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1
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
ANNUAL REPORT
PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended Commission File Number
December 28, 1996 0-27422
ARTHROCARE CORPORATION
(Exact name of Registrant as specified in its charter)
Delaware 94-3180312
(State or other jurisdiction of incorporation (I.R.S. employer
or organization) identification number)
595 North Pastoria Avenue, Sunnyvale, California 94086
(Address of principal executive offices and zip code)
(408) 736-0224
(Registrant's telephone number, including area code)
Securities registered pursuant to 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: Common Stock, $0.001
Par Value;
Preferred Share
Purchase Rights
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.
As of March 1, 1997, the aggregate market value of the voting stock held by
non-affiliates of the Registrant was $33,957,729 (based upon the closing sales
price of such stock as reported by The Nasdaq Stock Market on such date). Shares
of Common Stock held by each officer, director, and holder of 5% or more of the
outstanding Common Stock on that date have been excluded in that such persons
may be deemed to be affiliates. This determination of affiliate status is not
necessarily a conclusive determination for other purposes.
As of March 1, 1997, the number of outstanding shares of the Registrants' Common
Stock was 8,790,450.
DOCUMENTS INCORPORATED BY REFERENCE
Certain information required by Items 10, 11, 12 and 13 of Form 10-K is
incorporated by reference from the Registrant's proxy statement for the 1997
Annual Stockholders Meeting (the "Proxy Statement"), which will be filed with
the Securities and Exchange Commission within 120 days after the close of the
Registrant's fiscal year ended December 28, 1996.
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PART I
ITEM 1. BUSINESS.
OVERVIEW
This Report on Form 10-K contains certain forward looking statements
regarding future events with respect to the Company. Actual events or results
may differ significantly as a result of the factors described herein and in the
documents incorporated herein by reference including those factors described
under "Additional Risk Factors."
ArthroCare Corporation designs, develops, manufactures and markets
arthroscopic surgical equipment that ablates (removes) soft tissue with minimal
damage to surrounding healthy tissue, and that simultaneously achieves
hemostasis (sealing small bleeding vessels). The ArthroCare Arthroscopic System
is designed to replace the multiple surgical tools used in arthroscopic
procedures with one multi-purpose, electrosurgery system that consists of a
controller unit and a series of disposable ArthroWand surgical tools specialized
for particular types of surgery. This dual approach allows the surgeon to remove
damaged tissue while reducing the need for the frequent exchange of instruments
that is common in arthroscopic procedures. The Company began shipping products
for use in arthroscopic surgery of the shoulder and knee in December 1995. In
March 1995, the Company received clearance of its 510(k) premarket notification
to market the ArthroCare Arthroscopic System for use in arthroscopic surgery of
the knee, shoulder, ankle and elbow. In July 1996, it received clearance of its
510(k) premarket notification to market its Arthroscopic System for use in
arthroscopic surgery of the wrist and hip. In addition, in 1996 the Company
received clearance of its 510(k) premarket notification to market tissue
ablation products for the treatment of certain urological and periodontal
conditions. The Company has filed 510(k) submissions for clearance to market
tissue ablation products to treat certain dermatological and gynecological
conditions. The FDA has indicated that the 510(k) submission for certain
gynecological conditions must be supported by data from clinical trials.
The Company has a limited history of operations that, to date, has
consisted primarily of research and development, product engineering, obtaining
FDA clearance of its Arthroscopic System, developing a network of distributors
in the United States to market the Arthroscopic System and 13 months of product
sales. The Company has started to realize revenues from the sale of its
products, but continues to generate operating losses and anticipates generating
losses in the future. Whether the Company can successfully manage the transition
to a larger-scale commercial enterprise will depend upon increasing sales of
disposable ArthroWands from its domestic distribution network, obtaining foreign
regulatory approvals for the Arthroscopic System, obtaining domestic and foreign
regulatory approvals for potential products and maintaining its financial and
management systems, procedures and controls.
THE MARKET FOR SURGICAL JOINT REPAIR
Historically, severe joint injuries have been treated using open
surgery involving large incisions, a hospital stay and a prolonged recovery
period. In contrast, arthroscopic surgery, which was introduced in the early
1980s, is performed through several small incisions called portals and can be
performed on an outpatient basis. The Company believes that arthroscopic surgery
has gained wide market acceptance because it promises shorter hospital stays and
reduced recovery time.
In 1995, approximately 2.0 million arthroscopic procedures were
performed in the United States. According to industry sources, the number of
arthroscopic procedures is growing due to patient demand for less invasive
procedures as well as the increasing incidence of joint injuries caused by a
greater emphasis on physical fitness and an aging population. Joints are
susceptible to injuries from blows, falls or twisting, as well as from natural
deterioration and stiffening associated with aging.
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To perform arthroscopic surgery, a surgeon must use a tool to visualize
the site and a tool to perform the surgery. The tool used to visualize the site,
called an arthroscope, is a small fiber-optic viewing instrument made up of a
small lens, a light source and a video camera, which allows the surgeon to view
the surgical procedure on a video monitor. During the arthroscopic procedure, an
irrigant, such as saline or sterile water, is flushed through the joint to
permit clear visualization through the arthroscope and to create the space
within the joint for the surgical procedure. The surgeon inserts the arthroscope
into the joint through a portal measuring approximately six millimeters (1/4 of
an inch) in length. Other portals are used for the insertion of surgical
instruments to perform the surgery and to facilitate the flow of irrigants. With
small incision sites and direct access to most areas of the joint, a surgeon can
diagnose and correct an array of joint problems such as cartilage tears,
ligament tears and removal of loose and degenerative tissue.
The advantages of arthroscopic surgery over open surgery are often
significant. Due to the smaller incisions and reduced surgical trauma, the
patient might experience several benefits including reduced pain; treatment on
an out-patient basis; reduced need of lengthy hospitalization; immediate joint
mobility and less muscle atrophy; less surrounding tissue damage; lower rate of
complications; and generally quicker rehabilitation. In addition, treatment on
an out-patient basis and reduced operating time can significantly lower hospital
costs.
Knee
The knee is the most commonly injured joint. In 1995, it accounted for
approximately 1.4 million arthroscopic procedures in the United States. Damage
to a meniscus - a pad of cartilage that helps cushion the knee joint - is a
common form of knee injury. A meniscus can be torn by a twist of the leg when
the knee is flexed, displaced either inward toward the center of the tibia
(central shin bone) or outward beyond the surface of the femur (central
thighbone), or worn down by normal aging. The knee is also susceptible to
partial or complete tears of the ligaments and degeneration of the cartilage on
the underside on the patella (knee cap). In addition, the cartilage covering the
bony surfaces of the knee wears down with age and can become rough or tear loose
from the bone, causing pain and interfering with smooth joint movement.
Shoulder
The shoulder joint, because of its range of motion, is susceptible to a
number of injuries. In 1995, approximately 400,000 arthroscopic procedures in
the shoulder were performed in the United States. The Company believes that
shoulder arthroscopy is the fastest-growing portion of the arthroscopy market.
With repetitive motion and lifting of the arm, such as that which occurs during
a tennis serve, the acromion (the "roof" of bone formed where the scapula, or
shoulder blade, extends over the humerus, the bone of the upper arm) may pinch
one of the shoulder muscles and cause persistent pain, known as a rotator cuff
injury. This condition can be treated by strengthening exercises and
physiotherapy; however, many rotator cuff injuries require surgical
intervention. The Company believes that a significant percentage of the
population is born with an acromion that hooks over the humerus, making such
individuals more susceptible to rotator cuff injuries.
Elbow, Ankle, Wrist and Hip
The elbow, ankle, wrist and hip joints are also susceptible to certain
stress-related injuries and deterioration due to aging. In 1995, approximately
210,000 arthroscopic procedures were performed in the elbow, ankle, wrist and
hip in the United States. The Company believes that the current number of
surgical procedures in the elbow, ankle, wrist and hip is relatively small due
to the limitations on conventional arthroscopic surgical equipment.
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CONVENTIONAL TREATMENT METHODOLOGIES: THE PROBLEM
Most arthroscopic procedures require the surgeon to probe, cut, sculpt,
shape and cauterize (seal bleeding vessels) to achieve satisfactory results.
Surgeons frequently use a combination of the available instruments when
performing an arthroscopic procedure because each instrument is designed to
perform a specific function. Use of an assortment of tools requires the surgeon
to insert and remove each of the tools from the portals several times during the
same procedure.
Surgical procedures can employ one or more of four groups of surgical
instruments: (1) power or motorized instruments, such as cartilage and bone
shavers; (2) mechanical instruments, such as basket punches, graspers and
scissors; (3) electrosurgery systems (Bovie); or (4) laser systems.
Power instruments are generally used to smooth tissue and cartilage
defects on the surface of the bones on the joint. The damaged tissue is removed
from the joint using suction through a cannula surrounding the shaft of the
tool, which can become obstructed by bits of tissue and bone. Power shavers have
rotating cutters inside a tube and are not currently available in a wide variety
of tip angles or sizes for the precise shaving of tissue. This prevents the
power shavers from being used in many areas of the joint.
Mechanical instruments are used primarily in meniscus removal by
snipping away the unwanted tissue. Because mechanical tools must open and shut
to operate, they cannot be used in small areas such as the back of the knee. In
addition, mechanical tools must be resharpened at regular intervals and
sterilized after each procedure.
Electrosurgery systems are primarily used to achieve hemostasis, which
is necessary to minimize bleeding and maximize the arthroscopic surgeon's
visibility of the procedure through the arthroscope. Bleeding occurs most
commonly in shoulder arthroscopies. Electrosurgical systems contain two
electrodes: the electrode tip held by the surgeon and a dispersive pad that
rests under the patient's body. The metal electrode tip of the instrument,
which resembles a pencil point, is placed on or near the bleeding blood vessel
to be sealed. A generator connected to the electrode delivers high-frequency
voltage that arcs between the electrode and the target tissue, sealing blood
vessels in its vicinity. After arcing, the current travels through the
remaining tissue of the patient, through the skin to the dispersive electrode
pad, before being directed back to the generator. A non-conductive media such
as sterile water is used in the surgical space so that the electricity is
forced into the tissue instead of the surrounding fluid. As a result of its
conductivity, saline - the preferred irrigant - cannot be used during the
procedure.
Laser systems are used to ablate tissue while achieving simultaneous
hemostasis. Laser systems are not tactile tools, meaning that the surgeon cannot
feel how much tissue is being ablated. The surgeon must be extensively trained
to precisely position the laser to control the depth of tissue penetration to
minimize unintended tissue damage. The Company believes that laser tools have
not received wide acceptance because of high cost, lack of tactile feedback for
the surgeon and required training and certification.
ARTHROCARE'S SOLUTION: THE ARTHROCARE ARTHROSCOPIC SYSTEM
The Company's Arthroscopic System is a high-frequency, electrosurgical
device intended for use in arthroscopic surgery to perform tissue ablation and
simultaneous hemostasis. The Company has received FDA clearance and has begun
selling its Arthroscopic System for use in all six major joints: knee, shoulder,
elbow, ankle, wrist and hip. Tissues such as meniscus, synovium, cartilage and
ligaments can be ablated using the Arthroscopic System.
The Company's Arthroscopic System is comprised of the disposable
bipolar multielectrode ArthroWand, a connecting cable and a radio frequency
power controller. The controller, approximately 14 inches by 11 inches by five
inches, is used to deliver high-frequency power to the ArthroWand. To ablate
different tissues, the user can
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change the voltage level using the keys on the front panel of the controller.
The cable, which is approximately 10 feet in length, connects the controller to
the ArthroWand. Power is transmitted through the cable to the ArthroWand by
depressing a foot pedal, thereby enabling surgeons to use the ArthroWand as a
conventional probe as well as an instrument that ablates and cauterizes.
Accordingly, the surgeon using the Arthroscopic System need not remove
and insert a variety of instruments to perform different tasks, as is required
when using conventional arthroscopic instruments. The ArthroWand is approved for
sale in tip sizes 1.5 mm to 4.5 mm, and in tip angles ranging from 0 to 90
degrees. The Company currently sells 11 models in various tip sizes, angles and
shapes. These different tip sizes and tip angles enable the surgeon to ablate
different volumes of tissue and to reach treatment sites not readily accessible
by existing mechanical instruments and motorized cutting tools.
The Company commercially introduced the Arthroscopic System in December
1995 and by the year ended December 28, 1996, had reported 13 months of sales.
By the end of 1996, the Company had sold more than 580 controller units, with
approximately 370 sold to hospitals and clinics and the remainder sold to
dealers for use as demonstration units. In addition, the Company has sold more
than 40,000 ArthroWands. The Company has ramped up its manufacturing
capabilities to produce production-level volumes with high yields.
The Arthroscopic System is the Company's only commercial product and
will account for substantially all of the Company's revenue for the foreseeable
future. As such, the Company is highly dependent on its Arthroscopic System.
Currently, virtually all the Company's sales come from the United States. Before
the Arthroscopic System can be sold outside of the United States, the Company
will have to obtain foreign regulatory approvals and establish foreign
distribution capability. If such regulatory approval is obtained, there can be
no assurance that the Company will be able to establish a successful foreign
distribution capability.
The Company's Arthroscopic System and potential products are based upon
a new method of tissue ablation, and there can be no assurance that any of these
products will gain market acceptance. Physicians might not use the Company's
products unless they determine, based on experience, clinical data and other
factors, that these products are an attractive alternative to conventional means
of tissue ablation. To date, the Arthroscopic System has been used to treat only
a limited number of patients, and no published clinical reports exist to support
the Company's marketing efforts, which may have an adverse effect on its ability
to obtain physician acceptance. The Company believes that recommendations and
endorsements by influential physicians will continue to be essential for market
acceptance of its products. If the Arthroscopic System is not commercially
successful, the Company's business, financial condition and results of
operations would be materially adversely affected.
ARTHROCARE'S TECHNOLOGY
The ArthroCare Arthroscopic System is based on a patented core
technology and is designed to achieve precise ablation of soft tissue and
simultaneous hemostasis while minimizing damage to the surrounding healthy
tissue. The Company's bipolar, multielectrode configuration and power control
system allow high-frequency electrical energy to be precisely focused on the
surface of the tissue being treated. Using a bipolar array of electrodes
eliminates the need to deliver energy through the surgical site to a dispersive
electrode pad located outside the body, because the energy is directed from the
tip of the probe to a return electrode contained on its shaft. The electric
current travels a shorter distance from the electrode array to the target
tissue before returning to the electrode on the shaft, allowing the
Arthroscopic System to use lower voltages than conventional monopolar
electrosurgical systems.
As illustrated below, the ArthroWand's energy is concentrated only at
the tip electrodes. This configuration allows the energy to be focused on the
surface layer of the tissue being ablated, thereby minimizing the risk of
unwanted damage to surrounding healthy tissue. The controller provides power
individually to each of the electrodes at the tip of the ArthroWand, enabling
only those electrodes that come in contact with tissue to deliver sufficient
energy to
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ablate tissue. During use, the high frequency current flows from the controller
through each electrode to the tissue, returning to the controller via the return
electrode on the shaft of the ArthroWand. The operation of a 90 degree
ArthroWand is depicted below.
