10-Q 1 e-5649.txt QUARTERLY REPORT FOR THE PERIOD ENDED 09/30/2000 ================================================================================ U.S. SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2000 [ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from __________ to __________ Commission file number: 000-22600 EMPLOYEE SOLUTIONS, INC. (Exact name of registrant as specified in its charter) Arizona 86-0676898 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 6225 North 24th Street, Phoenix, Arizona 85016 (Address of principal executive offices) Issuer's telephone number: (602) 955-5556 Securities registered pursuant to Section 12(b) of the Act: Title of each class: Name of each exchange on which registered: -------------------- ------------------------------------------ None N/A Securities registered pursuant to Section 12(g) of the Act: No Par Value Common Stock Rights to Purchase Shares of Series A Junior Participating Preferred Stock (Title of Class) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such report(s)), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] APPLICABLE ONLY TO CORPORATE ISSUERS State the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: 39,284,158 Common shares, no par value were outstanding as of October 30, 2000. ================================================================================ EMPLOYEE SOLUTIONS, INC. FORM 10-Q QUARTERLY REPORT FOR THE PERIOD ENDED SEPTEMBER 30, 2000 INDEX Page PART I. Financial Information Number Item 1. Financial Statements Consolidated Balance Sheets - September 30, 2000 and December 31, 1999 2 Consolidated Statements of Operations for the Quarters and Nine Months Ended September 30, 2000 and 1999 3 Consolidated Statement of Changes in Stockholders' Equity for the Nine Months Ended September 30, 2000 4 Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2000 and 1999 5 Notes to Consolidated Financial Statements 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 23 Item 3. Quantitative and Qualitative Disclosure about Market Risk 33 PART II. Other Information Item 1. Legal Proceedings 34 Item 3. Defaults Upon Senior Securities 34 Item 6. Exhibits and Reports on Form 8-K 35 Signatures 36 ITEM 1. FINANCIAL STATEMENTS EMPLOYEE SOLUTIONS, INC. CONSOLIDATED BALANCE SHEETS September 30, December 31, (In thousands of dollars, except share data) 2000 1999 -------------------------------------------- --------- --------- ASSETS CURRENT ASSETS: Cash and cash equivalents $ 15,930 $ 34,014 Investments and marketable securities -- 100 Restricted cash and investments 83 1,000 Accounts receivable, net 28,098 38,296 Receivables from insurance companies 6,885 6,618 Prepaid expenses and deposits 4,755 1,088 --------- --------- Total current assets 55,751 81,116 Property and equipment, net 3,247 4,211 Goodwill and other assets, net 34,316 37,000 --------- --------- Total assets $ 93,314 $ 122,327 ========= ========= LIABILITIES AND STOCKHOLDERS' (DEFICIT) EQUITY CURRENT LIABILITIES: Bank overdraft $ 3,889 $ 2,472 Accrued salaries, wages and payroll taxes 19,222 31,175 Accounts payable 5,379 6,224 Accrued workers' compensation and health insurance 7,944 7,188 Income taxes payable 287 363 Other accrued expenses 11,418 6,379 Interest payable 8,259 1,905 Note payable 88,000 10,000 --------- --------- Total current liabilities 144,398 65,706 --------- --------- Long-term debt -- 85,000 --------- --------- Other long-term liabilities 387 347 --------- --------- Commitments and contingencies STOCKHOLDERS' (DEFICIT) EQUITY Class A convertible preferred stock, nonvoting, no par value, 10,000,000 shares authorized, no shares issued and outstanding -- -- Common stock, no par value, 75,000,000 shares authorized, 38,433,027 shares issued and outstanding September 30, 2000, and 36,182,547 shares issued and outstanding December 31, 1999 41,525 39,550 Common stock to be issued 5,922 7,871 Accumulated deficit (98,918) (76,147) Cumulative unrealized net gain on investment securities -- -- --------- --------- Total stockholders' (deficit) equity (51,471) (28,726) --------- --------- Total liabilities and stockholders' equity $ 93,314 $ 122,327 ========= ========= The accompanying notes are an integral part of these consolidated financial statements. 2 EMPLOYEE SOLUTIONS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS

The accompanying notes are an integral part of these consolidated financial statements. 3 EMPLOYEE SOLUTIONS, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY NINE MONTHS ENDED SEPTEMBER 30, 2000

The accompanying notes are an integral part of these consolidated financial statements. 4 EMPLOYEE SOLUTIONS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS Nine months ended September 30, ----------------------- (In thousands of dollars) 2000 1999 ------------------------- --------- --------- CASH FLOWS FROM OPERATING ACTIVITIES: Cash received from customers $ 554,742 $ 614,683 Cash paid to suppliers and employees (567,384) (629,913) Interest received 861 937 Interest paid (1,389) (4,264) Income taxes refunded (paid), net (76) 4,529 --------- --------- Net cash used in operating activities (13,246) (14,028) --------- --------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of property and equipment (246) (381) Business acquisitions -- (5,895) Change in investments and marketable securities 100 7,426 Decrease in restricted cash and investments 917 88 Disbursements for deferred costs -- (103) --------- --------- Net cash provided by investing activities 771 1,135 --------- --------- CASH FLOWS FROM FINANCING ACTIVITIES: Payment of deferred loan costs (52) -- Proceeds from issuance of common stock 26 3 Increase (decrease) in bank overdraft and other 1,417 (13,727) Decrease in short-term debt (7,000) -- --------- --------- Net cash used in financing activities (5,609) (13,724) --------- --------- Net decrease in cash and cash equivalents (18,084) (26,617) CASH AND CASH EQUIVALENTS, beginning of period 34,014 39,287 --------- --------- CASH AND CASH EQUIVALENTS, end of period $ 15,930 $ 12,670 ========= ========= The accompanying notes are an integral part of these consolidated financial statements. 5 EMPLOYEE SOLUTIONS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED) Nine months ended September 30, -------------------- 2000 1999 -------- -------- RECONCILIATION OF LOSS TO NET CASH USED IN OPERATING ACTIVITIES: Net loss $(22,771) $(10,321) -------- -------- ADJUSTMENTS TO RECONCILE NET LOSS TO NET CASH USED IN OPERATING ACTIVITIES: Depreciation and amortization 3,922 5,256 Decrease (increase) in accounts receivable, net 10,198 (12,732) (Increase) decrease in insurance company receivables (267) 805 Increase in prepaid expenses and deposits (3,667) (2,590) Decrease (increase) in other assets 22 (2,479) (Decrease) increase in accrued salaries, wages and payroll taxes (11,951) 2,237 Increase (decrease) in accrued workers' compensation and health insurance 756 (75) Increase in accounts payable, other accrued expenses and other long term liabilities 10,588 1,342 Change in income taxes payable/receivable (76) 4,529 -------- -------- 9,525 (3,707) -------- -------- Net cash used in operating activities $(13,246) $(14,028) ======== ======== The accompanying notes are an integral part of these consolidated financial statements. 6 EMPLOYEE SOLUTIONS, INC. SEPTEMBER 30, 2000 -------------------------------------------------------------------------------- EMPLOYEE SOLUTIONS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 2000 (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: NATURE OF CORPORATION Employee Solutions, Inc. (together with its subsidiaries, "ESI" or the "Company") is a leading professional employer organization (PEO) providing employers throughout the United States with comprehensive employee payroll, human resources and benefits outsourcing services. The Company's integrated outsourcing services include payroll processing and reporting, human resources administration, employment regulatory compliance management, risk management/workers' compensation services, retirement and health care programs, and other products and services provided directly to worksite employees. At September 30, 2000, ESI serviced approximately 1,794 client companies with approximately 30,963 worksite employees in 45 states. The Company conducts its business on a national scale across many industries and is not concentrated to any material extent within a single local market or industry, although the transportation industry, at approximately 27%, represents the largest concentration of clients. BASIS OF PRESENTATION The accompanying unaudited consolidated financial statements of the Company have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with generally accepted accounting principles have been omitted pursuant to such rules and regulations. In the opinion of management the consolidated financial statements include all adjustments, consisting only of normal recurring adjustments, necessary in order to make the consolidated financial statements not misleading. Results of operations for the quarter and nine months ended September 30, 2000 are not necessarily indicative of the results that may be expected for the year ending December 31, 2000. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 1999. PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the activities of Employee Solutions, Inc. and its wholly owned subsidiaries from their respective acquisition dates. All acquisitions were accounted for as purchases. All significant intercompany accounts and transactions have been eliminated. USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles 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 revenues and expenses during the reporting period. The nature of the Company's business requires significant estimates to be made in the areas of workers' compensation and revenue recognized for retrospectively rated insurance policies. The actual results of these estimates may be unknown for a period of years. Actual results could differ from those estimates. 7 EMPLOYEE SOLUTIONS, INC. SEPTEMBER 30, 2000 -------------------------------------------------------------------------------- CASH AND CASH EQUIVALENTS Cash and cash equivalents consist of cash and highly liquid investments with original maturities of three months or less when purchased. All cash equivalents are invested in high quality investment grade instruments, such as certificates of deposit, at September 30, 2000 and December 31, 1999, and are stated at fair market value. Substantially all cash and cash equivalents, including restricted cash, are not insured at September 30, 2000. INVESTMENTS AND MARKETABLE SECURITIES At September 30, 2000, the Company maintained approximately $9.3 million of investments in its cash and cash equivalents and investments and marketable securities accounts. These securities are considered available-for-sale and, accordingly, are recorded at market value. Securities with original maturities of 90 days or less consisted of money market and mutual funds that had an estimated fair value of $9.3 million at September 30, 2000. RESTRICTED CASH AND INVESTMENTS At September 30, 2000, restricted cash was $83 thousand, which represents cash collateral held for securing short-term indebtedness under a loan agreement. See Note 2. BANK OVERDRAFT Bank overdraft represents outstanding checks in excess of cash on hand at the applicable bank, and generally result from timing differences in the transfer of funds between banks. Historically, these checks are covered when presented for payment through the transfer of funds from other Company cash accounts held in other banks. CREDIT RISK The Company conducts only a limited credit investigation prior to accepting most new clients and thus may encounter collection problems which could adversely affect its cash flow. The nature of the Company's business is such that a small number of client credit failures could have an adverse effect on its business and financial condition. 8 EMPLOYEE SOLUTIONS, INC. SEPTEMBER 30, 2000 -------------------------------------------------------------------------------- NET INCOME PER COMMON AND COMMON EQUIVALENT SHARE The computation of adjusted net loss and weighted average common and common equivalent shares used in the calculation of net loss per common share is as follows:

