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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
/X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES ACT OF 1934 FOR THE FISCAL YEAR ENDED
DECEMBER 31, 1999 OR
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934.
COMMISSION FILE NUMBER 0-18962
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CYGNUS, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 94-2978092
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
400 PENOBSCOT DRIVE, REDWOOD CITY, CALIFORNIA 94063
(Address of principal executive offices and zip code)
(650) 369-4300
(Registrant's telephone number, including area code)
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Securities registered pursuant to Section 12(b) of the Act: NONE
Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK, $0.001
PAR VALUE
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Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes /X/ No / /
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. / /
The aggregate market value of voting stock held by non-affiliates of the
registrant, based upon the closing price of Common Stock on MARCH 15, 2000 as
reported on the Nasdaq National Market was APPROXIMATELY $409,203,216.
Determination of affiliate status for this purpose is not a determination of
affiliate status for any other purpose.
25,575,201
(Number of shares of Common Stock outstanding as of MARCH 15, 2000)
DOCUMENTS INCORPORATED BY REFERENCE
Registrant's consolidated financial statements for the fiscal year ended
December 31, 1999 and definitive Proxy Statement to be filed pursuant to
Regulation 14A for its 2000 Annual Meeting of Stockholders are incorporated by
reference into Part III hereof.
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CYGNUS, INC.
1999 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
PAGE
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PART I
ITEM 1. Business.................................................... 1
ITEM 2. Properties.................................................. 14
ITEM 3. Legal Proceedings........................................... 14
PART II
ITEM 5. Market for Registrant's Common Equity and Related
Stockholder Matters....................................... 15
ITEM 6. Selected Financial Data..................................... 15
ITEM 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................. 17
ITEM 7A. Quantitative and Qualitative Disclosures About Market
Risk...................................................... 29
ITEM 8. Financial Statements and Supplementary Data................. 30
ITEM 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.................................. 30
PART III
ITEM 10. Directors and Executive Officers of the Registrant.......... 31
ITEM 11. Executive Compensation...................................... 32
ITEM 12. Security Ownership of Certain Beneficial Owners and
Management................................................ 32
ITEM 13. Certain Relationships and Related Transactions.............. 32
PART IV
ITEM 14. Exhibits, Financial Statement Schedules and Reports on
Form 8-K.................................................. 33
SIGNATURES............................................................ 39
PART I
ITEM 1. BUSINESS
OVERVIEW
THIS REPORT CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND
UNCERTAINTIES RELATING TO THE FUTURE FINANCIAL PERFORMANCE OF CYGNUS, INC.
("CYGNUS," "THE COMPANY," "WE," "OUR," OR "US"), AND ACTUAL EVENTS OR RESULTS
MAY DIFFER MATERIALLY. IN EVALUATING SUCH STATEMENTS, STOCKHOLDERS AND INVESTORS
SHOULD SPECIFICALLY CONSIDER THE VARIOUS FACTORS IDENTIFIED UNDER THE CAPTION
"RISK FACTORS" CONTAINED IN THE MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS THAT COULD CAUSE ACTUAL RESULTS TO
DIFFER MATERIALLY FROM THOSE INDICATED BY SUCH FORWARD-LOOKING STATEMENTS. WE
UNDERTAKE NO OBLIGATION TO PUBLICLY RELEASE THE RESULTS OF ANY REVISIONS TO
THESE FORWARD-LOOKING STATEMENTS WHICH MAY BE MADE TO REFLECT EVENTS OR
CIRCUMSTANCES AFTER THE DATE HEREOF OR TO REFLECT THE OCCURRENCES OF
UNANTICIPATED EVENTS.
We are engaged in the development and manufacture of diagnostic medical
devices, utilizing proprietary technologies to satisfy unmet medical needs cost
effectively. Our current efforts are focused on a frequent, automatic and
non-invasive glucose monitoring device, the GlucoWatch-Registered Trademark-
biographer, and enhancements thereto.
Cygnus was incorporated in California in 1985 and was merged into a Delaware
corporation in September 1995. Our principal executive offices are located at
400 Penobscot Drive, Redwood City, California 94063, our telephone number at
that address is (650) 369-4300 and our facsimile number at that address is (650)
369-5318. Additionally, our website is www.cygn.com.
On July 9, 1999, John C Hodgman, President and Chief Executive Officer,
succeeded Gary W. Cleary, Ph.D., as Chairman of the Board of Directors. (Dr.
Cleary resigned as Chief Technical Officer effective the same date.) Dr. Cleary
served as Chairman Emeritus of the Board from July 9, 1999 until February 22,
2000, when he resigned from the Board of Directors.
CYGNUS' BUSINESS STRATEGY
In 1999 we chose to focus solely on glucose monitoring systems and sold our
drug delivery business to Ortho-McNeil Pharmaceutical, Inc., a Johnson & Johnson
company. Our GlucoWatch-Registered Trademark- system represents a potential
advance in glucose monitoring technology as compared to the currently prevailing
"finger stick" blood monitoring methods. The GlucoWatch system is designed to
measure glucose frequently, automatically and non-invasively through the ease
and convenience of a device worn like a wristwatch. Worldwide sales of blood
glucose self-monitoring products were approximately $2.5 billion in 1997 (Boston
Biomedical Consultants, Inc.). More than forty million people in North America,
Europe, Japan and Korea have diabetes. In the United States alone, more than ten
million people have been diagnosed with diabetes, with another five million
believed to have the condition. The number of people with diabetes is expected
to continue to grow with the aging of the population, while the number of
diagnosed cases is also expected to increase with changes in diagnostic
standards and new diagnostic technologies.
Clinical studies sponsored by the National Institutes of Health (NIH)
indicate that better management of glucose levels through more frequent testing
and more frequent insulin injections would enable people with diabetes to reduce
or significantly delay many serious diabetes-related
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health complications. However, largely due to the pain of repetitive finger
sticking and the associated disruption of daily life, most people with diabetes
currently test their glucose levels less than half as often as recommended,
resulting in limited glucose information to make decisions that could better
control glucose fluctuations. We believe this lack of information presents a
significant unmet need for a new type of glucose monitoring device.
To address this unmet need, our GlucoWatch system provides frequent,
automatic and non-invasive glucose measurements and is intended for detecting
trends and tracking patterns of glucose levels in adults, 18 years and older,
who have diabetes. The device is intended for use at home and in healthcare
facilities to supplement, not replace, information obtained from standard home
blood glucose monitoring devices. Following a three-hour warm-up period and
calibration from a finger stick blood measurement, the device is capable of
providing up to thirty-six non-invasive glucose measurements over twelve hours.
The extracted glucose is collected in a consumable component called the
AutoSensor, which is attached to the back of the biographer and replaced after
twelve hours of measurements. The GlucoWatch system (i.e., the biographer and
AutoSensor ) offers features such as alerts indicating hypoglycemic and
hyperglycemic conditions, and event markers that record factors affecting
glucose levels.
On December 6, 1999, we announced that our Premarket Approval application
(PMA) for the GlucoWatch system received a unanimous recommendation for approval
with conditions by the United States Food and Drug Administration's (FDA)
Clinical Chemistry and Clinical Toxicology Devices Panel of the Medical Devices
Advisory Committee. The Advisory Committee suggested three conditions for
approval. The first is the creation of an education program, about which we have
already been in discussions with the FDA concerning the substance of such a
program. The second condition is that our product labeling will be revised in
accordance with recommendations given to the FDA by the Committee, and we are
currently in discussions with the FDA on proposed labeling. Third, the Committee
suggested a post-market study of detection of hypoglycemia and hyperglycemia.
This lattermost condition does not need to be satisfied prior to FDA approval.
Although the FDA is not bound by the decisions of the Advisory Committee, the
agency typically follows its advisory committees' advice. By way of background,
our 5,000-page PMA application included analyses of clinical studies conducted
on more than 600 people with diabetes, who used the device from a few hours to
up to six weeks. The studies, which were performed at more than 15 clinical
sites across the United States, involved over 25,000 hours of use of the
GlucoWatch system. The participants consisted of a cross-section of racial and
age groups, diabetes types (both type 1 and type 2), and other defining
characteristics. Approximately 19,000 paired data points were generated from the
studies, comparing interstitial fluid glucose measurements obtained by the
GlucoWatch system to glucose measurements obtained with finger stick monitors
using capillary blood.
On December 2, 1999, we announced the receipt of a CE Certificate for the
GlucoWatch system, indicating that the product has met the essential
requirements and other criteria of the European Community Directive 93/42/ECC,
Annex V, Section 3.2. The CE Certificate is required for selling products in the
European Community. We are compliant with ISO 9002 and EN 46002.
In December 1999, we entered into a five-year Supply Agreement with Hydrogel
Design Systems, Inc. relating to the manufacture of the AutoSensor hydrogel
laminate used in the GlucoWatch system. Also, in December 1999, we entered into
a three-year Supply Agreement with Key Tronic Corporation relating to the
manufacture of the biosensor component of the AutoSensor.
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Both of these agreements contain percentage minimum requirements of product that
we must purchase from these companies if and when the GlucoWatch system is
commercialized. Additionally, we are currently in negotiations with a
third-party manufacturer for the GlucoWatch system.
In September 1999, we were awarded a six-month Phase I Small Business
Innovative Research Grant for "High Performance Biosensor Electrode Materials"
from the National Institute of Diabetes and Digestive and Kidney Diseases
division of the National Institutes of Health (NIH) in the amount of
$0.1 million. This funding is used to investigate advancements in biosensor
materials used for glucose detection and measurement, potentially to include in
future versions of the GlucoWatch system.
In June 1998, we entered into long-term agreements with E.I. du Pont de
Nemours & Company ("DuPont") for the development and supply of thick film
materials for our GlucoWatch system. In July 1997, we entered into a Product
Supply Agreement with Contract Manufacturing, Inc. relating to the assembly of
the AutoSensor and also the final packaging of the GlucoWatch system starter
kits. This latter agreement continues for five years from date of first
commercial sale, and contains minimum requirements of product that we must
purchase from this company if and when the GlucoWatch system is commercialized.
In 1996, we entered into a collaboration agreement with Yamanouchi
Pharmaceutical Co., Ltd. for the commercialization of the GlucoWatch system in
Japan and Korea, and also a collaboration agreement with Becton Dickinson &
Company for the commercialization of the GlucoWatch system in the rest of the
world. Under the Yamanouchi agreement, we are eligible to receive milestone
payments prior to commercialization and to receive a percentage of the product's
future commercial success in Japan and Korea. In March of 1998, we announced the
termination of our agreement with Becton Dickinson. One of our priorities is to
establish an alliance or alliances for the commercialization of the GlucoWatch
system in North America and Europe. The purpose of such an alliance or alliances
is for us to secure certain commercialization functions, such as distribution,
sales and customer service. We are in discussions with several companies
regarding this objective. Some of the companies are international in scope and
would provide the requisite commercialization functions worldwide. Other
companies focus on certain geographies and/or certain commercialization
functions. The potential signing of a worldwide commercialization agreement may
or may not coincide with the launch of our GlucoWatch system, assuming we
receive FDA approval. We are evaluating out-sourced capabilities for a U.S.
launch without a worldwide commercialization alliance. There can be no assurance
that we will be able to enter into a commercialization alliance or alliances or
that we will be able to out-source certain commercialization capabilities for
launch without a worldwide commercialization alliance in place.
In 1995, we entered into an exclusive license agreement with The Regents of
the University of California to patents and patent applications relating to
devices for iontophoretic non-invasive sampling of substances. Under this
license, if our GlucoWatch system is commercialized and is covered by the scope
of the license, we will pay the University of California certain royalties.
SALE OF OUR TRANSDERMAL DRUG DELIVERY SYSTEMS
On December 15, 1999, we completed the sale of substantially all of our drug
delivery business assets to Ortho-McNeil Pharmaceutical, Inc., a Johnson &
Johnson company. The transaction was
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finalized upon receiving clearance under the Hart-Scott-Rodino Antitrust
Improvements Act of 1976. We sold all of the assets of our drug delivery
business to Ortho-McNeil except those relating to a nicotine patch under
development and one other early- stage project, both of which were terminated
before year end.
Cygnus products that were sold to Ortho-McNeil include certain assets
related to the Nicotrol-Registered Trademark- (Pharmacia AB, Stockholm, Sweden)
nicotine system (currently marketed by Pharmacia & Upjohn in Europe and by
McNeil Consumer Healthcare, a Johnson & Johnson company, in the U.S.); two
hormone replacement transdermal products (a 7-day estrogen patch recently
approved by the U.S. Food and Drug Administration and an estrogen/progestin
combination product that completed Phase III clinical trials); and the EVRA-TM-
(Johnson & Johnson, New Brunswick, New Jersey) contraceptive patch we were
developing with the R.W. Johnson Pharmaceutical Research Institute.
Under the terms of the agreement with Ortho-McNeil, we received $20 million
in cash at closing, and Ortho-McNeil will pay up to an additional $55 million in
cash, contingent on the achievement of certain milestones. The contingent
payments relate to the achievement by Ortho-McNeil of certain technical,
regulatory and commercialization milestones related to the EVRA transdermal
contraceptive patch. We are eligible to receive up to $14.8 million of these
contingent milestones in the year 2000; however, because the achievement of
these milestones is not within our control, we cannot predict the likelihood or
timing of these contingent payments in the year 2000 and beyond.
The Final Award in an arbitration matter between Sanofi, S.A. and Cygnus
relating to transdermal hormone replacement therapy systems, however, remained
with Cygnus and is not part of the Ortho-McNeil sale. This Final Award was
entered as a judgment of the U.S. District Court for the Northern District of
California on December 11, 1997. Cygnus' obligations under the Final Award are
as follows: (i) the $14.0 million cash payment already made by Cygnus to Sanofi
in January 1998, (ii) payments of an aggregate amount equal to $17.0 million,
commencing in 2001 and ending in 2005, and (iii) a convertible promissory note
in the principal amount of $6.0 million, issued in December 1997, payable in
full at the end of four years and bearing interest at 6.5% per annum. (The note
will be convertible into our Common Stock at Sanofi's option, exercisable at any
time during the four year term, at a conversion rate of $21.725 per share.) The
underlying agreement, which was the subject matter of the arbitration, was
terminated on December 15, 1999.
The primary reason for selling the drug delivery business was to focus
management attention and corporate resources on our glucose monitoring business.
We will use the proceeds to accelerate commercialization activities for the
GlucoWatch system.
OUR FREQUENT, AUTOMATIC AND NON-INVASIVE GLUCOSE MONITORING SYSTEMS
MARKET OPPORTUNITY
People with diabetes measure blood glucose levels to adjust their diet,
medication and insulin use to better control their glucose levels in order to
prevent diabetes-related complications. Currently, to measure their glucose
levels, people with diabetes must prick their fingers, draw blood and place a
drop of blood on a glucose reagent strip inserted in an instrument that provides
a glucose reading. Each day of testing can involve numerous sticks and the
complete procedure is not only painful but disruptive to daily life. As a result
of this pain and disruption, most people with diabetes
4
monitor their blood glucose levels less than twice per day, instead of the
recommended four to seven times per day. Even at the recommended level of
testing, the market for products for self-monitoring of glucose levels by people
with diabetes is quite substantial.
Worldwide sales of products for the self-monitoring of blood glucose levels
were approximately $2.5 billion in 1997. Approximately 80% to 90% of the sales
were related to disposable glucose reagent strips for finger stick monitoring
(Boston Biomedical Consultants, Inc.). In the U.S., a majority of glucose level
testing is conducted by a relatively small segment of people with diabetes; for
example, of these people, just 19% (about 1.6 million) account for 52% of the
tests performed. The number of people diagnosed with diabetes has been growing
and is expected to continue to grow due to the aging of the population, changes
in diagnostic standards and new diagnostic technologies. Specifically, the
diagnostic standards in the U.S. have been changed such that a fasting plasma
glucose value of greater than or equal to 126 mg/dL now indicates a diagnosis of
diabetes, whereas such diagnosis previously required a value of greater than or
equal to 140 mg/dL. Diabetes can lead to severe complications over time,
including blindness, loss of kidney function and peripheral neuropathy, causing
circulation problems to the arms and legs, pain and potential amputation. The
American Diabetes Association (ADA) estimated that the complications arising
from diabetes cost the U.S. healthcare system in excess of $45 billion in 1992.
These complications are largely a consequence of years of poor management of
glucose levels by people with diabetes. Results of the Diabetes Control and
Complication Trial, a major clinical trial sponsored by the National Institutes
of Health and published in 1993, showed that more frequently monitored blood
glucose levels and rigid adherence to a program of diet, exercise and insulin
injections could prevent or significantly delay the onset of many of the
long-term complications of diabetes.
THE GLUCOWATCH-REGISTERED TRADEMARK- SYSTEM
We believe that there is an unmet need for automatic, frequent and
non-invasive glucose monitoring. In an effort to address this unmet need, we
have developed the GlucoWatch biographer, which is worn like a wristwatch and,
after calibrating each new AutoSensor with a standard blood glucose monitor,
automatically extracts and measures glucose levels through intact skin
approximately every twenty minutes. The durable GlucoWatch biographer displays
and stores current and past glucose levels and trend data. The extracted glucose
is collected in a consumable AutoSensor attached to the back of the device and
replaced after twelve hours of readings. The GlucoWatch system offers, in a
portable and discreet device, features not available in currently marketed
devices. These include frequent data collection, electronic memory to store and
display glucose levels, alerts indicating hypoglycemic and hyperglycemic
conditions and event markers that record factors that affect glucose levels. The
GlucoWatch biographer is designed to be worn day and/or night for glucose
monitoring, and is expected to reduce significant drawbacks of the finger stick
technique, such as the pain of repetitive sticking and the disruption of normal
activities caused by cumbersome procedures. We believe that the GlucoWatch
system can provide additional information that can help people with diabetes
understand fluctuations in their glucose levels.
Specifically, our GlucoWatch system extracts glucose molecules through
intact skin utilizing a patented sampling process called electro-osmosis (or
"reverse iontophoresis"). The glucose is extracted from interstitial fluid, not
blood, and is collected and measured by the consumable AutoSensor, which
includes an enzyme-containing hydrogel and electrodes for electro-osmotic
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extraction and biosensing. The glucose collected in the AutoSensor triggers an
electro-chemical reaction in the AutoSensor, generating electrons. The biosensor
measures the electrons and an application-specific integrated circuit ("ASIC")
in the GlucoWatch system equates the number of electrons to a concentration of
blood glucose. The GlucoWatch system automatically measures glucose levels at
twenty-minute intervals, and displays the most recent readings and trends at the
push of a button. Its electronic memory capabilities permit the retrieval of
past data, allowing longer-term trend analysis. Additionally, we are developing
future generation glucose monitoring products, as well as enhancements to the
GlucoWatch system. Such enhancements include, but are not limited to, features
for increased user convenience such as a shorter warm-up period, extension of
the AutoSensor measurement duration beyond twelve hours, an increase in the
number of glucose measurements per hour, addition of a delayed start feature,
and personal computer linkages for downloading data, as well as various cost
reductions in the manufacturing process. Other enhancements are also under
consideration. We are in the early developmental stages for a future telemetric
product that allows both greater flexibility in the location of the glucose
extraction component and a new form of the monitor that stores and displays
glucose data.
REGULATORY STATUS
On January 25, 1999, we submitted the first part of our PMA for the
GlucoWatch system to the FDA. This submission included a variety of information,
including manufacturing documentation. We submitted the remainder of the PMA in
June 1999, including analysis of a series of clinical studies totaling more than
600 people with diabetes, at more than 15 clinical sites across the U.S., who
used our biographer from a few hours to up to six weeks, as well as two
additional studies. The participants in our clinical studies consisted of a
cross-section of racial and age groups, diabetes types (both type 1 and type 2),
and other defining characteristics. This represented over 25,000 hours of use of
the GlucoWatch biographer. Approximately 19,000 paired data points were
generated from the studies, comparing glucose measurements obtained by the
GlucoWatch biographer to glucose measurements obtained with finger stick
monitors using capillary blood. In July 1999, the FDA notified Cygnus that our
PMA was deemed suitable for filing and was granted expedited review status. On
December 6, 1999, our PMA for the GlucoWatch biographer received a unanimous
recommendation for approval with conditions by the FDA's Clinical Chemistry and
Clinical Toxicology Devices Panel of the Medical Devices Advisory Committee. The
Advisory Committee suggested three conditions for approval. The first is the
creation of an education program, about which we have already been in discussion
with the FDA concerning the substance of such a program. The second condition is
that our product labeling will be revised in accordance with recommendations
given to the FDA by the Committee, and we are currently in discussions with the
FDA on proposed labeling. Third, the Committee suggested post-market study of
detection of hypoglycemia and hyperglycemia. This lattermost condition does not
need to be satisfied prior to FDA approval. Although the FDA is not bound by the
decisions of the advisory committee, the agency typically follows its Advisory
Committees' advice; however, no assurance can be given that the FDA will approve
our GlucoWatch biographer and we cannot predict the timing of such approval, if
given.
