1998 - -------------------------------------------------------------------------------- PruTech Research and Annual Development Partnership III Report LETTER TO UNITHOLDERS FOR PRUTECH RESEARCH AND DEVELOPMENT PARTNERSHIP III (a limited partnership) 1 PRUTECH III INVESTMENTS The Partnership had a position in the following investments and/or royalty rights as of December 31, 1998. CREATIVE BIOMOLECULES, INC. (CBMI) Position: 20,000 shares of common stock; royalty rights on soft tissue growth factor products which expire December 1999 During the fourth quarter of 1998, the Partnership sold 4,484 shares of CBMI common stock for approximately $12,000. The stock price of CBMI was $2.50 per share as of March 24, 1999. It appears unlikely that the Partnership's projects will produce sales royalties for the Partnership as the Partnership's royalty rights expire in 1999. FOREST LABORATORIES, INC. (FRX) Position: Royalty rights to a drug treatment for Alzheimer's disease which expire December 1999 The filing of a New Drug Application with the Food and Drug Administration, seeking approval of Synapton, a drug developed by FRX for the treatment of Alzheimer's disease, was made on November 18, 1997. On November 18, 1998, FRX announced that it was evaluating and would be preparing a response to a non-approvable letter received from the Food and Drug Administration on its new drug application for Synapton. Forest has recently advised the Partnership that it will be meeting with the FDA to discuss the status of Synapton. 2 PricewaterhouseCoopers (LOGO) PricewaterhouseCoopers LLP 1177 Avenue of the Americas New York, NY 10036 Telephone (212) 596 8000 Facsimile (212) 596 8910 Report of Independent Accountants February 12, 1999 To the Partners of PruTech Research and Development Partnership III In our opinion, the accompanying statements of financial condition and the related statements of operations, changes in partners' capital and cash flows present fairly, in all material respects, the financial position of PruTech Research and Development Partnership III at December 31, 1998 and 1997, and the results of its operations and the changes in its cash flows for each of the three years in the period ended December 31, 1998 in conformity with generally accepted accounting principles. These financial statements are the responsibility of the general partner; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by the general partner, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. /s/ PricewaterhouseCoopers LLP 3 PRUTECH RESEARCH AND DEVELOPMENT PARTNERSHIP III (a limited partnership) STATEMENTS OF FINANCIAL CONDITION December 31, ----------------------------- 1998 1997 - ---------------------------------------------------------------------------------------------------- ASSETS Cash and cash equivalents $1,157,931 $3,668,595 Investments in equity securities 73,760 552,790 ------------ ------------ Total assets $1,231,691 $4,221,385 ------------ ------------ ------------ ------------ LIABILITIES AND PARTNERS' CAPITAL Liabilities Accrued management fee $ 62,500 $ 62,500 Accrued expenses and other liabilities 57,698 84,357 ------------ ------------ Total liabilities 120,198 146,857 ------------ ------------ Contingencies Partners' capital Unitholders (40,934 units issued and outstanding) 985,900 3,405,966 General partner 117,283 386,179 Accumulated other comprehensive income 8,310 282,383 ------------ ------------ Total partners' capital 1,111,493 4,074,528 ------------ ------------ Total liabilities and partners' capital $1,231,691 $4,221,385 ------------ ------------ ------------ ------------ - ---------------------------------------------------------------------------------------------------- The accompanying notes are an integral part of these statements. 4 PRUTECH RESEARCH AND DEVELOPMENT PARTNERSHIP III (a limited partnership) STATEMENTS OF OPERATIONS Year ended December 31, -------------------------------------- 1998 1997 1996 - --------------------------------------------------------------------------------------------------- REVENUES Gain on sale of investments in equity securities $243,595 $7,888,065 $5,194,202 Interest and other income 116,202 135,893 38,019 Royalty income -- -- 216,665 -------- ---------- ---------- 359,797 8,023,958 5,448,886 -------- ---------- ---------- EXPENSES Management fee 250,000 534,340 818,680 General and administrative 69,826 138,378 95,688 Write-down of investments in equity securities -- 295,000 -- -------- ---------- ---------- 319,826 967,718 914,368 -------- ---------- ---------- Net income $ 39,971 $7,056,240 $4,534,518 -------- ---------- ---------- -------- ---------- ---------- ALLOCATION OF NET INCOME Unitholders $ 35,974 $6,350,616 $4,081,066 -------- ---------- ---------- -------- ---------- ---------- General partner $ 3,997 $ 705,624 $ 453,452 -------- ---------- ---------- -------- ---------- ---------- Net income per unit $ .88 $ 155.14 $ 99.70 -------- ---------- ---------- -------- ---------- ---------- - --------------------------------------------------------------------------------------------------- STATEMENTS OF CHANGES IN PARTNERS' CAPITAL ACCUMULATED OTHER GENERAL COMPREHENSIVE UNITHOLDERS PARTNER INCOME (LOSS) TOTAL - ------------------------------------------------------------------------------------------------------- Partners' capital--December 31, 1995 $ 7,505,854 $ 841,722 $ 11,254,503 $ 19,602,079 Comprehensive loss: Net income 4,081,066 453,452 4,534,518 Net unrealized losses on investments in equity securities (5,118,761) (5,118,761) ------------ Comprehensive loss (584,243) ------------ Distributions (3,274,720) (363,858) (3,638,578) ------------ ----------- -------------- ------------ Partners' capital--December 31, 1996 8,312,200 931,316 6,135,742 15,379,258 Comprehensive income: Net income 6,350,616 705,624 7,056,240 Net unrealized losses on investments in equity securities (5,853,359) (5,853,359) ------------ Comprehensive income 1,202,881 ------------ Distributions (11,256,850) (1,250,761) (12,507,611) ------------ ----------- -------------- ------------ Partners' capital--December 31, 1997 3,405,966 386,179 282,383 4,074,528 Comprehensive loss: Net income 35,974 3,997 39,971 Net unrealized losses on investments in equity securities (274,073) (274,073) ------------ Comprehensive loss (234,102) ------------ Distribution (2,456,040) (272,893) (2,728,933) ------------ ----------- -------------- ------------ Partners' capital--December 31, 1998 $ 985,900 $ 117,283 $ 8,310 $ 1,111,493 ------------ ----------- -------------- ------------ ------------ ----------- -------------- ------------ - ------------------------------------------------------------------------------------------------------- The accompanying notes are an integral part of these statements. 5 PRUTECH RESEARCH AND DEVELOPMENT PARTNERSHIP III (a limited partnership) STATEMENTS OF CASH FLOWS Year ended December 31, -------------------------------------------- 1998 1997 1996 - ----------------------------------------------------------------------------------------------------- CASH FLOWS FROM OPERATING ACTIVITIES Interest and other income received $ 116,202 $ 135,893 $ 38,019 Management fee paid (250,000) (676,510) (818,680) General and administrative expenses paid (96,485) (134,459) (88,341) Royalty income received -- -- 216,665 Cash received for other assets -- -- 216,669 ----------- ------------ ----------- Net cash used in operating activities (230,283) (675,076) (435,668) ----------- ------------ ----------- CASH FLOWS FROM INVESTING ACTIVITIES Proceeds from the sale of investments in equity securities 448,552 14,567,491 5,935,995 Purchase of investments in equity securities -- (58,650) -- ----------- ------------ ----------- Net cash provided by investing activities 448,552 14,508,841 5,935,995 ----------- ------------ ----------- CASH FLOWS FROM FINANCING ACTIVITIES Distributions (2,728,933) (12,507,611) (3,638,578) ----------- ------------ ----------- Net (decrease) increase in cash and cash equivalents (2,510,664) 1,326,154 1,861,749 Cash and cash equivalents at beginning of year 3,668,595 2,342,441 480,692 ----------- ------------ ----------- Cash and cash equivalents at end of year $ 1,157,931 $ 3,668,595 $ 2,342,441 ----------- ------------ ----------- ----------- ------------ ----------- - ----------------------------------------------------------------------------------------------------- (continued on next page) 6 PRUTECH RESEARCH AND DEVELOPMENT PARTNERSHIP III (a limited partnership) STATEMENTS OF CASH FLOWS (Cont'd) Year ended December 31, -------------------------------------------- 1998 1997 1996 - ----------------------------------------------------------------------------------------------------- RECONCILIATION OF NET INCOME TO NET CASH USED IN OPERATING ACTIVITIES Net income $ 39,971 $ 7,056,240 $ 4,534,518 ----------- ------------ ----------- Adjustments to reconcile net income to net cash used in operating activities: Gain on sale of investments in equity securities (243,595) (7,888,065) (5,194,202) Write-down of investments in equity securities -- 295,000 -- Changes in: Accrued expenses and other liabilities (26,659) 3,919 7,347 Accrued management fee -- (142,170) -- Other assets -- -- 216,669 ----------- ------------ ----------- Total adjustments (270,254) (7,731,316) (4,970,186) ----------- ------------ ----------- Net cash used in operating activities $ (230,283) $ (675,076) $ (435,668) ----------- ------------ ----------- ----------- ------------ ----------- - ----------------------------------------------------------------------------------------------------- SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING ACTIVITIES 1997 At March 31, 1997, the General Partner concluded that an impairment in value that was not temporary had occurred for the Partnership's equity investment in Somatix Therapy Corporation. As a result, the value of the Partnership's 295,000 shares of Somatix Therapy Corporation common stock was written down by $295,000. On June 2, 1997, Cell Genesys Corporation acquired Somatix Therapy Corporation. As a result, the Partnership received 111,265 of Cell Genesys Corporation common stock or 0.385 shares for each of its 289,000 shares of Somatix Therapy Corporation common stock. - ----------------------------------------------------------------------------------------------------- The accompanying notes are an integral part of these statements. 7 PRUTECH RESEARCH AND DEVELOPMENT PARTNERSHIP III (a limited partnership) NOTES TO FINANCIAL STATEMENTS A. General PruTech Research and Development Partnership III (the 'Partnership'), a California limited partnership, was formed on June 2, 1986 and will terminate on December 31, 2006 unless terminated sooner (see discussion below) under the provisions of the Agreement of Limited Partnership, as amended (the 'Partnership Agreement'). Capital resources were originally provided by the sale of depositary units and by contributions of the General Partner equal to ten percent of depositary contributions. The Partnership was formed to seek cash flow from the research and development of new technologies with potential commercial applications. The general partner of the Partnership is R&D Funding Corp (the 'General Partner'), an affiliate of Prudential Securities Incorporated ('PSI'). Both the General Partner and PSI are wholly owned subsidiaries of Prudential Securities Group Inc. ('PSGI'). The assignor limited partner is Prudential-Bache Investor Services Inc., an affiliate of the General Partner, which has assigned substantially all the rights attributable to its limited partnership interest to investors. At December 31, 1998, the Partnership has an investment in the common stock of Creative BioMolecules, Inc. (OTC-CBMI) and royalty positions with Forest Laboratories, Inc. ('Forest') and Creative BioMolecules, Inc., that will expire in December 1999. The Partnership's royalty position with Creative BioMolecules, Inc. is believed to have little to no value and the equity position's value is easily determinable and is salable. The Partnership's royalty position in Synapton, a drug developed by Forest for the treatment of Alzheimer's disease, is illiquid, and any estimate of its value is subject to significant uncertainty due to a number of factors including, among other things, (i) whether the Food and Drug Administration (the 'FDA') will approve Synapton for sale, which would require that the FDA reverse its non-approval position issued in November 1998,(ii) the difficulty, in light of the fact that FDA approval is yet to be obtained, in manufacturing and distributing the product prior to the expiration of the Partnership's royalty position and (iii) market acceptance of the product. Due to the nature of the Forest royalty, the General Partner is not able at this time to predict with any degree of certainty, the value, if any, of the royalty position. Forest has advised the Partnership that it will be meeting with the FDA to discuss the status of Synapton. Depending on the timing and results of that meeting, the General Partner may determine that the royalty interest in Synapton does not warrant the continuing operation of the Partnership through the end of the royalty period at which point the General Partner will liquidate and distribute any remaining assets (reduced by a reserve to satisfy any liabilities of the Partnership) and dissolve the Partnership. In the event that the General Partner determines that continuing operations through the expiration date of the Synapton royalty position may be in the best interest of the Partnership, the General Partner will proceed to dissolve the Partnership as soon as practicable thereafter. B. Summary of Significant Accounting Policies Basis of accounting The books and records of the Partnership are maintained on the accrual basis of accounting in accordance with generally accepted accounting principles. The preparation of financial statements in conformity with generally accepted accounting principles requires the General Partner to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Certain balances from prior years have been reclassified to conform with the current financial