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U.S. Securities and Exchange Commission
Washington, D.C. 20549
FORM 10-KSB
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the Fiscal Year Ended December 31, 1996
[ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the Transition Period from N/A to N/A
Commission File No. 33-97156
WHITEWING LABS, INC.
(Name of small business issuer in its charter)
Delaware 95-4437350
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
15455 San Fernando Mission Blvd., #105, Mission Hills, California 91345
(Address of principal executive offices) (Zip Code)
Issuer's Telephone Number: (818) 898-2167
Securities registered under Section 12(b) of the Exchange Act:
None
Securities registered under Section 12(g) of the Exchange Act:
Common Stock, $.001 par value
(Title of Class)
Check whether the issuer (1) filed all reports required to be filed by
Section 12 or 15(d) of the Exchange Act during the past 12 months (or for
such shorter period that the registrant was required to file such reports),
and (2) has been subject to such filing requirements for the past 90 days.
Yes [X] No [ ]
Check if there is no disclosure of delinquent filers in response to Item
405 of Regulation S-B is contained in this form, and no disclosure will 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-KSB or any amendment to this Form 10-KSB. [X]
The issuer's revenue for the year ended December 31, 1996 was
$3,537,480. The aggregate market value of the voting stock held by
non-affiliates as of February 28, 1997, computed by reference to the price at
which the stock was sold, or the average closing bid and asked quotations of
such stock, was $4,019,608.
DOCUMENTS INCORPORATED BY REFERENCE: None
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PART I
Item 1. Description of Business.
General
Whitewing Labs, Inc. (the "Company") develops, or seeks to acquire through
license, nutritional supplements that can be sold to the over age forty market
in the United States. The over age forty market is the fastest growing
segment of the population and a population for whom quality of life has
become one of the most important issues associated with aging. Direct mail
and magazine advertisements are the primary vehicles used by the Company to
reach this expanding population segment. Utilizing formulations that include
only herbs and other natural ingredients, the Company's products are intended
to offer alternatives to conventional treatments for symptoms associated with
the aging process. Customers confronted with concerns such as a lack of
convenient transportation, unsafe shopping areas, and the loss of personal
mobility, also enjoy the added benefit of ordering and receiving the
products in the comfort and security of their own homes.
Whitewing Labs was incorporated under the laws of the State of
California on July 29, 1993, initially as a wholly-owned subsidiary of
Acacia Research Corporation, a California corporation ("Acacia").
The Company was incorporated under the laws of the State of Delaware on
December 13, 1995, in order to participate in the reincorporation of
Whitewing Labs in the State of Delaware (the "Reincorporation"). In connection
with the Reincorporation, which became effective on February 9, 1996,
Whitewing Labs merged with and into the Company, which was the surviving
corporation in the merger, and the holders of all of Whitewing Labs'
securities received or became entitled to purchase three shares of the
Company's Common Stock for every two shares of Whitewing Labs' common or
preferred stock outstanding or issuable upon exercise of outstanding stock
options.
On February 14, 1996, the Company's Registration Statement on Form S-1
became effective under the Securities Act of 1933, pursuant to which the
Company completed its initial public offering, selling 1,035,000 shares of
Common Stock at $5.00 per share and 1,035,000 Common Stock purchase
warrants ("Warrants") at $.20 per Warrant, generating aggregate net proceeds
of approximately $4,270,000, after offering costs and broker discounts of
$1,111,752. Two Warrants entitle the holder to purchase one share of the
Company's Common Stock at a price of $7.00 during the three year period ending
February 14, 1999, and may be redeemed by the Company under certain
circumstances. See Item 5, "Market for Registrant's Common Stock and Related
Stockholder Matters."
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Market
Census data indicates that the U.S. population includes more than 38
million men between the ages of 45 and 85. That number is projected to
increase to 43 million by the year 2000. Women between the ages of 55 and 85
now number approximately 46 million, and are expected to number more than 51
million by the year 2000.
According to health experts the human body is capable of living up to 120
years. Most adults approaching their 80's and 90's experience health
disorders. The U.S. Food and Drug Administration estimates that 80% of all
men will experience urination difficulty, increased frequency or urgency of
urination or other prostate symptoms. Moreover, more than half of the men
between the ages of 40 and 70 experience some degree of sexual impotence. All
women experience menopause, although each woman experiences the transition to
middle age individually with different degrees of the symptoms, which include
dizziness, hot flashes and fatigue, experienced over varying time periods and
at different ages.
The growth of the nutritional supplement industry is due primarily to
heightened public awareness of the positive effects of vitamins and other
nutritional supplements. Many individuals are now using nutritional
supplements as a means of preventive health care. Retail sales of
nutritional supplements increased from $3.5 billion in 1991 to approximately
$4.2 billion in 1993, as reported by The Overview of Nutritional Supplement
Market prepared by the Council for Responsible Nutrition. Furthermore,
industry trade sources estimated that 1994 sales of nutritional supplements
were $4.7 billion, and 1995 sales of nutritional supplements were estimated to
be approximately $5.3 billion.
Marketing Strategy
The Company's strategic marketing plan utilizes a two-pronged approach.
The first approach (or "front-end" component) entails efforts to capture new
customers from the target population through direct mail and advertising.
Since October 1993, over 100 different mailing lists have been tested by
selecting at least 5,000 names randomly from each list. Based upon responses,
the Company determines which of the lists tested have the most potential for
generating meaningful sales, and thus should be used on a more extensive
basis. In addition, the Company has placed display advertisements in a
wide variety of local and national magazines. Direct mail advertising
includes postcard inserts, tear sheets, holiday special mailers and the
Journal of Natural Health "TM". The strategy for 1997 involves a more defined
approach to attracting new customers. Based on market experience gained from
the results of its product advertising programs in 1996, the Company is
focusing on select print media. The Company began to test electronic in-home
delivery of product advertising in February 1997.
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The second part of the Company's approach, and the potentially more
profitable element of its marketing strategy, involves generating repeat
orders from existing customers, since the selling and advertising costs
incurred in these orders are expected to continue to be considerably lower.
Four mailings per year to its customer base are planned for the Company's
in-house Journal of Natural Health "TM", which promotes products available
from the Company. In addition, the Company offers two or three holiday sales
per year. The Company's products are sold with an unconditional, money back
guarantee which alleviates the basis for customer complaints. Product returns
through December 31, 1996, have been less than 3% of sales.
Products
The Company's two main products are:
PROSTSAFE "R": Formulated to alleviate the symptoms associated
with prostatitis and benign prostate hyperplasia ("BPH"). Helps to reduce
troublesome symptoms such as urination difficulties, increased frequency
and urgency of urination, and low back pain. A blend of natural herbs,
vitamins, minerals and amino acids.
SEXHILARATE "TM": Assists in increasing male virility and
decreasing sexual dysfunction by working to improve blood flow, increase
hormone production, stimulate the libido and restore physical stamina.
A unique combination of herbs, vitamins and minerals.
Other products currently available from the Company include the
following:
PROPAUSE "TM": Formulated to ease menopausal symptoms. Propause
works gently and naturally to help regulate hormonal imbalances, reduce
hot flashes, improve mood, and increase energy level. A combination of
selected vitamins and herbs.
ARTHRIVIVE "TM": Addresses the internal problems that cause joint
pain and discomfort. Arthrivive contains natural anti-inflammatories that
help to relieve arthritic pain, reduce stiffness and inflammation, and
improve flexibility. Contains herbs, vitamins and minerals.
ARTHRIVIVE CREAM "TM": Applied topically, this cream penetrates the
skin quickly to relieve minor arthritic aches and pains in muscles and joints.
Contains natural pain-relieving agents.
DE-STRESS "TM": Helps to ease tension and to meet the increased
nutritional demands that result from environmental, physical and
emotional stress. A combination of vitamins, minerals and herbs.
VIM! "TM": Provides nutrients needed to create and sustain a high
energy level. Consists of selected vitamins, minerals and herbs needed
to maintain a feeling of well-being and physical stamina.
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IMMUNE DEFENSE "TM": Combines important nutrients to help the
body's immune system combat viruses, bacteria, foreign proteins, yeasts
and fungi. Immune Defense can increase immune system activity as well
as strengthening the fundamental organs and glands involved in the
body's immune response.
DIMI-OXIDE "TM": Formulated to protect the body against
free-radical damage and associated tissue and cell destruction. A
combination of antioxidant vitamins, minerals and herbs.
COLON PURE "TM": Formulated to promote proper balance of
intestinal flora, relieve constipation and diarrhea, and guard against
hemorrhoids.
POWER MIND "TM": Helps to improve concentration and cognition,
enhance memory, sharpen the thinking process, and prevent deterioration
of brain cells. Includes vitamins, minerals, herbs, and amino acids
which work to restore healthy neurotransmitter levels and optimize
brain function.
CHOLEST-LESS "TM": Includes plant extracts and vitamins to
support control and lowering of cholesterol levels when added to a low
fat, low cholesterol diet and an exercise program.
PRESSURE CONTROL "TM": Formulated from high quality herbal
extracts, minerals and vitamins to promote the prevention of hypertension
when used in conjunction with proper exercise and diet.
FRUIT MIGHT "TM", VEGGIE MIGHT "TM", and GREEN MIGHT "TM":
Developed to provide phytochemicals and carotenoids as supplements to a
healthy diet which includes fruits and vegetables. Includes wheat grass,
chlorella and other natural extracts.
OSTEO SAFE "TM": Contains bone-supporting minerals, herbs and
vitamins to help ensure healthy bones. Contains calcium, flaxseed,
magnesium and other ingredients which help preserve bone mass.
ENERG-EYES "TM": A nutritional supplement to help protect vision
and reduce free radical production. Its minerals, plant extracts,
amino acids and vitamins are designed to help protect the strength of
the vascular and capillary walls that supply the eyes.
The following new products were developed during 1996:
SLEEPSAFE "TM": Uses natural ingredients to help reduce the delay in
sleep onset to help promote a natural, non-addictive restful sleep.
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RESTPIRATION "TM": Alleviates the symptoms of asthma, hay fever,
allergies, sinusitis and bronchitis by helping the body expel foreign
organisms that cause irritation, inflammation and mucous production.
