Back to GetFilings.com



Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

Form 10-K

 

(Mark One)

x   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2004

 

OR

 

¨   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from             to            

 

Commission file number:  000-31615

 


 

DURECT CORPORATION

(Exact name of registrant as specified in its charter)

 

Delaware   94-3297098
(State or other jurisdiction of
incorporation or organization)
 

(I.R.S. Employer

Identification No.)

 

10240 Bubb Road

Cupertino, CA 95014

(Address of principal executive offices, including zip code)

 

Registrant’s telephone number, including area code: (408) 777-1417

 


 

Securities registered pursuant to Section 12(b) of the Act:

None

 

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $0.0001 par value

(Title of Class)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period than 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.    x

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).    YES  x    NO  ¨

 

The aggregate market value of the voting stock held by non-affiliates of the registrant was approximately $125,910,995 as of June 30, 2004 based upon the closing sale price on the Nasdaq National Market reported for such date. Shares of Common Stock held by each officer and director and by each person who may be deemed to be an affiliate have been excluded. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

 

There were 51,875,088 shares of the registrant’s Common Stock issued and outstanding as of February 28, 2005.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Part III incorporates information by reference from the definitive Proxy Statement for the 2005 annual meeting of stockholders, which is expected to be filed not later than 120 days after the Registrant’s fiscal year ended December 31, 2004.

 



Table of Contents

DURECT CORPORATION

 

ANNUAL REPORT ON FORM 10-K

 

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004

 

TABLE OF CONTENTS

 

          Page

     PART I     

ITEM 1.

  

Business

   1

ITEM 2.

  

Properties

   22

ITEM 3.

  

Legal Proceedings

   22

ITEM 4.

  

Submission of Matters to a Vote of Security Holders

   22
     PART II     

ITEM 5.

  

Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

   23

ITEM 6.

  

Selected Financial Data

   23

ITEM 7.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   25

ITEM 7A.

  

Quantitative and Qualitative Disclosures About Market Risk

   54

ITEM 8.

  

Financial Statements and Supplementary Data

   56

ITEM 9.

  

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

   86

ITEM 9A.

  

Controls and Procedures

   86

ITEM 9B.

  

Other Information

   86
     PART III     

ITEM 10.

  

Directors and Executive Officers of the Registrant

   86

ITEM 11.

  

Executive Compensation

   86

ITEM 12.

  

Security Ownership of Certain Beneficial Owners and Management

   86

ITEM 13.

  

Certain Relationships and Related Transactions

   86

ITEM 14.

  

Principal Accountant Fees and Services

   86
     PART IV     

ITEM 15.

  

Exhibits and Financial Statement Schedules

   86

Signatures

   90

 

 


Table of Contents

PART I

 

Item 1.    Business.

 

Overview

 

We are an emerging specialty pharmaceuticals systems company focused on the development of pharmaceutical systems based on the following proprietary drug delivery technology platforms: the SABER Delivery System (a patented and versatile depot injectable useful for protein and small molecule delivery), the TRANSDUR Delivery System (a proprietary transdermal technology), the ORADUR sustained release oral gel-cap technology (an oral sustained release technology with several potential abuse deterrent properties), the DURIN Biodegradable Implant (a biodegradable drug-loaded implant), the DUROS® System, (an osmotic implant technology licensed to us for specified fields from ALZA Corporation, a Johnson & Johnson Company) and the MICRODUR Biodegradable Microparticulates (a microspheres injectable system).

 

Our pharmaceutical systems combine engineering innovations and delivery technology from the drug delivery and medical device industries with our proprietary pharmaceutical and biotechnology drug formulations. By integrating these technologies, we are able to control the rate and duration of drug administration as well as target the delivery of the drug to its intended site of action, allowing our pharmaceutical systems to meet the special challenges associated with treating chronic diseases or conditions. Our pharmaceutical systems can enable new drug therapies or optimize existing therapies based on a broad range of compounds, including small molecule pharmaceuticals as well as biotechnology molecules such as proteins, peptides and genes.

 

Our pharmaceutical systems are suitable for providing long-term drug therapy because they store highly concentrated, stabilized drugs in a small volume and can protect the drug from degradation by the body. This, in combination with our ability to continuously deliver precise and accurate doses of a drug, allows us to extend the therapeutic value of a wide variety of drugs, including those which would otherwise be ineffective, too unstable, too potent or cause adverse side effects. In some cases, delivering the drug directly to the intended site of action can improve efficacy while minimizing unwanted side effects elsewhere in the body, which often limit the long-term use of many drugs. Our pharmaceutical systems can thus provide better therapy for chronic diseases or conditions by replacing multiple injection therapy or oral dosing, improving drug efficacy, reducing side effects and ensuring dosing compliance. Our pharmaceutical systems can improve patients’ quality of life by eliminating more repetitive treatments, reducing dependence on caregivers and allowing patients to lead more independent lives.

 

We focus on the treatment of chronic diseases and the development of pharmaceutical product candidates incorporating pharmaceutical or biotechnology agents. We may also choose to develop product candidates for acute indications, such as our SABER-based post-operative pain product candidate, to the extent it makes strategic sense to do so. In addition to developing our own proprietary products, we also partner with pharmaceutical companies to develop and commercialize proprietary and enhanced pharmaceutical products based on our technologies. DURECT has five disclosed on-going development programs of which three are in collaboration with pharmaceutical partners. The following are our most advanced product candidates in development:

 

SABER-Bupivacaine

 

Our post-operative pain relief depot product candidate (SABER-bupivacaine) is a sustained release injectible using our SABER delivery system to deliver bupivacaine. SABER is a patented controlled drug delivery technology that can be formulated for systemic or local administration of drugs via the parenteral (i.e., injectible) or oral route. This product candidate is designed to be administered around a surgical site after surgery

 


NOTE: CHRONOGESIC®, ALZET®, SABER, TRANSDUR, LACTEL®, DURIN and MICRODUR are trademarks of DURECT Corporation. Other trademarks referred to belong to their respective owners.

 

1


Table of Contents

for post-operative pain relief and is intended to provide local analgesia for up to three days, which we believe coincides with the time period of the greatest need for post surgical pain control in most patients. Bupivacaine, the active agent for the product candidate, is currently FDA-approved for use as a local anesthetic. We initiated the Phase II program for this product candidate in October 2004.

 

TRANSDUR-Sufentanil

 

Our transdermal sufentanil product candidate (TRANSDUR-Sufentanil) uses our proprietary TRANSDUR delivery system to deliver sufentanil, an opioid medication, to provide extended chronic pain relief for up to seven days, as compared to the three days of relief provided with currently available opiate patches. We anticipate that the small size of our sufentanil patch (potentially as small as 1/5th the size of currently marketed transdermal fentanyl patches for a therapeutically equivalent dose) may offer improved convenience and compliance for patients. We commenced the Phase II program for this product candidate in February 2005. In March 2005, we entered into an agreement with Endo Pharmaceuticals Inc. (Endo) granting Endo exclusive rights to develop, market and commercialize TRANSDUR-sufentanil in the U.S. and Canada.

 

ORADUR- Oxycodone (Remoxy)

 

In December 2002, we entered into an agreement with Pain Therapeutics, Inc. (Pain Therapeutics) under which we granted Pain Therapeutics the exclusive, worldwide right to develop and commercialize selected long-acting oral opioid products using our ORADUR technology. ORADUR is our SABER-based oral gel cap technology. Products based on the ORADUR technology can take the form of an easy to swallow gelatin capsule that provides controlled release of active ingredients for a period of from 12 to 24 hours of drug delivery. Oral dosage forms based on the ORADUR technology may also have the added benefit of being less prone to abuse than other sustained release dosage forms on the market today. The first product candidate being developed under the collaboration is Remoxy, a novel long-acting oral formulation of the opioid oxycodone targeted to decrease the potential for oxycodone abuse. Pain Therapeutics began Phase III clinical studies for Remoxy in December 2004.

 

DURIN-Leuprolide

 

In July 2002, we entered into a development and commercialization agreement with Voyager Pharmaceutical Corporation (Voyager) under which we granted Voyager the exclusive, worldwide right to develop and commercialize a product candidate using the DURIN implant system to deliver the peptide leuprolide to treat Alzheimer’s disease based on Voyager’s patented method of treatment. DURIN is our proprietary biodegradable polymeric implant drug delivery technology which can deliver a wide variety of drugs from several weeks to six months or more. Voyager completed enrollment of a Phase I pharmacokinetic trial in volunteers for this product candidate in January 2005.

 

CHRONOGESIC® (sufentanil) Pain Therapy System

 

The CHRONOGESIC (sufentanil) Pain Therapy System is an osmotic implant that is intended to continuously deliver sufentanil for an extended duration. This product candidate is intended to treat chronic pain, and is based on the DUROS System, a miniature osmotic pump capable of continuously delivering drugs for up to a year in duration. We have granted to Endo exclusive commercialization rights for the CHRONOGESIC product candidate in the U.S. and Canada. To date, we have completed a Phase I clinical trial, a Phase II clinical trial, a pharmacokinetic trial and a pilot Phase III clinical trial for the CHRONOGESIC product candidate. We are presently working to redesign the delivery system to address a premature shutdown of the system prior to end of the intended drug delivery period that we have observed in a small fraction of units. We have stopped all clinical testing of the product candidate and will not resume clinical testing until the system design is completed.

 

We are also currently researching and developing additional pharmaceutical systems in a variety of therapeutic areas, including chronic pain, central nervous system disorders and cardiovascular disease based on our proprietary drug delivery platform technologies.

 

2


Table of Contents

Industry Background

 

Chronic Diseases and Conditions

 

Although the pharmaceutical, biotechnology and medical device industries have played key roles in increasing life expectancy and improving health, many chronic, debilitating diseases continue to be inadequately addressed with current drugs or medical devices. Cardiovascular disease, cancer, neurodegenerative diseases, diabetes, arthritis, epilepsy and other chronic diseases claim the lives of millions of Americans each year. These illnesses are prolonged, are rarely cured completely, and pose a significant societal burden in mortality, morbidity and cost. The Centers for Disease Control estimates that the major chronic diseases are responsible for approximately 70% of all deaths in the U.S., and medical care costs for these conditions totaled more than $400 billion annually. Currently, more than 60% of total health care spending in the U.S. is devoted to the treatment of chronic diseases. Demographic trends suggest that, as the U.S. population ages, the cost of treating chronic diseases as a proportion of total health care spending will increase.

 

Current Approaches to Treatment

 

Drugs are available to treat many chronic diseases, but harmful side effects can limit prolonged treatment. In addition, patients with chronic diseases commonly take multiple medications, often several times a day, for the remainder of their lives. If patients fail to take drugs as prescribed, they often do not receive the intended benefits or may experience side effects, which are harmful or decrease quality of life. These problems become more common as the number of drugs being taken increases, the regimen of dosing becomes more complicated, or the patient ages or becomes cognitively impaired. It is estimated that only half of prescribed medicines are taken correctly.

 

The Pharmaceutical Industry.    The pharmaceutical industry has traditionally focused on the chemical structure of small molecules to create drugs that can treat diseases and medical conditions. The ability to use these molecules as drugs is based on their potency, safety and efficacy. Therapeutic outcome and ultimately the suitability of a molecule as a drug depends to a large extent on how it gets into the body, distributes throughout the body, reacts with its intended site of action and is eliminated from the body. However, small molecules can act in diverse tissues throughout the body resulting in unwanted side effects.

 

Most drugs require a minimum level in blood and tissues to have significant therapeutic effects. Above a maximum level, however, the drug becomes toxic or has some unwanted side effects. These two levels define the therapeutic range of the drug. With conventional oral dosing and injections, typically a large quantity of drug is administered to the patient at one time, which results in high blood levels of drug immediately after dosing. Because of these high levels, the patient can be over-medicated during the period immediately following dosing, resulting in wasted drug and possible side effects. Due to distribution processes and drug clearance, the blood level of drug falls as time elapses from the last dose. For some duration, the patient is within the desired therapeutic range of blood levels. Eventually, the blood level of drug falls sufficiently such that the patient becomes under-medicated and experiences little or no drug effect until the next dose is administered.

 

The Biotechnology Industry.    Over the past twenty years, the biotechnology revolution and the expanding field of genomics have led to the discovery of huge numbers of proteins and genes. Tremendous resources have been committed in the hope of developing drug therapies that would better mimic the body’s own processes and allow for greater therapeutic specificity than is possible with small molecule drugs. Unfortunately, this huge effort has led to only a limited number of therapeutic products. The proteins and genes identified by the biotechnology industry are large, complex, intricate molecules, and many are unsuitable as drugs. If these molecules are given orally, they are often digested before they can have an effect; if given by injection, they may be destroyed by the body’s natural processes before they can reach their intended sites of action. The body’s natural elimination processes require frequent, high dose injections that may result in unwanted side effects. As a result, the development of biotechnology molecules for the treatment of human diseases has been limited.

 

3


Table of Contents

The Drug Delivery Industry.    In the last thirty years, a multibillion dollar drug delivery industry has developed on the basis that medicine can be improved by delivering drugs to patients in a precise, controlled fashion. Several commercially successful oral controlled release products, transdermal controlled release patches, and injectable controlled release formulations have been developed. These products demonstrate that the delivery system can be as important to the ultimate therapeutic value of a pharmaceutical product as the drug itself. However, drug delivery products on the market today can still be improved, for example, by providing reduced abuse potential, targeted delivery to minimize system effects and longer delivery durations where useful. Furthermore, traditional drug delivery products are generally not capable of administering biotechnology agents such as proteins, peptides and genes.

 

The Medical Device Industry.    Advances in the field of medical device technology have dramatically improved device miniaturization and sophistication and allowed minimally invasive surgical access to remote locations within the body. For example, a coronary bypass patient can be treated with a stent in a procedure with a relatively short recovery, rather than with major surgery. Most devices, however, apply only mechanical solutions, rather than delivering chemical or biological agents.

 

The DURECT Solution: Pharmaceutical Systems

 

We are pioneering the treatment of chronic diseases and conditions by developing and commercializing pharmaceutical systems that will deliver the right drug to the right place in the right amount at the right time. By integrating chemistry and engineering advancements, we can achieve what drugs or devices alone cannot. Our pharmaceutical systems enable optimized therapy for a given disease or patient population by controlling the rate and duration of drug administration. In addition, if advantageous for the therapy, our pharmaceutical systems can target the delivery of the drug to its intended site of action.

 

  ·   The Right Drug: By precisely controlling the dosage or targeting delivery to a specific site, we can expand the therapeutic use of compounds that otherwise would be too potent to be administered systemically, do not remain in the body long enough to be effective, or have significant side effects when administered systemically. This flexibility allows us to work with a variety of drug candidates including small molecules, proteins, peptides or genes.

 

  ·   The Right Place: In addition to enabling systemic delivery, if advantageous for the therapy, with precise placement of our proprietary catheters or biodegradable drug delivery formulations, we can design our pharmaceutical systems to deliver drugs directly to the intended site of action. This can ensure that the drug reaches the target tissue in effective concentrations, eliminate many side effects caused by delivery of drug to unintended sites in the body, and reduce the total amount of drug administered to the body.

 

  ·   The Right Amount: Our pharmaceutical systems can automatically deliver drug dosages continuously within the desired therapeutic range for the duration of the treatment period, from days to up to one year, without the fluctuations in drug levels associated with conventional pills or injections. This can reduce side effects, eliminate gaps in drug therapy, conveniently ensure accurate dosing and patient compliance, and may reduce the total amount of drug administered to the body.

 

  ·   The Right Time: Our pharmaceutical systems technologies are designed to minimize the need for intervention by the patient or care-giver and enhance dosing compliance. In addition to reducing the cost of care, continuous drug therapy frees the patient from repeated treatment or hospitalization, improving convenience and quality of life. Our systems are well-suited to deliver drug for the right period of time for the intended indication, whether for hours or days for acute indications or months or years for treating chronic, debilitating diseases such as chronic pain, cancer, heart disease, and neurodegenerative diseases. We believe that it is more effective to treat chronic diseases with continuous, long-term therapy than with alternatives such as multiple conventional injections or oral dosage forms that create short-term effects.

 

4


Table of Contents

DURECT Pharmaceutical Systems Technology

 

DURECT’s pharmaceutical systems combine technology innovations from the drug delivery and medical device industries with proprietary pharmaceutical and biotechnology drug formulations. These capabilities can enable new drug therapies or optimize existing therapies based on a broad range of compounds, including small molecule pharmaceuticals as well as biotechnology molecules such as proteins, peptides and genes. We currently have six major technology platforms:

 

The SABER Delivery System

 

The SABER system is a patented controlled-release technology that can be formulated for systemic or local administration of active agents via the parenteral or oral route. We are researching and developing a variety of controlled-release products based on the SABER technology. These include injectable controlled release products for systemic and local delivery and oral products.

 

We believe that our SABER system can provide the basis for the development of a state-of-the-art biodegradable, controlled-release injectable. The SABER system uses a high-viscosity base component, such as sucrose acetate isobutyrate (SAIB), to provide controlled release of the drug. When the high viscosity SAIB is formulated with drug, a biocompatible solvent and other additives, the resulting formulation is liquid enough to inject easily with standard syringes and needles. After injection of a SABER formulation, the solvent diffuses away, leaving a viscous depot. Depending on how it is formulated, the SABER system can successfully deliver therapeutic levels of a wide spectrum of drugs from 1 day to 3 months from a single injection. Based on research and development work to date, our SABER technology has shown the following advantages:

 

  ·   Peptide/Protein Delivery — The chemical nature of the SABER system tends to repel water and body enzymes from its interior and thereby stabilizes proteins and peptides. For this reason, we believe that the SABER system is well suited as a platform for biotechnology therapeutics based on proteins and peptides.

 

  ·   Less Burst — Typically, controlled release injections are associated with an initial higher release of drug immediately after injection (a so called “burst”). Animal studies have shown that injectables based on the SABER technology can be associated with less post-injection burst than is typically associated with other commercially available injectable controlled release technologies.

 

  ·   High Drug Concentration — Drug concentration in a SABER formulation can be as high as 30%, considerably greater than is typical with other commercially available injectable controlled release technologies. As a result, smaller injection volumes are possible with this technology.

 

  ·   Ease of Administration — Prior to injection, SABER formulations are fairly liquid and therefore can be injected through small needles. Additionally, because of the higher drug concentration of SABER formulations, less volume is required to be injected. Small injection volumes and more liquid solutions are expected to result in easier, less painful administration.

 

  ·   Strong Patent Protection — The SABER system, SABER-like materials, and various applications of this technology to pharmaceuticals, medical devices and drug delivery are covered by United States and foreign patents. See “Patents, Licenses and Proprietary Rights” below.

 

  ·   Ease of Manufacture — Compared to microspheres and other polymer-based controlled release injectable systems, SABER is readily manufacturable at low cost.

 

The SABER Technology is the basis of our injectable post-operative pain relief depot product candidate currently under Phase II clinical testing. In our clinical studies thus far, SABER formulations have been observed to be safe and well-tolerated, and no significant side effects or adverse events were reported.

 

5


Table of Contents

The TRANSDUR Transdermal Delivery System

 

Our TRANSDUR technology is a proprietary transdermal delivery system that enables delivery of drugs continuously for up to 7 days. The TRANSDUR technology is the basis for our transdermal sufentanil patch product candidate currently under Phase II testing, which we have licensed to Endo in the U.S. and Canada.

 

The ORADUR Sustained Release Gel Cap Technology

 

We are developing ORADUR sustained release oral technology based on our SABER technology. We believe that ORADUR can transform short-acting oral capsule dosage forms into sustained release oral products. Products based on our ORADUR technology (previously referred to as SABER oral gel cap technology) can take the form of an easy to swallow gelatin capsule that uses a high-viscosity base component such as sucrose acetate isobutyrate (SAIB) to provide controlled release of active ingredients for a period of 12 to 24 hours of drug delivery. Oral dosage forms based on the ORADUR gel-cap may also have the added benefit of being less prone to abuse (e.g., by crushing or alcohol or water extraction) than other controlled release dosage forms on the market today. ORADUR-based products can be manufactured by a simple process using conventional methods making them readily scalable. These properties have the potential to make ORADUR-based products an attractive option for pharmaceutical companies that seek to develop abuse resistant oral products. The ORADUR Technology is the basis of Remoxy, a novel long-acting oral formulation of the opioid oxycodone which is targeted to decrease the potential for oxycodone abuse currently under Phase III clinical testing by Pain Therapeutics.

 

The DURIN Biodegradeable Implant Technology

 

Our DURIN technology is a proprietary biodegradable implant that enables parenteral delivery of drugs from several weeks to six months or more using our Lactel® brand polymers and co-polymers of lactic and glycolic acid. The DURIN technology can deliver a wide variety of drugs including small and large molecule compounds. Our proprietary implant design allows for a variety of possible delivery profiles including constant rate delivery. Because DURIN implants are biodegradable, at the end of its delivery life, what remains of the DURIN implant is absorbed by the body. DURECT is researching and developing products based on the DURIN technology for a variety of chronic disease applications. The DURIN technology is the basis of DURIN-Leuprolide, our product candidate for the treatment of Alzheimer’s disease currently under clinical testing by Voyager.

 

The DUROS Technology

 

The DUROS system is a miniature drug-dispensing pump made out of titanium which can be as small as a wooden matchstick. We have licensed the DUROS system for specified fields of use from ALZA Corporation, a Johnson & Johnson Company, pursuant to a development and commercialization agreement entered into effective April 1998. The potential of the DUROS technology as a platform for providing drug therapy was demonstrated by the Food and Drug Administration’s approval in March 2000 of ALZA’s VIADUR® product (leuprolide acetate implant), a once-yearly implant for the palliative treatment of prostate cancer, the first approved product to incorporate the DUROS implant technology. The DUROS system can be used for therapies requiring systemic or site-specific administration of drug. To deliver drugs systemically as in our CHRONOGESIC product, the DUROS system is placed just under the skin, for example in the inner side of the upper arm, in an outpatient procedure that is completed in just a few minutes using local anesthetic. Removal or replacement of the product is also a simple and quick procedure completed in the doctor’s office. To deliver drug to a specific site, we are developing proprietary miniaturized catheter technology that can be attached to the DUROS system to direct the flow of drug directly to a target organ, tissue or synthetic medical structure, such as a graft. The DUROS system is the basis of our CHRONOGESIC product candidate under development in collaboration with Endo in the U.S. and Canada.

 

6


Table of Contents

The MICRODUR Biodegradable Microparticulate Technology

 

Our MICRODUR technology is a patented biodegradable microparticulate depot injectable. We have experience in microencapsulation of a broad spectrum of drugs using our Lactel® brand polymers and co-polymers of lactic and glycolic acid. In our MICRODUR process, both standard and proprietary polymers are used to entrap an active agent in solid matrices or capsules comprising particles generally between 10 and 125 microns in diameter. Through suitable choice of polymers and processing, sustained release from a few days to many months can be achieved. As with the DURIN technology, MICRODUR particles degrade fully in the body after the active agent is released. Our range of experience extends from manufacture of the polymer raw material to process and product development, scale up and cGMP manufacture.

 

DURECT Strategy

 

Our objective is to develop and commercialize pharmaceutical systems that address significant medical needs and improve patients’ quality of life. To achieve this objective, our strategy includes the following key elements:

 

Focus on Chronic Debilitating Medical Conditions.    Many of the diseases that present the greatest challenges to medicine are chronic, debilitating diseases such as chronic pain, central nervous system disorders, cardiovascular disorders, cancer and degenerative neurological diseases. Our initial efforts will focus on using our versatile drug delivery platform technologies to develop products that address these diseases.

 

Minimize Product Development Risk and Speed Time-to-Market.    Initially, we intend to minimize product development risk and speed time-to-market by using our drug delivery platform technologies to administer drugs for which medical data on efficacy and safety are available. This strategy reduces much of the development risk that is inherent in traditional pharmaceutical product discovery. We anticipate that we can expand the medical usefulness of existing well-characterized drugs in several ways:

 

  ·   expand uses or create new uses for existing drugs by delivering drugs continuously for convenient long dosing intervals;

 

  ·   create new uses for drugs which were previously considered to be too potent to be used safely by precisely controlling dosing or by delivering them directly to the site of action; and

 

  ·   enhance drug performance by minimizing side effects.

 

We anticipate that our products can be more rapidly developed at lower cost than comparable products that are developed purely based on chemical solutions to the problems of efficacy, side effects, stability and delivery of the active agent. We believe that our ability to innovate more rapidly will allow us to respond more quickly to market feedback to optimize our existing products or develop line extensions that address new market needs.

 

Enable the Development of Pharmaceutical Systems Based on Biotechnology and Other New Compounds.    We believe there is a significant opportunity for pharmaceutical systems to add value to therapeutic medicine by administering biotechnology products, such as proteins, peptides and genes. We believe our technologies will improve the specificity, potency, convenience and cost-effectiveness of proteins, peptides, genes and other newly discovered drugs. Our systems can enable these compounds to be effectively administered, thus allowing them to become viable medicines. We can address the stability and storage needs of these compounds through our advanced formulation technology and package them in a suitable pharmaceutical system for optimum delivery. Through continuous administration, the SABER, TRANSDUR, ORADUR, DURIN, DUROS and MICRODUR technology platforms may eliminate the need for multiple injections of these drugs. In addition, through the use of our proprietary miniature catheter technology or by precise placement of our proprietary biodegradable drug formulations, proteins and genes can be delivered to specific tissues for extended periods of time, thus ensuring that large molecule agents are present at the desired site of action and minimizing the potential for adverse side effects elsewhere in the body.

 

7


Table of Contents

Expand Our Technology Platforms.    Beyond our core technology platforms, we will continue to develop, license and acquire other technologies consistent with our objective of delivering the right drug to the right place in the right amount at the right time. For example, through our April 2001 acquisition of Southern BioSystems, Inc. (SBS), we acquired an experienced team of specialists and patented technologies in the field of controlled release injectables, implants, microspheres and biodegradable polymers. This acquisition, along with our internal development activities, has increased the breadth and depth of our technology platforms. We expect to continue to license or acquire technology that will complement our core capabilities.

 

Enable Product Development Through Strategic Partnerships.    We believe that selective partnering of our product development programs can enhance the success of our product development and commercialization, diversify our product portfolio and enable us to better manage our operating costs. We currently have the following significant product collaborations with third party companies:

 

  ·   Pain Therapeutics Inc.    In December 2002, we entered into an exclusive agreement with Pain Therapeutics to develop and commercialize on a worldwide basis selected long-acting oral opioid products using our ORADUR technology. The agreement also provides Pain Therapeutics with the exclusive right to commercialize products developed under the agreement on a worldwide basis. In connection with the execution of the agreement, Pain Therapeutics paid us an upfront fee. We are responsible for formulation development, supply of selected raw materials and other specified tasks. We will receive payments upon the achievement of certain development and regulatory milestones, payments for research and development expenditures, as well as royalties based on product sales. This agreement can be terminated by either party for material breach by the other party and by Pain Therapeutics without cause.

 

  ·   Voyager Pharmaceutical Corporation.    In July 2002, we entered into a development and commercialization agreement with Voyager. Under the terms of the agreement, we will collaborate with Voyager to develop a product using our DURIN technology to provide a sustained release therapy based on Voyager’s patented method of treatment of Alzheimer’s disease. The agreement also provides Voyager with the right to commercialize the product on a worldwide basis. We are responsible for preclinical development, product manufacture and other specified tasks. We will receive payments upon the achievement of certain development and regulatory milestones, payments for research and development expenditures, as well as royalties based on product sales. This agreement can be terminated by either party for material breach by the other party and by Voyager without cause.

 

  ·  

Endo Pharmaceuticals Inc. (CHRONOGESIC).    In November 2002, we entered into a development, commercialization and supply license agreement with Endo under which the companies will collaborate on the development and commercialization of our CHRONOGESIC product for the U.S. and Canada. The agreement was amended in January 2004 and again in November 2004 to take into account the delay in the CHRONOGESIC development program due to DURECT’s implementation of necessary design and manufacturing enhancements to the product candidate. In connection with the execution of the agreement in November 2002, Endo purchased 1,533,742 shares of newly issued common stock of DURECT at an aggregate purchase price of approximately $5.0 million. Under the terms of the agreement, as amended, we will be responsible for the CHRONOGESIC product’s design and development. For the period commencing January 1, 2004 until the earlier of January 1, 2006 or the commencement of a specified clinical trial, Endo will fund 25% of the ongoing development costs for the CHRONOGESIC product in the U.S. and Canada excluding system redesign costs and pharmacokinetic trials necessitated by any system redesign, up to an aggregate amount of $250,000 for the period. Commencing on January 1, 2006 or, if earlier, the commencement of a specified clinical trial for the CHRONOGESIC product, Endo will fund 50% of the ongoing development costs and will reimburse us for a portion of our prior development costs for the product upon the achievement of certain milestones. Development-based milestone payments made by Endo under this agreement could total up to $52 million. Under the agreement, Endo has licensed exclusive promotional rights to the CHRONOGESIC product in the U.S. and Canada. Endo will be responsible for marketing, sales and

 

8


Table of Contents
 

distribution, including providing specialty sales representatives dedicated to supplying technical and training support for CHRONOGESIC therapy and will pay for product launch costs. We will be responsible for the manufacture of the CHRONOGESIC product. We will share profits from the commercialization of the product in the U.S. and Canada with Endo based on the financial performance of the CHRONOGESIC product. Based on our projected financial performance of the product in the U.S. and Canada, we anticipate that our share of such profits from commercialization of the product will be approximately 50%. Our agreement with Endo provides each party with specified termination rights. In particular, our agreement can be terminated by Endo in January 2006 in the event we have not commenced a specified clinical trial by January 1, 2006.

 

  ·   Endo Pharmaceuticals Inc. (TRANSDUR-Sufentanil).    On March 10, 2005, we entered into a license agreement with Endo under which we granted to Endo the exclusive right to develop and commercialize TRANSDUR-Sufentanil in the U.S. and Canada. Under the terms of the agreement, Endo will assume all remaining development and regulatory filing responsibility in the U.S. and Canada, including the funding thereof. We will perform all formulation development for Endo unless we default on such obligations and we will be reimbursed for our fully allocated cost in performance of such work. Endo will also be responsible and pay for the manufacture, marketing, sales and distribution of TRANSDUR-Sufentanil in the U.S. and Canada. Endo will pay us an upfront fee of $10 million, with additional payments of up to approximately $35 million in the aggregate based upon achievement of predetermined regulatory and commercial milestones. Endo will also pay us product royalties based on the net sales of TRANSDUR-Sufentanil under the agreement. We have the right to co-promote TRANSDUR-Sufentanil under terms specified in the agreement. The agreement also contains terms and conditions customary for this type of arrangement, including representations, warranties and indemnities. The agreement shall continue in effect until terminated. The agreement provides each party with specified termination rights, including the right of each party to terminate the agreement upon material breach of the agreement by the other party. In addition, Endo shall have the right to terminate the agreement at any time without cause subject to a specified notice period and due to adverse product events, legal impediment or the issuance of a final, non-appealable court order enjoining Endo from selling TRANSDUR-Sufentanil in the U.S. and Canada as a result of an action for patent infringement by a third party, provided that in the latter instance, we will be required to pay Endo a termination fee ranging from $5 million to $10 million, depending on the date of termination. We have the right to terminate the agreement in the event that Endo pursues directly or indirectly any proceeding seeking to have any of our TRANSDUR-Sufentanil related patents revoked or declared invalid, unpatentable or unenforceable.

 

  ·   NeuroSystec Corporation.    In May 2004, we entered into an exclusive license agreement with NeuroSystec Corporation (NeuroSystec) under which we granted to NeuroSystec exclusive worldwide rights to develop and commercialize products designed for the treatment of tinnitus and to improve post-operative recovery and tolerance of surgical implantation of cochlear devices using specified DURECT proprietary drug treatment methods and drug delivery technologies to deliver precise doses of appropriate medications directly to the middle or inner ear. The first product candidate is currently in pre-clinical development. We are responsible for formulation development of product candidates utilizing our drug delivery platforms and manufacture and supply of product components consisting of our drug delivery platforms. We will receive certain milestone payments related to the development and commercialization of products under this agreement, as well as royalties based on product sales. This agreement can be terminated by either party for material breach by the other party and by NeuroSystec without cause. In connection with the agreement, we received equity constituting a minority ownership interest in NeuroSystec.