9 EMPLOYEE SOLUTIONS, INC. SEPTEMBER 30, 2000 --------------------------------------------------------------------------------

(2) NOTE PAYABLE: On October 26, 1999 the Company entered into a loan and security agreement (as amended, the "Loan Agreement") with Foothill Capital Corporation and Ableco Finance LLC (the "Lenders") providing for a term loan of $10 million at an initial interest rate of 13.5% and a revolving loan (based on eligible accounts receivable) to a maximum of $10 million (including letters of credit drawn thereunder) at an interest rate of prime plus 2%. The Company received the proceeds of the term loan on October 29, 1999. The Company has not drawn on the revolving loan facility except as security for various letters of credit ($5.4 million at September 30, 2000). The Company paid a closing fee of $800,000 and is paying a commitment fee of 50 basis points on the unused portion of the revolving line, as well as letter of credit fees initially set at 2.0%. Because the term loan then remained outstanding, a fee of $100,000 was paid after July 29, 2000 and after October 29, 2000. The Loan Agreement matures on January 1, 2001. The principal loan covenants are as follows: tangible net worth of ($72,390,000) at December 31, 1999, ($71,320,000) at March 31, 2000, ($70,220,000) at June 30, 2000, ($68,270,000) at September 30, 2000 and ($66,090,000) at December 31, 2000; and EBITDA (as defined) of $1,230,000 at December 31, 1999, $2,560,000 at March 31, 2000, $2,780,000 at June 30, 2000, $3,410,000 at September 30, 2000 and $3,770,000 at December 31, 2000. The Loan Agreement also includes covenants relating to capital expenditure limits and worksite employee headcount and average gross margin requirements. The Loan Agreement further contains, among other limitations, restrictions on mergers or the sale of significant assets or use of the proceeds thereof, investments and business acquisitions, and additional indebtedness or liens. The Loan Agreement includes certain other customary covenants, and is secured by substantially all of the Company's assets (including pledges of the stock of the Company's subsidiaries and control agreements over substantially all of the Company's cash accounts). The Company has not been in compliance with one or more of the covenants set forth above commencing as of March 31, 2000 and has therefore classified the debt obligation as a current liability. The Company has also classified the 10% Senior Notes due 2004 as a current note payable obligation. See Note 3. 10 EMPLOYEE SOLUTIONS, INC. SEPTEMBER 30, 2000 -------------------------------------------------------------------------------- The Company and the Lenders entered into a Waiver and Amendment Agreement dated as of July 6, 2000, under which the Lenders waived any rights and remedies available for defaults under designated covenants with respect to which the Company was then in default. The annual interest rate on the term loan was increased to 15.5% effective April 30, 2000, increasing by 25 basis points per month beginning on September 1, 2000 so long as any portion of the term loan remains outstanding. The fee payable for undrawn letters of credit was increased to 6% per annum. As additional security, the Company agreed to deposit $5 million in a deposit account subject to a control agreement in form satisfactory to the Lenders, and to deposit an additional $1 million in such account on August 1, 2000 and on the first day of each month thereafter so long as any amounts remain owing to the Lenders. On September 11, 2000 the Company and the Lenders signed an additional letter agreement whereby the Lenders agreed to waive all prepayment penalties upon the repayment of $7 million of the term loan, which was subsequently paid by the Company in September 2000. On September 26, 2000, an additional agreement was reached whereby the Lenders agreed to waive all future prepayment penalties on payments of $1 million each on the first day of October, November and December (constituting the remaining outstanding balance on the term loan). The Company believes that the Loan Agreement will not be renewed at its maturity date (January 1, 2001). The Company is seeking a replacement facility, though there can be no assurance that the Company will be able to obtain one. (3) LONG-TERM DEBT: NOTE OFFERING On October 21, 1997, the Company issued $85 million of 10% Senior Notes due 2004 (the Notes) in an Offering (the Offering) exempt from registration under the Securities Act of 1933 as amended (Securities Act). Interest under the Notes is payable semi-annually commencing April 15, 1998, and the Notes are not callable until October 2001 subject to the terms of the Indenture under which the Notes were issued. The Company filed a registration statement under the Securities Act, relating to an exchange offer for these Notes, which was declared effective in April 1998. The indenture under which the Notes were issued includes certain restrictions on use of cash, and other expenditures, by the Company including limitations on dividends, repurchases of Company shares and the incurrence of new indebtedness. The Company is engaged in negotiations with the holders of these Notes. In connection with the negotiations, the Company's Board of Directors elected to withhold the $4.25 million semi-annual interest payments due on each of April 15 and October 15, 2000. Under the terms of the Indenture pursuant to which the Notes were issued, such withholding of interest constitutes an Event of Default (as defined in the Indenture). The Company received a written agreement from the holders of the Notes under which the holders agreed to forbear from exercising their rights and remedies through the first to occur of August 30, 2000 or the occurrence of a new default. The waiver has expired, though the holders of the Notes have not sought to exercise their rights and remedies during the pendency of the negotiations between the Company and the holders of the Notes. The Notes are general unsecured obligations of the Company and are unconditionally guaranteed on a joint and several basis by certain of the Company's wholly-owned current and future subsidiaries. The Company's wholly-owned insurance subsidiary, which is a non-guarantor subsidiary, is subject to certain statutory and contractual restrictions which limit its ability to pay dividends or make loans to the Company or other subsidiaries. The financial statements presented below include the separate or combined financial position as of September 30, 2000 and December 31, 1999, and the results of operations and cash flows for each of the quarters and nine month periods ended September 30, 2000 and September 30, 1999, of Employee Solutions, Inc. (Parent), the guarantor subsidiaries (Guarantors) and the subsidiaries which are not guarantors (Non-guarantors). 11 EMPLOYEE SOLUTIONS, INC. SEPTEMBER 30, 2000 -------------------------------------------------------------------------------- BALANCE SHEETS