Furthermore, we are in the process of preparing an Investigational Device
Exemption (IDE) for filing with the FDA so that we can conduct clinical trials
on an ongoing basis. We also anticipate commencing clinical trials with children
and adolescents if the IDE is obtained.
6
COMPETITION
The glucose monitoring market is highly competitive. Currently the market is
dominated by finger stick blood glucose monitoring products sold by a few major
companies. These companies have established products and distribution channels.
Finger stick glucose monitoring presents a number of barriers to generating more
frequent blood glucose measurements, including the pain of repetitive finger
sticking and the disruption of normal activities, as often people with diabetes
do not want to go through the finger stick process in public. Several companies
are developing alternative invasive, semi-invasive, minimally invasive or
non-invasive methods to monitor glucose levels in a less painful or painless
manner, as well as on a continuous or continual basis. Companies are attempting
to develop a variety of methods to extract interstitial fluid and measure the
glucose concentration therein. Another technology that some companies are
pursuing is the use of infrared spectroscopy, which uses radiation to measure
glucose levels. We are not aware of any products under development that offer
the range of potential benefits of the GlucoWatch system. However, there can be
no assurance that other products will not be more accepted in the marketplace
than the GlucoWatch system or will not render our devices uncompetitive or
obsolete. A number of companies have developed or are seeking to develop new
drugs to treat diabetes that could reduce demand for glucose monitoring systems.
In addition, many of our competitors and potential competitors have
substantially greater resources, research and development staffs and facilities
than we do and have significantly greater experience in developing,
manufacturing and marketing glucose monitoring devices. Competition within the
glucose monitoring industry could also result in price reductions for glucose
monitoring devices such that we may not be able to sell the GlucoWatch system at
a price level adequate for us to realize a return on our investment.
DEPENDENCE ON NEW PRODUCTS; UNCERTAINTY OF MARKET ACCEPTANCE
For Cygnus to be successful, we will need to continue to develop glucose
monitoring products that address the needs of people with diabetes. Enhanced
glucose monitoring products based on our technologies are currently under
development. In addition, we will be evaluating new products outside of the
glucose monitoring field that can utilize our diagnostic technologies. These
products will require significant additional development and investment,
including preclinical and clinical testing, prior to their commercialization.
From time to time, we have experienced delays or setbacks in the development of
certain of our products. For example, in the past, we experienced development
delays in the miniaturization of the GlucoWatch biographer. There can be no
assurance that we will be able to successfully address problems that may arise
during the development and commercialization process. In addition, there can be
no assurance that the GlucoWatch system, its enhancements or future products can
or will be successfully developed, prove to be safe and effective in clinical
trials, meet applicable regulatory standards, be capable of being manufactured
in commercial quantities at a reasonable cost, be marketed successfully or
achieve market acceptance. If any of our development programs are not
successfully completed, required regulatory approvals or clearances are not
obtained, or products for which approvals or clearances are obtained are not
commercially successful, our business, financial condition and results of
operations could be materially adversely affected.
Our business is subject to the risks inherent in the development of new
products using new technologies and approaches. There can be no assurance that
unforeseen problems will not develop with these technologies or applications,
that we will be able to successfully address technological
7
challenges we encounter in our research and development programs or that we will
be able to develop commercially feasible products.
GOVERNMENT REGULATION; NO ASSURANCE OF REGULATORY APPROVALS
The design, manufacturing, labeling, distribution and marketing of our
products are subject to extensive and rigorous government regulation in the U.S.
and certain other countries where the process of obtaining and maintaining
required regulatory clearance or approvals is lengthy, expensive and uncertain.
In order for us to market our products in the U.S., we must obtain clearance or
approval from the FDA after clinical trials. To date, we have two products which
have received FDA approval; however, these were both in the drug delivery
business that has since been sold to Ortho-McNeil Pharmaceutical, Inc. For the
initial GlucoWatch system, we filed a PMA with the FDA. We anticipate that, if
and when enhancements are added and/or manufacturing processes are modified in
cost-effective ways, we will file one or more supplements to this PMA. We cannot
assure you that these supplements will be approved or that we will not have to
file a new PMA for future enhancements and products. The time required for
regulatory approval of our products after filing is uncertain. There can be no
assurance that problems will not arise that could delay or prevent the
commercialization of our products or that the FDA and foreign regulatory
agencies will be satisfied with the results of clinical trials or approve the
marketing of any products. Moreover, even if regulatory approval is granted,
such approval may include significant limitations on indicated uses for which
any such products could be marketed.
A medical device and its manufacturer are subject to continual review after
approval, and later discovery of previously unknown problems with a product or
the manufacturing process may result in restrictions on such product or the
manufacturer, including withdrawal of the product from the market. Failure to
comply with applicable regulatory requirements may, among other things, result
in fines, suspensions of regulatory approvals, product recalls, operating
restrictions and criminal prosecution. In addition, new government regulations
may be established that could delay or prevent regulatory approval of our
potential products. We are also subject to federal, state and local regulations
regarding work place safety, environmental protection and hazardous material
controls, among others.
In order for us to market our products in Europe, Japan and certain other
foreign jurisdictions, we and any of our distributors and agents must obtain
required regulatory registrations or approvals and otherwise comply with
extensive regulations regarding safety, efficacy and quality in those
jurisdictions. Specifically, certain foreign regulatory bodies have adopted
various regulations governing product standards, packaging requirements,
labeling requirements, import restrictions, tariff regulations, duties and tax
requirements. These regulations vary from country to country. Failure to receive
foreign regulatory approvals could have a material adverse effect on our
business, financial condition and results of operations. There can be no
assurance that we will obtain any other required regulatory registrations or
approvals in such countries or that we will not be required to incur significant
costs in obtaining or maintaining such regulatory registrations or approvals.
Delays in obtaining any registrations or approvals required to market our
products, failure to receive these registrations or approvals, or future loss of
previously obtained registrations or approvals could have a material adverse
effect on our business, financial condition and results of operations.
8
Even if we receive the necessary regulatory approvals for the GlucoWatch
system, there can be no assurance that unforeseen problems will not occur in
product manufacturing and commercial scale-up or marketing or product
distribution. Any such occurrence could significantly delay the
commercialization of the GlucoWatch system or prevent its market introduction
entirely. Furthermore, even if the GlucoWatch system is successfully developed,
the commercial success of the GlucoWatch system will depend on its acceptance in
the market as well as on our ability to generate enhanced products.
MANUFACTURING; DEPENDENCE ON THIRD-PARTY SUPPLIERS
Our GlucoWatch system has not yet been manufactured for commercial sale, and
we have no experience manufacturing the volumes that would be necessary for us
to achieve significant commercial sales. To successfully commercialize the
GlucoWatch system, it will have to be manufactured in compliance with regulatory
requirements, in a timely manner and in sufficient quantities while maintaining
product performance, quality and acceptable manufacturing costs. There can be no
assurance that we will be able to establish and maintain reliable, full-scale
manufacturing of the GlucoWatch system at commercially reasonable prices.
Manufacturers often encounter difficulties in scaling up production of new
products, including problems involving product performance, production yields,
quality control and assurance, and shortages of personnel. In addition,
manufacturing facilities will be subject to extensive regulations, including
international quality standards and other regulatory requirements. Difficulties
encountered in manufacturing scale-up or failure by us to implement and maintain
manufacturing facilities in accordance with international quality standards or
other regulatory requirements could result in a delay or termination of
production, which could have a material adverse effect on our business,
financial condition and results of operations.
In the past, we have experienced these problems in scaling up our
transdermal drug delivery products for commercial launch. There can be no
assurance that similar problems will not be encountered in the future with our
new diagnostic devices. In addition, there can be no assurance that we will be
able to achieve and maintain product performance, quality and reliability if and
when we are able to produce our GlucoWatch system in the quantities required for
commercialization, or that the GlucoWatch system can be assembled and
manufactured at an acceptable cost.
The GlucoWatch system will be manufactured from components purchased from
outside suppliers, most of which are our single source for such components. In
the event we are unable to obtain these components from our suppliers, we will
be required to obtain components from alternate suppliers. Any interruption in
the supply of GlucoWatch system components could have a material adverse effect
on our business, financial condition and results of operations.
Currently, our facility complies with ISO 9002, EN 46002, and U.S. Quality
System Regulations standards. We hold a medical Device Manufacturing License
from the California Department of Health Services, Food and Drug Branch. We are
currently establishing our AutoSensor and biographer commercial manufacturing
operations in two existing third-party facilities, which also comply with
applicable regulatory requirements. We cannot, however, assure you that these
facilities will maintain compliance with regulatory requirements.
9
THIRD-PARTY REIMBURSEMENT
Successful commercialization of certain of our products may depend in part
on the availability of reimbursement from third-party healthcare payers, such as
private insurance plans and the government. There can be no assurance that such
reimbursement will be available. Third-party payers are increasingly attempting
to contain healthcare costs by limiting both coverage and the level of
reimbursement for new therapeutic and diagnostic products. There can be no
assurance that adequate levels of reimbursement will be available to enable us
to achieve market acceptance of the GlucoWatch system or other new products
under development or to maintain price levels sufficient to realize an
appropriate return on our investment. In certain countries, the period of time
needed to obtain such reimbursement can be lengthy. We may delay the launch of
our products in certain countries until eligibility for reimbursement is
established. This could potentially harm our business, financial condition and
results of operations.
CONVERTIBLE DEBT
In February 1998, we entered into Note Purchase Agreements with certain
institutional investors to issue and sell approximately $43.0 million of 4%
Senior Subordinated Convertible Notes Due in 2005 ("Notes"). On October 28,
1998, we restructured the Notes. Key provisions in the restructured Notes
included the October 1998 repayment of $18.5 million in principal (reducing the
principal balance from $43.0 million to $24.5 million), a delay in the
convertibility of the majority of the Notes to June 30, 1999 or after,
modification of the conversion prices of the Notes, our ability to redeem at par
at any time all or part of the new principal amount of the Notes, an increase in
the interest rate to 5.5% paid annually on the new principal balance and a
change in the final maturity of the Notes to October 1, 2000.
The restructured Notes, which totaled $24.5 million, were divided into three
tranches. The first tranche had an original principal amount of $6.0 million and
was fully converted into Common Stock by January 1999 at $3.54 per share. The
second tranche also had an original principal amount of $6.0 million and was
fully converted into Common Stock on June 30, 1999 at $6.89 per share (such
conversion price determined by a market-based formula on February 1, 1999). The
third tranche of the restructured Notes had an original principal amount of
$12.5 million and could not have been converted into Common Stock until July 1,
1999, at a conversion price that would have been determined based on
market-based pricing formulas which contained look-back provisions. Also, under
the terms of the restructured Notes, if we issued a call before July 1, 1999 for
the redemption of the third tranche, the Note Holders would not be entitled to
convert any portion of that tranche. On June 29, 1999, we issued redemption
notices for the entire third tranche and, accordingly, the Note Holders were not
entitled to convert any portion of that tranche. On July 9, 1999, we paid $12.5
million in principal and $0.4 million in accrued interest to redeem the third
tranche. As a result, the remaining unamortized debt issuance costs of $1.1
million were expensed.
On the date the Notes were restructured (October 28, 1998), the conversion
price for the first tranche was below the quoted market price of our Common
Stock. Consequently, we computed a beneficial conversion feature by comparing
the quoted market price of our Common Stock on that date ($6.06125) to the
conversion price of the first tranche ($3.5375) and then by multiplying the
difference by the number of shares (1.7 million) into which the first tranche
was convertible. The
10
above computation resulted in a total charge of $4.2 million, which was written
off as interest expense at the date of restructuring.
In order to help finance the redemption of the third tranche discussed
above, and to provide additional capital, in 1999 we entered into two new
financing arrangements: a Convertible Debenture and Warrant Purchase Agreement
and a Structured Equity Line Flexible Financing Agreement.
On June 29, 1999, we entered into a Convertible Debenture and Warrant
Purchase Agreement with institutional investors ("Investors") to issue and sell
$14.0 million principal amount of 8.5% Convertible Debentures Due June 29, 2004
("Convertible Debentures"). These Convertible Debentures are convertible into
shares of Common Stock at any time at a conversion price of $12.705 per share.
We received gross proceeds of $14.0 million from the issuance of the Convertible
Debentures and incurred debt issuance costs of $0.5 million. With the mutual
agreement of the Investors and us, or if certain trading volume, pricing and
other conditions are met, we and/or the Investors will have the right to require
the sale to existing Investors of an additional $6.0 million in additional
aggregate principal amount of Convertible Debentures in two separate tranches of
$3.0 million each (each an "Additional Tranche"), provided that the second
Additional Tranche notice date may not be earlier than sixty days after the
first Additional Tranche notice date. The conversion price for each Additional
Tranche will be the average of the closing bid prices for the ten trading days
prior to and including the respective Additional Tranche notice date and the ten
trading days subsequent to the respective Additional Tranche notice date
("Additional Closing Price") multiplied by 110%. On September 29, 1999 we
received $3.0 million in gross proceeds from the issuance of the first
Additional Tranche due September 29, 2004, with a conversion price of $11.8663
(determined by the above market-based formula), and incurred debt issuance costs
of $0.1 million. Neither the June 29, 1999 nor the September 29, 1999
Convertible Debentures contained any beneficial conversion features.
In conjunction with the issuance of Convertible Debentures in June, 1999,
and the first Additional Tranche in September 1999, we issued to the debenture
holders warrants to purchase approximately 606 thousand shares and 139 thousand
shares of Common Stock, at the exercise price of $13.86 per share and $16.18 per
share, respectively. Each tranche of warrants had a contractual term of
five years from the date of respective grant. At the respective dates of grant,
the fair values ascribed to these warrants were approximately $5.0 million and
$1.1 million, respectively, based on a Black-Scholes valuation model, and were
recorded as debt discount and are being amortized as additional interest expense
over the debt term. We recorded amortization of $0.6 million in 1999. As of
December 31, 1999, the unamortized fair value amounted to $5.5 million. We will
be required to issue warrants if the second Additional Tranche of the
Convertible Debentures is sold. Such warrants will be priced at 150% of the
respective Additional Closing Price. The number of additional warrants to be
issued will be determined by dividing 50% of the respective Additional Tranche
by the respective Additional Closing Price.
We also issued to the placement agent warrants to purchase 50 thousand
shares of Common Stock at the exercise price of $13.86 per share. At the date of
grant, the fair value ascribed to the warrants was approximately $417 thousand,
based on a Black-Scholes valuation model, and that amount was recorded as
deferred financing cost and is being amortized as additional interest expense
over the debt term. We recorded amortization of $42 thousand in 1999.
11
The Convertible Debentures have a stated interest rate of 8.5% and an
effective interest rate of 18.20%. The effective interest rate includes a
non-cash charge of $6.6 million for the amortization of the implicit value of
warrants issued in connection with the Convertible Debentures.
STRUCTURED EQUITY LINE
On June 30, 1999, we also entered into a Structured Equity Line Flexible
Financing Agreement ("Equity Line") with certain institutional investors
("Investors"). The Equity Line is effective for two years ("Commitment Period")
and allows us, at our sole discretion, to sell Common Stock with a maximum
aggregate issue price of $30.0 million over the Commitment Period. On June 30,
1999, we received net proceeds of approximately $3.8 million, after deducting
the issuance costs, from the sale of approximately 346 thousand shares of Common
Stock (the "Initial Investment"). The number of shares of Common Stock for the
Initial Investment was determined on the basis of the average closing bid price
for the ten trading days prior to June 30, 1999 ("Initial Investment Purchase
Price"). Under the terms of the Equity Line, over a period of eighty
trading days following June 30, 1999 ("Initial Period"), the Investors were
required to deliver purchase notices from time to time for the aggregate amount
of the Initial Investment ($4.0 million) to purchase shares of our Common Stock.
The per-share price for each such purchase notice equaled 98% of the average of
the two lowest daily trade prices during the six trading days immediately prior
to the respective purchase notice. The number of shares originally issued was
subject to an upward adjustment, if required, to match the aggregate number of
shares covered by the $4.0 million of purchase notices. We issued an additional
92 thousand shares to reflect the actual purchase prices on the purchase
notices.
On September 29, 1999, we issued 361 thousand shares of Common Stock for
$4.0 million ("Additional Investment") pursuant to an amendment to the Equity
Line agreement which allowed for an Additional Investment period of 110 days
("Additional Period"). The terms for this Additional Investment are similar to
those applied to the Initial Investment, and the number of shares was adjusted
upwards at the end of the Additional Period, resulting in the issuance of an
additional 92 thousand shares of Common Stock.
After the Initial Period and the Additional Period, on a monthly basis
("Investment Period"), we can elect, at our sole discretion, to sell up to $1.5
million ("Company Election") in additional shares of Common Stock. In addition
to the above and upon our approval, the Investors may also elect to purchase an
additional $1.0 million ("Investor Election") of Common Stock in each Investment
Period. In each Investment Period in which we elect to sell additional shares,
the Investors will from time to time issue purchase notices for the aggregate
amount of the Company Election and the Investor Election, if applicable. The
per-share price of Common Stock to be sold for each such purchase notice will
equal 98% of the average of the two daily low trade prices during the six
trading days immediately prior to the respective purchase notice. At the
beginning of each Investment Period, we can set a minimum sales price ("Floor
Price") for our Common Stock. The Investors may require the aggregate dollar
amount of the Company Election and Investor Election for any Investment Period
to be less than requested, based on certain market trading volume guidelines. In
December 1999, we sold 100 thousand shares of Common Stock for $1.5 million
pursuant to the Equity Line. In January 2000, we sold an additional 59 thousand
share of Common Stock for $1.0 million pursuant to the Equity Line.
12
In conjunction with the Equity Line, in January 2000 we issued five-year
warrants to the Investors to purchase 95 thousand shares of Common Stock at
$11.51 per share. The price of the warrants will be determined each calendar
year and will equal 120% of the weighted average per-share sales price of all
shares of Common Stock sold pursuant to the Equity Line that year. The number of
shares will equal 1% of the aggregate proceeds received for all shares sold
pursuant to the Equity Line during the year. Warrants to purchase a minimum of
120 thousand shares must be issued under the Equity Line and, if at the end of
the Commitment Period, warrants to purchase less than 120 thousand shares of
Common Stock have been issued, we must issue a warrant to purchase the number of
shares equal to the difference, at a price equal to 120% of the average exercise
price of all warrants previously issued pursuant to the Equity Line.
PATENTS AND PROPRIETARY RIGHTS
It is our policy to aggressively protect our investments in technology and
marketing by filing patent and trademark applications in the U.S. and key
foreign countries. We also rely on trade secrets, know-how, licensing
opportunities, and collaborative relationships to develop and maintain our
competitive position.
As of December 1999, and after the sale of substantially all of our drug
delivery business assets, including the intellectual property associated
therewith, we have seven issued U.S. patents and six issued foreign patents,
with approximately sixty additional patent applications pending worldwide. These
patents and applications cover various aspects of analyte monitoring, including
glucose monitoring systems and represent over twenty patent families. As of
December 1999, we have four U.S. trademark registrations, with four U.S.
trademark applications pending or published, and about thirty-nine foreign
trademark registrations, with approximately twenty-one additional foreign
trademark applications pending. Our "GlucoWatch" trademark is registered in the
U.S., the European Community, and additional foreign countries.
Additionally, our GlucoWatch system incorporates technology licensed
exclusively to us by The Regents of the University of California. The Regents
hold U.S. and foreign patents covering technology for transdermal extraction of
glucose and other analytes.
