In April 2005, the Company raised net proceeds of $29.7 million through a private placement of $31.5 million of 5-1/2% convertible senior subordinated notes (“Notes”) due April 1, 2010. The Notes require semi-annual payments of interest in cash at a rate of 5-1/2%; convert, at the option of the holder, into the Company’s common stock at an initial conversion price of $14.76 per share subject to adjustment; convert, at the Company’s option, into common stock if the Company’s common stock reaches a price of $22.14 per share; will be provisionally redeemable at the Company’s option for a redemption price of 100% of the principal amount of the Notes to be redeemed, plus accrued and unpaid interest, plus an interest make-whole payment, under certain circumstances, including among others, that the closing price of the Company’s common stock has exceeded $22.14 per share, subject to adjustment, for at least 20 trading days within a period of 30 consecutive trading days; and constitute senior subordinated obligations of the Company. The Company, at its own option, may redeem the Notes for face value plus accrued interest and an interest make-whole payment. If a change in control occurs on or prior to the stated maturity of the Notes, the holders of the Notes may require the Company to repurchase the Notes and pay a make-whole premium to the holders of the Notes. If the holders request such a repurchase, the Company or the successor entity, may choose to pay in cash, common stock or a combination of cash and common stock. This feature constitutes a put-option derivative liability.
The Company initially valued the derivative liability associated with the Notes at $1.8 million. This amount was accounted for as a reduction in the initial carrying value of the Notes and an increase to current liabilities. This discount to the Notes is being amortized over five years using the effective interest method. Interest expense for the three and six months ended June 30, 2005 reflects non-cash amortization charges of $0.1 million related to this discount. For the three and six months ended June 30, 2005, valuation adjustments expense of $0.2 million represented the increase in the fair value of the derivative liability.
The Company incurred financing expenses associated with the Notes of $1.8 million. This amount was accounted for as an increase to non-current other assets. The financing expenses are being amortized over five years using the straight-line method. Interest expense for the three and six months ended June 30, 2005 reflects non-cash amortization charges of $0.1 million related to these expenses.
Interest expense on the Notes for the three and six months ended June 30, 2005 was $0.6 million. The Company estimates the fair market value of the Notes to be $35.6 million at June 30, 2005.
The Note and related derivatives have been valued using the Monte Carlo fair value methodology. The Company completed the valuation of the Note and the change in control put option. The Monte Carlo methodology allows flexibility in incorporating various assumptions such as probabilities of a change in control. The valuations are based on the information available as of the various valuation dates.
The inputs for valuation analysis included the market value of the Company’s common stock, the estimated volatility of the Company’s common stock, the Company’s market capitalization, the conversion rate of the Notes, the risk free interest rate as well as the credit spread, which represents the Company’s risk premium over the risk free interest rate. The key inputs for the valuation analysis were as follows:
Pursuant to the Notes, the Company has agreed to register the shares issuable upon conversion of the Notes for resale under the Securities Act of 1933, as amended (“Securities Act”). The Company has agreed to file with the SEC a registration statement (“Registration Statement”) with respect to these shares no later than thirty days following (“Filing Date”) the first date it becomes current in its reporting requirements under the Securities and Exchange Act of 1934 and to use its best efforts to cause the Registration Statement to become effective on or before the date that is the earlier of (1) in the event of no review by the SEC no later than 90 days after the Filing Date, (2) in the event of a review by the SEC, no later than 120 days after the Filing Date (the earlier of (1) and (2), “Required Effective Date”).
The Company will be liable for liquidated damages under the following circumstances (“Defaults”):
In the event of a Default, the Company shall pay as liquidated damages, for each 30-day period of a Default, an amount in cash equal to 1% of the principal amount of the Notes until the applicable failure has been cured. The liquidated damages payable under the Stock Purchase Agreement will apply on a pro rata basis for any portion of a 30-day period of a Default.
7. Employee Stock Purchase Plan
The Company’s 2001 Purchase Plan (“ESPP”) is implemented by a series of 24-month offering periods (each an “Offering Period” and collectively “Offering Periods”). Offering Periods were suspended effective July 1, 2004 as a result of the Company’s delisting in August 2004. In March 2005, the Board of Directors approved the extension of the Offering Period ending in March 2005 which resulted in a modification of the terms of the underlying options. As of June 30, 2005, the Offering Period ending in June 2005 was also extended. During the three and six months ended June 30, 2005, the Company recorded $0.1 million and $2.2 million, respectively, in non-cash research and development compensation expense for these modifications. During the three and six months ended June 30, 2005, the Company recorded zero and $0.7 million, respectively, in non-cash general and administrative compensation expense for these modifications.
8. Warrants
On May 23, 2001, VaxGen sold 20,000 shares of Series A Preferred Stock and issued common stock purchase warrants (“Series A Warrants”). VaxGen did not file its Quarterly Report on Form 10-Q for the quarter ended March 31, 2004 by the extended filing deadline of May 17, 2004. As a result, its registration statement on Form S-3 covering the resale of the common stock issuable upon exercise of the Series A Warrants was suspended. On September 21, 2004, VaxGen exchanged the Series A Warrants pursuant to section 3(a)(9) of the Securities Act of 1933, as amended, for warrants to purchase a total of 1,146,388 shares of common stock, exercisable until September 21, 2005, at an exercise price of $0.01 per share (“$0.01 Warrants”). In connection with the exchange, the agreements governing the Series A Warrants were terminated. In 2004, $0.01 Warrants for 716,494 shares were exercised. In January 2005, 429,640 shares of unregistered common stock were issued as a result of the exercise of the remaining $0.01 Warrants.
On April 13, 2004, Celltrion granted warrants to all of its existing stockholders to acquire 4.0 million shares of its convertible preferred stock. The exercise price was 5,000 Korean Won ($4.38 equivalent) per preferred share. The exercise period was April 13, 2004 to December 31, 2004. On December 30, 2004, Celltrion’s Board of Directors agreed to extend the warrants expiration date from December 31, 2004 to March 31, 2005 (“Extended Tranche”). In March 2005, Celltrion issued 1,949,700 shares of preferred stock under the Extended Tranche at a price of 5,000 Korean Won ($4.99 equivalent) per share, resulting in net proceeds of 9,698 million Korean Won ($9.5 million equivalent).
In March 2005, Celltrion also converted all 12,515,000 preferred shares (including the 1,949,700 shares) into common stock upon approval at their stockholders’ meeting. In May 2005, Celltrion issued 2,872,840 shares of common stock to existing stockholders in a proportionate stock dividend.
9. Related Party Transactions
In December 2002, Celltrion engaged Daewoo Engineering and Construction Co., Ltd. (“Daewoo”) to manage the construction of the Incheon manufacturing facility and administration buildings. In January 2003, Daewoo purchased 260,000 shares of Celltrion’s preferred stock at a price of 22,348 Korean Won per share (equivalent to $18.78 per share). At the time of this purchase, Nexol’s and Celltrion’s Chief Executive Officer, who are the same person, entered into a purchase agreement with Daewoo. Per the terms of this purchase agreement, upon the completion of the construction of Celltrion’s facility, Daewoo would sell these shares to Nexol at the original purchase price. Celltrion’s Chief Executive Officer guaranteed this agreement. Celltrion had outstanding construction accruals due to Daewoo of $13.0 million and $12.4 million as of June 30, 2005 and December 31, 2004, respectively. Celltrion paid Daewoo $1.8 million and $4.3 million during the three months ended June 30, 2005 and 2004, respectively, and $10.9 million and $13.6 million during the six months ended June 30, 2005 and 2004, respectively, related to the construction of the Incheon facilities.
10. Commitments and Contingencies
In December 2002, Celltrion entered into an engineering, procurement and construction agreement (“Construction Agreement”) with Daewoo pursuant to which Daewoo agreed to engineer and construct Celltrion’s Incheon facility. The cost under the Construction Agreement is estimated to be 47,400 million Korean Won plus 25.7 million Swiss francs, which in the aggregate was the equivalent of $56.8 million in December 2002, subject to certain exceptions for change orders and changed circumstances such as force majeure and changes in law. Celltrion may terminate the Construction Agreement and pay only for services rendered. Amounts due under the Construction Agreement are paid by Celltrion based on monthly invoicing and achievement of specified milestone events.
On April 14, 2005, VaxGen entered into an amended lease agreement to secure space to support the production of its recombinant anthrax vaccine candidate as well as its other programs. This space, which totals 105,000 square feet, is used for manufacturing, quality assurance, quality control, research and development and other functions. The amended lease replaces VaxGen’s previous sublease for 49,919 square feet and previous lease of 19,933 square feet. It also provides an additional 35,000 square feet of new space. This lease terminates in December 2016; however, VaxGen has options to renew the lease
15
for two additional five-year periods. In connection with the amended lease agreement, an amended letter of credit in the amount of $2.4 million was issued to the lessors. The letter of credit is collateralized by a certificate of deposit held by the bank that issued the letter of credit. The certificate of deposit is included in restricted cash in the consolidated balance sheet as of December 31, 2005. In addition, the amended lease agreement provides for up to $2.2 million in reimbursements for the costs of certain tenant improvements. VaxGen billed for and received the full $2.2 million in reimbursements.
Per the terms of the amended lease agreement, VaxGen’s future minimum annual payments as of June 30, 2005 under operating lease obligations are as follows:
| | | | |
Year ending December 31: | | | | |
| | | | |
2005 remainder | | $ | 1,746 | |
2006 | | | 3,934 | |
2007 | | | 3,272 | |
2008 | | | 2,838 | |
2009 | | | 3,414 | |
2010 and beyond | | | 28,056 | |
| |
|
| |
Total | | $ | 43,260 | |
| |
|
| |
In June 2005, Celltrion entered into several agreements to manufacture biologic products being developed by Bristol-Myers Squibb Company (“BMS”). Technology transfer activities began immediately upon the execution of the BMS agreements. Production of product, which will be manufactured according to U.S. cGMP standards, is expected to utilize 60,000 liters of Celltrion’s planned 180,000 liters of bioreactor capacity and began in 2006. VaxGen and Celltrion entered into a Technical Support and Services Sub-Agreement (“Sub-Agreement”) effective in June 2005. The Sub-Agreement provides for VaxGen to assist Celltrion with services required under the BMS agreement. Under the Sub-Agreement, VaxGen will be paid for out-of-pocket expenses and services rendered.
Substantially all of the Company’s revenue is derived from government contracts and grants. Future sales to U.S. government agencies will depend, in part, on the Company’s ability to meet U.S. government agency contract requirements. U.S. government contracts typically contain unfavorable termination provisions and are subject to audit and modification by the government at its sole discretion. The U.S. government may terminate any of its contracts with the Company either for its convenience or if the Company defaults by failing to perform in accordance with the contract schedule and terms. If the U.S. government terminates any of its contracts, the Company may be liable to the U.S. government for damages or to sub-contractors, service providers or vendors for goods and services that may no longer be reimbursable by the U.S. government. See Subsequent Events in Note 13.
11. Legal Proceedings
On March 17, 2003, a civil complaint for violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 was filed in the United States District Court for the Northern District of California, entitled Janice Whitkens v. VaxGen, Inc., et al., Civil Action No. C03-1129 JSW. Named, as defendants are VaxGen, Inc., Chief Executive Officer Lance K. Gordon and former President Donald P. Francis. The plaintiff seeks to represent a class of persons who purchased the Company’s securities between August 6, 2002 and February 26, 2003, and alleges that the defendants misled investors about the progress of certain clinical trials and the Company’s future manufacturing and marketing plans. Following the filing of the Whitkens complaint, several additional class action complaints were filed in the same court, each making identical or similar allegations against the same defendants. In May 2005, the United States District Court for the Northern District of California dismissed with prejudice this class action lawsuit.
On or about March 21, 2003, two separate but virtually identical shareholder derivative actions were filed in California Superior Court for San Mateo County entitled Rhodes v. Allen, et al. civil action No. CIV 430087, and MacDonald v. Allen, et al., civil action No. CIV 430088. A consolidated complaint was filed in June 2003. Named as defendants in the action are VaxGen directors Lance K. Gordon, Randall L-W. Caudill, and William D. Young, and former VaxGen directors Donald P. Francis, Phillip W. Berman, David W. Beier, and Stephen C. Francis (“Company Directors”). Also named as defendants are Paul Allen and Vulcan Ventures, Inc. (“Vulcan Defendants”). The allegations of the consolidated complaint (“Derivative Lawsuit”) are similar to those contained in the class action, although unlike the class action, in the Derivative Lawsuit the plaintiff purports to seek recovery on behalf of VaxGen, rather than from VaxGen. Plaintiffs allege as well that the Vulcan Defendants sold shares of the Company’s stock while in possession of material non-public information about the Company. Plaintiffs, purportedly suing on behalf of VaxGen, assert claims against all defendants for breach of fiduciary duty, mismanagement, waste and unjust enrichment and against the Vulcan Defendants for breach of fiduciary duty and insider trading. As of June 30, 2005, the Company has provided $0.5 million for the settlement of these derivative actions. See Subsequent Events in Note 13.
16
The Company is subject to a wide variety of laws and regulations relating to land use and development and to environmental compliance and permitting obligations, including those related to the use, storage, discharge, emission and disposal of hazardous materials. Certain claims, suits and complaints in the ordinary course of business are pending or may arise. While there can be no assurance as to the ultimate outcome of any litigation involving the Company, the Company does not believe any pending legal proceeding will result in a judgment or settlement that would have a material adverse effect on the Company’s consolidated financial position, results of operations or cash flows.
12. Segment Information
The Company’s segment information has been prepared in accordance with FAS No. 131,Disclosures about Segments of an Enterprise and Related Information. Upon consolidation, all intercompany accounts and transactions are eliminated. Prior to January 1, 2004, the Company operated in one business segment. As a result of the consolidation of Celltrion, effective January 1, 2004, the Company operates in two business segments. VaxGen operates in one business segment, the development of vaccines that immunize against infectious disease, and Celltrion operates in another, mammalian cell culture biomanufacturing. Each segment has discrete financial information and its own management structure.
Substantially all of VaxGen’s revenue is derived from federal government contracts and grants, primarily from the U.S. Department of Health and Human Services, the National Institutes of Health and related entities. From its inception through June 30, 2005, Celltrion had not been operational or earned any revenues. All of VaxGen’s operating assets are located in the United States of America. Celltrion’s operating assets are located in the Republic of Korea.
Information regarding the segments is stated below (in thousands):
| | | | | | | | | | | | | |
| | Three Months Ended
June 30, | | Six Months Ended
June 30, | |
| |
| |
| |
Revenues | | 2005 | | 2004 | | 2005 | | 2004 | |
| |
| |
| |
| |
| |
VaxGen | | $ | 10,069 | | $ | 11,241 | | $ | 17,754 | | $ | 15,321 | |
Celltrion | | | — | | | — | | | — | | | — | |
Eliminations | | | (88 | ) | | (132 | ) | | (127 | ) | | (267 | ) |
| |
|
| |
|
| |
|
| |
|
| |
Total | | $ | 9,981 | | $ | 11,109 | | $ | 17,627 | | $ | 15,054 | |
| |
|
| |
|
| |
|
| |
|
| |
| | | | | | | | | | | | | |
| | Three Months Ended
June 30, | | Six Months Ended
June 30, | |
| |
| |
| |
Depreciation and Amortization | | 2005 | | 2004 | | 2005 | | 2004 | |
| |
| |
| |
| |
| |
VaxGen | | $ | 982 | | $ | 442 | | $ | 1,862 | | $ | 746 | |
Celltrion | | | 887 | | | 445 | | | 1,538 | | | 882 | |
Eliminations | | | (465 | ) | | (407 | ) | | (931 | ) | | (810 | ) |
| |
|
| |
|
| |
|
| |
|
| |
Total | | $ | 1,404 | | $ | 480 | | $ | 2,469 | | $ | 818 | |
| |
|
| |
|
| |
|
| |
|
| |
| | | | | | | | | | | | | |
| | Three Months Ended
June 30, | | Six Months Ended
June 30, | |
| |
| |
| |
Interest Expense | | 2005 | | 2004 | | 2005 | | 2004 | |
| |
| |
| |
| |
| |
VaxGen | | $ | 590 | | $ | — | | $ | 590 | | $ | — | |
Celltrion | | | 399 | | | — | | | 524 | | | — | |
| |
|
| |
|
| |
|
| |
|
| |
Total | | $ | 989 | | $ | — | | $ | 1,114 | | $ | — | |
| |
|
| |
|
| |
|
| |
|
| |
| | | | | | | | | | | | | |
| | Three Months Ended
June 30, | | Six Months Ended
June 30, | |
| |
| |
| |
Equity in Loss of Affiliate | | 2005 | | 2004 | | 2005 | | 2004 | |
| |
| |
| |
| |
| |
VaxGen (in Celltrion) | | $ | (1,141 | ) | $ | (780 | ) | $ | (2,026 | ) | $ | (1,432 | ) |
Celltrion (in VCI) | | | — | | | (144 | ) | | — | | | (527 | ) |
Eliminations | | | 1,141 | | | 924 | | | 2,026 | | | 1,959 | |
| |
|
| |
|
| |
|
| |
|
| |
Total | | $ | — | | $ | — | | $ | — | | $ | — | |
| |
|
| |
|
| |
|
| |
|
| |
| | | | | | | | | | | | | |
| | Three Months Ended
June 30, | | Six Months Ended
June 30, | |
| |
| |
| |
Net Loss | | 2005 | | 2004 | | 2005 | | 2004 | |
| |
| |
| |
| |
| |
VaxGen | | $ | (15,280 | ) | $ | (17,551 | ) | $ | (28,615 | ) | $ | (25,977 | ) |
Celltrion | | | 28,568 | | | (1,643 | ) | | 25,617 | | | (3,051 | ) |
Eliminations | | | (28,619 | ) | | 1,596 | | | (25,707 | ) | | 2,937 | |
| |
|
| |
|
| |
|
| |
|
| |
Total | | $ | (15,331 | ) | $ | (17,598 | ) | $ | (28,705 | ) | $ | (26,091 | ) |
| |
|
| |
|
| |
|
| |
|
| |
17
| | | | | | | |
Property and Equipment, net | | June 30,
2005 | | December 31,
2004 | |
| |
| |
| |
VaxGen | | $ | 26,309 | | $ | 22,017 | |
Celltrion | | | 139,034 | | | 116,359 | |
Eliminations | | | (4 | ) | | (130 | ) |
| |
|
| |
|
| |
Total | | $ | 165,339 | | $ | 138,246 | |
| |
|
| |
|
| |
| | | | | | | |
Investment in Affiliate | | June 30,
2005 | | December 31,
2004 | |
| |
| |
| |
VaxGen (in Celltrion) | | $ | 20,212 | | $ | 25,450 | |
Eliminations | | | (20,212 | ) | | (25,450 | ) |
| |
|
| |
|
| |
Total | | $ | — | | $ | — | |
| |
|
| |
|
| |
| | | | | | | |
Total Assets | | June 30,
2005 | | December 31,
2004 | |
| |
| |
| |
VaxGen | | $ | 103,126 | | $ | 92,056 | |
Celltrion | | | 178,744 | | | 165,641 | |
Eliminations | | | (52,357 | ) | | (59,230 | ) |
| |
|
| |
|
| |
Total | | $ | 229,513 | | $ | 198,467 | |
| |
|
| |
|
| |
| | | | | | | | | | | | | |
| | Three Months Ended
June 30, | | Six Months Ended
June 30, | |
| |
| |
| |
Purchases of Property and Equipment | | 2005 | | 2004 | | 2005 | | 2004 | |
| |
| |
| |
| |
| |
VaxGen | | $ | (4,094 | ) | $ | (1,169 | ) | $ | (6,294 | ) | $ | (2,300 | ) |
Celltrion | | | (8,010 | ) | | (6,877 | ) | | (22,466 | ) | | (18,459 | ) |
Eliminations | | | — | | | — | | | — | | | — | |
| |
|
| |
|
| |
|
| |
|
| |
Total | | $ | (12,104 | ) | $ | (8,046 | ) | $ | (28,760 | ) | $ | (20,759 | ) |
| |
|
| |
|
| |
|
| |
|
| |
13. Subsequent Events
SNS Contract
In November 2006, VaxGen received a clinical hold notification from the Food and Drug Administration that postponed the initiation of the second Phase 2 trial for its investigational anthrax vaccine, rPA102. In December 2006, the department of Health and Human Services (“HHS”) terminated for default VaxGen’s contract with the U.S. government Strategic National Stockpile (“SNS”) (“SNS Contract”). HHS based the decision on its determination that VaxGen “failed to successfully cure the condition endangering performance and failed to” meet a milestone imposed by HHS that required VaxGen to initiate a clinical trial of the vaccine candidate by December 18, 2006.
