10-Q

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2000

OR

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

For the transition period from ______________ to ___________

000-22073
(Commission File No.)

DAOU SYSTEMS, INC.
(Exact name of registrant as specified in its charter)

Delaware
(State or other jurisdiction of
incorporation or organization)

33-0284454
(I.R.S. Employer Identification No.)

5120 Shoreham Place
San Diego, California
(Address of principal executive offices)

92122
(Zip Code)

(858) 452-2221
(Registrant’s telephone number, including area code)

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

             The number of shares of Registrant’s Common Stock, par value $.001 per share, outstanding as of November 11, 2000: 17,712,768

DAOU SYSTEMS, INC.

INDEX TO FORM 10-Q

		Page
PART I.	FINANCIAL INFORMATION
Item 1.	Condensed Consolidated Financial Statements	3
	Condensed Consolidated Balance Sheets at September 30,    2000 (unaudited) and December 31, 1999	3
	Condensed Consolidated Statements of Operations (unaudited) for the    Three Months and Nine Months Ended September 30, 2000 and 1999	4
	Condensed Consolidated Statements of Cash Flows (unaudited) for the    Nine Months Ended September 30, 2000 and 1999	5
	Notes to Condensed Consolidated Financial Statements	6
Item 2.	Management’s Discussion and Analysis of Financial Condition    and Results of Operations	10
Item 3.	Quantitative and Qualitative Disclosure about Market Risk	15
PART II.	OTHER INFORMATION
Item 1.	Legal Proceedings	16
Item 2.	Changes in Securities and Use of Proceeds	16
Item 6.	Exhibits and Reports on Form 8-K	16

SIGNATURES 17

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PART I. FINANCIAL INFORMATION

Item 1.   Condensed Consolidated Financial Statements

DAOU SYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except for per share data)

	September 30, 2000			December 31, 1999
	(unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	12,036		$	15,480
Short-term investments, available-for-sale		81			68
Accounts receivable, net of allowance for doubtful accounts of $1,114 and       $1,868 at September 30, 2000 and December 31, 1999, respectively		13,391			21,912
Contract work in progress		323			2,816
Income tax receivable		—			378
Other current assets		1,761			670
Total current assets		27,592			41,324
Due from officers/stockholders		—			98
Equipment, furniture and fixtures, net		3,314			4,319
Other assets		155			319
Total Assets	$	31,061		$	46,060
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Trade accounts payable and other accrued liabilities	$	2,230		$	4,698
Accrued salaries and benefits		3,519			4,248
Current portion of severance payable		210			210
Total current liabilities		5,959			9,156
Long-term liabilities		429			548
Commitments and contingencies
Redeemable convertible preferred stock, $.001 par value. Authorized 3,520    shares; issued and outstanding 2,182 shares at September 30, 2000 and    December 31, 1999		11,940			11,382
Stockholders’ equity:
Common stock, $.001 par value. Authorized shares 50,000 shares; issued and       outstanding 17,713 shares at September 30, 2000 and 17,712 shares at       December 31, 1999		18			18
Additional paid-in capital		37,396			37,395
Deferred compensation		(78	)		(192	)
Accumulated other comprehensive income		(50	)		(43	)
Accumulated deficit		(24,553	)		(12,204	)
Total stockholders’ equity		12,733			24,974
Total Liabilities and Stockholders’ Equity	$	31,061		$	46,060

See accompanying notes to the condensed consolidated financial statements.

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DAOU SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except for per share data)
(Unaudited)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2000			1999			2000			1999
Revenues	$	15,341		$	25,382		$	49,043		$	79,755
Cost of revenues		13,259			17,701			42,260			58,638
Gross profit		2,082			7,681			6,783			21,117
Operating expenses:
Sales and marketing		1,390			2,233			4,831			7,552
General and administrative		4,791			4,790			13,433			15,449
Restructuring charges		—			—			827			—
		6,181			7,023			19,091			23,001
Income (loss) from operations		(4,099	)		658			(12,308	)		(1,884	)
Interest income, net		184			614			517			433
Income (loss) before income taxes		(3,915	)		1,272			(11,791	)		(1,451	)
Provision (benefit) for income taxes		—			519			—			(596	)
Net income (loss)		(3,915	)		753			(11,791	)		(855	)
Accrued dividends on preferred stock		(189	)		(128	)		(558	)		(128	)
Net income (loss) available to common stockholders	$	(4,104	)	$	625		$	(12,349	)	$	(983	)
Net income (loss) per common share:
Basic	$	(0.23	)	$	0.04		$	(0.70	)	$	(0.06	)
Diluted	$	(0.23	)	$	0.04		$	(0.70	)	$	(0.06	)
Shares used in computing net income (loss) per share:
Basic		17,713			17,695			17,712			17,692
Diluted		17,713			17,805			17,712			17,692

See accompanying notes to the condensed consolidated financial statements.

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DAOU SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

	Nine Months Ended September 30,
	2000			1999
Operating Activities:
Net loss	$	(11,791	)	$	(855)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Depreciation and amortization		1,898			1,173
Provision for uncollectible accounts		197			154
Deferred income taxes		—			(1,560	)
Changes in operating assets and liabilities:
Accounts receivable		8,324			2,984
Contract work in process		2,493			3,776
Other current assets		(713	)		(75	)
Accounts payable and accrued liabilities		(2,468	)		(3,863	)
Accrued salaries and benefits		(729	)		1,612
Other accounts		153			85
Net cash provided by (used in) operating activities		(2,636	)		3,431
Investing Activities:
Purchases of equipment, furniture and fixtures, net		(893	)		(1,136	)
Maturities (purchases) of short-term investments		(20	)		742
Changes in other assets		262			(21	)
Net cash used in investing activities		(651	)		(415	)
Financing Activities:
Repayments of long-term debt and line of credit		(158	)		(5,479	)
Proceeds from issuance of common stock		1			82
Proceeds from issuance of preferred stock		—			11,128
Net cash provided by (used in) financing activities		(157	)		5,731
Increase (decrease) in cash and cash equivalents		(3,444	)		8,747
Cash and cash equivalents at beginning of period		15,480			6,756
Cash and cash equivalents at end of period	$	12,036		$	15,503

See accompanying notes to the condensed consolidated financial statements.

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DAOU SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1.   Basis of Presentation

             The unaudited condensed consolidated financial statements of DAOU Systems, Inc. (“DAOU” or the “Company”) at September 30, 2000 and for the three and nine-month periods ended September 30, 2000 and 1999 have been prepared in accordance with generally accepted accounting principles (“GAAP”) for interim financial information. Accordingly, they do not include all information and footnotes required by GAAP for a complete set of financial statements. These financial statements reflect all adjustments, consisting of normal recurring adjustments, which in the opinion of management are necessary to fairly present the financial position of the Company at September 30, 2000 and the results of operations for the three and nine-month periods ended September 30, 2000 and 1999. The results of operations for the three and nine months ended September 30, 2000 are not necessarily indicative of the results to be expected for the year ending December 31, 2000. The Company has experienced significant quarterly fluctuations in operating results and it expects that these fluctuations in revenues, expenses and net income or losses will continue.

             The financial statements and related disclosures have been prepared with the presumption that users of the interim financial information have read or have access to the audited financial statements for the preceding fiscal year. Accordingly, these financials should be read in conjunction with the audited financial statements and the related notes thereto contained in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission (“SEC”) on March 30, 2000.

2.   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.

3.   Lines of Credit

             On June 29, 1999, the Company obtained an $8.0 million revolving line of credit, which expires June 29, 2001. The line of credit bears interest at prime plus 1% per annum and is secured by substantially all of the assets of the Company and contains customary covenants and restrictions. There are no compensating balance requirements and borrowings under the line of credit are limited to 80% of qualifying receivables. At September 30, 2000, the Company was not in compliance with certain debt covenants; however, the Company obtained a waiver from the lender. With the renegotiation of the preferred stock, as discussed below, the Company is in compliance with its debt covenants. No amounts were outstanding under this revolving line of credit as of September 30, 2000.

4.   Net Income (Loss) Per Share

             Net income (loss) per share is computed in accordance with FASB Statement No. 128, EARNINGS PER SHARE. Basic net income (loss) per share is computed using the weighted average number of common shares outstanding during each period. Diluted net income (loss) per share includes the dilutive effect of common shares potentially issuable upon the exercise of stock options and warrants. In 2000 and for the nine months ended September 30, 1999, diluted loss per share is unchanged from basic loss per share because the effects of the assumed conversion of stock options and warrants would be antidilutive.

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             The following table details the computation of basic and diluted net income (loss) per share:

(In thousands, except per share information)
(Unaudited)

	Three Months Ended September 30,					Nine Months Ended September 30,
	2000			1999		2000			1999
Numerator:
Net income (loss) available to common stockholders	$	(4,104	)	$	625	$	(12,349	)	$	(983	)
Denominator:
Denominator for basic net income (loss) per share—weighted    average common shares outstanding		17,713			17,695		17,712			17,692
Effect of dilutive securities:
Common stock options		—			110		—			—
		—			110		—			—
Denominator for diluted net income (loss) per share—adjusted    weighted average common shares outstanding		17,713			17,805		17,712			17,692
Basic net income (loss) per share	$	(0.23	)		0.04	$	(0.70	)		(0.06	)
Diluted net income (loss) per share	$	(0.23	)		0.04	$	(0.70	)		(0.06	)

5.    Comprehensive Loss

             Comprehensive income (loss) for the three months ended September 30, 2000 and 1999 totaled $(4,107,000) and $254,000, respectively. Comprehensive loss for the nine months ended September 30, 2000 and 1999 totaled $(12,356,000) and $(1,132,000), respectively. The difference from reported net loss arises from the unrealized gains and losses on short-term investments.

6.   Series A Preferred Stock

             Holders of the Series A Preferred Stock are entitled to receive cumulative dividends at the rate of six percent per annum, payable in the form of shares of Series A Preferred Stock. Such dividend rate shall increase an additional one-percent per annum for each successive year after the second anniversary of the purchase date. As of September 30, 2000, the Company has accrued but undeclared preferred stock dividends of $866,000, payable in shares of Series A Preferred Stock. See “Fourth Quarter Events” under Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

7.   Restructuring Charges

             In connection with the Restructuring Plan, the Company has undertaken various actions to reduce the cost structure of the Company. As a result, the Company recorded restructuring charges in the second quarter of 2000, totaling approximately $827,000. Such charges were determined in accordance with Staff Accounting Bulletin No. 100, RESTRUCTURING AND IMPAIRMENT CHARGES, and Emerging Issues Task Force No. 94-3, LIABILITY RECOGNITION FOR CERTAIN EMPLOYEE TERMINATION BENEFITS AND OTHER COSTS TO EXIT AN ACTIVITY (INCLUDING CERTAIN COSTS INCURRED IN A RESTRUCTURING). These charges include severance costs related to a reduction in work force of $752,000 and the closure and combination of certain facilities of $75,000. As of September 30, 2000, the Company has paid and charged all of the restructuring liability.

8.   Disclosure of Segment Information

             For the three months and nine months ended September 30, 2000 and 1999, the Company has the following five reportable segments: information technology (IT) consulting and managed care implementation, communications infrastructure, applications implementation, integration services, and outsourcing. Beginning in early 2000, the Company formed a new segment, Enosus. The IT consulting and managed care implementation group focuses on providing senior consultants to assist healthcare management to plan and meet their business and IT objectives. The communications infrastructure group installs, implements and maintains IT infrastructure for healthcare organizations. The applications implementation group provides IT consulting resources to hospitals and other healthcare organizations. The integration services group concentrates on integration of existing healthcare systems (financial, clinical and management) to reduce overall costs and improve the quality of care. The

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outsourcing group performs a full range of IT outsourcing services including co-source or outsource of help desks, desktop support, server management, network management, voice management and complete IT department outsourcing. Enosus provides Internet professional services and solutions to organizations executing an eBusiness strategy.

             On September 30, 2000, the Company terminated an unprofitable contract to provide desktop outsourcing services for a large healthcare network. As a result of the termination, the Company recorded a write-off of a receivable totaling $318,000 in the period ending September 30, 2000. Revenues related to this contract were $869,000 and $2,169,000 for the three and nine months ending September 30, 2000, respectively.

             The Company manages segment reporting at a gross margin level. Selling, general and administrative expenses, and fixed assets are managed at the corporate level separately from the segments and therefore are not separately allocated to the segments. The Company’s segments are managed on an integrated basis in order to serve clients by assembling multi-disciplinary teams, which provide comprehensive services across its principal services.

	IT Consulting and Managed Care Implementation			Communications Infrastructure			Application Implementation			Integration Services			Outsourcing			Enosus			Total
Three months  ended September  30, 2000
Total revenues	$	2,526		$	2,007		$	3,187		$	2,507		$	5,005		$	109		$	15,341
Cost of revenues		2,071			2,008			2,719			1,605			4,450			406			13,259
Gross profit		455			(1	)		468			902			555			(297	)		2,082
Gross profit percent		18	%		0	%		15	%		36	%		11	%		(273	)%		14	%
Sales and marketing																				1,390
General and    administrative																				4,791
Loss from operations																			$	(4,099	)
Three months ended September  30, 1999
Total revenues	$	3,285			4,107		$	8,788		$	3,289		$	5,913		$	—		$	25,382
Cost of revenues		1,881			3,878			4,970			2,218			4,754			—			17,701
Gross profit		1,404			229			3,818			1,071			1,159			—			7,681
Gross profit percent		43	%		6	%		43	%		33	%		20	%		—			30	%
Sales and marketing																				2,233
General and    administrative																				4,790
Income from    operations																			$	658

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	IT Consulting and Managed Care Implementation			Communications Infrastructure			Application Implementation			Integration Services			Outsourcing			Enosus			Total
Nine months ended September  30, 2000
Total revenues	$	5,652		$	8,448		$	11,359		$	7,493		$	15,599		$	492		$	49,043
Cost of revenues		4,893			7,773			9,595			5,483			13,491			1,025			42,260
Gross profit		759			675			1,764			2,010			2,108			(533	)		6,783
Gross profit percent		13	%		8	%		16	%		27	%		13	%		(108	)%		14	%
Sales and marketing																				4,831
General and    administrative																				13,433
Restructuring charges																				827
Loss from operations																			$	(12,308	)
Nine month ended September  30, 1999
Total revenues	$	8,679		$	17,195		$	25,198		$	10,147		$	18,536		$	—		$	79,755
Cost of revenues		5,076			18,940			13,670			6,558			14,394			—			58,638
Gross profit		3,603			(1,745	)		11,528			3,589			4,142			—			21,117
Gross profit percent		42	%		(10	)%		46	%		35	%		22	%		—			26	%
Sales and marketing																				7,552
General and    administrative																				15,449
Loss from operations																			$	(1,884	)

9.   Contingencies

             On August 24, 1998, August 31, 1998, September 14, 1998 and September 23, 1998, separate complaints were filed against the Company and certain of its officers and directors in the United States District Court for the Southern District of California. A group of shareholders has been appointed the lead plaintiffs. They filed an amended consolidated complaint on February 24, 1999 and a second amended consolidated complaint on January 21, 2000. The new complaint realleges the same theory of liability previously asserted, namely the alleged improper use of the percentage-of-completion accounting method for revenue recognition. These complaints were brought on behalf of a purported class of investors in the Company’s Common Stock and do not allege specific damage amounts. In addition, on October 7, 1998 and October 15, 1998, separate complaints were filed in the Superior Court of San Diego, California. These additional complaints mirror the allegations set forth in the federal complaints and assert common law fraud and the violation of certain California statutes. By stipulation of the parties, the state court litigation has been stayed pending the resolution of a motion to dismiss, which was filed on February 22, 2000 in the federal litigation. That motion has been fully briefed and awaits the Court’s ruling which will occur at the January 29, 2001 hearing on the matter. The Company believes that the allegations set forth in all of the foregoing complaints are without merit and intends to defend against these allegations vigorously. No assurance as to the outcome of this matter can be given, however, and an unfavorable resolution of this matter could have a material adverse effect on the Company’s business, results of operations and financial condition.