Also provides support to the immune system, soothes inflamed sinus
tissues and assists the adrenal glands.
EVENING GLOW "TM": Contains botanicals and nutrients that have been
studied for their ability to boost the level of hormones that aid in sexual
arousal with the intention of increasing the circulating levels of estrogen
and testosterone.
All products are formulated with natural ingredients, with no
preservatives, synthetics, artificial colors, lactose, starch or sugar.
The average price for a one month supply of any one of the current
products is between $19.95 and $34.95.
The Company markets a video WHEN SOMEONE YOU LOVE IS AT RISK FOR
PROSTSAFE DISEASE, which raises awareness about the prostate, prostate
diseases and symptoms and diagnosis and prevention. The tape is sold for
$19.95. The Company also has available two audio tapes, both thirty minutes
in length. The first is for men: THE NATURAL PATH OF MEN'S HEALTH: PROSTATE
CARE. The second is for women: PASSAGE TO YOUR SECOND LIFE: FLOURISHING
AFTER MENOPAUSE. Each of these tapes is sold for $14.95.
Product Planning and Development
The Company anticipates continuing to expand its product line of
approximately 25 items over the next two years. Product development begins
with researching medical conditions that can be affected by herbal
remedies utilizing completed current studies from recognized doctors,
pharmacologists, scientists, and experts. When sufficient information is
accumulated on a specific health problem, the Company summarizes the
information and presents it to a number of experts in the nutritional
field, including Dr. Charles Thomas, Ph.D., an independent consultant to
the Company since its inception, who has formulated a number of
nutritional products sold nationally by other companies. These experts
work with the Company to develop formulas and compile substantiation for
new products to be offered. In addition to its product development
efforts, the Company intends to expand its product offerings by obtaining
the right to market licensed products that complement the overall product
line and are not currently offered via direct mail. For example, the
Company is currently considering various cosmetic, hair care, and
educational products with established brand names that could be marketed
to its existing customer base.
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Production, Order Procurement and Fulfillment
The Company's nutritional products currently are produced by Vita
Minerals, Inc., which also bottles and labels the products. Vita
Minerals then ships them to the distribution center where order
fulfillment is handled for the Company by an independent contractor.
Although there is no formal contract between the Company and Vita
Minerals, with all purchases made pursuant to simple purchase orders, the
Company does provide Vita Minerals with an advance quarterly forecast of
the Company's product requirements that is used by Vita Minerals to
procure sufficient quantities of herbs that have a limited growing season.
Vita Minerals has manufactured drugs, as well as vitamins, for over 75
years, and its operations are subject to regulations of, and monitoring
by, the FDA. Since the FDA does not monitor the operations of
manufacturers who produce only vitamins, management believes that the
Company's use of Vita Minerals, Inc. for production, packaging and
labeling significantly enhances controls on the quality of the Company's
products. Vita Minerals, Inc. is also regulated by, and holds a variety
of licenses for drug and processed food manufacture issued by, various
state and local regulatory authorities, including the State of California
Department of Consumer Affairs and the County of Los Angeles. Although
the Company does not engage in the manufacture of any of the products it
markets and sells, the Company could be exposed to product liability
claims. The Company has not had any such claims to date. Although the
Company maintains a limited amount of products liability insurance,
additional insurance covering products sold by the Company is also
provided by Vita Minerals, Inc. There can, however, be no assurance
that the Company will not be subject to claims in the future or that
available insurance coverage will be adequate.
Independent contractors and outside service agencies are used to
perform a number of tasks under the supervision of management,
including advertising placement, in-bound order taking, and order fulfillment.
The Company also has entered into an agreement with Professional Marketing
Associates, Inc. to provide warehousing and distribution of the Company's
products which automatically renews for successive six-month periods unless
terminated by either party.
Outsourcing of production, order taking and order fulfillment to an
outside company and two independent contractors respectively,
potentially subjects the Company to concentration of supplier risk. In
addition substantially all printing is handled by an outside company
and substantially all advertising placement including purchase of
mailing lists for direct mail programs is handled by an outside service
agency. Although these services are currently concentrated with a few
key suppliers, management believes that other suppliers could provide
similar services or comparable terms. A change in suppliers however
could cause delay in manufacturing, shipping, advertising placements
and implementation of direct mail programs and a possible loss of sales
which could affect operating results adversely.
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Regulation
The U.S. Food and Drug Administration ("FDA") and the Federal Trade
Commission ("FTC") are the primary agencies that monitor the health care
and direct marketing industries in the United States. Because
nutritional supplements are classified as foods, they do not require FDA
approval. However, product labeling and advertising copy must be within
FDA established guidelines. FTC regulations also address advertising
copy, fraud, and specific guidelines for shipping and refunds. The
Company's promotional literature presents the effectiveness of ingredients
contained in the formula, based on documented studies conducted by
reputable independent health care professionals, along with testimonials
from satisfied users of the products. In addition, the Company maintains
a library of articles and studies cited in promotional materials as well
as original letters from customers' testimonials.
In November 1991, the FDA issued proposed regulations designed to,
among other things, amend its food labeling regulations. The proposed
regulations met with substantial opposition. In October, 1994, the
"Dietary Supplement Health and Education Act of 1994" (the "Dietary
Supplement Law") was enacted. Section 11 of the Dietary Supplement Law
provided that the advance notice of proposed rule making by the FDA
concerning dietary supplements was null and void. FDA regulations that
became effective on June 1, 1994, would require standard format nutrition
labeling on dietary supplements. However, because the new Dietary
Supplement Law also addresses labeling of dietary supplements, the FDA
has indicated that it will not enforce its labeling regulations until
January 1, 1998. In the interim, new regulations are expected to be
proposed by the FDA. Because the FDA has not yet reconciled its
existing regulations with the new Dietary Supplement Law, the Company
cannot determine to what extent any changed or amended regulations will
affect its business.
The Dietary Supplement Law did not affect the July 1, 1994
effectiveness of the FDA's health claims regulations. Those regulations
prohibit any express or implied claims for dietary supplements unless such
claims are approved in advance by the FDA through the promulgation of
specific authorizing regulations. Such approvals are rarely provided by
the FDA. Therefore, no claim may be made on a dietary supplement label or
in printed sales literature, "that expressly or by implication
characterizes the relationship of any substance to a disease or
health-related condition." The Company cannot determine what effect
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currently proposed FDA regulations, when and if promulgated, will have
on its business in the future. Such regulations could, among other
things, require expanded or different labeling, the recall or
discontinuance of certain products, additional record keeping and
expanded documentation of the properties of certain products and
scientific substantiation. In addition, the Company cannot predict
whether new legislation regulating its activities will be enacted, which
new legislation could have a material effect on the Company.
The Company has an ongoing compliance program with assistance from
outside consultants regarding the nature and scope of food and drug legal
matters affecting the Company's business and products. The Company is
unaware, except as disclosed in Item 3, "Legal Proceedings", of any legal
actions pending or threatened by the FDA or any other governmental authority
against the Company.
Competition
The market for nutritional supplements is characterized by extensive
competition, frequent new product introductions, short product life
cycles, rapid price declines and eroding profit margins, and changing
customer preferences, and the Company expects to face substantial
competition in its efforts to successfully capture a significant share of
the over age forty market. There are a number of companies that
currently offer competing products, and it can be expected that
additional competing products will be introduced by other companies in
the future. In addition, there are a variety of channels of distribution
for nutritional supplements other than through direct response marketing,
including multi-level distributors, specialty retail health and nutrition
stores, drug stores and supermarkets. Many of the Company's existing and
potential competitors have greater financial, marketing, distribution, and
research capabilities than the Company. The performance of the Company
will depend on its ability to develop and market new products that can
gain customer acceptance and loyalty, as well as its ability to adapt
its product offerings to meet changing pricing considerations and other
market factors. The Company attempts to differentiate itself from
competitors by focusing on products formulated to meet the specific needs
of a given population group and which contain only natural ingredients,
and marketing these products directly to the Company's target age group.
Proprietary Rights
The Company has received federal trademark registration for
PROSTSAFE "R", and intends to seek trademark protection for a number of
the brand names under which the Company's products are marketed. The
Company will be required to rely upon common law concepts of
confidentiality and trade secret laws to protect its product formulations.
In addition, each quarterly edition of the Journal of Natural Health "TM",
which promotes products available from the Company, is copyrighted.
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Employees
In addition to its President, the Company has a total of five employees,
one of whom is involved in general administration and four of whom are
involved in customer service and order processing control and reporting.. The
Company's success also depends to a significant extent upon the continued
service of its President, Cynthia Kolke. The loss of this individual, who may
terminate her services to the Company at any time, could have a material
adverse effect on the Company. The Company maintains a $500,000 key-person
insurance policy on the life of Ms. Kolke. The Company also will depend on its
ability to retain its key personnel, and on its ability to attract, retain,
train and motivate additional highly skilled and dedicated employees. The
Company is not a party to any collective bargaining agreement. The Company
has never experienced a work stoppage and believes that its relations with its
employees are excellent. From time to time, the Company may retain
independent third parties to provide services on a contract, "as needed"
basis.
Item 2. Description of Property.
The Company leases a 1,754 square foot office in Mission Hills,
California, that management believes is sufficient for the Company's current
needs and future growth. If needed, a large amount of additional space is
available for rental on a comparable basis within the same complex as the
Company's present location.
Item 3. Legal Proceedings.
The Company was notified by letter dated January 12, 1996, that the
Federal Trade Commission (FTC) was conducting a preliminary, non-public
investigation regarding the advertising and sale of Prostsafe, which
represented 79% of total Company sales during the year ended December 31,
1996. The Company did not believe that this advertisement made any false or
unsubstantiated claims and had submitted a formal written response to the FTC
inquiry. On March 26, 1997, the Company was notified by its legal counsel that
the FTC had concluded its investigation and closed its file without taking any
action.