In April 2007, the Company entered into a settlement agreement with HHS. In accordance with the agreement, the parties terminated the remaining contract related to the development and delivery of a next-generation anthrax vaccine through a separate contract modification. As part of the settlement agreement, NIAID agreed to pay the Company $11.0 million. The settlement agreement also released both parties of all liabilities associated with the Company’s three anthrax government contracts: the 2002 Anthrax Contract, the 2003 Anthrax Contract and the SNS Contract. As part of the settlement agreement, the parties converted the termination of the SNS Contract, which HHS terminated for default on December 19, 2006, to a termination for convenience and also, terminated the 2003 Anthrax Contract under a bilateral contract modification for the convenience of the government on a no-cost basis, effective April 3, 2007.
Restructurings
In January 2007, the Company restructured operations to significantly reduce operating costs and announced it was actively pursuing avenues to enhance stockholder value through a strategic transaction. Restructuring costs included employee termination benefits and costs associated with the consolidation of the California facilities. Estimated costs of the related termination benefits are $3.2 million; estimated facilities-related and other costs are $0.8 million. These costs were recovered from the U.S. government as part of the 2007 settlement agreement.
In May 2007, the Company reduced its workforce to further reduce operating costs. Restructuring costs included employee termination and benefit costs. Estimated costs of the restructuring are $0.6 million.
2003 Anthrax Contract
In December 2004, NIAID notified the Company of its intent to terminate, for its convenience, a portion of the 2003 Anthrax Contract and redirect the funds earmarked for the terminated portion into other contract milestones, leaving the total contract value unchanged. The portion of the contract which was terminated included activities the Company had subcontracted to a fill/finish service provider. In March 2006, the Company agreed to pay this service provider $1.5 million for costs relating to the termination of the subcontract, which are not reimbursable under the terms of the Company’s contract with NIAID.
18
Equity Financings
In February 2006, VaxGen raised net proceeds of $25.3 million through a private placement of 3.5 million shares of common stock at $7.70 per share to a group of accredited institutional investors. In connection with the February 2006 financing, VaxGen also issued to the investors five-year warrants initially exercisable to purchase 700,000 shares of common stock at an exercise price of $9.24 per share. Because VaxGen did not file all of its delinquent periodic reports with the SEC by January 31, 2007, the warrants became exercisable for an additional 700,000 shares of common stock, at a price of $9.24 per share.
As part of the February 2006 private placement, the Company agreed to file a registration statement on Form S-1 no later than 30 days after the first day that the Company becomes current with its reporting requirements under the Exchange Act of 1934. The registration for resale applies to the common stock issued in both transactions as well as the stock issuable upon exercise of the warrants from the February 2006 transaction. The Company may be liable for liquidated damages of 1% of the purchase price per month to holders of the shares and shares issuable upon exercise of the warrants (a) if the registration statement is not filed on or prior to 30 days of the Company becoming current in its reporting requirements; (b) if the registration statement is not declared effective by the SEC on or prior to 120 days from filing; or (c) if the registration statement (after being declared effective) ceases to be effective in a manner that violates such obligations.
$16.00 Warrants
On September 21, 2004, the Company completed transactions in which the warrants issued in 2001 in association with Series A Preferred Stock were surrendered in exchange for two new series of warrants (“Exchange Warrants”). The Company issued to the holders of the Series A Warrants, Exchange Warrants to purchase a total of 1,146,388 shares of common stock, exercisable until September 21, 2005, at an exercise price of $0.01 per share, and Exchange Warrants to purchase a total of 655,078 shares of common stock, exercisable until September 21, 2007, at an exercise price of $16.00 per share (“$16.00 Warrants”).
In December 2006, the Company entered into an addendum (“Addendum”) with the holders of the $16.00 Warrants under which the term of these warrants was extended by three additional years. The $16.00 Warrants, as amended, will expire September 21, 2010 instead of September 21, 2007. No other terms of the $16.00 Warrants were amended. In connection with entering into the Addendum, the Company received releases from the holders of the $16.00 Warrants regarding potential claims related to these warrants.
Resolution of Class Action Suit and Derivative Suit
The Company settled the shareholder’s derivative lawsuit that had been filed following the February 2003 announcement by the Company of clinical trial results relating to its AIDSVAX product. Under the terms of the settlement, the Company paid $0.5 million to the derivative plaintiffs to cover attorney’s fees and agreed to make certain changes in its disclosure practices and procedures. The court approved the settlement in September 2005.
Other
On August 8, 2005, at a special meeting of stockholders, the stockholders of the Company approved an amendment to the Company’s Amended and Restated Certificate of Incorporation to increase the authorized number of shares of common stock from 40 million shares to 65 million shares.
In September 2005, the Compensation Committee of the Company’s Board of Directors approved a contingent bonus program for employees participating in the ESPP. Under this program, a bonus would be payable to ESPP participants in the event the ESPP was terminated by the Company. In November 2005, the Company terminated the ESPP and the bonus therefore became payable. Payment of this bonus was contingent upon the successful completion of a financing subsequent to the termination of the ESPP and was available only to individuals who were employees of the Company at the time of the bonus payment. Accordingly, in September 2005, the Company recorded an expense of $3.2 million for the estimated cost of this bonus program. In the first quarter of 2006, the Company paid employees in satisfaction of this bonus program.
Agreements between VaxGen and Celltrion
In July 2005, VaxGen participated in a round of fund-raising with the Korean Investors and purchased from Celltrion 239,068 shares of common stock for $1.2 million.
In September 2005, VaxGen entered into an agreement to raise $15.1 million in gross proceeds through the sale of 1.2 million of its shares in Celltrion to a group of Korean investors. In 2005, VaxGen received $12.4 million of the gross proceeds from the transaction. VaxGen received the remaining proceeds in the first quarter of 2006. Nexol Co purchased 250,000 of these shares. Subsequent to this transaction, Nexol and its related parties became the largest stockholder of Celltrion. As a result, VaxGen was no longer the primary beneficiary of Celltrion and, in accordance with FIN 46R, Celltrion will be deconsolidated from VaxGen; and, thereafter, VaxGen’s investment in Celltrion will be accounted for under the equity method.
19
In February 2006, VaxGen and Celltrion entered into an agreement whereby Celltrion agreed to use its best efforts to timely prepare annual and quarterly financial statements in accordance with U.S. GAAP (“Agreement to Provide U.S. GAAP Financial Information”). Under the agreement, VaxGen agreed to reimburse Celltrion for all invoiced costs of the independent accountants relating to the preparation of U.S. GAAP financial statements as well as all invoiced costs of audits and reviews performed by the independent auditors. In addition, VaxGen will compensate Celltrion for the cost of internal resources utilized in support of these activities at a rate of 190% of the employee’s hourly wage; such costs shall not exceed 300 million Korean Won ($0.3 million equivalent) per year and shall be subject to approval in advance by VaxGen. In March 2007, Celltrion and VaxGen amended the Technical Support and Services Sub-Agreement as well as the Agreement to Provide U.S. GAAP Financial Information to reflect a reduction in overhead rate on services performed from 90% to 40%.
During 2006, VaxGen received gross proceeds of $130 million from the sale of most of its Celltrion common stock to Nexol and affiliates of Nexol. As a result, as of June 30, 2006, VaxGen was no longer entitled to hold two seats on Celltrion’s Board of Directors or appoint a Representative Director. Accordingly, VaxGen no longer had the ability to exercise significant influence over operating and financial policies of Celltrion, and as of July 1, 2006, VaxGen’s investment in Celltrion will be accounted for under the cost method in accordance with APB 29. In September 2006, the joint venture agreement between VaxGen and the Korean Investors was terminated and the Korean Investors entered into a Celltrion shareholders’ agreement. In November 2006, Celltrion’s stockholders approved the appointment of their non-VaxGen Co-CEO as the sole CEO of Celltrion.
Celltrion Agreements
In July 2005, Celltrion and Aphton Corporation’s wholly-owned subsidiary (“Igeneon”) signed a licensing and commercialization agreement and a product development and manufacturing agreement related to the manufacturing, marketing and distribution of Igeneon’s clinical product candidate IGN311. Under the agreements, Igeneon granted Celltrion a license to commercialize IGN311 in certain Asian countries, including Japan. In return, Igeneon will receive from Celltrion milestone payments totaling $6.0 million. In addition, Celltrion will provide development and manufacturing services related to the optimization and upscaling of IGN311 and will produce material for further clinical development.
In April 2006, Celltrion entered into several agreements with A&G Pharmaceutical, Inc. (“A&G”) to manufacture and supply clinical and commercial material of GP88Ab as well as to develop and commercialize a partner for GP88Ab. Under the agreements, A&G granted or will grant to Celltrion a first right of negotiation to manufacture and supply the clinical materials for Phase 3 clinical trials as well as the commercial materials. Also, A&G granted Celltrion an exclusive license and sublicense to develop and have developed, make, use, offer for sale, sell and have sold products in the certain territory and additionally the right to give a sublicense to third parties with the approval of A&G. In return, A&G will receive from Celltrion milestone payments totaling $2 million upon completion of various phases to reach the Phase 2 clinical trials. In consideration for the commercialization license, Celltrion shall pay to A&G a royalty equal to a certain percentage of the net sales of Celltrion. Separately, in July 2006, Celltrion purchased 769,230 shares of A&G common stock for $2.0 million and 145,773 shares of preferred stock for $0.5 million in December 2006.
In July 2006, Celltrion entered into a new Supply Agreement with BMS and commenced construction of a new facility, which is adjacent to the current facility.
Financing for Facility Construction and Expansion
In October 2005, Celltrion issued a one-year bond for 20,000 million Korean Won ($19.2 million equivalent) to Shinhan Bank at a variable interest rate, equal to the 91-day CD rate plus 2.05%. Subsequent to the issuance of the bond, Celltrion entered into an interest rate swap agreement with the bank at a fixed interest rate of 6.63%.
During 2005 and 2006, Celltrion modified the construction design and work scope for the production of generic and specific products in its construction agreement with Daewoo. As a result of this modification, the total construction cost increased to 67,551 million Korean Won plus 26.9 million Swiss francs (equivalent to $93.1 million) from the original construction agreement in January 2003 which was for 47,400 million Korean Won plus 25.7 million Swiss francs.
In February 2006, Celltrion entered into a Land Purchase Agreement with Incheon Metropolitan City at a stated price of 24,700 million Korean Won ($25.5 million equivalent) and made an advance principal payment of 2,470 million Korean Won ($2.5 million equivalent). In March 2006, Celltrion and Incheon Metropolitan City entered into an amended agreement, which reduced the original discount received and increased the stated price of the land to 32,931 million Korean Won ($33.9 million equivalent). As a result, Celltrion made an additional advance payment of 823 million Korean Won ($0.8 million equivalent). Celltrion is obligated to pay for the land in five annual installments of 5,928 million Korean Won ($6.1 million equivalent), plus interest at 4.0%, beginning in March 2007.
20
In June 2006, Celltrion obtained collateralized long-term financing of 20,000 million Korean Won (equivalent to $21.1 million at the exchange rate on June 30, 2006) and $20.8 million from Woori Bank (“Woori”) and Shinhan Bank (“Shinhan”), respectively, to be used for construction of a second manufacturing facility adjacent to the current facility. In addition, Celltrion entered into an interest rate swap agreement with Shinhan in order to hedge the variable interest rate. Celltrion also entered into a currency swap agreement with Shinhan to convert the U.S. dollar-denominated borrowing into Korean Won-denominated borrowing.
In September 2006, Celltrion obtained additional U.S. dollar-denominated collateralized long-term financing of $3.8 million from Shinhan to be used for construction of a second manufacturing facility adjacent to the current facility. In addition, Celltrion entered into an interest rate swap agreement with Shinhan in order to hedge the variable interest rate. Celltrion also entered into a currency swap agreement with Shinhan to convert the U.S. dollar-denominated borrowing into Korean Won-denominated borrowing.
During the three months ended December 31, 2006, Celltrion:
| |
• | extended the maturity of a 20,000 million Korean Won ($21.0 million equivalent) bond issued from Shinhan with a variable interest rate and a maturity of two years; |
| |
• | entered into an interest rate swap agreement with Shinhan in order to hedge the variable interest rate; |
| |
• | issued a collateralized three-year bond for 20,000 million Korean Won ($21.4 million equivalent) to Woori at a variable interest rate, equal to the bank’s 91-day CD rate plus 1.4% (aggregate rate of 6.1% in November 2006); |
| |
• | entered into a land purchase agreement for 783 million Korean Won ($0.8 million equivalent) which is required to be paid within 6 months; |
| |
• | obtained short-term borrowings of 10,000 million Korean Won ($10.8 million equivalent) from Woori; |
| |
• | obtained a commitment for a letter of credit of $10.0 million from Shinhan and $20.0 million from Woori; |
| |
• | obtained additional collateralized long-term financing of $2.0 million from Shinhan; and |
| |
• | entered into a currency swap agreement with Shinhan in order to hedge the exposure to foreign currency. |
Celltrion Stock, Options and Warrants
In July 2005, Celltrion sold 3 million shares of its common stock to the existing stockholders and others at a price of 5,000 Korean Won ($4.80 equivalent) per share, resulting in proceeds of 15,000 million Korean Won ($14.4 million equivalent). Celltrion’s non-VaxGen Co-CEO and his affiliates purchased an aggregate of 711,837 of these shares, two members of Celltrion’s Board of Directors purchased an aggregate of 756,321 of these shares, VaxGen purchased 239,068 shares, employees purchased an aggregate of 20,230 shares and two vendors purchased an aggregate of 24,554 shares.
In August 2005, Celltrion issued 1,986,301 shares of its common stock under the Second Tranche at a price of 5,000 Korean Won ($4.92 equivalent) per share, resulting in proceeds of 9,932 million Korean Won ($9.8 million equivalent). Also in August 2005, Celltrion issued 33,924 shares of its common stock to JS at a price of 22,500 Korean Won ($22.16 equivalent) per share, resulting in proceeds of 763 million Korean Won ($0.8 million equivalent). Celltrion’s stockholder holding the reallocation Warrants allowed the following parties to purchase a portion of its reallocation shares, consistent with the terms of the reallocation Warrants: a member of Celltrion’s Board of Directors purchased 79,149 of these shares, an employee purchased 924 shares and a vendor purchased 8,041 shares. Prior to becoming a member of Celltrion’s Board of Directors, this individual purchased 158,298 shares of Celltrion’s preferred stock in 2004 under the First Tranche at a price of 5,000 Korean Won ($4.92 equivalent) per share.
In August 2005, Nexol purchased 260,000 shares of Celltrion’s common stock from Daewoo.
In September 2005, Nexol Co purchased all of the outstanding common shares of JS. In October 2005, JS became an affiliate of Nexol. In connection with its acquisition by Nexol, its name was changed to Nexol Venture Capital Co., Ltd.
In January 2006, Celltrion issued 1,136,360 shares of its common stock to institutional investors at a price of 22,000 Korean Won ($22.28 equivalent) per share, resulting in proceeds of 25,000 million Korean Won ($25.3 million equivalent).
On March 24, 2006, Celltrion awarded stock option grants to employees for 267,950 common shares at an exercise price of 7,047 Korean Won ($7.20 equivalent) per share. These grants and all previous Celltrion option grants contain an anti-dilution provision. Accordingly, in 2006, all Celltrion stock option grants’ exercise prices and the number of shares granted were modified, per the terms of the original stock option agreements.
21
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Special Note Regarding Forward-Looking Statements
This discussion and analysis should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2004, filed on February 7, 2007, and our unaudited condensed consolidated financial statements and related notes thereto appearing in Item 1 of this Quarterly Report on Form 10-Q. In addition to the other information contained or incorporated by reference in this Quarterly Report on Form 10-Q, you should carefully consider the risk factors described in Part II – Item 1A herein when evaluating an investment in our common stock. This Quarterly Report includes “forward-looking statements” within the meaning of Section 27A of the Securities Act, and Section 21E of the Exchange Act. All statements other than statements of historical fact are “forward-looking statements” for purposes of these provisions, including any statements of the plans and objectives of management for future operations, any statements regarding future operations, any statements concerning proposed new products or services, any statements regarding pending or future mergers or acquisitions, any statements regarding future economic conditions or performance, and any statement of assumptions underlying any of the foregoing. In some cases, forward-looking statements can be identified by the use of terminology such as “may,” “will,” “expects,” “plans,” “anticipates,” “estimates,” “potential” or “continue” or the negative thereof or other comparable terminology.
There can be no assurance that such expectations or any of the forward-looking statements will prove to be correct, and actual results could differ materially from those projected or assumed in the forward-looking statements. Our forward-looking statements are subject to inherent risks and uncertainties including, but not limited to, the risk factors set forth in this Quarterly Report. Factors that could cause or contribute to such differences include, but are not limited to, our limited cash resources, our ability to finance our research, our significant corporate and SEC-related expenses and limited revenue to offset these expenses, availability of appropriate prospective acquisitions or investment opportunities, litigation and the risks discussed in our other SEC filings. All forward-looking statements and reasons why results may differ included in this Quarterly Report are made as of the date hereof, and we assume no obligation to update any such forward-looking statement or reason why actual results might differ.
When used in the report, unless otherwise indicated, “we,” “our” and “us” refers to VaxGen.