statement presentation. Effective January 1, 1998, the Partnership adopted the provisions of Statement of Financial Accounting Standards ('SFAS') No. 130, 'Reporting Comprehensive Income.' This Statement establishes standards for reporting and display of comprehensive income and its components within financial statements. Comprehensive income includes net income as well as certain revenues, expenses, gains and losses that are excluded from net income under generally accepted accounting principles ('other comprehensive 8 income/loss'). During each of the three years ended December 31, 1998, the Partnership's only source of other comprehensive income/loss was net unrealized losses on investments in marketable equity securities, which are included in the statements of changes in partners' capital and are more fully described in Note D. The adoption of SFAS No. 130 has had no impact on earnings or total partners' capital. Cash and cash equivalents Cash and cash equivalents include money market funds. Investments The Partnership's equity securities that have readily determinable fair values are classified as available-for-sale securities. These securities are measured at fair value in the statements of financial condition and unrealized gains and losses are reported as a separate component of partners' capital under the caption 'Accumulated Other Comprehensive Income'. Equity securities traded on a national securities exchange or the Nasdaq national market are valued at the last reported sales price on the primary exchange on which they are traded. Equity securities traded in the over-the-counter market and thinly traded securities are valued at the mean between the last reported bid and asked prices. The carrying value of an investment is written down to its fair value when a decline in value is considered to be other than temporary. The Partnership uses the average cost method to determine gains or losses on the sale of securities. Royalty income Royalty income represents revenue generated from licenses granted by the Partnership. Management fee This fee provides for the cost of overseeing, supervising and monitoring the conduct of the development projects and for overseeing and monitoring product exploitation resulting from the development projects. The General Partner was paid an annual management fee equal to two percent of the unitholders' original capital contributions through June 30, 1997. Effective July 1, 1997, the General Partner reduced its management fee to the greater of (a) $250,000 annually or (b) ten percent of the aggregate amount received from the Partnership's royalty position in Synapton after July 1, 1997 until the dissolution and liquidation of the Partnership, not to exceed the aggregate management fee payable under the terms of the Partnership Agreement ($818,680 per annum). Income taxes The Partnership is not required to provide for, or pay, any Federal or state income taxes. Income tax attributes that arise from its operations are passed directly to the individual partners. The Partnership may be subject to other state and local taxes in jurisdictions in which it operates. Profit and loss allocations and distributions Profits and losses are allocated ninety percent to the unitholders and ten percent to the General Partner until such time as the total net profits allocated to each unitholder equal all losses previously allocated whereupon the General Partner will be allocated net profits in an additional amount of twenty-five percent with a corresponding reduction to the unitholders to be shared in proportion to their capital contributions. Distributions of cash are made in accordance with the Partnership Agreement and are allocated ninety percent to the unitholders and ten percent to the General Partner. C. Royalties At December 31, 1998 and 1997, the Partnership retains certain royalty rights with Forest and Creative BioMolecules, Inc. whose carrying values for financial reporting purposes are zero. The royalty rights with Forest relate to Synapton. Forest filed a new drug application with the FDA, seeking approval of Synapton, on November 18, 1997. On November 18, 1998, Forest announced that it was evaluating and would be preparing a response to a non-approvable letter received from the FDA on its new drug application for Synapton. Forest has recently advised the Partnership that it will be meeting with the FDA to discuss the status of Synapton. The Partnership's royalty rights with Forest and Creative BioMolecules, Inc. will expire in December 1999 (Refer to Note A for further discussion). 