-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, BuP/XEv9FHdLRVu1i88DEhCwfIxlECJgymQaHyWsBA4Xi9h8T2OY/dKYLAt9XCnn DLJ14KgRcapL7WvcrUIAIg== 0000912057-97-001374.txt : 19970122 0000912057-97-001374.hdr.sgml : 19970122 ACCESSION NUMBER: 0000912057-97-001374 CONFORMED SUBMISSION TYPE: SB-2/A PUBLIC DOCUMENT COUNT: 13 FILED AS OF DATE: 19970121 SROS: NONE FILER: COMPANY DATA: COMPANY CONFORMED NAME: DAOU SYSTEMS INC CENTRAL INDEX KEY: 0001003989 STANDARD INDUSTRIAL CLASSIFICATION: RETAIL-RETAIL STORES, NEC [5990] FILING VALUES: FORM TYPE: SB-2/A SEC ACT: 1933 Act SEC FILE NUMBER: 333-18155 FILM NUMBER: 97508359 BUSINESS ADDRESS: STREET 1: 5120 SHOREHAM PL CITY: SAN DIEGO STATE: CA ZIP: 92122 BUSINESS PHONE: 6196462996 MAIL ADDRESS: STREET 1: 5120 SHOREHAM PL CITY: SAN DIEGO STATE: CA ZIP: 92122 SB-2/A 1 SB-2/A AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON JANUARY 21, 1997 REGISTRATION STATEMENT NO. 333-18155 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- U.S. SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ---------------- AMENDMENT NO.1 TO FORM SB-2 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933 -------------- DAOU SYSTEMS, INC. (Name of Small Business Issuer in Its Charter) DELAWARE 5995 330284454 (State or other jurisdiction (Primary Standard (I.R.S. Employer of incorporation or Industrial Identification No.) organization) Classification Code Number)
---------------- 5120 SHOREHAM PLACE SAN DIEGO, CALIFORNIA 92122 (619) 452-2221 (Address and telephone number of principal executive offices and principal place of business) ---------------- DANIEL J. DAOU PRESIDENT 5120 SHOREHAM PLACE SAN DIEGO, CALIFORNIA 92122 (619) 452-2221 (Name, address and telephone number of Agent for Service) ---------------- COPIES TO: JOHN J. HENTRICH, ESQ. FREDERICK T. MUTO, ESQ. CARLOS D. HEREDIA, ESQ. JEREMY D. GLASER, ESQ. BAKER & MCKENZIE COOLEY GODWARD LLP 101 WEST BROADWAY, TWELFTH FLOOR 4365 EXECUTIVE DRIVE, SUITE 1100 SAN DIEGO, CALIFORNIA 92101 SAN DIEGO, CALIFORNIA 92037 (619) 236-1441 (619) 550-6045
---------------- APPROXIMATE DATE OF PROPOSED SALE TO THE PUBLIC: AS SOON AS PRACTICABLE AFTER THIS REGISTRATION STATEMENT BECOMES EFFECTIVE. If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. / / If the Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. / / If delivery of the prospectus is expected to be made pursuant to Rule 434, please check the following box. / / ---------------- THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT SHALL FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(A) OF THE SECURITIES ACT OF 1933 OR UNTIL THE REGISTRATION STATEMENT SHALL BECOME EFFECTIVE ON SUCH DATE AS THE COMMISSION, ACTING PURSUANT TO SAID SECTION 8(A), MAY DETERMINE. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SUBJECT TO COMPLETION INFORMATION CONTAINED HEREIN IS SUBJECT TO COMPLETION OR AMENDMENT. A REGISTRATION STATEMENT RELATING TO THESE SECURITIES HAS BEEN FILED WITH THE SECURITIES AND EXCHANGE COMMISSION. THESE SECURITIES MAY NOT BE SOLD NOR MAY OFFERS TO BUY BE ACCEPTED PRIOR TO THE TIME THE REGISTRATION STATEMENT BECOMES EFFECTIVE. THIS PROSPECTUS SHALL NOT CONSTITUTE AN OFFER TO SELL OR THE SOLICITATION OF AN OFFER TO BUY NOR SHALL THERE BE ANY SALE OF THESE SECURITIES IN ANY STATE IN WHICH SUCH OFFER, SOLICITATION OR SALE WOULD BE UNLAWFUL PRIOR TO REGISTRATION OR QUALIFICATION UNDER THE SECURITIES LAWS OF ANY SUCH STATE. JANUARY 21, 1997 3,850,000 SHARES [LOGO] COMMON STOCK --------- Of the 3,850,000 shares of Common Stock (the "Common Stock") offered hereby, 2,900,000 shares are being sold by DAOU Systems, Inc. ("DAOU" or the "Company"), and 950,000 shares are being sold by the Selling Stockholders named herein under "Principal and Selling Stockholders" (the "Selling Stockholders"). The Company will not receive any of the proceeds from shares sold by the Selling Stockholders. Prior to this offering, there has been no public market for the Common Stock. It is currently estimated that the initial public offering price will be between $12.00 and $14.00 per share. See "Underwriting" for a discussion of the factors to be considered in determining the initial public offering price. Application has been made for quotation of the Common Stock on the Nasdaq National Market under the symbol DAOU. -------------- THE COMMON STOCK OFFERED HEREBY INVOLVES A HIGH DEGREE OF RISK. SEE "RISK FACTORS" COMMENCING ON PAGE 5. ------------- THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS THE SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION PASSED UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE.
PRICE UNDERWRITING PROCEEDS TO TO DISCOUNTS AND PROCEEDS TO SELLING PUBLIC COMMISSIONS(1) COMPANY(2) STOCKHOLDERS Per Share..................... $ $ $ $ Total(3)...................... $ $ $ $
(1) See "Underwriting" for indemnification arrangements with the several Underwriters. (2) Before deducting expenses of the offering estimated at $500,000. (3) The Company has granted the Underwriters a 30-day option to purchase up to 577,500 additional shares of Common Stock solely to cover over-allotments, if any. To the extent that the option is exercised, the Underwriters will offer the additional shares at the Price to Public shown above. If the option is exercised in full, the total Price to Public, Underwriting Discounts and Commissions, and Proceeds to the Company will be $ , $ and $ , respectively. See "Underwriting." -------------- The shares of Common Stock are offered by the several Underwriters, subject to prior sale, when, as and if delivered to and accepted by them, and subject to the right of the Underwriters to reject any order in whole or in part. It is expected that delivery of the shares of Common Stock will be made at the offices of Alex. Brown & Sons Incorporated, Baltimore, Maryland on or about February , 1997. ALEX. BROWN & SONS INCORPORATED COWEN & COMPANY HAMBRECHT & QUIST THE DATE OF THIS PROSPECTUS IS FEBRUARY , 1997. [INSIDE FRONT COVER PAGE] PHOTOGRAPH DESCRIPTIONS AND CAPTIONS 1. Top border: DAOU masthead and logo in color. Caption: Healthcare Information Technology Solutions -- DAOU Systems designs, implements, supports and manages computer network systems for large, complex healthcare provider organizations, such as integrated delivery systems. Advanced computer networks enable provider organizations to access information such as patient records, X-rays and billing information at each location where care is provided. 2. Center left side: Color photo of DAOU engineer configuring a network of computer servers at DAOU's on-site computer lab. Caption: Network Services -- The Company combines its knowledge of the specialized information needs of the healthcare industry with its expertise in computer technology to design and install advanced, reliable and cost-effective computer network solutions. The Company uses the products and applications of various hardware and software vendors to create advanced computer network systems. - Network Design - Network Implementation 3. Bottom right side corner: Color photo of individual viewing Palomar-Palmerado Health System's website which was created by the Company. Caption: Network Management Services -- As computer networks become increasingly complex, provider organizations are experiencing difficulties in hiring, training and retaining qualified personnel who can maintain the performance of their computer network systems. DAOU's network management services are designed to continuously monitor and enhance the efficiency and functionality of a provider organization's computer network system. The Company offers the following management services to its customers: - Enterprise Network Management Services - DAOU Employees On-Site - Continuous Network Planning - "Burst Mode" Implementation - Network Support - I/S Outsourcing IN CONNECTION WITH THIS OFFERING, THE UNDERWRITERS MAY OVER-ALLOT OR EFFECT TRANSACTIONS WHICH STABILIZE OR MAINTAIN THE MARKET PRICE OF THE COMMON STOCK OF THE COMPANY AT A LEVEL ABOVE THAT WHICH MIGHT OTHERWISE PREVAIL IN THE OPEN MARKET. SUCH TRANSACTIONS MAY BE EFFECTED ON THE NASDAQ NATIONAL MARKET, IN THE OVER-THE-COUNTER MARKET OR OTHERWISE. SUCH STABILIZING, IF COMMENCED, MAY BE DISCONTINUED AT ANY TIME. DAOU-SM- AND THE DAOU LOGO ARE SERVICE MARKS OF THE COMPANY. TRADEMARKS AND SERVICE MARKS OF OTHER COMPANIES ARE ALSO REFERRED TO IN THIS PROSPECTUS. 2 PROSPECTUS SUMMARY THE FOLLOWING SUMMARY IS QUALIFIED IN ITS ENTIRETY BY THE MORE DETAILED INFORMATION AND FINANCIAL STATEMENTS AND NOTES THERETO APPEARING ELSEWHERE IN THIS PROSPECTUS. THIS PROSPECTUS CONTAINS CERTAIN STATEMENTS OF A FORWARD-LOOKING NATURE RELATING TO FUTURE EVENTS OR THE FUTURE FINANCIAL PERFORMANCE OF THE COMPANY. PROSPECTIVE INVESTORS ARE CAUTIONED THAT SUCH STATEMENTS ARE ONLY PREDICTIONS AND THAT ACTUAL EVENTS OR RESULTS MAY DIFFER MATERIALLY. IN EVALUATING SUCH STATEMENTS, PROSPECTIVE INVESTORS SHOULD SPECIFICALLY CONSIDER THE VARIOUS FACTORS IDENTIFIED IN THIS PROSPECTUS, INCLUDING THE MATTERS SET FORTH UNDER THE CAPTION "RISK FACTORS," WHICH COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE INDICATED BY SUCH FORWARD-LOOKING STATEMENTS. DAOU Systems, Inc. ("DAOU" or the "Company") designs, implements, supports and manages advanced computer network systems for hospitals, integrated healthcare delivery systems ("IDSs"), and other healthcare provider organizations ("provider organizations"). DAOU combines its knowledge of the specialized information needs of the healthcare industry with its technological expertise in computer network systems to provide advanced, reliable and cost-effective computer network solutions to provider organizations. The Company believes that its success is attributable to its healthcare industry focus, depth and breadth of technological expertise, ability to objectively evaluate its customers' computer network systems due to its vendor independence and its history of successful customer engagements. Since 1987, the Company has provided computer network services to over 350 customers ranging in size from single-site organizations to multi-state organizations with over 80 sites. The Company's customers include Catholic Medical Center of Brooklyn and Queens, Inc., New York ("CMC"); Mercy Health Services, Farmington Hills, Michigan ("Mercy"); Atlantic Health System, Morristown, New Jersey; Lutheran Health Systems, Fargo, North Dakota; Candler Health System, Savannah, Georgia ("Candler"); and St. Mary's Health Network, Reno, Nevada. Pressure to control escalating healthcare costs is causing healthcare providers to consolidate and form multi-entity provider organizations such as IDSs. This consolidation has resulted in the need for prompt access to consistent and comprehensive patient information at multiple locations where care is provided. The existing information systems in these provider organizations are frequently inadequate because they were developed to meet the needs of a single facility, such as a hospital or an outpatient surgery center. In addition, the increasing variety of hardware and software applications utilized throughout provider organizations has resulted in connectivity and compatibility problems for many computer networks. Consequently, provider organizations have found it increasingly difficult to internally implement and manage their computer network systems and are looking to third parties for the technological expertise and personnel to meet their information systems requirements. DAOU believes that the ongoing consolidation among healthcare provider organizations and the increasing complexity and rapid evolution of computer network system technologies have created a significant opportunity for companies specializing in providing computer network system solutions to provider organizations. DAOU offers a broad array of services to assist hospitals, IDSs and other provider organizations in designing, implementing, supporting and managing complex computer network systems consistent with their unique and changing information needs. The Company's design services include an assessment of the customer's existing computer network system and the preparation of voice, video and data network specifications, technical design documentation and diagrams. DAOU's implementation services include the purchase, delivery and installation of enterprise-wide computer network systems. The Company's support and management services include remote and on-site network management services, as well as information systems outsourcing ("I/S outsourcing"), and are typically provided under multi-year contracts. The Company provides network support services to its customers through its regional sales and support structure and a 24-hour technical support hotline available seven days a week. DAOU typically provides its services on a fixed-price, fixed-time frame basis. DAOU's strategy is to be a leading provider of advanced computer network systems and network management services to healthcare provider organizations by continuing to focus its sales and marketing efforts on major medical centers and hospitals around which IDSs are forming, expanding and developing services that complement its existing services, and continuing to develop its expertise in emerging technologies. 3 THE OFFERING Common Stock offered by the Company............. 2,900,000 shares Common Stock offered by the Selling 950,000 shares Stockholders.................................. Common Stock to be outstanding after the 11,167,678 shares (1) offering...................................... Use of proceeds................................. Working capital and other general corporate purposes. Proposed Nasdaq National Market symbol.......... DAOU
SUMMARY FINANCIAL INFORMATION (IN THOUSANDS, EXCEPT PER SHARE DATA)
YEARS ENDED DECEMBER 31, ------------------------------------------------------- 1992 1993 1994 1995 1996 --------- --------- --------- ---------- ---------- STATEMENT OF OPERATIONS DATA: Revenues...................................................... $ 2,728 $ 3,483 $ 8,521 $ 14,330 $ 19,311 Gross profit.................................................. 947 1,161 2,336 5,855 5,755 Income (loss) from operations................................. 1 (54) 33 2,024 5 Net income (loss)............................................. 5 (52) 26 1,240 83 Pro forma net income per share(2)............................. $ 0.01 Shares used in computing pro forma net income per share(2).... 8,888
DECEMBER 31, 1996 ----------------------- AS ACTUAL ADJUSTED(3) --------- ------------ BALANCE SHEET DATA: Cash, cash equivalents and short-term investments..................................... $ 2,284 $ 36,845 Total assets.......................................................................... 11,910 46,471 Long-term debt, less current portion.................................................. -- -- Redeemable preferred stock............................................................ 8,190 -- Total stockholders' equity............................................................ 857 43,608
- -------------- (1) Excludes (i) 941,413 shares of Common Stock issuable upon exercise of stock options outstanding under the Company's 1996 Stock Option Plan with a weighted average exercise price of $5.16 per share at December 31, and (ii) 133,285 shares of Common Stock issuable upon exercise of outstanding warrants at an exercise price of $4.99 per share. See "Management -- 1996 Stock Option Plan," "Certain Transactions," "Description of Capital Stock" and Note 6 of Notes to Financial Statements. (2) See Note 1 of Notes to Financial Statements for information concerning the calculation of pro forma net income per share. (3) Adjusted to give effect to the conversion of all outstanding shares of the Company's Preferred Stock into 1,603,430 shares of Common Stock upon the completion of this offering and to the estimated net proceeds of this offering based upon an assumed initial public offering price of $13.00 per share. See "Use of Proceeds." -------------- EXCEPT AS OTHERWISE SPECIFIED, ALL INFORMATION IN THIS PROSPECTUS ASSUMES NO EXERCISE OF THE UNDERWRITERS' OVER-ALLOTMENT OPTION. SEE "UNDERWRITING." EXCEPT AS SET FORTH IN THE FINANCIAL STATEMENTS AND AS OTHERWISE NOTED, ALL INFORMATION IN THIS PROSPECTUS HAS BEEN ADJUSTED TO GIVE EFFECT TO THE REINCORPORATION OF THE COMPANY IN DELAWARE PRIOR TO THE COMPLETION OF THIS OFFERING AND THE CONVERSION OF ALL OUTSTANDING SHARES OF PREFERRED STOCK INTO COMMON STOCK UPON THE COMPLETION OF THIS OFFERING. SEE "CAPITALIZATION" AND "DESCRIPTION OF CAPITAL STOCK." 4 RISK FACTORS IN ADDITION TO THE OTHER INFORMATION IN THIS PROSPECTUS, THE FOLLOWING FACTORS SHOULD BE CONSIDERED CAREFULLY IN EVALUATING AN INVESTMENT IN THE SHARES OF COMMON STOCK OFFERED BY THIS PROSPECTUS. THIS PROSPECTUS CONTAINS CERTAIN STATEMENTS OF A FORWARD-LOOKING NATURE RELATING TO FUTURE EVENTS OR THE FUTURE FINANCIAL PERFORMANCE OF THE COMPANY. PROSPECTIVE INVESTORS ARE CAUTIONED THAT SUCH STATEMENTS ARE ONLY PREDICTIONS AND THAT ACTUAL EVENTS OR RESULTS MAY DIFFER MATERIALLY. IN EVALUATING SUCH STATEMENTS, PROSPECTIVE INVESTORS SHOULD SPECIFICALLY CONSIDER THE VARIOUS FACTORS IDENTIFIED IN THIS PROSPECTUS, INCLUDING THE MATTERS SET FORTH BELOW, WHICH COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE INDICATED BY SUCH FORWARD-LOOKING STATEMENTS. MANAGEMENT OF GROWTH. The Company is currently experiencing a period of rapid growth which has placed significant and increasing demands on the Company's management and operational, technical, financial and other resources. The Company's revenues increased 35% in 1996, from $14.3 million in 1995 to $19.3 million in 1996, and increased 68% in 1995, from $8.5 million in 1994 to $14.3 million in 1995. In addition, since January 1, 1995, the Company's workforce increased from 78 to 126 full-time employees as of December 31, 1996. Further increases in staffing levels are expected during 1997 although the Company does not believe that these rates of growth are sustainable. This growth has resulted in new and increased responsibilities for management personnel and has placed significant demands on the Company's management and operating and financial systems. The Company will be required to continue to develop and improve its operational, financial and other internal systems to accommodate the increased number of transactions and customers and the increased size of the Company's operations, workforce and facilities. There can be no assurance, however, that the Company's management or systems will be adequate to support the Company's existing or future operations. Any failure to develop and improve the Company's systems or to hire and retain appropriate personnel to manage its operations could have a material adverse effect on the Company's business, financial condition and results of operations. In addition, any future unexpected shortfall in revenues without a corresponding and timely reduction in staffing and other expenses (or redeployment of employees to other customer projects), or any staffing increase that is unaccompanied by a corresponding increase in revenues, could have a material adverse effect on the Company's business, financial condition and results of operations. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." NEED TO ATTRACT AND RETAIN KEY EMPLOYEES AND QUALIFIED NETWORK ENGINEERS. The Company's success and execution of its business strategy will depend in large part on the continued services of its key management and technical personnel. The loss of the services of one or more of the Company's key employees or the inability to hire additional key personnel as needed could have a material adverse effect on the Company's business, financial condition and results of operations. The Company's business involves the delivery of computer network services and is labor-intensive. As a result, its future success will depend in large part on its ability to hire, train and retain qualified network engineers who together have expertise in a wide array of network and computer systems and a broad understanding of the provider organizations that the Company serves. Competition for qualified network engineers is intense and is expected to increase. In particular, competition is intense for the limited number of qualified management personnel and senior network engineers. There can be no assurance that the Company will be successful in attracting and retaining such personnel. While the Company is currently experiencing low rates of turnover, there can be no assurance that these rates of turnover will not increase in the future. Any inability of the Company to hire, train and retain a sufficient number of qualified network engineers could impair the Company's ability to adequately manage and complete its existing projects or to obtain new projects, which, in turn, could have a material adverse effect on the Company's business, financial condition and results of operations. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Business -- Recruiting and Training of Technical Employees." 5 VARIABILITY OF QUARTERLY OPERATING RESULTS. A substantial majority of the Company's operating expenses, particularly personnel and related costs, depreciation and rent, are relatively fixed in advance of any particular quarter. However, variations in the Company's revenues and operating results may occur from time to time, as a result of various factors, including: (i) the reduction in size, delay in commencement, interruption or termination of one or more significant projects or contracts; (ii) the commencement or completion during a quarter of one or more significant projects; (iii) the failure to estimate accurately the resources required to complete new or ongoing projects; (iv) the relatively longer sales cycle in obtaining new customers and larger contracts; (v) the timing and extent of employee training or the loss of key employees; (vi) competition; (vii) the development and introduction of new services; and (viii) general economic conditions which may affect the buying decisions of the Company's current and prospective customers. In addition, the Company plans to continue to expand its operations by hiring additional network engineers and other employees, and adding new offices, systems and other infrastructure. The resulting increase in operating expenses will generally be incurred prior to any increase in revenues. Consequently, the Company's business, financial condition and results of operations would be materially and adversely affected if revenues do not increase to support such expenses. A variation in the timing of the commencement or completion of customer assignments, particularly at or near the end of any quarter, may cause significant variations in operating results from quarter to quarter and could result in losses for a particular quarter. In addition, an unanticipated delay or termination of a major project could require the Company to maintain or terminate under-utilized employees which could, in either case, result in higher than expected expenses during a quarter. The Company believes that quarterly revenues and operating results are likely to vary significantly in the future and that period-to-period comparisons of its revenues and operating results are not necessarily meaningful and should not be relied on as indications of future performance. Furthermore, these variations in revenues and operating results could cause significant variations in the price of the Company's Common Stock. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." CUSTOMER CONCENTRATION. The Company has derived, and believes that it will continue to derive, a significant portion of its revenues from a relatively limited number of large customer contracts. In 1996, the Company's five largest customers accounted for approximately 72% of total revenues, with CMC, Mercy and Candler accounting for approximately 21%, 18% and 15% of such revenues, respectively. In 1995, the Company's five largest customers accounted for approximately 77% of total revenues, with Mercy and Candler accounting for approximately 48% and 11% of such revenues, respectively. The volume of work performed for specific customers is likely to vary from year to year, and a major customer in one year may not provide the same level of revenues in any subsequent year. In particular, the annual revenues under the Company's five-year contract with Candler are subject to annual budgetary approval and may decrease from year to year. The loss of any large customer could have a material adverse effect on the Company's business, financial condition and results of operations. See "Risk Factors -- Consolidation and Uncertainty in the Healthcare Industry" and "Management's Discussion and Analysis of Financial Condition and Results of Operations." PROJECT RISKS. The Company's computer network systems are designed to provide access to and accurate delivery of a wide range of information within a provider organization, including information used by clinicians in the diagnosis and treatment of patients. Many of the Company's projects are critical to the operation of its customers' businesses and, therefore, the Company may expose itself to potentially adverse risks in the event that the Company's services do not meet the desired expectations of its customers. For example, the failure to perform services that meet a customer's expectations may result in the Company not being paid for services rendered and may damage the Company's reputation and adversely affect its ability to attract new business. In addition, any failure by the Company's computer network systems to provide accurate, reliable and timely information could result in claims against the Company. For example, where the unavailability of such information to a provider of healthcare services is alleged to have resulted in any physical or emotional injury to a patient, such provider may become subject to a medical malpractice, product liability or other claim. The Company could then become subject to a claim relating to its installation or management of a computer network system. The Company is also subject to claims by its customers for actions of the Company's employees which may have caused 6 damages to customers' businesses or otherwise. Although the Company maintains errors or omissions insurance, there can be no assurance that such insurance coverage would adequately cover any claims asserted against the Company and any such claim could have a material adverse effect on the Company's business, financial condition and results of operations. In addition, there can be no assurance that the Company will not be subject to claims that will result in liability in excess of its insurance coverage or that appropriate insurance will continue to be available to the Company in the future at commercially reasonable rates. See "Business -- Information Technology Services." LONG SALES AND PROJECT DELIVERY CYCLES. The Company's sales process is often subject to delays associated with the lengthy approval process that typically accompanies significant capital expenditures by a customer. During this process, the Company expends substantial time, effort and resources marketing its services, preparing contract proposals and negotiating contracts. Any failure by the Company to procure a signed contract after expending significant time, effort and resources could have a material adverse effect on the Company's business, financial condition and results of operations. The delivery of computer network services generally requires a significant commitment of resources by the Company and by the customer. The length of time required to complete a project may depend on many factors outside the control of the Company, including the state of the customer's existing information systems, budgetary constraints and the customer's ability to commit the personnel and other resources necessary to complete elements of the project for which the customer is responsible. In certain instances, projects have been prolonged substantially as a result of delays attributable to customers. The Company's contracts with certain of its customers provide for a reduction in the implementation fee if, among other things, the Company fails to meet certain milestones on a timely basis. Consequently, the failure of the Company to deliver its services on a timely and cost-efficient basis could have a material adverse effect on the Company's business, financial condition and results of operations. See "Business -- Sales and Marketing" and "Management's Discussion and Analysis of Financial Condition and Results of Operations." COMPETITION. The healthcare network services industry is comprised of a large number of participants and is subject to rapid change and intense competition. The Company's competitors include system integrators, value added resellers ("VARs"), consulting companies, local and regional network services firms, telecommunications providers and network equipment, computer systems and healthcare software vendors, many of which have significantly greater financial, technical and marketing resources and greater name recognition than does the Company. In particular, the Company competes with (i) large information technology companies such as Hewlett-Packard Company ("Hewlett-Packard"), Electronic Data Systems Corporation ("EDS"), and Integrated Systems Solutions Corporation, a subsidiary of International Business Machines Corporation ("IBM"); (ii) healthcare information technology companies such as HBO & Company; and (iii) smaller regional network systems firms. In addition, the Company has faced, and expects to continue to face, additional competition from new entrants into its markets. Other healthcare information technology companies not presently offering or emphasizing network systems services and large network services companies not currently focusing on healthcare may enter the Company's markets. Increased competition could result in price reductions, fewer customer projects, under-utilization of employees, reduced operating margins and loss of market share, any of which could materially and adversely affect the Company's business, financial condition and results of operations. There can be no assurance that the Company will be able to compete successfully against current and future competitors. The failure of the Company to compete successfully would have a material adverse effect on the Company's business, financial condition and results of operations. In addition, most of the Company's customers have internal network support and service capabilities and could choose to satisfy their needs through internal resources rather than through outside service providers. As a result, the decision by the Company's customers or potential customers to perform network services internally could have a material adverse effect on the Company's business, financial condition and results of operations. See "Business -- Competition." FIXED-PRICE, FIXED-TIME FRAME CONTRACTS. The Company offers the majority of its computer network systems services on a fixed-price, fixed-time frame basis, rather than on a time-and-expense 7 basis. Consequently, the Company bears the risk of cost over-runs in connection with these projects. The Company's failure to estimate accurately the resources and time required for a project or its failure to complete its contractual obligations within the fixed-time frame committed could have a material adverse effect on the Company's business, financial condition and results of operations. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." CONTRACT CANCELLATION RIGHTS; ABSENCE OF LONG-TERM CONTRACTS. Although the Company enters into agreements with certain of its customers which contemplate multi-year contract terms, the Company's customers are generally able to reduce or cancel their use of the Company's services before the end of the contract term. As a result, the Company believes that the number and size of its existing projects are not reliable indicators or measures of future revenues. In addition, the Company has in the past provided, and is likely in the future to provide, services to customers without long-term contracts. When a customer defers, modifies or cancels a project, the Company must be able to rapidly redeploy network engineers and other personnel to other projects in order to minimize the under-utilization of employees and the resulting adverse impact on operating results. In addition, the Company's operating expenses are relatively fixed and cannot be reduced on short notice to compensate for unanticipated variations in the number or size of projects in progress. As a result, any termination, significant reduction or modification of its business relationships with any of its significant customers or with a number of smaller customers could have a material adverse effect on the Company's business, financial condition and results of operations. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Business -- Sales and Marketing." CONSOLIDATION AND UNCERTAINTY IN THE HEALTHCARE INDUSTRY. Substantially all of the Company's revenues are derived from customers involved in the healthcare industry. As a result, the Company's business, financial condition and results of operations are influenced by conditions affecting this industry. Many provider organizations are consolidating to create larger organizations with greater regional market power and are forming affiliations for purchasing products and services. This consolidation could reduce the Company's target market and result in the termination of certain engagements of the Company. In particular, this consolidation has resulted, and is likely to continue to result, in the acquisition of certain of the Company's customers, and such customers may scale back or terminate their relationship with the Company following their acquisition. For example, Candler, the Company's first I/S outsourcing customer, recently signed a letter of intent with St. Joseph's Hospital to form a joint operating company. The Company anticipates that the chief executive officer of St. Joseph's Hospital will manage the surviving entity. The Company believes that it will likely continue its I/S outsourcing contract with Candler, due in large part to its successful engagement with Candler and a contractual penalty of $600,000 payable to the Company in the event of the early termination of this contract due to Candler's merger with St. Joseph's Hospital. There can be no assurance, however, that the surviving entity will continue its business relationship with the Company. Moreover, these consolidating and affiliating enterprises could also have greater bargaining power which could lead to reductions in the amounts paid to the Company for its services. The reduction in the size of the Company's target market or the failure of the Company to maintain adequate price levels could have a material adverse effect on the Company's business, financial condition and results of operations. The healthcare industry is also subject to changing political, economic and regulatory influences that may affect the procurement practices and operations of participants in the healthcare industry. The Company cannot predict with any certainty what impact, if any, these developments could have on its business, financial condition and results of operations. See "Business -- Industry Overview." RAPID TECHNOLOGICAL CHANGE. The Company has derived, and expects to continue to derive, substantially all of its revenues from projects based on complex computer networks. The markets for computer network products and services are continuing to develop and are subject to rapid change. The Company's success will depend in part on its ability to offer services that keep pace with continuing changes in technology, evolving industry standards and changing customer preferences and to hire, train and retain network engineers who can fulfill the increasingly complex needs of its customers. There can be no assurance that the Company will be successful in addressing these developments in a timely 8 manner. Any delay or failure by the Company to address these developments could have a material adverse effect on the Company's business, financial condition and results of operations. In addition, there can be no assurance that products, systems or technologies developed by third parties will not render certain of the Company's services noncompetitive or obsolete. See "Business -- Information Technology Services." DEPENDENCE ON THIRD-PARTY HARDWARE AND SOFTWARE VENDORS. The network systems solutions delivered by the Company utilize the products of third-party hardware and software vendors. A significant portion of the Company's implementation service revenues are derived from the purchase and resale of these products. Although the Company has distribution agreements with certain product vendors, there can be no assurance that these agreements will be renewed. Any significant adverse change in any of these relationships could have a material adverse effect on the Company's business, financial condition and results of operations. See "Business -- Information Technology Services." RISKS ASSOCIATED WITH POSSIBLE ACQUISITIONS. The Company may in the future pursue acquisitions of complementary businesses as it seeks to compete in the rapidly changing industry of healthcare information technology. Acquisitions involve numerous risks, including difficulties in the assimilation of the operations and personnel of the acquired business, the diversion of management's attention from other business concerns, risks of entering markets in which the Company has no direct prior experience, and the potential loss of key employees of the acquired business. In addition, future acquisitions by the Company may result in potentially dilutive issuances of equity securities, the incurrence of additional debt and amortization expenses related to goodwill and other intangible assets, which could adversely affect the Company's business, financial condition and results of operations. The Company currently does not have any plans, proposals, arrangements or understandings with respect to any future acquisitions. FUTURE ADDITIONAL CAPITAL REQUIREMENTS. Since its inception, the Company has financed its operations through cash provided by operations, the sale of equity and through debt. In the event that the Company is unable to generate sufficient revenues to fund its operations in the future, the Company may be required to raise additional funds to meet its capital and operating requirements through public or private financing, including equity financing. Any additional equity financing may be dilutive to stockholders, and debt financing, if available, will require payment of interest and may involve restrictive covenants that could impose limitations on the operating flexibility of the Company. Adequate funds for the Company's operations may not be available when needed and, if available, may not be on terms attractive to the Company. The failure to obtain funding on a timely basis could have a material adverse effect on the Company's business, financial condition and results of operations. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." CONTROL BY EXISTING STOCKHOLDERS AND MANAGEMENT. Upon the completion of this offering, the present executive officers, directors and their respective affiliates will beneficially own approximately 44.1% of the outstanding Common Stock (41.9% if the Underwriters' over-allotment option is exercised in full). As a result, these stockholders will be able to exercise significant influence over all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions. Such concentration of ownership may also have the effect of delaying or preventing a change in control of the Company. See "Principal and Selling Stockholders" and "Description of Capital Stock." NO PRIOR PUBLIC MARKET; POSSIBLE VOLATILITY OF STOCK PRICE. Prior to this offering, there has been no public market for the Common Stock and there can be no assurance that an active trading market will develop or be sustained. The initial public offering price will be determined by negotiations among the Company, the Selling Stockholders and the representatives of the Underwriters based on several factors, and may not reflect the price at which the Common Stock will trade after this offering. In addition, the stock market historically has experienced volatility which has affected the market price of securities of many companies and which sometimes has been unrelated to the operating performance of such companies. The trading price of the Common Stock could also be subject to significant fluctuations in 9 response to variations in quarterly results of operations, announcements of new services by the Company or its competitors, changes in earnings estimates by analysts, government regulatory action, general trends in the industry, overall market conditions and other factors. See "Underwriting." SHARES ELIGIBLE FOR FUTURE SALE. Sales of substantial amounts of Common Stock in the public market after this offering, or the possibility of such sales occurring, could adversely affect prevailing market prices for the Common Stock. Of the 11,167,678 shares to be outstanding after this offering, the 3,850,000 shares of Common Stock offered hereby will be freely tradeable without restriction in the public market, unless such shares are held by "affiliates" of the Company, as such term is defined in Rule 144 ("Rule 144") under the Securities Act of 1933, as amended (the "Securities Act"). The remaining 7,317,678 shares will be "restricted securities" as such term is defined in Rule 144. Pursuant to certain lock-up agreements, all of the Company's stockholders and option holders, including the Company's executive officers and directors who beneficially hold an aggregate of approximately 4,948,160 shares, have agreed not to offer, sell or otherwise dispose of any of their shares of Common Stock for a period of 180 days after the date of this Prospectus without the prior written consent of Alex. Brown & Sons Incorporated. The Company has also entered into an agreement with the representatives of the Underwriters that it will not offer, sell or otherwise dispose of shares of Common Stock for a period of 180 days from the date of this Prospectus other than pursuant to the Company's 1996 Stock Option Plan and currently outstanding warrants. The representatives of the Underwriters may, in their sole discretion and at any time without notice, release all or any portion of the shares subject to such lock-up agreements. Upon the completion of this offering, the beneficial owners of approximately 2,220,800 shares of Common Stock and 133,285 shares of Common Stock issuable upon the exercise of outstanding warrants will be entitled to certain rights with respect to the registration of such shares under the Securities Act. In addition, the Company intends to file a Registration Statement on Form S-8 after the date of this Prospectus in order to register an aggregate of 1,367,925 shares of Common Stock reserved for issuance under its 1996 Stock Option Plan, of which options to purchase a total of 941,413 shares were outstanding as of December 31, 1996. See "Principal and Selling Stockholders," "Shares Eligible for Future Sale" and "Underwriting." POTENTIAL ANTI-TAKEOVER EFFECTS OF DELAWARE LAW AND CERTAIN CHARTER PROVISIONS. Certain provisions of Delaware law applicable to the Company could delay or make more difficult a merger, tender offer or proxy contest involving the Company, including Section 203 of the Delaware General Corporation Law, which prohibits a Delaware corporation from engaging in any business combination with any interested stockholder for a period of three years from the date the person became an interested stockholder unless certain conditions are met. In addition, the Board of Directors of the Company may issue shares of Preferred Stock without stockholder approval on such terms as the Board may determine. The rights of the holders of Common Stock will be subject to, and may be adversely affected by, the rights of the holders of any Preferred Stock that may be issued in the future. In addition, the Company's Certificate of Incorporation and Bylaws provide for a classified board of directors, eliminate the right of stockholders to act by written consent without a meeting, require advanced stockholder notice to nominate directors and raise matters at the annual stockholders meeting, eliminate cumulative voting in the election of directors and allow for the removal of directors only for cause and with a two-thirds vote of the Company's outstanding shares. All of the foregoing could have the effect of delaying, deferring or preventing a change in control of the Company and could limit the price that certain investors might be willing to pay in the future for shares of the Company's Common Stock. See "Management" and "Description of Capital Stock -- Certain Change of Control Provisions." ABSENCE OF DIVIDENDS. The Company has never declared nor paid cash dividends on its capital stock. The Company currently intends to retain any earnings for funding growth and, therefore, does not intend to pay any cash dividends in the foreseeable future. See "Dividend Policy." DILUTION. The initial public offering price is substantially higher than the pro forma net tangible book value per share of Common Stock. Investors purchasing shares of Common Stock in this offering will therefore incur immediate and substantial net tangible book value dilution. See "Dilution." 10 THE COMPANY DAOU Systems, Inc. was incorporated in California in 1987 and intends to reincorporate in Delaware prior to the completion of this offering. Unless the context otherwise requires, references in this Prospectus to "DAOU" and the "Company" refer to DAOU Systems, Inc., a Delaware corporation, and where applicable to its California predecessor. The Company's executive offices are located at 5120 Shoreham Place, San Diego, California 92122. Its telephone number is (619) 452-2221. USE OF PROCEEDS The net proceeds to the Company from the sale of the 2,900,000 shares of Common Stock offered hereby at an assumed initial offering price of $13.00 per share are estimated to be $34.6 million ($41.5 million if the over-allotment option is exercised in full), after deducting the underwriting discounts and commissions and the estimated expenses of this offering. The Company expects to use the net proceeds from this offering principally for working capital and general corporate purposes. The Company may also use a portion of the proceeds to fund acquisitions of complementary businesses, although there are no current plans, proposals, arrangements or understandings, and the Company is not currently engaged in negotiations, with respect to any such transactions. Pending such uses, the Company intends to invest the net proceeds of this offering in short-term, interest bearing, investment grade securities. The Company will not receive any proceeds from the sale of shares of Common Stock by the Selling Stockholders. DIVIDEND POLICY The Company has never declared nor paid cash dividends on its capital stock. The Company currently intends to retain any earnings for funding growth and, therefore, does not intend to pay any cash dividends in the foreseeable future. 11 CAPITALIZATION The following table sets forth the capitalization of the Company as of December 31, 1996 (i) on an actual basis; (ii) on a pro forma basis after giving effect to the conversion of all outstanding shares of Preferred Stock into 1,603,430 shares of Common Stock upon the completion of this offering and (iii) as adjusted to give effect to the receipt by the Company of the net proceeds from the sale of 2,900,000 shares of Common Stock offered hereby at an assumed initial public offering price of $13.00 per share and after deducting underwriting discounts and commissions and estimated offering expenses:
DECEMBER 31, 1996 ---------------------------------- ACTUAL PRO FORMA AS ADJUSTED --------- --------- ------------ (IN THOUSANDS) Redeemable preferred stock................................................... $ 8,190 $ -- $ -- Stockholders' equity (1): Preferred stock: $.001 par value, 5,000,000 shares authorized, actual, pro forma and as adjusted; no shares issued and outstanding, actual pro forma and as adjusted.......................................................... -- -- -- Common stock: $.001 par value, 50,000,000 shares authorized, actual, pro forma and as adjusted; 6,664,248 shares issued and outstanding, actual; 8,267,678 shares issued and outstanding, pro forma; and 11,167,678 shares issued and outstanding, as adjusted (2).................................. 7 8 11 Additional paid-in capital................................................. 1,246 8,863 43,421 Deferred compensation...................................................... (1,166) (1,166) (1,166) Accretion of redeemable preferred stock.................................... (572) -- -- Retained earnings.......................................................... 1,342 1,342 1,342 --------- --------- ------------ Total stockholders' equity 857 9,047 43,608 --------- --------- ------------ Total capitalization................................................... $ 9,047 $ 9,047 $ 43,608 --------- --------- ------------ --------- --------- ------------
- -------------- (1) The Company does not have any short-term or long-term debt. (2) Excludes (i) 941,413 shares of Common Stock issuable upon exercise of stock options outstanding under the Company's 1996 Stock Option Plan with a weighted average exercise price of $5.16 per share at December 31, 1996 and (ii) 133,285 shares of Common Stock issuable upon exercise of outstanding warrants at an exercise price of $4.99 per share. See "Management -- 1996 Stock Option Plan," "Certain Transactions," "Description of Capital Stock" and Note 6 of Notes to Financial Statements. 12 DILUTION The pro forma net tangible book value of the Company's Common Stock as of December 31, 1996 was approximately $9.0 million or $1.09 per share. Pro forma net tangible book value per share represents the amount of the Company's stockholders' equity, less intangible assets, divided by 8,267,678 shares of Common Stock outstanding after giving effect to the conversion of all outstanding shares of Preferred Stock into 1,603,430 shares of Common Stock upon the completion of this offering. Net tangible book value dilution per share represents the difference between the amount per share paid by purchasers of shares of Common Stock in the offering made hereby and the pro forma net tangible book value per share of Common Stock immediately after the completion of this offering. After giving effect to the sale of the 2,900,000 shares of Common Stock offered hereby at an assumed offering price of $13.00 per share, and after deducting underwriting discounts and commissions and estimated offering expenses payable by the Company, the Company's pro forma net tangible book value at December 31, 1996 would have been approximately $43.6 million, or $3.90 per share. This represents an immediate increase in pro forma net tangible book value of $2.81 per share to existing stockholders and an immediate dilution in net tangible book value of $9.10 per share to new investors purchasing Common Stock in this offering. The following table illustrates this dilution on a per share basis: Assumed initial public offering price per share............................. $ 13.00 Pro forma net tangible book value per share at December 31, 1996.......... $ 1.09 Increase per share attributable to new investors.......................... 2.81 --------- Pro forma net tangible book value per share after the offering.............. 3.90 --------- Net tangible book value dilution per share to new investors................. $ 9.10 ---------
The following table sets forth, on a pro forma basis as of December 31, 1996, after giving effect to the conversion of all outstanding shares of Preferred Stock into Common Stock upon the completion of this offering, the difference between the existing stockholders and the purchasers of shares in the offering (at an assumed offering price of $13.00 per share) with respect to the number of shares purchased from the Company, the total consideration paid and the average price per share paid:
SHARES PURCHASED(1) TOTAL CONSIDERATION AVERAGE -------------------------- --------------------------- PRICE NUMBER PERCENT AMOUNT PERCENT PER SHARE ------------- ----------- -------------- ----------- ----------- Existing stockholders............................. 8,267,678 74.0% $ 8,010,000 17.5% $ 0.97 New investors..................................... 2,900,000 26.0 37,700,000 82.5 $ 13.00 ------------- ----- -------------- ----- Total......................................... 11,167,678 100.0% $ 45,710,000 100.0% ------------- ----- -------------- ----- ------------- ----- -------------- -----
- -------------- (1) Sales by Selling Stockholders in this offering will cause the number of shares held by the existing stockholders to be reduced to 7,317,678, or approximately 65.5% of the total number of shares of Common Stock to be outstanding after this offering. See "Principal and Selling Stockholders." The foregoing computations assume no exercise of stock options or warrants outstanding at December 31, 1996. At December 31, 1996, there were outstanding stock options to purchase an aggregate of 941,413 shares of Common Stock at a weighted average exercise price of $5.16 per share. In addition, at December 31, 1996, 133,285 shares of Common Stock were issuable upon exercise of outstanding warrants at an exercise price of $4.99 per share. To the extent these stock options and warrants are exercised, there will be further dilution to purchasers in this offering. See "Management -- 1996 Stock Option Plan," "Certain Transactions," "Description of Capital Stock" and Note 6 of Notes to Financial Statements. 13 SELECTED FINANCIAL DATA The selected financial data set forth below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Financial Statements of the Company and Notes thereto included elsewhere in this Prospectus. The statements of operations data for the years ended December 31, 1994, 1995 and 1996 and the balance sheet data at December 31, 1995 and 1996 are derived from the Company's financial statements that have been audited by Ernst & Young LLP, independent auditors, included elsewhere in this Prospectus. The selected balance sheet data as of December 31, 1994 is derived from the Company's audited balance sheet not included in this Prospectus. The selected financial data as of December 31, 1992 and 1993 and for the years then ended is derived from unaudited financial data not included in this Prospectus. The unaudited financial data include, in the opinion of management, all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of the Company's financial position at those dates and results of operations for those periods.
YEARS ENDED DECEMBER 31, ----------------------------------------------------- 1992 1993 1994 1995 1996 --------- --------- --------- --------- --------- (IN THOUSANDS, EXCEPT PER SHARE DATA) STATEMENT OF OPERATIONS DATA: Revenues........................................................... $ 2,728 $ 3,483 $ 8,521 $ 14,330 $ 19,311 Cost of revenues................................................... 1,781 2,322 6,185 8,475 13,556 --------- --------- --------- --------- --------- Gross profit....................................................... 947 1,161 2,336 5,855 5,755 Operating expenses: Sales and marketing.............................................. 390 640 796 938 1,853 General and administrative....................................... 556 575 1,507 2,893 3,897 --------- --------- --------- --------- --------- Total operating expenses........................................... 946 1,215 2,303 3,831 5,750 --------- --------- --------- --------- --------- Income (loss) from operations...................................... 1 (54) 33 2,024 5 Interest income (expense) net...................................... 4 2 12 67 197 --------- --------- --------- --------- --------- Income (loss) before income taxes.................................. 5 (52) 45 2,091 202 Provision for income taxes......................................... -- -- 19 851 119 --------- --------- --------- --------- --------- Net income (loss).................................................. 5 (52) 26 1,240 83 Accretion of redeemable preferred stock............................ -- -- -- 87 485 --------- --------- --------- --------- --------- Net income (loss) attributable to common stock..................... $ 5 $ (52) $ 26 $ 1,153 $ (402) --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- Pro forma net income per share(1).................................. $ 0.01 --------- --------- Shares used in computing pro forma net income per share(1)......... 8,888 --------- ---------
DECEMBER 31, ----------------------------------------------------- 1992 1993 1994 1995 1996 --------- --------- --------- --------- --------- (IN THOUSANDS) BALANCE SHEET DATA: Cash, cash equivalents and short-term investments......... $ 81 $ 278 $ 264 $ 6,285 $ 2,284 Total assets.............................................. 557 1,474 1,727 12,545 11,910 Long-term debt, less current portion...................... 8 4 -- -- -- Redeemable preferred stock................................ -- -- -- 7,705 8,190 Total stockholders' equity................................ 52 -- 29 1,182 857
- ---------------- (1) See Note 1 of Notes to Financial Statements for information concerning the calculation of pro forma net income per share. 14 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS THIS PROSPECTUS CONTAINS CERTAIN STATEMENTS OF A FORWARD-LOOKING NATURE RELATING TO FUTURE EVENTS OR THE FUTURE FINANCIAL PERFORMANCE OF THE COMPANY. PROSPECTIVE INVESTORS ARE CAUTIONED THAT SUCH STATEMENTS ARE ONLY PREDICTIONS AND THAT ACTUAL EVENTS OR RESULTS MAY DIFFER MATERIALLY. IN EVALUATING SUCH STATEMENTS, PROSPECTIVE INVESTORS SHOULD SPECIFICALLY CONSIDER THE VARIOUS FACTORS IDENTIFIED IN THIS PROSPECTUS, INCLUDING THE MATTERS SET FORTH UNDER THE CAPTION "RISK FACTORS," WHICH COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE INDICATED BY SUCH FORWARD-LOOKING STATEMENTS. OVERVIEW The Company designs, implements, supports and manages advanced computer network systems for hospitals, IDSs and other provider organizations. The Company believes that its success is attributable to its healthcare industry focus, depth and breadth of technological expertise, ability to objectively evaluate its customers' computer network systems due to its vendor independence and its history of successful customer engagements. The Company's design services include an assessment of the customer's existing computer network system, the preparation of voice, video and data network specifications, technical design documentation and diagrams. DAOU's implementation services include the purchase, delivery and installation of enterprise-wide computer network systems. In 1996, revenues from design services averaged approximately $49,000 per project. In addition, revenues in 1996 from enterprise-wide implementation service engagements ranged from approximately $500,000 to $4.6 million per project, while revenues from other implementation projects averaged approximately $70,000. Implementation service revenues consist of third-party hardware and software products, as well as the Company's professional services. The Company's gross margin with respect to implementation services varies significantly depending on the percentage of such services consisting of products (with respect to which the Company obtains a lower margin) versus professional services. The Company's support and management services include remote and on-site network management, as well as I/S outsourcing. The Company typically provides these services under multi-year contracts. Historically, the majority of the Company's revenues have been derived from network design and implementation services which are generally provided on a fixed-fee basis. These revenues are recognized using the percentage-of-completion method with progress to completion measured by labor costs incurred to date compared to total estimated labor costs. The Company may also provide design and implementation services on a "time and expense" basis for which revenues are also recognized as services are performed. A design project typically lasts from three to five months. The time to complete implementation projects generally ranges from three to six months, although certain projects have required up to 13 months for completion. Support and management service revenues are recognized ratably over the period that these services are provided. The Company anticipates that revenues from support and management services will increase as a percent of total revenues in the future. Payments received in advance of services performed are recorded as deferred revenues. Certain contract payment terms may result in customer billing occurring at a pace slower than revenue recognition. The resulting revenues recognized in excess of amounts billed and project costs are classified as contract work in progress on the Company's balance sheet. RESULTS OF OPERATIONS YEARS ENDED DECEMBER 31, 1996 AND 1995 The Company's revenues were $19.3 million and $14.3 million for the years ended December 31, 1996 and 1995, respectively, representing an increase of 35%. Revenues increased primarily due to the introduction of the Company's I/S outsourcing services for Candler in April 1996. Services to CMC, Mercy and Candler accounted for approximately $4.1 million, $3.4 million and $2.9 million of total revenues in 1996, representing approximately 21%, 18% and 15% of total revenues, respectively. 15 Cost of revenues was $13.6 million and $8.5 million for the years ended December 31, 1996 and 1995, respectively, representing an increase of 60%. Gross margin was 30% and 41% for the years ended December 31, 1996 and 1995, respectively. This decrease in gross margin was primarily due to the increased content of professional services in certain implementation projects during 1995, as well as the lower gross margin related to the Company's I/S outsourcing services initiated in 1996. The Company believes that the 1996 gross margin is more indicative of future results than its 1995 gross margin due to the anticipated growth of its I/S outsourcing services relative to other services. Sales and marketing expenses were $1.9 million and $938,000 for the years ended December 31, 1996 and 1995, respectively, representing an increase of 98%. This increase was primarily due to the establishment of a regional sales structure, an increase in sales and marketing personnel and the expansion of the Company's marketing programs. Sales and marketing expenses were 10% and 7% of revenues for the years ended December 31, 1996 and 1995, respectively. The Company intends to continue investing in its sales infrastructure and expects that sales and marketing expenses will continue to increase in dollar terms to support the anticipated growth in the Company's business. General and administrative expenses were $3.9 million and $2.9 million for the years ended December 31, 1996 and 1995, respectively, representing an increase of 35%. The primary factors contributing to this increase were costs associated with the Company's larger corporate facility, implementation of a management information system and the addition of senior management during 1996. General and administrative expenses were 20% of revenues for the years ended December 31, 1996 and 1995. The Company expects that general and administrative expenses will continue to increase in dollar terms to support the anticipated growth in the Company's business. Net interest income was $197,000 and $67,000 for the years ended December 31, 1996 and 1995, respectively. Interest income consists of interest on short-term investments, cash and cash equivalents and notes receivable from officers and stockholders. Interest expense consists of interest associated with the Company's business line of credit and term financing of insurance premiums, but was not significant during either period. YEARS ENDED DECEMBER 31, 1995 AND 1994 The Company's revenues were $14.3 million and $8.5 million for the years ended December 31, 1995 and 1994, respectively, representing an increase of 68%. Revenues increased primarily due to growth in design and implementation service revenues. Increases in both the number and size of management service projects from both new and existing customers resulted in a 42% increase in management service revenues in 1995. Services to Mercy accounted for $6.8 million, or approximately 48%, of total revenues in 1995. Cost of revenues was $8.5 million and $6.2 million for the years ended December 31, 1995 and 1994, respectively, representing an increase of 37%. Cost of revenues increased primarily due to greater product costs associated with implementation projects and increased labor costs associated with new management service contracts. Gross margin was 41% and 27% of revenues for the years ended December 31, 1995 and 1994, respectively. This increase was attributable primarily to the higher content of professional services in implementation projects, an increase in the number of management service contracts, a reduction in the use of third-party professional services and increased utilization of internal engineering resources. Sales and marketing expenses were $938,000 and $796,000 for the years ended December 31, 1995 and 1994, respectively, representing an increase of 18%. This increase was due primarily to the growth in revenues and the number of people involved in sales activities, as well as the introduction of a new corporate marketing strategy. Sales and marketing expenses were 7% and 9% of revenues for the years ended December 31, 1995 and 1994, respectively. This decrease as a percentage of revenues was due primarily to increased revenues and decreased commissions. 16 General and administrative expenses were $2.9 million and $1.5 million for the years ended December 31, 1995 and 1994, respectively, representing an increase of 92%. This increase was due to one-time relocation costs and expenses of approximately $205,000 associated with the Company's move to new corporate facilities and continued growth in administrative staffing levels in finance, purchasing and human resources. General and administrative expenses were 20% and 18% of revenues for the years ended December 31, 1995 and 1994, respectively. Excluding one-time relocation expenses, there was no significant change on a percentage of revenue basis. INCOME TAXES In 1996, 1995 and 1994, the effective tax rates were 59%, 41% and 42%, respectively, and exceeded the expected combined federal and state statutory rate of 40% primarily due to the nondeductibility of certain operating expenses, including the amortization expense related to compensatory stock options granted during 1996. LIQUIDITY AND CAPITAL RESOURCES Since its inception, the Company has financed its operations primarily through a combination of cash generated from operations and the private sale of equity securities. As of December 31, 1996, the Company had raised $7.6 million, net of issuance costs, from the private sale of equity securities. At December 31, 1996, the Company had $2.3 million in cash and cash equivalents and $1.5 million available under a revolving line of credit. Advances under the revolving line of credit bear interest at the bank's reference rate (8.25% at December 31, 1996) plus 0.5% per annum. Through December 31, 1996, there have been no borrowings under the revolving line of credit, which expires October 1, 1997. This line of credit is secured by substantially all of the assets of the Company and contains customary covenants and restrictions. As of December 31, 1996, the Company was in compliance with all such covenants and restrictions. During the year ended December 31, 1996, cash used in operating activities was $3.2 million, which resulted primarily from an increase in unbilled receivables and cash expended for contract costs reported as contract work in progress on the Company's balance sheet (see Note 1 of Notes to Financial Statements). The net cash used in operating activities was offset by the liquidation of short-term investments upon maturity. The Company believes that the net proceeds from this offering, together with available funds, will be sufficient to meet its capital requirements for the foreseeable future. The Company may also utilize cash to acquire or invest in complementary businesses, although the Company does not have any plans, proposals, arrangements or understandings with respect to any future acquisitions. The Company may sell additional equity or debt securities or obtain additional credit facilities. The sale of additional equity securities could result in additional dilution to the Company's stockholders and the incurrence of additional debt could result in additional interest expense. 17 QUARTERLY RESULTS AND SEASONALITY The following table presents quarterly operating results for each of the last eight quarters. This information has been derived from unaudited financial statements and has been prepared on the same basis as the Company's audited financial statements which appear elsewhere in this Prospectus. In the opinion of the Company's management, this information reflects all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of such information in accordance with generally accepted accounting principles. The operating results for any quarter are not necessarily indicative of the results for any future period.
