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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE
ACT OF 1934
For the quarterly period ended: September 30, 2002
Commission File Number: 0-23413
INTERLEUKIN GENETICS, INC.
(Exact name of registrant as specified in its Charter)
DELAWARE 94-3123681
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
135 BEAVER STREET
WALTHAM, MA 02452
(Address of principal executive offices) (Zip Code)
(781) 398-0700
Registrant's Telephone Number, including area code
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 ( )
Title of Each Class Outstanding at November 4, 2002
------------------- -----------------------------
Common stock, $.001 Par value 23,115,354
INTERLEUKIN GENETICS, INC.
FORM 10-Q
INDEX
PART I. FINANCIAL INFORMATION
Item 1.
Condensed Consolidated Balance Sheets at
September 30, 2002 and December 31, 2001.............................. 1
Condensed Consolidated Statements of Operations for the
Three and nine months ended September 30, 2002 and
September 30, 2001.................................................... 2
Condensed Consolidated Statements of Cash Flows for the
nine months ended September 30, 2002 and September 30, 2001........... 3
Notes to Condensed Consolidated Financial Statements.................. 4
Item 2.
Management's Discussion and Analysis of Financial Condition
And Results of Operations............................................. 10
Item 3.
Quantitative and Qualitative Disclosure About Market Risk............. 28
Item 4.
Controls and Procedures............................................... 28
PART II. OTHER INFORMATION
Item 1. Legal Proceedings.................................................. 29
Item 2. Changes in Securities and Use of Proceeds.......................... 29
Item 3. Default Upon Senior Securities..................................... 29
Item 4. Submission of Matters to a Vote of Security Holders................ 29
Item 5. Other Information.................................................. 29
Item 6. Exhibits and Reports on Form 8-K................................... 29
2
INTERLEUKIN GENETICS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
- --------------------------------------------------------------------------------
ASSETS
As of
---------------------------------------
September 30, 2002 December 31, 2001
------------------ -----------------
Current assets:
Cash and cash equivalents $ 507,697 $ 3,922,736
Accounts receivable, net of allowance for doubtful accounts
of $13,000 and $14,000 at September 30, 2002 and December
31, 2001, respectively 6,257 75,982
Prepaid expenses and other current assets 92,825 103,436
----------- -----------
Total current assets 606,779 4,102,154
FIXED ASSETS, NET 335,273 178,904
OTHER ASSETS 92,225 112,068
----------- -----------
TOTAL ASSETS $ 1,034,277 $ 4,393,126
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
CURRENT LIABILITIES:
Accounts payable $ 259,674 $ 181,554
Accrued expenses 563,451 477,368
Deferred revenue and prepaid revenue 242,679 142,349
Bridge Loan , net of discount 224,833 --
Current portion of capital lease obligations 30,577 30,216
----------- -----------
Total current liabilities 1,321,214 831,487
CAPITAL LEASE OBLIGATIONS, LESS CURRENT PORTION 21,798 11,091
----------- -----------
Total liabilities 1,343,012 842,578
----------- -----------
STOCKHOLDERS' EQUITY (DEFICIT):
Preferred stock, no par value - 5,000,000 shares
authorized; none issued or outstanding -- --
Common stock, $0.001 par value - 50,000,000 shares
authorized; 21,463,723 and 21,452,326 shares issued
and 21,439,096 and 21,427,699 outstanding at September 30,
2002 and December 31, 2001, respectively 21,464 21,452
Treasury stock - 24,627 shares at cost (250,119) (250,119)
Additional paid-in capital 39,659,640 39,292,936
Accumulated deficit (39,739,720) (35,513,721)
----------- ------------
Total stockholders' equity (deficit): (308,735) 3,550,548
----------- ------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT) $ 1,034,277 $ 4,393,126
=========== ============
The accompanying notes are an integral part of these condensed
consolidated financial statements
1
INTERLEUKIN GENETICS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
- --------------------------------------------------------------------------------
FOR THE THREE MONTHS ENDED SEPTEMBER 30 FOR THE NINE MONTHS ENDED SEPTEMBER 30,
--------------------------------------- ---------------------------------------
2002 2001 2002 2001
------------ ------------ ----------- -----------
REVENUE $ 79,677 $ 24,978 $ 102,229 $ 183,923
COST OF REVENUE 106 8,443 441 43,387
------------ ------------ ----------- -----------
GROSS PROFIT 79,571 16,535 101,788 140,536
------------ ------------ ----------- -----------
OPERATING EXPENSES:
Research and development 716,964 634,719 2,504,132 2,050,665
Selling, general and administrative 652,637 565,110 1,764,343 1,741,231
------------ ------------ ----------- -----------
Total operating expenses 1,369,601 1,199,829 4,268,475 3,791,896
------------ ------------ ----------- -----------
LOSS FROM OPERATIONS (1,290,030) (1,183,294) (4,166,687) (3,651,360)
------------ ------------ ----------- -----------
OTHER INCOME (EXPENSE):
Interest income 2,520 49,661 22,276 237,252
Interest expense (15,983) (2,396) (22,251) (8,165)
Amortization of note discount (60,034) -- (60,034) --
Other income, net -- 149 697 202
------------- ------------ ----------- -----------
Total other income (expense): (73,497) 47,414 (59,312) 229,289
------------ ------------ ----------- -----------
NET LOSS $ (1,363,527) $ (1,135,880) $(4,225,999) $(3,422,071)
============ ============ =========== ===========
BASIC AND DILUTED NET LOSS PER SHARE $ (0.06) $ (0.05) $ (0.20) $ (0.16)
============ ============ =========== ===========
Weighted average common shares
OUTSTANDING 21,436,231 21,424,105 21,431,558 20,922,361
============ ============ =========== ===========
The accompanying notes are an integral part of these condensed
consolidated financial statements
2
INTERLEUKIN GENETICS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
- --------------------------------------------------------------------------------
FOR THE NINE MONTHS ENDED SEPTEMBER 30,
---------------------------------------
2002 2001
------------- -------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss $ (4,225,999) $ (3,422,071)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization 125,390 32,772
Change in value of stock options issued as compensation
for services rendered (848) 165,331
Unrealized loss on marketable securities -- (13,244)
Changes in assets and liabilities:
Accounts receivable, net 69,726 32,878
Prepaid expenses and other current assets 10,611 64,749
Accounts payable 78,120 (105,881)
Accrued expenses 86,083 142,206
Prepaid and deferred revenue 100,330 (120,859)
------------ ------------
Net cash used in operating activities (3,756,587) (3,224,119)
------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of fixed assets (179,487) (43,769)
Decrease (increase) in other assets 19,842 (97,954)
Proceeds from maturity of investments -- 2,999,040
------------ ------------
Net cash (used in) provided by investing activities (159,645) 2,857,317
------------ ------------
CASH FLOW FROM FINANCING ACTIVITIES
Net proceeds from issuance of bridge loan 525,000 --
Net proceeds from sales of common stock, net 7,363 2,911,006
Proceeds from exercises of warrants and stock options -- 482,406
Payments of capitalized lease obligations (31,170) (46,844)
------------ ------------
Net cash provided by financing activities 501,193 3,346,568
------------ ------------
Net (decrease) increase in cash and equivalents (3,415,039) 2,979,766
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 3,922,736 2,391,561
------------ -----------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 507,697 $ 5,371,327
============ ===========
Supplemental disclosures of cash flow information:
Cash paid for interest $ 7,599 $ 8,165
============ ===========
Cash paid for income taxes $ -- $ --
============ ===========
SUPPLEMENTAL DISCLOSURES OF NONCASH INVESTING AND
FINANCING ACTIVITIES:
Acquisition of fixed assets under capital leases $ 42,238 $ --
============ ===========
The accompanying notes are an integral part of these condensed
consolidated financial statements
3
NOTE 1 - PRESENTATION OF INTERIM INFORMATION
Interleukin Genetics, Inc., a Delaware corporation is a functional genomics
company focused on personalized medicine. We believe that by identifying
individuals at risk for certain diseases and combining this knowledge with
specific therapeutic interventions, better healthcare decisions can be made,
reducing costs and greatly improving patient health outcomes. We have a growing
portfolio of patents covering the genetics of a number of common diseases and
conditions.
We have prepared the accompanying unaudited condensed consolidated financial
statements in accordance with generally accepted accounting principles for
interim financial reporting and with Securities Exchange Commission rules and
regulations for Form 10-Q. It is recommended that these interim condensed
consolidated financial statements be read in conjunction with the consolidated
financial statements and the notes in our Annual Report on Form 10-K for the
year ended December 31, 2001. The interim condensed consolidated financial
statements are unaudited; however, in the opinion of our management, include all
adjustments, consisting only of normal recurring adjustments, necessary to make
the interim financial information not misleading. All significant intercompany
transactions and accounts have been eliminated in consolidation. Results for
interim periods are not necessarily indicative of those to be expected for the
full year.
Since our inception, we have incurred accumulated deficits of approximately
$39.7 million, including a net loss of approximately $4.2 million during the
nine months ended September 30, 2002. For the nine months ended September 30,
2002, we have incurred negative cash flows from operating activities of
approximately $3.8 million.
We anticipate that our current cash resources, including cash received from the
recent sale of term promissory notes (See Note 7: "Term Promissory Notes",
beginning on page 7, for more details) and an interim financing arrangement with
Pyxis Innovations, Inc. ("Pyxis")(See Note 8 "Interim Financing from Pyxis
Innovations, Inc."), are adequate to fund operations approximately through
December 2002 if Pyxis does not elect to purchase the third $500,000 promissory
note contemplated in the financing arrangement or January 2003 if they do elect
to purchase the third $500,000 promissory note. As a result, there is
significant doubt about our ability to continue as a going concern. Our future
capital requirements are anticipated to be substantial, and we do not have
commitments for additional capital at this time. Our capital requirements are
expected to arise from continued research and development efforts, the
protection of our intellectual property rights (including preparing and filing
of patent applications), repayment of the principal and interest on our 15% term
promissory notes due August 2003 and December 2003, the commercial launch of
additional genetic tests, as well as operational, administrative, legal and
accounting expenses. We are currently pursuing various sources of capital and
strategic partnerships in order to raise the capital necessary to continue
operations past the end of January 2003. WE CAN GIVE NO ASSURANCE THAT WE WILL
BE ABLE TO RAISE ANY ADDITIONAL CAPITAL, OR IF WE DO RAISE ADDITIONAL CAPITAL,
THAT IT WILL BE ON TERMS ACCEPTABLE TO OUR STOCKHOLDERS OR US. IF ADDITIONAL
AMOUNTS CANNOT BE RAISED, WE WOULD SUFFER MATERIAL ADVERSE CONSEQUENCES TO OUR
BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS AND WOULD LIKELY BE
REQUIRED TO SEEK OTHER ALTERNATIVES UP TO AND INCLUDING PROTECTION UNDER THE
UNITED STATES BANKRUPTCY LAWS.
