and 2004, respectively. The decreaseas a percentage of ratings and advisory revenue is primarily due to our ongoing base of business.We pay a lesser percentage of commissions to our sales group upon retention of contracts withhospitals than we pay with respect to new contracts. Sales and marketing costs also includepayments to internet search engines for placement on the internet. This expense was approximately$865,000 and $757,000 in 2005 and 2004, respectively.Productdevelopment costs. Product development costs increased to approximately $3.0 million from $2.0 million for the sameperiod of 2004. This increase is principally due to additional personnel hired to support ourproduct development efforts, including both the improvement of existing products as well as thedevelopment of new product offerings, including costs incurred with respect to our agreement withHewitt that were properly not capitalized. In addition, we continue to invest in the improvementof our physician data. The physician data we maintain relates to over 600,000 physicians. Thisdata does not identify physicians by a unique physician identifier (such as a social securitynumber for an individual). Therefore, in order to properly match the various data points that wemaintain to the appropriate physician, we must conduct a robust matching process. We continue toacquire new physician data and refine our matching process to improve the accuracy of our data.
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General and administrative expenses. For the year ended December 31, 2005, general andadministrative expenses were approximately $4.9 million, an increase of approximately $1.6 millionfrom general and administrative expenses of approximately $3.3 million for the same period of 2004.The increase in general and administrative expenses is due to various items including an increasein legal fees of approximately $400,000, which includes indemnification expenses with respect toour chief executive officer (described in Note 15 to the financial statements), additionalaccounting fees of approximately $170,000 related principally to an outside consultant retained toassist us with respect to our Sarbanes-Oxley compliance efforts, additional office rent ofapproximately $160,000 related to our move into a office location in Golden, Colorado, increasedinvestor relations fees of approximately $130,000 (including $50,000 with respect to our NASDAQCapital Market listing fee) and other items, including additional personnel and depreciationexpenses related to our growth and move into our expanded office space during 2005.Interest expense     For the year ended December 31, 2005, we incurred interest expense of approximately $800 withrespect to interest paid on capital lease obligations for the security system lease at our facilityin Golden.Interest income     We maintain cash in an overnight investment account that includes short-term U.S. governmentobligations with maturities not exceeding three months and investments in a short-term investmentaccount that includes U.S. government and government agency debt securities with originalmaturities not exceeding three months. As of December 31, 2005, our total investment in theseaccounts amounted to approximately $6.1 million. This amount is included within the cash and cashequivalent line item of our balance sheet. For the twelve months ended December 31, 2005, interestearned on this account was $177,899. As of December 31, 2005, we also maintained short-terminvestments in U.S. government and government agency debt securities with maturities of greaterthan 90 days and less than 180 days. As of December 31, 2005, our investment in these securitiestotaled approximately $2.0 million and is included within the short-term investment line item ofour balance sheet. For the twelve months ended December 31, 2005, interest earned on investmentsin this account was $27,225. Any decrease in interest rates in either of these investment accountswould not have a material impact on our financial position.YEAR ENDED DECEMBER 31, 2004 COMPARED TO YEAR ENDED DECEMBER 31, 2003Ratings and advisory revenue. For the year ended December 31, 2004, ratings and advisory revenuewas 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 marketingservices to hospitals. Although revenue from our marketing services declined as a percentage oftotal revenue from 2003 to 2004, revenues from this product area increased by approximately $2.4million to $8.8 million for the year ended December 31, 2004. This increase is principally due tothe addition of new clients in 2004. We continued to add clients for our existing service lines aswell 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 qualityimprovement services to hospitals for the year ended December 31, 2004 compared to 11% for the sameperiod of 2003. Sales of our quality information totaled 24% of our ratings and advisory revenuefor the year ended December 31, 2004 compared to 14% for the same period of 2003. Strong growthin our direct sales of quality reports to consumers via our website and our relationship withHewitt Associates, through whom we provide our quality information to over 125 of the Fortune 1000companies, was a principal reason for the increase in sales of our quality information.Cost of ratings and advisory revenue. For the years ended December 31, 2004 and 2003, cost ofratings and advisory revenue was approximately $2.5 million and $2.0 million, respectively, orapproximately 17% and 22% of ratings and advisory revenue. The decrease in cost of ratings andadvisory revenue as a percentage of ratings and advisory revenue is due to the fact that ourrevenue growth was principally from our marketing services to hospitals and sales of