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SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
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FORM 10-K
(Mark One)
[X]ANNUAL REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF
1934
For the fiscal year ended December 31, 2000
[_]TRANSITION REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT
OF 1934
For the transition period from to
Commission File Number: 0-15324
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STAR SCIENTIFIC, INC.
(Exact name of registrant as specified in its charter)
Delaware 52-1402131
(State of incorporation) (I.R.S. Employer Identification No.)
801 Liberty Way (804) 530-0535
Chester, VA 23836 (Registrant's telephone number,
(Address of principal executive offices) including area code)
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Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $.01 par value
(Title of Class)
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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 of 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 the Registrant's voting stock held by non-
affiliates of the Registrant as of March 1, 2001 is approximately $25,595,850.
Shares of voting stock held by each executive officer and director and by each
person who owns 5% or more of the Registrant's voting stock have been excluded
in that such persons may be deemed affiliates of the Registrant. This
determination of affiliate status is not necessarily a conclusive
determination for other purposes.
Number of shares outstanding of each class of common equity as of March 1,
2001: 59,008,127 shares of Common Stock.
DOCUMENTS INCORPORATED BY REFERENCE:
None
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NOTE ON FORWARD-LOOKING STATEMENTS
This report on Form 10-K contains certain forward-looking statements within
the meaning of the Private Securities Litigation Reform Act of 1995. The
Company has tried, whenever possible, to identify these forward-looking
statements using words such as "anticipates," "believes," "estimates,"
"expects," "plans," "intends" and similar expressions. These statements
reflect the Company's current beliefs and are based upon information currently
available to it. Forward-looking statements involve known and unknown risks,
uncertainties and other factors which could cause the Company's actual
results, performance or achievements to differ materially from those expressed
in, or implied by, such statements, and any such statements are qualified by
reference to the following factors.
The Company is subject to risks, uncertainties and contingencies that
include, without limitation, the risks of operating in the tobacco industry
even as a health oriented tobacco technology company, the challenges inherent
in new product development initiatives, including market acceptance of the
Company's products and proposed new products, the Company's ability to raise
the capital necessary to grow its business and unforeseen difficulties in the
management of growth, potential disputes concerning the Company's intellectual
property, competition from companies that may have certain competitive
advantages over the Company, the Company's dependence on key employees and its
relationship with Brown & Williamson Tobacco Corporation, a key strategic
customer, supplier and lender, and the Company's decision not to join the
Master Settlement Agreement ("MSA"). Other risks include further regulatory
restrictions on the sale and marketing of tobacco products given the health
concerns related to the use of tobacco products generally, the effect of state
statutes adopted under the MSA and any subsequent modification of the MSA,
litigation, including litigation related to the MSA, and the effects of excise
tax increases on tobacco consumption rates.
See additional discussion under "Factors That May Affect Future Results"
under Item 1 below, and other factors detailed from time to time in the
Company's other filings with the Securities and Exchange Commission.
1
PART I
Item 1. Business
General
Star Scientific, Inc. ("Star") and its wholly-owned subsidiary, Star Tobacco
& Pharmaceuticals, Inc. ("ST&P" and together with Star, the "Company") are
engaged in: (1) the development of scientific technology for the curing of
StarCured(TM) tobacco so as to prevent, retard or significantly reduce the
formation of carcinogenic toxins present in tobacco and tobacco smoke,
primarily, the tobacco specific nitrosamines ("TSNAs"); (2) the development of
tobacco products that deliver substantially less carcinogenic toxins, namely
TSNAs, along with enlarged health warnings and comparative content information
so that adult tobacco consumers will have the option to make informed choices
about the use of tobacco products which pose a range of serious health related
risks (the TSNA levels in the Company's tobacco products will continue to be
substantially reduced to very low levels, measured in parts per billion, using
the StarCured(TM) tobacco curing process); (3) the manufacture and sale of
four discount cigarette brands which currently contain only a small portion of
its very low-TSNA StarCured(TM) tobacco (only because of Star's initial
limited supply and its existing contractual delivery requirements of millions
of pounds of very low-TSNA tobacco to Brown & Williamson Tobacco Corporation
("B&W"), the third largest tobacco company in the United States, as the
Company remains committed to increase the percentage of very low-TSNA tobacco
in its discount products as its supply of very low-TSNA tobacco increases
during the next two growing seasons) and which are equipped with a carbon
(charcoal)/acetate filter which reduces additional gas phase toxins; (4) the
development of very low nitrosamine smokeless tobacco products, i.e., moist
snuff and hard snuff tobacco, using the StarCured(TM) tobacco curing process
to produce cured tobacco with very low levels of carcinogenic TSNAs; and (5)
the research and continued development of smoking cessation products.
The Company's primary focus will continue to be the research and development
of products that deliver less toxins. The Company's overall objective is to
reduce the range of serious health hazards associated with the use of smoked
tobacco products. Accordingly, its primary corporate mission is to demonstrate
the commercial viability of products that deliver less toxins and are
potentially less harmful, although the Company has attempted to share with
adult consumers the fact that there is not now sufficient evidence to
demonstrate that reduced toxin delivery can be quantified in terms of reduced
health risk. The Company fully accepts the evidence showing links between
smoking tobacco and a variety of diseases and premature death and believes
that it is unlikely that the health risks of smoked tobacco can be completely
eliminated. Nevertheless, in a world where an estimated 1.2 billion people
smoke and use other tobacco products, there is an urgent need to reduce the
toxicity of tobacco products to the maximum extent possible given available
technologies. The Company believes that it has a corporate responsibility to
continue to expand its research and development efforts to manufacture tobacco
products in the least hazardous manner possible given available technology,
particularly the StarCured(TM) tobacco curing process. The Company believes it
has the technology to reduce carcinogenic TSNAs to the lowest possible levels
and has demonstrated that the method it has developed for curing tobacco using
the StarCured(TM) tobacco curing process can be scaled up to meet broad
commercial needs in the United States and abroad. The Company is also
committed to continuing to advocate meaningful federal regulation for all
tobacco products and has publicly announced its support for comprehensive
regulation of tobacco products by the United States Food and Drug
Administration (the "FDA").
The Company has an exclusive, worldwide license under patents issued and
patents pending relating to methods to prevent or substantially reduce the
formation of TSNAs in tobacco including the StarCured(TM) tobacco curing
process. TSNAs are generally regarded by recognized cancer researchers and
respected scientists to be among the most abundant and potent carcinogens in
tobacco and tobacco smoke.
The Company's revenues are generated principally through ST&P. ST&P's
predecessor, a closely held private company, was organized in 1990 and, until
1994, primarily was engaged in the business of manufacturing cigars and
cigarettes for others as a contract manufacturer. By late 1994, ST&P had
commenced development and commercialization of its own brands of discount
cigarettes using primarily Virginia flue-cured tobacco and
2
competed principally on the basis of price. At about that same time, ST&P
commenced a program of research and development relating to the development of
a range of tobacco products that deliver less toxins as well as tobacco
cessation products wherein ST&P secured certain Investigatory New Drug
applications ("INDs") from the FDA to commence human clinical testing. Shortly
thereafter, ST&P shifted its near-term research to technology focused on
reducing the carcinogenic TSNAs in the tobacco leaf and tobacco smoke. In
February 1998, ST&P merged with Eye Technology, Inc., a publicly-held OTC
Bulletin Board company based in Minneapolis, Minnesota. While Eye Technology
technically was the surviving corporation, in effect control of the surviving
corporation shifted to the former stockholders of ST&P and the management of
ST&P became the control management of the survivor in the merger. By December
30, 1998, the assets and liabilities that comprised the pre-merger business of
Eye Technology, Inc. had been sold or liquidated, and the stockholders of Eye
Technology voted to change its name to Star Scientific, Inc. The Company's
primary corporate focus from that time forward has centered on the development
of reduced toxin, and potentially reduced risk, tobacco products, and, on a
more long-term basis, development of smoking cessation products either with a
joint venture partner or a corporate pharmaceutical partner with significant
resources, and/or an experience in scientific and regulatory infrastructure so
as to assist and accelerate the Food and Drug Administration's New Drug
Application regulatory process necessary for market entry.
The StarCured(TM) tobacco curing process, to which the Company has an
exclusive license, as discussed herein, from Regent Court Technologies
("Regent Court"), involves the use of specially designed curing barns and in
certain applications microwave and/or electronic beam technology. The
StarCured(TM) process virtually precludes and/or substantially reduces the
formation in the tobacco leaf of the carcinogenic TSNAs, which are widely
believed by medical and scientific experts to be among the most potent and
powerful cancer-causing toxins present in tobacco and in side stream tobacco
smoke. In 1999 and 2000, the Company processed over 3.5 million pounds and
approximately 19 million pounds, respectively, of very low-TSNA flue-cured
tobacco using the StarCured(TM) process, and believes that this process can be
applicable to burley and other varieties of tobacco on a broad-scale
commercial basis. Star continues to support research and technological
development directed to varieties other than flue-cured tobacco and will
conduct limited experiments this year in Kentucky on burley tobacco in
conjunction with Associate Professor Harold Burton and his staff at the
University of Kentucky's Department of Agronomy and The Burley Tobacco Growers
Cooperative Association, Inc.
Star's long-term strategy is to encourage other tobacco manufacturers to
utilize and sub-license the StarCured(TM) tobacco curing technology to produce
very low-TSNA tobacco (carcinogenic NNKs and NNNs at 200 parts per billion and
below). Further, Star is committed to continue to explore the development of
products that deliver less toxins and are potentially less harmful than
conventional smoked tobacco, namely smokeless tobacco products, as well as the
development of tobacco cessation products. The Company has started the process
of integrating its very low-TSNA StarCured(TM) tobacco into ST&P's present
discount cigarette brands. ST&P presently markets four brands, namely,
SPORT(R), MAINSTREET(R), VEGAS(R) and G-SMOKE(R), all of which have activated
charcoal filters and contain approximately 3% of very low-TSNA flue-cured
tobacco because of the limited supply of very low-TSNA tobacco at this time.
The Company expects over the next two growing seasons to be able to
significantly increase the amount of StarCured(TM) low-TSNA flue-cured tobacco
in ST&P's four existing cigarette brands which utilize a carbon/acetate filter
that reduces additional gas phase toxins. In October 2000 the Company launched
its first very low-TSNA conventional premium cigarette, Advance(R), in two
test markets: Richmond, Virginia and Lexington, Kentucky. Advance(R) also has
a carbon/acetate filter aimed at reducing the levels of certain additional
vapor phase toxins. Unlike conventional brands of cigarettes, Advance(R) has
enhanced health warnings on the back of each pack as well as in a series of
package "onserts" attached to each pack of Advance(R).
In February 2001, the Company and B&W signed a non-binding Letter of
Understanding ("Letter of Understanding"). The transactions contemplated by
the Letter of Understanding are subject to execution of definitive agreements.
Under one of the provisions of the Letter of Understanding, B&W will undertake
to test market the Advance(R) brand and potentially to market this brand on a
national basis, if its market tests are successful. The Company intends to
launch its own very low-TSNA cigarette brand by the 3rd quarter of 2001.
3
Under the Letter of Understanding, it is anticipated that Star will process
approximately 18-20 million pounds of very low-TSNA tobacco cured using the
StarCured(TM) tobacco curing process per year for each of the next three years
for sale to B&W and for its own use. The production of this amount of
StarCured(TM) tobacco will allow the Company to integrate its very low-TSNA
StarCured(TM) tobacco into ST&P's four existing brands, to launch a new very
low-TSNA flue-cured cigarette brand aimed at the generic market and very low-
TSNA smokeless products. Contemporaneously it intends to fulfill its tobacco
supply commitments to B&W. (See "Relationship with B&W").
Products
See Note 12 of the Company's Consolidated Financial Statements for financial
information about the Company's segments.
Leaf Tobacco
In 1999 and 2000, Star processed and sold over 3.5 million and approximately
19 million pounds, respectively, of very low-TSNA flue-cured tobacco that had
been cured using the StarCured(TM) tobacco curing process. The vast majority
of these sales were made to B&W, pursuant to Star's contractual arrangements
with B&W described elsewhere in this Report. These sales accounted for
approximately 10% and 21% of the Company's net sales in 1999 and 2000,
respectively. Under the February 2001 Letter of Understanding, it is
anticipated that the Company will process approximately 18-20 million pounds
of very low-TSNA flue-cured tobacco in each of the next three growing seasons
beginning in 2001, for sale to B&W and for use in the Company's own brands.
The tobacco will be cured using the StarCured(TM) tobacco curing process.
The bulk of processed tobacco sales occur in the third and fourth quarter of
each year, resulting in higher revenues in those quarters. The Company's long-
term goal is to derive an increasingly larger percentage of its revenues from
sublicensing the StarCured(TM) tobacco curing process to major cigarette
manufacturers.
Discount Cigarettes
ST&P manufactures and sells four brands of discount cigarettes through
approximately 225 tobacco distributors throughout the United States. These
cigarettes are sold as discount brands. ST&P does not engage in extensive
advertising or marketing programs for its cigarette products, but relies
primarily upon communications with distributors, product placement by its
field sales force (the field sales force focuses primarily on placing ST&P's
products with retailers in Texas, Florida, Mississippi and Minnesota), pricing
appropriate for discount cigarettes, and, to a lesser extent, on brand,
product appearance and taste in order to compete in the marketplace. Star has
avoided any marketing efforts aimed at young persons, and the Company is
committed to keeping its products out of the hands of youngsters. There were
no export sales by the Company in 2000.
In an effort to implement the Company's corporate mission to develop
products that deliver less toxins and potentially less harmful tobacco
products (although the Company does not now have any evidence to support the
scientific conclusions that such products can be classified or considered to
be "reduced risk products"), the Company intends to phase its very low-TSNA
tobacco which has been cured through the StarCured(TM) tobacco curing process
into its discount cigarettes within the next two growing seasons. The Company
is hopeful that meaningful future regulations by the FDA will provide
appropriate scientific and regulatory guidelines and standards under which
tobacco products can be classified as "reduced risk products." As of July 1,
1999, ST&P changed all of its filters to activated carbon/acetate because
several leading health advocates and respected research scientists believe
that activated charcoal filters reduce certain vapor phase toxins in tobacco
smoke. Since January 2001 the Company has undertaken to increase the amount of
activated charcoal in its filters to 30 mg for all new production of ST&P's
discount brands. The Company intends to continue to use activated charcoal
filters in all of ST&P's discount cigarettes, and in Star's new low-TSNA flue-
cured cigarette brand which the Company hopes to develop and market in 2001
for the generic cigarette market.
4
Low-TSNA Cigarettes
Star launched the first very low-TSNA cigarette, Advance(R), in October 2000
in 2 test markets--Richmond, Virginia and Lexington, Kentucky. Advance(R) is
the first conventional cigarette to be manufactured to deliver less
carcinogenic TSNAs. The Advance(R) cigarette reduces additional toxic smoke
constituents through a unique dalmatian type activated carbon/acetate filter.
Advance(R) is also different from conventional premium brands because it
provides adult tobacco consumers with enhanced health warnings (not required
by the Surgeon General) and comparative content information on the back of the
package. Advance(R) also has informational package "onserts" that contain
additional health and related information on the chemical constituents in
Advance(R) compared to leading lights brands as well as detailed information
about the range of adverse health consequences associated with long-term
smoking that affords adult consumers the opportunity to make an informed
choice about products which continue to expose the user to a range of health
risks.
Star intends to introduce a new low-TSNA cigarette brand in 2001. The
Company intends this brand to be a nationally available low-TSNA cigarette,
though the Company plans on focusing sales in Texas, Florida, Minnesota and
Mississippi where the Company's field sales force is positioned.
Smokeless Tobacco Products Containing Very Low-TSNA Tobacco
Scientific research has shown that TSNAs may be the most significant
carcinogens in smokeless tobacco products commonly known as "chew," "dip" and
"snuff". Accordingly, during this past year, Star devoted substantial
resources toward the development of very low-TSNA smokeless tobacco products
and intends to introduce two of these products, a moist snuff and a hard
tobacco product, in 2001. Star views these two new flagship smokeless products
as significant innovations that will continue to transform the tobacco
industry, just as its work with low-TSNA tobacco has created a new industry
standard. However, despite continued research and development, no assurance
can be given at this time that such products will be developed and
successfully commercialized.
Tobacco-Flavored Chewing Gum and Lozenges and Chewing Gum Containing Tobacco
Extract
Approximately four years ago, the Company produced for pilot Phase I testing
both a chewing gum and a tobacco lozenge, each containing very low-TSNA
tobacco, as potential smoking cessation products. The gum/lozenge products
contained nicotine, as well as the MAO-inhibitor known to be present in
tobacco. In anticipation of a then pending legislative proposal to provide the
FDA with new legislative authority to regulate tobacco products, the Company
submitted and received approval of an IND for the gum product from the FDA.
The Company commenced a Phase I Human Clinical Trial in the second quarter of
1998 in order to attempt to demonstrate the safety of this product for smoking
cessation purposes. Given the present uncertain status of the FDA's authority
to regulate tobacco products, among other factors, it now appears that to be
sold as pharmaceutical products these tobacco-containing cessation products
would be required to undergo all of the preclinical and clinical testing
required of a new drug product. It seems unlikely at the present time that
undertaking such testing would produce an adequate return on investment except
if Star partners with an established pharmaceutical or healthcare company that
has the necessary scientific infrastructure to adequately institute the types
of clinical testing necessary to secure an NDA from the FDA. Star continues to
investigate and explore opportunities for these products in Western and
Eastern Europe, and in other countries where regulating authorities appear to
be more receptive to the development of potentially reduced risk products that
deliver less toxins. Star has taken a public position, unanimously supported
by its Board of Directors, that it is in favor of comprehensive FDA regulation
of all tobacco products. Star continues to explore entering into a joint
venture, partnership and/or technology license, preferably with a major
pharmaceutical company, to produce tobacco cessation products using
StarCured(TM) tobacco as the focal point of such products.
Sales and Marketing
ST&P's four brands of discount cigarettes are each sold in a variety of
sizes and styles such as king size and 100s, soft pack and hinged box, regular
flavor and menthol, and full flavor, lights and ultra lights. ST&P utilizes
its own specified blend of tobaccos in each brand. The blend consists of
Virginia flue-cured, burley and oriental varieties of tobacco, which is
typical of American-style cigarettes.
5
ST&P uses stylized packaging designs for its four brands of discount
cigarettes. As is typical in the cigarette industry, ST&P utilizes different
colors, such as green for menthol and similar designs on its packaging to
denote different product styles. It is ST&P's strategy to rely to a large
degree upon distributors to promote ST&P's brands to retail customers. ST&P
provides to its distributor customers, for redistribution to retailers, point-
of-sale materials such as posters, pole signs, display racks and counter top
and floor displays. Also, ST&P produces marketing materials for use by
distributors and their direct sales force to promote ST&P cigarettes to their
retail customers.
ST&P sells its discount cigarettes through approximately 225 tobacco
distributors throughout the United States. Of these 225 distributors,
approximately 90 are located in Texas, Florida, Minnesota, and Mississippi
where Star's sales force is now concentrated. The distributors maintain state
and, where applicable, municipal government tobacco product licenses, apply
state and/or local cigarette tax stamps when needed to resell the cigarettes.
ST&P delivers its products directly to distributors mainly by common carrier
trucks. ST&P's distributor customers primarily serve convenience stores, gas
stations and other outlets and stores. No one distributor accounted for more
than 10% of ST&P's revenue in 2000. The overall number of distributors was
reduced from approximately 325 in 1999 to approximately 225 in 2000 due to
price increases as well as the Company's focus on enhancing its market share
in states in which it does not have purported obligations to make payments
into escrow under state qualifying statutes enacted pursuant to the Tobacco
Master Settlement Agreement (the "Master Settlement Agreement" or "MSA").
Three of the Company's officers, Mr. Jonnie R. Williams, Star's Chief
Executive Officer, Mr. David M. Dean, Star's Vice President of Sales and
Marketing, and Mr. Sheldon Bogaz, ST&P's Vice President of Trade Operations,
lead the Company's sales and marketing activities. Mr. Bogaz supervises a
staff of seven regional sales representatives who direct ST&P's field sales
force.
During 2000, ST&P re-positioned and consolidated its field sales force and
reanalyzed its approach given the realities of competition from foreign and
domestic companies selling discount brands. By the end of 2000, ST&P had 35
field sales personnel positioned in Texas, Florida, Minnesota and Mississippi.
In 2001, ST&P will continue to expand its field sales force in those states.
During 2000, ST&P experienced substantial sales growth. ST&P believes that
the price increases imposed upon the major cigarette manufacturers, arising
from the settlement of major litigation, created an increased demand for low-
price cigarettes. In 2000, ST&P expanded its marketing and sales organization
to respond to the anticipated increase in demand, not only for its present
products, but also for ST&P's anticipated low-TSNA cigarettes and smokeless
tobacco products.
The Company intends to test market and launch a new very low-TSNA flue-cured
cigarette brand in the third quarter of 2001. This brand will be equipped with
a carbon/acetate filter. This new low-TSNA brand, whose name will be announced
shortly before the test marketing, will be distributed by the Company and will
be aimed at the generic cigarette market. The Company anticipates that its
very low-TSNA flue-cured brand will be available nationally but that sales
will be initially focused in those states in which the Company maintains a
sales force.
Purchasing
Star purchases its very low-TSNA tobacco for its leaf tobacco sales from
StarCured(TM) participating tobacco farmers who cure their tobacco in
specifically designed StarCured(TM) barns. Star believes that it will be able
to purchase a sufficient supply of flue-cured, StarCured(TM) leaf tobacco from
these farmers for its own use and to satisfy commitments to B&W for the
foreseeable future. The Company anticipates that it will be able to process
the tobacco purchased from the farmers within its Chase City processing
facility within one to three days of delivery to the facility.
During 2000, the majority of tobacco used in ST&P's cigarettes was purchased
from B&W's Export Leaf Division in "cut rag" form, meaning that the tobacco
has been cut, processed and flavored to ST&P's
6
specifications, and is ready when delivered to ST&P for the manufacturing
process. ST&P expects to continue purchasing "cut rag", low-TSNA StarCured(TM)
tobacco and other tobacco for the next several years from B&W's Export Leaf
Division and thereafter to either continue purchasing "cut rag" tobacco from
B&W Export Leaf Division or to purchase increasing amounts of tobacco needed
for its business from other sources. Buying tobacco from B&W's Export Leaf
Division allows ST&P to avoid having to dedicate substantial amounts of
working capital to tobacco inventories.
At the end of 2000, Star had approximately 858,000 pounds of burley tobacco
in inventory. Star continues its R&D to attempt to perfect the StarCured(TM)
tobacco curing process for burley tobacco, and anticipates conducting
additional tests with burley tobacco during the 2001 growing season in
conjunction with the University of Kentucky's Department of Agronomy, The
Burley Tobacco Growers Cooperative Association, Inc. and Star's scientific and
technical advisors. Once the outcome of the on-going work on burley tobacco is
known, Star will make a decision on how to proceed with its program for burley
tobacco. While Star believes that the StarCured(TM) process is applicable to
burley tobacco, no assurance can be given at this time that the low-TSNA
StarCured(TM) tobacco curing process for burley tobacco will be developed and
successfully commercialized during 2001.
Manufacturing
All of the flue-cured tobacco which the Company plans to use in 2001 and
thereafter in the production of its very low-TSNA tobacco either for sale to
B&W and potentially other parties, or for gradual incorporation into ST&P's
own cigarettes, or in Star's smokeless tobacco products, will be cured using
the StarCured(TM) tobacco curing process. The StarCured(TM) tobacco curing
process utilizes specially equipped curing barns and in certain applications
microwave and/or electronic beam technology. The specially designed curing
barns, which incorporate the StarCured(TM) tobacco processing technology, are
manufactured exclusively for Star by Powell Manufacturing Company of
Bennettsville, South Carolina ("Powell"). These specially designed barns are
erected on site at the tobacco farms which provide Star with its source of
very low-TSNA tobacco. A total of 1,125 Star barns have been manufactured, and
approximately 880 have been delivered to farmers who produce flue-cured
tobacco. It is anticipated that 136 flue-cured barns will be shipped prior to
the 2001 growing season to farmers requesting additional barns. In 2000, 100
barns were delivered to farmers in Kentucky in connection with the research,
development and testing of the StarCured(TM) tobacco curing process for burley
tobacco in conjunction with the previously-mentioned joint program with The
Burley Tobacco Growers Cooperative Association, Inc. Star will conduct limited
experiments this year in Kentucky. Although Star believes that the
StarCured(TM) tobacco curing process is equally applicable to both flue-cured
and burley tobacco, Star acknowledges that this pilot program may well take a
longer period of time to perfect than the flue-cured program.