12 EMPLOYEE SOLUTIONS, INC. SEPTEMBER 30, 2000 -------------------------------------------------------------------------------- BALANCE SHEETS

13 EMPLOYEE SOLUTIONS, INC. SEPTEMBER 30, 2000 -------------------------------------------------------------------------------- STATEMENTS OF OPERATIONS

14 EMPLOYEE SOLUTIONS, INC. SEPTEMBER 30, 2000 -------------------------------------------------------------------------------- STATEMENTS OF OPERATIONS

15 EMPLOYEE SOLUTIONS, INC. SEPTEMBER 30, 2000 -------------------------------------------------------------------------------- STATEMENTS OF OPERATIONS

16 EMPLOYEE SOLUTIONS, INC. SEPTEMBER 30, 2000 -------------------------------------------------------------------------------- STATEMENTS OF OPERATIONS

17 EMPLOYEE SOLUTIONS, INC. SEPTEMBER 30, 2000 -------------------------------------------------------------------------------- STATEMENTS OF CASH FLOWS

18 EMPLOYEE SOLUTIONS, INC. SEPTEMBER 30, 2000 -------------------------------------------------------------------------------- STATEMENTS OF CASH FLOWS

19 EMPLOYEE SOLUTIONS, INC. SEPTEMBER 30, 2000 -------------------------------------------------------------------------------- (3) SEGMENT INFORMATION The Company, in relation to SFAS No. 131 "Disclosure About Segments of an Enterprise and Related Information," has defined the following three reportable segments: Core PEO services, Logistics Personnel Corp. and TEAM Services. The Company, through its Core PEO segment, provides a full-range of services and products to its customers. Typically, ESI becomes the "employer of record" for the client company's employees and provides payroll administration, workers' compensation insurance and risk management administration, human resources administration and benefits programs. Additionally, other products and services are offered directly to worksite employees, such as employee payroll deduction programs for disability and specialty health insurance and other personal financial services. Logistics Personnel Corp (LPC) provides specialized leasing of all types of distribution personnel, including drivers, warehouse workers, mechanics, dispatchers, forklift operators and administrators. A full range of services, including employee recruiting, hiring and management; payroll administration; claims and audit handling; workers' compensation insurance coverage; employee benefits programs and tax reporting is provided to its customers. TEAM Services specializes in leasing commercial talent (actors and actresses), musicians and recording engineers to the music and advertising segments of the entertainment industry. In addition, TEAM generates revenue from touring bands with the entertainment industry. The accounting policies of the segments are the same as those described in the summary of significant accounting policies. 20 EMPLOYEE SOLUTIONS, INC. SEPTEMBER 30, 2000 -------------------------------------------------------------------------------- Information concerning revenue, gross profit and assets by business segment was as follows:

21 EMPLOYEE SOLUTIONS, INC. SEPTEMBER 30, 2000 -------------------------------------------------------------------------------- (4) CONTINGENCIES: The Company has received a letter from the Arizona Department of Economic Security indicating that the Company has been assigned a higher state unemployment tax rate for calendar year 1994 than the Company believes it is entitled. In consultation with legal counsel the Company believes that based on Arizona Revised Statutes it is entitled to the lower rate. If it was ultimately determined that the higher rate applies, the Company would owe $500,000 (before interest and the income tax effect) more than is reflected in the Company's financial statements. As of September 30, 2000, the compounded interest totaled approximately $ 360,000. International Color Services, L.L.C. filed for arbitration in December 1998 alleging breach of contract regarding fee issues under the PEO service agreement between the parties. Plaintiff seeks damages of over $500,000 (recently increased by plaintiff to over $1 million) plus attorneys' fees and costs and unspecified punitive damages. The Court recently granted motions for summary judgment filed by the Company that, among other things, defeated plaintiff's punitive damage claims. The Company is contesting the claim vigorously. The matter has been set for trial in January 2001. Stirling Cooke Insurance Services Inc. filed suit in the United States District Court for the Middle District of Florida against the Company in December 1999 alleging breach of contract and failure to pay insurance premiums in violation of Florida law. Stirling Cooke, in its capacity as managing and general agent, placed workers compensation insurance for the Company with three insurance companies for calendar year 1998. Stirling Cooke alleges that ESI owes unpaid premium in the amount of $2,797,905 to those companies. The Company believes that Stirling Cooke's suit is without merit based on an explicit Memorandum of Understanding between the parties that defined the applicable rates for the 1998 workers' compensation program and intends to defend the suit vigorously. The State of Ohio has issued an assessment of $5.2 million (plus interest and penalty) relating to sales taxes potentially applicable to certain types of PEO services provided by the Company. Contingent upon completion of a financial restructuring of the Company (including, in particular, the Notes), the Company has entered into a settlement agreement with the State of Ohio whereby it has agreed to pay an aggregate of $2.85 million in January 2001 in resolution of applicable sales tax liabilities. The State of Ohio also issued a sales tax assessment in the amount of approximately $16.5 million (including interest and penalties) in July 1999 against HDVT, Inc. (the seller of certain assets acquired by the Company in February 1997) with respect to the operations of HDVT prior to the Company's acquisition of certain assets of HDVT (then known as Employers Trust) in February 1997. The State of Ohio concurrently issued an assessment in the same amount against the Company as successor to HDVT. The Company believes that meritorious defenses are available to the assessment. In addition, $6.0 million of cash and 675,000 shares of the Company's Common Stock are being held in escrow for payment of amounts, if any, ultimately determined to be due pursuant to such assessment. If the Company is held to have liability pursuant to such assessment, the escrowed assets prove insufficient to satisfy such liability, and HDVT is unable to pay any such shortfall, the Company's maximum liability with respect to the assessment is approximately $3.2 million. The assessment is not included in the settlement agreement described in the preceding paragraph and remains outstanding. A Demand for Arbitration was filed with the American Arbitration Association on April 26, 2000 by the previous owners of Team Services. These individuals, along with a former member of the Company's Board of Directors and current President of the Company's TEAM Services subsidiary, sold TEAM Services to the Company pursuant to a 1996 acquisition agreement. The Demand for Arbitration alleges that the Company caused damages of approximately $800,000 by failing to provide a price protection payment required under the 1996 agreement with respect to the shares of the Company's Common Stock issued to the claimants in December 1999 as consideration for the acquisition. The Company intends to contest the claim vigorously. 22 EMPLOYEE SOLUTIONS, INC. SEPTEMBER 30, 2000 -------------------------------------------------------------------------------- ITEM 2. - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with, and is qualified in its entirety by, the Company's Consolidated Financial Statements and the Notes thereto appearing elsewhere herein and in the Company's Report on Form 10-K for the year ended December 31, 1999. Historical results are not necessarily indicative of trends in operating results for any future period. Except for the historical information contained herein, the discussion in this Form 10-Q contains or may contain forward-looking statements (which include statements in the future tense and statements using the terms "believe," "anticipate," "expect," "intend" or similar terms) that involve risks and uncertainties. The Company's actual results could differ materially from those discussed here. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this Management's Discussion and Analysis (particularly in "Outlook: Issues and Risks") in addition to those discussed in "Item 1 - Business" and "Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations" of the Company's Report on Form 10-K for the year ended December 31, 1999, as well as those factors discussed elsewhere herein or in any document incorporated herein by reference. RESULTS OF OPERATIONS -- OVERVIEW The following is a summary of certain factors which affect results of operations and which have generally applied to the Company in all periods presented. REVENUES The most significant components of the Company's revenues are payments received from customers for gross salaries and wages paid to PEO worksite employees and the Company's service fee. The Company negotiates service fees on a client-by-client basis based on factors such as market conditions, client needs and services requested, the clients' workers' compensation and benefit plan experience, Company administrative resources required, expected profit, and other factors. These are generally expressed as a fixed percentage of the client's gross salaries and wages except for certain costs, primarily employer's health care contributions, which are billed to clients on an add-on basis. Because the service fees are negotiated separately with each client and vary according to circumstances, the Company's service fees, and therefore its gross margin, will fluctuate based on the Company's client mix. COSTS OF REVENUES The Company's direct costs of revenues include salaries and wages paid to worksite employees, employment related taxes, costs of health and welfare benefit plans, and workers' compensation insurance costs. The largest component of direct costs is salaries and wages to worksite employees. Although this cost is generally directly passed through to clients, the Company may be responsible for payment of these costs even if not reimbursed by its clients. Employment related taxes consist of the employer's portion of payroll taxes required under FICA, which includes Social Security and Medicare; and federal and state unemployment taxes. The federal tax rates are defined by the appropriate federal regulations. State unemployment rates are subject to change each year based on claims histories and vary from state to state. In periods from and after January 1, 1998, workers' compensation liabilities are fully insured under a guaranteed cost policy, subject to limited exceptions described below. Accordingly, workers' compensation expense includes premiums paid to the Company's third party insurance carriers for workers' compensation insurance. Workers' compensation expense also includes the cost of a defined portfolio of stand-alone policies in place at December 31, 1997 which policies expired at various dates during 1998 and as to which the Company retains 23 EMPLOYEE SOLUTIONS, INC. SEPTEMBER 30, 2000 -------------------------------------------------------------------------------- liability of $250,000 per occurrence plus costs as described in the following paragraph; and costs under the Company's self-insurance program in Ohio, with respect to which the Company retains liability of $50,000 per occurrence. With respect to the Ohio and defined portfolio of stand-alone policies, the Company's accrued workers' compensation reserves are primarily based on industry-wide data, and to a lesser extent, the Company's past claims experience up to the retained limits. The liability recorded may be more or less than the actual amount of the claims when they are submitted and paid. Changes in the liability are charged or credited to operations as the estimates are revised. Administrative costs include fees paid to the Company's insurers and costs of claims management by third party administrators. Premium taxes include taxes and related fees paid to various states based on premiums written. Premium for excess reinsurance and accidental death and dismemberment relate to premium payments to the Company's insurers for the retention of risks above specified limits. Health care and other employee benefits costs consist of medical and dental insurance premiums, payments of and reserves for claims subject to deductibles and the costs of vision care, disability, life insurance and other similar benefit plans. The Company's health care benefit plans consist of a mixture of fully-insured programs and one self-insured program with a built-in maximum coverage cap of $100,000 per person per year. The Company recognizes a liability for self-insured and partially self-insured health insurance claims at the time a claim is reported to the Company by the third party claims administrator, and also provides for claims incurred, but not reported based on industry-wide data and the Company's past claims experience. The liability recorded may be more or less than the actual amount of ultimate claims. While the Company believes that its reserves for healthcare and workers' compensation claims are adequate for future claims payments, there can be no assurance that this will be the case. See "Outlook: Issues and Risks" herein. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES The Company's primary operating expenses are personnel expenses, other general and administrative expenses, and sales and marketing expenses. Personnel expenses include compensation, fringe benefits and other personnel expenses related to the Company's internal employees. Other general and administrative expenses include rent, office supplies and expenses, legal and accounting fees, bad debt expenses, insurance and other operating expenses. Sales and marketing expenses include commissions to sales personnel and related expenses. DEPRECIATION AND AMORTIZATION Depreciation and amortization consists primarily of the amortization of goodwill and acquisition costs from the Company's prior acquisitions. The Company amortizes goodwill and acquisition costs over periods of three to thirty years, depending on the assets acquired, using the straight-line method. OPERATING RESULTS Margin comparisons are affected by the relative mix of full PEO services, TEAM Services services, and driver leasing services in any particular period. Certain employment-related taxes are based on the cumulative earnings of individual employees up to a specified wage level. Therefore, these expenses tend to decline over the course of a year. Since the Company's revenues for an individual client are generally earned and collected at a relatively constant rate throughout each year, payment of such unemployment tax obligations can adversely affect first quarter results but positively impact the Company's working capital and results of operations as the year progresses. 24 EMPLOYEE SOLUTIONS, INC. SEPTEMBER 30, 2000 -------------------------------------------------------------------------------- RESULTS OF OPERATIONS-- QUARTER AND NINE MONTHS ENDED SEPTEMBER 30, 2000 COMPARED TO QUARTER AND NINE MONTHS ENDED SEPTEMBER 30, 1999