4
NOTE 2 - RESEARCH ARRANGEMENTS
We have had a collaborative relationship with Sheffield University since 1994.
In July 1999, we entered into an arrangement with Sheffield whereby we acquired
the right to develop and commercialize Sheffield's past and future discoveries.
Pursuant to this Research and Technology Transfer Agreement, Sheffield agreed to
forego its rights to future royalties and granted us commercialization rights to
future discoveries in exchange for 275,000 shares of our common stock. This
common stock had a market value of $653,000 at the time of issuance and was
recorded as a research and development expense in the period of issuance. This
agreement also requires us to issue options on July 1st of each year to
Sheffield to purchase our common stock. Each option issued is exercisable at the
then current market price for a number of shares determined as follows: (i)
25,000 shares if this agreement is in effect and (ii) 10,000 shares for each
patent application related to Sheffield's discoveries that we filed during the
preceding 12 months. This agreement has a term of five years and may be canceled
by us if the principal collaborator at Sheffield, Dr. Gordon Duff, leaves
Sheffield or by either party upon six months' notice. Under the terms of this
agreement we have issued options to acquire 35,000 shares of our common stock in
both 2001 and 2002. In total we have issued options to acquire 105,000 shares of
our common stock. These options were fully vested upon issuance and expire five
years from the dates of issuance.
We also entered into a Research Support Agreement with Sheffield in July 1999
that requires us to pay the costs of all genetic research being conducted on our
behalf at Sheffield. Sheffield conducts this research according to an Annual
Research Plan that is determined by a Steering Committee made up equally of
members from Sheffield and us. This agreement automatically renews in one-year
increments, but may be canceled by us if Dr. Duff leaves Sheffield or by either
party upon six months' notice. In the event Sheffield terminated the agreement,
it is doubtful we could discover or commercialize new products without incurring
greater expense and increased utilization of our resources. We have made
payments of approximately $161,000 to Sheffield for the nine months ended
September 30, 2002 and an aggregate amount of $699,000 to Sheffield under the
terms of this agreement through September 30, 2002.
In September 1999, we entered into a five-year Consulting Agreement with Dr.
Gordon Duff, Sheffield's key collaborator. In accordance with the Consulting
Agreement, Dr. Duff received 200,000 shares of our common stock for
relinquishing interests in previous research agreements, the value of which was
$475,000 and was recorded as research and development expense in the period of
issuance. Under this agreement Dr. Duff will also receive a royalty equal to one
percent of the first $4 million of net sales under the PST technology and two
percent of net sales above $4 million. In July 2000, in consideration of future
services, Dr. Duff received an option to purchase 25,000 shares of our common
stock at the then current market price. In both July 2001 and July 2002, Dr.
Duff received an additional option to purchase 25,000 shares our common stock at
the market price as of that date in consideration of his ongoing consulting for
us. These options were fully vested upon issuance and expire five years from the
date of issuance. Dr. Duff also received cash payments of approximately $71,000
for the nine months ended September 30, 2002 for services rendered under the
terms of this consulting agreement.
5
In December 2001, we entered into a research collaboration agreement with Kaiser
Permanente's Center for Health Research ("Kaiser"), to study genetic risk
factors for chronic diseases that are affected by inflammation. This agreement
requires us to fund clinical trials completed at Kaiser per specific research
study plans. The first study plan that we are funding is a study to assess the
genetic risk that diabetic patients have of developing cardiovascular disease.
We expect to announce additional studies with Kaiser. It is hoped that knowledge
resulting from this work will enable us to develop new diagnostic tools that
physicians and health care organizations can use to assess their patients'
genetic risk for many diseases.
In March 2002, we entered into a research collaboration agreement with
UnitedHealth Group's research arm, the Center for Healthcare Policy and
Evaluation, to study how commonly inherited gene variants affect the response of
patients with certain inflammatory diseases to specific drugs. Knowledge
resulting from this work will help us develop pharmacogenetic tests that
physicians and managed care organizations can use to assist in the selection of
the optimal drug for an individual patient.
NOTE 3 - REVENUE RECOGNITION
Revenue from genetic susceptibility tests is recognized when the tests have been
completed and the results reported to the doctors, provided that collection of
the related receivable is probable. To the extent test kits have been purchased
but not yet submitted for test results, revenue recognition is deferred. Amounts
received prior to meeting the above revenue recognition criteria are presented
as deferred revenue in the accompanying balance sheets. Contract revenues are
recognized ratably as services are provided. In accordance with Staff Accounting
Bulletin No. 101, up front non-refundable license fees are deferred and
recognized ratably over the license term.
NOTE 4 - USE OF ESTIMATES
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America 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, as well as the reported amounts of revenues and
expenses during the reported periods. Actual results could differ from those
estimates.
NOTE 5 - BASIC AND DILUTED NET LOSS PER COMMON SHARE
Statement of Financial Accounting Standards (SFAS) No. 128 (SFAS 128), "Earnings
per Share," outlines methods for computing and presenting earnings per share.
SFAS 128 requires a calculation of basic and diluted earnings per share for all
periods presented. We reported losses for the three and nine month periods ended
September 30, 2002 and 2001 and accordingly, outstanding options and warrants
have been excluded from the calculation of the diluted weighted average shares
outstanding as they are antidilutive in loss periods. The calculation of diluted
net loss per share excludes 2,775,302 and 2,629,279 stock options outstanding at
September 30, 2002 and September 30, 2001, respectively and 1,569,407 and
1,345,952 warrants to purchase common stock outstanding at September 30, 2002
and September 30, 2001 respectively.
6
NOTE 6 - STOCKHOLDERS' EQUITY
In January 2001, we sold in a private placement 1.2 million shares of common
stock for $2.50 per share. The purchasers of the common stock also received
warrants to purchase up to 600,000 shares of common stock exercisable at $3.00
per share. We generated net proceeds of approximately $2.9 million from this
transaction. Under the terms of this private placement we were required to
adjust downward the price per share paid in the offering, by issuing additional
shares to match any lower price per share paid in subsequent offerings prior to
May 23, 2003. On October 22, 2002, this agreement was amended. (See Note 8)
In December 2000, we sold in a private placement 542,373 shares of common stock
for $3.69 per share. The purchasers of the common stock also received warrants
to purchase up to 135,593 shares of common stock exercisable at $4.83 per share.
We generated net proceeds of approximately $2.0 million from this transaction.
Under the terms of this private placement we were required to adjust downward
the price per share paid in the offering, by issuing additional shares, to match
any lower price per share paid in subsequent offerings prior to February 9,
2003. Following the January 2001 private placement described above, we issued an
additional 257,627 shares of common stock to the purchasers in the December 2000
private placement, and new warrants to purchase 264,407 shares of Common Stock
exercisable at a price of $3.13 per share to replace the previously issued
warrants to purchase 135,593 shares of Common Stock at a price of $4.83 per
share. On October 22, 2002, this agreement was amended. (See Note 8)
On October 9, 2002 we received a letter from NASDAQ stating that we do not meet
the criteria for the continued listing of our common stock on the NASDAQ
SmallCap Market. The letter stated that our common stock is not in compliance
with the $1 minimum bid price, that our stockholders' equity does not meet the
$2.5 million minimum requirement, and that the NASDAQ Staff rejected our plan to
regain compliance with those listing criteria. We have requested a hearing
before the NASDAQ Listing Qualifications Panel to appeal the ruling by the
NASDAQ Staff and have been notified that our hearing will be held on November
14, 2002. During the appeals process, which we expect may take up to 45 days,
our common stock will continue to trade on the NASDAQ SmallCap Market. In the
event that the Panel does not grant continued listing, our common stock will be
immediately delisted from the Nasdaq SmallCap market and we expect it will trade
on the OTC Bulletin Board (OTCBB). There can be no assurance that the Panel will
grant our request for continued listing.
NOTE 7 - TERM PROMISSORY NOTES
On August 9, 2002 we received approximately $475,000 in net proceeds from the
sale of term promissory notes with an original aggregate principal amount of
$525,000. These notes mature in August 2003 and accrue interest at a rate of
15%. The outstanding principal amount and all accrued interest are to be paid
upon maturity. We can prepay the principal and accrued interest at any time
without penalty. The purchasers of the promissory notes received warrants to
purchase one share of our common stock at a purchase price of $2.50 for every
dollar invested in the promissory notes. In total warrants to purchase 525,000
shares of our common stock were issued. These warrants expire in ten years.
7
NOTE 8 - INTERIM FINANCING FROM PYXIS INNOVATIONS, INC.
On October 23, 2002, subsequent to the end of the fiscal quarter, we entered
into an interim financing agreement with Pyxis Innovations, Inc. to provide debt
financing of up to $1.5 million. The financing is to be in the form of three
$500,000 promissory notes, the first of which was closed on October 23, 2002.
Subject to the satisfaction of certain condition, we expect to issue the second
note on November 15, 2002. The third note will only be issued at the option of
Pyxis on December 16, 2002. These notes will mature on December 31, 2003 and
accrue interest at a rate of 15%. The outstanding principal amount and all
accrued interest are to be paid upon maturity. We can prepay the principal and
accrued interest at any time without penalty. These notes are secured by all of
our intellectual property except intellectual property relating to periodontal
disease and sepsis.