Star does not anticipate purchasing any additional barns from Powell in 2001
because the Company has sufficient barns in place to process approximately 18
to 20 million pounds of StarCured(TM) flue-cured tobacco which will meet the
Company's needs for this growing season. Financing for approximately half of
these barns has been provided by B&W (see "Relationship With B&W"). Upon
completion of the continuing experimental program for burley tobacco,
additional barns may be required for the StarCured(TM) processing of burley
tobacco.
In early 2000, Star's processing facility in Chase City underwent a
substantial expansion of its capacity to process significantly larger amounts
of very low-TSNA tobacco, as well as provide sufficient space for the
installation of new equipment to be used in conjunction with the manufacturing
of both of Star's anticipated flagship smokeless tobacco products. This
expansion allowed Star to process approximately 19 million pounds of
StarCured(TM) tobacco during 2000. As a result of the expansion, the Chase
City facility will have more than adequate capacity for volumes anticipated
for B&W under the Letter of Understanding, as well as Star's need for tobacco,
and for additional needs should those needs arise.
ST&P expanded its cigarette manufacturing capability in 2000 by outsourcing
a portion of its manufacturing through a contract with B&W to manufacture
cigarettes. Through this outsourcing, the Company hopes to avoid
7
the need to buy new cigarette manufacturing equipment. The tobacco used in
manufacturing ST&P's cigarettes is combined with filters and paper in a
"maker" which produces finished cigarettes, which, in turn, are placed in a
"packer" which provides packaging into standard 20-cigarette packs and ten-
pack cartons. ST&P believes its manufacturing facilities, plus the additional
contract manufacturing relationship now in place with B&W, will allow ST&P to
respond to its growing demand for the foreseeable future.
Relationship with B&W
On October 12, 1999, the Company and B&W entered into a Supply Agreement
under which B&W agreed to purchase StarCured(TM) tobacco. During 1999 and
2000, Star produced and delivered to B&W approximately 3.5 million pounds and
19 million pounds, respectively, of very low-TSNA StarCured(TM) processed
tobacco. Some of this tobacco has been or will be purchased by the Company for
use in ST&P's own discount cigarettes, Star's very low-TSNA cigarettes, and in
Star's new hard tobacco and moist snuff products.
In addition during 2000, B&W collaborated with the Company in the
development of a new very low-TSNA cigarette named Advance(R). B&W also has
been manufacturing cigarettes for ST&P, supplying leaf tobacco to ST&P for use
in its tobacco products, and warehousing burley tobacco for Star.
The non-binding Letter of Understanding envisions a new set of agreements
which would supercede the Supply Agreement. Under the Letter of Understanding,
B&W intends to expand its commitment to purchase very low-TSNA StarCured(TM)
tobacco during each of the next three years through Star's established
StarCured(TM) tobacco program. The Letter of Understanding also addresses a
range of other issues, including B&W test marketing of the Advance(R) brand,
and the future production of a potentially less-hazardous, low-TSNA hard
tobacco product that is intended to be aesthetically pleasing to both present
cigarette smokers and current users of smokeless tobacco products. The
transactions contemplated by the Letter of Understanding are subject to
execution of definitive agreements and the approval of Star and B&W's
respective Boards of Directors. The Company also expects that the agreements,
consistent with the Letter of Understanding, will extend B&W's long-term
credit facility, which has been used to support Star's expanded barn program
and the continuing development of innovative tobacco products focused on
reduced toxin delivery.
Competition
The Company's primary competition for cigarettes is from the four "majors,"
that is, Philip Morris, the brands of which accounted for more than 50% of all
cigarette sales in the United States in 2000, R.J. Reynolds, B&W and
Lorillard, as well as Vector (the parent company of Liggett), each of which
has substantially greater financial and operating resources than the Company.
The Company also encounters significant competition from several other smaller
U.S. manufacturers of cigarettes, as well as importers of cigarettes
manufactured in foreign countries. Many of these manufacturers and importers
have substantially greater financial, manufacturing, marketing and other
resources than the Company. Further, several newer discount competitors have
not, and it appears do not intend to make deposits into escrow accounts
purportedly required by the MSA, allowing these competitors to undercut the
current discount market and unfairly compete against ST&P for discount
cigarette sales.
ST&P's current discount cigarettes compete principally on the basis of price
and possibly quality of product. Generally speaking, there are three price
categories of cigarettes in the United States, "premium," which includes such
brands as Marlboro(R) and Camel(R), "full-price," which includes such brands
as Doral(R) and GPC(R), and "discount," which as a group account for only a
small percentage of the U.S. cigarette market. Each of ST&P's brands is priced
in the discount category. Other competitive factors include package design,
taste and the amount of marketing support provided to distributors and
retailers. At the consumer level, brand loyalty also is a significant factor.
In 2000, the Company established an escrow account as required by the MSA
for sales of cigarettes in 1999, and in 2000 it has focused sales (and its
field sales force) to increase its market share in states that were not part
8
of the MSA in order to minimize its MSA escrow payment obligation. However, in
the 46 states that did join the MSA, ST&P faces significant competition from
cigarette manufacturers and captive distributors of overseas manufacturers who
have not made MSA escrow payments. Such companies are able to sell discount
cigarettes at a substantial cost reduction compared to ST&P and as a result
ST&P is at a significant cost disadvantage in competing with these entities.
The Company is not aware of any other company which currently produces very
low-TSNA tobacco on a commercially viable basis. The Company believes that no
producer of discount cigarettes appears to be incorporating a very low TSNA
tobacco and activated carbon/acetate filters into their discount brands. There
have been published reports that at least one of the major cigarette
manufacturers is developing its own low-TSNA cigarettes, which may or may not
be brought to market during 2001. One Swedish company, Swedish Match, has
worked with various varieties of tobacco under crop management environments
and other methods in an effort to maintain low-TSNA levels in its smokeless
products. Star is not aware of any other company that now incorporates very
low-TSNA tobacco into its cigarettes or other smoked tobacco products. B&W now
has in its possession very low-TSNA tobacco from both the 1999 and 2000
growing season, but has not yet made a public announcement of when it will
start using that tobacco in its current products or in a new product. However,
recent announcements by several of the major tobacco companies indicate that
certain of these companies either have commenced or intend to explore the
production of low-TSNA tobacco and the incorporation of low-TSNA tobacco into
their cigarettes. Also, the industry has initiated a program that is intended
to require all tobacco sold at auction to be cured in a manner that is
intended to result in reduced levels of TSNAs. Star believes that if it is
successful in commercializing its unique very low-TSNA cigarettes and/or in
developing and commercializing very low-TSNA smokeless tobacco products, it is
inevitable that many of the major tobacco companies will follow its lead and
may seek to sub-license the StarCured(TM) technology.
If the Company is successful in developing and commercializing smoking
reduction or cessation products, it will encounter stiff competition. Smoking
cessation products that are approved for sale in the United States by the FDA
are primarily nicotine delivery products (nicotine only) designed to wean the
patient from nicotine addiction over a period of time ranging from 30 days to
six weeks. These products are referred to as nicotine replacement products.
Three products, Nicorette(R), a nicotine chewing gum, and Nicotrol(R) and
NicoDerm(R), both transdermal nicotine patches, constituted substantially all
of the U.S. pharmaceutical nicotine market in 1999 and 2000. All of these
products are sold over-the-counter. Zyban(R), (bupropion), a prescription drug
which originally was developed and is still sold under another proprietary
name as an antidepressant, was introduced to the market in 1997 and has been
demonstrated to be useful as a cessation product. Star understands that sales
of Zyban(R) to date have been substantial and that Zyban(R) is often
prescribed by physicians to be used in conjunction with nicotine delivery
products.
Star's principal competitors in the cessation and reduction market would
include Smith Kline Beecham, the McNeil Consumer Division of Johnson &
Johnson, Glaxo-Wellcome and Pharmacia-Upjohn, all of which have capital
resources, research and development staffs, facilities, experience in
conducting clinical trials and obtaining regulatory approvals, and experience
in manufacturing and marketing their products which are significantly greater
than those of Star. In addition, there are several companies developing new
technologies aimed at smoking cessation therapies. There also are a number of
consumer products which do not require FDA approval as therapeutic drug
products but which nevertheless are advertised as alternatives to smoking or
as a help in the reduction of smoking. For example, at least one of the
leading United States confectionery chewing gum manufacturers has advertised
its gum products as an alternative to cigarettes. There are also non-tobacco
cigarettes produced with fillers such as lettuce and herbs. In addition to the
use of consumable products for smoking cessation or reduction purposes,
medical practitioners and others have developed a variety of programs intended
to assist a person in withdrawing from nicotine dependence. Treatments used
include psychological counseling, hypnosis, group therapy and behavior
modification techniques. There can be no assurance that Star can overcome
regulatory barriers to marketing its tobacco-containing cessation products or
that Star's competitors will not succeed in developing technologies and
products that are more effective than Star's product candidates, that are less
toxic than Star's products or that would render Star's products obsolete or
non-competitive.
9
Government Regulation
The manufacture and sale of cigarettes and other tobacco products and of
pharmaceutical products are subject to extensive federal and state
governmental regulation in the United States and by comparable authorities in
many foreign countries. These national agencies and other federal, state and
local entities regulate, among other things, research and development
activities and the testing, manufacture, safety, effectiveness, labeling,
storage, record keeping, approval, advertising and promotion of Star's
products.
There are multiple bills pending before the 107th Congress and in several
state legislatures which, if enacted, would significantly change the United
States tobacco industry. Some of these federal bills contain provisions which
would provide substantial federal government funds for smoking cessation
programs and products, as well as incentives to tobacco companies and others
to produce less toxic or reduced-risk tobacco products under potential
specific standards. Star is unable to predict what effect, if any, these
provisions, if enacted, would have on Star's technology for very low-TSNA
tobacco or the sale of Star's smoking cessation products and/or potentially
reduced-risk tobacco products. The Company believes, however, that any bill
that requires manufacturers to reduce or disclose levels of TSNAs in tobacco
or tobacco smoke would be beneficial.
Star announced on February 29, 2000, at a press conference held at the
Dirksen Senate Office Building in Washington, D.C., its support of a bi-
partisan tobacco labeling Bill (S. 2125) introduced by Senators Frank
Lautenberg (D. N.J.), Richard Lugar (R. IND.), Richard J. Durbin, (D. ILL.),
and Lincoln D. Chafee (R. R.I.). To the best of Star's knowledge, it was the
only tobacco company asked to support this bi-partisan bill which focused upon
brand disclosures not now mandated by the Surgeon General or HHS. The Senate
Bill, entitled the "Smoker's Right to Know and Truth in Tobacco Labeling Act",
would have significantly enhanced the current tobacco package warning labels
and required disclosure of toxic ingredients and health effects. The Bill
would have required all manufacturers to disclose cancer-causing agents,
including carcinogenic TSNAs, as well as the percentage of such carcinogens
"relative to the average of such concentration of such carcinogen in the sales
weighted average of all cigarettes marketed in the United States."
In March 2000, Representatives Greg Ganske (R, Iowa), John Dingell (D,
Michigan), and Henry Waxman (D, California) co-sponsored the introduction of
the "FDA Tobacco Authority Amendments Act." This bill would have given the FDA
regulatory power over all tobacco products. The Company actively supported
this Bill, and wrote a letter to the sponsors asking them to consider an
amendment which would require manufacturers to follow standards adopted by the
FDA before making reduced risk claims. On March 9, 2001, the Company wrote to
Representative Ganske to support the re-introduction of the "FDA Tobacco
Authority Amendments Act" which took place on March 15, 2001.
In May 2000, Senators McCain (R, Arizona) and Dr. William Frist (R,
Tennessee) introduced Senate Bill (S. 2566) entitled "The National Youth
Smoking Reduction Act". The central goal of the legislation was to reduce the
number of youths who are smoking and to provide the FDA with regulatory
authority over tobacco products. Senator McCain echoed the views of the
Company when he commented that a significant aspect of the proposed Bill would
include language that "provides a mechanism for lower-risk tobacco products to
be tested, reviewed and approved." Senator Frist introduced a similar bill in
January 2001. It is expected that Senator McCain will introduce an FDA tobacco
bill during April 2001.
President's Commission On Improving Economic Opportunity In Communities
Dependent Upon Tobacco Production
Star has been actively supporting the vast majority of the recommendations
of The President's Commission on "Improving Economic Opportunity in
Communities Dependent upon Tobacco Production while Protecting Public Health".
Star is keenly interested in supporting the American tobacco farming community
and assisting farmers in obtaining higher prices for very low-TSNA tobacco,
while promoting public health related issues by giving the farmers an
opportunity to produce very low-TSNA tobacco using StarCured(TM) tobacco
curing barns that have been provided to the farmers by Star. Star testified
before the President's Commission in Louisville, Kentucky last year, and
provided written comments on the Commissions' preliminary recommendations in
March 2001.
10
FDA Regulation
In 1996 the FDA promulgated regulations governing the sale and advertising
of tobacco products designed primarily to discourage the sale to, and
consumption by, adolescents and children. The authority of the FDA to
promulgate such regulations was challenged in the federal courts by the major
tobacco companies. A federal District Court upheld the FDA's authority to
promulgate such regulations but ruled that certain of the regulations
restricting advertising were invalid as violative of the constitutional right
of free speech. On appeal, the United States Court of Appeals for the Fourth
Circuit affirmed portions of the District Court opinion that held the FDA
could not regulate tobacco advertising and ruled that the executive branch of
the United States government, in particular the FDA, does not have any
authority to regulate tobacco products generally. The federal government
appealed the Appeals Court's ruling and the matter was heard by the United
States Supreme Court in late 1999. On March 21, 2000, the Supreme Court in a
five to four decision held that Congress has not given the FDA authority to
regulate tobacco products as customarily marketed. Given the decision by the
Supreme Court it is unclear whether Congress will act to grant such authority
to the FDA, although legislation that would create such authority has been
introduced.
The Company believes that in the future reasoned FDA regulation should
better enable the Company to compete in its particular market niche. The
Company has publicly stated its position in favor of reasoned FDA regulation
of tobacco products for approximately the last three years. The Company has
shared the results of the StarCured(TM) tobacco curing technology with the
FDA. (See "Research and Development-Prior Development of CigRx(TM)" for a
discussion of the Company's prior submission of a cigarette product to the
FDA.) The Company believes that the commercial value of the StarCured(TM)
curing process will depend in part upon its validation by the scientific,
health care and public health communities and on the basis of the type of
standards likely to be mandated by Congress and the FDA, should jurisdiction
be congressionally granted to the FDA.
Institute of Medicine
On February 22, 2001, the Institute of Medicine issued a comprehensive
report, entitled "Clearing the Smoke: Assessing the Science Base for Tobacco
Harm Reduction," in response to a request from the FDA to assess the
scientific basis for possible harm reduction relating to the use of tobacco.
This voluminous report suggests, among other findings, that it is
scientifically feasible to design and manufacture a range of emerging
"potential reduced-exposure products" (which the report referred to as
"PREPs"), but that without appropriate governmental regulation and independent
scientific evaluation of PREPs, the public is left without clear information
regarding the degree to which these products have reduced the risks associated
with smoking. The Company provided testimony before the Institute of Medicine
and shared certain of its scientific and applied research and findings related
to the development of products which deliver less of certain toxins (TSNAs)
and other gas and vapor phase toxic substance in tobacco smoke. Star's
innovative products that deliver less toxins and the StarCured(TM) process
were referred to in the Institute of Medicine's discussion of PREPs.
Federal Trade Commission
The requirements for health warnings on cigarettes is governed by the
Federal Cigarette Labeling and Advertising Act ("Labeling Act"). The Labeling
Act imposes labeling and advertising requirements on the manufacturers,
packagers and importers of cigarettes and requires any company wishing to sell
cigarettes within the United States to submit a plan to the Federal Trade
Commission explaining how it will comply with the warning label display
requirements. Star has submitted labeling plans for its cigarette products in
the past, and the Federal Trade Commission (the "FTC") has approved such
plans. Similar requirements relating to smokeless tobacco products are
included in the Comprehensive Smokeless Tobacco Health Education Act of 1986.
Also, Star shared with the FTC its enhanced warning labels for Advance(R)
prior to the initiation of the test marketing of Advance(R) in October and
submitted a labeling plan for Advance(R) that was subsequently approved by the
FTC. Star's warning labels and comparative content disclosure of toxic smoke
constituents were subsequently utilized in the Advance(R) test marketing
program. Star intends to provide the FTC with similar information prior to the
introduction of its new very low-TSNA cigarettes and smokeless tobacco
products.
11
Bureau of Alcohol, Tobacco and Firearms
Manufacturers and importers of tobacco products are taxed pursuant to
regulations promulgated by the federal Bureau of Alcohol, Tobacco and Firearms
under authority of the Internal Revenue Code of 1986, as amended. The
Company's tobacco products are subject to tax under such regulations.
State and Municipal Laws
The sale of tobacco products is subject to taxation through excise taxes in
all fifty states. State excise taxes range from $.025 per pack in Virginia to
$1.11 per pack in New York. The federal excise tax on cigarettes rose from
$.24 per pack in 1999 to $.34 in 2000, and will increase to $.39 per pack in
2002. In addition, some states permit municipalities to impose an additional
sales tax, and many municipalities do so. The state and municipal sales taxes
are imposed upon wholesalers and/or retailers but not manufacturers, and
therefore the Company has no liability for such taxes. The Company is required
by many states, however, to report its shipments of cigarettes to
distributors/retailers located within their jurisdiction. Star is aware of at
least two states, Massachusetts and Minnesota, which have recently adopted
laws and regulations regarding the disclosure by manufacturers of certain
chemical constituents in their products. If upheld Star intends to fully
comply with such laws and believes it will benefit from such disclosure.
Master Tobacco Settlement Agreement
In November 1998, 46 states and several U.S. territories entered into a
settlement agreement (the "Master Settlement Agreement" or "MSA") to resolve
litigation that had been instituted against the major tobacco manufacturers.
The Company was not named as a defendant in any of the litigation matters and
chose not to become a participating manufacturer under the terms of the Master
Settlement Agreement. As a nonparticipating manufacturer, the Company is
required to satisfy certain purported escrow obligations under statutes which
the Master Settlement Agreement required participating states to pass, if they
were to receive the full benefits of the settlement. The so-called "level
playing field" statutes require nonparticipating manufacturers to fund escrow
accounts that could be used to satisfy judgments or settlements in lawsuits
that may at some future date be filed by the participating states against such
nonparticipating tobacco manufacturers. Under these statutes the Company is
obligated to place an amount equal to $1.88 per carton for 1999 and $2.09 in
2000, and increased amounts per carton for subsequent years ($2.72 in 2001-
2002, $3.35 in 2003-2006 and $3.77 thereafter), in escrow accounts for sales
of cigarettes occurring in the prior year in each such state after the
effective date of each state specific statute. An inflation adjustment is also
added to these deposits at the higher of 3% or the Consumer Price Index each
year. Such escrowed funds will be available to satisfy tobacco-related
judgments or settlements, if any, in some states. If not used to satisfy
judgments or settlements, the funds will be returned to the Company 25 years
after the applicable date of deposit on a rolling basis. Also, absent a
challenge to the state specific statutes or some accommodation as to the
escrow amounts, the failure to place the required amounts in escrow could
result in penalties to the Company and potential restrictions on its ability
to sell tobacco products within particular states. Because all of the MSA
states have passed the so-called "level playing field" statutes, the Company
expects that a material portion of its cigarette sales will continue to be
subject to such purported escrow obligations.
As of January 1, 2000, thirty-eight states and the District of Columbia had
adopted so-called model "level playing field" statutes and Star's purported
net obligations under those statutes was approximately $11.6 million with
respect to 1999 sales. As of January 1, 2001, forty-six states had adopted
model "level playing field" statutes. Star's purported net obligations under
those statutes is approximately $13.0 million with respect to 2000 sales. The
Company's Board of Directors is anticipated to authorize the Company to fund
the escrow obligation for 2000 on or before April 15, 2001, again under
protest. The funds placed in escrow continue to be an asset of the Company and
the Company will receive the interest income generated by the escrow deposits.
After almost two years of negotiations with the National Association of
Attorneys General ("NAAG"), the Company concluded that NAAG had little
interest in working with Star to come to a reasonable solution under which the
Company could become a participant in the Master Settlement Agreement.
Accordingly, on
12
December 15, 2000, the Company filed a lawsuit in the United States District
Court for the Eastern District of Virginia requesting that the court declare
both the MSA and Virginia's Qualifying Statute unconstitutional and,
therefore, invalid. The Company's complaint challenges the MSA on the grounds
that it violates the Interstate Compact Clause and the Commerce Clause of the
Constitution of the United States. It challenges the Qualifying Statute on the
grounds that it violates the Equal Protection, Due Process, Takings and
Commerce Clauses of the Constitution. Neither Virginia Attorney General Earley
nor any other state attorney general has ever charged the Company with the
tortious and unlawful conduct asserted against other cigarette manufacturers
in lawsuits by various states which led to the execution of the MSA. Despite
the absence of any claim against the Company, which is focused primarily on
producing less toxic and potentially less hazardous tobacco and tobacco
products, the MSA and the Qualifying Statute impose a severe burden on its
research and development activities.
On March 12, 2001, the District Court heard oral argument on the
Commonwealth's Motion to Dismiss, after both sides exchanged briefs on all the
constitutional and related issues. On March 26, 2001, the District Court
dismissed the Company's complaint, but in its opinion, the District Court did
note that Star "must now suffer as a result of the bad faith of previous
market entrants." The District Court further noted that Star "has never been
accused of the fraudulent, collusive and intentionally dishonest activities of
the Big Four," "was not even in existence during the bulk of the time that
these activities were occurring," and has taken "every step to provide
complete disclosure about the harmful nature of its products." The District
Court also stated that the "financial burden on Star Scientific and others
like it may hamper efforts to develop new tobacco technologies." The Company
promptly appealed the District Court's ruling, and continues to believe that
the MSA and the Virginia Qualifying Statute are constitutionally flawed.
Virginia Incentive Rebates
In 1999, the Commonwealth of Virginia enacted legislation that explicitly
encouraged the manufacture and sale of "products that reduce the carcinogenic
TSNA levels in tobacco products." That legislation, pursuant to House Bill
2635 and Senate Bill 1165 (1999), provided that $2,000,000 should be made
available to the Virginia Economic Development Partnership to provide for
economic development incentive rebates to assist Virginia companies that
reduce carcinogenic TSNA levels in tobacco products and pass a portion of that
rebate on to Virginia tobacco farmers.
Star was the only company that qualified for those rebates, and in June
2000, was awarded $2 million by the Commonwealth of Virginia. Approximately
$275,000 of those funds was subsequently provided by the Company to certain
Virginia farmers to help defray their costs relating to the installation of
the Company's StarCuredTM tobacco curing barns.
World Health Organization ("WHO") Global Public Health Advocacy
Star testified on October 13, 2000, at the World Health Organization public
hearings in Geneva, Switzerland on its view of the structure of a Global
Framework Convention on Tobacco Control ("FCTC"). In that testimony Star
reiterated its support for comprehensive regulation of all tobacco products in
the U.S. and worldwide to create a more rational environment in which
minimizing toxicity rather than marketing creativity would determine relevant
market share. Star also testified before the WHO Scientific Advisory Committee
on Tobacco product regulation on February 1, 2001, and again reiterated its
support for comprehensive world wide tobacco regulation within the FCTC
proposed structure.
Research and Development
In the mid-1990's, Star commenced research and development activities based
upon newly-conceived technology for the processing of tobacco so as to
preclude, eliminate or substantially reduce TSNAs to very low levels. This
technology is under exclusive license from a partnership in which the
technology's inventor and the Company's founder and current Chief Executive
Officer, Jonnie R. Williams, is part owner. (See "Patents, Trademarks and
Licenses.") TSNAs are generally recognized by health researchers and respected
scientists to
13
be among the most potent and abundant carcinogens in tobacco and tobacco
smoke. Star's research and development activities have focused on: (1)
perfecting and testing methods for processing low-TSNA tobacco: (2) developing
products which incorporate Star's specially-processed tobacco, including
products for the smoked and smokeless tobacco markets; (3) establishing a
patent position; and (4) developing relationships with tobacco farmers, as
well as the tobacco industry, with a view to the commercialization of Star's
processes through licensing and royalty arrangements, among other vehicles, to
generate income for the Company. Star's research and development efforts
culminated in the development of various aspects of the StarCuredTM tobacco
curing process, with respect to which Star has exclusive rights to patents as
well as patent applications which are pending (See "Patents, Trademarks and
Licenses"). Star has convened a Scientific Advisory Board of highly regarded
physicians, scientists, researchers and public health experts to provide it
with counsel on how best to proceed in a variety of scientific and research
oriented areas.
