A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following material weaknesses have been identified and included in management’s assessment: 

1.	The Company did not maintain effective controls over the calculation of earnings per share. There are no controls in place to prevent inadvertent errors that could result in a material misstatement.

2.

The Company did not maintain effective controls over the calculation of the income tax provision or the related footnote disclosures. The Company relies primarily on a single individual and does not possess adequate resources to perform a comprehensive review. Such process is ineffective in preventing an inadvertent error that could result in a material misstatement.

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3.	The Company did not maintain effective controls over the preparation of disclosures required by generally accepted accounting principles. There are no controls in place to prevent inadvertent errors that could result in a material disclosure deficiency.

These material weaknesses were considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2006 consolidated financial statements and this report does not affect our report dated March 7, 2007, except for Note 16 as to which the date is March 14, 2007, on those consolidated financial statements.

In our opinion, management’s assessment that Netsmart Technologies, Inc. and Subsidiaries did not maintain effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, because of the effect of the material weaknesses described above on the achievement of the objectives of the control criteria, Netsmart Technologies, Inc. and Subsidiaries has not maintained effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.

 

 

/s/ Marcum & Kliegman LLP

 

Marcum & Kliegman LLP

Melville, New York

Item 9B.

Other Information.

None

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Part III

Item 10.  Directors and Executive Officers of the Registrant.

Our directors and executive officers are as follows:

Name	Age	Position
James L. Conway	59	Chief Executive Officer and Director
Anthony F. Grisanti	57	Chief Financial Officer, Treasurer and Secretary
Alan Tillinghast	43	Director
Kevin Scalia	46	Director
Francis J. Calcagno1, 2 & 3	57	Director
John S.T. Gallagher1, 2 & 3	75	Director
Yacov Shamash3	57	Director
Joseph G. Sicinski1 & 2	74	Director

____________

1	Member of the compensation committee.

2	Member of the audit committee.

3	Member of the nominating and governance committee.

Director and Executive Officer Biographies

Mr. James L. Conway has been the Company’s chief executive officer since April 1998, a director since January 1996 and president from January 1996 until January 2001. From 1993 until April 1998, he was president of a Long Island based manufacturer of specialty vending equipment for postal, telecommunication and other industries. He was previously vice president, treasurer and director of ITT Credit Corporation. Mr. Conway was recently elected to the board of LISTnet which is an organization with the objective of promoting Long Island as one of the national centers of excellence for software and technology solutions. He also serves and is a member of the CEO Roundtable for Long Island.

Mr. Anthony F. Grisanti has been our Treasurer since June 1994, Secretary since February 1995 and Chief Financial Officer since January 1996.

Mr. Alan B. Tillinghast was elected as a director in December 2006. Mr. Tillinghast was appointed as Netsmart’s Chief Technology Officer and Executive Vice President for Operations in December 2006. Prior thereto, Mr. Tillinghast held senior executive positions with the Company’s wholly-owned subsidiary Netsmart New York since 1999. Previously Mr. Tillinghast held senior positions with Saint Vincent’s Catholic Medical Center where he was responsible for the implementation of a variety of systems for their Behavioral Healthcare Division. He also serves as a board member for Options for Community Living, a not-for-profit organization serving the health and human service needs of Long Island.

Mr. Kevin Scalia was elected as a director in December 2006. Mr. Scalia was appointed as Netsmart’s Executive Vice President, Corporate Development in December 2006 and prior to that date was serving as Executive Vice President, Corporate Development of the Company’s wholly-owned subsidiary, Netsmart New York since October 2005. From January 2004 to October 2005, he served as Vice-President of Operations of Netsmart New York. From 2002 to 2004 Kevin was director of business development for the company and its subsidiaries. Prior to joining Netsmart, Mr. Scalia served as President and COO of Galt Technologies, Melville, New York, a Long Island based professional services firm which provided enterprise applications to mid-size and fortune 500 companies, and served as chairman and CEO of a manufacturer of supercomputers, security equipment and medical imaging equipment. He is a Founding Member of the Long Island Software and Technology Network, and a member of the College of Engineering Advisory Board, State University of New York at Stony Brook.

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Mr. Francis J. Calcagno has been one of the Company’s directors since September 2001. He is a senior managing director of Dominick & Dominick LLC, 150 E.52nd Street, New York, New York 10022, an investment banking firm, a position he has held since 1997. From 1993 until 1997, he was a managing director of Deloitte and Touche, LLP.

Mr. John S.T. Gallagher has been one of the Company’s directors since March 2002. He has been a consultant to the President of SUNY Stony Brook, Stony Brook, New York 11794-2200, since December 2005. From 2001 until 2005, he was deputy county executive for health and human services in Nassau County, New York, 1 West Street, Mineola, New York 11501. Prior thereto he was a senior executive officer of North Shore University Hospital and North Shore—Long Island Jewish Health System since 1982, having served as executive vice president of North Shore from 1982 until 1992, president from 1992 until 1997 and chief executive officer of the combined hospital system from 1997 until January 2002. In January 2002, he became co-chairman of the North Shore—Long Island Jewish Heath System Foundation. Mr. Gallagher is also a director of Perot Systems Corporation, a worldwide provider of information technology services.

Dr. Yacov Shamash has been one of the Company’s directors since January 2004. Dr. Shamash is Vice President for Economic Development and the Dean of the College of Engineering and Applied Sciences at Stony Brook University, Stony Brook, New York 11794-2200. Prior to joining SUNY Stony Brook in 1992, Dr. Shamash served as the Director of the School of Electrical Engineering and Computer Science at Washington State University. He has also held faculty positions at Florida Atlantic University, the University of Pennsylvania and Tel Aviv University. He received his undergraduate and graduate degrees from Imperial College of Science and Technology in London, England. Dr. Shamash has been a member of the Board of Directors of KeyTronic Corporation, a contract manufacturer, since 1989, of American Medical Alert Corporation, a healthcare service provider, since 2001 and of Applied DNA Sciences, Inc., a company engaged in the business of researching, developing and selling security and anti-counterfeiting products that utilize plant DNA for verification purposes, since 2006 and is a member of the board of directors of LISTnet which is an organization with the objective of promoting Long Island as one of the national centers of excellence for software and technology solutions.

Mr. Joseph G. Sicinski has been one of the Company’s directors since June 1998. He was president and director of Trans Global Services, Inc., 8707 Katy Freeway, Suite 300, Houston, Texas 77024, a technical staffing company, from September 1992 until April 1998. From April 1998 until September 2002 he was also chief executive officer of Trans Global. In September 2003 he retired from Trans Global and co-founded Novus Management Services, Inc, a company providing services related to the insurance industry where he is also a board member. In February 2004 he co-founded BDS Strategic Solutions, Inc., a company providing permanent and temporary staffing solution services and programs related to human resource issues. He is chairman of the board of directors of BDS.

Directors are elected for a term of one year.

None of our officers and directors are related.

Our certificate of incorporation includes certain provisions, permitted under Delaware law, which provide that a director shall not be personally liable to us or our stockholders for monetary damages for breach of fiduciary duty as a director except for liability (i) for any breach of the director’s duty of loyalty to us or our stockholders, (ii) for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law, (iii) for any transaction from which the director derived an improper personal benefit, or (iv) for certain conduct prohibited by law. The Certificate of Incorporation also contains broad indemnification provisions. These provisions do not affect the liability of any director under federal or applicable state securities laws.

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Board Committees

Our board of directors has three standing committees - the audit committee, the compensation committee and the nominating and governance committee. The board of directors also established a special committee to evaluate the advisability of entering into the Merger Agreement. All of the members of each committee are “independent” as defined under Nasdaq rules.

The responsibilities of the audit committee include overseeing our financial reporting process, reporting the results of its activities to the board, retaining and ensuring the independence of our independent registered public accountants, approving services to be provided by our independent registered public accountants, reviewing our periodic filings with the independent registered public accountants prior to filing, and reviewing and responding to any matters raised by the Independent Registered Public Accountants in their management letter and SAS 61 Communications. The audit committee consists of Mr. John S.T. Gallagher, who is chairman of the committee and Messrs. Francis Calcagno and Joseph G. Sicinski. The board of directors has determined that each of Messrs. Gallagher and Calcagno, qualifies as an “Audit Committee financial expert,” as defined by Securities and Exchange Commission rules, based in his education, experience and background. A copy of the Audit Committee charter can be found on our website at www.ntst.com.

The compensation committee serves as the stock option committee for our stock option plans and the employee stock purchase plan, and it reviews and approves any employment agreements with management and changes in compensation for our executive officers. The members of the compensation committee are Mr. Gallagher, who is chairman of the committee and Messrs. Calcagno and Sicinski. A copy of the Compensation Committee charter can be found on our website at www.ntst.com.

The nominating and governance committee is primarily responsible for reviewing our corporate governance principles and independence standards: overseeing the annual evaluation of our board and its committees; discharging the board’s responsibilities related to compensation of directors; identifying and evaluating individuals for board and committee membership and chairs; making recommendations to the board concerning the selection of director nominees and making recommendations as to the size and composition of the board and its committees. It will consider director nominee recommendations by stockholders provided that the names of such nominees, accompanied by relevant biographical information are properly submitted to our Secretary in accordance with the stockholder nomination procedures adopted by the Board of Directors, as described below. The members of the Nominating and Governance Committee are Dr. Shamash, who is the chairman of the committee and Messrs. Gallagher and Calcagno. A copy of the Nominating and Governance Committee charter can be found on our website at www.ntst.com.

The board of directors established the special committee to represent the interests of the unaffiliated stockholders in considering whether to pursue a proposal to sell Netsmart and the strategy of continuing Netsmart’s business without engaging in such a transaction. The special committee consists of Mr. Calcagno, who is chairman of the committee, and Messrs. Gallagher, Shamash and Sicinski.

Excluding actions by unanimous written consent, during 2006, the board of directors held twelve meetings, the compensation committee held six meetings, the nominating and governance committee held one meeting and the audit committee held five meetings. The special committee held twelve meetings and the independent directors held four meetings.

The audit committee met with our independent registered public accountants and chief financial officer prior to filing of this Form 10-K annual report to review the 2006 audited financial statements with the independent registered public accountants. During 2006, all of our directors attended at least 75% of the aggregate of meetings of the board and the meetings of any committee of which they are members.

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Section 16(a) Beneficial Ownership Reporting Compliance

Section 16(a) of the Securities Exchange Act of 1934 requires our executive officers, directors and persons who own more than ten percent of a registered class of our equity securities ("Reporting Persons") to file reports of ownership and changes in ownership on Forms 3, 4 and 5 with the Securities and Exchange Commission and the Nasdaq Stock Exchange. These Reporting Persons are required by SEC regulation to furnish us with copies of all Forms 3, 4 and 5 they file with the SEC and Nasdaq. Based solely upon our review of the copies of the forms we have received, and upon representations received from such Reporting Persons, we believe that all Reporting Persons complied on a timely basis with all filing requirements applicable to them with respect to transactions during fiscal 2005 except that each of Messrs. Gallagher, Sicinski, Calcagno and Shamash failed to timely file the requisite Form 4 reporting the grant of certain options pursuant to the automatic grant provisions of our 2001 Long Term Incentive Plan.

Code of Ethics

We have adopted a Code of Ethics applicable to our principal executive officers, principal financial officer, principal accounting officer and controller and a Code of Business Conduct applicable to all of our employees, each which is posted on our website at www.ntst.com. Our Board of Directors has adopted a Code of Business Conduct applicable to the Company’s officers and employees, and has also adopted a Code of Ethics for its senior financial officers. These codes of ethics are posted on the Company’s website at www.ntst.com in the Investor Relations section. Any amendment of the codes of ethics or waiver thereof applicable to any director or executive officer of the Company, including the Chief Executive Officer or any senior financial officer, will be disclosed on the Company’s website within four business days of the date of such amendment or waiver. In the case of a waiver, the nature of the waiver, the name of the person to whom the waiver was granted and the date of the waiver will also be disclosed. A copy of the codes of ethics may also be obtained without charge by writing to Mr. Anthony F. Grisanti, Chief Financial Officer, Netsmart Technologies, Inc, 3500 Sunrise Highway, Great River, NY 11739.

Item 11.

Executive Compensation.

Executive Compensation Program Objectives and Overview

Netsmart’s current executive compensation programs are intended to achieve three fundamental objectives: (1) attract and retain qualified executives; (2) motivate performance to achieve specific strategic and operating objectives of Netsmart; and (3) align executives’ interests with the long-term interests of Netsmart’s stockholders. As described in more detail below, the material elements of our current executive compensation program for our principal executive officer, principal financial officer and the other most highly compensated executive officers, (“Named Officers”) include a base salary, an annual bonus opportunity, perquisites, retirement benefits, severance protection for certain actual or constructive terminations of the Named Officers’ employment, and other post-termination benefits payable upon retirement, death or disability.

 

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We believe that each element of our executive compensation program helps us to achieve one or more of our compensation objectives. The table below lists each material element of our executive compensation program and the compensation objective or objectives that it is designed to achieve.

 

Compensation Element		Compensation Objectives Attempted to be Achieved
Base Salary		Attract and retain qualified executives
Bonus Compensation		Motivate performance to achieve specific strategies and operating objectives Attract and retain qualified executives
Perquisites and Personal Benefits		Attract and retain qualified executives
Equity-Based Compensation (stock options)		Align Named Officers’ long-term interests with stockholders’ long-term interests Motivate performance to achieve specific strategies and operating objectives Attract and retain qualified executives
Retirement Benefits (e.g., 401(k), Executive Retirement, Non Competition and Consulting Plan		Attract and retain qualified executives
Severance and Other Benefits Upon Termination of Employment		Attract and retain qualified executives Motivate performance to achieve specific strategies and operating objectives

As illustrated by the table above, base salaries, perquisites and personal benefits, retirement benefits and severance and other termination benefits are all primarily intended to attract and retain qualified executives. These are the elements of our current executive compensation program where the value of the benefit in any given year is not dependent on performance (although base salary amounts and benefits determined by reference to base salary will increase from year to year depending on performance, among other things). We believe that in order to attract and retain top-caliber executives, we need to provide executives with predictable benefit amounts that reward the executive’s continued service. Some of the elements, such as base salaries and perquisites and personal benefits, are generally paid out on a short-term or current basis. The other elements are generally paid out on a longer-term basis, such as upon retirement or other termination of employment. We believe that this mix of longer-term and short-term elements allows us to achieve our dual goals of attracting and retaining executives (with the longer-term benefits geared toward retention and the short-term awards focused on recruitment).

Our annual bonus opportunity is primarily intended to motivate our executives’ performance to achieve specific strategies and operating objectives, although we also believe it helps us attract and retain executives. Certain of our executives are also eligible for commissions based on sales. Our equity-based compensation is primarily intended to align our executives’ long-term interests with stockholders’ long-term interests, although we also believe they help motivate performance and help us attract and retain executives. These are the elements of our current executive compensation program that are designed to reward performance and the creation of stockholder value, and therefore the value of these benefits is dependent on performance. Each executive’s annual bonus opportunity is paid out on an annual short-term basis and is designed to reward performance for that period. Equity-based compensation is generally paid out or earned on a longer-term basis and is designed to reward performance over the term of the award.

The Compensation Committee’s general philosophy is that bonus and equity compensation should fluctuate with the Company’s success in achieving financial and other goals, and that Netsmart should continue to use long-term compensation such as stock options to align stockholder and executives’ interests. The Compensation Committee and Netsmart’s Chairman believe in reserving significant amounts for results-based incentive compensation and thus setting fixed-amount base salaries near the median of peer companies.

 

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The Company retains GK Partners, an outside executive compensation consulting firm (which provides no other services to the Company) to provide general compensation expertise, explore alternative incentive programs and analyze comparative compensation information for the Compensation Committee. In carrying out its responsibilities in 2006, the Committee sought the consulting firm’s advice regarding compensation levels within the industry and the advisability of adopting alternative or additional performance incentives. In addition, the consulting firm provided valuable information to the Committee by benchmarking the Committee’s executive compensation program against those of a peer group of comparable software companies, which was suggested by the consulting firm and which included such companies as American Medical Alert, Applix, Inc., Bitstream, Inc., CAS Medical Systems, Inc., Enzo Biochem, Inc., Exar Corporation, Hauppauge Digital, Inc., Hi Tech Pharmacal Co., Inc., Insightful Corp., LanVision Systems, Inc., Mediware Systems, Inc. and Quality Systems, Inc. This benchmarking was performed for comparative purposes. The Committee then determined the amount of the components of our executive compensation program using, among other factors, the information provided to it by the consulting firm. Because we generally determine the components of our executive compensation program, in part, by using such benchmarked information, we do not generally factor in amounts realized from prior compensation paid to our executives.

Current Executive Compensation Program Elements

Base Salaries

Like most companies, Netsmart’s policy is to pay our executives’ base salaries in cash.

In April 2004, we entered into revised employment agreements with Messrs. James L. Conway and Anthony F. Grisanti. The terms and conditions of the revised contracts are identical in all material respects to the previous contracts except that (i) the term of each individual’s contract was extended by one year, so that Messrs. Conway and Grisanti’s contract will expire on December 31, 2006 and (ii) the revised contracts do not provide for a five-year consulting period following each individual’s respective term of employment during which such individual would have been entitled to compensation of $75,000 per year. Messrs. Conway and Grisanti’s contracts also provide for an option, which has been exercised, to extend their contracts for one additional year so that their contracts now expire on December 31, 2006.

In January 2006, one of our subsidiaries, Netsmart-NY entered into an employment agreement with Mr. Alan Tillinghast as an Executive Vice President with such contract expiring on December 31, 2008 (the “Tillinghast Agreement”). The Tillinghast Agreement provides for an option to extend his contract for continuing subsequent two year terms unless terminated by Netsmart-NY or Mr. Tillinghast on not less than sixty days written notice prior to the expiration of the contract. Mr. Tillinghast was appointed as an executive officer of Netsmart on December 2007. In February 2005, one of our subsidiaries, Netsmart-NY entered into an employment agreement with Mr. Kevin Scalia as an Executive Vice President with such contract expiring on February 14, 2008 (the “Scalia Agreement”). The Scalia Agreement provides for an option to extend his contract for continuing subsequent two year terms unless terminated by Netsmart-NY or Mr. Scalia on not less than sixty days written notice prior to the expiration of the contract. Mr. Scalia was appointed as an executive officer of Netsmart in December 2006.

The agreements provide for annual increases associated with cost of living indexes or 5%, whichever is greater. The agreements provide that the executives are eligible to participate in a bonus pool to be determined annually by the board, based on the executive’s performance. The agreements also provide each of these officers with an automobile allowance and insurance benefits. In approving our executives’ salary increases, our board took into account, among other things, the greater responsibility of our executives positions, peer group comparisons provided by the Committee’s outside consulting firm, and the executives’ individual experience and increased responsibilities. The base salary that was paid to each Named Officer in 2006 is the amount reported for such officer in Column (c) of the Summary Compensation Table.

 

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In connection with the proposed merger transaction, we entered into new contracts with each of Mr. Conway (the “Conway Agreement”) and Mr. Grisanti (the “Grisanti Agreement”). These agreements were entered into in connection with the proposed merger transaction and are not a part of our compensation program. Consequently, the Conway Agreement and Grisanti Agreement were not approved by the Compensation Committee. The Conway Agreement provides that following the closing of the proposed merger, Mr. Conway will continue to act as the Chief Executive Officer of Netsmart for a term of two years commencing on the date of the closing of the merger, such term to be automatically renewed for successive one year terms thereafter unless the Conway Agreement is terminated pursuant to its terms. During the term of the Conway Agreement, Mr. Conway will continue to receive a base salary of $367,500, which is his current base salary, and will no longer have the right to automatic annual base salary increases, as provided in his current employment agreement.