EMPLOYEES
As of December 31, 1999, we had eighty-four full-time employees. Of this
total number of employees, forty-six were engaged in research and development,
including process developments; eight in scientific affairs and quality
assurance; twenty-three in general administrative; and seven in operations. None
of our employees is represented by a labor union. We have experienced no work
stoppages and believe our employee relations are good.
Our success will depend in large part on the continued services of our
scientific, managerial and manufacturing personnel. The loss of a significant
group of key personnel could have a material adverse effect on us. Our success
also depends upon our ability to continue to attract and retain other highly
qualified scientific, managerial and manufacturing personnel. Competition for
such personnel is intense. In this respect, we compete with numerous
pharmaceutical and healthcare companies, as well as universities and nonprofit
research organizations. There can be no assurance that we will continue to be
able to attract and retain sufficient qualified personnel.
13
ITEM 2. PROPERTIES
We lease approximately 92,000 square feet in four buildings. Three buildings
are located in Redwood City, California and the fourth is located in Menlo Park,
California. The first building, approximately 38,000 square feet, is used by us.
The second building, approximately 11,000 square feet, is subleased to The 3DO
Company, and this sublease runs concurrent with our main leases through 2003.
The third building has approximately 21,000 square feet, and is subleased to
Ortho-McNeil Pharmaceutical, Inc., with this sublease also running concurrently
with our main leases through 2003. The fourth building, which is located in
Menlo Park, has approximately 22,000 square feet, and is currently used by us
for storage. The three buildings in Redwood City are leased through 2003, with
an option to renew at the then-prevailing market rent through 2008. The facility
in Menlo Park is leased over a two-year period ending in October 2001.
The applicable Cygnus facility complies with ISO 9002, EN 46002, and U.S.
Quality System Regulations standards. We hold a medical Device Manufacturing
License from the California Department of Health Services, Food and Drug Branch.
We are currently establishing our AutoSensor and GlucoWatch biographer
commercial manufacturing operations in two existing third-party facilities,
which also comply with applicable regulatory requirements.
ITEM 3. LEGAL PROCEEDINGS
None.
14
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS
The market price for shares of our Common Stock has been highly volatile.
Factors such as the results of clinical trials for our products or products of
our competitors, announcements of technological innovations, strategic
relationships, new product introductions by us or our competitors, governmental
regulation, regulatory approvals or delays, and developments relating to our
patent or proprietary rights or those of our competitors, as well as
period-to-period fluctuations in financial results, may have a significant
impact on the market price of the Common Stock. Additionally, in recent years,
the stock market has experienced extreme price and volume fluctuations.
Our Common Stock trades on the Nasdaq national market tier of the Nasdaq
Stock Market-SM- under the symbol "CYGN." The following table sets forth, for
the periods indicated, the high and low closing sale prices per share of the
Common Stock as reported by the national market.
HIGH LOW
----------- -------------
1999:
First Quarter......................................... $ 8 1/4 $ 4 1/2
Second Quarter........................................ 13 8 7/32
Third Quarter......................................... 12 1/2 9 1/4
Fourth Quarter........................................ 19 5/8 8 13/16
HIGH LOW
----------- -------------
1998:
First Quarter......................................... $ 20 5/8 $ 16
Second Quarter........................................ 13 1/2 5 25/32
Third Quarter......................................... 10 1/4 3 1/16
Fourth Quarter........................................ 6 7/8 2 5/8
As of December 31, 1999, there were approximately 626 record holders of our
Common Stock. We have not paid any cash dividends since our inception and do not
expect to pay any cash dividends on our Common Stock in the foreseeable future.
In addition, we are precluded from paying any dividends under certain of our
financing arrangements.
ITEM 6. SELECTED FINANCIAL DATA
The selected consolidated financial data presented below are derived from
the audited consolidated financial statements of Cygnus, Inc. The consolidated
financial statements as of December 31, 1999 and 1998 and for each of the three
years in the three-year period ended December 31, 1999 are included elsewhere
herein. The selected financial data as of December 31, 1997, 1996, and 1995 and
for each of the years in the two-year period ended December 31, 1996 are derived
from audited consolidated financial statements not included herein. We have
restated our consolidated statements of operations for the years ended December
31, 1998, 1997, 1996 and 1995 to reflect the results of the drug delivery
business as a discontinued operation. The data should be read in conjunction
with the consolidated financial statements and related notes, the information
set forth under "Management's
15
Discussion and Analysis of Financial Conditions and Results of Operations" and
other financial information included herein.
YEAR ENDED DECEMBER 31,
----------------------------------------------------
1999 1998 1997 1996 1995
-------- -------- -------- -------- --------
(IN THOUSANDS, EXCEPT PER-SHARE DATA)
CONSOLIDATED STATEMENTS OF OPERATIONS
DATA:
Contract revenues.................... $ 2,061 $ 457 $ 2,146 $ 2,712 $ --
Costs and expenses:
Research and development........... 15,745 25,635 16,198 11,079 3,249
Marketing, general and
administrative................... 4,794 8,810 2,205 1,903 309
-------- -------- -------- -------- --------
Total costs and expenses......... 20,539 34,445 18,403 12,982 3,558
-------- -------- -------- -------- --------
Loss from operations................. (18,478) (33,988) (16,257) (10,270) (3,558)
Other income and (expense)........... (3,496) (6,446) 1,140 1,865 296
-------- -------- -------- -------- --------
Loss from continuing operations
before tax......................... (21,974) (40,434) (15,117) (8,405) (3,262)
Provision for tax.................... (200) -- -- -- --
-------- -------- -------- -------- --------
Loss from continuing operations...... (22,174) (40,434) (15,117) (8,405) (3,262)
-------- -------- -------- -------- --------
Discontinued operations:
Income/(loss) from operations of
discontinued segment............. 3,031 1,006 (35,343) (2,647) (9,580)
Gain on disposal of segment........ 16,308 -- -- -- --
-------- -------- -------- -------- --------
Net loss............................. $ (2,835) $(39,428) $(50,460) $(11,052) $(12,842)
======== ======== ======== ======== ========
Net loss per share from continuing
operations, basic and diluted...... (0.95) (2.00) (0.80) (0.45) (0.20)
======== ======== ======== ======== ========
Net income/(loss) per share from
discontinued segment, basic and
diluted............................ 0.83 0.05 (1.87) (0.15) (0.59)
======== ======== ======== ======== ========
Net income/(loss) per share, basic
and diluted........................ $ (0.12) $ (1.95) $ (2.67) $ (0.60) $ (0.79)
======== ======== ======== ======== ========
Shares used in computation of net
loss per share, basic and
diluted............................ 23,354 20,226 18,928 18,544 16,265
======== ======== ======== ======== ========
16
DECEMBER 31,
-------------------------------------------------------
1999 1998 1997 1996 1995
--------- --------- --------- -------- --------
(IN THOUSANDS)
CONSOLIDATED BALANCE SHEET DATA:
Working capital................... $ 30,111 $ 11,542 $ 9,941 $ 36,386 $ 38,555
Total assets...................... 46,976 43,454 49,277 68,798 57,854
Long-term liabilities............. 44,071 60,220 33,234 13,437 8,331
Accumulated deficit............... (178,790) (175,955) (136,527) (86,067) (75,015)
Stockholders' equity (net capital
deficiency)..................... (1,204) (32,767) (13,800) 31,213 38,252
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
THIS REPORT CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND
UNCERTAINTIES RELATING TO THE FUTURE FINANCIAL PERFORMANCE OF CYGNUS, INC.
("CYGNUS," "THE COMPANY," "WE," "OUR," "US" ), AND ACTUAL EVENTS OR RESULTS MAY
DIFFER MATERIALLY. IN EVALUATING SUCH STATEMENTS, STOCKHOLDERS AND INVESTORS
SHOULD SPECIFICALLY CONSIDER THE VARIOUS FACTORS IDENTIFIED UNDER THE CAPTION
"RISK FACTORS" CONTAINED BELOW IN THIS MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATION, AS WELL AS UNDER BUSINESS ABOVE,
WHICH COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE INDICATED BY
SUCH FORWARD-LOOKING STATEMENTS. WE UNDERTAKE NO OBLIGATION TO PUBLICLY RELEASE
THE RESULTS OF ANY REVISIONS TO THESE FORWARD-LOOKING STATEMENTS WHICH MAY BE
MADE TO REFLECT EVENTS OR CIRCUMSTANCES AFTER THE DATE HEREOF OR TO REFLECT THE
OCCURRENCES OF UNANTICIPATED EVENTS.
GENERAL
We are engaged in the development and manufacture of diagnostic medical
devices, utilizing proprietary technologies to satisfy unmet medical needs cost
effectively. Our current efforts are primarily focused on a frequent, automatic
and non-invasive glucose monitoring device, the GlucoWatch-Registered Trademark-
system, and enhancements thereto. In 1999, we sold substantially all of our drug
delivery business to Ortho-McNeil Pharmaceutical, Inc., and chose to focus on
glucose monitoring systems. The drug delivery business has been accounted for as
a discontinued operation and prior years' financial statements have been
restated to report only continuing operations. For us to remain competitive, we
will need to develop, in-license or acquire new diagnostic products.
Our results of operations vary significantly from year to year and have
depended on, among other factors, the signing of new product development
agreements and the timing of recognizing payment amounts specified thereunder,
the timing of recognizing license or distribution fees and cost reimbursement
payments made by pharmaceutical licensees, and the demand for our products. The
level of revenues in any given period is not necessarily indicative of expected
revenues for future periods. In 1999, 97% of our revenues were attributable to
one customer. We have incurred net losses each year since our inception and do
not believe we will achieve profitability in 2000. At December 31, 1999, our
accumulated deficit and net capital deficiency were approximately
$178.8 million and $1.2 million, respectively.
17
RESULTS OF OPERATIONS:
The drug delivery business has been accounted for as a discontinued
operation and prior years' financial statements have been restated to report
only continuing operations. As a result no product revenues, royalty revenues or
costs of products sold have been reflected in our financial statements.
COMPARISON FOR THE YEARS ENDED DECEMBER 31, 1999 AND 1998
CONTRACT REVENUES for the year ended December 31, 1999 were $2.1 million,
compared to the $0.5 million for the year ended December 31, 1998. Contract
revenues primarily reflect the amortization of previously deferred and
additional milestone payments relating to the GlucoWatch system. The increase in
contract revenue was primarily due to the amortization of an additional
milestone payment received in 1999.
In 1996, we entered into a collaboration agreement with Yamanouchi
Pharmaceutical Co., Ltd. for the commercialization of the GlucoWatch biographer
in Japan and Korea. Cygnus is eligible to receive milestone payments prior to
commercialization and to receive a percentage of the product's future commercial
success in Japan and Korea.
In September 1999, we were awarded a six-month Phase I Small Business
Innovative Research Grant for "High Performance Biosensor Electrode Materials"
from the National Institute of Diabetes and Digestive and Kidney Diseases
division of the NIH in the amount of $0.1 million. We are using the funding to
investigate advancements in biosensor materials used for glucose detection and
measurement, potentially to include in future versions of the GlucoWatch system.
Revenue is recognized as reimbursable expenses are incurred.
Contract revenues, if any, are expected to fluctuate from quarter to quarter
and from year to year, and future contract revenues, if any, cannot be
reasonably predicted. The contributing factors to achieving contract revenues
include, but are not limited to, future successes in finalizing new
collaborative agreements, achievement of milestones under our current contract,
and strategic decisions on self-funding certain projects. We are unable to
predict to what extent the termination of any existing contracts or new
collaborative agreements, if any, will impact overall contract revenues in 2000
and subsequent future periods.
RESEARCH AND DEVELOPMENT EXPENSES for the year ended December 31, 1999 were
$15.7 million, compared to $25.6 million for the year ended December 31, 1998.
This decrease reflects a reduction in clinical studies and development
expenditures associated with the GlucoWatch system. Research, development and
clinical activities primarily included support and development for the glucose
monitoring program. We anticipate that the development of new products and
technologies, along with additional clinical trials, will result in an increase
in our overall research and development expenses in 2000.
MARKETING, GENERAL AND ADMINISTRATIVE EXPENSES for the year ended
December 31, 1999 were $4.8 million, compared to $8.8 million for the year ended
December 31, 1998. The decrease was primarily due to reduced compensation and
market research expenses. We expect that marketing, general and administrative
expenses will increase in 2000 as we plan for possible regulatory approval and
commercialization of our GlucoWatch system.
18
INTEREST INCOME (EXPENSE), NET OF INTEREST AND OTHER EXPENSE for the year
ended December 31, 1999 was ($3.5) million, compared to ($6.4) million for the
year ended December 31, 1998. The decrease was due primarily to the recording in
1998 of the (i) $4.2 million non-cash costs of the beneficial conversion feature
associated with the October 1998 restructuring of the 4% Senior Subordinated
Convertible Notes and (ii) write-off of the previously deferred debt issuance
cost of $1.0 million, in conjunction with the partial repayment of the Senior
Subordinated Convertible Notes, offset by a net arbitration settlement with
Pharmacia & Upjohn from which Cygnus received $2.7 million.
INCOME FROM OPERATIONS OF DISCONTINUED SEGMENT for the year ended
December 31, 1999 was $3.0 million, compared to $1.0 million for the year ended
December 31, 1998. The increase was due primarily to a decrease in overall
segment expenses.
DISCONTINUED OPERATIONS. On December 15, 1999, we completed the sale of
substantially all the assets of our drug delivery business to Ortho-McNeil
Pharmaceutical, Inc. Total revenues and net income on the discontinued
operations were $12.3 million and $3.0 million, respectively, for the year ended
December 31, 1999. We also recorded a gain of $16.3 million on the disposal of
the segment.
COMPARISON FOR THE YEARS ENDED DECEMBER 31, 1998 AND 1997
CONTRACT REVENUES for the year ended December 31, 1998 were $0.5 million,
compared to the $2.1 million for the year ended December 31, 1997. Contract
revenues primarily reflected the amortization of previously deferred milestone
payments relating to our GlucoWatch system. The decrease in contract revenue was
primarily attributable to the decrease in amortization of these milestone
payments.
RESEARCH AND DEVELOPMENT EXPENSES for the year ended December 31, 1998 were
$25.6 million, compared to $16.2 million for the year ended December 31, 1997.
The increase in research and development expenses for the year ended
December 31, 1998 was primarily due to the increased costs associated with the
GlucoWatch biographer and the AutoSensor in the following areas: material,
design and scale-up for development efforts, and material and outside charges
for the accelerated level of clinical activities. Research and development and
clinical activities primarily included support and development for the glucose
monitoring program.
MARKETING, GENERAL AND ADMINISTRATIVE EXPENSES for the year ended
December 31, 1998 were $8.8 million, compared to $2.2 million for the year ended
December 31, 1997. The increase was primarily due to increased sales and
marketing expenses related to the GlucoWatch system, in particular marketing
research expenses.
INTEREST INCOME (EXPENSE), NET OF INTEREST AND OTHER EXPENSE for the year
ended December 31, 1998 was ($6.4) million, compared to $1.1 million for the
year ended December 31, 1997. The decrease was due primarily to the
$4.2 million non-cash costs of the beneficial conversion feature associated with
the October 1998 restructuring of the 4% Senior Subordinated Convertible Notes,
the interest expense associated with the subordinated convertible debt, the
amortization of the financing fees related to this debt and the interest related
to the additional long-term debt incurred in the second quarter of 1998.
INCOME/(LOSS) FROM OPERATIONS OF DISCONTINUED SEGMENT for the year ended
December 31, 1998 was a profit of $1.0 million, compared to a loss of
($35.3) million for the year ended December 31, 1997.
19
The change was due primarily to a non-recurring arbitration settlement expense
with Sanofi of $39.7 million.
LIQUIDITY AND CAPITAL RESOURCES
Cash, cash equivalents and investment balances as of December 31, 1999
totaled $38.9 million, representing an increase of $10.1 million from the total
as of December 31, 1998. As of December 31, 1999, we had a negative net worth of
$1.2 million.
Through December 1999, we have received net proceeds of approximately
$104.5 million from public offerings of our Common Stock.
Through December 1999, we financed approximately $11.1 million of
manufacturing and research equipment under capital loan and lease arrangements.
Borrowings under those arrangements are secured by specific Cygnus assets.
We have an outstanding bank loan with Silicon Valley Bank that requires
monthly principal and interest payments through November 2001, in addition to
compliance with various financial covenants. As of December 31, 1999 there was
$5.6 million outstanding under this agreement. Borrowings under this agreement
are secured by specific Cygnus assets.
In February 1998, we entered into Note Purchase Agreements with
institutional investors to issue and sell approximately $43.0 million of 4%
Senior Subordinated Convertible Notes Due 2005 (the "Notes"). On October 28,
1998, we restructured the Notes. Key provisions in the restructured Notes
include the October 1998 repayment of $18.5 million in principal (reducing the
principal balance from $43.0 million to $24.5 million), a delay in the
convertibility of the majority of the Notes to September 30, 1999, modification
of conversion prices of the Notes, our ability to redeem at par at any time all
or part of the new principal amount of the Notes, an increase in the interest
rate to 5.5% paid annually on the new principal balance and a change in the
final maturity of the Notes to October 1, 2000. Through June 30, 1999,
$6.0 million was converted into Common Stock at a price of $3.54 per share and
$6.0 million was converted into Common Stock at a price of $6.89 per share. The
remaining $12.5 million and accrued interest was redeemed in July 1999.
In June 1999, we entered into a Convertible Debenture and Warrant Purchase
Agreement with institutional investors to issue and sell up to $20 million
principal amount of 8.5% five-year Convertible Debentures. In June 1999, we
issued $14.0 million principal amount of 8.5% Convertible Debentures Due
June 29, 2004 at par. On September 29, 1999 we issued $3.0 principal amount of
8.5% Convertible Debentures due September 29, 2004 at par.
On June 30, 1999, we also entered into a Structured Equity Line Flexible
Financing Agreement. The Equity Line is effective for two years and allows us,
at our sole discretion, to sell shares of our Common Stock with a maximum
aggregate sales price of up to $30.0 million. On June 30, 1999 we received
$4.0 million from the sale of a total of 438 thousand shares of Common Stock
under the Equity Line. On September 29, 1999, we received an additional
$4.0 million in exchange for a total of 453 thousand shares of Common Stock
pursuant to the Equity Line agreement. In December 1999, we sold 100 thousand
shares of Common Stock for $1.5 million. In January 2000, we sold an additional
59 thousand shares of Common Stock for $1.0 million pursuant to the Equity Line.
(See Note 9 in the "Notes to Consolidated Financial Statements" in this report.)
20
In addition to the cash received from the offerings, issuance of Notes,
Equity Line, equipment lease and short-term working capital financing, we have
financed our operations primarily through revenues and interest income.
Net cash used in operating activities for the year ended December 31, 1999
was $17.9 million, compared with net cash used of $42.5 million for year ended
December 31, 1998. Cash used in operating activities during the year ended
December 31, 1999 was primarily due to the net loss from continuing operations
of $22.2 million, and decreases in deferred compensation and other liabilities
of $4.4 million, offset by a decrease in deferred compensation, prepaid expenses
and other assets of $4.4 million and accounts receivable of $0.8 million;
depreciation and amortization of 1.9 million; and debt issuance and financing
costs and debt discount of $1.7 million. Cash used in operating activities
during the year ended December 31, 1998 was primarily due to our net loss of
$39.4 million and a $14.0 million cash payment made in January 1998 to Sanofi
under the terms of the arbitration settlement; offset by the non-cash beneficial
conversion costs of $4.2 million associated with the October 1998 restructuring
of the Notes, an increase in accounts payable and other accrued liabilities of
$2.3 million, depreciation and amortization of $1.9 million, and amortization of
debt issuance and financing costs and debt discount of $1.6 million.
The current level of cash used in operating activities is not necessarily
indicative of the level of future cash usage. We expect an increase in operating
cash usage for 2000.
Net cash provided by investing activities of $24.8 million for the year
ended December 31, 1999 resulted primarily from the receipt of $20.0 million
from the sale of the drug delivery business, net sales of investments of
$8.3 million, offset by capital expenditures of $2.7 million and a contract
termination fee of $0.8 million in conjunction with disposal of the drug
delivery segment. Net cash used in investing activities of $7.6 million for the
year ended December 31, 1998 resulted primarily from net purchases of
investments of $4.2 million and capital expenditures of $3.4 million.