[Graphic depicting a simulation of the ArthroWand ablating tissue]
In preparation for use, the physician connects the appropriate
ArthroWand to the cable and the controller. The physician then selects a power
level based on the type of tissue to be removed. Precise tissue ablation and
cutting are accomplished by brushing the ArthroWand over the target tissue.
Variable power settings of the controller and a variety of ArthroWand sizes and
electrode array configurations allow the Company's technology to be applied to a
wide range of arthroscopic procedures in the knee, shoulder, elbow, ankle, wrist
and hip. ArthroWands are available in different sizes and tip configurations,
which permit access to tissue treatment sites not readily accessed using
existing mechanical instruments or powered shavers.
The Company's patented multielectrode, bipolar, electrosurgical
technology offers a number of benefits that the Company believes may provide
advantages over competing surgical methods and devices. The principal benefits
include:
- EASE OF USE. The Arthroscopic System performs many of the
functions of mechanical tools, power tools and electrosurgery
instruments, allowing the surgeon to use a single instrument.
The lightweight probe is simple to use and complements the
surgeon's existing tactile skills without the need for
extensive training.
- PRECISION. In contrast to conventional tools, the Arthroscopic
System permits surgeons to perform more precise tissue
ablation and sculpting. The Company believes this may result
in more rapid patient rehabilitation.
- SIMULTANEOUS ABLATION AND HEMOSTASIS. The Arthroscopic System
efficiently seals small bleeding vessels during the tissue
ablation process, which improves the surgeon's visibility of
the operative site.
- COST REDUCTION. The Arthroscopic System eliminates the need to
introduce multiple instruments to remove and sculpt tissue and
seal small bleeding vessels. The Company believes this may
reduce operating time and thereby produce cost savings for
health care providers.
Despite the benefits of the ArthroCare Arthroscpoic System, there can
be no assurance that doctors and surgical centers will buy the Arthroscopic
System. In order to secure the benefits of the Arthroscopic System, however, a
hospital or surgical center must procure and use a specifically designed
controller to power the ArthroWand. At hospital sites or surgical centers where
several arthroscopic surgery procedures can be performed simultaneously, the
procurement of multiple controllers is required. To date, the Company has
placed its controllers at substantial discounts in order to stimulate demand
for its Arthroscopic System. In addition, motorized and mechanical instruments
and electrosurgery systems currently used by hospitals and surgical centers for
arthroscopic procedures have a history of success and have become widely
accepted by orthopedic surgeons. If physicians do not determine that the
Arthroscopic System is an attractive alternative to conventional means of
tissue ablation, the Arthroscopic System will not be commercially acceptable,
and the Company's business, financial condition and results of operations would
be materially adversely affected.
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ARTHROCARE STRATEGY
The Company's objective is to use its proprietary technology to design,
develop, manufacture and sell innovative, clinically superior electrosurgical
devices for the arthroscopic surgical treatment of joint injuries and for the
surgical treatment of other soft tissue conditions. The key elements of the
Company's strategy to achieve this objective include:
- PENETRATE EXISTING ARTHROSCOPIC SURGICAL INSTRUMENT MARKET.
The Company's initial sales efforts are focused on marketing
the Company's products to orthopedic surgeons performing
high-volume arthroscopy and to opinion leaders in orthopedic
surgery.
- EXPAND INTO NEW ARTHROSCOPIC SURGICAL MARKETS. The Company
encourages surgeons to use its Arthroscopic System to treat
joints that have been primarily treated by open surgery, such
as the shoulder, elbow and ankle. Because of the small size,
varying shapes and tactile feel of the Company's ArthroWand,
the Company believes surgeons will be able to arthroscopically
access areas difficult to reach by conventional arthroscopic
surgical tools.
- TARGET KEY INTERNATIONAL MARKETS. The Company intends to
market its Arthroscopic System in certain international
markets if required regulatory approvals are received. The
Company is developing a network of independent distributors in
Europe and intends to collaborate with one or more marketing
partners to assist with regulatory requirements and to market
and distribute the Arthroscopic System in Japan and
Australia.
- LEVERAGE BROADLY APPLICABLE PROPRIETARY TECHNOLOGY. The
Company expects to leverage its proprietary technology by
developing additional wands for use in a variety of surgical
procedures, including urology (e.g., trans-urethral resection
of the prostate), dermatology (e.g., abnormal skin growth and
wrinkle removal), periodontics (e.g., gingivectomy) and
gynecology (e.g., endometrial ablation).
- PURSUE REGULATORY APPROVALS THROUGH 510(K) APPLICATIONS. The
Company continues to pursue additional applications of its
technology in indications that will require FDA clearance
through the shorter, less costly 510(k) regulatory process.
RESEARCH AND DEVELOPMENT
The Company believes that its core technology is applicable to other
soft tissue surgical applications that will use a system substantially the same
as the Arthroscopic System. The Company expects to change the wand design to
accommodate the specific requirements of the indications in various surgical
fields. However, the Company believes that the design, materials and
manufacturing methods incorporated into the initial Arthroscopic System should
be applicable to subsequent products and indications.
The Company has undertaken preliminary animal studies and development
for the use of its ablation technology in urology, dermatology, dental surgery
and gynecology. Each of these products is at an early stage of development, and
the Company will be required to undertake time-consuming and costly development
activities and seek regulatory approval before these devices can be marketed.
There can be no assurance that product development will ever be successfully
completed, that 510(k)s applied for will be granted by the FDA on a timely
basis, if at all, or that the products will ever achieve commercial acceptance.
Failure by the Company to develop, obtain necessary regulatory approval for or
to successfully market new products could have a material adverse effect on the
Company's business, financial condition and results of operations.
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A significant portion of the Company's research and development is
performed by Philip E. Eggers, a director of the Company, pursuant to a
consulting agreement between the Company and Eggers & Associates, Inc., a
corporation wholly owned by Mr. Eggers. Mr. Eggers is not employed by the
Company on a full-time basis and, as a result, may not be available to devote
his full time or attention to the Company's affairs.
MANUFACTURING
The Company's manufacturing operations consist of an in-house assembly
operation for the manufacturing of ArthroWands. The ArthroWand is manufactured
manually by the Company from several components. In 1996, the Company ramped up
its manufacturing capacity to production levels to support sales of more than
40,000 ArthroWands per year and received Quality System Regulations (QS
Regulations) approval from the FDA and ISO 9001 certification and the CE mark
for sales in Europe. Even so, the Company has limited experience in
manufacturing the ArthroWands. The ArthroWand is shipped to a single
subcontractor who performs the sterilization. After sterilization, the
ArthroWands are sent back to the Company before shipment to customers.
The Company subcontracts the manufacturing of both its controllers and
cables to third parties. The controller for the Company's Arthroscopic System
uses standard components and is assembled by a single contract manufacturer.
The agreement between the Company and the contract manufacturer requires the
Company to purchase all of its controllers from the contract manufacturer
through July 1998, but does not obligate the Company to purchase any minimum
number of units. The Company purchases controllers pursuant to three-month
binding purchase orders. In addition, the connector housings at each end of the
cable are available only from a single source. The connector housings are
shipped to the Company for testing and the Company then ships the tested
connector housings to a manufacturer of medical-grade insulated wiring for
assembly with such wiring to produce the cable.
The controllers are tested by both the contract manufacturer and the
Company before shipment to customers. The Company and its contract manufacturer
are required to operate in conformance with QS Regulations, in order
to produce products for sale in the United States, and ISO 9001 standards, in
order to produce products for sale in Europe. Any failure by the Company and its
contract manufacturer to remain in compliance with QS Regulations or ISO 9001
standards could have a material adverse effect on the Company's business,
financial condition and results of operations.
There can be no assurance that an alternate contract manufacturer,
sterilizer or connector housing supplier could be established if necessary or
that available inventories would be adequate to meet the Company's product needs
during any prolonged interruption of supply. A reduction or stoppage in supply
of the sole-source component, or the Company's inability to secure an
alternative contract manufacturer or sterilizer, if required, would limit its
ability to manufacture the Arthroscopic System and would have a material adverse
effect on the Company's business, financial condition and results of operations.
Although the Company has taken all actions that it believes are reasonable to
assure that its contract manufacturer, subcontractors and suppliers are in
compliance with applicable regulations, there can be no assurance that the FDA,
or a state, local or foreign regulator, will not take action against a contract
manufacturer, subcontractor or supplier found to be violating such regulations.
In April 1995, the Company filed an application with the State of
California for a license to manufacture medical devices. In September 1995, the
State of California required the Company to cease shipping products until a
manufacturing license was obtained, and the FDA, following a Good Manufacturing
Practices ("GMP") audit, instructed the Company to correct certain
record-keeping practices and enter into a written contract with the third party
that sterilizes the ArthroWand. There can be no assurance that the Company will
not encounter any further manufacturing difficulties, or that any of its
contract manufacturers will not experience similar difficulties, including
problems involving production yields, quality control and assurance, supplies of
components or shortages of qualified personnel.
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In October 1995, the Company discovered that the ArthroWand packaging
was subject to cracking due to a flawed design of the packaging tray and
undertook a voluntary product recall of the 61 ArthroWands affected. The Company
completed execution of its corrective action and received written confirmation
from the FDA that the recall has been closed. There can be no assurances that
there will be no further product recalls or required redesign of the Company's
packaging or products. Any further product recalls or required redesign of the
Company's packaging or products would have a material adverse effect on the
Company's business, financial condition and results of operations.
MARKETING AND SALES
Of the 18,500 orthopedic surgeons in the United States, approximately
80% perform arthroscopy and approximately 40% consider arthroscopy to be their
major practice area. These 40% of orthopedic surgeons perform an estimated 70%
of the total arthroscopic procedures. In addition to marketing efforts aimed at
these surgeons, the Company also recognizes that purchase decisions are greatly
influenced by health care administrators, who are subject to increasing
pressures to reduce costs. Health care administrators must determine that the
Arthroscopic System and the Company's potential products are cost-effective
alternatives to current means of tissue ablation.
The Company sold over 580 Arthroscopic System controller units and more
than 40,000 ArthroWands by the end of 1996. The Company is marketing and selling
its Arthroscopic System in the United States through a network of independent
orthopedic distributors. The Company has 40 distributors representing more than
200 field sales representatives. The distributors are supervised by five
regional field sales managers who are employed by the Company. The Company
expects that the network of distributors will market directly to more than 7,000
orthopedic surgeons who primarily perform arthroscopic surgery. To date, the
Arthroscopic System has been used to treat only a limited number of patients,
and no published clinical reports exist to support the Company's marketing
efforts, which may have an adverse effect on its ability to obtain physician
acceptance. These distributors sell orthopedic arthroscopy devices for a number
of other manufacturers, and there can be no assurance that they will commit the
necessary resources to effectively market and sell the Company's Arthroscopic
System, or that they will be successful in closing sales with doctors and
hospitals. The Company believes that recommendations and endorsements by
influential physicians will be essential for market acceptance of its products.
The Company may be required to continue to offer substantial discounts on its
controller to generate demand of its ArthroWands. The inability to place
sufficient quantities of controllers would adversely impact demand for the
ArthroWands and would have a material adverse effect on the
Company's business, financial condition and results of operations.
In October 1996, the Company signed a distribution agreement with
Advanced Surgical Technologies Pty Ltd (AST), a large orthopedic distributor
based in Australia, to exclusively sell the Company's Arthroscopic System in
Australia, and AST obtained the necessary regulatory approval to market and sell
the Arthroscopic System in Australia. If the Company is successful in obtaining
other necessary regulatory approvals in foreign markets, it expects to establish
a sales and marketing capability in those markets. In these other international
markets, the Company intends to collaborate with one or more marketing partners
to establish marketing and distribution channels for the Arthroscopic System and
to assist with regulatory requirements in such distributors' jurisdiction.
However, regulatory requirements vary by region, and compliance with such
regulations maybe costly and time-consuming. Accordingly, the distribution,
pricing and marketing structure to be established by the Company may vary from
country to country.
No assurance can be given that the Company will obtain any additional
necessary foreign regulatory approvals, that the Company will establish a
network of distributors and successfully sell its products in Australia and
Europe, that the Company will secure a marketing partner to obtain additional
necessary foreign regulatory approvals on behalf of the Company in other
international markets, successfully sell its Arthroscopic System in foreign
markets or that any other foreign distributors and marketing partners will
commit the necessary resources to obtain additional necessary foreign
regulatory approvals on behalf of the Company and successfully sell the
Arthroscopic System in foreign markets.
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The success of the Company's marketing efforts in the United States and
abroad will depend on whether it can obtain the necessary regulatory approvals,
successfully demonstrate the cost-effectiveness of its Arthroscopic System,
maintain a network of distributors in the United States and secure marketing
partners in international markets on acceptable terms. If the Company secures
the necessary regulatory approvals to sell any of its potential products in the
United States or in foreign markets, the Company would have to establish a
separate marketing and sales capability for those products. This would require
significant effort and expense and would be subject to all the risks attendant
to establishing a marketing and sales capability for its Arthroscopic System.
Failure by the Company to successfully market its Arthroscopic System
domestically or internationally could have a material adverse effect on the
Company's business, financial condition and results of operations.
PATENTS AND PROPRIETARY RIGHTS
The Company's ability to compete effectively will depend in part on its
ability to develop and maintain proprietary aspects of its platform technology.
The Company owns four issued United States patents, 16 pending United States
patent applications and international patent applications in Europe (covering 16
separate countries), Japan, Canada, Australia and New Zealand corresponding to
three of the United States filings relating to its multielectrode technology.
The initial patent is currently set to expire in 2008, and the other three
issued patents are currently expected to expire between 2008 and 2012. Although
the Company believes that the issued patents cover the core technology used in
the Company's Arthroscopic System, none of the issued patents have specific
arthroscopic claims.
The issued patents cover, among other things, probes having an
electrode array and a means to supply current independently to individual
electrodes in certain interventional cardiology and other procedures. The
pending patent applications include coverage for the fundamental tissue ablation
and cutting technology as well as methods and apparatus specific to procedures
in the fields of orthopedic, urological, gynecological, dermatological, plastic,
oral, general and cardiovascular surgery. There can be no assurance that the
patents that have been issued to the Company or any patents that may be issued
as a result of the Company's United States or international patent applications
will provide any competitive advantages for the Company's products or that they
will not be successfully challenged, invalidated or circumvented in the future.
In addition, there can be no assurance that competitors, many of which have
substantial resources and have made substantial investments in competing
technologies, will not seek to apply for and obtain patents that will prevent,
limit or interfere with the Company's ability to make, use and sell its products
either in the United States or in international markets.
A number of medical device and other companies, universities and
research institutions have filed patent applications or have issued patents
relating to monopolar and/or bipolar electrosurgical methods and apparatus. If
third-party patents or patent applications contain claims infringed by the
Company's technology and such claims are ultimately determined to be valid,
there can be no assurance that the Company would be able to obtain licenses to
those patents at a reasonable cost, if at all, or be able to develop or obtain
alternative technology, either of which would have a material adverse effect on
the Company's business, financial condition and results of operations. There can
be no assurance that the Company will not be obligated to defend itself in court
against allegations of infringement of third-party patents.
