EXHIBIT 13.1
GALAGEN INC.
INDEX TO FINANCIAL INFORMATION
1998
PAGE
----
Management's Discussion and Analysis of Financial Condition and Results of Operations.............................. 1
Quantitative and Qualitative Disclosures About Market Risk......................................................... 5
Balance Sheets..................................................................................................... 6
Statements of Operations........................................................................................... 7
Statement of Changes in Stockholders' Equity....................................................................... 8
Statements of Cash Flows........................................................................................... 10
Notes to Financial Statements...................................................................................... 11
Report of Independent Auditors..................................................................................... 23
Selected Financial Data............................................................................................ 24
Market for Registrant's Common Equity and Related Stockholder Matters.............................................. 26
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
FORWARD-LOOKING STATEMENTS
The information presented in this Annual Report to Stockholders for the
year ended December 31, 1998 (the "Annual Report") contains forward-looking
statements within the meaning of the safe harbor provisions of Section 21E of
the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Such
statements are subject to risks and uncertainties, including those discussed
below under "Disclosure Regarding Forward-Looking Statements" and in the
Company's Annual Report on Form 10-K for the year ended December 31, 1998
("Form 10-K") under "Risk Factors", that could cause actual results to differ
materially from those projected. Because actual results may differ, readers
are cautioned not to place undue reliance on these forward-looking statements.
GENERAL
GalaGen's mission is to become the leading presence in foods, beverages
and dietary supplements that help enhance the immune system. To accomplish
this mission, the Company is focusing its efforts on channels that demand
immune-enhancing benefits in certain segments of the consumer food and
beverage products market and in certain segments of the clinical nutrition
products markets. A critical factor for success of the Company is its
immune-enhancing ingredient which is derived from colostrum, the highly
nutritious first milk from a dairy cow after its calf is born, which has been
branded Proventra-TM-Brand Natural Immune Components ("Proventra"). The
primary immune-enhancing components of Proventra are antibodies, which are
proteins that enhance the body's immune system to protect against harmful
pathogens. Secondary immune-enhancing components of Proventra providing
further disease resistance are proteins, such as lactoferrin, as well as
multiple vitamins and minerals. The Company, in conjunction with strategic
partners, continues to expand applications for its technology and is
developing a portfolio of Proventra-based products that target the needs
of consumers and the healthcare market.
In December 1998, the Company acquired a developed line of critical
care enteral nutrition products and formulas from Nutrition Medical, Inc.
("NMI"). These products are being sold to the hospital and home healthcare
industries. The Company is researching ways in which to incorporate certain
of its immune-enhancing ingredients into selected products acquired from NMI
to provide additional proprietary protection and added benefits that are not
currently available in that market segment.
RESULTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
GENERAL. The net loss applicable to common stockholders decreased by
$1,114,905, or 19.8%, in 1998 to $4,520,229 from $5,635,134 in 1997 and
decreased $9,148,457, or 61.9%, in 1997 from $14,783,591 in 1996. The
decrease in 1998 was primarily due to increased revenue from the Company's
critical care product line acquired from NMI, increased product development
revenue related to a license agreement with Wyeth-Ayerst, decreased product
development costs due to the discontinuation of the pharmaceutical program
and decreased product development expense due to the receipt of a fee
received from the re-licensing of previously licensed technology offset by
increased selling, marketing and general and administrative expense in
support of the consumer and clinical nutrition product development programs
described above. The decrease in 1997 was due primarily to the non-cash
charge to earnings in April 1996 of $7,296,844 for a preferred stock
dividend, as described below, relating to the value of additional shares
issued to holders of certain preferred stock upon conversion into Common
Stock at the closing of the Company's initial public offering (the
"Offering"), which occurred in April 1996.
1
REVENUES. In 1998 revenues of $876,079 consisted of approximately
$584,000 in sales of the Company's critical care nutrition products,
approximately $32,000 in sales of the Company's Proventra product and
approximately $260,000 of product development revenue relating to a license
and research collaboration agreement with Wyeth-Ayerst (see also Note 6 of
Notes to the Financial Statements).
COST OF GOODS SOLD. For 1998 the cost of goods sold was $244,141, which
consisted of approximately $228,000 from the critical care nutrition product
sales and approximately $16,000 related to the Proventra product sales.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses increased $694,519, or 45.1%, in 1998 to $2,235,362
from $1,540,843 in 1997 and increased $60,347, or 4.1%, in 1997 from
$1,480,496 in 1996. The increase in 1998 is due to increased sales,
marketing and personnel expense for the Company's consumer and critical care
nutrition products of approximately $739,000 and increased shareholder
relations expense of approximately $42,000 offset by decreased insurance
costs of approximately $40,000, decreased financing expenses of approximately
$24,000, and decreased legal expenses of approximately $22,000 . The
increase in 1997 is due primarily to increased public reporting and
shareholder relations expense of approximately $75,000 and increased
insurance costs of approximately $68,000 offset by decreased outside
consulting expense of approximately $83,000.
PRODUCT DEVELOPMENT EXPENSES. Expenses for product development
decreased $1,845,791, or 49.1%, in 1998 to $1,914,295 from $3,760,086 in 1997
and decreased $1,497,534, or 28.5%, in 1997 from $5,257,620 in 1996.
Approximately $852,000 of the decrease in 1998 was due to the decreased
development expenses related to the terminated pharmaceutical programs,
approximately $684,000 of the decrease was due to decreased associated
personnel and consulting expense, approximately $250,000 of the decrease was
related to the fee received from the re-licensing of previously licensed
technology, which was offset against product development expense, and
approximately $60,000 of the decrease was from decreases in other program
expenses. The decrease in 1997 was due primarily to decreased expenses
associated with the pharmaceutical program of approximately $1,680,000 and
decreased personnel and administration expenses of approximately $280,000
offset primarily by increased manufacturing facility expenses of
approximately $262,000 and increased nutritional product development expense
of approximately $200,000.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization increased
$166,585, or 27.7%, in 1998 to $767,474 from $600,889 and increased $192,026,
or 47.0%, in 1997 from $408,863 in 1996. The increase in 1998 was due
primarily to increased amortization of warrants issued for services of
approximately $168,000 and increased deferred expense amortization of
approximately $113,000 offset by decreased deferred compensation amortization
of approximately $88,000 and decreased depreciation expense of approximately
$26,000. In 1997 the increase was due to increased depreciation expense of
approximately $196,000, which was primarily depreciation on the Company's
completed manufacturing facility, and increased warrant amortization of
approximately $62,000 offset by decreased deferred compensation amortization
of approximately $66,000.
INTEREST INCOME. Interest income for 1998 decreased $110,315, or
24.6%, to $338,007 from $448,322 in 1997 and decreased $157,226, or 26.0%,
from $605,548 in 1996. The decreases were primarily attributable to the
decreased levels of investable funds.
INTEREST EXPENSE. Interest expense increased $391,405, or 215.5%, in
1998 to $573,043 from $181,638 in 1997 and decreased $763,678, or 80.8%, from
$945,316 in 1996. In 1998 approximately $465,000 of the interest expense was
the amortization of the value of warrants plus the value of the discount in
connection with the convertible debentures the Company issued in November
1997 (see Note 8 in Notes to the Financial Statements) and approximately
$108,000 was line of credit interest expense (see Note 7 in Notes to the
Financial Statements). Interest expense for 1997 consisted primarily of line
of credit interest expense of approximately $92,000 and amortization of the
value of warrants plus the value of the discount in connection with
convertible debentures of approximately $82,000. Interest expense for 1996
was due primarily to warrants valued at $768,064 which were issued to
guarantors of a line of credit for the Company and to
2
purchasers of the Company's promissory notes and to interest over a period of
approximately three months on the convertible promissory notes (the
"Convertible Promissory Notes") issued by the Company. The Convertible
Promissory Notes converted into Common Stock upon the closing of the Offering.
PREFERRED STOCK DIVIDEND. The non-cash preferred stock dividend of
$7,296,844 in 1996 related to the value of additional Common Stock received
by the holders of Convertible Promissory Notes, Series E and Series F-1
Preferred Stock upon the conversion of such securities into Common Stock at
the closing of the Offering (the Convertible Promissory Notes converting
first into Series D Preferred Stock which in turn converted immediately into
Common Stock at the closing). The Convertible Promissory Notes and the
Series D, Series E and Series F-1 Preferred Stock provided that their
conversion prices be automatically adjusted to reflect the lower of their
currently effective conversion price or 70% of the Offering price.