9 On April 1, 1990, the Partnership entered into a Technology Development Investment Agreement with Kopin Corporation ('Kopin') for the development of LED technology. Pursuant to the Agreement, Kopin was obligated to pay to the Partnership royalties on the sale of products containing the technology through April 1, 1996, with a minimum royalty payment of $433,334 due April 1, 1996 (payable in cash or by the delivery of a promissory note). Kopin agreed to pay cash for the minimum royalty because the Partnership also agreed to transfer to Kopin its GaAs technology developed under an earlier contract. During the second quarter of 1996, the Partnership received the $433,334 minimum royalty payment of which $216,669 represented a reduction of its receivable from Kopin and $216,665 was recorded as royalty income. As a result, the Partnership holds no technology or royalty positions with Kopin and, therefore, no further royalties will be received by the Partnership from Kopin. D. Investments In connection with certain of its research and development contracts, the Partnership has exercised its warrants or has converted its technology, royalty rights, warrants or notes receivable into an equity position in the companies performing the research and development. Investments in equity securities available-for-sale at December 31, 1998 and 1997 include the following: 1998 1997 -------------------------------------------------- -------------------------------------------------- Gross unrealized Carrying Gross unrealized Carrying Shares Cost basis gain value Shares Cost basis gains value - ------------------------------------------------------------------------ -------------------------------------------- Creative BioMolecules, Inc.-Common Stock 20,000 $ 65,450 $ 8,310 $ 73,760 24,484 $ 80,124 $ 100,446 $ 180,570 Kopin Corporation- Common Stock -- -- -- -- 13,310 99,556 124,212 223,768 Cell Genesys Corporation- Common Stock -- -- -- -- 17,465 90,727 57,725 148,452 ---------- ---------------- ----------- ---------- ---------------- ----------- $ 65,450 $ 8,310 $ 73,760 $ 270,407 $ 282,383 $ 552,790 ---------- ---------------- ----------- ---------- ---------------- ----------- ---------- ---------------- ----------- ---------- ---------------- ----------- If upon the sale of the Partnership's remaining equity investment the gross unrealized gain is realized, such gain would be allocated ninety percent to the unitholders and ten percent to the General Partner; however, there is no assurance that the Partnership would receive such amount in the event of the sale of its remaining equity position. Creative BioMolecules, Inc. During the fourth quarter of 1998, the Partnership sold 4,484 shares of Creative BioMolecules, Inc. common stock with a cost basis of approximately $15,000 resulting in a loss of approximately $3,000. During the first quarter of 1997, the Partnership sold 441,898 shares of Creative BioMolecules, Inc. common stock with a cost basis of approximately $1,446,000 resulting in a gain of approximately $3,573,000, and the Partnership exercised its option to purchase 6,900 shares of Creative BioMolecules, Inc. common stock at an exercise price of $8.50 per share for a total cost of approximately $59,000. During the remainder of 1997, the Partnership sold 49,900 shares of Creative BioMolecules, Inc. common stock with a cost basis of approximately $199,000 resulting in a gain of approximately $307,000. During 1997, revenues from the Partnership's investment in Creative BioMolecules, Inc. represented approximately 48% of the Partnership's total 1997 revenues. During December 1996, the Partnership sold 214,900 shares of Creative BioMolecules, Inc. common stock with a cost basis of approximately $703,000 resulting in a gain of approximately $1,573,000. During 1996, revenues from the Partnership's investment in Creative BioMolecules, Inc. represented approximately 29% of the Partnership's total 1996 revenues. Kopin Corporation During the second quarter of 1998, the Partnership sold its remaining 13,310 shares of Kopin Corporation common stock for approximately $286,000 resulting in a gain of approximately $186,000. During 1998, revenues relating to the Partnership's investment in Kopin Corporation represented approximately 52% of the Partnership's total revenues. 