UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-QSB
(MARK ONE)
|X| QUARTERLY REPORT PURSUANT -TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2006
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ________ TO ________
COMMISSION FILE NUMBER 000-32045
DIOMED HOLDINGS, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 84-1480636
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
1 DUNDEE PARK
ANDOVER, MA 01810
(Address of principal executive offices) (Zip Code)
(978) 475-7771
(Registrant's telephone number)
INDICATE BY CHECK MARK WHETHER THE REGISTRANT (1) HAS FILED ALL REPORTS REQUIRED
TO BE FILED BY SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 DURING
THE PRECEDING 12 MONTHS (OR FOR SUCH SHORTER PERIOD THAT THE REGISTRANT WAS
REQUIRED TO FILE SUCH REPORTS), AND (2) HAS BEEN SUBJECT TO SUCH FILING
REQUIREMENTS FOR THE PAST 90 DAYS. YES |X| NO |_|
AS OF NOVEMBER 9, 2006, THERE WERE 19,448,728 SHARES OF COMMON STOCK, PAR VALUE
$0.001, OUTSTANDING.
DIOMED HOLDINGS, INC. AND SUBSIDIARIES
QUARTERLY REPORT ON FORM 10-QSB
FOR THE THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 2006
TABLE OF CONTENTS
Item Page
Number Number
- ------ ------
Part I - Financial Information
1 Condensed Consolidated Balance Sheets - F-1
September 30, 2006 (unaudited) and December 31, 2005
Unaudited Consolidated Statements of Operations - F-2
Three Months and Nine Months Ended September 30, 2006 and 2005
Unaudited Consolidated Statements of Cash Flows - F-3
Nine Months Ended September 30, 2006 and 2005
Notes to Consolidated Financial Statements F-4
2 Management's Discussion and Analysis of Operations 1
3 Controls and Procedures 15
Part II - Other Information 16
1 Legal Proceedings 16
4 Submission of Matters to a vote of Security Holders 18
6 Reports on Form 8-K 18
Signatures 20
Diomed Holdings, Inc.
Condensed Consolidated Balance Sheets
As of September 30, 2006 (unaudited) and December 31, 2005
September 30, December 31,
2006 2005
------------- ------------
Assets
Current assets:
Cash and cash equivalents $12,941,840 $ 9,562,087
Short term investments 498,595 3,566,454
Accounts receivable, net 2,629,923 2,824,717
Inventories 3,874,721 3,059,886
Prepaid expenses and other current assets 713,820 444,453
----------- -----------
Total current assets 20,658,899 19,457,597
Property, plant and equipment, net 1,272,790 1,171,703
Intangible assets, net 4,125,294 4,302,915
Investment in Luminetx 1,000,000 500,000
Other assets 229,014 294,810
----------- -----------
Total assets $27,285,997 $25,727,025
=========== ===========
Liabilities, preferred stock and stockholders' equity
Current liabilities:
Accounts payable $ 4,180,333 $ 3,561,786
Accrued expenses 2,104,597 2,298,823
Current portion of deferred revenue 260,625 257,889
Bank loan 420,519 53,924
Current maturities of capital lease obligations 1,389 2,047
EVLT technology payable (zero face value at September 30,
2006 and $250,000 face value, net of $4,902 debt
discount at December 31, 2005) -- 245,098
Warrant liability -- 1,898,213
----------- -----------
Total current liabilities 6,967,463 8,317,780
Deferred revenue, net of current portion 108,527 144,428
Capital lease obligation, net of current maturities 2,778 4,094
Convertible notes payable ($3,712,000 face value, net of
$3,049,341 debt discount at September 30, 2006 and
$3,712,000 face value, net of $1,081,727 debt
discount at December 31, 2005) 662,659 2,630,273
----------- -----------
Total liabilities 7,741,427 11,096,575
----------- -----------
Commitments and contingencies
Preferred stock -- 7,819,658
----------- -----------
Stockholders' equity 19,544,570 6,810,792
----------- -----------
Total liabilities, preferred stock and stockholders' equity $27,285,997 $25,727,025
=========== ===========
The accompanying notes are an integral part of these consolidated financial
statements.
F-1
Diomed Holdings, Inc.
Unaudited Condensed Consolidated Statements of Operations
Three Months and Nine Months Ended September 30, 2006 and 2005
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------- --------------------------
2006 2005 2006 2005
----------- ----------- ------------ -----------
Revenues $ 5,321,080 $ 4,582,840 $ 15,972,476 $13,488,120
Cost of revenues 3,042,223 2,511,536 8,786,487 7,325,127
----------- ----------- ------------ -----------
Gross profit 2,278,857 2,071,304 7,185,989 6,162,993
----------- ----------- ------------ -----------
Operating expenses:
Research and development 422,596 403,498 1,140,170 1,150,712
Selling and marketing 2,687,000 2,080,723 8,490,263 6,693,660
General and administrative 1,906,886 1,811,921 5,865,439 5,475,535
----------- ----------- ------------ -----------
Total operating expenses 5,016,482 4,296,142 15,495,872 13,319,907
----------- ----------- ------------ -----------
Loss from operations (2,737,625) (2,224,838) (8,309,883) (7,156,914)
----------- ----------- ------------ -----------
Other (income) expense:
(Gain)/loss on fair value adjustment on
warrant liability 68,995 -- (971,442) --
Interest expense, non-cash 96,078 98,904 288,229 1,502,760
Interest expense, net, and other (income) 76,480 35,405 (958) 187,773
----------- ----------- ------------ -----------
Total other (income) expense, net 241,553 134,309 (684,171) 1,690,533
----------- ----------- ------------ -----------
Net loss (2,979,178) (2,359,147) (7,625,712) (8,847,447)
Less preferred stock cash dividends (149,063) -- (447,353) --
Less preferred stock non-cash dividends (167,480) (762,656) (483,586) (762,656)
Less beneficial conversion feature on
2006 preferred stock (469,938) -- (469,938) --
Less deemed dividend on the exchange of
2005 preferred stock (2,980,439) -- (2,980,439) --
----------- ----------- ------------ -----------
Net loss applicable to common stockholders $(6,746,098) $(3,121,803) $(12,007,028) $(9,610,103)
=========== =========== ============ ===========
Basic and diluted net loss per share
applicable to common stockholders $ (0.35) $ (0.16) $ (0.62) $ (0.50)
=========== =========== ============ ===========
Basic and diluted weighted average
common shares outstanding 19,448,728 19,423,728 19,447,812 19,143,276
=========== =========== ============ ===========
The accompanying notes are an integral part of these consolidated financial
statements.
F-2
DIOMED HOLDINGS, INC.
Unaudited Consolidated Statements of Cash Flows
Nine Months Ended
September 30,
-------------------------
2006 2005
----------- -----------
Cash Flows from Operating Activities:
Net loss $(7,625,712) $(8,847,447)
Adjustments to reconcile net loss
to net cash used in operating activities:
Depreciation and amortization 690,166 688,545
Amortization of EVLT(R) discount 4,902 57,025
Non-cash interest expense 288,229 1,502,760
Accretion of discount on marketable securities (105,157) --
Amortization of deferred financing costs 72,727 --
Fair value of stock options 443,524 35,440
Gain on fair value adjustment on warrant liability (971,442) --
Changes in operating assets and liabilities:
Accounts receivable 194,794 (592,694)
Inventories (814,835) (897,840)
Prepaid expenses and other current assets (269,367) (194,963)
Deposits (6,931) 175,277
Accounts payable 368,547 952,423
Accrued expenses and deferred revenue (227,391) 392,330
----------- -----------
Net cash used in operating activities (7,957,946) (6,729,144)
----------- -----------
Cash Flows from Investing Activities:
Purchase of property and equipment (500,012) (406,048)
Purchase of available for sale securities (687,099) (1,749,323)
Proceeds from maturities of available for sale
securities 3,800,000 --
Note receivable - Luminetx (500,000)
Investment in Luminetx (250,000) --
----------- -----------
Net cash provided by (used in) investing activities 2,362,889 (2,655,371)
----------- -----------
Cash Flows from Financing Activities:
Net proceeds (payments) on bank borrowings 366,595 193,329
Payments on EVLT(R) purchase obligation (250,000) (750,000)
Proceeds from the exercise of warrants -- 404,903
Dividend payments (447,353) --
Payments on capital lease obligations (1,974) (40,168)
Proceeds from preferred stock financing 9,349,400 10,000,000
----------- -----------
Net cash provided by financing activities 9,016,668 9,808,064
----------- -----------
Effect of Exchange Rate Changes (41,858) (59,095)
----------- -----------
Net Increase in Cash and Cash Equivalents 3,379,753 364,454
Cash and Cash Equivalents, beginning of period 9,562,087 14,436,053
----------- -----------
Cash and Cash Equivalents, end of period $12,941,840 $14,800,507
=========== ===========
Supplemental Disclosure of Cash Flow Information:
Cash paid for interest $ 275,883 $ 228,647
=========== ===========
Non-cash Investing and Financing Activities:
Fair value of warrants exchanged for distribution rights $ 137,403 $ 332,630
=========== ===========
Value ascribed to debt discount related toconvertible debt $ 2,255,843 $ --
=========== ===========
Fair value adjustment on preferred stock to bring preferred
stock to its immediately exchangeable value $ 2,980,439 $ --
=========== ===========
Non-cash note payable for Luminetx investment $ 250,000 $ --
=========== ===========
The accompanying notes are an integral part of these consolidated financial
statements.
F-3
DIOMED HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006
(UNAUDITED)
(1) OPERATIONS
Diomed Holdings, Inc. ("Diomed" or "the Company") develops and commercializes
minimally invasive medical procedures that employ its laser technologies and
associated disposable products. Using its proprietary technology, including its
exclusive rights to U.S. Patent No. 6,398,777, the Company currently focuses on
endovenous laser treatment (EVLT(R)) of varicose veins. The Company also
develops and markets lasers and disposable products for photodynamic therapy
(PDT) cancer procedures and products for other clinical applications, including
dental and general surgical procedures.
In developing and marketing its clinical solutions, the Company uses proprietary
technology and aims to secure strong commercial advantages over competitors by
gaining governmental approvals in advance of others, by developing and offering
innovative practice enhancement programs, including physician training and
promotional materials, and by obtaining exclusive commercial arrangements. To
optimize revenues, Diomed focuses on clinical procedures that generate revenues
from both capital equipment and disposable products, such as procedure kits and
optical fibers.
Diomed's high power semiconductor diode lasers combine clinical efficacy,
operational efficiency and cost effectiveness in a versatile, compact,
lightweight, easy-to-use and easy-to-maintain system. Along with lasers and
single-use procedure kits for EVLT(R), the Company provides its customers with
state of the art physician training and practice development support. The
EVLT(R) procedure and the Company's related products were cleared by the United
States FDA in January of 2002.
(2) BASIS OF PRESENTATION
In the opinion of management, these unaudited consolidated financial statements
contain all adjustments considered normal and recurring and necessary for their
fair presentation. Interim results are not necessarily indicative of results to
be expected for the year. These interim financial statements have been prepared
in accordance with the instructions for Form 10-QSB, and therefore, do not
include all information and footnotes necessary for a complete presentation of
operations, financial position, and cash flows of the Company in conformity with
accounting principles generally accepted in the United States. The Company filed
with the Securities and Exchange Commission its 2005 annual report on Form
10-KSB/A on April 13, 2006, which included audited consolidated financial
statements for the year ended December 31, 2005, and included information and
footnotes necessary for such presentation. These unaudited consolidated
financial statements should be read in conjunction with the audited consolidated
financial statements and the notes thereto included in our annual report on Form
10-KSB/A for the year ended December 31, 2005.
(3) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Our Annual Report on Form 10-KSB/A for the year ended December 31, 2005 includes
a comprehensive summary of the significant accounting policies and methods used
in the preparation of our consolidated financial statements. The application of
these policies has a significant impact on our reported results. In addition,
the application of some of these policies depends on management's judgment, with
financial reporting results relying on estimations and assumptions about the
effect of matters that are inherently uncertain. For all of these policies,
management cautions that future events rarely develop exactly as forecast and
the best estimates routinely require adjustment.
F-4
DIOMED HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006
(UNAUDITED)
(a) INVENTORIES
Inventories are valued at the lower of cost (first-in, first-out) or market.
Work-in-progress and finished goods consist of materials, labor and
manufacturing overhead. Inventories consist of the following:
September 30, December 31,
2006 2005
------------- -----------
Raw Materials $1,532,738 $1,415,546
Work-in-Process 767,871 674,010
Finished Goods 1,574,112 970,330
---------- ----------
$3,874,721 $3,059,886
========== ==========
(b) DEFERRED REVENUE
Deferred revenue at September 30, 2006 was as follows:
September 30,
2006
-------------
Beginning balance $ 402,317
Additions 402,245
Revenue/release (435,410)
---------
Ending balance $ 369,152
=========
(c) ACCOUNTING FOR STOCK-BASED COMPENSATION
Effective January 1, 2006, the Company adopted Statement No. 123R, Share-Based
Payment ("SFAS 123R"), which requires companies to measure and recognize
compensation expense for all share-based payment awards made to employees and
directors based on estimated fair values. SFAS 123R is being applied on the
modified prospective basis. Prior to the adoption of SFAS 123R, the Company
accounted for its stock-based compensation plans under the recognition and
measurement principles of Accounting Principles Board (APB) Opinion No. 25,
Accounting for Stock Issued to Employees, as provided by SFAS 123, "Accounting
for Stock Based Compensation" ("SFAS 123") and accordingly, recognized no
compensation expense related to the stock-based plans as stock options granted
to employees and directors were equal to the fair market value of the underlying
stock at the date of grant. In March 2005, the SEC issued Staff Accounting
Bulletin No. 107 ("SAB 107") relating to SFAS 123R. The Company has applied the
provisions of SAB 107 in its adoption of SFAS 123R.
Under the modified prospective approach, SFAS 123R applies to new awards and to
awards that were outstanding on January 1, 2006 that are subsequently modified,
repurchased or cancelled. Under the modified prospective approach, compensation
cost recognized includes compensation cost for all share-based payments granted
prior to, but not yet vested on, January 1, 2006, based on the grant-date fair
value estimated in accordance with the provisions of SFAS 123, and compensation
cost for all share-based payments granted subsequent to January 1, 2006, based
on the grant-date fair value estimated in accordance with the provisions of SFAS
123R. Prior periods were not restated to reflect the impact of adopting the new
standard. During the three and nine month periods ended September 30, 2006, the
Company recorded $126,000 and $444,000, respectively, in non-cash charges in
accordance with of SFAS 123R. As of September 30, 2006, there was approximately
$801,000 of total unrecognized compensation cost related to unvested options.
That cost is expected to be recognized over a weighted average period of 1.92
years. The Company plans on obtaining shares to be issued upon exercise of stock
options through authorized common stock. There have been no stock options
exercised during the nine-month period ended September 30, 2006.
