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 December 31, 2007
   
OR
   
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
Commission file number 0-13801
 
QUALITY SYSTEMS, INC.
(Exact name of Registrant as specified in its charter)
     
California    95-2888568
 (State or Other Jurisdiction of
 Incorporation or Organization)
   (I.R.S. Employer
Identification No.)
     
18191 Von Karman Avenue, Irvine California   92612
(Address of Principal Executive Offices)    (Zip Code)
 
Registrant’s telephone number, including area code: (949) 255-2600
 

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 twelve 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 ninety days. Yes x No o

Indicate by check mark whether the Registrant is a large accelerated filers, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12B-2 of the Exchange Act. (Check one): Large accelerated filer o    Accelerated filer x    Non-accelerated filer o

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x

Indicate the number of shares outstanding of each of the Registrant’s classes of Common Stock as of the latest practicable date 27,392,965 shares of Common Stock, $0.01 par value, as of December 19, 2007.

 




PART I
CONSOLIDATED FINANCIAL INFORMATION
 
ITEM 1 – FINANCIAL STATEMENTS
 
QUALITY SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
 
December 31,
2007
  March 31,
2007
 
 
 
 
ASSETS        
Current assets:            
     Cash and cash equivalents $ 30,013   $ 60,028  
     Marketable securities   48,400      
     Accounts receivable, net   72,906     63,945  
     Inventories, net   1,333     1,175  
     Net current deferred tax assets   4,106     3,443  
     Other current assets   3,498     4,507  
 
 
 
               Total current assets   160,256     133,098  
             
Equipment and improvements, net   4,946     5,029  
Capitalized software costs, net   8,367     6,982  
Net deferred tax assets   1,636     1,180  
Goodwill   1,840     1,840  
Other assets   2,498     2,552  
 
 
 
  $ 179,543   $ 150,681  
 
 
 
             
LIABILITIES AND SHAREHOLDERS’ EQUITY            
Current liabilities:            
     Accounts payable $ 5,818   $ 5,246  
     Deferred revenue   40,574     38,774  
     Accrued compensation and related benefits   7,420     6,521  
     Income taxes payable   2,899     315  
     Other current liabilities   5,218     5,626  
 
 
 
               Total current liabilities   61,929     56,482  
             
Deferred revenue, net of current   717     674  
Deferred compensation   2,231     2,279  
 
 
 
    64,877     59,435  
 
 
 
             
Commitments and contingencies            
             
Shareholders’ equity:            
        Common stock, $0.01 par value; authorized 50,000 shares;
        issued and outstanding 27,393 and 27,123 shares at
        December 31, 2007 and March 31, 2007, respectively.
  274     271  
     Additional paid-in capital   73,871     65,666  
     Retained earnings   40,521     25,309  
 
 
 
               Total shareholders’ equity   114,666     91,246  
 
 
 
               Total liabilities and shareholders’ equity $ 179,543   $ 150,681  
 
 
 
 
The accompanying condensed notes to these unaudited consolidated financial statements are an
integral part of these consolidated statements.

2



QUALITY SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
 
Three Months Ended Nine Months Ended
 
 
 
December 31, 2007   December 31, 2006   December 31, 2007   December 31, 2006  
 
 
 
 
 
Revenues:                
 Software, hardware and supplies $ 20,591   $ 16,088   $ 55,844   $ 47,854  
 Implementation and training services   3,115     2,885     9,545     8,687  
 
 
 
 
 
System sales   23,706     18,973     65,389     56,541  
                         
 Maintenance   14,861     11,069     40,862     30,107  
 Electronic data interchange services   5,739     4,290     16,169     12,333  
 Other services   3,784     4,164     12,848     13,048  
 
 
 
 
 
Maintenance, EDI and Other services   24,384     19,523     69,879     55,488  
                         
 
 
 
 
 
   Total revenue   48,090     38,496     135,268     112,029  
 
 
 
 
 
                         
Cost of revenue:                        
 Software, hardware and supplies   2,984     1,798     7,949     5,210  
 Implementation and training services   2,638     2,169     7,469     6,285  
 
 
 
 
 
Total cost of system sales   5,622     3,967     15,418     11,495  
                         
 Maintenance   3,131     3,058     9,292     8,987  
 Electronic data interchange services   4,162     3,144     11,413     8,850  
 Other services   3,233     2,528     9,342     6,655  
 
 
 
 
 
Total cost of maintenance and other services   10,526     8,730     30,047     24,492  
 
 
 
 
 
   Total cost of revenue   16,148     12,697     45,465     35,987  
 
 
 
 
 
  
   Gross profit   31,942     25,799     89,803     76,042  
 
 
 
 
 
                         
Operating expenses:                        
  Selling, general and administrative   13,283     10,593     39,114     30,787  
  Research and development costs   2,874     2,601     8,362     7,510  
 
 
 
 
 
     Total operating expenses   16,157     13,194     47,476     38,297  
 
 
 
 
 
   Income from operations   15,785     12,605     42,327     37,745  
                         
Interest income   710     935     2,094     2,421  
Other income   953         953      
                         
Income before provision for income taxes   17,448     13,540     45,374     40,166  
Provision for income taxes   6,234     4,819     16,548     15,439  
 
 
 
 
 
   
   Net income $ 11,214   $ 8,721   $ 28,826   $ 24,727  
 
 
 
 
 
                         
Net income per share:                        
  Basic $ 0.41   $ 0.32   $ 1.06   $ 0.92  
  Diluted $ 0.40   $ 0.32   $ 1.04   $ 0.90  
                         
Weighted average shares outstanding:                        
Basic   27,362     26,966     27,261     26,828  
Diluted   27,696     27,507     27,739     27,441  
Dividends declared per common share $ 0.25   $   $ 0.75   $  
 
The accompanying condensed notes to these unaudited consolidated financial statements are an
integral part of these consolidated statements.

3



QUALITY SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
 
  Nine Months Ended  
 
 
December 31,
2007
  December 31,
2006
 
 
 
 
             
Cash flows from operating activities:        
   Net income $ 28,826   $ 24,727  
   Adjustments to reconcile net income to net cash provided
   by operating activities:
           
     Depreciation   1,755     1,382  
     Amortization of capitalized software costs   3,089     2,326  
     Gain on life insurance proceeds, net   (755 )    
     Provision for bad debts   30     701  
     Non-cash share-based compensation   2,956     2,666  
     Deferred income taxes   (1,119 )   1,094  
     Tax benefit from exercise of stock options   1,357     2,063  
     Excess tax benefit from share-based compensation   (1,295 )   (2,046 )
   Changes in assets and liabilities:            
     Accounts receivable   (8,991 )   (15,051 )
     Inventories   (158 )   (750 )
     Income tax receivable       (550 )
     Other current assets   1,009     (647 )
     Other assets   54     (441 )
     Accounts payable   572     340  
     Deferred revenue   1,843     4,630  
     Accrued compensation and related benefits   899     (616 )
     Income taxes payable   2,584      
     Other current liabilities   (408 )   3,015  
     Deferred compensation   (48 )   445  
 
 
 
Net cash provided by operating activities   32,200     23,288  
 
 
 
             
Cash flows from investing activities:            
   Additions to capitalized software costs   (4,474 )   (3,478 )
   Additions to equipment and improvements   (1,672 )   (2,470 )
   Purchases of marketable securities   (83,500 )    
   Sales of marketable securities   35,100      
   Proceeds from life insurance policy, net   755      
 
 
 
Net cash used in investing activities   (53,791 )   (5,948 )
 
 
 
             
Cash flows from financing activities:            
   Dividends paid   (13,614 )    
   Excess tax benefit from share-based compensation   1,295     2,046  
   Proceeds from the exercise of stock options   3,895     3,799  
 
 
 
Net cash (used in) provided by financing activities   (8,424 )   5,845  
 
 
 
             
Net (decrease) increase in cash and cash equivalents   (30,015 )   23,185  
             
Cash and cash equivalents at beginning of period   60,028     57,225  
 
 
 
             
Cash and cash equivalents at end of period $ 30,013   $ 80,410  
 
 
 
             
Supplemental disclosures of cash flow information:            
   Cash paid during the period for income taxes, net of refunds $ 13,895   $ 12,802  
 
The accompanying condensed notes to these unaudited consolidated financial statements are an
integral part of these consolidated statements.

4



 QUALITY SYSTEMS, INC.
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
( UNAUDITED)

1.     Basis of Presentation

The accompanying unaudited consolidated financial statements as of December 31, 2007 and for the three and nine months ended December 31, 2007 and 2006, have been prepared in accordance with the requirements of Form 10-Q and Article 10 of Regulation S-X, and therefore do not include all information and footnotes which would be presented were such consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). These consolidated financial statements should be read in conjunction with the audited consolidated financial statements presented in the Company’s Annual Report on Form 10-K for the fiscal year ended March 31, 2007. Amounts related to disclosures of March 31, 2007 balances within these interim consolidated financial statements were derived from the aforementioned Form 10-K. In the opinion of management, the accompanying consolidated financial statements reflect all adjustments which are necessary for a fair presentation of the results of operations and cash flows for the periods presented. The results of operations for such interim periods are not necessarily indicative of results of operations to be expected for the full year.

References to dollar amounts in this financial statement section are in thousands, except share and per share data, unless otherwise specified.

2.     Summary of Significant Accounting Policies

Principles of consolidation.  The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary. All significant inter-company accounts and transactions have been eliminated.

Revenue recognition. The Company recognizes revenue pursuant to Statement of Position No. 97-2, “Software Revenue Recognition” (SOP 97-2), as amended by Statement of Position No. 98-9 “Modification of SOP 97-2, Software Revenue Recognition” (SOP 98-9). The Company generates revenue from the sale of licensing rights to its software products directly to end-users and value-added resellers (VARs). The Company also generates revenue from sales of hardware and third party software, implementation, training, EDI, post-contract support (maintenance) and other services performed for customers who license its products.

A typical system contract contains multiple elements of the above items. SOP 98-9 requires revenue earned on software arrangements involving multiple elements to be allocated to each element based on the relative fair values of those elements. The fair value of an element must be based on vendor specific objective evidence (VSOE). The Company limits its assessment of VSOE for each element to either the price charged when the same element is sold separately (using a rolling average of stand alone transactions) or the price established by management having the relevant authority to do so, for an element not yet sold separately. VSOE calculations are updated and reviewed quarterly or annually depending on the nature of the product or service.

When evidence of fair value exists for the delivered and undelivered elements of a transaction, then discounts for individual elements are aggregated and the total discount is allocated to the individual elements in proportion to the elements’ fair value relative to the total contract fair value.

When evidence of fair value exists for the undelivered elements only, the residual method, provided for under SOP 98-9, is used. Under the residual method, the Company defers revenue related to the undelivered elements in a system sale based on VSOE of fair value of each of the undelivered elements, and allocates the remainder of the contract price net of all discounts to revenue recognized from the delivered elements. If VSOE of fair value of any undelivered element does not exist, all revenue is deferred until VSOE of fair value of the undelivered element is established or the element has been delivered.

The Company bills for the entire contract amount upon contract execution except for maintenance which is billed separately. Amounts billed in excess of the amounts contractually due are recorded in accounts receivable as advance billings. Amounts are contractually due when services are performed or in accordance with contractually specified payment dates. Provided the fees are fixed and determinable and collection is considered probable, revenue from licensing rights and sales of hardware and third party


5



software is generally recognized upon shipment and transfer of title. In certain transactions where collections risk is high, the cash basis method is used to recognize revenue. If the fee is not fixed or determinable, then the revenue recognized in each period (subject to application of other revenue recognition criteria) will be the lesser of the aggregate of amounts due and payable or the amount of the arrangement fee that would have been recognized if the fees were being recognized using the residual method. Fees which are considered fixed or determinable at the inception of the Company’s arrangements must include the following characteristics:

 
The fee must be negotiated at the outset of an arrangement, and generally be based on the specific volume of products to be delivered without being subject to change based on variable pricing mechanisms such as the number of units copied or distributed or the expected number of users.
 
Payment terms must not be considered extended. If a significant portion of the fee is due more than 12 months after delivery or after the expiration of the license, the fee is presumed not fixed and determinable.
 

Revenue from implementation and training services is recognized as the corresponding services are performed. Maintenance revenue is recognized ratably over the contractual maintenance period.

Contract accounting is applied where services include significant software modification, development or customization. In such instances, the arrangement fee is accounted for in accordance with Statement of Position No. 81-1 “Accounting for Performance of Construction-Type and Certain Production-Type Contracts” (SOP 81-1). Pursuant to SOP 81-1, the Company uses the percentage of completion method provided all of the following conditions exist:

 
the contract includes provisions that clearly specify the enforceable rights regarding goods or services to be provided and received by the parties, the consideration to be exchanged, and the manner and terms of settlement;
   
the customer can be expected to satisfy its obligations under the contract;
 
 
the Company can be expected to perform its contractual obligations; and
 
 
reliable estimates of progress towards completion can be made.
 

The Company measures completion using labor input hours. Costs of providing services, including services accounted for in accordance with SOP 81-1, are expensed as incurred.

If a situation occurs in which a contract is so short term that the financial statements would not vary materially from using the percentage-of-completion method or in which the Company is unable to make reliable estimates of progress of completion of the contract, the completed contract method is utilized.

Individual product returns are estimated in accordance with Statement of Financial Accounting Standards No. 48, “Revenue Recognition When Right of Return Exists” (SFAS 48). The Company also ensures that the other criteria in SFAS 48 have been met prior to recognition of revenue:

 
the price is fixed or determinable;
 
 
the customer is obligated to pay and there are no contingencies surrounding the obligation or the payment;
 
 
the customer’s obligation would not change in the event of theft or damage to the product;
 
 
the customer has economic substance;
 
 
the amount of returns can be reasonably estimated; and
 
 
the Company does not have significant obligations for future performance in order to bring about resale of the product by the customer.
 

The Company has historically offered short-term rights of return in certain sales arrangements. If the Company is able to estimate returns for these types of arrangements, revenue is recognized and these arrangements are recorded in the consolidated financial statements. If the Company is unable to estimate returns for these types of arrangements, revenue is not recognized in the consolidated financial statements until the rights of return expire.

Revenue related to sales arrangements which include the right to use software stored on the Company’s hardware is accounted for under the Emerging Issues Task Force Issue (EITF) No. 00-3 “Application of AICPA Statement of Position 97-2 to arrangements that include the


6



right to use software stored on another entity’s hardware”. EITF No. 00-3 requires that for software licenses and related implementation services to continue to fall under SOP No. 97-2, the customer must have the contractual right to take possession of the software without incurring a significant penalty and it must be feasible for the customer to either host the software themselves or through another third party. If an arrangement is not deemed to be accounted for under SOP 97-2, the entire arrangement is accounted for as a service contract in accordance with EITF Issue No. 00-21 “Revenue arrangements with multiple deliverables”. In that instance, the entire arrangement would be recognized as the hosting services are being performed.

From time to time, the Company offers future purchase discounts on its products and services as part of its sales arrangements. Pursuant to AICPA TPA 5100.50, such discounts which are incremental to the range of discounts reflected in the pricing of the other elements of the arrangement, which are incremental to the range of discounts typically given in comparable transactions, and which are significant, are treated as an additional element of the contract to be deferred. Amounts deferred related to future purchase options are not recognized until either the customer exercises the discount offer or the offer expires.

Revenue is divided into two categories, “system sales” and “maintenance, EDI and other services”. Revenue in the system sales category includes software license fees, third party hardware and software, and implementation and training services related to purchase of the Company’s software systems. The majority of the revenue in the system sales category is related to the sale of software. Revenue in the maintenance, EDI and other services category includes maintenance, EDI, follow on training and implementation services, annual third party license fees and other revenue.

Cash and cash equivalents. Cash and cash equivalents generally consist of cash and money market funds and short-term U.S. Treasury securities with original maturities of less than 90 days. The money market fund in which the Company holds a portion of its cash invests in only investment grade money market instruments from a variety of industries, and therefore bears relatively low market risk. The average maturity of the investments owned by the money market fund is approximately two months.

Marketable securities. As of December 31, 2007, the Company had short-term investments in tax exempt Auction Rate Securities (ARS) of approximately $48.4 million. The ARS are rated AAA or AA by one or more national rating agencies and have contractual terms of up to 30 years, but generally have interest rate reset dates that occur every 7, 28 or 35 days and despite the long-term nature of their stated contractual maturities, management anticipates having the opportunity to liquidate these securities at ongoing auctions which are held in conjunction with the interest reset dates every 35 days or less. The investments in ARS are classified as available-for-sale on the Company’s Consolidated Balance Sheets. The investments are recorded at cost which approximates fair market value due to their variable interest rates, which typically resets every 7, 28 or 35 days. As a result, no cumulative gross unrealized holding gains/losses from the investments have been realized. All income generated from these investments is recorded as interest income.

Allowance for doubtful accounts.  The Company provides credit terms typically ranging from thirty days to less than twelve months for most system and maintenance contract sales and generally does not require collateral. The Company performs credit evaluations of its customers and maintains reserves for estimated credit losses. Reserves for potential credit losses are determined by establishing both specific and general reserves. Specific reserves are based on management’s estimate of the probability of collection for certain troubled accounts. General reserves are established based on the Company’s historical experience with bad debt expense and the aging of the Company’s accounts receivable balances net of deferred revenues and specifically reserved accounts. Accounts are written off as uncollectible only after the Company has expended extensive collection efforts.

Included in accounts receivable are amounts related to maintenance and services which were billed, but which had not yet been rendered as of the end of the period. Undelivered maintenance and services are included on the accompanying Consolidated Balance Sheets as deferred revenue (see also Note 4).

Inventories. Inventories consist of hardware for specific customer orders and spare parts, and are valued at lower of cost (first-in, first-out) or market. Management provides a reserve to reduce inventory to its net realizable value.

Equipment and improvements. Equipment and improvements are stated at cost less accumulated depreciation and amortization. Depreciation and amortization of equipment and


7



improvements are provided over the estimated useful lives of the assets, or the related lease terms if shorter, by the straight-line method. Useful lives range as follows:
       
Computers and electronic test equipment 3-5 years  
       
Furniture and fixtures 5-7 years  
   
Leasehold improvements lesser of lease term or estimated useful life of asset  
   

Software development costs. Development costs incurred in the research and development of new software products and enhancements to existing software products are expensed as incurred until technological feasibility has been established. After technological feasibility is established, any additional development costs are capitalized in accordance with Statement of Financial Accounting Standards No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed” (SFAS 86). Such capitalized costs are amortized on a straight-line basis over the estimated economic life of the related product of three years. The Company provides support services on the current and prior two versions of its software. Management performs an annual review of the estimated economic life and the recoverability of such capitalized software costs. If a determination is made that capitalized amounts are not recoverable based on the estimated cash flows to be generated from the applicable research and development activities, any remaining capitalized amounts are written off.

Income taxes.   Income taxes are provided for the tax effects of transactions reported in the consolidated financial statements and consists of taxes currently due plus deferred taxes related to temporary differences between the basis of assets and liabilities for financial and tax reporting. The deferred income tax assets and liabilities represent the future state and federal tax return consequences of those differences, which will either be taxable or deductible when the assets and liabilities are recovered or settled. Deferred income taxes also are recognized for operating losses that are available to offset future taxable income and tax credits that are available to offset future income taxes. Valuation allowances are established as a reduction of net deferred income tax assets if management determines that it is more likely than not that the deferred assets will not be realized.

Share-Based Compensation

Statement of Financial Accounting Standard No. 123R, “Share-Based Payment” (SFAS 123R), requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. Expected term is estimated using the simplified method which is equal to the midpoint between the vesting period and the contractual term. Volatility is estimated by using the weighted average historical volatility of our common stock, which approximates expected volatility. The risk free rate is the implied yield available on the U.S Treasury zero-coupon issues with remaining terms equal to the expected term. The expected dividend yield is the average dividend rate during a period equal to the expected term of the option. Those inputs are then entered into the Black Scholes model to determine the estimated fair value. The value of the portion of the award that is ultimately expected to vest is recognized ratably as expense over the requisite service period in the Company’s Consolidated Statements of Income.

The following table shows total stock-based employee compensation expense included in the Consolidated Statement of Income for the three and nine month periods ended December 31, 2007 and 2006.


8



Three Months
Ended December
31, 2007
  Three Months
Ended December
31, 2006
  Nine Months
Ended December
31, 2007
  Nine Months
Ended December
31, 2006
 

 
 
 
 
Costs and expenses:                
  Cost of revenue $ 119   $ 123   $ 391   $ 364  
  Research and development   184     207     635     614  
  Selling, general and administrative   618     559     1,930     1,688  




                         
Total share-based compensation
for the period
$ 921   $ 889   $ 2,956   $ 2,666  
                         
Amounts capitalized in software
development costs
  (9 )   (7 )   (31 )   (30 )




                         
Amounts charged against earnings,
before income tax benefit
$ 912   $ 882   $ 2,925   $ 2,636  




                         
Amount of related income tax benefit
recognized in earnings
$ 234   $ 237   $ 771   $ 681  




 

3.     Recent Accounting Pronouncements

In December 2007, the FASB issued SFAS No. 141 (Revised 2007), “Business Combinations” (SFAS 141R). retains the fundamental requirements of the original pronouncement requiring that the purchase method be used for all business combinations. SFAS 141(R) defines the acquirer as the entity that obtains control of one or more businesses in the business combination, establishes the acquisition date as the date that the acquirer achieves control and requires the acquirer to recognize the assets acquired, liabilities assumed and any noncontrolling interest at their fair values as of the acquisition date. In addition, SFAS 141(R) requires expensing of acquisition-related and restructure-related costs, remeasurement of earn out provisions at fair value, measurement of equity securities issued for purchase at the date of close of the transaction and non-expensing of in-process research and development related intangibles. SFAS 141(R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. An entity may not apply it before that date. This pronouncement will be applied by the Company when it becomes effective and when or if the Company effectuates a business combination, otherwise there is no impact on the Company’s financial statements.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities—including an amendment of SFAS No. 115”, (SFAS 159) which applies to all entities with available-for-sale and trading securities. This Statement permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. This Statement is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. Early adoption is permitted as of the beginning of a fiscal year that begins on or before November 15, 2007, provided the entity also elects to apply the provisions of FASB Statement No. 157, “Fair Value Measurements”. The Company plans to adopt SFAS 159 effective April 1, 2008 and is in the process of determining the effect, if any, the adoption of SFAS 159 will have on its consolidated financial statements.

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (SFAS 157), which defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. SFAS 157 does not require any new fair value measurements, but provides guidance on how to measure fair value by providing a fair value hierarchy used to classify the source of the information. This statement is effective for fiscal years beginning after November 15, 2007. The Company is currently evaluating the impact, if any, the adoption of this standard will have on its consolidated financial statements.


9



4.     Composition of Certain Financial Statement Captions

Accounts receivable include amounts related to maintenance and services which were billed but not yet rendered as of the end of the period. Undelivered maintenance and services are included on the accompanying Consolidated Balance Sheets as part of the deferred revenue balance.

 
December 31, 2007   March 31, 2007  

 
 
Accounts receivable, excluding undelivered software,
maintenance and services
$ 49,867   $ 42,574  
Undelivered software, maintenance and implementation
services billed in advance, included in deferred revenue
  25,447     23,809  


Accounts receivable, gross   75,314     66,383  
             
Allowance for doubtful accounts   (2,408 )   (2,438 )


             
Accounts receivable, net $ 72,906   $ 63,945  


 
Inventories are summarized as follows:
 
December 31, 2007   March 31, 2007  

 
 
Computer systems and components, net of reserve for
   obsolescence of $324 for both periods
$ 1,297   $ 1,147  
Miscellaneous parts and supplies   36     28  
 

             
Inventories, net $ 1,333   $ 1,175  
 

 
Accrued compensation and related benefits are summarized as follows:
 
December 31, 2007   March 31, 2007  

 
 
Bonus $ 4,784   $ 4,158  
Vacation   2,636     2,363  
 

             
Accrued compensation and related benefits $ 7,420   $ 6,521  
 

 
Short and long-term deferred revenue are summarized as follows:
 
December 31, 2007   March 31, 2007  

 
 
Maintenance $ 8,056   $ 10,241  
Implementation services   24,947     24,246  
Annual license services   6,420     2,219  
Undelivered software and other   1,868     2,742  


             
Deferred Revenue $ 41,291   $ 39,448  



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Other current liabilities are summarized as follows:
 
December 31, 2007   March 31, 2007  

 
 
         
Sales tax payable $ 975   $ 805  
Deferred rent   627     652  
Customer deposits   612     703  
Accrued EDI expenses   533     613  
Accrued royalties   357     463  
Commission payable   341     767  
Professional fees   177     425  
Other accrued expenses   1,596     1,198  


             
Other current liabilities $ 5,218   $ 5,626  


 

5.     Intangible Assets – Goodwill

In accordance with Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (SFAS 142), the Company does not amortize goodwill as the goodwill has been determined to have indefinite useful life. The balance of goodwill is related to the Company’s NextGen Healthcare Information Systems Division (NextGen or Division), which was acquired by virtue of two acquisitions completed in May of 1996 and 1997, respectively. In accordance with SFAS 142, the Company has compared the fair value of the NextGen Division with the carrying amount of assets associated with the Division and determined that none of the goodwill recorded as of June 30, 2007 (the annual assessment date) was impaired. Assessments are performed annually unless there is a triggering event which would require an earlier assessment. The fair value of NextGen was determined using a reasonable estimate of future cash flows of the Division and a risk adjusted discount rate to compute a net present value of future cash flows.

6.     Intangible Assets – Capitalized Software Development Costs

 
The Company had the following amounts related to intangible assets with definite lives (in thousands):
 
December 31, 2007   March 31, 2007  

 
 
         
Gross carrying amount $ 26,100   $ 21,626  
Accumulated amortization   (17,733 )   (14,644 )


             
Net capitalized software development $ 8,367   $ 6,982  


             
Aggregate amortization expense during the nine month and
twelve month period
$ 3,089   $ 3,231  


 
Activity related to net capitalized software costs for the nine month period ended December 31, 2007 and 2006 is as follows:
 
December 31, 2007   December 31, 2006  

 
 
Beginning of the period $ 6,982   $ 5,171  
Capitalization   4,474     3,478  
Amortization   (3,089 )   (2,326 )


End of the period $ 8,367   $ 6,323  



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The following table represents the remaining estimated amortization of intangible assets with determinable lives as of December 31, 2007:
 
For the year ended March 31,    
2008 $ 1,143  
2009   3,867  
2010   2,614  
2011   743  

Total $ 8,367  

 

7.     Employee Stock Option Plans

In September 1998, the Company’s shareholders approved a stock option plan (the “1998 Plan”) under which 4,000,000 shares of Common Stock were reserved for the issuance of options. The 1998 Plan provides that employees, directors and consultants of the Company, at the discretion of the Board of Directors or a duly designated compensation committee, be granted options to purchase shares of Common Stock. The exercise price of each option granted shall be determined by the Board of Directors at the date of grant, and options under the 1998 Plan expire no later than ten years from the grant date. Options granted will generally become exercisable in accordance with the terms of the agreement pursuant to which they were granted. Certain option grants to directors became exercisable three months from the date of grant. Upon an acquisition of the Company by merger or asset sale, each outstanding option may be subject to accelerated vesting under certain circumstances. The 1998 Plan terminated on December 31, 2007. As of December 31, 2007, there were 1,338,665 outstanding options related to this Plan.

In October 2005, the Company’s shareholders approved a stock option and incentive plan (the “2005 Plan”) under which 2,400,000 shares of Common Stock have been reserved for the issuance of awards, including stock options, incentive stock options and non-qualified stock options, stock appreciation rights, restricted stock, unrestricted stock, restricted stock units, performance shares, performance units (including performance options) and other share-based awards. The 2005 Plan provides that employees, directors and consultants of the Company, at the discretion of the Board of Directors or a duly designated compensation committee, be granted awards to purchase shares of Common Stock. The exercise price of each award granted shall be determined by the Board of Directors at the date of grant in accordance with the terms of the 2005 Plan, and under the 2005 Plan awards expire no later than ten years from the grant date. Options granted will generally become exercisable in accordance with the terms of the agreement pursuant to which they were granted. Upon an acquisition of the Company by merger or asset sale, each outstanding award may be subject to accelerated vesting under certain circumstances. The 2005 Plan terminates on May 25, 2015, unless sooner terminated by the Board. At December 31, 2007, 2,400,000 shares were available for future grant under the 2005 Plan. As of December 31, 2007, there were no outstanding options related to this Plan.

