UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K/A AMENDMENT NUMBER 1 TO THE ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For The Fiscal Year Ended December 31, 1998 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 0-29048 ACCENT COLOR SCIENCES, INC. (Exact name of registrant as specified in its charter) Connecticut 06-1380314 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 800 Connecticut Boulevard, East Hartford, Connecticut 06108 (Address of principal executive office) (Zip Code) Registrant's telephone number, including area code: (860) 610-4000 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. /X/ The aggregate market value of common stock held by non-affiliates of the registrant as of March 5, 1999 was $7,038,099. The number of shares outstanding of the registrant's common stock as of March 5, 1999 was 13,942,721. DOCUMENTS INCORPORATED BY REFERENCE None. The registrant is amending its Annual Report on Form 10-K to include amendments to Items 6, 7 and 8. ACCENT COLOR SCIENCES, INC. FORM 10-K/A For The Year Ended December 31, 1998 INDEX Part II Item 6. Selected Financial Data 3 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 4 Item 8. Financial Statements and Supplementary Data 11 Signatures 28 Item 6. Selected Financial Data For the year ended December 31, 1994 1995 1996 1997 1998 Statement of Operations Data: Sales $ - $ - $ - $ 1,578 $ 8,220 Costs and expenses: Costs of production - - 1,272 7,397 9,836 Research and development 805 3,051 6,932 8,786 4,249 Marketing, general and administrative 336 1,003 4,394 4,439 3,822 Related party administrative expense - 80 25 - - ------ ------ ------ ------ ------ 1,142 4,134 12,623 20,622 17,907 Other(income) expense: Interest expense 12 83 656 246 200 Interest income - - (113) (599) (117) ------ ------ ------ ------ ------ 12 83 543 (353) 83 Net loss before ------ ------ ------ ------ ------ extraordinary item (1,154) (4,217) (13,166) (18,691) (9,770) ------ ------ ------ ------ ------ Extraordinary item: Loss on early extinguishment of debt, net of income taxes of nil - - (573) - - ------ ------ ------ ------ ------ Net loss (1,154) (4,217) (13,739) (18,691) (9,770) ------ ------ ------ ------ ------ Non-cash imputed dividend on mandatorily redeemable convertible preferred stock - - - - (920) ------ ------ ------ ------ ------ Net loss applicable to common stock $ (1,154) $(4,217) $(13,739) $(18,691) $(10,690) ======= ======= ====== ====== ======= Net loss (basic and diluted) per common share: $ (.66) $ (2.33) $ (3.57) $ (1.77) $ (.87) Weighted average ======= ======= ====== ====== ======= common shares outstanding 1,756,841 1,809,240 3,852,982 10,566,890 12,330,903 ========= ========= ========= ========== ========== December 31, 1994 1995 1996 1997 1998 Balance Sheet Data: Cash and cash equivalents $ 165 $ 1 $ 20,289 $ 4,006 $ 1,048 Working capital (deficit) (86) (1,862) 18,189 4,836 2,646 Total assets 246 728 26,951 12,407 6,860 Short-term debt - 50 1,000 - - Long-term debt, less current portion - 2,020 1,272 - 2,236 Mandatorily redeemable convertible preferred stock - - - - 3,097 Total shareholders' equity (deficit) (57)(3,164) 19,345 7,270 (1,307) Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Overview Accent Color Sciences, Inc. ("Accent Color" or the "Company") designs, manufactures and sells innovative, high-speed, spot color printing systems ("Truecolor Systems"). The Company was formed in 1993 initially to develop a high-speed, color printer to attach to cut sheet, black-on- white production printers. Development and testing of a prototype began in January 1994 and was first announced at the On-Demand Trade Show (a major printing industry trade show) in May 1994. In November 1994, a "proof-of-concept" Truecolor System was shown at the Xplor International Global Electronic Document Systems Conference ("Xplor") (the primary production printing industry trade show). After Xplor in November 1994, International Business Machines Corporation ("IBM") approached the Company and requested that the Company develop a version of its Truecolor System to work in conjunction with the IBM 3900 continuous form production printing system. During 1995, the Company began negotiations with IBM and Siemens Nixdorf Printing Systems USA, Inc. (which was acquired by an affiliate of Oce Printing Systems GmbH ("Oce") in 1996) to enter into a formal development relationship. During the same period, the Company accelerated its engineering and development activities as its efforts were focused on designing and building the next generation prototypes which were demonstrated at Xplor in November 1995. During 1996, the Company was focused on refining the Truecolor System design and preparing for the commencement of commercial production in the first half of 1997. The Company entered into a Product Purchase Agreement with IBM in April 1996. In October 1996, the Company signed a memorandum of understanding with Oce. At Xplor in October 1996, the Company demonstrated its Truecolor Systems, as well as certain enhancements planned for production in 1998. On May 6, 1997, IBM announced the limited availability product introduction phase of the Company's continuous form version of the Truecolor System designed for integration with IBM's 3900 production printing system, which IBM will market as the IBM InfoPrint Hi-Lite Color, model HC1 post processor. The product was announced for general worldwide availability on September 15, 1997. In August 1997, the Company signed an agreement with Groupe SET International ("Groupe SET"), a European provider of high speed digital printing solutions headquartered in Paris, France. Pursuant to this agreement, Groupe SET will market, sell and service the Company's Truecolor Systems with the SET-M3056SF and other high speed black-on- white printing systems. In addition, Groupe SET agreed to develop a version of its "plug-and-play" Color Enabler Solution data interpreter and print controller technologies to allow the Company's Truecolor Systems to interface with a wide variety of high speed continuous form and cut sheet black-on-white printers that are not highlight color enabled. On March 27, 1998, the Company and IBM announced the availability of the IBM InfoPrint Hi-Lite Color post processor, Model HC2. The Model HC2, which incorporates Accent Color Sciences' spot color printing technology, increases color coverage capability by over 250% compared to the Model HC1. The Model HC2 supports configurations of most models of IBM's InfoPrint 4000 and 3900 continuous form high-speed printers. Accent Color also sells related consumables and spare parts. Currently, the only consumables sold by the Company are wax-based inks, which it acquires from a vendor. The sale of consumables is expected to generate recurring revenue, which the Company believes will continue to increase as the installed base and usage of Truecolor Systems increases. Results of Operations Comparison of Year Ended December 31, 1998 to Year Ended December 31, 1997 Total Net Sales. The Company currently sells its Truecolor system with a 90-day warranty, which starts when the printer is installed at the end- user customer site. Prior to the quarter ended December 31, 1998, the Company deferred revenue on printer shipments until the end of the 90-day warranty period. During the quarter ended December 31, 1998, the Company, in accordance with its revenue recognition policy on printer sales, determined that it had adequate warranty experience to begin recognizing revenue upon shipment of printers to its primary OEM customer. The Company will continue to defer revenue on shipments to its second OEM customer until systems are in production and are past the warranty period or until the Company has adequate warranty history with that customer. As of December 31, 1998 and 1997, the Company had deferred revenue of $595,000 and $2,496,000 related to Truecolor Systems shipped. Total net sales were $8,220,000 for the year ended December 31, 1998 compared to $1,578,000 for the year ended December 31, 1997. Of the sales recognized in 1998, $2,496,000 resulted from deferred revenue recorded in 1997. Printer sales represented 81% of total net sales for the year ended December 31, 1998 while sales of consumables and spare parts represented 19%. Printers. Printer sales were $6,654,000 for the year ended December 31, 1998 compared to $658,000 for the year ended December 31, 1997. Of the sales recognized in 1998, $2,496,000 resulted from deferred revenue recorded in 1997. Sales for 1998 consisted of 48 new systems and 25 system upgrades. A total of 27 systems and 23 system upgrades were shipped during 1998, of which 5 systems shipped in 1998 were recorded as deferred revenue. Below is a summary of system shipments and system revenue for the year ended December 31, 1998: Units Dollars New System New Systems & Systems Upgrades Upgrades Deferred revenue as of December 31, 1997 26 2 $ 2,496,000 Plus: Shipments in 1998 27 23 4,753,000 Less: Revenue (48) (25) (6,654,000) recognized in 1998 Deferred revenue as of December 31, 1998 5 - $ 595,000 As of December 31, 1998, the Company's backlog consisted of 35 systems, 3 system upgrades and consumables totaling $4,838,000. Consumables and Spare Parts Sales. Consumables and spare parts sales were $1,566,000 for the year ended December 31, 1998 compared to $920,000 for the year ended December 31, 1997. Costs of Production. Costs of production increased from $7,397,000 for the year ended December 31, 1997 to $9,836,000 for the year ended December 31, 1998. This increase was attributed to the cost of goods sold related to the increased sales of printers, consumables and spare parts totaling $5,877,000 and was off-set by reduced overhead spending mainly in payroll related costs and reductions in charges for inventory reserves totaling $1,142,000 and $1,814,000, respectively. Research and Development Expenses. Research and development expenses primarily consist of the cost of personnel and equipment needed to conduct the Company's research and development efforts, including manufacturing prototype systems. Research and development expenses decreased 52% from $8,786,000 for the year ended December 31, 1997 to $4,249,000 for the year ended December 31, 1998 as the Company directed its efforts toward production and market development with less significant emphasis on research and development. The decrease in research and development was primarily attributed to four major factors: (i) a reduction in payroll and related costs due to the reduction in personnel in 1998, (ii) a reduction in design and development costs paid to Spectra associated with the development of ink jet printheads for the enhanced wide-head version of the Truecolor Model HC2 system, (iii) the Company's completion of the payments, in 1997, to Spectra to maintain exclusivity rights, and (iv) a decrease in general design and development costs. Marketing, General and Administrative Expenses. Marketing, general and administrative expenses decreased from $4,439,000 for the year ended December 31, 1997 to $3,822,000 for the year ended December 31, 1998. This decrease was primarily due to a reduction in payroll related costs as a result of the reduction in administrative personnel in 1998 and a reduction in professional service costs. These items were offset by an increase in marketing and service expenses of approximately $443,000, which included increased marketing costs for travel and consultants to support the increased sales and marketing efforts and a reclassification of service related costs. Service costs, consisting primarily of customer technical support, were classified as costs of production during 1997. Beginning in 1998, such costs are now classified as marketing, general and administrative. Interest Expense and Other (Income) Expense. Interest expense decreased 18.7% from $246,000 for the year ended December 