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Section 1: 10-Q (10-Q)

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
_________________________
FORM 10-Q
_________________________
  
(Mark One)
Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
 
For the quarterly period ended September 30, 2016
OR
 
Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
 
For the transition period from              to               
 
Commission File Number:  001-37415
_________________________
 
Evolent Health, Inc.
(Exact name of registrant as specified in its charter)
_________________________
Delaware
32-0454912
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
 
 
800 N. Glebe Road, Suite 500, Arlington, Virginia
22203
(Address of principal executive offices)
(Zip Code)
  
(571) 389-6000
(Registrant’s telephone number, including area code)
 
Not Applicable
(Former name, former address and former fiscal year, if changed since last report.)
_________________________
 
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 ☒ No ☐
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☒ No ☐
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  (Check one):
 
Large accelerated filer ☐ Accelerated filer ☐ Non-accelerated filer ☒ (Do not check if a smaller reporting company)
Smaller reporting company ☐
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No  ☒
 
As of November 7, 2016, there were 52,576,422 shares of the registrant’s Class A common stock outstanding and 15,346,981 shares of the registrant’s Class B common stock outstanding.



Evolent Health, Inc.
Table of Contents

Item
 
Page
 
 
1.
2.
3.
4.
 
 
1.
1A.
2.
3.
4.
5.
6.
 
 
E-1





Explanatory Note

In this Quarterly Report on Form 10-Q, unless the context otherwise requires, “Evolent,” the “Company,” “we,” “our” and “us” refer to (1) prior to the completion of the Offering Reorganization described in “Part I - Item 1. Business - Initial Public Offering and Organizational Transactions - the Offering Reorganization in our Annual Report on Form 10-K for the year ended December 31, 2015, as amended, filed with the SEC on February 29, 2016 (“2015 Form 10-K”), Evolent Health Holdings, Inc., our predecessor, (including its operating subsidiary, Evolent Health LLC), and (2) after giving effect to such reorganization, Evolent Health, Inc. and its consolidated subsidiaries. Evolent Health LLC, a subsidiary of Evolent Health, Inc. through which we conduct our operations, has owned all of our operating assets and substantially all of our business since inception. Evolent Health, Inc. is a holding company and its principal asset is all of the Class A common units of Evolent Health LLC. As described below under “Part I - Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations,” the financial statements of Evolent Health, Inc. for the nine months ended September 30, 2015, do not reflect a complete view of the operational results for that period. Evolent Health, Inc.’s results reflect only the investment of Evolent Health, Inc.’s predecessor in its equity method investee, Evolent Health LLC, for the period from January 1, 2015, through June 3, 2015.

For more information about the Offering Reorganization, refer to “Part I - Item 1. Business - Initial Public Offering and Organizational Transactions” in our 2015 Form 10-K.

FORWARD-LOOKING STATEMENTS - CAUTIONARY LANGUAGE
 
Certain statements made in this report and in other written or oral statements made by us or on our behalf are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 (“PSLRA”).  A forward-looking statement is a statement that is not a historical fact and, without limitation, includes any statement that may predict, forecast, indicate or imply future results, performance or achievements, and may contain words like:  “believe,” “anticipate,” “expect,” “estimate,” “aim,” “predict,” “potential,” “continue,” “plan,” “project,” “will,” “should,” “shall,” “may,” “might” and other words or phrases with similar meaning in connection with a discussion of future operating or financial performance.  In particular, these include statements relating to future actions, trends in our businesses, prospective services, future performance or financial results and the outcome of contingencies, such as legal proceedings.  We claim the protection afforded by the safe harbor for forward-looking statements provided by the PSLRA.
These statements are only predictions based on our current expectations and projections about future events. Forward-looking statements involve risks and uncertainties that may cause actual results, level of activity, performance or achievements to differ materially from the results contained in the forward-looking statements.  Risks and uncertainties that may cause actual results to vary materially, some of which are described within the forward-looking statements, include, among others:

certain risks and uncertainties associated with the acquisition of Valence Health, Inc., excluding its contracts serving certain state insurance cooperatives (“Valence Health”), including:
revenues of Valence Health before and after the merger may be less than expected, and expected results of Evolent may not be impacted as anticipated;
our ability to implement integration plans for the merger and to recognize the anticipated growth, benefits, cost savings and synergies of the merger;
the risks that the merger and the other transactions contemplated by the merger agreement disrupt current plans and operations and the potential difficulties in retention of any members of senior management of Valence Health and any other key employees that Evolent is interested in retaining after the closing of the merger;
the effect of the merger on Evolent’s and Valence Health’s business relationships, customers, suppliers, other partners, standing with regulators, operating results and businesses generally;
the amount of any costs, fees, expenses, impairments and charges related to the merger; and
the market price for our Class A common stock potentially being affected, following the merger, by factors that historically have not affected the market price for our Class A common stock;
the structural change in the market for healthcare in the United States;
our ability to effectively manage our growth;
the significant portion of revenue we derive from our largest partners;
our ability to offer new and innovative products and services;
the growth and success of our partners, which is difficult to predict and is subject to factors outside of our control, including premium pricing reductions and the ability to control and, if necessary, reduce health care costs;
our ability to attract new partners;
our ability to recover the significant upfront costs in our partner relationships;
our ability to estimate the size of our target market;
our ability to maintain and enhance our reputation and brand recognition;
consolidation in the healthcare industry;
competition which could limit our ability to maintain or expand market share within our industry;
our ability to partner with providers due to exclusivity provisions in our contracts;
uncertainty in the healthcare regulatory framework;

1


restrictions and penalties as a result of privacy and data protection laws;
adequate protection of our intellectual property;
any alleged infringement, misappropriation or violation of third-party proprietary rights;
our use of “open source” software;
our ability to protect the confidentiality of our trade secrets, know-how and other proprietary information;
our reliance on third parties;
our ability to use, disclose, de-identify or license data and to integrate third-party technologies;
data loss or corruption due to failures or errors in our systems and service disruptions at our data centers;
breaches or failures of our security measures;
our reliance on Internet infrastructure, bandwidth providers, data center providers, other third parties and our own systems for providing services to our users;
our dependency on our key personnel, and our ability to attract, hire, integrate and retain key personnel;
risks related to acquisitions, investments and alliances;
the risk of potential future goodwill impairment on our results of operations;
our future indebtedness and our ability to obtain additional financing;
our ability to achieve profitability in the future;
the requirements of being a public company;
our adjusted results may not be representative of our future performance;
the risk of potential future litigation;
our ability to remediate the material weakness in our internal control over financial reporting;
our holding company structure and dependence on distributions from Evolent Health LLC;
our obligations to make payments to certain of our pre-IPO investors for certain tax benefits we may claim in the future;
our ability to utilize benefits under the tax receivables agreement;
our ability to realize all or a portion of the tax benefits that we currently expect to result from past and future exchanges of Class B common units of Evolent Health LLC for our Class A common stock, and to utilize certain tax attributes of Evolent Health Holdings and an affiliate of TPG;
distributions that Evolent Health LLC will be required to make to us and to the other members of Evolent Health LLC;
our obligations to make payments under the tax receivables agreement that may be accelerated or may exceed the tax benefits we realize;
different interests among our pre-IPO investors, or between us and our pre-IPO investors;
the terms of agreements between us and certain of our pre-IPO investors;
our exemption from certain corporate governance requirements due to our previous status as a “controlled company” within the meaning of the New York Stock Exchange rules;
the potential volatility of our Class A common stock price;
the potential decline of our Class A common stock price if a substantial number of shares become available for sale or if a large number of Class B common units is exchanged for shares of Class A common stock;
provisions in our amended and restated certificate of incorporation and amended and restated by-laws and provisions of Delaware law that discourage or prevent strategic transactions, including a takeover of us;
the ability of certain of our investors to compete with us without restrictions;
provisions in our certificate of incorporation which could limit our stockholders’ ability to obtain a favorable judicial forum for disputes with us or our directors, officers or employees;
our intention not to pay cash dividends on our Class A common stock; and
our status as an “emerging growth company.”

