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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
Form 10-K
(MARK ONE)
[ X ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1996
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM _____________ TO ______________
COMMISSION FILE NUMBER 0-27212
ENDOCARE, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 33-0618093
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
18 TECHNOLOGY DRIVE, SUITE 134, IRVINE, CALIFORNIA 92618
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (714) 450-1410
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
COMMON STOCK, $.001 PAR VALUE
(TITLE OF CLASS)
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-K. [ ]
The number of shares of the registrant's common stock outstanding as of
February 12, 1997 was 8,195,853.
The aggregate market value of the registrant's common stock held by
non-affiliates of the registrant was $32,783,875 (computed using the average
bid and asked prices quoted on the NASD Electronic Bulletin board on February
12, 1997).
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ENDOCARE, INC.
INDEX TO ANNUAL REPORT ON FORM 10-K
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1996
Item Number and Caption
----------------------- Page
PART I Number
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Item 1. Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Item 2. Properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Item 3. Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Item 4. Submission of Matters to a Vote of Security Holders . . . . . . . . . . . . . . . . . 14
PART II
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Item 5. Market for Registrant's Common Equity
and Related Shareholder Matters . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Item 6. Selected Financial Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations . . . . . . . . . . . . . . . . . . . . . . . . 18
Item 8. Financial Statements and Supplementary Data . . . . . . . . . . . . . . . . . . . . . 21
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure . . . . . . . . . . . . . . . . . . . . . . . . 21
PART III
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Item 10. Directors and Executive Officers of the Registrant . . . . . . . . . . . . . . . . . 22
Item 11. Executive Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Item 12. Security Ownership of Certain Beneficial
Owners and Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
Item 13. Certain Relationships and Related Transactions . . . . . . . . . . . . . . . . . . . 28
PART IV
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Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K . . . . . . . . . . 29
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PART I
ITEM 1. BUSINESS
GENERAL
ENDOcare develops, manufactures and markets minimally invasive medical
devices to treat a variety of urological conditions. The Company has focused
its efforts on the development of surgical devices for the treatment of the two
most common diseases of the prostate: Benign Prostate Hyperplasia ("BPH") and
prostate cancer. To date, the Company has received marketing clearance by the
FDA for six of its products and has an attractive research and development
pipeline for the development of other novel urological devices.
ENDOcare has developed and recently introduced an innovative, second
generation cryosurgical system for the treatment of prostate cancer. The
CRYOcare System(TM) offers the advantage of controlled, targeted freezing of
the tumor with the benefit of faster patient recovery and minimal
complications. In November 1996, the Company entered into an exclusive
worldwide distribution agreement with Boston Scientific Corporation ("Boston
Scientific") to market and sell the CRYOcare System for urological
applications. The Company expects that the partnership with Boston Scientific
will allow the proper clinical and market development necessary to position the
CRYOcare System as an accepted outpatient therapy for the treatment of prostate
cancer.
ENDOcare also is developing new therapies for the improved treatment of
BPH. The Company's initial product development efforts for BPH involve the use
of stent technology to provide both immediate and long-term relief to BPH
patients. ENDOcare is implementing a two-part strategy for the
commercialization of its stent-based BPH therapies. The first stage is the
development of the Company's Horizon Temporary Stent. This nitinol-based
stent has shape memory characteristics for easy placement via a catheter
following surgical intervention of the prostate and convenient atraumatic
removal of the stent following the healing process. The Company believes that
its Horizon Temporary Stent will address one of the major issues of BPH
therapy, the immediate relief of patients following thermotherapy and surgical
resection. ENDOcare has recently commenced preclinical studies for the Horizon
Temporary Stent and expects to begin clinical trials in 1997.
The second stage in developing the Company's stent technology will
combine a nitinol stent with a catheter system to deliver thermotherapy. The
Company believes that this Hot Stent will provide immediate and long-term
therapy in a one-step process. Both stent applications are being designed to
be performed on an outpatient basis. The ability to perform BPH therapy in
this manner is expected to result in an increase in the number of BPH sufferers
who will seek curative surgical procedures.
Since its formation in 1990, ENDOcare operated first as a research and
development department, then later as a division of Medstone International,
Inc. ("Medstone"). Effective January 1, 1996, ENDOcare became a totally
independent, publicly-owned corporation. At the beginning of 1996, ENDOcare,
Inc. issued 5,616,528 shares of ENDOcare common stock to Medstone in exchange
for $500,000 cash and the accounts receivable, inventory, and other net assets
of the ENDOcare Division. On February 6, 1996, Medstone distributed to
existing Medstone shareholders a stock dividend of one share of ENDOcare common
stock for each share of Medstone common stock outstanding on December 29, 1995.
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On January 27, 1997, ENDOcare completed a $7,765,499 private placement of
its common stock whereby 2,218,714 shares were placed with qualified
institutional investors at a price of $3.50 per share. Net proceeds after
deducting commissions and estimated other expenses of sale were approximately
$7,050,000. Oppenheimer & Co., Inc. served as the placement agent for the
Offering.
MARKET BACKGROUND
PROSTATE CANCER
The incidence of prostate cancer has risen steadily since 1980 to become
the second most common cause of cancer-related deaths among men. The dramatic
increase in prostate cancer cases may be largely attributable to heightened
awareness of the disease, which has led to increased rates of testing and
improved diagnostic methods.
Therapeutic alternatives for patients with prostate cancer have been both
limited and unattractive. Current treatment options include radical surgery,
radiation therapy, hormone therapy, cryotherapy and "watchful waiting." These
options are evaluated using a number of criteria, including the patient's age,
physical condition and stage of the disease. However, due to the slow
progression of the disease, the decision for treatment typically is based upon
the severity of the condition and the resulting quality of life.
Radical prostatectomy is most often the therapy of choice due to the high
degree of confidence in surgically removing the cancerous tissue, particularly
for patients having more advanced stages of the disease and those who fail to
respond to less invasive alternatives. The procedure is dependent on the skill
of the surgeon and is highly morbid, often associated with high rates of
impotence, incontinence and operative mortality.
Cryosurgery, freezing tissue to destroy tumor cells, was first developed
in the 1960's. During this period, the use of "cold probes," or cryoprobes,
was explored as a manner to kill prostate tissue without having to use radical
surgery. Although effective in killing cancer cells, the lack of control as to
the amount of tissue frozen prevented broad use and development of cryotherapy
for prostate cancer.
In the late 1980's, progress in ultrasound imaging allowed for a revival
in the use of cryosurgery. Using ultrasound, the cryoprobe may be guided to
the targeted tissue from outside the body through a small incision. The
physician activates the cryoprobe and uses ultrasound to monitor the growth of
ice in the prostate as it is occurring. When the ice encompasses the entire
prostate, the probe is turned off. This feedback mechanism of watching the
therapy as it is administered allows the physician precise control during
application. Recent published studies suggest that cryosurgery may be able to
deliver disease free rates comparable to radical surgery, but with the benefit
of being performed in an outpatient setting and with lower rates of
incontinence and mortality.
BENIGN PROSTATE HYPERPLASIA
BPH, which affects a large number of adult men, is a non-cancerous
enlargement of the innermost part of the prostate. BPH frequently results in a
gradual squeezing of the part of the urethra which runs through the prostate.
This causes patients to experience a frequent urge to urinate because of the
incomplete emptying of the bladder and a burning sensation or similar
discomfort during urination. The obstruction of urinary flow can also lead to
a general lack of control over urination, including difficulty initiating
urination when desired as well as difficulty preventing urinary flow because of
the residual
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volume of urine in the bladder (a condition known as urinary incontinence).
BPH symptoms may disturb sleep by causing the BPH sufferer to awaken frequently
to urinate. Although symptoms occasionally stabilize or diminish without
intervention, they generally become more severe over the course of the disease.
Left untreated, the obstruction caused by BPH can lead to acute urinary
retention (complete inability to urinate), serious urinary tract infections and
permanent bladder and kidney damage.
Most males will eventually suffer from BPH. The incidence of BPH for men
in their fifties is approximately 50% and rises to approximately 80% by the age
of 80. The general aging of the United States population, as well as
increasing life expectancies, is anticipated to contribute to the continued
growth in the number of BPH sufferers.
Patients diagnosed with BPH generally have four options for treatment:
(i) "watchful waiting," (ii) drug therapy; (iii) surgical intervention,
including transurethral resection of the prostate ("TURP") and laser assisted
prostatectomy; and (iv) new, less invasive thermal therapies. Currently the
number of patients who are actually treated by surgical approaches is
approximately 2% to 3% of patients with BPH. Treatment is generally reserved
for patients with intolerable symptoms or those with significant potential
symptoms if treatment were withheld. A large number delay discussing their
symptoms or elect "watchful waiting" to see if the condition remains tolerable.
The Company believes the development of less invasive procedures for treatment
of BPH could result in a substantial increase in the number of BPH patients who
elect to receive interventional therapy.
Drug Therapies: Some drugs are designed to shrink the prostate by
inhibiting or slowing the growth of prostate cells. Other drugs are designed
to relax the muscles in the prostate and bladder neck to relieve urethral
obstruction. Current drug therapy generally requires daily administration for
the duration of the patient's life.
Surgical Interventions: The most common surgical procedure,
transurethral resection of the prostate ("TURP"), involves the removal of the
prostate's innermost core in order to reduce pressure on the urethra. TURP is
performed by introducing an electrosurgical cutting loop through a cystoscope
into the urethra and "chipping out" both the prostatic urethra and surrounding
prostate tissue up to the surgical capsule, thereby completely clearing the
obstruction. The average TURP procedure costs approximately $8,000 and
requires a hospital stay of approximately four days.
Modified Electrosurgical Electrodes: These devices have made it possible
to surgically remove prostate tissue in a "near bloodless" procedure using an
electrode which cauterizes as it removes tissue. Introduced in 1995, this new
technology has rapidly gained acceptance in the urology community as a means of
ablating prostate tissue in a well controlled and near-bloodless fashion.
However, like a conventional TURP, this procedure must be performed in a
hospital under general or spinal anesthesia, results in destruction of the
prostatic urethra and requires insertion of a urinary catheter post-surgery.
Laser Ablation of the Prostate: Laser assisted prostatectomy includes
two similar procedures, visual laser ablation of the prostate ( V- LAP ) and
contact laser ablation of the prostate ( C-LAP ), in which a laser fiber
catheter is guided through a cystoscope and used to ablate and coagulate the
prostatic urethra and prostatic tissue. Typically, the procedure is performed
in the hospital under either general or spinal anesthesia, and an overnight
hospital stay is required. In V-LAP, the burnt prostatic tissue then necroses,
or dies, and over four to twelve weeks is sloughed off during urination. In
C-LAP, the prostatic and urethral tissue is burned on contact and vaporized.
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Less Invasive Thermal Therapies: Other technologies under development
are non-surgical, catheter based therapies that use thermal energy to
preferentially heat diseased areas of the prostate to a temperature sufficient
to cause cell death. Thermal energy forms being utilized include microwave,
radio frequency ("RF") and ultrasound energy. The procedures are typically
performed in an outpatient setting under local anesthesia. Both microwave and
RF therapy systems are currently being marketed worldwide, including the United
States, where the first FDA clearances were obtained in May and October 1996,
for microwave and RF, respectively.
ENDOCARE PRODUCTS
PRODUCT NAME TARGETED INDICATION STATUS LAUNCH DATE
Prolase II General Urology Marketing October 1993
Prolase I General Urology Marketing November 1994
Diolase 60 watt laser General Urology Marketing May 1994
Vaporbar BPH Marketing November 1995
Uroloop BPH Marketing November 1995
CRYOcare System Prostate Cancer Marketing May 1996
Horizon Temporary Stent BPH Pre-Clinical Studies ------
Hot Stent BPH Development ------
CRYOCARE SYSTEM
ENDOcare has developed the CRYOcare System, a second generation
cryosurgery system designed to overcome the limitations of existing systems and
to allow the urologist to treat prostate cancer in a minimally invasive manner
in an outpatient setting. The CRYOcare System has been designed to freeze
tissue much faster and with more control than existing systems. This product
will be marketed worldwide by Boston Scientific pursuant to an exclusive
distribution agreement.
The Company believes the CRYOcare System is significantly more efficient
than current competitive technology in creating the lethal temperatures in the
cryoprobe necessary to kill cancer cells. Current technology employs a tank of
liquid nitrogen, which is at -186 degrees C, and pumps it through a tube to the
cryoprobe. The challenge for current liquid nitrogen technology is to not
"leak" the cold prior to delivering it to the tumor site. Liquid nitrogen
technology starts out coldest at the storage tank and can only get warmer and
less effective by the time it reaches the tumor site and attempts to freeze the
tissue.
ENDOcare's CRYOcare System utilizes a system that converts argon gas to a
liquid form at the tip of the probe. The gas itself is at room temperature
until reaching the tip, making it easier to handle and eliminating the need to
store liquid nitrogen. In addition, a temperature of -150 degrees C is achieved
at the tip of the cryoprobe, considerably colder than the -90 degrees C achieved
using liquid nitrogen systems, which results in substantially faster tissue
freezing rates.
The CRYOcare System incorporates enhanced control mechanisms to minimize
the risk of unintended damage to tissue surrounding the prostate. Most
significantly, the CRYOcare probes stop freezing
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instantly, whereas probes using liquid nitrogen take up to one minute to stop
freezing tissue. Use of four to six temperature probes selectively placed in
the prostate near the rectal tissue, sphincter muscles (which control
continence) and neurovascular bundles (which control potency) enables the
physician to monitor temperatures of tissue adjacent to the prostate. Combining
these control features allows the physician to treat prostate cancer with a
high degree of control and precision that was not previously possible. The
CRYOcare System is approximately one quarter of the size of currently available
systems and one tenth of the weight.