LIQUIDITY AND CAPITAL RESOURCES; CASH FLOW ANALYSIS
The Company was incorporated in March 1992. On July 24, 1992, Procor,
the Company's predecessor, was merged with and into the Company (the
"Procor-GalaGen Merger"). At the time of the Procor-GalaGen Merger, Procor
was a wholly-owned subsidiary of Land O'Lakes. Since the Company's inception
through December 31, 1998, investments in the Company have totaled
approximately $53.4 million, including approximately $7.1 million of
inter-company obligations payable to Land O'Lakes which were forgiven and
recorded as contributed capital at the time of the Procor-GalaGen Merger,
$17.9 million from the Offering (after deducting underwriting discounts and
offering expenses) and approximately $28.4 million from private placements of
equity and convertible debt and from conversion of accrued interest on such
debt and the exercise of stock options and warrants. The Company has invested
funds received in the Offering and private placements in investment-grade,
interest-bearing obligations.
Cash used in operating activities decreased by $2,511,294, or 41.5%, in
1998 to $3,540,854 from $6,052,148 and decreased $83,664, or 1.4%, in 1997
from $6,135,812 in 1996. Cash used in operations went primarily to fund
operating losses and was offset slightly by changes in operating assets and
liabilities.
The Company redeemed $7,511,619 of available-for-sale securities in
1998 and invested $13,276 in 1997 and $7,498,343 in 1996 in
available-for-sale securities. The Company invested $39,365 in 1998,
$215,320 in 1997 and $1,264,342 in 1996 in equipment and tenant improvements
related to the Company's manufacturing facility, the majority of which is
leased (see Note 7 of Notes to the Financial Statements). The Company
invested $50,475 in 1998, $63,685 in 1997 and $193,012 in 1996 in lab
equipment, computer equipment and software and furniture used primarily to
support the Company's operations. In 1998 the Company invested $141,363 in
fixed assets and inventory received relating to the asset purchase agreement
with NMI (see Note 5 in Notes to the Financial Statements).
The Company converted it's previously established note payable, which
was secured by certain fixed assets, into an operating lease in accordance
with FAS 13 in June 1998 which calls for future minimum monthly payments of
approximately $34,000 through May 2001 with a final payment of $165,000 in
June 2001. The Company's seven-year operating lease for manufacturing
equipment requires annual payments of approximately $131,000 through 2003.
Additionally, the Company's five-year lease agreement with Land O' Lakes for
specified manufacturing space requires future annual payments of
approximately $87,000 through June 2001 (see Note 10 in Notes to the
Financial Statements).
3
The Company anticipates that its existing resources and interest thereon
will be sufficient to satisfy its anticipated cash requirements through
approximately the first quarter of 2000. The Company's working capital and
capital requirements will depend upon numerous factors, including the
progress of the Company's market research, product development and ability to
obtain partners with the appropriate manufacturing, sales, distribution and
marketing capabilities. The Company's capital requirements also will depend
on the levels of resources devoted to the development of manufacturing
capabilities, technological advances, the status of competitive products and
the ability of the Company to establish partners or strategic alliances to
provide funding to the Company for certain manufacturing, sales, product
development and marketing activities.
The Company expects to incur substantial additional marketing expense
and product development expense. Capital expenditures may be necessary to
establish additional commercial scale manufacturing facilities. The Company
will need to raise substantial additional funds for longer-term product
development, manufacturing and marketing activities that may be required in
the future. The Company's ability to continue funding its planned operations
beyond the first quarter of 2000 is dependent upon its ability to generate
product revenues or to obtain additional funds through equity or debt
financing, strategic alliances, license agreements or from other financing
sources. A lack of adequate revenues or funding could eventually result in
the insolvency or bankruptcy of the Company. At a minimum, if adequate funds
are not available, the Company may be required to delay or to eliminate
expenditures for certain of its product development efforts or to license to
third parties the rights to commercialize products or technologies that we
would otherwise seek to develop itself. Because of the Company's significant
long-term capital requirements, it may seek to raise funds when conditions
are favorable, even if the Company does not have an immediate need for such
additional capital at such time. If the Company has not raised funds prior
to when its needs for funding become immediate, the Company may be forced to
raise funds when conditions are unfavorable, which could result in
significant dilution for current stockholders.
YEAR 2000 ISSUES
The Company began the process of assessing its risks associated with
Year 2000 date conversion in 1998. This assessment included three main areas:
- the business hardware and software applications, mainly certain
accounting applications and office network, the Company's
Information Technology ("IT"),
- manufacturing facilities and
- external third party business partners or suppliers.
Prior to the asset acquisition of NMI's critical care nutrition
products, the Company completed its assessment and concluded that the Year
2000 risk was focused mainly in the area of its business computer hardware
and computer software applications. Subsequent to the NMI asset purchase, the
Company has undertaken a reassessment and has determined that the risk
associated with non-compliant external business partners and suppliers has
significantly increased. The assessment has been completed for the IT and
manufacturing facilities and will be completed for the third party partners
and suppliers in mid 1999.
The Company has addressed these issues by:
- authorizing the installation of new network server hardware and
software, specifically for its accounting applications and office
network. This remediation process has begun and is anticipated to be
completed in early 1999 with total costs of approximately $60,000, of
which approximately $48,000 has been expensed in 1998. The Company
has contracted this work to outside parties. The manufacturers of the
hardware and software have stated that these products are Year 2000
compliant. In planning for the worst case scenarios, the Company has
addressed this issue in its plan. The Company believes that its
hardware and software systems for its business will be operational for
Year 2000, but it may experience isolated incidences of non-
4
compliance. The testing of the newly installed hardware and
software, along with the Company's older hardware and software, is
anticipated to begin upon completion of the new installation
described above and is anticipated to conclude shortly thereafter; and
- identifying its key business partners and suppliers, particularly
relating to its critical care nutrition business, and assessing their
readiness for Year 2000 to mitigate the risk to the Company if they
are not Year 2000 compliant. The Company has its critical care
nutrition products manufactured by third parties. If certain vendors,
including these critical care product manufacturers, are unable to
deliver product on a timely basis due to their own Year 2000 issues,
the Company anticipates that there will be other companies who will be
able to deliver such product on a timely basis. Upon completion of
this assessment, the Company will determine whether any remediation is
needed. The Company also recognizes the risks to other key suppliers
in utilities, communications, banking and government are not ready for
Year 2000, but does not believe the Company will be materially
adversely impacted.
The Company's manufacturing facility, completed and operational in
mid-1997, has been Year 2000 compliant since inception and no further work is
considered necessary. The most reasonably likely worst case scenario would
be the inability of the Company to have its critical care nutrition products
manufactured on a timely basis which could result in significantly decreased
revenues. The Company is currently in the process of developing its
contingency plans for each of its three main areas and should have them
completed in mid-1999.
DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS
This Annual Report to Stockholders contains certain forward looking
statements within the meaning of Section 21E of the Exchange Act. Such
forward-looking statements are based on the beliefs of the Company's
management as well as on assumptions made by and information currently
available to the Company at the time such statements were made. When used in
this Annual Report, the words "anticipate", "believe", "estimate", "expect",
"intend" and similar expressions, as they relate to the Company, are intended
to identify such forward-looking statements. Although the Company believes
these statements are reasonable, readers of this Annual Report should be
aware that actual results could differ materially from those projected by
such forward-looking statements as a result of the risk factors listed below
and set forth in the Company's Form 10-K under the caption "Risk Factors."
Readers of this Annual Report should consider carefully the factors listed
below and under the caption "Risk Factors" in the Company's Form 10-K, as
well as the other information and data contained in this Annual Report. The
Company cautions the reader, however, that such list of factors under the
caption "Risk Factors" in the Company's Form 10-K and listed below may not be
exhaustive and that those or other factors, many of which are outside of the
Company's control, could have a material adverse effect on the Company and
its results of operations. Factors that could cause actual results to differ
include, without limitation, the Company's ability to generate sufficient
working capital and obtain necessary financing to meet capital requirements,
loss of Nasdaq National Listing, the Company's ability to form strategic
alliances with marketing and distribution partners, the Company's exposure to
product liability claims, consumers' perception of product safety and
quality, the Company's reliance on flawed market research, potential
competitors that are larger and financially stronger, the Company's ability
to receive regulatory approval for its products and the Company's ability to
manufacture an acceptable product on a commercial scale. All forward-looking
statements attributable to the Company or persons acting on its behalf are
expressly qualified in their entirety by the cautionary statements set forth
hereunder and under the caption "Risk Factors" in the Company's Form 10-K.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company's market risk is unlikely to have a material adverse effect
on the Company's business, results of operations or financial condition.
5
GALAGEN INC.