On October 22, 2002, as a condition for the interim financing with Pyxis noted
above, we entered into separate agreements with the purchasers in the December
2000 and January 2001 private placements to temporarily waive certain provisions
of these private placement agreements. Specifically, the purchasers temporarily
waived their right, through March 31, 2003, to receive cash payments of up to
$100,000 per month if our common stock is delisted from the Nasdaq SmallCap
Market. Also waived through March 31, 2003 is the purchasers' right to receive
additional shares of our common stock for no additional consideration if we
issue shares of our common stock at a price below $2.50 per share (for the
purchaser in the December 2000 private placement this waiver is permanent, its
right will expire February 9, 2003). Under these agreements the purchasers have
also agreed to cancel warrants to purchase an aggregate of 864,407 shares of
common stock. In exchange, we are required to issue an aggregate of 1,676,258
shares of our common stock to the purchasers for no additional cash
consideration. If we receive an equity investment of at least $3,000,000 from
Pyxis prior to March 31, 2003 the temporary waivers of rights by the purchasers
will become permanent. If we do not receive such an equity investment by that
date, the temporary waivers will terminate and we will be required to issue
warrants to purchase an aggregate of 864,407 shares of our common stock
exercisable at $1.70 per share, subject to any shareholder approvals required by
the NASDAQ SmallCap Market or any other market or exchange on which our common
stock is then traded or quoted. Of these warrants, the exercise price of
warrants to purchase 600,000 shares of common stock will be subject to
adjustment downward to equal 125% of the price per share at which we sell any
shares of our common stock (or securities convertible into common stock) prior
to May 23, 2003.
NOTE 9 - SEGMENT INFORMATION
We follow the provisions of SFAS No. 131 (SFAS 131), "Disclosures about Segments
of an Enterprise and Related Information." SFAS 131 establishes standards for
reporting information about operating segments in annual and interim financial
statements, requiring that public business enterprises report financial and
descriptive information about reportable segments based on a management
approach. SFAS 131 also establishes standards for related disclosures about
products and services, geographic areas and major customers. In applying the
requirements of this statement, we continue to have one reportable segment,
which is the development of genetic susceptibility tests and therapeutic targets
for common diseases.
8
During 2000, we closed our foreign operations. Therefore, we no longer have any
assets outside of the United States. For the nine-month periods ended September
30, 2002 and 2001 all assets were located, and all revenue was primarily
generated in the United States.
NOTE 10 - RECENT ACCOUNTING PRONOUNCEMENTS
In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements No.
4, 44 and 64, Amendment of FASB 13, and Technical Corrections", which is
effective for fiscal years beginning after May 15, 2002. Upon adoption of SFAS
No. 145, companies will be required to apply the criteria in APB Opinion No. 30,
"Reporting the Results Operations - Reporting the Effects of Disposal of a
Segment of a Business and Extraordinary, Unusual and Infrequently Occurring
Events and Transactions" in determining the classification of gains/losses
resulting from the extinguishment of debt shall be classified under the criteria
in APB Opinion No. 30. We do not expect Adoption of SFAS No. 145 to have a
material impact on our financial statements.
In July 2002, FASB issued SFAS No. 146 "Accounting for Costs Associated with
Exit or Disposal Activities", which becomes effective January 2003. SFAS No. 146
requires companies to recognize costs associated with exit or disposal
activities when they are incurred rather than at the date of commitment. We do
not expect Adoption of SFAS No. 146 to have a material impact on our financial
statements.
9
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
FORWARD LOOKING STATEMENTS
THIS QUARTERLY REPORT ON FORM 10-Q CONTAINS CERTAIN FORWARD-LOOKING STATEMENTS
WITHIN THE MEANING OF SECTION 27A OF THE SECURITIES ACT AND SECTION 21E OF THE
SECURITIES EXCHANGE ACT. STATEMENTS CONTAINED IN THIS REPORT THAT ARE NOT
STATEMENTS OF HISTORICAL FACT MAY BE DEEMED TO BE FORWARD-LOOKING STATEMENTS.
WORDS OR PHRASES SUCH AS "WILL LIKELY RESULT", "WILL ENABLE", "EXPECT", "WILL
CONTINUE", "ANTICIPATE", "ESTIMATE", "INTEND", "PLAN", "PROJECT", "OUTLOOK", OR
SIMILAR EXPRESSIONS ARE INTENDED TO IDENTIFY FORWARD-LOOKING STATEMENTS.
FORWARD-LOOKING STATEMENTS ADDRESS OR MAY ADDRESS THE FOLLOWING SUBJECTS:
- THE SUFFICIENCY OF OUR CURRENT CASH RESOURCES AND FINANCING
ARRANGEMENTS TO FUND OPERATIONS THROUGH JANUARY 2003;
- OUR EXPECTATION THAT WE WILL ISSUE AND SELL ALL THREE $500,000
PROMISSORY NOTES CONTEMPLATED IN OUR INTERIM FINANCING AGREEMENT WITH
PYXIS INNOVATIONS, INC.;
- OUR ABILITY TO RAISE ADDITIONAL CAPITAL TO FUND OPERATIONS PAST
DECEMBER 2002;
- ANY EXPECTATION THAT WE MIGHT NEGOTIATE A STRATEGIC PARTNERSHIP, JOINT
VENTURE OR RECEIVE EQUITY FINANCING FROM PYXIS INNOVATIONS, INC.;
- OUR CONTINUED LISTING ON THE NASDAQ SMALLCAP MARKET;
- OUR EXPECTATION OF THE BENEFITS THAT WILL RESULT FROM ONGOING RESEARCH
PROGRAMS THAT OUTSIDE PARTIES ARE CONDUCTING ON OUR BEHALF;
- OUR EXPECTATION OF THE BENEFITS THAT WILL RESULT FROM THE ONGOING
RESEARCH WE ARE FUNDING AT SHEFFIELD UNIVERSITY;
- ANY EXPECTATION WE MAY HAVE REGARDING THE SUCCESS OF DEVELOPING
PRODUCTS, THE TIMING OF RELEASING PRODUCTS FOR SALE OR THE SUCCESS OF
THESE PRODUCTS WHEN THEY ARE RELEASED;
- OUR EXPECTATION THAT TOTAL RESEARCH AND DEVELOPMENT COSTS, INCLUDING
CLINICAL COSTS, WILL BE BETWEEN APPROXIMATELY $3.2 AND $3.4 MILLION FOR
THE YEAR ENDED DECEMBER 31, 2002; AND
- OUR EXPECTATION THAT WE WILL CONTINUE TO EXPERIENCE LOSSES UNTIL OUR
GENETIC TESTING REVENUES GROW SUBSTANTIALLY FROM CURRENT LEVELS.
ACTUAL RESULTS MAY VARY MATERIALLY FROM THOSE EXPRESSED IN FORWARD-LOOKING
STATEMENTS. FACTORS THAT COULD CAUSE ACTUAL RESULTS TO DIFFER FROM EXPECTATIONS
INCLUDE BUT ARE NOT LIMITED TO: OUR ABILITY TO OBTAIN ADEQUATE CAPITAL, OUR
ABILITY TO SELL ALL OF THE PROMISSORY NOTES CONTEMPLATED IN OUR INTERIM
FINANCING AGREEMENT, RISKS RELATED TO MARKET ACCEPTANCE OF GENETIC RISK
ASSESSMENT TESTS IN GENERAL AND OUR PRODUCTS IN PARTICULAR, RISK RELATED TO
TECHNOLOGY AND PRODUCT OBSOLESCENCE, DELAYS IN DEVELOPMENT OF PRODUCTS,
DEPENDENCE ON THIRD PARTIES, COMPETITIVE RISKS AND THOSE RISKS SET FORTH WITHIN
THE SECTION BELOW TITLED "CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS OF
OPERATIONS". WE CANNOT BE CERTAIN THAT OUR RESULTS WILL NOT BE ADVERSELY
AFFECTED BY ONE OR MORE OF THOSE FACTORS OR BY OTHER FACTORS NOT CURRENTLY
ANTICIPATED. ALL INFORMATION SET FORTH IN THIS FORM 10-Q IS AS OF THE DATE OF
THIS FORM 10-Q. UNLESS REQUIRED BY LAW WE ACCEPT NO RESPONSIBILITY TO UPDATE
THIS INFORMATION.
10
GENERAL OVERVIEW
We develop and sell genetic susceptibility tests, tests that identify which
individuals will respond to specific drug therapies and medical research tools.
We focus our efforts on discovering genetic factors that predict the
susceptibility of individuals to various diseases or determine which individuals
will respond to a specific drug therapy or to specific nutritional products. We
market PST(R) in the United States and Europe. PST is our only genetic test
currently on the market and predicts the risk of periodontal disease. Products
currently under development include tests that predict the risk of osteoporosis,
coronary artery disease and complications from diabetes and a test that predicts
which drug treatment will be most effective for patients with advanced
Rheumatoid Arthritis.
Every living organism has a unique "genome," a master blueprint of all the
cellular structures and activities necessary to build and support life. A genome
is a map of the organism's DNA, which is in part comprised of segments called
"genes." Genes contain the specific sequences of information responsible for
particular physiological traits and processes. Each gene contains a sequence of
nucleotides, which provide precise genetic instructions to create, or "express"
a protein. Proteins are the primary building blocks of an organism's
physiological characteristics. A typical human cell contains thousands of
different proteins essential to its structure, growth and function. If even one
gene or single nucleotide is abnormal, it can severely alter the cell's function
and result in a disease condition. Throughout the past decade, researchers have
focused on discovering genes and sequencing the human genome to determine the
order of nucleotides in a specific gene, permitting identification of the gene
and the protein it produces using a variety of techniques. For example,
scientists have used cDNA libraries, which contain copies of DNA with only the
expressed portion of the gene, in conjunction with computer software to identify
locations of genes within the genome. Recent advances have allowed these
technologies to operate in a high-throughput manner, causing the discovery of
genes to become much more efficient and allowing researchers to focus on the
functional aspects of genes. Understanding the functional aspects of genes
permits the researchers to correlate those genes to medically relevant
conditions. The efforts to discover and understand these functional aspects of
the genes in the human genome are commonly referred to as "functional genomics."
Identifying genes that may predispose a person to a particular disease may allow
researchers to develop diagnostic tests for the disease permitting early
diagnosis and more successful treatment. We believe that combining genetic
susceptibility tests with specific therapeutic strategies results in improved
clinical outcomes and more cost-effective disease management.
We also develop and license our medical research tools to pharmaceutical and
biotech companies. For instance, BioFusion(R) is our proprietary computer
modeling system that simulates complex diseases and allows researchers to
identify useful information from the rapidly increasing genetic information
databases that companies and academic centers worldwide generate.