The risks included here are not exhaustive.  Although we believe the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, level of activity, performance or achievements. Our 2015 Form 10-K and other documents filed with the SEC include additional factors that could affect our businesses and financial performance.  Moreover, we operate in a rapidly changing and competitive environment.  New risk factors emerge from time to time, and it is not possible for management to predict all such risk factors.

Further, it is not possible to assess the effect of all risk factors on our businesses or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.  Given these risks and uncertainties, investors should not place undue reliance on forward-looking statements as a prediction of actual results.  In addition, we disclaim any obligation to update any forward-looking statements to reflect events or circumstances that occur after the date of this report. 

2


PART I – FINANCIAL INFORMATION
Item 1. Financial Statements
EVOLENT HEALTH, INC.
CONSOLIDATED BALANCE SHEETS
(unaudited, in thousands, except share data)

 
As of
 
As of
 
September 30,
 
December 31,
  
2016
 
2015
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
109,777

 
$
145,726

Restricted cash
4,990

 
4,703

Accounts receivable, net (amounts related to affiliates: 2016 - $5,768; 2015 - $10,185)
21,986

 
20,381

Prepaid expenses and other current assets (amounts related to affiliates: 2016 - $37; 2015 - $1,220)
4,983

 
4,208

Investments, at amortized cost
49,693

 
9,445

Total current assets
191,429

 
184,463

Restricted cash
1,580

 
1,582

Investments, at amortized cost

 
44,618

Investments in and advances to affiliates
2,538

 

Property and equipment, net
21,123

 
12,796

Prepaid expenses and other non-current assets
12,118

 

Intangible assets, net
162,789

 
163,152

Goodwill
459,703

 
608,903

Total assets
$
851,280

 
$
1,015,514


 
 
 
LIABILITIES AND SHAREHOLDERS’ EQUITY (DEFICIT)
 
 
 

 
 
 
Liabilities
 
 
 
Current liabilities:
 
 
 
Accounts payable (amounts related to affiliates: 2016 - $11,506; 2015 - $13,311)
$
14,486

 
$
16,699

Accrued liabilities (amounts related to affiliates: 2016 - $629; 2015 - $828)
11,839

 
6,047

Accrued compensation and employee benefits
21,287

 
21,925

Deferred revenue
17,717

 
14,835

Total current liabilities
65,329

 
59,506

Other long-term liabilities
7,997

 
111

Deferred tax liabilities, net
18,097

 
21,318

Total liabilities
91,423

 
80,935


 
 
 
Commitments and Contingencies (See Note 8)

 


 
 
 
Shareholders' Equity (Deficit)
 
 
 
Class A common stock - $0.01 par value; 750,000,000 shares authorized; 45,028,807 and 41,491,498
 
 
 
shares issued and outstanding as of September 30, 2016, and December 31, 2015, respectively
448

 
415

Class B common stock - $0.01 par value; 100,000,000 shares authorized; 15,346,981 and 17,524,596
 
 
 
shares issued and outstanding as of September 30, 2016, and December 31, 2015, respectively
153

 
175

Additional paid-in-capital
397,603

 
342,063

Retained earnings (accumulated deficit)
164,024

 
306,688

Total shareholders' equity (deficit) attributable to Evolent Health, Inc.
562,228

 
649,341

Non-controlling interests
197,629

 
285,238

Total equity (deficit)
759,857

 
934,579

Total liabilities and shareholders' equity (deficit)
$
851,280

 
$
1,015,514


See accompanying Notes to Consolidated Financial Statements
3


EVOLENT HEALTH, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited, in thousands, except per share data)

 
For the Three
 
For the Nine
 
Months Ended
 
Months Ended
 
September 30,
 
September 30,
 
2016

2015
 
2016
 
2015
Revenue
 
 
 
 
 
 
 
Transformation (1)
$
7,757

 
$
6,783

 
$
26,259

 
$
9,486

Platform and operations (1)
52,453

 
33,623

 
139,918

 
41,334

Total revenue
60,210

 
40,406

 
166,177

 
50,820

 
 
 
 
 
 
 
 
Expenses
 
 
 
 
 
 
 
Cost of revenue (exclusive of depreciation and amortization
 
 
 
 
 
 
 
expenses presented separately below) (1)
33,905

 
24,762

 
95,294

 
32,649

Selling, general and administrative expenses (1)
38,398

 
29,834

 
103,101

 
42,916

Depreciation and amortization expenses
3,746

 
3,056

 
10,728

 
4,040

Goodwill impairment

 

 
160,600

 

Total operating expenses
76,049

 
57,652

 
369,723

 
79,605

Operating income (loss)
(15,839
)
 
(17,246
)
 
(203,546
)
 
(28,785
)
Interest income (expense), net
255

 
54

 
805

 
67

Gain on consolidation

 

 

 
414,133

Income (loss) from affiliates
(448
)
 

 
(462
)
 
(28,165
)
Other income (expense), net
1

 

 
4

 

Income (loss) before income taxes and non-controlling interests
(16,031
)
 
(17,192
)
 
(203,199
)
 
357,250

Provision (benefit) for income taxes
(256
)
 
(104
)
 
(1,614
)
 
29,169

Net income (loss)
(15,775
)
 
(17,088
)
 
(201,585
)
 
328,081

Net income (loss) attributable to non-controlling interests
(4,567
)
 
(5,108
)
 
(59,250
)
 
(8,532
)
Net income (loss) attributable to Evolent Health, Inc.
$
(11,208
)
 
$
(11,980
)
 
$
(142,335
)
 
$
336,613

 
 
 
 
 
 
 
 
Earnings (Loss) Available for Common Shareholders
 
 
 
 
 
 
 
Basic
$
(11,208
)
 
$
(11,980
)
 
$
(142,335
)
 
$
334,429

Diluted
(11,208
)
 
(11,980
)
 
(142,335
)
 
328,081

 
 
 
 
 
 
 
 
Earnings (Loss) per Common Share
 
 
 
 
 
 
 
Basic
$
(0.26
)
 
$
(0.29
)
 
$
(3.34
)
 
$
17.05

Diluted
(0.26
)
 
(0.29
)
 
(3.34
)
 
7.93

 
 
 
 
 
 
 
 
Weighted-Average Common Shares Outstanding
 
 
 
 
 
 
 
Basic
43,110

 
41,468

 
42,632

 
19,618

Diluted
43,110

 
41,468

 
42,632

 
41,398


(1) 
Amounts related to affiliates included above are as follows (see Note 15):
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Revenue
 
 
 
 
 
 
 
 
Transformation
$
67

 
$
485

 
$
169

 
$
534

 
Platform and operations
8,636

 
10,732

 
24,342

 
14,660

 
 
 
 
 
 
 
 
 
 
Expenses
 
 
 
 
 
 
 
 
Cost of revenue (exclusive of depreciation and amortization)
$
3,723

 
$
6,470

 
$
14,209

 
$
8,303

 
Selling, general and administrative expenses
531

 
689

 
1,298

 
940



See accompanying Notes to Consolidated Financial Statements
4



EVOLENT HEALTH, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited, in thousands)

 
For the Nine
 
Months Ended
 
September 30,
  
2016
 
2015
Cash Flows from Operating Activities
 
 
 
Net income (loss)
$
(201,585
)
 
$
328,081

Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
 
 
 
Gain on consolidation

 
(414,133
)
(Income) loss from affiliates
462

 
28,165

Depreciation and amortization expenses
10,728

 
4,040

Goodwill impairment
160,600

 

Stock-based compensation expense
13,844

 
10,536

Deferred tax provision (benefit)
(1,614
)
 
29,169

Other
443

 
93

Changes in assets and liabilities:


 


Accounts receivables, net
(1,605
)
 
3,663

Prepaid expenses and other current assets
(112
)
 
(1,348
)
Accounts payable
(3,692
)
 
1,073

Accrued liabilities
6,165

 
(6,384
)
Accrued compensation and employee benefits
(638
)
 
6,322

Deferred revenue
2,882

 
(1,434
)
Other long-term liabilities
117

 

Net cash provided by (used in) operating activities
(14,005
)
 
(12,157
)
 
 
 