F-5
DIOMED HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006
(UNAUDITED)
The following table illustrates the effect on net loss and net loss per share
had the Company accounted for stock-based compensation in accordance with SFAS
123R in fiscal 2005:
Three Months Nine Months
Ended Ended
September 30, September 30,
2005 2005
------------- ------------
Net loss applicable to common
stockholders as reported: $(3,121,803) $ (9,610,103)
Deduct: total stock-based employee compensation;
expense determined under the fair value-based
method for all awards, net of tax (426,732) (1,255,352)
----------- ------------
Proforma net loss applicable to common
stockholders $(3,548,535) $(10,865,455)
=========== ============
Loss per share:
Basic and diluted - as reported $ (0.16) $ (0.50)
=========== ============
The weighted average grant date fair value of options granted during the nine
months ended September 30, 2006 of $1.62 was estimated on the grant date using
the Black-Scholes option-pricing model with the following assumptions: expected
volatility of 86.95%, expected term of 5.68 years, risk-free interest rate of
4.34%, and expected dividend yield of 0%. The weighted average grant date fair
value of options granted during the nine months ended September 30, 2005 of
$2.58 was estimated on the grant date using the Black-Scholes option-pricing
model with the following assumptions: expected volatility of 75%, expected term
of 4.9 years, risk-free interest rate of 3.72%, and expected dividend yield of
0%. Expected volatility is based on a weighted average of the historical
volatility of the Company's stock and peer company volatility. The average
expected life used in 2006 was calculated using the simplified method under SAB
107. The risk-free rate is based on the rate of U.S. Treasury zero-coupon issues
with a remaining term equal to the expected life of option grants. The Company
uses historical data to estimate pre-vesting forfeiture rates.
(d) COMPREHENSIVE INCOME
SFAS No. 130, Reporting Comprehensive Income, requires disclosure of all
components of comprehensive income (loss). Comprehensive income is defined as
the change in stockholders' equity of a business enterprise during a period from
transactions and other events and circumstances from non-owner sources. For all
periods presented, comprehensive loss consists of the Company's net loss,
changes in the cumulative translation adjustment account, and unrealized gains
(loss) on marketable securities. Comprehensive net loss for all periods
presented is as follows:
F-6
DIOMED HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006
(UNAUDITED)
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------- --------------------------
2006 2005 2006 2005
----------- ----------- ----------- -----------
Net loss $(2,979,178) $(2,359,147) $(7,625,712) $(8,847,447)
Unrealized holding gain (loss)
on marketable securities 29 1,768 (202) (331)
Foreign currency translation adjustment 37,559 140,636 164,378 (42,836)
----------- ----------- ----------- -----------
Comprehensive loss $(2,941,590) $(2,216,743) $(7,461,536) $(8,890,614)
=========== =========== =========== ===========
(e) SHORT TERM INVESTMENTS
Marketable securities with original maturities greater than three months are
classified as short-term investments. Investments designated as short-term
consist of U.S. Agency discount notes and corporate bonds, are classified as
available-for-sale, and are reported at fair value using the specific
identification method. Unrealized gains and losses, net of related tax effects,
are reflected in other comprehensive income (loss) until realized.
Marketable securities included in cash and cash equivalents and short term
investments at September 30, 2006, all of which mature within one year, consist
of the following:
Unrealized Unrealized
Amortized Cost Fair Value Gains Losses
-------------- ---------- ---------- ----------
Money Market Funds $1,476,678 $1,476,678 $-- $ --
Commercial Paper 498,501 498,595 -- (94)
---------- ---------- --- ----
$1,975,179 $1,975,273 $-- $(94)
========== ========== === ====
As Reported:
Unrealized Unrealized
Amortized Cost Fair Value Gains Losses
-------------- ---------- ---------- ----------
Cash and Cash
Equivalents $1,476,678 $1,476,678 $-- $ --
Marketable Securities 498,501 498,595 -- (94)
---------- ---------- --- ----
$1,975,179 $1,975,273 $-- $(94)
========== ========== === ====
Marketable securities included in cash and cash equivalents and short term
investments at December 31, 2005, all of which mature within one year, consist
of the following:
Unrealized Unrealized
Amortized Cost Fair Value Gains Losses
-------------- ---------- ---------- ----------
Money Market Funds $ 3,815,711 $ 3,815,712 $ -- $ --
Commercial Paper 5,852,606 5,852,408 -- (198)
U.S. Agency Notes 2,096,266 2,096,760 495 --
----------- ----------- ---- -----
$11,764,583 $11,764,880 $495 $(198)
=========== =========== ==== =====
As Reported:
Unrealized Unrealized
Amortized Cost Fair Value Gains Losses
-------------- ---------- ---------- ----------
Cash and Cash
Equivalents $ 8,197,697 $ 8,198,426 $729 $ --
Marketable Securities 3,566,886 3,566,454 -- (432)
----------- ----------- ---- ----
$11,764,583 $11,764,880 $729 $(432)
=========== =========== ==== =====
Net unrealized losses for the nine month period ended September 30, 2006 totaled
$94. The unrealized losses were caused by increasing market interest rates.
Based on the scheduled maturities of these marketable securities and our intent
and ability to hold these securities until maturity, we have concluded that
these unrealized losses are not other-than-temporary.
F-7
DIOMED HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006
(UNAUDITED)
(4) NET LOSS PER SHARE
Net loss per share is computed based on the guidance of SFAS No. 128, Earnings
per Share. SFAS No. 128 requires companies to report both basic loss per share,
which is based on the weighted average number of common shares outstanding, and
diluted loss per share, which is based on the weighted average number of common
shares outstanding and the dilutive potential common shares outstanding using
the treasury stock method. The calculation of net loss applicable to common
stockholders for the three and nine month periods ended September 30, 2006
includes $167,480 and $483,586, respectively, in non-cash preferred stock
dividends accreted for future increasing rate dividends and $149,063 and
$447,353, respectively, of preferred stock cash dividends earned during the
period related to the September 30, 2005 private placement. Upon completion of
the 2006 preferred stock financing, the Company recorded a one-time, non-cash,
non-operating beneficial conversion feature charge of $469,938 as the market
price of the Company's common stock on September 29, 2006 of $1.20 was above the
$1.15 effective conversion price of the immediately convertible preferred stock.
As a result of the 2006 preferred stock financing, the Company exchanged the
2005 preferred stock and recorded a one-time, non-cash, non-operating deemed
dividend of $2,980,439 based on the difference between the fair value of
consideration transferred to the holders of the preferred stock over the
carrying amount, net of original issuance costs.
As a result of the losses incurred by the Company for the three and nine month
periods ended September 30, 2006 and 2005, respectively, all potential common
shares were antidilutive and were excluded from the diluted net loss per share
calculations. The following table summarizes securities outstanding as of each
of the periods, which were not included in the calculation of diluted net loss
per share since their inclusion would be antidilutive.
Three Months Ended Nine Months Ended
September 30, September 30,
---------------------- ----------------------
2006 2005 2006 2005
---------- --------- ---------- ---------
Common Stock Options 2,423,787 1,711,225 2,423,787 1,711,225
========== ========= ========== =========
Common Stock Warrants 6,055,303 5,198,452 6,055,303 5,198,452
========== ========= ========== =========
Convertible Debt 3,227,826 1,620,961 3,227,826 1,620,961
========== ========= ========== =========
Preferred Stock 17,354,347 4,000,000 17,354,347 4,000,000
========== ========= ========== =========
(5) LINE OF CREDIT ARRANGEMENTS
Diomed, Ltd., the Company's United Kingdom-based subsidiary, utilizes an
overdraft facility as well as an accounts receivable line of credit with
Barclays Bank, limited to the lesser of (GBP) 100,000 or 80% of eligible
accounts receivable. The Company received a waiver to increase the overdraft to
80% of accounts receivable or $420,519 at September 30, 2006. The credit line
bears interest at a rate of 2.5% above Barclays' base rate (4.75% at September
30, 2006) and borrowings are due upon collection of receivables from customers.
As security for the line of credit, Barclay's Bank has a lien on all of the
assets of Diomed, Ltd., excluding certain intellectual property. As of September
30, 2006, there was $420,519 outstanding and at December 31, 2005, there was
approximately $53,924 outstanding under this line of credit.
F-8
DIOMED HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006
(UNAUDITED)
(6) STOCK OPTIONS
(a) In November 2003, the Company's stockholders approved the 2003 Omnibus Plan,
under which the Company reserved 1,600,000 shares of common stock for future
issuance. In May 2005, the Company's stockholders approved an increase of
1,500,000 reserved shares providing for a total of 3,100,000 shares of common
stock reserved for future issuance. The 2003 Omnibus Plan provides for grants or
awards of stock options, restricted stock awards, restricted stock units,
performance grants, stock awards, and stock appreciation rights. Only present
and future employees and outside directors and consultants are eligible to
receive incentive awards under the 2003 Omnibus Plan.
The exercise price and vesting are determined by the Board of Directors at the
date of grant. Options generally vest over two to three years and expire 10
years after the date of grant. Incentive stock options under the Plans are
granted at not less than fair market value per share of Common Stock on the date
of grant or 110% of fair market value for any stockholder who holds more than
10% of the total combined voting power of all classes of stock of the Company.
The Company plans on settling any exercised employee stock options by issuing
authorized but unissued shares.
As of September 30, 2006, 853,725 options and other incentive stock awards were
available for future grants under the 2003 Omnibus Plan. In addition, 4,542
options were available under the 2001 Plan and 339 options were available under
the 1998 Plan as of September 30, 2006.
A summary of stock option activity for the 2003 Omnibus Plan, the 2001 Plan and
the 1998 Plan is as follows:
Range of Number Weighted Average Weighted Average
Exercise Price of Shares Exercise Price Remaining Life
--------------- --------- ---------------- ----------------
Outstanding, December 31, 2005 $2.00 - $205.75 1,733,398 $6.01
Granted 1.02 - 2.70 722,250 2.21
Forfeited 2.24 - 133.75 (55,168) 8.45
--------------- --------- -----
Outstanding, September 30, 2006 $1.02 - $205.75 2,400,480 $4.77 8.09
=============== ========= ===== ====
Exercisable, September 30, 2006 $1.02 - $205.75 1,880,148 $5.45 7.79
=============== ========= ===== ====
The intrinsic value of options vested at September 30, 2006 was $698. The fair
value of options vested at September 30, 2006 was $455,027. At September 30,
2006, there were 520,332 unvested shares outstanding with a weighted average
grant date fair value of $1.65.
F-9
DIOMED HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006
(UNAUDITED)
The following table summarizes currently outstanding and exercisable options as
of September 30, 2006.
OUTSTANDING EXERCISABLE
---------------------------------------------- ----------------------------
Weighted Average Weighted Average
Exercise Price Shares Remaining Life* Exercise Price Shares Exercise Price
- ---------------- --------- --------------- ---------------- --------- ----------------
$ 1.02 - $2.15 112,565 7.84 $ 1.87 86,440 $ 1.95
2.16 - 2.29 639,143 9.29 2.24 211,184 2.24
2.30 - 4.00 170,417 7.98 3.19 105,836 3.20
4.01 - 4.75 746,211 8.08 4.24 746,211 4.24
4.76 - 5.00 600,200 7.41 5.00 598,533 5.00
5.01 - 11.50 104,491 6.39 8.59 104,491 8.59
11.51 - 49.00 12,256 4.72 31.20 12,256 31.20
49.01 - 87.00 4,700 5.31 51.06 4,700 51.06
87.01 - 164.00 4,113 1.67 114.55 4,113 114.55
164.01 - 205.75 6,384 1.50 174.47 6,384 174.47
--------- ------- --------- -------
2,400,480 $ 4.77 1,880,148 $ 5.45
========= ======= ========= =======
* Weighted average remaining contractual life (in years).
(b) A summary of warrant activity is as follows:
Weighted Average
Range of Number of Weighted Average Remaining Contractual
Exercise Price Shares Exercise Price Life (In Years)
-------------- --------- ---------------- ---------------------
Outstanding, December 31, 2005(i) $0.025 - $2.90 5,196,775 $2.35 4.00
Granted to 2005 PIPE Holders(ii) 1.98 472,000 1.98 4.00
Granted to Placement Agent 2003(iii) 1.50 - 1.77 16,528 1.72 2.16
Granted to Placement Agent 2006(iv) 1.15 370,000 1.15 5.00
-------------- --------- ----- ----
Outstanding, September 30, 2006 $0.025 - $2.90 6,055,303 $1.63 3.61
============== ========= ===== ====
Exercisable, September 30, 2006 $0.025 - $2.90 6,055,303 $1.63 3.61
============== ========= ===== ====
(i) the exercise price of the warrants to purchase shares of the common stock
issued to the investors in the Company's financing transaction completed
October 28, 2004 (the "2004 Warrants") was reduced from $2.10 to $1.15 per
share of the common stock;
(ii) the exercise price of the warrants to purchase shares of the common stock
issued to the investors in the Company's financing transaction completed
September 30, 2005 (the "2005 Warrants") was reduced from $2.50 to $1.98
per share, and the number of shares of the common stock issuable upon
exercise of the 2005 Warrants was increased from 1,800,000 to 2,272,000;
See Footnote 9.
(iii) the exercise price of certain warrants to purchase shares of the common
stock issued to designees of the Company's former placement agent, Sunrise
Securities Corp. (the "Sunrise Warrants"), was reduced and the number of
shares of common stock issuable upon exercise of these Sunrise Warrants
was increased from 139,315 to 155,843 as follows:
- - the exercise price of certain Sunrise Warrants was decreased from $2.32 to
$1.77 per share, and the number of shares of common stock issuable upon
exercise of these Sunrise Warrants was increased from 42,282 to 55,559;
- - the exercise price of certain Sunrise Warrants was decreased from $1.93 to
$1.50 per share, and the number of shares of common stock issuable upon
exercise of these Sunrise Warrants was increased from 11,455 to 14,706;
and
- - the exercise price of certain Sunrise Warrants was decreased from $2.10 to
$1.15 per share (no adjustments impacted the remaining Sunrise Warrants).
(iv) The Company granted the placement agent, Musket Research Associates, Inc.,
370,000 warrants at an exercise price of $1.15 per share of common stock
under the 2006 preferred stock financing.
F-10
DIOMED HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006
(UNAUDITED)
(7) SEGMENT REPORTING
The Company's reportable segments are determined by product type: laser systems;
and fibers, accessories and service. The Board of Directors evaluates segment
performance based on revenue. Accordingly, all expenses are considered corporate
level activities and are not allocated to segments. Also, the Board of Directors
does not assign assets to its segments.
