1 Exhibit 13.1 1996 Annual Report to Shareholders (to be deemed filed only to the extent required by the instructions to exhibits for reports on Form 10-K). 2 EXHIBIT 13 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS o Overview Since its inception in October 1989, DepoTech Corporation (the "Company") has devoted substantially all of its resources to the development of its potential products. To date, the Company has not received any revenues from the sale of products. The Company has funded its development programs primarily from equity-derived working capital and through strategic alliances with other companies. The Company has been unprofitable since its inception and expects to incur additional operating losses over at least the next 18 months. As of December 31, 1996, the Company's accumulated deficit was approximately $42.4 million. The following discussion is qualified in its entirety by the more detailed information and the Financial Statements and Notes thereto appearing elsewhere in this Annual Report, including information under "Risk and Uncertainties." o Results of Operations The Company had total revenues of $4.4 million for the year ended December 31, 1996 compared to $6.8 million for 1995 and $0.6 million for 1994. Total revenues were principally attributed to the Company's collaborative agreement with Chiron. Total revenues were primarily derived from reimbursement of 50% of the clinical trial and manufacturing scale-up expenses for the Company's lead product, DepoCyt, under the Chiron agreement. In addition, Chiron reimbursed DepoTech for 100% of pre-clinical development costs for DepoIGF-1 and feasibility studies performed on their behalf. Total revenues in 1995 included a one-time marketing rights fee and reimbursement of prior year clinical trial expenses for DepoCyt totaling $3.5 million, earned by the Company upon achievement of a development milestone under the Chiron agreement. Revenues from the reimbursement of clinical trial expenses from prior years and the marketing rights fee were one time payments which will not re-occur in future periods. Revenues may fluctuate from year to year depending on the level of clinical and development activity for projects under collaborative agreements with Chiron and other companies and the achievement of future milestones. Research and development expenses increased to $18.0 million for the year ended December 31, 1996, from $12.7 million in 1995 and $7.4 million in 1994. Factors contributing to these increases include substantial expansion in staff, research and process development supplies, payments to clinical sites, and the expansion of manufacturing and laboratory facilities and equipment depreciation expense in support of clinical trials and manufacturing scale-up of products under development. During 1996, DepoTech completed a Phase III clinical trial for DepoCyt in the solid tumor indication and a Phase I clinical trial of DepoAmikacin. The Company has Phase III clinical trials in progress for two other indications of DepoCyt and has begun a Phase IV clinical trial. Other pre-clinical development programs included DepoMorphine and DepoIGF-1. In addition, the Company is evaluating the feasibility of developing several early stage compounds. Research and development expenses are expected to continue to increase in 1997 as a result of: (1) on-going or new clinical trials for DepoCyt, DepoMorphine and DepoAmikacin; (2) manufacturing scale-up for DepoMorphine and (3) preclinical development and feasibility efforts associated with other potential DepoFoam products. General and administrative expenses increased to $4.1 million during 1996 from $2.8 million in 1995 and $1.9 million in 1994. The increases were primarily due to expansion in administrative staffing, higher facility expenses and costs associated with being a public company. Included in general and administrative expenses for 1996 were 50% of the pre-launch expenses, or $0.6 million, incurred for DepoCyt prior to the onset of any product revenue. Under the collaborative agreement with Chiron, the Company is obligated to share in the funding of these expenses. DepoCyt sales and marketing expenses are expected to increase significantly in 1997 in anticipation of the possible launch of DepoCyt. Other general and administrative expenses are expected to increase modestly during 1997. Interest income was $1.7 million for the year ended December 31, 1996 compared to $1.1 million in 1995 and $0.3 million in 1994. The increases were principally due to higher average cash investment balances and increases in available market interest rates. Interest expense was $0.8 million for the year ended December 31, 1996 compared to $0.4 million in 1995 and $0.1 million in 1994. The increases in interest expense were due to higher balances outstanding for obligations under capital leases and a note payable. 