qualityinformation, and increased sales of these items do not entail a substantial amount of incrementalcost. In addition, one of the significant components of cost of ratings and advisory revenue isour cost to acquire data, which remained relatively fixed in 2004 compared to 2003. Moreover, oursales of our healthcare quality reports do not require any commission costs as these are soldonline directly to consumers. Costs related to our healthcare quality reports are principallyrelated to payments to internet search engines for placement on the internet, as well as fees paidto a consultant. The fees we pay to a consultant are variable based upon the revenue generatedfrom the sale of our healthcare quality reports to consumers, less certain expenses, and aresubject to a monthly cap. These costs are included in sales and marketing expense in ourconsolidated statements of operations.Sales and marketing costs for the year ended December 31, 2004 increased to approximately $4.9million from $3.4 million for the
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same period of 2003. As a percentage of ratings and advisory revenue, sales and marketing costswere 34% and 38%, respectively. The decrease as a percentage of ratings and advisory revenue isprimarily due to our increased existing base of business. We pay a lesser percentage ofcommissions to our sales group upon renewals of contracts with hospitals than we pay with respectto new contracts.General and administrative expenses. For the year ended December 31, 2004, general andadministrative expenses were approximately $3.3 million, an increase of approximately $505,000 fromgeneral 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 increasein professional fees related to our internal control efforts with respect to Sarbanes-Oxley, anincrease in legal fees, indemnification expenses (described in Note 15 to the financial statementsincluded in this report), additional office rent related to an increase in office space ofapproximately 3,000 square feet during 2004 and other items related to our growth during 2004.LIQUIDITY AND CAPITAL RESOURCESAs of December 31, 2005, we had working capital of approximately $5.0 million, an increase of $4.9million from our working capital of approximately $96,000 as of December 31, 2004. Included incurrent liabilities as of December 31, 2005 is $11.7 million in deferred revenue, principallyrepresenting 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 yearended December 31, 2005, cash flow provided by operations was approximately $6.6 million comparedto cash provided by operations of approximately $2.8 million for the same period of 2004. Inaddition to the positive effect of our net income, cash provided by operations for the year endedDecember 31, 2005 includes a reduction in income taxes payable of approximately $1.2 millionrelated to certain employee stock option transactions.During the year ended December 31, 2005, the number of our common shares issued increased byapproximately 2.8 million shares due to the exercise of stock options and warrants. We receivedapproximately $713,000 in cash from this exercise of stock options and warrants, which representsthe exercise price of these instruments. As of December 31, 2005, we have outstanding options topurchase approximately 8.0 million shares of our common stock, the majority of which have exerciseprices of less than $2.00 per share. Therefore, we anticipate that additional options will beexercised.Through February 13, 2006, we had a $1.0 million line of credit arrangement (the “Agreement”) withSilicon Valley Bank.In February 2006, our line of credit arrangement with Silicon Valley Bank expired. We did notrenew the arrangement, although we had outstanding a standby letter of credit drawn on the bank inthe amount of approximately $500,000, which was provided in January 2005 in connection with ourentry into a lease for our headquarters office in Golden, Colorado. We anticipate that our$500,000 standby letter of credit with Silicon Valley Bank will be secured as a compensatingbalance against the cash and cash equivalents we maintain with Silicon Valley Bank.During theyear ended December 31, 2005, we incurred approximately $1.6 million in capitalexpenditures. These expenditures included the following: leasehold improvements and furniture forour new office space (approximately $600,000), software development costs capitalized with respectto our application to deliver data to Hewitt’s clients, as described further in Note 5 to thefinancial statements included in this report (approximately $400,000) and server equipment,computers and other capital items for new employees (approximately $600,000). In addition, we paid$200,000 to acquire certain intangible assets (survey tools as well as a survey builderapplication) from the Foundation for Accountability, a not-for-profit organization. These toolsare intended to enable consumers to compare their healthcare experience to evidence-basedguidelines for specific conditions. In addition to the capital expenditures related to our newfacility, we anticipate incurring certain capital expenditures during 2006 primarily to upgradesome of our information technology hardware and software.We anticipate that we have sufficient funds available to support ongoing operations at theircurrent level. As noted above, upon execution of our SQI, SQP and QAI agreements, we typicallyreceive a non-refundable payment for the first year of the contract term (which is typically threeyears, subject to a cancellation right that may be exercised by either the client or us on eachannual anniversary date). We record the cash payment as deferred revenue, which is a currentliability on our consolidated balance sheet that is then amortized to revenue over the first yearof the term. Annual renewal payments, which are made in advance of the year to which the paymentrelates, are treated in the same manner during each of the following two years. As a result, ouroperating 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 planincludes growth in new sales from these agreements. A significant failure to achieve sales