This table presents revenues by reportable segment:
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------- -------------------------
2006 2005 2006 2005
---------- ---------- ----------- -----------
Laser systems $1,980,183 $2,193,635 $ 6,125,422 $ 6,762,513
Fibers, accessories, and service 3,340,897 2,389,205 9,847,054 6,725,607
---------- ---------- ----------- -----------
Total $5,321,080 $4,582,840 $15,972,476 $13,488,120
========== ========== =========== ===========
The following table represents percentage of revenues and long-lived assets by
geographic destination:
% of Revenue Long-lived Assets
------------------------------- ----------------------------
Nine Months Ended September 30,
------------------------------- September 30, December 31,
2006 2005 2006 2005
-------- -------- ------------- ------------
United States 75% 75% $6,226,894 $5,930,287
Asia/Pacific 9% 14% -- --
Europe 12% 8% 400,204 339,141
Other 4% 3% -- --
---- ---- ---------- ----------
Total 100% 100% $6,627,098 $6,269,428
==== ==== ========== ==========
F-11
DIOMED HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006
(UNAUDITED)
(8) COMMITMENTS AND CONTINGENCIES
On July 21, 2005, a lawsuit was filed against us in the United States District
Court for the Northern District of California by VNUS Medical Technologies,
Inc., alleging infringement of U.S. Patents Nos. 6,258,084, 6,638,273,
6,752,803, and 6,769,433. The complaint was served on us on July 27, 2005. On
September 15, 2005, the Company filed an answer denying the allegations of
infringement, and counterclaiming against VNUS for a declaration that none of
the patents are infringed and that they are all invalid.
On October 12, 2005, VNUS served an amended complaint adding two additional
parties, AngioDynamics, Inc. and Vascular Solutions, Inc., as defendants. On
October 31, 2005, the Company filed an answer to the First Amended Complaint,
again denying the allegations of infringement, and counterclaiming against VNUS
for a declaration that none of the patents are infringed, that they are all
invalid and that two of VNUS' patents are unenforceable for inequitable conduct.
The Company is now proceeding with the discovery phase of this litigation. A
claim construction hearing was held on October 30, 2006. The court will provide
their ruling on the hearing at a later date. The Company intends to continue to
defend its position, however, management is unable to predict the outcome of
this lawsuit.
During 2004, the Company filed lawsuits in the United States Federal District
Court for the District of Massachusetts against four competitors seeking
injunctive relief and damages for infringement of the Company's U.S. Patent
Number 6,398,777 covering the endovascular laser treatment of varicose veins
which the Company uses in its EVLT(R) product line. The Company is presently
prosecuting these lawsuits, however, management is unable to predict the outcome
of these lawsuits.
On August 30, 2006 U.S. District Judge Nathaniel M. Gorton ruled that the '777
patent is valid and enforceable. In granting Diomed's motion for summary
judgment; the court rejected defenses advanced by defendants AngioDynamics and
Vascular Solutions that Diomed's patent was invalid and unenforceable. The court
denied separate motions by each of the parties for summary judgment on the issue
of infringement by the defendants, in effect ruling that Diomed is entitled to
proceed to trial on its claims for an injunction and damages against the
defendants. If the Company does not prevail in the infringement actions and is
not be able to exclude third parties from using the Company's EVLT(R)
technology, the EVLT(R) patent may be determined to be impaired and the
Company's EVLT(R) revenue stream may be adversely affected.
Insofar as legal proceedings other than patent litigation are concerned, from
time to time the Company is the defendant in legal and administrative
proceedings and claims of various types. Although any such litigation contains
an element of uncertainty, management, in consultation with the Company's
general counsel, presently believes that the outcome of such proceedings or
claims which are pending or known to be threatened, or all of them combined,
will not have a material adverse effect on the Company.
(9) PRIVATE PLACEMENT EQUITY FINANCING COMPLETED SEPTEMBER 29, 2006
On September 29, 2006, the Company issued 1,735.4347 shares of preferred stock,
each share of which has a stated value of $11,500 per share, for gross proceeds
of $10,010,000. The Company issued 870.4348 of these shares to investors who
purchased these shares for cash at a price of $11,500 per share, and the Company
issued 864.9999 shares to investors who tendered their shares of the 3,975,000
outstanding shares of preferred stock the Company issued in 2005 in exchange for
shares of the 2006 preferred stock, all in accordance with the terms of a
Securities Purchase Agreement the Company entered into with the investors in
July 2006.
Exchange Provisions. At an investor's option, each share of the 2006 preferred
stock may be exchanged for shares of the common stock. Subject to applicable
limitations on ownership (described below), each share of the 2006 preferred
stock is exchangeable for the number of shares of the common stock equal to
$11,500 divided by the exchange rate. The exchange rate initially is $1.15 and
is subject to certain adjustments, including reduction if we make certain
dilutive issuances of equity securities in the future. The antidilution
adjustment provides that if the Company sells shares of the common stock (or the
rights to acquire the common stock) for a price lower than the then-current
exchange rate, the exchange rate will be reduced to the weighted average price
of the common stock issued after giving effect to the dilutive issuance.
F-12
DIOMED HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006
(UNAUDITED)
The Company also has the right to require the investors to exchange their shares
of the 2006 preferred stock if the trading price of the common stock achieves
and remains at a price level of $2.875 per share and certain other conditions
are satisfied. Upon a change of control (as defined), shares of the preferred
stock will automatically be exchanged for the right to receive either (1) the
liquidation preference of the 2006 preferred stock of $13,800 per share or (2)
the consideration which would have become payable in the change of control
transaction to the holders of the preferred stock in respect of the shares of
common stock underlying the preferred stock, whichever is greater. For purposes
of the preferred stock, a "change of control" is defined to include only (i) the
sale by the Company of all or substantially all of our assets or (ii) a merger,
consolidation or other business combination where either (1) the Company is not
the surviving entity or (2) either the holders of the Company's capital stock
immediately prior to the transaction have 50% or less of the voting rights of
the surviving entity or own 50% or less of the outstanding voting securities of
the surviving entity immediately following the transaction or the board of
directors immediately prior to the transaction comprise 50% or less of the board
of directors of the surviving entity. A change in ownership of our outstanding
capital stock is excluded from the definition of "change in control."
Redemption. The investors do not have the right to require the Company to redeem
their shares of the 2006 preferred stock. The Company, however, has the right to
redeem the 2006 preferred stock after the fifth anniversary of the completion of
the financing transaction at a price equal to 120% of the issue price, or
$13,800 per share.
Dividends. Dividends do not accrue on the 2006 preferred stock unless and until
the Company completes a transaction in the future that reduces the effective
conversion price of our outstanding convertible debentures below the conversion
price in effect upon the completion of the financing transaction, $1.15, as a
result of the operation of the anti-dilution rights of the holders of the
debentures, but only if at the time of the future transaction the reduction in
conversion price affects debentures having an aggregate principal amount of at
least $1,000,000. Thereafter, dividends will accrue on the issued and
outstanding shares of the 2006 preferred stock at the rate of 15% per annum and
will be payable quarterly in arrears.
Voting Rights. The holders of 2006 preferred stock will be entitled to vote on
all matters submitted to a vote of the Company's stockholders, together with the
holders of common stock, voting as a single class. The holders of 2006 preferred
stock will vote their shares on the basis of the number of shares of common
stock into which the 2006 preferred stock is then exchangeable (subject to the
applicable limitations on ownership described below). If, under the Delaware
General Corporation Law, the holders of 2006 preferred stock are required to
approve any action by separately voting as a class, the vote of the holders of
at least 65% of the outstanding shares of the 2006 preferred stock will be
required to approve such action.
Liquidation. The 2006 preferred stock shall be preferred over and senior to the
common stock and any other class or series of capital stock created by the
Company. Upon the occurrence of any event causing our liquidation or any change
of control transaction (as defined) by the Company, the holders of
then-outstanding shares of preferred stock will be entitled to receive, from the
proceeds of such event or transaction, before any distribution is made to any
other class or series of capital stock, an amount equal to the greater of (i)
$13,800 per share of the preferred stock or (ii) such amount per share of the
preferred stock as would have been payable had each share been exchanged into
common stock immediately prior to the event or transaction. If there are
sufficient proceeds from the liquidation or change of control transaction (as
defined) remaining after the distribution to the holders of the preferred stock,
the remaining proceeds will be distributed ratably among the holders of the
common stock.
Anti-Dilution Adjustments to the Exchange Rate. The exchange rate of the 2006
preferred stock will be adjusted if the Company offers or sells any common stock
or common stock equivalent securities at an effective price per share of less
than the exchange rate of the 2006 preferred stock, initially, $1.15. The
exchange rate will not be adjusted, however, for the Company's issuance of
common stock or common stock equivalent securities exercisable below the
exchange rate if such issuance is limited to: (i) shares of common stock or
options issued to employees, officers, directors or consultants pursuant to an
equity plan approved by the stockholders or (ii) the exchange of exchangeable or
convertible securities already outstanding as of the date of the Securities
Purchase Agreement.
F-13
DIOMED HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006
(UNAUDITED)
Liquidated Damages. The Company may be required to pay liquidated damages to the
investors if the Company fails to timely comply with an investor's request to
exchange shares of the 2006 preferred stock for shares of the common stock or if
the Company does not timely remove restrictive legends from certificates
representing shares of the common stock when requested by the investor and
permitted by applicable law. The liquidated damages are payable in the amount of
1% per day of the issue price of the shares of the 2006 preferred stock subject
to the investor's request and are subject to an aggregate cap of 25% of the
issue price paid by the investor for the 2006 preferred stock (inclusive of any
other liquidated damages payable by us in respect of the 2006 preferred stock).
If the Company fails to timely issue shares of the common stock upon exchange or
remove legends from shares of the common stock when requested by investors and
permitted by applicable law and the investor purchases other shares of common
stock to settle the sale of shares of common stock that were intended to be
settled by shares of common stock issuable upon exchange of the unlegended
shares, then the Company may also be required to pay to the investors the
difference between the proceeds of sale of the shares of the common stock sold
and the price paid for the other shares of the common stock purchased for
settlement purposes.
Registration Rights. Upon completing the financing transaction on September 29,
2006, the Company entered into a registration rights agreement among the Company
and the investors. Pursuant to the Registration Rights Agreement, the Company
agreed to file a registration statement on Form SB-2 with the SEC, registering
for public resale the "registrable securities" consisting of the shares of the
common stock that are issuable upon exchange of the shares of 2006 preferred
stock issued to investors in the financing transaction and the shares of common
stock that are issuable upon exercise of the par warrants, as defined under the
Securities Purchase Agreement, should any par warrants be issued in lieu of
common stock as a result of applicable limitations on ownership.
The Company is required to file the registration statement within 45 days of the
closing of the financing transaction, and to use its best efforts to cause the
registration statement to be declared effective as soon as practicable but no
more than 120 days of the closing of the financing transaction. The Company
agreed to pay liquidated damages to the investors if the Company does not file
the registration statement within 45 days of the closing date of the financing
transaction, if the registration statement is not declared effective within 120
days of the closing date, or is not continually effective for any period that
exceeds 20 consecutive days or 30 aggregate days during any 12-month period, or
if the common stock does not remain listed on an applicable stock exchange after
the effective date of the registration statement. If any of the foregoing
occurs, the Company may be required to pay each investor liquidated damages for
the period from the date on which such event occurs until the event is cured, at
a monthly rate equal to 3% of the original issue price of the 2006 preferred
stock, prorated for partial months based on the number of days in the month. The
liquidated damages are subject to an aggregate cap of 25% of the issue price
paid by the investors for the shares of the 2006 preferred stock (inclusive of
any other liquidated damages payable by the Company in respect of the preferred
stock).
In accordance with EITF Number 00-27, "Application of Issue No. 98-5 to Certain
Convertible Instruments," (EITF 00-27), the Company compared the amount
allocated to the preferred stock of $10,010,000 to the fair value of the common
stock that would be received upon conversion to determine if a beneficial
conversion feature existed. The Company determined that a beneficial conversion
feature of $469,938 existed and, in accordance with EITF 00-27, amortized that
amount immediately to the value of the preferred stock, as the preferred stock
is immediately convertible. In accordance with EITF 98-5, this adjustment of
$469,938 is analogous to a dividend and recognized as a return to the
shareholders and has been included in the beneficial conversion feature of 2006
Preferred Stock in the Company's calculation of Net Loss Applicable to Common
stockholders and Basic and Diluted Net Loss per Share. The Company recorded the
2006 preferred stock to permanent equity in accordance with the terms of EITF
Abstracts - Appendix D - Topic D-98: Classification and Measurement of
Redeemable Securities ("Topic D-98").
The Company also issued 370,000 placement fee warrants to Musket Research
Associates, Inc. ("MRA") and $610,600 in cash in consideration of services to
both MRA and Roth Capital Partners. The placement fee warrants are exercisable
for five years from the date of listing with the American Stock Exchange at an
exercise price of $1.15 per share, subject to reduction in the case of dilutive
issuances.
F-14
DIOMED HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006
(UNAUDITED)
In addition, the holders of the Placement Fee Warrants may exercise their
warrants by means of a "cashless exercise" instead of paying cash to the Company
upon exercise, in which case the holder shall be entitled to receive a
certificate for the number of warrant shares equal to the quotient obtained by
dividing [(A-B)(X)] by (A), where:
A = the VWAP on the Trading Day immediately preceding the date of such
election;
B = the Exercise Price of this warrant, as adjusted; and
X = the number of Warrant Shares issuable upon exercise of this Warrant in
accordance with the terms of this Warrant by means of a cash exercise rather
than a cashless exercise
Where:
"VWAP" means, for any security as of any date, the price determined by the first
of the following clauses that applices: (a) if the common stock is then listed
or quoted on a Trading Market, the daily volume weighted average price of the
common stock for such date on the Trading Market on which the common stock is
then listed or quoted as reported by Bloomberg Financial L.P. (based on a
Trading Day from 9:30 a.m. Eastern Time to 4:02 p.m. Eastern Time); (b) if the
common stock is not then listed or quoted on a Trading Market and if prices for
the common stock are then quoted on the OTC Bulletin Board, the volume weighted
average price of the common stock for such date on the OTC Bulletin Board; (c)
if the common stock is not then listed or quoted on the OTC Bulletin Board and
if prices for the common stock are then reported in the "Pink Sheets" published
by the National Quotation Bureau Incorporated (or a similar organization or
agency succeeding to its functions of reporting prices), the most recent bid
price per share of the common stock so reported; or (d) in all other cases, the
fair market value of a share of common stock as determined by an independent
appraiser selected in good faith by the holders of the preferred stock and
reasonably acceptable to the Corporation, where "Trading Day" means a day on
which the common stock is traded on a Trading Market, and "Trading Market" means
the following markets or exchanges on which the common stock is listed or quoted
for trading on the date in question: the Nasdaq SmallCap Market, the American
Stock Exchange, the New York Stock Exchange or the Nasdaq National Market.