 

In 2004, revenues from our collaborative agreements with Pain Therapeutics and Voyager represented 29% and 18% of our total revenues. In 2003, revenues from our collaborative agreements with Pain Therapeutics and Voyager represented 24% and 10% of our total revenues. We expect to continue to partner select product development activities when it is advantageous to DURECT from a financial and risk management perspective.

 

9


Table of Contents

Product Research and Development Programs

 

Our development efforts are focused on the application of our pharmaceutical systems technologies to potential products in a variety of chronic disease areas including pain, cardiovascular disease, CNS disorders and other chronic diseases. Our ongoing product research and development efforts in these areas are set forth in the following table:

 

Disease/Indication


  

Product


  

Partner


  

Technology Platform


  

Stage


Post Operative Pain

  

•  Controlled Release Injection of Local Anesthetic

  

•  No

  

•  SABER

  

•  Phase II

Chronic Pain

  

•  Transdermal sufentanil

  

•  Yes

  

•  TRANSDUR

  

•  Phase II

Chronic Pain

  

•  Oral controlled release opioid (Remoxy)

  

•  Yes

  

•  ORADUR

  

•   Phase III

Alzheimer’s Disease

  

•  Controlled Release Implant

  

•  Yes

  

•  DURIN

  

•  Phase I

Chronic Pain

  

•  Systemic sufentanil (CHRONOGESIC)

  

•  Yes

  

•  DUROS

  

•  Phase II/III

Central Nervous System Disorders

  

•  Various

  

•  No

  

•  SABER/DUROS/DURIN

  

•  Preclinical/Research Stages

Cardiovascular Disorders

  

•  Various

  

•  No

  

•  SABER/DUROS/DURIN

  

•  Research Stage

 

Chronic Pain (Systemic)

 

Market Opportunity.    Chronic pain, defined as pain lasting 6 months or longer, is a significant problem associated with chronic diseases, including cancer and various neurological and skeletal disorders. Chronic nonmalignant pain affects as many as 34 million Americans annually. In addition, the National Cancer Institute estimates that 8.4 million Americans alive today have a history of cancer. About 1.2 million new cancer cases are expected to be diagnosed annually, and about 50%-70% of cancer patients experience chronic pain during the course of the disease. Sales of opioids for the treatment of malignant and nonmalignant pain exceed $4.0 billion.

 

Development Strategy.    We are developing three product candidates for the chronic pain market: our proprietary TRANDUR transdermal sufentanil patch, a transdermal patch that is intended to provide sufentanil for a period of seven days from a single application, an ORADUR-based oral oxycodone product candidate intended to decrease the potential of oxycodone abuse in collaboration with Pain Therapeutics and the CHRONOGESIC (sufentanil) Pain Therapy System, a subcutaneous, implantable DUROS-based system that delivers sufentanil systemically at a constant rate for 3 months in collaboration with Endo Pharmaceuticals.

 

TRANSDUR-Sufentanil Patch

 

Our transdermal sufentanil patch under development is based on our proprietary TRANSDUR transdermal technology and is intended to provide continuous delivery of sufentanil for up to seven days from a single application, as compared to the three days of relief provided by currently available opioid patches. Sufentanil is an off-patent, highly potent opioid that is currently used in hospitals as an analgesic. We anticipate that the small size of our sufentanil patch (potentially as small as 1/5th the size of currently marketed transdermal fentanyl patches for a therapeutically equivalent dose) and longer duration of delivery may offer improved convenience for patients. Worldwide sales for DURAGESIC®, a leading transdermal fentanyl product, exceeded $2.1 billion in 2004. In 2004, we initiated a Phase I clinical trial to determine the pharmacokinetics of our transdermal sufentanil patch product in normal, healthy volunteers in Europe. The objectives of the clinical study are to determine the safety and tolerability of our transdermal sufentanil patch as well as evaluate the pharmacokinetics

 

10


Table of Contents

of sufentanil following transdermal administration. In February 2005, based on the results of our Phase I trial that showed good safety, tolerability and drug release for up to 7 days, we initiated the first clinical trial in our Phase II program. The objectives of the Phase II program are to evaluate the pharmacokinetics, efficacy, and safety of repetitive applications of our sufentanil patch in chronic pain patients for a period of up to four weeks. We anticipate that we will complete Phase II trials for the product candidate in the second half of 2005. In March 2005, we entered into an agreement with Endo granting Endo exclusive rights to develop, market and commercialize TRANSDUR-sufentanil in the U.S. and Canada. We will receive an initial payment of $10 million, plus additional milestone payments upon the achievement of specified development milestones and royalties based on sale of TRANSDUR-sufentanil upon commercialization in the U.S. and Canada.

 

ORADUR-Oxycodone (Remoxy)

 

Remoxy is an oral, long-acting oxycodone gelatin capsule under development with Pain Therapeutics, to which we have licensed exclusive, worldwide, development and commercialization rights under a development and license agreement entered into in December 2002. Remoxy is formulated with our ORADUR technology and incorporates several abuse-deterrent properties with the convenience of twice-a-day dosing. Oxycodone is also the active drug ingredient in OxyContin®, a brand name narcotic painkiller with annual sales exceeding $1.9 billion. We will receive from Pain Therapeutics milestone payments upon the achievement of specified development milestones and royalties on based on sale of Remoxy upon commercialization anywhere in the world. Pain Therapeutics began Phase III clinical testing of the Remoxy product candidate in December 2004.

 

CHRONOGESIC

 

Our CHRONOGESIC product candidate, based on the DUROS technology, is intended for patients with chronic pain that is stable and opioid responsive and results from a variety of causes. The product candidate consists of a small titanium pump, about the size of a match stick, which is implanted under the skin of a patient in a simple out-patient procedure. Once implanted, the product candidate is designed to delivery sufentanil for period of up to 3 months from a single application. If approved for marketing and sale, this product will provide an alternative to current therapies for the treatment of chronic pain such as pills and patches, as well as providing the potential advantages of physician controlled dosing, improved patient compliance and convenience and reduced potential for opioid abuse. We will develop a family of dosage strengths, tailored to meet market needs. Our CHRONOGESIC product candidate is being developed for the U.S. and Canadian markets in collaboration with Endo Pharmaceutics, to which we have granted exclusive commercialization rights pursuant to a development, commercialization and supply license agreement entered into effective November 2002. We will receive from Endo milestone payments upon the achievement of specified development milestones and royalties on based on sale of CHRONOGESIC upon commercialization in the U.S. and Canada.

 

We have completed an initial Phase I clinical trial, a Phase II clinical trial, a pilot Phase III clinical trial and a pharmacokinetic trial for our CHRONOGESIC product candidate. We initiated our first pivotal Phase III clinical trial for the CHRONOGESIC product candidate in June 2002. In August 2002, the FDA requested that we delay enrolling new patients in our Phase III clinical trial initiated in June 2002 until the clinical trial protocol is revised and approved by the FDA to provide for additional patient monitoring and data collection. These requested protocol changes were not in response to any observed patient safety or adverse event. We subsequently discontinued all patients from the clinical trial at our discretion in September 2002. Independently from the FDA’s request for protocol changes, in October 2002, we started to implement manufacturing process enhancements to the CHRONOGESIC product to permit terminal sterilization of the product and system design enhancements to prevent a premature shutdown in the delivery of drug prior to the end of the intended 3-month delivery period which was observed in a small fraction of units utilizing the previous system design. We are presently working to redesign the delivery system to address the premature shutdown of the system prior to end of the intended drug delivery period. We have stopped all clinical testing of the product candidate and will not resume clinical testing until the system design is completed.

 

11


Table of Contents

Local Post-Operative Pain

 

Market Opportunity.    More than 60% of patients who undergo surgery experience moderate to extreme-post operative pain. In the United States, over 25 million patients are afflicted with post surgical pain annually. The current standard of care for post surgical pain includes oral opiate and non-opiate analgesics, transdermal opiate patches and muscle relaxants. While oral analgesics can effectively control post surgical pain, they commonly cause side effects such as drowsiness, constipation and cognitive impairment. Effective pain management can be compromised if patients fail to adhere to recommended dosing regimens because they are sleeping or disoriented. The majority of post surgical pain can be localized to the incision site. Post surgical pain can be treated effectively with local anesthetics; however, the usefulness of these medications is limited by their short duration of action.

 

Development Strategy.    We are developing a sustained-release formulation of bupivacaine, a local anesthetic using our SABER delivery system for the treatment of post surgical pain. The physician would administer this product at the time of surgery. Placed in the tissues immediately adjacent to the surgical site, this formulation is designed to provide sustained regional analgesia from a single dose. We believe that by delivering effective amounts of a potent analgesic to the location from which the pain originates, adequate pain control can be achieved with minimal exposure to the remainder of the body, and hence minimal side effects. The duration of local delivery of the anesthetic by the product is expected to be a few days, which we believe coincides with the typical timeline by which post surgical pain resolves in most patients.

 

In October 2004, we initiated a Phase II clinical study for SABER bupivacaine, our post-operative pain relief depot. This product candidate is a sustained release injectable designed to provide up to 72 hours of post-surgical pain relief and is based on our patented SABER delivery system. We anticipate that the trial will enroll approximately 60 patients, with an option to enroll an additional 30 patients. The Phase II trial is a dose escalation study, conducted in three cohorts, for the treatment of pain in patients following repair of inguinal hernia. Patients are administered SABER-Bupivacaine at the completion of surgery, and the trial will be used to evaluate the safety and efficacy of the therapy. The study end points include a pharmacokinetic evaluation of plasma bupivacaine levels, time to first supplemental analgesic, total supplemental analgesics, and analysis of the sum of pain intensity and total pain relief. We completed dosing of the first cohort of the Phase II clinical in February 2005 and are presently actively enrolling patients in the second cohort of the trial. We intend to complete our on-going Phase II trial and announce the clinical results in the second half of 2005. We retain the full commercialization rights to this product candidate.

 

Alzheimer’s Disease

 

Market Opportunity.    Alzheimer’s disease is an incurable, neurodegenerative disorder that affects over 4 million Americans. This disease typically leads to progressive memory loss, impairments in behavior and language, and physical deterioration. The market potential for Alzheimer’s disease treatments is estimated to be in excess of $10 billion.

 

Development Strategy.    We are developing a product candidate for the treatment of Alzheimer’s disease in collaboration with Voyager to which we have licensed exclusive, worldwide development and commercialization rights under a development and license agreement entered into in July 2002. This product candidate uses our proprietary DURIN technology to provide sustained release of the peptide leuprolide acetate and is based on Voyager’s patented method of treatment of Alzheimer’s disease. In December 2004, the FDA accepted an Investigational New Drug Application and clinical protocol submitted by Voyager for the DURIN-Leuprolide product candidate. The trial consists of a pharmacokinetic study in normal, healthy volunteers, the objectives of which are to determine the safety and tolerability of the DURIN implant, as well as to evaluate the pharmacokinetic profile of the active agent (leuprolide acetate) following administration of the product candidate. Voyager completed enrollment of the clinical trial in January 2005. In 2005, Voyager plans to complete the on-going Phase I study with our DURIN-based product, complete its ongoing Phase II study in women with the active agent and complete an interim analysis of its ongoing Phase II study in men with the

 

12


Table of Contents

active agent. Based on the results of these three studies, Voyager plans to begin Phase III pivotal studies of the DURIN-Leuprolide Alzheimer’s product candidate during the second half of 2005. We will receive from Voyager milestone payments upon the achievement of specified development milestones and royalties based on sale of the resulting product upon commercialization anywhere in the world.

 

Central Nervous System Disorders

 

Market Opportunity.    Millions of people suffer from chronic diseases and disorders of the central nervous system (CNS), including brain and spinal cord tumors, chronic pain, psychosis, epilepsy, spasticity, spinal meningitis, Parkinson’s disease, and multiple sclerosis. The following are some therapeutic opportunities that we are pursuing in this area:

 

It is estimated that 180,000 new brain tumors are diagnosed in the United States every year. In addition, approximately 350,000 patients are living with primary brain tumors, of which, about 25% are malignant. Current treatments for CNS tumors include radiation, resection and chemotherapy. Treatment success rates vary by tumor type, but are generally low, and the risk of side effects or disability is high. It is generally recognized that improvements in treating primary metastatic brain tumors are needed, particularly for those which are inoperable.

 

Schizophrenia, a disease of the brain that manifests itself through multiple signs and symptoms involving thought, perception and behavior, is another CNS disorder estimated to affect about 2.5 million patients in the U.S.; worldwide, the incidence is about 250 million. Patients typically begin exhibiting symptoms early in life and the illness is usually severe and long lasting, requiring lifelong treatment. Adherence to prescribed drug regimens is recognized as a significant treatment obstacle in the schizophrenic population. Although it is estimated that 50% of patients in the U.S. are either untreated or under treated, the aggregated sales of antipyschotic medications in 2002 exceeded $5.7 billion. Opportunities exist to apply our pharmaceutical systems for treatment of these and other CNS disorders.

 

Development Strategy.    We are developing our platform technologies for systemic and targeted delivery of drugs to treat select CNS disorders.

 

We are conducting preclinical research on a SABER-based injectable controlled release product to deliver a potent antipsychotic agent systemically in a controlled fashion, with a goal to deliver medication for 30 days from a single injection. We also currently have research exploring the feasibility of targeted delivery of drugs directly to the central nervous system. We view our research as a proof-of-concept application of our drug delivery technologies to treat CNS disorders. Once we have demonstrated proof-of-concept, our long-term plan is to use our platform technologies with therapeutic agents to develop products for CNS disorders.

 

Cardiovascular Disease

 

Market Opportunity.    Cardiovascular disease, principally heart disease and stroke, accounts for 40% of all deaths, or 960,000 fatalities, annually in the U.S. About 58 million Americans, roughly 25% of the population, are currently living with some form of cardiovascular disease. The aggregate annual cost of cardiovascular disease in the U.S., including treatment and lost productivity, is estimated at $274 billion.

 

Ischemic heart disease, one of the major forms of cardiovascular disease, is the leading cause of death worldwide. Existing treatments for ischemia, or insufficient blood flow to the heart muscle, include cardiovascular bypass, angioplasty and the use of cardiovascular stents and similar medical devices. While effective, these treatments are invasive, and in roughly 40% of patients, ischemia returns within 2 years. There is a need for less invasive and more long lasting treatments for ischemic heart disease.

 

Development Strategy.    In collaboration with the University of Maastricht in The Netherlands, we are working to develop methods for treating ischemic heart disease and other chronic cardiovascular diseases

 

13


Table of Contents

through continuous delivery of drugs to the pericardial sac of the heart, a thin membrane that envelops the heart. To date, our research in animal models suggests that ischemic heart disease may be treated by the induction of new blood vessel growth as a way of regenerating normal blood flow to the heart and thereby restoring function to the diseased heart. Our research data showed that the delivery of a proprietary angiogenic factor directly to the pericardial sac of a test animal resulted in the growth of new blood vessels and increased bloodflow in the heart. Should we choose to develop and commercialize a product using such proprietary angiogenic factor or other proprietary agent, we may be required to obtain a license to use such agent in our product. Any required licenses may not be available to us on acceptable terms, if at all. See “Factors that May Affect Future Results—We may be required to obtain rights to certain drugs.”

 

Commercial Businesses

 

ALZET

 

We currently make and sell the ALZET® product on a worldwide basis. We market the ALZET product through a direct sales force in the U.S. and through a network of distributors outside the U.S.

 

The ALZET product is a miniature, implantable osmotic pump used for experimental research in mice, rats and other laboratory animals. These pumps are neither approved nor intended for human use. ALZET pumps continuously deliver drugs, hormones and other test agents at controlled rates from one day to four weeks without the need for external connections, frequent handling or repeated dosing. In laboratory research, these infusion pumps can be used for systemic administration when implanted under the skin or in the body. They can be attached to a catheter for intravenous, intracerebral, or intra-arterial infusion or for targeted delivery, where the effects of a drug or test agent are localized in a particular tissue or organ.

 

We acquired the ALZET product and assets used primarily in the manufacture, sale and distribution of this product from ALZA in April 2000. We believe that the ALZET business provides us with innovative design and application opportunities for potential new products.

 

Polymer Supply

 

We currently design, develop and manufacture a wide range of standard and custom biodegradable polymers based on lactide, glycolide and caprolactone under the LACTEL® brand for pharmaceutical and medical device clients for use as raw materials in their products. These materials are manufactured and sold by us directly from our facility in Pelham, Alabama and are used by us and our third-party customers for a variety of controlled-release and medical-device applications, including several FDA-approved commercial products. Until December 31, 2004, this business was conducted by our wholly owned subsidiary, Absorbable Polymers International Corporation (API), formerly known as Birmingham Polymers Inc., an Alabama corporation. API was merged with and into DURECT on December 31, 2004.

 

Marketing and Sales

 

We intend to establish our own sales force when strategically or economically advantageous. Historically, we have established strategic distribution and marketing alliances for our pharmaceutical systems. We recognize that certain pharmaceutical companies have established sales organizations in markets we are targeting. By partnering, we plan to leverage these sales organizations to achieve greater market penetration for some of our products than we could on our own. Because our first products combine drugs for which medical data on efficacy and safety are available with a proven technology platform, we believe we have the flexibility to enter into these alliances under circumstances that allow us to retain greater economic participation.

 

We market and sell our ALZET product in the U.S. through a direct sales force, and we have a network of distributors for this product outside of the U.S.

 

14


Table of Contents

Customers

 

A substantial portion of our product revenues is derived from sale of the ALZET product line. Until such time that we are able to bring our pharmaceutical systems to market, if at all, we expect this trend to continue. Since our acquisition of the ALZET product line in April 2000, one customer accounted for 11% of our total revenue in 2002. We also receive revenue from collaborative research and development arrangements with our strategic partners.

 

Manufacturing

 

The process for manufacturing our pharmaceutical systems is technically complex, requires special skills, and must be performed in a qualified facility. Our manufacturing facility in Cupertino is a functional multi-discipline site that we have used to manufacture research and clinical supplies of several of our pharmaceutical system product candidates under GMP, including SABER-Bupivacaine, TRANSDUR-sufentanil, Remoxy and CHRONOGESIC. We have recently made significant site improvements and equipment installations to upgrade and expand our manufacturing capabilities. In the future, we intend to develop additional manufacturing capabilities for our pharmaceutical systems and components to meet our demands and those of our third party collaborators by contracting with third party manufacturers and by construction of additional manufacturing space at our current facilities in Cupertino, CA and Pelham, AL. We manufacture our ALZET product in a leased facility located in Vacaville, California.

 

Patents, Licenses and Proprietary Rights

 

Our success depends in part on our ability to obtain patents, to protect trade secrets, to operate without infringing upon the proprietary rights of others and to prevent others from infringing on our proprietary rights. Our policy is to seek to protect our proprietary position by, among other methods, filing U.S. and foreign patent applications related to our proprietary technology, inventions and improvements that are important to the development of our business. As of December 31, 2004, we held 25 issued U.S. patents and 13 issued foreign patents. In addition, we have 35 pending U.S. patent applications and have filed 48 patent applications under the Patent Cooperation Treaty, from which 86 national phase applications are currently pending in Europe, Australia, Japan, Canada, Mexico, New Zealand, Brazil and China. Our patents expire at various dates starting in the year 2012.

 

Proprietary rights relating to our planned and potential products will be protected from unauthorized use by third parties only to the extent that they are covered by valid and enforceable patents or are effectively maintained as trade secrets. Patents owned by or licensed to us may not afford protection against competitors, and our pending patent applications now or hereafter filed by or licensed to us may not result in patents being issued. In addition, the laws of certain foreign countries may not protect our intellectual property rights to the same extent as do the laws of the U.S.

 

The patent positions of biopharmaceutical companies involve complex legal and factual questions and, therefore, their enforceability cannot be predicted with certainty. Our patents or patent applications, or those licensed to us, if issued, may be challenged, invalidated or circumvented, and the rights granted thereunder may not provide proprietary protection or competitive advantages to us against competitors with similar technology. Furthermore, our competitors may independently develop similar technologies or duplicate any technology developed by us. Because of the extensive time required for development, testing and regulatory review of a potential product, it is possible that, before any of our products can be commercialized, any related patent may expire or remain in existence for only a short period following commercialization, thus reducing any advantage of the patent, which could adversely affect our ability to protect future product development and, consequently, our operating results and financial position.

 

15


Table of Contents

Because patent applications in the U.S. are maintained in secrecy for at least 18 months after filing and since publication of discoveries in the scientific or patent literature often lag behind actual discoveries, we cannot be certain that we were the first to make the inventions covered by each of our issued or pending patent applications or that we were the first to file for protection of inventions set forth in such patent applications.

 

Our planned or potential products may be covered by third-party patents or other intellectual property rights, in which case we would need to obtain a license to continue developing or marketing these products. Any required licenses may not be available to us on acceptable terms, if at all. If we do not obtain any required licenses, we could encounter delays in product introductions while we attempt to design around these patents, or could find that the development, manufacture or sale of products requiring such licenses is foreclosed. Litigation may be necessary to defend against or assert such claims of infringement, to enforce patents issued to us, to protect trade secrets or know-how owned by us, or to determine the scope and validity of the proprietary rights of others. In addition, interference proceedings declared by the U.S. Patent and Trademark Office may be necessary to determine the priority of inventions with respect to our patent applications. Litigation or interference proceedings could result in substantial costs to and diversion of effort by us, and could have a material adverse effect on our business, financial condition and results of operations. These efforts by us may not be successful.

 

We may rely, in certain circumstances, on trade secrets to protect our technology. However, trade secrets are difficult to protect. We seek to protect our proprietary technology and processes, in part, by confidentiality agreements with our employees and certain contractors. There can be no assurance that these agreements will not be breached, that we will have adequate remedies for any breach, or that our trade secrets will not otherwise become known or be independently discovered by competitors. To the extent that our employees, consultants or contractors use intellectual property owned by others in their work for us, disputes may also arise as to the rights in related or resulting know-how and inventions.

 

Development and Commercialization Agreement with ALZA Corporation

 

On April 21, 1998, we entered into a Development and Commercialization Agreement with ALZA Corporation (presently a Johnson & Johnson company), which was amended and restated on April 28, 1999, April 14, 2000 and October 1, 2002. Pursuant to this agreement, ALZA granted to us exclusive, worldwide rights under ALZA intellectual property, including patents, trade secrets and know-how, to develop and commercialize products using the DUROS drug delivery technology in the fields of the delivery of drugs by catheter (except for the sufentanil product) to the central nervous system to treat selected central nervous system disorders, the delivery of drugs by catheter to the middle and inner ear, the delivery of drugs by catheter into the pericardial sac of the heart, the delivery of selected drugs by catheter into vascular grafts and the delivery of selected cancer antigens. As part of the amendments made to the agreement in October 1, 2002, ALZA may obtain from us, for its own behalf or on behalf of one of its affiliates, the exclusive right to develop and commercialize a product in a field of use exclusively licensed to us, provided that such product does not incorporate a drug in the same drug class and is not intended for the same therapeutic indication as a product which is then being developed or commercialized by us or for which we have made commitments to a third party. In the event that ALZA or an affiliate commercializes such a product, ALZA or its affiliate will pay us a royalty on sales of such product at a specified rate.

 

Under this agreement, we have the right to subcontract to third parties product development activities including development of components of the DUROS system, provided that design of the DUROS system and other development activities relating to the DUROS system must be performed by ourselves or ALZA unless ALZA permits us to subcontract out such development. We have the right to subcontract manufacturing activities relating to our products other than the assemblage of the components of the DUROS system itself. In the event of a change in our corporate control, including an acquisition of us, our right to develop and manufacture the DUROS system would terminate, and ALZA would have the right to develop and manufacture DUROS systems for us for so long as ALZA can meet our specification and supply requirements following such change in control.

 

16


Table of Contents

We also have the right to partner with third parties to commercialize our products on a product-by-product basis, provided that ALZA has options to distribute our cancer antigen products which do not incorporate proprietary molecules owned by a third party throughout the world. We must allow ALZA an opportunity to negotiate in good faith for commercialization rights to our products developed under the agreement prior to granting these rights to a third party, other than products that are subject to ALZA’s option or products for which we have obtained funding or access to a proprietary drug from a third party to whom we have granted commercialization rights prior to commencement of human clinical trials.

 

Any inventions and related intellectual property rights developed by us or ALZA under the agreement which relate to the DUROS system or its manufacture or to any combination of the DUROS system with other components, active agents, features or processes, shall be owned exclusively by ALZA. All other inventions and related intellectual property rights developed under the agreement, whether by us or ALZA, shall be owned exclusively by us.

 

In consideration for the rights granted to us under this agreement, ALZA received 5,600,000 shares of our Series A-1 Preferred Stock which was converted into 5,600,000 shares of our common stock concurrent with our initial public offering of common stock. As additional consideration, ALZA is entitled to receive a royalty on the net sales of products in an amount not less than 2.5% nor more than 5% of such net sales for so long as we sell the product. ALZA is also entitled to a percentage of any up-front license fees, milestone or any special fees, payments or other consideration we receive, excluding research and development funding, in an amount of 5% of such payment. In connection with the amendment to the agreement made in April 2000, ALZA received 1,000,000 shares of our common stock.

 

Government Regulation

 

The FDA and comparable regulatory agencies in state and local jurisdictions and in foreign countries impose substantial requirements upon the clinical development, manufacture and marketing of pharmaceutical products. These agencies and other federal, state and local entities regulate research and development activities and the testing, manufacture, quality control, safety, effectiveness, labeling, storage, record keeping, approval, advertising and promotion of our products. We believe that our initial products will be regulated as drugs by the FDA rather than as biologics or devices, whereas later products may be regulated as combination products with a device designation for all or some of the final product components.

 

The process required by the FDA under the new drug provisions of the Federal Food, Drug and Cosmetics Act before our initial products may be marketed in the U.S. generally involves the following:

 

  ·   preclinical laboratory and animal tests;

 

  ·   submission of an IND application which must become effective before clinical trials may begin;

 

  ·   adequate and well-controlled human clinical trials to establish the safety and efficacy of the proposed pharmaceutical in our intended use; and

 

  ·   FDA approval of a new drug application.

 

The testing and approval process requires substantial time, effort, and financial resources and we cannot be certain that any approval will be granted on a timely basis, if at all.

 

Preclinical tests include laboratory evaluation of the product, its chemistry, formulation and stability, as well as animal studies to assess the potential safety and efficacy of the product. We then submit the results of the preclinical tests, together with manufacturing information and analytical data, to the FDA as part of an IND, which must become effective before we may begin human clinical trials. The IND automatically becomes effective 30 days after receipt by the FDA, unless the FDA, within the 30-day time period, raises concerns or questions about the conduct of the trials as outlined in the IND and imposes a clinical hold. In such a case, the IND sponsor and the FDA must resolve any outstanding concerns before clinical trials can begin. Our submission

 

17


Table of Contents

of an IND may not result in FDA authorization to commence clinical trials. Further, an independent Institutional Review Board at each medical center proposing to conduct the clinical trials must review and approve any clinical study.

 

Human clinical trials are typically conducted in three sequential phases which may overlap:

 

  ·   PHASE I:    The drug is initially introduced into healthy human subjects or patients and tested for safety, dosage tolerance, absorption, metabolism, distribution and excretion.

 

  ·   PHASE II:    Involves studies in a limited patient population to identify possible adverse effects and safety risks, to determine the efficacy of the product for specific targeted diseases and to determine dosage tolerance and optimal dosage.

 

  ·   PHASE III:    When Phase II evaluations demonstrate that a dosage range of the product is effective and has an acceptable safety profile, Phase III trials are undertaken to further evaluate dosage, clinical efficacy and to further test for safety in an expanded patient population, often at geographically dispersed clinical study sites.

 

In the case of products for severe diseases, such as chronic pain, or life-threatening diseases such as cancer, the initial human testing is often conducted in patients with disease rather than in healthy volunteers. Since these patients already have the target disease or condition, these studies may provide initial evidence of efficacy traditionally obtained in Phase II trials and thus these trials are frequently referred to as Phase I/II trials. We cannot be certain that we will successfully complete Phase I, Phase II or Phase III testing of our product candidates within any specific time period, if at all. Furthermore, the FDA or the Institutional Review Board or the sponsor may suspend clinical trials at any time on various grounds, including a finding that the subjects or patients are being exposed to an unacceptable health risk.

 

The results of product development, preclinical studies and clinical studies are submitted to the FDA as part of a new drug application for approval of the marketing and commercial shipment of the product. The FDA may deny a new drug application if the applicable regulatory criteria are not satisfied or may require additional clinical data. Even if such data is submitted, the FDA may ultimately decide that the new drug application does not satisfy the criteria for approval. Once issued, the FDA may withdraw product approval if compliance with regulatory standards is not maintained or if safety problems occur after the product reaches the market. In addition, the FDA requires surveillance programs to monitor approved products which have been commercialized, and the agency has the power to require changes in labeling or to prevent further marketing of a product based on the results of these post-marketing programs.

 

In addition to the drug approval requirements applicable to our initial product for the treatment of chronic pain through the Center for Drug Evaluation and Research (CDER), the FDA may require an intercenter consultation review by the Center for Devices and Radiological Health (CDRH). This request for consultation may be based on the device-like nature of a number of aspects of the DUROS technology.

 

Satisfaction of the above FDA requirements or similar requirements of state, local and foreign regulatory agencies typically takes several years and the actual time required may vary substantially, based upon the type, complexity and novelty of the pharmaceutical product. Government regulation may delay or prevent marketing of potential products for a considerable period of time and impose costly procedures upon our activities. We cannot be certain that the FDA or any other regulatory agency will grant approval for any of our products under development on a timely basis, if at all. Success in preclinical or early stage clinical trials does not assure success in later stage clinical trials. Data obtained from preclinical and clinical activities is not always conclusive and may be susceptible to varying interpretations which could delay, limit or prevent regulatory approval. Even if a product receives regulatory approval, the approval may be significantly limited to specific indications. Further, even after regulatory approval is obtained, later discovery of previously unknown problems with a product may result in restrictions on the product or even complete withdrawal of the product from the market. Delays in obtaining, or failures to obtain regulatory approvals would have a material adverse effect on our business.

 

18


Table of Contents

Marketing our products abroad will require similar regulatory approvals and is subject to similar risks. In addition, we cannot predict what adverse governmental regulations may arise from future U.S. or foreign governmental action.

 

Any products manufactured or distributed by us pursuant to FDA clearances or approvals are subject to pervasive and continuing regulation by the FDA, including record-keeping requirements and reporting of adverse experiences with the drug. Drug manufacturers and their subcontractors are required to register their establishments with the FDA and state agencies, and are subject to periodic unannounced inspections by the FDA and state agencies for compliance with good manufacturing practices, which impose procedural and documentation requirements upon us and our third party manufacturers. We cannot be certain that we or our present or future suppliers will be able to comply with the GMP regulations and other FDA regulatory requirements.

 

The FDA regulates drug labeling and promotion activities. The FDA has actively enforced regulations prohibiting the marketing of products for unapproved uses. Under the FDA Modernization Act of 1997, the FDA will permit the promotion of a drug for an unapproved use in certain circumstances, but subject to very stringent requirements. We and our products are also subject to a variety of state laws and regulations in those states or localities where our products are or will be marketed. Any applicable state or local regulations may hinder our ability to market our products in those states or localities. We are also subject to numerous federal, state and local laws relating to such matters as safe working conditions, manufacturing practices, environmental protection, fire hazard control, and disposal of hazardous or potentially hazardous substances. We may incur significant costs to comply with such laws and regulations now or in the future.

 

The FDA’s policies may change and additional government regulations may be enacted which could prevent or delay regulatory approval of our potential products. Moreover, increased attention to the containment of health care costs in the U.S. and in foreign markets could result in new government regulations that could have a material adverse effect on our business. We cannot predict the likelihood, nature or extent of adverse governmental regulation that might arise from future legislative or administrative action, either in the U.S. or abroad.

 

Competition

 

We may face competition from other companies in numerous industries including pharmaceuticals, medical devices and drug delivery. Our SABER-Bupivacaine, TRANSDUR-Sufentanil, Remoxy, CHRONOGESIC product candidates, if approved, will compete with currently marketed oral opioids, transdermal opioid patches, and implantable and external infusion pumps which can be used for infusion of opioids. Products of these types are marketed by Purdue Pharma, Knoll, Janssen, Medtronic, AstraZeneca, Arrow International, Tricumed and others. Numerous companies are applying significant resources and expertise to the problems of drug delivery and several of these are focusing or may focus on delivery of drugs to the intended site of action, including Alkermes, Atrix, Genetronics, The Liposome Company, Focal, I-Flow and others. Although we have exclusivity with respect to our license of the DUROS technology in specific fields of therapy, ALZA is also a potential competitor with technologies other than DUROS.