10.   Subsequent Events

             On November 9, 2000, the Company’s Board of Directors appointed James T. Roberto to the Board and to succeed Larry D. Grandia as the Company’s president and chief executive officer. Mr. Grandia, however, will remain on the Board. In addition, Richard B. Jaffe and John H. Moragne have resigned from the Board and the Board has adopted a resolution fixing the membership of the Board to five.

             Mr. Grandia’s resignation as the president and chief executive officer of the Company would have given the holders of the Company’s Series A Preferred Stock the right to cause the Company to redeem their Series A Preferred Stock for approximately $12.9 million. However, the Company and the holders of the Series A Preferred Stock have permanently waived their redemption rights in return for $2.0 million in cash and warrants to purchase 3,540,000 shares of the Company’s common stock exercisable at $.01 per share. The total consideration of this

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transaction is valued at approximately $4.0 million and for financial reporting purposes will be recorded as a one-time dividend in the fourth quarter of 2000.

Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations

             This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Prospective investors are cautioned that such statements are only predictions and that actual events or results may differ materially. Forward-looking statements usually contain the words “estimate,” “anticipate,” “believe,” “expect” or similar expressions. All forward-looking statements are inherently uncertain as they are based on various expectations and assumptions concerning future events and are subject to numerous known and unknown risks and uncertainties. The forward-looking statements included herein are based on current expectations and entail various risks and uncertainties, including risks and uncertainties relating to: the Company’ s ability to launch and manage successfully its new eCommerce services to health care and non-health care customers, including the hiring, retention and training of professionals dedicated to eCommerce services; the management and integration of the Company’s operations as it develops new service offerings and management practices and implements staffing reorganizations; the ability of the Company to successfully execute strategies for realizing full shareholder value; and the effects of health care industry consolidation and changes in the health care regulatory environment on existing customer contracts and the Company’s ability to obtain new customer contracts. These uncertainties and risk factors and the matters set forth in the Company’s other SEC filings, including those more fully set forth in the “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other sections of the Company’s Form 10-K for the year ended December 31, 1999 on file with the SEC, and in the Company’s Proxy Statement Schedule 14A Information filed with the SEC on May 1, 2000 could cause the Company’s actual results to differ materially from those projected in the forward-looking statements. The Company disclaims any obligation to update or publicly announce revisions to any such statements to reflect future events or developments.

Fourth Quarter Events

             On November 9, 2000, the Company’s Board of Directors appointed James T. Roberto to the Board and to succeed Larry D. Grandia as the Company’s president and chief executive officer. Mr. Grandia, however, will remain on the Board. In addition, Richard B. Jaffe and John H. Moragne have resigned from the Board and the Board has adopted a resolution fixing the membership of the Board to five.

             Prior to his employment with the Company, Mr. Roberto served as chief executive officer of Prompt Associates, a high-technology hospital billing review and analysis firm from 1993-1998. From 1985 to 1991, Mr. Roberto served as the chief executive officer of Co-optics of America, a nationwide primary eyecare PPO. Mr. Roberto received his Bachelor of Science degree with honors in Finance, and his Master of Business Administration, from The Pennsylvania State University.

             Mr. Grandia’s resignation as the president and chief executive officer of the Company would have given the holders of the Company’s Series A Preferred Stock the right to cause the Company to redeem their Series A Preferred Stock for approximately $12.9 million. However, the Company and holders of the Series A Preferred Stock have reached an agreement whereby the holders of the Series A Preferred Stock have permanently waived their redemption rights in return for $2.0 million in cash and warrants to purchase 3,540,000 shares of the Company’s common stock exercisable at $.01 per share. The total consideration of this transaction is valued at approximately $4.0 million and for financial reporting purposes will be recorded as a one-time dividend in the fourth quarter of 2000. Even though the holders of the Series A Preferred Stock have waived their redemption rights, the Company still has its right to redeem the Series A Preferred Stock anytime after the fourth anniversary of the purchase date for the issue price and accrued dividends per share.

Overview

             DAOU provides integrated information technology (IT) solutions and services to the U.S. healthcare and Internet professional services industries. The Company’s capabilities range from strategic planning (using IT to support key business goals), to the design and integration of IT components (voice, video and data networks, application implementation, Internet infrastructure, data warehouses), to the management and delivery of operational

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services (IT department, desktop management, ASP services, network management), and to Internet solutions and professional services supporting organizations executing an eBusiness strategy.

             The Company’s service offerings are segmented into the following business units:

• IT consulting and managed care implementation (IT Consulting)—develops business and IT strategic plans and solves execution challenges for managed care and healthcare delivery organizations, installs and integrates managed care applications, and manages IT systems.

• Communications infrastructure—focuses on the IT infrastructure in healthcare enterprises, primarily IDNs, hospitals, academic medical centers and medical groups, provides networking, desktop, and voice, video and data solutions.

• Application implementation—supplies hospitals and other healthcare organizations with temporary, certified consultants who are capable of installing and servicing approximately 90% of the most common healthcare software applications.

• Integration services—focuses on integration of the customers information systems with existing or new infrastructure that allow healthcare organizations to share and access data housed across multiple platforms and environments.

• Outsourcing—performs a full range of IT outsourcing services including co-source or outsource of help desks, desktop support, server management, network management, voice management and complete IT department outsourcing.

• Enosus—provides Internet professional services and solutions to organizations executing an eBusiness strategy.

             The Company’s service offerings represent aggregated end-to-end healthcare IT solutions. Depending on the specific needs of its customers, the Company’s relationships may begin anywhere along the IT solution process, growing within one of the groups or developing cohesively across the complete end-to-end IT solution process from conceptualization to operation.

             The Company generally provides its professional services on a “time and expense” basis, under which revenues are recognized as the services are performed. Billings for these services occur on a semi-monthly or monthly basis. The Company also provides support and management service revenues, which are recognized ratably over the period that these services are provided. The Company’s gross margin with respect to fixed-fee based service contracts varies significantly depending on the percentage of third-party products versus professional services provided by the Company. 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 the cost of unprocessed third-party hardware project costs are included in contract work in progress on the Company’s balance sheet.

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Results of Operations

             The following table sets forth, for the periods indicated, certain statement of operations data as a percentage of net revenues.

	Three Months Ended September 30,						Nine Months Ended September 30,
	2000			1999			2000			1999
Revenues		100	%		100	%		100	%		100	%
Cost of revenues		86			70			86			74
Gross profit		14			30			14			26
Selling, general and administrative expenses		40			27			37			29
Restructuring charges		—			—			2			—
Income (loss) from operations		(27	)		3			(25	)		(3	)
Interest income, net		1			2			1			1
Income (loss) before income taxes		(26	)		5			(24	)		(2	)
Provision (benefit) for income taxes		—			2			—			(1	)
Net income (loss)		(26	)		3			(24	)		(1	)

Three Months Ended September 30, 2000 and 1999

             The Company’s revenues decreased 40% or $10.1 million to $15.3 million for the three months ended September 30, 2000 from $25.4 million for the three months ended September 30, 1999, primarily due to continued weakness in the Company’s core health care information technology (IT) business. Management attributes such weakness to reduced demand for such services as compared to fiscal year 1999, in which customers dedicated more resources to information technology matters in light of Year 2000 issues. Services to DAOU’s five largest customers accounted for 35% or $5.4 million of total revenues for the three months ended September 30, 2000.

             Cost of revenues decreased 25% or $4.4 million to $13.3 million for the three months ended September 30, 2000 from $17.7 million for the three months September 30, 1999, primarily as a result of a reduction in the workforce and employee related expenses driven by the reduced demand for professional services. Included in the third quarter of 2000 were $0.5 million of non-recurring costs related to the termination of an unprofitable outsourcing contract and the one-time accrual of certain employee costs related to consolidation of employee benefit plans. Gross profit as a percentage of revenues decreased to 14% for the three months ended September 30, 2000 from 30% for the three months ended September 30, 1999.

             Sales and marketing expenses decreased 36% or $0.8 million to $1.4 million for the three months ended September 30, 2000 from $2.2 million for the three months ended September 30, 1999, primarily due to a reduction in the Company’s national sales personnel and marketing expenditures. Sales and marketing expenses represented approximately 9% of total revenues for the three months ended September 30, 2000 and 1999.

             General and administrative expenses were $4.8 million for the three months ended September 30, 2000 and 1999. The three months ended September 30, 2000 included non-recurring general and administrative expenses of $1.1 million related to (i) the write off of a receivable as a result of the termination of an unprofitable outsourcing contract, (ii) the costs associated with terminated merger discussions, and (iii) the one-time accrual of certain employee costs related to consolidation of employee benefit plans. The Company has reduced the on-going general and administrative costs from the same period in 1999, primarily as a result of synergies related to the integration of acquired companies, the closure of certain administrative offices and a reduction in administrative staff. Excluding non-recurring costs, general and administrative expenses represented approximately 24% and 19% of total revenues for the three months ended September 30, 2000 and 1999, respectively.

             Other income, net, was $184,000 and $614,000 for the three months ended September 30, 2000 and 1999, respectively. Other income is primarily interest income on cash and cash equivalents and short-term investments offset by interest associated with the Company’s business lines of credit. The decrease in other income, net, was primarily due to a $540,000 gain from the sale of investments in the three months ended September 30, 1999, offset by higher average cash reserves available for investment and reduced interest expense after the payoff of outstanding debt during the third quarter of 1999.

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             Due to the Company’s current operating loss and tax loss carryforwards, no provision for income taxes was recorded in 2000. During 1999, the Company estimated that it would receive a net tax benefit for its losses. In the fourth quarter, the tax benefit previously recorded was reversed when the realization of the tax benefit became uncertain.

Nine Months Ended September 30, 2000 and 1999

             The Company’s revenues decreased 39% or $30.8 million to $49.0 million for the nine months ended September 30, 2000 from $79.8 million for the nine months ended September 30, 1999, primarily due to continued weakness in the Company’s core health care information technology (IT) business. Management attributes such weakness to reduced demand for such services as compared to fiscal year 1999 in which customers dedicated more resources to information technology matters in light of Year 2000 issues. In addition, for the nine months ended September 30, 1999 revenues include $2.8 million from its former cabling division, DAOU On-line, Inc., and an outsourcing contract the Company terminated in early 1999. Services to DAOU’s five largest customers accounted for 34% or $16.5 million of total revenues for the nine months ended September 30, 2000.

             Cost of revenues decreased 28% or $16.3 million to $42.3 million for the nine months ended September 30, 2000 from $58.6 million for the nine months ended September 30, 1999, primarily as a result of a workforce reduction and employee related expenses in the second quarter driven by the reduced demand for professional services. Included in the period ended September 30, 2000 were $0.6 million of non-recurring costs related to the termination of an unprofitable outsourcing contract and the one-time accrual of certain employee costs related to consolidation of employee benefit plans. Gross profit as a percentage of revenues decreased to 14% for the nine months ended September 30, 2000 from 26% for the nine months ended September 30, 1999.

             Sales and marketing expenses decreased 37% or $2.8 million to $4.8 million for the nine months ended September 30, 2000 from $7.6 million for the nine months ended September 30, 1999, primarily due to a reduction in the Company’s national sales personnel and marketing expenditures. Sales and marketing expenses represented approximately 10% of total revenues for the nine months ended September 30, 2000 compared to 9% for the same period in 1999, due to a reduction in revenues from 1999.

             General and administrative expenses decreased 13% or $2.0 million to $13.4 million for the nine months ended September 30, 2000 from $15.4 million for the nine months ended September 30, 1999. The three months ended September 30, 2000 included non-recurring general and administrative expense of $1.1 million related to (i) the write-off of a receivable as a result of the termination of an unprofitable outsourcing contract, (ii) the costs associated with terminated merger discussions, and (iii) the one-time accrual of certain employee costs related to consolidation of employee benefit plans. The Company has reduced the on-going general and administrative costs from the same period in 1999, primarily as a result of synergies related to the integration of acquired companies and a workforce reduction and employee related expenses. Excluding non-recurring costs, general and administrative expenses represented approximately 25% and 20% of total revenues for the nine months ended September 30, 2000 and 1999, respectively.

             To improve its cost structure, the Company recorded restructuring charges in the second quarter of 2000 totaling $827,000. These charges result primarily from severance costs related to a workforce reduction and the costs related to the closure and combination of certain facilities.

             Other income, net, was $517,000 and $433,000 for the nine months ended September 30, 2000 and 1999, respectively. Other income is primarily interest income on cash and cash equivalents, and short-term investments offset by interest associated with the Company’s business lines of credit. The increase in other income (expense), net, was primarily due to higher average cash reserves available for investment and reduced interest expense after the payoff of outstanding debt in 1999 offset by a $540,000 gain from the sale of investments in the third quarter of 1999.