Effect on 2005 Preferred Stock
As a result of the 2006 preferred stock financing, the Company exchanged the
2005 preferred stock for new 2006 preferred stock. As illustrated in EITF Topic
D-42: The Effect on the Calculation of Earnings per Share for the Redemption or
Induced Conversion of Preferred Stock, ("Topic D-42"), the preferred
stockholders received additional value as the exchange price was adjusted down
below the original effective exchange price. The Company compared the excess of
the fair value of the consideration transferred to the holders of the 2005
preferred stock over the carrying amount of the 2005 preferred stock in the
Company's balance sheet to approximate the return to the 2005 preferred
stockholder. For the purposes of calculating the excess of (1) the fair value of
the consideration transferred to the holders of the 2005 preferred stock over
(2) the carrying amount of the 2005 preferred stock in the registrant's balance
sheet, the carrying amount of the 2005 preferred stock was reduced by the
issuance costs of the 2005 preferred stock.
Accordingly, since the value of the 864.999 shares of 2006 preferred stock can
be exchanged for common stock at the ratio of 1 for 10,000 common shares,
multiplied by the market price of common stock on the day of the closing ($1.20)
was $10,379,988; and the carrying value of $8,248,993 less the issuance costs of
$849,444 represents $7,399,549; the residual fair value of $2,980,439 was
recorded as an increase to preferred stock and a decrease to Additional Paid-in
Capital. The Company also recorded the $2,980,439 as a deemed dividend on the
exchange of the 2005 preferred stock in the calculation of basic and diluted
earnings per share. The 2005 preferred stock fair value of $11,229,432 was
reclassified to permanent equity as a result of the exchange and included within
the 2006 Preferred Stock on the Company's Balance Sheet in accordance with Topic
D-98.
As a result of the exchange and the corresponding implementation of a liquidated
damages cap in an amount that represents a reasonable percentage discount of the
fair value of an unregistered share versus a registered share, the warrants are
no longer required to be accounted for as a liability under EITF 00-19.
Therefore, the warrant liability of $926,771 was marked to market one final time
at September 29, 2006, through a charge to the Statement of Operations in the
amount of $68,995, and then reclassified to Additional Paid-in Capital.
F-15
DIOMED HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2006
(UNAUDITED)
In accordance with the contingent anti-dilution terms of the 2005 preferred
stock warrant agreement, the exercise price and number of warrants originally
issued to the 2005 preferred stockholders were adjusted so that the number of
warrants increased by 472,000 and the exercise price decreased to $1.98.
Increasing rate dividends and cash dividends of the 2005 Preferred Stock were
eliminated when the 2005 preferred stock was exchanged for the 2006 preferred
stock.
Effect on 2004 Convertible Debentures
The Company determined that the conversion and exercise price changes were not
modifications to the terms of their respective agreements, but were executions
of contingent conversion options within those agreements. Under EITF 00-27
"Application of Issue No. 98-5 to Certain Convertible Instruments" ("EITF
00-27"), the Task Force reached a consensus that if the terms of a contingent
conversion option do not permit an issuer to compute the number of shares that
the holder would receive if the contingent event occurs and the conversion price
is adjusted, an issuer should wait until the contingent event occurs and then
compute the resulting number of shares that would be received pursuant to the
new conversion price.
Prior to the transaction, the 2004 debt was convertible into 1,620,961 shares,
and after the 2006 Preferred Stock Financing the 2004 debt is convertible into
3,227,826 shares. The difference of 1,606,865 shares multiplied by the market
price of our common stock on the date of the closing of $1.20 results a new fair
value of $3,631,516. Because the result was in excess of the carrying value of
the debt, the Company recorded a discount of $2,255,843. This debt discount will
be accreted back to debt over the remaining two year term of the 2004
convertible debt agreement through charges against non-cash interest expense in
the Company's Statements of Operations.
The exercise price of warrants originally issued to the 2004 debt holders was
adjusted so that the exercise price decreased to $1.15 in accordance with the
original contingent anti-dilution terms of those 2004 debenture agreements.
(10) SUBSEQUENT EVENTS
Commitment for Luminetx Investment
Under separate agreement entered into on August 4, 2006, the Company agreed to
fund the $500,000 investment in two equal installments, one of which was paid
upon execution of the August 4, 2006 agreement, and the other was subsequently
paid on October 30, 2006. Effective August 4, 2006, and with the initial
payment, the Company was issued 250,000 shares of preferred stock and 50,000
warrants under the same terms as the private placement financing announced by
Luminetx on November 4, 2005. These shares and warrants were held as collateral
by Luminetx until the Company funded the remaining $250,000 installment on
October 30, 2006.
F-16
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF OPERATIONS
In this Quarterly Report, the terms "Company" and "Diomed Holdings" both refer
to Diomed Holdings, Inc. The term "Diomed" refers to the Company's principal
subsidiary, Diomed, Inc. and its consolidated subsidiaries. We use the terms
"we,", "our" and "us" when we do not need to distinguish among these entities or
their predecessors, or when any distinction is clear from the context.
This section contains forward-looking statements, which involve known and
unknown risks and uncertainties. These statements relate to our future plans,
objectives, expectations and intentions. These statements may be identified by
the use of words such as "may," "will," "should," "potential," "expects,"
"anticipates," "intends," "plans," "believes" and similar expressions. These
statements are based on our current beliefs, expectations and assumptions and
are subject to a number of risks and uncertainties. Our actual results could
differ materially from those discussed in these statements. Our 2005 Annual
Report on Form SEC 10-KSB/A (the "Annual Report") contains a discussion of
certain of the risks and uncertainties that affect our business. We refer you to
the "Risk Factors" on pages 23 through 38 of the Annual Report for a discussion
of certain risks, including those relating to our business as a medical device
company without a significant operating record and with operating losses, our
risks relating to the commercialization of our current and future products and
applications, and risks relating to our common stock and its market value.
In view of our relatively limited operating history, we have limited experience
forecasting our revenues and operating costs. Therefore, we believe that
period-to-period comparisons of financial results are not necessarily meaningful
and should not be relied upon as an indication of future performance. To date,
the Company has incurred substantial costs to create or acquire our products. As
of September 30, 2006, we had an accumulated deficit of approximately $88
million including $17.5 million in non-cash interest expense, $935,000 gain
related to the adjustment of the market value for the warrant liability, and
$444,000 in SFAS 123R compensation expense. We may continue to incur operating
losses due to spending on research and development programs, clinical trials,
regulatory activities, and sales, marketing and administrative activities. This
spending may not correspond with any meaningful increases in revenues in the
near term, if at all. As such, these costs may result in losses until such time
as the Company generates sufficient revenue to offset such costs.
The following discussion should be read in conjunction with the Consolidated
Financial Statements and Notes set forth above in this Quarterly Report and in
the Annual Report.
(1) OVERVIEW
We develop and commercialize minimally invasive medical procedures that employ
our laser technologies and associated disposable products. Using our proprietary
technology, including our exclusive rights to U.S. Patent No. 6,398,777, we
currently focus on endovenous laser treatment (EVLT(R)) of varicose veins. We
also develop and market lasers and disposable products for photodynamic therapy
(PDT) cancer procedures and products for other clinical applications, including
dental and general surgical procedures.
In developing and marketing our clinical solutions, we use proprietary
technology and aim to secure strong commercial advantages over competitors by
obtaining exclusive commercial arrangements, gaining governmental approvals in
advance of others and developing and offering innovative practice enhancement
programs, including physician training and promotional materials. To optimize
revenues, we focus on clinical procedures that generate revenues from both
capital equipment and disposable products, such as procedure kits and optical
fibers.
Our high power semiconductor diode lasers combine clinical efficacy, operational
efficiency and cost effectiveness in a versatile, compact, lightweight,
easy-to-use and easy-to-maintain system. Along with lasers and single-use
procedure kits for EVLT(R), we provide our customers with state-of-the-art
physician training and practice development support.
In 2001, we pioneered the commercialization of endovenous laser treatment
(EVLT(R)), an innovative minimally invasive laser procedure for the treatment of
varicose veins caused by greater saphenous vein reflux. In September 2001, we
were the first company to receive the CE mark of the European Economic Union for
approval for endovenous laser treatment with respect to marketing EVLT(R) in
Europe. In January 2002, we were the first company to receive FDA clearance for
endovenous laser treatment of the greater saphenous vein. In December 2004, we
received FDA clearance to expand the application of EVLT(R) to other superficial
veins in the lower extremities.
1
EVLT(R) was a primary source of revenue in the first three quarters of 2006, and
will continue to be our primary source of revenue in 2006. We believe that
EVLT(R) will achieve a high level of commercial acceptance due to its relative
short recovery period, immediate return to the patient's normal routine barring
vigorous physical activities, reduced pain and minimal scarring, and reduced
costs compared to other treatments for varicose veins. We developed our EVLT(R)
product line as a complete clinical solution and marketing model, including a
laser, disposable kit, clinical training and customized marketing programs, to
assist office-based and hospital-based physicians in responding to the growing
demand for treatment of varicose veins in a minimally invasive manner. We have
also published a health insurance reimbursement guide to assist physicians in
the reimbursement submission process. We believe that these attributes, in
addition to EVLT(R)'s superior clinical trial results, provide EVLT(R) with a
competitive advantage over competing traditional and minimally invasive varicose
vein treatment products.
We expect that as the number of EVLT(R) procedures increases, so will our sales
of associated disposable items. We believe that the U.S. represents the single
largest market for EVLT(R). We target our sales and marketing efforts at private
physician practices, hospitals, and clinics and focus on specialists in vascular
surgery, interventional radiology, general surgery, interventional cardiology,
phlebology, gynecology and dermatology.
We primarily use a direct sales force to market our products in the United
States and in select markets internationally, we also utilize a network of more
than 30 distributors to market our products abroad. In August 2005, we entered
into a three year agreement with Luminetx, Inc. to acquire exclusive
distribution rights to the VeinViewer(TM) Imaging System for the sclerotherapy,
phlebectomy and varicose vein treatment markets in the United States and United
Kingdom. The VeinViewer(TM) became commercially available in April 2006.
We have developed and maintain a website - www.EVLT.com - to assist both
patients and physicians. EVLT.com provides patients with education about
treatment options and benefits of EVLT(R) and provides physicians with education
about the EVLT(R) procedure. At www.EVLT.com, patients can also locate the
nearest physician performing EVLT(R) by inputting their city and state. We also
maintain a corporate website - www.diomedinc.com - which includes information
about the Company and our physician support initiatives, among other things.
Our management team focuses on developing and marketing solutions that address
serious medical problems with significant market potential. Our determinations
are based upon the number of procedures that may be conducted in a market and
projections of the associated revenue. Currently, EVLT(R) applications fall
within this guideline, and we believe that photodynamic therapy may have the
potential to do so at some time in the future. However, EVLT(R), and not PDT, is
the emphasis of our current business plan. Although we have continued to focus
on the development and growth of EVLT(R) sales both domestically and
internationally, we will continue to support the development and approval of new
applications for PDT products and the development of enhancements to our
products in order to further improve their quality, effectiveness and
manufacturability.
(2) RESULTS OF OPERATIONS
THREE MONTHS ENDED SEPTEMBER 30, 2006 COMPARED TO THE THREE MONTHS ENDED
SEPTEMBER 30, 2005
REVENUE
Diomed delivered revenue for the three months ended September 30, 2006 of
$5,321,000, increasing approximately $738,000, or 16%, from $4,583,000 for the
same period in 2005. Revenue from the EVLT(R) product line increased 22% over
the same period last year, including growth of 44% in disposable procedure
product revenue, demonstrating the continued and growing acceptance of EVLT(R)
by the medical community and patients alike.
In the three months ended September 30, 2006, approximately $1,980,000, or 37%,
of our total revenue was derived from laser sales, as compared to approximately
$2,194,000, or 48%, in the same period in 2005. In the three months ended
September 30, 2006, approximately $3,341,000, or 63%, of our total revenues were
from sales of disposable fibers and kits, accessories, service and
VeinViewer(TM), as compared to approximately $2,389,000, or 52%, in the same
period in 2005. We expect the proportion of revenue derived from disposables to
increase as we establish a larger base of installed lasers and the number of
EVLT(R) procedures performed grows.
2
The increase in revenue is attributable primarily to:
- increased penetration in the EVLT(R) market,
- the compounding impact of the recurring revenue stream from
disposable sales to both new and existing customers,
- the impact of increased acceptance of the EVLT(R) procedure and
expanded reimbursement coverage by health care insurers.
COST OF REVENUE AND GROSS PROFIT
Cost of revenue for the three months ended September 30, 2006 was $3,042,000,
increasing approximately $531,000, or 21%, from $2,511,000 for the three months
ended September 30, 2005. The increase in cost of revenue in 2006 was primarily
a result of increased revenues and lower overhead absorption.
Gross profit for the three months ended September 30, 2006 was $2,279,000,
increasing approximately $208,000, or 10% from $2,071,000 from the three months
ended September 30, 2005. The increase in gross profit in 2006 was primarily a
result of incremental sales volume. On a percent-of-sales-basis, the gross
profit of 43% decreased two percentage points compared with the gross margin of
45% in the prior year. The reduction in margin was a result a less favorable
product mix and lower overhead absorption, which offset favorable pricing
variances. We believe that gross profit as a percentage of sales may reach 60%,
or more, assuming increases in sales volume and pricing adjustments that may
occur after successful completion of the '777 patent litigation.
OPERATING EXPENSES
RESEARCH AND DEVELOPMENT EXPENSES for the three months ended September 30, 2006
of $423,000, increased by $19,000, or 5%, from the three months ended September
30, 2005. We expect R&D expenditures to remain relatively stable, as we continue
to drive product functionality, cost improvements, and other enhancements.
SELLING AND MARKETING EXPENSES for the three months ended September 30, 2006 of
$2,687,000, increased $606,000, or 29%, over the three months ended September
30, 2005. The increase was driven by an expansion in the size of the sales force
of $289,000 and higher sales commissions resulting from the increased sales
volume, and increased sales and marketing expenditures in support of the sales
efforts. We anticipate continued increased expenses resulting from the larger
sales organization and increased commissions due to expected increases in
volume.
GENERAL AND ADMINISTRATIVE EXPENSES for the three months ended September 30,
2006 of $1,907,000, increased $95,000, or 5%, from the three months ended
September 30, 2005. The increase was primarily attributable to $67,000 in SFAS
123R stock based compensation costs, in accordance with SFAS 123R incurred in
the three months ended September 30, 2006 as well as $126,000 in other
administration costs, reduced by Sarbanes-Oxley costs of $106,000, as initial
internal control assessment costs incurred in the three-months ended September
30, 2005 did not reoccur in the three months ended September 30, 2006. Total
legal costs during the quarter decreased by $24,000 to $718,000 and included a
reduction in the continuing cost of litigation against our primary laser
competitors, partially offset by an increase in the cost of litigation in the
VNUS Medical Technologies, Inc. ("VNUS") litigation.
