---

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

T

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

For the quarterly period ended September 30, 2014

o

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

For the transition period from to

Commission file number 001–33006

MERGE HEALTHCARE INCORPORATED

(Exact name of Registrant as specified in its charter)

350 North Orleans Street, 1^st Floor

Chicago, Illinois 60654

(Address of principal executive offices, including zip code)

(Registrant’s telephone number, including area code) (312) 565-6868

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes T No o

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b–2 of the Exchange Act.

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b–2 of the Act).

Yes o No T

The number of shares outstanding of the Registrant’s common stock, par value $0.01 per share, as of October 29, 2014: 98,601,322

 

---

---

INDEX

---

PART I – FINANCIAL INFORMATION

Item 1.

Condensed Consolidated Financial Statements

MERGE HEALTHCARE INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

(in thousands, except for share data)

See accompanying notes to unaudited condensed consolidated financial statements.

---

MERGE HEALTHCARE INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(in thousands, except for share and per share data)

See accompanying notes to unaudited condensed consolidated financial statements.

---

MERGE HEALTHCARE INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(Unaudited)

(in thousands)

See accompanying notes to unaudited condensed consolidated financial statements.

---

MERGE HEALTHCARE INCORPORATED AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(in thousands)

(1)

Net of restricted cash of $392 and $813 at December 31, 2013 and 2012, respectively

(2)

Net of restricted cash of $209 and $753 at September 30, 2014 and 2013, respectively

See accompanying notes to unaudited condensed consolidated financial statements.

---

Merge Healthcare Incorporated and Subsidiaries

Notes to Condensed Consolidated Financial Statements

(Unaudited and in thousands, except for share and per share data)

(1)	Basis of Presentation and Significant Accounting Policies

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission (SEC) for reporting on Form 10-Q. Accordingly, certain information and notes required by United States of America generally accepted accounting principles (GAAP) for annual financial statements are not included herein. These interim statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Annual Report on Form 10-K for the year ended December 31, 2013, of Merge Healthcare Incorporated, a Delaware corporation, and its subsidiaries and affiliates (which we sometimes refer to collectively as Merge, we, us or our). Certain prior year amounts have been reclassified to conform to the 2014 presentation.

Principles of Consolidation

Our unaudited condensed consolidated financial statements reflect all adjustments, which are, in the opinion of management, necessary for a fair presentation of our financial position and results of operations. Such adjustments are of a normal recurring nature, unless otherwise noted. The results of operations in the three and nine month periods ended September 30, 2014 and 2013, are not necessarily indicative of the results to be expected for any future period.

Our unaudited condensed consolidated financial statements are prepared in accordance with GAAP. These accounting principles require us to make certain estimates, judgments and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. We believe that the estimates, judgments and assumptions are reasonable based on information available at the time they are made. Actual results could differ materially from those estimates.

(2)	Other Current Assets and Other Current Liabilities

Other current assets consist primarily of revenue recognized that has not yet been billed to a customer, but are expected to be within the next twelve months. The balances are comprised of the following as of the dates indicated:

Other current liabilities consist primarily of customer deposits, the current portion of certain acquisition obligations, accrued taxes, and other non-trade payables, all of which are due within the next twelve months. The balances are comprised of the following as of the dates indicated:

---

(3)	Goodwill and Other Intangible Assets

Goodwill

The carrying amount of goodwill in each of our segments remained unchanged in the nine months ended September 30, 2014.

Other Intangible Assets

The following is a summary of our intangible assets subject to amortization as of September 30, 2014:

Estimated aggregate amortization expense for our intangible assets, which are expected to become fully amortized in 2023, is as follows:

Amortization expense of our intangible assets is set forth in the following table:

During 2014, we have added $300 of purchased software and $3,139 of capitalized software. Upon completing the exit of an immaterial product line in the third quarter of 2014, we recorded a $727 charge to depreciation and amortization in operating expenses for the reduction in the useful life of related customer relationships and wrote off the fully amortized backlog and customer relationships of $1,580 and $2,520, respectively. For the nine months ended September 30, 2014, we have written off fully amortized purchased software, backlog, customer relationships and non-competes of $390, $1,580, $2,670 and $90, respectively.