THREE MONTHS ENDED ----------------------------------------------------------------------------------------- MAR. 31, JUNE 30, SEPT. 30, DEC. 31, MAR. 31, JUNE 30, SEPT. 30, 1995 1995 1995 1995 1996 1996 1996 ----------- ----------- ----------- ----------- ----------- ----------- ----------- (IN THOUSANDS, EXCEPT PER SHARE DATA) Revenues............................. $ 2,597 $ 1,390 $ 3,096 $ 7,247 $ 2,329 $ 5,201 $ 4,827 Cost of revenues..................... 847 1,013 2,005 4,610 1,675 3,668 3,307 ----------- ----------- ----------- ----------- ----------- ----------- ----------- Gross profit......................... 1,750 377 1,091 2,637 654 1,533 1,520 Operating expenses: Sales and marketing................ 273 216 202 247 330 376 461 General and administrative......... 372 478 827 1,216 791 944 926 ----------- ----------- ----------- ----------- ----------- ----------- ----------- Total operating expenses............. 645 694 1,029 1,463 1,121 1,320 1,387 ----------- ----------- ----------- ----------- ----------- ----------- ----------- Income (loss) from operations........ 1,105 (317) 62 1,174 (467) 213 133 Interest income (expense), net....... -- (4) (2) 73 70 50 43 ----------- ----------- ----------- ----------- ----------- ----------- ----------- Income (loss) before income taxes.... 1,105 (321) 60 1,247 (397) 263 176 Provision (benefit) for income taxes............................... 399 (149) 61 540 (234) 155 104 ----------- ----------- ----------- ----------- ----------- ----------- ----------- Net income (loss).................... $ 706 $ (172) $ (1) $ 707 $ (163) $ 108 $ 72 ----------- ----------- ----------- ----------- ----------- ----------- ----------- ----------- ----------- ----------- ----------- ----------- ----------- ----------- DEC. 31, 1996 ----------- Revenues............................. $ 6,954 Cost of revenues..................... 4,906 ----------- Gross profit......................... 2,048 Operating expenses: Sales and marketing................ 686 General and administrative......... 1,236 ----------- Total operating expenses............. 1,922 ----------- Income (loss) from operations........ 126 Interest income (expense), net....... 34 ----------- Income (loss) before income taxes.... 160 Provision (benefit) for income taxes............................... 94 ----------- Net income (loss).................... $ 66 ----------- -----------
The following table sets forth, as a percentage of revenues, certain unaudited quarterly statements of operations data:
THREE MONTHS ENDED ----------------------------------------------------------------------------------------- MAR. 31, JUNE 30, SEPT. 30, DEC. 31, MAR. 31, JUNE 30, SEPT. 30, 1995 1995 1995 1995 1996 1996 1996 ----------- ----------- ----------- ----------- ----------- ----------- ----------- AS A PERCENT OF REVENUES: Revenues............................. 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% Gross margin......................... 67.4 27.1 35.2 36.4 28.1 29.5 31.5 Sales and marketing.................. 10.5 15.5 6.5 3.4 14.2 7.2 9.6 General and administrative........... 14.3 34.4 26.7 16.8 34.0 18.2 19.2 Income (loss) from operations........ 42.6 (22.8) 2.0 16.2 (20.1) 4.1 2.8 Net income (loss).................... 27.2 (12.4) 0.0 9.8 (9.8) 2.2 1.5 DEC. 31, 1996 ----------- AS A PERCENT OF REVENUES: Revenues............................. 100.0% Gross margin......................... 29.5 Sales and marketing.................. 9.9 General and administrative........... 17.8 Income (loss) from operations........ 1.8 Net income (loss).................... 1.0
A substantial majority of the Company's operating expenses, particularly personnel and related costs, depreciation and rent, are relatively fixed in advance of any particular quarter. However, variations in the Company's revenues and operating results occur from time to time, as a result of various factors, including: (i) the reduction in size, delay in commencement, interruption or termination of one or more significant projects or contracts; (ii) the completion during a quarter of one or more significant projects; (iii) the failure to estimate accurately the resources required to complete new or ongoing projects; (iv) the relatively longer sales cycle in obtaining new customers and larger contracts; (v) the timing and extent of employee training or the loss of key employees; (vi) competition; (vii) the development and introduction of new services; and (viii) general economic conditions which may affect the buying decisions of the Company's current and prospective customers. In addition, the Company plans to continue to expand its operations by hiring additional network engineers and other employees, and 18 adding new offices, systems and other infrastructure. The resulting increase in operating expenses will generally be incurred prior to any increase in revenues. Consequently, the Company's business, financial condition and results of operations would be materially and adversely affected if revenues do not increase to support such expenses. A variation in the timing of the commencement or completion of customer assignments, particularly at or near the end of any quarter, may cause significant variations in operating results from quarter to quarter and could result in losses for a particular quarter. In addition, an unanticipated delay or termination of a major project could require the Company to maintain or terminate under-utilized employees which could, in either case, result in higher than expected expenses during a quarter. The Company believes that quarterly revenues and operating results are likely to vary significantly in the future and that period-to-period comparisons of its revenues and operating results are not necessarily meaningful and should not be relied on as indications of future performance. Furthermore, these variations in revenues and operating results could cause significant variations in the price of the Company's Common Stock. 19 BUSINESS THE COMPANY DAOU Systems, Inc. ("DAOU" or the "Company") designs, implements, supports and manages advanced computer network systems for hospitals, integrated healthcare delivery systems ("IDSs"), and other healthcare provider organizations ("provider organizations"). DAOU combines its knowledge of the specialized information needs of the healthcare industry with its technological expertise in computer network systems to provide advanced, reliable and cost-effective computer network solutions to provider organizations. The Company believes that its success is attributable to its healthcare industry focus, depth and breadth of technological expertise, ability to objectively evaluate its customers' computer network systems due to its vendor independence and its history of successful customer engagements. The Company's design services include an assessment of the customer's existing computer network system and the preparation of voice, video and data network specifications, technical design documentation and diagrams. DAOU's implementation services include the purchase, delivery and installation of enterprise-wide computer network systems. The Company's support and management services are typically provided under multi-year contracts and include remote and on-site network management services, as well as information systems outsourcing ("I/S outsourcing"). The Company provides network support services to its customers through its regional sales and support structure and a 24-hour technical support hotline available seven days a week. DAOU typically provides its services on a fixed-price, fixed-time frame basis. Since 1987, the Company has provided computer network services to over 350 customers ranging in size from single-site organizations to multi-state organizations with over 80 sites. The Company's customers include Catholic Medical Center of Brooklyn and Queens, Inc., New York ("CMC"); Mercy Health Services, Farmington Hills, Michigan ("Mercy"); Atlantic Health System, Morristown, New Jersey; Lutheran Health Systems, Fargo, North Dakota; Candler Health System, Savannah, Georgia ("Candler"); and St. Mary's Health Network, Reno, Nevada. INDUSTRY OVERVIEW Pressure by employers, health insurers and government payors to control escalating healthcare costs is driving a movement in the healthcare industry towards managed care and new forms of reimbursement for healthcare providers. Payors are also demanding that providers differentiate their services by demonstrating quality of care. These economic and competitive pressures are causing healthcare providers to consolidate and form multi-entity provider organizations such as IDSs. IDSs may consist of hospitals, primary care and multi-specialty physician groups, out-patient care facilities and home healthcare providers, and are designed to serve economically the healthcare needs of a regional population. The consolidation of provider organizations and the formation of IDSs have resulted in changing healthcare information needs as these organizations increasingly require prompt access to consistent and comprehensive patient information at each location where care is provided. The existing information systems in many provider organizations were developed to meet the needs of a single facility, such as a hospital or an out-patient surgery center. The consolidation of these facilities and the formation of IDSs create complex organizations with many disparate and specialized information system infrastructures. The Company believes that these infrastructures frequently are inadequate to support the flow and integration of information necessary to efficiently manage a complex provider organization. A typical multi-site IDS, for example, requires a computer network that is capable of supporting multiple applications and processing high volumes of data across geographically remote locations. In addition, the increasing variety of hardware and software applications utilized throughout provider organizations has resulted in connectivity and compatibility problems for many computer networks. These networks must not only meet the heightened information needs of provider organizations, but also have the capability to migrate to emerging technologies. As a result of the competitive healthcare environment and the growing complexity of computer network systems, provider organizations have found it increasingly difficult to implement and manage these systems. In addition, the Company believes that the high demand for qualified network engineers and other technical personnel has made it increasingly difficult for provider organizations to recruit and 20 train qualified information technology professionals. Consequently, many provider organizations are looking to third parties for the technological expertise and personnel to meet their information systems requirements. DAOU believes that the ongoing consolidation among healthcare provider organizations and the increasing complexity and rapid evolution of computer network system technologies have created a significant opportunity for companies specializing in providing computer network system solutions to provider organizations. THE DAOU SOLUTION DAOU provides a broad array of services to assist hospitals, IDSs and other provider organizations in designing, implementing, supporting and managing complex computer network systems consistent with their unique and changing information needs. The Company believes that the delivery of a combination of design, implementation and management services better enables the Company's personnel to fully understand the customer's computing and operating environments, install computer networks that meet the customer's specialized requirements, train the customer's users and internal network management staff prior to the full migration to a new computer network system and provide effective, ongoing support and management of the computer network. DAOU has extensive experience resolving the integration, implementation and management issues faced by provider organizations. In addition, the Company has substantial knowledge of numerous software applications developed by healthcare information system and software vendors, as well as extensive expertise in advanced information technologies and computer network systems, including WANs, network/host security, high-performance LANs, Internet/Intranet and asynchronous transfer mode ("ATM") technologies. DAOU uses the products and applications of various hardware and software vendors to integrate the existing computing and communication devices and equipment of legacy systems to create advanced computer network systems. In addition, the Company does not manufacture hardware or develop software, nor does it have exclusive arrangements with any vendors of these products. DAOU believes that this vendor independence enables it to objectively assess its customers' information technology requirements and select the optimal mix of applications and products. The Company believes that its cumulative experience, healthcare focus and technology expertise enable it to deliver advanced computer network systems and services on a timely basis and at fixed prices. STRATEGY The Company's objective is to be a leading provider of advanced computer network systems and network management services to healthcare provider organizations. The principal elements of the Company's strategy are: - EXPAND AND STRENGTHEN CUSTOMER RELATIONSHIPS. The Company will continue to focus its sales and marketing efforts on major medical centers and hospitals around which IDSs are forming. In addition, the Company plans to focus additional resources on serving the information technology needs of emerging provider organizations, such as physician practice management companies, long-term care providers and rehabilitation service providers. DAOU intends to further develop its regional sales and support structure in order to monitor more closely the needs of existing and prospective customers. For example, the Company recently has placed throughout its regional structure customer-dedicated account managers who are responsible for maintaining customer satisfaction and developing new business opportunities. - DEVELOP COMPLEMENTARY SERVICES. The Company intends to develop services which complement its existing services and increase its recurring revenue stream. Currently, DAOU is expanding its services in the areas of voice, video and data integration, telemedicine, I/S outsourcing, Internet/ Intranet and cabling services. The Company intends to develop additional service capabilities such as network outsourcing, remote network monitoring and network traffic pattern analysis. To obtain feedback regarding its present and future services from a customer perspective, the Company has established an advisory board comprised of chief information officers in the healthcare industry. 21 - MAINTAIN TECHNOLOGY EXPERTISE. The Company believes that demand for complex, emerging technologies will grow as provider organizations seek to employ new applications that combine voice, video and data. The Company intends to remain at the forefront of information technology solutions for provider organizations and to continue developing its expertise in emerging technologies. Specific development efforts include in-house vendor presentations to educate employees on technological advances and new products, in-house testing of new systems, products and applications, attendance at various information technology trade shows and participation in the ATM Forum, an industry council that provides input regarding emerging ATM standards. - RECRUIT, TRAIN AND RETAIN QUALIFIED PERSONNEL. The Company believes that its competitive position is enhanced by its ability to hire, train and retain qualified technical and management personnel. DAOU believes that a key factor in recruiting and retaining its technical personnel is its ability to provide them with exposure to and training in a variety of leading edge technologies. The Company intends to continue dedicating significant resources to train its technical employees by conducting in-house workshops presented by senior network engineers, inviting vendors to provide on-site presentations and sponsoring employees to attend vendor certification programs. - HEIGHTEN DAOU'S HEALTHCARE INDUSTRY PRESENCE. The Company intends to leverage its history of successful customer engagements to become a recognized leader in providing information technology solutions to provider organizations. The Company is expanding its marketing program to enhance the market presence and visibility of the Company and its services among potential healthcare customers. INFORMATION TECHNOLOGY SERVICES DAOU designs, implements, supports and manages computer network systems that are capable of providing access to information such as patient records, X-rays and billing information at each site of a provider organization. The Company provides to its customers a broad range of computer network services, which often follow a progression from initial network design through implementation and computer network management. DAOU believes that the delivery of a combination of design, implementation and management services better enables the Company's personnel to fully understand the customer's computing and operating environments, install computer networks that meet the customer's specialized requirements, train the customer's users and internal network management staff prior to the full migration to a new computer network system and provide effective, ongoing support and management of the computer network. The Company uses the products and applications of various hardware and software vendors to integrate the existing computing and communication devices and equipment of legacy systems to create advanced computer network systems. The Company focuses on the specialized requirements of each customer project and utilizes formal planning, monitoring and communication systems and methodologies to ensure proper project completion and customer satisfaction. NETWORK SERVICES DAOU provides network services ranging from network design to large-scale network implementation. The Company generally provides network design services prior to the delivery of its other network or management services in order to determine the proper scope and delivery of these other services. DAOU generally contracts with its customers on a fixed-price basis for defined services delivered in accordance with scheduled milestones. The typical sales cycle for these services begins with an engagement for network design followed by the installation of enterprise-wide computer network systems. NETWORK DESIGN. DAOU's network design services include a review and audit of a customer's existing information technology infrastructure and an assessment of the functional requirements of its computer network system. The Company conducts detailed site visits and interviews key customer personnel in order to identify the specific technologies to be used. The Company then determines how new technologies will integrate into the customer's existing hardware and software and how the entire computer network system will be managed on an ongoing basis. Following its review, the Company 22 prepares technical design documentation and diagrams of the physical, logical, operational and communication infrastructures. The Company also prepares voice, video and data network specifications, as appropriate, and details the implementation steps necessary to meet the customer's specific computer network requirements. As part of this process, the Company designs integration strategies for designated applications, fault-tolerant strategies to help ensure reliable network operation and migration strategies for customer utilization of emerging technologies. The Company also develops detailed recommendations for computer network systems, including the selection of appropriate network products and the design of multi-vendor integration plans. The typical engagement period for network design services is three to five months. NETWORK IMPLEMENTATION. The Company's network implementation services involve the purchase, delivery, testing and installation of enterprise-wide computer network systems. Networks installed by the Company provide a variety of features and services, including switch/bridge/router configuration, PC-to-host emulation, legacy network integration, gateway installation, universal workstation design and installation, remote-site connectivity solutions, dial-up remote access solutions, document management, imaging installations, video conferencing and telemedicine installations. For each implementation project, the Company assigns a project management team typically consisting of a project manager, an account manager, a senior engineer and other technical personnel, as well as subcontractors and third-party vendors if required. Each project management team is carefully selected for its technical expertise in specific areas to meet the requirements of a particular project. The project team is responsible for creating an installation schedule, ensuring compliance with established milestones, providing on-site coordination of the activities of DAOU's personnel, subcontractors and third-party vendors, testing network performance, including stress and data traffic diagnostics, and providing regular progress reports to the project manager. The Company installs a computer network by first conducting a detailed review of the network design to determine the connectivity and product requirements. DAOU typically purchases the various network components which have been specified. After delivery to its facilities, the Company connects these components prior to installation at the customer's site and then conducts various tests of the computer network system, simulating the customer's actual computing environment in accordance with the customer's software applications and specifications. The Company also tests the network's configuration, connectivity and compatibility and analyzes the load and data throughput capacity of the network. This testing process reduces downtime risk and helps ensure that the network installation will occur with minimal disruption to the customer's ongoing business operations. The Company manages the installation of the computer network equipment, as well as software and cabling, using its own personnel or selected subcontractors. Throughout the installation process, the Company's personnel monitor the project's progress to ensure compliance with all network specifications. Upon completion of the equipment installation, the Company conducts additional connectivity testing and diagnostics. The engagement period for these services generally ranges from three to six months, but varies depending on the size and complexity of the implementation project. MANAGEMENT SERVICES As computer network systems become more complex, provider organizations are experiencing difficulties in hiring, training and retaining information technology professionals who can maintain the performance and functionality of their computer network systems. Accordingly, provider organizations have begun to outsource certain maintenance and management functions of their information systems departments. DAOU provides support and management services that are designed to maintain the effective performance of a customer's computer network system, as well as I/S outsourcing services that are designed to manage a customer's information services functions. The Company generally provides these services in multi-year engagements on a fixed-price basis. 23 NETWORK SUPPORT. The Company provides a 24-hour technical support hotline available seven days a week, as well as other network support resources such as on-site seminars and on-line support. DAOU also informs its customers of new technological advances and network solutions that may help increase the utility and functionality of their computer network systems. The Company intends to develop additional support services such as continuous network monitoring in order to monitor remotely the performance of computer network systems on an ongoing basis and detect and report network problems. The initial engagement period for the Company's existing support services typically is for one year, subject to annual renewal. ENTERPRISE NETWORK MANAGEMENT. The Company provides a range of enterprise network management services to manage and support a customer's computer network system. The Company uses its technical expertise and staffing experience to package, price and deliver combinations of these services at collective rates which are frequently lower than if provided in-house by the customer. The customer benefits from the Company's experience in providing enterprise network management services in a broad range of operating environments, including client/server networks supporting both Internet and workgroup protocols intermingled with legacy networks. The engagement period for these services typically ranges from one to five years. The Company's enterprise network management services include combinations of the following services, which are selected by the customer to meet its specific needs: - DAOU EMPLOYEES ON-SITE. DAOU works with a customer to assess the appropriate staffing needs to maintain and support its computer network system. The Company places its employees on-site on a full-time basis to provide network support services and ongoing training of the customer's internal staff. This service allows the customer to benefit continuously from DAOU's technical expertise and to reduce its hiring and training of internal network management personnel. - CONTINUOUS NETWORK PLANNING. DAOU's design personnel evaluate a customer's computer network system and provide recommendations for new network capabilities and capacity on an ongoing basis consistent with the evolving needs and strategy of the customer. In addition, DAOU evaluates hardware and software options, interprets research and development results, updates existing network designs and researches specific products and technologies of interest to customers. The Company provides these services subject to predetermined schedules. - "BURST MODE" IMPLEMENTATION. DAOU provides additional technical personnel during periods of peak network requirements to accommodate and assist in network upgrade implementation or to accommodate the anticipated or unanticipated need for additional technical staff. This service enables the customer to preplan changes in its computer network without the problems associated with recruiting and training temporary staff or hiring excess permanent technical personnel. - NETWORK SUPPORT. Depending on the specific needs of each customer, the Company also provides network support services as part of its combination of enterprise network management services. I/S OUTSOURCING. The Company has recently introduced comprehensive I/S outsourcing services for provider organizations that elect to outsource all or a portion of their information systems functions. I/S outsourcing services involve long-term engagements with customers whereby the Company may staff up to the entire information systems department and is responsible for the management and support of the customer's computer network system. DAOU provides its I/S outsourcing services in accordance with pre-determined, detailed schedules and plans established with the customer. DAOU entered into its first I/S outsourcing contract in April 1996 with Candler (the "Candler Contract"). Under the Candler Contract, the Company is responsible for the management and staffing of Candler's information systems functions with the Company's own employees and acts on behalf of Candler with respect to ongoing enhancements and maintenance of hardware and software products from third-party vendors. Additional I/S outsourcing services under the Candler Contract include: (i) the implementation of operating procedures for and management and staffing of various information systems departments; (ii) the establishment and management of the information systems budget, including personnel and capital expenditures; (iii) the negotiation and management of hardware and software vendor contracts; (iv) attendance at internal and external management meetings, user groups, convention activity and corporate meetings; 24 (v) the development and implementation of an information technology strategic plan; and (vi) ongoing recruiting and training of Candler's employees with respect to the computer network and its applications. The term of the Candler Contract is for five years and the Company anticipates that the typical contract period for additional I/S outsourcing contracts will be for three to five years. There can be no assurance, however, that a customer will not terminate its contract with the Company prior to the completion of the contract term. See "Risk Factors -- Contract Cancellation Rights; Absence of Long-Term Agreements" and "-- Consolidation and Uncertainty in the Healthcare Industry." OTHER SERVICES The Company is expanding its current services and developing new services that will assist provider organizations with the management and support of their computer network systems. DAOU is expanding its current services in the areas of voice, video and data integration, telemedicine, I/S outsourcing, Internet/Intranet and cabling. The Company intends to develop new service capabilities, such as network outsourcing (whereby the Company outsources hardware as well as personnel), remote network monitoring and network traffic pattern analysis. The Company intends to expand or develop these services either internally or through acquisitions. DAOU ADVISORY BOARD In 1994, the Company established its Advisory Board (the "Advisory Board"), a non-governing body currently comprised of twelve chief information officers ("CIOs") of various provider organizations. The Advisory Board meets as a group annually and the members confer separately with the Company periodically to provide advice on issues and trends in the healthcare industry and emerging technologies, as well as to provide strategic direction and feedback regarding the Company's present and future services. Members of the Advisory Board are reimbursed for travel, lodging and meal expenses incurred in connection with attendance at the Advisory Board's sessions and may also receive options to purchase shares of the Company's Common Stock. Larry Grandia, the CIO of Intermountain Health Care Inc., serves as the Chairman of the Advisory Board. RECRUITING AND TRAINING OF TECHNICAL EMPLOYEES The Company dedicates significant time and resources to recruit, train and retain qualified technical personnel. The technical staff of the Company consists of senior network engineers, network engineers and network systems technicians. The Company hires many of its technical staff as entry-level network systems technicians and provides these individuals with the necessary training and experience to become network engineers who are responsible for network configuration, testing, burn-in analysis, installation and documentation. Further training and experience is provided to enable these engineers to become senior network engineers who are responsible for project and resource management. The Company's technical staff undergoes extensive training and maintains certifications from leading network technology vendors such as Cisco Systems, Inc., Bay Networks, Inc., Microsoft Corporation and 3Com Corporation. In addition, the Company is a member of leading technological forums and organizations, including the ATM Forum, the CHIM Telecommunications Committee, the HL7 Committee and the BICSI Organization. The Company believes that its future success will depend in large part on its ability to hire, train and retain qualified network engineers who together have expertise in a wide array of network and computer systems and a broad understanding of the provider organizations that the Company serves. Competition for qualified network engineers is intense and is expected to increase. In particular, competition is intense for the limited number of qualified senior network engineers. Consequently, there can be no assurance that the Company will be successful in attracting and retaining such personnel. While the Company is currently experiencing low rates of turnover, there can be no assurance that these rates of turnover will not increase in the future. Any inability of the Company to hire, train and retain a sufficient number of qualified network engineers could impair the Company's ability to adequately manage and 25 complete its existing projects or to obtain new projects, which, in turn, could have a material adverse effect on the Company's business, financial condition and results of operations. Each technical employee is required to enter into a confidentiality agreement with the Company designed to protect the Company's trade secrets and other confidential information during and subsequent to employment with the Company. Any significant loss of employees to a competitor could have a material adverse effect on the Company's business, financial condition and results of operations. SALES AND MARKETING The Company's sales and support operations are divided into four regional organizations located in the west, midwest, east and southeast regions of the United States. A vice president heads each regional organization and oversees the management of existing customers by the account managers and the development of new customers by the account executives. In particular, account managers are responsible for maintaining customer satisfaction and developing new business opportunities as customer needs for computer network services evolve or increase. The Company intends to create a fifth regional organization in the southwest region during 1997. The Company seeks to establish long-term relationships with its customers by providing high levels of service and by becoming an integral part of their computer network systems operations. The Company focuses its sales and marketing efforts on the CIOs and other technology decision makers of IDSs, hospitals and other provider organizations. The Company relies upon its reputation in the marketplace, the personal contacts and networking of its professionals and the various programs of its marketing department to develop new business opportunities. The Company also receives sales leads directly from consultants, VARs and product and service vendors. The principal objectives of the Company's marketing department are to increase the Company's market presence, provide strategic direction and to generate sales leads. As a supplement to the direct selling efforts of the Company, the marketing department has developed various programs that include advertising campaigns, trade show participation, direct mail campaigns, public relations programs, marketing research and communications and the development of sales presentation materials. The Company's marketing efforts are enhanced by speaking engagements and the publication of technical articles and reports directed to the healthcare information technology industry. The Company's marketing department is also responsible for the continued development of the Company's presence on the Internet as a new marketing channel. COMPETITION The healthcare network services industry is comprised of a large number of participants and is subject to rapid change and intense competition. The Company's competitors include system integrators, VARs, consulting companies, local and regional network services firms, telecommunications providers and network equipment, computer systems and healthcare software vendors, many of which have significantly greater financial, technical and marketing resources and greater name recognition than does the Company. In particular, the Company competes with (i) large information technology companies such as Hewlett-Packard, EDS and Integrated Systems Solutions Corporation, a subsidiary of IBM; (ii) healthcare information technology companies such as HBO & Company; and (iii) smaller regional network systems firms. In addition, the Company has faced, and expects to continue to face, additional competition from new entrants into its markets. Other healthcare information technology companies not presently offering or emphasizing network systems services and large network services companies not currently focusing on healthcare may enter the Company's markets. Increased competition could result in price reductions, fewer customer projects, under-utilization of employees, reduced operating margins and loss of market share, any of which could materially and adversely affect the Company's business, financial condition and results of operations. There can be no assurance that the Company will be able to compete successfully against current and future competitors. The failure of the Company to compete successfully would have a material adverse effect on the Company's business, financial condition and results of operations. In addition, most of the Company's customers have internal network support and 26 service capabilities and could choose to satisfy their needs through internal resources rather than through outside service providers. As a result, the decision by the Company's customers or potential customers to perform network services internally could have a material adverse effect on the Company's business, financial condition and results of operations. The Company believes that the principal competitive factors in the markets in which it competes include: reputation, healthcare industry expertise, network performance and reliability, timely delivery of services, quality of service, responsiveness to customers, product knowledge and technological expertise, marketing, customer relationships and price. The Company believes that it is competitive with respect to the above mentioned factors. CUSTOMERS Since 1987, DAOU has provided computer network services to over 350 customers ranging in size from single-site organizations to multi-state organizations with over 80 sites. The Company's customers include CMC, New York; Mercy, Farmington Hills, Michigan; Atlantic, Morristown, New Jersey; Lutheran Health Systems, Fargo, North Dakota; Candler, Savannah, Georgia; and St. Mary's Health Network, Reno, Nevada. The Company has derived, and believes that it will continue to derive, a significant portion of its revenues from a relatively limited number of large customer contracts. In 1996, CMC, Mercy and Candler accounted for approximately 21%, 18% and 15% of total revenues, respectively. In 1995, Mercy and Candler accounted for approximately 48% and 11% of total revenues, respectively. No other customer accounted for more than 10% of the Company's revenues during such periods. BACKLOG The Company includes in sales backlog all unrecognized revenues attributable to signed contracts for network and management services. At December 31, 1996 and December 31, 1995, the Company's sales backlog was approximately $15.8 million and $6.0 million, respectively. The Company estimates that approximately 46% of its backlog at December 31, 1996 will not be recognized as revenues during the following twelve months due to the long-term nature of the Company's contracts. Although the Candler Contract has an initial term of five years, sales backlog at December 31, 1996 includes estimated payments to be received under the Candler Contract only through December 31, 1997, because the Company cannot determine with certainty the exact amounts of the payments to be received under the Candler Contract subsequent to that date. Furthermore, the Company's customers are generally able to reduce or cancel their use of the Company's services before the end of the contract term. Consequently, there can be no assurance that services included in sales backlog will generate revenues in the amount estimated or that such revenues will be recognized during the specified twelve-month period or at all. See "Risk Factors -- Contract Cancellation Rights; Absence of Long-Term Contracts" and "--Consolidation and Uncertainty in the Healthcare Industry." EMPLOYEES As of December 31, 1996, the Company employed 126 persons. Of these employees, 82 were involved in providing computer network services, 13 in sales and marketing and 31 in general administration, finance and clerical. The Company's employees are not represented by a labor union and the Company's management believes that its relationship with its employees is good. FACILITIES The Company leases approximately 32,000 square feet of office space in San Diego, California for its principal administrative, support and training facilities. This lease expires in September 1998. In addition, the Company has executive offices in Chicago and Atlanta to provide regional sales and support activities to its customers and plans to establish executive offices in Boston and Philadelphia during the first quarter of 1997. The Company continually evaluates the adequacy of its existing facilities and believes that its current and planned facilities will be adequate for the next twelve months. 27 MANAGEMENT EXECUTIVE OFFICERS AND DIRECTORS The executive officers and directors of the Company and their ages as of the date of this Prospectus are as follows:
NAME AGE POSITION - --------------------------------------- --- ------------------------------------------------------------- Georges J. Daou........................ 35 Chairman of the Board and Chief Executive Officer Daniel J. Daou......................... 31 President and Director Robert J. McNeill...................... 58 Executive Vice President and Chief Operating Officer Fred C. McGee.......................... 50 Senior Vice President, Chief Financial Officer and Secretary Dan L. Porter.......................... 57 Senior Vice President, Human Resources Ron V. Mirabile........................ 35 Vice President, Field Services Eric S. Ringwall....................... 32 Vice President, Technology Services David W. Jahns (1)(2).................. 31 Director Bernard F. McDonagh (1)(2)............. 53 Director John H. Moragne (1)(2)................. 39 Director
- -------------- (1) Member of the Audit Committee (2) Member of the Compensation Committee MR. GEORGES DAOU, a founder of the Company, has served as Chairman of the Board and Chief Executive Officer since the Company's inception in 1987. Mr. Daou sits on the boards of various healthcare and community organizations, including the College of Healthcare Management Executives and the Healthcare Information Managers Association. He holds a B.S. in Electrical Engineering and an M.S. in Information and Communication Theory from the University of California, San Diego. MR. DANIEL DAOU, a founder of the Company, has served as President since December 1994 and as a director since the Company's inception in 1987. From November 1992 to December 1994, he was the President of Complex Network Solutions, Inc., an engineering services company. From July 1987 to November 1992, he served as Vice President of the Company. Mr. Daou sits on the board of a private software company. He holds a B.S. in Computer Engineering from the University of California, San Diego. MR. MCNEILL joined the Company as Executive Vice President and Chief Operating Officer in November 1996. From September 1981 through November 1996, he served in various executive capacities with Shared Medical Systems Corporation ("SMS"), a healthcare information services company. In his most recent position with SMS as Senior Vice President of Marketing, Mr. McNeill was responsible for marketing and professional services and managed several business units, including networking and imaging systems integration. He holds a B.S. in Accounting from St. Joseph's University. MR. MCGEE joined the Company as Senior Vice President and Chief Financial Officer in August 1996. From October 1988 through July 1996, Mr. McGee was Vice President of Finance and Chief Financial Officer of Infrasonics, Inc., a publicly-traded manufacturer of medical devices used in respiratory care. Prior thereto, Mr. McGee held various financial and management positions with Sears Roebuck & Co. and other retail, wholesale and manufacturing companies. He holds a B.S. in Finance from San Diego State University. MR. PORTER has served as Senior Vice President, Human Resources, of the Company since June 1994. From October 1993 to June 1994, he was the Director, Human Resources of the San Diego Convention Center. From October 1979 to October 1993, Mr. Porter was the Corporate Vice President, Human Resources, of Scripps Memorial Hospitals, where he was responsible for all human resources activities at five acute-care facilities, two extended-care facilities and all affiliated businesses. He holds a B.A. in Psychology from the University of Tulsa. 28 MR. MIRABILE has served as Vice President, Field Services, since January 1996 and is responsible for network implementation and the Company's engineering department. After joining the Company as a network engineer in March 1989, he served as Director of Technical Services from July 1994 to December 1995. Mr. Mirabile holds a B.S. in Business Information and Decision Systems from San Diego State University. MR. RINGWALL has served as Vice President, Technology Services, since January 1996. From May 1993 to January 1996, he worked as an engineering consultant to the Company designing computer networks for provider organizations nationwide. From September 1992 to May 1993, Mr. Ringwall was a network engineer for Citizens National Mortgage Corporation, a mortgage loan institution. Prior thereto, he obtained a masters degree in Information Systems Management from the Naval Postgraduate School. Mr. Ringwall holds a B.A. in Biology from Cornell University. MR. JAHNS has been a director of the Company since October 1995. Mr. Jahns joined Galen Associates, a venture capital investment firm, in January 1993, and has served as Vice President since January 1994. Prior thereto, he earned an M.B.A. from the J.L. Kellogg Graduate School of Business. Mr. Jahns currently serves on the board of directors of various private healthcare services and technology companies. He holds a B.A. in Political Science and Economics from Colgate University. MR. MCDONAGH has been a director of the Company since March 1996. Since February 1995, he has been Vice President, Investor Relations and Business Research for United Healthcare Corporation, a managed care services provider, where he is responsible for the venture investments of that company. From August 1989 to February 1995, Mr. McDonagh was a Senior Healthcare Services Analyst and managing director for Piper Jaffray, Inc., an investment banking firm. He holds a B.A. from Manhattan College, a Ph.D. in Statistics from The Catholic University of America and an M.B.A. from the University of Minnesota. MR. MORAGNE has been a director of the Company since October 1995. Mr. Moragne has been a managing director of Trident Capital, Inc., a private investment firm, since May 1993 and a member of Trident Capital Management, LLC, an affiliated entity, since October 1995. From August 1989 to May 1993, Mr. Moragne was a principal of Bain Capital, a private investment firm, as well as a principal of Information Partners, a private equity firm associated with Dun & Bradstreet Enterprises and Bain Capital. He currently serves on the board of directors of various private information technology companies. He holds a B.A. from Dartmouth College, an M.S. from the Stanford Graduate School of Applied Engineering and an M.B.A. from the Stanford Graduate School of Business. All directors currently hold office until the next annual meeting of stockholders and until their successors have been duly elected and qualified. After this offering, the Company intends to elect two additional directors to the Board of Directors who are not affiliated with the Company. Upon reincorporation in Delaware, the Board of Directors will be classified into three classes. Each class will consist of approximately the same number of directors, who will serve for a one, two or three-year period or until their successors are duly elected and qualified. At each annual meeting of stockholders, the successors to the class of directors whose term then expires will be elected to hold office for a term expiring at the annual meeting of stockholders held subsequently in three years. The Board of Directors has a Compensation Committee and an Audit Committee, each composed of Messrs. Jahns, McDonagh and Moragne. The Compensation Committee makes recommendations to the Board of Directors concerning salaries and incentive compensation for the Company's officers and employees and administers the Company's 1996 Stock Option Plan. The Audit Committee aids management in the establishment and supervision of the Company's financial controls, evaluates the scope of the annual audit, reviews audit results, consults with management and the Company's independent auditors prior to the presentation of financial statements to the stockholders and, if appropriate, initiates inquiries into aspects of the Company's financial affairs. Officers are elected by and serve at the discretion of the Board of Directors. Georges Daou and Daniel Daou are brothers and Joseph Daou, a Selling Stockholder and a former officer and director of the Company, is their father. 29 EXECUTIVE COMPENSATION The following table sets forth certain information for the year ended December 31, 1996, regarding the compensation of the Company's Chief Executive Officer and each of the four most highly compensated executive officers of the Company whose salary and bonus for such year were in excess of $100,000 on an annualized basis (the "Named Executive Officers"): SUMMARY COMPENSATION TABLE
ANNUAL COMPENSATION ------------------------ ALL OTHER NAME AND PRINCIPAL POSITION SALARY BONUS COMPENSATION - ----------------------------------------------------------------------- ----------- ----------- -------------- Georges Daou Chairman of the Board and Chief Executive Officer.............................................. $ 201,923 $ 35,409 $ 4,774(1) Daniel Daou President............................................................ 201,923 41,129 8,244(2) Joseph Daou Former Treasurer..................................................... 105,769 -- 6,264(3) Robert J. McNeill Executive Vice President and Chief Operating Officer.............................................. 16,827(4) -- 105,000(5) Fred C. McGee Senior Vice President, Chief Financial Officer and Secretary................................ 44,269(6) -- --
- -------------- (1) Includes $3,056 of automobile expenses and $1,718 of health insurance benefits. (2) Includes $2,480 of automobile expenses, $3,536 of health insurance benefits and $2,228 of contributions made by the Company under its 401(k) plan. (3) Includes $2,728 of automobile expenses and $3,536 of health insurance benefits. (4) The Company hired Mr. McNeill in November 1996 at an annual salary of $175,000. (5) Reflects a one-time signing bonus. See "--Employment Agreement." (6) The Company hired Mr. McGee in August 1996 at an annual salary of $130,000. 30 OPTION GRANTS. The following table sets forth certain information for the year ended December 31, 1996, with respect to grants of stock options to Named Executive Officers. The Company has not granted any stock appreciation rights to Named Executive Officers. OPTION GRANTS IN THE LAST FISCAL YEAR
INDIVIDUAL GRANTS POTENTIAL REALIZABLE ------------------------------------------------------------------------- VALUE AT ASSUMED NUMBER OF PERCENT OF ANNUAL RATES OF SECURITIES TOTAL OPTIONS STOCK PRICE UNDERLYING GRANTED TO FAIR MARKET APPRECIATION FOR OPTIONS EMPLOYEES IN EXERCISE VALUE ON OPTION TERM(3) GRANTED FISCAL YEAR PRICE DATE OF GRANT EXPIRATION --------------------------------- NAME (#)(1) 1996 ($/SH)(2) ($/SH) DATE 0%($) 5%($) 10%($) - --------------------- ----------- ----------------- ----------- --------------- ----------- --------- ---------- ---------- Robert J. McNeill (4)................. 140,300 14.9% $4.28 $ 10.69 11/10/06 $ 899,323 $1,842,139 $3,290,035 Fred C. McGee (5).... 63,135 6.7% 4.28 4.28 01/01/06 -- 169,833 430,581
- -------------- (1) These options were granted under the Company's 1996 Stock Option Plan. (2) The exercise price is to be paid in cash, by surrendering shares of Common Stock held by optionee for more than 12 months, or in any combination of such consideration or such other consideration and method of payment permitted under applicable law. (3) The 0%, 5% and 10% assumed annual rates of compounded stock price appreciation are mandated by rules of the Securities and Exchange Commission. There can be no assurance that the actual stock price appreciation over the ten-year option term will be at the assumed 0%, 5% or 10% levels or at any other defined level. (4) In November 1996, the Company granted to Mr. McNeill an option to purchase 140,300 shares of Common Stock at an exercise price of $4.28 per share. This option vests over five years on each anniversary of November 1, 1996. The Company has agreed to pay to Mr. McNeill a cash bonus in the amount of the difference, if any, between (i) the net value of the options at the end of the third anniversary of their date of issuance and (ii) $1,550,000. See "--Employment Agreement." (5) In August 1996, the Company granted to Mr. McGee an option to purchase 63,135 shares of Common Stock at an exercise price of $4.28 per share. This option vests over five years on each anniversary of January 2, 1996. The following table sets forth information for the Named Executive Officers regarding the value of unexercised options held as of December 31, 1996. No options were exercised by the Named Executive Officers during the year ended December 31, 1996. FISCAL YEAR-END OPTION VALUES
VALUE OF UNEXERCISED NUMBER OF SECURITIES IN-THE-MONEY UNDERLYING UNEXERCISED OPTIONS AT OPTIONS AT DECEMBER 31, 1996(#) DECEMBER 31, 1996($)(1) NAME (EXERCISABLE/UNEXERCISABLE) (EXERCISABLE/UNEXERCISABLE) - ------------------------------------------------ ---------------------------------- --------------------------- Robert J. McNeill (2)........................... --/140,300 $ --/$899,323 Fred C. McGee................................... --/63,135(3) --/ 404,695
- -------------- (1) Calculated by determining the difference between the fair market value of the securities underlying the option at December 23, 1996 ($10.69 per share as determined by the Board of Directors) and the exercise price of the option. (2) The Company has agreed to pay to Mr. McNeill a cash bonus in the amount of the difference, if any, between (i) the net value of the options at the end of the third anniversary of their date of issuance and (ii) $1,550,000. See "--Employment Agreement." (3) Includes options to purchase 12,627 shares which vested on January 2, 1997. 31 EMPLOYMENT AGREEMENT The Company entered into an employment agreement effective as of November 11, 1996 with Robert McNeill, its Executive Vice President and Chief Operating Officer. The agreement provides for (i) a base salary of $175,000 per year, (ii) a one-time signing bonus not to exceed $105,000 and (iii) up to $120,000 in annual bonus compensation, subject to achievement by the Company of specified performance goals. In addition, the Company granted to Mr. McNeill non-qualified stock options to purchase 140,300 shares of Common Stock at an exercise price of $4.28 per share, and has agreed to pay to Mr. McNeill a cash bonus in the amount of the difference, if any, between (i) the net value of the options at the end of the third anniversary of their date of issuance and (ii) $1,550,000. The agreement also contains provisions designed to ensure that the after-tax effect of the options issued to Mr. McNeill will be equivalent to the result that would pertain had they been issued as incentive stock options ("ISOs") rather than non-qualified stock options. To accomplish this, the agreement provides that (i) the Company loan to Mr. McNeill on an interest fee basis an amount of money equal to the tax liability he incurs upon exercise of the options in excess of the amount that would have been incurred had the options been originally issued as ISOs, and (ii) the aforementioned loan will become due and payable at the earlier of (a) the time of sale or disposition of the shares subject to the options, (b) the termination date of Mr. McNeill's employment with the Company or (c) January 17, 2002. The loan amount subject to repayment will be reduced by the amount, if any, by which the cumulative tax liability on exercise of the options and on disposition of the underlying shares by Mr. McNeill exceeds the tax that would have been incurred had the options originally been issued as ISOs. In the event that Mr. McNeill is terminated without cause, he will be entitled to severance payments in an aggregate amount not to exceed 18 months of his base salary. See "Certain Transactions." DIRECTOR COMPENSATION Directors of the Company do not receive cash for services that they provide as directors or as committee members. The Company has granted to each non-employee director an option to purchase 21,045 shares of Common Stock at an exercise price of $4.28 per share. These options vest over three years. The Company anticipates that it will compensate its independent directors in the future. See "Management -- 1996 Stock Option Plan" and "Certain Transactions." COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION In 1996, the Compensation Committee of the Board of Directors consisted of Messrs. Daniel Daou and Moragne and currently consists of Messrs. Jahns, McDonagh and Moragne. Entities affiliated with Messrs. Jahns, McDonagh and Moragne have purchased 1,052,975, 210,596 and 737,083 shares of Common Stock, respectively. No executive officer of the Company served on the compensation committee of another entity or on any other committee of the board of directors of another entity performing similar functions during the last fiscal year. 1996 STOCK OPTION PLAN The Company's 1996 Stock Option Plan (the "1996 Stock Option Plan") provides for the grant of incentive stock options to employees and nonstatutory stock options to employees, directors and consultants. A total of 1,367,925 shares of Common Stock have been reserved for issuance under the 1996 Stock Option Plan, under which options to purchase 941,413 shares of Common Stock have been granted as of December 31, 1996. Options granted under the 1996 Stock Option Plan typically vest over five years. The Compensation Committee of the Board of Directors administers the 1996 Stock Option Plan and determines the exercise price of options granted thereunder. The exercise price of incentive stock options must be at least equal to the fair market value of the Common Stock on the date of grant. In addition, the exercise price of any stock option granted to an optionee who owns stock representing more than 10% of the voting power of all classes of stock of the Company must equal at least 110% of the fair market value of the Common Stock on the date of grant. The exercise price may be paid in such consideration as determined by the Board of Directors. With respect to any participant who owns stock representing more than 10% of the voting power of all classes of stock of the Company, the term of the option is limited to five years or less. The term for all other options may not exceed ten years. The Board of Directors may amend or modify the 1996 Stock Option Plan at any time without the consent of the optionees, so long as such action does not adversely affect their outstanding options. The 32 1996 Stock Option Plan will terminate in 2006, unless terminated earlier by the Board of Directors. Each outstanding option provides that, in the event of a "change in control," including the dissolution or liquidation of the Company or a merger of the Company with or into another corporation, each optionee will be entitled to exercise up to 70% of the shares of Common Stock underlying his unvested options immediately prior to the consummation of such "change in control" event. SECTION 401(K) PLAN In August, 1994, the Company adopted a 401(k) Salary Savings Plan (the "401(k) Plan") covering the Company's full-time employees located in the United States. The 401(k) Plan is intended to qualify under Section 401(k) of the Internal Revenue Code, so that contributions to the 401(k) Plan by employees or by the Company, and the investment earnings thereon, are not taxable to employees until withdrawn from the 401(k) Plan, and so that contributions by the Company, if any, will be deductible by the Company when made. Pursuant to the 401(k) Plan, employees may elect to reduce their current compensation by up to the statutorily prescribed annual limit ($9,500 in 1996) and to have the amount of such reduction contributed to the 401(k) Plan. The 401(k) Plan permits, but does not require, additional matching contributions to the 401(k) Plan by the Company on behalf of all participants in the 401(k) Plan. LIMITATIONS ON DIRECTORS' LIABILITY AND INDEMNIFICATION The Company has adopted provisions in its Certificate of Incorporation that limit the liability of directors to the maximum extent permitted by Delaware law. Delaware law provides that directors of a corporation will not be personally liable for monetary damages for breach of their fiduciary duties as directors, except liability for (i) any breach of their duty of loyalty to the corporation or its stockholders, (ii) acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law, (iii) unlawful payments of dividends or unlawful stock repurchases or redemptions, or (iv) any transaction from which the director derived an improper personal benefit. Such limitation of liability does not apply to liabilities arising under the federal securities laws and does not affect the availability of equitable remedies such as injunctive relief or rescission. The Company's Bylaws provide that the Company shall indemnify its directors and executive officers and may indemnify its other officers and employees and other agents to the fullest extent permitted by law. The Company believes that indemnification under its Bylaws covers at least negligence and gross negligence on the part of indemnified parties. The Company's Bylaws also permit it to secure insurance on behalf of any officer, director, employee or other agent for any liability arising out of his or her actions in such capacity, regardless of whether the Bylaws permit such indemnification. The Company has entered into agreements to indemnify its directors and executive officers, in addition to indemnification provided for in the Company's Bylaws. These agreements, among other things, indemnify the Company's directors and executive officers against expenses (including attorneys' fees), judgments, fines and settlement amounts incurred by any such person in any action or proceeding, including expenses incurred in connection with any action by or in the right of the Company, arising out of such person's services as a director or executive officer of the Company, any subsidiary of the Company or any other company or enterprise to which the person provides services at the request of the Company. The Company believes that these provisions and agreements are necessary to attract and retain qualified persons as directors and executive officers. The Company's indemnification provisions set forth in its Certificate of Incorporation, Bylaws and agreements with directors and executive officers provide for broad indemnification under Delaware law with no express exclusion for liabilities arising under or in connection with the Securities Act of 1933 (the "Securities Act"). Insofar as indemnification for liabilities arising under the Securities Act may be permitted to directors, officers and controlling persons of the Company pursuant to the foregoing provisions, or otherwise, the Company has been advised that, in the opinion of the Securities and Exchange Commission, such indemnification is against public policy as expressed in the Securities Act and is, therefore, unenforceable. At present, there is no pending litigation or proceeding involving a director or officer of the Company in which indemnification is required or permitted, and the Company is not aware of any threatened litigation or proceeding that may result in a claim for such indemnification. 33 CERTAIN TRANSACTIONS In October 1995, the Company issued and sold an aggregate of 1,603,430 shares of Preferred Stock at a purchase price of $4.99 per share. Upon the completion of this offering, each share of Preferred Stock will convert into one share of Common Stock. In connection with the Company's sale of Preferred Stock, Georges Daou, Daniel Daou and Joseph Daou sold an aggregate of 818,416 shares of Common Stock to the same investors at $4.28 per share. The purchasers of such shares of Common Stock and Preferred Stock included, among others, the following entities affiliated with directors of the Company:
SHARES OF SHARES OF NAME COMMON STOCK PREFERRED STOCK - ------------------------------------------------------------------------------- --------------- ---------------- ENTITIES AFFILIATED WITH DIRECTORS Galen Partners II, L.P. (1).................................................. 256,251 502,041 Galen Partners International, L.P. (1)....................................... 98,043 192,086 Galen Employee Fund, L.P. (1)................................................ 1,539 3,015 Information Associates, L.P. (2)............................................. 233,344 457,163 Information Associates, C.V. (2)............................................. 15,739 30,837 HLM Partners VII, L.P. (3)................................................... 71,167 139,429
- -------------- (1) David Jahns, a director of the Company, is a Vice President of Galen Associates, which is affiliated with Galen Partners II, L.P., Galen Partners International, L.P. and Galen Employee Fund, L.P. Mr. Jahns disclaims beneficial ownership of the shares held by these entities, except to the extent of his interest in the shares of Galen Employee Fund, L.P. arising from his limited partnership interest in such fund. In addition, the Company has granted to Mr. Jahns options to purchase 21,045 shares of Common Stock at a price of $4.28 per share. (2) John Moragne, a director of the Company, is a member of Trident Capital Management, LLC, the general partner of Information Associates, L.P. and Information Associates, C.V. Mr. Moragne disclaims beneficial ownership of the shares held by these entities, except to the extent of his interest in such shares arising from his interest in Trident Capital Management, LLC. In addition, the Company has granted to Mr. Moragne options to purchase 21,045 shares of Common Stock at a price of $4.28 per share. (3) Bernard McDonagh, a director of the Company, is the Vice President, Investor Relations and Business Research at United Healthcare Corporation, which is affiliated with HLM Partners VII, L.P. Mr. McDonagh disclaims beneficial ownership of the shares held by this entity. In addition, the Company has granted to Mr. McDonagh options to purchase 21,045 shares of Common Stock at a price of $4.28 per share. The Company has an employment agreement with Robert McNeill, its Executive Vice President and Chief Operating Officer. See "Management -- Employment Agreement." Complex Network Solutions, Inc. ("CNS"), a company founded in October 1992 by Georges Daou, Daniel Daou and Joseph Daou and of which Daniel Daou served as President, provided certain engineering services to the Company from October 1992 to December 1994. The Company paid an aggregate of approximately $1.6 million for these services in 1994, but does not intend to enter into any future business arrangements with CNS. The Company has from time to time granted options and other compensation to its directors and executive officers. See "Management -- Executive Compensation," "-- Director Compensation," "-- 1996 Stock Option Plan" and "Principal and Selling Stockholders." The Company loaned to Georges Daou, Daniel Daou and Joseph Daou certain amounts for personal use. As of December 31, 1996, the balances of these loans to Messrs. George Daou, Daniel Daou and Joseph Daou were $79,709, $77,374 and $70,797, respectively. These loans are unsecured, accrue interest at the rate of 6% per annum and are due and payable prior to the completion of this offering. 34 All future transaction, including any loans from the Company to its officers, directors, principal stockholders or affiliates, will be approved by a majority of the Board of Directors, including a majority of the disinterested members of the Board of Directors or, if required by law, a majority of disinterested stockholders, and will be on terms no less favorable to the Company than could be obtained from unaffiliated third parties. 35 PRINCIPAL AND SELLING STOCKHOLDERS The following table sets forth information known to the Company with respect to the beneficial ownership of its Common Stock as of December 31, 1996, and as adjusted to reflect the sale of Common Stock offered by the Company hereby and conversion of all outstanding shares of Preferred Stock into shares of Common Stock, for (i) each person who is known by the Company to own beneficially more than five percent of the Common Stock, (ii) each of the Company's directors, (iii) each of the Named Executive Officers and (iv) all directors and executive officers as a group. Unless otherwise indicated in the footnotes to the table set forth below, each person or entity named below has an address in care of the Company's principal executive offices.