12 3 o Liquidity and Capital Resources Since its inception, DepoTech has financed its operations primarily through public and private placements of equity securities, which provided aggregate net proceeds of approximately $67.5 million through December 31, 1996, and through capital equipment lease financing. In October 1995, the Company completed an initial public offering ("IPO") of common stock which raised net proceeds of $38.1 million. In January 1997, the Company completed a private placement of newly issued shares of common stock which raised net proceeds of $19.1 million. Working capital decreased to $14.9 million as of December 31, 1996 compared to $35.4 million as of December 31, 1995. The decrease in working capital in 1996 was primarily due to cash used to fund operations of $15.0 million. As of December 31, 1996, DepoTech had cash, cash equivalents and short-term investments totaling $18.2 million. During 1996, the Company entered into an agreement to expand an existing leaseline from $2.6 million to $5.1 million. The incremental borrowing amount of $2.5 million was used principally to finance certain tenant improvement and equipment costs incurred in 1996. In May 1996, the Company signed a bank credit facility for $9.0 million to finance future capital equipment purchases, of which $2.2 million was utilized through December 31, 1996. The Company believes the impact of inflation on its business activities has not been significant to date. Through December 31, 1996, the Company has invested an aggregate of $19.8 million in leasehold improvements and manufacturing, laboratory and office equipment, of which $11.4 million has been funded through capital leases or bank credit facilities. The Company intends to continue to fund capital expenditures through external financing supplemented by internal cash resources where appropriate. In September 1995, the Company occupied the initial phase (50,000 square feet) of an 82,000 square foot build-to-suit facility housing its administrative, research and clinical activities. DepoTech began paying rent in mid-March 1996 for the remaining space (32,000 square feet) which is intended to provide future manufacturing and process development capabilities. The minimum rental commitment for this facility ranges from approximately $2.1 million to $4.3 million per year, over 20 years, based upon pre-established annual rent increases. The Company is installing a manufacturing line in this facility to support clinical and commercial production of DepoFoam products under development. The cost of equipment and tenant improvement expenses are estimated to total approximately $8.1 million through 1997. DepoTech intends to finance such expenditures through new and existing bank credit facilities. The Company has a right of first refusal and right of first offer to purchase land located adjacent to its headquarters which must be exercised on or before October 15, 1997. At present, the Company has not made a decision concerning the exercise of such option. The Company's operations to date have consumed substantial amounts of cash, which is expected to continue over the foreseeable future. The amount of net losses and the time required for the Company to achieve profitability are highly uncertain. There can be no assurance that the Company will be able to achieve profitability at all or on a sustained basis. It is the Company's intention to fund product research and development, manufacturing, and sales and marketing costs through additional collaborative relationships with suitable corporate partners. There can be no assurance that the Company will enter into collaborative arrangements with corporate partners or that any agreements resulting from these discussions will successfully reduce the Company's funding requirements. Additional equity or debt financing will be required, and there can be no assurance that these funds will be available on terms favorable to the Company, if at all. If adequate funds are not available, the Company may be required to delay, scale back or eliminate one or more of its product development programs or obtain funds through arrangements with collaborative partners or others that may require the Company to relinquish rights to certain of its technologies, product candidates or products that the Company would not otherwise relinquish. DepoTech anticipates that its existing available cash, cash equivalents and short-term investments, committed future contract revenue, projected funding from equipment leases and interest income will be adequate to satisfy its capital requirements and fund operating losses into 1998. The Company's future capital requirements will depend on many factors, including continued scientific progress in its products and process development programs, progress with preclinical testing and clinical trials, the time and costs involved in obtaining regulatory approvals, the costs involved in filing and maintaining patents, competing technological and market developments, changes in existing collaborative relationships, the ability of the Company to establish development arrangements, the cost of manufacturing scale-up, and the establishment of effective sales and marketing arrangements. 13 4 SELECTED FINANCIAL DATA DepoTech Corporation Years Ended December 31, (dollars, except share amounts) 1996 1995 1994 1993 1992 Statement of Operations Data: Total revenues $4,391,024 $6,825,784 $582,120 $69,500 $15,000 Total expenses 22,039,072 15,525,785 9,307,676 4,058,419 1,175,662 Net loss (16,775,605) (8,020,547) (8,561,487) (3,896,906) (1,209,506) Net loss per share (1.46) (0.92) (1.26) (0.78) (0.52) Shares used in computing net loss per share 11,451,334 8,717,550 6,773,178 4,989,332 2,326,059 Balance Sheet Data: Cash, cash equivalents and short-term investments 18,198,097 38,661,534 9,983,046 7,519,096 6,095,987 Total assets 37,608,405 48,977,573 15,346,654 10,107,087 6,333,479 Long-term liabilities 7,272,025 3,218,957 2,618,664 408,538 90,148 Shareholders' equity 25,229,234 41,505,530 10,903,253 