A summary of stock option transactions during the nine months ended December 31, 2007 is as follows:

 
Number of
Shares
  Weighted
Average
Exercise Price
  Weighted
Average
Remaining
Contractual Life
  Aggregate
Intrinsic
Value (in
thousands)
 

 
 
 
 
Outstanding, April 1, 2007   1,461,950   $ 18.46     4.00        
Granted   200,500   $ 39.22     4.84        
Exercised   (270,010 ) $ 14.42     2.64   $ 4,338  
Forfeited/Canceled   (53,775 ) $ 20.42     3.55        
Outstanding, December 31, 2007   1,338,665   $ 22.34     3.60   $ 13,624  

     
Exercisable, December 31, 2007   482,404   $ 19.31     3.15   $ 5,837  

     
Vested and expected to vest,
December 31, 2007
  1,326,724   $ 22.32     3.60   $ 13,516  

     

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The Company continues to utilize the Black-Scholes valuation model for estimating the fair value of stock-based compensation after the adoption of SFAS 123R. The following assumptions were utilized for options granted during the period:
 
Nine Months Ended
December 31, 2007
  Nine Months Ended
December 31, 2006
 

 
         
Expected life   3.75 years     3.75 - 4.75 years  
Expected volatility   42.37% - 44.81%     47.7% - 48.5%  
Expected dividends   2.67% - 2.99%     2.05% - 2.36%  
Risk-free rate   3.07% - 5.09%     4.60% - 5.09%  
 

During the nine months ended December 31, 2007 and 2006, 200,500 and 75,000 options were granted, respectively, under the 1998 Stock Option Plan. The Company issues new shares to satisfy option exercises. Based on historical experience of option cancellations, the Company has estimated an annualized forfeiture rate of 1.4% for employee options and 0.0% for director options. Forfeiture rates will be adjusted over the requisite service period when actual forfeitures differ, or are expected to differ, from the estimate. The weighted average grant date fair value of stock options granted during the nine months ended December 31, 2007 and 2006 was $12.78 per share and $14.33 per share, respectively.

On November 5, 2007, the Board of Directors granted 6,000 options under the Company’s 1998 Plan to an employee, at an exercise price equal to the market price of the Company’s common stock on the date of grant ($33.25 per share). The options vest in four equal annual installments beginning November 5, 2008 and expire on November 5, 2012.

On August 9, 2007, the Board of Directors granted a total of 35,000 options under the Company’s 1998 Plan to non-management directors pursuant to the Company’s previously announced compensation plan for non-management directors, at an exercise price equal to the market price of the Company’s common stock on the date of grant ($43.26 per share). The options vest in four equal annual installments beginning August 9, 2008 and expire on August 9, 2012.

On June 12, 2007, the Board of Directors granted a total of 159,500 options under a previously approved performance-based equity incentive program for selected employees based on fiscal year 2007 performance. These shares were issued under the Company’s 1998 Stock Option Plan at an exercise price equal to the market price of the Company’s common stock on the date of grant ($38.83 per share). The options vest in four equal annual installments beginning June 12, 2008 and expire on June 12, 2012.

On May 31, 2007, the Board of Directors approved a performance-based equity incentive program for employees to be awarded options to purchase the Company’s common stock based on meeting certain target increases in earnings per share performance and revenue growth during fiscal year 2008. Under the program, options may also be granted as an incentive to prospective employees to join the Company. If earned, the options shall be issued pursuant to one of the Company’s shareholder approved option plans, have an exercise price equal to the closing price of the Company’s shares on the date of grant, a term of five years, vesting in four equal installments commencing one year following the date of grant. The maximum number of options available under the performance-based equity incentive program plan is 310,000, of which 20,000 is reserved for new employees. Based on performance versus established plan targets, no share-based compensation expense related to the performance plan was recorded for the nine months ended December 31, 2007.


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Non-vested stock option award activity, including awards for the nine month period ended December 31, 2007, is summarized as follows:
 
Non-vested
Number of
Shares
  Weighted-Average
Grant Date Fair
Value per Share
 

 
Non-vested, April 1, 2007   941,300   $ 7.89  
Granted   200,500   $ 12.78  
Vested   (231,764 ) $ 3.08  
Forfeited/Canceled   (53,775 ) $ 9.04  

 
Non-vested, December 31, 2007   856,261   $ 9.42  

 
 

As of December 31, 2007, $5,034 of total unrecognized compensation costs related to stock options is expected to be recognized over a weighted average period of 3.08 years. This amount does not include the cost of new options that may be granted in future periods or any changes in the Company’s forfeiture percentage. The total fair value of shares vested during the nine months ended December 31, 2007 and 2006 was $714 and $1,347.

8.     Income Taxes

The provision for income taxes for the three months ended December 31, 2007 was $6,234 as compared to $4,819 for the year ago period. The effective tax rates for the three months ended December 31, 2007 and 2006 were 35.7% and 35.6%, respectively. The provision for income taxes for the three months ended December 31, 2007 was significantly impacted by a deduction for company-owned life insurance proceeds. The provision for income taxes for the three months ended December 31, 2006 differs from the combined statutory rates primarily due to the re-enactment of federal research and development tax credits which occurred in December 2006. The re-enactment was retroactive to the start of our fiscal year, resulting in a benefit for research and development credits recorded during the quarter ended December 31, 2006.

The provision for income taxes for the nine months ended December 31, 2007 was $16,548 as compared to $15,439 for the year ago period. The effective tax rates for the nine months ended December 31, 2007 and 2006 was 36.5% and 38.4%, respectively. The provision for income taxes for the nine months ended December 31, 2007 differs primarily from the combined statutory rates due to the impact of the varying state income tax rates, federal and state research and development tax credits, Qualified Production Activities Deduction, and exclusions for company-owned life insurance proceeds and tax-exempt interest income. The effective rate for the nine months ended December 31, 2007 decreased from the prior year primarily from an increase in the statutory deduction for qualified production activities, an exclusion for company-owned life insurance proceeds and tax-exempt interest income. The provision for income taxes for the nine months ended December 31, 2006 differed from the combined statutory rates primarily due to the impact of federal and state research and development tax credits. The effective rate for the nine month period ended December 31, 2006 also included a benefit from the Qualified Production Activities Deduction, which was mostly offset by non-deductible option expense related to incentive stock options.

For the nine months ended December 31, 2007, the Company claimed federal and state research and development tax credits of $779 and $111, respectively. The Company expects to capture this benefit on its tax returns.

For the nine months ended December 31, 2006, the Company claimed federal and state research and development tax credits of $578 and $76, respectively. The Company captured this benefit on its tax returns.

For the nine months ended December 31, 2007, the Company estimated a federal and state Qualified Production Activities Deduction of $2,165 and $1,013, respectively. The Company expects to capture this benefit on its tax returns.

For the nine months ended December 31, 2006, the Company estimated a federal and state Qualified Production Activities Deduction of $1,071 and $538, respectively. The Company captured this benefit on its tax returns.


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On April 1, 2007, the Company adopted the provisions of Financial Standards Accounting Board Interpretation No. 48, “Accounting for Uncertainty in Income Taxes (“FIN 48”) an interpretation of FASB Statement No. 109 (“SFAS 109”).” The adoption of the provisions of FIN 48 had no material effect on the consolidated financial statements. As a result, there was no cumulative effect related to adopting FIN 48. However, certain amounts have been reclassified in the statement of financial position in order to comply with the requirements of the statement.

At adoption, and as of December 31, 2007, the Company had $394 and $152, respectively, of unrecognized tax benefits, $46 of which would affect the Company’s effective tax rate if recognized in the future.

The Company’s continuing practice is to recognize interest and/or penalties related to income tax matters in general and administrative expenses. At adoption and as of December 31, 2007, the Company had $45 and $38, respectively, accrued for interest payable and no penalties were accrued.

The Company’s income tax returns filed for tax years 2003 through 2006 and 2002 through 2006 are subject to examination by the federal and state taxing authorities, respectively.

The Company does not anticipate that total unrecognized tax benefits will significantly change due to the settlement of audits or the expiration of statute of limitations within the next twelve months.

9.     Net Income Per Share

The following table reconciles the weighted average shares outstanding for basic and diluted net income per share for the periods indicated. Basic net income per share is based upon the weighted average number of common shares outstanding. Diluted net income per share is based on the assumption that the Company’s outstanding options are included in the calculation of diluted earnings per share, except when their effect would be anti-dilutive. Dilution is computed by applying the treasury stock method. Under this method, options are assumed to be exercised at the beginning of the period (or at the time of issuance, if later), and as if funds obtained thereby were used to purchase common stock at the average market price during the period.

 
Three Months Ended
December 31,
Nine Months Ended
December 31,

 
 
  2007   2006   2007   2006  

 
 
 
 
Net income $ 11,214   $ 8,721   $ 28,826   $ 24,727  
Basic net income per common share:                        
  Weighted average of common
   shares outstanding
  27,362     26,966     27,261     26,828  




Basic net income per common share $ 0.41   $ 0.32   $ 1.06   $ 0.92  




                         
Net income $ 11,214   $ 8,721   $ 28,826   $ 24,727  
Diluted net income per common share:                        
 Weighted average of common
  shares outstanding
  27,362     26,966     27,261     26,828  
 Effect of potentially
  dilutive securities (options)
  334     541     478     613  




 Weighted average of common
  shares outstanding-diluted
  27,696     27,507     27,739     27,441  




Diluted net income per common share $ 0.40   $ 0.32   $ 1.04   $ 0.90  




 
The computation of diluted net income per share does not include 382,850 and 278,850 options for the three and nine months ended December 31, 2007, respectively, because their inclusion would have an anti-dilutive effect on net income per share. The computation of diluted net income per share does not include 92,500 options for the three and nine months ended December 31, 2006, respectively, because their inclusion would have an anti-dilutive effect on net income per share.

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10.     Operating Segment Information

The Company has prepared operating segment information in accordance with SFAS 131 “Disclosures About Segments of an Enterprise and Related Information” to report components that are evaluated regularly by its chief operating decision maker, or decision making group in deciding how to allocate resources and in assessing performance. Reportable operating segments include the NextGen Division and the QSI Division.

The two divisions operate largely as stand-alone operations, with each division maintaining its own distinct product lines, product platforms, development, implementation and support teams, sales staffing, and branding. The two divisions share the resources of the Company’s “corporate office” which includes a variety of accounting and other administrative functions. Additionally, there are a small number of clients who are simultaneously utilizing software from each of the Company’s two divisions.

The QSI Division, co-located with the Company’s Corporate Headquarters in Irvine, California, currently focuses on developing, marketing and supporting software suites sold to dental and certain niche medical practices. In addition, the division supports a number of medical clients that utilize the division’s UNIXa based medical practice management software product. The NextGen Division, with headquarters in Horsham, Pennsylvania, and a second significant location in Atlanta, Georgia, focuses principally on developing and marketing products and services for medical practices.

The accounting policies of the Company’s operating segments are the same as those described in Note 2 - Summary of Significant Accounting Policies, except that the disaggregated financial results of the segments reflect allocation of certain functional expense categories consistent with the basis and manner in which Company management internally disaggregates financial information for the purpose of assisting in making internal operating decisions. Certain corporate overhead costs, such as executive and accounting department personnel-related expenses, are not allocated to the individual segments by management. Management evaluates performance based on stand-alone segment operating income. Because the Company does not evaluate performance based on return on assets at the operating segment level, assets are not tracked internally by segment. Therefore, segment asset information is not presented.

Operating segment data for the three and nine month periods ended December 31, 2007 and 2006 is as follows:

 
Three Months Ended
December 31,
Nine Months Ended
December 31,
 
 
 
 
  2007   2006   2007   2006  
 
 
 
 
 
Revenue:                
  QSI Division $ 4,072   $ 4,267   $ 12,060   $ 12,129  
  NextGen Division   44,018     34,229     123,208     99,900  
 
 
 
 
 
Consolidated revenue $ 48,090   $ 38,496   $ 135,268   $ 112,029  
 
 
 
 
 
                         
Operating income(loss):                        
  QSI Division $ 650   $ 1,368   $ 2,996   $ 3,526  
  NextGen Division   17,823     13,424     47,425     40,873  
  Unallocated corporate expenses   (2,688 )   (2,187 )   (8,094 )   (6,654 )
 
 
 
 
 
Consolidated operating income $ 15,785   $ 12,605   $ 42,327   $ 37,745  
 
 
 
 
 
 
11.     Concentration of Credit Risk
 
The Company had cash deposits at U.S. banks and financial institutions which exceeded federally insured limits at December 31, 2007. The Company is exposed to credit loss for amounts in excess of insured limits in the event of non-performance by the institutions; however, the Company does not anticipate non-performance by these institutions.
 
12.     Commitments, Guarantees and Contingencies
 
____________________
a UNIX is a registered trademark of the AT&T Corporation.

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Commitments and Guarantees
 

Software license agreements in both the QSI and NextGen Divisions include a performance guarantee that the Company’s software products will substantially operate as described in the applicable program documentation for a period of 365 days after delivery. To date, the Company has not incurred any significant costs associated with these warranties and does not expect to incur significant warranty costs in the future. Therefore, no accrual has been made for potential costs associated with these warranties. Certain arrangements also include performance guarantees related to response time, availability for operational use, and other performance-related guarantees. Certain arrangements also include penalties in the form of maintenance credits should the performance of the software fail to meet the performance guarantees. To date, the Company has not incurred any significant costs associated with these warranties and does not expect to incur significant warranty costs in the future. Therefore, no accrual has been made for potential costs associated with these warranties.

The Company has historically offered short-term rights of return in certain sales arrangements. If the Company is able to estimate returns for these types of arrangements and all other criteria for revenue recognition have been met, revenue is recognized and these arrangements are recorded in the consolidated financial statements. If the Company is unable to estimate returns for these types of arrangements, revenue is not recognized in the consolidated financial statements until the rights of return expire, provided also, that all other criteria of revenue recognition have been met.

The Company’s standard sales agreements in the NextGen Division contain an indemnification provision pursuant to which it shall indemnify, hold harmless, and reimburse the indemnified party for losses suffered or incurred by the indemnified party in connection with any United States patent, any copyright or other intellectual property infringement claim by any third party with respect to its software. The QSI Division arrangements occasionally utilize this type of language as well. As the Company has not incurred any significant costs to defend lawsuits or settle claims related to these indemnification agreements, the Company believes that its estimated exposure on these agreements is currently minimal. Accordingly, the Company has no liabilities recorded for these indemnification obligations.

From time to time, the Company offers future purchase discounts on its products and services as part of its sales arrangements. Discounts which are incremental to the range of discounts reflected in the pricing of the other elements of the arrangement, which are incremental to the range of discounts typically given in comparable transactions, and which are significant, are treated as an additional element of the contract to be deferred. Amounts deferred related to future purchase options are not recognized until either the customer exercises the discount offer or the offer expires.

The Company has entered into marketing assistance agreements with existing users of the Company’s products which provide the opportunity for those users to earn commissions if and only if they host specific site visits upon the Company’s request for prospective customers which directly result in a purchase of the Company’s software by the visiting prospects. Amounts earned by existing users under this program are treated as a selling expense in the period when earned.

13.     Gain from Life Insurance Proceeds

On September 26, 2007, Mr. Gregory Flynn, Executive Vice President and General Manager of the Company’s QSI Division passed away. Mr. Flynn participated in the Company’s deferred compensation plan which is funded through the purchase of life insurance policies with the Company named as beneficiary. As a result of Mr. Flynn’s passing, the Company recorded additional compensation expense of $198 which was offset by net insurance proceeds of $953. The additional compensation expense was recorded in Selling, General and Administrative Expenses and the insurance proceeds were recorded as Other Income in the Consolidated Statement of Income for the quarter ended December 31, 2007.

14.     Subsequent Event

On January 30, 2008, the Board of Directors approved a regular quarterly dividend of twenty-five cents ($0.25) per share payable on its outstanding shares of common stock. The cash dividend record date is March 14, 2008 and the cash dividend is expected to be distributed to shareholders on or about April 7, 2008.


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

Except for the historical information contained herein, the matters discussed in this quarterly report may include forward-looking statements that involve certain risks and uncertainties. Actual results may differ from those anticipated by us as a result of various factors, both foreseen and unforeseen, including, but not limited to, our ability to continue to develop new products and increase systems sales in markets characterized by rapid technological evolution, consolidation, and competition from larger, better capitalized competitors. Many other economic, competitive, governmental and technological factors could impact our ability to achieve our goals, and interested persons are urged to review any new risks which may be described in “Risk Factors” set forth herein and other risk factors appearing in our most recent filing on Form 10-K, as supplemented by additional risk factors, if any, in our interim filings on Form 10-Q, as well as in our other public disclosures and filings with the Securities and Exchange Commission.

The following discussion should be read in conjunction with, and is qualified in its entirety by, the Consolidated Financial Statements and related notes thereto included elsewhere in this report. Historical results of operations, percentage profit fluctuations and any trends that may be inferred from the discussion below are not necessarily indicative of the operating results for any future period.

Critical Accounting Policies and Estimates. The discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosures of contingent assets and liabilities. On an on-going basis, we evaluate estimates, including but not limited to those related to revenue recognition, uncollectible accounts receivable, intangible assets, software development cost, and income taxes for reasonableness. We base our estimates on historical experience and on various other assumptions that management believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe revenue recognition, the allowance for doubtful accounts, capitalized software costs, share-based compensation and income taxes are among the most critical accounting policies and estimates that impact our consolidated financial statements. We believe that our significant accounting policies, as described in Note 2 of our Condensed Notes to Consolidated Financial Statements, “Summary of Significant Accounting Policies”, should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” 

Revenue Recognition. We currently recognize revenue pursuant to SOP 97-2, as amended by SOP 98-9. We generate revenue from the sale of licensing rights to use our software products sold directly to end-users and value-added resellers (VARs). We also generate revenue from sales of hardware and third party software, and implementation, training, software customization, EDI, post-contract support (“maintenance”) and other services performed for customers who license our products.

A typical system contract contains multiple elements of the above items. SOP 97-2, as amended, requires revenue earned on software arrangements involving multiple elements to be allocated to each element based on the relative fair values of those elements. The fair value of an element must be based on vendor specific objective evidence (VSOE). We limit our assessment of VSOE for each element to either the price charged when the same element is sold separately (using a rolling average of stand alone transactions) or the price established by management having the relevant authority to do so, for an element not yet sold separately. VSOE calculations are updated and reviewed at the end of each quarter or annually depending on the nature of the product or service.

When evidence of fair value exists for the delivered and undelivered elements of a transaction, then discounts for individual elements are aggregated and the total discount is allocated to the individual elements in proportion to the elements’ fair value relative to the total contract fair value.

When evidence of fair value exists for the undelivered elements only, the residual method, provided for under SOP 98-9, is used. Under the residual method, we defer revenue


18



related to the undelivered elements in a system sale based on VSOE of fair value of each of the undelivered elements, and allocate the remainder of the contract price net of all discounts to revenue recognized from the delivered elements. Undelivered elements of a system sale may include implementation and training services, hardware and third party software, maintenance, future purchase discounts, or other services. If VSOE of fair value of any undelivered element does not exist, all revenue is deferred until VSOE of fair value of the undelivered element is established or the element has been delivered.

We bill for the entire contract amount upon contract execution except for maintenance which is billed separately. Amounts billed in excess of the amounts contractually due are recorded in accounts receivable as advance billings. Amounts are contractually due when services are performed or in accordance with contractually specified payment dates. Provided the fees are fixed and determinable and collection is considered probable, revenue from licensing rights and sales of hardware and third party software is generally recognized upon shipment and transfer of title. In certain transactions whose collections risk is high, the cash basis method is used to recognize revenue. If the fee is not fixed or determinable, then the revenue recognized in each period (subject to application of other revenue recognition criteria) will be the lesser of the aggregate of amounts due and payable or the amount of the arrangement fee that would have been recognized if the fees were being recognized using the residual method. Fees which are considered fixed or determinable at the inception of our arrangements must include the following characteristics:

 
The fee must be negotiated at the outset of an arrangement, and generally be based on the specific volume of products to be delivered without being subject to change based on variable pricing mechanisms such as the number of units copied or distributed or the expected number of users.
 
Payment terms must not be considered extended. If a significant portion of the fee is due more than 12 months after delivery or after the expiration of the license, the fee is presumed not fixed and determinable.
 

Revenue from implementation and training services is recognized as the corresponding services are performed. Maintenance revenue is recognized ratably over the contractual maintenance period.

Contract accounting is applied where services include significant software modification, development or customization. In such instances, the arrangement fee is accounted for in accordance with Statement of Position No. 81-1 “Accounting for Performance of Construction-Type and Certain Production-Type Contracts” (SOP 81-1).

Pursuant to SOP 81-1, we use the percentage of completion method provided all of the following conditions exist:

 
The contract includes provisions that clearly specify the enforceable rights regarding goods or services to be provided and received by the parties, the consideration to be exchanged, and the manner and terms of settlement;
 
 
The customer can be expected to satisfy its obligations under the contract;
 
 
We can be expected to perform our contractual obligations; and
 
 
Reliable estimates of progress towards completion can be made.
 

We measure completion using labor input hours. Costs of providing services, including services accounted for in accordance with SOP 81-1, are expensed as incurred.

If a situation occurs in which a contract is so short term that the consolidated financial statements would not vary materially from using the percentage-of-completion method or in which we are unable to make reliable estimates of progress of completion of the contract, the completed contract method is utilized.

Product returns are estimated in accordance with Statement of Financial Accounting Standards No. 48, “Revenue Recognition When Right of Return Exists” (SFAS 48). The Company also ensures that the other criteria in SFAS 48 have been met prior to recognition of revenue:

 
The price is fixed or determinable;
   
The customer is obligated to pay and there are no contingencies surrounding the obligation or the payment;

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The customer’s obligation would not change in the event of theft or damage to the product;
 
The customer has economic substance;
 
The amount of returns can be reasonably estimated; and
 
We do not have significant obligations for future performance in order to bring about resale of the product by the customer.
 

We have historically offered short-term rights of return of less than 30 days in certain sales arrangements. If we are able to estimate returns for these types of arrangements, revenue is recognized and these arrangements are recorded in the consolidated financial statements. If we are unable to estimate returns for these types of arrangements, revenue is not recognized in our consolidated financial statements until the rights of return expire.

Revenue related to sales arrangements which include the right to use software stored on the Company’s hardware are accounted for under the Emerging Issues Task Force Issue No. 00-3 “Application of AICPA Statement of Position 97-2 to arrangements that include the right to use software stored on another entity’s hardware”. EITF No. 00-3 requires that for software licenses and related implementation services to continue to fall under SOP No. 97-2, the customer must have the contractual right to take possession of the software without incurring a significant penalty and it must be feasible for the customer to either host the software themselves or through another third party. If an arrangement is not deemed to be accounted for under SOP 97-2, the entire arrangement is accounted for as a service contract in accordance with EITF Issue No. 00-21 “Revenue arrangements with multiple deliverables”. In that instance, the entire arrangement would be recognized as the hosting services are being performed.

From time to time, we offer future purchase discounts on our products and services as part of our sales arrangements. Pursuant to AICPA TPA 5100.51, discounts which are incremental to the range of discounts reflected in the pricing of the other elements of the arrangement, which are incremental to the range of discounts typically given in comparable transactions, and which are significant, are treated as an additional element of the contract to be deferred. Amounts deferred related to future purchase options are not recognized until either the customer exercises the discount offer or the offer expires.

Revenue is divided into two categories, “system sales” and “maintenance, EDI and other services”. Revenue in the system sales category includes software license fees, third party hardware and software, and implementation and training services related to purchase of the Company’s software systems. The majority of the revenue in the system sales category is related to the sale of software. Revenue in the maintenance, EDI and other services category includes, maintenance, EDI, follow on training and implementation services, annual third party license fees and other revenue.

Allowance for Doubtful Accounts.  We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. We perform credit evaluations of our customers and maintain reserves for estimated credit losses. Reserves for potential credit losses are determined by establishing both specific and general reserves. Specific reserves are based on management’s estimate of the probability of collection for certain troubled accounts. General reserves are established based on our historical experience of bad debt expense and the aging of our accounts receivable balances net of deferred revenue and specifically reserved accounts. If the financial condition of our customers were to deteriorate resulting in an impairment of their ability to make payments, additional allowances would be required.

Software Development Costs. Development costs incurred in the research and development of new software products and enhancements to existing software products are expensed as incurred until technological feasibility has been established. After technological feasibility is established with the completion of a working model of the enhancement or product, any additional development costs are capitalized in accordance with Statement of Financial Accounting Standards No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed” (SFAS 86). Such capitalized costs are amortized on a straight line basis over the estimated economic life of the related product, which is generally three years. We perform an annual review of the recoverability of such capitalized software costs. At the time a determination is made that capitalized amounts are not recoverable based on the estimated cash flows to be generated from the applicable software, any remaining capitalized amounts are written off.


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Share-Based Compensation. On April 1, 2006, we adopted Statement of Financial Accounting Standard No. 123R, “Share-Based Payment” (SFAS 123R) which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors based on estimated fair values. SFAS 123R supersedes our previous accounting under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25). SFAS 123R requires us to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. We use the simplified method for estimating expected term equal to the midpoint between the vesting period and the contractual term. Prior to using the simplified method, we estimated the expected term of an option. We estimate volatility by using the weighted average historical volatility of our common stock, which we believe approximates expected volatility. The risk free rate is the implied yield available on the U.S Treasury zero-coupon issues with remaining terms equal to the expected term. The expected dividend yield is the average dividend rate during a period equal to the expected term of the option. Those inputs are then entered into the Black Scholes model to determine the estimated fair value. The value of the portion of the award that is expected to vest is recognized as expense over the requisite service period in our consolidated statement of income.

Research and Development Tax Credits. Management’s treatment of research and development tax credits represented a significant estimate which affected the effective income tax rate for the Company for the nine months ended December 31, 2007 and 2006. Research and development credits taken by the Company involve certain assumptions and judgments regarding qualified expenses under Internal Revenue Code Section 41. These credits are subject to examination by the federal and state taxing authorities.

For the nine months ended December 31, 2007, the Company claimed federal and state research and development tax credits of $0.8 million and $0.1 million, respectively. The Company expects to capture this benefit on its tax returns.

Qualified Production Activities Deduction. Management’s treatment of this deduction represented an estimate that affected the effective income tax rate for the Company for the nine months ended December 31, 2007 and 2006. The deduction taken by the Company involved certain assumptions and judgments regarding the allocation of indirect expenses as prescribed under Internal Revenue Code Section 199.

For the nine months ended December 31, 2007, the Company estimated a federal and state deduction of $2.2 million and $1.0 million, respectively. The Company expects to capture this benefit on its tax returns.

Company Overview 

Quality Systems Inc., comprised of the QSI Division (QSI Division) and a wholly owned subsidiary, NextGen Healthcare Information Systems, Inc. (NextGen Division) (collectively, the Company, we, our, or us) develops and markets healthcare information systems that automate certain aspects of medical and dental practices, networks of practices such as physician hospital organizations (PHO’s) and management service organizations (MSO’s), ambulatory care centers, community health centers, and medical and dental schools.

The Company, a California corporation formed in 1974, was founded with an early focus on providing information systems to dental group practices. In the mid-1980’s, we capitalized on the increasing focus on medical cost containment and further expanded our information processing systems to serve the medical market. In the mid-1990’s we made two acquisitions that accelerated our penetration of the medical market. These two acquisitions formed the basis for what is today the NextGen Division. Today, we serve the medical and dental markets through our two divisions.

The two divisions operate largely as stand-alone operations with each division maintaining its own distinct product lines, product platforms, development, implementation and support teams, sales staffing, and branding. The two divisions share the resources of the “corporate office” which includes a variety of accounting and other administrative functions. Additionally, there are a small number of clients who are simultaneously utilizing software from each of our two divisions.

The QSI Division, co-located with our corporate headquarters in Irvine, California, currently focuses on developing, marketing and supporting software suites sold to dental and certain niche medical practices. In addition, the Division supports a number of


21



medical clients that utilize the Division’s UNIX1 based medical practice management software product.

The NextGen Division, with headquarters in Horsham, Pennsylvania, and a second significant location in Atlanta, Georgia, focuses principally on developing and marketing products and services for medical practices.

Both divisions develop and market practice management software which is designed to automate and streamline a number of the administrative functions required for operating a medical or dental practice. Examples of practice management software functions include scheduling and billing capabilities. It is important to note that in both the medical and dental environments, practice management software systems have already been implemented by the vast majority of practices. Therefore, we actively compete for the replacement market.

In addition, both divisions develop and market software that automates the patient record. Adoption of this software, commonly referred to as clinical software, is in its relatively early stages. Therefore, we are typically competing to replace paper-based patient record alternatives as opposed to replacing previously purchased systems.

Electronic Data Interchange (EDI)/connectivity products are intended to automate a number of manual, often paper-based or telephony intensive communications between patients and/or providers and/or payors. Two of the more common EDI services are forwarding insurance claims electronically from providers to payors and assisting practices with issuing statements to patients. Most practices utilize at least some of these services from us or one of our competitors. Other EDI/connectivity services are used more sporadically by client practices. We typically compete to displace incumbent vendors for claims and statements accounts, and attempt to increase usage of other elements in our EDI/connectivity product line. In general, EDI services are only sold to those accounts utilizing software from one of our divisions.

The QSI Division’s practice management software suite utilizes a UNIX operating system. Its Clinical Product Suite (CPS) utilizes a Windows NT2 operating system and can be fully integrated with the practice management software from each division. CPS incorporates a wide range of clinical tools including, but not limited to, periodontal charting and digital imaging of X-ray and inter-oral camera images as part of the electronic patient record. The Division develops, markets, and manages our EDI/connectivity applications. The QSInet Application Service Provider (ASP/Internet) offering is also developed and marketed by this Division.