StarCured(TM) Technology
The process of curing or drying tobacco so that it is suitable for
production into tobacco products begins immediately upon harvesting of the
tobacco leaf. The two principal varieties of tobacco leaf in the United States
are Virginia flue-cured tobacco and burley tobacco, both of which are
typically used in American-made cigarettes to produce what is referred to as
an American blend. Under conventional curing methods with Virginia flue-cured
tobacco, the leaves are placed in enclosed barns and are then exposed to gas-
fired heat, while with burley tobacco the leaves are hung in sheds to dry
naturally. The curing process for Virginia flue-cured tobacco takes
approximately 5 to 7 days and for burley tobacco a month, or more.
The StarCured(TM) technology is applicable to Virginia flue-cured tobacco
and, Star believes, to burley tobacco, and most likely to other varieties of
tobacco on a broad-scale commercial basis. Star's curing process essentially
arrests or eliminates microbial activity that normally occurs during curing,
thereby preventing the production of TSNAs. The StarCured(TM) curing
technology does not, however, alter or affect taste, color or the nicotine
content of tobacco. Star makes no claim or representation that the
StarCured(TM) tobacco curing process reduces any harmful chemical constituents
in tobacco and/or tobacco smoke other than TSNAs. Additionally, Star makes no
claim that the elimination of TSNAs reduces the risk of disease from smoking.
Star has been careful not to make any health claims, directly or indirectly,
since there is not yet clinical evidence to show that a reduction in these
specific carcinogens in tobacco will translate into a reduced health risk.
The StarCured(TM) technology has been licensed to the Company in an
agreement which grants to the Company certain exclusive worldwide rights with
a right of sublicense. (See "Patents, Trademarks and Licenses" below). It is
the Company's objective to achieve widespread acceptance of the StarCured(TM)
tobacco curing technology as a standard for the manufacture of potentially
less harmful tobacco products and as a basis for the use of very low-TSNA
tobacco in the production of smoking cessation products.
Star conducted a pilot program during the 1998 U.S. tobacco harvest season
(July through October). The purposes of this program were: (1) to continue to
test and perfect Star's curing processes in quantities and under conditions
which would serve as a model for future operations; (2) to test custom
designed equipment; (3) to provide processed tobacco to major manufacturers in
quantities for testing and test market purposes; and (4) to demonstrate the
commercial feasibility of adoption of Star's processes for widespread use in
the production of tobacco products. The program was operated from the
Company's facility in Chase City, Virginia. Star completed the pilot program
and believes it achieved the objectives described above. During 1999 and 2000,
Star processed over 3.5 million pounds and approximately 19 million pounds,
respectively, of very low-TSNA tobacco using the StarCured(TM) tobacco curing
process.
Development of Very Low-TSNA Cigarette
Beginning in October 2000, Star test-marketed Advance(R), which the Company
believes is the first very low-TSNA premium cigarette to be sold in the United
States which contains enlarged health warnings on the package, comparative
content information and informational package "onserts" attached to each pack
which contain
14
additional information regarding the health hazards of smoking. Advance(R)
utilizes StarCured(TM) very low-TSNA flue-cured tobacco, as well as other
tobaccos (burley and oriental) selected for their low-TSNA levels. Advance(R)
also has a 40 mg activated carbon/acetate filter that reduces other gas and
vapor phase toxic substances.
Under the transactions contemplated by the Letter of Understanding, B&W is
planning to conduct a test market of Advance(R) and potentially market the
Advance(R) brand on a national basis if the market tests are successful. The
Company plans to introduce its own new very low-TSNA flue-cured brand of
cigarette during 2001 with an activated carbon/acetate filter. The Company
currently intends to implement expanded warning labels and comparative content
disclosure of toxic smoke constituents, comparable to those used in the
Advance(R) test marketing program, on such product. In a fashion similar to
Advance(R) these warning labels will not make any health claims, directly or
indirectly, since there is not yet clinical evidence to show that a reduction
in these specific carcinogens in tobacco will translate into a reduced health
risk.
Prior Development of CigRx(TM)
In 1997 Star submitted a cigarette product that it called "CigRx(TM)" to the
FDA as a pharmaceutical product. The objective was to offer a product to help
patients who relapse after a trial of smoking cessation to prepare for another
cessation attempt while reducing exposure to TSNAs. Star is not aware of any
other company submitting a tobacco product for FDA clearance. Star's strategy
has since changed, and it will not seek FDA approval for CigRx(TM). A Phase I
study, under an FDA-reviewed protocol, was completed at the Virginia
Commonwealth University under the direction of Professor William Barr,
Director of the Center for Drug Studies. The study, involving male and female
subjects, was a cross-over study designed to test in vivo elimination or
reduction of TSNAs following the smoking of CigRx(TM) cigarettes compared to
the subjects' normally used cigarettes. These test cigarettes were made
entirely from flue-cured Virginia tobacco with no added flavorings. The
average total TSNA levels in the tobacco itself at the time of testing were
about 100 parts per billion, as compared to more than 3,000 parts per billion
in popular brands. As measured by the current FTC method, the CigRx(TM)
cigarettes used in the study delivered substantially less carbon monoxide (4.8
milligrams versus 12.2 milligrams) and about half as much tar (7.0 milligrams
versus 14.0 milligrams) compared to an average of the best selling full-
flavored cigarettes. The study contrasted Star's product with conventional
brands in terms of breath levels of carbon monoxide, blood levels of nicotine,
and urinary levels of TSNAs. On the CigRx(TM) product, blood nicotine levels
were somewhat higher and carbon monoxide was substantially lower. Urinary
levels of TSNA (as measured by NNAL) were analyzed by the American Health
Foundation. The average levels of NNAL and its metabolite after 9 days on the
CigRx(TM) product were reduced substantially, consistent with published data
showing that TSNAs leave the body slowly over 90 to 120 days.
Product Liability
In the United States, there have been numerous and well-publicized lawsuits
against the largest manufacturers of cigarettes and other tobacco products
initiated by state and municipal governmental units, health care providers and
insurers, individuals (for themselves and on a class-action basis) and by
others. The legal theories underlying such lawsuits are varied, but are
generally based upon one or more of the following: (1) manufacturer defendants
have deceived consumers about the health risks associated with tobacco product
consumption; (2) such defendants knew or should have known about various
harmful ingredients of their products and failed to adequately warn consumers
about the potential harmful effects of those ingredients; and (3) such
defendants knew of the addictive attributes of nicotine and have purposefully
manipulated their product ingredients so as to enhance the delivery of
nicotine.
The Company believes that it has conducted its business in a manner which
decreases the risk of liability in a lawsuit of the type described above
because the Company:
. has attempted to consistently present to the public the most current
information regarding the health risks of long-term smoking;
. has never denied the addictive nature of nicotine;
15
. has never targeted adolescent or young persons as customers;
. does not advertise its tobacco products to consumers except for point-
of-sale materials;
. has conducted research on the chemical or other constituents of its
products only in the course of trying to reduce the delivery of toxic
materials;
. has stated unequivocally that smoking involves a range of serious health
risks, is addictive, and that smoked cigarettes products can never be
produced in a "safe" fashion; and
. did not produce its own brands until late 1994/early 1995, and the
volume of sales has not been substantial in relation to the volume
generated by the larger manufacturers.
The Company maintains product liability insurance which is limited to any
claims that tobacco products manufactured by or for the Company contain any
foreign object. Such insurance does not cover health-related claims such as
those that have been made against the major manufacturers of tobacco products.
The Company does not believe that insurance for health-related claims can
currently be obtained. A lawsuit against the Company based upon claims not
covered by its product liability insurance could have a materially adverse
effect upon the Company.
Patents, Trademarks and Licenses
License Agreement with Regent Court
The Company is the licensee under a license agreement (the "License
Agreement") with Regent Court a partnership of which Jonnie R. Williams, the
Company's founder and Chief Executive Officer and Francis E. O'Donnell, Jr.,
M.D. are the owners. The License Agreement provides, among other things, for
the grant of an exclusive, worldwide, irrevocable license to the Company, with
the right to grant sublicenses, to make, use and sell tobacco and products
containing tobacco under the licensor's patent rights and know-how relating to
the processes for curing tobacco so as to eliminate TSNAs or reduce them to
insignificant levels, and to develop products containing such tobacco, whether
such patent rights and know-how are now in existence or hereinafter developed.
This license includes inventions of Regent Court and its affiliates during the
term of the License Agreement relating to the production, treatment or curing
of tobacco, or a method of manufacturing a product containing tobacco, and of
extracting one or more substances from tobacco for the purpose of
incorporating such substance or substances in a product or products.
The Company is obligated to pay to Regent Court a royalty of 2% on all net
sales of products by it and any affiliated sublicensees, and 6% on all fees
and royalties received by it from unaffiliated sublicensees, less any related
research and development costs incurred by the Company. The License Agreement
expires with the expiration of the last of any applicable patents. Four United
States patents have been issued, and additional patent applications are
pending in the United States and in approximately 80 foreign jurisdictions.
The Company paid no royalties under the License Agreement in 1999 or 2000.
The License Agreement may be terminated by the Company upon 30 days written
notice. The License Agreement may also be terminated by Regent Court upon (a)
a default in the payment of royalties or a failure to submit a correct
accounting continuing for at least 30 days after written notice or (b) a
material breach of any other obligation of the Company under the License
Agreement continuing for at least 60 days after written notice. A material
breach may include a sublicense of the Patent Rights (as defined in the
License Agreement) without obtaining a written agreement of the sublicensee to
be obligated to Regent Court under the License Agreement. The Company is also
obligated to provide Regent Court with copies of all patent applications by it
relating to the Patent Rights. For purposes of determining materiality, a
breach is deemed material if such breach results in a loss of royalties
exceeding $100,000.
The License Agreement obligates the Company to prosecute and pay for United
States and foreign patent rights. The License Agreement contains other
provisions typically found in a patent license agreement, such as provisions
governing patent enforcement and the defense of any infringement claims
against the Company and
16
its sublicensees. The License Agreement further provides that any obligation
or liability related to patent infringement matters brought against the
Company will be borne by the Company. The Company has agreed to indemnify and
defend the licensor and its affiliates against losses incurred in connection
with the Company's use, sale or other disposition of any licensed product or
the exercise of any rights under the License Agreement. Regent Court has made
no representations to the Company in any documents regarding the efficacy of
the licensed technology.
Patents and Proprietary Rights
Under the License Agreement, the Company has exclusive rights to four issued
patents and pending patent applications, which are the only patents issued to
or applied for by Regent Court. The issued and pending patents cover the
current technology for reducing the level of TSNAs in tobacco. Corresponding
patent filings have been initiated in numerous foreign countries. The Company
has no rights to any other patent or patent applications. There can be no
assurance that patents will issue from any of the pending applications, that
claims which may be allowed thereunder will be sufficient to protect the
intellectual property owned or licensed by the Company, or that the Company or
Regent Court has or will develop or obtain the rights to any additional
products or processes that are patentable. In addition, no assurance can be
given that any patents issued to or licensed by the Company will not be
challenged, invalidated, infringed or circumvented, or that the rights granted
thereunder will provide competitive advantages to the Company.
On October 24, 2000, the United States Patent Office issued a patent for
tobacco products made from tobacco having very low levels of TSNA. On March
20, 2001, it issued a patent covering a process for curing harvested tobacco
in a manner which substantially reduces the formation of one or more TSNAs.
Under the License Agreement, the Company has exclusive rights to those
patents. The Company believes that it is the world leader in curing technology
which consistently produces very low-TSNA tobacco.
Employees and Consultants
As of December 31, 2000, the Company employed approximately 180 full-time
employees. From time to time, the Company engages temporary personnel to
augment its regular employee staff. Further, the Company utilizes the services
of consultants, scientific and technical experts and independent contractors
to provide key functions in the scientific, medical, public health care,
compliance, technological, legal, communications, financial and related areas.
The use of such outside providers enables the Company to secure unique
expertise in a wide variety of areas that it might otherwise not be in a
position to secure or which it would otherwise be required to secure through
the hiring of many additional Company-employed personnel at potentially
greater cost to the Company. Substantially all of the Company's research and
development efforts have been, and are expected to continue to be, conducted
pursuant to contractual arrangements with universities and scientific, medical
and public health consultants and investigators.
Factors That May Affect Future Results
We Are Dependent on the Domestic Tobacco Business
Substantially all of our revenues in 1999 and 2000 were derived from sales
in the United States of ST&P's four brands of discount cigarettes. The other
portion of our revenue stream was generated by the sales of StarCured(TM)
processed leaf tobacco. The U.S. cigarette business has been contracting in
recent years. If the U.S. cigarette market continues to contract, we may not
have significant tobacco sales abroad or sales of other products to offset
these effects. This trend could adversely affect our sales volumes, operating
income and cash flows.
Competition From Other Cigarette Makers Could Adversely Affect Us
The cigarette industry is highly competitive. Our primary competition for
conventional cigarettes is from the "major" cigarette manufacturers, each of
which has substantially greater financial and operating resources
17
than we do. We continue to encounter significant competition from several
other smaller U.S. manufacturers of cigarettes, as well as importers of
cigarettes manufactured in foreign countries. Many of these manufacturers and
importers have substantially greater financial, manufacturing, marketing and
other resources than we do. While we are not aware of any other company which
produces very low-TSNA tobacco for commercial use or incorporates very low-
TSNA tobacco into their cigarettes or other tobacco products, other major
tobacco companies are expected to follow our lead and the industry has
initiated a program that would require all tobacco sold at auction to be cured
in a manner that is intended to result in reduced levels of TSNAs.
Additionally, our competitors may also develop other less toxic tobacco
products that can compete with our very low-TSNA products.
Very Low-TSNA Tobacco May Not Be Accepted by the Marketplace
While we have produced and test marketed limited quantities of our very low-
TSNA cigarette, Advance(R), and have been encouraged by the initial results,
very low-TSNA tobacco may not be ultimately accepted by adult smokers in the
national marketplace. Adult smokers may decide not to purchase smoked or
smokeless tobacco products made with very low-TSNA tobacco due to taste or
other preferences, particularly in light of Star's decision to introduce its
new very low-TSNA cigarette product with an activated carbon/acetate filter
which may impact the taste of products in which it is utilized, and due to the
extensive health warnings contained on the packaging for the Company's
products.
The Cigarette Industry is Subject to Substantial and Increasing Regulation
and Taxation
Various federal, state and local laws limit the advertising, sale and use of
cigarettes, and these laws have proliferated in recent years. If this trend
continues, it may have material and adverse effects on our sales volumes,
operating income and cash flows. In addition, cigarettes are subject to
substantial and increasing excise taxes. The federal excise tax on cigarettes
will rise from $.34 per pack in 2000 to $.39 per pack in 2002. Additionally,
state excise taxes range from $.025 per pack in Virginia to $1.11 per pack in
New York. Increased excise taxes may result in declines in overall sales
volume. This result could adversely affect our operating income and cash
flows.
In 1996, the FDA promulgated regulations governing the sale and advertising
of tobacco products. These regulations were designed primarily to discourage
the sale to, and consumption by, adolescents and children. The authority of
the FDA to promulgate such regulations was challenged in the federal courts.
On March 21, 2000, the United States Supreme Court in a five to four decision
held that the Congress has not given the FDA authority to regulate tobacco
products as customarily marketed. Given the decision by the Supreme Court it
is unclear whether the 107th Congress will act to grant such authority to the
FDA, although legislation that would create such authority has already been
introduced in Congress.
We Have Substantial Obligations Under State Laws Adopted Under the Master
Settlement Agreement
Absent a successful legal challenge to the MSA and/or statutes passed by
various states in connection with the Master Settlement Agreement entered into
in 1998 between the major tobacco companies and 46 states, or an agreement
with NAAG with respect to the funding of the required escrow amount, in April
of each year, beginning April 2000, we have a purported obligation to place in
escrow accounts an amount equal to $1.88 per carton for 1999, $2.09 in 2000,
$2.72 in 2001-2002, $3.35 in 2003-2006 and $3.77 thereafter, for sales of
cigarettes occurring in the prior year in each such state after the effective
date of each state specific statute. An inflation adjustment is also added to
these deposits at the higher of 3% or the Consumer Price Index each year. The
failure to place such required amounts into escrow could result in severe
penalties to us and potential restrictions on our ability to sell tobacco
products within particular states. Because of this purported escrow
requirement, a substantial portion of our net income from operations will be
unavailable for our use and the amount required to be placed in escrow for
each carton sold may exceed the net cash flow generated by each carton sold.
This will adversely affect our ability to apply the capital generated from our
present cigarette sales toward the further scientific development of less
toxic and potentially less hazardous tobacco products and the
18
growth of our business. In addition, the escrow obligations will impede our
ability to distribute dividends to our stockholders. The Company, under
protest, placed approximately $11.6 million into escrow in April 2000.
We have tried to mitigate the costs of the MSA by focusing our field sales
force and seeking to increase market share in states that were not
participants in the MSA among other approaches to lessen the harmful effects
of what we believe to be an unconstitutional compact that impermissibly
regulates interstate commerce. Once ST&P sells product to independent
distributors it is not in a position to monitor subsequent sales by such
entities and it does not do so. However, certain of the Attorneys General in
MSA States and NAAG have taken this position that the Company is responsible
to escrow funds for any sales in MSA States whether made by ST&P directly or
by a third party to whom ST&P has sold product.
Our Current Supply Contracts and Other Contracts with B&W May Not Be Extended
In October 1999, we entered into a Supply Agreement with B&W under which B&W
agreed to purchase StarCured(TM) tobacco in the period 2000-2001, with the
right to purchase tobacco from us on a long-term basis in later years. If B&W
were to stop purchasing our tobacco that has been cured using the
StarCured(TM) tobacco curing process, it could adversely affect our sales
volumes, operating income and cash flows. Additionally, we currently have
other business relationships with B&W. B&W has: (1) loaned us a total of $29
million, which was primarily used to purchase specially manufactured curing
barns, (2) agreed to manufacture cigarettes for us and (3) agreed to supply
tobacco to us. The termination of any of these agreements could negatively
affect our business operations.
We have signed the non-binding Letter of Understanding with B&W under which
we will update B&W's supply requirements, re-schedule debt payments, as well
as accomplish a number of other business objectives. If B&W and Star were not
to be successful in converting the Letter of Understanding into a series of
agreements, this could materially affect our sales volumes, operating income
and cash flows.
Lawsuits May Affect Our Profitability; We Have Limited Insurance Coverage
We are not, nor have we ever been, named as a defendant in any legal actions
affecting the tobacco industry, including proceedings and claims arising out
of the sale, distribution, manufacture, development, advertising, marketing
and claimed health effects of cigarettes. While we believe that the risk of
being named a defendant in such a lawsuit is relatively low, we may be named
as a defendant in the future as there has been a noteworthy increase in the
number of these cases pending. Punitive damages, often in amounts ranging into
the hundreds of millions, or even billions of dollars, are specifically
pleaded in a number of these cases in addition to compensatory and other
damages. We maintain product liability insurance which is limited to any
claims that tobacco products manufactured by or for us contain any foreign
object. Such insurance does not cover health-related claims such as those that
have been made against the major manufacturers of tobacco products. We do not
believe that such insurance currently can be obtained. Accordingly, our
inclusion in any of these actions or any future action could have a material
and adverse effect on our financial condition.
We May Not Properly Manage Our Growth
If we are successful in maintaining and increasing market acceptance for our
products, we will be required to manage substantial volume from our customers.
To accommodate any such growth and compete effectively, we will be required to
attract, integrate, motivate and retain additional highly skilled sales,
technical and other employees. We face competition for these people. Our
ability to successfully manage such volume also will be dependent on our
ability to scale up our tobacco processing and production operations. There
can be no assurance that we can overcome the challenge of scaling up our
processing and production operations or that our personnel, systems,
procedures and controls will be adequate to support our future operations. Any
failure to implement and improve our operational, financial and management
systems or to attract, integrate, motivate and retain additional employees
required by future growth, if any, could have a material and adverse effect on
our business and prospects, financial condition and results of operations.
19
We May Not Be Successful in Protecting Our Intellectual Property Rights
Our success in commercially exploiting our licensed tobacco curing
technology depends in large part on our ability to defend issued patents, to
obtain further patent protection for the technology in the United States and
other jurisdictions, and to operate without infringing upon the patents and
proprietary rights of others. Additionally, we must be able to obtain
appropriate licenses to patents or proprietary rights held by third parties if
infringement would otherwise occur, both in the United States and in foreign
countries.
Patent positions, including our patent positions (owned or licensed) are
uncertain and involve complex legal and factual questions for which important
legal principles are unresolved. Any conflicts resulting from third party
patent applications and patents could significantly reduce the coverage of our
patents and limit our ability to obtain meaningful patent protection. If
patents are issued to other companies that contain competitive or conflicting
claims, we may be required to obtain licenses to these patents or to develop
or obtain alternative technology. Such licensing agreements, if required, may
be unavailable on acceptable terms or at all. If such licenses are not
obtained, we could be delayed in or prevented from pursuing the development or
commercialization of our products.
Litigation which could result in substantial cost may also be necessary to
enforce any patents to which we have rights, or to determine the scope,
validity and unenforceability of other parties' proprietary rights which may
affect our rights. U.S. patents carry a presumption of validity and generally
can be invalidated only through clear and convincing evidence. We may also
have to participate in interference proceedings declared by the U.S. Patent
and Trademark Office to determine the priority of an invention, which could
result in substantial cost. There can be no assurance that our licensed
patents would be held valid by a court or administrative body or that an
alleged infringer would be found to be infringing. The mere uncertainty
resulting from the institution and continuation of any technology-related
litigation or interference proceeding could have a material and adverse effect
on our business and prospects.
We may also rely on unpatented trade secrets and know-how to maintain our
competitive position, which we seek to protect, in part, by confidentiality
agreements with employees, consultants, suppliers and others. There can be no
assurance that these agreements will not be breached or terminated, that we
will have adequate remedies for any breach, or that our trade secrets will not
otherwise become known or be independently discovered by competitors.
We Depend On Key Personnel
We depend upon the continued services of our senior management team for our
continued success. The loss of any one of the Company's Chief Executive
Officer, Jonnie R. Williams, the Company's Chairman, President and Chief
Operating Officer, Paul L. Perito, the Vice President of Sales and Marketing,
David M. Dean, the Company's Chief Financial Officer, Christopher G. Miller or
the Company's General Counsel, Robert E. Pokusa, who joined the Company on
March 30, 2001, could have a serious negative impact upon our business and
operating results. To minimize the present risk of the loss any one of these
senior executives, the Company has hired additional senior management and
continues to search for other senior executives who will be able to share some
of the responsibilities now assumed by Messrs. Williams, Perito, Miller, Dean
or Pokusa.
The Company's success depends in large part on its ability to attract and
retain, on a continuing basis, consulting services from highly qualified
scientific, technical, management, financial and marketing personnel.
Competition for such personnel is intense and there can be no assurance that
the Company will be able to attract and retain the personnel necessary for the
development and operation of its business. The loss of the services of its key
personnel or the termination of its contracts with independent scientific and
medical investigators could have a material and adverse effect on the
Company's business.
Management and Significant Stockholders Can Exercise Influence over the
Company
Based upon stock ownership as of December 31, 2000, our executive officers,
directors and their associates, own an aggregate of approximately 78% of our
outstanding shares. As a result, these persons acting together
20
may have the ability to control matters submitted to our stockholders for
approval and to control the management and affairs of the Company. This
concentration of ownership may have the effect of delaying or preventing a
change in control of the Company, impede a merger, consolidation, or takeover
or other business combination, or discourage a potential acquirer from
attempting to obtain control. This concentration of control could also have a
negative effect on the market price of our shares.
Pursuant to our Certificate of Incorporation and Bylaws, the Board of
Directors is divided into three classes. Members of each class serve for a
three-year term and until the election and qualification of their successors,
or their earlier resignation or removal. Because the Board of Directors is
divided into classes, only those directors in a single class may be changed in
any one year. Consequently, changing a majority of the Board of Directors
generally would require two years. A classified Board of Directors, which may
be regarded as an "anti-takeover" provision, may make it more difficult for
our stockholders to change the majority of directors and thus have the effect
of maintaining continuity of management.