REVENUES Revenues decreased to $175.2 million for the quarter ended September 30, 2000, from $222.4 million for the quarter ended Sepetember 30, 1999, a decrease of 21%. For the nine months ended September 30, 2000, revenue was $544.5 million compared to $627.4 million for the nine months ended September 30, 1999, a decrease of 13%. The number of worksite employees decreased to approximately 30,963 covering approximately 1,794 client companies at September 30, 2000 from approximately 37,300 covering 2,015 client companies at September 30, 1999. The Company's 2000 operating plan depends in significant part upon achieving revenue growth through internal sales and on the reduction of customer attrition. However, the Company's efforts to achieve revenue growth and reduce attrition have been materially adversely affected by the market's current negative perception of the Company's financial stability. The Company anticipates that this effect will continue unless and until negotiations with respect to the Notes are concluded successfully. COST OF REVENUES Cost of revenues decreased 21% to $169.2 million in the quarter ended September 30, 2000 from $213.1 million for the quarter ended September 30, 1999. For the nine month period ended September 30, 2000, the cost of revenues was $525.9 million, a decrease of 13% over the $601.8 million for the nine month period ended September 30, 1999. This decrease was caused primarily by the reduction in internal sales and increased customer attrition. GROSS PROFIT The Company's gross profit margin decreased to 3.4% in the quarter ended September 30, 2000 from 4.2% in the quarter ended September 30, 1999. For the nine month period ended September 30, 2000, the gross profit margin was 3.4% compared to 4.1% for the same period in 1999. This decrease was attributable primarily to a reduction in the proportion of gross profit derived from driver leasing services which have higher margins, relative to the same period in 1999. Additional factors contributing to this decline were the loss of certain higher margin customers, and increased medical and workers' compensation costs beginning in 2000 that the Company has been unable to pass through to its customers due to competitive factors. While the Company's TEAM Services subsidiary has contributed a larger proportion of revenues in recent periods, the Company continues to derive a lower percentage of gross profit from such revenues relative to its core PEO and driver leasing operations, and therefore has determined to resume prior efforts to divest the subsidiary. 25 EMPLOYEE SOLUTIONS, INC. SEPTEMBER 30, 2000 -------------------------------------------------------------------------------- The Company has been advised that renewal of its primary workers' compensation and medical benefits programs for 2001 is dependent upon, among other things, completion of a financial restructuring of the Company (and, in particular, the Notes). See "OUTLOOK: ISSUES AND RISKS - INCREASES IN HEALTH INSURANCE PREMIUMS, UNEMPLOYMENT TAXES AND WORKERS' COMPENSATION RATES; AVAILABILITY OF PROGRAMS." If a restructuring is not completed, the Company has been advised that these programs will expire on December 31, 2000, and the Company does not believe that it would be able to continue normal PEO operations. SELLING, GENERAL AND ADMINISTRATIVE Selling, general and administrative expenses for the quarter ended September 30, 2000 increased approximately $2.2 million to $11.0 million, or 25%, from $8.8 million for the quarter ended September 30, 1999. Included in the quarter ended September 30, 2000 was a provision for the settlement of Ohio sales tax liabilities of $2.85 million and $350 thousand for litigation. Without these unusual items selling, general and administrative expenses actually declined by $1.0 million, or 12.8% from the previous year's $8.8 million. For the nine month periods ended September 30, 2000 and 1999, selling, general and administrative expenses were $30.7 million and $25.2 million, a 22% increase. This increase was primarily the result of the provision of $2.85 million for the settlement of Ohio sales tax liabilities, $900 thousand for litigation, $2.3 million for uncollectible accounts receivable and $1.7 million of professional fees attributable to the Company's restructuring efforts. Without these unusual items selling, general and administrative expenses actually declined by $2.4 million, or 9.3% from the previous year's $25.2 million. DEPRECIATION AND AMORTIZATION Depreciation and amortization represents depreciation of property and equipment and amortization of organizational costs, customer lists and goodwill. For the quarter ended September 30, 2000, depreciation and amortization expense totaled $1.3 million compared to $1.9 million for the quarter ended September 30, 1999. Total depreciation and amortization expense for the nine months ended September 30, 2000 was $3.9 compared to $5.3 million for the nine month period ended September 30, 1999. The decrease is primarily due to the goodwill impairment charge which was recorded during the fourth quarter of 1999, which has reduced the amount of goodwill being amortized for previous acquisitions on a prospective basis. INTEREST Interest expense for the quarter ended September 30, 2000 totaled $2.6 million compared to $2.1 million for the quarter ended September 30, 1999. For the nine month periods ended September 30, 2000 and 1999, interest expense totaled $7.8 million and $6.4 million, respectively. The increase is primarily the result of interest expense charged on the Loan Agreement, under which the Company borrowed $10.0 million in October 1999 at an initial interest rate of 13.5% and has paid certain other fees and expenses. The interest rate has been increased to 15.5% effective April 30, 2000, with additional monthly increases of 25 basis points commencing September 1, 2000 for so long as amounts remain outstanding. (SEE FOOTNOTE 2- NOTE PAYABLE AND "OUTLOOK: ISSUES AND RISKS - FUTURE CAPITAL AND LIQUIDITY NEEDS; UNCERTAINTY OF ADDITIONAL FINANCING; NONCOMPLIANCE WITH LOAN AGREEMENT" FOR ADDITIONAL INFORMATION CONCERNING THE LOAN AGREEMENT). EFFECTIVE TAX RATE The Company's effective tax rate provides for federal, state and local income taxes. As of September 30, 2000, the Company has incurred losses in excess of what can be carried back and applied against prior years' income to generate federal income tax refunds. The remaining operating loss will be available for carry-forward benefit only to the extent of any subsequently generated taxable income, subject to any limitation or the possible loss of carry-forward benefits directly attributable to the successful completion of the Company's restructuring efforts. 26 EMPLOYEE SOLUTIONS, INC. SEPTEMBER 30, 2000 -------------------------------------------------------------------------------- LIQUIDITY AND CAPITAL RESOURCES The Company's liquidity position is such that, absent a financial restructuring of the Company (including, in particular, the Notes), the Company does not believe that it will be able to continue normal PEO operations. See in particular "OUTLOOK: ISSUES AND RISKS -- INCREASES IN HEALTH INSURANCE PREMIUMS, UNEMPLOYMENT TAXES AND WORKERS' COMPENSATION RATES; AVAILABILITY OF PROGRAMS." The Company continues to engage in negotiations with regard to such a restructuring. However, there can be no assurance as to whether a restructuring can be accomplished or as to the timing or terms thereof. For additional information, see "OUTLOOK: ISSUES AND RISKS - `SUBSTANTIAL LEVERAGE; NEGOTIATIONS WITH HOLDERS OF INDEBTEDNESS; POTENTIAL SUBSTANTIAL DILUTION OF COMMON STOCKHOLDERS,' `FUTURE CAPITAL AND LIQUIDITY NEEDS; UNCERTAINTY OF ADDITIONAL FINANCING; NONCOMPLIANCE WITH LOAN AGREEMENT' AND ` IMPLEMENTATION OF OPERATING PLAN; CUSTOMER ATTRITION.'" The Company defines liquidity as the ability to mobilize cash to meet operating and capital needs. The Company's primary use of cash in the nine months ended September 30, 2000 was for operating activities and the reduction of short-term debt. The Company's liquidity position was materially reduced due to the use of cash during the first nine months of 2000. Cash used in operating activities was $13.3 million during the first nine months of 2000 compared to $14.0 million during the comparable period in 1999. The Company's primary use of cash in the nine months ended September 30, 2000 was for the payment customer payrolls, payroll taxes, interest, legal and professional fees, other operating activities, and the payment of prepaid workers' compensation premiums under the Company's guaranteed cost policy. Operating cash flows are derived from customers for PEO services rendered by the Company. Payments from PEO customers typically are received on or within a few days of the date on which payroll checks are delivered to customers, and cover the cost of the payroll, payroll taxes, insurance, other benefit costs and the Company's administration fee. The Company's TEAM Services and LPC operations extend credit terms generally from 15 to 45 days as is customary in their respective market segments. Cash provided by investing activities was $771 thousand during the first nine months of 2000, compared to $1.1 million during the comparable prior year period. Included in investing activities in 2000 is a decrease of $917 thousand in restricted cash. For the nine months ended September 30, 2000 and 1999, capital expenditures were $246,000 and $381,000, respectively. Capital expenditures in 2000 consisted primarily of software development cost to enhance the Company's data processing capabilities and to support the increased use of the Internet by customers to transfer payroll information to the Company for processing. Although the Company continuously reviews its capital expenditure needs, management expects that 2000 capital expenditures will continue at a level comparable to the first nine months of the year. Cash used in financing activities was $5.6 million for the nine months ended September 30, 2000 compared to $13.7 million for the same period in 1999. Cash used in 2000 was primarily due to the reduction of $7.0 million in short-term debt, offset by an increase in bank overdrafts of $1.4 million, compared to a reduction of bank overdrafts of $13.7 million during the same period in 1999. These bank overdrafts represent outstanding checks in excess of the cash recorded on the Company's books for specific bank accounts and generally represent timing differences between the transfer of funds between banks, and do not represent actual bank overdrafts of collected funds held at banks which is available for the payment of payroll obligations. OUTLOOK: ISSUES AND RISKS The following issues and risks, among others (including those discussed elsewhere herein), should be considered in evaluating the Company's outlook. 