Table of Contents
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
(MARK ONE)
x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2003
o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
FOR THE TRANSITION PERIOD FROM ____________ TO ____________ .
COMMISSION FILE NUMBER: 000-30369
VIROLOGIC, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE | 94-3234479 | |
(STATE OR OTHER JURISDICTION OF | (IRS EMPLOYER | |
INCORPORATION OR ORGANIZATION) | IDENTIFICATION NO.) |
345 OYSTER POINT BLVD
SOUTH SAN FRANCISCO, CA 94080
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
TELEPHONE NUMBER (650) 635-1100
(REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE)
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [x] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes [ ] No [x]
As of August 4, 2003 there were 32,988,996 shares of the registrant’s common stock outstanding.
Table of Contents
VIROLOGIC, INC.
INDEX
PAGE | |||||
NO. | |||||
PART I. FINANCIAL INFORMATION | |||||
Item 1. Financial Statements | |||||
Condensed Balance Sheets as of June 30, 2003 and December 31, 2002 | 3 | ||||
Condensed Statements of Operations for the three and six months ended June 30, 2003 and 2002 | 4 | ||||
Condensed Statements of Cash Flows for the six months ended June 30, 2003 and 2002 | 5 | ||||
Notes to Condensed Financial Statements | 6 | ||||
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations | 13 | ||||
Item 3. Quantitative and Qualitative Disclosures About Market Risk | 32 | ||||
Item 4. Controls and Procedures | 32 | ||||
PART II. OTHER INFORMATION | |||||
Item 1. Legal Proceedings | 33 | ||||
Item 2. Changes in Securities and Use of Proceeds | 33 | ||||
Item 3. Defaults Upon Senior Securities | 33 | ||||
Item 4. Submission of Matters to a Vote of Security Holders | 33 | ||||
Item 5. Other Information | 34 | ||||
Item 6. Exhibits and Reports on Form 8-K | 34 | ||||
Signatures | 35 |
2
Table of Contents
VIROLOGIC, INC.
CONDENSED BALANCE SHEETS
(In thousands)
June 30, | December 31, | |||||||||
2003 | 2002 | |||||||||
Unaudited | (Note 1) | |||||||||
ASSETS | ||||||||||
Current assets: | ||||||||||
Cash and cash equivalents | $ | 7,763 | $ | 10,559 | ||||||
Short-term investments | 589 | 586 | ||||||||
Accounts receivable, net of allowance for doubtful accounts of $606 and $989 in 2003 and 2002, respectively | 4,390 | 4,924 | ||||||||
Prepaid expenses | 979 | 811 | ||||||||
Inventory | 746 | 958 | ||||||||
Restricted cash | 426 | 257 | ||||||||
Other current assets | 108 | 125 | ||||||||
Total current assets | 15,001 | 18,220 | ||||||||
Property and equipment, net | 9,602 | 10,961 | ||||||||
Restricted cash | 350 | 450 | ||||||||
Other assets | 1,039 | 855 | ||||||||
Total assets | $ | 25,992 | $ | 30,486 | ||||||
LIABILITIES AND STOCKHOLDERS’ EQUITY | ||||||||||
Current liabilities: | ||||||||||
Accounts payable | $ | 1,563 | $ | 831 | ||||||
Accrued compensation | 844 | 863 | ||||||||
Accrued liabilities | 2,055 | 2,456 | ||||||||
Deferred revenue | 663 | 674 | ||||||||
Convertible promissory notes | — | 12,046 | ||||||||
Current portion of capital lease obligations | 842 | 1,173 | ||||||||
Current portion of loans payable | — | 416 | ||||||||
Total current liabilities | 5,967 | 18,459 | ||||||||
Long-term portion of capital lease obligations | 249 | 419 | ||||||||
Long-term deferred rent | 325 | 345 | ||||||||
Redeemable convertible preferred stock, $0.001 par value, 606 shares authorized, designated by series, 589 shares issued and outstanding at June 30, 2003 and December 31, 2002; aggregate liquidation preference of $6,070 at June 30, 2003 | 4,249 | 4,249 | ||||||||
Commitments | ||||||||||
Stockholders’ equity: | ||||||||||
Preferred stock, $0.001 par value, 4,999,394 shares authorized, designated by series, 1,691 and 706 shares issued and outstanding at June 30, 2003 and December 31, 2002, respectively; aggregate liquidation preference of $16,911 at June 30, 2003 | — | — | ||||||||
Common stock, $0.001 par value, 100,000,000 shares authorized; 32,248,337 and 28,263,255 shares issued and outstanding at June 30, 2003 and December 31, 2002, respectively | 32 | 28 | ||||||||
Additional paid-in capital | 120,651 | 107,925 | ||||||||
Deferred compensation | (49 | ) | (182 | ) | ||||||
Accumulated other comprehensive income | 6 | 7 | ||||||||
Accumulated deficit | (105,438 | ) | (100,764 | ) | ||||||
Total stockholders’ equity | 15,202 | 7,014 | ||||||||
Total liabilities and stockholders’ equity | $ | 25,992 | $ | 30,486 | ||||||
See accompanying notes to Condensed Financial Statements.
3
Table of Contents
VIROLOGIC, INC.
CONDENSED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)
Three Months Ended | Six Months Ended | |||||||||||||||||
June 30, | June 30, | |||||||||||||||||
2003 | 2002 | 2003 | 2002 | |||||||||||||||
Revenue: | ||||||||||||||||||
Product revenue | $ | 7,786 | $ | 6,430 | $ | 14,337 | $ | 11,923 | ||||||||||
Contract revenue | 167 | 227 | 584 | 442 | ||||||||||||||
Total revenue | 7,953 | 6,657 | 14,921 | 12,365 | ||||||||||||||
Operating costs and expenses: | ||||||||||||||||||
Cost of product revenue | 4,268 | 3,761 | 8,087 | 7,186 | ||||||||||||||
Research and development | 1,089 | 2,862 | 2,435 | 5,817 | ||||||||||||||
General and administrative | 2,375 | 2,638 | 4,841 | 5,382 | ||||||||||||||
Sales and marketing | 2,469 | 2,976 | 4,311 | 5,848 | ||||||||||||||
Total costs and expenses | 10,201 | 12,237 | 19,674 | 24,233 | ||||||||||||||
Operating loss | (2,248 | ) | (5,580 | ) | (4,753 | ) | (11,868 | ) | ||||||||||
Interest income | 26 | 92 | 63 | 198 | ||||||||||||||
Interest expense | (36 | ) | (80 | ) | (88 | ) | (171 | ) | ||||||||||
Other income | 52 | 108 | 104 | 243 | ||||||||||||||
Net loss | (2,206 | ) | (5,460 | ) | (4,674 | ) | (11,598 | ) | ||||||||||
Deemed dividend to preferred stockholders | — | — | (2,155 | ) | (2,860 | ) | ||||||||||||
Preferred stock dividend | (506 | ) | (258 | ) | (973 | ) | (466 | ) | ||||||||||
Net loss applicable to common stockholders | $ | (2,712 | ) | $ | (5,718 | ) | $ | (7,802 | ) | $ | (14,924 | ) | ||||||
Basic and diluted net loss per common share | $ | (0.09 | ) | $ | (0.24 | ) | $ | (0.27 | ) | $ | (0.65 | ) | ||||||
Weighted-average shares used in computing basic and diluted net loss per common share | 29,643 | 24,289 | 29,001 | 22,815 | ||||||||||||||
See accompanying notes to Condensed Financial Statements.
4
Table of Contents
VIROLOGIC, INC.
CONDENSED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
Six Months Ended | |||||||||||
June 30, | |||||||||||
2003 | 2002 | ||||||||||
OPERATING ACTIVITIES | |||||||||||
Net loss | $ | (4,674 | ) | $ | (11,598 | ) | |||||
Adjustments to reconcile net loss to net cash used in operating activities: | |||||||||||
Depreciation and amortization | 1,708 | 1,913 | |||||||||
Non-cash stock-based compensation | 149 | 595 | |||||||||
Amortization of deferred gain on lease assignment | (104 | ) | — | ||||||||
Amortization of subtenant advance | — | (327 | ) | ||||||||
Changes in assets and liabilities: | |||||||||||
Accounts receivable | 534 | (990 | ) | ||||||||
Prepaid expenses | (168 | ) | (63 | ) | |||||||
Inventory | 212 | (369 | ) | ||||||||
Other current assets | 17 | (127 | ) | ||||||||
Accounts payable | 732 | (917 | ) | ||||||||
Accrued compensation | (19 | ) | (433 | ) | |||||||
Accrued liabilities | (343 | ) | (46 | ) | |||||||
Deferred revenue | (11 | ) | 169 | ||||||||
Long-term deferred rent | (20 | ) | (100 | ) | |||||||
Net cash used in operating activities | (1,987 | ) | (12,293 | ) | |||||||
INVESTING ACTIVITIES | |||||||||||
Purchases of short-term investments | (4,569 | ) | (5,912 | ) | |||||||
Maturities and sales of short-term investments | 4,565 | 9,622 | |||||||||
Restricted cash | (69 | ) | 343 | ||||||||
Capital expenditures | (349 | ) | (1,079 | ) | |||||||
Lease assignment | — | 2,465 | |||||||||
Tenant improvement reimbursement | — | 1,286 | |||||||||
Other assets | (184 | ) | 58 | ||||||||
Net cash provided by (used in) investing activities | (606 | ) | 6,783 | ||||||||
FINANCING ACTIVITIES | |||||||||||
Principal payments on loans payable | (416 | ) | (784 | ) | |||||||
Principal payments on capital lease obligations | (501 | ) | (485 | ) | |||||||
Net proceeds from issuance of common stock | 1,111 | 5 | |||||||||
Net proceeds from (costs relating to) issuance of preferred stock | (397 | ) | 9,835 | ||||||||
Net cash provided by (used in) financing activities | (203 | ) | 8,571 | ||||||||
Net increase (decrease) in cash and cash equivalents | (2,796 | ) | 3,061 | ||||||||
Cash and cash equivalents at beginning of period | 10,559 | 1,399 | |||||||||
Cash and cash equivalents at end of period | $ | 7,763 | $ | 4,460 | |||||||
See accompanying notes to Condensed Financial Statements.
5
Table of Contents
VIROLOGIC, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS
June 30, 2003
(Unaudited)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The accompanying unaudited condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of adjustments of a normal recurring nature) considered necessary for a fair presentation have been included. Operating results for the six-month period ended June 30, 2003 are not necessarily indicative of the results that may be expected for the year ending December 31, 2003 or any other future periods. The condensed balance sheet as of December 31, 2002 has been derived from the audited financial statements as of that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. For further information, refer to the audited financial statements and notes thereto included in our Annual Report to Stockholders on Form 10-K for the year ended December 31, 2002.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
Revenue Recognition
Product revenue is recognized upon completion of tests made on samples provided by customers and the shipment of test results to those customers. Services are provided to certain patients covered by various third-party payor programs, including Medicare. Billings for services under third-party payor programs are included in revenues net of an allowance for contractual discounts and an allowance for differences between the amounts billed and estimated payment amounts. The Company estimates these allowances based on historical payment information and current sales data. If the government and other third-party payors significantly change their reimbursement policies or the relative mix of third-party payors changes, an adjustment to the allowance may be necessary. Revenue generated from the Company’s database of resistance test results is recognized when earned under the terms of the related agreements, generally at the shipment of the requested reports. Contract revenue consists of revenue generated from National Institutes of Health (“NIH”) grants and commercial assay development, and other non-product revenue. NIH grant revenue is recorded on a reimbursement basis as grant costs are incurred. The costs associated with contract revenue are included in research and development expenses. Deferred revenue relates to cash received in advance of meeting the revenue recognition criteria described above.
Inventory
Inventory is stated at the lower of standard cost, which approximates actual cost, or market. Inventory consists of the following (in thousands):
June 30, | December 31, | |||||||
2003 | 2002 | |||||||
Raw materials | $ | 371 | $ | 712 | ||||
Work in process | 375 | 246 | ||||||
Total | $ | 746 | $ | 958 | ||||
Stock-Based Compensation
The Company has elected to continue to follow Accounting Principles Board Opinion No. 25 “Accounting for Stock-Based Compensation” (“APB 25”) to account for employee stock options. Under APB 25, no compensation expense is recognized when the exercise price of the Company’s employee stock options equals the market price of the underlying stock on the date of grant. Deferred compensation, if recorded, is amortized using the graded vesting method. Statement of Financial Accounting Standards Board Statement No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) as amended by Statement of Financial Accounting
6
Table of Contents
Standards Board Statement No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure — an amendment of FASB Statement No. 123” (“SFAS 148”) requires the disclosure of pro forma information regarding net loss and net loss per share as if the Company had accounted for its stock options under the fair value method.
The information regarding net loss applicable to common stockholders and net loss per share prepared in accordance with SFAS 123 has been determined as if the Company had accounted for its employee stock option and employee stock purchase plans using the fair value method prescribed by SFAS 123. The resulting effect on net loss applicable to common stockholders and net loss per share pursuant to SFAS 123 as amended by SFAS 148 is not likely to be representative of the effects in future years, due to subsequent years including additional grants and years of vesting.
The Company has two stock-based employee compensation plans: the 2000 Equity Incentive Plan and the 2000 Employee Stock Purchase Plan. The Company estimates the fair value of these stock options and stock purchase rights at the date of grant using the Black-Scholes option valuation model with the following weighted-average assumptions for the three and six months ended June 30, 2003 and 2002: risk-free interest rate of 2.9%; a weighted-average expected life of stock options from grant date of four years; a weighted-average expected stock purchase right of six months; volatility factor of the expected market price of the Company’s common stock of 100%; and a dividend yield of zero.