10 During 1997, the Partnership sold 524,023 shares of Kopin Corporation common stock with a cost basis of approximately $3,920,000 resulting in a gain of approximately $3,932,000. During 1997, revenues from the Partnership's investment in Kopin Corporation represented approximately 49% of the Partnership's total 1997 revenues. During the first quarter of 1996, the Partnership sold 4,334 shares of Kopin Corporation common stock with a cost basis of approximately $32,000 resulting in a gain of approximately $27,000. Somatix Therapy Corporation/Cell Genesys Corporation During the second quarter of 1998, the Partnership sold its remaining 17,465 shares of Cell Genesys Corporation common stock for approximately $151,000 resulting in a gain of approximately $60,000. During 1998, revenues relating to the Partnership's investment in Cell Genesys Corporation represented approximately 17% of the Partnership's total revenues. During the first quarter of 1997, the Partnership sold 205,000 shares of Somatix Therapy Corporation common stock with a cost basis of approximately $615,000 resulting in a loss of approximately $98,000. At March 31, 1997, the General Partner concluded that an impairment in value that was not temporary had occurred for the Partnership's equity investment in Somatix Therapy Corporation. As a result, the value of the Partnership's investment in Somatix Therapy Corporation common stock was written down by $295,000. During the second quarter of 1997, the Partnership sold 6,000 shares of Somatix Therapy Corporation common stock with a cost basis of approximately $12,000 resulting in no gain or loss to the Partnership. On June 2, 1997, Cell Genesys Corporation acquired Somatix Therapy Corporation. As a result, the Partnership received 111,265 shares of Cell Genesys Corporation common stock or 0.385 shares for each of its 289,000 shares of Somatix Therapy Corporation common stock. During the second half of 1997, the Partnership sold 93,800 shares of Cell Genesys Corporation common stock with a cost basis of approximately $487,000 resulting in a gain of approximately $174,000. Forest Laboratories, Inc. During the first quarter of 1996, the Partnership sold its remaining 75,000 shares of Forest common stock with a cost basis of approximately $6,000 resulting in a gain of approximately $3,594,000. During 1996, revenues relating to the Partnership's investment in Forest represented approximately 66% of the Partnership's total 1996 revenues. Net Unrealized Losses on Investment in Equity Securities For the three years ended December 31, 1998, the Partnership's net unrealized losses on investments in equity securities were comprised as follows: 1998 1997 1996 ----------------------------------------- Unrealized holding gain/loss $ (30,478) $ 2,034,706 $ 75,441 Less: reclassification adjustment for realized gains included in net income (243,595) (7,888,065) (5,194,202) --------- ----------- ----------- Net unrealized losses on investment in equity securities $(274,073) $(5,853,359) $(5,118,761) --------- ----------- ----------- --------- ----------- ----------- 11 E. Income Taxes The following is a reconciliation of net income for financial reporting purposes to net income (loss) for tax reporting purposes: Year ended December 31, ---------------------------------------- 1998 1997 1996 ---------------------------------------- Net income per financial statements $ 39,971 $7,056,240 $ 4,534,518 Gain on sale of investments in equity securities (100,959) (1,107,903) -- Write-down/write-off of investment in equity securities -- 295,000 (511,194) Royalty income -- -- (76,698) --------- ---------- ----------- Tax basis net income (loss) $ (60,988) $6,243,337 $ 3,946,626 --------- ---------- ----------- --------- ---------- ----------- The differences between the tax basis and book basis of partners' capital are primarily attributable to the cumulative effect of the book to tax income adjustments. F. Related Parties The General Partner and its affiliates perform certain services for the Partnership (for which they are reimbursed through the management fee) which include, but are not limited to: accounting and financial management; registrar, transfer and assignment functions; asset management; investor communications and other administrative services. The Partnership also reimburses an affiliate of the General Partner for printing services. The costs and expenses were: Year ended December 31, ---------------------------------- 1998 1997 1996 ---------------------------------- Management fee $250,000 $534,340 $818,680 Printing 6,444 13,448 11,849 -------- -------- -------- $256,444 $547,788 $830,529 -------- -------- -------- -------- -------- -------- Effective July 1, 1997, the General Partner reduced its management fee to the greater of (a) $250,000 annually or (b) ten percent of the aggregate amount received from the Partnership's royalty position in Synapton after July 1, 1997 until the dissolution and liquidation of the Partnership, not to exceed the aggregate management fee payable under the terms of the Partnership Agreement ($818,680 per annum). Printing costs payable to an affiliate of the General Partner (which are included in accrued expenses) as of December 31, 1998 and 1997 were $5,025 and $7,788, respectively. Prudential Securities Incorporated, an affiliate of R&D