8,702,521 6,170,556 15 5 STATEMENTS OF OPERATIONS DepoTech Corporation Years Ended December 31, 1996 1995 1994 Revenues: Contract revenue $ 4,391,024 $ 5,825,784 $ 582,120 Marketing rights fee - 1,000,000 - ------------ ----------- ----------- Total revenues 4,391,024 6,825,784 582,120 Costs and expenses: Research and development 17,951,636 12,699,247 7,426,815 General and administration 4,087,436 2,826,538 1,880,861 ------------ ----------- ----------- Total costs and expenses 22,039,072 15,525,785 9,307,676 ------------ ----------- ----------- Loss from operations (17,648,048) (8,700,001) (8,725,556) Interest income 1,659,852 1,084,244 286,984 Interest expense (787,409) (404,790) (122,915) ------------ ----------- ----------- Net loss $(16,775,605) $(8,020,547) $(8,561,487) ============ =========== =========== Net loss per share $(1.46) $(0.92) $(1.26) ============ =========== =========== Shares used in computing net loss per share 11,451,334 8,717,550 6,773,178 ============ =========== =========== See accompanying notes. 16 6 BALANCE SHEETS DepoTech Corporation December 31, 1996 1995 ASSETS Current assets: Cash and cash equivalents $ 1,966,626 $ 5,883,911 Short-term investments 16,231,471 32,777,623 Accounts receivable from Chiron collaboration 614,580 400,000 Other current assets 1,160,394 566,924 ----------- ----------- Total current assets 19,973,071 39,628,458 Property and equipment, net 16,851,574 8,610,978 Restricted cash 289,023 420,860 Deposits and other assets 494,737 317,277 ----------- ----------- Total assets $37,608,405 $48,977,573 =========== =========== LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Accounts payable $ 1,633,756 $ 1,741,724 Current portion of note payable 493,481 - Other accrued liabilities 939,331 705,868 Current portion of obligations under capital leases and loans 2,040,578 1,805,494 ----------- ----------- Total current liabilities 5,107,146 4,253,086 Deferred revenue 54,839 - Obligations under capital leases, less current portion 4,129,750 2,831,010 Note payable, less current portion 1,709,813 - Deferred rent 1,377,623 387,947 Commitments SHAREHOLDERS' EQUITY Common stock, no par value; 30,000,000 shares authorized; 11,543,816 and 11,285,630 shares issued and outstanding at December 31, 1996 and 1995,respectively 67,797,617 67,133,738 Deferred compensation related to stock options (161,960) (214,448) Unrealized (loss) gain on short-term investments (10,886) 206,172 Accumulated deficit (42,395,537) (25,619,932) ----------- ----------- Total shareholders' equity 25,229,234 41,505,530 ----------- ----------- Total liabilities and shareholders' equity $37,608,405 $48,977,573 =========== =========== See accompanying notes. 17 7 STATEMENTS OF CASH FLOWS DepoTech Corporation Years Ended December 31, 1996 1995 1994 OPERATING ACTIVITIES Net loss $(16,775,605) $ (8,020,547) $ (8,561,487) Adjustments to reconcile net loss to net cash used by operating activities: Depreciation and amortization 1,512,151 837,168 582,939 Deferred revenue from Chiron collaboration - (1,000,000) 1,000,000 Amortization of deferred compensation 52,488 47,990 - Deferred rent 989,676 275,602 7,173 Deferred revenue 54,839 - - Issuance of note payable in exchange for acquired technology - - 231,938 Forgiveness of employee notes receivable 39,283 56,333 128,508 Changes in operating assets and liabilities: Accounts receivable from Chiron collaboration (214,580) (156,123) (243,877) Other current assets (632,753) (494,873) 22,662 Deposits and other assets (196,931) (115,614) (162,064) Accounts payable and other accrued liabilities 125,495 1,376,791 592,537 ------------ ------------ ------------ Net cash used by operating activities (15,045,937) (7,193,273) (6,401,671) INVESTING ACTIVITIES Purchases of short-term investments (17,244,027) (38,410,705) (12,228,388) Proceeds from sale or maturities of short-term investments 33,573,121 11,171,032 6,896,610 Purchases of property and equipment (6,395,815) (1,419,044) (1,362,231) Restricted cash 131,837 16,740 166,651 ------------ ------------ ------------ Net cash provided (used) by investing activities 10,065,116 (28,641,977) (6,527,358) FINANCING ACTIVITIES Repayment of capital lease obligations (1,803,637) (831,262) (300,842) Proceeds from notes payable 2,203,294 - - Proceeds from issuance of common stock, net 663,879 38,163,652 69,395 Proceeds from issuances of convertible preferred stock, net - - 10,678,720 Repayment of facilities payable - (237,569) (413,000) Proceeds from bank borrowing - 4,000,000 - Repayment of bank borrowing - (4,000,000) - ------------ ------------ ------------ Net cash provided by financing activities 1,063,536 37,094,821 10,034,273 ------------ ------------ ------------ Net (decrease) increase in cash and cash equivalents (3,917,285) 1,259,571 (2,894,756) Cash and cash equivalents at the beginning of year 5,883,911 4,624,340 7,519,096 ------------ ------------ ------------ Cash and cash equivalents at the end of year 1,966,626 5,883,911 4,624,340 Short-term investments at the end of year 16,231,471 32,777,623 5,358,706 ------------ ------------ ------------ Cash, cash equivalents and short-term investments at the end of year $ 18,198,097 $ 38,661,534 $ 9,983,046 ============ ============ ============ SUPPLEMENTAL INFORMATION Property and equipment acquired through capital leases and loans $ 3,337,461 $ 3,677,018 $ 1,661,036 ============ ============ ============ Facilities payable recorded for leasehold improvements $ - $ - $ 237,569 ============ ============ ============ Issuance of common stock in exchange for note payable $ - $ 231,938 $ - ============ ============ ============ Interest paid $ 787,409 $ 404,790 $ 122,915 ============ ============ ============ See accompanying notes. 