Under the terms of the Grisanti Agreement, following the closing of the proposed merger transaction, Mr. Grisanti will continue to act as the Chief Financial Officer of Netsmart for a term of two years commencing on the date of the closing of the merger, such term to be automatically renewed for successive one year terms thereafter unless the Grisanti Agreement is terminated pursuant to its terms. During the term of the Grisanti Agreement, Mr. Grisanti will continue to receive a base salary of $204,750, which is his current base salary, and will no longer have the right to automatic annual base salary increases, as provided in his current employment agreement.

Annual Bonuses

Netsmart’s policy is to pay any discretionary annual bonuses to the Named Officers in cash. Each of the Named Officers have agreements whereby they are eligible to participate in a bonus pool to be determined annually by the Compensation Committee, based upon their performance. The Compensation Committee, in accordance with the compensation philosophy outlined above, approved cash bonuses for 2006 for the Named Officers as shown in column (d) of the Summary Compensation Table. The bonuses provided for our Named Officers were included in an executive bonus pool that was calculated at approximately 12% of income before taxes and provision for such bonuses. This pool provided bonuses for other executives in addition to the Named Executives. In considering the amount of the bonuses for the Named Officers for fiscal 2006, the Committee took into account the executive’s responsibilities, his performance, and other factors such as Company profitability, market share and industry position. For 2006, the Named Officers’ salaries and bonuses represented the following percentages of their respective total compensation: Mr. Conway—93%, Mr. Grisanti—89%, Mr. Tillinghast—68% and Mr. Scalia—68%. Additionally, Messrs. Tillinghast and Scalia participate in a commission pool and each receives .25% of our commissionable sales bookings for the year. Commissions earned by Messrs. Tillinghast and Scalia for 2006 were $109,080 and $100,022, respectively. According to the Company’s outside compensation consulting firm, the Company’s executive compensation is in line with average executive compensation among peer companies.

Pursuant to the Conway Agreement, for the 2006 fiscal year, Mr. Conway is entitled to receive a bonus in the amount of $140,000, which is the target bonus previously established by the Company at the beginning of the 2006 fiscal year. Thereafter, Mr. Conway is entitled to receive an annual bonus of at least $225,000 if Company performance targets are met as determined by the compensation committee of the Company’s board of directors. In addition, no later than the tenth day following the closing of the merger, Mr. Conway will receive a special one-time cash bonus in the amount of $1,000,000, provided that he executes an effective release in favor of Netsmart and Parent and certain of their respective affiliates releasing his existing rights to payments under his existing employment agreement and the Netsmart Executive Retirement, Non Competition and Consulting Plan, as amended (the “Retirement Plan”), including his right to receive a change-in-control payment of approximately $2,300,000 upon consummation of the merger.

Pursuant to the Grisanti Agreement, for the 2006 fiscal year, Mr. Grisanti is entitled to receive a bonus in the amount of $96,000, which is the target bonus previously established by the Company at the beginning of the 2006 fiscal year. Thereafter, Mr. Grisanti is entitled to receive an annual bonus of at least $96,000 if Company performance targets are met, as determined by the compensation committee of the Company’s board of directors.

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In addition, no later than the tenth day after the closing of the merger, Mr. Grisanti will receive a special one-time cash bonus in the amount of $601,500, provided that he executes an effective release in favor of Netsmart and Parent and certain of their affiliates releasing his existing rights to payments under his existing employment agreement and the Retirement Plan, including his right to receive a change-in control payment of approximately $1,400,000 upon consummation of the merger.

Perquisites

In addition to base salaries and annual bonus opportunities, Netsmart provides the Named Officers with certain perquisites and personal benefits, including automobile-related expenses. We believe that perquisites and personal benefits are often a tax-advantaged way to provide the Named Officers with additional annual compensation that supplements their base salaries and bonus opportunities. When determining each Named Officer’s base salary, we take the value of each Named Officer’s perquisites and personal benefits into consideration.

The perquisites and personal benefits paid to each Named Officer in 2006 are reported in Column (i) of the Summary Compensation Table below, and are further described in footnotes (2), (3), (4) and (5) to the Summary Compensation Table.

Equity-Based Compensation

Netsmart’s policy is that the Named Officers’ long-term compensation should be directly linked to the value provided to stockholders of Netsmart common stock. Accordingly, the Compensation Committee grants equity awards under the 2001 Long Term Incentive Plan designed to link an increase in stockholder value to compensation. During 2006, the Compensation Committee did not award any grants of Incentive Stock Options to any of the Named Officers. Nevertheless, the Compensation Committee believes that the use of these awards encourages executives to continue to use their best professional skills and to remain in Netsmart’s employ. Options granted by Netsmart under the 2001 Long Term Incentive Plan generally vest and become exercisable in installments of 50% after six months and 100% thereafter. The life of the options is generally five years. When considering the equity grants, the Compensation Committee considers each Named Officer’s responsibilities, his performance during the prior year, his expected future contribution to Netsmart’s performance, competitive data on grant values at comparable companies.

Pursuant to the Conway Agreement, within thirty days after the closing of the merger, upon approval by the Compensation Committee, Mr. Conway will be granted an option to purchase shares of the Parent’s common stock having a value equal to an aggregate 2.25% of the fully diluted shares (including all options, warrants and convertible securities on an exercised or as-converted basis) of the Parent’s common stock as of the closing date with an exercise price based on the “Merger Consideration” (as such term is defined in the Merger Agreement), a portion of which shall be subject to time-based vesting and a portion of which shall be subject to performance-based vesting, which options shall be memorialized in a stock option agreement pursuant to a stock option plan to be established by Parent consistent with his employment agreement.

Pursuant to the Grisanti Agreement, within thirty days after the closing of the merger, upon approval by the compensation committee, Mr. Grisanti will be granted an option to purchase shares of Parent’s common stock having a value equal to 0.5% of the fully diluted shares (including all options, warrants and convertible securities on an exercised or as-converted basis) of Parent’s common stock as of the closing date with an exercise price based on the “Merger Consideration” (as such term is defined in the Merger Agreement), which shall be subject to time-based vesting, which option shall be memorialized in a stock option agreement pursuant to a stock option plan to be established by Parent.

 

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Retirement Benefits and Deferred Compensation Opportunities

Effective April 1, 2004, we adopted an Executive Retirement, Non-Competition and Consulting Plan which was subsequently amended August 5, 2004 effective April 1, 2004, pursuant to which, following their retirement, selected officers will be entitled to receive a minimum payment of approximately $85,000 per year for a period of six years, provided, that such officers (i) provide a minimum amount of consulting days each month and (ii) agree to certain covenants not to compete. The annual payments are subject to 10% increases up to a maximum of $136,893 per year. Pursuant to the Executive Retirement, Non-Competition and Consulting Plan, the selected officers are also entitled to receive health benefits for life, provided that there are no breaches of the covenants not to compete. Each of Messrs. Conway and Grisanti are entitled to receive benefits under the plan.

Deferred compensation is a tax-advantaged means of providing the Named Officers with additional compensation that supplements their base salaries and bonus opportunities.

Severance and Other Benefits Upon Termination of Employment

Netsmart’s policy is to provide Named Officers with certain payments in the event of the termination of their employment prior to the end of their current employment term due to death, disability or other than “for cause” (as defined in their respective employment agreements). Netsmart selected such events because they are standard termination triggers in employment contracts. Netsmart determined that its failure to provide such standard termination provisions would adversely affect its ability to achieve its compensation objectives.

Please see the “Potential Payments Upon Termination or Change in Control” section below for a description of the potential payments that may be made to the Named Officers in connection with their termination of employment or a change in control.

The Company does not have formal guidelines for the amount of officer and director Netsmart stock ownership.

Section 162(m) Policy

Section 162(m) of the Internal Revenue Code limits the deductibility by Netsmart of cash compensation in excess of $1 million paid to the Chief Executive Officer and the four highest compensated executive officers during any taxable year, unless such compensation meets certain requirements. Base compensation and the subjective portion of the cash bonuses paid to executive officers for 2006 were within the $1 million Section 162(m) threshold and should, therefore, also be deductible by Netsmart. Stock options under Netsmart’s existing plans, as well as the formulaic portion of the cash bonus, are intended to comply with the rules under Section 162(m) for treatment as performance based compensation. Therefore, Netsmart should be allowed to deduct compensation related to options granted under each of these plans and the formula portion of the cash bonuses.

 

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Netsmart’s Compensation Committee has certain duties and powers as described in its charter. The Compensation Committee is currently composed of the three non-employee directors named at the end of this report each of whom is independent as defined by the NASD Rule 4200(a)(15). The Compensation Committee has reviewed and discussed with management the disclosures contained in the Compensation Discussion and Analysis section of this Item 11. Based upon this review and our discussions, the Netsmart Compensation Committee recommended to its Board of Directors that the Compensation Discussion and Analysis section be included in this Annual Report on Form 10-K.

Compensation Committee of

John S. T. Gallagher (Chair)

The Compensation Committee members whose names appear above were committee members during all of 2006. No member of the Compensation Committee is or has been a former or current officer or employee of the Company or had any relationships requiring disclosure by the Company under the SEC’s rules requiring disclosure of certain relationships and related-party transactions. None of the Company’s executive officers served as a director or a member of a compensation committee (or other committee serving an equivalent function) of any other entity, the executive officers of which served as a director or member of the Compensation Committee during the fiscal year ended December 31, 2006.

 

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Name and Principal Position	Year		Salary ($)		Bonus ($)		Option Awards ($)(2)		All Other Compensation ($)		Total ($)
(a)	(b)		(c)		(d)		(e)		(f)		(g)
James L. Conway(1) (3) Chief Executive Officer	2006 2005 2004		367,500 290,386 197,073		140,000 75,000 175,000		-- 100,000 215,900		38,987 23,004 21,625		546,487 488,390 609,598
Anthony F. Grisanti (4) Chief Financial Officer, Treasurer, and Secretary	2006 2005 2004		204,750 178,415 147,804		96,000 60,000 125,000		-- 180,000 139,700		35,554 26,017 19,731		336,304 444,432 432,235
Alan Tillinghast,(5) (6) Executive Vice President, Operations	2006		178,759		80,000		--		123,480		382,239
Kevin Scalia(5) (7) Executive Vice President, Corporate Development	2006		166,295		80,000				114,422		360,717

 

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(1)	Messrs. Conway, Tillinghast and Scalia serve on the Board of Directors but receive no compensation for their service as directors.

(2)

The value of the option awards in each year was calculated using the Black Scholes value at the date of grant multiplied by the number of options granted to the Named Officer. The Black Scholes value for options granted was $4.00 and $5.08 per share for options granted in 2005 and 2004, respectively.

(3)	All Other Compensation for 2006 consists of $14,400 for automobile allowance, $20,192 in vacation pay and $4,395 for life insurance premiums.

(4)	All Other Compensation for 2006 consists of $14,400 for automobile allowance, $16,500 in vacation pay and $4,654 for life insurance premiums.

(5)	Messrs. Tillinghast and Scalia were appointed as executive officers in December 2006.

(6)	All Other Compensation for 2006 consists of $109,080 in commissions and $14,400 for automobile allowance.

(7)	All Other Compensation for 2006 consists of $100,022 in commissions and $14,400 for automobile allowance.

The Summary Compensation Table should be read in connection with the tables and narrative descriptions that follow. The Outstanding Equity Awards at Fiscal Year End and Option Exercises and Stock Vested tables provide further information on the Named Officers’ potential realizable value and actual value realized with respect to their equity awards.

The discussion of the potential payments due upon a termination of employment or change in control is intended to further explain the potential future payments that are, or may become, payable to our Named Officers.

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Netsmart has traditionally awarded annual stock incentives to employees (including the Named Officers) each year. However, Netsmart did not make any grants of plan-based awards in 2006.

 

		Outstanding Equity Awards At Fiscal Year End
		Option Awards
Name		Number of Securities Underlying Unexercised Options Exercisable			Number of Securities Underlying Unexercised Options Unexercisable			Option Exercise Price			Option Expiration Date
James L. Conway			100,000			-		$	9.85			7/13/2010
			42,500			-		$	8.49			5/13/2009
			142,500			-
Anthony F. Grisanti			10,000			-		$	4.37			5/21/2008
			17,500			-		$	4.93			1/26/2008
			45,000			-		$	9.85			7/13/2010
			27,500			-		$	8.49			5/13/2009
			100,000			-
Alan Tillinghast			5,000			-		$	4.37			5/21/2008
			27,500			-		$	8.49			5/13/2009
			45,000			-		$	9.85			7/13/2010
			77,500			-
Kevin Scalia			5,000			-		$	6.61			8/11/2013
			878			-		$	4.93			1/26/2008
			45,000			-		$	9.85			7/13/2010
			22,500			-		$	8.49			5/13/2009
			73,378			-

 

There were no stock awards.

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Name		Option Awards Number of Shares Acquired on Exercise (#)			Value Realized on Exercise ($)
(a)		(b)			(c)
James L. Conway		None			None
Anthony F. Grisanti		None			None
Alan Tillinghast		None			None
Kevin Scalia		10,000			$73,000

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Severance Provisions of Employment Agreements

Messrs. Conway and Grisanti’s current employment agreements provide that in the event of their dismissal or resignation or a material change in their duties or in the event of a termination of employment by the executive or us as a result of a change in control, Messrs. Conway and Grisanti may receive severance payments of 48 months compensation. Under the Conway and the Grisanti Agreement, Each of Messrs. Conway and Grisanti’s existing employment agreements also provides for severance benefits and welfare and perquisite continuation in the event that the executive officer is terminated for a reason other than death, disability or cause or resigns as a result of or following a change of control. The completion of the transactions contemplated by the Merger Agreement would constitute a change of control under each executive officer’s employment agreement. In such event, each of Messrs. Conway and Grisanti is entitled to receive severance payments calculated by determining the greatest after-tax benefit to the officer of payment of either (i) 48 months’ compensation or (ii) an amount equal to 2.99 times his “base compensation amount,” as defined in Section 280G of the Internal Revenue Code. For the purposes of determining the amount of 48 months’ compensation, each of Messrs. Conway and Grisanti is entitled to receive an amount equal to the product of 48 multiplied by one-twelfth of the sum of his salary, average bonus for the prior three years, annual automobile allowance and annual vacation pay.

Pursuant to the Tillinghast Agreement, if Mr. Tillinghast’s employment is terminated as a result of death or disability, then the Company is required to pay to Mr. Tillinghast his salary at the annual rate in effect at the date of death or termination resulting from a disability, until the earlier of six months from the date of death of termination or the expiration of the term. If Mr. Tillinghast’s employment is terminated for causes other than death, disability or for cause (excluding any termination upon a change in control (as defined in the Tillinghast Agreement) or disposition of Netsmart-NY, as discussed below), then the Company shall pay to Mr. Tillinghast as severance payments his salary and expenses for the balance of the term of his contract as well as the bonus and commissions which he would otherwise be entitled to receive. The bonus and commission amount payable is defined as the greater of the prior year’s bonus and commissions or the average bonus and commissions paid to Mr. Tillinghast over the preceding three years. In addition, for a period of eighteen months after such termination, the Company shall provide Mr. Tillinghast, or his beneficiary, with the hospitalization, life insurance, medical and major medical benefits which would have been provided to him if he had continued his employ with the Company, except that the Company shall not be required to provide life insurance coverage for any beneficiary of Mr. Tillinghast. The Tillinghast Agreement provides for certain payments in the event of his termination upon either (i) a change in control (as defined in the employment agreement) or (ii) a disposition by Netsmart of the business of the Company’s Netsmart-NY subsidiary. In such event, if Mr. Tillinghast resigns due to either (i) a significant change in his duties or (ii) the Company changes his place of work to a location more than 50 miles from the current headquarters in Great River, NY, then he would be entitled to receive an amount (based on his rate of pay at the time of his termination) equal to his salary for 24 months, his bonus amount for the two preceding years, any unpaid commissions through the end of the term and all other benefits due to him pursuant to the terms of his agreement.

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Pursuant to the Scalia Agreement, if Mr. Scalia’s employment is terminated as a result of death or disability, then the Company is required to pay to Mr. Scalia his salary at the annual rate in effect at the date of death or termination resulting from a disability, until the earlier of six months from the date of death of termination or the expiration of the term. If Mr. Scalia’s employment is terminated for causes other than death, disability or for cause (excluding any termination upon a change in control (as defined in the Scalia Agreement) or disposition of Netsmart-NY, as discussed below), then the Company shall pay to Mr. Scalia as severance payments his salary and expenses for the balance of the term of his contract as well as the bonus and commissions which he would otherwise be entitled to receive. The bonus and commission amount payable is defined as the greater of the prior year’s bonus and commissions or the average bonus and commissions paid to Mr. Scalia over the preceding three years. In addition, for a period of eighteen months after such termination, the Company shall provide Mr. Scalia, or his beneficiary, with the hospitalization, life insurance, medical and major medical benefits which would have been provided to him if he had continued his employ with the Company, except that the Company shall not be required to provide life insurance coverage for any beneficiary of Mr. Scalia. The Scalia Agreement provides for certain payments in the event of his termination upon either (i) a change in control (as defined in the employment agreement) or (ii) a disposition by Netsmart of the business of the Company’s Netsmart-NY subsidiary. In such event, if Mr. Scalia resigns due to either (i) a significant change in his duties or (ii) the Company changes his place of work to a location more than 50 miles from the current headquarters in Great River, NY, then he would be entitled to receive an amount (based on his rate of pay at the time of his termination) equal to his salary for 24 months, his bonus amount for the two preceding years, any unpaid commissions through the end of the term and all other benefits due to him pursuant to the terms of his agreement.

 

Pursuant to the Conway Agreement, if Mr. Conway’s employment is terminated for cause (as such term is defined in the Conway Agreement), he will receive his accrued but unpaid salary, and lifetime medical insurance at a cost to Netsmart not to exceed $600 per month. If Mr. Conway terminates his employment without good reason (as such term is defined in the Conway Agreement), Mr. Conway will receive accrued but unpaid salary, any accrued but unpaid bonus, retirement benefits (in a series of annual payments not to exceed $684,465 in the aggregate) and the lifetime medical insurance as described in the immediately preceding sentence. However, if Mr. Conway terminates his employment during 2007 or 2008 without good reason (as such term is defined in the Conway Agreement), he will forfeit his retirement benefits. If Mr. Conway’s employment is terminated without cause, he terminates his employment for good reason or the Company provides notice of non-renewal of the term of his employment agreement, he will receive an amount equal to one year of his then current annual salary, a bonus prorated for the number of days worked during the year of termination (assuming that any personal performance criteria applicable to the bonus are maximally obtained), the payment of any accrued but unpaid bonus earned during the year prior to the year in which the termination occurs, the lifetime medical insurance and retirement benefits described above, and accelerated vesting as of the termination date of that portion of his time-based vesting options that would have vested if he had remained employed for an additional year (with full accelerated vesting if such termination is within one year of a subsequent change in control of the Company), provided that if Mr. Conway’s employment is terminated for any reason other than for cause on or after the second anniversary of the Closing of the merger and his performance-based vesting options have fully vested, no less than three quarters of his time-based vesting options shall be deemed to be fully vested as of his termination date. In the event of Mr. Conway’s death during the employment term, his estate shall receive the bonus earned during the year of his death, calculated on a pro-rata basis for the number of days worked (assuming that any personal performance criteria applicable to the bonus are maximally obtained), any bonus earned but unpaid in the year prior to the year of his death, any earned but unpaid salary, retirement benefits (in a series of annual payments not to exceed $746,688 in the aggregate) and accelerated vesting as of the termination date of that portion of his time-based vesting options that would have vested if he had remained employed for an additional year. If Mr. Conway’s employment is terminated due to his disability, he shall receive the same benefits as he would upon his death, with the addition of the lifetime medical insurance described above. Upon any employment termination (other than a termination for cause), a portion of the benefits for which the executive shall be eligible shall be subject to his (or his representative’s) effective execution of a release in favor of the Company and its related parties. If Mr. Conway’s employment is terminated by Netsmart without cause or he terminates his employment for good reason within two years after the closing date of the merger, he shall also be eligible to receive an additional payment to negate the after-tax effect of a portion of the excise tax he incurs (if any) as a result of the merger under the so-called “golden parachute” rules of Internal Revenue Code Section 280G.

