Back to GetFilings.com
1
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------
FORM 10-K
------------------------
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2000
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER: 0-22873
------------------------
HYSEQ, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
NEVADA 36-3855489
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
670 ALMANOR AVENUE, SUNNYVALE, CA 94085
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: 408-524-8100
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE EXCHANGE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE EXCHANGE ACT:
COMMON STOCK, $.001
------------------------
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
The aggregate market value of the Common Stock held by non-affiliates of
the Registrant on March 1, 2001 was $142,940,000, based on the last sale price
of the Common Stock as reported by the Nasdaq Stock Market.
As of March 1, 2001, the Registrant had 13,757,882 shares of common stock
outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's Proxy Statement, which will be filed with the
Commission pursuant to Section 14A in connection with the 2001 meeting of
stockholders, are incorporated by reference into Part III of this Form 10-K.
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
2
PART I
ITEM 1. BUSINESS
This Annual Report on Form 10-K contains historical information as well as
forward-looking statements that involve risks and uncertainty. Our actual
results could differ significantly from discussions and forward-looking
statements in this document. Factors that could cause or contribute to such
differences include but are not limited to those discussed in this section under
the caption "Risk Factors," as well as those under "Item 7. Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
those discussed elsewhere in this Annual Report on Form 10-K.
COMPANY OVERVIEW
We are engaged in research and development of novel biopharmaceutical
products from our collection of proprietary genes discovered using our
high-throughput screening-by-hybridization platform . We believe our
screening-by-hybridization platform, which is related to our proprietary
sequencing-by-hybridization (SBH) technology, gives us a significant advantage
in discovering novel, rarely-expressed genes. We believe we possess one of the
most important proprietary databases of full-length human gene sequences. To
date, our activities have focused primarily on full-length gene sequencing,
patenting, bioinformatics and early stage research activities to prioritize our
therapeutic protein candidates. As of March 1, 2001, we had filed patent
applications on more than 5,600 full-length gene sequences. We are currently
advancing two molecules, IL-1Hy1 with potential applications for inflammatory
diseases and CD39L4 with potential applications for heart disease, into
development in order to generate data required to file an Investigational New
Drug (IND) application with the Food and Drug Administration (FDA). Meanwhile,
we are expanding and accelerating our research activities to elucidate the role
of other novel genes in our proprietary database. Our database includes genes
which encode chemokines, growth factors, stem cell factors, interferons,
integrins, hormones, receptors and other potential protein therapeutics or drug
targets.
SCIENTIFIC AND INDUSTRY BACKGROUND
Genes are the hereditary units that control the structure, health and
function of all organisms. The study of genes and their functions has led to the
development of products and services for diverse markets, ranging from health
care to agriculture. Genomics, the study of all genetic information of
organisms, is a growing field that is expected to lead to the development of
additional gene-based therapeutics. The large market potential for the
gene-based products has led to a worldwide effort to discover and sequence the
human genome in searching for new drugs and treatments for unmet medical needs.
The entire genetic content of each organism, known as its genome, is
encoded in deoxyribonucleic acid (DNA). DNA, which is found in cells, is a
molecule comprising two single strands entwined in the form of a double helix.
Various combinations of four chemical building blocks or "bases" of DNA, adenine
(A), thymine (T), cytosine (C) and guanine (G), are linked together in series to
form each DNA strand. The bases of one DNA strand bind to the bases of the other
strand in a specific fashion to form base pairs: A pairs with T and G pairs with
C. In humans, there are approximately six billion base pairs organized into 23
pairs of DNA structures called chromosomes.
Scientists believe that each gene has at least two basic regions, a
structural region and a regulatory region. The structural region of a gene
encodes the specific protein. The process by which the structural region of a
gene directs the production of a protein is known as gene expression. In that
process, the sequence of bases in a gene is copied into a related molecule
called messenger ribonucleic acid (mRNA). The mRNA instructs the cell to combine
amino acids together in a particular order to form a protein. The regulatory
region of a gene is responsible for determining when, and how much of a
resultant protein is produced in specific cells of the body.
Because genes encode proteins, which govern functions of the human body,
the sequences of genes and their levels of expression determine when, where and
how well essential functions are performed. The addition, deletion or
substitution of one or more bases in a gene, known as a mutation, can alter the
resultant protein's
1
3
structure and/or level of expression and result in a disease. Most diseases are
believed to be polygenic, meaning that multiple genes interact to cause the
disease. In developing a drug for a polygenic disease, the most effective target
may be best selected when all genes which interact to cause or affect the
disease are known.
STRATEGY
Our goal is to build a fully-integrated biopharmaceutical company. Our
execution strategy will involve a combination of carefully-staged internal
infrastructure growth, strategic relationships to share research and development
efforts and marketing opportunities with other biotechnology and pharmaceutical
companies, and outsourcing, on a fee-for-service basis, to accelerate and expand
our drug discovery and development efforts.
The first part of our strategy involves internal infrastructure growth to
expand our staff and bring additional expertise into the company. Our early
efforts have been focused on gene discovery, which requires a research staff of
molecular biologists and bioinformatics personnel. As we begin to characterize
the genes in our database, we are expanding our research and development staff
to include additional expertise in basic biology, physiology, cell biology and
protein sciences. Further progress into development will require additional
expertise in project management and product development including pharmacology,
toxicology, assay development, formulation and process development, medical and
regulatory affairs, quality control and quality assurance and an expanded
capability in facilities and engineering. Expertise in these areas will be
required to ensure that we meet FDA and foreign regulatory requirements for
conducting clinical trials.
Internal infrastructure growth will also involve building out additional
research and development space. We have leased an additional 59,000 square feet
of space in Sunnyvale, California. Our plan is to build out approximately 34,000
square feet of this space in the initial phase of our planned facilities
expansion to support new research and development laboratories and offices. This
laboratory space is expected to bolster our preclinical development
capabilities, including preliminary preclinical safety and efficacy studies in
rodents, functional cell biology assays, cell based functional screening
efforts, protein production (in multiple systems), protein characterization and
analytical assay development. This additional lab space, and related staffing,
is expected to expand our ability to identify, clone and express, purify and
characterize our preclinical candidates. To complete the initial phase of our
build out as currently planned, we intend to seek necessary additional financing
before the end of 2001. The remaining approximately 25,000 square feet of space,
located in an adjacent building, may be used for further expansion of
preclinical efforts or to build a pilot manufacturing plant capable of producing
protein therapeutics according to current good manufacturing practices (cGMP)
for testing in Phase I and Phase II clinical trials. Planning for the second
phase of the build out is underway and will be dictated by our needs over the
next year.
The second part of our strategy involves strategic relationships to share
research and development efforts and marketing opportunities with other
biotechnology and pharmaceutical companies. We believe this approach will
greatly enhance our chances to move a number of drug candidates into clinical
trials over the next several years. As we have shifted our business focus from
gene discovery to research and development of biopharmaceutical candidates, we
did not enter into any additional gene discovery collaborations during 2000. We
are now focusing instead on new corporate relationships with other biotechnology
and pharmaceutical companies to share costs and expertise of identifying and
developing product candidates. This focus also includes plans to collaborate
with strategic partners with expertise to develop antibodies and small molecules
from our proprietary targets.
The third part of our strategy involves outsourcing, on a fee-for-service
basis, to accelerate and expand our drug discovery and development efforts.
Initially, we intend to use outsourcing while we expand our in-house
capabilities, although we expect to continue to use outsourcing when there are
opportunities to accelerate and expand our drug discovery and development
efforts. We currently use contract research organizations and university
collaborators to supplement our ability to conduct in vitro and in vivo testing
of our therapeutic protein candidates. We also intend to use contract research
organizations to conduct good
2
4
laboratory practices (GLP) toxicology and other studies required for filing an
IND, for the production of any cGMP drug and for conducting clinical trials on
our lead therapeutic protein candidates.
RESEARCH AND DEVELOPMENT
We have discovered a large collection of novel genes with our
screening-by-hybridization platform. See "-- SBH Technology and Applications."
Since 1997 we have used our screening-by-hybridization platform to discover
genes expressed in a large number of tissue-specific complementary DNA (cDNA)
libraries. Our bioinformatics group conducts high-throughput analysis using
sequence analysis and protein structure modeling techniques to identify
candidate genes for biological screening. In general, candidates are grouped
into the broad categories of potential protein therapeutics and small molecule
or antibody targets. We believe genes with sequence characteristics and motifs
similar to those found in known secreted proteins are more likely to be useful
as protein therapeutics and those with characteristics of membrane or
intracellular proteins are more likely to serve as targets for antibodies and
small molecules. Our focus has been on development of molecules that we believe
will result in protein therapeutics. We plan to pursue targets for antibodies
and small molecules through strategic relationships.
The process of selecting and evaluating drug candidates involves a broad
range of skills and a highly-trained scientific staff. Following initial
candidate identification by our bioinformatics group, full-length genes are
obtained, expressed, and screened for biological activity by our cloning and
cell screening groups. Molecules showing biological activity, and molecules with
sequence or structural homology to known proteins, are further evaluated by our
functional genomics group. Our protein production and purification group is
responsible for providing larger quantities of selected proteins for further in
vitro and in vivo testing. These tests are conducted by our functional genomics
group, working in conjunction with contract research organizations and
university collaborators. Throughout this process, information is provided to
our legal group to pursue patent protection for our candidates. To expand these
efforts, we have leased additional space and planned the initial phase of
building out additional laboratory space, including the establishment of our own
animal facility, and staffing for a preclinical safety and efficacy group. To
complete the initial phase of our build out as currently planned, we intend to
seek additional financing before the end of 2001. Following initial safety and
pharmacokinetic analysis, the preclinical safety and efficacy group will be
responsible for working with contract research organizations to conduct GLP
toxicology and other studies required for filing an IND. Until adequate staff
and facilities are established in-house, we plan to use contract organizations
for the production of cGMP drug and for conducting clinical trials on our lead
therapeutic protein candidates.
The chart below indicates the stage of development for product candidates
in our discovery pipeline as of December 31, 2000, which have been publicly
discussed.
CANDIDATE POTENTIAL APPLICATIONS DEVELOPMENT STAGE
- --------- ---------------------- -----------------
IL-1Hy1 Inflammatory Diseases Preclinical
CD39L4 Heart Disease Preclinical
IL-1Hy2 Inflammatory Diseases Research
CD39L2 Heart Disease Research
BPIL-196 Infectious Diseases Research
BPIL-232 Infectious Diseases Research
BPIL-325 Infectious Diseases Research
EGFL-6 Oncology Research
IL-1Hy1: Product Candidate for Treating Inflammatory Disease
The IL-1Hy1 protein may have therapeutic applications in the treatment of
inflammatory disease. Our scientists have published results for IL-1Hy1 in
Biochemical & Biophysical Research Communications. IL-1Hy1 was found to be
expressed in the skin, spleen and other tissues consistent with its potential
role as a mediator of inflammatory processes. In addition, our research
demonstrated that IL-1Hy1 can be activated by
3
5
signals that induce inflammation and immune responses. We are currently focusing
research on the protein's ability to disrupt the process of inflammation in
allergic diseases.
CD39L4: Product Candidate for Preventing Blood Clotting
We believe that our CD39L4 anti-clotting product candidate may help prevent
or treat blood vessel blockage that can cause heart attacks and strokes. Our
scientists have published results for CD39L4 in The Journal of Biological
Chemistry. When blood vessels are damaged, a substance called adenosine
diphosphate (ADP) is released at the site of injury to initiate blood clotting
for repair. In cardiovascular disease, blood clotting can be excessive and
result in blockage of blood flow. By decreasing the levels of ADP, abnormal
clotting and blockage of blood flow may be reduced or prevented. CD39L4 breaks
down ADP, as well as other nucleotide diphosphates, but does not significantly
affect a related substance, adenosine triphosphate (ATP) that regulates other
physiological processes. We believe this specificity, and the protein's
solubility, makes CD39L4 a promising therapeutic candidate.
None of our therapeutic protein product candidates has progressed beyond
preclinical testing. Accordingly, the results of testing to date may not be
indicative of results that will be obtained in further preclinical studies or in
clinical trials. Human clinical results could be different from our expectations
following our preclinical studies. Consequently, there is no assurance that the
results in our preclinical testing are predictive of the results that we will
see in our clinical trials with humans. As further results of tests are
received, we may abandon or reduce our efforts regarding particular projects.
Additionally, there can be no assurance that clinical trials as to any
particular product candidate, if commenced, will be successful, that the
proposed disease indication will prove true, or that any product can be
successfully commercialized. See "Risk Factors -- Development of Our Products
Will Take Years; Our Products Will Require Approval Before They Can Be Sold" and
"Risk Factors -- The Success of Our Potential Products in Preclinical Studies
Does Not Guarantee that these Results Will Be Replicated in Humans."
INTELLECTUAL PROPERTY
We seek patent protection on isolated partial and full-length gene
sequences, as well as their resultant proteins. As of March 1, 2001, we had
filed patent applications on more than 5,600 full-length gene sequences and
their corresponding proteins. We have also filed patent applications on more
than 830,000 partial gene sequences. See "-- Patents and Trade Secrets" and
"Risk Factors -- Dependence upon Proprietary Rights; Risks of Infringement."
We hold ten United States patents with claims covering the methods,
compositions, apparatus and applications relating to SBH technology. We have
filed several additional patent applications covering improvements to and new
applications of the SBH technology. We are currently in litigation with
Affymetrix alleging infringement by Affymetrix of five of our SBH technology
patents. Affymetrix has alleged infringement by us of three of their patents.
See "Item 3. Legal Proceedings."
RESEARCH AND DEVELOPMENT COLLABORATIONS
As we have shifted our business focus from gene discovery to research and
development of biopharmaceutical candidates, we did not enter into any
additional gene discovery collaborations during 2000. We are now focusing
instead on strategic relationships to share research and development efforts and
marketing opportunities with other biotechnology and pharmaceutical companies.
Our current collaborations include gene discovery collaborations with BASF Plant
Sciences GmbH (BASF), Chiron Corporation (Chiron) and Kirin Brewery Co, Ltd. of
Japan (Kirin), and a collaboration with the University of California, San
Francisco (UCSF) to conduct research on genes that may have important roles in
the development of cardiovascular and related diseases. We also have a
collaboration with the Applied Biosystems Group of Applera Corporation (Applied
Biosystems) to commercialize one application of our SBH technology.
4
6
Chiron
In May 1997, we entered into a collaboration with Chiron in which we used
our screening-by-hybridization platform to target solid tumor cancer
therapeutics, diagnostic molecules and vaccines. The collaboration had an
initial term of three years ending in May 2000, and has been extended by Chiron
for an additional two-year period ending in May 2002. At its option, Chiron may
extend the collaboration for one more two-year period before the current
extension ends in May 2002. Our gene sequencing obligations under the original
term of the agreement are substantially completed. Chiron has the exclusive
right to commercialize any solid tumor products resulting from the
collaboration. We will receive royalties on any such products. In addition to
research funding payments, in 1997 Chiron made an equity investment in us of
$7.5 million in conjunction with the collaboration.
Applied Biosystems
In May 1997, we entered into an agreement with Applied Biosystems to
commercialize HyChip products. Pursuant to this agreement, we were required to
commit $5.0 million to further development of the chip component of the HyChip
system, which we satisfied in 1998. Applied Biosystems must also commit certain
funds for development of the overall system. The collaboration has an initial
term of five years and will be extended automatically thereafter unless the
parties mutually agree to termination. The agreement required us to design,
develop and manufacture the HyChip chip component, while Applied Biosystems is
responsible for the design, development and manufacture of the system that
processes and analyzes data from the HyChip chip, as well as marketing and
customer support. We are highly dependent upon the performance of Applied
Biosystems for commercialization of HyChip products. We do not directly control
the amount or timing of resources devoted by Applied Biosystems to development
of the overall HyChip system. The development of the HyChip system is,
therefore, not entirely in our control. In 1997, Applera Corporation made an
equity investment in us of $10.0 million in conjunction with the collaboration.
University of California, San Francisco
In February 1998, we entered into an agreement with UCSF to conduct
research on genes that may have important roles in the development of
cardiovascular and related diseases. Under the agreement, researchers at UCSF
are collecting DNA samples from up to 20,000 genetically diverse individuals. We
can use these DNA samples to identify genetic traits related to heart disease
and hypertension.
Kirin
In October 1998, we entered into a collaboration with Kirin in which we use
our screening-by-hybridization platform to target potential pharmaceutical
candidates involved in cell growth regulation from specific cell lines provided
by Kirin. During the fourth quarter of 2000, we extended the term of our
collaboration with Kirin through March 2001 in order to complete additional
research. We retain rights in North America to develop pharmaceutical products
resulting from the collaboration, subject to milestone and royalty payments to
Kirin. Kirin has equivalent rights in Asia and Oceania, and we share rights
equally in Europe and in the rest of the world. Our gene sequencing obligations
under the original term of the agreement are substantially complete.
BASF
In December 1999, we entered into a collaboration with American Cyanamid
Company in which we use our screening-by-hybridization platform to target
potential agricultural products. During 2000, BASF Aktiengesellschaft acquired
the crop protection business of American Cyanamid Company and subsequently
assigned our collaboration with American Cyanamid to BASF Plant Sciences GmbH.
The collaboration provides for funding of $60 million over its initial term of
three and one half years. The collaboration can be extended by mutual agreement,
for up to four additional one-year terms. BASF has the exclusive right to
commercialize any agricultural products resulting from the collaboration. We
will receive royalties on any
5
7
such products. The agreement requires us to generate data at a specified level
per year which, if not met, could result in our breach of the agreement.
SBH TECHNOLOGY AND APPLICATIONS
Our proprietary SBH technology generally involves using DNA probes of known
sequence that are hybridized with DNA samples. Different probe sets can be used
for different applications. We use a complete set of probes of a given length,
or a subset of probes that are selected based on statistical properties, to
assemble an unknown sequence of a DNA sample. DNA analysis applications using
complete sets or subsets of probes include de novo sequencing, resequencing,
genotyping, mutation discovery and polymorphism detection. In addition, we have
a proprietary screening-by-hybridization technology in which we use a small set
of probes to screen for and discover genes in a large number of DNA samples.
Gene Discovery using High-Throughput Screening
Using our high-throughput screening-by-hybridization platform, we have
screened large numbers of DNA samples for our internal gene discovery and in our
gene discovery collaborations. Our screening-by-hybridization platform is
related to our SBH technology but uses a small set of probes to group or cluster
DNA samples derived from either DNA or cDNA libraries. As this small set of
probes is applied to large numbers of DNA samples, certain probes in the small
set hybridize to the DNA samples and generate a pattern (called a "signature").
We use these signatures to identify genes, and to group or cluster DNA samples
with similar signatures.
DNA Analysis Applications using SBH
While our screening-by-hybridization platform uses a small set of probes,
in DNA analysis applications of our SBH technology we use a complete set of
probes of a given length, or a subset of probes that are selected based on
statistical properties. The complete set or subset of probes of known sequences
is combined with a DNA sample for hybridization. Following the hybridization
process, the sequences of hybridized probes can be used to assemble or determine
the sequence of the DNA sample. DNA analysis applications of our SBH technology
using complete sets or subsets of probes include de novo sequencing,
resequencing, genotyping, mutation discovery and polymorphism detection. Our
HyChip system is an example of a DNA analysis application of our SBH technology.
Licensed Technology
In 1994, we acquired an exclusive license from Arch Development
Corporation, a not-for-profit corporation affiliated with the University of
Chicago that manages The Argonne National Laboratories (Argonne), to further
develop and use certain SBH improvements developed by one of our chief
scientists while he was at Argonne. In July 1997, we began paying minimum
royalties as required under the exclusive license.
PATENTS AND TRADE SECRETS
The U.S. Patent and Trademark Office (USPTO) and patent authorities outside
the United States issue patents for inventions based on genes that have been
isolated from their natural state (through a purifying step that separates the
gene from other molecules naturally associated with it), but only if the
invention meets all the criteria for a patent. Each country has its own
standards for granting a patent. In the United States, to be eligible for patent
protection, an invention must at least be novel and useful and the patent
application must contain sufficient detail to allow one skilled in the art or
technology to reproduce the invention. We apply for patent applications on both
partial and full-length gene sequences. As of March 1, 2001, we had filed patent
applications on more than 5,600 full-length gene sequences and their
corresponding proteins. Fewer than 5,000 applications are pending because some
of our patent applications include many gene sequences in one application. These
applications may or may not result in the issuance of patents. In January 2001,
the USPTO issued final revised guidelines on the standard of utility required
for inventions, including gene-based
6
8
inventions. The revised guidelines state that a patent application for an
invention must disclose a well-established utility or a specific, substantial
and credible utility for the isolated and purified gene. There can be no
assurance that our disclosures in these applications are sufficient to meet the
statutory requirements for patentability in all cases. We cannot assure you that
any of our currently pending or future applications will issue as patents, or
that any patent issued to us will not be challenged, invalidated, circumvented
or held unenforceable by way of an interference proceeding or litigation.