In addition to patents, the Company relies on trade secrets and
proprietary know-how, which it seeks to protect, in part, through
confidentiality and proprietary information agreements. The Company requires its
key employees and consultants to execute confidentiality agreements upon the
commencement of an employment or consulting relationship with the Company. These
agreements generally provide that all confidential information, developed or
made known to the individual by the Company during the course of the
individual's relationship with the Company, is to be kept confidential and not
disclosed to third parties. These agreements also generally provide that
inventions conceived by the individual in the course of rendering services to
the Company shall be the exclusive property of the Company. There can be no
assurance that such agreements will not be breached, that the Company
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would have adequate remedies for any breach or that the Company's trade secrets
will not otherwise become known to or be independently developed by competitors.
The medical device industry has been characterized by extensive
litigation regarding patents and other intellectual property rights, and
companies in the medical device industry have employed intellectual property
litigation to gain a competitive advantage. There can be no assurance that the
Company will not become subject to patent infringement claims or litigation or
interference proceedings declared by the United States Patent and Trademark
Office ("USPTO") to determine the priority of inventions. The defense and
prosecution of intellectual property suits, USPTO interference proceedings and
related legal and administrative proceedings are both costly and time-consuming.
Litigation may be necessary to enforce patents issued to the Company, to protect
trade secrets or know-how owned by the Company or to determine the
enforceability, scope and validity of the proprietary rights of others. Any
litigation or interference proceedings will result in substantial expense to the
Company and significant diversion of effort by the Company's technical and
management personnel. An adverse determination in litigation or interference
proceedings to which the Company may become a party could subject the Company to
significant liabilities to third parties, require disputed rights to be licensed
from third parties or require the Company to cease using such technology.
Although patent and intellectual property disputes in the medical device area
have often been settled through licensing or similar arrangements, costs
associated with such arrangements may be substantial and could include ongoing
royalties. Furthermore, there can be no assurance that necessary licenses would
be available to the Company on satisfactory terms, if at all. Adverse
determinations in a judicial or administrative proceeding or failure to obtain
necessary licenses could prevent the Company from manufacturing and selling its
products, which would have a material adverse effect on the Company's business,
financial condition and results of operations.
COMPETITION
The arthroscopic medical device industry is intensely competitive. The
Company competes with providers of laser systems, electrosurgical systems,
manual instruments and power shavers. Many of these competitors have
significantly greater financial, manufacturing, marketing, distribution and
technical resources than the Company. There can be no assurance that the Company
can effectively compete against such competitors. In addition, there can be no
assurance that these or other companies will not succeed in developing
technologies and products that are more effective than the Company's or that
would render the Company's technology or products obsolete or uncompetitive.
The Company believes that its Arthroscopic System, comprised of the
controller unit and disposable ArthroWands, presents a competitive pricing
structure compared to alternative tools being used in arthroscopic procedures.
The list price of the controller, including the cable, is approximately
$13,000. The disposable ArthroWand, which can be used by surgeons as a
conventional probe as well as to ablate soft tissue and seal small bleeding
vessels, has a list price of approximately $120. Motorized cutting tools
consist of a power source with list prices of approximately $8,000 to $10,000
and disposable tips, with list prices of approximately $60 to $80. Reuseable
mechanical tools have list prices of approximately $150 to $950 and it is not
unusual for 30 (thirty) different shaped tools to be resterilized for each
procedure. Neither motorized nor mechanical tools perform hemostasis, and
therefore additional tools may need to be purchased for that purpose.
Electrosurgical systems, used to stop the bleeding from small blood vessels
during surgery, consist of a power source with list prices of approximately
$4,000 to $9,000 plus a disposable tip with list prices of approximately $40 to
$50, including a single-use, dispersive electrode pad. Electrosurgical systems
are not generally used to cut or remove tissue. Laser systems, with list prices
of approximately $80,000 to $125,000, are used in conjunction with disposable
or reusable tips, with list prices of approximately $60 to $300, to ablate soft
tissue and simultaneously achieve hemostasis.
Smith & Nephew Endoscopy, Inc. (which owns Acufex Microsurgical, Inc.
and Dyonics, Inc.), Bristol-Myers Squibb Company (including its Linvatec
division) and Stryker Corp. each have large shares of the market for manual
instruments, power shavers and arthroscopes. These companies offer broad product
lines, which they may offer as a single package; have substantially greater
resources and name recognition than the Company; and frequently offer
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significant discounts as a competitive tactic. In addition, Pfizer Inc.
(including its Valley Labs division) and Bristol-Myers Squibb Company each
have large shares of the market for electrosurgical systems, and Trimedyne,
Inc. and Stryker Corp. each have large shares of the market for laser systems.
The Company expects that competition from these and other well-established
competitors will increase as will competition from start-up and development
stage medical device companies such as Gyrus Medical Ltd., a company based in
the United Kingdom, and Orotec Interventions, Inc., a company based in Menlo
Park, California. The Company is aware that Johnson & Johnson (including its
Ethicon unit) is marketing a bipolar electrosurgical tool developed by Gyrus
Medical Ltd. In order to successfully compete in the arthroscopic medical
device industry, the Company anticipates that it may have to continue to offer
substantial discounts on its controller in order to stimulate demand for the
disposable ArthroWand, and that such competition could have a material adverse
effect on the Company's business, financial condition and results of
operations.
The Company believes that the primary competition factors in the market
for tissue ablation are precision, ease of use and price. The Company believes
that its tissue ablation instruments will be easier to use than current ablation
instruments on the market while also providing the surgeon with a more precise
and efficient means of ablating tissue. As a result, the Company believes that
its products compete favorable with respect to these factors, although no
assurance can be given that they will be able to continue to do so in the
future, or that new instruments that perform more favorably will not be
introduced.
The Company has received 510(k) premarket notifications for clearance
to market tissue ablation products to treat certain urological, and periodontal
conditions and has filed 510(k) premarket notification for clearance to market
dermatological and gynecological conditions, and the FDA has indicated that the
510(k) submission for certain gynecological conditions must be supported by
data from clinical trials. These fields are intensely competitive and no
assurance can be given that these potential products, if approved, would be
successfully marketed.
GOVERNMENT REGULATION
United States
The Company's products are regulated in the United States as medical
devices by the FDA under the Federal Food, Drug, and Cosmetic Act ("FDC Act")
and require premarket clearance or approval by the FDA prior to
commercialization. In addition, certain material changes or modifications to
medical devices also are subject to FDA review and clearance or approval.
Pursuant to the FDC Act, the FDA regulates the research, testing, manufacture,
safety, labeling, storage, record keeping, advertising, distribution and
production of medical devices in the United States. Noncompliance with
applicable requirements can result in warning letters, fines, injunctions, civil
penalties, recall or seizure of products, total or partial suspension of
production, failure of the government to grant premarket clearance or premarket
approval for devices, and criminal prosecution. Medical devices are classified
into one of three classes, Class I, II or III, on the basis of the controls
deemed by the FDA to be necessary to reasonably ensure their safety and
effectiveness. Class I devices are subject to general controls (e.g., labeling,
premarket notification for non-exempt devices and adherence to GMPs or QS
Regulations for most devices). Class II devices are subject to general controls
and to special controls (e.g., performance standards, postmarket surveillance,
patient registries, and FDA guidelines). Generally, Class III devices are those
that must receive premarket approval by the FDA to ensure their safety and
effectiveness (e.g., life-sustaining, life-supporting and implantable devices,
or new devices that have not been found substantially equivalent to legally
marketed devices), and generally require clinical testing to ensure safety and
effectiveness and FDA approval prior to marketing and distribution. The FDA also
has the authority to require clinical testing of Class I and Class II devices. A
PMA application must be filed if the proposed device is not substantially
equivalent to a legally marketed Class I or Class II predicate device or if it
is a Class III device for which the FDA has called for such applications.
If human clinical trials of a device are required and if the device
presents a "significant risk," the manufacturer or the distributor of the device
is required to file an investigational device exemption ("IDE") application
prior to commencing human clinical trials. The IDE application must be supported
by data, typically including the results
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of animal and, possibly, mechanical testing. If the FDA does not object to the
IDE application within 30 days from filing of the application, human clinical
trials may begin as defined in the IDE. Sponsors of clinical trials are
permitted to sell investigational devices distributed in the course of the
study, provided such costs do not exceed recovery of the costs of manufacture,
research, development and handling. The clinical trials must be conducted under
the auspices of an independent Institutional Review Board ("IRB") established
pursuant to FDA regulations, and with appropriate informed consent.
Generally, before a new device can be introduced into the market in the
United States, the manufacturer or distributor must obtain FDA clearance of a
510(k) notification or approval of a PMA application. If a medical device
manufacturer or distributor can establish that a device is "substantially
equivalent" to a legally marketed Class I or Class II device, or to a Class III
device for which FDA has not called for PMAs, the manufacturer or distributor
may seek clearance from FDA to market the device by filing a 510(k)
notification. The 510(k) notification will need to be supported by appropriate
data establishing the claim of substantial equivalence to the satisfaction of
FDA. FDA recently has been requiring a more rigorous demonstration of
substantial equivalence.
Following submission of the 510(k) notification, the manufacturer or
distributor may not place the device into commercial distribution until an order
is issued by the FDA. No law or regulation specifies the time limit by which FDA
must respond to a 510(k) notification. At this time, the FDA typically responds
to the submission of a 510(k) notification within 150 to 200 days, but it may
take longer. An FDA order may declare that the device is substantially
equivalent to another legally marketed device and allow the proposed device to
be marketed in the United States. The FDA, however, may determine that the
proposed device is not substantially equivalent or require further information,
including clinical data, to make a determination regarding substantial
equivalence. Such determination or request for additional information could
delay market introduction of the products that are the subject of the 510(k)
notification.
The Company has received clearance of 510(k) premarket notifications to
market its Arthroscopic System for surgery of the knee, shoulder, elbow, wrist,
hip and ankle joints. In addition, the Company received clearance of 510(k)
premarket notifications to market products based upon its proprietary core
technology to treat certain urological and periodontal conditions. There can be
no assurance that the Company will be able to obtain necessary clearances or
approvals to market any other products on a timely basis, if at all, and delays
in receipt or failure to receive such clearances or approvals, the loss of
previously received clearances or approvals, or failure to comply with existing
or future regulatory requirements could have a material adverse effect on the
Company's business, financial condition and results of operations.
If a manufacturer or distributor of medical devices cannot establish
that a proposed device is substantially equivalent to a legally marketed device,
the manufacturer or distributor must seek premarket approval of the proposed
device through submission of a PMA application. A PMA application must be
supported by extensive data, including, in many instances, preclinical and
clinical trial data, as well as extensive literature to prove the safety and
effectiveness of the device. Following receipt of a PMA application, if the FDA
determines that the application is sufficiently complete to permit a substantive
review, the FDA will "file" the application. Under the FDC Act, the FDA has 180
days to review a PMA application, although the review of such an application
more often occurs over a protracted time period, and generally takes
approximately two years or more from the date of filing to complete.
The PMA application approval process can be expensive, uncertain and
lengthy. A number of devices for which premarket approval has been sought have
never been approved for marketing. The review time is often significantly
extended by the FDA, which may require more information or clarification of
information already provided in the submission. During the review period, an
advisory committee likely will be convened to review and evaluate the
application and provide recommendations to the FDA as to whether the device
should be approved. In addition, the FDA will inspect the manufacturing facility
to ensure compliance with the FDA's GMP or QS
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Regulations requirements prior to approval of an application. If granted, the
approval of the PMA application may include significant limitations on the
indicated uses for which a product may be marketed.
If necessary, the Company will file a PMA application with the FDA for
approval to sell its potential products commercially in the United States when
it has developed such products. There can be no assurance that the Company will
be able to obtain necessary PMA application approvals to market such products on
a timely basis, if at all, and delays in receipt or failure to receive such
approvals, the loss of previously received approvals, or failure to comply with
existing or future regulatory requirements could have a material adverse effect
on the Company's business, financial condition and results of operations.
The Company is also required to register as a medical device
manufacturer with the FDA and state agencies, such as the California Department
of Health Services ("CDHS") and to list its products with the FDA. As such, the
Company is subject to inspections by both the FDA and the CDHS for compliance
with the FDA's GMP or QS Regulations and other applicable regulations. These
regulations require that the Company maintain its documents in a prescribed
manner with respect to manufacturing, testing and control activities. Further,
the Company and the third party manufacturers of its products are required to
comply with various FDA requirements for design, safety, advertising and
labeling. In April 1995, the Company filed an application with the State of
California for a license to manufacture medical devices. In September 1995, the
State of California required the Company to cease shipping products until a
manufacturing license was obtained, and the FDA, following a GMP audit,
instructed the Company to correct certain record-keeping practices and enter
into a written contract with the third party that sterilizes the ArthroWand.
There can be no assurance that the Company will not encounter any further
manufacturing difficulties, or that any of its contract manufacturers will not
experience similar difficulties, including problems involving production yields,
quality control and assurance, supplies of components or shortages of qualified
personnel.
The Company is required to provide information to the FDA on death or
serious injuries alleged to have been associated with the use of its medical
devices, as well as product malfunctions that would likely cause or contribute
to death or serious injury if the malfunction were to recur. In addition, the
FDA prohibits a cleared or approved device from being marketed for uncleared or
unapproved applications. If the FDA believes that a company is not in compliance
with the law, it can institute proceedings to detain or seize products, issue a
recall, enjoin future violations and assess civil and criminal penalties against
the company, its officers and its employees. Failure to comply with the
regulatory requirements could have a material adverse effect on the Company's
business, financial condition and results of operations.
The advertising of most FDA-regulated products is subject to both FDA
and Federal Trade Commission jurisdiction. The Company also is subject to
regulation by the Occupational Safety and Health Administration and by other
governmental entities.
Regulations regarding the manufacture and sale of the Company's
products are subject to change. The Company cannot predict the effect, if any,
that such changes might have on its business, financial condition or results of
operations.
International
International sales of the Company's products are subject to the
regulatory agency product registration requirements of each country. The
regulatory review process varies from country to country. The Company has
obtained regulatory clearance to market the Arthroscopic System in Australia and
Europe but has not obtained any other international regulatory approvals
permitting sales of its products outside of the United States. The Company
intends to seek regulatory approvals in certain other international markets.
There can be no assurance, however, that such approvals will be obtained on a
timely basis or at all.
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In Europe, the Company and its third party manufacturers have received
ISO 9001 certification and the CE mark. ISO 9001 certification standards for
quality operations have been developed to ensure that companies know, on a
worldwide basis, the standards of quality to which they will be held. The
European Union has promulgated rules that require that medical products receive
by mid-1998 the CE mark, an international symbol of quality and compliance with
applicable European medical device directives. Failure to maintain the CE mark
will prohibit the Company from selling its products in Europe. ISO 9001
certification is one of the CE mark requirements. There can be no assurance that
the Company will be successful in maintaining certification requirements.