 

Some of these competitors may be addressing the same therapeutic areas or indications as we are. Our current and potential competitors may succeed in obtaining patent protection or commercializing products before us. Any products we develop using our pharmaceutical systems technologies will compete in highly competitive markets. Many of our potential competitors in these markets have greater development, financial, manufacturing, marketing, and sales resources than we do and we cannot be certain that they will not succeed in developing products or technologies which will render our technologies and products obsolete or noncompetitive. In addition, many of those potential competitors have significantly greater experience than we do in their respective fields.

 

19


Table of Contents

Corporate History, Headquarters and Website Information

 

DURECT Corporation was incorporated in Delaware in February 1998. We completed our initial public offering on September 28, 2000. Our principal executive offices are located at 10240 Bubb Road, Cupertino, California, 95014. Our telephone number is (408) 777-1417, and our web site address is www.durect.com. We make our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports available free of charge on our web site as soon as reasonably practicable after we file these reports with the Securities and Exchange Commission.

 

Employees

 

As of February 28, 2005 we had 132 employees, including 75 in research and development, 21 in manufacturing and 36 in selling, general and administrative. From time to time, we also employ independent contractors to support our research, development and administrative organizations. None of our employees are represented by a collective bargaining unit, and we have never experienced a work stoppage. We consider our relations with our employees to be good.

 

Executive Officers of the Registrant.

 

The executive officers of DURECT Corporation and their ages as of February 28, 2005 are as follows:

 

Name


   Age

   Position

Felix Theeuwes, D.Sc.

   67    Chairman, Chief Scientific Officer and Director

James E. Brown, D.V.M.

   48    President, Chief Executive Officer and Director

Thomas A. Schreck

   47    Chief Financial Officer and Director

Jean I Liu

   36    Senior Vice President and General Counsel

Paula Mendenhall, Ph.D.

   61    Senior Vice President, Operations

Timothy S. Nelson

   41    Senior Vice President, Business and Commercial Development

Su Il Yum, Ph.D.

   65    Senior Vice President, Engineering

Tai Wah Chan, Ph.D.

   60    Vice President, Pharmaceutical Research and Development

Steven Halladay, Ph.D.

   57    Vice President, Clinical and Regulatory

Jian Li

   34    Vice President, Finance and Corporate Controller

 

Felix Theeuwes, D.Sc. co-founded DURECT in February 1998 and has served as our Chairman, Chief Scientific Officer and a Director since July 1998. Prior to that, Dr. Theeuwes held various positions at ALZA Corporation, a pharmaceutical and drug delivery company which is an affiliate of us, including President of New Ventures from August 1997 to August 1998, President of ALZA Research and Development from 1995 to August 1997, President of ALZA Technology Institute from 1994 to April 1995 and Chief Scientist from 1982 to June 1997. Dr. Theeuwes is also a director of Genetronics, a medical device company. Dr. Theeuwes holds a D.Sc. degree in Physics from the University of Leuven (Louvain), Belgium. He also served as a post-doctoral fellow and visiting research assistant professor in the Department of Chemistry at the University of Kansas and has completed the Stanford Executive Program.

 

James E. Brown, D.V.M. co-founded DURECT in February 1998 and has served as our President, Chief Executive Officer and a Director since June 1998. He previously worked at ALZA Corporation as Vice President of Biopharmaceutical and Implant Research and Development from June 1995 to June 1998. Prior to that, Dr. Brown held various positions at Syntex Corporation, a pharmaceutical company, including Director of Business Development from May 1994 to May 1995, Director of Joint Ventures for Discovery Research from April 1992 to May 1995, and held a number of positions including Program Director for Syntex Research and Development from October 1985 to March 1992. Dr. Brown holds a B.A. from San Jose State University and a D.V.M. (Doctor of Veterinary Medicine) from the University of California, Davis where he also conducted post-graduate work in pharmacology and toxicology.

 

20


Table of Contents

Thomas A. Schreck co-founded DURECT in February 1998 and served as Chief Executive Officer, Chief Financial Officer and President from February 1998 to June 1998. Since June 1998, he has served as our Chief Financial Officer and a Director. Prior to founding DURECT, he founded and was President of Schreck Merchant Group, Inc., an investment bank specializing in private placements and mergers and acquisitions, from June 1994 to February 1998. Mr. Schreck also founded and served as Risk Manager to Genesis Merchant Group/Portola Capital Partners, L.P., a convertible arbitrage fund, from 1993 to 1994. He also served as a Manager of the Convertible Securities Department at Montgomery Securities, from 1988 to 1991. Mr. Schreck holds a B.A. from Williams College.

 

Jean I Liu has served as our Senior Vice President and General Counsel since February 2003. Prior to that, she served as our Vice President of Legal and General Counsel from February 1999 to February 2003. Previously, from October 1998, Ms. Liu served as our Vice President of Legal. Prior to that, Ms. Liu worked as an attorney at Venture Law Group, a law firm, from May 1997 to October 1998. Ms. Liu worked as an attorney at Pillsbury Madison & Sutro LLP, a law firm, from September 1993 to May 1997. Ms. Liu holds a B.S. in Cellular & Molecular Biology from University of Michigan, an M.S. in Biology from Stanford University and a J.D. from Columbia University School of Law.

 

Paula Mendenhall, Ph.D. has served as our Senior Vice President of Operations since January 2005. Prior to joining DURECT, Dr. Mendenhall was an independent consultant for various pharmaceutical companies for in-house and outsourcing of pharmaceutical manufacturing, including development of manufacturing strategies and plans and development and training of personnel. From 1997 to 2000, Dr. Mendenhall served as Vice President, Group Vice President and President of Oread Pharmaceutical Manufacturing at Oread Inc. From 1979 to 1997, Dr. Mendenhall served in a variety of roles for Hoffmann-La Roche Inc./Syntex, including in the areas of manufacturing, quality assurance, finance, planning and facilities, as well as provided technical assistance and support to Syntex Global Operations for marketed products and new product launches. Dr. Mendenhall received a Pharm D. degree from the University of California, San Francisco, and is a member of the American Association of Pharmaceutical Scientists, the American Pharmaceutical Association and the Society of Cosmetic Chemists.

 

Timothy S. Nelson has served as our Senior Vice President of Business and Commercial Development since February 2003. Prior to that, he served as our Vice President of Business and Commercial Development from September 1998 to February 2003. Previously, Mr. Nelson held various positions at Medtronic, Inc., a medical device company, including Business Director of Neurological Division, Europe, Middle East and Africa from June 1996 to September 1998, and Manager of Drug Delivery Ventures and Business Development from August 1992 to June 1996. Mr. Nelson holds a Bachelor of Chemical Engineering degree from the University of Minnesota and a Master of Management degree with Distinction from the J.L. Kellogg Graduate School of Management, Northwestern University.

 

Dr. Su IL Yum, Ph.D. has served as our Senior Vice President, Engineering since December 2003. Previously, Dr. Yum served as our Vice President of Engineering from December 1999 to December 2003. Prior to joining DURECT, Dr. Yum served as Senior Technical Advisor at Amira Medical in Scotts Valley, California, where he participated in the development of a pain-free blood glucose detector called AtLast®. Prior to joining Amira, he held a number of senior positions in project management and engineering at Alza Corporation. Dr. Yum earned his Ph.D. degree in Chemical Engineering from the University of Minnesota, and completed a Post-doctoral research in Biomedical Engineering at the University of Utah. He has more than 40 scientific publications and is the holder of more than 60 U.S. and foreign patents. Dr. Yum is a Fellow of the AAPS.

 

Tai Wah Chan, Ph.D. has served as our Vice President of Pharmaceutical Research and Development since August 2001. Previously, Dr. Chan served as our Executive Director of Pharmaceutical Research from February 2000 to August 2001 and served as our Senior Director of Pharmaceutical Research from November 1999 to February 2000. Prior to that, Dr. Chan was self employed as a pharmaceutical consultant from October 1997 to November 1999 and was a Senior Scientist at Oread, Inc., a pharmaceutical contract research organization, from

 

21


Table of Contents

October 1996 to October 1997. Dr. Chan holds a B.S. in Physics and Chemistry from the University of Hong Kong and a Ph.D. in Chemistry from the University of Chicago.

 

Steven Halladay, Ph.D. has served as Vice President of Clinical and Regulatory since April 2003. Prior to that, Dr. Halladay served as our Medical Director from November 2002 and April 2003. Prior to joining DURECT, Dr. Halladay held various positions at Clingenix, Inc., Research Services, Inc., Hoffmann-La Roche, Syntex Laboratories, ALZA Corporation and Dynapol. Following 20 years with Syntex and Hoffmann-La Roche, Dr. Halladay founded Research Services, Inc., an innovative pharmaceutical research company. After 5 years as President and CEO, Research Services merged with Clingenix, Inc. As Senior Executive Vice President at Clingenix his corporate responsibilities included pharmacogenomic program development, new business development, strategic alliances/relationships, and all aspects associated with clinical research and pharmacogenomic medical application. Dr. Halladay holds a B.S. from Southern Utah University, M.S. in Toxicology from University of Arizona and a Ph.D. from the Arizona Medical Center, Tucson, Arizona in Clinical Pharmacology.

 

Jian Li has served as our Vice President of Finance and Corporate Controller since December 2003. Previously, Ms. Li served as our Corporate Controller from April 2001 to December 2003, Assistant Controller from December 2000 to April 2001 and our Accounting Manager from March 2000 to December 2000. Prior to joining DURECT, she held various positions at Elan Pharmaceuticals in California and GTE Hawaiian Telephone in Honolulu, Hawaii in the roles of Financial Analyst, Accountant and Marketing Analyst. Ms. Li holds an M.B.A. from the University of Hawaii at Manoa. She is also a Certified Public Accountant and a member of American Institute of Certified Public Accountants.

 

Item 2.    Properties.

 

We are headquartered in Cupertino, California, where we lease approximately 30,000 square feet of space under a lease expiring in February 2009 with an option to extend for up to an additional five years. This facility contains both office and laboratory space and is also the site of the manufacturing facility we have constructed. In June 2001, we leased approximately 20,000 square feet of additional corporate office space in Cupertino, California, under a lease expiring in May 2006 with options to extend for up to an additional eight years. In December 2003, we leased approximately 20,000 square feet of additional corporate office and laboratory space in Cupertino, California, under a lease expiring in February 2009 with an option to extend for up to an additional five years. We also lease approximately 7,800 square feet of space in Vacaville, California, which contains manufacturing space for the ALZET product. Our lease of this facility expires in August 2005 with an option to extend for two years. In addition, we leased approximately 2,500 square feet of office and laboratory space in Birmingham, Alabama, under a lease which expires in April 2005 and leased approximately 9,400 square feet of office and laboratory space in Pelham, Alabama, under a lease expiring in September 2009 with one option to extend for five years. We believe that our existing facilities are adequate to meet our current and foreseeable requirements or that suitable additional or substitute space will be available as needed.

 

Item 3.    Legal Proceedings.

 

We are not a party to any material legal proceedings.

 

Item 4.    Submission of Matters to a Vote of Security Holders.

 

Not applicable.

 

22


Table of Contents

PART II

 

Item 5.    Market for Registrant’s Common Equity, Related Stockholder Matter and Issuer Purchases of                      Equity Securities

 

Price Range of Common Stock

 

Our common stock has been listed for quotation on the Nasdaq National Market under the symbol “DRRX” since our initial public offering on September 28, 2000. The following table shows the high and low sales prices of our common stock as reported by the Nasdaq National Market for the period indicated.

 

Fiscal 2003


   High

   Low

Quarter ended March 31, 2003

   $ 2.31    $ 1.12

Quarter ended June 30, 2003

   $ 4.00    $ 1.41

Quarter ended September 30, 2003

   $ 3.55    $ 1.87

Quarter ended December 31, 2003

   $ 3.99    $ 2.15

 

Fiscal 2004


   High

   Low

Quarter ended March 31, 2004

   $ 3.49    $ 2.51

Quarter ended June 30, 2004

   $ 4.23    $ 3.25

Quarter ended September 30, 2004

   $ 3.36    $ 1.26

Quarter ended December 31, 2004

   $ 3.45    $ 1.41

 

The closing sale price of the common stock as reported on the Nasdaq National Market on February 28, 2005 was $3.11 per share. As of that date there were approximately 203 holders of record of the common stock. This does not include the number of persons whose stock is in nominee or “street name” accounts through brokers. The market price of our common stock has been and may continue to be subject to wide fluctuations in response to a number of events and factors, such as progress in our development programs, quarterly variations in our operating results, announcements of technological innovations or new products by us or our competitors, changes in financial estimates and recommendations by securities analysts, the operating and stock performance of other companies that investors may deem comparable to us, and news reports relating to trends in our markets. These fluctuations, as well as general economic and market conditions, may adversely affect the market price for our common stock.

 

Dividend Policy

 

We have never paid cash dividends on our common stock. We currently intend to retain any future earnings to fund the development and growth of our business. Therefore, we do not currently anticipate paying any cash dividends in the foreseeable future.

 

Purchases of Equity Securities by the Issuer and Affiliated Purchasers

 

In the twelve months ended December 31, 2004, we purchased the following shares of our common stock:

 

Period


  

Total Number of Shares Purchased


   Average Price
Paid Per Share


February 2004

   1,250*    $ 1.00
  *   Purchased from a departing employee pursuant to pre-existing contractual rights.

 

We have no publicly announced programs to repurchase shares of our common stock.

 

Item 6.    Selected Financial Data.

 

The following selected consolidated financial data should be read in conjunction with and are qualified by reference to “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and related notes, which are included in this Form 10-K. The statement of

 

23


Table of Contents

operations data for the years ended December 31, 2004, 2003 and 2002 and the balance sheet data at December 31, 2004 and 2003 are derived from, and are qualified by reference to, the audited financial statements included elsewhere in this Form 10-K. The statement of operations data for the years ended December 31, 2001 and 2000, and the balance sheet data at December 31, 2002, 2001 and 2000 are derived from our audited statements not included in this Form 10-K. Historical operating results are not necessarily indicative of results in the future. See Note 1 of notes to consolidated financial statements for an explanation of the determination of the shares used in computing net loss per share.

 

     Year Ended December 31,

 
     2004

    2003

    2002

    2001

    2000

 
     (in thousands, except per share data)  

Statement of Operations Data:

                                        

Product revenue, net

   $ 6,416     $ 6,691     $ 6,314     $ 6,166     $ 3,155  

Collaborative research and development and other revenue

     7,437       5,144       871       358       —    
    


 


 


 


 


Total revenue

     13,853       11,835       7,185       6,524       3,155  
    


 


 


 


 


Operating expenses:

                                        

Cost of revenue

     2,729       2,427       3,086       3,252       1,876  

Research and development

     24,231       20,935       29,535       24,472       12,669  

Research and development—related party

     2       13       19       98       666  

Selling, general and administrative

     9,747       8,498       10,970       8,779       4,874  

Amortization of intangible assets

     1,249       1,343       1,340       1,844       850  

Stock-based compensation

     204       (102 )     1,204       3,451       5,043  

Acquired in-process research and development

     —         —         —         14,030       —    
    


 


 


 


 


Total operating expenses

     38,162       33,114       46,154       55,926       25,978  
    


 


 


 


 


Loss from operations

     (24,309 )     (21,279 )     (38,969 )     (49,402 )     (22,823 )

Other income (expense):

                                        

Interest income

     1,236       1,041       2,076       4,796       3,103  

Interest expense and other

     (4,546 )     (2,460 )     (280 )     (322 )     (131 )
    


 


 


 


 


Net other income (expense)

     (3,310 )     (1,419 )     1,796       4,474       2,972  
    


 


 


 


 


Loss before income taxes

     (27,619 )     (22,698 )     (37,173 )     (44,928 )     (19,851 )

Income tax provision

     18       —         —         —         —    
    


 


 


 


 


Net loss

     (27,637 )     (22,698 )     (37,173 )     (44,928 )     (19,851 )

Accretion of cumulative dividends on Series B convertible preferred stock

     —         —         —         —         972  
    


 


 


 


 


Net loss attributable to common stockholders

   $ (27,637 )   $ (22,698 )   $ (37,173 )   $ (44,928 )   $ (20,823 )
    


 


 


 


 


Basic and diluted net loss attributable to common stockholders per common share

   $ (0.54 )   $ (0.45 )   $ (0.77 )   $ (0.97 )   $ (1.22 )

Shares used in computing basic and diluted net loss per share

     51,507       50,510       48,318       46,414       17,120  
     As of December 31,

 
     2004

    2003

    2002

    2001

    2000

 
     (in thousands)  

Balance Sheet Data:

                                        

Cash, cash equivalents and investments

   $ 61,813     $ 85,167     $ 48,268     $ 76,622     $ 106,084  

Working capital

     42,082       61,050       41,856       54,463       105,060  

Total assets

     85,468       112,407       72,971       104,943       120,612  

Long-term liabilities, net of current portion

     61,589       62,278       1,604       2,147       1,105  

Stockholders’ equity

     18,390       45,115       66,182       97,048       115,254  

 

 

24


Table of Contents

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 as of December 31, 2004, 2003, and 2002 should be read in conjunction with our Consolidated Financial Statements, including the Notes thereto, and “Factors that May Affect Future Results” section included elsewhere in this Form 10-K. This Form 10-K contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended. When used in this report or elsewhere by management from time to time, the words “believe,” “anticipate,” “intend,” “plan,” “estimate,” and similar expressions are forward looking statements. Such forward-looking statements contained herein are based on current expectations. Any such forward-looking statements are not guarantees of future performance and involve risks and uncertainties. Actual events or results may differ materially from those discussed in the forward-looking statements as a result of various factors. For a more detailed discussion of such forward looking statements and the potential risks and uncertainties that may impact upon their accuracy, see the “Factors that May Affect Future Results” and “Overview” sections of this Management’s Discussion and Analysis of Financial Condition and Results of Operations. These forward-looking statements reflect our view only as of the date of this report. We undertake no obligations to update any forward-looking statements. You should also carefully consider the factors set forth in other reports or documents that we file from time to time with the Securities and Exchange Commission.

 

Overview

 

We are an emerging specialty pharmaceuticals systems company focused on the development of pharmaceutical systems based on the following proprietary drug delivery technology platforms: the SABER Delivery System (a patented and versatile depot injectable useful for protein and small molecule delivery), the TRANSDUR Delivery System (a proprietary transdermal technology), the ORADUR sustained release oral gel-cap technology (an oral sustained release technology with several potential abuse deterrent properties), the DURIN Biodegradable Implant (a biodegradable drug-loaded implant), the DUROS® System, (an osmotic implant technology licensed to us for specified fields from ALZA Corporation, a Johnson & Johnson Company) and the MICRODUR Biodegradable Microparticulates (a microspheres injectable system).

 

Collaborative Agreements

 

In order to rapidly identify and fund additional product opportunities, we may enter into agreements with various companies who wish to explore the feasibility of combining their drugs with our drug delivery technologies to develop product candidates. In addition, we may enter into agreements with companies who wish to collaborate on the development and commercialization of our existing product candidates in development. To date, we have entered into such arrangements with Pain Therapeutics, Voyager, Endo and NeuroSystec. Under these collaborative agreements, we perform research and development activities to develop product candidates utilizing our drug delivery technologies and recognize collaborative research and development revenue on reimbursement payments of expenses and milestone payments from our collaborators. Depending on the agreement, we may also have royalty, distribution, or other rights once product candidates are commercialized under the agreement.

 

In 2004, revenues from our collaborative agreements with Pain Therapeutics and Voyager represented 29% and 18% of our total revenues. In 2003, revenues from our collaborative agreements with Pain Therapeutics and Voyager represented 24% and 10% of our total revenues.

 

Product Revenues

 

We currently generate product revenue from the sale of two product lines:

 

  ·   ALZET osmotic pumps for animal research use; and

 

  ·   LACTEL biodegradable polymers which are used by our customers as raw materials in their pharmaceutical and medical products. This product line was sold through our wholly-owned subsidiary API until it was merged with and into us as of December 31, 2004.

 

25


Table of Contents

Because we consider our core business to be developing and commercializing pharmaceutical systems, we do not intend to significantly increase our investments in or efforts to sell or market any of our existing product lines. However, we expect that we will continue to make efforts to increase our revenue related to collaborative research and development by entering into additional research and development agreements with third party partners to develop product candidates based on our drug delivery technologies.

 

Since our inception in 1998, we have had a history of operating losses. At December 31, 2004, we had an accumulated deficit of $163.9 million and our net losses were $27.6 million, $22.7 million and $37.2 million for the twelve months ended December 31, 2004, 2003 and 2002, respectively. These losses have resulted primarily from costs incurred to research and develop our product candidates and to a lesser extent, from selling, general and administrative costs associated with our operations and product sales. We expect our research and development expenses to increase modestly in the near future as we expect to continue to expand our animal studies, clinical trials and other research and development activities. We expect our general and administrative expenses to increase modestly in the near future in light of the additional cost of corporate governance requirements. We also expect to incur additional non-cash expenses relating to amortization of intangible assets and stock-based compensation. We do not anticipate revenues from our pharmaceutical systems, should they be approved, for at least several years. Therefore, we expect to incur continuing losses and negative cash flow from operations for the foreseeable future.

 

Critical Accounting Policies and Estimates

 

General

 

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. The most significant estimates and assumptions relate to revenue recognition, the recoverability of our long-lived assets, including goodwill and other intangible assets, accrued liabilities and contract research liabilities. Actual amounts could differ significantly from these estimates.

 

Revenue Recognition

 

Revenue from the sale of products is recognized at the time the product is shipped and title transfers to customers, provided no continuing obligation exists and the collectibility of the amounts owed is reasonably assured. Incorrect assumptions at the time of sale about our customers’ ability to pay could result in an overstatement of revenue.

 

Revenue related to research and development with our collaborators is recognized as the related research and development services are performed over the related funding periods for each agreement. The payments received under each respective agreement are not refundable and are generally based on reimbursement of qualified expenses, as defined in the agreements. Research and development expenses under the collaborative and development research agreements approximate or exceed the revenue recognized under such agreements over the term of the respective agreements. Deferred revenue may result when we do not expend the required level of effort during a specific period in comparison to funds received under the respective agreement. Milestone and royalties payments, if any, are recognized as earned. Incorrect determination of qualified expenses could result in greater or lesser revenue being recorded.

 

Revenue on cost-plus-fee contracts, such as other contract research and development revenue, is recognized only to the extent of reimbursable costs incurred plus estimated fees thereon. In all cases, revenue is recognized only after a signed agreement is in place. For contracts that have a ceiling price or contract value, losses on contracts are recognized in the period in which the losses become known and estimable. Incorrect estimates as to

 

26


Table of Contents

percentage of completion or losses expected to be incurred could result in greater or lesser revenues or losses being recorded.

 

Intangible Assets and Goodwill

 

We record intangible assets when we acquire other companies. The cost of an acquisition is allocated to the assets acquired and liabilities assumed, including intangible assets, with the remaining amount being classified as goodwill. Certain intangible assets such as completed or core technology are amortized over time, while acquired in-process research and development is recorded as a one-time charge on the acquisition date. Acquired in-process research and development represents the value of research projects in process at the time of acquisition which have not yet reached technological feasibility, and which have no alternative future use. The determination of the amount of acquired in-process research and development involves several estimates and judgments, including the percentage of completion of the in-process technology and assumptions about future cash flows to be derived from the technology and discount rates. Different assumptions employed in determining the value of in-process research and development could result in a greater or lesser amount being recorded.

 

As of January 1, 2002, goodwill is not amortized to expense but rather periodically assessed for impairment. The allocation of the cost of an acquisition to intangible assets and goodwill therefore has a significant impact on our future operating results. The allocation process requires the extensive use of estimates and assumptions, including estimates of future cash flows expected to be generated by the acquired assets. We are also required to estimate the useful lives of those intangible assets subject to amortization, which determines the amount of amortization that will be recorded in a given future period and how quickly the total balance will be amortized. We periodically review the estimated remaining useful lives of our intangible assets. A reduction in our estimate of remaining useful lives, if any, could result in increased amortization expense in future periods.

 

We assess the impairment of identifiable intangible assets, long-lived assets and goodwill whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include the following:

 

  ·   significant underperformance relative to expected historical or projected future operating results;

 

  ·   significant changes in the manner of our use of the acquired assets or the strategy for our overall business;

 

  ·   significant negative industry or economic trends;

 

  ·   significant decline in our stock price for a sustained period; and

 

  ·   our market capitalization relative to net book value.

 

When we determine that the carrying value of intangibles, long-lived assets and goodwill may not be recoverable based upon the existence of one or more of the above indicators of impairment, we measure any impairment based on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model. The amount of any impairment charge is significantly impacted by and highly dependent upon assumptions as to future cash flows and the appropriate discount rate. Management believes that the discount rate used in this analysis is reasonable in light of currently available information. The use of different assumptions or discount rates could result in a materially different impairment charge.

 

In 2002, Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (SFAS 142) became effective. As a result, we ceased amortizing approximately $4.7 million of goodwill and assembled workforce. In lieu of amortization, we perform a review for impairment at least annually. No impairment of goodwill has been recorded through December 31, 2004. However, there can be no assurance that at the time other periodic reviews are completed, a material impairment charge will not be recorded.

 

27


Table of Contents

Accrued Liabilities and Contract Research Liabilities

 

We incur significant costs associated with third party consultants and organizations for clinical trials, engineering, validation, testing, and other research and development-related services. We are required to estimate periodically the cost of services rendered but unbilled based on managements’ estimates of project status. If these good faith estimates are inaccurate, actual expenses incurred could materially differ from our estimates.

 

The above listing is not intended to be a comprehensive list of all of our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by accounting principles generally accepted in the United States, with no need for management’s judgment in their application. There are also areas in which management’s judgment in selecting any available alternative would not produce a materially different result. See our audited consolidated financial statements and notes thereto in Item 8 of our Form 10-K which contain accounting policies and other disclosures required by generally accepted accounting principles.

 

Results of Operations

 

Comparison of years ended December 31, 2004 and 2003

 

Revenue.    Total revenues were $13.9 million in 2004 compared to $11.8 million in 2003. The increase in total revenue was primarily attributable to higher collaborative research and development and milestone revenue recognized from our agreements with Pain Therapeutics, Voyager Pharmaceutical Corporation and other strategic partners. A portion of our revenues is derived from our product sales, which include our ALZET mini pump product line, and to a lesser extent our polymer products and ear catheter products.

 

Net product revenues were $6.4 million in 2004 compared to $6.7 million in 2003. The decrease was primarily due to a lower product revenue from our ALZET mini pump product line in 2004, partially offset by higher polymer revenue from our API biodegradable polymer product line. We ceased selling IntraEAR catheter products in September 2003 due to a change in business strategic focus. IntraEAR products comprised zero and $81,000 of net product revenue in 2004 and 2003, respectively.

 

We also recognize revenues from collaborative research and development activities, service contracts and to a lesser extent license activities. We recorded $6.9 million of collaborative research and development and milestone revenue in 2004 compared to $5.0 million in 2003. Collaborative research and development and milestone revenue represents reimbursement of qualified expenses related to the collaborative agreements with various third parties to research, develop and commercialize potential product candidates using our drug delivery technologies and milestone payments upon achieving certain regulatory milestones under the collaboration agreements. The increase in collaborative research and development revenue in 2004 was primarily attributable to our increased development activities for Remoxy (collaboration with Pain Therapeutics) and DURIN-based Alzheimer’s disease product (collaboration with Voyager) compared with 2003. We recognized $1.0 million of milestone revenue in 2004 under the collaboration agreements with Pain Therapeutics and Voyager compared with none in 2003. We expect our collaborative research and development revenue to increase in the future years as we continue to increase our effort to develop partnered products with various strategic partners.

 

Other revenue from service contracts was $502,000 in 2004 compared to $149,000 in 2003. Service contract revenues were related to certain polymer related service contracts API signed with various customers. Other license revenue was $82,000 in 2004 compared with none in 2003. Our license revenue was recognized in connection with our agreement with NeuroSystec.

 

In 2004, revenues from our collaborative agreements with Pain Therapeutics and Voyager represented 29% and 18% of our total revenues. In 2003, revenues from our collaborative agreements with Pain Therapeutics and Voyager represented 24% and 10% of our total revenues.

 

28


Table of Contents

In the future, we do not intend to significantly increase our investments in or efforts to sell or market any of our existing product lines. However, we will continue to make efforts to increase our revenue related to collaborative research and development by entering into additional research and development agreements with third party partners to develop products based on our drug delivery technologies.

 

Cost of revenue.    Cost of revenue increased to $2.7 million in 2004 from $2.4 million in 2003. Cost of revenue includes cost of product revenue and cost of contract services provided by us. The increase in cost of revenue was primarily due to increased cost of service revenue related to API service contracts in 2004. Cost of revenue associated with the product revenue was $2.3 million in both 2004 and in 2003. Cost of other revenue from service contracts increased to $407,000 in 2004 from $119,000 in 2003 due to higher manufacturing costs for additional service contracts we performed for API customers in 2004. As of December 31, 2004, we had 21 manufacturing employees compared with 20 as of the corresponding date in 2003. We expect cost of revenue to remain comparable in the future, as we do not expect product revenues and service contract revenues to increase significantly in the future.

 

Research and development.    Research and development expenses increased to $24.2 million in 2004 from $20.9 million in 2003. The increase was primarily attributable to higher development costs related to our SABER post-operative pain product candidate, transdermal sufentanil pain product candidate, CHRONOGESIC and other partnered product candidates in development. As of December 31, 2004, we had 72 research and development employees compared with 60 as of the corresponding date in 2003. We expect research and development expenses to increase in the near future as we continue to conduct clinical trials and toxicological studies for our SABER post-operative pain depot product candidate and transdermal sufentanil pain product candidate and continue product development efforts for other internal and partnered product candidates.

 

Selling, general and administrative.    Selling, general and administrative expenses increased to $9.7 million in 2004 from $8.5 million in 2003. The increase primarily resulted from higher internal and external expenses to comply with Section 404 of the Sarbanes-Oxley Act of approximately $700,000. As of December 31, 2004, we had 34 selling, general and administrative personnel compared with 31 as of the corresponding date in 2003. We expect selling, general and administrative expenses to increase modestly in the near future in light of the additional cost of corporate governance requirements.

 

Amortization of intangible assets.    Amortization of intangible assets was $1.2 million in 2004 compared with $1.3 million in 2003. The amortization of intangible assets decreased in 2004 as certain intangible assets were fully amortized in the quarter ended June 30, 2004. In 2004 and 2003, goodwill was evaluated for impairment in accordance with SFAS 142. Based on our evaluation, no indicators of impairment were noted. Should goodwill become impaired in the future, we may be required to record an impairment charge to write the goodwill down to its estimated fair value.

 

The net amount of intangible assets at December 31, 2004 was $1.7 million, which will be amortized as follows: $1.2 million in the year of 2005, $424,000 in the year 2006, $31,000 in each of the years 2007, 2008 and 2009, and $19,000 in the year 2010. Should other intangible assets become impaired, the Company will write them down to their estimated fair values.

 

Stock-based compensation.    Since inception, we have recorded aggregate deferred compensation charges of $11.2 million in connection with stock options granted to employees and directors, including $918,000 that we recorded at the time of our acquisition of Southern BioSystems, Inc. (SBS) in April 2001 for the assumption of outstanding unvested stock options granted to employees and directors of that company. Of the total amount, we have amortized or reversed (due to employee terminations) approximately $11.2 million through December 31, 2004. Employee stock-based compensation expense, net of reversal, was ($15,000) in 2004 and ($276,000) in 2003. Of these amounts, employee stock compensation related to the following: cost of revenue of $1,000 in

 

29


Table of Contents

2004 and $18,000 in 2003; research and development expenses of ($30,000) in 2004 and ($384,000) in 2003; and selling, general and administrative expenses of $14,000 in 2004 and $90,000 in 2003.

 

Total stock compensation expense related to modification of stock option terms was $5,000 in 2004 and $78,000 in 2003.