18 8 STATEMENTS OF SHAREHOLDERS' EQUITY DepoTech Corporation Deferred Convertible Notes Compensation Unrealized Preferred Stock Common Stock Receivable Related Gain Total ------------------- ------------------------- from to Stock (Loss) on Accumulated Shareholders' Shares Amount Shares Amount Shareholders Options Investments Deficit Equity ------------------------------------------------------------------------------------------------------------ Balance at January 1, 1994 4,379,101 $14,008,505 1,309,111 $13,091 $(9,600) $- $ - $ (5,309,475) $ 8,702,521 Issuance of common stock - - 222,152 69,395 - - - - 69,395 Issuance of convertible preferred stock 1,603,890 10,656,296 - - - - - - 10,656,296 Accretion on convertible preferred stock - 1,896,029 - - - - - (1,896,029) - Forgiveness of notes receivable from shareholders - - - - 9,600 - - - 9,600 Unrealized gain on investments - - - - - - 26,928 - 26,928 Net loss - - - - - - - (8,561,487) (8,561,487) --------- ----------- --------- ------- ------ -- -------- ------------ ----------- Balance at December 31, 1994 5,982,991 26,560,830 1,531,263 82,486 - - 26,928 (15,766,991) 10,903,253 Issuance of common stock - - 78,908 36,306 - - - - 36,306 Exercise of warrants - - 242,468 308,654 - - - - 308,654 Deferred compensation related to issuance of stock options - - - 262,438 - (262,438) - - - Amortization of deferred compensation - - - - - 47,990 - - 47,990 Accretion on convertible preferred stock - 1,832,394 - - - - - (1,832,394) - Unrealized gain on investments - - - - - - 179,244 - 179,244 Issuance of common stock upon initial public offering, net - - 3,450,000 38,050,630 - - - - 38,050,630 Conversion of convertible preferred stock upon initial public offering (5,982,991) (28,393,224) 5,982,991 28,393,224 - - - - - Net loss - - - - - - - (8,020,547) (8,020,547) --------- ----------- --------- ------- ------ -- -------- ------------ ----------- Balance at December 31, 1995 - - 11,285,630 67,133,738 - (214,448) 206,172 (25,619,932) 41,505,530 Issuance of common stock - - 258,186 663,879 - - - - 663,879 Amortization of deferred compensation - - - - - 52,488 - - 52,488 Unrealized loss on investments - - - - - - (217,058) - (217,058) Net loss - - - - - - - (16,775,605) (16,775,605) --------- ----------- --------- ------- ------ -- -------- ------------ ----------- Balance at December 31, 1996 - $ - 11,543,816 $67,797,617 $ - $(161,960) $(10,886) $(42,395,537) $25,229,234 ========= =========== ========== =========== ====== ========= ======== ============ =========== See accompanying notes. 19 9 NOTES TO FINANCIAL STATEMENTS DepoTech Corporation December 31, 1996 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES o Organization and Business Activities DepoTech Corporation (the "Company") was incorporated in California on October 30, 1989. The Company is a drug delivery company engaged in the development and manufacture of sustained-release therapeutic products based on DepoFoam, an injectable, depot drug delivery technology. o Cash, Cash Equivalents and Short-Term Investments The Company invests its excess cash in deposit accounts, money market accounts, commercial paper and U.S. Government securities. The Company has established guidelines relative to diversification and maturities that maintain safety and an adequate level of liquidity. These guidelines are periodically reviewed and modified to take advantage of trends in yields and interest rates. The Company considers all highly liquid investments with a maturity of three months or less from the date of purchase that are readily convertible into cash to be cash equivalents. Short-term investments are classified as available-for-sale, and are carried at market value, in accordance with Financial Accounting Standards Board Statement No. 115, "Accounting for Certain Investments in Debt and Equity Securities." The unrealized gain or loss on such investments is reported as a separate component of shareholders' equity. o Property and Equipment Property and equipment consist primarily of manufacturing, laboratory and office equipment and leasehold improvements and are stated at cost. Property and equipment under capital leases are recorded at the present value of the minimum lease payments. Depreciation and amortization are calculated using the straight-line method over the shorter of the estimated useful life of the assets (ranging from three to fifteen years) or the lease term. o Restricted Cash Restricted cash consists of certificates of deposit maintained as collateral for letters of credit securing certain lease agreements. o Patent Costs Deposits and other assets consist primarily of patent and trademark filing costs totaling approximately $453,000 and $299,000 at December 31, 1996 and 1995, respectively, which are amortized over the estimated economic life of the patents or trademarks. o Deferred Rent Rent expense is recognized on a straight-line basis over the term of the lease. Accordingly, rent expense incurred in excess of rent paid is accrued and recorded as deferred rent in the accompanying balance sheets. o Contract Revenues and Expenses Contract revenue is recorded as earned based on the performance requirements of the contract. Research and development costs are expensed as incurred. o Accounting Standard on Impairment of Long-Lived Assets Effective January 1, 1996, the Company adopted Statement of Financial Accounting Standards No. 121 "Accounting for Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of" ("FAS 121"), regarding the impairment of long-lived assets, identifiable intangibles and goodwill related to those assets. The adoption of FAS 121 had no effect on the accompanying financial statements. o Use of Estimates in the Preparation of Financial Statements 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. 