 
Cash Flows from Investing Activities
 
 
 
Cash acquired upon consolidation of affiliate

 
13,065

Cash paid for asset acquisition or business combination
(14,000
)
 

Purchases of investments

 
(2,023
)
Investments in and advances to affiliates
(3,000
)
 

Maturities and sales of investments
4,099

 
4,000

Purchases of property and equipment
(11,116
)
 
(3,907
)
Change in restricted cash
1,194

 

Net cash provided by (used in) investing activities
(22,823
)
 
11,135

 
 
 
 
Cash Flows from Financing Activities
 
 
 
Proceeds from initial public offering, net of offering costs

 
209,087

Proceeds from stock option exercises
1,244

 
92

Taxes withheld for vesting of restricted stock units
(365
)
 

Net cash provided by (used in) financing activities
879

 
209,179

 
 
 
 
Net increase (decrease) in cash and cash equivalents
(35,949
)
 
208,157

Cash and cash equivalents as of beginning-of-period
145,726

 

Cash and cash equivalents as of end-of-period
$
109,777

 
$
208,157

Supplemental Disclosure of Non-cash Investing and Financing Activities
 
 
 
Non-cash contribution of common stock to Evolent Health LLC prior to the Offering Reorganization
$

 
$
21,810

Unsettled investment purchases

 
22,048

Accrued property and equipment purchases
374

 
53

Stock issued in connection with business combinations
10,534

 

Effects of the Offering Reorganization:
 
 
 
Reclassification of deferred offering costs acquired to additional paid-in capital

 
3,154

Conversion of existing equity as part of the Offering Reorganization

 
39,014

Issuance of Class B common stock

 
196

Assumption of non-controlling interest as a result of merger with TPG affiliate

 
34,875

Effects of the Secondary Offering
 
 
 
Decrease in non-controlling interests as a result of the Exchange
28,220

 


See accompanying Notes to Consolidated Financial Statements
5




EVOLENT HEALTH, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (DEFICIT) AND REDEEMABLE PREFERRED STOCK
(unaudited, in thousands)

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Retained
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Earnings
 
 
 
 
Series A Redeemable
 
Series B Redeemable
Series B-1 Redeemable
Series A
 
Class A
 
Class B
Additional
(Accum-
 
Non-
 
Total
 
Preferred Stock
 
Preferred Stock
 
Preferred Stock
Preferred Stock
 
Common Stock
 
Common Stock
 
Paid-in
 
ulated
controlling
Equity
 
Shares
 
Amount
 
Shares
 
Amount
 
Shares
 
Amount
Shares
 
Amount
 
Shares
 
Amount
 
Shares
 
Amount
 
Capital
 
Deficit)
 
Interests
 
(Deficit)
Balance as of December 31, 2014
7,900

 
$
12,847

 
6,468

 
$
24,833

 
360

 
$
1,593

7,400

 
$
2

 
4,048

 
$
1

 

 
$

 
$
23,733

 
$
(25,806
)
 
$

 
$
(2,070
)
Non-cash issuance of common stock
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
to Evolent Health LLC

 

 

 

 

 


 

 

 

 

 

 
21,810

 

 

 
21,810

Net income (loss) prior to the Offering
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Reorganization

 

 

 

 

 


 

 

 

 

 

 

 
(28,165
)
 

 
(28,165
)
Effects of the Offering Reorganization:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Conversion of existing equity
(7,900
)
 
(12,847
)
 
(6,468
)
 
(24,833
)
 
(360
)
 
(1,593
)
(7,400
)
 
(2
)
 
22,128

 
261

 

 

 
39,014

 

 

 
39,273

Issuance of Class B common stock

 

 

 

 

 


 

 

 

 
19,576

 
196

 
(196
)
 

 
332,793

 
332,793

Merger with TPG affiliate

 

 

 

 

 


 

 
2,051

 
21

 
(2,051
)
 
(21
)
 
34,875

 

 
(34,875
)
 

Issuance of Class A common stock
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
sold in initial public offering, net of
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
offering costs

 

 

 

 

 


 

 
13,225

 
132

 

 

 
205,801

 

 

 
205,933

Tax effect of Offering Reorganization

 

 

 

 

 


 

 

 

 

 

 
2,144

 

 

 
2,144

Stock-based compensation expense
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
subsequent to the Offering Reorganization

 

 

 

 

 


 

 

 

 

 

 
14,730

 

 

 
14,730

Exercise of stock options

 

 

 

 

 


 

 
39

 

 

 

 
152

 

 

 
152

Net income (loss) subsequent to the
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Offering Reorganization

 

 

 

 

 


 

 

 

 

 

 

 
360,659

 
(12,680
)
 
347,979

Balance as of December 31, 2015

 

 

 

 

 


 

 
41,491

 
415

 
17,525

 
175

 
342,063

 
306,688

 
285,238

 
934,579

Cumulative-effect adjustment from
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
adoption of new accounting principle

 

 

 

 

 


 

 

 

 

 

 
468

 
(329
)
 
(139
)
 

Stock-based compensation expense

 

 

 

 

 


 

 

 

 

 

 
13,844

 

 

 
13,844

Exercise of stock options

 

 

 

 

 


 

 
217

 

 

 

 
1,244

 

 

 
1,244

Restricted stock units vested, net of shares
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
withheld for taxes

 

 

 

 

 


 

 
76

 

 

 

 
(365
)
 

 

 
(365
)
Exchange of Class B common stock

 

 

 

 

 


 

 
2,178

 
22

 
(2,178
)
 
(22
)
 
28,220

 

 
(28,220
)
 

Tax impact of Class B common stock exchange

 

 

 

 

 


 

 

 

 

 

 
1,606

 

 

 
1,606

Issuance of common stock for
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
business combination

 

 

 

 

 


 

 
1,067

 
11

 

 

 
10,523

 

 

 
10,534

Net income (loss)

 

 

 

 

 


 

 

 

 

 

 

 
(142,335
)
 
(59,250
)
 
(201,585
)
Balance as of September 30, 2016

 
$

 

 
$

 

 
$


 
$

 
45,029

 
$
448

 
15,347

 
$
153

 
$
397,603

 
$
164,024

 
$
197,629

 
$
759,857


See accompanying Notes to Consolidated Financial Statements
6


EVOLENT HEALTH, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


1. Organization

Evolent Health, Inc. was incorporated in December 2014 in the state of Delaware, and is a managed services firm that supports leading health systems and physician organizations in their migration toward value-based care and population health management. The Company’s services include providing our customers, which we refer to as partners, with a population management platform, integrated data and analytics capabilities, pharmacy benefit management (“PBM”) services and comprehensive health plan administration services. Together these services enable health systems to manage patient health in a more cost-effective manner. The Company’s contracts are structured as a combination of advisory fees, monthly member service fees, percentage of plan premiums and shared medical savings arrangements. The Company’s headquarters is located in Arlington, Virginia.

Our predecessor, Evolent Health Holdings, Inc. (“Evolent Health Holdings”), merged with and into Evolent Health, Inc. in connection with the Offering Reorganization. As a result, the consolidated financial statements of Evolent Health, Inc. reflect the historical accounting of Evolent Health Holdings.

Prior to the organizational transactions noted below, due to certain participating rights granted to our investor, TPG Global, LLC and certain of its affiliates (“TPG”), Evolent Health Holdings did not control Evolent Health LLC, our operating subsidiary company, but was able to exert significant influence and, accordingly, accounted for its investment in Evolent Health LLC using the equity method of accounting through June 3, 2015. Subsequent to the Offering Reorganization (as defined below), initial public offering (“IPO”) and secondary offering described below, as of September 30, 2016, Evolent Health, Inc. owns 74.6% of Evolent Health LLC, holds 100% of the voting rights, is the sole managing member and, therefore, controls its operations. Accordingly, the financial results of Evolent Health LLC are consolidated in the financial statements of Evolent Health, Inc. subsequent to the Offering Reorganization.