The CRYOcare System has been cleared for marketing by the FDA and was
introduced in May 1996. The Company has installed CRYOcare Systems at six
sites in North America, with over 75 patients treated to date. Early clinical
data at the first two CRYOcare Systems clinical sites are encouraging. In the
initial series of 25 patients treated, 12 have had six month follow up and 100%
have reported no evidence of disease. While the early series of patients is
promising, further clinical work is needed to establish cryotherapy as a
primary treatment for prostate cancer. The Company expects that further
studies will be required prior to the establishment of national reimbursement
by Medicare. Until such time as Medicare reimbursement is approved, sales of
CRYOcare Systems may be limited within the urology market to small commercial,
self-paying, and international customers.
The Company has filed patent applications relating to the technology used
to create the freezing process and to precisely control the shape of the freeze
zone produced by the cryoprobes. This also may allow for expanded therapeutic
applications by tailoring the cryoprobe performance to other anatomical
targets, such as liver cancer and gynecology applications.
OFFICE-BASED BPH THERAPY
The goal of developing bloodless, anesthesia free, and pain free BPH
therapies has resulted in a category of new devices called thermotherapy
systems. In thermotherapy, a device is introduced into the prostate in the
gentlest manner possible and heat is delivered very slowly to thermally destroy
the enlarged tissue. The advantage of these thermotherapy systems is their
ability to destroy the obstruction without bleeding or anesthesia, thus
allowing the patient to be treated in the urologist's office. The
less-invasive nature of the therapy allows for faster and easier recovery
periods.
The disadvantage of thermotherapy based systems is the manner in which
the obstructive tissue is removed. The tissue temperature of the obstructive
tissue is slowly raised to the point the cells can no longer survive. The dead
tissue is left in place, in contrast to the traditional surgical techniques, in
which the obstructive tissue is removed immediately. The period it takes for
the dead cells to be completely cleared, and thus for the obstruction to be
removed, can be up to six months. Patients who are treated by thermotherapy
typically recover quickly, but need to be catheterized for up to one week post
treatment to maintain urine flow.
ENDOcare is developing innovative products that will address BPH therapy
to include thermotherapy approaches. The development process will occur in two
discrete steps. The first step will deliver an immediate relief component to
be used with existing thermotherapy systems. The second step will offer a
combination device that will be able to provide immediate relief and long-term
removal of the obstructive tissue without bleeding or anesthesia.
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Horizon Temporary Stent. ENDOcare is developing a new urological stent
which has been designed to provide immediate relief for BPH patients who
undergo thermotherapy. The Company's Horizon Temporary Stent is made of
nitinol, a new titanium metal alloy that employs a feature called shape memory.
This shape memory feature allows the Horizon Temporary Stent to be soft and
flexible in its relaxed state, allowing the device to be introduced in a
relatively pain free manner using a catheter. When the device is heated to its
transition temperature, the device self-expands to a pre-determined shape. In
the case of the Horizon Temporary Stent, the predetermined shape is that of a
rigid tube, or stent. The catheter will be inserted using a local anesthetic,
and positioned in the prostatic urethra under direct vision. The stent will be
activated by flowing warm water through the catheter, causing the shape memory
to open to its tube-like position. After approximately 30 days, the stent is
removed by the physician by flushing cold water through a flexible endoscope,
causing the stent to return to its soft, relaxed state. The stent will be
removed by retrieving it through the working channel of the flexible endoscope.
ENDOcare has completed the design of its Horizon Temporary Stent and has
recently commenced preclinical studies to demonstrate the ease of
administration and removal. The Company plans to file an IDE in early 1997 to
commence human clinical trials. Because the stent will be removed from the
patients within 30 to 60 days, the Company expects that the regulatory process
may be expedited. However, there can be no assurance that the FDA will not
require more time consuming and extensive clinical studies.
Hot Stent. ENDOcare's Hot Stent is expected to be the second product
developed for the Company's office-based therapy product line. The Hot Stent
is being designed to combine thermotherapy with the Company's nitinol stent.
The Company has secured a patent position on the Hot Stent device. In
April 1996, ENDOcare licensed from the Brigham and Women's Hospital an issued
patent covering urological applications of the delivery of thermal energy by a
stent. The Company has filed an additional patent application which describes
the device under development and its use to achieve temporary relief.
SURGICAL DISPOSABLES
Since its formation, ENDOcare has developed a line of surgical
disposables targeting improved treatment of BPH. The common element in the
development of each of the disposable devices is the ability to remove tissue
in a near bloodless manner.
In 1993, ENDOcare received FDA clearance to market a laser fiber which
allows urologists to heat the prostate tissue which causes the obstructive
symptoms of BPH. The device, Prolase, is a fiber optic catheter which bends
the laser energy sideways, enabling urologists to more easily reach the
obstructive tissue. Although lasers are effective in bloodlessly treating BPH,
sales of Prolase fibers have been inhibited by the high capital cost of
purchasing laser generators that has impacted the use of V-LAP generally.
ENDOcare also developed and is marketing the Diolase 60, a 60-watt
medical diode laser. This system was designed to be rugged, light weight, air
cooled and extremely efficient, making it an excellent
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surgical laser for use in the restrictive clinical environment. It was
introduced in 1994 and was designed to be used with the Prolase laser fiber.
In 1995, ENDOcare developed a line of disposable electrodes that vaporize
prostate tissue while cutting. The combination of vaporization and cutting
results in near bloodless removal of the obstructed tissue. The Uroloop and
Vaporbar electrodes represent the next step in the evolution of near bloodless,
outpatient procedures for BPH.
PATENTS AND INTELLECTUAL PROPERTY
The Company's policy is to secure and protect intellectual property
rights relating to its technology. While ENDOcare believes that the protection
of patents and licenses is important to its business, it also relies on trade
secrets, know-how and continuing technological innovation to maintain its
competitive position. The Company has received patents relating to its Prolase
line of side-firing laser fibers. The Company entered into a worldwide
licensing agreement relating to urological applications of a patent from
Brigham and Women's Hospital for the Hot Stent product ENDOcare is developing.
This issued patent covers the concept of a variety of methods to heat occluded
body passageways by use of a stent. The Company has filed a patent application
which focuses on the use of a combination therapy of a stent for short term
relief of the occlusion and thermotherapy for long-term relief. Certain
patents for some of the new products described under "Products" have been filed
or are in the process of being filed.
No assurance can be given that ENDOcare's processes or products will not
infringe patents or proprietary rights of others or that any license required
would be made available under any such patents or proprietary rights, on terms
acceptable to ENDOcare or at all. From time to time, the Company has received
correspondence alleging infringement of proprietary rights of third parties.
No assurance can be given that any relevant claims of third parties would not
be upheld as valid and enforceable, and therefore that the Company could be
prevented from practicing the subject matter claimed or would be required to
obtain licenses from the owners of any such proprietary rights to avoid
infringement.
The Company seeks to preserve the confidentiality of its technology by
entering into confidentiality agreements with its employees, consultants,
customers and key vendors and by other means. No assurance can be given,
however, that these measures will prevent the unauthorized disclosure or use of
such technology.
SALES AND MARKETING
For urological applications, ENDOcare's CRYOcare System is distributed
worldwide by Boston Scientific Corporation. In Canada it is distributed by
Mentor Medical Systems under a three-year distribution agreement. With the
exception of the CRYOcare System, the Company sells its products domestically
and internationally primarily through independent distributors. Overall,
international sales represented approximately 53% of revenue during 1996. The
Company's distributor agreements typically provide the distributor with
exclusive selling rights to certain products in a particular territory, and are
terminable by either party on 180 days notice. Each party bears its own
expenses in performing under the agreement. The Company's ability to
distribute its products depends substantially on the capabilities of its
distributors. There can be no assurance that the Company will be able to
maintain or
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expand its relationships with its distributors or to replace a distributor in
the event any such relationship were terminated. In the event that the
Company's relationships with any of its distributors were terminated and the
Company were unable to replace the distribution capability. The Company's
ability to distribute its products would be materially adversely affected,
which would have a material adverse effect on the Company's business, financial
condition and results of operations. In addition, in such event, the Company's
current sales and marketing personnel and financial resources might not be
sufficient to enable the Company to establish its own distribution capability
to market and sell its products.
In November 1996, the Company entered into an eight-year worldwide
exclusive distribution agreement with Boston Scientific to market the CRYOcare
System for urology. As a result, future sales of the CRYOcare System, the
Company's main current product, will be dependent upon the marketing efforts of
Boston Scientific. During 1996, no sales were made to Boston Scientific.
The Company derives a majority of its revenues from the sales of CRYOcare
Systems and expects that sales of CRYOcare Systems will continue to constitute
the majority of net sales for the foreseeable future. Accordingly, any factor
adversely affecting the sales of CRYOcare Systems would have a material adverse
effect on the Company's business, financial condition and results of its
operations. Although the distributorship agreement requires Boston Scientific
to purchase a minimum number of products, if and when there were a lack of
sales as a result of unforeseen regulatory (including lack of Medicare
reimbursement of cryosurgical ablation of the prostate) or clinical
circumstances relating to a product or failure of the Company to deliver
products in a timely manner, the minimum purchase requirements can be
renegotiated. Currently, Medicare does not provide reimbursement for
cryosurgical ablation of the prostate, the approved use of the Company's eight
probe CRYOcare System.
In addition, under the distribution agreement, Boston Scientific has a
right of first refusal to match any offer received by the Company from a third
party to purchase the assets related to the CRYOcare System, and a right to buy
the assets and technology related to the CRYOcare System at purchase dates of
twenty-four, thirty-six and forty-eight months after the date that Medicare
provides reimbursement for cryosurgical ablation of the prostate, for a
purchase price of 1.7, 1.5 and 1.3 times net sales for the product for the
preceding twelve months, but not less than $40 million, $50 million and $60
million, respectively.
BACKLOG
At December 31, 1996, the Company's backlog, consisting of firm orders
scheduled for delivery within the next twelve months, was approximately
$19,000. ENDOcare's policy is to stock enough inventory to be able to ship
most orders within a few days of receipt of order. Historically, most of the
Company's orders have been for shipment within 30 days of the placement of the
order. Therefore, backlog information as of the end of a particular period is
not necessarily indicative of future levels of the Company's revenue.
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MANUFACTURING
The Company uses a combination of internal manufacturing capacity and
third party manufacturers in its manufacturing efforts. Most of the Company's
purchased components and processes are available from more than one vendor.
However, certain components and processes are currently available from or
performed by a single vendor. The ability of third party manufacturing sources
to deliver components or finished goods will affect the Company's ability to
commercialize its products, and the Company's dependence on third party sources
may adversely affect the Company's profit margins. Further, although the
Company is in the process of identifying alternative vendors, the qualification
of additional or replacement vendors for certain components or services could
be a lengthy process. Any supply interruption from a single source vendor
would have a material adverse effect on the Company's ability to manufacture
its products until a new source of supply was qualified and, as a result, could
have a material adverse effect on the Company's business, financial condition
and results of operations.
Additionally, the Company's success will depend in part upon its ability
to manufacture its products in compliance with the FDA's current Good
Manufacturing Practices ("GMP") regulations and other regulatory requirements,
in sufficient quantities and on a timely basis, while maintaining product
quality and acceptable manufacturing costs. Failure to increase production
volumes in a timely or cost effective manner or to maintain compliance with
current GMP or other regulatory requirements could have a material adverse
effect on the Company's business, financial condition and results of
operations. ENDOcare also has obtained from the California Department of
Health Services a license to manufacture medical devices and is subject to
periodic inspections and other regulation by that agency.
Further, the Company has limited experience in producing its products in
commercial quantities. Manufacturers often encounter difficulties in scaling
up production of new products, including problems involving production yields,
quality control and assurance, component supply and shortages of qualified
personnel. The Company's failure to overcome these manufacturing problems
could have a material adverse effect on the Company's business, financial
condition and results of operations.
GOVERNMENT REGULATION
Governmental regulation in the United States and other countries is a
significant factor affecting the research and development, manufacture and
marketing of the Company's products. In the United States, the FDA has broad
authority under the Federal Food, Drug and Cosmetic Act and the Public Health
Service Act to regulate the distribution, manufacture and sale of medical
devices. Foreign sales of medical devices are subject to foreign governmental
regulation and restrictions which vary from country to country.
Medical devices intended for human use in the United States are
classified into one of three categories, depending upon the degree of
regulatory control to which they will be subject. Such devices are classified
by regulation into either class I (general controls), class II (performance
standards) or class III (pre-market approval) depending upon the level of
regulatory control required to provide reasonable assurance of the safety and
effectiveness of the device. Good Manufacturing Practices, labeling,
maintenance of records and filings with the FDA also apply to medical devices.
- 11 -
12
A subset of medical devices categorized as class I or II devices that
were commercially distributed before March 28, 1976 or are substantially
equivalent to a device that was in commercial distribution before that date may
be marketed after the acceptance of the pre-market notification under a 510(k)
exemption. The 510(k) section of the Federal Food, Drug and Cosmetic Act
allows an exemption from the requirement of pre-market notification.
Generally, devices that have an existing history or track record are included
in this category.
The process of obtaining FDA and other required regulatory clearances or
approvals is lengthy and expensive. There can be no assurance that ENDOcare
will be able to obtain necessary clearances or approvals for clinical testing
or for manufacturing or marketing of its products. Failure to comply with
applicable regulatory approvals can, among other things, result in warning
letters, fines, suspensions of regulatory approvals, product recalls, operating
restrictions and criminal prosecution. In addition, governmental regulation
may be established which could prevent, delay, modify or rescind regulatory
clearance or approval of ENDOcare's products. For example, in January 1993,
the FDA, subsequent to approving the use of lasers as in the Company's Prolase
products, deemed such use "experimental" for a particular procedure, which
dramatically decreased sales of the Company's Prolase products. Although such
designation was later rescinded by the FDA, there can be no assurance that any
such position by the FDA, or change of position by the FDA, would not adversely
impact the Company's business, financial condition or results of operations.