20 10 o Net Loss Per Share For periods subsequent to the completion of the Company's initial public offering ("IPO") in October 1995, net loss per share is computed using the weighted average number of common shares outstanding. Common share equivalents have not been included in computing net loss per share since the effect would be antidilutive. Prior to the IPO, net loss per share is computed using the weighted average number of common shares outstanding during the period. Pursuant to the requirements of the Securities and Exchange Commission ("SEC"), common stock issued by the Company during the twelve months immediately preceding the IPO, plus the number of common equivalent shares which were granted or issued during the same period pursuant to the grant or issuance of stock options and warrants, have been included in the calculation of the shares used in computing net loss per share as if these shares were outstanding for all periods presented using the treasury stock method. In addition, pursuant to SEC policy, the calculation of the shares used in computing net loss per share also includes convertible preferred shares which converted into common shares immediately prior to the closing of the IPO as if they were converted into common shares as of the original dates of issuance. o Reclassifications Certain prior year amounts have been reclassified to conform with the current year presentation. NOTE 2 - CHIRON COLLABORATION In March 1994, the Company entered into a collaboration agreement ("the Collaboration Agreement") with Chiron Corporation ("Chiron") to develop and commercialize sustained release formulations of selected generic products and certain Chiron proprietary products using the Company's drug delivery technology. Under the agreement, Chiron purchased 400,000 shares of the Company's Series C preferred stock for $6.25 per share, for an aggregate consideration of $2.5 million, and a warrant to purchase 365,000 shares of Series C preferred stock at an exercise price of $6.25 per share for $1 million. The warrant was terminated and converted into a marketing rights fee to the Company upon the achievement of a development milestone in January 1995. The Collaboration Agreement grants Chiron rights to market and sell the Company's initial product, DepoCyt(TM), in the United States, Canada and Europe (the "Territory"). Phase III clinical trial costs of DepoCyt incurred subsequent to June 1993 will be shared equally by Chiron and the Company. Any additional clinical trials required in Europe will be funded entirely by Chiron. Canadian registration expenses will be funded by Chiron. The Company will manufacture DepoCyt in the Territory, Chiron will market, sell and distribute the product in the Territory, and the parties will share all profits equally. Chiron will make additional payments to the Company upon achievement of certain milestones in the development of DepoCyt. Chiron also has a right of first refusal to obtain a license to alternate DepoFoam formulations of cytarabine under terms and conditions to be negotiated in the future. Reimbursable clinical and manufacturing scale-up costs for DepoCyt incurred by the Company totaled $3,194,312, $2,541,847 and $1,790,460 for the years ended December 31, 1996, 1995 and 1994, respectively. The cumulative amount due through December 31, 1994 became billable and was recognized as contract revenue upon the achievement of a development milestone in January 1995. The Collaboration Agreement also provides for the joint development of DepoFoam formulations of certain compounds proprietary to Chiron ("Chiron Products"). Chiron must fund one feasibility program for a Chiron Product per year or lose its option to develop DepoFoam formulations of additional Chiron proprietary compounds. Through 1996, the Company has completed feasibility studies on two Chiron proprietary proteins, one of which has been selected for further preclinical development. A third feasibility study is on-going. The agreement provides that Chiron will pay the Company for its feasibility efforts, and that Chiron will be responsible for all development costs thereafter. The agreement also provides for Chiron to make payments to the Company upon achievement of certain development milestones for the Chiron Products. Chiron will have exclusive, worldwide distribution rights to all Chiron Products and will manufacture the bulk unencapsulated drug. The Company will then encapsulate the bulk drug in DepoFoam creating the Chiron Products, and Chiron will market, sell and distribute the Chiron Products. Chiron will compensate the Company based on its manufacturing costs, including a manufacturing profit, and a percentage of Chiron's net sales of the Chiron Products. Both the Company and Chiron have the ability to terminate a portion or all of the collaboration at certain intervals and with advance notice. In addition, Chiron has the ability to terminate the development of a Chiron Product with a limited amount of advance notice. 