27 EMPLOYEE SOLUTIONS, INC. SEPTEMBER 30, 2000 -------------------------------------------------------------------------------- SUBSTANTIAL LEVERAGE; NEGOTIATIONS WITH HOLDERS OF INDEBTEDNESS; POTENTIAL SUBSTANTIAL DILUTION OF COMMON STOCKHOLDERS The Company has incurred significant debt primarily in connection with the October 1997 issuance of its $85 million 10% Senior Notes due 2004 (the "Notes") and a secured loan facility obtained in October 1999 (the "Loan Agreement"). At September 30, 2000, the Company had outstanding indebtedness of $3.0 million under the Loan Agreement (not including letters of credit drawn thereunder in the amount of $5.4 million), outstanding senior indebtedness of $85.0 million and a deficit in stockholders' equity of approximately $51.5 million. The Company believes that it currently is leveraged to a significantly greater extent than any of its principal competitors. In an effort to improve cash flows and reduce the Company's indebtedness, the Company has been engaged in negotiations with the holders of the Notes (the "Noteholders"). The Company is seeking to negotiate the reduction or elimination of the outstanding principal amount of the Notes and accrued interest thereon in exchange for the issuance of shares of its equity securities. If the Company is able to reach agreement upon such a transaction, the Company anticipates that the percentage ownership of the then current shareholders of the Company will be materially reduced, and the equity securities issued to participating Noteholders (or other sources of equity, as the case may be) also may have rights, preferences or privileges senior to those of the holders of the Company's Common Stock. While delays have been experienced, the Company continues to seek to complete such negotiations, and intends to submit to shareholders for approval a proposal or proposals relating to all or a portion of the negotiations. There can be no assurance whether or when a satisfactory agreement can be reached with respect to the Notes. If the Company is unable to complete a satisfactory agreement, the Company likely will be unable to continue PEO operations. See "INCREASES IN HEALTH INSURANCE PREMIUM, UNEMPLOYMENT TAXES AND WORKERS' COMPENSATION RATES; AVAILABILITY OF PROGRAMS." If no agreement is reached, the Company also will remain subject to the current principal and interest obligations (and other terms and conditions) associated with the Notes, it will not likely be able to retain certain of its key employees, and its liquidity position will be materially adversely affected. Among its obligations under the Notes were regular semi-annual interest payments of $4.25 million due on each of April 15 and October 15, 2000. In connection with the negotiations, the Company's Board of Directors elected to withhold these payments, thereby creating an event of default with respect to the Notes. The Company has received a written agreement from the holders of the Notes under which the holders agreed to forbear from exercising their rights and remedies relating to such default through the first to occur of August 30, 2000 or the occurrence of a new default. The waiver has expired, though the holders of the Notes have not sought to exercise their rights and remedies during the pendency of negotiations between the Company and the holders of the Notes. A default with respect to the Notes also constitutes a default, by virtue of cross-default provisions, under the Loan Agreement. See "FUTURE CAPITAL AND LIQUIDITY NEEDS; UNCERTAINTY OF ADDITIONAL FINANCING; NONCOMPLIANCE WITH LOAN AGREEMENT." FUTURE CAPITAL AND LIQUIDITY NEEDS; UNCERTAINTY OF ADDITIONAL FINANCING; NONCOMPLIANCE WITH LOAN AGREEMENT If a satisfactory agreement with respect to the Notes can be reached (see "SUBSTANTIAL LEVERAGE; NEGOTIATIONS WITH HOLDERS OF INDEBTEDNESS; POTENTIAL SUBSTANTIAL DILUTION OF COMMON STOCKHOLDERS," above), management believes that, based on its 2000-2001 operating plan and subject to the discussion herein concerning the Loan Agreement, cash flow from operations and other available cash will be adequate to meet the Company's anticipated future requirements for working capital expenditures, scheduled lease payments and scheduled payments of interest on its remaining indebtedness. The Company will need to raise additional funds through public or private debt or equity financing if satisfactory arrangements cannot be reached with its principal lenders, the revenue and cash flow elements of its 2000-2001 operating plan are not met, or to deal with unanticipated cash requirements, such as adverse litigation outcomes or material customer payment defaults. For a discussion of risks associated with the Company's 2000-2001 operating plan, see "IMPLEMENTATION OF OPERATING PLAN; CUSTOMER ATTRITION" If additional funds are raised through the issuance of equity securities, the percentage ownership of the then current 28 EMPLOYEE SOLUTIONS, INC. SEPTEMBER 30, 2000 -------------------------------------------------------------------------------- shareholders of the Company will be materially reduced, and such equity securities may have rights, preferences or privileges senior to those of the holders of the Company's Common Stock. There can be no assurance that additional financing will be available on terms acceptable to the Company, or at all. If adequate funds are not available or are not available on acceptable terms, the Company's business, operating results, financial condition and ability to operate will be materially adversely affected. The Company has not been in compliance with one or more of the covenants set forth in the Loan Agreement commencing as of March 31, 2000. The Company recently received a waiver of such noncompliance in exchange for its agreement to provide additional cash collateral, pay an increased interest rate and certain additional fees, and arrange for early reduction of the outstanding principal balance. There can be no assurance that the Company will be able to obtain additional waivers in the event of future defaults, if any. The Company believes that the Loan Agreement will not be renewed at its maturity date (January 1, 2001). The Company is seeking a replacement facility, though there can be no assurance that the Company will be able to obtain one. Unless satisfactory refinancing arrangements can be made, of which there can be no assurance, the Company's financial condition and ability to operate will be materially adversely affected if the lenders under the Loan Agreement accelerate the Company's obligations under the Loan Agreement as a result of defaults or otherwise or at the Loan Agreement's maturity date. At September 30, 2000, the Company had outstanding indebtedness of $3.0 million under the Loan Agreement (not including letters of credit drawn thereunder in the amount of $5.4 million). ABILITY TO SERVICE INDEBTEDNESS; CONSEQUENCES OF SUBSTANTIAL LEVERAGE The Company's ability to make scheduled principal payments in respect of, or to pay the interest on, or to refinance, any of its indebtedness (including the Loan Agreement and any outstanding Notes) will depend on its future performance, which, to a certain extent, is subject to general economic, financial, competitive, regulatory and other factors beyond its control. There can be no assurance that the Company's business will generate sufficient cash flow from operations, that anticipated growth will occur or that funds will be available from other sources or otherwise in an amount sufficient to enable the Company to service or refinance its indebtedness, including the Loan Agreement and the Notes, or make anticipated capital expenditures and lease payments. See "SUBSTANTIAL LEVERAGE; NEGOTIATIONS WITH HOLDERS OF INDEBTEDNESS; POTENTIAL SUBSTANTIAL DILUTION OF COMMON STOCKHOLDERS," "FUTURE CAPITAL AND LIQUIDITY NEEDS; UNCERTAINTY OF ADDITIONAL FINANCING; NONCOMPLIANCE WITH LOAN AGREEMENT" AND "IMPLEMENTATION OF OPERATION PLAN; CUSTOMER ATTRITION." The degree to which the Company is leveraged has important consequences, including, but not limited to, the following: (i) a substantial portion of the Company's cash flow from operations will be dedicated to debt service, including repayment of principal, and will not be available for other purposes; (ii) the Company's ability to obtain additional financing in the future could be limited; and (iii) the Loan Agreement and Notes indenture contain financial and restrictive covenants that limit the ability of the Company to, among other things, borrow additional funds. Failure by the Company to comply with such covenants could result in an event of default which, if not cured or waived, could have a material adverse effect on the Company's liquidity position, business and financial performance. IMPLEMENTATION OF OPERATING PLAN; CUSTOMER ATTRITION In addition to completion of a financial restructuring, the Company's 2000-2001 operating plan depends in significant part upon achieving revenue growth through internal sales and marketing efforts. The Company recently focused its sales and marketing efforts in 2000 on target industries and geographic territories that it believes present the greatest opportunities for profitable growth, and to emphasize marketing through third-party alliances. While the Company believes that its refocused sales and marketing plan will result in consistent and profitable revenue growth, because of the negative market perception and the effect on sales, the Company has not yet demonstrated successful implementation of the plan and there can be no assurance that successful implementation can be achieved. The Company's 2000-2001 operating plan also depends on a significant