We distribute PST through third party distributors. Kimball Genetics markets PST
in the United States and Hain Diagnostika/ADA GmbH distributes PST in all
countries outside of North America and Japan. Hain has extensive experience in
commercializing genetic tests in several fields, as well as a specific
11
commitment to marketing products directly to dentists. Sales of PST have
generated minimal revenues to date, and we do not know if or when PST will
achieve commercial acceptance.
Commercial success of genetic susceptibility tests will depend upon their
acceptance as medically useful and cost-effective by patients, physicians,
dentists, other members of the medical and dental community, and third-party
payers. We are not certain whether we will be successful in developing and
bringing to market our current or future tests based on the genetic discoveries
made by our collaborators and us.
Our ability to successfully commercialize genetic susceptibility tests depends
partly on obtaining adequate reimbursement for such products and related
treatment from government and private health care insurers and other third-party
payers. Doctors' decisions to recommend genetic susceptibility tests may be
influenced by the scope and reimbursement for such tests by third-party payers.
If both third-party payers and individuals are unwilling to pay for the test,
then the number of tests performed will significantly decrease, therefore
resulting in a reduction of revenues.
Research in the field of disease predisposing genes and genetic markers is
intense and highly competitive. We have many competitors in the United States
and abroad that have considerably greater financial, technical, marketing, and
other resources available. If we do not discover disease predisposing genes or
genetic markers and develop susceptibility tests and launch such services or
products before our competitors, then revenues may be reduced or eliminated.
RESULTS OF OPERATIONS
COMPARISON OF THREE MONTHS ENDED SEPTEMBER 30, 2002 TO THREE MONTHS ENDED
SEPTEMBER 30, 2001
Revenue for the three months ended September 30, 2002 was $79,677 compared to
$24,978 for the three months ended September 30, 2001, an increase of 219%. The
increase was entirely due to the amortized revenue associated with an option fee
that was received from Pyxis Innovations, Inc. during the period. Excluding this
fee, revenue decreased 67% in comparison to the same period last year. In the
three months ended September 30, 2002, we recorded revenue from 381 PST tests
compared to 577 tests in the same period in 2001. Cost of revenue was $106 for
the three months ended September 30, 2002 compared to $8,443 for the same period
in 2001. Gross profit margin was 99% in the three months ended September 30,
2002 compared to 66% for the same period in 2001.
The decrease in test revenue was the result of the decrease in the number of PST
tests processed and the replacement of our prior PST distributor, Straumann
Company, with our current distributor, Kimball Genetics, as our primary
distributor within the United States. We receive less revenue per test from
Kimball than we did from Straumann but we do not need to pay a processing fee
back to them. This change in distributors has reduced our revenue but improved
our gross margin percentage. The gross profit per test to us is approximately
the same for Kimball as it was for Straumann.
For the three months ended September 30, 2002, we had research and development
expenses of $716,964 as compared to $634,719 for the same quarter of 2001, an
increase of 13%. The increase was primarily the result of
12
increases in personnel costs associated with the staffing of our new research
laboratory and the cost of supplying the laboratory.
We are currently conducting several research and clinical projects both in-house
and through collaborative partners. The most significant projects are the
following:
CARDIOVASCULAR DISEASE: We are working with Kaiser Permanente's Center for
Health Research to investigate the value of testing for genetic differences
among people who have type 2 diabetes to determine their relative risk of
developing cardiovascular disease. It is hoped that this program will enable us
to develop new diagnostic tools for assessing diabetic patients' genetic risk
for heart disease. Enrollment on this study is complete and the analysis is
underway. If we are successful we expect to have a test predictive of
cardiovascular complications from diabetes on the market in 2003.
RHEUMATOID ARTHRITIS: In collaboration with United Health Group, we are
conducting a study to determine whether analysis of genotype will be useful to
predict responses to anti-cytokine therapy for individuals with rheumatoid
arthritis. Different anti-cytokine therapies act very differently on a patient's
biology. Two of the three anti-cytokine therapies used to treat rheumatoid
arthritis are anti TNFa drugs; the other acts upon the IL-1 gene. We believe
that depending upon the specific genetics of individual patients, we might be
able to predict which class of drugs would be most effective.
In collaboration with the University of Sheffield School of Health and Related
Research (ScHARR), we are conducting a study to determine if it is cost
effective to analyze patient genotypes prior to the use of Kineret in the
treatment of Rheumatoid Arthritis. The preliminary results of this study were
announced at the American College of Rheumatoid meeting on October 26, 2002. The
results of the economic modeling indicate that use of a pharmacogenetic test
prior to prescribing Kineret could potentially be cost-effective, producing
higher response rates and potential cost savings.
ALZHEIMER'S DISEASE: We are working with the University of Arkansas for Medical
Sciences to study the genetic causes of inflammation in relation to Alzheimer's
Disease. This study will focus on how IL-1 genetic variations alter inflammation
in the brain leading to Alzheimer's Disease. This information, together with
other genetic data, might be used to develop new drug targets and help in the
development of therapeutics for individuals with genetic differences in their
inflammatory mechanisms.
SHEFFIELD STUDIES: We are funding research at Sheffield University in support of
several research projects including the following: A study to determine the
haplotypes, or sets of genetic variations that are inherited together, that
exist within the IL-1 cluster; A study to discover novel drug targets for
inflammatory diseases by discovering genes involved in the responses of cells
after they have been activated by IL-1; the development of a system that
measures the net IL-1 biologic activity of blood or any tissue fluid and the
discovery of the genetic variations that control patient to patient differences
in inflammatory mechanisms. We believe that the completion of these studies will
greatly enhance our understanding of the IL-1 gene cluster and the relationship
of this gene cluster to inflammatory responses and disease risk.
13
FUNCTIONAL GENETICS RESEARCH: We are currently conducting the following studies
at our research center in Waltham, Massachusetts:
- Identify functional SNPs: A project to determine which of the SNPs,
within the IL-1 gene cluster, leads to an alteration in the expression
of the IL-1 genes.
- Create IL-1 genotype and haplotype specific cell models that can be
used for studying drug responses. It is hoped that these models will be
critical to the analyses of drug or nutriceutical product response for
use in future partnerships and collaborative projects in support of the
development of new drugs or nutriceuticals.
- Investigate IL-1 genotype and haplotype influences on the expression of
inflammatory response genes derived from normal and disease tissues.
OSTEOPOROSIS: We anticipate conducting one or more clinical studies that we hope
will confirm our initial findings of association between polymorphisms in the
IL-1 and TNFa and a woman's risk for vertebral fracture. Any further studies
will depend upon our ability to raise additional funds.
We expect total research and development costs, including clinical costs, to be
between approximately $3.2 and $3.4 million for the calendar year 2002. Actual
costs may vary from this estimate as a result of our ability to raise additional
new capital, changes in technology, the success of current and future research
projects, the success or failure of our current or future strategic alliances
and collaborations and the identification of new business opportunities.
We have not made an attempt to finalize an estimate of our research and
development expenses beyond 2002 due to the factors listed above.
Selling, general and administrative expenses were $652,637 during the three
months ended September 30, 2002 compared to $565,110 during the same quarter
last year, an increase of 15%. The increase was primarily the result of an
increase in legal expenses related to our efforts to obtain additional
financing. This was partially offset by reduction in administrative, sales and
marketing expense related to the sale and distribution of PST and a decrease in
travel expense.
Interest income for the three months ended September 30, 2002 was $2,520
compared to $49,661 for the same period in 2001. This decrease is due primarily
to the lower average cash and cash equivalent balances in 2002 in comparison to
the same period in 2001. Interest expense of $15,983 was incurred during the
quarter ended September 30, 2002, compared to $2,396 in the same period in 2001.
The increase is primarily due to interest expense related to the bridge
financing entered into in August 2002. Other expense of $60,034 is related to
the amortization of the value of the warrants associated with that bridge
financing. This expense is being amortized over the life of the loan.
COMPARISON OF NINE MONTHS ENDED SEPTEMBER 30, 2002 TO NINE MONTHS ENDED
SEPTEMBER 30, 2001
Revenue for the nine months ended September 30, 2002 was $102,229 compared to
$183,923 for the nine months ended September 30, 2001, a decrease of 44%. In the
nine months ended September 30, 2002, we recorded revenue from 1,374 PST
14
tests compared to 3,035 tests in the same period in 2001. Cost of revenue was
$441 for the nine months ended September 30, 2002 compared to $43,387 for the
same period in 2001. Gross profit margin was 99% in the nine months ended
September 30, 2002 compared to 76% for the same period in 2001.
The decrease in revenue was the result of (i) the inclusion in last year's
revenue totals of $101,520 for the processing of 1,128 tests in association with
a single clinical trial that was conducted by Washington Delta Dental, (ii) a
decrease in the number of PST tests processed, exclusive of the clinical trial
mentioned above, and (iii) the replacement of our prior PST distributor,
Straumann Company, with our current distributor, Kimball Genetics, as our
primary distributor within the United States. We receive less revenue per test
from Kimball than we had from Straumann but we do not need to pay a processing
fee back to them. This change in distributors has reduced our revenue but
improved our gross margin percentage. The gross profit per test to us is
approximately the same for Kimball as it was for Straumann. This decrease was
partially offset by the amortized revenue associated with the receipt of an
option fee from Pyxis Innovations, Inc. that was received during the period.
For the nine months ended September 30, 2002, we had research and development
expenses of $2,504,132 as compared to $2,050,665 for the same period of 2001, an
increase of 22%. The increase was primarily the result of increases in personnel
costs associated with an increased number of ongoing clinical projects and with
staffing of our new research laboratory and the cost of supplying the
laboratory.
Selling, general and administrative expenses were $1,764,343 during the nine
months ended September 30, 2002 compared to $1,741,231 during the same period
last year, an increase of 1%. Increases in legal expenses, rent and expenses
related to our business development effort were almost completely offset by
decreases in travel, consulting and reductions in administrative, sales and
marketing expense related to the sale and distribution of PST.