31, 1997 to $200,000 for the year ended December 31, 1998. This decrease was due to the Company having an outstanding loan from Xerox for the full year 1997 compared to a similar sized loan from IBM for only 7 months in 1998. Interest income decreased 80.5% from $599,000 for the year ended December 31, 1997 to $117,000 for the year ended December 31, 1998. This decrease in interest income was attributed to a greater amount of cash available for investment in 1997 as compared to 1998. Comparison of Year Ended December 31, 1997 to Year Ended December 31, 1996 Total Net Sales. Total net sales were $1,578,000 for the year ended December 31, 1997 compared to none for the year ended December 31, 1996. Printer sales constituted 41.7% of total net sales for the year ended December 31, 1997 while sales of consumables and spare parts constituted 58.3%. Printers. Printer sales were $658,000 for the year ended December 31, 1997 compared to none for the year ended December 31, 1996. Sales for 1997 consisted of three pre-production systems and two production systems. A total of 27 production systems were shipped during 1997, which were recorded as deferred revenue in accordance with the revenue recognition policy of the Company. As of December 31, 1997, the Company's backlog consisted of 18 systems totaling $2,138,000. Consumables and Spare Parts Sales. Consumables and spare parts sales were $920,000 for the year ended December 31, 1997 compared to none for the year ended December 31, 1996. These sales were primarily attributed to the shipment of consumables in the second and third quarters of 1997 to fill the channels of an OEM customer. Costs of Production. Costs of production increased from $1,272,000 for the year ended December 31, 1996 to $7,397,000 for the year ended December 31, 1997. This increase was attributed to three major factors: (i) ramp-up manufacturing expenses related to the Company's launch of the commercial production of its Truecolor Systems, (ii) cost of goods sold related to the sale of printers, consumables and spare parts and (iii) a charge for obsolete inventory due to the enhancement of the Company's product from narrow to wide printhead systems and a cancellation charge related to purchase commitments of inventory totaling $1,250,000 and $300,000, respectively. Research and Development Expenses. Research and development expenses increased 26.7% from $6,932,000 for the year ended December 31, 1996 to $8,786,000 for the year ended December 31, 1997. This increase was primarily attributed to engineering and product ramp-up costs associated with the development of the wide ink jet printhead in addition to an increase in payroll costs for personnel retained to support such efforts. This increase was partially offset by a decrease in materials procured for research and development as in 1997, the Company's efforts were primarily focused on production with a less significant emphasis on research and development. During 1996, however, systems were built for research and development purposes and the related components were utilized for design improvements and testing. Marketing, General and Administrative Expenses. Marketing, general and administrative expenses increased from $4,393,000 for the year ended December 31, 1996 to $4,439,000 for the year ended December 31, 1997. This increase was primarily attributed to the hiring of additional marketing and administrative personnel, expenses associated with promotional activities and costs incurred for professional services to support the Company's anticipated revenue growth and manufacturing activities. This increase was partially offset by expenses incurred in 1996 related to the recruiting of personnel, system documentation, regulatory testing, deferred financing costs and the Company's relocation to a new facility, which were not incurred during the comparable time in 1997. Interest Expense and Other (Income) Expense. Interest expense decreased 62.5% from $656,000 for the year ended December 31, 1996 to $246,000 for the year ended December 31, 1997. This decrease was primarily attributed to the elimination of interest expense related to extinguished debentures originally issued in October 1995, February 1996 and October 1996. Interest income increased by $486,000 from $113,000 for the year ended December 31, 1996 to $599,000 for the year ended December 31, 1997. This increase in interest income was attributed to a greater amount of cash available for investment in 1997 as compared to 1996, primarily due to the Company's initial public offering in December 1996. Liquidity and Capital Resources The Company's need for funding has increased from period to period as it has increased its marketing, sales and service efforts, continued its research and development activities for the enhancement of Truecolor systems and increased production of Truecolor systems. To date, the Company has financed its operations through customer payments, borrowings and the sale of equity securities. On January 13, 1998, the Company completed a private equity financing providing net proceeds to the Company of $3.9 million. Pursuant to the financing, the Company issued 4,500 shares of Series B Mandatorily Redeemable Convertible Preferred Stock at a price of $1,000 per share and warrants to purchase the Company's common stock. The warrants issued are exercisable into 300,000 shares of common stock with an exercise price of $2.75 and an expiration date of January 9, 2008. Additionally, warrants exercisable into 115,385 shares of common stock with an exercise price of $2.50 and an expiration date of January 9, 2003 were issued to the placement agent for services provided. On July 21, 1998, the Company entered into a loan agreement with IBM to borrow $2.5 million at a fixed interest rate of 10% per year. Interest payments are due quarterly beginning October 1, 1998. The loan is due in full on December 31, 2000 and is secured by the assets and intellectual property of the Company. As part of the loan agreement, the Company issued a warrant to IBM that provides the right to purchase 500,000 shares of common stock at an exercise price of $2.50 per share, until the warrant expires on July 21, 2003. The warrant was valued at $325,000, which was allocated to common stock with an equivalent discount on the loan. The discount is being amortized over the life of the loan resulting in a non-cash charge to interest expense. Amortization expense was $60,593 for the year ended December 31, 1998. Operating activities consumed $9.2 million in cash in 1998 compared to $18.9 million in 1997. This decrease was primarily attributed to a decrease in the net loss of the Company and a decrease in inventories. This was partially offset by an increase in accounts receivable, a decrease in accrued expenses and a decrease in deferred revenues. Capital expenditures decreased 87% from $1.3 million for the year ended December 31, 1997 to $169,000 for the year ended December 31, 1998. Capital expenditures during 1998 primarily reflected acquisitions of equipment to support the Company's manufacturing activities. This decrease was primarily attributed to lower capital expenditures requirements in 1998, since in 1997, the Company had completed the majority of equipment acquisitions to support its near-term manufacturing needs. The Company had no significant capital expenditure commitments at December 31, 1998. During 1998, the Company continued to adjust its staffing levels from a high of 140 full-time, part-time and contract employees as of December 31, 1997 to 67 employees as of December 31, 1998. On March 11, 1999, the Company completed a reduction of personnel to align its expenses with current sales demand. In connection with this reduction, the Company eliminated 19 positions and recorded a charge of approximately $61,000 for employee severance. Of the total reduction, approximately 37% was in the area of operations, 53% in research and development and 10% in marketing, general and administrative. As of December 31, 1998, the Company's primary source of liquidity was cash and cash equivalents totaling $1.0 million. Based on the current operating plan of the Company, the primary requirements for cash through the remainder of 1999 will be to fund operating losses, marketing and sales efforts, commercial production of the enhanced Truecolor System and the further development and enhancement of the Company's products. The Company's currently planned research and development activities are focused on value engineering to improve system profit margin and developing higher resolution ink jet printing and other enhancements to the Truecolor Systems. Based on its current operating plan, the Company anticipates that additional financing will be required to finance its operations and capital expenditures during the second half of 1999. The Company's currently anticipated levels of revenue and cash flow are subject to many uncertainties and cannot be assured. The amount of funds required by the Company will depend on many factors, including the extent and timing of sales of Truecolor Systems, product costs, engineering and customer and technical support requirements. The inability to obtain additional financing and to generate sufficient cash from operations could require the Company to reduce or eliminate expenditures for research and development, production or marketing of its products, or otherwise to curtail or discontinue its operations. The Company expects that quarterly net losses will continue through at least the fourth quarter of 1999. Year 2000 Year 2000 Compliance. The information presented below related to year 2000 compliance contains forward-looking statements that are subject to risks and uncertainties. The Company's actual results may differ significantly from the results discussed below and elsewhere in this Form 10-K regarding Year 2000 compliance. Year 2000 Issue Defined. The Year 2000 ("Y2K") issue is the result of certain computer hardware, operating system software and software application programs having been developed using two digits rather than four digits to define a year. For example the clock circuit in the hardware may be incapable of holding a date beyond the year 1999; some operating systems recognize a date using "00" as the year 1900 rather than 2000 and certain applications may have limited date processing capabilities. These problems could result in the failure of major systems or miscalculations, which could have material impact on companies through business interruption or shutdown, financial loss, damage to reputation, and legal liability to third parties. State of Readiness. The Company's Information Technology ("IT") department began addressing the Y2K issue in 1996 as we evaluated the purchase of new software applications and hardware systems. During the fourth quarter of 1996, IT researched methodologies to manage the Y2K program and established a process that matched the resources available within the Company. The initial step in the process was to organize a team of both IT and non-IT employees and explain their roles in the process. The second step of the process was to establish an inventory of all potential areas where the Y2K problem could exist. The inventory included; server hardware (BIOS), server operating systems, server application software, network device hardware and software, PC hardware (BIOS), PC operating systems, PC application software, phone system, security system, the Company's products (hardware BIOS and software), and our vendors. Each area listed in the inventory was assigned to a team member to evaluate the current Y2K compliance and where required, recommend a solution correct a Y2K problem. A database was created for all items to track the status to completion. All IT systems, except the phone system, have been updated to be Y2K complaint. The phone system will be updated in second