THIRD PARTY REIMBURSEMENT
In the United States, health care providers, such as hospitals and
physicians, that purchase medical devices, such as the Company's Arthroscopic
System and potential products, generally rely on third party payors, principally
federal Medicare, state Medicaid and private health insurance plans, to
reimburse all or part of the cost of the procedure in which the medical device
is being used. Reimbursement for arthroscopic procedures performed using devices
that have received FDA approval has generally been available in the United
States. In addition, certain health care providers are moving toward a managed
care system in which such providers contract to provide comprehensive health
care for a fixed cost per person. Managed care providers are attempting to
control the cost of health care by authorizing fewer elective surgical
procedures, such as certain knee and shoulder, ankle, wrist, elbow and hip
arthroscopic procedures.
The Company is unable to predict what changes will be made in the
reimbursement methods used by third-party health care payors. The Company
anticipates that in a prospective payment system, such as the DRG system
utilized by Medicare, and in many managed care systems used by private health
care payors, the cost of the Company's products will be incorporated into the
overall cost of the procedure and that there will be no separate, additional
reimbursement for the Company's products. The Company anticipates that hospital
administrators and physicians will justify the use of the Company's products by
the attendant cost savings and clinical benefits that the Company believes will
be derived from the use of its products. However, there can be no assurance that
this will be the case. Furthermore, the Company could be adversely affected by
changes in reimbursement policies of governmental or private health care payors,
particularly to the extent any such changes affect reimbursement for procedures
in which the Company's products are used. Failure by physicians, hospitals and
other users of the Company's products to obtain sufficient reimbursement from
health care payors for procedures in which the Company's products are used or
adverse changes in governmental and private third-party payors, policies toward
reimbursement for such procedures would have a material adverse effect on the
Company's business, financial condition and results of operations.
If the Company obtains the necessary foreign regulatory approvals,
market acceptance of the Company's products in international markets would be
dependent, in part, upon the availability of reimbursement within prevailing
health care payment systems. Reimbursement and health care payment systems in
international markets vary significantly by country, and include both
government-sponsored health care and private insurance. The Company intends to
seek international reimbursement approvals, although there can be no assurance
that any such approvals will be obtained in a timely manner, if at all.
PRODUCT LIABILITY AND INSURANCE
The development, manufacture and sale of medical products entail
significant risk of product liability claims. The Company's current product
liability insurance coverage limits are $5,000,000 per occurrence and $5,000,000
in the aggregate. There can be no assurance that such coverage limits are
adequate to protect the Company from any liabilities it might incur in
connection with the development, manufacture and sale of its Arthroscopic System
and potential products. In addition, the Company may require increased product
liability coverage if any potential products are successfully commercialized.
Product liability insurance is expensive and in the future may not be
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available to the Company on acceptable terms, if at all. The Company has been
selling its product since December 1995 and has not experienced any product
liability claims to date. However, a successful product liability claim or
series of claims brought against the Company in excess of its insurance coverage
could have a material adverse effect on the Company's business, financial
condition and results of operations.
EMPLOYEES
As of December 28, 1996, the Company had 79 employees. Twenty-nine
persons are engaged in manufacturing activities, 13 are engaged in research and
development activities, 14 persons are engaged in sales and marketing
activities, 12 persons are engaged in regulatory affairs and quality assurance
and 11 persons are engaged in administration and accounting. The Company also
had consulting and other contract arrangements with nine persons, including
members of its Scientific Advisory Board. No employees are covered by collective
bargaining agreements, and the Company believes it maintains good relations with
its employees.
The Company is dependent upon a number of key management and technical
personnel. The loss of the services of one or more key employees or consultants
could have a material adverse effect on the Company. The Company's success will
also depend on its ability to attract and retain additional highly qualified
management and technical personnel. The Company faces intense competition for
qualified personnel, many of whom are often subject to competing employment
offers, and there can be no assurance that the Company will be able to attract
and retain such personnel. Furthermore, the Company's scientific advisory board
members all are otherwise employed on a full-time basis. As a result, the
scientific advisory board members are not available to devote their full time or
attention to the Company's affairs.
FACILITIES
The Company leases approximately 22,000 square feet in Sunnyvale,
California, which comprise the Company's administrative offices and
manufacturing and warehousing space. The Company's lease for this facility
extends through February 2002. The Company believes that its existing facilities
will be sufficient for its operational purposes through 1997.
ADDITIONAL RISK FACTORS
HISTORY OF LOSSES; FLUCTUATIONS IN OPERATING RESULTS; LOSSES EXPECTED TO
CONTINUE
The Company has experienced significant operating losses since
inception and, as of December 28, 1996, had an accumulated deficit of $17.6
million. The Company expects to generate additional losses due to increased
operating expenditures primarily attributable to the expansion of marketing and
sales activities, increased research and development, and activities to support
regulatory applications. Results of operations may fluctuate significantly from
quarter to quarter due to the timing of such expenditures, absence of a backlog
of orders, timing of the receipt of orders, promotional discounts of the
Company's products, re-use of the Company's disposable products, in addition to
those detailed above. The Company's revenues and profitability will be
critically dependent on whether it can successfully continue to market its
Arthroscopic System. In addition, the Company's gross margins may be adversely
affected due to the necessity to promote and sell its products at significantly
reduced prices. There can be no assurance that significant profitability will
ever be achieved.
CONTROL BY DIRECTORS, EXECUTIVE OFFICERS AND AFFILIATED ENTITIES
The Company's directors, executive officers and entities affiliated
with them, in the aggregate, beneficially own approximately 44.85% of the
Company's outstanding Common Stock. These stockholders, if acting together,
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will have significant influence over all matters requiring approval by the
stockholders of the Company, including the election of directors and the
approval of mergers or other business combination transactions.
POTENTIAL VOLATILITY OF STOCK PRICE
The stock markets have experienced price and volume fluctuations that
have particularly affected medical technology companies, resulting in changes
in the market prices of the stocks of many companies that may not have been
directly related to the operating performance of those companies. Such broad
market fluctuations may adversely affect the market price of the Common Stock.
In addition, the market price of the Company's Common Stock may be highly
volatile. Factors such as variations in the Company's financial results,
comments by security analysts, announcements of technological innovations or
new products by the Company or its competitors, changing government regulations
and developments with respect to FDA submissions, patents, proprietary rights,
sales of a substantial number of shares of the Company's Common Stock in the
public market or litigation may have a significant adverse effect on the market
price of the Common Stock.
ANTI-TAKEOVER EFFECT OF STOCKHOLDER RIGHTS PLAN AND CERTAIN CHARTER AND BYLAW
PROVISIONS
In November 1996, the Company's Board of Directors adopted a
Stockholder Rights Plan. The Stockholder Rights Plan provides for a dividend
distribution of one Preferred Shares Purchase Right (a "Right") on each
outstanding share of the Company's Common Stock. Each Right entitles
stockholders to buy 1/1000th of a share of the Company's Series A Participating
Preferred Stock at an exercise price of $50.00. The Rights will become
exercisable following the tenth day after a person or group announces
acquisition of 15 percent or more of the Company's Common Stock, or announces
commencement of a tender offer, the consummation of which would result in
ownership by the person or group of 15 percent or more of the Company's Common
Stock. The Company will be entitled to redeem the Rights at $0.01 per Right at
any time on or before the tenth day following acquisition by a person or group
of 15 percent or more of the Company's Common Stock.
The Stockholder Rights Plan and certain provisions of the Company's
Certificate of Incorporation and Bylaws may have the effect of making it more
difficult for a third party to acquire, or of discouraging a third party from
attempting to acquire, control of the Company. This could limit the price that
certain investors might be willing to pay in the future for shares of the
Company's Common Stock. Certain provisions of the Company's Certificate of
Incorporation and Bylaws allow the Company to issue Preferred Stock without any
vote or further action by the stockholders, eliminate the right of stockholders
to act by written consent without a meeting, specify procedures for director
nominations by stockholders and submission of other proposals for consideration
at stockholder meetings, and eliminate cumulative voting in the election of
directors. Certain provisions of the Delaware General Corporation Law
applicable to the Company could also delay or make more difficult a merger,
tender offer or proxy contest involving the Company, including Section 203,
which prohibits a Delaware corporation from engaging in any business
combination with any interested stockholder for a period of three years unless
certain conditions are met. The Stockholder Rights Plan, the possible issuance
of Preferred Stock, the procedures required for director nominations and
stockholder proposals and Delaware law could have the effect of delaying,
deferring or preventing a change in control of the Company, including
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without limitation, discouraging a proxy contest or making more difficult the
acquisition of a substantial block of the Company's Common Stock. These
provisions could also limit the price that investors might be willing to pay in
the future for shares of the Company's Common Stock.
LACK OF DIVIDENDS
The Company has not paid any dividends and does not anticipate paying
any dividends in the foreseeable future.
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Item 2. PROPERTIES
The Company leases approximately 22,000 square feet in Sunnyvale,
California, which comprise the Company's administrative offices and
manufacturing and warehousing space. The Company's lease for this facility
extends through February 2002. The Company believes that its existing facilities
will be sufficient for its operational purposes through 1997.
Item 3. LEGAL PROCEEDINGS
Not applicable.
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
EXECUTIVE OFFICERS
The executive officers of the Company who are elected by and serve at
the discretion of the Board of Directors, and their ages are as follows:
NAME AGE POSITION
- --------------------------- --------- ---------------------------------------
Hira V. Thapliyal, Ph.D. 47 President and Chief Executive Officer
Robert T. Hagan 51 Vice President, Manufacturing
A. Larry Tannenbaum 45 Chief Financial Officer
Allan Weinstein 43 Vice President, Sales and Marketing
Hira V. Thapliyal, Ph.D., a founder of the Company, has served as
President, Chief Executive Officer and a Director of the Company since its
inception in April, 1993. From 1989 to 1993, Dr. Thapliyal was President and
Chief Executive Officer of MicroBionics, Inc., a privately held company
developing an in-vivo continuous blood gas monitor. In 1986, Dr. Thapliyal
founded Cardiovascular Imaging Systems, Inc. ("CVIS") and served as its
President until 1988. CVIS develops and markets catheters for ultrasonic
intraluminal imaging of human arteries. From 1984 to 1986, Dr. Thapliyal was
Vice President, Engineering of Devices for Vascular Interventions, Inc., a
leader in marketing atherectomy systems for treatment of atherosclerotic
disease. Dr. Thapliyal holds an M.S. degree in Electrical Engineering from
University of Idaho and a Ph.D. in Materials Science & Engineering from Cornell
University.
Robert T. Hagan joined the Company in August 1995 as Vice President,
Manufacturing. From October 1992 to July 1995, Mr. Hagan was retired. From
October 1984 to September 1992, Mr. Hagan held several manufacturing oversight
positions with Haemonetics Corporation, a manufacturer of blood processing
equipment and sterile disposables. His most recent position at Haemonetics
Corporation was Director of Advanced Manufacturing Technologies. Mr. Hagan holds
a B.S. degree in Electrical Engineering from Tennessee Technology University.
A. Larry Tannenbaum joined the Company in September 1995 as Chief
Financial Officer. From July 1995 until August 1995, Mr. Tannenbaum was
negotiating the terms of his employment with the Company. From May 1992 to May
1995, Mr. Tannenbaum was Vice President of Finance and Administration and the
Chief Financial Officer of Target Therapeutics, Inc. ("Target"), a leading
manufacturer of disposable medical devices for the treatment of various brain
diseases. Prior to joining Target, he was the Financial Business Manager,
Western Region, from
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20
October 1988 to May 1992 and Manager of Corporate Finance, from May 1987 to
October 1988 for Tandem Computers Incorporated. Mr. Tannenbaum holds an M.B.A.
degree from the University of Utah.
Allan Weinstein joined the Company in January 1995 as Vice President,
Sales and Marketing. From December 1982 to December 1994, Mr. Weinstein held
various marketing positions with Acufex Microsurgical, Inc. ("Acufex"), a
manufacturer of arthroscopic instruments. His most recent position at Acufex was
Director of Sales, North and South America. Mr. Weinstein holds a B.A. degree in
Communications from Seton Hall University.
DISCLOSURE WITH REGARD TO DELINQUENT FILINGS
Based solely on a review of Forms 3, 4, and 5 furnished to the Company
during 1996, the Company believes that director Annette J. Campbell-White
failed to timely file one Form 4 disclosing one covered transaction; Robert F.
Kibble who is affiliated with a ten percent shareholder failed to timely file
one Form 4 disclosing one covered transaction; director John S. Lewis failed to
timely file one Form 4 disclosing one covered transaction; officer A. Larry
Tannenbaum failed to timely file on Form 4 disclosing one covered transaction;
and officer Allan Weinstein failed to timely file one Form 4 disclosing one
covered transaction.
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PART II
Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock trades publicly on The Nasdaq Stock Market
under the symbol "ARTC." The following table sets forth for the periods
indicated the quarterly high and low closing sales prices of the Common Stock on
The Nasdaq Stock Market.
THREE MONTHS ENDED
-------------------------------------------------------
1996 March 30(1) June 29 September 28 December 28
- -------------------------- ----------- ------- ------------ ------------
High...................... $25.75 $24.75 $18.00 $11.00
Low....................... 16.875 14.813 8.75 6.75
(1) Prior to February 5, 1996, there was no established public trading
market for the Common Stock. Market prices presented for the quarter
ended March 31, 1996 are for the period commencing February 5, 1996 and
ending March 31, 1996.
As of March 1, 1997, there were no outstanding shares of Preferred
Stock and 249 holders of record of 8,790,450 shares of outstanding Common Stock.
The Company has not paid any dividends since its inception and does not intend
to pay any dividends on its Common Stock in the foreseeable future.
Item 6. SELECTED FINANCIAL DATA
The following is a summary of the Company's unaudited quarterly results
for the four quarters ended December 28, 1996 and December 31, 1995, the
audited annual results for the year ended December 28, 1996 and December 31,
1995 and 1994 and the results for the period from April 29, 1993 (date of
inception) to December 31, 1993. In management's opinion, the quarterly results
have been prepared on a basis consistent with the audited financial statements
contained elsewhere herein, and include all adjustments, consisting only of
normal recurring adjustments, necessary for a fair presentation of the
information for the periods presented. The information set forth below is not
necessarily indicative of the results of future operations and should be read
in conjunction with the financial statements and notes thereto appearing in
Item 8 of this report.