SHARES BENEFICIALLY OWNED SHARES BENEFICIALLY BEFORE OWNED AFTER OFFERING OFFERING ------------------------- ------------------------- NAMES AND ADDRESSES(1) NUMBER PERCENT NUMBER PERCENT - ------------------------------------------------------------------ ----------- ------------ ----------- ------------ Georges J. Daou................................................... 1,957,361 23.7% 1,757,361 15.7% Chairman of the Board and Chief Executive Officer Daniel J. Daou.................................................... 1,952,361 23.6 1,752,361 15.7 President and Director Joseph H. Daou.................................................... 1,660,661 20.1 1,376,706 12.3 Former Treasurer and Former Director Entities Affiliated with Galen Associates (2)..................... 1,059,990 12.8 954,990 8.6 666 Third Avenue, Suite 1400 New York, New York 10017-4011 Entities Affiliated with Trident Capital (3)...................... 744,098 9.0 669,098 6.0 2480 Sand Hill Road, Suite 100 Menlo Park, California 94025 HLM Partners VII, L.P. (4)........................................ 217,611 2.6 196,566 1.8 222 Berkeley Street Boston, Massachusetts 02116 The Eparchy of Our Lady of Lebanon of Los Angeles, on behalf of St. John Maron Mission.......................................... 35,000 * 0 * 1546 E. La Palma Avenue Anaheim, California 92805 The Eparchy of Our Lady of Lebanon of Los Angeles, on behalf of St. Ephrem Maronite Mission..................................... 30,000 * 0 * 6310 Rancho Mission Road #157 San Diego, California 92108 All directors and executive officers as a group (10 persons) (5)................................................ 5,632,115 67.6% 4,948,160 44.1%
- -------------- * Less than 1%. (1) Except as otherwise indicated in the footnotes to this table and pursuant to applicable community property laws, the persons named in the table have sole voting and investment power with respect to all shares of Common Stock. Beneficial ownership is determined in accordance with the rules of the Securities and Exchange Commission and generally includes voting or investment power with respect to securities. Shares of Common Stock subject to options or warrants exercisable within 60 days of December 31, 1996 are deemed outstanding for computing the percentage of the person or entity holding such options but are not deemed outstanding for computing the percentage of any other person. 36 (2) Of the total shares indicated as beneficially owned, Galen Partners II, L.P. owned 758,292 shares (9.2% of total shares) before this offering and will own 682,760 shares (6.1% of total shares) after this offering. Galen Partners International, L.P. owned 290,129 shares (3.5% of total shares) before this offering and will own 261,116 shares (2.3% of total shares) after this offering. Galen Employee Fund, L.P. owned 4,554 shares (less than one percent of total shares) before this offering and will own 4,099 shares (less than one percent of total shares) after this offering. The general partner of Galen Partners II, L.P., a Delaware limited partnership, and Galen Partners International, L.P., a Delaware limited partnership, is GWW Partners, L.P., a Delaware limited partnership, the general partners of which are William R. Grant, L. John Wilkerson, Bruce F. Wesson and Rebound Two (Delaware), L.L.C., a Delaware limited liability company. Mr. Wesson is also the general partner of Galen Employee Fund, L.P., a Delaware limited partnership. The total share amounts for the "Entities Affiliated with Galen Associates" set forth in the above table include 7,015 shares issuable under stock options held by David Jahns which are exercisable within 60 days of December 31, 1996. Mr. Jahns is a Vice President of Galen Associates, the investment manager of these entities, and a limited partner of Galen Employee Fund, L.P. Mr. Jahns disclaims beneficial ownership of the shares held by these entities, except to the extent of his interest in the shares of Galen Employee Fund, L.P. arising from his interest in such entity. (3) Of the total shares indicated as beneficially owned, Information Associates, L.P. owned 690,507 shares (8.4% of total shares) before this offering and will own 617,543 shares (5.5% of total shares) after this offering. Information Associates, C.V. owned 46,576 shares (less than one percent of total shares) before this offering and will own 44,540 shares (less than one percent of total shares) after this offering. Information Associates, L.P. is a Delaware limited partnership and Information Associates, C.V. is a Netherlands Antilles limited partnership. The general partner of each of these entities is Trident Capital Management, L.L.C., a Delaware limited liability company ("Trident Capital"), the members of which include Donald R. Dixon, Stephen M. Hall, Robert C. McCormack, Rockwell A. Schnabel and John Moragne, a director of the Company. The total share amounts for the "Entities Affiliated with Trident Capital" set forth in the above table include 7,015 shares issuable under stock options held by Mr. Moragne which are exercisable within 60 days of December 31, 1996. Mr. Moragne disclaims beneficial ownership of the shares held by these entities, except to the extent of his interest in such shares arising from his interest in Trident Capital. (4) Includes 7,015 shares issuable under stock options granted to Bernard McDonagh which are exercisable within 60 days of December 31, 1996. HLM Partners VII, L.P. is a Delaware limited partnership, the general partners of which are Peter Grua, James Mahoney, Frances Hawk, Judith Lawrie and A.R. Haberkorn, III. (5) Includes 61,732 shares issuable under stock options held by directors and executive officers exercisable within 60 days of December 31, 1996. 37 DESCRIPTION OF CAPITAL STOCK The authorized capital stock of the Company will consist of 50,000,000 shares of Common Stock, par value $0.001 per share, and 5,000,000 shares of Preferred Stock, par value $0.001 per share, after giving effect to the Company's reincorporation in Delaware and the completion of this offering. The following summaries of certain provisions of the Common Stock and Preferred Stock do not purport to be complete and are subject to, and qualified in their entirety by, the provisions of the Company's Restated Certificate of Incorporation, which is included as an exhibit to the Registration Statement of which this Prospectus forms a part, and by applicable law. COMMON STOCK As of December 31, 1996, after giving effect to the conversion of all shares of Preferred Stock into shares of Common Stock, there were 8,267,678 shares of Common Stock outstanding, which were held of record by 19 stockholders. The holders of Common Stock are entitled to one vote per share on all matters submitted to a vote of the stockholders. Subject to preferences that may be applicable to outstanding shares of Preferred Stock, if any, holders of Common Stock are entitled to receive ratably such dividends, if any, as may be declared from time to time by the Board of Directors out of funds legally available therefor. See "Dividend Policy." In the event of a liquidation, dissolution or winding up of the Company, holders of Common Stock are entitled to share ratably in all assets remaining after payment of the Company's liabilities and the liquidation preference, if any, of any outstanding shares of Preferred Stock. Holders of Common Stock have no preemptive rights and no rights to convert their shares of Common Stock into any other securities, and there are no redemption or sinking fund provisions with respect to such shares. All of the outstanding shares of Common Stock are fully paid and non-assessable, and the shares of Common Stock to be outstanding upon the completion of this offering will be fully paid and non-assessable. The rights, preferences and privileges of holders of Common Stock are subject to, and may be adversely affected by, the rights of the holders of shares of any series of Preferred Stock which the Company may designate and issue in the future. PREFERRED STOCK The Board of Directors has the authority, without action by the stockholders, to designate and issue Preferred Stock in one or more series and to designate the rights, preferences and privileges of each series, any or all of which may be greater than the rights of the Common Stock. It is not possible to state the actual effect of the issuance of any shares of Preferred Stock upon the rights of holders of the Common Stock until the Board of Directors determines the specific rights of the holders of such Preferred Stock. However, the effects might include, among other things, restricting dividends on the Common Stock, diluting the voting power of the Common Stock, impairing the liquidation rights of the Common Stock and delaying or preventing a change in control of the Company without further action by the stockholders. The Company has no present plans to issue any shares of Preferred Stock. WARRANTS Upon the completion of this offering and the conversion of all of the issued and outstanding shares of the Company's Preferred Stock into Common Stock, the Company will have two warrants outstanding, exercisable into a total of 133,285 shares of Common Stock at an exercise price of $4.99 per share. The warrants expire on October 26, 2000. REGISTRATION RIGHTS The holders of approximately 2,220,800 shares of Common Stock and warrants to purchase 133,285 shares of Common Stock (collectively the "Registrable Securities"), or their transferees, are entitled to certain rights with respect to the registration of such shares under the Securities Act. These rights are provided under the terms of the Investors' Rights Agreement between the Company and such holders. Subject to certain limitations in such agreement, the holders of a majority of the Registrable Securities 38 have the right to require on one occasion that the Company register their shares for public resale. In addition, if the Company registers any of its Common Stock either for its own account or for the account of any other stockholders, the holders of Registrable Securities are entitled to include their shares of Common Stock in up to two registrations. A holder's right to include shares in an underwritten registration is subject to the good faith determination by the Company that the inclusion of such shares is compatible with the success of the offering. All expenses incurred in connection with any registration effected pursuant to the Investors' Rights Agreement (other than the underwriting discounts and commissions) will be borne by the Company. The foregoing registration rights terminate seven years following the consummation of this offering. CERTAIN CHANGE OF CONTROL PROVISIONS As a Delaware corporation, the Company is subject to Section 203 of the Delaware General Corporation Law, an anti-takeover law. In general, Section 203 prohibits a publicly-held Delaware corporation from engaging in a "business combination" with an "interested stockholder" for a period of three years following the date that the person became an interested stockholder, unless (with certain exceptions) the "business combination" or the transaction in which the person became an interested stockholder is approved in a prescribed manner. Generally, a "business combination" incudes a merger, asset or stock sale, or other transaction resulting in a financial benefit to the interested stockholder. Generally, an "interested stockholder" is a person who, together with affiliates and associates, owns (or within three years prior to the determination of interested stockholder status, did own) 15% or more of a corporation's voting stock. The existence of this provision would be expected to have anti-takeover effects with respect to transactions not approved in advance by the Board of Directors, such as discouraging takeover attempts that might result in a premium over the market price of the Common Stock. The Company's Certificate of Incorporation provides that the Board of Directors will be divided into three classes of directors, with each class serving a staggered three-year term. The classification system of electing directors may tend to discourage a third party from making a tender offer or otherwise attempting to obtain control of the Company and may maintain the incumbency of the Board of Directors, as a classified board of directors generally increases the difficulty of replacing a majority of the directors. The Certificate of Incorporation and Bylaws do not provide for cumulative voting in the election of directors and allow for the removal of directors only for cause and with a two-thirds vote of the Company's outstanding shares. In addition, the Company's Certificate of Incorporation and Bylaws eliminate the right of stockholders to act by written consent without a meeting and require advanced stockholder notice to nominate directors and raise matters at the annual stockholders meeting. Furthermore, the authorization of undesignated Preferred Stock makes it possible for the Board of Directors to issue Preferred Stock with voting or other rights or preferences that could impede the success of any attempt to change control of the Company. These and other provisions may have the effect of deferring hostile takeovers or delaying changes in control or management of the Company. The amendment of any of these provisions would require approval by holders of at least two-thirds of the outstanding shares of Common Stock. TRANSFER AGENT AND REGISTRAR The transfer agent and registrar for the Company's Common Stock is Continental Stock Transfer & Trust Company. Its telephone number is (212) 509-4000. 39 SHARES ELIGIBLE FOR FUTURE SALE Prior to this offering, there has been no market for the Common Stock of the Company. Future sales of substantial amounts of Common Stock in the public market could adversely affect market prices prevailing from time to time and the ability of the Company to raise equity capital in the future. Upon the completion of this offering, the Company will have 11,167,678 shares of Common Stock outstanding, assuming no exercise of the Underwriters' over-allotment, option and no exercise of outstanding warrants or outstanding options granted under the 1996 Stock Option Plan after December 31, 1996. Of these shares, the 3,850,000 shares of Common Stock sold in this offering will be freely tradeable without restriction under the Securities Act, unless held by "affiliates" of the Company, as that term is defined in Rule 144 under the Securities Act. The remaining 7,317,678 shares of Common Stock held by existing stockholders will be "restricted securities" as that term is defined in Rule 144 of the Securities Act (the "Restricted Shares"). The Restricted Shares may be sold in the public market only if registered under the Securities Act or if they qualify for an exemption from registration under Rule 144 or Rule 701 promulgated under the Securities Act. Sales of the Restricted Shares in the public market, or the availability of such shares for sale, could adversely affect the market price of the Common Stock. The holders of all of the Restricted Shares have entered into lock-up agreements, under which they have agreed not to offer, sell, contract to sell, grant any option to purchase or otherwise dispose of, or agree to dispose of, directly or indirectly, any shares of Common Stock, options or warrants to acquire shares of Common Stock or securities exchangeable for or convertible into Common Stock owned by them for a period of 180 days after the date of this Prospectus, without the prior written consent of Alex. Brown & Sons Incorporated. The Company has entered into a similar agreement, except that it may issue, and grant options to purchase, shares of Common Stock under the 1996 Stock Option Plan and pursuant to currently outstanding warrants. As of December 31, 1996, an aggregate of 941,413 shares were subject to outstanding options under the 1996 Stock Option Plan and 133,285 shares were subject to outstanding warrants. All of these shares are subject to the lock-up agreements described above. After the date of this Prospectus, the Company intends to file a registration statement on Form S-8 covering shares issuable under the 1996 Stock Option Plan (including shares subject to then outstanding options), thus permitting the resale of such shares in the public market without restriction under the Securities Act after expiration of the lock-up agreements. Based on the number of shares reserved for issuance and previously exercised, approximately 1,367,925 shares will be registered. Accordingly, shares registered under such registration statement will, subject to Rule 144 volume limitations applicable to affiliates, be available for sale in the public market, unless such shares are subject to vesting restrictions with the Company or the lock-up agreements described above. Upon expiration of the lock-up agreements, 5,019,619 shares of Common Stock (including approximately 133,191 shares subject to outstanding vested options) will become eligible for immediate public resale, subject in some cases to volume limitations pursuant to Rule 144. The remaining approximately 2,431,250 shares held by existing stockholders will become eligible for public resale at various times over a period of less than two years following the completion of this offering, subject in some cases to vesting provisions and volume limitations. Approximately 2,220,800 of the shares outstanding immediately following the completion of this offering will be entitled to registration rights with respect to such shares upon the release of lock-up agreements. The number of shares sold in the public market could increase if such rights are exercised. In general, under Rule 144 as currently in effect, a person (or persons whose shares are aggregated) who has beneficially owned shares for at least two years (including the holding period of any prior owner, except an affiliate) is entitled to sell in "broker's transactions" or to market makers, within any three-month period commencing 90 days after the date of this Prospectus, a number of shares that does not exceed the greater of (i) one percent of the number of shares of Common Stock then outstanding (approximately 111,677 shares immediately after this offering) or (ii) the average weekly trading volume of the Common Stock during the four calendar weeks preceding the required filing of a Form 144 with respect to such sale. Sales under Rule 144 are generally subject to certain manner of sale provisions and 40 notice requirements and to the availability of current public information about the Company. Under Rule 144(k), a person who is not deemed to have been an affiliate of the Company at any time during the 90 days preceding a sale, and who has beneficially owned the shares proposed to be sold for at least three years, is entitled to sell such shares without having to comply with the manner of sale, public information, volume limitation or notice provisions of Rule 144. Under Rule 701 under the Securities Act, persons who purchase shares upon exercise of options granted prior to the effective date of this offering are entitled to sell such shares 90 days after the effective date of this offering in reliance on Rule 144, without having to comply with the holding period requirements of Rule 144 and, in the case of nonaffiliates, without having to comply with the public information, volume limitation or notice provisions of Rule 144. The Securities and Exchange Commission (the "Commission") has recently proposed reducing the initial Rule 144 holding period to one year and the Rule 144(k) holding period to two years. There can be no assurance as to when or whether such rule changes will be enacted. If enacted, such modification will have a material effect on the time when shares of the Company's Common Stock become eligible for resale. 41 UNDERWRITING Subject to the terms and conditions of the Underwriting Agreement, the Underwriters named below (the "Underwriters"), through their Representatives, Alex. Brown & Sons Incorporated, Cowen & Company and Hambrecht & Quist LLC, have severally agreed to purchase from the Company the following respective numbers of shares of Common Stock at the initial public offering price less the underwriting discounts and commissions set forth on the cover page of this Prospectus:
NUMBER OF UNDERWRITER SHARES - ----------------------------------------------------------------------------------------------------- ----------- Alex. Brown & Sons Incorporated...................................................................... Cowen & Company...................................................................................... Hambrecht & Quist LLC................................................................................ ----------- Total.......................................................................................... 3,850,000 ----------- -----------
The Underwriting Agreement provides that the obligations of the Underwriters are subject to certain conditions precedent and that the Underwriters will purchase all shares of the Common Stock offered hereby if any of such shares are purchased. The Company has been advised by the Representatives of the Underwriters that the Underwriters propose to offer the shares of Common Stock to the public at the initial public offering price set forth on the cover page of this Prospectus and to certain dealers at such price less a concession not in excess of $ . The Underwriters may allow, and such dealers may reallow, a concession not in excess of $ per share to certain other dealers. After the initial public offering, the offering price and other selling terms may be changed by the Representatives of the Underwriters. The Company has granted to the Underwriters an option, exercisable not later than 30 days after the date of this Prospectus, to purchase up to 577,500 additional shares of Common Stock at the initial public offering price less the underwriting discounts and commissions set forth on the cover page of this Prospectus. To the extent that the Underwriters exercise such option, each of the Underwriters will have a firm commitment to purchase approximately the same percentage thereof that the number of shares of Common Stock to be purchased by it shown in the above table bears to 3,850,000, and the Company will be obligated, pursuant to the option, to sell such shares to the Underwriters. The Underwriters may exercise such option only to cover over-allotments made in connection with the sale of Common Stock offered hereby. If purchased, the Underwriters will offer such additional shares on the same terms as those on which the 3,850,000 shares are being offered. The Company has agreed to indemnify the Underwriters against certain liabilities, including liabilities under the Securities Act of 1933, as amended. Stockholders of the Company, holding in the aggregate 7,317,678 shares of Common Stock, have agreed not to offer, sell or otherwise dispose of any of such shares of Common Stock for a period of 180 days after the date of this Prospectus without the prior written consent of Alex. Brown & Sons Incorporated. The Company has entered into a similar agreement, except that it may issue, and grant options to purchase, shares of Common Stock under the 1996 Stock Option Plan and pursuant to currently outstanding warrants. See "Shares Eligible for Future Sale." The Representatives of the Underwriters have advised the Company that the Underwriters do not intend to confirm sales to any account over which they exercise discretionary authority. 42 Prior to this offering, there has been no public market for the Common Stock of the Company. Consequently, the initial public offering price for the Common Stock will be determined by negotiation among the Company, the Selling Stockholders and the Representatives of the Underwriters. Among the factors to be considered in such negotiations will be prevailing market conditions, the results of operations of the Company in recent periods, the market capitalizations and stages of development of other companies which the Company, the Selling Stockholders and the Representatives of the Underwriters believe to be comparable to the Company, estimates of the business potential of the Company, the present stage of the Company's development and other factors deemed relevant. LEGAL MATTERS Certain legal matters with respect to the legality of the issuance of the shares of Common Stock offered hereby will be passed upon for the Company by Baker & McKenzie, San Diego, California. Certain legal matters related to this offering will be passed upon for the Underwriters by Cooley Godward LLP, San Diego, California. EXPERTS The Financial Statements of the Company at December 31, 1995 and 1996 and for each of the three years in the period ended December 31, 1996 appearing in this Prospectus and Registration Statement have been audited by Ernst & Young LLP, independent auditors, as set forth in their report thereon appearing elsewhere herein and in the Registration Statement, and are included in reliance upon such report given upon the authority of such firm as experts in accounting and auditing. ADDITIONAL INFORMATION The Company is not currently subject to the information requirements of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). As a result of this offering, the Company will be required to file reports and other information with the Commission pursuant to the informational requirements of the Exchange Act. The Company has filed with the Commission a Registration Statement on Form SB-2 under the Securities Act, with respect to the Common Stock offered hereby. As permitted by the rules and regulations of the Commission, this Prospectus, which is part of the Registration Statement, omits certain information, exhibits, schedules and undertakings set forth in the Registration Statement. For further information pertaining to the Company and the Common Stock, reference is made to such Registration Statement and the exhibits and schedules thereto. Statements contained in this Prospectus as to the contents or provisions of any documents referred to herein are not necessarily complete, and in each instance, reference is made to the copy of the document filed as an exhibit to the Registration Statement. The Registration Statement may be inspected without charge at the office of the Commission at 450 Fifth Street, N.W., Washington, D.C. 20549. Copies of the Registration Statement may be obtained from the Commission at prescribed rates from the Public Reference Section of the Commission at such address, and at the Commission's regional offices located at 7 World Trade Center, 13th Floor, New York, New York 10048, and at Northwestern Atrium Center, 500 West Madison Street, Suite 1400, Chicago, Illinois 60661. In addition, registration statements and certain other filings made with the Commission through its Electronic Data Gathering, Analysis and Retrieval ("EDGAR") system are publicly available through the Commission's site on the Internet's World Wide Web, located at http://www.sec.gov. The Registration Statement, including all exhibits thereto and amendments thereof, has been filed with the Commission through EDGAR. The Company intends to furnish to its stockholders annual reports containing audited financial statements examined by independent auditors and quarterly reports containing interim unaudited financial information for the first three quarters of each fiscal year. 43 DAOU SYSTEMS, INC. INDEX TO FINANCIAL STATEMENTS Report of Ernst & Young LLP, Independent Auditors......................... F-2 Balance Sheets at December 31, 1995 and 1996.............................. F-3 Statements of Operations for the years ended December 31, 1994, 1995 and 1996.................................................................... F-4 Statements of Stockholders' Equity for the years ended December 31, 1994, 1995 and 1996........................................................... F-5 Statements of Cash Flows for the years ended December 31, 1994, 1995 and 1996.................................................................... F-6 Notes to Financial Statements............................................. F-7
F-1 REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS The Board of Directors and Stockholders DAOU Systems, Inc. We have audited the accompanying balance sheets of DAOU Systems, Inc. as of December 31, 1995 and 1996 and the related statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1996. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of DAOU Systems, Inc. at December 31, 1995 and 1996 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1996 in conformity with generally accepted accounting principles. ERNST & YOUNG LLP San Diego, California January 14, 1997 F-2 DAOU SYSTEMS, INC. BALANCE SHEETS (IN THOUSANDS) ASSETS
DECEMBER 31, -------------------- 1995 1996 --------- --------- PRO FORMA STOCKHOLDERS' EQUITY AT DECEMBER 31, 1996 -------------- (UNAUDITED) Current assets: Cash and cash equivalents..................................................... $ 2,599 $ 2,284 $ -- Short-term investments........................................................ 3,686 -- Accounts receivable........................................................... 5,038 4,085 Contract work in progress..................................................... 394 3,600 Deferred income taxes......................................................... 209 176 Other current assets.......................................................... 102 572 --------- --------- Total current assets........................................................ 12,028 10,717 Due from officers/stockholders.................................................. 211 228 Equipment, furniture and fixtures, net.......................................... 280 827 Deferred income taxes........................................................... 10 23 Other assets.................................................................... 16 115 --------- --------- $ 12,545 $ 11,910 --------- --------- --------- --------- LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Trade accounts payable........................................................ $ 607 $ 530 Accrued salaries and wages.................................................... 327 583 Deferred revenue.............................................................. 441 844 Other accrued liabilities..................................................... 1,306 745 Income taxes payable.......................................................... 975 99 --------- --------- Total current liabilities................................................... 3,656 2,801 Deferred rent................................................................... 2 62 Commitments and contingencies................................................... Redeemable preferred stock...................................................... 7,705 8,190 Stockholders' equity: Preferred stock, $.001 par value: Authorized shares -- 5,000 Issued and outstanding shares -- none....................................... -- -- -- Common stock, $.001 par value: Authorized shares -- 50,000 Issued and outstanding shares -- 6,664 at December 31, 1995 and 1996 (8,268 shares pro forma)......................................................... 7 7 8 Additional paid-in capital.................................................... 3 1,246 8,863 Deferred compensation......................................................... -- (1,166) (1,166) Accretion of redeemable preferred stock....................................... (87) (572) -- Retained earnings............................................................. 1,259 1,342 1,342 --------- --------- ------- Total stockholders' equity.................................................. 1,182 857 $ 9,047 --------- --------- ------- ------- $ 12,545 $ 11,910 --------- --------- --------- ---------
See accompanying notes. F-3 DAOU SYSTEMS, INC. STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT FOR PER SHARE DATA)
YEARS ENDED DECEMBER 31, ------------------------------- 1994 1995 1996 --------- --------- --------- Revenues....................................................................... $ 8,521 $ 14,330 $ 19,311 Cost of revenues............................................................... 6,185 8,475 13,556 --------- --------- --------- Gross profit................................................................... 2,336 5,855 5,755 Operating expenses: Sales and marketing.......................................................... 796 938 1,853 General and administrative................................................... 1,507 2,893 3,897 --------- --------- --------- 2,303 3,831 5,750 --------- --------- --------- Income from operations......................................................... 33 2,024 5 Interest income (expense), net................................................. 12 67 197 --------- --------- --------- Income before income taxes..................................................... 45 2,091 202 Provision (benefit) for income taxes........................................... 19 851 119 --------- --------- --------- Net income..................................................................... 26 1,240 83 Accretion of redeemable preferred stock........................................ -- 87 485 --------- --------- --------- Net income (loss) attributable to common stock................................. $ 26 $ 1,153 $ (402) --------- --------- --------- --------- --------- --------- Pro forma net income per share................................................. $ 0.01 --------- --------- Shares used in computing pro forma net income per common share................. 8,888 --------- ---------
See accompanying notes. F-4 DAOU SYSTEMS, INC. STATEMENTS OF STOCKHOLDERS' EQUITY (IN THOUSANDS)
ACCRETION OF COMMON STOCK ADDITIONAL REDEEMABLE RETAINED -------------- PAID-IN DEFERRED PREFERRED EARNINGS SHARES AMOUNT CAPITAL COMPENSATION STOCK (DEFICIT) TOTAL ------ ------ ---------- ------------ ------------ ------- ------- Balance at December 31, 1993........................ 6,664 $ 7 $ 3 $ -- $ -- $ (7 ) $ 3 Net income.................. -- -- -- 26 26 ------ ------ ---------- ------------ ------ ------- ------- Balance at December 31, 1994........................ 6,664 7 3 -- -- 19 29 Accretion of redeemable preferred stock........... -- -- -- -- (87 ) -- (87) Net income.................. -- -- -- -- -- 1,240 1,240 ------ ------ ---------- ------------ ------ ------- ------- Balance at December 31, 1995........................ 6,664 7 3 -- (87 ) 1,259 1,182 Deferred compensation....... -- -- 1,243 (1,243 ) -- -- -- Amortization of deferred compensation.............. -- -- -- 77 -- -- 77 Accretion of redeemable preferred stock........... -- -- -- -- (485 ) -- (485) Net income.................. -- -- -- -- -- 83 83 ------ ------ ---------- ------------ ------ ------- ------- Balance at December 31, 1996........................ 6,664 $ 7 $ 1,246 $ (1,166 ) $ (572 ) $1,342 $ 857 ------ ------ ---------- ------------ ------ ------- ------- ------ ------ ---------- ------------ ------ ------- -------
See accompanying notes. F-5 DAOU SYSTEMS, INC. STATEMENTS OF CASH FLOWS (IN THOUSANDS)
YEARS ENDED DECEMBER 31, ------------------------------- 1994 1995 1996 --------- --------- --------- OPERATING ACTIVITIES Net income........................................................................ $ 26 $ 1,240 $ 83 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation and amortization................................................... 101 252 280 Provision for uncollectible accounts............................................ -- -- 100 Deferred income taxes........................................................... (24) (192) 20 Changes in operating assets and liabilities: Accounts receivable........................................................... (285) (4,642) 853 Contract work in progress..................................................... 213 179 (3,206) Other assets.................................................................. (25) (81) (569) Trade accounts payable........................................................ 331 96 (77) Accrued salaries and wages.................................................... -- 167 256 Deferred revenue.............................................................. (399) (415) 403 Other accrued liabilities..................................................... 296 1,208 (561) Income taxes payable.......................................................... -- 932 (876) Deferred rent................................................................. 1 (29) 60 --------- --------- --------- Net cash provided by (used in) operating activities............................... 235 (1,285) (3,234) INVESTING ACTIVITIES Purchases of equipment, furniture and fixtures.................................... (309) (215) (750) Purchase of short-term investments................................................ -- (3,686) -- Maturities of short-term investments.............................................. -- -- 3,686 Advances to officers/stockholders................................................. (149) (306) (17) Proceeds from repayment of due from officers...................................... 213 209 -- --------- --------- --------- Net cash (used in) provided by investing activities............................... (245) (3,998) 2,919 FINANCING ACTIVITIES Repayment of long-term debt....................................................... (4) -- -- Proceeds from issuance of redeemable preferred stock.............................. -- 7,618 -- --------- --------- --------- Net cash (used in) provided by financial activities............................... (4) 7,618 -- --------- --------- --------- (Decrease) increase in cash and cash equivalents.................................. (14) 2,335 (315) Cash and cash equivalents at beginning of period.................................. 278 264 2,599 --------- --------- --------- Cash and cash equivalents at end of period........................................ $ 264 $ 2,599 $ 2,284 --------- --------- --------- --------- --------- --------- SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Income taxes paid................................................................. $ -- $ 111 $ 975 --------- --------- --------- --------- --------- ---------
See accompanying notes. F-6 DAOU SYSTEMS, INC. NOTES TO FINANCIAL STATEMENTS 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION DAOU Systems, Inc. (the "Company") designs, implements, supports and manages advanced computer network systems for hospitals, integrated healthcare delivery systems and other healthcare provider organizations. The Company's design services include an assessment of the customer's existing computer network system and the preparation of voice, video and data network specifications, technical design documentation and diagrams. DAOU's implementation services include the purchase, delivery and installation of enterprise-wide computer network systems. The Company's support and management services are typically provided under multi-year contracts and include remote and on-site network management services, as well as information systems outsourcing. DAOU typically provides its services on a fixed-price, fixed-time frame basis. On November 12, 1996 the Company's Board of Directors approved the reincorporation of the Company in Delaware which was accomplished through a merger of the existing California corporation into a new Delaware corporation. The ratio of exchange was 1.403 to one. The number of authorized shares of the new Delaware corporation are 50,000,000 shares of common stock and 5,000,000 shares of preferred stock. All share and per share amounts and stock option data have been restated to retroactively give effect to the reincorporation. REVENUE RECOGNITION Contract revenue for the development and implementation of network solutions is recognized on the percentage-of-completion method with progress to completion measured by labor costs incurred to date compared to total estimated labor costs. Provisions for estimated losses on contracts, if any, are made during the period when the loss becomes probable and can be reasonably estimated. Revenues recognized in excess of amounts billed and project costs are classified as contract work in progress. Revenue from technical support and network management services is recognized over the period the services are performed. Payments received in advance of services performed are recorded as deferred revenue. CONCENTRATION OF CREDIT RISK Substantially all of the Company's accounts receivable are from hospitals and other healthcare providers. Generally, the Company obtains a significant deposit from its customers upon signing a contract and collateral is not required. The Company provides for losses from uncollectible accounts and such losses have historically not exceeded management's expectations. CASH, CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS Cash and cash equivalents consist of cash and highly liquid investments with maturities of three months or less when purchased. Short-term investments are recorded at amortized cost plus accrued interest which approximates market value. The Company generally invests its excess cash in U.S. government securities. The Company has established guidelines relative to diversification and maturities that are periodically reviewed and modified to take advantage of trends in yields and interest rates. The Company historically has not experienced any losses on its cash equivalents or short-term investments. The Company applies Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" to value its investments. Under the statement, the Company F-7 DAOU SYSTEMS, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) classifies its short-term investments as "Available-for-Sale" and records such assets at estimated fair value in the balance sheet. As of December 31, 1995 and 1996, the cost of cash equivalents and short-term investments was equal to estimated fair value. EQUIPMENT, FURNITURE AND FIXTURES Equipment, furniture and fixtures are carried at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, generally three years. Leasehold improvements are amortized over the estimated useful lives of the assets or the remaining lease term, whichever is less. USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions about the future that affect the amounts reported in the financial statements and disclosures made in the accompanying notes of the financial statements. The actual results could differ from those estimates. IMPAIRMENT OF LONG-LIVED ASSETS Effective January 1, 1996, DAOU Systems, Inc. adopted Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of" ("SFAS 121"). SFAS 121 establishes accounting standards for recording the impairment of long-lived assets, certain identifiable intangibles and goodwill. The adoption of SFAS 121 did not have a material impact on DAOU's financial position or the results of its operations. NET INCOME PER SHARE Historical net income per share is computed using the weighted average number of common shares and common stock equivalents outstanding during the periods presented. Common equivalent shares result from stock options, warrants to purchase redeemable preferred stock and redeemable preferred stock. For loss periods, common equivalent shares are excluded from the computation as their effect would be antidilutive, except that the Securities and Exchange Commission requires common and common share equivalents issued during the twelve-month period prior to the initial filing of a proposed public offering, to be included in the calculation as if they were outstanding for all periods presented (using the treasury stock method and the assumed initial public offering price). Historical net income per share information is as follows:
YEARS ENDED DECEMBER 31, ------------------------------- 1994 1995 1996 --------- --------- --------- Net income per share............................................................... $ -- $ 0.16 $ 0.01 --------- --------- --------- --------- --------- --------- Shares used in computing net income per share (in thousands)....................... 7,231 7,519 8,487 --------- --------- --------- --------- --------- ---------
PRO FORMA NET INCOME PER SHARE AND UNAUDITED PRO FORMA STOCKHOLDERS' EQUITY Pro forma net income per share has been computed as described above and also gives effect to the conversion of the redeemable preferred stock, which will automatically convert to common stock upon completion of the Company's initial public offering, using the as if-converted method from the original date of issuance which was October 26, 1995. F-8 DAOU SYSTEMS, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) If the offering contemplated by this Prospectus is consummated, all of the convertible preferred stock outstanding as of the closing date will automatically be converted into 1,603,430 shares of common stock. Unaudited pro forma stockholders' equity at December 31, 1996, as adjusted for the conversion of redeemable preferred stock, is disclosed in the accompanying balance sheet. STOCK OPTIONS In October 1995, the Financial Accounting Standards Board issued SFAS No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION, which is effective for the year ending December 31, 1996. SFAS No. 123 allows companies to either account for stock-based compensation under the new provisions of SFAS No. 123 or under the provisions of Accounting Principles Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES("APB 25"), but requires pro forma disclosure in the footnotes to the financial statements as if the measurement provisions of SFAS No. 123 had been adopted. The Company has continued accounting for its stock-based compensation in accordance with the provisions of APB 25. 2. SELECTED BALANCE SHEET DETAILS Equipment, furniture and fixtures consist of the following (in thousands):
DECEMBER 31, -------------------- 1995 1996 --------- --------- Equipment and furniture........................................................................ $ 691 $ 1,340 Leasehold improvements......................................................................... 6 91 --------- --------- 697 1,431 Less accumulated depreciation and amortization................................................. (417) (604) --------- --------- $ 280 $ 827 --------- --------- --------- ---------
Other accrued liabilities consist of the following (in thousands):
DECEMBER 31, -------------------- 1995 1996 --------- --------- Accrued job related costs.................................................................... $ 932 $ 626 Other accrued liabilities.................................................................... 374 119 --------- --------- $ 1,306 $ 745 --------- --------- --------- ---------
3. LINE OF CREDIT In October 1996, the Company entered into a $1.5 million line of credit. The line bears interest at a rate equal to the Bank's reference rate plus 0.5% (8.75% at December 31, 1996) and expires October 1, 1997. At December 31, 1996, no amounts were outstanding under the line of credit. 4. LEASE COMMITMENTS The Company leases its facilities and certain equipment under operating lease agreements. The facility leases provide for abatement of rent during certain periods and escalating rent payments during the lease term. Rent expense for 1994, 1995 and 1996 totaled $105,000, $106,000 and $347,000, respectively. F-9 DAOU SYSTEMS, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) 4. LEASE COMMITMENTS (CONTINUED) Future minimum lease payments under noncancellable operating leases with initial terms of one year or more consist of the following (in thousands):
YEARS ENDING DECEMBER 31, - ----------------------------------------------------------- 1997....................................................... $ 512 1998....................................................... 283 1999....................................................... 12 2000....................................................... 12 2001....................................................... 7 ------------- $ 826 ------------- -------------
In October 1995, the Company's Board of Directors approved a relocation to a larger facility. In connection with the relocation, the Company recorded a provision for relocation costs and expenses of $205,000 which included an accrual for future rent commitments on the Company's former facility, losses on non-recoverable leaseholds and other assets and other costs directly associated with the relocation. This charge is included in general and administrative expenses in the 1995 statement of operations. During 1996, the Company's former facility was subleased to a related party. Aggregate future minimum rentals to be received under the sublease are $126,000. 5. MAJOR CUSTOMERS Sales to individual customers exceeding 10% or more of revenues in the years ended December 31 were as follows: during 1994, one customer accounted for 30% of revenues; during 1995, two customers accounted for 48% and 11% of revenues, respectively; and during 1996, three customers accounted for 21%, 18% and 15% of revenues, respectively. 6. REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY REDEEMABLE PREFERRED STOCK During 1995, 1,603,430 shares of redeemable preferred stock were issued at $4.99 per share for proceeds of $7,618,000 net of issuance costs. Holders of the redeemable preferred stock are entitled to receive cumulative dividends at the rate of $0.03 per share per annum, when and if declared by the Board of Directors and prior to any dividends on the common shares. The redeemable preferred stock has a liquidation preference of $4.99 per share plus any declared but unpaid dividends and is convertible at the option of the holder into one share of common stock, subject to certain antidilution adjustments. The shares of preferred stock are automatically convertible in the event of an initial public offering of the Company's common stock. The holder of each share of preferred stock is entitled to one vote for each share into which it would convert. On or after August 31, 2000, the redeemable preferred stock is redeemable subject to a written request from the holders of a majority of the then outstanding shares. The price of the redemption is equal to the original issue price plus 6% of the original issue price compounded annually, less any dividends paid. The increase in the redemption value of the redeemable preferred stock was $87,000 in 1995 and $485,000 in 1996. F-10 DAOU SYSTEMS, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) 6. REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY (CONTINUED) STOCK OPTION PLANS During 1996, the Company adopted the 1996 Stock Option Plan (the "Plan"), under which 947,025 shares of the Company's common stock were initially reserved for issuance upon exercise of options granted by the Company. During November 1996, the Board of Directors increased the number of shares reserved for issuance under the plan to 1,367,925. The Plan provides for the grant of both incentive and nonstatutory stock options to officers, directors, employees and consultants of the Company. Options granted by the Company generally vest over a three to five-year period and are exercisable for a period of ten years from the date of the grant. The Company recorded $1,243,000 of deferred compensation for options granted during the year ended December 31, 1996, representing the difference between the option exercise price and the deemed fair market value for financial statement presentation purposes. The Company is amortizing the deferred compensation ratably over the vesting period of the options. A summary of stock option transactions is as follows:
WEIGHTED AVERAGE EXERCISE OPTION PRICE PRICE PER SHARES PER SHARE SHARE --------- --------------- ----------- Outstanding at January 1, 1996.......................................... -- $ -- -- Granted............................................................... 962,458 4.28 - 10.69 $ 5.16 Exercised............................................................. -- -- -- Canceled.............................................................. (21,045) 4.28 4.28 --------- --------------- ----- Outstanding at December 31, 1996........................................ 941,413 4.28 - 10.69 $ 5.16 --------- --------------- ----- --------- --------------- -----
At December 31, 1996, no options to purchase common shares were exercisable and 426,512 options to purchase common shares were available for future grant. Adjusted pro forma information regarding net income is required by SFAS 123, and has been determined as if the Company had accounted for its employee stock options under the fair value method of that Statement. The fair value for these options was estimated at the date of grant using the "minimal value" method for option pricing with the following weighted-average assumptions: risk-free interest rate of 6%; dividend yield of 0%; and a weighted-average expected life of the option of seven years. For purposes of adjusted pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. The Company's adjusted pro forma information is as follows (in thousands, except for per share information):
YEAR ENDED DECEMBER 31, 1996 --------------------- Adjusted pro forma net income (loss)......................................................... $ (40) Adjusted pro forma net income (loss) per share............................................... $ --
The weighted-average fair value of options granted during 1996 was $2.81. F-11 DAOU SYSTEMS, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) 6. REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY (CONTINUED) WARRANTS In connection with the issuance of the redeemable preferred stock, the Company issued two warrants to purchase an aggregate of 133,285 shares of redeemable preferred stock at an exercise price of $4.99 per share. The warrants are exercisable immediately and expire on October 26, 2000. COMMON STOCK RESERVED At December 31, 1996, a total of 3,104,640 shares of the Company's common stock have been reserved for the conversion of redeemable preferred stock and the exercise of stock options and warrants. 7. INCOME TAXES The provision for income taxes consists of the following (in thousands):
YEARS ENDED DECEMBER 31, ------------------------------- 1994 1995 1996 --------- --------- --------- Current: Federal............................................................................ $ 36 $ 816 $ 62 State.............................................................................. 7 227 37 --------- --------- --------- 43 1,043 99 Deferred: Federal............................................................................ (21) (166) 32 State.............................................................................. (3) (26) (12) --------- --------- --------- (24) (192) 20 --------- --------- --------- $ 19 $ 851 $ 119 --------- --------- --------- --------- --------- ---------
Deferred income taxes are provided for temporary differences in recognizing certain income and expense items for financial and tax reporting purposes. Significant components of the Company's deferred tax assets and liabilities consist of the following (in thousands):
DECEMBER 31, -------------------- 1995 1996 --------- --------- Deferred tax assets (liabilities): Reserves and allowances......................................................................... $ 209 $ 201 Tax depreciation differences.................................................................... 10 (2) --------- --------- Net deferred tax assets........................................................................... $ 219 $ 199 --------- --------- --------- ---------
F-12 DAOU SYSTEMS, INC. NOTES TO FINANCIAL STATEMENTS (CONTINUED) 7. INCOME TAXES (CONTINUED) The reconciliation of income tax computed at the federal statutory rate to the total provision for income taxes is as follows:
YEARS ENDED DECEMBER 31, ---------------------------------- 1994 1995 1996 ---------- ---------- ---------- Tax at federal statutory rate........................................................ 34.0% 34.0% 34.0% Nondeductible expenses............................................................... 8.2 2.3 16.7 Other, including compensatory stock options.......................................... -- 4.4 8.2 --- --- --- 42.2% 40.7% 58.9% --- --- --- --- --- ---
8. BENEFIT PLAN The Company sponsors the DAOU Systems, Inc. 401(k) Salary Savings Plan which covers employees who meet certain age and service requirements. Employees may contribute a portion of their earnings each plan year subject to certain Internal Revenue Service limitations. The Company made elective contributions to the Plan of $2,000, $13,000 and $16,000 for the years ended December 31, 1994, 1995 and 1996, respectively. F-13 - ------------------------------------------- ------------------------------------------- - ------------------------------------------- ------------------------------------------- NO PERSON HAS BEEN AUTHORIZED IN CONNECTION WITH THE OFFERING MADE HEREBY TO GIVE ANY INFORMATION OR TO MAKE ANY REPRESENTATION NOT CONTAINED IN THIS PROSPECTUS AND, IF GIVEN OR MADE, SUCH INFORMATION OR REPRESENTATION MUST NOT BE RELIED UPON AS HAVING BEEN AUTHORIZED BY THE COMPANY, ANY SELLING STOCKHOLDER OR ANY UNDERWRITER. THIS PROSPECTUS DOES NOT CONSTITUTE AN OFFER TO SELL OR A SOLICITATION OF ANY OFFER TO BUY ANY OF THE SECURITIES OFFERED HEREBY TO ANY PERSON OR BY ANYONE IN ANY JURISDICTION IN WHICH IT IS UNLAWFUL TO MAKE SUCH OFFER OR SOLICITATION. NEITHER THE DELIVERY OF THIS PROSPECTUS NOR ANY SALE MADE HEREUNDER SHALL, UNDER ANY CIRCUMSTANCES, CREATE ANY IMPLICATION THAT THE INFORMATION CONTAINED HEREIN IS CORRECT AS OF ANY DATE SUBSEQUENT TO THE DATE HEREOF. -------------- TABLE OF CONTENTS
PAGE ----- Prospectus Summary............................. 3 Risk Factors................................... 5 The Company.................................... 11 Use of Proceeds................................ 11 Dividend Policy................................ 11 Capitalization................................. 12 Dilution....................................... 13 Selected Financial Data........................ 14 Management's Discussion and Analysis of Financial Condition and Results of Operations................................... 15 Business....................................... 20 Management..................................... 28 Certain Transactions........................... 34 Principal and Selling Stockholders............. 36 Description of Capital Stock................... 38 Shares Eligible for Future Sale................ 40 Underwriting................................... 42 Legal Matters.................................. 43 Experts........................................ 43 Additional Information......................... 43 Index to Financial Statements.................. F-1
-------------- UNTIL , 1997 (25 DAYS AFTER THE DATE OF THIS PROSPECTUS), ALL DEALERS EFFECTING TRANSACTIONS IN THE COMMON STOCK OFFERED HEREBY, WHETHER OR NOT PARTICIPATING IN THIS DISTRIBUTION, MAY BE REQUIRED TO DELIVER A PROSPECTUS. THIS IS IN ADDITION TO THE OBLIGATIONS OF DEALERS TO DELIVER A PROSPECTUS WHEN ACTING AS UNDERWRITERS AND WITH RESPECT TO THEIR UNSOLD ALLOTMENTS OR SUBSCRIPTIONS. 3,850,000 SHARES [LOGO] COMMON STOCK ------------ PROSPECTUS ------------ ALEX. BROWN & SONS INCORPORATED COWEN & COMPANY HAMBRECHT & QUIST February , 1997 - ------------------------------------------- ------------------------------------------- - ------------------------------------------- ------------------------------------------- PART II INFORMATION NOT REQUIRED IN PROSPECTUS ITEM 24. INDEMNIFICATION OF DIRECTORS AND OFFICERS. Section 145 of the Delaware General Corporation Law permits a corporation to indemnify its directors, officers, employees and other agents in terms sufficiently broad to permit indemnification (including reimbursement for expenses) under certain circumstances for liabilities arising under the Securities Act of 1933, as amended (the "Securities Act"). The Registrant's Bylaws provide for the indemnification of directors and executive officers to the fullest extent not prohibited by the Delaware General Corporation Law and authorize the indemnification by the Registrant of other officers, employees and other agents as set forth in the Delaware General Corporation Law. The Registrant has entered into indemnification agreements with its directors and executive officers, in addition to the indemnification provided for in the Registrant's Bylaws. The Underwriting Agreement filed as Exhibit 1.1 to this Registration Statement provides for indemnification by the Underwriters of the Registrant and its officers and directors for certain liabilities arising under the Securities Act or otherwise. ITEM 25. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION. The following table sets forth the costs and expenses, other than underwriting discounts and commissions, in connection with the sale of Common Stock being registered. All amounts are estimated except the SEC registration fee, the NASD filing fee and the Nasdaq listing fee.