On August 16, 1996, a former director of the Company and her husband,
filed a legal action against the Company and Acacia Research Corporation, its
largest shareholder in the United States District Court in Los Angeles,
entitled Christoper D. Hodges and Ann P. Hodges v. Acacia Research Corporation
and Whitewing Labs, Inc., Case No 96-5551R (Ex). The suit alleges,
among other things, that the Company improperly refused to permit the
exercise of an option to purchase 15,000 shares of the Company's
common stock and seeks $106,000 in damages from the Company. Legal counsel
has been jointly retained by the Company and Acacia, the co-defendant, and
Acacia has assumed primary defense thereof as well as assuming sole
responsibility for all litigation costs incurred in connection with such joint
representation. Although the ultimate outcome of this litigation cannot be
predicted with certainty, the Company's management does not believe that this
matter will have a material effect on the Company's results of operations or
financial position.
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The Company maintains $1,000,000 in general commercial liability insurance,
with specific coverage for "advertising injury" for up to $500,000.
Item 4. Submission of Matters to a Vote of Security Holders.
None
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters.
Recent Market Prices
The Company's Common Stock and Warrants have traded separately on the
Nasdaq SmallCap Market under the symbols "WWLI" and "WWLI-W", respectively,
since February 14, 1996. Prior to the Company's initial public offering
there was no public market for the Company's securities, and no assurance
can be given that an active trading market for the Common Stock and
Warrants will be sustained in the future. The markets for securities such
as the Company's Common Stock historically have experienced extreme price
and volume fluctuations during certain periods. These broad market
fluctuations and other factors, such as new product developments and trends
in the Company's industry and the investment markets generally, as well
as economic conditions and quarterly variations in the Company's results
of operations, may adversely affect the market price of the Company's
Common Stock. Although the Common Stock and Warrants currently are traded
on the Nasdaq SmallCap Market, there can be no assurance that they will
remain eligible to be included on Nasdaq. In the event that the
Company's Common Stock were no longer eligible for quotation on Nasdaq,
the Common Stock could become subject to rules adopted by the
Commission regulating broker-dealer practices in connection with
transactions in "penny stocks." Penny stock generally are equity
securities with a price of less than $5.00 (other than securities
registered on certain national securities exchanges or quoted on
Nasdaq, provided that current price and volume information with
respect to transactions in such securities is provided by the exchange
or the Nasdaq system). Unless an exemption from the definition of a
"penny stock" were available, any broker engaging in a transaction in
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the Company's Common Stock would be required to provide any customer
with a risk disclosure document, disclosure of market conditions, if
any, disclosure of the compensation of the broker-dealer and its
salesperson in the transaction, and monthly accounts showing the market
values of the Company's Common Stock held in the customers account. The
bid and offer quotation and compensation information must be provided
prior to effecting the transaction and must be contained on the
customer's confirmation. It may be anticipated that a number of brokers
may be unwilling to engage in transactions in the Company's Common
Stock because of the need to comply with the "penny stock" rules,
thereby making it more difficult for holders of Common Stock to dispose
of their shares.
The following table sets forth the high and low closing bid quotations for
a share of the Company's Common Stock as well as the high and low closing bid
quotations for a Warrant, during the periods presented, as reported by Nasdaq.
Bid quotations represent high and low prices quoted between dealers, do not
include commissions, mark-ups, or mark-downs, and may not represent actual
transactions.
<TABLE>
<CAPTION>
High Low
Common Stock
<S> <C> <C>
February 14 - March 31, 1996 $7-1/4 $4-5/8
Second Quarter ended June 30, 1996 $5-5/8 $3-3/4
Third Quarter ended September 30, 1996 $4-1/8 $1-7/8
Fourth Quarter ended December 31, 1996 $2-3/8 $1-1/2
Warrants
February 14 - March 31, 1996 $2-5/8 $1
Second Quarter ended June 30, 1996 $1-1/2 $3/4
Third Quarter ended September 30, 1996 $15/16 $1/4
Fourth Quarter ended December 31, 1996 $1/2 $3/16
</TABLE>
On February 28, 1997, the closing bid and asked quotations for the
Common Stock, as reported on Nasdaq, were $1-5/16 and $1-1/2, respectively,
per share. On that date, the closing bid and asked quotations for the
Warrants, as reported on Nasdaq, were $9/32 and $7/16 respectively, per
Warrant.
Description of Securities
The Company is authorized to issue up to 10,000,000 shares of Common
Stock, $.001 par value, and 500,000 shares of preferred stock, $.001 par
value. As of February 28, 1997, there were 52 holders of record of shares
of the Company's Common Stock, and 13 holders of record of Warrants,
including shares and Warrants held in "street" or "nominee" names for an
undetermined number of beneficial holders. Prior to the Company's public
offering, shares of preferred stock were sold to raise equity capital. See
Item 6, "Management's Discussion and Analysis, Liquidity and Capital
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Resources". In connection with the public offering, all of these shares were
converted into common stock. No shares of preferred stock were outstanding as
of February 28, 1997.
Holders of the Company's Common Stock are entitled to one vote per
share on all matters to be voted upon by the stockholders, and there is
no cumulative voting for the election of directors to the Company's
classified Board of Directors. Holders of the Company's Common Stock will
be entitled to receive ratably such dividends, if any, as may be declared
by the Board of Directors out of funds legally available therefore. Upon
the liquidation, dissolution, or winding up of the Company, the holders of
the Company's Common Stock will be entitled to share ratably in all assets
of the Company which are legally available for distribution, after payment
of all debts and other liabilities. Holders of the Company's Common
Stock have no preemptive, subscription, redemption or conversion rights.
Shares of the Company's Preferred Stock may be issued from time to time
in one or more series as may be determined by the Board of Directors.
The voting powers and preferences, the relative rights of each series, and
the qualifications, limitations and restrictions thereof shall be
established by the Board of Directors without any further vote or action
by the Company's stockholders, except that no holder of Preferred Stock
will have preemptive rights. Issuance of shares of the Company's
Preferred Stock may have the effect of delaying, deferring or preventing
a change in control of the Company. The Company has no present plan to
issue any shares of its Preferred Stock in the foreseeable future.
The holder of two Warrants is entitled to purchase one share of the
Company's Common Stock at a price of $7.00 per share during a three-year
period ending on February 14, 1999. The Company may at any time and from
time to time extend the term of the Warrants or reduce the exercise price
of the Warrants. Unless exercised during the exercise period, the
Warrants will expire automatically. The holders of Warrants as such, are
not entitled to vote, to receive dividends or to exercise any of the
rights of stockholders for any purpose. Since February 9, 1997, the Company
has been entitled, at its discretion, to call all of the Warrants for
redemption on 45 days' prior written notice at a redemption price of $.05 per
Warrant. However the Warrants cannot be called for redemption unless and
until: (i) the closing bid price of the Company's Common Stock exceeds the
exercise price of the Warrants by at least 50% during a period of at least 20
of the 30 trading days immediately preceding the Notice of Redemption; (ii)
the Company has in effect a current registration statement covering the Common
Stock issuable upon exercise of the Warrants; and (iii) the expiration of the
45 day notice period is within the term of the Warrants. If the Company
elects to exercise its redemption right, holders of Warrants may either
exercise their Warrants, sell such Warrants in the market or tender their
Warrants to the Company for redemption. Within five business days after
the end of the 45 day period, the Company will mail a redemption check to
each holder of a Warrant who holds unexercised Warrants as of the end of
the 45 day period, whether or not such holder has surrendered the Warrant
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certificates for redemption. The Warrants may not be exercised after the
end of such 45 day period.
U.S. Stock Transfer Corporation, 1745 Gardena Avenue, Glendale,
California 91204-2991, is the appointed Transfer Agent and Registrar for
the Common Stock and the Warrants, and the Warrant Agent under the
Warrant Agreement.
Shares Eligible for Future Sale
All of the issued and outstanding shares of the Company's Common
Stock have been registered under Securities Act of 1933, as amended (the
"Securities Act"). However, 789,709 of these shares are held of record
by Acacia, an "affiliate" of the Company, and therefore are considered
"restricted securities", as those terms are defined under the Securities
Act and the rules and regulations thereunder. Shares of the Company's
Common Stock owned by "affiliates" (including Acacia) may be publicly
sold only by complying with Rule 144 under the Securities Act (exclusive
of the two-year holding period) unless registered under the Securities Act,
or some other exemption from further registration thereunder is available.
Sales of substantial amounts of these shares, or even the potential for
such sales, could have an adverse effect on any market price for shares of
the Company's Common Stock that could develop, and could impair the
Company's ability to raise capital through the sale of its equity
securities.
Rights to Acquire Shares
As of February 28, 1997, a total of 521,685 shares of Common Stock have
been reserved for issuance upon exercise of outstanding options granted
under the Company's Stock Option Plan. All of these shares, together with
the additional 215,241 shares available for the future grant of options
under the Stock Option Plan, have been registered under the Securities
Act. The exercise price of the outstanding options ranges between $0.089 and
$5.00, with a weighted average exercise price of $1.34 per share. In
connection with the Company's initial public offering, the Representatives
of the Underwriters acquired options to purchase up to 90,000 shares of
Common Stock at $6.00 a share and 90,000 Warrants at $.24 a warrant in
connection therewith (the "Representative's Securities"). The
Representative's Securities are through February 9, 2001. The
Representatives were also granted certain registration rights with regards to
the Representative's Securities which could result in substantial expense to
the Company. During the terms of the outstanding options and the
Representative's Securities, all of which expire on or before July 11, 2000,
the holders thereof will have the opportunity to profit from an increase in
the market price of the Company's Common Stock with resulting dilution in the
interest of holders of Common Stock. The existence of such stock options and
the Representative's Securities may adversely affect the terms on which the
Company can obtain additional financing, and the holders of such options
13
<PAGE>
can be expected to exercise or convert such options at a time when the
Company, in all likelihood, would be able to obtain additional capital by
offering shares of its Common Stock on terms more favorable to the Company
than those provided by the exercise or conversion of such options.
Dividend Policy
The Company has never paid any cash dividends on its Common Stock and
does not anticipate that it will pay dividends in the foreseeable future.
Instead, the Company intends to apply any earnings to the development and
expansion of its business.
Item 6. Management's Discussion and Analysis or Plan of Operation.