We have also filed United States patent applications on more than 830,000
partial human gene sequences. There can be no assurance that the disclosures in
these applications are sufficient to meet the statutory requirements for
patentability. Where only a partial sequence is disclosed, the USPTO may issue
patents of a very limited scope that will not cover a full-length gene sequence
that includes the partial sequence. Therefore, there is a significant risk that
the USPTO will not issue patents based on patent disclosures limited to partial
gene sequences or will issue patents of a very limited scope. The commercial
protection provided by any patents issued on the basis of partial gene sequences
is uncertain.
Other companies or institutions may have filed patent applications, or may
file patent applications in the future, which attempt to patent genes similar to
or the same as those covered in our patent applications, including applications
based on our potential products. The USPTO would decide the priority of
competing patent claims in an interference proceeding. Any patent application
filed by a third party may have priority over a patent application we filed, in
which event such third party may require us to stop pursuing a potential
product, or negotiate a royalty arrangement to pursue and commercialize the
potential product.
Issued patents may not provide freedom to operate with respect to our
potential products because certain uses of our potential products may give rise
to claims that such uses infringe the patents of others. This risk will increase
as the biotechnology industry expands and as other companies obtain more patents
and attempt to discover the utility and function of all known genes. Other
persons could bring legal actions against us to claim damages or to stop our
manufacturing and marketing of the affected products. If any of these actions
are successful, in addition to any potential liability for past damages, these
persons may require us to obtain a license in order to continue to manufacture
or market the affected products. We believe that there will continue to be
significant litigation in our industry regarding patent and other intellectual
property rights. We are currently involved in patent litigation with Affymetrix.
See "Item 3. Legal Proceedings." If we become involved in additional patent
litigation related to our technology or potential products, it could consume a
substantial portion of our resources.
We pursue patent protection for products and processes where appropriate
and we also rely on trade secrets, know-how and continuing technological
advancement to develop and maintain our competitive position. Our policy is to
have each employee enter into an agreement that contains provisions prohibiting
the disclosure of confidential information to anyone outside the company.
Research and development contracts and relationships between us and our
scientific consultants provide access to aspects of our know-how that is
protected generally under confidentiality agreements with the parties involved.
There can be no assurance, however, that these confidentiality agreements will
be honored or that we can effectively protect our rights to our unpatented trade
secrets. Moreover, there can be no assurance that others will not independently
develop substantially equivalent proprietary information and techniques or
otherwise gain access to our trade secrets.
COMPETITION
Our strategy as a biopharmaceutical company is to define and patent human
genes that are most likely to be involved in a disease condition and to focus on
identifying product candidates from the proteins produced by these genes. There
are a finite number of genes in the human genome, virtually all of which will
soon be identified. Other active companies include major pharmaceutical and
biotechnology firms, not-for-profit entities and United States and foreign
government-financed programs, many of which have substantially greater research
and product development capabilities and financial, scientific, marketing and
human resources than we do. As a result, they may succeed in identifying genes
and determining their functions or developing products earlier than we or our
current or future collaboration partners do. They also may obtain patents and
regulatory approvals for such products more rapidly than we or our current or
future collaboration
7
9
partners, or develop products that are more effective than those proposed to be
developed by us or our collaboration partners. Further, any potential products
based on genes we identify ultimately will face competition from other companies
developing gene-based products as well as from companies developing other forms
of treatment for diseases which may be caused by, or related to, the genes we
identify. There can be no assurance that research and development by others will
not render the products which we may develop obsolete or uneconomical or result
in treatments, cures or diagnostics superior to any therapy or diagnostic
developed by us or that any therapy we develop will be preferred to any existing
or newly developed technologies. Certain of our collaboration partners may now
be, or could become, competitors.
Competition in the area of DNA analysis tools is intense and expected to
increase. Technologies in this area are new and rapidly evolving. Applications
of our SBH technology compete primarily with Affymetrix and Applied Biosystems.
See "Item 3. Legal Proceedings," regarding our litigation with Affymetrix.
Although we are collaborating with Applied Biosystems to develop an application
of our SBH technology, Applied Biosystems presently markets gel sequencers, a
well-established sequencing technology, which compete with applications of our
SBH technology. Other companies also are developing or have developed DNA
analysis tools that may compete with applications of our SBH technology,
including Aclara Biosciences, Inc., Agilent Technologies, Inc., Corning, Inc.,
CuraGen, Inc., IBM, Illumina, Inc., Molecular Dynamics, Motorola Inc., Nanogen,
Inc., Sequenome, Inc. and Synteni (Incyte). Many of these companies have
significantly greater research and development, marketing and financial
resources than we do, and therefore represent significant competition.
GOVERNMENT REGULATION
Regulation by governmental authorities in the United States and most
foreign countries will be a significant factor in manufacturing and marketing
our potential products and in our ongoing research and product development
activities. Virtually all of our products and those of our partners, such as
Chiron and Kirin, will require regulatory approval by governmental agencies
prior to commercialization. In particular, human therapeutic products are
subject to rigorous preclinical and clinical testing and other approval
requirements by the FDA and comparable agencies in foreign countries. The time
required for completing such testing and obtaining such approvals is uncertain.
Unexpected biological activities, some of which may result in safety issues, may
arise during preclinical evaluation. Such observations could delay or alter the
course of a development program or ultimately result in the termination of a
program. Any delay in clinical testing may also delay product development. In
addition, delays or rejections may be encountered based on changes in FDA or
foreign regulatory policy during the period of product development and testing.
Various federal statutes and regulations also regulate the manufacturing,
safety, labeling, storage, record-keeping and marketing of such products. The
lengthy process of obtaining regulatory approvals and ensuring compliance with
appropriate federal statutes and regulations requires the expenditure of
substantial resources. Any delay or failure by us or by our collaboration
partners to obtain regulatory approval could adversely affect the
commercialization of products we or they are developing, our ability to achieve
product collaboration milestones or receive royalty revenue and thus negatively
impact our liquidity and capital resources.
Preclinical studies are generally conducted in the laboratory to evaluate
the potential efficacy and safety of a therapeutic product. The results of these
studies are submitted to the FDA as part of an IND, which must be reviewed by
FDA personnel before clinical testing can begin. Typically, clinical evaluation
involves three sequential phases, which may overlap. During Phase I, clinical
trials are conducted with a relatively small number of subjects to determine the
early safety profile of a drug, as well as the pattern of drug distribution and
drug metabolism. In Phase II, trials are conducted with groups of patients
afflicted by a specific target disease to determine preliminary efficacy,
optimal dosages, and dosage tolerance and to gather additional safety data. In
Phase III, larger-scale, multi-center comparative trials are conducted with
patients afflicted with a specific target disease to provide data for the
statistical proof of efficacy and safety as required by the FDA and foreign
regulatory agencies. The FDA, the clinical trial sponsor or the investigator may
suspend clinical trials at any time if they believe that clinical subjects are
being exposed to an unacceptable health risk.
The results of preclinical and clinical testing are submitted to the FDA in
the form of a New Drug Application (NDA) for small molecule products or a
Biologic License Application (BLA) for biological
8
10
products. In responding to an NDA or BLA, it may grant marketing approval,
request additional information, or deny the application if the FDA determines
that the application does not satisfy its regulatory approval criteria. There
can be no assurance that approvals will be granted on a timely basis, if at all.
The failure to obtain timely permission for clinical testing or timely approval
for product marketing would have a material negative effect on us. Product
approvals may subsequently be withdrawn if compliance with regulatory standards
is not maintained or if problems are identified after the product reaches the
market. The FDA may require testing and surveillance programs to monitor the
effect of a new product and may prevent or limit future marketing of the product
based on the results of these post-marketing programs.
Our policy is to conduct research activities in compliance with the
National Institute of Health Guidelines for Research Involving Recombinant DNA
Molecules. We also are subject to various federal, state and local laws,
regulations and recommendations relating to safe working conditions, laboratory
and manufacturing practices, the experimental use of animals and the use and
disposal of hazardous or potentially hazardous substances, including radioactive
compounds and infectious disease agents, used in connection with our work. The
extent and character of governmental regulation that might result from future
legislation or administrative action and its effect on us cannot be accurately
predicted.
Even if regulatory approval for a product is obtained, the product and the
facilities manufacturing the product are subject to continued review and
periodic inspection. Each drug and device manufacturing establishment in the
United States must be registered with the FDA. Domestic manufacturing
establishments are subject to biannual inspections by the FDA and must comply
with the FDA's cGMP regulations, as well as regulatory agencies in other
countries if products are sold outside the United States. If we manufacture for
sale to third parties diagnostic product applications of our SBH technology, we
will need to comply with cGMP regulations pertaining to devices. We will need to
spend funds, time and effort to ensure full technical compliance with these
regulations. The FDA stringently applies regulatory standards for manufacturing
drugs, biologics, and medical devices. The FDA's cGMP regulations require that
drugs and medical devices be manufactured and records be maintained in a
prescribed manner with respect to manufacturing, testing and control activities.
We are subject to federal, state and local laws and regulations governing
the use, storage, handling and disposal of hazardous materials, including 33P, a
low energy radioactive isotope used in labeling some of our probes and
subsequently present in certain waste products. Although we believe that our
safety procedures for such materials comply with the standards prescribed by
local, state, and federal laws and regulations, the risk of accidental
contamination or injury from these materials cannot be completely eliminated. In
the event of such an accident, we could be held liable for any damages that
result and any liability could exceed our resources.
HUMAN RESOURCES
At December 31, 2000, we had 257 full-time equivalent employees, including
approximately 220 scientists. Fifty-nine of our employees hold doctorate
degrees. No employees are represented by unions. We believe that relations with
our employees are good.
RISK FACTORS
We Must Be Able to Continue to Secure Additional Financing
Our business does not currently generate the cash needed to finance our
operations. We will require substantial additional financial resources to
conduct the time-consuming and costly research, preclinical development,
clinical trials and regulatory approval and marketing activities necessary to
commercialize our potential products. Also, in pursuing our goal of building a
fully-integrated biopharmaceutical company, we intend to expand our facilities
and hire and train significant numbers of employees to staff these facilities,
which will require substantial additional funds. We will need to secure
additional financing within the next fiscal year in order to conduct our
research and expand our facilities as we have planned. Unanticipated expenses,
or unanticipated opportunities that require financial commitments, could give
rise to requirements for additional financing sooner than we expect. However,
financing may be unavailable when we need it or
9
11
may not be available on acceptable terms. If we are unable to raise additional
funds when we need them, we may be required to delay, scale back or eliminate
expenditures for some of our development programs or our facilities expansion
plans, or grant rights to third parties to develop and market product candidates
that we would prefer to develop and market ourselves. If we are required to
grant such rights, the ultimate value of these product candidates to us would be
reduced.
We intend to seek additional funding through collaborations and public or
private equity or debt financings. We have financed our operations since
inception primarily through sale of equity securities and revenue from corporate
collaborations. We have not generated royalty revenues from product sales, and
do not expect to receive significant revenues from royalties in the foreseeable
future, if ever. To execute our current operating plan, we will need to secure
additional financing by at least the fourth quarter of 2001, however, we plan to
seek additional funding prior to that time.
Additional financing, however, may not be available on acceptable terms, if
at all. For approximately the past six months, the capital markets have been
volatile and uncertain. Given the current state of the markets for public and
private offerings of securities, we may have difficulty raising the amount of
funds, on reasonable terms, necessary to finance our current operating plan. If
we cannot raise the financing that our current operating plan requires, we may
have to scale back some of our operations, including our planned facilities
expansion, which may have a negative effect on our business. In addition, the
perception in the capital markets that we may not be able to raise the amount of
financing we desire, or on terms favorable to us, may have a negative effect on
the trading price of our stock. Additional equity financings could result in
significant dilution of stockholders' equity interests. If sufficient capital is
not available, we may be required to delay, reduce the scope of, eliminate or
divest one or more of our discovery, research or development programs or our
planned facilities expansion. Any such action could significantly harm our
business, financial condition and results of operations.
Our future capital requirements and the adequacy of our currently available
funds will depend on many factors, including, among others, the following:
- continued scientific progress in our research and development programs,
including progress in our research and preclinical studies on our
therapeutic protein candidates;
- the cost involved in our facilities expansion to support research and
development of our therapeutic protein candidates;
- our ability to attract additional financing on favorable terms;
- the magnitude and scope of our research and development programs,
including development of therapeutic protein candidates and SBH
technology and applications;
- our ability to maintain, and the financial commitments involved in, our
existing collaborative and licensing arrangements;
- our ability to establish new corporate relationships with other
biotechnology and pharmaceutical companies to share costs and expertise
of identifying and developing product candidates;
- the cost of prosecuting and enforcing our intellectual property rights,
including our patent litigation with Affymetrix;
- the cost of manufacturing material for preclinical, clinical and
commercial purposes;
- the time and cost involved in obtaining regulatory approvals;
- our need to develop, acquire or license new technologies or products;
- competing technological and market developments; and
- other factors not within our control.
10
12
Development of Our Products Will Take Years; Our Products Will Require
Approval Before They Can Be Sold
Because substantially all of our potential products currently are in
research or preclinical development, revenues from sales of any products will
not occur for at least the next several years, if at all. We cannot be certain
that any of our products will be safe and effective or that we will obtain
regulatory approvals. In addition, any products that we develop may not be
economical to manufacture on a commercial scale. Even if we develop a product
that becomes available for commercial sale, we cannot be certain that consumers
will accept the product. We cannot predict whether we will be able to
successfully develop and commercialize any of our protein candidates. If we are
unable to do so, our business, results of operations and financial condition
will be materially adversely affected.
We do not yet have products in the commercial markets. All of our potential
products are in research or preclinical development. We cannot apply for
regulatory approval of our potential products until we have performed additional
research and development and testing. We cannot be certain that we, or our
strategic partners, will be permitted to undertake clinical testing of our
potential products and, if we are successful in initiating clinical trials, we
may experience delays in conducting them. Our clinical trials may not
demonstrate the safety and efficacy of our potential products, and we may
encounter unacceptable side effects or other problems in the clinical trials.
Should this occur, we may have to delay or discontinue development of the
potential product that causes the problem. After a successful clinical trial, we
cannot market products in the United States until we receive regulatory
approval. Even if we are able to gain regulatory approval of our products after
successful clinical trials and then commercialize and sell those products, we
may be unable to manufacture enough product to maintain our business which could
have a negative impact on our financial condition.
The Success of Our Potential Products in Preclinical Studies Does Not
Guarantee that these Results Will Be Replicated in Humans
Even though some of our therapeutic protein candidates have shown results
in preclinical studies, these results may not be replicated in our clinical
trials with humans. Human clinical results could be different from our
expectations following our preclinical studies. Consequently, there is no
assurance that the results in our preclinical studies are predictive of the
results that we will see in our clinical trials with humans. Also, while we have
demonstrated some evidence that our therapeutic protein candidates have utility
in preclinical studies, these results do not mean that the resulting products
will be safe and effective in humans. Our therapeutic protein candidates may
have undesirable and unintended side effects or other characteristics that may
prevent or limit their use.
Our Ability To Commercialize Gene-Based Products is Unproven
We have not developed any therapeutic or diagnostic products using proteins
produced by the genes we have discovered. Before we make any products available
to the public, we or our collaboration partners will need to conduct further
research and development and complete laboratory testing and animal and human
studies. Moreover, with respect to biopharmaceutical products, we or our
collaboration partners will need to obtain regulatory approval before releasing
any such products. With respect to agricultural products, our collaboration
partner may need to obtain regulatory approval before releasing any such
products. We have spent, and expect to continue to spend, significant amounts of
time and money in determining the function of genes and the proteins they
produce. Such determination process constitutes the first step in developing
commercial products. We also have spent and expect to continue to spend
significant amounts of time and money in developing our most advanced product
candidates, IL-1Hy1 and CD39L4. However, a commercially viable product may never
be developed from our gene discoveries, either by us alone or with our
collaboration partners.
11
13
Our development of gene-based products is subject to several risks,
including but not limited to:
- the possibility that a product is toxic, ineffective or unreliable;
- failure to obtain regulatory approval for the product;
- the product may be hard to manufacture on a large scale or may not be
economically feasible to market;
- competitors may develop a superior product; or
- other persons' or companies' patents may preclude our marketing of a
product.
Our biopharmaceutical development programs are currently in the research
stage or in preclinical development. None of our therapeutic protein candidates
have advanced to Phase I clinical trials. Our programs may not move beyond their
current stages of development. Even if our research does advance, we will need
to engage in certain additional preclinical development efforts to determine
whether a product is sufficiently safe and efficacious to enter clinical trials.
We have little experience with these activities and may not be successful in
developing or commercializing products.
Under our collaboration arrangement with Chiron in the solid tumor cancer
field, Chiron maintains responsibility for the development of a product. Under
our collaboration arrangement with Kirin, Kirin has primary responsibility for
clinical development in its territory and we have primary responsibility in our
territory. With respect to these arrangements, we run the risk that Chiron or
Kirin may not pursue clinical development in a timely or effective manner, if at
all.
If a product receives approval from the FDA to enter clinical trials, Phase
III of those trials include multi-phase, multi-center clinical studies to
determine the product's safety and efficacy prior to marketing. We cannot
predict the number or extent of clinical trials that will be required or the
length of the period of mandatory patient follow-up that will be imposed.
Assuming clinical trials of any product are successful and other data appear
satisfactory to us, we or our applicable collaboration partner will submit an
application to the FDA and appropriate regulatory bodies in other countries to
seek permission to market the product. Typically, the review process at the FDA
is not predictable and can take up to several years. Upon completion of such
review, the FDA may not approve our or our collaboration partner's application
or may require us to conduct additional clinical trials or provide other data
prior to approval. Furthermore, even if our products or our collaboration
partner's products receive regulatory approval, delays in the approval process
could significantly harm our business, financial condition and results of
operations.
In addition, we may not be able to produce any products in commercial
quantities at a reasonable cost or may not be able to successfully market such
products. If we do not develop a commercially viable product, then we would
suffer significant harm to our business, financial condition and operating
results.
The Success of Our Business Depends on Patents and Other Proprietary
Information
We currently have patents that cover some of our technological discoveries
and patent applications that we expect to cover our gene, protein and
technological discoveries. We will continue to apply for patents for our
discoveries. We cannot assure you that any of our currently pending or future
applications will issue as patents, or that any patent issued to us will not be
challenged, invalidated, circumvented or held unenforceable by way of an
interference proceeding or litigation. The patent positions of biotechnology
companies involve complex legal and factual questions. Even though we own
patents, we cannot be certain that:
- our patents will not be challenged;
- protection against competitors will be provided by such patents; or
- competitors will not independently develop similar products or design
around our patents.
12
14
We seek patents on:
- full-length gene sequences;
- partially-sequenced gene sequences;
- proteins produced by those genes; and
- processes, devices and other technology that enhance our ability to
develop and/or manufacture gene-based products.
To obtain a patent, we must identify a utility for the gene or the protein
we seek to patent. Identifying a utility may require significant research and
development with respect to which we may incur a substantial expense and invest
a significant amount of time. Patent applications we may apply for with respect
to human therapeutics could require us to generate data which may involve
substantial costs. Finally, we cannot predict the timing of the grant of a
patent.
We also rely on trade secret protection for our confidential and
proprietary information. Although our policy is to enforce security measures to
protect our assets, trade secrets are difficult to protect. We require all
employees to enter into confidentiality agreements with us. However:
- competitors may independently develop substantially equivalent
proprietary information and techniques;
- competitors may otherwise gain access to our trade secrets;
- persons with whom we have confidentiality agreements may disclose our
trade secrets; or
- we may be unable to protect our trade secrets meaningfully.
Certain of our patents protecting our SBH technology are filed only in the
United States. Therefore, we currently are not able to prevent others from
practicing SBH technology outside of the United States. Furthermore, although we
intend to defend our patents, we may not prevail in a court case against others
who use our SBH technology. We currently have two suits against, and are
defending a countersuit and suit against us by, our competitor Affymetrix. We
have claimed that Affymetrix has infringed our SBH patents and Affymetrix claims
that our patents are invalid. If we lose our exclusive rights to SBH technology
because of the litigation, then competitors could be free to design products
that incorporate or use such technology. We have and will continue to incur
substantial costs and expend substantial personnel time in defending our patents
rights in court. See "Item 3. Legal Proceedings," for additional information.