AMOUNT ---------- SEC Registration Fee........................................... $18,784.00 NASD Filing Fee................................................ 6,698.50 Nasdaq Listing Fee............................................. 45,419.20 Printing and Engraving Expenses................................ * Legal Fees and Expenses........................................ * Blue Sky Fees and Expenses..................................... * Accounting Fees and Expenses................................... * Transfer Agent and Registrar Fees and Expenses................. * Miscellaneous Expenses......................................... * ---------- Total...................................................... $ * ---------- ----------
- -------------- * To be completed by amendment ITEM 26. RECENT SALES OF UNREGISTERED SECURITIES. The Registrant has sold within the past three years (without payment of any selling commission to any person) the following unregistered securities: 1. During the period January 2, 1996 to December 31, 1996, the Registrant granted incentive and non-statutory stock options to employees, officers and directors of and consultants to the Registrant under its 1996 Stock Option Plan (the "1996 Stock Option Plan"), covering an aggregate of 941,413 shares of the Registrant's Common Stock. These options typically vest over a period of three to five years following their respective dates of grant. 2. In October 1995, the Registrant issued 1,603,430 shares of its Series A Preferred Stock to 12 investors for an aggregate purchase price of $7,999,999. These investors consisted of (i) 11 accredited investors which were venture capital funds and related entities and individuals and (ii) one non-accredited investor, Galen Employee Fund, L.P., the purchaser representative of which was a venture II-1 capital investor who had such knowledge and experience in financial and business matters that he was capable of evaluating the merits and risk of this investment. 3. In October 1995, the Registrant issued to Needham & Company, Inc. and Needham Capital S.B.I.C., L.P., which entities acted as finders with respect to the placement described in paragraph (2) above, warrants to purchase up to 130,393 and 2,892 shares of the Registrant's Series A Preferred Stock, respectively, at an exercise price of $4.99 per share. The sales and issuances of the securities in the transactions described in paragraph (1) above were deemed to be exempt from registration under the Securities Act by virtue of Rule 701 promulgated thereunder in that they were offered and sold either pursuant to written compensatory benefit plans or pursuant to a written contract relating to compensation, as provided by Rule 701. The sales and issuances of securities in the transactions described in paragraphs (2) and (3) above were deemed to be exempt from registration under the Securities Act by virtue of Section 4(2) and/or Rule 506 of Regulation D promulgated thereunder. The recipients represented their intention to acquire the securities for investment only and not with a view to the distribution thereof. Appropriate legends are affixed to the stock certificates issued in such transactions. Similar legends were imposed in connection with any subsequent sales of such securities. All recipients either received adequate information about the Registrant or had access, through employment or other relationships, to such information. ITEM 27. EXHIBITS.
EXHIBIT NUMBER DESCRIPTION - ---------- ---------------------------------------------------------------------------- 1.1 -- Form of Underwriting Agreement. 2.1 -- Agreement and Plan of Merger, dated January 9, 1997, by and between DAOU Systems, Inc., a Delaware corporation, and DAOU Systems, Inc., a California corporation. 3.1 -- Registrant's Amended and Restated Certificate of Incorporation. 3.2 -- Registrant's Bylaws. 4.1 -- Reference is made to Exhibits 3.1 and 3.2. 4.2* -- Specimen stock certificate. 4.3** -- Investors' Rights Agreement, dated October 26, 1995, between the Registrant and the parties named therein. 4.4** -- Series A Preferred Stock Purchase Warrant No. 1, dated October 26, 1995, between the Registrant and Needham & Company, Inc. 4.5** -- Series A Preferred Stock Purchase Warrant No. 2, dated October 26, 1995, between the Registrant and Needham Capital S.B.I.C., L.P. 5.1* -- Opinion of Baker & McKenzie. 10.1** -- Form of Indemnification Agreement. 10.2 -- 1996 Stock Option Plan. 10.3 -- Form of Incentive Stock Option Agreement under the 1996 Stock Option Plan. 10.4 -- Form of Nonstatutory Stock Option Agreement under the 1996 Stock Option Plan. 10.5** -- Sublease Agreement, dated March 1, 1996, between the Registrant and Adobe Systems Incorporated.
II-2
EXHIBIT NUMBER DESCRIPTION - ---------- ---------------------------------------------------------------------------- 10.6+ -- Information Management Agreement, dated April 1, 1996, between the Registrant and Candler Health System. 10.7+,** -- Principle Agreement, dated June 18, 1996, between the Registrant and Catholic Medical Center of Brooklyn & Queens, Inc. 10.8+,** -- Principal Agreement, dated June 29, 1995, between the Registrant and Mercy Health Services. 10.9+,** -- Master Agreement, dated June 4, 1996, between the Registrant and Atlantic Health System. 10.10** -- Form of Master Services Agreement. 10.11 -- Employment Agreement, effective as of November 11, 1996, between Robert C. McNeill and the Registrant. 10.12** -- Promissory Note, dated October 26, 1995, from Georges J. Daou to the Registrant in the principal amount of $70,642. 10.13** -- Promissory Note, dated October 26, 1995, from Daniel J. Daou to the Registrant in the principal amount of $69,897. 10.14** -- Promissory Note, dated October 26, 1995, from Joseph H. Daou to the Registrant in the principal amount of $66,103. 10.15** -- Lease Agreement, dated October 1, 1995, between the Registrant and Daniel J. Daou. 11.1 -- Statement of Computation of Earnings Per Share. 23.1 -- Consent of Ernst & Young LLP, independent auditors. 23.2* -- Consent of Baker & McKenzie -- Included in Exhibit 5.1. 24.1** -- Power of Attorney -- Reference is made to page II-5. 27.1 -- Financial Data Schedule.
- -------------- * To be filed by amendment. + The Registrant has applied for confidential treatment of portions of this exhibit. ** Previously filed. ITEM 28. UNDERTAKINGS. The undersigned Registrant will provide to the Underwriters at the closing specified in the Underwriting Agreement filed as Exhibit 1.1 to this Registration Statement certificates in such denominations and registered in such names as required by the Underwriters to permit prompt delivery to each purchaser. Insofar as indemnification for liabilities arising under the Securities Act may be permitted to directors, officers and controlling persons of the Registrant pursuant to the foregoing provisions, or otherwise, the Registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the Registrant of expenses incurred or paid by a director, officer or controlling person of the Registrant in the successful defense of any action, suit, or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the Registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate II-3 jurisdiction the question whether such indemnification by it is against public policy as expressed in the Securities Act and will be governed by the final adjudication of such issue. The undersigned Registrant undertakes that: (1) for the purpose of determining any liability under the Securities Act, the information omitted from the form of prospectus filed as part of this Registration Statement in reliance upon Rule 430A and contained in the form of prospectus filed by the Registrant under Rule 424(b)(1), or (4) or 497(h) under the Securities Act shall be deemed to be part of this Registration Statement as of the time it was declared effective, and (2) for the purpose of determining any liability under the Securities Act, each post-effective amendment that contains a form of prospectus shall be deemed to be a new registration statement for the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof. II-4 SIGNATURES In accordance with the requirements of the Securities Act of 1933, the registrant certifies that it has reasonable grounds to believe that it meets all of the requirements for filing on Form SB-2 and authorizes this Amendment No. 1 to Registration Statement to be signed on its behalf by the undersigned in the City of San Diego, State of California on the 21st of January, 1997.
DAOU SYSTEMS, INC. By: /s/ DANIEL J. DAOU ----------------------------------------- Daniel J. Daou, PRESIDENT
POWER OF ATTORNEY In accordance with the requirements of the Securities Act of 1933, this Amendment No. 1 to Registration Statement has been signed by the following persons in the capacities indicated on January 21, 1997.
SIGNATURE TITLE - ------------------------------ -------------------------- Chief Executive Officer * and Chairman of the - ------------------------------ Board of Directors Georges J. Daou (Principal Executive Officer) /s/ DANIEL J. DAOU - ------------------------------ President and Director Daniel J. Daou Senior Vice President, /s/ FRED C. MCGEE Chief Financial Officer - ------------------------------ and Secretary (Principal Fred C. McGee Financial and Accounting Officer) * - ------------------------------ Director David W. Jahns * - ------------------------------ Director Bernard P. McDonagh * - ------------------------------ Director John H. Moragne
/s/ DANIEL J. DAOU -------------------------- Daniel J. Daou, *By: ATTORNEY-IN-FACT
II-5 EXHIBIT INDEX
EXHIBIT SEQUENTIALLY NUMBER EXHIBIT NUMBERED PAGES - --------- --------------------------------------------------------------- ----------------- 1.1 -- Form of Underwriting Agreement. 2.1 -- Agreement and Plan of Merger, dated January 9, 1997, by and between DAOU Systems, Inc., a Delaware corporation, and DAOU Systems, Inc., a California corporation. 3.1 -- Registrant's Amended and Restated Certificate of Incorporation. 3.2 -- Registrant's Bylaws. 4.1 -- Reference is made to Exhibits 3.1 and 3.2. 4.2* -- Specimen stock certificate. 4.3** -- Investors' Rights Agreement, dated October 26, 1995, between the Registrant and the parties named therein. 4.4** -- Series A Preferred Stock Purchase Warrant No. 1, dated October 26, 1995, between the Registrant and Needham & Company, Inc. 4.5** -- Series A Preferred Stock Purchase Warrant No. 2, dated October 26, 1995, between the Registrant and Needham Capital S.B.I.C., L.P. 5.1* -- Opinion of Baker & McKenzie. 10.1** -- Form of Indemnification Agreement. 10.2 -- 1996 Stock Option Plan. 10.3 -- Form of Incentive Stock Option Agreement under the 1996 Stock Option Plan. 10.4 -- Form of Nonstatutory Stock Option Agreement under the 1996 Stock Option Plan. 10.5** -- Sublease Agreement, dated March 1, 1996, between the Registrant and Adobe Systems Incorporated. 10.6+ -- Information Management Agreement, dated April 1, 1996, between the Registrant and Candler Health System. 10.7+,** -- Principle Agreement, dated June 18, 1996, between the Registrant and Catholic Medical Center of Brooklyn & Queens, Inc. 10.8+,** -- Principal Agreement, dated June 29, 1995, between the Registrant and Mercy Health Services. 10.9+,** -- Master Agreement, dated June 4, 1996, between the Registrant and Atlantic Health System. 10.10** -- Form of Master Services Agreement. 10.11 -- Employment Agreement, effective as of November 11, 1996, between Robert C. McNeill and the Registrant. 10.12** -- Promissory Note, dated October 26, 1995, from Georges J. Daou to the Registrant in the principal amount of $70,642. 10.13** -- Promissory Note, dated October 26, 1995, from Daniel J. Daou to the Registrant in the principal amount of $69,897.
EXHIBIT SEQUENTIALLY NUMBER EXHIBIT NUMBERED PAGES - --------- --------------------------------------------------------------- ----------------- 10.14** -- Promissory Note, dated October 26, 1995, from Joseph H. Daou to the Registrant in the principal amount of $66,103. 10.15** -- Lease Agreement, dated October 1, 1995, between the Registrant and Daniel J. Daou. 11.1 -- Statement of Computation of Earnings Per Share. 23.1 -- Consent of Ernst & Young LLP, independent auditors. 23.2* -- Consent of Baker & McKenzie -- Included in Exhibit 5.1. 24.1** -- Power of Attorney -- Reference is made to page II-5 of the Registration Statement. 27.1 -- Financial Data Schedule.
- -------------- * To be filed by amendment. + The Registrant has applied for confidential treatment of portions of this exhibit. ** Previously filed. EX-1.1 2 EXHIBIT 1.1 UNDERWRITING AGREEMENT 3,850,000 SHARES DAOU SYSTEMS, INC. COMMON STOCK ($0.001 PAR VALUE) UNDERWRITING AGREEMENT February ___, 1997 Alex. Brown & Sons Incorporated Cowen & Company Hambrecht & Quist LLC As Representative(s) of the Several Underwriters c/o Alex. Brown & Sons Incorporated 135 East Baltimore Street Baltimore, Maryland 21202 Gentlemen: Daou Systems, Inc., a Delaware corporation (the "Company"), and certain stockholders of the Company (the "Selling Stockholders") propose to sell to the several underwriters (the "Underwriters") named in Schedule I hereto for whom you are acting as representatives (the "Representatives") an aggregate of 3,850,000 shares of the Company's Common Stock, $0.001 par value (the "Firm Shares"), of which 2,900,000 shares will be sold by the Company and 950,000 shares will be sold by the Selling Stockholders. The respective amounts of the Firm Shares to be so purchased by the several Underwriters are set forth opposite their names in Schedule I hereto, and the respective amounts to be sold by the Selling Stockholders are set forth opposite their names in Schedule II hereto. The Company and the Selling Stockholders are sometimes referred to herein collectively as the "Sellers." The Company also proposes to sell at the Underwriters' option an aggregate of up to 577,500 additional shares of the Company's Common Stock (the "Option Shares") as set forth below. As the Representatives, you have advised the Company and the Selling Stockholders (a) that you are authorized to enter into this Agreement on behalf of the several Underwriters, and (b) that the several Underwriters are willing, acting severally and not jointly, to purchase the numbers of Firm Shares set forth opposite their respective names in Schedule I, plus their pro rata portion of the Option Shares if you elect to 1. exercise the over-allotment option in whole or in part for the accounts of the several Underwriters. The Firm Shares and the Option Shares (to the extent the aforementioned option is exercised) are herein collectively called the "Shares." This Underwriting Agreement, as amended, supplemented or modified from time to time is referred to herein as the "Agreement". In consideration of the mutual agreements contained herein and of the interests of the parties in the transactions contemplated hereby, the parties hereto agree as follows: 1. REPRESENTATIONS AND WARRANTIES OF THE COMPANY AND THE SELLING STOCKHOLDERS. (a) The Company represents and warrants as follows: (i) A registration statement on Form SB-2 (File No. 333 - 18155) with respect to the Shares has been carefully prepared by the Company in conformity with the requirements of the Securities Act of 1933, as amended (the "Act"), and the Rules and Regulations (the "Rules and Regulations") of the Securities and Exchange Commission (the "Commission") thereunder and has been filed with the Commission under the Act. The Company has complied with the conditions for the use of Form SB-2. Copies of such registration statement, including any amendments thereto, the preliminary prospectuses (meeting the requirements of Rule 430A of the Rules and Regulations) contained therein and the exhibits, financial statements and schedules, as finally amended and revised, have heretofore been delivered by the Company to you. Such registration statement, herein referred to as the "Registration Statement," which shall be deemed to include all information omitted therefrom in reliance upon Rule 430A and contained in the Prospectus referred to below, has been declared effective by the Commission under the Act and no post-effective amendment to the Registration Statement has been filed as of the date of this Agreement. The form of prospectus first filed by the Company with the Commission pursuant to its Rule 424(b) and Rule 430A, or if no form of prospectus is required to be filed pursuant to Rule 424(b), the form of prospectus included in the Registration Statement at the time it became effective, is herein referred to as the "Prospectus." Each preliminary prospectus included in the Registration Statement prior to the time it becomes effective is herein referred to as a "Preliminary Prospectus." (ii) The Company has been duly organized and is validly existing as a corporation in good standing under the laws of the State of Delaware with corporate power and authority to own its properties and conduct its business as described in the Registration Statement; the Company is duly qualified to transact business in all jurisdictions in which the conduct of its business requires such qualification, except where the failure, individually or in the aggregate, to be so qualified would not have a material adverse effect upon the condition, financial or otherwise, results of operations, 2. business affairs or business prospects of the Company (a "Material Adverse Effect"); and the Company has no direct or indirect subsidiaries. (iii) The outstanding shares of Common Stock of the Company, including all shares to be sold by the Selling Stockholders, have been duly authorized and validly issued and are fully paid and non-assessable; the portion of the Shares to be issued and sold by the Company have been duly authorized and when issued and paid for as contemplated herein will be validly issued, fully-paid and non-assessable; and no preemptive rights of stockholders exist with respect to any of the Shares or the issue and sale thereof. (iv) The Shares conform with the statements concerning them in the Registration Statement. (v) The Commission has not issued an order preventing or suspending the use of any Preliminary Prospectus relating to the proposed offering of the Shares nor instituted proceedings for that purpose. The Registration Statement contains and the Prospectus and any amendments or supplements thereto will contain all statements which are required to be stated therein by, and in all respects conform or will conform, as the case may be, to the applicable requirements of, the Act and the Rules and Regulations. Neither the Registration Statement nor any amendment thereto contains or will contain, as the case may be, any untrue statement of a material fact or omits or will omit to state any material fact required to be stated therein or necessary to make the statements therein, in the light of the circumstances under which they were made, not misleading; provided, however, that the Company makes no representations or warranties as to information contained in or omitted from the Registration Statement or the Prospectus, or any such amendment or supplement, in reliance upon, and in conformity with, written information furnished to the Company by or on behalf of any Underwriter through the Representatives, specifically for use in the preparation thereof. (vi) The financial statements of the Company, together with related notes and schedules as set forth in the Registration Statement (the "Financial Statements"), present fairly the financial position and the results of operations of the Company, at the indicated dates and for the indicated periods. The Financial Statements have been prepared in accordance with generally accepted principles of accounting, consistently applied throughout the periods involved, and all adjustments necessary for a fair presentation of results for such periods have been made (subject in the case of financial statements for interim periods, to normal and recurring year-end adjustments). The summary financial and statistical data included in the Registration Statement presents fairly the information shown therein and have been compiled on a basis consistent with the Financial Statements presented therein. 3. (vii) There is no action or proceeding pending or, to the knowledge of the Company, threatened against the Company before any court or administrative agency which, if determined adversely to the Company, might result in any material adverse change in the business or condition of the Company, except as set forth in the Registration Statement. (viii) Except as described in the Prospectus, the Company has good and marketable title to all of the properties and assets reflected in the Financial Statements (or as described in the Registration Statement), subject to no lien, mortgage, pledge, charge or encumbrance of any kind except those reflected in such Financial Statements (or as described in the Registration Statement) or which are not material in amount. The Company occupies its leased properties under valid and binding leases conforming to the description thereof set forth in the Registration Statement. (ix) The Company has filed all Federal, State and foreign income tax returns which have been required to be filed and has paid all taxes indicated by said returns and all assessments received by it to the extent that such taxes have become due. (x) Since the respective dates as of which information is given in the Registration Statement, as it may be amended or supplemented, there has not been any material adverse change or any development that may result in a prospective material adverse change in or affecting the condition, financial or otherwise, of the Company or the earnings, business affairs, management, or business prospects of the Company, whether or not occurring in the ordinary course of business, and there has not been any material transaction entered into by the Company, other than transactions in the ordinary course of business and changes and transactions contemplated by the Registration Statement, as it may be amended or supplemented. The Company has no material contingent obligations which are not disclosed in the Registration Statement, as it may be amended or supplemented. (xi) The Company is not in default under any agreement, lease, contract, indenture or other instrument or obligation to which it is a party or by which it or any of its properties is bound and which default is of material significance in respect of the business or financial condition of the Company. The sale of the shares by the Company hereunder will not conflict with or result in a breach of any of the terms or provisions of, or constitute a default under, any indenture, mortgage, deed of trust or other agreement or instrument to which the Company is a party, or of the certificate of incorporation or by-laws of the Company or any order, rule or regulation applicable to the Company of any court or of any regulatory body or administrative agency or other governmental body having jurisdiction which default would have a Material Adverse Effect on the Company. 4. (xii) Each approval, consent, order, authorization, designation, declaration or filing by or with any regulatory, administrative or other governmental body necessary in connection with the execution and delivery by the Company of this Agreement and the consummation of the transactions herein contemplated (except such additional steps as may be required by the National Association of Securities Dealers, Inc. (the "NASD") or may be necessary to qualify the Shares for public offering by the Underwriters under State or foreign securities or Blue Sky laws) has been obtained or made and is in full force and effect. (xiii) The Company holds all material licenses, certificates and permits from governmental authorities which are necessary to the conduct of its business as described in the Prospectus, except for certificates, authorizations or permits that are not material and do not interfere with the conduct of the business of the Company; and the Company has not received notice of infringement or of conflict with the asserted rights of others in respect of any patents, patent rights, trade names, trademarks or copyrights, which infringement, were it to result in an action determined adversely to the Company, would have a Material Adverse Effect on the business of the Company. (xiv) Ernst & Young LLP, who have certified certain of the financial statements filed with the Commission as part of the Registration Statement, are independent public accountants as required by the Act and the Rules and Regulations. (b) Each of the Selling Stockholders severally (and not jointly with the other Selling Stockholders) represents and warrants as follows: (i) Such Selling Stockholder has, and on the Closing Date (as such date is hereinafter defined) will have, good and marketable title to the Firm Shares to be sold by such Selling Stockholder, free of any liens, encumbrances and claims, and full right, power and authority to effect the sale and delivery of such Firm Shares; and upon the delivery of and payment for such Firm Shares pursuant to this Agreement, good and marketable title thereto, free of any liens, encumbrances and claims, will be transferred to the several Underwriters. (ii) The consummation by such Selling Stockholder of the transactions herein contemplated and the fulfillment by such Selling Stockholder of the terms hereof will not result in a breach of any of the terms and provisions of, or constitute a default under, any indenture, mortgage, deed of trust or other agreement or instrument to which such Selling Stockholder is a party, or of any order, rule or regulation applicable to such Selling Stockholder of any court or of any regulatory body or administrative agency or other governmental body having jurisdiction. 5. (iii) Such Selling Stockholder has not taken and will not take, directly or indirectly, any action designed to, or which has constituted, or which might reasonably be expected to cause or result in stabilization or manipulation of the price of the Common Stock of the Company. (iv) Such Selling Stockholder is familiar with the Registration Statement and, insofar as it relates to such Selling Stockholder, the Registration Statement does not and will not contain an untrue statement of a material fact or omit to state any material fact required to be stated therein or necessary to make the statements therein, in light of the circumstances in which they were made, not misleading. Such Selling Stockholder does not have any actual knowledge that the Registration Statement contains any untrue statement of material fact or omits to state any material fact required to be stated therein or necessary to make the statements therein, in light of the circumstances in which they were made, not misleading, or that the representations and warranties contained in Section 1 of this Agreement are not true and correct. The sale of the Firm Shares by such Selling Stockholder pursuant hereto is not prompted by actual knowledge of any information concerning the Company which is not set forth in the Registration Statement. 2. PURCHASE, SALE AND DELIVERY OF THE FIRM SHARES. On the basis of the representations, warranties and covenants herein contained, and subject to the conditions herein set forth, the Sellers agree to sell to the Underwriters and each Underwriter agrees, severally and not jointly, to purchase, at a price of $_________ per share, the respective number of Firm Shares set forth opposite the name of each Underwriter in Schedule 1 hereof, subject to adjustments in accordance with Section 9 hereof. The number of Firm Shares to be purchased by each Underwriter from each Seller shall be as nearly as practicable in the same proportion to the total number of Firm Shares being sold by each Seller as the number of firm Shares being purchased by each Underwriter bears to the total number of Firm Shares to be sold hereunder. The obligations of the Company and of each of the Selling Stockholders shall be several and not joint. Certificates in negotiable form for the total number of the Shares to be sold hereunder by the Selling Stockholders have been placed in custody with Continental Stock Transfer and Trust Company as custodian (the "Custodian") pursuant to the Custodian Agreement executed by each Selling Stockholder for delivery of all Firm Shares to be sold hereunder by the Selling Stockholders. Each of the Selling Stockholders specifically agrees that the Firm Shares represented by the certificates held in custody for the Selling Stockholders under the Custodian Agreement are subject to the interests of the Underwriters hereunder, that the arrangements made by the Selling Stockholders for such custody are to that extent irrevocable, and that the obligations of the Selling Stockholders hereunder shall not be terminable by any act or deed of the Selling Stockholders (or by any other person, firm or corporation including the Company, 6. the custodian or the Underwriters) or by operation of law (including the death of any individual Selling Stockholder or the dissolution of a corporate Selling Stockholder) or by the occurrence of any other event or events, except as set forth in the Custodian Agreement. If any such event should occur prior to the delivery to the Underwriters of the Firm Shares hereunder, certificates for the Firm Shares shall be delivered by the Custodian in accordance with the terms and conditions of this Agreement as if such event has not occurred. The Custodian is authorized to receive and acknowledge receipt of the proceeds of sale of the Shares held by it against delivery of such Shares. Payment for the Firm Shares to be sold hereunder is to be made in Federal Reserve funds immediately available by wire transfer to the account of the Company at a bank acceptable to the Underwriters for the shares to be sold by the Company and to the account of the custodian for the shares to be sold by the Selling Stockholders, in each case against delivery of certificates therefor to the Representatives for the several accounts of the Underwriters. Such payment and delivery are to be made at the offices of Alex. Brown & Sons Incorporated, 135 East Baltimore Street, Baltimore, Maryland, at 10:00 A.M., Baltimore time, on the third (or if the Firm Shares are priced as contemplated by Rule 15c6-1(c) of the Exchange Act, after 4:30 p.m., Baltimore time, the fourth) business day after the date of this Agreement or at such other time and date not later than five business days thereafter as you and the Company shall agree upon, such time and date being herein referred to as the "Closing Date." (As used herein, "business day" means a day on which the New York Stock Exchange is open for trading and on which banks in New York are open for business and not permitted by law or executive order to be closed; for purposes of Rule 15c6-1 under the Securities Exchange Act, the Closing Date (if later than the otherwise applicable settlement date) shall be the settlement date for payment of funds and delivery of securities for all Firm Shares sold.) The certificates for the Firm Shares will be delivered in such denominations and in such registrations as the Representatives request in writing not later than the third full business day prior to the Closing Date, and will be made available for inspection by the Representatives at least one business day prior to the Closing Date. In addition, on the basis of the representations and warranties herein contained and subject to the terms and conditions herein set forth, the Company hereby grants an option to the several Underwriters to purchase the Option Shares at the price per share as set forth in the first paragraph of this Section 2. The option granted hereby may be exercised in whole or in part but only once and at any time upon written notice given within 30 days after the date of this Agreement, by you, as Representatives of the several Underwriters, to the Company setting forth the number of Option Shares as to which the several Underwriters are exercising the option, the names and denominations in which the Option Shares are to be registered and the time and date at which such certificates are to be delivered. The time and date at which certificates for Option Shares are to be delivered shall be determined by the Representatives but shall not be earlier than three nor later 7. than 10 full business days after the exercise of such option, nor in any event prior to the Closing Date (such time and date being herein referred to as the "Option Closing Date"). If the date of exercise of the option is three or more days before the Closing Date, the notice of exercise shall set the Closing Date as the Option Closing Date. The number of Option Shares to be purchased by each Underwriter shall be in the same proportion to the total number of Option Shares being purchased as the number of Firm Shares being purchased by such Underwriter bears to the total number of Firm Shares, adjusted by you in such manner as to avoid fractional shares. The option with respect to the Option Shares granted hereunder may be exercised only to cover over-allotments in the sale of the Firm Shares by the Underwriters. You, as Representatives of the several Underwriters, may cancel such option at any time prior to its expiration by giving written notice of such cancellation to the Company. To the extent, if any, that the option is exercised, payment for the Option Shares shall be made on the Option Closing Date in Federal Reserve funds immediately available by wire transfer to the account of the Company at a bank acceptable to the Underwriters against delivery of certificates therefor at the offices of Alex. Brown & Sons Incorporated, 135 East Baltimore Street, Baltimore, Maryland. 3. OFFERING BY THE UNDERWRITERS. It is understood that the several Underwriters are to make a public offering of the Firm Shares as soon as the Representatives deem it advisable to do so. The Firm Shares are to be initially offered to the public at the initial public offering price set forth in the Prospectus. The Representatives may from time to time thereafter change the public offering price and other selling terms. To the extent, if at all, that any Option Shares are purchased pursuant to Section 2 hereof, the Underwriters will offer them to the public on the foregoing terms. It is further understood that you will act as the Representatives for the Underwriters in the offering and sale of the Shares in accordance with a Master Agreement Among Underwriters entered into by you and the several other Underwriters. 4. COVENANTS OF THE COMPANY AND THE SELLING STOCKHOLDERS. (a) The Company covenants and agrees with the several Underwriters that: (i) The Company will (i) prepare and timely file with the Commission under Rule 424(b) of the Rules and Regulations a Prospectus containing information previously omitted at the time of effectiveness of the Registration Statement in reliance on Rule 430A of the Rules and Regulations, (ii) not file any amendment to the Registration Statement or supplement to the Prospectus of which the Representatives shall not previously have been advised and furnished with a copy or to which the Representatives shall have reasonably objected in writing or which is not in compliance 8. with the Rules and Regulations and (iii) file on a timely basis all reports and any definitive proxy or information statements required to be filed by the Company with the Commission subsequent to the date of the Prospectus and prior to the termination of the offering of the Shares by the Underwriters. (ii) The Company will advise the Representatives promptly of any request of the Commission for amendment of the Registration Statement or for a supplement to the Prospectus or for any additional information, or of the issuance by the Commission of any stop order suspending the effectiveness of the Registration Statement or the use of the Prospectus or of the institution of any proceedings for that purpose, and the Company will use its best efforts to prevent the issuance of any such stop order preventing or suspending the use of the Prospectus and to obtain as soon as possible the lifting thereof, if issued. (iii) The Company will cooperate with the Representatives in endeavoring to qualify the Shares for sale under the securities laws of such jurisdictions as the Representatives may reasonably have designated in writing and will make such applications, execute and deliver such documents, and furnish such information as may be reasonably required for that purpose, provided the Company shall not be required to qualify as a foreign corporation or to consent to service of process in any jurisdiction where it is not now so qualified or subject to service of process. The Company will, from time to time, prepare and file such statements, reports, and other documents, as are or may be required to continue such qualifications in effect for so long a period as the Representatives may reasonably request for distribution of the Shares. (iv) The Company will deliver to, or upon the order of, the Representatives, from time to time, as many copies of any Preliminary Prospectus as the Representatives may reasonably request. The Company will deliver to, or upon the order of, the Representatives during the period when delivery of a Prospectus is required under the Act, as many copies of the Prospectus in final form, or as thereafter amended or supplemented, as the Representatives may reasonably request. The Company will deliver to the Representatives at or before the Closing Date, four signed copies of the Registration Statement and all amendments thereto including all exhibits filed therewith, and will deliver to the Representatives such number of copies of the Registration Statement, but without exhibits, and of all amendments thereto, as the Representatives may reasonably request. (v) If during the period in which a prospectus is required by law to be delivered by an Underwriter or dealer any event shall occur as a result of which it becomes necessary to amend or supplement the Prospectus in order to make the statements therein, in the light of the circumstances existing at the time the Prospectus is delivered to a purchaser, not misleading, or, if it is necessary at any time to amend or 9. supplement the Prospectus to comply with any law, the Company promptly will prepare and file with the Commission an appropriate amendment to the Registration Statement or supplement to the Prospectus so that the Prospectus as so amended or supplemented will not, in the light of the circumstances when it is so delivered, be misleading, or so that the Prospectus will comply with law. (vi) The Company will make generally available to its security holders, as soon as it is practicable to do so, but in any event not later than 15 months after the effective date of the Registration Statement, an earnings statement (which need not be audited) in reasonable detail, covering a period of at least 12 consecutive months beginning after the effective date of the Registration Statement, which earnings statement shall satisfy the requirements of Section 11(a) of the Act and Rule 158 of the Rules and Regulations and will advise you in writing when such statement has been so made available. (vii) The Company will, for a period of five years from the Closing Date, deliver to the Representatives copies of annual reports and copies of all other documents, reports and information furnished by the Company to its stockholders or filed with any securities exchange or the Nasdaq National Market pursuant to the requirements of such exchange or the Nasdaq National Market or with the Commission pursuant to the Act or the Securities Exchange Act of 1934, as amended. The Company will deliver to the Representatives similar reports with respect to significant subsidiaries, as that term is defined in the Rules and Regulations, which are not consolidated in the Company's financial statements. (viii) No offering, sale or other disposition of any Common Stock of the Company will be made for a period of 180 days after the date of this Agreement, directly or indirectly, by the Company otherwise than hereunder or with the prior written consent of Alex. Brown & Sons Incorporated, except that the Company may, without such consent, issue shares pursuant to the conversion or exchange of convertible or exchangeable securities or the exercise of warrants or options, in each case outstanding on the date hereof, grants of employee stock options pursuant to the terms of a plan in effect on the date hereof and issuance of securities pursuant to the exercise of such options. (ix) The Company will use its best efforts to list, subject to notice of issuance, the Shares on the Nasdaq National Market. (b) Each of the Selling Stockholders covenants and agrees severally (and not jointly with the other Selling Stockholders) with the several Underwriters that no offering, sale, pledge, contract to sell, grant of any option to purchase or other disposition of any Common Stock of the Company (including Common Stock which may be issued upon exercise of stock options or warrants) or any securities convertible into, derivative 10. of or exercisable or exchangeable for Common Stock will be made for a period of 180 days after the date of this Agreement, directly or indirectly, by such Selling Stockholder otherwise than hereunder or with the prior written consent of Alex. Brown & Sons, Incorporated. (c) In order to document the Underwriters' compliance with the reporting and withholding provisions of the Tax Equity and Fiscal Responsibility Act of 1982 and the Interest and Dividend Tax Compliance Act of 1983 with respect to the transactions herein contemplated, each of the Selling Stockholders agrees severally (and not jointly with the other Selling Stockholders) to deliver to you prior to or at the Closing Date a properly completed and executed United States Treasury Department Form W-9 (or other applicable from or statement specified by Treasury Department regulations in lieu thereof). 5. COSTS AND EXPENSES. The Company will pay all costs, expenses and fees incident to the performance of the obligations of the Sellers under this Agreement, including, without limiting the generality of the foregoing, the following: accounting fees of the Company; the fees and disbursements of counsel for the Company and the Selling Stockholders (as reasonably approved by the Company); the cost of printing and delivering to, or as requested by, the Underwriters copies of the Registration Statement, Preliminary Prospectuses, the Prospectus, this Agreement, the Agreement Among Underwriters, the Underwriters' Selling Memorandum, the Underwriters' Questionnaire, the Invitation Letter, the Power of Attorney, the Listing Application, the Blue Sky Survey and any supplements or amendments thereto; the filing fees of the Commission; the filing fees and expenses incident to securing any required review by the National Association of Securities Dealers, Inc. (the "NASD") of the terms of the sale of the Shares; the Listing Fee of the Nasdaq National Market; and the reasonable expenses, including the fees and disbursements of counsel for the Underwriters, incurred in connection with the qualification of the Shares under State Securities or Blue Sky laws. The Selling Stockholders have agreed with the Company to reimburse the Company for a portion of such expenses. To the extent, if at all, that any of the Selling Stockholders engage special legal counsel to represent them individually in connection with this offering, the fees and expenses of such counsel shall be borne by such Selling Stockholder. Underwriting discounts and commissions payable on the shares sold by the Selling Stockholders and any transfer taxes imposed on the sale of the Shares to the several Underwriters will be paid by the Sellers pro rata. The Sellers shall not, however, be required to pay for any of the Underwriters' expenses (other than those related to qualification under State securities or Blue Sky laws and any required review by the NASD) except that, if this Agreement shall not be consummated because the conditions in Section 7 hereof are not satisfied, or because this Agreement is terminated by the Representatives pursuant to Section 6 hereof, or by reason of any failure, refusal or inability on the part of the Company or the Selling Stockholders to perform any undertaking or satisfy any condition of this Agreement or to 11. comply with any of the terms hereof on their part to be performed, unless such failure to satisfy said condition or to comply with said terms be due to the default or omission of any Underwriter, then the Company shall reimburse the several Underwriters for reasonable out-of-pocket expenses, including fees and disbursements of counsel, reasonably incurred in connection with investigating, marketing and proposing to market the Shares or in contemplation of performing their obligations hereunder; but the Company and the Selling Stockholders shall not in any event be liable to any of the several Underwriters for damages on account of loss of anticipated profits from the sale by them of the Shares. 6. CONDITIONS OF OBLIGATIONS OF THE UNDERWRITERS. The several obligations of the Underwriters to purchase and pay for the Firm Shares on the Closing Date and the Option Shares, if any, on the Option Closing Date are subject to the accuracy, as of the Closing Date or the Option Closing Date, as the case may be, of the representations and warranties of the Company and the Selling Stockholders contained herein, and to the performance by the Company and the Selling Stockholders of their covenants and obligations hereunder and to the following additional conditions: (a) No stop order suspending the effectiveness of the Registration Statement, as amended from time to time, shall have been issued and no proceedings for that purpose shall have been taken or, to the knowledge of the Company or the Selling Stockholders, shall be contemplated by the Commission. (b) The Representatives shall have received on the Closing Date or the Option Closing Date, as the case may be, the opinion of Baker & McKenzie, counsel for the Company and the Selling Stockholders, dated the Closing Date or the Option Closing Date, as the case may be, addressed to the Underwriters to the effect that: (i) The Company has been duly incorporated and is validly existing as a corporation in good standing under the laws of the State of Delaware, with corporate power and authority to own its properties and conduct its business as described in the Prospectus; the Company is duly qualified to transact business in each jurisdiction in which it is known to such counsel to own or lease property or conduct business and the conduct of its business requires such qualification, or in which the failure to qualify would have a materially adverse effect upon the business of the Company; and the Company has no direct or indirect subsidiaries. (ii) The Company has authorized and outstanding capital stock as set forth under the caption "Capitalization" in the Prospectus; the authorized shares of its Common Stock have been duly authorized; the outstanding shares of its Common Stock, including the Shares to be sold by the Selling Stockholders, have been duly authorized and validly issued and are fully paid and non-assessable; all of the Shares conform to the 12. description thereof contained in the Prospectus; the certificates evidencing the Shares are in due and proper form; the shares of Common Stock, including the Option Shares, if any, to be sold by the Company pursuant to this Agreement have been duly authorized and will be validly issued, fully paid and non-assessable when sold as contemplated by this Agreement; and to the best knowledge of such counsel no preemptive rights of stockholders exist with respect to any of the Shares or the issue and sale thereof. (iii) The Registration Statement was declared effective under the Act and, to the best of the knowledge of such counsel, no stop order suspending the effectiveness of the Registration Statement has been issued and no proceedings with respect thereto have been instituted or are pending or threatened under the Act. (iv) The Registration Statement, all Preliminary Prospectuses, the Prospectus and each amendment or supplement thereto comply as to form in all material respects with the requirements of the Act and the applicable rules and regulations thereunder (except that such counsel need express no opinion as to the financial statements, schedules and other financial information included therein). (v) The statements under the captions "Description of Capital Stock" and "Shares Eligible for Future Sale" in the Prospectus, insofar as they are descriptions of laws, regulations and rules, of legal and governmental proceedings or of contracts, agreements, leases and other legal documents known to such counsel, or refer to statements of law or legal conclusions are complete and accurate in all material respects and fairly and correctly present the information called for with respect to such documents and matters. (vi) Such counsel does not know of any contracts or documents required to be filed as exhibits to the Registration Statement or described in the Registration Statement or the Prospectus which are not so filed or described as required, and such contracts and documents as are summarized in the Registration Statement or the Prospectus are fairly summarized in all material respects. (vii) Except as set forth in the Prospectus, to the best knowledge of such counsel, there are no pending or threatened proceedings against the Company that, if determined adversely to the Company would, individually or in the aggregate, have a Material Adverse Effect on the Company. (viii) The execution and delivery of this Agreement and the consummation of the transactions herein contemplated do not and will not conflict with or result in a breach of any of the terms or provisions of, or constitute a default under, the certificate of incorporation or bylaws of the Company, or any agreement or instrument known to such counsel to which the Company is a party or by which the Company may 13. be bound which breach, default or violation would have a Material Adverse Effect on the Company; (ix) This Agreement has been duly authorized, executed and delivered by the Company. (x) No approval, consent, order, authorization, designation, declaration or filing by or with any regulatory, administrative or other governmental body is necessary in connection with the execution and delivery of this Agreement and the consummation of the transactions herein contemplated (other than as may be required by the National Association of Securities Dealers, Inc. or as required by State or foreign securities and Blue Sky laws as to which such counsel need express no opinion) except such as have been obtained or made, specifying the same. In rendering such opinion Baker & McKenzie may rely as to matters governed by the laws of states other than California, the General Corporation Laws of the State of Delaware or Federal laws on local counsel in such jurisdictions, provided that Baker & McKenzie shall state that they believe that they and the Underwriters are justified in relying on such other counsel. In addition to the matters set forth above, Baker & McKenzie shall state that it has participated in conferences with officers and other representatives of the Company, representatives of the independent public accountants for the Company and the Representatives and counsel to the Underwriters at which the contents of the Registration Statement and Prospectus and related matters were discussed and, although such counsel has not undertaken to investigate or verify independently and does not assume any responsibility for the accuracy, completeness or fairness of the statements contained in the Registration Statement and Prospectus (except as otherwise expressly set forth herein), on the basis of the foregoing, no facts have come to such counsel's attention that caused such counsel to believe that any part of the Registration Statement (other than the financial statements and notes thereto and other financial, statistical and accounting data or schedules included therein, or omitted therefrom, as to which no opinion need be expressed), as amended or supplemented, at the time such part of the Registration Statement became effective, contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading (other than information omitted therefrom in reliance on Rule 430A under the Act), or the Prospectus (other than the financial statements and notes thereto and other financial, statistical and accounting data or schedules included therein, or omitted therefrom, as to which no opinion need be expressed), as amended or supplemented, on the date of filing thereof with the Commission and on the date hereof, contained an untrue statement of a material fact or omitted to state a material fact necessary in order to make the statements therein, in light of the circumstances under which they were made, not misleading. 14. (c) The Representatives shall have received the opinion contemplated in the Power of Attorney, executed and delivered by each Selling Stockholder and an opinion, dated such Closing Date of Reid & Priest, LLP, counsel for the Selling Stockholders, to the effect that: (i) This Agreement has been duly authorized, executed and delivered on behalf of the Selling Stockholders. (ii) Each Selling Stockholder has full legal right, power and authority, and has duly obtained any approval required by law (other than as required by State securities and Blue Sky laws as to which such counsel need express no opinion), to sell, assign, transfer and deliver the portion of the Shares to be sold by such Selling Stockholder pursuant to this Agreement. (iii) The Custodian Agreement executed and delivered by each Selling Stockholder is a valid, irrevocable instrument legally sufficient for the purposes intended. (iv) The Underwriters (assuming that they are bona fide purchasers within the meaning of the Uniform Commercial Code) have acquired good and marketable title to the Shares being sold by each Selling Stockholder on the Closing Date, free and clear of all claims, liens, encumbrances and security interests whatsoever. (d) The Representatives shall have received from Cooley Godward LLP, counsel for the Underwriters, an opinion dated the Closing Date or the Option Closing Date, as the case may be, substantially to the effect specified in subparagraphs (ii), (iii), (iv), (ix) and (xi) of Paragraph (b) of this Section 6, and that the Company is a validly incorporated and existing corporation under the laws of the State of Delaware. In rendering such opinion Cooley Godward LLP may rely as to all matters governed other than by the laws of the State of California, the General Corporation Laws of the State of Delaware or Federal laws on the opinion of the local counsel referred to in paragraph (b) of this Section 6. In addition to the matters set forth above, such opinion shall also include a statement to the effect that nothing has come to the attention of such counsel which leads them to believe that the Registration Statement, as of the time it became effective under the Act, and the Prospectus or any amendment or supplement thereto, on the date it was filed pursuant to Rule 424(b) and the Registration Statement and the Prospectus, or any amendment or supplement thereto, as of the Closing Date or the Option Closing Date, as the case may be, contain an untrue statement of a material fact or omit to state a material fact required to be stated therein or necessary to make the statements therein not misleading (except that such counsel need express no view as to 15. financial statements, the notes thereto, schedules and other financial or statistical information included therein). With respect to such statement, Cooley Godward LLP may state that their belief is based upon the procedures set forth therein, but is without independent check and verification. (e) The Representatives shall have received at or prior to the Closing Date from Cooley Godward LLP a memorandum or summary, in form and substance satisfactory to the Representatives, with respect to the qualification for offering and sale by the Underwriters of the Shares under the State securities or Blue Sky laws of such jurisdictions as the Representatives may reasonably have designated to the Company. (f) The Representatives shall have received on the Closing Date or the Option Closing Date, as the case may be, a signed letter from Ernst & Young LLP, dated the Closing Date or the Option Closing Date, as the case may be, which shall confirm, on the basis of a review in accordance with the procedures set forth in the letter singed by such firm and dated and delivered to the Representatives on the date hereof that nothing has come to their attention during the period from the date five days prior to the date hereof, to a date not more than five days prior to the Closing Date or the Option Closing Date, as the case may be, which would require any change in their letter dated the date hereof if it were required to be dated and delivered on the Closing Date or the Option Closing Date, as the case may be. All such letters shall be in form and substance satisfactory to the Representatives. (g) The Representatives shall have received on the Closing Date or the Option Closing Date, as the case may be, a certificate or certificates of the President and the Chief Financial Officer of the Company to the effect that, as of the Closing Date or the Option Closing Date, as the case may be, each of them severally represents as follows: (i) The Registration Statement has become effective under the Act and no stop order suspending the effectiveness of the Registration Statement has been issued, and no proceedings for such purpose have been taken or are, to his knowledge, contemplated by the Commission. (ii) He does not know of any litigation instituted or threatened against the Company of a character required to be disclosed in the Registration Statement which is not so disclosed; he does not know of any material contract required to be filed as an exhibit to the Registration Statement which is not so filed; and the representations and warranties of the Company contained in Section 1 hereof are true and correct as of the Closing Date or the Option Closing Date, as the case may be. 16. (iii) He has carefully examined the Registration Statement and the Prospectus and, in his opinion, as of the effective date of the Registration Statement, the statements contained in the Registration Statement were true and correct, and such Registration Statement and Prospectus did not omit to state a material fact required to be stated therein or necessary in order to make the statements therein not misleading and, in his opinion, since the effective date of the Registration Statement, no event has occurred which should have been set forth in a supplement to or an amendment of the Prospectus which has not been so set forth in such supplement or amendment. (h) The Company and the Selling Stockholders shall have furnished to the Representatives such further certificates and documents confirming the representations and warranties contained herein and related matters as the Representatives may reasonably have requested. (i) The Firm Shares and Option Shares, if any, have been approved for designation upon notice of issuance on the Nasdaq National Market. The opinions and certificates mentioned in this Agreement shall be deemed to be in compliance with the provisions hereof only if they are in all material respects satisfactory to the Representatives and to Cooley Godward LLP, counsel for the Underwriters. If any of the conditions hereinabove provided for in this Section 6 shall not have been fulfilled when and as required by this Agreement to be fulfilled, the obligations of the Underwriters hereunder may be terminated by the Representatives by notifying the Company and the Selling Stockholders of such termination in writing or by telegram at or prior to the Closing Date or the Option Closing Date, as the case may be. In such event, the Selling Stockholders, the Company and the Underwriters shall not be under any obligation to each other (except to the extent provided in Sections 5 and 8 hereof). 7. CONDITIONS OF THE OBLIGATIONS OF THE SELLERS. The obligations of the Sellers to sell and deliver the portion of the Shares required to be delivered as and when specified in this Agreement are subject to the conditions that at the Closing Date or the Option Closing Date, as the case may be, no stop order suspending the effectiveness of the Registration Statement shall have been issued and in effect or proceedings therefor initiated or threatened. 