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targets in the plan 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, 2005:                       Payments Due by Period       Less than 1          More than   Total  year  2-3 years  4-5 years  5 years    *Contractual Obligations*                    Capital Lease Obligations $25,866  $5,748  $11,496  $8,622  $— Operating Lease Obligations  2,009,629   475,433   898,047   636,149   — Employee Contracts  530,349   530,349   —   —   — Purchase Obligations  1,047,109   507,534   539,575   —   —                 Total $3,612,953  $1,519,064  $1,449,118  $644,771  $—                 Operating lease obligations relate principally to our office space lease.RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS*RentalCosts During a Construction Period*In October 2005, the Financial Accounting Standards Board issued FSP FAS 13-1, *Accounting forRental Costs Incurred during a Construction Period*(FSP FAS 13-1). Based on the provisions of FSPFAS 13-1, lessees are not permitted to capitalize rental costs associated with either ground orbuilding operating leases that are allocated to the construction period. These costs must berecognized as rental expense and included in income from continuing operations. FSP FAS 13-1 iseffective for us beginning January 1, 2006.As described in Note 13 to our financial statements included in this report, during 2005 we enteredinto a lease agreement for a new location in Golden, Colorado effective in February 2005. Duringthe construction period, prior to our occupancy, we capitalized approximately one and a half monthsof construction period rent, including common area maintenance charges, totaling approximately$65,000. This amount is being amortized to rent expense over the sixty-three month term of ourlease. FSP FAS 13-1 permits, but does not require, retrospectiveapplication of this position. Based on the provision of FSP FAS 13-1 if we enter into any new leases in the future, wewill no longer capitalize any construction period rent.*Share-Based Payments*In December 2004, the Financial Accounting Standards Board issued Statement of Financial AccountingStandards No. 123(R), *Share-Based Payment*(SFAS 123(R)).SFAS 123(R) requires employee stockoptions and rights to purchase shares under stock participation plans to be accounted for under thefair value method, and eliminates the ability to account for these instruments under the intrinsicvalue method prescribed by Accounting Principles Board (APB) Opinion No. 25, and allowed under theoriginal provisions of SFAS No. 123, *Accounting for Stock-Based Compensation*(SFAS 123). SFAS123(R) requires the use of an option pricing model for estimating fair value, which is amortized toexpense over the service periods. SFAS 123(R) is effective for public companies for fiscalyears that begin after June 15, 2005.In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin (SAB) 107.*Share-Based Payment*, to provide additional guidance to public companies in applying the provisionsof SFAS 123(R). During 2005, the FASB issued three FASB Staff Positions (FSP): FSP FAS123(R)-1, *Classification and Measurement of Freestanding Financial Instruments Originally Issued inExchange for Employee Services under FASB Statement No. 123(R),*FSP FAS 123(R)-2, *PracticalAccommodation to the Application of Grant Date as Defined in FASB Statement No. 123(R)*, and FSP FAS123(R)-3, *Transition Election Related to Accounting for the Tax Effects of Share-Based PaymentAwards.*We will adopt the provisions of SAB 107 in conjunction with the adoption of SFAS 123(R) and also consider the guidance provided in the FSPs as we consider the effect thatSFAS 123(R) will have on our results of operations, financial position and cash flows.We account for our stock-based compensation arrangements using the intrinsic value method under theprovisions of APB 25 and related interpretations. Under SFAS 123(R), we must determine theappropriate fair value model to be used for valuing share-based payments, the amortization methodfor compensation cost and the transition method to be used at the date of adoption. The transitionmethods include modified prospective and modified retrospective adoption options. Under themodified retrospective option, prior periods may be restated either as of the beginning of the yearof adoption or for all periods presented. The modified prospective method requires thatcompensation expense be recorded for all previously unvested stock options and restricted stock asthey vest, and for all awards issued or modified beginning on January 1, 2006.We have determined that we will adopt the modified prospective transition method. With respect tounvested options that were granted during 2005 and prior years, we will recognize compensation costas expense based on the grant date fair value of those awards calculated using the Black Scholesoption pricing model previously utilized under SFAS 123 for proforma disclosures.We expect to record additional compensation expense related to our adoption of SFAS 123(R) withrespect to the stock options that are outstanding as of December 31, 2005 of approximately $675,000for the year ended December 31, 2006. Depending upon the amount of any share-based payments granted during 2006, this amount may not be indicative of theactual expense we incur during 2006.