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Pursuant to the Grisanti Agreement, if Mr. Grisanti’s employment is terminated for cause (as such term is defined in the Grisanti Agreement), he will receive his accrued but unpaid salary, and lifetime medical insurance at a cost to Netsmart not to exceed $600 per month. If Mr. Grisanti terminates his employment without good reason (as such term is defined in the Grisanti Agreement), Mr. Grisanti will receive accrued but unpaid salary, any accrued but unpaid bonus, retirement benefits (in a series of annual payments not to exceed $452,450 in the aggregate) and the lifetime medical insurance as described in the immediately preceding sentence. If Mr. Grisanti’s employment is terminated without cause, he terminates his employment for good reason, or the Company provides a notice of non-renewal of the term of his agreement he will receive an amount equal to six months of his then current annual salary, a bonus prorated for the number of days worked during the year of termination (assuming that any personal performance criteria applicable to the bonus are maximally obtained), the payment of any accrued but unpaid salary and bonus earned during the year prior to the year in which the termination occurs, the lifetime medical insurance and retirement benefits described above, and accelerated vesting as of the termination date of that portion of his sign-on option that would have vested if he had remained employed for an additional year. In the event of Mr. Grisanti’s death during the employment term, his estate shall receive the bonus earned during the year of his death, calculated on a pro-rata basis for the number of days worked (assuming that any personal performance criteria applicable to the bonus are maximally obtained), any bonus earned but unpaid in the year prior to the year of the executive’s death, any earned but unpaid salary, retirement benefits (in a series of annual payments not to exceed $452,450 in the aggregate and accelerated vesting as of the termination date of that portion of his sign-on option that would have vested if he had remained employed for an additional year). If Mr. Grisanti’s employment is terminated due to his disability, he shall receive the same benefits as he would upon his death, with the addition of the lifetime medical insurance described above. Upon any employment termination (other than a termination for cause), a portion of the benefits for which the executive shall be eligible shall be subject to his (or his representative’s) effective execution of a release in favor of the Company and its related parties. To the extent that Mr. Grisanti would be subject to the so-called “golden parachute” rules of Internal Revenue Code Section 280G, the payments to which he would be entitled upon a termination of employment would be reduced below the threshold at which the golden parachute excise tax is imposed to the extent such reduction would enable him to retain a greater portion of the payments from Netsmart after remittance of tax than he would have had he received the unreduced payments.

Change in Control Severance Plan

Estimation of Benefits

Set forth below is an estimation of the benefits payable to each of the Named Officers assuming that such officer’s employment were terminated under the circumstances described above in connection with a change in control of the Company and that the event triggering such payment occurred on 12/31/06.

 

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Name	Estimated Total Value of Cash Payments (Base Salary and Annual (1) Bonus Amounts)
James L. Conway	$2,189,000
Anthony F. Grisanti	1,330,000

 

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⁽¹⁾ Payments are calculated pursuant to Mr. Conway and Mr. Grisanti’s current employment agreements based upon forty eight months multiplied by the sum of current annual salary plus the average bonus over the past three years plus auto allowance and vacation pay divided by twelve months.

Directors’ Compensation

Cash Compensation: Our directors play a critical role in guiding the Company’s strategic direction and overseeing the management of the Company. The increased demand for qualified and talented public company directors requires that we provide adequate incentives for our directors’ continued performance and participation. Our board of directors has three standing committees - the audit committee, the compensation committee and the nominating and governance committee. The board of directors also established a special committee to evaluate the advisability of entering into the Merger Agreement. For fiscal year 2006 each member of a committee of the Board (Audit, Compensation, and Nominating and Governance) received annual fees of $20,000 for their service. In addition, as set forth below, for his service as a chairperson of a committee (in addition to the fee for serving as a member of a committee) , the chairperson received the following additional fees:

Audit Committee Chair	$ 6,250
Compensation Committee Chair	$ 6,250

In addition, Messrs. Calcagno, Gallagher, Shamash and Sicinski received meeting fees of $1,500 per meeting of the special committee. Mr. Calcagno also received an additional $60,000 for his additional responsibilities as chairman of the special committee.

We are also authorized to reimburse directors for expenses in connection with attendance at meetings.

Equity Compensation: Non-employee directors also received an automatic grant of stock options pursuant to the automatic grant provisions of the Company’s 2001 Long-Term Incentive Plan.

The 2001 Long-Term Incentive Plan, as amended, currently provides for the following automatic grants of options to each non-employee director:

Automatic grant to each non-employee director of a non-qualified option to purchase 10,000 shares of common stock on April 1^st of each year; provided that each non-employee director serving as the chairman of the audit committee or compensation committee granted an option to purchase 12,500 shares of common stock on April 1^st of each year, provided, that if one person serves as chairman of both committees he receives a grant of options to purchase a total of 12,500 shares.

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All options granted under the Plan have a term of 5 years and are fully vested after six months. The exercise price of options granted under the Plan is determined by the Compensation Committee. It has been the practice if the Committee to use the closing price of the stock at the close of business on the date of grant.

2006 Director Compensation

								All
		Fees Earned			Option			Other
Name		or Paid in Cash			Awards (1)			Compensation			Total
James L. Conway(2)			None			--			--			--
Gerald O. Koop(2)			None			--			--			--
John F. Phillips (2)(3)			None			--			122,500			122,500
John S.T. Gallagher			63,000			24,214			--			87,214
Joseph Sicinski			38,000			18,904			--			56,904
Frank Calcagno			98,000			18,904			--			116,904
Yacov Shamash			38,000			18,904			--			56,904
Kevin Scalia(2)			None			--			--			--
Alan Tillinghast(2)			None			--			--			--

⁽¹⁾ The value of the option awards were calculated using the Black Scholes value at the date of grant multiplied by the amount of options granted in the respective years.

⁽²⁾ Messrs. Conway, Koop, Phillips, Scalia and Tillinghast do not receive compensation for their service as directors.

⁽³⁾ Included in all other compensation is $85,000 in payments under the Executive Retirement, Non-Competition and Consulting Plan and $37,500 under a separate consulting arrangement.

As of December 31, 2006, the following number of non-qualified stock options were outstanding and held by each Director.

2006 Director Stock Options

	Number of Options
Director	Outstanding
James L. Conway	142,500
Gerald O. Koop	65,000
John F. Phillips	None
John S.T. Gallagher	27,500
Joseph Sicinski	18,000
Frank Calcagno	28,000
Yacov Shamash	18,000
Kevin Scalia	73,378
Alan Tillinghast	77,500

 

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Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.

Set forth below is information as of February 20, 2007, as to each person known by us, based on information provided to us by the persons named below and filings with the Securities and Exchange Commission, to own beneficially at least 5% of our common stock, each director, each officer listed in the Summary Compensation Table and all officers and directors as a group.

Name and Address		Shares			Percent of Outstanding Common Stock
James L. Conway			248,848			3.7	%
Anthony F. Grisanti			204,815			3.1	%
Joseph G. Sicinski			43,000			*
Francis J. Calcagno			28,000			*
John S.T. Gallagher			37,500			*
Yacov Shamash			18,000			*
Alan Tillinghast			117,837			1.8	%
Kevin Scalia			73,378			1.1	%
All directors and officers as a group (eight individuals)			771,378			10.9	%
Eagle Asset Management 880 Carillon Parkway St. Petersburg, FL			868,099			13.2	%
Dawson Herman 354 Pequot Avenue Southport, CT			715,203			10.9	%
Daniel Zeff 50 California St. San Francisco, CA.			330,870			5.0	%
FMR Corp. 82 Devonshire St. Boston, MA			423,978			6.5	%
Mosaix Ventures L.P. 1822 North Mohawk Chicago, IL			612,055			9.2	%

_____________

* Less than 1%.

Except as set forth in the following paragraphs, each person has the sole voting and sole investment power and direct beneficial ownership of the shares. Each person is deemed to beneficially own shares of common stock issuable upon exercise of options or warrants which are exercisable on or within 60 days after the date as of which the information is provided.

 

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Except as otherwise noted above, the address of each person listed is c/o Netsmart Technologies, Inc., 3500 Sunrise Highway, Great River, NY 11739.

The number of shares owned by our directors and officers shown in the table above includes shares of common stock which are issuable upon exercise of options that are exercisable at February 20, 2007 or will become exercisable within 60 days after that date. Set forth below is the number of shares issuable upon exercise of those options for each of such directors and officers.

Name	Number
Yacov Shamash	18,000
James L. Conway	142,500
Anthony F. Grisanti	100,000
Joseph G. Sicinski	18,000
Francis J. Calcagno	28,000
John S.T. Gallagher	27,500
Alan Tillinghast	77,500
Kevin Scalia	73,378
All officers and directors as a group	484,878

Equity Compensation Plan Information

The following table sets forth information relating to our compensation plans as of December 31, 2006.

Plan Category		Number of securities to be issued upon exercise of outstanding options, warrants and rights			Weighted-average exercise price of outstanding options, warrants and rights			Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a))
		(a)			(b)			(c)
Equity compensation plans approved by security holders			898,505		$	8.790			586,0452
Equity compensation plans not approved by security holders			24,9001		$	14.77			--
Total			923,405		$	8.951			586,045

¹ Options to acquire 30,000 shares were granted to certain former employees of Netsmart-Ohio to induce them to remain in our employ. The options have a ten-year term, an exercise price of $14.77 per share and become exercisable over a period of three years.

2 Options to purchase an aggregate shares are granted annually to the four non-employee directors pursuant to the automatic grant provisions of the 2001 Long-Term Incentive Plan.

Item 13.

Certain Relationships and Related Transactions and Director Independence.

Effective April 1, 2004, we adopted an Executive Retirement, Non-Competition and Consulting Plan which was subsequently amended August 5, 2004 effective April 1, 2004, pursuant to which, following their retirement, selected officers will be entitled to receive a minimum payment of approximately $85,000 per year for a period of six years, provided, that such officers (i) provide a minimum amount of consulting days each month and (ii) agree to certain covenants not to compete. The annual payments are subject to 10% increases up to a maximum of $136,893 per year. Pursuant to the Executive Retirement, Non-Competition and Consulting Plan, the selected officers are also entitled to receive health benefits for life, provided that there are no breaches of the covenants not to compete. Each of Messrs. Conway, and Grisanti are entitled to receive benefits under the plan.

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Mr. Koop’s employment contract expired on December 31, 2005 and he retired as President as of that date. He is still employed by Netsmart but not as an executive officer. As of December 2006, Mr. Koop was no longer a member of the Board of Directors. Upon his retirement as an employee, pursuant to the terms of our Executive Retirement, Non-Competition and Consulting Plan, Mr. Koop will receive $85,000 per year for each of the six years following his retirement; provided, that he complies with the non-competition covenants of the plan.

Netsmart was a party to an employment agreement with John Phillips, a former Vice President. Mr. Phillip’s employment contract expired on December 31, 2003 and he retired effective April 1, 2004. Pursuant to the terms of Netsmart’s Executive Retirement, Non-Competition and Consulting Plan, Mr. Phillips will receive $85,000 per year for each of the next six years; provided that he complies with the non-competition covenants of the plan. As of December 2006, Mr. Phillips was no longer a member of the Board of Directors.

Each of Messrs. Calcagno, Gallagher, Sicinski and Shamash are independent in accordance with the categorical standars of independence included in NASD Rule 4200(a)(15), which includes a series of objective tests, such as that the director is not an employee of the companyand has not engaged in various types of business dealings with the company. All of the standing committees of the Board are composed of independent directors.

In connection with the proposed merger transaction, we entered into the Conway Agreement and the Grisanti Agreement. For a detailed description of the provisions of these agreements, see Item 11 “Executive Compensation-Current Executive Compensation Program Elements.”

Item 14.

Principal Accounting Fees and Services.

Audit Fees

We were billed by Marcum & Kliegman LLP the aggregate amount of approximately $401,200 in respect of fiscal 2006 Audit and Sarbanes-Oxley (“SOX”) Compliance and $337,000 in respect of fiscal 2005 for fees for professional services rendered for the audit of our annual financial statements and review of our financial statements included in our Forms 10-K and 10-Q.

Audit-Related Fees

We were billed by Marcum & Kliegman LLP in fiscal 2006 and 2005 in the amounts of $99,100 and $99,200, respectively for assurance and related services such as for our 401K audit, and acquisition services, that were reasonably related to the performance of the audit or review of our financial statements that are not reported under the preceding paragraph including services rendered in connection with acquisitions, reviews of registration statements and issuances of related consents, audits of employees benefit plans and advice regarding common stock purchase warrants and Sox 404 related efforts.

Tax Fees

We were billed by Marcum & Kliegman LLP the aggregate amount of $164,450 in respect of fiscal 2006 and $72,050 in respect of fiscal 2005 for fees for services consisting primarily of tax compliance, tax advice or tax planning in respect of the preparation of our federal and state tax returns.

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All Other Fees

Marcum & Kliegman did not render any other services during fiscal 2006 and fiscal 2005 that are not described in the preceding paragraphs.

Auditor Independence

Our Audit Committee has determined that the provision of services by Marcum & Kliegman LLP other than for audit related services is compatible with maintaining the independence of Marcum & Kliegman as our independent accountants.

Pre-Approval Policies

Our Audit Committee has pre-approved the provision by Marcum & Kliegman LLP of audit services and of non-prohibited audit related services for fees in an amount not to exceed an aggregate of $10,000 as well as $25,000 for acquisition due diligence services. Our Audit Committee has not otherwise adopted any blanket pre-approval policies.

Our Audit Committee approved all of the services provided by Marcum & Kliegman LLP and described in the preceding paragraphs.

Part IV

Item 15. Exhibits, Financial Statements Schedules and Reports on Form 8-K.

1.	Financial Statements

Report of Marcum & Kliegman LLP

Consolidated Balance Sheets as of December 31, 2004 and 2003

Consolidated Statements of Income for the Years Ended December 31, 2004, 2003 and

2002

Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2004,

2003 and 2002

Consolidated Statements of Cash Flows for the Years Ended December 31, 2004, 2003 and

2002

Notes to Consolidated Financial Statements

2.	Financial Statement Schedules

None

3.

Exhibits

3.1

Restated Certificate of Incorporation, as amended (Filed as an exhibit to the Registrant’s registration statement on Form S-1, File No. 333-2550, which was declared effective by the Commission on August 13, 1996, and incorporated herein by reference.)

3.2

By-Laws (Filed as an exhibit to the Registrant’s registration statement on Form S-1, File No. 333-2550, which was declared effective by the Commission on August 13, 1996, and incorporated herein by reference.)

10.1

Employment Agreement dated April 1, 2004, between the Registrant and James L. Conway (Filed as an exhibit to the Registrant’s 10-Q dated May 5, 2004.)

10.2

Consulting Agreement dated April 1, 2004, between the Registrant and John F. Phillips (Filed as an exhibit to the Registrant’s 10-Q dated May 5, 2004.)

10.3

Employment Agreement dated April 1, 2004, between the Registrant and Gerald O. Koop (Filed as an exhibit to the Registrant’s 10-Q dated May 5, 2004.)

10.4

Employment Agreement dated April 1, 2004, between the Registrant and Anthony F. Grisanti (Filed as an exhibit to the Registrant’s 10-Q dated May 5, 2004.)

10.6

1993 Long-Term Incentive Plan (Filed as an exhibit to the Registrant’s registration statement on Form S-1, File No. 333-2550, which was declared effective by the Commission on August 13, 1996, and incorporated herein by reference.)

10.7

1998 Long-Term Incentive Plan (Filed as an appendix to the Registrant’s proxy statement dated September 30, 1999, relating to its 1999 Annual Meeting of Stockholders and incorporated herein by reference.)

 

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10.8

1999 Long-Term Incentive Plan (Filed as an appendix to the Registrant’s proxy statement dated November 9, 2000, relating to its 2000 Annual Meeting of Stockholders and incorporated herein by reference.)

10.9

2001 Long-Term Incentive Plan - Amended (Filed as an exhibit to the Registrant’s 8-K dated June 16, 2005.)

10.10

1999 Employee Stock Purchase Plan (Filed as an appendix to the Registrant’s proxy statement dated November 9, 2000, relating to its 2000 Annual Meeting of Stockholders and incorporated herein by reference.)

10.11

Agreement dated June 1, 2001, between the Registrant and Fleet Bank (Filed as an exhibit to the Registrant’s 10-K/A dated August 21, 2003.)

10.12

AIMS Acquisition Agreement (Filed as an exhibit to the Registrant’s 8-K dated May 10, 2001.)

10.13

Agreement dated June 25, 2003, among Registrant, Creative Socio-Medics Corp., Shuttle Data Systems Corp., d/b/a/ ADIA Information Management Corp. and Steven Heintz, Jr. (Filed as an exhibit to the Registrant’s 8-K dated July 8, 2003.)

10.14

Lease agreement dated as of December 22, 2003, between Registrant and Spacely LLC. (Filed as an exhibit to the Registrant’s 10-K dated March 23, 2004.)

10.15

Amended Executive Retirement, Non Competition and Consulting Plan. (Filed as an exhibit to the Registrant’s 10-Q dated August 9, 2004.)

10.16

Merger Agreement dated September 20, 2005, between CMHC Systems, Inc., Hayes Acquisition Corp., a newly-formed wholly-owned subsidiary of the Registrant, and John Paton, solely in the capacity of Securities Holders Representative. (Filed as an exhibit to the Registrant’s Form 8-K dated September 19, 2005.)

10.17

Revolving Credit and Term Loan Agreement with Netsmart Technologies, Inc. and the Bank of America, N.A. (Filed as an exhibit to the Registrant’s Form 8-K dated October 7, 2005.)

10.18

Asset Purchase Agreement dated June 17, 2005 between Addiction Management Systems, Inc. and Creative Socio-Medics Corp. (Filed as an exhibit to the Registrant’s Form 8-K dated June 21, 2005.)

10.20

Amendment No. 1 to Employment Agreement dated June 16, 2005, between the Registrant and James L. Conway. (Filed as an exhibit to the Registrant’s Form 8-K dated June 16, 2005.)

10.21

Amendment No. 1 to Employment Agreement dated June 16, 2005 between the Registrant and Anthony F. Grisanti. (Filed as an exhibit to the Registrant’s Form 8-K dated June 16, 2005.)

10.22

Asset Purchase Agreement dated April 27, 2005 between ContinuedLearning LLC and Creative Socio-Medics Corp. (Filed as an exhibit to the Registrant’s Form 8-K dated April 27, 2005.)

10.23

Employment Agreement dated April 27, 2005 between Netsmart Technologies, Inc. and A. Sheree Graves. (Filed as an exhibit to the Registrant’s Form 8-K dated April 27, 2005.)

10.24

Letter Agreement between Griffin Securities, Inc. and Netsmart Technologies, Inc. dated as of August 9, 2005. (Filed as an exhibit to the Registrant’s Form S-3, File No. 333-129265.)

10.25

Letter Agreement between Griffin Securities, Inc. and Netsmart Technologies, Inc. dated as of October 11, 2005. (Filed as an exhibit to the Registrant’s Form S-3, File No. 333-129265.)