             Due to the Company’s current operating loss and the loss carryforwards, no provision for taxes was recorded in 2000. During 1999, the Company estimated that it would receive a net tax benefit for its losses. In the fourth quarter, the tax benefit previously recorded was reversed when the realization of the tax benefit became uncertain.

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Liquidity and Capital Resources

             On September 30, 2000, the Company had working capital of $21.6 million, a decrease of $10.6 million from $32.2 million on December 31, 1999. For the nine months ended September 30, 2000, cash used in operating activities was $2.6 million compared to cash provided by operating activities of $3.4 million for the nine months ended September 30, 1999. This change resulted primarily from the loss from operations and decreases in accounts payable and accrued liabilities offset by decreases in accounts receivable and contract work in progress.

             Net cash used in investing activities was $651,000 for the nine months ended September 30, 2000, compared to net cash used in investing activities of $415,000 in the comparable prior period. This change resulted primarily from slightly increased equipment purchases for the nine months ended September 30, 2000.

             Net cash used in financing activities was $157,000 for the nine months ended September 30, 2000, compared to net cash provided by financing activities of $5.7 million in the comparable prior period. This change resulted primarily from the issuance of the Company’s Series A Preferred Stock and repayments of debt and lines of credit during the nine months ended September 30, 1999.

             In July 1999, the Company issued 2,181,818 shares of Series A Preferred Stock. The Series A Preferred Stock accrues dividends at a six percent annual rate. Such rate will increase one percent each year after the second anniversary of the issue date of the Series A Preferred Stock. The dividend is payable in shares of Series A Preferred Stock except in certain cases, including liquidation. Certain events, including Mr. Grandia’s resignation as president and chief executive officer of the Company, would have given the holders of the Company’s Series A Preferred Stock the right to cause the Company to redeem their Series A Preferred Stock for approximately $12.9 million, which includes approximately $866,000 in accrued dividends as of September 30, 2000. However, on November 9, 2000, the Company and the holders of the Series A Preferred Stock reached an agreement whereby the holders of the Series A Preferred Stock have permanently waived their redemption rights in return for $2.0 million in cash and warrants to purchase 3,540,000 shares of the Company’s common stock exercisable at $.01 per share. The total consideration of this transaction is valued at approximately $4.0 million and for financial reporting purposes will be recorded as a one-time dividend in the fourth quarter of 2000.

             On June 29, 1999, the Company obtained an $8.0 million revolving line of credit that expires on June 29, 2001. The line of credit bears interest at prime plus 1% per annum, is secured by substantially all of the assets of the Company and contains customary covenants and restrictions. There are no compensating balance requirements and borrowings under the line of credit are limited to 80% of qualifying receivables. At September 30, 2000, the Company was not in compliance with certain debt covenants; however, the Company obtained a waiver from the lender. With the renegotiation of the preferred stock, as discussed above, the Company is in compliance with its debt covenants. No amounts are outstanding under this revolving line of credit and there are no outstanding letters of credit as of September 30, 2000.

             Although the Company has an accumulated deficit as of September 30, 2000, the Company believes that its existing cash and short term investments together with anticipated cash from operating activities will be sufficient to meet its capital requirements, including the start-up costs for Enosus, for the foreseeable future. The Company has recently taken various actions to improve its cost structure and is currently reviewing its operations to determine what additional steps need to be taken to return the Company to a positive cash flow position. There can be no assurance that management will be able to reduce costs or increase revenues to return the Company to a positive cash flow position before its current cash and short term investments are exhausted, if at all. In addition, there can be no assurance that efforts to reduce costs will not have a material adverse effect on the Company’s business, operations or financial condition. If Company needs additional funds to implement its restructuring plans, the Company may draw down its credit facility, sell additional equity or debt securities or obtain additional credit facilities. The sale of additional equity securities or issuance of equity securities in future acquisitions would result in dilution to the Company’s stockholders and the incurrence of additional debt could result in additional interest expense. However, there can be no assurance that the Company will be able to sell additional equity or debt securities or be able to obtain additional financing on terms acceptable to it, if at all.

Business Risks

             In addition to the factors addressed in the preceding sections, certain dynamics of the Company’s markets and operations create fluctuations in the Company’s quarterly results. Uncertainty and cost containment in healthcare

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and competitive conditions present various other risks to operating results which are more fully described in the Company’s Form 10-K filed with the SEC and other SEC filings.

Item 3.   Quantitative and Qualitative Disclosures About Market Risk

             The Company is exposed to changes in interest rates, primarily from its variable-rate long-term debt arrangements and, to a lessor extent, its investments in certain available-for-sale marketable securities. Under its current policies, the Company does not use interest rate derivatives instruments to manage this exposure to interest rate changes. The Company does not have the option to convert its variable-rate long-term debt arrangement to fixed-rate debt arrangements for a nominal transaction fee. At September 30, 2000, the Company had no outstanding balance on its variable-rate debt. A hypothetical 1% adverse move in the interest rates along the entire interest rate yield curve would not materially effect the fair value of the Company’s financial instruments that are exposed to changes in interest rates.

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PART II. OTHER INFORMATION

Item 1.   Legal Proceedings

             On August 24, 1998, August 31, 1998, September 14, 1998 and September 23, 1998, separate complaints were filed against the Company and certain of its officers and directors in the United States District Court for the Southern District of California. A group of shareholders has been appointed the lead plaintiffs. They filed an amended consolidated complaint on February 24, 1999 and a second amended complaint on January 21, 2000. The new complaint realleges the same theory of liability previously asserted, namely the alleged improper use of the percentage-of-completion accounting method for revenue recognition. These complaints were brought on behalf of a purported class of investors in the Company’s Common Stock and do not allege specific damage amounts. In addition, on October 7, 1998 and October 15, 1998, separate complaints were filed in the Superior Court of San Diego, California. These additional complaints mirror the allegations set forth in the federal complaints and assert common law fraud and the violation of certain California statutes. By stipulation of the parties, the state court litigation has been stayed pending the resolution of a motion to dismiss, which was filed on February 22, 2000 in the federal litigation. That motion has been fully briefed and awaits the Court’s ruling which will occur at the January 29, 2001 hearing on the matter. The Company believes that the allegations set forth in all of the foregoing complaints are without merit and intends to defend against these allegations vigorously. No assurance as to the outcome of this matter can be given, however, and an unfavorable resolution of this matter could have a material adverse effect on the Company’s business, results of operations and financial condition.

Item 2.   Changes in Securities and Use of Proceeds

             On November 9, 2000, the holders of the Series A Preferred Stock agreed to permanently waive their redemption rights in return for $2.0 million in cash and warrants to purchase 3,540,000 shares of the Company’s common stock at a price of $.01 per share. The warrants are exercisable for five years. The warrants were issued pursuant to Rule 506 of Regulation D promulgated under the Securities Act of 1934, as amended. In addition, the holders of the Series A Preferred Stock have also agreed (i) to vote in favor of any amendment to the Company’s certificate of incorporation for the purpose of which is to remove such redemption rights or (ii) to exchange their shares of Series A Preferred Stock for another series of preferred stock of the Company that is identical to the Series A Preferred Stock except that such series would not contain a redemption right.

Item 6.   Exhibits and Reports on Form 8-K

             (a) Exhibits

Exhibit Number	Description
4.1	Form of Warrant
10.1	Investment Agreement, dated November 9, 2000, by and among the Company and the investors party thereto.
10.2	Registration Rights Agreement, dated November 9, 2000, by and among the Company the investors party thereto
10.3	Separation and General Release, dated November 11, 2000, by and between the Company and Larry D. Grandia
27.1	Financial Data Schedule

             (b) Current Reports on Form 8-K. The Registrant did not file any Current Reports on Form 8-K with the Commission during the quarter ended September 30, 2000.

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SIGNATURES

             Pursuant to the requirements of the Securities Exchange Act of 1934, this registrant has duly caused this report to be signed on its behalf by the undersigned thereto duly authorized.

		DAOU SYSTEMS, INC.
Date:   November 13, 2000	By:	/s/ James T. Roberto
		James T. Roberto President and Chief Executive Officer, Duly authorized officer

By:	/s/ Neil R. Cassidy
	Neil R. Cassidy Executive Vice President, Chief Financial Officer, and Secretary, Principal financial and accounting officer.

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Exhibit Index

Exhibit Number	Description
4.1	Form of Warrant
10.1	Investment Agreement, dated November 9, 2000, by and among the Company and the investors party thereto.
10.2	Registration Rights Agreement, dated November 9, 2000, by and among the Company the investors party thereto
10.3	Separation and General Release, dated November 11, 2000, by and between the Company and Larry D. Grandia
27.1	Financial Data Schedule

EX-4.1

EXHIBIT 4.1

        THIS WARRANT AND ANY SECURITIES ACQUIRED UPON THE EXERCISE OF THIS WARRANT HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933, AS AMENDED (THE “ACT”), OR UNDER ANY STATE SECURITIES LAWS. NEITHER THIS WARRANT NOR ANY OF SUCH SECURITIES MAY BE SOLD, ASSIGNED, TRANSFERRED, OR OTHERWISE DISPOSED OF IN THE ABSENCE OF REGISTRATION UNDER SAID ACT AND UNDER APPLICABLE STATE SECURITIES LAWS OR EXEMPTIONS THEREFROM. THIS WARRANT MAY NOT BE SOLD, ASSIGNED, TRANSFERRED, OR OTHERWISE DISPOSED OF EXCEPT UPON THE CONDITIONS SPECIFIED IN THIS WARRANT, AND NO SALE, ASSIGNMENT, TRANSFER, OR OTHER DISPOSITION OF THIS WARRANT SHALL BE VALID OR EFFECTIVE UNLESS AND UNTIL SUCH CONDITIONS SHALL HAVE BEEN COMPLIED WITH.

DAOU SYSTEMS, INC.

Common Stock Purchase Warrant No. 2000-___

Warrant to Purchase ________ Shares (subject to adjustment) of Common Stock of DAOU Systems, Inc.

Void after 5:00 p.m.
Pacific Time
November ___, 2005

        THIS IS TO CERTIFY THAT, for value received, _________________________ (the “Holder”), upon due exercise of this Warrant, is entitled to purchase from DAOU Systems, Inc., a Delaware corporation (the “Company”), at any time after the date hereof but prior to 5:00 p.m., Pacific time, on November ____, 2005 (the “Expiration Date”) up to_______________ (______) shares (subject to adjustment as hereinafter provided) (the “Shares”) of fully paid and non-assessable common stock, par value $.001 per share (the “Common Stock”), of the Company, at an exercise price of $.01 per share (such price as from time to time to be adjusted as hereinafter provided being referred to herein as the “Exercise Price”). This Warrant is subject to the following terms, provisions and conditions:

        1.  Exercise of Warrant.

        (a)  Subject to subsection 1(b) below, the Holder may exercise this Warrant in whole at any time or in part from time to time, but only in such multiples as are required to permit the issuance by the Company of one or more full Shares, by surrender of this Warrant with the Form of Subscription attached hereto duly executed to the Company no later than 5:00 P.M. Pacific time on the Expiration Date together with the payment of the Exercise Price for each of the Shares for which this Warrant is exercised. Payment for the Shares to be purchased upon exercise of this Warrant may be made by wire transfer of Fed Funds or by the delivery of a certified or cashier’s check payable to the Company for the aggregate Exercise Price of the Shares purchased. In case of the exercise of this Warrant in part prior to the Expiration Date, the Company will deliver to the Holder a new Warrant of like tenor in the name of the Holder evidencing the right to purchase the number of Shares as to which this Warrant has not been exercised.

        (b)  The Warrant may not be exercised by the Holder unless, at the time of exercise, (i) there is either (A) a registration statement or prospectus covering the Shares that is effective under (1) the Act and (2) the securities laws of the state of the address of record of such Holder, or (B) an exemption available from such registration for the Warrant exercise and issuance of Shares in the opinion of counsel reasonably satisfactory to the Company provided by the Holder to the Company, and (ii) such exercise and issuance would otherwise be in compliance with applicable law in the opinion of such counsel provided to the Company. The Warrant may not be, directly or indirectly, transferred to, or exercised by, any person in any state where such transfer or exercise would violate any law, including securities laws, of such state. Legends as required by applicable federal and state laws may be placed on the certificates representing the Shares. The Holder agrees to execute such documents and

instruments as counsel for the Company reasonably deems necessary to effect compliance of the issuance of this Warrant and any Shares issued upon exercise hereof with applicable federal and state securities laws.

        (c)  The exercise of the Warrant will be deemed to have been effected at 5:00 P.M., Pacific time on the day the Holder complies with the terms of subsection 1(a) above.

        2.  Covenants and Conditions.

        (a)  The Company hereby covenants and agrees as follows:

        (i)  All Shares will, upon issuance, be legally and validly issued, fully paid, and non-assessable and free from preemptive rights, all taxes, liens and charges with respect to the issue thereof.

        (ii)  During the period within which this Warrant may be exercised, the Company will at all times have authorized, and reserved for the purpose of issue upon exercise of this Warrant, a sufficient number of shares of Common Stock to provide for the exercise of this Warrant.

        (iii)  The Company shall pay all expenses, transfer taxes and other charges payable in connection with the preparation, issue and delivery of stock certificates issued pursuant to this Warrant, except that, in case such stock certificates shall be registered in a name or names other than the name of the Holder, funds sufficient to pay all stock transfer taxes which shall be payable upon the issuance of such stock certificate or certificates shall be paid by the Holder at the time of delivering the notice of exercise mentioned above.