Net cash provided by financing activities of $11.6 million for the year
ended December 31, 1999 includes, as mentioned above, net proceeds of $16.4
million and $9.2 million from the June 1999 and September 1999 issuance of 8.5%
Convertible Debentures and from the sale of Common Stock under the Equity Line,
respectively, and additional stock proceeds of $5.7 million, offset by the July
1999 redemption of Senior Subordinated Convertible Notes of $12.5 million, and
long-term debt and capital lease repayments of $5.3 million and $1.9 million,
respectively. Net cash provided by financing activities of $39.7 million for the
year ended December 31, 1998 includes, as mentioned above, net proceeds of $40.4
million and $13.3 million from our February 1998 issuance of Senior Subordinated
Convertible Notes and from a direct public offering of our Common Stock,
respectively; additional stock proceeds of $0.9 million and $6.1 million from
the issuance of long-term debt, offset by a subordinated debt principal
repayment of $18.5 million, and long-term debt and capital lease repayments of
$2.0 million and $0.5 million, respectively.
Our long-term capital expenditure requirements will depend upon numerous
factors, including the progress of our research and development programs, the
time required to obtain regulatory approvals, the resources that we devote to
the development of self-funded products, proprietary manufacturing methods and
advanced technologies, our ability to obtain additional licensing arrangements
and to manufacture products under those arrangements, the additional
expenditures to support the manufacture of new products, if and when approved,
and possible acquisitions of
21
products, technologies and companies. As we evaluate the progress of our
development projects, in particular the GlucoWatch system and our enhanced
glucose monitoring products in development, our commercialization plans and the
lead time to set up manufacturing capabilities, we may commence long-term
planning for another manufacturing site. Nevertheless, we believe that such
long-term planning will not result in any material impact on cash flows and
liquidity for the next twelve months.
Based upon current expectations for operating losses and projected
short-term capital expenditures, we believe that existing unrestricted cash,
cash equivalents and investments of $38.9 million as of December 31, 1999, when
coupled with cash from revenues and other funding, such as from potential
product funding collaborations or from public financings (including debt or
equity financings) and earnings from investments, will be sufficient to meet our
operating expenses, debt servicing and repayments and capital expenditure
requirements at least through December 31, 2000. However, there can be no
assurance that we will not require additional financing, depending upon future
business strategies, manufacturing and commercialization efforts, results of
clinical trials and management decisions to accelerate certain research and
development programs and other factors.
INCOME TAXES. We recorded a $0.2 million income tax provision consisting
entirely of foreign withholding taxes for the year ended December 31, 1999. As
of December 31, 1999, we had federal net operating loss and research and
development tax credit carryforwards of approximately $152.6 million and $3.7
million, respectively. We had state net operating loss and tax credit
carryforwards of approximately $36.5 million and $3.1 million, respectively.
These carryforwards will expire at various dates beginning in 2000. Because of
the "change in ownership" provisions of the Internal Revenue Code, a substantial
portion of our net operating loss and tax credit carryforwards may be subject to
annual limitations. The annual limitations may result in the expiration of the
net operating losses and tax credits before utilization.
IMPACT OF YEAR 2000
In prior years, we discussed the nature and progress of our plans to become
Year 2000 ready. In late 1999, we completed our remediation and testing of
systems. As a result of those planning and implementation efforts, we
experienced no significant disruptions in mission critical information
technology and non-information technology systems and believe these systems
successfully responded to the Year 2000 date change. We expensed approximately
$150 thousand during 1999 in connection with remediating our systems. We are not
aware of any material problems resulting from Year 2000 issues, either with our
products, our internal systems, or the products and services of third parties.
We will continue to monitor our mission critical computer applications and those
of our suppliers and vendors throughout the year 2000 to ensure that any latent
Year 2000 matters that may arise are addressed promptly.
RISK FACTORS
We wish to caution stockholders and investors that the following important
factors, among others, in some cases have affected, and in the future could
affect, our actual results and could cause our actual consolidated results for
1999 and beyond to differ materially from those expressed in any forward-looking
statements made by or on behalf of Cygnus. The statements under this caption are
intended to serve as cautionary statements within the meaning of the Private
Securities Litigation
22
Reform Act of 1995. The following information is not intended to limit in any
way the characterization of other statements or information under other captions
as cautionary statements for such purpose.
OUR PRODUCT PIPELINE IS SEVERELY LIMITED.
With the sale of the majority of the drug delivery business assets to
Ortho-McNeil Pharmaceutical, Inc., and the termination of the remaining drug
delivery projects, we are now exclusively focused on diagnostic medical devices,
initially on a line of frequent, automatic and non-invasive glucose monitoring
devices. There is an inherent risk in not having a broad base of products in
development and we cannot assure you that we will be successful with this narrow
line of products.
WE MAY NOT RECEIVE FDA APPROVAL ON OUR PRODUCTS.
Although the FDA's Clinical Chemistry and Toxicology Devices Panel of the
Medical Devices Advisory Committee has recommended the GlucoWatch biographer for
approval for sale with three conditions, there can be no assurance that we can
meet these conditions or, if we can, that the recommendation of the Advisory
Committee will convince the FDA to approve the product. Additionally, there can
be no assurance that the FDA will approve the GlucoWatch biographer on the same
terms, if at all. Furthermore, as we seek regulatory approval for enhancements
and possible manufacturing changes through the PMA supplement process, there can
be assurances that such supplements will be approved or that one or more new
PMAs will not need to be filed.
Even if we receive the necessary regulatory approvals for the GlucoWatch
system, there can be no assurance that unforeseen problems will not occur in
product manufacturing and commercial scale-up or marketing or product
distribution. Any such occurrence could significantly delay the
commercialization of the GlucoWatch system or prevent its market introduction
entirely. Furthermore, even if the GlucoWatch system is successfully developed,
the commercial success of the GlucoWatch system will depend on its acceptance in
the market.
WE HAVE LIMITED MARKETING, DISTRIBUTION, MANUFACTURING AND SALES EXPERIENCE.
We have limited experience marketing, distributing, manufacturing or selling
medical device products. To successfully market, distribute, manufacture and
sell the GlucoWatch system or our other glucose monitoring products under
development, we must either develop a more extensive marketing, distributing,
manufacturing and sales force or enter into arrangements with third parties to
market, distribute, manufacture and sell our products. We cannot assure you that
we will be able to successfully develop a more extensive marketing,
distributing, manufacturing and sales force or that we will enter into
acceptable marketing, distributing, manufacturing and sales agreements with
third parties. If we maintain our own marketing, distributing, manufacturing and
sales capabilities, we will compete with other companies that have experienced
and well-funded marketing, distributing, manufacturing and sales operations. If
we enter into a marketing arrangement with a third party, any revenues we
receive will depend on the third party, and we will likely have to pay a sales
commission or similar amount. We may be unable to successfully commercialize our
products.
23
WE CANNOT PREDICT THE MARKET ACCEPTANCE OF OUR PRODUCTS.
We are focusing our efforts predominantly on a line of frequent, automatic,
and non-invasive glucose monitoring devices. No one can predict market
acceptance or penetration of such products, given that they are entirely
different from any glucose diagnostic product currently on the market. There is
a risk in introducing a very new type of product in a market of established
finger stick glucose monitors, and we cannot assure you that our products will
be accepted or to what degree. Additionally, some of our competitors have
announced, and others may be developing, new, frequent, automatic, and
non-invasive (or minimally invasive, semi-invasive or less-invasive) glucose
monitoring devices. We cannot predict what impact introduction of competing
products will have on our market sales.
WE DEPEND ON PROPRIETARY TECHNOLOGY.
Our success depends in large part on our ability to obtain patent protection
for our products, preserve our trade secrets and operate without infringing upon
the proprietary rights of others, both in the U.S. and abroad. Since currently
patent applications in the U.S. are maintained in secrecy until issuance, and
publication of discoveries in the scientific or patent literature tends to lag
behind actual discovery by several months, we cannot be certain that we were the
first to file our patent applications or that we will not infringe upon
third-party patents. We cannot assure you that any patents will be issued or
upheld with respect to any of our patent applications or that any patents will
provide competitive advantages for our products or will not be challenged or
circumvented by our competitors. We also rely on trade secrets and proprietary
know-how that we seek to protect, in part, by confidentiality agreements with
our licensees, employees and consultants. We cannot assure you that these
agreements will not be breached, that we would have adequate remedies for any
breach or that our trade secrets will not otherwise become known or be
independently developed by our competitors. Any litigation, in the U.S. or
abroad, as well as foreign opposition and/or domestic interference proceedings,
could result in substantial expense to us and significant diversion of effort by
our technical and management personnel. We may resort to litigation to enforce
our patents or protect trade secrets or know-how, as well as to defend against
infringement charges. A negative determination in such proceedings could subject
us to significant liabilities or require us to seek licenses from third parties.
Although patent and intellectual property disputes in the pharmaceutical product
area have often been settled through licensing or similar arrangements, costs
associated with such arrangements may be substantial and could include ongoing
royalties. Furthermore, we cannot assure you that necessary licenses would be
available to us on satisfactory terms, if at all. Accordingly, an adverse
determination in a judicial or administrative proceeding or failure to obtain
necessary licenses could prevent us from manufacturing and selling certain of
our products, and could materially adversely affect us.
WE FACE INTENSE COMPETITION.
The medical device industry in general, and the market in which we expect to
offer the GlucoWatch system in particular, is intensely competitive. Even if we
successfully develop the GlucoWatch system, we will compete with other providers
of personal glucose monitors. A number of our competitors are currently
marketing traditional glucose monitors. These monitors are widely
24
accepted in the healthcare industry and have long histories of accuracy and
effective use. Furthermore, a number of companies have announced that they are
developing products that permit less painful or painless, as well as continual
or continuous, glucose monitoring. Accordingly, we expect competition to
increase. Many of our competitors have substantially greater resources than we
do and have greater name recognition and lengthier operating histories in the
healthcare industry. We cannot assure you that we will be able to compete
effectively against our competitors. Additionally, we cannot assure you that the
GlucoWatch system or our other enhanced products under development will replace
any currently used devices or systems. Furthermore, we cannot assure you that
our competitors will not succeed in developing, even before we develop and
commercialize the GlucoWatch system or our other enhanced products under
development, devices and technologies that permit more-efficient and
less-expensive glucose monitoring devices. Pharmaceutical or other healthcare
companies may also develop therapeutic drugs, treatments or other products that
will substantially reduce the prevalence of diabetes or otherwise render our
products obsolete.
THIRD PARTIES MAY NOT REIMBURSE PATIENTS, HOSPITALS AND PHYSICIANS FOR THE COSTS
OF MEDICAL DEVICES.
Successful commercialization of certain of our products may depend in part
on the availability of reimbursement from third-party healthcare payers, such as
private insurance plans and the government. There can be no assurance that such
reimbursement will be available. Third-party payers are increasingly attempting
to contain healthcare costs by limiting both coverage and the level of
reimbursement for new therapeutic and diagnostic products. There can be no
assurance that adequate levels of reimbursement will be available to enable us
to achieve market acceptance of the GlucoWatch system or other new products
under development or to maintain price levels sufficient to realize an
appropriate return on our investment. In certain international countries, the
period of time needed to obtain such reimbursement can be lengthy. We may delay
the launch of our products in certain countries until eligibility for
reimbursement is established. This could potentially harm our business,
financial condition and results of operations.
WE HAVE INCURRED SUBSTANTIAL LOSSES, HAVE A HISTORY OF OPERATING LOSSES, HAVE AN
ACCUMULATED DEFICIT AND EXPECT CONTINUED OPERATING LOSSES.
We reported a net loss from continuing operations of $22.2 million for the
year ended December 31, 1999 and have experienced annual operating losses since
our inception. We expect to continue to incur operating losses at least until we
have significant sales, if we ever do, of the GlucoWatch system. We cannot
assure you that we will generate significant revenues or achieve profitability.
We do not have experience in manufacturing, marketing or selling our medical
device products. Our future development efforts may not result in commercially
viable products. We may fail in our efforts to introduce our products or to
obtain required regulatory clearances. Our products may never gain market
acceptance, and we may never generate revenues or achieve profitability. Our
revenues to date have been derived primarily from product development and
licensing fees related to our products under development, and manufacturing and
royalty revenues from our discontinued operations, including
Nicotrol-Registered Trademark- (Pharmacia AB, Stockholm, Sweden) nicotine patch
and the Fempatch-Registered Trademark- (Warner-Lambert Co., Morris Plains, New
Jersey) system. As a result of the sale of our drug delivery business, we will
no longer receive manufacturing revenue or royalty payments from the Nicotrol
patch or the Fempatch system. If we obtain regulatory approvals, we expect that
a
25
substantial portion of our future revenues will be derived from sales of the
GlucoWatch system and other diagnostic products currently under development.
WE ARE HIGHLY LEVERAGED AND MAY BE UNABLE TO SERVICE OUR DEBT.
As of December 31, 1999, we had indebtedness of approximately
$47.0 million. The degree to which we are leveraged could materially adversely
affect our ability to obtain financing for working capital, acquisitions or
other purposes and could make us more vulnerable to industry downturns and
competitive pressures. Our ability to meet our debt service obligations depends
upon our future performance, which will depend upon financial, business and
other factors, many of which are beyond our control. Although we believe our
cash flows will be adequate to meet our interest payments, we cannot assure you
that we will continue to generate cash flows in the future sufficient to cover
our fixed charges or to permit us to satisfy any redemption obligations pursuant
to our indebtedness. If we cannot generate cash flows in the future sufficient
to cover our fixed charges or to permit us to satisfy any redemption obligations
pursuant to our indebtedness, and we cannot borrow sufficient funds either under
our credit facilities or from other sources, we may need to refinance all or a
portion of our existing debt, to sell all or a portion of our assets, or to sell
equity securities. There is no assurance that we could successfully refinance,
sell our assets or sell equity securities, or, if we could, we cannot give any
assurance as to the amount of proceeds we could realize. In the event of
insolvency, bankruptcy, liquidation, reorganization, dissolution or winding-up
of our business or upon default or acceleration relating to our debt
obligations, our assets will first be available to pay the amounts due under our
debt obligations. Holders of Common Stock would only receive the assets
remaining, if any, after payment of all indebtedness and Preferred Stock.
WE MAY NEED ADDITIONAL FINANCING AND IT MAY NOT BE AVAILABLE.
In order to continue to develop our diagnostic products, we will require
substantial resources to conduct research and development and clinical trials
necessary to bring our products to market and to establish production and
marketing capabilities. We may seek additional funding through public or private
financings, including debt or equity financings. We may also seek other
arrangements, including collaborative arrangements. Any additional equity
financings may dilute the holdings of current stockholders. Debt financing, if
available, may restrict our ability to issue dividends in the future and take
other actions. We may not be able to obtain adequate funds when we need them
from financial markets or arrangements with corporate partners or other sources.
Even if funds are available, they may not be on acceptable terms. If we cannot
obtain sufficient additional funds, we may have to delay, scale back or
eliminate some or all of our research and product development programs or
license or sell products or technologies that we would otherwise seek to develop
ourselves. We believe that our existing cash, cash equivalents and investments,
plus cash from revenues, other fundings such as potential product funding
collaborations or financings, and earnings from investments, will suffice to
meet our operating expenses, debt servicing and repayments and capital
expenditure requirements at least through the end of the year 2000. The amounts
and timing of future expenditures will depend on progress of ongoing research
and development, results of clinical trials, rates at which operating losses are
incurred, executing possible development and licensing agreements with corporate
partners, developing our products, manufacturing scale-up for the GlucoWatch
system, the FDA regulatory process, and several other factors, many of which are
beyond our control.
26
WE DEPEND ON LICENSEES, DISTRIBUTORS AND COLLABORATIVE ARRANGEMENTS.
Our strategy to develop, clinically test, obtain regulatory approval for,
manufacture and commercialize our products depends, in large part, upon our
ability to selectively enter into and maintain collaborative arrangements with
third-party partners, distributors, licensees, and other such parties. If we
commercialize our GlucoWatch system, we will depend upon Yamanouchi
Pharmaceutical Co., Ltd. to market and distribute the GlucoWatch system in Japan
and Korea. We do not have any marketing or distribution agreements for the
GlucoWatch system other than the Yamanouchi collaboration. One of our priorities
is to establish an alliance or alliances for the commercialization of the
GlucoWatch system in North America and Europe. The purpose of such an alliance
or alliances is for us to secure certain commercialization functions, such as
distribution, sales and customer service. We are in discussions with several
companies regarding this objective. Some of the companies are international in
scope and would provide the requisite commercialization functions worldwide.
Other companies focus on certain geographies and/or certain commercialization
functions. The potential signing of a worldwide commercialization agreement may
or may not coincide with the launch of our GlucoWatch system, assuming we
receive FDA approval. We are evaluating out-sourced capabilities for a U.S.
launch without a worldwide commercialization alliance. There can be no assurance
that we will be able to enter into a commercialization alliance or alliances or
that we will be able to out-source certain commercialization capabilities for
launch without a worldwide commercialization alliance in place. We cannot assure
you that such third parties will not, for competitive reasons, support, directly
or indirectly, a company or product that competes with one of our products.
Furthermore, any dispute between us and such a third party might require us to
initiate or defend against expensive litigation or arbitration proceedings. If
one of our partners, distributors or licensees terminates an arrangement, cannot
fund or otherwise satisfy its obligations under its arrangements, or
significantly disputes or breaches a contractual commitment, then we would
likely be required to seek an alternative partner, distributor, or licensee. We
cannot assure you that we would be able to reach agreement with a replacement
third party. If we were unable to find a replacement third party, we might not
be able to perform or fund the activities of the current partner, distributor or
licensee. Even if we were able to perform and fund these activities, our capital
requirements would increase substantially. Additionally, we may choose to
self-fund certain research and development projects in order to exploit our
technologies. If these activities result in a commercial product, they will help
our long-term operating results but will negatively affect our short-term
operating results. Furthermore, as discussed above, we have limited marketing,
manufacturing, distribution and sales experience.
WE MAY BE SUBJECT TO PRODUCT LIABILITY CLAIMS.
The design, development, manufacture and use of our medical products involve
an inherent risk of product liability claims and associated adverse publicity.
Producers of medical products may face substantial liability for damages in the
event of product failure or allegations that the product caused harm. We
currently maintain product liability insurance, but it is expensive and
difficult to obtain and may not be available in the future on acceptable terms.
We cannot assure you that we will not be subject to product liability claims,
that our current insurance would cover any claims, or that adequate insurance
will continue to be available on acceptable terms in the future. In the event we
are held liable for damages in excess of the limits of our insurance coverage,
or if any claim or
27
product recall creates significant adverse publicity, our business, financial
condition and results of operations could be materially adversely affected.
WE MAY NOT BE ABLE TO RETAIN OR HIRE KEY PERSONNEL.
Our ability to operate successfully and manage our potential future growth
significantly depends upon retaining key scientific, technical, managerial and
financial personnel, and attracting and retaining additional highly qualified
scientific, technical, managerial and financial personnel. We face intense
competition for qualified personnel in these areas, and we cannot assure you
that we will be able to attract and retain qualified personnel. The loss of key
personnel or our inability to hire and retain additional qualified personnel in
the future could adversely affect our business, financial condition and
operating results.
OUR CERTIFICATE OF INCORPORATION AND BYLAWS HAVE ANTI-TAKEOVER PROVISIONS.
Our Restated Certificate of Incorporation and Bylaws contain several
provisions that may make the acquisition of control of Cygnus more difficult or
expensive. The Certificate of Incorporation and Bylaws, among other things:
(i) provide that directors may be removed only for cause and only upon the
affirmative vote of the holders of at least a majority of the outstanding shares
of voting stock entitled to vote for such directors, (ii) permit the remaining
directors (but not the stockholders, unless the directors so resolve) to fill
vacancies and newly created directorships on the Board, (iii) eliminate the
ability of stockholders to act by written consent and (iv) require the vote of
stockholders holding at least 66 2/3% of the outstanding shares of voting stock
to amend, alter or repeal the Bylaws and certain provisions of the Restated
Certificate of Incorporation, including the provisions described in (i) through
(iv).