BALANCE SHEETS
ASSETS
DECEMBER 31
--------------------------------
1998 1997
--------------------------------
Current assets:
Cash and cash equivalents........................................................... $ 4,081,733 $ 155,908
Available-for-sale securities....................................................... - 7,511,619
Accounts receivable, net of allowance of $14,020 in 1998 ........................... 314,579 -
Inventory........................................................................... 303,150 -
Prepaid expenses.................................................................... 197,994 196,672
-------------- ---------------
Total current assets.................................................................. 4,897,456 7,864,199
Property and equipment................................................................ 671,796 1,869,974
Less accumulated depreciation....................................................... (270,418) (363,355)
-------------- ---------------
401,378 1,506,619
Deferred expenses..................................................................... 324,659 158,953
Customer list......................................................................... 450,000 -
Goodwill.............................................................................. 219,847 -
-------------- ---------------
994,506 158,953
Total assets.......................................................................... $ 6,293,340 $ 9,529,771
-------------- ---------------
-------------- ---------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable.................................................................... $ 641,922 $ 559,498
Development contract advance........................................................ 290,089 -
Note payable........................................................................ - 238,250
Accrued expenses.................................................................... 46,903 38,129
Convertible notes- net of discount of $6,667 in 1998................................ 193,333 -
-------------- ---------------
Total current liabilities............................................................. 1,172,247 835,877
Commitments
Convertible notes, net of discount of $428,182 in 1997................................ - 1,071,818
Note payable, long term portion....................................................... - 923,998
Other long-term liabilities........................................................... 45,000 45,000
Stockholders' equity:
Preferred stock, $.01 par value:
Authorized shares - 15,000,000
Issued and outstanding shares - none in 1998 and 1997............................ - -
Common stock, $.01 par value:
Authorized shares - 40,000,000
Issued and outstanding shares - 8,948,446 in 1998; 7,234,974 in 1997............. 89,484 72,350
Additional paid-in capital.......................................................... 62,386,292 59,669,586
Accumulated deficit ................................................................ (57,339,283) (52,819,054)
Deferred compensation............................................................... (60,400) (269,804)
-------------- ---------------
Total stockholders' equity.......................................................... 5,076,093 6,653,078
-------------- ---------------
Total liabilities and stockholders' equity............................................ $ 6,293,340 $ 9,529,771
-------------- ---------------
-------------- ---------------
See accompanying notes.
6
GALAGEN INC.
STATEMENTS OF OPERATIONS
YEAR ENDED DECEMBER 31
----------------------------------------------
1998 1997 1996
----------------------------------------------
Revenues:
Product sales....................................... $ 616,168 $ - $ -
Product licensing and development revenues.......... 259,911 - -
-------------- ------------ -----------
876,079 -
Operating expenses:
Cost of goods sold.................................. 244,141 - -
Selling, general and administrative................. 2,235,362 1,540,843 1,480,496
Product development................................. 1,914,295 3,760,086 5,257,620
Depreciation and amortization....................... 767,474 600,889 408,863
-------------- ------------ -----------
5,161,272 5,901,818 7,146,979
-------------- ------------ -----------
Operating loss....................................... (4,285,193) (5,901,818) (7,146,979)
Interest income...................................... 338,007 448,322 605,548
Interest expense..................................... (573,043) (181,638) (945,316)
--------------- ------------ ------------
Net loss for the period.............................. (4,520,229) (5,635,134) (7,486,747)
Less preferred stock dividend ....................... - - (7,296,844)
--------------- ------------ ------------
Net loss applicable to common stockholders........... $ (4,520,229) $ (5,635,134) $(14,783,591)
--------------- ------------ ------------
--------------- ------------ ------------
Net loss per share applicable to common stockholders $ (.56) $ (.78)$ (2.24)
Basic and Diluted..................................
Weighted average number of common shares outstanding
Basic and Diluted.................................. 8,067,564 7,184,722 6,604,902
See accompanying notes.
7
GALAGEN INC.
STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
SERIES A SERIES B SERIES C
PREFERRED STOCK PREFERRED STOCK PREFERRED STOCK
--------------------------- ------------------------- -----------------------
SHARES AMOUNT SHARES AMOUNT SHARES AMOUNT
------------- ------------- ------------ ------------ ----------- -----------
Balance at December 31, 1995..................... 2,500,000 $25,000 1,234,748 $12,347 551,000 $5,510
Sale of Series E Preferred Stock.............
Issuance of Series F-1 Preferred Stock.......
Warrant valuation for line of credit and notes
Warrant valuation for Convertible Promissory
Notes.....................................
Conversion of Series A Preferred Stock....... (2,500,000) (25,000)
Conversion of Series B Preferred Stock....... (1,234,748) (12,347)
Conversion of Series C Preferred Stock....... (551,000) (5,510)
Conversion of Series F-1 Preferred Stock.....
Conversion of Series E Preferred Stock.......
Conversion of Convertible Promissory Notes,
net of financing costs of $131,010..........
Initial public offering, net of offering
costs of $2,078,225.........................
Preferred stock dividend.....................
Stock issued through Employee Stock Purchase
Plan......................................
Amortization of deferred compensation........
Deferred compensation adjustment, canceled
options...................................
Exercise of stock options....................
Net loss for the year........................
------------- ------------- ------------ ------------ ----------- -----------
Balance at December 31, 1996..................... - - - - - -
Amortization of deferred compensation........
Deferred compensation adjustment, canceled
options...................................
Exercise of stock options....................
Common stock issued for services.............
Discount valuation for convertible
debentures................................
Valuation of issued options and warrants......
Warrant valuation for note payable............
Stock issued through Employee Stock Purchase
Plan......................................
Net loss for the year........................
------------- ------------- ------------ ------------ ----------- -----------
Balance at December 31, 1997..................... - - - - - -
Amortization of deferred compensation........
Deferred compensation adjustment, canceled
options...................................
Exercise of stock options and warrants.......
Conversion of convertible debentures.........
Valuation of issued warrants.................
Common stock issued for asset purchase.......
Stock issued through Employee Stock Purchase
Plan......................................
Net loss for the year........................
------------- ------------- ------------ ------------ ----------- -----------
Balance at December 31, 1998..................... - $ - - $ - - $ -
------------- ------------- ------------ ------------ ----------- -----------
------------- ------------- ------------ ------------ ----------- -----------
See accompanying notes.
8
SERIES F-1 SERIES E
PREFERRED STOCK PREFERRED STOCK COMMON STOCK
----------------------- ---------------------- ----------------------
SHARES AMOUNT SHARES AMOUNT SHARES AMOUNT
------------ ---------- ------------ --------- ----------- ----------
Balance at December 31, 1995..................... 17,143 $171 338,461 $3,385 1,952,252 $19,522
Sale of Series E Preferred Stock............. 46,154 461
Issuance of Series F-1 Preferred Stock....... 17,144 171
Warrant valuation for line of credit and notes
Warrant valuation for Convertible Promissory
Notes.....................................
Conversion of Series A Preferred Stock....... 677,063 6,771
Conversion of Series B Preferred Stock....... 543,413 5,434
Conversion of Series C Preferred Stock....... 248,758 2,488
Conversion of Series F-1 Preferred Stock..... (34,287) (342) 85,717 857
Conversion of Series E Preferred Stock....... (384,615) (3,846) 178,568 1,786
Conversion of Convertible Promissory Notes,
net of financing costs of $131,010.......... 1,434,495 14,345
Initial public offering, net of offering
costs of $2,078,225......................... 2,000,000 20,000
Preferred stock dividend.....................
Stock issued through Employee Stock Purchase
Plan...................................... 3,642 36
Amortization of deferred compensation........
Deferred compensation adjustment, canceled
options...................................
Exercise of stock options.................... 39,861 399
Net loss for the year........................
------------ ---------- ------------ --------- ----------- ----------
Balance at December 31, 1996..................... - - - - 7,163,769 71,638
Amortization of deferred compensation........
Deferred compensation adjustment, canceled
options...................................
Exercise of stock options.................... 64,703 647
Common stock issued for services............. 1,493 15
Discount valuation for convertible
debentures................................
Valuation of issued options and warrants.....
Warrant valuation for note payable...........
Stock issued through Employee Stock Purchase
Plan...................................... 5,009 50
Net loss for the year........................
------------ ---------- ------------ --------- ----------- ----------
Balance at December 31, 1997..................... - - - - 7,234,974 72,350
Amortization of deferred compensation........
Deferred compensation adjustment, canceled
options...................................
Exercise of stock options and warrants....... 111,325 1,113
Conversion of convertible debentures......... 1,260,073 12,601
Valuation of issued warrants.................
Common stock issued for asset purchase....... 318,800 3,188
Stock issued through Employee Stock Purchase
Plan...................................... 23,274 232
Net loss for the year........................