 

Total non-employee stock compensation was $214,000 in 2004 and $96,000 in 2003. Of these amounts, non-employee stock compensation related to the following: research and development expenses of $182,000 in 2004 and $96,000 in 2003 and selling, general and administrative expenses of $30,000 in 2004 and none in 2003. Expenses for non-employee stock options are recorded over the vesting period of the options, with the amount determined by the Black-Scholes option valuation method and remeasured over the vesting term.

 

The remaining deferred employee stock compensation at December 31, 2004 was $4,000, which will be amortized as follows: $3,000 in 2005 and $1,000 in 2006. Termination of employment of option holders could cause stock-based compensation in future years to be less than indicated.

 

Other income (expense).    Interest income increased to $1.2 million in 2004 from $1.0 million in 2003. The increase in interest income was primarily attributable to higher yields on cash and debt security investments. We expect interest income to decline as our average outstanding investment balances decline. The increase in interest expense to $4.5 million for 2004 from $2.5 million for 2003 was primarily due to interest expense incurred on the $60.0 million of convertible subordinated notes issued in June and July 2003. We expect interest expense to remain comparable in the near future as we continue to make interest payments on our convertible notes and to amortize the issuance costs to interest expenses.

 

Income taxes.    Income tax provision was $18,000 in 2004 due to state income taxes paid for API in 2004 compared with zero in 2003. Prior to 2004, we had no provision for income taxes, as we incurred losses for all periods presented. As of December 31, 2004, we had net operating loss carryforwards for federal income tax purposes of approximately $132.3 million, which expire in the years 2018 through 2024 and federal research and development tax credits of approximately $1.6 million, which expire at various dates beginning in 2018 through 2024, if not utilized.

 

As of December 31, 2004, we had net operating loss carryforwards for state income tax purpose of approximately $71.1 million, which expire in the years 2008 through 2014 and state research and development tax credits of approximately $1.4 million, which do not expire.

 

Utilization of the net operating losses may be subject to a substantial annual limitation due to federal and state ownership change limitations. The annual limitation may result in the expiration of net operating losses and credits before utilization.

 

As of December 31, 2004 and 2003, we had net deferred tax assets of $57.0 million and $44.5 million. Deferred tax assets reflect the net tax effects of net operating loss and credit carryforwards and the temporary differences between the carrying amounts of assets and liabilities for financial reporting and the amounts used for income tax purposes. Realization of deferred tax assets is dependent upon future earnings, if any, the timing and amount of which are uncertain. Accordingly, the net deferred tax assets have been fully offset by a valuation allowance.

 

Comparison of years ended December 31, 2003 and 2002

 

Revenue.    Total revenues were $11.8 million in 2003 compared to $7.2 million in 2002. A significant portion of our revenues is derived from our product sales, which include our ALZET mini pump product line, and to a lesser extent our polymer and ear catheter products. The increase in total revenue was primarily attributable to higher collaborative research and development revenue recognized from our collaborative agreements with various strategic partners.

 

30


Table of Contents

Net product revenues were $6.7 million in 2003 compared to $6.3 million in 2002. The increase was primarily due to a modest increase in revenue from our ALZET mini pump product line and API biodegradable polymer product line. We ceased selling IntraEAR catheter products in September 2003 due to a change in business strategic focus. IntraEAR products comprised $81,000 and $149,000 of revenue in 2003 and 2002, respectively.

 

We also recognize a portion of our revenue from collaborative research and development activities and service contract revenue. We recorded $5.0 million of collaborative research and development revenue in 2003 compared to $507,000 in 2002. Collaborative research and development revenue represent reimbursement of qualified expenses related to the collaborative agreements we signed in 2002 with various corporate partners to research, develop and commercialize potential products using our drug delivery technologies. The increase in collaborative research and development revenue in 2003 was primarily attributable to our full year development activities in 2003 for Remoxy (collaboration with Pain Therapeutics) and DURIN-based Alzheimer’s disease product (collaboration with Voyager) under the agreements we signed with Pain Therapeutics in December 2002 and Voyager in July 2002. Total other revenue from service contracts was $149,000 in 2003 compared to $364,000 in 2002. The other revenues in 2003 were related to polymer service contracts provided by API, whereas the service contract revenues in 2002 were related to certain feasibility evaluation agreements.

 

In fiscal year 2003, revenues from our collaborative agreements with Pain Therapeutics and Voyager represented 24% and 10% of our total revenues. In the fiscal years 2003 and 2002, one Alzet customer accounted for 8% and 11% of our total revenues respectively.

 

Cost of revenue.    Cost of revenue decreased to $2.4 million in 2003 from $3.1 million in 2002. Cost of revenue includes cost of product revenue and to a lesser extent, cost of contract services provided by us. The decrease in cost of revenue was primarily due to manufacturing efficiencies achieved in our ALZET product line. Cost of revenue associated with the product revenue decreased to $2.3 million in 2003 from $2.6 million in 2002. Cost of other revenue from service contracts decreased to $119,000 in 2003 from $503,000 in 2002 as we incurred final costs related to service contracts activities in 2002. As of December 31, 2003, we had 20 manufacturing employees compared with 18 as of the corresponding date in 2002.

 

Research and development.    Research and development expenses decreased to $20.9 million in 2003 from $29.5 million in 2002. The decrease was primarily attributable to the lower development costs related to CHRONOGESIC, offset by a slight increase in research and development expenses for our post-operative pain product and other direct expenses incurred under our collaborative agreements. The decrease in the research and development expenses also resulted from lower personnel expenses in 2003 compared with the same period of 2002. In the fourth quarter of 2002, we reduced our research and development workforce in order to conserve capital following the discontinuation of our pivotal Phase III clinical trial for CHRONOGESIC. As of December 31, 2003, we had 60 research and development employees compared with 79 as of the corresponding date in 2002.

 

Selling, general and administrative.    Selling, general and administrative expenses decreased to $8.5 million in 2003 from $11.0 million in 2002. The decrease was primarily due to effective cost controls in the existing corporate infrastructure in 2003 and a one-time expense of $1.7 million for strategic partner advisory services in connection with the Endo agreement, which was executed in the fourth quarter of 2002. As of December 31, 2003, we had 31 selling, general and administrative personnel compared with 38 as of the corresponding date in 2002.

 

Amortization of intangible assets.    Amortization of intangible assets was $1.3 million in each of 2003 and 2002. In 2003 and 2002, goodwill was evaluated for impairment in accordance with SFAS 142. Based on our evaluation, no indicators of impairment were noted. Should goodwill become impaired in the future, we may be required to record an impairment charge to write the goodwill down to its estimated fair value.

 

31


Table of Contents

Stock-based compensation.    Employee stock-based compensation expense, net of reversals, was ($198,000) in 2003 and $1.1 million in 2002. Of these amounts, employee stock compensation related to the following: cost of revenue of $18,000 in 2003 and $72,000 for 2002; research and development expenses of ($306,000) in 2003 and $490,000 in 2002; and selling, general and administrative expenses of $90,000 in 2003 and $507,000 for 2002.

 

Non-employee stock compensation related to research and development expenses was $96,000 in 2003 and $132,000 in 2002. Non-employee stock compensation related to selling, general and administrative expenses was none in 2003 and $3,000 in 2002. Expenses for non-employee stock options are recorded over the vesting period of the options, with the amount determined by the Black-Scholes option valuation method and remeasured over the vesting term.

 

The remaining deferred employee stock compensation at December 31, 2003 was $59,000, which will be amortized as follows: $45,000 in 2004, $13,000 in 2005, and $1,000 in 2006. Termination of employment of option holders could cause stock-based compensation in future years to be less than indicated.

 

Other income (expense).    Interest income decreased to $1.0 million in 2003 from $2.1 million in 2002. The decrease in interest income was primarily attributable to lower yields on debt security investments, partially offset by higher outstanding investment balances from the net issuance of our convertible subordinated notes. The increase in interest expense to $2.5 million for 2003 from $280,000 for 2002 was primarily due to interest expense incurred on the $60.0 million of convertible subordinated notes issued in June and July 2003.

 

Liquidity and Capital Resources

 

We had cash, cash equivalents, and investments totaling $61.8 million, $85.2 million and $48.3 million at December 31, 2004, 2003, and 2002, respectively. This includes $2.8 million, $3.1 million and $2.9 million of interest-bearing marketable securities classified as restricted investments on our balance sheet as of December 31, 2004, 2003 and 2002 respectively, which serve as collateral for letters of credit securing a leased facility and Alabama State Industrial Development Bonds payments which was assumed by us as part of our acquisition of SBS (SBS Bonds). The letters of credit related to security deposit of the leased facility and the SBS bonds will expire in June 2006 and November 2009, respectively. From inception through the time of our initial public offering, we raised $53.2 million, net of issuance costs, through convertible preferred stock financings. We raised $84.0 million, net of issuance costs, through our sale of stock in our initial public offering in 2000. We received $56.7 million, net of issuance costs, through our issuance of $60.0 million aggregate principal amount of convertible subordinated notes due 2008 in June and July of 2003. The decrease in cash, cash equivalents and investments from 2003 to 2004 was primarily the result of increased operating and capital expenditures and interest payments for our convertible subordinated notes, offset by payments received from customers and collaborative partners. The increase in cash, cash equivalents and investments from 2002 to 2003 was primarily the result of receipt of net proceeds from issuance of the convertible subordinated notes and payments received from customers and collaborative partners, partially offset by ongoing operating expenses.

 

We expect to receive a $10 million upfront payment in April 2005 from Endo in connection with our March 2005 license agreement for our TRANSDUR-sufentanil product candidate.

 

Working capital was $42.1 million, $61.1 million and $41.9 million at December 31, 2004, 2003 and 2002, respectively. The decrease from 2003 to 2004 was primarily attributable to expenditures related to our research and development efforts in general, and purchases of certain long-term investments. The increase from 2002 to 2003 was primarily attributable to the net proceeds from $60.0 million convertible notes, offset by our operating expenditures related to our research and development efforts.

 

32


Table of Contents

We used $22.2 million, $19.2 million and $31.3 million of cash for operations in the years ended December 31, 2004, 2003, and 2002, respectively. The increase in cash used in operating activities in 2004 compared to 2003 was primarily attributable to higher operating expenses related to our SABER post-operative pain product candidate, transdermal sufentanil pain product candidate, CHRONOGESIC and other partnered product candidates in development. The decrease in 2003 compared to 2002 was primarily due to the lower development expenses related to our CHRONOGESIC product and lower personnel related expenses in 2003 following the discontinuation of our pivotal Phase III clinical trial for CHRONOGESIC in 2002.

 

We received $20.8 million of cash from investing activities in the year ended December 31, 2004, compared with $30.9 million of cash used in investing activities in the year ended December 31, 2003 and $27.9 million of cash received from investing activities in the year ended December 31, 2002. In 2004, cash received from investing activities was primarily attributable to proceeds from maturities of investments, offset by purchases of investment. The decrease in cash provided by investing activities in 2003 compared to 2002 was primarily due to higher purchases of investments in 2003, including our investment of the net proceeds from the $60 million convertible notes in June and July of 2003.

 

We received $245,000, $57.3 million and $4.9 million of cash from financing activities in the years ended December 31, 2004, 2003 and 2002, respectively. In 2004, cash received from financing activities was primarily due to proceeds from exercises of stock options and purchases of our common stock under our employee stock purchase plan, offset by payments on a term loan and long term debt. In 2003, cash received from financing activities was primarily due to the net proceeds from our $60.0 million aggregate principal amount of convertible notes. In 2002, cash received related primarily to $5.0 million of proceeds from the sale of stock to Endo Pharmaceutical, a collaborative partner.

 

In August 2004, we issued an aggregate of 184,910 shares of our common stock, valued at $250,000, at the first anniversary of the closing of the merger to former shareholders of Absorbable Polymers Technologies, Inc. (APT) pursuant to the merger agreement signed in August 2003.

 

In June and July 2003, we completed a private placement of an aggregate of $60.0 million in convertible subordinated notes. The notes bear interest at a fixed rate of 6.25% per annum and are due on June 15, 2008. The notes are convertible at the option of the note holders into our common stock at a conversion rate of 317.4603 shares per $1,000 principal amount of notes, subject to adjustment in certain circumstances. Interest on the notes is payable semi-annually in arrears in June and December. We received net proceeds of approximately $56.7 million after deducting underwriting fees of $3.0 million and related expenses of $300,000. The convertible subordinated notes are unsecured obligation of ours and are subordinate to any secured debt we currently have or any future senior debt we may have. The proceeds from the convertible notes will be used to fund the research, development, manufacture and commercialization of existing and future products and for general corporate purpose, including working capital and capital expenditures.

 

In conjunction with the acquisition of SBS in April 2001, we assumed the SBS Bonds with remaining principal payments of $1.7 million and a current interest rate of 6.35% increasing each year up to 7.20% at maturity on November 1, 2009. As part of the acquisition agreement, we were required to guarantee and collateralize these bonds with a letter of credit of approximately $2.4 million that we secured with investments deposited with a financial institution in July 2001. Interest payments are due semi-annually and principal payments are due annually. Principal payments increase in annual increments from $150,000 to $240,000 over the term of the bonds until the principal is fully amortized in 2009. We have an option to call the SBS Bonds at any time. On December 31, 2002, SBS was merged into DURECT, and the SBS bonds were assigned to DURECT with the terms unchanged. At December 31, 2004, the remaining principal payments of the bonds were $1.1 million.

 

We anticipate that cash used in operating activities will slightly decrease in the near future as we continue to research, develop, and manufacture our products through partnering activities and internal efforts, and service

 

33


Table of Contents

our debt obligations. In aggregate, we are required to make future payments pursuant to our existing contractual obligations as follows:

 

Contractual Obligations


   2005

   2006

   2007

   2008

   2009

   Total

Convertible subordinated notes (1)

   $ 3,750    $ 3,750    $ 3,750    $ 61,875    $ —      $ 73,125

Long-term debt (1)

     266      263      258      258      258      1,303

Term loan (1)

     292      24      —        —        —        316

APT acquisition consideration payable (2)

     250      500      —        —        —        750

Capital lease (1)

     11      11      11      10      6      49

Operating lease obligations

     2,706      1,827      1,244      1,257      270      7,304
    

  

  

  

  

  

Total contractual cash obligations

   $ 7,275    $ 6,375    $ 5,263    $ 63,400    $ 534    $ 82,847
    

  

  

  

  

  


Note (1): Includes principal and interest payments

Note (2): To be paid in our common stock or cash at our election

 

We also anticipate incurring capital expenditures of at least $2 million over the next 12 months to purchase research and development and manufacturing equipment. The amount and timing of these capital expenditures will depend, among other things, on the success of clinical trials for our products and our collaborative research and development activities.

 

We believe that our existing cash, cash equivalents and investments will be sufficient to fund our planned operations, existing debt and contractual commitments, and planned capital expenditures through at least 12 months. We may consume available resources more rapidly than currently anticipated, resulting in the need for additional funding. Additionally, we do not expect to generate revenues from our pharmaceutical systems currently under development for at least the next several years, if at all. Accordingly, we may be required to raise additional capital through a variety of sources, including:

 

  ·   the public equity market;

 

  ·   private equity financing;

 

  ·   collaborative arrangements; and

 

  ·   public or private debt.

 

There can be no assurance that additional capital will be available on favorable terms, if at all. If adequate funds are not available, we may be required to significantly reduce or refocus our operations or to obtain funds through arrangements that may require us to relinquish rights to certain of our products, technologies or potential markets, either of which could have a material adverse effect on our business, financial condition and results of operations. To the extent that additional capital is raised through the sale of equity or convertible debt securities, the issuance of such securities would result in ownership dilution to our existing stockholders.

 

We have not utilized and do not intend to utilize “off-balance sheet” arrangements, special purpose entities, hedging and derivative strategies, or other complex financial techniques to fund our operations or otherwise manage our financial position.

 

Our cash and investments policy emphasizes liquidity and preservation of principal over other portfolio considerations. We select investments that maximize interest income to the extent possible given these two constraints. We satisfy liquidity requirements by investing excess cash in securities with different maturities to match projected cash needs and limit concentration of credit risk by diversifying our investments among a variety of high credit-quality issuers.

 

34


Table of Contents

Recent Accounting Pronouncements

 

In March 2004, the FASB approved the consensus reached on the Emerging Issues Task Force (EITF) Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” The Issue’s objective is to provide guidance for identifying other-than-temporarily impaired investments. EITF 03-1 also provides new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB issued a FASB Staff Position (FSP) EITF 03-1-1 that delays the effective date of the measurement and recognition guidance in EITF 03-1 until further notice. The disclosure requirements of EITF 03-1 are effective with this annual report for fiscal 2004. Once the FASB reaches a final decision on the measurement and recognition provisions, the company will evaluate the impact of the adoption of the accounting provisions of EITF 03-1.

 

In December 2004, the FASB issued Statement No. 123 (revised 2004, or FAS 123R), “Share-Based Payment,” effective for annual or interim periods beginning after June 15, 2005. FAS 123R supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and will require companies to recognize compensation expense, using a fair-value based method, for costs related to share-based payments including stock options and stock issued under our employee stock purchase plans. We will be required to implement FAS 123R no later than the quarter that begins July 1, 2005. Our adoption will be applied on a modified prospective basis and measured compensation expense will be recognized commencing on July 1, 2005. We are currently evaluating option valuation methodologies and assumptions in light of FAS 123R, and therefore cannot estimate the impact of our adoption at this time. These methodologies and assumptions may be different than those currently employed by the company in applying FAS 123, outlined above in “Stock-Based Compensation” section of this note. We expect that our adoption of FAS 123R will have a material adverse impact on our consolidated results of operations and financial position.

 

Management’s Report on Controls and Procedures

 

Evaluation of Disclosure Controls and Procedures: The Company’s principal executive and financial officers reviewed and evaluated the Company’s disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)) as of the end of the period covered by this Form 10-K. Based on that evaluation, the Company’s principal executive and financial officers concluded that the Company’s disclosure controls and procedures are effective in timely providing them with material information relating to the Company, as required to be disclosed in the reports the Company files under the Exchange Act.

 

Management’s Annual Report on Internal Control Over Financial Reporting: The Company’s management is responsible for establishing and maintaining adequate internal control over the Company’s financial reporting. Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Based on the assessment using those criteria, management concluded that, as of December 31, 2004, our internal control over financial reporting was effective.

 

The Company’s independent registered public accountants, Ernst & Young LLP, audited the consolidated financial statements included in this Annual Report on Form 10-K and have issued an audit report on management’s assessment of our internal control over financial reporting as well as on the effectiveness of the Company’s internal control over financial reporting. The report on the audit of the consolidated financial statements appears on or about page 56 of this Annual Report on Form 10-K and the report on the audit of internal control over financial reporting appears on or about page 57 of this Annual Report on Form 10-K.

 

Changes in Internal Control Over Financial Reporting: There were no significant changes in the Company’s internal control over financial reporting during the Company’s most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

35


Table of Contents

Factors that May Affect Future Results

 

In addition to the other information in this Form 10-K, a number of factors may affect our business and prospects. These factors include but are not limited to the following, which you should consider carefully in evaluating our business and prospects.

 

We have not completed development of any of our pharmaceutical systems, and we cannot be certain that our pharmaceutical systems will be able to be commercialized

 

To be profitable, we must successfully research, develop, obtain regulatory approval for, manufacture, introduce, market and distribute our pharmaceutical systems under development. For each pharmaceutical system that we or our third party collaborators intend to commercialize, we must successfully meet a number of critical developmental milestones for each disease or medical condition targeted, including:

 

  ·   selecting and developing drug delivery platform technology to deliver the proper dose of drug over the desired period of time;

 

  ·   determining the appropriate drug dosage for use in the pharmaceutical system;

 

  ·   developing drug compound formulations that will be tolerated, safe and effective and that will be compatible with the system;

 

  ·   demonstrating the drug formulation will be stable for commercially reasonable time periods;

 

  ·   selecting and developing catheter or other targeting technology, if appropriate, to deliver the drug to a specific location within the body; and

 

  ·   demonstrating through clinical trials that the drug and system combination is safe and effective in patients for the intended indication.

 

The time frame necessary to achieve these developmental milestones for any individual product candidate is long and uncertain, and we may not successfully complete these milestones for any of our product candidates in development. We have not yet selected the drug dosages nor finalized the formulation or the system design of any pharmaceutical systems, including our SABER-based post-operative pain depot, our TRANSDUR sufentanil patch, Remoxy, our DURIN-based Alzheimer’s disease product candidate and our CHRONOGESIC product candidate, and DURECT has limited experience in developing such products. We may not be able to finalize the design or formulation of any of our product candidates. In addition, we may select components, solvents, excipients or other ingredients to include in our pharmaceutical systems that have not been previously approved for use in pharmaceutical products, which may require us to perform additional studies and may delay clinical testing and regulatory approval of our pharmaceutical systems. Even after we complete the design of the product candidate, the product candidate must still complete required clinical trials and additional safety testing in animals before approval for commercialization. See “We must conduct and satisfactorily complete required laboratory performance and safety testing, animal studies and clinical trials for our pharmaceutical systems before we can sell them.” We are continuing testing and development of our product candidates and may explore possible design or formulation changes to address issues of safety, manufacturing efficiency and performance. We may not be able to complete development of any product candidates that will be safe and effective and that will have a commercially reasonable treatment and storage period. If we are unable to complete development of our SABER-based post-operative pain depot product candidate, our TRANSDUR sufentanil patch, Remoxy, our DURIN-based Alzheimer’s disease product candidate, CHRONOGESIC or other product candidates, we will not be able to earn revenue from them, which would materially harm our business.

 

We must conduct and satisfactorily complete required laboratory performance and safety testing, animal studies and clinical trials for our pharmaceutical systems before they can be sold

 

Before we can obtain government approval to sell any of our pharmaceutical systems, we must demonstrate through laboratory performance studies and safety testing, preclinical (animal) studies and clinical (human) trials

 

36


Table of Contents

that each system is safe and effective for human use for each targeted disease. The clinical development status of our most advanced programs is as follows:

 

  ·   SABER-Bupivacaine—Phase I trial completed and Phase II trial initiated. Dosing of first cohort of Phase II trial completed as of February 2005.

 

  ·   TRANSDUR-Sufentanil Patch—Dosing of Phase I trial completed and first trial of Phase II program initiated as of February 2005.

 

  ·   ORADUR-Oxycodone (Remoxy)—Phase I trial completed and Phase III program initiated by Pain Therapeutics.

 

  ·   DURIN-Leuprolide for Alzheimer’s disease—Phase I trial initiated by Voyager Pharmaceutical. Enrollment completed in Phase I trial as of January 2005.

 

  ·   CHRONOGESIC—Phase I, Phase II and Pilot Phase III completed. Redesigning the system to address premature shutdown problem and will resume clinical trials when system design is completed.

 

We are currently in the preclinical or research stages with respect to all our other product candidates under development. We plan to continue extensive and costly tests, clinical trials and safety studies in animals to assess the safety and effectiveness of our product candidates. These studies include laboratory performance studies and safety testing, clinical trials and animal toxicological studies necessary to support regulatory approval of product candidates in the United States and other countries of the world. These studies are costly, complex and last for long durations, and may not yield the data required for regulatory approval. We may not be permitted to begin or continue our planned clinical trials for our potential product candidates. If our trials are permitted, our potential product candidates may not prove to be safe or produce their intended effects. In addition, we may be required by regulatory agencies to conduct additional animal or human studies regarding the safety and efficacy of our product candidates which we have not planned or anticipated that could delay commercialization of such product candidates and harm our business and financial conditions.

 

The length of our clinical trials will depend upon, among other factors, the rate of trial site and patient enrollment and the number of patients required to be enrolled in such studies. We may fail to obtain adequate levels of patient enrollment in our clinical trials. Delays in planned patient enrollment may result in increased costs, delays or termination of clinical trials, which could have a material adverse effect on us. In addition, even if we enroll the number of patients we expect in the time frame we expect, our clinical trials may not provide the data necessary to support regulatory approval for the product candidates for which they were conducted. Additionally, we may fail to effectively oversee and monitor these clinical trials, which would result in increased costs or delays of our clinical trials. Even if these clinical trials are completed, we may fail to complete and submit a new drug application as scheduled. Even if we are able to submit a new drug application as scheduled, the Food and Drug Administration may not clear our application in a timely manner or may deny the application entirely.

 

Data already obtained from preclinical studies and clinical trials of our pharmaceutical systems do not necessarily predict the results that will be obtained from later preclinical studies and clinical trials. Moreover, preclinical and clinical data such as ours is susceptible to varying interpretations, which could delay, limit or prevent regulatory approval. A number of companies in the pharmaceutical industry have suffered significant setbacks in advanced clinical trials, even after promising results in earlier trials. The failure to adequately demonstrate the safety and effectiveness of a product candidate under development could delay or prevent regulatory clearance of the potential product candidate, resulting in delays to the commercialization of our product candidates, and could materially harm our business. Our clinical trials may not demonstrate the sufficient levels of safety and efficacy necessary to obtain the requisite regulatory approvals for our product candidates, and thus our product candidates may not be approved for marketing.

 

37


Table of Contents

We and our third party collaborators may not be able to manufacture sufficient quantities of our products and components to support the clinical and commercial requirements of our collaborators and ourselves at an acceptable cost, and we have limited manufacturing experience

 

We or our third party collaborators to whom we have assigned such responsibility must manufacture our product candidates and components in clinical and commercial quantities, either directly or through third parties, in compliance with regulatory requirements and at an acceptable cost. The manufacture processes associated with our pharmaceutical systems are complex. We and our third party collaborators, where relevant, have not yet completed development of the manufacturing process for any product candidates or components including our SABER-based post-operative pain depot, our TRANSDUR sufentanil patch product candidate, Remoxy, our DURIN-based Alzheimer’s disease product candidate and our CHRONOGESIC product candidate. If we and our third party collaborators, where relevant, fail to timely complete the development of the manufacturing process for our product candidates, we and our third party collaborators, where relevant, will not be able to timely produce product for clinical trials and commercialization of our product candidates. In the future, we will continue to consider ways to optimize our manufacturing process and to explore possible changes to improve product performance and quality, increase efficiencies and lower costs. We have also committed to manufacture and supply product or components under a number of our collaborative agreements with third party companies. We have limited experience manufacturing pharmaceutical products, and we may not be able to timely accomplish these tasks. If we and our third party collaborators, where relevant, fail to develop manufacturing processes to permit us to manufacture a product candidate or component at an acceptable cost, then we and our third party partners may not be able to commercialize that product candidate or we may be in breach of our supply obligations to our third party partners.

 

Our manufacturing facility in Cupertino is a functional multi-discipline site that we have used to manufacture research and clinical supplies of several of our pharmaceutical system product candidates under GMP, including SABER-Bupivacaine, TRANSDUR-sufentanil, Remoxy and CHRONOGESIC. We have recently made significant site improvements and equipment installations to upgrade and expand our manufacturing capabilities. In the future, we intend to develop additional manufacturing capabilities for our pharmaceutical systems and components to meet our demands and those of our third party collaborators by contracting with third party manufacturers and by construction of additional manufacturing space at our current facilities in Cupertino, CA and Pelham, AL. We have limited experience building and validating manufacturing facilities, and we may not be able to timely accomplish these tasks.

 

In order to manufacture clinical and commercial supplies of our pharmaceutical systems or components for our third party collaborators or ourselves, we must attain and maintain compliance with applicable federal, state and foreign regulatory standards relating to manufacture of pharmaceutical products which are rigorous, complex and subject to varying interpretations. Furthermore, our facilities will be subject to government audits to determine compliance with good manufacturing practices regulations, and we may be unable to pass inspection with the applicable regulatory agencies or may be asked to undertake corrective measures which may be costly and cause delay.

 

If we and our third party collaborators, where relevant, are unable to manufacture product or components in a timely manner or at an acceptable cost, quality or performance level, and attain and maintain compliance with applicable regulations, the clinical trials and the commercial sale of our pharmaceutical systems and those of our third party partners could be delayed. Additionally, we may need to alter our facility design or manufacturing processes, install additional equipment or do additional construction or testing in order to meet regulatory requirements, optimize the production process, increase efficiencies or production capacity or for other reasons, which may result in additional cost to us or delay production of product needed for the clinical trials and commercial launch of our product candidates and those of our third party collaborators. We and our third party collaborators, where relevant, may also need or choose to subcontract with third party contractors to perform manufacturing steps of our pharmaceutical systems or supply required components for our pharmaceutical systems in which case we will be subject to the schedule, expertise and performance of third parties as well as incur significant additional costs. See “We rely heavily on third parties to support development, clinical testing and manufacturing of our product candidates” and “Key Components of our pharmaceutical systems are provided

 

38


Table of Contents

by limited numbers of suppliers, and supply shortages or loss of these suppliers could result in interruptions in supply or increased costs.” Under our development and commercialization agreement with ALZA, we cannot subcontract the manufacture of subassemblies of the DUROS system components of our DUROS-based pharmaceutical system product candidates to third parties which have not been approved by ALZA. If we cannot manufacture product or components in time to meet the clinical or commercial requirements of our partners or ourselves or at an acceptable cost, our operating results will be harmed.

 

In April 2000, we acquired the ALZET product and related assets from ALZA. We manufacture subassemblies of the ALZET product at our Vacaville facility. We currently rely on a third party, to perform the coating process for the manufacture of the ALZET product under a contract that expires in January 2008.

 

Failure to obtain product approvals or comply with ongoing governmental regulations could delay or limit introduction of our product candidates and result in failure to achieve anticipated revenues

 

The manufacture and marketing of our product candidates and our research and development activities are subject to extensive regulation for safety, efficacy and quality by numerous government authorities in the United States and abroad. We must obtain clearance or approval from applicable regulatory authorities before we can market or sell our product candidates in the U.S. or abroad. Before receiving approval or clearance to market a product in the U.S. or in any other country, we will have to demonstrate to the satisfaction of applicable regulatory agencies that the product is safe and effective on the patient population and for the diseases that will be treated. Clinical trials, manufacturing and marketing of products are subject to the rigorous testing and approval process of the FDA and equivalent foreign regulatory authorities.

 

The Federal Food, Drug and Cosmetic Act and other federal, state and foreign statutes and regulations govern and influence the testing, manufacture, labeling, advertising, distribution and promotion of drugs and medical devices. These laws and regulations are complex and subject to change. Furthermore, these laws and regulations may be subject to varying interpretations, and we may not be able to predict how an applicable regulatory body or agency may choose to interpret or apply any law or regulation. As a result, clinical trials and regulatory approval can take a number of years to accomplish and require the expenditure of substantial resources. We may encounter delays or rejections based upon administrative action or interpretations of current rules and regulations. We may not be able to timely reach agreement with the FDA on our clinical trial protocols or on the required data we must collect to continue with our clinical trials or eventually commercialize our product candidates.

 

We may also encounter delays or rejections based upon additional government regulation from future legislation, administrative action or changes in FDA policy during the period of product development, clinical trials and FDA regulatory review. We may encounter similar delays in foreign countries. Sales of our product candidates outside the U.S. are subject to foreign regulatory standards that vary from country to country. The time required to obtain approvals from foreign countries may be shorter or longer than that required for FDA approval, and requirements for foreign licensing may differ from FDA requirements. We may be unable to obtain requisite approvals from the FDA and foreign regulatory authorities, and even if obtained, such approvals may not be on a timely basis, or they may not cover the clinical uses that we specify. If we fail to obtain timely clearance or approval for our product candidates, we will not be able to market and sell our product candidates, which will limit our ability to generate revenue.

 

Marketing or promoting a drug is subject to very strict controls. Furthermore, clearance or approval may entail ongoing requirements for post-marketing studies. The manufacture and marketing of drugs are subject to continuing FDA and foreign regulatory review and requirements that we update our regulatory filings. Later discovery of previously unknown problems with a product, manufacturer or facility, or our failure to update regulatory files, may result in restrictions, including withdrawal of the product from the market. Any of the following events, if they were to occur, could delay or preclude us from further developing, marketing or realizing full commercial use of our product candidates, which in turn would materially harm our business, financial condition and results of operations:

 

  ·   failure to obtain or maintain requisite governmental approvals;

 

39


Table of Contents
  ·   failure to obtain approvals for clinically intended uses of our product candidates under development; or

 

  ·   identification of serious and unanticipated adverse side effects in our product candidates under development.