THREE MONTH PERIOD ENDED
---------------------------------------------------
March 31, June 30, September 30, December 31,
1995 1995 1995 1995
--------- --------- ------------- ------------
(in thousands)
Revenue $ 218
Gross Margin (229)
Operating Expense $1,227 $1,521 $2,064 2,128
Net Loss (1,206) (1,447) (2,009) (2,288)
THREE MONTH PERIOD ENDED
---------------------------------------------------
March 30, June 29, September 28, December 28,
1996 1996 1996 1996
--------- --------- ------------- ------------
(in thousands)
Revenue $1,159 $1,406 $1,574 $1,883
Gross Margin 94 170 209 307
Operating Expense 2,098 2,349 2,534 3,008
Net Loss (1,743) (1,735) (1,932) (2,295)
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FOR THE
PERIOD FROM
APRIL 29,
1993 (DATE OF
YEAR ENDED YEAR ENDED INCEPTION) TO
DECEMBER 28, DECEMBER 31, DECEMBER 31,
1996 1995 1994 1993
------------ ------ ------ -------------
(in thousands, except per share data)
STATEMENTS OF OPERATING DATA:
Net sales $ 6,022 $ 218
Cost of sales 5,242 447
------- -------
Gross profit (loss) 780 (229)
------- -------
Costs and expenses:
Research and development 3,772 4,009 $ 2,119 $ 750
Sales and marketing 3,635 1,351
General and administrative 2,582 1,320 128 107
Non-recurring charge for acquired
technology 260
------- ------- ------- -------
Total operating expenses 9,989 6,940 2,247 857
------- ------- ------- -------
Loss from operations (9,209) (7,169) (2,247) (857)
Interest income 1,514 219 126 15
Other expense (9)
------- ------- ------- -------
Net loss before provision for income (7,704) (6,950) (2,121) (842)
taxes
Provision for income taxes (1)
------- ------- ------- -------
Net loss $(7,705) $(6,950) $(2,121) $ (842)
======= ======= ======= =======
Net loss per share $ (0.94) $ (1.00) $ (0.33) $ (0.18)
======= ======= ======= =======
Shares used in computing net loss per 8,236 6,929 6,415 4,768
share ======= ======= ======= =======
FOR THE
PERIOD FROM
APRIL 29,
1993 (DATE OF
YEAR ENDED YEAR ENDED INCEPTION) TO
DECEMBER 28, DECEMBER 31, DECEMBER 31,
1996 1995 1994 1993
------------ ------ ------ -------------
(in thousands, except per share data)
BALANCE SHEET DATA:
Cash and cash equivalent $ 11,359 $ 4,774 $ 2,599 $ 993
Working capital 23,468 5,119 2,467 858
Total assets 33,297 7,800 2,917 1,048
Total stockholders equity 30,782 6,325 2,727 890
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Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
OVERVIEW
Since commencing operations in April 1993, ArthroCare Corporation has
primarily engaged in the design, development, clinical testing, manufacturing
and sale of its Arthroscopic System. The Arthroscopic System consists of a
disposable, bipolar ArthroWand, a radio frequency controller that powers the
ArthroWand and a cable that connects the ArthroWand to the controller. The
ArthroWand ablates (removes) soft tissue with minimal damage to surrounding
healthy tissue, and simultaneously achieves hemostasis (sealing of small
bleeding vessels).
The Company has a limited history of operations. The Company received
clearance of its 510(k) premarket notification from the FDA in March 1995 to
market its Arthroscopic System in the United States for use in arthroscopic
surgery of the knee, shoulder, elbow and ankle. The Company has since received
clearance for use in the wrist and hip. In December 1995, the Company
commercially introduced its Arthroscopic System through a network of
distributors in the United States. The Company's strategy includes placing
controllers with arthroscopic surgeons that are intended to generate future wand
revenues. The Company believes that if it places controllers with arthroscopic
surgeons, the controllers will be used by the surgeons and that the continued
use of the controllers will generate future wand sales. The Company's long term
strategy includes applying its proprietary platform technology to a range of
other soft tissue surgical procedures in the fields of urology, dermatology,
dental surgery, and gynecology. In that regard, the Company has received 510(k)
clearance for use of its technology in the field of urology and dental surgery,
and the Company is continuing to work with the FDA to obtain 510(k) clearance
for use of its technology in the field of dermatology and gynecology. There can
be no assurance that the Company's 510(k) applications for its dermatology and
gynecology systems under development will be cleared by the FDA on a timely
basis, if at all, or that the products, if cleared for marketing, will ever
achieve commercial acceptance. See "Business--Research and
Development", "--Marketing and Sales" and "--Government Regulation."
This Report on Form 10-K contains certain forward looking statements
regarding future events with respect to the Company. Actual events or results
may differ significantly as a result of the factors described herein and in the
documents incorporated herein by reference including, in particular, those
factors described under "Business" and those factors described under "Additional
Risk Factors."
RESULTS OF OPERATIONS
Overview
The year ended December 28, 1996 was the Company's first full year of
product shipments. The Company was in its development stage during the
comparable years ended December 31, 1995 and December 31, 1994.
Revenues
Revenues for the year ended December 28, 1996 were $6.0 million. The
Company was in its development stage during 1995 and 1994 and first shipped its
Arthroscopic System in December 1995. Revenues for the year ended December 31,
1995 were $0.2 million and there were no revenues in the year ended December 31,
1994. The Company's strategy is to increase the installed base of controllers by
offering aggressive promotional programs which bundle heavily discounted
controllers with volume wand sales or sales
-23-
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commitments. While this strategy has adversely impacted controller revenue and
gross margins, the installed base of controllers has grown to over 580 units
including over 370 controllers placed with doctors and hospitals. This installed
base of controllers generated sales of over 40,000 wands in 1996. The Company
expects to continue offering these promotional programs to keep the installed
base of controllers growing.
During the first quarter of 1996, controller placements were heavily
weighted toward dealers as they bought initial stocking inventory. From quarter
to quarter, the percentage of doctor and hospital placements of controllers
increased due in part to dealer demonstrations and promotional programs. The
Company expects placements of controllers with doctors and hospitals to remain
high as a percentage of overall placements in the future.
In each quarter of 1996, wand revenue increased as a percentage of
total revenue due to the growing installed base of controllers and related wand
purchases. For the year ended December 28, 1996, the revenue mix was
approximately 80% wand revenue and 20% controller revenue. The Company expects
wand sales to remain the primary component of revenues in the future.
The Company believes that, in its first full year of product shipment,
it has penetrated over 2% of the arthroscopic surgical tools market in the
United States. The Company also believes that approximately two-thirds of the
Company's wand revenue is being generated by wands purchased for use in shoulder
procedures. While the Company believes that shoulder procedures are the fastest
growing segment of the arthroscopic market, knee procedures represent the
largest segment of arthroscopic surgery in terms of the absolute number of
procedures. Accordingly, in order to achieve increasing wand sales over time,
the Company needs to increase wand sales for knee procedures. During the year,
the Company introduced additional wand styles designed to be used in both knee
and shoulder arthroscopic procedures which are intended to increase wand sales.
There can be no assurance that those wand styles will be adopted by doctors.
Overall, wands sold at or near list price during the year. Average
selling price (ASP) was somewhat higher in the second half of the year than in
the first half due to the large number of wands sold to dealers at discounts in
the first and second quarters of the year as dealers stocked initial inventory.
However, the Company does not expect wand ASP to continue to increase.
Controller ASP was negatively impacted by promotional programs which
discount controller prices when packaged with volume wand purchases or purchase
commitments. The Company expects to continue these promotional programs as a
strategy to increase controller placements which could result in increased wand
sales.
The Company has limited sales and marketing experience and can make no
assurance that current trends in sales and product acceptance will continue. See
"Business--ArthroCare's Solution: The ArthroCare ArthroScopic System"
and "--Marketing and Sales."
Cost of Sales
Cost of sales was $5.2 million, or 87% of revenues for the year ended
December 28, 1996. The Company was in its development stage during 1995 and 1994
and first shipped its Arthroscopic System in December 1995. Cost of sales for
year ended December 31, 1995 was $0.4 million, or 205% of revenues. There was no
cost of sales in 1994 since there were no sales.
Gross margins improved each quarter throughout the year, although
controller promotional programs had an offsetting affect on gross margins. The
Company believes that if its promotional programs maintain the same or higher
number of wands bundled with a discounted controller, and if the demand for the
disposable wands increases over a growing installed base of controllers, then
the cost of sales will continue to decrease as
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25
a percentage of revenue and gross margins will increase. However, there can be
no assurance the Company will be successful in maintaining the mix of wands to
discounted controllers in its promotional programs or increasing demand for its
disposable wands. See "Additional Risk Factors--History of Losses; Fluctuations
in Operating Results; Substantial Losses Expected to Continue."
Operating Expenses:
Research and development expense, which includes expenditures for
regulatory compliance and quality assurance, decreased to $3.8 million in the
year ended December 28, 1996 as compared to $4.0 million in the year ended
December 31, 1995. The decrease is due to the inclusion of manufacturing startup
costs in the year ended December 31, 1995 when the Company was in its
development stage. Research and development expense increased from $2.1 million
for the year ended December 31, 1994 to $4.0 million for the year ended December
31, 1995 due primarily to costs associated with additional product research,
prototype development, patent preparation and filing, increased facility
requirements, and additional costs associated with the Company's increased
regulatory and clinical personnel. The Company acquired Thapliyal & Eggers
Partners in March 1995, resulting in a non-recurring charge for acquired
technology of $260,000.
The Company believes that continued investment in its platform
technology is essential if it is to maintain its competitive position. The
Company expects to continue to make substantial expenditures on new product
development, regulatory affairs, clinical studies, and to increase research and
development spending. See "Business--Competition."
Sales and marketing expense increased substantially to $3.6 million in
the year ended December 28, 1996 from $1.4 million in the year ended December
31, 1995 when the Company was in its development stage. The increase was
primarily due to dealer commissions, and promotional, demonstration, and sample
expenses. There were no sales and marketing expenses for the year ended December
31, 1994. In the year ended December 31, 1995 the Company hired sales and
marketing personnel and expended $1.4 million on sales and marketing. The
Company currently anticipates that sales and marketing spending will continue to
increase due to dealer commissions, promotional, demonstration and sample
expenses, and additional investment in sales, marketing and support staff
necessary to market its products.
General and administrative expense doubled to $2.6 million for the year
ended December 28, 1996 from $1.3 million for the year ended December 31, 1995
due to additional staffing including management personnel, the increased cost of
being a public company, business development activities, and consulting fees and
expenses necessary to expand the corporate infrastructure. In the prior year,
general and administrative expenses increased to $1.3 million for the year ended
December 31, 1995 from $128,000 for the year ended December 31, 1994 due to the
Company's move to a new and larger facility in 1995, establishing the Company's
administrative infrastructure and costs related to the hiring of additional
personnel. The Company expects that general and administrative expenses will
continue to increase as the Company further expands its staffing and other
support operations.
Interest and Other Income
Net interest income increased to $1.5 million for the year ended
December 28, 1996 from $219,000 in the prior year ended December 31, 1995 due to
interest received on the investment of the proceeds of the 1996 initial public
offering of the Company's Common Stock. At the end of 1996 the Company had $29.3
million in cash, cash equivalents, and available-for-sale securities which
include long term available-for-sale securities. In the year ended December 31,
1995, interest income increased to $219,000 from $126,000 for the year ended
December 31, 1994. The increase is due to interest received on a higher level of
cash and cash equivalents resulting from the sale of additional shares of the
Company's Preferred Stock during 1995. The Company
-25-
26
expects that interest income will decrease as the Company reduces its
investments to meet the cash needs of the business.
Net Loss
Net loss was $7.7 million for the year ended December 28, 1996 compared
to $7.0 million in the year ended December 31, 1995. The increased loss is due
to higher operating expenses resulting from increased business activity
including product development, manufacturing ramp-up, dealer commissions, sales
and marketing expenses necessary to promote the product and building the
corporate infrastructure. The higher operating expense was partially offset by a
positive gross margin and higher interest and other income.
The net loss of $7.0 million for the year ended December 31, 1995
increased from $2.1 million net loss for the year ended December 31, 1994. The
increased loss is due to losses on the initial sales of the Company's product
and a significant increase in operating expense resulting from a higher research
and development necessary to bring the product to market, building the
manufacturing capacity, establishing a sales and marketing organization, the
Company's move to a new and larger facility in 1995, establishing the Company's
administrative infrastructure and costs related to the hiring of additional
personnel. The Company expects the net losses to continue and possibly increase
since operating expense increases may not be offset by increased sales at
improved gross margins.
LIQUIDITY AND CAPITAL RESOURCES
At December 28, 1996, the Company had $23.5 million in working capital
and its principal sources of liquidity consisted of $29.3 million in cash, cash
equivalents, and available-for-sale securities which include long-term
available-for-sale securities. The cash and cash equivalents are highly liquid
with original maturities of ninety days or less. The available-for-sale
securities consist mainly of bank notes, commercial paper, corporate bonds,
foreign debt securities rated A1/P1, A1/A or better and U.S. government
securities.
The Company's cash used in operations decreased slightly to $6.4
million for the year ended December 28, 1996 from $6.6 million for the year
ended December 31, 1995 reflecting higher accounts receivable, net loss, and
inventory at the end of 1996, offset by higher accrued compensation, accounts
payable and financial reporting expenses, and lower prepayments to a supplier of
the Company's inventory. Cash used in operations during the year ended December
31, 1995 increased to $6.6 million dollars from $2.1 million for the year ended
December 31, 1994, reflecting expenditures made primarily to increase research
and development, to form a marketing and sales organization, to support the
administrative infrastructure, to expand to a 22,000 square foot facility and to
begin building product inventory.
Accounts receivable increased to $1.3 million as of December 28, 1996
from $212,000 as of December 31, 1995, due to the increased selling activities.
The Company began commercial delivery of its product in December 1995. There
were no accounts receivable as of December 31, 1994.
Inventories increased to $759,000 as of December 28, 1996 as compared
to $516,000 as of December 31, 1995 due to the higher level of product sales
activity in 1996. Inventory built during 1995 was primarily due to the Company's
purchase of controller units and cables from its subcontractors and to the
buildup of inventory of ArthroWands in anticipation of the commercial launch in
December 1995. There was no inventory as of December 31, 1994. The Company
expects future inventory levels to grow both in absolute value and as a
percentage of sales.
Net property and equipment increased to $ 1.5 million as of December
28, 1996 from $1.1 million as of December 31, 1995 primarily due to purchases of
computer equipment, manufacturing equipment and
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27
machinery, and office equipment. During 1996, the Company upgraded its computer
network and made other acquisitions necessary to support its manufacturing,
research and development, sales and administrative activities. Net property and
equipment increased $900,000 during 1995 to $1.1 million as of December 31,
1995, primarily due to a $475,000 increase in manufacturing equipment and
machinery and office equipment. During this period, the Company installed the
necessary software and hardware systems to support its operations. In 1997, the
Company has planned but not committed to approximately $1.3 million in capital
expenditures.
The Company plans to finance its capital needs principally from cash,
cash equivalents, and available-for-sale securities which include long term
available-for-sale securities and related interest, existing capital resources
and to the extent available, lines of credit. The Company currently has no
commitments for any credit facilities such as revolving credit agreements or
lines of credit that could provide additional working capital. The Company
believes that its current cash, cash equivalents and available-for-sale
securities, together with interest thereon and the Company's existing capital
resources, will be sufficient to fund its operations at least through fiscal
1998. The Company's future liquidity and capital requirements will depend on
numerous factors including the Company's success of commercializing the
Arthroscopic System, the ability of the Company's suppliers to continue to meet
the demands of the Company at current prices, obtaining and enforcing patents
important to the Company's business, the status of regulatory approvals and
competition. There can be no assurance that the Company will not be required to
raise additional capital or that such capital will be available on acceptable
terms, if at all.
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Certain information required by this Item is included in Item 6 of
Part II of this Report and is incorporated herein by reference. All other
information required by this Item is included on pages 34 to 51 in Item 14 of
Part IV of this Report and is incorporated herein by reference.