10.26

First Amendment and Waiver to Loan Agreement dated as of December 31, 2005 between the Registrant and Bank of America, N.A. (Filed as an exhibit to Registrant’s Form 8-K dated February 23, 2006)

10.27

Employment Agreement between the Registrant and Gerald Koop dated April 5, 2006(Filed as an exhibit to Registrant’s Form 8-K dated April 5, 2006)

10.28

Asset Purchase Agreement dated as of July 31, 2006 by and between QS Technologies, Inc. and Intelligent Systems Corporation, as Sellers and Netsmart Public Health, Inc., as Buyer and Netsmart Technologies, Inc. (Filed as an exhibit to Registrant’s Form 8-K dated August 1, 2006)

10.29

Second Amendment and Waiver to Loan Agreement dated as of July 31, 2006 between the Registrant and Bank of America, N.A. (Filed as an exhibit to Registrant’s Form 8-K dated September 29, 2006)

10.30

Merger Agreement dated November 18, 2006 between Netsmart Technologies, Inc., a Delaware corporation with NT Acquisition, Inc., NT Merger Sub, Inc.,and NT Acquisition, Inc. (Filed as an exhibit to the Registrant’s Form 8-K dated November 18, 2006.)

10.31

Amendment to employment agreement, between James L. Conway, dated as of November 18, 2006, with NT Investor Holdings, Inc., and the Registrant. (Filed as an exhibit to the Registrant’s Form 8-K/A dated November 30, 2006).

10.32

Amendment to employment agreement, between Anthony F. Grisanti, dated as of November 18, 2006, with NT Investor Holdings, Inc., and the Registrant. (Filed as an exhibit to the Registrant’s Form 8-K/A dated November 30, 2006).

21.1

Subsidiaries of the Registrant

23.1

Consent of Marcum & Kliegman LLP

24

Powers of Attorney (See Signature Page)

31.1

Certification of Chief Executive Officer

31.2

Certification of Chief Financial Officer

32

Certification pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

61

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NETSMART TECHNOLOGIES, INC.

AND SUBSIDIARIES

 

 

 

 

 

F-1

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NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

---

INDEX

---

	Page to Page
Report of Independent Registered Public Accounting Firm	F-3
Consolidated Balance Sheets	F-4   F-5
Consolidated Statements of Income	F-6   F-7
Consolidated Statements of Stockholders' Equity	F-8
Consolidated Statements of Cash Flows	F-9   F-11
Notes to Consolidated Financial Statements	F-12   F-45

 

.  .  .  .  .  .  .  .  .  .  ..

 

F-2

---

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Audit Committee of the

Board of Directors and Stockholders of

Netsmart Technologies, Inc.

We have audited the accompanying consolidated balance sheets of Netsmart Technologies, Inc. and Subsidiaries (the "Company") as of December 31, 2006 and 2005, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2006. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Netsmart Technologies, Inc. and Subsidiaries, as of December 31, 2006 and 2005, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2006 in conformity with generally accepted accounting principles (United States).

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company's internal control over financial reporting as of December 31, 2006, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated, March 7, 2007, expressed an unqualified opinion on management's assessment of the effectiveness of the Company's internal control over financial reporting and an adverse opinion on the effectiveness of the Company's internal control over financial reporting because of the existence of three material weaknesses.

/s/ Marcum & Kliegman LLP

Marcum & Kliegman LLP

Melville, New York

March 7, 2007, except for the Note 16 as to which the date is March 14, 2007

 

F-3

---

NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

---

CONSOLIDATED BALANCE SHEETS

---

		December 31,
		2006			2005
Assets:
Current Assets:
Cash and Cash Equivalents		$	10,163,291		$	11,445,525
Accounts Receivable - Net			16,370,032			11,524,811
Costs and Estimated Profits in Excess
of Interim Billings			2,936,575			1,811,986
Deferred taxes			754,863			1,594,863
Other Current Assets			1,607,490			1,466,577
Total Current Assets			31,832,251			27,843,762
Property and Equipment - Net			2,726,423			2,665,429
Other Assets:
Goodwill			18,445,646			18,735,751
Capitalized Software Costs - Net			7,227,002			6,534,551
Customer Lists - Net			9,898,827			8,110,864
Contract Backlog - Net			--			379,500
Other Assets			394,404			351,997
Total Other Assets			35,965,879			34,112,663
Total Assets		$	70,524,553		$	64,621,854

 

See Notes to Consolidated Financial Statements.

F-4

---

NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

---

 

CONSOLIDATED BALANCE SHEETS

---

 

		December 31,
		2006			2005
Liabilities and Stockholders’ Equity:
CurrentLiabilities:
Current Portion - Long Term Debt		$	951,802		$	833,369
Current Portion Capital Lease Obligations			9,521			61,315
Accounts Payable			2,799,952			2,013,968
Accrued Expenses			2,893,531			2,916,021
Interim Billings in Excess of Costs and Estimated
Profits			4,995,402			7,938,422
Deferred Revenue			16,424,427			10,037,813
Total Current Liabilities			28,074,635			23,800,908
Long Term Debt - Less current portion			2,257,328			1,916,667
Capital Lease Obligations - Less current portion			--			9,521
Interest Rate Swaps at Fair Value			--			7,812
Deferred Tax Liability			883,091			2,118,603
Deferred Rent Payable			538,185			482,048
Total Non Current Liabilities			3,678,604			4,534,651
Commitments and Contingencies
Stockholders’ Equity:
Preferred Stock - $.01 Par Value, 3,000,000
Shares Authorized; None issued and outstanding			--			--
Common Stock - $.01 Par Value; Authorized
15,000,000 Shares; Issued and outstanding
6,787,396 and 6,555,183 shares at December 31, 2006,
6,719,517 and 6,487,943 shares at December 31, 2005			67,874			67,195
Additional Paid-in Capital			40,622,043			39,997,558
Accumulated Comprehensive Income (Loss) - Interest
Rate Swap			6,780			(7,812	)
Accumulated Deficit			(150,669	)		(2,004,132	)
			40,546,028			38,052,809
Less: cost of shares of Common Stock held
in treasury - 232,213 shares at December 31, 2006
and 231,574 shares at December 31, 2005			1,774,714			1,766,514
Total Stockholders’ Equity			38,771,314			36,286,295
Total Liabilities and Stockholders’ Equity		$	70,524,553		$	64,621,854

See Notes to Consolidated Financial Statements.

 

F-5

---

 

NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

---

CONSOLIDATED STATEMENTS OF INCOME

---

		Year ended December 31,
		2006			2005			2004
Revenues:
Software and Related
Systems and Services:
Turnkey Systems		$	27,156,766		$	20,326,805		$	16,931,606
Maintenance Contract Services			26,601,208			13,317,744			8,289,525
Application Service Provider Services			3,555,769			2,538,457			1,725,473
Data Center Services			1,735,940			1,795,448			2,058,240
Total Revenues			59,049,683			37,978,454			29,004,844
Cost of Revenues:
Software and Related
Systems and Services:
Turnkey Systems			16,895,754			11,682,754			9,203,071
Maintenance Contract Services			9,327,734			5,421,575			4,168,975
Application Service Provider Services			2,230,290			1,611,026			926,333
Data Center Services			817,203			887,169			849,353
Total Cost of Revenues			29,270,981			19,602,524			15,147,732
Gross Profit			29,778,702			18,375,930			13,857,112
Selling, General and
Administrative Expenses			19,087,284			11,272,446			7,293,865
Research, Development and Maintenance			6,552,541			4,547,114			3,498,448
Total			25,639,825			15,819,560			10,792,313
Operating Income			4,138,877			2,556,370			3,064,799
Interest and Other Income			376,998			311,496			126,379
Interest and Other Expense			(252,412	)		(119,090	)		(129,213	)
Income before Income Tax			4,263,463			2,748,776			3,061,965
Income Tax			2,410,000			1,159,000			309,000
Net Income		$	1,853,463		$	1,589,776		$	2,752,965

 

See Notes to Consolidated Financial Statements.

F-6

---

NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

---

CONSOLIDATED STATEMENTS OF INCOME

---

		Year ended December 31,
		2006			2005			2004
Earnings Per Share (“EPS”) of Common Stock
Basic EPS		$	.28		$	.28		$	.52
Weighted Average Number of Shares of
Common Stock Outstanding			6,529,343			5,684,191			5,331,700
Diluted EPS		$	.27		$	.27		$	.50
Weighted Average Number of Shares of
Common Stock and Common Stock
Equivalents Outstanding			6,747,983			5,935,405			5,536,731

 

See Notes to Consolidated Financial Statements.

F-7

---

NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

---

 

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

---

 

														Accumulated
														Comprehensive
								Additional						Income (Loss)												Total
		Common Stock						Paid-In			Accumulated			Interest Rate			Comprehensive			Treasury Shares						Stockholders’
		Shares			Amount			Capital			Deficit			Swap			Income			Shares			Amount			Equity
Balance - January 1, 2004			5,528,247		$	55,282		$	29,010,212		$	(6,346,873	)	$	(59,068	)	$	--			223,758		$	(1,659,449	)	$	21,000,104
Common Stock Issued - Exercise of Options			38,877			389			166,011			--			--			--			4,166			(53,533	)		112,867
Change in Deferred Tax Asset Valuation Allowance			--			--			717,000			--			--			--			--			--			717,000
Change in Fair Value of Interest Rate Swap			--			--			--			--			43,916			43,916			--			--			43,916
Net Income			--			--			--			2,752,965			--			2,752,965			--			--			2,752,965
																	$	2,796,881
Balance - December 31, 2004			5,567,124			55,671			29,893,223			(3,593,908	)		(15,152	)					227,924			(1,712,982	)		24,626,852
Common Stock Issued - Exercise of Options			206,658			2,067			852,173			--			--		$	--			3,650			(53,532	)		800,708
Common Stock Issued - Private Placement			490,000			4,900			4,488,204			--			--			--			--			--			4,493,104
Cost Related to Private Placement			--			--			(377,976	)		--			--			--			--			--			(377,976	)
Common Stock Issued - Acquisitions			455,735			4,557			5,101,934			--			--			--			--			--			5,106,491
Change in Fair Value of Interest Rate Swaps			--			--			--			--			7,340			7,340			--			--			7,340
Tax Benefit from Exercise of Options			--			--			40,000			--			--			--			--			--			40,000
Net Income			--			--			--			1,589,776			--			1,589,776			--			--			1,589,776
																	$	1,597,116
Balance - December 31, 2005			6,719,517			67,195			39,997,558			(2,004,132	)		(7,812	)					231,574			(1,766,514	)		36,286,295
Common Stock Issued - Exercise of Options And Warrants			64,390			644			569,711			--			--			--			639			(8,200	)		562,155
Shares Issued for Services			3,489			35			44,965			--			--			--			--			--			45,000
Change in Fair Value of Interest Rate Swap			--			--			--			--			14,592			14,592			--			--			14,592
Costs Related to 2005 Private Placement			--			--			(158,349	)		--			--			--			--			--			(158,349	)
Share-Based Compensation Expense			--			--			120,158			--			--			--			--			--			120,158
Tax Benefit from Exercise of Options			--			--			48,000			--			--			--			--			--			48,000
Net Income			--			--			--			1,853,463			--			1,853,463			--			--			1,853,463
																	$	1,868,055
Balance - December 31, 2006			6,787,396		$	67,874		$	40,622,043		$	(150,669	)	$	6,780						232,213		$	(1,774,714	)	$	38,771,314

See Notes to Consolidated Financial Statements.

F-8

---

NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

---

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

---

 

		Year ended December 31,
		2006			2005			2004
Operating Activities:
Net Income		$	1,853,463		$	1,589,776		$	2,752,965
Adjustments to Reconcile Net Income
to Net Cash Provided by Operating Activities:
Depreciation and Amortization			4,317,317			2,451,456			1,624,393
Share-Based Compensation			165,158			--			--
Provision for Doubtful Accounts			770,727			465,004			(204,000	)
Excess tax Benefit from Exercise of Options			48,000			40,000			--
Deferred Income Taxes			121,488			805,431			122,000
Changes in Assets and Liabilities:
[Increase] Decrease in:
Accounts Receivable			(5,615,948	)		953,963			(3,506,210	)
Costs and Estimated Profits in
Excess of Interim Billings			(982,438	)		(840,448	)		1,180,150
Other Current Assets			13,055			(686,023	)		(54,795	)
Other Assets			(71,460	)		(258,856	)		28,431
Increase [Decrease] in:
Accounts Payable			693,340			(3,274,348	)		243,165
Accrued Expenses			563,300			(681,174	)		(43,046	)
Deferred Rent Payable			56,137			26,621			455,427
Interim Billings in Excess of
Costs and Estimated Profits			(2,943,020	)		440,649			234,488
Deferred Revenue			4,353,341			945,721			(197,705	)
Total Adjustments			1,392,997			387,996			(117,702	)
Net Cash Provided by Operating Activities			3,246,460			1,977,772			2,635,263
Investing Activities:
Acquisition of Property and
Equipment			(1,144,482	)		(458,092	)		(1,328,050	)
Capitalized Software Development			--			(42,000	)		(185,000	)
Business Acquisitions - Net of $4,218,614
of Acquired Cash in 2005			(2,798,797	)		(12,554,994	)		(16,263	)
Net Cash Used In Investing Activities		$	(3,943,279	)	$	(13,055,086	)	$	(1,529,313	)

See Notes to Consolidated Financial Statements.

 

F-9

---

 

NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

---

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

---

 

		Year ended December 31,
		2006			2005			2004
Financing Activities:
Payment of Capitalized Lease Obligations		$	(61,315	)	$	(60,327	)	$	(61,416	)
Proceeds from Term Loan			--			2,500,000			--
Repayment of Promissory Note
Assumed in Acquisition			--			(494,413	)
Cost Related to Private Placement			(158,349	)		--			--
Net Proceeds from Stock Options and
Warrants Exercised			562,155			800,708			112,867
Net Proceeds from Private Placement			--			4,115,128			--
Payments of Long-Term Debt			(975,906	)		(749,992	)		(666,659	)
Excess tax benefit from Exercise of Option			48,000			--			--
Net Cash (Used in) Provided by
Financing Activities			(585,415	)		6,111,104			(615,208	)
Net (Decrease) Increase in Cash
and Cash Equivalents			(1,282,234	)		(4,966,210	)		490,742
Cash and Cash Equivalents -
Beginning of Year			11,445,525			16,411,735			15,920,993
Cash and Cash Equivalents -
End of Year		$	10,163,291		$	11,445,525		$	16,411,735
Supplemental Disclosure of Cash Flow Information:
Cash paid during the years for:
Interest		$	246,171		$	107,810		$	132,635
Income Taxes		$	2,465,338		$	338,254		$	237,879

Supplemental Disclosures of Non-Cash Investing and Financing Activities:

Year Ended December 31, 2006:

The fair value of the interest rate swap increased by $14,592 for the year ended December 31, 2006.

On August 1, 2006, Netsmart Technologies, Inc. and Subsidiaries (the “Company”), acquired certain assets, including computer software, customer lists and computer equipment of QS Technologies, Inc. (“QS”). The purchase price totaled approximately $5,466,000 as follows: an initial payment of $1,900,000 in cash and a three year $1,435,000 promissory note paid monthly, at an annual rate of 8.25% together with the assumption of approximately $2,095,000 in net liabilities, consisting principally of deferred revenue, and acquisition costs of approximately $36,000.

During 2006, the Company received 639 shares of its common stock in consideration for the cashless exercise of certain stock options. The value of the shares received was $8,200, which was the market value of the common stock on the date of exercise.

During 2006, the Company issued, 3,489 shares of its common stock in connection with an investor relations agreement.

 

F-10

---

 

During 2006, the Company analyzed the value of the assets previously acquired from CMHC Systems, Inc. (“CMHC”), as more fully described below, and increased deferred revenue by $151,218 and accrued expenses by $342,766, offset by an increase in deferred tax assets of $517,000. It also settled its working capital payoff by paying $524,935 in settlement of $792,024, which was the original provision. As a result accrued expenses were reduced by $267,089. The above adjustments resulted in a net decrease to goodwill in the amount of $290,105.

 

Year Ended December 31, 2005

During 2005, the Company acquired for $489,238 in cash and stock, the software, customer lists and other assets of ContinuedLearning LLC. The consideration consisted of $252,917 in cash plus 20,000 shares of common stock, valued at $191,400, based upon the average weighted stock price of $9.57 for the period commencing three days before and ending three days after the acquisition was agreed to and announced. The consideration also included the assumption of $44,921 for certain liabilities for services to be performed in the future. The agreement also included contingent consideration of $250,000 if certain revenue targets were met within one year of the closing of the acquisition, which closed on April 28, 2005. Based upon results through the end of fiscal 2005, the Company has provided for the full $250,000 of this contingent consideration and has adjusted the related balance sheet accounts accordingly. The $250,000 additional provision is included in accrued expenses. These revenue targets were met during 2006 and the $250,000 has been paid.

During 2005, the Company acquired for $3,610,682, the software, customer lists and other assets of Addiction Management Systems. The consideration consisted of $2,641,945 in cash plus legal fees of $19,904 and the assumption of $948,833 for certain liabilities for services to be performed in the future.

During 2005, the Company acquired 100% of the equity interest in CMHC. The purchase price totaled approximately $19,565,956 as follows: 435,735 shares of Netsmart’s common stock (valued at $4,915,091), $12,994,758 in cash plus additional cash consideration initially estimated at $792,024 required by the “working capital adjustment”, calculated and payable in accordance with the merger agreement, and acquisition costs of $864,083. The value of the 435,735 shares of common stock was based upon the average weighted stock price of $11.28 for the period commencing three days before and ending three days after the acquisition was agreed to and announced. The working capital adjustment was finalized in fiscal 2006, resulting in a reduction in accrued expenses, as more fully described above.

During 2005, the Company received 3,650 shares of its common stock as consideration for the exercise of certain stock options. The value of the shares received was $53,533, which was the market value of the common stock on the date of exercise.

Year Ended December 31, 2004:

During 2004, the Company received 4,166 shares of its common stock as consideration for the exercise of certain stock options. The value of the shares received was $53,533, which was the market value of the common stock on the date of exercise.

During 2004, the Company acquired for $250,000 TxM software and customer lists. The consideration consisted of $16,263 in cash and the assumption of $233,707 for certain liabilities for services to be performed in the future.

The fair value of the interest rate swap decreased by $43,916 for the year ended December 31, 2004. At December 31, 2004, it is valued at $15,152.

See Notes to Consolidated Financial Statements

F-11

---

NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

---

 

[1] The Company 

The Company licenses, customizes and installs its proprietary software products, operates a service bureau (“Data Center Services”) and provides Application Service Provider (“ASP”) Services and enters into long term maintenance agreements with behavioral health and public health organizations, methadone clinics and other substance abuse facilities throughout the United States. The Company currently classifies it operations in five business segments: (1) Software and Related Systems and Services - New York (2) Software and Related Systems and Services - Ohio (3) Software and Related Systems and Services - Public Health (4) Data Center Services and (5) Application Service Provider Services (“ASP”). Software and Related Systems and Services for each of the NY, Public Health and Ohio segments refer to the design, installation, implementation and maintenance of computer information systems that provide comprehensive healthcare information technology solutions including billing, patient tracking and scheduling for inpatient and out patient environments, as well as clinical documentation and medical record generation and management. Within these segments are large turnkey and small turnkey components. The large turnkey components consist mostly of the Avatar suite of products. When the Company is engaged in a fixed price arrangement, these large turnkey installations will usually extend over a six-month to a multi-year time period; these installations are performed in the New York segment. The duration of the implementation is dependant on the size and complexity of the customer organization and the specifics of the implementation. The small turnkey components are usually completed within a six-month period. Small turnkey contracts performed in the New York segment are mostly related to the Avatar methadone related products. The small turnkey contracts in the Ohio and Public Health segments are for system installations for behavioral healthcare and public health information management software for mental health, substance abuse, and addiction services agencies, developmental disability centers and behavioral health-related managed care organizations. Revenue for these segments is recognized based on the nature of the product sold. See note 2.