8. INDEMNIFICATION. (a) The Company agrees to indemnify and hold harmless each Underwriter and each person, if any, who controls any Underwriter within the meaning of 17. the Act against any losses, claims, damages or liabilities to which such Underwriter or such controlling person may become subject under the Act or otherwise, insofar as such losses, claims, damages or liabilities (or actions or proceedings in respect thereof) arise out of or are based upon (i) any untrue statement or alleged untrue statement of any material fact contained in the Registration Statement, any Preliminary Prospectus, the Prospectus or any amendment or supplement thereto, or (ii) the omission or alleged omission to state therein a material fact required to be stated therein or necessary to make the statements therein not misleading, and will reimburse each Underwriter and each such controlling person for any legal or other expenses reasonably incurred by such Underwriter or such controlling person in connection with investigating or defending any such loss, claim, damage, liability, action or proceeding; provided, however, that the Company will not be liable in any such case to the extent that any such loss, claim, damage or liability arises out of or is based upon an untrue statement or alleged untrue statement, or omission or alleged omission made in the Registration Statement, any Preliminary Prospectus, the Prospectus, or such amendment or supplement, in reliance upon and in conformity with written information furnished to the Company by or through the Representatives specifically for use in the preparation thereof and provided, further, that such indemnity with respect to any untrue statement or misstatement of a material fact contained in any Preliminary Prospectus shall not inure to the benefit of any Underwriter from whom the person asserting any such losses, claims, damages or liabilities purchased the shares that are subject thereof if such person did not receive a copy of the Prospectus (or the Prospectus as supplemented) at or prior to the confirmation of the sale of such shares to such person in any case where delivery is required under the Act and such untrue statement or omission of a material fact contained in any preliminary prospectus was corrected in the Prospectus (or the Prospectus as supplemented). This indemnity agreement will be in addition to any liability which the Company may otherwise have. (b) Each Selling Stockholder severally (and not jointly with the other Selling Stockholders) agrees to indemnify and hold harmless each Underwriter and each person, if any, who controls any Underwriter within the meaning of the Act to the same extent as the indemnity from the Company to each Underwriter set forth in Section 8(a) hereof, but only with respect to information relating to such Selling Stockholder furnished by or on behalf of such Selling Stockholder to the Company expressly for use in the Registration Statement, any Preliminary Prospectus, the Prospectus or any amendment or supplement thereto. In no event, however, shall the liability of any Selling Stockholder for indemnification under this Section 8(b) exceed the net proceeds received by such Selling Stockholder from the Underwriters in the offering. This indemnity agreement will be in addition to any liability which the Selling Stockholders may otherwise have. (c) Each Underwriter will severally indemnify and hold harmless the Company, each of its directors, each of its officers who have signed the Registration 18. Statement, the Selling Stockholders, and each person, if any, who controls the Company or the Selling Stockholders within the meaning of the Act, against any losses, claims, damages or liabilities to which the Company or any such director, officer, Selling Stockholder or controlling person may become subject under the Act or otherwise, insofar as such losses, claims, damages or liabilities (or actions or proceedings in respect thereof) arise out of or are based upon any untrue statement or alleged untrue statement of any material fact contained in the Registration Statement, any Preliminary Prospectus, the Prospectus or any amendment or supplement thereto, or arise out of or are based upon the omission or the alleged omission to state therein a material fact required to be stated therein or necessary to make the statements therein not misleading in the light of the circumstances under which they were made; and will reimburse any legal or other expenses reasonably incurred by the Company or any such director, officer, Selling Stockholder or controlling person in connection with investigating or defending any such loss, claim, damage, liability, action or proceeding; provided, however, that each Underwriter will be liable in each case to the extent, but only to the extent, that such untrue statement or alleged untrue statement or omission or alleged omission has been made in the Registration Statement, any Preliminary Prospectus, the Prospectus or such amendment or supplement, in reliance upon and in conformity with written information furnished to the Company by or through the Representatives specifically for use in the preparation thereof. This indemnity agreement will be in addition to any liability which such Underwriter may otherwise have. (d) In case any proceeding (including any governmental investigation) shall be instituted involving any person in respect of which indemnity may be sought pursuant to this Section 8, such person (the "indemnified party") shall promptly notify the person against whom such indemnity may be sought (the "indemnifying party") in writing. No indemnification provided for in Section 8(a), (b) or (c) shall be available to any party who shall fail to give notice as provided in this Section 8(d) if the party to whom notice was not given was unaware of the proceeding to which such notice would have related and was prejudiced by the failure to give such notice, but the failure to give such notice shall not relieve the indemnifying party or parties from any liability which it or they may have to the indemnified party for contribution or otherwise than on account of the provisions of Section 8(a), (b) or (c). In case any such proceeding shall be brought against any indemnified party and it shall notify the indemnifying party of the commencement thereof, the indemnifying party shall be entitled to participate therein and, to the extent that it shall wish, jointly with any other indemnifying party similarly notified, to assume the defense thereof, with counsel reasonably satisfactory to such indemnified party and shall pay as incurred the fees and disbursements of such counsel related to such proceeding. In any such proceeding, any indemnified party shall have the right to retain its own counsel at its own expense. Notwithstanding the foregoing, the indemnifying party shall pay as incurred the fees and expenses of the counsel retained by 19. the indemnified party in the event (i) the indemnifying party and the indemnified party shall have mutually agreed to the retention of such counsel or (ii) the named parties to any such proceeding (including any impleaded parties) include both the indemnifying party and the indemnified party and representation of both parties by the same counsel would, in the reasonable judgment of the indemnified party, be inappropriate due to actual or potential differing interests between them. It is understood that the indemnifying party shall not, in connection with any proceeding or related proceedings in the same jurisdiction, be liable for the reasonable fees and expenses of more than one separate firm for all such indemnified parties. Such firm shall be designated in writing by you in the case of parties indemnified pursuant to Sections 8(a) and (b) and by the Company and the Selling Stockholders in the case of parties indemnified pursuant to Section 8(c). The indemnifying party shall not be liable for any settlement of any proceeding effected without its written consent, but if settled with such consent or if there be a final judgment for the plaintiff, the indemnifying party agrees to indemnify the indemnified party from and against any loss or liability by reason of such settlement or judgment. No indemnifying party shall, without the prior written consent of the indemnified party, effect any settlement of any pending or threatened action in respect to which any indemnified party is or could have been a party and indemnity could have been sought hereunder by such indemnified party unless such settlement includes an unconditional release of such indemnified party from all liability on such claims that are the subject matter of such action. An indemnifying party will not be liable for any settlement of any action or claim effected without its written consent. (e) If the indemnification provided for in this Section 8 is unavailable to or insufficient to hold harmless an indemnified party under Section 8(a), (b) or (c) above in respect of any losses, claims, damages or liabilities (or actions or proceedings in respect thereof) referred to therein, then each indemnifying party shall contribute to the amount paid or payable by such indemnified party as a result of such losses, claims, damages or liabilities (or actions or proceedings in respect thereof) in such proportion as is appropriate to reflect the relative benefits received by the Company and each Selling Stockholder on the one hand and the Underwriters on the other from the offering of the Shares. If, however, the allocation provided by the immediately preceding sentence is not permitted by applicable law or if the indemnified party failed to give the notice required under Section 8(d) above, then each indemnifying party shall contribute to such amount paid or payable by such indemnified party in such proportion as is appropriate to reflect not only such relative benefits but also the relative fault of the Company and each Selling Stockholder on the one hand and the Underwriters on the other in connection with the statements or omissions which resulted in such losses, claims, damages or liabilities (or actions or proceedings in respect thereof), as well as any other relevant equitable considerations. The relative benefits received by the Company and each Selling Stockholder on the one hand and the Underwriters on the other shall be deemed to be in 20. the same proportion as the total net proceeds from the offering (before deducting expenses) received by the Company and such Selling Stockholder bear to the total underwriting discounts and commissions received by the Underwriters, in each case as set forth in the table on the cover page of the Prospectus. The relative fault shall be determined by reference to, among other things, whether the untrue or alleged untrue statement of a material fact or the omission or alleged omission to state a material fact relates to information supplied by the Company or the Selling Stockholders on the one hand or the Underwriters on the other and the parties' relative intent, knowledge, access to information and opportunity to correct or prevent such statement or omission. The Company, the Selling Stockholders and the Underwriters agree that it would not be just and equitable if contributions pursuant to this Section 8(e) were determined by pro rata allocation (even if the Underwriters were treated as one entity for such purpose) or by any other method of allocation which does not take account of the equitable considerations referred to above in this Section 8(e). The amount paid or payable by an indemnified party as a result of the losses, claims, damages or liabilities (or actions or proceedings in respect thereof) referred to above in this Section 8(e) shall be deemed to include any legal or other expenses reasonably incurred by such indemnified party in connection with investigating or defending any such action or claim. Notwithstanding the provisions of this subsection (e), (i) no Underwriter shall be required to contribute any amount in excess of the underwriting discounts and commissions applicable to the Shares purchased by such Underwriter, (ii) no person guilty of fraudulent misrepresentation (within the meaning of Section 11(f) of the Act) shall be entitled to contribution from any person who was not guilty of such fraudulent misrepresentation, and (iii) no Selling Stockholder shall be required to contribute any amount in excess of the net proceeds received by such Selling Stockholder from the Underwriters in the offering. The Underwriters' obligations in this Section 8(e) to contribute are several in proportion to their respective underwriting obligations and not joint. (f) In any proceeding relating to the Registration Statement, any Preliminary Prospectus, the Prospectus or any supplement or amendment thereto, each party against whom contribution may be sought under this Section 8 hereby consents to the jurisdiction of any court having jurisdiction over any other contributing party, agrees that process issuing from such court may be served upon him or it by any other contributing party and consents to the service of such process and agrees that any other contributing party may join him or it as an additional defendant in any such proceeding in which such other contributing party is a party. 9. DEFAULT BY UNDERWRITERS. If on the Closing Date or the Option Closing Date, as the case may be, any Underwriter shall fail to purchase and pay for the portion of the Shares which such Underwriter has agreed to purchase and pay for on such date (otherwise than by reason of any default on the part of the Company or a Selling 21. Stockholder), you, as Representatives of the Underwriters, shall use your best efforts to procure within 24 hours thereafter one or more of the other Underwriters, or any others, to purchase from the Company and the Selling Stockholders such amounts as may be agreed upon and upon the terms set forth herein, the Firm Shares or Option Shares, as the case may be, which the defaulting Underwriter or Underwriters failed to purchase. If during such 24 hours you, as such Representatives, shall not have procured such other Underwriters, or any others, to purchase the Firm Shares or Option Shares, as the case may be, agreed to be purchased by the defaulting Underwriter or Underwriters, then (a) if the aggregate number of shares with respect to which such default shall occur does not exceed 10% of the Firm Shares or Option Shares, as the case may be, covered hereby, the remaining Underwriters shall be obligated, severally, in proportion to the respective numbers of Firm Shares or Option Shares, as the case may be, which they are obligated to purchase hereunder, to purchase the Firm Shares or Option Shares, as the case may be, which such defaulting Underwriter or Underwriters failed to purchase, or (b) if the aggregate number of shares of Firm Shares or Option Shares, as the case may be, with respect to which such default shall occur exceeds 10% of the Firm Shares or Option Shares, as the case may be, covered hereby, the Company and the Selling Stockholders or you as the Representatives of the Underwriters will have the right, by written notice given within the next 24-hour period to the parties to this Agreement, to terminate this Agreement without liability on the part of the non-defaulting Underwriters or of the Company or of the Selling Stockholders except to the extent provided in Sections 5 and 8 hereof. In the event of a default by any Underwriter or Underwriters, as set forth in this Section 9, the Closing Date or Option Closing date, as the case may be, may be postponed for such period, not exceeding seven days, as you, as Representatives, may determine in order that the required changes in the Registration Statement or in the Prospectus or in any other documents or arrangements may be effected. The term "Underwriter" includes any person substituted for a defaulting Underwriter. Any action taken under this Section 9 shall not relieve any defaulting Underwriter from liability in respect of any default of such Underwriter under this Agreement. 10. NOTICES. All communications hereunder shall be in writing and, except as otherwise provided herein, will be mailed, delivered or telegraphed and confirmed as follows: if to the Underwriters, to Alex. Brown & Sons Incorporated, 135 East Baltimore Street, Baltimore, Maryland 21202, Attention: ______________________; if to the Company or the Selling Stockholders, to Daou Systems, Inc., 5120 Shoreham Place, San Diego, California 92122, Attention: President, with a copy to Baker & McKenzie, The Wells Fargo Plaza, 12th Floor, 101 West Broadway, San Diego, California 92101-9890, Attn: John J. Hentrich, Esq., or if sent to the Selling Stockholders or any of them, will be mailed, delivered or telegraphed and confirmed to the Selling Stockholders at the addresses set forth on Schedule B below each Selling Stockholder's name, with a copy to 22. Reid & Priest LLP, 40 West 57th Street, New York, New York 10019, Attn: Peter K. Anglum, Esq. 11. TERMINATION. This Agreement may be terminated by you by notice to the Sellers as follows: (a) at any time prior to the earlier of (i) the time the Shares are released by you for sale by notice to the Underwriters, or (ii) 11:30 A.M. on the first business day following the date of this Agreement; (b) at any time prior to the Closing Date if any of the following has occurred: (i) since the respective dates as of which information is given in the Registration Statement and the Prospectus, any material adverse change or any development involving a prospective material adverse change in or affecting the condition, financial or otherwise, of the Company or the earnings, business affairs, management or business prospects of the Company, whether or not arising in the ordinary course of business, (ii) any outbreak of hostilities or other national or international calamity or crisis or change in economic or political conditions if the effect of such outbreak, calamity, crisis or change on the financial markets of the United States would, in your reasonable judgment, make the offering or delivery of the Shares impracticable, (iii) suspension of trading in securities on the New York Stock Exchange, the American Stock Exchange or the Nasdaq National Market or limitation on prices (other than limitations on hours or numbers of days of trading) for securities on any such Exchange or Market, (iv) the enactment, publication, decree or other promulgation of any federal or state statute, regulation, rule or order of any court or other governmental authority which in your reasonable opinion materially and adversely affects or will materially or adversely affect the business or operations of the Company, (v) declaration of a banking moratorium by either federal or New York State authorities, or (vi) the taking of any action by any federal, state or local government or agency in respect of its monetary or fiscal affairs which in your reasonable opinion has a material adverse effect on the securities markets in the United States; or (c) as provided in Sections 6 and 9 of this Agreement. This Agreement also may be terminated by you, by notice to the Sellers, as to any obligation of the Underwriters to purchase the Option Shares, upon the occurrence at any time prior to the Option Closing Date of any of the events described in subparagraph (b) above or as provided in Sections 6 and 9 of this Agreement. 12. SUCCESSORS. This Agreement has been and is made solely for the benefit of the Underwriters, the Company and the Selling Stockholders and their respective successors, executors, administrators, heirs and assigns, and the officers, directors and 23. controlling persons referred to herein, and no other person will have any right or obligation hereunder. The term "successors" shall not include any purchaser of the Shares merely because of such purchase. 13. MISCELLANEOUS. The reimbursement, indemnification and contribution agreements contained in this Agreement and the representations, warranties and covenants in this Agreement shall remain in full force and effect regardless of (a) any termination of this Agreement, (b) any investigation made by or on behalf of any Underwriter or controlling person thereof, or by or on behalf of the Company or its directors or officers and (c) delivery of and payment for the Shares under this Agreement. This Agreement may be executed in two or more counterparts, each of which shall be deemed an original, but all of which together shall constitute one and the same instrument. This Agreement shall be governed by, and construed in accordance with, the laws of the State of New York, without regard to principles of conflicts of laws. 24. If the foregoing letter is in accordance with your understanding of our agreement, please sign and return to us the enclosed duplicates hereof, whereupon this Agreement will become a binding agreement among the Selling Stockholders, the Company and the several Underwriters in accordance with its terms. Very truly yours, DAOU SYSTEMS, INC. By ----------------------------- Daniel J. Daou, President Selling Stockholders listed on Schedule II By ----------------------------------- , Attorney-in-Fact ------------ The foregoing Underwriting Agreement is hereby confirmed and accepted as of the date first above written. ALEX. BROWN & SONS INCORPORATED COWEN & COMPANY HAMBRECHT & QUIST LLC As Representatives of the several Underwriters listed on Schedule I By ALEX. BROWN & SONS INCORPORATED By , Authorized Officer -------------------- 25. SCHEDULE I SCHEDULE OF UNDERWRITERS NUMBER OF FIRM SHARES TO BE UNDERWRITER PURCHASED Alex. Brown & Sons Incorporated Cowen & Company Hambrecht & Quist LLC ----------------- Total ----------------- ----------------- SCHEDULE II SCHEDULE OF SELLING STOCKHOLDERS SELLING STOCKHOLDER NUMBER OF FIRM SHARES TO BE SOLD Georges J. Daou Daniel J. Daou Joseph H. Daou ----------------- Total ----------------- ----------------- EX-2.1 3 EXHIBIT 2.1: AGMT. & PLAN OF MERGER AGREEMENT AND PLAN OF MERGER THIS AGREEMENT AND PLAN OF MERGER (this "Agreement") is made and entered into as of this 9th day of January, 1997, by and between DAOU Systems, Inc., a California corporation ("DAOU California"), and DAOU Systems, Inc., a Delaware corporation ("DAOU Delaware"). RECITALS A. DAOU California is a corporation duly organized and existing under the laws of the State of California. B. DAOU Delaware is a corporation duly organized and existing under the laws of the State of Delaware. C. On the date of this Agreement, DAOU Delaware has authority to issue 56,603,430 shares, 50,000,000 of which are Common Stock with a par value of $0.001 per share (the "DAOU Delaware Common Stock"), and 6,603,430 of which are Preferred Stock with a par value of $0.001 per share (the "DAOU Delaware Preferred Stock"), of which one hundred (100) shares of Common Stock are issued and outstanding and owned by DAOU California. D. On the date of this Agreement, DAOU California has authority to issue 25,000,000 shares, 15,000,000 of which are of Common Stock (the "DAOU California Common Stock"), and 10,000,000 of which are of Preferred Stock, including 1,821,191 shares of Series A Preferred Stock (the "DAOU California Preferred Stock"), of which 4,750,000 shares of Common Stock and 1,142,857 shares of Series A Preferred Stock are issued and outstanding. E. Each of the respective Boards of Directors of DAOU Delaware and DAOU California has determined that, for the purpose of effecting the reincorporation of DAOU California in the State of Delaware, it is advisable and to the advantage of said two corporations and their shareholders that DAOU California merge with and into DAOU Delaware upon the terms and conditions herein provided. F. The respective Boards of Directors of DAOU Delaware and DAOU California, the shareholders of DAOU California and the sole stockholder of DAOU Delaware have adopted and approved this Agreement. NOW, THEREFORE, in consideration of the mutual agreements and covenants set forth herein, DAOU California and DAOU Delaware hereby agree to merge as follows: ARTICLE I. MERGER 1.1 THE MERGER. In accordance with the provisions of this Agreement, the General Corporation Law of the State of Delaware (the "Delaware Law") and the Corporations Code of the State of California (the "California Code"), DAOU California shall be merged with and into DAOU Delaware (the "Merger"), the separate existence of DAOU California shall cease, and DAOU Delaware shall be, and is herein sometimes referred to as, the "Surviving Corporation." 1.2 EFFECTIVE TIME OF THE MERGER. Subject to the provisions herein, this Agreement, together with required related certificates, if any, shall be duly executed and filed in accordance with the Delaware Law and the California Code. The Merger shall become effective at the time of the filing of an executed counterpart of this Agreement and any other required certificates with the Delaware Secretary of State (the "Effective Time of the Merger"). 1.3 EFFECTS OF THE MERGER. At the Effective Time of the Merger, the separate existence of DAOU California shall cease and DAOU Delaware, as the Surviving Corporation, shall: (a) continue its corporate existence under the name of DAOU Systems, Inc.; (b) succeed, without other transfer, to all rights, titles, assets, powers and properties of DAOU California in the manner more fully set forth in Section 259 of the Delaware Law; (c) continue to be subject to all of the debts, liabilities and obligations of DAOU Delaware as constituted immediately prior to the Effective Time of the Merger; and (d) succeed, without other transfer, to all of the debts, liabilities and obligations of DAOU California, including any obligations of DAOU California under employee benefit plans in effect as of said date or with respect to which employee rights or accrued benefits are outstanding as of said date, in the same manner as if DAOU Delaware had itself incurred them, all as more fully provided under the applicable provisions of the Delaware Law and the California Code. ARTICLE II. CHARTER DOCUMENTS, DIRECTORS AND OFFICERS 2.1 CERTIFICATE OF INCORPORATION. At the Effective Time of the Merger, the Certificate of Incorporation of DAOU Delaware shall continue in full force and effect as the Certificate of Incorporation of the Surviving Corporation without change or amendment until further amended in accordance with the provisions thereof and applicable laws. 2.2 BYLAWS. The Bylaws of DAOU Delaware as in effect immediately prior to the Effective Time of the Merger shall continue in full force and effect as the Bylaws of the Surviving Corporation without change or amendment until further amended in accordance with the provisions thereof and applicable laws. -2- 2.3 DIRECTORS AND OFFICERS. At the Effective Time of the Merger, the directors and officers of DAOU California shall become the directors and officers of DAOU Delaware and the members of each committee of the Board of Directors of DAOU California shall become the members of such committees of DAOU Delaware. ARTICLE III. EFFECT ON CAPITAL STOCK 3.1 CONVERSION OF DAOU CALIFORNIA CAPITAL STOCK. At the Effective Time of the Merger, by virtue of the Merger and without any action on the part of the holder thereof: (a) each share of DAOU California Common Stock outstanding immediately prior thereto shall be changed and converted into 1.403 fully paid and nonassessable shares of DAOU Delaware Common Stock; and (b) each share of DAOU California's Series A Preferred Stock shall be changed and converted into 1.403 fully paid and nonassessable shares of DAOU Delaware Preferred Stock. 3.2 CONVERSION OF DAOU CALIFORNIA STOCK OPTIONS. At the Effective Time of the Merger, by virtue of the Merger and without any action on the part of the holder thereof, each outstanding option, warrant or other right to purchase shares of DAOU California Common Stock, including, but not limited to those options granted under the 1996 Stock Option Plan (the "Option Plan"), shall be converted into and become an option, warrant or right to purchase 1.403 shares of DAOU Delaware Common Stock at the exercise price of the DAOU California option, warrant or right divided by 1.403. A number of shares of DAOU Delaware Common Stock shall be reserved for purposes of such options, warrants and rights that is equal to the number of shares of DAOU California Common Stock so reserved immediately prior to the Effective Time of the Merger and multiplied by 1.403, and DAOU Delaware shall assume all obligations of DAOU California under agreements pertaining to such options, warrants and rights, including the Option Plan. 3.3 CONVERSION OF DAOU DELAWARE COMMON STOCK. Forthwith upon the Effective Time of the Merger, the one hundred (100) shares of DAOU Delaware Common Stock presently issued and outstanding in the name of DAOU California shall be canceled and retired and shall resume the status of authorized and unissued shares of DAOU Delaware Common Stock, and no shares of DAOU Delaware Common Stock or other securities of DAOU Delaware shall be issued in respect thereof. 3.4 FRACTIONAL SHARES. No fractional share which a DAOU Delaware stockholder would otherwise be entitled to receive by reason of the exchange of DAOU California stock for DAOU Delaware stock shall be issued. In the event of any fractional share to which a holder otherwise is entitled (determined on a certificate by certificate basis), DAOU Delaware shall round such fractional share to the closest whole integer and deliver to such holder one (1) whole share of DAOU Delaware Common Stock or DAOU Delaware Series A Preferred Stock, as the case may be. No cash shall be paid in lieu of any fractional share. 3.5 STOCK CERTIFICATES. On and after the Effective Time of the Merger, all of the outstanding certificates which prior to that time represented shares of DAOU California stock shall -3- be deemed for all purposes to evidence ownership of and to represent the shares of DAOU Delaware stock into which the shares of DAOU California stock have been converted as herein provided. In addition, on or after the Effective Time of the Merger, the records and books of DAOU California shall be deemed for all purposes to be the records and books of DAOU Delaware. The registered owner on the books and records of DAOU Delaware or its transfer agent of any such outstanding stock certificate shall, until such certificate shall have been surrendered for transfer or otherwise accounted for to DAOU Delaware or its transfer agent, have and be entitled to exercise any voting and other rights with respect to and to receive any dividend and other distributions upon the shares of DAOU Delaware stock evidenced by such outstanding certificate as above provided. ARTICLE IV. ADDITIONAL COVENANTS 4.1 COVENANTS OF DAOU DELAWARE. DAOU Delaware covenants and agrees that it shall, on or before the Effective Time of the Merger: (a) qualify to do business as a foreign corporation in the State of California and in all other states in which DAOU California is so qualified and in which the failure to so qualify would have a material adverse impact on the business or financial condition of the Surviving Corporation; (b) irrevocably appoint an agent for service of process as required under the provisions of Section 2105 of the California Corporations Code and under applicable provisions of state law in other states in which qualification is required hereunder; and (c) file any and all documents with the California Franchise Tax Board necessary to the assumption by DAOU Delaware of all of the franchise tax liabilities of DAOU California. 4.2 FURTHER ASSURANCES. From time to time, as and when required by DAOU Delaware or by its successors and assigns, there shall be executed and delivered on behalf of DAOU California such deeds and other instruments, and there shall be taken or caused to be taken by it such further and other action, as shall be appropriate or necessary in order to vest, perfect or confirm, of record or otherwise, in DAOU Delaware the title to and possession of all the property, interests, assets, rights, privileges, immunities, powers, franchises and authority of DAOU California, and otherwise to carry out the purposes of this Agreement and the officers and directors of DAOU Delaware are fully authorized in the name and on behalf of DAOU California or otherwise to take any and all such action and to execute and deliver any and all such deeds and other instruments. -4- ARTICLE V. MISCELLANEOUS PROVISIONS 5.1 AMENDMENT. Except for the terms of Article III of this Agreement, at any time before or after approval and adoption by the shareholders of DAOU California, this Agreement may be amended in any manner as may be determined in the judgment of the respective Boards of Directors of DAOU Delaware and DAOU California to be necessary, desirable or expedient in order to clarify the intention of the parties hereto or to effect or facilitate the purposes and intent of this Agreement. 5.2 ABANDONMENT. At any time before the Effective Time of the Merger, this Agreement may be terminated and the Merger may be abandoned by the Board of Directors of either DAOU California or DAOU Delaware or both, notwithstanding the prior approval of this Agreement by the sole stockholder of DAOU Delaware and by the shareholders of DAOU California. 5.3 GOVERNING LAW. This Agreement shall in all respects be construed, interpreted and enforced in accordance with Delaware Law, so far as applicable, the merger provisions of the California Code. 5.4 COUNTERPARTS. In order to facilitate the filing and recording of this Agreement, the same may be executed in any number of counterparts, each of which shall be deemed to be an original. IN WITNESS WHEREOF, this Agreement, having first been duly approved by resolution of the Boards of Directors of DAOU California and DAOU Delaware, is hereby executed on behalf of each of said corporations by their respective officers thereunto duly authorized. DAOU Systems, Inc., DAOU Systems, Inc., a California Corporation a Delaware Corporation By: /s/ Daniel J. Daou By: /s/ Daniel J. Daou ------------------------------- ------------------------------- Daniel J. Daou, President Daniel J. Daou, President -5- CERTIFICATE OF SECRETARY OF DAOU SYSTEMS, INC., A DELAWARE CORPORATION The undersigned, Fred McGee, the Secretary of DAOU Systems, Inc., a Delaware corporation (the "Corporation"), hereby certifies that the Agreement and Plan of Merger to which this Certificate is attached was duly signed on behalf of the Corporation by its President under the corporate seal of the Corporation and was duly approved and adopted by written consent of the sole stockholder of the Corporation dated January 9, 1997. Dated: January 9, 1997. /s/ Fred McGee -------------------------------------------- Fred McGee, Secretary EX-3.1 4 EXHIBIT 3.1: CERT. OF INCORPORATION AMENDED AND RESTATED CERTIFICATE OF INCORPORATION OF DAOU SYSTEMS, INC. I, Lynn M. Morris, the incorporator of DAOU Systems, Inc., a corporation duly organized under the laws of the State of Delaware (the "CORPORATION"), do hereby certify as follows: 1. The name of the Corporation is DAOU Systems, Inc. and the original Certificate of Incorporation of the Corporation was filed with the Secretary of State of the State of Delaware on November 15, 1996 (the "ORIGINAL CERTIFICATE OF INCORPORATION"). 2. The Corporation has not received any payment for any of its stock. 3. No directors were named in the Original Certificate of Incorporation and none have been elected. 4. Pursuant to Sections 241 and 245 of the General Corporation Law of the State of Delaware, the following resolution restating, integrating and further amending the Certificate of Incorporation of the Corporation was approved by Written Consent by the Sole Incorporator dated as of November 21, 1996: NOW, THEREFORE, BE IT RESOLVED, that the Certificate of Incorporation of the Corporation be, and hereby is, restated and further amended to read in its entirety as follows: ARTICLE I The name of the corporation is DAOU Systems, Inc., (hereinafter referred to as (the "CORPORATION"). ARTICLE II The address of the Corporation's registered office in the State of Delaware is 1013 Centre Road, City of Wilmington, County of New Castle, Delaware. The name of its registered agent at such address is Corporation Services Company. ARTICLE III The purpose of the Corporation is to engage in any lawful act or activity for which corporations may be organized under the General Corporation Law of the State of Delaware. ARTICLE IV A. The Corporation is authorized to issue two classes of stock to be designated, respectively, "Common Stock" and "Preferred Stock." The total number of shares which the Corporation is authorized to issue is 56,603,430 shares, 50,000,000 shares of which shall be Common Stock with a par value of $0.001 each, and 6,603,430 shares of which shall be Preferred Stock with a par value of $0.001. B. The Preferred Stock of the Corporation may be issued as a class, without series or, if so determined from time to time by the Board of Directors of the Corporation, in one or more series, each series to be expressly designated by a distinguishing number, letter or title. The Preferred Stock, and each series thereof, shall have such voting powers and other rights, privileges, preferences and restrictions as shall be set forth in the resolutions of the Board of Directors providing for the issuance of such preferred stock. There is hereby expressly granted to the Board of Directors of the Corporation the authority to determine, fix, alter or revoke any and all of the rights, preferences, privileges and restrictions and other terms of the Preferred Stock and any series thereof, and the number of shares constituting any series and the designation thereof, and to increase or decrease the number of shares of any series subsequent to the issuance of shares of that series, but not below the number of shares of such series then outstanding, or to eliminate entirely any series if there no longer are any outstanding shares of such series (and, thereupon, the shares previously designated for such series shall become authorized but undesignated shares). In case the number of shares of any series shall be so decreased, the shares constituting such shall resume the status they had prior to the adoption of the resolution originally setting forth the number of shares of such series. 1,603,430 of the authorized shares of Preferred Stock are hereby designated the "Series A Preferred Stock." C. The rights, preferences, privileges, restrictions and other matters relating to the Series A Preferred Stock are as follows: 1. DIVIDEND PROVISIONS. Subject to the rights of series of Preferred Stock which may from time to time come into existence in compliance with the provisions of SECTION 7, the holders of shares of the Series A Preferred Stock shall be entitled to receive dividends out of any assets legally available therefor, prior and in preference to any declaration or payment of any dividend (other than a dividend payable solely in Common Stock or other securities and rights convertible into or entitling the holder thereof to receive, directly or indirectly, additional shares of Common Stock) on the Common Stock, at the rate of six percent (6%) per annum based on the 2 Series A Issue Price (as hereinafter defined in SUBSECTION 2(a)) per share of the Series A Preferred Stock (appropriately adjusted for any stock split, dividend, combination or other recapitalization) when, as and if declared by the Board of Directors. Such dividends shall not be cumulative and, subject to the rights of series of Preferred Stock which may from time to time come into existence in compliance with the provisions of SECTION 7, shall be paid to the extent assets are legally available therefor and any amounts for which assets are not legally available shall be paid promptly as assets become legally available therefor; any partial payment will be made pro rata among the holders of such shares. Unless full dividends on the Series A Preferred Stock for the then current dividend period shall have been paid or declared and a sum sufficient for the payment thereof set apart, no dividend whatsoever (other than a dividend payable solely in Common Stock or other securities and rights convertible into or entitling the holder thereof to receive, directly or indirectly, additional shares of Common Stock) shall be paid or declared, and no distribution shall be made, on any Common Stock. After full dividends on the Series A Preferred Stock for the then current dividend period have been paid, the holders of shares of Series A Preferred Stock and the holders of shares of Common Stock shall participate in any further dividends on a pro rata basis determined by the number of shares of Common Stock held by each (assuming conversion of all such Series A Preferred Stock). 2. LIQUIDATION PREFERENCE. a. In the event of any liquidation, dissolution or winding up of the Corporation, either voluntary or involuntary, subject to the rights of series of Preferred Stock which may from time to time come into existence in compliance with the provisions of SECTION 7, the holders of Series A Preferred Stock shall be entitled to receive, prior and in preference to any distribution of any of the assets of the Corporation to the holders of Common Stock by reason of their ownership thereof, an amount per share equal to the sum of (i) Four Dollars and Ninety-Nine Cents ($4.99) for each outstanding share of Series A Preferred Stock (the "SERIES A ISSUE PRICE") and (ii) an amount equal to six percent (6%) of the Series A Issue Price (compounded annually and computed on the basis of a 360-day year of 30-day months and, for any period less than a month, the actual number of days elapsed in such month for the period of time that has passed since the original issuance of the Series A Preferred Stock) less any dividends actually paid on the Series A Preferred Stock (such amount being referred to herein as the "PREMIUM"). If upon the occurrence of such event, the assets and funds thus distributed among the holders of the Series A Preferred Stock shall be insufficient to permit the payment to such holders of the full aforesaid preferential amounts, then, subject to the rights of series of Preferred Stock which may from time to time come into existence in compliance with the provisions of SECTION 7, the entire assets and funds of the Corporation legally available for distribution shall be distributed ratably among the holders of the Series A Preferred Stock in proportion to the amount of such stock owned by each such holder. b. Upon the completion of the distribution required by SUBSECTION (a) of this SECTION 2 and any other distribution which may be required with respect to series of Preferred Stock which may from time to time come into existence in compliance with the provision of SECTION 7, if assets remain in the Corporation, the holders of the Common Stock of the Corporation shall 3 receive an aggregate amount equal to the total amount received by the holders of the Series A Preferred Stock pursuant to SUBSECTION (a). c. After the distributions described in SUBSECTION (a) and (b) above have been paid, subject to the rights of series of Preferred Stock which may from time to time come into existence in compliance with the provisions of SECTION 7, the remaining assets of the Corporation available for distribution to stockholders shall be distributed among the holders of Series A Preferred Stock and Common Stock pro rata based on the number of shares of Common Stock held by each (assuming conversion of all such Series A Preferred Stock). d. A consolidation or merger of the Corporation with or into any other corporation or corporations, or a sale, conveyance or disposition of all or substantially all of the assets of the Corporation or the effectuation by the Corporation of a transaction or series of related transactions in which more than fifty percent (50%) of the voting power of the Corporation is disposed of, shall not be deemed to be a liquidation, dissolution or winding up within the meaning of this SECTION 2, but shall instead be treated pursuant to SECTION 5. e. The liquidation preference of the Series A Preferred Stock set forth in this SECTION 2 shall not be applicable to any transaction in which the holders of Series A Preferred Stock receive not less than two times the Series A Issue Price (appropriately adjusted for any stock split, dividend, combination or other recapitalization) before August 31, 1997 and not less than three times the Series A Issue Price (appropriately adjusted for any stock split, dividend, combination or other recapitalization) thereafter; provided, however, that in any such transaction the holders of shares of Series A Preferred Stock and the holders of shares of Common Stock will share in the consideration received on a pro rata basis determined by the number of shares of Common Stock held by each (assuming conversion of all such Series A Preferred Stock). 3. REDEMPTION. a. On or after August 31, 2000, subject to the rights of series of Preferred Stock which may from time to time come into existence in compliance with the provisions of SECTION 7, within thirty (30) days after the receipt by the Corporation of a written request from the holders of a majority of the then outstanding Series A Preferred Stock, but not less then one third of the originally issued shares of Series A Preferred Stock (the "ORIGINAL SERIES A PREFERRED STOCK"), that all or some of such holders' shares be redeemed, and concurrently with surrender by such holders of the certificates representing such shares, the Corporation shall, to the extent it may lawfully do so, redeem the shares specified in such request by paying in cash therefor a sum per share equal to the Series A Issue Price plus an amount equal to six percent (6%) of the Series A Issue Price compounded annually and computed for the period of time that has passed since the original issuance of the Series A Preferred Stock on the basis of a 360-day year of 30-day months and, for any period less than a month, the actual number of days elapsed in such month, less any dividends actually paid on the Series A Preferred Stock (the "SERIES A REDEMPTION PRICE"). The Corporation shall give each holder of Series A Preferred Stock at least ten (10) days written notice of the date (the "REDEMPTION DATE") and place of redemption and the dollar amount of the Series A 4 Redemption Price, which notice shall be effective upon delivery or deposit in the United States mail, postage prepaid and addressed to each holder of record at his address appearing on the books of the Corporation. Payment of the Series A Redemption Price shall be made as follows: (A) one-third of such price shall be paid in cash on the Redemption Date; and (B) one-third of such price (plus interest on unpaid balance of six percent (6%) compounded annually) shall be paid in cash on each of the first and second anniversary dates of such Redemption Date, respectively. If the certificate surrendered represents a greater number of shares than the number redeemed, the Corporation shall issue to such holder a new certificate representing the shares which remain outstanding. b. From and after the Redemption Date, unless there shall have been a default in payment of the Series A Redemption Price, all dividends on the Series A Preferred Stock designated for redemption in the Redemption Notice shall cease to accrue, all rights of the holders of such shares as holders of Series A Preferred Stock (except the right to receive the Redemption Price without interest upon surrender of their certificate or certificates) shall cease with respect to such shares, and such shares shall not thereafter be transferred on the books of the Corporation or be deemed to be outstanding for any purpose whatsoever. Subject to the rights of series of Preferred Stock which may from time to time come into existence in compliance with the provisions of SECTION 7, if the funds of the Corporation legally available for redemption of shares of Series A Preferred Stock on any Redemption Date, or any subsequent date as provided in SUBSECTION 3(a), are insufficient to redeem the total number of shares of Series A Preferred Stock to be redeemed on such date, those funds which are legally available will be used to redeem the maximum possible number of such shares ratably among the holders of such shares to be redeemed. The shares of Series A Preferred Stock not redeemed shall remain outstanding and entitled to all the rights and preferences provided herein. Subject to the rights of series of Preferred Stock which may from time to time come into existence in compliance with the provisions of SECTION 7, at any time thereafter when additional funds of the Company are legally available for the redemption of shares of Series A Preferred Stock, such funds will immediately be used to redeem the balance of the shares which the Company has become obligated to redeem on any Redemption Date but which it has not redeemed. c. If at any time less than twenty-five percent (25%) of the Series A Preferred Stock remains outstanding, the Corporation may, upon a vote of its Board of Directors, redeem the remaining outstanding Series A Preferred Stock by payment in cash of the Series A Redemption Price in accordance with the notice and other terms and conditions set forth above in this SECTION 3. 4. CONVERSION. The holders of the Series A Preferred Stock shall have conversion rights as follows (the "CONVERSION RIGHTS"): a. RIGHT TO CONVERT. i. Subject to SUBSECTION (c), each share of Series A Preferred Stock shall be convertible, at the option of the holder thereof, at any time after the date of issuance of such share and prior to the close of business on any Redemption Date as may have been fixed in any Redemption Notice with respect to such share, at the office of the Corporation or any transfer 5 agent for the Series A Preferred Stock, into such number of fully paid and nonassessable shares of Common Stock as is determined by dividing the Series A Issue Price by the Conversion Price at the time in effect for such share. The initial "CONVERSION PRICE" per share for shares of Series A Preferred Stock shall be the Series A Issue Price; provided, however, that the Conversion Price for the Series A Preferred Stock shall be subject to adjustment as set forth in SUBSECTION 4(c). ii. In the event of a call for redemption of any shares of Series A Preferred Stock pursuant to SECTION 3, unless there shall have been a default in payment of the Series A Redemption Price, the Conversion Rights shall terminate as to the shares designated for redemption at the close of business on the Redemption Date. iii. Each share of Series A Preferred Stock shall automatically be converted into shares of Common Stock at the Conversion Price at the time in effect for such Series A Preferred Stock immediately upon the consummation of the Corporation's sale of its Common Stock in a public offering pursuant to a registration statement under the Securities Act of 1933, as amended, the public offering price of which was not less than two (2) times the Series A Issue Price (appropriately adjusted for any stock split, dividend, combination or other recapitalization) prior to August 31, 1997 and not less than three (3) times such amount thereafter and $15,000,000 in the aggregate. b. MECHANICS OF CONVERSION. Before any holder of Series A Preferred Stock shall be entitled to convert the same into shares of Common Stock, he shall surrender the certificate or certificates therefor, duly endorsed, at the office of the Corporation or of any transfer agent for the Series A Preferred Stock, and shall give written notice by mail, postage prepaid, to the Corporation at its principal corporate office, of the election to convert the same and shall state therein the name or names in which the certificate or certificates for shares of Common Stock are to be issued. The Corporation shall, as soon as practicable thereafter, issue and deliver at such office to such holder of Series A Preferred Stock, or to the nominee or nominees of such holder, a certificate or certificates for the number of shares of Common Stock to which such holder shall be entitled as aforesaid. Such conversion shall be deemed to have been made immediately prior to the close of business on the date of such surrender of the shares of Series A Preferred Stock to be converted, and the person or persons entitled to receive the shares of Common Stock issuable upon such conversion shall be treated for all purposes as the record holder or holders of such shares of Common Stock as of such date. If the conversion is in connection with an underwritten offer of securities registered pursuant to the Securities Act of 1933, the conversion may, at the option of any holder tendering Series A Preferred Stock for conversion, be conditioned upon the closing with the underwriter of the sale of securities pursuant to such offering, in which event the person(s) entitled to receive the Common Stock issuable upon such conversion of the Series A Preferred Stock shall not be deemed to have converted such Series A Preferred Stock until immediately prior to the closing of such sale of securities. c. CONVERSION PRICE ADJUSTMENTS OF PREFERRED STOCK. The Conversion Price of the Series A Preferred Stock shall be subject to adjustment from time to time as follows: 6 i. A. Upon each issuance by the Corporation of any Additional Stock (as defined below), after the date upon which any shares of the Series A Preferred Stock were first issued (the "PURCHASE DATE" with respect to such series), without consideration or for a consideration per share less than the Conversion Price for such series in effect immediately prior to the issuance of such Additional Stock, the Conversion Price for such series in effect immediately prior to each such issuance shall forthwith (except as otherwise provided in this CLAUSE (i)) be adjusted to a price determined by multiplying such Conversion Price by a fraction, the numerator of which shall be the number of shares of Common Stock outstanding immediately prior to such issuance (not including shares excluded from the definition of Additional Stock by SUBSECTION 4(c)(ii)(B)) plus the number of shares of Common Stock which the aggregate consideration received by the Corporation for such issuance of Additional Stock would purchase at such Conversion Price; and the denominator of which shall be the number of shares of Common Stock outstanding immediately prior to such issuance (not including shares excluded from the definition of Additional Stock by SUBSECTION 4(c)(ii)(B)) plus the number of shares of such Additional Stock. However, the foregoing calculation shall not take into account shares deemed issued pursuant to SUBSECTION 4(c)(i)(E) on account of options, rights or convertible or exchangeable securities (or the actual or deemed consideration therefor), except to the extent (i) such options, rights or convertible or exchangeable securities have been exercised, converted or exchanged or (ii) the consideration to be paid upon such exercise, conversion or exchange per share of underlying Common Stock is less than or equal to the per share consideration for the Additional Stock which has given rise to the Conversion Price adjustment being calculated. B. Except to the limited extent provided for in SUBSECTIONS (E)(3) and (E)(4), no adjustment of such Conversion Price pursuant to this SUBSECTION 4(c)(i) shall have the effect of increasing the Conversion Price above the Conversion Price in effect immediately prior to such adjustment, and (for purposes of clarification only) in no event will such adjustment have the effect of increasing the Conversion Price above the Series A Issue Price. C. In the case of the issuance of Common Stock for cash, the consideration shall be deemed to be the amount of cash paid therefor before deducting any reasonable discounts, commissions or other expenses allowed, paid or incurred by the Corporation for any underwriting or otherwise in connection with the issuance and sale thereof. D. In the case of the issuance of the Common Stock for a consideration in whole or in part other than cash, the consideration other than cash shall be deemed to be the fair value thereof as determined by the Board of Directors irrespective of any accounting treatment. E. In the case of the issuance (whether before, on or after the applicable Purchase Date) of options to purchase or rights to subscribe for Common Stock, securities by their terms convertible into or exchangeable for Common Stock or options to purchase 7 or rights to subscribe for such convertible or exchangeable securities, the following provisions shall apply for all purposes of this SUBSECTION 4(c)(i) and SUBSECTION 4(c)(ii): 1. The aggregate maximum number of shares of Common Stock deliverable upon exercise (assuming the satisfaction of any conditions to exercisability, including without limitation, the passage of time, but without taking into account potential antidilution adjustments) of such options to purchase or rights to subscribe for Common Stock shall be deemed to have been issued at the time such options or rights were issued and for a consideration equal to the consideration (determined in the manner provided in SUBSECTIONS 4(c)(i)(C) and (c)(i)(D)), if any, received by the Corporation upon the issuance of such options or rights plus the exercise price provided in such options or rights for the Common Stock covered thereby. 2. The aggregate maximum number of shares of Common Stock deliverable upon conversion of or in exchange (assuming the satisfaction of any conditions to convertibility or exchangeability, including, without limitation, the passage of time, but without taking into account potential antidilution adjustments) for any such convertible or exchangeable securities or upon the exercise of options to purchase or rights to subscribe for such convertible or exchangeable securities and subsequent conversion or exchange thereof shall be deemed to have been issued at the time such securities were issued or such options or rights were issued and for a consideration equal to the consideration, if any, received by the Corporation for any such securities and related options or rights (excluding any cash received on account of accrued interest or accrued dividends), plus the additional consideration, if any, to be received by the Corporation upon the conversion or exchange of such securities or the exercise of any related options or rights (the consideration in each case to be determined in the manner provided in SUBSECTIONS 4(c)(i)(C) and (c)(i)(D)). 3. In the event of any change in the number of shares of Common Stock deliverable or in the consideration payable to the Corporation upon exercise of such options or rights or upon conversion of or in exchange for such convertible or exchangeable securities, including, but not limited to, a change resulting from the antidilution provisions thereof, the Conversion Price of the Series A Preferred Stock, to the extent in any way affected by or computed using such options, rights or securities, shall be recomputed to reflect such change, but no further adjustment shall be made for the actual issuance of Common Stock or any payment of such consideration upon the exercise of any such options or rights or the conversion or exchange of such securities. 4. Upon the expiration of any such options or rights, the termination of any such rights to convert or exchange or the expiration of any options or rights related to such convertible or exchangeable securities, the Conversion Price of the Series A Preferred Stock, to the extent in any way affected by or computed using such options, rights or securities or options or rights related to such securities, shall be recomputed to reflect the issuance of only the number of shares of Common Stock (and convertible or exchangeable securities which 8 remain in effect) actually issued upon the exercise of such options or rights, upon the conversion or exchange of such securities or upon the exercise of the options or rights related to such securities. 5. The number of shares of Common Stock deemed issued and the consideration deemed paid therefor pursuant to SUBSECTIONS 4(c)(i)(E)(1) and (2) shall be appropriately adjusted to reflect any change, termination or expiration of the type described in either SUBSECTION 4(c)(i)(E)(3) or (4). ii. "ADDITIONAL STOCK" shall mean any shares of Common Stock issued (or deemed to have been issued pursuant to SUBSECTION 4(c)(i)(E)) by the Corporation after the Purchase Date other than: A. Common Stock issued pursuant to a transaction described in SUBSECTION 4(c)(iii), B. shares of Common Stock issuable or issued to employees consultants or directors of the Corporation directly or pursuant to a stock option plan or restricted stock plan approved by the Board of Directors of the Corporation, or in connection with lease lines, bank financings or other similar transactions or C. shares of Common Stock issued or issuable (I) in a public offering in connection with which all outstanding shares of Series A Preferred Stock will be converted to Common Stock pursuant to SUBSECTION 4(a)(iii) or (II) upon exercise of warrants or rights granted to underwriters in connection with such a public offering. iii. In the event the Corporation should at any time or from time to time after the Purchase Date fix a record date for the effectuation of a split or subdivision of the outstanding shares of Common Stock or the determination of holders of Common Stock entitled to receive a dividend or other distribution payable in additional shares of Common Stock or other securities or rights convertible into, or entitling the holder thereof to receive directly or indirectly, additional shares of Common Stock (hereinafter referred to as "COMMON STOCK EQUIVALENTS") without payment of any consideration by such holder for the additional shares of Common Stock or the Common Stock Equivalents (including the additional shares of Common Stock issuable upon conversion or exercise thereof), then, as of such record date (or the date of such dividend distribution, split or subdivision if no record date is fixed), the Conversion Price of the Series A Preferred Stock shall be appropriately decreased so that the number of shares of Common Stock issuable on conversion of each share of such series shall be increased in proportion to such increase of the aggregate of shares of Common Stock outstanding and those issuable with respect to such Common Stock Equivalents with the number of shares issuable with respect to Common Stock Equivalents determined from time to time in the manner provided for deemed issuances in SUBSECTION 4(c)(i)(E). iv. If the number of shares of Common Stock outstanding at any time after the Purchase Date is decreased by a combination of the outstanding shares of Common 9 Stock, then, following the record date of such combination, the Conversion Price for the Series A Preferred Stock shall be appropriately increased so that the number of shares of Common Stock issuable on conversion of each share of such series shall be decreased in proportion to such decrease in outstanding shares. d. OTHER DISTRIBUTIONS. In the event the Corporation shall declare a distribution payable in securities of other persons, evidences of indebtedness issued by the Corporation or other persons, assets (excluding cash dividends) or options or rights not referred to in SUBSECTION 4(c)(iii), then, in each such case for the purpose of this SUBSECTION 4(d), the holders of the Series A Preferred Stock shall be entitled to a proportionate share of any such distribution as though they were the holders of the number of shares of Common Stock of the Corporation into which their shares of Series A Preferred Stock are convertible as of the record date fixed for the determination of the holders of Common Stock of the Corporation entitled to receive such distribution. e. RECAPITALIZATIONS. If at any time or from time to time there shall be a recapitalization of the Common Stock (other than a subdivision, combination or merger or sale of assets transaction provided for elsewhere in this SECTION 4 or SECTION 5), provision shall be made so that the holders of the Series A Preferred Stock shall thereafter be entitled to receive upon conversion of the Series A Preferred Stock the number of shares of stock or other securities or property of the Company or otherwise, to which a holder of Common Stock deliverable upon conversion would have been entitled on such recapitalization. In any such case, appropriate adjustment shall be made in the application of the provisions of this SECTION 4 with respect to the rights of the holders of the Series A Preferred Stock after the recapitalization to the end that the provisions of this SECTION 4 (including adjustment of the Conversion Price then in effect and the number of shares purchasable upon conversion of the Series A Preferred Stock) shall be applicable after that event as nearly equivalent as may be practicable. f. NO IMPAIRMENT. The Corporation will not, by amendment of its Certificate of Incorporation or through any reorganization, recapitalization, transfer of assets, consolidation, merger, dissolution, issue or sale of securities or any other voluntary action, avoid or seek to avoid the observance or performance of any of the terms to be observed or performed hereunder by the Corporation, but will at all times in good faith assist in the carrying out of all the provisions of this SECTION 4 and in the taking of all such action as may be necessary or appropriate in order to protect the Conversion Rights of the holders of the Series A Preferred Stock against impairment. g. NO FRACTIONAL SHARES AND CERTIFICATE AS TO ADJUSTMENTS. i. No fractional shares shall be issued upon conversion of the Series A Preferred Stock, and the number of shares of Common Stock to be issued shall be rounded up to the nearest whole share. ii. Upon the occurrence of each adjustment or readjustment of the Conversion Price of Series A Preferred Stock pursuant to this SECTION 4, the Corporation, at its 10 expense, shall promptly compute such adjustment or readjustment in accordance with the terms hereof and prepare and furnish to each holder of Series A Preferred Stock a certificate setting forth such adjustment or readjustment and showing in detail the facts upon which such adjustment or readjustment is based. The Corporation shall, upon the written request at any time of any holder of Series A Preferred Stock, furnish or cause to be furnished to such holder a like certificate setting forth (A) such adjustment and readjustment, (B) the Conversion Price at the time in effect, and (C) the number of shares of Common Stock and the amount, if any, of other property which at the time would be received upon the conversion of a share of Series A Preferred Stock. h. NOTICES OF RECORD DATE. In the event of any taking by the Corporation of a record of the holders of any class of securities for the purpose of determining the holders thereof who are entitled to receive any dividend (other than a cash dividend) or other distribution, any right to subscribe for, purchase or otherwise acquire any shares of stock of any class or any other securities or property, or to receive any other right, the Corporation shall mail to each holder of Series A Preferred Stock, at least twenty (20) days prior to the date specified therein, a notice specifying the date on which any such record is to be taken for the purpose of such dividend, distribution or right, and the amount and character of such dividend, distribution or right. i. RESERVATION OF STOCK ISSUABLE UPON CONVERSION. The Corporation shall at all times reserve and keep available out of its authorized but unissued shares of Common Stock solely for the purpose of effecting the conversion of the shares of the Series A Preferred Stock such number of its shares of Common Stock as shall from time to time be sufficient to effect the conversion of all outstanding shares of the Series A Preferred Stock; and if at any time the number of authorized but unissued shares of Common Stock shall not be sufficient to effect the conversion of all then outstanding shares of the Series A Preferred Stock, in addition to such other remedies as shall be available to the holder of such Preferred Stock, the Corporation will take such corporate action as may, in the opinion of its counsel, be necessary to increase its authorized but unissued shares of Common Stock to such number of shares as shall be sufficient for such purposes. j. NOTICES. Any notice required by the provisions of this SECTION 4 to be given to the holders of shares of Series A Preferred Stock shall be deemed given if deposited in the United States mail, postage prepaid, and addressed to each holder of record at his address appearing on the books of the Corporation. 