quarter, 1999. During second quarter 1999, we will test the compliance of primary software applications in our test environment to confirm that vendor statements are consistent with our test results. Accent Color Sciences Products. The Company designs and manufactures high- speed color printing systems for integration with digital high-speed black on white printers. The Company has tested and confirmed that the printer's BIOS are compliant where required. Software that operates on the printer has been tested and is confirmed to be Y2K compliant. Future software releases will include as part of the software regression test a reconfirmation that the software remains Y2K compliant. Third Party Relationships. The Company's business operations are heavily dependent on third party materials suppliers. The Company is working with all key external partners to identify and to mitigate the potential risks of Y2K. The failure of external parties to resolve their own Y2K issues, in a timely manner, could result in a material financial risk to the Company. As part of the overall Y2K program, the Company is actively communicating with third parties through correspondence. Because the Company's Y2K compliance is dependant on the timely Y2K compliance of third parties, there can be no assurance that the Company's efforts alone will resolve all Y2K issues. Contingency Plans. The Company has not conducted its assessment of the reasonably likely worst case scenario of systems or product failures and their related consequences. It is expected that the planned testing of IT systems and the completed testing of the Company's product testing will greatly reduce the need for substantial contingency planning. Contingency planning, if required, would begin in third quarter, 1999. Costs to Address Year 2000 Issues. The Y2K costs incurred to date have not been material. Most software applications, BIOS and operating system upgrades to Y2K compliance were incorporated into the Company's standard licensing agreements. As part of the contingency planning effort we will examine additional potential Y2K costs, where applicable. Factors Affecting Future Results The foregoing Management's Discussion and Analysis and discussion of the Company's business contains various statements which are forward looking in nature. Such forward-looking statements are made pursuant to the "safe harbor" provisions of Section 21E of the Securities Exchange Act of 1934, as amended, which were enacted as part of the Private Securities Litigation Reform Act of 1995. The Company cautions readers that the following important factors, among others, in some cases have affected and, in the future, could materially adversely affect the Company's actual results and cause the Company's actual results to differ materially from the results expressed in any forward-looking statements made by, or on behalf of, the Company. Need For Additional Funding For Operating And Capital Requirements. The Company's currently anticipated levels of revenue and cash flow are subject to many uncertainties and cannot be assured. Further, the Company's business plan may change, or unforeseen events may occur, requiring the Company to raise additional funds. The amount of funds required by the Company will depend on many factors, including the extent and timing of the sale of Truecolor Systems, the cost associated sales and marketing and customer technical support and the Company's operating results. There can be no assurance that, when needed, additional financing will be available, or available on acceptable terms, and the Company's ability to raise additional funds has been adversely impacted by the March 17, 1999 delisting from the NASDAQ Stock Market. The inability to obtain additional financing or generate sufficient cash from operations could require the Company to reduce or eliminate expenditures for research and development, production or marketing of its products, or otherwise to curtail or discontinue its operations, which could have a material adverse effect on the Company's business, financial condition and results of operations. Limited Operating History; History Of Losses; Uncertainty Of Future Financial Results. The Company was formed in May 1993 and has limited operating history. The Company incurred losses in each year of existence and incurred a net loss of $10,690,000 for the year ended December 31, 1998. As a result of these losses, as of December 31, 1998, the Company had an accumulated deficit of $47,615,000. It is expected that quarterly net losses will continue through at least the fourth quarter of 1999 and that the Company will incur a net loss for 1999. Uncertainty Of Market Development And Acceptance Of Accent Color's Products. The digital, high-speed printing market has traditionally relied mainly on black-on-white print. There can be no assurance that a market for high-speed, variable data color printing will develop or achieve significant growth. The failure of such market to develop or achieve significant growth would have a material adverse effect on the Company's future results. The Company's products are installed in extremely demanding environments and there can be no assurance the Company's systems will operate successfully in combination with mature black-on-white host systems. Dependence On A Limited Number Of Customers; Revenue Concentration. The Company anticipates that sales of its Truecolor Systems and consumables to a limited number of OEM customers will account for substantially all of the Company's revenue. As of December 31, 1998, the Company had contracts with only two customers, IBM and Groupe SET. There can be no assurance that these customers will purchase a significant volume of the Company's products. Product Warranty; Limit On Prices For Spare Parts. The Company warrants its Truecolor Systems to be free of defects in workmanship and materials for 90 days from installation at the location of the end user. Furthermore, under the IBM Agreement, the Company has agreed to provide spare parts for its products at prices which will yield a monthly parts cost per Truecolor System not to exceed a specified amount. There can be no assurance that the Company will not experience warranty claims or parts failure rates in excess of those, which it has assumed in pricing its products and spare parts. Any such excess warranty claims or spare parts failure rates could have a material adverse effect on the Company's business, financial condition or results of operations. Dependence On Third Party Marketing, Distribution And Support. A significant element of the Company's marketing strategy is to form alliances with third parties for the marketing and distribution of its products. To this end, the Company has entered into the IBM Agreement and the SET Agreements for the marketing, distribution and support of the Company's products. There can be no assurance that (i) the Company will be successful in maintaining such alliances or forming and maintaining other alliances, (ii) the Company will be able to satisfy its contractual obligations with its OEM customers or (iii) the Company's OEM customers will devote adequate resources to market and distribute the Company's products successfully. Dependence On Spectra. The Company is dependent on Spectra, a wholly owned subsidiary of Markem Corporation ("Markem"), as its sole source supplier of ink jet printheads and the hot melt, wax-based inks included in and used by Truecolor Systems. Spectra has agreed to supply the Company with ink jet printheads and wax-based inks under a supply agreement, subject to a number of conditions. The Company's reliance on Spectra involves several risks, including a potential inability to obtain an adequate supply of required printheads or inks, and reduced control over the quality, pricing and timing of delivery of these items. To date, Spectra has only produced a limited number of ink jet printheads. Accordingly, there can be no assurance that Spectra will be able to provide a stable source of supply of these components. Spectra has granted the Company the exclusive right to supply products including Spectra printheads in the worldwide market for printing color on the output from specified high-speed, black-on-white printers from Xerox, IBM, Oce and certain other parties through December 31, 2002. To maintain such exclusive rights, the Company is required to purchase a minimum number of ink jet printheads each year, to continue to purchase its wax- based ink requirements from Spectra and to make certain payments. There can be no assurance that the Company will be able to meet the minimum purchase requirements or make these payments. Limited History Of Product Manufacturing. To date, the Company has manufactured only limited quantities of Truecolor Systems. To be profitable, the Company's products must be manufactured in sufficient quantities and at acceptable costs. Future production in sufficient quantities may pose technical and financial challenges for the Company, and no assurance can be given that the Company will be able to reduce its current product costs to an acceptable level and to make a successful transition to high-volume production. Dependence On Major Subcontractors And Suppliers. The Company relies on subcontractors and suppliers to manufacture, subassemble and perform certain testing of some modules and parts of Truecolor Systems. The Company currently performs the final assembly and testing of various Truecolor System components and of each complete Truecolor System, and the Company plans to eventually outsource the full assembly and testing of the major modules of the Truecolor Systems. There can be no assurance that subcontractors or suppliers will meet the Company's price, quality, quantity and delivery requirements or otherwise perform to the Company's expectations. Significant Fluctuations In Quarterly Results. The Company's quarterly operating results are likely to vary significantly in the future based upon a number of factors. Historically, there has existed seasonality in the purchase of major equipment such as the Company's Truecolor Systems, with many companies experiencing higher sales in the fourth calendar quarter. Furthermore, a significant portion of the Company's operating expenses are relatively fixed in the short term, and planned expenditures are based on sales forecasts. Sales forecasts by the Company's OEM customers are generally not binding. If revenue levels are below expectations, operating results may be disproportionately affected because only a small portion of the Company's expenses vary with revenue in the short term, which could have a material adverse effect on the Company's future results. Dependence On A Single Product Line. The Company anticipates that it will derive substantially all of its revenue in the foreseeable future from sales of Truecolor Systems, related consumables and spare parts. If the Company is unable to generate sufficient sales of Truecolor Systems due to market conditions, manufacturing difficulties or other reasons or if purchasers of Truecolor Systems were to purchase wax-based ink or spare parts from suppliers other than the Company, there could be a material adverse effect of the Company's future results. Rapid Technological Change Requires Ongoing Product Development Efforts. The high-speed printer industry is characterized by evolving technology and changing market requirements. The Company's future success will depend on a number of factors, including its ability to continue to develop and manufacture new products and to enhance existing products. Consequently, the Company considers the enhancement of its products to be a development priority. Additionally, in a new and evolving market, customer preferences can change rapidly and new technology could render existing technology obsolete. Failure by the Company to respond adequately to