21 11 NOTE 3 - SHORT-TERM INVESTMENTS The following is a summary of available-for-sale short-term investments: Gross Gross DECEMBER 31, 1996 Cost Unrealized Gains Unrealized Losses Estimated Fair Value U.S. government securities $12,208,677 $ - $ (13,986) $ 12,194,691 Certificates of deposit 498,940 1,020 - 499,960 Corporate obligations 3,534,740 2,080 - 3,536,820 ----------- --------- --------- ------------ $16,242,357 $ 3,100 $ (13,986) $ 16,231,471 ----------- --------- --------- ------------ DECEMBER 31, 1995 U.S. government securities $32,072,511 $ 205,047 $ - $ 32,277,558 Certificates of deposit 498,940 1,125 - 500,065 ----------- --------- --------- ------------ $32,571,451 $ 206,172 $ - $ 32,777,623 =========== ========= ========== ============= The amortized cost and estimated fair value of short-term investments at December 31, 1996, by contractual maturity, are shown below: Cost Estimated Fair Value Due in one year or less $ 8,879,965 $ 8,882,591 Due after one year through three years 7,362,392 7,348,880 ----------- ----------- $16,242,357 $16,231,471 =========== =========== NOTE 4 - PROPERTY AND EQUIPMENT Property and equipment consist of the following: December 31, 1996 1995 Manufacturing, laboratory and office equipment $12,254,274 $ 7,184,905 Leasehold improvements 2,041,001 1,989,257 Leasehold improvements and manufacturing equipment under construction 5,552,015 939,853 ----------- ------------ 19,847,290 10,114,015 Less accumulated depreciation and amortization (2,995,716) (1,503,037) ----------- ------------ $16,851,574 $ 8,610,978 =========== ============ NOTE 5 - TECHNOLOGY ASSIGNMENT In 1994, in connection with an assignment agreement under which the Company was assigned exclusive rights to certain intellectual property, the Company issued 108,029 shares of common stock and a warrant to purchase 154,327 shares of preferred stock at $2.00 per share. The Company also issued a non-interest bearing note payable in the amount of $231,938, which was expensed as acquired in-process research and development. Upon the completion of the IPO, the warrant was exercised and the note and cash were exchanged for common stock. Royalties or a percentage of royalties will be paid to the assignor on net revenues in connection with the sale of products incorporating the acquired intellectual property or received by the Company from licensees. 22 12 The assignor has the right to terminate the agreement or to convert the exclusive nature of the rights granted under the agreement into a nonexclusive license in the event that the Company does not make certain minimum annual payments or upon certain other events. NOTE 6 - COMMITMENTS o Lease Obligations The Company leases its facilities and certain equipment under operating and capital leases. Provisions of the facilities leases provide for abatement of rent during certain periods and escalating rent payments during the lease terms which extend through August 1, 2015. Included in restricted cash and deposits and other assets are $300,709 and $449,107 related to these agreements at December 31, 1996 and 1995, respectively. Annual future minimum lease payments as of December 31, 1996 are as follows: Operating Leases Capital Leases 1997 $3,128,085 $ 2,661,423 1998 3,228,701 2,409,226 1999 3,312,314 1,628,090 2000 3,432,296 631,866 2001 3,560,700 - Thereafter 52,360,160 - ---------- ----------- Total $69,022,256 7,330,605 ========== Less amount representing interest (1,160,277) ----------- Present value of net minimum payments 6,170,328 Less current portion (2,040,578) ----------- Amounts due after one year $ 4,129,750 =========== The Company subleased certain of its existing laboratory and administrative facilities. Rental income from the sublease agreement over the next four years will range from $223,000 to $290,000 per year. Assets acquired under capital leases consist of manufacturing, laboratory and office equipment, and leasehold improvements with an aggregate cost of approximately $9.1 million and $5.8 million at December 31, 1996 and 1995, respectively. Accumulated amortization of assets acquired under these arrangements is included in total depreciation and amortization. Rent expense was approximately $3,895,000, $1,467,000 and $583,000 during the years ended December 31, 1996, 1995 and 1994, respectively. o Note Payable During June 1996, the Company established a credit line with a bank for borrowing up to $9 million to finance certain capital equipment expenditures. Borrowing under the credit line bears interest at a floating rate equal to prime plus .5% (8.75% at December 31, 1996) on the outstanding balance. The credit line expires on June 30, 2001 and all borrowings are secured by the capital equipment financed. At December 31, 1996, approximately $6,797,000 remains available for future equipment acquisitions. Annual future minimum payments as of December 31, 1996 are as follows: 1997 $ 650,074 1998 650,074 1999 650,075 2000 650,075 ---------- Total 2,600,298 Less amount representing interest (397,004) ---------- Present value of net minimum payments 2,203,294 Less current portion (493,481) ---------- Amounts due after one year $1,709,813 ========== 23 13 NOTE 7 - SHAREHOLDERS' EQUITY o Stock Purchase Warrants In connection with various stock purchase or lease financing transactions, the Company has