OVERVIEW
We are a biopharmaceutical company focused on the development, manufacture and commercialization of biologic products for the prevention and treatment of human infectious disease. Our business strategy focuses on the development and commercialization of biologic products to counter potential bioterrorism threats, principally vaccines against inhalation anthrax and smallpox.
We were incorporated in 1995 and formed to complete the development of an investigational recombinant protein vaccine (“AIDSVAX”) intended to prevent infection by human immunodeficiency virus. In 2002, we broadened our product development portfolio to also include biodefense vaccines.
We are developing vaccines against inhalation anthrax and smallpox for the purpose of biodefense. In 2002 and 2003, we were awarded contracts involving an aggregate consideration of up to $101.2 million for the development of our anthrax vaccine (“NIAID Contracts”). On November 4, 2004, we were awarded the SNS contract for $877.5 million to provide 75 million doses of our recombinant anthrax vaccine to the U.S. government SNS for civilian defense. The SNS Contract also includes up to an additional $69 million in cost-plus fixed-fee task orders, which may be awarded at the government’s discretion. We expect to receive payment under the SNS Contract when we deliver our anthrax vaccine and it is accepted by the U.S. government into the SNS.
On August 6, 2004, we announced that we had received notification from the Nasdaq Listing Qualifications Panel (“Nasdaq Panel”) that our stock would discontinue trading on the Nasdaq National Market, now the Nasdaq Global Market (“Nasdaq”), effective August 9, 2004. This action followed our appeal to Nasdaq for a listing extension after not meeting the stated time requirements to file Quarterly Reports on Form 10-Q for the quarters ended March 31 and June 30, 2004. The Nasdaq Panel’s decision to delist our stock was based on our filing delinquency and our determination that previously filed financial statements for the years ended December 31, 2003, 2002 and 2001 should not be relied upon.
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Celltrion
During 2004, we adopted the provisions of Financial Accounting Standards Board Interpretation No. 46,Consolidation of Variable Interest Entities (as revised, “FIN 46R”), and determined that Celltrion, Inc. (“Celltrion”), our equity method investee as of the date of adoption, constituted a variable interest entity (“VIE”) and that we are its primary beneficiary. Accordingly, in accordance with FIN 46R, our consolidated financial statements include the accounts of our VIE effective January 1, 2004, as if Celltrion has been consolidated since its inception.
Celltrion is a development stage bio-manufacturing company incorporated on February 26, 2002 and since that date its principal activities have consisted of design and construction of a manufacturing facility in Incheon, Republic of Korea, and partially funding the construction of our U.S. biopharmaceutical manufacturing facility, as well as raising capital and recruiting scientific and management personnel.
As a part of the initial capitalization of Celltrion, we made an in-kind contribution to Celltrion of the license and sub-license of certain cell culture technology used for the manufacture of pharmaceutical products. We received 7.8 million shares of Celltrion’s common stock for this contribution, representing approximately half of the then outstanding shares. In March 2002, we entered into a Supply Agreement, a License Agreement and a Sub-License Agreement with Celltrion. At June 30, 2005, we owned 32% of Celltrion and were the largest stockholder.
In June 2005, Celltrion entered into several agreements to manufacture biologic products being developed by Bristol-Myers Squibb Company (“BMS”). Technology transfer activities began immediately upon the execution of the BMS agreements. Production of product, which will be manufactured according to U.S. cGMP standards, is expected to utilize a significant portion of Celltrion’s 50,000 liters of bioreactor capacity and began in 2006.
Celltrion’s development activities involve inherent risks. These risks include, among others, dependence on key personnel and the ongoing need to finance its operations prior to commencement of manufacturing operations. Successful future operations will depend on Celltrion’s ability to secure contract manufacturing agreements for biopharmaceutical products. In addition, Celltrion is dependent on us to provide certain technical support.
Debt financing
In April 2005, we raised aggregate gross proceeds of $31.5 million through a private placement of 5-1/2% Convertible Senior Subordinated Notes (“Notes”) due April 1, 2010.
Subsequent Events
In September 2005, we entered into an agreement to raise $15.1 million in gross proceeds through the sale of 1.2 million of our shares in Celltrion to a group of Korean investors. Subsequent to this transaction, Nexol and its related parties became the largest stockholder of Celltrion. As a result, as of September 2005, we were no longer the primary beneficiary of Celltrion and, in accordance with FIN 46R, Celltrion will be deconsolidated from VaxGen; and, thereafter, our investment in Celltrion will be accounted for under the equity method.
In February 2006, we raised net proceeds of $25.3 million through a private placement of 3.5 million shares of common stock at $7.70 per share.
During 2006, we received gross proceeds of $130 million from the sale of most of our Celltrion common stock to Nexol and affiliates of Nexol.
In December 2006, the department of Health and Human Services terminated for default the SNS Contract. In April 2007, we entered into a settlement agreement with HHS, in which HHS modified the SNS Contract from a termination for default to a termination for convenience. The settlement agreement also released both parties of all liabilities associated with our three anthrax government contracts. We also mutually terminated the 2003 Anthrax Contract for the convenience of the government.
In January and May 2007, we restructured operations to significantly reduce operating costs and announced we were actively pursuing avenues to enhance stockholder value through a strategic transaction.
See Subsequent Events in Note 13 to the unaudited condensed financial statements for more information regarding events occurring after June 30, 2005.
23
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Reference should be made to Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, in our Annual Report on Form 10-K for the fiscal year ended December 31, 2004, filed with the SEC on February 7, 2007, for a description of our critical accounting policies. The following policy on Valuation of Derivative Instruments has been expanded to reflect its application to the valuation of a derivative liability resulting from our April 2005 Notes financing. There have been no other significant changes to our policies since we filed that report.
Valuation of Derivative Instruments
We value certain embedded features we have issued in connection with the financing of our Notes in 2005 as derivative liabilities. We estimate the fair value of our derivative liabilities each quarter using the Monte Carlo Simulation methodology. This methodology allows flexibility in incorporating various assumptions such as probabilities of certain triggering events. The valuations are based on the information available as of the various valuation dates. Factors affecting the amount of these liabilities include the market value of our common stock, the estimated volatility of our common stock, our market capitalization, the risk free interest rate and other assumptions such as the probability of a change in control event. Changes in value are recorded as non-cash valuation adjustments within other income (expense) in our consolidated statements of operations.
RESULTS OF OPERATIONS
Comparison of Fiscal Quarters Ended June 30, 2005 and 2004
Revenues
| | | | | | | | | | | | | | | | | | | |
| | Three Months Ended
June 30, | | Percent
change
2005/2004 | | Six Months Ended
June 30, | | Percent
change
2005/2004 | |
| |
| | |
| | |
| | 2005 | | 2004 | | | 2005 | | 2004 | | |
| |
| |
| |
| |
| |
| |
| |
| | (in thousands) | | | | (in thousands) | | | | |
Revenues | | $ | 9,981 | | $ | 11,109 | | | (10%) | | $ | 17,627 | | $ | 15,054 | | | 17% | |
Revenues in the three months ended June 30, 2005 and 2004 were primarily from our Anthrax Contracts principally reflecting work performed under our NIAID Contracts. In 2005, NIAID-related activities were relatively unchanged while AIDSVAX-related activities decreased by $0.7 million from the comparable period in the prior year as we continued to reduce our focus on AIDSVAX.
Revenues in the six months ended June 30, 2005 and 2004 were primarily from our Anthrax Contracts principally reflecting work performed under our NIAID Contracts. In 2005, as a result of the timing of NIAID-related activities these revenues increased by $3.4 million while AIDSVAX-related activities decreased by $0.8 million from the comparable period in the prior year as we continued to reduce our focus on AIDSVAX. Celltrion did not earn any revenues during these periods.
Revenues earned in one period are not indicative of revenues to be earned in future periods. We expect future years’ revenues to be progressively less, as efforts shift from work done under the advanced development contracts to work under the SNS contract, from which no revenues will be earned until shipments commence.
Research and development expenses
| | | | | | | | | | | | | | | | | | | |
| | Three Months Ended
June 30, | | Percent
change
2005/2004 | | Six Months Ended
June 30, | | Percent
change
2005/2004 | |
| |
| | |
| | |
| | 2005 | | 2004 | | | 2005 | | 2004 | | |
| |
| |
| |
| |
| |
| |
| |
| | (in thousands) | | | | (in thousands) | | | | |
Research and development expenses | | $ | 18,004 | | $ | 11,738 | | | 53% | | $ | 33,506 | | $ | 18,431 | | | 82% | |
Research expenses include costs associated with research and testing of our product candidates prior to reaching the development stage and include the costs of internal personnel, outside contractors, allocated overhead and laboratory supplies. Product development expenses include costs of preclinical development and conducting clinical trials, costs of internal personnel, drug supply costs, research fees charged by outside contractors, allocated overhead and co-development costs.
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The following table details research and development expenses by major project:
| | | | | | | | | | | | | | | | | | | |
| | Three Months Ended
June 30, | | Percent
change
2005/2004 | | Six Months Ended
June 30, | | Percent
change
2005/2004 | |
| |
| | |
| | |
| | 2005 | | 2004 | | | 2005 | | 2004 | | |
| |
| |
| |
| |
| |
| |
| |
| | (in thousands) | | | | (in thousands) | | | | |
Direct Costs: | | | | | | | | | | | | | | | | | | | |
Anthrax Contracts | | $ | 8,164 | | $ | 6,845 | | 19 | % | | $ | 13,693 | | $ | 8,869 | | 54 | % | |
AIDSVAX | | | 274 | | | 187 | | 47 | % | | | 460 | | | 378 | | 21 | % | |
Smallpox | | | 1,365 | | | 754 | | 81 | % | | | 2,045 | | | 1,295 | | 58 | % | |
VCI | | | 1,741 | | | 721 | | 141 | % | | | 3,707 | | | 1,904 | | 95 | % | |
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|
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|
| | | | |
|
| |
|
| | | | |
Total direct costs | | | 11,544 | | | 8,507 | | 36 | % | | | 19,905 | | | 12,446 | | 60 | % | |
Indirect and other costs | | | 6,460 | | | 3,231 | | 100 | % | | | 13,601 | | | 5,985 | | 127 | % | |
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|
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|
| | | | |
|
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|
| | | | |
Research and development expenses | | $ | 18,004 | | $ | 11,738 | | 53 | % | | $ | 33,506 | | $ | 18,431 | | 82 | % | |
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|
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|
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|
| | | | |
The increase of $6.3 million in research and development expenses in the three months ended June 30, 2005 over the comparable period in 2004 was primarily due to:
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| • | Indirect research and development costs, which increased by $3.2 million, consisting primarily of: |
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| - | Other development costs, which increased by $1.6 million due to expanded operations; |
| | |
| - | Facilities overhead costs, which increased by $0.9 million due to the expansion of the VCI facility; |
| | |
| - | Celltrion’s research and development expenses, which increased by $0.6 million as part of their efforts to develop their manufacturing facility production capabilities; and |
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| - | Stock compensation charges, which increased by $0.1 million in connection with the 2005 modification of offering periods of our employee stock purchase plan; |
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| • | Direct costs associated with our Anthrax Contracts, which increased by $1.4 million primarily due to increased development work; |
| | |
| • | Direct costs associated with supporting VCI, which increased by $1.0 million due to the expansion of the facility; |
| | |
| • | Direct costs associated with our smallpox program, consisting primarily of labor costs, which increased by $0.6 million as we expand our program efforts; and |
| | |
| • | Direct costs associated with our AIDSVAX program, which increased by $0.1 million. |
The increase of $15.1 million in research and development expenses in the six months ended June 30, 2005 over the comparable period in 2004 was primarily due to:
| | |
| • | Indirect research and development costs, which increased by $7.6 million, consisting primarily of: |
| | |
| - | Other development costs, which increased by $3.1 million due to expanded operations; |
| | |
| - | Facilities overhead costs, which increased by $1.3 million as we expanded to accommodate additional headcount; |
| | |
| - | Celltrion’s research and development expenses, which increased by $1.0 million as part of their efforts to develop their manufacturing facility production capabilities; and |
| | |
| - | Stock compensation charges, which increased by $2.2 million in connection with the 2005 modification of offering periods of our employee stock purchase plan; |
| | |
| • | Direct costs associated with our Anthrax Contracts, which increased by $4.8 million primarily due to increased development work; |
| | |
| • | Direct costs associated with supporting VCI, which increased by $1.8 million due to the expansion of the facility; |
| | |
| • | Direct costs associated with our smallpox program, consisting primarily of labor costs, which increased by $0.8 million as we expand our program efforts; and |
| | |
| • | Direct costs associated with our AIDSVAX program, which increased by $0.1 million. |
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The process of conducting preclinical studies and clinical trials necessary to obtain FDA approval is costly and time consuming. The probability of success for each product candidate and clinical trial may be affected by a variety of factors, including, among others, the quality of product candidate early clinical data, investment in the program, competition, manufacturing capabilities and commercial viability. As a result of the uncertainties discussed above, the uncertainty associated with clinical trial enrollments and the risks inherent in the development process, we are unable to determine the duration and completion costs of current or future clinical stages of our product candidates. Development timelines, probability of success and development costs vary widely. While we are primarily focused on developing our anthrax product candidate, we anticipate that we will make determinations as to which additional programs to pursue and how much funding to direct to each program on an ongoing basis in response to the scientific and clinical success of each product candidate, as well as an ongoing assessment as to each product candidate’s commercial potential. We anticipate developing additional product candidates internally and we intend to consider in-licensing product candidates, which will increase our research and development expenses in future periods.
We expect VaxGen’s research and development expenses to increase substantially during the remainder of 2005 and in 2006 as we advance development of our product candidates.
General and administrative expenses
| | | | | | | | | | | | | | | | | | | |
| | Three Months Ended
June 30, | | Percent
change
2005/2004 | | Six Months Ended
June 30, | | Percent
change
2005/2004 | |
| |
| | |
| | |
| | 2005 | | 2004 | | | 2005 | | 2004 | | |
| |
| |
| |
| |
| |
| |
| |
| | (in thousands) | | | | (in thousands) | | | | |
General and administrative expenses | | $ | 8,985 | | $ | 5,675 | | | 58% | | $ | 16,112 | | $ | 10,533 | | | 53% | |
General and administrative expenses consist primarily of compensation costs, occupancy costs including depreciation expense, fees for accounting, legal and other professional services and other general corporate expenses.
The increase of $3.3 million in general and administrative expenses in the three months ended June 30, 2005 over the comparable period of 2004 was primarily due to:
| | |
| • | Celltrion’s general and administrative expenses, which increased by $1.6 million as Celltrion expanded its operations; |
| | |
| • | Personnel costs, which increased by $1.2 million due to increased headcount to support our expanding operations consisting of: |
| | |
| - | Non cash compensation charges due to accelerated option vesting associated with an executive termination, which increased $0.6 million; and |
| | |
| - | Salary and related benefits, which increased $0.6 million as we expanded our administrative capabilities in support of the newly awarded supply contract; |
| | |
| • | Overhead expenses included in general and administrative expenses, which increased by $0.4 million in 2005 compared to 2004 consisting of: |
| | |
| - | Occupancy costs, principally, rent and security services, which increased by $0.7 million due to our amended lease in April 2005 to secure space to support the production of our recombinant anthrax vaccine candidate as well as our other programs; |
| | |
| - | Computer and office equipment purchases or leases as well as maintenance costs, which increased by $0.3 million in support of increased headcount; |
| | |
| - | General operating expenses necessary to support our expanded infrastructure, which increased $0.3 million; and |
| | |
| - | Partially offset by $0.9 million in 2005 for costs that were allocated to research and development resulting from increased headcount to support our anthrax activities; |
| | |
| • | Professional services, which increased by $0.1 million principally reflecting services consisting of consulting fees associated with our efforts to comply with various reporting and regulatory requirements. |
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The increase of $5.6 million in general and administrative expenses in the six months ended June 30, 2005 over the comparable period of 2004 was primarily due to:
| | |
| • | Celltrion’s general and administrative expenses, which increased by $2.7 million as Celltrion expanded its operations; |
| | |
| • | Personnel costs, which increased by $2.3 million due to increased headcount to support our expanding operations consisting of: |
| | |
| - | Salary and related benefits, which increased $1.0 million as we expanded our administrative capabilities in support of the newly awarded supply contract; |
| | |
| - | Charges in connection with the 2005 modification of offering periods of our employee stock purchase plan, which increased $0.7 million; and |
| | |
| - | Non cash compensation charges due to accelerated option vesting associated with an executive termination, which increased $0.6 million; |
| | |
| • | Overhead expenses included in general and administrative expenses, which increased by $1.7 million in 2005 compared to 2004 consisting of: |
| | |
| - | Occupancy costs, principally, rent and security services, which increased by $0.9 million due to our amended lease in April 2005 to secure space to support the production of our recombinant anthrax vaccine candidate as well as our other programs; |
| | |
| - | Computer and office equipment purchases or leases as well as maintenance costs, which increased by $0.4 million in support of increased headcount; and |
| | |
| - | General operating expenses necessary to support our expanded infrastructure, which increased $0.4 million; |
| | |
| • | Professional services, which increased by $0.7 million principally reflecting services consisting of consulting fees associated with our efforts to comply with various reporting and regulatory requirements; and |
| | |
| • | Partially offset by $1.3 million in 2005 for costs that were allocated to research and development resulting from increased headcount; and a decrease of $0.5 million for the settlement of derivative lawsuits which we provided for in 2004 that was not repeated in 2005. |
We expect that VaxGen’s general and administrative expenses will exceed historical levels during the remainder of 2005 and in 2006 and will reflect substantial additional resources required to support our increased research and development activities, operations and public reporting requirements.
Other income (expense)
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| | Three Months Ended
June 30, | | Percent
change
2005/2004 | | Six Months Ended
June 30, | | Percent
change
2005/2004 | |
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| | 2005 | | 2004 | | | 2005 | | 2004 | | |
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| | (in thousands) | | | | (in thousands) | | | | |
Interest and other | | $ | (573 | ) | $ | 168 | | | (441% | ) | $ | (647 | ) | $ | 416 | | | (256% | ) |
Valuation adjustments | | | (176 | ) | | (12,046 | ) | | (99% | ) | | (176 | ) | | (13,722 | ) | | (99% | ) |
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Other expense | | $ | (749 | ) | $ | (11,878 | ) | | (94% | ) | $ | (823 | ) | $ | (13,306 | ) | | (94% | ) |
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The decrease in other expense of $11.1 million in the three months ended June 30, 2005 from the comparable period in 2004 was primarily due to:
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| • | Mark-to-market valuation adjustments related to derivatives, which decreased $11.9 million primarily because the 2004 derivatives were no longer outstanding in 2005 and the 2005 derivatives originated in April 2005; and |
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| • | Interest expense increased primarily due to the issuance of $31.5 million of convertible notes in April 2005. |
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The decrease in other expense of $12.5 million in the six months ended June 30, 2005 from the comparable period in 2004 was primarily due to:
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| • | Mark-to-market valuation adjustments related to derivatives, which decreased $13.5 million primarily because the 2004 derivatives were no longer outstanding in 2005 and the 2005 derivatives originated in April 2005; and |
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| • | Interest expense increased $0.6 million primarily due to the accrual of 5.5% interest due on the $31.5 million of convertible notes we issued in April 2005. |
We expect future mark-to-market adjustments relating to the valuation of derivatives will fluctuate, as the valuation calculation is sensitive to, and directly related to, the likelihood of derivative instrument triggering events occurring and the market price of our common stock on any given measurement date. Also, we anticipate future investment income will fluctuate and will be primarily driven by our future cash, cash equivalents and investments balances. In addition, we anticipate quarterly interest expense in 2005 and 2006 to continue at the level for the three months ended June 30, 2005 as a result of the Notes continuing to be outstanding.