Our NextGen Division develops and sells proprietary electronic medical records software and practice management systems under the NextGen®3  product name. Major product categories of the NextGen suite include Electronic Medical Records (NextGenemr), Enterprise Practice Management (NextGenepm), Enterprise Appointment Scheduling (NextGeneas), Enterprise Master Patient Index (NextGenepi), NextGen Image Control System (NextGenics), Managed Care Server (NextGenmcs), Electronic Data Interchange, System Interfaces, Internet Operability (NextGenweb), a Patient-centric and Provider-centric Web Portal solution (NextMD4 .com), NextGen Express, a version of NextGenemr  designed for small practices and NextGen Community Health Solution (NextGenchs). Beginning in the fiscal year ended March 31, 2008, the NextGen Division began offering optional NextGen Hosting Solutions to new and existing customers. NextGen also introduced a formal rollout of a new revenue cycle management service in fiscal year 2008. NextGen products utilize Microsoft Windows technology and can operate in a client-server environment as well as via private intranet, the Internet, or in an ASP environment.

We continue to pursue product enhancement initiatives within each division. The majority of such expenditures are currently targeted to the NextGen Division product line and client base.

Inclusive of divisional EDI revenue, the NextGen Division accounted for approximately 91.5% of our revenue for the third quarter of fiscal 2008 compared to 88.9% in the third quarter of fiscal 2007. The QSI Division accounted for 8.5% and 11.1% of revenue in the third quarter of fiscal 2008 and 2007, respectively. The NextGen Division’s year over year

___________________________
1 UNIX is a registered trademark of the AT&T Corporation.
 
2 Windows NT is registered trademarks of the Microsoft Corporation.
 
3 NextGen is a registered trademark of NextGen Healthcare Information Systems, Inc.
 
4 NextMD is a registered trademark of NextGen Healthcare Information Systems, Inc.

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revenue grew at 28.6% and 49.6% in the third quarter of fiscal 2008 and 2007, respectively, while the QSI Division’s year over year revenue declined 4.6% in the third quarter of fiscal 2008 and increased by 10.3% in the third quarter of fiscal year 2007, respectively.

In addition to the aforementioned software solutions which we offer through our two divisions, we also offer comprehensive hardware and software installation services, maintenance and support services, revenue cycle management and system training services.

Results of Operations

Overview of results

 
Consolidated revenue grew 20.8% in the nine months ended December 31, 2007 versus the same period in 2006 and 33.8% in the nine months ended December 31, 2006 versus the same period in 2005.
 
Consolidated income from operations grew 12.2% in the nine months ended December 31, 2007 versus the same period in 2006 and grew 56.9% in the nine months ended December 31, 2006 versus 2005. For the nine months ended December 31, 2007, operating income was impacted by a shift in the revenue mix with increased hardware and EDI revenue resulting in a decline in our gross profit margin. Also, headcount additions resulted in higher selling, general and administrative expenses as a percentage of revenue.
 
We have benefited and hope to continue to benefit from the increased demands on healthcare providers for greater efficiency and lower costs, as well as increased adoption rates for electronic medical records and other technology in the healthcare arena.
 

NextGen Division

 
Our NextGen Division’s revenue grew 23.3% in the nine months ended December 31, 2007 versus 2006 and 38.7% in the nine months ended December 31, 2006 versus 2005. Divisional operating income (which excludes unallocated corporate expenses) grew 16.0% in the nine months ended December 31, 2007 versus 2006 and 54.5% in the nine months ended December 31, 2006 versus 2005. For the nine months ended December 31, 2007, operating income was impacted by a shift in the revenue mix with increased hardware and EDI revenue resulting in a decline in our gross profit margin. Margins were also negatively impacted by headcount additions which resulted in higher selling, general and administrative expenses as a percentage of revenue.
 
During the nine months ended December 31, 2007, we added staffing resources to most of our client-interfacing departments, and intend to continue doing so in future quarters.
 
Our goals include continuing to further enhance and expand the marketing and sales of our existing products, developing new products for targeted markets, continuing to add new customers, selling additional software and services to existing customers and expanding penetration of connectivity and other services to new and existing customers.
 

QSI Division

 
Our QSI Division revenue decreased 1.0% in the nine months ended December 31, 2007 versus the same period in 2006 and grew 3.5% in the nine months ended December 31, 2006 versus the same period in 2005. The Division experienced a $0.5 million or 15.0% decrease in operating income (excluding unallocated corporate expenses) in the nine months ended December 31, 2007 versus the same period in 2006 as compared to an 18.7% increase in operating income in the nine months ended December 31, 2006 versus the same period in 2005. Approximately $0.2 million of the decrease is a due to additional compensation expense as a result of recognizing proceeds from a life insurance policy related to the passing of Mr. Greg Flynn. The additional compensation expense was recorded in Selling, General and Administrative Expenses during the quarter ended December 31, 2007. In addition, for the nine months ended December 31, 2007, operating income was further negatively impacted by lower revenues as well as a decline in the gross profit margin, driven by slight changes in mix toward increased hardware and EDI revenue.
 
Our goals for the QSI Division include maximizing profit performance given the constraints represented by a relatively weak purchasing environment in the dental group practice market.

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The following table sets forth for the periods indicated the percentage of revenues represented by each item in our Consolidated Statements of Income (unaudited).
 
(Unaudited) Three Months Ended
December 31,
Nine Months Ended
December 31,


2007 2006 2007 2006




Revenues:                
  Software, hardware and supplies   42.8 %   41.8 %   41.3 %   42.7 %
  Implementation and training services   6.5     7.5     7.1     7.8  




System sales   49.3     49.3     48.3     50.5  
  
  Maintenance   30.9     28.8     30.2     26.9  
  Electronic data interchange services   11.9     11.1     12.0     11.0  
  Other services   7.9     10.8     9.5     11.6  




  
Maintenance, EDI and other services   50.7     50.7     51.7     49.5  




   Total revenue   100.0     100.0     100.0     100.0  




  
Cost of revenue:                        
  Software, hardware and supplies   6.2     4.7     5.9     4.7  
  Implementation and training services   5.5     5.6     5.5     5.6  




Total cost of system sales   11.7     10.3     11.4     10.3  
  
  Maintenance   6.5     7.9     6.9     8.0  
  Electronic data interchange services   8.7     8.2     8.4     7.9  
  Other services   6.7     6.6     6.9     5.9  




Total cost of maintenance, EDI and other
services
  21.9     22.7     22.2     21.8  
  




   Total cost of revenue   33.6     33.0     33.6     32.1  




  
   Gross profit   66.4     67.0     66.4     67.9  




  
   Selling, general and administrative   27.6     27.5     28.9     27.5  
   Research and development   6.0     6.8     6.2     6.7  




  
   Income from operations   32.8     32.7     31.3     33.7  




  
Interest income   1.5     2.4     1.5     2.2  
Other income   2.0     0.0     0.7     0.0  




  
Income before provision for income taxes   36.3     35.2     33.5     35.9  
Provision for income taxes   13.0     12.5     12.2     13.8  




  
   Net income   23.3 %   22.7 %   21.3 %   22.1 %




 

For the Three-Month Periods Ended December 31, 2007 versus 2006

Net Income.  The Company’s net income for the three months ended December 31, 2007 was $11.2 million or $0.41 per share on a basic and $0.40 per share on a fully diluted basis. In comparison, we earned $8.7 million or $0.32 per share on a basic and fully diluted basis for the three months ended December 31, 2006. The increase in net income for the three months ended December 31, 2007 was a result of the following:

 
a 24.9% increase in consolidated revenue;
 
 
a 28.6% increase in NextGen Division revenue which accounted for 91.5% of consolidated revenue; and
 
approximately $1.0 million gain on life insurance proceeds the Company recorded, which was offset by additional compensation expense of approximately $0.2 million. The additional compensation expense was recorded in Selling, General and Administrative Expenses and the insurance proceeds were recorded as Other Income in the Consolidated Statement of Income for the quarter ended December 31, 2007.

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The above positive factors to net income were offset by a decline in gross profit margin resulting from a greater proportion of revenue being derived from hardware and EDI revenue which have relatively lower gross margin percentages. The gross profit margin declined to 66.4% in the three months ended December 31, 2007 versus 67.0% in the prior year period.

Revenue.   Revenue for the three months ended December 31, 2007 increased 24.9% to $48.1 million from $38.5 million for the three months ended December 31, 2006. NextGen Division revenue increased 28.6% from $34.2 million in the three months ended December 31, 2006 to approximately $44.0 million in the three months ended December 31, 2007, while QSI Division revenue decreased by 4.6% during the three months ended December 31, 2007 over the prior year period.

We divide revenue into two categories, “system sales” and “maintenance, EDI and other services”. Revenue in the system sales category includes software license fees, third party hardware and software, and implementation and training services related to purchase of the Company’s software systems. The majority of the revenue in the system sales category is related to the sale of software. Revenue in the maintenance, EDI and other services category includes, maintenance, EDI, follow-on training and implementation services, annual third party license fees and other revenue. Maintenance revenue includes amounts initially deferred in conjunction with new customer arrangements and subsequently amortized and billings to existing customers.

System Sales.   Revenue earned from company-wide sales of systems for the three months ended December 31, 2007, increased 25.0% to $23.7 million from $19.0 million in the prior year period.

Our increase in revenue from sales of systems was principally the result of an 27.6% increase in category revenue at our NextGen Division. Divisional sales in this category grew from $17.9 million during the three months ended December 31, 2006 to $22.8 million during the three months ended December 31, 2007. This increase was driven by higher sales of NextGenemr and NextGenepm software to both new and existing clients, as well as increases in sales of hardware, third party software and supplies and implementation and training services.

The following table breaks down our reported system sales into software, hardware, third party software, supplies, and implementation and training services components by division:

 
 
 
Software   Hardware,
Third Party
Software
and Supplies
  Implementation
and Training
Services
  Total
System
Sales
 
 
 
 
 
 
Three months ended
  December 31, 2007
               
QSI Division $ 179   $ 307   $ 371   $ 857  
NextGen Division   18,510     1,595     2,744     22,849  




Consolidated $ 18,689   $ 1,902   $ 3,115   $ 23,706  




                         
Three months ended
  December 31, 2006
                       
QSI Division $ 235   $ 710   $ 119   $ 1,064  
NextGen Division   14,612     531     2,766     17,909  




Consolidated $ 14,847   $ 1,241   $ 2,885   $ 18,973  




 
NextGen Division software license revenue increased 26.7% between the three months ended December 31, 2007 and the prior year period. The Division’s software revenue accounted for 81.0% of divisional system sales revenue during the three months ended December 31, 2007. As of December 31, 2006, divisional software revenue as a percentage of divisional system sales revenue was 81.6%. Sales of additional licenses to existing customers was $9.4 million during the three months ended December 31, 2007 up from $4.5 million in the prior year period. The sale of licenses to existing customers can fluctuate significantly from quarter to quarter and year to year. NextGen’s growing client base has been a source of increased sales of add-on licenses.
 
Software license revenue growth continues to be an area of primary emphasis for the NextGen Division.

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During the three months ended December 31, 2007, 7.0% of NextGen’s system sales revenue was represented by hardware and third party software compared to 3.0% in the prior year period.  During the three months ended December 31, 2007, there was a shift in the revenue mix with increased revenue coming from hardware revenue. The number of customers who purchase hardware and third party software and the dollar amount of hardware and third party software revenue fluctuates each quarter depending on the needs of customers. The inclusion of hardware and third party software in the Division’s sales arrangements is typically at the request of the customer and is not a priority focus for us.

Implementation and training revenue related to system sales at the NextGen Division remained unchanged in the three months ended December 31, 2007 compared to the three months ended December 31, 2006. The amount of implementation and training services revenue in any given quarter is dependent on several factors, including timing of customer implementations, the availability of qualified staff, and the mix of services being rendered. The number of implementation and training staff increased during the three months ended December 31, 2007 versus 2006 in order to accommodate the increased amount of implementation services sold in conjunction with increased software sales. In order to achieve growth in this area, additional staffing increases and additional training facilities are anticipated, though actual future increases in revenue and staff will depend upon the availability of qualified staff, business mix and conditions, and our ability to retain current staff members.

The NextGen Division’s growth has come in part from investments in sales and marketing activities including hiring additional sales representatives, trade show attendance, and advertising expenditures. We have also benefited from winning numerous industry awards for the NextGen Division’s flagship NextGenemr and NextGenepm software products and the apparent increasing acceptance of electronic medical records technology in the healthcare industry.

For the QSI Division, total system sales decreased 19.4% in the three months ended December 31, 2007 versus the same period ended December 31, 2006. We do not presently foresee any material changes in the business environment for the Division with respect to the weak purchasing environment in the dental group practice market that has existed for the past several years.

Maintenance, EDI and Other Services. For the three months ended December 31, 2007, Company-wide revenue from maintenance, EDI and other services grew 24.9% to $24.4 million from $19.5 million in the prior year period. The increase in this category resulted from an increase in maintenance, EDI and other services revenue from the NextGen Division’s client base. Total NextGen Division maintenance revenue for the three months ended December 31, 2007 grew 40.7% to $13.1 million from $9.3 million in the prior year period, while EDI revenue grew 44.1% to $4.6 million compared to $3.2 million during the prior year period. Other services revenue for the three months ended December 31, 2007 declined 9.0% to $3.5 million from $3.8 million in the prior year period. QSI Division maintenance revenue remained fairly unchanged in the three months ended December 31, 2007 as compared to the prior year period while QSI divisional EDI revenue increased by 3.4% in the three months ended December 31, 2007 as compared to the prior year period.

The following table details revenue included in the maintenance, EDI and other category for the three month periods ended December 31, 2007 and 2006:

 
 
 
  Maintenance   EDI   Other   Total  
 
 
 
 
 
Three months ended
  December 31, 2007
               
QSI Division $ 1,795   $ 1,123   $ 297   $ 3,215  
NextGen Division   13,066     4,616     3,487     21,169  




Consolidated $ 14,861   $ 5,739   $ 3,784   $ 24,384  




                         
Three months ended
  December 31, 2006
                       
QSI Division $ 1,784   $ 1,086   $ 333   $ 3,203  
NextGen Division   9,285     3,204     3,831     16,320  




Consolidated $ 11,069   $ 4,290   $ 4,164   $ 19,523  




 
The growth in maintenance revenue for the NextGen Division has come from new customers that have been added each quarter, existing customers who have purchased additional

26



licenses, and our relative success in retaining existing maintenance customers. NextGen’s EDI revenue growth has come from new customers and from further penetration of the Division’s existing customer base. We intend to continue to promote maintenance and EDI services to both new and existing customers.
 
The following table provides the number of billing sites which were receiving maintenance services as of the last business day of the quarters ended December 31, 2007 and 2006 respectively, as well as the number of billing sites receiving EDI services during the last month of each respective period at each division of the Company. The table presents summary information only and includes billing entities added and removed for any reason. Note also that a single client may include one or multiple billing sites, and changes in billing protocols for certain clients can cause period to period changes in the number of billing sites.
 
 
 
  NextGen   QSI   Consolidated  
 
 
 
 
  Maintenance   EDI   Maintenance   EDI   Maintenance   EDI  
 
 
December 31, 2006   931     710     260     180     1,191     890  
Billing sites added   206     307     7     22     213     329  
Billing sites removed   (46 )   (51 )   (14 )   (35 )   (60 )   (86 )






                                     
December 31, 2007   1,091     966     253     167     1,344     1,133  






 

Cost of Revenue.  Cost of revenue for the three months ended December 31, 2007 increased 27.2% to $16.1 million from $12.7 million in the quarter ended December 31, 2006 and the cost of revenue as a percentage of revenue increased to 33.6% from 33.0% due to the fact that the rate of growth in cost of revenue grew faster than the aggregate revenue growth rate for the Company.

The increase in our consolidated cost of revenue as a percentage of revenue between the three months ended December 31, 2007 and the three months ended December 31, 2006 is primarily attributable to an increase in the level of hardware and third party software, an increase in other expense as a percentage of revenue in the NextGen Division as well as an increase in cost of revenue in the QSI Division, which accounted for 8.5% of consolidated revenue. Other expense, which consists of outside service costs, amortization of software development costs and other costs, increased to 17.9% of total revenue during the three months ended December 31, 2007 from 16.6% of total revenue during the three months ended December 31, 2006.

The following table details the individual components of cost of revenue and gross profit as a percentage of total revenue for our Company and our two divisions.

 
Hardware,
Third Party
Software
  Payroll and
related
Benefits
  Other   Total
Cost of
Revenue
  Gross
Profit
 
 
 
 
 
 
 
Three months ended
December 31, 2007
                   
QSI Division   8.9 %   18.6 %   21.1 %   48.6 %   51.4 %
NextGen Division   4.2 %   10.4 %   17.6 %   32.2 %   67.8 %





Consolidated   4.6 %   11.1 %   17.9 %   33.6 %   66.4 %





 
Three months ended
December 31, 2006
                             
QSI Division   8.6 %   16.1 %   19.4 %   44.1 %   55.9 %
NextGen Division   2.6 %   12.7 %   16.3 %   31.6 %   68.4 %





Consolidated   3.3 %   13.1 %   16.6 %   33.0 %   67.0 %





 
During the three months ended December 31, 2007, hardware and third party software constituted a larger portion of consolidated cost of revenue compared to the prior year period. The number of customers who purchase hardware and third party software and the dollar amount of hardware and third party software purchased fluctuates each quarter depending on the needs of the customers and is not a priority focus for us.
 
Our payroll and benefits expense associated with delivering our products and services decreased to 11.1% of consolidated revenue in the three months ended December 31, 2007

27



compared to 13.1% during the three months ended December 31, 2006. The absolute level of consolidated payroll and benefit expenses grew from $5.0 million in the three months ended December 31, 2006 to $5.3 million in the three months ended December 31, 2007, an increase of 6% or approximately $0.3 million. The increase was due primarily to additions to related headcount, payroll and benefits expense associated with delivering products and services in the NextGen Division where such expenses increased to $4.6 million in the three months ended December 31, 2007 from $4.4 million in the three months ended December 31, 2006. Payroll and benefits expense associated with delivering products and services in the QSI Division increased to $0.8 million during the three months ended December 31, 2007 from $0.7 million in the three months ended December 31, 2006. The adoption of SFAS 123R added approximately $0.1 million in compensation expense to cost of revenue for both the three months ended December 31, 2007 and 2006, respectively.
 
We anticipate continued additions to headcount in the NextGen Division in areas related to delivering products and services in future periods but due to the uncertainties in the timing of our sales arrangements, our sales mix, the acquisition and training of qualified personnel, and other issues. We cannot accurately predict if related headcount expense as a percentage of revenue will increase or decrease in the future.
 
We do not currently intend to make any significant additions to related headcount at the QSI Division.
 
As a result of the foregoing events and activities, the gross profit percentage for the Company and our NextGen Division decreased for the three month period ended December 31, 2007 versus the prior year period.
 
The following table details revenue and cost of revenue on a consolidated and divisional basis for the three month periods ended December 31, 2007 and 2006:
 

Three months ended December 31, Three months ended December 31,


  2007    %   2006   %  




QSI Division                
Revenue $ 4,072     100.0 % $ 4,267     100.0 %
Cost of revenue   1,978     48.6 %   1,880     44.1 %




Gross profit $ 2,094     51.4 % $ 2,387     55.9 %




  
NextGen Division                        
Revenue $ 44,018     100.0 % $ 34,229     100.0 %
Cost of revenue   14,170     32.2 %   10,817     31.6 %




Gross profit $ 29,848     67.8 % $ 23,412     68.4 %




  
Consolidated                        
Revenue $ 48,090     100.0 % $ 38,496     100.0 %
Cost of revenue   16,148     33.6 %   12,697     33.0 %




Gross profit $ 31,942     66.4 % $ 25,799     67.0 %




 

Selling, General and Administrative Expenses.  Selling, general and administrative expenses for the three months ended December 31, 2007 increased 25.4% to $13.3 million as compared to $10.6 million for the three months ended December 31, 2006. The increase in these expenses resulted from a $1.9 million increase in compensation expense in the NextGen Division, $0.6 million in selling related expenses in the NextGen Division, a $0.5 million increase in corporate related expenses, offset by a net $0.3 million decrease in other selling, general and administrative expenses in the NextGen Division. The adoption of SFAS 123R added approximately $0.6 million in compensation expense to selling, general and administrative expenses for both the three months ended December 31, 2007 and 2006, and is included in the aforementioned amounts. Selling, general and administrative expenses as a percentage of revenue increased slightly from 27.5% in the three months ended December 31, 2006 to 27.6% in the three months ended December 31, 2007, due in part to the fact that the rate of growth in revenue was slower than the selling, general and administrative expense growth rate for the Company.

We anticipate increased expenditures for trade shows, advertising and the employment of additional sales and administrative staff at the NextGen Division. We also anticipate future increases in corporate expenditures being made in a wide range of areas. While we expect selling, general and administrative expenses to increase on an absolute basis, we


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cannot accurately predict the impact these additional expenditures will have on selling, general, and administrative expenses as a percentage of revenue.

Research and Development Costs.  Research and development costs for the three months ended December 31, 2007 and 2006 were $2.9 million and $2.6 million, respectively. The increases in research and development expenses were due in part to increased investment in the NextGen product line. Additionally, the adoption of SFAS 123R added approximately $0.2 million in compensation expense to research and development costs for both the three months ended December 31, 2007 and 2006. Additions to capitalized software costs offset research and development costs. For the three months ended December 31, 2007, $1.5 million was added to capitalized software costs while $1.3 million was capitalized during the three months ended December 31, 2006. Research and development costs as a percentage of revenue decreased to 6.0% during the three months ended December 31, 2007 from 6.8% for the same period in 2006. Research and development expenses are expected to continue at or above current dollar levels.

Interest Income.   Interest income for the three months ended December 31, 2007 decreased to $0.7 million compared to $0.9 million in the three months ended December 31, 2006. Interest income in the three months ended December 31, 2007 decreased primarily due to a greater proportion of funds invested in tax favored auction rate securities which offer lower interest rates but higher after-tax yields compared to money market or short term U.S. Treasuries, as well as comparatively lower amounts of funds available for investment during the three months ended December 31, 2007 due to the regular quarterly dividend program adopted by our Board of Directors commencing with conclusion of our first fiscal quarter of 2008 (June 30, 2007) and continuing each fiscal quarter thereafter.

Our investment policy is determined by our Board of Directors. We currently maintain our cash in very liquid short term assets including money market funds and auction rate securities with maturities or interest reset dates of 35 days or less. Our Board of Directors continues to review alternate uses for our cash including, but not limited to, payment of a special dividend, initiation of a stock buy back program, an expansion of our investment policy to include investments with longer maturities of greater than 90 days, or other items. Additionally, it is possible that we will utilize some or all of our cash to fund an acquisition or other similar business activity. Any or all of these programs could significantly impact our investment income in future periods.

Other Income.   Other income for the three months ended December 31, 2007 was approximately $1.0 million. There was no Other income recorded for the three months ended December 31, 2006. The Company recorded a gain on life insurance proceeds as a result of the passing of Gregory Flynn, Executive Vice President and General Manager of the Company’s QSI Division. Mr. Flynn participated in the Company’s deferred compensation plan which is funded through the purchase of life insurance policies with the Company named as beneficiary.

Provision for Income Taxes. The provision for income taxes for the three months ended December 31, 2007 was approximately $6.2 million as compared to approximately $4.8 million for the year ago period. The effective tax rates for the three months ended December 31, 2007 and 2006 were 35.7% and 35.6%, respectively. The provision for income taxes for the three months ended December 31, 2007 was significantly impacted by a deduction for company-owned life insurance proceeds. The provision for income taxes for the three months ended December 31, 2006 differs from the combined statutory rates primarily due to the re-enactment of federal research and development tax credits which occurred in December 2006. The re-enactment was retroactive to the start of our fiscal year, resulting in a benefit for research and development credits recorded during the quarter ended December 31, 2006.

For the Nine-Month Periods Ended December 31, 2007 versus 2006

Net Income. The Company’s net income for the nine months ended December 31, 2007 was $28.8 million or $1.06 per share on a basic and $1.04 per share on a fully diluted basis. In comparison, we earned $24.7 million or $0.92 per share on a basic and $0.90 per share on a fully diluted basis in the nine months ended December 31, 2006. The increase in net income for the nine months ended December 31, 2007, was achieved primarily through the following:   

 
a 20.8% increase in consolidated revenue;
   
a 23.3% increase in NextGen Division revenue which accounted for 91.1% of consolidated revenue; and
   
a $1.0 million gain on life insurance proceeds the Company recorded, which was offset by additional compensation expense of approximately $0.2 million. The additional

29



 
compensation expense was recorded in Selling, General and Administrative Expenses and the insurance proceeds were recorded as Other Income in the Consolidated Statement of Income for the quarter ended December 31, 2007.
 

The above positive factors to net income were offset by a decline in gross profit margin resulting form a greater proportion of revenue being derived from hardware and EDI revenue which have relatively lower gross margin percentages. The gross profit margin declined to 66.4% in the nine months ended December 31, 2007 versus 67.9% in the prior year period.

 

Revenue. Revenue for the nine months ended December 31, 2007 increased 20.8% to $135.3 million from $112.0 million for the nine months ended December 31, 2006. NextGen Division revenue increased 23.3% from $99.9 million during the nine months ended December 31, 2006 to $123.2 million during the nine months ended December 31, 2007, while QSI Division revenue remained unchanged at $12.1 million during the nine month ended December 31, 2007 and 2006, respectively.

We divide revenue into two categories, “system sales” and “maintenance, EDI and other services”. Revenue in the system sales category includes software license fees, third party hardware and software, and implementation and training services related to purchase of the Company’s software systems. The majority of the revenue in the system sales category is related to the sale of software. Revenue in the maintenance, EDI and other services category includes, maintenance, EDI, follow on training and implementation services, annual third party license fees and other revenue.

System Sales. Company-wide sales of systems for the nine months ended December 31, 2007 increased 15.7% to $65.4 million from $56.5 million in the same prior year period.

Our increase in revenue from sales of systems was principally the result of an 16.8% increase in category revenue at our NextGen Division whose systems sales grew from $54.2 million to $63.3 million during the nine months ended December 31, 2007. This increase was driven primarily by higher sales of NextGenemr and NextGenepm software to both new and existing clients, as well as increases in the sale of hardware, third party software, and supplies.

Category revenue in the QSI Division decreased slightly on a year over year basis during the nine months ended December 31, 2007.

The following table breaks down our reported systems sales into software, hardware and third party software and supplies, and implementation and training services components by division:

   

  Software Hardware, Third
Party Software
and Supplies
Implementation
and Training
Services
Total System
Sales
 



Nine months ended                  
    December 31, 2007                          
QSI Division   $ 300   $ 837   $ 911   $ 2,048  
NextGen Division     50,755     3,952     8,633     63,340  
 
 
 
 
 
Consolidated   $ 51,055   $ 4,789   $ 9,544   $ 65,388  
 
 
 
 
 
                           
Nine months ended                  
   December 31, 2006                          
QSI Division   $ 510   $ 1,380   $ 414   $ 2,304  
NextGen Division     44,258     1,706     8,273     54,237  
 
 
 
 
 
Consolidated   $ 44,768   $ 3,086   $ 8,687   $ 56,541  
 
 
 
 
 
   

NextGen Division software license revenue increased 14.7% between the nine months ended December 31, 2007 and the nine months ended December 31, 2006. The Division’s software revenue accounted for 80.1% of divisional systems sales revenue during the nine months ending December 31, 2007, a decrease from 81.6% in the nine months ended December 31, 2006. Sales of additional licenses to existing customers was $24.6 million during the nine months ended December 31, 2007 up from $19.3 million in the prior year period. The sale of licenses to existing customers can fluctuate significantly from quarter to quarter and year to year. NextGen has benefited from a growing client base with which to sales add-on licenses.


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Software license revenue growth continues to be an area of primary emphasis for the NextGen Division.

During the nine months ended December 31, 2007, 6.2% of NextGen’s system sales revenue was represented by hardware and third party software compared to 3.1% in the prior year period. During the nine months ended December 31, 2007, there was an increase in the proportion of revenue coming from hardware sales. The number of customers who purchase hardware and third party software and the dollar amount of hardware and third party software revenue fluctuates each quarter depending on the needs of customers. The inclusion of hardware and third party software in the Division’s sales arrangements is typically at the request of the customer and is not a priority focus for us.

Implementation and training revenue at the NextGen Division increased 4.4% from the nine months ended December 31, 2007 compared to the nine months ended December 31, 2006 while implementation and training revenue related to system sales decreased its share of category revenue from 15.2% in the nine months ended December 31, 2006 to 13.6% in the nine months ended December 31, 2007. The number of implementation and training staff increased during the course of the nine months ended December 31, 2007 versus 2006 in order to accommodate the increases in implementation services sold in conjunction with increased software sales. In order to achieve continued increasing revenue in this area, additional staffing increases are anticipated, though actual future increases will depend upon the availability of qualified staff, business conditions, and our ability to retain current staff members.

The NextGen Division’s growth has come in part from investments in sales and marketing activities including hiring additional sales representatives, trade show attendance, and advertising expenditures. We have also benefited from winning numerous industry awards for the NextGen Division’s flagship NextGenemr and NextGenepm software products, as well as the apparent increasing acceptance of electronic medical records technology in the healthcare industry.