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28
Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE
None
-28-
29
PART III
Item 10. EXECUTIVE OFFICERS AND DIRECTORS OF THE REGISTRANT
Information regarding the Directors of the Company is incorporated by
reference from the information set forth under the caption "Proposal No. 1:
Election of Directors" in the Proxy Statement. Information regarding the
executive officers of the Company is incorporated by reference from the
information set forth under the caption "Executive Officers of the Company" at
the end of Part I of this report. Information with respect to Directors and
Officers of the Company required by Item 405 of Regulation S-K is incorporated
herein by reference from information set forth under the caption "Filing of
Reports by Directors and Officers" in the Proxy Statement.
Item 11. EXECUTIVE COMPENSATION
The information required by this item is incorporated by reference from
the discussion in the Proxy Statement captioned "Executive Compensation."
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item is incorporated by reference from
the discussion in the Proxy Statement captioned "Share Ownership of Directors,
Officers and Certain Beneficial Owners."
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item is incorporated by reference
from the discussion in the Proxy Statement captioned "Certain Transactions."
Item 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES AND REPORTS ON FORM
8-K
(a) The following documents are filed as part of this Report.
Page
1. FINANCIAL STATEMENTS. The following financial statements
of the Company and the Report of Independent Accountants, are included
in Part IV of this report on the pages indicated.
Report of Independent Accountants.................................. 34
Balance Sheets as of December 28, 1996 and December 31, 1995....... 35
Statements of Operations for the years ended December 28, 1996,
and December 31, 1995, and 1994.................................... 36
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30
Statements of Stockholders' Equity for the years ended December
28, 1996 and December 31, 1995, and 1994....................... 37
Statements of Cash Flows for the years ended December 28, 1996
and December 31, 1995, and 1994................................ 38
Notes to Financial Statements.................................. 39
2. FINANCIAL STATEMENT SCHEDULE. The following financial statement
schedule of the Company as of and for the years ended December
31, 1996 and 1995, and the Report of Independent Accountants on
Financial Statements Schedule (page) are included in Part IV of
this Report on the pages indicated. This financial statement
schedule should be read in conjunction with the Financial
Statements, and notes thereto, of the Company.
SCHEDULE TITLE PAGE
II Valuation and Qualifying Accounts....................... 51
Schedules not listed above have been omitted because they are
not applicable, not required, or the information required to
be set forth therein is included in the Financial Statements
or notes thereto.
3. EXHIBITS (in accordance with Item 601 of Regulation S-K).
3.2* Certificate of Incorporation of the Registrant.
3.3* Bylaws of the Registrant.
4.1* Specimen Common Stock Certificate.
10.1* Form of Indemnification Agreement between the
Registrant and each of its directors and officers.
10.2* Incentive Stock Plan and form of Stock Option
Agreement thereunder.
10.3* Director Option Plan and form of Director Stock Option
Agreement thereunder.
10.4* Employee Stock Purchase Plan and forms of agreements
thereunder.
10.5* Form of Exclusive Distribution Agreement.
10.6* Form of Exclusive Sales Representative Agreement.
10.7* Consulting Agreement, dated May 10, 1993, between the
Registrant and Philip E. Eggers, and amendment
thereto.
10.8* Consulting Agreement, dated May 20, 1993, between the
Registrant and Eggers & Associates, Inc., and
amendment thereto.
10.9*+ Development and Supply Agreement, dated March 1, 1994,
between the Registrant and SeaMed Corporation.
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31
10.10* Lease Agreement, dated September 15, 1994, between the
Registrant and The Arrillaga Foundation and the Peery
Foundation for the Company's facility located at 595
North Pastoria Avenue, Sunnyvale, California 94086.
10.11 Employment Letter Agreement, dated October 21, 1994,
between the Registrant and Allan Weinstein and
amendment thereto.
10.12* Purchase Assistance Promissory Note, dated January 19,
1995, between the Registrant and Allan Weinstein.
10.13* Sublease Agreement, dated February 1, 1995, between
the Registrant and Guided Medical Systems, Inc. for
the Company's former facility at 453 Ravendale Drive,
Mountain View, California, 94043.
10.14* Mortgage Assistance Promissory Note Agreement, dated
February 5, 1995, between the Registrant and Allan
Weinstein.
10.15* Restricted Stock Purchase and Security Agreement,
dated February 5, 1995, between the Registrant and
Allan Weinstein.
10.16* Employment Letter Agreement, dated July 18, 1995,
between the Registrant and Robert T. Hagan.
10.17* Restricted Stock Purchase and Security Agreement,
dated August 1, 1995, between the Registrant and
Robert T. Hagan.
10.18* Employment Letter Agreement, dated September 3, 1995,
between the Registrant and A. Larry Tannenbaum.
10.19*+ Radiation Services Agreement, dated September 13,
1995, between the Registrant and SteriGenics
International.
10.20* Amended and Restated Stockholder Rights Agreement,
dated October 16, 1995, between the Registrant and
certain holders of the Company's securities.
10.21* Contribution Agreement, dated March 31, 1995, by and
among Philip E. Eggers, Robert S. Garvie, Anthony J.
Manlove, Hira V. Thapliyal and the Registrant.
10.22** Preferred Shares Rights Agreement, dated November 14,
1996, between the Registrant and Norwest Bank
Minnesota, N.A.
11.1 Calculation of net loss per share.
23.1* Consent of Coopers & Lybrand L.L.P., Independent
Public Accountants.
24.1* Power of Attorney (See "Power of Attorney").
27.1 Financial Data Schedule.
- ----------
* Incorporated herein by reference to the same-numbered exhibit previously
filed with the Company's Registration Statement on Form S-1 (Registration
No. 33-80453).
** Previously filed as Exhibit 5 to Registration Statement on Form 8-A
(Registration No. 000- 27422) and incorporated herein by reference.
+ Confidential treatment granted.
-31-
32
Schedules have been omitted because the information required to be set
forth therein is not applicable or is shown in the consolidated financial
statements or notes thereto incorporated by reference herein.
-32-
33
ARTHROCARE CORPORATION
FINANCIAL STATEMENTS
AS OF DECEMBER 28, 1996 AND DECEMBER 31, 1995
AND FOR EACH OF THE THREE YEARS
IN THE PERIOD ENDED DECEMBER 28, 1996
-33-
34
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders
ArthroCare Corporation:
We have audited the accompanying balance sheets of ArthroCare Corporation as of
December 28, 1996 and December 31, 1995, and the related statements of
operations, stockholders' equity and cash flows for each of the three years in
the period ended December 28, 1996. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of ArthroCare Corporation as of
December 28, 1996 and December 31, 1995, and the results of its operations and
its cash flows for each of the three years in the period ended December 28, 1996
in conformity with generally accepted accounting principles.
/s/ COOPERS & LYBRAND L.L.P.
San Jose, California
February 28, 1997
-34-
35
ARTHROCARE CORPORATION
BALANCE SHEETS
(in thousands, except per share data)
December 28, December 31,
1996 1995
------------ ------------
ASSETS
Current assets:
Cash and cash equivalents $ 11,359 $ 4,774
Available-for-sale securities 12,281 -
Accounts receivable, net 1,251 212
Inventories 759 516
Prepaid expenses and other current assets 155 891
------------ ------------
Total current assets 25,805 6,393
Available-for-sale securities 5,641 -
Property and equipment, net 1,484 1,135
Related party receivables 298 223
Other 69 49
------------ ------------
Total assets $ 33,297 $ 7,800
============ ============
LIABILITIES
Current liabilities:
Accounts payable:
Trade $ 1,001 $ 732
Related parties 54 35
Accrued liabilities 1,245 472
Capital lease obligation, current portion 37 35
------------ ------------
Total current liabilities 2,337 1,274
Capital lease obligation, less current portion 21 53
Deferred rent 157 148
------------ ------------
Total liabilities 2,515 1,475
------------ ------------
Commitments (Note 8).
STOCKHOLDERS' EQUITY
Convertible preferred stock, par value $0.001:
Authorized: 5,000 shares in 1996 and 8,945 shares in 1995;
Series A:
Issued and outstanding: none in 1996 and 1,856 shares in 2
1995;
(Liquidation preference: none in 1996 and $1,763 in 1995)
Series B:
Issued and outstanding: none in 1996 and 2,500 shares in 3
1995;
(Liquidation preference: none in 1996 and $4,000 in 1995)
Series C:
Issued and outstanding: none in 1996 and 2,923 shares in 3
1995;
(Liquidation preference: none in 1996 and $5,845 in 1995)
Series D:
Issued and outstanding: none in 1996 and 1,667 shares in 1
1995;
(Liquidation preference: none in 1996 and $4,197 in 1995)
Common stock, par value $0.001:
Authorized: 20,000 shares;
Issued and outstanding: 8,778 shares in 1996 and 1,793 9 2
shares in 1995
Additional paid in capital 48,862 16,869
Notes receivable from stockholder (92) (92)
Deferred compensation (388) (550)
Unrealized gain on available-for-sale securities 9 -
Accumulated deficit (17,618) (9,913)
------------ ------------
Total stockholders' equity 30,782 6,325
------------ ------------
Total liabilities and stockholders' equity $ 33,297 $ 7,800
============ ============
The accompanying notes are an integral part of these financial statements.
-35-
36
ARTHROCARE CORPORATION
STATEMENTS OF OPERATIONS
(in thousands, except per share data)
YEAR ENDED YEAR ENDED
DECEMBER 28, DECEMBER 31,
1996 1995 1994
------- ------- -------
Net sales $ 6,022 $ 218
Cost of sales 5,242 447
------- -------
Gross profit (loss) 780 (229)
------- -------
Costs and expenses:
Research and development 3,772 4,009 $ 2,119
Sales and marketing 3,635 1,351
General and administrative 2,582 1,320 128
Non-recurring charge for acquired technology 260
------- ------- -------
Total operating expenses 9,989 6,940 2,247
------- ------- -------
Loss from operations (9,209) (7,169) (2,247)
Interest income 1,514 219 126
Other expense (9)
------- ------- -------
Net loss before provision for income taxes (7,704) (6,950) (2,121)
Provision for income taxes (1) -- --
------- ------- -------
Net loss $(7,705) $(6,950) $(2,121)
======= ======= =======
Net loss per share $ (0.94) $ (1.00) $ (0.33)
======= ======= =======
Shares used in computing net loss per share 8,236 6,929 6,415
======= ======= =======
The accompanying notes are an integral part of these financial statements.
-36-
37
ARTHROCARE CORPORATION
STATEMENT OF STOCKHOLDERS' EQUITY
for the years ended December 28, 1996, December 31, 1995 and 1994
PREFERRED STOCK COMMON STOCK
-------------------------- -----------------------------
SHARES AMOUNT SHARES AMOUNT
---------- ------------ --------- ------------
BALANCES, DECEMBER 31, 1993 1,856,127 $ 1,856 1,176,475 $ 1,177
Issuance of Series B preferred stock for cash at $1.60 per share in
January 1994, net of issuance costs of $43,841 2,500,000 2,500
Proceeds from exercise of options to purchase common stock at
$0.20 in December 1994 7,500 8
Issuance of common stock under a restricted stock purchase
agreement at $0.32 in December 1994 2,500 2
Net loss
---------- ------------ --------- ------------
BALANCES, DECEMBER 31, 1994 4,356,127 4,356 1,186,475 1,187
Issuance of Series C preferred stock for cash at $2.00 per share in
March and June 1995, net of issuance costs of $17,223 2,922,500 2,923
Issuance of notes receivable in exchange for exercise of options to
purchase common stock at $0.32 per share in February 1995 and
$0.80 per share in August 1995 190,000 190
Issuance of common stock at $0.40 per share in exchange for
intellectual property rights in March 1995 400,000 400
Proceeds from exercise of options to purchase common stock at
$0.32 per share in April 1995 1,250 1
Proceeds from exercise of options to purchase common stock at
$1.60 per share in October 1995 15,000 15
Issuance of Series D preferred stock for cash at $3.00 per share in
October 1995, net of issuance costs of $7,076 1,399,109 1,399
Repayment of note receivable from stockholder in November 1995
Deferred compensation related to grants of stock options
Amortization of deferred compensation
Net loss
---------- ------------ --------- ------------
BALANCES, DECEMBER 31, 1995 8,677,736 8,678 1,792,725 1,793
Issuance of common stock through:
Initial public offering at $14.00 per share in February 1996, net
of issuance costs of $3,563,209 2,530,000 2,530
Conversion of preferred shares in connection with initial public
offering in February 1996 (8,677,736) (8,678) 4,338,868 4,338
Exercise of stock options 106,650 106
Exercise of purchase rights 10,101 10
Deferred compensation related to issuance of common stock and
grants of stock options
Amortization of deferred compensation
Unrealized gain on available-for-sale securities
Net loss
---------- ------------ --------- ------------
BALANCES, DECEMBER 28, 1996 -- $ -- 8,778,344 $ 8,777
========== ============ ========= ============
NOTES
ADDITIONAL RECEIVABLE
PAID-IN FROM DEFERRED UNREALIZED
CAPITAL STOCKHOLDER COMPENSATION GAIN
------------ ------------ ------------ ------------
BALANCES, DECEMBER 31, 1993 $ 1,728,960
Issuance of Series B preferred stock for cash at $1.60 per share in
January 1994, net of issuance costs of $43,841 3,953,659
Proceeds from exercise of options to purchase common stock at
$0.20 in December 1994 1,492
Issuance of common stock under a restricted stock purchase
agreement at $0.32 in December 1994 798
Net loss
------------
BALANCES, DECEMBER 31, 1994 5,684,909
Issuance of Series C preferred stock for cash at $2.00 per share in
March and June 1995, net of issuance costs of $17,223 5,824,854
Issuance of notes receivable in exchange for exercise of options to
purchase common stock at $0.32 per share in February 1995 and
$0.80 per share in August 1995 103,810 $ (104,000)
Issuance of common stock at $0.40 per share in exchange for
intellectual property rights in March 1995 159,600
Proceeds from exercise of options to purchase common stock at
$0.32 per share in April 1995 399
Proceeds from exercise of options to purchase common stock at
$1.60 per share in October 1995 23,985
Issuance of Series D preferred stock for cash at $3.00 per share in
October 1995, net of issuance costs of $7,076 4,188,852
Repayment of note receivable from stockholder in November 1995 12,000
Deferred compensation related to grants of stock options 882,280 $ (882,280)
Amortization of deferred compensation 332,673
Net loss
------------ ------------ ------------
BALANCES, DECEMBER 31, 1995 16,868,689 (92,000) (549,607)
Issuance of common stock through:
Initial public offering at $14.00 per share in February 1996, net
of issuance costs of $3,563,209 31,854,261
Conversion of preferred shares in connection with initial public
offering in February 1996 4,340
Exercise of stock options 63,524
Exercise of purchase rights 66,059
Deferred compensation related to issuance of common stock and
grants of stock options 5,271 (5,271)
Amortization of deferred compensation 166,841
Unrealized gain on available-for-sale securities
$ 8,674
Net loss
------------ ------------ ------------ ------------
BALANCES, DECEMBER 28, 1996 $ 48,862,144 $ (92,000) $ (388,037) $ 8,674
============ ============ ============ ============
TOTAL
ACCUMULATED STOCKHOLDERS'
DEFICIT EQUITY
------------ ------------
BALANCES, DECEMBER 31, 1993 $ (841,829) $ 890,164
Issuance of Series B preferred stock for cash at $1.60 per share in
January 1994, net of issuance costs of $43,841 3,956,159
Proceeds from exercise of options to purchase common stock at
$0.20 in December 1994 1,500
Issuance of common stock under a restricted stock purchase
agreement at $0.32 in December 1994 800
Net loss (2,121,197) (2,121,197)
------------ ------------
BALANCES, DECEMBER 31, 1994 (2,963,026) 2,727,426
Issuance of Series C preferred stock for cash at $2.00 per share in
March and June 1995, net of issuance costs of $17,223 5,827,777
Issuance of notes receivable in exchange for exercise of options to