5. MERGER, CONSOLIDATION. a. At any time, in the event of: i. any transaction or series of related transactions (including, without limitation, any reorganization, merger or consolidation) which will result in the Corporation's stockholders immediately prior to such transaction not holding (by virtue of such shares or securities issued solely 11 with respect thereto) at least fifty percent (50%) of the voting power of the surviving or continuing entity, ii. a sale of all or substantially all of the assets of the Corporation, unless the Corporation's stockholders immediately prior to such sale will, as a result of such sale, hold (by virtue of securities issued as consideration for the Corporation's sale) at least fifty percent (50%) of the voting power of the purchasing entity, then, subject to the rights of series of Preferred Stock which may from time to time come into existence in compliance with the provisions of SECTION 7, holders of the Series A Preferred Stock shall receive for each share of such stock in cash or in securities received from the acquiring corporation, or in a combination thereof, at the closing of any such transaction, an amount equal to the greater of (A) the Series A Issue Price, plus an amount equal to the Premium as of the date of closing of such transaction or (B) that share of the total consideration to be paid by the acquiring entity in such transaction as equals the proportion that the number of shares of Common Stock and Common Stock issuable upon conversion of the outstanding Series A Preferred Stock then held by each of them bears to the total number of shares of outstanding Common Stock and shares of Common Stock issuable upon conversion of the outstanding Series A Preferred Stock. Such payments shall be made with respect to the Series A Preferred Stock (A) by redemption of such shares in one installment pursuant to SUBSECTION 3(b) (provided that in such event the moment immediately prior to the closing of such transaction shall, for purposes of this subparagraph, be deemed to be the "REDEMPTION DATE", only twenty (20) days' prior notice of the date fixed for redemption need be given and the consent of the holders of the Series A Preferred Stock shall be deemed to have been given) or (B) by purchase of such shares of Series A Preferred Stock by the surviving corporation, entity or person or by the Corporation. In the event the proceeds of the transaction are not sufficient to make full payment of the aforesaid preferential amounts to the holders of the Series A Preferred Stock in accordance herewith, then, subject to the rights of series of Preferred Stock which may from time to time come into existence in compliance with the provisions of SECTION 7, the entire amount payable in respect of the proposed transaction shall be distributed among the holders of the Series A Preferred Stock in proportion to the amount of such stock owned by each such holder. b. Any securities to be delivered to the holders of the Series A Preferred Stock pursuant to SUBSECTION 5(a) above shall be valued as follows: i. Securities not subject to investment letter or other similar restrictions on free marketability (covered by (ii) below): A. If traded on a securities exchange, the value shall be deemed to be the average of the closing prices of the securities on such exchange over the 15-day period ending three (3) days prior to the closing; 12 B. If actively traded over-the-counter, the value shall be deemed to be the average of the closing bid or sale prices (whichever are applicable) over the 15-day period ending three (3) days prior to the closing; and C. If there is no active public market, the value shall be the fair market value thereof, as mutually determined by the Corporation and the holders of Preferred Stock which would be entitled to receive such securities or the same type of securities and which Preferred Stock represents at least a majority of the voting power of all then outstanding shares of such Preferred Stock. ii. The method of valuation of securities subject to investment letter or other restrictions on free marketability shall be to make an appropriate discount from the market value determined as above in (i) (A), (B) or (C) to reflect the approximate fair market value thereof, as mutually determined by the Corporation and the holders of Preferred Stock which would be entitled to receive such securities or the same type of securities and which represent at least a majority of the voting power of all then outstanding shares of such Preferred Stock. c. In the event the requirements of SUBSECTION 5(a) are not complied with, the Corporation shall forthwith either: i. cause such closing to be postponed until such time as the requirements of this SECTION 5 have been complied with, or ii. cancel such transaction, in which event the rights, preferences and privileges of the holders of the Series A Preferred Stock shall revert to and be the same as such rights, preferences and privileges existing immediately prior to the date of the first notice referred to in SECTION 5. d. The Corporation shall give each holder of record of Series A Preferred Stock written notice of such impending transaction not later than twenty (20) days prior to the stockholders' meeting called to approve such transaction, or twenty (20) days prior to the closing of such transaction, whichever is earlier, and shall also notify such holders in writing of the final approval of such transaction. The first of such notices shall describe the material terms and conditions of the impending transaction and the provisions of this SECTION 5, and the Corporation shall thereafter give such holders prompt notice of any material changes. The transaction shall in no event take place sooner than twenty (20) days after the Corporation has given the first notice provided for herein or sooner than ten (10) days after the Corporation has given notice of any material changes provided for herein; provided, however, that such periods may be shortened upon the written consent of the holders of Preferred Stock which is entitled to such notice rights or similar notice rights and which represents at least a majority of the voting power of all then outstanding shares of such Preferred Stock. e. The provisions of this SECTION 5 are in addition to the protective provisions of SECTION 7. 13 6. VOTING RIGHTS. The holder of each share of Series A Preferred Stock shall have the right to one vote for each share of Common Stock into which such Series A Preferred Stock could then be converted (with any fractional share determined on an aggregate conversion basis being rounded up to the nearest whole share), and with respect to such vote, such holder shall have full voting rights and powers equal to the voting rights and powers of the holders of Common Stock, and shall be entitled, notwithstanding any provision hereof, to notice of any stockholders' meeting in accordance with the Bylaws of the Corporation, and shall be entitled to vote, together with holders of Common Stock, with respect to any question upon which holders of Common Stock have the right to vote. 7. PROTECTIVE PROVISIONS. So long as a majority of the Series A Preferred Stock are outstanding, the Corporation shall not without first obtaining the approval (by vote or written consent, as provided by law) of the holders of at least a majority of the then outstanding shares of Series A Preferred Stock, voting as a separate class: a. sell, convey, or otherwise dispose of or encumber all or substantially all of its property or business or merge into or consolidate with any other corporation (other than a wholly owned subsidiary corporation) or effect any transaction or series of related transactions in which more than fifty percent (50%) of the voting power of the Corporation is disposed of (provided, however that the holders of Series A Preferred Stock will not be entitled to vote as a class on mergers, consolidations, sale of assets, business combinations or similar transactions in which the holders of Series A Preferred Stock receive per share not less than two (2) times the Series A Issue Price (appropriately adjusted for any stock split, dividend, combination or other recapitalization) prior to August 31, 1997 and not less than three (3) times such amount thereafter; or b. alter or change the rights, preferences or privileges of the shares of Series A Preferred Stock so as to affect adversely such shares; or c. increase the authorized number of shares of Series A Preferred Stock; or d. create any new class or reclassify any series of stock or any other securities convertible into equity securities of the Corporation having a preference over, or being on a parity with, the Series A Preferred Stock with respect to voting, redemption, dividends or upon liquidation; or e. repurchase or redeem any shares of the Corporation's capital stock other than shares repurchased at cost from employees or officers. 8. STATUS OF CONVERTED OR REDEEMED STOCK. In the event any shares of Series A Preferred Stock shall be redeemed or converted pursuant to SECTION 3 or SECTION 4, the shares so converted or redeemed shall be canceled and shall not be issuable by the Corporation. The 14 Certificate of Incorporation of the Corporation shall be appropriately amended to effect the corresponding reduction in the Corporation's authorized capital stock. ARTICLE V The Board of Directors shall have the power to adopt, amend and repeal the Bylaws of the Corporation (except so far as the Bylaws of the Corporation adopted by the stockholders shall otherwise provide). Any bylaws adopted by the directors under the powers conferred hereby may be amended or repealed by the directors or by the stockholders. Notwithstanding the foregoing and anything contained in this Certificate of Incorporation to the contrary, Article II, Sections 1(c), 5 and 7; Article III, Section 2; and Article VII of the Bylaws of the Corporation as originally adopted by the sole incorporator shall not be amended or repealed and no provision inconsistent therewith shall be adopted without the affirmative vote of the holders of at least sixty-six and two-thirds percent (66-2/3%) of the voting power of all the shares of the Corporation entitled to vote generally in the election of directors, voting together as a single class. ARTICLE VI A. The Corporation shall indemnify to the fullest extent permitted by the General Corporation Law of Delaware any person who has been made, or is threatened to be made, a party to an action, suit or proceeding, whether civil, criminal, administrative, investigative, or otherwise (including an action, suit or proceeding by or in the right of the Corporation), by reason of the fact that the person is or was a director or officer of the Corporation, or a fiduciary within the meaning of the Employee Retirement Income Security Act of 1974 with respect to an employee benefit plan of the Corporation, or serves or served at the request of the Corporation as a director, or as an officer, or as a fiduciary of an employee benefit plan, of another corporation, partnership, joint venture, trust or other enterprise. In addition, the Corporation shall pay for or reimburse any expenses incurred by such persons who are parties to such proceedings, in advance of the final disposition of such proceedings, to the full extent permitted by the General Corporation Law of Delaware. B. Neither any amendment nor repeal of this ARTICLE VI, nor the adoption of any provisions of this Certificate of Incorporation inconsistent with this ARTICLE VI, shall eliminate or reduce the effect of this ARTICLE VI in respect of any matter occurring or arising or that, but for this ARTICLE VI, would accrue or arise, prior to such amendment, repeal or adoption of an inconsistent provision. ARTICLE VII A. The business and affairs of the Corporation shall be managed by the Board of Directors of the Corporation. 15 B. Except as otherwise provided for or fixed by or pursuant to the provisions of ARTICLE IV hereof relating to the rights of the holders of Preferred Stock to elect directors under specified circumstances, the number of the directors of Corporation shall be fixed from time to time by or pursuant to the Bylaws of the Corporation. From and after the annual meeting of stockholders held in 1997, the directors, other than those who may be elected by the holders of Preferred Stock, shall be classified, with respect to the time for which they severally hold office, into three classes, as nearly equal in number as possible, as shall be provided in the manner specified in the Bylaws of the Corporation, one class to be originally elected for a term expiring at the annual meeting of stockholders to be held in 1998, another class to be originally elected for a term expiring at the annual meeting of stockholders to be held in 1999, and another class to be originally elected for a term expiring at the annual meeting of stockholders to be held in 2000, with each class to hold office until its successor is elected and qualified. At each annual meeting of the stockholders, the successors of the class of directors whose term expires at that meeting shall be elected to hold office for a term expiring at the annual meeting of stockholders held in the third year following the year of their elections. C. Advance notice of stockholder nominations for the election of directors shall be given in the manner provided in the Bylaws of the Corporation. Election of directors need not be by written ballot unless the Bylaws of the Corporation shall so provide. D. Except as otherwise provided for or fixed by or pursuant to the provisions of ARTICLE IV hereof in relation to the rights of the holders of Preferred Stock to elect directors under specified circumstances, newly-created directorships resulting from any increase in the number of directors and any vacancies on the Board of Directors resulting from death, resignation, disqualification, removal or other cause shall be filled by the affirmative vote of a majority of the remaining directors then in office, even though less than a quorum of the Board of Directors. Any director elected in accordance with the preceding sentence shall hold office for the remainder of the full term of the class of directors in which the new directorship was created or the vacancy occurred and until such director's successor shall have been elected and qualified. No decrease in the number of directors constituting the Board of Directors shall shorten the term of any incumbent director. E. Subject to the rights of any Preferred Stock to elect directors under specified circumstances, any director may be removed from office only with cause and only by the affirmative vote of the holders of at least sixty-six and two- thirds percent (66-2/3%) of the voting power of all shares of the Corporation entitled to vote generally in the election of directors, voting together as a single class. F. To the fullest extent permitted by the General Corporation Law of the State of Delaware, a director of the Corporation shall not be personally liable to the Corporation or its stockholders for monetary damages for breach of fiduciary duty as a director. Any repeal or modification of this paragraph shall be prospective only and shall not adversely affect any limitation on the personal liability of a director of the Corporation with respect to any act or omission occurring prior to the time of such repeal or modification. 16 G. Notwithstanding anything contained in this Certificate of Incorporation to the contrary, the affirmative vote of the holders of at least sixty-six and two-thirds percent (66-2/3%) of the voting power of all outstanding shares of the Corporation entitled to vote generally in the election of directors, voting together as a single class, shall be required to alter, amend, adopt any provision inconsistent with or repeal this ARTICLE VII. ARTICLE VIII Any action required or permitted to be taken by the stockholders of the Corporation must be effected at a duly called annual or special meeting of such holders and may not be effected by any consent in writing of such holders. Except as otherwise required by law and subject to the rights of the holders of the Preferred Stock, special meetings of stockholders of the Corporation may be called only by the Chairman of the Board, the President or the Board of Directors pursuant to a resolution approved by a majority of the entire Board of Directors. Notwithstanding anything contained in this Certificate of Incorporation to the contrary, the affirmative vote of the holders of at least sixty-six and two-thirds percent (66-2/3%) of the voting power of all shares of the Corporation entitled to vote generally in the election of directors, voting together as a single class, shall be required to alter, amend, or adopt any provision inconsistent with or repeal this ARTICLE VIII. ARTICLE IX Subject to the other terms of this Certificate of Incorporation, the Corporation reserves the right to amend, alter, change or repeal any provision contained in this Certificate of Incorporation, in the manner now or hereafter prescribed by statute and this Certificate of Incorporation, and all rights conferred on stockholders herein are granted subject to this reservation. [REMAINDER OF PAGE INTENTIONALLY LEFT BLANK] 17 ARTICLE X The undersigned Incorporator hereby acknowledges that the foregoing Amended and Restated Certificate of Incorporation is her act and deed and that the facts stated therein are true. Dated: January 3, 1997 /s/ Lynn M. Morris ---------------------------------- Lynn M. Morris, Incorporator [SIGNATURE PAGE TO DAOU SYSTEMS, INC. RESTATED CERTIFICATE OF INCORPORATION] 18 EX-3.2 5 EXHIBIT 3.2: BYLAWS (DELAWARE) BYLAWS OF DAOU SYSTEMS, INC. TABLE OF CONTENTS PAGE ---- ARTICLE I OFFICES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Section 1. Registered Office. . . . . . . . . . . . . . . . . . . . 1 Section 2. Other Offices. . . . . . . . . . . . . . . . . . . . . . 1 ARTICLE II STOCKHOLDERS. . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Section 1. Meetings . . . . . . . . . . . . . . . . . . . . . . . . 1 Section 2. Notice of Meetings . . . . . . . . . . . . . . . . . . . 2 Section 3. Manner of Giving Notice; Affidavit of Notice . . . . . . 2 Section 4. Stockholder List . . . . . . . . . . . . . . . . . . . . 2 Section 5. Stockholder Action . . . . . . . . . . . . . . . . . . . 3 Section 6. Quorum . . . . . . . . . . . . . . . . . . . . . . . . . 3 Section 7. Notice of Agenda Matters . . . . . . . . . . . . . . . . 3 Section 8. Proxies. . . . . . . . . . . . . . . . . . . . . . . . . 4 Section 9. Voting . . . . . . . . . . . . . . . . . . . . . . . . . 4 Section 10. Voting of Certain Shares. . . . . . . . . . . . . . . . 4 Section 11. Treasury Stock. . . . . . . . . . . . . . . . . . . . . 5 ARTICLE III DIRECTORS . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Section 1. Powers . . . . . . . . . . . . . . . . . . . . . . . . . 5 Section 2. Election of Directors. . . . . . . . . . . . . . . . . . 5 Section 3. Dividends and Reserves . . . . . . . . . . . . . . . . . 6 Section 4. Regular Meetings . . . . . . . . . . . . . . . . . . . . 6 Section 5. Special Meetings . . . . . . . . . . . . . . . . . . . . 7 Section 6. Quorum . . . . . . . . . . . . . . . . . . . . . . . . . 7 Section 7. Written Action . . . . . . . . . . . . . . . . . . . . . 7 Section 8. Waiver of Notice . . . . . . . . . . . . . . . . . . . . 7 Section 9. Participation in Meetings by Conference Telephone. . . . 7 Section 10. Committees. . . . . . . . . . . . . . . . . . . . . . . 7 Section 11. Fees and Compensation of Directors. . . . . . . . . . . 8 Section 12. Rules . . . . . . . . . . . . . . . . . . . . . . . . . 8 Section 13. Interested Directors. . . . . . . . . . . . . . . . . . 8 ARTICLE IV OFFICERS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Section 1. Offices and Official Positions . . . . . . . . . . . . . 9 Section 2. Compensation . . . . . . . . . . . . . . . . . . . . . . 9 Section 3. Succession . . . . . . . . . . . . . . . . . . . . . . . 9 i TABLE OF CONTENTS (CONTINUED) PAGE ---- Section 4. Resignations . . . . . . . . . . . . . . . . . . . . . . 9 Section 5. Authority and Duties . . . . . . . . . . . . . . . . . . 9 Section 6. Approval of Loans to Officers. . . . . . . . . . . . . . 9 ARTICLE V CONTRACTS, LOANS, CHECKS AND DEPOSITS . . . . . . . . . . . . . .10 Section 1. Contracts and Other Instruments. . . . . . . . . . . . .10 Section 2. Loans. . . . . . . . . . . . . . . . . . . . . . . . . .10 Section 3. Checks, Drafts, etc. . . . . . . . . . . . . . . . . . .10 Section 4. Deposits . . . . . . . . . . . . . . . . . . . . . . . .10 ARTICLE VI STOCKS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10 Section 1. Certificates . . . . . . . . . . . . . . . . . . . . . .10 Section 2. Transfer . . . . . . . . . . . . . . . . . . . . . . . .11 Section 3. Lost, Stolen or Destroyed Certificates . . . . . . . . .11 Section 4. Record Date. . . . . . . . . . . . . . . . . . . . . . .11 Section 5. Registered Owners. . . . . . . . . . . . . . . . . . . .12 ARTICLE VII INDEMNIFICATION AND INSURANCE . . . . . . . . . . . . . . . . . .12 Section 1. Indemnification. . . . . . . . . . . . . . . . . . . . .12 Section 2. Contract . . . . . . . . . . . . . . . . . . . . . . . .13 Section 3. Non-exclusivity. . . . . . . . . . . . . . . . . . . . .13 Section 4. Indemnification of Employees and Agents. . . . . . . . .13 Section 5. Insurance. . . . . . . . . . . . . . . . . . . . . . . .14 ARTICLE VIII GENERAL PROVISIONS. . . . . . . . . . . . . . . . . . . . . . . .14 Section 1. Fiscal Year. . . . . . . . . . . . . . . . . . . . . . .14 Section 2. Corporate Seal . . . . . . . . . . . . . . . . . . . . .14 Section 3. Reliance upon Books, Reports and Records . . . . . . . .14 Section 4. Time Periods . . . . . . . . . . . . . . . . . . . . . .14 Section 5. Dividends. . . . . . . . . . . . . . . . . . . . . . . .14 Section 6. Construction and Definitions . . . . . . . . . . . . . .15 ARTICLE IX AMENDMENTS. . . . . . . . . . . . . . . . . . . . . . . . . . . .15 Section 1. Amendments . . . . . . . . . . . . . . . . . . . . . . .15 ii BYLAWS OF DAOU SYSTEMS, INC. ARTICLE I OFFICES Section 1. REGISTERED OFFICE. The registered office of DAOU Systems, Inc., a Delaware corporation (the "Corporation"), in the State of Delaware shall be located in the City of Wilmington, County of New Castle, State of Delaware, and the name of its registered agent is Corporation Services Company. Section 2. OTHER OFFICES. The Corporation may also have offices at such other places both within and without the State of Delaware as the Board of Directors may from time to time determine or the business of the Corporation may require. ARTICLE II STOCKHOLDERS Section 1. MEETINGS. (a) TIME AND PLACE OF MEETINGS. All meetings of the stockholders for the election of directors or for any other purpose shall be held at any place within or without the State of Delaware, as may be authorized by the Board of Directors and stated in the notice of the meeting or in a duly executed waiver of notice thereof. (b) ANNUAL MEETING. Annual meetings of stockholders shall be held on a date and time as shall be designated from time to time by the Board of Directors, at which meeting the stockholders shall elect by plurality vote the directors to succeed those whose terms expire and shall transact such other business as may properly be brought before the meeting. (c) SPECIAL MEETINGS. Special meetings of the stockholders, for any purpose or purposes, unless otherwise prescribed by statute or by Certificate of Incorporation, may be called by the Chairman of the Board of Directors, the President or the Board of Directors pursuant to a resolution approved by a majority of the entire Board of Directors. Business transacted at any special meeting of the stockholders shall be limited to the purposes stated in the notice of such meeting. Section 2. NOTICE OF MEETINGS. Written notice of every meeting of the stockholders, stating the place, date and hour of the meeting and, in the case of a special meeting, the purpose or purposes for which the meeting is called, shall be given not less than ten (10) nor more than sixty (60) days before the date of the meeting to each stockholder entitled to vote at such meeting, except as otherwise provided herein or by law. When a meeting is adjourned to another place, date or time, written notice need not be given of the adjourned meeting if the place, date and time thereof are announced at the meeting at which the adjournment is taken; provided, however, that if the adjournment is for more than thirty days, or if after the adjournment a new record date is fixed for the adjourned meeting, written notice of the place, date and time of the adjourned meeting shall be given in conformity herewith. At any adjourned meeting, any business may be transacted which might have been transacted at the original meeting. Notice of the time, place and purpose of any meeting of the stockholders may be waived in writing either before or after such meeting and will be waived by any stockholder by such stockholder's attendance at the meeting in person or by proxy. Any stockholder so waiving notice of such a meeting shall be bound by the proceedings of any such meeting in all respects as if due notice thereof had been given. At a special meeting, notice of which has been given in accordance with this Section 2, action may not be taken with respect to business, the general nature of which has not been stated in such notice. At an annual meeting, action may be taken with respect to business stated in the notice of such meeting, given in accordance with this Section 2 and with respect to any other business as may properly come before the meeting. Section 3. MANNER OF GIVING NOTICE; AFFIDAVIT OF NOTICE. Written notice of any meeting of stockholders, if mailed, is given when deposited in the United States mail, postage prepaid, directed to the stockholder at his address as it appears on the records of the Corporation. An affidavit of the Secretary or an assistant secretary or of the transfer agent of the Corporation that the notice has been given shall, in the absence of fraud, be prima facie evidence of the facts stated therein. Section 4. STOCKHOLDER LIST. The officer who has charge of the stock ledger of the Corporation shall prepare and make, at least ten (10) days before every meeting of stockholders, a complete list of the stockholders entitled to vote at such meeting, arranged in alphabetical order, and showing the address of each such stockholder and the number of shares registered in the name of each such stockholder. Such list shall be open to examination of any stockholder of the Corporation during ordinary business hours, for any purpose germane to the meeting, for a period of at least ten (10) days prior to the meeting, either at a place within the city where the meeting is to be held, which place shall be specified in the notice of the meeting, or, if not so specified, at the place where the meeting is to be held. The list shall also be produced and kept at the time and place of meeting during the entire time thereof, and subject to the inspection for any purpose germane to the meeting of any stockholder who may be present. 2 Section 5. STOCKHOLDER ACTION. After the Corporation first has a class of securities registered pursuant to Section 12(b) or 12(g) of the Securities Exchange Act of 1934, as amended, any action required or permitted to be taken by the stockholders of the Corporation must be effected at a duly called annual or special meeting of such holders and may not be effected by any consent in writing by such holders. Section 6. QUORUM. The holders of a majority of the stock issued and outstanding and entitled to vote thereat, present in person or represented by proxy, shall constitute a quorum at all meetings of the stockholders for the transaction of business except as otherwise provided by law or by the Certificate of Incorporation. If, however, such quorum shall not be present or represented at any meeting of the stockholders, the stockholders entitled to vote thereat, present in person or represented by proxy, shall have power to adjourn the meeting from time to time, without notice other than announcement at the meeting, until a quorum shall be present or represented. At such adjourned meeting at which a quorum is present or represented, any business may be transacted that might have been transacted at the meeting as originally noticed. The affirmative vote of the majority of shares present in person or represented by proxy at the meeting and entitled to vote on the subject matter shall be the act of the stockholders. Where a separate vote by class is required, the affirmative vote of the majority of shares of such class present in person or represented by proxy at the meeting shall be the act of such class. Section 7. NOTICE OF AGENDA MATTERS. At any annual or special meeting of stockholders, only such business shall be conducted as shall have been brought before the meeting by or at the direction of the Board of Directors or by any stockholder who complies with the procedures set forth in this Section 7. For business properly to be brought before the annual meeting by a stockholder, the stockholder must have given timely notice thereof in proper written form to the Secretary of the Corporation. To be timely, a stockholder's notice must be delivered to or mailed and received by the Secretary of the Corporation not less than ninety (90) days prior to the anniversary date of the Corporation's notice of annual meeting provided with respect to the previous year's annual meeting; provided, however, that in the event that less than forty (40) days' notice or prior public disclosure of the date of the meeting is given or made to stockholders, notice by the stockholder to be timely must be received not later than the close of business on the 10th day following the day on which such notice of the date of the annual meeting was mailed or such public disclosure was made. To be in properly written form, a stockholder's notice to the Secretary shall set forth in writing as to each matter the stockholder proposes to bring before the annual meeting: (i) a brief description of the business desired to be brought before the annual meeting and the reasons for conducting such business at the annual meeting; (ii) the name and address, as they appear on the Corporation's books, of the stockholder proposing such business; (iii) the class and number of shares of the Corporation which are beneficially owned by the stockholder; and (iv) any material interest of the stockholder in such business. Notwithstanding anything in the Bylaws to the contrary, no 3 business shall be conducted at an annual meeting except in accordance with the procedures set forth in this Section 7. The chairman of an annual meeting shall, if the facts warrant, determine and declare to the meeting that business was not properly brought before the meeting in accordance with the provisions of this Section 7, and if he should so determine, he shall so declare to the meeting, and any such business not properly brought before the meeting shall not be transacted. Section 8. PROXIES. At every meeting of the stockholders, each stockholder having the right to vote thereat shall be entitled to vote in person or by proxy. Such proxy shall be appointed by an instrument in writing subscribed by such stockholder and bearing a date not more than three (3) years prior to such meeting, unless such proxy provides for a longer period; and it shall be filed with the Secretary of the Corporation before, or at the time of, the meeting. Section 9. VOTING. The stockholders entitled to vote at any meeting of stockholders shall be determined in accordance with the provisions of Article V, Section 4 of these Bylaws, subject to the provisions of Sections 217 and 218 of the General Corporation Law of Delaware (relating to voting rights of fiduciaries, pledgors and joint owners of stock and to voting trusts and other voting agreements). Except as otherwise provided by statute or by the Certificate of Incorporation, each stockholder shall be entitled at every meeting of the stockholders to one vote for each share of stock having voting power standing in the name of such stockholder on the books of the Corporation on the record date for the meeting and such votes may be cast either in person or by written proxy. Every proxy must be executed in writing by the stockholder or his or her duly authorized attorney. Such proxy shall be filed with the Secretary of the Corporation before or at the time of the meeting. All elections of directors shall be by written ballot, unless otherwise provided in the Certificate of Incorporation. When a quorum is present at any meeting, the vote of the holders of a majority of the stock which has voting power present in person or represented by proxy and which has actually voted shall decide any question properly brought before such meeting, unless the question is one upon which by express provision of law, the Certificate of Incorporation or these Bylaws, a different vote is required, in which case such express provision shall govern and control the decision of such question. Section 10. VOTING OF CERTAIN SHARES. Shares standing in the name of another corporation, domestic or foreign, and entitled to vote may be voted by such officer, agent, or proxy as the bylaws of such corporation may prescribe or, in the absence of such provision, as the Board of Directors of such corporation may determine. Shares standing in the name of a deceased person, a minor or an incompetent and entitled to vote may be voted by his administrator, executor, guardian or conservator, as the case may be, either in person or by proxy. Shares standing in the name of a trustee, receiver or pledgee and entitled to vote maybe voted by such trustee, receiver or pledgee either in person or by proxy as provided by Delaware law. 4 Section 11. TREASURY STOCK. Shares of its own stock belonging to the Corporation or to another corporation, if a majority of the shares entitled to vote in the election of directors of such other corporation is held by the Corporation, shall not be voted at any meeting and shall not be counted in determining the total number of outstanding shares for the purpose of determining whether a quorum is present. Nothing in this section shall be construed to limit the right of the Corporation to vote shares of its own stock held by it in a fiduciary capacity. ARTICLE III DIRECTORS Section 1. POWERS. The business and affairs of the Corporation shall be managed by or under the direction of its Board of Directors, which may exercise all such powers of the Corporation and do all such lawful acts and things as are not by statute or by the Certificate of Incorporation or by these Bylaws directed or required to be exercised or done by the stockholders. Section 2. ELECTION OF DIRECTORS. (a) NUMBER AND TERM OF OFFICE. The Board of Directors shall consist of at least one (1) and not more than eleven (11) directors. The authorized number of directors of the Corporation shall be set initially at five (5), and shall be subject to change as set from time to time pursuant to a resolution approved by a majority of the Board of Directors then in office. The directors shall be classified, with respect to the time for which they severally hold office, into three (3) classes, as nearly equal in number as possible: the term of office of those of the first class to expire at the annual meeting next ensuing; of the second class, one (1) year thereafter; of the third class, two (2) years thereafter; and at each annual election held after such classification and election, directors shall be chosen for a full term to succeed those whose terms expire. Any decrease in the authorized number of directors shall not be effective until the expiration of the term of the directors then in office, unless, at the time of such decrease there shall be vacancies on the Board of Directors which are being eliminated by such decrease. (b) RESIGNATIONS AND VACANCIES. Any director may resign at any time by giving written notice to the Chairman of the Board of Directors, the Chief Executive Officer, the President or the Board of Directors. Any such resignation shall take effect at the date of the receipt of such notice or at any later time specified therein; and, unless otherwise specified therein, the acceptance of such resignation shall not be necessary to make it effective. If, at any other time than the annual meeting of the stockholders, any vacancy occurs in the Board of Directors caused by resignation, death, retirement, disqualification or removal from office of any director or otherwise, or any new directorship is created by an increase in the authorized number of directors by amendment of Section 2 of Article III of these Bylaws, a majority of the directors then in office, although less than a quorum, may choose a successor, or fill the newly created directorship, and the 5 director so chosen shall hold office until the next annual election of directors by the stockholders and until his successor shall be duly elected and qualified, unless sooner displaced. (c) NOTIFICATION OF NOMINATIONS. Subject to the rights of holders of any class or series of stock having a preference over the Common Stock as to dividends or upon liquidation, nominations for the election of directors may be made by the Board of Directors or a proxy committee appointed by the Board of Directors or by any stockholder entitled to vote in the election of directors generally. However, any such stockholder may nominate one or more persons for election as directors at a meeting only if such stockholder has given timely notice in proper written form of his intent to make such nomination or nominations. To be timely, a stockholder's notice must be delivered to or mailed and received by the Secretary of the Corporation not later than ninety (90) days prior to such meeting; provided, however, that in the event that less than forty (40) days' notice or prior public disclosure of the date of the meeting is given or made to stockholders, notice by the stockholder to be timely must be received not later than the close of business on the 10th day following the date on which such notice of the date of such meeting was mailed or such public disclosure was made. To be in proper written form, a stockholder's notice to the Secretary shall set forth: (i) the name and address of the stockholder who intends to make the nomination and of the person or persons to be nominated; (ii) a representation that the stockholder is a holder of record of stock of the Corporation entitled to vote at such meeting and intends to appear in person or by proxy at the meeting to nominate the person or persons specified in the notice; (iii) a description of all arrangements or understandings between the stockholder and each nominee and any other person or persons (naming such person or persons) pursuant to which the nomination or nominations are to be made by the stockholder; (iv) such other information regarding each nominee proposed by such stockholder as would be required to be included in a proxy statement filed pursuant to the proxy rules of the Securities and Exchange Commission had the nominee been nominated, or intended to be nominated, by the Board of Directors; and (v) the consent of each nominee to serve as a director of the Corporation if so elected. The chairman of the meeting may refuse to acknowledge the nomination of any person not made in compliance with the foregoing procedure. Section 3. DIVIDENDS AND RESERVES. Dividends upon stock of the Corporation may be declared by the Board of Directors at any regular or special meeting, pursuant to law. Dividends may be paid in cash, in property, in shares of stock or otherwise in the form, and to the extent, permitted by law. The Board of Directors may set apart, out of any funds of the Corporation available for dividends, a reserve or reserves for working capital or for any other lawful purpose, and also may abolish any such reserve in the manner in which it was created. Section 4. REGULAR MEETINGS. Regular meetings of the Board of Directors may be held without notice immediately after the annual meeting of the stockholders and at such other time and place as shall from time to time be determined by the Board of Directors. 6 Section 5. SPECIAL MEETINGS. Special meetings of the Board of Directors may be called by the Chairman of the Board of Directors, the Chief Executive Officer, the President, the Secretary of the Corporation, or any two (2) directors. Section 6. QUORUM. At all meetings of the Board of Directors, a majority of the total number of directors then in office shall constitute a quorum for the transaction of business, and the act of a majority of the directors present at any meeting at which there is a quorum shall be the act of the Board of Directors, except as may be otherwise specifically provided by statute or by the Certificate of Incorporation. If a quorum shall not be present at any meeting of the Board of Directors, the directors present thereat may adjourn the meeting from time to time to another place, time or date, without notice other than announcement at the meeting, until a quorum shall be present. Section 7. WRITTEN ACTION. Any action required or permitted to be taken at any meeting of the Board of Directors or of any committee thereof may be taken without a meeting if all members of the Board of Directors or committee, as the case may be, consent thereto in writing, and the writing or writings are filed with the minutes or proceedings of the Board of Directors or Committee. Section 8. WAIVER OF NOTICE. The transactions of any meeting of the Board of Directors or any committee, however called and noticed or wherever held, shall be valid as though had at a meeting duly held after regular call and notice, if a quorum be present and if, either before or after the meeting, each of the directors not present signs a written waiver of notice, or a consent to hold such meeting, or an approval of the minutes thereof. All such waivers, consents or approvals shall be filed with the Corporate records or made a part of the minutes of the meeting. Section 9. PARTICIPATION IN MEETINGS BY CONFERENCE TELEPHONE. Members of the Board of Directors, or any committee designated by the Board of Directors, may participate in a meeting of the Board of Directors, or any such committee, by means of conference telephone or similar communications equipment by means of which all persons participating in the meeting can hear each other, and such participation in a meeting shall constitute presence in person at the meeting. Section 10. COMMITTEES. The Board of Directors may, by resolution passed by a majority of the entire Board of Directors, designate one or more committees, each committee to consist of one or more of the directors of the Corporation and each to have such lawfully delegable powers and duties as the Board of Directors may confer. Each such committee shall serve at the pleasure of the Board of Directors. The Board of Directors may designate one or more directors as alternate members of any committee, who may replace any absent or disqualified member at any meeting of the committee. Except as otherwise provided by law, any such committee, to the extent provided in the resolution of the Board of Directors, shall have and may exercise all the powers and authority of the Board of Directors in the management of the business and affairs of the Corporation, and may authorize the seal of the Corporation to be affixed to all papers which may require it; but 7 no such committee shall have the power or authority in reference to approving, adopting or recommending to the stockholders any action or matter expressly required by law to be submitted to stockholders for approval, or adopting, amending or repealing the Bylaws of the Corporation. Any committee or committees so designated by the Board of Directors shall have such name or names as may be determined from time to time by resolution adopted by the Board of Directors. Unless otherwise prescribed by the Board of Directors, a majority of the members of the committee shall constitute a quorum for the transaction of business, and the act of a majority of the members present at a meeting at which there is a quorum shall be the act of such committee. Each committee shall prescribe its own rules for calling and holding meetings and its method of procedure, subject to any rules prescribed by the Board of Directors, and shall keep a written record of all actions taken by it. Section 11. FEES AND COMPENSATION OF DIRECTORS. Each director may receive such fees and other compensation, along with reimbursement of expenses incurred on behalf of the Corporation or in connection with attendance at meetings, as the Board of Directors may from time to time determine. No such payment of fees or other compensation shall be construed to preclude any director from serving the Corporation in any other capacity and receiving fees and compensation for such services. Section 12. RULES. The Board of Directors may adopt such special rules and regulations for the conduct of their meetings and the management of the affairs of the Corporation as they may deem proper, not inconsistent with law or these Bylaws. Section 13. INTERESTED DIRECTORS. No contract or transaction between the Corporation and one or more of its directors or officers, or between the Corporation and any other corporation, partnership, association, or other organization in which one or more of its directors or officers are directors or officers, or have a financial interest, shall be void or voidable solely for this reason, or solely because the directors or officers are present at or participate in the meeting of the Board of Directors or the committee thereof which authorizes the contract or transaction, or solely because his or their votes are counted for such purpose if: (i) the material facts as to his or their relationship or interest and as to the contract or transaction are disclosed or are known to the Board of Directors or the committee, and the Board of Directors or committee in good faith authorizes the contract or transaction by the affirmative vote of a majority of the disinterested directors, even though the disinterested directors be less than a quorum; or (ii) the material facts as to his or their relationship or interest and as to the contract or transaction is specifically approved in good faith by vote of the shareholders; or (iii) the contract or transaction is fair as to the Corporation as of the time it is authorized, approved or ratified by the Board of Directors, a committee thereof, or the stockholders. Common or interested directors may be counted in determining the presence of a quorum at a meeting of the Board of Directors or of a committee which authorizes the contract or transaction. 8 ARTICLE IV OFFICERS Section 1. OFFICES AND OFFICIAL POSITIONS. The officers of the Corporation shall be chosen by the Board of Directors and may include a Chairman of the Board of Directors (who must be a director as chosen by the Board of Directors) and shall include a Chief Executive Officer, a President, one or more Vice Presidents (if so elected by the Board of Directors), a Secretary and a Chief Financial Officer. The Board of Directors also may appoint a Treasurer and such Assistant Vice Presidents, Assistant Secretaries, Assistant Treasurers, and other officers as the Board of Directors shall determine. Any two or more offices may be held by the same person. With the exception of the Chairman of the Board of Directors, none of the officers need be a director, a stockholder of the Corporation or a resident of the State of Delaware. Section 2. COMPENSATION. The compensation of all officers and agents of the Corporation who are also directors of the Corporation shall be fixed by the Board of Directors. The Board of Directors may delegate the power to fix the compensation of other officers and agents of the Corporation to an officer of the Corporation. Section 3. SUCCESSION. The officers of the Corporation shall hold office until their successors are elected and qualified. Any officer elected or appointed by the Board of Directors may be removed at any time by the affirmative vote of a majority of the Board of Directors. Any vacancy occurring in any office of the Corporation may be filled by the Board of Directors. Section 4. RESIGNATIONS. Any officer may resign at any time by giving written notice to the Board of Directors (or to a principal officer if the Board of Directors has delegated to such principal officer the power to appoint and to remove such officer). The resignation of any officer shall take effect upon receipt of notice thereof or at such later time as shall be specified in such notice; unless otherwise specified therein, the acceptance of such resignation shall not be necessary to make it effective. Section 5. AUTHORITY AND DUTIES. Each of the officers of the Corporation shall have such authority and shall perform such duties incident to each of their respective offices and such other duties as may be specified from time to time by the Board of Directors in a resolution which is not inconsistent with these Bylaws. Section 6. APPROVAL OF LOANS TO OFFICERS. The Corporation may lend money to, or guarantee any obligation of, or otherwise assist any officer or any other employee of the Corporation or of its subsidiary, including any officer or employee who is a director of the Corporation or its subsidiary, whenever, in the judgment of the directors, such loan, guaranty or assistance may 9 reasonably be expected to benefit the Corporation. The loan, guaranty or other assistance may be with or without interest and may be unsecured, or secured in such manner as the Board of Directors shall approve, including, without limitation, a pledge of shares of stock of the Corporation. Nothing contained in this section shall be deemed to deny, limit or restrict the powers of guaranty or warranty of the Corporation at common law or under any statute. ARTICLE V CONTRACTS, LOANS, CHECKS AND DEPOSITS Section 1. CONTRACTS AND OTHER INSTRUMENTS. The Board of Directors may authorize any officer or officers, agent or agents, to enter into any contract or execute and deliver any instrument in the name of and on behalf of the Corporation, or of any division thereof, and such authority may be general or confirmed to specific instances. Section 2. LOANS. No loans shall be contracted on behalf of the Corporation, or any division thereof, and no evidence of indebtedness shall be issued in the name of the Corporation or any division thereof, unless authorized by a resolution of the Board of Directors. Such authority may be general or confined to specific instances. Section 3. CHECKS, DRAFTS, ETC. All checks, demands, drafts or other orders for the payment of money, notes or other evidences of indebtedness issued in the name of the Corporation, or any division thereof, shall be signed by such officer or officers, agent or agents of the Corporation, and in such manner, as shall from time to time be authorized by the Board of Directors. Section 4. DEPOSITS. All funds of the Corporation, or any division thereof, not otherwise employed shall be deposited from time to time to the credit of the Corporation in such banks, trust companies or other depositories as the Board of Directors may select. ARTICLE VI STOCKS Section 1. CERTIFICATES. Certificates representing shares of stock of the Corporation shall be in such form as shall be determined by the Board of Directors, subject to applicable legal requirements. Such certificates shall be numbered and their issuance recorded in the books of the Corporation, and such certificate shall exhibit the holder's name and the number of shares and shall be signed by, or in the name of the Corporation by, the Chairman of the Board of Directors or the President and the Secretary or an Assistant Secretary or the Treasurer or an Assistant Treasurer of the Corporation and shall bear the corporate seal. Where any such certificate is countersigned by 10 a transfer agent or a registrar other than the Corporation or its employee, the signatures of any such officers of the Corporation and the seal of the Corporation, if any, upon such certificates may be facsimiles, engraved or printed. Section 2. TRANSFER. Upon surrender to the Corporation or the transfer agent of the Corporation of a certificate for shares duly endorsed or accompanied by proper evidence of succession, assignment or authority to transfer, it shall be the duty of the Corporation to issue, or to cause its transfer agent to issue, a new certificate to the person entitled thereto, cancel the old certificate and record the transaction upon its books. Section 3. LOST, STOLEN OR DESTROYED CERTIFICATES. The President or the Board of Directors may direct a new certificate or certificates to be issued in place of any certificate or certificates theretofore issued by the Corporation alleged to have been lost, stolen or destroyed, upon the making of an affidavit of that fact, satisfactory to the President, by the person claiming the certificate of stock to be lost, stolen or destroyed. As a condition precedent to the issuance of a new certificate or certificates the President requires the owner of such lost, stolen or destroyed certificate or certificates to give the Corporation a bond in such sum and with such surety or sureties as the President may direct as indemnity against any claims that may be made against the Corporation with respect to the certificate alleged to have been lost, stolen or destroyed or the issuance of the new certificate. Section 4. RECORD DATE. In order that the Corporation may determine the stockholders entitled to notice of or to vote at any meeting of stockholders or any adjournment thereof, the Board of Directors may fix a record date, which record date shall not precede the date upon which the resolution fixing the record date is adopted by the Board of Directors, and which record date shall not be more than sixty (60) nor less than ten (10) days before the date of such meeting. If no record date is fixed by the Board of Directors, the record date for determining stockholders entitled to notice of or to vote at a meeting of stockholders shall be at the close of business on the day next preceding the day on which notice is given, or, if notice is waived, at the close of business on the day next preceding the day on which the meeting is held. A determination of stockholders of record entitled to notice of or to vote at a meeting of stockholders shall apply to any adjournment of the meeting; provided, however, that the Board of Directors may fix a new record date for the adjourned meeting. In order that the Corporation may determine the stockholders entitled to consent to corporate action in writing without a meeting, the Board of Directors may fix a record date, which record date shall not precede the date upon which the resolution fixing the record date is adopted by the Board of Directors, and which date shall not be more than ten (10) days after the date upon which the resolution fixing the record date is adopted by the Board of Directors. If no record date has been fixed by the Board of Directors, the record date for determining stockholders entitled to consent to corporate action in writing without a meeting, when no prior action by the Board of Directors is required by this chapter, shall be the first date on which a signed written consent setting 11 forth the action taken or proposed to be taken is delivered to the Corporation by delivery to its registered office in Delaware, its principal place of business, or an officer or agent of the Corporation having custody of the book in which proceedings of meetings of stockholders are recorded. Delivery made to a Corporation's registered office shall be by hand or by certified or registered mail, return receipt requested. If no record date has been fixed by the Board of Directors and prior action by the Board of Directors is required by law, the record date for determining stockholders entitled to consent to corporate action in writing without a meeting shall be at the close of business on the day on which the Board of Directors adopts the resolution taking such prior action. In order that the Corporation may determine the stockholders entitled to receive payment of any dividend or other distribution or allotment of any rights or the stockholders entitled to exercise any rights in respect of any change, conversion or exchange of stock, or for the purpose of any other lawful action, the Board of Directors may fix a record date, which record date shall not precede the date upon which the resolution fixing the record date is adopted, and which record date shall be not more than sixty (60) days prior to such action. If no record date is fixed, the record date for determining stockholders for any such purpose shall be at the close of business on the day on which the Board of Directors adopts the resolution relating thereto. Section 5. REGISTERED OWNERS. The Corporation shall be entitled to recognize the exclusive right of a person registered on its books as the owner of shares to receive dividends, and to vote as such owner, and to hold liable for calls and assessments a person registered on its books as the owner of shares, and shall not be bound to recognize any equitable or other claim to or interest in such share or shares on the part of any other person, whether or not it shall have express or other notice thereof, except as otherwise required by law. ARTICLE VII INDEMNIFICATION AND INSURANCE Section 1. INDEMNIFICATION. The Corporation, to the maximum extent permitted by the General Corporation Law of the State of Delaware, including, without limitation, to the fullest extent permitted by Section 145 of the General Corporation Law of the State of Delaware (as that Section may be amended and supplemented from time to time), indemnify any director, officer or trustee which it shall have power to indemnify under Section 145 against any expenses, liabilities or other matters referred to in or covered by that Section. The indemnification provided for in this Article (i) shall not be deemed exclusive of any other rights to which those indemnified may be entitled under any Bylaw, agreement or vote of stockholders or disinterested directors or otherwise, both as to action in their official capacities and as to action in another capacity while holding such office, (ii) shall continue as to a person who has ceased to be a director, officer or trustee and (iii) shall inure to the benefit of the heirs, executors and administrators of such a person. The 12 Corporation's obligation to provide indemnification under this Article shall be offset to the extent of any other source of indemnification or any otherwise applicable insurance coverage under a policy maintained by the Corporation or any other person. Expenses incurred by a director of the Corporation in defending a civil or criminal action, suit or proceeding by reason of the fact that he is or was a director of the Corporation (or was serving at the Corporation's request as a director or officer of another corporation) shall be paid by the Corporation in advance of the final disposition of such action, suit or proceeding upon receipt of an undertaking by or on behalf of such director to repay such amount if it shall ultimately be determined that he is not entitled to be indemnified by the Corporation as authorized by relevant sections of the General Corporation Law of the State of Delaware. To assure indemnification under this Article of all such persons who are determined by the Corporation or otherwise to be or to have been "fiduciaries" of any employee benefit plan of the Corporation which may exist from time to time, such Section 145 shall, for the purposes of this Article, be interpreted as follows: an "other enterprise" shall be deemed to include such an employee benefit plan, including, without limitation, any plan of the Corporation which is governed by the Act of Congress entitled "Employee Retirement Income Security Act of 1974," as amended from time to time; the Corporation shall be deemed to have requested a person to serve an employee benefit plan where the performance by such person of his duties to the Corporation also imposes duties on, or otherwise involves services by, such person to the plan or participants or beneficiaries of the plan; excise taxes assessed on a person with respect to an employee benefit plan pursuant to such Act of Congress shall be deemed "fines"; and action taken or omitted by a person with respect to an employee benefit plan in the performance of such person's duties for a purpose reasonably believed by such person to be in the interest of the participants and beneficiaries of the plan shall be deemed to be for a purpose which is not opposed to the best interests of the Corporation. Section 2. CONTRACT. The provisions of Section 1 of this Article VII shall be deemed to be a contract between the Corporation and each director and officer who serves in such capacity at any time while such Bylaw is in effect, and any repeal or modification thereof shall not affect any rights or obligations then existing with respect to any state of facts then or theretofore existing or any action, suit or proceeding theretofore or thereafter based in whole or in part upon any such state of facts. Section 3. NON-EXCLUSIVITY. The rights of indemnification provided by this Article VII shall not be deemed exclusive of any other rights to which any director or officer of the Corporation may be entitled apart from the provisions of this Article VII. Section 4. INDEMNIFICATION OF EMPLOYEES AND AGENTS. The Board of Directors in its discretion shall have the power on behalf of the Corporation to indemnify any person, other than a director or officer, made a party to any action, suit or proceeding by reason of the fact that such person or such person's testator or intestate, is or was an employee or agent of the Corporation. 