Interest income for the nine months ended September 30, 2002 was $22,276
compared to $237,252 for the same period in 2001. This decrease is due primarily
to the lower average cash and cash equivalent balances in 2002 in comparison to
the same period in 2001. Interest expense of $22,251 was incurred during the
nine months ended September 30, 2002, compared to $8,165 in the same period in
2001. This increase was primarily due to interest expense associated with the
bridge financing that was closed in August 2002. We had other expense of $59,337
during the nine months ended September 30, 2002. This was primarily the
amortization of the expense related to issuing warrants associated with that
August 2002 financing.
LIQUIDITY AND CAPITAL RESOURCES
To date, we have funded our operations primarily through public and private
sales of equity and private sales of debt. During 2001, we raised net proceeds
of approximately $2.9 million, from a private placement of common stock and
approximately $480,000 from the exercise of stock options and warrants.
On August 9, 2002, we received approximately $475,000, net proceeds, from the
sale of term promissory notes with an aggregate original principal amount of
$525,000. These notes mature in one year and pay interest at a rate of 15%.
15
The principal and all interest are to be paid upon maturity. We can prepay the
principal and accrued interest without penalty. The promissory notes purchasers
received warrants to purchase one share of stock for a purchase price of $2.50
for every dollar invested in the promissory notes. In total warrants to purchase
525,000 shares of stock were issued. These warrants expire in ten years.
On September 3, 2002 we received an option fee from Pyxis Innovations, Inc. in
conjunction with a letter of intent that was signed with that company. The
option fee allows Pyxis to exclusively negotiate a joint venture or license
agreement with us in the area of nutritional genomics over a period of 105 days.
The revenue from this option agreement is being recognized over the life of the
option period.
On October 23, 2002, subsequent to the end of the fiscal quarter, we entered
into an interim financing agreement with Pyxis for debt financing of up to $1.5
million. The financing is to be in the form of three $500,000 promissory notes,
the first of which was issued on October 23, 2002. We expect the second note to
be issued on November 15, 2002. The third note will be issued, at the option of
Pyxis, on December 16, 2002. These notes will mature on December 31, 2003 and
accrue interest at a rate of 15%. The outstanding principal amount and all
accrued interest are to be paid upon maturity. We can prepay the principal and
accrued interest at any time without penalty. These notes are secured by all of
our intellectual property except intellectual property relating to periodontal
disease and sepsis.
Since inception, we have incurred accumulated deficits of approximately $39.7
million, including losses of approximately $4.2 million during the nine months
ended September 30, 2002. Net cash used in operating activities was $3.8 million
during the nine months ended September 30, 2002 and $3.2 million during the same
period last year.
We anticipate that we will continue to experience losses until our genetic
testing revenues grow substantially from current levels. In addition, if we are
successful in reaching agreements with strategic partners, milestone payments,
if any, from these strategic partners would help fund our research and
development efforts. We cannot give any assurances that we will be able to
increase our revenues, either from genetic tests or licensing revenue, or that
we will be able to reach strategic partnering agreements.
We will be required to repay $603,750 in principal and interest on our 15% term
promissory notes during August 2003 and approximately $590,000 in principal and
interest on our first $500,000 promissory note issued to Pyxis during December
2003. In December 2003, we will also be required to repay an aggregate of
approximately $1,160,000 if the second and third notes contemplated in our
interim financing arrangement are issued. The letter stated that our common
stock is not in compliance with the $1 minimum bid price, that our stockholders'
equity does not meet the $2.5 million minimum requirement, and that the NASDAQ
Staff rejected our plan to regain compliance with those listing criteria. We
have requested a hearing before the NASDAQ Listing Qualifications Panel to
appeal the ruling by the NASDAQ Staff and have been notified that our hearing
will be held on November 14, 2002. During the appeals process, which we expect
may take up to 45 days, our common stock will continue to trade on the NASDAQ
SmallCap Market. In the event that the Panel does not grant continued listing,
our common stock will be immediately delisted from the Nasdaq SmallCap market
and we expect it will
16
trade on the OTC Bulletin Board (OTCBB). There can be no assurance that the
Panel will grant our request for continued listing.
Our obligation at September 30, 2002 for capitalized lease obligations totaled
approximately $52,000, of which $22,000 is classified as long-term and $30,000
is classified as current. We currently do not have any commitments for material
capital expenditures.
As of September 30, 2002 we had cash and cash equivalents totaling $508,000
compared to $3.9 million as of December 31, 2001. We anticipate that existing
cash and cash equivalents, including funds received from the recent sale of
promissory notes (described above) are adequate to fund operations approximately
through December 2002 if Pyxis does not elect to purchase the third $500,000
promissory note contemplated in the financing arrangement or January 2003 if
they do elect to purchase the third $500,000 promissory note. As a result, there
is significant doubt about our ability to continue as a going concern. Our
future capital requirements are anticipated to be substantial, and we do not
have commitments for additional capital at this time. Capital requirements are
expected to arise from the commercial launch of additional genetic tests,
continued research and development efforts, the protection of intellectual
property rights (including preparing and filing of patent applications), and
repayment of the principal and interest on our 15% term promissory notes due in
August 2003 and December 2003, as well as operational, administrative, legal and
accounting expenses. We are currently pursuing sources of capital and strategic
partnerships in order to raise the capital necessary to continue operations past
January 2003. WE CAN GIVE NO ASSURANCE THAT WE WILL BE ABLE TO RAISE ANY
ADDITIONAL CAPITAL, OR IF WE DO RAISE ADDITIONAL CAPITAL, THAT IT WILL BE ON
TERMS ACCEPTABLE TO OUR STOCKHOLDERS OR US. IF ADDITIONAL AMOUNTS CANNOT BE
RAISED, WE WOULD SUFFER MATERIAL ADVERSE CONSEQUENCES TO OUR BUSINESS, FINANCIAL
CONDITION AND RESULTS OF OPERATIONS AND WOULD LIKELY BE REQUIRED TO SEEK OTHER
ALTERNATIVES UP TO AND INCLUDING PROTECTION UNDER THE UNITED STATES BANKRUPTCY
LAWS.
CRITICAL ACCOUNTING POLICIES
Our significant accounting policies are described in Note 2 to the
consolidated financial statements included in this report. We believe our most
critical accounting policies are in the areas of revenue recognition, cost
estimations of certain ongoing research contracts and our decision to expense
all patent related costs as incurred.
Revenue recognition:
Revenue from genetic susceptibility tests is recognized when the tests have
been completed and the results reported to the doctors. To the extent test kits
have been purchased but not yet submitted for test results, we defer recognition
of revenue. This amount is presented on our balance sheet as deferred revenue.
Contract revenues are recognized ratably as services are provided based on a
fixed contract price or on negotiated hourly rates. Fees for the sale or
licensing of product rights are recorded as deferred revenue upon receipt and
recognized as revenue on the straight-line basis over the period that the
related products or services are delivered or obligations as defined in the
agreement are performed.
Cost estimates:
17
Much of our research and development is done on contract by outside parties.
It is not unusual that at the end of an accounting period we need to estimate
both the total cost of these projects and the percent of that project which was
completed as of the accounting date. We then need to adjust those estimates when
final invoices are received. To date, these adjustments have not been material
to our financial statements, and we believe that the estimates that we made as
of September 30, 2002 are reflective of the actual expenses incurred as of that
date. However, readers should be cautioned that the possibility exists that
certain research projects might cost more than we have estimated and that these
higher costs will be reflected in future periods.
Patent expenses:
We have made the decision to expense patent expenses as incurred due to the
possibility that we will never be able to derive any benefits from our patents.
We have exclusive rights in nine issued U.S. patents and have twenty pending
U.S. patents applications. We have also been granted a number of corresponding
foreign patents and we have a number of foreign counterparts of our U.S. patents
and patent applications pending. Since inception we have expensed over to $2.2
million in the effort to obtain patent protection for our intellectual property
including approximately $310,000 during the nine months ended September 2002. If
we had decided to record the costs of developing patent protection as an
intangible asset on the balance sheet it would have had a material effect on the
presentation of our financial statements. In future periods we may decide to
change this presentation as the realizability of return on this investment
becomes more certain.
Research and Development expenses:
We expense research and development expenses as incurred. Research and
Development expenses include all expenses related to clinical trials, laboratory
research and outside research completed on our behalf. It also includes all
payroll, benefit, supply and travel expenses of those employees whose activities
are in support of the efforts described above.
CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS OF OPERATIONS
IF WE FAIL TO OBTAIN ADDITIONAL CAPITAL, OR OBTAIN IT ON UNFAVORABLE TERMS, THEN
WE MAY HAVE TO END OUR RESEARCH AND DEVELOPMENT PROGRAMS AND OTHER OPERATIONS
We anticipate that our current financial resources are adequate to maintain our
current and planned operations through November 2002. We anticipate that our
current financial resources together with the proceeds from the sale of notes to
Pyxis Innovations, Inc. will be adequate to maintain our current and planned
operations through December 2002 (if Pyxis does not elect to purchase the third
$500,000 note) or January 2003 (if Pyxis does elect to purchase the third
$500,000 note). If we cannot raise additional capital prior to any of these
dates, we will be unable to fund our business operations and will be required to
seek other strategic alternatives and may be required to declare bankruptcy. Any
future issuances of equity securities by the Company may require stockholder
approval for an increase in authorized shares. If the
18
Company is unable to obtain such approval, it will be required to seek other
strategic alternatives and may be required to declare bankruptcy.
Our future capital needs depend on many factors. We will need capital for the
commercial launch of additional genetic tests, continued research and
development efforts, obtaining and protecting patents and administrative
expenses. Additional financing may not be available when needed, or, if
available, it may not be available on favorable terms. If we cannot obtain
additional funding on acceptable terms when needed, we may have to discontinue
operations, or, at a minimum, curtail one or more of our research and
development programs.