We may be required to obtain licenses to patents or other proprietary
rights of others. These required licenses may not, however, be made available on
terms acceptable to us, or at all. If we do not obtain these licenses, we may
not be able to develop, manufacture or sell products, or encounter delays in
product market introductions, or incur substantial costs while we attempt to
design around existing patents. Any of these obstacles could significantly harm
our business, financial condition and operating results.
Certain Litigation
We have filed suit against Affymetrix alleging infringement of five of our
patents related to our SBH technology. Affymetrix has filed a countersuit and a
suit of its own alleging that our patents are invalid and that we infringe
certain of Affymetrix' patents. We have incurred, and will continue to incur,
substantial costs and personnel time in asserting our patent rights against
Affymetrix, and in our defense in the suit brought by Affymetrix. We may not be
successful in asserting our patent rights or in our defense against Affymetrix.
We cannot assure you that any of our patents will not be challenged,
invalidated, circumvented or held unenforceable by way of an interference
proceeding or litigation. Failure to enforce our patent rights successfully, or
the loss of these patent rights covering our proprietary technologies, also
could remove a legal obstacle to competitors in designing platforms with similar
competitive advantages, which could significantly harm our business, financial
condition and operating results. See "Item 3. Legal Proceedings," for additional
information.
13
15
Our Business is Difficult to Evaluate Because We Have Been Focused on Our
Current Business Strategy for Only Approximately Three Years.
Our company commenced operations in the fourth quarter of 1994. Our initial
business focused on gene discovery using our screening-by-hybridization
platform, and applications of our SBH technology including the HyChip system,
although our vision has been to become a biopharmaceutical company. Not only is
our operating history relatively short, but we began to transition our business
strategy from gene discovery to research and development of potential
biopharmaceutical candidates in 1998. Accordingly, we have a limited operating
history from which you can evaluate our present business and future prospects.
As a relatively new entrant to the business of biopharmaceutical research and
development, we face risks and uncertainties relating to our ability to
implement our business plan successfully. Our prospects must be considered in
light of the risks, expenses and difficulties frequently encountered by
companies in their early state of development, particularly companies in new and
rapidly evolving markets such as research and development of gene-based
products. If we are unsuccessful in addressing these risks and uncertainties,
our business, results of operations, financial condition and prospects will be
materially adversely affected.
We Lack Manufacturing Experience and We Intend to Rely Initially on Contract
Manufacturers
We do not currently have significant manufacturing facilities. We are
dependent on contract research and manufacturing organizations, and will be
subject to the risk of finalizing contractual arrangements, transferring
technology and maintaining relationships with such organizations in order to
file an IND with the FDA and proceed with clinical trials for any of our
therapeutic protein candidates. We are dependent on third-party contract
research organizations to conduct certain research, including GLP toxicology
studies in order to gather the data necessary to file an IND with the FDA for
any of our therapeutic protein candidates. Our therapeutic protein candidates
have never been manufactured on a commercial scale. Third-party manufacturers
may not be able to manufacture such proteins at a cost or in quantities
necessary to make them commercially viable. In addition, if any of our
therapeutic protein candidates enter the clinical trial phase, initially we will
be dependent on third-party contract manufacturers to produce the volume of cGMP
materials needed to complete such trials. We expect to enter into relationships
with third-party contract research organizations that are capable of conducting
such research and third-party contract manufacturers that are capable of
producing such volume of material. We will need to enter into contractual
relationships with these or other organizations in order to (i) complete the GLP
toxicology and other studies necessary to file an IND with the FDA, and (ii)
produce a sufficient volume of cGMP material in order to conduct clinical trials
of our therapeutic protein candidates. We cannot assure you that we will be able
to do so on a timely basis or that we will be able to obtain sufficient
quantities of material on commercially reasonable terms. In addition, the
failure of any of these relationships with third-party contract organizations
may result in a delay of our filing for an IND, or our progress through the
clinical trial phase. Any significant delay or interruption would have a
material adverse effect on our ability to file an IND with the FDA and/or
proceed with the clinical trial phase for any of our therapeutic protein
candidates.
Moreover, contract manufacturers that we may use must continually adhere to
current cGMP regulations enforced by the FDA through a facilities inspection
program. If the facilities of such manufacturers cannot pass a pre-approval
plant inspection, the FDA premarket approval of our products will not be
granted.
We Are Dependent Upon Collaborative Arrangements
As we have transitioned our business from gene discovery to research and
development of biopharmaceutical candidates, we have shifted our focus for new
collaborative arrangements. We are now focusing on new collaborative
arrangements where we would share costs of identifying, developing and marketing
product candidates. There can be no assurance that we will be able to negotiate
new collaboration arrangements of this type on acceptable terms, or at all.
14
16
The success of our business is dependent, in significant part, upon our
ability to enter into multiple collaboration arrangements and to effectively
manage the numerous issues that arise from such collaborations. Management of
our relationships with our collaboration partners will require:
- our management team to devote a significant amount of time and effort to
the management of these relationships;
- effective allocation of our resources to multiple projects; and
- an ability to obtain and retain management, scientific and other
personnel.
Our need to manage simultaneously a number of collaboration arrangements may not
be successful, and the failure to effectively manage such collaborations would
significantly harm our business, financial condition and results of operations.
The research we perform in our gene discovery collaborative arrangements is
at an early stage of product development. The successful development of products
under these collaborations is highly dependent on the performance of our
collaboration partners. Under our gene discovery collaborative arrangements, our
collaboration partners are generally required to (i) undertake and fund certain
research and development activities with us, (ii) make payments to us upon
achievement of certain scientific milestones and (iii) pay royalties to us when
and if they commercially market a product developed from the collaborative
arrangement. We do not directly control the amount or timing of resources
devoted to development activities by our collaboration partners. We, therefore,
face a risk that our collaboration partners may not commit sufficient resources
to our research and development programs or the commercialization of our
products or may not perform their obligations as expected. If any collaboration
partner fails to conduct its activities to be performed under our collaboration
arrangement in a timely manner, or at all, our expectations of royalties and
milestone payments related to such collaboration arrangement could be delayed or
eliminated. Also, our current or future collaboration partners, if any, may
independently pursue existing or other development-stage products or alternative
technologies in preference to those they are developing in collaboration with
us. Further, disputes may arise with respect to ownership of products developed
under any such collaboration arrangement. Finally, any of our current
collaboration arrangements may be terminated or not renewed by our collaboration
partners, and we may not be able to negotiate additional collaboration
arrangements in the future on acceptable terms, or at all.
We Are Dependent on Key Personnel
The success of our business is highly dependent on the principal members of
our scientific and management staff. The loss of the services of such
individuals might significantly delay or prevent us from achieving our
scientific or business objectives. Competition among biotechnology and
biopharmaceutical companies for qualified employees is intense. The ability to
retain and attract qualified individuals is critical to our success. We may not
be able to attract and retain qualified employees currently or in the future on
acceptable terms, or at all. The failure to do so would significantly harm our
business, financial condition and results of operations.
Management of Growth
We expect to significantly increase the number of our employees and the
scope of our operations. Such growth may place a significant strain on our
management and operations. In order to execute our strategy to build a
fully-integrated biopharmaceutical company, develop therapeutic or diagnostic
products, and obtain regulatory approvals, we will need to:
- attract and train skilled employees;
- attract and retain employees with expertise to ensure that we meet FDA
and foreign regulatory requirements for conducting clinical trials;
- expand our facilities for additional research and development
laboratories and offices and acquire additional equipment and supplies;
15
17
- expand our protein production capacity; and
- enter into and manage contractual relationships with contract research
and manufacturing organizations.
Our ability to manage such growth effectively will depend upon our ability
to broaden our management team and to attract, hire and retain skilled
employees. Our success also will depend on the ability of our officers and key
employees to continue to implement and improve our operational, management
information and financial control systems and to expand, train and manage our
employee base. Inability to manage growth effectively could significantly harm
our business, financial condition and operating results.
We Must Attract and Retain Qualified Employees and Consultants
Our success will depend on our ability to retain our key executive officers
and scientific staff to develop our potential products and formulate our
research and development strategy. We have programs in place to retain
personnel, including programs to create a positive work environment and
competitive compensation packages. Because competition for employees in our
field is intense, however, we may be unable to retain our existing personnel or
attract additional qualified employees. Our success also depends on the
continued availability of outside scientific collaborators to perform research
and develop processes to advance and augment our internal research efforts.
Competition for collaborators is intense. If we do not attract and retain
qualified personnel and scientific collaborators, and if we experience
significant turnover or difficulties recruiting new employees, our research and
development programs could be delayed and we could experience difficulties in
generating sufficient revenue to maintain our business.
Future Sales of Our Common Stock May Depress Our Stock Price
Sales in the public market of substantial amounts of our common stock could
depress prevailing market prices of our common stock. As of March 1, 2001, we
had 13,757,882 shares of our common stock outstanding. All of these shares are
freely transferable without restriction or further registration under the
Securities Act of 1933, as amended (Securities Act), except for shares held by
our affiliates. Our affiliates hold 2,207,141 shares of our common stock which
are transferable pursuant to Rule 144 as promulgated under the Securities Act,
subject to the volume limitations of Rule 144. Although we do not believe that
our affiliates have any present intentions to dispose of any shares of common
stock owned by them, there can be no assurance that such intentions will not
change in the future. An additional 708,480 shares owned by a Yugoslav entity
have been held in a blocked account pursuant to restrictions imposed by the U.S.
Department of Treasury arising from the political situation in former Yugoslavia
and therefore have not been able to be voted or transferred. We believe that
some of these restrictions may have recently been removed and the remaining
restrictions may be removed in the future. There can be no assurance as to how
long any such restrictions will remain in effect.
As of March 1, 2001, warrants to purchase 312,881 shares of our common
stock were outstanding. In addition, under registration statements on Form S-8
under the Securities Act, we have registered approximately 2,592,974 shares of
our common stock for sale upon the exercise of outstanding options under our
1995 Stock Option Plan, Non-Employee Director Stock Option Plan, Scientific
Advisory Board/Consultants Stock Option Plan, and stock option agreements
entered into outside of any of our stock option plans. Shares of our common
stock acquired pursuant to these plans and agreements are available for sale in
the open market. In addition, we have reserved approximately 468,160 shares of
our common stock for issuance upon the exercise of outstanding options under a
stock option agreement entered into outside of any of our stock option plans. As
of March 1, 2001, 150,000 of these 468,160 shares of this option were
exercisable. Although these shares have not been registered under the Securities
Act, and therefore are restricted securities within the meaning of Rule 144
under the Securities Act, we intend to register these shares on a registration
statement on Form S-8 under the Securities Act. Certain options or warrants may
have exercise prices that are substantially below the prevailing market price of
our common stock. The exercise of those options or warrants, and the prompt
resale of shares of our common stock received, may result in downward pressure
on the price of our common stock.
16
18
The existence of the currently outstanding warrants and options to purchase our
common stock may negatively affect our ability to complete future equity
financings at acceptable prices and on acceptable terms.
We Have a History of Operating Losses and May Never Be Profitable
For the years ended December 31, 2000, 1999 and 1998, we had net losses of
$22.3 million, $18.5 million and $16.4 million, respectively. As of December 31,
2000, we had an accumulated deficit of $71.9 million. The process of developing
our therapeutic protein candidates will require significant additional research
and development, preclinical testing, clinical trials and regulatory approvals.
These activities, together with general administrative expenses, are expected to
result in operating losses for the foreseeable future. We may never generate
profits, and if we do become profitable, we may be unable to sustain or increase
profitability on a quarterly or annual basis. As a result, the trading price of
our stock could decline.
We May Face Fluctuations in Operating Results
Our operating results may rise or fall significantly as a result of many
factors, including:
- the amount of research and development we engage in;
- the progress we make with research and preclinical studies on our
therapeutic protein candidates, and the number of candidates in research
and preclinical studies;
- our ability to expand our facilities to support our operations;
- the ability to enter into new strategic relationships;
- the nature, effectiveness, size, timing or termination of our
collaborative arrangements;
- the costs involved in preparing, filing, prosecuting, maintaining and
enforcing patent claims;
- the possibility that others may have or obtain patent rights that are
superior to ours;
- changes in government regulation; and
- competitors' release of successful products into the market.
Because substantially all of our potential products currently are in
research or preclinical development, revenues from sales of any products will
not occur for at least the next several years, if at all. We also have a high
percentage of fixed costs such as lease obligations. As a result, we may
experience fluctuations in our operating results from quarter to quarter and
continue to generate losses. Quarterly comparisons of our financial results may
not necessarily be meaningful and investors should not rely upon such results as
an indication of our future performance.
We Face Potential Volatility of Our Stock Price
Our common stock has been traded on the Nasdaq National Market only since
August 1997. The market price of our common stock may fluctuate substantially
because of a variety of factors, including:
- volatility and uncertain in the capital markets in general;
- quarterly fluctuations in our results of operations;
- adverse circumstances affecting the introduction or market acceptance of
new products we offer;
- announcements by competitors;
- developments in our litigation proceedings;
- changes in our earnings estimates;
- changes in accounting principles;
- sales of our common stock by existing holders;
17
19
- loss of key personnel; and
- economic and other external factors.
In addition, the stock market in general, and the market for biotechnology
and other life science stocks in particular, has historically been subject to
extreme price and volume fluctuations. This volatility has had a significant
effect on the market prices of securities issued by many companies for reasons
unrelated to the operating performance of these companies. In the past,
following periods of volatility in the market price of a company's securities,
class action securities litigation has often been instituted against such a
company. Any such litigation instigated against us could result in substantial
costs and a diversion of management's attention and resources, which could
significantly harm our business, financial condition and operating results.
FDA Regulatory Approval of Our Products is Uncertain; We Face Heavy Government
Regulation
Products such as those proposed to be developed by us, alone, or in
conjunction with our collaboration partners, typically will be subject to an
extensive regulatory process by federal, state and local governmental
authorities, including the FDA, and comparable agencies in other countries
before we may market and sell such products. In order to obtain regulatory
approval of a drug product, we, alone, or in conjunction with our collaboration
partners, must demonstrate to the satisfaction of the applicable regulatory
agency, among other things, that such product is safe and effective for its
intended uses. In addition, we must show that the manufacturing facilities used
to produce the products are in compliance with cGMP requirements. In the event
we, alone, or in conjunction with our collaboration partners, develop products
classified as drugs, we and our collaboration partners will be required to
obtain appropriate approvals as well.
If we sell applications of our SBH technology for clinical diagnostics, we
will need to comply with appropriate cGMP regulations pertaining to devices. The
new Quality System Regulation imposes design controls and makes other
significant changes in the requirements applicable to manufacturers. We must
also demonstrate that a BLA or NDA for any biological products would be approved
by the applicable government agency. In addition, if we market applications of
our SBH technology as diagnostic products, they may be considered to be medical
devices and we or our collaboration partners will be required to show that the
diagnostic product is substantially equivalent to a legally marketed product not
requiring FDA approval. In addition, we must demonstrate that we are capable of
manufacturing the product in accordance with the relevant standards. To obtain
FDA approval for such products, we must submit extensive data to the FDA,
including pre-clinical and clinical trial data to prove the safety and efficacy
of the device. Clinical trials are normally conducted over a two- to five-year
period, but may take longer to complete as a result of many factors, including:
- slower than anticipated patient enrollment;
- difficulty in finding a sufficient number of patients fitting the
appropriate inclusion criteria;
- difficulty in acquiring a sufficient supply of clinical trial materials;
or
- adverse events occurring during the trials.
Furthermore, data obtained from preclinical and clinical activities are
susceptible to varying interpretations which could delay, limit or prevent
regulatory approval or clearance for a product.
The process of obtaining FDA and other required regulatory approvals and
clearances is lengthy and will require us to expend substantial capital and
resources. We may not ultimately be able to obtain the necessary approvals and
clearances. Moreover, if and when our products do obtain such approval or
clearances, the marketing, distribution and manufacture of such products would
remain subject to extensive ongoing regulatory requirements. Failure to comply
with applicable regulatory requirements can result in:
- warning letters;
- fines;
- injunctions;
18
20
- civil penalties;
- recall or seizure of products;
- total or partial suspension of production;
- refusal of the government to grant approvals, premarket clearance or
premarket approval; or
- withdrawal of approvals and criminal prosecution.
We also are subject to numerous federal, state and local laws, regulations
and recommendations relating to safe working conditions, laboratory and
manufacturing practices, the experimental use of animals, the environment and
the use and disposal of hazardous substances used in connection with our
discovery, research and development work, including radioactive compounds and
infectious disease agents. In addition, we cannot predict the extent of
government regulations or the impact of new governmental regulations which might
significantly harm the discovery, development, production and marketing of our
products. We may be required to incur significant costs to comply with current
or future laws or regulations and we may be adversely affected by the cost of
such compliance.
If we market therapeutic and diagnostic products outside the United States,
such products will be subject to foreign regulatory requirements governing the
conduct of clinical trials, product licensing, pricing and reimbursement. Such
requirements vary from country to country and are becoming more restrictive
throughout the European Community. The process of obtaining foreign regulatory
approvals can be lengthy and require the expenditure of substantial capital and
resources. We or our collaboration partners may not be successful in obtaining
the necessary approvals.
Any delay or failure by us or our collaboration partners to obtain
regulatory approvals for our products:
- would adversely affect our ability to generate product and royalty
revenues;
- could impose significant additional costs on us or our collaboration
partners;
- could diminish competitive advantages that we may attain; and
- would adversely affect the marketing of our products.
We Lack Marketing Experience for Biopharmaceuticals
We currently have no sales, marketing or distribution capability. For the
foreseeable future, we intend to rely primarily on our current and future
collaboration partners or licensors, if any, to market our products. Such
collaboration partners, however, may not have effective sales forces and
distribution systems. If we are unable to maintain or establish such
relationships and are required to market any of our products directly, we will
have to develop our own marketing and sales force with the appropriate technical
expertise and with supporting distribution capabilities. We may not be able to
maintain or establish such relationships with third parties or develop in-house
sales and distribution capabilities. To the extent that we depend on our
collaboration partners or third parties for marketing and distribution, any
revenues we receive will depend upon the efforts of such collaboration partners
or third parties. Such efforts may not be successful.
Our Products May Not Be Accepted in the Marketplace
Even if they are approved for marketing, products we develop may never
achieve market acceptance. Our products, if successfully developed, will compete
with a number of traditional drugs and therapies manufactured and marketed by
major pharmaceutical and other biotechnology companies. Our products will also
compete with new products currently under development by such companies and
others. The degree of market acceptance of any products developed by us, alone,
or in conjunction with our collaboration partners, will depend on a number of
factors, including:
- the establishment and demonstration of the clinical efficacy and safety
of the products;
- our products' potential advantage over alternative treatment methods; and
19
21
- reimbursement policies of government and third-party payors.
Physicians, patients or the medical community in general may not accept and
utilize any of the products that we alone, or in conjunction with our
collaboration partners, develop. The lack of such market acceptance would
significantly harm our business, financial condition and results of operations.
We may develop diagnostic testing products in the future. Our success in
diagnostics will depend in large part upon our ability to obtain customers and
upon the ability of these customers to properly market genetic tests performed
with our technology. Genetic tests, including any performed using applications
of our SBH technology, may be difficult to interpret and may lead to
misinformation or misdiagnosis. Even when a genetic test identifies the
existence of a mutation in a person, the test cannot determine with absolute
certainty whether the tested individual will develop the disease or condition
for which the test is performed. The prospect of broadly available genetic
predisposition testing has raised societal and governmental concerns regarding
the appropriate use and the confidentiality of information provided by such
testing. Government authorities could limit the use of genetic testing or
prohibit testing for genetic predisposition to certain conditions. Ethical
concerns about genetic testing may adversely effect market acceptance of our
technology for diagnostic applications. Impaired market acceptance of our
technology could significantly harm our business, financial condition and
operating results.
We Face Uncertainties Related to SBH Technology Applications
We have developed applications of our SBH technology, including the chip
component to be used with the HyChip system. As we continue development of SBH
technology applications, we may discover problems in the functioning of these
applications, including the HyChip system. We may be unable to improve
applications of our SBH technology enough to be able to market them
successfully. Further, SBH technology applications compete against other DNA
analysis tools and well-established technologies. We cannot predict the outcome
of these uncertainties.
We Face Intense Competition
The genomics and biopharmaceutical industries are intensely competitive.