Regulatory clearances or approvals, if granted, may include significant
limitations on the indicated uses for which the Company's products may be
marketed. In addition, to obtain such clearances or approvals, the FDA and
foreign regulatory authorities may impose numerous other requirements on the
Company. FDA enforcement policy strictly prohibits the marketing of approved
medical devices for unapproved uses. In addition, product approvals can be
withdrawn for failure to comply with regulatory standards or the occurrence of
unforeseen problems following initial marketing. There can be no assurance
that the Company will be able to obtain regulatory clearances or approvals for
its products on a timely basis or at all, and delays in receipt of or failure
to receive such approvals, the loss of previously obtained approvals, or
failure to comply with existing or future regulatory requirements would have a
material adverse effect on the Company's business, financial condition and
results of operations.
ENDOcare's current surgical disposable products and its new eight probe
CRYOcare System have received FDA clearance for sale in the United States for
approved urological uses. ENDOcare's new manufacturing facility was subject to
an FDA audit in August 1996, and the Company received no notice that it did not
comply with the FDA's current GMP regulations. In addition, ENDOcare has
obtained from the California Department of Health Services a license to
manufacture medical devices, subject to periodic inspections and other
regulation by that agency.
COMPETITION
Currently, the Company markets products in the following categories:
side-firing laser fibers, high power diode lasers, electrosurgical disposables
and cryosurgical systems. Significant competitors include Cryomedical
Sciences, Inc., Urologix, Inc., VidaMed, Inc., EDAP/TMS, S.A., C.R. Bard, Inc.
and ACMI/Circon Corporation.
- 12 -
13
Many of the Company's competitors are significantly larger than the
Company and have greater financial, technical, research, marketing, sales,
distribution and other resources than the Company. Additionally, the Company
believes there will be intense price competition for products developed in the
Company's market. There can be no assurance that the Company's competitors
will not succeed in developing or marketing technologies and products that are
more effective or commercially attractive than any that are being developed or
marketed by the Company, or that such competitors will not succeed in obtaining
regulatory approval, introducing or commercializing any such products prior to
the Company. Such developments could have a material adverse effect on the
Company's business, financial condition and results of operations. Further,
there can be no assurance that, even if the Company is able to compete
successfully, that it would do so in a profitable manner.
EMPLOYEES
As of December 31, 1996, ENDOcare had a total of 20 employees. Of the 20
employees, 6 are engaged directly in research and development activities, 2 in
regulatory affairs/quality assurance, 5 in manufacturing, 4 in sales and
marketing, and 3 in general and administrative positions. The Company expects
to substantially increase employment in anticipation of a commercial launch of
the CRYOcare System with Boston Scientific and expanded research and
development activities related to the Horizon Temporary Stent and Hot Stent
programs. The Company has never experienced a work stoppage, none of its
employees are represented by a labor organization, and the Company considers
its employee relations to be good.
Although ENDOcare conducts most of its research and development using its
own employees, the Company occasionally has funded and plans to continue to
fund research using consultants. Consultants provide services under written
agreements and are paid based on the amount of time spent on Company matters.
Under their consulting agreements, such consultants are required to disclose
and assign to the Company any ideas, discoveries and inventions developed by
them in the course of providing consulting services.
ITEM 2. PROPERTIES
The Company currently occupies 5,100 square feet of office,
manufacturing, engineering, warehouse, and research and development
laboratories in Irvine, California. The property is leased for a term of 24
months, expiring August 31, 1998.
On February 11, 1997, ENDOcare signed a five-year lease agreement for a
new, larger 16,100 square foot facility. The Company plans to sublease its
existing facility and move to the new one in March 1997.
- 13 -
14
ITEM 3. LEGAL PROCEEDINGS
On November 27, 1996, Cryomedical Sciences, Inc. ("CMS") filed a
complaint in the Circuit Court for Montgomery County, Maryland against the
Company and Dr. Chang, the Company's Vice President of Research and Development
and former employee of CMS. The suit alleges that Dr. Chang breached his
employment contract with CMS, that the Company tortiously interfered with the
employment contract and the prospective business relations of CMS,
misappropriated trade secrets and confidential information, competed unfairly
with and conspired against CMS. CMS is seeking injunctive relief and damages.
On January 23, 1997 a temporary restraining order was issued by the court
against the Company and Dr. Chang for the limited purpose of preventing
disclosure of certain information at a cryosurgery conference. The order
expired by its terms on February 3, 1997 and no other injunction or other
relief has been granted to CMS. The Company denies all allegations of
wrongdoing in the complaint and intends to defend the lawsuit vigorously.
However, the costs of defending the lawsuit could be material and there can be
no assurance that damages, which could have a material adverse effect on the
Company, will not be assessed. The Company is not a party to any other legal
proceedings.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
- 14 -
15
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
SHAREHOLDER MATTERS
Trading in ENDOcare's common stock is conducted in the over-the-counter
market on the NASDAQ Electronic Bulletin Board under the symbol "ENDO." The
following table sets forth the high and low bid prices for ENDOcare's common
stock during the periods indicated as quoted on the NASDAQ Electronic Bulletin
Board:
High Low
---------- ----------
Fiscal year ended December 31, 1996:
- ------------------------------------
Fourth quarter $ 6.38 $ 3.38
Third quarter 5.00 2.25
Second quarter 5.88 1.88
First quarter (from February 20, 1996) 3.00 0.38
ENDOcare's common stock first traded publicly on February 20, 1996, at a
price of $0.375 per share. As of February 12, 1997, ENDOcare had approximately
372 shareholders of record. On February 12, 1997, there were 8,195,853 shares
of ENDOcare common stock issued and outstanding.
ENDOcare has not paid any cash dividends on its common stock and does not
intend to pay any cash dividends in the foreseeable future.
RECENT SALES OF UNREGISTERED SECURITIES
Common Stock
On February 28, 1996, 12,500 shares of ENDOcare common stock were issued
as part of a settlement and termination agreement with an unaffiliated
consultant. The shares were issued in consideration of the consultant's
services and were valued at $0.375 per share.
On May 3, 1996, an additional 6,111 shares were issued to a Medstone
shareholder who had exercised an option to purchase Medstone shares in December
1995. It was determined that such shares should have been issued to that
shareholder as part of the Distribution to Medstone shareholders in February
1996.
On August 26, 1996, 10,000 shares were issued to four partnerships
managed by Technology Funding Inc. in consideration of their origination of an
aggregate of $1,500,000 convertible promissory notes for ENDOcare. On January
27, 1997, an aggregate of 332,000 shares of common stock were issued upon
conversion of an aggregate principal amount of $750,000, plus accrued interest
on such promissory notes.
On January 27, 1997, ENDOcare sold 2,218,714 shares of common stock at a
price of $3.50 per share in a private placement, with Oppenheimer & Co., Inc.
acting as placement agent.
- 15 -
16
The sales and issuances of the common stock described above were deemed
to be exempt from registration under the Securities Act of 1933, as amended
(the "Securities Act") in reliance upon Section 4(2) thereof, as transactions
not involving a public offering. The purchasers in such private offerings of
stock represented their intention to acquire the securities for investment only
and not with a view to the distribution thereof.
Stock Options
During the period from January 1, 1996 through December 31, 1996, the
Company granted stock options to 14 individuals covering an aggregate of
526,000 shares of its common stock. All such options were granted at fair
market value, vest over a four year period, and are exercisable over a ten year
period. No consideration was paid for such options. Such grants were exempt
from the registration requirement of the Securities Act as not involving the
sale of a security.
Warrants
As of February 20, 1997, ENDOcare had issued warrants for the purchase of
382,497 shares of common stock.
On April 17, 1996, ENDOcare issued a warrant to purchase up to 10,000
shares of common stock to Brigham and Women's Hospital, Inc. in connection with
that unaffiliated entity's license of patent rights and other technology to the
Company.
On August 26, 1996, ENDOcare issued warrants to purchase up to 150,000
shares of common stock to four partnerships managed by Technology Funding Inc.,
one officer of which, Peter F. Bernardoni, has served on ENDOcare's Board of
Directors since November 1995. These warrants were issued in connection with
Technology Funding Inc.'s purchase of $1,500,000 of convertible promissory notes
from ENDOcare.
On January 27, 1997, ENDOcare issued a warrant to purchase up to 177,497
shares of common stock to Oppenheimer & Co., Inc. in connection with their
services as placement agent for the Company's private placement of common stock.
On February 14, 1997, ENDOcare issued a warrant to purchase up to 25,000
shares of common stock in connection with a license of technology.
On February 17, 1997, ENDOcare issued a warrant to purchase up to 20,000
shares of common stock to a consultant of the Company.
Such issuances of warrants described above were exempt from the
registration under the Securities Act in reliance upon Section 4(2) thereof.
- 16 -
17
ITEM 6. SELECTED FINANCIAL DATA
The following table presents selected financial data of ENDOcare, Inc.
for the year ended December 31, 1996 and for its predecessor, ENDOcare,
Division of Medstone, for previous years. Prior to 1996, ENDOcare was not an
independent company with publicly traded shares. Hence, no earnings per share
data is presented for those years.
Years Ended December 31,
--------------------------------------------------------------
1992 1993 1994 1995 1996
-------- -------- -------- -------- --------
(in thousands, except per share data)
Statement of Operations Data:
- -----------------------------
Revenues:
Net product sales . . . . . . . . . . $ --- $ 2,697 $ 2,283 $ 951 $ 2,008
Revenue from collaborative agreements --- --- --- --- 250
Research revenue from related party . 581 480 379 377 1
-------- -------- -------- -------- --------
Total revenues . . . . . . . . . . 581 3,177 2,662 1,328 2,259
Costs and expenses:
Cost of product sales . . . . . . . . 8 630 638 380 1,054
Research and development . . . . . . 1,163 1,061 911 852 1,023
Selling, general and administrative . 84 2,000 1,376 673 1,383
Impairment loss on long-lived assets --- --- --- --- 325
-------- -------- -------- -------- --------
Total costs and expenses . . . . . 1,255 3,691 2,925 1,905 3,785
-------- -------- -------- -------- --------
Loss from operations . . . . . . . . . . (674) (514) (263) (577) (1,526)
Provision for income taxes . . . . . . . --- --- --- --- 5
-------- -------- -------- -------- --------
Net loss . . . . . . . . . . . . . . . . $ (674) $ (514) $ (263) $ (577) $ (1,531)
======== ======== ======== ======== ========
Net loss per share . . . . . . . . . . . $ (.27)
========
Weighted average shares outstanding . . . 5,634,561
=========
Balances at December 31,
--------------------------------------------------------------
1992 1993 1994 1995 1996
-------- -------- -------- -------- --------
(in thousands)
Balance Sheet Data:
- -------------------
Working capital . . . . . . . . . . . . . $ 35 $ 236 $ 295 $ 328 $ 519
Total assets . . . . . . . . . . . . . . 133 1,041 972 806 1,775
Long-term debt . . . . . . . . . . . . . --- --- --- --- 750
Total shareholders'/division
equity (deficiency) . . . . . . . . . 118 867 864 803 (149)
- 17 -
18
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
GENERAL
ENDOcare, designs, manufactures, and markets medical devices to treat
diseases of the prostate, including prostate cancer and prostate enlargement.
ENDOcare began marketing disposable surgical devices in 1993 with the
introduction of the Prolase laser catheter. In late 1995, ENDOcare began
marketing two new disposable product families, the Uroloop and Vaporbar
electrosurgical cutting elements, sales of which became the more significant
portion of revenue in early 1996. In May 1996, the Company introduced its new
CRYOcare cryosurgical system for the treatment of prostate cancer. In November
1996, ENDOcare signed a distribution agreement with Boston Scientific
Corporation granting that company exclusive world-wide marketing rights for
CRYOcare systems for urological applications.
ENDOcare currently is developing additional, innovative therapies for
prostate enlargement. The Company does not expect to be profitable in the
immediate future because of increased operating expenses from expanded research
and development efforts and support of clinical trials for products currently
under development.
Since its formation in 1990, ENDOcare operated first as a research and
development department, then later as a division of Medstone International,
Inc. In this form, ENDOcare shared facilities and certain personnel with its
parent. Effective January 1, 1996, ENDOcare began operating as an independent
corporation. Comparisons of financial results for 1996 with those of 1995 may
be impacted significantly by these two different organizational structures. In
1995 ENDOcare received direction, services, funding, and accounting allocations
from Medstone. All 1996 charges were directly incurred by ENDOcare as it
replaced services previously provided by Medstone with its own resources.
RESULTS OF OPERATIONS
The following table sets forth, for the periods indicated, certain
financial data as a percentage of total revenues.
Years Ended December 31,
-----------------------------------
1994 1995 1996
-------- -------- --------
Revenues:
Net product sales . . . . . . . . . . . . . . 86 % 72 % 89 %
Revenue from collaborative agreements . . . . --- --- 11
Research revenue from related party . . . . . 14 28 ---
-------- -------- --------
Total revenues . . . . . . . . . . . . . 100 % 100 % 100 %
Costs and expenses:
Cost of product sales . . . . . . . . . . . . 24 29 47
Research and development . . . . . . . . . . 34 63 46
Selling, general and administrative . . . . . 52 51 61
Impairment loss on long-lived assets . . . . --- --- 14
-------- -------- --------
Total costs and expenses . . . . . . . . 110 143 168
-------- -------- --------
Net loss before income taxes . . . . . . . . . . . (10) (43) (68)
Provision for income taxes . . . . . . . . . . . . --- --- ---
-------- -------- --------
Net loss . . . . . . . . . . . . . . . . . . . . . (10)% (43)% (68)%
======== ======== ========
- 18 -
19
Year Ended December 31, 1996 Compared to Year Ended December 31, 1995
Revenue from product sales for the year ended December 31, 1996 increased
111% to $2,008,000 compared to $951,000 for the year ended December 31, 1995.