For purposes of disclosures pursuant to SFAS 123 as amended by SFAS 148, the estimated fair value of the stock options and stock purchase rights are amortized to expense over the vesting period. The Company’s pro forma information is as follows:
Three Months Ended | Six Months Ended | ||||||||||||||||
June 30, | June 30, | ||||||||||||||||
2003 | 2002 | 2003 | 2002 | ||||||||||||||
(In thousands, except per share amounts) | |||||||||||||||||
Net loss applicable to common stockholders — as reported | $ | (2,712 | ) | $ | (5,718 | ) | $ | (7,802 | ) | $ | (14,924 | ) | |||||
Add back: | |||||||||||||||||
Amortization of deferred compensation | 48 | 183 | 125 | 406 | |||||||||||||
Deduct: | |||||||||||||||||
Stock-based compensation expense determined under SFAS 123 | (384 | ) | (1,107 | ) | (888 | ) | (2,524 | ) | |||||||||
Pro forma net loss applicable to common stockholders | $ | (3,048 | ) | $ | (6,642 | ) | $ | (8,565 | ) | $ | (17,042 | ) | |||||
Net loss per share: | |||||||||||||||||
Net loss applicable to common stockholders — as reported | $ | (0.09 | ) | $ | (0.24 | ) | $ | (0.27 | ) | $ | (0.65 | ) | |||||
Net loss applicable to common stockholders — pro forma | $ | (0.10 | ) | $ | (0.27 | ) | $ | (0.30 | ) | $ | (0.75 | ) | |||||
The Company accounts for stock option grants to non-employees in accordance with the Emerging Issues Task Force Consensus No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services,” which requires the options subject to vesting to be periodically re-valued and expensed over their vesting periods, which approximates the period over which services are rendered or goods are received.
Reclassification
Reclassifications have been made to certain 2002 amounts to conform to the 2003 presentation.
Recent Accounting Pronouncements
In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150 “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (“SFAS 150”). SFAS 150 established standards for classifying and measuring as liabilities certain financial instruments that embody obligations of the issuer and have characteristics of both liabilities and equity. SFAS 150 must be applied immediately to instruments entered into or modified after May 31, 2003. The adoption of SFAS 150 did not have a material effect on the Company’s results of operations or financial position.
In April 2003, the FASB issued Statement of Financial Accounting Standards No. 149 “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (“SFAS 149”). SFAS 149 amends SFAS 133 to provide clarification on the financial accounting and reporting of derivative instruments and hedging activities and requires contracts with similar characteristics to be accounted for on a comparable basis. The provisions of SFAS 149 are effective for contracts entered into or modified after June 30, 2003. The adoption of SFAS 149 did not have a material effect on the Company’s results of operations or financial position.
7
Table of Contents
In November 2002, the FASB issued Emerging Issues Task Force Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables” (“EITF 00-21”). EITF 00-21 addresses certain aspects of the accounting by a company for arrangements under which it will perform multiple revenue-generating activities. EITF 00-21 addresses when and how an arrangement involving multiple deliverables should be divided into separate units of accounting. EITF 00-21 provides guidance with respect to the effect of certain customer rights due to company nonperformance on the recognition of revenue allocated to delivered units of accounting. EITF 00-21 also addresses the impact on the measurement and/or allocation of arrangement consideration of customer cancellation provisions and consideration that varies as a result of future actions of the customer or the company. Finally, EITF 00-21 provides guidance with respect to the recognition of the cost of certain deliverables that are excluded from the revenue accounting arrangement. The provisions of EITF 00-21 will apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The adoption of EITF 00-21 is not expected to have a material effect on the Company’s results of operations or financial position.
In November 2002, the FASB issued Interpretation 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”). FIN 45 requires a guarantor to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. FIN 45 also expands the disclosures required to be made by a guarantor about its obligations under certain guarantees that it has issued. Initial recognition and measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or modified. The disclosure requirements are effective immediately. The adoption of the recognition and measurement provisions of FIN 45 did not have a material effect on the Company’s results of operations or financial position.
In June 2002, the FASB issued Statement of Financial Accounting Standards No. 146 “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS 146”). SFAS 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” SFAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized and measured initially at fair value when the liability is incurred, rather than at the date of an entity’s commitment to an exit plan. The provisions of SFAS 146 are effective for exit or disposal activities that are initiated after December 31, 2002. The adoption of SFAS 146 did not have a material effect on the Company’s results of operations or financial position.
2. COMPREHENSIVE INCOME (LOSS)
Comprehensive income (loss) is comprised of net loss and other comprehensive income (loss). Other comprehensive income includes certain changes in equity that are excluded from net income (loss). Specifically, unrealized gains and losses on our available-for-sale securities, which are reported separately in stockholders’ equity, are included in accumulated other comprehensive income. Comprehensive income (loss) and its components are as follows (in thousands):
Three Months Ended | Six Months Ended | |||||||||||||||
June 30, | June 30, | |||||||||||||||
2003 | 2002 | 2003 | 2002 | |||||||||||||
Net loss | $ | (2,206 | ) | $ | (5,460 | ) | $ | (4,674 | ) | $ | (11,598 | ) | ||||
Changes in unrealized gain on securities available-for-sale, net of tax | (1 | ) | (7 | ) | (1 | ) | (71 | ) | ||||||||
Comprehensive loss | $ | (2,207 | ) | $ | (5,467 | ) | $ | (4,675 | ) | $ | (11,669 | ) | ||||
3. NET LOSS PER SHARE
Basic earnings (loss) per share is calculated based on the weighted-average number of common shares outstanding during the periods presented. Diluted earnings per share would give effect to the dilutive effect of common stock equivalents consisting of convertible preferred stock and stock options and warrants, calculated using the treasury stock method. Potentially dilutive securities have been excluded from the diluted earnings per share computations as they have an anti-dilutive effect due to the Company’s net loss.
4. CONVERTIBLE PROMISSORY NOTES
On February 4, 2003, the Company’s stockholders approved the conversion of certain convertible secured promissory notes (“Notes”) into an aggregate of 1,204.6 shares of the Company’s Series C Convertible Preferred Stock (“Series C Preferred Stock”). In addition, the Company’s stockholders approved the issuance of warrants to purchase approximately 5.0 million shares of the Company’s common stock at an exercise price of $1.11 per share in exchange for warrants originally issued in connection with the issuance of the Company’s Series B Redeemable Convertible Preferred Stock (“Series B Preferred Stock”). See the “Capital Stock” note below for further details.
8
Table of Contents
5. CAPITAL STOCK
Preferred Stock
Series A Redeemable Convertible Preferred Stock
During 2001, the Company issued and sold, in a private placement, an aggregate of 1,625 shares of the Company’s Series A Redeemable Convertible Preferred Stock (“Series A Preferred Stock”) and warrants to purchase an aggregate of 3.2 million shares of common stock, for an aggregate purchase price of $16.25 million.
Of the 1,625 shares issued in the financing, 589 shares remain outstanding as of June 30, 2003, and the remainder were converted into an aggregate of 4.6 million shares of the Company’s common stock. As a result of the Company’s sale of Series C Preferred Stock, which is described below, the conversion price of the Series A Preferred Stock and the exercise price of the warrants issued to the purchasers of the Series A Preferred Stock has each been reduced to $1.11. Accordingly, the 589 shares of Series A Preferred Stock outstanding are convertible into approximately 5.3 million shares of common stock, and the outstanding warrants are exercisable for approximately 6.2 million shares of common stock.
The Series A Preferred Stock bears an initial 6% annual dividend rate which increases to an 8% annual rate on the fourth such payment, then increases by 2 percentage points every six months up to a maximum annual rate of 14%. This dividend is paid as a stock dividend semi-annually. Subject to the limitations described below, the holders of Series A Preferred Stock may elect to convert their shares into the Company’s common stock at any time, just as they may choose to exercise their warrants at any time. Also subject to the limitations described below, the Company may, at its option, convert the Series A Preferred Stock into common stock at any time after June 21, 2002 for Series A Preferred Stock issued at the first closing and after July 9, 2002 for Series A Preferred Stock issued at the second closing, but only if the Company’s stock price exceeds $5.10 for 20 consecutive trading days. The Company may also, at its option, convert the Series A Preferred Stock into common stock upon a sale of common stock in a firm commitment underwritten offering to the public if the public offering price exceeds $5.10, the aggregate gross proceeds exceed $40 million and the registration statements covering shares underlying the Series A Preferred Stock are effective.
The holders are not subject to any limitations on the number of conversions of Series A Preferred Stock or subsequent sales of the corresponding common stock, that they can effect, other than a prohibition on any holder acquiring beneficial ownership of more than 4.99% of the outstanding shares of the Company’s common stock. This limitation also applies to the Company’s ability to convert Series A Preferred Stock.
The holders of Series A Preferred Stock have the right to require the Company to redeem all of the Series A Preferred Stock for cash equal to the greater of (i) 115% of their original purchase price plus 115% of any accrued and unpaid dividend or (ii) the aggregate fair market value of the shares of common stock into which such shares of Series A Preferred Stock are then convertible. Series A Preferred Stock is redeemable by the holders in any of the following situations:
• | If the Company fails to remove a restrictive legend on any certificate representing any common stock that was issued to any holder of such series upon conversion of their preferred stock or exercise of their warrant and that may be sold pursuant to an effective registration statement or an exemption from the registration requirements of the federal securities laws | ||
• | If the Company fails to have sufficient shares of common stock reserved to satisfy conversions of the series | ||
• | If the Company fails to honor requests for conversion, or if the Company notifies any holder of such series of its intention not to honor future requests for conversion | ||
• | If the Company institutes voluntary bankruptcy or similar proceedings | ||
• | If the Company makes an assignment for the benefit of creditors, or applies for or consents to the appointment of a receiver or trustee for the Company or for a substantial part of the Company’s property or business, or such a receiver or trustee shall otherwise be appointed | ||
• | If the Company sells all or substantially all of its assets | ||
• | If the Company merges, consolidates or engages in any other business combination (with some exceptions), provided that such transaction is required to be reported pursuant to Item 1 of Form 8-K |
9
Table of Contents
• | If the Company commits a material breach under, or otherwise materially violates the terms of, the transaction documents entered into in connection with the issuance of such series | ||
• | If the registration statements covering shares of common stock underlying the Series A Preferred Stock and related warrants cannot be used by the respective selling security holders for the resale of all the underlying shares of common stock for an aggregate of more than 30 days | ||
• | If the Company’s common stock is not tradable on the NYSE, the AMEX, the Nasdaq National Market or the Nasdaq SmallCap market for an aggregate of twenty trading days in any nine month period. In order for the Company’s common stock to continue to be quoted on the National Market, the Company must continue to satisfy various listing maintenance standards established by Nasdaq, including, among other things, a requirement that the Company has stockholders’ equity of at least $10 million and that the Company’s stock price consistently trades at or above $1.00 per share | ||
• | If 35% or more of the Company’s voting power is held by any one person, entity or group | ||
• | If the Company fails to pay any indebtedness in excess of $350,000 when due, or if there is any event of default under any agreement that is likely to have a material adverse effect on the Company | ||
• | Upon the institution of involuntary bankruptcy proceedings |
Upon the occurrence of any of the redemption events described above, individual holders of the Series A Preferred Stock would have the option, while such event continues, to require the Company to purchase some or all of the then outstanding shares of Series A Preferred Stock held by such holder. If the Company receives any notice of redemption, the Company is required to immediately (no later than one business day following such receipt) deliver a written notice to all holders of the same series of preferred stock stating the date when the Company received the redemption notice and the amount of preferred stock covered by the notice. If holders of the Series A Preferred Stock were to exercise their rights to redeem a material number of their shares as a result of any of the events described above, such a redemption could have a material adverse effect on the Company.
The Company may redeem the Series A Preferred Stock at any time after June 29, 2003, for Series A Preferred Stock issued at the first closing and after September 27, 2003 for Series A Preferred Stock issued at the second closing. Due to the nature of the redemption features of the Series A Preferred Stock, such stock has been excluded from permanent equity in the Company’s financial statements.
The Company initially recorded the Series A Preferred Stock at its fair value on the date of issuance. In accordance with EITF Topic D-98: Classification and Measurement of Redeemable Securities (“EITF Topic D-98”), the Company has elected not to adjust the carrying value of the Series A Preferred Stock to the redemption value of such shares, since it is uncertain whether or when the redemption events described above will occur. Subsequent adjustments to increase the carrying value to the redemption value will be made when it becomes probable that such redemption will occur. As of June 30, 2003, the redemption value of the Series A Preferred Stock was $7.0 million.
Series B Redeemable Convertible Preferred Stock
During 2002, the Company issued and sold, in a private placement, an aggregate of 1,005 shares of Series B Preferred Stock and warrants to purchase an aggregate of 2.2 million shares of common stock, for an aggregate purchase price of $10.05 million. In connection with this financing, the Company also granted warrants to purchase an aggregate of 637,261 shares of common stock to holders of Series A Preferred Stock, as a payment in order to secure their consent and waiver concerning the financing and the resulting impact on the Series A Preferred Stock.
The Company recorded a deemed dividend of $2.9 million in the first quarter of 2002 relating to the beneficial conversion feature of the Series B Preferred Stock and the additional warrants issued to the holders of the Series A Preferred Stock in connection with the Series B Preferred Stock financing. The net proceeds of $2.6 million attributable to the fair value of warrants are included in additional paid-in capital.
In connection with the sale of Series C Preferred Stock, described below, on November 19, 2002, the Company repurchased all of the outstanding Series B Preferred Stock in exchange for Notes. The aggregate principal amount of the Notes was $12.05 million. In addition, the Notes bore an interest rate of 8%, had a maturity date of March 19, 2003 and were secured by substantially all of the Company’s assets. On February 4, 2003, the Company’s stockholders approved the conversion of the Notes into an aggregate of
10
Table of Contents
1,204.6 shares of Series C Preferred Stock. In addition, the Company’s stockholders approved the issuance of warrants to purchase approximately 5.0 million shares of the Company’s common stock at an exercise price of $1.11 per share in exchange for warrants originally issued in connection with Series B Preferred Stock.