------------ ---------- ------------ --------- ----------- ----------
Balance at December 31, 1998..................... - $ - - $ - 8,948,446 $ 89,484
------------ ---------- ------------ --------- ----------- ----------
------------ ---------- ------------ --------- ----------- ----------
ADDITIONAL DEFERRED
PAID-IN COMPEN- ACCUMULATED
CAPITAL SATION DEFICIT TOTAL
------------- -------------- -------------- --------------
Balance at December 31, 1995..................... $23,812,105 $(1,180,734) $(32,400,329) $(9,703,023)
Sale of Series E Preferred Stock............. 149,539 150,000
Issuance of Series F-1 Preferred Stock....... 299,849 300,020
Warrant valuation for line of credit and notes 768,064 768,064
Warrant valuation for Convertible Promissory
Notes..................................... (68,474) (68,474)
Conversion of Series A Preferred Stock....... 18,229 -
Conversion of Series B Preferred Stock....... 6,913 -
Conversion of Series C Preferred Stock....... 3,022 -
Conversion of Series F-1 Preferred Stock..... (515) -
Conversion of Series E Preferred Stock....... 2060 -
Conversion of Convertible Promissory Notes,
net of financing costs of $131,010.......... 8,918,954 8,933,299
Initial public offering, net of offering
costs of $2,078,225......................... 17,901,775 17,921,775
Preferred stock dividend..................... 7,296,844 7,296,844
Stock issued through Employee Stock Purchase
Plan...................................... 13,512 13,548
Amortization of deferred compensation........ 340,066 340,066
Deferred compensation adjustment, canceled
options................................... (261,200) 261,200 -
Exercise of stock options.................... 65,977 66,376
Net loss for the year........................ (14,783,591) (14,783,591)
------------- -------------- -------------- --------------
Balance at December 31, 1996..................... 58,926,654 (579,468) (47,183,920) 11,234,904
Amortization of deferred compensation........ 273,864 273,864
Deferred compensation adjustment, canceled
options................................... (35,800) 35,800 -
Exercise of stock options.................... 79,004 79,651
Common stock issued for services............. 14,376 14,391
Discount valuation for convertible
debentures................................ 318,182 318,182
Valuation of issued options and warrants..... 280,450 280,450
Warrant valuation for note payable........... 78,800 78,800
Stock issued through Employee Stock Purchase
Plan...................................... 7,920 7,970
Net loss for the year........................ (5,635,134) (5,635,134)
------------- -------------- -------------- --------------
Balance at December 31, 1997..................... 59,669,586 (269,804) (52,819,054) 6,653,078
Amortization of deferred compensation........ 185,404 185,404
Deferred compensation adjustment, canceled
options................................... (24,000) 24,000 -
Exercise of stock options and warrants....... 261,097 262,210
Conversion of convertible debentures......... 1,330,882 1,343,483
Valuation of issued warrants................. 488,750 488,750
Common stock issued for asset purchase....... 621,812 625,000
Stock issued through Employee Stock Purchase
Plan...................................... 38,165 38,397
Net loss for the year........................ (4,520,229) (4,520,229)
------------- -------------- -------------- --------------
Balance at December 31, 1998..................... $62,386,292 $(60,400) $(57,339,283) $ 5,076,093
------------- -------------- -------------- --------------
------------- -------------- -------------- --------------
See accompanying notes.
9
GALAGEN INC.
STATEMENTS OF CASH FLOWS
YEAR ENDED DECEMBER 31
-------------------------------------------
1998 1997 1996
-------------------------------------------
OPERATING ACTIVITIES:
Net loss.................................................. $ (4,520,229) $ (5,635,134) $(14,783,591)
Adjustments to reconcile net loss to cash used in
operating activities:
Depreciation expense................................... 238,918 264,741 68,797
Deferred expense amortization.......................... 112,893 - -
Amortization of warrants issued for services........... 230,259 62,284 768,064
Noncash interest cost of convertible debentures........ 464,998 81,378 -
Deferred compensation amortization..................... 185,404 273,864 340,066
Preferred stock dividend ................................ - - 7,296,844
Stock issued for services and license agreement.......... - 14,391 -
Changes in operating assets and liabilities:
Inventory............................................ (237,634) - -
Accounts receivable.................................. (314,579) - -
Prepaid expenses..................................... (82,171) (31,738) (5,571)
Other assets......................................... - - 123,967
Accounts payable and accrued expenses................ 381,287 (1,081,934) 55,612
------------ ------------ -----------
Net cash used in operating activities.....................
(3,540,854) (6,052,148) (6,135,812)
------------ ------------ -----------
INVESTING ACTIVITIES:
Purchase of property and equipment........................ (89,840) (279,005) (1,457,354)
Payment for asset purchase................................ (141,363) - -
Sale/purchase of available-for-sale securities, net....... 7,511,619 (13,276) (7,498,343)
------------ ------------ -----------
Net cash provided by(used in) investing activities........ 7,280,416 (292,281) (8,955,697)
------------ ------------ -----------
FINANCING ACTIVITIES:
Proceeds from sale of common stock, net of offering costs - - 17,921,775
Proceeds from sale of preferred stock .................... - - 450,020
Proceeds from common stock options exercised............. 262,210 79,651 66,376
Proceeds from borrowings from investors.................. - - 500,000
Proceeds from convertible notes, net of issuance costs.... - 1,380,919 -
Net proceeds(payment) from(on) note payable............... (114,344) 1,162,248 -
Payment to investors on borrowings........................ - - (500,000)
Proceeds from Employee Stock Purchase Plan................ 38,397 7,970 13,548
------------- ------------ -------------
Net cash provided by financing activities................. 186,263 2,630,788 18,451,719
------------ ------------ ------------
Increase (decrease) in cash............................... 3,925,825 (3,713,641) 3,360,210
Cash and cash equivalents at beginning of year............ 155,908 3,869,549 509,339
------------ ------------- --------------
Cash and cash equivalents at end of year.................. $ 4,081,733 $ 155,908 $ 3,869,549
------------ ------------- --------------
------------ ------------- --------------
SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES:
Discount valuation for convertible debentures............ $ - $ 318,182 $ -
Valuation of issued options and warrants ................. 488,750 359,250 -
Stock issued for asset purchase........................... 625,000 - -
Conversion of note payable to operating lease............. 1,047,904 - -
Deferred compensation adjustment, canceled options........ 24,000 35,800 261,200
Conversion of convertible promissory notes plus related
accrued interest, to common stock....................... 1,343,483 - 8,864,825
See accompanying notes.
10
GALAGEN INC.
NOTES TO FINANCIAL STATEMENTS
1. DESCRIPTION OF BUSINESS
GalaGen Inc. is a nutritional products company that is utilizing its
proprietary immune-enhancing ingredients and patented manufacturing processes
to commercialize health-promoting foods and beverages. These immune-enhancing
ingredients, including Proventra-TM- Brand Natural Immune Components
("Proventra"), are comprised of antibodies and other proteins that are
derived from the milk collected in the first few milkings of a dairy cow
after its calf is born. The Company continues to expand applications for its
technology and is developing a portfolio of immune-enhancing products that
target the needs of consumers and the healthcare market. In December 1998,
the Company acquired a developed line of critical care enteral nutrition
products and formulas from Nutrition Medical, Inc. ("NMI"). These products
are being sold to the hospital and home healthcare industries. The Company
operates in a single business segment.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
DEVELOPMENT STAGE
Prior to 1998 the Company was a development stage company.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements and
accompanying notes. Actual results could differ from those estimates.
RECLASSIFICATION
Certain prior year amounts have been reclassified to conform with the
current year presentation.
REVENUE RECOGNITION
Revenue from product sales is recognized at the time of shipment.
PRODUCT DEVELOPMENT COSTS
All product development costs are charged to operations as incurred.
NET LOSS PER SHARE
Net loss per share is presented in accordance with the provisions of
Statement of Financial Accounting Standards No. 128, EARNINGS PER SHARE
("Statement 128"). Under Statement 128, basic earnings per share is
computed by dividing the net loss by the weighted average number of common
shares outstanding for the year. Diluted earnings per share reflects the
potential dilution that could occur if securities or other contracts to issue
common stock were exercised or converted into common stock and resulted in
the issuance of common stock. Basic and diluted earnings per share are the
same in all years presented as all potential common shares were antidilutive.
11
INCOME TAXES
Income taxes are accounted for using the liability method. Deferred
income taxes are provided for temporary differences between financial
reporting and tax bases of assets and liabilities.
CASH EQUIVALENTS
Cash equivalents are available-for-sale and are carried at cost which
approximates fair market value.
INVESTMENTS
Investments in debt securities with a remaining maturity of more than
three months at the date of purchase are classified as marketable securities.
Management determines the appropriate classification of debt securities at
the time of purchase and reevaluates such designation as of each balance
sheet date. Debt securities were classified as available-for-sale as of
December 31, 1997. The book value of the investments approximated their
estimated market value.
INVENTORY
Inventories are stated at the lower of cost or market using the
first-in, first-out method. The Company evaluates the need for reserves
associated with obsolete inventory as needed. Inventory at December 31
consisted of the following:
1998
-------------------
Finished goods.................................. $ 235,155
Raw materials and supplies...................... 67,995
-------------------
$ 303,150
-------------------
-------------------
PROPERTY AND EQUIPMENT
Property and equipment are recorded at cost and depreciated on a
straight-line basis over their estimated useful lives of three to seven
years.
IMPAIRMENT
The Company evaluates its long-lived assets for impairment losses when
indicators of impairment are present by comparing the non-discounted cash
flows to the asset's carrying amount. An impairment loss is recorded if
necessary. In management's opinion, no impairment exists on December 31,
1998.
CUSTOMER LIST
Customer list represents the value of the acquired customer database.