 

Manufacturers of drugs also must comply with the applicable FDA good manufacturing practice regulations, which include production design controls, testing, quality control and quality assurance requirements as well as the corresponding maintenance of records and documentation. Compliance with current good manufacturing practices regulations is difficult and costly. Manufacturing facilities are subject to ongoing periodic inspection by the FDA and corresponding state agencies, including unannounced inspections, and must be licensed before they can be used for the commercial manufacture of our product candidates. We and/or our present or future suppliers and distributors may be unable to comply with the applicable good manufacturing practice regulations and other FDA regulatory requirements. We have not been subject to a good manufacturing regulation inspection by the FDA relating to our pharmaceutical systems. If we do not achieve compliance for the product candidates we manufacture, the FDA may refuse or withdraw marketing clearance or require product recall, which may cause interruptions or delays in the manufacture and sale of our product candidates.

 

Our near-term revenues depend on collaborations agreements with other companies. These agreements subject us to obligations which must be fulfilled and require us to manage complex relationships with third parties. If we are unable to meet our obligations or manage our relationships with our collaborators under these agreements or enter into additional collaboration agreements or if our existing collaborations are terminated, our revenues may decrease

 

Our near-term revenues are based to a significant extent on collaborative arrangements with third parties, pursuant to which we receive payments based on our performance of research and development activities and the attainment of milestones set forth in the agreements. We may not be able to fulfill our obligations or attain milestones set forth in any specific agreement, which could cause our revenues to fluctuate or be less than anticipated and may expose us to liability for contractual breach. In addition, these agreements may require us to devote significant time and resources to communicating with and managing our relationship with such collaborators and resolving possible issues of contractual interpretation which may detract from time our management would otherwise devote to our managing our operations. In general, our collaboration agreements, including our agreements with Endo with respect to CHRONOGESIC and TRANSDUR-Sufentanil, Pain Therapeutics, Voyager and NeuroSystec, may be terminated by the other party at will or upon specified conditions including, for example, if we fail to satisfy specified performance milestones or if we breach the terms of the agreement.

 

Our agreement with Endo for the development and commercialization of our CHRONOGESIC product candidate in the U.S. and Canada can be terminated by Endo starting in January 2006 in the event we have not commenced a specified clinical trial for the CHRONOGESIC product candidate by January 1, 2006 provided that Endo provides us written notice of termination prior to January 31, 2006.

 

If any of our collaborative agreements are terminated, our revenues will be reduced and our product candidates related to those agreements may not be commercialized.

 

We do not have or have limited control over the development, sales and distribution for our product candidates which are the subject of third party collaborative or license agreements

 

We have yet to establish any marketing, sales or distribution capabilities for our pharmaceutical system product candidates, and therefore are dependent on such third party companies to market, sell and distribute such product candidates. We have entered into agreements with Endo related to the promotion and distribution of our CHRONOGESIC and TRANSDUR-Sufentanil product candidates in the U.S. and Canada once such products are approved for commercialization. In addition, we have entered into agreements with Endo, Pain Therapeutics, Voyager and NeuroSystec under which we granted such third parties the right to develop, apply for regulatory approval for, market, promote or distribute the resulting developed products subject to payments to us in the form

 

40


Table of Contents

of product royalties and other payments. See “Item 1—Business—DURECT Strategy.” We have limited or no control over the expertise or resources that any collaborator may devote to the development, marketing or sale of these product candidates, or the timing of their activities. Any of our present or future collaborators may not perform their obligations as expected. These collaborators may breach or terminate their agreement with us or otherwise fail to conduct their collaborative activities successfully and in a timely manner. Further, our collaborators may elect not to develop or commercialize products arising out of our collaborative arrangements or not devote sufficient resources to the development, manufacture, marketing or sale of these products. If any of these events occur, we may not be able to develop our technologies or recognize revenue from the commercialization of our product candidates based on such collaborations. In addition, these third parties may have similar or competitive products to the ones which are the subject of their collaborations with us, or relationships with our competitors, which may reduce their interest in developing or selling our product candidates.

 

We and our third party collaborators compete with many other companies that currently have extensive and well-funded marketing and sales operations. Our marketing and sales efforts and those of our third party collaborations may be unable to compete successfully against these other companies. We and our third party collaborators, if relevant, may be unable to establish a sufficient sales and marketing organization on a timely basis, if at all. We and our third party collaborators, if relevant, may be unable to engage qualified distributors. Even if engaged, these distributors may:

 

  ·   fail to satisfy financial or contractual obligations to us;

 

  ·   fail to adequately market our products;

 

  ·   cease operations with little or no notice to us;

 

  ·   offer, design, manufacture or promote competing product lines;

 

  ·   fail to maintain adequate inventory and thereby restrict use of our products; or

 

  ·   build up inventory in excess of demand thereby limiting future purchases or our products resulting in significant quarter-to-quarter variability in our sales.

 

The failure of us or our third party collaborators to effectively develop, gain regulatory approval for sell and market our products will hurt our business and financial results.

 

We rely heavily on third parties to support development, clinical testing and manufacturing of our product candidates

 

We rely on third party contract research organizations, service providers and suppliers to provide critical services to support development, clinical testing, and manufacturing of our pharmaceutical systems. For example, we currently depend on third party vendors to manage and monitor our clinical trials and to perform critical manufacturing steps for our pharmaceutical systems. In the past, we relied on a third party contract manufacturer to perform the final manufacturing steps of our CHRONOGESIC product candidate, and we anticipate that in the near future that we will need or choose to rely on a third party manufacturer to manufacture or perform manufacturing steps relating to our pharmaceutical systems or components. See “We may not be able to manufacture sufficient quantities of our product candidates to support our clinical and commercial requirements at an acceptable cost, and we have limited manufacturing experience.” We anticipate that we will continue to rely on these and other third party contractors to support development, clinical testing, and manufacturing of our pharmaceutical systems. Failure of these contractors to provide the required services in a timely manner or on reasonable commercial terms could materially delay the development and approval of our product candidates, increase our expenses and materially harm our business, financial condition and results of operations.

 

Key components of our pharmaceutical systems are provided by limited numbers of suppliers, and supply shortages or loss of these suppliers could result in interruptions in supply or increased costs

 

Certain components and drug substances used in our pharmaceutical systems (including the SABER post-operative pain depot, the TRANSDUR sufentanil patch, Remoxy, the DURIN-based Alzheimer’s Disease

 

41


Table of Contents

product and the CHRONOGESIC product candidates) are currently purchased from a single or a limited number of outside sources. The reliance on a sole or limited number of suppliers could result in:

 

  ·   delays associated with redesigning a product candidate due to a failure to obtain a single source component;

 

  ·   an inability to obtain an adequate supply of required components; and

 

  ·   reduced control over pricing, quality and time delivery.

 

We have a supply agreement with Mallinckrodt, Inc. for our sufentanil requirements for our CHRONOGESIC product candidate, the term of which is subject to automatic renewal for one year terms unless terminated by either party upon one year’s prior written notice. Other than this agreement, we do not have long-term agreements with any of our suppliers, and therefore the supply of a particular component could be terminated at any time without penalty to the supplier. In addition, we may not be able to procure required components or drugs from third party suppliers at a quantity, quality and cost acceptable to us. Any interruption in the supply of single source components could cause us to seek alternative sources of supply or manufacture these components internally. If the supply of any components for our pharmaceutical systems is interrupted, components from alternative suppliers may not be available in sufficient volumes or at acceptable quality levels within required timeframes, if at all, to meet our needs. This could delay our ability to complete clinical trials and obtain approval for commercialization and marketing of our product candidates, causing us to lose sales, incur additional costs and delay new product introductions and could harm our reputation.

 

If we do not generate sufficient cash flow through increased revenues or raising additional capital, then we may not be able to meet our substantial debt obligations

 

As of December 31, 2004, we had approximately $60.0 million in long-term convertible subordinated notes which mature in June 2008, $24,000 in non-current term loan obligations, $36,000 in non-current lease obligations, $875,000 in non-current bonds payable and $654,000 in other long-term liabilities. Our substantial indebtedness, which totals $61.6 million, has and will continue to impact us by:

 

  ·   making it more difficult to obtain additional financing; and

 

  ·   constraining our ability to react quickly in an unfavorable economic climate.

 

Currently we are not generating positive cash flow. Adverse occurrences related to our product development efforts will adversely impact our ability to meet our obligations to repay the principal amounts on our convertible subordinated notes when due in June 2008. In addition, if the market price of our common stock on the due date of our notes is below $3.15 per share, the approximate equity conversion price of the notes, it will be highly unlikely that the holders of a large percentage of our outstanding convertible subordinated notes will convert such securities to equity in accordance with their existing terms. If we are unable to satisfy our debt service requirements, substantial liquidity problems could result. As of December 31, 2004 we had cash and investments valued at approximately $61.8 million. We expect to use substantially all of these assets to fund our on-going operations over the next few years. We may not generate sufficient cash from operations to repay our convertible subordinated notes or satisfy any other of these obligations when they become due and may have to raise additional financing from the sale of equity or debt securities or otherwise restructure our obligations in order to do so. There can be no assurance that any such financing or restructuring will be available to us on commercially acceptable terms, if at all. If we are unable to restructure our obligations, we may be forced to seek protection under applicable bankruptcy laws. Any restructure or bankruptcy could materially impair the value of our common stock.

 

We may not have sufficient funds to redeem our outstanding convertible subordinated notes if required to do so, and the redemption rights in our outstanding convertible subordinated notes could discourage a potential acquirer

 

If we engage in any transaction or event in connection with which all or substantially all of our common stock is exchanged for, converted into, acquired for or constitutes solely the right to receive consideration which

 

42


Table of Contents

is not all or substantially all common stock listed on a United States national securities exchange or approved for quotation on the NASDAQ National Market or any similar United States system of automated dissemination of quotations of securities prices, or, if for any reason, our common stock is no longer listed for trading on a United States national securities exchange nor approved for trading on the NASDAQ National Market (a “fundamental change”), we may be required to redeem all or part of the $60 million in outstanding principal, plus any accrued but unpaid interest on our outstanding convertible promissory notes. We may not have enough funds to pay the redemption price for all tendered notes. In addition, any credit agreement or other agreements relating to our indebtedness may contain provisions prohibiting redemption of the notes under certain circumstances, or expressly prohibit our redemption of the notes upon a designated event or may provide that a designated event constitutes an event of default under that agreement. Our failure to redeem tendered notes would constitute an event of default under the indenture, which might also constitute a default under the terms of our other indebtedness. Any such default could cause us to seek to restructure our indebtedness or seek protection under applicable bankruptcy laws, either of which could materially impair the value of our common stock.

 

A fundamental change could also discourage a potential acquirer. However, this redemption feature is not the result of management’s knowledge of any specific effort to obtain control of us by means of a merger, tender offer or solicitation, or part of a plan by management to adopt a series of anti-takeover provisions. The term “fundamental change” is limited to specified transactions and may not include other events that might adversely affect our financial condition or business operations.

 

We have a history of operating losses, expect to continue to have losses in the future and may never achieve or maintain profitability

 

We have incurred significant operating losses since our inception in 1998 and, as of December 31, 2004, had an accumulated deficit of approximately $163.9 million. We expect to continue to incur significant operating losses over the next several years as we continue to incur costs for research and development, clinical trials and manufacturing. Our ability to achieve profitability depends upon our ability, alone or with others, to successfully complete the development of our proposed product candidates, obtain the required regulatory clearances and manufacture and market our proposed product candidates. Development of pharmaceutical systems is costly and requires significant investment. In addition, we may choose to license either additional drug delivery platform technology or rights to particular drugs or other appropriate technology for use in our pharmaceutical systems. The license fees for these technologies or rights would increase the costs of our pharmaceutical systems.

 

To date, we have not generated significant revenue from the commercial sale of our products and do not expect to receive significant revenue in the near future. Our current product revenues are from the sale of the ALZET product we acquired in April 2000 from ALZA and the sale of biodegradable polymers. We do not expect these product revenues to increase significantly in future periods. We do not anticipate commercialization and marketing of our product candidates in development in the near future, and therefore do not expect to generate sufficient revenues to cover expenses or achieve profitability in the near future.

 

We may have difficulty raising needed capital in the future

 

Our business currently does not generate sufficient revenues to meet our capital requirements and we do not expect that it will do so in the near future. We have expended and will continue to expend substantial funds to complete the research, development and clinical testing of our product candidates. We will require additional funds for these purposes, to establish additional clinical- and commercial-scale manufacturing arrangements and facilities and to provide for the marketing and distribution of our product candidates. Additional funds may not be available on acceptable terms, if at all. If adequate funds are unavailable from operations or additional sources of financing, we may have to delay, reduce the scope of or eliminate one or more of our research or development programs which would materially harm our business, financial condition and results of operations.

 

43


Table of Contents

We believe that our cash, cash equivalents and investments, will be adequate to satisfy our capital needs for at least the next 12 months. However, our actual capital requirements will depend on many factors, including:

 

  ·   continued progress and cost of our research and development programs;

 

  ·   success in entering into collaboration agreements and meeting milestones under such agreements;

 

  ·   progress with preclinical studies and clinical trials;

 

  ·   the time and costs involved in obtaining regulatory clearance;

 

  ·   costs involved in preparing, filing, prosecuting, maintaining and enforcing patent claims;

 

  ·   costs of developing sales, marketing and distribution channels and our ability to sell our product candidates;

 

  ·   costs involved in establishing manufacturing capabilities for clinical and commercial quantities of our product candidates;

 

  ·   competing technological and market developments;

 

  ·   market acceptance of our product candidates; and

 

  ·   costs for recruiting and retaining employees and consultants.

 

We may consume available resources more rapidly than currently anticipated, resulting in the need for additional funding. We may seek to raise any necessary additional funds through equity or debt financings, convertible debt financings, collaborative arrangements with corporate partners or other sources, which may be dilutive to existing stockholders and may cause the price of our common stock to decline. In addition, in the event that additional funds are obtained through arrangements with collaborators or other sources, we may have to relinquish rights to some of our technologies, product candidates or products that we would otherwise seek to develop or commercialize ourselves. If adequate funds are not available, we may be required to significantly reduce or refocus our product development efforts, resulting in loss of sales, increased costs, and reduced revenues.

 

Investors may experience substantial dilution of their investment

 

In the past, we have issued and have assumed, pursuant to the SBS acquisition, options and warrants to acquire common stock. To the extent these outstanding options are ultimately exercised, there will be dilution to investors. In addition, conversion of some or all of the $60.0 million aggregate principal amount of convertible subordinated notes that we issued in June and July 2003 will dilute the ownership interests of investors. Investors may experience further dilution of their investment if we raise capital through the sale of additional equity securities or convertible debt securities. See “Liquidity and Capital Resources”. Any sales in the public market of the common stock issuable upon such conversion could adversely affect prevailing market prices for our common stock.

 

Our stock price may fluctuate, and your investment in our stock could decline in value

 

The average daily trading volume of our common stock for the twelve months ending December 31, 2004, was 312,374 shares. The limited trading volume of our stock may contribute to its volatility, and an active trading market in our stock might not develop or continue. In accordance with our Common Stock Purchase Agreement with Endo, we filed a registration statement on Form S-3 with the SEC on August 29, 2003 to register 1,533,742 shares of our common stock issued to Endo and 485,122 shares issued to former APT shareholders for resale. The registration statement was declared effective by the SEC on September 26, 2003. Pursuant to a Purchase Agreement with Morgan Stanley & Co., Incorporated, we filed a registration statement with the SEC on Form S-3 to register an aggregate of $60.0 million in convertible subordinated notes for resale on August 29, 2003. The registration statement was declared effective by the SEC on November 3, 2003. The convertible subordinated notes are convertible into shares of our common stock at a conversion rate of 317.4603 shares per $1,000 principal amount of notes, subject to adjustment and will bear interest at a rate of 6.25% per annum. So long as these registration statements are effective, shares covered thereunder are tradeable without limitation. If

 

44


Table of Contents

substantial amounts of our common stock were to be sold in the public market, the market price of our common stock could fall. In addition, the existence of our convertible subordinated notes may encourage short selling by market participants. The market price of our common stock may fluctuate significantly in response to factors which are beyond our control. The stock market in general has recently experienced extreme price and volume fluctuations. In addition, the market prices of securities of technology and pharmaceutical companies have also been extremely volatile, and have experienced fluctuations that often have been unrelated or disproportionate to the operating performance of these companies. These broad market fluctuations could result in extreme fluctuations in the price of our common stock, which could cause a decline in the value of our investors’ stock.

 

We could be exposed to significant product liability claims which could be time consuming and costly to defend, divert management attention and adversely impact our ability to obtain and maintain insurance coverage

 

The testing, manufacture, marketing and sale of our product candidates involve an inherent risk that product liability claims will be asserted against us. Although we are insured against such risks up to an annual aggregate limit in connection with clinical trials and commercial sales of our product candidates, our present product liability insurance may be inadequate and may not fully cover the costs of any claim or any ultimate damages we might be required to pay. Product liability claims or other claims related to our product candidates, regardless of their outcome, could require us to spend significant time and money in litigation or to pay significant damages. Any successful product liability claim may prevent us from obtaining adequate product liability insurance in the future on commercially desirable or reasonable terms. In addition, product liability coverage may cease to be available in sufficient amounts or at an acceptable cost. An inability to obtain sufficient insurance coverage at an acceptable cost or otherwise to protect against potential product liability claims could prevent or inhibit the commercialization of our pharmaceutical systems. A product liability claim could also significantly harm our reputation and delay market acceptance of our product candidates.

 

We may be required to obtain rights to certain drugs

 

Some of the pharmaceutical systems that we are currently developing require the use of proprietary drugs to which we do not have commercial rights. For example, our research collaboration with the University of Maastricht has demonstrated that the use of a proprietary angiogenic factor in a pharmaceutical system can lead to elevated local concentration of the angiogenic factor in the pericardial sac of the heart, resulting in physical changes, including the growth of new blood vessels. We do not currently have a license to develop or commercialize a product candidate containing such proprietary angiogenic factor.

 

To complete the development and commercialization of pharmaceutical systems containing drugs to which we do not have commercial rights, we will be required to obtain rights to those drugs. We may not be able to do this at an acceptable cost, if at all. If we are not able to obtain required rights to commercialize certain drugs, we may not be able to complete the development of pharmaceutical systems which require use of those drugs. This could result in the cessation of certain development projects and the potential write-off of certain assets.

 

Technologies and businesses which we have acquired may be difficult to integrate, disrupt our business, dilute stockholder value or divert management attention. We may also acquire additional businesses or technologies in the future, which could have these same effects

 

We may acquire technologies, products or businesses to broaden the scope of our existing and planned product lines and technologies. For example, in October 1999, we acquired substantially all of the assets of IntraEAR, Inc., in April 2000 we acquired the ALZET product and related assets from ALZA, in April 2001, we completed the acquisition of SBS and in August 2003, we acquired APT. These and our future acquisitions expose us to:

 

  ·   increased costs associated with the acquisition and operation of the new businesses or technologies and the management of geographically dispersed operations;

 

  ·   the risks associated with the assimilation of new technologies, operations, sites and personnel;

 

45


Table of Contents
  ·   the diversion of resources from our existing business and technologies;

 

  ·   the inability to generate revenues to offset associated acquisition costs;

 

  ·   the requirement to maintain uniform standards, controls, and procedures; and

 

  ·   the impairment of relationships with employees and customers as a result of any integration of new management personnel.

 

Acquisitions may also result in the issuance of dilutive equity securities, the incurrence or assumption of debt or additional expenses associated with the amortization of acquired intangible assets or potential businesses. Past acquisitions, such as our acquisitions of IntraEAR, ALZET, SBS and APT, as well future acquisitions, may not generate any additional revenue or provide any benefit to our business.

 

Our limited operating history makes evaluating our stock difficult

 

Investors can only evaluate our business based on a limited operating history. We were incorporated in February 1998 and have engaged primarily in research and development, licensing technology, raising capital and recruiting scientific and management personnel. This short history may not be adequate to enable investors to fully assess our ability to successfully develop our product candidates, achieve market acceptance of our product candidates and respond to competition. Furthermore, we anticipate that our quarterly and annual results of operations will fluctuate for the foreseeable future. We believe that period-to-period comparisons of our operating results should not be relied upon as predictive of future performance. Our prospects must be considered in light of the risks, expenses and difficulties encountered by companies at an early stage of development, particularly companies in new and rapidly evolving markets such as pharmaceuticals, drug delivery, and biotechnology. To address these risks, we must, among other things, obtain regulatory approval for and commercialize our product candidates, which may not occur. We may not be successful in addressing these risks and difficulties. We may require additional funds to complete the development of our product candidates and to fund operating losses to be incurred in the next several years.

 

Acceptance of our product candidates in the marketplace is uncertain, and failure to achieve market acceptance will delay our ability to generate or grow revenues

 

Our future financial performance will depend upon the successful introduction and customer acceptance of our future products, including our SABER post-operative pain depot, TRANSDER sufentanil patch, Remoxy, DURIN-based Alzheimer’s disease and CHRONOGESIC product candidates. Even if approved for marketing, our product candidates may not achieve market acceptance. The degree of market acceptance will depend upon a number of factors, including:

 

  ·   the receipt of regulatory clearance of marketing claims for the uses that we are developing;

 

  ·   the establishment and demonstration in the medical community of the safety and clinical efficacy of our products and their potential advantages over existing therapeutic products, including oral medication, transdermal drug delivery products such as drug patches, or external or implantable drug delivery products; and

 

  ·   pricing and reimbursement policies of government and third-party payors such as insurance companies, health maintenance organizations and other health plan administrators.

 

Physicians, patients, payors or the medical community in general may be unwilling to accept, utilize or recommend any of our products. If we are unable to obtain regulatory approval, commercialize and market our future products when planned and achieve market acceptance, we will not achieve anticipated revenues.

 

46


Table of Contents

If users of our products are unable to obtain adequate reimbursement from third-party payors, or if new restrictive legislation is adopted, market acceptance of our products may be limited and we may not achieve anticipated revenues

 

The continuing efforts of government and insurance companies, health maintenance organizations and other payors of healthcare costs to contain or reduce costs of health care may affect our future revenues and profitability, and the future revenues and profitability of our potential customers, suppliers and collaborative partners and the availability of capital. For example, in certain foreign markets, pricing or profitability of prescription pharmaceuticals is subject to government control. In the United States, recent federal and state government initiatives have been directed at lowering the total cost of health care, and the U.S. Congress and state legislatures will likely continue to focus on health care reform, the cost of prescription pharmaceuticals and on the reform of the Medicare and Medicaid systems. While we cannot predict whether any such legislative or regulatory proposals will be adopted, the announcement or adoption of such proposals could materially harm our business, financial condition and results of operations.

 

The successful commercialization of our product candidates will depend in part on the extent to which appropriate reimbursement levels for the cost of our product candidates and related treatment are obtained by governmental authorities, private health insurers and other organizations, such as HMOs. Third-party payors are increasingly limiting payments or reimbursement for medical products and services. Also, the trend toward managed health care in the United States and the concurrent growth of organizations such as HMOs, which could control or significantly influence the purchase of health care services and products, as well as legislative proposals to reform health care or reduce government insurance programs, may limit reimbursement or payment for our products. The cost containment measures that health care payors and providers are instituting and the effect of any health care reform could materially harm our ability to operate profitably.

 

We may be sued by third parties which claim that our product candidates infringe on their intellectual property rights, particularly because there is substantial uncertainty about the validity and breadth of medical patents

 

We may be exposed to future litigation by third parties based on claims that our product candidates or activities infringe the intellectual property rights of others or that we have misappropriated the trade secrets of others. This risk is exacerbated by the fact that the validity and breadth of claims covered in medical technology patents and the breadth and scope of trade secret protection involve complex legal and factual questions for which important legal principles are unresolved. Any litigation or claims against us, whether or not valid, could result in substantial costs, could place a significant strain on our financial resources and could harm our reputation. In addition, intellectual property litigation or claims could force us to do one or more of the following, any of which could harm our business or financial results:

 

  ·   cease selling, incorporating or using any of our product candidates that incorporate the challenged intellectual property, which would adversely affect our revenue;

 

  ·   obtain a license from the holder of the infringed intellectual property right, which license may be costly or may not be available on reasonable terms, if at all; or

 

  ·   redesign our product candidates, which would be costly and time-consuming.

 

If we are unable to adequately protect or enforce our intellectual property rights or secure rights to third-party patents, we may lose valuable assets, experience reduced market share or incur costly litigation to protect our rights

 

Our success will depend in part on our ability to obtain patents, maintain trade secret protection and operate without infringing the proprietary rights of others. As of December 31, 2004, we held 25 issued U.S. patents and 13 issued foreign patents. In addition, we have 35 pending U.S. patent applications and have filed 48 patent applications under the Patent Cooperation Treaty, from which 86 national phase applications are currently

 

47


Table of Contents

pending in Europe, Australia, Japan, Canada, Mexico, New Zealand, Brazil, Israel and China. Our patents expire at various dates starting in the year 2012. Under our agreement with ALZA, we must assign to ALZA any intellectual property rights relating to the DUROS system and its manufacture and any combination of the DUROS system with other components, active agents, features or processes. In addition, ALZA retains the right to enforce and defend against infringement actions relating to the DUROS system, and if ALZA exercises these rights, it will be entitled to the proceeds of these infringement actions.

 

The patent positions of pharmaceutical companies, including ours, are uncertain and involve complex legal and factual questions. In addition, the coverage claimed in a patent application can be significantly reduced before the patent is issued. Consequently, our patent applications or those of ALZA that are licensed to us may not issue into patents, and any issued patents may not provide protection against competitive technologies or may be held invalid if challenged or circumvented. Our competitors may also independently develop products similar to ours or design around or otherwise circumvent patents issued to us or licensed by us. In addition, the laws of some foreign countries may not protect our proprietary rights to the same extent as U.S. law.

 

We also rely upon trade secrets, technical know-how and continuing technological innovation to develop and maintain our competitive position. We require our employees, consultants, advisors and collaborators to execute appropriate confidentiality and assignment-of-inventions agreements with us. These agreements typically provide that all materials and confidential information developed or made known to the individual during the course of the individual’s relationship with us is to be kept confidential and not disclosed to third parties except in specific circumstances, and that all inventions arising out of the individual’s relationship with us shall be our exclusive property. These agreements may be breached, and in some instances, we may not have an appropriate remedy available for breach of the agreements. Furthermore, our competitors may independently develop substantially equivalent proprietary information and techniques, reverse engineer our information and techniques, or otherwise gain access to our proprietary technology.

 

We may be unable to meaningfully protect our rights in trade secrets, technical know-how and other non-patented technology. We may have to resort to litigation to protect our intellectual property rights, or to determine their scope, validity or enforceability. Enforcing or defending our proprietary rights is expensive, could cause diversion of our resources and may not prove successful. Any failure to enforce or protect our rights could cause us to lose the ability to exclude others from using our technology to develop or sell competing products.

 

If we or our third party collaborators are unable to train physicians to use our pharmaceutical systems to treat patients’ diseases or medical conditions, we may incur delays in market acceptance of our products

 

Broad use of our pharmaceutical systems will require extensive training of numerous physicians on the proper and safe use of our products. The time required to begin and complete training of physicians could delay introduction of our products and adversely affect market acceptance of our products. We or third parties selling our products may be unable to rapidly train physicians in numbers sufficient to generate adequate demand for our pharmaceutical systems. Any delay in training would materially delay the demand for our systems and harm our business and financial results. In addition, we may expend significant funds towards such training before any orders are placed for our products, which would increase our expenses and harm our financial results.

 

Some of our product candidates contain controlled substances, the making, use, sale, importation and distribution of which are subject to regulation by state, federal and foreign law enforcement and other regulatory agencies

 

Some of our product candidates currently under development contain, and our products in the future may contain, controlled substances which are subject to state, federal and foreign laws and regulations regarding their manufacture, use, sale, importation and distribution. Our TRANSDUR sufentanil patch, Remoxy and CHRONOGESIC product candidates and other product candidates we have under development contain opioids

 

48


Table of Contents

which are classified as Schedule II controlled substances under the regulations of the U.S. Drug Enforcement Agency. For our product candidates containing controlled substances, we and our suppliers, manufacturers, contractors, customers and distributors are required to obtain and maintain applicable registrations from state, federal and foreign law enforcement and regulatory agencies and comply with state, federal and foreign laws and regulations regarding the manufacture, use, sale, importation and distribution of controlled substances. These regulations are extensive and include regulations governing manufacturing, labeling, packaging, testing, dispensing, production and procurement quotas, record keeping, reporting, handling, shipment and disposal. Failure to obtain and maintain required registrations or comply with any applicable regulations could delay or preclude us from developing and commercializing our product candidates containing controlled substances and subject us to enforcement action. In addition, because of their restrictive nature, these regulations could limit our commercialization of our product candidates containing controlled substances.

 

Write-offs related to the impairment of long-lived assets and other non-cash charges, as well as future deferred compensation expenses may adversely impact or delay our profitability

 

We may incur significant non-cash charges related to impairment write-downs of our long-lived assets, including goodwill and other intangible assets. In 2002, Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (SFAS 142) became effective and as a result, we ceased to amortize approximately $4.7 million of goodwill and assembled workforce on January 1, 2002.

 

However, we will continue to incur non-cash charges related to amortization of other intangible assets. We are required to perform periodic impairment reviews of our goodwill at least annually. To the extent these reviews conclude that the expected future cash flows generated from our business activities are not sufficient to recover the cost of our long-lived assets, we will be required to measure and record an impairment charge to write down these assets to their realizable values. We completed our last review during the fourth quarter of 2004 and determined that goodwill was not impaired as of December 31, 2004. However, there can be no assurance that upon completion of subsequent reviews a material impairment charge will not be recorded. If future periodic reviews determine that our assets are impaired and a write down is required, it will adversely impact or delay our profitability.

 

To date, we have recorded deferred compensation expenses related to stock options grants, including stock options assumed in our acquisition of SBS, which will be amortized through 2006. In addition, deferred compensation expense related to option awards to non-employees will be calculated during the vesting period of the option based on the then-current price of our common stock, which could result in significant charges that adversely impact or delay our profitability. Furthermore, we have issued to ALZA common stock and a warrant to purchase common stock with an aggregate value of approximately $13.5 million, which will be amortized over time based on sales of our DUROS-based products and which will also adversely impact or delay our profitability.

 

We depend upon key personnel who may terminate their employment with us at any time, and we need to hire additional qualified personnel

 

Our success will depend to a significant degree upon the continued services of key management, technical, and scientific personnel, including Felix Theeuwes, our Chairman and Chief Scientific Officer, James E. Brown, our President and Chief Executive Officer and Thomas A. Schreck, our Chief Financial Officer. Although we have obtained key man life insurance policies for each of Messrs. Theeuwes, Brown and Schreck in the amount of $1.0 million, this insurance may not adequately compensate us for the loss of their services. In addition, our success will depend on our ability to attract and retain other highly skilled personnel. Competition for qualified personnel is intense, and the process of hiring and integrating such qualified personnel is often lengthy. We may be unable to recruit such personnel on a timely basis, if at all. Our management and other employees may voluntarily terminate their employment with us at any time. The loss of the services of key personnel, or the inability to attract and retain additional qualified personnel, could result in delays to product development or approval, loss of sales and diversion of management resources.

 

49


Table of Contents

We may not successfully manage our growth

 

Our success will depend on the timely expansion of our operations and the effective management of growth, which will place a significant strain on our management and on our administrative, operational and financial resources. To manage such growth, we must expand our facilities, augment our operational, financial and management systems and hire, train and supervise additional qualified personnel. If we were unable to manage growth effectively our business would be harmed.

 

The market for our product candidates is new, rapidly changing and competitive, and new products or technologies developed by others could impair our ability to grow our business and remain competitive

 

The pharmaceutical industry is subject to rapid and substantial technological change. Developments by others may render our product candidates under development or technologies noncompetitive or obsolete, or we may be unable to keep pace with technological developments or other market factors. Technological competition in the industry from pharmaceutical and biotechnology companies, universities, governmental entities and others diversifying into the field is intense and is expected to increase. Many of these entities have significantly greater research and development capabilities than we do, as well as substantially more marketing, manufacturing, financial and managerial resources. These entities represent significant competition for us. Acquisitions of, or investments in, competing pharmaceutical or biotechnology companies by large corporations could increase such competitors’ financial, marketing, manufacturing and other resources.