Item 2. Properties
The Company's executive, marketing, sales and administrative offices are
located in Chester, Virginia. The Company has approximately four years
remaining on a five-year lease for a 45,000 square foot warehouse facility,
including 7,000 square feet of office space. The warehouse space is used for
storing and shipping cigarette products.
An additional 5,600 square feet of office space is currently being leased by
the Company in Bethesda, Maryland pursuant to a lease expiring in 2005. This
additional space houses executive, administrative, and scientific offices.
This location in Bethesda was selected to afford Star's scientific and medical
consultants access to the FDA, National Institutes of Health and the U.S.
National Medical Library.
The Company's manufacturing facilities are located in Petersburg, Virginia.
The Company owns its Petersburg facilities, which consist of a 50,000 square
foot, four-story manufacturing building and an adjacent 6,000 square foot,
single-story office building. The Company leases a 10,000 square foot
warehouse in Petersburg, Virginia, about one mile from its manufacturing
facilities, pursuant to a month-to-month lease.
The Company leases seven acres of land and an approximately 100,000 square
foot building thereon in Chase City, Virginia, that is used in processing
tobacco utilizing the Company's StarCuredTM tobacco curing method. During
2000, this facility was expanded from approximately 50,000 square feet to its
current size by completing a construction project which cost approximately
$500,000. The Company has approximately nine years remaining on a ten-year
lease for the Chase City property, which covers the expanded facility, and it
has an option to purchase the property at any time during the term of the
lease.
The Company considers its facilities adequate for the purposes for which
they are used.
Item 3. Legal Proceedings
After almost two years of negotiations with the National Association of
Attorneys General, the Company concluded that NAAG had little interest in
working with Star to come to a reasonable solution under which the Company
could become a participant in the Master Settlement Agreement. Accordingly, on
December 15, 2000, the Company filed a lawsuit in the United States District
Court for the Eastern District of Virginia requesting that the court declare
both the MSA and Virginia's Qualifying Statute unconstitutional and,
therefore, invalid. The Company's complaint challenges the MSA on the grounds
that it violates the Interstate Compact Clause and the Commerce Clause of the
Constitution of the United States. It challenges the Virginia Qualifying
Statute on the grounds that it violates the Equal Protection, Due Process,
Takings and Commerce Clauses of the Constitution. Neither Virginia Attorney
General Earley nor any other state attorney general has ever charged the
Company with the tortious and unlawful conduct asserted against other
cigarette manufacturers in lawsuits by various states which led to the
execution of the MSA. Despite the absence of any claim against the Company,
which is focused primarily on producing less toxic and potentially less
hazardous tobacco and tobacco products, the MSA and the Virginia Qualifying
Statute impose a severe burden on its research and development activities.
21
On March 12, 2001, the District Court heard oral argument on the
Commonwealth's Motion to Dismiss, after both sides exchange briefs on all of
the constitutional and related issues. On March 26, 2001, the District Court
dismissed the Company's complaint, but in its opinion, the District Court did
note that Star "must now suffer as a result of the bad faith of previous
market entrants." The Court further noted that Star "has never been accused of
the fraudulent, collusive and intentionally dishonest activities of the Big
Four," "was not even in existence during the bulk of the time that these
activities were occurring," and has taken "every step to provide complete
disclosure about the harmful nature of its products." The District Court also
stated that the "financial burden on Star Scientific and others like it may
hamper efforts to develop new tobacco technologies." The Company promptly
appealed the District Court's ruling, and continues to believe that the MSA
and the Virginia Qualifying Statute are constitutionally flawed.
The Company is not involved in any other material legal proceedings.
Item 4. Submission of Matters to a Vote of Security Holders
The 2000 annual meeting of stockholders of the Company (the "Meeting") was
held on October 6, 2000. At the Meeting, the stockholders voted upon a number
of proposals, each of which is summarized below, along with the votes cast for
and against each such proposal, votes withheld or abstaining therefrom and
broker non-votes.
Election of Directors
At the Meeting, the stockholders elected the following persons to the Board
of Directors of the Company until the date of the annual stockholders meeting
in the calendar year set forth opposite the name of each such person:
Votes Broker
Name Term Votes For Against Abstaining Non-Votes
- ---- ---- ---------- ------- ---------- ---------
Class Two Directors
Mark W. Johnson................... 2003 50,635,037 0 394,227 0
Martin Leader..................... 2003 50,635,037 0 394,227 0
Jonnie R. Williams................ 2003 50,635,037 0 394,227 0
Class Three Director
Christopher G. Miller............. 2001 50,635,037 0 394,227 0
Approval of 2000 Equity Incentive Plan.
At the Meeting, the stockholders of the Company voted on and ratified the
Company's 2000 Equity Incentive Plan. 50,335,210 votes were cast for such
proposal, 685,267 votes were cast against or withheld, with 8,787 votes
abstaining and no broker non-votes.
Approval of 2000 Performance Bonus Plan.
At the Meeting, the stockholders of the Company voted on and ratified the
Company's 2000 Performance Bonus Plan. 44,557,962 votes were cast for such
proposal, 671,361 votes were cast against or withheld, with 5,799,941 votes
abstaining and no broker non-votes.
Ratification of Accountants.
At the Meeting, the stockholders of the Company voted on and ratified the
appointment of Aidman, Piser & Company, P.A. as independent accountants for
2000. 50,992,480 votes were cast for such proposal, 31,560 votes were cast
against or withheld, with 5,224 votes abstaining and no broker non-votes.
22
PART II
Item 5. Market for Common Equity and Related Stockholder Matters
Until March 21, 2000, the Common Stock of the Company was traded in the
over-the-counter market and was quoted on the OTC Bulletin Board under the
symbol "STSI." On March 21, 2000, the Common Stock of the Company commenced
trading on the NASDAQ National Market System under the symbol "STSI." Set
forth below are (a) the high and low bid prices (which reflect prices between
dealers and do not include retail markup, markdown or commission and may not
represent actual transactions) for each full quarterly period during 1999
through March 20, 2000, as reported by the National Quotation Bureau and (b)
the high and low sales prices from March 21, 2000 and for each quarterly
period thereafter, as reported by NASDAQ. From time to time, during the
periods indicated, trading activity in the Company's stock was infrequent. As
of March 1, 2001, there were approximately 641 record holders of the Company's
Common Stock.
2000 High Low
---- ---- ---
First Quarter.................................................. $7.500 $5.625
Second Quarter................................................. $6.750 $3.375
Third Quarter.................................................. $5.000 $3.750
Fourth Quarter................................................. $4.063 $2.031
1999 High Low
---- ---- ---
First Quarter.................................................. $2.125 $1.625
Second Quarter................................................. $3.625 $1.563
Third Quarter.................................................. $5.188 $3.125
Fourth Quarter................................................. $8.563 $5.063
The Company has never paid dividends on its Common Stock, and the Board of
Directors currently intends to retain any earnings for use in the Company's
business for the foreseeable future. Any future determination as to the
payment of such cash dividends would depend on a number of factors including
future earnings, results of operations, capital requirements, the Company's
financial condition and any restrictions under credit agreements outstanding
at the time, as well as such other factors as the Board of Directors might
deem relevant. No assurance can be given that the Company will pay any
dividends in the future.
Item 6. Selected Financial Data
The selected consolidated financial data of the Company for and as of the
end of each of the periods indicated in the five-year period ended December
31, 2000 have been derived from the audited consolidated financial statements
of the Company. The selected consolidated financial data should be read in
conjunction with the consolidated financial statements of the Company,
including the notes to those consolidated financial statements contained
elsewhere in this report.
Year Ended December 31,
------------------------------------------
2000 1999 1998 1997 1996
-------- ------- ------- ------- -------
(In thousands, except per share data)
Statement of Operations Data:
Net Sales......................... $223,051 $99,325 $19,445 $20,764 $34,260
Cost of goods sold................ 93,951 31,878 7,669 10,033 16,150
Gross Profit...................... 45,507 33,624 2,938 2,920 4,639
Operating income (loss)........... 17,056 17,078 (3,475) (1,986) (753)
Net income (loss)................. 10,041 11,515 (4,196) (1,986) (753)
Basic income (loss) per share..... 0.17 0.32 (0.42) (0.58) (0.22)
Diluted income (loss) per share... 0.17 0.23 (0.42) (0.58) (0.22)
Weighted average shares
outstanding...................... 59,008 36,207 8,327 3,435 3,437
23
Year Ended December 31,
----------------------------------
2000 1999 1998 1997 1996
------ ------ ----- ------ -----
(In thousands, except per share
data)
Balance Sheet Data:
Cash and cash equivalents.................. 16,747 17,205 103 11 11
Property, plant & equipment................ 27,400 10,974 1,704 2,416 2,767
MSA escrow funds........................... 11,605 -- -- -- --
Total assets............................... 69,467 38,709 4,435 4,120 6,644
Long-term obligations...................... 13,272 7,505 612 1,099 2,655
Stockholders' equity (deficit)............. 25,276 12,319 (639) (1,742) (838)
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operation
The following discussion of the results of operations and financial
condition of the Company should be read in conjunction with the Company's
Consolidated Financial Statements and related notes included elsewhere in this
report. This discussion contains forward-looking statements based on current
expectations that involve risks and uncertainties. See "Business Factors That
May Affect Future Results" and "Forward-Looking Statements."
Results of Operations--Fiscal 2000 Compared to Fiscal 1999
During 2000, the Company's net sales increased to $223.1 million, reflecting
an increase of $124.1 million, or 125% over 1999 net sales. Net sales in 2000
included $46.2 million in very low-TSNA tobacco sold to B&W, delivered
primarily in the third and fourth quarters of 2000, which compares to a total
of $9.8 million in fourth quarter sales in 1999. The Company did not have any
leaf sales in the third quarter of 1999.
In addition to the very low-TSNA tobacco sales made to B&W, substantially
all of the Company's other revenues in 2000 were derived from sales of ST&P's
four brands of "discount" cigarettes. ST&P's shipment volume during 2000
increased approximately 79% to 5.0 billion units over 1999's shipment volume
of 2.8 billion units, reflecting a continued upswing in sales of the ST&P's
cigarettes as a result of growing the customer base, including the addition of
several major retail chains and a concentration of the field sales force in
four states. Slight increases in product pricing also contributed to higher
net sales.
During 2000, gross margin increased to $45.5 million compared to $33.6
million in 1999. As a percent of sales, however, the Company's gross margins
from our overall operations decreased from 33.8% in 1999 to 20.4% in 2000.
Specifically, ST&P's four discount cigarette brands experienced an increase in
excise taxes (from $12 per 1,000 cigarettes in 1999 to $17 per 1,000
cigarettes in 2000), resulting in an increase in excise taxes paid as a
percentage of cigarette net sales from 37.8% in 1999 to 47.3% of cigarette net
sales in 2000. Further, operating income was affected by the expansion of
ST&P's discount cigarette market, which required the addition of a sales force
in early 2000, as well as marketing and incentive programs at the
wholesale/distributor level to achieve increased market penetration.
Depreciation costs were $1.8 million in 2000 compared to $0.4 million in 1999,
reflecting the increase in the number of barns and the amount of tobacco
processed. Finally, R&D, product development, legal and consulting expenses
for specific medical, health, compliance, communications, and technical advice
associated with the Company's growth and new product launches also contributed
to the Company's lowered profit margin.
Marketing and distribution expenses totaled $13.0 million for 2000, an
increase of $6.7 million over 1999 which is in line with the increased sales
volume and, in part, reflects salary and incentive compensation payments to
sales personnel. The Company's marketing and distribution expenses are
expected to grow significantly during 2001 as the Company expands its
commercialization capabilities.
General and administrative expenses for 2000 totaled $13.2 million compared
to $9.9 million for 1999, an increase of $3.3 million primarily attributable
to increased operating costs for the Company's greatly expanded barn program
and additions to the Company's management and consulting team. Other
components of general and administrative expenses were relatively flat when
compared to the comparable periods in 1999; however, there were some cost
increases associated with the higher sales volume, as well as increased legal
and consulting costs associated with the Company's fulfillment of its
compliance obligations as a publicly-held company,
24
pursuance of its legal and public health strategies in the legislative,
regulatory and executive agency arenas, its technical recruitment efforts,
expansion of its Scientific Advisory Board and increased scientific
consulting.
Research and development expenses were $1.7 million in 2000 versus $0.5
million in 1999 and were specifically related to the development of the
Company's TSNA reduction technology and associated low-TSNA products. These
expenses consisted primarily of costs incurred by the Company for consulting
services, and professional fees and expenses in connection with the Company's
continuing research and development programs.
Higher income tax expense in 2000 reflects the use of the Company's net
operating loss carryover from previous years during 1999 to lower the
Company's 1999 income tax expense.
Higher net interest expense in 2000 was the result of interest expense from
the credit facility with B&W, partially offset by the interest income
generated by the Company's deposit into the MSA escrow fund.
Net income of $10.0 million for 2000 compares with $11.5 million for 1999, a
decrease of $1.5 million. In 2000, the Company had basic and diluted earnings
per share of $0.17, respectively, compared with basic earnings of $0.32 and
diluted earnings of $0.23 in 1999. In 2000, basic and diluted weighted average
shares outstanding were 59,008,127 and 60,645,061, respectively versus
36,207,390 and 50,301,998, respectively, for 1999. The number of basic shares
increased primarily due to the conversion of Class B Preferred Stock to Common
Stock in April 1999. With the completion of that conversion, there were no
further outstanding shares of any preferred stock.
Results of Operations--Fiscal 1999 Compared to Fiscal 1998
During 1999, the Company's net sales increased to $99.3 million, reflecting
an increase of $79.9 million, or 411% over 1998 net sales. Net sales in 1999
included $9.8 million in very low-TSNA tobacco sold and delivered to B&W in
the fourth quarter of 1999. There were no such sales in 1998, except for minor
leaf deliveries to major tobacco companies during the development stage of the
Company's very low-TSNA program.
Other than very low-TSNA tobacco sales made to B&W, substantially all of the
Company's revenues in 1999 were derived from sales of ST&P's four brands of
"discount" cigarettes. ST&P's shipment volume during 1999 increased
approximately 276% over 1998 to 2.8 billion units, reflecting a continued
upswing in sales of ST&P's cigarettes as a result of growing the customer base
across the country, including the addition of several major retail chains.
Slight increases in product pricing also contributed to higher net sales.
During 1999, the Company's gross profit increased to $33.6 million,
reflecting an increase of $30.7 million over 1998, as increases in net sales
of $79.9 million were partially offset by increased costs of goods sold
($24.2 million) and increased excise taxes ($25.0 million). Increased costs of
goods sold were related to volume increases, and were partially offset by a
decrease in the average cost of tobacco purchased by the Company.
Marketing and distribution expenses totaled $6.3 million for 1999, an
increase of $5.1 million over 1998 which is in line with the increased sales
volume and reflects salary and incentive compensation payments to sales
personnel.
General and administrative expenses for 1999 totaled $9.9 million, an
increase of $6.7 million partially attributable to operating costs for the
Company's Chase City facility. This facility processes the very low-TSNA
tobacco during the months of June through November. Chase City facility costs
in 1998 were significantly lower, due to the experimental nature of the
operation at the time, and were classified in 1998 as research and development
costs, in keeping with the Company's mission at the time to develop the
StarCured(TM) tobacco curing process to a commercially feasible production
level, which was accomplished in 1999. Other general and administrative costs
are relatively flat when compared to the comparable periods in 1998; however,
there are some cost increases associated with the higher sales volume, as well
as increased legal and consulting costs
25
associated with the Company's fulfillment of its compliance obligations as a
publicly-held company, pursuance of its legal and public health strategies in
the legislative, regulatory and executive agency arenas, its technical
recruitment efforts, expansion of its Scientific Advisory Board and increased
scientific consulting.
Research and development expenses were significantly higher in 1998
primarily as a result of costs incurred in this period specifically related to
the development of the Company's TSNA reduction technology. Those expenses
consisted primarily of costs incurred by the Company for consulting services
and professional fees and expenses in connection with the Company's continuing
research and development programs.
Net interest income in 1999 reflected positively against net interest
expense in 1998, reflecting interest on higher 1999 cash balances generated by
the improved operating results.
Income tax expense reflects use of the Company's net operating loss
carryover from 1998, the benefit of which was previously reserved.
In 1998, the Company recorded charges to earnings for the discontinued
operations of its ophthalmic business and a loss on the disposal (sale) of
such business totaling $972,000. These charges resulted in a loss from
discontinued operations equal to ($0.12) per share. As a result of various
settlements with the Company's creditors, reached prior to the merger with Eye
Technology in February 1998, the Company also recorded an extraordinary gain
of $252,000 in 1998 or $0.03 per share.
Net income of $11.5 million for 1999 compared favorably with a net loss of
($4.2) million for 1998. In 1999, the Company had basic and diluted earnings
per share from continuing operations equal to $0.32 per share and $0.23,
respectively, versus basic and diluted losses per share from continuing
operations of ($0.42) per share for 1998. In 1999, basic weighted average
shares outstanding were 36,207,390 versus 8,327,345 for 1998, and diluted
weighted average shares outstanding in 1999 were 50,301,998 versus 8,327,345
for 1998.
Liquidity and Capital Resources
Accounts receivable and accounts payable throughout 2000 were current and
the Company has normal industry terms with all of its suppliers. In 2000, cash
used in investing activities exceeded cash generated by operating and
financing activities. In 2000, $13.1 million of cash was provided by operating
activities compared to $20.8 million of cash provided in 1999. The decrease in
cash provided by operating activities was due to the Company's investment in
working capital in 2000. In 2000, $17.4 million of cash was provided by
financing activities versus $7.8 million of cash in 1999, generated by
proceeds from notes issued to B&W. Cash used in investment activities
increased to $19.4 million in 2000 from $11.5 million in 1999 due to an
increase in purchases of curing barns in 2000 as discussed below.
During 2000, the Company incurred $18.6 million in capital expenditures,
compared to $10.0 million in 1999, virtually all of its as part of the
StarCured(TM) tobacco barn production program with Powell. In 1999, B&W agreed
to loan the Company capital necessary to finance the purchase of curing barns,
designed by the Company and specially manufactured for the Company by Powell.
During 2000, the Company borrowed $13.2 million from B&W under this long-term
credit facility restricted to borrowings to finance the purchase of tobacco
curing barns. Interest on this credit facility accrues at a rate of prime plus
1%, and is payable monthly. Principal is payable in 60 equal monthly
installments commencing September 2004. The credit facility is non- recourse
to the Company, but is collateralized by the Company's curing barns and leaf
tobacco inventory.
On August 21, 2000, the Company entered into a Restated Loan Agreement (the
"Restated Loan Agreement") with B&W. The Restated Loan Agreement restates the
Loan Agreement dated October 12, 1999 between the Company and B&W (the "Prior
Loan Agreement") in which B&W agreed to lend the Company capital necessary to
finance the purchase of specially manufactured tobacco curing barns, up to an
aggregate of $22,000,000 (the "Prior Loan"). As of August 20, 2000 Star had
borrowed $13.2 million under the Prior Loan
26
Agreement. In addition, as of August 20, 2000, B&W advanced $11,000,000 (the
"Advance") to Star against delivery of StarCured(TM) flue-cured tobacco from
the year 2001 flue-cured tobacco crop.
Under the Restated Loan Agreement, (i) B&W made a one-year term loan to Star
of an additional $4,950,000 for working capital purposes, at a fluctuating
annual interest rate equal to prime plus 1% (the "New Loan"), and deferred
repayment of the Advance for one year and (ii) B&W and Star agreed to collapse
into one restated agreement the terms of the Prior Loan, the Advance and the
New Loan (together, the Prior Loan, the Advance and the New Loan are referred
to as the "August 2001 Loan"). The Advance is evidenced by a promissory note
the principal of which shall be reduced by deliveries by Star to B&W of
StarCured(TM) flue-cured tobacco from the year 2001 flue-cured tobacco crop.
If the required StarCured(TM) flue-cured tobacco deliveries are not made by
December 31, 2001, then the outstanding principal will be payable on demand.
Any outstanding principal after December 31, 2001 shall bear interest at a
fluctuating interest rate per annum equal to prime plus 1%.
The Company has granted B&W a first priority security interest in the
Company's intellectual property as collateral for the Loan. In addition, Star
and ST&P have each guaranteed the payment of the other's obligations under the
Loan. The August 2000 Loan is also secured by tobacco leaf inventory and the
barns which were the original collateral under the Prior Loan Agreement.
As follow-on to the Restated Loan Agreement, the Letter of Understanding
provides for a substantial restructuring of the Company's loan obligations to
B&W. The parties have signed the non-binding Letter of Understanding which
contemplates the execution of definitive agreements by the parties updating
B&W's supply requirements, rescheduling of the Company's debt payments, and
accomplishing certain other business objectives. If B&W and Star were not to
be successful in converting the Letter of Understanding into a series of
agreements, Star's sales volumes, operating income and cash flows could be
materially affected. The Company believes that it should be able to finalize
the agreements required to put into effect the Letter of Understanding,
however, the Company cannot guarantee that the Letter of Understanding will be
completed as envisioned.
During the second quarter of 2000, the Company increased its negotiated line
of credit with a working capital lender to $7.5 million. This line of credit
is collateralized by accounts receivable from its cigarette business. At
December 31, 2000 and 1999, the Company had no borrowings under this line of
credit.
In September 2000, the Company also received approximately $1.9 million in
proceeds from the exercise of warrants to purchase 967,600 shares of the
Company's common stock (the warrants had an exercise price of $2.00 per
share). In October 1999, the Company received approximately $1.0 million in
proceeds from the exercise of a warrant to purchase 522,920 shares of the
Company's common stock. The Company also issued 250,000 warrants to Banner &
Witcoff in 2000 for their work relating to the Company's intellectual
property, which are the only warrants outstanding to purchase common stock.
Under the Master Settlement Agreement, absent a successful legal challenge
to the state specific statutes or an agreement with the NAAG with respect to
the funding of the required escrow accounts, the Company is purportedly
obligated to place an amount equal to $1.88 per carton for 1999, $2.09 in
2000, $2.72 in 2001, and increased amounts per carton for subsequent years, in
escrow for sales of cigarettes occurring in each such state after the
effective date of each state specific statute. An inflation adjustment is also
added to these deposits at the higher of 3% or the Consumer Price Index each
year. Such escrowed funds will be used to pay judgments in tobacco-related
litigation or settlements, if any, and if not so used returned to the Company
after 25 years. On April 14, 2000, under protest, the Company placed into
escrow approximately $11.6 million for sales made in 1999. The next escrow
payment date is April 15, 2001 for sales made during 2000. The funds placed in
escrow will continue to be an asset of the Company and the Company will
receive the interest income generated by the escrow deposit. However, these
escrow obligations will significantly impede the Company's ability to apply
the capital generated from its cigarette sales as it sees fit and the amount
required to be placed in escrow for each carton sold may exceed the net cash
flow generated by each carton sold. Based on Star's projected increase in
sales for future years, the Company will have to pay significant sums into
these escrow accounts to meet the Master Settlement Agreement requirements.
The Company has attempted to mitigate these MSA payments by,
27
among other things, focusing its efforts on increasing market share in states
in which it does not have purported obligations to make payments into escrow
under state qualifying statutes enacted pursuant to the MSA.
Assuming consummation of the transactions contemplated by the Letter of
Understanding, the Company believes that its existing working capital,
together with anticipated earnings from its operations, will be sufficient to
meet its liquidity and capital requirements in the foreseeable future. The
Company's need, if any, to raise additional funds to meet its working capital
and capital requirements will depend upon numerous factors, including the
results of its marketing and sales activities, any escrow obligations it may
be required to comply with under the MSA, the success of the Company's new
product development efforts and the other factors described under "Factors
That May Affect Future Results."
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
The Company has not entered into any transactions using derivative financial
instruments or derivative commodity instruments and believe that its exposure
to market risk associated with other financial instruments (such as
investments and borrowings) and interest rate risk is not material.
Item 8. Financial Statements
This information is contained on F-1 through F-25 hereof and is incorporated
into Part I of this report by reference.
28
Item 9. Changes in and Disagreements with Accountants and Financial Disclosure
None.
PART III
Item 10. Directors and Executive Officers of the Registrant
The Board of Directors is divided into three classes. Members of each class
serve for a three-year term and until the election and qualification of their
successors, or their earlier resignation or removal. The term of office for
the Class Three Directors, Robert J. DeLorenzo, M.D., Ph.D., M.P.H., Leo S.