WE MAY BE DELISTED FROM NASDAQ RESULTING IN A LIMITED PUBLIC MARKET FOR OUR
COMMON STOCK AND VOLATILITY IN OUR STOCK PRICE
Our common stock is currently listed on the Nasdaq SmallCap Market and the
Boston Stock Exchange. On April 2, 2002 we received a notice from Nasdaq stating
that we were not in compliance with their continued listing requirements because
our common stock bid price had fallen below Nasdaq's $1.00 minimum bid price
requirement. The Rule states that if our stock price is below the minimum bid
price requirement for 30 consecutive trading days, we would have 180 days to
regain compliance with this requirement or face delisting. The 180-day grace
period expired September 30, 2002. To meet the bid price requirement, the bid
price of our common stock had to close at or above $1.00 per share for more than
ten consecutive trading days prior to September 30, 2002. From April 1, 2002
through September 30, 2002, our closing bid price ranged from $0.50 to $1.02,
but did not close above $1 for more than two consecutive days. In addition, we
received a notice from Nasdaq that as of June 30, 2002 we did not satisfy the
Nasdaq rule that we have stockholders' equity of at least $2.5 million. We
presented a plan for achieving compliance to Nasdaq on September 13, 2002.
Nasdaq did not approve of our plan and announced its decision to delist our
common stock anyway. We have requested a hearing regarding this decision and
have been notified that the hearing will be held on November 14, 2002. While we
expect the Listing Qualifications Panel to take up to 45 days to issue its
decision, it could do so at any time following the hearing and if they reject
our appeal our common stock will be immediately delisted from the Nasdaq
SmallCap Market. If they accept our appeal and grant us additional time to
regain compliance with the listing criteria, among other things we will need to
increase stockholder's equity by a total of approximately $5 million in order to
satisfy the stockholders' equity requirements through December 31, 2002.
Accordingly, whether or not our appeal is successful we may not be able to
maintain our continued listing on the Nasdaq or the Boston Stock Exchange.
If we are unable to maintain our Nasdaq Smallcap market quotation, our common
stock would likely begin to trade on the NASD's OTC Bulletin Board and become a
"penny stock", as long as it trades below $5.00 per share. Broker-dealer
practices in connection with transactions in penny stocks are regulated by penny
stock rules adopted by the SEC. The penny stock rules require a broker-dealer,
prior to a transaction in a penny stock not otherwise exempt from the rules, to
deliver a standardized risk disclosure statement prepared by the SEC that
provides information about penny stocks and the nature and level of risks in the
penny stock market. The broker-dealer also must provide the customer with
current bid and offer quotations for the penny stock, the compensation of the
broker-dealer and its salesperson in the transaction, as well as the monthly
account statements showing the market value of each penny stock held
19
in the customer's account. In addition, the penny stock rules require that,
prior to a transaction in a penny stock not otherwise exempt from such rules,
the broker-dealer must make a special written determination that the penny stock
is a suitable investment for the purchaser and receive the purchaser's written
agreement to the transaction.
Selling our common stock will also be more difficult because of reduced trading
volume and transaction size. Transactions could also be delayed, and security
analysts' and news media's coverage, if any, of us will be reduced. These
factors may result in lower prices and larger spreads in the bid and ask prices
for our shares. The delisting of our shares would also greatly impair our
ability to raise additional necessary capital through equity or debt financing.
Historically, our common stock has experienced low trading volumes. The market
price of our common stock has been highly volatile, and it may continue to be
highly volatile, as has been the case with the securities of other public
biotechnology companies. Factors such as announcements by us or by our
competitors concerning technological innovations, new commercial products or
procedures, proposed government regulations and developments or disputes
relating to patents or proprietary rights are likely to affect the market price
of our common stock. Changes in the market price of our common stock may bear no
relation to our actual operational or financial results.
IF OUR COMMON STOCK IS DELISTED FROM NASDAQ, WE MAY NEED TO PAY PENALTIES OF
$100,000 PER MONTH.
Pursuant to the terms of our December 2000 and January 2001 financings, if our
common stock is delisted from Nasdaq, we must pay $100,000 per month to the
investors in those financings continuing indefinitely. We recently entered into
agreements with each of these investors in which the investors agreed to waive
their rights to any such payments until April 1, 2003. If we receive at least $3
million of equity financing from Pyxis Innovations, Inc. or its affiliates prior
to April 1, 2003 these provisions will be permanently waived. These payments, if
they become required, would make it more difficult for us to raise additional
funds and to operate our business.
WE HAVE A HISTORY OF OPERATING LOSSES AND EXPECT THESE LOSSES TO CONTINUE IN THE
FUTURE
We have experienced significant operating losses since our inception and expect
these losses to continue for the foreseeable future. We incurred losses from
operations of $6.2 million in 1999, $5.2 million in 2000 and $4.8 million in
2001. As of September 30, 2002, our accumulated deficit was $39.7 million. Our
losses result primarily from research and development and selling, general and
administrative expenses. We have not generated significant revenues from product
sales, and we do not know if we will ever generate significant revenues from
product sales. We will need to generate significant revenues to continue our
research and development programs and achieve profitability. We cannot predict
when, if ever, we will achieve profitability.
THE MARKET FOR GENETIC SUSCEPTIBILITY TESTS IS UNPROVEN
The market for genetic susceptibility tests is at an early stage of development
and may not continue to grow. The general scientific community, including us,
has only a limited understanding of the role of genes in predicting disease.
When we identify a gene or genetic marker that may predict
20
disease, we conduct clinical trials to confirm the initial scientific discovery
and to establish the scientific discovery's clinical utility in the marketplace.
The results of these clinical trials could limit or delay our ability to bring
the test to market, reduce the test's acceptance by our customers or cause us to
cancel the program, any of which limit or delay sales and cause additional
losses. The only genetic susceptibility test we currently market is PST, and it
has produced only minimal revenues to date. The marketplace may never accept our
products, and we may never be able to sell our products at a profit. We may not
complete development of or commercialize our other genetic susceptibility tests.
The success of our genetic susceptibility tests will depend upon their
acceptance as medically useful and cost-effective by patients, physicians,
dentists, other members of the medical and dental community and by third-party
payors, such as insurance companies and the government. We can achieve broad
market acceptance only with substantial education about the benefits and
limitations of genetic susceptibility tests. Our tests may not gain market
acceptance on a timely basis, if at all. If patients, dentists and physicians do
not accept our tests, or take a longer time to accept them than we anticipate,
then it will reduce our sales, resulting in additional losses.
WE RELY HEAVILY ON THIRD PARTIES TO PERFORM SALES, MARKETING AND DISTRIBUTION
FUNCTIONS ON OUR BEHALF, WHICH COULD LIMIT OUR EFFORTS TO SUCCESSFULLY MARKET
PRODUCTS
We have limited experience and capabilities with respect to distributing,
marketing and selling genetic susceptibility tests. We have relied and plan to
continue to rely significantly on sales, marketing and distribution arrangements
with third parties, over which we have limited influence. If these third parties
do not successfully market our products, it will reduce our sales and increase
our losses. If we are unable to negotiate acceptable marketing and distribution
agreements with future third parties, or if in the future we elect to perform
sales, marketing and distribution functions ourselves, we will incur significant
costs and face a number of additional risks, including the need to recruit
experienced marketing and sales personnel.
WE RELY HEAVILY ON THIRD PARTIES TO PERFORM RESEARCH AND DEVELOPMENT ON OUR
BEHALF, WHICH COULD LIMIT OUR EFFORTS TO SUCCESSFULLY DEVELOP PRODUCTS
We have limited research and development capabilities. In July 1999, we entered
into a new contractual arrangement with the University of Sheffield, replacing
the research and development agreement that had been in place since 1996. Under
our arrangement with Sheffield, we will undertake the business development and
commercialization of discoveries resulting from Sheffield's research. The
agreement is non-cancelable for those discoveries on which Sheffield and we have
reached a specific business development agreement, but otherwise either party
can end the arrangement upon six months' notice. This agreement with Sheffield
has a five-year term with an automatic yearly renewal. As part of this
arrangement, we issued an aggregate of 475,000 shares of our common stock to
Sheffield and its researchers in exchange for patent rights and other interests
held by Sheffield and its researchers under our previous project agreements. Our
agreement with Sheffield requires us to fund agreed upon research and
development activities at the University of Sheffield on our behalf based upon
annual budgets. We also entered into a five-year consulting agreement with
Sheffield's key collaborator, Dr. Gordon Duff.
21
Reliance on third-party research and development entails risks we would not be
subject to if we performed this function ourselves. These risks include reliance
on the third party for regulatory compliance and quality assurance, the
possibility of breach of agreements by third parties because of factors beyond
our control and the possibility of terminations or nonrenewals of agreements by
third parties, based on their own business priorities, at times that are costly
or inconvenient for us. We may in the future elect to perform all research and
development ourselves, which will require us to raise substantial additional
funds and recruit additional qualified personnel.
IF WE ARE UNSUCCESSFUL IN ESTABLISHING ADDITIONAL STRATEGIC ALLIANCES, OUR
ABILITY TO DEVELOP AND MARKET PRODUCTS AND SERVICES WILL BE DAMAGED
Entering into strategic alliances for the development and commercialization of
products and services based on our discoveries is an important element of our
business strategy. We anticipate entering into additional collaborative
arrangements with Sheffield and other parties in the future. We face significant
competition in seeking appropriate collaborators. In addition, these alliance
arrangements are complex to negotiate and time-consuming to document. If we fail
to maintain existing alliances or establish additional strategic alliances or
other alternative arrangements, then our ability to develop and market products
and services will be damaged. In addition, the terms of any future strategic
alliances may be unfavorable to us or these strategic alliances may be
unsuccessful.
IF WE FAIL TO OBTAIN AN ADEQUATE LEVEL OF REIMBURSEMENT FOR OUR PRODUCTS OR
SERVICES BY THIRD-PARTY PAYORS, THEN OUR PRODUCTS AND SERVICES WILL NOT BE
COMMERCIALLY VIABLE
The availability and levels of reimbursement by governmental and other
third-party payors affect the market for any healthcare service. These
third-party payors continually attempt to contain or reduce the costs of
healthcare by challenging the prices charged for medical products and services.
Our ability to successfully commercialize our existing genetic susceptibility
test and others that we may develop depends on obtaining adequate reimbursement
from third-party payors. The extent of third-party payor reimbursement will
likely heavily influence physicians' and dentists' decisions to recommend
genetic susceptibility tests, as well as patients' elections to pursue testing.