We anticipate general and administrative expenses to remain at this level as we
continue to incur legal fees in connection with our intellectual property '777
patent infringement actions lawsuits, some of which we expect to proceed to
trial in early 2007, as well as defense costs pertaining to the patent
infringement action initiated by VNUS.
3
LOSS FROM OPERATIONS
As a result of the factors outlined above, the loss from operations for the
three months ended September 30, 2006 was $2,738,000, increasing $513,000 from
$2,225,000 for the three months ended September 30, 2005, as the expansion of
our sales and marketing efforts during the quarter drove incremental revenue,
which was offset by an increase in sales and marketing costs.
OTHER (INCOME) EXPENSE, NET
Other expense, net for the three months ended September 30, 2006 was $242,000,
compared to other expense, net of $134,000 for the three months ended September
30, 2005. Other expense, net for the three months ended September 30, 2006
includes $69,000 for the non-cash, non-operating charge, for the effect of the
change in market value of the warrants issued in the private placement financing
completed on September 30, 2005.
As a result of the financing closed on September 29, 2006, the Company marked to
market the warrant obligation for a final time and reclassified its mezzanine
level preferred stock and warrant liability to permanent equity.
NET LOSS
Net loss for the three months ended September 30, 2006 was $2,979,000 compared
to $2,359,000 for three months ended September 30, 2005. The expansion of our
sales and marketing efforts during the three months ended September 30, 2006
drove incremental revenue, resulting in increased gross margin, increased
commissions, and increases in other sales and marketing costs. Also, included in
the net loss is $126,000 in non-cash charges in accordance with SFAS 123R for
the fair value of stock options issued to employees and directors. This expense
has been allocated between Selling, General and Administrative and Cost of Sales
departmental expenses.
NET LOSS APPLICABLE TO COMMON STOCKHOLDERS
Net loss applicable to common stockholders for the three months ended September
30, 2006 was $6,746,000, or $0.35 per share, compared to $3,122,000, or $0.16
per share, for the three months ended September 30, 2005. During 2005, we agreed
to pay cash dividends to holders of the 2005 preferred stock. These cash
dividends amounted to $149,000 during the three months ended September 30, 2006.
In addition, because the dividend percentage was considered below market for
accounting purposes, we recorded an incremental non-cash dividend of $167,000 to
reflect an effective interest rate of 16.5%. As a result of the preferred stock
financing closed on September 29, 2006, the 2005 preferred stock was exchanged
for the 2006 preferred stock, which does not accrue dividends unless a future
dilutive financing is completed within certain terms. Therefore, the Company
will cease paying or accreting these dividends on a prospective basis. The 2006
preferred stock does not currently accrue dividends.
Upon completion of the 2006 preferred stock financing, the company recorded a
one-time, non-cash, non-operating beneficial conversion feature charge of
$469,938, since the market price of the Company's common stock on September 29,
2006 of $1.20 was above the $1.15 effective conversion price of the immediately
convertible preferred stock. The Company also recorded a one-time, non-cash,
non-operating deemed dividend of $3.0 million on the exchange of the 2005
preferred stock for the 2006 preferred stock.
NINE MONTHS ENDED SEPTEMBER 30, 2006 COMPARED TO THE NINE MONTHS ENDED
SEPTEMBER 30, 2005
REVENUE
Diomed delivered revenue for the nine months ended September 30, 2006 of
$15,972,000, increasing approximately $2,484,000, or 18%, from $13,488,000 for
the nine months ended September 30, 2005. Revenue from the EVLT(R) product line
increased 23% over the nine months ended September 30, 2005.
4
For the nine months ended September 30, 2006, approximately $6,125,000, or 38%,
of our total revenue was derived from laser sales, as compared to approximately
$6,763,000 or 50%, in the nine months ended September 30, 2005. In the nine
months ended September 30, 2006, approximately $9,847,000, or 62%, of our total
revenues were derived from sales of disposable fibers and kits, accessories,
service and VeinViewer(TM), as compared to approximately $6,726,000, or 50%, in
the nine months ended September 30, 2005. We expect the proportion of revenue
derived from disposables to increase as we establish a larger base of installed
lasers and the number of EVLT(R) procedures performed grows.
The increase in revenue is attributable primarily to:
- increased penetration in the EVLT(R) market,
- the compounding impact of the recurring revenue stream from
disposable sales to both new and existing customers,
- the impact of increased acceptance of the EVLT(R) procedure and
expanded reimbursement coverage by health care insurers.
COST OF REVENUE AND GROSS PROFIT
Cost of revenue for the nine months ended September 30, 2006 was $8,786,000,
increasing approximately $1,461,000, or 20%, from $7,325,000 for the same period
in 2005. The increase in cost of revenue in 2006 was driven by the corresponding
increase in the number of disposable products sold. Cost of revenue, as a
percentage of sales of 55%, was comparable to cost of revenue on a year-to-year
basis.
Gross profit for the nine months ended September 30, 2006 was $7,186,000,
increasing approximately $1,023,000 from $6,163,000 for the same period in 2005.
On a percent-of-sales-basis, gross profit of 45% was comparable with the gross
margin in the prior year, as fixed cost leverage from incremental sales volume
was offset by unfavorable product mix. We believe that gross profit as a
percentage of sales may reach 60%, or more, assuming increases in sales volume
and pricing adjustments that may occur after successful completion of the '777
patent litigation.
OPERATING EXPENSES
RESEARCH AND DEVELOPMENT EXPENSES for the nine months ended September 30, 2006
were $1,140,000, a decrease of $11,000, or 1%, from the same period in 2005. We
expect R&D expenditures to remain relatively stable, as we continue to drive
product functionality, cost improvements, and other enhancements.
SELLING AND MARKETING EXPENSES for the nine months ended September 30, 2006 were
$8,490,000, an increase of $1,797,000, or 27%, over 2005. The increase was
driven by an expansion in the size of the sales force of $1,052,000 and higher
sales commissions resulting from the increased sales volume, and increased sales
and marketing expenditures in support of the sales efforts.
GENERAL AND ADMINISTRATIVE EXPENSES for the nine months ended September 30, 2006
were $5,865,000, an increase of $390,000, or 7%, from the same period in 2005.
The increase was primarily attributable to incremental legal fees of $339,000
and SFAS 123R expenses of $274,000, as we implemented SFAS 123R in the nine
months ended September 30, 2006. These increased costs were offset by decreased
Sarbanes-Oxley costs of $179,000, as initial internal control assessment costs
incurred in the nine-months ended September 30, 2005 did not reoccur in the nine
months ended September 30, 2006. Legal expenses included the continuing cost of
patent litigation against four competitors commenced during 2004, as well as
defense costs pertaining to the patent infringement action initiated by VNUS.
LOSS FROM OPERATIONS
Loss from operations for the nine months ended September 30, 2006 was
$8,310,000, an increase of approximately $1,153,000 from the same period in
2005, as incremental gross profit from an increased revenue base was primarily
offset by increased selling and marketing expense and legal costs related to our
patent litigation.
5
OTHER (INCOME) EXPENSE, NET
Other income for the nine months ended September 30, 2006 was $684,000, compared
to other expense, net of $1,691,000 for the same period in 2005. Other income in
the nine months ended September 30, 2006 includes $971,000 for the non-cash,
non-operating gain, after giving effect to the change in market value of the
warrants issued in the private placement financing completed on September 30,
2005. Other income also includes the non-operating impact of the theft of trade
secrets settlement with Vascular Solutions, Inc.
Interest expense in the nine months ended September 30, 2005 included non-cash
charges totaling $1,404,000 related to the amortization and acceleration of the
debt discount related to the first quarter 2005 conversion of $3,288,000 in debt
issued in the September 28, 2004 equity and debt financing.
As a result of the financing closed on September 29, 2006, the Company marked to
market the warrant obligation for a final time and reclassified its mezzanine
level preferred stock and warrant liability to permanent equity.
NET LOSS
Net loss for the nine months ended September 30, 2006 was $7,626,000 compared to
$8,847,000 for the same period 2005. The expansion of our sales and marketing
efforts during the year drove incremental revenue, which was offset by the
increased legal costs and supplemented by $971,000 for the non-cash,
non-operating gain on warrant liability, after giving effect to the change in
market value of the warrants issued in the private placement financing completed
on September 30, 2005.
NET LOSS APPLICABLE TO COMMON STOCKHOLDERS
Net loss applicable to common stockholders was $12,007,000, or $0.62 per share,
compared to $9,610,000, or $0.50 per share, for the same period 2005.
During 2005, we agreed to pay cash dividends to holders of the preferred stock.
These cash dividends amounted to $447,000 during the nine months ended September
30, 2006. In addition, because the dividend percentage was considered below
market for accounting purposes, we recorded an incremental non-cash dividend to
reflect an effective interest rate of 16.5%. As a result, in the nine months
ended September 30, 2006, we recorded $484,000 of non-cash preferred stock
dividend. As a result of the preferred stock financing closed on September 29,
2006, the 2005 preferred stock was exchanged for the 2006 preferred stock and
the Company will cease paying and accreting these dividends on a prospective
basis. The 2006 preferred stock does not currently accrue dividends.
Upon completion of the 2006 preferred stock financing, the company recorded a
one-time, non-cash, non-operating beneficial conversion feature charge of
$469,938, since the market price of the Company's common stock on September 29,
2006 of $1.20 was above the $1.15 effective conversion price of the immediately
convertible preferred stock. The Company also recorded a one-time, non-cash,
non-operating deemed dividend of $3.0 million on the exchange of the 2005
preferred stock for the 2006 preferred stock.
(3) LIQUIDITY, CAPITAL RESOURCES AND CAPITAL TRANSACTIONS
CASH POSITION AND CASH FLOW
The Company has financed its operations primarily through private placements of
common stock and preferred stock, and private placements of convertible notes
and short-term notes and credit arrangements. The Company had cash and
short-term investment balances of approximately $13,440,000 and $13,129,000 at
September 30, 2006 and December 31, 2005, respectively.
CASH USED IN OPERATIONS
Cash used in operations for the nine months ended September 30, 2006 was
$7,958,000. The cash used in operations reflects the net loss of $7,626,000
which includes $2,212,000 in legal fees incurred in asserting our EVLT(R) patent
and $444,000 for stock based compensation. The cash flow impact of the net loss
was offset by changes in working capital balance sheet accounts.
6
CASH PROVIDED BY INVESTING
Cash provided by investing activities for the nine months ended September 30,
2006 was approximately $2,363,000, including purchases of marketable securities
of $687,000, proceeds from maturities of marketable securities of $3,800,000,
$250,000 paid to Luminetx per our distribution agreement and purchases of
computer and demonstration equipment of $500,000.
CASH PROVIDED BY FINANCING
Cash provided by financing activities for the nine months ended September 30,
2006 was $9,017,000, consisting of $250,000 for the final EVLT(R) technology
acquisition obligation and $447,000 in dividends paid to the September 2005 PIPE
investors, offset by net proceeds of $9,349,000 from the preferred stock
financing closed on September 29, 2006.
BANK LINES OF CREDIT
Diomed, Ltd., the Company's United Kingdom-based subsidiary, utilizes an
overdraft facility as well as an accounts receivable line of credit with
Barclays Bank, limited to the lesser of (GBP)100,000 or 80% of eligible accounts
receivable. We received a waiver to increase the overdraft to 80% of accounts
receivable or $420,519 at September 30, 2006. The credit line bears interest at
a rate of 2.5% above Barclays' base rate (4.75% at September 30, 2006) and
borrowings are due upon collection of receivables from customers. As security
for the line of credit, Barclay's Bank has a lien on all of the assets of Diomed
Ltd., excluding certain intellectual property. As of September 30, 2006, there
was $420,519 outstanding and at December 31, 2005, there was approximately
$53,924 outstanding under this line of credit.
FUTURE AVAILABILITY OF CREDIT
As of September 30, 2006, other than the security under the Barclays Bank line
of credit, our assets were not subject to any liens or encumbrances. Therefore,
these unencumbered assets may be available as security for credit facilities we
may seek in the future. However, under the terms of the convertible debentures
that we issued on October 25, 2004, we agreed that, so long as at least 10% of
the original principal amount of any debenture was outstanding, we would not
incur indebtedness or create a lien that is senior to or having an equal
priority with our obligations under the debentures, except for purchase money
security interests and otherwise to the extent that we do so in the ordinary
course of our business. As of September 30, 2006, two of the three investors who
purchased debentures in 2004 continued to hold debentures of at least 10% of the
original principal amount. Also, under the terms of the September 29, 2006
financing transaction, we agreed that so long as any investor owned at least 25%
of the shares of preferred stock initially purchased, we would not incur
indebtedness (other than ordinary course trade payables and installment loans)
in excess of $1 million (including the Barclays Bank line of credit) without
prior approval of the holders of the 65% of the outstanding 2006 preferred
stock.
PRIVATE PLACEMENT EQUITY FINANCING COMPLETED SEPTEMBER 29, 2006
Description of the 2006 preferred stock
On September 29, 2006, we issued 1,735.4347 shares of preferred stock, each
share of which has a stated value of $11,500 per share. We issued 870.4348 of
these shares to investors who purchased these shares for cash at a price of
$11,500 per share, and we issued 864.9999 shares to investors who tendered
3,975,000 shares of preferred stock we issued in 2005, all in accordance with
the terms of a Securities Purchase Agreement we entered into with the investors
in July 2006.
Exchange Provisions. At an investor's option, each share of the 2006
preferred stock may be exchanged for shares of the common stock. Subject to
applicable limitations on ownership (described below), each share of the 2006
preferred stock is exchangeable for the number of shares of the common stock
equal to $11,500 divided by the exchange rate. The exchange rate initially is
$1.15 and is subject to certain adjustments, including reduction if we make
certain dilutive issuances of equity securities in the future. The antidilution
adjustment provides that if we sells shares of the common stock (or the rights
to acquire the common stock) for a price lower than the then-current exchange
rate, the exchange rate will be reduced to the weighted average price of the
common stock issued after giving effect to the dilutive issuance.
7
We also have the right to require the investors to exchange their shares of the
2006 preferred stock if the trading price of the common stock achieves and
remains at a price level of $2.875 per share and certain other conditions are
satisfied. Upon a change of control (as defined), shares of the preferred stock
will automatically be exchanged for the right to receive either (1) the
liquidation preference of the 2006 preferred stock of $13,800 per share or (2)
the consideration which would have become payable in the change of control
transaction to the holders of the preferred stock in respect of the shares of
common stock underlying the preferred stock, whichever is greater. For purposes
of the preferred stock, a "change of control" is defined to include only (i) the
sale by us of all or substantially all of our assets or (ii) a merger,
consolidation or other business combination where either (1) we are not the
surviving entity or (2) either the holders of our capital stock immediately
prior to the transaction have 50% or less of the voting rights of the surviving
entity or own 50% or less of the outstanding voting securities of the surviving
entity immediately following the transaction or the board of directors
immediately prior to the transaction comprise 50% or less of the board of
directors of the surviving entity. A change in ownership of our outstanding
capital stock is excluded from the definition of "change in control."