Tonkin, Christopher G. Miller and Neil Chayet will expire on the date of the
2004 Annual Meeting if they are reelected at the 2001 Annual Meeting. Paul L.
Perito and Elliot D. Prager, M.D. currently serve as Class One Directors and
their current term in office expires at the 2002 Annual Meeting. Jonnie R.
Williams, Martin Leader, and Mark W. Johnson currently serve as Class Two
Directors and their current term in office expires at the 2003 Annual Meeting.
Class Three Directors--Terms Expiring at the Annual Meeting in 2001
Neil Chayet. Mr. Chayet, 62, is a Class Three director of the Company. He
was elected to the Board in November 2000. He is President of Chayet
Communications Group, Inc., and Special Counsel to the law firm of Mintz,
Levin, Cohn, Ferris, Glovsky and Popeo, P.C. He is also a member of the
Faculty of the Harvard Medical School, serving as a Lecturer in Forensic
Psychiatry in the Department of Psychiatry. He also serves as a member of the
Faculty of the Tufts University Schools of Dental Medicine and Veterinary
Medicine. He served as a Trustee of Tufts for ten years, and presently is a
member of the Board of Overseers of the Tufts University School of Veterinary
Medicine. He has recently been named Vice President of the Harvard Law School
Association. Mr. Chayet began his career teaching law to psychiatrists at the
Boston University Law-Medicine Institute and has long been involved with
issues related to medicine and the law. He is the author of four books and
more than 60 articles in the field of law and medicine. He has also
represented physicians, hospitals and pharmaceutical companies in matters
involving malpractice, certificate of need, fraud and abuse, and approval and
reimbursement of drugs and devices. In recent years he has developed
particular expertise in matters related to the Health Care Financing
Administration, including Medicare reimbursement, fraud and abuse and Medicaid
computer systems. Mr. Chayet is perhaps best known as the host of a CBS daily
nationally syndicated radio program "Looking at the Law" and a weekly two-hour
call-in program originating on WBZ in Boston. Mr. Chayet is a graduate of
Tufts University and the Harvard Law School.
Robert J. DeLorenzo, M.D., Ph.D., M.P.H. Dr. DeLorenzo, 52, is a Class Three
director of the Company. He has served as a director of the Company from
February 1998 and served as Chairman of the Company's Board of Directors from
February 1998 until August 2000. Dr. DeLorenzo served as the Company's Chief
Executive Officer from October 1998 through November 1999. Since 1985, he has
served as Chairman of the Department of Neurology, the George B. Bliley
Professor of Neurology, and Professor of Pharmacology and Toxicology and
Biochemistry and Biophysics at Virginia Commonwealth University, as well as
Neurologist-in-Chief of the Medical College of Virginia Hospitals and Director
of the Molecular Neurobiology Laboratories at the Medical College of Virginia.
Prior to 1985, Dr. DeLorenzo was on the neurology faculty at Yale University.
Dr. DeLorenzo has authored over 300 original publications and has received
numerous research awards including the Jacob Javits Award from the National
Institutes of Health and the Jordi-Folch-Pi Award from the American Society of
Neurochemistry. He serves on the editorial boards of several scientific
journals and served on and chaired National Institutes of Health Study
Sections. Dr. DeLorenzo holds a Ph.D. in neuropharmacology from Yale
University, an M.D. from Yale University School of Medicine and an M.P.H. from
the Yale School of Epidemiology and Public Health.
Christopher G. Miller. Mr. Miller, 42, is a Class Three director of the
Company and served as the Company's Acting Chief Financial Officer from April
2000 until September 2000, and as Chief Financial Officer beginning in
September 2000. He also serves as Chief Executive Officer of The Special
Opportunities Group
29
LLC. Prior to his service at The Special Opportunities Group LLC, Mr. Miller
served as Chief Financial Officer of The Gilder Group from 1998 to 1999, Chief
Executive Officer of American Healthcare Ltd. from 1994 to 1998, Chief
Executive Officer of International Medical Care, Ltd. from 1992 to 1993, and
Chief Financial Officer and Executive Vice President of Hospital Corporation
International from 1991 to 1992. Upon his graduation from Harvard Business
School, Mr. Miller was employed by Bear Stearns Companies Inc. in New York as
an Associate in Investment Banking. Mr. Miller serves on the Board of
Directors of XiTec, SignalQuest, Ana Mandara and Zhou Li's Marco Polo
Collections. Mr. Miller graduated from the U.S. Military Academy at West Point
in 1980 with a B.S. in Engineering and received an MBA from Harvard Business
School in 1987.
Leo S. Tonkin. Mr. Tonkin, 63, is a Class Three Director of the Company. He
has served as a director of the Company since October 1998. He is Founding
Director of the Washington Workshops Foundation, established in 1967 and
serves as President of Travel Seminars, Inc. He served as a member of the
White House Conference on Youth in 1971, Special Assistant to the Chairman of
the U.S. House of Representatives Select Committee on Crime, Legal Consultant
to the U.S. House of Representatives Higher Education Subcommittee, and
Executive Director of the Commissioners' Council on Higher Education in
Washington, D.C. He has served as Chairman of the Board of Trustees of St.
Thomas Aquinas College and as a Board member of Southeastern University and
Immaculata College. He is a vice president of the London, England Federation
of Youth Clubs and advisor to the Retinitis Pigmentosa Foundation in
California. Mr. Tonkin is a graduate of Johns Hopkins University and received
his law degree from Harvard Law School.
Class One Directors--Terms Expiring at the Annual Meeting in 2002
Paul L. Perito. Mr. Perito, 64, is a Class One director of the Company and
the Company's Chairman, President and Chief Operating Officer. He has served
as Chairman of the Company since August 2000, as a director of the Company
since December 1999 and as the Company's President and Chief Operating Officer
since November 1999. Mr. Perito served as the Company's Executive Vice
President, General Counsel and Chief Ethics Officer from June 1999 through
November 1999. Previously, Mr. Perito was a senior partner in the law firm of
Paul, Hastings, Janofsky & Walker LLP ("PHJ&W") from July 1991 until June 1999
when he became a senior counsel to the firm at the time he joined the Company.
Mr. Perito has resigned his position as senior counsel to PHJ&W as of March
31, 2001 after serving as National Co-Chair of the White Collar Corporate
Defense Practice Group at PHJ&W since 1991, and Chair of the Litigation
Department in that firm's Washington, D.C. office since 1995. Prior to his re-
entry into private practice, he served as Chief Counsel and Deputy Director of
the White House Special Action Office on Drug Abuse Prevention ("Drug Czar's
Office") from 1971 to 1973. Mr. Perito was confirmed by the Senate for that
position in March 1972. From 1970 to 1971, Mr. Perito served as Chief Counsel
and Staff Director to the U.S. House of Representatives Select Committee on
Crime. Immediately prior to serving the Congress, Mr. Perito was an Assistant
United States Attorney in the Southern District of New York, U.S. Department
of Justice from 1966 to 1970. Mr. Perito graduated from Tufts University and
Harvard Law School. Mr. Perito was a Rotary International Scholar at the
Victoria University of Manchester in Manchester, England and in Lund
University, Lund, Sweden in P.P.E. in 1960-61 before entering Harvard Law
School. Mr. Perito graduated from Harvard Law School (LLB/JD), as an Edward
John Noble Scholar, in 1964 and was thereafter admitted to the Bar of the
Commonwealth of Massachusetts. He is also a member of the District of Columbia
Bar and is admitted to practice in numerous federal District Courts, Courts of
Appeal and the United States Supreme Court.
Elliot D. Prager, M.D. Dr. Prager, 58, is a Class One director of the
Company. He has served as a director of the Company since August 1999. From
1974 to 2000, he performed colon and rectal surgery at the Sansum Medical
Clinic in Santa Barbara, California, and served on its Board of Directors from
1980 to 1986. From 1995 to September 1999, he served as Chairman of the
Residency Review Committee for Colon and Rectal Surgery. From 1998 to the
present he has served as Medical Director of the Cottage Hospital Operating
Room. He holds an appointment as Associate Clinical Professor at the
University of Southern California. Dr. Prager graduated from Dartmouth College
and holds his M.D. from Harvard Medical School.
30
Class Two Directors--Terms Expiring at the Annual Meeting in 2003
Jonnie R. Williams. Mr. Williams, 44, is a Class Two director of the Company
and the Company's Chief Executive Officer. Mr. Williams was one of the
original founders of ST&P, and has served as Chief Operating Officer ("COO"),
Executive Vice President ("EVP") and a Director of the Company since October
1998. On July 1, 1999, in order to concentrate upon the expanding demands of
Star's sales and new product development, Mr. Williams resigned as COO and EVP
to assume the primary responsibilities of Director of Product Development and
Sales. Mr. Williams, a principal stockholder of the Company, is also the
inventor of the StarCuredTM tobacco curing process for reducing and/or
virtually eliminating the formation of TSNAs in tobacco and tobacco smoke. Mr.
Williams has been involved in venture capital start-up bio-tech companies for
over a decade where he has been either a major shareholder or a co-founder of
the following companies: LaserSight, LaserVision, VISX and APP (a New York-
based pharmaceutical company). Also, Mr. Williams is a partner of Regent
Court, and is a principal in Jonnie Williams Venture Capital Corp., as well as
a principal in Hopkins Capital Partners, Ltd., a closely held bio-tech company
engaged in developing drugs for the treatment of AIDS and cancer, some of
which are now undergoing FDA clinical trials.
Mark W. Johnson. Mr. Johnson, 37, is a Class Two director of the Company. He
has served as a director of the Company since June 1999. He currently serves
as Chief Executive Officer of Innosight, LLC, where he has been since 1999,
and previously served as Chief Operating Officer. Prior to his service at
Innosight, LLC, Mr. Johnson served as Senior Vice President of the Gilder
Group. From 1994 to 1999, he served as a management consultant with Booz-Allen
& Hamilton, Inc. From 1989 to 1994, he served as a nuclear power trained Naval
officer in Virginia Beach, Virginia and Washington, D.C. He also serves as a
director of the Washington Workshops Foundation. Mr. Johnson graduated from
the United States Naval Academy, received a Masters of Science in Civil
Engineering and Engineering Mechanics from Columbia University and
subsequently graduated from the Harvard Business School.
Martin Leader. Mr. Leader, 60, is a Class Two director of the Company. He
has served as a director of the Company since June 2000. Mr. Leader currently
is a partner at the law firm of Shaw Pittman in Washington, D.C. Prior to his
service at Shaw Pittman, Mr. Leader was a senior partner with the law firm of
Fisher Wayland Cooper Leader & Zaragoz in Washington, D.C. from 1973 to 1999.
He is currently a principal and director of OnlineLaunch. Mr. Leader has
served on the staff of the Office of Opinions and Review of the Federal
Communications Commission. He is a member of the District of Columbia Bar and
of the Federal Communications Bar Association. Mr. Leader graduated from Tufts
University and Vanderbilt University Law School.
Executive Officers of the Company who are not Directors
Sheldon L. Bogaz. Mr. Bogaz, 35, has served as ST&P's Vice President of
Trade Operations since October 1999 and is responsible for managing customer
relationships, developing new business, and formulating and implementing
pricing and trade programs. He served as the Vice President of Sales and Trade
Operations of the Company from September 1995 to October 1999. Prior to
joining the Company in 1995, Mr. Bogaz served as a Commercial Lender with
NationsBank from 1992 to 1995. He holds a Bachelor of Science Degree in
Business Administration from Virginia Commonwealth University.
David M. Dean. Mr. Dean, 41, has served as Vice President of Sales and
Marketing of the Company since November 1999. From 1998 to October 1999, he
served as a Principal of Group Insurance Concepts of Virginia, L.C., an
employee benefits consulting firm and an affiliate of Northwestern Mutual.
From 1984 to 1998, Mr. Dean was employed with Trigon Blue Cross/Blue Shield in
Richmond, Virginia, where he held a variety of executive positions over a 14
year period, including Vice President of the Eastern Region from 1994 to 1996,
Vice President of Sales from 1996 to 1997 and Vice President of Sales and
Account Management for the Eastern and Western Regions from 1997 to 1998.
Trigon Blue Cross/Blue Shield is the largest health insurer in Virginia. Mr.
Dean is a graduate of Elon College.
31
Paul H. Lamb, III. Mr. Lamb, 68, has served as a director and as President
and Chief Executive Officer of ST&P since December 1999. From 1990 to 1994, he
served as President of ST&P, and he has served as a director of that company
since 1990. He served as a consultant to the Company until assuming his
current position in January 1999. From 1986 to 1990, Mr. Lamb founded and
operated Lamb Services, Ltd., an engineering consulting firm, and from 1958 to
1986 he was employed with Brown & Williamson Tobacco Corporation where he held
a variety of engineering positions. Mr. Lamb has served as a director of the
Southside Regional Medical Center in Petersburg, Virginia for twenty-six
years. Mr. Lamb graduated from Virginia Military Institute (VMI) with a degree
in civil engineering.
Section 16 (a) Beneficial Ownership Reporting Compliance
Section 16 of the Securities Exchange Act of 1934, as amended (the "Exchange
Act") requires directors and executive officers and persons, if any, owning
more than ten percent of a class of the Company's equity securities to file
with the Securities and Exchange Commission (the "SEC") initial reports of
ownership and reports of changes in ownership of the Company's equity and
equity derivative securities. Based solely upon a review of the copies of such
reports furnished to the Company, or written representations from reporting
persons, the Company believes that all required persons during 2000 were in
compliance. During 2000, Mr. Leader was delinquent in filing a Form 4 due to
an administrative error, but Mr. Leader is now in compliance.
Item 11. Executive Compensation
Summary Compensation Table
The following table sets forth, for each individual who served as Chief
Executive Officer and the other most highly compensated officers of the
Company (the "Named Executive Officers"), certain information concerning
compensation.
Long Term
Annual Compensation Compensation Awards
---------------------- ------------------------
Other Annual Restricted Securities
Name and Principal Salary Compensation Stock Underlying All Other
Position Year ($) Bonus ($) ($) Award ($)(1) Options (#) Compensation
- ------------------ ---- --------- --------- ------------ ------------ ----------- ------------
Jonnie R. Williams...... 2000 1,000,000 1,400,000 287,906 -- -- --
Chief Executive
Officer(2) 1999 1,000,000 1,400,000 -- -- -- --
1998 400,000(3) -- -- -- -- --
Paul L. Perito.......... 2000 1,000,000 900,000 -- -- -- --
Chairman, President and
Chief 1999 350,432 250,000(5) 25,000(6) -- 1,000,000 --
Operating Officer(4)
David M. Dean........... 2000 251,500 120,229 11,334 -- 350,000 --
Vice President 1999 49,563 -- 3,436 -- -- --
Sheldon L. Bogaz........ 2000 -- 261,239 20,926 -- 250,000 --
Vice President ST&P 1999 -- 306,546 10,119 -- -- --
- --------
(1) The Company did not award any stock appreciation rights to the executive
officers or make any long-term incentive plan payouts in 2000, 1999, 1998
and 1997.
(2) Mr. Williams was appointed Chief Executive Officer in November 1999. Mr.
Williams served as Senior Vice President of Marketing and Product
Development of the Company from June 1999 to November 1999 and served as
the Company's Chief Operating Officer and Executive Vice President from
October 1998 through June 1999.
(3) Represents management fees paid to Mr. Williams prior to his employment
with the Company.
(4) Mr. Perito was elected as the Company's Chairman in August 2000. Mr.
Perito was appointed as the Company's President and Chief Operating
Officer in November 1999. Mr. Perito served as the Company's Executive
Vice President, General Counsel, Secretary and Chief Ethics Officer from
June 1999 until November 1999.
(5) The Company paid Mr. Perito $250,000 in the form of a signing bonus in
1999 and paid Mr. Perito a bonus of $250,000, based on the Company's and
Mr. Perito's performance in March 2000.
(6) Represents the difference between the price paid by Mr. Perito for
2,000,000 shares of the Company's Common Stock and the fair market value
of such stock as determined by the Company in compliance with Internal
Revenue Service regulations.
32
Option Grants During 2000
The following table sets forth, for the Named Executive Officers, certain
information concerning stock options granted to them during 2000. We have
never issued stock appreciation rights. Options were generally granted at an
exercise price equal to the fair market value of the Common Stock at the date
of grant. The term of each option granted is generally ten years from the date
of grant. Options may terminate before their expiration dates, if the
optionee's status as an employee or a consultant is terminated or upon the
optionee's death or disability.
Individual Grants
---------------------
Potential Realizable
Value at Assumed
% of Total Rates of Stock
Options Exercise Price Appreciation
Granted to or Base Market Price for Option Term(1)
Options Employees in Price on Date of Expiration ---------------------
Name Granted Fiscal Year ($/Sh) Grant($) Date 5%($) 10%($)
- ---- ------- ------------ -------- ------------ ---------- --------- -----------
David M. Dean........... 350,000 51.9% $4.00 $4.00 10/5/10 $880,600 $2,231,600
Sheldon L. Bogaz........ 250,000 37.0 $4.00 $4.00 10/5/10 $629,000 $1,594,000
- --------
(1) The dollar amounts under these columns are the result of calculations at
the 5% and 10% rates set by the Securities and Exchange Commission and
therefore are not intended to forecast possible future appreciation, if
any, of the stock price of the Company. If the Company's stock price were
in fact to appreciate at the assumed 5% or 10% annual rate for the ten
year term of these options, a $1,000 investment in the Common Stock of the
Company would be worth $1,629 and $2,594, respectively, at the end of the
term.
Aggregated Option Exercises in 2000 and Year-End Option Values
The following table sets forth, for the Named Executive Officers, certain
information concerning options exercised during fiscal 2000 and the number of
shares subject to both exercisable and unexercisable stock options as of
December 31, 2000. The values for "in-the-money" options are calculated by
determining the difference between the fair market value of the securities
underlying the options as of December 31, 2000 ($2.438 per share) and the
exercise price of the officer's options. The Company has never issued stock
appreciation rights.
Number of Securities
Underlying Unexercised Value of Unexercised
Number of Options at In-The-Money Options at
Shares December 31, 2000 December 31, 2000($)
Acquired on Value ------------------------- -------------------------
Name Exercise(#) Realized($) Exercisable Unexercisable Exercisable Unexercisable
- ---- ----------- ----------- ----------- ------------- ----------- -------------
Jonnie R. Williams...... -- -- -- -- -- --
Paul L. Perito.......... -- -- 1,000,000 -- $753,000 --
David M. Dean........... -- -- 218,750 131,250 -- --
Sheldon L. Bogaz........ -- -- 250,000 -- -- --
The Company does not have a defined benefit plan or actuarial pension plan.
During 2000, the Company did not have a "long-term incentive plan", and the
Company did not make any "long-term incentive awards", as such terms are
defined in Item 402 of Regulation S-K. During 2000, no stock options were
exercised by any optionee.
Compensation Committee Interlocks and Insider Participation
None.
Board of Directors Compensation
Each independent director of the Company, as classified as such by the Board
of Directors ("Independent Directors"), is granted a stock option to purchase
up to 50,000 shares of Common Stock on the date such Independent Director is
first elected to the Board of Directors, exercisable over a three-year period,
in equal installments on each of the first three anniversaries of the date of
grant. As an annual retainer, each Independent Director additionally receives
a stock option to purchase up to 25,000 shares of Common Stock granted on each
anniversary of such Independent Director's initial election to the Board of
Directors, exercisable immediately. Each stock option granted to an
Independent Director under the Company's 2000 Equity Incentive Plan will be
exercisable at a price equal to the fair market value of the Common Stock on
the date of grant (as determined in accordance with the Plan).
33
Each Independent Director also receives a payment of $2,500 for his
participation in each meeting of the Board of Directors and any committee
meeting attended personally and $1,500 for his participation in each meeting
of the Board of Directors and any committee meeting attended telephonically.
Messrs. Chayet, Johnson, Leader, Tonkin and Dr. Prager currently are
designated as Independent Directors. This designation is intended solely for
the purpose of clarifying which directors are entitled to compensation for
their services as directors. Directors not designated as Independent Directors
generally are those who in the past have been, or currently are being,
compensated by the Company for other services rendered, or who have waived
their right to receive director compensation. Directors who are employees
receive compensation in their capacity as Company employees but do not receive
any compensation for board or committee meetings, nor do they receive the
"Options Package" made available to individuals serving as Independent
Directors.
Employment Agreements
During April 1999, the Company entered into an employment agreement with Mr.
Perito which expires June 15, 2002. In addition to a $1,000,000 base salary,
the agreement provides for annual performance bonuses as approved by the
Compensation Committee. The agreement with Mr. Perito also granted him the
right to purchase 2,000,000 shares of the Company's common stock at $1 per
share, and the Company agreed to finance the purchase with a loan bearing
interest at 7% (due annually) with all principal due in July 2005. The stock
purchase occurred in 1999, and the related $2,000,000 note receivable is
presented as a reduction of stockholders' equity in the 2000 and 1999 balance
sheets. Since the note is non-recourse with respect to accrued unpaid interest
and 85% of the principal, this stock purchase right has been accounted for as
an option. The Company has recognized interest income of approximately
$134,000 and $90,000 during 2000 and 1999, respectively, in connection with
the note. In connection with the aforementioned agreement, Mr. Perito was also
granted qualified stock options to purchase 1,000,000 share of stock at
$1 11/16 per share, the price of the Company's common stock on the date of
grant. Such options vested immediately.
Upon termination by the Company of Mr. Perito's employment without Cause or
by Mr. Perito for Good Reason (as defined in the employment agreement), the
Company will be obligated to pay to Mr. Perito all salary, benefits, bonuses
and other compensation that would be due under the employment agreement
through the end of the term of the employment agreement. Upon termination of
Mr. Perito's employment as a result of his death or disability, the Company
will be obligated to pay to Mr. Perito all salary, benefits, bonuses and other
compensation that would be due under the employment agreement for a period of
one year from the date of such termination. In connection with certain
transactions that may result in a change in voting control of the Company
(each, a "Disposition Transaction") or certain changes in the Company's senior
management, Mr. Perito will be entitled to terminate the employment agreement,
to a one-time termination payment of $2,500,000 and to participate in the
Disposition Transaction upon the same terms and conditions as certain
principal stockholders of the Company. The Company also will be obligated to
reimburse Mr. Perito for any taxes which may become due as a result of the
application of Section 280G of the Code to the payment described in the
preceding sentence.
On October 6, 2000, the Company entered into an employment agreement with
David Dean, as the Vice President of Sales and Marketing, which expires on
December 31, 2001. In addition to a $250,000 base salary, the agreement
provides for a commission on the sale of cigarettes made by the Company up to
a maximum of $250,000 per year during 2000 and 2001. The agreement with Mr.
Dean also grants him the right to purchase 350,000 shares of the Company's
common stock at $4.00 per share, of which 175,000 options vested as of the
date of the employment agreement, and the remaining balance of 175,000
options, vest in equal monthly increments over the twelve-month period
following execution of the employment agreement. Upon termination by the
Company of Mr. Dean's employment without Cause or by Mr. Dean for Good Reason)
as defined in the employment agreement), the Company will be obligated to pay
to Mr. Dean all salary and commissions that would be due under the employment
agreement through the end of the term of the employment agreement. Under the
terms of Mr. Dean's employment agreement, termination for Good Reason
includes, but is not limited to, certain transactions which result in a change
in voting control of the Company or a disposition of a majority of
34
the Company's income producing assets. Furthermore, in the event Mr. Dean does
not accept the position of president and chief operating officer of ST&P in
the event of a sale of ST&P, Mr. Dean may terminate his employment for Good
Reason.
On September 15, 2000, the Company entered into an employment agreement with
Christopher G. Miller, the Chief Financial Officer, which was to expire on
September 15, 2002, with certain renewal options. In addition to a $120,000
base salary, the agreement provided for annual performance bonuses as approved
by the Compensation Committee. The agreement with Mr. Miller also granted him
the right to purchase 50,000 shares of the Company's common stock at $4.00 per
share, of which 25,000 shares vested on September 15, 2001 and 25,000 shares
vest on September 15, 2002. As of March 15, 2001, the Company entered into an
Amended and Restated Employment Agreement with Mr. Miller, which expires on
March 15, 2003, with certain renewal options. In addition to a base salary of
$225,000, the agreement provides for performance bonuses as approved by the
Compensation Committee. This amended and restated agreement supercedes the
September 15, 2000 employment agreement, except as to the option granted to
Mr. Miller under that agreement. The amended and restated agreement with Mr.