13 Section 5. INSURANCE. The Corporation may purchase and maintain insurance on behalf of any person who is or was a director, officer, employee or agent of the Corporation or is or was serving at the request of the Corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise against any liability asserted against him and incurred by him in any such capacity, or arising out of his status as such, whether or not the Corporation would have the power to indemnify him against such liability under the provisions of the General Corporation Law of Delaware. ARTICLE VIII GENERAL PROVISIONS Section 1. FISCAL YEAR. The fiscal year of the Corporation shall be fixed from time to time by resolution of the Board of Directors. Section 2. CORPORATE SEAL. The Board of Directors may adopt a corporate seal and use the same by causing it or a facsimile thereof to be impressed or affixed or reproduced or otherwise. Section 3. RELIANCE UPON BOOKS, REPORTS AND RECORDS. Each director, each member of a committee designated by the Board of Directors, and each officer of the Corporation shall, in the performance of his or her duties, be fully protected in relying in good faith upon the records of the Corporation and upon such information, opinions, reports or statements presented to the Corporation by any of the Corporation's officers or employees, or committees of the Board of Directors, or by any other person as to matters the director, committee member or officer believes are within such other person's professional or expert competence and who has been selected with reasonable care by or on behalf of the Corporation. Section 4. TIME PERIODS. In applying any provision of these Bylaws which requires that an act be done or not be done a specified number of days prior to an event or that an act be done during a period of a specified number of days prior to an event, calendar days shall be used, the day of the doing of the act shall be excluded and the day of the event shall be included. Section 5. DIVIDENDS. Dividends upon the capital stock of the Corporation, subject to the provisions of the Certificate of Incorporation, if any, may be declared by the Board of Directors at any regular or special meeting, pursuant to statute. Dividends may be paid in cash, in property, or in shares of the capital stock, subject to the provisions of the Certificate of Incorporation. 14 Before payment of any dividend, there may be set aside out of any funds of the Corporation available for dividends such sum or sums as the directors from time to time, in their absolute discretion, think proper as a reserve or reserves to meet contingencies, or for equalizing dividends, or for repairing or maintaining any property of the Corporation, or for such other purposes as the directors shall think conducive to the interest of the Corporation, and the directors may modify or abolish any such reserve in the manner in which it was created. Section 6. CONSTRUCTION AND DEFINITIONS. Unless the context requires otherwise, the general provisions, rules of construction and definitions in the General Corporation Law of the State of Delaware shall govern the construction of these Bylaws. ARTICLE IX AMENDMENTS Section 1. AMENDMENTS. Subject to the provisions of the Certificate of Incorporation, these Bylaws may be altered, amended or repealed or new Bylaws may be adopted by the stockholders or by the Board of Directors, when such power is conferred upon the Board of Directors by the Certificate of Incorporation, at any regular meeting of the stockholders or of the Board of Directors or at any special meeting thereof duly called for that purpose if notice of such alteration, amendment, repeal or adoption of new Bylaws be contained in the notice of such special meeting. Subject to the laws of the State of Delaware, the Certificate of Incorporation and these Bylaws, the Board of Directors may, by majority vote of those present at any meeting at which a quorum is present amend the Bylaws, or enact such other bylaws as in their judgment may be advisable for the regulation of the conduct of the affairs of the Corporation. 15 CERTIFICATE OF SECRETARY I, Fred McGee, Secretary of DAOU Systems, Inc., a Delaware corporation, do hereby certify that the foregoing Bylaws of DAOU Systems, Inc. are the duly adopted Bylaws of said Corporation as they are in effect on the date hereof. Executed at San Diego, California effective as of December 3, 1996. /s/ Fred McGee ----------------------------- Fred McGee, Secretary 16 EX-10.2 6 EXHIBIT 10.2 AMEND #1 TO 1996 STOCK OPTION AGREE AMENDMENT NO. 1 TO DAOU SYSTEMS, INC. 1996 STOCK OPTION PLAN 1. PURPOSE. The DAOU SYSTEMS, INC. STOCK OPTION PLAN (the "PLAN") is intended to provide to officers, directors, key employees, and consultants of the corporation an opportunity to acquire a proprietary interest in the corporation, to encourage such key individuals to remain in the employ of or to contract with the corporation, and to attract and retain new employees, consultants, and directors with outstanding qualifications. Pursuant to the Plan, the Corporation may grant to officers, directors, consultants, and key employees of the Corporation options to purchase shares of common stock of the Corporation upon such terms and conditions as provided herein. 2. DEFINITIONS. (a) "AFFILIATE" means any corporation (other than the Corporation) in an unbroken chain of corporations that includes the Corporation if each of such corporations, other than the last corporation in the chain, owns at least 50% of the total voting power of one of the other corporations. (b) "BOARD" means the Board of Directors of the Corporation. (c) "CODE" means the Internal Revenue Code of 1986, as amended. (d) "COMMITTEE" means the committee appointed by the Board to administer the Plan, or if no such committee is appointed, the Board. (e) "COMMON STOCK" means the voting common stock of the Corporation. (f) "CONSULTANT" means any person who, or any employee of any firm which, is engaged by the Company or any Affiliate to render consulting services and is compensated for such consulting services, and any non-employee director of the Company whether compensated for such services or not. (g) "CORPORATION" means DAOU Systems, Inc., a California corporation. (h) "EFFECTIVE DATE" means January 1, 1996. (i) "EMPLOYEE" means any individual who is employed, within the meaning of Section 3401 of the Code and the regulations thereunder, by the Corporation or by any Affiliate. For purposes of the Plan and only for purposes of the Plan, and in regard to Nonstatutory Stock Options but not for Incentive Stock Options, a Consultant or director of the Corporation or any Affiliate will be deemed to be an Employee, and service as a Consultant or director with the Corporation or any Affiliate will be deemed to be employment, but no Incentive Stock Option 1 will be granted to a Consultant or director who is not an employee of the Corporation or any Affiliate within the meaning of Section 3401 of the Code and the regulations thereunder. In the case of a non-employee director or Consultant, the provisions governing when a termination of employment has occurred for purposes of the Plan will be set forth in the written Stock Option Agreement between the Optionee and the Corporation, or, if not so set forth, the Committee will have the discretion to determine when a termination of "employment" has occurred for purposes of the Plan. (j) "ESCROW AGENT" means the person selected by the Corporation, if any, to hold the stock certificates representing Shares issued in the name of an Optionee pursuant to such Optionee's exercise of an Option. (k) "EXCHANGE ACT" means the Securities Exchange Act of 1934, as amended. (l) "EXERCISE PRICE" means the price per Share at which an Option may be exercised, as determined by the Committee and as specified in the Optionee's stock option agreement. (m) "FAIR MARKET VALUE" means the value of each Share as determined by the Board, subject to the limitations of Section 260.140.50 of Title 10 of the California Code of Regulations. (n) "INCENTIVE STOCK OPTION" means an Option of the type described in Section 422(b) of the Code. (o) "JOINT ESCROW INSTRUCTIONS" means joint escrow instructions entered into between Optionee and the Corporation in such form as may be approved by the Committee from time to time. (p) "NONSTATUTORY STOCK OPTION" means an Option of the type not described in Section 422(b) or 423(b) of the Code. (q) "OPTION" means an option to purchase Common Stock granted pursuant to the Plan. (r) "OPTIONEE" means any person who holds an Option pursuant to the Plan. (s) "PLAN" means this stock option plan as it may be amended from time to time. (t) "PURCHASE PRICE" means at any particular time the Exercise Price times the number of Shares for which an Option is being exercised. (u) "SHARE" means one share of authorized Common Stock. 2 3. ADMINISTRATION. (a) THE COMMITTEE. (i) The Board may administer the Plan or appoint a Committee to administer the Plan. The Committee will consist of not less than two members who may also be members of the Board. Members of the Board or the Committee who are either eligible for Options or have been granted Options may vote on any matters affecting the administration of the Plan or the grant of any Options pursuant to the Plan, except that no such member will act upon the granting of an Option to himself or herself, but any such member may be counted in determining the existence of a quorum at any meeting of the Committee and will be excluded in determining unanimity of an act in writing, for any action which is taken with respect to the granting of an Option to such member. (ii) If the Corporation registers any class of any equity security pursuant to Section 12 of the Exchange Act, from the effective date of such registration until six months after the termination of such registration, the Plan will be administered by a Committee of directors which will consist of not less than two members, who during the one year prior to service as an administrator of the Plan, will not have been granted or awarded equity securities pursuant to the Plan or any other plan of the Corporation or any of its Affiliates except as permitted under Rule 16b-3 under the Exchange Act which provides that participation in a formula plan meeting the conditions of Rule 16(b)(3)(c)(2)(ii) or in an ongoing securities acquisition plan meeting the conditions in Rule 16(b)(3)(d)(2)(i) will not disqualify a member of the Committee from serving as an administrator of the Plan. In addition, an election to receive an annual retainer fee in either cash or an equivalent amount of securities, or partly in cash and partly in securities, will not disqualify a member of the Committee from serving as an administrator of the Plan. The Board may from time to time designate individuals as ineligible to participate in the Plan for a specified period in order to become eligible to be a member of the Committee. (b) POWERS OF THE COMMITTEE. Subject to the provisions of the Plan, the Committee will have the authority, in its discretion and on behalf of the Corporation: (i) to grant Options; (ii) to determine the Exercise Price per Share of Options to be granted; (iii) to determine the Employees to whom, and the time or times at which, Options will be granted and the number of Shares for which an Option will be exercisable; (iv) to interpret the Plan; (v) to prescribe, amend, and rescind rules and regulations relating to the Plan; 3 (vi) to determine the terms and provisions of each Option granted and, with the consent of the holder thereof, modify or amend each Option; (vii) to accelerate or defer, with the consent of the Optionee, the exercise date of any Option; (viii) to authorize any person to execute on behalf of the Corporation any instrument required to effectuate the grant of an Option previously granted by the Committee; (ix) with the consent of the Optionee, to reprice, cancel, and regrant, or otherwise adjust the Exercise Price of an Option previously granted by the Committee; and (x) to make all other determinations deemed necessary or advisable for the administration of the Plan. (c) BOARD'S DETERMINATION OF FAIR MARKET VALUE. The Board will have the authority to determine, upon review of relevant information, the Fair Market Value of the Common Stock, subject to the provisions of the Plan and irrespective of whether the Board has appointed a Committee to administer the Plan. The Board may delegate this authority to the Committee. (d) COMMITTEE'S INTERPRETATION OF THE PLAN. The interpretation and construction by the Committee of any provision of the Plan or of any Option granted hereunder will be final and binding on all parties claiming an interest in an Option granted under the Plan. No member of the Committee will be liable for any action or determination made in good faith with respect to the Plan or any Option. (e) ALL COMMITTEE ACTIONS TO BE IN WRITING. Any and all actions of the Committee taken in exercise of the powers granted to it in this SECTION 3 will be in writing. 4. PARTICIPATION. (a) ELIGIBILITY. The Optionees will be such persons as the Committee may select from among the Employees, provided that Consultants are not eligible to receive Incentive Stock Options. (b) TEN PERCENT SHAREHOLDERS. Any Employee who owns Stock possessing more than 10% of the total combined voting power of all classes of outstanding stock of the Corporation or any Affiliate will not be eligible to receive an Option unless: (i) the Exercise Price of the Shares subject to such Option when granted is at least 110% of the Fair Market Value of such Shares, and (ii) such Option by its terms is not exercisable after the expiration of five years from the date of grant. 4 (c) STOCK OWNERSHIP. For purposes of SECTION 4(b), in determining stock ownership, an Employee will be considered as owning the stock owned, directly or indirectly, by or for his or her brothers and sisters, spouse, ancestors, and lineal descendants. Stock owned, directly or indirectly, by or for a corporation, partnership, estate, or trust will be considered as being owned proportionately by or for its shareholders, partners, or beneficiaries, respectively. Stock with respect to which such Employee or any other person holds an Option will be disregarded. (d) OUTSTANDING STOCK. For purposes of SECTION 4(b), the term "outstanding stock" will include all stock actually issued and outstanding immediately after the grant of the Option to the Optionee but will not include any share for which an Option is exercisable by any person. 5. SHARES. (a) SHARES SUBJECT TO THIS PLAN. The aggregate number of Shares which may be issued upon exercise of Options under the Plan will not exceed Nine Hundred and Seventy Five Thousand (975,000) shares of Common Stock, subject to adjustment pursuant to SECTION 9 . (b) OPTIONS NOT TO EXCEED SHARES AVAILABLE. The number of Shares for which an Option is exercisable at any time will not exceed the number of Shares remaining available for issuance under the Plan. If any Option expires or is terminated, the number of Shares for which such Option was exercisable may be made exercisable pursuant to other Options under the Plan. If the Corporation reacquires any Shares pursuant to SECTIONS 11 or 12, such Shares may again be made exercisable pursuant to an Option. The limitations established by this SECTION 5(b) will be subject to adjustment in the manner provided in SECTION 9 upon the occurrence of an event specified therein. 6. TERMS AND CONDITIONS OF OPTIONS. (a) STOCK OPTION AGREEMENTS. Options will be evidenced by written stock option agreements between the Optionee and the Corporation in such form as the Committee will from time to time determine. No Option or purported Option will be a valid and binding obligation of the Corporation unless so evidenced in writing. (b) NUMBER OF SHARES. Each stock option agreement will state the number of Shares for which the Option is exercisable and will provide for the adjustment thereof in accordance with SECTION 9 . (c) VESTING. An Optionee may not exercise his or her Option for any Shares until the Option, in regard to such Shares, has vested. Each stock option agreement will include a vesting schedule which will show when the Option becomes exercisable, provided each Option will vest at a rate of at least 20% per year over a period of five years with the first 20% becoming exercisable on the first anniversary of the date the Options were granted. The vesting schedule will not impose upon the Corporation or any Affiliate any obligation to retain the Optionee in its 5 employ or under contract for any period or otherwise change the employment-at- will status of an Optionee who is an employee of the Corporation or any Affiliate. (d) LAPSE OF OPTIONS. Each stock option agreement will state the time or times when the Option covered thereby lapses and becomes unexercisable in part or in full. An Option will lapse on the earliest of the following events (unless otherwise determined by the Committee and reflected in an option agreement): (i) The tenth anniversary of the date of granting the Option; (ii) The first anniversary of the Optionee's death; (iii) The first anniversary of the date the Optionee ceases to be an Employee due to total and permanent disability; (iv) On the date provided in SECTION 6(h)(i), unless with respect to a Nonstatutory Stock Option, the Committee otherwise extends such period before the applicable expiration date; (v) On the date provided in SECTION 9 for a transaction described in such Section; (vi) The date the Optionee files or has filed against him or her a petition in bankruptcy; or (vii) The expiration date specified in an Optionee's stock option agreement. (e) EXERCISE PRICE. Each stock option agreement will state the Exercise Price for the Shares for which the Option is exercisable. Subject to SECTION 4(B), the Exercise Price of an Incentive Stock Option and a Nonstatutory Stock Option will, when granted, be not less than 100% and 85% of the Fair Market Value of the Shares for which the Option is exercisable, respectively, and not less than the par value of the Shares. (f) MEDIUM AND TIME OF PAYMENT. The Purchase Price will be payable in full in cash upon the exercise of an Option but the Committee may allow the Optionee to pay the Purchase Price: (i) by surrendering Shares in good form for transfer, owned by the Optionee for more than 12 months and having a Fair Market Value on the date of exercise equal to the Purchase Price; or (ii) in any combination of such consideration or such other consideration and method of payment for the issuance of Shares to the extent permitted under applicable law as long as the sum of the cash so paid, the Fair Market Value of the Shares so 6 surrendered. (iii) The Committee or a stock option agreement may prescribe requirements with respect to the exercise of Options, including the submission by the Optionee of such forms and documents as the Committee may require and, the delivery by the Optionee of cash sufficient to satisfy applicable withholding requirements. The Committee may vary the exercise requirements and procedures from time to time to facilitate, for example, the broker-assisted exercise of Options. (g) NONTRANSFERABILITY OF OPTIONS. During the lifetime of the Optionee, the Option will be exercisable only by the Optionee or the Optionee's conservator or legal representative and will not be assignable or transferable except pursuant to a qualified domestic relations order as defined by the Code. In the event of the Optionee's death, the Option will not be transferable by the Optionee other than by will or the laws of descent and distribution. (h) TERMINATION OF EMPLOYMENT OTHER THAN BY DEATH OR DISABILITY. (i) If an Optionee ceases to be an Employee for any reason other than his or her death or disability, the Optionee will have the right, subject to the provisions of this SECTION 6, to exercise any Option held by the Optionee for 30 days after his or her termination of employment, but not beyond the otherwise applicable term of the Option and only to the extent that on such date of termination of employment the Optionee's right to exercise such Option had vested. (ii) For purposes of this SECTION 6(h), the employment relationship will be treated as continuing intact while the Optionee is an active employee of the Corporation or any Affiliate, or is on military leave, sick leave, or other bona fide leave of absence to be determined in the sole discretion of the Committee. The preceding sentence notwithstanding, in the case of an Incentive Stock Option, employment will be deemed to terminate on the date the Optionee ceases active employment with the Corporation or any Affiliate, unless the Optionee's reemployment rights are guaranteed by statute or contract. (i) DEATH OF OPTIONEE. If an Optionee dies while an Employee, or after ceasing to be an Employee but during the period while he or she could have exercised an Option under SECTION 6(h), any Option granted to the Optionee may be exercised, to the extent it had vested at the time of death and subject to the Plan, at any time within 12 months after the Optionee's death, by the executors or administrators of his or her estate or by any person or persons who acquire the Option by will or the laws of descent and distribution, but not beyond the otherwise applicable term of the Option. (j) DISABILITY OF OPTIONEE. If an Optionee ceases to be an Employee due to becoming totally and permanently disabled within the meaning of Section 22(e)(3) of the Code, any Option granted to the Optionee may be exercised to the extent it had vested at the time of cessation and, subject to the Plan, at any time within 12 months after the Optionee's termination of employment, but not beyond the otherwise applicable term of the Option. 7 (k) RIGHTS AS A SHAREHOLDER. An Optionee, or a transferee of an Optionee, will have no rights as a shareholder of the Corporation with respect to any Shares for which his or her Option is exercisable until the date of the issuance of a stock certificate for such Shares. No adjustment will be made for dividends, ordinary or extraordinary or whether in currency, securities, or other property, distributions, or other rights for which the record date is prior to the date such stock certificate is issued, except as provided in SECTION 9. (l) MODIFICATION, EXTENSION, AND RENEWAL OF OPTIONS. Within the limitations of the Plan, the Committee may modify, extend or renew outstanding Options or accept the cancellation of outstanding Options for the granting of new Options in substitution therefor. Notwithstanding the preceding sentence, no modification of an Option will, without the consent of the Optionee, alter or impair any rights or obligations under any Option previously granted. (m) OTHER PROVISIONS. The stock option agreements authorized under the Plan may contain such other provisions which are not inconsistent with the terms of the Plan, including, without limitation, restrictions upon the exercise of the Option, as the Committee will deem advisable. 7. $100,000 PER YEAR LIMITATION ON VESTING OF ISOS. To the extent that the Fair Market Value of Shares (determined for each Share as of the date of grant of the Option covering such Share) subject to Options granted under this Plan (or any other plan of the Corporation or any Affiliate) which are designated as Incentive Stock Options and which become exercisable by an Optionee for the first time during a single calendar year exceeds $100,000, the Option(s) (or portion thereof) covering such Shares will be recharacterized (to the extent of such excess over $100,000) as a Nonstatutory Stock Option. In determining which Option(s) will be treated as Nonstatutory Stock Options under the preceding sentence, the Options will be taken into account in the order granted, with the result that a later granted Option will be recharacterized as a Nonstatutory Stock Option prior to such recharacterization of a previously granted Option. 8. TERM OF PLAN. Options may be granted pursuant to the Plan until a date no more than 10 years from the date the Plan is adopted or the date the Plan is approved by the shareholders of the Corporation, whichever is earlier, and all Options which are outstanding on such date will remain in effect until they are exercised or expire by their terms. 9. RECAPITALIZATION, TAKEOVERS, AND LIQUIDATIONS. (a) REORGANIZATIONS. The number of Shares covered by the Plan, as provided in SECTION 5, and the number of Shares for which each Option is exercisable will be proportionately adjusted for any increase or decrease in the number of issued Shares resulting from the payment of a stock split, a reverse stock split, a stock dividend, recapitalization, combination or reclassification of the Corporation's stock or any other event which results in an increase or decrease in the number of issued Shares effected without receipt of consideration by the Corporation, and the Exercise Price will be proportionately increased in the event the number of Shares subject to such Option are decreased and will be proportionately decreased in the event 8 the number of Shares subject to such Option are increased. For the purposes of this SUBSECTION 9(a), conversion of any convertible securities of the Corporation will not be deemed to have been "effected without receipt of consideration." Adjustments will be made by the Board, whose determination in that respect will be final, binding and conclusive. Except as expressly provided in this Plan, no issuance by the Corporation of shares of stock of any class, or securities convertible into shares of stock of any class, will affect, and no adjustment by reason thereof will be made with respect to, the number or price of Shares subject to an Option. (b) LIQUIDATION. In the event of the dissolution or liquidation of the Corporation, each Option will terminate immediately prior to the consummation of such action. The Committee will notify the Optionee not less than 15 days prior to the proposed consummation of a pending dissolution or liquidation, and the Option will be exercisable as to all Shares which are vested prior to expiration until immediately prior to the consummation of such action. (c) MERGER. In the event of (i) a proposed merger of the Corporation with or into another corporation, as a result of which the Corporation is not the surviving corporation and (ii) the Option is not assumed or an equivalent option substituted by the successor corporation or a parent or subsidiary of the successor corporation, then in such case each Option will terminate immediately prior to the consummation of such transaction. The Committee will notify the Optionee not less than 15 days prior to the proposed consummation of such transaction, and the Option will be exercisable as to all Shares which are vested prior to expiration and until immediately prior to the consummation of such transaction. (d) DETERMINATION BY COMMITTEE. All adjustments described in this SECTION 9 will be made by the Committee, whose determination will be conclusive and binding on all persons. (e) LIMITATION ON RIGHTS OF OPTIONEE. Except as expressly provided in this SECTION 9, no Optionee will have any rights by reason of any payment of any stock dividend, stock split or reverse stock split or any other increase or decrease in the number of shares of stock of any class, or by reason of any reorganization, consolidation, dissolution, liquidation, merger, exchange, split-up or reverse split-up, or spin-off of assets or stock of another corporation. Any issuance by the Corporation of Shares, Options or securities convertible into Shares or Options will not affect, and no adjustment by reason thereof will be made with respect to, the number or Exercise Price of the Shares for which an Option is exercisable. Notwithstanding the foregoing, if the Corporation will enter into a transaction affecting the Corporation's capital stock or distributions to the holders of its capital stock for which a revision in the terms of each Option is not required pursuant to this SECTION 9, the Committee will have the right, but not the obligation, to revise the terms of each Option in a manner the Committee, in its sole discretion, deems fair and reasonable given the transaction involved. If necessary or appropriate in connection with such transaction, the Committee may declare that any Option will terminate as of a date fixed by the Committee and give each Optionee the right to exercise his or her Option in whole or in part, including exercise as to Shares to which the Option would not otherwise be exercisable. 9 (f) NO RESTRICTION ON RIGHTS OF CORPORATION. The grant of an Option will not affect or restrict in any way the right or power of the Corporation to make adjustments, reclassifications, reorganizations, or changes of its capital or business structure, or to merge or consolidate, or to dissolve, liquidate, sell, or transfer all or any part of its business or assets. 10. SECURITIES LAW REQUIREMENTS. (a) LEGALITY OF ISSUANCE. No Share will be issued upon the exercise of any Option unless and until the Corporation has determined that: (i) The Corporation and the Optionee have taken all actions required to exempt the issuance of the Shares from the registration requirements under the Securities Act of 1933, as amended (the "ACT"), or the Corporation and the Optionee will determine that the registration requirements of the Act do not apply to such exercise; (ii) Any applicable listing requirement of any stock exchange on which the Common Stock is listed has been satisfied; and (iii) Any other applicable provision of state or Federal law has been satisfied. (b) RESTRICTIONS ON TRANSFER; REPRESENTATIONS OF OPTIONEE; LEGENDS. Regardless of whether the offering and sale of Shares has been registered under the Act or has been registered or qualified under the securities laws of any state, the Corporation may impose restrictions upon the sale, pledge, or other transfer of such Shares, including the placement of appropriate legends on stock certificates, if, in the judgment of the Corporation and its counsel, such restrictions are necessary or desirable in order to achieve compliance with the provisions of the Act, the securities laws of any state, or any other law. If the sale of Shares is not registered under the Act and the Corporation will determine that the registration requirements of the Act apply to such sale, but an exemption is available which requires an investment representation or other representation, the Optionee will be required, as a condition to purchasing Shares by exercise of his or her Option, to represent that such Shares are being acquired for investment, and not with a view to the sale or distribution thereof, except in compliance with the Act, and to make such other representations as are deemed necessary or appropriate by the Corporation and its counsel. Stock certificates evidencing Shares acquired pursuant to an unregistered transaction to which the Act applies will bear a restrictive legend substantially in the following form and such other restrictive legends as are required or deemed advisable under the Plan or the provisions of any applicable law: "THE SHARES REPRESENTED BY THIS CERTIFICATE HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933, AS AMENDED (THE "ACT"), OR QUALIFIED UNDER THE SECURITIES LAWS OF ANY STATE. THESE SHARES HAVE BEEN ACQUIRED FOR INVESTMENT AND NOT WITH A VIEW TO OR FOR SALE IN CONNECTION WITH ANY DISTRIBUTION THEREOF, AND MAY NOT BE SOLD, MORTGAGED, 10 PLEDGED, HYPOTHECATED OR OTHERWISE TRANSFERRED WITHOUT AN EFFECTIVE REGISTRATION UNDER THE ACT AND/OR QUALIFICATION UNDER ANY APPLICABLE STATE SECURITIES LAWS, OR WITHOUT AN OPINION OF COUNSEL ACCEPTABLE TO THE CORPORATION AND ITS COUNSEL THAT SUCH REGISTRATION OR QUALIFICATION IS NOT REQUIRED." The Corporation will also place legends on stock certificates representing its right of repurchase under SECTION 11 and the right of first refusal under SECTION 12 . Any determination by the Corporation and its counsel in connection with any of the matters set forth in this SECTION 10 will be conclusive and binding on all persons. (c) REGISTRATION OR QUALIFICATION OF SECURITIES. The Corporation may, but will not be obligated to, register or qualify the sale of Shares under the Act or any other applicable law. In connection with any such registration or qualification, the Corporation will provide each Optionee with such information required pursuant to all applicable laws and regulations. (d) EXCHANGE OF CERTIFICATES. If, in the opinion of the Corporation and its counsel, any legend placed on a stock certificate representing Shares sold hereunder is no longer required, the Optionee or the holder of such certificate will be entitled to exchange such certificate for a certificate representing the same number of Shares but lacking such legend. 11. RIGHT OF REPURCHASE. (a) REPURCHASE RIGHT. At the Committee's discretion, Shares issued pursuant to the exercise of an Option may be subject to a right, but not an obligation, of repurchase by the Corporation (the "RIGHT OF REPURCHASE"), at the price specified in SECTION 11(b), if the Optionee ceases to be an Employee for any reason ("EMPLOYMENT TERMINATION") at any time after the grant of the Option pursuant to which such Shares were issued. Shares issued by the Corporation will only be transferable by the Optionee subject to the Right of Repurchase, and the Corporation will legend the Right of Repurchase on the stock certificates evidencing such Shares and will take such other steps as it deems necessary to ensure compliance with this restriction. The Corporation's rights under this SECTION 11(a) will be freely assignable, in whole or in part. (b) REPURCHASE PRICE. The price per Share at which the Corporation may exercise the Right of Repurchase under SECTION 11(a) (the "REPURCHASE PRICE") will be the higher of the Exercise Price of each Share as paid by the Optionee, or Fair Market Value of the Shares on the date the Corporation sends the notice to the Optionee of its exercise of its Right of Repurchase pursuant to SECTION 11(a). (c) REPURCHASE PROCEDURE. The Corporation may exercise its Right of Repurchase by sending a written notice to the Optionee and to the Escrow Agent, if any, of its taking such action and specifying the number of Shares being repurchased. The Corporation's Right of Repurchase will terminate if not exercised by written notice from the Corporation to the 11 Optionee within 90 days of the date on which the Corporation learns of the Employment Termination or the last date any Option granted to such Optionee is exercised, which ever is later. If the Corporation exercises its Right of Repurchase, the Optionee, or if applicable, the Escrow Agent, will deliver to the Corporation every stock certificate representing the Shares being repurchased, together with appropriate Assignments Separate from Certificates, and the Corporation will then promptly pay the total Repurchase Price in cash (or cancellation of purchase money indebtedness for the Shares, if applicable) to the Optionee, or if applicable, to the Escrow Agent, for delivery to the Optionee. (d) ELECTION TO DEFER PURCHASE OF INCENTIVE STOCK OPTION SHARES. (i) Notwithstanding the preceding provisions of this SECTION 11, an Optionee whose Shares were issued pursuant to an Incentive Stock Option may elect to defer the Corporation's repurchase of such Shares pursuant to this SECTION 11 until the holding period requirements of Section 422(a) of the Code are met. Such election will be in writing in such form as the Committee may require and will be delivered to the Corporation and to the Escrow Agent by certified mail no later than seven days after the date on which the Optionee receives notice that the Corporation elects to exercise its Right of Repurchase. Such election will pertain to all such Shares issued to the Optionee and will be irrevocable. (ii) With respect to an Optionee who makes the election described in SUBSECTION 11(d)(i), the Corporation will repurchase such Shares on or before the date which is 90 days following the earlier of the date on which the Optionee dies or the date on which the holding period requirements of Section 422(a) of the Code are met. The Repurchase Price of each such Share determined under SECTION 11(b) will be calculated by substituting for the Optionee's Employment Termination date the earlier of the date on which the Optionee dies or the date on which such holding period requirements are met. (e) ESCROW. To facilitate the consummation of the Corporation's Right of Repurchase under this SECTION 11, at the request of the Committee, the Optionee and the Corporation will execute Joint Escrow Instructions and the Optionee will deliver and deposit with the Escrow Agent named in the Joint Escrow Instructions two "Assignments Separate from Certificate," together with all certificates evidencing the Shares of Common Stock issued to the Optionee pursuant to the Plan, duly endorsed in blank. The Escrow Agent will hold such documents and deliver the same to the Corporation pursuant to the Joint Escrow Instructions and in accordance with the terms of this SECTION 11, as applicable. (f) BINDING EFFECT. The Corporation's Right of Repurchase will inure to the benefit of its successors and assigns and will be binding upon any representative, executor, administrator, heir, or legatee of the Optionee. (g) PAYMENT OF NET AMOUNT OWING. Notwithstanding anything to the contrary contained herein, if the Corporation determines to exercise its Rights of Repurchase pursuant to this Section before any Shares have been issued as a result of an exercise of an Option, in lieu of issuing any Shares, the Corporation will have the right, but not the obligation, 12 to pay to the Optionee the net amount owing to the Optionee. (h) TERMINATION OR RIGHT OF REPURCHASE. Notwithstanding any other provision of this SECTION 11, in the event that the Common Stock is listed on any United States securities exchange or traded on any formal over-the-counter market in general use in the United States at the time the Optionee would otherwise be required to transfer his or her Shares, the Corporation will no longer have the Right of Repurchase, and the Optionee will have no obligation to comply with this SECTION 11. 12. RIGHT OF FIRST REFUSAL. (a) RIGHT OF FIRST REFUSAL. At the Committee's discretion, shares issued pursuant to the exercise of an Option may be subject to a requirement that if an Optionee proposes to sell, pledge, or otherwise transfer any Shares acquired pursuant to exercise of an Option, or any interest in such Shares, to any person or entity, the Corporation will have a right of first refusal (the "RIGHT OF FIRST REFUSAL") with respect to such Shares. Any Optionee desiring to transfer Shares subject to the Right of First Refusal will give a written notice (the "TRANSFER NOTICE") to the Corporation describing fully the proposed transfer, including the number of Shares proposed to be transferred, the proposed transfer price, and the name and address of the proposed transferee. The Transfer Notice will be signed both by the Optionee and by the proposed transferee and must constitute a binding commitment of both parties to the transfer of the Shares. The Corporation will have the right to purchase the Shares subject to the Transfer Notice on the terms of the proposal referred to in the Transfer Notice, subject to any change in such terms permitted under SECTION 12(b), by delivery of a notice of exercise of the Right of First Refusal within 30 days after the date the Transfer Notice is received by the Corporation. The Corporation's rights under this SECTION 12(a) will be freely assignable, in whole or in part. (b) TRANSFER OF SHARES. If the Corporation fails to exercise the Right of First Refusal within 30 days after the date on which it receives the Transfer Notice, the Optionee may, not later than six months following receipt of the Transfer Notice by the Corporation, consummate a transfer of the Shares subject to the Transfer Notice on the terms and conditions described in the Transfer Notice. Any proposed transfer on terms and conditions different from those described in the Transfer Notice, as well as any subsequent proposed transfer by the Optionee, will again be subject to the Right of First Refusal and will again require compliance with the procedure described in SECTION 12(a). If the Corporation exercises its Right of First Refusal, the Optionee will immediately endorse and deliver to the Corporation every stock certificate representing the Shares being purchased, and the Corporation will then promptly pay the purchase price in accordance with the terms set forth in the Transfer Notice. (c) REPURCHASE PAYMENT. The amount payable to an Optionee pursuant to the Corporation's exercise of the Right of First Refusal will be paid to the Optionee in accordance with the terms and conditions of the Transfer Notice or may, at the election of the Corporation, be paid in full in cash. (d) BINDING EFFECT. The Corporation's Right of First Refusal will inure to the 13 benefit of its successors and assigns and will be binding upon any transferee of the Shares, other than a transferee acquiring Shares in a transaction with respect to which the Corporation failed to exercise its Right of First Refusal (a "FREE TRANSFEREE") or a transferee of a Free Transferee. (e) TERMINATION OF RIGHT OF FIRST REFUSAL. Notwithstanding any other provision of this SECTION 12, if the Common Stock is listed on any United States securities exchange or traded on any formal over-the-counter market in general use in the United States at the time the Optionee desires to transfer his or her Shares, the Corporation will no longer have the Right of First Refusal, and the Optionee will have no obligation to comply with this SECTION 12. 13. EXERCISE OF UNVESTED OPTIONS. The Committee may grant any Optionee the right to exercise any Option prior to the complete vesting of such Option. Without limiting the generality of the foregoing, the Committee may provide that if an Option is exercised prior to having completely vested, the Shares issued upon such exercise will remain subject to vesting at the same rate as under the Option so exercised and will be subject to a right, but not an obligation, of repurchase by the Corporation with respect to all unvested Shares if the Optionee ceases to be an Employee for any reason. For the purposes of facilitating the enforcement of any such right of repurchase, at the request of the Committee, the Optionee will enter into the Joint Escrow Instructions with the Corporation and deliver every certificate for his or her unvested Shares with a stock power executed in blank by the Optionee and by the Optionee's spouse, if required for transfer. 14. AMENDMENT OF THE PLAN. The Board or the Committee may, from time to time, terminate, suspend or discontinue the Plan, in whole or in part, or revise or amend it in any respect whatsoever including, but not limited to, the adoption of any amendment(s) deemed necessary or advisable to qualify the Options under rules and regulations promulgated by the Securities and Exchange Commission with respect to Employees who are subject to the provisions of Section 16 of the Exchange Act or to correct any defect or supply any omission or reconcile any inconsistency in the Plan or in any Option granted thereunder, without approval of the shareholders of the Corporation, but without the approval of the Corporation's shareholders, no such revision or amendment will: (i) Increase the number of Shares subject to the Plan, other than any increase pursuant to SECTION 9; (ii) Materially modify the requirements as to eligibility for participation in the Plan; (iii) Materially increase the benefits accruing to Optionees under the Plan; (iv) Extend the term of the Plan; or (v) Amend this SECTION 14 to defeat its purpose. 14 No amendment, termination or modification of the Plan will affect any Option theretofore granted in any material adverse way without the consent of the Optionee. 15. APPLICATION OF FUNDS. The proceeds received by the Corporation from the sale of Common Stock pursuant to the exercise of an Option will be used for general corporate purposes. 16. APPROVAL OF SHAREHOLDERS. The Plan will be subject to approval by the affirmative vote of the holders of a majority of all classes of the outstanding shares present and entitled to vote at the first meeting of shareholders of the Corporation following the adoption of the Plan or by written consent, and in no event later than one year following the Effective Date. Prior to such approval, Options may be granted but will not be exercisable. Any amendment described in SECTION 14 (i) to (iv) will also be subject to approval by the Corporation's shareholders. 17. WITHHOLDING OF TAXES. In the event the Corporation or an Affiliate determines that it is required to withhold federal, state, or local taxes in connection with the exercise of an Option or the disposition of Shares issued pursuant to the exercise of an Option, the Optionee or any person succeeding to the rights of the Optionee, as a condition to such exercise or disposition, may be required to make arrangements satisfactory to the Corporation or the Affiliate to enable it to satisfy such withholding requirements. Alternatively the Corporation may issue or transfer Shares net of the number of Shares sufficient to satisfy withholding tax requirements. For withholding tax purposes, the Shares will be valued on the date the withholding obligation is incurred. 18. RIGHTS AS AN EMPLOYEE. Neither the Plan nor any Option granted pursuant thereto will be construed to give any person the right to remain in the employ of the Corporation or any Affiliate, or to affect the right of the Corporation or any Affiliate to terminate such individual's employment at any time with or without cause. The grant of an Option will not entitle the Optionee to, or disqualify the Optionee from, participation in the grant of any other Option under the Plan or participation in any other benefit plan maintained by the Corporation or any Affiliate. 19. DISAVOWAL OF REPRESENTATIONS, UNDERTAKINGS, OR CREATION OF IMPLIED RIGHTS. In adopting and maintaining this Plan and granting options hereunder, neither the Corporation nor any Affiliate makes any representations or undertakings with respect to the initial qualification or treatment of Options under federal or state tax or securities laws. The Corporation and each Affiliate expressly disavows the creation of any rights in Employees, Optionees, or beneficiaries of any obligations on the part of the Corporation, any Affiliate or the Committee, except as expressly provided herein. 20. INSPECTION OF RECORDS. Copies of the Plan, records reflecting each Optionee's Option, and any other documents and records which an Optionee is entitled by law to inspect will be open to inspection by the Optionee and his or her duly authorized representative at the office of the Committee at any reasonable business hour. 15 21. INFORMATION TO OPTIONEES. Each Optionee will be provided with such information regarding the Corporation as the Committee from time to time deems necessary or appropriate; provided however, that each Optionee will at all times be provided with such information as is required to be provided from time to time pursuant to applicable regulatory requirements, including, but not limited to, the requirement in Section 260.140.46 of Title 10 of the California Code of Regulations of annual financial statements and any other applicable requirements of the Securities and Exchange Commission, the California Department of Corporations, and other state securities agencies. 16 EX-10.3 7 EXHIBIT 10.3 FORM OF INCENTIVE STOCK OPTION AGREE THE SECURITIES REPRESENTED HEREBY HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933, AS AMENDED, AND MAY NOT BE SOLD, PLEDGED, OR OTHERWISE TRANSFERRED WITHOUT AN EFFECTIVE REGISTRATION THEREOF UNDER SUCH ACT OR AN OPINION OF COUNSEL, SATISFACTORY TO THE CORPORATION AND ITS COUNSEL, THAT SUCH REGISTRATION IS NOT REQUIRED. FORM OF INCENTIVE STOCK OPTION AGREEMENT This Stock Option Agreement is made and entered into this day of, ______, pursuant to the DAOU SYSTEMS, INC. 1996 Stock Option Plan (the "PLAN"). Any terms not defined in this Agreement will have the meanings ascribed to such terms in the Plan. The Committee administering the Plan has selected _________________________________________________________ (the "OPTIONEE") to receive the following grant of an incentive stock option ("STOCK OPTION") to purchase shares of the common stock of DAOU SYSTEMS, INC., a California corporation (the "CORPORATION"), on the terms and conditions set forth below to which Optionee accepts and agrees: 1. Stock Options Granted: Number of Shares Subject to Option _______________ Date of Grant _______________ Vesting Commencement Date _______________ Exercise Price Per Share _______________ Expiration Date _______________ 2. The Stock Option is granted pursuant to the Plan to purchase the number of shares of authorized but unissued common stock of the Corporation specified in SECTION 1 (the "SHARES"). The Stock Option will expire, and all rights to exercise it will terminate on the earliest of: (a) the date provided below in SECTIONS 5 AND 6, (b) the Expiration Date, and (c) such earlier date as provided in the Plan. The number of shares subject to the Stock Option granted pursuant to this Agreement will be adjusted as provided in the Plan. 3. The Stock Option will be exercisable in all respects in accordance with the terms of the Plan which are incorporated herein by this reference. Optionee acknowledges having received and read a copy of the Plan. All shares of the Corporation's common stock issued pursuant to the exercise of this Stock Option will be subject to the Corporation's Right of Repurchase and Right of First Refusal as set forth in Sections 11 and 12 of the Plan. 4. Optionee will have the right to exercise the Stock Option in accordance with the following schedule: 1 i. The Stock Option may not be exercised in whole or in part at any time prior to the end of the first full year following the Vesting Commencement Date. ii. Optionee may exercise the Stock Option as to 20% the Shares at the end of the first full year following the Vesting Commencement Date. iii. Optionee may exercise the Stock Option as to an additional 20% of the Shares at the end of each full year thereafter following the Vesting Commencement Date. iv. If at any time after the end of the first full year following the Vesting Commencement Date a change in control (as defined in the following sentence) occurs, then Optionee may exercise the Stock Option as to 70% of the Shares which are not otherwise vested on the date of the change in control. For purposes of this SECTION 4, "change in control" means any person becoming the beneficial owner (as defined in Rule 13d-3 under the Exchange Act), directly or indirectly, of more than 50% of the Common Stock of the Corporation outstanding at such time, without the prior approval of the Board, but does not include any changes in ownership upon any firm commitment underwritten offering of its securities to the general public. v. The right to exercise the Stock Option will be cumulative. Optionee may buy all, or from time to time any part, of the maximum number of shares which are exercisable under the Stock Option, but in no case may Optionee exercise the Stock Option with regard to a fraction of a share, or for any share for which the Stock Option is not exercisable. c. The Stock Option will lapse and becomes unexercisable in full on the earliest of the following events: i. the first anniversary of the Optionee's death, as provided below in SECTION 6; ii. the first anniversary of the date the Optionee ceases to be an Employee due to total and permanent disability, as provided below in SECTION 6; iii. the date otherwise provided below in SECTION 6, unless the Committee otherwise extends such period before the applicable expiration date (if permissible pursuant to applicable tax regulation); iv. the date provided in Section 9 of the Plan for a transaction 2 described in such Section; or v. the date the Optionee files or has filed against him or her a petition in bankruptcy. f. If Optionee ceases to be an Employee for any reason other than his or her death or disability, the Optionee will have the right, subject to the other provisions of this Agreement, to exercise the Stock Option for 30 days after his or her termination of employment, but not beyond the otherwise applicable term of the Option and only to the extent that on such date of termination of employment the Optionee's right to exercise such Option had vested, and at the end of such 30-day period the Stock Option will expire, and all rights to exercise it will terminate. i. For purposes of this SECTION 6, employment will be deemed to terminate on the date the Optionee ceases active employment with the Corporation or any Affiliate, unless the Optionee's reemployment rights are guaranteed by statute or contract. ii. If Optionee dies while an Employee, or after ceasing to be an Employee but during the period while he or she could have exercised an Option under the preceeding sub-Sections (a) or (b), the Option granted to the Optionee may be exercised, to the extent it has vested at the time of death and subject to the Plan, at any time within 12 months after the Optionee's death, by the executors or administrators of his or her estate or by any person or persons who acquire the Option by will or the laws of descent and distribution, but not beyond the otherwise applicable term of the Option. iii. If Optionee ceases to be an Employee due to becoming totally and permanently disabled within the meaning of Section 22(e)(3) of the Code, the Stock Option may be exercised to the extent it has vested at the time of cessation and, subject to the Plan, at any time within 12 months after the Optionee's termination of employment, but not beyond the otherwise applicable term of the Stock Option. g. The Optionee agrees to comply with all laws, rules, and regulations applicable to the grant and exercise of the Stock Option and the sale or other disposition of the common stock of the Corporation received pursuant to the exercise of such Stock Option. h. The Stock Option will not become exercisable unless and until the shares exercisable under the Stock Option have been qualified under the California Corporate Securities Law of 1968 pursuant to a permit application filed with the California Department of Corporations or unless the exercise is otherwise exempt 3 from the qualification requirements of such law. The Stock Option is conditioned upon the Optionee's representation, which Optionee hereby confirms as of the date of this Agreement and which Optionee must confirm as of the date of any exercise of all or any part of the Stock Option, that: i Optionee understands that both this Stock Option and any shares purchased upon its exercise are securities, the issuance of which require compliance with state and federal securities laws; ii. Optionee understands that neither the Options nor the Shares have been registered under the Securities Act of 1933 (the "ACT") in reliance upon a specific exemption contained in the Act which depends upon Optionee's bona fide investment intention in acquiring these securities; that Optionee's intention is to hold these securities for Optionee's own benefit for an indefinite period; that Optionee has no present intention of selling or transferring any part thereof (recognizing that the Stock Option is not transferable) and that certain restrictions may exist on transfer of the shares issued upon exercise of the Stock Option; iii. Optionee understands that the Shares issued upon exercise of this Stock Option, in addition to other restrictions on transfer, must be held indefinitely unless subsequently registered under the Act, or unless an exemption from registration is available; that Rule 701 and Rule 144, two exemptions from registration which may be available, are only available after the satisfaction of certain conditions and require the presence of a U.S. public market for such Shares; that no certainty exists that a U.S. public market for the shares will exist, and that otherwise Optionee may have to sell the Shares pursuant to another exemption from registration which exemption may be difficult to satisfy; and iv. The Corporation will not be under any obligation to issue any Shares upon the exercise of this Stock Option unless and until the Corporation has determined that: (i) it and Optionee have taken all actions required to register such Shares under the Securities Act, or to perfect an exemption from the registration requirements thereof; (ii) any applicable listing requirement of any stock exchange on which such Shares are listed has been satisfied; and (iii) all other applicable provisions of state and federal law have been satisfied. 4 IN WITNESS WHEREOF, each of the parties hereto has executed this Stock Option Agreement, in the case of the Corporation by its duly authorized officer, as of the date and year written above. OPTIONEE DAOU SYSTEMS, INC., a California corporation - ----------------------------- By:________________________________ (signature) (signature) - ----------------------------- Its: ______________________________ (Type or Print Name) Address: ____________________________________ ____________________________________ ____________________________________ [SIGNATURE PAGE TO DAOU SYSTEMS, INC. INCENTIVE STOCK OPTION AGREEMENT] 5 EX-10.4 8 EXHIBIT 10.4 FORM OF NONSTATUTORY STOCK OPTION THE SECURITIES REPRESENTED HEREBY HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933, AS AMENDED, AND MAY NOT BE SOLD, PLEDGED, OR OTHERWISE TRANSFERRED WITHOUT AN EFFECTIVE REGISTRATION THEREOF UNDER SUCH ACT OR AN OPINION OF COUNSEL, SATISFACTORY TO THE CORPORATION AND ITS COUNSEL, THAT SUCH REGISTRATION IS NOT REQUIRED. FORM OF NONSTATUTORY STOCK OPTION AGREEMENT -EMPLOYEE- -DIRECTOR- This Stock Option Agreement is made and entered into this ____ day of,___, ______, pursuant to the DAOU SYSTEMS, INC. 1996 Stock Option Plan (the "PLAN"). Any terms not defined in this Agreement will have the meanings ascribed to such terms in the Plan. The Committee administering the Plan has selected ________ ____________________________________________________________ (the "OPTIONEE") to receive the following grant of a nonstatutory stock option ("STOCK OPTION") to purchase shares of the common stock of DAOU SYSTEMS, INC., a California corporation (the "CORPORATION"), on the terms and conditions set forth below to which Optionee accepts and agrees: 1. Stock Options Granted: Number of Shares Subject to Option_______________ Date of Grant_______________ Vesting Commencement Date_______________ Exercise Price Per Share_______________ Expiration Date_______________ 2. The Stock Option is granted pursuant to the Plan to purchase the number of shares of authorized but unissued common stock of the Corporation specified in SECTION 1 (the "SHARES"). The Stock Option will expire, and all rights to exercise it will terminate on the earliest of: (a) the date provided below in SECTIONS 5 AND 6, (b) the Expiration Date, and (c) such earlier date as provided in the Plan. The number of shares subject to the Stock Option granted pursuant to this Agreement will be adjusted as provided in the Plan. This Stock Option is intended by the Corporation and the Optionee to be a Nonstatutory Stock Option and does not qualify for any special tax benefits to the Optionee and is not subject to Section 7 of the Plan. 3. The Stock Option will be exercisable in all respects in accordance with the terms of the Plan which are incorporated herein by this reference. Optionee acknowledges having received and read a copy of the Plan. All shares of the Corporation's common stock issued pursuant to the exercise of this Stock Option 1 will be subject to the Corporation's Right of Repurchase and Right of First Refusal as set forth in Sections 11 and 12 of the Plan. 4. Optionee will have the right to exercise the Stock Option in accordance with the following schedule: 1. The Stock Option may not be exercised in whole or in part at any time prior to the end of the first full year following the Vesting Commencement Date. 2. Optionee may exercise the Stock Option as to 20% of the Shares at the end of the first full year following the Vesting Commencement Date. 3. Optionee may exercise the Stock Option as to an additional 20% of the Shares at the end of each full year thereafter following the Vesting Commencement Date. 4. If at any time after the end of the first full year following the Vesting Commencement Date a change in control (as defined in the following sentence) occurs, then Optionee may exercise the Stock Option as to 70% of the Shares which are not otherwise vested on the date of the change in control. For purposes of this SECTION 4, "change in control" means any person becoming the beneficial owner (as defined in Rule 13d-3 under the Exchange Act), directly or indirectly, of more than 50% of the Common Stock of the Corporation outstanding at such time, without the prior approval of the Board, but does not include any changes in ownership upon any firm commitment underwritten offering of its securities to the general public. 