Minority interest in loss of variable interest entity
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| | Three Months Ended
June 30, | | Percent
change
2005/2004 | | Six Months Ended
June 30, | | Percent
change
2005/2004 | |
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| | 2005 | | 2004 | | | 2005 | | 2004 | | |
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| | (in thousands) | | | | (in thousands) | | | | |
Minority interest in loss of variable interest entity | | $ | 2,426 | | $ | 584 | | | 315% | | $ | 4,109 | | $ | 1,125 | | | 265% | |
Minority interest in loss of variable interest entity for the three months and six months ended June 30, 2005 reflects the interests of Celltrion’s other stockholders in the net loss of Celltrion. The three month increase from 2004 is the result of a $2.5 million increase in the losses incurred by Celltrion and an increase in the average percentage ownership of the other stockholders from 53% during the three months ended June 30, 2004 to 68% during the three months ended June 30, 2005. The six month increase from 2004 is the result of a $4.0 million increase in the losses incurred by Celltrion and an increase in the average percentage ownership of the other stockholders from 53% during the six months ended June 30, 2004 to 67% during the six months ended June 30, 2005.
See Note 12, Segment Information, included in the notes to the consolidated financial statements in Part I – Item 1 of this report for segment information.
LIQUIDITY AND CAPITAL RESOURCES
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| | 2005 | | 2004 | |
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| | (in thousands) | |
As of June 30: | | | | | | | |
Cash, cash equivalents and investment securities | | $ | 36,339 | | $ | 18,240 | |
Working capital (deficit) | | | 6,351 | | | (6,238 | ) |
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Six months ended June 30: | | | | | | | |
Cash provided by (used in): | | | | | | | |
Operating activities | | $ | (27,525 | ) | $ | (10,867 | ) |
Investing activities | | | (25,766 | ) | | (13,225 | ) |
Financing activities | | | 49,618 | | | 12,635 | |
Effect of exchange rate changes on cash and cash equivalents | | | 125 | | | 209 | |
Capital expenditures (included in investing activities above) | | | (28,760 | ) | | (20,759 | ) |
Our primary financing requirements are for funding our day-to-day working capital requirements and capital equipment expenditures related to the manufacturing facilities in the Republic of Korea and California. As of June 30, 2005, we had 1,803 million Korean Won ($1.7 million equivalent) available for additional borrowing. The liabilities recognized as a result of consolidating Celltrion do not represent additional claims on VaxGen’s or VCI’s assets. Rather, they represent claims against the specific assets of Celltrion. Conversely, the assets recognized as a result of consolidating Celltrion do not represent additional assets that could be used to satisfy claims against VaxGen’s or VCI’s assets. The general creditors of VaxGen and VCI have no recourse to the general credit of Celltrion. The general creditors of Celltrion have no recourse to the general credit of VaxGen and VCI.
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Through June 30, 2005, we financed our operations primarily through sales of our common stock, Celltrion’s sales of preferred stock, the issuance of Series A Preferred Stock, convertible notes as well as through revenues from research contracts and grants and debt to finance the purchase of land and construction of facilities in the Republic of Korea. Our future capital requirements will depend on several factors, including:
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| • | Our ability to negotiate government contracts or grants, particularly our ability to win contracts to continue to develop or to sell our vaccine candidates; |
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| • | The timing of collection of accounts receivable from our government contracts and grants; |
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| • | Progress of internal research and development projects; |
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| • | Levels and timing of capital expenditures on the manufacturing facilities in the Republic of Korea and California; and |
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| • | Our ability to identify and exploit business development opportunities. |
Net cash used in operating activities of $27.5 million and $10.9 million for the six months ended June 30, 2005 and 2004, respectively, was primarily attributable to our net losses although the effect of non-cash charges upon net cash used in operating activities was significant in both years. For example,
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| • | Compensation expense of $3.9 million in 2005 and $0.8 million in 2004. The increase from 2004 is primarily the result of modifications to the Company’s ESPP in 2005 ($2.9 million); |
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| • | Valuation adjustments of $0.2 million and $13.4 million in the six months ended June 30, 2005 and 2004, respectively, reflecting changes in the fair value of outstanding derivatives. The 2004 changes in fair value primarily resulted from the May 2004 suspension of our SEC registration statement which caused the Series A Warrants to become redeemable for cash at the option of the Series A Warrant holders and due to changes in the fair value of our common stock; |
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| • | Depreciation and amortization of $2.5 million and $0.8 million for the six months ended June 30, 2005, and 2004, respectively. The increase primarily reflects the California facility beginning operations during late 2004 and its expansion ($1.1 million) and the expansion of the Korean operations ($0.5 million); and |
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| • | Minority interest for the non-VaxGen share in the losses of Celltrion of $4.1 million in 2005 and $1.1 million in 2004. The increase from 2004 is the result of a $4.0 million increase in the losses incurred by Celltrion and an increase in the average percentage ownership of the other stockholders from 53% during the six months ended June 30, 2004 to 67% during the six months ended June 30, 2005. |
Net cash used in investing activities consisted primarily of activities relating to the purchase and sale of investment securities as well as capital expenditures. Capital expenditures in the six months ended June 30, 2005 and 2004 were made in connection with the expansion of the Korean manufacturing facility ($22.4 million and $18.5 million, respectively) and research and development laboratories and leasehold improvements associated with the California manufacturing facility and office facilities ($4.8 million and $2.3 million, respectively). In addition, during 2005 we purchased $1.5 million of software related to the implementation of a new enterprise resource planning system. We expect capital expenditures during the remainder of 2005 to increase due to the ongoing expansion of Californian manufacturing facilities. Net cash used in investing activities in 2004 also included $9.7 million from the consolidation of Celltrion as a variable interest entity effective January 1, 2004.
Net cash provided by our financing activities increased to $49.6 million in the six months ended June 30, 2005 from $12.6 million in the comparable period in 2004. In April 2005, we raised net proceeds of $29.7 million through a private placement of 5-1/2% convertible senior subordinated notes due April 1, 2010. In March 2005, Celltrion issued 1,949,700 shares of preferred stock at a price of 5,000 Korean Won ($4.99 equivalent) per share, resulting in proceeds of 9,749 million Korean Won ($9.5 million equivalent). In May 2004, Celltrion issued 693,500 shares of preferred stock at a price of 5,000 Korean Won per share ($4.28 equivalent), resulting in proceeds of 3,447 million Korean Won ($3.0 million equivalent). In January 2003, Celltrion obtained collaterized long-term financing of 52,000 million Korean Won (equivalent to $44.2 million) with a nine-year term from a Korean bank (“Loan”). Funds from the Loan, $10.5 million in 2005 and $9.8 million in 2004, are used for construction of the Incheon administration buildings and manufacturing facility.
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At June 30, 2005, $36.3 million, or 16%, of our assets consisted of cash, cash equivalents and investment securities. We had working capital of $6.4 million at June 30, 2005, compared to a working capital deficit of $6.2 million at June 30, 2004. This $12.6 million increase in working capital is primarily due to the following:
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| • | Cash, cash equivalents and investment securities, which increased by $15.2 million primarily as a result of the Notes; |
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| • | Derivative liabilities, which decreased by $14.9 million primarily as a result of the exchange of the 2001 preferred stock warrants, for which the liabilities existed, for new warrants without associated derivative liabilities during the three months ended September 30, 2004; |
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| • | Accounts payable and accrued expenses, which increased by $14.2 million due to the timing of payments; |
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| • | Partially offset by current obligations, which increased by $7.2 million as a result of increased construction related short-term debt for Celltrion; |
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| • | Due to related parties, which increased by $7.1 million as a result of increased construction related accruals in Korea; and |
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| • | Receivables, which increased by $5.5 million primarily due to the timing of collections from the U.S. government. |
We continually review alternatives to obtain additional financing and to increase revenues by procuring future contracts to supply anthrax and smallpox vaccines to the U.S. government and other potential customers. There can be no assurances that we will be successful in these efforts. The cancellation of the SNS Contract, the reaudit of our financial statements for the three years ended December 31, 2003, the resulting restatement of reports previously filed with the Securities and Exchange Commission, the lapsing of our registration statements and the delisting of our common stock may have an adverse impact on whether financing will be available or that it will be available on terms that we will accept. See Subsequent Events in Note 13.
Contractual Obligations
On April 14, 2005, VaxGen entered into an amended lease agreement to secure space to support the production of its recombinant anthrax vaccine candidate as well as its other programs. There were no other significant changes in our contractual obligations during the six months ended June 30, 2005. The following table summarizes our significant contractual obligations at June 30, 2005, and the effect such obligations are expected to have on our liquidity and cash flows in future periods.
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| | Payments Due by Period | |
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| | Total | | 2005 | | 2006-07 | | 2008-09 | | 2010 and
beyond | |
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| | (in thousands) | |
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Note obligations (1) | | $ | 40,162 | | $ | 866 | | $ | 3,465 | | $ | 3,465 | | $ | 32,366 | |
Short-term debt obligations (2) | | | 7,326 | | | 7,326 | | | — | | | — | | | — | |
Operating lease obligations (3) | | | 43,260 | | | 1,746 | | | 7,206 | | | 6,252 | | | 28,056 | |
Celltrion obligations (4) | | | 62,747 | | | — | | | 12,710 | | | 23,361 | | | 26,676 | |
Purchase obligations (5) | | | 2,588 | | | 500 | | | 1,783 | | | 206 | | | 99 | |
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Total contractual obligations | | $ | 156,083 | | $ | 10,438 | | $ | 25,164 | | $ | 33,284 | | $ | 87,197 | |
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(1) | Note obligations consist of our payment obligations on our Notes. |
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(2) | Short-term debt obligations relate to Celltrion’s short-term working capital requirements. |
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(3) | Operating lease obligations include office and laboratory facilities under non-cancelable operating leases. |
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(4) | Celltrion obligations reflect principal and interest payments due on Celltrion’s construction loans and land financing as translated on June 30, 2005. |
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(5) | Purchase obligations include service agreements, contracts related to manufacturing and research operations and license agreements. |
Off-Balance Sheet Arrangements
As of June 30, 2005, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.
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Recent Accounting Pronouncements
In December 2004, the FASB issued FAS No. 153,Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29, Accounting for Nonmonetary Transactions (“FAS 153”). FAS 153 addresses the measurement of exchanges of nonmonetary assets and redefines the scope of transactions that should be measured based on the fair value of the assets exchanged. The provisions in FAS 153 are effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005, which is effective with our first quarter of fiscal 2006. We do not expect adoption of FAS 153 will have a material impact on our consolidated financial position, results of operations or cash flows.
In December 2004, the FASB issued Statement of Financial Accounting Standards (“FAS”) No. 123(R),Share-Based Payment (“FAS 123R”) which is a revision of FAS No. 123,Accounting for Stock-Based Compensation (“FAS 123”). Generally, the approach in FAS 123R is similar to the approach described in FAS 123. However, FAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the consolidated statement of operations based on their fair values. Pro forma disclosure is no longer an alternative. The new rule applies to option grants made after adoption as well as options that are not vested at the date of adoption. FAS 123R must be adopted in annual periods beginning after July 1, 2005. We began applying FAS 123R prospectively in the first quarter of 2006. Additionally, in August 2005, the FASB issued FASB Staff Position (“FSP”) FSP FAS 123R-1,Classification and Measurement of Freestanding Financial Instruments Originally Issued in Exchange for Employee Services under FASB Statement No. 123(R) (“FSP1”). In FSP1, the FASB decided to defer the requirements in FAS 123 that make a freestanding financial instrument subject to the recognition and measurement requirements of other GAAP when the rights conveyed by the instrument are no longer dependent on the holder being an employee. In October 2005, the FASB issued FSP FAS 123R-2,Practical Accommodation to the Application of Grant Date as Defined in FASB Statement No. 123(R) (“FSP2”). In FSP2, the FASB is providing companies with a “practical accommodation” when determining the grant date of an award that is subject to the accounting provisions in FAS 123R. In November 2005, the FASB issued FSP FAS 123R-3,Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards(“FSP3”). FSP3 provides an elective alternative method that establishes a computational component to arrive at the beginning balance of the accumulated paid-in capital pool related to employee compensation and a simplified method to determine the subsequent impact on the accumulated paid-in capital pool of employee awards that are fully vested and outstanding upon the adoption of FAS 123R. In February 2006, the FASB issued FSP FAS 123R-4,Classification of Options and Similar Instruments Issued as Employee Compensation That Allow for Cash Settlement upon the Occurrence of a Contingent Event (“FSP4”), which concludes that a cash settlement feature that can be exercised only upon the occurrence of a contingent event that is outside the employee’s control does not become a liability until it becomes probable that the event will occur. An option or similar instrument that is classified as equity, but subsequently becomes a liability because the contingent cash settlement event is probable of occurring, shall be accounted for similar to modification from an equity to liability award. To the extent that the liability exceeds the amount previously recognized in equity, the excess is recognized as compensation cost. The total recognized compensation cost for an award with a contingent cash settlement feature shall at least equal the fair value of the award at the grant date. FSP4 is applicable only for options or similar instruments issued as part of employee compensation arrangements. In October 2006, the FASB issued FSP FAS 123R-5,Amendment of FASB Staff Position FAS 123(R)-1 (“FSP5”), which addresses whether a modification of an instrument in connection with an equity restructuring should be considered a modification for purposes of applying FSP1. The provisions in FSP5 are effective for the first reporting period beginning after October 10, 2006. Also, in October 2006, the FASB issued FSP FAS 123R-6,Technical Corrections of FASB Statement No. 123 (revised 2004) (“FSP6”), which addresses certain technical corrections of FAS 123R. The provisions in FSP6 are effective for the first reporting period beginning after October 20, 2006. The guidance in FSP1, FSP2, FSP3, FSP4, FSP5 and FSP6 will be applied upon our adoption of FAS 123R. We are currently evaluating the impact of adopting the guidance in FAS 123R, FSP1, FSP2, FSP3, FSP4, FSP5 and FSP6 on our consolidated financial position, results of operations and cash flows.
In March 2005, the SEC published Staff Accounting Bulletin No. 107 (“SAB 107”). The interpretations in this staff accounting bulletin express the views of the staff regarding the interaction between FAS 123R and certain SEC rules and regulations and provide the staff’s views regarding the valuation of share-based payment arrangements for public companies. In particular, SAB 107 provides guidance related to share-based payment transactions with non-employees, the transition from nonpublic to public entity status, valuation methods (including assumptions such as expected volatility and expected term), the accounting for certain redeemable financial instruments issued under share-based payment arrangements, the classification of compensation expense, non-GAAP financial measures, first-time adoption of FAS 123R in an interim period, capitalization of compensation cost related to share-based payment arrangements, the accounting for income tax effects of share-based payment arrangements upon adoption of FAS 123R, the modification of employee share options prior to adoption of FAS 123R and disclosures in Management’s Discussion and Analysis subsequent to adoption of FAS 123R. We will comply with SAB 107 upon our adoption of FAS 123R. We are currently evaluating the impact of adopting SAB 107 on our consolidated financial position, results of operations and cash flows.
31
In April 2005, the FASB issued FIN 46(R)-6,Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R) (“FSP FIN 46R-6”). FSP FIN 46R-6 addresses certain major implementation issues related to FIN 46(R). Specifically, FSP FIN 46R-6 addresses how a reporting enterprise should determine the variability to be considered in applying FIN 46R. The variability that is considered in applying FIN 46R affects the determination of (a) whether the entity is a variable interest entity or VIE, (b) which interests are “variable interests” in the entity, and (c) which party, if any, is the primary beneficiary of the VIE. That variability will affect any calculation of expected losses and expected residual returns, if such a calculation is necessary. The effective date and transition requirements prescribed by FSP FIN 46R-6 are complex. For example, an enterprise is required to apply the guidance in the FSP prospectively to all entities (including newly created entities) with which that enterprise first becomes involved and to all entities previously required to be analyzed under FIN 46R when a “reconsideration event” has occurred as defined in FIN 46R beginning the first day of the first reporting period beginning after June 15, 2006. Retrospective application is permitted but not required; however, a company that chooses retrospective application must do so no later than the end of the first annual reporting period ending after July 15, 2006. We are currently evaluating the impact of adopting FSP FIN 46R-6 on our consolidated financial position, results of operations and cash flows.
In May 2005, the FASB issued FAS No. 154, Accounting Changes and Error Corrections—A replacement of APB Opinion No. 20 and FASB Statement No. 3 (“FAS 154”). FAS 154 replaces APB Opinion No. 20, Accounting Changes, and FAS No. 3, Reporting Accounting Changes in Interim Financial Statements, and changes the requirements for the accounting for, and reporting of, a change in accounting principles. FAS 154 applies to all voluntary changes in accounting principles and changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. Under previous guidance, changes in accounting principle were recognized as a cumulative effect in the net income of the period of the change. FAS 154 requires retrospective application of changes in accounting principle, limited to the direct effects of the change, to prior periods’ financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change in accounting principle. Additionally, FAS 154 requires that a change in depreciation, amortization or depletion method for long-lived, nonfinancial assets be accounted for as a change in accounting estimate affected by a change in accounting principle and that correction of errors in previously issued financial statements should be termed a “restatement.” The provisions in FAS 154 are effective for accounting changes and correction of errors made in fiscal years beginning after December 15, 2005, which is effective with our first quarter of fiscal 2006. We are currently evaluating the impact of adopting FAS 154 on our consolidated financial position, results of operations and cash flows.
In June 2005, the FASB issued FSP FAS 150-5, Issuers Accounting under FASB Statement No. 150 for Freestanding Warrants and Other Similar Instruments on Shares that are Redeemable (“FAS 150-5”). FAS 150-5 clarifies that freestanding warrants and similar instruments on shares that are redeemable should be accounted for as liabilities under FAS 150 regardless of the timing of the redemption feature or price, even though the underlying shares may be classified as equity. FAS 150-5 is effective for the first reporting period beginning after June 30, 2005. Although we had outstanding warrants as of July 1, 2005, the shares issued upon exercise of the warrants are not redeemable; consequently, we do not expect the adoption of FAS 150-5 will have a material impact on our consolidated financial position, results of operations or cash flows.