We did not structure the definition of "change of control" for the purpose of
discouraging a takeover of the Company. Rather, we defined "change of control"
in this manner to ensure that the 2006 preferred stock would not become
redeemable by the holders as a result of an event outside of our control. We
believe that under applicable accounting standards, this, together with the
other terms and conditions of the 2006 preferred stock, enabled us to categorize
the 2006 preferred stock as stockholders' equity on our balance sheet, which in
turn will assist us in complying with the minimum stockholders' equity required
by the AMEX in its continued listing criteria.
Redemption. The investors do not have the right to require us to redeem
their shares of the 2006 preferred stock. We, however, have the right to redeem
the 2006 preferred stock after the fifth anniversary of the completion of the
financing transaction at a price equal to 120% of the issue price, or $13,800
per share.
Dividends. Dividends do not accrue on the 2006 preferred stock unless and
until we complete a transaction in the future that reduces the effective
conversion price of our outstanding convertible debentures below the conversion
price in effect upon the completion of the financing transaction (or, $1.15), as
a result of the operation of the antidilution rights of the holders of the
debentures, but only if at the time of the future transaction the reduction in
conversion price affects debentures having an aggregate principal amount of at
least $1,000,000. Thereafter, dividends will accrue on the issued and
outstanding shares of the 2006 preferred stock at the rate of 15% per annum and
will be payable quarterly in arrears.
Voting Rights. The holders of 2006 preferred stock will be entitled to
vote on all matters submitted to a vote of our stockholders, together with the
holders of common stock, voting as a single class. The holders of 2006 preferred
stock will vote their shares on the basis of the number of shares of common
stock into which the 2006 preferred stock is then exchangeable (subject to the
applicable limitations on ownership described below). If, under the Delaware
General Corporation Law, the holders of 2006 preferred stock are required to
approve any action by separately voting as a class, the vote of the holders of
at least 65% of the outstanding shares of the 2006 preferred stock will be
required to approve such action.
Liquidation. The 2006 preferred stock shall be preferred over and senior
to the common stock and any other class or series of capital stock created by
the Company. Upon the occurrence of any event causing our liquidation or any
change of control transaction (as defined) by the Company, the holders of
then-outstanding shares of preferred stock will be entitled to receive, from the
proceeds of such event or transaction, before any distribution is made to any
other class or series of capital stock, an amount equal to the greater of (i)
$13,800 per share of the preferred stock or (ii) such amount per share of the
preferred stock as would have been payable had each share been exchanged into
common stock immediately prior to the event or transaction. If there are
sufficient proceeds from the liquidation or change of control transaction (as
defined) remaining after the distribution to the holders of the preferred stock,
the remaining proceeds will be distributed ratably among the holders of the
common stock.
Anti-Dilution Adjustments to the Exchange Rate. The exchange rate of the
2006 preferred stock will be adjusted if we offer or sell any common stock or
common stock equivalent securities at an effective price per share of less than
the exchange rate of the 2006 preferred stock, (initially, $1.15). The exchange
rate will not be adjusted, however, for our issuance of common stock or common
stock equivalent securities exercisable below the exchange rate if such issuance
is limited to: (i) shares of common stock or options issued to employees,
officers, directors or consultants pursuant to an equity plan approved by the
stockholders or (ii) the exchange of exchangeable or convertible securities
already outstanding as of the date of the Securities Purchase Agreement.
8
Liquidated Damages. We may be required to pay liquidated damages to the
investors if we fail to timely comply with an investor's request to exchange
shares of the 2006 preferred stock for shares of the common stock or if we do
not timely remove restrictive legends from certificates representing shares of
the common stock when requested by the Investor and permitted by applicable law.
The liquidated damages are payable in the amount of 1% per day of the issue
price of the shares of the 2006 preferred stock subject to the investor's
request and are subject to an aggregate cap of 25% of the issue price paid by
the Investor for the 2006 preferred stock (inclusive of any other liquidated
damages payable by we in respect of the 2006 preferred stock). If we fail to
timely issue shares of the common stock upon exchange or remove legends from
shares of the common stock when requested by investors and permitted by
applicable law and the investor purchases other shares of common stock to settle
the sale of shares of common stock that were intended to be settled by shares of
common stock issuable upon exchange of the unlegended shares, then we may also
be required to pay to the investors the difference between the proceeds of sale
of the shares of the common stock sold and the price paid for the other shares
of the common stock purchased for settlement purposes.
In accordance with EITF Number 00-27, "Application of Issue No. 98-5 to Certain
Convertible Instruments," (EITF 00-27), we compared the amount allocated to the
preferred stock of $10,010,000 to the fair value of the common stock that would
be received upon conversion to determine if a beneficial conversion feature
existed. We determined that a beneficial conversion feature of $469,938 existed
and, in accordance with EITF 00-27, amortized that amount immediately to the
value of the preferred stock, as the preferred stock is immediately convertible.
In accordance with EITF 98-5, this adjustment of $469,938 is analogous to a
dividend and recognized as a return to the shareholders and has been included in
the beneficial conversion feature of 2006 Preferred Stock in the Company's
calculation of Net Loss Applicable to Common stockholders and Basic and Diluted
Net Loss per Share. We recorded the 2006 preferred stock to permanent equity in
accordance with the terms of EITF Abstracts - Appendix D - Topic D-98:
Classification and Measurement of Redeemable Securities ("Topic D-98").
We also issued 370,000 placement fee warrants to Musket Research Associates,
Inc. ("MRA") and $610,600 in consideration of services to both MRA and Roth
Capital Partners. The placement fee warrants are exercisable for five years from
the date of listing with the American Stock Exchange at an exercise price of
$1.15 per share, subject to reduction in the case of dilutive issuances.
In addition, the holders of the Placement Fee Warrants may exercise their
warrants by means of a "cashless exercise" instead of paying cash to us upon
exercise, in which case the holder shall be entitled to receive a certificate
for the number of warrant shares equal to the quotient obtained by dividing
[(A-B)(X)] by (A), where:
A = the VWAP on the Trading Day immediately preceding the date of such
election;
B = the Exercise Price of this warrant, as adjusted; and
X = the number of Warrant Shares issuable upon exercise of this Warrant in
accordance with the terms of this Warrant by means of a cash exercise rather
than a cashless exercise
Where:
"VWAP" means, for any security as of any date, the price determined by the first
of the following clauses that applices: (a) if the common stock is then listed
or quoted on a Trading Market, the daily volume weighted average price of the
common stock for such date on the Trading Market on which the common stock is
then listed or quoted as reported by Bloomberg Financial L.P. (based on a
Trading Day from 9:30 a.m. Eastern Time to 4:02 p.m. Eastern Time); (b) if the
common stock is not then listed or quoted on a Trading Market and if prices for
the common stock are then quoted on the OTC Bulletin Board, the volume weighted
average price of the common stock for such date on the OTC Bulletin Board; (c)
if the common stock is not then listed or quoted on the OTC Bulletin Board and
if prices for the common stock are then reported in the "Pink Sheets" published
by the National Quotation Bureau Incorporated (or a similar organization or
agency succeeding to its functions of reporting prices), the most recent bid
price per share of the common stock so reported; or (d) in all other cases, the
fair market value of a share of common stock as determined by an independent
appraiser selected in good faith by the holders of the preferred stock and
reasonably acceptable to the Corporation, where "Trading Day" means a day on
which the common stock is traded on a Trading Market, and "Trading Market" means
the following markets or exchanges on which the common stock is listed or quoted
for trading on the date in question: the Nasdaq SmallCap Market, the American
Stock Exchange, the New York Stock Exchange or the Nasdaq National Market.
9
Description of the Transaction Documents
Securities Purchase Agreement
The following summary sets forth the provisions of the Securities Purchase
Agreement:
On July 27, 2006, we entered into a Securities Purchase Agreement with the
investors, under which we agreed to issue and sell to the investors an aggregate
of 1,735.4347 shares of the 2006 preferred stock. Of this total, we agreed to
sell 870.4348 shares of the 2006 preferred stock for cash at a price per share
of $11,500 per share, which will result in gross proceeds of $10,010,000 to the
Company. We agreed to issue the other 864.9999 shares of the 2006 preferred
stock in exchange for all 3,975,000 currently outstanding shares of the 2005
preferred stock. Each share of the 2006 preferred stock will be exchangeable for
10,000 shares of our common stock. For a discussion of the terms and conditions
on which we and the investors have agreed that the shares of the 2006 preferred
stock may be exchanged, see "Description of the 2006 Preferred Stock," above.
Following the completion of the transactions set forth in the Securities
Purchase Agreement on September 29, 2006, no shares of the 2005 preferred stock
were issued or outstanding, and 1,735.4347 shares of the 2006 preferred stock
were issued and outstanding. The shares of the 2006 preferred stock then issued
and outstanding exchangeable for, in the aggregate, 17,354,347 shares of common
stock.
Form of Par Warrant
The Securities Purchase Agreement places limitations on ownership on the
investors of either 4.99% of the total outstanding shares of common stock or
9.99% of the outstanding shares of common stock (depending on the particular
investor). To the extent that exchanging shares of the 2006 preferred stock for
shares of common stock would violate these limitations on ownership of the
common stock, we may issue a common stock purchase warrant (the "Par Warrant"),
exercisable for the number of shares of our common stock which exceeds the
shares that the Investor could have acquired if not for the limitation on
ownership.
The following summarizes the terms of the Par Warrants:
Each Par Warrant will be exercisable for a purchase price of $0.001 per share
for a period of five years from the date the Par Warrant is issued to investor.
The Par Warrants are exercisable by the holder at any time (subject to common
stock ownership limitations) by delivering a Notice of Exercise Form to us in
substantially the form attached to the Par Warrants, provided that the investor
delivers the original Par Warrant to us within three days of sending the Notice
of Exercise to us. No Par Warrant exercise will be accepted by us if such
exercise causes the common stock ownership of the investor exercising the Par
Warrant to exceed the limitation on common stock ownership set forth in the
Securities Purchase Agreement applicable to such investor. We agreed to register
the shares of common stock underlying the Par Warrants on the same registration
statement as the other Securities and upon the terms set forth in the
Registration Rights Agreement.
Upon an investor's exercise of its Par Warrant, we will deliver to the investor
a certificate representing the shares underlying the exercised Par Warrant
within two trading days of the exercise date. If at any time we fail to deliver
the common stock underlying the Par Warrant to an investor upon the investor's
proper exercise of the Par Warrant, we will pay the investor any difference in
market price of such shares of common stock on the date the common stock should
be delivered and the date the common stock is actually delivered to the
investor. Penalties under the Par Warrant are subject to the 25% cap on
liquidated damages set forth in the Securities Purchase Agreement.
The exercise price of the Par Warrants will be adjusted in the event of any
stock dividends, stock splits, distributions of our assets and pro rata
distribution by we of convertible securities or instruments to holders of common
stock. Additionally, in the event we undergoe a change of control (as defined),
liquidation, share exchange or other fundamental transaction, the Par Warrant
holder will have the right to receive the stock, cash or other property such
holder would have received had the Par Warrant holder held the number of shares
of common stock for which the Par Warrant is exercisable.
The laws of New York would govern the construction and enforcement of the Par
Warrants.
10
Registration Rights Agreement
Upon completing the financing transaction on September 29, 2006, we entered into
a registration rights agreement among us and the investors. Pursuant to the
Registration Rights Agreement, we agreed to file (at our expense) a registration
statement on Form SB-2 with the SEC, registering for public resale the
"registrable securities" consisting of the shares of the common stock that are
issuable upon exchange of the shares of 2006 preferred stock issued to investors
in the financing transaction and the shares of common stock that are issuable
upon exercise of the Par Warrants, should any Par Warrants be issued in lieu of
common stock as a result of applicable limitations on ownership.
We were required to file the registration statement within 45 days of the
closing of the financing transaction and to use our best efforts to cause the
registration statement to be declared as soon as practicable, but no more than
120 days of the closing of the financing transaction. We agreed to pay
liquidated damages to the investors if we do not file the registration statement
within 45 days of the closing date of the financing transaction; if the
registration statement is not declared effective within 120 days of the closing
date, is not continually effective for any period that exceeds 20 consecutive
days or 30 aggregate days during any 12-month period; or if the common stock
does not remain listed on an applicable stock exchange after the effective date
of the registration statement. If any of the foregoing occurs, we may be
required to pay each investor liquidated damages for the period from the date on
which such event occurs until the event is cured, at a monthly rate equal to 3%
of the original issue price of the 2006 preferred stock, prorated for partial
months based on the number of days in the month. The liquidated damages are
subject to an aggregate cap of 25% of the issue price paid by the investors for
the shares of the 2006 preferred stock (inclusive of any other liquidated
damages payable by us in respect of the preferred stock).
The initial number of securities included in the registration statement and any
increase in the number of registrable securities included therein shall be
allocated pro rata among the investors based on the number of registrable
securities held by each investor at the time the registration statement is
declared effective by the SEC. If an investor sells or otherwise transfers any
of the investor's securities to one or more of the other investors, each
transferee investor shall be allocated a pro rata portion of the number of
registrable securities included in such registration statement for such
transferor investor at the time of transfer. Any shares of common stock included
in a registration statement that remain allocated to any investor which ceases
to hold any securities covered by the registration statement shall be allocated
to the remaining investors, pro rata, based on the number of registrable
securities covered by the registration statement which are then held by such
investors.
We also agreed that if the SEC does not permit the shares of common stock
underlying the Par Warrants to be registered in the same registration statement
as the shares of common stock issuable upon exchange of the 2006 preferred
stock, we shall prepare and file with the SEC, as soon as practicable and in any
event no later than our first issuance of any Par Warrants, an additional resale
registration statement covering the resale of the warrant shares issuable upon
exercise of any and all Par Warrants that we may issue from time to time.
We shall bear all fees and expenses incident to the performance of or compliance
with the Registration Rights Agreement, whether or not any registrable
securities are sold pursuant to the registration statement.
The Registration Rights Agreement contains indemnification provisions that
obligate us to indemnify and hold harmless each investor and its directors,
legal counsel and accountants and any underwriter for losses caused by (i) any
untrue statement of material fact or omission of a material fact in the
registration statement or any prospectus included therein, (ii) our violation of
the Securities Act or the Exchange Act, or any rule or regulation thereunder
relating to our acts or omissions in connection with the registration statement.
The laws of New York are expected to govern the construction and enforcement of
the Registration Rights Agreements. The Registration Rights Agreements also
contain other customary terms found in similar agreements, including provisions
concerning registration procedures.