 

We are engaged in the development of novel therapeutic technologies. Our resources are limited and we may experience technical challenges inherent in such novel technologies. Competitors have developed or are in the process of developing technologies that are, or in the future may be, the basis for competitive products. Some of these products may have an entirely different approach or means of accomplishing similar therapeutic effects than our product candidates. Our competitors may develop products that are safer, more effective or less costly than our product candidates and, therefore, present a serious competitive threat to our product offerings.

 

The widespread acceptance of therapies that are alternatives to ours may limit market acceptance of our product candidates even if commercialized. Chronic and post-operative pain are currently being treated by oral medication, transdermal drug delivery systems, such as drug patches, and implantable drug delivery devices which will be competitive with our product candidates. These treatments are widely accepted in the medical community and have a long history of use. The established use of these competitive products may limit the potential for our product candidates to receive widespread acceptance if commercialized.

 

Our business involves environmental risks and risks related to handling regulated substances

 

In connection with our research and development activities and our manufacture of materials and product candidates, we are subject to federal, state and local laws, rules, regulations and policies governing the use, generation, manufacture, storage, air emission, effluent discharge, handling and disposal of certain materials, biological specimens and wastes. Although we believe that we have complied with the applicable laws, regulations and policies in all material respects and have not been required to correct any material noncompliance, we may be required to incur significant costs to comply with environmental and health and safety regulations in the future. Our research and development involves the use, generation and disposal of hazardous materials, including but not limited to certain hazardous chemicals, solvents, agents and biohazardous materials. The extent of our use, generation and disposal of such substances has increased substantially since we started manufacturing and selling biodegradable polymers. Although we believe that our safety procedures for storing, handling and disposing of such materials comply with the standards prescribed by state and federal regulations, we cannot completely eliminate the risk of accidental contamination or injury from these materials. We currently contract with third parties to dispose of these substances generated by us, and we rely on these third parties to properly dispose of these substances in compliance with applicable laws and regulations. If these third parties do not properly dispose of these substances in compliance with applicable laws and regulations, we may be subject to legal action by governmental agencies or private parties for improper disposal of these substances.

 

50


Table of Contents

The costs of defending such actions and the potential liability resulting from such actions are often very large. In the event we are subject to such legal action or we otherwise fail to comply with applicable laws and regulations governing the use, generation and disposal of hazardous materials and chemicals, we could be held liable for any damages that result, and any such liability could exceed our resources.

 

Our agreement with ALZA limits our fields of operation for our DUROS-based pharmaceutical systems and gives ALZA a first right to negotiate to distribute selected products for us

 

Our agreement with ALZA gives us exclusive rights to develop, commercialize and manufacture products using ALZA’s DUROS technology to deliver by catheter:

 

  ·   drugs to the central nervous system to treat select nervous system disorders;

 

  ·   drugs to the middle and inner ear;

 

  ·   drugs to the pericardial sac of the heart; and

 

  ·   select drugs into vascular grafts.

 

We also have the right to use the DUROS technology to deliver systemically and by catheter:

 

  ·   sufentanil to treat chronic pain; and

 

  ·   select cancer antigens.

 

We may not develop, manufacture or commercialize DUROS-based pharmaceutical systems outside of these specific fields without ALZA’s prior approval. In addition, if we develop or commercialize any drug delivery technology for use in a manner similar to the DUROS technology in a field covered in our license agreement with ALZA, then we may lose our exclusive rights to use the DUROS technology in such field as well as the right to develop new product candidates using DUROS technology in such field. In order to maintain commercialization rights for our products on a worldwide basis, we must diligently develop our product candidates, procure required regulatory approvals and commercialize the product candidates in selected major market countries. If we fail to meet commercialization diligence requirements, we may lose rights for products in some or all countries, including the U.S. These rights would revert to ALZA, which could then develop DUROS-based pharmaceutical products in such countries itself or license others to do so. In addition, in the event that our rights terminate with respect to any product or country, or this agreement terminates or expires in its entirety (except for termination by us due to a breach by ALZA), ALZA will have the exclusive right to use all of our data, rights and information relating to the products developed under the agreement as necessary for ALZA to commercialize these products, subject to the payment of a royalty to us based on the net sales of the products by ALZA.

 

Our agreement with ALZA gives us the right to perform development work and manufacture the DUROS pump component of our DUROS-based pharmaceutical systems. In the event of a change in our corporate control, including an acquisition of us, our right to manufacture and perform development work on the DUROS pump would terminate and ALZA would have the right to manufacture and develop DUROS systems for us so long as ALZA can meet our specification and supply requirements following such change in control.

 

Under the ALZA agreement, we must pay ALZA royalties on sales of DUROS-based pharmaceutical systems we commercialize and a percentage of any up-front license fees, milestone or special fees, payments or other consideration we receive, excluding research and development funding. In addition, commencing upon the commercial sale of a product developed under the agreement, we are obligated to make minimum product payments to ALZA on a quarterly basis based on our good faith projections of our net product sales of the product. These minimum payments will be fully credited against the product royalty payments we must pay to ALZA.

 

51


Table of Contents

ALZA may obtain from us, for its own behalf or on behalf of one of its affiliates, the exclusive right to develop and commercialize a product in a field of use exclusively licensed to us, provided that such product does not incorporate a drug in the same drug class and is not intended for the same therapeutic indication as a product which is then being developed or commercialized by us or for which we have made commitments to a third party. In the event that ALZA or an affiliate commercializes such a product, ALZA or its affiliate will pay us a royalty on sales of such product at a specified rate.

 

ALZA also has an exclusive option to distribute any DUROS-based pharmaceutical system we develop to deliver non-proprietary cancer antigens worldwide. The terms of any distribution arrangement have not been set and are to be negotiated in good faith between ALZA and us. ALZA’s option to acquire distribution rights limits our ability to negotiate with other distributors for these products and may result in lower payments to us than if these rights were subject to competitive negotiations. We must allow ALZA an opportunity to negotiate in good faith for commercialization rights to our products developed under the agreement prior to granting these rights to a third party. These rights do not apply to products that are subject to ALZA’s option or products for which we have obtained funding or access to a proprietary drug from a third party to whom we have granted commercialization rights prior to the commencement of human clinical trials.

 

ALZA has the right to terminate the agreement in the event that we breach a material obligation under the agreement and do not cure the breach in a timely manner. In addition, ALZA has the right to terminate the agreement if at any time prior to July 2006, we solicit for employment or hire, without ALZA’s consent, a person who is or within the previous 180 days has been an employee of ALZA in the DUROS technology group.

 

We do not control ALZA’s ability to develop and commercialize DUROS technology outside of fields licensed to us, and problems encountered by ALZA could result in negative publicity, loss of sales and delays in market acceptance of our DUROS-based pharmaceutical systems

 

ALZA retains complete rights to the DUROS technology for fields outside the specific fields licensed to us. Accordingly, ALZA may develop and commercialize DUROS-based products or license others to do so, so long as there is no conflict with the rights granted to us. ALZA received FDA approval to market its first DUROS-based product, VIADUR (leuprolide acetate implants) for the palliative treatment of advanced prostate cancer in March 2000. If ALZA or its commercialization partner, Bayer, fails to commercialize this product successfully, or encounters problems associated with this product, negative publicity could be created about all DUROS-based products, which could result in harm to our reputation and cause reduced sales of our DUROS-based product candidates. In addition, if any third-party that may be licensed by ALZA fails to develop and commercialize DUROS-based products successfully, the success of all DUROS-based systems could be impeded, including ours, resulting in delay or loss of revenue or damage to our reputation, any one of which could harm our business.

 

Our corporate headquarters, manufacturing facilities and personnel are located in a geographical area that is seismically active

 

Our corporate headquarters, manufacturing facilities and personnel are located in a geographical area that is known to be seismically active and prone to earthquakes. Should such a natural disaster occur, our ability to conduct our business could be severely restricted, and our business and assets, including the results of our research and development efforts, could be destroyed.

 

We have broad discretion over the use of our cash and investments, and their investment may not yield a favorable return

 

Our management has broad discretion over how our cash and investments are used and may invest in ways with which our stockholders may not agree and that do not yield favorable returns.

 

52


Table of Contents

Executive officers, directors and entities affiliated with them have substantial control over us, which could delay or prevent a change in our corporate control favored by our other stockholders

 

Our directors, executive officers and principal stockholders, together with their affiliates have substantial control over us. The interests of these stockholders may differ from the interests of other stockholders. As a result, these stockholders, if acting together, would have the ability to exercise control over all corporate actions requiring stockholder approval irrespective of how our other stockholders may vote, including:

 

  ·   the election of directors;

 

  ·   the amendment of charter documents;

 

  ·   the approval of certain mergers and other significant corporate transactions, including a sale of substantially all of our assets; or

 

  ·   the defeat of any non-negotiated takeover attempt that might otherwise benefit the public stockholders.

 

Our certificate of incorporation, our bylaws, Delaware law and our stockholder rights plan contain provisions that could discourage another company from acquiring us

 

Provisions of Delaware law, our certificate of incorporation, bylaws and stockholder rights plan may discourage, delay or prevent a merger or acquisition that stockholders may consider favorable, including transactions in which you might otherwise receive a premium for your shares. These provisions include:

 

  ·   authorizing the issuance of “blank check” preferred stock without any need for action by stockholders;

 

  ·   providing for a dividend on our common stock, commonly referred to as a “poison pill”, which can be triggered after a person or group acquires 17.5% or more of common stock;

 

  ·   providing for a classified board of directors with staggered terms;

 

  ·   requiring supermajority stockholder voting to effect certain amendments to our certificate of incorporation and by-laws;

 

  ·   eliminating the ability of stockholders to call special meetings of stockholders;

 

  ·   prohibiting stockholder action by written consent; and

 

  ·   establishing advance notice requirements for nominations for election to the board of directors or for proposing matters that can be acted on by stockholders at stockholder meetings.

 

Legislative actions, potential new accounting pronouncements and higher insurance costs are likely to impact our future financial position or results of operations

 

Future changes in financial accounting standards, including proposed changes in accounting for employee stock-based awards, may cause adverse, unexpected fluctuations in the timing of the recognition of revenues or expenses and may affect our financial position or results of operations. New pronouncements and varying interpretations of pronouncements have occurred with frequency and may occur in the future and we may make changes in our accounting policies in the future. Compliance with changing regulation of corporate governance and public disclosure may result in additional expenses. Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations, PCAOB pronouncements and Nasdaq National Market rules, are creating uncertainty for companies such as ours and insurance, accounting and auditing costs are increasing as a result of this uncertainty and other factors. We are committed to maintaining high standards of corporate governance and public disclosure. As a result, we intend to invest all reasonably necessary resources to comply with evolving standards, and this investment may result in increased general and administrative expenses and a diversion of management time and attention from revenue-generating activities to compliance activities.

 

53


Table of Contents

In December 2004, the FASB issued Statement No. 123 (revised 2004, or FAS 123R), “Share-Based Payment,” effective for annual or interim periods beginning after June 15, 2005. FAS 123R supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and will require companies to recognize compensation expense, using a fair-value based method, for costs related to share-based payments including stock options and stock issued under our employee stock purchase plans. We will be required to implement FAS 123R no later than the quarter that begins July 1, 2005. Our adoption will be applied on a modified prospective basis and measured and compensation expense will be recognized commencing on July 1, 2005. We are currently evaluating option valuation methodologies and assumptions in light of FAS 123R, and therefore cannot estimate the impact of our adoption at this time. These methodologies and assumptions may be different than those currently employed by the company in applying FAS 123, outlined above in “Stock-Based Compensation “ section of this note. We expect that our adoption of FAS 123R will have a material adverse impact on our consolidated results of operations and financial position.

 

Item 7A.    Quantitative and Qualitative Disclosures About Market Risk.

 

Interest Rate Sensitivity

 

Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio and long-term debt obligations. Fixed rate securities and borrowings may have their fair market value adversely impacted due to fluctuations in interest rates, while floating rate securities may produce less income than expected if interest rates fall and floating rate borrowings may lead to additional interest expense if interest rates increase. Due in part to these factors, our future investment income may fall short of expectations due to changes in interest rates or we may suffer losses in principal if forced to sell securities which have declined in market value due to changes in interest rates.

 

Our primary investment objective is to preserve principal while at the same time maximizing yields without significantly increasing risk. Our portfolio includes money markets funds, commercial paper, medium-term notes, corporate notes, government securities, auction rate securities, corporate bonds and market auction preferreds. The diversity of our portfolio helps us to achieve our investment objective. As of December 31, 2004, approximately 70% of our investment portfolio is composed of investments with original maturities of one year or less and approximately 33% of our investment portfolio matures less than 90 days from the date of purchase.

 

The following table presents the amounts of our cash equivalents and investments that may be subject to interest rate risk and the average interest rates as of December 31, 2004 by year of maturity (dollars in thousands):

 

     2005

    2006

    2007

    Total

 

Cash equivalents:

                                

Fixed rate

   $ 19,036     $       $ —       $ 19,036  

Average fixed rate

     2.31 %     —         —         2.31 %

Variable rate

   $ 19       —         —       $ 19  

Average variable rate

     1.08 %     —         —         1.08 %

Short-term investments:

                                

Fixed rate

   $ 19,515     $ —         —       $ 19,515  

Average fixed rate

     1.72 %     —         —         1.72 %

Variable rate

   $ 2,250       —         —       $ 2,250  

Average variable rate

     2.43 %     —         —         2.43 %

Long-term investments:

                                

Fixed rate

   $ —       $ 15,176     $ 2,042     $ 17,218  

Average fixed rate

     —         2.35 %     3.35 %     2.48 %

Restricted investments:

                                

Fixed rate

   $ 2,798     $ —       $ —       $ 2,798  

Average fixed rate

     0.88 %                     0.88 %
    


 


 


 


Total investment securities

   $ 43,618     $ 15,176     $ 2,042     $ 60,836  
    


 


 


 


Average rate

     1.79 %     2.35 %     3.35 %     2.02 %

 

54


Table of Contents

The following table presents the amounts of our cash equivalents and investments that may be subject to interest rate risk and the average interest rates as of December 31, 2003 by year of maturity (dollars in thousands):

 

     2004

    2005

    2006

    Total

 

Cash equivalents:

                                

Fixed rate

   $ 19,414     $ —       $ —       $ 19,414  

Average fixed rate

     1.13 %     —         —         1.13 %

Variable rate

   $ 976       —         —       $ 976  

Average variable rate

     1.00 %     —         —         1.00 %

Short-term investments:

                                

Fixed rate

   $ 17,511     $ —         —       $ 17,511  

Average fixed rate

     1.43 %     —         —         1.43 %

Variable rate

   $ 22,000       —         —       $ 22,000  

Average variable rate

     1.21 %     —         —         1.21 %

Long-term investments:

                                

Fixed rate

   $ —       $ 8,935     $ 12,399     $ 21,334  

Average fixed rate

     —         1.80 %     2.43 %     2.14 %

Restricted investments:

                                

Fixed rate

   $ 3,119     $ —       $ —       $ 3,119  

Average fixed rate

     1.06 %     —         —         1.06 %
    


 


 


 


Total investment securities

   $ 63,020     $ 8,935     $ 12,399     $ 84,354  
    


 


 


 


Average rate

     1.23 %     1.80 %     2.43 %     1.51 %

 

55


Table of Contents

Item 8.    Financial Statements and Supplementary Data.

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

The Board of Directors and Stockholders

DURECT Corporation

 

We have audited the accompanying consolidated balance sheets of DURECT Corporation as of December 31, 2004 and 2003, and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2004. Our audits also included the financial statement schedule listed in the Index at Item 15(a)(2) of the Annual Report on Form 10-K for the year ended December 31, 2004. These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (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 consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of DURECT Corporation at December 31, 2004 and 2003, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of DURECT Corporation’s internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 10, 2005 expressed an unqualified opinion thereon.

 

/s/ ERNST & YOUNG LLP

 

Palo Alto, California

March 10, 2005

 

 

56


Table of Contents

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

The Board of Directors and Stockholders

DURECT Corporation

 

We have audited management’s assessment, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting, that DURECT Corporation maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). DURECT Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

In our opinion, management’s assessment that DURECT Corporation maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, DURECT Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on the COSO criteria.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of DURECT Corporation as of December 31, 2004 and 2003, and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2004 and our report dated March 10, 2005 expressed an unqualified opinion thereon.

 

/s/ ERNST & YOUNG LLP

 

Palo Alto, California

March 10, 2005

 

57


Table of Contents

DURECT CORPORATION

 

CONSOLIDATED BALANCE SHEETS

(in thousands, except per share amounts)

 

     December 31,

 
     2004

    2003

 
A S S E T S                 

Current assets:

                

Cash and cash equivalents

   $ 20,032     $ 21,203  

Short-term investments

     21,765       39,511  

Accounts receivable, net of allowances of $208 and $141, respectively

     2,481       1,968  

Inventories

     1,929       1,902  

Prepaid expenses and other current assets

     1,364       1,480  
    


 


Total current assets

     47,571       66,064  

Property and equipment, net

     7,112       9,316  

Goodwill

     6,399       6,399  

Intangible assets, net

     1,745       2,994  

Long-term investments

     17,218       21,334  

Restricted investments

     2,798       3,119  

Other long-term assets

     2,625       3,181  
    


 


Total assets

   $ 85,468     $ 112,407  
    


 


L I A B I L I T I E A N S T O C K H O L D E R SE Q U I T Y

                

Current liabilities:

                

Accounts payable

   $ 1,658     $ 616  

Accrued liabilities

     2,549       2,618  

Contract research liability

     554       987  

Accrued liabilities to related party

     —         17  

Interest payable on convertible notes

     167       167  

Deferred revenue

     78       146  

Equipment financing obligations and term loan, current portion

     293       283  

Bonds payable, current portion

     190       180  
    


 


Total current liabilities

     5,489       5,014  

Equipment financing obligations and term loan, noncurrent portion

     60       307  

Bonds payable, noncurrent portion

     875       1,065  

Convertible subordinated notes

     60,000       60,000  

Other long-term liabilities

     654       906  

Commitments (Note 10)

                

Stockholders’ equity:

                

Common stock, $0.0001 par value: 110,000 shares authorized at December 31, 2004 and 2003 respectively; 51,870 and 51,163 shares issued and outstanding at December 31, 2004 and 2003, respectively

     5       5  

Additional paid-in capital

     196,065       194,968  

Notes receivable from stockholders

     (37 )     (50 )

Deferred compensation

     (4 )     (59 )

Deferred royalties and commercial rights

     (13,480 )     (13,480 )

Accumulated other comprehensive loss

     (268 )     (15 )

Accumulated deficit

     (163,891 )     (136,254 )
    


 


Stockholders’ equity

     18,390       45,115  
    


 


Total liabilities and stockholders’ equity

   $ 85,468     $ 112,407  
    


 


 

The accompanying notes are an integral part of these consolidated financial statements.

 

58


Table of Contents

DURECT CORPORATION

 

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

 

     Year ended December 31,

 
     2004

    2003

    2002

 

Product revenue, net

   $ 6,416     $ 6,691     $ 6,314  

Collaborative research and development and other revenue

     7,437       5,144       871  
    


 


 


Total revenue

     13,853       11,835       7,185  
    


 


 


Operating expenses:

                        

Cost of revenue

     2,729       2,427       3,086  

Research and development

     24,231       20,935       29,535  

Research and development—related party

     2       13       19  

Selling, general and administrative

     9,747       8,498       10,970  

Amortization of intangible assets

     1,249       1,343       1,340  

Stock-based compensation(1)

     204       (102 )     1,204  
    


 


 


Total operating expenses

     38,162       33,114       46,154  
    


 


 


Loss from operations

     (24,309 )     (21,279 )     (38,969 )

Other income (expense):

                        

Interest income

     1,236       1,041       2,076  

Interest and other expense

     (4,546 )     (2,460 )     (280 )
    


 


 


Net other income (expense)

     (3,310 )     (1,419 )     1,796  
    


 


 


Loss before income taxes

     (27,619 )     (22,698 )     (37,173 )

Income tax provision

     18       —         —    
    


 


 


Net loss

   $ (27,637 )   $ (22,698 )   $ (37,173 )
    


 


 


Net loss per common share, basic and diluted

   $ (0.54 )   $ (0.45 )   $ (0.77 )
    


 


 


Shares used in computing basic and diluted net loss per share

     51,507       50,510       48,318  
    


 


 



(1)   Stock-based compensation related to the following:

Cost of revenue

   $ 1    $ 18     $ 72

Research and development

     157      (210 )     622

Selling, general and administrative

     46      90       510
    

  


 

     $ 204    $ (102 )   $ 1,204
    

  


 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

 

59


Table of Contents

DURECT CORPORATION

 

CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

(in thousands)

 

     Common Stock

   Additional
Paid-In
Capital


   

Notes

Receivable

From

Stockholders


   

Deferred

Compensation


   

Deferred

Royalties
And

Commercial

Rights


   

Accumulated

Other

Comprehensive

Income (Loss)


    

Accumulated

Deficit


    

Total

Stockholders’

Equity


 
                     
     Shares

    Amount

                

Balance at December 31, 2001

   48,758     $ 4    $ 189,396     $ (597 )   $ (2,551 )   $ (13,480 )   $ 659      $ (76,383 )    $ 97,048  

Issuance of common stock upon exercise of stock options, warrants and purchases of ESPP shares

   251       —        579       —         —         —         —          —          579  

Repurchase of unvested stock for cash and cancellation of certain notes receivable from stockholders

   (100 )     —        (47 )     25       —         —         —          —          (22 )

Repayment of notes receivable

   —         —        —         103       —         —         —          —          103  

Issuance of common stock to corporate partner for cash.

   1,534       1      4,999       —         —         —         —          —          5,000  

Amortization of deferred stock compensation

   —         —        —         —         1,069       —         —          —          1,069  

Reversal of deferred compensation related to cancelled employee stock options

   —         —        (750 )     —         750       —         —          —          —    

Noncash charges related to equity securities issued to non-employees

   —         —        135       —         —         —         —          —          135  

Net unrealized loss on available-for-sale securities

   —         —        —         —         —         —         (557 )      —          (557 )

Net loss

   —         —        —         —         —         —         —          (37,173 )      (37,173 )
                                                                   


Total comprehensive net loss

   —         —        —         —         —         —         —          —          (37,730 )
    

 

  


 


 


 


 


  


  


Balance at December 31, 2002 (carried forward)

   50,443     $ 5    $ 194,312     $ (469 )   $ (732 )   $ (13,480 )   $ 102      $ (113,556 )    $ 66,182  

 

The accompanying notes are an integral part of these consolidated financial statements.

 

60


Table of Contents

DURECT CORPORATION

 

CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY—(Continued)

(in thousands)

 

    Common Stock

 

Additional
Paid-In

Capital


   

Notes

Receivable

From

Stockholders


   

Deferred

Compensation


   

Deferred

Royalties

And

Commercial

Rights


   

Accumulated

Other

Comprehensive

Income (Loss)


   

Accumulated

Deficit


   

Total

Stockholders’

Equity


 
                 
                 
                 
    Shares

    Amount

             

Balance at December 31, 2002 (carried forward)

  50,443     $ 5   $ 194,312     $ (469 )   $ (732 )   $ (13,480 )   $ 102     $ (113,556 )   $ 66,182  

Issuance of common stock upon exercise of stock options, warrants and purchases of ESPP shares

  311       —       486       —         —         —         —         —         486  

Repurchase of unvested stock for cash and cancellation of certain notes receivable from stockholders

  (76 )     —       (66 )     66       —         —         —         —         —    

Repayment of notes receivable

  —         —       —         353       —         —         —         —         353  

Issuance of common stock in connection with acquisition of Absorbable Polymer Technologies, Inc.

  485       —       1,053       —         —         —         —         —         1,053  

Issuance costs in connection with issuance of common stock to corporate partner for cash.

  —         —       (42 )     —         —         —         —         —         (42 )

Amortization of deferred stock compensation

  —         —       —         —         (276 )     —         —         —         (276 )

Stock compensation related to modifications of stock option terms

  —         —       78       —         —         —         —         —         78  

Reversal of deferred compensation related to cancelled employee stock options

  —         —       (949 )     —         949       —         —         —         —    

Noncash charges related to equity securities issued to non-employees

  —         —       96       —         —         —         —         —         96  

Net unrealized loss on available-for-sale securities

  —         —       —         —         —         —         (117 )     —         (117 )

Net loss

  —         —       —         —         —         —         —         (22,698 )     (22,698 )
                                                               


Total comprehensive net loss

  —         —       —         —         —         —         —         —         (22,815 )
   

 

 


 


 


 


 


 


 


Balance at December 31, 2003

  51,163       5     194,968       (50 )     (59 )     (13,480 )     (15 )     (136,254 )     45,115  

Issuance of common stock upon exercise of stock options and purchases of ESPP shares

  510       —       662       —         —         —         —         —         662  

Repurchase of unvested stock for cash and cancellation of certain notes receivable from stockholders

  (1 )     —       (1 )     1       —         —         —         —         —    

Repayment of notes receivable

  —         —       —         49       —         —         —         —         49  

Issuance of common stock in connection with acquisition of Absorbable Polymer Technologies, Inc.

  185       —       250       —         —         —         —         —         250  

Issuance of common stock to an employee for notes receivable.

  13       —       37       (37 )     —         —         —         —         —    

Amortization of deferred stock compensation

  —         —       —         —         (15 )     —         —         —         (15 )

Stock compensation related to modifications of stock option terms

  —         —       5       —         —         —         —         —         5  

Reversal of deferred compensation related to cancelled employee stock options

  —         —       (70 )     —         70       —         —         —         —    

Noncash charges related to equity securities issued to non-employees

  —         —       214       —         —         —         —         —         214  

Net unrealized loss on available-for-sale securities

  —         —       —         —         —         —         (253 )     —         (253 )

Net loss

  —         —       —         —         —         —         —         (27,637 )     (27,637 )
                                                               


Total comprehensive net loss

  —         —       —         —         —         —         —         —         (27,890 )
   

 

 


 


 


 


 


 


 


Balance at December 31, 2004

  51,870     $ 5   $ 196,065     $ (37 )   $ (4 )   $ (13,480 )   $ (268 )   $ (163,891 )   $ 18,390  
   

 

 


 


 


 


 


 


 


 

The accompanying notes are an integral part of these consolidated financial statements.

 

 

61


Table of Contents

DURECT CORPORATION

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

 

     Year ended December 31,

 
     2004

    2003

    2002

 

Cash flows from operating activities

                        

Net loss

   $ (27,637 )   $ (22,698 )   $ (37,173 )

Adjustments to reconcile net loss to net cash used in operating activities:

                        

Depreciation

     3,391       3,402       2,979  

Amortization

     1,249       1,343       1,340  

Noncash charges related to stock-based compensation

     204       (102 )     1,204  

Changes in assets and liabilities:

                        

Accounts receivable

     (513 )     (956 )     (126 )

Inventories

     (27 )     (47 )     157  

Prepaid expenses and other assets

     672       233       735  

Accounts payable

     1,042       264       (1,651 )

Accrued liabilities

     (71 )     91       (222 )

Accrued liabilities to related party

     (17 )     —         2  

Contract research liability

     (433 )     (141 )     548  

Interest payable on convertible notes

     —         167       —    

Deferred revenue

     (68 )     (802 )     900  
    


 


 


Total adjustments

     5,429       3,452       5,866  
    


 


 


Net cash and cash equivalents used in operating activities

     (22,208 )     (19,246 )     (31,307 )

Cash flows from investing activities

                        

Purchase of property and equipment

     (1,138 )     (961 )     (1,413 )

Purchase of available-for-sale securities

     (47,729 )     (113,971 )     (30,639 )

Proceeds from maturities of available-for-sale securities

     69,659       84,069       59,929  

Payment for acquisition, net of cash acquired

     —         (81 )     —    
    


 


 


Net cash and cash equivalents provided by (used in) investing activities

     20,792       (30,944 )     27,877  
    


 


 


Cash flows from financing activities

                        

Net proceeds from convertible subordinated notes

     —         56,700       —    

Proceeds from term loan

     —         850       —    

Payments on term loan and equipment financing obligations

     (287 )     (873 )     (577 )

Payment on long term debt

     (180 )     (170 )     (160 )

Net proceeds from issuances of common stock and stockholders’ notes

     712       797       5,660  
    


 


 


Net cash and cash equivalents provided by financing activities

     245       57,304       4,923  
    


 


 


Net increase (decrease) in cash and cash equivalents

     (1,171 )     7,114       1,493  

Cash and cash equivalents at beginning of year

     21,203       14,089       12,596  
    


 


 


Cash and cash equivalents at end of year

   $ 20,032     $ 21,203     $ 14,089  
    


 


 


Supplemental disclosure of cash flow information

                        

Cash paid during the year for income taxes

   $ 18     $ —       $ —    
    


 


 


Cash paid during the year for interest

   $ 3,874     $ 2,073     $ 294  
    


 


 


Notes receivable issued in connection with exercise of stock options

   $ 37     $ —       $ —    
    


 


 


Issuance of common stock for acquisition of APT

   $ 250     $ 1,053     $ —    
    


 


 


 

The accompanying notes are an integral part of these consolidated financial statements.

 

62


Table of Contents

DURECT CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

1.    Summary of Significant Accounting Policies

 

Nature of Operations and Basis of Presentation

 

DURECT Corporation (the Company) was incorporated in the state of Delaware on February 6, 1998. The Company is a pharmaceutical company developing therapies for the treatment of chronic diseases and conditions with its proprietary drug formulations and delivery platform technologies. The Company has several product candidates under development by itself and with third party collaborators in the areas of pain and other chronic diseases and disorders. The Company also manufactures and sells osmotic pumps used in laboratory research. In addition, the Company conducts research and development of pharmaceutical product candidates with third party pharmaceutical and biotechnology company partners.

 

The Company also designs, develops and manufactures a wide range of standard and custom biodegradable polymers for pharmaceutical and medical device clients for use as raw materials in their products. Until December 31, 2004, this business was conducted by the Company’s wholly owned subsidiary, Absorbable Polymers International Corporation (API), formerly known as Birmingham Polymers Inc., an Alabama corporation. API was merged with and into DURECT on December 31, 2004.

 

Basis of Consolidation

 

The consolidated financial statements include the accounts of the Company and its subsidiary existing as of the reported period. All significant intercompany accounts and transactions have been eliminated.

 

Use of Estimates

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reported period. Actual results could differ materially from those estimates.

 

Cash, Cash Equivalents and Investments

 

The Company considers all highly liquid investments with maturities of 90 days or less from the date of purchase to be cash equivalents. Investments with maturities of greater than 90 days from the date of purchase but less than one year are classified as short-term investments, while investments with maturities beyond one year from the balance sheet date are classified as long-term investments. Management determines the appropriate classification of its cash equivalents and investment securities at the time of purchase and re-evaluates such determination as of each balance sheet date. Management has classified the Company’s cash equivalents and investments as available-for-sale securities in the accompanying consolidated financial statements. Available-for-sale securities are carried at fair value, with unrealized gains and losses reported as a component of accumulated other comprehensive income (loss). Realized gains and losses are included in interest income. There were no material realized gains or losses in the periods presented. The cost of securities sold is based on the specific identification method.

 

The Company invests its excess cash in debt instruments of financial institutions and corporations, and money market funds with high credit ratings. The Company has established guidelines regarding diversification of its investments and their maturities with the objectives of maintaining safety and liquidity, while maximizing yield.

 

63


Table of Contents

DURECT CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Concentrations of Credit Risk

 

Financial instruments that potentially subject the Company to credit risk consist principally of interest-bearing investments and trade receivables. The Company maintains cash, cash equivalents and investments with various major financial institutions. The Company performs periodic evaluations of the relative credit standing of these financial institutions and limits the amount of credit exposure with any one institution. In addition, the Company performs periodic evaluations of the relative credit quality of its investments.

 

Universities, pharmaceutical companies and hospitals account for a substantial portion of the Company’s trade receivables. The Company provides credit in the normal course of business to its customers and collateral for these receivables is generally not required. The risk associated with this concentration is limited due to the large number of accounts and their geographic dispersion. The Company monitors the creditworthiness of its customers to which it grants credit terms in the normal course of business. The Company maintains reserves for estimated credit losses and, to date, such losses have been within management’s expectations. At December 31, 2004 and 2003, one customer accounted for 40% and 19% of the Company’s gross accounts receivable and another customer accounted for 26% and 8% of the Company’s gross accounts receivable, respectively.