---

(4)	Fair Value Measurements

Our financial instruments include cash and cash equivalents, accounts receivable, non‑marketable securities, accounts payable, a term loan and certain accrued liabilities. The carrying amounts of our cash and cash equivalents (which are comprised primarily of deposit and overnight sweep accounts), accounts receivable, accounts payable, and certain accrued liabilities approximate fair value due to the short maturity of these instruments. The estimated fair values of the non-marketable equity securities have been determined from information obtained from independent valuations and management estimates. The carrying value of our long-term debt recognized in the consolidated balance sheets as of September 30, 2014 and December 31, 2013, was approximately $228,190 and $236,432, respectively, while the fair value of long-term debt as of September 30, 2014 and December 31, 2013, was approximately $235,000 and $226,789, respectively based on Level 2 inputs consisting of quoted market prices for the same issues or quoted market prices for similar issues in active markets. See note 6 for further discussion of our debt.

At September 30, 2014, we held equity securities in two private companies, which are classified within other assets in our condensed consolidated balance sheets. The investments in these equity securities are classified as Level 3 investments and are accounted for using the equity method of accounting. Any losses due to impairment in value are recorded as realized losses when such losses occur. The carrying value of these Level 3 investments at September 30, 2014 and December 31, 2013, is $453.

During the third quarter of 2013, we sold an equity security investment for $1,785 that was classified as a Level 1 trading security. The Other, net line in our condensed consolidated statements of operations for the three and nine months ended September 30, 2013, includes a realized gain of $135 and realized losses of $231, respectively, related to this equity security investment.

During the third quarter of 2013, we wrote off an investment in a company that filed for bankruptcy protection. The investment in this publicly traded company, over which we did not exert significant influence, was classified as available-for-sale and reported at fair value on a recurring basis using Level 1 inputs. Unrealized gains and losses were reported within the accumulated other comprehensive income component of shareholders’ equity. As a result of the bankruptcy filing, we reclassified $454 out of accumulated other comprehensive income and recognized a $414 loss (net of tax) in the Other, net line in our condensed consolidated statements of operations for the three and nine months ended September 30, 2013.

(5)	Restructuring

The following table sets forth the activity in the nine months ended September 30, 2014, related to restructuring activities undertaken in prior periods:

Non-cash adjustments primarily relate to settlements of employee or contract exit obligations that did not require cash outlays.

(6)

Debt

Term Loan

On April 29, 2014, we completed a debt refinancing that resulted in a new six-year term loan (the Term Loan) of $235,000. The Term Loan replaced an existing term loan (the Prior Term Loan) and revolving credit facility, each of which was terminated upon completion of the debt refinancing. Proceeds from the Term Loan were used to repay the aggregate principal outstanding under the Prior Term Loan in addition to funding related transaction costs. The Prior Term Loan had a final outstanding balance of $230,133.

The Term Loan was established pursuant to a credit agreement (the Credit Agreement) which contains financial covenants consisting of total leverage and interest coverage ratios which are applicable beginning with the quarter ending March 31, 2015. Borrowings under the Credit Agreement bear interest at a floating rate that can be, at our option, either (i) a LIBOR borrowing rate for a specified interest period plus an applicable margin or, (ii) an alternative base rate plus an applicable margin, subject to a LIBOR rate floor of 1%, or a base rate floor of 2%, as applicable. The applicable margin for borrowings under the Credit Agreement is 6% per annum for LIBOR loans and 5% per annum for base rate loans. If an event of default occurs under the Credit Agreement, the applicable interest rate will increase by 2% per annum during the continuance of such event of default. Based on an election we made pursuant to the terms of the Credit Agreement with respect to the interest period and optional rate, borrowings under the Credit Agreement bore interest at a rate of 7.00% per annum through September 30, 2014. As of September 30, 2014, borrowings had a weighted average interest rate of 7.00%. Interest is currently payable on the last business day of each month and is dependent upon the type of loan outstanding under the Credit Agreement.

---

We are required to make quarterly principal payments totaling $2,938 over the life of the Term Loan, the first of which was made on September 30, 2014. The future maturities of principal under the Term Loan for the remainder of 2014 and for each of the years ending December 31, 2015, 2016, 2017, 2018 and 2019 are $2,938 and $11,750, respectively, with $170,375 due in 2020.