Funding Corp, owned 724 units in the Partnership at December 31, 1998. The Partnership maintains an account with the Prudential Institutional Liquidity Portfolio Fund, an affiliate of R&D Funding Corp, for investment of its available cash in short-term instruments pursuant to the guidelines established by the Partnership Agreement. The Partnership has engaged in research and development co-investment projects with PruTech Research and Development Partnership which was dissolved and liquidated in December 1996, PruTech Research and Development Partnership II which was dissolved and liquidated in December 1998 and PruTech Project Development Partnership (collectively, the 'PruTech R&D Partnerships'), for which R&D Funding Corp serves as the general partner. The allocation of the co-investment projects' profits or losses among the PruTech R&D Partnerships is consistent with the costs incurred to fund the research and development projects. G. Contingencies On April 15, 1994, a multiparty petition captioned Mack et al. v. Prudential Securities Incorporated et al. (Cause No. 94-17695) was filed in the 80th Judicial District Court of Harris County, Texas, purportedly on behalf of investors in the Partnership against the Partnership, the General Partner, PSI, The Prudential Insurance Company of America and a number of other defendants. The petition alleged common law fraud 12 and fraud in the inducement and negligent misrepresentation in connection with the offering of the Partnership; negligence and breach of fiduciary duty in connection with the operation of the Partnership; civil conspiracy; and violations of the federal Securities Act of 1933 (sections 11 and 12), and of the Texas Securities and Deceptive Trade Practices statutes. The suit sought, among other things, compensatory and punitive damages, costs and attorneys' fees. The claims of all plaintiffs have been settled or dismissed. The Partnership did not contribute to any settlement or pay any costs of the litigation. 13 PRUTECH RESEARCH AND DEVELOPMENT PARTNERSHIP III (a limited partnership) MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources At December 31, 1998, the Partnership has an investment in the common stock of Creative BioMolecules, Inc. (OTC-CMBI) and royalty positions with Forest Laboratories, Inc. ('Forest') and Creative BioMolecules, Inc., that will expire in December 1999. The Partnership's royalty position with Creative BioMolecules, Inc. is believed to have little to no value and the equity position's value (approximately $74,000 at December 31, 1998) is easily determinable and is salable. The Partnership's royalty position in Synapton, a drug developed by Forest for the treatment of Alzheimer's disease, is illiquid, and any estimate of its value is subject to significant uncertainty due to a number of factors including, among other things, (i) whether the Food and Drug Administration (the 'FDA') will approve the Synapton for sale, which would require that the FDA reverse its non-approval position issued in November 1998, (ii) the difficulty, in light of the fact that FDA approval is yet to be obtained, in manufacturing and distributing the product prior to the expiration of the Partnership's royalty position and (iii) market acceptance of the product. Due to the nature of the Forest royalty, the General Partner is not able at this time to predict with any degree of certainty, the value, if any, of the royalty position. Forest has advised the Partnership that it will be meeting with the FDA to discuss the status of Synapton. Depending on the timing and results of that meeting, the General Partner may determine that the royalty interest in Synapton does not warrant the continuing operation of the Partnership through the end of the royalty period at which point the General Partner will liquidate and distribute any remaining assets (reduced by a reserve to satisfy any liabilities of the Partnership) and dissolve the Partnership. In the event that the General Partner determines that continuing operations through the expiration date of the Synapton royalty position may be in the best interest of the Partnership, the general partner will proceed to dissolve the Partnership as soon as practicable thereafter. As of December 31, 1998, the Partnership had approximately $1,158,000 of cash and cash equivalents which is a decrease of approximately $2,511,000 as compared to December 31, 1997. The decrease in cash and cash equivalents was primarily due to the payment of distributions and management fees, offset by proceeds from the sales of certain investments in equity securities, as further discussed below. The amount to be distributed by the Partnership in future quarters will be based on the extent to which the