This increase resulted from the introduction of new products. In 1995 product
sales consisted almost entirely of Prolase laser catheters, the volumes of
which had dropped considerably by the end of 1995. At the beginning of 1996,
ENDOcare's newly introduced Uroloops and Vaporbars began contributing
significant revenue. In May 1996, ENDOcare introduced its new CRYOcare
surgical system, which generated $1,020,000 of revenue in 1996.
Revenue from collaborative agreements increased from zero in 1995 to
$250,000 for the year ended December 31, 1996. This $250,000 in 1996 was a
non-refundable, lump-sum payment from Boston Scientific Corporation to ENDOcare
upon signing of a distribution agreement giving Boston Scientific exclusive
world-wide marketing rights for CRYOcare systems in urological applications.
Research revenue from related party decreased from $377,000 in 1995 to
$1,600 in 1996. In 1996 ENDOcare focused its research efforts on its own
internal product development, rather than performing research services for its
former parent, Medstone.
Gross margins on product sales were 47% in 1996 compared to 60% in 1995.
This difference was caused by changes in ENDOcare's product revenue mix as new
products were introduced and older products exhibited margin declines. In 1995
ENDOcare's revenue was almost entirely from high margin Prolase sales. In
early 1996, Prolase margins were declining, and the dominant source of revenue
for the Company was Uroloops and Vaporbars, whose margins were lower than those
of Prolase. With the mid-year introduction of CRYOcare systems, some early
units were shipped with lower, introductory prices. Also, 1996 margins were
impacted by the sale of several low margin Diolase units.
Research and development expense increased 20% to $1,023,000 in 1996 from
$852,000 in 1995. These increases primarily reflect increased development
efforts completing development of the new CRYOcare system in the beginning of
1996 and the initiation of other new product development later in the year.
Selling, general and administrative expense increased 105% to $1,383,000
in 1996 from $673,000 in 1995. This increase reflects the higher
administrative expense of operating as an independent, publicly-traded company,
as well as general investment in sales and marketing resources to establish a
foundation for future revenue growth. Also, during the second quarter of 1996,
sales and marketing expenses increased for the introduction of the new CRYOcare
system.
ENDOcare's net loss increased to $1,531,000 in 1996 from $577,000 in
1995. This increase was primarily due to the increase in selling, general and
administrative expense described above. In addition, a major factor
contributing to the loss was the effect of adopting the new accounting
pronouncement requiring review of long-lived assets for possible impairment.
As described in Note 4 to the financial statements, review of the assets
contributed to ENDOcare by Medstone resulted in a write-down of $325,000
effective January 1, 1996.
- 19 -
20
Year Ended December 31, 1995 Compared to Year Ended December 31, 1994
Revenues in 1995 decreased by $1,334,000, or 50%, from 1994. Product
sales decreased by $1,332,000, or 58%, due to increased market competition and
downward unit price pressure on Prolase laser catheters. Partially offsetting
this decrease was $134,000 revenue from the fourth quarter introduction of two
new technology products, Uroloops and Vaporbars.
Cost of sales decreased from $638,000 in 1994 to $379,000 in 1995. As a
percentage of net product sales, cost of sales increased to 40% in 1995 from
28% in 1994 due to the continued decline in Prolase unit sales prices and the
lower-revenue higher-volume nature of the new products. Although absolute
dollar costs of overhead were reduced, they increased on a per unit basis due
to the lower volumes.
Research and development costs declined 6% to $852,000 due to the
decrease in the Company's research effort at Medstone's direction.
Selling, general and administrative expenses decreased 51% to $673,000,
primarily due to the shift to non-commissioned stocking distributors rather
than the previous commission-based distribution.
The operating loss in 1995 increased by 119% to $577,000 due to the
reduced revenues as the Company transitioned from relying on an aging single
product line to offering a broad spectrum of products serving its target
market.
LIQUIDITY AND CAPITAL RESOURCES
At December 31, 1996, ENDOcare's cash balance was $477,000, compared to
$2,000 at December 31, 1995. This cash increase was provided by product sales
as well as two financing transactions.
In connection with the January 1996 spin-out, Medstone contributed
$500,000 cash to ENDOcare. In addition, ENDOcare took possession of $102,000
of its accounts receivable and $219,000 of inventory. Medstone retained
responsibility for all financial liabilities incurred before January 1, 1996.
In August 1996, ENDOcare obtained a two-year $1,500,000 secured borrowing
facility from four partnerships managed by Technology Funding Inc., a venture
capital firm. At December 31, 1996, $750,000 was outstanding under this loan.
Additional working capital has been used as ENDOcare's operations have
increased in 1996. With higher revenue levels, net accounts receivable
increased to $662,000 at December 31, 1996, compared to $102,000 at December 31,
1995. To support higher production levels, inventory increased to $347,000 at
December 31, 1996, compared to $219,000 at the beginning of the year. Fixed
asset additions during 1996 were approximately $111,000. As described in Note
4 to the financial statements, implementation of a new accounting standard
resulted in a non-cash write-off of $325,000 of non-current assets effective
January 1, 1996. Working capital was provided as accounts payable and other
current liabilities grew to an operating level of approximately $1,008,000,
starting from the initial zero balance at the January 1, 1996, spin-out from
Medstone.
At December 31, 1996, ENDOcare's net working capital was $519,000 and the
ratio of current assets to current liabilities was 1.5 to 1.
- 20 -
21
As described in Note 13 to the financial statements, subsequent to
year-end ENDOcare consummated two financial transactions which increased its
liquidity and capital resources.
On January 27, 1997, ENDOcare sold 2,218,714 shares of common stock at a
price of $3.50 per share in a private placement, with Oppenheimer & Co., Inc.
acting as placement agent. After deducting commissions and other estimated
expenses of the sale, this offering added approximately $7,050,000 to
ENDOcare's capital base.
Also on January 27, 1997, the four partnerships managed by Technology
Funding Inc. converted the outstanding principal amount of their $750,000
promissory notes and $50,000 of accrued interest into common stock at the
conversion rate of $2.50 per share. To induce conversion at that time,
ENDOcare issued to the partnerships an additional 12,000 shares of stock, with
a fair market value on that date of approximately $50,000. These transactions
converted the outstanding debt into equity so that ENDOcare will not be
required to re-pay principal or to continue to incur interest expense.
With these January 1997 capital infusions, the Company believes that its
existing cash resources and anticipated cash flows from future operations will
provide sufficient resources to meet present and reasonably foreseeable working
capital requirements and other cash needs through at least the end of 1997.
Insofar as the Company may elect to undertake or accelerate significant
research and development projects for new products or may pursue corporate
acquisitions, it may require additional outside financing prior to such time.
The preceding forward-looking statements are subject to uncertainties in
economic conditions, regulatory issues, and other risk factors. Such factors
may cause actual future results to differ significantly from management's
current expectations.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See Item 14, "Exhibits, Financial Statement Schedules, and Reports on Form
8-K."
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE
There are no disagreements with the Company's present or past accountants
on accounting and financial disclosure.
On April 29, 1996, ENDOcare terminated the previous appointment of Ernst
& Young LLP and engaged KPMG Peat Marwick LLP as the Company's principal
accounting firm. Such change was approved by the Company's Board of Directors.
A report on Form 8-K was filed dated April 29, 1996.
- 21 -
22
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
EXECUTIVE OFFICERS AND DIRECTORS
The executive officers and directors of the Company and their ages as of
February 12, 1997 are as follows:
Name Age Position
- ---------------- ------- -----------------------------------------------------------
Paul W. Mikus 31 President, Chief Executive Officer, Chief Financial Officer,
Treasurer, Chairman of the Board and Director
David J. Battles 39 Vice President, Sales
Ralph L. Quigley 53 Vice President, Operations
Peter F. Bernardoni 37 Director
Kevin Marinelli 32 Director
Paul W. Mikus has served as Chief Executive Officer, Chairman and
Director since January 1996. Prior to that time, he was President of ENDOcare
as a division of Medstone from June 1995. Prior to becoming President of
ENDOcare, he managed worldwide sales and marketing for Prosurg, Inc. From July
1989 to September 1994 he worked for Medstone as manager of engineering where
he was a co-founder of ENDOcare. Mr. Mikus holds a BS degree in Electrical
Engineering.
David J. Battles has served as Vice President, Sales for ENDOcare since
January 1996. Prior to that, from January 1995 to January 1996, he managed an
independent medical sales and distribution company, Aslan International. From
1993 to January 1995 he was the Managing Director of International Sales for
Medstone and ENDOcare. From 1990 to 1992 he worked as the Sales Manager, Asia
Pacific for Marquest Medical Products. Previously, he held a variety of sales
and management positions at Abbott Laboratories and Coast Medical Corporation.
He has a BS degree in Business Management from California Polytechnic State
University.
Ralph L. Quigley has served as Vice President, Operations since May 1996.
Prior to joining ENDOcare, Mr. Quigley served as Director and Division General
Manager at Everett-Charles Test Equipment Company from 1982 to 1988. From 1991
to 1993, Mr. Quigley was Vice President, Operations at L.H. Research, Inc., a
power supply manufacturer, where he was responsible for both domestic and
international operations with facilities in Malaysia and the Dominican
Republic. From 1993 to 1996, Mr. Quigley served as Director of Operations for
Workstation Technologies, a digital video equipment manufacturer.
Peter F. Bernardoni has served as a Director since November 1995. Mr.
Bernardoni has been a vice president of Technology Funding Inc. since 1991
and a partner in Technology Funding Ltd. since 1994. He serves on the board
of directors of Urogen, Corp. He has an MS in Mechanical Engineering from
Stanford University.
- 22 -
23
Kevin Marinelli has served as a Director since January 1996. From 1991
to present Mr. Marinelli has been the Chief Financial Officer of BKM, a
privately-held office furnishings and services company. He is a Certified
Management Accountant and has a BS in Accountancy.
COMPLIANCE WITH SECTION 16(A) OF THE SECURITIES EXCHANGE ACT OF 1934
Section 16(a) of the Exchange Act ("Section 16(a)") requires the
Company's directors and certain of its officers, and persons who own more than
10% of a registered class of the Company's equity securities (collectively,
"Insiders"), to file reports of ownership and changes in ownership with the
Commission. Insiders are required by Commission regulations to furnish the
Company with copies of all Section 16(a) forms they file.
Based solely on its review of the copies of such forms received by it, or
written representations from certain reporting persons that no Form 5's were
required for those persons, the Company believes that (i) each of the directors
and executive officers identified in Item 10 above and Ralph Brady and
Jacqueline Hibbs (each a former executive officer of the Company) failed to
file a Form 3, (ii) Mr. Battles failed to report a grant of an option on a Form
4, (iii) Ms. Hibbs failed to report one acquisition on a Form 4 (although Ms.
Hibbs disclaims beneficial ownership of such shares), and (iv) Mr. Bernardoni
did not file a Form 4 for two acquisitions and one sale of ENDOcare's common
stock and for one acquisition of warrants (although Mr. Bernardoni disclaims
beneficial ownership of such shares). Each of the aforementioned individuals
has filed a Form 5 within the required time period to reflect such late
filings.
ITEM 11. EXECUTIVE COMPENSATION
EXECUTIVE COMPENSATION
The following table sets forth all compensation awarded to, earned by or
paid to the Chief Executive Officer and the other most highly compensated
executive officers with total compensation in excess of $100,000 other than the
Chief Executive Officer (the "Named Executive Officers") for their services to
the Company for the year ended December 31, 1996.
- 23 -
24
Long-Term
Compensation
Annual Compensation Awards
------------------------------------------- ------------
Securities
Other Annual Underlying All Other
Name and Compen- Options/ Compen-
Principal Position Year Salary($) Bonus($) sation($) SAR's(#) (1) sation($)
- ------------------ ---- --------- -------- ----------- ------------ -------------
Paul W. Mikus 1996 97,500 --- --- --- 4,818 (2)
Chairman, President, Chief
Executive Officer, Chief
Financial Officer and
Treasurer
David J. Battles 1996 52,083 --- --- 100,000 43,185 (3)
Vice President, Sales
Ralph L. Quigley 1996 51,795 --- --- 75,000 370 (4)
Vice President, Operations
- -------------------------
(1) The Company does not grant Stock Appreciation Rights.
(2) Represents $130 of group term life insurance payments and $4,688 of
commissions on sale of a CRYOcare System.
(3) Represents $55 of group term life insurance payments and $43,130 of
commissions.
(4) Represents group term life insurance payments.
STOCK OPTIONS
The following table sets forth information concerning each grant of stock
options made during 1996 to each of the Named Executive Officers.
OPTION GRANTS IN LAST FISCAL YEAR
Individual Grants
-------------------------------------------------------------- Potential Realizable Value
Number of Percent of at Assumed Annual Rates
Shares Total Options of Stock Price Appreciation
Underlying Granted to Exercise for Option Term (1)
Options Employees Price Expiration ---------------------------
Name Granted (2) in Period Per Share Date 5% 10%
- -------------- -------------- -------------- ----------- ------------ ---------- ----------
Paul W. Mikus --- --- --- --- --- ---
David J. Battles 100,000 19.0% $0.18 02/08/06 $ 11,340 $ 28,620
Ralph L. Quigley 75,000 14.3% $3.63 04/17/06 $171,518 $432,878
- -------------------------
(1) The potential realizable value is calculated based on the term of the
option at its time of grant (ten years). It is calculated by assuming
that the stock price on the date of grant appreciates at the indicated
annual rate, compounded annually for the entire term of the option.
(2) All options become exercisable upon the merger of the Company with or into
another corporation or the sale of substantially all of the Company's
assets.
(3) The options vest over a four-year period with 25% on February 9, 1997 and
the remaining 75% exercisable in equal monthly installments thereafter
over the next three years.
(4) The options vest over a four-year period with 25% on April 18, 1997 and
the remaining 75% exercisable in equal monthly installments thereafter
over the next three years.
- 24 -
25
The following table sets forth the number and value as of December 31,
1996 of shares underlying unexercised options held by each of the Named
Executive Officers.