In July 2005, the FASB issued FSP APB 18-1,Accounting by an Investor for its Proportionate Share of Accumulated Other Comprehensive Income of an Investee Accounted for under the Equity Method in Accordance with APB Opinion No. 18 upon a Loss of Significant Influence (“FSP APB 18-1”), which provides guidance on how an investor should account for its proportional share of an investee’s equity adjustments for other comprehensive income (“OCI”) upon a loss of significant influence as detailed in paragraph 121 of FAS No. 130,Reporting Comprehensive Income (“FAS 130”).APB Opinion No. 18,The Equity Method of Accounting for Investments in Common Stock (“APB 18”) requires a transaction of an equity method investee of a capital nature be accounted for as if the investee was a consolidated subsidiary, which requires the investor to record its proportionate share of the investee’s adjustments for OCI as increases or decreases to the investment account with corresponding adjustments in equity. FSP APB 18-1 requires that an investor’s proportionate share of an investee’s equity adjustments for OCI should be offset against the carrying value of the investment at the time significant influence is lost and equity method accounting is no longer appropriate. However, to the extent that the offset results in a carrying value of the investment that is less than zero, an investor should (a) reduce the carrying value of the investment to zero and (b) record the remaining balance in income. The guidance in FSP APB 18-1 is effective for us on October 1, 2005. We are currently evaluating the impact of adopting FSP APB 18-1 on our consolidated financial position, results of operations and cash flows.
In September 2005, the EITF reached a consensus on Issue No. 05-7,Accounting for Modifications to Conversion Options Embedded in Debt Instruments and Related Issues (“EITF 05-7”). EITF 05-7 requires that a change in the fair value of a conversion option brought about by modifying the debt agreement be included in analyzing in accordance with EITF consensus on Issue No. 96-19,Debtor’s Accounting for a Modification or Exchange of Debt Instruments (“EITF 96-19”), whether a debt instrument is considered extinguished. Under EITF 96-19’s requirements, an issuer who modifies a debt instrument must compare the present value of the original debt instrument’s cash flows to the present value of the cash flows of the modified debt. If the present value of those cash flows varies by more than 10 percent, the modification is considered significant and extinguishments accounting is applied to the original debt. If the change in the present value of the cash flows is less than 10 percent, the debt is considered to be modified and is subject to EITF 96-19’s modification accounting. EITF 05-7 requires that in applying the 10 percent test the change in the fair value of the conversion option be treated in the same manner as a current period cash flow. EITF 05-7 also requires that, if a modification does not result in an extinguishment, the change in fair value of the conversion option be accounted for as an adjustment to interest expense over the remaining term of the debt. The issuer should not recognize a beneficial conversion feature (“BCF”) or reassess an existing BCF upon modification of the conversion option of a debt instrument that does not result in an extinguishment. EITF 05-7 is effective for modifications of debt instruments beginning in the first interim or annual reporting period beginning after December 15, 2005. We do not expect the adoption of EITF 05-7 to have material impact on our consolidated financial position, results of operations or cash flows.
32
In September 2005, the EITF reached a consensus on Issue No. 05-8,Income Tax Consequences of Issuing Convertible Debt with a Beneficial Conversion Feature (“EITF 05-8”). Under EITF 05-8, the issuance of convertible debt with a BCF results in a temporary difference for purposes of applying FAS No. 109,Accounting for Income Taxes. The deferred taxes recognized for the temporary difference should be recorded as an adjustment to paid-in capital. EITF 98-5,Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios, and EITF 00-27,Application of Issue No. 98-5 to Certain Convertible Instruments, require that the nondetachable conversion feature of a convertible debt security be accounted for separately if it is a BCF. A BCF is recognized and measured by allocating to additional paid-in capital a portion of the proceeds equal to the conversion feature’s intrinsic value. A discount on the convertible debt is recognized for the amount that is allocated to additional paid-in capital. The debt discount is accreted from the date of issuance to the stated redemption date of the convertible instrument or through the earliest conversion date if the instrument does not have a stated redemption date. The U.S. Federal Income Tax Code includes the entire amount of proceeds received at issuance as the tax basis of the convertible debt security. EITF 05-8 should be applied retrospectively to all instruments with a BCF accounted for under EITF 98-5 and EITF 00-27 for periods beginning after December 15, 2005. We do not expect the adoption of EITF 05-8 to have material impact on our consolidated financial position, results of operations or cash flows.
In November 2005, the FASB issued FSP FAS 115-1 and FAS 124-1,The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (“FSP FAS 115-1 and FAS 124-1”). This FSP nullifies certain requirements of EITF Issue No. 03-1 and supersedes EITF Abstracts, Topic No. D-44,Recognition of Other-Than-Temporary Impairment upon the Planned Sale of aSecurity Whose Cost Exceeds Fair Value.Based on the clarification provided in FSP FAS 115-1 and FAS 124-1, the amount of any other-than-temporary impairment that needs to be recognized will continue to be dependent on market conditions, the occurrence of certain events or changes in circumstances relative to an investee and an entity’s intent and ability to hold the impaired investment at the time of the valuation. FSP FAS 115-1 and FAS 124-1 are effective for reporting periods beginning after December 15, 2005. We are evaluating the impact of adopting the guidance in FSP FAS 115-1 and FAS 124-1on our consolidated financial position, results of operations and cash flows.
In February 2006, the FASB issued FAS No. 155,Accounting for Certain Hybrid Financial Instruments(“FAS 155”), which amends FAS No. 133, Accounting for Derivative Instruments and Hedging Activities and FAS No. 140,Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, and improves the financial reporting of certain hybrid financial instruments by requiring more consistent accounting that eliminates exemptions and provides a means to simplify the accounting for these instruments. Specifically, FAS 155 allows financial instruments that have embedded derivatives to be accounted for as a whole (eliminating the need to bifurcate the derivative from its host) if the holder elects to account for the whole instrument on a fair value basis. FAS 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. We do not expect the adoption of FAS 155 will have a material impact on our consolidated financial position, results of operations or cash flows.
In March 2006, the EITF reached a tentative consensus on Issue No. 06-3,How Sales Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross Versus Net Presentation) (“EITF 06-3”). EITF 06-3 addresses income statement classification and disclosure requirements of externally-imposed taxes on revenue-producing transactions. EITF 06-3 is effective for periods beginning after December 15, 2006. We do not expect the implementation of EITF 06-3 to have a material impact on our consolidated financial position, results of operations or cash flows.
In July 2006, the FASB issued Interpretation No. 48,Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109(“FIN 48”), which clarifies the accounting for uncertainty in tax positions. FIN 48 requires that we recognize in our financial statements the impact of a tax position if that position is more likely than not of being sustained upon audit, based on the technical merits of the position. FIN 48 is effective for fiscal years beginning after December 15, 2006 which is the beginning of our fiscal 2007.
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We are currently evaluating the impact of adopting FIN 48 on our consolidated financial position, results of operations and cash flows.
In September 2006, the FASB issued FAS No. 157,Fair Value Measurement (“FAS 157”). FAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. We are evaluating the impact of adopting FAS 157 on our consolidated financial position, results of operations and cash flows.
In September 2006, the SEC published Staff Accounting Bulletin Topic 1N,Financial Statements — Considering the Effects of Prior Year Misstatements When Quantifying Misstatements in Current Year Financial Statements (“SAB 108”). SAB 108 addresses how a company should quantify the effect of an error on the financial statements. The SEC staff concludes in SAB 108 that a dual approach should be used to compute the amount of a misstatement. Specifically, the amount should be computed using both the “rollover” (current year income statement perspective) and “iron curtain” (year-end balance sheet perspective) methods. SAB 108 does not address how to evaluate materiality, that is, how to assess the quantitative and qualitative effects of a misstatement on the financial statements. The SEC staff’s views on evaluating the materiality of an error are covered in SAB Topic 1M,Financial Statements — Materiality (“SAB 99”). Companies that will need to change their method for computing the amount of an error must adopt the dual approach for fiscal years ending after November 15, 2006, which is effective with our year ended December 31, 2006. A change in the method of quantifying errors represents a change in accounting policy. Accordingly, if the use of the dual approach results in a larger, material misstatement, we will have to adjust its financial statements. Under FAS 154, changes in accounting policy generally are accounted for using retrospective application; however, SAB 108 permits public companies to report the cumulative effect of the new policy as an adjustment to opening retained earnings. We do not expect the adoption of SAB 108 to have a material impact on our consolidated financial position, results of operations or cash flows.
In November 2006, the FASB ratified EITF Issue No. 06-6,Application of EITF Issue No. 05-7, ‘Accounting for Modifications to Conversion Options Embedded in Debt Instruments and Related Issues’ (“EITF 06-6”). EITF 06-6 addresses the modification of a convertible debt instrument that changes the fair value of an embedded conversion option and the subsequent recognition of interest expense for the associated debt instrument when the modification does not result in a debt extinguishment pursuant to EITF 96-19. We do not expect the adoption of EITF 06-6 to have a material impact on our consolidated financial position, results of operations or cash flows.
In November 2006, the FASB ratified EITF Issue No. 06-7,Issuer’s Accounting for a Previously Bifurcated Conversion Option in a Convertible Debt Instrument When the Conversion Option No Longer Meets the Bifurcation Criteria in FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities (“EITF 06-7”). At the time of issuance, an embedded conversion option in a convertible debt instrument may be required to be bifurcated from the debt instrument and accounted for separately by the issuer as a derivative under FAS 133, based on the application of EITF Issue 00-19,Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock, (“EITF 00-19”).. Subsequent to the issuance of the convertible debt, facts may change and cause the embedded conversion option to no longer meet the conditions for separate accounting as a derivative instrument, such as when the bifurcated instrument meets the conditions of EITF 00-19 to be classified in stockholders’ equity. Under EITF 06-7, when an embedded conversion option previously accounted for as a derivative under FAS 133 no longer meets the bifurcation criteria under that standard, an issuer shall disclose a description of the principal changes causing the embedded conversion option to no longer require bifurcation under FAS 133 and the amount of the liability for the conversion option reclassified to stockholders’ equity. EITF 06-7 should be applied to all previously bifurcated conversion options in convertible debt instruments that no longer meet the bifurcation criteria in FAS 133 in interim or annual periods beginning after December 15, 2006, regardless of whether the debt instrument was entered into prior or subsequent to the effective date of EITF 06-7. Earlier application of EITF 06-7 is permitted in periods for which financial statements have not yet been issued. We do not expect the adoption of EITF 06-7 to have a material impact on our consolidated financial position, results of operations or cash flows.
In February 2007, the FASB issued FAS No. 159,The Fair Value Option for Financial Assets and Financial Liabilities - Including an Amendment of FASB Statement No. 115 (“FAS 159”) which permits all entities to choose to measure eligible items, including many financial instruments, at fair value at specified election dates. A business entity will report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. The fair value option: (a) may be applied instrument by instrument, with a few exceptions, such as investments otherwise accounted for by the equity method; (b) is irrevocable (unless a new election date occurs); and (c) is applied only to entire instruments and not to portions of instruments. Most of the provisions in FAS 159 are elective; however, the amendment to FAS No. 115,Accounting for Certain Investments in Debt and Equity Securities,applies to all entities with available-for-sale and trading securities. FAS 159 is effective for fiscal years beginning after November 15, 2007. We are evaluating the impact of adopting FAS 159 on our consolidated financial position, results of operations and cash flows.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our operations and cash flows are subject to fluctuations due to changes in interest rates in our investment portfolio of debt securities and to foreign currency exchange rates.
Interest Rate Risk
We are exposed to market rate changes by debt securities included in our investment portfolio. By policy, we invest in debt instruments of the U.S. government, federal agencies and high-quality corporate issuers, limit the amount of credit exposure to any one issuer, and limit duration by restricting the term. Investments in both fixed rate and floating rate instruments carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely affected due to a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. Due in part to these factors, our future investment income may decrease due to changes in interest rates or due to losses we may suffer when securities decline in market value. At June 30, 2005, we held available-for-sale securities in the principal amount of $19.2 million. If market interest rates were to increase immediately and uniformly by 10% from levels at June 30, 2005, the fair value of our portfolio would decline by an immaterial amount, and would not have a significant effect on our operations or cash flows. Our exposure to losses as a result of interest rate changes is managed through investing in a portfolio of securities with a weighted-average maturity of one year or less.
Indebtedness
In January 2003, Celltrion obtained collateralized long-term financing of 52,000 million Korean Won ($44.2 million equivalent) with a nine-year term from a Korean bank (“Loan”). Funds from the Loan are to be used for construction of the administration buildings and manufacturing facility. As construction progresses, the bank funds 60% of the progress payments (up to 52,000 million Korean Won), while Celltrion pays the remaining 40%. Celltrion’s land and construction in progress represent collateral for the outstanding Loan balance. Only interest payments are due monthly for the first four years of the Loan term, and principal and interest payments are due monthly for the remaining five years of the Loan term. Interest is adjusted quarterly, based on a 3-month Korean certificate of deposit rate plus 1.5% (an aggregate rate of 5.0% at June 30, 2005). At June 30, 2005, Celltrion owed 52,000 million Korean Won ($50.3 million equivalent) related to the Loan. If market interest rates were to increase immediately and uniformly by 10% from levels at June 30, 2005, the increase in interest payments due under the Loan would increase by an immaterial amount, and would not have a significant effect on our operations or cash flows.
At June 30, 2005, our outstanding non-current liabilities include $31.5 million of our 5 1/2 % Convertible Senior Notes due April 1, 2010 pursuant to our financing through a private placement of these Notes in April 2005. As the Notes bear interest at a fixed rate, our results of operations would not be affected by interest rate changes.
As of June 30, 2005, we did not invest in derivative financial instruments, interest rate swaps or other investments that alter interest rate exposure.
Foreign Currency Risk
Our exposure to foreign currency exchange rates is related primarily to our investment in Celltrion. Our international business is subject to risks, including, but not limited to, differing economic conditions, changes in political climate, differing tax structures, other regulations and restrictions and foreign exchange rate volatility when compared to the United States dollar. Accordingly, our future results could be materially affected by changes in these or other factors. We are also affected by exchange rate fluctuations as the financial statements of our foreign subsidiary are translated from Korean Won into the United States dollar in consolidation. As exchange rates vary, these results, when translated, may vary from expectations and could adversely impact overall profitability. If market foreign currency exchange rates were to change immediately and uniformly by 10% from levels at June 30, 2005, the change would not have a significant effect on our operations or cash flows. As of June 30, 2005, we did not invest in derivative financial instruments, currency swaps or other investments that alter foreign currency exposure.
Derivative Valuation Risk
The terms of our convertible notes include put features not under our control. These features are considered to be an embedded derivative liability and we determined the fair value of this derivative to be $1.8 million on the date of issuance. Due to the quarterly revaluation of the embedded derivative liability, we recorded in our statements of operations other expense of $0.2 million for the three and six months ended June 30, 2005. At June 30, 2005, the embedded derivative liability was valued at $1.9 million. We determine the fair value of the derivative liabilities using the Monte Carlo Simulation methodology. This methodology allows flexibility in incorporating various assumptions such as probabilities of certain triggering events. The valuations are based on the information available as of the various valuation dates. Factors affecting the amount of these liabilities include expectations regarding triggering events, the market value of our common stock, the estimated volatility of our common stock, our market capitalization, the risk free interest rate and other assumptions. The
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inputs for the valuation analysis of the derivatives include the probabilities of certain triggering events, which we believed to be unlikely as of June 30, 2005. A change in this probability and or a change in the market value of our common stock could have a significant impact on the results of our operations; however, there would not be any impact on our cash flows.
ITEM 4. CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
As required by Rule 13a-15(b) under the Securities Exchange Act of 1934, as amended, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Disclosure controls and procedures are designed to ensure that the information required to be disclosed in our reports which we file or submit under the Securities Exchange Act of 1934 is (i) accumulated and communicated to our management (including the Chief Executive Officer and Chief Financial Officer) as appropriate to allow timely decisions regarding required disclosures, and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Based upon this evaluation of the unremediated material weaknesses in internal control over financial reporting as disclosed in Item 9A of our Form 10-K for the year ended December 31, 2004, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were not effective as of the end of the period covered by this report.
The certifications of our principal executive officer and principal financial officer required in accordance with Section 302 of the Sarbanes-Oxley Act of 2002 are attached as exhibits to this Quarterly Report on Form 10-Q. The disclosures set forth in this Item 4 contain information concerning the evaluation of our disclosure controls and procedures and changes in internal control over financial reporting, referred to in the certifications. Those certifications should be read in conjunction with this Item 4 for a complete understanding of the matters covered by the certifications.
We have taken the remediation steps described in Item 9A of our 2004 10-K. In connection with the preparation of this Quarterly Report, our management undertook and completed reconciliations, analyses, reviews and control procedures in addition to those historically completed to confirm that this Quarterly Report fairly presents in all material aspects our financial position, results of operations and cash flows as of, and for, the period presented in accordance with U.S. generally accepted accounting principles.
Changes in Internal Control over Financial Reporting
There has been no change in internal control over financial reporting in the fiscal quarter ended June 30, 2005, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. We continue to develop a remediation plan to address the material weaknesses in our internal control over financial reporting. The development of our remediation plan is described Item 9A of our 2004 10-K. We expect that the implementation of this plan will extend through the rest of 2005 and beyond.
Inherent Limitations on Effectiveness of Controls
Our management, including the Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected.
PART II
OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
On March 17, 2003, a civil complaint for violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 was filed in the United States District Court for the Northern District of California, entitled Janice Whitkens v. VaxGen, Inc., et al., Civil Action No. C03-1129 JSW. Named, as defendants are VaxGen, Inc., Chief Executive Officer Lance K. Gordon and former President Donald P. Francis. The plaintiff seeks to represent a class of persons who purchased our securities between August 6, 2002 and February 26, 2003, and alleges that the defendants misled investors about the progress of certain clinical trials and our future manufacturing and marketing plans. Following the filing of the Whitkens complaint, several additional class action complaints were filed in the same court, each making identical or similar allegations against the same defendants. In May 2005, the United States District Court for the Northern District of California dismissed with prejudice this class action lawsuit.
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On or about March 21, 2003, two separate but virtually identical shareholder derivative actions were filed in California Superior Court for San Mateo County entitled Rhodes v. Allen, et al. civil action No. CIV 430087, and MacDonald v. Allen, et al., civil action No. CIV 430088. A consolidated complaint was filed in June 2003. Named as defendants in the action are VaxGen directors Lance K. Gordon, Randall L-W. Caudill, and William D. Young, and former VaxGen directors Donald P. Francis, Phillip W. Berman, David W. Beier, and Stephen C. Francis (“Company Directors”). Also named as defendants are Paul Allen and Vulcan Ventures, Inc. (“Vulcan Defendants”). The allegations of the consolidated complaint (“Derivative Lawsuit”) are similar to those contained in the class action, although unlike the class action, in the Derivative Lawsuit the plaintiff purports to seek recovery on behalf of VaxGen, rather than from VaxGen. Plaintiffs allege as well that the Vulcan Defendants sold shares of our stock while in possession of material non-public information about the Company. Plaintiffs, purportedly suing on behalf of VaxGen, assert claims against all defendants for breach of fiduciary duty, mismanagement, waste and unjust enrichment and against the Vulcan Defendants for breach of fiduciary duty and insider trading. As of June 30, 2005, we have provided $0.5 million for the settlement of these derivative actions. See Subsequent Events in Note 13 to the unaudited condensed financial statements.