changes in its target market, to develop or acquire new technology or to successfully conform to market preferences could have a material adverse effect on future results of the Company. Limited Protection Of Proprietary Technology And Risks Of Third-Party Claims. The Company's ability to compete effectively will depend, in part, on the ability of the Company to maintain the proprietary nature of its technology. The Company relies, in part, on proprietary technology, know-how and trade secrets related to certain aspects of its principal products and operations. To protect its rights in these areas, the Company generally requires its OEM customers, suppliers, employees and independent contractors to enter into nondisclosure agreements. In addition, the Company has received a patent, and has filed additional U.S. and foreign patent applications to protect technology, which the Company believes is proprietary about its technology. There can be no assurance, however, that these agreements, arrangements or patents will provide meaningful protection for the Company's trade secrets, know-how or other proprietary information. A failure of such protection could have a material adverse effect on future results of the Company. Competition. The Company expects to encounter varying degrees of competition in the markets in which it intends to compete. Products or product improvements based on new technologies could be introduced by other companies with little or no advance notice. Manufacturers of high- speed, black-on-white printers may also, in time, develop comparable or more effective color capability within their own products, which may render the Company's products obsolete. There can be no assurance that the Company will be able to compete against future competitors successfully or that competitive pressures faced by the Company will not have a material adverse effect upon its future results. Risks Associated With International Operations. The Company intends to have its products marketed worldwide and therefore may enter into contracts with foreign companies. International sales are subject to certain inherent risks, including unexpected changes in regulatory requirements, tariffs and other trade barriers, fluctuations in exchange rates, government controls, political instability and potential adverse tax consequences. There can be no assurance that these factors will not have a material adverse effect on the Company's future results. Inflation Although certain of the Company's expenses increase with general inflation in the economy, inflation has not had a material impact on the Company's financial results to date. Item 8. Financial Statements and Supplementary Data REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of Accent Color Sciences, Inc. In our opinion, the accompanying balance sheets and the related statements of operations, of cash flows and of changes in shareholders' equity (deficit), after the reclassification described in Note 7, present fairly, in all material respects, the financial position of Accent Color Sciences, Inc. at December 31, 1998 and 1997, and the results of its operations and 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 Company's management; 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 management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the financial statements, the Company has suffered recurring losses and negative cash flows from operations that raise substantial doubt about the Company's ability to continue as a going concern. The Company's plans in regard to this matter are described in Note 1. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/ PricewaterhouseCoopers LLP Hartford, Connecticut March 9, 1999, except as to Note 7 which is as of September 14, 1999 ACCENT COLOR SCIENCES, INC. BALANCE SHEETS December 31, 1998 1997 Assets Current assets: Cash and cash equivalents $ 1,048,425 $ 4,005,563 Accounts receivable 1,321,782 439,934 Inventories (Notes 2 and 4) 2,269,016 4,611,216 Prepaid expenses and other current assets 216,564 323,306 ----------- ----------- Total current assets 4,855,787 9,380,019 Fixed assets, net (Notes 2 and 3) 1,933,043 2,974,422 Other assets, net (Note 2) 71,575 52,698 ----------- ----------- Total assets $ 6,860,405 $12,407,139 =========== =========== Liabilities, Mandatorily Redeemable Convertible Preferred Stock and Shareholders' Equity (Deficit) Current liabilities: Obligations under capital leases (Note 9) $ 64,014 $ 61,360 Accounts payable 961,626 859,693 Accrued expenses (Note 2) 588,966 1,041,383 Customer advances and deposits (Note 2) - 85,600 Deferred revenue (Note 2) 595,000 2,496,000 ----------- ----------- Total current liabilities 2,209,606 4,544,036 Obligations under capital leases (Note 9) 23,116 91,937 Long-term debt, net of discount (Note 5) 2,235,593 - Other long-term liabilities (Notes 8 and 9) 601,759 501,644 Total non-current liabilities 2,860,468 593,581 ----------- ----------- Total liabilities 5,070,074 5,137,617 ----------- ----------- Commitments and contingencies (Notes 9 and 13) Mandatorily redeemable convertible preferred stock, no par value, 500,000 shares authorized, 3500 and 0 issued and outstanding (Reclassified Note 7) 3,097,368 - ----------- ----------- Shareholders' equity (Notes 6 and 8): Common stock, no par value, 35,000,000 and 25,000,000 shares authorized, 12,841,881 and 11,989,855 shares issued and outstanding 46,307,927 45,114,633 Accumulated deficit (47,614,964) (37,845,111) ----------- ----------- Total shareholders' equity (deficit) (1,307,037) 7,269,522 ----------- ----------- Total liabilities, mandatorily redeemable convertible preferred stock and shareholders' equity $ 6,860,405 $ 12,407,139 =========== =========== The accompanying notes are an integral part of these financial statements. ACCENT COLOR SCIENCES, INC. STATEMENTS OF OPERATIONS For the year ended December 31, 1998 1997 1996 ------ ------ ------ Revenue (Note 2) $ 8,219,586 $ 1,577,508 $ - ---------- ---------- ---------- Costs and expenses: Costs of production 9,836,379 7,396,828 1,272,357 Research and development 4,248,779 8,786,217 6,932,017 Marketing, general and administrative (Note 12) 3,822,113 4,438,518 4,418,380 ---------- ---------- ---------- 17,907,271 20,621,563 12,622,754 ---------- ---------- ---------- Other (income) expense: Interest expense 199,572 245,550 655,730 Interest income (117,404) (599,041) (113,126) ---------- ---------- ---------- 82,168 (353,491) 542,604 ---------- ---------- ---------- Net loss before extraordinary item (9,769,853) (18,690,564) (13,165,358) Extraordinary item: Loss on early extinguishment of debt, net of income taxes of nil - - (573,303) ---------- ---------- ---------- Net loss (9,769,853) (18,690,564) (13,738,661) ---------- ---------- ---------- Imputed dividend on mandatorily redeemable convertible preferred stock (Note 7) (920,000) - - ---------- ---------- ---------- Net loss applicable to common stock $(10,689,853) $(18,690,564) $(13,738,661) =========== =========== =========== Net loss (basic and diluted) per common share (Note 2): $ (.87) $ (1.77) $ (3.57) =========== =========== =========== Weighted average common shares Outstanding (Note 2) 12,330,903 10,566,890 3,852,982 =========== =========== =========== The accompanying notes are an integral part of these financial statements. ACCENT COLOR SCIENCES, INC. STATEMENT OF CASH FLOWS For the year ended December 31, 1998 1997 1996 Cash flows from operating ------ ------ ------ activities: Net loss $ (9,769,853) $ (18,690,564) $ (13,738,661) Adjustments to reconcile net loss to net cash used in Operating activities: Depreciation and amortization 1,208,368 1,128,533 974,184 Expense related to stock and options granted 13,054 345,230 - Loss on disposal of fixed assets 4,552 11,460 82,691 Conversion of accrued interest to common stock - - 231,147 Extraordinary loss on extinguishment of debt - - 573,303 Changes in assets and liabilities: Accounts receivable (881,848) (410,463) (29,471) Inventories 2,342,200 (1,248,964) (3,362,252) Prepaid expenses and other assets 106,742 188,327 (523,487) Accounts payable and accrued expenses (350,484) (717,230) 1,366,969 Customer advances and deposits (85,600) (1,301,800) 837,400 Deferred revenue (1,901,000) 1,546,000 950,000 Other long-term liabilities 87,061 293,642 133,091 ----------- ----------- ----------- Net cash used in operating activities (9,226,808) (18,855,829) (12,505,086) ----------- ----------- ----------- Cash flows from investing activities: Proceeds from sale of fixed assets 58,475 - 5,524 Purchases of fixed assets (168,776) (1,256,244) (2,611,891) Cost of patents (19,524) (21,666) (28,534) ----------- ----------- ----------- Net cash used in investing activities (129,825) (1,277,910) (2,634,901) ----------- ----------- ----------- Cash flows from financing activities: Payment of capital lease obligations (66,167) (69,146) (71,953) Net proceeds from issuance of debentures - - 3,049,768 Proceeds from issuance of warrants 325,000 - 261,482 Net proceeds from issuance of common stock - 4,486,326 33,869,508 Proceeds from exercise of options and warrants 44,625 1,783,587 - Net proceeds from issuance of preferred stock 3,921,037 - - Payment of notes payable - - (50,000) Proceeds from long-term debt 2,175,000 - 2,223,750 Repayment of debentures - (2,350,000) (3,855,000) ----------- ----------- ----------- Net cash provided by financing activities 6,399,495 3,850,767 35,427,555 ----------- ----------- ----------- Net increase (decrease) in cash and cash equivalents (2,957,138) (16,282,972) 20,287,568 Cash and cash equivalents at beginning of period 4,005,563 20,288,535 967 ----------- ----------- ----------- Cash and cash equivalents at end of period $ 1,048,425 $ 4,005,563 $ 20,288,535 =========== =========== =========== Supplemental disclosure Cash paid for: Interest $ 75,089 $ 167,188 $ 246,509 =========== =========== =========== The accompanying notes are an integral part of these financial statements. ACCENT COLOR SCIENCES, INC. STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (DEFICIT) Common Stock Preferred Stock Accumulated Shares Amount Shares Amount Deficit Total December 31, 1995 2,094,840 $ 821,291 324,360 $1,430,634 $(5,415,886) $(3,163,961) Warrants issued with debt - 261,482 - - - 261,482 Proceeds from sale 2,625,000 9,460,044 - - - 9,460,044 Proceeds from initial public offering 3,450,000 24,409,464 - - - 24,409,464 Conversion of Series III debentures 607,626 2,116,575 - - - 2,116,575 Conversion of Preferred stock 1,362,309 1,430,634 (324,360) (1,430,634) - - Net loss - - - - (13,738,661) (13,738,661) ---------- ---------- --------- ---------- ----------- ---------- December 31, 1996 10,139,775 38,499,490 - - (19,154,547) 19,344,943 Exercise of options 92,250 465,067 - - - 465,067 Exercise of warrants 394,091 1,445,000 - - - 1,445,000 Shares issued in connection with the Xerox agreement 50,000 218,750 - - - 218,750 Proceeds from sale 1,313,739 4,486,326 - - - 4,486,326 Net loss - - - - (18,690,564) (18,690,564) ---------- ---------- --------- ---------- ----------- ---------- December 31, 1997 11,989,855 45,114,633 - - (37,845,111) 7,269,522 Exercise of options 37,500 44,625 - - - 44,625 Proceed from sale of warrants - 810,000 - - - 810,000 Imputed dividend on mandatorily redeemable convertible preferred stock - (920,000) - - - (920,000) Conversion of mandatorily redeemable convertible preferred stock 814,526 933,669 - - - 933,669 Warrants issued with debt - 325,000 - - - 325,000 Net loss - - - - (9,769,853) (9,769,853) ---------- ---------- --------- ---------- ----------- ---------- December 31, 1998 12,841,881 $46,307,927 - $ - $(47,614,964) $(1,307,037) ========== ========== ========= ========== =========== ========== The accompanying notes are an integral part of these financial statements. ACCENT COLOR SCIENCES, INC. NOTES TO FINANCIAL STATEMENTS 1. Formation and Operations