Initial Public Offering

In June 2015, we completed an IPO of 13.2 million shares of our Class A common stock at a public offering price of $17.00 per share. We received $209.1 million in proceeds, net of underwriting discounts and commissions. Offering expenses incurred were $3.2 million which were recorded as a reduction of proceeds from the offering. We used the net proceeds to purchase newly-issued Class A common units from Evolent Health LLC, our consolidated subsidiary. Evolent Health LLC will use the net proceeds for working capital and other general corporate and strategic purposes. See Note 4 for further details surrounding the IPO and related transactions.

Organizational Transactions

In connection with the IPO, we completed the following organizational transactions (the “Offering Reorganization”) as further described in Note 4:

We amended and restated our certificate of incorporation to, among other things, authorize two classes of common stock - Class A common stock and Class B exchangeable common stock. Both classes of stock will vote together as a single class.
We acquired, by merger, an affiliate of a member of Evolent Health LLC, for which we issued 2.1 million shares of Class A common stock.
We issued shares of our Class B exchangeable common stock to certain existing members of Evolent Health LLC.

Secondary Offering

In September 2016, the Company completed a secondary offering of 8.6 million shares of its Class A common stock at a price to the public of $22.50 per share. The shares sold in the offering were sold by certain affiliates of TPG Global, LLC, The Advisory Board Company, UPMC, Ptolemy Capital, LLC (together, the “Investor Stockholders”) and certain management selling stockholders (together with the Investor Stockholders, the “Selling Stockholders”). The Company did not receive any proceeds from the sale of the shares.

The shares sold in the offering consisted of 6.4 million existing shares of the Company’s Class A common stock owned and held by the Selling Stockholders and 2.2 million newly-issued shares of the Company’s Class A common stock received by certain Investor Stockholders pursuant to the exercise of an existing exchange right.

The newly-issued shares of the Company’s Class A common stock were issued to certain Investor Stockholders in exchange (the “Exchange”) for an equal number of shares of the Company’s Class B common stock (which were subsequently canceled) and an equal number of Evolent Health LLC’s Class B common units (“Class B units”). Class B units received by the Company from

7


relevant Investor Stockholders were simultaneously exchanged for an equivalent number of Class A units of Evolent Health LLC, and Evolent Health LLC canceled the Class B units it received in the Exchange.

As a result of the Exchange and Evolent Health LLC’s cancellation of the Class B units, the Company’s economic interest in Evolent Health LLC increased from 71.0% to 74.6% and, accordingly, we reclassified a portion of our non-controlling interests into shareholders’ equity attributable to Evolent Health, Inc. The Company’s economic interest in Evolent Health LLC will increase if further exchanges occur.

Since its inception, the Company has incurred losses from operations. As of September 30, 2016, the Company had cash and cash equivalents of $109.8 million. The Company believes it has sufficient liquidity for the next twelve months as of September 30, 2016.

2. Basis of Presentation and Summary of Significant Accounting Policies

Basis of Presentation

In our opinion, the accompanying unaudited interim consolidated financial statements include all adjustments, consisting of normal recurring adjustments, which are necessary to fairly state our financial position, results of operations, and cash flows. The consolidated balance sheet at December 31, 2015, has been derived from audited financial statements as of that date. The interim consolidated results of operations are not necessarily indicative of the results that may occur for the full fiscal year. Certain footnote disclosure normally included in financial statements prepared in accordance with United States of America generally accepted accounting principles (“GAAP”) has been omitted pursuant to instructions, rules, and regulations prescribed by the United States Securities and Exchange Commission (“SEC”). The disclosures provided herein should be read in conjunction with the audited financial statements and notes thereto included in our 2015 Form 10-K.

As discussed in Note 4, amounts for the nine months ended September 30, 2015, presented in our unaudited consolidated financial statements and notes to unaudited consolidated financial statements for that period, include the historical operations of our predecessor entity, Evolent Health Holdings, which did not consolidate the operations of Evolent Health LLC for the entire nine month period. The amounts as of and for the three and nine months ended September 30, 2016, reflect our operations, which consolidate the operations of Evolent Health LLC.

All inter-company accounts and transactions have been eliminated in consolidation.

Summary of Significant Accounting Policies
 
Certain GAAP policies, which significantly affect the determination of our financial position, results of operations and cash flows, are  summarized in our 2015 Form 10-K unless otherwise updated below.

Restricted Cash

Restricted cash is carried at cost, which approximates fair value, and includes cash used to collateralize various contractual obligations as follows (in thousands):

 
As of
 
As of
 
September 30,
 
December 31,
 
2016
 
2015
Letters of credit for facility leases
$
2,516

 
$
3,710

Pharmacy benefit management services
3,902

 
2,479

Other
152

 
96

Total restricted cash
6,570

 
6,285

Non-current restricted cash
1,580

 
1,582

Current restricted cash
$
4,990

 
$
4,703


Change in Accounting Principle

In March 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-09, which simplifies several aspects of the accounting for employee share-based payment transactions, including accounting for income taxes,

8


forfeitures and statutory tax withholding requirements, as well as classification in the statement of cash flows. The Company elected to early adopt ASU 2016-09 during the second quarter of 2016.

ASU 2016-09 requires that certain amendments resulting from the adoption of the new pronouncement be applied using a modified-retrospective transition method by means of a cumulative-effect adjustment to retained earnings as of the beginning of the period in which the guidance is adopted. Thus, the Company decreased beginning retained earnings by approximately ($0.5) million on January 1, 2016, for amendments related to an accounting policy election to recognize share-based award forfeitures as they occur rather than applying an estimated forfeiture rate. For the three months ended March 31, 2016, our net loss decreased by $0.1 million due to a reduction in stock compensation expense as a result of accounting for forfeitures as they occur, instead of using an estimated forfeiture rate. Therefore, the net impact to retained earnings as of March 31, 2016, was approximately ($0.4) million.

The following table summarizes the impact of the change in accounting principle to the Company’s consolidated statement of operations for the three months ended March 31, 2016 (in thousands):
 
 
 
As Reported
Adjustments
As Adjusted
Cost of revenue (exclusive of depreciation and amortization expenses)
 
$
28,562

 
$
48

 
$
28,610

Selling, general and administrative expenses
 
32,095

 
(149
)
 
31,946

Total operating expenses
 
224,628

 
(101
)
 
224,527

Operating income (loss)
 
(175,179
)
 
101

 
(175,078
)
Income (loss) before income taxes and non-controlling interests
 
(174,900
)
 
101

 
(174,799
)
Net income (loss)
 
(173,912
)
 
101

 
(173,811
)
Net income (loss) attributable to non-controlling interests
 
(51,100
)
 
29

 
(51,071
)
Net income (loss) attributable to Evolent Health, Inc.
 
(122,812
)
 
72

 
(122,740
)

The following table summarizes the impact of the change in accounting principle to the Company’s consolidated balance sheets, including the net amount charged to retained earnings as of March 31, 2016 (in thousands):
 
 
 
As Reported
Adjustments (1)
As Adjusted
Additional paid-in capital
 
$
357,047

 
$
367

 
$
357,414

Retained earnings (accumulated deficit)
 
183,876

 
(257
)

183,619

Total shareholders’ equity (deficit) attributable to Evolent Health, Inc.
 
541,524

 
(257
)
 
541,267

Non-controlling interests
 
234,138

 
(110
)
 
234,028


(1) The adjustments are a result of a cumulative-effect adjustment to beginning retained earnings of $(0.5) million, partially offset by an adjustment of $0.1 million to net income (loss) for the three months ended March 31, 2016, related to the policy election to recognize share-based award forfeitures as they occur, as opposed to applying an estimated forfeiture rate. Approximately $(0.3) million of the net adjustment was allocated to Evolent Health, Inc. and approximately $(0.1) million of the net adjustment was allocated to non-controlling interests.

In addition, the adoption of ASU 2016-09 changed how the Company recognizes excess tax benefits (“windfalls”) or deficiencies (“shortfalls”) related to share-based compensation. Prior to the adoption of ASU 2016-09, these windfalls and shortfalls were credited or charged, respectively, to additional paid-in capital in the Company’s consolidated balance sheets. Under the revised standard, these windfalls and shortfalls are recognized prospectively as discrete tax benefit or discrete tax expense, respectively, in the Company’s consolidated statement of operations. For the nine months ended September 30, 2016, the Company recognized a discrete tax benefit related to net windfall tax benefits from share-based compensation, which increased the net operating loss (“NOL”) deferred tax asset and our valuation allowance.