General
The Company formulated its business plans and strategies based
on certain assumptions of the Company's management regarding the size of the
market for nutritional supplements, the products which the Company will be
able to offer to the over age forty market, the Company's anticipated share of
the market, and the estimated prices for and acceptance of the Company's
products. Although these plans and assumptions were based on the best
estimates of management, there can be no assurance that these assessments will
prove to be correct. No independent marketing studies have been conducted on
behalf of or otherwise obtained by the Company, nor are any such studies
planned. Any future success that the Company might enjoy will depend upon
many factors, including factors which may be beyond the control of the Company
or which cannot be predicted at this time. These factors may include product
obsolescence, increased levels of competition, including the entry of
additional competitors and increased success by existing competitors, changes
in general economic conditions, increases in operating costs including costs
of supplies, personnel and equipment, reduced margins caused by competitive
pressures and other factors, and changes in governmental regulation imposed
under federal, state or local laws.
The Company continues to believe its business plans and the assumptions
upon which they are based are valid. Accordingly the Company continued its
plan of expanding its customer database during 1996 by increasing its magazine
advertisement placements and developing a direct mail campaign which both
tests new mailing lists and identifies new names on lists used in the past.
Utilizing a large portion of the net proceeds from its February 1996 initial
public offering, the Company invested approximately $2,700,000 in selling and
advertising expense in furtherance of this strategy during the year ended
December 31, 1996. Although these expenditures have yet to produce comparable
increases in revenues, with the result that the Company reported a substantial
loss for the year, it is anticipated that the Company will continue to stress
growth of the customer database over short-term profits; the Company's
management believes potential net earnings will be driven by continued growth
of the customer database.
The costs of deferred advertising placements and direct mailings
are amortized, based upon management's estimates, over the periods in which
the related direct responses are received. The Company evaluates the
realizability of its direct-response advertising by comparing the carrying
14
<PAGE>
amount of prepaid and deferred advertising at each balance sheet date on a
cost-pool-by-cost-pool basis to the probable remaining future net revenues
expected to result from such advertising. An excess carrying amount over
probable remaining future revenues is reported as advertising expense in the
current period.
Newspaper and weekly publications are amortized in the month of issue.
Magazines and direct mailings which are available prior to the middle of the
month preceding the issue date are amortized over a three month period.
Magazines which are available subsequent to the middle of the month
preceding the issue date are amortized over a four month period. The
advertising amortization percentages used by the Company amortize 90 to 100
percent of the deferred costs over three months with 60 to 80 percent of the
costs amortized over two months. Substantially all of the deferred
advertising costs will be fully amortized within four months of December 31,
1996. In 1996, the Company's advertising expense included a write-down to
net realizable value of $123,396.
Sales of the Company's PROSTSAFE "R" product accounted for substantially
all of the Company's net sales for the year ended December 31, 1994, and for
approximately 86% and 79% of net sales for the years ended December 31, 1995
and 1996 respectively. The Company anticipates that sales of PROSTSAFE "R"
will continue to contribute a substantial portion of total revenues in
subsequent periods. A decline in the demand for this product, whether as a
result of competition or other factors, could have a material adverse effect
on the Company's results of operations and financial condition. The markets
for the Company's products are characterized by changing customer demand,
short product life cycles, and frequent new product introductions. The
performance of the Company will depend on the ability of the Company to
develop and market new products that will gain customer acceptance and
loyalty, as well as its ability to adapt its product offerings to meet
changing pricing considerations and other market factors. The Company's
operating performance would be adversely affected if the Company were to incur
delays in developing new products or if such products did not gain market
acceptance. Therefore, there can be no assurance that the Company's existing
or future products will be sufficiently successful to enable the Company to
effectively compete in its prospective market or, should the Company's product
offerings meet with significant customer acceptance, that one or more current
or future competitors will not introduce products which render the Company's
products noncompetitive.
Like other distributors of consumer products, the Company encounters the
risk of product returns from its customers. The Company's products are sold
with an unconditional, money-back guarantee. Any customer who is not
satisfied with a Company product for any reason may return it or any unused
portion for a full refund of the purchase price. Although product returns to
date have been approximately 3% of sales, which is substantially less than the
national average of 5%, there can be no assurance that actual levels of
returns will not significantly exceed amounts anticipated by the Company.
15
<PAGE>
The Company's operating results may vary significantly due to a variety of
factors including changing customer profiles, the availability and cost of raw
materials, the introduction of new products by the Company or its competitors,
the timing of the Company's advertising and promotional campaigns, pricing
pressures, general economic and industry conditions that affect customer
demand, and other factors. It can be expected that future operating results
will continue to be subject to many of the problems, expenses, delays and
risks inherent in the establishment of a new business enterprise, many of
which the Company cannot control. There can be no assurance, therefore, that
the Company will be able to achieve or sustain profitability. Even if the
Company's operations prove to be marginally profitable, the value of the
Company's common stock, and the potential return to investors, could be
substantially diminished. Consequently, an investment in the Company is
highly speculative and no assurance can be given that purchasers of the shares
of common stock will realize any return on their investment or that purchasers
will not lose their entire investment.
In March 1997, the FASB issued SFAS No. 128, "Earnings per Share" (SFAS 128)
and SFAS 129 "Disclosure of Information about Capital Structure" (SFAS 129).
SFAS 128 revises and simplifies the computation for earnings per share and
requires certain additional disclosures. SFAS 129 requires additional
disclosures regarding the Company's capital structure. Both standards
will be adopted in fiscal 1997. Management does not expect the adoption
of these standards to have a material effect on the Company's financial
position or the results of operations.
Statements contained herein that are not purely historical are forward-
looking statements within the meaning of Section 27A of the Securities Act of
1933 and Section 21E of the Securities Exchange Act of 1934, including but not
limited to statements regarding the Company's expectations, hopes, beliefs,
intentions or strategies regarding the future. Actual results could differ
materially from those projected in any forward-looking statements as a result
of a number of factors, including those detailed in this Management's
Discussion and Analysis of Results of Operations and Financial Condition, as
well as those set forth elsewhere herein. The forward-looking statements are
made as of the date of these financial statements and the Company assumes no
obligation to update the forward-looking statements, or to update the reasons
why actual results could differ materially from those projected in the
forward-looking statements.
16
<PAGE>
Selected Financial Data
The following table sets forth for the periods indicated selected financial
data for the Company. The selected statement of operations and balance sheet
items which follow have been derived from the Company's financial statements
and notes thereto included elsewhere herein audited by Arthur Andersen LLP,
independent public accountants, as set forth in their report also included
elsewhere herein. This information should be read in conjunction with the
Financial Statements and related notes, "Management's Discussion and
Analysis of Financial Condition and Results of Operation" and the other
financial information included elsewhere in this form 10-K.
<TABLE>
Statement of Operations Data:
<CAPTION>
Years Ended December 31,
1994 1995 1996
<S> <C> <C> <C>
Net sales $ 455,359 $3,445,085 $3,537,480
Gross profit 416,523 2,985,424 3,026,266
Operating expenses:
Selling and advertising
expenses 418,625 2,289,886 4,668,533
General and administrative
expense 252,425 683,093 914,436
Total operating expenses 671,050 2,972,979 5,582,969
Income (loss) from operations (254,527) 12,445 (2,556,703)
Interest expense 28,473 20,021 4,259
Other Income, net - (29,121) (143,879)
Income (loss) before provision
for income taxes (283,000) 21,545 (2,417,083)
Income tax provision 1,000 850 850
Net income (loss) $(284,000) $ 20,695 $(2,417,933)
Preferred stock dividends
paid and accrued 52,544 $ 90,249 $ 10,129
Net loss attributable
to Common Shareholders $(336,544) $ (69,554) $(2,428,062)
Proforma income (loss) per
Common Share $ (0.20) $ 0.01 $ -
Income (loss) per
Common Share $ - $ - $ (.90)
Proforma weighted average number
of Common shares outstanding (1) 1,409,951 1,666,727 -
Weighted Average Number of
Common Shares Outstanding - - 2,691,149
</TABLE>
17
<PAGE>
<TABLE>
<CAPTION>
December 31,
Balance Sheet Data: 1994 1995 1996
<S> <C> <C> <C>
Working capital $187,192 $ 459,189 $2,571,473
Total assets 815,379 1,783,419 3,720,256
Total liabilities 600,795 561,651 561,042
Shareholders' equity 214,584 1,221,768 3,159,214
</TABLE>
(1) See Note 2 of Notes to Financial Statements.
Results of Operations
Net Sales. The Company's first mailing to prospective customers was
completed in October 1993. As the Company expanded its marketing efforts
through direct mail and advertising, and its customer base has correspondingly
grown, net sales also increased, primarily attributable to the growth in the
customer base and the frequency of repeat orders from existing customers. By
the end of 1994, net sales had increased to more than $100,000 per month, with
the Company generating net sales of $455,359 for the year ended December 31,
1994.
Net sales increased at a much slower rate during 1996, increasing from
$3,445,085 in 1995 to net sales of $3,537,480 for the year ended December 31,
1996, an increase of approximately 2.7%. At December 31, 1996, the Company's
customer base had grown to approximately 76,000 customers. Sales, particularly
of the Company's flagship product, Prostsafe "R", did not increase to the levels
anticipated, relative to the substantial increases in advertising and selling
costs. Moreover, although quantities sold of Prostsafe "R" and Sexhilarate
"TM" increased by approximately 5% and 58% respectively, sales of the
Sexual Energy package (including Prostsafe "R" and Sexhilarate "TM") which
yield a significantly lower margin, also increased.
Gross Profit. Cost of goods sold for the Company's products represents
only a small percentage of net sales. During the years ended December 31,
1994, 1995 and 1996, the Company recognized gross profit of $416,523,
$2,985,424 and $3,026,266 respectively, or 91.5%, 86.8% and 85.6% of net
sales, respectively.
18
<PAGE>
Selling and Advertising Expense. During the year ended December 31, 1995,
selling and advertising expense increased to $2,289,886, compared to $418,625
in 1994, but decreased as a percentage of net sales to 66.4%, compared to
91.9% of net sales for the year ended December 31, 1994. For the entire year
of 1995, the Company was able to realize a profit margin, after costs of goods
sold and selling and advertising expense, but before general and
administrative expenses, of approximately 63.2% or more on repeat orders, as
compared to profit margins, similarly computed, of approximately 15% on sales
to new customers. Reorders from existing customers accounted for
approximately 18% and 65% respectively of net sales generated for the years
ended December 31, 1995 and 1996.