The Data Center Services involve Company personnel performing data entry and data processing services for customers. ASP services involve the Company offering several of it software products on a virtual private network or internet delivery approach, thereby allowing its customers to utilize the Company’s products and pay on a monthly service basis.

[2] Summary of Significant Accounting Policies

Principles of Consolidation - The Consolidated Financial Statements include Netsmart Technologies, Inc. (“Netsmart”), and its wholly-owned subsidiaries, Netsmart New York, Inc., (“NTST-NY”) formerly Creative Socio-Medics Corp. (“CSM”), Netsmart Ohio, Inc., (“NTST-Ohio”), formerly CMHC and Netsmart Public Health Inc., (“NTST-PH”) which acquired the assets of QS Technologies, Inc. (“QS”). In addition, the results of operations from the ContinuedLearning LLC (“CL”) acquisition are included from April 28, 2005, the results of operations from the Addictions Management Systems, Inc. (“AMS”) acquisition are included from June 20, 2005, the results of operations of the NTST- Ohio acquisition are included from October 1, 2005, and the results of operations from the NTST-PH acquisition are included from August 1, 2006 (see note 5). All intercompany transactions are eliminated in consolidation.

Estimates - The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates 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 revenue and expenses during the

 

F-12

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NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

---

[2] Summary of Significant Accounting Policies - [Continued]

reporting period. Critical estimates include management’s judgements associated with: the application of the percentage of completion method to the recognition of revenue, determination of an allowance for doubtful accounts receivable, deferred income tax valuation allowance, the application of purchase accounting to the Company’s acquisitions and the capitalization, impairment analysis, depreciation and amortization of certain long-term assets. Actual results could differ from those estimates.

Cash and Cash Equivalents - The Company considers all highly liquid instruments purchased with a maturity of three months or less to be cash equivalents. Cash equivalents totaled approximately $6,786,000 and $8,218,000 at December 31, 2006 and 2005, respectively.

Concentration of Credit Risk - The Company extends credit to customers which results in accounts receivable and costs and estimated profits in excess of interim billings arising from its normal business activities. The Company does not require collateral or other security to support financial instruments subject to credit risk. The Company routinely assesses the financial strength of its customers and based upon factors surrounding the credit risk of the customers, believes that its accounts receivable credit risk exposure is limited. If the financial condition of the Company’s customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances might be required. In addition, since the Company evaluates each account and invoice on a case-by-case basis, the provision could vary from period to period.

The Company’s behavioral health information systems are marketed to specialized care facilities, many of which are operated by various state and local government entities and include entitlement programs. During the years ended December 31, 2006, 2005 and 2004, approximately 40%, 44% and 49% respectively, of the Company’s revenue were generated from contracts directly or indirectly with government agencies.

No one customer accounted for more than 10% of consolidated revenue for the years ended December 31, 2006, 2005 and 2004.

The Company places its cash and cash equivalents with high credit quality financial institutions. The amount on deposit in any one institution that exceeds federally insured limits is subject to credit risk. At December 31, 2006 and 2005, cash and cash equivalent balances of $10.0 million and $11.3 million respectively, were held at a financial institution in excess of federally insured limits.

Revenue Recognition - The Company presents its revenue in four different categories: Software and Related Systems and Services- Turnkey, Software and Related Systems and Services- Maintenance, ASP Services and Data Center Services, as follows:

Software and Related Systems and Services- Turnkey

The Company recognizes large turnkey revenue from long-term (six months or longer), fixed price contracts for financial statement purposes under the percentage of completion method when significant modification of the software package is required to meet the customer specifications. The percentage of completion method takes into account progress towards completion of a contract using time spent by technical personnel on a particular project as the measuring standard. Revisions in cost estimates and

 

F-13

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NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

---

[2] Summary of Significant Accounting Policies - [Continued]

recognition of losses on these contracts are reflected in the accounting period in which the facts become known. Contract terms provide for billing schedules that differ from revenue recognition and give rise to costs and estimated profits in excess of billings, and billings in excess of costs and estimated profits.

The Company recognizes small turnkey revenue from short-term (less than six months), fixed price contracts for financial statement purposes under the completed contract method. Payments received in advance by customers are deferred until earned and represented as deferred revenue in the accompanying balance sheet.

The Company also enters into multiple element arrangements contracts which do not require significant customization and modification, in which it includes a software license, one year’s maintenance and sometimes training. In accordance with Statement of Position 97-2 “Software Revenue Recognition”, as amended, revenue is allocated using the residual method. The Company sells both annual maintenance contracts and training separately, with long established pricing to its customers. Annual maintenance contracts are generally sold at a fee based upon a percentage of the underlying software license. The Company also sells training separately with established per diem rates for its trainers. Accordingly, the Company uses vendor specific objective evidence to ascertain the fair values of all undelivered elements in a multiple element arrangement. The residual amount is allocated to the software license. Each of these components is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed and determinable and collectibility is probable.

The Company also derives revenue from the sale of third party hardware and software which is recognized based upon the terms of each contract. These sources of revenue, which do not require significant customization or modification, are recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed and determinable and collectibility is probable.

Software and Related Systems and Services- Maintenance

Maintenance contract revenue consists of services provided to customers for telephone help services, as well as maintaining and upgrading the software, including ongoing enhancements. The Company’s maintenance contracts may require it to make modifications to meet any new federal or state reporting requirements which become effective during the term of the maintenance contract. Maintenance contract revenue sold under separate contractual arrangements is recognized on a straight-line basis over the life of the respective contract.

The cost of maintenance revenue, which consists solely of staff payroll and applicable overhead, is expensed as incurred.

ASP Services

ASP Services consist of the Company’s offering of its Avatar suite of products, including CareNet, Continued Learning (now Netsmart University) and InfoScriber products, on a virtual private network or internet delivery approach. This service allows the Company’s customers to rapidly deploy its products and pay on a monthly service basis instead of making a capital intensive investment in the purchase of the system at their own facility. ASP Services contract revenue, sold under separate contractual arrangements, is recognized on a straight-line basis over the life of the respective contract.

F-14

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NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

---

[2] Summary of Significant Accounting Policies - [Continued]

Data Center Services

Information processing revenue, which represents Data Center Services, is recognized in the period in which the service is provided. The Data Center provides software which performs clinical and billing services for outpatient facilities, including mental health, alcohol and substance abuse facilities. Data Center services include statistical reporting, data entry, electronic billing and submission. The Company bills its clients on a transaction basis or on a fixed monthly fee arrangement. Revenue is recognized as the services are performed.

Property and Equipment and Depreciation and Amortization - Property and equipment is stated at cost less accumulated depreciation and amortization. Depreciation of property and equipment is computed using the straight-line method at rates adequate to allocate the cost of applicable assets over their expected useful lives. Amortization of leasehold improvements is computed using the shorter of the lease term or the expected useful life of these assets.

Estimated useful lives are as follows:

Equipment	3-7 Years
Furniture and Fixtures	5-10 Years
Leasehold Improvements	Life of the Lease

Capitalized Software Costs - Capitalization of computer software development costs begins upon the establishment of technological feasibility. Technological feasibility for the Company’s computer software products is generally based upon achievement of a detail program design free of high risk development issues. The Company capitalizes only those costs directly attributable to the development of the software. The establishment of technological feasibility and the ongoing assessment of recoverability of capitalized computer software development costs requires considerable judgment by management with respect to certain external factors, including, but not limited to, technological feasibility, anticipated future gross revenue, estimated economic life and changes in software and hardware technology. Prior to reaching technological feasibility these costs are expensed as incurred and included in research, development and maintenance. Activities undertaken after the products are available for general release to customers to correct errors or keep the product updated are expensed as incurred and included in research, development and maintenance. Amortization of capitalized computer software development costs commences when the related products become available for general release to customers. Amortization is provided on a product by product basis and is included in the applicable cost of revenue. The annual amortization is the greater of the amount computed using (a) the ratio that current gross revenue for a product bears to the total of current and anticipated future gross revenue for that product or (b) the straight-line method over the remaining estimated economic life of the product. The estimated life of these products range from 3 to 8 years.

The Company periodically performs reviews 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.

F-15

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NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

---

[2] Summary of Significant Accounting Policies - [Continued]

The amounts allocated to purchased software development costs related to the NTST-PH acquisition in 2006, NTST-Ohio, CL and AMS acquisitions in 2005 (see note 5), totaled $2,305,881, $3,300,000, $692,020 and $2,050,700, respectively.

Capitalized software development costs applicable to operations are as follows:

Year ended December 31,		2006			2005			2004
Beginning of Year		$	6,534,551		$	1,132,453		$	1,087,116
Capitalized			2,305,881			6,084,720			334,872
Amortization			(1,613,430	)		(682,622	)		(289,535	)
Net		$	7,227,002		$	6,534,551		$	1,132,453

Customer Lists - Customer lists represent a listing of customers obtained through the acquisitions of CSM, Johnson Computing System, (“Johnson”), Advanced Institutional Management Systems (“AIMS”), CareNet, NTST-Ohio, CL, AMS and NTST-PH (see note 5), and other to which the Company can market its products. Customer lists are being amortized on a straight line method over an estimated useful life of 20 years for the NTST -Ohio list, 12 years for the NTST - NY and Johnson lists, 10 years for the NTST-PH list, 9 years for the CareNet list, 8 years for the AMS list, 7 years for the AIMS list, 3 years for the CL lists and 6 years for the other list. The amount allocated to customer lists related to the NTST-PH, NTST-Ohio, AMS and CL acquisitions are $2,965,100, $5,300,000, $1,396,902 and $5,218, respectively.

Customer lists at December 31, 2006 and 2005 are as follows:

		December 31,
		2006			2005
Customer Lists		$	15,948,519		$	12,983,419
Less: Accumulated Amortization			(6,049,692	)		(4,872,555	)
Net		$	9,898,827		$	8,110,864

Amortization expense amounted to $1,177,137, $770,493 and $606,352, respectively, for the years ended December 31, 2006, 2005 and 2004 and is included in selling, general and administrative expenses.

Future amortization of customer lists are approximately $1,037,000, $929,000, $890,000, $864,000 and $858,000 for the years ending December 31, 2007, 2008, 2009, 2010 and 2011 respectively, and $5,321,000 thereafter.

Contract Backlog - Contract backlog represented profit to be earned on customer contracts and purchase orders that were not fully completed as of the acquisition date of NTST- Ohio, but are expected to be completed at some future point. As a result, there was still revenue and profits to be earned on these orders.

 

F-16

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NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

---

[2] Summary of Significant Accounting Policies - [Continued]

Contract backlog costs were amortized over a one-year period commencing October 1, 2005 through September 30, 2006. Contract backlog costs at December 31, 2006 are as follows:

Contract backlog		$	502,000
Less: Accumulated Amortization			(502,000	)
Net		$	--

Amortization expense amounted to $379,500 for the year ended December 31, 2006.

Pursuant to Statement of Financial Accounting Standards (“SFAS”) No. 144, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of", the Company evaluates its long-lived assets for financial impairment, and continues to evaluate them as events or changes in circumstances indicate that the carrying amount of such assets may not be fully recoverable.

The Company evaluates the recoverability of long-lived assets by measuring the carrying amount of the assets against the estimated undiscounted future cash flows associated with them. At the time such evaluations indicate that the future undiscounted cash flows of certain long-lived assets are not sufficient to recover the carrying value of such assets, the assets are adjusted to their fair values.

Goodwill

Goodwill in the amount of $18,445,646 resulted from the acquisition of NTST-Ohio (See note 5). Goodwill is not amortized but is tested for impairment at least on an annual basis or more frequently if events or changes in circumstances indicate that the asset might be impaired. We determined that there was no impairment of goodwill at December 31, 2006.

Stock Options and Similar Equity Instruments - At December 31, 2006, the Company had three stock-based employee compensation plans as well as outstanding inducement options granted to certain employees of NTST-Ohio, which are described more fully in note 13. Effective January 1, 2006, the Company adopted the fair value recognition provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123 (Revised 2004), “Share-Based Payment,” (SFAS 123R), using the modified -prospective-transition method. As a result, the Company’s income before taxes for the year ended December 31, 2006 is $120,158 lower than if it had continued to account for share -based compensation under Accounting Principles Board (“APB”) Opinion No. 25, “Accounting For Stock Issued to Employees”.

The Company has $197,276 of stock based compensation expense remaining to be recognized over the period January 2007 through October 2008.

As permitted under SFAS No. 148, “Accounting for Stock-Based Compensation--Transition and Disclosure”, which amended SFAS No. 123 (SFAS 123), “Accounting for Stock-Based Compensation,” the Company elected to continue to follow the intrinsic value method in accounting for its stock-based employee compensation arrangements, as defined by APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations including Financial Accounting Standards Board

 

F-17

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NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

---

 

[2] Summary of Significant Accounting Policies - [Continued]

Interpretation No. 44, “Accounting for Certain Transactions Involving Stock Compensation,” an interpretation of APB No. 25 for the periods up to and including December 31, 2005. No stock-based employee compensation cost is reflected in net income for periods prior to December 31, 2005, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation for periods prior to December 31, 2005.

		Year ended
		December 31,
		2005			2004
Net Income as Reported		$	1,589,776		$	2,752,965
Deduct: Total stock-based employee compensation
expense determined under the fair value-based
method for all awards, net of related tax effect			1,724,201			1,368,139
Pro Forma Net (Loss) Income		$	(134,425	)	$	1,384,826
Basic Net Income Per Share as Reported		$	.28		$	.52
Basic Pro Forma Net (Loss) Income Per Share		$	(.02	)	$	.26
Diluted Net Income Per Share as Reported		$	.27		$	.50
Diluted Pro Forma Net (Loss) Income Per Share		$	(.02	)	$	.25

The fair value of options at date of grant was estimated using the Black-Scholes fair value based method with the following weighted average assumptions:

		2005			2004
Expected Life (Years)			5			5
Interest Rate			4.00	%		4.00	%
Annual Rate of Dividends			0	%		0	%
Volatility			65	%		68	%

The weighted average fair value of options at date of grant using the fair value based method during 2005 and 2004 is estimated at $5.39, and $3.95, respectively.

F-18

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NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

---

[2] Summary of Significant Accounting Policies - [Continued]

Earnings Per Share - Basic earnings per share of common stock is computed by dividing net income by the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share reflects the amount of earnings for the period available to each share of common stock outstanding during the reporting period, giving effect to all potentially dilutive shares of common stock from the potential exercise of stock options and warrants.

The computation of diluted earnings per share does not assume conversion, exercise or contingent issuance of securities that would have an antidilutive effect on earnings per share (i.e. improving earnings per share). The dilutive effect of outstanding options and warrants and their equivalents are reflected in diluted earnings per share by the application of the treasury stock method. Options and warrants will have a dilutive effect only when the average market price of the common stock during the period exceeds the exercise price of the options or warrants. The Company had potentially dilutive options and warrants outstanding of 39,900, 30,000 and 300,780 during the years ended December 31, 2006, 2005 and 2004, respectively, that were not included in the calculation of diluted earnings per share because they were anti dilutive.

The following table sets forth the computation of basic and diluted earnings per share:

		Year ended December 31,
		2006			2005			2004
Numerator:
Net Income		$	1,853,463		$	1,589,776		$	2,752,965
Denominator:
Weighted average shares			6,529,343			5,684,191			5,331,700
Effect of dilutive securities:
Employee stock options			200,733			244,416			205,031
Stock warrants			17,907			6,798			--
Dilutive potential common shares			218,640			251,214			205,031
Denominator for diluted earnings per
share-adjusted weighted average shares
after assumed conversions			6,747,983			5,953,405			5,536,731

Advertising - Advertising costs are expensed as incurred. Advertising expense amounted to $634,986, $395,476 and $392,575 for the years ended December 31, 2006, 2005 and 2004, respectively.

Financial Instruments - SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” as amended, requires the recognition of all derivative instruments as either assets or liabilities on the balance sheet measured at fair value. Generally, increases or decreases in the fair value of a derivative instrument will be recognized as gains or losses in earnings in the period of change. If the derivative instrument is designated and qualifies as a cash flow hedge, the change in fair value of the derivative instrument will be recorded as a separate component of stockholders’ equity.

 

F-19

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NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

---

[2] Summary of Significant Accounting Policies - [Continued]

The Company entered into interest rate swaps to hedge exposure related to changes in the LIBOR rate. Before entering into a derivative transaction for hedging purposes, it is determined that a high degree of initial effectiveness exists between the change in value of the hedged item and the change in the value of the determinative instrument from movement in interest rates. High effectiveness means that the change in the value of the derivative instrument will effectively offset the change in the fair value of the hedged item. The effectiveness of each hedged item is measured throughout the hedged period. Any hedge ineffectiveness as defined by SFAS No. 133 is recognized in the income statement.

New Accounting Pronouncements

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”).  SFAS 159 provides companies with an option to report selected financial assets and liabilities at fair value.  The objective of SFAS 159 is to reduce both complexity in accounting for financial instruments and the volatility in earnings caused by measuring related assets and liabilities differently. Generally accepted accounting principles have required different measurement attributes for different assets and liabilities that can create artificial volatility in earnings.  The FASB has indicated it believes that SFAS 159 helps to mitigate this type of accounting-induced volatility by enabling companies to report related assets and liabilities at fair value, which would likely reduce the need for companies to comply with detailed rules for hedge accounting. SFAS 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. SFAS 159 does not eliminate disclosure requirements included in other accounting standards, including requirements for disclosures about fair value measurements included in SFAS 157 and SFAS No. 107, “Disclosures about Fair Value of Financial Instruments.” SFAS 159 is effective for the Company as of the beginning of fiscal year 2009. The Company has not yet determined the impact SFAS 159 may have on its consolidated financial position, results of operations, or cash flows.

In December 2006, the FASB approved FASB Staff Position (FSP) No. EITF 00-19-2, “Accounting for Registration Payment Arrangements” (“FSP EITF 00-19-2”), which specifies that the contingent obligation to make future payments or otherwise transfer consideration under a registration payment arrangement, whether issued as a separate agreement or included as a provision of a financial instrument or other agreement, should be separately recognized and measured in accordance with SFAS No. 5, “Accounting for Contingencies”. FSP EITF 00-19-2 also requires additional disclosure regarding the nature of any registration payment arrangements, alternative settlement methods, the maximum potential amount of consideration and the current carrying amount of the liability, if any. The guidance in FSP EITF 00-19-2 amends FASB Statements No. 133, “Accounting for Derivative Instruments and Hedging Activities”, and No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity”, and FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others”, to include scope exceptions for registration payment arrangements. FSP EITF 00-19-2 is effective immediately for registration payment arrangements and the financial instruments subject to those arrangements that are entered into or modified subsequent to the issuance date of this FSP, or for financial statements issued for fiscal years beginning after December 15, 2006, and interim periods within those fiscal years, for registration payment arrangements entered into prior to the issuance date of this FSP. The adoption of this pronouncement is not expected to have an impact on the Company’s consolidated financial position, results of operations or cash flows.

 

F-20

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NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

---

[2] Summary of Significant Accounting Policies - [Continued]

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). This statement defines fair value, establishes a framework for measuring fair value in accordance with accounting principles generally accepted in the United States (“GAAP”), and expands disclosures about fair value measurements. SFAS 157 does not require any new fair value measurements. However, for some entities, the application of SFAS 157 will change current practice. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years, with earlier application permitted. The Company does not expect SFAS 157 to have a material impact on the Company’s financial position or results of operations.

In September 2006, the staff of the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108 (“SAB 108”) which provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. SAB 108 becomes effective in fiscal 2007. Adoption of SAB 108 did not have a material impact on the Company’s consolidated financial position or results of operations.