The customer list is amortized over the useful life of the asset.
GOODWILL
Goodwill represents the excess of purchase price and related costs over
the value assigned to the net assets acquired. Goodwill is amortized on a
straight-line basis over two-years because of the limited history of the
product line acquired.
12
STOCK BASED COMPENSATION
The Company has adopted the disclosure-only provisions of Statement of
Financial Accounting Standards No. 123, ACCOUNTING FOR STOCK BASED
COMPENSATION ("Statement 123"), but applies Accounting Principles Board
Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES ("APB 25"), and
related interpretations in accounting for its stock plans. Under APB 25,
when the exercise price of stock options equals the market price of the
underlying stock on the date of grant, no compensation expense is recognized.
3. RELATED PARTY TRANSACTIONS
During 1992, the Company entered into the following agreements with Land
O'Lakes, which are still in effect:
ROYALTY AGREEMENT
The Company will pay to Land O'Lakes a royalty on net receipts from any
product, other than infant formula, which is based on existing technology or
technology improvements, as defined by the agreement. The Company will pay
an additional royalty on net receipts from infant formula based on existing
or improved technology and an additional royalty on net receipts from infant
formula based on new technology, as defined by the agreement. This agreement
will continue until terminated by both parties. Royalty payments range from
one to two percent of net receipts.
LICENSE AGREEMENT
The Company has licensed to Land O'Lakes the rights to use the Company's
existing technologies and technology improvements, as defined by the
agreement, for Land O'Lakes' use in animal products, functional foods and
infant formula. The Company received a lump sum license fee. The Company has
agreed not to compete for fifteen years in the area of animal products and
functional foods based on milk and colostrum based immunoglobulin technology.
Land O'Lakes has agreed not to compete for fifteen years in the areas of
prescription drugs and over-the-counter drugs regulated by the Food and Drug
Administration. The term of this agreement is perpetual.
In March 1997, Land O'Lakes granted a five-year license, an amendment to
the license above, in the area of functional foods to use existing technology
and future technology improvements in the development, formulation,
manufacture, marketing, distribution and sale of kefir-based products, as
defined in the granted license. In consideration of granting the Company
this license, Land O'Lakes will receive a royalty of five percent from food
components or ingredients sold by the Company to be included in a kefir-based
product and one percent of net receipts from a kefir-based finished product
sold by the Company.
In March 1998, the Company and Land O'Lakes signed an amended and
restated license agreement in which the Company has significantly broadened
its rights to develop and market functional foods. Under the restated
license agreement, the Company can use, improve, exploit, license or share
existing technology, technology improvements and new technologies, as
defined, in all areas except under certain "reserved food" and "first refusal
food product" categories.
SUPPLY AGREEMENT
The Company has entered into an agreement with Land O'Lakes whereby the
Company will purchase and Land O'Lakes will supply, at their option, all of
the Company's commercial requirements for colostrum and milk. As part of this
agreement, Land O'Lakes will provide expertise in dairy herd selection,
on-farm management, membership relations and procurement to the Company for
the manufacture of antibody material. The agreement will last for ten years
and Land O'Lakes, at its sole discretion, has the option to extend the
agreement for an additional ten years.
13
MASTER SERVICES AGREEMENT
The Company has entered into an agreement with Land O'Lakes whereby the
Company may purchase services from Land O'Lakes for certain administrative
and research and development activities. This agreement will enable the
Company to access expertise, on an as-needed basis, from Land O'Lakes. The
agreement terminated on December 31, 1992, but has been renewed annually and
is currently extended through December 31, 1999. The Company was charged
approximately $375,000, $442,000 and $682,000 in 1998, 1997 and 1996,
respectively, in accordance with the Master Services Agreement.
Subsequent to 1992, the Company and Land O'Lakes have entered into other
related party agreements as noted below:
In December 1995 and January 1996, Land O'Lakes purchased 169,230 shares
of Series E preferred stock at $3.35 per share.
In January 1996, the Company entered into a $2.7 million line of credit
agreement with a commercial bank, which expired with the closing of the
Company's initial public offering (the "Offering"). Loans under this line of
credit were guaranteed by six parties and the guarantee was collateralized by
letters of credit posted by them in the aggregate amount of $2.7 million. In
consideration for the guarantees and letters of credit posted by these
parties, the Company issued warrants to purchase an initial aggregate of
162,011 shares of common stock at $7.00 per share. In connection with this
transaction Land O'Lakes guaranteed $500,000 of the $2.7 million line of
credit, and in exchange received a warrant to purchase 30,002 shares of
common stock at $7.00 per share. See Note 9.
In June 1996, the Company entered into a five-year lease agreement with
Land O'Lakes for specified space within the Land O'Lakes facility in
connection with the Company's manufacturing facility. See Note 10.
In December 1996, the Company entered into an equipment operating lease
which was guaranteed by Land O'Lakes. See Note 10.
4. STOCK
INITIAL PUBLIC OFFERING
GalaGen Inc. consummated an initial public offering on April 1, 1996,
which consisted of 2,000,000 shares of common stock at a $10 per share price
to the public. All of the Company's preferred stock mandatorily converted
into common stock immediately prior to the closing of the Offering. The
2,500,000 shares of Series A preferred stock, 1,234,748 shares of Series B
preferred stock and 551,000 shares of Series C preferred stock that were
outstanding prior to the Offering were converted into 677,063, 543,413 and
248,758 shares of common stock, respectively, upon the closing of the
Offering. The $8,275,000 of Convertible Promissory Notes to investors, plus
accrued interest, that were outstanding prior to the Offering converted into
shares of Series D preferred stock and simultaneously into 1,434,495 shares
of common stock upon the closing of the Offering. The 338,461 shares of
Series E preferred stock and 34,287 shares of Series F stock outstanding
prior to the Offering were converted into 178,568 and 85,717 shares,
respectively, of common stock upon the closing of the Offering.
PREFERRED STOCK DIVIDEND
The Series D preferred stock, Series E preferred stock and Series F-1
preferred stock converted into common stock at 70% of the Offering price.
These reductions in the conversion prices to 70% of the Offering price were
valued at $7,296,844 and recorded as a non-cash preferred stock dividend to
arrive at the net loss available to holders of common stock in the
calculation of net loss per share.
14
EMPLOYEE STOCK PURCHASE PLAN
In March 1996, the Company adopted the Employee Stock Purchase Plan
whereby 270,833 shares of common stock have been reserved. All employees who
have met the service eligibility requirements are eligible to participate and
may direct the Company to make payroll deductions of one to 10 percent of
their compensation during a purchase period for the purchase of shares under
the plan. Participants may purchase up to 5,000 shares of common stock for a
given calendar year provided the fair market value of the stock is not more
than $25,000 (determined at the beginning of each purchase period). The plan
provides a participating employee the right, subject to certain limitations,
to purchase the Company's common stock at a price equal to the lower of 85%
of the fair market value of the Company's common stock on the first day, or
the last day, of the applicable purchase period. The first purchase period
commenced on July 1, 1996 and ended on December 31, 1996, of which 3,642
shares of common stock were issued to employees for $13,548. In May 1997, the
Employee Stock Purchase Plan was amended by stockholders to have two six
month purchase periods beginning on January 1 and July 1 of each year. In
1998, 20,004 shares of common stock were purchased and issued to employees
and in 1997, 8,279 shares of common stock were purchased of which 3,270 and
5,009 were issued to employees in 1998 and 1997, respectively.
5. CRITICAL CARE PRODUCTS ASSET PURCHASE
In September 1998, the Company entered into an asset purchase agreement
with NMI to acquire NMI's developed line of critical care enteral nutrition
products and formulas. The asset purchase agreement closed in December 1998.
GalaGen purchased substantially all of NMI's critical care enteral nutrition
products and formulas, all related inventory valued at $65,516, certain other
fixed assets valued at $31,000 and the existing customer base of over 500
hospitals and home healthcare facilities valued at $450,000. Total
consideration for the transaction was $696,516, exclusive of closing costs of
$69,847, comprised of $71,516 cash and 318,800 shares of the Company's common
stock which was valued at $625,000. Goodwill of $219,847 was recorded and
will be amortized over a two-year period beginning in January 1999. The
Company will pay to NMI a royalty of nine percent of net U.S. sales, as
defined, of the critical care products in excess of (i) $5,000,000 during the
year ending December 31, 2000, (ii) $6,000,000 during the year ending
December 31, 2001, and (iii) $7,500,000 during the year ending December 31,
2002. Additionally, the Company will pay to NMI a royalty on international
sales, as defined, of the critical care products of (i) five percent of
net international sales in excess of $200,000 during the year ending on the
first anniversary of the closing date, and (ii) two and one half percent
of net international sales in excess of $200,000 during the year ending on
the second anniversary of the closing date.