of the Company Accent Color Sciences, Inc. (the "Company") was incorporated in Connecticut in May 1993. The Company designs, manufactures and sells innovative high- speed, color printers ("Truecolor Systems") to attach to high-speed, black- on-white printers. The Company also sells related consumables and spare parts. Development and testing of a prototype began in January 1994, with a "proof- of-concept" system developed in November 1994. During 1995, the Company began negotiations with major original equipment manufacturers ("OEMs") to enter into formal development relationships. At the same time, the Company accelerated its engineering and development activities as its efforts were focused on designing and building the next generation prototypes that were completed in 1995. As of December 31, 1996, the Company received $1.5 million for the delivery of seven prototype machines to various OEMs, which by the end of 1997, had been fully offset against research and development expense. During 1996, the Company was focused on refining the Truecolor System design and preparing for the commencement of commercial production in the first half of 1997. During 1997, an OEM announced general worldwide availability of the Company's continuous form version of the Truecolor System designed for integration with their production printing system and the Company launched into commercial production. In 1997, all sales were attributable to a single customer. During the first quarter of 1998, the Company introduced to the market a new enhanced version of its product, the wide-head Truecolor System, which it shipped throughout the year. For the year ended December 31, 1998, $8,121,938 or 99% of total sales were attributed to the Company's primary OEM customer. Through 1997, the Company was considered to be a development stage company as defined in Statement of Financial Accounting Standards No. 7. The Company is no longer considered to be a development stage enterprise as its planned principal operations, which generated significant revenues, commenced in 1998. Based on its current operating plan, the Company anticipates that additional financing will be required to finance its operations and capital expenditures during the second half of 1999. The Company's currently anticipated levels of revenue and cash flow are subject to many uncertainties and cannot be assured. The amount of funds required by the Company will depend on many factors, including the extent and timing of sales of Truecolor Systems, product costs, engineering and customer and technical support requirements. The inability to obtain additional financing and to generate sufficient cash from operations could require the Company to reduce or eliminate expenditures for research and development, production or marketing of its products, or otherwise to curtail or discontinue its operations. The Company expects that quarterly net losses will continue through at least the fourth quarter of 1999. 2. Summary of Significant Accounting Policies Significant accounting policies followed in the preparation of these financial statements are as follows: Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Revenue Recognition Revenue is generally recognized upon product shipment. The Company has established warranty policies that, under specific conditions, enable customers to return products. The Company provides reserves for potential returns and allowances and warranty costs at the time of revenue recognition. Until the Company had adequate information and experience to estimate potential returns, allowances and warranty costs, revenue resulting from Truecolor Systems was deferred until the end of the warranty period. During the fourth quarter of 1998, the Company determined that it had adequate warranty information and experience to begin recognizing revenue upon the shipment of systems to its primary OEM customer. The Company will continue to defer revenue on shipments to its second OEM customer until systems are in production and are past the warranty period or until the Company has adequate warranty history with that product. As of December 31, 1998 and 1997, the Company had deferred revenue of $595,000 and $2,496,000 related to Truecolor Systems shipped. In addition, estimated warranty costs of $344,206 and $83,000 were accrued by the Company as of December 31, 1998 and 1997, respectively. Warranty expense was $180,251, $164,000 and $0 for the years ended December 31, 1998, 1997 and 1996, respectively. Cash and Cash Equivalents Cash and cash equivalents include cash on deposit with banks, as well as short-term investments with original maturities of 90 days or less. Inventories Inventories are stated at the lower of cost or market. Cost is determined by the first-in, first-out method. Fixed Assets Fixed assets are stated at cost and are depreciated over their estimated useful lives using the straight-line method. The estimated useful lives are between three and five years. Leasehold improvements are amortized over the shorter of the term of the lease or the useful life of the asset. Patent Patent costs of $73,399 and $53,875 at December 31, 1998 and 1997, respectively, are capitalized as incurred and are amortized, once issued, using the straight-line method over the shorter of the legal term or estimated useful life. Accumulated amortization was $1,823, $1,177 and $746 at December 31, 1998, 1997 and 1996, respectively. Income Taxes The Company uses the liability method of accounting for income taxes, as set forth in Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes." Under this method, deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the carrying amounts and the tax basis of assets and liabilities. Research and Development Expenditures Research and development expenditures are charged to expense as incurred. Customer Advances and Deposits Customer Advances Under Research and Development Agreements Amounts advanced pursuant to customer sponsored research and development agreements are recognized as a liability until certain obligations (as defined in the agreements, including delivery and acceptance of certain test units) under the agreements have been met. When the obligations are met, the amounts are offset against research and development expense. There were no deferred advances as of December 31, 1998 and 1997. Amounts offset against research and development expense were $0, $600,000 and $300,000 for the years ended December 31, 1998, 1997 and 1996, respectively. Customer Deposits Based on sales contracts with certain customers, the Company was entitled, for a limited time, to a percentage of the sales price upon receipt of certain firm purchase orders. Customer deposits of $0 and $85,600 were deferred at December 31, 1998 and 1997, respectively. Stock-Based Compensation The Company applies APB Opinion 25 and related interpretations in accounting for its Stock Incentive Plan. Under APB 25, when the exercise price of employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized. Additional disclosures required under Financial Accounting Standard No. 123 "Accounting for Stock-Based Compensation," are included in Note 7, Stock Incentive Plan. Net Loss Per Common Share In the fourth quarter of 1997, the Company adopted Statement of Financial Accounting Standards No. 128, "Earnings per Share," for all periods presented. Basic earnings per share computations are determined based on the weighted average number of shares outstanding during the period. The effect of the exercise and conversion of all securities, including stock options and warrants would be antidilutive and thus is not included in the diluted earnings per share calculation. 3. Fixed Assets December 31, 1998 1997 Equipment 1,643,851 1,564,611 Computers 838,367 902,662 Furniture and fixtures 487,627 487,627 Leasehold improvements 950,755 953,699 Purchased software 369,252 369,606 Capital leases - equipment 294,397 294,397 Construction in process 29,317 - ---------- --------- 4,613,566 4,572,602 Less:accumulated depreciation and amortization 2,680,523 1,598,180 ---------- --------- 1,933,043 2,974,422 ========== ========= Amortization expense for capital leases amounted to $78,887, $77,250 and $42,454 for the years ended December 31, 1998, 1997 and 1996, respectively. Depreciation expense was $1,068,241, $971,601 and $485,191 for the years ended December 31, 1998, 1997 and 1996, respectively. 4. Inventories Inventories consist of the following: December 31, 1998 1997 Raw materials and components $ 1,185,529 $ 1,590,386 Work-in-process 299,271 403,585 Finished goods 784,216 2,617,245 --------- --------- $ 2,269,016 $ 4,611,216 ========= ========= 5. Debt The following table summarizes the Company's current outstanding debt: Stated December 31, Intere Maturity 1998 1997 st Rate Long-term debt, net of unamortized discount of $264,407 10.00% December 31, 2000 $ 2,235,593 $ - Less: current portion - - ----------- ----------- $ 2,235,593 $ - =========== =========== IBM Loan Agreement On July 21, 1998, the Company entered into a loan agreement with International Business Machines Corporation ("IBM") to borrow $2.5 million at a fixed interest rate of 10% per year. Interest payments are due quarterly beginning October 1, 1998. The loan is due in full on December 31, 2000 and is secured by the assets and intellectual property of the Company. As part of the loan agreement, the Company issued a warrant to IBM that provides the right to purchase 500,000 shares of common stock at an exercise price of $2.50 per share, until the warrant expires on July 21, 2003. The fair value of the warrant using an option pricing model was determined to be $325,000, which was allocated to common stock with an equivalent discount on the loan. The discount is being amortized over the life of the loan resulting in a non-cash charge to interest expense. Amortization expense was $60,593 for the year ended December 31, 1998. Private Financing On October 11, 1996, the Company completed a private financing (the "Interim Financing") of discounted notes in an aggregate principal amount of $3,450,000 bearing interest at a rate of 8.70% per annum (excluding debt discount). This financing resulted in net proceeds to the Company of $2,780,000. The Interim Financing was repaid upon the closing of the initial public offering on December 23, 1996. At the time of issuance, holders of notes of the Interim Financing received warrants to purchase an aggregate of 45,000 shares of common stock at an exercise price of $8.00 per share with an expiration date of October 11, 2001. The Interim Financing Warrants were valued at $123,450, and accordingly this amount was allocated to common stock with an equivalent discount recorded on the notes. The discount was amortized over the term of the debentures until its extinguishment on December 23, 1996. Amortization of the original issue discount and the warrant valuation was $0, $0 and $159,107 for the years ended December 31, 1998, 1997 and 1996, respectively. The unamortized discount remaining at extinguishment is included in the extraordinary loss due to early extinguishment of the debt. Related deferred debt issuance costs of $220,000 were capitalized and were amortized using the effective interest method over the term of the debt until its extinguishment on December 23, 1996. Amortization expense was $0, $0 and $61,040 for the years ended December 31, 1998, 1997 and 1996, respectively. The unamortized cost remaining at extinguishment is included in the extraordinary loss due to early extinguishment of the debt. Xerox Loan In 1996, the Company and a customer finalized terms of a loan that provided for a maximum commitment of $3,000,000, at an annual interest rate of 8.00%, through April 1, 1998. As part of the inducement to extend such commitment, the Company agreed to issue detachable warrants. During 1996, the Company received $2,350,000 