In July 2006, the FASB released FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting and reporting for uncertainties in income tax law. FIN 48 prescribes a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of uncertain tax positions taken or expected to be taken in income tax returns. FIN 48 shall be effective for fiscal years beginning after December 15, 2006. The cumulative effects, if any, of applying FIN 48 will be recorded as an adjustment to retained earnings as of the beginning of the period of adoption. The Company has commenced the process of evaluating the expected effect of FIN 48 on its financial position and results of operations and is currently unable to determine such effects.

In March 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets” (“SFAS 156”), which amends SFAS 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” with respect to the accounting for separately recognized servicing assets and servicing liabilities. SFAS 156 permits the choice of the amortization method or the fair value measurement method, with changes in fair value recorded in income for the subsequent measurement for each class of separately recognized servicing assets and servicing liabilities. The statement is effective for years beginning after September 15, 2006, with earlier adoption permitted. The Company does not expect SFAS 156 to have a material impact on the Company's financial position or results of operations.

In October 2005, the FASB issued FSP FAS 123(R)-2, “Practical Accommodation to the Application of Grant Date as Defined in FASB Statement No. 123(R)”, which provides clarification of the concept of mutual understanding between employer and employee with respect to the grant date of a share-based payment award. This FSP provides that a mutual understanding of the key terms and conditions of an award shall be presumed to exist on the date the award is approved by management if the recipient does not have the ability to negotiate the key terms and conditions of the award and those key terms and conditions will be communicated to the individual recipient within a relatively short time period after the date of approval. This guidance was applicable upon the initial adoption of SFAS 123(R). The adoption of this pronouncement did not have an impact on the Company's consolidated financial position, results of operations, or cash flows.

 

F-21

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NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

---

[3] Accounts Receivable 

Accounts receivable is shown net of allowance for doubtful accounts of $682,409 and $350,291 at December 31, 2006 and 2005, respectively. The changes in the allowance for doubtful accounts are summarized as follows:

		Year Ended December 31,
		2006			2005
Beginning Balance		$	443,666		$	517,095
Provision (credit) for Doubtful Accounts			770,727			465,004
Charge-offs			(531,984	)		(538,433	)
Ending Balance		$	682,409		$	443,666

[4] Costs, estimated profits, and billings on uncompleted contracts are summarized as follows:

		December 31,
		2006			2005
Costs Incurred on Uncompleted Contracts		$	10,032,972		$	5,389,787
Estimated Profits			3,599,608			3,028,931
Total			13,632,580			8,418,718
Billings to Date			15,691,407			14,545,154
Net		$	(2,058,827	)	$	(6,126,436	)

 

Included in the accompanying consolidated balance sheet under the following captions:

Costs and estimated profits in excess of interim billings		$	2,936,575		$	1,811,986
Interim billings in excess of costs and estimated profits			(4,995,402	)		(7,938,422	)
Net		$	(2,058,827	)	$	(6,126,436	)

F-22

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NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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[5] Acquisitions

On August 1, 2006, the Company acquired certain assets, including computer software, customer lists and computer equipment of QS. The purchase price totaled approximately $5,466,000 as follows: an initial payment of $1,900,000 in cash and a three year $1,435,000 promissory note paid monthly, with an annual interest rate of 8.25% together with the assumption of approximately $2,095,000 in net liabilities, consisting principally of deferred revenue, and acquisition costs of approximately $36,000. The transaction also provides for potential additional payments to the seller of up to $1,450,000 in 2008, contingent upon the attainment of performance milestones by the NTST-PH business through 2007. The milestones would result from the attainment of maintenance revenue, vital records contract awards, and other software contract awards. The attainment of these milestones would result in a contingent purchase price adjustment. The NTST-PH business delivers enterprise-wide public health solutions and vital records software to 70 public health agencies, including nine states. The Company also assumed the facility lease of NTST-PH in Greenville, South Carolina. This lease has a total square footage of 5,761, is non cancelable and expires on February 23, 2011. The annual rent is $77,772 and is subject to escalation clauses.

The cost of the NTST-PH acquisition was allocated as follows: $2,965,000 to customer lists, $2,306,000 to purchased software, $167,000 to other current assets and $28,000 to properly and equipment. The Company is amortizing the customer list over a 10 year life, the purchased software over a 6 year life and the property and equipment over a 2 year life.

In 2005, the Company completed acquisitions of three companies with products and services complementary to its existing offerings. The Company acquired Continued Learning (“CL”), a Florida-based provider of online training services on April 28, 2005. On June 20, 2005, the Company acquired Addiction Management Systems, Inc (“AMS”). In September 2005, the Company completed the acquisition of CMHC Systems (“NTST- Ohio”), a leading competitor in the behavioral healthcare software market.

CL

On April 28, 2005, the Company acquired substantially all of the assets, including computer software, customer lists and computer equipment, of CL, a company that offered a comprehensive family of web-based training products and services, including its Learning Management System. The total purchase price, including acquisition costs and a recognition of a probable additional payment, was $739,238 which consisted of cash of $252,917, which was paid out of existing working capital including legal fees of $18,632, and broker fees of $10,000, 20,000 shares of the Company’s common stock valued at $191,400, assumed liabilities of $44,921 and an accrual for a probable additional payment of $250,000.

 

F-23

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NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

---

[5] Acquisitions - [Continued]

The purchase agreement provides for the potential additional payment of up to $250,000 if certain revenue targets are met in year one. Based upon the attainment of certain revenue targets as of December 31, 2005, the Company recognized the full $250,000 of this additional payment at December 31, 2005. This amount has been paid in 2006. The Company also entered into a two year employment agreement at an annual salary of $100,000 per year with the principal of CL, whereby the principal can receive up to an additional $300,000 in cash, to be accounted for as compensation expense, if certain revenue targets are met within a two-year period. As of December 31, 2006, certain revenue targets have been met and additional compensation expense in the amount of $100,000 has been recognized and paid.

The cost of the CL acquisition was allocated as follows: $692,020 to purchased software, $5,218 to customer lists, $17,000 to computer hardware, and $25,000 to a covenant not to compete. The Company is amortizing the purchased software over a 6 year life, the customer lists and computer hardware over a 3 year life, and the covenant not to compete over a 2 year life. Amortization expense for the covenant not to compete was $8,333 for the year ended December 31, 2005.

AMS

On June 20, 2005, the Company acquired the assets of AMS. The total purchase price, including acquisition costs, was $3,610,682 which consisted of cash of $2,641,945, legal fees of $19,904 and assumed liabilities for services to be provided of $948,833.

The cost of the AMS acquisition was allocated as follows: $2,050,700 to purchased software, $1,396,902 to customer lists, $127,698 to accounts receivable, $32,048 to inventory, and $3,334 to a security deposit. The Company is amortizing the purchased software and the customer lists over an 8 year life.

NTST-Ohio

On September 28, 2005, the Company acquired 100% of the equity interest of NTST-Ohio (formerly CMHC) a company that offers a full suite of behavioral healthcare information management software for mental health, substance abuse, and addiction services agencies, developmental disability centers, and behavioral health-related managed care organizations. The primary reason for this acquisition was to acquire a significant customer base (over 400 clients) which provided a large recurring revenue stream, and included a workforce with significant domain knowledge.

The Company believes that due to the factors above and the potential long range benefits of the combined company that the purchase price paid fairly represents the value of NTST-Ohio. The purchase price totaled approximately $19,565,956 as follows: 435,735 shares of the Company’s common stock (valued at $4,915,091), $12,994,758 in cash plus additional cash consideration recorded in accrued expenses as of December 31, 2005, estimated at $792,024 as required by the “working capital adjustment”, calculated and payable in accordance with the merger agreement, and acquisition costs of $864,083. During 2006, the working capital adjustment was finalized and the estimated amount of $792,024 was settled for a payment of $524,935. The difference of $267,089 was reflected as a reduction in goodwill and accrued expenses. Additionally during 2006, the Company evaluated the assets and liabilities acquired from CMHC and increased deferred revenue by $151,218 and accrued

F-24

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NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

---

[5] Acquisitions - [Continued]

expenses by $342,766, which was partially offset by an increase in deferred tax asset of $517,000, resulting in a net increase to goodwill of $290,105.

The Company also renegotiated and assumed the NTST-Ohio facility lease in Dublin, Ohio. This facility is leased from a Partnership whose general partner is the former majority stockholder of CMHC and currently a 5.3% stockholder of the Company. This lease has a total square footage of 34,230, is non cancelable and expires on September 30, 2010. The annual rent is $377,172 and is subject to annual real estate tax assessments.

John Paton, the former majority stockholder of CMHC Systems, entered into an employment agreement with the Company pursuant to which Mr. Paton is to receive, in addition to the amounts he received as a former security holder of CMHC, a base salary at the rate of $150,000 per annum for the fifteen month term of the agreement.

The following table summarizes the estimated fair value of the assets acquired and liabilities assumed at the date of the acquisition of NTST-Ohio.

At September 30, 2005

($ in thousands)

Cash		$	4,218
Other current assets			2,880
Property and equipment - net			464
Capitalized software cost			3,300
Customer lists			5,300
Goodwill			18,736
Contract backlog			502
Deferred tax asset - long term			1,381
Other assets			26
Total assets acquired			36,807
Deferred revenue			8,134
Other current liabilities			5,898
Deferred tax liability - long term			3,171
Long-term debt			38
Total liabilities assumed			17,241
Net assets acquired		$	19,566

 

Included in other current liabilities of $5,898,000 is a promissory note which NTST-Ohio issued in April 2005 in the amount of $500,000. This note accrued interest at a rate of 14% per annum and was due on October 31, 2005. This promissory note was paid in full in October 2005.

None of the goodwill or amortization of the contract backlog, capitalized software or customer list will be deductible on the Company’s tax return. For financial statement purposes the Company is amortizing

F-25

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NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

---

[5] Acquisitions - [Continued]

the contract backlog over one year, the capitalized software over 4 years and the customer list over 20 years. The goodwill is not amortized and will be reviewed each year to determine if any impairment adjustment will be required.

The following unaudited proforma condensed financial information of operations assumes the CL, AMS, NTST-Ohio and NTST-PH acquisitions occurred on January 1, 2005. Shares related to the private placement (see note 9) are included in the weighted average per share calculations. In the opinion of management, all adjustments necessary to present fairly such unaudited proforma statements have been made. These proforma amounts may not be indicative of what would have occurred had the acquisitions been completed on January 1, 2005 or results which may occur in the future.

		Years Ended
		December 31,
		2006			2005
		Unaudited			Unaudited
		(in thousands, except share and per share amounts)
Revenue		$	60,554		$	60,053
Net Income			2,458			1,654
Net Income Per Share;
Basic		$	.38		$	.26
Diluted		$	.36		$	.25
Weighted Average Number
of Shares of Common
Stock Outstanding			6,529,343			6,387,381
Weighted Average Number
of Shares of Common
Stock and Common Stock
Equivalents Outstanding			6,747,983			6,638,595

The Company accounted for the CL, AMS, NTST-PH and NTST-Ohio acquisitions pursuant to the purchase method of accounting as required under SFAS No. 141 “Business Combinations”.

Purchase price allocations are subject to change. Changes could include a reallocation of intangible assets which would likely have the effect of increasing or decreasing future amortization expense, since the intangible assets are initially assigned varied lives. Additionally, the lives assigned to the identifiable intangible assets represent management’s best estimates of the time periods in which it will continue to receive benefits from these assets. The useful lives may need to be adjusted in the future based upon changes to the expected useful lives of such assets.

F-26

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NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

---

 

[6] Property and Equipment

Property and equipment consist of the following:

		December 31,
		2006			2005
Equipment, Furniture and Fixtures		$	4,962,940		$	3,843,666
Leasehold Improvements			678,186			632,989
Totals - At Cost			5,641,126			4,476,655
Less: Accumulated Depreciation
and Amortization			2,914,703			1,811,226
Net		$	2,726,423		$	2,665,429

Depreciation and amortization expense amounted to $1,111,417, $820,841, and $681,839, respectively for the years ended December 31, 2006, 2005 and 2004.

[7] Long Term Debt

Long-term debt at December 31, 2006 consists of the following:

Term loan payable, bank - due in monthly installments
of $41,667 (a)		$	1,916,662
Note payable, Intelligent Systems - due in monthly
installments of $45,133 which includes interest (b)			1,292,468
Total Long-Term Debt			3,209,130
Less: Current Portion			951,802
Long-Term Debt, Less Current Portion		$	2,257,328

(a) On October 7, 2005, the Company entered into a revolving credit and term loan agreement with Bank of America pursuant to which the bank has agreed to make loans to the Company consisting of (i) a $2,500,000 revolving credit loan and (ii) a $2,500,000 term loan (collectively, the “Loans”).

The Loans are secured by a security interest in the Company’s personal property, including a pledge of the stock of the Company’s wholly-owned subsidiaries. The Loans are guaranteed by the Company’s significant wholly-owned subsidiaries, NTST-NY, NTST-PH and NTST-Ohio, whose assets represent substantially all of the assets of the Company.

 

F-27

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NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

---

[7] Long Term Debt - [Continued]

 

On October 7, 2005, the Company borrowed the full amount of the $2,500,000 term Loan. The Company has not borrowed any amounts under the revolving credit Loan. The term Loan bears interest at LIBOR plus 2.25%. The Company has entered into an interest rate swap agreement with the Bank for the amount outstanding under the term Loan whereby it converted the variable rate on the term Loan to a fixed rate of 7.1% in order to reduce the interest rate risk associated with these borrowings (Note 12). The revolving credit facility will bear interest at a rate per annum to be elected by the Company, equal to either (1) the LIBOR rate plus 2% or (2) the Bank’s prime rate. The financing agreement contains certain covenants including limitations on the Company’s ability to incur liens, maintain a minimum tangible net worth of $2,250,000 and requires the maintenance of certain financial ratios. As of December 31, 2006, we were not in compliance with one of the financial covenants of the Financing Agreement. The Bank has waived our non-compliance so that at December 31, 2006, we were in compliance with the covenants of the term Loan.

(b) In connection with the acquisition of NTST-PH (see note 5), the Company issued a three year promissory note to Intelligent Systems, Inc. in the principal amount of $1,435,000 payable in 36 monthly installments of principal and interest calculated at 8.25%.

Maturities of long-term debt at December 31, 2006 are as follows:

For the Year Ending
December 31,		Amount
2007		$	951,802
2008			990,518
2009			850,148
2010			416,662
Total		$	3,209,130

 

[8] Income Taxes

The Company utilizes an asset and liability approach to determine the extent of any deferred income taxes, as described in SFAS No. 109, “Accounting for Income Taxes.” This method gives consideration to the future tax consequences associated with differences between financial statement and tax bases of assets and liabilities.

During the years ended December 31, 2006 and 2005, the Company utilized approximately $2.2 million and $2.9 million, respectively of net operating loss carryforwards. At December 31, 2006, the Company has remaining net operating loss carryforwards of approximately $3,321,000 expiring through 2025. Pursuant to Section 382 of the Internal Revenue Code regarding substantial changes in Company ownership, utilization of this net operating loss carryforward is limited. Approximately $830,000 can be used in each of 2007, 2008, 2009 and 2010; unused amounts can be carried forward. In addition, the $717,000 tax benefit related to approximately $1,800,000 of net operating losses generated in 2000 on exercise of non-qualified compensatory stock options and warrants was credited to paid-in-capital in 2004.

The Company’s provision for taxes for the year ended December 31, 2006 includes certain state and local taxes.

F-28

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NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

---

[8] Income Taxes - [Continued]

The expiration dates of net operating loss carryforwards are as follows:

December 31,		Total
		Amount
2021		$	1,537,000
2022			9,000
2023			709,000
2024			9,000
2025			1,057,000
		$	3,321,000

 

Provision for income taxes consists of the following:

		Year ended December 31,
		2006			2005			2004
Current:
Federal		$	1,730,000		$	63,000		$	56,000
State			559,000			261,000			131,000
			2,289,000			324,000			187,000
Deferred:
Federal			(113,000	)		642,000			104,000
State			234,000			193,000			18,000
			121,000			835,000			122,000
Total		$	2,410,000		$	1,159,000		$	309,000

 

F-29

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NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

---

[8] Income Taxes - [Continued]

The difference between income taxes at the statutory Federal income tax rate and income taxes reported in the income statement is as follows:

 

		Year ended December 31,
		2006			2005			2004
Income taxes at the federal statutory rate			34	%		34	%		34	%
State and local income taxes net of Federal taxes			7.7			6			3
Nondeductible expenses(1)			14.1			1			2
Federal Alternative Minimum Tax			--			1			2
Other			.7			--			--
Decrease in valuation allowance			--			--			(31	)%
			56.5	%		42	%		10	%

⁽¹⁾ Includes $1,581,000 of cost associated with the proposed merger transaction.

 

Significant components of the Company’s deferred taxes are comprised of the following:

 

		December 31,
		2006			2005
Deferred Tax Asset:
Net operating loss carryforward		$	1,214,000		$	2,024,000
Allowance for doubtful accounts			228,000			175,000
Accrued vacation and bonuses			233,000			384,000
Alternative minimum tax credit carryforward			--			241,000
Net book value property plant and equipment			47,000			278,000
Deferred Stock Option Compensation			46,000			--
Other			294,000			(37,000	)
Total deferred tax assets			2,062,000			3,065,000
Deferred Tax Liabilities:
Net book value - intangible assets			(2,190,000	)		(3,589,000	)
Net deferred tax liability assets		$	(128,000	)	$	(524,000	)

 

The deferred taxes are presented in the Consolidated Balance Sheet as follows:

 

		December 31,
		2006			2005
Current asset		$	755,000		$	1,595,000
Long term liability			(883,000	)		(2,119,000	)
Net deferred tax liability assets		$	(128,000	)	$	(524,000	)

F-30

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NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

---

[8] Income Taxes - [Continued] 

During 2004, the Company reduced the valuation allowance totaling $1,731,000 at January 1, 2004 to zero based upon its belief that it is more likely than not that the entire net operating loss carry forward will be utilized.

 

[9] Stockholders’ Equity

The Company’s Board of Directors is authorized to issue preferred stock from time to time without stockholder action, in one or more distinct series. The Board of Directors is authorized to determine the rights and preferences of the preferred stock when issued. The Board of Directors has authorized the issuance of Series A, Series B and Series D preferred stock. No shares of any series of preferred stock were outstanding on December 31, 2006.

Common Stock Issuances - In June 2006, the Company issued 3,489 shares of its common stock in connection with an investor relations agreement in addition to consulting fees. These shares were valued at $12.90, the fair market value at the date of grant. On April 28, 2005, the Company issued 20,000 shares of its common stock in connection with the acquisition of CL. On September 28, 2005, the Company issued 435,735 shares of its common stock in connection with the acquisition of NTST-Ohio.

In October 2003, the Company sold to investors, pursuant to a private placement agreement, an aggregate 490,000 shares of common stock and warrants to purchase 122,504 shares of common stock. The Company received $4,493,104 in gross proceeds and paid commissions of $275,000 and $102,976 in other professional costs during 2005 and $158,350 in other professional costs in 2006 related to the private placement. The Company also issued a warrant to purchase 24,500 shares to the placement agent. The private placement agreement required the Company to file a registration statement within 30 days of the closing of the private placement, and to use its reasonable best efforts to have such registration statement declared effective within 90 days of the closing to keep such registration statement effective for a two year period. Generally, the private placement agreement further provided for a penalty to be paid to the investors should the Company fail to meet its registration obligations. Such penalty was payable to the investors in cash at the rate of 2.5% of the gross proceeds per month, up to a maximum penalty of 20% of the gross proceeds. The Company has satisfied its registration obligations. The Company has accounted for the proceeds of the private placement as equity in accordance with View A of EITF 05-04, “The Effect of a Liquidated Damages Clause on a Freestanding Financial Instrument Subject to Issue No. 00-19”. Any potential penalties incurred pursuant to the registration rights agreement will be recorded in earnings when and if incurred as per SFAS 5, “Accounting for Contingencies”. As of December 31, 2006, the Company has not incurred any penalties relating to this private placement.