 

Customer and Product Line Concentrations

 

A substantial portion of the Company’s revenue is derived from its ALZET product line, which accounted for 36%, 44% and 69% of total revenues in fiscal years 2004, 2003 and 2002. In fiscal years 2004, 2003 and 2002, one customer accounted for 5%, 8% and 11% of the Company’s revenues, respectively. Revenue by geographic region for the years 2004, 2003 and 2002 is as follows (in thousands):

 

     Year ended December 31,

     2004

   2003

   2002

United States

   $ 11,928    $ 8,566    $ 5,085

Japan

     705      940      782

Europe

     754      1,899      711

Other

     466      430      607
    

  

  

Total

   $ 13,853    $ 11,835    $ 7,185
    

  

  

 

Revenues by geography is determined by the location of the customer.

 

In fiscal year 2004, Pain Therapeutics and Voyager accounted for 29% and 18% of our total revenues, respectively. In fiscal year 2003, Pain Therapeutics and Voyager accounted for 24% and 10% of the Company’s total revenues, respectively.

 

Inventories

 

Inventories are stated at the lower of cost or market, with cost determined on a first-in, first-out basis. The Company’s inventories consisted of the following (in thousands):

 

     December 31,

     2004

   2003

Raw materials

   $ 175    $ 212

Work in-process

     452      542

Finished goods

     1,302      1,148
    

  

Total inventories

   $ 1,929    $ 1,902
    

  

 

64


Table of Contents

DURECT CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Property and Equipment

 

Property and equipment are stated at cost less accumulated depreciation, which is computed using the straight-line method over the estimated useful lives of the assets, which range from three to five years. Leasehold improvements are amortized using the straight-line method over the estimated useful lives of the assets, or the terms of the related leases, whichever are shorter.

 

Acquired Intangible Assets and Goodwill

 

Acquired intangible assets consist of patents, developed technology, trademarks, assembled workforce and customer lists related to the Company’s acquisitions accounted for using the purchase method. Amortization of these purchased intangibles is calculated on a straight-line basis over the respective estimated useful lives of the assets ranging from four to seven years. Acquired in-process research and development without alternative future use is charged to operations when acquired. In July 2001, the FASB issued Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (SFAS 142), which requires the elimination of the amortization of goodwill and assembled workforce to be replaced with the periodic evaluation of intangibles for impairment. Accordingly, beginning in fiscal 2002, the Company ceased amortizing goodwill and assembled workforce, which has been reclassified to goodwill, and instead assesses goodwill for impairment on at least an annual basis in accordance with SFAS 142.

 

Impairment of Long-Lived Assets

 

In accordance with the provisions of Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS 144), the Company reviews long-lived assets, including property and equipment, intangible assets, and other long-term assets, for impairment whenever events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable. Factors we consider important which could trigger an impairment review include, but are not limited to, the following:

 

  ·   significant underperformance relative to expected historical or projected future operating results;

 

  ·   significant changes in the manner of our use of the acquired assets or the strategy for our overall business;

 

  ·   significant negative industry or economic trends;

 

  ·   significant decline in our stock price for a sustained period; and

 

  ·   our market capitalization relative to net book value.

 

Under SFAS 144, an impairment loss would be recognized when estimated undiscounted future cash flows expected to result from the use of the asset and its eventual disposition is less than its carrying amount. Impairment, if any, is calculated as the amount by which an asset’s carrying value exceeds its fair value, typically using discounted cash flows to determine fair value. Through December 31, 2004, there have been no such impairment losses. The Company adopted the provisions of SFAS 144 effective January 1, 2002, prior to which the Company followed the provisions of Statement of Financial Accounting Standards No. 121, Accounting for the Impairment of Long-Lived Assets and for Assets to be Disposed Of.

 

Stock-Based Compensation

 

The Company accounts for stock-based employee compensation arrangements in accordance with the provisions and related interpretations of Accounting Principles Board Opinion No. 25, Accounting for Stock

 

65


Table of Contents

DURECT CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Issued to Employees (APB 25), and has elected to follow the “disclosure only” alternative prescribed by Financial Accounting Standards Board’s Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (SFAS 123). Under APB 25, stock-based compensation is based on the difference, if any, on the date of grant, between the fair value of the Company’s stock and the exercise price. Unearned compensation is amortized using the graded vesting method and expensed over the vesting period of the respective options.

 

At December 31, 2004, the company has five stock-based employee compensation plans, which are described more fully in Note 11. The company accounts for those plans under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based employee compensation is reflected in the statement of operations when options granted under those plans have an exercise price equal to or greater than the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net loss and net loss per share if the company had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation (in thousands, except per share amounts).

 

     Year Ended December 31

 
     2004

    2003

    2002

 

Net loss

   $ (27,637 )   $ (22,698 )   $ (37,173 )

Add: Stock-based employee compensation expense included in reported net loss

     (10 )     (198 )     1,070  

Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards

     (3,017 )     (2,211 )     (5,337 )
    


 


 


Pro forma net loss

   $ (30,664 )   $ (25,107 )   $ (41,440 )
    


 


 


Net loss per share:

                        

Basic and diluted—as reported

   $ (0.54 )   $ (0.45 )   $ (0.77 )
    


 


 


Basic and diluted—pro forma

   $ (0.60 )   $ (0.50 )   $ (0.86 )
    


 


 


 

The Company accounts for equity instruments issued to non-employees in accordance with the provisions of SFAS 123 and Emerging Issues Task Force 96-18, Accounting for Equity Instruments that are Issued to other than Employees for Acquiring, or in Conjunction with Selling, Goods or Services. The fair value of equity instruments granted to non-employees is periodically remeasured as the underlying options vest.

 

Revenue Recognition

 

Revenue from the sale of products is recognized at the time the product is shipped and title transfers to customers, provided no continuing obligation exists and the collectibility of the amounts owed is reasonably assured.

 

Revenue related to research and development with the Company’s collaborators is recognized as the related research and development services are performed over the related funding periods for each agreement. The payments received under each respective agreement are not refundable and are generally based on reimbursement of qualified expenses, as defined in the agreements. Research and development expenses under the collaborative research and development agreements approximate or exceed the revenue recognized under such agreements over the term of the respective agreements. Deferred revenue may result when the Company does not expend the

 

66


Table of Contents

DURECT CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

required level of effort during a specific period in comparison to funds received under the respective agreements. Milestone and royalties payments, if any, are recognized as earned.

 

Revenue on cost-plus-fee contracts, such as contract research and development revenue, is recognized only to the extent of reimbursable costs incurred plus estimated fees thereon. In all cases, revenue is recognized only after a signed agreement is in place. For contracts that have a ceiling price or contract value, losses on contracts are recognized in the period in which the losses become known and estimable.

 

Research and Development Expenses

 

Research and development costs are expensed as incurred. Research and development costs paid to third parties under sponsored research agreements are recognized as the related services are performed, generally ratably over the period of service. Purchased research and development is recognized in purchase business combinations for the portion of the purchase price allocated to the appraised value of in-process technologies. The portion assigned to in-process technologies excludes the value of core and developed technologies, which are recorded as intangible assets.

 

Comprehensive Loss

 

Unrealized gains and losses on the Company’s available-for-sale securities are included in total comprehensive loss. For the year ended December 31, 2004, the Company’s total comprehensive loss was $27.9 million compared to its net loss of $27.6 million. For the year ended December 31, 2003, the Company’s total comprehensive loss was $22.8 million compared to its net loss of $22.7 million. For the year ended December 31, 2002, the Company’s total comprehensive loss was $37.7 million compared to its net loss of $37.2 million. The difference between net loss and comprehensive loss in all periods resulted from unrealized losses on available-for-sale investments.

 

Segment Reporting

 

The Company follows Statement of Financial Accounting Standard No. 131, Disclosures about Segments of an Enterprise and Related Information (SFAS 131). SFAS 131 establishes standards for reporting financial information about operating segments in financial statements, as well as additional disclosures about products and services, geographic areas, and major customers. The Company operates in one operating segment, research and development of pharmaceutical systems.

 

Net Loss Per Share

 

Basic net loss per share is calculated by dividing the net loss by the weighted-average number of common shares outstanding, less the weighted average number of common shares during the year subject to repurchase or held in escrow pursuant to an acquisition agreement. Diluted net loss per share is computed using the weighted-average number of common shares outstanding and common stock equivalents (i.e., options and warrants to purchase common stock, convertible subordinated notes) outstanding during the year, if dilutive, using the treasury stock method for options and warrants and the if-converted method for convertible subordinated notes.

 

67


Table of Contents

DURECT CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The following table presents the calculations of basic and diluted net loss per share (in thousands, except per share amounts):

 

     Year ended December 31,

 
     2004

    2003

    2002

 

Net loss

   $ (27,637 )   $ (22,698 )   $ (37,173 )
    


 


 


Basic and diluted weighted average shares:

                        

Weighted-average shares of common stock outstanding

     51,522       50,719       48,970  

Less: weighted-average shares subject to repurchase or held in escrow

     (15 )     (209 )     (652 )
    


 


 


Weighted-average shares used in computing basic and diluted net loss per share

     51,507       50,510       48,318  
    


 


 


Basic and diluted net loss per share

   $ (0.54 )   $ (0.45 )   $ (0.77 )
    


 


 


 

The computation of diluted net loss per share for the fiscal year ended December 31, 2004 excludes the impact of options to purchase 7.2 million shares of common stock, warrants to purchase 1.0 million shares of common stock and 19.0 million shares of common stock issuable upon conversion of the subordinated notes at December 31, 2004, as such impact would be antidilutive.

 

The computation of diluted net loss per share for the fiscal year ended December 31, 2003 excludes the impact of options to purchase 5.9 million shares of common stock, warrants to purchase 1.0 million shares of common stock and 10.3 million shares of common stock issuable upon conversion of the subordinated notes at December 31, 2003, as such impact would be antidilutive.

 

The computation of diluted net loss per share for the fiscal year ended December 31, 2002 excludes the impact of options to purchase 4.2 million shares of common stock and warrants to purchase 1.1 million shares of common stock, at December 31, 2002, as such impact would be antidilutive.

 

Shipping and Handling

 

Costs related to shipping and handling are included in cost of good sold for all periods presented.

 

Recent Accounting Pronouncements

 

In March 2004, the FASB approved the consensus reached on the Emerging Issues Task Force (EITF) Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” The Issue’s objective is to provide guidance for identifying other-than-temporarily impaired investments. EITF 03-1 also provides new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB issued a FASB Staff Position (FSP) EITF 03-1-1 that delays the effective date of the measurement and recognition guidance in EITF 03-1 until further notice. The disclosure requirements of EITF 03-1 are effective with this annual report for fiscal 2004. Once the FASB reaches a final decision on the measurement and recognition provisions, the company will evaluate the impact of the adoption of the accounting provisions of EITF 03-1.

 

In December 2004, the FASB issued Statement No. 123 (revised 2004, or FAS 123R), “Share-Based Payment,” effective for annual or interim periods beginning after June 15, 2005. FAS 123R supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and will require companies to recognize compensation expense, using a fair-value based method, for costs related to share-based payments including

 

68


Table of Contents

DURECT CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

stock options and stock issued under our employee stock purchase plans. The Company will be required to implement FAS 123R no later than the quarter that begins July 1, 2005. The Company’s adoption will be applied on a modified prospective basis and measured compensation expense will be recognized commencing on July 1, 2005. The Company is currently evaluating option valuation methodologies and assumptions in light of FAS 123R, and therefore cannot estimate the impact of the Company’s adoption at this time. These methodologies and assumptions may be different than those currently employed by the company in applying FAS 123, outlined above in “Stock-Based Compensation “ section of this note. The Company expects that the Company’s adoption of FAS 123R will have a material adverse impact on the Company’s consolidated results of operations and financial position.

 

2.    Strategic Agreements

 

Agreement with Endo Pharmaceuticals

 

In January 2004 and November 2004, the Company entered into two amendments to its agreement with Endo relating to the development and commercialization of the CHRONOGESIC product candidate in the U.S. and Canada. Prior to the amendments, in addition to other specified termination rights provided to both parties, the agreement provided Endo with a right to terminate the agreement in the event that the Company had not commenced a specified clinical trial for the CHRONOGESIC product candidate by December 31, 2003 and an additional right to terminate the agreement in the event that the Company had not commenced such clinical trial by June 30, 2004. As a result of the two amendments, Endo’s first right to terminate was eliminated and the second termination right was amended to replace the June 30, 2004 date with January 1, 2006. In addition, the parties agreed, under the amendments, to change the cap of the aggregate amount of development costs (excluding system redesign costs and pharmacokinetic trials necessitated by any system redesign) that Endo would be responsible for during the period commencing January 1, 2004 until the earlier of January 1, 2006 or the commencement of a specified clinical trial to $250,000.

 

Agreements with ALZA

 

In April 1998, the Company entered into a development and commercialization agreement with ALZA Corporation (ALZA) for certain product development rights, patent rights, and other know-how relating to the DUROS system. The Company issued 5,600,000 shares of Series A-1 preferred stock, which were subsequently converted into 5,600,000 shares of common stock concurrent with our initial public offering in 2000, to ALZA in connection with this agreement and is required to pay ALZA a royalty on the net sales of products and a percentage of up-front license fees, milestone payments, or any other payments or consideration received by the Company, excluding research and development funding.

 

In April 2000, ALZA and the Company amended and restated their development and commercialization agreement. This amendment includes a reduction in product royalties and up-front payments to ALZA by the Company under the agreement. As consideration for these amendments, ALZA received 1,000,000 shares of the Company’s common stock and, subject to conditions on exercise, a warrant to purchase 1,000,000 shares of common stock at an exercise price of $12.00 per share. The deemed fair value of the stock and the warrant was $13.5 million (See Note 10). This value was recorded as additional paid-in capital and deferred royalties and commercial rights, included as a contra-equity account in the statement of stockholders’ equity, and will be amortized as royalty expense and sales and marketing expense, respectively, as associated product sales commence. This warrant expired in September 2004, which was the fourth anniversary after the warrant first became exercisable. The Company will periodically evaluate the recoverability of these amounts and assess whether any indicators of impairment have occurred. Indicators of impairment for products under the agreement may include: failure to complete product development, unfavorable outcomes from clinical trials, suspension of clinical trial activities, failure to receive approval from the FDA, and/or lack of market acceptance.

 

69


Table of Contents

DURECT CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Effective October 1, 2002, the Company entered into a Third Amended and Restated Development and Commercialization Agreement with ALZA Corporation, which replaced and superseded the Second Amended and Restated Development and Commercialization Agreement entered into between ALZA and the Company effective April 28, 1999 and April 14, 2000. The agreement provides the Company with exclusive rights to develop, commercialize and manufacture products using ALZA’s patented DUROS® technology in selected fields of use. Under the amended agreement, the Company’s maintenance of exclusivity in these licensed fields is no longer subject to minimum annual requirements for development spending or the number of products under development by the Company.

 

In the years ended December 31, 2004, 2003 and 2002, the Company incurred development expenses of $2,000, $13,000, and $19,000, respectively, for work performed by ALZA, of which $6,000, $13,000 and $24,000 was paid during the years ended December 31, 2004, 2003 and 2002, respectively.

 

Agreements with other strategic partners

 

The Company also is party to collaboration research and development agreements with Pain Therapeutics and Voyager to develop drugs combining with the Company’s proprietary drug delivery technologies. Under these collaborative research and development agreements, the strategic partners reimburse to the Company all or portion of the research and development expenses incurred by the Company in connection with these partnering programs. In addition, the company received an upfront payment of $900,000 from a strategic partner upon execution of the collaboration agreement in December 2002.

 

3.    Acquisition of Absorbable Polymer Technologies, Inc.

 

On August 15, 2003, the Company acquired Absorbable Polymer Technologies, Inc. (APT), a privately held Alabama Corporation pursuant to an Agreement and Plan of Merger among Durect Corporation, Birmingham Polymers, Inc. and APT (the (“Merger Agreement”) for a total cost of approximately $2.2 million including the transaction cost of approximately $100,000. In connection with the acquisition, we issued an aggregate of 485,122 shares of our common stock, valued at $1.1 million and agreed to pay the remaining purchase consideration of $250,000, $250,000 and $500,000, respectively, through the issuance of additional shares of our common stock or cash in connection with the first, second and third anniversaries of the closing of the merger.

 

APT manufactured and sold polymer and provided analytical and product development services for third party pharmaceutical and biotechnology companies. This acquisition is intended to help the Company to gain market share in the polymers supply market and to expand custom polymer development capabilities. The purchase price was allocated to the tangible assets and identifiable intangible assets acquired based on their estimated fair value, as follows (in thousands):

 

Net tangible assets acquired

   $ 254

Intangible assets acquired:

      

Patents

     56

Developed technology

     160

Goodwill

     1,683
    

Total purchase price allocation

   $ 2,153
    

 

70


Table of Contents

DURECT CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Tangible net assets acquired include cash, accounts receivable, inventories and fixed assets. Liabilities assumed principally include accrued expenses and notes payable. Intangible assets represent the excess of the total acquisition cost over the fair value of identifiable net assets of business acquired. Intangible assets except goodwill are each being amortized on a straight-line basis over their estimated useful lives, which are both 7 years.

 

The acquisition of APT has been accounted for as a purchase, with the results of APT’s operations included in the Company’s results of operations from the date of acquisition. Pro forma financial information reflecting the acquisition of APT is not provided as the operating results of APT were not significant in relation to the Company’s operating results.

 

In August 2004, the Company issued an aggregate of 184,910 shares of our common stock, valued at $250,000, at the first anniversary of the closing of the merger to former shareholders of APT pursuant to the Merger Agreement. The remaining purchase price consideration to be paid by the Company was $750,000 as of December 31, 2004.

 

4.    Goodwill and Intangible Assets

 

Intangible assets recorded in connection with our acquisitions consist of the following (in thousands):

 

     December 31, 2004

     Gross
Intangibles


   Accumulated
Amortization


    Net
Intangibles


Developed technology

   $ 3,600    $ (2,647 )   $ 953

Patents

     466      (319 )     147

Other intangible assets

     3,260      (2,615 )     645
    

  


 

Total

   $ 7,326    $ (5,581 )   $ 1,745
    

  


 

     December 31, 2003

     Gross
Intangibles


   Accumulated
Amortization


    Net
Intangibles


Developed technology

   $ 3,600    $ (1,991 )   $ 1,609

Patents

     466      (252 )     214

Other intangible assets

     3,260      (2,089 )     1,171
    

  


 

Total

   $ 7,326    $ (4,332 )   $ 2,994
    

  


 

 

The intangible assets are being amortized on a straight-line basis over estimated useful lives ranging from four to seven years.

 

The net amount of intangible assets at December 31, 2004 was $1.7 million, which will be amortized as follows: $1.2 million in the year 2005, $424,000 in the year 2006, $31,000 in each of the years 2007, 2008 and 2009, and $19,000 in the year 2010. Should any intangible assets become impaired, the Company will write them down to their estimated fair value.

 

Goodwill totaled $6.4 million at December 31, 2004. On January 1, 2002, the Company adopted SFAS 142 and ceased amortizing goodwill. In addition, the Company reclassified the remaining balance of $855,000 of assembled workforce to goodwill. The Company also began periodically evaluating goodwill for impairment. In

 

71


Table of Contents

DURECT CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

2004 and 2003, goodwill was evaluated and no indicators of impairment were noted. Should goodwill become impaired, we may be required to record an impairment charge to write the goodwill down to its estimated fair value.

 

5.    Financial Instruments

 

The carrying amount of cash and cash equivalents reported on the balance sheet approximates its fair value. Short-term and long-term investments consist of marketable debt securities. The fair values of investments are based upon quoted market prices. The carrying amounts of the Company’s borrowings under its secured debt agreements approximate their fair values. The fair values are estimated using a discounted cash flow analysis based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements. As of December 31, 2004 and 2003, the fair market value of the Company’s convertible notes was $74.6 million and $57.6 million, respectively, compared with the carrying value of $60.0 million. The fair market value was obtained through quoted market prices.

 

72


Table of Contents

DURECT CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The following is a summary of available-for-sale securities as of December 31, 2004 and 2003 (in thousands):

 

     December 31, 2004

     Amortized
Cost


   Unrealized
Gain


   Unrealized
Loss


    Estimated
Fair
Value


Money market funds

   $ 19    $  —    $     $ 19

Certificates of deposit

     1,414                 1,414

Commercial paper

     20,422           (1 )     20,421

Market auction preferreds

     3,250                 3,250

Corporate bonds and notes

     10,015           (91 )     9,924

Federal agency debt securities

     24,981      3      (178 )     24,806

Others

     1,003           (1 )     1,002
    

  

  


 

     $ 61,104    $ 3    $ (271 )   $ 60,836
    

  

  


 

Reported as:

                            

Cash and cash equivalents

   $ 19,056    $    $ (1 )   $ 19,055

Short-term investments

     21,856           (91 )     21,765

Long-term investments

     17,393      3      (178 )     17,218

Restricted investments

     2,799           (1 )     2,798
    

  

  


 

     $ 61,104    $ 3    $ (271 )   $ 60,836
    

  

  


 

 

     December 31, 2003

     Amortized
Cost


   Unrealized
Gain


   Unrealized
Loss


    Estimated
Fair
Value


Money market funds

   $ 976    $  —    $     $ 976

Certificates of deposit

     1,601                 1,601

Commercial paper

     26,686      1      (6 )     26,681

Market auction preferreds

     22,000                 22,000

Corporate bonds and notes

     11,460      11      (18 )     11,453

Federal agency debt securities

     19,333      30      (33 )     19,330

Others

     2,313      1      (1 )     2,313
    

  

  


 

     $ 84,369    $ 43    $ (58 )   $ 84,354
    

  

  


 

Reported as:

                            

Cash and cash equivalents

   $ 20,394    $ 1    $ (5 )   $ 20,390

Short-term investments

     39,522      5      (16 )     39,511

Long-term investments

     21,334      37      (37 )     21,334

Restricted investments

     3,119                 3,119
    

  

  


 

     $ 84,369    $ 43    $ (58 )   $ 84,354
    

  

  


 

 

73


Table of Contents

DURECT CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The following is a summary of the cost and estimated fair value of available-for-sale securities at December 31, 2004 and 2003, by contractual maturity (in thousands):

 

     2004

   2003

     Amortized
Cost


   Estimated
Fair
Value


   Amortized
Cost


   Estimated
Fair
Value


Mature in one year or less

   $ 43,711    $ 43,618    $ 63,035    $ 63,020

Mature after one year through three years

     17,393      17,218      21,334      21,334
    

  

  

  

Total

   $ 61,104    $ 60,836    $ 84,369    $ 84,354
    

  

  

  

 

The follow is a summary of unrealized losses for available-for-sale securities at December 31, 2004 (in thousands):

 

     Unrealized Loss for
Less than 12 Months


 
     Fair
Value


   Unrealized
Loss


 

Commercial paper

   $ 20,421    $ (1 )

Corporate bonds and notes

     9,924      (91 )

Federal agency debt securities

     21,834      (150 )

Others

     1,002      (1 )
    

  


     $ 53,181    $ (243 )
    

  


     Unrealized Loss for
More than 12 Months


 
     Fair
Value


   Unrealized
Loss


 

Federal agency debt securities

   $ 1,972    $ (28 )
    

  


 

The follow is a summary of unrealized losses for available-for-sale securities at December 31, 2003 (in thousands):

 

     Unrealized Loss for
Less than 12 Months


 
     Fair
Value


   Unrealized
Loss


 

Commercial paper

   $ 9,858    $ (6 )

Corporate bonds and notes

     8,047      (18 )

Federal agency debt securities

     9,882      (33 )

Others

     697      (1 )
    

  


     $ 28,484    $ (58 )
    

  


 

There were no unrealized losses for available-for-sale securities that are greater than twelve months at December 31, 2003.

 

To date the Company has not recorded any impairment charges on marketable securities related to other-than-temporary declines in market value. The Company recognizes an impairment charge when the decline in the

 

74


Table of Contents

DURECT CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

estimated fair value of a marketable security below the amortized cost is determined to be other-than-temporary. The Company considers various factors in determining whether to recognize an impairment charge, including the duration of time and the severity to which the fair value has been less than our amortized cost, any adverse changes in the investees’ financial condition and our intent and ability to hold the marketable security for a period of time sufficient to allow for any anticipated recovery in market value.

 

6.     Notes Receivable

 

In November 2003, the Company issued a promissory note in the amount of $150,000 to a private company, Sinexus, Inc. and recorded the $150,000 as part of prepaid expenses and other current assets on the Company’s balance sheet as of December 31, 2003. Sinexus is a start-up venture developing site specific treatments for chronic sinusitis, an inflammatory disease affecting the paranasal sinuses. In order to provide bridge funding for Sinexus, the Company and a venture capital firm agreed to loan Sinexus $150,000 each in convertible notes as a pre-Series A seed financing of Sinexus, Inc. This note is secured by a security interest in Sinexus’ current and pending intellectual property and earns 6% interest until it is paid in full or converted to Sinexus’ preferred stock when certain conversion events occur. The Company’s investment in Sinexus represents an interest in a “variable interest entity”. However, the Company is not primary beneficiary of Sinexus and the Company’s maximum exposure to loss as a result of the Company’s involvement with Sinexus is $150,000.

 

In 2003 and 2004, the Company performed certain research and development activities on behalf of Sinexus. Any amounts received from Sinexus in connection with the Company’s performance of research and development activities were accounted for as a direct reduction of the Company’s investment.

 

During 2004, the Company re-evaluated the recoverability of the note receivable. Accordingly, the Company recorded a provision to reduce the carrying value of the note to zero.

 

7.     Property and Equipment

 

Property and equipment consist of the following (in thousands):

 

     December 31,

 
     2004

    2003

 

Equipment

   $ 9,914     $ 9,324  

Leasehold improvement

     7,525       8,462  

Construction-in-progress

     178       31  
    


 


       17,617       17,817  

Less accumulated depreciation

     (10,505 )     (8,501 )
    


 


Property and equipment, net

   $ 7,112     $ 9,316  
    


 


 

At December 31, 2004 and 2003, no equipment was collateralized as security for equipment financing facilities.

 

8.    Restricted Investments

 

In April 2001, the Company deposited $1.0 million in the form of a certificate of deposit with a financial institution as a letter of credit to secure a lease for the Company’s office facility in Cupertino, California. The restriction on these funds will be released upon termination of the lease in June 2006, but may be reduced by

 

75


Table of Contents

DURECT CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

$200,000 annually provided timely rental payments are made. In 2002, $200,000 was released by the bank from restriction as of December 31, 2002. However, the Company did not request the bank to release another $200,000 from restriction in 2003. In 2004, another $200,000 was released from restriction.

 

In July 2001, the Company also deposited $2.4 million in investment grade securities with the same institution to guarantee bonds assumed in the acquisition of SBS (see Note 10). This guarantee will be released upon the sooner of the Company’s exercise of its option to call the bonds at any time, or the bond’s maturity date in November 2009. In 2002, 2003 and 2004, as allowed under the guarantee agreement, a total of approximately $1.0 million of this collateral was released from restriction following the exchange of the investment grade securities for corporate debt securities with a higher investment grade to conform with the Company’s investment policy.

 

In January 2003, the Company refinanced the previous equipment loan and lease obligations with a three-year term loan with a local bank. The principal of the new term loan was $850,000 with a fixed interest rate of 4.95%. The term loan is secured by a certificate of deposit the Company placed with the same bank. In 2003, approximately $68,000 of collateral was released from restriction.

 

9.    Equipment Financing Obligations and Term Loan

 

Equipment Financing Obligations

 

In January 2000, the Company amended and restated a loan agreement to include a one-time advance of $750,000. This advance was repayable in monthly installments of principal and interest over 42 months with a balloon payment of $75,000 due at the end of the term. The effective interest rate for this loan was 8.61%. Simultaneously, the Company entered into a lease agreement with the same bank that allows the Company to finance up to $1,500,000 of future equipment purchases and leasehold improvements. The payment terms of the lease are substantially the same as the loan, with a 10 percent balloon payment due at the end of the lease. The Company had three lease draws totaling $859,000 under the lease agreement in 2000. The effective interest rates for the lease draws ranged from 13.01% to 13.55%. Both the loan and the lease are secured by the equipment financed. The Company paid in full the outstanding equipment loan and lease obligations in January 2003.

 

Term Loan

 

In January 2003, the Company refinanced the previous equipment loan and lease obligations with a three-year term loan with a local bank. The principal of the new term loan was $850,000 with a fixed interest rate of 4.95%. The term loan is secured by a certificate of deposit the Company placed with the same bank. The Company does not have any lines of credit or available balances under the term loan.

 

Aggregate future minimum loan payments on term loan are due as follows (in thousands):

 

Year ending December 31,


      

2005

   $ 292  

2006

     24  
    


Total minimum principal and interest payments

     316  

Less: Amount representing interest

     (9 )
    


Present value of future lease payments

     307  

Less: Current portion of term loan

     (283 )
    


Long-term portion of term loan

   $ 24  
    


 

76


Table of Contents

DURECT CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

10.    Long-term Debt and Commitments

 

Convertible Subordinated Notes due 2008

 

On June 18, 2003, the Company completed a private placement of an aggregate of $50.0 million in convertible subordinated notes (the “notes”). The notes bear interest at a fixed rate of 6.25% per annum and are due on June 15, 2008. On July 14, 2003, the initial purchaser of $50.0 million of the notes elected to exercise its option to purchase an additional $10.0 million in principal amount of such notes. The notes are convertible at the option of the note holders into our common stock at a conversion rate of 317.4603 shares per $1,000 principal amount of the notes, subject to adjustment in certain circumstances. Interest on the notes is payable semi-annually in arrears in June and December. We received net proceeds of approximately $56.7 million after deducting underwriting fees of $3.0 million and related expenses of $300,000. The total issuance cost of approximately $3.3 million has been included in other long-term assets on the balance sheet and is amortized to interest expense using the effective interest rate method over the duration of the notes, which is 5 years. The notes are unsecured obligations of the Company and are subordinate to any secured debt the Company currently has or any future senior indebtedness of the Company.

 

Alabama State Industrial Development Bonds

 

In conjunction with the acquisition of SBS in April 2001, the Company assumed Alabama State Industrial Development Bonds (“SBS Bonds”) with remaining principal payments of $1.7 million and a current interest rate of 6.35% increasing each year up to 7.20% at maturity on November 1, 2009. As part of the acquisition agreement, the Company was required to guarantee and collateralize these bonds with a letter of credit of approximately $2.4 million that the Company supported with investments deposited with a financial institution in July 2001. In 2002, 2003 and 2004, as allowed under the guarantee agreement, a total of approximately $1.0 million of this collateral was released from restriction following the exchange of the investment grade securities for corporate debt securities with a higher investment grade to conform with the Company’s investment policy.

 

Interest payments are due semi-annually and principal payments are due annually. Principal payments increase in annual increments from $150,000 to $240,000 over the term of the bonds until the principal is fully amortized in 2009. The Company has an option to call the SBS Bonds at any time. As of December 31, 2004, the remaining principal payments totals $1.1 million.

 

Operating Leases

 

The Company leases its Cupertino, California office and research facility under a noncancelable operating lease which expires in February 2009, with an option to extend the lease for 5 years. The company also renewed the lease in its Vacaville, California manufacturing facility under a noncancelable operating lease which expires in August 2005, with an option to extend the lease for a period of 2 years. In March 2001, the Company leased additional office space in Cupertino, California, under a noncancelable operating lease which commenced in June 2001, expires in May 2006 and has two options to extend the lease term for 3 years and 5 years each. Pursuant to the Company’s acquisition of SBS in April 2001, the Company assumed leases for approximately 23,000 square feet of office and laboratory space in Birmingham, Alabama, which expired in May 2003 and we subsequently renewed the lease for a term of fourteen months, which expired in July 2004.

 

In connection with the Company’s acquisition of APT in August 2003, the Company assumed a lease for approximately 6,650 square feet of office and laboratory space in Pelham, Alabama, which expires in February 2006. Pursuant to the Merger Agreement, the Company amended the lease in September 2004 to lease additional office and laboratory space of approximately 2,750 square feet. The amended lease expires in September 2009 with one option to extend for five years.

 

77


Table of Contents

DURECT CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

In December 2003, the Company leased approximately 20,000 square feet of additional corporate office and laboratory space in Cupertino, California, under a lease expiring in February 2009 with options to extend for up to an additional five years.