Debt Modification and Extinguishment, Issuance Costs and Discount

We accounted for the April 29, 2014 debt refinancing in accordance with ASC 470-50-40. Accordingly, a portion of our Prior Term Loan was deemed modified and a portion was deemed extinguished. For the portion of the Prior Term Loan deemed extinguished, unamortized issuance costs of $3,080 and unamortized debt discount of $1,679 were written off as debt extinguishment costs in the condensed consolidated statement of operations for the nine months ended September 30, 2014. For the portion of the Prior Term Loan deemed modified, unamortized debt issuance costs of $678 and unamortized debt discount of $410 were deferred to be amortized over the life of the Term Loan. In addition, $202 of third-party costs were deferred as additional issuance costs of the Term Loan and $62 of third-party costs were expensed. Creditor fees of $2,575 and deferred unamortized debt discount of $410 were treated as additional debt discount, and, along with the Term Loan original issue discount of $1,175, are included in the condensed consolidated balance sheet as a reduction of long-term debt. The debt discount will be amortized over the life of the Term Loan using the effective interest method.

As of September 30, 2014, the long-term debt balance in our condensed consolidated balance sheet includes $3,872 of unamortized discount. The balance of unamortized issuance costs included in other assets as of September 30, 2014, was $819. As of September 30, 2014, our borrowings under the Term Loan had an effective interest rate of 7.50%.

Variable Interest Rate Risk

To partially offset variable interest rate risks, we maintain an interest rate cap at 3.00% (versus the 1.00% LIBOR floor) with a notional amount equal to $122,906 as of September 30, 2014. The notional amount of the interest rate cap decreases over time to $121,950 as of September 29, 2015, and thereafter is equal to $62,316 through termination on October 23, 2015.

Interest Expense and Other

In the three and nine months ended September 30, 2014, we recorded $4,425 and $12,722, respectively, of interest expense related to our debt, including $36 and $429, respectively, of amortization of debt issuance costs and $172 and $491, respectively, of debt discount amortization.

Prior Term Loan and Revolving Credit Facility

On April 23, 2013, we entered into a senior secured credit facility consisting of a six-year term loan (the Prior Term Loan) of $255,000 issued at 99% of the Prior Term Loan amount and a five-year revolving credit facility (the Revolving Credit Facility) of up to $20,000. The Prior Term Loan replaced $252,000 of Senior Secured Notes that bore interest at 11.75% (the Notes). The Prior Term Loan and Revolving Credit Facility were terminated on April 29, 2014. In 2014, we made required principal payments of $592 against the Prior Term Loan as well as additional voluntary payments of $8,000.

During 2013, we capitalized $4,588 of debt issuance costs in other assets in our condensed consolidated balance sheet. These issuance costs and the original issue discount of $2,550 related to the Prior Term Loan were being amortized over the life of the loan using the effective interest method. The balances of unamortized debt issuance costs and debt discount as of December 31, 2013, were $4,127 and $2,293, respectively.

---

$252,000 Senior Secured Notes

The Notes were replaced by our Prior Term Loan and Revolving Credit Facility in April 2013. For the nine months ended September 30, 2013, we recorded a charge of $23,822 for early debt extinguishment of the Notes in our condensed consolidated statement of operations. This charge consisted of $5,235 for unamortized debt issuance costs, $1,724 for unamortized net debt discount and $16,863 for early retirement costs associated with the extinguishment of the Notes.

(7)	Share-Based Compensation

Stock Options

The following table summarizes share-based compensation expense recognized during the periods indicated:

Stock option activity in the nine months ended September 30, 2014, is set forth in the following table:

Restricted Stock

Restricted stock activity in the nine months ended September 30, 2014, is set forth in the following table:

As of September 30, 2014, there was approximately $7,878 of unrecognized compensation cost related to stock options and restricted stock that may be recognized in future periods.