6. AMERICAN HOME PRODUCTS CORPORATION AGREEMENT
In October 1998, the Company entered into a collaboration and license
agreement and a manufacturing and supply agreement with Wyeth-Ayerst
Laboratories, a division of American Home Products Corporation ("AHP"). The
two companies will develop and commercialize a proprietary ingredient with
unique antibacterial properties for use in pediatric formula and other
nutritional products. The companies will collaborate during the research and
development phase of the product, which will be funded by Wyeth-Ayerst,
through payments to the Company. Additionally, Wyeth-Ayerst will have
financial and oversight responsibilities for all clinical trials and
regulatory compliance related to the use of the ingredient in pediatric
formula products. Wyeth-Ayerst will have worldwide rights to the use of the
ingredient in its pediatric formula and other nutritional products. The
Company will retain its right to manufacture the ingredient and has the right
to request a sublicense from Wyeth-Ayerst to develop and commercialize
non-pediatric formula nutritional products. The Company received a $250,000
licensing fee and a $300,000 research and development advance from AHP. The
Company has recorded the $250,000 as licensing revenue and the $300,000 as a
contract payable which will be amortized to research and development revenue
when the Company incurs the associated expenses. In 1998, $9,911 of the
advance was amortized and recorded as research and development revenue.
Seven-year warrants were issued to AHP to purchase 200,000 shares of common
stock at $2.45 per share. The fair value of the warrant was $250,000, which
the Company is amortizing over the 2-year term of the research and
15
development program. In 1998, $31,250 was amortized.
7. OPERATING LEASE
In June 1997, the Company established a note payable for approximately
$1,319,000 for fixed assets with Transamerica Business Credit Corporation
("Transamerica") of which $1,162,248 was outstanding at December 31, 1997.
In June 1998, the Company converted the note payable into an operating lease.
At the time of the conversion the net book value of the associated assets
approximated the note payable balance. Terms of the operating lease include
monthly payments through May 2001 of approximately $36,000 with a final
payment of $165,000 in June 2001. The operating lease is secured by the
Company's property and equipment. Transamerica received a warrant for 40,000
shares of common stock exercisable at $2.50 per share. The warrant was
valued at approximately $79,000 and was amortized to interest expense over
the term of the note payable.
8. CONVERTIBLE DEBENTURES
In November 1997, the Company raised $1,500,000 through the private
placement sale of 6% convertible debentures (the "Debentures") to three
institutional investors pursuant to Regulation D under the Securities Act of
1933. The principal and interest of the Debentures can be converted into
shares of the Company's common stock at 82.5% of the lowest closing bid price
of the Company's common stock three days prior to conversion. An aggregate
maximum of 1,400,000 discounted shares of common stock (the "Discounted
Shares") can be issued upon the conversion of the Debentures, with each
investor owning at any given time a maximum of 4.99% of the then issued and
outstanding shares of common stock. If there remains any unconverted
principal and accrued interest due to all the Discounted Shares being issued,
the Company has the obligation to repay the investors, in the aggregate, a
maximum principal of $500,000. The Debentures automatically convert into the
Discounted Shares eighteen months from the closing date. Five-year warrants
were issued to the investors to purchase, in the aggregate, 200,000 shares of
common stock at 110% of the market value of the common stock on the closing
date. The value of the warrants plus the value of the discount of the
Discounted Shares was $500,182, which the Company is amortizing over the term
of the Debentures to interest expense. In 1998 and 1997, $421,515 and $72,000
was amortized and recorded as interest expense, respectively. A deferred
expense was recorded for $144,467, which represents costs associated with
closing the Debentures. These deferred expenses are being amortized until the
Debentures are converted into Discounted Shares. In 1998 and 1997, $112,893
and $9,378 was amortized and recorded as an expense, respectively. In 1998,
$1,300,000 of Debenture principal plus accrued interest was converted into
1,260,073 shares of common stock. In 1998, 73,000 shares of common stock
were issued pursuant to warrant exercises. The net carrying value of the
Debentures approximates fair market value. In connection with this private
placement, the Company reserved 1,400,000 shares of common stock for issuance
for the Discounted Shares and 200,000 shares of common stock for issuance for
the warrants.
9. OPTIONS AND WARRANTS
STOCK OPTION PLAN
The Company has established a 1992 Stock Plan (the "1992 Plan") and a
1997 Incentive Plan (the "1997 Plan"), under which both incentive and
non-qualified options may be granted, which have reserved 880,210 and
1,250,000 shares of common stock, respectively, for issuance. The Company
uses these plans as an incentive for employees, directors and technical
advisors. Stock awards in the aggregate of 100,000 shares of common stock
may also be granted under the 1997 Plan. Options are granted at fair market
value as determined on the date of grant and normally vest over three to five
years.
16
The following plan and non-plan options are outstanding at December 31,
1998:
NON WEIGHTED
1992 PLAN 1997 PLAN PLAN AVERAGE
OPTIONS OPTIONS OPTIONS OPTION
OUTSTANDING OUTSTANDING OUTSTANDING PRICE
------------------------------------------------------------
Balance at December 31, 1995....... 351,133 154,371 $5.67
Granted........................... 477,476 57,003 4.68
Exercised......................... (39,902) - 1.66
Canceled.......................... (118,479) (25,730) 7.36
--------------- --------------
Balance at December 31, 1996....... 670,228 185,644 4.74
Granted........................... - 379,300 - 3.96
Exercised......................... (51,162) - (13,541) 1.23
Canceled.......................... (69,335) (60,000) (4,334) 4.51
--------------- -------------- --------------
Balance at December 31, 1997....... 549,731 319,300 167,769 4.96
Granted........................... 475,088 798,962 166,687 2.70
Exercised......................... (27,248) (10,000) (1,082) 2.37
Canceled.......................... (682,533) (355,540) (208,524) 4.54
--------------- -------------- --------------
Balance at December 31, 1998....... 315,038 752,722 124,850 $2.79
--------------- -------------- --------------
--------------- -------------- --------------
The following table summarizes information about the stock options
outstanding at December 31, 1998:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
-------------------------------------------------- --------------------------------
WEIGHTED-AVERAGE WEIGHTED WEIGHTED AVERAGE
RANGE OF EXERCISE NUMBER REMAINING AVERAGE NUMBER EXERCISE
PRICE OUTSTANDING CONTRACTUAL LIFE EXERCISE PRICE EXERCISABLE PRICE
------------------- ------------------ ------------------- ----------------- -------------- ------------------
$ 1.50 6,000 9 years $ 1.50 6,000 $ 1.50
2.19 25,000 10 years 2.19 - -
2.38 66,000 10 years 2.38 10,000 2.38
2.56 677,347 7 years 2.56 393,145 2.56
3.13 384,722 10 years 3.13 - -
3.25 20,000 8 years 3.25 15,000 3.25
7.39 13,541 5 years 7.39 13,541 7.39
------------------ --------------
$1.50 - 7.39 1,192,610 $2.79 437,686 $2.72
Options expire in five years and three months to ten years from the
original grant date. Fully vested and exercisable options were 437,686,
355,349 and 189,986 as of December 31, 1998, 1997 and 1996, respectively. The
weighted average exercise prices for the fully vested and exercisable options
as of December 31, 1998, 1997 and 1996 were $2.72, $4.86 and $3.80,
respectively. In May 1997, the Company granted options for 20,000 shares of
common stock to two consultants for services provided, of which 15,000 are
fully vested. In August 1997, a consultant was granted a stock award, based
upon the value of the common stock at the date of grant, from the 1997 Plan
of 1,493 shares of common stock in exchange for services provided. In
September and October 1998, a consultant was granted ten-year options from
the 1997 Plan for 35,000 shares of common stock at fair market value of the
date of grant for services to be provided, of which 10,000 are fully vested.
WARRANTS
In connection with the June 1994 to October 1995 Convertible Promissory
Notes (the "Notes") issuance of $8,275,000, each Note holder received a
warrant, exercisable at $11.07 per share, to purchase that number of shares
of common stock equal to 20% of the principal amount of such holder's Note
divided
17
by $11.07. The Company granted warrants to purchase 149,384 shares of the
Company's common stock. These warrants expire five years from the date of
grant, which expiration dates range from June 1999 to October 2000.
In March 1995, Chiron was issued warrants to purchase 200,000 shares of
the Company's Series F preferred stock for which the Company was paid
$150,000. The Company issued the warrants to purchase 200,000 shares of
Series F preferred stock to Chiron as follows: (i) warrant to purchase 17,144
shares of Series F-1 preferred stock, exercise price of $17.50 per share
(pre-Offering) or $24.00 per share (post-Offering); (ii) warrant to purchase
42,856 shares of Series F-2 preferred stock, exercise price of $18.70 per
share (pre-Offering) or $27.00 per share (post-Offering); (iii) warrant to
purchase 60,000 shares of Series F-3 preferred stock, exercise price of
$25.00 per share (pre-Offering) or $33.00 per share (post-Offering); and (iv)
warrant to purchase 80,000 shares of Series F-3 preferred stock, exercise
price of $25.00 per share (pre-Offering) or $36.00 per share (post-Offering).