Miller also grants him the right to purchase 250,000 shares of the Company's
common stock at $1.844 per share, of which 100,000 options vest immediately,
100,000 vest on March 13, 2002, and 50,000 vest on September 15, 2002. Upon
termination by the Company of Mr. Miller's employment without Cause, the
Company will be obligated to pay to Mr. Miller severance payments equal to six
months salary, paid on a monthly basis. Furthermore, if there is a change of
control of the Company (as defined in the employment agreement), and Mr.
Miller's agreement does not continue in effect after such a change in control,
the Company will, within 60 days of notifying Mr. Miller of such termination,
pay to Mr. Miller (a) a lump sum payment equal to all salary then due and
payable and (b) severance payments equal to six months salary, paid on a
monthly basis.
35
Item 12. Security Ownership of Certain Beneficial Owners and Management
The following table sets forth as of February 28, 2001 certain information
with respect to the beneficial ownership of the Company's Common Stock by each
beneficial owner of more than 5% of the Company's voting securities, each
Director and each executive officer, and all Directors, executive officers and
officers of the Company as a group, except as qualified by the information set
forth in the notes to this table.
Shares
Beneficially Percentage
Name Owned(1) Owned(2)
- ---- ------------ ----------
Irrevocable Trust #1 FBO(3)........................... 19,058,576 31.9%
Francis E. O'Donnell, M.D.
709 The Hamptons Lane
Chesterfield, MO 63017
Jonnie R. Williams(4)................................. 5,845,264 26.5%
Prometheus Pacific Growth Fund, LDC................... 5,202,640 8.7%
P.O. Box 1062
George Town, Grand Cayman, B.W.I.
Francis E. O'Donnell, Jr., M.D.(5).................... 3,368,362 5.6%
709 The Hamptons Lane
Chesterfield, MO 63017
Paul L. Perito(6)..................................... 3,049,000 5.0%
7475 Wisconsin Ave, Suite 850
Bethesda, MD 20814
Robert DeLorenzo, M.D., Ph.D., M.P.H.(7).............. 1,021,000 *
David M. Dean(8)...................................... 321,350 *
Christopher G. Miller(9).............................. 163,000 *
Elliot D. Prager(10).................................. 152,445 *
Mark W. Johnson(11)................................... 118,000 *
Sheldon L. Bogaz(12).................................. 61,100 *
Leo S. Tonkin(13)..................................... 75,000 *
Martin Leader(14)..................................... 30,000 *
Neil Chayet(15)....................................... 15,000 *
All Directors, Executive Officers and Officers (14
Persons)............................................. 48,480,737 78.5%
- --------
(1) Beneficial ownership is determined in accordance with rules of the
Securities and Exchange Commission and includes shares over which the
indicated beneficial owner exercises voting and/or investment power.
Shares of Common Stock subject to options currently exercisable or
exercisable within 60 days, by April 30, 2001, are deemed outstanding for
purposes of computing the percentage ownership of the person holding such
securities, but not deemed outstanding for purposes of computing the
percentage ownership of any other person. Except as indicated, and subject
to community property laws where applicable, the persons named in the
table above have sole voting and investment power with respect to all
shares of voting stock shown as beneficially owned by them. Unless
otherwise noted, the address for each of the above persons is c/o Star
Scientific, Inc. 801 Liberty Way, Chester, Virginia 23836.
(2) The "Percentage Owned" calculations are based on the outstanding shares of
Common Stock as of February 28, 2001.
(3) Includes 19,058,576 shares owned by a trust for the benefit of Francis E.
O'Donnell, Jr., M.D., over which Kathleen O'Donnell has sole voting and
investment power. Excludes 2,268,362 shares owned by a trust for the
benefit of Dr. O'Donnell's children, over which Mrs. P. O'Donnell has sole
voting and investment power.
36
(4) Includes 15,915,264 shares held by Mr. Williams. Also includes 1,100,000
shares held by Regent Court of which Mr. Williams is deemed to have
beneficial ownership by virtue of his membership in Regent Court and over
which he shares voting and investment power with Dr. O'Donnell.
(5) Includes 2,268,362 shares owned by a trust for the benefit of Mr.
Williams' children, over which Dr. O'Donnell has sole voting and
investment power. Also includes 1,100,000 shares held by Regent Court of
which Dr. O'Donnell is deemed to have beneficial ownership by virtue of
his membership in Regent Court and over which he shares voting and
investment power with Mr. Williams.
(6) Includes 2,000,000 shares held by Mr. Perito, 1,000,000 shares which Mr.
Perito has the right to acquire upon exercise of stock options which are
presently exercisable and an aggregate of 49,000 shares held by his
children or in trust for the benefit of his children, of which Mr. Perito
disclaims beneficial ownership.
(7) Includes 30,000 shares held by Dr. DeLorenzo's children. Dr. DeLorenzo
disclaims beneficial ownership of shares held by his children. Includes
500,000 shares which Dr. DeLorenzo has the right to acquire upon exercise
of stock options which are presently exercisable.
(8) Includes 36,250 shares which Mr. Dean has the right to acquire upon
exercise of stock options which are presently exercisable and 1,100 shares
owned by Mr. Dean's spouse.
(9) Includes 163,000 shares which Mr. Miller has the right to acquire upon
exercise of stock options which are presently exercisable.
(10) Includes 75,000 shares which Dr. Prager has the right to acquire upon
exercise of stock options which are presently exercisable. Also includes
3,000 shares owned by Dr. Prager's children and 1,000 shares owned by Dr.
Prager's Mother-in-Law, of which Dr. Prager disclaims beneficial
ownership.
(11) Includes 118,000 shares which Mr. Johnson has the right to acquire upon
exercise of stock options which are presently exercisable.
(12) Includes 50,000 shares which Mr. Bogaz has the right to acquire upon
exercise of stock options which are presently exercisable.
(13) Includes 75,000 shares which Mr. Tonkin has the right to acquire upon
exercise of stock options which are presently exercisable.
(14) Includes 25,000 shares which Mr. Leader has the right to acquire upon
exercise of stock options which are presently exercisable.
(15) Includes 15,000 shares which Mr. Chayet has the right to acquire upon
exercise of stock options which are presently exercisable.
Item 13. Certain Relationships and Related Transactions
The Company acquired the manufacturing facility in Petersburg, Virginia in
June 1995 from a partnership comprised of Francis E. O'Donnell, Jr., M.D.,
Jonnie R. Williams, the Chief Executive Officer of the Company and Paul Lamb,
the President and Chief Executive Officer of ST&P for a note in the principal
amount of $300,000, which was subsequently reissued as three notes of $100,000
each payable to Dr. O'Donnell, a trust for the benefit of Mr. Williams'
children and Mr. Lamb. The notes to Dr. O'Donnell and the Williams'
children's' trust were paid in 1998 and the note to Mr. Lamb was paid in 1999.
Mr. Williams and Dr. O'Donnell jointly own an airplane. The Company has
utilized the airplane for business travel throughout the United States and to
Mexico to client, vendor and scientific or technical consultant locations that
are not near or easily accessible to airports with regularly scheduled or
frequent commercial airline services. Payments made by the Company to Dr.
O'Donnell and Mr. Williams with respect to aircraft expenses were $787,610 in
2000, $442,238 in 1999 and $185,544 in 1998, and were billed at cost.
During 1998, Mr. Williams made loans to the Company on a short-term basis at
the minimum level of interest provided for by the Internal Revenue Service.
These loans amounted to $710,000 in 1998. All such loans were repaid in full
during the year in which they were made. On December 31, 1999, Mr. Williams
signed a promissory note for $1,087,806 in connection with a loan by the
Company to Mr. Williams in the same amount.
37
The promissory note was repayable on December 31, 2000 and bore interest at
5.66%. Mr. Williams repaid this note via compensation reduction. On December
31, 2000, Mr. Williams signed a promissory note for $800,000 in connection
with a loan by the Company to Mr. Williams in the same amount. The promissory
note is repayable on December 31, 2001 and bears interest at 5.66%.
The Company paid to Golden Leaf, a company owned by Malcolm L. "Mac" Bailey,
a former director of the Company until November 2000 and the Company's
President from October 1998 to November 1999, approximately $1.60 million in
2000, $630,000 in 1999 and $60,000 in 1998 for tobacco purchases and
commissions in connection with Golden Leaf's processing of StarCuredTM tobacco
at the Chase City facility, and the Company received $709,000 in 2000,
$580,000 in 1999 and $165,000 in 1998 for the sale of tobacco to Golden Leaf.
Additionally, pursuant to a consulting agreement entered into between the
Company and Mr. Bailey in 1998, Mr. Bailey agreed to provide consulting
services to the Company. The Company was required to pay Mr. Bailey $80,000
per year plus a commission to Golden Leaf on all flue-cured tobacco processed
by the Company. The Company paid Mr. Bailey $86,667 in 2000 and $118,000 in
1999 pursuant to this agreement and for services as President of the Company,
and the commission to Golden Leaf noted above in connection with the
processing of StarCured(TM) tobacco at the Chase City facility. The consulting
agreement would have expired in October 2003, but was terminated in February
2001 in place of a new agreement (the "February 2001 Agreement"). Under the
February 2001 Agreement, the Company is required to pay Mr. Bailey a
commission equal to $0.07 per pound on the first 15 million pounds and $0.05
per pound on all additional flue-cured tobacco processed at Star's facility in
Chase City through 2003. Mr. Bailey, through Golden Leaf, is responsible for
processing tobacco at the Chase City facility. Under the February 2001
Agreement, Mr. Bailey also has the right to purchase barns from the Company
and to obtain a license for low-TSNA tobacco.
In 2000 and 1999, the Company paid $1,946,159 and $940,000, respectively, to
PHJ&W with respect to various services and legal matters relating to a broad
variety of professional issues connected with the Company's business. Mr.
Perito was a partner of such firm until June 1999 and senior counsel to the
firm until he resigned from the position of senior counsel on March 31, 2001,
Mr. Perito received no income from PHJ&W based on any work it performed for
the Company.
The Company employs Chayet Communications Inc., a company owned by Neil
Chayet, a director of the Company, for communications and legal consulting on
a month-to-month basis. Services rendered by Chayet Communications include
communications, consulting with the public health and legal sectors on matters
relating to the labeling of new products and the development of enhanced
health warning and comparative content disclosure. In this capacity, Chayet
Communications was compensated at a rate of $8,000 per month for a total of
$96,000 in 2000, and in 1999 Mr. Chayet received options to purchase 15,000
shares at an exercise price of $5.70 per share. These options are fully
vested.
In 2000, the Company paid Mark W. Johnson, a director of the Company,
$100,000 for consulting services performed up until June 30, 2000. Such
services rendered by Mr. Johnson included the development of a strategic plan
for the Company and recommendations to implement such plan. In 1999, Mr.
Johnson received options to purchase 43,000 shares of Common Stock at an
exercise price of $3.375 in exchange for consulting services.
In 2000, the Company paid Christopher G. Miller, a director of the Company,
$31,500 for consulting services performed from April 6, 2000 until September
15, 2000 during the time that he was serving as the Acting Chief Financial
Officer. Mr. Miller also received options to purchase 25,000 shares of Common
Stock at an exercise price of $4.125 as part of compensation for these
services. On September 15, 2000, Mr. Miller signed an Employment Agreement
with the Company. (See Employment Agreements). In 1999, Mr. Miller received
$6,667 and options to purchase 38,000 shares of Common Stock at an exercise
price of $3.375 in exchange for consulting services.
38
Item 14. Exhibits and Reports on Form 8-K
1. Exhibits
Number Description
------ -----------
2.01 Asset Purchase Agreement between Star Scientific, Inc., a Delaware
Corporation and Eyetech, LLC, a Minnesota Limited Liability Company, by
Robert J. Fitzsimmons, an individual residing in St. Paul, Minnesota,
dated December 30, 1998(1)
2.02 Escrow Agreement between Star Scientific, Inc., a Delaware Corporation,
Eyetech, LLC, a Minnesota Limited Liability Company and Robert J.
Fitzsimmons, an individual residing in St. Paul, Minnesota, and Jonnie
R. Williams and Vincent Ellis as Escrow Agents, dated February 16,
1999, and effective December 30, 1998(1)
3.01 Restated Certificate of Incorporation(2)
3.02 Certificate of Amendment of Restated Certificate of Incorporation,
dated March 25, 1993, and effective April 2, 1993(3)
3.03 Certificate of Amendment of Restated Certificate of Incorporation,
dated March 25, 1993, and effective April 2, 1993(3)
3.04 Certificate of Amendment of Certificate of Incorporation, dated
December 15, 1998(4)
3.05 Bylaws of the Company as Amended to Date(2)
10.18 Stock Exchange Agreement between the Company and the stockholders of
Star Tobacco & Pharmaceuticals, Inc., dated February 6, 1998(5)
10.19 License Agreement between Star Tobacco & Pharmaceuticals, Inc., as
Licensee and Regent Court Technologies, Jonnie R. Williams, and Francis
E. O'Donnell, J.R. , M.D., as Licensor, dated January 5, 1998(6)
10.21 Exclusive Supply Agreement between Star Tobacco & Pharmaceuticals, Inc.
and Amana Company, L.P., dated August 18, 1998(7)
10.22 Purchase and Sale Agreement between Prometheus Pacific Growth Fund LDC,
a Cayman Island Limited Duration Company, and Eye Technology, Inc., a
Delaware Corporation, dated July 10, 1998(8)
10.23 Amendment No. 1 to License Agreement between Regent Court Technologies,
Jonnie R. Williams, Francis E. O'Donnell, J.R., M.D. and Star Tobacco &
Pharmaceuticals, Inc., dated August 3, 1998(9)
10.24 1998 Stock Option Plan, as amended(10)
10.25 2000 Equity Incentive Plan
10.26 Executive Employment Agreement dated as of April 27, 1999 entered into
by the Company, Jonnie R. Williams and Paul L. Perito(11)
10.27 Qualified Stock Option Agreement dated as of April 27, 1999 between the
Company and Paul L. Perito(12)
10.28 Executive Employment Agreement dated as of April 12, 1999 entered into
by the Company and James A. McNulty(12)
10.29 Stock Option Agreement dated as of April 12, 1999 entered into by the
Company and James A. McNulty(12)
10.30 Restricted Stock Award Agreement dated as of April 12, 1999 entered
into by the Company and James A. McNulty(12)
10.31 Amended and Restated Manufacture and License Agreement between the
Company and Powell Manufacturing Company, Inc., dated October 12,
1999(13)
10.32 Agreement between the Company and Brown & Williamson Tobacco
Corporation, dated October 12, 1999(13)
39
Number Description
------ -----------
10.33 Loan Agreement between the Company and Brown & Williamson Tobacco
Corporation, dated October 12, 1999(13)
10.34 Security Agreement between the Company and Brown & Williamson Tobacco
Corporation, dated December 16, 1999(13)
10.35 Supply Agreement between Star Tobacco & Pharmaceuticals, Inc. and Brown
& Williamson Tobacco Corporation, dated January 1, 2000(13)
10.36 Cigarette Manufacturing Agreement between Star Tobacco &
Pharmaceuticals, Inc. and Brown & Williamson Tobacco Corporation, dated
January 1, 2000(13)
10.37 Loan and Security Agreement between Star Tobacco & Pharmaceuticals,
Inc. and Finova Capital Corporation, dated January 20, 2000(13)
10.38 Lease and Purchase Option Contract between the Company and the
Industrial Development Authority of the Town of Chase City, Virginia,
dated March 10, 2000(13)
10.39 Form of Director Indemnification Agreement(10)
10.40 Form of Officer Indemnification Agreement(10)
10.41 First Amendment to Loan and Security Agreement between Star Tobacco &
Pharmaceuticals, Inc. and Finova Capital Corporation, Business Credit,
dated April 12, 2000(10)
10.42 Modification Agreement among the Company, Jonnie R. Williams and Paul
L. Perito, dated December 1, 1999(10)
10.43 Second Modification Agreement among the Company, Jonnie R. Williams and
Paul L. Perito, dated October 6, 2000
10.44 Executive Employment Agreement between the Company and David Dean,
dated October 6, 2000
10.45 Restated Loan Agreement between the Company, Star Tobacco &
Pharmaceuticals, Inc. and Brown & Williamson Tobacco Corporation, dated
August 21, 2000(14)
10.46 Restated Security Agreement between the Company and Brown & Williamson
Tobacco Corporation, dated August 21, 2000(14)
10.47 Security Agreement between Star Tobacco & Pharmaceuticals, Inc. and
Brown & Williamson Tobacco Corporation, dated August 21, 2000(14)
10.48 Guaranty Agreement between the Company and Brown & Williamson Tobacco
Corporation, dated August 21, 2000(14)
10.49 Guarantee Agreement between Star Tobacco & Pharmaceuticals, Inc. and
Brown & Williamson Tobacco Corporation, dated August 21, 2000(14)
10.50 Executive Employment Agreement dated as of September 15, 2000 between
the Company and Christopher G. Miller(14)
10.51 Amended and Restated Executive Employment Agreement dated as of March
15, 2001 between the Company and Christopher G. Miller
10.52 Executive Employment Agreement dated as of March 30, 2001 between the
Company and Robert E. Pokusa
16.03 Response Letter from Keiter, Stephens, Hurst, Gary & Shreaves, dated
January 20, 1999(4)
21 Subsidiaries of the Company(15)
23 Consent of Independent Public Accountants
24 Powers of Attorney (included on signature page)
40
- --------
(1) Incorporated by reference to the Company's Current Report on Form 8-K
dated March 2, 1999
(2) Incorporated by reference to the Company's Annual Report on Form 10-KSB
for the year ended December 31, 1992
(3) Incorporated by reference to the Company's Annual Report on Form 10-KSA
for the year ended December 31, 1996
(4) Incorporated by reference to the Company's Current Report on Form 8-K
dated January 15, 1999
(5) Incorporated by reference to the Company's Current Report on Form 8-K
dated February 19, 1998
(6) Incorporated by reference to the Company's Quarterly Report on Form 10-
QSB for the quarter ended March 31, 1998
(7) Incorporated by reference to the Company's Quarterly Report on Form 10-
QSB for the quarter ended September 30, 1998
(8) Incorporated by reference to the Company's Current Report on Form 8-K
dated July 15, 1998
(9) Incorporated by reference to the Company's Current Report on Form 8-K
dated September 11, 1998
(10) Incorporated by reference to the Company's Annual Report on Form 10-K
for the year ended December 31, 1999
(11) Incorporated by reference to the Company's Quarterly Report on Form 10-
QSB for the quarter ended June 30, 1999
(12) Incorporated by reference to the Company's Quarterly Report on Form 10-
QSB for the quarter ended September 30, 1999
(13) Incorporated by reference to the Company's Registration Statement on
Form S-1/A dated May 8, 2000
(14) Incorporated by reference to the Company's Quarterly Report on Form 10-Q
for the quarter ended September 30, 2000
(15) Incorporated by reference to the Company's Annual Report on Form 10-KSB
for the year ended December 31, 1998
2. Reports on Form 8-K
A Current Report on Form 8-K was filed on August 22, 2000 in connection with
the Restated Security Agreement between the Company and Brown & Williamson
Tobacco Corporation, dated August 21, 2000.
41
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Report to be signed
on its behalf by the undersigned, thereunto duly authorized in Virginia on the
2nd day of April, 2001.
STAR SCIENTIFIC, INC.
/s/ Jonnie R. Williams
By: _________________________________
Jonnie R. Williams
Chief Executive Officer
POWER OF ATTORNEY
KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints Jonnie R. Williams and Paul L. Perito, or
either of them, his attorney-in-fact, each with the power of substitution, for
him in any and all capacities, to sign any amendments to this Report, 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 each of said attorneys-in-fact, or his substitute or
substitutes, may do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this
Report has been signed by the following persons in the capacities indicated.
Signature Title Date
--------- ----- ----
/s/ Jonnie R. Williams Chief Executive Officer April 2, 2001
______________________________________ and Director
Jonnie R. Williams (Principal Executive
Officer)
/s/ Paul L. Perito Chairman of the Board, April 2, 2001
______________________________________ President and Chief
Paul L. Perito Operating Officer
/s/ Christopher G. Miller Chief Financial Officer April 2, 2001
______________________________________ and Director
Christopher G. Miller (Principal Financial and
Accounting Officer)
/s/ Neil Chayet Director April 2, 2001
______________________________________
Neil Chayet
/s/ Robert J. DeLorenzo Director April 2, 2001
______________________________________
Robert J. DeLorenzo
/s/ Mark W. Johnson Director April 2, 2001
______________________________________
Mark W. Johnson
/s/ Martin Leader Director April 2, 2001
______________________________________
Martin Leader
/s/ Elliot D. Prager Director April 2, 2001
______________________________________
Elliot D. Prager
/s/ Leo S. Tonkin Director April 2, 2001
______________________________________
Leo S. Tonkin
42
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
DECEMBER 31, 2000 AND 1999
FINANCIAL STATEMENTS
F-1
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Stockholders of
Star Scientific, Inc. and Subsidiaries
Chester, Virginia
We have audited the accompanying consolidated balance sheets of Star
Scientific, Inc. and Subsidiaries as of December 31, 2000 and 1999 and the
related consolidated statements of operations, stockholders' equity, and cash
flows for each of the three years in the period ended December 31, 2000. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
As discussed in Note 14, the Company elected not to join in the Master
Settlement Agreement ("MSA") among forty-six states, several U.S. territories
and a number of tobacco manufacturers, as a Subsequent Participating
Manufacturer. As a result thereof, the Company is purportedly required to
annually contribute funds into escrow under statutes which the MSA required
participating states to pass if they were to receive the full benefits of the
settlement. Such escrowed funds will be available to pay judgments or
settlements in tobacco-related litigation, if any, filed by the states and, if
not used, returned to the Company in twenty-five years. The Company's 2000 net
escrow obligation of approximately $13,000,000 must be funded by April 15,
2001, and this escrow funding obligation may increase in future years.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position
of Star Scientific, Inc. and Subsidiaries as of December 31, 2000 and 1999 and
the consolidated results of their operations and their cash flows for each of
the three years in the period ended December 31, 2000 in conformity with
generally accepted accounting principles.
/s/ AIDMAN, PISER & COMPANY, P.A.
January 19, 2001
Tampa, Florida
F-2
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31, 2000 and 1999
2000 1999
----------- -----------
ASSETS
Current assets:
Cash and cash equivalents.......................... $16,746,599 $17,205,248
Accounts receivable, trade......................... 5,472,503 3,599,965
Inventories........................................ 5,945,157 3,570,609
Prepaid expenses and other current assets.......... 443,565 338,790
Deferred tax asset................................. 320,000 2,303,000
----------- -----------
Total current assets.............................. 28,927,824 27,017,612
Property, plant and equipment, net.................. 27,400,960 10,974,029
Intangibles, net of accumulated amortization, (2000,
$236,017; 1999, $205,217).......................... 709,969 338,043
Other assets........................................ 823,328 296,263
Deferred tax asset.................................. -- 83,000
MSA Escrow fund..................................... 11,605,155 --
----------- -----------
$69,467,236 $38,708,947
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Notes payable...................................... $15,950,000 $ --
Current maturities of long-term debt............... 111,176 275,000
Accounts payable, trade............................ 3,180,976 3,492,755
Federal excise taxes payable....................... 6,481,351 1,476,524
Accrued expenses................................... 2,593,396 1,442,521
Income taxes payable............................... 1,702,000 6,198,000
Customer deposit................................... -- 6,000,000
----------- -----------
Total current liabilities......................... 30,018,899 18,884,800
Deferred tax liability.............................. 900,000 --
Long-term debt, less current maturities............. 13,272,332 7,504,679
----------- -----------
Total liabilities................................. 44,271,231 26,389,479
----------- -----------
Commitments and contingencies....................... -- --
Stockholders' equity:
Common stock(a).................................... 597,414 587,492
Preferred stock(b)................................. -- --
Additional paid-in capital......................... 13,250,166 10,631,876
Retained earnings.................................. 14,228,425 4,187,906
Notes receivable, officers......................... (2,800,000) (3,087,806)
----------- -----------
Total stockholders' equity........................ 25,276,005 12,319,468
----------- -----------
$69,467,236 $38,708,947
=========== ===========
- --------
(a) ($.01 par value, 100,000,000 shares authorized, 59,741,460 and 58,749,200
shares issued and outstanding in 2000 and 1999, respectively)
(b) (Class A, convertible, 400 shares authorized, no shares issued and
outstanding; Series B, convertible; $.01 par value 15,000 shares
authorized, no shares issued and outstanding)
See notes to consolidated financial statements.