FISCAL YEAR-END OPTION VALUES
Number of Shares Underlying Value of Unexercised
Unexercised Options as of In the Money Options as of
December 31, 1996 December 31, 1996 (1) ($)
------------------------------------- --------------------------------------
Name Exercisable Unexercisable Exercisable Unexercisable
- ------------------ ----------------- ----------------- ----------------- -----------------
Paul W. Mikus (2) 125,000 375,000 $415,000 $1,245,000
David J. Battles (3) 6,250 118,750 $ 20,750 $ 394,250
Ralph L. Quigley (4) --- 75,000 --- 0
- -------------------------
(1) Based on the fair market value (computed using the average bid and ask
prices quoted on the NASDAQ Electronic Bulletin Board as of December 31,
1996, ($3.50 per share)) less the exercise price payable upon exercise of
such options.
(2) The options vest over a four-year period with 25% on December 1, 1996 and
the remaining 75% exercisable in equal monthly installments thereafter
over the next three years.
(3) 100,000 options vest as set forth above, with the remaining 25,000 options
vesting over a four-year period with 25% on December 1, 1996 and the
remaining 75% exercisable in equal monthly installments thereafter over
the next three years.
(4) All of Mr. Quigley's options were out of the money at December 31, 1996.
The exercise price of his 75,000 options was greater than the fair market
value of the Company's common stock (as calculated in footnote (1) above)
at December 31, 1996.
1995 STOCK PLAN
On November 1, 1995, ENDOcare adopted the ENDOcare, Inc. 1995 Stock Plan
(the "1995 Stock Plan"), a stock incentive plan covering 1,500,000 shares of
common stock of ENDOcare which may be awarded in order to attract and retain
qualified personnel. The Compensation Committee of the Board of Directors
administers the 1995 Stock Plan. Any employee or other person providing
services to the Company is eligible to receive awards under the 1995 Stock
Plan. Awards available under the 1995 Stock Plan include common stock purchase
options and restricted common stock.
BOARD COMMITTEES
Audit Committee: The Board of Directors established the Audit Committee
on October 31, 1995 to: (i) make recommendations concerning the engagement of
independent public accountants; (ii) review with the independent public
accountants the plans for, and scope of, the audit procedures to be utilized
and results of the audit; (iii) approve the professional services provided by
the independent public accountants; (iv) review the independence of the
independent public accountants; and (v) review the adequacy and effectiveness
of the Company's internal accounting controls. Mr. Peter F. Bernardoni and Mr.
Kevin Marinelli are the members of the Audit Committee.
Compensation Committee: The Board of Directors established the
Compensation Committee on October 31, 1995 consisting of Mr. Peter F. Bernardoni
and Mr. Kevin Marinelli, neither of whom are employees of the Company. The
Compensation Committee determines the compensation of the Company's executive
officers and administers the 1995 Stock Plan and the 1995 Director Option Plan.
- 25 -
26
COMPENSATION OF DIRECTORS
Directors are elected annually. The Company does not compensate its
directors for their services as such. However, directors are reimbursed for
their out of pocket expenses in attending Board meetings, and each of the
Company's non-employee directors participates in the 1995 Director Option Plan.
In 1995, ENDOcare adopted the ENDOcare, Inc. 1995 Director Option Plan
(the "Director Plan") covering 100,000 shares of ENDOcare common stock. The
Director Plan provides that each non-employee director (each, an "Outside
Director") is automatically granted an option to purchase 10,000 shares of
ENDOcare common stock upon his or her initial election or appointment as an
Outside Director. Subsequently, each Outside Director who has served for at
least six months will be granted an additional option to purchase 5,000 shares
of ENDOcare common stock on January 1 of each year so long as he or she remains
an Outside Director.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
The Company's Compensation Committee, which was established on October
31, 1995, consists of Messrs. Bernardoni and Marinelli, neither of whom was at
any time during fiscal 1996 or at any other time an officer or employee of the
Company. There are no compensation committee interlocks between the Company
and other entities involving the Company's executive officers and Board members
who serve as executive officers or Board members of such other entities.
INDEMNIFICATION AND EXCULPATION ARRANGEMENTS
The Restated Certificate of Incorporation of ENDOcare limits the
liability of directors to ENDOcare or its stockholders to the fullest extent
permitted by the Delaware General Corporation Law (the "DGCL"). Accordingly,
pursuant to the provisions of the DGCL presently in effect, directors of
ENDOcare will not be personally liable for monetary damages for breach of a
director's fiduciary duty as a director, except for liability: (i) for any
breach of the director's duty of loyalty to the Company or its shareholders;
(ii) for acts or omissions not in good faith or which involve intentional
misconduct or a knowing violation of law; (iii) under Section 174 of the DGCL;
or (iv) for any transaction from which the director derived an improper
personal benefit. In addition, the bylaws of ENDOcare require ENDOcare to
indemnify its directors and officers to the fullest extent permitted by the
laws of the State of Delaware.
- 26 -
27
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
AND MANAGEMENT
The following table sets forth information with respect to the beneficial
ownership of ENDOcare common stock owned as of February 1, 1997 by (i) the
holders of more than 5% of the ENDOcare common stock, (ii) each director of the
Company, (iii) each of ENDOcare's Named Executive Officers, and (iv) all
directors and executive officers of the Company as a group.
Amount and Nature
Name and Address of Beneficial
Title of Class of Beneficial Owner (1) Ownership (2) Percent of Class
- -------------- ----------------------- ------------- ----------------
Common Stock The Kaufman Fund 1,066,000 13.0%
140 E. 45th Street
New York, NY 10017
Peter F. Bernardoni (3) 634,500 7.7%
Technology Funding
2000 Alameda de las Pulgas
San Mateo, CA 94402
Paul W. Mikus (5) 166,667 (4) 2.0%
David J. Battles (5) 44,416 (4) *
Ralph L. Quigley (5) --- *
Kevin Marinelli 2,500 (4) *
113 Cottage Lane
Aliso Viejo, CA 92656
All executive officers and directors 848,083 9.9%
as a group (5 persons)
_____________________________________________________
* Less than 1%.
(1) All such shares were held of record with sole voting and investment
power, subject to applicable community property laws, by the named
individual and/or by his wife, except as indicated in the following
footnotes.
(2) Beneficial ownership is determined in accordance with the rules of
the Commission and generally includes voting or investment power with
respect to securities. Shares of common stock relating to options
currently exercisable or exercisable within 60 days of February 1,
1997, are deemed outstanding for computing the percentage of the
person holding such securities but are not deemed outstanding for
computing the percentage of any other person. Except as indicated by
footnote, and subject to community property laws where applicable,
the persons named in the table above have sole voting and investment
power with respect to all shares shown as beneficially owned by them.
(3) Includes 632,000 shares held by Technology Funding Partners III,
L.P., Technology Funding Venture Partners IV, an Aggressive Growth
Fund, L.P., Technology Funding Venture Partners V, an Aggressive
Growth Fund, L.P., and Technology Funding Medical Partners I, L.P.
(collectively, the "Funds"). Mr. Bernardoni is an officer of
Technology Funding Inc., and a partner of Technology Funding Ltd.,
each a general partner of the Funds. Mr. Bernardoni has sole voting
and shared investment power with respect to all shares owned by the
Funds, and therefore may be deemed to be beneficial owner of such
shares. Also includes 2,500 shares issuable with respect to exercise
of options.
(4) Represents 35,416 shares issuable with respect to the exercise of
options.
(5) The address of such persons is 18 Technology Drive, Suite 134, Irvine,
California 92618.
- 27 -
28
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Relationship Between ENDOcare and Medstone After the Distribution
Prior to 1996, ENDOcare had operated as a division of Medstone
International. ENDOcare, Inc. was incorporated as a wholly-owned subsidiary in
1994. Through 1995, the Company relied upon Medstone for financial support and
administrative assistance. Since completion of the Distribution at the
beginning of 1996, ENDOcare has operated independently from Medstone.
Prior to the Distribution, ENDOcare and Medstone entered into a
Distribution Agreement, a Research and Development Services Agreement, an
Administrative Services Agreement and a Contribution Agreement. The full text
of these agreements has been filed as exhibits to the Registration Statement at
the time of the Distribution.
During 1996 ENDOcare and Medstone exchanged few services. During the
first quarter, Medstone billed ENDOcare approximately $3,000 for administrative
services, and ENDOcare billed Medstone approximately $3,000 for engineering and
administrative services. Throughout 1996, ENDOcare provided health insurance
to its employees through continuation of Medstone's policy. Effective January
1, 1997, ENDOcare is providing its own, independent health insurance.
Relationship Between ENDOcare and Technology Funding
Peter F. Bernardoni has served on ENDOcare's Board of Directors since
November 1995. He also is a partner of Technology Funding Ltd. and an officer
of Technology Funding Inc., a venture capital group. In August 1996 ENDOcare
obtained a two-year $1,500,000 borrowing facility from four partnerships
managed by Technology Funding Inc. The outstanding principal balance of
$750,000 was convertible and, at the option of the holders, was converted on
January 27, 1997 into 300,000 shares of ENDOcare common stock at a conversion
price of $2.50 per share. Interest on the loan had accrued at a rate of 16%
per year, and all $50,000 was converted into 20,000 shares on that same date at
the same $2.50 per share. Also on January 27, 1997, the four partnerships
managed by Technology Funding Inc. received an additional 12,000 shares
($50,250 total market value) to induce conversion at that time. On August 26,
1996, the partnerships also received warrants for the purchase of up to 150,000
shares of ENDOcare common stock at any time on or before August 26, 2001, at a
price of $3.00 per share. The partnerships received an origination fee of
10,000 shares of common stock on that same date.
- 28 -
29
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES,
AND REPORTS ON FORM 8-K
(a) DOCUMENTS FILED AS A PART OF THIS REPORT
(1) Index to Financial Statements
Independent Auditors' Reports 32
Statements of Operations for the years ended
December 31, 1994, 1995 and 1996 34
Balance Sheets at December 31, 1995 and 1996 35
Statement of Shareholders'/Division Equity (Deficiency)
for the year ended December 31, 1996 36
Statements of Cash Flows for the years ended 37
December 31, 1994, 1995 and 1996
Notes to Financial Statements 38
(2) Financial Statement Schedules
Schedule II -- Valuation and Qualifying Accounts 49
(All other schedules are omitted because they are not applicable
or the required information is included in the consolidated
financial statements or notes thereto.)
- 29 -
30
(3) Exhibits
2.1 Distribution Agreement between the Registrant and Medstone
International, Inc., dated October 31, 1995 (1)
3.1 Certificate of Incorporation of the Company (2)
3.2 Amended and Restated Bylaws of the Company (1)
4.1 Specimen Certificate of the Company's Common Stock (3)
10.1 Facility Lease on 18 Technology Drive (2)
10.2 Contribution Agreement between Medstone International, Inc.
and the Company, dated October 31, 1995 (1)
10.3 Research and Development Services Agreement between Medstone
International, Inc. and the Company, dated October 31,
1995 (1)
10.4 Form of Indemnification Agreement (2) *
10.5 1995 Stock Plan (1) *
10.6 1995 Director Option Plan (1) *
10.7 Patent License Agreement between the Company and Brigham
and Women's Hospital, Inc., dated April 17, 1996 (4)
10.8 Form of Convertible Secured Promissory Note due
August 26, 1998, issued by ENDOcare, Inc. in an aggregate
principal amount of $1,500,000, dated August 26, 1996 (5)
10.9 Form of Warrant to purchase an aggregate of 150,000 shares of
common stock, dated August 26, 1996 (5)
10.10 Distributorship Agreement between the Company and Boston
Scientific Corporation, dated November 18, 1996 (6)
10.11 Common Stock Purchase Agreement by and among the Company and
the persons listed on the Schedule of Investors attached
thereto as Exhibit A, dated January 21, 1997 (7)
11.1 Earnings Per Share Calculation **
27.1 Financial Data Schedule **
29.1 ENDOcare, Inc. Information Statement distributed to
shareholders of Medstone International, Inc., dated
February 6, 1996 (8)
- -----------------------------------------------
(1) Previously filed with the Company's Application for Registration on Form
10-SB under the Securities Exchange Act of 1934, filed on November 14,
1995, and incorporated herein by reference. Each such exhibit had the
same exhibit number in that filing, except that the 1995 Stock Plan was
exhibit number 10.6 and the 1995 Director Option Plan was exhibit 10.7.
(2) Previously filed with Amendment number 1 to Company's Application for
Registration on Form 10-SB, filed on December 21, 1995, and incorporated
herein by reference.
(3) Previously filed with the Company's Annual Report on Form 10-K for the
year ended December 31, 1995, and incorporated herein by reference.
(4) Previously filed with the Company's Current Report on Form 8-K, as
amended, dated April 25, 1996 as filed with the Securities and Exchange
Commission on April 26, 1996, and incorporated herein by reference.
(5) Previously filed with the Company's Current Report on Form 8-K dated
August 26, 1996 as filed with the Securities and Exchange Commission on
September 10, 1996, and incorporated herein by reference.
(6) Previously filed with the Company's Current Report on Form 8-K dated
November 18, 1996 as filed with the Securities and Exchange Commission on
December 3, 1996, and incorporated herein by reference.
(7) Previously filed with the Company's Current Report on Form 8-K dated
January 27, 1997 as filed with the Securities and Exchange Commission on
January 31, 1997, and incorporated herein by reference.
(8) Previously filed on February 9, 1996 by Medstone International, Inc. under
Section 14(c) of the Securities Exchange Act of 1934, and incorporated
herein by reference.
* Management contract or compensatory plan or arrangement required to be
filed as an exhibit pursuant to applicable rules of the Securities and
Exchange Commission.