        (b)  Neither this Warrant nor the Shares have been registered under the Act or any state securities laws. This Warrant and the Shares have been acquired for investment purposes and not with a view to distribution or resale and the Shares may not be made subject to a security interest, pledged, hypothecated, sold, or otherwise transferred without an effective registration statement therefor under the Act and such applicable state securities laws or an opinion of counsel (which opinion and counsel rendering same shall be reasonably acceptable to the Company) that registration is not required under the Act and under any applicable state securities laws. The certificates representing the Shares shall bear substantially the following legend:

             THE SHARES OF STOCK REPRESENTED BY THIS CERTIFICATE HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933, AS AMENDED (THE “ACT”), OR ANY APPLICABLE STATE SECURITIES LAWS, BUT HAVE BEEN ACQUIRED FOR THE PRIVATE INVESTMENT OF THE HOLDER HEREOF AND MAY NOT BE OFFERED, SOLD OR TRANSFERRED UNTIL A REGISTRATION STATEMENT UNDER THE ACT OR SUCH APPLICABLE STATE SECURITIES LAWS SHALL HAVE BECOME EFFECTIVE WITH REGARD THERETO, OR IN THE OPINION OF COUNSEL ACCEPTABLE TO THE COMPANY REGISTRATION UNDER THE ACT OR SUCH APPLICABLE STATE SECURITIES LAWS IS NOT REQUIRED IN CONNECTION WITH SUCH PROPOSED OFFER, SALE OR TRANSFER.

        Other legends as required by applicable federal and state laws may be placed on such certificates. The Holder and the Company agree to execute such documents and instruments as counsel for the Company reasonably deems necessary to effect compliance of the issuance of this Warrant and any Shares issued upon exercise hereof with applicable federal and state securities laws. Holder agrees that the Company may decline to permit a transfer of this Warrant if the proposed transferee does not meet then applicable qualifications for investors in securities offerings exempt from registration.

        3.  Stock Dividends Reclassifications, Reorganization, Anti-Dilution Provisions, Etc.

This Warrant is subject to the following further provisions:

        (a)  Stock Dividends and Stock Splits. In case, after the date hereof and prior to the expiration of this Warrant by exercise or by its terms, the Company issues any shares of its Common Stock as a stock dividend or distribution or divides the number of shares of Common Stock, then, in either of such cases, the Exercise Price per share of the Shares purchasable pursuant to this Warrant in effect at the time of such action will be proportionately reduced and the number of the Shares at that time purchasable pursuant to this Warrant shall be proportionately increased; and conversely, in the event the Company shall combine such shares of its Common Stock into a smaller

2

number of shares, then, and in such event, the Exercise Price per share of the Shares purchasable pursuant to this Warrant in effect at the time of such action shall be proportionately increased and the number of Shares at that time purchasable pursuant to this Warrant shall be proportionately decreased.

        (b)  Certain Corporate Events. In case, after the date hereof and prior to the expiration of this Warrant by exercise or by its terms, (i) the Company is recapitalized by reclassifying its outstanding Common Stock into stock with a different par value or by changing its outstanding Common Stock with par value to stock without par value, (ii) the Company or a successor entity consolidates or merges with or conveys all or substantially all of its or of any successor entity’s property and assets to one or more, or any combination of, corporations, partnerships, limited liability companies, joint ventures or other entities (any such entity being included within the meaning of the term “successor entity” in the event of any consolidation or merger of any such entity with, or the sale of all or substantially all of the property of any such entity to, another entity or entities) or (iii) the Company or a successor entity dissolves, liquidates or winds up its affairs, the Holder of this Warrant will thereafter receive, upon the terms and conditions and during the time specified in this Warrant, in lieu of the Shares theretofore purchasable upon the exercise of this Warrant, the kind and amount of shares of stock, other securities and/or assets receivable upon such recapitalization or consolidation, merger, conveyance, dissolution, liquidation or winding up by the holder of the number of shares of Common Stock which the Holder of this Warrant might have purchased, immediately prior to such recapitalization or consolidation, merger, conveyance, dissolution, liquidation or winding up after deduction or payment of the appropriate Exercise Price.

        (c)  Computation of Adjustments. Upon the occurrence of each event requiring an adjustment of the Exercise Price and/or of the number of Shares purchasable pursuant to this Warrant in accordance with, and as required by, the terms of this Section 3, the Company shall compute, or if requested by the Holder shall forthwith employ a firm of certified public accountants (who may be the regular accountants for the Company) who shall compute, the adjusted Exercise Price and the adjusted number of Shares purchasable at such adjusted Exercise Price by reason of such event in accordance with the provisions of this Section 3 and shall prepare a certificate setting forth such adjusted Exercise Price and the adjusted number of Shares and showing in detail the facts upon which such conclusions are based. All such calculations shall be to the nearest ten-thousandths; provided that any adjusted Exercise Price shall not be less than the par value for the Common Stock at such time. Any adjusted number of Shares shall be rounded to the nearest whole Share. The Company shall mail forthwith to the Holder of this Warrant a copy of such certificate, and thereafter said certificate shall be conclusive and shall be binding upon such Holder unless contested by such Holder by written notice to the Company within 10 days after receipt of the certificate by such Holder.

        (d)  Notice. In case:

        (i)  of any classification, reclassification or other reorganization of the capital stock of the Company, consolidation or merger of the Company with or into another entity where the Company is not the surviving entity, or conveyance of all or substantially all of the assets of the Company;

        (ii)  of the voluntary or involuntary dissolution, liquidation or winding up of the Company; or

        (iii)  of a proposal by the Company to take any action of the type described in this Section 3 (but only if the action of the type described in this Section 3 would result in an adjustment in the Exercise Price or the number of Shares into which this Warrant is exercisable or a change in the type of securities or property to be delivered upon exercise of this Warrant),

the Company shall give notice to the Holder, which notice shall specify the record date, if any, with respect to any such action and the approximate date on which such action is to take place. Such notice shall also set forth the facts with respect thereto as shall be reasonably necessary to indicate the effect on the Exercise Price and the number, kind or class of shares or other securities or property which shall be deliverable upon exercise of this Warrant. In the case of any action which would require the fixing of a record date, such notice shall be given at least 10 days prior to the date so fixed, and in case of all other action, such notice shall be given at least 15 days prior to the taking of such proposed action. Failure to give such notice, or any defect therein, shall not affect the legality or validity of any such action.

        4.  Non-transferability. Except to an “accredited investor,” as defined under the Securities Act, and in compliance with all applicable federal and state securities laws, this Warrant may not be sold, pledged, assigned, hypothecated, transferred or disposed of in any manner other than by will or by the laws of descent and distribution.

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Any Shares issued hereunder may not be transferred in violation of any applicable securities laws. Any attempted assignment, transfer, pledge, hypothecation or other encumbrance of this Warrant and any Shares issued upon exercise hereof contrary to the provisions hereof, and any execution, attachment or similar process upon this Warrant, will be null, void and of no effect.

        5.  No Rights or Liabilities as a Shareholder. This Warrant shall not entitle the Holder hereof to any voting rights or other rights whatsoever as a shareholder of the Company. No provision of this Warrant, in the absence of affirmative action by the Holder hereof to purchase the Shares, and no mere enumeration herein of the rights or privileges of the Holder hereof, shall give rise to any liability of such Holder for the Exercise Price or as a shareholder of the Company, whether such liability is asserted by the Company or by creditors of the Company.

        6.  Loss, Theft, Destruction or Mutilation. Upon receipt by the Company of evidence satisfactory to it (in the exercise of its reasonable discretion) of the ownership of and the loss, theft, destruction or mutilation of this Warrant and (in the case of loss, theft or destruction) of an indemnity from the Holder satisfactory to the Company (in the exercise of its reasonable discretion), and (in the case of mutilation) upon surrender and cancellation thereof, the Company, at its expense, will execute and deliver to the Holder in lieu thereof, a new Warrant of like tenor.

        7.  Register. The Company shall maintain, at its principal office located at 5120 Shoreham Place, San Diego, California 92122 (or such other office or agency of the Company as it may designate by notice to the Holder hereof), a register for this Warrant, in which the Company shall record the name and address of the person in whose name this Warrant has been issued, as well as the name and address of each transferee as may be permitted under the terms of this Warrant and each prior owner of this Warrant.

        8.  Exercise or Transfer Without Registration. Anything in this Warrant to the contrary notwithstanding if, at the time of the surrender of this Warrant in connection with any exercise, transfer or exchange of this Warrant, this Warrant shall not be registered under the Act and under applicable state securities laws, the Company may require, as a condition of allowing such exercise, transfer or exchange, that (i) the Holder of this Warrant, furnish to the Company a written opinion of counsel, which opinion and counsel are acceptable to the Company, to the effect that such exercise, transfer or exchange may be made without registration under said Act and under applicable state securities laws; provided that, if the Holder is the original Holder hereof, no opinion shall be required upon the exercise of this Warrant, and (ii) the Holder execute and deliver to the Company an investment letter in form and substance acceptable to the Company. The Holder of this Warrant, by taking and holding the same, hereby represents to the Company that such Holder is an “accredited investor” as defined under the Act and is acquiring this Warrant for investment and not with a view to the distribution thereof.

        9.  Notices. All notices requests and other communications required or permitted to be given or delivered hereunder to the Holder of this Warrant or to the Holder of Shares acquired upon exercise of this Warrant shall be in writing, and shall be personally delivered or shall be sent by first class, certified or registered mail, postage prepaid and addressed to such Holder at the address shown for such Holder on the books of the Company, or at such other address as shall have been furnished to the Company by notice from such Holder. All notices, requests and other communications required or permitted to be given or delivered hereunder to the Company shall be in writing, and shall be personally delivered or shall be sent by first class, certified or registered mail, postage prepaid and addressed, to the office of the Company at 5120 Shoreham Place, San Diego, California 92122, Attention: Corporate Secretary, or at such other address as shall have been furnished to the Holder of this Warrant or to the Holder of Shares acquired upon exercise of this Warrant by notice from the Company. Any such notice, request, or other communication may be sent by telegram, facsimile or telex, but shall in such case be subsequently confirmed by a writing personally delivered or sent by first class, certified or registered mail as provided above. All notices, requests, and other communications shall be deemed to have been given either at the time of the delivery thereof to (or the receipt by, in the case of a telegram, facsimile or telex) the person entitled to receive such notice at the address of such person for purposes of this Section 9, or, if mailed, at the completion of the third full business day following the time of such mailing thereof to such address, as the case may be.

        10.  Governing Law. This Warrant shall be construed and enforced in accordance with and governed by the laws of the State of Delaware.

        11.  Net Issuable Exchange.

        (a)  In addition to and without limiting the rights of the Holder under the terms of this Warrant, the Holder shall have the right (the “Conversion Right”) to convert this Warrant or any portion hereof into Shares as

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provided in this Section 11 at any time or from time to time prior to the Expiration Date. Upon exercise of the Conversion Right with respect to a particular number of Shares subject to this Warrant (the “Converted Warrant Shares”), the Company shall deliver to the Holder, without payment by the Holder of any exercise price or any cash or consideration other than the surrender of the right to exercise this Warrant as to the Converted Warrant Shares, a number of Shares determined by multiplying the number of Converted Warrant Shares by the following:

FMV — Exercise Price
FMV

        FMV shall be the Market Price (as defined below) of the Common Stock as of the Conversion Date and the Exercise Price shall be determined as of the close of business on the Conversion Date (as defined below).

        (b)  For purposes of this Warrant, the “Market Price” of a share of Common Stock as of a particular date shall mean, if the Common Stock is traded on a securities exchange or quoted on the Nasdaq National Market or the Nasdaq SmallCap Market, the closing sale price of the Common Stock on such exchange or market for the date in question. If the Common Stock is not traded on a securities exchange or quoted on the Nasdaq National Market or the Nasdaq SmallCap Market, but bid and asked prices in the over-the-counter market are reported by the National Association of Securities Dealers, Inc. Automated Quotations System, Inc. (or if not so reported, by the National Quotation Bureau Incorporated) for the Common Stock, then the “Market Price” of a share of Common Stock shall be the average mean of such reported bid and asked prices on the date in question. If at any time the Common Stock is not traded on an exchange or quoted on the Nasdaq National Market or the Nasdaq SmallCap Market or otherwise traded in the over-the-counter market, the Conversion Right may only be exercised once and the Market Price shall be deemed to be the fair market value thereof determined in good faith by any firm of independent public accountants or a nationally recognized independent investment banking firm selected by the Board of Directors of the Company.

        (c)  The Conversion Right may be exercised by the Holder by surrendering this Warrant at the principal office of the Company together with a written statement specifying that the Holder thereby intends to exercise the Conversion Right and indicating the number of Shares subject to this Warrant which are being surrendered (referred to in subsection (a) above as the Converted Warrant Shares) in exercise of the Conversion Right. Such conversion shall be effective upon receipt by the Company of this Warrant together with the aforesaid written statement or on such later date as is specified therein (the “Conversion Date”), but not later than the Expiration Date. Certificates for the Shares issuable upon exercise of the Conversion Right and, in the case of a partial exercise, a new warrant certificate evidencing the Shares remaining subject to this Warrant shall be issued as of the Conversion Date and shall be delivered to the Holder within 15 days following the Conversion Date.

        12.  Miscellaneous.

        (a)  Amendments. This Warrant or any provision hereof may not be changed, waived, discharged or terminated orally, but only by an instrument in writing signed by the party (or any predecessor in interest thereof) against which enforcement of the same is sought.

        (b)  Descriptive Headings. The descriptive headings of the several sections of this Warrant are inserted for purposes of reference only, and shall not affect the meaning or construction of any of the provisions hereof.

        (c)  Successors and Assigns. This Warrant shall be binding upon any entity succeeding to the Company by merger, consolidation or acquisition of all or substantially all the Company’s assets.

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IN WITNESS WHEREOF, the Company has caused this Warrant to be signed by its duly authorized officer on this 9th day of November, 2000.

	DAOU SYSTEMS, INC.
By:
	Name:  Neil R. Cassidy Title:  Executive Vice President and              Chief Financial Officer

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FORM OF SUBSCRIPTION

Dated: _________, ___.

To: _______________________________

        The undersigned, pursuant to the provisions set forth in the within Warrant Number ________ hereby agrees to purchase ______ shares of Common Stock covered by such Warrant, and makes payment herewith in full therefor at the price per share provided by such Warrant in cash or by certified or official bank check in the amount of $_______________. Please issue a certificate of certificates for such shares of Common Stock in the following name:

        Name:      ________________________

        Address:________________________

                        ________________________

        Signature:_______________________

        Title of Signing Officer or Agent (if any):

Note: The above signature should correspond exactly with the name on the face of the within Warrant and, if said number of shares of Common Stock shall not be all the shares purchasable under the within Warrant, a new Warrant is to be issued in the name of said Holder covering the balance of the shares purchasable thereunder.