reduction of customer attrition. The Company experienced significant attrition in 1999, resulting in a net reduction of approximately 5,900 worksite employees during 29 EMPLOYEE SOLUTIONS, INC. SEPTEMBER 30, 2000 -------------------------------------------------------------------------------- the year. Attrition during the nine months ended September 30, 2000 was an approximate net 3,922 worksite employees. While a portion of this attrition resulted from the Company's proactive elimination of unprofitable or high-risk customers, the Company also experienced attrition based on violation of noncompetition agreements by former salespersons and other factors. The Company's 2000-2001 operating plan includes continuing improvements in customer service functions intended to reduce attrition, and the Company is aggressively seeking to enforce its noncompetition agreements. There can be no assurance that customer retention can be materially improved. The Company's efforts to achieve revenue growth and reduce attrition have been materially adversely affected by the market's current negative perception of the Company's financial stability, and the Company anticipates that this effect will continue unless and until negotiations with respect to the Notes are concluded successfully. The Company's agreements with its customers historically have been subject to cancellation upon 30 days written notice of termination by either party, except where different arrangements are required by applicable law. While the Company has commenced the use of longer-term agreements, the short-term nature of most current customer agreements means that customers could terminate a substantial portion of the Company's business upon short NOTICE. COMPETITION The market for many of the services provided by the Company is highly fragmented, with over 2,300 PEOs currently competing in the United States. Many of these PEOs have limited operations with relatively few worksite employees, though several are larger than or comparable to the Company in size. The Company also competes with non-PEO companies, whose offerings overlap with some of the Company's services, including payroll processing firms, insurance companies, temporary personnel companies and human resource consulting firms. In addition, the Company expects that as the PEO industry becomes better established, competition will increase because existing PEO firms will likely consolidate into fewer and better competitors and well organized new entrants with greater resources than the Company, including some of the non-PEO companies described above, have entered or will enter the PEO market. LITIGATION AND OTHER CONTINGENCIES While certain significant litigation matters have been resolved in 1999 and 2000, other significant matters remain unresolved. The Company faces claims relating to prior contractual relationships and other matters. While the Company will continue to seek vigorously to resolve these matters favorably, there can be no assurance that the outcome of these matters, or any of them, will not have a material adverse effect upon the Company's results of operations or financial position. INCREASES IN HEALTH INSURANCE PREMIUMS, UNEMPLOYMENT TAXES AND WORKERS' COMPENSATION RATES; AVAILABILITY OF PROGRAMS State unemployment taxes are, in part, determined by the Company's unemployment claims experience. Medical claims experience also greatly impacts the Company's health insurance rates and claims cost from year to year. Similarly, workers' compensation costs are directly affected by experience. Should the Company experience an increase in claims activity for unemployment, workers' compensation and/or healthcare, or if other factors result in higher expenses in these areas, the Company's costs in these areas would increase. In such a case, the Company may not be able to pass these higher costs to its customers due to contractual or competitive factors. By way of example, the Company experienced certain cost increases for 2000, not all of which were able to be passed onto customers. In addition, the Company may experience difficulty competing with PEOs with lower rates that may offer lower rates to clients. The maintenance of health and workers' compensation insurance plans that cover worksite employees is a significant part of the Company's business. As discussed in "Liquidity and Capital Resources," above, the Company has been advised that its primary workers compensation insurance and medical benefits programs renewal for 2001 is conditioned upon, among other things, completion of a satisfactory financial restructuring of the Company. Absent renewal on reasonable terms, the programs will expire on December 31, 2000, and the Company does not believe that it would be able to continue normal PEO operations under such circumstances. If renewal of its medical benefits program can be obtained, the Company also anticipates an increase of approximately 25% in the cost of health insurance premiums for 2001. The Company is also expecting to incur an increase in 2001 workers' compensation cost of approximately 30%. 30 EMPLOYEE SOLUTIONS, INC. SEPTEMBER 30, 2000 -------------------------------------------------------------------------------- TAX TREATMENT The attractiveness to clients of a full-service PEO arrangement depends in part upon the tax treatment of payments for particular services and products under the Code (for example, the opportunity of employees to pay for certain benefits under a cafeteria plan using pre-tax dollars). The Internal Revenue Service (IRS) has formed a Market Segment Study Group to examine whether PEOs, such as the Company, are for certain employee benefit and tax purposes the "employers" of worksite employees under the Code. The Company cannot predict either the timing or the nature of any final decision that may be reached by the IRS with respect to the Market Segment Study Group or the ultimate outcome of any such decision, nor can the Company predict whether the Treasury Department will issue a policy statement with respect to its position on these issues or, if issued, whether such statement would be favorable or unfavorable to the Company. If the IRS were to determine that the Company is not an "employer" under certain provisions of the Code, it could materially adversely affect the Company in several ways. With respect to benefit plans, the tax qualified status of the Company's 401(k) plans could be revoked, and the Company's cafeteria and medical reimbursement plans may lose their favorable tax status. If an adverse IRS determination were applied retroactively to disqualify benefit plans, employees' vested account balances under 401(k) plans would become taxable, an administrative employer such as the Company would lose its tax deductions to the extent its matching contributions were not vested, a 401(k) plan's trust could become a taxable trust and the administrative employer could be subject to liability with respect to its failure to withhold applicable taxes and with respect to certain contributions and trust earnings. In such event, the Company also would face the risk of client dissatisfaction and potential litigation by clients or worksite employees. As the employer of record for many client companies and their worksite employees, the Company must account for and remit payroll, unemployment and other employment-related taxes to numerous federal, state and local tax, labor and unemployment authorities, and is subject to substantial penalties for failure to do so. From time to time, the Company has received notices or challenges which may adversely affect its tax rates and payments. In light of the IRS Market Segment Study Group and the general uncertainty in this area, certain proposed legislation has been drafted to clarify the employer status of PEOs in the context of the Code and benefit plans. However, there can be no assurance that such legislation will be proposed and adopted or in what form it would be adopted. Even if it were adopted, the Company may need to change aspects of its operations or programs to comply with any requirements which may ultimately be adopted. In particular, the Company may need to retain increased sole or shared control over worksite employees if the legislation is passed in its current form. CREDIT RISKS As the employer of record for its worksite employees, the Company generally is contractually obligated to pay their wages, benefit costs and payroll taxes whether or not the Company receives payment from its customer. The Company typically bills a client company for these amounts in advance of or at each payroll date, and reserves the right to terminate its agreement with the client, and thereby the Company's liability for future payrolls to the client's worksite employees, if timely payment is not received. Limited extended payment terms are offered in certain cases subject to local competitive conditions. The rapid turnaround necessary to process and make payroll payments leaves the Company vulnerable to client credit risks, some of which may not be identified prior to the time payroll payments are made. There can be no assurance that the Company will be able to timely terminate any delinquent accounts or that its contractual termination rights will be judicially enforced. In addition, the Company competes in several market segments in which PEOs typically advance wages, benefit costs and payroll taxes to their clients. The Company intends to continue this practice despite the potentially greater credit risk posed by such practices. The Company conducts a limited credit review before accepting new clients. However, the nature of the Company's business and pricing margins is such that a small number of client credit failures could have an adverse effect on its business and financial performance. 