Such provisions may make the removal of incumbent directors more difficult
and time-consuming and may have the effect of discouraging a tender offer or
other takeover attempt not previously approved by the Board of Directors. Under
the Restated Certificate of Incorporation, the Board of Directors also has the
authority to issue shares of Preferred Stock in one or more series and to fix
the powers, preferences and rights of any such series without stockholder
approval. The Board of Directors could, therefore, issue, without stockholder
approval, Preferred Stock with voting and other rights that could adversely
affect the voting power of the holders of Common Stock and could make it more
difficult for a third party to gain control of Cygnus. In addition, we have
adopted a Stockholder Rights Plan which, under certain circumstances, would
significantly dilute the equity interest of persons seeking to acquire control
over us without the prior approval of the Board of Directors.
OUR STOCK PRICE IS VOLATILE.
The trading price of our Common Stock substantially fluctuates in response
to factors such as, but not limited to: announcements by us or our competitors
of results of regulatory approval filings or clinical trials or testing,
developments or disputes governing proprietary rights, technological innovations
or new commercial products, government regulatory action, and general conditions
in the medical technology industry, changes in securities analysts'
recommendations, or other events or factors, many of which are beyond our
control. In addition, the stock market in general has experienced extreme price
and volume fluctuations in recent years that have particularly affected the
28
market prices of many medical technology companies, unrelated to the operating
performance of these companies. Fluctuations or decreases in the trading price
of our Common Stock may adversely affect the market for our Common Stock. In the
past, following periods of volatility in the market price for a company's
securities, securities class action litigation often has been instituted. Such
litigation could result in substantial costs and a diversion of management
attention and resources, which could have a material adverse effect on our
business, financial condition and operating results.
WE DO NOT PAY DIVIDENDS.
We have never declared or paid cash dividends on our Common Stock. Our
current bank term loan precludes us from paying dividends to stockholders. We
currently intend to retain any earnings for use in our business and therefore do
not anticipate paying any dividends in the future.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
INTEREST RATE RISK
Our exposure to market risk for changes in interest rates relates primarily
to our investment portfolio and long-term debt obligations. We do not use
derivative financial instruments in our investment portfolio. We place our
investments with high credit quality issuers and, by policy, limit the amount of
credit exposure to any one issuer. As stated in our policy, we are averse to
principal loss and ensure the safety and preservation of our invested funds by
limiting default risk, market risk and reinvestment risk.
We mitigate default risk by investing in only the highest credit quality
securities. The portfolio includes only marketable securities with active
secondary or resale markets to ensure portfolio liquidity.
We have no cash flow exposure due to rate changes for our $17.0 million
Convertible Debentures, our $0.7 million equipment loans, and our $6.0 million
convertible promissory note related to the Sanofi arbitration settlement, which
all have fixed rates. We also have no cash flow exposure due to the rate change
for certain long-term portions of our Sanofi arbitration obligations, as such
obligations are not interest-bearing. We do have cash flow exposure on our $5.6
million bank term loan due to its variable interest rate (prime plus 1.0%). We
primarily enter into debt obligations to support general corporate purposes,
including capital expenditures and working capital needs.
Because we do not have any assets or liabilities in foreign currencies, we
have no risk from exchange rate changes.
29
The table below presents principal amounts and related weighted-average
interest rates by year of maturity for our investment portfolio and debt
obligations.
FAIR
2000 2001 2002 2003 2004 TOTAL VALUE
(DOLLARS IN THOUSANDS) -------- -------- -------- -------- -------- -------- --------
ASSETS:
Cash equivalents
Fixed.................................... $ 6,842 -- -- -- -- $ 6,842 $ 6,842
Average rate............................. 6.15% -- -- -- -- 6.15% --
Variable rate............................ $20,744 -- -- -- -- $20,744 $20,744
Average rate............................. 4.71% -- -- -- -- 4.71% --
Short-term investments
Fixed.................................... $10,239 -- -- -- -- $10,239 $10,215
Average rate............................. 6.40% -- -- -- -- 6.40% --
Total investments
Securities............................... $37,825 -- -- -- -- $37,825 $37,801
Average rate............................. 5.42% -- -- -- -- 5.42% --
LIABILITIES:
Total long-term debt, including current
portion
Senior Subordinated
Convertible Notes........................ -- -- -- -- $17,000 $17,000 $17,000
Fixed.................................... -- -- -- -- 8.5% 8.5% --
Other
Fixed.................................... $ 535 $6,151 -- -- -- $ 6,686 $ 6,686
Average rate............................. 9.11% 6.56% -- -- -- 6.76% --
Variable rate............................ $ 2,708 $2,938 -- -- -- $ 5,646 $ 5,646
Average rate............................. 8.75% 8.75% -- -- -- 8.75% --
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The consolidated financial statements for the years ended December 31, 1999,
1998 and 1997 are incorporated herein by reference and submitted as a separate
section of this Form 10-K. (See Item 14.)
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
None.
30
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The executive officers of the Company, who serve at the discretion of the
Board of Directors, are as follows, in alphabetical order:
NAME AGE TITLE
- ---- -------- -----------------------------------------------------
Neil R. Ackerman, Ph.D..... 56 Senior Vice President, Research & Development and
Scientific Affairs
Craig W. Carlson........... 52 Chief Financial Officer and Senior Vice President,
Finance
John C Hodgman............. 46 Chairman of the Board, President and Chief Executive
Officer
Barbara G. McClung......... 45 Senior Vice President, General Counsel and Secretary
DR. ACKERMAN joined Cygnus in May of 1994 as Vice President, Research &
Development. In September 1998, Dr. Ackerman was promoted to Senior Vice
President, Research & Development and Scientific Affairs. From January 1997 to
September 1998, Dr. Ackerman served as Senior Vice President, Research &
Development. From 1990 to May 1994, Dr. Ackerman served as Vice President of
Research and Development for Glycomed, leading its discovery efforts focused on
cardiovascular and inflammatory diseases. From 1982 to 1990, he was Research
Director, Cancer and Inflammatory Diseases with DuPont Pharmaceuticals,
responsible for leading a 100-person staff that had the objective of discovering
therapeutics for cancer, inflammatory and immune-based diseases. Prior to that
he was employed by Syntex Corporation and Pfizer, Inc. in research and
management capacities. Dr. Ackerman received B.S. and Ph.D. degrees from the
University of Maryland and completed a post-doctoral fellowship at Stanford
University.
MR. CARLSON was appointed Chief Financial Officer effective December 8,
1998, with responsibilities for the Finance, Information Technology and
Corporate Communications functions at Cygnus. He joined Cygnus in July 1993 as
Vice President, Corporate Communications, became Vice President, Strategic
Planning and Corporate Marketing, then assumed responsibility for the Finance
and Information Technologies functions in 1997 as Senior Vice President,
Finance. From 1988 to July 1993, he was Vice President and Group Director at
Young & Rubicam Advertising in San Francisco. Prior to that, Mr. Carlson was
Vice President of Campbell-Mithun Advertising. He holds a B.A. from Union
College and an M.B.A. from Stanford University.
MR. HODGMAN was appointed Chairman of the Board effective July 9, 1999 and
has served as President and Chief Executive Officer since August 1998. From May
1995 to August 1998, Mr. Hodgman served as President, Cygnus Diagnostics, for
which he was responsible for all commercialization efforts for the GlucoWatch
biographer, and as Chief Financial Officer. Mr. Hodgman joined Cygnus in August
1994 as Vice President, Finance and Chief Financial Officer. Prior to joining
Cygnus, Mr. Hodgman served as Vice President of Operations and Finance and Chief
Financial Officer for Central Point Software, a personal computer and networking
software company. Prior to that, he was the Vice President of Finance and
Administration and Chief Financial Officer of Ateq Corporation. Mr. Hodgman
holds a B.S. degree from Brigham Young University and an M.B.A. from the
University of Utah.
31
MS. McCLUNG joined Cygnus in January 1998 as Vice President, Intellectual
Property. In August 1998, Ms. McClung was promoted to Vice President and General
Counsel. In December 1998, Ms. McClung was promoted to Senior Vice President,
General Counsel and Secretary, and also assumed responsibilities for the Human
Resources function shortly thereafter. From August 1990 to January 1998, she was
Corporate Patent Counsel at Chiron Corporation, a biotechnology company. Prior
to that she was Patent Counsel at DuPont. She is a member of the California,
Delaware, and Pennsylvania bars, as well as being a registered patent attorney
before the U.S. Patent and Trademark Office. Ms. McClung received a J.D. from
the University of Pennsylvania Law School, as well as a B.A. from the University
of California, San Diego, and an M.A. from the University of Pennsylvania.
Additionally, we incorporate by reference the information concerning our
directors set forth under the heading "Proposal One--Re-election of Directors"
in our definitive Proxy Statement to be filed pursuant to Regulation 14A for our
2000 Annual Meeting of Stockholders.
ITEM 11. EXECUTIVE COMPENSATION
We incorporate by reference the information set forth under the heading
"Executive Compensation and Other Information" in our definitive Proxy Statement
to be filed pursuant to Regulation 14A for our 2000 Annual Meeting of
Stockholders.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
We incorporate by reference the information set forth under the heading
"Security Ownership of Certain Beneficial Owners and Management" in our
definitive Proxy Statement to be filed pursuant to Regulation 14A for our 2000
Annual Meeting of Stockholders.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
We incorporate by reference the information set forth under the headings
"Proposal One--Re-election of Directors" and "Executive Compensation and Other
Information" in our definitive Proxy Statement to be filed pursuant to
Regulation 14A for our 2000 Annual Meeting of Stockholders.
32
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
A.1) FINANCIAL STATEMENTS AND REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
PAGE
--------
Report of Ernst & Young LLP, Independent Auditors........... F-3
Consolidated Balance Sheets as of December 31, 1999 and
1998...................................................... F-4
Consolidated Statements of Operations for the years ended
December 31, 1999, 1998 and 1997.......................... F-5
Consolidated Statements of Stockholders' Net Capital
Deficiency for the years ended December 31, 1999, 1998 and
1997...................................................... F-6
Consolidated Statements of Cash Flows for the years ended
December 31, 1999, 1998 and 1997.......................... F-7
Notes to Consolidated Financial Statements.................. F-8
A.2) FINANCIAL STATEMENT SCHEDULE
All other schedules have been omitted because the required information is
not present or is not present in amounts sufficient to require submission of the
schedule, or because the information required is included in the consolidated
financial statements, including the notes thereto.
B) REPORTS ON FORM 8-K
We have recently filed the following Current Reports on Form 8-K.
On February 18, 2000, we filed an Amendment No. 1 to Current Report on Form
8-K, reporting under Item 2 that we completed the sale of substantially all of
our drug delivery business assets to Ortho-McNeil Pharmaceutical, Inc., a
Johnson & Johnson company, for up to $75 million in cash.
On December 30, 1999, we filed a Current Report on Form 8-K, reporting under
Item 2 that we completed the sale of substantially all of our drug delivery
business assets to Ortho-McNeil Pharmaceutical, Inc. for up to $75 million in
cash.
On December 13, 1999, we filed a Current Report on Form 8-K, reporting under
Item 5: (i) that we received a CE Certificate for the GlucoWatch system, which
is required for selling products in the European Community; (ii) that our
Premarket Approval application (PMA) for the GlucoWatch system received a
unanimous recommendation for approval with conditions by the Food and Drug
Administration's (FDA) Clinical Chemistry and Clinical Toxicology Devises Panel
of the Medical Devices Advisor Committee; and (iii) a copy of our condensed
consolidated balance sheet and pro forma condensed consolidated statements of
income to illustrate the effect of the sale of substantially all of our drug
delivery business assets to Ortho-McNeil Pharmaceutical, Inc.
On November 22, 1999, we filed a Current Report on Form 8-K, reporting under
Item 5 that we signed a binding agreement to sell substantially all of the
assets of our drug delivery business to Ortho-McNeil Pharmaceutical, Inc.
33
On November 4, 1999, we filed a Current Report on Form 8-K, reporting under
Item 5 that the FDA had scheduled December 6, 1999 as the date for an advisory
committee review of our PMA for the GlucoWatch system.
C) EXHIBITS
The following exhibits are filed herewith or incorporated by reference:
3.01 Bylaws of the Registrant, as amended, incorporated by
reference to Exhibit 3.3 of the Registrant's Registration
Statement Form S-1 No. 33-38363.
3.02 Restated Articles of Incorporation of the Registrant, as
amended to date, incorporated by reference to Exhibit 3.4
of the Registrant's Registration Statement Form S-1 No.
33-38363.
4.01 Specimen of Common Stock certificate of the Registrant,
incorporated by reference to Exhibit 4.1 of the
Registrant's Registration Statement Form S-1 No. 33-38363.
4.02 Form of Senior Indenture incorporated herein by reference to
Exhibit 4.1 filed with the Company's Registration
Statement on Form S-3 (File No. 33-39275) declared
effective by the Securities and Exchange Commission on
November 12, 1997 (the November 1997 Form S-3).
4.03 Form of Subordinated Indenture incorporated herein by
reference to Exhibit 4.2 filed with the Company's
November 1997 Form S-3.
4.04 Form of Senior Debt Security (included in Exhibit 4.1)
incorporated herein by reference to Exhibit 4.3 filed with
the Company's November 1997 Form S-3.
4.05 Form of Subordinated Debt Security (included in
Exhibit 4.2) incorporated herein by reference to
Exhibit 4.4 filed with the Company's November 1997
Form S-3.
4.06 First Supplemental Indenture dated as of February 2, 1998 by
and between Cygnus, Inc. and State Street Bank and Trust
Company of California, N.A. Incorporated by reference to
Exhibit 4.5 of the Company's Form 8-K dated February 4,
1998.
4.07 Second Supplemental Indenture, dated as of October 28, 1998,
by and between Cygnus, Inc. and State Street Bank and
Trust Company of California, N.A., to the Indenture dated
as of February 3, 1998 and the First Supplemental
Indenture dated as of February 3, 1998, incorporated by
reference to Exhibit 4.8 of the Company's Form 8-K filed
on October 30, 1998.
4.08 Amended and Restated Rights Agreement dated October 27, 1998
between the Company and ChaseMellon Shareholder Services,
L.L.C. (the Rights Agent successor to Chemical Trust),
which includes the Certificate of Determination for the
Series A Junior Participating Preferred Stock as
Exhibit A, the form of Right Certificate as Exhibit B and
the Summary of Rights to purchase Preferred Shares as
Exhibit C, incorporated by reference to Exhibit 99.2 of
the Registrant's Form 8A/A filed on December 14, 1998,
Registration No. 0-19962.
34
4.09 Registration Rights Agreement dated June 30, 1999 between
the Registrant and Cripple Creek Securities, LLC.,
incorporated by reference to Exhibit 4.11 of the
Registrant's Form 10-Q for the quarter ended June 30,
1999.
4.10 Registration Rights Agreement dated June 29, 1999 between
the Registrant and the listed investors on Schedule I
thereto, incorporated by reference to Exhibit 4.12 of the
Registrant's Form 10-Q for the quarter ended June 30,
1999.
10.001 Ten-year Industrial Net Lease Agreement (Building No. 2)
dated September 27, 1988 between the Registrant and
Seaport Centre Venture Phase I, incorporated by reference
to Exhibit 10.26 of the Registrant's Form S-1 Registration
Statement No. 33-38363.
10.002 Ten-year Industrial Net Lease Agreement (Building No. 8)
dated September 27, 1988 between the Registrant and
Seaport Centre Venture Phase I, incorporated by reference
to Exhibit 10.27 of the Registrant's Form S-1 Registration
Statement No. 33-38363.
10.003 Lease Agreement dated as of October 15, 1991 between the
Registrant and Lincoln Menlo Associates Limited, a
California Limited Partnership, incorporated by reference
to Exhibit 10.34 of the Registrant's Form S-1 Registration
Statement No. 33-45180.
10.004 First Amendment to Ten-year Industrial Net Lease Agreement
(Building No. 2) dated June 9, 1998 between the Registrant
and Metropolitan Life Insurance Company, a New York
corporation (predecessor in interest to Seaport Centre
Venture Phase I), incorporated by reference to
Exhibit 10.29 of the Registrant's Form 10-K for the period
ending December 31, 1998.
10.005 Third Amendment to Ten-year Industrial Net Lease Agreement
(Building No. 8) dated June 9, 1998 between the Registrant
and Metropolitan Life Insurance Company, a New York
corporation (predecessor in interest to Seaport Centre
Venture Phase I), incorporated by reference to
Exhibit 10.29 of the Registrant's Form 10-K for the period
ending December 31, 1998.
10.006 Sublease Agreement dated February 19, 1999 between the
Registrant and The 3DO Company, incorporated by reference
to Exhibit 10.39 of the Registrant's Form 10-Q for the
period ending March 31, 1999.
10.007 Amendment No. 4 Lease Extension dated July 20, 1999 between
the Registrant and Lincoln Menlo Associates Limited, a
California Limited Partnership, incorporated by reference
to Exhibit 10.44 of the Registrant's Form 10-Q for the
period ending March 31, 1999.
10.008 Sublease dated December 15, 1999 between the Registrant and
Ortho-McNeil Pharmaceutical, Inc.
10.009 through 10.099 Reserved.
10.101 Structured Equity Line Flexible Financing Agreement, dated
June 30, 1999 between the Registrant and Cripple Creek
Securities, LLC, incorporated by referenced to Exhibit 1
of the Registrant's Form 8-K filed on July 2, 1999.
35
10.102 Convertible Debenture and Warrant Purchase Agreement dated
June 29, 1999 between the Registrant and the listed
investors on Schedule I thereto, incorporated by reference
to Exhibit 10.41 of the Registrant's Form 10-Q for the
quarter ended June 30, 1999.
10.103 Form of 8.5% Convertible Debenture Due June 29, 2004,
incorporated by reference to Exhibit 10.42 of the
Registrant's Form 10-Q for the quarter ended June 30,
1999.
10.104 Form of Common Stock Purchase Warrant, incorporated by
reference to Exhibit 10.43 of the Registrant's Form 10-Q
for the quarter ended June 30, 1999.
10.105 Amendment No. 1 to Structured Equity Line Flexible Financing
Agreement, dated September 29, 1999 between the Registrant
and Cripple Creek Securities, LLC, incorporated by
reference to Exhibit 1.1 of the Registrant's Form 8-K
filed on October 7, 1999.
10.106 Form of Note Purchase Agreement dated as of February 2, 1998
between Cygnus, Inc. and certain institutional investors.
Incorporated by reference to Exhibit 10.28 of the
Company's Form 8-K dated February 4, 1998.
10.107 Form Common Stock Purchase Agreement dated February 2, 1998
between Cygnus, Inc. and certain institutional investors.
Incorporated by reverence to exhibit 10.29 of the
Company's Form 8-K dated February 4, 1998.
10.108 Amended and Restated Loan and Security Agreement between the
Registrant and Silicon Valley Bank entered into as of
April 30, 1998, incorporated by reference to exhibit 10.45
of the Company's Form 10-Q for the quarter ended
September 30, 1998.
10.109 through 10.199 Reserved.
*10.201 Product Supply and Distribution Agreement between the
Registrant and Yamanouchi Pharmaceutical Co., Ltd., dated
as of July 14, 1996 Incorporated by reference to exhibit
10.1 of the Company's Form 10-Q for the quarter ended
June 30, 1996.
*10.202 Product Supply Agreement between the Registrant and Contract
Manufacturing, Inc. dated July 15, 1997.
*10.203 Supply Agreement dated June 19, 1998 between the Registrant
and E.I. du Pont de Nemours & Co., a Delaware corporation,
incorporated by reference to Exhibit .10.34 of
Registrant's Form 10-K for period ending December 31,
1998.
*10.204 Detection of Analytes Product Development and License
Agreement dated June 19, 1998 between the Registrant and
E.I. du Pont de Nemours & Co., a Delaware corporation,
incorporated by reference to Exhibit 10.35 of Registrant's
Form 10-K for period ending December 31, 1998.
*10.205 Supply Agreement between the Registrant and Key Tronic
Corporation dated December 1, 1999.
*10.206 Supply Agreement between the Registrant and Hydrogel Design
Systems, Inc. dated December 31, 1999.
10.207 through 10.299 Reserved.
36
*10.301 Exclusive License Agreement between the Registrant and The
Regents of the University of California dated January 31,
1995.
*10.302 License Agreement Amendment between the Registrant and The
Regents of the University of California dated April 23,
1998.
10.303 through 10.399 Reserved.