purchase common stock at $0.32 per share in February 1995 and
$0.80 per share in August 1995 --
Issuance of common stock at $0.40 per share in exchange for
intellectual property rights in March 1995 160,000
Proceeds from exercise of options to purchase common stock at
$0.32 per share in April 1995 400
Proceeds from exercise of options to purchase common stock at
$1.60 per share in October 1995 24,000
Issuance of Series D preferred stock for cash at $3.00 per share in
October 1995, net of issuance costs of $7,076 4,190,251
Repayment of note receivable from stockholder in November 1995 12,000
Deferred compensation related to grants of stock options --
Amortization of deferred compensation 332,673
Net loss (6,949,970) (6,949,970)
------------ ------------
BALANCES, DECEMBER 31, 1995 (9,912,996) 6,324,557
Issuance of common stock through:
Initial public offering at $14.00 per share in February 1996, net
of issuance costs of $3,563,209 31,856,791
Conversion of preferred shares in connection with initial public
offering in February 1996
Exercise of stock options 63,630
Exercise of purchase rights 66,069
Deferred compensation related to issuance of common stock and
grants of stock options --
Amortization of deferred compensation 166,841
Unrealized gain on available-for-sale securities 8,674
Net loss (7,704,759) (7,704,759)
------------ ------------
BALANCES, DECEMBER 28, 1996 $(17,617,755) $(30,781,803)
============ ============
-37-
38
ARTHROCARE CORPORATION
STATEMENTS OF CASH FLOWS
(in thousands)
YEAR ENDED YEAR ENDED
DECEMBER 28, DECEMBER 31,
1996 1995 1994
--------- --------- ---------
Cash flows from operating activities:
Net loss $ (7,704) $ (6,950) $ (2,121)
Adjustments to reconcile net loss to net cash used in operating activities:
Non-recurring charge for acquired technology 260
Amortization of deferred compensation 166 333
Depreciation and amortization 370 173 28
Write off of property and equipment 309
Provision for doubtful accounts receivable and product returns 313 5
Provision for excess and obsolete inventories 50 50
Deferred rent 9 136 6
Changes in operating assets and liabilities:
Accounts receivable (1,352) (217)
Inventory (293) (566)
Prepaid expenses and other current assets 736 (860) 2
Accounts payable 288 647 (13)
Accrued liabilities 772 437 21
Change in other assets (20) (37) (6)
--------- --------- ---------
Net cash used in operating activities (6,356) (6,589) (2,083)
--------- --------- ---------
Cash flows from investing activities:
Purchases of property and equipment (1,028) (920) (248)
Purchase of available-for-sale securities (189,648) (2,500)
Sales or maturities of available-for-sale securities 171,735 2,500
Purchase of intellectual property rights (100)
--------- --------- ---------
Net cash used in investing activities (18,941) (1,020) (248)
--------- --------- ---------
Cash flows from financing activities:
Issuance of notes receivable to related parties (75) (223)
Repayment of capital leases (29) (47) (1)
Repayment of note receivable from stockholder 12
Proceeds from issuance of common and preferred stock, net of issuance costs 31,923 10,018 3,956
Proceeds from exercise of options to purchase common stock 63 24 2
--------- --------- ---------
Net cash provided by financing activities 31,882 9,784 3,957
--------- --------- ---------
Net increase in cash and cash equivalents 6,585 2,175 1,626
Cash and cash equivalents, beginning of period 4,774 2,599 973
--------- --------- ---------
Cash and cash equivalents, end of period $ 11,359 $ 4,774 $ 2,599
========= ========= =========
SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES:
Additions to property and equipment acquired under capital lease $ 113 $ 20
Common stock issued for note receivable $ 104
Common stock issued in exchange for intellectual property rights $ 160
Conversion of preferred stock to common stock in connection
with the Company's initial public offering $ 15,705
The accompanying notes are an integral part of these financial statements.
-38-
39
ARTHROCARE CORPORATION
NOTES TO FINANCIAL STATEMENTS
1. Formation and Business of the Company:
ArthroCare Corporation, referred to hereafter as the Company, was
incorporated on April 29, 1993. The Company designs, develops,
manufactures and markets medical devices for use in arthroscopic and
orthopedic procedures. The Company's principal operations commenced in
August 1995, at which time it emerged from the development stage.
On November 22, 1995, the Company was reincorporated in the state of
Delaware with the associated exchange of shares of each class and
series of stock of the predecessor company for one share of each
identical class and series of stock of the Delaware successor company
having a par value of $0.001 per share for both common stock and
preferred stock.
The Company sold 2,530,000 shares of common stock (including 330,000
shares from the exercise of the underwriter's overallotment option) at
$14.00 per share through an initial public offering in February 1996.
Net proceeds (after underwriter's commissions and fees along with other
costs associated with the offering) totaled $31,856,791. Upon
completion of the offering, all outstanding shares of preferred stock
(a total of 8,677,736 shares) were converted into shares of common
stock on a one-for-two basis.
In the course of its development activities, the Company has sustained
operating losses and expects such losses to continue through December
31, 1997. The Company will finance its operations primarily through
its cash, cash equivalents and available-for-sale securities, together
with future revenues. There can be no assurance that the Company will
not require additional funding and should this prove necessary, the
Company may sell additional shares of its common or preferred stock
through private placement or further public offerings.
2. Summary of Significant Accounting Policies:
STOCK SPLIT:
On December 12, 1995, the Company effected a 1-for-2 reverse common
stock split and a corresponding change in the preferred stock
conversion ratios. All common stock data in the accompanying financial
statements has been retroactively adjusted to reflect the reverse stock
split.
USE OF ESTIMATES:
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities of the
date of the financial statements and the reported amounts of revenues
and expenses during the reporting period. Actual results could differ
from those estimates.
CASH AND CASH EQUIVALENTS AND AVAILABLE-FOR-SALE SECURITIES:
The Company considers all highly liquid investments purchased with
original maturities of three months or less to be cash equivalents.
Cash and cash equivalents include money market funds and various
deposit accounts.
-39-
40
ARTHROCARE CORPORATION
NOTES TO FINANCIAL STATEMENTS, Continued
2. Summary of Significant Accounting Policies continued:
The Company has classified its investments as "available-for-sale."
Such investments are recorded at fair value and unrealized gains and
losses, if material, are recorded as a separate component of equity
until realized. Interest income is recorded using an effective interest
rate, with associated premium or discount amortized to "investment
income." The cost of securities sold is based upon the specific
identification method.
INVENTORIES:
Inventories are stated at the lower of cost (determined on a first-in,
first-out basis) or market value.
DEPRECIATION:
Property and equipment are stated at cost and are depreciated on a
straight-line basis over their estimated useful lives of three to five
years. Leasehold improvements are amortized over their estimated useful
lives, or the lease term, if shorter.
REVENUE RECOGNITION:
The Company recognizes revenue upon shipment of product to the
customer, upon fulfillment of acceptance terms, if any, and when no
significant contractual obligations remain.
RESEARCH AND DEVELOPMENT:
Research and development costs are charged to operations as incurred.
CONCENTRATION OF CREDIT RISK:
The Company's cash and cash equivalents are maintained at four
financial institutions. Deposits at these institutions may exceed the
amount of insurance provided on such deposits.
For accounts receivable, management of the Company performs ongoing
credit evaluations of its customers and maintains allowances for
doubtful accounts. As of December 28, 1996, no individual customer
accounted for more than 10% of accounts receivable. As of December 31,
1995, one customer accounted for 17% gross accounts receivable.
RISK AND UNCERTAINTIES:
The Company's products require approvals from the Food and Drug
Administration (FDA) and international regulatory agencies prior to the
commencement of commercialized sales. There can be no assurance that
the Company's products will receive any of these required approvals. If
the Company was denied such approvals, or such approvals were delayed,
it would have a materially adverse impact on the Company.
-40-
41
ARTHROCARE CORPORATION
NOTES TO FINANCIAL STATEMENTS, Continued
2. Summary of Significant Accounting Policies continued:
INCOME TAXES:
The Company accounts for income taxes under Statement of Financial
Accounting Standard (SFAS) No. 109, "Accounting for Income Taxes,"
which prescribes the use of the liability method whereby deferred tax
asset or liability account balances are calculated at the balance sheet
date using current tax laws and rates in effect for the year in which
the differences are expected to affect taxable income. Valuation
allowances are established when necessary to reduce deferred tax assets
to the amounts expected to be realized.
NET LOSS PER SHARE:
The net loss per share is computed using the weighted average number of
shares of common stock outstanding. Common equivalent shares from stock
options, warrants and preferred stock are excluded from the computation
as their effect is anti-dilutive, except that, pursuant to the
Securities and Exchange Commission Staff Accounting Bulletin, common
and common equivalent shares issued at prices below the public offering
price during the 12 months immediately preceding the initial filing
date have been included in the calculation as if they were outstanding
for all periods prior to the initial filing date (using the treasury
stock method and the initial public offering price).
3. Available-For-Sale Securities:
The following summarizes the Company's available-for-sale securities
(in thousands):
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED ACCRUED MARKET
COST GAINS LOSSES INTEREST VALUE
------- ------- ------- ------- -------
December 28, 1996:
U.S. government notes and bonds ... $ 1,588 $ 7 $ 42 $ 1,637
Corporate notes and bonds ....... 13,040 12 $ (10) 336 13,378
Corporate equities .............. 2,900 7 2,907
------- ------- ------- ------- -------
$17,528 $ 19 $ (10) $ 385 $17,922
======= ======= ======= ======= =======
Available-for-sale debt securities by contractual maturity at December
28, 1996 are shown below (in thousands):
AMORTIZED MARKET
COST VALUE
------- -------
Less than one year ................... $14,628 $15,015
======= =======
-41-
42
ARTHROCARE CORPORATION
NOTES TO FINANCIAL STATEMENTS, Continued
4. Inventories:
Inventories comprise (in thousands):
DECEMBER 28, DECEMBER 31,
1996 1995
------------ ------------
Raw materials ................................ $345 $418
Work-in-process .............................. 32 2
Finished goods ............................... 382 96
---- ----
Total inventories ................... $759 $516
==== ====
5. Prepaid Expenses and Other Current Assets:
Prepaid expenses and other current assets comprise (in thousands):
DECEMBER 28, DECEMBER 31,
1996 1995
------------ ------------
Prepaid costs associated with initial
public offering ................................ $489
Advances to contract manufacturer ................ 213
Prepaid marketing expenses ....................... 137
Prepaid insurance ................................ $ 45
Prepaid rent ..................................... 34
Other ............................................ 76 52
---- ----
$155 $891
==== ====
6. Property and Equipment:
Property and equipment comprise (in thousands):
DECEMBER 28, DECEMBER 31,
1996 1995
Office equipment ........................... $ 200 $ 425
Computer equipment ......................... 732 111
Machinery and equipment .................... 1,100 802
Leasehold improvements ..................... 25
------- -------
2,057 1,338
Less accumulated depreciation and
amortization ............................... (573) (203)
------- -------
$ 1,484 $ 1,135
======= =======
-42-
43
ARTHROCARE CORPORATION
NOTES TO FINANCIAL STATEMENTS, Continued
6. Property and Equipment continued:
Equipment acquired under capital leases included in property and
equipment above comprise:
DECEMBER 28, DECEMBER 31,
1996 1995
------------ ------------
Machinery and equipment .... $ 109 $ 112
Less accumulated amortization .. (54) (24)
----- -----
$ 55 $ 88
===== =====
7. Accrued Liabilities:
Accrued liabilities comprise (in thousands):
DECEMBER 28, DECEMBER 31,
1996 1995
------------ ------------
Accrued professional fees ...... $ 163
Accrued compensation ........... 777 $ 280
Accrued warranty ............... 123
Accrued costs associated with initial
public offering ........... 150
Other .......................... 182 42
------ ------
$1,245 $ 472
====== ======
8. Commitments:
CAPITAL LEASE:
The Company leases certain of its office and computer equipment under
capital lease agreements with finance companies which expire in
November 1998. At December 28, 1996, future minimum payments under
capital leases are as follows (in thousands):
1997...................................... $47
1998...................................... 16
---
Minimum lease payments.................... 63
Less amount representing interest......... (5)
---
Present value of minimum lease payments... 58
Less current portion...................... (37)
---
$21
===
-43-
44
ARTHROCARE CORPORATION
NOTES TO FINANCIAL STATEMENTS, Continued
8. Commitments, continued:
OPERATING LEASES:
The Company rents its office facilities under an operating lease which
expires in February 2002.
OPERATING LEASES:
At December 28, 1996, total future minimum facility lease payments are
as follows (in thousands):
1997..................................... $ 281
1998..................................... 328
1999..................................... 341
2000..................................... 354
2001..................................... 367
Thereafter............................... 62
------
$1,733
======
Rent expense for the years ended December 28, 1996, December 31, 1995
and 1994 was $345,000, $263,000 and $54,000, respectively.
DEVELOPMENT AGREEMENT:
On March 1, 1994, the Company entered into a three-year agreement with
a contract manufacturer whereby the contract manufacturer would
manufacture and sell electrosurgical device controllers to the Company.
At December 28, 1996, the Company is required to make payments of
approximately $1,389,000 to the contract manufacturer during 1997.
9. Stockholders' Equity
PREFERRED STOCK:
Under the Company's Articles of Incorporation, the Company's preferred
stock is issuable in series. At December 28, 1996, 5,000,000 shares of
preferred stock are authorized and no preferred stock is issued and
outstanding as the previously outstanding preferred stock was converted
into common shares in connection with the Company's Initial Public
Offering effective February 5, 1996.
STOCK OPTION PLANS:
In May 1993, the Company approved the 1993 Stock Plan (the Plan) under
which the Board of Directors of the Company are authorized and directed
to enter into stock option agreements with selected individuals.
Options granted under the plan generally become exercisable 12/48 at
the end of one year following date of grant and additional 1/48 of the
shares shall become exercisable on the last day of each full calendar
month thereafter until all of the shares have become exercisable.
-44-
45
ARTHROCARE CORPORATION
NOTES TO FINANCIAL STATEMENTS, Continued
9. Stockholders' Equity, continued:
In August 1993, the Company revised the vesting of stock options
granted to certain individuals. For these individuals, one-third of the
total options granted are exercisable at the end of each full year
following the date of grant until all options are exercisable or,
alternatively, all options become exercisable upon final approval of
the appropriate authorities of the Company's 510(k) application for the
particular project for which the individual was responsible for
directing.