Series C Convertible Preferred Stock
On November 14, 2002, the Company entered into a securities purchase agreement with several investors to issue and sell, in a private placement, an aggregate of 706 shares of Series C Preferred Stock and warrants to purchase an aggregate of 4.4 million shares of common stock, for an aggregate purchase price of $7.06 million. The transaction closed on November 19, 2002. On February 4, 2003, the Company issued an aggregate of 1,204.6 additional shares of Series C Preferred Stock upon conversion of the Notes. The rights, preferences and privileges of the Series C Preferred Stock are set forth in the Certificate of Designations, Preferences and Rights of Series C Preferred Stock (“Certificate”), as amended on February 4, 2003 to (a) provide that any dividend payments due thereunder may be paid in either cash or shares of common stock at the option of the Company, and (b) include anti-dilution provisions substantially identical to those applicable with respect to Series A Preferred Stock. The warrants are subject to the terms and conditions of the stock purchase warrants issued by the Company and evidencing the warrants.
The Series C Preferred Stock bears an initial 8% annual dividend rate which increases to a 9% annual dividend rate on June 30, 2004, then increases by 1 percentage point every quarter thereafter up to a maximum annual rate of 14%, subject to an additional increase to an annual rate of 15% under certain circumstances. Subject to the limitations described below, the holders of Series C Preferred Stock may elect to convert their shares into common stock at any time. Upon conversion, each share of Series C Preferred Stock is convertible into approximately 8,264 shares of common stock. Subject to the limitations described below, the Company may, at its option, convert the Series C Preferred Stock into common stock (i) at any time after the first anniversary of the issuance of the Series C Preferred Stock, but only if the Company’s stock price exceeds $2.42 for 20 consecutive trading days or (ii) with the consent of a majority of the holders of the Series C Preferred Stock. The warrants are exercisable beginning May 20, 2003 and expire November 19, 2007. The exercise price of the warrants is $1.11 per share.
The holders of Series C Preferred Stock are not subject to any limitations on the number of conversions of Series C Preferred Stock or subsequent sales of the corresponding common stock that they can effect, other than a prohibition on any holder acquiring, upon conversion, beneficial ownership of more than 4.99% of the outstanding shares of our common stock, or, in the case of Biotech Target NV and its affiliates, more than 19.99% of the outstanding shares of the Company’s common stock. This limitation also applies to the Company’s ability to convert Series C Preferred Stock to common stock.
The Company recorded a deemed dividend of $7.7 million in the fourth quarter of 2002 relating to the issuance of the Series C Preferred Stock. The charge includes deemed dividends associated with an automatic adjustment of the conversion price of the Company’s Series A Preferred Stock, which was triggered as a result of the issuance of the Series C Preferred Stock. The charge also includes deemed dividends associated with the exchange of the Series B Preferred Stock for Notes and the sale of the Series C Preferred Stock together with the warrants described above. The Company recorded a deemed dividend of $2.2 million in the first quarter of 2003, relating to the warrant exchange. The deemed dividend increased the loss applicable to common stockholders in the calculation of basic and diluted net loss per common share and is included in stockholders’ equity as offsetting charges and credits to additional paid-in capital.
The Series C Preferred Stock is non-voting, except with respect to certain extraordinary transactions as set forth in the Certificate. In addition, until November 19, 2004, in the event that the Company proposes to issue any equity securities or debt which is convertible into equity securities, each holder of Series C Preferred Stock will have the right to purchase a certain amount of such securities or debt based upon its holdings of Series C Preferred Stock.
The investors of Series C Preferred Stock have the right to require the Company to redeem all of the Series C Preferred Stock for cash equal to the greater of (i) 120% of their original purchase price plus 120% of any accrued and unpaid dividend or (ii) the aggregate fair market value of the shares of common stock into which such shares of Series C Preferred Stock are then convertible. The Series C Preferred Stock is redeemable by the holders in any of the following situations:
• | If the Company fails to remove a restrictive legend on any certificate representing any common stock that was issued to any holder of such series upon conversion of their preferred stock or exercise of their warrant and that may be sold pursuant to an effective registration statement or an exemption from the registration requirements of the federal securities laws | ||
• | If the Company fails to have sufficient shares of common stock reserved to satisfy conversions of the series |
11
Table of Contents
• | If the Company fails to honor requests for conversion, or if the Company notifies any holder of such series of its intention not to honor future requests for conversion | ||
• | If the Company institutes voluntary bankruptcy or similar proceedings | ||
• | If the Company makes an assignment for the benefit of creditors, or apply for or consent to the appointment of a receiver or trustee for the Company or for a substantial part of the Company’s property or business, or such a receiver or trustee shall otherwise be appointed | ||
• | If the Company sells all or substantially all of its assets | ||
• | If the Company merges, consolidates or engages in any other business combination (with some exceptions), provided that such transaction is required to be reported pursuant to Item 1 of Form 8-K | ||
• | If the Company commits a material breach under, or otherwise materially violates the terms of, the transaction documents entered into in connection with the issuance of such series |
In addition, the Series C Preferred Stock is redeemable by its holders if, on or prior to November 19, 2004, the two year anniversary of the initial issuance of the Series C Preferred Stock, the Company issues equity, equity-linked securities, or debt which is convertible into equity, other than (i) upon the exercise of warrants, options or convertible securities issued and outstanding as of the issuance of the Series C Preferred Stock, (ii) upon the grant or exercise of stock options under any stock option plan, (iii) upon issuance or conversion of the Series C Preferred Stock or exercise of the warrants issued in connection with the Series C Preferred Stock, (iv) the issuance of securities in connection with strategic business partnerships, (v) pursuant to an equipment financing from a financial or lending institution and (vi) common stock issued as premium payments on Series A or Series C Preferred Stock.
Upon the occurrence of any of the redemption events described above, individual holders of the Series C Preferred Stock would have the option, while such event continues, to require the Company to purchase some or all of the then outstanding shares of Series C Preferred Stock, held by such holder. If the Company receives any notice of redemption, the Company is required to immediately (no later than one business day following such receipt) deliver a written notice to all holders of the same series of preferred stock stating the date when the Company received the redemption notice and the amount of preferred stock covered by the notice.
If holders of Series C Preferred Stock were to exercise their rights to have redeemed a material number of their shares as a result of any of the events described above, and such a redemption were to have a material adverse effect on the Company, all holders of the Company’s Series A Preferred Stock may be able to redeem their shares as well, further endangering the Company’s financial position.
The redemption events described above are all within the control of the Company. Therefore, in accordance with EITF Topic D-98, the Company has classified the Series C Preferred Stock in permanent equity. In addition, the Company initially recorded the Series C Preferred Stock at its fair value on the date of issuance. It has elected not to adjust the carrying value of the Series C Preferred Stock to the redemption value of such shares, since it is uncertain whether or when the redemption events described above will occur. Subsequent adjustments to increase the carrying value to the redemption value will be made when it becomes probable that such redemption will occur. As of June 30, 2003, the redemption value of the Series C Preferred Stock was $20.3 million.
Liquidation Preference
In the event of any liquidation, dissolution or winding up of the Company, or the sale of substantially all of the Company’s assets, the holders of the Series C Preferred Stock are entitled to receive, prior to any distribution to the holders of any other capital stock of the Company, an amount equal to the greater of:
• | $10,000 per share plus all accrued and unpaid premiums thereon, and | ||
• | an amount equal to the amount that such holder would have received had the holder converted such holder’s shares of Series C Preferred Stock into common stock immediately prior to the event. |
After payment of the liquidation preference of the Series C Preferred Stock set forth above, the holders of the Series A Preferred Stock are entitled to receive an amount equal to $10,000 per share of Series A Preferred Stock plus all accrued and unpaid premiums thereon. Any assets remaining for distribution following the payment of the preferences to the holders of the Series C Preferred Stock and Series A Preferred Stock set forth above shall be distributed to the holders of the common stock.
12
Table of Contents
In the event funds are not sufficient to make a complete distribution to either the holders of Series C Preferred Stock or Series A Preferred Stock as described above, the assets of the Company available for distribution will be distributed ratably among the holders of Series C Preferred Stock or Series A Preferred Stock, respectively. As of June 30, 2003, the liquidation value of the Series A and C Preferred Stock was $6.1 million and $16.9 million, respectively.
6. COMMITMENTS
The Company leases two buildings and subleases one building, totaling approximately 80,000 square feet of laboratory and office space in South San Francisco, California. The leases expire in the years 2004 and 2010 and provide the Company with options to extend the terms for an additional seven and ten years, respectively. The sublease, which covers approximately 14,000 square feet, expires on December 31, 2003. In addition, the Company is currently marketing one of the leased buildings totaling approximately 25,000 square feet for sublease.
In June 2002, the Company assigned a lease of excess laboratory and office space and transferred ownership through the sale of related leasehold improvements and equipment to a third party. The Company received net proceeds from the lease assignment of $3.8 million, resulting in a net gain of $0.3 million which is included in accrued liabilities and other long-term liabilities and is recognized as other income over the sublease term. In the event of default by the assignee, the Company would be contractually obligated for payments under the lease of: $0.5 million in 2003; $1.4 million in 2004; $1.4 million in 2005; and $8.5 million from 2006 through 2011.
At June 30, 2003, contractual obligations for the next five years and thereafter, excluding the lease assignment guarantee discussed above, are as follows:
Payments Due By Period | |||||||||||||||||||||
Less Than | |||||||||||||||||||||
1 Year | 2-3 Years | 4-5 Years | Thereafter | Total | |||||||||||||||||
(In thousands) | |||||||||||||||||||||
Operating leases | $ | 1,537 | $ | 2,152 | $ | 2,013 | $ | 2,129 | $ | 7,831 | |||||||||||
Capital leases | 837 | 233 | 32 | — | 1,102 | ||||||||||||||||
Total | $ | 2,374 | $ | 2,385 | $ | 2,045 | $ | 2,129 | $ | 8,933 | |||||||||||
In addition, the Company is obligated to pay dividends to the Series A and C preferred stockholders. See “Capital Stock” note for further discussion.
7. SUBSEQUENT EVENT
The Company was awarded three Small Business Innovation Research (SBIR) grants from the National Institute of Allergy and Infectious Diseases (NIAID), a division of the U.S. National Institutes of Health, for more than $3 million over three years. The grants will support the development of analytical and database tools to facilitate the identification and characterization of drug resistant strains of HIV, and assays that will aid in the pre-clinical and clinical evaluation of the next generation of anti-viral therapeutics.
Item 2. Management’s Discussion and Analysis of Financial Condition and Results Of Operations
The following discussion of the financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto included in this Form 10-Q.
Forward-Looking Statements
This Quarterly Report on Form 10-Q contains certain forward-looking statements within the meaning of the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995 including, without limitation, statements regarding our PhenoSense and GeneSeq testing products, the growth of our pharmaceutical business, research and development expenditures, adequacy of our capital resources, and other financial matters. These statements, which sometimes include words such as “expect,” “goal,” “may,” “anticipate,” “should,” “continue,” or “will,” reflect our expectations and assumptions as of the date of this Quarterly Report based on currently available operating, financial and competitive information. Actual results could differ materially from those in the forward-looking statements as a result of a number of factors, including our ability to raise additional capital, the market acceptance of our resistance testing products, the effectiveness of our competitors’ existing products and new products, the ability to effectively manage
13
Table of Contents
growth and the risks associated with our dependence on patents and proprietary rights. These factors and others are more fully described in “Risk Factors” and elsewhere in this Form 10-Q. We assume no obligation to update any forward-looking statements.
OVERVIEW
We are a biotechnology company developing, marketing and selling innovative products to guide and improve treatment of viral diseases. We incorporated in the state of Delaware on November 14, 1995 and commenced commercial operations in 1999. We developed a practical way of directly measuring the impact of genetic mutations on drug resistance and using this information to guide therapy. We have proprietary technology, called PhenoSense, for testing drug resistance in viruses that cause serious viral diseases such as HIV/AIDS and hepatitis. Our products are used by physicians in selecting optimal treatments for their HIV patients and by industry, academia and government for clinical studies, drug screening and characterization, and basic research.
SUMMARY OF CRITICAL ACCOUNTING POLICIES
The preparation of our financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in our financial statements and accompanying notes. Actual results could differ materially from those estimates. See Note 1 to the financial statements for further discussion. Items in our financial statements requiring significant estimates and judgments are as follows:
Revenue Recognition
Product revenue is recognized upon completion of tests made on samples provided by customers and the shipment of test results to those customers. Services are provided to certain patients covered by various third-party payor programs, including Medicare. Billings for services under third-party payor programs are included in revenues net of an allowance for contractual discounts and an allowance for differences between the amounts billed and estimated payment amounts. We estimate these allowances based on historical payment information and current sales data. If the government and other third-party payors significantly change their reimbursement policies or the relative mix of third-party payors changes, an adjustment to the allowance may be necessary. Revenue generated from our database of resistance test results is recognized when earned under the terms of the related agreements, generally at the shipment of the requested reports. Contract revenue consists of revenue generated from National Institutes of Health (“NIH”) grants and commercial assay development, and other non-product revenue. NIH grant revenue is recorded on a reimbursement basis as grant costs are incurred. The costs associated with contract revenue are included in research and development expenses. Deferred revenue relates to cash received in advance of meeting the revenue recognition criteria described above.
Deferred Tax Assets
We recorded a valuation allowance to reduce our deferred tax assets to the amount that we believe is more likely than not to be realized. Due to our lack of earnings history, the net deferred tax assets have been fully offset by a valuation allowance.
Deemed Dividends
We estimated a beneficial conversion feature for our convertible preferred stock in accordance with Emerging Issues Task Force Consensus No. 98-5, “Accounting for Convertible Securities with Beneficial Conversion Features” and No. 00-27, “Application of Issue No. 98-5 to Certain Convertible Instruments” based on the difference between the estimated conversion price and common stock fair market value at the date of issuance. We recorded the beneficial conversion feature as a deemed dividend on the Statement of Operations, resulting in an increase to the net loss applicable to common stockholders in the calculation of basic and diluted net loss per common share.