Maintenance, EDI and Other Services. For the nine months ended December 31, 2007, Company-wide revenue from maintenance, EDI and other services grew 25.9% to $69.9 million from $55.5 million during the same period last year. The increase in this category resulted principally from an increase in maintenance and EDI revenues from the NextGen Division’s client base. Total NextGen Division maintenance revenue for the nine months ended December 31, 2007 grew 43.0% to $35.5 million from $24.8 million in the period a year ago, while EDI revenue grew 43.1% to $12.8 million compared to $8.9 million during the same period. QSI Division maintenance, EDI and other revenue increased 1.9% over the year ago period.

The following table details revenue included in Maintenance, EDI and other services for the nine month periods ended December 31, 2007 and 2006:

  
 
 
  Maintenance   EDI   Other   Total  
 
 
 
 
 
Nine months ended                  
   December 31, 2007                  
QSI Division   $ 5,371   $ 3,417   $ 1,224   $ 10,012  
NextGen Division     35,491     12,752     11,624     59,867  
 



Consolidated   $ 40,862   $ 16,169   $ 12,848   $ 69,879  
 



                           
Nine months ended                  
   December 31, 2006                  
QSI Division   $ 5,279   $ 3,422   $ 1,124   $ 9,825  
NextGen Division     24,828     8,911     11,924     45,663  
 



Consolidated   $ 30,107   $ 12,333   $ 13,048   $ 55,488  
 



  

The growth in overall maintenance revenue has come from new customers that have been added each quarter, additional software purchases by existing customers, as well as our relative success in retaining existing maintenance customers. NextGen EDI revenue growth has come from new customers and from further penetration of the Division’s existing customer base. We intend to continue to promote maintenance and EDI services to both new and existing customers.


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The following table provides the number of billing sites which were receiving maintenance services as of the last business day of the quarters ended December 31, 2007 and 2006 respectively, as well as the number of billing sites receiving EDI services during the last month of each respective period at each division of the Company. The table presents summary information only and includes billing entities added and removed for any reason. Note also that a single client may include one or multiple billing sites, and changes in billing arrangements with certain clients can cause period to period changes in the number of billing sites.
  
 
 
  NextGen   QSI   Consolidated  
 
 
 
 
  Maintenance   EDI   Maintenance   EDI   Maintenance   EDI  
 
 
December 31, 2006     931     710     260     180     1,191     890  
Billing sites added     206     307     7     22     213     329  
Billing sites removed     (46 )   (51 )   (14 )   (35 )   (60 )   (86 )
 





  
December 31, 2007     1,091     966     253     167     1,344     1,133  
 





  

Cost of Revenue.  The cost of revenue for the nine months ended December 31, 2007 increased 26.3% to $45.5 million from $36.0 million, while the cost of revenue as a percentage of net revenue increased to 33.6% from 32.1% during the same period a year ago.

The increase in our consolidated cost of revenue as a percentage of revenue between the nine months ended December 31, 2007 and the nine months ended December 31, 2006 is primarily attributable to an increase in the level of hardware and third party software included in the period’s transactions as well as an increase in EDI revenue, which carries relatively lower gross margins. Additionally, other expense, which consists of outside service costs, amortization of software development costs and other costs, increased to 18.0% of revenue during the nine months ended December 31, 2007 from 16.2% of revenue during the nine months ended December 31, 2006.

The following table details the individual components of cost of revenue and gross profit as a percentage of total revenue for our Company and our two divisions:

  
  Hardware,
Third Party
Software
Payroll and
related
Benefits
Other Total Cost
of Revenue
Gross
Profit
 




Nine months ended            
   December 31, 2007  
QSI Division   7.1 % 18.7 % 20.1 % 45.9 % 54.1 %
NextGen Division   3.7 % 10.9 % 17.8 % 32.4 % 67.6 %
 




Consolidated   4.0 % 11.6 % 18.0 % 33.6 % 66.4 %
 




           
Nine months ended  
   December 31, 2006  
QSI Division   7.6 % 17.6 % 20.8 % 46.0 % 54.0 %
NextGen Division   2.5 % 12.3 % 15.6 % 30.4 % 69.6 %
 




Consolidated   3.0 % 12.9 % 16.2 % 32.1 % 67.9 %
 




  

During the nine months ended December 31, 2007, the cost of hardware and third party software constituted 4.0% of consolidated revenue compared to 3.0% in the same year ago period. The number of customers who purchase hardware and third party software and the dollar amount of hardware and third party software purchased fluctuates each quarter depending on the needs of the customers and is not a priority focus for us.

Our payroll and benefits expense associated with delivering our products and services decreased to 11.6% of consolidated revenue in the nine months ended December 31, 2007 compared to 12.9% in the nine months ended December 31, 2006. The absolute level of consolidated payroll and benefit expenses grew from $14.4 million in the nine months ended December 31, 2006 to $15.7 million in the nine months ended December 31, 2007, an increase of 9%. This increase was due primarily to additions to headcount, payroll and benefits expense associated with delivering products and services in the NextGen Division, where divisional expenses increased from $12.3 million in the nine months ended December 31, 2006 compared to $13.4 million in the nine months ended December 31, 2007, an increase of 9%. The NextGen Division’s payroll and benefits expense associated with delivering products and services as a percentage of divisional revenue in the nine months ended


32



December 31, 2007 decreased to 10.9% compared to 12.3% in the prior year period, as revenue grew at a faster rate than the increase in payroll and benefits expenses. Headcount expense as a percentage of revenue for the nine month period ended December 31, 2007 at the QSI Division increased compared to the prior year at 18.7% versus 17.6% in the prior year period. The adoption of SFAS 123R added approximately $0.4 million of compensation expense to cost of revenue in the nine months ended December 31, 2007 and 2006.

We anticipate continued additions to headcount in the NextGen Division in areas related to delivering products and services in future periods but due to the uncertainties in the timing of our sales arrangements, our sales mix, the acquisition and training of qualified personnel, and other issues we cannot accurately predict if related headcount expense as a percentage of revenue will increase or decrease in the future.

We do not currently intend to make any significant additions to related headcount at the QSI Division.

Should the NextGen Division continue to represent an increasing share of our revenue and should NextGen continue to show higher gross profit percentages compared to the QSI Division, our gross profit percentages and trends should more closely match those of the NextGen Division.

As a result of the foregoing events and activities, our gross profit percentage for the Company and our NextGen operating Division decreased for the nine month period ended December 31, 2007 versus the prior year period.

The following table details revenue and cost of revenue on a consolidated and divisional basis for the nine month periods ended December 31, 2007 and 2006:

  
Nine months ended December 31, Nine months ended December 31,


2007 % 2006 %
 
 
 
 
 
QSI Division              
Revenue   $ 12,060   100.0 % $ 12,129   100.0 %
Cost of revenue     5,534   45.9 %   5,580   46.0 %
 



Gross profit   $ 6,526   54.1 % $ 6,549   54.0 %
 



   
NextGen Division              
Revenue   $ 123,208   100.0 % $ 99,900   100.0 %
Cost of revenue     39,931   32.4 %   30,407   30.4 %
 



Gross profit   $ 83,277   67.6 % $ 69,493   69.6 %
 



   
Consolidated              
Revenue   $ 135,268   100.0 % $ 112,029   100.0 %
Cost of revenue     45,465   33.6 %   35,987   32.1 %
 



Gross profit   $ 89,803   66.4 % $ 76,042   67.9 %
 



  

Selling, General and Administrative Expenses.  Selling, general and administrative expenses for the nine months ended December 31, 2007 increased 27.1% to $39.1 million as compared to $30.8 million for the nine months ended December 31, 2006. The increase in the amount of such expenses resulted primarily from increases of $4.9 million in salaries, commissions, and related benefits in the NextGen Division, $1.6 million in selling related expenses in the NextGen Division, $0.6 million in other selling and general expenses in the NextGen Division and $1.2 million in increased corporate related expenses. The increase in corporate expenses was primarily composed of salaries and related benefits. The adoption of SFAS 123R added $1.9 million and $1.7 million of compensation expense to selling, general and administrative expenses for the nine months ended December 31, 2007 and 2006, respectively, and is included in the aforementioned amounts. Selling, general and administrative expenses as a percentage of revenue increased from 27.5% in the nine months ended December 31, 2006 to 28.9% in the nine months ended December 31, 2007 due in to the fact that the rate of growth in selling, general and administrative expense was faster than the revenue growth rate for the Company.

We anticipate increased expenditures for trade shows, advertising and the employment of additional sales and administrative staff at the NextGen Division. We also anticipate future increases in corporate expenditures being made in areas including but not limited to staffing and professional services. While we expect selling, general and administrative expenses to increase on an absolute basis, we cannot accurately predict the


33



impact these additional expenditures will have on selling, general, and administrative expenses as a percentage of revenue.

Research and Development Costs.  Research and development costs for the nine months ended December 31, 2007 and 2006 were $8.4 million and $7.5 million, respectively. The increases in research and development expenses were primarily due to increased investment in the NextGen product line. Additions to capitalized software costs offset research and development costs. For the nine months ended December 31, 2007, $4.5 million was added to capitalized software costs while $3.5 million was capitalized during the nine months ended December 31, 2006. The adoption of SFAS 123R added $0.6 million of compensation expense to research and development costs for the nine months ended December 31, 2007 and 2006. Research and development costs as a percentage of net revenue decreased to 6.2% from 6.7% due to the fact that higher amounts were added to capitalized software costs in the nine months ended December 31, 2007 over the prior year period and the growth in revenue exceeded the growth in research and development spending. Research and development expenses are expected to continue at or above current levels.

Interest Income.   Interest income for the nine months ended December 31, 2007 decreased 13.5% to $2.1 million compared to $2.4 million in the nine months ended December 31, 2006. Interest income in the nine months ended December 31, 2007 decreased primarily due to a greater proportion of funds invested in tax favored auction rate securities which offer lower interest rates but higher after-tax yields compared to money market or short term U.S. Treasuries as well as comparatively lower amounts of funds available for investment during the nine months ended December 31, 2007 due to the regular quarterly dividend program adopted by our Board of Directors commencing with conclusion of our first fiscal quarter of 2008 (June 30, 2007) and continuing each fiscal quarter thereafter.

Our investment policy is determined by our Board of Directors. We currently maintain our cash in very liquid short term assets including money market funds and auction rate securities with maturities or interest reset dates of less than 90 days. Our Board of Directors continues to review alternate uses for our cash including, but not limited to payment of a special dividend, initiation of a stock buy back program, an expansion of our investment policy to include investments with maturities of greater than 90 days, or other items. Additionally, it is possible that we will utilize some or all of our cash to fund an acquisition or other similar business activity. Any or all of these programs could significantly impact our investment income in future periods.

Other Income.   Other income for the nine months ended December 31, 2007 was approximately $1.0 million. There was no Other income recorded for the nine months ended December 31, 2006. The Company recorded a gain on life insurance proceeds as a result of the passing of Gregory Flynn, Executive Vice President and General Manager of the Company’s QSI Division. Mr. Flynn participated in the Company’s deferred compensation plan which is funded through the purchase of life insurance policies with the Company named as beneficiary.

Provision for Income Taxes. The provision for income taxes for the nine months ended December 31, 2007 was $16.5 as compared to $15.4 for the year ago period. The effective tax rates for the nine months ended December 31, 2007 and 2006 was 36.5% and 38.4%, respectively. The provision for income taxes for the nine months ended December 31, 2007 differs primarily from the combined statutory rates due to the impact of the varying state income tax rates, federal and state research and development tax credits, Qualified Production Activities deduction, and exclusions for company-owned life insurance proceeds and tax-exempt interest income. The effective rate for the nine months ended December 31, 2007 decreased from the prior year primarily from an increase in the statutory deduction for Qualified Production Activities, a deduction related to tax-exempt interest income and an exclusion for company-owned life insurance proceeds. The provision for income taxes for the nine months ended December 31, 2006 differed from the combined statutory rates primarily due to the impact of federal and state research and development tax credits. The effective rate for the nine month period ended December 31, 2006 also included a benefit from the Qualified Production Activities Deduction, which was mostly offset by non-deductible option expense related to incentive stock options.


34



Liquidity and Capital Resources

The following table presents selected financial statistics and information as of and for each of the nine months ended December 31, 2007 and 2006:

 
Nine months ended December 31,

2007 2006

 
  
Cash and cash equivalents   $ 30,013   $ 80,410  
  
Net (decrease) increase in cash and cash              
equivalents during the nine month period   $ (30,015 ) $ 23,185  
  
Net income during the nine month period   $ 28,826   $ 24,727  
  
Net cash provided by operations during the nine              
month period   $ 32,200   $ 23,288  
  
Number of days of sales outstanding at start of              
the period     129     122  
  
Number of days of sales outstanding at the end              
of the period     138     140  
 

Cash Flow from Operating Activities

Cash provided by operations has historically been our primary source of cash and has primarily been driven by our net income and secondarily by non-cash expenses including depreciation, amortization of capitalized software, provisions for bad debts, net deferred income taxes and stock option expenses.

The following table summarizes our statement of cash flows for the nine month period ended December 31, 2007 and 2006: 

  
  Nine months ended December 31,  
 
 
  2007   2006  

 
  
Net income   $ 28,826   $ 24,727  
  
Non-cash expenses     6,773     8,186  
  
Gain on life insurance proceeds, net     (755 )    
  
Change in deferred revenue     1,843     4,630  
  
Change in accounts receivable     (8,991 )   (15,051 )
  
Change in other assets and liabilities     4,504     (796 )
 

  
Net cash provided by operating activities   $ 32,200   $ 23,288  
 

  

Net Income

As referenced in the above table, net income makes up the majority of our cash generated from operations for the nine month period ended December 31, 2007 and 2006. Our NextGen Division’s contribution to net income has increased each year due to that division’s operating income increasing more quickly than the Company as a whole.

Non-Cash expenses

For the nine months ended December 31, 2007, non-cash expenses primarily include $1.8 million of depreciation, $ 3.1 million of amortization of capitalized software and $3.0 million of stock option expenses offset by a $1.1 million benefit from deferred income taxes. Total non-cash expense was approximately $6.8 million and $8.2 million for the nine month periods ended December 31, 2007 and 2006, respectively.

Deferred Revenue

Cash from operations benefited from increases in deferred revenue primarily due to an increase in the volume of implementation and maintenance services invoiced by the NextGen


35



Division which had not yet been rendered or recognized as revenue, but for which cash was received.  Deferred revenue grew by approximately $1.8 million in the nine month period ending December 31, 2007 versus $4.6 million in the prior year period.

Accounts Receivable

Accounts receivable grew by approximately $9.0 million and $15.1 million in the nine month periods ending December 31, 2007 and 2006, respectively. The increase in accounts receivable in both periods is due to the following factors:

 
NextGen Division revenue grew 23.3% and 38.7% on a year over year basis, in the nine month periods ended December 31, 2007 and 2006, respectively; 
 
The NextGen Division constituted a larger percentage of our receivables at December 31, 2007 compared to March 31, 2007. Turnover of accounts receivable in the NextGen Division is slower than the QSI Division due to the fact that the majority of the QSI Division’s revenue is coming from maintenance and EDI services which typically have shorter payment terms than systems sales related revenue which historically have accounted for a major portion of NextGen Division sales; and 
 
We experienced an increase in the volume of undelivered services billed in advance by the NextGen Division which were unpaid as of the end of each period and included in accounts receivable. This resulted in an increase in both deferred revenue and accounts receivable of approximately $0.2 million in the nine month period ended December 31, 2007 and approximately $7.5 million in the nine month period ended December 31, 2006, respectively.
 

The turnover of accounts receivable measured in terms of days sales outstanding (DSO) increased from 129 days to 138 days during the nine month period ended December 31, 2007, due, in part, to the above mentioned factors. The beginning DSO figure of 129 days was relatively low due to a significant increase in revenue in the quarter ended March 31, 2007 which contributed to a lower beginning DSO calculation. DSO increased from 122 days to 140 days during the nine month period ended December 30, 2006, primarily due to the above mentioned factors. The nine month period ended December 31, 2006 was also negatively impacted by an increase in accounts receivable with one significant customer. DSOs can also be impacted by the effectiveness of the collection staff. We have not attempted to quantify the impact of the staffing factor.

If amounts included in both accounts receivable and deferred revenue were netted, the Company’s turnover of accounts receivable expressed as DSO would be 90 days as of December 31, 2007 and 81 days as of December 31, 2006, respectively. Provided turnover of accounts receivable, deferred revenue, and profitability remain consistent with the first nine months ended December 31, 2007, we anticipate being able to continue to generate cash from operations during fiscal 2008 primarily from the net income of the Company.

Cash flows from investing activities

Net cash used in investing activities for the nine months ended December 31, 2007 and 2006 was $53.8 million and $5.9 million, respectively. The increase in cash used in investing activities is a result of the Company’s net purchases of short-term investments in ARS of approximately $48.4 million. As discussed above, these ARS are classified as short-term investments on the accompanying Consolidated Balance Sheets. In addition to purchases and sales of marketable securities, net cash used in investing activities for the nine months ended December 31, 2007 consisted of additions to equipment and improvements and capitalized software. Net cash used in investing activities for the nine months ended December 31, 2006 consisted of additions to equipment and improvements and capitalized software.

Cash flows from financing activities

During the nine months ended December 31, 2007, we received proceeds of $3.9 million from the exercise of stock options, paid dividends totaling $13.6 million, and recorded a reduction in income tax liability of $1.3 million related to tax deductions received from employee stock option exercises. The benefit was recorded as additional paid in capital.

Cash and cash equivalents and marketable securities

At December 31, 2007, we had cash and cash equivalents of $30.0 million and marketable securities of $48.4 million. We intend to expend some of these funds for the development of products complementary to our existing product line as well as new versions of certain of our products. These developments are intended to take advantage of more powerful technologies and to increase the integration of our products. We have no additional significant current capital commitments.


36



In January 2007, our Board of Directors adopted a policy whereby we intend to pay a regular quarterly dividend of $0.25 per share on our outstanding common stock commencing with conclusion of our first fiscal quarter of 2008 (June 30, 2007) and continuing each fiscal quarter thereafter, subject to further review and approval as well as establishment of record and distribution dates by our Board of Directors prior to the declaration of each such quarterly dividend. We anticipate that future quarterly dividends, if and when declared by the Board pursuant to this policy, would likely be distributable on or about the fifth day of each of the months of October, January, April and July.

On July 31, 2007, our Board of Directors approved a regular quarterly dividend of twenty-five cents ($0.25) per share payable on its outstanding shares of common stock. The cash dividend record date was September 14, 2007 and was distributed to shareholders on or about October 5, 2007.

On October 25, 2007, the Board approved a quarterly cash dividend of $0.25 per share on our outstanding shares of common stock, payable to shareholders of record as of December 14, 2007 with an expected distribution date on or about January 7, 2008.

On January 30, 2008, the Board approved a quarterly cash dividend of $0.25 per share on our outstanding shares of common stock, payable to shareholders of record as of March 14, 2008 with an expected distribution date on or about April 7, 2008.

Management believes that its cash and cash equivalents on hand at December 31, 2007, together with its marketable securities and cash flows from operations, if any, will be sufficient to meet its working capital and capital expenditure requirements as well as any dividends paid in the ordinary course of business for the balance of fiscal 2008.

Contractual Obligations

The following table summarizes our significant contractual obligations at December 31, 2007, and the effect that such obligations are expected to have on our liquidity and cash in future periods:

 
     Contractual Obligations – Non-cancelable lease obligations     (in thousands)  

         
Year Ending March 31,      
2008   $ 696  
2009     3,170  
2010     3,233  
2011     3,249  
2012 and beyond     2,578  
 
    $ 12,926  
 
 

Item 3.      Qualitative and Quantitative Disclosures About Market Risk

We have a significant amount of cash and short-term investments. This cash and investment portfolio exposes us to interest rate risk as short-term investment rates can be volatile. Given the short-term maturity structure of our cash portfolio and the short term reset dates of our ARS, we believe that it is not subject to principal fluctuations and the effective interest rate of our portfolio tracks closely to various short-term money market interest rate benchmarks.

As of December 31, 2007, we had short-term investments in tax exempt ARS of approximately $48.4 million. The ARS are rated AAA or AA by one or more national rating agencies and have contractual terms of up to 30 years, but generally have interest rate reset dates that occur every 7, 28 or 35 days and despite the long-term nature of their stated contractual maturities, management anticipates having the opportunity to liquidate these securities at ongoing auctions which are held in conjunction with the interest reset dates every 35 days or less. The investments in ARS are classified as available-for-sale on the Company’s Consolidated Balance Sheets. The investments are recorded at cost which approximates fair market value due to their variable interest rates, which typically resets every 7, 28 or 35 days. As a result, no cumulative gross unrealized holding gains/losses from the investments have been realized. All income generated from these investments is recorded as interest income.

Item 4.      Controls and Procedures


37



The Chief Executive Officer and Chief Financial Officer (our principal executive officer and principal financial officer, respectively) conducted an evaluation of the design and operation of our “disclosure controls and procedures” (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (“Exchange Act”)). Based on their evaluation of our disclosure controls and procedures, as of December 31, 2007, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures result in the effective recordation, processing, summarization and reporting of information that is required to be disclosed in the reports that we file under the Exchange Act and the rules thereunder.

During the quarter ended December 31, 2007, no significant changes have occurred in our “internal controls over financial reporting” (as defined in Rule 13a-15(f) under the Exchange Act) that have materially affected, or are reasonably likely to materially affect, our financial reporting function. We are performing ongoing evaluations and enhancements to our internal controls system.

PART II

OTHER INFORMATION

 
Item 1. Legal Proceedings.  
   
None.  
   
Item 1A. Risk Factors.
   
None.  
   
Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds.

   
None.  
   
Item 3. Defaults Upon Senior Securities.
   
None.  
   
Item 4. Submission of Matters to a Vote of Securities Holders.
   
None.  
   
Item 5. Other Information.
   
None.  
   
Item 6. Exhibits.
 

Exhibits:

 
10.21
 

 
31.1
 
31.2
   
32.1

38



SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, we have duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 
    QUALITY SYSTEMS, INC.    
     
Date:  February 6, 2008   By: /s/ Louis Silverman
   
    Louis Silverman
    Chief Executive Officer
     
     
Date:  February 6, 2008   By: /s/ Paul Holt
   
    Paul Holt
    Chief Financial Officer; Principal Accounting
    Officer

39



OFFICE LEASE

LAKESHORE TOWERS

LAKESHORE TOWERS LIMITED PARTNERSHIP PHASE II,

a California limited partnership,

as Landlord,

and

QUALITY SYSTEMS, INC.,

a California corporation,

as Tenant.

LAKESHORE TOWERS BUILDING III
[Quality Systems, Inc.]



TABLE OF CONTENTS

 

 

 

 

 

 

 

 

 

 

 

Page

ARTICLE 1          PREMISES, BUILDING, PROJECT, AND COMMON AREAS

 

4

 

 

 

 

 

 

 

1.1

 

Premises, Building, Project and Common Areas

 

4

 

1.2

 

Verification of Rentable Square Feet and Usable Square Feet of Premises, Building, and Project

 

4

 

1.3

 

Right of First Offer

 

5

 

 

 

ARTICLE 2          LEASE TERM; OPTION TERM

 

6

 

 

 

 

2.1

 

Lease Term

 

6

 

2.2

 

Lease Commencement Date Delay

 

6

 

2.3

 

Option Term

 

7

 

2.4

 

Early Termination

 

9

 

 

 

ARTICLE 3          BASE RENT

 

9

 

 

 

ARTICLE 4          ADDITIONAL RENT; SECURITY DEPOSIT

 

10

 

 

 

 

4.1

 

General Terms

 

10

 

4.2

 

Definitions of Key Terms Relating to Additional Rent

 

10

 

4.3

 

Allocation of Direct Expenses

 

16

 

4.4

 

Calculation and Payment of Additional Rent

 

16

 

4.5

 

Taxes and Other Charges for Which Tenant Is Directly Responsible

 

16

 

4.6

 

Landlord’s Books and Records

 

17

 

4.7

 

Security Deposit

 

18

 

 

 

ARTICLE 5          USE OF PREMISES

 

18

 

 

 

 

5.1

 

Permitted Use

 

18

 

5.2

 

Prohibited Uses

 

18

 

5.3

 

Tenant’s Security Responsibilities

 

19

 

 

 

ARTICLE 6          SERVICES AND UTILITIES

 

19

 

 

 

 

6.1

 

Standard Tenant Services

 

19

 

6.2

 

Overstandard Tenant Use

 

19

 

6.3

 

Interruption of Use

 

20

 

 

 

ARTICLE 7          REPAIRS

 

20

 

 

 

ARTICLE 8          ADDITIONS AND ALTERATIONS

 

21

 

 

 

 

8.1

 

Landlord’s Consent to Alterations

 

21

 

8.2

 

Manner of Construction

 

21

 

8.3

 

Payment for Improvements

 

22

 

8.4

 

Construction Insurance

 

22

 

8.5

 

Landlord’s Property

 

22

 

8.6

 

Communications and Computer Lines

 

22

 

 

 

ARTICLE 9          COVENANT AGAINST LIENS

 

23

 

 

 

ARTICLE 10        INSURANCE

 

23

 

 

 

 

10.1

 

Indemnification and Waiver

 

23

 

10.2

 

Tenant’s Compliance With Landlord’s Fire and Casualty Insurance

 

23

 

10.3

 

Tenant’s Insurance

 

24

 

10.4

 

Form of Policies

 

24

 

10.5

 

Subrogation

 

24

 

10.6

 

Additional Insurance Obligations

 

25

 

 

 

ARTICLE 11        DAMAGE AND DESTRUCTION

 

25

 

 

 

 

11.1

 

Repair of Damage to Premises by Landlord

 

25

 

11.2

 

Landlord’s Option to Repair

 

25

 

11.3

 

Tenant’s Option to Cause Early Expiration

 

26


 

 

 

LAKESHORE TOWERS BUILDING III

-i-

[Quality Systems, Inc.]




TABLE OF CONTENTS
(continued)

 

 

 

 

 

 

 

 

 

 

 

Page

 

11.4

 

Waiver of Statutory Provisions

 

26

 

 

 

ARTICLE 12          NONWAIVER

 

26

 

 

 

ARTICLE 13          CONDEMNATION

 

27

 

 

 

ARTICLE 14          ASSIGNMENT AND SUBLETTING

 

27

 

 

 

 

14.1

 

Transfers

 

27

 

14.2

 

Landlord’s Consent

 

28

 

14.3

 

Transfer Premium

 

28

 

14.4

 

Landlord’s Option as to Subject Space

 

29

 

14.5

 

Effect of Transfer

 

29

 

14.6

 

Occurrence of Default

 

30

 

14.7

 

Non-Transfers

 

30

 

 

 

ARTICLE 15          SURRENDER OF PREMISES; OWNERSHIP AND REMOVAL OF TRADE FIXTURES

 

30

 

 

 

 

15.1

 

Surrender of Premises

 

30

 

15.2

 

Removal of Tenant Property by Tenant

 

30

 

 

 

ARTICLE 16          HOLDING OVER

 

31

 

 

 

ARTICLE 17          ESTOPPEL CERTIFICATES; FINANCIAL STATEMENTS

 

31

 

 

 

 

17.1

 

Estoppel Certificates

 

31

 

17.2

 

Financial Statements

 

31

 

 

 

ARTICLE 18          SUBORDINATION

 

31

 

 

 

ARTICLE 19          DEFAULTS; REMEDIES

 

32

 

 

 

 

19.1

 

Events of Default

 

32

 

19.2

 

Remedies Upon Default

 

32

 

19.3

 

Subleases of Tenant

 

33

 

19.4

 

Efforts to Relet

 

34

 

19.5

 

Landlord Default

 

34

 

 

 

ARTICLE 20          COVENANT OF QUIET ENJOYMENT

 

34

 

 

 

ARTICLE 21          34

 

 

 

 

 

[INTENTIONALLY DELETED]

 

34

 

 

 

ARTICLE 22          SIGNS

 

34

 

 

 

 

22.1

 

Full Floor

 

34

 

22.2

 

Prohibited Signage and Other Items

 

34

 

22.3

 

Building Directory

 

34

 

 

 

ARTICLE 23          COMPLIANCE WITH LAW

 

35

 

 

 

 

23.1

 

Applicable Laws

 

35

 

23.2

 

Hazardous Materials

 

35

 

23.3

 

Warranties; Notice of Release and Investigation

 

35

 

23.4

 

Indemnification

 

36

 

23.5

 

Remediation Obligations; Tenant’s Rights on Cleanup by Landlord

 

36

 

23.6

 

Definition of “Hazardous Material”

 

36

 

 

 

ARTICLE 24          LATE CHARGES

 

37

 

 

 

ARTICLE 25          LANDLORD’S RIGHT TO CURE DEFAULT; PAYMENTS BY TENANT

 

37


 

 

 

LAKESHORE TOWERS BUILDING III

-ii-

[Quality Systems, Inc.]