ITEM 1A. RISK FACTORS
For the six months ended June 30, 2005, there has been no significant change to the identified risk factors filed in our Annual Report on Form 10-K for the year ended December 31, 2004 filed with the Securities and Exchange Commission on February 7, 2007, other than the addition of risk factors associated with the financing of our convertible notes in 2005 as well as the potential impact on our operating results of recently adopted changes in accounting for stock compensation plans, which are discussed below.
You should carefully consider the following risk factors as well as other information in our filings under the Exchange Act before making any investment decisions regarding our common stock. The risks and uncertainties described herein are not the only ones we face. Additional risks and uncertainties that we do not presently know or that we currently deem immaterial may also impair our business, financial condition, operating results and prospects. If events corresponding to any of these risks actually occur, they could materially adversely affect our business, financial condition, operating results or prospects. In that case, the trading price of our common stock could decline. When used in the report, unless otherwise indicated, “we,” “our” and “us” refers to VaxGen.
Risks Relating to Our Business
We do not have current financial statements and therefore you are not able to evaluate our current financial condition or operating history and results.
We have had to restate certain historical financial statements and have engaged our new independent registered public accounting firm to reaudit those financial statements. In July 2004, we announced that we were reauditing and restating our financial statements for the fiscal years ended December 31, 2003 and 2002 because we determined that we should recognize revenue from certain government contracts as costs were incurred, instead of after completing contract milestones. In October 2004, we announced that we would also be reauditing and restating our financial statements for the fiscal year ended December 31, 2001. In connection with the restatement of our financial statements for the fiscal year ended December 31, 2001, we also made adjustments to our balance sheet as of December 31, 2000.
Effective January 1, 2004, we are required to consolidate Celltrion’s financial statements into our own. Celltrion maintains its records in accordance with Korean accounting principles; however, we require financial statements that are prepared in accordance with GAAP and which have been audited in conformity with U.S. Auditing Standards. Celltrion’s internal controls over financial reporting may be insufficient to enable them to report their interim GAAP financial results to us on a timely basis. In addition, their independent registered public accounting firm could conclude that Celltrion’s internal controls over financial reporting are insufficient to enable the registered public accounting firm to complete their required annual audit of Celltrion’s GAAP financial statements in a timely fashion, if at all.
If we do not receive adequate timely financial reporting from Celltrion, we could continue to be delinquent in our filings required under Section 13 of the Exchange Act and we might not be able to maintain or file registration statements relating to shares of our common stock. If we are relisted and are unable to timely file periodic reports, we could again be delisted from Nasdaq. In addition, Celltrion’s failure to achieve and maintain an effective internal control environment for GAAP periodic financial reporting may also cause our investors to lose confidence in our filed financial statements, which could have a material adverse effect on the market price of our common stock.
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We are not currently listed on a national exchange, including the Nasdaq National Market or Nasdaq SmallCap Market, and cannot assure you we will ever be listed.
As a result of our failure to have current financial statements for the fiscal years ended December 31, 2003, 2002 and 2001, we were delisted from the Nasdaq, and our common stock is not currently listed on any other national stock exchange. Until we complete all necessary filings with the SEC pursuant to Sections 13 and 15(d) of the Exchange Act, we will not be able to apply for our common stock to be listed on a national exchange. We do not know when, if ever, this will be completed, and thus, whether our common stock will ever be listed. In addition, we cannot be certain that Nasdaq will approve our stock for relisting or that any other exchange will approve our stock for listing. In order to be eligible for relisting or listing, we must meet Nasdaq’s or any other exchange’s initial listing criteria, and we believe we will need to be in compliance with Sections 13 and 15(d) of the Exchange Act. Our common stock is currently quoted on the Pink Sheets, LLC.
We are not compliant with Section 404 under the Sarbanes-Oxley Act of 2002.
Section 404 under the Sarbanes-Oxley Act of 2002 requires that we perform an assessment of our internal controls over financial reporting, and engage our independent registered public accounting firm to perform an audit of our internal control over financial reporting. We were required to complete the assessment as to the adequacy of our internal control reporting as of December 31, 2004.
Given the focus on completing and filing our financial statements, we did not have sufficient time nor did we provide sufficient time to our independent registered public accounting firm to complete our and their respective responsibilities before December 31, 2004. Our independent registered public accounting firm concluded that we failed to complete the required assessment as to the effectiveness of our internal controls over financial reporting, and they were unable to complete their required audit of internal control over financial reporting. Accordingly, they disclaimed an opinion as to the effectiveness of our internal control over financial reporting for 2004.
We do not believe that the SEC has provided guidance as to the effect of such a disclaimer. Having received such a disclaimer, our Annual Report on Form 10-K for the year ended December 31, 2004, may be deemed to be deficient by the SEC. If our 2004 10-K were deemed to be deficient, the SEC may conclude that we are in violation of Sections 13 and 15(d) of the Exchange Act.
We are currently ineligible to register securities with the SEC, and we may never regain compliance.
Until we have filed current financial statements and made all the necessary filings with the SEC pursuant to Sections 13 and 15(d) of the Exchange Act, we will not be able to register any securities for re-sale. Until we are able to register securities with the SEC for resale, any purchasers who purchase our common stock or other securities directly from us, will have to rely on an exemption from the federal and state securities laws in order to resell their securities. We cannot estimate when, if ever, we will have, completed the restatement of our 2001 through 2003 financial statements, filed amended and outstanding reports and regained compliance with Sections 13 and 15(d) of the Exchange Act.
Our internal controls may be insufficient to ensure timely and reliable financial information.
In response to a letter the Audit Committee of our Board of Directors received from our current independent registered public accounting firm regarding material weaknesses in the effectiveness of our internal control over financial reporting, we believe we need to correct deficiencies in our internal controls and procedures for financial reporting. These deficiencies include inadequate controls and procedures relating to revenue recognition for government contracts, account reconciliations, segregation of duties, journal entries, accounting for investments in affiliates, accounting for equity securities and derivatives, accounting for stock-based compensation, cut-off procedures and depth of accounting knowledge.
Failure to address these deficiencies in a timely manner might increase the risk of future financial reporting misstatements and may prevent us from being able to meet our filing deadlines. Under the supervision of our Audit Committee, we are continuing the process of identifying and implementing corrective actions where required to improve the design and effectiveness of our internal controls, including the enhancement of systems and procedures. Significant additional resources will be required to establish and maintain appropriate controls and procedures and to prepare the required financial and other information during this process.
Even after corrective actions are implemented, the effectiveness of our controls and procedures may be limited by a variety of risks including:
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| • | faulty human judgment and simple errors, omissions or mistakes; |
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| • | collusion of two or more people; |
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| • | inappropriate management override of procedures; and |
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| • | the risk that enhanced controls and procedures may still not be adequate to assure timely and reliable financial information. |
If we fail to have effective internal controls and procedures for financial reporting in place, we could be unable to provide timely and reliable financial information. Additionally, if we fail to have effective internal controls and procedures for financial reporting in place, it could adversely affect our financial reporting requirements under our government contracts.
We will need to raise additional capital, and any inability to raise required funds could harm our business.
We will need to raise substantial additional capital in order to satisfy the requirements under the SNS Contract for acceptance of our anthrax vaccine and to continue operations. We may attempt to raise these funds through equity or debt financings, collaborative arrangements with corporate partners or from other sources, including notes exchangeable into all or a portion of our interest in Celltrion prior to an initial public offering by Celltrion, or through the sale of our Celltrion stock after an initial public offering by Celltrion.
If additional funds are raised through the issuance of preferred equity or debt securities, these securities could have rights, preferences and privileges senior or otherwise superior to those of the shares of our common shares, and debt financings will likely involve covenants restricting our business activities. Any sale of additional equity or convertible debt securities will be dilutive to existing stockholders. We cannot guarantee you that additional funds will be available on acceptable terms, or at all. If we are unable to raise additional capital when necessary, we may be required to relinquish our rights to certain key technologies, vaccine candidates or marketing territories under the terms of certain of our collaborative agreements. Furthermore, if we are unable to raise additional capital when necessary, we may be unable to perform under our existing contracts, we may default on our contracts, our contracts may be terminated and we may not be able to secure new contracts.
We will need to amend our Amended and Restated Certificate of Incorporation in order to increase the amount of our authorized common stock.
As of February 28, 2005, we had 29,606,523 shares of common stock outstanding, and outstanding options and warrants exercisable for 5,701,855 shares of common stock, and 472,356 shares of our common stock reserved for future issuance under our 2001 Employee Stock Purchase Plan. We will have only 4,219,266 shares of common stock authorized and available for issuance under our Amended and Restated Certificate of Incorporation (“Restated Certificate”). We will need to increase the amount of shares of common stock available for issuance pursuant to our Restated Certificate. In order to amend and restate our Restated Certificate, we will be required to receive the approval of our stockholders, which we intend to seek at our next annual meeting of stockholders. In order to hold our annual meeting of stockholders we must have a quorum of the voting power of our outstanding common stock either present at the meeting, or through proxy. However, we cannot solicit proxies from our stockholders for an annual meeting because we are delinquent in our periodic filing requirements under the Exchange Act. We will be delayed in holding our annual meeting of stockholders because we would not likely be able to have a quorum of the voting power of our outstanding common stock attend our annual meeting of stockholders in person. Once we hold our next annual meeting or a special meeting of stockholders, if our stockholders do not approve the amendment of the Restated Certificate, we will be limited in our ability to pursue equity financing in the future. If our stockholders approve an increase to the amount of common stock authorized for issuance, and we do issue additional shares of common stock, our stockholders equity will be diluted.
Our operating results may be adversely impacted by recently adopted changes in accounting for stock options.
FAS123R, which we will implement effective January 1, 2006, requires all share-based payments to employees, including grants of employee stock options, to be recognized in the statement of operations based on their fair values. Accordingly, the adoption of FAS 123R’s fair value method will have a significant impact on our results of operations. The impact of adoption of FAS 123R cannot be predicted at this time because it will depend on levels of share-based payments granted in the future and the valuation model we ultimately select. We plan to use the Black-Scholes option pricing model allowed under FAS 123R.
If we fail to meet our obligations under the Convertible Notes, our payment obligations may be accelerated.
In April 2005, we raised gross proceeds of $31.5 million through a private placement of 5 1/2% Convertible Senior Subordinated Notes (“Notes”) due April 1, 2010. The Notes have the following features:
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| • | require semi-annual payment of interest in cash at a rate of 5 1/2%; |
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| • | convert, at the option of the holder, into shares of our common stock at an initial conversion price of approximately $14.76 per share subject to adjustment; |
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| • | convert, at our option, into common stock if our common stock reaches a market price of $22.14 per share; |
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| • | will be provisionally redeemable at our option in cash upon the occurrence of certain circumstances, including among others, that the closing price of VaxGen common stock exceeds approximately $22.14 per share subject to adjustment, for at least 20 trading days within a period of 30 consecutive trading days; and |
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| • | constitute senior subordinated obligations. |
Under the terms of the Notes, if certain events occur, including, without limitation, our failure to pay any installment of principal or interest due under the Notes, then the holders may, among other things, elect to accelerate our obligations under the Notes and declare the outstanding principal balance of the Notes and accrued but unpaid interest thereon immediately due and payable. In the event that the holders declare the Notes immediately due and payable or seek to foreclose on any of our assets, it would have a material adverse effect on our financial position and we may not have sufficient cash to satisfy our obligation.
If we fail to cause a registration statement to be declared effective in accordance with the timetable set forth in the Notes, or in accordance with agreements we have made in connection with private placements of our common stock, we will be subject to liquidated damages or liability for breach of contract.
We agreed to register under the Securities Act shares of our common stock issuable upon conversion of the Notes, as well as shares issued or issuable in private placements of our common stock. We have agreed to file registration statements for these shares within 30 days following the first date we become current in our reporting requirements under the Exchange Act, and to use our best efforts to cause the registration statements to become effective in no event later than 120 days after the filing of such registration statements. We have also made other customary agreements regarding such registrations, including matters relating to indemnification, maintenance of the registration statements, payment of expenses and compliance with state “blue sky” laws. We may be liable for liquidated damages to each Note holder and purchaser in the private placements (a) if the registration statements are not filed on or prior to 30 days of becoming current in our reporting requirements; (b) if the registration statements are not declared effective by the SEC on or prior to 120 days from filing; or (c) if the registration statements (after being declared effective) cease to be effective in a manner that violates such agreements (collectively “Registration Default”).
In the event of a Registration Default, we may be required to pay liquidated damages. Should we become obligated to make payment of these liquidated damages, it could have a material adverse effect on our financial position and our results of operations, particularly if we become obligated to make a payment in full for all liquidated damages potentially due and payable under these agreements.
Our indebtedness could adversely affect our financial health, limit our cash flow available to invest in the ongoing requirements of our business and adversely affect the price of our common stock.
Our existing indebtedness consists of $31.5 million in convertible notes. This indebtedness, and any future indebtedness we may incur, could have important consequences, including the following:
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| • | making it more difficult for us to satisfy our financial and payment obligations, or to refinance maturing indebtedness; |
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| • | making us more vulnerable to a downturn in the economy or our business; |
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| • | limiting our ability to obtain additional financing in the future for working capital, capital expenditures, acquisitions and other general corporate purposes; |
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| • | requiring application of a significant portion of our cash flow from operations to the payment of debt service costs, which would reduce the funds available to us for our operations; |
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| • | limiting our flexibility in planning for, or reacting to, changes in our industry, business and markets; and |
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| • | placing us at a competitive disadvantage to the extent we are more highly leveraged than some of our competitors. |
We may incur significant additional indebtedness in the future to fund our continued operations or future acquisitions. To the extent new debt is added to our current debt levels, the substantial leverage risks described above would increase. We may be required to repurchase the notes if certain change in control events occur.
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We may fail to fulfill our obligations under our contract to supply the Strategic National Stockpile (“SNS”) of anthrax vaccines to the U.S. government, and we may be unable to commercialize our vaccine candidates.
The U.S. government has undertaken commitments to help secure improved countermeasures against bioterrorism, including the stockpiling of vaccines for anthrax and smallpox. On November 4, 2004, we were awarded the SNS Contract to supply the U.S. government with up to 75 million doses of our anthrax vaccine candidate over five years. We expect to substantially increase our employee base to fulfill certain obligations under the SNS Contract. There is no guarantee that we will be able to find and hire suitable employees or that we will be able to integrate them into our operation properly so as to enable us to fulfill the obligations under the SNS Contract. If we fail to fulfill certain obligations under the SNS Contract, the government may terminate the SNS Contract with us. In addition, the U.S. government may terminate any government contract awarded to us for its convenience at any time.
The government’s determination to award the SNS Contract to us may be challenged by an interested party, such as another bidder, at the General Accounting Office or in federal court.
The laws and regulations governing the procurement of goods and services by the U.S. government provide procedures by which other bidders and other interested parties may challenge the award of a government contract. Given the high dollar value of the SNS Contract, such protests could be filed even if there are not any valid legal grounds on which to base the protest. If any such protests are filed, the government agency may decide to suspend our performance under the contract while such protests are being considered by the General Accounting Office or the applicable federal court, thus potentially delaying delivery of and payment for the vaccines. In addition, we may be forced to expend considerable funds to defend the award. If a protest is successful, the government may be ordered to terminate our contract for its convenience and resolicit bids. The government could even be directed to award the contract to one of the other bidders. The loss of the SNS Contract would make it difficult for us to generate sufficient revenue to continue operations or commercialize our anthrax vaccine.
The U.S. Congress may instigate an investigation into the award of the SNS Contract to us.
Senator Charles Grassley, Chairman of the U.S. Senate Finance Committee, sent a letter to the Department of Health and Human Services (“HHS”) on January 28, 2005 requesting information about the SNS Contract and its award to us. The letter alleges that HHS may have acted prematurely in awarding the SNS Contract to us. There can be no assurance that Senator Grassley or the U.S. Senate Finance Committee or other Congressional committees will not pursue an inquiry into the award of the SNS Contract. Such an inquiry, if it were initiated, could include public hearings that could lead to negative publicity, a change to the SNS Contract, and an adverse effect on the value of our common stock.
The award of the SNS Contract does not mean there will be any future contracts awarded.
The award of one government contract does not necessarily secure the award of future contracts covering the same vaccine. By law, the U.S. government must usually seek competition when procuring goods and services. In addition, if we do not perform in accordance with the terms of the SNS Contract, we may receive a poor performance report which would be considered in making any future awards, thus making it more difficult for us to win the award of such future contracts. Accordingly, we cannot be certain that we will be awarded any future contracts to supply a government stockpile of anthrax vaccine. It is possible that future awards to provide the U.S. government with emergency stockpiles of anthrax vaccine will be granted solely to another supplier. If the U.S. government makes significant future contract awards for the supply of its emergency stockpile to our competitors, such as Avecia, our business will be harmed and it is unlikely that we will be able to ultimately commercialize that particular vaccine. In addition, the determination of when and whether a product is ready for large scale purchase and potential use will be made by the government through consultation with a number of governmental agencies, including the Food and Drug Administration (“FDA”), the National Institutes of Health (“NIH”), the Centers for Disease Control (“CDC”) and the Department of Homeland Security. President Bush has proposed, and Congress is considering, measures to accelerate the development of biodefense products through NIH funding, the review process by the FDA and the final government procurement contracting authority. While this may help speed the approval of our vaccine candidates, it may also encourage competitors to develop their own vaccine candidates. If competitive vaccine candidates gain approval, we could face severe competition, which could harm our business.
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If the U.S. government fails to continue funding our anthrax vaccine candidate development efforts or fails to purchase sufficient quantities of any future biodefense vaccine candidate, we may be unable to generate sufficient revenues to continue operations.
We have received funding from the U.S. government for the development of our anthrax vaccine candidate. Changes in government budgets and agendas may result in future funding being decreased and de-prioritized, and government contracts typically contain provisions that permit cancellation in the event that funds are unavailable to the governmental agency. Furthermore, we cannot be certain of the timing of any future funding, and substantial delays or cancellations of funding could also result from protests or challenges from third parties or for other reasons. If the U.S. government fails to continue to adequately fund our research and development programs, we may be unable to generate sufficient revenues to continue operations. Similarly, if we develop an anthrax vaccine candidate that is approved by the FDA, but the U.S. government does not place sufficient orders for this product, our future business will be harmed.
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We may encounter difficulties managing the change and growth of our operations, which could adversely affect our business.
We have experienced a period of rapid change in our business as a result of increased emphasis on biodefense opportunities. In addition, we expect to experience substantial growth in 2005 in manufacturing, quality systems, clinical and regulatory functions associated with our SNS Contract. This change and growth in our business has strained and may continue to strain our administrative, financial and operational functions. We will need to, among other things, expand our staff and improve our systems and procedures to manage our expected growth and to maintain an adequate system of internal controls. Furthermore we will have to increase our capital expenditures in order to fulfill certain obligations under the SNS Contract, far in excess of what we have done in the past. As a result of a rapid increase in hiring employees and increased capital expenditures our operating budgets are significantly greater that they have been in the past. If we are unable to manage the change and growth of our business effectively, we may be unable to obtain future government contracts and our results of operations and financial condition will be adversely affected.