---

Employee Stock Purchase Plan

We maintain an ESPP that allows eligible employees to purchase shares of our common stock through payroll deductions of up to 10% of eligible compensation on an after-tax basis. The eligible employees receive a 5% discount from the market price at the end of each calendar quarter. There is no stock-based compensation expense associated with our ESPP. During the second quarter of 2014, our shareholders approved an increase in the number of shares available for purchase under the ESPP by 500,000 shares.

(8)	Commitments and Contingencies

Litigation

On June 1, 2009, Merge Healthcare was sued in the Milwaukee County Circuit Court, State of Wisconsin, by William C. Mortimore and David M. Noshay with respect to the separation of Mortimore’s and Noshay’s employment and our subsequent refusal to indemnify them with respect to litigation related to their services as officers of Merge Healthcare. The plaintiffs alleged that we breached their employment agreements, unreasonably refused their requests for indemnification and breached other covenants of good faith and fair dealing. Mortimore’s claims for indemnification and damages were heard at arbitration from March 3, 2014 through March 7, 2014. The arbitrator rendered his interim decision on April 30, 2014. In his decision, the arbitrator denied all but one of Mortimore’s claims. We filed a motion for partial summary judgment in the Noshay matter, and on July 17, 2014, the judge granted our motion and entered judgment in Merge Healthcare’s favor on Noshay’s claims for breach of contract and breach of the covenant of good faith and fair dealing leaving Noshay’s claim for attorneys' fees for asserting his right to indemnification, Merge Healthcare’s claim for an award of attorneys’ fee pursuant to the prevailing party provision in Noshay’s employment contract for successfully defending Noshay’s breach of contract and breach of the covenant of good faith and fair dealing claims, and Merge Healthcare’s claim to an award of damages on its remaining counterclaims as the remaining issues to be tried. On October 6, 2014, Merge Healthcare entered into a Settlement Agreement and Mutual Release with Mortimore and Noshay pursuant to which the parties agreed to a mutual release of any further liability arising out of Mortimore’s and Noshay’s respective tenures as officers and/or employees of Merge Healthcare, and, in the case of Mortimore, as chairman of the Board of Directors. Furthermore, Mortimore and Noshay each agreed to issue a statement of regret to Merge Healthcare’s Board of Directors and to reimburse Merge Healthcare a portion of the legal fees and expenses incurred by Merge Healthcare in defending the arbitration and lawsuit.

In August 2010, Merge Healthcare was sued in the Northern District of Texas by the Court-appointed receiver for Stanford International Bank, Ltd. The receiver alleges that Merge Healthcare was a recipient of a fraudulent conveyance as a result of a Ponzi scheme orchestrated by Robert Stanford and Stanford International Bank, Ltd. (SIBL). Merge Healthcare is not alleged to have participated in the Ponzi scheme. The receiver’s claims arise from the failed acquisition of Emageon, Inc. (Emageon) by Health Systems Solutions, Inc. (HSS), an affiliate of SIBL, in February 2009, which resulted in the payment of a $9,000 break-up fee by HSS, which payment is alleged to have been financed by SIBL. Merge Healthcare subsequently acquired Emageon as part of our AMICAS acquisition. The complaint seeks to recover the $9,000 payment to Emageon, plus interest, costs, and attorneys’ fees. We have retained litigation counsel and intend to vigorously defend this action. We filed a motion to dismiss the complaint, which motion was denied. Trial has been scheduled for May 2015. Discovery in this matter is ongoing. We believe it is reasonably possible that we may incur a loss with respect to this matter. The potential loss may lie in a range from zero to the full amount claimed, plus interest.