Our strategy as a biopharmaceutical company is to find the genes of the human
genome that are most likely to be involved in a disease condition and to focus
on identifying product candidates from the proteins produced by genes. There are
a finite number of genes in the human genome, virtually all of which will soon
be identified. Our competitors include major pharmaceutical and biotechnology
firms, not-for-profit entities and United States and foreign government-financed
programs, many of which have substantially greater research and product
development capabilities and financial, scientific, marketing and human
resources than we do. As a result, they may succeed in identifying genes and
determining their functions or developing products earlier than we or our
current or future collaboration partners do. They also may obtain patents and
regulatory approvals for such products more rapidly than we or our current or
future collaboration partners, or develop products that are more effective than
those proposed to be developed by us or our collaboration partners. Further, any
potential products based on genes we identify ultimately will face competition
from other companies developing gene-based products as well as from companies
developing other forms of treatment for diseases which may be caused by, or
related to, the genes we identify.
Many of the companies developing competing products have significantly
greater financial resources than we have. Many such companies also have greater
expertise than we or our collaboration partners have in discovery, research and
development, manufacturing, preclinical and clinical testing, obtaining
regulatory approvals and marketing. Other smaller companies may also prove to be
significant competitors, particularly through collaborative arrangements with
large and established companies. Academic institutions, government agencies and
other public and private research organizations may also conduct research, seek
patent protection and establish collaborative arrangements for discovery,
research, clinical development and marketing of products similar to our
products. These companies and institutions compete with us in recruiting and
retaining
20
22
qualified scientific and management personnel as well as in acquiring
technologies complementary to our programs. We will face competition with
respect to:
- product efficacy and safety;
- the timing and scope of regulatory approvals;
- availability of resources;
- reimbursement coverage; and
- price and patent position, including potentially dominant patent
positions of others.
There can be no assurance that research and development by others will not
render the products which we may develop obsolete or uneconomical or result in
treatments, cures or diagnostics superior to any therapy or diagnostic developed
by us or that any therapy we develop will be preferred to any existing or newly
developed technologies. While we believe that our technology provides a
significant competitive advantage, any one of our competitors may discover and
establish a patent position in one or more genes which we designate as a product
candidate before we do. Competition in this field is expected to intensify.
Certain of our collaboration partners may now be, or could become, competitors.
Competition in the area of DNA analysis tools is intense and expected to
increase. Technologies in this area are new and rapidly evolving. Applications
of our SBH technology compete primarily with Affymetrix and Applied Biosystems.
See "Item 3. Legal Proceedings," regarding our litigation with Affymetrix.
Although we are collaborating with Applied Biosystems to develop an application
of our SBH technology, Applied Biosystems presently markets gel sequencers, a
well-established sequencing technology, which compete with applications of our
SBH technology. Other companies also are developing or have developed DNA
analysis tools that may compete with applications of our SBH technology. Many of
these companies have significantly greater research and development, marketing
and financial resources than we do, and therefore represent significant
competition.
We Face Uncertainty With Respect to Pricing, Third-Party Reimbursement and
Health Care Reform
Our ability to collect significant royalties from our products may depend
on our ability, and the ability of our collaboration partners or customers, to
obtain adequate levels of reimbursement from third-party payors such as:
- government health administration authorities;
- private health insurers;
- health maintenance organizations;
- pharmacy benefit management companies; and
- other health care related organizations.
Currently, third-party payors are increasingly challenging the prices
charged for medical products and services, and the overall availability of
third-party reimbursement is limited and uncertain for genetic predisposition
tests. Third-party payors may deny their insured reimbursement if they determine
that a prescribed device or diagnostic test (i) has not received appropriate
clearances from the FDA or other government regulators, (ii) is not used in
accordance with cost-effective treatment methods as determined by the
third-party payor, or (iii) is experimental, unnecessary or inappropriate. If
third-party payors routinely deny reimbursement, we may not be able to market
our products effectively. We also face the risk that we will have to offer our
diagnostic products at low prices as a result of the current trend in the United
States towards managed health care through health maintenance organizations.
Prices could be driven down by health maintenance organizations which control or
significantly influence purchases of health care services and products.
Legislative proposals to reform health care or reduce government insurance
programs could also adversely affect prices of our products. The cost
containment measures that health care providers are instituting and the results
of potential health care reforms may prevent us from maintaining prices for our
21
23
products that are sufficient for us to realize profits and may otherwise
significantly harm our business, financial condition and operating results.
We Face Product Liability Exposure and Potential Unavailability of Insurance
We risk financial exposure to product liability claims in the event that
the use of products developed by us, alone or in conjunction with our
collaboration partners, if any, result in personal injury. We may experience
losses due to product liability claims in the future. We have obtained limited
product liability insurance coverage. Such coverage, however, may not be
adequate or may not continue to be available to us in sufficient amounts or at
an acceptable cost, or at all. We may not be able to obtain commercially
reasonable product liability insurance for any product approved for marketing. A
product liability claim or other claim, product recalls, as well as any claims
for uninsured liabilities or in excess of insured liabilities, may significantly
harm our business, financial condition and results of operations.
We Use Hazardous Materials
Our research and development activities involve the controlled use of
hazardous materials. Although we believe that our safety procedures for handling
and disposing of these materials comply with applicable laws and regulations, we
cannot eliminate the risk of accidental contamination or injury from hazardous
materials. If a hazardous material accident occurred, we would be liable for any
resulting damages. This liability could exceed our financial resources.
Additionally, hazardous materials are subject to regulatory oversight. If our
access to hazardous materials necessary for our operations is limited by
federal, state or local regulatory agencies, we could experience delays in our
research and development programs. Paying damages or experiencing delays caused
by restricted access to necessary materials could reduce our ability to generate
revenues and make it more difficult to fund our operations.
We Have Implemented Anti-Takeover Provisions that May Reduce the Market Price
of Our Common Stock
Our Amended and Restated By-Laws provide that members of our board of
directors serve staggered three-year terms. Our Amended and Restated Articles of
Incorporation provide that all stockholder action must be effected at a duly
called meeting and not by a consent in writing. The Amended and Restated By-Laws
provide, however, that our stockholders may call a special meeting of
stockholders only upon a request of stockholders owning at least 50% of our
capital stock. These provisions of our Amended and Restated Articles of
Incorporation and our Amended and Restated By-Laws could discourage potential
acquisition proposals and could delay or prevent a change in control. These
provisions are intended to enhance the likelihood of continuity and stability in
the composition of our board of directors and in the policies formulated by our
board of directors. We also intended these provisions to discourage certain
types of transactions that may involve an actual or threatened change of
control. We designed these provisions to reduce our vulnerability to unsolicited
acquisition proposals and to discourage certain tactics that may be used in
proxy fights. These provisions, however, could also have the effect of
discouraging others from making tender offers for our shares. As a consequence,
they also may inhibit fluctuations in the market price of our shares that could
result from actual or rumored takeover attempts. Such provisions also may have
the effect of preventing changes in our management.
We are permitted to issue shares of our preferred stock without stockholder
approval upon such terms as our board of directors determines. Therefore, the
rights of the holders of our common stock are subject to, and may be adversely
affected by, the rights of the holders of our preferred stock that may be issued
in the future. In addition, the issuance of preferred stock could have a
dilutive effect on the holdings of our current stockholders.
On June 5, 1998, our board of directors adopted a rights plan and declared
a dividend with respect to each share of our common stock then outstanding. This
dividend took the form of a right which entitles the holders to purchase one-one
thousandth of a share of our Series B Junior Participating Preferred Stock at a
purchase price of $175, subject to adjustment from time to time. These rights
have also been issued in connection with each share of our common stock issued
after June 5, 1998. The rights are exercisable only if a person or entity
22
24
or affiliated group of persons or entities acquires, or has announced its
intention to acquire, 15% (27.5% in the case of certain approved stockholders)
or more of our outstanding common stock. The adoption of the rights plan makes
it more difficult for a third party to acquire control of us without the
approval of our board of directors.
Nevada Revised Statutes Sections 78.411 through 78.444 prohibit an
"interested stockholder," under certain circumstances, from entering into
specified combination transactions with a Nevada corporation, unless certain
conditions are met. Under the statute, an "interested stockholder" is a person
who, together with affiliates and associates, beneficially owns (or within the
prior three years, did beneficially own) 10% or more of a corporation's voting
stock. According to the statute, we may not engage in a combination within three
years after an interested stockholder acquires our shares, unless (i) our board
of directors approves the combination prior to the interested stockholder
becoming an interested stockholder or (ii) holders of a majority of voting power
not beneficially owned by the interested stockholder approve the combination at
a meeting called no earlier than three years after the date the interested
stockholder became an interested stockholder.
Nevada Revised Statutes Sections 78.378 through 78.3793 further prohibit an
acquirer, under certain circumstances, from voting shares of a target
corporation's stock after crossing certain threshold ownership percentages,
unless the acquirer obtains the approval of the target corporation's
stockholders. This statute only applies to Nevada corporations that do business
directly or indirectly in Nevada. We do not intend to do business in Nevada
within the meaning of the statute. Therefore, it is unlikely that the statute
will apply to us.
The provisions of our governing documents, our existing agreements and
current Nevada law may, collectively:
- lengthen the time required for a person or entity to acquire control of
us through a proxy contest for the election of a majority of our board of
directors;
- discourage bids for our common stock at a premium over market price; and
- generally deter efforts to obtain control of us.
Risk of Natural Disasters and Power Blackouts
Our facilities are located in Sunnyvale, California. In the event that a
fire or other natural disaster (such as an earthquake) prevents us from
operating our production line, our business, financial condition and operating
results would be materially, adversely affected. Some of our landlords maintain
earthquake coverage for our facilities. Although we maintain personal property
and business interruption, we do not maintain earthquake coverage for personal
property or resulting business interruption.
In addition, the State of California has experienced natural gas and
electricity problems which have resulted in rolling power blackouts. Power
blackouts have disrupted our business, and may continue to disrupt our business
until these problems are resolved. In addition, we, like others, have
experienced large increases in our natural gas rates and may experience steep
increases in our electric rates. Although we have an auxiliary generator, it is
intended for emergency backup in the event of a power outage and is not capable
of powering our entire operations. Continued power blackouts and/or large
increases in our utility costs could harm our business, financial condition and
results of operations.
ITEM 2. PROPERTIES
We lease a 12,000 square foot facility at 670 Almanor Avenue, Sunnyvale,
California. The lease on this facility expires June 30, 2005, and requires base
payments on average of approximately $25,000 per month. We also lease
approximately 59,000 square feet of space at 675 Almanor Avenue, Sunnyvale,
California, which is across the street from 670 Almanor. This lease expires on
June 30, 2005, and has a five-year renewal option which, if exercised, would
extend the lease to June 30, 2010. It requires base payments on average of
approximately $95,000 per month. In June 2000 we leased an additional
approximately 59,000 square feet of space at 225, 249 and 257 Humbolt Court in
Sunnyvale, California, approximately one mile from our current
23
25
operating facilities. The lease on this new space requires base lease payments
on average of approximately $317,000 per month and extends through July 2011. In
the initial phase of our facilities expansion, we plan to build out
approximately 34,000 square feet of this space to accommodate new research and
development offices and laboratories to support preclinical development
activities, including preliminary preclinical safety and efficacy studies in
rodents, functional cell biology assays, cell based functional screening
efforts, protein production, protein characterization and analytical assay
development. To complete this build out as planned, we will need to secure
additional financing before the end of the 2001 fiscal year. In the next phase
of build out, we expect to expand our in-house capabilities for the production
and purification of proteins, although this may not provide us with
manufacturing facilities capable of supplying materials suitable for clinical
trials or for commercial sale. We expect to rely on a third party for the
production of proteins for use in our early clinical work.
ITEM 3. LEGAL PROCEEDINGS
On March 3, 1997, we sued Affymetrix, Inc. in the U.S. District Court for
the Northern District of California, San Jose Division, alleging infringement by
Affymetrix of our U.S. Patent Nos. 5,202,231 and 5,525,464 (Hyseq, Inc. v.
Affymetrix, Inc., Case No. C 97-20188 RMW (PVT)) (Hyseq I). On May 5, 1997, we
filed an Amended Complaint. On December 9, 1997, we filed a second lawsuit
against Affymetrix alleging infringement by Affymetrix of our U.S. Patent No.
5,695,940 (Hyseq, Inc. v. Affymetrix, Inc., Case No. C-97 4469 THE) (Hyseq II).
On April 22, 1998 the two cases were consolidated before Judge Ronald M. Whyte.
The consolidated suits allege that Affymetrix willfully infringed, and
continues to infringe, our patents covering SBH technology. Through the lawsuit,
we seek both to enjoin Affymetrix from infringing our patents covering SBH
technology and an award of monetary damages for Affymetrix' past infringement.
On May 19, 1997, Affymetrix filed an Answer and Affirmative Defenses to the
First Amended Complaint in Hyseq I and also filed a counterclaim against us. The
counterclaim seeks a declaratory judgment of invalidity and non-infringement
with respect to the two patents asserted in Hyseq I. On September 9, 1997, we
filed a reply to the counterclaim in which we denied the allegations of
invalidity and non-infringement. A similar answer and counterclaim was filed by
Affymetrix in Hyseq II on December 28, 1997, and a similar reply to the
counterclaim was filed by us on January 29, 1998. On August 1, 1997 (Hyseq I),
and on March 28, 1998 (Hyseq II), initial case management conferences were held
in each case in which the Court entered a pre-trial schedule. The Court held a
claims construction hearing on November 17 and 18, 1998 in Hyseq I and II. On
July 12, 1999, Affymetrix filed an amended answer and counterclaim alleging the
additional defense that the patents were obtained through inequitable conduct.
On October 27, 1999, the Court issued a Claims Construction Order construing
terms in the claims of the patents-in-suit and inviting the parties to submit
briefs setting forth any perceived errors or inconsistencies in the Order.
Affymetrix and we submitted our briefs on December 17 and 27, 1999,
respectively. On January 7, 2000, the Court held a further Case Management
Conference. On February 22, 2000, the Court received oral argument from the
parties regarding the claims construction Order. On July 27, 2000, the Court
issued a modified claims construction Order. Affymetrix and we are currently
engaged in pretrial discovery during which documents and other written discovery
are being exchanged and depositions are being taken. While we believe we have
asserted valid claims and have meritorious defenses to the counterclaims, this
litigation is at an early stage and there can be no assurance that we will
prevail in these actions.
On August 18, 1998, Affymetrix filed suit against us in the U.S. District
Court for the Northern District of California, San Francisco Division, alleging
that we infringed two of Affymetrix' U.S. Patents Nos. 5,795,716 and 5,744,305
(Affymetrix, Inc. v. Hyseq, Inc., Case No. C 98-13192). Affymetrix filed an
amended complaint on September 1, 1998 alleging infringement of its U.S. Patent
No. 5,800,992. The case was reassigned to Judge Jeremy Fogel in the San Jose
Division. At the time of the assignment to Judge Fogel, the case was also
renumbered as Case No. C 99-21163 JF (MEJ). A Case Management Conference before
Judge Fogel was held on July 10, 2000. A claims construction hearing was held
November 29-30, 2000 with respect to U.S. Patents Nos. 5,445,934, 5,744,305,
5,800,992 and 5,795,716. The Court issued an Order on January 22, 2001
construing certain claim terms and requesting additional briefing regarding U.S.
Patent No. 5,800,992. We believe that Affymetrix' allegations are without merit
and we intend to vigorously defend
24
26
the action. However, the litigation is at a very early stage and it is
impossible to predict the ultimate outcome of this matter.
On October 26, 1999, we filed a third lawsuit against Affymetrix in the
U.S. District Court for the Northern District of California, San Francisco
Division (Hyseq, Inc. v. Affymetrix, Inc., Case No. C-99 4735 MJJ) (Hyseq III),
alleging infringement by Affymetrix of our U.S. Patent No. 5,972,619 ('619
Patent). We also allege that Affymetrix' U.S. Patent No. 5,795,716 is invalid
because the subject matter was first invented by our scientists and is claimed
and covered by our '619 Patent. Affymetrix filed an answer and counterclaim on
November 15, 1999. The counterclaim seeks a declaratory judgment of invalidity,
unenforceability and non-infringement with respect to our '619 Patent. On
December 9, 1999, we filed a reply to the counterclaim in which we denied the
allegations of invalidity, unenforceability, and non-infringement. Subsequently,
Hyseq III was reassigned to Judge Fogel and was given Case No. C-00-20050
JF/PVT. A Case Management Conference was held on July 10, 2000 along with
Affymetrix, Inc. v. Hyseq, Inc. On September 6, 2000, we filed a motion seeking
the Court's permission to supplement our complaint in Hyseq III to add a claim
for infringement by Affymetrix of our U.S. Patent No. 6,018,041 ('041 patent),
which was issued to us on January 25, 2000. On November 2, 2000, Judge Fogel
granted our motion. On October 12, 2000, Affymetrix filed an Ex Parte
application before Judges Fogel and Whyte requesting reassignment of our
infringement claims under the '619 patent from Judge Fogel to Judge Whyte. On
November 2, 2000, Judges Fogel and Whyte reassigned our infringement claims
against Affymetrix under the '619 patent (as well as our infringement claims
against Affymetrix under the '041 patent) to Judge Whyte, and ordered that the
claim construction of the '619 patent claims would proceed before Judge Whyte.
On March 20, 2001, the Court issued a tentative Claims Construction Order
construing terms in the '619 patent. In the Order, Judge Whyte indicated that
the tentative order will be adopted as the Claims Construction Order unless one
of the parties files a written request for a hearing within 15 days.
On January 20, 2001, the USPTO Board of Patent Appeals and Interferences
declared an interference between one of our pending patent applications covering
subject matter related to SBH technology and Affymetrix' issued patent no.
5,795,716 (Chee and Lipshutz v. Drmanac and Crkvenjakov). We are the senior
party to the interference.
We have incurred substantial costs and expended substantial personnel time
in asserting our patent rights and defending our technology against Affymetrix
and may continue to incur such costs in asserting our patent rights and
defending our technology against Affymetrix or others. There can be no assurance
that we will be successful in these efforts. Failure to successfully enforce our
patent rights or the loss of these patent rights covering SBH technology could
remove a legal obstacle to competitors in designing platforms with similar
competitive advantages.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to the vote of stockholders through the
solicitation of proxies or otherwise during the fourth quarter of the year ended
December 31, 2000.
25
27
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Our common stock began trading on the Nasdaq Stock Market on August 8, 1997
under the symbol "HYSQ." Prior to that date, there was no established trading
market for the common stock. The following table sets forth, for the periods
indicated, the high and low bid information for the common stock, as reported by
the Nasdaq Stock Market:
HIGH LOW
------- ------
FISCAL 1999:
First Quarter............................................. $ 5.19 $ 2.50
Second Quarter............................................ $ 3.56 $ 2.56
Third Quarter............................................. $ 8.38 $ 2.75
Fourth Quarter............................................ $ 20.00 $ 4.00
FISCAL 2000:
First Quarter............................................. $139.50 $12.44
Second Quarter............................................ $ 46.88 $17.00
Third Quarter............................................. $ 53.25 $30.25
Fourth Quarter............................................ $ 37.00 $11.25
As of March 1, 2001, there were approximately 182 stockholders of record of
our common stock. We have not paid dividends to our stockholders since our
inception and we do not plan to pay cash dividends in the foreseeable future. We
currently intend to retain earnings, if any, to finance our growth.
26
28
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
YEAR ENDED DECEMBER 31,
------------------------------------------------------
2000 1999 1998 1997 1996
-------- -------- -------- ------- -------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
STATEMENTS OF OPERATIONS DATA:
Contract revenues..................... $ 15,604 $ 6,397 $ 9,590 $ 6,199 $ 426
Net loss.............................. $(22,253) $(18,547) $(16,369) $(6,537) $(4,839)
Basic and diluted net loss per
share............................... $ (1.65) $ (1.43) $ (1.27) $ (0.86) $ (0.91)
Shares used in computing basic and
diluted net loss per share.......... 13,449 13,004 12,839 7,589 5,344
DECEMBER 31,
--------------------------------------------------
2000 1999 1998 1997 1996
------- ------- ------- ------- ------
(IN THOUSANDS)
BALANCE SHEET DATA:
Working capital........................... $(2,577) $22,077 $42,345 $56,824 $5,955
Total assets.................... $21,288 $45,364 $57,914 $66,950 $9,366
Noncurrent portion of capital lease and
loan obligations........................ $ 4,722 $ 5,221 $ 4,479 $ 613 $ 791
A factor that affected the comparability of information between 1996 and
1997 was the Company's initial public offering completed in the third quarter of
1997 and private placements in May and August of 1997 in which an aggregate of
4,798,794 shares of common stock were sold for net proceeds of $61.4 million.
27
29
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
This Management's Discussion and Analysis of Financial Condition and
Results of Operations contains forward-looking statements as that term is
defined in the Private Securities Litigation Reform Act of 1995. Forward-looking
statements may be identified by words including "anticipate," "believe,"
"intends," "estimates," "expect," "should," "may," "potential" and similar
expressions. Such statements are based on our management's current expectations
and involve risks and uncertainties. Actual results and performance could differ
materially from those projected in the forward-looking statements as a result of
many factors discussed herein. Actual results and performance could also differ
materially from time to time from those projected in our filings with the
Securities and Exchange Commission as a result of certain factors, including
those set forth in this section as well as under "Item 1. Business," including
"Risk Factors."