F-3
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
For the Years Ended December 31, 2000, 1999 and 1998
2000 1999 1998
------------ ----------- -----------
Net sales............................. $223,051,180 $99,324,789 $19,445,491
Less:
Cost of goods sold................... 93,951,534 31,878,879 7,669,428
Excise taxes on products............. 83,591,686 33,821,112 8,837,868
------------ ----------- -----------
Gross profit......................... 45,507,960 33,624,798 2,938,195
------------ ----------- -----------
Operating expenses:
Marketing and distribution........... 12,973,670 6,253,265 1,198,757
General and administrative........... 13,183,842 9,899,165 3,173,991
Research and development............. 1,702,310 535,782 1,377,657
------------ ----------- -----------
Total operating expenses............ 27,859,822 16,688,212 5,750,405
------------ ----------- -----------
Operating income (loss)............. 17,648,138 16,936,586 (2,812,210)
------------ ----------- -----------
Other income (expenses):
Interest income...................... 1,236,628 227,648 17,167
Interest expense..................... (1,828,247) (85,604) (255,113)
Loss on disposal of assets........... -- -- (425,316)
------------ ----------- -----------
(591,619) 142,044 (663,262)
------------ ----------- -----------
Income (loss) from continuing
operations before income taxes....... 17,056,519 17,078,630 (3,475,472)
Income tax expense.................... 7,016,000 5,564,000 --
------------ ----------- -----------
Income (loss) from continuing
operations........................... 10,040,519 11,514,630 (3,475,472)
Discontinued operations:
Loss from discontinued operations (no
applicable income taxes)............ -- -- (751,080)
Loss on disposal of business segment
(no applicable income taxes)........ -- -- (221,290)
------------ ----------- -----------
Income (loss) before extraordinary
item................................. 10,040,519 11,514,630 (4,447,842)
Extraordinary gain from extinguishment
of debt (no applicable income
taxes)............................... -- -- 251,767
------------ ----------- -----------
Net income (loss)..................... $ 10,040,519 $11,514,630 $(4,196,075)
============ =========== ===========
Basic income (loss) per common share:
Continuing operations................ $ .17 $ .32 $ (.42)
Discontinued operations.............. -- -- (.12)
Extraordinary gain................... -- -- .03
------------ ----------- -----------
Net income (loss).................... $ .17 $ .32 $ (.51)
============ =========== ===========
Diluted income (loss) per share....... $ .17 $ .23 $ (.51)
============ =========== ===========
Weighted average shares outstanding--
basic................................ 59,008,127 36,207,390 8,327,345
============ =========== ===========
Weighted average shares outstanding--
diluted.............................. 60,645,061 50,301,998 8,327,345
============ =========== ===========
See notes to consolidated financial statements.
F-4
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
For the Year Ended December 31, 1998
Preferred
Stock
--------------
Retained
Series B Common Stock Additional Earnings Treasury Stock Unearned
-------------- ------------------ Paid-In (Accumulated ------------------ Compen-
Shares Amount Shares Amount Capital Deficit) Shares Amount sation Total
------ ------ --------- -------- ---------- ------------ ---------- ------ -------- -----------
Balances, January
1, 1998......... -- $-- 200 $383,557 $1,004,607 $(3,130,649) -- $-- $ -- $(1,742,485)
Conversion of
debt to equity.. 1,402,550 14,026 483,623 497,649
Reverse merger
and
reorganization.. 3,434,990 (349,205) (117,577) (466,782)
Stock issued
pursuant to
merger.......... 13,831 138 -- -- (138) --
Mandatory
redeemable
preferred stock
converted to
common.......... 232,000 2,320 229,680 232,000
Increase of
Series A
Preferred Stock
to Redemption
value........... (19,000) (19,000)
Exchange of
preferred stock
for common...... 305 3 (3) (1,000,000)
Shares gifted to
company and
retired......... (1,144) (11) 11
Issuance of
common stock
pursuant to
private
placements...... 763 8 4,400,000 44,000 3,905,992 1,000,000 3,950,000
Issuance of
preferred stock
pursuant to
private
placements...... 304 3 999,997 1,000,000
Stock issuance
costs........... (220,000) (220,000)
Stock issued for
current and
future
services........ 25 2 350,000 3,500 401,200 (79,167) 325,535
Net loss for the
year............ (4,196,075) (4,196,075)
------ ---- --------- -------- ---------- ----------- ---------- ---- -------- -----------
Balances,
December 31,
1998............ 14,084 $143 9,819,740 $ 98,198 $6,668,392 $(7,326,724) -- $-- $(79,167) $ (639,158)
====== ==== ========= ======== ========== =========== ========== ==== ======== ===========
See notes to consolidated financial statements.
F-5
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
For the Year Ended December 31, 1999
Preferred
Stock
---------------
Retained
Series B Common Stock Additional Earnings Unearned Notes
--------------- ------------------- Paid-In (Accumulated Compen- Receivable,
Shares Amount Shares Amount Capital Deficit) sation Officers Total
------- ------ ---------- -------- ----------- ------------ -------- ----------- -----------
Balances, December 31,
1998, carried
forward............... 14,084 $143 9,819,740 $ 98,198 6,668,392 (7,326,724) $(79,167) -- (639,158)
Conversion of preferred
stock to common....... (14,084) (143) 46,217,500 462,175 (462,032) --
Amortization of
unearned stock-based
compensation.......... 79,167 79,167
Mandatory redeemable
preferred stock
converted to common... 20,000 200 43,800 44,000
Issuance of stock...... 2,000,000 20,000 1,980,000 (2,000,000) --
Stock issued for
services.............. 39,000 390 97,405 97,795
Issuance of common
stock to charitable
organizations......... 130,000 1,300 767,342 768,642
Common stock options
and stock purchase
rights issued......... 536,278 536,278
Warrants exercised..... 522,960 5,229 1,040,691 1,045,920
Stock issuance costs
associated with
warrants.............. (40,000) (40,000)
Note receivable
issued................ (1,087,806) (1,087,806)
Net income............. 11,514,630 -- 11,514,630
------- ---- ---------- -------- ----------- ---------- -------- ----------- -----------
Balances, December 31,
1999.................. -- $-- 58,749,200 $587,492 $10,631,876 $4,187,906 $ -- $(3,087,806) $12,319,468
======= ==== ========== ======== =========== ========== ======== =========== ===========
See notes to consolidated financial statements.
F-6
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
For the Year Ended December 31, 2000
Common Stock Additional Notes
------------------- Paid-In Retained Receivable,
Shares Amount Capital Earnings officers Total
---------- -------- ----------- ----------- ----------- -----------
Balances, December 31,
1999, carried forward.. 58,749,200 $587,492 $10,631,876 $ 4,187,906 ($3,087,806) $12,319,468
Collection of note
receivable............. -- -- -- -- 1,087,806 1,087,806
Note receivable issued.. -- -- -- -- (800,000) (800,000)
Issuance of common stock
options and warrants... -- -- -- 648,692 648,692
Options exercised....... 24,820 248 44,392 -- 44,640
Warrants exercised...... 967,440 9,674 1,925,206 -- 1,934,880
Net income.............. -- -- -- 10,040,519 10,040,519
---------- -------- ----------- ----------- ----------- -----------
Balances December 31,
2000................... 59,741,460 $597,414 $13,250,166 $14,228,425 ($2,800,000) $25,276,005
========== ======== =========== =========== =========== ===========
See notes to consolidated financial statements.
F-7
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Years Ended December 31, 2000, 1999 and 1998
2000 1999 1998
----------- ----------- -----------
Operating activities:
Net income (loss)...................... $10,040,519 $11,514,630 $(4,196,075)
Adjustments to reconcile net income
(loss) to net cash provided by (used
in) operating activities:
Depreciation.......................... 2,211,143 745,205 359,135
Amortization of intangibles and other
non-cash charges..................... 58,251 38,546 1,062,794
Deferred income taxes................. 2,966,000 (2,386,000) --
Stock-based compensation expense...... 578,892 1,481,882 325,535
Extraordinary gain on extinguishment
of debt.............................. -- -- 251,767)
Increase (decrease) in cash resulting
from changes in:
Accounts receivable, trade........... (1,872,538) (2,034,237) (790,560)
Inventories.......................... (2,374,548) (2,934,153) (31,064)
Prepaid expenses and other current
assets.............................. (104,775) (168,786) (164,137)
Note receivable, officer............. 287,806 -- --
Accounts payable..................... (311,669) 976,097 (57,582)
Federal excise taxes payable......... 5,004,827 599,649 517,092
Accrued expenses..................... 1,150,875 796,406 561,007
Income taxes payable................. (4,496,000) 6,198,000 --
Customer deposit..................... -- 6,000,000 --
----------- ----------- -----------
Net cash provided by (used in)
operating activities.................. 13,138,783 20,827,239 (2,665,622)
----------- ----------- -----------
Investing activities:
Collections of notes receivable....... -- 17,213 1,915
Purchases of property, plant and
equipment............................ (18,572,964) (10,014,665) (454,888)
Proceeds from disposal of property and
equipment............................ 5,102 -- (175,000)
Acquisition of intangible assets...... (332,927) (240,681) (48,815)
Deposits on property and equipment.... (527,065) (193,700) --
Note receivable from officer.......... -- (1,087,806) --
----------- ----------- -----------
Net cash used in investing activities.. (19,427,854) (11,519,639) (326,788)
----------- ----------- -----------
See notes to consolidated financial statements.
F-8
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS-(Continued)
For the Years Ended December 31, 2000, 1999 and 1998
2000 1999 1998
----------- ----------- -----------
Financing activities:
Payments on line of credit, net....... $ -- -- ($1,095,801)
Proceeds from notes payable........... 15,978,000 7,172,000 --
Payments on long-term debt............ (521,943) (382,967) (550,023)
Proceeds from sale of stock........... 1,979,520 1,045,920 4,950,000
Stock offering costs paid............. -- (40,000) (220,000)
----------- ----------- -----------
Net cash provided by financing
activities............................ 17,435,577 7,794,953 3,084,176
----------- ----------- -----------
Deposits to MSA Escrow fund............ (11,605,155) -- --
----------- ----------- -----------
Increase (decrease) in cash and cash
equivalents........................... (458,649) 17,102,553 91,766
Cash and cash equivalents, beginning of
year.................................. 17,205,248 102,695 10,929
----------- ----------- -----------
Cash and cash equivalents, end of
year.................................. $16,746,599 $17,205,248 $ 102,695
=========== =========== ===========
Supplemental disclosure of cash flow
information:
Cash paid during the year for:
Interest............................. $ 1,581,348 $ 123,119 $ 254,713
=========== =========== ===========
Income taxes......................... $ 8,502,000 $ 1,752,000 $ --
=========== =========== ===========
Supplemental schedule of non-cash
investing and financing activities:
Purchase of fixed assets financed by
capital leases...................... $ 97,772 $ -- $ --
=========== =========== ===========
Conversion of debt to equity......... $ -- $ -- $ 497,649
=========== =========== ===========
Conversion of redeemable preferred
stock to equity..................... $ -- $ 44,000 $ 232,000
=========== =========== ===========
Notes payable reduced by proceeds
from equipment sale................. $ -- $ 255,000 $ --
=========== =========== ===========
Acquisition (reverse merger):
Fair value of assets acquired....... $ -- $ -- $ 1,237,238
Liabilities assumed................. -- -- (2,001,688)
----------- ----------- -----------
Excess assigned to goodwill......... $ -- $ -- $ 764,450
=========== =========== ===========
Warrants issued in connection with
patent costs........................ $ 69,800 $ -- $ --
=========== =========== ===========
Customer deposit converted to short-
term note payable................... $ 6,000,000 $ -- $ --
=========== =========== ===========
See notes to consolidated financial statements.
F-9
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Years Ended December 31, 2000, 1999 and 1998
1. Summary of significant accounting policies:
Organization and basis of presentation:
Star Scientific, Inc. and Subsidiaries was formerly known as Eye Technology,
Inc. and Subsidiaries (the "Company"). In December 1998, the Company changed
its name to Star Scientific, Inc.
On February 6, 1998, the Company and its subsidiaries, entered into a stock
exchange agreement with the stockholders of Star Tobacco & Pharmaceuticals,
Inc. ("Star"), a privately owned corporation and Star became a subsidiary of
the Company. Under the agreement, Star stockholders exchanged all of their
common stock for 13,831 shares of Series B Preferred Stock, par value $.01 per
share. When converted, this stock would equal 46,127,500 shares of common
stock, or approximately 90% of the outstanding common stock of the Company and
its subsidiaries as of the conversion date. As the former stockholders of Star
held the larger portion of the voting rights of the combined corporation, the
transaction was recorded as a reverse acquisition with Star as the accounting
acquirer. The merger was recorded using the historical cost basis for the
assets and liabilities of Star, as adjusted, and the estimated fair value of
the Company's and its subsidiaries assets and liabilities. The excess of the
Company's and its subsidiaries' liabilities assumed over assets acquired of
$764,450 was assigned to goodwill which was being amortized over five years
until the (See Note 2) disposal of this business segment at which time the
goodwill was written off.
The accompanying consolidated financial statements include the accounts of
Star, and the Company and its Subsidiaries. All intercompany accounts and
transactions have been eliminated. The results of operations of the Company
are included in the accompanying consolidated financial statements from the
date of acquisition.
Organization and basis of presentation:
The following summarized pro-forma information assumes the acquisition had
occurred as of January 1, 1998.
1998
-----------
Net sales....................................................... $20,134,099
Operating loss.................................................. $(3,299,669)
Net loss........................................................ $(4,209,784)
Loss per share:
Basic and diluted.............................................. $ (.51)
Nature of business:
Star has been engaged since 1990 in the manufacture and sale of tobacco
products. Since 1994, Star has engaged in extensive research and development
activities relating to (1) the development of proprietary scientific
technology for the curing of tobacco so as to prevent or retard the formation
of certain toxic carcinogens present in tobacco and tobacco smoke, namely, the
tobacco specific nitrosamines, (2) the development of products that deliver
less toxins and are potentially less harmful tobacco products, which have been
cured pursuant to licensed patented StarCured(TM) technology (3) the
manufacture and sale of discount cigarettes, without additives, and with
activated charcoal/acetate filters (4) the development of very low nitrosamine
smokeless tobacco products and (5) the research and continued development of
tobacco-smoking cessation products. Through the year ended December 31, 1998,
the Company had not yet marketed or received any revenues from products
developed from its research and development activities.
F-10
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Years Ended December 31, 2000, 1999 and 1998
Star had sales to a major domestic tobacco company which represented
approximately 21% and 9% of net sales in 2000 and 1999, respectively. Star had
purchases from this same company which represented 32% and 21% of cost of
sales in 2000 and 1999, respectively. The Company also borrowed $15,950,000
and $7,172,000 in 2000 and 1999, respectively, from this same company to
finance property, plant and equipment acquisitions (See Notes 5 and 6).
Advertising Costs:
Advertising costs are expensed as incurred and are included in marketing and
distribution expenses. For the years ended December 31, 2000, 1999 and 1998,
advertising costs were $197,000, $36,000 and $38,000, respectively.
Use of estimates:
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of income and expenses during the
reporting period. Actual results could differ from those estimates.
Cash equivalents:
For purposes of the statement of cash flows, the Company classifies all
highly liquid investments with an original maturity of three months or less as
cash equivalents.
MSA Escrow fund:
Cash deposits restricted pursuant to the Master Settlement agreement are
reflected as a non-current asset in the accompanying 2000 balance sheet. All
interest earned on this account is unrestricted and reflected in current
earnings.
Inventories:
Inventories are valued at the lower of cost or market. Cost is determined on
the first-in, first-out (FIFO) method.
Property, plant and equipment:
Property, plant and equipment are recorded at cost. Depreciation is
determined using the straight-line method over the estimated useful lives of
three to seven years for office equipment and machinery and equipment and
thirty-nine years for buildings and improvements. Depreciation for barns is
determined using the units of production method over the estimated useful life
of ten years.
Intangibles:
Intangibles consist primarily of licensing costs, patents and trademarks and
packaging design costs. Intangibles are amortized by the straight-line method
over a period of 15 years for trademarks, 17 years for patents and licensing
costs and 5 years for packaging design costs.
F-11
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Years Ended December 31, 2000, 1999 and 1998
Income taxes:
Star was an S Corporation from inception through February 6, 1998 for
federal income tax purposes. As a result of the change in ownership previously
discussed Star became a C Corporation effective February 6, 1998. Deferred
income tax assets and liabilities are computed annually for differences
between the financial statement and federal income tax bases of assets and
liabilities that will result in taxable or deductible amounts in the future,
based on enacted tax laws and rates applicable to the periods in which the
differences are expected to affect taxable income. Valuation allowances are
established when necessary to reduce deferred tax assets to the amount
expected to be realized.
Employee stock-based compensation:
During 1999, the Company adopted the accounting and disclosure provisions of
Financial Accounting Standard No. 123--Accounting for Stock-Based Compensation
("FAS 123"), which requires use of the fair-value based method to determine
compensation for all arrangements under which employees and others receive
shares of stock or equity instruments (warrants and options). There were no
stock-based compensation transactions with employees in 1998 that would have
been subject to the accounting or disclosure provisions of FAS 123.
Segment reporting:
During 1999, the Company commenced operations in a new business segment and
as a result, adopted Statement of Financial Accounting Standards No. 131,
"Disclosures about Segments of an Enterprise and Related Information".
Statement No. 131 establishes standards for reporting information about
operating segments in annual financial statements. Operating segments are
defined as components of an enterprise about which separate financial
information is available that is evaluated on a regular basis by the chief
operating decision maker or decision making group, in deciding how to allocate
resources to an individual segment and in assessing performance of the
segment. The Company has identified these segments based on the nature of
business conducted by each. The identifiable segments at December 31, 2000 are
1) the manufacture and sale of discount cigarettes to wholesalers, and 2) the
sale of tobacco cured utilizing the Company's proprietary technology. This
second segment also includes costs incurred in the research and development of
methods of manufacturing less toxic and potentially less harmful tobacco
products.
Net income (loss) per common share:
Basic income (loss) per common share is computed using the weighted-average
number of common shares outstanding.
Diluted earnings per share is computed assuming conversion of all preferred
stock and potentially dilutive stock options and warrants. Potential common
shares outstanding are excluded from the computation if their effect is
antidilutive.
Revenue Recognition:
Revenue is recognized when products are delivered to customers and title
passes. The Company also records appropriate provisions for uncollectible
accounts and credit for returns.
Shipping costs:
Shipping costs are included in marketing and distribution expenses and
aggregated approximately $2,700,000, $2,000,000 and $500,000 in 2000, 1999,
and 1998, respectively.
F-12
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Years Ended December 31, 2000, 1999 and 1998
2. Discontinued operations:
On December 30, 1998, the Company completed the sale of its ophthalmic and
intraocular business. As a result thereof, the Company recorded an after tax
loss on the disposal of $221,290. Results of operations of the discontinued
business segment have been classified as discontinued operations from the date
of the Eye Technology, Inc. acquisition in February 1998 through December 31,
1998.
Net sales and loss from discontinued operations are as follows for 1998:
Net sales.......................................................... $629,715
--------
Operating losses................................................... $751,080
--------
Income taxes....................................................... --
--------
Loss from discontinued operations.................................. $751,080
--------
Loss on disposal................................................... $221,290
--------
3.Inventories:
Inventories consist of the following:
2000 1999
----------- ----------
Raw materials......................................... $ 2,658,473 $ 623,692
Packaging materials................................... 1,046,988 781,448
Finished goods........................................ 2,239,696 2,165,469
----------- ----------
$ 5,945,157 $3,570,609
=========== ==========
4.Property, plant and equipment:
Property, plant and equipment consists of the following:
2000 1999
------------ -----------
Land............................................... $ 172,572 $ 172,572
Buildings.......................................... 340,139 340,139
Leasehold improvements............................. 567,991 --
Tobacco curing barns............................... 25,312,445 8,661,312
Machinery and equipment............................ 3,918,373 3,202,577
Office and sales equipment......................... 1,136,203 586,087
Equipment under capital leases..................... 129,550 --
------------ -----------
31,577,273 12,962,687
Less accumulated depreciation...................... 4,176,313 1,988,658
------------ -----------
$ 27,400,960 $10,974,029
============ ===========
5. Long-term supply agreement/major customer information:
During October 1999, the Company entered into an agreement with Brown &
Williamson Tobacco Corporation, ("B&W"), the third largest tobacco company in
the U.S., and the largest affiliate of British American Tobacco, PLC, the
second largest tobacco company in the world. B&W will, subject to certain
conditions, purchase quantities of the Company's low nitrosamine tobacco leaf
(StarCure(TM) tobacco) and
F-13
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Years Ended December 31, 2000, 1999 and 1998
evaluate the potential for that tobacco in the marketplace. Additionally, B&W
has agreed to finance the purchase/construction of tobacco curing barns which
will assist the Company in its production of low nitrosamine tobacco products
to be marketed by the Company, the customer and others in the industry (see
Note 6 regarding financing provided). Tobacco leaf sales under this agreement
were approximately $45,500,000 and $9,300,000 in 2000 and 1999, respectively.
Under the October 1999 agreement, B&W is obligated to purchase $15,000,000
of Virginia flue-cured tobacco that has been cured using the StarCured(TM)
tobacco curing process, and B&W has an option to purchase burley tobacco cured
using the same process. Under the October 1999 agreement, B&W also has the
option to become the exclusive purchaser of tobacco cured using the
StarCured(TM) tobacco curing process in each of the years 2002 through 2004,
if it purchases at least thirty million pounds of tobacco in each of those
years. If B&W were to stop purchasing flue-cured tobacco that has been cured
using the StarCured(TM) tobacco curing process after the year 2001, the
Company's sales volume, operating income and cash flows could be negatively
effected.
In February 2001, the Company and B&W signed a Letter of Understanding
("Letter of Understanding"). Under the Letter of Understanding, B&W intends to
expand its commitment to purchase millions of pounds of very low-TSNA
StarCured(TM) leaf tobacco during each of the next three years. The Letter of
Understanding also addresses a range of other issues including the future
production of a potentially less-hazardous, low-TSNA smokeless tobacco product
that is intended to be aesthetically pleasing to both present cigarette
smokers and current users of smokeless tobacco products. The Company
anticipates executing a series of agreements which will be subject to the
approval of Star's and B&W's respective Boards of Directors. The Company also
expects that the agreements, consistent with the Letter of Understanding, will
extend the B&W long-term credit facility, which has been used to support
Star's expanded barn program and the continuing development of innovative
tobacco products focused on reduced toxin delivery.
6. Notes payable and long-term debt:
Notes payable at December 31, 2000 consists of the following:
Advances pursuant to a one year credit agreement, with interest
at prime plus 1%, principal and accrued interest payable August
2001(a)........................................................ $ 4,950,000
Short-term non-interest bearing note, payable in 2001 through
deliveries of flue-cured green tobacco at established prices
(pursuant to the long-term supply agreement discussed in Note
5). Failure to make the required deliveries by December 31,
2001 would constitute a default. Upon default the loan is due
on demand and thereafter bears interest at prime plus 1%(a).... 11,000,000
-----------
$15,950,000
===========
- --------
(a) Lender is the major domestic tobacco company discussed in Notes 1 and 5.
All borrowings are collateralized by tobacco curing barns, tobacco leaf
inventory, and intellectual property.
(b) The weighted average interest rate of short-term borrowings outstanding at
December 31, 2000 was 3.26%.
In addition to the above short-term borrowings, the Company has a $7,500,000
revolving line of credit agreement. Borrowings under the line of credit are
limited to 80% of eligible accounts receivable, as defined, and bear interest
at a rate linked to the prime rate. The agreement places restrictions on new
debt and the Company's ability to further pledge its assets and stipulates a
minimum fixed charge coverage ratio, as defined. Borrowings under the line of
credit are secured by substantially all assets not otherwise pledged. There
were no outstanding borrowings at December 31, 2000 or 1999.
F-14
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Years Ended December 31, 2000, 1999 and 1998
Long-term debt consists of the following:
2000 1999
------------ ----------
Note payable under a $13,200,000 credit facility
restricted for the purchase of tobacco curing
barns; interest at prime plus 1% payable
commencing December 2000; principal payable in 60
equal monthly installments commencing September
2004(a)........................................... $ 13,200,000 $7,172,000
Notes payable, repaid in 2000...................... -- 431,812
Other.............................................. 183,508 175,867
------------ ----------
13,383,508 7,779,679
Less current maturities............................ 111,176 275,000
------------ ----------
$ 13,272,332 $7,504,679
============ ==========
- --------
(a) Lender is the major domestic tobacco company discussed in Notes 1 and 5.