On January 16, 2014, a purported shareholder class action complaint was filed in the United States District Court for the Northern District of Illinois by Fernando Rossy, who claims to be a Merge Healthcare stockholder, against Merge Healthcare and certain current and former directors and officers claiming violations of federal securities laws and asserting that a class of our stockholders suffered damages due to the alleged dissemination or approval of false and misleading statements by Merge Healthcare from August 1, 2012 through January 7, 2014 related to falsified subscription backlog figures and a reluctance amongst large health systems to make enterprise purchases, as well as a lack of effective controls. Several other putative shareholder class action complaints alleging materially the same causes of action were subsequently filed. A hearing was held on March 26, 2014 before the Court of the Northern District Illinois, at which time the Court granted the motion of the Arkansas Teacher Retirement System (“ATRS”) to consolidate the class action cases and to appoint ATRS as lead plaintiff. ATRS filed an amended complaint on May 28, 2014. We have filed a motion to dismiss the purported class action lawsuit, which we expect to be heard in the fourth quarter of 2014. On February 14, 2014, William B. Federman, who claims to be a Merge Healthcare stockholder, filed a derivative complaint in the Circuit Court of Cook County, Illinois against certain of our current and former directors and officers, asserting breaches of fiduciary duty arising out of materially the same conduct alleged in the securities fraud class action complaints. Subsequently, two other derivative complaints were filed in the United States District Court of the Northern District of Illinois. On June 6, 2014, the judge assigned to the class action case granted our motion to reassign the two Federal derivative actions to her on the basis of relatedness and stayed the Federal derivative cases until she rules on our motion to dismiss the class action case. The plaintiffs in the class action and derivative cases have not claimed a specific amount of damages. Merge Healthcare and the other named defendants are actively considering all possible responses to these complaints. While we intend to defend the claims vigorously and carry directors and officers insurance, it is reasonably possible that we may incur a loss in this matter. At this stage of the proceedings, however, it is not possible for management to reasonably estimate either the likelihood of such a loss or its magnitude.

---

In addition to the matters discussed above, we are involved in various legal matters that are in the process of litigation or settlement in the ordinary course of business. Although the final results of all such matters and claims cannot be predicted with certainty, we believe that the ultimate resolution of all such matters and claims will not have a material adverse effect on Merge’s financial condition. Professional legal fees are expensed when incurred. We accrue for contingent losses when such losses are probable and reasonably estimable. In the event that estimates or assumptions prove to differ from actual results, adjustments are made in subsequent periods to reflect more current information. Should we fail to prevail in any legal matter or should several legal matters be resolved against us in the same reporting period, such matters could have a material adverse effect on our operating results and cash flows for that particular period.

(9)	Transactions with Related Party

 Merrick Ventures, LLC (Merrick Ventures) and Merrick Venture Management Holdings, LLC (Merrick Holdings), beneficially own, as of September 30, 2014, approximately 26.8% of our outstanding common stock. Michael W. Ferro, Jr., the former Chairman of the Board of Merge Healthcare, and trusts for the benefit of Mr. Ferro’s family members beneficially own a majority of the equity interests in Merrick Ventures and Merrick Holdings. Mr. Ferro serves as the chairman and chief executive officer of each of Merrick Holdings and of Merrick Ventures. Accordingly, Mr. Ferro indirectly controls all of the shares of Common Stock owned by Merrick Holdings and Merrick Ventures.

Beginning in 2009 we were a party to a consulting agreement with Merrick RIS, LLC, an affiliate of Merrick Holdings and Merrick Ventures, under which Merrick provided services including financial analysis and strategic planning. In 2012 we entered into a second amendment to extend the term of the consulting agreement with Merrick RIS, LLC through December 31, 2013, and modified the fee structure to include a quarterly retainer in the amount of $150 in addition to a per transaction fee of $250 for acquisitions by Merge Healthcare. The consulting agreement expired on December 31, 2013. We paid $177 and $327 to Merrick for such services and recognized $150 and $450 in acquisition related expenses for the three and nine months ended September 30, 2013, respectively. We also recognized $27 in general and administrative expenses in the nine months ended September 30, 2013. As of December 31, 2013, we had no remaining liability or obligations under this agreement.

From September 8, 2010 through expiration on December 9, 2013, we were party to an assignment agreement with Merrick Ventures under which Merrick Ventures assigned to us its sublease with Aon Corporation for approximately 11,934 square feet located on the 20th floor of 200 East Randolph Street, in Chicago, Illinois. During 2013, the base rental rate was approximately $20.0 per month from January 1, 2013 to July 31, 2013 and $20.5 per month from August 1, 2013 to December 9, 2013. The rent was paid to the sub–landlord monthly and was the same rate as Merrick Ventures paid under the sublease.