- 30 -
31
** Filed herewith.
(b) REPORTS ON FORM 8-K
The registrant filed a Current Report on Form 8-K dated November 18, 1996
with the Securities and Exchange Commission on December 3, 1996 describing
the Distribution Agreement dated November 18, 1996 between the Company and
Boston Scientific Corporation.
- 31 -
32
REPORT OF INDEPENDENT AUDITORS
To the Board of Directors and Shareholders
ENDOcare, Inc.:
We have audited the accompanying balance sheet of ENDOcare, Inc. (the Company)
as of December 31, 1996, and the related statements of operations, shareholders'
equity (deficiency), and cash flows for the year ended December 31, 1996. In
connection with our audit of the financial statements, we also have audited the
financial statement schedule as listed in the Index at Item 14(a). These
financial statements and financial statement schedule are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements and financial statement schedule based on our audit.
We conducted our audit 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 audit provides 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 ENDOcare, Inc. as of December
31, 1996, and the results of its operations and its cash flows for the year
then ended. Also in our opinion, the related financial statement schedule,
when considered in relation to the basic financial statements taken as a whole,
presents fairly, in all material respects, the information set forth therein.
As discussed in note 2 to the financial statements, the Company adopted the
provisions of Statement of Financial Accounting Standards No. 121, "Accounting
for the Impairment of Long-Lived Assets and for Long-Lived Assets to be
Disposed Of," as of January 1, 1996.
KPMG PEAT MARWICK LLP
Orange County, California
February 3, 1997
- 32 -
33
REPORT OF INDEPENDENT AUDITORS
To the Board of Directors and Shareholders
Endocare, Inc.
We have audited the accompanying balance sheet of Endocare (a division of
Medstone International, Inc.) as of December 31, 1995, and the related
statements of operations and cash flows for each of the two years in the period
ended December 31, 1995. Our audits also included the financial statement
schedule listed in the Index at Item 14(a). These financial statements and
schedule are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements and
schedule 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 Endocare (a division of
Medstone International, Inc.) at December 31, 1995, and the results of its
operations and its cash flows for each of the two years in the period ended
December 31, 1995, in conformity with generally accepted accounting principles.
Also, in our opinion, the related financial statement schedule, when considered
in relation to the basic financial statements taken as a whole, presents fairly
in all material respects the information set forth therein.
ERNST & YOUNG LLP
Orange County, California
February 14, 1996
- 33 -
34
ENDOCARE, INC.
STATEMENTS OF OPERATIONS
For the Years Ended December 31,
------------------------------------------------------------
1994 1995 1996
---------------- ---------------- ---------------
Revenues:
Net product sales $ 2,282,819 $ 951,311 $ 2,007,678
Revenue from collaborative agreements --- --- 250,000
Research revenue from related party 379,309 376,533 1,600
---------------- ---------------- ---------------
Total revenues 2,662,128 1,327,844 2,259,278
Costs and expenses:
Cost of product sales 638,294 379,478 1,054,614
Research and development 910,929 852,025 1,023,172
Selling, general and administrative 1,375,845 673,258 1,383,062
Impairment loss on long-lived assets --- --- 324,878
---------------- ---------------- ---------------
Total costs and expenses 2,925,068 1,904,761 3,785,726
---------------- ---------------- ---------------
Loss before income taxes (262,940) (576,917) (1,526,448)
Provision for income taxes --- --- 5,000
---------------- ---------------- ---------------
Net loss $ (262,940) $ (576,917) $ (1,531,448)
================ ================ ===============
Net loss per share of common stock $ (.27)
=======
Weighted average shares and common
stock equivalents outstanding 5,634,561
===============
The accompanying notes are an integral part of these financial statements.
- 34 -
35
ENDOCARE, INC.
BALANCE SHEETS
Pro Forma
Actual, December 31 Dec. 31, 1996
-------------------------------- (unaudited)
1995 1996 (Note 13)
------------- ------------- --------------
ASSETS
------
Current assets:
Cash and cash equivalents $ 1,941 $ 476,854 $ 7,700,468
Accounts receivable, less allowances of $46,948
and $123,699 at December 31, 1995 and 1996 102,416 662,385 662,385
Inventories 219,298 346,725 346,725
Prepaid expenses and other current assets 7,335 41,398 41,398
------------- ------------- --------------
Total current assets 330,990 1,527,362 8,750,976
Property and equipment, net 397,965 178,788 178,788
Intangible assets 60,831 --- ---
Other assets 15,907 69,191 36,057
------------- ------------- --------------
Total assets $ 805,693 $ 1,775,341 $ 8,965,821
============= ============= ==============
LIABILITIES AND SHAREHOLDERS'/DIVISION EQUITY (DEFICIENCY)
- -------------------------------------------------------------
Current liabilities:
Accounts payable $ --- $ 668,761 $ 668,761
Accrued compensation --- 57,390 57,390
Other accrued liabilities --- 153,639 251,704
Deferred revenue 1,628 128,333 128,333
Customer deposits 932 --- ---
------------- ------------- --------------
Total current liabilities 2,560 1,008,123 1,106,188
Deferred revenue --- 166,667 166,667
Convertible note payable --- 750,000 ---
Commitments and contingencies
Shareholders'/division equity (deficiency):
Advances from Medstone International, Inc. 2,831,364 --- ---
Preferred stock, $.001 par value; 1,000,000 shares
authorized; zero issued and outstanding --- --- ---
Common stock, $.001 par value; 20,000,000 shares
authorized; zero and 5,645,139 issued and
outstanding at December 31, 1995 and 1996 --- 5,645 8,193
Additional paid-in capital --- 1,376,354 9,266,471
Accumulated deficit (2,028,231) (1,531,448) (1,581,698)
------------- ------------- --------------
Total shareholders'/division equity (deficiency) 803,133 (149,449) 7,692,966
------------- ------------- --------------
Subsequent events
Total liabilities and equity (deficiency) $ 805,693 $ 1,775,341 $ 8,965,821
============= ============= ==============
The accompanying notes are an integral part of these financial statements.
- 35 -
36
ENDOCARE, INC.
STATEMENT OF SHAREHOLDERS'/DIVISION EQUITY (DEFICIENCY)
Total
Shareholders'/
Common Stock Additional Advances Division
------------------------ Paid-In from Accumulated Equity
Shares Amount Capital Medstone Deficit (Deficiency)
----------- ----------- ----------- ----------- ----------- ------------
BALANCE AT DECEMBER 31, 1995 --- $ --- $ --- $2,831,364 $(2,028,231) $ 803,133
Common stock issued in
Medstone Distribution 5,616,528 5,617 1,297,516 (2,831,364) 2,028,231 500,000
Other common stock issued 28,611 28 59,868 --- --- 59,896
Equity provided by
warrant amortization --- --- 18,970 --- --- 18,970
Net loss --- --- --- --- (1,531,448) (1,531,448)
----------- ----------- ----------- ----------- ----------- -----------
BALANCE AT DECEMBER 31, 1996 5,645,139 $ 5,645 $1,376,354 $ --- $(1,531,448) $ (149,449)
=========== =========== =========== =========== ============ ===========
No data is presented for periods prior to December 31, 1995, because at that
time ENDOcare was operating as a division of Medstone, not as an independent
public corporation. (See note 12).
The accompanying notes are an integral part of these financial statements.
- 36 -
37
ENDOCARE, INC.
STATEMENTS OF CASH FLOWS
For the Years Ended December 31,
---------------------------------------------------
1994 1995 1996
-------------- -------------- --------------
Cash flows from operating activities:
- -------------------------------------
Net loss $ (262,940) $ (576,917) $ (1,531,448)
Adjustments to reconcile net loss to net
cash used in operating activities:
Depreciation and amortization 156,065 163,193 38,325
Amortization of warrant value --- --- 18,970
Common stock issued for services --- --- 59,896
Impairment loss on long-lived assets --- --- 324,878
Changes in operating assets and liabilities:
Accounts receivable 113,724 87,365 (559,969)
Inventories (111,175) (21,605) (127,427)
Prepaid expenses and other current assets 3,800 8,565 (34,063)
Other assets --- (66,738) (53,284)
Accounts payable (40,032) (4,968) 668,761
Accrued compensation (4,941) (101,775) 57,390
Other accrued liabilities (13,502) (122) 153,639
Deferred revenue --- --- 293,372
Customer deposits (7,000) 932 (932)
------------- ------------- -------------
Net cash used in operating activities (166,001) (512,070) (691,892)
Cash flows from investing activities:
- -------------------------------------
Purchases of property and equipment (125,601) (28,697) (110,569)
Proceeds from sale of property and equipment 31,748 26,594 27,374
------------- ------------- -------------
Net cash used in investing activities (93,853) (2,103) (83,195)
Cash flows from financing activities:
- -------------------------------------
Advances from Medstone 259,854 516,114 ---
Issuance of common stock, Medstone Distribution --- --- 500,000
Borrowing on convertible note payable --- --- 750,000
------------- ------------- -------------
Net cash provided by financing activities 259,854 516,114 1,250,000
------------- ------------- -------------
Net increase in cash and cash equivalents --- 1,941 474,913
Cash and cash equivalents, beginning of year --- --- 1,941
------------- ------------- -------------
Cash and cash equivalents, end of year $ --- $ 1,941 $ 476,854
============= ============= =============
Non-cash activities:
- --------------------
Book value of net assets contributed by
Medstone at time of spin-out and
initial capitalization of ENDOcare, Inc. $ --- $ --- $ 803,133
============= ============= =============
The accompanying notes are an integral part of these financial statements.
- 37 -
38
ENDOCARE, INC.
NOTES TO FINANCIAL STATEMENTS
1. ORGANIZATION AND OPERATIONS OF THE COMPANY
ENDOcare, Inc. (the "Company") designs, manufactures, and markets medical
devices to treat prostate diseases worldwide.
Since its formation in 1990, ENDOcare operated first as a research and
development department, then later as a division of Medstone
International, Inc. ("Medstone"). Effective January 1, 1996, ENDOcare
became a totally independent, publicly-owned corporation. At the
beginning of 1996, ENDOcare, Inc. issued 5,616,528 shares of ENDOcare
common stock to Medstone in exchange for $500,000 cash and the accounts
receivable, inventory, and other net assets of the ENDOcare Division. On
February 6, 1996, Medstone distributed to existing Medstone shareholders
a stock dividend of one share of ENDOcare common stock for each share of
Medstone common stock outstanding on December 29, 1995.
All 1995 and earlier comparative amounts shown in the accompanying
financial statements reflect operations while ENDOcare was a division of
Medstone. In particular, the December 31, 1995 Balance Sheet is before
Medstone's conversion of its net advance to equity and before Medstone's
contribution of $500,000 cash.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Cash and Cash Equivalents: All highly liquid investments purchased with
an original maturity of three months or less are considered to be cash
equivalents.
Inventories: Inventories are stated at the lower of actual cost
(first-in, first-out) or net realizable value.
Property and Equipment: Property and equipment are stated at cost and
are depreciated on a straight-line basis over the estimated useful lives
of the respective assets, which range from two to five years. Leasehold
improvements are amortized over the shorter of the estimated useful lives
of the assets or the related lease term.
Long-Lived Assets: In 1995 the Financial Accounting Standards Board
issued Statement of Financial Accounting Standards No. 121, "Accounting
for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be
Disposed Of" ("SFAS 121"). ENDOcare adopted SFAS 121 in the first
quarter of 1996. Per this statement's provisions, ENDOcare reviews
property, equipment, and intangible assets for possible impairment
whenever events or circumstances indicate that the carrying amounts may
not be recoverable. If the sum of the expected future undiscounted cash
flows is less than the carrying amount of an asset, an impairment loss is
recognized. See Note 4 for impairment adjustments in 1996.
- 38 -
39
Revenue Recognition: ENDOcare recognizes product revenue upon the
shipment of its products and records reserves for estimated returns and
price adjustments. A portion of such sales is made on extended terms of
up to 365 days. Research and service revenues are recognized as the
related activities are performed or milestones are met.
Warranty Costs: Certain of the Company's products are covered by
warranties against defects in material and workmanship for periods of up
to twelve months. The estimated warranty cost is recorded at the time of
sale and is adjusted periodically to reflect actual experience.
Research and Development: Research and development costs relate to both
present and future products and are expensed immediately as incurred.
Stock-Based Compensation: In October 1995, the Financial Accounting
Standards Board issued Statement of Financial Accounting Standards No.
123, "Accounting for Stock-Based Compensation." Effective January 1,
1996, ENDOcare adopted this pronouncement to account for stock options
and warrants. Under this standard's "fair value" method, compensation
cost is measured based on the fair value of the award computed as of the
grant date and is recognized over the service period of the award, which
usually is the vesting period. In accordance with this standard, the
Company has elected to follow the guidance of Accounting Principles Board
Opinion No. 25, "Accounting for Stock Issued to Employees," disclosing
the effect of fair value in Note 10.
Earnings (Loss) Per Share: Earnings (loss) per share data for 1996 is
computed using the weighted average number of common shares and dilutive
common stock options and warrants outstanding. Fully diluted earnings
(loss) per share amounts are not presented because they approximate
primary earnings (loss) per share. Earnings (loss) per share data is not
presented for 1995 or earlier, because at that time ENDOcare was
operating as a division of Medstone. ENDOcare, Inc. shares were not
outstanding at any time during 1995.
Fair Value of Financial Instruments: The carrying amount of cash and
cash equivalents approximates fair value for all periods presented
because of the short-term maturity of these financial instruments. The
carrying amounts of all other financial instruments on the balance sheets
approximate fair values.
Use of Estimates: Company management has made a number of estimates and
assumptions relating to the reporting of assets and liabilities in
conformity with generally accepted accounting principles. Actual results
could differ from these estimates.