market value of its remaining investment in Creative BioMolecules, Inc. can be realized and from the revenue stream from royalties, if any, and interest income. It is not expected that the Partnership's eventual total distributions will equal the Unitholders' initial investments. During May 1998, the Partnership made a $2,728,933 distribution. Unitholders received a total of $2,456,040 ($60 per unit) and the General Partner received its 10% share. During the second quarter of 1998, the Partnership sold its remaining 13,310 shares of Kopin Corporation common stock for approximately $286,000, and its remaining 17,465 shares of Cell Genesys Corporation common stock for approximately $151,000. During the fourth quarter of 1998, the Partnership sold 4,484 shares of Creative BioMolecules, Inc. common stock for approximately $12,000. Results of Operations Net income for the years ended December 31, 1998, 1997 and 1996 was approximately $40,000, $7,056,000 and $4,535,000, respectively. The primary reasons for the fluctuations in operating results are discussed below. During 1998, the Partnership recorded gains of approximately $186,000 and $60,000, respectively on the sale of its remaining 13,310 shares of Kopin Corporation common stock and its remaining 17,465 shares of Cell Genesys Corporation common stock. During 1997, the Partnership recorded gains on the sale of common stock totalling approximately $7,888,000, including gains of $3,932,000 and $3,880,000 on the sale of common stock of Kopin Corporation and Creative BioMolecules, Inc., respectively. During 1996, the Partnership recorded gains of approximately $3,594,000 and $1,573,000 on the sale of 75,000 shares of 14 Forest Laboratories, Inc. common stock and 214,900 shares of Creative BioMolecules, Inc. common stock, respectively. At March 31, 1997, the General Partner concluded that an impairment in value that was not temporary had occurred for the Partnership's equity investment in Somatix Therapy Corporation. As a result, the value of the Partnership's investment in Somatix Therapy Corporation common stock was written down by $295,000. No royalties were earned by the Partnership in 1998 and 1997. Royalty income for the year ended December 31, 1996 was approximately $217,000 and related to an agreement in which the Partnership received a minimum royalty payment from Kopin Corporation and transferred to Kopin Corporation its rights to certain technologies and royalties. As a result of the agreement, the Partnership holds no technology or royalty positions with Kopin Corporation. Interest and other income for the year ended December 31, 1998 decreased by approximately $20,000 as compared to 1997 and increased by approximately $98,000 for the year ended December 31, 1997 as compared to 1996. These fluctuations in interest and other income largely reflect the level of Partnership funds invested in short-term instruments which has varied with the timing of sales of investments in equity securities and subsequent distributions to unitholders. Management fees for the years ended 1998 and 1997 each decreased by approximately $284,000 as compared to prior years. Effective July 1, 1997, the General Partner reduced its management fee to the greater of (a) $250,000 annually or (b) ten percent of the aggregate amount received from the Partnership's royalty position in Synapton after July 1, 1997 until the dissolution and liquidation of the Partnership, not to exceed the aggregate management fee payable under the terms of the Agreement of Limited Partnership ($818,680 per annum.) General and administrative expenses for the year ended December 31, 1998 decreased by approximately $69,000 as compared to 1997 but increased by approximately $43,000 for the year ended December 31, 1997 as compared to 1996. The 1997 increase was due primarily to professional and other costs incurred in 1997 in considering alternatives for the orderly liquidation of the Partnership. Such costs did not recur at the same level during 1998. Additionally, the 1998 decrease reflects lower evaluation and monitoring expenses as overall activity decreased in the Partnership's R&D projects and license agreements. Inflation Inflation has had no direct material impact on operations or on the financial condition of the Partnership from inception through December 31, 1998. 15 OTHER INFORMATION The Partnership's Annual Report on Form 10-K as filed with the Securities and Exchange Commission is available to Unitholders without charge upon written request to: PruTech Research and Development Partnership III P.O. Box 2016 Peck Slip Station New York, New York 10272-2016 16 Peck Slip Station BULK RATE P.O. Box 2016 U.S. POSTAGE New York, NY 10272 PAID Automatic Mail PRUTEC386/170864