3. Recently Issued Accounting Standards

Adoption of New Accounting Standards

In March 2016, the FASB issued ASU 2016-09, Compensation – Stock Compensation: Improvements to Employee Share-Based Payment Accounting. The update simplifies several aspects of the accounting for employee share-based payment transactions, including accounting for income taxes, forfeitures and statutory tax withholding requirements, as well as classification in the statement of cash flows. This standard is effective for annual periods beginning after December 15, 2016, and interim periods within those annual periods, with early adoption permitted for any interim or annual period. The Company elected to early adopt this ASU during the second quarter of 2016, as described in Note 2 above.


9


Future Adoption of New Accounting Standards

In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows - Classification of Certain Cash Receipts and Cash Payments. This ASU provides updated guidance on eight specific cash flow issues to reduce diversity in practice in how certain cash receipts and cash payments are presented and classified in the statement of cash flows. The amendments are effective for public business entities for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted, including adoption in an interim period. If an entity early adopts the amendments in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period. We intend to adopt the requirements of this standard effective January 1, 2018 and are currently evaluating the impact of the adoption on our statement of cash flows.

In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses: Measurement of Credit Losses on Financial Instruments. With respect to assets measured at amortized cost, such as held-to-maturity assets, the update requires presentation of the amortized cost net of a credit loss allowance. The update eliminates the probable initial recognition threshold that was previously required prior to recognizing a credit loss on financial instruments. The credit loss estimate can now reflect an entity’s current estimate of all future expected credit losses as opposed to the previous standard, when an entity only considered past events and current conditions. With respect to available for sale debt securities, the update requires that credit losses be presented as an allowance rather than as a write-down. The update is effective for fiscal years beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted as of the fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. We intend to adopt the requirements of this standard effective January 1, 2020 and are currently evaluating the impact of the adoption on our financial condition and results of operations.

In February 2016, the FASB issued ASU 2016-02, Leases, in order to establish the principles to report transparent and economically neutral information about the assets and liabilities that arise from leases. This update introduces a new standard on accounting for leases, including a lessee model that brings most leases on the balance sheet. The new standard also aligns many of the underlying principles of the new lessor model with those in ASC 606, the FASB’s new revenue recognition standard (e.g., those related to evaluating when profit can be recognized). The standard also requires lessors to increase the transparency of their exposure to changes in value of their residual assets and how they manage that exposure. The ASU is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early application is permitted. We intend to adopt the requirements of this standard effective January 1, 2019, and are currently evaluating the impact of the adoption on our financial condition and results of operations.

In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers, in order to clarify the principles of recognizing revenue. This standard establishes the core principle of recognizing revenue to depict the transfer of promised goods or services in an amount that reflects the consideration the entity expects to be entitled in exchange for those goods or services. The FASB defines a five-step process that systematically identifies the various components of the revenue recognition process, culminating with the recognition of revenue upon satisfaction of an entity’s performance obligation. By completing all five steps of the process, the core principles of revenue recognition will be achieved. In March 2016, the FASB issued an update to the new revenue standard (ASU 2014-09) in the form of ASU 2016-08, which amended the principal-versus-agent implementation guidance and illustrations in the new revenue guidance. The update clarifies that an entity should evaluate whether it is the principal or the agent for each specified good or service promised in a contract with a customer. In April 2016, the FASB issued another update to the new revenue standard in the form of ASU 2016-10, which amended the guidance on identifying performance obligations and the implementation guidance on licensing. These ASUs were followed by two further updates issued during May 2016, including ASU 2016-11, which rescinds certain SEC guidance, such as the adoption of ASUs 2014-09 and 2014-16, including accounting for consideration given by a vendor to a customer, and ASU 2016-12, which is intended to clarify the objective of the collectability criterion while identifying the contract(s) with a customer. The new revenue standard (including updates) will be effective for annual and interim reporting periods beginning after December 15, 2017, with early adoption permitted only as of annual reporting periods beginning after December 15, 2016. We intend to adopt the requirements of this standard effective January 1, 2018, and, while we are evaluating the impact to our financial condition and results of operations, we expect the adoption of this ASU to require the inclusion of additional disclosures surrounding the nature and timing of our revenue.

In August 2014, the FASB issued ASU 2014-15, Presentation of Financial Statements – Going Concern: Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern. This standard requires management to assess an entity’s ability to continue as a going concern by incorporating and expanding upon certain principles that are currently in U.S. auditing standards by requiring an assessment for a period of one year after the date that the financial statements are issued. Further, based on certain conditions and circumstances, additional disclosures may be required. This standard is effective beginning with the first annual period ending after December 15, 2016, and for all annual and interim periods thereafter. Early application is permitted. The Company does not expect this standard to have an impact on the Company’s financial statements or related disclosures.

We have evaluated all other issued and unadopted ASUs and believe the adoption of these standards will not have a material impact on our results of operations, financial position, or cash flows.

10



4. Acquisitions and Business Combinations

Business Combinations

Passport

On February 1, 2016, the Company entered into a strategic alliance with University Health Care d/b/a Passport Health Plan (“Passport”), a nonprofit community-based and provider-sponsored health plan administering Kentucky Medicaid and federal Medicare Advantage benefits to over 280,000 Kentucky Medicaid and Medicare Advantage beneficiaries. As part of the transaction, we issued 1.1 million Class A common shares to acquire capabilities and assets from Passport to enable us to build out a Medicaid Center of Excellence based in Louisville, Kentucky. Additional equity consideration of up to $10.0 million may be earned by Passport should we obtain new third party Medicaid businesses in future periods. This transaction also includes a 10-year arrangement under which we will provide various health plan management and managed care services to Passport. The Company has accounted for the transactions with Passport as a business combination using purchase accounting.

The fair value of the total consideration transferred in connection with the close of the transaction was $18.2 million, of which the Class A common shares were valued at $10.5 million and the contingent equity consideration was valued at $7.8 million. The contingent consideration is recorded within “Other long-term liabilities” on our consolidated balance sheets. The fair value of the shares issued was determined based on the closing price of the Company’s Class A common stock on the NYSE as of February 1, 2016, and the quantity of shares issued was determined under a pricing collar set forth in the purchase agreement. The fair value of the contingent equity consideration was estimated based on the real options approach, a form of the income approach, which estimated the probability of the Company achieving future revenues under the agreement. Key assumptions include the discount rate and the probability-adjusted recurring revenue forecast. A further discussion of the fair value measurement of the contingent consideration is provided in Note 14.

The purchase price was allocated to the assets acquired based on their estimated fair values as of February 1, 2016, as follows (in thousands):

Purchase price
$
18,200

 
Less amount allocated to prepaid asset
6,900

 
Goodwill
$
11,300

 

The prepaid asset is related to an acquired facility license agreement as the Company was provided with leased facilities which house the acquired Passport employees at no future cost. The fair value of the acquired facility license agreement was determined by comparing the current market value of similar lease spaces to the facilities occupied by the acquired Passport personnel to obtain a market value of the occupied space, with the present value of the determined market value of the occupied space classified as the acquired facility license agreement prepaid asset. The goodwill is attributable partially to the acquired assembled workforce. The transaction was a taxable event for the Company and the amount of goodwill determined for tax purposes is deductible upon the beginning of the amortization period for tax purposes.

Results for the three and nine months ended September 30, 2016, include revenues and related expenses from our services agreement with Passport and amortization of the acquired intangibles for the period February 1, 2016, through September 30, 2016. The consolidated statements of operations include $15.0 million and $31.1 million of revenues and $(3.0) million and $(4.4) million of net income (loss) attributable to Passport for the three and nine months ended September 30, 2016, respectively.