Treasury Stock - During 2006, options and warrants to purchase 64,390 shares were exercised and the Company received gross proceeds of $570,355. Pursuant to option grants, employees have the right to pay for the exercise price of the options by delivering “mature” shares of common stock owned by them. Included in the proceeds received upon the exercise of options were 639 shares of the Company’s common stock. The value of the shares received was $8,200, which was based upon the market value of the common stock on the date of exercise in accordance with the cashless exercise provisions of the Company’s stock option plans.

F-31

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NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

---

[9] Stockholders’ Equity - [Continued]

During 2005, options to purchase 206,658 shares were exercised and the Company received gross proceeds of $854,240. Pursuant to option grants, employees have the right to pay for the exercise price of the options by delivering “mature” shares of common stock owned by them. Included in the 2005 exercise of options were 12,250 options owned by a Company officer. These options were exercised by the delivery of 3,650 shares of the Company’s common stock, which were valued at $53,532, which was based upon the market price of the common stock on the dates of exercise in accordance with the cashless exercise provisions of the Company’s stock option plans.

During 2004, options to purchase 38,877 shares were exercised and the Company received gross proceeds of $166,400. Pursuant to the option grants, employees have the right to pay for the exercise price of the options by delivering “mature” shares of common stock owned by them. Included in the 2004 exercise of options were 12,250 options owned by a Company officer. These options were exercised by the delivery of 4,166 shares of the Company’s common stock, which were valued at $53,533, which was based upon the market price of the common stock on the dates of exercise in accordance with the cashless exercise provisions of the Company’s stock option plans.

Stock Options and Warrants - See note 13 for information relating to the Company’s 1998, 1999 and 2001 Long-Term Incentive Plans.

During 2005, the Company announced the completion of a private placement of units consisting of an aggregate 490,000 shares of its common stock and warrants to purchase 147,003 shares of common stock, which include 24,500 warrants issued to the placement agent. The warrants have an exercise price of $11 per share. The Company received net proceeds of approximately $4.0 million.

During 2005, the Company granted 30,000 inducement options to employees of NTST-Ohio to encourage the recipients to continue to remain in the employ of NTST-Ohio after the acquisition. The options were granted at a price of $14.77 which was equal to the fair market value at the date of grant. The options vest over a period of three years. The fair value of the options granted was $250,000.

On December 21, 2000, the stockholders of the Company approved the 1999 Employee Stock Purchase Plan. The plan reserves 150,000 shares of common stock. The plan provides eligible employees with the opportunity to purchase shares of common stock at a discounted price through regular payroll deductions. No shares have been issued as of December 31, 2006 under this plan.

F-32

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NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

---

[10] Capital Lease Obligations

Future minimum payments under capital lease obligations as of December 31, 2006 are as follows:

Year ending
December 31,
Total Minimum Payments due in 2007		$	9,695
Less Amount Representing Interest at 11.63% Per annum			174
Balance		$	9,521

 

Capital lease obligations are collateralized by equipment which has a cost of $37,180 at December 31, 2006 and $214,426 at December 31, 2005 and accumulated amortization of $34,082 and $162,119 at December 31, 2006 and 2005, respectively. Amortization of $33,580 in 2006 and $70,456 in 2005 and 61,109 in 2004, respectively, has been included in depreciation expense.

 

[11] Fair Value of Financial Instruments

The carrying amount of cash and cash equivalents, accounts receivable, accounts payable and the note payable to Intelligent Systems approximate the fair value of these instruments because of their short maturities or floating interest rates.

The bank debt (see note 7), including current maturities, has a carrying value of $1,916,662 and an estimated fair value of $1,910,000. Estimated fair value is based on the expected current rates offered to the Company for instruments of the same or similar maturities, after considering the effect of the interest rate swap.

 

[12] Commitments and Contingencies

Leases

The Company leases space for its executive offices and facilities under an operating lease expiring October 2014 which has an option to cancel in December 2009. The lease is for a ten year and ten month period. The lease provides for a fixed monthly rent of $45,700 and includes an annual escalation increase of 3%. There are no lease payments required during the first ten months of the lease and the Company has the option of canceling the lease after six years. However, upon cancellation, certain unamortized costs must be reimbursed to the landlord. Future maturities of this lease were considered for the entire ten year and ten month period. In addition, the Company leases six sales and service offices under non cancelable operating leases expiring at various times through December 2010. The Company leases space for NTST-Ohio under a non-cancellable operating lease expiring September 2010. The lease provides for a fixed monthly rent of approximately $31,000. This facility is leased from a Partnership whose general partner is a 5.3% stockholder of the Company. The amount paid in connection with this facility was $377,000 for the year ended December 31, 2006.

F-33

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NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

---

[12] Commitments and Contingencies - [Continued]

Minimum annual rentals under noncancellable operating leases having terms of more than one year are as follows:

Year ending
December 31,
2007			1,317,000
2008			1,328,000
2009			1,270,000
2010			1,201,000
2011			853,000
Thereafter			2,588,000
Total		$	8,557,000

 

Rent expense amounted to $1,277,900, $1,009,700 and $833,000 respectively, for the years ended December 31, 2006, 2005 and 2004.

Employment Agreements

In April 2004, the Company entered into revised employment agreements with Messrs. James L. Conway and Anthony F. Grisanti. The terms and conditions of the revised contracts are identical in all material respects to the previous contracts except that (i) the term of each individual’s contract was extended by one year, so that Messrs. Conway and Grisanti’s contract were to expire on December 31, 2006 and (ii) the revised contracts do not provide for a five-year consulting period following each individual’s respective term of employment during which such individual would have been entitled to compensation of $75,000 per year. Messrs. Conway and Grisanti’s contracts also provide for an option, which have been exercised, to extend their contracts for one additional year so that their contracts would expire on December 31, 2007.

During November 2006, in connection with the proposed merger transaction, we entered into new contracts with each of Mr. Conway (the “Conway Agreement”) and Mr. Grisanti (the “Grisanti Agreement”). These agreements were entered into in connection with the proposed merger transaction and are not a part of our compensation program. Consequently, the Conway Agreement and Grisanti Agreement were not approved by the Compensation Committee. The Conway Agreement provides that following the closing of the proposed merger, Mr. Conway will continue to act as the Chief Executive Officer of Netsmart for a term of two years commencing on the date of the closing of the merger, such term to be automatically renewed for successive one year terms thereafter unless the Conway Agreement is terminated pursuant to its terms. During the term of the Conway Agreement, Mr. Conway will continue to receive a base salary of $367,500, which is his current base salary, and will no longer have the right to automatic annual base salary increases, as provided in his current employment agreement. The Conway agreement also provides for a change of control payment in the amount of $1 million.

F-34

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NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

---

[12] Commitments and Contingencies - [Continued]

Under the terms of the Grisanti Agreement, following the closing of the proposed merger transaction, Mr. Grisanti will continue to act as the Chief Financial Officer of Netsmart for a term of two years commencing on the date of the closing of the merger, such term to be automatically renewed for successive one year terms thereafter unless the Grisanti Agreement is terminated pursuant to its terms. During the term of the Grisanti Agreement, Mr. Grisanti will continue to receive a base salary of $204,750, which is his current base salary, and will no longer have the right to automatic annual base salary increases, as provided in his current employment agreement. The Grisanti agreement also provides for a change of control payment in the amount of $601,500.

In February 2005, one of our subsidiaries, Netsmart New York, entered into an employment agreement with Mr. Kevin Scalia as an Executive Vice President of the Company with such contract expiring on February 14, 2008. Mr. Scalia’s contract provides for an option to extend his contract for continuing subsequent two year terms unless terminated by the Company or Mr. Scalia on not less than sixty days written notice prior to the expiration of the contract.

In January 2006, one of our subsidiaries, Netsmart New York, entered into an employment agreement with Mr. Alan Tillinghast as an Executive Vice President of the Company with such contract expiring on December 31, 2008. Mr. Tillinghast’s contract provides for an option to extend his contract for continuing subsequent two year terms unless terminated by the Company or Mr. Tillinghast on not less than sixty days written notice prior to the expiration of the contract.

The minimum aggregate base compensation for its four officers is $930,000 for 2006. The minimum aggregate base compensation for its four officers is $976,000 in 2007 and $222,000 in 2008, subject to annual increases equal to the greater of 5% or the increase in the cost of living index. The agreements also provide for the officers with an automobile allowance. In the event of a change of control, Messrs. Conway and Grisanti may receive severance payments equal to 48 months compensation.

The Company also has a consulting agreement with a former Director, which provides for annual fees of $75,000 through December 31, 2007. The agreement also provides the former Director with an automobile allowance. In the event of a change of control, the former Director may receive severance payments of 36 months compensation.

Effective April 1, 2004, the Company adopted an Executive Retirement, Non-Competition and Consulting Plan which was subsequently amended August 5, 2004 retroactively effective to April 1, 2004, pursuant to which, following their retirement, selected officers will be entitled to receive a minimum payment of approximately $85,000 per year for a period of six years, provided, that such officers (i) provide a minimum amount of consulting days each month and (ii) agree to certain covenants not to compete. The annual payments are subject to 10% increases up to a maximum of $136,893 per year. Pursuant to the Executive Retirement, Non-Competition and Consulting Plan, the selected officers are also entitled to receive health benefits for life, provided that there are no breaches of the covenants not to compete. Each of Messrs. Conway and Grisanti are entitled to receive benefits under the plan.

The Company was a party to an employment agreement with John Phillips, a former Vice President and director of the Company. Mr. Phillip’s employment contract expired on December 31, 2003 and he retired

 

F-35

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NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

---

[12] Commitments and Contingencies - [Continued]

effective April 1, 2004. Pursuant to the terms of the Company’s Executive Retirement, Non-Competition and Consulting Plan, Mr. Phillips will receive $85,000 per year for each of the next six years commencing from the date of retirement; provided that he complies with the non-competition covenants of the plan.

Future minimum payments related to consulting and Executive Retirement, Non-Competition and Consulting agreements for the next five years are as follows:

Year Ending
December 31,		Amount
2007			169,000
2008			85,000
2009			85,000
2010			21,000
Total		$	360,000

 

Interest Rate Swap

In June 2001, the Company entered into an interest rate swap with a bank, which expired on June 1, 2006. In October, 2005, the Company entered into another interest rate swap with a bank, which expires on October 6, 2010. The swap transactions were entered into to protect the Company from upward movement in interest rates relating to outstanding bank debt (see note 7) and calls for a fixed rate of 7.95% for the 2001 transaction and 7.1% for the 2005 transaction. When the one-month LIBOR rate is below the fixed rate then the Company is obligated to pay the bank for the difference in rates. When the one-month LIBOR rate is above the fixed rate then the bank is obligated to pay the Company for the difference in rates. At December 31, 2006 and 2005 the fair value of the swaps of $(6,780) and $7,812, respectively, is recorded as a non current asset in 2006 and as a non-current liability in 2005. The swap transactions have been accounted for as a hedge, and accordingly, the change in the fair value of the swaps of $(14,952), $7,340 and $43,916 during the years ended December 31, 2006, 2005, and 2004, respectively, has been recorded as part of comprehensive income.

Letter of Credit

The Company relocated its Islip, New York headquarters to a larger facility in Great River, New York. Included in the terms and conditions of the Great River lease is the requirement that the Company provide to the landlord a letter of credit in the amount of $292,980, which represents approximately six months rent. This letter of credit was provided to the landlord on October 31, 2003. On June 15, 2006, the letter of credit was reduced to $244,150. The Company has currently applied to reduce the letter of credit to $195,320 and will apply for subsequent reduction as follows:

$146,490 for months 47 through 58 of the lease.

$97,660 for months 59 to the expiration of the lease.

 

[13] Stock-Based Compensation

Long Term Incentive Plans - The Company has three long-term incentive plans, the 1998 Long-Term

F-36

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NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

---

[13] Stock-Based Compensation - [Continued]

Incentive Plan (the “1998 Plan”), as amended, the 1999 Long-Term Incentive Plan (the “1999 Plan”) and the 2001 Long-Term Incentive Plan (the “2001 Plan”), as amended. The 2001 Plan was approved by the stockholders on March 7, 2002 and originally provided for the issuance of 180,000 shares of common stock. In January 2003, the 2001 Plan was amended and approved by the stockholders to provide for an increase in the number of shares subject to the plan from 180,000 to 550,000. In May 2004, the 2001 Plan was further amended and approved by the stockholders to provide an increase in the number of shares subject to the plan from 550,000 to 950,000. In July 2005, the plan was amended and approved by the stockholders to provide an increase in the number of shares subject to the plan from 950,000 to 1,350,000. In December 2006, the plan was amended and approved by the stockholders to provide an increase in the number of shares subject to the plan from 1,350,000 to 1,950,000. The maximum shares issuable by the Company are 790,000, 300,000 and 1,950,000 shares of Common Stock pursuant to the 1998 Plan, the 1999 Plan and the 2001 Plan, respectively. The options, when granted vest ratably over one year except for the 400,000 options granted in July 2005, which vested prior to December 31, 2005. These 400,000 options were granted at an exercise of $9.85 which was equal to the fair market value at the date of grant. Automatic options granted to the independent members of the Board of Directors vest fully after six months. At December 31, 2006 there were 0, 0 and 586,045 shares available for further issuance under the 1998 Plan, the 1999 Plan and 2001 Plan, respectively.

The 1998 Plan, the 1999 Plan and the 2001 Plan (collectively, the “Plans”) are administered by the Compensation Committee of the board of directors. Officers and other key employees, consultants and directors (other than non-employee directors) are eligible to receive options or other equity-based incentives under the Plans.

The 2001 Plan provides that each non-employee director automatically receives a nonqualified stock option to purchase 10,000 shares of common stock and the chairman of the audit committee and the compensation committee will receive a nonqualified stock option to purchase 12,500 shares of common stock on April 1 of each year. However, if there are not sufficient shares available under the applicable Plan, the non-employee director will receive a lesser number of shares. In April 2006, the Company granted 10,500 options to its non-employee directors under the automatic grant provisions of its 2001 Plan. These options were granted at a price of $13.86 which was equal to the fair market value of the options at the date of grant. These options were fully vested by December 31, 2006. In December 2006, upon the approval of the increase in shares available under the 2001 Plan, the Company granted 15,000 options to its non-employee directors under the 2001 plan. These options were granted at a price if $16.21 which was equal to the fair market value of the options at the date of grant. These options will be fully vested by May 2007.

 

F-37

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NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

---

[13] Stock-Based Compensation - [Continued]

A summary of the activity under the Plans and the NTST-Ohio inducement options (see note 9) are as follows:

 

		2006						2005						2004
					Weighted						Weighted						Weighted
					Average						Average						Average
					Exercise						Exercise						Exercise
		Shares			Price			Shares			Price			Shares			Price
Outstanding - Beginning of
Year			945,467		$	8.758			724,333		$	6.476			365,755		$	4.111
Granted During the Year			25,500			15.242			438,292			10.181			397,455			8.438
Canceled During the Year			(6,142	)		13.935			(10,500	)		1.81			--			--
Exercised During the Year			(41,420	)		7.67			(206,658	)		4.134			(38,877	)		4.280
Outstanding - End of Year			923,405		$	8.951			945,467		$	8.758			724,333		$	6.476
Exercisable - End of Year			895,688		$	8.751			915,467		$	8.561			525,606		$	5.734

The aggregate intrinsic values of the outstanding and exercisable shares at December 31, 2006 were $6,730,679 and $6,707,935, respectively.

The weighted average fair value of options issued at date of grant using the fair value based method during 2006 is estimated at $3.17. The total intrinsic value of options exercised during 2006 was $207,809.

The following table summarizes stock option information as of December 31, 2006:

 

					Options Outstanding
					Weighted
					Average Remaining			Options
Exercise Prices		Number Outstanding			Contractual Life			Exercisable
$16.21			15,000			4.92 Years			2,500
$14.77			24,900			3.83 Years			9,683
$13.86			10,500			4.33 Years			10,500
$13.29			1,500			2.25 Years			1,500
$ 9.85			396,458			3.50 Years			396,458
$ 9.57			8,292			3.25 Years			8,292
$ 8.49			276,460			2.42 Years			276,460
$ 8.20			75,775			2.50 Years			75,775
$ 6.61			8,000			1.58 Years			8,000
$ 4.93			59,378			1.08 Years			59,378
$ 4.37			7,500			6.50 Years			7,500
$ 4.37			31,642			1.50 Years			31,642
$ 2.50			3,000			.25 Years			3,000
$ 2.38			5,000			.50 Years			5,000
Totals			923,405			2.89 Years			895,688

F-38

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NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

---

[13] Stock-Based Compensation - [Continued]

A summary of the option activity of nonvested options at December 31 2006, and changes during the year ended December 31, 2006 is presented below:

					Weighted
					Average
					Grant Date
		2006			Fair Value
Nonvested at January 1,			23,234		$	14.770
Vested			(12,500	)	$	14.744
Issued			15,000		$	16.21
Forfeited			1,983			--
Nonvested at December 31,			27,717		$	15.075

The total fair value of shares vested during the year ended December 31, 2006 was $66,939.

The fair value of options at date of grant was estimated using the Black-Scholes fair value based method during 2006 with the following weighted average assumptions:

		2006
Expected Life (Years)			1.95
Risk Free Rate			4.68	%
Expected Dividends			--	%
Volatility			30	%

 

F-39

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NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

---

[13] Stock-Based Compensation - [Continued]

Warrants

During 2005, the Company announced the completion of a private placement of units consisting of an aggregate 490,000 shares of its common stock and warrants to purchase 147,003 shares of common stock, which include 24,500 warrants issued to the placement agent. The warrants have an exercise price of $11 per share and will expire in October 2010. The Company received net proceeds of approximately $4.0 million.

A summary of warrant activity is as follows:

		2006						2005						2004
					Weighted						Weighted						Weighted
					Average						Average						Average
					Exercise						Exercise						Exercise
		Shares			Price			Shares			Price			Shares			Price
Outstanding - Beginning
of Year			147,003		$	11.00			--			--			--			--
Granted During the Year			--			--			147,003		$	11.00			--			--
Expired During the Year			--			--			--			--			--			--
Exercised During the Year			(22,970	)	$	11.00			--			--			--			--
Outstanding - End of Year			124,033		$	11.00			147,003		$	11.00			--			--
Exercisable - End of Year			124,033		$	11.00			147,003		$	11.00			--			--

F-40

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NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

---

[14] Operating Segments

The Company currently classifies its operations in five business segments: (1) Software and Related Systems and Services - New York, (2) Software and Related Systems and Services - Ohio, (3) Software and Related Systems and Services - Public Health, (4) Data Center Services and (5) Application Service Provider Services (“ASP”). Software and Related Systems and Services - Public Health is a new segment resulting from the Company’s acquisition of QS Technologies, Inc. in August 2006, consisting of the subsidiary NTST - PH which delivers enterprise wide public health solutions and vital records software to public health agencies. Software and Related Systems and Services - Ohio is a new segment resulting from the Company’s acquisition of CMHC in September 2005. NTST - Ohio offers a full suite of behavioral healthcare information management software for mental health, substance abuse and addiction services agencies, developmental disability centers, and behavioral health-related managed care organizations. Software and Related Systems and Services for each of the New York, Public Health and Ohio segments refers to the design, installation, implementation and maintenance of computer information systems that provide comprehensive healthcare information technology solutions including billing, patient tracking and scheduling for inpatient and out patient environments, as well as clinical documentation and medical record generation and management. Within these segments are large turnkey and small turnkey components. The large turnkey components consist mostly of the Avatar suite of products. When the Company is engaged in a fixed price arrangement, these installations will usually extend over a six-month to a multi-year time period. The duration of the implementation is dependent on the size and complexity of the customer organization and the specifics of the implementation. The small turnkey components are usually completed within a six-month period. Small turnkey contracts performed in the New York segment are mostly related to the Avatar methadone related products. The small turnkey contracts in the Ohio and Public Health segments are for system installations for behavioral healthcare and public health information management software for mental health, substance abuse and addiction services agencies, developmental disability centers and behavioral health-related managed care organizations.