3. SUPPLEMENTAL FINANCIAL STATEMENT DATA
December 31,
--------------------------------------
1995 1996
-------------- --------------
Inventories:
------------
Raw materials $ 168,788 $ 213,154
Work in process 2,849 86,130
Finished goods 47,661 47,441
-------------- --------------
Total inventories $ 219,298 $ 346,725
============== ==============
- 39 -
40
December 31,
-------------------------------------
1995 1996
------------- -------------
Property and Equipment:
-----------------------
Production equipment $ 721,104 $ 201,106
Furniture and fixtures 38,907 49,037
Leasehold improvements --- 7,076
Assets held for disposal (net of reserves) --- 190,573
------------- -------------
Total property and equipment, at cost 760,011 447,792
Accumulated depreciation and amortization (362,046) (269,004)
------------- -------------
Net property and equipment $ 397,965 $ 178,788
============= =============
4. IMPLEMENTATION OF NEW ACCOUNTING PRONOUNCEMENT: ASSET IMPAIRMENT
In March 1995, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 121, "Accounting for the Impairment
of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of."
Effective January 1, 1996, ENDOcare adopted this pronouncement. In
accordance with this standard, the Company reviewed the cash flows being
generated by certain assets which were not expected to be utilized fully
in the Company's operations after its spin-out from Medstone
International, Inc. Based upon this review, effective January 1, 1996,
ENDOcare reduced the value of certain property and equipment by $264,047
and intangible organizational costs by $60,831 to their estimated fair
market values. These adjustments were charged to operations in the
quarter ended March 31, 1996.
The majority of the property and equipment adjustment pertained to laser
machines which were no longer generating sales of the Company's ProLase
laser catheters. At the December 31, 1995 spin-out date, these sixteen
lasers had a net book value of $311,665. Effective January 1, 1996,
ENDOcare reduced them to their estimated disposal value of $50,000, of
which $27,374 was realized during 1996.
The $60,831 adjustment to intangible organizational costs is described in
Note 5 below.
5. INTANGIBLE ASSETS
At the end of 1995, Medstone International, Inc. incurred significant
legal, accounting, and other professional expenses in connection with its
Distribution of its subsidiaries, ENDOcare and Urogen, to its existing
Medstone shareholders. Medstone elected to capitalize these expenses as
deferred organizational costs on its Balance Sheet. At the time of the
actual Distribution, $60,831 was allocated by Medstone to ENDOcare,
appearing as Intangible Assets on ENDOcare's initial December 31, 1995
Balance Sheet. Effective January 1, 1996, in accordance with the new
accounting standard described in Note 4 above, ENDOcare wrote off these
amounts entirely.
6. CONVERTIBLE LOAN PAYABLE
On August 26, 1996, ENDOcare obtained a two-year $1,500,000 borrowing
facility from four partnerships (the "Partnerships") managed by
Technology Funding Inc., a venture capital firm. Peter F. Bernardoni
is an officer of Technology Funding Inc. and has served as a member of
ENDOcare's Board of Directors since November 1995. At December 31, 1996,
$750,000 was outstanding under this loan.
- 40 -
41
In connection with entering into this loan, ENDOcare issued to the four
partnerships 10,000 shares of common stock as an origination fee and
warrants to purchase an aggregate of up to 150,000 shares of ENDOcare
common stock. The warrants are exercisable at any time between August 26,
1996 and August 26, 2001, at an exercise price of $3.00 per share, subject
to adjustment. At December 31, 1996, $750,000 was outstanding under this
loan.
The loan accrues interest at the rate of 16% per year, which is due and
payable in arrears on the maturity date. The outstanding principal and
interest under the loan is convertible into common stock of ENDOcare at a
conversion price of $2.50 per share, subject to certain conditions. All
of the obligations under the loan are secured by a security interest in
all present and after acquired personal property of ENDOcare.
On January 27, 1997, the partnerships converted their $750,000 principal
amount and accrued interest into 320,000 shares of common stock. Also,
12,000 additional shares of common stock were issued to the partnerships
as an inducement to convert at that time. The Convertible Loan which
provided an additional $750,000 of borrowing facility was cancelled as of
the conversion date. See Note 13 "Subsequent Events -- Private Placement
and Note Conversion."
7. COLLABORATIVE AGREEMENTS
Brigham: On April 17, 1996, ENDOcare entered into a patent license
agreement with Brigham and Women's Hospital, Inc., ("Brigham") an
affiliate of Harvard University. This agreement gives ENDOcare the
worldwide exclusive right to use Brigham's patented thermal radiation
technology in the Company's planned Hot Stent product. In return,
Brigham received a warrant to purchase up to 10,000 shares of ENDOcare
common stock at a price of $2.875 per share. The warrants are
exercisable at any time between April 17, 1996 and April 17, 2001. In
addition, if ENDOcare successfully brings the product to market, Brigham
may receive royalties on Hot Stent product sales. No royalties were
earned or paid in 1996.
Boston Scientific: On November 18, 1996, ENDOcare signed a distribution
agreement with Boston Scientific Corporation ("Boston Scientific"). This
agreement grants Boston Scientific exclusive worldwide marketing rights
for ENDOcare's CRYOcare system for urology. ENDOcare retains marketing
rights for other applications. In return Boston Scientific has
guaranteed ENDOcare certain minimum purchases of CRYOcare systems over
the next five years subject to certain conditions and renegotiation. In
addition, Boston Scientific has committed to pay ENDOcare four payments
of $250,000 each, based upon meeting certain specified milestones. The
first milestone, based upon contract signing, was received in November
1996, and revenue was recognized in the fourth quarter of 1996. Cash
related to the second milestone was received in December, but no revenue
was recognized in 1996. ENDOcare plans to recognize revenue on this
second milestone as it is earned over the three-year period beginning in
January 1997.
In addition, under the distribution agreement, Boston Scientific has a
right of first refusal to match any offer received by the Company from a
third party to purchase the assets related to the CRYOcare System, and a
right to buy the assets and technology related to the CRYOcare System at
purchase dates of twenty-four, thirty-six and forty-eight months after
the date that Medicare provides reimbursement for cryosurgical ablation
of the prostate, for a purchase price of 1.7, 1.5 and 1.3 times net sales
for the product for the preceding twelve months, but not less than $40
million, $50 million, and $60 million, respectively.
- 41 -
42
8. COMMITMENTS AND CONTINGENCIES
Commitments
Prior to September 1995, ENDOcare incurred no outside rental expense,
since it shared facilities with its parent, Medstone. In September 1995,
ENDOcare moved to its own facility in Irvine, California. Rent expense
was $9,184 and $51,391 in 1995 and 1996, respectively. This facility
lease expires in September 1998. Future minimum commitments on this lease
are $40,872 in 1997 and $30,654 in 1998. In February 1997, ENDOcare
signed a new five-year lease for a larger 16,100 square foot facility in
Irvine, California, with contractual rentals of $119,383 in 1997, $153,860
in 1998, $157,727 in 1999, $161,593 in 2000, and $165,460 in 2001,
thereafter $34,639. The Company expects to sublease its previous facility
for its remaining term. However, if the Company is unsuccessful in finding
a sublease tenant, the Company would be liable for the entire remaining
lease payments.
ENDOcare also leases various office equipment, with lease commitments
totaling $11,320 in 1997, $10,557 in 1998, $7,937 in 1999, and $5,358 in
2000.
As of December 31, 1996, ENDOcare has no other facility leases, capital
leases, or other long-term commitments.
Contingencies
On November 27, 1996, Cryomedical Sciences, Inc. ("CMS") filed a complaint
in the Circuit Court for Montgomery County, Maryland against the Company
and Dr. Chang, the Company's Vice President of Research and Development
and former employee of CMS. The suit alleges that Dr. Chang breached his
employment contract with CMS, that the Company tortiously interfered with
the employment contract and the prospective business relations of CMS,
misappropriated trade secrets and confidential information, competed
unfairly with and conspired against CMS. CMS is seeking injunctive relief
and damages. On January 23, 1997 a temporary restraining order was issued
by the court against the Company and Dr. Chang for the limited purpose of
preventing disclosure of certain information at a cryosurgery conference.
The order expired by its terms on February 3, 1997 and no other injunction
or other relief has been granted to CMS. The Company denies all
allegations of wrongdoing in the complaint and intends to defend the
lawsuit vigorously. However, the costs of defending the lawsuit could be
material and there can be no assurance that damages, which could have a
material adverse effect on the Company, will not be assessed. The Company
is not a party to any other legal proceedings.
From time to time, the Company has received correspondence alleging
infringement of proprietary rights of third parties. No assurance can be
given that any relevant claims of third parties would not be upheld as
valid and enforceable, and therefore that the Company could be prevented
from practicing the subject matter claimed or would be required to obtain
licenses from the owners of any such proprietary rights to avoid
infringement. Management does not expect any material adverse effect on
financial condition or the results of operations because of such actions.
- 42 -
43
9. INCOME TAXES
Income tax expense for the year ended December 31, 1996 consisted of:
Current: Federal $ ---
State and local 5,000
Deferred: Federal ---
State and local ---
--------------
Total $ 5,000
==============
The following table summarizes the tax effects of temporary differences
which give rise to significant portions of the deferred tax assets at
December 31, 1996:
Deferred tax assets:
Product and contingent liability reserves
established for book purposes $ 20,000
Fixed asset reserve 123,000
Inventory obsolescence reserve 44,000
Accounts receivable reserve 26,000
Net operating loss carryforwards 131,000
Other 7,000
--------------
Gross deferred tax assets 351,000
Valuation allowance (351,000)
--------------
Net deferred tax assets $ ---
==============
The valuation allowance increased by $351,000 for the year ended December
31, 1996.
Actual income tax expense differs from amounts computed by applying the
U.S. federal income tax rate of 34% to pretax income as a result of the
following:
Computed expected tax benefit $ (519,000)
State income taxes net of federal benefit 2,000
Nondeductible expenses 3,000
Change in valuation allowance 351,000
Change in tax rate with respect to net operating loss 165,000
Other 3,000
--------------
Actual tax expense $ 5,000
==============
As of December 31, 1996, the Company has net operating loss carryforwards
for federal income tax purposes of approximately $871,000 which are
available to offset future federal taxable income, if any, through the
year 2011. For state income tax purposes, the Company has net operating
loss carryforwards of approximately $267,000 which are available to
offset future state taxable income, if any, through the year 2001.
In accordance with Internal Revenue Code Section 382, the annual
utilization of net operating loss carryforwards and credits existing
prior to a change in control may be limited.
- 43 -
44
Prior to 1996, ENDOcare's net operating losses and research and
development credits have been included in the consolidated tax returns of
Medstone and have been fully utilized. As a result, ENDOcare had no net
operating losses or research and development credits to offset against
future taxable income at the time of the spin-out from Medstone.
10. STOCK OPTIONS AND WARRANTS
At December 31, 1996, ENDOcare had two stock-based compensation plans, as
described below. Per FASB Statement No. 123, the Company has elected to
apply APB Opinion No. 25 and related Interpretations in accounting for
its plans. Accordingly, no compensation expense has been recognized for
these plans in the Statements of Operations.
The 1995 Stock Plan authorizes the Board or one or more committees which
the Board may appoint from among its members (the "Committee") to grant
options and rights to purchase common stock to employees and certain
consultants and distributors. Options granted under the 1995 Stock Plan
may be either "incentive stock options" as defined in Section 422 of the
Internal Revenue Code of 1986, as amended, or nonstatutory stock options,
as determined by the Board or the Committee. The exercise price of
options granted under the 1995 Stock Plan is equal to the fair market
value of ENDOcare common stock on the date of grant. Options vest 25% on
the one year anniversary date, with the remaining 75% vesting monthly
over the following three years. Options are exercisable for ten years.
A total of 1,500,000 shares of common stock has been reserved for
issuance under the 1995 Stock Plan. As of December 31, 1996, options to
purchase a total of 1,486,000 shares of the Company's common stock have
been granted under the 1995 Stock Plan.
The 1995 Director Option Plan (the "Director Plan") was adopted by the
Board of Directors (the "Board") in October 1995 and approved by the
shareholders in November 1995. It provides automatic, nondiscretionary
grants of options to ENDOcare's non-employee directors ("Outside
Directors"). The Director Plan provides that each Outside Director is
automatically granted an option to purchase 10,000 shares of ENDOcare
common stock upon his or her initial election or appointment as an
Outside Director. Subsequently, each Outside Director who has served for
at least six months will be granted an additional option to purchase
5,000 shares of ENDOcare common stock on January 1 of each year so long
as he or she remains an Outside Director. The exercise price of options
granted to Outside Directors must be the fair market value of ENDOcare
common stock on the date of grant. Options granted to Outside Directors
have ten-year terms, subject to an Outside Director's continued service
as a director. Options granted to the Outside Directors vest over four
years at the rate of 25% per year. A total of 100,000 shares of common
stock has been reserved for issuance under the Director Plan. As of
December 31, 1996, options to purchase a total of 20,000 shares of the
Company's common stock have been granted under the Director Plan.
- 44 -
45
The following two tables summarize ENDOcare's option activity:
1 9 9 5 1 9 9 6
------------------------------ -------------------------------
Weighted Avg. Weighted Avg.
Number of Exercise Price Number of Exercise Price
Options Per Option Options Per Option
------------- ------------- -------------- --------------
Outstanding, beginning of year --- 980,000 $0.18
Granted during year 980,000 $0.18 626,000 $2.07
Cancelled during year --- --- (100,000) $2.09
------------- ------------- -------------- --------------
Outstanding, end of year 980,000 $0.18 1,506,000 $0.84
============= ============= ============== ==============
Options Outstanding Options Exercisable
------------------------------------------------ ------------------------------
Number Weighted-Avg. Number
Range of Outstanding Remaining Weighted-Avg. Exercisable Weighted-Avg.