31 EMPLOYEE SOLUTIONS, INC. SEPTEMBER 30, 2000 -------------------------------------------------------------------------------- UNCERTAINTY OF EXTENT OF PEO'S LIABILITY; GOVERNMENT REGULATION OF PEOS Employers are regulated by numerous federal and state laws relating to labor, tax and employment matters. Generally, these laws prohibit race, age, sex, disability and religious discrimination, mandate safety regulations in the workplace, set minimum wage rates and regulate employee benefits. Because many of these laws were enacted prior to the development of non-traditional employment relationships, such as PEO services, many of these laws do not specifically address the obligations and responsibilities of non-traditional "co-employers" such as the Company, and there are many legal uncertainties about employee relationships created by PEOs, such as the extent of the PEO's liability for violations of employment and discrimination laws. The Company may be subject to liability for violations of these or other laws even if it does not participate in such violations. As a result, interpretive issues concerning the definition of the term "employer" in various federal laws have arisen pertaining to the employment relationship. Unfavorable resolution of these issues could have a material adverse effect on the Company's results of operations or financial condition. The Company's standard forms of customer service agreement establish the contractual division of responsibilities between the Company and its clients for various personnel management matters, including compliance with and liability under various governmental regulations. However, because the Company acts as a co-employer, and in some instances acts as sole employer (such as in the driver leasing program), the Company may be subject to liability for violations of these or other laws despite these contractual provisions, even if it does not participate in such violations. The circumstances in which the Company acts as sole employer may expose the Company to increased risk of such liabilities for an employee's actions. The Company has been sued in tort actions alleging responsibility for employee actions (which it considers to be incidental to its business). Although it believes it has meritorious defenses, and maintains insurance (and requires its clients to maintain insurance) covering certain of such liabilities, there can be no assurances that the Company will not be found to be liable for damages in any such suit, or that such liability would not have a material adverse effect on the Company. In addition, the Company believes that a portion of its clients are not maintaining the insurance coverage required under their service agreements with the Company. Although the client generally is required to indemnify the Company for any liability attributable to the conduct of the client or employee, the Company may not be able to collect on such a contractual indemnification claim and thus may be responsible for satisfying such liabilities. In addition, employees of the client may be deemed to be agents of the Company, subjecting the Company to liability for the actions of such employees. While many states do not explicitly regulate PEOs, various states have passed laws that have licensing or registration requirements and other states are considering such regulation. Such laws vary from state to state but generally provide for monitoring the fiscal responsibility of PEOs. There can be no assurance that the Company will be able to satisfy licensing requirements or other applicable regulations of any particular state from time to time. ADEQUACY OF LOSS RESERVES The Company obtained fully-insured guaranteed cost workers' compensation coverage effective January 1, 1998, thereby eliminating, with certain exceptions, the Company's risk retention on workers' compensation claims arising after that date. The Company retained risk up to $250,000 per occurrence with respect to a defined portfolio of stand-alone policies, which expired at various dates during 1998. The Company also retained risk up to $50,000 per occurrence for claims under Ohio's monopolistic workers' compensation structure, with an aggregate liability limitation. The Company's reserves for losses and loss adjustment expenses under the Ohio and stand-alone programs referred to in the preceding paragraph are estimates of amounts needed to pay reported and unreported claims and related loss adjustment expenses. Loss reserves are inherently uncertain and are subject to a number of circumstances that are highly variable and difficult to predict. If the Company's reserves prove to be inadequate, the Company will be required to increase reserves or corresponding loss payments with a corresponding reduction, which may be material, to the Company's operating results in the period in which the deficiency is identified. 32 EMPLOYEE SOLUTIONS, INC. SEPTEMBER 30, 2000 -------------------------------------------------------------------------------- ITEM 3. - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company is primarily exposed to market risks from fluctuations in interest rates and the effects of those fluctuations on the market values of its investments and marketable securities that are classified as AVAILABLE-FOR-SALE marketable securities. Cash equivalent short-term investments consist primarily of high quality investment grade instruments, such as certificates of deposit, which are not significantly exposed to interest rate risk, except to the extent that changes in interest rates will ultimately affect the amount of interest income earned on these investments. The available-for-sale marketable securities are subject to interest rate risk because these securities generally include financial instruments, such as certificates of deposit, that have an original maturity of greater than 90 days. Because these instruments are considered highly liquid, they are not significantly exposed to interest rate risk. However, the market values of these securities may be affected by changes in prevailing interest rates. The Company attempts to limit its exposure to interest rate risk primarily through diversification and strict adherence to the Company's investment policy. The Company's investment policy is designed to maximize interest income while preserving its principal investment. 33 EMPLOYEE SOLUTIONS, INC. SEPTEMBER 30, 2000 -------------------------------------------------------------------------------- PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS International Color Services, L.L.C. filed for arbitration in December 1998 alleging breach of contract regarding fee issues under the PEO service agreement between the parties. Plaintiff seeks damages of over $500,000 (recently increased by plaintiff to over $1 million) plus attorneys' fees and costs and unspecified punitive damages. The Court recently granted motions for summary judgment filed by the Company that, among other things, defeated plaintiff's punitive damage claims. The Company is contesting the claim vigorously. The matter has been set for trial in January 2001. The State of Ohio has issued an assessment of $5.2 million (plus interest and penalty) relating to sales taxes potentially applicable to certain types of PEO services provided by the Company. Contingent upon completion of a financial restructuring of the Company (including, in particular, the Notes), the Company has entered into a settlement agreement with the State of Ohio whereby it has agreed to pay an aggregate of $2.85 million in January 2001 in resolution of applicable sales tax liabilities. From time to time, the Company is named as a defendant in lawsuits in the ordinary course of business. See Part I, Item 2 - "Management's Discussion and Analysis - Outlook: Issues and Risks - Uncertainty of Extent of PEO's Liability; Government Regulation of PEOs; Credit Risks." ITEM 3. DEFAULTS UPON SENIOR SECURITIES The Company is engaged in negotiations with respect to its $85 million 10% Senior Notes due 2004 (the Notes). See "OUTLOOK: ISSUES AND RISKS- SUBSTANTIAL LEVERAGE; NEGOTIATIONS WITH HOLDERS OF INDEBTEDNESS; POTENTIAL SUBSTANTIAL DILUTION OF COMMON STOCKHOLDERS," which is incorporated by this reference into this Part II, Item 3. In connection with the negotiations, the Company's Board of Directors elected to withhold the $4.25 million semi-annual interest payments due on each of April 15 and October 15, 2000. Under the terms of the Indenture pursuant to which the Notes were issued, such withholding of interest constitutes an Event of Default (as defined in the Indenture). The Company received a written agreement from the holders of the Notes under which the holders agreed to forbear from exercising their rights and remedies through the first to occur of August 30, 2000 or the occurrence of a new default. The waiver has expired, though the holders of the Notes have not sought to exercise their rights and remedies during the pendency of the negotiations between the Company and the holders of the Notes. The Company has classified the debt obligation as a current liability. The Company was not in compliance with one or more of the covenants set forth in a loan and security agreement (the "Loan Agreement") with Foothill Capital Corporation and Ableco Finance LLC (the "Lenders") commencing as of March 31, 2000. The Company recently received a waiver of such noncompliance in exchange for its agreement to provide additional cash collateral, pay an increased interest rate and certain additional fees, and materially reduce the outstanding principal balance. There can be no assurance that the Company will be able to obtain additional waivers in the event of future defaults, if any. The Company is actively seeking a replacement financing source. See "OUTLOOK: ISSUES AND RISKS -- FUTURE CAPITAL AND LIQUIDITY NEEDS; UNCERTAINTY OF ADDITIONAL FINANCING; NONCOMPLIANCE WITH LOAN AGREEMENT." 34 EMPLOYEE SOLUTIONS, INC. SEPTEMBER 30, 2000 -------------------------------------------------------------------------------- ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) EXHIBITS Exhibit Number Description ------- ----------- 27 Financial Data Schedule (b) REPORTS ON FORM 8-K. None. 35 EMPLOYEE SOLUTIONS, INC. SEPTEMBER 30, 2000 -------------------------------------------------------------------------------- SIGNATURES Pursuant to the requirements 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. EMPLOYEE SOLUTIONS, INC. Date: November 14, 2000 /s/ Quentin P. Smith, Jr. ----------------- ---------------------------------------- Quentin P. Smith, Jr. Chief Executive Officer /s/ John V. Prince ---------------------------------------- John V. Prince Chief Financial Officer

EMPLOYEE SOLUTIONS INC 10-Q