TABLE OF CONTENTS
(continued)

 

 

 

 

 

 

 

 

 

 

 

Page

 

25.1

 

Landlord’s Cure

 

37

 

25.2

 

Tenant’s Reimbursement

 

37

 

 

 

ARTICLE 26          ENTRY BY LANDLORD

 

37

 

 

 

ARTICLE 27          TENANT PARKING

 

38

 

 

 

 

27.1

 

Parking In General

 

38

 

27.2

 

Landlord Reservations

 

38

 

27.3

 

Visitor Validations

 

38

 

27.4

 

Parking Pass System

 

38

 

 

 

ARTICLE 28          MISCELLANEOUS PROVISIONS

 

39

 

 

 

 

28.1

 

Terms; Captions

 

39

 

28.2

 

Binding Effect

 

39

 

28.3

 

No Air Rights

 

39

 

28.4

 

Modification of Lease

 

39

 

28.5

 

Transfer of Landlord’s Interest

 

39

 

28.6

 

Prohibition Against Recording

 

39

 

28.7

 

Landlord’s Title

 

39

 

28.8

 

Relationship of Parties

 

39

 

28.9

 

Application of Payments

 

39

 

28.10

 

Time of Essence

 

40

 

28.11

 

Partial Invalidity

 

40

 

28.12

 

No Warranty

 

40

 

28.13

 

Landlord Exculpation

 

40

 

28.14

 

Entire Agreement

 

40

 

28.15

 

Right to Lease

 

40

 

28.16

 

Force Majeure

 

40

 

28.17

 

Waiver of Redemption by Tenant

 

41

 

28.18

 

Notices

 

41

 

28.19

 

Joint and Several

 

41

 

28.20

 

Authority

 

41

 

28.21

 

Attorneys’ Fees

 

41

 

28.22

 

GOVERNING LAW; WAIVER OF TRIAL BY JURY

 

41

 

28.23

 

Submission of Lease

 

42

 

28.24

 

Brokers

 

42

 

28.25

 

Independent Covenants

 

42

 

28.26

 

Project or Building Name and Signage

 

42

 

28.27

 

Counterparts

 

42

 

28.28

 

Confidentiality

 

42

 

28.29

 

Development of the Project

 

42

 

28.30

 

Building Renovations

 

43

 

28.31

 

No Violation

 

43

 

28.32

 

No Discrimination

 

43

 

28.33

 

OFAC Compliance

 

43

 

28.34

 

Definition of Landlord

 

44


 

 

 

LAKESHORE TOWERS BUILDING III

-iii-

[Quality Systems, Inc.]




LIST OF DEFINED TERMS

 

 

 

 

 

 

 

 

 

Accountant

 

17

 

 

 

Additional Rent

 

10

 

 

 

Additional Required Work

 

22

 

 

 

Affiliate

 

31

 

 

 

Alterations

 

21

 

 

 

Anticipated First Offer Date

 

5

 

 

 

Applicable Laws

 

35

 

 

 

Arbitration Fair Market Rental Value

 

8

 

 

 

Base Building

 

22

 

 

 

Base Rent

 

9

 

 

 

Base Taxes

 

15

 

 

 

Base Year

 

10

 

 

 

BOMA

 

16

 

 

 

Brokers

 

43

 

 

 

Building

 

4

 

 

 

Building Common Areas

 

4

 

 

 

Building Direct Expenses

 

10

 

 

 

Building Hours

 

19

 

 

 

Building Operating Expenses

 

10

 

 

 

Building Tax Expenses

 

10

 

 

 

CEW Report

 

36

 

 

 

Comparable Buildings

 

4

 

 

 

Contemplated Effective Date

 

29

 

 

 

Contemplated Transfer Space

 

29

 

 

 

Control

 

31

 

 

 

Current Premises

 

7

 

 

 

Direct Expenses

 

10

 

 

 

Effective Date

 

6

 

 

 

Electricity Usage Standard

 

20

 

 

 

Embargoed Person

 

44

 

 

 

Environmental Laws

 

36

 

 

 

Estimate Statement

 

16

 

 

 

Estimated Excess

 

16

 

 

 

Expense Year

 

10

 

 

 

Extended Repair Notice

 

26

 

 

 

Fair Market Rental Value

 

8

 

 

 

First Offer Notice

 

5

 

 

 

Force Majeure

 

41

 

 

 

Hazardous Material

 

37

 

 

 

Holidays

 

19

 

 

 

HVAC

 

19

 

 

 

Intention to Transfer Notice

 

29

 

 

 

Landlord

 

1

 

 

 

Landlord Parties

 

23

 

 

 

Landlord Repair Notice

 

25

 

 

 

Lease

 

1

 

 

 

Lease Commencement Date

 

6

 

 

 

Lease Expiration Date

 

6, 7

 

 

 

Lease Term

 

6

 

 

 

Lines

 

23

 

 

 

List

 

44

 

 

 

Mail

 

41

 

 

 

Management Fee Cap

 

13

 

 

 

None-Month Period

 

30

 

 

 

Notices

 

41

 

 

 

OFAC

 

44

 

 

 

Operating Expenses

 

10

 

 

 

Option Term

 

7

 

 

 

Original Improvements

 

24


 

 

 

LAKESHORE TOWERS BUILDING III

iv

[Quality Systems, Inc.]




 

 

 

 

 

 

 

 

 

Original Tenant

 

7

 

 

 

Other Improvements

 

43

 

 

 

Outside Agreement Date

 

8

 

 

 

Outside Date

 

6

 

 

 

Parking Structure

 

39

 

 

 

Premises

 

4

 

 

 

Project

 

4

 

 

 

Proposition 13

 

14

 

 

 

Renovations

 

44

 

 

 

Rent

 

10

 

 

 

Security Deposit

 

18

 

 

 

Subject Space

 

28

 

 

 

Summary

 

1

 

 

 

Superior Leases

 

5

 

 

 

Superior Rights

 

5

 

 

 

Tax Expenses

 

14

 

 

 

Tenant

 

1, 7

 

 

 

Tenant Auditor

 

17

 

 

 

Tenant Work Letter

 

4

 

 

 

Tenant’s Share

 

15

 

 

 

Tenant’s Transfer Costs

 

29

 

 

 

Termination Notice

 

6

 

 

 

Transfer Notice

 

28

 

 

 

Transfer Premium

 

29

 

 

 

Transfer(s)

 

28

 

 

 

Transferee

 

28


 

 

 

LAKESHORE TOWERS BUILDING III

v

[Quality Systems, Inc.]




EXHIBITS

 

 

A

OUTLINE OF PREMISES

 

 

B

TENANT WORK LETTER

 

 

C

LEGAL DESCRIPTION

 

 

D

FORM OF NOTICE OF LEASE TERM DATES

 

 

E

DIRECT EXPENSES ALLOCATION

 

 

F

RULES AND REGULATIONS

 

 

G

FORM OF TENANT’S ESTOPPEL CERTIFICATE


 

 

 

LAKESHORE TOWERS BUILDING III

vi

[Quality Systems, Inc.]




LAKESHORE TOWERS

OFFICE LEASE

          This Office Lease (the “Lease”) , dated as of the date set forth in Section 1 of the Summary of Basic Lease Information (the “Summary”), below, is made by and between LAKESHORE TOWERS LIMITED PARTNERSHIP PHASE II, a California limited partnership (“Landlord”), and QUALITY SYSTEMS, INC., a California corporation (“Tenant”).

SUMMARY OF BASIC LEASE INFORMATION

 

 

 

 

 

TERMS OF LEASE

 

DESCRIPTION


 


 

 

 

 

 

1.

Date:

 

 

October 18, 2007

 

 

 

 

 

2.

Premises
(Article 1):

 

 

 

 

 

 

 

 

2.1

Building:

 

Lakeshore Towers Building III 18111 Von Karman Avenue Irvine, California

 

 

 

 

 

 

2.2

Premises:

 

Approximately 23,759 rentable (21,548 usable) square feet of space located on the sixth floor of the Building and commonly known as Suite 600, as further set forth in Exhibit A to the Lease.

 

 

 

 

 

3.

Lease Term
(Article 2).

 

 

 

 

 

 

 

 

3.1

Length of Term of Lease of Premises:

 

Sixty (60) months, plus the partial month, if any, between the Lease Commencement Date and the first day of the following calendar month.

 

 

 

 

 

 

3.2

Lease Commencement Date:

 

The Lease Commencement Date shall be as set forth in Section 2.1.

 

 

 

 

 

 

3.3

Lease Expiration Date:

 

The last day of the sixtieth (60) month of the Lease Term.

 

 

 

 

 

4.

Base Rent
(Article 3):

 

 


 

 

 

 

 

 

 

 

 

 

 

Lease Year

 

Annual
Base Rent

 

Monthly
Installment
of Base Rent

 

Annual
Rental Rate
per Rentable
Square Foot

 


 


 


 


 

 

 

 

 

 

 

 

 

 

 

 

Lease
Commencement
Date
through Month 48*

 

$

776,919.30

 

$

64,743.28

 

$

32.70

 

 

 

 

 

 

 

 

 

 

 

 

Month 49
through Month 60

 

$

812,557.80

 

$

67,713.15

 

$

34.20

 


 

 

 

LAKESHORE TOWERS BUILDING III

1

[Quality Systems, Inc.]




 

 

 

 

 

As used herein a “month” means a calendar month. If the Lease Commencement Date is other than the first day of a calendar month, the Base Rent for such partial calendar month shall be prorated pursuant to Article 3 of the Lease and such prorated Base Rent shall be due and payable on the tenth (10th) day following the Lease Commencement Date. For example, if the Lease Commencement Date is the 15th day of February 2008, prorated Base Rent for February 2008 would be due on February 25, 2008.

 

 

 

 

 

*Notwithstanding anything herein to the contrary, monthly installments of Base Rent for the period from the Lease Commencement Date through May 31, 2008 shall be $60,244.78.

 

 

 

 

 

5.

Base Year
(Article 4):

 

Calendar year 2008

 

 

 

 

 

6.

Tenant’s Share
(Article 4):

 

Approximately 10.265%

 

 

 

 

 

7.

Permitted Use
(Article 5):

 

General office use consistent with a first-class office building.

 

 

 

 

 

8.

Security Deposit
(Article 4):

 

$64,149.30

 

 

 

 

 

9.

Parking
(Article 27):

 

81 unreserved parking spaces of which four (4) spaces may, subject to the terms of Article 27 of this Lease, be for the use of reserved parking spaces in the Building. To the extent available, Tenant shall have the right to use an additional thirteen (13) unreserved parking spaces in the Parking Structure at the rates provided below subject to Tenant’s advising Landlord not less than thirty (30) days in advance of the date Tenant desires to use such additional unreserved parking spaces. To the extent available, Tenant shall have the right to use additional reserved parking spaces in the Building at the reserved rate then being charged by Landlord to other tenants; provided such use may be terminated by Landlord on ten (10) days advance written notice to Tenant.


 

 

 

 

 

 

 

 

 

 

 

Parking
Space Fees:

 

Unreserved Rate
Per Space
Per Month

 

Reserved Rate
Per Space
Per Month

 

Building
Reserved Rate
Per Space
Per Month

 

 

 


 


 


 

 

 

 

 

 

 

 

 

 

 

 

      Lease Commencement

 

 

 

 

 

 

 

 

 

 

Date through May 31, 2008

 

$

50.00

 

$

125.00

 

$

145.00

 

 

 

 

 

 

 

 

 

 

 

 

June 1, 2008 through
Lease Expiration Date

 

$

65.00

 

$

125.00

 

$

150.00

 


 

 

 

 

 

10.

Address of Tenant
(Section 28.18):

 

Prior to Lease Commencement Date:

 

 

 

 

 

 

 

 

 

Quality Systems, Inc.
18191 Von Karman Avenue, Suite 450
Irvine, California 92612


 

 

 

LAKESHORE TOWERS BUILDING III

2

[Quality Systems, Inc.]




 

 

 

 

 

 

 

 

 

After Lease Commencement Date:

 

 

 

 

 

 

 

 

 

Quality Systems, Inc.
18111 Von Karman Avenue, Suite 600
Irvine, California 92612

 

 

 

 

 

11.

Address of Landlord
(Section 28.18):

 

See Section 28.18 of the Lease.

 

 

 

 

 

12.

Broker(s)
(Section 28.24):

 

Kern Olson Real Estate Services
4101 Birch Street, Suite 150
Newport Beach, California 92660
Attention: James F. Kern

 

 

 

 

 

 

 

 

 

and

 

 

 

 

 

 

 

 

Cushman & Wakefield of California, Inc.
1920 Main Street, Suite 600
Irvine, California 92614
Attention: Rick Kaplan and Robert Lambert


 

 

 

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ARTICLE 1

                       PREMISES, BUILDING, PROJECT, AND COMMON AREAS

          1.1     Premises, Building, Project and Common Areas.

                    1.1.1           The Premises. Landlord hereby leases to Tenant and Tenant hereby leases from Landlord the premises set forth in Section 2.2 of the Summary (the “Premises”). The outline of the Premises is set forth in Exhibit A attached hereto and the Premises has the number of rentable square feet as set forth in Section 2.2 of the Summary. The parties hereto agree that the lease of the Premises is upon and subject to the terms, covenants and conditions herein set forth, and Tenant covenants as a material part of the consideration for this Lease to keep and perform each and all of such terms, covenants and conditions by it to be kept and performed and that this Lease is made upon the condition of such performance. The parties hereto hereby acknowledge that the purpose of Exhibit A is to show the approximate location of the Premises in the Building (as defined below) only, and such exhibit is not meant to constitute an agreement, representation or warranty as to the construction of the Premises, the precise area thereof or the specific location of the Common Areas (as defined below) or the elements thereof or of the accessways to the Premises or the Project (as defined below). Except as specifically set forth in this Lease and in the Tenant Work Letter attached hereto as Exhibit B (the “Tenant Work Letter”), Landlord shall not be obligated to provide or pay for any improvement work or services related to the improvement of the Premises. Tenant also acknowledges that neither Landlord nor any agent of Landlord has made any representation or warranty regarding the condition of the Premises, the Building or the Project or with respect to the suitability of any of the foregoing for the conduct of Tenant’s business, except as specifically set forth in this Lease and the Tenant Work Letter.

                    1.1.2           The Building and The Project. The Premises are a part of the building set forth in Section 2.1 of the Summary (the “Building”). The Building is part of an office project known as “Lakeshore Towers”. The term “Project”, as used in this Lease, shall mean (i) the land on which the Project is located which land is described in Exhibit C hereto, (ii) the Building, (iii) the Common Areas, (iv) the other buildings located in the Project, and (v) at Landlord’s discretion, any additional real property, areas, land, buildings or other improvements added thereto outside of the Project.

                    1.1.3          Common Areas. Tenant shall have the non-exclusive right to use in common with Project tenants the Project Common Areas and the non-exclusive right to use in common with other Building tenants the Building Common Areas, subject to the rules and regulations referred to in Article 5 of this Lease. Those portions of the Project which are provided, from time to time, for use in common by Landlord, Tenant and any other tenants of the Project and such other portions of the Project designated by Landlord, in its discretion, including certain areas designated for the exclusive use of certain tenants, or to be shared by Landlord and certain tenants, are collectively referred to herein as the “Common Areas”. The Common Areas shall consist of the Project Common Areas and the Building Common Areas. The term “Project Common Areas” shall mean (i) the portion of the Project designated as such by Landlord and (ii) all common areas designated in that certain Declaration of Covenants, Conditions and Restrictions and Reservation of Easements for the Lakeshore Towers, dated October 17, 1989, recorded October 23, 1989, as Instrument No. 89569018 of the Official Records of Orange County, California (the “CC&Rs”). The term “Building Common Areas” shall mean the portions of the Common Areas located within the Building designated as such by Landlord. The manner in which the Common Areas are maintained and operated shall be at the sole discretion of Landlord, provided that Landlord shall maintain and operate same in a manner consistent with that of other first-class, high-rise office buildings in the John Wayne Airport/South Coast Plaza, Costa Mesa, California area, which are comparable in size (containing at least 250,000 rentable square feet), quality of construction, and services and amenities to the Building (the “Comparable Buildings”) and the use thereof shall be subject to such rules, regulations and restrictions as Landlord may make from time to time. Landlord reserves the right to close temporarily, make alterations or additions to, or change the location of elements of the Project and the Common Areas.

          1.2     Verification of Rentable Square Feet and Usable Square Feet of Premises, Building, and Project. For purposes of this Lease, “rentable square feet” and “usable square

 

 

 

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feet” shall be calculated pursuant to BOMA (as defined below). In the event that the rentable area of the Premises, the Building and/or the Project shall hereafter change due to subsequent alterations and/or other modifications to the Premises, the Building and/or the Project, the rentable area of the Premises, the Building and/or the Project, as the case may be, shall be appropriately adjusted as of the date of such alteration and/or other modification, based upon the written verification by Landlord’s space planner of such revised rentable area. In the event of any such adjustment to the rentable area of the Premises, the Building and/or the Project, all amounts, percentages and figures appearing or referred to in this Lease based upon such rentable area (including, without limitation, the amount of the Rent (as defined below)) shall be modified in accordance with such determination.

          1.3     Right of First Offer. Landlord hereby grants to Original Tenant (as defined below), a right of first offer with respect to any space on the fourth (4th) floor of the Building (the “First Offer Space”). Notwithstanding the foregoing, (i) such first offer right of Tenant shall commence only following the expiration or earlier termination of (A) that certain Lease between Landlord and Ernst & Young U.S. LLP, (B) that certain lease between Landlord and Pepperdine University and (C) that certain lease between Landlord and City National Bank (items (A), (B) and (C), collectively, the “Superior Leases”), including any renewal or extension of such Superior Leases, provided such renewal or extension is pursuant to an express written provision in such Superior Lease, but regardless of whether any such renewal or extension is consummated strictly pursuant to the terms of such express written provisions, or pursuant to a lease amendment or a new lease, and (ii) such first offer right shall be subordinate and secondary to all rights of expansion, first refusal, rights of first offer or similar rights previously granted to the tenants of the Superior Leases (the rights described in items (i) and (ii) above to be known collectively as “Superior Rights”). Tenant’s Right of First Offer shall be on the terms and conditions set forth in this Section 1.3.

                    1.3.1          Procedure for Offer. Landlord shall notify Tenant (the “First Offer Notice”) from time to time when Landlord determines that marketing for any portion of the First Offer Space will commence because such portion of the First Offer Space shall become available for lease to third parties, provided that no holder of a Superior Right wishes to lease such space. Pursuant to such First Offer Notice, Landlord shall offer to lease to Tenant the then available First Offer Space. The First Offer Notice shall describe the space so offered to Tenant, shall set forth the date (“Anticipated First Offer Date”) upon which Landlord anticipates that the First Offer Space shall become available for lease to third parties (subject to any holdover of any then existing tenant).

                    1.3.2           Procedure for Acceptance. During the fifteen (15) day period following receipt of the First Offer Notice, Landlord and Tenant shall meet and negotiate in good faith in an attempt to reach an agreement with respect to rent, length of lease and other terms and conditions for the lease by Tenant from Landlord of the First Offer Space (if Tenant elects to lease the First Offer Space, such election shall be with respect to all of the First Offer Space offered by Landlord to Tenant at any particular time, and Tenant may not elect to lease only a portion thereof). If Landlord and Tenant are unable to agree upon the terms and conditions for Tenant’s lease of the First Offer Space during such fifteen (15) day period, Landlord may lease the First Offer Space to any other person or entity on such terms and conditions as are acceptable to Landlord and Tenant shall have no further rights with respect to such First Offer Space.

                    1.3.3           Construction In First Offer Space. Tenant shall lease the First Offer Space in its “as is” condition (except to the extent an improvement allowance is agreed upon by Landlord and Tenant during negotiations as contemplated at Section 1.3.2 above).

                    1.3.4           Amendment to Lease. If Tenant and Landlord reach agreement on Tenant’s lease of the First Offer Space as set forth herein, Landlord and Tenant shall within fifteen (15) days after such agreement execute a lease for such First Offer Space or an amendment to this Lease adding such First Offer Space to the Premises upon the terms and conditions agreed upon by Landlord and Tenant.

                    1.3.5           Termination of Right of First Offer. The rights contained in this Section 1.3 shall be personal to the Original Tenant and may only be exercised by the Original Tenant (and not any other assignee, sublessee or transferee of the Original Tenant’s interest in

 

 

 

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this Lease) if the Original Tenant occupies all of the Premises as of the date of the First Offer Notice.

ARTICLE 2

LEASE TERM; OPTION TERM

          2.1     Lease Term. The terms and provisions of this Lease shall be effective as of the date of this Lease. The term of this Lease (the “Lease Term”) shall be as set forth in Section 3.1 of the Summary and shall, subject to Force Majeure, commence on the date (the “Lease Commencement Date”) that Landlord delivers the Premises substantially complete (as defined in the Tenant Work Letter attached hereto as Exhibit B). The term of this Lease shall terminate on the date set forth in Section 3.3 of the Summary (the “Lease Expiration Date”) unless this Lease is sooner terminated as hereinafter provided. At any time during the Lease Term, Landlord may deliver to Tenant a notice in the form as set forth in Exhibit D, attached hereto, as a confirmation only of the information set forth therein, which Tenant shall execute and return to Landlord within five (5) days of receipt thereof.

          2.2     Lease Commencement Date Delay.

                    2.2.1           Delay In Possession. If Landlord is unable to deliver possession of the Premises to Tenant with the Tenant Improvements substantially complete on or before April 1, 2008, Landlord shall not be subject to any liability for its failure to do so. If Landlord is unable to deliver possession of the Premises to Tenant with the Tenant Improvements substantially complete on or before the Outside Date, Tenant’s sole remedy shall be to terminate this Lease as provided in Section 2.2.2 below. For purposes of this Lease, the “Outside Date” shall be July 1, 2008 as extended by the number of days of “Tenant Delays” as described in Exhibit B hereto and by the number of days of delay due to Force Majeure (as defined below).

                    2.2.2           Tenant’s Notice of Termination. If Landlord fails to deliver the Premises to Tenant with the Tenant Improvements substantially complete by the Outside Date, Tenant’s sole remedy shall be the right to deliver a notice to Landlord (“Termination Notice”) electing to terminate this Lease effective on Landlord’s receipt of the Termination Notice (“Effective Date”). Except as provided below, the Termination Notice must be delivered to Landlord by Tenant, if at all, no later than fifteen (15) business days after the Outside Date. In the event that the Termination Notice is delivered, upon the Effective Date (subject to any suspension of such date pursuant to Section 2.2.3 below) Tenant’s right to occupy the Current Premises (as defined below) shall be extended until the date which is the later of the “Expiration Date” under the Current Premises Lease (as defined below) or three (3) calendar months following the Effective Date (subject to any suspension of such date pursuant to Section 2.2.3 below). Landlord shall cause the landlord of the Current Premises to waive any holdover rent which is in excess of the amount of base rent and/or additional rent that would then be due under the Current Premises Lease during such three month period.

                    2.2.3           Landlord’s Suspension of Effective Date. If Tenant delivers the Termination Notice to Landlord, Landlord shall have the right to suspend the Effective Date until thirty (30) days after the original Effective Date. In order to suspend the Effective Date, Landlord must deliver to Tenant, within five (5) business days after receipt of the Termination Notice, a certificate of the general contractor in charge of construction certifying that it is that contractor’s best good faith judgment that the delivery of the Premises with the Tenant Improvements substantially complete will occur within thirty (30) days after the original Effective Date. If Landlord provides this certificate and delivery of the Tenant Improvements substantially complete occurs within that thirty (30) day suspension period, the Termination Notice shall be of no force or effect. If, however, such delivery does not occur within that thirty (30) day suspension period, this Lease shall terminate as of the date of expiration of the thirty (30) day period.

                    2.2.4           Extension of Outside Date. If before the Outside Date Landlord determines that delivery of the Premises with the Tenant Improvements substantially complete will not occur by the Outside Date, Landlord shall have the right to deliver a written notice to Tenant stating Landlord’s reasonable, good faith estimate of the date by which such delivery will occur. Tenant will be required within ten (10) business days after receipt of such notice either to

 

 

 

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deliver the Termination Notice (which will mean that this Lease shall terminate and be of no further force and effect) or agree to extend the Outside Date to the date stated in Landlord’s notice. Tenant’s failure to respond in writing within such ten (10) business day period shall constitute Tenant’s agreement to extend the Outside Date to the date stated in Landlord’s notice. If the Outside Date is so extended, Landlord’s right to request Tenant to elect to either terminate or further extend the Outside Date shall remain and continue to remain, with each of the notice periods and response periods set forth above, until possession of the Premises with Tenant Improvements substantially complete have been delivered to Tenant or until this Lease is terminated.

                   2.2.5           Tenant’s Current Lease. Tenant currently leases Suite 450 at 18191 Von Karman Avenue, Irvine, California (“Current Premises”) pursuant to that certain Office Lease dated September 15, 2004 (“Current Premises Lease”). The building in which the Current Premises are located is part of the Project. Tenant shall deliver possession of the Current Premises to the landlord of the Current Premises within fifteen (15) days following the Lease Commencement Date and such delivery date shall be the “Lease Expiration Date” for purposes of the Current Premises Lease.

          Landlord shall cause the landlord under the Current Premises Lease to accept the following:

                    (i) if the “Lease Expiration Date” under the Current Premises Lease occurs prior to the Lease Commencement Date, the Current Premises landlord shall waive any holdover rent which is in excess of the amount of base rent and/or additional rent that would then be due under the Current Premises Lease. If the Current Premises have not been delivered to the Current Premises landlord within fifteen (15) days following the Lease Commencement Date, the foregoing waiver shall be of no force or effect.

                    (ii) the Current Premises landlord shall waive any base rent and/or additional rent that would be due under the Current Premises Lease during the fifteen-day period following the Lease Commencement Date. If the Current Premises have not been delivered to the Current Premises landlord within fifteen (15) days following the Lease Commencement Date, the foregoing waiver shall be of no force or effect.

          The foregoing shall not relieve Tenant of any obligation to pay for additional services or work by the Current Premises landlord at Tenant’s specific request (e.g., after hours HVAC costs, visitor parking validation and parking charges in excess of parking charges under the Current Premises Lease). Nothing herein modifies Tenant’s duties and obligations under the Current Premises Lease including, without limitation, the condition of the Current Premises upon delivery to the Current Premises landlord.

          2.3          Option Term.

                         2.3.1           Option Right. Landlord hereby grants Quality Systems, Inc. (the “Original Tenant”) one (1) option to extend the Lease Term for a period of five (5) years (the “Option Term”), which option shall be exercisable only by written notice delivered by Tenant to Landlord as provided below, provided that, as of the date of delivery of such notice, Tenant is not in default under this Lease, after the expiration of applicable cure periods, and Tenant has not previously been in default under this Lease, after the expiration of applicable cure periods, more than once. Upon the proper exercise of such option to extend, and provided that, as of the end of the initial Lease Term, Tenant is not in default under this Lease, after the expiration of applicable cure periods, and Tenant has not previously been in default under this Lease, after the expiration of applicable cure periods, more than once, the Lease Term, as it applies to the Premises, shall be extended for a period of five (5) years. The rights contained in this Section 2.3 shall be personal to Tenant and may only be exercised by Tenant (and not any other assignee, sublessee or transferee of Tenant’s interest in this Lease) if Original Tenant occupies the entire Premises. (References to “Tenant” in this Section 2.3 and elsewhere in this Lease with respect to the Option Term shall mean Original Tenant.)

                        2.3.2           Option Rent. The rent payable by Tenant during the Option Term (the “Option Rent”) shall be equal to the “Fair Market Rental Value” for the Premises. As used herein, “Fair Market Rental Value” shall be equal to the rent (including additional rent and

 

 

 

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considering any “base year” or “expense stop” applicable thereto), including all escalations, at which, as of the commencement of the Option Term taking into consideration only those transactions involving the services of a professional real estate broker, tenants are leasing non-sublease, non-encumbered, non-equity space comparable in size, location and quality to the Premises for a term of five (5) years which comparable space is located in the Project and in Comparable Buildings, in either case taking into consideration the following: (a) rental abatement concessions, if any, being granted such tenants in connection with such comparable space; (b) tenant improvements or allowances provided or to be provided for such comparable space, taking into account, and deducting the value of, the existing improvements in the Premises, such value to be based upon the age, quality and layout of the improvements and the extent to which the same can be utilized by Tenant based upon the fact that the precise tenant improvements existing in the Premises are specifically suitable to Tenant; and (c) other reasonable monetary concessions being granted or charges being imposed upon such tenants in connection with such comparable space, including parking concessions or charges; provided, however, that in calculating the Fair Market Rental Value, no consideration shall be given to the fact that Landlord is or is not required to pay a real estate brokerage commission in connection with Tenant’s extension of its lease of the Premises, or the fact that landlords are or are not paying real estate brokerage commissions in connection with such comparable space. When considering rental rates in the Comparable Buildings, adjustments shall be made to such rates to increase or decrease such rates, as applicable, based on substantial historical differences between the rental rates of the Building and any applicable Comparable Building. In calculating the Option Rent, no consideration shall be given to any period of rental abatement granted to tenants in comparable transactions in connection with the design, permitting and construction of tenant improvements in such comparable spaces.

                    2.3.3           Exercise of Option. The option contained in this Section 2.3 shall be exercised by Tenant, if at all, delivering written notice (“Option Exercise Notice”) to Landlord not more than fifteen (15) months nor less than twelve (12) months prior to the expiration of the initial Lease Term, stating that Tenant is exercising its option. Landlord, after receipt of Option Exercise Notice, shall deliver notice (the “Option Rent Notice”) to Tenant not less than six (6) months prior to the expiration of the initial Lease Term setting forth the Option Rent. Within thirty (30) days after Tenant’s receipt of the Option Rent Notice, Tenant may, at its option, object to the Option Rent contained in the Option Rent Notice. If Tenant timely and appropriately objects to the Option Rent contained in the Option Rent Notice, the parties shall follow the procedure and the Option Rent shall be determined as set forth in Section 2.3.4, below.