During the year ended December 31, 1996, selling and advertising expense
increased by 103.9% to $4,668,533, representing 132% of net sales, compared
to $2,289,886 in 1995. The increase resulted primarily from substantially
increased magazine advertisement placement and direct mail program costs as
the Company sought to aggressively expand its customer base. In 1996 and
1995, advertising expense was $2,684,795 and $1,304,251 respectively,
or 75.9% and 37.9% of net sales respectively, which includes a write-down to
net realizable value of $123,396 and none in 1996 and 1995, respectively.
Prepaid advertising includes approximately $184,000 of costs related to
the development of electronic in-home delivery of product advertising which
the Company has begun test airing in February 1997. Additional unpaid costs
of electronic delivery advertising of $75,000 become due and payable in 1997.
The Company is obligated to pay related talent costs of 3 percent of gross
profits from sales generated in 1997 after the test airing is completed. It
is management's intention to expense the costs related to the electronic
in-home delivery of product advertising beginning in 1997 and over a
period not to exceed the lesser of the revenue earning stream directly related
to the electronic in-home delivery of product advertising or one year,
whichever comes first.
General and Administrative Expense. General and administrative expenses
have increased as a function of the increasing volume of sales, as the Company
was required to expand its office facilities, purchase additional computers
and other office equipment, and pay for increased postage and supplies. Also
included in general and administrative expense are legal expenses relating to
trademark research on new products and review of the quarterly Journal of
Natural Health "TM". For the year ended December 31, 1994, general and
administrative expense represented 55.4% of net sales.
With the increasing levels of net sales generated during the year ended
December 31, 1995, general and administrative expenses increased to $683,093.
However, as a percentage of net sales, general and administrative expense
declined to 19.8% for the year ended December 31, 1995. General and
administrative expenses increased to $914,436 or 25.8% of net sales during
1996 primarily as a result of increased shareholder relations expenses and
salaries costs incurred after the Company completed its inital public offering
in February 1996.
19
<PAGE>
Income (Loss) From Operations. Although the Company incurred losses from
operations of $284,000 for the year ended December 31, 1994, most of these
operating losses were attributable to selling and general and administrative
expenses that were incurred before the Company attained a commensurate level
of sales. As a result of continuing increases in net sales during the year
ended December 31, 1995, the Company's operating profit was 20,695.
However during the year ended December 31, 1996 revenues remained
relatively level despite substantial increases in advertising and selling
costs. As a result the Company reported a loss from operations of $2,417,933.
With the influx of capital following the public offering, the Company
substantially increased its advertising and promotional expenditures in
anticipation of incremental increases in revenue. Revenues commensurate with
the increased advertising and selling costs did not materialize. The Company
gained market experience from the results of its product advertising programs
in 1996. The strategy for 1997 involves a more defined approach to attracting
new customers.
Interest Expense. As the Company borrowed additional sums from Acacia
Research Corporation to finance the development of its business, interest
expense related to these borrowings decreased from $28,473, or 6.3% of net
sales, for the year ended December 31, 1994 to $15,036 or 0.4% of net sales
for the year ended December 31, 1995. All the amounts remaining due and
payable to Acacia Research Corporation, including interest expense of $4,259,
representing 0.1% of sales, were paid out of the net proceeds to the Company
from the public offering in February, 1996.
Liquidity and Capital Resources
From inception through September 30, 1995, the Company operated at a loss, as
its efforts were focused on the development of a customer base. During the
year ended December 31, 1995, the Company's operations required approximately
$461,907 in cash. As of December 31, 1995, the Company had cash on hand of
approximately $423,622. Prior to its initial public offering in February
1996, the Company financed its operations through the private sale of equity
securities and loans from Acacia, its largest shareholder.
In connection with the incorporation of the Company in July 1993, an
aggregate of 1,125,000 shares of the Company's Common Stock was issued to
Acacia for $100,000 in cash. Through December 31, 1994, Acacia also loaned
the Company an aggregate of $314,247. This loan was repayable in full,
together with simple interest at the rate of 8% per annum from the respective
dates on which the funds were advanced to the Company, upon demand by Acacia.
During the second quarter of 1995, the Company repaid $200,000 of the loan
principal, leaving a remaining balance of $114,247 owing to Acacia at December
31, 1995. All amounts then owing to Acacia were repaid out of the net
proceeds to the Company from its initial public offering.
In December 1994, the Company completed a private placement of 272,250
shares of its 10% Cumulative Convertible Preferred Stock (the "Preferred
Stock"), at $3.33 per share, resulting in proceeds to the Company before
expenses of $907,500. At the time of this private placement, one investor
loaned the Company the sum of $200,000, at 10% interest, which was converted
into 60,000 shares of the Company's Common Stock, at $3.33 per share, on April
1, 1995. Between February 24 and September 10, 1995, the Company privately
sold an aggregate of 249,626 shares of its Common Stock to a total of 8
20
<PAGE>
"accredited investors" (as that term is defined in the rules and regulations
of the Securities and Exchange Commission under the Securities Act of 1933, as
amended), raising gross proceeds totaling $1,029,000. In addition, options
to purchase an aggregate of 526,200 shares of the Company's Common Stock have
been granted to key employees of and consultants to the Company.
In April 1995, the Company used $100,000 of available cash to acquire a
limited partnership interest in Acacia Capital Partners, L.P., an investment
limited partnership of which Acacia is one of the general partners, in the
expectation that the Company could obtain a better return on these funds than
that offered on bank or other institutional interest bearing deposits. The
primary objective of this partnership is to generate profits from the trading
of securities. The partnership's funds will be used to purchase securities
selected by Acacia's proprietary computer models, which will also be used to
determine, on a statistical basis, when specified stocks should be sold. The
funds invested by the Company in this limited partnership will be subject to
all of the risks to be encountered by all investors therein as a result of the
investment strategy adopted for the investment partnership by the general
partners thereof, including the risks associated with short sales, hedging,
option trading, trading on margin and other leverage transactions. No
assurance can be given that this investment strategy will not result in
material losses for the partnership. On the other hand, if the investment
partnership were profitable, the partners thereof, including the Company,
would be credited with partnership net income, and would therefor incur income
tax liability, even if they receive little or no cash distributions from the
partnership. Since the stated intention of the partnership is to reinvest
substantially all income and gain allocable to the partners thereof, it should
not be expected that distributions of partnership cash will be made to the
partners, including the Company, that could be used to pay any income tax on
partnership profits allocated to their respective accounts. The Company's
investment in the limited partnership is also subject to a significant lack of
liquidity, since there is no public market for interests in the limited
partnership and no such market can be expected to develop. The Company may,
however, on advance notice to the general partners, withdraw all or part (at
least $25,000) of its capital account as of any June 30 or December 31
following the first anniversary of the Company's admission to the partnership.
The general partners may waive these withdrawal restrictions for any limited
partner. The value of the Company's investment, as estimated by the general
partners, was approximately $127,000 at December 31, 1996. The Company agreed
with the representative of the underwriters of its initial public offering
that the Company will not make any further investments in Acacia Capital
Partners, L.P., or any similar limited partnership or other investment entity,
whether out of the proceeds from the public offering or otherwise.
In its initial public offering in February 1996, the Company raised net
proceeds, after deduction of underwriting discounts and other expenses of the
offering amounting to $1,111,752, of approximately $4,270,000. Of the
net proceeds to the Company, $2,700,000 was used to finance expanded
advertising, marketing and sales activities, with the balance available for use
for other general corporate purposes to support the Company's ongoing
operations, including general administrative costs and expenses. A portion of
these proceeds was used to pay the principal balance of $114,247, plus accrued
interest of $47,310 owing to Acacia in respect of loans previously made to the
Company by Acacia, the Company's principal stockholder. In connection with the
Company's initial public offering, all of the outstanding preferred stock was
converted into common stock.
21
<PAGE>
The Company initiated an open market stock repurchase program in July 1996
in which up to 200,000 shares or 7% of outstanding shares of the Company's
common stock may be acquired in the open market. The Company acquired 17,600
shares of its common stock for $45,419 during 1996. As of February 28, 1997,
the Company had repurchased an additional 15,400 shares of common stock for
$22,322 and has authorized a repurchase of up to an additional 14,600 shares
during the first quarter of 1997 and may or may not make future repurchases
depending on the availability of cash flows.
The Company has commitments for magazine placements of approximately
$261,000 as of December 31, 1996.
The Company is involved in certain legal proceedings. See Item 3, "Legal
Proceedings." However, it is not anticipated that these proceedings will have
any significant adverse effect upon the Company's liquidity or capital
resources, since management believes that the Company is adequately insured
against reasonably anticipated costs and expenses that might be incurred in
connection therewith. For a discussion of the Company's investments of
available cash in prepaid and deferred advertising, see "Results of Operations
- Selling and Advertising Expense."
Assuming that implementation of the Company's more defined approach to
attracting new customers in 1997 results in revenues which exceed costs,
management expects that the Company will generate sufficient cash flow,
supplemented by the remaining balance of the net proceeds to the Company from
its initial public offering, to finance the Company's operations at currently
anticipated levels at least through the end of 1998. However, there can be no
assurance that the Company will not encounter unforeseen difficulties that may
deplete its capital resources more rapidly than anticipated. In addition,
management believes that the Company's growth can be accelerated by continuing
to use the net proceeds to finance various marketing, advertising and
promotional activities, and the increasing levels of inventory expected to
result therefrom.