*10.401 Asset Purchase Agreement dated November 17, 1999 between the
Registrant and Ortho-McNeil Pharmaceutical, Inc.,
incorporated by reference to Exhibit 10.49 of Registrant's
Form 8-K filed December 30, 1999.
10.402 through 10.499 Reserved
10.501 Cygnus, Inc. 1999 Stock Incentive Plan (As Amended and
Restated March 1, 2000)
10.502 Cygnus, Inc. Amended 1991 Employee Stock Purchase Plan (As
Amended and Restated March 1, 2000).
10.503 Form of Indemnification Agreement for Directors and
Officers, incorporated by reference to Exhibit 10.29 of
the Registrant's Form S-1 Registration Statement No.
33-38363.
10.504 Form of Agreement (Termination of Employment Without
Cause--Officers) between the Company and each of the
Executive officers, incorporated by reference to
Exhibit 10.46 of the Company's Form 10-Q for the period
ended September 30, 1998.
10.505 Form of Agreement (Change of Control) between the Company
and each of the Executive officers, incorporated by
reference to Exhibit 10.47 of the Company's Form 10-Q for
the period ended September 30, 1998.
10.506 Form of Special Addendum to Stock Option Agreement
(Termination of Employment Without Cause--Officers),
incorporated by reference to Exhibit 99.4 of the Company's
Form S-8 Registration Statement No. 333-67331, filed
November 16, 1998.
10.507 Form of Special Addendum to Stock Option Agreement
(Termination of Employment Without Cause--Key Employee),
incorporated by reference to Exhibit 99.5 of the Company's
Form S-8 Registration Statement No. 333-67331, filed
November 16, 1998.
10.508 Form of Special Addendum to Stock Option Agreement (Change
in Control), incorporated by reference to Exhibit 99.3 of
the Company's Form S-8 Registration Statement No.
333-67331, filed November 16, 1998.
10.509 Written Compensation Agreement dated August 28, 1998 between
Registrant and Andre F. Marion, incorporated by reference
to Exhibit 99.7 of the Company's Form S-8 Registration
Statement No. 333-67331, filed November 16, 1998.
37
10.510 Stock Option Agreement between Registrant and Andre F.
Marion, incorporated by reference to Exhibit 99.8 of the
Company's Form S-8 Registration Statement No. 333-67331,
filed November 16.1998.
25.1 Power of Attorney (see page 40)
27.0 Financial Data Schedule
- ------------------------
* A confidential treatment request has been applied for or granted with
respect to a portion of this document.
38
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, Registrant has duly caused this Report to be signed on its
behalf by the undersigned, thereunto duly authorized, on the 22nd day of March,
2000.
CYGNUS, INC.
By: /s/ JOHN C HODGMAN
------------------------------------
John C Hodgman
CHAIRMAN, PRESIDENT AND CHIEF
EXECUTIVE OFFICER (PRINCIPAL
EXECUTIVE OFFICER)
39
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints John C Hodgman attorney-in-fact for the
undersigned, with the power of substitution, for the undersigned in any and all
capacities, to sign any and all amendments to this Report on Form 10-K, and to
file the same, with exhibits thereto and other documents in connection
therewith, with the Securities and Exchange Commission, hereby ratifying and
confirming all that said attorney-in-fact, or his substitute or substitutes, may
do or cause to be done by virtue hereof.
IN WITNESS WHEREOF, each of the undersigned has executed this Power of
Attorney as of the date indicated opposite his/her name.
Pursuant to the requirements of the Securities Exchange Act of 1934, this
Report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE
--------- ----- ----
Chairman of the Board of
/s/ JOHN C HODGMAN Directors, President
------------------------------------------- and Chief Executive
John C Hodgman Officer (Principal
Executive Officer) March 22, 2000
Chief Financial Officer
/s/ CRAIG W. CARLSON and Senior Vice
------------------------------------------- President, Finance
Craig W. Carlson (Principal Accounting
Officer) March 22, 2000
/s/ ANDRE F. MARION
------------------------------------------- Vice Chairman of the
Andre F. Marion Board of Directors March 22, 2000
/s/ FRANK T. CARY
------------------------------------------- Director
Frank T. Cary March 22, 2000
/s/ RICHARD G. ROGERS
------------------------------------------- Director
Richard G. Rogers March 22, 2000
/s/ WALTER B. WRISTON
------------------------------------------- Director
Walter B. Wriston March 22, 2000
40
CYGNUS, INC.
CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
WITH
REPORT OF INDEPENDENT AUDITORS
F-1
CYGNUS, INC.
CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
CONTENTS
Report of Ernst & Young LLP, Independent Auditors........... F-3
Audited Consolidated Financial Statements:
Consolidated Balance Sheets................................. F-4
Consolidated Statements of Operations....................... F-5
Consolidated Statements of Shareholders' Net Capital
Deficiency................................................ F-6
Consolidated Statements of Cash Flows....................... F-7
Notes to Consolidated Financial Statements.................. F-8
F-2
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors and Stockholders
Cygnus, Inc.
We have audited the accompanying consolidated balance sheets of Cygnus, Inc.
as of December 31, 1999 and 1998, and the related consolidated statements of
operations, stockholders' equity (net capital deficiency) and cash flows for
each of the three years in the period ended December 31, 1999. These financial
statements are the responsibility of Cygnus' management. Our responsibility is
to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States. 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 consolidated financial position of Cygnus, Inc. at
December 31, 1999 and 1998, and the consolidated results of its operations and
its cash flows for each of the three years in the period ended December 31,
1999, in conformity with accounting principles generally accepted in the United
States.
/s/ ERNST & YOUNG LLP
Palo Alto, California
January 28, 2000
F-3
CYGNUS, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
DECEMBER 31,
---------------------
1999 1998
--------- ---------
ASSETS:
CURRENT ASSETS:
Cash and cash equivalents................................. $ 28,677 $ 10,219
Short-term investments.................................... 10,215 14,982
Trade accounts receivable, net of allowance ($123 in
1998)................................................... 62 876
Inventories............................................... -- 771
Prepaid expenses and other current assets................. 498 510
Current portion of employee notes receivable.............. 162 185
Current portion of unamortized deferred financing cost.... 201 --
--------- ---------
Total current assets.................................. 39,815 27,543
EQUIPMENT AND IMPROVEMENTS:
Office and laboratory equipment........................... 7,856 14,421
Leasehold improvements.................................... 426 1,304
Construction in progress.................................. 4,417 3,816
--------- ---------
12,699 19,541
Less accumulated depreciation and amortization............ (6,610) (13,077)
--------- ---------
Net equipment and improvements........................ 6,089 6,464
Long-term investments..................................... -- 3,622
Long-term portion of employee notes receivable............ 201 286
Deferred compensation and other assets.................... 162 4,451
Unamortized portion of deferred financing cost............ 709 1,088
--------- ---------
Total Assets.......................................... $ 46,976 $ 43,454
========= =========
LIABILITIES AND NET CAPITAL DEFICIENCY:
CURRENT LIABILITIES:
Accounts payable.......................................... $ 1,884 $ 2,585
Amounts payable to related parties........................ -- 1,043
Accrued clinical trials expenses.......................... 118 831
Accrued compensation...................................... 2,919 4,593
Other accrued liabilities................................. 640 1,939
Current portion of deferred revenue....................... 900 1,153
Current portion of long-term debt......................... 3,243 3,415
Current portion of capital lease obligations.............. -- 442
--------- ---------
Total current liabilities............................. 9,704 16,001
Arbitration obligation...................................... 23,000 24,158
Long-term portion of debt................................... 3,088 8,252
Long-term portion of capital lease obligations.............. -- 581
Senior Subordinated Convertible Notes....................... -- 22,563
Convertible Debentures, net of discount of $5,595 in 1999... 12,084 --
Deferred compensation and other long-term liabilities....... 304 4,666
STOCKHOLDERS' NET CAPITAL DEFICIENCY:
Preferred stock, $0.001 par value: 5,000 shares
authorized; no shares issued and outstanding............ -- --
Common Stock, $0.001 par value: 55,000 and 40,000 shares
authorized; Issued and outstanding: 25,411 and 20,886
shares at December 31, 1999 and 1998, respectively...... 25 21
Additional paid-in-capital................................ 177,576 143,155
Accumulated deficit....................................... (178,790) (175,955)
Accumulated other comprehensive income/(loss)............. (15) 12
--------- ---------
Net capital deficiency.................................... (1,204) (32,767)
--------- ---------
Total liabilities and stockholders' net capital
deficiency............................................. $ 46,976 $ 43,454
========= =========
See accompanying notes.
F-4
CYGNUS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER-SHARE DATA)
YEARS ENDED DECEMBER 31,
------------------------------
1999 1998 1997
-------- -------- --------
CONTRACT REVENUES......................................... $ 2,061 $ 457 $ 2,146
COSTS AND EXPENSES:
Research and development................................ 15,745 25,635 16,198
Marketing, general and administrative................... 4,794 8,810 2,205
-------- -------- --------
TOTAL COSTS AND EXPENSES.............................. 20,539 34,445 18,403
LOSS FROM OPERATIONS...................................... (18,478) $(33,988) (16,257)
Interest and other income............................... 194 3,284 2,989
Interest and other expense.............................. (3,690) (9,730) (1,849)
-------- -------- --------
LOSS FROM CONTINUING OPERATIONS BEFORE TAX................ (21,974) (40,434) (15,117)
Provision for tax......................................... (200) -- --
-------- -------- --------
LOSS FROM CONTINUING OPERATIONS........................... (22,174) (40,434) (15,117)
DISCONTINUED OPERATIONS:
Income/(loss) from operations of discontinued segment... 3,031 1,006 (35,343)
Gain on disposal of segment............................. 16,308 -- --
-------- -------- --------
NET LOSS.................................................. $ (2,835) $(39,428) $(50,460)
======== ======== ========
NET LOSS PER SHARE FROM CONTINUING OPERATIONS, BASIC AND
DILUTED................................................. $ (0.95) $ (2.00) $ (0.80)
======== ======== ========
NET INCOME/(LOSS) PER SHARE FROM DISCONTINUED SEGMENT,
BASIC AND DILUTED....................................... $ 0.83 0.05 $ (1.87)
======== ======== ========
NET LOSS PER SHARE, BASIC AND DILUTED..................... $ (0.12) $ (1.95) $ (2.67)
======== ======== ========
SHARES USED IN COMPUTATION OF NET LOSS PER SHARE, BASIC
AND DILUTED............................................. 23,354 20,226 18,928
======== ======== ========
See accompanying notes.
F-5
CYGNUS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' NET CAPTIAL DEFICIENCY
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
(IN THOUSANDS)
ACCUMULATED TOTAL
ADDITIONAL OTHER STOCKHOLDERS'
COMMON PAID-IN- ACCUMULATED COMPREHENSIVE NET CAPITAL
STOCK CAPITAL DEFICIT INCOME/(LOSS) DEFICIENCY
-------- ---------- ------------ -------------- -------------
BALANCE, DECEMBER 31, 1996...................... $18 $117,266 $ (86,067) $ (4) $ 31,213
Issuance of 322 shares of Common Stock under the
Employee Stock Option Plan and Employee Stock
Purchase Plan................................. 1 2,918 -- -- 2,919
Issuance of 255 shares of Common Stock through
exercise of warrant........................... -- 2,525 -- -- 2,525
Net loss...................................... -- -- (50,460) -- (50,460)
Unrealized gain on available-for-sale
securities.................................. -- -- -- 3 3
--------
Net comprehensive loss........................ -- -- -- -- (50,457)
--- -------- --------- ---- --------
BALANCE, DECEMBER 31, 1997...................... $19 $122,709 $(136,527) $ (1) $(13,800)
=== ======== ========= ==== ========
Issuance of 144 shares of Common Stock under the
Employee Stock Option Plan and Employee Stock
Purchase Plan................................. $-- $ 892 $ -- $ -- $ 892
Issuance of 906 shares of Common Stock in fourth
public offering, net of issuance costs........ 1 13,326 -- -- 13,327
Issuance of 565 shares arising upon conversion
of the Senior Subordinated Note............... 1 1,998 -- -- 1,999
Additional paid-in capital arising from the
beneficial conversion feature in connection
with the restructuring of the Senior
Subordinated Notes............................ -- 4,230 -- -- 4,230
Net loss...................................... -- -- (39,428) -- (39,428)
Unrealized gain on available-for-sale
securities.................................. -- -- -- 13 13
--------
Net comprehensive loss........................ -- -- -- -- (39,415)
--- -------- --------- ---- --------
BALANCE, DECEMBER 31, 1998...................... $21 $143,155 $(175,955) $ 12 $(32,767)
=== ======== ========= ==== ========
Issuance of 1,103 shares of Common Stock under
the Employee Stock Incentive Plan and Employee
Stock Purchase Plan........................... $ 1 $ 6,694 $ -- $ -- $ 6,695
Issuance of 259 shares of Common Stock for
services rendered............................. -- 864 -- -- 864
Stock-based compensation........................ -- 378 -- -- 378
Issuance of 991 shares of Common Stock pursuant
to the Equity Line Agreement, net of issuance
costs......................................... 1 9,117 -- -- 9,118
Issuance of 120 shares of Common Stock upon
exercise of warrant........................... -- 531 -- -- 531
Issuance of 2,053 shares upon conversion of the
Senior Subordinated Note...................... 2 10,265 -- -- 10,267
Issuance of warrants in connection with the
Convertible Debentures........................ -- 6,572 -- -- 6,572
Net loss...................................... -- -- (2,835) -- (2,835)
Unrealized loss on available-for-sale
securities.................................. -- -- -- (27) (27)
--------
Net comprehensive loss........................ -- -- -- -- (2,862)
--- -------- --------- ---- --------
BALANCE, DECEMBER 31, 1999...................... $25 $177,576 $(178,790) $(15) $ (1,204)
=== ======== ========= ==== ========
See accompanying notes.
F-6
CYGNUS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
YEARS ENDED DECEMBER 31,
------------------------------
1999 1998 1997
-------- -------- --------
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss.................................................... $ (2,835) $(39,428) $(50,460)
Adjustments to reconcile net loss to net cash (used
in)/provided by operating activities:
Depreciation.............................................. 1,850 1,665 1,971
Amortization.............................................. 12 256 768
Loss on write-down of equipment........................... -- -- 1,350
Beneficial conversion feature of restructured Notes....... 4,230 --
Amortization of debt issuance and financing costs and debt
discount................................................ 1,743 1,561 --
Stock-based compensation.................................. 378 -- --
Gain on disposal of segment............................... (16,308) -- --
Change in operating assets and liabilities:
Trade accounts receivables................................ 814 1,163 5,719
Inventories............................................... 771 153 1,407
Deferred compensation, prepaid expenses and other
assets.................................................. 4,409 1,454 (3,201)
Other..................................................... 77 (125) (133)
Accounts payable and other accrued liabilities............ (3,351) 2,316 (2,432)
Accrued compensation...................................... 317 1,295 121
Deferred revenue.......................................... (253) (1,881) (10,445)
Arbitration liability..................................... (1,157) (15,005) 39,223
Deferred compensation and other liabilities............... (4,362) (178) 1,494
-------- -------- --------
Net cash used in operating activities................... (17,895) (42,524) (14,618)
-------- -------- --------
CASH FLOWS FROM INVESTING ACTIVITIES
Capital expenditures........................................ (2,725) (3,365) (3,095)
Proceeds from disposal of segment........................... 20,000 -- --
Contract termination fee in conjunction with disposal of
segment................................................... (750) -- --
Purchases of investments.................................... (11,301) (48,314) (30,148)
Maturity and sale of investments............................ 19,574 44,073 32,408
-------- -------- --------
Net cash provided by/(used) in investing activities..... 24,798 (7,606) (835)
-------- -------- --------
CASH FLOWS FROM FINANCING ACTIVITIES
Issuance of Common Stock.................................... 14,926 14,219 5,444
Net proceeds from the issuance of Senior Subordinated
Convertible Notes......................................... -- 40,351 --
Net proceeds from the issuance of Convertible Debentures.... 16,407 -- --
Proceeds from issuance of long-term debt.................... -- 6,110 1,331
Principal payments of Senior Subordinated Convertible
Notes..................................................... (12,500) (18,500) --
Principal payments of long-term debt........................ (5,335) (2,023) (2,486)
Payments of capital lease obligations....................... (1,943) (477) (1,315)
-------- -------- --------
Net cash provided by financing activities............... 11,555 39,680 2,974
-------- -------- --------
Net increase/(decrease) in cash and cash equivalents........ 18,458 (10,450) (12,479)
Cash and cash equivalents at beginning of year.............. 10,219 20,669 33,148
-------- -------- --------
Cash and cash equivalents at end of year.................... $ 28,677 $ 10,219 $ 20,669
======== ======== ========
See accompanying notes.
F-7
CYGNUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEAR ENDED DECEMBER 31, 1999
(IN THOUSANDS, EXCEPT PER-SHARE DATA)
NOTE 1: BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
DESCRIPTION OF BUSINESS
Cygnus was incorporated in California in 1985 and was merged into a Delaware
corporation in September 1995. We are engaged in the development and manufacture
of diagnostic systems, utilizing proprietary technologies to satisfy unmet
medical needs cost effectively. Our current efforts are primarily focused on a
frequent, automatic and non-invasive glucose monitoring device, the GlucoWatch
biographer, and enhancements thereto.
CONSOLIDATION
The consolidated financial statements include the accounts of Cygnus and its
wholly-owned subsidiaries after elimination of all material inter-company
balances and transactions. Cygnus' subsidiaries were inactive in 1999, 1998 and
1997, and were dissolved effective February 21, 2000.
USE OF ESTIMATES
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the amounts reported in the financial
statements and accompanying notes. Actual results could differ from those
estimates.
FINANCIAL PRESENTATION
Certain prior-year amounts have been reclassified to conform to the current
year's presentation.
DISCONTINUED OPERATIONS
On December 15, 1999, we completed the sale of substantially all of our drug
delivery business segment assets to Ortho-McNeil, except for certain assets with
a net book value of $505 thousand of which assets with a net book value of $205
thousand were written off prior to year end.
We have restated our consolidated statements of operations for the years
ended December 31, 1998 and 1997 to reflect the results of the drug delivery
business as a discontinued operation, in accordance with Accounting Principles
Board Opinion No. 30 (APB 30).
REVENUE RECOGNITION
Our contract revenues include up-front and interim milestone payments from
development contracts. The amortization of the initial fees and interim
milestone payments is based on the total person hours expended to date by
project, as compared to the estimated total project person hours
F-8
CYGNUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEAR ENDED DECEMBER 31, 1999
(IN THOUSANDS, EXCEPT PER-SHARE DATA)
required, a manner similar to the percentage of completion methodology. Due the
nature of the projects we have undertaken, revenue recognized using our current
policy approximates the revenue that would be recognized using a straight-line
basis. However, contract revenues are not always aligned with the timing of
related expenses. To date, research and development expenses generally have
exceeded contract revenues in any particular period. Deferred revenue includes
the portion of up-front and interim milestone payments received on research,
development and distribution agreements which have been deferred and will be
recognized over the related development period in relation to efforts expended
under the agreement.
CUSTOMER CONCENTRATION
One customer provided 97% of the 1999 contract revenues. In 1998 this
customer provided 40% of our contract revenues and in 1997 this customer
provided 69% of our contract revenues. Another customer provided zero percent
(0%) of our 1999 contract revenues, 60% of our 1998 contract revenues, and 31%
of our 1997 contract revenues. No other customer provided more than 10% of
contract revenues during the three years ended December 31, 1999.
RESEARCH AND DEVELOPMENT
Research and development expenses are expensed as incurred.
INVENTORIES
The December 31, 1998 net inventory consisted primarily of raw materials and
was stated at the lower of cost (first-in, first-out method) or market, after
appropriate consideration was given to obsolescence and inventory in excess of
anticipated future demand.
EQUIPMENT AND IMPROVEMENTS
Equipment and improvements are recorded at the lower of cost or net
realizable value. Depreciation of equipment is computed on a straight-line basis
over the estimated useful lives of eighteen months to sixty months. Leasehold
improvements and assets recorded under capital leases are amortized using the
straight-line method over the shorter of the estimated useful life of the assets
or the term of the leases. No depreciation charge is computed on assets under
construction.