RESULTS OF OPERATIONS
Contract Revenues
Comparison of Years Ended December 31, 2000 and 1999. Our contract revenues
were $15.6 million for 2000 compared to $6.4 million for 1999. The increase was
primarily due to higher revenues earned from our collaboration with BASF as a
result of our initiating gene screening services to target potential
agricultural products, and completion of the related data center. Processing was
at full contractual capacity of approximately 1.0 million clones per month in
the second half of 2000. Our collaboration with Chiron was extended for an
additional two-year period in May 2000 and requires Chiron to pay a minimum
annual research funding payment of $1.0 million, which is being recognized on a
straight-line basis over the extension term. Chiron has the right to extend the
agreement for one additional two-year period.
Our contract revenues earned during 2000 included $11.7 million under our
agreement with BASF, $3.3 million under our agreement with Chiron, $0.3 million
under our agreement with Kirin and $0.3 million under an agreement that expanded
our relationship with Applied Biosystems. Revenues recognized under our
agreement with Chiron include a portion of the $1.0 million minimum annual
research funding payment received for the first year of the two-year extension.
Revenues recognized under our agreement with Kirin represented the completion of
the initial phase of the collaboration.
Our revenues typically vary from quarter to quarter and may result in
significant fluctuations in our operating results from year to year. In the
future, we may not be able to maintain existing collaborations, obtain
additional collaboration partners or obtain revenue from other sources. The
failure to maintain existing collaborations, the inability to enter into
additional collaborative arrangements or obtain revenue from other sources could
have a material adverse effect on our revenues and operating results.
Comparison of Years Ended December 31, 1999 and 1998. Our contract revenues
decreased by $3.2 million to $6.4 million in 1999 compared to $9.6 million for
1998. Contract revenues recognized in 1999 included $4.9 million from Chiron and
$1.2 million from Kirin. The decrease of $3.2 million was due primarily to a
decrease in revenues earned from our collaboration with Chiron during 1999 due
to minimum production requirements being higher under the Chiron agreement in
1998, and additionally some of the scheduled requirements for the first half of
1999, and therefore our recognition of that revenue, were accelerated into 1998.
Operating Expenses
Comparison of Years Ended December 31, 2000 and 1999. Our total operating
expenses, consisting of research and development expenses and general and
administrative expenses, increased by $12.0 million to $38.3 million for 2000
compared to $26.3 million for 1999.
For 2000, our research and development expenses increased by $10.8 million
to $29.0 million compared to $18.2 million for 1999. This increase in our
research and development expenses was primarily attributable to $5.1 million
increase in costs associated with the addition of scientific and bioinformatic
personnel, $1.9 million increase in outside contract services, $2.5 million
increase in supplies purchases related to our
28
30
collaborations, a $0.6 million write-off of certain capitalized software
development costs and an increase in production throughput in our gene discovery
and complete gene sequencing programs.
Our general and administrative expenses increased $1.2 million to $9.3
million in 2000 compared to $8.1 million in 1999. The increase in general and
administrative expenses during 2000 included $0.8 million increase in rent
expenses associated with the new leased facilities for laboratory and office
expansion which is expected to be occupied during 2001, $0.5 million increase in
recruiting and salary expenses, plus increases in legal expenses related to our
patent litigation with Affymetrix, and other outside services.
We expect operating expenses to increase during 2001 as we plan to continue
research and development of our therapeutic protein candidates, expansion of our
facilities to support our research and development efforts, further development
of SBH technology applications, and efforts related to prosecuting and enforcing
our intellectual property rights, including expenses related to our patent
litigation with Affymetrix.
The magnitude of the increases in our operating expenses will be
significantly affected by our ability to secure adequate sources of external
financing or additional sources of revenue. If we do not obtain adequate
financing or revenue in a timely manner, this could significantly harm our
business, financial condition and results of operations, and may require us to
delay or eliminate one or more of our research or development programs and/or
delay the build out and occupation of our new leased facilities. See
"-- Liquidity and Capital Resources."
Comparison of Years Ended December 31, 1999 and 1998. Our total operating
expenses, consisting of research and development expenses and general and
administrative expenses, decreased by $2.4 million to $26.3 million for 1999
compared to $28.7 million for 1998.
For 1999, our research and development expenses decreased by $1.0 million
to $18.2 million compared to $19.2 million for 1998. Our lower 1999 research and
development expenses primarily reflect lower material consumption costs
resulting from decreased gene screening activities during our facilities
expansion in 1999, partially offset by higher salary expenses, increased
depreciation and rental expenses associated with the expansion of our
facilities, and increased expenditures related to prosecuting and enforcing our
intellectual property rights.
For 1999, our general and administrative expenses decreased by $1.4 million
to $8.1 million compared to $9.5 million in 1998. The decrease in general and
administrative expenses during 1999 resulted primarily from lower legal expenses
during this period. Legal expenses decreased, in part, due to delayed activity
in our litigation with Affymetrix while awaiting the results of the November
1998 claims construction hearing that the Court released in October 1999. The
decrease in legal expenses was partially offset by increased staffing costs and
higher costs associated with business development.
Interest Income and Expense, Net
Comparison of Years Ended December 31, 2000 and 1999. Our interest income
and expense, net decreased by $0.8 million to $0.5 million for 2000 compared to
$1.3 million for 1999. This decrease in 2000 resulted from lower cash and
investment balances held by us and higher interest expense from our increased
financing activities.
Comparison of Years Ended December 31, 1999 and 1998. Our interest income
and expense, net decreased by $1.4 million to $1.3 million for 1999 compared to
$2.7 million for 1998. This decrease in 1999 resulted from lower cash and
investment balances held by us and higher interest expense from our increased
financing activities.
Net Loss
Since our inception, we have incurred net losses, and as of December 31,
2000, we had an accumulated deficit of $71.9 million. During 2000, we incurred a
net loss of $22.3 million as compared to an $18.5 million net loss in 1999 and a
net loss of $16.4 million in 1998. We expect to continue to incur significant
net losses,
29
31
which may increase substantially as we pursue research and development of our
therapeutic protein candidates and other operations, and prosecute and enforce
our intellectual property rights.
LIQUIDITY AND CAPITAL RESOURCES
Cash and Cash Equivalents and Short-Term Investments
Comparison of Years Ended December 31, 2000 and 1999. As of December 31,
2000, we had $2.7 million in cash and cash equivalents. These amounts reflect a
net decrease of $27.9 million from the $30.6 million in cash, cash equivalents
and short-term investments we had as of December 31, 1999. This decrease
resulted primarily from $21.0 million of net cash used in operating activities
plus $8.3 million investments in equipment and capitalized software.
In 2000, we entered into a new facilities lease to accommodate a planned
expansion of our biopharmaceutical development efforts. We are currently
building this space out to meet our specifications. In order to continue with
and complete this build out, we will need to secure additional financing before
the end of the 2001 fiscal year. In connection with the execution of this lease,
we paid $2.0 million in advance rent and a security deposit of $0.4 million. The
advance rent and security deposit are accounted for as a prepaid asset and as
other assets, respectively. Lease payments over the eleven-year term of the
lease total approximately $42.0 million.
In November 2000, we received a commitment from our Chairman to provide a
line of credit of up to $20.0 million in aggregate principal amount, secured by
a promissory note and available for draw down through November 29, 2002. Amounts
outstanding under the line of credit bear interest at prime plus 1% and are
payable in 48 equal monthly installments beginning upon the expiration date of
November 30, 2002. The promissory note issued pursuant to such line of credit
may be converted at our option into shares of our common stock at fair market
value on the day we elect such conversion. On March 20, 2001, our Board of
Directors decided to complete the draw down of the balance of the $20.0 million
available under the line of credit and pay off the outstanding principal balance
in shares of our common stock, as provided in the agreement. As a consequence,
we issued 2,237,637 shares of common stock to our Chairman in satisfaction of
$20.0 million of outstanding principal under the line of credit. See Note 10 of
Notes to Consolidated Financial Statements.
All of our investments in marketable securities have had maturities of less
than one year, have been considered available-for-sale and as such have been
classified as short-term investments. We have held our cash equivalents and
investments in investment-grade commercial paper, bank certificates of deposit
and other interest-bearing securities. We make our investments in accordance
with our investment policy. The primary objectives of our investment policy are
liquidity, safety of principal and diversity of investments. At December 31,
2000, we did not hold any marketable securities.
In addition, we have $2.1 million in restricted cash on deposit as security
for a $2.0 million letter of credit in conjunction with a facility lease.
Provided that no event of default under the lease occurs, the letter of credit
and the cash collateralizing it will be reduced by $0.5 million per year
commencing in July 2001. The cash on deposit at any time in conjunction with
this letter of credit is restricted and cannot be withdrawn. We control the
investment of the cash and receive the interest earned thereon.
Cash Used in Operating Activities
Comparison of Years Ended December 31, 2000 and 1999. The amount of net
cash used by operating activities increased by $8.0 million to $21.0 million in
2000 from $13.0 million in 1999. This increase in cash used for operations in
2000 compared to 1999 was due primarily to increased research and development
expenses related to our collaborations, our product candidates and our complete
gene sequencing programs, increased scientific personnel headcount and addition
of new leased facilities for laboratory and office expansion and payment of
advanced rent on our new lease facilities, partially offset by a decrease in
accounts receivable and increased amounts received from collaborative partners.
30
32
Comparison of Years Ended December 31, 1999 and 1998. The amount of net
cash used in operating activities increased by $1.3 million to $13.0 million
during 1999 from $11.7 million in 1998. The increase in cash used for operations
for 1999 compared to 1998 was due primarily to a significant increase in our
accounts receivables balance, increased expenses related to our complete gene
sequencing programs, expansion of our functional genomics and protein
purification efforts to support research and development of our therapeutic
protein candidates, and efforts related to prosecuting our intellectual property
rights. This increase in cash used in operations for 1999 was partially offset
by lower spending related to enforcing our intellectual property rights.
Cash Provided by Investing Activities
Our investing activities, other than purchases and sales of short-term
investments, have consisted primarily of capital expenditures.
Comparison of Years Ended December 31, 2000 and 1999. Net cash provided by
investing activities increased by $5.2 million to $8.7 million in 2000 compared
to $3.5 million in 1999. The increase was primarily due to higher net
redemptions of short-term investments which were higher in 2000 than 1999,
partially offset by higher purchases of equipment used to support our expanding
research and development activities and investment in capitalized software. In
2000, all of our short-term investments were reinvested upon maturity into
commercial paper with maturities of less than 90 days.
Comparison of Years Ended December 31, 1999 and 1998. Net cash provided by
investing activities decreased by $1.0 million to $3.5 million for 1999 compared
to $4.5 million for 1998. Our capital expenditures slightly decreased in 1999
primarily due to lower expenditures related to the facilities expansion compared
to 1998. Offsetting this, our net redemptions of short-term investments were
lower in 1999 than in 1998.
Cash Provided by Financing Activities
Comparison of Years Ended December 31, 2000 and 1999. Net cash provided by
financing activities decreased slightly to $1.3 million in 2000 compared to $1.6
million in 1999. The decrease was primarily due to lower proceeds from financing
arrangements, partially offset by higher proceeds from employee stock option
exercises and higher payments on loan obligations. In 2000, we borrowed the
remaining $2.0 million of a $5.0 million asset-backed financing commitment
obtained in 1999.
Comparison of Years Ended December 31, 1999 and 1998. Net cash provided by
financing activities decreased by $4.0 million to $1.6 million for 1999 compared
to $5.6 million for 1998. The net cash provided in 1999 was primarily derived
from $3.0 million of proceeds we received from asset-backed financing. The
financing was partially offset by higher payments on loan obligations. In 1998,
the net cash provided by financing activities resulted primarily from our $5.0
million asset-backed financing and higher proceeds from employee stock option
exercises.
We anticipate that existing capital resources, anticipated cash from
existing collaborative partners and commitments will be sufficient to support
our current biopharmaceutical research and development and other operations
through 2001. However, we plan to seek additional funding prior to that time in
order to finance the expansion of our biopharmaceutical research and the build
out of our new leased facilities to support such research. If we do not obtain
adequate financing or revenue in a timely manner, this could significantly harm
our business, financial condition and results of operations, and may require us
to delay, scale back or eliminate one or more of our research or development
programs, discontinue the build out of our new leased facilities, or relinquish
greater or all rights to products at an earlier stage of development or on less
favorable terms than we would otherwise seek to obtain, which could materially
adversely affect our business, financial condition and operating results.
Our future capital requirements and the adequacy of our available funds
will depend on many factors, including, but not limited to:
- continued scientific progress in our research and development programs,
including progress in our research and preclinical studies on our
therapeutic protein candidates;
31
33
- the cost involved in our facilities expansion to support research and
development of our therapeutic protein candidates;
- our ability to attract additional financing on favorable terms;
- the magnitude and scope of our research and development programs,
including development of therapeutic protein candidates and SBH
technology and applications;
- our ability to maintain, and the financial commitments involved in, our
existing collaborative and licensing arrangements;
- our ability to establish new corporate relationships with other
biotechnology and pharmaceutical companies to share costs and expertise
of identifying and developing product candidates;
- the cost of prosecuting and enforcing our intellectual property rights,
including our patent litigation with Affymetrix;
- the cost of manufacturing material for preclinical, clinical and
commercial purposes;
- the time and cost involved in obtaining regulatory approvals;
- our need to develop, acquire or license new technologies or products;
- competing technological and market developments; and
- other factors not within our control.
We may not be able to secure additional financing to meet our funding
requirements on acceptable terms, if at all. If we raise additional funds by
issuing equity securities, substantial dilution to our existing stockholders may
result.
Recent Accounting Pronouncements
In June 1998, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 133, "Accounting for Derivative
Instruments and Hedging Activities" (SFAS 133), which establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts, and for hedging activities. In
accordance with SFAS 133, an entity is required to recognize all derivatives as
either assets or liabilities in the statement of financial position and measure
those instruments at fair value. SFAS 133 requires that changes in the
derivative's fair value be recognized currently in earnings unless specific
hedge accounting criteria are met. Special accounting for qualifying hedges
allows a derivative's gains and losses to offset related results on the hedged
item in the income statement and requires that a company formally document,
designate and assess the effectiveness of transactions that receive hedge
accounting. SFAS 133, as amended by SFAS 137 and 138, shall be effective for the
Company January 1, 2001. Implementation of SFAS 133, as amended, will not have a
material effect on the Company's results of operations or financial position as
the Company holds no derivative instruments.
ITEM 7A.QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK
Market Rate Risk
We have exposure to changes in interest rates in our short term
investments, which are held primarily in money market accounts which earn
interest at variable rates. We do not use derivative financial instruments in
our investment portfolio. We place our investments with high quality issuers
and, by policy, limit the amount of credit exposure to any one issuee. We are
averse to principal loss and ensure the safety and preservation of our invested
funds by limiting default, market and reinvestment risk.
We also have exposure to changes in interest rates in our line of credit
with our Chairman, which bears interest at the prime rate plus one percentage
point. See Note 10 of Notes to Consolidated Financial Statements.
32
34
Changes in interest rates do not affect interest income on our restricted
cash as it is maintained in commercial paper with fixed rates and maturities of
less than 90 days.
Changes in interest rates do not affect interest expense on our lease
obligations as they bear fixed rates of interest.
The table below presents the amounts and related interest rates of our
short-term investments, restricted cash, lease obligations and line of credit at
December 31, 2000:
AVERAGE CARRYING
RATE AMOUNT
------- --------------
(IN THOUSANDS)
Short-term investments................................ 5.50% $2,699
Restricted cash....................................... 6.42% $2,106
Lease obligation...................................... 11.90% $7,100
Line of credit........................................ N/A% $ --
33
35
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Hyseq, Inc.'s financial statements and notes thereto appear on pages 35 to
54 of this Annual Report on Form 10-K.
PAGE
NO.
----
Report of KPMG LLP, Independent Auditors.................... 35
Report of Ernst & Young LLP, Independent Auditors........... 36
Consolidated Balance Sheets as of December 31, 2000 and
1999...................................................... 37
Consolidated Statements of Operations for the years ended
December 31, 2000, 1999 and 1998.......................... 38
Consolidated Statements of Shareholders' Equity for the
years ended December 31, 2000, 1999 and 1998.............. 39
Consolidated Statements of Cash Flows for the years ended
December 31, 2000, 1999 and 1998.......................... 40
Notes to Consolidated Financial Statements.................. 41
34
36
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders of
Hyseq, Inc.
We have audited the accompanying consolidated balance sheet of Hyseq, Inc.
as of December 31, 2000, and the related consolidated statement of operations,
stockholders' equity and cash flows for the year then ended. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audit.
We conducted our audit in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit provides a
reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Hyseq, Inc. at
December 31, 2000, and the consolidated results of its operations and its cash
flows for the year then ended, in conformity with accounting principles
generally accepted in the United States of America.
/s/ KPMG LLP
San Francisco, California
February 2, 2001
35
37
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors and Stockholders
Hyseq, Inc.
We have audited the accompanying consolidated balance sheet of Hyseq, Inc.
as of December 31, 1999, and the related consolidated statements of operations,
stockholders' equity and cash flows for each of the two years in the period
ended December 31, 1999. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Hyseq, Inc. at
December 31, 1999, and the consolidated results of its operations and its cash
flows for each of the two years in the period ended December 31, 1999, in
conformity with accounting principles generally accepted in the United States.
/s/ ERNST & YOUNG LLP
Palo Alto, California
February 2, 2000
36
38
HYSEQ, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE INFORMATION)
ASSETS
AT DECEMBER 31,
--------------------
2000 1999
-------- --------
Cash and cash equivalents................................... $ 2,699 $ 13,675
Short-term investments...................................... -- 16,962
Accounts receivable......................................... 22 1,250
Prepaid rent................................................ 2,224 117
Other current assets........................................ 682 994
-------- --------
Total current assets.............................. 5,627 32,998
Cash on deposit............................................. 2,106 2,106
Equipment, leasehold improvements and capitalized software,
net....................................................... 12,465 8,427
Patents, licenses and other assets, net..................... 1,090 1,833
-------- --------
Total assets...................................... $ 21,288 $ 45,364
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Accounts payable............................................ $ 1,979 $ 1,473
Accrued professional fees, related parties.................. -- 119
Accrued professional fees, other............................ 833 1,659
Accrued vacation............................................ 556 237
Other current liabilities................................... 659 343
Deferred revenue............................................ 1,798 5,000
Current portion of capital lease and loan obligations....... 2,379 2,090
-------- --------
Total current liabilities......................... 8,204 10,921
Noncurrent portion of capital lease and loan obligations.... 4,722 5,221
-------- --------
Total liabilities................................. 12,926 16,142
-------- --------
Commitments and contingencies
Stockholders' equity:
Preferred stock, par value $0.001; 8,000,000 shares
authorized; none issued and outstanding as of December 31,
2000 and 1999............................................. -- --
Common stock, par value $0.001; 50,000,000 shares
authorized; 13,722,388 and 13,083,242 issued and
outstanding as of December 31, 2000 and 1999,
respectively.............................................. 14 13
Additional paid-in capital.................................. 80,278 82,450
Notes receivable from stockholders.......................... -- (3,503)
Deferred stock compensation................................. (8) (37)
Accumulated other comprehensive loss........................ -- (32)
Accumulated deficit......................................... (71,922) (49,669)
-------- --------
Total stockholders' equity........................ 8,362 29,222
-------- --------
Total liabilities and stockholders' equity........ $ 21,288 $ 45,364
======== ========
See accompanying Notes to Consolidated Financial Statements.
37
39
HYSEQ, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
YEAR ENDED DECEMBER 31,
--------------------------------
2000 1999 1998
-------- -------- --------
Contract revenues.......................................... $ 15,604 $ 6,397 $ 9,590
-------- -------- --------
Operating expenses:
Research and development................................. 29,018 18,157 19,207
General and administrative............................... 9,315 8,101 9,495
-------- -------- --------
Total operating expenses......................... 38,333 26,258 28,702
-------- -------- --------
Loss from operations....................................... (22,729) (19,861) (19,112)
Interest income............................................ 1,347 2,004 2,919
Interest expense........................................... (871) (690) (176)
-------- -------- --------
Net loss................................................... $(22,253) $(18,547) $(16,369)
======== ======== ========
Basic and diluted net loss per share....................... $ (1.65) $ (1.43) $ (1.27)
======== ======== ========
Weighted average shares used in computing basic and diluted
net loss per share....................................... 13,449 13,004 12,839
======== ======== ========
See accompanying Notes to Consolidated Financial Statements.