11
Placement Agent Agreements
We engaged Musket Research Associates, Inc. ("MRA") and Roth Capital Partners,
LLC ("RCP") as our placement agents in connection with the financing
transaction, and we agreed to pay fees to MRA and RCP out of the proceeds of the
financing transaction for their services, as follows:
o MRA. We agreed to pay (i) cash fees equal to 6.0% of the aggregate
cash proceeds received from the MRA Contacts (as defined in the
agreement between us and MRA) and (ii) issue common stock purchase
warrants to designees of MRA exercisable at the same price per share
as paid by the investors in the financing transaction, exercisable
for five years, in that number equal to 5% of the number of the
common stock equivalent securities actually purchased by MRA
Contacts, and
o RCP. We agreed to pay (i) cash fees equal to the greater of (a) 6%
of the amount raised by RCP from Existing RCP investors and New RCP
investors (as defined in the agreement between RCP and the Company)
and (b) $100,000, as long as each of the Existing RCP investors has
either exercised its rights to receive the benefit of future
preferential financing terms or has waived certain redemption and
other rights pursuant to the waiver attached to the term sheet for
the financing, in each case, as to all shares of the 2005 preferred
stock purchased by the Existing RCP investors from us on September
30, 2005, and (ii) issue Placement Agent Warrants in that number
equal to 5% of the number of the common stock equivalents purchased
by New RCP investors.
Accordingly, upon completion of the financing transaction on September 29, 2006,
we paid an aggregate of $610,600 in cash to MRA and RCP, and issued placement
agent warrants representing 370,000 shares of common stock to designees of MRA
(no Placement Agent Warrants were issued to RCP).
David Musket, a principal of MRA, invested $138,500 from the fees payable to MRA
that MRA would have otherwise paid over to Mr. Musket.
Both MRA and Mr. Musket are affiliates of ProMed Partners, L.P., whose
affiliated parties beneficially owned in excess of five percent of our
outstanding shares of common stock prior to the September 29, 2006 financing
transaction.
ANTIDILUTION ADJUSTMENTS TO OUTSTANDING SECURITIES RESULTING FROM SEPTEMBER 29,
2006 FINANCING TRANSACTION
The terms of certain of our previously issued and outstanding securities (the
"Anti-Dilution Securities") provide for adjustments to the effective price
payable for shares of the common stock upon conversion or exercise of those
Anti-Dilution Securities and, in certain cases, for an increase in the number of
underlying shares of common stock, if we complete certain future transactions
and the effective price per share of the common stock or common stock
equivalents that we issue in the future transaction is less than the effective
price per share under the terms of the Anti-Dilution Security. The September 29,
2006 financing transaction was at an effective price per share of common stock
of $1.15, which constituted a dilutive transaction under the terms of the
Anti-Dilution Securities.
Accordingly, when we completed the financing transaction, antidilution
provisions of Anti-Dilution Securities resulted in the following adjustments:
o the conversion price of the outstanding convertible debentures we
issued in our October 25, 2004 financing transaction ($3.712 million
principal amount) was reduced from $2.29 per share common stock to
$1.15 per share which, when converted will result in an increase in
the number of shares of common stock to be issued from 1,620,961 to
3,227,826;
o the exercise price of the warrants to purchase common stock we
issued to the investors in our October 25, 2004 financing
transaction (the "2004 Warrants") was reduced from $2.10 to $1.15
per share of the common stock;
o the exercise price of the warrants to purchase common stock we
issued to the investors in our September 30, 2005 financing
transaction (the "2005 Warrants") was reduced from $2.50 to $1.98
per share, and the number of shares of common stock issuable upon
exercise of the 2005 Warrants increased from 1,800,000 to 2,272,000;
and
12
o the exercise price of certain warrants to purchase shares of the
common stock we issued to designees of our former placement agent,
Sunrise Securities Corp. (the "Sunrise Warrants"), was reduced and
the number of shares of common stock issuable upon exercise of these
Sunrise Warrants increased from 139,315 to 155,843 as follows:
a. the exercise price of certain Sunrise Warrants decreased from
$2.32 to $1.77 per share, and the number of shares of common
stock issuable upon exercise of these Sunrise Warrants
increased from 42,282 to 55,559;
b. the exercise price of certain Sunrise Warrants decreased from
$1.93 to $1.50 per share, and the number of shares of common
stock issuable upon exercise of these Sunrise Warrants
increased from 11,455 to 14,706; and
c. the exercise price of certain Sunrise Warrants decreased from
$2.10 to $1.15 per share (no adjustments were impact the
remaining Sunrise Warrants).
The following table sets forth the numbers of shares of common stock currently
underlying the Anti-Dilution Securities and the numbers of shares that underly
the Anti-Dilution Securities following completion of the September 29, 2006
financing transaction.
Number Number of
of Underlying Underlying
Common Shares Shares
Description of Before After Net Increase
Anti-Dilution Antidilution Antidilution in Underlying
Security Adjustment Adjustment Common Shares
- ---------------- -------------- ------------ -------------
Debentures 1,620,961 3,227,826 1,606,865
2005 Warrants 1,800,000 2,272,000 472,000
Sunrise Warrants 139,315 155,843 16,528
--------- --------- ---------
TOTAL 3,560,276 5,655,669 2,095,393
========= ========= =========
AMENDMENT TO CERTIFICATE OF INCORPORATION APPROVED SEPTEMBER 27, 2006
Prior to the September 29, 2006 financing transaction, our Certificate of
Incorporation authorized us to issue up to, 50,000,000 shares of common stock
and 20,000,000 shares of preferred stock. In contemplation of the financing
transaction that we completed on September 29, 2006, on September 27, 2006, our
stockholders approved an amendment to our certificate of incorporation
authorizing us to issue up to 1,736 shares of the new series of preferred stock
and to increase the number of shares of our common stock that we are authorized
to issue to 65,000,000 shares.
The amendment to the certificate of incorporation had the effect of canceling
the shares of preferred stock that we issued on September 30, 2005, which the
holders of these shares surrendered to us in exchange for shares of the new 2006
series of preferred stock. The amendment removed the provision of our former
certificate of incorporation that authorized our board to issue preferred shares
with voting and preference rights as assigned by the board. We are now only
authorized to issue only 1,736 shares of our 2006 preferred stock, all but a
fraction of which are now issued and outstanding, and 65,000,000 shares of our
common stock, 19,448,728 of which are now issued and outstanding. The rights,
preferences and privileges relating to the 2006 series of preferred stock are
described at "Description of the 2006 Preferred Stock," above.
The additional shares of common stock authorized by our amended certificate of
incorporation have rights identical to the currently outstanding shares of our
common stock. The future issuance of these shares of common stock will not
affect the rights of the holders of our currently outstanding common stock,
except for effects incidental to increasing the number of shares of our common
stock outstanding, such as dilution of the earnings per share.
Though our board has no other plans to issue the additional shares of common
stock, it desires to have the shares available to enable us to have a limited
number of shares reserved and to provide additional flexibility to use common
stock for business and financial purposes in the future. The additional shares
may be used for various purposes without further stockholder approval, except to
the extent required by applicable rules of the AMEX. These purposes may include
raising capital, establishing strategic relationships with other companies,
expanding our business or product lines through the acquisition of other
businesses or products, and other purposes.
13
We could also use the additional shares of common stock that would become
available for issuance to oppose a hostile takeover attempt or to delay or
prevent changes in control or our management, including transactions in which
the stockholders might otherwise receive a premium for their shares over then
current market prices. Although the number of shares is unlikely to be large
enough to be effective in that regard, it is possible that, without further
stockholder approval, our board could strategically sell shares of common stock
in a private transaction to purchasers who would oppose a takeover or favor the
current board, and the number of shares so issued could result in a vote in
favor of our current board.
Impact of the 2006 Preferred Stock Financing on September 30, 2005 Financing
As a result of the 2006 preferred stock financing, we exchanged the 2005
preferred stock for new 2006 preferred stock. As illustrated in EITF Topic D-42:
The Effect on the Calculation of Earnings per Share for the Redemption or
Induced Conversion of Preferred Stock, ("Topic D-42"), the 2005 preferred
stockholders received additional value as the exchange price was adjusted down
below the original effective exchange price. We compared the excess of the fair
value of the consideration transferred to the holders of the 2005 preferred
stock over the carrying amount of the 2005 preferred stock in our balance sheet
to approximate the return to the 2005 preferred stockholder. For the purposes of
calculating the excess of (1) the fair value of the consideration transferred to
the holders of the 2005 preferred stock over (2) the carrying amount of the 2005
preferred stock in our balance sheet, the carrying amount of the 2005 preferred
stock was reduced by the issuance costs of the 2005 preferred stock.
Accordingly, since the value of the 864.999 shares of 2006 preferred stock can
be exchanged for common stock at the ratio of 1 for 10,000 common shares,
multiplied by the market price of common stock on the day of the closing ($1.20)
was $10,379,988; and the carrying value of $8,248,993 less the issuance costs of
$849,444 represents $7,399,549; the residual fair value of $2,980,439 was
recorded as an increase to preferred stock and a decrease to Additional Paid-in
Capital. We also recorded the $2,980,439 as a deemed dividend on the exchange of
the 2005 preferred stock in the calculation of basic and diluted earnings per
share. We reclassified 2005 preferred stock fair value of $11,229,432 to
permanent equity as a result of the exchange and included within the 2006
preferred stock on our Balance Sheet in accordance with Topic D-98.
As a result of the exchange and the corresponding implementation of a liquidated
damages cap in an amount that represents a reasonable percentage discount of the
fair value of an unregistered share versus a registered share, the warrants are
no longer required to be accounted for as a liability under EITF 00-19.
Therefore, the warrant liability of $926,771 was marked to market one final time
at September 29, 2006, through a charge to the Statement of Operations in the
amount of $68,995, and then reclassified to Additional Paid-in Capital.
In accordance with the contingent anti-dilution terms of the 2005 preferred
stock warrant agreement, the exercise price and number of warrants originally
issued to the 2005 preferred stockholders were adjusted so that the number of
warrants increased by 472,000 and the exercise price decreased to $1.98.
Increasing rate dividends and cash dividends of the 2005 preferred stock were
eliminated when the 2005 preferred stock was exchanged for the 2006 preferred
stock.
Impact of the 2006 Preferred Stock Financing on October 25, 2004 Financing
We determined that the conversion and exercise price changes were not
modifications to the terms of their respective agreements, but were executions
of contingent conversion options within those agreements. Under EITF 00-27
"Application of Issue No. 98-5 to Certain Convertible Instruments" ("EITF
00-27"), the Task Force reached a consensus that if the terms of a contingent
conversion option do not permit an issuer to compute the number of shares that
the holder would receive if the contingent event occurs and the conversion price
is adjusted, an issuer should wait until the contingent event occurs and then
compute the resulting number of shares that would be received pursuant to the
new conversion price.
Prior to the transaction, the 2004 debt was convertible into 1,620,961 shares,
and after the 2006 preferred stock financing the 2004 debt is convertible into
3,227,826 shares. The difference of 1,606,865 shares multiplied by the market
price of our common stock on the date of the closing of $1.20 results a new fair
value of $3,631,516. Because the result was in excess of the carrying value of
the debt, we recorded a discount of $2,255,843. This debt discount will be
accreted back to debt over the remaining two year term of the 2004 convertible
debt agreement through charges against non-cash interest expense in our
Statements of Operations.
The exercise price of warrants originally issued to the 2004 debt holders was
adjusted so that the exercise price decreased to $1.15 in accordance with the
original contingent anti-dilution terms of those 2004 warrants.
COMMITMENT FOR LUMINETX INVESTMENT
On August 5, 2005, we entered into a distribution agreement with Luminetx,
pursuant to which Luminetx appointed us a distributor and granted us the
exclusive right to distribute and sell the Luminetx patented biomedical imaging
system known as the VeinViewer(TM) Imaging System for physicians who perform
sclerotherapy, phlebectomies or varicose vein treatments, in the United States
and the United Kingdom.
We and Luminetx anticipate that Luminetx will sell to us a certain minimum
number of VeinViewer(TM) systems that we will distribute to our customers at
specified prices during the term of our distribution agreement. As a condition
to receiving the exclusive rights under the distribution agreement, we agreed
under the distribution agreement to loan $1 million to Luminetx, of which
$500,000 was provided to Luminetx on August 5, 2005 as specified in our
distribution agreement. We later converted our $500,000 loan to Luminetx into
250,000 shares of Luminetx preferred stock, convertible into common stock on a
share-for-share basis, and warrants to purchase 50,000 shares of Luminetx common
stock at $2.00 per share, exercisable for five years, as part of an $11 million
private placement financing that Luminetx announced on November 4, 2005. On
August 4, 2006, Luminetx notified us that it had achieved the contractual
milestones necessary to effect the remaining $500,000 investment as required
under the distribution agreement. Under separate agreement entered into on
August 4, 2006, we agreed to fund the $500,000 investment in two equal
installments. We paid the first installment upon execution of the August 4, 2006
agreement and we paid the second and final installment on October 30, 2006.
Effective August 4, 2006, and with the initial installment payment, Luminetx
issued to us 250,000 shares of its preferred stock and 50,000 warrants under the
same terms as the private placement financing announced by Luminetx on November
4, 2005. These shares and warrants were held as collateral by Luminetx until we
funded the remaining $250,000 installment on October 30, 2006.
(4) CRITICAL ACCOUNTING POLICIES
In the opinion of management, these unaudited consolidated financial statements
contain all adjustments considered normal and recurring and necessary for their
fair presentation. Interim results are not necessarily indicative of results to
be expected for the year. These interim financial statements have been prepared
in accordance with the instructions for Form 10-QSB, and therefore, do not
include all information and footnotes necessary for a complete presentation of
operations, financial position, and cash flows of the Company in conformity with
accounting principles generally accepted in the United States. The Company filed
its 2005 Annual Report on Form 10-KSB/A with the Securities and Exchange
Commission on April 13, 2006, which included audited consolidated financial
statements for the year ended December 31, 2005, and included information and
footnotes necessary for such presentation. These unaudited consolidated
financial statements should be read in conjunction with the audited consolidated
financial statements and the notes thereto included in our annual report on Form
10-KSB/A for the year ended December 31, 2005.
Our discussion and analysis of the Company's financial condition, results of
operations, and cash flows are based on the Company's consolidated financial
statements. The preparation of these financial statements requires us to make
estimates and judgments that affect the reported amounts of assets, liabilities,
revenues and expenses, and related disclosure of contingent assets and
liabilities. We have chosen accounting policies we believe are appropriate to
report accurately and fairly our operating results and financial position, and
we apply those accounting policies in a consistent manner. As discussed in Item
6, "Management's Discussion and Analysis of Financial Condition or Plan of
Operation" of the Company's Annual Report on Form 10-KSB/A for the fiscal year
ended December 31, 2005, we consider certain policies to be the most critical in
the preparation of our consolidated financial statements because they involve
the most difficult, or subjective judgments about the effect of matters that are
inherently uncertain. We base our estimates on historical experience and on
various other assumptions that we believe to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent from
other sources. Actual results may differ from these estimates under different
assumptions or conditions. In connection with the adoption of SFAS 123R as of
the beginning of the Company's first quarter of fiscal year 2006, we have added
"Stock-Based Compensation" as a critical accounting policy.