Stock-Based Compensation
We have elected to continue to follow Accounting Principles Board Opinion No. 25 “Accounting for Stock-Based Compensation” (“APB 25”) to account for employee stock options. Under APB 25, no compensation expense is recognized because the exercise price of our employee stock options equals the market price of the underlying stock on the date of grant. Deferred compensation, if recorded, is amortized using the graded vesting method. Statement of Financial Accounting Standards Board Statement No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) as amended by Statement of Financial Accounting Standards Board Statement No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure — an amendment of FASB Statement No. 123” (“SFAS 148”) requires the disclosure of pro forma information regarding net loss and net loss per share as if we had accounted for its stock options under the fair value method. See “Summary of Significant Accounting Policies” note to the financial statements for further discussion.
14
Table of Contents
We account for stock option grants to non-employees in accordance with the Emerging Issues Task Force Consensus No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services,” which requires the options subject to vesting to be periodically re-valued and expensed over their vesting periods.
RESULTS OF OPERATIONS
Three and Six Months Ended June 30, 2003 and 2002
Three Months Ended | Six Months Ended | ||||||||||||||||
June 30, | June 30, | ||||||||||||||||
2003 | 2002 | 2003 | 2002 | ||||||||||||||
(In thousands) | |||||||||||||||||
Patient testing | $ | 6,101 | $ | 4,666 | $ | 11,395 | $ | 8,305 | |||||||||
Pharmaceutical company testing | 1,685 | 1,764 | 2,942 | 3,618 | |||||||||||||
Product revenue | 7,786 | 6,430 | 14,337 | 11,923 | |||||||||||||
Contract revenue | 167 | 227 | 584 | 442 | |||||||||||||
Total revenue | $ | 7,953 | $ | 6,657 | $ | 14,921 | $ | 12,365 | |||||||||
Revenue. Revenue was $8.0 million and $14.9 million for the three and six months ended June 30, 2003, compared to $6.7 million and $12.4 million for the corresponding periods in 2002. The increase was primarily attributable to greater sales of PhenoSense HIV, GeneSeq HIV and PhenoSense GT for patient testing. Contract revenue consists of revenue from NIH research grants and commercial assay development, and other non-product revenue. We were awarded three Small Business Innovation Research (SBIR) grants from the National Institute of Allergy and Infectious Diseases (NIAID), a division of the U.S. National Institutes of Health, for more than $3 million over three years. The grants will support the development of analytical and database tools to facilitate the identification and characterization of drug resistant strains of HIV, and assays that will aid in the pre-clinical and clinical evaluation of the next generation of anti-viral therapeutics. We anticipate NIH revenue relating to these grants to be approximately $0.5 million in the second half of 2003. We believe increased demand for existing and new products will be the primary factors contributing to an increased level of sales in 2003 as compared to 2002. We anticipate quarterly differences in the revenue growth rate due to timing of various clinical studies for pharmaceutical customers and the seasonal effects observed in patient testing, which has historically occurred in the first and third quarters.
Cost of product revenue. Cost of product revenue was $4.3 million and $8.1 million for the three and six months ended June 30, 2003, compared to $3.8 million and $7.2 million for the corresponding periods in 2002. The increase was primarily due to the higher volume of testing. Included in these costs are materials, supplies, labor and overhead related to product revenue. Gross margin on product revenue increased to 45% and 44% for the three and six months ended June 20, 2003 compared to 42% and 40% for the corresponding periods in 2002. The increase is primarily due to improved operational efficiency and economies of scale, and the implementation of the business restructuring plan as discussed below. We anticipate that gross margin on our product revenue will continue to improve as revenue increases and further economies of scale are achieved.
Research and development. Research and development expenses were $1.1 million and $2.4 million for the three and six months ended June 30, 2003, compared to $2.9 million and $5.8 million for the corresponding periods in 2002. The decrease was primarily the result of reallocating certain clinical research and research and development resources to revenue generating activities and the implementation of the business restructuring plan as discussed below. Total research and development expenses included costs associated with contract revenue as follows:
Three Months Ended | Six Months Ended | |||||||||||||||||
June 30, | June 30, | |||||||||||||||||
2003 | 2002 | 2003 | 2002 | |||||||||||||||
(In thousands) | (In thousands) | |||||||||||||||||
NIH Grants: | ||||||||||||||||||
PhenoSense HIV Entry and GeneSeq HIV Entry assays | $ | 120 | $ | 235 | ||||||||||||||
Replication Capacity HIV assay | 107 | 207 | ||||||||||||||||
Commercial assay development and other projects | $ | 145 | — | $ | 335 | — | ||||||||||||
Total | $ | 145 | $ | 227 | $ | 335 | $ | 442 | ||||||||||
Because our resistance tests target viral diseases and our product lines overlap, most of our core research and development activities are advancing multiple potential product lines. Due to this substantial overlap, we do not track costs on a project by project basis, except for the costs reimbursed by the NIH as discussed above. We expect research and development spending in the future to trend with the level of NIH grants and/or other research and development cost reimbursement arrangements under contract.
15
Table of Contents
Below is a summary of products and products in development. The information in the column labeled “Estimated Completion” contains forward-looking statements regarding completion of products in development and is dependent on securing NIH grants and/or other research and development funding as well as demand for the products. The actual timing of completion of those products could differ materially from the estimates provided in the table.
The following summarizes our products and products in development:
Estimated | |||||
Completion | |||||
PhenoSense HIV, a phenotypic HIV test | |||||
Pharmaceutical and patient testing | Completed | ||||
GeneSeq HIV, a genotypic HIV test | |||||
Pharmaceutical and patient testing | Completed | ||||
PhenoSense GT, a combination phenotype/genotype HIV test | |||||
Patient testing | Completed | ||||
Replication Capacity HIV, a measurement of fitness(1) | |||||
Pharmaceutical and patient testing | Completed | ||||
PhenoScreen, a high-throughput screening assay | |||||
Pharmaceutical testing | Completed | ||||
PhenoSense HIV Entry and GeneSeq HIV Entry Assays, entry inhibitor assays(2) | |||||
Pharmaceutical testing | Completed | ||||
Patient testing (3) | 2004 | ||||
PhenoSense HIV Vaccine Entry, an entry neutralization assay | |||||
Pharmaceutical testing | Completed | ||||
PhenoSense HCV, a phenotypic hepatitis C test | |||||
Pharmaceutical testing | 2004 | ||||
Patient testing(3) | 2006 | ||||
GeneSeq HCV, a genotypic hepatitis C test | |||||
Pharmaceutical testing | 2003 | ||||
Patient testing(3) | 2005 | ||||
GeneSeq HBV, a genotypic hepatitis B test | |||||
Pharmaceutical testing | Completed | ||||
Patient testing | (4 | ) | |||
PhenoSense HBV, a phenotypic hepatitis B test | |||||
Pharmaceutical testing | (4 | ) | |||
Patient testing | (4 | ) |
(1) | Currently offered free of charge on phenotypic reports; in the future may be offered as a stand-alone product. | |
(2) | This test may be incorporated into one of our existing products or possibly offered as a stand-alone product. | |
(3) | This test is expected to be offered after pharmaceutical drugs are available for patient use. | |
(4) | The timing of estimated completion is under evaluation and is dependant on securing NIH grants and/or other research and development funding as well as demand for the products. |
General and administrative. General and administrative expenses were $2.4 million and $4.8 million for the three and six months ended June 30, 2003, compared to $2.6 million and $5.4 million for the corresponding periods in 2002. The decrease was primarily due to the implementation of the business restructuring plan as discussed below and a reduction in noncash compensation expenses related to granting stock and options prior to our initial public offering, and was partially offset by an increase in fees for professional services and costs associated with facilities currently marketed for sublease. We expect general and administrative expenses to decrease in 2003 as compared to 2002 primarily due to continued leveraging of existing infrastructure and the implementation of the business restructuring plan as discussed below.
Sales and marketing. Sales and marketing expenses were $2.5 million and $4.3 million for the three and six months ended June 30, 2003, compared to $3.0 million and $5.8 million for the corresponding periods in 2002. This decrease was primarily due to continued effective utilization of our sales and marketing capabilities and the implementation of the business restructuring plan as discussed below. In addition, in 2002, we incurred expenses for sales and marketing programs related to the commercialization of PhenoSense GT and Replication Capacity. We currently have 20 personnel in our direct sales force. We expect sales and marketing expenses to decrease in 2003 as compared to 2002 primarily due to continued effective utilization of our sales and marketing capabilities and the implementation of the business restructuring plan as discussed below.
16
Table of Contents
Interest income. Interest income was $26,000 and $63,000 for the three and six months ended June 30, 2003, compared to $92,000 and $198,000 for the corresponding periods in 2002. This decrease was primarily due to lower average cash balances and lower interest rates.
Interest expense. Interest expense was $36,000 and $88,000 for the three and six months ended June 30, 2003, compared to $80,000 and $171,000 for the corresponding periods in 2002. This decrease was primarily due to the payoff of several equipment loans which ended.
Other income.Other income was $52,000 and $104,000 for the three and six months ended June 30, 2003, compared to $108,000 and $243,000 for the corresponding periods in 2002. Other income represents residual income from our lease assignment in 2002.
Deemed dividend.On February 4, 2003, our stockholders approved the conversion of certain convertible secured promissory notes (“Notes”) issued to prior Series B preferred stockholders into Series C Preferred Stock and the issuance of warrants to purchase shares of our common stock in exchange for warrants originally issued in connection with Series B Preferred Stock. The warrant exchange resulted in a charge of $2.2 million which was recorded at the time of the exchange in the first quarter of 2003.
In the first quarter of 2002, we sold 1,005 shares of Series B Preferred Stock with warrants to purchase an aggregate of 2.2 million shares of common stock, for an aggregate purchase price of $10.05 million. In connection with this financing, we also granted warrants to purchase an aggregate of 637,261 shares of common stock to holders of Series A Preferred Stock as a payment in order to secure their consent and waiver concerning the financing and the resulting impact on the Series A Preferred Stock. The issuance of the Series B Preferred Stock resulted in a beneficial conversion feature of $2.9 million.
The beneficial conversion features were calculated in accordance with Emerging Issues Task Force Consensus No. 98-5, “Accounting for Convertible Securities with Beneficial Conversion Features” and Emerging Issues Task Force Consensus No. 00-27 “Application of Issue No. 98-5 to Certain Convertible Instruments.” The beneficial conversion features were reflected as deemed dividends in the Statement of Operations of $2.2 million and $2.9 million in the first quarter of 2003 and 2002, respectively, and are included in stockholders’ equity as offsetting charges and credits to additional paid-in capital.
Preferred stock dividend.We recorded a preferred stock dividend of $0.5 million and $1.0 million for the three and six months ended June 30, 2003, compared to $0.3 million and $0.5 million for the corresponding periods in 2002. The Series A Preferred Stock issued in 2001 bears an initial 6% annual dividend rate, payable twice a year in shares of common stock, which increases to an 8% annual rate on the fourth such payment, and then increases by 2 percentage points every six months thereafter up to a maximum annual rate of 14%. The Series C Preferred Stock bears an initial 8% annual dividend rate, payable quarterly, which increases to a 9% annual dividend rate on June 30, 2004, then increases by one percentage point every quarter thereafter up to a maximum annual rate of 14% and is payable in cash or shares of common stock at our option. In 2003, we paid the Series C dividend in shares of common stock.
Business restructuring.In the fourth quarter of 2002, we implemented a business restructuring plan to reallocate certain resources to revenue maximizing activities and reduce cash consumption. The plan included a reduction in force of approximately 17% or 35 employees: 8 employees in laboratory operations; 6 employees in research and development; 8 employees in sales and marketing; and 13 employees in administration. In the fourth quarter of 2002, we recorded a charge for salaries, severance and other personnel related costs to the respective departments totaling $0.3 million. We did not incur any additional expenses relating to the business restructuring in the first half of 2003.
LIQUIDITY AND CAPITAL RESOURCES
We expect our available cash and cash equivalents, short-term investments and short-term restricted cash of $8.8 million at June 30, 2003, funds provided by the sale of our products, contract revenue, and borrowing under equipment financing arrangements will be adequate to fund our operations through December 2003, assuming revenues reach projected levels and cost containment measures continue to be effective. In addition, we plan to continue to evaluate various strategic opportunities, including among others, research and development collaborations, international alliances and marketing partnerships.
We have funded our operations since inception primarily through public and private sales of common and preferred stock, equipment financing arrangements, product revenue and contract revenue. In particular, we have completed three private financings since our initial public offering in May 2000. Although we expect our operating and capital resources will be sufficient to meet future requirements through December 2003, we may have to raise additional funds to continue the development and commercialization of future technologies and our business operations in general. These funds may not be available on favorable terms, or at all. If adequate funds are not available on commercially reasonable terms, we may be required to curtail operations significantly or sell significant
17
Table of Contents
assets and may not be able to continue as a going concern. In addition, we may choose to raise additional capital due to market conditions or strategic considerations even if we believe that we have sufficient funds for current or future operating plans.
Net cash used in operating activities was $2.0 million and $12.3 million for the six months ended June 30, 2003 and 2002, respectively. The decrease in cash used in operating activities primarily relates to lower operating losses as discussed above.
Net cash used in investing activities of $0.6 million for the six months ended June 30, 2003 resulted primarily from capital expenditures and costs associated with acquiring other assets. Net cash provided by investing activities of $6.8 million for the six months ended June 30, 2002 resulted primarily from the net proceeds from maturities and sales of short-term investments, a lease assignment of $2.5 million, and a tenant improvement reimbursement of $1.3 million, partially offset by capital expenditures of $1.1 million.
Net cash used in financing activities of $0.2 million for the six months ended June 30, 2003 resulted primarily from payments on loans and capital lease obligations, partially offset by proceeds from common stock issuance of $1.1 million. Net cash provided by financing activities of $8.6 million for the six months ended June 30, 2002 resulted primarily from the sale of Series B Preferred Stock in March 2002 for net proceeds of $9.8 million, partially offset by payments on loans and capital lease obligations.