Activity under the Plan is as follows (in thousands, except per share
data):
SHARES OUTSTANDING OPTIONS
AVAILABLE ------------------------------------------
FOR NUMBER EXERCISE AGGREGATE
GRANT OF SHARES PRICE PRICE
--------- --------- ------------- ---------
Balances, December 31, 1993 ...... 1 135 $ 0.20 $ 27
Additional shares authorized ... 250
Stock granted .................. (100) 100 $ 0.32 32
Options granted ................ (41) 41 $ 0.32 13
Options exercised .............. (8) $ 0.20 (1)
Options canceled ............... 15 (15) $ 0.20 (3)
----- ---- -------
Balances, December 31, 1994 ...... 125 253 $ 0.20-$ 0.32 68
Additional shares authorized ... 1,150
Stock purchased ................ (100) $ 0.32 (32)
Options granted ................ (365) 365 $ 0.32-$ 9.00 885
Options exercised .............. (16) $ 0.32-$ 1.60 (24)
Options canceled ............... 9 (9) $ 0.32-$ 1.60 (5)
----- ---- -------
Balances, December 31, 1995 ...... 919 493 $ 0.20-$ 9.00 892
Options granted ................ (263) 262 $9.375-$24.25 3,291
Options exercised .............. (106) $ 0.20-$ 5.00 (64)
Options canceled ............... 55 (55) $ 0.20-$24.25 (221)
----- ---- -------
Balances, December 28, 1996 ...... 711 594 $ 0.20-$24.25 $ 3,898
===== ==== =======
At December 28, 1996, 147,000 options had vested.
In December 1995, the Company adopted the Director Option Plan and
reserved 100,000 shares of common stock for issuance. As of December
28, 1996, no stock options had been granted under the Plan.
-45-
46
ARTHROCARE CORPORATION
NOTES TO FINANCIAL STATEMENTS, Continued
9. Stockholders' Equity, continued:
In January 1995, pursuant to a restricted stock purchase agreement,
100,000 shares were purchased by an officer of the Company at $0.32 per
share. The restricted stock purchase agreement contains provisions for
the repurchase of common stock by the Company in the event of
termination of employment during the four years following January 3,
1995. At December 28, 1996, 41,667 shares were subject to repurchase
and will be released ratably over the following 25 months.
In August 1995, 90,000 shares of common stock were purchased by an
officer of the Company at $0.80 per share pursuant to a restricted
stock purchase agreement. The restricted stock purchase agreement
contains provisions for the repurchase of common stock by the Company
in the event of termination of employment during the four years
following the date of the Agreement. At December 28, 1996, 48,438
shares are subject to repurchase under this restricted stock purchase
agreement and will be released ratably over the following 31 months.
EMPLOYEE STOCK PURCHASE PLAN:
In December 1995, the Company approved the Employee Stock Purchase Plan
and reserved 150,000 shares of common stock for issuance under this
plan. As of December 28, 1996, 10,101 shares of common stock have been
sold under the Employee Stock Purchase Plan.
In November 1996, the Board of Directors approved a Shareholders Rights
Plan declaring a dividend distribution of one Preferred Share Purchase
Right on each outstanding share of the Company's Common Stock. Each
right will entitle stockholders to buy one-thousand of one share of the
Company's Series A Participating Preferred Stock at an exercise price
of $50. The Rights are designed to assure that the Company's
stockholders receive fair and equal treatment in the event of any
proposed takeover of the Company and to guard against partial tender
offers and other abusive tactics to gain control of the Company without
paying all stockholders the fair value of their shares, including a
"control premium."
STOCK-BASED COMPENSATION:
The Company has adopted the disclosure only provisions of Statement of
Financial Accounting Standards No. 123 (SFAS No. 123) "Accounting for
Stock-Based Compensation." Had compensation cost for the 1993 Plan, the
Director Option Plan and the Employee Stock Purchase Plan been
determined based on the fair value at the grant date for awards in 1996
and 1995 consistent with the provisions of SFAS No. 123, the Company's
net loss and net loss per share for the years ended December 28, 1996
and December 31, 1995 would have been increased to the pro forma
amounts indicated below (in thousands, except per share data):
1996 1995
--------- ---------
Net loss - as reported ....................... $ 7,706 $ 6,950
Net loss - pro forma ......................... $ 7,914 $ 6,959
Net loss per share - as reported ............. $ 0.94 $ 1.00
Net loss per share - pro forma ............... $ 0.96 $ 1.00
-46-
47
ARTHROCARE CORPORATION
NOTES TO FINANCIAL STATEMENTS, Continued
9. Stockholders' Equity, continued:
The fair value of each option grant is estimated on the date of grant
using the Black Scholes model with the following weighted average
assumptions:
Risk-free interest rate 5.32%-7.13%
Expected life 4 years
Expected dividends --
Expected volatility 50%
The options outstanding and currently exercisable by exercise price at
December 28, 1996 are as follows (in thousands, except per share data):
OPTIONS CURRENTLY
OPTIONS OUTSTANDING EXERCISABLE
------------------------------------------------------------------ -----------------------------
WEIGHTED
AVERAGE WEIGHTED WEIGHTED
REMAINING AVERAGE AVERAGE
EXERCISE NUMBER CONTRACTUAL EXERCISE NUMBER EXERCISE
PRICE OUTSTANDING LIFE PRICE EXERCISABLE PRICE
----------------- ----------- ------------ -------- ----------- ---------
$0.20 43 6.409 $ 0.20 39 $0.20
$0.32-$0.40 101 8.252 $ 0.38 41 $0.38
$0.80 12 8.532 $ 0.80 4 $0.80
$1.60 121 8.659 $ 1.60 38 $1.60
$3.00 5 8.748 $ 3.00 2 $3.00
$5.00-$6.00 11 8.881 $ 6.00 3 $6.00
$9.00-$11.00 240 9.552 $ 9.68 20 $9.44
$14.00-$19.75 32 9.742 $16.94 -- --
$24.25 29 9.621 $24.25 -- --
Deferred compensation to be recognized as a result of stock options
granted and common stock issued subject to repurchase provisions as of
December 28, 1996 totals $887,551. Amortization of deferred
compensation is generally over vesting periods of one to four years,
with compensation expense recognized in the years ended December 28,
1996 and December 31, 1995 being $166,841 and $332,673, respectively.
No deferred compensation expense was recognized in fiscal 1994.
10. Related Parties:
In connection with the formation of the Company, several of the
founders and partnerships of the founders entered into a licensing
agreement to facilitate patent transfers. As a result, the Company
acquired an exclusive worldwide perpetual royalty-license, with right
of sublicense, to make, use and sell products and use patent methods
covered by the patent rights limited to surgical orthopedic and
arthroscopic applications.
Also in connection with its incorporation, the Company entered into a
consulting agreement with a consulting and research firm, which is
headed by one of the Company's founders. This consulting and research
firm was contracted to perform research related to the development of a
hand-held instrument used in arthroscopic procedures. Research and
development costs incurred on this contract in 1996, 1995 and 1994 were
approximately $456,000, $481,000 and $296,000, respectively.
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48
ARTHROCARE CORPORATION
NOTES TO FINANCIAL STATEMENTS, Continued
10. Related Parties, continued:
In January 1995, the Company loaned to an officer $120,000 pursuant to
a provision in the officer's employment agreement. The resulting
promissory note bears interest at the rate of 6% per annum and is due
on the earlier of January 31, 1999 or termination of employment. At
December 28, 1996, $134,000 of principal and interest was outstanding
on this note. Also in February 1995, the Company agreed to loan this
officer up to an additional $144,000. The loan will be made in $3,000
monthly increments. The resulting promissory note bears interest at the
rate of 6% per annum and is due on the earlier of October 21, 1999 or
termination of employment. At December 28, 1996, $73,000 of principal
and interest was outstanding on this note.
In December 1995, the Company loaned an employee $62,000 pursuant to a
provision in the employee's employment agreement. The resulting
promissory note bears interest at the rate of 6% per annum and is due
on the earlier of July 24, 2000 or the termination of employment. The
note also permits the Company to loan this employee up to an additional
$34,000 in $2,000 monthly increments. The aforementioned note is
secured by a pledge of this employee's option for 50,000 shares of the
Company's common stock and any shares issued upon exercise of such
options. At December 28, 1996, $91,000 of principal and interest was
outstanding on this note.
On March 31, 1995, the Company issued 400,000 shares of common stock
for $0.40 per share and $100,000 cash in exchange for certain
intellectual property rights of a related research firm headed by
several of the Company's directors and co-founders. This transaction
was accounted for as a non-recurring charge to operating expense.
11. Income Taxes:
At December 28, 1996, the Company has approximately $6,048,000 and
$1,811,000 in federal and state net operating loss carryforwards,
respectively which expire in the years 2009 through 2012.
The Tax Reform Act of 1986 substantially changed the rates relative to
net operating loss and tax credit carryforwards in the case of an
"ownership change" of a corporation. Any ownership changes, as defined,
may restrict utilization of carryforwards.
Temporary differences and carryforwards which gave rise to significant
portions of deferred tax assets and liabilities are as follows (in
thousands):
DECEMBER 28, DECEMBER 31,
1996 1995
------------ ------------
Deferred tax assets:
Net operating loss carryforwards .............. $ 2,167 $ 2,025
Capitalized research and development costs .... 3,036 1,004
Capitalized start-up costs .................... 710 630
Purchased patents ............................. 104 104
Research and development credit ............... 446 231
Allowances and reserves ....................... 699
Other ......................................... 130 214
Less: valuation allowance (7,292) (4,208)
------- -------
Net deferred tax assets $ -- $ --
======= =======
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49
ARTHROCARE CORPORATION
NOTES TO FINANCIAL STATEMENTS, Continued
In accordance with generally accepted accounting principles, a
valuation allowance must be established for a deferred tax asset if it
is more likely than not that a tax benefit may not realized from the
asset in the future. The Company has established a valuation allowance
to the extent of its deferred tax assets since it is more likely than
not that a benefit can not be realized in the future due to the
Company's recurring operating losses. The Company's valuation allowance
increased from $4,208,000 at December 31, 1995 to $7,292,000 at
December 28, 1996.
12. Employee Benefit Plan:
The company maintains a Retirement Savings and Investment Plan (the
401(k) Plan) which covers substantially all employees. Eligible
employees may make salary deferral (before tax) contributions up to a
specified maximum. The Company, at its discretion, may make additional
matching contributions on behalf of the participants in the 401(k)
Plan. To date, the Company has not made any contributions to the 401(k)
Plan.
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50
EXHIBIT 11.1
ARTHROCARE CORPORATION
COMPUTATION OF NET LOSS PER SHARE
(in thousands, except per share data)
YEAR ENDED
DECEMBER 28, DECEMBER 31, DECEMBER 31,
1996 1995 1994
------------ ------------ -----------
Weighted average common shares
outstanding for the period ............. 5,119 3,812 3,298
Common equivalent shares pursuant to
Staff Accounting Bulletin No. 83 ....... 3,117 3,117 3,117
------- ------- -------
Shares used in per share calculation ......... 8,236 6,929 6,415
======= ======= =======
Net loss ..................................... $(7,705) $(6,950) $(2,121)
======= ======= =======
Net loss per share ........................... $ (0.94) $ (1.00) $(0.33)
======= ======= =======
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51
SCHEDULE II
ARTHROCARE CORPORATION
VALUATION AND QUALIFYING ACCOUNTS
(in thousands)
COLUMN A COLUMN COLUMN COLUMN COLUMN
B C D E
ADDITIONS
CHARGED
BALANCE AT TO COSTS BALANCE
BEGINNING AND AT END OF
OF PERIOD EXPENSES DEDUCTION PERIOD
--------- -------- --------- ------
YEAR ENDED DECEMBER 31, 1995:
Deducted from asset accounts:
Allowance for doubtful accounts and product returns $ -- $ 5 $ -- $ 5
Allowance for excess and obsolete inventory $ -- $ 50 $ -- $ 50
YEAR ENDED DECEMBER 31, 1996:
Deducted from asset accounts:
Allowance for doubtful accounts and product returns $ 5 $313 $ -- $318
Allowance for excess and obsolete inventory $ 50 $ 50 $ -- $100
REPORT OF INDEPENDENT ACCOUNTANTS
Our report on the financial statements of ArthroCare Corporation is included at
page 43 of this Form 10-K. In connection with our audits of such financial
statements, we have also audited the related financial statement schedule
included at page [49] of this Form 10-K.
In our opinion, the financial statement schedule referred to above, when
considered in relation to the basic financial statements taken as a whole,
presents fairly, in all material respects, the information required to be
included therein.
/s/ COOPERS & LYBRAND L.L.P.
San Jose, California
February 28, 1997
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52
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized:
ARTHROCARE CORPORATION
a Delaware Corporation
By: /s/ HIRA V. THAPLIYAL
---------------------------------------------
HIRA V. THAPLIYAL
President and Chief Executive Officer
Date: March 27, 1997
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints each of Hira V. Thapliyal and A. Larry
Tannenbaum as his attorney-in-fact for him, in any and all capacities, to sign
each amendment to this Report on Form 10-K, and to file the same, with exhibits
thereto and other documents in connection therewith, with the Securities and
Exchange Commission, hereby ratifying and confirming all that said
attorney-in-fact or his substitute or substitutes may lawfully do or cause to be
done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this
Report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated:
SIGNATURE TITLE DATE
- ------------------------------ ----------------------------------------------- --------------
/s/ HIRA V. THAPLIYAL President, Chief Executive Officer and Director March 27, 1997
- ------------------------------ (Principal Executive Officer)
Hira V. Thapliyal
/s/ A. LARRY TANNENBAUM Chief Financial Officer and Assistant Secretary March 27, 1997
- ------------------------------ (Principal Financial and Accounting Officer)
A. Larry Tannenbaum
/s/ ANNETTE J. CAMPBELL-WHITE Director March 27, 1997
- ------------------------------
Annette J. Campbell-White
/s/ PHILIP E. EGGERS Director March 27, 1997
- ------------------------------
Philip E. Eggers
/s/ C. RAYMOND LARKIN, Jr. Director March 27, 1997
- ------------------------------
C. Raymond Larkin, Jr.
/s/ JOHN S. LEWIS Director March 27, 1997
- ------------------------------
John S. Lewis
/s/ ROBERT R. MOMSEN Director March 27, 1997
- ------------------------------
Robert R. Momsen
ARTHROCARE CORPORATION
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53
Report on Form 10-K for
the year ended December 28, 1996
INDEX TO EXHIBITS*
EXHIBIT
NUMBER EXHIBIT NAME
- --------------------------------------------------------------------------------
11.1 Calculation of net loss per share (see page 50).
23.1 Consent of Coopers & Lybrand L.L.P., Independent Public Accountants.
24.1 Power of Attorney (see page 52).
27.1 Financial Data Schedule.
* Only exhibits actually filed are listed. Exhibits incorporated by reference
are set forth in the exhibit listing included in Item 14 of the Report on
Form 10-K.
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