The development and expansion of the Company's business that was financed
using the net proceeds from the Company's initial public offering placed
significant demands on the Company's infra-structure, and required the Company
to hire additional personnel, to implement additional operating, manufacturing
and financial controls, install additional reporting and management
information systems for order processing, system monitoring, customer service
22
<PAGE>
and financial reporting, and otherwise to improve coordination between
formulation, manufacturing, marketing, sales and finance functions. The
Company's future operating results will depend on management's ability to
manage future growth, and there can be no assurance that efforts to manage
future growth will be successful. Management also believes that the
availability of proceeds from the Company's initial public offering may
enhance the Company's ability to increase the scope of its business more
rapidly by taking advantage of opportunities to acquire additional product
offerings, or even complementary businesses, on a favorable basis. Although
the Company is not currently a party to any agreement or understanding with
respect to any prospective acquisition, it has explored and continues to
evaluate possible opportunities to license or otherwise acquire the right to
market products that complement the Company's product line.
If circumstances indicate that the Company should endeavor to expand its
business at a faster rate than that currently planned for, it is likely that
the Company would attempt to raise additional capital to accelerate its
growth. In all events, the Company's ability to continue operations beyond
will depend upon its ability to generate a significant cash flow from its
expanded operations. If sufficient cash flow is not being generated at the
end of this period, the Company would be required to seek additional funds
through equity, debt or other external financing. There can be no assurance
that any additional capital resources which the Company may need will be
available to the Company if and when required, or on terms that will be
acceptable to the Company. If additional financing is required, or desired,
the Company may be required to forego a substantial interest in its future
revenues or dilute the equity interests of existing shareholders, and a change
in the control of the Company may result.
Item 7. Financial Statements.
The financial statements and supplemental data required by this Item are
filed as exhibits hereto, as listed in the Index to Financial Statements
included under Item 13(c) of Part IV below, and are incorporated herein by
this reference.
Item 8. Changes In and Disagreements With Accountants on Accounting and
Financial Disclosure.
None
PART III
Item 9. Directors, Executive Officers, Promoters and Control Persons;
Compliance With Section 16(a) of the Exchange Act.
The directors and executive officers of the Company are as follows:
23
<PAGE>
<TABLE>
<CAPTION>
Name Age Positions
<S> <C> <C>
Cynthia Kolke 49 President, Assistant Secretary and Director
R. Bruce Stewart 57 Chairman of the Board, Secretary and Treasurer
Paul R. Ryan 51 Director
William D. Fox 58 Director
</TABLE.
Ms. Kolke has 26 years experience in sales and marketing. From 1965 through
1986 she was employed in a number of capacities, including Director of
Marketing, by The Service Bureau Corporation, a division of IBM which was
sold to Control Data in 1973. Between 1986 and 1989, Ms. Kolke served as the
Vice President of Sales for Light Signatures, and operated as an independent
marketing consultant thereafter until she joined G.B Data Systems, Inc., a
direct mail, nutritional supplement marketing company, in April 1990 as its
Operations Manager. In July 1993, she left G.B. Data Systems, Inc. to
co-found Whitewing Labs on July 29, 1993, as its President, Assistant
Secretary as a director. She holds a Bachelor's degree in Marketing
and Data Processing from the Detroit College of Business.
From 1991 to the present, Mr. Stewart, Chairman, President and Chief
Executive Officer of Acacia Research Corporation, devoted much of his time to
the formation of Whitewing Labs and the development of its plan of operations.
During this period, he also formed Acacia, the Company's largest
shareholder. From August 1977 to March 1991, Mr. Stewart served as President
of Annandale Corporation, a financial consulting firm. He was also a licensed
principal of Annandale Securities, Inc. from August 1987 to August 1990.
Paul R. Ryan became a director of the Company in October 1996. Since June
1994, he has been the Executive Vice President and Chief Investment Officer
of Acacia Research. He received a B.S. degree from Cornell University and
attended New York University Graduate School of Business. Mr. Ryan was a
general partner of the American Health Care Fund, L.P until 1993. Prior to
this, he was a financial consultant with Merrill Lynch.
Mr. Fox has owned Classic Tire, an automotive repair and tires retailer
since 1992. For the previous seven years, he conducted an independent
management consulting business. He joined the Company's Board of Directors
in February 1996, upon consummation of the Company's initial public offering.
From 1963 through 1984, Mr. Fox held numerous positions with IBM and Control
Data, including Branch Manager and Marketing Program Administrator. He
graduated from Middlebury College with a B.A. degree in Political Science.
24
<PAGE>
The Company's Board of Directors has established an audit committee
comprised of Mr. Stewart, Mr. Ryan and Mr. Fox, which will meet to consult
with the Company's independent auditors concerning their engagement and audit
plan, and thereafter concerning the auditor's report and management letter
and, with the assistance of the independent auditors, will also monitor the
adequacy of the Company's internal accounting controls. There have been
no meetings with the auditors to date. The Board has not established
separate compensation or nominating committees. Rather, all members of the
Company's Board of Directors meet to review and determine the compensation
of the Company's executive officers, administer the Company's Stock Option
Plan, adopt compensation policies and practices, review and pass upon all
transactions with affiliates and other persons having a material financial
interest in the Company, and nominate the individuals to be proposed by the
Board of Directors for election as directors of the Company.
Subject to the terms of applicable employment agreements, of which there
currently are none, officers are appointed by and serve at the discretion of
the Board of Directors. The Directors are elected by shareholders for a
one-year term. No family relationships exist between any of the officers or
directors of the Company.
Compliance with Section 16(a) of the Securities Exchange Act of 1934
Section 16(a) of the Securities Exchange Act of 1934 requires the
Company's officers and directors, and persons who own more than ten percent of
the Company's Common Stock to file reports of ownership and changes in
ownership with the Securities and Exchange Commission ("SEC"). Officers,
directors and greater than ten percent shareholders are required by SEC
regulations to furnish the Company with copies of all Section 16(a) forms they
file. Management believes all such individuals were in compliance with
Section 16(a) as of the filing date of this Annual Report on Form 10-KSB, and
that none were delinquent.
Item 10. Executive Compensation.
The following table summarizes the annual and long term compensation paid
by the Company during fiscal years ended December 31, 1994, 1995 and 1996 to
the President of the Company. No other executive officer of the Company
received an annual salary and bonus exceeding $100,000 during the year ended
December 31, 1996.
25
<PAGE>
</TABLE>
<TABLE>
Summary Compensation Table
<CAPTION>
Long-Term Compensation
Annual Compensation Awards Payouts
Name and Restricted LTIP
Principal Stock
Position Year Salary Bonus Other Awards Options Payouts All Other
$ $ $ $ # $ Compensation
Cynthia Kolke, President, Assistant Secretary and Director
<S> <C> <C> <C> <C> <C> <C> <C>
1994 61,600 -0- -0- -0- -0- -0- -0-
1995 71,400 -0- -0- -0- -0- -0- -0-
1996 84,200 -0- -0- -0- 37,500 -0- -0-
</TABLE>
The Company leases and pays the insurance on an automobile on Ms. Kolke's
behalf at an annual cost of $13,842 in 1996.
Each director of the Company who is not otherwise employed full-time by
the Company or Acacia Research Corporation will be paid $500 for each Board
meeting attended. Directors will also be reimbursed for their travel expenses
incurred in attending Board or committee meetings. Directors have previously
not been compensated for their attendance at Board meetings, except for
reimbursement of travel expenses. In connection with Mr. Ryan's election to
the Company's Board of Directors in October 1996, he was granted an option to
purchase 15,000 shares of the Company's Common Stock at the price per share of
$1.69. The options vest at 3,000 per year and expire five years after the date
of grant. At the same time it was decided to cancel and reissue Mr. Fox's
options at the price per share of $1.69.
Stock Options
The Company's 1993 Stock Option Plan, as amended (the "Stock Option
Plan"), authorizes the granting of options to employees that are intended to
qualify as "incentive stock options" under the Internal Revenue Code of 1986
("Incentive Stock Options"), as well as stock options that are not intended to
so qualify ("Nonstatutory Options") which may be granted to officers,
directors, employees, consultants, and others expected to provide significant
services to the Company or its subsidiaries. The Stock Option Plan, which is
administered by the Board of Directors, currently covers an aggregate of
736,925 shares. The maximum term of a stock option granted under the Stock
Option Plan is ten years, but if the optionee at the time of grant has voting
power over more than 10% of the Company's Stock, the maximum term is five
years. If an option granted expires or terminates, the shares subject to the
unexercised portion of that option will become available for the grant of
future options under the Stock Option Plan. If an optionee terminates his or
her service to the Company, the optionee may exercise only those option shares
vested as of the date of termination and must effect such exercise within
26
<PAGE>
three months, although the Board of Directors may set a longer period for
exercise of stock options. The Stock Option Plan may be amended at any time
by the Board of Directors, although certain amendments would require
stockholder approval. The Stock Option Plan will terminate in 1998 unless
earlier terminated by the Board.
The exercise price of Incentive Stock Options granted under the Stock
Option Plan must be at least equal to the fair market value of the stock
subject to the option on the date of grant, except that the exercise price of
an Incentive Stock Option granted to an optionee who owns stock possessing
more than 10% of the voting power of the Company's outstanding capital stock
must equal at least 110% of the fair market value of the stock subject to the
option on the date of grant. The exercise price of Nonstatutory Stock Options
granted under the Stock Option Plan must be at least equal to 85% of the fair
market value of the stock subject to the option on the date of the grant.
Payment of the exercise price may be made in cash, promissory notes or other
consideration as determined by the Board of Directors.
As of February 28, 1997, options to purchase an aggregate of 439,685
shares of Common Stock, at prices ranging from $0.089 to $5.00 per share,
under the Stock Option Plan were outstanding and held by a total of 11
officers, directors, employees and consultants, including options to purchase
247,500, 143,000, 15,000, and 15,000 shares granted to Ms. Kolke, Mr.
Stewart, Mr. Ryan and Mr. Fox, respectively. Mr. Stewart exercised 44,500
options in the fiscal year ended December 31, 1996.
The following table sets forth certain information regarding options
granted by the Company during the year ended December 31, 1996.
<TABLE>
Options Granted in Calendar Year 1996
<CAPTION>
Potential Realized
No. of Value at Assumed
Shares % of Annual Rates of Stock
Subject Total Price Appreciation
Name Options Options For Option Term (3)
of Granted Granted to Exercise Expiration
Optionee (2) Employees Price Date 5%($) 10%($)
Cynthia Kolke
<S> <C> <C> <C> <C> <C>
37,500 48% $5.00 1/5/2006 N/A N/A
</TABLE>
(1) The exercise price of each option was the market price of a share of
the Company's Common Stock on the date of grant.