issued warrants to purchase 42,354, 22,400 and 503,287 shares of common stock at prices of $2.75, $6.25 and $7.00 per share, respectively. The warrants are generally exercisable through 2001, and these warrants remain outstanding at December 31, 1996. o Deferred Compensation Pursuant to certain provisions of the SEC regulations, the Company recorded and is amortizing over the related vesting periods deferred compensation representing the difference between the exercise price of stock options granted and the deemed fair value (for accounting purposes) of the Company's common stock at the date of grant. Stock options generally vest over four to five years. Shares included in the computation of deferred compensation include option grants to employees and officers of the Company from July 1994 through June 1995. o Stock Option Plans The Company has elected to follow Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25") and related interpretations in accounting for its employee stock options because, as discussed below, the alternative fair value accounting provided for under FASB Statement No. 123, "Accounting for Stock-Based Compensation" ("FAS 123"), requires use of option valuation models that were not developed for use in valuing employee stock options. Under APB 25, because the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized. The Company's 1995 Stock Option/Stock Issuance Plan has authorized the grant of options to employees, directors and consultants of the Company for up to 2,000,000 shares of the Company's common stock. No options granted under the Plan have a term in excess of ten years. Pro forma information regarding net income and earnings per share is required by FAS 123, and has been determined as if the Company has accounted for its employee stock options under the fair value method of that Statement. The fair value of these options was estimated at the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions for 1995 and 1996, respectively: risk-free interest rates of 6.5% and 6.1%; dividend yields of 0%; volatility factors of the expected market price of the Company's common stock of 73% and 58%; and a weighted-average life of the option of 4 years. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. The Company's pro forma net loss for the years ended December 31, 1996 and 1995 reflect increases of approximately $307,000 and $55,000, respectively. The pro forma net loss per share for the years ended December 31, 1996 and 1995 are ($1.49) and ($0.93) per share, respectively. The results above are not likely to be representative of the effects of applying FAS 123 on reported net income or loss for future years as these amounts reflect the expense for only one or two years vesting. 24 14 A summary of the Company's stock option activity, and related information for the years ended December 31, are as follows: 1996 1995 1994 Weighted Weighted Weighted Average Average Average Options Exercise Price Options Exercise Price Options Exercise Price Outstanding-beginning of year 1,102,439 $ 2.02 917,314 $ .68 758,850 $ .31 Granted 467,744 19.77 258,300 6.54 389,650 1.32 Exercised (209,848) .68 (48,908) .75 (222,152) .31 Forfeited (64,472) 14.46 (24,267) 1.84 (9,034) .71 ----------------------- ----------------------- -------------------- Outstanding-end of year 1,295,863 $ 8.03 1,102,439 $2.02 917,314 $ .68 ======================= ======================= ==================== Exercisable at end of year 547,407 415,790 230,425 Weighted average fair value of options granted during the year $ 9.69 $2.50 A summary of the Company's stock options outstanding at December 31, 1996 is as follows: Options Outstanding Options Exercisable Weighted Average Range of Number Remaining Weighted Average Number Weighted Average Exercise Prices Outstanding Contractual Life Exercise Price Exercisable Exercise Price $ 0.10 to $ 4.00 749,017 6.9 years $ 1.13 463,960 $ 0.81 $ 7.00 to $12.00 84,633 8.6 years $ 8.30 27,718 $ 9.01 $15.25 to $19.625 394,963 9.5 years $18.30 47,389 $18.64 $23.50 to $25.125 67,250 9.3 years $24.32 8,340 $23.52 The weighted-average remaining contractual life of those options is 7.9 years. At December 31, 1996, options for 222,147 shares were available for future grant. o Employee Stock Purchase Plan In October 1995, the Company adopted an Employee Stock Purchase Plan ("the ESPP") whereby employees, at their option, can purchase shares of Company common stock through payroll deductions at the lower of 85% of fair market value on the ESPP offering date or on certain other predetermined exercise dates. The Company has reserved 250,000 shares of common stock for issuance under the ESPP, of which 48,338 shares have been issued as of December 31, 1996. 