EX-10.1

EXHIBIT 10.1

INVESTMENT AGREEMENT

        Agreement entered into as of November 9, 2000, by and between Galen Partners III, L.P., a Delaware limited partnership (“Galen Partners”), Galen Partners International III, L.P., a Delaware limited partnership (“Galen International”), Galen Employee Fund III, L.P., a Delaware limited partnership (“Employee Fund”), and DAOU Systems, Inc., a Delaware corporation (the “Company”). Galen Partners, Galen International, Employee Fund, and the Company are referred to collectively herein as the “Parties.”

        WHEREAS, each of Galen Partners, Galen International, and the Employee Fund (collectively, the “Investors”) owns all of the issued and outstanding shares of Series A Preferred Stock, par value $0.001 per share, of the Company (the “Series A Preferred Stock”) set forth opposite its name on Schedule 1;

        WHEREAS, the Series A Preferred Stock is redeemable at the option of the holders upon the occurrence of certain events; and

        WHEREAS, the Investors have agreed to waive such redemption rights now and hereafter in return for the grant of certain warrants to purchase common stock, par value $0.001 per share, of the Company (the “Common Stock”) and the payment of $2,000,000 in cash as an advisory fee to Galen Associates, a Delaware general partnership.

        NOW, THEREFORE, in consideration of the premises and the mutual promises herein made, and in consideration of the representations, warranties, and covenants herein contained, the Parties agree as follows:

1.  Issuance of Warrants.

        (a)  Basic Transaction. Subject to the terms and conditions of this Agreement, at the Closing (as defined below) the Company will issue to the Investors warrants exercisable for an aggregate of 3,540,000 shares of the Company’s Common Stock allocated among the Investors as set forth on Schedule 1, which warrants will be substantially in the form set forth on Exhibit A hereto.

        (b)  The Closing. The closing of the transactions contemplated by this Agreement (the “Closing”) shall take place at the offices of DAOU Systems, Inc. at 5120 Shoreham Place, San Diego, CA 92122, or such other place as the Parties may mutually determine on November 9, 2000 (the “Closing Date”).

2.  Representations And Warranties Concerning The Transaction.

        (a)  Representations and Warranties of the Company. The Company represents and warrants to each Investor that the statements contained in this §2(a) are correct and complete as of the date of this Agreement and will be correct and complete as of the Closing Date (as though made then and as though the Closing Date were substituted for the date of this Agreement throughout this §2(a)) with respect to itself.

              (i)  Organization of the Company. The Company is a corporation duly organized, validly existing, and in good standing under the laws of the jurisdiction of its formation.

              (ii)  Authorization of Transaction. The Company has full power and authority (including full corporate power and authority) to execute and deliver this Agreement and to perform its obligations hereunder. This Agreement constitutes the valid and legally binding obligation of the Company, enforceable against the Company in accordance with its terms. The Company need not give any notice to, make any filing with, or obtain any authorization, consent, or approval of any government or governmental agency in order to consummate the transactions contemplated by this Agreement.

              (iii)  Noncontravention. Neither the execution and the delivery of this Agreement, nor the consummation of the transactions contemplated hereby, will violate any constitution, statute, regulation, rule, injunction, judgment, order, decree, ruling, charge, or other restriction of any government, governmental agency, or court to which the Company is subject or any provision of its charter or bylaws.

        (b)  Representations and Warranties of the Investors. Each Investor represents and warrants to the Company that the statements contained in this §2(b) are correct and complete as of the date of this Agreement and will be correct and complete as of the Closing Date with respect to such Investor (as though made then and as though the Closing Date were substituted for the date of this Agreement throughout this §2(b)).

              (i)  Organization of the Investor; Ownership of Series A Preferred Stock. The Investor is a limited partnership duly formed and validly existing and in good standing under the laws of the jurisdiction of its incorporation. The Investor owns all of the Series A Preferred Stock set forth opposite its name on Schedule 1 and has not assigned, pledged, hypothecated, or otherwise transferred any of the shares of Series A Preferred Stock acquired from the Company regardless of whether or not set forth on Schedule 1 hereto.

              (ii)  Authorization of Transaction. The Investor has full power and authority to execute and deliver this Agreement and to perform its obligations hereunder. This Agreement constitutes the valid and legally binding obligation of the Investor, enforceable against the Investor in accordance with its terms. The Investor need not give any notice to, make any filing with, or obtain any authorization, consent, or approval of any government or governmental agency in order to consummate the transactions contemplated by this Agreement.

              (iii)  Noncontravention. Neither the execution and the delivery of this Agreement, nor the consummation of the transactions contemplated hereby, will violate any constitution, statute, regulation, rule, injunction, judgment, order, decree, ruling, charge, or other restriction of any government, governmental agency, or court to which the Investor is subject or any provision of its charter documents.

              (iv)  Acquired Entirely for Own Account. This Agreement is made with each Investor in reliance upon such Investor’s representation to the Company, which by such Investor’s execution of this Agreement such Investor hereby confirms, that the Warrant to be received by such Investor and the Common Stock issuable upon exercise thereof (collectively, the “ Securities”) will be acquired for investment for such Investor’s own account, not as a nominee or agent, and not with a view to the resale or distribution of any part thereof, and that such Investor has no present intention of selling, granting any participation in, or otherwise distributing the same. By executing this Agreement, each Investor further represents that such Investor does not have any contract, undertaking, agreement, or arrangement with any person to sell, transfer, or grant participations to such person or to any third person, with respect to any of the Securities.

              (v)  Due Diligence; Disclosure of Information. Each Investor has performed a due diligence investigation of the Company and its industry. Each Investor further represents that it has had an opportunity to ask questions and receive answers from the Company regarding the terms and conditions of the offering of the Securities. Each Investor believes it has received all of the information it considers necessary in order to enter into this Agreement and consummate the transactions contemplated hereby.

              (vi)  Investment Experience. Each Investor is a professional investor with substantial knowledge about the industry in which the Company functions. Accordingly, each Investor has such knowledge and experience regarding the industry of the Company and in financial or business matters that it is capable of evaluating fully the merits and risks of the investment in the Securities. Each Investor acknowledges that it is able to fend for itself and can bear the economic risk of its investment, and each Investor also represents that it has not been organized for the purpose of acquiring the Securities. Each Investor represents and warrants that it maintains its principal place of business at the address indicated for such Investor on Schedule 1 of this Agreement and that it is organized under the laws of the state of Delaware.

              (vii)  Accredited Investor; Investor Status. Each Investor is an “accredited investor” within the meaning of SEC Rule 501 of Regulation D, as presently in effect. Each of Galen Partners, Galen International and the Employee Fund is an institutional buyer as referenced in the General Business Law of the State of New York.

              (viii)  Restricted Securities. Each Investor understands that the Securities are characterized as “restricted securities” under the federal securities laws inasmuch as they are being acquired from the Company in a transaction not involving a public offering and that under such laws and applicable regulations such securities may be resold without registration under the Securities Act of 1933, as amended (the “Act”), only in certain limited circumstances. In this connection, each Investor represents that it is familiar with SEC Rule 144, as presently in effect, and understands the resale limitations imposed thereby and by the Act. In addition, each Investor agrees that it will not transfer any Securities in violation of any state or federal securities law.

              (ix)  Legends. It is understood that the certificates evidencing the Warrant (and the Common Stock issuable upon exercise thereof) may bear one or all of the following legends as appropriate in substantially the form set forth below:

                     (A)  THIS WARRANT AND ANY SECURITIES ACQUIRED UPON THE EXERCISE OF THIS WARRANT HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933, AS AMENDED (THE “ACT”), OR UNDER ANY STATE SECURITIES LAWS. NEITHER THIS WARRANT NOR ANY OF SUCH SECURITIES MAY BE SOLD, ASSIGNED, TRANSFERRED, OR OTHERWISE DISPOSED OF IN THE ABSENCE OF REGISTRATION UNDER SAID ACT AND UNDER APPLICABLE STATE SECURITIES LAWS OR EXEMPTIONS THEREFROM. THIS WARRANT MAY NOT BE SOLD, ASSIGNED, TRANSFERRED, OR OTHERWISE DISPOSED OF EXCEPT UPON THE CONDITIONS SPECIFIED IN THIS WARRANT, AND NO SALE, ASSIGNMENT, TRANSFER, OR OTHER DISPOSITION OF THIS WARRANT SHALL BE VALID OR EFFECTIVE UNLESS AND UNTIL SUCH CONDITIONS SHALL HAVE BEEN COMPLIED WITH.

                     (B)  THE SHARES OF STOCK REPRESENTED BY THIS CERTIFICATE HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933, AS AMENDED (THE “ACT”), OR ANY APPLICABLE STATE SECURITIES LAWS, BUT HAVE BEEN ACQUIRED FOR THE PRIVATE INVESTMENT OF THE HOLDER HEREOF AND MAY NOT BE OFFERED, SOLD OR TRANSFERRED UNTIL A REGISTRATION STATEMENT UNDER THE ACT OR SUCH APPLICABLE STATE SECURITIES LAWS SHALL HAVE BECOME EFFECTIVE WITH REGARD THERETO, OR IN THE OPINION OF COUNSEL ACCEPTABLE TO THE COMPANY REGISTRATION UNDER THE ACT OR SUCH APPLICABLE STATE SECURITIES LAWS IS NOT REQUIRED IN CONNECTION WITH SUCH PROPOSED OFFER, SALE OR TRANSFER.

                     (C)  THE SHARES EVIDENCED HEREBY ARE SUBJECT TO CERTAIN VOTING RIGHTS AND RESTRICTIONS WITH RESPECT TO THE ELECTIONS OF DIRECTORS AS MORE FULLY SET FORTH IN THE INVESTMENT AGREEMENT, DATED NOVEMBER 9, 2000, BY AND BETWEEN THE CORPORATION AND THE SHAREHOLDERS PARTY THERETO.

                     (D)  Any legend required by the laws of the State of California, including any legend required by the California Department of Corporations and Sections 417 and 418 of the Code.

                     (E)  Any other legend required to comply with applicable state securities laws.

              (x)  Securities Law Compliance. Each Investor acknowledges and understands that the Company is relying on the representations and warranties set forth above in this §2 for compliance with applicable federal and state securities laws.

3.  Waiver of Redemptive Rights.

        (a)  Each Investor unequivocally and irrevocably waives any and all rights that such Investor now has, or hereafter may have, pursuant to Section 3 of the Certificate of Designations, Preferences and Relative Rights of Preferred Stock and Qualifications, Limitations, and Restrictions thereof of Series A Preferred Stock, dated July 22, 1997 (the “Series A Certificate of Designations”) concerning rights of redemption with respect to the Series A Preferred Stock and agrees not to exercise such rights now or in the future. Each Investor agrees that it shall not transfer any interest in the Series A Preferred Stock unless such transferee agrees to be bound by this Section 3 and shall cause each transferee to comply with this Section 3. In addition, each Investor agrees (i) to vote its Voting Securities (as defined below) in favor of any amendment to the Company’s Certificate of Incorporat ion the purpose of which is to remove such provisions from the Series A Certificate of Designations and (ii) to exchange, if so requested by the Board, its Series A Preferred Stock for preferred stock of the Company that is identical to the Series A Preferred Stock except that such preferred stock does not contain a right of redemption.

        (b)  Each Investor agrees to have the following legend placed on each and every Certificate, either now held by the Investor or hereinafter issued to the Investor, representing Series A Preferred Stock:

              THESE SHARES EVIDENCED HEREBY ARE SUBJECT TO CERTAIN RESTRICTIONS, INCLUDING RESTRICTIONS ON THEIR RIGHT OF REDEMPTION, AS SET FORTH IN THAT CERTAIN INVESTMENT AGREEMENT, DATED NOVEMBER 9, 2000 BY AND BETWEEN THE CORPORATION AND THE SHAREHOLDERS PARTY THERETO.

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4.  Additional Agreements.

        (a)  Voting. Except as otherwise provided herein, each Investor shall take such action as may be required so that all shares of Common Stock, Series A Preferred Stock or any other securities generally entitled to vote in matters brought before the stockholders of the Company (collectively, the “Voting Securities”) owned directly or indirectly by it or any Affiliate shall be present for quorum purposes, in person or represented by proxy (or consent) at every meeting of holders of Common Stock (or, if applicable, in any matter to be voted upon by consent of stockholders without a meeting). Nothing set forth in this Section 4(a) shall limit or otherwise restrict how any Investor votes its Voting Securities at a meeting of stockholders or by consent of stockholders without a meeting.

        (b)  Directorship. Galen Partners shall not nominate more than one person for election to the Board of Directors of the Company if the election of all such nominees would result in such nominees, if elected, comprising over 25% of the membership of the Board. If at any time, more than one such nominee sits on the Board and such nominees comprise over 25% of the membership of the Board, a sufficient number of nominees shall promptly resign so that any remaining nominees comprise 25% or less of the membership of the Board. If an Investor nominee resigns or is removed, except if the replacement of such nominee will result in Galen Partners having more than one nominee on the Board and such nominees will represent over 25% of the membership of the Board, Galen Partners shall be entitled to select a replacement. The Board of Directors shall approve such replacement. Without the consent of Galen Partners, which such consent shall not be unreasonably withheld, the number of Directors constituting the Board of Directors shall not exceed five.

5.  Pre-Closing Covenants. The Parties agree as follows with respect to the period between the execution of this Agreement and the Closing.

        (a)  General. Each of the Parties will use its commercially reasonable efforts to take all action and to do all things necessary in order to consummate and make effective the transactions contemplated by this Agreement (including satisfaction, but not waiver, of the closing conditions set forth in §6 below).

        (b)  Notices and Consents. Each of the Parties will give any notices to, make any filings with, and use its commercially reasonable efforts to obtain any authorizations, consents, and approvals of, governments and governmental agencies in connection with the matters referred to in §2(a)(ii) and (iii) and §2(b)(ii) and (iii), above.

6.  Conditions to Obligation to Close.

        (a)  Conditions to Obligation of the Investors. The obligation of the Investors to consummate the transactions to be performed by them in connection with the Closing is subject to satisfaction of the following conditions:

              (i)  the representations and warranties set forth in §2(a) above shall be true and correct in all material respects at and as of the Closing Date;

              (ii)  the Company shall have performed and complied with all of its covenants hereunder in all material respects through the Closing; and

              (iii)  there shall not be any injunction, judgment, order, decree, ruling, or charge in effect preventing consummation of any of the transactions contemplated by this Agreement.