Exercise Prices at 12/31/96 Contractual Life Exercise Price at 12/31/96 Exercise Price
--------------- -------------- ---------------- -------------- -------------- --------------
$0.18 1,205,000 8.9 years $0.18 245,000 $0.18
$1.88 6,000 9.2 years $1.88 --- $1.88
$3.25 85,000 9.7 years $3.25 --- $3.25
$3.38 50,000 9.6 years $3.38 --- $3.38
$3.63 75,000 9.3 years $3.63 --- $3.63
$3.75 70,000 9.7 years $3.75 --- $3.75
$3.88 15,000 9.4 years $3.88 --- $3.88
-------------- -------------
$0.18 to $3.88 1,506,000 9.1 years $0.84 245,000 $0.18
============== =============
No options were exercisable at December 31, 1995.
The following table presents pro forma information as if ENDOcare
recorded compensation cost using the fair value of the issued stock
options using the Black-Scholes valuation model:
1995 1996
----------------- -----------------
Net loss:
---------
As reported $ (576,917) $ (1,531,448)
Assumed stock compensation cost (4,545) (107,011)
----------------- -----------------
Pro forma, adjusted $ (581,462) $ (1,638,459)
================= =================
Net loss per share:
-------------------
As reported $ (0.27)
Pro forma, adjusted $ (0.29)
The fair value of each option grant is estimated on the date of grant
using the Black-Scholes option pricing model, with the following
assumptions:
1995 1996
----------------- -----------------
Stock volatility .3 .3
Risk-free interest rate 8.00% 8.00%
Option term in years 10 years 10 years
Stock dividend yield --- ---
- 45 -
46
During 1996, ENDOcare issued warrants to purchase 160,000 shares of the
Company's common stock. Using the Black-Scholes valuation model, the
weighted-average grant-date fair value of these warrants was $0.75 per
share. The Company amortizes these fair values to expense over the
service period of the related warrants. No warrants were issued in 1995
or earlier.
11. MAJOR CUSTOMERS AND CONCENTRATION OF CREDIT RISK
ENDOcare sells its devices worldwide to distributors of medical devices
and directly to hospitals and other medical professional organizations.
With its November 18, 1996 signing of a distribution agreement with
Boston Scientific (see Note 7), ENDOcare's CRYOcare systems will be
distributed exclusively by Boston Scientific for that product's original
market, urological applications.
Customer credit may be extended based upon evaluation of the customer's
financial condition. In general, on sales of major surgical systems,
such as CRYOcare and Diolase, ENDOcare attempts to secure an up-front
deposit and payment at time of delivery, often through a secured letter
of credit. The Company maintains reserves for credit losses, and Company
management considers such reserves to be adequate based upon historical
experience.
During the year ended December 31, 1996, two customers accounted for over
10% of the Company's revenues. A Canadian distributor accounted for 13%
of total revenues, and Boston Scientific accounted for 11%. At December
31, 1996, four customers accounted for over 10% of gross accounts
receivable. A Taiwanese distributor accounted for 18% of gross
receivables, an Australian distributor accounted for 16%, a Michigan
medical group accounted for 13%, and a Texas distributor accounted for
13%. The Company derived 53% of its total revenues from foreign
customers during the year ended December 31, 1996.
During the year ended December 31, 1995, two customers accounted for over
10% of the Company's revenues. A domestic distributor accounted for 17%
of total revenues, and a Korean distributor accounted for 10%. The
Company derived 38% of its total revenues from foreign customers during
the year ended December 31, 1995. During the year ended December 31,
1994, no single customer accounted for 10% or more of the total revenue,
and the Company derived 16% of its total revenues from foreign customers.
12. RELATED PARTY TRANSACTIONS
Relationship with Medstone
Since its inception, ENDOcare operated as a division of Medstone
International. Prior to becoming an independent corporation in January
1996, ENDOcare received funding and certain administrative services from
Medstone. In return, ENDOcare provided certain research and development
services to Medstone, and Medstone received the cash collected from
ENDOcare's outside sales. With the Distribution of ENDOcare as an
independent company, no Advances were outstanding effective January 1,
1996.
- 46 -
47
Until October 1995, ENDOcare's operations were located within Medstone's
facilities. Medstone allocated to ENDOcare a charge for rent and other
facilities-related expenses based upon square footage occupied. ENDOcare
and Medstone shared the services of certain employees, whose costs,
including salary, payroll taxes, and group benefits were allocated to
ENDOcare based upon the percentage of time spent on ENDOcare projects.
Expenses other than those related to facilities and employees were
allocated to ENDOcare based upon actual usage, headcount, or other bases.
Medstone management believed the allocations discussed above were made on
a reasonable basis and were representative of the expenses ENDOcare would
have incurred on a stand-alone basis.
During 1996 ENDOcare and Medstone exchanged very little services. During
the first quarter, Medstone billed ENDOcare approximately $3,000 for
administrative services, and ENDOcare billed Medstone approximately $3,000
for engineering and administrative services. Throughout 1996, ENDOcare
provided health insurance to its employees through continuation of
Medstone's policy.
The following table summarizes the transactions reflected in the Advances
from Medstone:
Advances from
Medstone
----------------
Balance at December 31, 1993 . . . $ 2,055,396
Cash expended by Medstone on behalf of ENDOcare . . . 2,773,226
Expenses allocated to ENDOcare by Medstone . . . . . . 399,290
Expenses allocated to Medstone by ENDOcare . . . . . . (135,316)
Cash collected from ENDOcare net product sales . . . . (2,398,037)
Research revenues recorded by ENDOcare for services
performed on behalf of Medstone . . . . . . . . . (379,309)
----------------
Balance at December 31, 1994 . . . 2,315,250
Cash expended by Medstone on behalf of ENDOcare . . . 1,624,399
Expenses allocated to ENDOcare by Medstone . . . . . . 306,775
Expenses allocated to Medstone by ENDOcare . . . . . . ---
Cash collected from ENDOcare net product sales . . . . (1,038,527)
Research revenues recorded by ENDOcare for services
performed on behalf of Medstone . . . . . . . . . (376,533)
----------------
Balance at December 31, 1995 . . . 2,831,364
Conversion of Advance to equity in Distribution . . . $ (2,831,364)
---------------
Balance at December 31, 1996 . . . $ ---
================
- 47 -
48
Relationship with Technology Funding
Peter F. Bernardoni has served on ENDOcare's Board of Directors since
November 1995. He also is a partner of Technology Funding Ltd. and an
officer of Technology Funding Inc., a venture capital group. In August
1996 ENDOcare obtained a two-year $1,500,000 borrowing facility from four
partnerships managed by Technology Funding Inc. The outstanding
principal balance of $750,000 was convertible and, at the option of the
holders, was converted on January 27, 1997 into 300,000 shares of
ENDOcare common stock at a conversion price of $2.50 per share. Interest
on the loan had accrued at a rate of 16% per year, and all $50,000 was
converted into 20,000 shares on that same date at the same $2.50 per
share. Also on January 27, 1997, the four partnerships managed by
Technology Funding Inc. received an additional 12,000 shares ($50,250
total market value) to induce conversion at that time. On August 26,
1996, the partnerships also received warrants for the purchase of up to
150,000 shares of ENDOcare common stock at any time on or before August
26, 2001, at a price of $3.00 per share. The partnerships received an
origination fee of 10,000 shares of common stock on that same date.
13. SUBSEQUENT EVENTS -- PRIVATE PLACEMENT AND NOTE CONVERSION
On January 27, 1997, ENDOcare sold 2,218,714 shares of common stock at a
price of $3.50 per share in a private placement, with Oppenheimer & Co.,
Inc. ("Oppenheimer") acting as placement agent. After expenses, the net
contribution to the Company's capital was approximately $7,050,000.
Expenses deducted from the proceeds include a commission to Oppenheimer
of $543,585 and estimated legal, accounting, and other professional
expenses of $160,000 (actual expenses may be different). In addition,
Oppenheimer received a warrant to purchase 177,497 shares of ENDOcare
common stock for a period of five years at a price of $4.20 per share.
The warrants are exercisable at any time between January 27, 1998 and
January 27, 2002.
Also on January 27, 1997, the four partnerships managed by Technology
Funding Inc. converted the $750,000 outstanding principal amount under
the promissory notes and $50,000 of accrued interest into common stock at
the conversion rate of $2.50 per share. To induce conversion at the same
time as the private placement, the Company issued an additional 12,000
shares of common stock to the partnerships (fair market value of $50,250
at January 27, 1997). At ENDOcare's election, the remaining borrowing
facility was cancelled on that same date.
The unaudited pro forma column on the Balance Sheet reflects the December
31, 1996 Balance Sheet assuming that both the private placement and the
note conversion occurred on December 31, 1996.
14. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)
Net Income (Loss)
Total -------------------------------
Revenue Total Per Share
-------------- -------------- --------------
Quarter Ended:
- --------------
December 31, 1996 $ 829,764 $ (273,045) $ (0.05)
September 30, 1996 639,073 (286,262) (0.05)
June 30, 1996 419,785 (394,557) (0.07)
March 31, 1996 370,656 (577,584) (0.10)
- 48 -
49
ENDOCARE, INC.
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
Allowance for Reserve for
Doubtful Receivables Inventory Obsolescence
and Sales Returns and Net Realizable Value
----------------- ------------------------
Balance at December 31, 1993 . . . . . . . . $ 98,600 $ ---
Charges to operations . . . . . . . . . --- ---
Deductions . . . . . . . . . . . . . . (1,494) ---
Other . . . . . . . . . . . . . . . . . --- ---
-------------- --------------
Balance at December 31, 1994 . . . . . . . . 97,106 ---
Charges to operations . . . . . . . . . --- ---
Deductions . . . . . . . . . . . . . . (50,158) ---
Other . . . . . . . . . . . . . . . . . --- ---
-------------- --------------
Balance at December 31, 1995 . . . . . . . . 46,948 ---
Charges to operations . . . . . . . . . 88,247 77,236
Deductions . . . . . . . . . . . . . . 11,496 ---
Other . . . . . . . . . . . . . . . . . --- ---
-------------- --------------
Balance at December 31, 1996 . . . . . . . . $ 123,699 $ 77,236
============== ==============
- 49 -
50
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.
ENDOCARE, INC.
By: /s/ Paul W. Mikus
------------------------------------------
Paul W. Mikus
Chief Executive Officer, President,
Chief Financial Officer, and Treasurer
Dated: February 20, 1997
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 indicated on February 20, 1997.
Signature Title
----------- ---------
Chief Executive Officer, President,
/s/ Paul W. Mikus Chief Financial Officer, and Treasurer
- --------------------------------------------------- (Principal Executive Officer
Paul W. Mikus and Principal Financial
and Accounting Officer)
/s/ Peter F. Bernardoni Director
- ---------------------------------------------------
Peter F. Bernardoni
/s/ Kevin Marinelli Director
- ---------------------------------------------------
Kevin Marinelli
- 50 -
51
ENDOCARE, INC.
INDEX TO EXHIBITS
2.1 Distribution Agreement between the Registrant and Medstone
International, Inc., dated October 31, 1995 (1)
3.1 Certificate of Incorporation of the Company (2)
3.2 Amended and Restated Bylaws of the Company (1)
4.1 Specimen Certificate of the Company's Common Stock (3)
10.1 Facility Lease on 18 Technology Drive (2)
10.2 Contribution Agreement between Medstone International, Inc.
and the Company, dated October 31, 1995 (1)
10.3 Research and Development Services Agreement between Medstone
International, Inc. and the Company, dated
October 31, 1995 (1)
10.4 Form of Indemnification Agreement (2) *
10.5 1995 Stock Plan (1) *
10.6 1995 Director Option Plan (1) *
10.7 Patent License Agreement between the Company and Brigham and
Women's Hospital, Inc., dated April 17, 1996 (4)
10.8 Form of Convertible Secured Promissory Note due
August 26, 1998, issued by ENDOcare, Inc. in an aggregate
principal amount of $1,500,000, dated August 26, 1996 (5)
10.9 Form of Warrant to purchase an aggregate of 150,000 shares of
common stock, dated August 26, 1996 (5)
10.10 Distributorship Agreement between the Company and Boston
Scientific Corporation, dated November 18, 1996 (6)
10.11 Common Stock Purchase Agreement by and among the Company and
the persons listed on the Schedule of Investors attached
thereto as Exhibit A, dated January 21, 1997 (7)
11.1 Earnings Per Share Calculation **
27.1 Financial Data Schedule **
29.1 ENDOcare, Inc. Information Statement distributed to
shareholders of Medstone International, Inc., dated
February 6, 1996 (8)
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(1) Previously filed with the Company's Application for Registration on Form
10-SB under the Securities Exchange Act of 1934, filed on November 14,
1995, and incorporated herein by reference. Each such exhibit had the
same exhibit number in that filing, except that the 1995 Stock Plan was
exhibit number 10.6 and the 1995 Director Option Plan was exhibit 10.7.
(2) Previously filed with Amendment number 1 to Company's Application for
Registration on Form 10-SB, filed on December 21, 1995, and incorporated
herein by reference.
(3) Previously filed with the Company's Annual Report on Form 10-K for the
year ended December 31, 1995, and incorporated herein by reference.
(4) Previously filed with the Company's Current Report on Form 8-K, as
amended, dated April 25, 1996 as filed with the Securities and Exchange
Commission on April 26, 1996, and incorporated herein by reference.
(5) Previously filed with the Company's Current Report on Form 8-K dated
August 26, 1996 as filed with the Securities and Exchange Commission on
September 10, 1996, and incorporated herein by reference.
(6) Previously filed with the Company's Current Report on Form 8-K dated
November 18, 1996 as filed with the Securities and Exchange Commission on
December 3, 1996, and incorporated herein by reference.
(7) Previously filed with the Company's Current Report on Form 8-K dated
January 27, 1997 as filed with the Securities and Exchange Commission on
January 31, 1997, and incorporated herein by reference.
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(8) Previously filed on February 9, 1996 by Medstone International, Inc. under
Section 14(c) of the Securities Exchange Act of 1934, and incorporated
herein by reference.
* Management contract or compensatory plan or arrangement required to be
filed as an exhibit pursuant to applicable rules of the Securities and
Exchange Commission.
** Filed herewith.
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