We lease two buildings and sublease one building, totaling approximately 80,000 square feet of laboratory and office space in South San Francisco, California. The leases expire in the years 2004 and 2010 and provide us with options to extend the terms for an additional seven and ten years, respectively. The sublease, which covers approximately 14,000 square feet expires on December 31, 2003. In addition, we are currently marketing one of the leased buildings totaling approximately 25,000 square feet for sublease.
In June 2002, we assigned a lease of excess laboratory and office space and transferred ownership through the sale of related leasehold improvements and equipment to a third party. We received net proceeds from the lease assignment of $3.8 million, resulting in a net gain of $0.3 million which is included in accrued liabilities and other long-term liabilities and is recognized as other income over the sublease term. In the event of default by the assignee, we would be contractually obligated for payments under the lease of: $0.5 million in 2003; $1.4 million in 2004; $1.4 million in 2005; and $8.5 million from 2006 through 2011.
At June 30, 2003, our contractual obligations for the next five years and thereafter, excluding the lease assignment guarantee discussed above, are as follows:
Payments Due By Period | |||||||||||||||||||||
Less Than | |||||||||||||||||||||
1 Year | 2-3 Years | 4-5 Years | Thereafter | Total | |||||||||||||||||
(In thousands) | |||||||||||||||||||||
Operating leases | $ | 1,537 | $ | 2,152 | $ | 2,013 | $ | 2,129 | $ | 7,831 | |||||||||||
Capital leases | 837 | 233 | 32 | — | 1,102 | ||||||||||||||||
Total | $ | 2,374 | $ | 2,385 | $ | 2,045 | $ | 2,129 | $ | 8,933 | |||||||||||
In addition, we are obligated to pay dividends to the Series A and C preferred stockholders. See “Capital Stock” note to the financial statements for further discussion.
The contractual obligations discussed above are fixed costs. If we are unable to generate sufficient cash from operations to meet these contractual obligations, we may have to raise additional funds. These funds may not be available on favorable terms or at all.
RECENTLY ISSUED ACCOUNTING STANDARDS
In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150 “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (“SFAS 150”). SFAS 150 established standards for classifying and measuring as liabilities certain financial instruments that embody obligations of the issuer and have characteristics of both liabilities
18
Table of Contents
and equity. SFAS 150 must be applied immediately to instruments entered into or modified after May 31, 2003. The adoption of SFAS 150 did not have a material effect on our results of operations or financial position.
In April 2003, the FASB issued Statement of Financial Accounting Standards No. 149 “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (“SFAS 149”). SFAS 149 amends SFAS 133 to provide clarification on the financial accounting and reporting of derivative instruments and hedging activities and requires contracts with similar characteristics to be accounted for on a comparable basis. The provisions of SFAS 149 are effective for contracts entered into or modified after June 30, 2003. The adoption of SFAS 149 did not have a material effect on our results of operations or financial position.
In November 2002, the FASB issued Emerging Issues Task Force Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables” (“EITF 00-21”). EITF 00-21 addresses certain aspects of the accounting by a company for arrangements under which it will perform multiple revenue-generating activities. EITF 00-21 addresses when and how an arrangement involving multiple deliverables should be divided into separate units of accounting. EITF 00-21 provides guidance with respect to the effect of certain customer rights due to company nonperformance on the recognition of revenue allocated to delivered units of accounting. EITF 00-21 also addresses the impact on the measurement and/or allocation of arrangement consideration of customer cancellation provisions and consideration that varies as a result of future actions of the customer or the company. Finally, EITF 00-21 provides guidance with respect to the recognition of the cost of certain deliverables that are excluded from the revenue accounting arrangement. The provisions of EITF 00-21 will apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The adoption of EITF 00-21 is not expected to have a material effect on our results of operations or financial position.
In November 2002, the FASB issued Interpretation 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”). FIN 45 requires a guarantor to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. FIN 45 also expands the disclosures required to be made by a guarantor about its obligations under certain guarantees that it has issued. Initial recognition and measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or modified. The disclosure requirements are effective immediately. The adoption of the recognition and measurement provisions of FIN 45 did not have a material effect on our results of operations or financial position.
In June 2002, the FASB issued Statement of Financial Accounting Standards No. 146 “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS 146”). SFAS 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” SFAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized and measured initially at fair value when the liability is incurred, rather than at the date of an entity’s commitment to an exit plan. The provisions of SFAS 146 are effective for exit or disposal activities that are initiated after December 31, 2002. The adoption of SFAS 146 did not have a material effect on our results of operations or financial position.
RISK FACTORS
You should carefully consider the following factors and other information in this Form 10-Q when considering our company and its stock.
In the event that we need to raise additional capital, our stockholders could experience substantial additional dilution. If such financing is not available on commercially reasonable terms, we may have to significantly curtail our operations or sell significant assets and may be unable to continue as a going concern.
As of June 30, 2003, we had available cash and cash equivalents, short-term investments and short-term restricted cash of $8.8 million. We anticipate that our existing capital resources together with funds from the sale of our products, contract revenue and borrowing under equipment financing arrangements will enable us to maintain currently planned operations through December 31, 2003. However, we may need additional funding sooner than that. To the extent operating and capital resources are insufficient to meet future requirements, we will have to raise additional funds to continue the development and commercialization of our technologies. Our inability to raise capital would seriously harm our business and product development efforts. In addition, we may choose to raise additional capital due to market conditions or strategic considerations even if we believe we have sufficient funds for our current or future operating plans. However, we cannot guarantee that additional financing, in any form, will be available at all, or on terms acceptable to us. Our ability to raise additional capital also may be dependent upon our common stock being quoted on the Nasdaq Stock Market. We cannot guarantee that we will be able to satisfy the criteria for continued listing on the Nasdaq Stock Market or any other market. If we sell equity or convertible debt securities to raise additional funds, our existing stockholders may incur substantial dilution and any shares so issued will likely have rights, preferences and privileges superior to the rights, preferences
19
Table of Contents
and privileges of our outstanding common and preferred stock. In the event financing is not available in the time frame required, we will be forced to reduce our operating expenses, curtail sales and marketing activities, reschedule research and development projects or delay, scale back or eliminate some or all of our activities. Further, we might be required to sell certain of our assets or obtain funds through arrangements with third parties that require us to relinquish rights to certain of our technologies or products that we would seek to develop or commercialize ourselves. These actions, while necessary for the continuance of operations during a time of cash constraints and a shortage of working capital, could make it difficult or impossible to implement our long-term business plans or could affect our ability to continue as a going concern.
We expect to incur future losses and may not achieve profitability as soon as expected, which may cause our stock price to fall.
We have experienced significant losses each year since our inception and expect to incur additional losses. We experienced net losses applicable to common stockholders of approximately $7.8 million in the six month period ended June 30, 2003, $33.3 million in 2002, $28.8 million in 2001 and $38.9 million in 2000. As of June 30, 2003, we had an accumulated deficit of approximately $105.4 million. We expect to continue to incur losses primarily as a result of spending related to:
• | Expanding patient sample processing capabilities | ||
• | Research and product development costs | ||
• | Sales and marketing activities | ||
• | Additional clinical laboratory and research space and other necessary facilities | ||
• | General and administrative costs |
If our history of losses continues, our stock price may fall and you may lose part or all of your investment.
Our stockholders will experience substantial additional dilution if our shares of preferred stock or their related warrants are converted into or exercised for shares of common stock. As of June 30, 2003, our outstanding shares of preferred stock and related warrants are convertible into or exercisable for up to an aggregate of 35,195,951 shares of common stock, or approximately 109% of the number of shares of outstanding common stock.
As of June 30, 2003, we had approximately 32,248,337 shares of common stock outstanding. However, as of June 30, 2003, we also had outstanding the following shares of preferred stock and related warrants:
• | 589 shares of Series A Redeemable Convertible Preferred Stock (“Series A Preferred Stock”), convertible into 5,306,306 shares of common stock (not including the conversion of accrued but unpaid premiums) | ||
• | 1,691.11 shares of Series C Convertible Preferred Stock (“Series C Preferred Stock”), convertible into 13,976,122 shares of common stock | ||
• | warrants issued to the purchasers of our preferred stock in connection with our preferred stock financings to purchase 15,913,523 shares of common stock |
Together, the common shares reserved for issuance upon conversion of the Series A Preferred Stock and Series C Preferred Stock, and upon exercise of the warrants referenced above, represent approximately 35,195,951 shares of common stock, or 109% of the outstanding shares of our common stock at June 30, 2003, all of which are issuable for an approximate weighted-average effective price of $1.20 per share.
The number of shares of common stock that we may be required to issue upon conversion of the Series A Preferred Stock, and exercise of the warrants granted to purchasers of our Series A Preferred Stock in connection with the issuance thereof, can increase substantially upon the occurrence of several events, including if:
• | We issue shares of stock (with certain exceptions) for an effective price less than the conversion price of the Series A Preferred Stock or the related warrants (each $1.11 as of July 29, 2003). This could be likely given that this sort of adjustment has already occurred, our stock price has been below $1.11, the historical volatility of our stock price and the recent volatility of stocks of companies in our industry and of the stock market in general |
20
Table of Contents
• | We fail to have sufficient shares of common stock reserved to satisfy conversions, exercises and other issuances | ||
• | We fail to honor requests for conversion, or notify any holder of Series A Preferred Stock of our intention not to honor requests for conversion | ||
• | We fail to issue shares upon exercise of the warrants | ||
• | We fail to redeem any shares of Series A Preferred Stock when required |
We are also obligated to issue additional shares of common stock every six months to the holders of the Series A Preferred Stock as “premium payments.” As of July 29, 2003, these issuances equaled about 328 shares of common stock for every share of Series A Preferred Stock outstanding at the time the issuance is made. This number of shares will increase every six months, starting with the fourth such issuance (to be made in the second half of 2003), by about 82 shares of common stock for each share of Series A Preferred Stock, up to a maximum of about 574 shares of common stock for every share of Series A Preferred Stock. All of the previous share totals are based upon an assumed stock price of $1.22, which was the closing price of our stock on the Nasdaq National Market on July 29, 2003, but the actual number of shares will be based upon our stock price from time to time as of the payment dates. To date, we have issued 600,771 shares of common stock to holders of Series A Preferred Stock as premium payments on those shares. If the 589 shares of the Series A Preferred Stock outstanding as of June 30, 2003 remain outstanding for five years following such date, we will be required to issue as premium payments an additional 3,089,836 shares of common stock (again based on an assumed stock price of $1.22) to holders of the Series A Preferred Stock, which is 9.6% of the shares of common stock outstanding as of June 30, 2003. We do not receive payment or other consideration for these issuances.
We amended the rights of the Series C Preferred Stock to (i) provide that any premium payments due thereunder may be paid in either cash or shares of common stock at our option, and (ii) include anti-dilution provisions substantially identical to those applicable with respect to our Series A Preferred Stock. As a result, the number of shares of common stock that we may be required to issue upon conversion of the Series C Preferred Stock will increase substantially in the event that we issue shares of stock for an effective price less than the then conversion price of the Series C Preferred Stock ($1.21 as of July 29, 2003). The premium payment due on each share of Series C Preferred Stock each quarter is currently equal to $200, but will increase beginning with the payment due on June 30, 2004 by $25 per share up to a maximum of $350 per share. To date, we have issued 570,885 shares of common stock to holders of Series C Preferred Stock as premium payments on those shares. If all 1,691.1 shares of Series C Preferred Stock outstanding as of June 30, 2003 remain outstanding for five years following such date, and we choose to pay all premium amounts due on those shares in common stock instead of cash, we will issue an additional 8,559,512 shares of common stock (again based on an assumed stock price of $1.22) to holders of the Series C Preferred Stock, which is 26.5% of the shares of common stock outstanding as of June 30, 2003. We do not receive payment or other consideration for these issuances.
All of the foregoing issuances of common stock would be substantially dilutive to the outstanding shares of common stock, especially where, as described above, the shares of common stock are issued without additional consideration. We cannot predict whether or how many additional shares of our common stock will become issuable due to these provisions.
Any dilution or potential dilution may cause our stockholders to sell their shares, which would contribute to a downward movement in the stock price of our common stock. This could prevent us from sustaining a per share price sufficient to enable us to maintain an active trading market on, or meet the continued listing requests of, the Nasdaq National Market. In addition, any downward pressure on the trading price of our common stock could encourage investors to engage in short sales, which could further contribute to a downward trend in the price of our common stock.
We may be obligated to redeem our Series A and Series C Preferred Stock at a premium to the purchase price.
Holders of our Series A Preferred Stock and Series C Preferred Stock have the right, under certain circumstances, to require us to redeem for cash all of the preferred stock that they own. The redemption price for the Series A Preferred Stock is the greater of (i) 115% of the original purchase price plus 115% of any accrued premium payment thereon and (ii) the aggregate fair market value of the shares of common stock into which such shares of Series A Preferred Stock are then convertible. The redemption price for the Series C Preferred Stock is the greater of (i) 120% of the original purchase price plus 120% of any accrued premium payment thereon and (ii) the aggregate fair market value of the shares of common stock into which such shares of Series C Preferred Stock are then convertible. As of June 30, 2003, there were 589 shares of Series A Preferred Stock and 1,691 shares of Series C Preferred Stock outstanding, with an aggregate redemption price equal to approximately $7.0 million and $20.3 million, respectively.