All borrowings are collateralized by tobacco curing barns, tobacco leaf
inventory, and intellectual property .
The future maturities of long-term debt are as follows:
Year ending December 31
-----------------------
2001............................................................ $ 111,176
2002............................................................ 32,835
2003............................................................ 32,814
2004............................................................ 226,683
2005............................................................ 2,640,000
Thereafter...................................................... 10,340,000
-----------
$13,383,508
===========
7. Stockholders' equity:
Preferred stock:
Class A:
The Company has authorized 4,000 shares of $.01 par value Class A
Convertible Redeemable preferred stock. Each share of the Preferred Stock is
convertible into 80 shares of common stock of the Company at the option of the
holder and has voting rights equal to the number of common shares issuable if
converted. The Preferred Stock has the right to share in dividends declared on
the Company's common stock and has certain liquidation preferences. No Class A
preferred shares are outstanding.
Series B:
The Company has authorized 15,000 shares of $.01 par value Series B
Preferred Stock. The stock was convertible into common stock at the holders'
option prior to December 31, 2002 at 3,280 shares of common for each share of
Series B Preferred. Holders of Series B Preferred Stock were entitled to 500
votes for each share held. During 1999, holders of all of the 14,084 shares of
Series B Preferred Stock converted their shares to common. No Series B
preferred shares are outstanding.
F-15
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Years Ended December 31, 2000, 1999 and 1998
Common stock warrants:
Common stock warrants issued, redeemed and outstanding during the years
ended December 31, 1999 and 2000 are as follows:
Weighted
Average
Exercise
Price
Number Per Share
-------- ---------
Issued during 1998 pursuant to private placements of
stock and outstanding January 1, 1999 and 2000....... 976,880 $ 2.00
Exercised during 2000................................. (976,880) $(2.00)
-------- -------
Outstanding and exercisable at December 31, 2000...... -- $ --
======== =======
Stock option plan:
In 1998, the Company adopted the 1998 Stock Option Plan (the "Plan") which
provides for grants of options to those officers, key employees, directors and
consultants whose substantial contributions are essential to the continued
growth and success of the Company. The Plan, and its subsequent amendments,
provide for grants of both qualified and non-qualified stock options to
purchase up to 5,000,000 shares at a purchase price equal to the fair market
value on the date of grant in the case of qualified options granted to
employees.
Common stock options and warrants issued, redeemed and outstanding during
the years ended December 31, 1999 and 2000 are as follows:
Weighted
Average
Exercise
Price
Number Per Share
--------- ---------
Outstanding January 1, 1999........................... -- $ --
Options issued during 1999............................ 3,258,406 2.17
Outstanding December 31, 1999......................... 3,258,406 2.17
Options issued during 2000............................ 1,200,000 4.10
Warrants issued to patent counsel during 2000......... 250,000 2.00
Options exercised during 2000......................... (15,000) (1.66)
Options forfeited during 2000......................... (33,406) (8.56)
--------- ------
Options and warrants outstanding and exercisable at
December 31, 2000.................................... 4,660,000 $ 2.84
========= ======
F-16
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Years Ended December 31, 2000, 1999 and 1998
The following table summarizes information for options outstanding and
exercisable at December 31, 2000.
Options and Warrants Outstanding Exercisable
--------------------------------------- ------------------------
Weighted Avg. Weighted Avg. Weighted Avg.
Range of Prices Number Remaining Life Exercise Price Number Exercise Price
--------------- --------- -------------- -------------- --------- --------------
$1.00-2.00.............. 2,735,000 8.48 yrs. $1.82 2,485,000 $1.80
2.01-3.00.............. 500,000 8.17 yrs. 3.00 250,000 3.00
3.01-4.00.............. 875,000 9.66 yrs. 3.96 375,000 3.89
4.01-5.00.............. 125,000 9.09 yrs. 4.20 125,000 4.20
5.01-7.00.............. 425,000 9.02 yrs. 6.56 275,000 6.32
--------- --------- ----- --------- -----
$1.00-7.00.............. 4,660,000 8.73 yrs. $2.84 3,510,000 $2.55
========= ========= ===== ========= =====
The weighted average grant-date fair value of options granted during 2000
was $4.29 per share (there were none issued in 2000 whose exercise price was
different from the market price of the stock at date of grant).
In addition to stock options in 1999, the Company granted a stock purchase
right to acquire 2,000,000 shares of common stock at $1.00 per share. This
stock purchase right was accounted for as an option (see Note 14--Employment
Agreement) and had a grant-date fair value of $48,400.
The fair value of options and the stock purchase right granted in 2000 were
estimated on the date of grant using the Black-Scholes option pricing model
with the following weighted average assumptions:
2000 1999
---- ----
Expected life of options 2.25 years 1.25 years
Risk free interest rate............................... 6.24% 5.03%
Expected volatility................................... 50% 39%
Expected dividend yield............................... 0% 0%
Total stock-based compensation (stock, stock options and warrants) cost
recognized in 2000 and in 1999 is as follows:
2000 1999 1998
--------- ---------- --------
Employee...................................... $ 258,166 $ 265,618 $ 95,593
Non-employee consultants and directors........ 320,726 447,622 229,942
Charitable institutions....................... -- 768,642 --
Patent costs (capitalized).................... 69,800 -- --
--------- ---------- --------
$ 648,692 $1,481,882 $325,535
========= ========== ========
F-17
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Years Ended December 31, 2000, 1999 and 1998
8. Earnings per share:
The following table sets forth the computation of basic and diluted earnings
per share for the years ended December 31:
2000 1999 1998
----------- ----------- -----------
Net income (loss)...................... $10,040,519 $11,514,630 $(4,196,075)
=========== =========== ===========
Denominator for basic earnings per
share-weighted average shares......... 59,008,127 36,207,390 8,327,345
Effect of dilutive securities:
Preferred stock....................... -- 11,536,747 --
Warrants outstanding.................. -- 729,621 --
Stock options outstanding............. 1,636,934 1,828,240 --
----------- ----------- -----------
Denominator for diluted earnings per
share-- weighted average shares
adjusted for dilutive securities...... 60,645,061 50,301,998 8,327,345
=========== =========== ===========
Earnings (loss) per common share-
basic................................. $ .17 $ .32 $ (.51)
=========== =========== ===========
Earnings (loss) per common share-
diluted............................... $ .17 $ .23 $ (.51)
=========== =========== ===========
9. Income taxes:
Net deferred tax assets and liabilities consist of the following:
2000 1999
----------- ----------
Deferred tax assets:
Non-refundable deposit taxable currently......... $ -- $2,280,000
Net operating loss carryforwards (subject to
annual limitation).............................. 380,000 423,000
Expenses not currently deductible................ 400,000 --
Other............................................ 20,000 43,000
----------- ----------
800,000 2,746,000
----------- ----------
Deferred tax liabilities:
Differing bases in property, plant and equipment
for tax and financial reporting purposes........ (1,280,000) (360,000)
Tax imputed interest............................. (100,000) --
----------- ----------
(1,380,000) (360,000)
----------- ----------
$ (580,000) $2,386,000
=========== ==========
F-18
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Years Ended December 31, 2000, 1999 and 1998
Net deferred tax assets are reflected in the accompanying balance sheets as
follows:
2000 1999
-------- ----------
Current asset............................................ $320,000 $2,303,000
Non-current asset........................................ -- 83,000
-------- ----------
$320,000 $2,386,000
======== ==========
Non-current liability.................................... $900,000 $ --
-------- ----------
$900,000 $ --
======== ==========
Income tax expense consists of the following:
2000 1999 1998
----------- ----------- -----------
Current:
Federal............................. $ 3,420,000 $ 6,598,500 $ --
State............................... 630,000 1,351,500 --
----------- ----------- -----------
4,050,000 7,950,000 --
Deferred............................. 2,966,000 (1,061,000) (1,325,000)
Increase (decrease) in valuation
allowance(a)........................ -- (1,325,000) 1,325,000
----------- ----------- -----------
$ 7,016,000 $ 5,564,000 $ --
=========== =========== ===========
- --------
(a) During 1999, the Company reevaluated the deferred tax asset valuation
allowance based on the Company's current operations and determined that it
was more likely than not that these deferred tax assets would be
recoverable and, as such, decreased the previously recorded valuation
allowance.
The provision for income tax expense (income tax benefit) varies from that
which would be expected based upon applying the statutory federal rate to pre-
tax accounting income (loss) as follows:
2000 1999 1998
---- ---- ----
Statutory federal rate.................................. 34% 34 % (34)%
Non-deductible compensation for stock options and
grants................................................. 2 4 --
State tax provision, net of federal benefit............. 5 3
Non-deductible officer compensation..................... -- 4 --
Change in deferred tax asset valuation allowance........ -- (12) 34
--- --- ---
41% 33 % -- %
=== === ===
At December 31, 2000 the Company had a net operating loss carryforward of
approximately $1,000,000, which expires from 2003 through 2009. As a result of
previous changes in the Company's ownership, the net operating loss
carryforward utilization is limited to $116,320 annually.
F-19
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Years Ended December 31, 2000, 1999 and 1998
10. Related party transactions:
The Company has entered into certain transactions with companies and trusts
that are owned by members of management and stockholders. The following is a
summary of the significant related party transactions for the years ended
December 31, 2000, 1999 and 1998.
2000 1999 1998
---------- ---------- --------
Business travel--aircraft expense........... $ 787,610 $ 442,238 $185,544
Loan repayments............................. $ -- $ -- $200,000
Legal fees(c)............................... $1,946,159 $ 940,000 $ --
Advance to officers(a)(d)................... $ 800,000 $1,087,806 $ --
Collection of advance funded through
compensation expense....................... $1,087,806 $ -- $ --
Note receivable, officer(d)
(See Note 14-Employment Agreement)......... $2,000,000 $2,000,000 $ --
Interest receivable on stock note receivable
officers(b)................................ $ 285,303 $ 94,889 $ --
Interest income on officer notes and
advances................................... $ 190,914 $ 94,889 $ --
Consulting fees paid to organization
controlled by an officer/director(e)....... $ 96,000 $ -- $ --
Tobacco purchases from commissions paid to
organization controlled by an
officer/director for processing tobacco.... $1,688,896 $ 627,577 $ 59,429
Tobacco sales to an organization controlled
by an officer/director..................... $ 709,478 $ 578,683 $165,347
Consulting fees paid to directors........... $ 142,000 $ -- $ --
- --------
(a) Unsecured note receivable due from officer, bearing interest at 5.66%.
1999 note collected in 2000 via compensation reduction; 2000 note matures
December 31, 2001.
(b) Included in prepaid expenses and other current assets in the accompanying
balance sheets.
(c) The Company paid legal fees to Paul Hastings, Janofsky & Walker LLP with
respect to various legal matters. An executive officer of the Company is
senior counsel and a former partner of such firm but received no
compensation from the firm for work undertaken on behalf of the Company.
(d) Presented as a reduction in stockholders' equity in the accompanying
balance sheets.
(e) Consulting fees paid to Chayet Communications, Inc. for communications
consulting.
Effective January 1, 1998, Star entered into a license agreement with the
principal stockholder wherein Star has the exclusive world-wide rights to
produce and sell tobacco products with low-TSNA (tobacco specific
nitrosamines) tobacco. In connection with this agreement, Star is obligated to
pay royalties equal to 2% of all product sales (less certain costs) and 6% of
any royalty income earned from sublicensing (less certain costs). There were
no royalties due under this agreement for 2000, 1999 or 1998.
11. Employee benefit plan:
The Company is the sponsor of a defined contribution retirement plan under
Section 401(k) of the Internal Revenue Code. The plan covers all employees who
meet certain eligibility and participation requirements. Participants may
contribute up to 15% of their annual compensation. The Company may make an
annual discretionary contribution (approximately $79,000, $44,000 and $0 in
2000, 1999 and 1998, respectively).
F-20
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Years Ended December 31, 2000, 1999 and 1998
12. Segment reporting:
The Company's reportable segments are strategic business units that offer
different products and have separate management teams. These segments are 1)
the manufacture and sale of discount cigarettes and 2) the sale of tobacco
cured using licensed technology, which commenced on a commercial basis in
1999. Financial information by business segment is as follows:
2000
-------------------------------------
Leaf Discount
Tobacco Cigarettes Consolidated
----------- ------------ ------------
Sales................................. $46,224,079 $176,827,101 $223,051,180
============
Cost of sales......................... 42,092,907 51,858,627 $ 93,951,534
Excise taxes.......................... -- 83,591,686 83,591,686
------------
Gross profit.......................... 4,131,172 41,376,788 $ 45,507,960
============
Depreciation.......................... 1,771,633 439,510 $ 2,211,143
============
Research and development.............. 1,702,310 -- $ 1,702,310
============
Property and equipment................ 25,654,681 1,746,279 $ 27,400,960
============
Capital expenditures.................. 18,357,023 313,713 $ 18,670,736
============
1999
-------------------------------------
Leaf Discount
Tobacco Cigarettes Consolidated
----------- ------------ ------------
Sales................................. $ 9,845,516 $ 89,479,273 $ 99,324,789
============
Cost of sales......................... 6,565,901 25,312,978 $ 31,878,879
Excise taxes.......................... -- 33,821,112 33,821,112
------------
Gross profit.......................... 3,279,615 30,345,183 $ 33,624,798
============
Depreciation.......................... 407,011 338,194 $ 745,205
============
Research and development.............. 535,782 -- $ 535,782
============
Property and equipment................ 9,107,039 1,866,990 $ 10,974,029
============
Capital expenditures.................. 9,150,000 864,665 $ 10,014,665
============
13. Fair value of financial instruments and credit risk:
Fair value of financial instruments:
The estimated fair value of cash and cash equivalents, trade receivables,
MSA Escrow funds, long-term debt and trade payables approximate the carrying
amount due to their short-term nature or variable interest component. The
estimated fair-value amounts have been determined using available market
information and appropriate valuation methodologies. However, considerable
judgement is necessarily required in interpreting market data to develop
estimates of fair value. Accordingly, the estimates presented herein are not
necessarily indicative of the amounts that the Company would realize in a
current market exchange.
F-21
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Years Ended December 31, 2000, 1999 and 1998
The estimated fair value of notes payable at December 31, 2000, is
summarized as follows:
2000
-----------------------
Carrying Estimated
Amount Fair Value
----------- -----------
Notes payable........................................ $15,950,000 $14,907,337
Differences between fair value and carrying amount are primarily due to
instruments that provide fixed interest rates or contain fixed interest rate
elements. Inherently, such instruments are subject to fluctuations in fair
value due to subsequent movements in interest rates.
Credit risk:
Financial instruments which potentially subject the Company to
concentrations of credit risk consist principally of cash and cash equivalents
and accounts receivable.
The Company maintains its cash and cash equivalents balances in 3 financial
institutions. Each of the balances in the domestic banks are insured by the
Federal Deposit Insurance Corporation up to $100,000.
Trade accounts receivable result from sales of tobacco products to its
various customers throughout the United States. Credit is extended to
customers after an evaluation for credit worthiness; however, the Company does
not require collateral or other security from customers.
14. Commitments and contingencies:
Obligations under master settlement agreement:
In November 1998, 46 states and several U.S. territories entered into a
settlement agreement to resolve litigation that had been instituted by them
against the major tobacco manufacturers. The Company was not named as a
defendant in any of the litigation matters and chose not to become a
participating manufacturer under the terms of the Master Settlement Agreement
("MSA"). Nonparticipating manufacturers are required to fund escrow accounts
pursuant to the MSA based on the volume of cigarette sales in states that are
participating members of the MSA.
In April 2000, The Company, on behalf of Star, deposited into escrow $11.6
million to fund its purported escrow obligations, with respect to sales volume
in 1999, under the MSA and specific state statutes that were passed by states
that are participating members of the MSA.
The Company estimates that the purported net funding requirement for 2000
sales will be approximately $13,000,000, which is required to be deposited by
April 15, 2001. The so-called "level playing field" statutes require non-
participating manufacturers to fund escrow accounts that could be used to
satisfy judgments or settlements in lawsuits that may at some future date be
filed by the participating states. In the foreseeable future, the Company
expects that a material portion of its sales will continue to be subject to
such purported escrow obligations. To date no states have filed suits against
the Company to compel any payments under the MSA and state statutes. If not
used to satisfy judgments or settlements, the funds will be returned to the
Company 25 years after the applicable date of deposit on a rolling basis. The
Company does, however, continue to receive interest earnings on the invested
escrowed amounts.
The Company has also been advised by several states and the Chairman of the
Tobacco Committee of the National Association of Attorneys General ("NAAG")
that the states and the Committee interpret the escrow obligation under the
MSA in a fashion that would require the Company to make escrow payments based
on any
F-22
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Years Ended December 31, 2000, 1999 and 1998
sales in a state signing the MSA, and not based simply on sales made directly
by the Company in those states. The Company has advised NAAG and the various
states that the Company disagrees with this interpretation and believes the
interpretation violates the Due Process and Commerce Clauses of the United
States Constitution.
After almost two years of negotiations with the National Association of
Attorneys General ("NAAG"), the Company concluded that NAAG had little
interest in working with Star to come to a reasonable solution under which the
Company could become a participant in the Master Settlement Agreement.
Accordingly, on December 15, 2000, the Company filed a lawsuit in the United
States District Court for the Eastern District of Virginia requesting that the
court declare both the MSA and Virginia's Qualifying Statute unconstitutional
and, therefore, invalid. The Company's complaint challenges the MSA on the
grounds that it violates the Interstate Compact Clause and the Commerce Clause
of the Constitution of the United States. It challenges the Qualifying Statute
on the grounds that it violates the Equal Protection, Due Process, Takings and
Commerce Clauses of the Constitution. Neither Virginia Attorney General Earley
nor any other state attorney general has ever charged the Company with the
tortious and unlawful conduct asserted against other cigarette manufacturers
in lawsuits by various states which led to the execution of the MSA. Despite
the absence of any claim against the Company, which is focused primarily on
producing less toxic and potentially less hazardous tobacco and tobacco
products, the MSA and the Qualifying Statute impose a severe burden on its
research and development activities.
On March 12, 2001, the District Court heard oral argument on the
Commonwealth's Motion to Dismiss, after both sides exchanged briefs on all the
constitutional and related issues. On March 26, 2001, the District Court
dismissed the Company's complaint, but in its opinion, the District Court did
note that Star "must now suffer as a result of the bad faith of previous
market entrants." The District Court further noted that Star "has never been
accused of the fraudulent, collusive and intentionally dishonest activities of
the Big Four," "was not even in existence during the bulk of the time that
these activities were occurring," and has taken "every step to provide
complete disclosure about the harmful nature of its products." The District
Court also stated that the "financial burden on Star Scientific and others
like it may hamper efforts to develop new tobacco technologies." The Company
promptly appealed the District Court's ruling, and continues to believe, that
the MSA and the Virginia Qualifying Statute are constitutionally flawed.
The Company believes that its existing working capital, together with
anticipated earnings from its tobacco-leaf operations and available funding on
existing lines of credit, will be sufficient to meet its liquidity and capital
requirements in the foreseeable future. The Company's need, if any, to raise
additional funds to meet its working capital and capital requirements will
depend upon numerous factors, including the results of its marketing and sales
activities, any escrow obligations the Company may be required to comply with
under the MSA and the success of the Company's new product development
efforts. If B&W and the Company were not to be successful in converting the
Letter of Understanding into a series of Agreements, this could materially
affect the Company's sales volumes, operating income and cash flows. The
Company's need, if any, to raise additional funds to meet its working capital
and capital requirements will depend upon numerous factors, including the
results of its marketing and sales activities, any escrow obligations the
Company may be required to comply with under the MSA and the success of the
Company's new product development efforts.
Leases:
The Company leases its office and warehouse facilities and various vehicles
and operating equipment under non-cancelable operating leases expiring in
various years through 2010.
F-23
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For the Years Ended December 31, 2000, 1999 and 1998
The following represents the future minimum rental payments required under
operating leases that have initial or remaining non-cancelable lease terms in
excess of one year as of December 31, 2000.
Year ending December 31, Amount
------------------------ ----------
2001............................................................ $ 783,255
2002............................................................ 773,875
2003............................................................ 562,575
2004............................................................ 339,813
2005............................................................ 339,813
Thereafter...................................................... 1,014,023
----------
$3,813,354
==========
Rent expense for all operating leases was approximately $1,553,000,
$153,000, and $107,000 for the years ended December 31, 2000, 1999 and 1998,
respectively.
Employment Agreement:
During April 1999, the Company entered into an employment agreement with an
Executive Officer (the "officer"), which expires June 15, 2002. In addition to
a $1,000,000 base salary, the agreement provides for annual performance
bonuses as approved by the compensation committee. Compensation expense
pursuant to this agreement in 2000 and 1999 was approximately $1,900,000 and
$860,000, respectively.
The agreement also granted the officer the right to purchase 2,000,000
shares of the Company's common stock at $1 per share, and the Company agreed
to finance the purchase with a loan bearing interest at 7% (due annually) and
all principal due July 2005. The stock purchase occurred in 1999, and the
related $2,000,000 note receivable is presented as a reduction of
stockholders' equity in the accompanying 2000 and 1999 balance sheets. Since
the note is non-recourse with respect to accrued unpaid interest and 85% of
the principal, this stock purchase right has been accounted for as an option.
The Company has recognized interest income of approximately $134,000 and
$90,000 during 2000 and 1999, respectively, in connection with the note. In
connection with the aforementioned agreement, the officer was also granted
qualified stock options to purchase 1,000,000 shares of stock at $1 11/16 per
share, the price of the Company's common stock on the date of grant. Such
options vested immediately.
On October 6, 2000, the Company entered into an employment agreement with
David Dean, as the Vice President of Sales and Marketing, which expires on
December 31, 2001. In addition to a $250,000 base salary, the agreement
provides for a commission on the sale of cigarettes made by the Company up to
a maximum of $250,000 per year during 2000 and 2001. The agreement with Mr.
Dean also grants him the right to purchase 350,000 shares of the Company's
common stock at $4.00 per share, of which 175,000 options vested as of the
date of the employment agreement, and the remaining balance of 175,000
options, vest in equal monthly increments over the twelve-month period
following execution of the employment agreement. Upon termination by the
Company of Mr. Dean's employment without Cause or by Mr. Dean for Good Reason)
as defined in the employment agreement), the Company will be obligated to pay
to Mr. Dean all salary and commissions that would be due under the employment
agreement through the end of the term of the employment agreement. Under the
terms of Mr. Dean's employment agreement, termination for Good Reason
includes, but is not limited to, certain transactions which result in a change
in voting control of the Company or a disposition of a majority of the
Company's income producing assets. Furthermore, in the event Mr. Dean does not
accept the position of president and chief operating officer of ST&P in the
event of a sale of ST&P, Mr. Dean may terminate his employment for Good
Reason.
F-24
On September 15, 2000, the Company entered into an employment agreement with
Christopher G. Miller, the Chief Financial Officer, which was to expire on
September 15, 2002, with certain renewal options. In addition to a $120,000
base salary, the agreement provided for annual performance bonuses as approved
by the Compensation Committee. The agreement with Mr. Miller also granted him
the right to purchase 50,000 shares of the Company's common stock at $4.00 per
share, of which 25,000 shares vested on September 15, 2001 and 25,000 shares
vest on September 15, 2002. As of March 15, 2001, the Company entered into an
Amended and Restated Employment Agreement with Mr. Miller, which expires on
March 15, 2003, with certain renewal options. In addition to a base salary of
$225,000, the agreement provides for performance bonuses as approved by the
Compensation Committee. This amended and restated agreement supercedes the
September 15, 2000 employment agreement, except as to the option granted to
Mr. Miller under that agreement. The amended and restated agreement with Mr.
Miller also grants him the right to purchase 250,000 shares of the Company's
common stock at $1.844 per share, of which 100,000 options vest immediately,
100,000 vest on March 13, 2002, and 50,000 vest on September 15, 2002. Upon
termination by the Company of Mr. Miller's employment without Cause, the
Company will be obligated to pay to Mr. Miller severance payments equal to six
months salary, paid on a monthly basis. Furthermore, if there is a change of
control of the Company (as defined in the employment agreement), and Mr.
Miller's agreement does not continue in effect after such a change in control,
the Company will, within 60 days of notifying Mr. Miller of such termination,
pay to Mr. Miller (a) a lump sum payment equal to all salary then due and
payable and (b) severance payments equal to six months salary, paid on a
monthly basis.
F-25