5. The right to exercise the Stock Option will be cumulative. Optionee may buy all, or from time to time any part, of the maximum number of shares which are exercisable under the Stock Option, but in no case may Optionee exercise the Stock Option with regard to a fraction of a share, or for any share for which the Stock Option is not exercisable. 5. The Stock Option will lapse and becomes unexercisable in full on the earliest of the following events: 1. the first anniversary of the Optionee's death, as provided below in SECTION 6; 2. the first anniversary of the date the Optionee ceases to be an Employee due to total and permanent disability, as provided below in SECTION 6; 2 3. the date otherwise provided below in SECTION 6, unless the Committee otherwise extends such period before the applicable expiration date; 4. the date provided in Section 9 of the Plan for a transaction described in such Section; or 5. the date the Optionee files or has filed against him or her a petition in bankruptcy. 6. If Optionee ceases to be an Employee for any reason other than his or her death or disability, the Optionee will have the right, subject to the other provisions of this Agreement, to exercise the Stock Option for 30 days after his or her termination of employment, but not beyond the otherwise applicable term of the Option and only to the extent that on such date of termination of employment the Optionee's right to exercise such Option had vested, and at the end of such 30-day period the Stock Option will expire, and all rights to exercise it will terminate. 1. For purposes of this SECTION 6, the employment relationship will be treated as continuing intact while the Optionee is an active employee of the Corporation or any Affiliate, or is on military leave, sick leave, or other bona fide leave of absence to be determined in the sole discretion of the Committee. 2. If Optionee dies while an Employee, or after ceasing to be an Employee but during the period while he or she could have exercised an Option under the preceeding sub-Sections (a) or (b), the Option granted to the Optionee may be exercised, to the extent it has vested at the time of death and subject to the Plan, at any time within 12 months after the Optionee's death, by the executors or administrators of his or her estate or by any person or persons who acquire the Option by will or the laws of descent and distribution, but not beyond the otherwise applicable term of the Option. 3. If Optionee ceases to be an Employee due to becoming totally and permanently disabled within the meaning of Section 22(e)(3) of the Code, the Stock Option may be exercised to the extent it has vested at the time of cessation and, subject to the Plan, at any time within 12 months after the Optionee's termination of employment, but not beyond the otherwise applicable term of the Stock Option. 7. The Optionee agrees to comply with all laws, rules, and regulations applicable to the grant and exercise of the Stock Option and the sale or other disposition of the common stock of the Corporation received pursuant to the 3 exercise of such Stock Option. 8. The Stock Option will not become exercisable unless and until the shares exercisable under the Stock Option have been qualified under the California Corporate Securities Law of 1968 pursuant to a permit application filed with the California Department of Corporations or unless the exercise is otherwise exempt from the qualification requirements of such law. The Stock Option is conditioned upon the Optionee's representation, which Optionee hereby confirms as of the date of this Agreement and which Optionee must confirm as of the date of any exercise of all or any part of the Stock Option, that: 1. Optionee understands that both this Stock Option and any shares purchased upon its exercise are securities, the issuance of which require compliance with state and Federal securities laws; 2. Optionee understands that neither the Options nor the Shares have been registered under the Securities Act of 1933 (the "ACT") in reliance upon a specific exemption contained in the Act which depends upon Optionee's bona fide investment intention in acquiring these securities; that Optionee's intention is to hold these securities for Optionee's own benefit for an indefinite period; that Optionee has no present intention of selling or transferring any part thereof (recognizing that the Stock Option is not transferable) and that certain restrictions may exist on transfer of the shares issued upon exercise of the Stock Option; 3. Optionee understands that the Shares issued upon exercise of this Stock Option, in addition to other restrictions on transfer, must be held indefinitely unless subsequently registered under the Act, or unless an exemption from registration is available; that Rule 701 and Rule 144, two exemptions from registration which may be available, are only available after the satisfaction of certain conditions and require the presence of a U.S. public market for such Shares; that no certainty exists that a U.S. public market for the shares will exist, and that otherwise Optionee may have to sell the Shares pursuant to another exemption from registration which exemption may be difficult to satisfy; and 4. The Corporation will not be under any obligation to issue any Shares upon the exercise of this Stock Option unless and until the Corporation has determined that: (i) it and Optionee have taken all actions required to register such Shares under the Securities Act, or to perfect an exemption from the registration requirements thereof; (ii) any applicable listing requirement of any stock exchange on which 4 such Shares are listed has been satisfied; and (iii) all other applicable provisions of state and federal law have been satisfied. [REMAINDER OF PAGE INTENTIONALLY LEFT BLANK] 5 IN WITNESS WHEREOF, each of the parties hereto has executed this Stock Option Agreement, in the case of the Corporation by its duly authorized officer, as of the date and year written above. OPTIONEE DAOU SYSTEMS, INC., a California corporation By: - ------------------------------------ ----------------------------------- (signature) (signature) Its: - ------------------------------------- --------------------------------- (Type or Print Name) Address: --------------------------- --------------------------- --------------------------- [SIGNATURE PAGE TO DAOU SYSTEMS, INC. NONSTATUTORY STOCK OPTION AGREEMENT] 6 EX-10.6 9 INFO. MGMT. AGMT (AUXILIARY) INFORMATION MANAGEMENT AGREEMENT THIS AGREEMENT is entered into as of this first day of April, 1996, by and between Candler Health System located at PO Box 9787, Savannah, Georgia ("Client") and DAOU Systems, Inc., a California corporation ("DAOU"). RECITALS (A) DAOU is in the business of furnishing Information Management Services in order to better align Client's organization leadership vision with their operating practices through the applications of technology, and is capable of providing trained personnel to perform management services, consultation engagements, operational management functions and to staff technical information processing activities of clients and has agreed to do so in accordance with the terms of this Agreement; (B) The Client desires to contract with DAOU to plan, manage, improve, and operate the Management Information Services functions through the application of DAOU's trained employees (C) The Client has specific need for information management services including management, operations, system administration, application support, programming support, network management, and software acquisition and development support, and currently identified in Exhibit A, Scope of Service and Exhibit B, Level of Services, to this Agreement; (D) DAOU and the Client are entering into this Agreement on the understanding that the price for DAOU's services under this Agreement has been set to reflect the fact that the legal and equitable remedies available to each party under this Agreement are strictly limited to those remedies set forth in this Agreement and neither party has undertaken and neither party can undertake any liability for indirect, incidental, consequential or punitive damages including but not limited to any loss of revenues, loss of income, loss of profits or other financial remedies not expressly set forth in this Agreement; and (E) DAOU and the Client desire to avoid litigation and to fully and finally resolve any disputes and all other disagreements pursuant to the mediation and arbitration provisions of this Agreement. In consideration of the foregoing and mutual promises contained herein, the Client and DAOU agree as follows: IT IS AGREED THAT: SECTION 1. DEFINITIONS The following definitions shall apply to the terms used in this Agreement: 1.1 AGREEMENT The term "Agreement" means this Agreement and any Addendum, supplement or other written amendment hereto signed by the parties to this Agreement. 1.2 CONFIDENTIAL INFORMATION The term "Confidential Information" means all business, financial, statistical, medical, personnel and technical data in tangible and/or intangible form which is clearly and conspicuously marked "CONFIDENTIAL" or as defined as confidential by law, or provided or disclosed, by one party to the other, with notice of its confidential nature. * CONFIDENTIAL TREATMENT REQUESTED 1.3 CONTRACT ADMINISTRATOR The term "Contract Administrator" means that person. or his or her replacement, designated by Client under Paragraph 3.2 of this Agreement. 1.4 EXCLUSIVE REMEDIES The term "Exclusive Remedies" shall mean those remedies which are the sole and exclusive remedies of each party under this Agreement as set forth in Paragraph 9. 1.5 EXISTING SYSTEMS The term "Existing Systems" shall mean those computer hardware and software configurations set forth on Exhibit A hereto. 1.6 INFORMATION MANAGEMENT SERVICES The term "Information Management Services" means the Services to be provided to Client by DAOU as described in Exhibit A. 1.7 CHIEF INFORMATION OFFICER The term " Chief Information Officer" means the individual designated by DAOU to be responsible for the Services to be provided to the Client under the terms of this Agreement. 1.8 LEVEL OF SERVICE The term "Level of Service" means the level of services and during the hours described in Exhibit B for which DAOU shall provide Client with Information Management Services in accordance with the terms hereof. 1.9 PERFORMANCE STANDARDS The term "Performance Standards" shall mean the standards to be developed in Exhibit C for those services described in Exhibit A herein, at the Level of Service described in Exhibit B. 1.10 SERVICE FEE The term "Service Fee" shall mean the fees set forth in Exhibit B for those services described in Exhibit A herein, at the Level of Service described in Exhibit B. 1.11 SERVICES The term "Services" means collectively the services described in Exhibit A of this Agreement and the Level of Service described in Exhibit B of this Agreement to be provided by DAOU to the Client 1.12 SUPPLEMENTAL SERVICES The term "Supplemental Services" means those additional and separately billable Information Management Services, software development or other services which are beyond the Level of Service defined by this Agreement or which are in addition to the items set forth in Exhibits A and B. * CONFIDENTIAL TREATMENT REQUESTED 1.13 SYSTEM The term "System" shall mean the Existing Systems, including but not be limited to all replacements thereof and additions thereto, and the software, operating together as a system. 1.14 TRANSITION SERVICES The term "Transition Services" means the services described in Exhibit D provided by DAOU at the termination of this Agreement. SECTION 2. SERVICE 2.1 SCOPE OF SERVICE DAOU agrees to furnish Client Information Management Services, Level of Service, Performance Standards, and Transition Services as specifically described in Exhibits A, B, C and D respectively. DAOU and Client may only expand Services provided by DAOU by execution of amended exhibits signed by both parties. 2.2 LEVEL OF SERVICE The Level of Service, as described in Exhibit 8, is the basis for the monthly fees provided for in Section 6. If, during the term of this Agreement, or any renewals, the Level of Service to Client shall change, the total monthly fee shall change as described in Exhibit B. 2.3 SUPPLEMENTAL SERVICES Upon the written consent of Client and DAOU, DAOU shall provide Supplemental Services, in addition to that listed in the attached exhibits, at either the DAOU current published or negotiated rates between the parties. Any such Supplemental Services shall be in accordance with all terms and conditions of this Agreement. Nothing in this Agreement shall require that either Client or DAOU agree to any Supplemental Services. 2.4 THIRD PARTY VENDORS Client represents that the Existing System includes software of third party vendors, which software is property owned by or property subject to licensing or similar agreements between the Client and such vendors and includes the rights of the Client for maintenance, upgrades and enhancements. The Client shall, as soon as is practicable after the execution hereof, deliver copies of all such agreements to DAOU. DAOU shall use reasonable efforts to act on the Client's behalf with respect to such third party agreements. SECTION 3. PERSONNEL 3.1 CHIEF INFORMATION OFFICER DAOU will designate , after consultation with client, a Chief Information Officer who shall be responsible for coordinating DAOU's efforts thereunder and for communicating with Client's Contract Administrator with regard to the proper execution of this Agreement and the obligations and duties thereunder. 3.2 CONTRACT ADMINISTRATOR * CONFIDENTIAL TREATMENT REQUESTED Client shall designate the CFO or his or her designee as its Contract Administrator. The Contract Administrator shall be responsible for communicating with DAOU's Information Services Manager with regard to the proper execution of this Agreement and the obligations and duties thereunder. The Contract Administrator shall have complete authority to make decisions on behalf of Client with regard to all matters relating to this Agreement. 3.3 DAOU/CLIENT REPORTING RELATIONSHIP (a) DAOU shall provide written status reports to the Contract Administrator on a monthly basis Such status reports shall provide the information reasonably necessary to evaluate DAOU's performance. (b) DAOU shall report to Client regarding an event or circumstance which has occurred which shall materially impair DAOU's performance under this Agreement and DAOU's proposed response to such event or circumstance. 3.4 CONTINGENCY SERVICES DAOU personnel may occasionally perform services for the Client at other locations or for others using the resources located on Client's premises for which DAOU is responsible and DAOU may do so as long as the DAOU Services under this Agreement shall not be adversely affected. 3.5 [*] SECTION 4. TERM The initial term of this Agreement shall be for a period of 5 years commencing April 1, 1996 and continuing through March 31, 2001 with an option, by mutual agreement to extend for an additional one 1 year thereafter. Both parties agree that the fees outlined in Exhibit B are in consideration of the entire initial term and that any adjustments to those fees within the Term of this Agreement, other than those identified in Paragraph 6.3 below, must be mutually agreed to and incorporated as an addendum. 4.1 CHANGE OF CONTROL In the event that Client merges with St. Joseph's Hospital (Savannah, GA) or otherwise becomes controlled by or in common control with any entity which also controls St. Joseph's Hospital, [*] [*] Client shall pay the sum of six hundred thousand dollars ($600,000) upon early termination due to the Change in control as provided herein. [*] * CONFIDENTIAL TREATMENT REQUESTED SECTION 5. TERMINATION 5.1 EVENTS OF TERMINATION This Agreement may be terminated: (a) By either party, to the extent permitted under applicable law, if the other ceases to function as a going concern becomes insolvent, makes an assignment for the benefit of creditors, files a petition in bankruptcy, permits a petition in bankruptcy to be filed against it (which is not dismissed within sixty (60) days) or admits in writing its inability to pay its debts as they mature; or if a receiver is appointed over a substantial part of its assets (which is not dismissed within sixty (60) days); (b) By DAOU for the non-payment of any monthly fees or charges to Client and which nonpayment continues for a period of thirty (30) days from the date of invoice; provided, however, that if Client has a bona fide dispute regarding a specific invoice, then such non-payment shall not be grounds for a termination hereof if Client pays to DAOU the entire invoiced amount whether or not disputed and continues to pay fully in accordance with Paragraph 9.3 while submitting the dispute to the dispute resolution procedures as set forth in Paragraph 9.2; (c) By either party in event of a material breach or nonperformance by the other of any provision of this Agreement, provided however, that written notice of the alleged breach shall have been given to the allegedly breaching party who shall not have remedied or cured the alleged breach within thirty (30) days after delivery of such notice; or if remedy or cure requires more than thirty (30) days, who shall not have actively commenced and diligently continued efforts to remedy or cure the alleged breach, provided further, that this Agreement shall not be terminated by such alleged breach if such alleged breach is submitted to the dispute resolution procedures set forth herein; or (d) [*] 5.2 TRANSITION PLAN Upon a proper notice of termination given by Client in accordance with Paragraph 5.1, at the request of Client, DAOU shall make available to Client, the personnel necessary to carry out a mutually agreed to transition plan to be executed within the remaining term of the Agreement. The topics to be included in the transition plan include, but are not limited, to those outlined in attached and incorporated Exhibit D. Each party will cooperate fully with the other and/or its designees, so that the transition of Services rendered under this Agreement shall be timely and efficient and implemented in a manner so as to least interfere with the orderly conduct of Client's business and so as not to unduly interfere with DAOU's other operations. 5.3 PERSONNEL TRAINING Upon a proper notice of termination given by Client in accordance with Paragraph 5.1 for any reason other than breach by Client for non-payment by Client, Client, after notice and preceding termination date, shall have the right to assign a reasonable number of Client's employees to participate with the employees of DAOU in the performance of their remaining services. DAOU shall cause its employees to acquaint and instruct the employees of Client regarding the work, to facilitate a smooth transition according to the Transition Plan, and to continuously operate all data processing functions 5.4 EQUIPMENT Upon expiration or termination of this Agreement, or any extension or renewals thereof, all office furniture, equipment, documents, records, books, tapes, disks and files provided by Client or DAOU shall be returned to Client * CONFIDENTIAL TREATMENT REQUESTED or DAOU in substantially the same condition as received, ordinary wear and tear expected. Neither Client nor DAOU shall dispose of the other party's property without the prior consent of the other party. SECTION 6. FEES FOR SERVICES AND TERMS OF PAYMENT 6.1 FEES FOR SERVICE The monthly fees for Services provided thereunder are described in Exhibit B. 6.2 PAYMENT Monthly fees shall be due and payable the first day of each month. Fractional months shall be prorated. Payment for Supplemental "Services shall be invoiced monthly and due ten (10) days from the receipt of invoice. Balances past due in excess of thirty (30) days from receipt of invoice shall bear overdue service charges at one and one-half (1-1/2) percent per month or the highest rate permitted by law, whichever is less. 6.3 ANNUAL ADJUSTMENT OF MONTHLY FEES Annually, on the anniversary date of this Agreement, the Fees for Services set forth in Exhibit B shall be adjusted, equal to the adjustment provided by Client to Client employees during the most recent 12 month period.. This adjustment shall apply only to the personnel portion of this Agreement. SECTION 7. INSURANCE AND TAXES 7.1 INSURANCE DAOU shall procure and maintain public liability insurance in the amount of [*] errors and omissions insurance in the amount of [*] per occurrence on a claims made basis with a total of [*] aggregate on an annual claims made basis, and workers' compensation insurance on its own employees. DAOU shall provide Client with at least thirty (30) days' advance written notice prior to any cancellation or reduction in coverage. 7.2 TAX AND LICENSES Taxes, other than income taxes, applicable business taxes and license fees, imposed by any taxing authority based upon any Services furnished under this Agreement shall be the responsibility of Client and shall be payable in addition to other fees or charges. Each party may provide the other, in lieu of paying any such tax, with a certificate of exemption in form reasonably satisfactory to the other party. SECTION 8. PERFORMANCE UNDER THIS AGREEMENT 8.1 IN GENERAL The parties acknowledge and agree that performance under this Agreement will require the availability of their respective representatives for the continued definition and setting of priorities, the balancing of competing tasks and schedules, and the adjustment of priorities over different tasks and different schedules so as to address, on a daily basis, the needs of the Client within the scope of this Agreement. * CONFIDENTIAL TREATMENT REQUESTED 8.2. COOPERATION DAOU and the Client agree that they will each use good faith and reasonable efforts to define, plan and coordinate the different priorities and schedules agreed to by the parties within the scope of this Agreement. 8.3 FULL DISCLAIMER OF WARRANTIES DAOU HEREBY DISCLAIMS ALL WARRANTIES OF ANY KIND, INCLUDING BUT NOT LIMITED TO, ANY EXPRESS WARRANTIES NOT INCORPORATED INTO THIS AGREEMENT OR ANY IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE IMPOSED BY LAW OR WHICH COULD OTHERWISE ARISE IN CONNECTION WITH DAOU'S OBLIGATIONS UNDER THIS AGREEMENT. DAOU'S SOLE AND EXCLUSIVE OBLIGATION THEREUNDER IS TO USE REASONABLE EFFORTS AND ITS BEST BUSINESS JUDGMENT IN PERFORMING THE TASKS SET FORTH IN THIS AGREEMENT, IN ACCORDANCE WITH THE RESOURCE ASSUMPTIONS AND PARAMETERS SET FORTH HEREIN. 8.4 PROBLEMS IN PERFORMANCE In the event of any failure of the parties mutually to agree on any matters under this Agreement or in the event that either party believes that the other has failed to satisfactorily perform or otherwise is in breach of the Agreement and if the parties are unable to resolve such matter through their respective representatives then the parties shall submit the matter to resolution in accordance with the procedures set forth in Section 9 below. SECTION 9. REMEDIES 9.1 LIMITATION OF LIABILITY; INDEMNIFICATION BY CLIENT Except for the Service Fees and other amounts expressly due and payable to DAOU, in no event shall either party be liable to the other for any damages arising in any manner under this Agreement including but not limited to indirect, incidental, consequential, special, exemplary or other damages or loss of revenues, loss of income, loss of profits, other financial remedies except those remedies for direct damages set forth as follows. To the extent any claim is made and fully covered by insurance provided in Paragraph 7.1 of this Agreement, the limitations of liability of this Paragraph 9.1 shall not apply, but, if a claim by one party to this Agreement against the other is not covered or is only partly covered by insurance provided in Paragraph 7.1, then in no event shall either party's liability to the other if there be any for any claims whatsoever or for any reason whatsoever) exceed two hundred and fifty thousand dollars ($250,000). 9.2 Dispute Resolution Procedure In the event that the parties have any disagreement, dispute, breach or claim of breach, or nonperformance or repudiation arising from, in relation to or in connection with this Agreement or any of the terms or conditions hereof, or any transaction thereunder including but not limited to either party's failure or alleged failure to comply with any of the provisions of this Agreement (hereinafter collectively the "Dispute"), the parties shall first promptly provide in writing to the other a general written statement of their respective claims. This statement need not be complete and will not limit the claims of either party in any further procedure with respect to this Agreement. The statement shall indicate that it is the first statement of a formal dispute resolution process under this Agreement. If the parties are unable to resolve the dispute within ten (10) business days of receipt of such written statement, the claimant may proceed as otherwise contemplated by this Agreement. (a) INTERNAL RESOLUTION PROCEDURES * CONFIDENTIAL TREATMENT REQUESTED (i) Within ten (10) working days of the time that one party informs the other of a Dispute, the Client's Contract Administrator and DAOU's Chief Information Officer shall conduct a meeting to reach an agreement to use their best efforts to either (a) resolve the matter and set forth such resolution in writing or (b) define the Dispute in writing including a description of the position of each party and the other projects and tasks which would be affected by the proposed resolution submitted by the Client's Contract Administrator and by the proposed resolution submitted by DAOU's Chief Information Officer, ii) If the Client's Contract Administrator and DAOU's Chief Information Officer are unable to reach an agreement pursuant to Subparagraph (i), then within ten (10) working days of such failure to agree, at least one knowledgeable representative of DAOU management and at least one knowledgeable representative of the Client shall meet in Savannah, GA, to attempt to reach a resolution of the matter in light of the description of the Dispute submitted by the parties and further discussion among and between the parties and their respective representatives. (b) MEDIATION RESOLUTION PROCEDURE If the procedure set forth in Subparagraph (a) is unsuccessful in resolving the Dispute, the parties shall, within fifteen (15) working days, commence a mediation session by notice of selection of a third party, neutral mediator and a proposed time and date for the mediation. If the other party does not propose an alternative mediator then the mediation shall occur before the first person proposed. If the other party does propose an alternative mediator, then the two proposed shall promptly jointly select a third party, neutral to act as the sole mediator. The mediation shall take place in Savannah, Georgia, and all mediator fees shall be equally shared by the parties. If the parties are able to reach a resolution of the Dispute, the resolution so reached shall be memorialized in writing and shall, upon the mutual written consent of both parties, become part of this Agreement. If the parties are unable to resolve the Dispute through mediation, either party has the option to terminate mediation and upon doing so, the parties shall continue under this Agreement in accordance with Section 9.3 and the parties shall submit any disputes to binding arbitration under subsection (c) below. (c) BINDING ARBITRATION If the parties are unable to reach an agreement pursuant to subparagraphs (a) and (b) above, the Dispute shall be resolved by mandatory, binding expedited arbitration in Savannah, Georgia in accordance with the following terms and conditions: (i) AAA Rules Apply. Any dispute relating to or arising out of the interpretation or performance of this Agreement (other than claims for which injunctive relief is sought) and which have not been resolved pursuant to the procedures set forth in Section 9.2 (a) shall be resolved at the request of either party through binding arbitration pursuant to and under the then existing commercial arbitration rules of the American Arbitration Association. The decision of the arbitrators(s) shall be limited by those Exclusive Remedies set forth herein, including but not limited to the Limitation on Liability set forth in Section 9.1 herein. (ii) Discovery. The parties shall be permitted to obtain discovery from each other of documents and other tangible evidence at a time reasonably prior to the arbitration hearing. No depositions shall be allowed. (iii) Hearing. The arbitration hearing shall be conducted in Savannah, Georgia The parties shall agree on a single arbitrator with computer industry or data processing expertise or if they cannot so agree, they shall each name one arbitrator and the two arbitrators shall jointly name a third neutral arbitrator who has expertise in information management and/or data processing services, and a decision of any two of the three arbitrators shall bind the parties in all matters thereunder, * CONFIDENTIAL TREATMENT REQUESTED (iv) Award. The arbitrators award shall be final and judgment upon any award by the arbitrator may be entered by the state or federal district courts in Savannah, Georgia (v) Binding Obligation. Failure to meet any of the timelines in this Section shall not be considered default in performance, nor shall it affect the enforceability of the resolution procedures under this Section. 9.3 PERFORMANCE DURING DISPUTES DAOU shall be under the obligation to continue to provide Services to the Client while the parties are seeking to resolve any Dispute so long as the Client shall continue to pay DAOU all Service Fees, both past due and as they come due, with or without Client's reservation of rights. SECTION 10. CONFIDENTIALITY 10.1 CONFIDENTIAL INFORMATION Subject to Paragraph 10.2 below, both parties agree that: (a) Each party shall not disclose any Confidential Information of the other party to any third party without first obtaining written consent; (b) Each party shall limit dissemination of the other party's Confidential Information only to those employees, contractors and agents who require access thereto to perform their functions under this Agreement; (c) Each party agrees to return the Confidential Information to the disclosing party upon receipt of written request therefor, (d) Each party agrees that the standard of care to be applied in the performance of the obligations set forth above shall be the standard of care applied by the receiving party in treating its own Confidential Information, but at least reasonable care to prevent unauthorized copying, use, publication or disclosure; and (e) The term of the provisions of this Section shall survive termination of the Services or any determination that this Agreement or any portion hereof or Exhibit hereto is void or voidable. 10.2 EXCEPTIONS TO CONFIDENTIALITY The obligation of confidentiality set forth in Paragraph 10.1 shall not apply to any data or information that the receiving party proves: (a) Was already rightfully in the possession of the receiving party or any of its related companies prior to disclosure; (b) Was independently developed by employees having no access to Confidential Information; (c) Was publicly disclosed by a person other than the receiving party or its employees or agents without restrictions; (d) Was rightfully received from a third party without restrictions on disclosure or use; (e) Was approved for unrestricted release or unrestricted disclosure by the disclosing party; * CONFIDENTIAL TREATMENT REQUESTED (f) Was available by inspection of products or services marketed without restrictions, offered for sale or leased in the ordinary course of business by either party hereto or others; or (g) Was required to be produced or disclosed pursuant to applicable laws, regulations or court order, provided the receiving party has given the disclosing party the opportunity to defend, limit or protect such production or disclosure. 10.3 [*] SECTION 11. GENERAL 11.1 NOTICES Any notice required or permitted by this Agreement shall be in writing and accomplished by registered or certified mail. Such notice shall be deemed to have been delivered five (5) days after it has been mailed If to DAOU: President DAOU Systems, Inc. 5120 Shoreham Place San Diego, CA 92121 If to Client: Chief Financial Officer Candler Health System P. O. Box 9787 Savannah, GA 31405 * CONFIDENTIAL TREATMENT REQUESTED 11.2 WAIVER Waiver of breach or failure to perform any provision of this Agreement shall not be deemed a waiver of future performance nor shall it prejudice the waiving party's right to require strict performance of the same provision or any other provision in the future. No term or condition of this Agreement shall be waived, modified or deleted except by an instrument, in writing, signed by the parties hereto. 11.3 ASSIGNMENT Neither this Agreement, nor any of either party's obligations under this Agreement, shall be assignable by operation of law or otherwise, without the prior written consent of both parties. 11.4 NO AUTHORITY The parties are and shall remain independent contractors. Neither party shall have any authority, and neither party shall represent that it has any authority, to assume or create any obligation, express or implied, on behalf of the other party, except as provided in this Agreement. This Agreement shall not be construed as creating a partnership, joint venture, franchise, agency or employment relationship between the parties or as creating any other form of legal association that would impose liability on one party for the act or failure to act of the other party. 11.5 EXHIBITS All exhibits referred to in this Agreement are hereby incorporated by reference as though fully set forth in the text of this Agreement; in the event of any conflict between the body of this Agreement and any Exhibit to this Agreement, the body of this Agreement shall control over any conflicting provision in any Exhibit to this Agreement. 11.6 GOVERNING LAW This Agreement shall be interpreted by the laws of the State of Georgia. 11.7 ATTORNEY'S FEES Subject to Paragraphs 11.10 and 11.11 below, in the event any action is instituted to enforce any right granted herein, neither party shall be entitled to recover attorneys' fees or other costs incurred except for such costs, if any, (excluding attorneys' fees) awarded by arbitration. 11.8 TIME TO SUE All actions by either party arising out of this Agreement shall be commenced within twelve (1 2) months after the party has knowledge of the claim or within six (6) months of the expiration or earlier termination of this Agreement, whichever first occurs. No action may be brought by either party more than one (1) year after the cause of action has arisen. 11.9 SEVERABILITY If any part of this Agreement found to be invalid by a court of competent jurisdiction, all other provisions shall remain in full force and effect and the provisions found invalid shall be enforced by the court to the maximum enforceable by law. 11.10 INDEMNITY BY DAOU. * CONFIDENTIAL TREATMENT REQUESTED DAOU will defend Client against a claim that the licensed programs or licensed materials furnished by by DAOU and used within the scope of this Agreement by DAOU infringe a U.S. patent or copyright or another proprietary right of a third party. DAOU will pay resulting costs, damages and attorney fees finally awarded provided that: a) Client promptly notifies DAOU in writing of the claim, and b) DAOU has sole control of the defense and of all related settlement negotiations. If such claim has occurred or in DAOU's opinion is likely to occur, Client agrees to permit DAOU, at its option and expense, either to procure for Client the right to continue using the licensed programs or licensed materials or to replace or modify the same with functionally equivalent programs so that they become non-infringing. 11.11 INDEMNITY BY CLIENT Client will defend DAOU against a claim that the licensed programs or licensed materials fumished by Client and used within the scope of this Agreement by Client infringe a U.S. patent or copyright or another proprietary right of a third party. Client will pay resulting costs, damages and attorney fees finally awarded provided that: a) DAOU promptly notifies Client in writing of the claim, and b) Client has sole control of the defense and of all related settlement negotiations. If such claim has occurred or in Client's opinion is likely to occur, DAOU agrees to permit Client, at its option and expense, either to procure for DAOU the right to continue using the licensed programs or licensed materials or to replace or modify the same with functionally equivalent programs so they become non-infringing. 11.12 FORCE MAJEURE Neither party shall be liable for any delay or failure to perform its obligations thereunder to the extent that such delay or failure is caused by a force or event beyond the control of such party, including without limitation, war, embargoes, strikes, governmental restrictions, riots, fires, floods, earthquakes, or other Acts of God (the "Force Majeure") provided that DAOU shall use its best efforts to assist Client in establishing necessary Services elsewhere, in the event of the occurrences of a Force Majeure which: (a) Materially prevents DAOU from providing any of the Services for more than ten (10) business days, and DAOU has not successfully transferred Client's data processing to a backup facility under terms and conditions reasonably acceptable to the Client, or (b) Causes the normal operations of the site to be interrupted for more than forty-five (45) days, and in Client's reasonable business judgment it is necessary to pursue alternative means of meeting Client's data processing needs. DAOU shall use its best efforts to assist Client in establishing necessary Services elsewhere. 11.13 AFFIRMATIVE ACTION DAOU certifies that it is in compliance with the Equal Employment Opportunity Requirement of Executive Order 11246 as amended by Executive Order 11375, Section 503 of the Rehabilitation Act of 1973 as amended and 38 U.S.C. 4212 (the Vietnam Era Veterans Readjustment Assistance Act of 1974 as amended), Title VIl of the Civil Rights Restoration Act of 1987, the California Fair Employment Practices Act, and any other federal or state laws pertaining to equal employment opportunity, and that it will not discriminate against any employee or applicant for employment on the basis of race, color, religion, handicap, age, sex, national origin or ancestry in matters pertaining to recruitment, hiring, training, upgrading, transfer, compensation or termination. 11.14 MEDICARE ACCESS TO BOOKS AND RECORDS Until four (4) years following the completion of this Agreement, DAOU shall make available to the Secretary of Health and Human Services, the Inspector General, or their designees, any and all such books and records as are necessary to substantiate the Services provided under this Agreement. Should DAOU fulfill any part of the Services * CONFIDENTIAL TREATMENT REQUESTED rendered under this Agreement via subcontract with fees of ten thousand dollars ($1 0,000) or more, DAOU shall require such access to subcontractors' books and records as a condition of entering subcontract. SECTION 12. ENTIRE AGREEMENT THIS AGREEMENT SIGNED BY BOTH PARTIES, AND SO INITIALED BY BOTH PARTIES IN THE MARGIN OPPOSITE THIS SECTION, CONSTITUTES A FINAL WRITTEN EXPRESSION OF ALL OF THE TERMS OF THIS AGREEMENT AND IS A COMPLETE AND EXCLUSIVE STATEMENT OF THOSE TERMS. CLIENT WAS NOT INDUCED TO ------------- ENTER THIS AGREEMENT BY ANY STATEMENTS OR Client REPRESENTATIONS NOT CONTAINED IN THIS AGREEMENT. ANY AND ALL REPRESENTATIONS, PROMISES, WARRANTIES OR STATEMENTS BY DAOU'S OFFICERS, EMPLOYEES, OR OTHER AGENTS THAT DIFFER IN ANY WAY FROM THE TERMS OF THIS WRITTEN AGREEMENT SHALL BE GIVEN NO FORCE OF AFFECT. ------------- THIS AGREEMENT SHALL BE CHANGED, AMENDED OR MODIFIED DAOU ONLY BY WRITTEN INSTRUMENT SIGNED BY BOTH CLIENT AND DAOU. This Agreement shall not be modified or altered by any course of performance by either party or usage of the trade or otherwise except through an instrument signed by both Client and DAOU. Candler Health System DAOU Systems, Inc. By: /s/Kenneth W. Wood By: --------------------------------- ------------------------------ Title: President Title: ------------------------------ --------------------------- Date: April 19, 1996 Date: ------------------------------ ---------------------------- * CONFIDENTIAL TREATMENT REQUESTED EXHIBIT A THROUGH EXHIBIT D [CONFIDENTIAL TREATMENT REQUESTED] EX-10.11 10 EXHIBIT 10.11 EMP. AGMT. (AUXILIARY) EMPLOYMENT AGREEMENT THIS EMPLOYMENT AGREEMENT (the "Agreement"), dated January 17, 1997, is made by and between DAOU Systems, Inc., a Delaware Corporation having its principal offices at 5120 Shoreham Place, San Diego, California 92122 (the "Company") and Robert McNeill ("Employee"). AGREEMENT 1. EFFECTIVE DATE. Employee's employment commenced on November 11, 1996. This Agreement formalizes the terms and conditions to which Employee orally agreed prior to accepting and beginning his employment with the Company. This Agreement therefore memorializes an Agreement already in existence between the parties, and will, upon signature, be retroactive to November 11, 1996. 2. AT-WILL EMPLOYMENT. Employee's employment relationship with the Company is at-will, terminable at any time and for any reason by either the Company or Employee. The Company nonetheless reserves the right to discharge an employee for acts of gross misconduct in the performance of his duties or may otherwise terminate the employee for a specific reason or for "cause". While certain paragraphs of this Agreement describe events which could occur at a particular time in the future, nothing in this Agreement may be construed as a guarantee of employment of any length. 3. EMPLOYMENT DUTIES. a. TITLE/RESPONSIBILITIES. Employee shall hold the title of Executive Vice President of the Company. Employee shall also perform all duties which from time to time are assigned to him by the Board of Directors ("BOARD"). b. FULL TIME ATTENTION. Employee shall devote all of his business time and attention, energy and skills to the Company during the time he is employed under this Agreement. c. POLICY COMPLIANCE. Employee is required to comply with the Company policy, practice and procedure in effect during his employment. Employee must agree to the terms and conditions of the Company's Employee Confidentiality and Inventions Agreement ("CONFIDENTIALITY AGREEMENT," attached to this Agreement as Exhibit 1 and incorporated by reference.) 4. COMPENSATION. a. BASE SALARY. The Company shall pay Employee an annual Base Salary of One Hundred Seventy Five Thousand Dollars ($175,000.00), which will be paid bi-weekly during the year. Any increase to the Base Salary is within the sole discretion of the Company. b. SIGNING BONUS. In order to assist Employee in exercising the options which he presently holds for shares of stock in his former employer, Shared Medical Systems Corporation ("SMS"), the Company will pay Employee a signing bonus of an amount equal to the tax liability Employee incurs in exercising the above referenced options, up to a maximum payment of $105,000.00. Employee understands and agrees to repay the Company the unearned portion of the bonus if employee resigns or is discharged for "cause" prior to completion of three years of employment. The bonus is earned pro rata over three years. c. BONUS COMPENSATION. In addition to the compensation provided above, the Company will pay Employee an incentive bonus in the amount of up to $30,000.00 per quarter during the employment relationship. For 1996, Employee is eligible for a pro-rata portion of this bonus, for the period from November 11, 1996 through December 31, 1996. Thereafter, from January 1, 1997, the bonus will be paid quarterly, and will be paid within 10 days of the end of the quarter. Such bonus shall be contingent upon the Company's achievement of Quarterly Goals for revenue and profit. These Quarterly Goals will be set by the Company at the beginning of each calendar year. All bonus arrangements are established and reviewed by the Board and may be modified at any time by the Board in its sole discretion. d. STOCK OPTIONS. (1) GRANT OF OPTIONS. Employee acknowledges that effective November 11, 1996 he has been granted non-qualified options to purchase 100,000 shares of the Company's common stock under DAOU's 1996 Stock Option Plan ("THE PLAN") subject to the terms and conditions of the Stock Option Agreements reflecting that grant (the "OPTION AGREEMENTS") as follows: Employee has been granted a non-qualified stock option exercisable into one hundred thousand shares, in each case, at an exercise price of Six Dollars ($6) per share. These options shall vest in five equal annual increments commencing on the first anniversary date of his employment, rounded to the nearest whole number of shares. The stock options are subject to the terms and provisions set forth in the Option Agreements and the Plan as well as applicable state and federal laws including, but not limited to, tax and securities laws. The length of time the option to purchase will remain open and details of this grant are formalized in the Option Agreement and the Plan. (2) TAX EFFECT OF EXERCISE, SALE OR GIFT. The Company and Employee intend that the after-tax effect of the options to Employee shall be equivalent to the 2 result that would pertain had they originally been issued as incentive stock options (ISOs) with the same terms and conditions. Accordingly, should Employee incur a tax liability as a result of the exercise of the options in excess of the tax liability that would have been incurred had the options originally been issued as ISOs ("Excess Tax"), the Company shall make an interest-free loan to Employee equal to the Excess Tax. At the time of sale or other disposition of the shares subject to the options, the loan will be due and payable, but the amount payable shall be reduced by the amount, if any, by which (1) the cumulative tax liability on exercise of the options and on disposition of the underlying shares exceeds (2) the tax that would have been incurred had the options originally been issued as ISOs. If the shares are not sold or otherwise disposed of on or before the earlier of (1) the Employee's date of termination or (2) January 17, 2002, the loan will be due and payable in full. Other repayment terms will be established in writing at the time of the loan ("Loan Agreement"). In the event Employee fails to repay the loan in a timely manner, according to the Loan Agreement, the Company reserves the right to offset the debt from Employee's future bonus payments, if any. (3) STOCK SPLIT. The Company is currently contemplating an Initial Public Offering ("IPO"). The number of such shares into which Employee's stock options are exercisable ("OPTION SHARES") will be adjusted upward proportionately in the event of a stock split or other upward adjustment in the number of outstanding shares of capital stock in the Company (by merger or otherwise) preparation for that IPO, PROVIDED, HOWEVER, that in no event shall the number of Option Shares exceed 200,000 at the time of the first split. (4) SHORTFALL. If Employee is employed by the Company three years from the option date, and if at that time the originally issued options do not have a net value (exercise price of such options minus market value of the Company's common stock, as defined below) of at least $1,550,000.00, a cash bonus will be paid to make up the shortfall. If the Company is public, the market value of the common stock will be determined by calculating the trading price for the common stock (or any other securities received by Employee in lieu thereof) for a sixty day trading period preceding that three year date. Otherwise, the market value will be determined by the fair market value of such securities as reasonably determined by the Board or the Committee as that group is defined in the Plan. (5) TAX IMPLICATIONS. The Company does not make any warranty or representation with respect to the taxability or tax consequence of any of the above grant of options or of the tax consequences of any exercise of the options or consequent sale of the shares purchased. Employee is advised to consult with his own tax advisor with respect to the tax treatment of the option grant. e. FRINGE BENEFITS. (1) VACATION. During the Term of this Agreement, Employee shall be entitled to vacation in accordance with The Company's vacation policy as set forth in the Employee Handbook. 3 (2) HEALTH BENEFITS. The Company agrees to provide Employee with comprehensive health insurance benefits during his employment. (3) 401(k) PARTICIPATION. Employee may participate in any 401(k) or other employee retirement plan according to the requirements of those plans starting January, 1997. (4) LIFE INSURANCE. The Company shall maintain a term life insurance policy providing for payment of $500,000.00 to Employee's designated beneficiaries. (5) SHORT TERM AND LONG TERM DISABILITY INSURANCE. In the event Employee suffers a short term disability, Employee will seek state short term disability benefits. The Company shall provide short term disability payments to ensure that Employee receives, in combination with state disability benefits, if any, One Hundred Percent (100%) of Employee's base salary for a period of six consecutive months of disability. The Company shall provide long term disability insurance to provide Employee with $8,500.00 per month for any consecutive period of disabilities after the six consecutive months of disability for the term set by the policy. (6) AUTOMOBILE. During his employment, the Company agrees to provide Employee with an automobile allowance in the initial amount of $550.00 per month towards an automobile to be used in connection with the Company's business. f. REIMBURSEMENT OF EXPENSES. During his Employment, with approval by the Chief Financial Officer, Employee shall be entitled to reimbursement of reasonable and actual expenses, incurred on behalf of the Company, including but not limited to travel and entertainment expenses, supplies and cellular phone expenses. 5. CONFIDENTIALITY. As set forth above, Employee agrees to comply with the terms and conditions of the Company's Employee Confidentiality and Inventions Agreement (EXHIBIT 1). 6. RETURN OF PROPERTY. Employee agrees that all documents, records, apparatus, equipment and other physical property which is furnished or obtained by Employee in the course of his employment with the Company shall be and remain the sole property of the Company. Employee agrees that, upon the termination of his employment, he shall return all such property (whether or not it pertains to Proprietary Information), and agrees not to make or retain copies, reproductions or summaries of any such property. 7. NON COMPETITION. During the term of his employment, Employee shall not, directly or indirectly, either as an employee, employer, consultant, corporate officer, 4 director, or in any other individual or representative capacity, engage or participate in any business that is in competition in with the business of the Company in any location, unless such participation or interest is fully disclosed to the Company and approved by the Board. 8. AGREEMENT WITH PREVIOUS EMPLOYERS. Employee agrees that he does not have any agreement with any previous employer which will prevent him from performing under this agreement or which will limit his performance except as follows: By virtue of an agreement with SMS, Employee is prohibited, for a period of eighteen months from November 11, 1996, from using information which he gained by soliciting and negotiating SMS contracts with (1) Crozer-Chester Medical Center, Philadelphia; (2) Childrens' Medical Center, Pittsburgh; and (3) Pinnacle Health Systems, Harrisburg, to displace SMS services or to reduce SMS's revenues received from these three clients. 9. SEVERANCE. a. UPON TERMINATION WITHOUT "CAUSE" As set forth above, the employment relationship between the parties is at-will, terminable at any time by either party for any reason or no reason. Where Employee is discharged without "cause", Employee is eligible for severance payments equivalent to eighteen months of base salary paid over an eighteen (18) month period. These payments will cease if Employee obtains new employment within the eighteen month period or becomes a consultant to any company. b. UPON RESIGNATION, AT COMPANY OPTION If Employee voluntarily resigns his employment at his own initiative with the Company, the Company at its option and in its sole discretion may offer severance of up to eighteen (18) monthly payments of base salary, IF AND ONLY IF he agrees to extend the non- competition requirements set forth in paragraph 7 above for the severance period. The Company reserves the right to cease any remaining Severance Payments in the event Employee violates this Agreement. c. DISCHARGE WITH "CAUSE" Where Employee is discharged as a result of gross misconduct or otherwise for "cause", he is not eligible for severance. d. COBRA REIMBURSEMENT Upon termination of the employment relationship, Employee will be provided with election forms for medical insurance continuation as provided by the Consolidated Omnibus Budget Reconciliation Act (COBRA). If Employee elects to continue insurance under COBRA, the Company will reimburse Employee for the cost of his continued health insurance (not dependents), for up to eighteen (18) months. This does not extend the length of the COBRA period. In the event Employee becomes eligible for or obtains insurance through any replacement employment, this benefit will cease. 5 10. DISPUTE RESOLUTION PROCEDURES. Any dispute or claim arising out of this agreement shall be subject to final and binding arbitration. The arbitration will be conducted by one arbitrator who is a member of the American Arbitration Association (AAA) or of the Judicial Arbitration and Mediation Services (JAMS) and will be governed by the Model Employment Arbitration rules of AAA. The arbitration shall be held in San Diego, California. The arbitrator shall have all authority to determine the arbitrability of any claim and enter a final and binding judgment at the conclusion of any proceedings in respect of the arbitration. Any final judgment only may be appealed on the grounds of improper bias or improper conduct of the arbitrator. Notwithstanding any rule of AAA to the contrary, the parties will be entitled to conduct discovery (i.e. investigation of facts through depositions and other means) which shall be governed by the Code of Civil Procedure section 1283.05. The arbitrator shall have all power and authority to enter orders relating to such discovery as are allowed under the Code. The arbitrator will apply California substantive law in all respects. The party prevailing in the resolution of any such claim will be entitled, in addition to such other relief as may be granted, to an award of all actual attorneys fees and costs incurred in pursuit of the claim, without regard to any statute, schedule, or rule of court purported to restrict such award. 11. GENERAL PROVISIONS. a. GOVERNING LAW. This Agreement will be governed by and construed in accordance with the laws of the State of California. b. ASSIGNMENT. Employee may not assign, pledge or encumber his interest in this Agreement or any part thereof. c. NO WAIVER OF BREACH. The failure to enforce any provision of this Agreement will not be construed as a waiver of any such provision, nor prevent a party thereafter from enforcing the provision or any other provision of this Agreement. The rights granted the parties are cumulative, and the election of one will not constitute a waiver of such party's right to assert all other legal and equitable remedies available under the circumstances. d. SEVERABILITY. The provisions of this Agreement are severable, and if any provision will be held to be invalid or otherwise unenforceable, in whole or in part, the remainder of the provisions, or enforceable parts of this Agreement, will not be affected. e. ENTIRE AGREEMENT. This Agreement constitutes the entire agreement of the parties with respect to the subject matter of this Agreement, and supersedes all prior and contemporaneous negotiations, agreements and understandings between the parties, oral or written, including but not limited to the Offer Letter. 6 f. MODIFICATION; WAIVERS. No modification, termination or attempted waiver of this Agreement will be valid unless in writing, signed by the party against whom such modification, termination or waiver is sought to be enforced. g. FEES AND EXPENSES. If any proceeding is brought for the enforcement or interpretation of this Agreement, or because of any alleged dispute, breach, default or misrepresentation in connection with any provisions of this Agreement, the successful or prevailing party will be entitled to recover from the other party reasonable attorneys' fees and other costs incurred in that proceeding (including, in the case of an arbitration, arbitration fees and expenses), in addition to any other relief to which such party may be entitled. h. AMENDMENT. This Agreement may be amended or supplemented only by a writing signed by both of the parties hereto. i. DUPLICATE COUNTERPARTS. This Agreement may be executed in duplicate counterparts, each of which shall be deemed an original; provided, however, such counterparts shall together constitute only one instrument. j. INTERPRETATION. The headings contained in this Agreement are for reference purposes only and shall not affect in any way the meaning or interpretation of this Agreement. k. DRAFTING AMBIGUITIES. Each party to this Agreement and its counsel have reviewed and revised this Agreement. The rule of construction that any ambiguities are to be resolved against the drafting party shall not be employed in the interpretation of this Agreement or any of the amendments to this Agreement. Dated: January 20, 1997 DAOU Systems, Inc. ---------------- By: /s/ Fred McGee ----------------------------------- Fred McGee, Chief Financial Officer Dated: January 20, 1997 /s/ Robert McNeill ----------------- ------------------------------------ Robert McNeill EX-11.1 11 STATEMENT REGARDING CALCULATIONS EXHIBIT 11.1 STATEMENT OF COMPUTATION OF EARNINGS PER SHARE (AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
YEARS ENDED DECEMBER 31, ------------------------------- 1994 1995 1996 --------- --------- --------- HISTORICAL EARNINGS PER SHARE Net income......................................................................... $ 26 $ 1,240 $ 83 --------- --------- --------- --------- --------- --------- Weighted average common shares outstanding......................................... 6,664 6,664 6,664 Net effect of dilutive common share equivalents (stock options) using the treasury stock method...................................................................... -- 288 1,256 Adjustments to reflect requirements of the Securities and Exchange Commission (Effect of SAB 83)................................................................ 567 567 567 --------- --------- --------- Adjusted shares outstanding........................................................ 7,231 7,519 8,487 --------- --------- --------- --------- --------- --------- Historical net income per common share............................................. $ 0.00 $ 0.16 $ 0.01 --------- --------- --------- --------- --------- --------- PRO FORMA EARNINGS PER SHARE Net income......................................................................... $ 83 --------- --------- Weighted average common shares outstanding......................................... 6,664 Net effect of dilutive common share equivalents (stock options) using the treasury stock method...................................................................... 54 Effect of assumed conversion of preferred shares................................... 1,603 Adjustments to reflect requirements of the Securities and Exchange Commission (Effect of SAB 83)................................................................ 567 --------- Adjusted shares outstanding........................................................ 8,888 --------- --------- Pro forma net income per common share.............................................. $ 0.01 --------- ---------
EX-23.1 12 CONSENT OF ERNST & YOUNG EXHIBIT 23.1 CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS We consent to the reference to our firm under the caption "Experts" and "Selected Financial Data" and to the use of our report dated January 14, 1997, in the Registration Statement (Form SB-2) and the related Prospectus of DAOU Systems, Inc. for the registration of shares of its common stock. ERNST & YOUNG LLP San Diego, California January 21, 1997 EX-27 13 EXHIBIT 27 FDS
5 This schedule contains summary financial information extracted from the Registrant's Financial statements as of and for the year ended December 31, 1996, and is qualified in its entirety by reference to such financial statements. 1,000 YEAR DEC-31-1996 DEC-31-1996 2,284 0 4,195 110 0 10,717 1,430 604 11,910 2,801 0 8,190 0 7 850 11,910 19,311 19,311 13,556 19,306 0 0 (197) 202 119 83 0 0 0 83 .01 .01
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