The Offering Reorganization

Evolent Health, Inc. was incorporated as a Delaware corporation on December 12, 2014, for the purpose of pursuing the Company’s IPO. Immediately prior to the completion of the IPO in June 2015, we amended and restated our certificate of incorporation to, among other things, authorize two classes of common stock, Class A common stock and Class B common stock. Each share of our Class A common stock and Class B common stock entitles its holder to one vote on all matters to be voted on by stockholders, and holders of Class A common stock and holders of Class B common stock vote together as a single class on all matters presented to stockholders for their vote or approval (except as otherwise required by law). Pursuant to the Offering Reorganization:

Evolent Health Holdings merged with and into Evolent Health, Inc. and the surviving corporation of the merger was Evolent Health, Inc.;
An affiliate of TPG merged with and into Evolent Health, Inc. and the surviving corporation of the merger was Evolent Health, Inc.;

11


Each of the then-existing stockholders of Evolent Health Holdings received four shares of our Class A common stock and the right to certain payments under the Tax Receivables Agreement (“TRA”) in exchange for each share of Class A common stock held in Evolent Health Holdings;
TPG received 2.1 million shares of Class A common stock of Evolent Health, Inc., together with the right to certain payments under the TRA in exchange for 100% of the equity that it held in its affiliate that was merged with Evolent Health, Inc.; and
We issued shares of our Class B common stock and the right to certain payments under the TRA to The Advisory Board Company (“The Advisory Board”), TPG and another investor, each of which was a member of Evolent Health LLC prior to the Offering Reorganization.

The existing shareholders of Evolent Health Holdings held the same economic and voting interest before and after the merger of Evolent Health Holdings with and into Evolent Health, Inc., which represents a transaction among entities with a high degree of common ownership. As such, the merger is viewed as non-substantive and the consolidated financial statements of Evolent Health, Inc. reflect the historical accounting of Evolent Health Holdings except that the legal capital reflects the capital of Evolent Health, Inc.

In addition, in connection with the Offering Reorganization, Evolent Health LLC amended and restated its operating agreement to establish two classes of equity (voting Class A common units and non-voting Class B common units); after the amendment, the pre-reorganization members of Evolent Health LLC (other than Evolent Health, Inc.) hold 100% of the Class B common units and Evolent Health, Inc. holds the Class A voting common units. Evolent Health LLC’s Class B common units can be exchanged (together with a corresponding number of shares of our Class B common stock) for one share of our Class A common stock.

As of September 30, 2016, the Company owns 74.6% of the economic interests and 100% of the voting rights in Evolent Health LLC. Our operations will continue to be conducted through Evolent Health LLC and subsequent to the Offering Reorganization the financial results of Evolent Health LLC are consolidated in the financial statements of Evolent Health, Inc. Evolent Health, Inc. is a holding company whose principal asset is all of the Class A common units it holds in Evolent Health LLC, and its only business is to act as sole managing member of Evolent Health LLC.

Pro Forma Financial Information (Unaudited)

The unaudited pro forma statement of operations data presented below gives effect to (1) the Passport transaction as if it had occurred on January 1, 2015, and (2) the consolidation of Evolent Health LLC as if it had occurred on January 1, 2014. The following pro forma information includes adjustments to:

Remove transaction costs related to the Passport transaction of $0.3 million recorded during the nine months ended September 30, 2016, and reclassify said amounts to the nine months ended September 30, 2015;
Remove transaction costs related to the Passport transaction of $0.2 million recorded in the fourth quarter of 2015 and reclassify said amounts to the nine months ended September 30, 2015;
Remove the gain recognized upon the consolidation of the previously held equity method investment in 2015 and reclassify said amount to 2014;
Remove transaction costs related to the Offering Reorganization of $1.2 million in 2015 and reclassify said amount to 2014;
Record amortization expenses related to intangible assets beginning January 1, 2014, for intangibles related to the Offering Reorganization;
Record rent expense related to Passport prepaid lease beginning January 1, 2015; and
Record adjustments of income taxes associated with these pro forma adjustments.


12


This pro forma data is presented for informational purposes only and does not purport to be indicative of the results of future operations or of the results that would have occurred had the transactions described above occurred in the specified prior periods. The pro forma adjustments were based on available information and assumptions that the Company believes are reasonable to reflect the impact of these transactions on the Company’s historical financial information on a pro forma basis (in thousands).

 
For the Three
 
For the Nine
 
Months Ended
 
Months Ended
 
September 30,
 
September 30,
 
2016
 
2015
 
2016
 
2015
Revenue
$
60,210

 
$
55,363

 
$
169,370

 
$
145,189

Net income (loss)
(15,717
)
 
(12,015
)
 
(198,198
)
 
(57,637
)
Net income (loss) attributable
 
 
 
 
 
 
 
to non-controlling interests
(4,567
)
 
(3,505
)
 
(57,984
)
 
(21,494
)
Net income (loss) attributable
 
 
 
 
 
 
 
to Evolent Health, Inc.
(11,150
)
 
(8,510
)
 
(140,214
)
 
(36,143
)
 
 
 
 
 
 
 
 
Net income (loss) available to
 
 
 
 
 
 
 
common shareholders:
 
 
 
 
 
 
 
Basic
(0.26
)
 
(0.20
)
 
(3.28
)
 
(1.75
)
Diluted
(0.26
)
 
(0.20
)
 
(3.28
)
 
(1.75
)

Asset Acquisitions

Vestica

On March 1, 2016, the Company entered into an Asset Purchase Agreement between Vestica Healthcare, LLC (“Vestica”) and Evolent Health, LLC. As part of the transaction, we paid $7.5 million to acquire certain assets from Vestica to further align our interests with one of our existing partners. Vestica can earn an additional $4.0 million in consideration (the “Vestica earn-out”), which is being held in escrow, based on certain future events. This transaction also includes an arrangement under which Vestica will continue to perform certain services on our behalf related to the acquired assets.

We accounted for the transaction as an asset acquisition where the assets acquired were measured based on the amount of cash paid to Vestica as well as transaction costs incurred as the fair value of the assets given was more readily determinable than the fair value of the assets received. We classified and designated identifiable assets acquired and we assessed and determined the useful lives of the acquired intangible assets subject to amortization. As a result, we recorded a $7.5 million customer relationship intangible asset with a useful life of thirteen years. The transaction was a taxable event.

5. Investments

The amortized cost, gross unrealized gains and losses, and fair value of our investments as measured using Level 2 inputs (in thousands) were as follows:

 
 
As of September 30, 2016
 
As of December 31, 2015
 
 
 
 
Gross
 
Gross
 
 
 
 
 
Gross
 
Gross
 
 
 
 
Amortized
 
Unrealized
 
Unrealized
 
Fair
 
Amortized
 
Unrealized
 
Unrealized
 
Fair
  
 
Costs
 
Gains
 
Losses
 
Value
 
Costs
 
Gains
 
Losses
 
Value
U.S. Treasury bills
 
$
28,166

 
$
40

 
$
11

 
$
28,195

 
$
28,306

 
$
115

 
$
181

 
$
28,240

Corporate bonds
 
21,527

 
95

 
8

 
21,614

 
25,757

 
110

 
80

 
25,787

Total investments
 
$
49,693

 
$
135

 
$
19

 
$
49,809

 
$
54,063

 
$
225

 
$
261

 
$
54,027



13


The amortized cost and fair value of our investments by contractual maturities (in thousands) were as follows:
 
As of
 
As of
 
September 30,
 
December 31,
 
2016
 
2016
 
Amortized
 
Fair
 
Amortized
 
Fair
  
Costs
 
Value
 
Costs
 
Value
Due in one year or less
$
49,693

 
$
49,809

 
$
9,445

 
$
9,451

Due after one year through five years

 

 
44,618

 
44,576

Total
$
49,693

 
$
49,809

 
$
54,063

 
$
54,027



The following table summarizes our held-to-maturity securities in an unrealized loss position as of the periods noted below. These securities are aggregated by major security type and length of time that the individual securities have been in a continuous unrealized loss position (in thousands, except number of securities):

 
As of September 30, 2016
 
As of December 31, 2015
 
Number of
 
Fair
 
Unrealized
 
Number of
 
Fair
 
Unrealized
 
Securities
 
Value
 
Losses
 
Securities
 
Value
 
Losses
Unrealized loss for less than twelve months:
 
 
 
 
 
 
 
 
 
 
 
U.S. Treasury bills
2

 
$
8,045

 
$
4

 
7

 
$
28,240

 
$
181

Corporate Bonds

 

 

 
14

 
21,674

 
80

Total
2

 
$
8,045

 
$
4

 
21

 
$
49,914

 
$
261


We did not hold any securities in a continuous unrealized loss position for twelve months or longer as of September 30, 2016, or December 31, 2015.