If reimbursement is unavailable or limited in scope or amount, then we cannot
sell our products and services profitably. In particular, third-party payors
tend to deny reimbursement for services which they determine to be
investigational in nature or which are not considered "reasonable and necessary"
for diagnosis or treatment. To date, few third-party payors have agreed to
reimburse patients for genetic susceptibility tests, and we do not know if
third-party payors will, in the future, provide full reimbursement coverage for
these genetic tests. If third-party payors do not provide adequate reimbursement
coverage, then individuals may choose to directly pay for the test. If both
third-party payors and individuals are unwilling to pay for the tests, then the
number of tests we can sell will be significantly decreased, resulting in
reduced revenues and additional losses.
IF WE FAIL TO OBTAIN PATENT PROTECTION FOR OUR PRODUCTS AND PRESERVE OUR TRADE
SECRETS, THEN COMPETITORS MAY DEVELOP COMPETING PRODUCTS AND SERVICES, WHICH
WILL DECREASE OUR SALES AND MARKET SHARE
22
Our success will partly depend on our ability to obtain patent protection, in
the United States and in other countries, for our products and services. In
addition, our success will also depend upon our ability to preserve our trade
secrets and to operate without infringing upon the proprietary rights of third
parties.
We own exclusive rights in nine issued U.S. patents and have 20 U.S. patent
applications pending. We have also been granted a number of corresponding
foreign patents and have a number of foreign counterparts of our U.S patents and
patent applications pending. Our patent positions, and those of other
pharmaceutical and biotechnology companies, are generally uncertain and involve
complex legal, scientific and factual questions. Our ability to develop and
commercialize products and services depends on our ability to:
- Obtain patents;
- Obtain licenses to the proprietary rights of others;
- Prevent others from infringing on our proprietary rights; and
- Protect trade secrets.
Our pending patent applications may not result in issued patents or any issued
patents may never afford meaningful protection for our technology or products.
Further, others may develop competing products which avoid legally infringing
upon, or conflicting with, our patents. In addition, competitors may challenge
any patents issued to us, and these patents may subsequently be narrowed,
invalidated or circumvented.
We also rely on trade secrets and proprietary know-how that we seek to protect,
in part, by confidentiality agreements. The third parties we contract with may
breach these agreements, and we might not have adequate remedies for any breach.
Additionally, our competitors may discover or independently develop our trade
secrets.
THIRD PARTIES MAY OWN OR CONTROL PATENTS OR PATENT APPLICATIONS AND REQUIRE US
TO SEEK LICENSES, WHICH COULD INCREASE OUR COSTS OR PREVENT US FROM DEVELOPING
OR MARKETING OUR PRODUCTS OR SERVICES
We may not have rights under patents or patent applications which are related to
our current or proposed products. Third parties may own or control these patents
and patent applications in the United States and abroad. Therefore, in some
cases, to develop or sell any proposed products or services, with patent rights
controlled by third parties, our collaborators or we may seek, or may be
required to seek, licenses under third-party patents and patent applications. If
this occurs, we will pay license fees or royalties or both to the licensor. If
licenses are not available to us on acceptable terms, we or our collaborators
may be prohibited from developing or selling our products or services.
If third parties believe our products or services infringe upon their patents,
they could bring legal proceedings against us seeking damages or seeking to
enjoin us from testing, manufacturing or marketing our products or services. Any
litigation could result in substantial expenses to us and significant diversion
of attention by our technical and management personnel. Even if we prevail, the
time, cost and diversion of resources of patent litigation would
23
likely damage our business. If the other parties in any patent litigation
brought against us are successful, in addition to any liability for damages, we
may have to cease the infringing activity or obtain a license.
TECHNOLOGICAL CHANGES MAY CAUSE OUR PRODUCTS AND SERVICES TO BE OBSOLETE
Our competitors may develop susceptibility tests that are more effective than
our technologies or that make our technologies obsolete. Innovations in the
treatment of the diseases in which we have products or product candidates could
make our products obsolete. These innovations could prevent us from selling, and
significantly reduce or eliminate the markets for, our products.
WE HAVE COMPLETED FINANCIAL TRANSACTIONS THAT MAY REQUIRE US TO ISSUE MORE
SHARES TO EXISTING SHAREHOLDERS WHICH WILL DILUTE THE VALUE OF THE STOCK
In December 2000 and January 2001 we sold a total of 2 million shares of our
common stock in private placements for $2.50 per share and issued warrants to
purchase 600,000 shares of common stock exercisable at $3.00 per share and
264,407 shares of common stock exercisable at $3.13. Under the terms of these
private placements we are required to adjust downward the price per share in the
offering, by issuing additional shares, to match any offering price paid in
subsequent offerings during a 24-month period following completion of the
private placements. In connection with the investors' waiver of certain rights,
we recently issued a total of 1,676,258 additional shares to these same
investors, resulting in an effective purchase price to the investors of $1.36
per share and the investors surrendered their warrants for cancellation. If we
do not receive equity investment of at least $3 million from Pyxis Innovations,
Inc. or its affiliates prior to April 1, 2003, we are required, subject to the
receipt of any required stockholder approvals, to issue to the investors new
warrants to purchase an aggregate of 864,407 shares of common stock exercisable
at $1.70 per share. Of these warrants, the exercise price of warrants to
purchase 600,000 shares of common stock will be subject to adjustment downward
to equal 125% of the price per share at which we sell any shares of our common
stock (or securities convertible into common stock) prior to May 23, 2003. The
price of our common stock has been volatile and has recently been trading below
$1.00 per share. This low share price will make it very difficult to raise
additional capital at a price matching the adjusted effective purchase price of
the private placements. The remainder of the 24-month period has been waived by
the December 2000 investor while the 24-month period for the January 2001
investor expires in May 2003. Therefore, it is likely that we will need to issue
additional shares to the investors in the January 2001 offerings, if we are to
raise additional capital. This might significantly dilute the value of the
outstanding common stock.
WE MAY BE PROHIBITED FROM FULLY USING OUR NET OPERATING LOSS CARRYFORWARDS,
WHICH COULD AFFECT OUR FINANCIAL PERFORMANCE
As a result of the losses incurred since inception, we have not recorded a
federal income tax provision and have recorded a valuation allowance against all
future tax benefits. As of December 31, 2001, we had net operating loss
carryforwards of approximately $27.9 million for federal and state income tax
purposes, expiring in varying amounts through the year 2021. We also had a
research tax credit of approximately $397,000 at December 31, 2001, that expires
in varying amounts through the year 2021. Our ability to use these net operating
loss and credit carryforwards is subject to restrictions contained in the
Internal Revenue Code which provide for limitations on our utilization
24
of our net operating loss and credit carryforwards following a greater than 50%
ownership change during the prescribed testing period. We experienced a change
in ownership interest in June 1999. As a result, approximately $15.6 million of
our net operating loss carryforwards are limited in utilization to approximately
$825,000 annually. The annual limitation may result in the expiration of the
carryforwards prior to utilization. In addition, in order to realize the future
tax benefits of our net operating loss and tax credit carryforwards, we must
generate taxable income, of which there is no assurance.
WE ARE SUBJECT TO INTENSE COMPETITION FROM OTHER COMPANIES, WHICH MAY DAMAGE OUR
BUSINESS
Our industry is highly competitive. Our competitors in the United States and
abroad are numerous and include major pharmaceutical and diagnostic companies,
specialized biotechnology firms, universities and other research institutions,
including those receiving funding from the Human Genome Project. Many of our
competitors have considerably greater financial resources, research and
development staffs, facilities, technical personnel, marketing and other
resources than we do. Furthermore, many of these competitors are more
experienced than we are in discovering, commercializing and marketing products.
These greater resources may allow our competitors to discover important genes or
genetic markers before we do. If we, in conjunction with the University of
Sheffield, do not discover disease predisposing genes and commercialize these
discoveries before our competitors, then our ability to generate sales and
revenues will be reduced or eliminated, and could make our products obsolete. We
expect competition to intensify in our industry as technical advances are made
and become more widely known.
WE ARE SUBJECT TO GOVERNMENT REGULATION WHICH MAY SIGNIFICANTLY INCREASE OUR
COSTS AND DELAY INTRODUCTION OF FUTURE PRODUCTS
The sale, performance or analysis of our genetic tests do not currently require
FDA or other federal regulatory authority approval. Changes in existing
regulations could require advance regulatory approval of genetic susceptibility
tests, resulting in a substantial curtailment or even prohibition of our
activities without regulatory approval. If our genetic tests ever require
regulatory approval, on either a state or federal level, then the costs of
introduction will increase and marketing and sales of products may be
significantly delayed.
WE MAY BE SUBJECT TO PRODUCT LIABILITY CLAIMS THAT ARE COSTLY TO DEFEND AND THAT
COULD LIMIT OUR ABILITY TO USE SOME TECHNOLOGIES IN THE FUTURE
The design, development, manufacture and use of our genetic susceptibility tests
involve an inherent risk of product liability claims and associated adverse
publicity. Producers of medical products face substantial liability for damages
in the event of product failure or allegations that the product caused harm. We
currently maintain product liability insurance, but it is expensive and
difficult to obtain, may not be available in the future on economically
acceptable terms and may not be adequate to fully protect us against all claims.
We may become subject to product liability claims that, even if they are without
merit, could result in significant legal defense costs. We could be held liable
for damages in excess of the limits of our insurance coverage, and any claim or
resulting product recall could create significant adverse publicity.
25
ETHICAL, LEGAL AND SOCIAL ISSUES RELATED TO GENETIC TESTING MAY REDUCE DEMAND
FOR OUR PRODUCTS
Genetic testing has raised issues regarding the appropriate utilization and the
confidentiality of information provided by genetic testing. Genetic tests for
assessing a person's likelihood of developing a chronic disease have focused
public attention on the need to protect the privacy of genetic assessment
medical information. For example, concerns have been expressed that insurance
carriers and employers may use these tests to discriminate on the basis of
genetic information, resulting in barriers to the acceptance of genetic tests by
consumers. This could lead to governmental authorities prohibiting genetic
testing or calling for limits on or regulating the use of genetic testing,
particularly for diseases for which there is no known cure. Any of these
scenarios would decrease demand for our products and result in substantial
losses.