The Series A Preferred Stock and Series C Preferred Stock are each redeemable by the holders of the respective series in any of the following situations:
21
Table of Contents
• | If we fail to remove a restrictive legend on any certificate representing any common stock that was issued to any holder of such series upon conversion of their preferred stock or exercise of their warrants and that may be sold pursuant to an effective registration statement or an exemption from the registration requirements of the federal securities laws | ||
• | If we fail to have sufficient shares of common stock reserved to satisfy conversions of the series | ||
• | If we fail to honor requests for conversion, or if we notify any holder of such series of our intention not to honor future requests for conversion | ||
• | If we institute voluntary bankruptcy or similar proceedings | ||
• | If we make an assignment for the benefit of creditors, or apply for or consent to the appointment of a receiver or trustee for us or for a substantial part of our property or business, or such a receiver or trustee shall otherwise be appointed | ||
• | If we sell all or substantially all of our assets | ||
• | If we merge, consolidate or engage in any other business combination (with some exceptions), provided that such transaction is required to be reported pursuant to Item 1 of Form 8-K | ||
• | If we commit a material breach under, or otherwise materially violate the terms of, the transaction documents entered into in connection with the issuance of such series |
In addition to the situations already mentioned, the Series A Preferred Stock is redeemable by its holders in either of the following circumstances:
• | If the registration statements covering shares of common stock underlying the Series A Preferred Stock and related warrants cannot be used by the respective selling security holders for the resale of all the underlying shares of common stock for an aggregate of more than 30 days. | ||
• | If our common stock is not tradable on the NYSE, the AMEX, the Nasdaq National Market or the Nasdaq SmallCap market for an aggregate of twenty trading days in any nine month period. In order for our common stock to continue to be quoted on the National Market, we must continue to satisfy various listing maintenance standards established by Nasdaq, including, among other things, a requirement that we have stockholders’ equity of at least $10 million and that our stock price consistently trades at or above $1.00 per share. We have had, and may continue to have, challenges meeting these requirements to maintain a listing on the Nasdaq National Market. | ||
• | If 35% or more of our voting power is held by any one person, entity or group | ||
• | If we fail to pay any indebtedness in excess of $350,000 when due, or if there is any event of default under any agreement that is likely to have a material adverse effect on us | ||
• | Upon the institution of involuntary bankruptcy proceedings |
In addition, the Series C Preferred Stock is redeemable by its holders if, on or prior to November 19, 2004, the two year anniversary of the initial issuance of the Series C Preferred Stock, we issue equity, equity-linked securities, or debt which is convertible into equity, other than (i) upon the exercise of warrants, options or convertible securities issued and outstanding as of the issuance of the Series C Preferred Stock, (ii) upon the grant or exercise of stock options under any stock option plan, (iii) upon issuance or conversion of the Series C Preferred Stock or exercise of the warrants issued in connection with the Series C Preferred Stock, (iv) the issuance of securities in connection with strategic business partnerships, (v) pursuant to an equipment financing from a financial or lending institution and (vi) common stock issued as premium payments on Series A Preferred Stock or Series C Preferred Stock.
Upon the occurrence of any of the events described above, individual holders of the relevant series of preferred stock (or both series in those cases where the right of redemption is triggered for both the Series A Preferred Stock and the Series C Preferred Stock) would have the option, while such event continues, to require us to purchase some or all of the then outstanding shares of Series A Preferred Stock and/or Series C Preferred Stock, as applicable, held by such holder. If we receive any notice of redemption, we are required to immediately (no later than one business day following such receipt) deliver a written notice to all holders of the same
22
Table of Contents
series of preferred stock stating the date when we received the redemption notice and the amount of preferred stock covered by the notice.
Redemption of the Series A Preferred Stock or Series C Preferred Stock in any event described above would require us to expend a significant amount of cash that would exceed our total available cash and cash equivalents and our ability to make such payments or raise additional capital. In addition, if holders of Series C Preferred Stock were to exercise their rights to have redeemed a material number of their shares as a result of any of the events described above, and such a redemption were to have a material adverse effect on the Company, all holders of our Series A Preferred Stock may be able to redeem their shares as well, further endangering our financial position. See the notes to the financial statement for further details.
Our testing products may not achieve market acceptance, which could limit our future revenue.
Our ability to establish phenotypic resistance testing as the standard of care to guide and improve the treatment of viral diseases will depend on physicians’ and clinicians’ acceptance and use of phenotypic resistance testing. Phenotypic resistance testing is still relatively new. We cannot predict the extent to which physicians and clinicians will accept and use phenotypic resistance testing. They may prefer competing technologies and products. The commercial success of phenotypic resistance testing will require demonstrations of its advantages and potential economic value in relation to the current standard of care, as well as to competing products. We have introduced two products using our proprietary PhenoSense technology, PhenoSense HIV and PhenoSense GT, which we began actively marketing in November 1999 and November 2001, respectively. We are still in the early stages of development of new products applying our PhenoSense technology to other viral diseases. If PhenoSense HIV or PhenoSense GT is not accepted in the marketplace, our ability to sell other PhenoSense products would be undermined. Market acceptance will depend on:
• | Our marketing efforts and continued ability to demonstrate the utility of PhenoSense in guiding anti-viral drug therapy, for example, through the results of retrospective and prospective clinical studies | ||
• | Our ability to demonstrate the advantages and potential economic value of our PhenoSense testing products over current treatment methods and other resistance tests |
If the market does not accept phenotypic resistance testing, or our PhenoSense products in particular, our ability to generate revenue will be limited.
Our revenues will be diminished if government and third-party payors limit the amounts that they will reimburse for our current products, or do not authorize reimbursement for our planned products.
Government and third-party payors, which reimburse patients and healthcare providers for medical expenses, are attempting to contain or reduce the costs of healthcare and are challenging the prices charged for medical products and services. In addition, increasing emphasis on managed care in the United States will continue to put pressure on the pricing of healthcare products. This could in the future limit the price that we can charge for our products. This could also hurt our ability to generate revenues. Significant uncertainty exists as to the reimbursement status of new medical products like the products we are currently developing, particularly if these products fail to show demonstrable value in clinical studies. Currently, nearly all public and a majority of private payors have approved the reimbursement of our existing products. However, the majority of our payors are currently reimbursing our products at varying levels from 70% to 100% of our list prices. If government and other third-party payors do not continue to provide adequate coverage and reimbursement for our testing products or do not authorize reimbursement for our planned products, our revenues will be reduced.
Billing complexities associated with health care payors may result in increased bad debt expense, which could impair our cash flow and limit our ability to reach profitability.
Billing for laboratory services is complex. Laboratories must bill various payors, such as patients, insurance companies, Medicare, Medicaid, doctors and employer groups, all of whom have different requirements. Billing difficulties often result in bad debt expense which impairs cash flow and ultimately reduces profitability. Most of the bad debt expense is the result of several noncredit related issues, primarily missing or incorrect billing information on requisitions. We perform the requested tests and report test results regardless of incorrect or missing billing information. We subsequently attempt to obtain any missing information and rectify incorrect billing information received from the healthcare provider. Missing or incorrect information on requisitions slows the billing process, creates backlogs of unbilled requisitions and generally increases the aging of accounts receivable. Among many other factors complicating billing are:
• | Pricing differences between our fee schedules and those of the payors |
23
Table of Contents
• | Disputes between payors as to which party is responsible for payment | ||
• | Disparity in coverage among various payors | ||
• | Difficulties of adherence to specific compliance requirements and procedures mandated by various payors |
Ultimately, if all issues are not resolved in a timely manner, the related receivables are charged to the allowance for doubtful accounts.
We may incur substantial costs related to the defense of employment claims. We do not have any insurance coverage for such claims.
In November 2002, we implemented a business restructuring plan to reduce the rate of our cash consumption and better align our operating structure with current and expected future economic conditions. The restructuring plan included an immediate reduction in force by approximately 17 percent, or 35 employees, to 176 employees, with reductions occurring in all functional areas. With the exception of one, all of the terminated employees signed a release of claims. We also reduced officers salaries and consolidated certain operations, including sales and marketing. We recorded a charge of approximately $0.3 million in the fourth quarter of 2002 associated with these actions. The restructuring could affect our ability to attract and maintain qualified personnel in the future. In addition, we have received correspondence from a former employee terminated pursuant to the reduction in force who threatens to bring claims against us that stem from termination. We have also received correspondence from an employee terminated for cause threatening to bring claims pursuant to the Americans with Disabilities Act. We do not have employee practices liability insurance to cover any potential claims by employees terminated in the reduction of force.
We have limited experience processing patient samples for our resistance tests and may encounter problems or delays in processing tests, or in expanding our automated testing systems, which could result in lost revenue.
In 2002, we processed approximately 28,000 tests. In order to meet future projected demand for our products and fully utilize our current clinical laboratory facilities, we estimate that we will have to approximately double the volume of patient samples that we process. We are also continuing to develop our quality-control procedures and to establish more consistency with respect to test turnaround so that results are delivered in a timely manner. Thus, we need to develop and implement additional automated systems to perform our tests. We also need to, and may not be able to, develop or purchase more sophisticated software to support the automated tests, analyze the data generated by our tests, and report the results. Further, as we attempt to scale up our processing of patient samples, processing or quality-control problems may arise. If we are unable to consistently process patient samples on a timely basis because of these or other factors, or if we encounter problems with our automated processes, our revenues will be limited. We have experienced periods during which our test results were delayed, which in turn delayed delivery of results to our customers. While we take steps to minimize the likelihood of delays, future delays may nevertheless occur.
We face intense competition, and if our competitors’ existing products or new products are more effective than our products, the commercial opportunity for our products will be reduced or eliminated.
The commercial opportunity for our products will be reduced or eliminated if our competitors develop and market new testing products that are superior to, or are less expensive than, our phenotypic and/or genotypic resistance testing products we develop using our proprietary technology. The biotechnology industry evolves at a rapid pace and is highly competitive. Our major competitors include manufacturers and distributors of phenotypic drug resistance technology, such as Tibotec-Virco (division of Johnson & Johnson) and Specialty Laboratory. We also compete with makers of genotypic tests such as Applied Biosystems Group, Visible Genetics Inc. (division of Bayer Diagnostics) and laboratories performing genotypic testing as well as other genotypic testing referred to as virtual phenotyping. Each of these competitors is attempting to establish its test as the standard of care. Tibotec-Virco’s (division of Johnson & Johnson) phenotypic test and genotypic tests have been commercially available for a longer time than has PhenoSense HIV or GeneSeq HIV. Genotypic tests are cheaper and generally faster than phenotypic resistance tests. Our competitors may successfully develop and market other testing products that are either superior to those that we may develop or that are marketed prior to marketing of our testing products. Some of our competitors have substantially greater financial resources and research and development staffs than we do. In addition, some of our competitors have significantly greater experience in developing products, and in obtaining the necessary regulatory approvals of products and processing and marketing products.
We derive a significant portion of our revenues from a small number of customers and our revenues may decline significantly if any major customer cancels or delays a purchase of our products.
24
Table of Contents
Our revenues to date and for the foreseeable future consist largely of sales of our PhenoSense products. Sales to our largest customer, Quest Laboratories, accounted for approximately 10% of our total revenues in 2002. Unless and until we diversify and expand our customer base, our future success will significantly depend upon the timing and size of future sales to Quest Laboratories and our other large customers.
It is likely that we will continue to have significant customer concentration. Our customers are not typically required to purchase tests from us under long-term contracts, and may stop ordering tests from us at any time. The loss of any major customer, a slowdown in the pace of increasing physician and physician group sales as a percentage of sales, or the delay of significant orders from any significant customer, even if only temporary, could have a significant negative impact on our revenues and our ability to fund operations from revenues, generate cash from operations or achieve profitability.
Various testing materials that we use are purchased from single qualified suppliers, which could result in our inability to secure sufficient materials to conduct our business.
We purchase some of the testing materials used in our laboratory operations from single qualified suppliers. Although these materials could be purchased from other suppliers, we would need to qualify the suppliers prior to using their materials in our commercial operations. Although we believe we have ample inventory stock to allow validation of another source, in the event of a material interruption of these supplies, the quantity of our stock may not be adequate. Any extended interruption, delay or decreased availability of the supply of these materials could prevent us from running our business as contemplated and result in our failure to meet our customers’ demands. If significant customer relationships were harmed by our failure to meet customer demands, our revenues may decrease. We might also face significant additional expenses if we are forced to find alternate sources of supplies, or change materials we use. Such expenses could make it more difficult for us to attain profitability, offer our tests at competitive prices and continue our business as currently conducted or at all.
We are dependent on a license for technology we use in our resistance testing, and our business would suffer if the license was terminated.
We license technology that we use in our PhenoSense and GeneSeq tests from Roche. We hold a non-exclusive license for the life of the patent term of the last licensed Roche patent. Currently, the last Roche patent expires in 2005. However, if additional patents are identified that would be necessary or useful for our operations, such patents could be added to the license at our option, which may extend the term of the license. We believe that many of our competitors, including Tibotec-Virco (division of Johnson & Johnson) and other resistance testing companies, also license this technology on non-exclusive terms. Roche has the right to terminate this license if we fail to pay royalties, make a semi-annual royalty report or participate in proficiency testing. We believe we are in compliance with these requirements. The license allows us to use technology covered by the licensed Roche patents within a broad field that includes all of our currently planned products. If we were to expand our product line beyond the licensed field, however, we would need to negotiate an expansion of the license. If the license were to be terminated by Roche, we would have to change a portion of our testing methodology, which would halt our testing, at least temporarily, and cause us to incur substantial additional expenses.
The intellectual property protection for our technology and trade secrets may not be adequate, allowing third parties to use our technology or similar technologies, and thus reducing our ability to compete in the market.