Each Investor may waive any condition specified in this §6(a) if it executes a writing so stating at or prior to the Closing.

        (b)  Conditions to Obligation of the Company. The obligation of the Company to consummate the transactions to be performed by it in connection with the Closing is subject to satisfaction of the following conditions:

              (i)  the representations and warranties set forth in §2(b) above shall be true and correct in all material respects at and as of the Closing Date;

              (ii)  the Investors shall have performed and complied with all of their covenants hereunder in all material respects through the Closing; and

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              (iii)  there shall not be any injunction, judgment, order, decree, ruling, or charge in effect preventing consummation of any of the transactions contemplated by this Agreement.

The Company may waive any condition specified in this §6(b) if it executes a writing so stating at or prior to the Closing.

7.  Termination.

        (a)  The Company and the Investors may terminate this Agreement by mutual written consent at any time prior to the Closing.

        (b)  The Agreement will automatically terminate when the Investor Group beneficially owns less than 10% of the Voting Securities; provided that Sections 2 and 3 hereof will survive such termination.

8.  Miscellaneous.

        (a)  Press Releases and Public Announcements. No Party shall issue any press release or make any public announcement relating to the subject matter of this Agreement prior to the Closing without the prior written approval of the other Parties; provided, however, that any Party may make any public disclosure it believes in good faith is required by applicable law.

        (b)  Third Party Beneficiaries. This Agreement shall not confer any rights or remedies upon any Person other than the Parties, and their respective successors and permitted assigns.

        (c)  Entire Agreement. This Agreement (including the documents referred to herein) constitutes the entire agreement among the Parties and supersedes any prior understandings, agreements, or representations by or among the Parties, written or oral, to the extent they have related in any way to the subject matter hereof.

        (d)  Succession and Assignment. This Agreement shall be binding upon and inure to the benefit of the Parties named herein and their respective successors and permitted assigns. No Party may assign either this Agreement or any of its rights, interests, or obligations hereunder without the prior written approval of the other Parties.

        (e)  Counterparts. This Agreement may be executed in one or more counterparts, each of which shall be deemed an original but all of which together will constitute one and the same instrument.

        (f)  Headings. The section headings contained in this Agreement are inserted for convenience only and shall not affect in any way the meaning or interpretation of this Agreement.

        (g)  Notices. All notices, requests, demands, claims, and other communications hereunder will be in writing. Any notice, request, demand, claim, or other communication hereunder shall be deemed duly given if (and then five business days after) it is sent by registered or certified mail, return receipt requested, postage prepaid, and addressed to the intended recipient as set forth below:

If to the Company:

Daou Systems, Inc.
5120 Shoreham Place
San Diego, California 92122
Attn.: Chief Financial Officer
Facsimile: 858-452-2789

with a copy to: Baker & McKenzie
1301 McKinney Street, Suite 3300
Houston, Texas 77010-3019
Attn: Alan Harvey
Facsimile: 713-427-5099

If to the Investors:

To the address listed on Schedule 1

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with a copy to: Thelen Reid & Priest LLP
40 West 57th Street
New York, New York 10019
Attn: Peter K. Anglum
Facsimile: 212-603-2001

Any Party may send any notice, request, demand, claim, or other communication hereunder to the intended recipient at the address set forth above using any other means (including personal delivery, expedited courier, messenger service, telecopy, telex, ordinary mail, or electronic mail), but no such notice, request, demand, claim, or other communication shall be deemed to have been duly given unless and until it actually is received by the intended recipient. Any Party may change the address to which notices, requests, demands, claims, and other communications hereunder are to be delivered by giving the other Parties notice in the manner herein set forth.

        (h)  Aggregation of Stock. All shares of the Series A Preferred Stock held or acquired by affiliated entities or persons will be aggregated together for the purpose of determining the availability of any rights under this Agreement.

        (i)  Governing Law. This Agreement shall be governed by and construed in accordance with the domestic laws of the State of Delaware without giving effect to any choice or conflict of law provision or rule (whether of the State of Delaware or any other jurisdiction) that would cause the application of the laws of any jurisdiction other than the State of Delaware.

        (j)  Amendments and Waivers. No amendment of any provision of this Agreement shall be valid unless the same shall be in writing and signed by each of the Parties. No waiver by any Party of any default, misrepresentation, or breach of warranty or covenant hereunder, whether intentional or not, shall be deemed to extend to any prior or subsequent default, misrepresentation, or breach of warranty or covenant hereunder or affect in any way any rights arising by virtue of any prior or subsequent such occurrence.

        (k)  Severability. Any term or provision of this Agreement that is invalid or unenforceable in any situation in any jurisdiction shall not affect the validity or enforceability of the remaining terms and provisions hereof or the validity or enforceability of the offending term or provision in any other situation or in any other jurisdiction.

        (l)  Expenses. Each of the Parties will bear its own costs and expenses (including legal fees and expenses) incurred in connection with this Agreement and the transactions contemplated hereby; provided that the Company will reimburse the Investors up to $30,000 for their costs and expenses.

        (m)  Specific Performance. Each of the Parties acknowledges and agrees that the other parties would be damaged irreparably in the event any of the provisions of this Agreement are not performed in accordance with their specific terms or otherwise are breached. Accordingly, each Party agrees that the other Party shall be entitled to an injunction or injunctions to prevent breaches of the provisions of this Agreement and to enforce specifically this Agreement and the terms and provisions hereof in any action instituted in any court of the United States or any state thereof having jurisdiction over the parties and the matter, in addition to any other remedy to which they may be entitled, at law or in equity.

        (n)  Construction. The Parties have participated jointly in the negotiation and drafting of this Agreement. In the event an ambiguity or question of intent or interpretation arises, this Agreement shall be construed as if drafted jointly by the Parties and no presumption or burden of proof shall arise favoring or disfavoring any Party by virtue of the authorship of any of the provisions of this Agreement. Any reference to any federal, state, local, or foreign statute or law shall be deemed also to refer to all rules and regulations promulgated thereunder, unless the context requires otherwise.

        (o)  Further Assurances. The Parties agree (i) to furnish upon request to each other such further information, (ii) to execute and deliver to each other such other documents, and (iii) to do such other acts and things, all as the other party may reasonably request for the purpose of carrying out the intent of this Agreement and the documents referred to in this Agreement.

        (p)  Incorporation of Exhibits, Annexes, and Schedules. The Exhibits, Annexes, and Schedules identified in this Agreement are incorporated herein by reference and made a part hereof.

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        IN WITNESS WHEREOF, the Parties hereto have executed this Agreement as of the date first above written.

	THE COMPANY: DAOU SYSTEMS, INC.
By:	/s/  Neil R. Cassidy
	Name:   Neil R. Cassidy Title:   Executive Vice President and    Chief Financial Officer

	THE INVESTORS: GALEN PARTNERS III, L.P., a Delaware Limited Partnership
By:	Claudius, L.L.C., a Delaware Limited Liability Company

By:	/s/  Bruce F. Wesson
	Name:   Bruce F. Wesson Title:   Senior Managing Member

	GALEN PARTNERS INTERNATIONAL III, L.P., a Delaware Limited Partnership
By:	Claudius, L.L.C., a Delaware Limited Liability Company

By:	/s/  Bruce F. Wesson
	Name:   Bruce F. Wesson Title:   Senior Managing Member

	GALEN EMPLOYEE FUND III, L.P., a Delaware Limited Partnership
By:	Wesson Enterprises, Inc.

By:	/s/  Bruce F. Wesson
	Name:   Bruce F. Wesson Title:   President

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SCHEDULE 1

	Shares Owned		Warrants
GALEN PARTNERS III, L.P.    610 Fifth Avenue, 5th Floor    New York, New York 10020    Attn.: Bruce F. Wesson     Facsimile:		2,114,623		3,234,022
GALEN PARTNERS INTERNATIONAL III, L.P.    610 Fifth Avenue, 5th Floor    New York, New York 10020    Attn.: Bruce F. Wesson     Facsimile:		191,410		292,735
GALEN EMPLOYEE FUND III, L.P.    610 Fifth Avenue, 5th Floor    New York, New York 10020    Attn.: Bruce F. Wesson     Facsimile:		8,659		13,243

EX-10.2

EXHIBIT 10.2

AMENDED AND RESTATED
REGISTRATION RIGHTS AGREEMENT

        This Amended and Restated Registration Rights Agreement, dated as of November 9, 2000, is among DAOU Systems, Inc., a Delaware corporation (the “Company”), and the investors listed on Schedule 1 to this Agreement, each of which is referred to in this Agreement as an “Investor.”

RECITALS

        WHEREAS, the Company and the Investors are parties to the Series A Stock Purchase Agreement, dated July 26, 1999 (the “Series A Agreement”), and the Investment Agreement dated of even date herewith (the “Investment Agreement”);

        WHEREAS, the Company and the Investors previously entered into a Registration Rights Agreement, dated July 26, 1999 (the “Registration Rights Agreement”), to cause the Company to register the shares of the Company’s common stock, par value $0.001 per share (the “Common Stock”), issuable upon the conversion of shares of Series A Preferred Stock, par value $0.001 per share (the “ Series A Preferred Stock”), as set forth therein; and

        WHEREAS, in order to induce the Investors to enter into the Investment Agreement pursuant to which the Company granted certain warrants exercisable for shares of Common Stock (the “Warrants”) to the Investors and in return the Investors waived certain redemption rights associated with the Series A Preferred Stock, the Company and Investors hereby agree to amend and restate the Registration Rights Agreement to cause the Company to register shares of the Common Stock issuable to the Investors upon conversion of the Series A Preferred Stock and upon the exercise the Warrants.

        NOW, THEREFORE, the parties hereby agree as follows:

ARTICLE I
REGISTRATION RIGHTS

1.1.  Definitions. For Purposes of this Agreement:

        (a)  the term “Register,” “Registered,” and “Registration” refer to a registration effected by preparing and filing a registration statement or similar document in compliance with the Securities Act of 1933, as amended (the “Act”), and the declaration or ordering of effectiveness of such registration statement or document;

        (b)  the term “Registrable Securities” means (i) the Common Stock issuable or issued upon conversion of the Series A Preferred Stock whether or not sold pursuant to the Series A Agreement or upon exercise of the Warrants and (ii) any Common Stock issued as (or issuable upon the conversion or exercise of any warrant, right or other security which is issued as) a dividend or other distribution with respect to, or in exchange for or in replacement of, such Series A Preferred Stock, the Warrants or Common Stock, as applicable, excluding in all cases, however, any Registrable Securities sold by a person in a transaction in which such person’s rights under this Article I are not assigned;

        (c)  the number of shares of “Registrable Securities then outstanding” will be determined by the number of shares of Common Stock outstanding which are, and the number of shares of Common Stock issuable pursuant to then exercisable or convertible securities which are, Registrable Securities;

        (d)  the term “Holder” means any person owning or having the right to acquire Registrable Securities or any permitted assignee thereof; and

        (e)  the term “Form S-3” means such form under the Act as in effect on the date of this Agreement or any registration form under the Act subsequently adopted by the Securities and Exchange Commission (“SEC”) which permits inclusion or incorporation of substantial information by reference to other documents filed by the Company with the SEC.

1.2.  Form S-3 Registration.

        As soon as reasonably practicable after the date hereof (currently anticipated to be approximately 45 days), the Company shall file with the SEC one or more Registration Statements on Form S-3 (or other similar form) covering the continuous sale of the Registrable Securities pursuant to Rule 415 under the Securities Act or any successor thereto (each, a “Shelf Registration Statement”), in the manner specified therein. The Company shall use all reasonable efforts to cause each Shelf Registration Statement to be declared effective by the SEC as soon as reasonably practicable after its filing with the SEC, and to remain effective until the earlier of (x) such time as all of the Registrable Securities are sold pursuant to such Shelf Registration Statement or (y) each Holder is able to sell within any 90-day period all Registrable Securities owned by such Holder pursuant to SEC Rules as then in effect, including Rule 144 und er the Securities Act, or any successor thereto (“SEC Rule 144”) (the “Effective Period”); provided that in the event that Company determines in good faith that, because it has under consideration a significant (as defined under Regulation S-X of the SEC) acquisition or disposition or other material transaction or corporate event that has not been publicly disclosed or that it is in the process of preparing for filing with the SEC a Current Report on Form 8-K or other form, a Shelf Registration Statement may contain a material misstatement or omission, Parent may cause such Shelf Registration Statement to not be used during the period in question. The Company agrees it will use its best efforts to ensure that such deferral will be for the shortest period of time reasonably required not exceeding, in the aggregate, 90 days in any 12-month period.

1.3.  Company Registration.

        In the event that (i) the Company fails to satisfy its obligations pursuant to Section 1.2 or (ii) for any period of not less than 30 consecutive days a Shelf Registration Statement may not be used for any reason, and if (but without any obligation to do so) the Company proposes to register (including for this purpose a registration effected by the Company for shareholders other than the Holders) any of its stock or other securities under the Act in connection with the public offering of such securities solely for cash (other than a registration relating solely to the sale of securities to participants in a Company stock plan, or a registration on any form which does not include substantially the same information as would be required to be included in a registration statement covering the sale of the Registrable Securities), the Company will, at such time, promptly give each Holder written notice of such registration. Upon the wr itten request of each Holder given within 20 days after mailing of such notice by the Company in accordance with Section 2.5, the Company will, subject to the provisions of Section 1.7, cause to be registered under the Act all of the Registrable Securities that each such Holder has requested to be registered.

1.4.  Obligations of the Company.

        Except as otherwise expressly specified in this Agreement, whenever required under this Article I to effect the registration of any Registrable Securities, the Company will, as expeditiously as reasonably practicable:

        (a)  Prepare and file with the SEC such amendments and supplements to such registration statement and the prospectus used in connection with such registration statement as may be necessary to comply with the provisions of the Act with respect to the disposition of all securities covered by such registration statement.

        (b)  Furnish to the Holders such number of copies of a prospectus, including a preliminary prospectus, in conformity with the requirements of the Act, and such other documents as they may reasonably request in order to facilitate the disposition of Registrable Securities owned by them.