(2) The options vest upon the date of grant.
(3) Assumes that a share of Common Stock was valued at $2.00 per share on
December 31, 1996 and since exercise price exceeds market price, there is no
inherent value.
27
<PAGE>
The following table sets forth information with respect to ownership of
options by the executive officers of the Company identified above, and their
respective option values, as of December 31, 1996. The Company has no
outstanding stock appreciation rights, either freestanding or in tandem with
options.
<TABLE>
Option Values as of December 31, 1996
<CAPTION>
Number of Unexercised Value of Unexercised
Options at In-the-Money Options at
Fiscal Year-end (#) Fiscal Year-End ($) (1)
Name Exercisable/Unexercisable Exercisable/Unexercisable
<S> <C> <C>
Cynthia Kolke 247,500 / 0 $288,810/ 0
</TABLE>
(1) Assumes that a share of Common Stock was valued at $2.00 per share on
December 31, 1996. Amounts reflected are based on this assumed price minus
the exercise price and do not indicate that shares were sold.
Limitation of Directors' and Officers' Liability and Indemnification
The Company's Certificate of Incorporation limits the liability of
directors to the maximum extent permitted by Delaware law. Delaware law
provides that directors of a Delaware corporation will not be personally
liable for monetary damages for breach of the fiduciary duties as directors
except for liability as a result of their duty of loyalty to the company for
acts or omissions not in good faith or which involve intentional misconduct or
a knowing violation of law, unlawful payments of dividends or stock
transactions, unauthorized distributions of assets, loan of corporate assets
to an officer or director, unauthorized purchase of shares, commencing
business before obtaining minimum capital, or any transaction from which a
director derived an improper benefit. Such limitations do not affect the
availability of equitable remedies such as injunctive relief or rescission.
In addition, the Company's Bylaws provide that the Company must indemnify its
officers and directors, and may indemnify its employees and other agents, to
the fullest extent permitted by Delaware law. At present, there is no pending
litigation or proceeding involving any director, officer, employee, or agent
of the Company where indemnification will be required or permitted. Insofar
as indemnification for liabilities arising under the Securities Act of 1933,
as amended, may be permitted to officers, directors or persons controlling the
Company pursuant to the foregoing provisions, the Company has been informed
that in the opinion of the Securities and Exchange Commission such
indemnification is against public policy as expressed in the Securities Act of
1933, as amended, and is therefore unenforceable.
28
<PAGE>
Item 11. Security Ownership of Certain Beneficial Owners and Management.
The following table sets forth certain information regarding the beneficial
ownership of the Company's Common Stock as of February 28, 1997, by (i) each
director and executive officer of the Company, (ii) each person known to the
Company to be the beneficial owner of more than 5% of the outstanding Common
Stock, and (iii) all directors and executive officers of the Company as a
group. Except as may be indicated in the footnotes to the table, each of such
persons has sole voting and investment power with respect to the shares owned,
subject to applicable community property laws. The address of each individual
listed is in care of the Company, 15455 San Fernando Mission Boulevard, Suite
105, Mission Hills, California 91345.
<TABLE>
<CAPTION>
Shares Beneficially Owned*
Number Percent
<S> <C> <C>
Acacia Research Corporation (1)
12 S. Raymond Ave., Ste. B
Pasadena, CA 91105 789,709 27.5%
R. Bruce Stewart (2)(3) 977,209 32.5
Cynthia Kolke (3) 247,500 7.9
Paul R. Ryan (2)(3) 794,709 27.7
William D. Fox (3) 3,000 0.10
All directors and executive
officers as a group (4 persons) (2)(3) 1,232,709 37.8
</TABLE>
* In calculating beneficial and percentage ownership, all shares of Common
Stock which a named stockholder will have the right to acquire from February
28, 1997, upon exercise of stock options are deemed to be outstanding for the
purpose of computing the ownership of such stockholder, but are not deemed to
be outstanding for the purpose of computing the percentage of Common Stock
owned by any other stockholder. As of February 28, 1997, an aggregate of
2,858,388 shares of Common Stock were outstanding. Except as otherwise
indicated in the footnotes to the table, this does not take into account
currently exercisable stock options outstanding as of February 28, 1997 to
purchase an aggregate of 128,185 shares, nor the Warrants outstanding as of
February 28, 1997 to purchase up to 517,500 additional shares of Common Stock.
(1) Includes 257,250 shares held of record by Acacia as security for
repayment of debts owed to Acacia by third parties.
29
<PAGE>
(2) Includes in the case of each of Messrs. Stewart and Ryan all
shares held of record by Acacia Research Corporation, of which they are
directors, and of which Mr. Stewart is an executive officer.
(3) Includes shares issuable upon exercise of currently exercisable
options, including 143,000 shares in the case of Mr. Stewart and 247,500
shares in the case of Ms. Kolke. Although an option to purchase 15,000 shares
has been granted to Mr. Ryan, it does not become exercisable as to any of the
shares covered thereby until October 17, 1997. Twenty percent of the options
to purchase 15,000 shares granted to Mr. Fox became exercisable on January 6,
1997 and are therefore included.
Item 12. Certain Relationships and Related Transactions
In April 1995, the Company invested $100,000 to purchase a limited
partnership interest in Acacia Capital Partners, L.P., a California limited
partnership formed by Acacia to manage investments using proprietary software
models. See Item 6, "Management's Discussion and Analysis or Plan of Operation
- -Liquidity and Capital Resources".Except as described below, all profits and
losses of the partnership will be allocated on a quarterly among the general
partners and limited partners in proportion to their respective capital
accounts as of the beginning of each quarter. The general partners will be
allocated on an annual basis (subject to certain exceptions) 20% of the amount
by which profits of the partnership otherwise allocable to each of the limited
partners in that year exceed losses allocated to the limited partners that
have not been recouped. The general partners of this investment partnership
are entitled to annual management fees payable by each limited partner in an
amount equal to 1% of the value of that limited partner's capital account.
Acacia Research Corporation will receive three-fourths, and the other general
partner will receive one-fourth, of such fees. These management fees are
payable quarterly in advance at the beginning of each quarter based on the net
asset value of the limited partner's capital account on the first day of the
quarter. The partnership will also pay or reimburse the general partners for
all costs and expenses incurred by or on behalf of the partnership, including
all legal and accounting fees and expenses. Although the partnership will not
be obligated to reimburse the general partners for any of the general partners'
own operating, general, administrative and overhead costs and expenses,
some or all of these expenses may be paid by securities brokerage firms that
execute securities trades for the partnership.
For a description of the options to purchase shares of the Company's
Common Stock granted to the Company's executive officers and directors, see
Item 10, "Executive Compensation." For a description of certain arrangements
between Acacia Research Corporation and the Company, regarding a lawsuit in
which they are co-defendants, see Item 3, "Legal Proceedings".
Management of the Company believes that each of the foregoing transactions
was in the Company's best interests. As a matter of policy, all future
transactions between the Company and any of its executive officers, directors,
or principal shareholders, or any of their affiliates, will be on terms that a
majority of the independent, disinterested members of the Company's Board of
Directors believe to be no less favorable to the Company than those that could
have been obtained from an unaffiliated third party in an arms-length
transaction.
30
<PAGE>
Item 13. Exhibits and Reports on Form 8-K.
(a) Exhibits. The following exhibits are either filed herewith or
incorporated herein by reference:
<TABLE>
<CAPTION>
<S> <C>
3.1 Certificate of Incorporation*
3.2 Bylaws*
3.3 Reincorporation Agreement*
4.1 Form of Warrant*
4.2 Agreement Not to Sell*
10.1 Lease of Company's Executive Offices*
10.2 Stock Option Plan*
10.4 Fulfillment Services Agreement with Professional Marketing
Associates, Inc.*
10.5 Consulting Agreement*
</TABLE>
* Incorporated by reference from the Company's Registration Statement on
Form S-1 (33-97156) which became effective under the Securities Act of 1933,
as amended, on February 9, 1996.
(b) Reports on Form 8-K. None.
<TABLE>
(c) Index to Financial Statements.
<CAPTION>
Page
<S> <C>
Report of Independent Public Accountants F-1
Balance Sheets as of December 31, 1995 and 1996 F-2
Statements of Operations for each of the Three Years
in the period ended December 31, 1996 F-3
Statements of Shareholders' Equity for each of the Three
Years in the period ended December 31, 1996 F-4
Statements of Cash Flows for each of the Three Years
in the period ended December 31, 1996 F-5
Notes to Financial Statements F-6
</TABLE>
31
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has caused this report to be signed on its behalf
by the undersigned, thereunto duly authorized.
Whitewing Labs, Inc
By: /s/ Cynthia Kolke
Cynthia Kolke
President, Assistant Secretary and Director
Dated: March 27, 1997
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.
/s/ R. Bruce Stewart Chairman of the Board March 27, 1997
R. Bruce Stewart of Directors, Secretary
and Treasurer
/s/ Cynthia Kolke Director, Assistant March 27, 1997
Cynthia Kolke Secretary
/s/ Paul R. Ryan Director March 27, 1997
Paul R. Ryan
/s/ William D. Fox Director March 27, 1997
William D. Fox
/s/ Elizabeth M. Meisler Chief Financial Officer March 27, 1997
Elizabeth M. Meisler
32
<PAGE>
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Whitewing Labs, Inc.:
We have audited the accompanying balance sheets of WHITEWING LABS, INC. (a
Delaware corporation and a 54 and 27 percent subsidiary of Acacia Research
Corporation at December 31, 1995 and 1996, respectively) as of December 31,
1995 and 1996, and the related statements of operations, shareholders' equity
and cash flows for each of the three years in the period ended December 31,
1996. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audits to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Whitewing Labs, Inc. as of
December 31, 1995 and 1996, and the results of its operations and its cash
flows for each of the three years in the period ended December 31, 1996 in
conformity with generally accepted accounting principles.