From February 24, 2012 through expiration on December 13, 2013, we were party to agreement with Merrick Ventures under which Merge agreed to sublease from Merrick approximately 4,700 square feet located at 200 E. Randolph Street, 22nd floor, Chicago, Illinois at an annual rental of $80. The rent was paid to Merrick monthly and was the same rate as Merrick paid under its lease. Merge paid approximately $74 (which represents the book value) for all fixtures, leasehold improvements and furniture located in the space. We vacated the space that we subleased from Merrick Ventures in September 2013.

(10)	Income Taxes

We are subject to tax in multiple jurisdictions and record income tax expense on an interim basis using an estimated annual effective tax rate. The estimated annual effective tax rate is modified to exclude the effect of losses for those jurisdictions where the tax benefit cannot be recognized and a separate estimated annual tax rate is required. If a reliable estimate of the annual effective tax rate cannot be made, the year-to-date effective tax rate is utilized under the discrete method. The current period income tax provision was calculated under the discrete method as management determined that an annual effective tax rate method would not provide a reliable estimate. Items discrete to a specific quarter are reflected in tax expense for that period. Further limitations may apply to deferred tax assets if certain ownership changes occur. We do not expect a significant change in unrecognized tax benefits within the next twelve months.

---

We evaluate our deferred income taxes quarterly to determine if valuation allowances are required or should be adjusted. U.S. GAAP requires that companies assess whether valuation allowances should be established against their deferred tax assets based on consideration of all available evidence, both positive and negative, using a “more likely than not” standard. This assessment considers, among other matters, the nature, frequency and amount of recent losses, the duration of statutory carryforward periods, and tax planning strategies. In making such judgments, significant weight is given to evidence that can be objectively verified.

In the nine months ended September 30, 2014, we reversed a portion of the tax valuation allowance against our net deferred tax assets related to a separate legal entity’s state jurisdictions. The release of this valuation allowance is a result of a separate legal entity’s consistent cumulative income position and ability to satisfy the internal policy to rely on forecasted earnings. The net income impact of the tax valuation allowance release was a tax benefit of approximately $786. A valuation allowance was retained on the portion of the separate legal entity’s state net operating losses that are estimated to not be utilized based on income forecasts and Section 382 limitations. The state NOLs expire in various tax years through 2031.

(11)	Net Income (Loss) Per Share Attributable to Common Shareholders of Merge

Basic and diluted net income or loss per share are computed by dividing net income or loss available to common shareholders by the weighted average number of common shares outstanding during the period. The computation of net income or loss available to common shareholders is presented in our condensed consolidated statements of operations. Diluted net income per share includes the dilution that could occur based on the potential exercise of stock options, except for stock options with an exercise price of more than the average market price of our common stock during the period, as such exercise would be anti-dilutive, and assuming the potential lapse of restrictions on outstanding restricted stock awards.

In the three months ended September 30, 2014 and 2013, options to purchase 5,289,175 and 3,412,352 shares of our common stock, respectively, had exercise prices greater than the average market price of our common stock, and, therefore, are not considered in the calculations of diluted net income or loss per share. For the nine months ended September 30, 2014 and 2013, options to purchase 5,564,762 and 4,902,352 of our common shares, respectively, had exercise prices greater than the average market price of our common stock, and, therefore, are not considered in the calculations of diluted net income or loss per share.

As a result of the loss incurred in the nine months ended September 30, 2014, incremental shares from the assumed exercise of employee stock options totaling 694,523 have been excluded from the calculation of diluted loss per share as their inclusion would have been anti-dilutive. Potentially dilutive common stock equivalent securities, including securities that might have been considered in the calculation of diluted net income per share if there was net income for the nine months ended September 30, 2014 and 2013, were 8,708,148 and 9,934,540, respectively.

(12)	Segment Information

We have two operating groups which constitute reportable operating segments: Merge Healthcare and Merge DNA. We evaluate the performance of these operating groups based on their respective revenues and operating income, which exclude public company costs, certain corporate costs (amortization expense that is not specific to a segment), net interest expense and income taxes.

---

The following tables present operating group financial information for the periods indicated:

(1) Net corporate/other expenses include public company costs, corporate administration expenses, amortization expense which is not attributable to business segments, acquisition-related expenses, net interest expense and loss on debt extinguishment.