14
Stock Based Compensation
We maintain stock-based incentive plans, under which we provide stock incentives
to employees and directors. We grant options to employees and directors to
purchase common stock at an option price equal to the market value of the stock
at the date of grant. Prior to the effective date of SFAS 123R, we applied APB
25, and related interpretations, for our stock option grants. APB 25 provides
that the compensation expense relative to our stock options is measured based on
the intrinsic value of the stock option at date of grant.
Effective the beginning of the first quarter of fiscal year 2006, we adopted the
provisions of SFAS 123R using the modified prospective transition method. Under
this method, prior periods are not restated. We use the Black-Scholes option
pricing model which requires extensive use of accounting judgment and financial
estimates, including estimates of the expected term participants will retain
their vested stock options before exercising them, the estimated volatility of
our common stock price over the expected term, and the number of options that
will be forfeited prior to the completion of their vesting requirements.
Application of alternative assumptions could produce significantly different
estimates of the fair value of stock-based compensation and consequently, the
related amounts recognized in the Consolidated Statements of Operations. The
provisions of SFAS 123R apply to new stock options and stock options
outstanding, but not yet vested, on the date we adopted SFAS 123R. Stock-based
compensation expense was included in applicable departmental expense categories
in the Consolidated Statements of Operations.
(5) RECENT ACCOUNTING PRONOUNCEMENTS
In November 2004, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 151 ("SFAS 151"), Inventory Costs. SFAS 151
amends Accounting Research Bulletin No. 43 to clarify the accounting for
abnormal amounts of idle facility expense, freight, handling and spoilage. The
statement also requires that the allocation of fixed production overheads to
inventory be based on normal production capacity. We adopted the standard as of
January 1, 2006. The adoption did not have an impact on our consolidated
financial statements.
In June 2006, the Financial Accounting Standards Board issued FASB
Interpretation No. 48 ("FIN 48"), Accounting for Uncertainty in Income Taxes.
FIN 48 amends FASB Statement No. 109 to clarify the accounting for uncertainty
in income taxes recognized in an enterprise's financial statements. The
Interpretation prescribes a recognition threshold and measurement attribute for
the financial statement recognition and measurement of a tax position taken or
expected to be taken in a tax return as well as provides guidance on
derecognition, classification, interest and penalties, accounting in interim
periods, disclosure, and transition. This Interpretation is effective for fiscal
years beginning after December 15, 2006. Adoption of FIN 48 is not expected to
have a material impact on our consolidated financial statements.
ITEM 3. CONTROLS AND PROCEDURES
(a) Evaluation of disclosure controls and procedures.
The Company's principal executive officer and its principal financial officer
have carried out an evaluation of the effectiveness of our disclosure controls
and procedures (as defined in Rules 13a -15(e) and 15d-15(e) under the
Securities Exchange Act of 1934) as of September 30, 2006 and have concluded
that, as of such date, the Company's disclosure controls and procedures in place
are effective in ensuring that material information and other information
requiring disclosure is identified and communicated on a timely basis.
(b) Changes in internal control over financial reporting.
During the period covered by this report, there have been no changes in our
internal control over financial reporting that have materially affected or are
reasonably likely to materially affect our internal control over financial
reporting.
15
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
'777 Patent Litigation
On January 6, 2004, we filed a lawsuit in the United States District Court for
the District of Massachusetts against AngioDynamics, Inc. seeking injunctive
relief and damages for infringement of our '777 patent. AngioDynamics generally
denied our allegations and sought a declaratory judgment of invalidity of the
'777 patent. AngioDynamics also added certain counterclaims against us,
including antitrust violations, patent misuse and other allegations, all arising
from our obtaining and seeking to enforce the '777 patent. The court bifurcated
the case, so that those counterclaims will not be litigated until we resolve our
patent infringement claims against AngioDynamics.
On March 4, 2004, we filed a second lawsuit against Vascular Solutions in the
United States District Court for the District of Massachusetts seeking
injunctive relief and damages for infringement of our U.S. Patent Number
6,398,777 (the "'777 patent") covering the endovascular laser treatment of
varicose veins which we use in our EVLT(R) product line, the exclusive rights to
which we acquired on September 3, 2003.
On April 28, 2004, Vascular Solutions answered the complaint and filed a
counterclaim for declaratory judgment that the '777 patent is invalid and not
infringed. Vascular Solutions amended its answer and counterclaims to further
allege patent unenforceability. In addition, Vascular Solutions moved to
bifurcate the damages and willful infringement aspects of this case. We opposed
this motion and on June 28, 2005 the court denied Vascular Solutions' motion. At
the parties' joint request, however, our patent cases involving AngioDynamics
and Vascular Solutions were consolidated by the court for pretrial purposes. We
subsequently completed the discovery phase of the litigation.
On April 12, 2005, the Court issued a claim construction ruling, which
interpreted certain claim language in the '777 patent. We believe that the
evidence we have developed to date in the course of these lawsuits, if admitted
and fully credited, will show that AngioDynamics and Vascular Solutions are
infringing our patent as it has been interpreted by the Court.
On December 21, 2005, we moved for summary judgment that the '777 patent is
valid, enforcable, and infringed by both Vascular Solutions and AngioDynamics.
On the same date, AngioDynamics and Vascular Solutions moved for summary
judgment of noninfringement. The Court initially scheduled a hearing on the
parties' respective motions, but that hearing date was cancelled when the judge
originally assigned to the case (Judge Richard Stearns) recused himself due to
his having consulted one of Diomed's expert witnesses for a personal medical
condition. The cases were reassigned to another Judge in the same District
(Nathaniel Gorton).
On August 20, 2006, Judge Gorton issued a favorable ruling on the summary
judgment motions. In particular, Judge Gorton rejected all of the various
challenges raised by the defendants to the validity or enforceability of our
'777 patent, and granted us summary judgment of validity and enforceability of
the patent. Judge Gorton further denied all parties' cross-motions for summary
judgment on infringement, as a result of which the case will proceed to trial as
we had expected. A trial date has not yet been set, but the Court has scheduled
a pretrial conference on December 8, 2006.
On April 2, 2004, we filed a lawsuit in the United States District Court for the
District of Massachusetts against Total Vein Solutions, LLC, seeking injunctive
relief and damages for infringement of the '777 patent covering the endovascular
laser treatment of varicose veins which we use in our EVLT(R) product line. On
May 21, 2004, Total Vein Solutions answered the complaint, generally denying our
allegations and counterclaiming for declaratory judgment of non-infringement and
invalidity of the EVLT(R) patent. We are in the discovery phase of this
litigation. For the same reasons discussed above, this case has also been
reassigned from Judge Stearns to Judge Gorton.
On October 14, 2004, we filed a lawsuit in the United States Federal District
Court for the District of Massachusetts against New Star Lasers, Inc., d/b/a
Cooltouch, Inc., seeking injunctive relief and damages for infringement of the
'777 patent covering the endovascular laser treatment of varicose veins which we
use in our EVLT(R) product line. On December 3, 2004, CoolTouch answered the
complaint, generally denying our allegations and counterclaiming for declaratory
judgment of non-infringement and invalidity of the EVLT(R) patent. We are now
proceeding with the discovery phase of this litigation. For the same reasons
discussed above, this case has also been reassigned from Judge Stearns to Judge
Gorton.
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VNUS Technologies Litigation
On July 21, 2005, a lawsuit was filed against us in the United States District
Court for the Northern District of California by VNUS Medical Technologies,
Inc., alleging infringement of U.S. patents Nos. 6,258,084, 6,638,273,
6,752,803, and 6,769,433. The complaint was served on us on July 27, 2005. On
September 15, 2005, we filed an answer denying the allegations of infringement,
and counterclaiming against VNUS for a declaration that none of the patents are
infringed and that they are all invalid.
On October 12, 2005, VNUS served an amended complaint adding two additional
parties, AngioDynamics, Inc. and Vascular Solutions, Inc., as defendants. On
October 31, 2005, we filed an answer to the First Amended Complaint, again
denying the allegations of infringement, and counterclaiming against VNUS for a
declaration that none of the patents are infringed, that they are all invalid
and that two of VNUS' patents are unenforceable for inequitable conduct. We are
now proceeding with the discovery phase of this litigation, which is scheduled
to continue through mid-2007, with a preliminary trial date in late October
2007.
The Court held a claim construction tutorial and a hearing on claim construction
issues on October 30, 2006. The Court has not yet ruled on the results of that
hearing.
We intend to continue to defend against the allegations against us in this case.
Misappropriation Litigation vs. Vascular Solutions
On December 12, 2003, we filed a lawsuit in the United States District Court for
the District of Massachusetts seeking injunctive and other relief against
Vascular Solutions, Inc. and one of its executives. We alleged, among other
things, that Vascular Solutions and the executive misappropriated our trade
secrets and then improperly used that information to develop and market laser
accessory products. We also sought to redress what we alleged to be the willful
and deceptive manner in which Vascular Solutions had been marketing its laser
accessory products.
On June 16, 2004, Vascular Solutions and the other the defendant answered the
complaint, and filed a counterclaim for invalidity of the EVLT(R) trademark. On
July 13, 2005 the Court heard oral argument on Vascular Solutions' motion for
summary judgment on all claims. Vascular Solutions conceded that it would
stipulate to desist from any further use of the mark ELT, which Diomed alleged
it infringed Diomed's federally-registered EVLT(R) trademark. Vascular Solutions
further stipulated that it would desist from any further dissemination of the
defamatory statements alleged in our complaint.
On March 3, 2006, the Court referred the parties to nonbinding mediation. At the
mediation on May 24, 2006, the case was settled. The terms of the settlement are
confidential. A joint stipulated dismissal was filed on June 23, 2006, ending
the case.
'971 and '976 Patent Declaratory Judgment Litigation
On January 3, 2006, AngioDynamics filed a lawsuit against us in the U.S.
District Court for the District of Delaware, seeking a declaratory judgment that
the claims of our U.S. Patent Number 6,981,971 (the "'971 Patent"), for an
introducer sheath/optical fiber arrangement that may be used in the endovascular
laser treatment of varicose veins, are invalid, unenforceable and not infringed
by AngioDynamics. The '971 Patent was issued by the U.S. Patent and Trademark
Office on January 3, 2006, the same day AngioDynamics filed the lawsuit. On
January 17, 2006, AngioDynamics filed an Amended Complaint seeking a declaratory
judgment with respect to our U.S. Patent Number 6,986,766 (the "'766 Patent").
The '766 Patent relates to methods of using an introducer sheath/optical fiber
arrangement in the endovascular laser treatment of varicose veins. We filed a
motion to dismiss AngioDynamics' declaratory judgment action in its entirety,
based primarily on lack of declaratory judgment jurisdiction. We also asserted
in our motion to dismiss that the court should dismiss the action in its
discretion, and because AngioDynamics' complaint contained a number of
deficiencies which we believe warranted dismissal. On September 7, 2006, the
Court granted our motion to dismiss the action, denied AngioDynamics' Motion to
Amend the Complaint, and dismissed the Complaint as we had requested.
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ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
a) On September 27, 2006, the Company held a special meeting of stockholders,
pursuant to a proxy statement that it had filed with the Securities and Exchange
Commission and had furnished to holders of record of the outstanding shares of
its common stock and preferred stock as of August 15, 2006. Of 23,423,728
shares, including 3,975,000 of preferred stock, entitled to vote at the meeting,
15,106,559 shares voted, and a quorum was present.
b) The Company presented the following proposals to our stockholders at that
meeting:
1. To approve the sale and issuance of $19,947,500 of 2006 preferred stock,
including the terms and provisions of the 2006 preferred stock that is
exchangeable for shares of our common stock, to certain institutional and other
investors, including existing holders of our preferred stock.
The results of which were as follows:
For Against Abstained
- ---------- --------- ---------
13,796,341 1,282,393 27,825
Accordingly, the proposal was approved.
2. To approve the amendment of our certificate of incorporation to add a new
class of preferred stock and to increase to 65,000,000 the number of authorized
shares of our common stock.
The results of which were as follows:
For Against Abstained
- ---------- --------- ---------
13,716,102 1,343,385 47,072
Accordingly, the proposal was approved.
ITEM 6. EXHIBITS AND CURRENT REPORTS ON FORM 8-K
(a) Exhibits
31.1 Certification by the Chief Executive Officer pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002
31.2 Certification by the Chief Financial Officer pursuant to Section 302 of
the Sarbanes-Oxley Act of 2002
32.1 Certification of Principal Executive Officer pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002
32.2 Certification of Principal Financial Officer pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002
(b) Current reports on Form 8-K.
During the fiscal quarter ended September 30, 2006, we filed with the Securities
and Exchange Commission Current Reports on Form 8-K as follows:
On July 13, 2006, we filed a Current Report on Form 8-K regarding the
resignation of Kevin Stearn, the Managing Director of Diomed Ltd.
On July 27, 2006, we filed a Current Report on Form 8-K regarding the press
release we filed related to the earnings results for the period ending June 30,
2006.
On August 1, 2006, we filed a Current Report on Form 8-K regarding the
definitive agreements entered into for the sale and issuance of shares of a new
series of the Company's preferred stock in a private placement financing
transaction.
On August 7, 2006, we filed a Current Report on Form 8-K regarding the response
that the American Stock Exchange ("AMEX") relayed to the Company in relation to
its plan to regain compliance with Section 1003 (a) (ii) of the AMEX's Company
Guide's standards for continued listing on the AMEX.
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On September 6, 2006, we filed a Current Report on Form 8-K regarding the press
release we filed related to the motions for summary judgment in the '777 patent
infringement case, noting that our '777 patent was both valid and enforceable,
and that we could proceed to trial on the basis of infringement.
On September 13, 2006, we filed a Current Report on Form 8-K regarding the press
release we filed related to the recent ruling of the '971 patent infringment
case vs. AngioDynamics.
On September 27, 2006, we filed a Current Report on Form 8-K regarding
shareholder approval obtained at the shareholder meeting in relation to the 2006
preferred stock private placement mentioned in the Form 8-K filed August 1,
2006.
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SIGNATURES
In accordance with Section 13 or 15(d) of the Exchange Act, the registrant has
duly caused this report to be signed on its behalf by the undersigned hereunto
duly authorized.
DIOMED HOLDINGS, INC.
(REGISTRANT)
By: /s/ JAMES A. WYLIE, JR.
------------------------------------
Name: James A. Wylie, Jr.
Title: President and Chief Executive
Officer, Director
Date: November 13, 2006
By: /s/ DAVID B. SWANK
------------------------------------
Name: David B. Swank
Title: Chief Financial Officer,
Director
Date: November 13, 2006
20