OUR DEPENDENCE ON KEY EXECUTIVES AND SCIENTISTS COULD ADVERSELY IMPACT THE
DEVELOPMENT AND MANAGEMENT OF OUR BUSINESS
Our success substantially depends on the ability, experience and performance of
our senior management and other key personnel. If we lose one or more of the
members of our senior management or other key employees, it could damage our
development programs and our business. In addition, our success depends on our
ability to continue to hire, train, retain and motivate skilled managerial and
scientific personnel. The pool of personnel with the skill that we require is
limited. Competition to hire from this limited pool is intense. We compete with
numerous pharmaceutical and health care companies, as well as universities and
nonprofit research organizations in the highly competitive Boston, Massachusetts
business area. Loss of the services of Dr. Philip R. Reilly, our Chairman and
CEO, Dr. Kenneth Kornman, our President, or Dr. Paul M. Martha, our Chief
Medical Officer, could delay our research and development programs and damage
our business. We have entered into employment agreements with three to five year
terms with Drs. Reilly, Kornman and Martha. Any of these employees can terminate
his employment upon 30 days notice. We do not maintain key man life insurance on
any of our personnel.
BECAUSE OUR PRINCIPAL SHAREHOLDERS, OFFICERS AND DIRECTORS CONTROL A LARGE
PERCENTAGE OF OUR VOTING POWER, OTHER STOCKHOLDERS' VOTING POWER MAY BE LIMITED
As of February 28, 2002, our directors, executive officers and certain of their
affiliates beneficially owned approximately 18% of our outstanding common stock.
Accordingly, these shareholders, individually and as a group, may be able to
influence the outcome of shareholder votes, including votes concerning the
election of directors, the adoption or amendment of provisions in our
Certificate of Incorporation or By-Laws and the approval of certain mergers and
other significant corporate transactions, including a sale of substantially all
of our assets. These shareholders may make decisions that are adverse to other
shareholders' or warrantholders' interests. This ownership concentration may
also adversely affect the market price of our common stock.
26
WE DO NOT EXPECT TO PAY DIVIDENDS FOR THE FORESEEABLE FUTURE AND YOU SHOULD NOT
EXPECT TO RECEIVE ANY FUNDS WITHOUT SELLING YOUR SHARES OF COMMON STOCK, WHICH
YOU MAY ONLY BE ABLE TO DO AT A LOSS
We have never declared or paid any cash dividends on our capital stock. We
currently intend to retain any earnings for use in the operation and expansion
of our business and do not anticipate paying any cash dividends on our common
stock in the foreseeable future. Therefore, you should not expect to receive any
funds without selling your shares, which you may only be able to do at a loss.
IF WE DEFAULT ON OUR OBLIGATIONS UNDER PROMISSORY NOTES ISSUED TO PYXIS
INNOVATIONS, INC. WE MAY BE REQUIRED TO REPAY TO PYXIS THE FULL PRINCIPAL AMOUNT
OF THE NOTES, TOGETHER WITH INTEREST, AND WE MAY INCUR ADDITIONAL FINANCIAL
OBLIGATIONS TO PYXIS.
Under the terms of the promissory note that we issued to Pyxis Innovations, Inc.
in October 2002 and those that we may issue to Pyxis in the future, Pyxis may
declare the full principal amount of the note, together with all accrued but
unpaid interest on the note and other amounts that we owe to Pyxis on the date
of acceleration, to be immediately due and payable in cash upon the occurrence
of an event of default. As of November 1, 2002, there was $500,000 in principal
amount outstanding under the note, which is due on December 31, 2003. Interest
on the note accrues at 15% annually and is payable on December 31, 2003. Any one
of the following events will constitute an event of default under the note:
- our default in the timely payment to Pyxis of the principal amount of,
or interest on, the notes;
- our default in the timely repayment of indebtedness (including our 15%
term promissory notes due August 2003), or failure to perform any
obligation, to any other party;
- any representation or warranty that we made to Pyxis proves to have
been incorrect when we made it under the note or the agreements under
which the note was issued;
- our failure to observe or perform any covenant or agreement under, or
our breach of, the note or the agreements pursuant to which the note
was issued
- any bankruptcy, insolvency or reorganization proceedings involving us
or any of our subsidiaries; or
- any change of control.
OUR FORMER USE OF ARTHUR ANDERSEN LLP AS OUR INDEPENDENT AUDITORS MAY POSE RISK
TO US AND WILL LIMIT YOUR ABILITY TO SEEK POTENTIAL RECOVERIES FROM THEM RELATED
TO THEIR WORK.
On June 15, 2002, Arthur Andersen LLP, our former independent auditor, was
convicted on a federal obstruction of justice charge. Some investors, including
institutional investors, may choose not to invest in or hold securities of a
company whose financial statements were audited by Arthur
27
Andersen, which may serve to, among other things, depress the price of our
common stock. In July and August 2002, our board of directors decided to no
longer engage Arthur Andersen and engaged Grant Thornton LLP to serve as our
independent auditors.
SEC rules require us to present our audited financial statements in various SEC
filings, along with Arthur Andersen's consent to our inclusion of its audit
report in those filings. The SEC recently has provided regulatory relief
designed to allow companies that file reports with the SEC to dispense with the
requirement to file a consent of Arthur Andersen in certain circumstances.
Notwithstanding the SEC's regulatory relief, the inability of Arthur Andersen to
provide its consent or to provide assurance services to us could negatively
affect our ability to, among other things, access the public capital markets.
Any delay or inability to access the public markets as a result of this
situation could have a material adverse impact on our business. Also, an
investor's ability to seek potential recoveries from Arthur Andersen related to
any claims that an investor may assert as a result of the work performed by
Arthur Andersen will be limited significantly in the absence of a consent and
may be further limited by the diminished amount of assets of Arthur Andersen
that are or may in the future be available for claims.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
As of September 30, 2002 the only financial instruments we carried were cash and
cash equivalents. We believe the market risk arising from holding these
financial instruments is not material.
Some of our sales occur outside the United States and are transacted in foreign
currencies. Accordingly, we are subject to exposure from adverse movements in
foreign currency exchange rates. At this time we do not believe this risk is
material and we do not currently use derivative financial instruments to manage
foreign currency fluctuation risk. However, if foreign sales increase and the
risk of foreign currency exchange rate fluctuation increases, we may in the
future consider utilizing derivative instruments to mitigate these risks.
ITEM 4. CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
Our principal executive officer and principal financial officer, after
evaluating the effectiveness of our disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14(c) and 15d-14(c)) on November 6, 2002 have
concluded that, based on such evaluation, our disclosure controls and procedures
were adequate and effective to ensure that material information relating to us,
including our consolidated subsidiaries, was made known to them by others within
those entities, particularly during the period in which this Quarterly Report on
Form 10-Q was being prepared.
CHANGES IN INTERNAL CONTROLS
There were no significant changes in our internal controls or in other factors
that could significantly affect these controls subsequent to the date of their
evaluation, nor were there any significant deficiencies or material
28
weaknesses in our internal controls. Accordingly, no corrective actions were
required or undertaken.
PART II
OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company is not a party to, nor is its property the subject of, any pending
legal proceeding.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
On August 9, 2002 we issued term promissory notes with an original aggregate
principal amount of $525,000 to purchasers including members of our Board of
Directors and our Chief Executive Officer. These notes mature in August 2003 and
accrue interest at a rate of 15%. The purchasers of the promissory notes also
received warrants to purchase one share of our common stock at an exercise price
of $2.50 for every dollar invested in the promissory notes. In total, warrants
to purchase 525,000 shares of our common stock were issued. These warrants
expire in ten years. This offering was exempt from registration under the
Securities Act of 1933, as amended pursuant to Section 4(2) thereof and Rule 506
of Regulation D promulgated thereunder. In connection with the offering, we also
entered into a Registration Rights Agreement, dated as of August 9, 2002, with
the purchasers. Pursuant to the Registration Rights Agreement, we agreed to file
a registration statement with the Securities and Exchange Commission prior to
August 9, 2003 covering the resale by the purchasers of the shares of our common
stock issuable to the purchasers upon the exercise of the warrants.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
ITEM 5. OTHER INFORMATION
None
c) Not applicable
d) Not applicable
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
On July 3, 2002 the Company filed a report on Form 8-K to disclose the dismissal
of Arthur Andersen LLP as the Company's independent public accountants.
29
On August 5, 2002 the Company filed a report on Form 8-K to disclose the
engagement of Grant Thornton LLP as the Company's independent public accountants
for the year ending December 31, 2002.
On August 5, 2002 the Company filed a report on Form 8-K to disclose an
announcement of the securing of interim financing to support operations into
October 2002.
On September 3, 2002 the Company filed a report on Form 8-K to disclose the
announcement of the signing of a letter of intent with Pyxis Innovations, Inc.
EXHIBITS:
Exhibit 10.1: Form of Note and Warrant Subscription Agreement, by and between
the Registrant and each Investor.
Exhibit 10.2: Form of Promissory Note, dated as of August 9, 2002, issued to
each Investor.
Exhibit 10.3: Form of Common Stock Purchase Warrant, dated as of August 9, 2002,
issued to each Investor.
Exhibit 10.4: Registration Rights Agreement, dated as of August 9, 2002, by and
among the Registrant and the Investors.
30
SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
INTERLEUKIN GENETICS, INC.
Date: November 6, 2002 By: /s/ Philip R. Reilly
---------------------------------
Philip R. Reilly
Chairman of the Board and
Chief Executive Officer
(Principal Executive Officer)
By: /s/ Fenel M. Eloi
---------------------------------
Fenel M. Eloi
Chief Financial Officer,
Secretary & Treasurer
(Principal Financial and
Accounting Officer)
31
CERTIFICATIONS PURSUANT TO
SECTION 302 OF
THE SARBANES-OXLEY ACT OF 2002
CERTIFICATION
- -------------
I, Philip R. Reilly, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Interleukin
Genetics, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our evaluation
as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit committee
of registrant's board of directors (or persons performing the equivalent
function):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
32
controls subsequent to the date of our most recent evaluation, including any
corrective actions with regard to significant deficiencies and material
weaknesses.
Date: November 6, 2002
/s/ PHILIP R. REILLY
PHILIP R. REILLY
CHIEF EXECUTIVE OFFICER
CERTIFICATION
- -------------
I, Fenel M. Eloi, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Interleukin
Genetics, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our evaluation
as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrant's auditors and the audit committee
of registrant's board of directors (or persons performing the equivalent
function):
33
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: November 6, 2002
/s/ FENEL M. ELOI
FENEL M. ELOI
CHIEF FINANCIAL OFFICER
34