Data Center Services involve Company personnel performing data entry and data processing services for customers. ASP services involve the Company offering several of it software products on a virtual private network or internet delivery approach, thereby allowing its customers to utilize the Company’s products and pay on a monthly service basis.

Intersegment sales and sales outside the United States are not material. Information concerning the Company’s business segments is as follows:

F-41

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NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

---

[14] Operating Segments - [Continued] 

 

		Sotware and Related Systems and Services - New York			Data Center Services			Application Service Provider Services			Sofware and Related Systems and Services - Ohio			Software and Related Systems and Services - Public Health			Total
Year Ended December 31, 2006
Revenue
Large Turnkey		$	18,051,217		$	-		$	-		$	-		$	-		$	18,051,217
Small Turnkey			1,888,693			-			-			6,090,613			1,126,243			9,105,549
Maintenance			10,933,446			-			-			14,803,280			864,482			26,601,208
Other			-			1,735,940			3,555,769			-			-			5,291,709
Total		$	30,873,356		$	1,735,940		$	3,555,769		$	20,893,893		$	1,990,725		$	59,049,683
Gross Profit
Turnkey		$	8,446,320		$	-		$	-		$	844,313		$	970,379		$	10,261,012
Maintenance			6,209,358			-			-			10,711,947			352,169			17,273,474
Other			-			918,737			1,325,479			-			-			2,244,216
Total		$	14,655,678		$	918,737		$	1,325,479		$	11,556,260		$	1,322,548		$	29,778,702
Income before Income Taxes		$	1,084,398		$	294,700		$	(328,304	)	$	2,689,516		$	523,153		$	4,263,463
Depreciation and Amortization		$	1,633,347		$	108,897		$	542,950		$	1,740,589		$	291,534		$	4,317,317
Capital Expenditures		$	493,058		$	6,937		$	243,983		$	379,743		$	5,291,742		$	6,415,463
Identifiable Assets		$	27,045,397		$	1,629,132		$	4,136,343		$	31,315,172		$	6,398,509		$	70,524,553
Goodwill			-			-			-		$	18,445,646			-		$	18,445,646
Year Ended December 31, 2005
Revenue
Large Turnkey			17,599,035			-			-						-			17,599,035
Small Turnkey			1,041,866			-			-			1,685,904			-			2,727,770
Maintenance			9,784,488			-			-			3,533,256			-			13,317,744
Other			-			1,795,448			2,538,457			-			-			4,333,905
Total			28,425,389			1,795,448			2,538,457			5,219,160			-			37,978,454
Gross Profit
Turnkey			8,434,026			-			-			210,025			-			8,644,051
Maintenance			5,402,433			-			-			2,493,736			-			7,896,169
Other			-			908,279			927,431			-			-			1,835,710
Total			13,836,459			908,279			927,431			2,703,761			-			18,375,930
Income before Income Taxes			2,151,923			384,465			(116,027	)		328,414			-			2,748,775
Depreciation and Amortization			1,489,017			110,479			401,835			450,125			-			2,451,456
Capital Expenditures			3,755,207			6,445			863,605			9,121,675			-			13,746,932
Identifiable Assets			26,219,605			1,909,546			3,221,333			33,271,370			-			64,621,854
Goodwill			-			-			-			18,735,751			-			18,735,751
Year Ended December 31, 2004
Revenue
Large Turnkey			16,003,646			-			-			-			-			16,003,646
Small Turnkey			927,960			-			-			-			-			927,960
Maintenance			8,289,525			-			-			-			-			8,289,525
Other			-			2,058,240			1,725,473			-			-			3,783,713
Total			25,221,131			2,058,240			1,725,473			-			-			29,004,844
Gross Profit
Turnkey			7,728,535			-			-			-			-			7,728,535
Maintenance			4,120,550			-			-			-			-			4,120,550
Other			-			1,208,887			799,140			-			-			2,008,027
Total			11,849,085			1,208,887			799,140			-			-			13,857,112
Income before Income Taxes			2,095,722			784,353			181,890			-			-			3,061,965
Depreciation and Amortization			1,247,962			113,676			262,755			-			-			1,624,393
Capital Expenditures			950,094			12,144			93,501			-			-			1,055,739
Identifiable Assets			31,291,838			2,775,036			3,640,027			-			-			37,706,901

 

F-42

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NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

---

[15] Subsequent Events

In 2007, the Company negotiated an additional 8,553 square feet at its Great River facility at an annual rental of $149,678 with a lease expiration of 10/22/14. The Company expects to occupy that space in early 2007.

 

[16] Going Private Transaction and Related Litigation

 

Going Private Transaction

On November 18, 2006, we entered into an Agreement and Plan of Merger (the “Merger Agreement”) with NT Acquisition, Inc., a Delaware corporation (“Buyer”) and NT Merger Sub, Inc., a Delaware corporation (“Merger Sub”). Under the terms of the Merger Agreement, Merger Sub will be merged with and into Netsmart (the “Merger”), the separate corporate existence of Merger Sub will cease with Netsmart continuing as the surviving corporation (the “Surviving Corporation”). Merger Sub and Buyer are or will be controlled by funds which are affiliated with Insight Venture Partners (“Insight”) and Bessemer Venture Partners (“Bessemer” and, together with Insight, the “Sponsors”), private equity firms.

At the effective time of the merger, each outstanding share of common stock of Netsmart, other than any shares owned by Merger Sub, its affiliates, Netsmart or any shareholders who are entitled to and who properly exercise appraisal rights under Delaware law, will be cancelled and converted into the right to receive $16.50 in cash, without interest. Warrant holders and option holders will be entitled to receive the difference between the exercise price of such security and $16.50 per share in cash.

A special meeting of stockholders has been called for Thursday, April 5, 2007 for the purpose of considering the Merger Agreement.

 

Litigation

 

On November 21, 2006, a class action complaint entitled Levy Investments, LTD. v. Netsmart Technologies, Inc., et al., Civil Action No. 2566-N, was filed against Netsmart, its directors, Buyer and Merger Sub in the Delaware Court of Chancery, New Castle County. On November 21, 2006, a class action complaint entitled Superior Partners v. James L. Conway, et al., Civil Action No. 2563-N, was filed against Netsmart, its directors, Kevin Scalia, Alan B. Tillinghast, Buyer and Merger Sub in the Delaware Court of Chancery, New Castle County. On November 21, 2006, a class action complaint entitled Joe B. Ingram v. Netsmart Technologies, Inc., et al., Index No. 06-32611, was filed against Netsmart and its directors in the Supreme Court of New York, Suffolk County. On November 22, 2006, a class action complaint entitled Mark Anthony v. Netsmart Technologies, Inc., et al., Index No. 06-32720, was filed against Netsmart, its directors, Alan B. Tillinghast, Kevin Scalia, Insight and Bessemer in the Supreme Court of New York, Suffolk County. On December 1, 2006, a class action complaint entitled Jon Landon v. Francis J. Calcagno et al., Civil Action No. 2586-N, was filed against Netsmart, its directors, Buyer, Merger Sub and NT Investor Holdings, Inc. (“Parent”) in the Delaware Court of Chancery, New Castle County. On December 12, 2006, a class action complaint entitled Leviticus Partners, L.P. v. James L. Conway, et al., Civil Action No. 2597-N,was filed against Netsmart, its directors, Buyer, Merger Sub, Insight and Bessemer in the Delaware Court of Chancery, New Castle County. The complaints allege, among other things, that each of the directors of Netsmart individually breached the fiduciary duties owing to the Netsmart shareholders by voting to approve the Merger Agreement, thereby enabling management to benefit to the detriment of the shareholders. Each of the complaints seeks, among other relief, the court’s designation of class action status, an injunction

 

F-43

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NETSMART TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

---

 

[16] Going Private Transaction and Related Litigation - [Continued]

preventing the consummation of the merger and, in the event of consummation of the merger, rescission and damages. In Mark Anthony v. Netsmart Technologies, Inc., et al., on December 6, 2006, the plaintiff moved for approval of voluntary discontinuance of the action. The motion was granted by order signed on January 4, 2007. On December 11, 2006, the Delaware Court of Chancery entered an order on consent consolidating the three actions filed in that court as of that date. On December 14, 2006, the plaintiff in Leviticus Partners, L.P. v. James L. Conway, et al. filed a motion for consolidation and for reconsideration of the order entered December 11, 2006, in the Delaware Court of Chancery. On December 18, 2006, the plaintiff in Leviticus Partners, L.P. v. James L. Conway, et. al. filed a notice of withdrawal of its motion for consolidation and reconsideration of the December 11, 2006 order and represented to the court its intent to file suit in Suffolk County, New York. By letter to the court dated December 19, 2006, the defendants requested the court to decline to enter the proposed order granting the notice of dismissal. On December 20, 2006, Vice Chancellor Leo E. Strine, Jr. of the Delaware Court of Chancery denied the plaintiff’s request to enter an order dismissing the action. On January 5, 2007, the plaintiffs in the consolidated Delaware action filed a Consolidated Amended Complaint, inter alia, adding certain nondisclosure claims based on Netsmart’s preliminary proxy statement. On January 10, 2007, the plaintiff in Joe B. Ingram v. Netsmart et al. filed a First Amended Class Action Complaint adding certain nondisclosure claims based on Netsmart’s preliminary proxy statement and naming as additional defendants Insight, Bessemer, Kevin Scalia and Alan B. Tillinghast. On January 12, 2007, the defendants in Joe B. Ingram v Netsmart et al. moved to dismiss the action in favor of the substantially identical actions pending in Delaware. By order dated February 6, 2007, the court granted the defendants motion and dismissed the Suffolk County action. On January 16, 2007, the Delaware Court of Chancery entered, on consent, an Amended Order of Consolidation consolidating Leviticus Partners, L.P. v James L. Conway, et al. with the three previously consolidated Delaware actions. On January 25, 2007, plaintiffs in the consolidated Delaware action filed (1) a motion for expedited discovery; and (2) a notice of intent to file a motion for a preliminary injunction. On January 26, 2007, Vice Chancellor Leo E. Strine, Jr. conducted a telephonic conference in the consolidated Delaware action. During this telephonic conference, Vice Chancellor Strine ordered that discovery was to be expedited and ordered defendants to produce, by no later than February 2, 2007, documents in response to plaintiffs’ request for production of documents, and that depositions of the witnesses be completed by no later than February 11, 2007. Vice Chancellor Strine also held a hearing for Plaintiff’s Motion for a Preliminary Injunction on February 27, 2007. On March 14, 2007, the Court of Chancery issued a decision permitting a stockholder vote on the merger to be held after Netsmart makes supplemental disclosures consisting of certain financial projections and the text of the Court’s decision. The board of directors unanimously believes that the actions are without merit, and intends for Netsmart and the directors to defend vigorously against them.

From time to time the Company is also involved in ordinary and routine litigation matters in the normal course of business. The Company believes that the resolution of these matters will not have a material adverse effect on its consolidated financial position and results of operations.

 

F-44

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

	NETSMART TECHNOLOGIES, INC.
Dated: March 16, 2007	By:	/s/ James L. Conway
		James L. Conway, Chief Executive Officer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Each person whose signature appears below hereby authorizes James L. Conway and Anthony F. Grisanti (or any of them acting in the absence of the others), as his true and lawful attorney-in-fact and agent, with full power of substitution and resubstitution for him and in his name, place and stead, in any and all capacities to sign any and all amendments to this report, and to file same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission.

 

Signature		Title	Date
/s/ James L. Conway		Chief Executive Officer	March 16, 2007
James L. Conway		and Director (Principal Executive Officer)
/s/ Anthony F. Grisanti		Chief Financial Officer	March 16, 2007
Anthony F. Grisanti		(Principal Financial and Accounting Officer)
/s/ Kevin Scalia		Executive Vice President
Kevin Scalia		and Director	March 16, 2007
/s/ Alan Tillinghast		Executive Vice President
Alan Tillinghast		and Director	March 16, 2007
/s/ Joseph G. Sicinski		Director	March 16, 2007
Joseph G. Sicinski
/s/ Francis J. Calcagno		Director	March 16, 2007
Francis J. Calcagno
/s/ John S.T. Gallagher		Director	March 16, 2007
John S.T. Gallagher
/s/ Yacov Shamash		Director	March 16, 2007
Dr. Yacov Shamash

 

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EXHIBIT INDEX

Exhibits

3.1

Restated Certificate of Incorporation, as amended (Filed as an exhibit to the Registrant’s registration statement on Form S-1, File No. 333-2550, which was declared effective by the Commission on August 13, 1996, and incorporated herein by reference.)

3.2

By-Laws (Filed as an exhibit to the Registrant’s registration statement on Form S-1, File No. 333-2550, which was declared effective by the Commission on August 13, 1996, and incorporated herein by reference.)

10.1

Employment Agreement dated April 1, 2004, between the Registrant and James L. Conway (Filed as an exhibit to the Registrant’s 10-Q dated May 5, 2004.)

10.2

Consulting Agreement dated April 1, 2004, between the Registrant and John F. Phillips (Filed as an exhibit to the Registrant’s 10-Q dated May 5, 2004.)

10.3

Employment Agreement dated April 1, 2004, between the Registrant and Gerald O. Koop (Filed as an exhibit to the Registrant’s 10-Q dated May 5, 2004.)

10.4

Employment Agreement dated April 1, 2004, between the Registrant and Anthony F. Grisanti (Filed as an exhibit to the Registrant’s 10-Q dated May 5, 2004.)

10.6

1993 Long-Term Incentive Plan (Filed as an exhibit to the Registrant’s registration statement on Form S-1, File No. 333-2550, which was declared effective by the Commission on August 13, 1996, and incorporated herein by reference.)

10.7

1998 Long-Term Incentive Plan (Filed as an appendix to the Registrant’s proxy statement dated September 30, 1999, relating to its 1999 Annual Meeting of Stockholders and incorporated herein by reference.)

10.8

1999 Long-Term Incentive Plan (Filed as an appendix to the Registrant’s proxy statement dated November 9, 2000, relating to its 2000 Annual Meeting of Stockholders and incorporated herein by reference.)

10.9

2001 Long-Term Incentive Plan - Amended (Filed as an exhibit to the Registrant’s 8-K dated June 16, 2005.)

10.10

1999 Employee Stock Purchase Plan (Filed as an appendix to the Registrant’s proxy statement dated November 9, 2000, relating to its 2000 Annual Meeting of Stockholders and incorporated herein by reference.)

10.11

Agreement dated June 1, 2001, between the Registrant and Fleet Bank (Filed as an exhibit to the Registrant’s 10-K/A dated August 21, 2003.)

10.12

AIMS Acquisition Agreement (Filed as an exhibit to the Registrant’s 8-K dated May 10, 2001.)

10.13

Agreement dated June 25, 2003, among Registrant, Creative Socio-Medics Corp., Shuttle Data Systems Corp., d/b/a/ ADIA Information Management Corp. and Steven Heintz, Jr. (Filed as an exhibit to the Registrant’s 8-K dated July 8, 2003.)

10.14

Lease agreement dated as of December 22, 2003, between Registrant and Spacely LLC. (Filed as an exhibit to the Registrant’s 10-K dated March 23, 2004.)

10.15

Amended Executive Retirement, Non Competition and Consulting Plan. (Filed as an exhibit to the Registrant’s 10-Q dated August 9, 2004.)

10.16

Merger Agreement dated September 20, 2005, between CMHC Systems, Inc., Hayes Acquisition Corp., a newly-formed wholly-owned subsidiary of the Registrant, and John Paton, solely in the capacity of Securities Holders Representative. (Filed as an exhibit to the Registrant’s Form 8-K dated September 19, 2005.)

10.17

Revolving Credit and Term Loan Agreement with Netsmart Technologies, Inc. and the Bank of America, N.A. (Filed as an exhibit to the Registrant’s Form 8-K dated October 7, 2005.)

10.18

Asset Purchase Agreement dated June 17, 2005 between Addiction Management Systems, Inc. and Creative Socio-Medics Corp. (Filed as an exhibit to the Registrant’s Form 8-K dated June 21, 2005.)

10.20

Amendment No. 1 to Employment Agreement dated June 16, 2005, between the Registrant and James L. Conway. (Filed as an exhibit to the Registrant’s Form 8-K dated June 16, 2005.)

10.21

Amendment No. 1 to Employment Agreement dated June 16, 2005 between the Registrant and Anthony F. Grisanti. (Filed as an exhibit to the Registrant’s Form 8-K dated June 16, 2005.)

10.22

Asset Purchase Agreement dated April 27, 2005 between ContinuedLearning LLC and Creative Socio-Medics Corp. (Filed as an exhibit to the Registrant’s Form 8-K dated April 27, 2005.)

10.23

Employment Agreement dated April 27, 2005 between Netsmart Technologies, Inc. and A. Sheree Graves. (Filed as an exhibit to the Registrant’s Form 8-K dated April 27, 2005.)

10.24

Letter Agreement between Griffin Securities, Inc. and Netsmart Technologies, Inc. dated as of August 9, 2005. (Filed as an exhibit to the Registrant’s Form S-3, File No. 333-129265.)

10.25

Letter Agreement between Griffin Securities, Inc. and Netsmart Technologies, Inc. dated as of October 11, 2005. (Filed as an exhibit to the Registrant’s Form S-3, File No. 333-129265.)

10.26

First Amendment and Waiver to Loan Agreement dated as of December 31, 2005 between the Registrant and Bank of America, N.A. (Filed as an exhibit to Registrant’s Form 8-K dated February 23, 2006)

10.27

Employment Agreement between the Registrant and Gerald Koop dated April 5, 2006(Filed as an exhibit to Registrant’s Form 8-K dated April 5, 2006)

 

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10.28

Asset Purchase Agreement dated as of July 31, 2006 by and between QS Technologies, Inc. and Intelligent Systems Corporation, as Sellers and Netsmart Public Health, Inc., as Buyer and Netsmart Technologies, Inc. (Filed as an exhibit to Registrant’s Form 8-K dated August 1, 2006)

10.29

Second Amendment and Waiver to Loan Agreement dated as of July 31, 2006 between the Registrant and Bank of America, N.A. (Filed as an exhibit to Registrant’s Form 8-K dated September 29, 2006)

10.30

Merger Agreement dated November 18, 2006 between Netsmart Technologies, Inc., a Delaware corporation with NT Acquisition, Inc., NT Merger Sub, Inc.,and NT Acquisition, Inc. (Filed as an exhibit to the Registrant’s Form 8-K dated November 18, 2006.)

10.31

Amendment to employment agreement, between James L. Conway, dated as of November 18, 2006, with NT Investor Holdings, Inc., and the Registrant. (Filed as an exhibit to the Registrant’s Form 8-K/A dated November 30, 2006).

10.32

Amendment to employment agreement, between Anthony F. Grisanti, dated as of November 18, 2006, with NT Investor Holdings, Inc., and the Registrant. (Filed as an exhibit to the Registrant’s Form 8-K/A dated November 30, 2006).

21.1

Subsidiaries of the Registrant

23.1

Consent of Marcum & Kliegman LLP

24

Powers of Attorney (See Signature Page)

31.1

Certification of Chief Executive Officer

31.2

Certification of Chief Financial Officer

32

Certification pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

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