ACCOUNTING FOR IMPAIRMENT OF LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE
DISPOSED OF
The Financial Accounting Standards Board Statement of Financial Accounting
Standards, No. 121 (FAS 121), "Accounting for the Impairment of Long-lived
Assets and for Long-lived Assets to be Disposed Of," prescribes the accounting
for the impairment of long-lived assets, such as property, plant, equipment, and
intangible assets, as well as the accounting for long-lived assets that are held
F-9
CYGNUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEAR ENDED DECEMBER 31, 1999
(IN THOUSANDS, EXCEPT PER-SHARE DATA)
for disposal. We review property, plant, equipment, and other long-lived assets
for impairment whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. Recoverability is measured
by comparison of its carrying amount to the future net cash flows the assets are
expected to generate. If such assets are considered to be impaired, the
impairment is recognized and is measured as the amount by which the carrying
amount of the asset exceeds the present value of the future net cash flows. In
December 1999, as part of the disposal of the drug delivery business segment, we
recorded a charge of $205 thousand. No charge was incurred during 1998. During
1997, we recorded a charge of $1.3 million relating to the write-off of certain
leasehold improvements resulting from the decision to coordinate research and
development facilities into existing space. This amount was included in research
and development expenses in the consolidated statement of operations for 1997.
DEFERRED COMPENSATION
In 1995, we adopted a non-qualified deferred compensation plan. The plan was
intended to be unfunded and was maintained primarily for the purpose of
providing deferred compensation for a select group of management. As of
December 31, 1999 and 1998, other long-term assets and other long-term
liabilities related to the plan, which included both contributions and net
investment earnings, amounted to $0.0 million and $4.3 million, respectively.
These investments were directed by the participants. In January 1999, we
terminated the plan and the plan assets were distributed to participants in the
first quarter of 1999.
NET LOSS PER SHARE
Basic and diluted net loss per share is computed using the weighted average
number of shares of Common Stock outstanding. Shares issuable from stock
options, warrants and Convertible Debentures outstanding are excluded from the
diluted-earnings-per-share computation, as their effect is anti-dilutive.
ACCOUNTING FOR STOCK-BASED COMPENSATION
Under Statement of Financial Accounting Standard No. 123, "Accounting for
Stock-Based Compensation"(FAS 123), stock-based compensation expense to
employees is measured using either the intrinsic-value method as prescribed by
Accounting Principle Board Opinion No. 25, "Accounting for Stock Issued to
Employees" (APB 25), or the fair-value method described in FAS 123. We have
elected to follow APB 25 and related interpretations in accounting for our
employee stock options and disclose only the pro forma impact of the fair value
method on net income and earnings per share. (See Note 4, "Stockholders'
Equity.")
F-10
CYGNUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEAR ENDED DECEMBER 31, 1999
(IN THOUSANDS, EXCEPT PER-SHARE DATA)
NEW ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standard No. 133, "Accounting for Derivative
Instruments and Hedging Activities" (FAS 133). FAS 133 requires all derivative
instruments to be recorded on the balance sheet at fair value. Changes in the
fair value of derivatives are recorded each period in current earnings or other
comprehensive income, depending on whether a derivative is designed as part of a
hedge transaction, and, if so, the type of hedge transaction. In June 1999, the
FASB issued FAS No. 137, "Accounting for Derivative Instruments and Hedging
Activities -- Deferral of the Effective Date of FASB Statement No. 133" (FAS
137), which amends FAS 133 to be effective for all fiscal years beginning after
June 15, 2000 (or January 1, 2001 for Cygnus). We do not currently expect that
adoption of FAS 137 will have a material impact on our financial position or
results of operations.
CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS
We consider all highly liquid investments with a maturity from the date of
purchase of three months or less to be cash equivalents. We invest our excess
cash in high credit quality, highly liquid instruments. These investments have
included Treasury Notes, Federal Agency Securities, Auction Rate Certificates,
Auction Rate Preferred Stock, and Commercial Paper.
We consider all short-term investments as available-for-sale. As such,
short-term investments are carried at estimated fair value with related
unrealized gains and losses included in stockholders' net capital deficiency.
Realized gains and losses and declines in value judged to be
other-than-temporary on available-for-sale securities are included in investment
income. The cost of securities sold is based on the specific identification
method. Interest and dividends on securities classified as available-for-sale
are included in investment income.
DEFERRED FINANCING COSTS
Deferred financing costs relate to costs incurred in connection with debt
financing that are amortized over the term of the related debt.
F-11
CYGNUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEAR ENDED DECEMBER 31, 1999
(IN THOUSANDS, EXCEPT PER-SHARE DATA)
NOTE 2: FAIR VALUE OF FINANCIAL INSTRUMENTS
The following is a summary of cash equivalents and investments as of
December 31, 1999 and 1998:
GROSS GROSS ESTIMATED
UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
-------- ---------- ---------- ---------
AS OF DECEMBER 31, 1999:
Cash Equivalents:
Money Market Fund.............................. $20,744 $-- $ -- $20,744
Certificate of Deposit......................... 871 -- -- 871
Short-term Corporate Note/Commercial Paper, due
in less than ninety days..................... 5,971 -- -- 5,971
------- --- ---- -------
Total Cash Equivalents....................... $27,586 $-- $ -- $27,586
======= === ==== =======
Short-Term Investments:
Federal Agency Securities...................... $ 3,819 $-- $(15) $ 3,804
Auction Rate Certificates...................... 6,411 -- -- 6,411
------- --- ---- -------
Total Short-Term Investments................. $10,230 $-- $(15) $10,215
======= === ==== =======
AS OF DECEMBER 31, 1998:
Cash Equivalents:
Money Market Fund.............................. $ 3,961 $-- $ -- $ 3,961
Certificate of Deposit......................... 4,000 -- -- 4,000
Federal Agency Security, due in less than
ninety days.................................. 1,305 -- -- 1,305
------- --- ---- -------
Total Cash Equivalents....................... $ 9,266 $-- $ -- $ 9,266
======= === ==== =======
Short-Term Investments:
Federal Agency Securities...................... 2,290 3 -- 2,293
Auction Rate Certificates...................... 11,049 -- -- 11,049
Corporate Notes................................ 1,640 -- -- 1,640
------- --- ---- -------
Total Short-Term Investments................. $14,979 $ 3 $ -- $14,982
======= === ==== =======
Long-Term Investments:
Federal Agency Securities...................... $ 3,613 $11 $ (2) $ 3,622
------- --- ---- -------
Total Long-Term Investments.................. $ 3,613 $11 $ (2) $ 3,622
======= === ==== =======
F-12
CYGNUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEAR ENDED DECEMBER 31, 1999
(IN THOUSANDS, EXCEPT PER-SHARE DATA)
For the years ended December 31, 1999 and 1998 the net realized gains and
losses on available-for-sale securities were immaterial.
NOTE 3: CREDIT LINES AND LONG-TERM DEBT
In 1998, we consolidated and amended our working capital bank loans. The new
loan will be repaid through November 2001. As of December 31, 1999, there was
$5.6 million outstanding under this agreement. The line bears interest at one
percentage point above the prime rate (9.50% in total as of December 31, 1999).
In June 1997, we entered into a loan agreement for $1.3 million to finance
additional capital equipment. This line bears interest at a fixed rate of 9.39%
per year. Borrowings under this agreement are secured by specific Cygnus assets.
This loan is being repaid monthly through June 2000. As of December 31, 1999,
there was $0.3 million outstanding. In the second quarter of 1998, we entered
into a new loan agreement for $1.4 million to finance additional capital
equipment. This line bears interest at a fixed rate of 8.87% per year.
Borrowings under this agreement are also secured by specific Cygnus assets and
are being repaid monthly through July 2001. As of December 31, 1999, there was
$0.4 million outstanding. All loan agreements are subject to certain financial
covenants, including minimum cash balances and tangible net worth. If certain of
these covenants are not met, the lenders may require collateral of the amounts
outstanding. In the event of default, the lenders may, at their option, exercise
their rights to remedies specified in the loan agreements, which include, among
other things, the acceleration of amounts due under the agreements. As of
December 31, 1999, we were in compliance with all these covenants.
In December 1999, we repaid all our lease liabilities and, consequently, at
December 31, 1999 we did not have any assets under capital lease. The future
aggregate principal payments of long-term debt, including equipment financing
lines, are as follows:
LONG-TERM
DEBT
---------
Years ending December 31,
2000...................................................... $3,243
2001...................................................... 3,088
------
Total principal payments................................ $6,331
======
The fair market value of the long-term debt approximates its carrying value
of $6,331.
We lease our facilities under non-cancelable operating leases expiring in
2003 for three of our four buildings. The terms of the leases provide for rental
payments on a graduated scale. We are recognizing rent expense on a
straight-line method over the lease periods and therefore have accrued for the
rent expense incurred but not paid. Additionally, we lease an off-site warehouse
with a three-year lease term ending in October 2001.
F-13
CYGNUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEAR ENDED DECEMBER 31, 1999
(IN THOUSANDS, EXCEPT PER-SHARE DATA)
Rent expense amounted to $1,861, $1,064, and $1,020 for the years ended
December 31, 1999, 1998, and 1997, respectively. Two of our buildings have been
subleased, and these subleases run concurrently with the operating leases.
Minimum future rental commitments and minimum future sublease rental
receipts under the operating leases on December 31, 1999 are as follows:
MINIMUM MINIMUM
FUTURE FUTURE
RENTAL SUBLEASE RENTAL
COMMITMENTS RECEIPTS
----------- ---------------
Years ending December 31,
2000....................................... $2,109 $ 882
2001....................................... 2,135 905
2002....................................... 2,017 931
2003....................................... 1,963 904
------ ------
$8,224 $3,622
====== ======
NOTE 4: STOCKHOLDERS' EQUITY
PREFERRED SHARE PURCHASE RIGHTS PLAN
Pursuant to our Stockholder Rights Plan, the Board of Directors declared a
dividend distribution of one Preferred Share Purchase Right ("Right") for each
outstanding share of Common Stock, issuable on October 18, 1993 to stockholders
of record on that date. These Rights will remain outstanding until
September 21, 2003.
WARRANTS
Currently, we account for all warrants issued in connection with services
rendered on the basis of the fair value of the warrants. We estimate the fair
value of such instruments by running a Black-Scholes model, and the fair value
thus computed is then recognized over the period for which the underlying
services are rendered.
On February 23, 1999, we issued two warrants to a consultant to purchase 60
thousand shares each for the exercise price of $0.01 and $3.25, respectively, in
connection with financing services rendered by the consultant. A fair value of
$335 thousand, computed on the basis of a Black-Scholes valuation model, was
ascribed to these warrants and was expensed at the time the services were
rendered. These warrants were exercised in February 1999 and April 1999,
respectively.
F-14
CYGNUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEAR ENDED DECEMBER 31, 1999
(IN THOUSANDS, EXCEPT PER-SHARE DATA)
In conjunction with the issuance of Convertible Debentures, we issued
five-year warrants to purchase 795 thousand shares of Common Stock, all of which
are outstanding at December 31, 1999. The fair value of these warrants was
determined to be $6.6 million and is being amortized over the term of the
Convertible Debentures. The total amortization of the fair value of the 795
thousand warrants in 1999 was $0.6 million. Included in the warrants for 795
thousand shares of Common Stock were warrants to purchase 745 thousand shares of
Common Stock that were issued to Investors. These warrants had a valuation of
$6.1 million and were recorded as a debt discount to the Convertible Debentures.
EMPLOYEE STOCK PURCHASE PLAN
As part of an employee retention program, we established the Amended 1991
Employee Stock Purchase Plan, as Amended and Restated as of October 1, 1999 (the
"Stock Purchase Plan") to provide employees with an opportunity to purchase our
Common Stock through payroll deductions. A total of 1.275 million shares of
Common Stock were reserved for issuance to eligible employees under the Stock
Purchase Plan. The Stock Purchase Plan will terminate in 2011 unless sooner
terminated by the Board of Directors. Under this Stock Purchase Plan, our
employees, subject to certain restrictions, may purchase shares of Common Stock
at 85% of the lesser of the fair market value of the Common Stock on the date of
the beginning of the two-year offering or the end of the purchase period. During
1999, 1998 and 1997, 250 thousand shares, 116 thousand shares and 64 thousand
shares, respectively, were issued under the Stock Purchase Plan, and, at
December 31, 1999, 461 thousand shares were available for issuance.
STOCK INCENTIVE PLAN
We have a 1999 Stock Incentive Plan (the "Stock Plan") that authorizes the
Board of Directors to grant incentive stock options, nonstatutory stock options,
stock purchase rights and stock bonuses to employees and consultants. The Stock
Plan authorizes the issuance of up to 7.916 million Common Shares, of which
1.447 million were available for grant as of December 31, 1999. Under the Stock
Plan, incentive stock options must be granted at fair market value at the date
of grant as determined by the Board of Directors or a committee thereof. Options
generally vest over a four-year period and are exercisable for a term of ten
years after issuance, unless otherwise determined by the Board of Directors or a
committee thereof.
We have elected to follow Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees" (APB 25), and related interpretations
in accounting for our employee stock options because the alternative fair value
accounting provided for under FAS Statement No. 123, "Accounting for Stock-Based
Compensation" (FAS 123), requires use of option valuation models that were not
developed for use in valuing employee stock options. Under APB 25, because the
exercise
F-15
CYGNUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEAR ENDED DECEMBER 31, 1999
(IN THOUSANDS, EXCEPT PER-SHARE DATA)
price of our employee stock options equals the market price of the underlying
stock on the date of grant, no compensation expense is recognized.
OPTION ACTIVITY SUMMARY FOR THE YEAR ENDED DECEMBER 31:
1999 1998 1997
-------------------------- -------------------------- --------------------------
WEIGHTED- WEIGHTED- WEIGHTED-
AVERAGE AVERAGE AVERAGE
OPTIONS EXERCISE OPTIONS EXERCISE OPTIONS EXERCISE
(IN THOUSANDS) PRICE (IN THOUSANDS) PRICE (IN THOUSANDS) PRICE
-------------- --------- -------------- --------- -------------- ---------
Outstanding at beginning
of year................. 4,427 $11.34 3,277 $13.26 2,432 $11.81
Granted................... 973 $ 6.78 1,458 $ 7.72 1,346 $14.96
Granted outside Plan...... 20 $ 3.25
---- ---- ---- ----
Exercised................. (852) $ 6.97 (25) $ 8.51 (258) $ 8.35
Forfeited................. (1,369) $13.20 (303) $14.36 (243) $13.24
------ ----- -----
Outstanding at end of
year.................... 3,179 $10.31 4,427 $11.34 3,277 $13.27
====== ===== =====
Exercisable at end of
year.................... 1,567 $12.90 2,512 $12.65 1,627 $11.89
====== ===== =====
Weighted-average fair
value of options granted
during the year......... $ 3.83 $4.26 $7.13
A summary of our stock option position as of December 31, 1999 is as
follows:
OPTIONS OUTSTANDING EXERCISABLE
-------------------------------------------------- -------------------------------
NUMBER WEIGHTED- NUMBER
OUTSTANDING AVERAGE WEIGHTED- EXERCISABLE WEIGHTED-
RANGE OF AT YEAR END REMAINING AVERAGE AT YEAR END AVERAGE
EXERCISE PRICES (IN THOUSANDS) CONTRACTUAL LIFE EXERCISE PRICE (IN THOUSANDS) EXERCISE PRICE
--------------- -------------- ---------------- -------------- -------------- --------------
$3.2500 - $3.2500 564 5.56 $ 3.2500 139 $ 3.2500
$4.2500 - $5.7500 671 9.15 $ 5.7218 10 $ 5.6567
$5.8750 - $11.1250 632 5.74 $ 8.8875 504 $ 8.5034
$11.6250 - $14.5000 662 7.37 $14.1363 424 $14.3511
$15.0000 - $22.5000 650 7.06 $18.6768 490 $19.0489
----- -----
3,179 7.05 $10.3130 1,567 $12.8982
===== =====
Pro forma information regarding net income and earnings per share is
required by FAS 123, which also requires that the information be determined as
if we had accounted for our employee stock options granted subsequent to
December 31, 1994 under the fair-value method of FAS123. The
F-16
CYGNUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEAR ENDED DECEMBER 31, 1999
(IN THOUSANDS, EXCEPT PER-SHARE DATA)
fair value for these options and the fair value for the stocks issued under the
Stock Purchase Plan were estimated at the date of grant using a Black-Scholes
option pricing model with the following weighted-average assumptions for 1999,
1998 and 1997: risk-free interest rate of 5.88%, 4.25% and 5.41%, respectively;
a dividend yield of 0.0%; volatility factors of the expected market price of our
Common Stock of .82, .78, and .66, respectively; and a weighted-average expected
life of the option of five years.
The Black-Scholes option valuation model was developed for use in estimating
the fair value of traded options that have no vesting restrictions and are fully
transferable. In addition, option valuation models require the input of highly
subjective assumptions, including the expected stock price volatility. Because
our employee stock options have characteristics significantly different from
those of traded options, and because changes in the subjective input assumptions
can materially affect the fair value estimate, in management's opinion the
existing models do not necessarily provide a reliable single measure of the fair
value of our employee stock options.
For purposes of pro forma disclosures, the estimated fair value of the
options issued under the Stock Plan is amortized to expense over the vesting
period of the options. The estimated fair value of the compensation benefit
received under the Stock Purchase Plan is expensed in the year of purchase. Our
pro forma information follows:
1999 1998 1997
-------- -------- --------
Pro forma net loss................................. $(8,576) $(44,898) $(54,691)
Pro forma net loss per share, basic and diluted.... $ (0.37) $ (2.22) $ (2.89)
Under the Stock Plan, stock may be sold and stock bonuses or rights to
purchase Common Stock may be granted by the Board of Directors or a committee
thereof for past services at the fair market value at the date of grant. The
Board may impose certain repurchase rights, in favor of Cygnus, in the event
that an employee is terminated prior to certain predetermined vesting dates. As
of December 31, 1999, 1998 and 1997, no shares were subject to repurchase.
F-17
CYGNUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEAR ENDED DECEMBER 31, 1999
(IN THOUSANDS, EXCEPT PER-SHARE DATA)
COMMON STOCK RESERVED FOR FUTURE ISSUANCE
At December 31, 1999, the total number of shares of Common Stock reserved
for issuance are as follows:
COMMON STOCK
RESERVED
------------
Under all employee stock plans............................ 5,087
Convertible Debentures.................................... 1,355
Outstanding warrants...................................... 795
Other potential issuances................................. 335
-----
Total Common Stock reserved............................. 7,572
=====
NOTE 5: INCOME TAXES
We recorded a $0.2 million income tax provision for the year ended
December 31, 1999 consisting entirely of foreign withholding taxes.
Significant components of our deferred tax assets as of December 31, 1999
and 1998 are as follows:
YEAR ENDED
DECEMBER 31,
-------------------
1999 1998
-------- --------
Net operating loss carryforwards............................ $ 54,000 $ 46,000
Research and development credits............................ 5,800 3,600
Reserves and accruals....................................... 700 4,500
Capitalized R&D............................................. 4,400 7,900
Arbitration obligation...................................... 9,500 10,000
Other--net.................................................. 4,400 2,700
-------- --------
Total deferred tax assets................................. $ 78,800 $ 74,700
Valuation allowance for deferred tax assets............... (78,800) (74,700)
-------- --------
Net deferred tax assets..................................... $ -- $ --
======== ========
Realization of deferred tax assets is dependent on future earnings, if any,
the timing and amount of which are uncertain. Accordingly, a valuation allowance
in an amount equal to the net deferred tax assets as of December 31, 1999 and
1998 has been established to reflect these uncertainties. The deferred tax asset
valuation allowance increased by $4.1 million and $17.4 million in 1999 and
1998, respectively.
F-18
CYGNUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEAR ENDED DECEMBER 31, 1999
(IN THOUSANDS, EXCEPT PER-SHARE DATA)
Approximately $5.8 million of the valuation allowance results from tax
deductions under the stock option plans and will be credited to Common Stock
when recognized.
At December 31, 1999, we had federal net operating loss and research and
development tax credit carryforwards of approximately $152.6 million and $3.7
million, respectively. We had state net operating loss and tax credit
carryforwards of approximately $36.5 million and $3.1 million, respectively.
These carryforwards will expire at various dates beginning in 2000 and through
2018.