(13)	Recent Accounting Pronouncements

We describe below recent pronouncements that have had or may have a significant effect on our financial statements or on our disclosures. We do not discuss recent pronouncements that a) are not anticipated to have an impact on, or b) are unrelated to our financial condition, results of operations, or related disclosures.

In July 2013, the FASB issued ASU No. 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exist, which is included in ASC Topic 740 (Income Taxes). ASU 2013-11 requires an entity to net its liability for unrecognized tax positions against a net operating loss carryforward, a similar tax loss or a tax credit carryforward when settlement in this manner is available under the tax law. The provisions of this new guidance are effective for reporting periods beginning after December 15, 2013. We applied this guidance in the first quarter of 2014 and it did not have a material impact on our statement of operations, financial position, or cash flows.

In April 2014, the FASB issued ASU No. 2014-08, Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity, which changes the criteria for determining which disposals can be presented as discontinued operations and modifies the related disclosure requirements. To qualify as a discontinued operation the standard requires a disposal to represent a strategic shift that has, or will have, a major effect on an entity's operations and financial results. The standard also expands the disclosures for discontinued operations and requires new disclosures related to individually material dispositions that do not qualify as discontinued operations. The standard is effective prospectively for fiscal years beginning after December 15, 2014, with early adoption permitted. We applied this guidance in the third quarter of 2014 and it did not have a material impact on our statement of operations, financial position, or cash flows.

---

In May 2014, the FASB issued ASU No. 2014- 09, Revenue from Contracts with Customers (Topic 606). ASU 2014-09 also adds Subtopic 340-40 Other Assets and deferred Costs‒Contracts with Customers. The FASB issued ASU 2014-09 to clarify the principles for recognizing revenue and to develop a common revenue standard for generally accepted accounting principles and International Financial Reporting Standards. The standard outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes the most current revenue recognition guidance. ASU 2014-09 requires retrospective application either, a) to each prior period presented, or, b) retrospectively with the cumulative effect of initially applying the guidance recognized at the date of initial application as an adjustment to opening retained earnings. The provisions of this new guidance are effective for annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. Earlier application is not permitted. We are currently evaluating the impact of the new guidance on our financial statements.

In August 2014, the FASB issued ASU N0. 2014-15, Presentation of Financial Statements—Going Concern (Subtopic 205-40), Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern which requires management to evaluate, in connection with preparing financial statements for each annual and interim reporting period, whether there are conditions or events, considered in the aggregate, that raise substantial doubt about an entity’s ability to continue as a going concern within one year after the date that the financial statements are issued (or within one year after the date that the financial statements are available to be issued when applicable) and provide related disclosures. ASU 2014-15 is effective for the annual period ending after December 15, 2016, and for annual and interim periods thereafter. Early adoption is permitted. We are currently evaluating the impact of the new guidance on our financial statements.

(14)	Subsequent Events

We have evaluated subsequent events from the balance sheet date through October 29, 2014, and we have concluded that no subsequent events occurred during that period.

---

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

Cautionary Note Regarding Forward-Looking Statements

The discussion below contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act, and Section 21E of the Exchange Act. We have used words such as “believes,” “anticipates,” “forecasts,” “projects,” “could,” “plans,” “expects,” “may,” “will,” “would,” “intends,” “estimates” and similar expressions, whether in the negative or affirmative, to identify forward-looking statements. These statements are based on information currently available to us and are subject to a number of risks and uncertainties that may cause our actual results of operations, financial condition, cash flows, performance, business prospects and opportunities and the timing of certain events to differ materially from those expressed in, or implied by, these statements. These risks, uncertainties and other factors include, without limitation, those matters discussed in Item 1A of Part I of our Annual Report on Form 10‑K for the year ended December 31, 2013. Except as expressly required by the federal securities laws, we undertake no obligation to update such factors or to publicly announce the results of any of the forward-looking statements contained herein to reflect future events, developments, or changed circumstances, or for any other reason. The following discussion should be read in conjunction with our consolidated financial statements and notes thereto appearing in our Annual Report on Form 10-K and Item 1A, “Risk Factors” for the year ended December 31, 2013.