                    2.3.4           Determination of Option Rent. If Tenant fails to timely and appropriately object to Option Rent, then the Option Rent shall be as set forth in the Option Rent Notice. If Tenant timely and appropriately objects to the Option Rent, Landlord and Tenant shall attempt to agree upon the applicable Fair Market Rental Value using their best good-faith efforts. If Landlord and Tenant fail to reach agreement within ten (10) days following Tenant’s objection to the Option Rent (the “Outside Agreement Date”), then each party shall make a separate determination of the applicable Fair Market Rental Value (the “Arbitration Fair Market Rental Value(s)”), within fifteen (15) days following the Outside Agreement Date and such determinations shall be submitted to arbitration in accordance with Sections 2.3.4.1 through 2.3.4.7 below.

                                   2.3.4.1          Landlord and Tenant shall each appoint one arbitrator who shall by profession be a real estate broker or appraiser who shall have been active over the five (5) year period ending on the date of such appointment in the leasing or appraisal, as the case may be, of commercial high rise properties in the South Coast Plaza/John Wayne Airport area. The determination of the arbitrators shall be limited solely to the issue of whether Landlord’s or Tenant’s submitted Arbitration Fair Market Rental Value is the closest to the actual Fair Market Rental Value as determined by the arbitrators, taking into account the requirements of Section 2.3.2 of this Lease. Each such arbitrator shall be appointed within twenty (20) days after the applicable Outside Agreement Date.

                                   2.3.4.2          The two arbitrators so appointed shall within ten (10) days of the date of the appointment of the last appointed arbitrator agree upon and appoint a third arbitrator who shall be qualified under the same criteria set forth hereinabove for qualification of the initial two arbitrators.

 

 

 

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                                   2.3.4.3          The three arbitrators shall within thirty (30) days of the appointment of the third arbitrator reach a decision as to whether the parties shall use Landlord’s or Tenant’s submitted Fair Market Rental Value, and shall notify Landlord and Tenant thereof.

                                   2.3.4.4          The decision of the majority of the three arbitrators shall be binding upon Landlord and Tenant.

                                   2.3.4.5          If either Landlord or Tenant fails to appoint an arbitrator within twenty (20) days after the applicable Outside Agreement Date, the arbitrator appointed by one of them shall reach a decision, notify Landlord and Tenant thereof, and such arbitrator’s decision shall be binding upon Landlord and Tenant.

                                   2.3.4.6          If the two arbitrators fail to agree upon and appoint a third arbitrator, or both parties fail to appoint an arbitrator, then the appointment of the third arbitrator or any arbitrator shall be dismissed and the matter to be decided shall be forthwith submitted to arbitration under the provisions of the American Arbitration Association Commercial Rules of Arbitration, but subject to the instruction set forth in this Section 2.3.4.

                                   2.3.4.7          The cost of the arbitrator appointed by Landlord shall be paid by Landlord. The cost of the arbitrator appointed by Tenant shall be paid by Tenant. The cost of the third arbitrator shall be shared equally by Landlord and Tenant.

          2.4          Early Termination. If a majority of the outstanding voting stock of Tenant is acquired by a person or entity which is not an Affiliate of Tenant (“Ownership Change”) at any time prior to the date which is the last day of the thirty-third (33rd) full calendar month of the Lease Term (the “Election Date”), Tenant may deliver, not later than the Election Date, written notice to Landlord electing to cause the Expiration Date to be the last day of the forty-second (42nd) full calendar month of the Lease Term (the “Early Expiration Date”). Such notice shall be effective only if reasonable evidence of such Ownership Change and the Termination Payment accompanies the Tenant’s notice electing the Early Expiration Date. As used herein, the “Termination Payment” means an amount equal to (i) the total unamortized out-of-pocket cost to Landlord as of the Early Expiration Date for the Tenant Improvements and payments to the brokers (as contemplated by Section 28.24 below) (such out-of-pocket costs to be amortized on a straight line basis assuming an eight percent (8%) interest rate over a sixty (60) month period commencing on the Lease Commencement Date or, if the Lease Commencement Date is not the first date of a calendar month, then the first day of the calendar month immediately following the Lease Commencement Date), plus (ii) Two Hundred Sixty-Six Thousand One Hundred and 80/100 Dollars ($266,100.80). Notwithstanding anything herein to the contrary, Tenant’s rights under Section 2.3 above shall automatically terminate without notice to Tenant upon Tenant’s delivery of the notice electing an early termination of this Lease.

ARTICLE 3

BASE RENT

          Tenant shall pay, without prior notice or demand, to Landlord or Landlord’s agent at the management office of the Project or, at Landlord’s option, at such other place as Landlord may from time to time designate in writing, by a check for currency which, at the time of payment, is legal tender for private or public debts in the United States of America, base rent (“Base Rent”) as set forth in Section 4 of the Summary, payable in equal monthly installments as set forth in Section 4 of the Summary in advance on or before the first day of each and every calendar month during the Lease Term, without any setoff or deduction whatsoever. If any Base Rent payment date (including the Lease Commencement Date) falls on a day of the month other than the first day of such month or if any payment of Base Rent is for a period which is shorter than one month, the Base Rent for any fractional month shall accrue on a daily basis for the period from the date such payment is due to the end of such calendar month or to the end of the Lease Term at a rate per day which is equal to 1/365 of the applicable annual Base Rent. All other payments or adjustments required to be made under the terms of this Lease that require proration on a time basis shall be prorated on the same basis.

 

 

 

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ARTICLE 4

ADDITIONAL RENT; SECURITY DEPOSIT

          4.1     General Terms. In addition to paying the Base Rent specified in Article 3 of this Lease, Tenant shall pay Tenant’s Share (as defined below) of the annual Building Direct Expenses (as defined below) which are in excess of the amount of Building Direct Expenses for the Base Year (as defined below); provided, however, that in no event shall any decrease in Building Direct Expenses for any Expense Year (as defined below) below Building Direct Expenses for the Base Year entitle Tenant to any decrease in Base Rent or any credit against sums due under this Lease. Such payments by Tenant, together with any and all other amounts payable by Tenant to Landlord pursuant to the terms of this Lease, are hereinafter collectively referred to as the “Additional Rent”, and the Base Rent and the Additional Rent are herein collectively referred to as “Rent”. All amounts due under this Article 4 as Additional Rent shall be payable for the same periods and in the same manner as the Base Rent. Without limitation on other obligations of Tenant which survive the expiration of the Lease Term, the obligations of Tenant to pay the Additional Rent provided for in this Article 4 shall survive the expiration of the Lease Term.

          4.2     Definitions of Key Terms Relating to Additional Rent. As used in this Article 4, the following terms shall have the meanings hereinafter set forth:

                    4.2.1           Base Year. “Base Year” shall mean the period set forth in Section 5 of the Summary.

                    4.2.2           Building Direct Expenses. “Building Direct Expenses” shall mean Building Operating Expenses and Building Tax Expenses (as defined below).

                    4.2.3           Building Operating Expenses. “Building Operating Expenses” shall mean the portion of Operating Expenses (as defined below) allocated to the tenants of the Building pursuant to the terms of Section 4.3 below.

                    4.2.4           Building Tax Expenses. “Building Tax Expenses” shall mean that portion of Tax Expenses (as defined below) allocated to the tenants of the Building pursuant to the terms of Section 4.3 below.

                    4.2.5           Direct Expenses. “Direct Expenses” shall mean Operating Expenses and Tax Expenses.

                    4.2.6           Expense Year. “Expense Year” shall mean each calendar year in which any portion of the Lease Term falls, through and including the calendar year in which the Lease Term expires. Landlord, upon notice to Tenant, may change the Expense Year from time to time to any other twelve (12) consecutive month period and, in the event of any such change, Tenant’s Share of Building Direct Expenses shall be equitably adjusted for any Expense Year involved in any such change.

                    4.2.7           Operating Expenses.

                              4.2.7.1           Inclusions to Operating Expenses. “Operating Expenses” shall mean all expenses, costs and amounts of every kind and nature which Landlord pays during any Expense Year because of or in connection with the ownership, management, maintenance, security, repair, replacement, restoration or operation of the Project, or any portion thereof, subject to the terms and provisions of Section 4.2.7. Without limiting the generality of the foregoing, Operating Expenses shall specifically include any and all of the following:

 

 

 

 

 

                    (i)          the cost of supplying all utilities, the cost of operating, repairing, maintaining, and renovating the utility, telephone, mechanical, sanitary, storm drainage, and elevator systems, and the cost of maintenance and service contracts in connection therewith;

 

 

 

 

 

                    (ii)          the cost of licenses, certificates, permits and inspections and the cost of contesting any governmental enactments which may affect


 

 

 

 

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Operating Expenses, and the costs incurred in connection with a governmentally mandated transportation system management program or similar program;

 

 

 

 

 

                    (iii)           the cost of earthquake insurance and all other insurance carried by Landlord in connection with the Project as reasonably determined by Landlord;

 

 

 

 

 

                    (iv)           the cost of landscaping, relamping, and all supplies, tools, equipment and materials used in the operation, repair and maintenance of the Project, or any portion thereof;

 

 

 

 

 

                    (v)           the cost of non-capital (as determined pursuant to generally accepted accounting principles) parking area repair, restoration, and maintenance;

 

 

 

 

 

                    (vi)           fees and other costs, including reasonable management fees, consulting fees, legal fees and accounting fees, of all contractors and consultants in connection with the management, operation, maintenance and repair of the Project;

 

 

                    (vii)           payments under any equipment rental agreements and the fair rental value of any management office space;

 

 

 

 

 

                    (viii)           subject to Section 4.2.7.2(vi) below, wages, salaries and other compensation and benefits, including taxes levied thereon, of all persons engaged in the operation, maintenance and security of the Project;

 

 

 

 

 

                    (ix)           operation, repair and maintenance of all systems and equipment and components thereof of the Project;

 

 

 

 

 

                    (x)           the cost of janitorial, alarm, security and other services, replacement of wall and floor coverings, ceiling tiles and fixtures in Common Areas, maintenance and replacement of curbs and walkways, and repair to roofs and reroofing;

 

 

 

 

 

                    (xi)           amortization (including interest on the unamortized cost) over the useful life, determined in accordance with generally accepted accounting principles, of the cost of acquiring or the rental expense of personal property used in the maintenance, operation and repair of the Project, or any portion thereof;

 

 

 

 

 

                    (xii)           the cost of capital improvements or other costs incurred in connection with the Project (A) which are intended to effect economies in the operation or maintenance of the Project, or any portion thereof (but only to the extent of the annual cost savings reasonably anticipated by Landlord), (B) that are required to comply with present or anticipated reasonable conservation programs, (C) which are replacements of nonstructural items located in the Common Areas required to keep the Common Areas in good order or condition, or (D) that are required under any governmental law or regulation enacted after the date of this Lease; provided, however, that any capital expenditure shall be amortized (including interest on the amortized cost) over its useful life reasonably determined in accordance with generally accepted accounting principles;

 

 

 

 

 

                    (xiii)           costs, fees, charges or assessments imposed by, or resulting from any mandate imposed on Landlord by, any federal, state or local government for fire and police protection, trash removal, community services, or other services which do not constitute Tax Expenses; and

 

 

 

 

 

                    (xiv)           payments under any easement, license, operating agreement, declaration, restrictive covenant, or instrument pertaining to the sharing of costs by the Building with other buildings in the Project.

 

 

 

                          4.2.7.2           Exclusions to Operating Expenses. Notwithstanding the provisions of Section 4.2.7.1 above, for purposes of this Lease, Operating Expenses shall not, however, include:


 

 

 

 

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                    (i)         costs, including marketing costs, legal fees, space planners’ fees, advertising and promotional expenses, and brokerage fees incurred in connection with the original construction or development, or original or future leasing of the Project, and costs, including permit, license and inspection costs, incurred with respect to the installation of tenant improvements made for new tenants initially occupying space in the Project after the Lease Commencement Date or incurred in renovating or otherwise improving, decorating, painting or redecorating vacant space for tenants or other occupants of the Project (excluding, however, such costs relating to any Common Areas or parking facilities);

 

 

 

 

 

                    (ii)        except as set forth in Sections 4.2.7. 1 (xi), (xii), and (xiii) above, depreciation, interest and principal payments on mortgages and other debt costs, if any, penalties and interest, costs of capital repairs and alterations, and costs of capital improvements and equipment;

 

 

 

 

 

                    (iii)       costs for which Landlord is reimbursed by any tenant or occupant of the Project or by insurance by its carrier or any tenant’s carrier or by anyone else, and electric power costs for which any tenant directly contracts with the local public service company;

 

 

 

 

 

                    (iv)       any bad debt loss, rent loss, or reserves for bad debts or rent loss;

 

 

 

 

 

                    (v)        costs associated with the operation of the business of the partnership or entity which constitutes Landlord, as the same are distinguished from the costs of operation of the Project (which shall specifically include, but not be limited to, accounting costs associated with the operation of the Project). Costs associated with the operation of the business of the partnership or entity which constitutes Landlord include costs of partnership accounting and legal matters, costs of defending any lawsuits with any mortgagee (except as the actions of the Tenant may be in issue), costs of selling, syndicating, financing, mortgaging or hypothecating any of Landlord’s interest in the Project, and costs incurred in connection with any disputes between Landlord and its employees, between Landlord and Project management, or between Landlord and other tenants or occupants, and Landlord’s general corporate overhead and general and administrative expenses;

 

 

 

 

 

                    (vi)       the wages and benefits of any employee who does not devote substantially all of his or her employed time to the Project unless such wages and benefits are prorated to reflect time spent on operating and managing the Project vis-a-vis time spent on matters unrelated to operating and managing the Project; provided, that in no event shall Operating Expenses for purposes of this Lease include wages and/or benefits attributable to personnel above the level of Project manager;

 

 

 

 

 

                    (vii)      amounts paid as ground rental for the Project by Landlord;

 

 

 

 

 

                    (viii)     except for a Project management fee to the extent allowed pursuant to item (xiii), below, overhead and profit increment paid to the Landlord or to subsidiaries or affiliates of Landlord for services in the Project to the extent the same exceeds the costs of such services rendered by qualified, first-class unaffiliated third parties on a competitive basis;

 

 

 

 

 

                    (ix)       any compensation paid to clerks, attendants or other persons in commercial concessions operated by Landlord, provided that any compensation paid to any concierge at the Project shall be includable as an Operating Expense;

 

 

 

 

 

                    (x)        rentals and other related expenses incurred in leasing air conditioning systems, elevators or other equipment which if purchased the cost of which would be excluded from Operating Expenses as a capital cost, except equipment not affixed to the Project which is used in providing janitorial or


 

 

 

 

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similar services and, further excepting from this exclusion such equipment rented or leased to remedy or ameliorate an emergency condition in the Project;

 

 

 

 

 

                    (xi)       all items and services for which Tenant or any other tenant in the Project reimburses Landlord or which Landlord provides selectively to one or more tenants (other than Tenant) without reimbursement;

 

 

 

 

 

                    (xii)      costs, other than those incurred in ordinary maintenance and repair, for sculpture, paintings, fountains or other objects of art;

 

 

 

 

 

                    (xiii)     fees payable by Landlord for management of the Project in excess of five percent (5%) (the “Management Fee Cap”) of Landlord’s gross rental revenues, adjusted and grossed up to reflect a one hundred percent (100%) occupancy of the Building with all tenants paying rent, including base rent, pass-throughs, and parking fees (but excluding the cost of after hours services or utilities) from the Project for any calendar year or portion thereof;

 

 

 

 

 

                    (xiv)     any costs expressly excluded from Operating Expenses elsewhere in this Lease;

 

 

 

 

 

                    (xv)       rent for any office space occupied by Project management personnel to the extent the size or rental rate of such office space exceeds the size or fair market rental value of office space occupied by management personnel of the Comparable Buildings in the vicinity of the Building, with adjustment where appropriate for the size of the applicable project;

 

 

 

 

 

                    (xvi)     costs arising from the negligence or willful misconduct of Landlord or its agents, employees, vendors, contractors, or providers of materials or services;

 

 

 

 

 

                    (xvii)    costs (A) incurred to comply with laws relating to the removal of Hazardous Material (as defined below) except for immaterial amounts completed in connection with routine maintenance and repairs; which was in existence in the Building or on the Project prior to the Lease Commencement Date, and was of such a nature that a federal, State or municipal governmental authority, if it then had knowledge of the presence of such Hazardous Material, in the state, and under the conditions that it then existed in the Building or on the Project, would have then required the removal of such Hazardous Material or other remedial or containment action with respect thereto; and (B) costs incurred to remove, remedy, contain, or treat Hazardous Material, which hazardous material is brought into the Building or onto the Project after the date hereof by Landlord or any other tenant of the Project and is of such a nature, at that time, that a federal, State or municipal governmental authority, if it had then had knowledge of the presence of such Hazardous Material, in the state, and under the conditions, that it then exists in the Building or on the Project, would have then required the removal of such Hazardous Material or other remedial or containment action with respect thereto except for immaterial amounts completed in connection with routine maintenance and repairs;

 

 

 

 

 

                    (xviii)   costs arising from Landlord’s charitable or political contributions;

 

 

 

 

 

                    (xix)     any gifts provided to any entity whatsoever, including, but not limited to, Tenant, other tenants, employees, vendors, contractors, prospective tenants and agents;

 

 

 

 

 

                    (xx)      the cost of any magazine, newspaper, trade or other subscriptions;

 

 

 

 

 

                    (xxi)     any amount paid to Landlord or to subsidiaries or affiliates of Landlord for services in the Project to the extent the same exceeds the cost of such services rendered by qualified, first-class unaffiliated third parties on a competitive basis;


 

 

 

 

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                    (xxii)     costs arising from Landlord’s failure to comply with any applicable governmental laws or regulations in existence at the time of the Lease Commencement Date;

 

 

 

 

 

                    (xxiii)    costs relating to categories of expenses for the Project parking areas which were not included in Operating Expenses during the Base Year, except to the extent the Base Year is retroactively adjusted to include such categories; and

 

 

 

 

 

                    (xxiv)    any entertainment expenses and travel expenses of Landlord, its employees, agents, partners and affiliates.

          If Landlord is not furnishing any particular work or service (the cost of which, if performed by Landlord, would be included in Operating Expenses) to a tenant who has undertaken to perform such work or service in lieu of the performance thereof by Landlord, Operating Expenses shall be deemed to be increased by an amount equal to the additional Operating Expenses which would reasonably have been incurred during such period by Landlord if it had at its own expense furnished such work or service to such tenant. If the Project is not at least ninety-five percent (95%) occupied during all or a portion of the Base Year or any Expense Year, Landlord shall make an appropriate adjustment to the components of Operating Expenses for such year to determine the amount of Operating Expenses that would have been incurred had the Project been ninety-five percent (95%) occupied; and the amount so determined shall be deemed to have been the amount of Operating Expenses for such year. Operating Expenses for the Base Year shall not include market-wide labor-rate increases due to extraordinary circumstances, including, but not limited to, boycotts and strikes, and utility rate increases due to extraordinary circumstances including, but not limited to, conservation surcharges, boycotts, embargoes or other shortages, or amortized costs relating to capital improvements.

                    4.2.8           Taxes.

                                   4.2.8.1 Tax Expenses. “Tax Expenses” shall mean all federal, state, county, or local governmental or municipal taxes, fees, charges or other impositions of every kind and nature, whether general, special, ordinary or extraordinary (including, without limitation, real estate taxes, general and special assessments, transit taxes, leasehold taxes or taxes based upon the receipt of rent, including gross receipts or sales taxes applicable to the receipt of rent, unless required to be paid by Tenant, personal property taxes imposed upon the fixtures, machinery, equipment, apparatus, systems and equipment, appurtenances, furniture and other personal property used in connection with the Project, or any portion thereof), which shall be paid or accrued during any Expense Year (without regard to any different fiscal year used by such governmental or municipal authority) because of or in connection with the ownership, leasing and operation of the Project, or any portion thereof including the parking areas. Tax Expenses shall include, without limitation:

 

 

 

 

 

                    (i)          any tax on the rent, right to rent or other income from the Project, or any portion thereof, or as against the business of leasing the Project, or any portion thereof;

 

 

 

 

 

                    (ii)          any assessment, tax, fee, levy or charge in addition to, or in substitution, partially or totally, of any assessment, tax, fee, levy or charge previously included within the definition of real property tax, it being acknowledged by Tenant and Landlord that Proposition 13 was adopted by the voters of the State of California in the June 1978 election (“Proposition 13”) and that assessments, taxes, fees, levies and charges may be imposed by governmental agencies for such services as fire protection, street, sidewalk and road maintenance, refuse removal and for other governmental services formerly provided without charge to property owners or occupants, and, in further recognition of the decrease in the level and quality of governmental services and amenities as a result of Proposition 13, Tax Expenses shall also include any governmental or private assessments or the Project’s contribution towards a governmental or private cost-sharing agreement for the purpose of augmenting or improving the quality of services and amenities normally provided by governmental agencies;


 

 

 

 

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                    (iii)           any assessment, tax, fee, levy, or charge allocable to or measured by the area of the Premises or the Rent payable hereunder, including, without limitation, any business or gross income tax or excise tax with respect to the receipt of such rent, or upon or with respect to the possession, leasing, operating, management, maintenance, alteration, repair, use or occupancy by Tenant of the Premises, or any portion thereof;

 

 

 

                    (iv)           any assessment, tax, fee, levy or charge, upon this transaction or any document to which Tenant is a party, creating or transferring an interest or an estate in the Premises; and

 

 

 

                    (v)           all of the real estate taxes and assessments imposed upon or with respect to the Building and Project. To the extent such taxes are not currently known, Landlord shall reasonably estimate the taxes and the Base Year Tax Expenses shall be adjusted accordingly upon receipt of the actual tax adjustment based upon such reassessment.

                              4.2.8.2           Other Costs. Any costs and expenses (including, without limitation, reasonable attorneys’ and consultants’ fees) incurred in attempting to protest, reduce or minimize Tax Expenses shall be included in Tax Expenses in the Expense Year such expenses are incurred. Tax refunds shall be credited against Tax Expenses and refunded to Tenant regardless of when received, based on the Expense Year to which the refund is applicable; provided, however, in no event shall the amount to be refunded Tenant for any such Expense Year exceed the total amount paid by Tenant as Additional Rent under this Article 4 for such Expense Year. If Tax Expenses for any period during the Lease Term or any extension thereof are increased after payment thereof for any reason, including, without limitation, error or reassessment by applicable governmental or municipal authorities, Tenant shall pay Landlord upon demand Tenant’s Share of any such increased Tax Expenses included by Landlord as Building Tax Expenses pursuant to the terms of this Lease. Notwithstanding anything to the contrary contained in this Section 4.2.8 (except as set forth in Section 4.2.8.1, above), there shall be excluded from Tax Expenses (i) all excess profits taxes, franchise taxes, gift taxes, capital stock taxes, inheritance and succession taxes, estate taxes, federal and state income taxes, and other taxes to the extent applicable to Landlord’s general or net income (as opposed to rents, receipts or income attributable to operations at the Project), (ii) any items included as Operating Expenses, and (iii) any items paid by Tenant under Section 4.5 of this Lease.

                              4.2.8.3           Base Taxes. The amount of Tax Expenses for the Base Year attributable to the valuation of the Project, inclusive of tenant improvements, shall be known as the “Base Taxes.” If in any comparison year subsequent to the Base Year the amount of Tax Expenses decreases below the amount of Base Taxes for the Premises, then for purposes of all subsequent comparison years, including the comparison year in which such decrease in Tax Expenses occurred, the Base Taxes and therefore the Base Year shall be decreased by an amount equal to the decrease in Tax Expenses; provided, however, if the amount of Tax Expenses for the Premises subsequently increases in any comparison year from that decreased amount, the Base Taxes for the Premises shall be increased by an amount equal to the increase in the Tax Expenses for the Premises but not in excess of the Base Taxes for the Base Year (calendar year 2008).

                    4.2.9           Tenant’s Share. “Tenant’s Share” shall mean the percentages set forth in Section 6 of the Summary. Tenant’s Share is calculated by multiplying the number of rentable square feet of the Premises as set forth in Section 2 of the Summary by 100, and dividing the applicable product by the rentable square feet in the Building. The rentable square feet in the Premises and Building is measured pursuant to the Building Owners and Managers Association Standard Method for Measuring Floor Area in Office Buildings, ANSI/BOMA Z65.1 - 1996 (“BOMA”), provided that the rentable square footage of the Building shall include all of, and the rentable square footage of the Premises therefore shall include a portion of, the square footage of the ground floor Common Areas located within the Building and the Common Area and occupied space of the portion of the Building or Project, dedicated to the service of the Building. In the event either the rentable square feet of the Premises and/or the total rentable square feet of the Building is remeasured, Tenant’s Share for the Premises shall be appropriately adjusted and, as to the Expense Year in which such change occurs, Tenant’s Share for the Premises for such Expense Year shall be determined on the basis of the number of days during such Expense Year that each such Tenant’s Share was in effect.

 

 

 

 

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          4.3           Allocation of Direct Expenses. The parties acknowledge that the Building is a part of a multi-building project and that the costs and expenses incurred in connection with the Project (i.e., the Direct Expenses) should be shared between the tenants of the Building and the tenants of the other buildings in the Project. Accordingly, as set forth in Section 4.2 above, Direct Expenses (which consist of Operating Expenses and Tax Expenses) are determined annually for the Project as a whole, and a portion of the Direct Expenses, which portion shall be determined by Landlord in accordance with the CC&Rs, shall be allocated to the tenants of the Building (as opposed to the tenants of any other buildings in the Project) and such portion shall be the Building Direct Expenses for purposes of this Lease (such allocation in accordance with the CC&Rs is further described in Exhibit E hereto). Such portion of Direct Expenses allocated to the tenants of the Building shall include all Direct Expenses attributable solely to the Building and an equitable portion of the Direct Expenses attributable to the Project as a whole.

          4.4           Calculation and Payment of Additional Rent. If for any Expense Year ending or commencing within the Lease Term, the applicable Tenant’s Share of Building Direct Expenses for such Expense Year exceeds the applicable Tenant’s Share of Building Direct Expenses applicable to the Base Year for the Premises, then Tenant shall pay to Landlord, in the manner set forth in Section 4.4.1, below, and as Additional Rent, an amount equal to the excess (the “Excess”).

                          4.4.1           Statement of Actual Building Direct Expenses and Payment by Tenant. Landlord shall give to Tenant following the end of each Expense Year, a statement (the “Statement”) which shall state the Building Direct Expenses incurred or accrued for such preceding Expense Year and which shall indicate the amount of the Excess. Upon receipt of the Statement for each Expense Year commencing or ending during the Lease Term, if an Excess is present, Tenant shall pay, with its next installment of Base Rent due, the full amount of the Excess for such Expense Year, less the amounts, if any, paid during such Expense Year as Estimated Excess (as defined below), and if Tenant paid more as Estimated Excess than the actual Excess, Tenant shall receive a credit in the amount of Tenant’s overpayment against Rent next due under this Lease. The failure of Landlord to timely furnish the Statement for any Expense Year shall not prejudice Landlord or Tenant from enforcing its rights under this Article 4. Even though the Lease Term has expired and Tenant has vacated the Premises, when the final determination is made of Tenant’s Share of Building Direct Expenses for the Expense Year in which this Lease terminates, if an Excess is present, Tenant shall immediately pay to Landlord such amount, and if Tenant paid more as Estimated Excess than the actual Excess, Landlord shall, within thirty (30) days, deliver a check payable to Tenant in the amount of the overpayment. The provisions of this Section 4.4.1 shall survive the expiration or earlier termination of the Lease Term.

                          4.4.2           Statement of Estimated Building Direct Expenses. Landlord shall give Tenant a yearly expense estimate statement (the “Estimate Statement”) which shall set forth Landlord’s reasonable estimate (the “Estimate”) of what the total amount of Building Direct Expenses for the then-current Expense Year shall be and the estimated excess (the “Estimated Excess”) as calculated by comparing the Building Direct Expenses for such Expense Year, which shall be based upon the Estimate, to the amount of Building Direct Expenses for the Base Year. The failure of Landlord to timely furnish the Estimate Statement for any Expense Year shall not preclude Landlord from enforcing its rights to collect any Estimated Excess under this Article 4, nor shall Landlord be prohibited from revising any Estimate Statement or Estimated Excess theretofore delivered to the extent necessary. Thereafter, Tenant shall pay, with its next installment of Base Rent due, a fraction of the Estimated Excess for the then-current Expense Year (reduced by any amounts paid pursuant to the last sentence of this Section 4.4.2). Such fraction shall have as its numerator the number of months which have elapsed in such current Expense Year, including the month of such payment, and twelve (12) as its denominator. Until a new Estimate Statement is furnished (which Landlord shall have the right to deliver to Tenant at any time), Tenant shall pay monthly, with the monthly Base Rent installments, an amount equal to one-twelfth (1/12) of the total Estimated Excess set forth in the previous Estimate Statement delivered by Landlord to Tenant.