The strength of our intellectual property protection is uncertain. In particular, we cannot be sure that:
• | We were the first to invent the technologies covered by our patent or pending patent applications | ||
• | We were the first to file patent applications for these inventions | ||
• | Others will not independently develop similar or alternative technologies or duplicate any of our technologies | ||
• | Any of our pending patent applications will result in issued patents | ||
• | Any patents issued to us will provide a basis for commercially viable products or will provide us with any competitive advantages or will not be challenged by third parties |
We currently have nine issued patents, five allowed patent applications, and pending applications for seventy-three additional patents, including international counterparts to our US patents. We have licensed seven patents under the Roche license discussed above. These patents cover a broad range of technology applicable across our entire current and planned product line. Other companies may have patents or patent applications relating to products or processes similar to, competitive with or otherwise related
25
Table of Contents
to our products. Patent law relating to the scope of claims in the technology fields in which we operate, including biotechnology and information technology, is still evolving and, consequently, patent positions in our industry are generally uncertain. We cannot assure you that we will prevail in any lawsuits regarding the enforcement of patent rights or that, if successful, we will be awarded commercially valuable remedies. In addition, it is possible that we will not have the required resources to pursue offensive litigation or to otherwise protect our patent rights. We also rely on unpatented trade secrets to protect our proprietary technology. Other companies may independently develop or otherwise acquire equivalent technology or gain access to our proprietary technology.
Our products could infringe on the intellectual property rights of others, which may cause us to engage in costly litigation and, if we are not successful defending any such litigation or we cannot obtain necessary licenses, could cause us to pay substantial damages and prohibit us from selling our products.
Companies in our industry typically receive a higher than average number of claims and threatened claims of infringement of intellectual property rights. Third parties have from time to time threatened to assert infringement or other intellectual property claims against us based on their patents or other intellectual property rights. For instance, we have been informed by the National Institutes of Health (“NIH”) that they believe we require one or more licenses in order to perform certain of our tests. We are in negotiations with the NIH and believe such licenses would be available on commercially reasonable terms. To date, we have not had to incur and do not expect to incur significant costs to defend against or settle such threatened claims. However, in the future we may have to pay substantial damages, possibly including treble damages, for infringement if it is ultimately determined that our products infringe a third party’s patents. Further, we may be prohibited from selling our products before we obtain a license, which, if available at all, may require us to pay substantial royalties. Even if infringement claims against us are without merit, defending a lawsuit takes significant time, may be expensive and may divert management attention from other business concerns.
If we do not successfully introduce new products using our technology, we may not sustain long-term revenue growth.
We may not be able to develop and market new resistance testing products for HIV and other serious diseases, including hepatitis. Demand for these products will depend in part on the development by others of additional anti-viral drugs to fight these diseases. Physicians will likely use our resistance tests to determine which drug is best for a particular patient only if there are multiple drug treatment options. Several anti-viral drugs currently are in development but we cannot assure you that they will be approved for marketing, or if these drugs are approved that there will be a need for our resistance tests. If we are unable to develop and market resistance test products for other viral diseases, or if an insufficient number of anti-viral drug products are approved for marketing, we may not sustain long-term revenue growth.
Our business operations and the operation of our clinical laboratory facility are subject to stringent regulations and if we are unable to comply with them, we may be prohibited from accepting patient samples or may incur additional expense to attain and maintain compliance.
The operation of our clinical laboratory facility is subject to a stringent level of regulation under the Clinical Laboratory Improvement Amendments of 1988. Laboratories must meet various requirements, including requirements relating to quality assurance, quality control and personnel standards. Our laboratory is also subject to regulation by the state of California and various other states. We have received accreditation by the College of American Pathologists and therefore are subject to their requirements and evaluation. Our failure to comply with applicable requirements could result in various penalties, including loss of certification or accreditation, and we may be prevented from conducting our business as we do now or as we may wish to in the future.
The FDA may impose medical device regulatory requirements on our tests, including possibly premarket approval requirements, which could be expensive and time-consuming and could prevent us from marketing these tests.
In the past, the FDA has not required that genotypic or phenotypic testing conducted at a clinical laboratory be subject to premarketing clearance or approval, although the FDA has stated that it believes its jurisdiction extends to tests generated in a clinical laboratory. We received a letter from the FDA in September 2001 that asserted such jurisdiction over in-house tests like ours, but which also stated the FDA is not currently requiring premarket approval for HIV monitoring tests such as ours provided that the promotional claims for such tests are limited to its analytical capabilities and do not mention the benefit of making treatment decisions on the basis of test results. The FDA letter also asserted that our GeneSeq test had been misbranded due to the use of purchased analyte specific reagents (ASRs), if test reports do not include a statement disclosing that the test has not been cleared or approved by the FDA. We now utilize in-house prepared ASRs in our products. The FDA has indicated in discussions that the focus of the letter was our genotypic tests and not our phenotypic tests, but there is no certainty its focus will remain narrow.
26
Table of Contents
We have had several discussions with the FDA related to its positions set forth in the letter. We do not at this point believe the FDA will require us to take steps that materially affect our business or financial performance, but we cannot guarantee this will remain the case.
We cannot be sure that the FDA will accept the steps we take, or that the FDA will not require us to alter our promotional claims or undertake the expensive and time-consuming process of seeking premarket approval with clinical data demonstrating the sensitivity and specificity of our tests. If premarket approval is required, we cannot be sure that we will be able to obtain it in a timely fashion or at all; and in such event the FDA would have authority to require us to cease marketing tests until such approval is granted.
In general, we cannot predict the extent of future FDA regulation of our business. We might be subject in the future to greater regulation, or different regulations, that could have a material effect on our finances and operations. If we fail to comply with existing or additional FDA regulations, it could cause us to incur civil or criminal fines and penalties, increase our expenses, prevent us from increasing revenues, or hinder our ability to conduct our business.
If we do not comply with laws and regulations governing the confidentiality of medical information, we may lose the state licensure we need to operate our business, and may be subject to civil, criminal or other penalties. Compliance with such laws and regulations could be expensive.
The Health Insurance Portability and Accountability Act of 1996, or HIPAA, includes the following provisions:
• | Transactions and Code Sets: Covered entities must adopt a standardized format for all electronic claims processing maintained by a health plan, health care provider or health care data clearinghouse. The compliance date for this provision was October 16, 2002. However, Congress approved a twelve-month extension for covered entities wishing to file a formal compliance extension plan. We filed a formal compliance extension plan due to vendor supplied code not being available until the first quarter of 2003. | ||
• | Privacy: Covered entities must provide for standardized protections for certain types of health-related information and its receipt, delivery and storage and establish a formal privacy program and designate a privacy officer. The compliance date for this provision was April 14, 2003. |
Our HIPAA project plans have two phases: 1) assessment of current systems, applications, processes and procedure testing and validation for HIPAA compliance; and 2) remediation of affected systems, applications, processes and procedure testing and validation for HIPAA compliance.
We have completed the assessment and remediation phases of the Privacy provision. We have met the April 2003 required date.
We have completed the assessment phase of the Transactions and Code Sets provision. Remediation is currently in progress and we expect to meet the October 2003 extension date. We believe that this project will add new functionality to existing systems and plan to capitalize these expenditures as incurred.
In addition to the HIPAA provisions described above, which have not yet been fully implemented, there are a number of state laws regarding the confidentiality of medical information, some of which apply to clinical laboratories. These laws vary widely, and new laws in this area are pending, but they most commonly restrict the use and disclosure of medical information without patient consent. Penalties for violation of these laws include sanctions against a laboratory’s state licensure, as well as civil and/or criminal penalties. Because laboratory orders and reports fall within the scope of HIPAA, the costs of HIPAA compliance will impact us and others in the clinical laboratory industry. Compliance with the HIPAA rules could require us to spend substantial sums, which could negatively impact our profitability. At this time, we cannot assess the total financial or other impact of the HIPAA regulations on us.
Our information and other internal systems may not work effectively and as a result we may not be able to process orders, record transactions and meet our reporting obligations, which in turn could affect our ability to run our business efficiently or profitably.
We have installed several information systems, including enterprise resource and laboratory information systems. If our information and internal systems do not work effectively, we may experience delays or failures in our operations. These delays or failures could adversely impact the promptness and accuracy of our transaction processing, financial accounting and reporting and ability to properly forecast earnings and cash requirements. Our current and planned systems, transaction processing, procedures and controls may not be adequate to support future operations. To manage the expected growth of our operations and personnel, we will need to continue to improve our operational and financial systems, transaction processing, procedures and controls.
27
Table of Contents
We may be unable to build brand loyalty because our trademarks and trade names may not be protected.
Our registered or unregistered trademarks or trade names such as the name PhenoSense, PhenoSense GT, PhenoScreen and GeneSeq may be challenged, canceled, infringed, circumvented or declared generic or determined to be infringing on other marks. We may not be able to protect our rights to these trademarks and trade names, which we need to build brand loyalty. Brand recognition is critical to our short-term and long-term marketing strategies especially as we commercialize future enhancements to our products.
Clinicians or patients using our products or services may sue us and our insurance may not sufficiently cover all claims brought against us which will increase our expenses.
Clinicians, patients and others may at times seek damages from us if drugs are incorrectly prescribed for a patient based on testing errors or similar claims. Although we have obtained liability insurance coverage, we cannot guarantee that liability insurance will continue to be available to us on acceptable terms or that our coverage will be sufficient to protect us against all claims that may be brought against us. We may incur significant legal defense expenses in connection with a liability claim, even one without merit or for which we have coverage.
Our lack of operating experience may cause us difficulty in managing our growth and attracting and retaining skilled personnel, which could hinder our commercial efforts and impair our ability to compete.
We have been operating since 1995, and began processing patient samples and selling products commercially in 1999. If our management is unable to manage our growth effectively, it is possible that our systems and our facilities may become inadequate. Our success also depends on our continued ability to attract and retain highly qualified management and scientific personnel. Competition for personnel is intense. It is difficult to fill certain positions. With the exception of Bill Young, our CEO, we do not have employment agreements with any of our employees, and we do not maintain “key man” insurance for any employee. If any of our key employees were to leave, we may incur significant costs searching for a replacement. In addition, we have entered into severance agreements with our officers that would, in some instances, require us to pay severance to such officers upon the termination of their employment. If we cannot successfully attract and retain qualified personnel, our research and development efforts could be hindered and our ability to run our business effectively and compete with others in our industry will be harmed. Although in the recent past, we have not experienced significant difficulty attracting and retaining key employees, there can be no assurance that we will not encounter difficulty in the future. We are not aware that any key employee has plans to retire or leave in the near future.
We may be subject to litigation, which would be time consuming and divert our resources and the attention of our management.
We have received correspondence from a former employee terminated pursuant to the reduction in force who threatens to bring claims against us that stem from termination. We have also received correspondence from an employee terminated for cause threatening to bring claims pursuant to the Americans with Disability Act. In addition, we may in the future be subject to other claims and may have to spend significant additional resources and time responding to such claims. Even if we are eventually successful in our defense of any such claim, the time and money spent may prevent us from operating our business effectively or profitably or may distract our management.
Preliminary investigations by the U.S. Attorney’s Office and the Securities and Exchange Commission may be expensive and divert the time and attention of our management.
Allegations of improper conduct concerning our 2001 and 2002 public revenue guidance were raised by one of our former employees, and similar allegations have been made in internet chat room postings, email and anonymous letter communications. Because these unsubstantiated allegations were repeated in communications to governmental agencies, they have necessarily precipitated preliminary investigations by the U.S. Attorney’s Office, Northern District of California, and the Securities and Exchange Commission.
On June 10, 2003, we were informed by the U.S. Attorney’s Office, Northern District of California that it had terminated its investigation, without prejudice to re-opening the investigation if and when appropriate credible and relevant evidence was brought forward. We believe the preliminary investigation by the Securities and Exchange Commission remains open.
Preliminary investigations may continue for a prolonged period and may not be concluded in the manner we expect. If these preliminary investigations are prolonged, or are not concluded in the manner we expect, we could incur substantial additional costs
28
Table of Contents
and our management’s attention and resources could be increasingly diverted, which generally may prevent management from focusing on the operation of our business and therefore delay our ability to operate profitably.
Our operating results may fluctuate from quarter to quarter, making it likely that, in some future quarter or quarters, we will fail to meet estimates of operating results or financial performance, causing our stock price to fall.
If revenue declines in a quarter, our losses will likely increase or our earnings will likely decline because many of our expenses are relatively fixed. Though our revenues may fluctuate significantly as we continue to build the market for our products, expenses such as research and development, sales and marketing and general and administrative are not affected directly by variations in revenue. In addition, our cost of product revenue could also fluctuate significantly due to variations in the demand for our product and the relatively fixed costs to produce it. We cannot accurately predict how volatile our future operating results will be because our past and present operating results, which reflect moderate sales activity, are not indicative of what we might expect in the future. As a result it is very difficult for us to forecast our revenues accurately. It is likely that in some future quarter or quarters, our operating results will be below the expectations of securities analysts or investors, as they have been in the past. In this event, the market price of our common stock may fall abruptly and significantly. Because our revenue and operating results are difficult to predict, we believe that period-to-period comparisons of our results of operations are not a good indication of our future performance.
If a natural disaster strikes our clinical laboratory facility, we would be unable to receive and or process our customers’ samples for a substantial amount of time and we would lose revenue.
We rely on a single clinical laboratory facility to process patient samples for our tests, which are received via delivery service or mail, and have no alternative facilities. We will also use this facility for conducting other tests we develop, and even if we move into different or additional facilities they will likely be in close proximity to our current clinical laboratory. Our clinical laboratory and some pieces of processing equipment are difficult to replace and could require substantial replacement lead-time. Our processing facility may be affected by natural disasters such as earthquakes and floods. Earthquakes are of particular significance since our clinical laboratory is located in South San Francisco, California, an earthquake-prone area. Our laboratory and equipment are insured up to $15.3 million against loss or damage in the event of a fire but not in the event of a flood or an earthquake. We also have business interruption insurance that provides coverage up to $25 million for business losses related to fire. Our insurance coverage may not be adequate to cover total losses incurred in a fire. However, even if covered by insurance, in the event our existing clinical laboratory facility or equipment is affected by natural disasters, we would be unable to process patient samples and meet customer demands or sales projections. If our patient sample processing operations were curtailed or ceased, we would not be able to perform our tests, which would reduce our revenues, and may cause us to lose the trust of our customers or market share.
Terrorist acts and acts of war may seriously harm our business and financial condition.