 

In May 2004, the Company leased approximately 2,500 square feet of office and laboratory space in Birmingham, Alabama, under a lease which was subsequently amended in August 2004. This lease expires in April 2005.

 

Under these leases, the Company is required to pay certain maintenance expenses in addition to monthly rent. Rent expense is recognized on a straight-line basis over the lease term for leases that have scheduled rental payment increases. Rent expense under all operating leases was $2.9 million, $2.7 million and $2.6 million, for the years ended December 31, 2004, 2003 and 2002, respectively.

 

Future minimum payments under these noncancelable leases and long-term obligations are as follows (in thousands):

 

Year ending December 31,


   Bond
Maturities


   Operating
Leases


2005

   $ 190    $ 2,706

2006

     200      1,827

2007

     210      1,244

2008

     225      1,257

Thereafter

     240      270
    

  

     $ 1,065    $ 7,304
    

  

 

11.    Stockholders’ Equity

 

Common Stock

 

As described in Note 2, in April 2000 the Company amended and restated its development and commercialization agreement with ALZA. As consideration for these amendments, ALZA received 1,000,000 shares of the Company’s common stock and, subject to conditions on exercise, a warrant to purchase 1,000,000 shares of common stock at an exercise price of $12.00 per share. The common stock issued to ALZA was valued at $7.00 per share. The fair value of the stock and the warrant was $13.5 million. The fair value of the warrant was determined to be $6,480,000, calculated using the Black-Scholes option pricing model, using the following assumptions: stock price of $12.00 per share; no dividends; contractual term of four years; risk-free interest rate of 6%; and expected volatility of 64%. This warrant expired in September 2004, which was the fourth anniversary after the warrant first became exercisable.

 

In connection with the acquisition of SBS, the Company assumed outstanding warrants to purchase 124,839 shares of common stock at the weighted-average exercise price of $2.40 per share. These warrants were exercisable immediately at the time of acquisition. The deemed fair value of the warrants was $773,000, calculated using the Black-Scholes option pricing model, using the following assumptions: stock price of $8.384 per share; no dividends; contractual term of 1 1/2 years; risk-free interest rate of 4.1%; and expected volatility of 64%. The fair value of the assumed outstanding warrants were included as part of the purchase price for SBS. As of December 31, 2004, warrants to purchase 91,033 shares of the company’s common stock had been exercised and the remaining unexercised warrants expired on April 30, 2003 pursuant to the terms of the warrants. As of December 31, 2004, no warrants assumed from the SBS acquisition to purchase the company’s common stock were outstanding.

 

78


Table of Contents

DURECT CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

In May 2001, the Company issued to a third party consultant a fully vested and exercisable warrant to purchase 770 shares of our common stock at an exercise price of $8.50 per share in connection with an Exclusive Trademark License and Assignment Agreement. The fair value of this warrant was $5,121 on the grant date.

 

As of December 31, 2004, shares of common stock reserved for future issuance consisted of the following:

 

     December
31, 2004


Warrants to purchase common stock

   770

Stock options outstanding

   8,611,995

Stock options available for grant

   1,978,090

Employee Stock Purchase Plan

   247,450

Convertible subordinated notes

   19,047,618
    
     29,885,923
    

 

Incentive Stock Plans

 

In March 1998, the Company adopted the DURECT Corporation 1998 Stock Option Plan under which incentive stock options and non-statutory stock options may be granted to employees, directors of, or consultants to, the Company and its affiliates. In January 2000, the Company ceased granting options from this plan.

 

In January 2000, the Company’s Board of Directors and stockholders adopted the DURECT Corporation 2000 Stock Option Plan, under which incentive stock options and non-statutory stock options and stock purchase rights may be granted to employees, consultants and non-employee directors. The 2000 Stock Option Plan was amended by written consent of the Board of Directors in March 2000 and written consent of the stockholders in August 2000. A total of 8,546,500 shares of common stock have been reserved for issuance under this plan.

 

Options granted under the 1998 and 2000 Stock Option Plans (“Plans”) expire no later than ten years from the date of grant. Options may be granted with different vesting terms from time to time not to exceed five years from the date of grant.

 

The option price of an incentive stock option granted to an employee or of a nonstatutory stock option granted to any person who owns stock representing more than 10% of the total combined voting power of all classes of stock of the Company (or any parent or subsidiary) shall be no less than 110% of the fair market value per share on the date of grant. The option price of an incentive stock option granted to any other employee shall be no less than 100% of the fair market value per share on the date of grant. The option price of a nonstatutory stock option that is granted to any other person shall be no less than 85% of the fair market value per share on the date of grant.

 

2000 Directors’ Stock Option Plan

 

In March 2000, the Board of Directors adopted the 2000 Directors’ Stock Option Plan. A total of 300,000 shares of common stock had been reserved initially for issuance under this plan. The directors’ plan provides that each person who becomes a non-employee director of the Company after the effective date of this offering will be granted a non-statutory stock option to purchase 20,000 shares of common stock on the date on which the optionee first becomes a non-employee director of the Company. This plan also provides that each option granted to a new director shall vest at the rate of 33 1/3% per year and each annual option of 5,000 shares shall vest in full at the end of one year. At the Company’s annual shareholders meeting in June 2002, the shareholders approved an amendment of the 2000 Directors’ Stock Option Plan to: (i) increase the number of stock options granted to a non-employee director on the date which such person first becomes a director from 20,000 to 30,000 shares of

 

79


Table of Contents

DURECT CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

common stock; (ii) increase the number of stock options granted to each non-employee director on the date of each annual meeting of the stockholders after which the director remains on the Board from 5,000 to 12,000 shares of common stock; and (iii) reserve 200,000 additional shares of common stock for issuance under the Directors’ Stock Option Plan so that the total number of shares reserved for issuance is 500,000. As of December 31, 2004, 205,000 shares have been granted under the directors’ plan.

 

1993 Stock Option Plan of Southern BioSystems, Inc.

 

In April 2001, the Company assumed the 1993 Stock Option Plan of Southern BioSystems, Inc. (1993 SBS Plan) in connection with its acquisition of SBS. Pursuant to the 1993 SBS Plan, incentive stock options may be granted to employees, and nonstatutory stock options may be granted to employees, directors, and consultants, of the Company and its affiliates. A total of 662,191 shares of common stock have been reserved for issuance under this plan. Options granted under the 1993 SBS Plan expire no later than ten years from the date of grant. Options may be granted with different vesting terms from time to time not to exceed five years from the date of grant. As of December 31, 2004, 214,167 shares of common stock have been exercised under the 1993 SBS Plan.

 

1995 Nonqualified Stock Option Plan of Southern Research Technologies, Inc.

 

In April 2001, the Company also assumed the 1995 Nonqualified Stock Option Plan of Southern Research Technologies, Inc. (1995 SRT Plan) in connection with its acquisition of SBS. Under this plan, non-statutory stock options may be granted to employees, directors, and consultants, of the Company and its affiliates. A total of 243,609 shares of common stock have been reserved for issuance under this plan. Options granted under the 1995 SRT Plan expire no later than ten years from the date of grant. Options may be granted with different vesting terms from time to time but not to exceed five years from the date of grant. As of December 31, 2004, 147,221 shares of common stock have been exercised under the 1995 SRT Plan.

 

Activity under all stock plans through December 31, 2004 is as follows:

 

     Shares
Available
for Grant


    Number of
Shares
Granted


   

Weighted—  

Average
Exercise
Price


Balance at December 31, 2001

   1,378,387     3,400,625     $ 6.51

Shares authorized, net

   2,450,000          

Options granted

   (1,429,207 )   1,429,207     $ 7.80

Options exercised

       (144,372 )   $ 0.89

Options canceled

   471,625     (476,446 )(1)   $ 8.66
    

 

 

Balance at December 31, 2002

   2,870,805     4,209,014     $ 6.89
    

 

 

Shares authorized, net

   2,250,000          

Options granted

   (3,078,743 )   3,078,743     $ 1.71

Options exercised

       (159,388 )   $ 0.95

Options canceled

   1,166,460     (1,512,573 )(1)   $ 4.62
    

 

 

Balance at December 31, 2003

   3,208,522     5,615,796     $ 4.62
    

 

 

Shares authorized, net

   2,250,000          

Options granted

   (4,395,937 )   4,395,937     $ 2.89

Options exercised

       (431,181 )   $ 1.26

Options canceled

   915,505     (968,557 )(1)   $ 4.34
    

 

 

Balance at December 31, 2004

   1,978,090     8,611,995     $ 3.93
    

 

 

 

80


Table of Contents

DURECT CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 


(1)   Options to purchase 2,500, and 35,550 shares of common stock granted under the 1998 Stock Option Plan were cancelled in 2002 and 2003, respectively and are not available for future grant. In addition, options to purchase 2,321, 139,198 and 53,052 shares of common stock under the 1993 SBS Plan in 2002, 2003 and 2004, respectively, and options to purchase 21,739 shares of common stock under the 1995 SRT Plan in 2003 were cancelled and are not available for future grant.

 

Since inception, the Company has recorded aggregate deferred compensation charges of $11.2 million in connection with stock options granted to employees and directors, including $918,000 recorded at the time of the Company’s acquisition of SBS in April 2001 for the assumption of outstanding stock options granted to employees and directors of that company. In 2004, 2003 and 2002, the company reversed $70,000, $949,000 and $750,000 of deferred compensation, respectively, as a result of terminated employees.

 

The Company has amortized or reversed (due to employee terminations) approximately $11.2 million of deferred compensation charges through December 31, 2004. Employee stock-based compensation expense, net of reversal, was ($15,000), ($276,000) and $1.1 million in 2004, 2003 and 2002. The remaining employee deferred stock compensation at December 31, 2004 was $4,000, which will be amortized as follows: $3,000 for 2005 and $1,000 for 2006.

 

Total stock compensation expense related to modification of stock option terms was $5,000 in 2004 and $78,000 in 2003.

 

The weighted-average grant-date fair value of options granted with exercise price equal to fair market value was $1.80 in 2004, $1.01 in 2003 and $4.15 in 2002. There were no options granted with exercise prices lower than fair market value in 2004, 2003 and 2002.

 

In 2004, the Company issued options to purchase 121,600 shares of common stock to several third party consultants in exchange for services. In connection with these options to purchase common stock, the Company recorded a non-cash charge of $214,000 in its statement of operations for the year ended December 31, 2004.

 

In 2003, the Company issued options to purchase 67,500 shares of common stock to several third party consultants in exchange for services. In connection with these options to purchase common stock, the Company recorded a non-cash charge of $96,000 in its statement of operations for the year ended December 31, 2003.

 

In 2002, the Company issued options to purchase 20,307 shares of common stock to several third party consultants in exchange for services. In connection with these options to purchase common stock, the Company recorded a non-cash charge of $134,000 in its statement of operations for the year ended December 31, 2002.

 

Expenses for non-employee stock options are recorded over the vesting period of the options, with the amount determined by the Black-Scholes option valuation method and remeasured over the vesting term.

 

81


Table of Contents

DURECT CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The following table summarizes information about stock options outstanding at December 31, 2004:

 

Range of

Exercise Price


  Number of
Options
Outstanding


 

Weighted—  

Average
Remaining
Contractual
Life


   

Weighted—  

Average
Exercise
Price


  Number of
Options
Exercisable


 

Weighted—  

Average
Exercise
Price


        (In years )                
$  0.35 –  1.53   431,590   6.00     $ 1.27   230,715   $ 1.15
$  1.55 –  1.58   1,756,043   8.11     $ 1.58   513,847   $ 1.58
$  1.63 –  2.32   176,000   8.86     $ 2.11   68,125   $ 2.03
$  2.33 –  2.51   1,415,125   9.13     $ 2.51   30,875   $ 2.43
$  2.57 –  3.10   416,446   7.13     $ 2.94   228,057   $ 2.95
$  3.15 –  3.20   1,481,587   9.96     $ 3.20   —     $ —  
$  3.22 –  3.87   1,112,509   8.92     $ 3.37   123,879   $ 3.65
$  3.92 –  9.19   1,127,665   6.82     $ 7.91   784,252   $ 7.67
$  9.25 –13.00   662,030   6.02     $ 11.42   600,288   $ 11.47
$13.56 –13.56   33,000   5.95     $ 13.56   33,000   $ 13.56
   
             
     
$  0.35 –13.56   8,611,995   8.23     $ 3.93   2,613,038   $ 6.03
   
             
     

 

As of December 31, 2004, outstanding options to purchase an aggregate of 2,613,038 shares of common stock were vested and exerciseable at a weighted-average exercise price per share of $6.03. As of December 31, 2003, outstanding options to purchase an aggregate of 2,313,240 shares of common stock were vested and exerciseable at a weighted-average exercise price per share of $5.60. As of December 31, 2002, outstanding options to purchase an aggregate of 1,569,207 shares of common stock were vested and exerciseable at a weighted-average exercise price per share of $5.34.

 

 

2000 Employee Stock Purchase Plan

 

In August 2000, the Company adopted the 2000 Employee Stock Purchase Plan. A total of 150,000 shares of common stock have been reserved for issuance under the purchase plan. This purchase plan will be implemented by a series of overlapping offering periods of approximately 24 months’ duration, with new offering periods, other than the first offering period, beginning on May 1 and November 1 of each year and ending April 30 and October 31, respectively, two years later. The purchase plan allows eligible employees to purchase common stock through payroll deductions at a price equal to the lower of 85% of the fair market value of the Company’s common stock at the beginning of each offering period or at the end of each purchase period. The initial offering period commenced on the effectiveness of the Company’s initial public offering.

 

Pro Forma Information

 

The Company has elected to follow APB 25 and related interpretations in accounting for its employee stock-based compensation plans. Because the exercise price of the employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is generally recognized. Pro forma information regarding net loss has been determined as if the Company accounted for its employee stock options (including shares issued under the Employee Stock Purchase Plan, collectively called “stock based awards”) under the fair value method prescribed by SFAS 123. The resulting effect on pro forma net loss disclosed is not likely to be representative of the effects on net loss on a pro forma basis in future years, due to additional grants and years of vesting in subsequent years. The fair value of the Company’s stock based awards granted to employees from inception (February 6, 1998) to the time of the initial public offering in September 2000, were

 

82


Table of Contents

DURECT CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

estimated on the date of grant using the minimum value method. Stock based awards granted subsequent to the Company’s initial public offering have been valued using the Black Scholes option valuation model.

 

The fair value of the Company’s stock based awards to employees was estimated using the following assumptions:

 

     Stock Options

   

Employee Stock

Purchase Plan


 
     Year ended December 31,

    Year ended December 31,

 
     2004

    2003

    2002

    2004

    2003

    2002

 

Risk-free interest rate

   2.2-3.6 %   1.9-2.6 %   2.2-4.5 %   1.8-2.4 %   1.3-1.5 %   1.5-2.6 %

Expected dividend yield

                        

Expected life of option (in years)

   3.5     3.5     3.5     1.25     1.25     1.25  

Volatility

   90-107 %   79-90 %   73-79 %   90-100 %   79-90 %   73-79 %

 

The Black Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. The Black Scholes model requires the input of highly subjective assumptions including the expected stock price volatility. Because the Company’s stock based awards to employees have characteristics significantly different from those of traded option, 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 stock based awards.

 

For the purposes of pro forma disclosures, the estimated fair value of the stock based awards is amortized to expense over the vesting period for options and the offering period for stock purchases under the Employee Stock Purchase Plan.

 

Stockholder Rights Plan

 

On July 6, 2001, the Board of Directors adopted a Stockholder Rights Plan. The rights issued pursuant to the plan expire on July 6, 2011 and are exercisable ten days after a person or group either (a) announces the acquisition of 17.5 percent or more of the Company’s outstanding common stock or (b) commences a tender offer, which would result in ownership by the person or group of 17.5 percent or more of the Company’s outstanding common stock. Upon exercise, all rights holders except the potential acquiror will be entitled to acquire the Company’s common stock at a discount. Under certain circumstances, the company’s Board of Directors may also exchange the rights (other than those owned by the acquiror or its affiliates) for the company’s common stock at an exchange ratio of one share of common stock per right. The Company is entitled to redeem the rights at any time on or before the tenth day following acquisition by a person or group of 17.5 percent or more of the Company’s common stock.

 

12.    Income Taxes

 

Income tax provision was $18,000 in 2004 due to state income taxes paid for API in 2004 compared with zero in 2003. Prior to 2004, the Company had no provision for income taxes, as the Company incurred losses for all periods presented.

 

83


Table of Contents

DURECT CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

The reconciliation of income tax expenses (benefit) at the statutory federal income tax rate of 34% to net income tax benefit included in the statement of operations for the years ended December 31, 2004, 2003 and 2002 is as follows (in thousands):

 

     Year Ended December 31,

 
     2004

    2003

    2002

 

U.S. federal taxes (benefit) at statutory rate

   $ (9,397 )   $ (7,717 )   $ (12,639 )

State taxes

     18       —         —    

Unutilized net operating loss

     9,432       7,730       12,413  

Stock based compensation

     (52 )     (30 )     207  

Other

     17       17       19  
    


 


 


Total

   $ 18     $ —       $ —    
    


 


 


 

Deferred tax assets and liabilities reflect the net tax effects of net operating loss and credit carryforwards and the temporary differences between the carrying amounts of assets and liabilities for financial reporting and the amounts used for income tax purposes. Significant components of the Company’s deferred tax assets are as follows (in thousands):

 

     December 31,

 
     2004

    2003

 

Deferred tax assets:

                

Net operating loss carryforwards

   $ 48,900     $ 38,400  

Capitalized research and development expenses

     2,970       3,480  

Other

     5,140       2,660  
    


 


Total deferred tax assets

     57,010       44,540  

Valuation allowance for deferred tax assets

     (57,010 )     (44,540 )
    


 


Net deferred tax assets

   $     $  
    


 


 

Realization of deferred tax assets is dependent upon future earnings, if any, the timing and amount of which are uncertain. Accordingly, the net deferred tax assets have been fully offset by a valuation allowance. The valuation allowance increased by $12.5 million and $8.4 million during 2004 and 2003, respectively.

 

As of December 31, 2004, the Company had net operating loss carryforwards for federal income tax purposes of approximately $132.3 million, which expire in the years 2018 through 2024 and federal research and development tax credits of approximately $1.6 million which expire at various dates beginning in 2018 through 2024, if not utilized.

 

As of December 31, 2004, the Company had net operating loss carryforwards for state income tax purpose of approximately $71.1 million, which expire in the years 2008 through 2014, if not utilized and state research and development tax credits of approximately $1.4 million, which do not expire.

 

Utilization of the net operating losses may be subject to a substantial annual limitation due to federal and state ownership change limitations. The annual limitation may result in the expiration of net operating losses before utilization.

 

84


Table of Contents

DURECT CORPORATION

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

13.    Unaudited Selected Quarterly Financial Data (in thousands, except per share amounts)

 

     First Quarter

    Second Quarter

    Third Quarter

    Fourth Quarter

 
     2004

    2003

    2004

    2003

    2004

    2003

    2004

    2003

 

Revenue, net

   $ 3,385     $ 2,581     $ 3,080     $ 3,200     $ 3,365     $ 2,950     $ 4,023     $ 3,104  

Net loss

   $ (5,990 )   $ (5,893 )   $ (7,433 )   $ (5,116 )   $ (7,260 )   $ (6,430 )   $ (6,954 )   $ (5,259 )

Basic and diluted net loss per share

   $ (0.12 )   $ (0.12 )   $ (0.14 )   $ (0.10 )   $ (0.14 )   $ (0.13 )   $ (0.13 )   $ (0.10 )

 

14.    Subsequent Event (unaudited)

 

On March 10, 2005, the Company entered into a license agreement with Endo Pharmaceuticals Inc. (Endo) under which the Company granted to Endo the exclusive right to develop and commercialize the Company’s proprietary sufentanil transdermal patch product candidate (TRANSDUR-Sufentanil) in the U.S. and Canada. Under the terms of the agreement, Endo will assume all remaining development and regulatory filing responsibility in the U.S. and Canada, including the funding thereof. The Company will perform all formulation development for Endo unless the Company defaults on such obligations and the Company will be reimbursed for its fully allocated cost in performance of such work. Endo will also be responsible and pay for the manufacture, marketing, sales and distribution of TRANSDUR-Sufentanil in the U.S. and Canada. Endo will pay the Company an upfront fee of $10 million with additional payments of up to approximately $35 million in the aggregate based upon achievement of predetermined regulatory and commercial milestones. Endo will also pay the Company product royalties based on the net sales of TRANSDUR-Sufentanil under the agreement. The Company has the right to co-promote TRANSDUR-Sufentanil under terms specified in the agreement. The agreement also contains terms and conditions customary for this type of arrangement, including representations, warranties and indemnities. The agreement shall continue in effect until terminated. The agreement provides each party with specified termination rights, including the right of each party to terminate the agreement upon material breach of the agreement by the other party. In addition, Endo shall have the right to terminate the agreement at any time without cause subject to a specified notice period and due to adverse product events, legal impediment or the issuance of a final, non-appealable court order enjoining Endo from selling TRANSDUR-Sufentanil in the U.S. and Canada as a result of an action for patent infringement by a third party, provided that in the latter instance, the Company will be required to pay Endo a termination fee ranging from $5 million to $10 million, depending on the date of termination. The Company has the right to terminate the agreement in the event that Endo pursues directly or indirectly any proceeding seeking to have any of the Company’s TRANSDUR-Sufentanil related patents revoked or declared invalid, unpatentable or unenforceable.

 

85


Table of Contents

Item 9.    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.

 

Not applicable.

 

Item 9A.    Controls and Procedures

 

See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Management’s Report on Controls and Procedures” appearing on page 35 of this annual report.

 

Item 9B.    Other Information

 

Not applicable.

 

PART III

 

The definitive proxy statement for our 2005 annual meeting of stockholders, when filed, pursuant to Regulation 14A of the Securities Exchange Act of 1934, will be incorporated by reference into this Form 10-K pursuant to General Instruction G (3) of Form 10-K and will provide the information required under Part III (Items 10-14), except for the information with respect to our executive officers, which is included in “Part I—Executive Officers of the Registrant.”

 

PART IV

 

Item 15.    Exhibits and Financial Statement Schedules.

 

  (a)   The following documents are filed as part of this report:

 

  (1)   Financial Statements

 

See Item 8 of this form 10-K

 

  (2)   Financial Statement Schedules

 

Schedule II—Valuation and Qualifying Accounts

 

Schedules not listed above have been omitted because the information required to be set forth therein is not applicable or is shown in the financial statements or notes thereto.

 

(3) Exhibits are incorporated herein by reference or are filed in accordance with Item 601 of Regulation S–K.

 

Number

  

Description


2.1   

Agreement and Plan of Merger dated April 18, 2001, among the Company, Target and Magnolia Acquisition Corporation (2).

3.3   

Amended and Restated Certificate of Incorporation of the Company (1).

3.5   

Amended and Restated Bylaws of the Company (1).

3.6   

Certificate of Designation of Rights, Preferences and Privileges of Series B-1 Preferred Stock (1).

3.7   

Certificate of Designation of Rights, Preferences and Privileges of Series C Preferred Stock (1).

4.2   

Second Amended and Restated Investors’ Rights Agreement (1).

4.3   

Preferred Shares Rights Agreement, dated as of July 6, 2001, between the Company and EquiServe Trust Company, N.A. including the Certificate of Designation, the form of the Rights Certificate and the Summary of Rights attached thereto as Exhibits A, B and C, respectively (3).

10.1   

Form of Indemnification Agreement between the Company and each of its Officers and Directors (1).

10.2   

1998 Stock Option Plan (1).

10.3   

2000 Stock Plan (1).

10.4   

2000 Employee Stock Purchase Plan (1).

10.5   

2000 Directors’ Stock Option Plan (1).

 

86


Table of Contents
Number

   

Description


10.6 **  

Second Amended and Restated Development and Commercialization Agreement between the Company and ALZA Corporation effective April 28,1999 (1).

10.7 **  

Product Acquisition Agreement between the Company and ALZA Corporation dated as of April 14, 2000 (1).

10.8    

Amended and Restated Loan and Security Agreement between the Company and Silicon Valley Bank dated as of October 28, 1998 (1).

10.9 **  

Manufacturing and Supply Agreement between Neuro-Biometrix, Inc. and Novel Biomedical, Inc. dated as of November 24, 1997 (1).

10.10 **  

Master Services Agreement between the Company and Quintiles, Inc. dated as of November 1, 1999 (1).

10.11    

Modified Net Single Tenant Lease Agreement between the Company and DeAnza Enterprises, Ltd. dated as of February 18, 1999 (1).

10.12    

Sublease Amendment between the Company and Ciena Corporation dated as of November 29, 1999 and Sublease Agreement between Company and Lightera Networks, Inc. dated as of March 10, 1999 (1).

10.13 **  

Project Proposal between the Company and Chesapeake Biological Laboratories, Inc. dated as of October 11, 1999 (1).

10.17    

Common Stock Purchase Agreement between the Company and ALZA Corporation dated April 14, 2000 (1).

10.18    

Warrant issued to ALZA Corporation dated April 14, 2000 (1).

10.19    

Amended and Restated Market Stand-off Agreement between the Company and ALZA Corporation dated as of April 14, 2000 (1).

10.20 **  

Asset Purchase Agreement between the Company and IntraEAR, Inc. dated as of September 24, 1999 (1).

10.21    

Warrant issued to Silicon Valley Bank dated December 16, 1999 (1).

10.22    

Amendment to Second Amended and Restated Investors’ Rights Agreement dated as of April 14, 2000 (1).

10.23 **  

Master Agreement between the Company and Pacific Data Designs, Inc. dated as of July 6, 2000 (1).

10.24 **  

Master Services Agreement between the Company and Clinimetrics Research Associates, Inc. dated as of July 11, 2000 (1).

10.25 **  

Supply Agreement between the Company and Mallinckrodt, Inc. dated as of October 1, 2000 (5).

10.26    

Lease between Sobrato Development Companies #850 and the Company (6).

10.27    

Southern BioSystems, Inc. 1993 Stock Option Plan (as amended) (4).

10.28    

Southern Research Technologies, Inc. 1995 Nonqualified Stock Option Plan (as amended) (4).

10.29 **  

Feasibility, Development and Commercialization Agreement between Southern BioSystems, Inc., an Alabama corporation and wholly-owned subsidiary of the Company (now merged into the Company), and Voyager Pharmaceutical Corporation dated as of July 22, 2002. (7).

10.30 **  

License & Option Agreement and Mutual Release between Southern BioSystems, Inc, an Alabama corporation and wholly-owned subsidiary of the Company (now merged into the Company), and Thorn BioScience LLC dated as of July 26, 2002 (7).

10.31 **  

Third Amended and Restated Development and Commercialization Agreement between the Company and ALZA Corporation dated as of October 1, 2002 (7).

10.32 **  

Development and License Agreement between the Company, Southern BioSystems, Inc, an Alabama corporation and wholly-owned subsidiary of the Company (now merged into the Company), and BioPartners, GmbH dated as of October 18, 2002.(8)

 

87


Table of Contents
Number

 

Description


10.33**  

Development, Commercialization and Supply License Agreement between the Company and Endo Pharmaceuticals Inc. dated as of November 8, 2002.(8)

10.34**  

Development and License Agreement between the Company, Southern BioSystems, Inc., an Alabama corporation and wholly-owned subsidiary of the Company (now merged into the Company), and Pain Therapeutics, Inc. dated as of December 19, 2002.(8)

10.35  

Sublease between the Company and Norian Corporation with commencement date of January 1, 2004.(9)

10.36  

Lease between the Company and Renault & Handley Employee Investments Co. with commencement date of January 1, 2005.(9)

10.37  

Amendment to Development, Commercialization and Supply License Agreement between the Company and Endo Pharmaceuticals Inc. dated as of January 28, 2004.(9)

10.38  

Indenture of Lease between the Company and the Board of Trustees of the University of Alabama dated as of May 1, 2004.(10)

10.39**  

License and Commercial Agreement between the Company and NeuroSystec Corporation dated as of May 13, 2004. (10)

10.40  

Commercial Lease between the Company and EWE, Inc. dated as of September 21, 2004.(11)

12.1  

Ratio of Earnings to Fixed Charges.

21.1  

Subsidiaries

23.1  

Consent of Independent Registered Public Accounting Firm

24.1  

Power of Attorney (see signature page of this Form 10-K).

31.1  

Rule 13a-14(a) Section 302 Certification.

31.2  

Rule 13a-14(a) Section 302 Certification.

32.1  

Certificate pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2  

Certificate pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.


  (1)   Incorporated by reference to our Registration Statement on Form S-1, as amended (File No. 333-35316), initially filed with the Securities and Exchange Commission on April 20, 2000.

 

  (2)   Incorporated by reference to our Current Report on Form 8-K (File No. 000-31615) filed with the Securities and Exchange Commission on May 15, 2001.

 

  (3)   Incorporated by reference to our Registration Statement on Form 8-A (File No. 000-31615) filed with the Securities and Exchange Commission on July 10, 2001.

 

  (4)   Incorporated by reference to our Registration Statement on Form S-8 (File No. 333-61224) filed with the Securities and Exchange Commission on May 18, 2001.

 

  (5)   Incorporated by reference to our Annual Report on Form 10-K (File No. 000-31615) filed with the Securities and Exchange Commission on March 30, 2001.

 

  (6)   Incorporated by reference to our Quarterly Report on Form 10-Q (File No. 000-31615) filed with the Securities and Exchange Commission on November 13, 2001.

 

  (7)   Incorporated by reference to our Quarterly Report on Form 10-Q (File No. 000-31615) filed with the Securities and Exchange Commission on November 14, 2002.

 

  (8)   Incorporated by reference to our Annual Report on Form 10-K (File No. 000-31615) filed with the Securities and Exchange Commission on March 14, 2003.

 

88


Table of Contents
  (9)   Incorporated by reference to our Annual Report on Form 10-K (File No. 000-31615) filed with the Securities and Exchange Commission on March 11, 2004.

 

(10)   Incorporated by reference to our Quarterly Report on Form 10-Q (File No. 000-31615) filed with the Securities and Exchange Commission on August 4, 2004.
(11)   Incorporated by reference to our Quarterly Report on Form 10-Q (File No. 000-31615) filed with the Securities and Exchange Commission on November 5, 2004.

 

**   Confidential treatment granted with respect to certain portions of this Exhibit.

 

89


Table of Contents

SCHEDULE II—VALUATION AND QUALIFYING ACCOUNTS

 

Year Ended December 31, 2004, 2003 and 2002

(in thousands)

 

     Balance at
beginning
of year


   Provision

    Write
Offs


    Balance at
end of the
year


December 31, 2004
Allowance for doubtful accounts

   $ 141    $ 112     $ (45 )   $ 208

December 31, 2003
Allowance for doubtful accounts

     207      70       (136 )     141

December 31, 2002
Allowance for doubtful accounts

   $ 263    $ (31 )   $ (25 )   $ 207

 

90


Table of Contents

SIGNATURES

 

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

DURECT CORPORATION

By:

 

/s/    JAMES E. BROWN        


   

James E. Brown

President and Chief Executive Officer

 

Date:  March 14, 2005

 

POWER OF ATTORNEY

 

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints James E. Brown and Felix Theeuwes, jointly and severally, his or her attorneys-in-fact, each with the power of substitution, for him or her in any and all capacities, to sign any amendments to this Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his or her substitute or substitutes may do or cause to be done by virtue hereof.

 

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

 

Signature


  

Title


 

Date


/s/    JAMES E. BROWN        


James E. Brown

  

President, Chief Executive Officer and Director (Principal Executive Officer)

  March 14, 2005

/s/    FELIX THEEUWES        


Felix Theeuwes

  

Chairman and Chief Scientific Officer

  March 14, 2005

/s/    THOMAS A. SCHRECK        


Thomas A. Schreck

  

Chief Financial Officer and Director (Principal Financial and Accounting Officer)

  March 14, 2005

/s/    MICHAEL D. CASEY        


Michael D. Casey

  

Director

  March 14, 2005

/s/    DAVID R. HOFFMANN        


David R. Hoffmann

  

Director

  March 14, 2005

/s/    ARMAND P. NEUKERMANS        


Armand Neukermans

  

Director

  March 14, 2005

/s/    JON S. SAXE        


Jon S. Saxe

  

Director

  March 14, 2005

/s/    ALBERT L. ZESIGER        


Albert L. Zesiger

  

Director

  March 14, 2005

 

 

91