Because of the "change in ownership" provisions of the Internal Revenue
Code, a substantial portion of our net operating loss and tax credit
carryforwards may be subject to annual limitations. The annual limitations may
result in the expiration of net operating losses and tax credits before
utilization.
NOTE 6: STATEMENTS OF CASH FLOWS DATA
1999 1998 1997
-------- -------- --------
SUPPLEMENTAL DISCLOSURE OF CASH FLOWS INFORMATION
Interest paid............................................... $ 1,352 $2,834 $1,631
Foreign tax paid............................................ $ 200 $ -- $ --
SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING AND FINANCING
ACTIVITIES
Conversion of principal and related interest of Senior
Subordinated Convertible Notes into Common Stock.......... $10,267 $ -- $ --
Fair value of the Common Stock warrants issued to Investors
and placement agent in connection with the Convertible
Debentures................................................ $ 6,572 $ -- $ --
NOTE 7: DISCONTINUED OPERATIONS
On December 15, 1999, we completed the sale of substantially all of our drug
delivery business to Ortho-McNeil Pharmaceutical, Inc. ("Ortho-McNeil"). We sold
all of our drug delivery business to Ortho-McNeil except two contracts relating
to a nicotine patch under development and one other early-stage project, both of
which were terminated prior to year end. Under the terms of the agreement, we
received $20.0 million in cash at closing, and Ortho-McNeil is obligated to pay
up to an additional $55.0 million in cash, contingent on the achievement of
certain milestones. The remaining contingent payments relate to the achievement
of certain technical, regulatory and commercialization milestones related to the
EVRA transdermal contraceptive patch. We are eligible to receive up to $14.8
million of these contingent milestones in the year 2000; however, because the
achievement of these milestones is not within our control, we cannot predict the
likelihood or timing of these contingent payments in the year 2000 and beyond.
The revenues of the drug delivery business were $12.3 million, $11.2 million and
$27.4 million for the years ended December 31, 1999,
F-19
CYGNUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEAR ENDED DECEMBER 31, 1999
(IN THOUSANDS, EXCEPT PER-SHARE DATA)
1998 and 1997, respectively. The net income/(loss) of the drug delivery business
was $3.0 million, $1.0 million and $(35.3) million for the years ended
December 31, 1999, 1998 and 1997, respectively.
NOTE 8: BUSINESS SEGMENTS
Prior to December 15, 1999, we operated in two business segments:
diagnostics and drug delivery. Both segments were engaged in development and
manufacture, utilizing proprietary technologies to satisfy unmet medical needs
cost effectively. The segments were strategic business units managed separately,
based on the differences in the technologies of their respective product lines.
On December 15, 1999, we completed the sale of substantially all of our drug
delivery business segment assets to Ortho-McNeil Pharmaceutical, Inc., except
for certain assets with a net book value of $505 thousand, of which assets with
a net book value of $205 thousand were written off prior to year end. The
remaining drug delivery assets are being held for sale at December 31, 1999 and
have a value of $300 thousand, which reflects management's best estimates of net
realizable value. All financial results related to the drug delivery business
are accounted for as discontinued operations in accordance with APB 30.
The accounting policies of the business segments are the same as those
described in the summary of significant accounting policies. We do not currently
have a measure of interest income or interest expense by business segment. We
utilized the following information for the purpose of making decisions and
assessing segments' performance.
F-20
CYGNUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEAR ENDED DECEMBER 31, 1999
(IN THOUSANDS, EXCEPT PER-SHARE DATA)
The table below details the segment information prior to the sale of the
drug delivery business, with a reconciling column to reflect totals related to
continuing operations.
BUSINESS SEGMENTS
----------------------------------------------------
CONTINUING
DRUG OPERATIONS
DIAGNOSTICS DELIVERY RECONCILIATION TOTAL
----------- -------- -------------- ----------
1999
Revenue..................................... $ 2,061 $ 12,293 $(12,293) $ 2,061
Profit/(loss)............................... (22,174) 3,031 (3,031) (22,174)
Depreciation and amortization............... 993 869 (869) 993
Other significant items:
Gain on sale of segment................... -- 16,308 (16,308) --
Identifiable assets......................... 46,976 1,036 (1,036) 46,976
1998
Revenue..................................... $ 457 $ 11,198 $(11,198) $ 457
Profit/(loss)............................... (40,434) 1,006 (1,006) (40,434)
Depreciation and amortization............... 950 971 (971) 950
Other significant items:
Beneficial conversion costs............... 4,230 -- -- 4,230
Identifiable assets......................... 39,130 4,324 -- 43,454
1997
Revenue..................................... $ 2,146 $ 27,356 $(27,356) $ 2,146
Profit/(loss)............................... (15,117) (35,343) 35,343 (15,117)
Depreciation and amortization............... 1,230 1,509 (1,509) 1,230
Other significant items:
Arbitration settlement.................... -- (39,666) 39,666 --
Writedown of assets....................... 15 1,275 (1,275) 15
Identifiable assets......................... 42,955 6,322 -- 49,277
All segment revenues have been generated in the U.S., and we currently do
not have any long-lived assets outside the U.S.
NOTE 9: CONVERTIBLE DEBT NOTES
SENIOR SUBORDINATED CONVERTIBLE NOTES
In February 1998, we entered into Note Purchase Agreements with certain
institutional investors to issue and sell approximately $43.0 million of 4%
Senior Subordinated Convertible Notes Due in 2005 ("Notes"). On October 28,
1998, we restructured the Notes. Key provisions in the restructured
F-21
CYGNUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEAR ENDED DECEMBER 31, 1999
(IN THOUSANDS, EXCEPT PER-SHARE DATA)
Notes included the October 1998 repayment of $18.5 million in principal
(reducing the principal balance from $43.0 million to $24.5 million), a delay in
the convertibility of the majority of the Notes to June 30, 1999 or after,
modification of the conversion prices of the Notes, our ability to redeem at par
at any time all or part of the new principal amount of the Notes, an increase in
the interest rate to 5.5% paid annually on the new principal balance and a
change in the final maturity of the Notes to October 1, 2000.
The restructured Notes, which totaled $24.5 million, were divided into three
tranches. The first tranche had an original principal amount of $6.0 million and
was fully converted into Common Stock by January 1999 at $3.54 per share. The
second tranche also had an original principal amount of $6.0 million and was
fully converted into Common Stock on June 30, 1999 at $6.89 per share (such
conversion price determined by a market-based formula on February 1, 1999). The
third tranche of the restructured Notes had an original principal amount of
$12.5 million and could not have been converted into Common Stock until July 1,
1999, at a conversion price that would have been determined based on
market-based pricing formulas which contained look-back provisions. Also, under
the terms of the restructured Notes, if we issued a call before July 1, 1999 for
the redemption of the third tranche, the Note Holders would not be entitled to
convert any portion of that tranche. On June 29, 1999, we issued redemption
notices for the entire third tranche and, accordingly, the Note Holders were not
entitled to convert any portion of that tranche. On July 9, 1999, we paid $12.5
million in principal and $0.4 million in accrued interest to redeem the third
tranche. As a result, the remaining unamortized debt issuance costs of $1.1
million were expensed.
On the date the Notes were restructured (October 28, 1998), the conversion
price for the first tranche was below the quoted market price of our Common
Stock. Consequently, we computed a beneficial conversion feature by comparing
the quoted market price of our Common Stock on that date ($6.06125) to the
conversion price of the first tranche ($3.5375) and then by multiplying the
difference by the number of shares (1.7 million) into which the first tranche
was convertible. The above computation resulted in a total charge of
$4.2 million, which was written off as interest expense at the date of
restructuring.
In order to help finance the redemption of the third tranche discussed
above, and to provide additional capital, in 1999 we entered into two new
financing arrangements: a Convertible Debenture and Warrant Purchase Agreement
and a Structured Equity Line Flexible Financing Agreement.
CONVERTIBLE DEBT AGREEMENT
On June 29, 1999, we entered into a Convertible Debenture and Warrant
Purchase Agreement with institutional investors ("Investors") to issue and sell
$14.0 million principal amount of 8.5% Convertible Debentures Due June 29, 2004
("Convertible Debentures"). These Convertible Debentures are convertible into
shares of Common Stock at any time at a conversion price of $12.705 per
F-22
CYGNUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEAR ENDED DECEMBER 31, 1999
(IN THOUSANDS, EXCEPT PER-SHARE DATA)
share. We received gross proceeds of $14.0 million from the issuance of the
Convertible Debentures and incurred debt issuance costs of $0.5 million. With
the mutual agreement of the Investors and us, or if certain trading volume,
pricing and other conditions are met, we and/or the Investors will have the
right to require the sale to existing Investors of an additional $6.0 million in
additional aggregate principal amount of Convertible Debentures in two separate
tranches of $3.0 million each (each an "Additional Tranche"), provided that the
second Additional Tranche notice date may not be earlier than sixty days after
the first Additional Tranche notice date. The conversion price for each
Additional Tranche will be the average of the closing bid prices for the ten
trading days prior to and including the respective Additional Tranche notice
date and the ten trading days subsequent to the respective Additional Tranche
notice date ("Additional Closing Price") multiplied by 110%. On September 29,
1999 we received $3.0 million in gross proceeds from the issuance of the first
Additional Tranche due September 29, 2004, with a conversion price of $11.8663
(determined by the above market-based formula), and incurred debt issuance costs
of $0.1 million. Neither the June 29, 1999 nor the September 29, 1999
Convertible Debentures contained any beneficial conversion features.
In conjunction with the issuance of Convertible Debentures in June, 1999,
and the first Additional Tranche in September 1999, we issued to the debenture
holders warrants to purchase approximately 606 thousand shares and 139 thousand
shares of Common Stock, at the exercise price of $13.86 per share and $16.18 per
share, respectively. Each tranche of warrants had a contractual term of
five years from the date of respective grant. At the respective dates of grant,
the fair values ascribed to these warrants were approximately $5.0 million and
$1.1 million, respectively, based on a Black-Scholes valuation model, and
recorded as debt discount and are being amortized as additional interest expense
over the debt term. We recorded amortization of $0.6 million in 1999. As of
December 31, 1999, the unamortized fair value amounted to $5.5 million. We will
be required to issue warrants if the second Additional Tranche of the
Convertible Debentures is sold. Such warrants will be priced at 150% of the
respective Additional Closing Price. The number of additional warrants to be
issued will be determined by dividing 50% of the respective Additional Tranche
by the respective Additional Closing Price.
We also issued to the placement agent warrants to purchase 50 thousand
shares of Common Stock at the exercise price of $13.86 per share. At the date of
grant, the fair value ascribed to the warrants was approximately $417 thousand,
based on a Black-Scholes valuation model, and that amount was recorded as
deferred financing cost and is being amortized as additional interest expense
over the debt term. We recorded amortization of $42 thousand in 1999.
The Convertible Debentures have a stated interest rate of 8.5% and an
effective interest rate of 18.20%. The effective interest rate includes a
non-cash charge of $6.6 million for the amortization of the implicit value of
warrants issued in connection with the Convertible Debentures.
F-23
CYGNUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEAR ENDED DECEMBER 31, 1999
(IN THOUSANDS, EXCEPT PER-SHARE DATA)
STRUCTURED EQUITY LINE NOTES
On June 30, 1999, we also entered into a Structured Equity Line Flexible
Financing Agreement ("Equity Line") with certain institutional investors
("Investors"). The Equity Line is effective for two years ("Commitment Period")
and allows us, at our sole discretion, to sell Common Stock with a maximum
aggregate issue price of $30.0 million over the Commitment Period. On June 30,
1999, we received net proceeds of approximately $3.8 million, after deducting
the issuance costs, from the sale of approximately 346 thousand shares of Common
Stock (the "Initial Investment"). The number of shares of Common Stock for the
Initial Investment was determined on the basis of the average closing bid price
for the ten trading days prior to June 30, 1999 ("Initial Investment Purchase
Price"). Under the terms of the Equity Line, over a period of eighty
trading days following June 30, 1999 ("Initial Period"), the Investors were
required to deliver purchase notices from time to time for the aggregate amount
of the Initial Investment ($4.0 million) to purchase shares of our Common Stock.
The per-share price for each such purchase notice equaled 98% of the average of
the two lowest daily trade prices during the six trading days immediately prior
to the respective purchase notice. The number of shares originally issued was
subject to an upward adjustment, if required, to match the aggregate number of
shares covered by the $4.0 million of purchase notices. We issued an additional
92 thousand shares to reflect the actual purchase prices on the purchase
notices.
On September 29, 1999, we issued 361 thousand shares of Common Stock for
$4.0 million ("Additional Investment") pursuant to an amendment to the Equity
Line agreement which allowed for an Additional Investment period of 110 days
("Additional Period"). The terms for this Additional Investment are similar to
those applied to the Initial Investment, and the number of shares was adjusted
upwards at the end of the Additional Period, resulting in the issuance of an
additional 92 thousand shares of Common Stock.
After the Initial Period and the Additional Period, on a monthly basis
("Investment Period"), we can elect, at our sole discretion, to sell up to $1.5
million ("Company Election") in additional shares of Common Stock. In addition
to the above and upon our approval, the Investors may also elect to purchase an
additional $1.0 million ("Investor Election") of Common Stock in each Investment
Period. In each Investment Period in which we elect to sell additional shares,
the Investors will from time to time issue purchase notices for the aggregate
amount of the Company Election and the Investor Election, if applicable. The
per-share price of Common Stock to be sold for each such purchase notice will
equal 98% of the average of the two daily low trade prices during the six
trading days immediately prior to the respective purchase notice. At the
beginning of each Investment Period, we can set a minimum sales price ("Floor
Price") for our Common Stock. The Investors may require the aggregate dollar
amount of the Company Election and Investor Election for any Investment Period
to be less than requested, based on certain market trading volume guidelines. In
December 1999, we sold 100 thousand shares of Common Stock for $1.5 million
pursuant to the
F-24
CYGNUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEAR ENDED DECEMBER 31, 1999
(IN THOUSANDS, EXCEPT PER-SHARE DATA)
Equity Line. In January 2000, we sold an additional 59 thousand share of Common
Stock for $1.0 million pursuant to the Equity Line.
In conjunction with the Equity Line, in January 2000 we issued five-year
warrants to the Investors to purchase 95 thousand shares of Common Stock at
$11.51 per share. The price of the warrants will be determined each calendar
year and will equal 120% of the weighted-average per-share sales price of all
shares of Common Stock sold pursuant to the Equity Line that year. The number of
shares will equal 1% of the aggregate proceeds received for all shares sold
pursuant to the Equity Line during the year. In January 2000, we issued warrants
to purchase 95 thousand shares of Common Stock. Warrants to purchase a minimum
of 120 thousand shares must be issued under the Equity Line and, if at the end
of the Commitment Period, warrants to purchase less than 120 thousand shares of
Common Stock have been issued, we must issue a warrant to purchase the number of
shares equal to the difference, at a price equal to 120% of the average exercise
price of all warrants previously issued pursuant to the Equity Line.
NOTE 10: RELATED PARTY TRANSACTIONS
We do business with two companies, including Contract Manufacturing, Inc.,
that are principally owned by a Cygnus non-officer employee. This individual's
employment with us will terminate on March 31, 2000. The two companies primarily
design and build manufacturing equipment for the GlucoWatch system and
manufacture components of the GlucoWatch system. During 1999, we purchased
approximately $3.2 million of goods and services from these companies. As of
December 31, 1999, we had non-cancelable purchase commitments to these companies
totaling $0.7 million. During 1998, we purchased approximately $4.0 million of
goods and services from these companies. As of December 31, 1998, $1.0 million
was payable to these companies. During 1997, we purchased approximately $2.7
million of goods and services from these companies.
NOTE 11: CONCENTRATION OF CREDIT RISK
We maintain our cash, cash equivalents and investments primarily with a bank
and two brokerage houses. This practice is consistent with our policy to
maintain high liquidity and to ensure safety of principal.
As of December 31, 1999, 100% of the trade accounts receivable are due from
one customer. As of December 31, 1998, three customers accounted for
approximately 61%, 18% and 18%, respectively, of the trade accounts receivable.
The remaining balances of the 1998 trade accounts receivable are due from two
customers, which are large pharmaceutical companies. Generally, we do not
require any collateral on receivable balances.
F-25
CYGNUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
FOR THE YEAR ENDED DECEMBER 31, 1999
(IN THOUSANDS, EXCEPT PER-SHARE DATA)
NOTE 12: EMPLOYEE BENEFIT PLAN
We have an employee savings plan ("Plan") that qualifies as a deferred
salary arrangement under Section 401(k) of the Internal Revenue Code covering
substantially all employees. The Plan provides for employee contributions up to
15% of their annual pre-tax compensation or to a maximum of 17% of the combined
pre-tax and after-tax compensation, as defined in the Plan. The Plan provides
for Cygnus to match a portion of the contributions. For the years ended
December 31, 1999, 1998 and 1997, we incurred defined contribution expense of
$0.08 million, $0.1 million and $0.08 million, respectively.
NOTE 13: LEGAL PROCEEDINGS
On November 20, 1998, the American Arbitration Association issued a Final
Award, which was not appealable, in an arbitration proceeding between Cygnus and
Pharmacia & Upjohn relating to the Nicotrol patch. Pursuant to the findings from
the arbitration proceedings, we were awarded $4.3 million for prevailing in some
of our claims, and Pharmacia was awarded $1.6 million for prevailing on some of
their claims. Accordingly, Cygnus realized a net amount of $2.7 million in 1998.
The Nicotrol patch business was sold to Ortho-McNeil as part of our drug
delivery sale.
On December 11, 1997, the International Court of Arbitration issued a Final
Award, which was not appealable, in an arbitration matter between Sanofi, S.A.
and Cygnus relating to transdermal hormone replacement therapy systems. This
Final Award was entered as a judgment of the U.S. District Court for the
Northern District of California. Although the drug delivery business was
subsequently sold to Ortho-McNeil, the following payments remain with Cygnus:
(i) the $14.0 million cash payment already made by Cygnus to Sanofi in
January 1998, (ii) payments of an aggregate amount equal to $17.0 million,
commencing in 2001 and ending in 2005 ($2.0 million for the year 2001,
$3.0 million for the year 2002, $4.0 million for the year 2003, $4.0 million for
the year 2004 and $4.0 million for the year 2005), and (iii) a convertible
promissory note in the principal amount of $6.0 million, issued in
December 1997, payable in full at the end of four years and bearing interest at
6.5% per annum. (The note will be convertible into our Common Stock at Sanofi's
option, exercisable at any time during the four year term, at a conversion rate
of $21.725 per share.) The underlying agreement, which was the subject matter of
the arbitration, was terminated on December 15, 1999.
F-26
SCHEDULE II
CYGNUS, INC.
VALUATION AND QUALIFYING ACCOUNTS
YEARS ENDED DECEMBER 31, 1999, 1998, AND 1997
(IN THOUSANDS)
BALANCE AT CHARGED TO CHARGED TO
BEGINNING OF COSTS AND OTHER BALANCE AT
YEAR EXPENSES ACCOUNTS DEDUCTIONS END OF YEAR
------------ ---------- ---------- ---------- -----------
YEAR ENDED DECEMBER 31, 1999:
DEDUCTED FROM ASSET ACCOUNTS:
ALLOWANCE FOR DOUBTFUL
ACCOUNTS.................... $ 123 $ -- $(123) $ -- $ --
WARRANTY RESERVE.............. 435 (435) -- -- --
------ ----- ----- ------- ----
$ 558 $(435) $(123) $ -- $ --
====== ===== ===== ======= ====
YEAR ENDED DECEMBER 31, 1998:
DEDUCTED FROM ASSET ACCOUNTS:
ALLOWANCE FOR DOUBTFUL
ACCOUNTS.................... $ 123 $ -- $ -- $ -- $123
WARRANTY RESERVE.............. 435 -- -- -- 435
------ ----- ----- ------- ----
$ 558 $ -- $ -- $ -- $558
====== ===== ===== ======= ====
YEAR ENDED DECEMBER 31, 1997:
DEDUCTED FROM ASSET ACCOUNTS:
ALLOWANCE FOR DOUBTFUL
ACCOUNTS.................... $1,137 $ -- $ -- $(1,014) $123
WARRANTY RESERVE.............. 435 -- -- -- 435
------ ----- ----- ------- ----
$1,572 $ -- $ -- $(1,014) $558
====== ===== ===== ======= ====
S-1