Our investments are classified as held-to-maturity as we have both the intent and ability to hold the investments until their individual maturities. When a held-to-maturity investment is in an unrealized loss position, we assess whether or not we expect to recover the entire cost basis of security, based on our best estimate of the present value of cash flows expected to be collected from the debt security. Factors considered in our analysis include the reasons for the unrealized loss position, the severity and duration of the unrealized loss position, credit worthiness and forecasted performance of the investee. In cases where the estimated present value of future cash flows is less than our cost basis, we recognize an other than temporary impairment and write the investment down to its fair value. The new cost basis would not be changed for subsequent recoveries in fair value. While some of the securities held in the investment portfolio have decreased in value since the date of acquisition, the severity of loss and the duration of the loss position are not significant for the three and nine months ended September 30, 2016 and 2015, respectively. The Company does not intend, nor does the Company believe that it is likely, that the Company will be required to sell these securities before the recovery of the cost basis.


14


6. Property and Equipment, Net

The following summarizes our property and equipment (in thousands):
 
 
As of
 
As of
  
September 30,
 
December 31,
  
2016
 
2015
Computer hardware
$
266

 
$
232

Furniture and equipment
1,609

 
1,604

Internal-use software development costs
17,065

 
6,363

Leasehold improvements
5,830

 
5,830

Total property and equipment
24,770

 
14,029

Accumulated depreciation and amortization
(3,647
)
 
(1,233
)
Total property and equipment, net
$
21,123

 
$
12,796


We had no property and equipment prior to the Offering Reorganization.

The Company capitalized $3.6 million and $10.7 million of internal-use software development costs for the three and nine months ended September 30, 2016, respectively, and $2.8 million and $3.8 million of internal-use software development costs for the three and nine months ended September 30, 2015. The net book value of capitalized internal-use software development costs was $16.1 million and $6.3 million as of September 30, 2016, and December 31, 2015, respectively.

Depreciation expense related to property and equipment was $0.9 million and $2.4 million for the three and nine months ended September 30, 2016, respectively, and $0.5 million and $0.7 million for the three and nine months ended September 30, 2015, of which amortization expense related to capitalized internal-use software development costs was $0.4 million and $0.9 million for the three and nine months ended September 30, 2016, respectively, and less than $0.1 million for the three and nine months ended September 30, 2015.

7. Goodwill and Intangible Assets, Net

Goodwill

Goodwill has an estimated indefinite life and is not amortized; rather it is reviewed for impairment at least annually or whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable.

In interim periods between annual goodwill reviews, we also evaluate qualitative factors that could cause us to believe our estimated fair value of our single reporting unit may be lower than the carrying value and trigger a Step 1 test including, but not limited to (i) macroeconomic conditions, (ii) industry and market considerations, (iii) our overall financial performance including an analysis of our current and projected cash flows, revenue and earnings, (iv) a sustained decrease in share price and (v) other relevant entity-specific events including changes in strategy, partners, or litigation.

As a result of the Offering Reorganization, we revalued our consolidated balance sheet to the market value of our IPO share price of $17.00 and recorded $608.9 million in goodwill on our consolidated balance sheets. Subsequent to our 2015 annual impairment testing in the fourth quarter of 2015, our common stock price declined significantly, reaching our historic low in the first quarter of 2016. During the three months ended March 31, 2016, our common stock traded between $8.48 and $12.32, or an average common stock price of $10.33 compared to an average common stock price of $19.51 and $14.73 during the three month periods ended September 30, 2015, and December 31, 2015, respectively. A sustained decline in our common stock price and the resulting impact on our market capitalization is one of several qualitative factors we consider each quarter when evaluating whether events or changes in circumstances indicate it is more likely than not that a potential goodwill impairment exists. We concluded that the further decline in common stock price observed during the first quarter of 2016 did represent a sustained decline and that triggering events occurred during the period requiring an interim goodwill impairment test as of March 31, 2016. As such, we performed a Step 1 impairment test of our goodwill as of March 31, 2016.

Step 1 Results

To determine the implied fair value for our single reporting unit, we used both a market multiple valuation approach (“market approach”) and a discounted cash flow valuation approach (“income approach”).  In determining the estimated fair value, we considered the level of our Class A common stock price and assumptions that we believed market participants would make in valuing

15


our reporting unit, including a control premium, as well as discounted cash flow calculations of management’s estimates of future financial performance and management’s long-term plans.  This analysis also required us to make judgments about revenues, expenses, fixed asset and working capital requirements, the timing of exchanges of our Class B common shares, capital market assumptions and discount rates.

In our March 31, 2016, Step 1 test, our most sensitive assumption for purposes of the market approach was our estimate of the control premium, and the most sensitive assumption related to the income approach, other than our cash flows, was the discount rate. As of March 31, 2016, our single reporting unit failed the Step 1 analysis as we determined that its implied fair value was less than its carrying value based on the weighting of the fair values determined under both the market and income approaches. As fair value was less than carrying value, we performed a Step 2 test to determine the implied fair value of our goodwill.

Step 2 Results

In our March 31, 2016, Step 2 test, the fair value of all assets and liabilities were estimated, including our tangible assets (corporate trade name, customer relationships and technology) for the purpose of deriving an estimate of the implied fair value of goodwill. The implied fair value of goodwill was then compared to the carrying amount of goodwill resulting in an impairment charge of $160.6 million on our consolidated statements of operations.

The impairment was driven primarily by the sustained decline in our share price as our estimates of our future cash flows and the control premium have remained consistent, combined with an increase in the discount rate period over period. As noted above, our determination of fair value used a weighting of the fair values determined under both the market and income approaches, with the market approach driving the significant reduction in overall firm value and related impairment of goodwill.

As part of the Passport transaction (refer to Note 4 for further information), we recorded an additional $11.3 million in goodwill on our consolidated balance sheets.

The following table summarizes the changes in the carrying amount of goodwill (in thousands):

 
For the Three
 
For the Nine
 
Months Ended
 
Months Ended
 
September 30,
 
September 30,
 
2016
 
2015
 
2016
 
2015
Balance as of beginning-of-period
$
459,703

 
$
608,903

 
$
608,903

 
$

Goodwill Acquired (1)

 

 
11,400

 
608,903

Goodwill Impairment

 

 
(160,600
)
 

Balance as of end-of-period
$
459,703

 
$
608,903

 
$
459,703

 
$
608,903


(1) Goodwill acquired as a result of the Offering Reorganization and the Passport transaction. See Note 4 for further discussion regarding both the Offering Reorganization and the Passport transaction.

Intangible Assets, Net

Details of our intangible assets (in thousands) are presented below:

 
 
As of September 30, 2016
 
 
Weighted-
 
 
 
 
Average
 
Gross
 
 
 
 
 
Net
 
Remaining
Carrying
Accumulated
Carrying
  
Useful Life
Amount
Amortization
Value
Corporate trade name
 
18.7
 
$
19,000

 
 
$
1,266

 
 
$
17,734

Customer relationships
 
23.0
 
127,500

 
 
6,733

 
 
120,767

Technology
 
5.7
 
30,000

 
 
5,712

 
 
24,288

Total
 
 
 
$
176,500

 
 
$
13,711

 
 
$
162,789



16


 
 
As of December 31, 2015
  
 
Weighted-
 
 
 
 
Average
 
Gross
 
 
 
 
 
Net
 
Remaining
Carrying
Accumulated
Carrying
 
Useful Life
Amount
Amortization
Value
Corporate trade name
 
19.4
 
$
19,000

 
 
$
554

 

$
18,446

Customer relationships
 
24.4
 
120,000

 
 
2,797

 

117,203

Technology
 
6.4
 
30,000

 
 
2,497

 

27,503

Total
 
 
 
$
169,000

 
 
$
5,848

 
 
$
163,152


We had no intangible assets prior to the Offering Reorganization.