          4.5           Taxes and Other Charges for Which Tenant Is Directly Responsible.

                          4.5.1           Personal Property Taxes. Tenant shall be liable for and shall pay ten (10) days before delinquency, taxes levied against Tenant’s equipment, furniture, fixtures and

 

 

 

 

 

 

 

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any other personal property located in or about the Premises. If any such taxes on Tenant’s equipment, furniture, fixtures and any other personal property are levied against Landlord or Landlord’s property or if the assessed value of Landlord’s property is increased by the inclusion therein of a value placed upon such equipment, furniture, fixtures or any other personal property and if Landlord pays the taxes based upon such increased assessment, which Landlord shall have the right to do regardless of the validity thereof but only under proper protest if requested by Tenant, Tenant shall upon demand repay to Landlord the taxes so levied against Landlord or the proportion of such taxes resulting from such increase in the assessment, as the case may be.

                          4.5.2           Taxes on Improvements in Premises. If the tenant improvements in the Premises, whether installed and/or paid for by Landlord or Tenant and whether or not affixed to the real property so as to become a part thereof, are assessed for real property tax purposes at a valuation higher than the valuation at which tenant improvements conforming to Landlord’s “building standard” in other space in the Building are assessed, then the Tax Expenses levied against Landlord or the property by reason of such excess assessed valuation shall be deemed to be taxes levied against personal property of Tenant and shall be governed by the provisions of Section 4.5.1, above; provided that Landlord uniformly applies such excess assessed valuation for the same period uniformly to all tenants in the Building.

                          4.5.3           Other Taxes. Notwithstanding any contrary provision herein, Tenant shall pay prior to delinquency any (i) rent tax or sales tax, service tax, transfer tax or value added tax, or any other applicable tax on the rent or services herein or otherwise respecting this Lease, (ii) taxes assessed upon or with respect to the possession, leasing, operation, management, maintenance, alteration, repair, use or occupancy by Tenant of the Premises or any portion of the Project, including the Project parking facility, or (iii) taxes assessed upon this transaction or any document to which Tenant is a party creating or transferring an interest or an estate in the Premises.

          4.6           Landlord’s Books and Records. Within six (6) months after receipt of a Statement by Tenant, if Tenant disputes the amount of Additional Rent set forth in the Statement, an independent certified public accountant (which accountant is a member of a nationally recognized accounting firm, has previous experience in reviewing financial operating records of landlords of office buildings, and is retained by Tenant on a non contingency fee basis) (the “Tenant Auditor”), designated and paid for by Tenant, may, after reasonable notice to Landlord and at reasonable times, inspect Landlord’s records with respect to the Statement at Landlord’s offices, provided that Tenant is not then in default under this Lease and Tenant has paid all amounts required to be paid under the applicable Estimated Statement and Statement, as the case may be. In connection with such inspection, Tenant and Tenant’s agents must agree in advance to follow Landlord’s reasonable rules and procedures regarding inspections of Landlord’s records, and shall execute a commercially reasonable confidentiality agreement regarding such inspection. Tenant’s failure to dispute the amount of Additional Rent set forth in any Statement within six (6) months following Tenant’s receipt of such Statement shall be deemed to be Tenant’s approval of such Statement and Tenant, thereafter, waives the right or ability to dispute the amounts set forth in such Statement. If after such inspection, Tenant still disputes such Additional Rent, a determination as to the proper amount shall be made, at Tenant’s expense, by an independent certified public accountant (the “Accountant”) selected by Landlord and subject to Tenant’s reasonable approval; provided that if such certification by the Accountant proves that Direct Expenses were overstated by more than five percent (5%), then the cost of the Accountant, and the cost of such determination certification, shall be paid by Landlord. Any reimbursement amounts determined to be owing by Landlord to Tenant or by Tenant to Landlord shall be (i) in the case of amounts owing from Tenant to Landlord, paid within thirty (30) days following such determination, and (ii) in the case of amounts owing from Landlord to Tenant, credited against the next payment of Rent due Landlord under the terms of this Lease, or if the Lease Term has expired, paid to Tenant within thirty (30) days following such determination. In no event shall this Section 4.6 be deemed to allow any review of any of Landlord’s records by any subtenant of Tenant. Tenant agrees that this Section 4.6 shall be the sole method to be used by Tenant to dispute the amount of any Direct Expenses payable or not payable by Tenant pursuant to the terms of this Lease, and Tenant hereby waives any other rights at law or in equity relating thereto.

 

 

 

 

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          4.7           Security Deposit.

                          4.7.1           Security Deposit. The amount of Sixty-Four Thousand One Hundred Forty-Nine and 30/100 Dollars ($64,149.30) shall serve as the security deposit hereunder (the “Security Deposit”). On the Lease Commencement Date, at Tenant’s request, Landlord shall cooperate with Tenant in the transfer of Tenant’s security deposit for the Current Premises subject to the rights of the landlord under the Current Premises Lease. Such sum shall be accepted by Landlord as a portion of the Security Deposit and Tenant shall on the Lease Commencement Date deliver to Landlord such additional funds as are necessary so that the Security Deposit held by Landlord under this Lease equals Sixty-Four Thousand One Hundred Forty-Nine and 30/100 Dollars ($64,149.30). Landlord shall hold the Security Deposit as security for the performance of Tenant’s obligations under this Lease. If Tenant defaults on any provision of this Lease, Landlord may, after such notice as may be required under this Lease and without prejudice to any other remedy it has, apply all or a part of the Security Deposit to:

                                              4.7.1.1           Any Rent or other sum in default; or

                                              4.7.1.2           Any expense, loss, or damage that Landlord may suffer because of Tenant’s default including, without limitation, Rent that would accrue after such default.

                          4.7.2           Landlord’s Transfer of Security Deposit on Transfer of Real Property. If Landlord disposes of its interests in the Premises, Landlord may deliver or credit the Security Deposit to Landlord’s successor-in-interest in the Premises and thereupon be relieved of further responsibility with respect to the Security Deposit.

                          4.7.3           Restoration of Security Deposit. If Landlord applies any portion of the Security Deposit pursuant to Section 4.7.1 above, Tenant shall, within thirty (30) days after demand by Landlord, deposit with Landlord an amount sufficient to restore the Security Deposit to its original amount.

                          4.7.4           Interest on Security Deposit. Tenant is not entitled to any interest on the Security Deposit.

                          4.7.5           Return of Security Deposit. If Tenant performs every provision of this Lease to be performed by Tenant, the unused portion of the Security Deposit shall be returned to Tenant or the last assignee of Tenant’s interest under this Lease within thirty (30) days following the expiration or termination of the Lease Term.

ARTICLE 5

USE OF PREMISES

          5.1           Permitted Use. Tenant shall use the Premises solely for the Permitted Use set forth in Section 7 of the Summary and Tenant shall not use or permit the Premises or the Project to be used for any other purpose or purposes whatsoever without the prior written consent of Landlord, which may be withheld in Landlord’s sole discretion.

          5.2           Prohibited Uses. Tenant further covenants and agrees that Tenant shall not use, or suffer or permit any person or persons to use, the Premises or any part thereof for any use or purpose contrary to the provisions of the Rules and Regulations set forth in Exhibit F, attached hereto, or in violation of the laws of the United States of America, the State of California, or the ordinances, regulations or requirements of the local municipal or county governing body or other lawful authorities having jurisdiction over the Project including, without limitation, any such laws, ordinances, regulations or requirements relating to Hazardous Material. Tenant shall not do or permit anything to be done in or about the Premises which will in any way obstruct or interfere with the rights of other tenants or occupants of the Building or Project, or injure or annoy them or use or allow the Premises to be used for any improper, unlawful or objectionable purpose, nor shall Tenant cause, maintain or permit any nuisance in, on or about the Premises. Tenant shall comply with, and Tenant’s rights and obligations under the Lease and Tenant’s use of the Premises shall be subject and subordinate to, all recorded easements, covenants, conditions and restrictions now or hereafter affecting the Project; provided, however, Landlord warrants that such recorded easements, covenants, conditions and restrictions do not materially interfere with Tenant’s use or occupancy of the Premises or Common Areas.

 

 

 

 

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          5.3           Tenant’s Security Responsibilities. Tenant shall (1) lock the doors to the Premises and take other reasonable steps to secure the Premises and the personal property of all Tenant Parties and any of Tenant’s transferees, contractors or licensees in the Common Areas and parking facilities of the Building and Project, from unlawful intrusion, theft, fire and other hazards; (2) keep and maintain in good working order all security and safety devices installed in the Premises by or for the benefit of Tenant (such as locks, smoke detectors and burglar alarms); and (3) cooperate with Landlord and other tenants in the Building on Building safety matters. Tenant acknowledges that Landlord is not obligated to provide security personnel or measures for the protection of Tenant, its employees, invitees or personal property. Tenant further acknowledges that any security or safety measures employed by Landlord are for the protection of Landlord’s own interests; that Landlord is not a guarantor of the security or safety of the Tenant Parties or their property; and that such security and safety matters are the responsibility of Tenant and the local law enforcement authorities.

ARTICLE 6

SERVICES AND UTILITIES

          6.1           Standard Tenant Services. Landlord shall provide the following services on all days (unless otherwise stated below) during the Lease Term.

                          6.1.1           Subject to limitations imposed by all governmental rules, regulations and guidelines applicable thereto, Landlord shall provide heating, ventilation and air conditioning (“HVAC”) when necessary for normal comfort for normal office use in the Premises from 8:00 A.M. to 6:00 P.M. Monday through Friday, and on Saturdays from 9:00 A.M. to 1:00 P.M. (collectively, the “Building Hours”), except for the date of observation of New Year’s Day, Independence Day, Labor Day, Memorial Day, Thanksgiving Day, Christmas Day and, at Landlord’s discretion, other locally or nationally recognized holidays (collectively, the “Holidays”).

                          6.1.2           Landlord shall provide adequate electrical wiring and facilities for connection to Tenant’s lighting fixtures and incidental use equipment, provided that (i) the connected electrical load of the incidental use equipment does not exceed an average of six (6) watts per usable square foot of the Premises, and (ii) the connected electrical load of Tenant’s lighting fixtures does not exceed an average of two (2) watts per usable square foot of the Premises, which electrical usage shall be subject to applicable laws and regulations, including Title 24. Tenant shall bear the cost of replacement of lamps, starters and ballasts for non-Building standard lighting fixtures within the Premises.

                          6.1.3           Landlord shall provide city water from the regular Building outlets for drinking, lavatory and toilet purposes in the Building Common Areas.

                          6.1.4           Landlord shall provide janitorial services to the Premises and window washing services in a manner consistent with Comparable Buildings.

                          6.1.5           Landlord shall provide nonexclusive, non-attended automatic passenger elevator service during the Building Hours and shall have one elevator available at all other times, including on the Holidays.

                          6.1.6           Landlord shall provide nonexclusive freight elevator service subject to scheduling by Landlord.

          Tenant shall cooperate fully with Landlord at all times and abide by all regulations and requirements that Landlord may reasonably prescribe for the proper functioning and protection of the HVAC, electrical, mechanical and plumbing systems.

          6.2           Overstandard Tenant Use.

                          6.2.1           Non-Electrical Usage. Tenant shall not, without Landlord’s prior written consent, use heat-generating machines, machines other than normal fractional horsepower office machines, or equipment or lighting other than Building standard lights in the Premises, which may affect the temperature otherwise maintained by the air conditioning system or increase the water normally furnished for the Premises by Landlord pursuant to the terms of

 

 

 

 

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Section 6.1 of this Lease. If Tenant uses water, heat or air conditioning in excess of that supplied by Landlord pursuant to Section 6.1 of this Lease, Tenant shall pay to Landlord, upon billing, the actual cost of such excess consumption, the cost of the installation, operation, and maintenance of equipment which is installed in order to supply such excess consumption, and the cost of the increased wear and tear on existing equipment caused by such excess consumption; and Landlord may install devices to separately meter any increased use and in such event Tenant shall pay the cost of such increased use directly to Landlord, on demand, at the rates charged by the public utility company furnishing the same, including the cost of such additional metering devices. If Tenant desires to use HVAC during non-Building Hours, Tenant shall give Landlord such prior notice, if any, as Landlord shall from time to time establish as appropriate, of Tenant’s desired use in order to supply HVAC, and Landlord shall supply HVAC to the Premises. The cost of after-hours HVAC is currently Sixty-Five Dollars ($65.00 ) per hour, per floor. Such cost shall increase hereafter to the extent of an increase occurring after the date of this Lease in the direct and indirect cost to Landlord of providing such HVAC services. The cost of HVAC supplied by Landlord during non-Building Hours shall be paid by Tenant as Additional Rent.

                        6.2.2          Electrical Usage. If in any month Tenant uses electricity (not including any electricity consumed in connection with the operation of the Building’s main HVAC system) in excess of the Electricity Usage Standard (as defined below), Tenant shall pay to Landlord, upon billing, Landlord’s cost of such excess consumption and the reasonable cost of the installation, operation, and maintenance of equipment which is required to be installed to supply such excess capacity and/or consumption to Tenant. For purposes hereof, the “Electricity Usage Standard” shall be an average of five (5) watts per rentable square foot of the Premises of actual consumption, on a monthly Business Hours basis. Tenant’s use of electricity shall not exceed the capacity of the feeders to the Project or the risers or wiring installation (which capacity is eight (8) watts per rentable square foot) and Tenant shall promptly discontinue any such excess use promptly following receipt of notice of the same from Landlord. In those cases where Landlord proposes to install equipment to be paid for by Tenant or otherwise is proposing to require Tenant to pay for any cost related to such excess consumption, Tenant may require Landlord, as a condition of such charge by Landlord, to reasonably demonstrate that Landlord’s actions and such charges are consistent with the requirements of this Lease.

          6.3          Interruption of Use. Tenant agrees that Landlord shall not be liable for damages, by abatement of Rent or otherwise, for failure to furnish or delay in furnishing any service (including telephone and telecommunication services), or for any diminution in the quality or quantity thereof, when such failure or delay or diminution is occasioned, in whole or in part, by breakage, repairs, replacements, or improvements, by any strike, lockout or other labor trouble, by inability to secure electricity, gas, water, or other fuel at the Building or Project after reasonable effort to do so, by any riot or other dangerous condition, emergency, accident or casualty whatsoever, by act or default of Tenant or other parties, or by any other cause beyond Landlord’s reasonable control; and such failures or delays or diminution shall never be deemed to constitute an eviction or disturbance of Tenant’s use and possession of the Premises or relieve Tenant from paying Rent or performing any of its obligations under this Lease. Furthermore, Landlord shall not be liable under any circumstances for a loss of, or injury to, property or for injury to, or interference with, Tenant’s business, including, without limitation, loss of profits, however occurring, through or in connection with or incidental to a failure to furnish any of the services or utilities as set forth in this Article 6.

ARTICLE 7

REPAIRS

          Tenant shall, at Tenant’s own expense, keep the Premises, including all improvements, fixtures and furnishings therein, in good order, repair and condition at all times during the Lease Term. In addition, Tenant shall, at Tenant’s own expense, but under the supervision and subject to the prior approval of Landlord, and within any reasonable period of time specified by Landlord, promptly and adequately repair all damage to the Premises and replace or repair all damaged, broken, or worn fixtures and appurtenances, except for damage caused by ordinary wear and tear or beyond the reasonable control of Tenant; provided however, that, at Landlord’s option, or if Tenant fails to make such repairs, Landlord may, but need not, make such repairs and replacements, and Tenant shall pay Landlord the cost thereof, including a percentage of the

 

 

 

 

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cost thereof (to be uniformly established for the Building and/or the Project) sufficient to reimburse Landlord for all overhead, general conditions, fees and other costs or expenses arising from Landlord’s involvement with such repairs and replacements forthwith upon being billed for same. Landlord may, but shall not be required to, enter the Premises at all reasonable times to make such repairs, alterations, improvements or additions to the Premises or to the Project or to any equipment located in the Project as Landlord shall desire or deem necessary or as Landlord may be required to do by governmental or quasi-governmental authority or court order or decree. Tenant hereby waives any and all rights under and benefits of subsection 1 of Section 1932 and Sections 1941 and 1942 of the California Civil Code or under any similar law, statute, or ordinance now or hereafter in effect.

ARTICLE 8

ADDITIONS AND ALTERATIONS

          8.1          Landlord’s Consent to Alterations. Tenant may not make any improvements, alterations, additions or changes to the Premises or any mechanical, plumbing or HVAC facilities or systems pertaining to the Premises (collectively, the “Alterations”) without first procuring the prior written consent of Landlord to such Alterations, which consent shall be requested by Tenant not less than thirty (30) days prior to the commencement thereof, and which consent shall not be unreasonably withheld by Landlord, provided it shall be deemed reasonable for Landlord to withhold its consent to any Alteration which adversely affects the structural portions or the systems or equipment of the Building or is visible from the exterior of the Building. The construction of the initial improvements to the Premises shall be governed by the terms of the Tenant Work Letter and not the terms of this Article 8.

          8.2          Manner of Construction.

                         8.2.1          Conditions to Alterations. Landlord may impose, as a condition of its consent to any and all Alterations or repairs of the Premises or about the Premises, such requirements as Landlord in its reasonable discretion may deem desirable, including, but not limited to, (i) the requirement that Tenant utilize for such purposes only contractors, subcontractors, materials, mechanics and materialmen selected by Tenant from a list provided and approved by Landlord, and (ii) the requirement that upon Landlord’s request Tenant shall, at Tenant’s expense, remove such Alterations upon the expiration or any early termination of the Lease Term. Tenant shall construct such Alterations and perform such repairs in a good and workmanlike manner, in conformance with any and all applicable federal, state, county or municipal laws, rules and regulations and pursuant to a valid building permit, issued by the City of Irvine, all in conformance with Landlord’s construction rules and regulations; provided, however, that prior to commencing to construct any Alteration, Tenant shall meet with Landlord to discuss Landlord’s design parameters and code compliance issues. In performing the work of any such Alterations, Tenant shall have the work performed in such manner as not to obstruct access to the Project or any portion thereof, by any other tenant of the Project, and so as not to obstruct the business of Landlord or other tenants in the Project. Tenant shall not use (and upon notice from Landlord shall cease using) contractors, services, workmen, labor, materials or equipment that, in Landlord’s reasonable judgment, would disturb labor harmony with the workforce or trades engaged in performing other work, labor or services in or about the Building or the Common Areas. In addition to Tenant’s obligations under Article 9 of this Lease, upon completion of any Alterations, Tenant agrees to cause a Notice of Completion to be recorded in the office of the Recorder of the County of Orange in accordance with Section 3093 of the Civil Code of the State of California or any successor statute, and Tenant shall deliver to the Project construction manager a reproducible copy of the “as built” drawings of the Alterations, as well as all permits, approvals and other documents issued by any governmental agency in connection with the Alterations.

                         8.2.2          Base Building Changes. In the event any Alterations which Tenant proposes to make to the Premises require or give rise to governmentally-required changes (“Additional Required Work”) to the Base Building, Landlord and Tenant shall work together to eliminate, if possible, or otherwise minimize the Additional Required Work. Absent elimination of such Additional Required Work or a mutually acceptable allocation of such changes as between Landlord and Tenant, the cost of such changes shall be borne by Tenant. As used herein, (i) “Base Building” means the structural portions of the Building, the Base Building

 

 

 

 

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Systems, the public restrooms, elevators, exit stairwells and the systems and equipment located in the internal core of the Building, and (ii) “Base Building Systems” means all systems and equipment (including plumbing, HVAC, electrical fire/life/safety elevator and security systems) that serve all or part of the Building.

          8.3          Payment for Improvements. If payment is made directly to contractors, Tenant shall (i) comply with Landlord’s requirements for final lien releases and waivers in connection with Tenant’s payment for work to contractors, and (ii) cause its contractors to sign Landlord’s standard contractor’s rules and regulations. If Tenant orders any work directly from Landlord, Tenant shall pay to Landlord an amount equal to five percent (5%) of the cost of such work to compensate Landlord for all overhead, general conditions, fees and other costs and expenses arising from Landlord’s involvement with such work. If Tenant does not order any work directly from Landlord, Tenant shall reimburse Landlord for Landlord’s reasonable, actual, out-of-pocket costs and expenses actually incurred in connection with Landlord’s review of such work.

          8.4          Construction Insurance. In addition to the requirements of Article 10 of this Lease, in the event that Tenant makes any Alterations, prior to the commencement of such Alterations, Tenant shall provide Landlord with evidence that Tenant carries “Builder’s All Risk” insurance in an amount approved by Landlord covering the construction of such Alterations, and such other insurance as Landlord may reasonably require, it being understood and agreed that all of such Alterations shall be insured by Tenant pursuant to Article 10 of this Lease immediately upon completion thereof. In addition, in connection with any Alteration, Landlord may, in its discretion, require Tenant to obtain a lien and completion bond or some alternate form of security satisfactory to Landlord in an amount sufficient to ensure the lien-free completion of such Alterations and naming Landlord as a co-obligee.

          8.5          Landlord’s Property. All Alterations, improvements, fixtures, equipment and/or appurtenances which may be installed or placed in or about the Premises, from time to time, shall be at the sole cost of Tenant and shall be and become the property of Landlord, except that Tenant may remove any Alterations, improvements, fixtures and/or equipment which Tenant can substantiate to Landlord have not been paid for with any Tenant improvement allowance funds provided to Tenant by Landlord, provided Tenant repairs any damage to the Premises and Building caused by such removal and returns the affected portion of the Premises to a building standard tenant improved condition as determined by Landlord. Furthermore, Landlord may, by written notice to Tenant prior to the end of the Lease Term, or given following any earlier termination of this Lease, require Tenant, at Tenant’s expense, to remove any such Alterations or improvements and to repair any damage to the Premises and Building caused by such removal and returns the affected portion of the Premises to a building standard tenant improved condition as determined by Landlord. If Tenant fails to complete such removal and/or to repair any damage caused by the removal of any Alterations or improvements in the Premises and return the affected portion of the Premises to a building standard tenant improved condition as reasonably determined by Landlord, Landlord may do so and may charge the cost thereof to Tenant. Tenant hereby protects, defends, indemnifies and holds Landlord harmless from any liability, cost, obligation, expense or claim of lien in any manner relating to the installation, placement, removal or financing of any such Alterations, improvements, fixtures and/or equipment in, on or about the Premises, which obligations of Tenant shall survive the expiration or earlier termination of this Lease.

          8.6          Communications and Computer Lines. Tenant may install, maintain, replace, remove or use any communications or computer wires and cables (collectively, the “Lines”) in or serving the Premises, provided that (i) Tenant shall obtain Landlord’s prior written consent, use an experienced and qualified contractor approved in writing by Landlord, and comply with all of the other provisions of Articles 7 and 8 of this Lease, (ii) an acceptable number of spare Lines and space for additional Lines shall be maintained for existing and future occupants of the Project, as determined in Landlord’s reasonable opinion, (iii) the Lines (including riser cables) shall be appropriately insulated to prevent excessive electromagnetic fields or radiation, and shall be surrounded by a protective conduit reasonably acceptable to Landlord, (iv) any new or existing Lines servicing the Premises shall comply with all applicable governmental laws and regulations, (v) as a condition to permitting the installation of new Lines, Landlord may require that Tenant remove existing Lines located in or serving the Premises and repair any damage in connection with such removal, and (vi) Tenant shall pay all costs in connection therewith. Landlord reserves the right to require that Tenant remove any Lines located in or serving the

 

 

 

 

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Premises which are installed in violation of these provisions, or which are at any time in violation of any laws or represent a dangerous or potentially dangerous condition.

ARTICLE 9

COVENANT AGAINST LIENS

          Tenant shall keep the Project and Premises free from any liens or encumbrances arising out of the work performed, materials furnished or obligations incurred by or on behalf of Tenant, and shall protect, defend, indemnify and hold Landlord harmless from and against any claims, liabilities, judgments or costs (including, without limitation, reasonable attorneys’ fees and costs) arising out of same or in connection therewith. Tenant shall give Landlord notice at least twenty (20) days prior to the commencement of any such work on the Premises (or such additional time as may be necessary under Applicable Laws (as defined below)) to afford Landlord the opportunity of posting and recording appropriate notices of non-responsibility. Tenant shall remove any such lien or encumbrance by bond or otherwise within ten (10) days after notice by Landlord, and if Tenant shall fail to do so, Landlord may pay the amount necessary to remove such lien or encumbrance, without being responsible for investigating the validity thereof. The amount so paid shall be deemed Additional Rent under this Lease payable upon demand, without limitation as to other remedies available to Landlord under this Lease. Nothing contained in this Lease shall authorize Tenant to do any act which shall subject Landlord’s title to the Building or Premises to any liens or encumbrances whether claimed by operation of law or express or implied contract. Any claim to a lien or encumbrance upon the Building or Premises arising in connection with any such work or respecting the Premises not performed by or at the request of Landlord shall be null and void, or at Landlord’s option shall attach only against Tenant’s interest in the Premises and shall in all respects be subordinate to Landlord’s title to the Project, Building and Premises.

ARTICLE 10

INSURANCE

          10.1          Indemnification and Waiver. Tenant hereby assumes all risk of damage to property or injury to persons in, upon or about the Premises from any cause whatsoever (including, but not limited to, any personal injuries resulting from a slip and fall in, upon or about the Premises) and agrees that Landlord, its partners, subpartners and their respective officers, agents, servants, employees, and independent contractors (collectively, “Landlord Parties”) shall not be liable for, and are hereby released from any responsibility for, any damage either to person or property or resulting from the loss of use thereof, which damage is sustained by Tenant or by other persons claiming through Tenant. Tenant shall indemnify, defend, protect, and hold harmless the Landlord Parties from any and all loss, cost, damage, expense and liability (including without limitation court costs and reasonable attorneys’ fees) incurred in connection with or arising from any cause in, on or about the Premises (including, but not limited to, a slip and fall), any acts, omissions or negligence of Tenant or of any person claiming by, through or under Tenant, or of the contractors, agents, servants, employees, invitees, guests or licensees of Tenant or any such person, in, on or about the Project or any breach of the terms of this Lease, either prior to, during, or after the expiration of the Lease Term, provided that the terms of the foregoing indemnity shall not apply to the gross negligence or willful misconduct of Landlord. Should Landlord be named as a defendant in any suit brought against Tenant in connection with or arising out of Tenant’s occupancy of the Premises, Tenant shall pay to Landlord its costs and expenses incurred in such suit, including without limitation, its actual professional fees such as reasonable appraisers’, accountants’ and attorneys’ fees. The provisions of this Section 10.1 shall survive the expiration or sooner termination of this Lease with respect to any claims or liability arising in connection with any event occurring prior to such expiration or termination.

          10.2          Tenant’s Compliance With Landlord’s Fire and Casualty Insurance. Tenant shall, at Tenant’s expense, comply with all insurance company requirements pertaining to the use of the Premises. If Tenant’s conduct or use of the Premises causes any increase in the premium for such insurance policies then Tenant shall reimburse Landlord for any such increase. Tenant, at Tenant’s expense, shall comply with all rules, orders, regulations or requirements of the American Insurance Association (formerly the National Board of Fire Underwriters) and with any similar body.

 

 

 

 

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          10.3          Tenant’s Insurance. Tenant shall maintain the following coverages in the following amounts.

                           10.3.1          Commercial General Liability Insurance covering the insured against claims of bodily injury, personal injury and property damage (including loss of use thereof) arising out of Tenant’s operations, and contractual liabilities (covering the performance by Tenant of its indemnity agreements) including a Broad Form endorsement covering the insuring provisions of this Lease and the performance by Tenant of the indemnity agreements set forth in Section 10.1 of this Lease, for limits of liability not less than:

 

 

Bodily Injury and

$3,000,000 each occurrence

Property Damage Liability

$3,000,000 annual aggregate

 

Personal Injury Liability

$3,000,000 each occurrence

 

$3,000,000 annual aggregate

 

0% Insured’s participation

                            10.3.2          Physical Damage Insurance covering (i) all office furniture, business and trade fixtures, office equipment, free-standing cabinet work, movable partitions, merchandise and all other items of Tenant’s property on the Premises installed by, for, or at the expense of Tenant, (ii) the Tenant Improvements, and any other improvements which exist in the Premises as of the Lease Commencement Date (excluding the Base Building) (the “Original Improvements”), and (iii) all other improvements, alterations and additions to the Premises. Such insurance shall be written on an “all risks” of physical loss or damage basis, for the full replacement cost value (subject to reasonable deductible amounts) new without deduction for depreciation of the covered items and in amounts that meet any co-insurance clauses of the policies of insurance and shall include coverage for damage or other loss caused by fire or other peril including, but not limited to, vandalism and malicious mischief, theft, water damage of any type, including sprinkler leakage, bursting or stoppage of pipes, and explosion, and providing business interruption coverage for a period of one year.

                            10.3.3          Worker’s Compensation and Employer’s Liability or other similar insurance pursuant to all applicable state and local statutes and regulations.