in loan proceeds and issued detachable warrants exercisable into 375,000 shares of common stock at $3.67 per share. A warrant to purchase 125,000 shares was issued with an expiration date of February 28, 1999 and a warrant to purchase 250,000 shares was issued with an expiration date of April 19, 1999. Accordingly, $126,250 was allocated to common stock with an equivalent discount recorded on the note. Amortization expense was $0, $78,362 and $47,888 for the years ended December 31, 1998, 1997 and 1996, respectively. The Company paid its first principal installment of $500,000 on July 1, 1997. During September 1997, the Company concluded an agreement with the customer that superceded the prior production and loan agreements. Under the new agreement, the customer exercised the warrants to purchase 375,000 shares of common stock. The exercise proceeds of $1,375,000 were applied to reduce the outstanding debt and accrued interest. The principal balance remaining after this reduction was paid in full in three equal installments prior to the end of 1997. In exchange for mutual releases from liability under the prior production agreement, the Company issued 50,000 shares of common stock to the customer. The Company's product deposits from the customer were offset against the charge resulting from the issuance of 50,000 shares of common stock and inventories specific to the project, resulting in no material impact to the Statement of Operations. Series IV Debentures During February 1996, the Company completed a private placement of 8% subordinated debentures (the "Series IV Debentures") for net proceeds of $405,000, of which $240,000 were issued to a director of the Company. The Series IV Debentures were non-convertible. The Series IV Debentures were due on August 31, 1996, and were repaid by the Company on August 29, 1996. In addition, each holder received detachable warrants (the "Series IV Warrants") to purchase common stock equal to the Series IV Debentures' principal amount divided by $3.67. The Series IV Warrants were valued at $0.11 per warrant. Accordingly, $11,782 was allocated to common stock, with an equivalent discount recorded on the Series IV Debentures. The entire discount was amortized in the year ended December 31, 1996. The Series IV Warrants issued are exercisable into 110,454 shares of common stock at an exercise price of $3.67 per share with an expiration date of February 28, 2001. Series III Debentures On October 31, 1995, the Company completed an offering of 8.00% convertible subordinated debentures (the "Series III Debentures") for net proceeds of $1,668,443. During 1995, the Company converted $50,000 of accounts payable to Series III Debentures. The Series III Debentures were convertible into common stock at a rate of $3.67 per share. The carrying value of the debentures, plus accrued interest of $231,147, converted into 607,626 common stock shares upon the closing of the initial public offering on December 23, 1996. At the time of issuance, each holder of a Series III Debenture received a detachable warrant (the "Series III Warrants") to purchase common stock for an amount of shares equal to the Series III Debentures' principal amount divided by the conversion rate. Series III Warrants issued were exercisable into 544,554 common shares at an exercise price of $3.67 per share with an expiration date of August 15, 1997. The Series III Warrants were valued at $56,631, and accordingly this amount was allocated to common stock with an equivalent discount recorded on the Series III Debentures. The discount was amortized over the term of the debentures until its conversion to common stock on December 23, 1996. Amortization expense was $0, $0, and $30,226 for the years ended December 31, 1998, 1997 and 1996, respectively. The unamortized discount remaining at conversion was included as a reduction in the carrying value of the related common stock. Related deferred debt issuance costs of $278,157 were amortized using the effective interest method over the term of the related debt until its conversion to common stock on December 23, 1996. Amortization expense was $0, $0, and $136,088 for the years ended December 31, 1998, 1997 and 1996, respectively. The unamortized cost remaining at conversion was included as a reduction in the carrying value of the related common stock. 6. Shareholders' Equity Capital Stock Transactions On September 15, 1994, the following changes in the Company's capital structure occurred: (i) the Company's Board of Directors declared a 450-for- 1 split of the common stock, effective upon the amendment of the Company's Certificate of Incorporation, (ii) the authorized number of common shares was increased to 1,000,000 and (iii) the par value of the common stock was changed from $.01 to no par value. In January 1995, the Company's Board of Directors amended the articles of incorporation to increase the authorized shares of common stock from 1,000,000 to 2,000,000. In April 1996, under the consent of the Board of Directors, the number of authorized shares of common stock was increased from 2,000,000 shares to 25,000,000 shares. On October 8, 1996, as authorized by the Board of Directors, the Company split its common stock 3-for-1. All shares and per share conversion amounts (unless otherwise indicated) in the accompanying financial statements have been restated to reflect the capital stock transactions described. Common Stock In June 1996, pursuant to a private placement offering, the Company issued 2,625,000 shares of common stock for $4.00 per share. This offering resulted in net proceeds of $9,460,044 to the Company. Stock purchase warrants exercisable into 300,000 common shares with an exercise price of $4.00 and an expiration date of June 28, 2001 were issued to the placement agent in connection with this offering. On December 23, 1996, the Company completed an initial public offering pursuant to which 3,450,000 common stock shares were issued at $8.00 each resulting in net proceeds of $24,409,464 to the Company. On October 16, 1997, the Company completed a private placement offering ("Unit Offering") of 437,913 units of its common stock at a price of $10.95 per unit, or $3.65 per share. Each unit consisted of three shares of common stock and a warrant exercisable into one share of common stock. The Unit Offering resulted in net proceeds of approximately $4,486,000 to the Company. The warrants were issued with an exercise price of $4.74 per share and an expiration date of October 16, 2002. Additionally, warrants exercisable into 102,500 shares of common stock were issued to the placement agents for services provided. These warrants were granted with an exercise price of $4.74 per share and an expiration date of October 16, 2002. Series A Preferred Stock From a class of preferred stock with 500,000 authorized shares, the Company's Board of Directors designated a series consisting of 300,000 of such shares as Series A Preferred Stock. The Series A Preferred Stock is nonredeemable, convertible and voting, with no par value. The holders shall be entitled to receive noncumulative cash dividends when and as declared by the Board of Directors. In the event of any voluntary or involuntary liquidation of the Company, the preferred shareholders shall be entitled to all unpaid dividends at the time of liquidation and $5.00 per share as a liquidating distribution prior to any liquidating distribution to the common shareholders. In 1994, pursuant to a private placement offering (the "Preferred Stock Offering"), the Company issued 160,000 shares of Series A Preferred Stock, with net proceeds of $643,770. In February 1995, the Board of Directors increased the authorized shares of Series A Preferred Stock from 300,000 shares to 350,000 shares. In 1995 the Company issued an additional 75,000 shares of Series A Preferred Stock, with net proceeds of $340,060. Series A Preferred Stock purchase warrants exercisable into 23,500 preferred shares with an exercise price of $5.50 and an expiration date of September 2000 for 8,000 shares and February 22, 2001 for 15,500 shares were issued to the placement agent in connection with these Preferred Stock offerings. In September 1994, the Company issued to a third party vendor 15,000 shares of Series A Preferred Stock as partial payment for services rendered pursuant to a development agreement between the third party vendor and the Company. The fair market value of the stock was recorded as $75,000. Upon effectiveness of the registration statement filed pursuant to the initial public offering of the Company on December 18, 1996, the 324,360 outstanding shares of Series A Preferred Stock converted at a rate of 4.2 common shares for one share of Series A Preferred Stock for a total of 1,362,309 common stock shares. Additionally, outstanding Series A Preferred Stock purchase warrants for 23,500 shares converted at a rate of 4.2 common stock warrants for one Series A Preferred Stock warrant for a total conversion to 98,700 common stock purchase warrants. Warrants As of December 31, 1998, the Company had outstanding common stock purchase warrants exercisable into an aggregate of 2,227,607 shares. Such shares have been authorized and reserved. The following summarizes the activity of outstanding warrants: Exercise Shares price under (per Warrants warrant share) Exercisable Outstanding at December 31, 1995 359,214 $ 3.67 359,214 Granted to Series IV Debenture holders 110,454 3.67 Granted to noteholder 375,000 3.67 Granted to service providers 13,635 3.67 Granted to service providers 15,000 3.67 Granted to placement agent 300,000 4.00 Conversion of 98,700 1.31 preferred stock warrants Granted to former advisor in settlement 32,433 4.40 Granted to former advisor in settlement 554 8.80 Granted to Interim Financing holders 45,000 7.40 Warrants surrendered (112,500) 3.67 ------------ Outstanding at December 31, 1996 1,237,490 $1.31 - $8.80 1,237,490 Anti-dilution adjustments pursuant to warrant agreements 673 $3.66 - $8.08 Exercised (394,091) 3.67 Expired (241,258) 3.67 Granted in unit offering 540,413 4.74 ------------ Outstanding at December 31, 1997 1,143,227 $1.31 - $8.08 1,143,227 Anti-dilution adjustments pursuant to warrant agreements 68,995 $3.41 - $7.04 Granted in preferred stock offering 300,000 2.75 Granted to advisors in preferred stock offering 115,385 2.50 Granted pursuant to IBM loan agreement 500,000 2.50 Granted to an employee 100,000 1.00 ------------ Outstanding at December 31, 1998 2,227,607 $1.00 - $7.04 2,227,607 ============ Pursuant to provisions in certain warrant agreements, anti-dilution adjustments are to be made to the exercise price and/or the number of shares purchasable under the warrant in certain circumstances. During 1998, adjustments were made for certain warrants in connection with the preferred stock offering, the IBM loan agreement and warrants granted to an employee. During 1997, adjustments were made in connection with the unit offering. All shares and per share conversion amounts are adjusted in the table above. 