U.S. government agencies have special contracting requirements, which create additional risks.
We have entered into contracts with NIAID and a license agreement with USAMRIID, which are U.S. government agencies. Substantially all of our revenue is derived from government contracts and grants. In contracting with government agencies, we are subject to various U.S. government agency contract requirements. Future sales to U.S. government agencies will depend, in part, on our ability to meet U.S. government agency contract requirements, certain of which we may not be able to satisfy.
U.S. government contracts typically contain unfavorable termination provisions and are subject to audit and modification by the government at its sole discretion, which subjects us to additional risks. These risks include the ability of the U.S. government to unilaterally:
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| • | suspend or prevent us for a set period of time from receiving new contracts or extending existing contracts based on violations or suspected violations of laws or regulations; |
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| • | terminate our existing contracts; |
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| • | reduce the scope and value of our existing contracts; |
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| • | audit and object to our contract-related costs and fees, including allocated indirect costs; |
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| • | control and potentially prohibit the export of our products; and |
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| • | change certain terms, conditions and requirements of our contracts. |
The U.S. government may terminate any of its contracts with us either for its convenience or if we default by failing to perform in accordance with the contract schedule and terms. Termination for convenience provisions generally enable us to recover only our costs incurred or committed, and settlement expenses and profit on the work completed prior to termination. Termination for default provisions do not permit these recoveries and may make us liable for excess costs incurred by the U.S. government in procuring undelivered items from another source.
As a U.S. government contractor, we are required to comply with applicable laws, regulations and standards relating to our accounting practices and are subject to periodic audits and reviews. As part of any such audit or review, the U.S. government may review the adequacy of, and our compliance with, our internal control systems and policies, including those relating to our purchasing, property, estimating, compensation and management information systems. Based on the results of its audits, the U.S. government may adjust our contract-related costs and fees, including allocated indirect costs. In addition, if an audit or review uncovers any improper or illegal activity, we may be subject to civil and criminal penalties and administrative sanctions, including termination of our contracts, forfeiture of profits, suspension of payments, fines and suspension or prohibition from doing business with the U.S. government. We could also suffer serious harm to our reputation if allegations of impropriety were made against us. Although adjustments arising from government audits and reviews have not seriously harmed our business in the past, future audits and reviews could cause adverse effects. In addition, under U.S. government purchasing regulations, some of our costs, including most financing costs, amortization of intangible assets, portions of our research and development costs, and some marketing expenses, may not be reimbursable or allowed under our contracts. Further, as a U.S. government contractor, we are subject to an increased risk of investigations, criminal prosecution, civil fraud, whistleblower lawsuits and other legal actions and liabilities to which purely private sector companies are not.
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In addition, the license agreement provides that USAMRIID reserves the right to require us and our affiliates to grant a nonexclusive, partially exclusive, or exclusive sublicense in any field of use to a responsible applicant, upon terms that are reasonable under the circumstances and under applicable law, to fulfill public health or safety needs.
Government contracts are subject to competitive bidding.
We obtain all of our government contracts through a competitive bidding process. We cannot assure you that we will continue to win competitively awarded contracts or that awarded contracts will generate revenues sufficient to result in profits. We are also subject to risks associated with:
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| • | the frequent need to bid on programs in advance of the completion of their design, which may result in unforeseen technological difficulties and/or cost overruns; and |
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| • | the substantial time and effort, including design and development activities, required to prepare bids and proposals for contracts that may not be awarded to us. |
Our fixed price and cost plus contracts may commit us to unfavorable terms.
We provide our products and services primarily through fixed price and cost plus contracts. In a fixed price contract, we must fully absorb our cost overruns, notwithstanding the difficulty of estimating costs that are related to performance in accordance with contract specifications. The failure to anticipate technical problems, estimate costs accurately or control costs during performance of a fixed price contract may reduce the profitability of a fixed price contract or cause a loss.
We license our vaccine candidates from third parties. If we fail to perform our obligations under these license agreements, we could lose our ability to develop and commercialize our vaccine candidates.
We license our anthrax vaccine candidate from USAMRIID and we license our smallpox vaccine candidate from Kaketsuken. Each of these license agreements requires that we perform certain obligations. If we fail to comply with our obligations under these agreements in a timely fashion, our licensors could terminate our rights to develop and commercialize our anthrax and smallpox vaccine candidates, which would adversely affect our business and prospects.
Our license agreement with Kaketsuken for our smallpox vaccine candidate may restrict our ability to develop and commercialize other smallpox vaccine products.
For a period of five years after the termination of the LC16m8 Agreement, we may not, without Kaketsuken’s prior written consent, file for or obtain regulatory approval, sell and or otherwise deal in any product potentially in competition with LC16m8. During the term of the LC16m8 Agreement, we may not, without the prior written consent of Kaketsuken, develop, sell, commercialize and/or otherwise deal in any products which may compete with LC16m8. These restrictions will be waived if the LC16m8 Agreement is terminated due to Kaketsuken’s uncured material breach of the LC16m8 Agreement or the FDA determines that LC16m8 is not approvable in the United States. These restrictions may adversely affect our ability to pursue attractive business opportunities.
Our suppliers may fail to provide, or may be delayed in providing, us with the necessary materials to produce our vaccine candidates.
We rely on suppliers to provide us with the necessary materials to produce our vaccine candidates. Any significant delays in obtaining any of these materials from our suppliers could cause us to fail to perform under our contracts, which may cause us to be in breach under those contracts and cause those contracts to be terminated. We cannot assure you that we will not face shortages from one or more of these subcontractors in the future.
Our subcontractors may fail to perform, or may be delayed in performing, certain tasks related to our ability to provide our vaccine candidates to the government under our contracts.
We rely on subcontractors to perform certain tasks related to our fulfilling the requirements of our contracts. In particular, to fulfill our obligations under the SNS Contract, we will provide bulk quantities of our anthrax vaccine candidate to subcontractors and our subcontractors will fill sterile individual-use syringes for delivery to the U.S. government. The processes and procedures used by our subcontractors in performing these tasks must be validated and approved by the U.S. government as compliant with applicable legal requirements, including the FDA’s cGMP regulations. Any significant delays in performing these tasks by our subcontractors, or a failure to perform them in compliance with applicable FDA or other governmental regulations, could cause us to fail to perform under our contracts, which may cause us to be in breach under those contracts and cause those contracts to be terminated. We cannot assure you that one or more of these subcontractors will not be delayed in performing, or fail to perform their obligations under these contracts in compliance with applicable legal requirements.
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We have only a limited operating history and we expect to continue to generate losses.
Developing our product candidates will require significant additional research and development, including non-clinical testing and clinical trials, as well as regulatory approval. We expect these activities, together with our general and administrative expenses, to result in operating losses for the foreseeable future. Our ability to achieve profitability will depend, in part, on our ability to procure future contracts to supply the anthrax and smallpox vaccines to the U.S. government, to successfully complete development of our proposed products, to obtain required regulatory approvals and to manufacture and market our products directly or through business partners. We cannot assure you that we will be able to accomplish any of these objectives.
Vaccine development is a long, expensive and uncertain process and the approval requirements for vaccines used to fight bioterrorism are still evolving. If we are unable to successfully develop and test our vaccine candidates in accordance with these requirements, our business will suffer.
We are subject to rigorous and extensive regulation by the FDA and comparable foreign regulatory authorities. In the United States, our vaccine candidates for anthrax and smallpox are regulated by the FDA as biological drug products, known as biologics. In order to obtain approval from the FDA to market our vaccine candidates, we will be required to submit to the FDA a Biologics License Application (“BLA”), which must include both preclinical and clinical trial data as prescribed by the FDA’s current regulatory criteria for vaccines such as our product candidates, as well as extensive data regarding the manufacturing procedures and processes for the vaccine candidates. Ordinarily, the FDA requires a sponsor to support a BLA application with substantial evidence of the product’s safety and effectiveness in treating the targeted indication based on data derived from adequate and well-controlled clinical trials, including Phase 3 effectiveness trials conducted in patients with the disease or condition being targeted. Because humans are not normally exposed to anthrax or smallpox, statistically significant effectiveness of our biodefense product candidates cannot be demonstrated in humans, but instead must be demonstrated, in part, by utilizing animal models before they can be approved for commercial sale. We believe that, according to the FDA’s current BLA requirements for certain biologics that cannot be feasibly or ethically tested in humans in Phase 3 efficacy studies, we may instead be able to obtain BLA approval based on clinical data from Phase 2 and Phase 3 trials in healthy subjects that demonstrate adequate safety and immune response and effectiveness data from studies in animals. Specifically, we intend to pursue FDA approval of our anthrax and smallpox vaccine candidates under requirements published by the FDA in 2002 that allow the FDA to approve certain vaccines used to reduce or prevent the toxicity of chemical, biological, radiological or nuclear substances based on human clinical data to demonstrate safety and immune response, and evidence of effectiveness derived from appropriate pre-clinical studies and any additional supporting data. We cannot predict whether we will obtain regulatory approval for any of our product candidates pursuant to these provisions, or at all. We may fail to obtain approval from the FDA or foreign regulatory authorities, or experience delays in obtaining such approvals, due to varying interpretations of data or failure to satisfy current safety, efficacy, and quality control requirements. Further, our business is subject to substantial risk because the FDA’s current policies governing biodefense vaccines may change suddenly and unpredictably and in ways that could impair our ability to obtain regulatory approval of these products, and we cannot guarantee that the FDA will approve our anthrax and smallpox vaccines.
Delays in successfully completing our clinical trials could jeopardize our ability to obtain regulatory approval or market our vaccine candidates on a timely basis.
Our business prospects will depend on our ability to complete patient enrollment in clinical trials, to obtain satisfactory results, to obtain required regulatory approvals and to successfully commercialize our vaccine candidates. Completion of our clinical trials, announcement of results of the trials and our ability to obtain regulatory approvals could be delayed for a variety of reasons, including:
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| • | slower-than-anticipated enrollment of volunteers in the trials; |
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| • | lower-than-anticipated recruitment or retention rate of volunteers in the trials; |
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| • | serious adverse events related to the vaccine candidates; |
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| • | unsatisfactory results of any clinical trial; |
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| • | the failure of our principal third-party investigators to perform our clinical trials on our anticipated schedules; or |
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| • | different interpretations of our preclinical and clinical data, which could initially lead to inconclusive results. |
Our development costs will increase if we have material delays in any clinical trial or if we need to perform more or larger clinical trials than planned. If the delays are significant, or if any of our vaccine candidates do not prove to be safe or effective or do not receive required regulatory approvals, our financial results and the commercial prospects for our product candidates will be harmed. Furthermore, our inability to complete our clinical trials in a timely manner could jeopardize our ability to obtain regulatory approval.
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The independent clinical investigators that we rely upon to conduct our clinical trials may not be diligent, careful or timely, and may make mistakes in the conduct of our clinical trials.
We depend on independent clinical investigators to conduct our clinical trials. The investigators are not our employees, and we cannot control the amount or timing of resources that they devote to our vaccine development programs. If independent investigators fail to devote sufficient time and resources to our vaccine development programs, or if their performance is substandard, it may delay FDA approval of our vaccine candidates. These independent investigators may also have relationships with other commercial entities, some of which may compete with us. If these independent investigators assist our competitors at our expense, it could harm our competitive position.
The approval requirements for vaccines used to fight bioterrorism are still evolving, and we cannot be certain that any vaccines we develop, if effective, would meet these requirements.
We are developing product candidates based upon current governmental policies regulating these vaccines. For instance, we intend to pursue FDA approval of our anthrax and smallpox vaccine candidates under requirements published by the FDA in 2002 that allow the FDA to approve certain vaccines used to reduce or prevent the toxicity of chemical, biological, radiological or nuclear substances based on human clinical data to demonstrate safety and immune response, and evidence of effectiveness derived from appropriate animal studies and any additional supporting data. Our business is subject to substantial risk because these policies may change suddenly and unpredictably and in ways that could impair our ability to obtain regulatory approval of these products, and we cannot guarantee that the FDA will approve our anthrax and smallpox vaccines.
If we fail to comply with extensive regulations enforced by domestic and foreign regulatory authorities, the commercialization of our product candidates could be prevented or delayed.
Vaccine candidates are subject to extensive government regulations related to development, testing, manufacturing and commercialization in the United States and other countries. Our vaccine candidates are in the preclinical and clinical stages of development and have not received required regulatory approval from the FDA to be commercially marketed and sold. With the exception of LC16m8, which was licensed and sold in Japan, our vaccine candidates have not received required regulatory approval from foreign regulatory agencies to be commercially marketed and sold. The process of obtaining and complying with FDA, other governmental and foreign regulatory approvals and regulations is costly, time consuming, uncertain and subject to unanticipated delays. Despite the time and expense exerted, regulatory approval is never guaranteed.
We also are subject to the following risks and obligations, among others:
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| • | the FDA or foreign regulators may refuse to approve an application if they believe that applicable regulatory criteria are not satisfied; |
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| • | the FDA or foreign regulators may require additional testing for safety and effectiveness; |
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| • | the FDA or foreign regulators may interpret data from preclinical testing and clinical trials in different ways than we interpret them; |
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| • | If regulatory approval of a product is granted, the approval may be limited to specific indications or limited with respect to its distribution. In addition, many foreign countries control pricing and coverage under their respective national social security systems; |
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| • | the FDA or foreign regulators may not approve our manufacturing processes or manufacturing facilities; |
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| • | the FDA or foreign regulators may change their approval policies or adopt new regulations; |
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| • | even if regulatory approval for any product is obtained, the marketing license will be subject to continual review, and newly discovered or developed safety or effectiveness data may result in suspension or revocation of the marketing license; |
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| • | if regulatory approval of the vaccine candidate is granted, the marketing of that vaccine would be subject to adverse event reporting requirements and a general prohibition against promoting products for unapproved or “off-label” uses; |
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| • | in some foreign countries, we may be subject to official release requirements that require each batch of the vaccine we produce to be officially released by regulatory authorities prior to its distribution by us; and |
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| • | we will be subject to continual regulatory review and periodic inspection and approval of manufacturing modifications, including compliance with cGMP regulations. |
Failure to comply with these or other regulatory requirements of the FDA and other applicable foreign regulatory bodies may subject us to administrative or judicially imposed sanctions, including:
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| • | warning letters; |
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| • | civil penalties; |
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| • | criminal penalties; |
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| • | injunctions; |
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| • | product seizure or detention; |
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| • | product recalls; |
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| • | total or partial suspension of production; and |
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| • | suspension or revocation of the marketing license. |
We and our subcontractors are subject to ongoing regulatory review and periodic inspection and approval of manufacturing procedures and operations, including compliance with cGMP regulations.
The manufacturing methods, equipment and processes used by us and our subcontractors must comply with the FDA’s cGMP (current Good Manufacturing Practices) regulations. The cGMP requirements govern, among other things, recordkeeping, production processes and controls, personnel and quality control. The FDA must approve the facilities used to manufacture our products before they can be used to commercially manufacture our vaccine products or commence deliveries under the SNS Contract, and these facilities are subject to ongoing and periodic inspections. If we or our subcontractors fail to comply with the cGMP requirements, or fail to pass a pre-approval inspection of our manufacturing facility in connection with the SNS Contract, we may not receive regulatory approval, and we would be subject to possible judicial or administrative sanctions. In addition, preparing a manufacturing facility for commercial manufacturing may involve unanticipated delays and the costs of complying with the cGMP regulations may be significant. Any material changes we make to our manufacturing processes after we obtain approval of a product may require approval by the FDA, state or foreign regulatory authorities.
Our product development efforts may not yield marketable products due to results of studies or trials, failure to achieve regulatory approvals or market acceptance, proprietary rights of others or manufacturing issues.
Our success depends on our ability to successfully develop and obtain regulatory approval to market new biopharmaceutical products. We expect that a significant portion of the research that we will conduct will involve new and unproven technologies. Development of a product requires substantial technical, financial and human resources even if the product is not successfully completed.
Our potential products may appear to be promising at various stages of development yet fail to reach the market for a number of reasons, including the:
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| • | lack of adequate quality or sufficient prevention benefit, or unacceptable safety during preclinical studies or clinical trials; |
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| • | failure to receive necessary regulatory approvals; |
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| • | existence of proprietary rights of third parties; or |
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| • | inability to develop manufacturing methods that are efficient, cost-effective and capable of meeting stringent regulatory standards. |
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Political or social factors may delay or impair our ability to market our vaccine products.
Products developed to treat diseases caused by or to combat the threat of bioterrorism will be subject to changing political and social environments. The political and social responses to bioterrorism have been highly charged and unpredictable. Political or social pressures may delay or cause resistance to bringing our products to market or limit pricing of our products, which would harm our business.
We may fail to protect our intellectual property or may infringe on the intellectual property rights of others, either of which could harm our business.
If we are unable to protect our intellectual property, we may be unable to prevent other companies from using our technology in competitive products. If we infringe on the intellectual property rights of others, we may be prevented from developing or marketing our product candidates. Given the rights retained and licenses granted to the U.S. government in regard to our anthrax vaccine, to the extent that the U.S. government or foreign governments or organizations procuring vaccines through treaties or agreements with the U.S. government constitute the primary market for any of our products, the licenses granted by the U.S. government will not provide us with a competitive advantage.
In addition, under our U.S. government contracts, we have a duty to disclose each invention that we conceive or reduce to practice in performing the agreement, and if we wish to retain title to such invention, we must affirmatively elect to do so. If we fail to strictly follow these disclosure requirements, the U.S. government could take title to such inventions and preclude us from using them. For each invention to which we retain title, the U.S. government has both a worldwide, irrevocable, royalty-free license to practice or have practiced such invention on behalf of the U.S. government, and certain “march-in” rights pursuant to which the U.S. government could require us to license the invention that we own to third parties, including our competitors.
Our technology, including technology licensed from Kaketsuken and USAMRIID, or technology that we may license in the future, if any, will be protected from unauthorized use by others only to the extent that it is covered by valid and enforceable patents or effectively maintained as trade secrets. Accordingly, we cannot predict the scope and breadth of patent claims that may be afforded to other companies’ patents. In addition, we could incur substantial costs in litigation if we are required to defend against patent suits brought by third parties, or if we initiate these suits.