           10.4          Form of Policies. The minimum limits of policies of insurance required of Tenant under this Lease shall in no event limit the liability of Tenant under this Lease. Such insurance shall (i) name Landlord, and any other party the Landlord so specifies, as an additional insured, including Landlord’s managing agent, if any; (ii) specifically cover the liability assumed by Tenant under this Lease, including, but not limited to, Tenant’s obligations under Section 10.1 of this Lease; (iii) be issued by an insurance company having a rating of not less than A-X in Best’s Insurance Guide or which is otherwise acceptable to Landlord and licensed to do business in the State of California; (iv) be primary insurance as to all claims thereunder and provide that any insurance carried by Landlord is excess and is non-contributing with any insurance requirement of Tenant; (v) be in form and content reasonably acceptable to Landlord; and (vi) provide that said insurance shall not be canceled or coverage changed unless thirty (30) days’ prior written notice shall have been given to Landlord and any mortgagee of Landlord. Tenant shall deliver said policy or policies or certificates thereof to Landlord on or before the Lease Commencement Date and at least thirty (30) days before the expiration dates thereof. In the event Tenant shall fail to procure such insurance, or to deliver such policies or certificate, Landlord may, at its option, procure such policies for the account of Tenant, and the cost thereof shall be paid to Landlord within five (5) days after delivery to Tenant of bills therefor.

          10.5          Subrogation. Landlord and Tenant intend that their respective property loss risks shall be borne by insurance carriers to the extent above provided, and Landlord and Tenant hereby agree to look solely to, and seek recovery only from, their respective insurance carriers in the event of a property loss to the extent that such coverage is agreed to be provided hereunder. The parties each hereby waive all rights and claims against each other for such losses, and waive all rights of subrogation of their respective insurers, provided such waiver of subrogation shall not affect the right to the insured to recover thereunder. The parties agree that their respective insurance policies are now, or shall be, endorsed such that the waiver of subrogation shall not affect the right of the insured to recover thereunder, so long as no material additional premium is charged therefor.

 

 

 

 

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          10.6          Additional Insurance Obligations. Tenant shall carry and maintain during the entire Lease Term, at Tenant’s sole cost and expense, increased amounts of the insurance required to be carried by Tenant pursuant to this Article 10 and such other reasonable types of insurance coverage and in such reasonable amounts covering the Premises and Tenant’s operations therein, as may be reasonably requested by Landlord, but in no event in excess of the amounts and types of insurance then being required of tenants in Comparable Buildings occupying comparable space and engaged in a similar use as Tenant.

ARTICLE 11

DAMAGE AND DESTRUCTION

          11.1          Repair of Damage to Premises by Landlord.

                           11.1.1          Damage to Building. Tenant shall promptly notify Landlord of any damage to the Premises resulting from fire or any other casualty. If the Premises or any Common Areas serving or providing access to the Premises shall be damaged by fire or other casualty, Landlord shall promptly and diligently, subject to reasonable delays for insurance adjustment or other matters beyond Landlord’s reasonable control, and subject to all other terms of this Article 11, restore the Base Building and such Common Areas. Such restoration shall be to substantially the same condition of the Base Building and the Common Areas prior to the casualty, except for modifications required by zoning and building codes and other laws or by the holder of a mortgage on the Building or Project or any other modifications to the Common Areas deemed desirable by Landlord, which are consistent with the character of the Project, provided that access to the Premises and any restrooms serving the Premises shall not be materially impaired.

                           11.1.2          Damage to Premises. Upon the occurrence of any damage to the Premises, upon notice (the “Landlord Repair Notice”) to Tenant from Landlord, Tenant shall assign to Landlord (or to any party designated by Landlord) all insurance proceeds payable to Tenant under Tenant’s insurance required under Section 10.3.2(ii) and (iii) of this Lease, and Landlord shall repair any injury or damage to the Tenant Improvements and the Original Improvements installed in the Premises and shall return such Tenant Improvements and Original Improvements to their original condition; provided that if the cost of such repair by Landlord exceeds the amount of insurance proceeds received by Landlord from Tenant’s insurance carrier, as assigned by Tenant, the cost of such repairs shall be paid by Tenant to Landlord prior to Landlord’s commencement of repair of the damage. In the event that Landlord does not deliver the Landlord Repair Notice within sixty (60) days following the date the casualty becomes known to Landlord, Tenant shall, at its sole cost and expense, repair any injury or damage to the Tenant Improvements and the Original Improvements installed in the Premises and shall return such Tenant Improvements and Original Improvements to their original condition. Whether or not Landlord delivers a Landlord Repair Notice, prior to the commencement of construction, Tenant shall submit to Landlord, for Landlord’s review and approval, all plans, specifications and working drawings relating thereto, and Landlord shall select the contractors to perform such improvement work. Landlord shall not be liable for any inconvenience or annoyance to Tenant or its visitors, or injury to Tenant’s business resulting in any way from such damage or the repair thereof; provided however, that if such fire or other casualty shall have damaged the Premises or Common Areas necessary to Tenant’s occupancy, and the Premises are not occupied by Tenant as a result thereof, then during the time and to the extent the Premises are unfit for occupancy, the Rent shall be abated in proportion to the ratio that the amount of rentable square feet of the Premises which is unfit for occupancy for the purposes permitted under this Lease bears to the total rentable square feet of the Premises. In the event that Landlord shall not deliver the Landlord Repair Notice, Tenant’s right to rent abatement pursuant to the preceding sentence shall terminate as of the date which is reasonably determined by Landlord to be the date Tenant should have completed repairs to the Premises assuming Tenant used reasonable due diligence in connection therewith.

          11.2          Landlord’s Option to Repair. Notwithstanding the terms of Section 11.1 of this Lease, Landlord may elect not to rebuild and/or restore the Premises, Building and/or Project, and instead terminate this Lease, by notifying Tenant in writing of such termination within sixty (60) days after the date of discovery of the damage, such notice to include a termination date giving Tenant sixty (60) days to vacate the Premises, but Landlord may so elect only if the

 

 

 

 

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Building or Project shall be damaged by fire or other casualty or cause, whether or not the Premises are affected, and one or more of the following conditions is present: (i) in Landlord’s reasonable judgment, repairs cannot reasonably be completed within one hundred eighty (180) days after the date of discovery of the damage (when such repairs are made without the payment of overtime or other premiums); (ii) the holder of any mortgage on the Building or Project or ground lessor with respect to the Building or Project shall require that the insurance proceeds or any portion thereof be used to retire the mortgage debt, or shall terminate the ground lease, as the case may be; (iii) the damage is not fully covered by Landlord’s insurance policies; (iv) Landlord decides to rebuild the Building or Common Areas so that they will be substantially different structurally or architecturally; or (v) the damage occurs during the last twelve (12) months of the Lease Term. In the event Landlord does not terminate this Lease as set forth above, and in Landlord’s reasonable judgment, (A) the repairs cannot be completed within such one hundred eighty (180) days, as set forth in (i) above, or (B) if the damage occurs during the last twelve (12) months of the Lease Term and the repairs cannot be completed within one hundred twenty (120) days after the date of discovery of the damage, Landlord shall provide Tenant with written notice (“Extended Repair Notice” ) of the time within which such repairs may be completed, in Landlord’s reasonable judgment.

          11.3           Tenant’s Option to Cause Early Expiration. If damage to the Project, Building or Premises causes the Premises to be unusable for their intended purposes and Landlord advises Tenant in the Extended Repair Notice that (i) repairs cannot be completed within one hundred eighty days (180) days after the date of discovery of the damage, or (ii) if the damage occurs during the last twelve (12) months of the Lease Term, repairs cannot be completed within one hundred twenty (120) days after the date of discovery of the damage, Tenant may elect to cause the Expiration Date to be accelerated. Such election shall be made in writing to Landlord within thirty (30) days after receipt of the Extended Repair Notice. Tenant’s election to accelerate the Expiration Date shall be made by written notice to Landlord within thirty(30) days after receipt of Landlord’s Notice and shall specify the new Expiration Date, which date shall not be later than forty-five (45) days after Tenant’s receipt of the Extended Repair Notice.

          11.4           Waiver of Statutory Provisions. The provisions of this Lease, including this Article 11, constitute an express agreement between Landlord and Tenant with respect to any and all damage to, or destruction of, all or any part of the Premises, the Building or the Project, and any statute or regulation of the State of California, including, without limitation, Sections 1932(2) and 1933(4) of the California Civil Code, with respect to any rights or obligations concerning damage or destruction in the absence of an express agreement between the parties, and any other statute or regulation, now or hereafter in effect, shall have no application to this Lease or any damage or destruction to all or any part of the Premises, the Building or the Project.

ARTICLE 12

NONWAIVER

No provision of this Lease shall be deemed waived by either party hereto unless expressly waived in a writing signed thereby. The waiver by either party hereto of any breach of any term, covenant or condition herein contained shall not be deemed to be a waiver of any subsequent breach of same or any other term, covenant or condition herein contained. The subsequent acceptance of Rent hereunder by Landlord shall not be deemed to be a waiver of any preceding breach by Tenant of any term, covenant or condition of this Lease, other than the failure of Tenant to pay the particular Rent so accepted, regardless of Landlord’s knowledge of such preceding breach at the time of acceptance of such Rent. No acceptance of a lesser amount than the Rent herein stipulated shall be deemed a waiver of Landlord’s right to receive the full amount due, nor shall any endorsement or statement on any check or payment or any letter accompanying such check or payment be deemed an accord and satisfaction, and Landlord may accept such check or payment without prejudice to Landlord’s right to recover the full amount due. No receipt of monies by Landlord from Tenant after the termination of this Lease shall in any way alter the length of the Lease Term or of Tenant’s right of possession hereunder, or after the giving of any notice shall reinstate, continue or extend the Lease Term or affect any notice given Tenant prior to the receipt of such monies, it being agreed that after the service of notice or the commencement of a suit, or after final judgment for possession of the Premises, Landlord may receive and collect any Rent due, and the payment of Rent shall not waive or affect said notice, suit or judgment.

 

 

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ARTICLE 13

CONDEMNATION

If the whole or any material part of the Premises, Building or Project shall be taken by power of eminent domain or condemned by any competent authority for any public or quasi-public use or purpose, or if any adjacent property or street shall be so taken or condemned, or reconfigured or vacated by such authority in such manner as to require the use, reconstruction or remodeling of any material part of the Premises, Building or Project, or if Landlord shall grant a deed or other instrument in lieu of such taking by eminent domain or condemnation, Landlord shall have the option to terminate this Lease effective as of the date possession is required to be surrendered to the authority. If more than twenty-five percent (25%) of the rentable square feet of the Premises is taken, or if access to the Premises is substantially impaired, in each case for a period in excess of one hundred eighty (180) days, Tenant shall have the option to terminate this Lease effective as of the date possession is required to be surrendered to the authority. Tenant shall not because of such taking assert any claim against Landlord or the authority for any compensation because of such taking and Landlord shall be entitled to the entire award or payment in connection therewith, except that Tenant shall have the right to file any separate claim available to Tenant for any taking of Tenant’s personal property and fixtures belonging to Tenant and removable by Tenant upon expiration of the Lease Term pursuant to the terms of this Lease, and for moving expenses, so long as such claims do not diminish the award available to Landlord, its ground lessor with respect to the Building or Project or its mortgagee, and such claim is payable separately to Tenant. All Rent shall be apportioned as of the date of such termination. If any part of the Premises shall be taken, and this Lease shall not be so terminated, the Rent shall be proportionately abated. Tenant hereby waives any and all rights it might otherwise have pursuant to Section 1265.130 of the California Code of Civil Procedure. Notwithstanding anything to the contrary contained in this Article 13, in the event of a temporary taking of all or any portion of the Premises for a period of one hundred eighty (180) days or less, then this Lease shall not terminate but the Base Rent and the Additional Rent shall be abated for the period of such taking in proportion to the ratio that the amount of rentable square feet of the Premises taken bears to the total rentable square feet of the Premises. Landlord shall be entitled to receive the entire award made in connection with any such temporary taking.

ARTICLE 14

ASSIGNMENT AND SUBLETTING

          14.1           Transfers. Tenant shall not, without the prior written consent of Landlord, assign, mortgage, pledge, hypothecate, encumber, or permit any lien to attach to, or otherwise transfer, this Lease or any interest hereunder, permit any assignment, or other transfer of this Lease or any interest hereunder by operation of law, sublet the Premises or any part thereof, or enter into any license or concession agreements or otherwise permit the occupancy or use of the Premises or any part thereof by any persons other than Tenant and its employees and contractors (all of the foregoing are hereinafter sometimes referred to collectively as “Transfer(s)” and any person to whom any Transfer is made or sought to be made is hereinafter sometimes referred to as a “Transferee”). If Tenant desires Landlord’s consent to any Transfer, Tenant shall notify Landlord in writing, which notice (the “Transfer Notice”) shall include (i) the proposed effective date of the Transfer, which shall not be less than thirty (30) days nor more than one hundred eighty (180) days after the date of delivery of the Transfer Notice, (ii) a description of the portion of the Premises to be transferred (the “Subject Space”), (iii) all of the terms of the proposed Transfer and the consideration therefor, including calculation of the Transfer Premium (as defined below) in connection with such Transfer, the name and address of the proposed Transferee, and a copy of all existing executed and/or proposed documentation pertaining to the proposed Transfer, including all existing operative documents to be executed to evidence such Transfer or the agreements incidental or related to such Transfer, (iv) current financial statements of the proposed Transferee certified by an officer, partner or owner thereof, business credit and personal references and history of the proposed Transferee and any other information reasonably required by Landlord which will enable Landlord to determine the financial responsibility, character, and reputation of the proposed Transferee, nature of such Transferee’s business and proposed use of the Subject Space, and (v) an executed estoppel certificate from Tenant in the form attached hereto as Exhibit G. Any Transfer made without Landlord’s prior written consent shall, at Landlord’s option, be null, void and of no effect, and shall, at Landlord’s option,

 

 

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constitute a default by Tenant under this Lease. Whether or not Landlord consents to any proposed Transfer, Tenant shall pay Landlord’s reasonable review and processing fees, as well as any reasonable professional fees (including, without limitation, attorneys’, accountants’, architects’, engineers’ and consultants’ fees) incurred by Landlord, within thirty (30) days after written request by Landlord, in an amount not to exceed One Thousand Five Hundred Dollars ($1,500) in the aggregate, for a Transfer in the ordinary course of business (for purposes hereof, a Transfer shall be deemed not to be in the “ordinary course of business” if Landlord is required to review documentation related to such Transfer on more than two (2) separate occasions).

          14.2           Landlord’s Consent. Landlord shall not unreasonably withhold or delay its consent to any proposed Transfer of the Subject Space to the Transferee on the terms specified in the Transfer Notice. Without limitation as to other reasonable grounds for withholding consent, the parties hereby agree that it shall be reasonable under this Lease and under any applicable law for Landlord to withhold consent to any proposed Transfer where one or more of the following apply:

 

                            14.2.1          The Transferee is of a character or reputation or engaged in a business which is not consistent with the quality of the Building or the Project;

 

                            14.2.2          The Transferee intends to use the Subject Space for purposes which are not permitted under this Lease;

 

                            14.2.3          The Transferee is either a governmental agency or instrumentality thereof;

 

                            14.2.4          The Transferee is not a party of reasonable financial worth and/or financial stability in light of the responsibilities to be undertaken in connection with the Transfer on the date consent is requested;

 

                            14.2.5          The proposed Transfer would cause a violation of another lease for space in the Project, or would give an occupant of the Project a right to cancel its lease; or

 

                            14.2.6          Either the proposed Transferee, or any person or entity which directly or indirectly, controls, is controlled by, or is under common control with, the proposed Transferee, (i) occupies space in the Project at the time of the request for consent, or (ii) is negotiating with Landlord or has negotiated with Landlord during the six (6) month period immediately preceding the date Landlord receives the Transfer Notice, to lease space in the Project.

          If Landlord consents to any Transfer pursuant to the terms of this Section 14.2, Tenant may within six (6) months after Landlord’s consent, but not later than the expiration of said six-month period, enter into such Transfer of the Premises or portion thereof, upon the same terms and conditions as are set forth in the Transfer Notice furnished by Tenant to Landlord pursuant to Section 14.1 of this Lease, provided that if there are any changes in the terms and conditions from those specified in the Transfer Notice (i) such that Landlord would initially have been entitled to refuse its consent to such Transfer under this Section 14.2, or (ii) which would cause the proposed Transfer to be more favorable to the Transferee than the terms set forth in Tenant’s original Transfer Notice, Tenant shall again submit the Transfer to Landlord for its approval and other action under this Article 14. Notwithstanding anything to the contrary in this Lease, if Tenant or any proposed Transferee claims that Landlord has unreasonably withheld or delayed its consent under Section 14.2 or otherwise has breached or acted unreasonably under this Article 14, their sole remedies shall be a suit for declaratory judgment and an injunction for the relief sought, and Tenant hereby waives all other remedies, including, without limitation, any right at law or equity to terminate this Lease, on its own behalf and, to the extent permitted under all applicable laws, on behalf of the proposed Transferee.

          14.3           Transfer Premium. If Landlord consents to a Transfer as a condition thereto which the parties hereby agree is reasonable, Tenant shall pay to Landlord one hundred percent (100%) of any Transfer Premium received by Tenant from such Transferee. “Transfer Premium” shall mean all rent, additional rent or other consideration payable by such Transferee in connection with the Transfer in excess of the Base Rent and Additional Rent payable by Tenant under this Lease during the term of the Transfer (on a per rentable square foot basis if less than all of the Premises is transferred), after deducting the reasonable expenses incurred by

 

 

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Tenant for (i) any changes, alterations and improvements to the Premises in connection with the Transfer, (ii) any free base rent reasonably provided to the Transferee in connection with the Transfer, (iii) any brokerage commissions in connection with the Transfer, and (iv) twenty-five percent (25%) of the amount of any Base Rent and Additional Rent paid by Tenant to Landlord with respect to the Subject Space during the period commencing on the later of (a) the date Tenant contracts with a reputable broker to market the Subject Space, and (b) the date Tenant vacates the Subject Space, until the commencement of the term of the Transfer (collectively, “Tenant’s Transfer Costs”). “Transfer Premium” shall also include, but not be limited to, key money, bonus money or other cash consideration paid by Transferee to Tenant in connection with such Transfer, and any payment in excess of fair market value for services rendered by Tenant to Transferee or for assets, fixtures, inventory, equipment, or furniture transferred by Tenant to Transferee in connection with such Transfer. The determination of the amount of Landlord’s applicable share of the Transfer Premium shall be made on a monthly basis as rent or other consideration is received by Tenant under the Transfer. For purposes of calculating the Transfer Premium on a monthly basis, Tenant’s Transfer Costs shall be deemed to be expended by Tenant in equal monthly amounts over the entire term of the Transfer.

          14.4           Landlord’s Option as to Subject Space. Notwithstanding anything to the contrary contained in this Article 14, in the event Tenant contemplates a Transfer of all or a portion of the Premises (or in the event of any other Transfer or Transfers entered into by Tenant as a subterfuge in order to avoid the terms of this Section 14.4), Tenant shall give Landlord notice (the “Intention to Transfer Notice”) of such contemplated transfer (whether or not such contemplated transfer or any of the terms of such contemplated transfer have been determined). The Intention to Transfer Notice shall specify the portion of the rentable amount of square feet of the Premises which Tenant intends to transfer (the “Contemplated Transfer Space”), the contemplated date of commencement of the contemplated transfer (the “Contemplated Effective Date”) and the contemplated length of the term of such contemplated transfer, and shall specify that such Intention to Transfer Notice is delivered to Landlord pursuant to this Section 14.4 in order to allow Landlord to elect to recapture the Contemplated Transfer Space for the term set forth in the Intention to Transfer Notice. Thereafter, Landlord shall have the option, by giving written notice to Tenant within thirty (30) days after receipt of any Intention to Transfer Notice, to recapture the Contemplated Transfer Space. Such recapture shall cancel and terminate this Lease with respect to such Contemplated Transfer Space as of the Contemplated Effective Date until the last day of the term of the contemplated transfer is set forth in the Intention to Transfer Notice. In the event of a recapture by Landlord, this Lease shall be cancelled with respect to less than the entire Premises, the Rent reserved herein shall be prorated on the basis of the number of rentable square feet retained by Tenant in proportion to the number of rentable square feet contained in the Premises, and this Lease as so amended shall continue thereafter in full force and effect, and upon request of either party, the parties shall execute written confirmation of the same. If Landlord declines, or fails to elect in a timely manner, to recapture such Contemplated Transfer Space under this Section 14.4, then, subject to the other terms of this Article 14, for a period of nine (9) months (the “Nine Month Period”) commencing on the last day of such thirty (30) day period, Landlord shall not have any right to recapture the Contemplated Transfer Space with respect to any transfer made during the Nine Month Period, provided that any such transfer is substantially on the terms set forth in the Intention to Transfer Notice and, provided further, that any such transfer shall be subject to the remaining terms of this Article 14. If such a transfer is not so consummated within the Nine Month Period (or if the transfer is so consummated, then upon the expiration of the term of any transfer of such Contemplated Transfer Space consummated within such Nine Month Period), Tenant shall again be required to submit a new Intention to Transfer Notice to Landlord with respect to any contemplated transfer, as provided above in this Section 14.4.

          14.5           Effect of Transfer. If Landlord consents to a Transfer, (i) the terms and conditions of this Lease shall in no way be deemed to have been waived or modified, (ii) such consent shall not be deemed consent to any further Transfer by either Tenant or a Transferee, (iii) Tenant shall deliver to Landlord, promptly after execution, an original executed copy of all documentation pertaining to the Transfer in form reasonably acceptable to Landlord, (iv) Tenant shall furnish upon Landlord’s request a complete statement, certified by an independent certified public accountant, or Tenant’s chief financial officer, setting forth in detail the computation of any Transfer Premium Tenant has derived and shall derive from such Transfer, and (v) no Transfer relating to this Lease or agreement entered into with respect thereto, whether with or without Landlord’s consent, shall relieve Tenant or any guarantor of the Lease from any liability

 

 

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under this Lease, including, without limitation, in connection with the Subject Space. Landlord or its authorized representatives shall have the right at all reasonable times to audit the books, records and papers of Tenant relating to any Transfer, and shall have the right to make copies thereof. If the Transfer Premium respecting any Transfer shall be found understated, Tenant shall, within thirty (30) days after demand, pay the deficiency, and if understated by more than five percent (5%), Tenant shall pay Landlord’s costs of such audit.

          14.6          Occurrence of Default. Any Transfer hereunder shall be subordinate and subject to the provisions of this Lease, and if this Lease shall be terminated during the term of any Transfer, Landlord shall have the right to: (i) treat such Transfer as canceled and repossess the Subject Space by any lawful means, or (ii) require that such Transferee attorn to and recognize Landlord as its landlord under any such Transfer. If Tenant shall be in default under this Lease, Landlord is hereby irrevocably authorized, as Tenant’s agent and attorney-in-fact, to direct any Transferee to make all payments under or in connection with the Transfer directly to Landlord (which Landlord shall apply towards Tenant’s obligations under this Lease) until such default is cured. Such Transferee shall rely on any representation by Landlord that Tenant is in default hereunder, without any need for confirmation thereof by Tenant. Upon any assignment, the assignee shall assume in writing all obligations and covenants of Tenant thereafter to be performed or observed under this Lease. No collection or acceptance of rent by Landlord from any Transferee shall be deemed a waiver of any provision of this Article 14 or the approval of any Transferee or a release of Tenant from any obligation under this Lease, whether theretofore or thereafter accruing. In no event shall Landlord’s enforcement of any provision of this Lease against any Transferee be deemed a waiver of Landlord’s right to enforce any term of this Lease against Tenant or any other person. If Tenant’s obligations hereunder have been guaranteed, Landlord’s consent to any Transfer shall not be effective unless the guarantor also consents to such Transfer.

          14.7          Non-Transfers. Notwithstanding anything to the contrary contained in this Article 14, an assignment or subletting of all or a portion of the Premises to an entity which is controlled by, controls, or is under common control with, Tenant (an “Affiliate”), shall not be deemed a Transfer under this Article 14, provided that Tenant notifies Landlord of any such assignment or sublease and promptly supplies Landlord with any documents or information requested by Landlord regarding such assignment or sublease or such Affiliate, and further provided that such assignment or sublease is not a subterfuge by Tenant to avoid its obligations under this Lease. “Control”, as used in this Section 14.7, shall mean the possession, directly or indirectly, of the power to direct or cause the direction of the management and policies of a person or entity, whether by the ownership of voting securities, by contract or otherwise.

ARTICLE 15

SURRENDER OF PREMISES; OWNERSHIP AND
REMOVAL OF TRADE FIXTURES

          15.1          Surrender of Premises. No act or thing done by Landlord or any agent or employee of Landlord during the Lease Term shall be deemed to constitute an acceptance by Landlord of a surrender of the Premises unless such intent is specifically acknowledged in writing by Landlord. The delivery of keys to the Premises to Landlord or any agent or employee of Landlord shall not constitute a surrender of the Premises or effect a termination of this Lease, whether or not the keys are thereafter retained by Landlord, and notwithstanding such delivery Tenant shall be entitled to the return of such keys at any reasonable time upon request until this Lease shall have been properly terminated. The voluntary or other surrender of this Lease by Tenant, whether accepted by Landlord or not, or a mutual termination hereof, shall not work a merger, and at the option of Landlord shall operate as an assignment to Landlord of all subleases or subtenancies affecting the Premises or terminate any or all such sublessees or subtenancies.

          15.2          Removal of Tenant Property by Tenant. Upon the expiration of the Lease Term, or upon any earlier termination of this Lease, Tenant shall, subject to the provisions of this Article 15, quit and surrender possession of the Premises to Landlord in as good order and condition as when Tenant took possession and as thereafter improved by Landlord and/or Tenant, reasonable wear and tear and repairs which are specifically made the responsibility of Landlord hereunder excepted. Upon such expiration or termination, Tenant shall, without expense to Landlord, remove or cause to be removed from the Premises all debris and rubbish,

 

 

 

 

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and such items of furniture, equipment, business and trade fixtures, free-standing cabinet work, movable partitions and other articles of personal property owned by Tenant or installed or placed by Tenant at its expense in the Premises, and such similar articles of any other persons claiming under Tenant, as Landlord may, in its sole discretion, require to be removed, and Tenant shall repair at its own expense all damage to the Premises and Building resulting from such removal.

ARTICLE 16

HOLDING OVER

          If Tenant holds over after the expiration of the Lease Term or earlier termination thereof, with or without the express or implied consent of Landlord, such tenancy shall be from month-to-month only, and shall not constitute a renewal hereof or an extension for any further term, and in such case Rent shall be payable at a monthly rate equal to the product of (i) the Rent applicable during the last rental period of the Lease Term under this Lease, and (ii) a percentage equal to 150%. Such month-to-month tenancy shall be subject to every other applicable term, covenant and agreement contained herein. Nothing contained in this Article 16 shall be construed as consent by Landlord to any holding over by Tenant, and Landlord expressly reserves the right to require Tenant to surrender possession of the Premises to Landlord as provided in this Lease upon the expiration or other termination of this Lease. The provisions of this Article 16 shall not be deemed to limit or constitute a waiver of any other rights or remedies of Landlord provided herein or at law. If Tenant fails to surrender the Premises upon the termination or expiration of this Lease, in addition to any other liabilities to Landlord accruing therefrom, Tenant shall protect, defend, indemnify and hold Landlord harmless from all loss, costs (including reasonable attorneys’ fees) and liability resulting from such failure, including, without limiting the generality of the foregoing, any claims made by any succeeding tenant founded upon such failure to surrender and any lost profits to Landlord resulting therefrom.

ARTICLE 17

ESTOPPEL CERTIFICATES; FINANCIAL STATEMENTS

          17.1           Estoppel Certificates. Within ten (10) business days following a request in writing by Landlord, Tenant shall execute, acknowledge and deliver to Landlord an estoppel certificate, which, as submitted by Landlord, shall be substantially in the form of Exhibit G, attached hereto (or such other form as may be required by any prospective mortgagee or purchaser of the Project, or any portion thereof), indicating therein any exceptions thereto that may exist at that time, and shall also contain any other information reasonably requested by Landlord or Landlord’s mortgagee or prospective mortgagee. Any such certificate may be relied upon by any prospective mortgagee or purchaser of all or any portion of the Project. Tenant shall execute and deliver whatever other instruments may be reasonably required for such purposes. Failure of Tenant to timely execute, acknowledge and deliver such estoppel certificate or other instruments shall constitute an acceptance of the Premises and an acknowledgment by Tenant that statements included in the estoppel certificate are true and correct, without exception.

          17.2           Financial Statements. At any time during the Lease Term, Landlord may require Tenant to provide Landlord with a current financial statement and financial statements of the two (2) years prior to the current financial statement year. Such statements shall be prepared in accordance with generally accepted accounting principles and, if such is the normal practice of Tenant, shall be audited by an independent certified public accountant.

ARTICLE 18

SUBORDINATION

          This Lease shall be subject and subordinate to all present (including that certain Second Amended and Restated Ground Lease (Parcel 1), dated September 25, 1989, between Parker-Hannifin Corporation, as lessor, and Landlord, as lessee, as amended by that certain First Amendment to Second Amended and Restated Ground Lease (Parcel 1), dated October 17, 1989) and future ground or underlying leases of the Building or Project and to the lien of any mortgage, trust deed or other encumbrances now or hereafter in force against the Building or Project or any part thereof, if any, and to all renewals, extensions, modifications, consolidations and