        (c)  Use its best efforts to register and qualify the securities covered by such registration statement under such other securities or Blue Sky laws of such jurisdictions as will be reasonably requested by the Holders, provided that the Company will not be required in connection therewith or as a condition thereto to qualify to do business or to file a general consent to service of process in any such states or jurisdictions.

        (d)  In the event of any underwritten public offering, enter into and perform its obligations under an underwriting agreement, in usual and customary form, with the managing underwriter of such offering. Each Holder participating in such underwriting will also enter into and perform its obligations under such an agreement.

        (e)  Notify each Holder of Registrable Securities covered by such registration statement at any time when a prospectus relating thereto is required to be delivered under the Act of the happening of any event as a result of which the prospectus included in such registration statement, as then in effect, includes an untrue statement of a material fact or omits to state a material fact required to be stated therein or necessary to make the statements therein not misleading in the light of the circumstances then existing.

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1.5.  Furnish Information.

        It will be a condition precedent to the obligations of the Company to take any action pursuant to this Article I with respect to the Registrable Securities of any selling Holder that such Holder will furnish to the Company such information regarding itself, the Registrable Securities held by it, the intended method of disposition of such securities and all of the other pertinent information as will be required to effect the registration of such Holder’s Registrable Securities.

1.6.  Expenses of Registration.

        Subject to restrictions under applicable state securities laws, all expenses other than underwriting discounts and commissions incurred in connection with registrations, filings or qualifications pursuant to Sections 1.2 and 1.3, including (without limitation) all registration, filing and qualification fees, printers’ and accounting fees, and fees and disbursements of counsel for the Company and the reasonable fees and disbursements of one counsel representing the Holders will be borne by the Company.

1.7.  Underwriting Requirements.

        In connection with any offering involving an underwriting of shares of the Company’s capital stock, the Company will not be required under Section 1.3 to include any of the Holders’ securities in such underwriting unless they accept the terms of the underwriting as agreed upon between the Company and the underwriters selected by it (or by other persons entitled to select the underwriters), and then the Company will have a right to limit the number of shares to such number as it will determine in good faith will not jeopardize the success of the offering by the Company. If the total amount of securities, including Registrable Securities, requested by shareholders to be included in such offering exceeds the amount of securities sold other than by the Company that the Company determines in good faith is compatible with the success of the offering, then the Company will be required to include in the offering only that number of such securities, including Registrable Securities, which the Company determines in good faith will not jeopardize the success of the offering (the securities so included to be apportioned pro rata first among selling shareholders which are Holders of Registrable Securities according to the total amount of securities entitled to be included therein owned by each such Holder or holders until all securities desired by such Holders are included, then among the other selling shareholders according to the total amount of securities entitled to be included therein owned by each other selling shareholder or in such other proportions as will mutually be agreed to by such selling shareholder; provided that any Registrable Securities held by officers and directors of the Company will be excluded from such registration to the extent required by such limitations). For purposes of the preceding parenthetical concerning apportionment, for any selling shareholder which is a Holder of Registrable Securities and which is a pa rtnership or corporation, the partners, retired partners and shareholders of such Holder, or the estates and family members of any such partners and retired partners an any trusts for the benefit of any of the foregoing persons will be deemed to be a single “Selling Shareholder,” and any pro-rata reduction with respect to such “selling shareholder” will be based upon the aggregate amount of shares carrying registration rights owned by all entities and individuals included in such “selling shareholder,” as defined in this sentence.

1.8.  Indemnification. If any Registrable Securities are included in a registration statement under this Article I:

        (a)  To the extent permitted by law, the Company will indemnify and hold harmless each Holder, each of its directors and each of its officers, any underwriter (as defined in the Act) for such Holder and each person, if any, who controls such Holder or underwriter within the meaning of the Act or the Securities Exchange Act of 1934, as amended (the “Exchange Act”), against any losses, claims, damages, or liabilities (joint or several) to which they may become subject under the Act, or the Exchange Act, insofar as such losses, claims, damages, or liabilities (or actions in respect thereof) arise out of or are based upon any of the following statements, omissions or violations (collectively a “Violation”): (i) any untrue statement or alleged untrue statement of a material fact contained in such registration statement, including any preliminary prospectus or final prospectus contained therein or any amendmen ts or supplements thereto, (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, or (iii) any violation or alleged violation by the Company of the Act, the Exchange Act, or any rule or regulation promulgated under the Act, or the Exchange Act; and the Company will pay to each such Holder, director, officer, underwriter or controlling person, any legal or other expenses reasonably incurred by them in connection with investigating or defending any such loss, claim, damage, liability, or action; provided, however, that the indemnity agreement contained in this Subsection 1.8(a) will not apply to amounts paid in settlement of any such loss, claim, damage, liability, or action if

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such settlement is effected without the consent of the Company (which consent will not be unreasonably withheld), nor will the Company be liable in any such case for any such loss, claim, damage, liability, or action to the extent that it arises out of or is based upon a Violation which occurs in reliance upon and in conformity with written information furnished expressly for use in connection with such registration by any such Holder, director, officer, underwriter or controlling person.

        (b)  To the extent permitted by law, each selling Holder will indemnify and hold harmless the Company, each of its directors, each of its officers who has signed the registration statement, each person, if any, who controls the Company within the meaning of the Act, any underwriter, any other Holder selling securities in such registration statement and any controlling person of any such underwriter or other Holder, against any losses, claims, damages, or liabilities (joint or several) to which any of the foregoing persons may become subject, under the Act or the Exchange Act insofar as such losses, claims, damages, or liabilities (or actions in respect thereto) arise out of or are based upon any Violation, in each case to the extent (and only to the extent) that such Violation occurs in reliance upon and in conformity with written information furnished by such Holder expressly for use in connection with such registration; an d each such Holder will pay any legal or other expenses reasonably incurred by any person intended to be indemnified pursuant to this Subsection 1.8(b), in connection with investigating or defending any such loss, claim, damage, liability, or action; provided, however, that the indemnity agreement contained in this Subsection 1.8(b) will not apply to amounts paid in settlement of any such loss, claim, damage, liability or action if such settlement is effected without the consent of the Holder, which consent will not be unreasonably withheld; provided, that, in no event will any indemnity under this Subsection 1.8(b) exceed the proceeds from the offering net of sales commission, if any, received by such Holder.

        (c)  Promptly after receipt by an indemnified party under this Section 1.8 of notice of the commencement of any action (including any governmental action), such indemnified party will, if a claim in respect thereof is to be made against any indemnifying party under this Section 1.8, deliver to the indemnifying party a written notice of the commencement thereof and the indemnifying party will have the right to participate in, and, to the extent the indemnifying party so desires, jointly with any other indemnifying party similarly noticed, to assume the defense thereof with counsel satisfactory to the indemnified party (which shall not unreasonably withhold its approval); provided, however, that an indemnified party (together with all other indemnified parties which may be represented without conflict by one counsel) will have the right to retain one separate counsel, with the reasonable fees and expenses to be paid by the indemnifying party, if representation of such indemnified party by the counsel retained by the indemnifying party is inappropriate due to actual or potential differing interests between such indemnified party and any other party represented by such counsel in such proceeding. The failure to deliver written notice to the indemnifying party within a reasonable time of the commencement of any such action, if prejudicial to its ability to defend such action, will relieve such indemnifying party of any liability to the indemnified party under this Section 1.8, but the omission so to deliver written notice to the indemnifying party will not relieve it of any liability that it may have to any indemnified party otherwise than under this Section 1.8.

        (d)  If the indemnification provided for in this Section 1.8 is held by a court of competent jurisdiction to be unavailable to an indemnified party with respect to any loss, liability, claim, damage, or expense referred to therein, then the indemnifying party, in lieu of indemnifying such indemnified party to this Agreement, will contribute to the amount paid or payable by such indemnified party as a result of such loss, liability, claim, damage, or expense in such proportion as is appropriate to reflect the relative fault of the indemnifying party on the one hand and of the indemnified party on the other in connection with the statements or omissions that resulted in such loss, liability, claim, damage, or expense as well as any other relevant equitable considerations. The relative fault of the indemnifying party and of the indemnified party will be determined by reference to, among other things, whether the untrue or alleged untrue statement of a material fact or the omission to state a material fact relates to information supplied by the indemnifying party or by the indemnified party and the parties’ relative intent, knowledge, access to information, and opportunity to correct or prevent such statement or omission.

        (e)  Notwithstanding the foregoing, to the extent that the provisions on indemnification and contribution contained in the underwriting agreement entered into in connection with the underwritten public offering are in conflict with the foregoing provisions, the provisions in the underwriting agreement will control.

        (f)  The obligations of the Company and Holders under this Section 1.8 will survive the completion of any offering of Registrable Securities in a registration statement under this Article I, and otherwise.

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1.9.  Reports Under 1934 Act.

        With a view to making available to the Holders the benefits of Rule 144 promulgated under the Act and any other rule or regulation of the SEC that may at any time permit a Holder to sell securities of the Company to the public without registration or pursuant to a registration on Form S-3, the Company will:

        (a)  make and keep public information available, as those terms are understood and defined in SEC Rule 144, at all times;

        (b)  file with the SEC in a timely manner all reports and other documents required of the Company under the Act and the Exchange Act; and

        (c)  furnish to any Holder, so long as the Holder owns any Registrable Securities, forthwith upon request (i) a written statement by the Company that it has complied with the reporting requirements of SEC Rule 144, the Act and the Exchange Act, or that it qualifies as a registrant whose securities may be resold pursuant to Form S-3 (at any time after it so qualifies), (ii) a copy of the most recent annual or quarterly report of the Company and such other reports and documents so filed by the Company, and (iii) such other information as may be reasonably requested in availing any Holder of any rule or regulation of the SEC which permits the selling of any such securities without registration or pursuant to such form.

1.10.  “Market Stand-Off” Agreement.

        Notwithstanding the rights granted pursuant to Section 1.2, each Investor hereby agrees that, during the period of duration (not to exceed 180 days) specified by the Company and an underwriter of Common Stock or other securities of the Company, following the effective date of a registration statement of the Company filed under the Act, it will not, to the extent requested by the Company and such underwriter, directly or indirectly sell, offer to sell, contract to sell (including, without limitation, any short sale), grant any option to purchase or otherwise transfer or dispose of (other than to donees who agree to be similarly bound) any securities of the Company held by it at any time during such period except Common Stock included in such registration; provided, however, that all executive officers and directors of the Company and all other persons with registration rights (whether or not pursuant to this Agreement) enter into simil ar agreements. The right of the Company hereunder may be exercised by it not more than once in any one-year period.

        In order to enforce the foregoing covenant, the Company may impose stop-transfer instructions with respect to the Registrable Securities of each Investor (and the shares or securities of every other person subject to the foregoing restriction) until the end of such period.

1.11.  Rule 144 Availability.

        Notwithstanding anything to the contrary above in this Article I, prior to exercising any right provided for in this Article I each Holder will (i) evaluate in good faith whether such Holder is otherwise permitted to sell the entire amount of Registrable Securities it is then seeking to register within the time period it desires to sell pursuant to Rule 144 of the Exchange Act, or any successor regulation thereto and (ii) exercise such rights only in the case that it determines in good faith that such rights are necessary to sell such Registrable Securities in a timely manner.

ARTICLE II
MISCELLANEOUS

2.1.  Successors and Assigns.

        Except as otherwise provided in this Agreement, the terms and conditions of this Agreement will inure to the benefit of and be binding upon the respective successors and assigns of the parties (including transferees of any shares of Registrable Securities). Nothing in this Agreement, express or implied, is intended to confer upon any party other than the parties to this Agreement or their respective successors and assigns any rights, remedies, obligations, or liabilities under or by reason of this Agreement, except as expressly provided in this Agreement.

2.2.  Governing Law.

        This Agreement will be governed by and construed under the laws of the State of Delaware.

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2.3.  Counterparts.

        This Agreement may be executed in two or more counterparts, each of which will be deemed an original, but all of which together will constitute one and the same instrument.

2.4.  Titles and Subtitles.

        The titles and subtitles used in this Agreement are used for convenience only and are not to be considered in construing or interpreting this Agreement.

2.5.  Notices.

        Unless otherwise provided, any notice required or permitted under this Agreement will be given in writing and will be deemed effectively given upon personal delivery to the party to be notified, by telecopy upon the appropriate answer-back, or upon deposit with the United States Post Office, by registered or certified mail, postage prepaid and addressed to the party to be notified at the address indicated for such party on Schedule 1 or at such other address as such party may designate by ten days’ advance written notice to the other parties.

2.6.  Expenses.

        If any action at law or in equity is necessary to enforce or interpret the terms of this Agreement, the prevailing party will be entitled to reasonable attorneys’ fees, costs and necessary disbursements in addition to any other relief to which such party may be entitled.

2.7.  Amendments and Waivers.

        Any term of this Agreement may be amended and the observance of any term of this Agreement may be waived (either generally or in a particular instance and either retroactively or prospectively), only with the written consent of the Company and the Holders of a majority of the Registrable Securities then outstanding. Any amendment or waiver effected in accordance with this paragraph will be binding upon each Holder of any Registrable Securities then outstanding, each future Holder of all such Registrable Securities, and the Company.

2.8.  Severability.

        If one or more provisions of this Agreement are held to be unenforceable under applicable law, such provision will be excluded from this Agreement and the balance of the Agreement will be interpreted as if such provision were so excluded and will be enforceable in accordance with its terms.

2.9.  Aggregation of Stock.

        All shares of Registrable Securities held or acquired by affiliated entities or persons will be aggregated together for the purpose of determining the availability of any rights under this Agreement.

2.10.  Entire Agreement, Amendment, Waiver.

        This Agreement (including the Schedules to this Agreement, if any) constitutes the full and entire understanding and agreement between the parties with regard to the subjects of this Agreement and thereof.

2.11.  Adjustments for Stock Splits.

        Wherever in this Agreement there is a reference to a specific number of shares of Common Stock or Preferred Stock of the Company of any class or series, or a reference to any amount of dollars per any such share, then, upon the occurrence of any subdivision, combination or stock dividend of such class or series of stock, the specific number of shares or the specific dollar amount so referenced in this Agreement will automatically be proportionately adjusted to reflect the effect on the outstanding shares of such class of series of stock by such subdivision, combination or stock dividend.

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        IN WITNESS WHEREOF, the parties have executed this Agreement as of the date first above written.