We recorded additional customer relationship intangible assets of $7.5 million in relation to the closing of the Vestica transaction during the first quarter of 2016.

Amortization expense related to intangible assets was $2.7 million and $7.9 million for the three and nine months ended September 30, 2016, respectively, and $2.5 million and $3.3 million for the three and nine months ended September 30, 2015.

8. Commitments and Contingencies

UPMC Reseller Agreement

The Company and the University of Pittsburgh Medical Center (“UPMC”) are parties to a Reseller, Services and Non-Competition Agreement, dated August 31, 2011 (the “Original UPMC Reseller Agreement”), which was amended and restated by the parties on June 27, 2013 (as amended through the date hereof, the “UPMC Reseller Agreement”). Under the terms of the UPMC Reseller Agreement, UPMC has appointed the Company as a non-exclusive reseller of certain services, subject to certain conditions and limitations specified in the UPMC Reseller Agreement. In consideration for the Company’s obligations under the UPMC Reseller Agreement and subject to certain conditions described therein, UPMC has agreed not to sell certain products and services directly to the Company’s customers and top prospects.

The Advisory Board Company Reseller Agreement

The Company and The Advisory Board are parties to a Services, Reseller, and Non-Competition Agreement, dated August 31, 2011 (the “Original Advisory Board Reseller Agreement”), which was amended and restated by the parties on June 27, 2013, and May 1, 2015 (as so amended, the “Advisory Board Company Reseller Agreement”). Under the terms of the Advisory Board Company Reseller Agreement, The Advisory Board provides certain services to the Company on an as-requested basis.  In addition, The Advisory Board has a right of first offer to provide certain specified services during the term of the Agreement and has the right to collect certain fees for specified referrals.

Contingencies

Tax Receivables Agreement

In connection with the Offering Reorganization, the Company entered into the TRA with certain of its investors, which provides for the payment by the Company to these investors of 85% of the amount of the tax benefits, if any, that the Company is deemed to realize as a result of increases in our tax basis related to exchanges of Class B common units as well as tax benefits attributable to the future utilization of pre-IPO NOLs. These payment obligations are obligations of the Company. For purposes of the TRA, the benefit deemed realized by the Company will be computed by comparing its actual income tax liability to the amount of such taxes that the Company would have been required to pay had there been no increase to the tax basis of the assets of the Company as a result of the exchanges or had the Company had no NOL carryforward balance. The actual amount and timing of any payments under the TRA will vary depending upon a number of factors, including:

The timing of the exchanges and the price of the Class A shares at the time of the transaction, triggering a tax basis increase in the Company’s asset and a corresponding benefit to be realized under the TRA; and
The amount and timing of our taxable income - the Company will be required to pay 85% of the tax savings as and when realized, if any. If the Company does not have taxable income, it will not be required to make payments under the TRA for that taxable year because no tax savings were actually realized.


17


Due to the items noted above, and the fact that the Company is in a full valuation allowance position such that the deferred tax assets related to the Company’s historical pre-IPO losses and tax basis increase benefit from exchanges have not been realized, the Company has not recorded a liability pursuant to the TRA.

Litigation Matters

We are engaged from time to time in certain legal disputes arising in the ordinary course of business, including employment claims. When the likelihood of a loss contingency becomes probable and the amount of the loss can be reasonably estimated, we accrue a liability for the loss contingency. We continue to review accruals and adjust them to reflect ongoing negotiations, settlements, rulings, advice of legal counsel, and other relevant information. To the extent new information is obtained, and our views on the probable outcomes of claims, suits, assessments, investigations, or legal proceedings change, changes in our accrued liabilities would be recorded in the period in which such determination is made. We had no material accruals as of September 30, 2016, and December 31, 2015.

Commitments

Lease Commitments

The Company has entered into lease agreements for its office location in Arlington, Virginia. In connection with these lease agreements, the Company is required to maintain a $2.5 million letter of credit, which declines annually throughout the term of the lease. As of September 30, 2016, the restricted funds held in connection with the lease were $2.5 million.

Total rental expense on operating leases was $1.1 million and $3.4 million for the three and nine months ended September 30, 2016, respectively, and $0.9 million and $1.3 million for the three and nine months ended September 30, 2015.

Indemnifications

The Company’s customer agreements generally include a provision by which the Company agrees to defend its partners against third party claims (a) for death, bodily injury, or damage to personal property caused by Company negligence or willful misconduct, (b) by former or current Company employees arising from such managed service agreements, (c) for intellectual property infringement under specified conditions and (d) for Company violation of applicable laws, and to indemnify them against any damages and costs awarded in connection with such claims. To date, the Company has not incurred any material costs as a result of such indemnities and has not accrued any liabilities related to such obligations in the accompanying financial statements.

Registration rights agreement

We entered into a registration rights agreement with The Advisory Board, UPMC, TPG and another investor to register for sale under the Securities Act of 1933, as amended (the “Securities Act”), shares of our Class A common stock, including those delivered in exchange for Class B common stock and Class B common units in the circumstances described above. Subject to certain conditions and limitations, this agreement provides these investors with certain demand, piggyback and shelf registration rights. The registration rights granted under the registration rights agreement will terminate upon the date the holders of shares that are a party thereto no longer hold any such shares that are entitled to registration rights. Pursuant to our contractual obligations under this agreement, we filed a registration statement on Form S-3 with the SEC on July 28, 2016, which was declared effective on August 12, 2016.

Pursuant to certain terms of the registration rights agreement, the Investor Stockholders sold 8.6 million shares of the Company’s Class A common stock in a secondary offering in September 2016. See Note 1 for further discussion of our secondary offering. Pursuant to the terms of the registration rights agreement, we paid $2.1 million in expenses related to the secondary offering for the three months ended September 30, 2016.

We will continue to pay all expenses relating to any demand, piggyback or shelf registration, other than underwriting discounts and commissions and any transfer taxes, subject to specified conditions and limitations. The registration rights agreement includes customary indemnification provisions, including indemnification of the participating holders of shares of Class A common stock and their directors, officers and employees by us for any losses, claims, damages or liabilities in respect thereof and expenses to which such holders may become subject under the Securities Act, state law or otherwise.


18


Credit and Concentration Risk

The Company is subject to significant concentrations of credit risk related to cash and cash equivalents, investments and accounts receivable. The Company’s cash and cash equivalents and investments are held at financial institutions that management believes to be of high credit quality. While the Company maintains its cash and cash equivalents and investments with financial institutions with high credit ratings, it often maintains these deposits in federally insured financial institutions in excess of federally insured limits. The Company has not experienced any losses on cash and cash equivalents or investments to date.

The following table summarizes those partners who represented at least 10% of our revenue for the periods presented:
 
 
For the Three
 
For the Nine
 
Months Ended
 
Months Ended
 
September 30,
 
September 30,
 
2016
 
2015
 
2016
 
2015
Customer A
24.9
%
 
*

 
18.7
%
 
*

Customer B
15.3
%
 
17.1
%
 
16.5
%
 
17.1
%
Customer C
14.3
%
 
13.6
%
 
14.7
%
 
13.1
%
Customer D
*

 
12.7
%
 
*

 
12.3
%
Customer E
*

 
10.6
%
 
*

 
10.5
%
Customer F
*

 
15.7
%
 
*

 
15.8
%
Customer G
*

 
14.3
%
 
*

 
14.6
%

* Represents less than 10.0% of the respective balance

The following table summarizes those partners who represented at least 10% of our trade accounts receivable for the periods presented:
 
As of
 
As of
 
September 30,
 
December 31,
 
2016
 
2015
Customer A
*

 
*

Customer B
14.5
%
 
12.9
%
Customer C
*

 
*

Customer D
33.2
%
 
28.1
%
Customer E
11.2
%
 
11.4
%
Customer F
10.5
%
 
23.2
%

* Represents less than 10.0% of the respective balance