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*Accounting Changes and Error Corrections*In May 2005, the Financial Accounting Standards Board issued Statement of Financial AccountingStandards No. 154, *Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20and FASB Statement No. 3*(SFAS 154). SFAS 154 replaces APB Opinion No. 20, *Accounting Changes*, andFASB Statement No. 3, *Reporting Accounting Changes in Interim Financial Statements*, and changes therequirements for the accounting for and reporting of a change in accounting principle. SFAS 154applies to all voluntary changes in accounting principle, and changes required byan accounting pronouncement in the unusual instance that the pronouncement does not includespecific transition provisions.SFAS 154 requires retrospective application to prior periods’ financial statements of changes inaccounting principle, unless it is impracticable to determine either the period-specific effects orthe cumulative effect of the change. SFAS 154 is effective for usbeginning January 1, 2006. We do notbelieve that the adoption of SFAS 154 will have a significant effecton our financial statements.Item 7a. Quantitative and Qualitative Disclosure about Market RiskWe maintain cash in an overnight investment account that includes short-term U.S. governmentobligations with maturities not exceeding three months and investments in a short-term investmentaccount that includes U.S. government and government agency debt securities with originalmaturities not exceeding three months. As of December 31, 2005, our total investment in theseaccounts amounted to approximately $6.1 million. This amount is included within the cash and cashequivalent line item of our balance sheet. For the twelve months ended December 31, 2005, interestearned on this account was $177,899. As of December 31, 2005, we also maintained short-terminvestments in U.S. government and government agency debt securities with maturities of greaterthan 90 days and less than 180 days. As of December 31, 2005, our investment in these securitiestotaled approximately $2.0 million and is included within the short-term investment line item ofour balance sheet. For the twelve months ended December 31, 2005, interest earned on investmentsin this account was $27,225. Any decrease in interest rates in either of these investment accountswould not have a material impact on our financial position.Item 8. Financial Statements and Supplementary DataINDEX TO FINANCIAL STATEMENTS     HEALTH GRADES, INC.:    Report of Independent Registered Public Accounting Firm  32 Balance Sheets  33 Statements of Operations  34 Statements of Stockholders’ Equity  35 Statements of Cash Flows  36 Notes to Financial Statements  37 
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Report of Independent Registered Public Accounting FirmBoard of Directors and Stockholders of Health Grades, Inc.We have audited the accompanying balance sheets of Health Grades, Inc. (a Delaware corporation) asof December 31, 2005 and 2004, and the related statements of operations, stockholders’ equity, andcash flows for each of the three years in the period ended December 31, 2005. These financialstatements are the responsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements based on our audits.We conducted our audits in accordance with the standards of the Public Company Accounting OversightBoard (United States). Those standards require that we plan and perform the audits to obtainreasonable assurance about whether the financial statements are free of material misstatement. TheCompany is not required to have, nor were we engaged to perform an audit of its internal controlover financial reporting. Our audits included consideration of internal control over financialreporting as a basis for designing audit procedures that are appropriate in the circumstances, butnot for the purpose of expressing an opinion on the effectiveness of the Company’s internal controlover financial reporting. Accordingly, we express no such opinion. An audit also includesexamining, on a test basis, evidence supporting the amounts and disclosures in the financialstatements, assessing the accounting principles used and significant estimates made by management,as well as evaluating the overall financial statement presentation. We believe that our auditsprovide a reasonable basis for our opinion.In our opinion, the financial statements referred to above present fairly, in all materialrespects, the