Terrorists acts or acts of war (wherever located around the world) may cause damage or disruption to our company, employees, facilities, partners, suppliers, distributors and resellers, and customers, which could significantly impact our revenues, costs and expenses and financial condition. The terrorist attacks that took place in the United States on September 11, 2001 and the potential for future attacks have created many economic and political uncertainties, some of which may materially harm our business and results of operations in ways that cannot presently be predicted. In addition, as our headquarters and our significant patient populations are located in major metropolitan areas of the United States, we may be impacted by actions against the United States. Depending on severity and location, such acts could impact our ability to receive shipments of patient samples or result in a substantial reduction in the number of ordered tests due to the inability of patients to get to their physicians. We will be predominantly uninsured for losses and interruptions caused by terrorist acts and acts of war.
Concentration of ownership among some of our stockholders may prevent other stockholders from influencing significant corporate decisions.
At March 31, 2003, approximately 34% of our common stock was beneficially held by a small number of stockholders including an affiliate of Pfizer, our directors, entities affiliated with our directors and former directors, and our executive officers. In addition, our Series A Preferred Stock and Series C Preferred Stock, described elsewhere, are held by a small number of stockholders, some of whom also own shares of our common stock and could acquire significant additional shares of common stock by converting shares of preferred stock. Consequently, a small number of our stockholders may be able to substantially influence our management and affairs. If acting together, they would be able to influence most matters requiring the approval by our stockholders, including the election of directors, any merger, consolidation or sale of all or substantially all of our assets and any other significant corporate transaction. The concentration of ownership may also delay or prevent a change in our control at a premium price if these stockholders oppose it. There are also certain approval rights of the Series A Preferred Stock and Series C Preferred Stock, and the few holders of those shares could prevent certain important corporate actions by not approving those actions.
29
Table of Contents
Our stock price may be volatile, and our stock could decline in value.
The market prices for securities of biotechnology companies in general have been highly volatile and may continue to be highly volatile in the future. Our stock price has fluctuated widely since we became a publicly traded company, from a high of $26.75 per share in July 2000 to a low of $0.72 per share in September 2002. The following factors, in addition to other risk factors described in this section, may have a significant negative impact on the market price of our common stock:
• | Period-to-period fluctuations in financial results | ||
• | Financing activities | ||
• | Litigation | ||
• | Announcements of technological innovations or new commercial products by our competitors | ||
• | Results from clinical studies | ||
• | Developments concerning proprietary rights, including patents | ||
• | Publicity regarding actual or potential medical results relating to products under development by our competitors | ||
• | Regulatory developments in the United States and foreign countries | ||
• | Changes in payor reimbursement policies | ||
• | Economic and other external factors or other disaster or crisis |
A low or volatile stock price may negatively impact our ability to raise capital and to attract and maintain key employees. In addition, should the market price of our common stock remain below $1.00 per share for an extended period and/or our stockholders’ equity falls below $10 million, we risk having our shares delisted from the Nasdaq National Market.
If we fail to meet Nasdaq’s continued listing requirements, our shares may be delisted from the Nasdaq National Market. This could reduce our stockholders’ liquidity, make it more difficult for us to raise capital and, in certain instances, require us to redeem our outstanding shares of Series A Preferred Stock.
In order for our common stock to continue to be quoted on the National Market, we must satisfy various listing maintenance standards established by Nasdaq, including, among other things, a requirement that we have stockholders’ equity of at least $10 million and that our stock price consistently trades at or above $1.00 per share. We have had, and may continue to have, challenges meeting these requirements to maintain a listing on the Nasdaq National Market.
If we were to be delisted from the National Market and move to an alternative market (including possibly the Nasdaq SmallCap Market), which may be less efficient and less broad-based, we may have a harder time accessing capital markets for additional funding, and our stockholders may experience reduced liquidity. In addition, if at any time we are not listed on the National Market, the SmallCap Market, the American Stock Exchange or the New York Stock Exchange, our outstanding shares of Series A Preferred Stock are subject to redemption, which could drain our financial resources and make it difficult or impossible to continue as a going concern.
We may be required to obtain the consent of the holders of our preferred stock before taking corporate actions, which could harm our business.
Our charter documents require us to obtain the consent of the holders of the Series A and Series C Preferred Stock, each voting as a separate series, before we may issue securities that have senior or equal rights to the respective series, or if we incur unsecured indebtedness for borrowed money, or take other actions with respect to the respective series or other securities. We are also required to obtain the consent of the holders of the Series A and Series C Preferred Stock, again each voting as a separate series, before we amend or modify our certificate of incorporation or bylaws to change any of the rights of such series. To obtain these consents, we would need to get consent from holders of a majority of the outstanding shares of the Series A and Series C Preferred Stock.
30
Table of Contents
These obligations, and our complicated capitalization structure in general, might frustrate attempts to remove our board or management by making it difficult to find suitable replacements willing to spend substantial amounts of time and efforts on company matters. Moreover, these obligations may deter a potential acquirer from completing a transaction with us. They may also prevent us from taking corporate actions that would be beneficial to our stockholders and us, such as raising capital. Even if we are not prevented from taking such actions, they might be more expensive to us. This was the case when we issued our Series B Preferred Stock in March 2002, because we had to grant additional warrants to holders of Series A Preferred Stock as consideration in order to secure their consent and waiver concerning the financing and the resulting impact on the Series A Preferred Stock. This was also the case when we issued our Series C Preferred Stock in November 2002, because we had to agree to exchange the shares of Series B Preferred Stock for notes that were convertible into Series C Preferred Stock, and to exchange the warrants associated with shares of Series B Preferred Stock for new warrants as consideration to secure the consent and waiver of the Series B Preferred Stock holders concerning the financing and the resulting impact on their respective preferred stock.
If our stockholders sell substantial amounts of our common stock, the market price of our common stock may fall.
If our stockholders sell substantial amounts of our common stock, including shares issued upon the exercise of outstanding options and warrants and upon the conversion of the Series A and Series C Preferred Stock, the market price of our common stock may fall. These sales also might make it more difficult for us to sell equity or equity-related securities in the future at a time and price that we deem appropriate. Sales of a substantial number of shares could occur at any time. This may decrease the price of our common stock and may impair our ability to raise capital in the future.
Provisions of our charter documents and Delaware law may make it difficult for our stockholders to replace our management and may inhibit a takeover, either of which could limit the price investors might be willing to pay in the future for our common stock.
Provisions in our certificate of incorporation and bylaws may make it difficult for our stockholders to replace or remove our current management, and may delay or prevent an acquisition or merger in which we are not the surviving company. In particular:
• | Our Board of Directors is classified into three classes, with only one of the three classes elected each year, so that it would take at least two years to replace a majority of our directors | ||
• | Our bylaws contain advance notice provisions that limit the business that may be brought at an annual meeting and place procedural restrictions on the ability to nominate directors | ||
• | Our stockholders are not permitted to call special meetings or act by written consent |
The Series A Preferred Stock and Series C Preferred Stock also have voting rights relating to many types of transactions, such as the creation or issuance of senior or pari passu equity or debt securities and the payment of dividends or distributions, and are subject to redemption at the option of the holder upon certain mergers, consolidations or other business combinations. In addition, because we are incorporated in Delaware, we are governed by the provisions of Section 203 of the Delaware General Corporation Law. These provisions could discourage changes of our management and acquisitions or other changes in our control and otherwise limit the price that investors might be willing to pay in the future for our common stock.
31
Table of Contents
Item 3. Quantitative and Qualitative Disclosures About Market Risk
The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. Some of the securities that we invest in may have market risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate. For example, if we hold a security that was issued with a fixed interest rate at the then-prevailing rate and the prevailing interest rate later rises, the principal amount of our investment will probably decline. To minimize this risk in the future, we intend to maintain our portfolio of cash equivalents and short-term investments in a variety of securities, including commercial paper, money market funds, government and non-government debt securities. Due to the relatively short-term nature of our investments, we believe we have no material exposure to interest rate risk arising from our investments. Therefore we have not included quantitative tabular disclosure in this Form 10-Q.
We do not enter into financial investments for speculation or trading purposes and are not a party to financial or commodity derivatives.
We have operated primarily in the United States and all sales to date have been made in U.S. Dollars. Accordingly, we have not had any material exposure to foreign currency rate fluctuations.
Item 4. Controls and Procedures
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our filings under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to management, including the Chief Executive Officer and the Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
Our Chief Executive Officer and Chief Financial Officer, with the assistance of other members of our management, have evaluated our disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as of the end of the period covered by this report, and have concluded based on that evaluation that those disclosure controls and procedures are effective. There has been no change in our internal control over financial reporting during the fiscal quarter ended June 30, 2003 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
32
Table of Contents
PART II
Item 1. Legal Proceedings
Allegations of improper conduct concerning our 2001 and 2002 public revenue guidance were raised by one of our former employees, and similar allegations have been made in internet chat room postings, email and anonymous letter communications. Because these unsubstantiated allegations were repeated in communications to governmental agencies, they have necessarily precipitated preliminary investigations by the U.S. Attorney’s Office, Northern District of California, and the Securities and Exchange Commission.
On June 10, 2003, we were informed by the U.S. Attorney’s Office, Northern District of California that it had terminated its investigation, without prejudice to re-opening the investigation if and when appropriate credible and relevant evidence was brought forward. We believe the preliminary investigation by the Securities and Exchange Commission remains open. As of the date of this Quarterly Report, no legal action has been filed against us, or any of our officers, directors or employees, and we do not expect that any such action will be filed.
Item 2. Changes In Securities and Use of Proceeds
(a) None.
(b) None.
(c) Recent Sales of Unregistered Securities
In May 2003, we issued 57,900 shares of our common stock to a holder of our warrants upon such holder’s exercise of warrants for an aggregate cash exercise price of $1.11 per share. For this issuance, we relied on the exemption provided by Section 4(2) of the Securities Act. |
In May 2003, we issued 158,226 shares of our common stock to two holders of our Series C Preferred Stock upon such holders’ conversion of certain shares of Series C Preferred Stock held by such holders. For this issuance, we relied on the exemption provided by Section 4(2) of the Securities Act. |
In June 2003, we issued 420,506 shares of our common stock to six holders of our warrants upon such holders’ net exercise of warrants held by such holders. In June 2003, we also issued 827,332 shares of our common stock to five holders of our warrants upon such holders’ exercise of warrants for an aggregate cash exercise price of $1.11 per share. For this issuance, we relied on the exemption provided by Section 4(2) of the Securities Act. |
In June 2003, we issued 235,386 shares of our common stock with a market value of $337,000 as of the date of such issuance as a dividend on certain outstanding shares of Series C Preferred Stock. For this issuance, we relied on the exemption provided by Section 4(2) of the Securities Act. |
In June 2003, we issued 1,495,818 shares of our common stock to three holders of our Series C Preferred Stock upon such holders’ conversion of certain shares of Series C Preferred Stock held by such holders. For this issuance, we relied on the exemption provided by Section 4(2) of the Securities Act. |
(d) None.
Item 3. Defaults Upon Senior Securities
None.
Item 4. Submission of Matters to Vote of Security Holders
We held our Annual Stockholders Meeting on May 21, 2003, and two matters were voted upon. A description of each matter and tabulation of votes are as follows:
1. | The following nominee was elected as a director to hold office until the 2006 Annual Stockholder Meeting or until his successor is elected and qualified: |
33
Table of Contents
Nominee | Votes For | Votes Against | ||||||
David H. Persing | 21,157,939 | 276,712 |
2. | The appointment of Ernst & Young LLP as the Company’s independent public accountants for the fiscal year ending December 31, 2003 was ratified. |
The voting for the proposal was as follows: |
For | 21,209,245 | |||
Against | 220,328 | |||
Abstain | 5,078 |
Item 5. Other Information
None.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
Exhibit | ||
Number | Caption | |
31.1 | Certification of Chief Executive Officer pursuant to Rule 13a-14(A) or Rule 15d-14(A) promulgated under the Securities Exchange Act of 1934. | |
31.2 | Certification of Chief Financial Officer pursuant to Rule 13a-14(A) or Rule 15d-14(A) promulgated under the Securities Exchange Act of 1934. | |
32.1 | Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350 and Rule 13a-14(B) or Rule 15d-14(B) promulgated under the Securities Exchange Act of 1934. |
(b) Reports on Form 8-K
On April 14, 2003, we filed a report on Form 8-K to furnish our unaudited condensed balance sheet as of February 28, 2003 as requested by Nasdaq before confirming that we were in compliance with the minimum stockholders’ equity and minimum bid price requirements for continued listing on The Nasdaq National Market.
On April 16, 2003, we filed a report on Form 8-K to report that we have received written confirmation from the Nasdaq Stock Market, Inc. that we were in compliance with the minimum stockholders’ equity and minimum bid price requirements for continued listing on The Nasdaq National Market.
On May 6, 2003, we filed a report on Form 8-K to furnish our earnings release for the quarter ended March 31, 2003.
34
Table of Contents
SIGNATURES
Pursuant to the requirements of the Securities Act of 1934, as amended, the registrant has duly caused this Quarterly Report on Form 10-Q to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of South San Francisco, County of San Mateo, State of California, on August 5, 2003.
ViroLogic, Inc. | ||
By: | /s/ William D. Young | |
William D. Young | ||
Chief Executive Officer | ||
(On Behalf of the Registrant) | ||
/s/ Karen J. Wilson | ||
Karen J. Wilson | ||
Vice President and Chief Financial Officer | ||
(Principal Financial and Accounting Officer) |
35
Table of Contents
EXHIBITS INDEX
Exhibit | ||
Number | Caption | |
31.1 | Certification of Chief Executive Officer pursuant to Rule 13a-14(A) or Rule 15d-14(A) promulgated under the Securities Exchange Act of 1934. | |
31.2 | Certification of Chief Financial Officer pursuant to Rule 13a-14(A) or Rule 15d-14(A) promulgated under the Securities Exchange Act of 1934. | |
32.1 | Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350 and Rule 13a-14(B) or Rule 15d-14(B) promulgated under the Securities Exchange Act of 1934. |
36