7. Mandatorily Redeemable Convertible Preferred Stock In December 1997, the Company's Board of Directors designated a series of 4,500 shares of the Company's previously authorized preferred stock, no par value per share, to be designated as the Series B Convertible Preferred Stock ("Series B Stock"). On January 13, 1998 the Company completed a private equity financing providing net proceeds to the Company of $3.9 million. In connection with the financing, the Company issued 4,500 shares of Series B Stock at a price of $1,000 per share and warrants to purchase the Company's common stock with net proceeds of $3,921,037. The warrants issued are exercisable into 300,000 shares of common stock with an exercise price of $2.75 and an expiration date of January 9, 2003. Additionally, warrants exercisable into 115,385 shares of common stock with an exercise price of $2.50 and an expiration date of January 9, 2003 were issued to the placement agent for services provided. The deemed fair market value of these warrants has been reflected as an increase to common shareholders' equity and a reduction of mandatorily redeemable convertible preferred stock. In connection with the sale of the units, the Company agreed to register the common stock issuable upon the conversion of the Series B Stock and the execution of the warrants. The Series B Stock, no par value per share, is convertible into such number of shares of common stock as is determined by dividing the stated value ($1,000) of each share of Series B Stock (as such value is increased by an annual premium of 6%) by the then current conversion price of the Series B Stock (which is determined, generally, by reference to 85% of the average of the closing market price of the common stock during the five consecutive trading days immediately preceding the date of determination) subject to certain restrictions and adjustments. The Series B Stock has voting rights as defined in the Company's Certificate of Incorporation, bears no dividends and ranks senior to the Company's common stock and Series A Preferred Stock. In the event of any voluntary or involuntary liquidation of the Company, the Series B holders shall be entitled to a liquidation preference equal to the stated value of the stock plus the accrued premium through the date of final distribution. Upon occurrence of specific events, as defined in the agreement, the holder may redeem the Series B Stock for cash. In certain, but not all, redemption events, the Company has the unilateral right to pre-empt the right of holders of the Series B Stock from demanding cash redemption of their shares by paying to them within five days of the specific event, as liquidated damages, 25% of the face amount of the Series B Stock then outstanding. Such liquidated damages can be paid in cash or shares at the Company's election. Management does not consider any of the events that would trigger mandatory redemption to be probable events, has determined a reasonable estimate of when the circumstances that would result in the shares becoming mandatorily redeemable cannot be made, and therefore at December 31, 1998 does not accrue for accretion. The Company initially reserved 6,300,000 shares of common stock for issuance pursuant to the conversion of the Series B Stock. This number of shares represented an estimate based on 200% of the number of common shares that would have been issuable upon conversion with an exercise price of $1.875 per share (4,800,000) plus 1,500,000 shares issuable under the terms of the Certificate of Designation in the event of certain failures by the Company to comply with various provisions thereof, including maintaining its common stock listing on the NASDAQ Stock Market. In addition, 415,385 shares of common stock, subject to adjustments in accordance with the terms of each warrant, were reserved for issuance pursuant to the exercise of the warrants described above. On August 10, 1998, pursuant to the terms of the Certificate of Designation and approval by the Board of Directors, the Company increased the number of reserved shares of common stock for issuance upon the conversion of the Series B Stock by 2,567,652 shares. This was done because the reserved amount had fallen below 135% of the number of shares of common stock issuable upon conversion of the then outstanding shares of Series B Stock. As of December 31, 1998, there were 8,053,126 shares of common stock reserved for issuance pursuant to the conversion of the remaining 3,500 shares of Series B Stock issued and outstanding. The actual number of shares issuable upon conversion could be materially less or more than this number depending on factors that cannot be predicted by the Company. The number of shares issuable upon conversion is dependent on (a) the market price of the common stock at the time of the conversion and (b) the Company's ability to maintain its NASDAQ listing. As of December 31, 1998, 1,000 shares of Series B Stock had been converted into 814,526 shares of common stock at an average conversion price of $1.15 per share (See Note 13). The terms of conversion of the Series B Stock afforded the holders a conversion price lower than the market price of the common stock at the time of issuance. The difference between the conversion price and market price was treated as an imputed (non-cash) dividend for purposes of calculating net loss per common share, although no assets of the Company were expended. The imputed dividend is approximately $920,000 and has the effect of increasing the net loss per common share by $.07 per share for the twelve months ended December 31, 1998. The imputed dividend has been recorded as a reduction to common shareholders' equity. In the course of a review of a Securities Act filing, the staff of the Securities and Exchange Commission ("the Commission") raised an issue regarding the classification of the Company's mandatorily redeemable convertible preferred stock. Due to certain of the mandatory redemption features mentioned above, the carrying value of the preferred shares, which were previously presented as a component of Shareholders' equity (deficit), has been reclassified as temporary equity, outside of shareholders' equity (deficit) at December 31, 1998. The reclassification of the 1998 financial statements for the matter described above had no effect on the Company's net loss, total assets or total liabilities. The Company's redeemable equity and total shareholders' equity (deficit) at December 31, 1998, as previously reported and reclassified, are as follows: December 31, 1998 Redeemable equity - previously reported.......... $ - Adjustment related to the presentation of the mandatorily redeemable convertible preferred shares as redeemable... 3,097,368 --------- As restated...................... $ 3,097,368 ========= Shareholders'equity (deficit) - previously reported..... $ 1,790,331 Adjustment related to the presentation of the mandatorily redeemable convertible preferred shares as redeemable... (3,097,368) --------- As restated...................... $(1,307,037) ========= 8. Stock Incentive Plan In January 1995, the Company's Board of Directors adopted and approved the 1995 Stock Incentive Plan (the "Plan") for directors, officers, key employees and other persons. The Plan permits the granting of incentive stock options, non-statutory stock options, stock appreciation rights and restricted stock awards to purchase up to 300,000 shares of common stock. In April 1996, the number of shares increased to 1,500,000. In May 1997, the number of shares increased to 2,000,000. Such shares have been authorized and reserved. Initially, options vested 20% each year, so that the options, or any unexercised portion thereof, would be fully exercisable after a period of five years following the date of their grant. In April 1996, the original vesting period of five years was modified to three years with options vesting 33% each year following the date of their grant. All options previously granted are subject to this modification. In certain circumstances, at the discretion of the Board of Directors, options are granted with a vesting schedule of other than three years. Stock options under the Plan have terms ranging from five to ten years. The 1995 Stock Incentive Plan activity is summarized as follows: For the year ended For the year ended December 31, 1998 December 31, 1997 Weighted Weighted Average Average Shares Exercise Shares Exercise Price Price Outstanding at 1,318,850 $ 3.85 1,280,850 $ 3.53 beginning of period Granted 2,870,450 2.03 302,675 6.44 Exercised (37,500) 1.19 (92,250) 3.67 Canceled (2,470,325) 3.56 (172,425) 6.12 ------------- ---------- Outstanding at period end 1,681,475 1.23 1,318,850 3.85 ============= ========== Options exercisable at period end 314,000 2.26 629,960 3.44 ============= ========== Weighted average fair value of options granted during the period $ 1.61 $ 5.20 ============= ========== By action of the Board of Directors on April 14, 1998, the Company re- priced all options outstanding under its 1995 Stock Incentive Plan which had a current exercise price exceeding $3.125 to an exercise price of $3.125 per share, the fair market value as of that date. A total of 1,137,200 options were re-priced, which resulted in a reduction of the weighted average exercise price of all options outstanding from $3.85 per share at December 31, 1997 to $2.93 per share after the re-pricing. On September 21, 1998, in an effort to retain key personnel, the Board of Directors approved a modification of the outstanding options under the 1995 Stock Option Plan for all active employees and directors of the Company. Each option holder could elect to continue to hold their existing options or could have the Company re-price their options to an exercise price of $1.00 per share, the fair market value of the common stock as of September 29, 1998 (the election date). If the employees elected to have their options re-priced, the vesting period for such options was extended for one year. A total of 1,066,625 options were modified, which further reduced the weighted average exercise price of all options outstanding to $1.26 per share after the re-pricing. No compensation expense was recognized pursuant to this modification because the exercise price of the modified stock option equaled the market price of the common stock on the date of the re-pricing. The following summarizes additional information about stock options outstanding at December 31, 1998: Options Outstanding Options Exercisable Number Number Outstanding Weighted Weighted Exercisable Weighted at Average Average at Average Exercise December Remaining Exercise December Exercise Prices 31, 1998 Contractual Price 31, 1998 Price Life $ .91 260,150 9.34 $ .91 20,000 $ .91 1.00 1,114,825 7.15 1.00 - - 1.19-2.31 127,750 5.23 1.28 117,000 1.19 3.13 178,750 4.78 3.13 177,000 3.13 ---------- -------- 1,681,475 7.09 $ 1.23 314,000 $ 2.26 ========== ======== Had compensation expense been recognized based on the fair value of the options at their grant dates, as prescribed in Financial Accounting Standard No. 123, the Company's net loss and net loss (basic and diluted) per share would have been as follows: Year ended Year ended December 31, December 31, 1998 1997 Net loss: As reported $ (10,689,853) $ (18,690,564) Pro forma under FAS 123 $ (12,470,414) $ (20,052,460) Pro forma net loss (basic and diluted) per share (unaudited): As reported $ (.87) $ (1.77) Pro forma under FAS 123 $ (1.01) $ (1.90) The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions used for grants during the applicable period: dividend yield of 0% for both periods; risk-free interest rates ranging from 4.24% to 5.74% for options granted during the year ended December 31, 1998 and 5.97% to 6.73% for options granted during the year ended December 31, 1997; expected volatility factors of 90% for the year ended December 31, 1998 and 87% for the year ended December 31, 1997; and an expected option term ranging from 2 to 10 years for the year ended December 31, 1998 and 5 to 10 years for the year ended December 31, 1997. Compensation expense of approximately $550,725 has been attributed to common stock options granted in August 1996. This compensation expense will be recognized over the three year vesting period, of which $118,671 and $174,420 was recognized as of December 31, 1998 and 1997, respectively. Additionally, compensation expense of approximately $126,000 is included in 1997 for options whose vesting was accelerated in 1997. 