38
40
HYSEQ, INC.
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2000, 1999 AND 1998
(IN THOUSANDS)
NOTES ACCUMULATED
COMMON STOCK ADDITIONAL RECEIVABLE OTHER
--------------- PAID-IN FROM DEFERRED COMPREHENSIVE ACCUMULATED
SHARES AMOUNT CAPITAL STOCKHOLDERS COMPENSATION LOSS DEFICIT
------ ------ ---------- ------------ ------------ ------------- -----------
BALANCE AT DECEMBER 31, 1997............ 12,734 $13 $81,782 $(3,658) $(445) $ (6) $(14,749)
Cash payments of note receivable from
stockholders.......................... -- -- -- 155 -- -- --
Issuance of common stock upon exercise
of stock option grants................ 24 -- 46 -- -- -- --
Issuance of common stock upon cashless
exercise of warrants.................. 173 -- 500 -- -- -- --
Amortization of deferred compensation... -- -- -- -- 319 -- --
Cost to repurchase stock for ESPP....... -- -- -- -- -- -- (4)
Comprehensive loss:
Net loss.............................. -- -- -- -- -- -- (16,369)
Other comprehensive income (loss)..... -- -- -- -- -- (8) --
Comprehensive loss......................
------ --- ------- ------- ----- ---- --------
BALANCE AT DECEMBER 31, 1998............ 12,931 $13 $82,328 $(3,503) $(126) $(14) $(31,122)
====== === ======= ======= ===== ==== ========
Issuance of common stock upon exercise
of stock options and under ESPP....... 152 -- 122 -- -- -- --
Amortization of deferred compensation... -- -- -- -- 89 -- --
Comprehensive loss:
Net loss.............................. -- -- -- -- -- -- (18,547)
Other comprehensive income (loss)..... -- -- -- -- -- (18) --
Comprehensive loss......................
------ --- ------- ------- ----- ---- --------
BALANCE AT DECEMBER 31, 1999............ 13,083 $13 $82,450 $(3,503) $ (37) $(32) $(49,669)
====== === ======= ======= ===== ==== ========
Issuance of common stock upon exercise
of stock options and under ESPP....... 560 1 1,481 -- -- -- --
Issuance of common stock upon cash
exercise of warrants.................. 1 -- 6 -- -- -- --
Issuance of common stock upon cashless
exercise of warrants.................. 149 -- -- -- -- -- --
Compensation expense related to SAB
option grants......................... -- -- 157 -- -- -- --
Notes receivable from stockholders
repaid by surrendering shares of
stock................................. (71) -- (3,816) 3,503 -- -- --
Amortization of deferred compensation... -- -- -- -- 29 -- --
Comprehensive loss:
Net loss.............................. -- -- -- -- -- -- (22,253)
Other comprehensive income (loss)..... -- -- -- -- -- 32 --
Comprehensive loss......................
------ --- ------- ------- ----- ---- --------
BALANCE AT DECEMBER 31, 2000............ 13,722 $14 $80,278 $ -- $ (8) $ -- $(71,922)
====== === ======= ======= ===== ==== ========
TOTAL
STOCKHOLDERS'
EQUITY
-------------
BALANCE AT DECEMBER 31, 1997............ $ 62,937
Cash payments of note receivable from
stockholders.......................... 155
Issuance of common stock upon exercise
of stock option grants................ 46
Issuance of common stock upon cashless
exercise of warrants.................. 500
Amortization of deferred compensation... 319
Cost to repurchase stock for ESPP....... (4)
Comprehensive loss:
Net loss.............................. (16,369)
Other comprehensive income (loss)..... (8)
--------
Comprehensive loss...................... (16,377)
--------
BALANCE AT DECEMBER 31, 1998............ $ 47,576
========
Issuance of common stock upon exercise
of stock options and under ESPP....... 122
Amortization of deferred compensation... 89
Comprehensive loss:
Net loss.............................. (18,547)
Other comprehensive income (loss)..... (18)
--------
Comprehensive loss...................... (18,565)
--------
BALANCE AT DECEMBER 31, 1999............ $ 29,222
========
Issuance of common stock upon exercise
of stock options and under ESPP....... 1,482
Issuance of common stock upon cash
exercise of warrants.................. 6
Issuance of common stock upon cashless
exercise of warrants.................. --
Compensation expense related to SAB
option grants......................... 157
Notes receivable from stockholders
repaid by surrendering shares of
stock................................. (313)
Amortization of deferred compensation... 29
Comprehensive loss:
Net loss.............................. (22,253)
Other comprehensive income (loss)..... 32
--------
Comprehensive loss...................... (22,221)
--------
BALANCE AT DECEMBER 31, 2000............ $ 8,362
========
See accompanying Notes to Consolidated Financial Statements.
39
41
HYSEQ, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
YEAR ENDED DECEMBER 31,
--------------------------------
2000 1999 1998
-------- -------- --------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss................................................. $(22,253) $(18,547) $(16,369)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization of patents and
licenses............................................ 3,095 2,876 1,691
Stock compensation expense............................ 157 -- --
Amortization of deferred stock compensation........... 29 89 319
Non-cash change in deferred revenue................... (11,954) -- --
Loss on disposal of assets............................ 578 -- --
Realized gain (loss) on short-term investments........ -- (18) (8)
Changes in operating assets and liabilities:
Accounts receivable................................... 1,228 (599) 1,535
Prepaid rent.......................................... (2,107) (11) (27)
Other current assets.................................. 17 18 (187)
Intangible and other assets........................... (639) (1,158) (94)
Deferred revenue...................................... 10,666 5,000 --
Accounts payable...................................... 506 (432) 334
Accrued professional fees............................. (945) 203 991
Accrued vacation...................................... 319 (39) (109)
Other current liabilities............................. 316 (406) 227
-------- -------- --------
Net cash used in operating activities............ (20,987) (13,024) (11,697)
-------- -------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment...................... (8,269) (4,374) (4,581)
Purchases of short-term investments...................... (57,101) (16,382) (44,511)
Maturities of short-term investments..................... 74,095 24,300 53,561
Proceeds from sale of fixed assets....................... 9 -- --
-------- -------- --------
Net cash provided by investing activities........ 8,734 3,544 4,469
-------- -------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from financing arrangements..................... 2,073 3,001 5,324
Payment on capital lease and loan obligations............ (2,283) (1,523) (442)
Repurchases of common stock.............................. -- (115) (4)
Payment of stockholder notes receivable.................. -- -- 155
Proceeds from issuance of common stock, net of issuance
costs................................................. 1,487 237 546
-------- -------- --------
Net cash provided by financing activities........ 1,277 1,600 5,579
-------- -------- --------
Net decrease in cash....................................... (10,976) (7,880) (1,649)
Cash and cash equivalents at beginning of year............. 13,675 21,555 23,204
-------- -------- --------
Cash and cash equivalents at end of year................... $ 2,699 $ 13,675 $ 21,555
======== ======== ========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Interest paid............................................ $ 868 $ 690 $ 176
======== ======== ========
Noncash investing and financing activities:
Cashless exercise of stock options.................... $ 687 $ -- $ 74
-------- -------- --------
Cashless exercise of warrants......................... $ 745 $ 206 $ --
-------- -------- --------
See accompanying Notes to Consolidated Financial Statements.
40
42
HYSEQ, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Organization
Hyseq, Inc. (the Company or Hyseq) was established in August 1992 as an
Illinois corporation and subsequently reincorporated as a Nevada corporation on
November 12, 1993. The Company's wholly-owned subsidiary, Hyseq Diagnostics,
Inc., was formed as a Nevada corporation on July 18, 1995. The Company's other
wholly-owned subsidiary, GeneSolutions Inc., was formed as a Nevada corporation
on July 23, 1999.
Hyseq researches and develops biopharmaceutical products from its
collection of novel genes discovered using its high-throughput screening
platform, related to its proprietary sequencing-by-hybridization (SBH)
technology. Hyseq has collaborations for discovering gene-based products and for
commercializing SBH technology applications.
Principles of Consolidation and Basis of Presentation
The consolidated financial statements include the accounts of the Company's
wholly-owned subsidiaries. All significant intercompany transactions and
accounts have been eliminated.
Use of Estimates
The preparation of the financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements and
accompanying notes. Actual results could differ from those estimates.
Cash, Cash Equivalents and Short-Term Investments
The Company considers all highly liquid investments with original
maturities of up to 90 days to be cash equivalents. Investments with maturities
of less than one year from the balance sheet date and with original maturities
greater than 90 days are considered short-term investments. Investments consist
primarily of money market accounts, commercial paper, certificates of deposit
and other short-term instruments. This is consistent with the Company's policy
to maintain high liquidity and ensure safety of principal.
The Company's short-term investments are classified as available-for-sale.
Available-for-sale securities are carried at fair value based on quoted market
prices, with the unrealized gains and losses, net of tax, included in
accumulated other comprehensive loss in stockholders' equity. The amortized cost
of debt securities in this category is adjusted for amortization of premiums and
accretion of discounts to maturity. Such amortization is included in interest
income. Realized gains and losses and declines in value judged to be
other-than-temporary on available-for-sale securities are included in interest
income and expense. Interest and dividends on securities classified as
available-for-sale are included in interest income. The cost of securities sold
is based on the specific identification method.
At December 31, 2000, the Company did not hold any short-term investments.
Equipment, Leasehold Improvements and Capitalized Software
Equipment, leasehold improvements and capitalized software are stated at
cost. Depreciation and amortization are computed using the straight-line method
over the estimated useful lives ranging from three to five years, except that
leasehold improvements are amortized over the shorter of the remaining life of
the lease or the life of the improvement.
41
43
HYSEQ, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Revenue Recognition
Revenues are recognized when persuasive evidence of an arrangement exists,
delivery has occurred or services have been rendered, the price is fixed and
determinable and collectibility is reasonably assured. Revenues related to
collaborative research agreements and government grants are generally recognized
over the related funding periods for each contract as the services are
performed. Nonrefundable up-front payments received in connection with
collaborative research agreements where the Company has no continuing
performance obligation are recognized when receivable. When a continuing
performance obligation exists, these revenues are deferred and recognized over
the relevant periods of service, generally the research term.
Revenues from collaborative agreements representing 10% or more of total
revenue are as follows:
YEAR ENDED DECEMBER 31,
-------------------------
2000 1999 1998
----- ----- -----
Source:
BASF Plant Sciences GmbH.................................. 75% * *
Chiron Corporation........................................ 21% 76% 84%
Kirin Brewery Co. Ltd..................................... * 19% 16%
- ---------------
* less than 10%
In December 1999, the Securities and Exchange Commission ("SEC") issued
Staff Accounting Bulletin No. 101 ("SAB 101"), "Revenue Recognition in Financial
Statements." This statement gives specific guidance and clarification on the
conditions that must be met before an entity may recognize revenue. The
implementation of SAB 101 should be accounted for as a cumulative effect of a
change in accounting principle pursuant to APB 20. In March 2000, the SEC issued
SAB 101A to defer the effective date of implementation of SAB 101. In June 2000,
the SEC issued SAB 101B to defer further the effective date of implementation of
SAB 101 with earlier application encouraged. The Company adopted SAB 101 as of
December 31, 1999. The implementation of SAB 101 did not have a material effect
on the Company's results of operations and financial position.
Revenues by Geographic Area
Revenues by geographic area are based on customers' country of domicile
rather than customer's shipping locations:
YEAR ENDED DECEMBER 31,
---------------------------
2000 1999 1998
------- ------ ------
(IN THOUSANDS)
Revenues:
Domestic.............................................. $ 3,639 $5,178 $8,090
Germany............................................... 11,665 19 --
Japan................................................. 300 1,200 1,500
------- ------ ------
Total revenues................................ $15,604 $6,397 $9,590
======= ====== ======
Stock-Based Compensation
In accordance with the provisions of Statement of Financial Accounting
Standards No. 123 (SFAS No. 123), "Accounting for Stock-Based Compensation" the
Company has elected to account for stock-based compensation to employees under
the provisions of Accounting Principles Board Opinion No. 25, "Accounting for
Stock Issued to Employees," and its related interpretations, and to adopt the
"disclosure only"
42
44
HYSEQ, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
alternative described in SFAS No. 123. Stock options granted to non-employees
are accounted for in accordance with SFAS No. 123.
Research and Development
Research and development costs are expensed to operations as incurred and
include costs related to the Company's collaborations. Collaboration related
costs of approximately $10.4 million, $7.0 million and $10.7 million were
recorded in 2000, 1999 and 1998, respectively.
Net Loss per Share
Basic and diluted net loss per share are presented in conformity with the
Statement of Financial Accounting Standards No. 128 (SFAS No. 128), "Earnings
Per Share" for all periods presented. In accordance with SFAS No. 128, basic and
diluted net loss per share has been computed using the weighted average number
of shares of common stock outstanding during the period.
In 2000, 1999 and 1998, outstanding options and warrants of 1,513,000,
369,000 and 728,000 shares, respectively, (as determined using the treasury
stock method) were not included as they were antidilutive.
Segment Reporting
To date, the Company has viewed its operations as principally one segment.
Operating segments are identified as components of an enterprise about which
separate discrete financial information is available for evaluation by the chief
operating decision maker in making decisions how to allocate resources and
assess performance. The Company's chief operating decision maker is the Chief
Executive Officer. As a result, the financial information disclosed herein
materially represents all of the financial information related to the Company's
principal operating segment.
Reclassification
Certain prior year amounts have been reclassified to conform to current
year presentation.
2. EQUIPMENT, LEASEHOLD IMPROVEMENTS AND CAPITALIZED SOFTWARE
Equipment, leasehold improvements and capitalized software, net consist of
the following (in thousands):
DECEMBER 31,
------------------
2000 1999
------- -------
Machinery, equipment and furniture....................... $ 8,535 $ 6,336
Computers and capitalized software....................... 7,633 4,991
Leasehold improvements................................... 5,191 2,901
------- -------
21,359 14,228
Less: accumulated depreciation........................... (8,894) (5,801)
------- -------
Equipment, leasehold improvements and capitalized
software, net.......................................... $12,465 $ 8,427
======= =======
Depreciation expense totaled $3.1 million, $2.8 million and $1.6 million
for the years ended December 31, 2000, 1999 and 1998, respectively. Equipment
and leasehold improvements at December 31, 2000 and 1999 include items under
capitalized leases in the amount of $0.7 million and $0.6 million, respectively,
and related accumulated depreciation of $0.5 million and $0.4 million at
December 31, 2000 and 1999, respectively. These leases are secured by the
equipment leased thereunder. During 2000, there were write-offs
43
45
HYSEQ, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
of certain capitalized software totaling $0.6 million. These write-offs are
included in research and development expenses in the accompanying Statement of
Operations.
3. ACCUMULATED OTHER COMPREHENSIVE LOSSES
Accumulated other comprehensive income or loss consists entirely of
unrealized gains and losses on securities. The change in accumulated other
comprehensive income (loss) was $32,000, ($18,000) and ($8,000) in 2000, 1999
and 1998, respectively. This change consisted entirely of unrealized gains
(losses) on securities.
4. PATENTS, LICENSES AND OTHER ASSETS
Patents and Licenses
Patent costs are incurred in connection with obtaining certain patents and
filing of related patent applications. Patent and license amortization expense
was $27,633, $27,633 and $65,133 for the years ended December 31, 2000, 1999 and
1998, respectively. Patent amortization expense is recorded on a straight-line
basis over the patent's estimated useful life which approximates 17 years.
Patent License Agreement
In 1994, the Company entered into a patent license agreement with an
affiliate of the University of Chicago for an exclusive license to use certain
proprietary technology developed by the Company's Chief Scientific Officer and
to develop, use, and sell licensed products or processes. The Company issued
15,244 shares of Series A preferred stock (which converted to common stock in
connection with the Company's initial public offering in 1997). The Company
began paying minimum royalties of $25,000 per annum beginning in 1997 and
increasing to $100,000 per annum in 1999, and will continue to pay minimum
royalties at the rate of $100,000 per annum over the term of the agreement,
which terminates upon the later to occur of (a) fifteen years after the date of
the agreement or (b) the expiration of the last-to-expire patents of the
licensed patent rights.
5. CAPITAL LEASE AND LOAN OBLIGATIONS
The Company has financed equipment purchases through capital lease and loan
agreements. The capital lease and loan obligations are to be repaid over terms
of 48 to 60 months at interest rates ranging from 8.10% to 14.98% and are
secured by the related equipment.
Future minimum payments under the capital lease and loan agreements are as
follows (in thousands):
YEARS ENDING DECEMBER 31:
2001..................................................... $ 3,105
2002..................................................... 2,938
2003..................................................... 1,432
2004..................................................... 871
2005..................................................... 198
-------
Total loan payments.............................. 8,544
Less: Amount representing interest....................... (1,443)
-------
Present value of future loan payments...................... 7,101
Less: Current portion.................................... (2,379)
-------
Noncurrent portion......................................... $ 4,722
=======
44
46
HYSEQ, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
6. COMMITMENTS AND CONTINGENCIES
Operating Leases
The Company leases two facilities under operating lease agreements that
expire in June 2005. One of the leases has a five-year renewal option, which if
exercised, would extend the lease to 2010. In June 2000 the Company leased an
additional approximately 59,000 square feet of space at 225, 249 and 257 Humbolt
Court in Sunnyvale, California, approximately one mile from our current
operating facilities. The lease on this new space requires base lease payments
on average of approximately $317,000 per month and extends through July 2011.
Rental expense was approximately $2.1 million in 2000, $1.4 million in 1999,
$1.1 million in 1998. The leases provide for scheduled rent increases annually
over the terms of the leases. The rent is being recognized as expense on a
straight-line basis.
Minimum future rental commitments under non-cancelable operating leases at
December 31, 2000 are as follows (in thousands):
MINIMUM RENTAL
COMMITMENTS
--------------
YEAR ENDED DECEMBER 31,
2001................................................ $ 4,674
2002................................................ 4,885
2003................................................ 5,103
2004................................................ 5,328
2005................................................ 4,717
2006 and thereafter................................. 20,971
-------
$45,678
=======
Letter of Credit
In accordance with the terms of a facility lease agreement signed in the
fourth quarter of 1997, the Company was required to obtain an irrevocable
standby letter of credit in the amount of $2.0 million as partial security for
the Company's lease obligations. In connection with obtaining the letter of
credit, the Company was required to place $2.1 million restricted cash on
deposit with the Company's primary bank as security for the letter of credit.
Provided that no event of default under the lease has occurred, the letter of
credit and the cash collateralizing it will be reduced by $0.5 million
commencing in July 2001 and will be further reduced by $0.5 million each year
thereafter. The cash on deposit at any time in conjunction with this letter of
credit is restricted and cannot be withdrawn. The Company controls the
investment of the cash and receives interest earned thereon.
Contingencies
On March 3, 1997, the Company sued Affymetrix, Inc. in the U.S. District
Court for the Northern District of California, San Jose Division, alleging
infringement by Affymetrix of its U.S. Patent Nos. 5,202,231 and 5,525,464
(Hyseq, Inc. v. Affymetrix, Inc., Case No. C 97-20188 RMW (PVT)) (Hyseq I). On
May 5, 1997, the Company filed an Amended Complaint. On December 9, 1997, the
Company filed a second lawsuit against Affymetrix alleging infringement by
Affymetrix of its U.S. Patent No. 5,695,940 (Hyseq, Inc. v. Affymetrix, Inc.,
Case No. C-97 4469 THE) (Hyseq II). On April 22, 1998 the two cases were
consolidated before Judge Ronald M. Whyte.
The consolidated suits allege that Affymetrix willfully infringed, and
continues to infringe, the Company's patents covering SBH technology. Through
the lawsuit, the Company seeks both to enjoin Affymetrix from infringing its
patents covering SBH technology and an award of monetary damages for Affymetrix'
past
45
47
HYSEQ, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
infringement. On May 19, 1997, Affymetrix filed an Answer and Affirmative
Defenses to the First Amended Complaint in Hyseq I and also filed a counterclaim
against the Company. The counterclaim seeks a declaratory judgment of invalidity
and non-infringement with respect to the two patents asserted in Hyseq I. On
September 9, 1997, the Company filed a reply to the counterclaim in which it
denied the allegations of invalidity and non-infringement. A similar answer and
counterclaim was filed by Affymetrix in Hyseq II on December 28, 1997, and a
similar reply to the counterclaim was filed by the Company on January 29, 1998.