financial position of Health Grades, Inc. as of December 31, 2005 and 2004, and theresults of its operations and its cash flows for each of the three years in the period endedDecember 31, 2005, in conformity with accounting principles generally accepted in the United Statesof America.Our audit was conducted for the purpose of forming an opinion on the basic financial statementstaken as a whole. Schedule II is presented for purposes of additional analysis and is not arequired part of the basic financial statements. This schedule has been subjected to the auditingprocedures applied in the audit of the basic financial statements and, in our opinion, is fairlystated in all material respects in relation to the basic financial statements taken as a whole.                  /s/ GRANT THORNTON LLP         Denver, Colorado      March 9, 2006      (exceptfor Note 19, as to which the date is March 28, 2006)      
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Health Grades, Inc.Balance Sheets           **DECEMBER 31**   **2005**  **2004** ASSETS        Cash and cash equivalents $9,682,106  $6,153,862 Short-term investments  1,988,154   — Accounts receivable, net  5,620,736   3,034,375 Prepaid expenses and other  562,540   253,839 Deferred income taxes  1,080,562   —        Total current assets  18,934,098   9,442,076          Property and equipment, net  1,595,065   382,870 Intangible assets, net  177,729   — Goodwill  3,106,181   3,106,181 Deferred income taxes  31,400   —        Total assets $23,844,473  $12,931,127                 LIABILITIES AND STOCKHOLDERS’ EQUITY        Accounts payable $278,912  $44,035 Accrued payroll, incentive compensation and related expenses  1,525,844   1,178,581 Accrued expenses  275,865   322,777 Current portion of capital lease obligations  1,310   — Current portion of deferred rent  70,263   — Deferred revenue  11,742,827   7,729,195 Income taxes payable  15,020   71,298        Total current liabilities  13,910,041   9,345,886          Long-term portion of capital lease obligations  5,254   — Long-term portion of deferred rent  311,599   —        Total liabilities  14,226,894   9,345,886          Commitments and contingencies                 Stockholders’ 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 47,674,779 and 44,880,176 shares issued in 2005 and2004, respectively  47,674   44,880 Additional paid-in capital  91,984,099   90,094,408 Accumulated deficit  (68,646,614)  (72,786,467)Treasury stock, 19,563,390 shares  (13,767,580)  (13,767,580)       Total stockholders’ equity  9,617,579   3,585,241                 Total liabilities and stockholders’ equity $23,844,473  $12,931,127        See accompanying notes to financial statements.
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Health Grades, Inc.Statements of OperationsYears ended December 31,               **2005**  **2004**  **2003** Revenue:            Ratings and advisory revenue $20,794,173  $14,536,304  $8,803,929 Other  13,333   1,447   1,551              20,807,506   14,537,751   8,805,480                        Expenses:            Cost of ratings and advisory revenue  3,168,668   2,488,202   1,963,949           Gross margin  17,638,838   12,049,549   6,841,531              Operating expenses:            Sales and marketing  5,801,590   4,932,210   3,357,874 Product development  3,035,728   2,017,441   1,433,965 Litigation settlement  —   —   491,000 General and administrative  4,859,096   3,339,298   2,834,467           Income (loss) from operations  3,942,424   1,760,600   (1,275,775)             Other:            Other  1,405   —   — Interest income  205,124   21,543   7,393 Interest expense  (763)  —   (15,305)                       Income (loss) before income taxes  4,148,190   1,782,143   (1,283,687)Income tax expense  (8,337)  —   —           Net income (loss) $4,139,853  $1,782,143  $(1,283,687)                       Net income (loss) per common share (basic) $0.15  $0.07  $(0.05)                       Weighted average number of common sharesused in computation (basic)  27,039,057   25,058,173   26,679,467                        Net income (loss) per common share (diluted) $0.12  $0.05  $(0.05)                       Weighted average number of common sharesused in computation (diluted)  34,833,521   33,031,087   26,679,467           See accompanying notes to financial statements.
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Health Grades, Inc.Statements of Stockholders’ Equity