9. Leases Operating Leases At December 31, 1998, the Company was committed under operating leases for equipment and facilities with initial terms of more than one year. The facility lease agreement provides for escalation of the lease payments over the term of the lease, however, rent expense is recognized using the straight-line method. Accrued rent related to this facility lease was $232,870 and $264,480 as of December 31, 1998 and 1997, respectively. Rent expense related to operating leases was $729,573 in 1998, $740,772 in 1997 and $468,862 in 1996. Minimum lease payments under the noncancelable leases are as follows: 1999 $ 844,023 2000 832,642 2001 780 2002 195 2003 - ----------- Total minimum obligations $ 1,677,640 =========== Capital Lease Obligations The Company is obligated under capital leases for certain office equipment that expire on various dates through the year 2000. Future minimum lease payments under these leases are as follows: 1999 $ 84,914 2000 25,388 2001 - 2002 - 2003 - ---------- Total minimum obligations $ 110,302 Less: amount representing interest 23,172 ---------- Present value of minimum lease payments 87,130 Less: current portion 64,014 ---------- $ 23,116 ========== 9. Income Taxes Deferred tax assets and liabilities are as follows: December 31, 1998 1997 Gross deferred tax assets: Carryforwards: Research tax credits $ 1,484,206 $ 447,000 Net operating losses 17,666,564 13,841,000 Other assets 1,114,064 1,316,000 ------------ ----------- Gross deferred tax assets 20,264,834 15,604,000 ------------ ----------- Gross deferred tax liabilities (28,868) (21,000) Valuation allowance (20,235,966) (15,583,000) ------------ ----------- $ - $ - ============ ============ The Company has provided a valuation allowance for the full amount of deferred tax assets in excess of deferred tax liabilities since the realization of these future benefits cannot be reasonably assured as of the end of each related period. If the Company achieves profitability, the deferred tax assets may be available to offset future income taxes. At December 31, 1998, the Company had approximately $43 million of federal net operating loss carryforwards that expire in years 2008 through 2013, approximately $43 million of state net operating loss carryforwards that expire in years 1999 through 2003 and research and development tax credit carryforwards of approximately $1.5 million that expire in years 2009 through 2013. As defined in the Internal Revenue Code, certain ownership changes limit the annual utilization of federal net operating loss and tax credit carryforwards. During 1996, the Company experienced such an ownership change that limits the amount of federal net operating loss carryforwards and research tax credits that can be utilized in any one taxable year. At December 31, 1998 the approximate Section 382 annual limitation is $4.6 million for net operating loss carryforwards and research tax credits incurred prior to the ownership change. Depending on the number of shares of Series B Stock converted into common shares and the timing of such conversions (Note 6), the transactions may result in further Section 382 annual limitations of net operating loss carryforwards. 10. Disclosure about Fair Value of Financial Instruments The carrying amount of cash, accounts receivable, prepaid expenses, accounts payable, accrued expenses, customer advances and deposits and deferred revenue approximates fair value because of the short-term nature of those instruments. The fair value of long-term debt is estimated based upon management estimates and current interest rates offered to the Company on similar debt. The estimated fair value of the Company's debt (see Note 5) approximates its carrying value as of December 31, 1998. 11. Related Party Transactions The Company entered into an agreement with Knickerbocker Securities Inc. ("Knickerbocker") on September 20, 1994, in which Knickerbocker would advise the Company with regard to financial matters and methods of financing for a three-year period commencing on January 1, 1996 for a fee of $1,000 per month. In March 1996, the Company terminated this agreement as well as all previous agreements with Knickerbocker. The total amount expensed relating to the advisory agreement and the termination of all existing agreements was $105,260 of which $25,000 was incurred in 1996. Additionally, 32,987 common stock purchase warrants were granted in 1996 as settlement for a compensation claim. Of the total warrants, 32,433 expire on June 27, 2001 and 554 October 10, 2001. A member of the Company's Board of Directors is a partner with the Company's primary legal firm. In connection with the Interim Financing (see Note 5), a director and a director's spouse purchased $250,000 and $100,000 of the notes, and received 3,750 and 1,500 of the related warrants, respectively. 12. Commitments and Contingencies On January 8, 1996, the Company signed a seven-year agreement with a vendor for the supply of inks and printheads. The agreement provides the Company with worldwide rights, as defined. The Company must pay the vendor royalties and license fees upon achieving certain volume purchase levels. The agreement also includes certain exclusivity features that benefit the Company. To maintain the exclusivity rights, quarterly payments of $250,000 were required beginning January 1, 1996 and ending on October 1, 1997, and the Company must purchase all ink and printhead requirements from the vendor and purchase specified minimum amounts each year. The Company is currently not in compliance with such specified minimum volume amounts necessary to maintain exclusivity and is in discussion with Spectra to establish a revised requirement for exclusivity, however, Management believes there is no material adverse financial impact for the Company. The Company has the option to terminate the exclusive rights leaving all other aspects of the agreement unchanged. It is the Company's intent to maintain such rights. As of December 31, 1998, there were two employment agreements outstanding for certain executive officers of the Company, each reflecting a three-year term. These agreements are subject to termination by either party, and provide for salary continuation and benefits for a specified period under certain circumstances including a change in control (as defined) of the Company. As of December 31, 1998, if such employees under contract were to be terminated by the Company without cause (as defined), the Company's liability would be approximately $873,000. 14. Subsequent Events and Reclassification of Mandatorily Redeemable Convertible Preferred Stock at Interim Reporting Dates (Unaudited) On March 11, 1999, the Company completed a reduction of personnel to align its expenses with current sales demand. In connection with this reduction, the Company eliminated 19 positions and recorded a charge of approximately $61,000 for employee severance. Of the total reduction, approximately 37% was in the area of operations, 53% in research and development and 10% in marketing, general and administrative. The Company's common stock was delisted from the NASDAQ Stock Market effective March 17, 1999 as the Company was in violation of NASDAQ's minimum bid price and net tangible asset level. Consequently, each holder of the Company's Series B Convertible Preferred Stock has the right, beginning March 31, 1999, to require the Company to redeem such holder's shares of Series B Preferred Stock at a redemption price, in cash or stock, specified in the Company's Certificate of Incorporation. The Company is not aware that any such holder intends to require such redemption, but cannot predict what each holder may elect to require. In the event a holder of Series B Preferred Stock were to demand redemption at a time when the Company's resources are insufficient to redeem such holder's shares, the rights of such holder would include the right to receive interest at the annual rate of 24% on the defaulted payment amount. The Company has the right to preempt the right of holders of Series B Preferred Stock from demanding redemption of their shares by paying to them, as liquidated damages, on or before April 6, 1999, 25% of the face amount of all outstanding shares of Series B Preferred Stock in cash or in shares of common stock valued at 50% of the average closing price of such stock during the five trading days ended March 30, 1999. As of March 17, 1999, such liquidated damages would amount to $713,750 in cash or 3,772,463 shares of common stock. On April 6, 1999, the Company elected to forgo its right to prevent demand redemption on its outstanding shares of Series B Preferred Stock which resulted in an additional $1,176,154 being accreted to Redeemable Preferred Stock to reflect the increase in redemption value from April 6, 1999 to June 30, 1999 in accordance with the redemption price specified in the Company's Certificate of Incorporation. Such accretion was charged against common stock and also increased the net loss applicable to common shareholders. As of June 30, 1999, there were 7,402,874 shares of common stock reserved for issuance pursuant to the conversion of the remaining 2,028 shares of Redeemable Preferred Stock issued and outstanding. The features and rights of the Redeemable Preferred Stock remain the same with the exception that the remaining holders may demand redemption of their outstanding shares at any point in time. In the course of a review of a Securities Act filing, the staff of the Securities and Exchange Commission ("the Commission") raised an issue regarding the classification of the Company's mandatorily redeemable convertible preferred stock. Due to certain mandatory redemption features, the carrying value of the preferred shares, which were previously presented as a component of shareholders' equity (deficit), has been reclassified as temporary equity, outside of shareholders' equity (deficit) for 1998. The reclassification of the preferred shares for the matter described above had no effect on the Company's net loss, total assets or total liabilities. The Company's redeemable equity and total shareholders' equity (deficit) at the interim reporting dates, as previously reported and reclassified, are as follows: 1998 -------------------------------- September 31 June 30 March 31 Redeemable equity-previously reported $ - $ - $ - Adjustment related to the presentation of the mandatorily redeemable convertible preferred shares as redeemable 3,377,466 3,657,565 4,031,038 ---------- ---------- ---------- As restated $3,377,466 $3,657,495 $4,031,038 ========== ========== ========== Shareholders' equity (deficit)- previously reported $3,502,208 $5,205,209 $8,159,813 Adjustment related to the presentation of the mandatorily redeemable convertible preferred shares as redeemable (3,377,466) (3,657,565) (4,031,038) ---------- ---------- ---------- As restated $ 124,742 $1,547,644 $4,128,775 ========== ========== ========== Signatures Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of East Hartford, State of Connecticut, on September 17, 1999. ACCENT COLOR SCIENCES, INC. By /s/ Charles E. Buchheit --------------------------- Charles E. Buchheit President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Registrant and in the capacities indicated on September 17, 1999. Signature Title Date /s/ Charles E. Buchheit - ------------------------ Charles E. Buchheit President and Chief September 17, 1999 Executive Officer (Principal Executive Officer) /s/ Tracy L. Hubert - ------------------------ Tracy L. Hubert Acting Chief Financial Officer September 17, 1999 (Principal Financial and Accounting Officer) - ----------*------------- Joseph T. Brophy Director September 17, 1999 - ----------*------------- Richard J. Coburn Director September 17, 1999 - ----------*------------- Richard Hodgson Director September 17, 1999 - ----------*------------- Norman L. Millard Director September 17, 1999 - ----------*------------- Willard F. Pinney, Jr. Director September 17, 1999 - ----------*------------- Robert H. Steele Director September 17, 1999 *By: Charles E. Buchheit Charles E. Buchheit Attorney-in-fact