	THE COMPANY: DAOU SYSTEMS, INC.
By:	/s/  Neil R. Cassidy
	Name:   Neil R. Cassidy Title:   Executive Vice President and    Chief Financial Officer

	THE INVESTORS: GALEN PARTNERS III, L.P., a Delaware Limited Partnership
By:	Claudius, L.L.C., a Delaware Limited Liability Company

By:	/s/  Bruce F. Wesson
	Name:   Bruce F. Wesson Title:   Senior Managing Member

	GALEN PARTNERS INTERNATIONAL III, L.P., a Delaware Limited Partnership
By:	Claudius, L.L.C., a Delaware Limited Liability Company

By:	/s/  Bruce F. Wesson
	Name:   Bruce F. Wesson Title:   Senior Managing Member

	GALEN EMPLOYEE FUND III, L.P., a Delaware Limited Partnership
By:	Wesson Enterprises, Inc.

By:	/s/  Bruce F. Wesson
	Name:   Bruce F. Wesson Title:   President

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SCHEDULE 1
INVESTORS

NAME AND ADDRESS

Galen Partners III, L.P. 610 Fifth Avenue 5th Floor New York, NY 10020

Galen Partners International III, L.P. 610 Fifth Avenue 5th Floor New York, NY 10020

Galen Employee Fund III, L.P. 610 Fifth Avenue 5th Floor New York, NY 10020

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EX-10.3 5 ex10-3.htm SEPARATION AND GENERAL RELEASE

EXHIBIT 10.3

SEPARATION AGREEMENT AND GENERAL RELEASE

             The parties to this Separation Agreement and General Release (“Agreement”) are Larry D. Grandia (“Grandia” ) and DAOU Systems, Inc. (“DAOU” or the “Company”), (collectively, the “Settling Parties”). The Effective Date of this Agreement is the date of execution.

RECITALS

             This Agreement is made with reference to the following facts:

        A.  Grandia intends to resign his position as Chief Executive Officer and President of the Company effective November 14, 2000 or as of the date a new Chief Executive Officer accepts employment with DAOU, whichever is sooner. The date of his resignation will be the “Separation Date” for purposes of this Agreement. For the period from October 31, 2000 through the Separation Date, Grandia agrees to devote significant attention and time as Chief Executive Officer of DAOU to the recruitment and selection of a new Chief Executive Officer of DAOU. As of the Separation Date, Grandia’s rights and obligations as an employee will cease, except as set forth in this Agreement.

        B.  The Company and Grandia desire to resolve and dispose of, fully and completely, all claims, demands, and causes of action, known or unknown, which Grandia may have against the Company or its subsidiaries or affiliates, including, those rights, claims, demands and causes of action arising out of the employment relationship, the June 15, 1999 employment agreement between Grandia and DAOU ( the “Employment Agreement”) and the termination of the employment relationship between Grandia and DAOU.

AGREEMENT

        1.  Effect of Separation on Salary and Benefits.

              1.1  On the Separation Date, DAOU shall provide Grandia with a final paycheck which includes accrued and unused vacation pay, less all applicable federal, state and local income, social security and other payroll taxes.

              1.2  Within 14 days of the Separation Date, DAOU will provide Grandia with election forms for medical insurance continuation as provided by the Consolidated Omnibus Budget Reconciliation Act of 1986 (“COBRA”). Any cost associated with the continuation of Grandia’s medical, life and car insurance through November 30, 2000 will be assumed by DAOU.

              1.3  The Company will pay Grandia’s reasonable and customary business expenses, if any, through November 30, 2000.

        2.  Additional Consideration to Grandia.

              2.1  Forgiveness of Loan. As of the Separation Date, DAOU releases Grandia from his obligation under Section 3.5 of the Employment Agreement to repay principal and accrued interest on the loan of Two Hundred Thousand Dollar ($200,000.00) described in that Section 3.5.

              2.2  Transfer in Ownership of Company Car and other DAOU property. On the Separation Date, DAOU agrees to transfer ownership to Grandia of the 1999 Infinity Q45 that Grandia utilized during his employment with DAOU. Grandia further is entitled to retain two DAOU personal computers that he utilized during his employment with DAOU.

              2.3  Exceptions to Covenants. Pursuant to Section 7.2(b) of the Employment Agreement, Grandia is prohibited for a period of one (1) year from the Separation Date from soliciting business of the same or similar type being carried on by DAOU, from any person known by Grandia to be a customer of DAOU and with whom Grandia had personal contact during and by reason of his employment with DAOU. DAOU acknowledges that Grandia has accepted the position of Executive Vice President, Chief Technology Officer for Premier, Inc. By this Agreement, DAOU releases Grandia from his obligations under Section 7.2(b) of the Employment Agreement

for the limited purpose of satisfying his employment obligations to Premier, Inc. Other than this limited exception, Grandia understands and agrees that he continues to be bound by the obligations described in Section 7.2(b) through 7.2(d) of the Employment Agreement for the time periods defined in the Employment Agreement.

              2.4  Continuation of Vesting. In connection with the Employment Agreement, Grandia received non-statutory options (the “ Non-Statutory Options”) and incentive stock options (the “Incentive Stock Options”) to purchase shares of DAOU Common Stock. A portion of the Non-Statutory Options were granted pursuant to DAOU’s 1996 Stock Option Plan (the “Plan ”) and a portion of the Non-Statutory Options were granted outside the Plan.

                     After the Separation Date and during any period in which Grandia serves on DAOU’s Board of Directors (the “Board”) pursuant to Section 2.2 below, Grandia will continue vesting any Non-Statutory Options covered by the Plan according to the schedule set forth in any stock option agreement between DAOU and Grandia reflecting the grant of Non-Statutory Options under the Plan. Grandia’s time to exercise any vested Non-Statutory Options covered by this Section will run from the date he, for any reason, ceases to serve on the Board.

                     From the Separation Date, Grandia will cease accruing any Non-Statutory Stock Options granted outside the Plan and any Incentive Stock Options. Treatment of the Non-Statutory Stock Options granted outside the Plan will be pursuant to any stock option agreement reflecting that grant. Treatment of any Incentive Stock Options will be pursuant to the Plan and any stock option agreement between Grandia and DAOU reflecting that grant.

              2.5  No Other Obligations. Except as specified above, the Company shall have no payment or other obligation to Grandia.

              2.6  Tax Consequences. The Company has made no representations to Grandia as to his tax liability with respect to any of the above Consideration. Grandia acknowledges that he has consulted with his own professional advisors with respect to all tax matters, and is not relying on any representation by the Company on any tax matter. Grandia will be solely responsible for any and all tax responsibility for the payment by the Company, and for any additional tax responsibility which may be assessed either against his or against the Company, including any penalties assessed by any agency against any party, which may arise as a result of his characterization of any payment.

        3.  Consideration from Grandia.

              3.1  General Release. In exchange for the consideration set forth above, and specifically in Sections 2.1-2.3 above, and for other good and valuable consideration, each of the Settling Parties, except as to such rights or claims as may be created by this Agreement, releases and forever discharges each of the Settling Parties, their present and former agents, employees, officers, directors, shareholders, principals, predecessors, alter egos, partners, parents, subsidiaries, affiliates, attorneys, insurers, successors and assigns, from any and all claims, demands, grievances, causes of action or suit of any kind arising out of, or in any way connected with, the dealings between the parties through the Separation Date, including the employment relationship and its termination. The Settling Parties also release and waive any and all legal or administrative claims arising under any express or implied contract, law, rule, regulation, or ordinance, including, but not limited to, Title VII of the Civil Rights Act of 1964, the Fair Labor Standards Act, the Americans with Disabilities Act, the California Fair Employment and Housing Act, the Family Rights’ Act, the Employee Retirement Income Security Act of 1974, as amended (“ERISA”) or the Age Discrimination in Employment Act of 1967, as amended (“ADEA”). Grandia agrees that, except as described in this Agreement, as of the Separation Date and the execution of this Agreement, Grandia is not entitled to any benefits, consideration or sums from DAOU.

              3.2  Transition Services. In exchange for the consideration set forth above, and specifically in Sections 2.1-2.3 above, and for no other additional compensation, after the Separation Date and through December 31, 2000 Grandia agrees to provide the Company with transition services as shall be reasonably requested by the Board (the “Transition Services”). DAOU agrees that Grandia will not be required to provide Transition Services in an amount greater than two hours per week.

              3.3  Board of Directors. In exchange for the consideration to Grandia described in Section 2.4 above, Grandia agrees to serve as a member of the Board for a period of one (1) year from the Separation Date.

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Grandia’s vesting as described in Section 2.4 will terminate in the event his status as a member of the Board terminates for any reason. Grandia will receive compensation as a member of the Board in an amount equal to that received by other members of the Board.

        4.  Indemnification. Nothing in this Agreement may be construed as a waiver by Grandia of any rights he may have for indemnification under any DAOU insurance policy or written indemnification agreement for acts by Grandia in his capacity as an officer or director of DAOU.

        5.  Acknowledgments. Each of the Settling Parties acknowledges that with this document they have been advised in writing of their right to consult with an attorney prior to executing this Agreement and release. The Settling Parties expressly waive any rights and benefits they otherwise might have under California Civil Code Section 1542, which provides:

        A GENERAL RELEASE DOES NOT EXTEND TO CLAIMS WHICH THE CREDITOR DOES NOT KNOW OR SUSPECT TO EXIST IN HIS FAVOR AT THE TIME OF EXECUTING THE RELEASE, WHICH IF KNOWN BY HIM MUST HAVE MATERIALLY AFFECTED HIS SETTLEMENT WITH THE DEBTOR.

        6.  Settlement. Nothing in this Agreement shall be construed as an admission by the Company of any liability of any kind to Grandia.

        7.  Confidentiality and Other Agreements.

              7.1  Grandia acknowledges and agrees that he has a continuing obligation to protect the Company’s Confidential Information according to the terms and conditions of the Company’s Confidentiality and Invention Agreement (“Confidentiality Agreement”) which he signed on June 15, 1999.

              7.2  The Settling Parties agree to keep confidential the terms of this Agreement and agree to refrain from disclosing any information regarding this Agreement to any third party unless required to do so (a) by a regulatory body (e.g. filings with the Securities Exchange Commission (“SEC”); (b) in financial disclosures to auditors or in audited financial statements; (c) under oath, if properly ordered, in a court of competent jurisdiction; (d) to his wife; or (e) previously disclosed publicly by the Company to the extent so disclosed. Each of the Settling Parties agrees to notify the other Settling Parties in writing upon first notification that he or it may be required by law to disclose any information deemed confidential by this Agreement. Notice must be provided in sufficient time for the party receiving notice to oppose or otherwise respond to the request.

              7.3  Grandia agrees that he will not interfere with or otherwise act adverse to the business affairs of the Company, including, without limitation, making disparaging remarks, either orally or in writing, to any person concerning the Company or the Company’s business.

        8.  Representations and Warranties. The parties represent and warrant as follows:

              8.1  Each party has read this Agreement, understands its contents, and understands its legal effect and binding nature. Each party further acknowledges that he or it is acting voluntarily and of his own free will in executing this Agreement.

              8.2  Grandia is not relying upon any statement, representation or promise of the Company, or any of its officers, directors, agents, partners, employees, consultants, representatives or attorneys in executing this Agreement or in making this settlement except as expressly stated in this Agreement.

              8.3  Grandia acknowledges that with this document he has been given a twenty-one (21) day period in which to consider entering into the release of the ADEA claims, if any. In addition, Grandia acknowledges that he has been informed that he may revoke a signed waiver of the ADEA claims for up to seven days after executing this Agreement.

        9.  Claims Arising out of this Agreement.

              9.1  To the extent there is any controversy or dispute concerning the interpretation or enforcement of any provisions of this Agreement, including the arbitrability of such dispute, the Settling Parties shall submit such dispute to arbitration in San Diego, California by one or more experienced labor and employment law arbitrators licensed to practice law in California and selected in accordance with the Employment Arbitration

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Rules of the American Arbitration Association. The arbitrator(s) shall not have the power to modify any of the provisions of this Agreement. The arbitrator(s)’ decision shall be final and binding upon the parties and judgment upon the award rendered by the arbitrator(s) may be entered in any court having jurisdiction. The arbitrator will decide how the costs of arbitration should be shared.

              9.2  In the event of any arbitration arising out of or relating to this Agreement, its breach or enforcement, including an action for declaratory relief, the prevailing party in such action or proceedings shall be entitled to receive his or its damages, court costs, and reasonable out-of-pocket expenses including reasonable attorneys’ fees. Such recovery shall include court costs, reasonable out-of-pocket expenses, and attorneys’ fees on appeal, if any. The arbitrator(s) or court shall determine who is the prevailing party, whether or not the dispute or controversy proceeds to final judgment. Both Grandia and the Company expressly acknowledge this paragraph is not intended to in any way alter the parties’ agreement that arbitration shall be the exclusive method of resolving any dispute related to this Agreement or Grandia’s employment with the Company.

        10.  Miscellaneous.

              10.1  This Agreement shall be deemed to have been executed and delivered within the State of California, and its rights and obligations shall be construed and enforced in accordance with and governed by, the laws of California.

              10.2  Grandia and the Company understand and agree that this Agreement shall bind and benefit their heirs, employees, parent corporation, subsidiaries, affiliates, controlled corporations, sister corporations, agents, representatives, predecessors, successors and assigns. The Company’s successors shall include (without limitation) any person, corporation or other entity who or which enters into a Corporate Transaction with the Company (hereinafter “Company Successor”). For purposes of this Agreement, a “Corporate Transaction” is defined to mean a transaction in which any person, corporation or other entity acquires, directly or indirectly, all or substantially all of the stock, business or assets of the Company, whether by way of merger, consolidation, sale, transfer or otherwise.

              10.3  This Agreement may be amended only by an agreement in writing designated as an amendment to this Agreement and signed by the parties.

              10.4  This Agreement may be executed in counterparts, and when each party has signed and delivered at least one such counterpart, each counterpart shall be deemed an original, and, when taken together with the other executed counterparts, shall constitute one Agreement, which shall be binding upon and effective as to all parties.

Dated: November 11, 2000	/s/ Larry D. Grandia
	Larry D. Grandia

		Daou Systems, Inc.
Dated: November 11, 2000	By:	/s/ Georges J. Daou
		Georges J. Daou Chairman of the Board of Directors

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