On August 1, 1997 (Hyseq I), and on March 28, 1998 (Hyseq II), initial case
management conferences were held in each case in which the Court entered a
pre-trial schedule. The Court held a claims construction hearing on November 17
and 18, 1998 in Hyseq I and II. On July 12, 1999, Affymetrix filed an amended
answer and counterclaim alleging the additional defense that the patents were
obtained through inequitable conduct. On October 27, 1999, the Court issued a
claims construction Order construing terms in the claims of the patents-in-suit
and inviting the parties to submit briefs setting forth any perceived errors or
inconsistencies in the Order. Affymetrix and the Company submitted briefs on
December 17 and 27, 1999, respectively. On January 7, 2000, the Court held a
further Case Management Conference. On February 22, 2000, the Court received
oral argument from the parties regarding the claims construction Order. On July
27, 2000, the Court issued a modified claims construction Order. Affymetrix and
the Company are currently engaged in pretrial discovery during which documents
and other written discovery are being exchanged and depositions are being taken.
While the Company believes it has asserted valid claims and has meritorious
defenses to the counterclaims, this litigation is at an early stage and there
can be no assurance that the Company will prevail in these actions.
On August 18, 1998, Affymetrix filed suit against the Company in the U.S.
District Court for the Northern District of California, San Francisco Division,
alleging that the Company infringed two of Affymetrix' U.S. Patents Nos.
5,795,716 and 5,744,305 (Affymetrix, Inc. v. Hyseq, Inc., Case No. C 98-13192).
Affymetrix filed an amended complaint on September 1, 1998 alleging infringement
of its U.S. Patent No. 5,800,992. The case was reassigned to Judge Jeremy Fogel
in the San Jose Division. At the time of the assignment to Judge Fogel, the case
was also renumbered as Case No. C 99-21163 JF (MEJ). A Case Management
Conference before Judge Fogel was held on July 10, 2000. A claims construction
hearing was held November 29 - 30, 2000 with respect to U.S. Patents Nos.
5,445,934, 5,744,305, 5,800,992 and 5,795,716. The Court issued an Order on
January 22, 2001 construing certain claim terms and requesting additional
briefing regarding U.S. Patent No. 5,800,992. The Company believes that
Affymetrix' allegations are without merit and intends to vigorously defend the
action. However, the litigation is at a very early stage and it is impossible to
predict the ultimate outcome of this matter.
On October 26, 1999, the Company filed a third lawsuit against Affymetrix
in the U.S. District Court for the Northern District of California, San
Francisco Division (Hyseq, Inc. v. Affymetrix, Inc., Case No. C-99 4735 MJJ)
(Hyseq III), alleging infringement by Affymetrix of its U.S. Patent No.
5,972,619 ('619 Patent). The Company also alleges that Affymetrix' U.S. Patent
No. 5,795,716 is invalid because the subject matter was first invented by the
Company's scientists and is claimed and covered by its '619 Patent. Affymetrix
filed an answer and counterclaim on November 15, 1999. The counterclaim seeks a
declaratory judgment of invalidity, unenforceability and non-infringement with
respect to the Company's '619 Patent. On December 9, 1999, the Company filed a
reply to the counterclaim in which it denied the allegations of invalidity,
unenforceability, and non-infringement. Subsequently, Hyseq III was reassigned
to Judge Fogel and was given Case No. C-00-20050 JF/PVT. A Case Management
Conference was held on July 10, 2000 along with Affymetrix, Inc. v. Hyseq, Inc.
On September 6, 2000, the Company filed a motion seeking the Court's permission
to supplement its complaint in Hyseq III to add a claim for infringement by
Affymetrix of its U.S. Patent No. 6,018,041 ('041 patent), which was issued on
January 25, 2000. On November 2, 2000, Judge Fogel granted the motion. On
October 12, 2000, Affymetrix filed an Ex Parte application before Judges Fogel
and Whyte requesting reassignment of the Company's infringement claims under the
'619 patent from Judge Fogel to Judge Whyte. On November 2, 2000, Judges Fogel
and Whyte reassigned the Company's
46
48
HYSEQ, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
infringement claims against Affymetrix under the '619 patent (as well as its
infringement claims against Affymetrix under the '041 patent) to Judge Whyte,
and ordered that the claim construction of the '619 patent claims would proceed
before Judge Whyte. On March 20, 2001, the Court issued a tentative Claims
Construction Order construing terms in the '619 patent. In the Order, Judge
Whyte indicated that the tentative order will be adopted as the Claims
Construction Order unless one of the parties files a written request for a
hearing within 15 days.
On January 20, 2001, the USPTO Board of Patent Appeals and Interferences
declared an interference between one of the Company's pending patent
applications covering subject matter related to SBH technology and Affymetrix'
issued patent no. 5,795,716 (Chee and Lipshutz v. Drmanac and Crkvenjakov). The
Company is the senior party to the interference.
The Company has incurred substantial costs and expended substantial
personnel time in asserting its patent rights and defending its technology
against Affymetrix and may continue to incur such costs in asserting its patent
rights and defending its technology against Affymetrix or others. There can be
no assurance that the Company will be successful in these efforts. Failure to
successfully enforce the Company's patent rights or the loss of these patent
rights covering SBH technology could remove a legal obstacle to competitors in
designing platforms with similar competitive advantages.
7. COLLABORATIVE AGREEMENTS
In December 1999, the Company entered into a collaboration with American
Cyanamid Company in which the Company uses its screening-by-hybridization
technology to target agricultural products. During 2000, BASF Aktiengesellschaft
acquired the crop protection business of American Cyanamid Company and
subsequently assigned our collaboration with American Cyanamid to BASF Plant
Sciences GmbH (BASF). The collaboration provides for funding of $60 million over
its initial term of three and one half years. The collaboration can be extended
by mutual agreement for up to four additional one-year terms. Subject to
compliance with the terms of the contract, the Company expects to recognize
revenue from this collaboration over the term of the agreement as services are
performed. Total revenue recognized in 2000 under the agreement was $11.7
million. BASF has the exclusive right to commercialize any agricultural products
resulting from the collaboration. The Company will receive royalties on any such
products. The agreement requires the Company to generate data at a specified
level per year that, if not met, could result in its breach of the agreement.
In October 1998, the Company entered into a collaboration with Kirin
Brewery Co. Ltd. (Kirin), in which the Company used its proprietary gene
discovery technologies to target novel genes relating to a specific growth
factor activity from certain cell lines provided by Kirin. The Company retains
exclusive rights to develop and market pharmaceutical products resulting from
the collaboration in North America, subject to milestone and royalty payments to
Kirin. Kirin retains equivalent rights and obligations in Asia and Oceania. The
Company and Kirin share such rights equally in Europe and the rest of the world.
Under the terms of the agreement, Kirin paid the Company $3.0 million for the
initial phase of the collaboration. Total revenue recognized in 2000, 1999 and
1998 under the agreement was $0.3 million, $1.2 million and $1.5 million,
respectively. The agreement has been extended through March 2001.
In May 1997, the Company entered into an exclusive collaboration with
Chiron Corporation (Chiron). Pursuant to the terms of the collaboration
agreement, the Company and Chiron are collaborating to develop solid tumor
therapeutics, diagnostic molecules and vaccines. The collaboration had an
initial term of three years and has been extended by Chiron for an additional
two-year period. Chiron may extend the collaboration for one more two-year
period. Chiron has the exclusive right to commercialize solid tumor
therapeutics, diagnostic molecules and vaccines resulting from the
collaboration. The Company will receive royalties on any such products.
Concurrently with execution of the collaboration agreement in 1997, Chiron made
an equity investment of $5.0 million in return for shares of the Company's
preferred stock, which subsequently
47
49
HYSEQ, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
converted into common stock upon the Company's initial public offering in 1997.
Chiron also purchased shares of common stock directly from the Company in a
private placement concurrent with the Company's initial public offering in 1997
for an aggregate purchase price of $2.5 million. Total revenue recognized in
2000, 1999, and 1998 under the agreement with Chiron was $3.3 million, $4.9
million, and $8.1 million, respectively, which the Company received as research
funding payments and recognized as revenue as earned. The Company has no future
performance obligations related to the revenue recognized in 2000, 1999 and 1998
and no portions of such revenues are refundable.
In May 1997, the Company entered into an agreement with the Applied
Biosystems Group of Applera Corporation (Applied Biosystems) to combine certain
of the Company's chip technology and Applied Biosystems' life science system
capabilities to commercialize the HyChip system. Pursuant to the terms of the
agreement, the Company committed $5.0 million to further development of the
Company's "chip" component of the HyChip system. The Company spent approximately
$2.0 million for the development of the chip component of the HyChip system from
June 1997 through December 1997. Of this amount, $0.5 million was reimbursed to
the Company under its NIST grant. As of December 31, 1998, the Company had
satisfied the $5.0 million obligation under its agreement with Applied
Biosystems. The collaboration has an initial term of five years and will be
extended automatically thereafter unless the parties mutually agree to terminate
the collaboration. Pursuant to the agreement, the design, development and
manufacture of the HyChip "chip" is under the direction of the Company, while
design, development, manufacture and marketing of the system is under the
direction of Applied Biosystems. The HyChip system will be distributed through
Applied Biosystems. In June 1997 Applied Biosystems made an equity investment of
$5.0 million in return for shares of the Company's preferred stock, which
subsequently converted into common stock upon the Company's initial public
offering in 1997. Applied Biosystems also purchased shares of common stock
directly from the Company in a private placement concurrent with the initial
public offering in 1997 for an aggregate purchase price of $5.0 million. The
Company recognized approximately $0.3 million in revenue in each of 2000 and
1999 from Applied Biosystems from research funding reimbursement under the
collaboration and from an expansion of the existing relationship as services
were performed.
In February 1998, the Company entered into a collaborative agreement with
the University of California San Francisco (UCSF) to conduct research on genes
that may have important roles in the development of cardiovascular and related
diseases. Under the terms of the five-year agreement, the Company makes
quarterly payments of approximately $0.1 million to UCSF in connection with the
agreement to reimburse UCSF for direct and indirect expenses incurred in
clinical sample collection and for research conducted.
8. STOCKHOLDERS' EQUITY
Preferred Stock
The Company is authorized to issue 8,000,000 shares of preferred stock. The
Company's Board of Directors may set the rights and privileges of any preferred
stock issued.
As of December 31, 2000 and 1999, there were no issued and outstanding
shares of preferred stock. On June 5, 1998, Hyseq's Board of Directors adopted a
rights plan and declared a dividend with respect to each share of common stock
then outstanding. This dividend took the form of a right that entitles the
holders to purchase one one-thousandth of a share of our Series B Junior
Participating Preferred Stock at a purchase price of $175, subject to adjustment
from time to time. These rights have also been issued in connection with each
share of common stock issued after June 5, 1998. The rights are exercisable only
if a person or entity or affiliated group of persons or entities acquires, or
has announced its intention to acquire, 15% (27.5% in the case of certain
approved stockholders) or more of the Company's outstanding common stock. The
adoption of the rights plan makes it more difficult for a third party to acquire
control of the Company without the approval of the Board of Directors.
48
50
HYSEQ, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Common Stock
In January 2000, a former officer of the Company repaid two promissory
notes, which were recorded as a reduction to stockholders' equity, plus accrued
interest totaling $2,003,624. The notes were repaid by surrendering to the
Company approximately 56,000 shares of common stock that were cancelled.
In February 2000, a former officer and director of the Company repaid two
promissory notes, which were recorded as a reduction to stockholders' equity,
plus accrued interest totaling $1,811,208. The notes were repaid by surrendering
to the Company approximately 15,000 shares of common stock that were cancelled.
Deferred Compensation
The Company recorded deferred compensation of $695,000 in 1997 representing
the difference between the issuance and exercise prices related to stock awards
and options and the fair value for financial reporting purposes of the Company's
common stock. The deferred compensation is being amortized to expense over the
vesting period of the options and over the two-year repurchase period for the
stock awards. The deferred compensation expense was $29,000, $89,000, and
$319,000 in 2000, 1999, and 1998, respectively. At December 31, 2000, the
deferred compensation balance was approximately $8,000.
Warrants
As of December 31, 2000, warrants to purchase 312,881 shares of common
stock were outstanding at exercise prices ranging from $3.42 to $5.21 ($3.79
weighted average exercise price) per share. These warrants are held by certain
investors and executive officers and expire at various times between November
2001 and July 2002.
Stock Option Plans
In 1995, the Company's stockholders adopted the 1995 Employee Stock Option
Plan (1995 Plan). The Company initially reserved a total of 1,152,000 common
shares for issuance under the 1995 Plan. At the 1998 annual meeting, the
Company's stockholders approved a proposal to increase the number of shares
authorized for issuance under the Plan to 2,152,000. Options granted under the
1995 Plan may be either incentive stock options or nonstatutory stock options.
Incentive stock options may be granted to employees with exercise prices of not
less than fair value and nonstatutory options may be granted to employees at
exercise prices of not less than par value of the common stock on the date of
grant as determined by the board of directors. Options vest as determined by the
board of directors (generally in four equal annual installments commencing one
year after the date of grant), and expire 10 years from the date of grant. At
December 31, 2000, 1,181,518 options were outstanding under the 1995 Plan.
The Company granted options to purchase common stock to several key
employees, directors, scientific advisory board members and scientists prior to
adoption of the 1995 Plan. Each option gives the holder the right to purchase
common stock at prices between $0.78 and $1.82 per share. In 1998, the Company
granted options outside of any of the Company's stock option plans to purchase a
total of 9,500 shares of common stock to three non-employee directors and a
scientific advisory board member at prices between $4.75 and $10.06 per share.
The options vest over periods up to four years. In February 2000, an officer and
director of the Company was granted an option to purchase 1,000,000 shares of
common stock at $31.69 per share, the closing price on the day prior to the
grant, as an inducement to become an employee of the Company. This option
becomes exercisable one-third upon the date of grant, one-third on the one-year
anniversary and one third on the two-year anniversary of the date of grant. As
of December 31, 2000, 1,276,946 options issued outside of any of the Company's
stock option plans were outstanding.
In 1997, the Company's stockholders adopted the Non-Employee Director Stock
Option Plan (Directors Plan) providing for periodic stock option grants to
non-employee directors of the Company. Under the
49
51
HYSEQ, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Directors Plan, each new, non-employee director receives a one-time grant of
options to purchase 23,040 shares of common stock, of which options to purchase
11,520 shares vest immediately, with the balance vesting in two equal allotments
on the first and second anniversaries of joining the Board. All non-employee
directors automatically receive options to purchase up to 5,760 shares each year
(such that the amount received under the Directors Plan when added to all prior
options granted to a director which vest in that year total 5,760) on the date
of the annual meeting of the stockholders commencing in 1997. Options under the
Directors Plan are granted at the fair market value of the Company's common
stock on the date of the grant. In 2000, the Company's stockholders approved an
amendment to the Directors Plan that changed the method for determining the
number of shares granted under the Plan, and lengthened the vesting date for the
new director's initial and first annual grants of options. Under the amendment,
the number of shares that are granted will be equal to the lesser of the number
determined by dividing $200,000 by the fair market value of our common stock on
the date of grant, or 10,000 shares. The amendment also revised the vesting date
for initial options that are granted when a new director joins our Board such
that 50% of a new director's option will vest one year after the grant date and
the other 50% will vest two years after the grant date. A total of 138,240
shares of common stock have been reserved for issuance under the Directors Plan,
of which options to purchase 102,915 shares were outstanding at December 31,
2000.
In 1999, the Company adopted a Scientific Advisory Board/Consultants Stock
Option Plan (SAB Plan), which provides for periodic grants of non-qualified
stock options to members of the Company's scientific advisory board and allows
the Board of Directors to approve grants of stock options to consultants. A
total of 30,000 shares of common stock have been reserved for issuance under the
SAB Plan, of which options to purchase 5,000 shares were outstanding at December
31, 2000. The Company recorded compensation expense of $157,000 in accordance
with SFAS 123 for stock options issued to non-employees during 2000, all of
which became exercisable on the date of grant. The fair value for these options
was estimated at the date of grant using the Black-Scholes option pricing model
with the following weighted-average assumptions: 10 years for the expected life
of the option, 6.2% risk-free interest rate, and 1.11 volatility rate.
The Directors Plan, the 1995 Plan, and the options granted to an officer
and director to purchase 1,000,000 shares (as described above) provide for the
acceleration of vesting of options upon certain specified events.
The Company values employee stock options using the intrinsic method of APB
25, rather than the fair value method of SFAS 123. Nevertheless, the Company is
required for purposes of comparison to present net loss and loss per share on a
pro forma basis as if the fair value method had been used. The fair value for
employee stock options was estimated at the date of grant using the
Black-Scholes option pricing model with the following weighted-average
assumptions:
YEAR ENDED DECEMBER 31,
-------------------------------------
2000 1999 1998
--------- --------- ---------
Volatility....................................... 1.38 1.64 .77
Risk-free interest rate.......................... 6.14% 6.25% 4.8%
Dividend yield................................... -- -- --
Expected life of option.......................... 2.6 years 2.5 years 2.3 years
The Black-Scholes option pricing model was developed for use in estimating
the fair value of traded options, which have no vesting restrictions and are
fully transferable. Because the Company's employee stock options have
characteristics significantly different from those of traded options, and
because changes in the subjective input assumptions can materially affect the
fair value estimate, in management's opinion, the existing models do not
necessarily provide a reliable single measure of the fair value of its employee
stock options.
50
52
HYSEQ, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
For purposes of pro forma disclosures, the estimated fair value of the
options is amortized to expense over the options' vesting period. Because SFAS
123 is applicable only to options granted subsequent to December 15, 1994, the
pro forma adjustment to net income was not fully reflected until fiscal year
1999.
The Company's pro forma information follows (in thousands, except for per
share information):
YEAR ENDED DECEMBER 31,
--------------------------------
2000 1999 1998
-------- -------- --------
Net loss as reported............................... $(22,253) $(18,547) $(16,369)
Pro forma net loss................................. (42,717) (19,484) (16,896)
Basic and diluted net loss per share as reported... (1.65) (1.43) (1.27)
Pro forma basic and diluted net loss per share..... (3.18) (1.50) (1.31)
A summary of the Company's stock option activity, and related information
follows:
YEAR ENDED DECEMBER 31,
--------------------------------------------------------------------------
2000 1999 1998
---------------------- ---------------------- ----------------------
WEIGHTED- WEIGHTED- WEIGHTED-
AVERAGE AVERAGE AVERAGE
NUMBER OF EXERCISE NUMBER OF EXERCISE NUMBER OF EXERCISE
SHARES PRICE SHARES PRICE SHARES PRICE
--------- --------- --------- --------- --------- ---------
Options outstanding at
beginning of period... 1,779,324 $ 3.80 1,583,558 $4.03 1,356,941 $3.88
Options granted....... 1,500,275 $31.80 776,720 $3.77 424,780 $5.87
Options exercised..... (562,722) $ 3.29 (144,466) $1.96 (39,138) $3.17
Options canceled...... (150,498) $ 7.19 (436,488) $5.18 (159,025) $7.91
--------- ------ --------- ----- --------- -----
Options outstanding at
end of period......... 2,566,379 $20.10 1,779,324 $3.80 1,583,558 $4.03
========= ====== ========= ===== ========= =====
The following table summarizes information about stock options outstanding
and exercisable at December 31, 2000:
OPTIONS OUTSTANDING
--------------------------------------------- OPTIONS EXERCISABLE
WEIGHTED- --------------------------
AVERAGE WEIGHTED- WEIGHTED-
RANGE OF NUMBER OF REMAINING AVERAGE NUMBER OF AVERAGE
EXERCISE PRICE SHARES CONTRACTUAL LIFE EXERCISE PRICE SHARES EXERCISE PRICE
- ---------------- --------- ---------------- -------------- --------- --------------
$ 0.78 - $ 3.30 558,382 6.77 $ 2.67 268,840 $ 2.00
$ 4.17 - $ 8.33 516,736 7.11 $ 5.43 296,607 $ 5.38
$10.06 - $ 31.00 385,861 9.70 $28.22 61,530 $24.23
$31.69 - $ 31.69 1,000,000 9.08 $31.69 333,333 $31.69
$31.88 - $101.44 105,400 9.49 $44.67 18,000 $48.47
--------- -------
2,566,379 8.29 $20.10 978,310 $15.39
========= =======
The weighted-average grant-date fair value of options granted during the
years ended December 31, 2000, 1999 and 1998 was $22.90, $3.52 and $3.71,
respectively.
Employee Stock Purchase Plan
In 1998, the Company's stockholders approved an Employee Stock Purchase
Plan (ESPP), covering an aggregate of 50,000 shares of the Company's common
stock. Each quarter, an eligible employee may elect to purchase shares of the
Company's stock through payroll deductions at a price equal to the lower of 85%
of the fair value of the stock as of the first business day of the quarter or
the last business day. In 1999, the Company's stockholders approved an amendment
to the Company's ESPP that increased the maximum
51
53
HYSEQ, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
number of shares of common stock available for purchase under the Plan from
50,000 to 250,000. In the year ended December 31, 2000, 21,973 shares of the
Company's stock were sold under the ESPP at a weighted-average price of $14.14
per share.