If, after the Company's Offering, the market value (as defined in the
purchase agreement for the warrants) of a share of common stock is less than
the stated post-Offering exercise price of any such warrant, the exercise
price is reduced to such per share market value and the number of shares of
common stock covered by the warrant are increased proportionately. Based upon
the warrant agreements, the ceiling price for the warrants described in
clauses (ii), (iii) and (iv) above were set at the closing of the Offering at
$10.11, $9.24 and $10.08, respectively, per share of common stock. Chiron
exercised the warrant described in clause (i) above in March 1996 which
converted into 42,860 shares of common stock at the closing of the Company's
Offering. Assuming the remaining three warrants were exercised in full on
December 31, 1998, 3,418,813 shares of the Company's common stock would have
been issued upon such exercise. The exercise price is based upon the twenty
day average of the average of the high and low closing market prices, as
reported by Nasdaq National Market, prior to December 31, 1998, which is
calculated at $1.76 per share. The warrants expire on the earlier of six
years from the date of issuance or 120 days after the warrant holder receives
notice from the Company of the occurrence of certain defined milestone
events.
In January 1996, the Company granted warrants to purchase 162,011 shares
of common stock at $7.00 per share to six parties, one of which is a company
which has a representative on the Company's Board which received a warrant to
purchase 30,002 shares of common stock, in return for their guarantee on the
Company's $2.7 million line of credit. The Company also granted warrants to
purchase 7,500 and 22,501 shares of the Company's common stock at $7.00 per
share to certain investment funds associated with a representative on the
Company's Board in return for their issuance of two convertible promissory
notes totaling $500,000. These warrants expire February 2001. The fair value
of the warrants was $768,064 which was recorded as interest expense in 1996.
In March 1997, the Company issued warrants to purchase 10,000 shares of
common stock, granted at $2.15, which was the fair market value on the date
of grant, for certain services to be rendered. The warrant expires in March
2002. The fair value of the warrant, approximately $5,000, was amortized and
expensed in 1997.
In December 1997, the Company issued five-year warrants to financial
consultants to purchase 25,000 and 40,000 shares of common stock at $2.50 and
$3.00, respectively, which was greater than the market value of the common
stock at the date of grant. These warrants have a fair value of $50,450
which is being amortized over the term of the consulting relationship.
In April, June and September 1998, the Company issued five-year warrants
to purchase 75,000, 25,000, 25,000 and 12,500 shares of common stock at
$1.38, $2.63, $3.00 and $1.81 per share, respectively, to an officer and
director of the Company for services performed while under a consulting
agreement. The fair value of the warrants is $68,750, which the Company has
amortized over the term of the consulting agreement.
18
In August 1998, five-year warrants were issued to individuals of an
investor relations firm to purchase 50,000 shares of common stock at $3.125
per share. The fair value of the warrants is $100,000, which the Company is
amortizing over the term of the investor relations agreement.
A summary of the warrants follow:
WARRANTS
GRANTED TO: OUTSTANDING EXPIRATION DATE GRANT PRICE
---------------------------------------- ---------------- ----------------------------- -------------------
Convertible Promissory Note Holders 149,384 June 1999 - October 2000 $11.07
Chiron Corporation 3,418,813 March 2002 $1.76
Line of Credit Guarantors 192,012 February 2001 $7.00
Consultants 10,000 March 2002 $2.13
TransAmerica 40,000 June 2002 $2.50
Debenture Holders 127,000 November 2002 $2.34
Financial Consultants 65,000 December 2002 $2.50 - $3.00
Officer and Director 137,500 April-September 2003 $1.38 - $3.00
Investor Relations 50,000 August 2003 $3.13
American Home Products Corporation 200,000 October 2005 $2.45
----------------
4,389,709
----------------
----------------
STOCK OPTION AND WARRANT AGREEMENT REVISIONS
In August 1996, the Company canceled all common stock option agreements
totaling 57,715 shares of common stock under the 1992 Plan and 18,958 shares
of common stock outside of the 1992 Plan, with the exception of officer and
director options, that were issued with a grant price greater than the fair
market value at the date of re-grant and issued new stock option agreements
with the same terms and conditions except that the grant prices were $5.375
per share.
In May 1998, the Company canceled all directors and employees common
stock option agreements, totaling 941,075 shares of common stock under the
1992 Plan, the 1997 Plan and nonplan options, that were issued with a grant
price greater than the fair market value at the date of re-grant. New stock
option agreements were issued with an exercise price of $2.56 per share and a
ten year term.
STOCK-BASED COMPENSATION
The Company has elected to follow APB 25 in accounting for its employee
stock options. Under APB 25, if 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.
Pro forma information regarding net loss and loss per share is required
by Statement 123, and has been determined as if the Company had accounted for
its employee stock options under the fair value method of Statement 123. The
fair value for these options was estimated at the date of grant using the
Black-Scholes option pricing model with the following weighted-average
assumptions for 1998, 1997 and 1996: risk-free interest rates approximating
5.0%, 6.2% and 6.2%, respectively; volatility factor of the expected market
price of the Company's common stock ranging from .3 to 1.08 for all three
years and a weighted-average expected life of the option of two to seven
years for all three years. The weighted average fair value of the options
granted in 1998, 1997 and 1996 is $2.36, $2.16 and $2.54 per share,
respectively, as computed as described above.
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. 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,
19
the existing models may 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 information is as follows:
1998 1997 1996
------------------- ------------------ ------------------
Pro forma amortized expense.............. $ 566,859 $ 435,589 $ 165,762
Pro forma net loss applicable
to common stockholder................... $ (5,087,088) $ (6,070,723) $ (14,949,353)
Pro forma net loss per common share,
Basic and Diluted....................... $ (0.63) $ (0.84) $ (2.26)
The pro forma effect on net loss for 1998, 1997 and 1996 is not
representative of the pro forma effect on net loss in future years because it
does not take into consideration pro forma compensation expense related to
grants made prior to 1995.
DEFERRED COMPENSATION
In December 1995, the Company canceled certain stock option agreements
within the Plan and certain stock options that were outside of the Plan that
had grant prices ranging from $7.38 per share to $11.07 per share and issued
new stock option agreements with the same terms and conditions except that
the grant prices were $3.69 per share. The Company recorded $1,657,000 as
deferred compensation for the difference between the new grant price per
share of common stock and the fair market value of the common stock per share
on the date of grant, as determined by the board of directors, multiplied by
the total number of options affected. In December 1998, 1997 and 1996, the
Company adjusted the deferred compensation balance by $24,000, $35,800 and
$261,200 to account for terminated employee options that were not vested. The
deferred compensation is amortized ratably over the vesting period of the
options. In 1998, 1997 and 1996, $185,404, $273,864 and $340,066 was
amortized, respectively. The remaining deferred compensation of $60,400 will
be amortized in 1999.
10. COMMITMENTS
The Company has commitments under the following agreements:
LICENSE AGREEMENTS
In August 1998, the Company received a $250,000 fee from a company for
the re-licensing of previously licensed technology. Pursuant to this
agreement, the Company is entitled to receive royalties on the net sales of
certain GalaGen ingredients and certain GalaGen nutritional products that
incorporate their technology.
In March 1995, the Company entered into a License and Collaboration
Agreement with Chiron Corporation involving the licensing of Chiron adjuvant
technology for certain products. Pursuant to this agreement, Chiron has
granted an exclusive worldwide license for certain of Chiron's proprietary
adjuvant technology to the Company for which the Company issued 17,143 shares
of its Series F-1 preferred stock to Chiron. See Note 9.
The royalties on the above agreements range from one-half to five
percent, depending on the volume, of certain net sales.
20
OTHER AGREEMENTS
A three-year service agreement that began in 1996 for specified raw
material preparation assistance requires payments of approximately $14,000
in 1999.
A twelve month contract that began in August 1998 for various consulting
and public relations services requires payments of approximately $56,000 in
1999.
A twelve month contract that began in September 1998 for international
sales consulting services requires payments of approximately $54,000 in 1999.
The contract also calls for sales commissions equal to the lower of 20% of
net international sales of the acquired NMI product line, or 50% of gross
margin on net international sales, as defined in the agreement.
LEASE COMMITMENTS
The Company leases certain office equipment under an operating lease.
During June 1996, the Company entered into a five-year lease agreement
with Land O'Lakes for specified space within the Land O'Lakes facility in
connection with the Company's manufacturing facility. The lease calls for
annual payments of approximately $87,000 and can be extended for additional
one-year periods at the option of the Company.
In December 1996, the Company entered into an operating lease with
Cargill Leasing Corporation for $835,393 of manufacturing equipment for the
Company's plant facility. Lease payments of approximately $11,000 per month
will continue for a period of seven years with the Company's option to extend
for an additional 12 months. The rental percentage was computed on a
weighted average of the 30-day LIBOR rate and the rate on five-year U.S.
Treasury Notes. The lease is guaranteed by Land O'Lakes.