The degree of future protection for our proprietary rights is uncertain, and we cannot ensure that:
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| • | others will not independently develop similar or alternative technologies or duplicate any of our technologies; |
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| • | any patents issued to us or licensed from Genentech, USAMRIID or other parties, or that we may license in the future, if any, will provide a basis for commercially viable products or will provide us with any competitive advantages or will not be challenged by third parties; |
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| • | we or any of our current or future licensors will adequately protect trade secrets; |
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| • | we will develop additional proprietary technologies that are patentable; or |
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| • | the patents of others will not have a material adverse effect on our business. |
We cannot be certain that patents issued to us in the future, if any, or patents that we have licensed from Genentech, Kaketsuken and USAMRIID, or that we may license in the future, if any, will be enforceable and afford protection against competitors. In this regard, the U.S. government has the right to use, for or on behalf of the U.S. government, any technologies developed by us under our U.S. government contracts and we cannot prohibit third parties, including our competitors, from using those technologies in providing products and services to the U.S. government. Accordingly, under our license agreement with USAMRIID granting us an exclusive license to commercialize the anthrax vaccine, the U.S. government retains a license for any federal government agency to practice and have practiced USAMRIID’s anthrax-related inventions, by or on behalf of the government, thereby allowing the use of the inventions in support of government contracts with other parties, including our competitors. In addition, we cannot assure you that our operations or technology will not infringe intellectual property rights of others. If we infringe the intellectual property of others, there can be no assurance that we would be able to obtain licenses to use the technology on commercially reasonable terms or at all.
Our Korean manufacturing joint venture may not be successful.
Celltrion has not yet completed its full capitalization. Two of the existing investors in Celltrion have failed to meet a total of $6.3 million in funding obligations. Celltrion will be unable to validate and operate the manufacturing facility in the Republic of Korea if Celltrion is unable to secure or raise the necessary funding or does not receive the necessary technology for the manufacture of mammalian cell culture or other biopharmaceutical products.
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Even if Celltrion successfully completes the construction of its Korean manufacturing facility, we cannot be certain that the facility will pass domestic or foreign regulatory approvals or be able to manufacture mammalian cell culture products in commercial quantities on a cost-effective basis or at all. In addition, it is uncertain whether there will be sufficient demand for mammalian cell culture biomanufacturing to make this facility profitable.
In addition, the political, social and economic situation in the Republic of Korea, and the stability of the Korean peninsula as a whole, may not provide an environment in which Celltrion would be able to manufacture products cost-efficiently or at all. The Korean government may impose regulations or restrictions that would make it difficult, impractical or impossible, whether economically, legally or otherwise, for Celltrion to conduct its business there. Celltrion’s manufacturing operations may expose our business to numerous risks inherent in international operations including:
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| • | foreign currency controls; |
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| • | currency fluctuations; |
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| • | trade restrictions or changes in tariffs; |
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| • | the difficulties associated with staffing and managing international operations; |
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| • | generally longer receivables collection periods; |
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| • | potentially limited protection for intellectual property rights; |
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| • | potentially adverse taxes; and |
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| • | international conflict and war. |
If Celltrion is unable to manufacture mammalian cell culture products, or if it becomes commercially impractical for Celltrion to manufacture such products, we may not gain financial or other benefit from the joint venture.
We face competition from several companies with greater financial, personnel and research and development resources than ours.
Our competitors are developing vaccine candidates for anthrax and smallpox, which could compete with the vaccine candidates we are developing. Our commercial opportunities will be reduced or eliminated if our competitors develop and market products for any of the diseases that we target that:
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| • | are more effective; |
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| • | have fewer or less severe adverse side effects; |
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| • | are better tolerated; |
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| • | are more adaptable to various modes of dosing; |
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| • | are easier to administer; or |
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| • | are less expensive than the products or product candidates we are developing. |
Even if we are successful in developing effective vaccine products, and obtain FDA and other regulatory approvals necessary for commercializing them, our products may not compete effectively with other successful products. Researchers are continually learning more about diseases, which may lead to new technologies for treatment. Our competitors may succeed in developing and marketing products either that are more effective than those that we may develop, alone or with our collaborators, or that are marketed before any products we develop are marketed.
Our competitors include fully integrated pharmaceutical companies and biotechnology companies that currently have drug and target discovery efforts, as well as universities and public and private research institutions. For instance, Avecia, in collaboration with Baxter Healthcare Corp. and the United Kingdom’s Defense Science and Technology Laboratory, was recently awarded a $71.3 million cost reimbursement plus fixed fee contract by NIAID to make three million doses of an anthrax vaccine for the U.S. government. Many of the organizations competing with us, including Avecia, may have substantially greater capital resources, larger research and development staffs and facilities, greater experience in drug development and in obtaining regulatory approvals, and greater marketing capabilities than we do.
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Natural disasters, including earthquakes, may damage our facilities.
VaxGen’s corporate and manufacturing facilities are primarily located in the San Francisco Bay area. In addition to office and research facilities, through our ownership position in both Celltrion and VCI, we have a significant investment in VCI’s biomanufacturing facilities in California, which contain sensitive and expensive bioreactor equipment. The San Francisco Bay area is in close proximity to known earthquake fault zones. As a result, our corporate, research and manufacturing facilities are susceptible to damage from earthquakes and other natural disasters, such as fires, floods and similar events. Although VaxGen maintains general business insurance against fires and some general business interruptions, there can be no assurance that the amount of coverage will be adequate in any particular case.
Celltrion’s manufacturing facilities are located in the Republic of Korea. These facilities are susceptible to damage from earthquakes and other natural disasters, such as fires, floods and similar events. Although Celltrion maintains general business insurance against fires and some general business interruptions, there can be no assurance that the scope or amount of coverage will be adequate in any particular case.
If we fail to manage successfully any company or product acquisitions, joint ventures or in-licensed product candidates, we may be limited in our ability to develop our product candidates and to continue to expand our product candidate pipeline.
Our current vaccine product development programs were initiated through in-licensing or collaborative arrangements. These collaborations include licensing proprietary technology from, and other relationships with, biotechnology companies and government research institutes and organizations. As part of our business strategy, we intend to continue to expand our product pipeline and capabilities through company or product acquisitions, in-licensing or joint venture arrangements.
Any such activities will be accompanied by certain risks including:
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| • | exposure to unknown liabilities of acquired companies; |
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| • | higher than anticipated acquisition costs and expenses; |
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| • | the difficulty and expense of integrating operations and personnel of acquired companies; |
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| • | disruption of our ongoing business; |
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| • | diversion of management’s time and attention; and |
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| • | possible dilution to stockholders. |
If our competitors successfully enter into partnering or license agreements with these groups, or we are unable to reach agreement on license or partnering agreements on terms acceptable to us, we may then be precluded from pursuing those specific opportunities. Since each of these opportunities is unique, we may not be able to find a substitute. In addition, if we are unable to manage successfully any acquisitions, joint ventures and other collaboration opportunities, we may be limited in our ability to develop new products and therefore to continue to expand our product pipeline.
Our use of hazardous materials, chemicals and viruses require us to comply with regulatory requirements and exposes us to potential liabilities.
Our research and development involves the controlled use of hazardous materials, chemicals and viruses. We are subject to federal, state, local and foreign laws governing the use, manufacture, storage, handling and disposal of such materials. Although we believe that our safety procedures for the use, manufacture, storage, handling and disposal of such materials comply with the standards prescribed by federal, state, local and foreign regulations, we cannot eliminate the risk of accidental contamination or injury from these materials. In the event of such an accident, we could be held liable for significant damages or fines. These damages could exceed our resources and any applicable insurance coverage. In addition, we may be required to incur significant costs to comply with regulatory requirements in the future.
We may become subject to product liability claims, which could reduce demand for our product candidates or result in damages that exceed our insurance coverage.
We face an inherent risk of exposure to product liability suits in connection with vaccines being tested in human clinical trials or sold commercially. We may become subject to a product liability suit if any vaccine we develop causes injury, or if vaccinated individuals subsequently become infected or otherwise suffer adverse effects from our vaccines or products. Regardless of merit or eventual outcome, product liability claims may result in decreased demand for a vaccine or product, injury to our reputation, withdrawal of clinical trial volunteers and loss of revenues. If a product liability claim is brought against us, the cost of defending the claim would be significant and any adverse determination could result in liabilities in excess of our insurance coverage. We currently have product liability insurance in the amount of $25.0 million for our anthrax program including the supply of three million doses of anthrax vaccine to NIAID, as well as separate product liability coverage in the amount of $25.0 million for our smallpox and AIDSVAX programs. However, we cannot be certain that our current insurance can be maintained, or that additional insurance coverage could be obtained, on acceptable terms, if at all.
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Legislation limiting or restricting liability for medical products used to fight bioterrorism is evolving, and we cannot be certain that any such protections will apply to our vaccines or products.
Legislation relating to medical products used to fight bioterrorism is evolving, and may enable the U.S. government to release and use certain medical products prior to such products obtaining FDA or other regulatory approval. According to the terms of one proposed bill, upon a declaration of emergency, the U.S. government may authorize the introduction and use of a qualified medical product prior to such medical product obtaining FDA regulatory approval. Further, such proposed legislation provides that the United States government may elect to purchase and stockpile quantities of vaccines or products prior to receipt of regulatory approval to fight bioterrorism. Legislation limiting or restricting liability for the use of such vaccines is evolving, and we cannot be certain that any such protections will apply to the vaccines or products developed by us. If the legislation does not provide sufficient protection, and we are not able to obtain these protections by contract, we may become subject to product liability suits and other third party claims if vaccines or products developed by us cause injury, or if vaccinated individuals subsequently become infected or otherwise suffer adverse effects from such vaccines or products.
We may be subject to claims that we or our employees have wrongfully used or disclosed alleged trade secrets of their former employers.
As is commonplace in the biotechnology industry, we employ individuals who were previously employed at other biotechnology or pharmaceutical companies, including our competitors or potential competitors. Although no claims against us are currently pending, we may be subject to claims that these employees or we have inadvertently or otherwise used or disclosed trade secrets or other proprietary information of their former employers. Litigation may be necessary to defend against these claims. Even if we are successful in defending against these claims, litigation could result in substantial costs and be a distraction to management.
Failure to hire and retain key management employees could adversely affect our ability to obtain financing, develop our products, conduct clinical trials or execute our business strategy.
We are highly dependent on our senior management and scientific staff. These individuals have played a critical role in raising capital, negotiating business development opportunities, developing the vaccine candidates, conducting clinical trials and manufacturing products. If we lose the services of any key members of senior management or scientific staff and we are unable to recruit qualified replacements where we deem it necessary, we may be unable to achieve our business objectives.
We currently do not have an internal marketing and sales force and may rely on third parties for the sales or marketing of some or all of our vaccines if they are successfully developed. Our dependence on third parties may delay or impair our ability to generate revenues, or adversely affect our profitability.
We lack any sales or marketing history, and as of present do not have plans on developing internally such capability, other than for sales directly to the U.S. government and certain foreign governments. We intend to rely on third parties for the sales and marketing of our products to entities other than the U.S. and foreign governments. Our lack of sales and marketing personnel and distribution relationships may impair our ability to generate revenues.
Other Risks
We are involved in litigation concerning the results of our AIDSVAX Phase 3 clinical trial.
Since the announcement of the results of the North American/European Phase 3 clinical trial for AIDSVAX, we have been named in several securities class action lawsuits and a shareholder derivative lawsuit relating to how those results were disclosed. We are engaged in defending against these class actions, which, if decided against us, could adversely affect our financial position. The derivative action is purportedly being brought on our behalf, but we are subject to certain obligations to indemnify the individual defendants in connection with their defense of the claims asserted against them. Furthermore, these actions are not likely to be resolved in less than a year. The costs incurred in connection with these lawsuits could be significant and may not be covered by our insurance policies. These lawsuits could also result in continued diversion of our time and attention away from business operations, which could harm our business.
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Our stockholders could experience substantial dilution as result of the issuance of additional preferred stock.
Our board of directors has the authority to establish the designation of 20 million additional shares of preferred stock that are convertible into common stock without any action by our stockholders, and to fix the rights, preferences, privileges and restrictions, including voting rights, of such shares. The issuance and conversion of any such preferred stock would further dilute the percentage ownership of our stockholders.
Our stock price may be volatile, and an investment in our stock could decline in value.
The trading price of our common stock has been and is likely to continue to be extremely volatile. Our stock price could be subject to wide fluctuations in response to a variety of factors, including the following:
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| • | failure to win future government contracts for anthrax or smallpox vaccines; |
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| • | adverse results or delays in clinical trials; |
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| • | delays in our product development efforts; |
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| • | real or perceived safety issues with any of our vaccine candidates; |
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| • | failure to obtain or maintain required regulatory approvals; |
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| • | delays in completion and/or validation of our manufacturing facilities in the Republic of Korea; |
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| • | changes in financial estimates by securities analysts; |
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| • | rumors about our business prospects, product development efforts or clinical trials; |
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| • | if our stock is delisted or not quoted on an approved stock exchange or the Nasdaq National Market or Small Cap Market for five consecutive days; or |
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| • | new products or services offered by us or our competitors or announcements relating to product developments by our competitors; |
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| • | issuances of debt or equity securities; |
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| • | sales by our stockholders of substantial amounts of our common stock, including shares issued upon exercise of outstanding options and warrants; and |
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| • | other events or factors, many of which are beyond our control. |
In addition, the stock market in general, and the Nasdaq National Market and biotechnology companies in particular, have experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of these companies. Broad market and industry factors may negatively affect the market price of our common stock, regardless of actual operating performance. In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been instituted against companies.
Fluctuations in foreign exchange rates may adversely affect our financial position and results of operations.
The operations of Celltrion expose us to currency fluctuations and exchange rate risks. Celltrion, which is incorporated in the Republic of Korea, records its transactions in Korean Won. Celltrion’s results, however, are reflected in our consolidated financial statements in U.S. dollars. Therefore, our reported results are exposed to fluctuations in the exchange rates between the U.S. dollar and the Korean Won. During a period in which the U.S. dollar weakens against the Korean Won, our reported consolidated net losses will increase because our share of Celltrion’s net losses in Korean Won will translate into relatively more U.S. dollars. In addition, Celltrion’s purchases of engineering and construction services in Swiss francs are translated into Korean Won at the time of payment.
The assets and liabilities of Celltrion that are denominated in foreign currencies are reflected in their balance sheet in Korean Won and translated at the spot rate at the balance sheet date. The operating expenses of Celltrion that are denominated in foreign currencies are reflected in their statement of operations in Korean Won and translated at the average exchange rates for the reporting period. The resulting foreign currency translation adjustments are recorded in our stockholders’ equity as accumulated other comprehensive income or loss.
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We have, in the past, not protected ourselves from the potential negative effects of exchange rate fluctuations resulting from Celltrion’s operations. We do not expect to enter into such hedging transactions or other forms of currency protection in the form of forward exchange contracts, options or similar agreements. Accordingly, changes in exchange rates will cause fluctuations in our net loss and stockholders’ equity. These factors could increase our net losses and could have a material adverse effect on our financial condition and results of operations.
On an ongoing basis, we are required to have current GAAP financial statements for Celltrion and until we receive this information, we may not be able to evaluate our financial condition or operating results on a timely basis.
Effective January 1, 2004, we are required to consolidate Celltrion’s financial statements into our own. Celltrion maintains its records in accordance with Korean accounting principles; however, we require financial statements that are prepared in accordance with GAAP and which have been audited in conformity with generally accepted auditing standards in the United States of America. Celltrion’s internal controls over financial reporting may be insufficient to enable them to report their interim GAAP financial results to us on a timely basis. In addition, their independent registered public accounting firm could conclude that Celltrion’s internal controls over financial reporting are insufficient to enable the registered public accounting firm to complete their required annual audit of Celltrion’s GAAP financial statements in a timely fashion, if at all.
If we do not receive adequate timely financial reporting from Celltrion, we could continue to be delinquent in our filings required under Section 13 of the Exchange Act and we might not be able to maintain or file registration statements relating to shares of our common stock. If we are relisted and are unable to timely file periodic reports, we could again be delisted from Nasdaq. In addition, Celltrion’s failure to achieve and maintain an effective internal control environment for GAAP periodic financial reporting may also cause our investors to lose confidence in our filed financial statements, which could have a material adverse effect on the market price of our common stock.
Celltrion’s subcontractors may fail to perform, or may be delayed in performing, certain tasks related to the construction of the Incheon manufacturing facility.
Celltrion relies on subcontractors to perform certain tasks related to the construction of its manufacturing facility. Any significant delays in performing these tasks by subcontractors, or a failure to perform them in compliance with applicable governmental regulations, could cause Celltrion to fail to complete its facility in a timely manner, if at all, which may cause Celltrion to be in breach under its customer contracts and cause those contracts to be terminated. We cannot assure you that one or more of these subcontractors will not be delayed in performing, or fail to perform their obligations under these contracts in compliance with applicable legal requirements.
Celltrion’s suppliers may fail to provide, or may be delayed in providing, Celltrion with the necessary materials to produce its products.
When Celltrion begins production at its manufacturing facility, it will be relying on suppliers to provide it with the necessary materials to produce its products. Any significant delays in obtaining any of these materials from suppliers or other failure by suppliers to perform as agreed may cause Celltrion to fail to perform under its contracts, which may cause Celltrion to be in breach under those contracts and cause those contracts to be terminated. We cannot assure you that Celltrion will not face shortages from one or more of these suppliers in the future. We cannot ensure that if a shortage of materials occurs, that Celltrion will be able to obtain suppliers that will agree to provide materials to us at terms favorable to us or at all.
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ITEM 2. | UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS |
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None. |
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ITEM 3. | DEFAULTS UPON SENIOR SECURITIES |
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None. |
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ITEM 4. | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS |
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None. |
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ITEM 5. | OTHER INFORMATION |
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None. |
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| (a) | Exhibits required by Item 601 of Regulation S-K: |
The following exhibits are filed as part of this report:
(Note: Management contracts and compensatory plans or arrangements are identified with a “+” in the following list.)
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| | | Incorporated by Reference |
Exhibit
No. | | Exhibit | | Form | | File No. | | Filing Date | | Exhibit
No. | | Filed
Herewith |
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|
| | | | | | | | | | | | |
10.72 | | Form of 5 ½% Convertible Senior Subordinated Note due 2010. | | 8-K | | 0-26483 | | 4-11-05 | | 4.1 | | |
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10.73 | | Indenture, dated April 5, 2005, between VaxGen and U.S. Bank National Association, as trustee. | | 8-K | | 0-26483 | | 4-11-05 | | 4.2 | | |
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10.74 | | Fifth Amendment to the Lease Agreement by and between VaxGen, Inc. and Oyster Point Tech Center LLC, dated April 14, 2005. | | 8-K | | 0-26483 | | 4-21-05 | | 10.1 | | |
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10.75 | | Separation Agreement between James M. Cunha and VaxGen, dated June 3, 2005. + | | 8-K | | 0-26483 | | 6-06-05 | | 10.1 | | |
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31.1 | | Certification of Chief Executive Officer | | | | | | | | | | X |
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31.2 | | Certification of Chief Financial Officer | | | | | | | | | | X |
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32.1 | | Section 1350 Certification | | | | | | | | | | X |
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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.
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| VaxGen, Inc. |
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Dated:May 30, 2007 | By: /s/ James P. Panek |
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|
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| James P. Panek |
| Chief Executive Officer |
| (Principal Executive Officer) |
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Dated:May 30, 2007 | By:/s/ Matthew J. Pfeffer |
|
|
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| Matthew J. Pfeffer |
| Chief Financial Officer |
| (Principal Financial Officer) |
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