25 15 NOTE 8 - INCOME TAXES At December 31, 1996, the Company has federal and California tax net operating loss carryforwards of approximately $39,874,000 and $7,667,000, respectively. The difference between the federal and California tax loss carryforwards is primarily attributable to the capitalization of research and development expenses for California franchise tax purposes and the fifty-percent limitation on California loss carryforwards. The federal and California tax loss carryforwards will begin expiring in 2005 and 1997, respectively, unless previously utilized. The Company also has federal and California research and development tax credit carryforwards totaling $1,086,000 and $557,000, respectively, which will being expiring in 2005 unless previously utilized. Pursuant to Internal Revenue Code Sections 382 and 383, annual use of the Company's net operating loss and credit carryforwards may be limited if a cumulative change in ownership of more than 50% occurs within any three year period. Significant components of the Company's deferred tax assets and liabilities are shown below. A valuation allowance of $17,622,000, of which $7,722,000 is related to 1996, has been recognized to offset the deferred tax assets as realization of such assets is uncertain. December 31, 1996 1995 Deferred tax assets: Net operating loss carryforwards $ 14,416,000 $ 8,192,000 Research and development credit carryforwards 1,448,000 912,000 Capitalized research expenses 1,713,000 826,000 Other, net 558,000 272,000 ------------ ----------- Net deferred tax assets 18,135,000 10,202,000 Valuation allowance for deferred tax assets (17,622,000) (9,900,000) ------------ ----------- Total deferred tax assets 513,000 302,000 Deferred tax liabilities: Depreciation (513,000) (302,000) ------------ ----------- Net deferred tax assets $ - $ - ============= =========== Approximately $974,000 of the valuation allowance for deferred tax assets relates to stock option deductions which, when recognized, will be allocated directly to common stock. NOTE 9 - SUBSEQUENT EVENT On January 3, 1997, the Company completed the private placement of 1,500,000 newly issued shares of common stock at $13.50 per share raising net proceeds totaling $19.1 million. 26 16 REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS The Board of Directors and Shareholders DepoTech Corporation We have audited the accompanying balance sheets of DepoTech Corporation as of December 31, 1996 and 1995, and the related statements of operations, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1996. 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 in accordance with generally accepted auditing standards. Those standards 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. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of DepoTech Corporation at December 31, 1996 and 1995, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1996, in conformity with generally accepted accounting principles. /s/ ERNST & YOUNG LLP San Diego, California January 29, 1997 27 17 CORPORATE INFORMATION DepoTech Corporation BOARD OF DIRECTORS o Chairman of the Board Fred A. Middleton General Partner Sanderling Ventures o Directors Roger C. Davisson General Partner Brentwood Associates Jean Deleage Managing Partner Burr, Egan, Deleage & Co. George W. Dunbar, Jr. President and Chief Executive Officer Metra Biosystems, Inc. Edward L. Erickson President and Chief Executive Officer DepoTech Corporation Stephen B. Howell, M.D. Professor of Medicine University of California San Diego Peter Preuss President Preuss Foundation Pieter J. Strijkert, Ph.D. Chairman IntroGene BV OFFICERS Edward L. Erickson President and Chief Executive Officer John P. Longenecker, Ph.D. Senior Vice President Research, Development and Operations David B. Thomas Senior Vice President Quality Assurance and Regulatory Affairs Williams S. Ettouati, D.Pharm Vice President, Marketing and Business Development Sinil Kim, M.D. Vice President, Advanced Technology Chief Scientific Officer and Director Emeritus Linda J. Paradiso, D.V.M. Vice President, Clinical Development Sheldon A. Schaffer, Ph.D. Vice President, Pharmaceutical Development Dana S. McGowan, C.P.A. Senior Director, Finance and Administration Chief Financial Officer, Treasurer and Assistant Secretary Faye H. Russell, Esq. Secretary OTHER MANAGEMENT Thomas E. Swedberg Senior Director, Human Resources CORPORATE INFORMATION o Corporate Headquarters 10450 Science Center Drive San Diego, California 92121 (619) 625-2424 o Shareholder Inquiries General information regarding the Company can be obtained by contacting Investor Relations at DepoTech. Inquiries relating to lost certificates should be directed to the Transfer Agent. o SEC Form 10-K A copy of the Company's annual report to the Securities and Exchange Commission on Form 10-K is available without charge by contacting Investor Relations at DepoTech Corporation. o Transfer Agent And Registrar Chase Mellon Shareholder Services 400 South Hope Street, 4th Floor Los Angeles, California 90071 (800) 522-6645 o Independent Auditors Ernst & Young LLP San Diego, California o Corporate Counsel Brobeck Phleger & Harrison LLP San Diego, California o Annual Meeting Of Shareholders The annual meeting of shareholders will be held at 9:00 AM on Wednesday, May 14, 1997, at DepoTech Corporation. o Price Range Of Common Stock The Company's Common Stock began trading on September 29, 1995 and is listed on the Nasdaq National Market under the symbol DEPO. High and low sales prices are set forth below for the periods indicated: High Low 1995 - ------------------------------------------------------------- 3rd Quarter $14.00 $12.75 4th Quarter $21.75 $12.50 1996 - ------------------------------------------------------------- 1st Quarter $25.50 $18.00 2nd Quarter $29.50 $22.50 3rd Quarter $25.50 $14.50 4th Quarter $17.00 $12.75 At March 20, 1997, there were approximately 1700 beneficial shareholders of record. The Company has never declared or paid dividends on its Common Stock. 18 High Low 1995 3rd Quarter $14.00 $12.75 4th Quarter $21.75 $12.50 1996 1st Quarter $25.50 $18.00 2nd Quarter $29.50 $22.50 3rd Quarter $25.50 $14.50 4th Quarter $17.00 $12.25 28