In 1999, the Company adopted a Non-Qualified Stock Purchase Plan covering
an aggregate of 50,000 shares of the Company's common stock, of which no shares
were sold as of December 31, 2000.
9. INCOME TAXES
A summary of the components of income tax expense as of December 31, 2000
follows (in thousands):
CURRENT DEFERRED TOTAL
------- -------- -----
Federal.................................................. -- -- --
State.................................................... -- -- --
-- -- --
Total.......................................... -- -- --
== == ==
The reconciliation between the amount computed by applying the U.S. federal
statutory tax rate of 34% to income taxes and the actual provision for income
taxes as of December 31, 2000 follows (in thousands):
Income tax at statutory rate (34%).......................... (7,566)
Net losses and temporary differences for which no current
benefit is recognized..................................... 11,322
Permanent differences....................................... (3,756)
------
Income tax expense reported................................. --
======
As of December 31, 2000, the Company had federal and state net operating
loss carryforwards of approximately $81.3 million and $22.2 million,
respectively. The Company also had federal and California research and
development tax credit carryforwards of approximately $3.8 million and $3.7
million, respectively. The federal net operating loss and credit carryforwards
will expire at various dates beginning in the year 2008 through 2020, if not
utilized. The State of California net operating losses will expire at various
dates beginning in 2001 through 2010, if not utilized.
Utilization of the Company's net operating loss carryforwards and credits
may be subject to an annual limitation due to the "change in ownership"
provisions of the Internal Revenue Code of 1986 and similar state provisions.
The annual limitation may result in the expiration of net operating losses and
credits before utilization.
Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets for financial reporting and the amount
used for income tax purposes. Significant components of the Company's deferred
tax assets for federal and state income taxes are as follows (in thousands):
YEAR ENDED DECEMBER 31,
------------------------
2000 1999
---------- ----------
Deferred Tax Assets:
Net operating loss carryforwards..................... $ 28,971 $ 16,400
Research and other credits........................... 6,564 3,100
Capitalized research expenses........................ 856 1,300
Other -- net......................................... 1,362 1,300
-------- --------
Total deferred tax assets.................... 37,753 22,100
Valuation allowance.................................. (37,753) (22,100)
-------- --------
Net deferred tax assets.............................. $ -- $ --
======== ========
52
54
HYSEQ, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Deferred tax assets are reduced by a valuation allowance as management
believes that it is more likely than not that the deferred tax assets will not
be realized. The net valuation allowance increased by $15.7 million, $8.3
million and $8.5 million for the fiscal years ended December 31, 2000, 1999 and
1998, respectively.
Approximately $11.9 million of the federal net operating losses and $6.4
million of the state net operating losses relate to deductions from stock based
compensation. No income statement benefit will result from the realization of
these losses.
10. TRANSACTIONS WITH RELATED PARTIES
As of December 31, 2000, 1999 and 1998, the Company had outstanding
accounts payable balances of $44,882, $86,180 and $100,237, respectively, for
professional services rendered by a law firm of which the spouse of the
Company's then President and Chief Executive Officer was a member during these
periods. The Company incurred legal fees and costs to this law firm of
approximately $400,000, $441,000 and $979,000 for the years ended December 31,
2000, 1999 and 1998, respectively.
In November 2000, the Company received a commitment from its Chairman to
provide a line of credit of up to $20.0 million in aggregate principal amount,
secured by a promissory note and available for draw down through November 29,
2002. Amounts outstanding under the line of credit bear interest at prime plus
1% and are payable in 48 equal monthly installments beginning upon the
expiration date of November 30, 2002. The promissory note issued pursuant to
such line of credit may be converted at the Company's option into shares of its
common stock at fair market value on the day the Company elects such conversion.
No amounts were drawn on this line of credit at December 31, 2000. In March
2001, the Company completed the draw down of the balance of the $20.0 million
available under the line of credit and paid off the outstanding principal
balance in shares of the Company's common stock as provided in the agreement. As
a consequence, the Company issued 2,237,637 shares of common stock to its
Chairman in satisfaction of $20.0 million of outstanding principal under the
line of credit. In February 2000, the Company granted an option to its Chairman
to purchase 1,000,000 shares as an incentive to join the Company as an employee.
The Chairman receives no cash compensation as an employee and instead receives
options to purchase 3,000 shares per month. However, to date, at the request of
the Chairman, the Company has not granted the Chairman any equity incentives
appropriate for an active Chairman of the Board, or in recognition of the line
of credit that the Chairman made available to the Company. While the Board has
taken no formal action to date, the Company believes that the Board is likely to
take action in the future to provide appropriate incentives to the Chairman in
order to ensure his continued active involvement in the Company.
11. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
Summarized selected quarterly financial data is as follows (in thousands):
QUARTER ENDED
------------------------------------------------------
DECEMBER 31, SEPTEMBER 30, JUNE 30, MARCH 31,
2000 2000 2000 2000
------------ ------------- -------- ---------
Contract revenues............................ $ 4,289 $ 5,936 $ 3,574 $ 1,805
------- ------- ------- -------
Loss from operations....................... $(6,627) $(4,199) $(5,331) $(6,572)
======= ======= ======= =======
Net loss................................ $(6,695) $(4,116) $(5,112) $(6,330)
======= ======= ======= =======
Basic and diluted net loss per share......... $ (0.49) $ (0.30) $ (0.38) $ (0.48)
======= ======= ======= =======
53
55
HYSEQ, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
QUARTER ENDED
------------------------------------------------------
DECEMBER 31, SEPTEMBER 30, JUNE 30, MARCH 31,
1999 1999 1999 1999
------------ ------------- -------- ---------
Contract revenues............................ $ 1,112 $ 1,490 $ 1,043 $ 2,752
------- ------- ------- -------
Loss from operations....................... $(5,284) $(4,656) $(4,882) $(5,039)
======= ======= ======= =======
Net loss................................ $(5,078) $(4,332) $(4,534) $(4,603)
======= ======= ======= =======
Basic and diluted net loss per share......... $ (0.39) $ (0.33) $ (0.35) $ (0.36)
======= ======= ======= =======
Historically, the Company's revenues have varied considerably from period
to period due to the nature of the Company's collaborative arrangements. As a
consequence, the Company's results in any one quarter are not necessarily
indicative of results to be expected for a full year.
The fourth quarter of 2000 included (i) an adjustment to reduce contract
revenues of approximately $402,000 and (ii) the write-off of certain capitalized
software costs of approximately $562,000.
12. SUBSEQUENT EVENTS
In January 2001, the Company entered into an employment agreement with an
officer and director of the Company. Pursuant to the employment agreement, the
officer will receive a severance package upon termination of his employment
under certain conditions. In addition, the employment agreement provided that
the officer would receive a payment of $4.0 million, less an offset measured by
appreciation of certain vested options, if the officer were not promoted to the
position of chief executive officer by July 1, 2002, or, if earlier, upon a
change of control of the Company under certain circumstances. The officer was
promoted to Chief Executive Officer in March 2001.
Also pursuant to the employment agreement, the officer was granted an
option to purchase 500,000 shares of common stock as an inducement to become an
employee of the Company. Of the 500,000 shares, this officer was granted (i) an
option under the Company's 1995 Employee Stock Option Plan to purchase 31,840
shares at an exercise price of $12.56 per share, the fair market value on the
date of grant as determined under the 1995 Plan, which shares become exercisable
in four equal annual installments commencing one year after the date of grant,
and (ii) an option to purchase 468,160 shares at an exercise price of $12.50 per
share, the closing price on the date of grant, of which 150,000 shares became
exercisable immediately and the remainder become exercisable in four equal
annual installments commencing one year after the date of grant. These option
agreements provide for the acceleration of vesting of options upon certain
specified events.
Also pursuant to the employment agreement, the Company entered into a loan
agreement with this officer. Under the terms of the loan agreement, the officer
may borrow up to $2.0 million from the Company. The interest rate on the loan is
the lowest applicable federal interest rate or such other higher rate of
interest, if required, to constitute a market rate of interest as contemplated
by the Rules and Regulations of the Financial Accounting Standards Board and the
U.S. Securities and Exchange Commission. Interest accrues but is deferred and
all interest and principal is due in January 2006.
The employment agreement provides that, at any time following his first
year of employment but before the third anniversary of beginning his employment,
this officer may forfeit the option to purchase 150,000 of the 500,000 shares of
the option granted to him in exchange for $2.0 million plus the accrued interest
under the loan agreement and the loan then becomes immediately due and payable.
The guaranteed value of the 150,000 options at $2.0 million will be recognized
ratably as compensation expense over the service period of one year.
In November 2000, the Company received a commitment from its Chairman to
provide a line of credit of up to $20.0 million in aggregate principal amount
secured by a promissory note. The promissory note issued pursuant to such line
of credit may be converted at the Company's option into shares of its common
stock at
54
56
HYSEQ, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
fair market value on the day the Company elects such conversion. No amounts were
drawn on this line of credit at December 31, 2000. On March 20, 2001, the
Company's Board of Directors decided to complete the draw down of the balance of
the $20.0 million available under the line of credit and pay off the outstanding
principal balance in shares of the Company's common stock, as provided in the
agreement. As a consequence, the Company issued 2,237,637 shares of common stock
to its Chairman in satisfaction of $20.0 million of outstanding principal under
the line of credit. See Note 10 of Notes to Consolidated Financial Statements.
55
57
ITEM 9.CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE
On April 21, 2000, the Company engaged the accounting firm of KPMG LLP
(KPMG) as its independent auditors to audit the Company's financial statements
for its fiscal year ending December 31, 2000. The engagement of new independent
auditors was approved by the Audit Committee and Board of Directors of the
Company. The Company dismissed its former independent auditors, Ernst & Young
(E&Y) effective as of April 7, 2000.
During the fiscal years ended December 31, 1999 and 1998, there were no
disagreements with E&Y on any matter of accounting principles or practices,
financial statement disclosures, or auditing scope or procedure which would have
caused E&Y to make reference in their report to such disagreements if not
resolved to their satisfaction. E&Y's reports on the financial statements for
the years ended December 31, 1999 and 1998, contained no adverse opinion or
disclaimer of opinion and were not modified as to uncertainty, audit scope or
accounting principles.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The response to this item is incorporated by reference from the discussion
responsive thereto under the captions "Management" and "Compliance with Section
16(a) of the Securities Exchange Act of 1934" in the Company's Proxy Statement
for its 2001 Annual Meeting of Stockholders.
ITEM 11. EXECUTIVE COMPENSATION
The response to this item is incorporated by reference to the Company's
Proxy Statement to be filed pursuant to Regulation 14A under the Securities
Exchange Act of 1934, as amended (Exchange Act), in connection with the
Company's annual meeting of stockholders.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The response to this item is incorporated by reference to the Company's
Proxy Statement to be filed pursuant to Regulation 14A under the Exchange Act,
in connection with the Company's annual meeting of stockholders.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The response to this item is incorporated by reference to the Company's
Proxy Statement to be filed pursuant to Regulation 14A under the Exchange Act,
in connection with the Company's annual meeting of stockholders.
56
58
PART IV
ITEM 14.EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a)(1) The Financial Statements and report of independent auditors required
by this Item are submitted in a separate section, beginning on page 35 of this
Report.
PAGE
NO.
----
Report of KPMG LLP, Independent Auditors.................... 35
Report of Ernst & Young LLP, Independent Auditors........... 36
Consolidated Balance Sheets................................. 37
Consolidated Statements of Operations....................... 38
Consolidated Statements of Stockholders' Equity............. 39
Consolidated Statements of Cash Flows....................... 40
Notes to Consolidated Financial Statements.................. 41
(a)(2) The schedules have been omitted because they are not applicable or
are not required or the information required to be set forth therein is included
in the Financial Statements or notes thereto.
(a)(3) Exhibits
The following documents are filed as part of this annual report on Form
10-K. The Company will furnish a copy of any exhibit listed to requesting
stockholders upon payment of the Company's reasonable expenses in furnishing
those materials.
EXHIBIT
NUMBER DESCRIPTION
------- -----------
3.1 Amended and Restated Articles of Incorporation of the
Company, as amended*
3.2(c) Amended and Restated By-Laws of the Company
4.1 Specimen Common Stock certificate*
4.2 Form of Registration Rights Agreement*
4.3 Form of Warrant Agreement*
4.4 Rights Agreement between Hyseq, Inc. and U.S. Stock Transfer
dated June 5, 1998**
10.1 Form of Indemnification Agreement between the Company and
each of its directors and officers*
10.2 Stock Option Plan, as amended+***
10.4 Non-Employee Director Stock Option Plan, as amended+****
10.5 Patent License Agreement between Arch Development
Corporation and Hyseq, Inc. dated June 7, 1994*
10.6 Stock Purchase Agreement for Series B Convertible Preferred
Stock dated May 28, 1997*
10.7 Collaboration Agreement between Hyseq Inc. and Chiron
Corporation dated May 28, 1997*
10.9 Collaboration Agreement between Hyseq Inc. and The
Perkin-Elmer Corporation dated May 28, 1997*
10.11 Employee Stock Purchase Plan+*****
10.12 Non-Qualified Employee Stock Purchase Plan********
10.13 Scientific Advisory Board/Consultants Stock Option
Plan********
10.14 Collaboration Agreement between Hyseq, Inc. and American
Cyanamid Company dated December 10, 1999******
10.15 Line of Credit Agreement between Hyseq, Inc. and Dr. George
B. Rathmann dated November 10, 2000*******
10.16 Employment Agreement between Hyseq, Inc. and Ted W. Love
dated January 11, 2001
57
59
EXHIBIT
NUMBER DESCRIPTION
------- -----------
10.17 Lease by and between AMB Property, L.P. and Hyseq, Inc.
dated June 23, 2000
21.1 Subsidiaries of Hyseq, Inc. as of December 31, 2000:
GeneSolutions Inc., a Nevada corporation
Hyseq Diagnostics, Inc., a Nevada corporation
23.1 Consent of KPMG LLP, Independent Auditors
23.2 Consent of Ernst & Young LLP, Independent Auditors
- ---------------
* Previously filed with the Commission as an Exhibit to and incorporated
herein by reference from the Company's Registration Statement filed on
Form S-1, File No. 333-29091.
** Previously filed with the Commission as an Exhibit to and incorporated
herein by reference from the Company's Form 8-K, filed on July 31,
1998, File No. 00-22873.
*** Previously filed with the Commission as an Exhibit to and incorporated
herein by reference from the Company's Registration Statement on Form
S-8, File No. 333-41663.
**** Previously filed with the Commission as an Exhibit to and incorporated
herein by reference from the Company's Registration Statement on Form
S-8, File No. 333-53089.
***** Previously filed with the Commission as an Exhibit to and incorporated
herein by reference from the Company's Registration Statement on Form
S-8, File No. 333-53087.
****** Previously filed with the Commission as an Exhibit to and incorporated
herein by reference from the Company's report on Form 8-K/A, filed on
March 17, 2000, File No. 00-22873.
******* Previously filed with the Commission as an Exhibit to and incorporated
herein by reference from the Company's report on Form 8-K, filed on
December 14, 2000, File No. 000-22873.
******** Previously filed with the Commission as an Exhibit to and incorporated
herein by reference from the Company's Annual Report on Form 10-K for
the year ended December 31, 1999, File No. 000-22873.
+ Denotes compensation plan in which an executive officer or director
participates.
(b) Reports on Form 8-K.
One report on Form 8-K was filed on behalf of the Company during the last
quarter of the year ended December 31, 2000 (Form 8-K filed on December 14,
2000, which included as an exhibit the Line of Credit Agreement between Hyseq,
Inc. and Dr. George B. Rathmann dated November 10, 2000).
58
60
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) the Securities Exchange
Act of 1934, the Registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized, in the City of Sunnyvale,
State of California, on March 30, 2001.
HYSEQ, INC.
By: /s/ TED W. LOVE
------------------------------------
Ted W. Love
President and Chief Executive
Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed by the following persons in the capacities indicated on
March 30, 2001.
SIGNATURE TITLE
--------- -----
/s/ TED W. LOVE President and Chief Executive
- ----------------------------------------------------- Officer (Principal Executive Officer),
Ted W. Love Director
/s/ MARK E. GITTER Chief Financial Officer
- ----------------------------------------------------- (Principal Financial and Accounting Officer)
Mark E. Gitter
/s/ GEORGE B. RATHMANN Chairman of the Board
- -----------------------------------------------------
George B. Rathmann
/s/ RADOJE T. DRMANAC Director
- -----------------------------------------------------
Radoje T. Drmanac
/s/ RAYMOND F. BADDOUR Director
- -----------------------------------------------------
Raymond F. Baddour
/s/ GRETA E. MARSHALL Director
- -----------------------------------------------------
Greta E. Marshall
/s/ THOMAS N. MCCARTER III Director
- -----------------------------------------------------
Thomas N. McCarter III
/s/ ERNST SCHWEIZER Director
- -----------------------------------------------------
Ernst Schweizer
/s/ ROBERT D. WEIST Director
- -----------------------------------------------------
Robert D. Weist
59
61
EXHIBIT INDEX
EXHIBIT
NUMBER DESCRIPTION
------- -----------
3.1 Amended and Restated Articles of Incorporation of the
Company, as amended*
3.2(c) Amended and Restated By-Laws of the Company
4.1 Specimen Common Stock certificate*
4.2 Form of Registration Rights Agreement*
4.3 Form of Warrant Agreement*
4.4 Rights Agreement between Hyseq, Inc. and U.S. Stock Transfer
dated June 5, 1998**
10.1 Form of Indemnification Agreement between the Company and
each of its directors and officers*
10.2 Stock Option Plan, as amended+***
10.4 Non-Employee Director Stock Option Plan, as amended+****
10.5 Patent License Agreement between Arch Development
Corporation and Hyseq, Inc. dated June 7, 1994*
10.6 Stock Purchase Agreement for Series B Convertible Preferred
Stock dated May 28, 1997*
10.7 Collaboration Agreement between Hyseq Inc. and Chiron
Corporation dated May 28, 1997*
10.9 Collaboration Agreement between Hyseq Inc. and The
Perkin-Elmer Corporation dated May 28, 1997*
10.11 Employee Stock Purchase Plan+*****
10.12 Non-Qualified Employee Stock Purchase Plan********
10.13 Scientific Advisory Board/Consultants Stock Option
Plan********
10.14 Collaboration Agreement between Hyseq, Inc. and American
Cyanamid Company dated December 10, 1999******
10.15 Line of Credit Agreement between Hyseq, Inc. and Dr. George
B. Rathmann dated November 10, 2000*******
10.16 Employment Agreement between Hyseq, Inc. and Ted W. Love
dated January 11, 2001
10.17 Lease by and between AMB Property, L.P. and Hyseq, Inc.
dated June 23, 2000
21.1 Subsidiaries of Hyseq, Inc. as of December 31, 2000:
GeneSolutions Inc., a Nevada corporation
Hyseq Diagnostics, Inc., a Nevada corporation
23.1 Consent of KPMG LLP, Independent Auditors
23.2 Consent of Ernst & Young LLP, Independent Auditors
- ---------------
* Previously filed with the Commission as an Exhibit to and incorporated
herein by reference from the Company's Registration Statement filed on
Form S-1, File No. 333-29091.
** Previously filed with the Commission as an Exhibit to and incorporated
herein by reference from the Company's Form 8-K, filed on July 31,
1998, File No. 00-22873.
*** Previously filed with the Commission as an Exhibit to and incorporated
herein by reference from the Company's Registration Statement on Form
S-8, File No. 333-41663.
**** Previously filed with the Commission as an Exhibit to and incorporated
herein by reference from the Company's Registration Statement on Form
S-8, File No. 333-53089.
***** Previously filed with the Commission as an Exhibit to and incorporated
herein by reference from the Company's Registration Statement on Form
S-8, File No. 333-53087.
****** Previously filed with the Commission as an Exhibit to and incorporated
herein by reference from the Company's report on Form 8-K/A, filed on
March 17, 2000, File No. 00-22873.
******* Previously filed with the Commission as an Exhibit to and incorporated
herein by reference from the Company's report on Form 8-K, filed on
December 14, 2000, File No. 000-22873.
62
******** Previously filed with the Commission as an Exhibit to and incorporated
herein by reference from the Company's Annual Report on Form 10-K for
the year ended December 31, 1999, File No. 000-22873.
+ Denotes compensation plan in which an executive officer or director
participates.