Management’s Discussion and Analysis is presented in the following order:

Overview

We develop software solutions that facilitate the sharing of images to create a more effective and efficient electronic healthcare experience for patients and physicians. Our solutions are designed to help solve some of the most difficult challenges in health information exchange today, such as the incorporation of medical images and diagnostic information into broader healthcare IT applications, the interoperability of proprietary software solutions, the profitability of outpatient imaging practices and the ability to improve the efficiency and cost effectiveness of our customers’ businesses. These solutions optimize processes for healthcare providers ranging in size from single provider practices to large health systems, to the sponsors of clinical trials and medical device manufacturers. We believe that our ability to innovate has driven consistent expansion of solutions and services and assisted our entry into new markets.

We operate under two reportable operating segments: Merge Healthcare and Merge DNA. Our Merge Healthcare segment represents about 84% of our year-to-date total revenues and markets, sells and implements interoperability, imaging and clinical solutions to healthcare providers. Our Merge DNA (Data and Analytics) segment represents the other 16% of revenues and focuses on data capture software for clinical trials and other solutions. We evaluate the performance of each operating group based on their respective revenues and operating income.

Our Merge Healthcare segment primarily generates revenue from the sale of software (including upgrades), hardware, professional services, maintenance and electronic data interchange (EDI) services. Our Merge DNA segment derives the vast majority of its revenue from software, professional services, and hosting through subscription arrangements. Going forward, we expect that substantially all revenues for Merge DNA will come from clinical trials. The majority of total revenue continues to be generated through perpetual license agreements with our customers. Under perpetual license agreements, the software, hardware and professional services are considered to be sources of non-recurring revenue and related backlog. The backlog of non-recurring revenue was approximately $24.0 million and $22.3 million as of September 30, 2014 and 2013, respectively.

Subscription-based pricing arrangements include contract elements that are payable by our customers over a number of years. Year-to-date, subscription revenue was approximately 16% of total net sales. Previously, these contracts included a minimum volume and/or dollar commitment, but, in order to utilize a disruptive contracting methodology to increase customer adoption, we have recently introduced a no minimum, pay-per-transaction structure for certain products. As such, we expect subscription revenue backlog to decrease over time, while revenue from these transactions should increase. Subscription-based pricing arrangements include contract elements that are recognized ratably over an extended period of time. Subscription arrangements include, but are not limited to, contracts that are structured with monthly payments (including leases), clinical trials, certain interoperability solutions, or renewable annual software contracts (with very high renewal rates). As of September 30, 2014, subscription revenue backlog was $52.1 million, compared to $54.4 million at September 30, 2013. Due to the variability in timing and length of maintenance renewals, we do not track backlog for maintenance and EDI.

---

In the second quarter of 2014, we completed a debt refinancing that resulted in a new six-year term loan (the Term Loan) of $235 million at a 7.00% interest rate. The Term Loan replaced an existing term loan (the Prior Term Loan) at a 6.00% interest rate with more restrictive financial ratio covenants, which was terminated upon completion of the debt refinancing. Proceeds from the Term Loan were used to repay the aggregate principal outstanding under the Prior Term Loan in addition to funding related transaction costs. The Prior Term Loan had an outstanding balance of $230.1 million as of April 29, 2014, and we recorded a non-cash charge of $4.8 million in the second quarter of 2014 associated with its extinguishment. The Prior Term Loan, completed in the second quarter of 2013, replaced Senior Secured Notes (which were at an 11.75% interest rate). In the second quarter of 2013, we recorded a charge of $23.8 million, including $7.0 million of non-cash expenses, for the early extinguishment of the Notes.

Business Segments

The following tables provide operating group information for the periods indicated, based on GAAP reported information (all amounts are in thousands, except percentages):

---

The following tables provide GAAP sales generated by non-recurring, subscription and maintenance and EDI revenue sources by segment for the periods indicated and non-recurring and subscription backlog as of September 30, 2014 and 2013 (all amounts are in thousands, except percentages):

---

Results of Operations

Three Months Ended September 30, 2014 Compared to the Three Months Ended September 30, 2013

The following table sets forth selected, summarized, unaudited, consolidated financial data for the periods indicated, as well as comparative data showing increases and decreases between the periods. All amounts, except percentages, are in thousands.