In June 1998 the Company entered into an operating lease with
Transamerica which calls for monthly payments of approximately $36,000 until
May 2001, with a final payment of $165,000 due June 2001. See Note 7.
The total lease expense was $441,972, $199,808 and $3,133, respectively,
for the years ended December 31, 1998, 1997, and 1996. The future minimum
annual lease payments are as follows:
1999............................................. $ 628,000
2000............................................. 628,000
2001............................................. 510,000
2002............................................. 131,000
2003............................................. 131,000
-----------------
$2,028,000
-----------------
-----------------
21
11. INCOME TAXES
Prior to the effective date of the merger with Procor, GalaGen's losses
were utilized by Land O'Lakes in its consolidated tax return. Subsequent to
the effective date of the merger and through December 31, 1998, GalaGen has
operating loss carryforwards to offset future taxable income of approximately
$36,300,000 which begin to expire in 2007. No benefit has been recorded for
such loss carryforwards, and utilization in future years may be limited, if
significant ownership changes have occurred.
Components of deferred tax assets are as follows:
DECEMBER 31
-------------------------------------------------------
1998 1997 1996
---- ---- ----
Loss carryforwards......................... $ 13,445,000 $ 12,000,000 $ 9,968,000
Research and development tax credit
carryforwards........................... 894,000 791,000 566,000
Deferred compensation...................... 472,000 403,000 302,000
-------------- -------------- --------------
$ 14,811,000 $ 13,194,000 $ 10,836,000
Less valuation allowance................... (14,811,000) (13,194,000) (10,836,000)
-------------- -------------- --------------
Net deferred tax assets.................... $ - $ - $ -
-------------- -------------- --------------
-------------- -------------- --------------
22
REPORT OF INDEPENDENT AUDITORS
Board of Directors
GalaGen Inc.
We have audited the accompanying balance sheets of GalaGen Inc. as of
December 31, 1998, and 1997, and the related statements of operations,
changes in stockholders' equity and cash flows for each of the three years in
the period ended December 31, 1998. These financial statements are the
responsibility of GalaGen'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 GalaGen Inc. at
December 31, 1998 and 1997 and the results of its operations and cash flows
for each of the three years in the period ended December 31, 1998 in
conformity with generally accepted accounting principles.
Ernst & Young LLP
Minneapolis, Minnesota
January 22, 1999
23
SELECTED FINANCIAL DATA
The selected financial data set forth below as of December 31, 1998
and 1997 and for each of the three years in the period ended December 31,
1998 are derived from the financial statements of the Company which have been
audited by Ernst & Young LLP, independent auditors, and are included herein.
The selected financial data as of December 31, 1996, 1995 and 1994 and for
each of the two years in the period ended December 31, 1995 are derived from
audited financial statements which are not included herein. The data set
forth below should be read in conjunction with the financial statements and
notes thereto included in the appendix and with "Management's Discussion and
Analysis of Financial Condition and Results of Operations", included above.
YEAR ENDED DECEMBER 31
------------------------------------------------------------------
1998 1997 1996 1995 1994
---------- ---------- ---------- ---------- ----------
(IN THOUSANDS, EXCEPT SHARE NUMBERS AND PER SHARE DATA)
STATEMENTS OF OPERATIONS:
Revenues....................................... $ 876 $ - $ - $ 150 $ -
Operating costs and expenses:
Cost of goods sold........................... 244 - - - -
Selling, general and administrative.......... 2,235 1,541 1,480 1,417 1,645
Product development.......................... 1,914 3,760 5,258 3,731 3,442
Depreciation and amortization................ 768 601 409 605 75
Operating loss................................. (4,285) (5,902) (7,147) (5,603) (5,162)
Interest income................................ 338 448 605 31 28
Interest expense............................... (573) (181) (945) (507) (260)
Net loss before extraordinary gain............. (4,520) (5,635) (7,487) (6,079) (5,394)
Extraordinary gain on extinguishment of
debt ........................................ - - - 605 -
Net loss for the period........................ (4,520) (5,635) (7,487) (5,474) (5,394)
Preferred stock dividend (1)................... - - (7,297) - -
Net loss applicable to common stockholders..... $ (4,520) $ (5,635) $ (14,784) $ (5,474) $ (5,394)
Net loss per share applicable to common
stockholders
Basic and Diluted............................ $ (.56) $ (.78) $ (2.24) $ (2.87) $ (2.89)
Weighted average number of common shares
outstanding
Basic and Diluted............................ 8,067,564 7,184,722 6,604,902 1,904,059 1,866,561
DECEMBER 31
------------------------------------------------------------------
1998 1997 1996 1995 1994
---------- ---------- ---------- ---------- ----------
(IN THOUSANDS)
BALANCE SHEET DATA:
Cash and cash equivalents.................. $ 4,082 $ 156 $ 3,870 $ 509 $ 430
Available-for-sale securities (2)............ - 7,512 7,498 - -
Accounts receivable, net of allowance...... 315 - - - -
Inventory.................................. 303 - - - -
Working capital (deficiency)............... 3,725 7,028 9,776 (1,033) (846)
Total assets............................... 6,293 9,530 12,959 818 686
Note payable (3)........................... - 1,162 - - -
Accrued expenses payable to Land O'Lakes - - - 225 26
Convertible notes (4)...................... 193 1,072 - 8,199 5,707
Total liabilities.......................... 1,217 2,877 1,724 10,521 7,278
Stockholders' equity (deficiency).......... 5,076 6,653 11,235 (9,703) (6,592)
- ---------------
Net loss per share applicable to common stockholders has been restated to
comply with the Financial Accounting Standards Board issued Statement No.
128, EARNINGS PER SHARE. See Note 2 of the Notes to the Financial Statements
for further discussion.
24
(1) See Note 4 of Notes to Financial Statements for an explanation of the
preferred stock dividend.
(2) See Note 2 of Notes to Financial Statements for an explanation of the
available-for-sale securities.
(3) See Note 7 of Notes to Financial Statements for an explanation of the
note.
(4) See Note 8 of Notes to Financial Statements for an explanation of
convertible notes.
25
MARKET FOR REGISTRANT'S COMMON EQUITY
AND RELATED STOCKHOLDER MATTERS
The Company's common stock, par value $.01 per share, has been publicly
traded since the closing of the Company's initial public offering on April 1,
1996. The common stock trades on the Nasdaq National Market tier of The
Nasdaq Stock Market under the symbol GGEN. At March 18, 1999, the number of
holders of the common stock was approximately 1,880, consisting of 220 record
holders and 1,660 stockholders whose stock is being held by a bank, broker or
other nominee. On March 18, 1999, the closing sale price of a share of the
common stock was $1.91.
The high and low sale prices per share of the common stock for the four
quarters during the years ended December 31, 1998 and 1997 were as follows:
1998 1997
-------------------------- ---------------------------
HIGH LOW HIGH LOW
------------- ------------ -------------- ------------
First Quarter $ 2.250 $ 0.844 $ 4.625 $ 1.750
Second Quarter $ 3.313 $ 1.563 $ 3.250 $ 2.000
Third Quarter $ 4.000 $ 1.625 $ 2.750 $ 2.000
Fourth Quarter $ 3.000 $ 1.375 $ 2.375 $ 1.500
The Company has never paid cash dividends on the common stock. The
Board of Directors does not anticipate paying cash dividends in the
foreseeable future.
RECENT SALES OF UNREGISTERED SECURITIES
During the year ended December 31, 1998, the Company has sold the
following equity securities pursuant to exemptions from registration under
the Securities Act of 1933, as amended (the "Securities Act"). All such
sales were made in reliance upon the exemptions from registration provided
under Sections 3(b) and 4(2) of the Securities Act.
1. In April, June and September 1998, the Company issued five-year
warrants to purchase 75,000, 25,000, 25,000 and 12,500 shares of common stock
at $1.38, $2.63, $3.00 and $1.81 per share, respectively, to Henry J.
Cardello, President and a director of the Company, for services performed
while under a consulting agreement with Marketing Venture of America, Inc.
The warrants were valued at fair market value on the date of grant. The fair
value of the warrants is $68,750, which the Company has amortized over the
term of the consulting agreement
2. In August 1998, five-year warrants were issued to William Young and
Rebecca Young, to purchase 50,000 shares of common stock at $3.125 per share.
The warrants were valued at fair market value on the date of grant. The fair
value of the warrants is $100,000, which the Company is amortizing over the
term of the investor relations agreement.
3. In October 1998, seven-year warrants were issued to American Home
Products Corporation to purchase 200,000 shares of common stock at $2.45 per
share, which was greater than the fair market value of the common stock on
the closing date. The fair value of the warrant is $250,000, which the
Company is amortizing over the term of the research and development program.
4. In December 1998, 318,800 shares of common stock were issued to NMI
as part of the total consideration paid for the asset acquisition from NMI.
The shares were issued at $1.96 per share, which was greater than the fair
market of the common stock on the closing date.
26