/s/ Arthur Andersen LLP
ARTHUR ANDERSEN LLP
Los Angeles, California
January 23, 1997
F1
<TABLE>
WHITEWING LABS, INC.
BALANCE SHEETS - DECEMBER 31, 1995 AND 1996
ASSETS
<CAPTION>
1995 1996
<S> <C> <C>
CURRENT ASSETS:
Cash and cash equivalents $ 423,622 $2,524,391
Inventories 193,234 143,519
Prepaid advertising 355,932 379,095
Other prepaid expenses 30,937 38,906
Other receivables 17,115 46,604
---------- ----------
Total current assets 1,020,840 3,132,515
---------- ----------
EQUIPMENT:
Furniture and fixtures 112,748 119,443
Less--Accumulated depreciation (18,848) (39,108)
---------- ----------
93,900 80,335
---------- ----------
OTHER ASSETS:
Deferred advertising 190,396 182,061
Deferred offering costs 152,071 -
Investment in related-party
partnership, at cost 100,000 100,000
Deferred taxes 220,000 220,000
Other 6,212 5,345
---------- ----------
668,679 507,406
---------- ----------
$1,783,419 $3,720,256
========== ==========
</TABLE>
The accompanying notes are an integral part of these balance sheets.
F2a
<TABLE>
WHITEWING LABS, INC.
BALANCE SHEETS - DECEMBER 31, 1995 AND 1996
LIABILITIES AND SHAREHOLDERS' EQUITY
<CAPTION>
1995 1996
<S> <C> <C>
CURRENT LIABILITIES:
Accounts payable $ 97,134 $ 295,393
Accounts payable to shareholder - 22,190
Accrued liabilities 64,531 23,459
Dividends payable 22,688 -
Accrued interest payable 43,051 -
Deferred taxes 220,000 220,000
Due to shareholder 114,247 -
---------- ----------
Total current liabilities 561,651 561,042
---------- ----------
COMMITMENTS AND CONTINGENCIES
SHAREHOLDERS' EQUITY:
Common stock, $.001 par value:
Authorized--10,000,000 shares
Issued and outstanding--1,434,626
shares at December 31, 1995 and
2,891,388 at December 31, 1996 1,434 2,891
Paid-in capital 1,909,507 6,318,977
Accumulated deficit (689,173) (3,117,235)
Less--
Treasury stock, at cost
17,600 shares - (45,419)
---------- ----------
Shareholders' equity 1,221,768 3,159,214
---------- ----------
$1,783,419 $3,720,256
========== ==========
</TABLE>
The accompanying notes are an integral part of these balance sheets.
F2b
<TABLE>
WHITEWING LABS, INC.
STATEMENTS OF OPERATIONS
FOR EACH OF THE THREE YEARS IN THE PERIOD ENDED DECEMBER 31, 1996
<CAPTION>
1994 1995 1996
<S> <C> <C> <C>
NET SALES $ 455,359 $3,445,085 $3,537,480
COST OF GOODS SOLD 38,836 459,661 511,214
--------- ---------- ----------
Gross profit 416,523 2,985,424 3,026,266
--------- ---------- ----------
OPERATING EXPENSES:
Advertising 163,917 1,304,251 2,684,795
Selling 254,708 985,635 1,983,738
General and administrative 252,425 683,093 914,436
--------- ---------- -----------
671,050 2,972,979 5,582,969
--------- ---------- -----------
Income (loss) from
operations (254,527) 12,445 (2,556,703)
INTEREST EXPENSE 28,473 20,021 4,259
OTHER INCOME, NET - (29,121) (143,879)
--------- ---------- -----------
Income (loss) before
provision for income
taxes (283,000) 21,545 (2,417,083)
PROVISION FOR INCOME TAXES 1,000 850 850
--------- ---------- -----------
NET INCOME (LOSS) (284,000) 20,695 (2,417,933)
PREFERRED STOCK DIVIDENDS PAID
AND ACCRUED 52,544 90,249 10,129
--------- ---------- -----------
Net loss attributable to
common shareholders $(336,544) $ (69,554) $(2,428,062)
========= ========== ===========
PROFORMA INCOME (LOSS) PER
COMMON SHARE $ (0.20) $ 0.01 $ -
========= ========== ===========
INCOME (LOSS) PER COMMON SHARE $ - $ - $ (0.90)
========= ========== ===========
PROFORMA WEIGHTED AVERAGE NUMBER
OF COMMON SHARES OUTSTANDING 1,409,951 1,666,727 -
========= ========== ===========
WEIGHTED AVERAGE NUMBER OF
COMMON SHARES OUTSTANDING - - 2,691,149
========= ========== ===========
</TABLE>
The accompanying notes are an integral part of these financial statements.
F3
<TABLE>
WHITEWING LABS, INC.
STATEMENTS OF SHAREHOLDERS' EQUITY
FOR EACH OF THE THREE YEARS IN THE PERIOD ENDED DECEMBER 31, 1996
<CAPTION>
Cumulative
Convertible
Preferred Stock Common Stock
------------------ -----------------
Shares Amount Shares Amount
<S> <C> <C> <C> <C>
BALANCE, December 31, 1993 - $ - 1,125,000 $1,125
Issuance of cumulative convertible
preferred stock for cash, net of
associated issuance costs of
$175,351 272,250 732,149 - -
Preferred cash dividends paid - - - -
Preferred cash dividends declared - - - -
Stock subscribed 15,000 15 - -
Note receivable from subscription (15,000) (15) - -
Net loss - - - -
------- -------- --------- ------
BALANCE, December 31, 1994 272,250 732,149 1,125,000 1,125
Issuance of common stock for cash,
net of associated issuance costs
of $150,208 - - 248,876 249
Note payable converted to common
stock - - 60,000 60
Common stock issued in lieu of
stock issuance commission - - 750 -
Preferred dividends paid - - - -
Preferred dividends declared - - - -
Net income - - - -
------- -------- --------- ------
BALANCE, December 31, 1995 272,250 732,149 1,434,626 1,434
Canceled stock subscribed (15,000) (15) - -
Canceled note receivable from
subscription 15,000 15 - -
Three-for-two stock split and
retirement of preferred stock (272,250) (732,149) 272,250 272
Preferred dividends paid - - - -
Stock offering, net of associated
offering costs and broker
discounts of $1,111,752 - - 1,035,000 1,035
Exercise of stock options - - 149,512 150
Repurchases of common stock - - - -
Net loss - - - -
------- -------- --------- ------
BALANCE, December 31, 1996 - $ - 2,891,388 $2,891
======= ======== ========= ======
</TABLE>
The accompanying notes are an integral part of these financial statements.
F4a
<TABLE>
WHITEWING LABS, INC.
STATEMENTS OF SHAREHOLDERS' EQUITY
FOR EACH OF THE THREE YEARS IN THE PERIOD ENDED DECEMBER 31, 1996
<CAPTION>
Treasury Stock Paid-In
Capital
------------------ ----------
Shares Amount
<S> <C> <C> <C>
BALANCE, December 31, 1993 - $ - $ 98,875
Issuance of cumulative convertible
preferred stock for cash, net of
associated issuance costs of
$175,351 - - -
Preferred cash dividends paid - - -
Preferred cash dividends declared - - -
Stock subscribed - - 49,985
Note receivable from subscription - - (49,985)
Net loss - - -
------- -------- ----------
BALANCE, December 31, 1994 - - 98,875
Issuance of common stock for cash,
net of associated issuance costs
of $150,208 - - 876,043
Note payable converted to common
stock - - 199,940
Common stock issued in lieu of
stock issuance commission - - 2,500
Preferred dividends paid - - -
Preferred dividends declared - - -
Net income - - -
------- -------- ----------
BALANCE, December 31, 1995 - - 1,177,358
Canceled stock subscribed - - (49,985)
Canceled note receivable from
subscription - - 49,985
Three-for-two stock split and
retirement of preferred stock - - 731,877
Preferred dividends paid - - -
Stock offering, net of associated
offering costs and broker
discounts of $1,111,752 - - 4,269,213
Exercise of stock options - - 140,529
Repurchases of common stock (17,600) (45,419) -
Net loss - - -
------- -------- ----------
BALANCE, December 31, 1996 (17,600) $(45,419) $6,318,977
======= ======== ==========
</TABLE>
The accompanying notes are an integral part of these financial statements.
F4b
<TABLE>
WHITEWING LABS, INC.
STATEMENTS OF SHAREHOLDERS' EQUITY
FOR EACH OF THE THREE YEARS IN THE PERIOD ENDED DECEMBER 31, 1996
<CAPTION>
Accumulated Total
Deficit
----------- ----------
<S> <C> <C>
BALANCE, December 31, 1993 $ (281,021) $ (181,021)
Issuance of cumulative convertible
preferred stock for cash, net of
associated issuance costs of
$175,351 - 732,149
Preferred cash dividends paid (31,910) (31,910)
Preferred cash dividends declared (20,634) (20,634)
Stock subscribed - 50,000
Note receivable from subscription - (50,000)
Net loss (284,000) (284,000)
----------- ----------
BALANCE, December 31, 1994 (617,565) 214,584
Issuance of common stock for cash,
net of associated issuance costs
of $150,208 - 876,292
Note payable converted to common
stock - 200,000
Common stock issued in lieu of
stock issuance commission - 2,500
Preferred dividends paid (69,615) (69,615)
Preferred dividends declared (22,688) (22,688)
Net income 20,695 20,695
----------- ----------
BALANCE, December 31, 1995 (689,173) 1,221,768
Canceled stock subscribed - (50,000)
Canceled note receivable from
subscription - 50,000
Three-for-two stock split and
retirement of preferred stock - -
Preferred dividends paid (10,129) (10,129)
Stock offering, net of associated
offering costs and broker
discounts of $1,111,752 - 4,270,248
Exercise of stock options - 140,679
Repurchases of common stock - (45,419)
Net loss (2,417,933) (2,417,933)
----------- ----------
BALANCE, December 31, 1996 $(3,117,235) $3,159,214
=========== ==========
</TABLE>
The accompanying notes are an integral part of these financial statements.
F4c
<TABLE>
WHITEWING LABS, INC.
STATEMENTS OF CASH FLOWS
FOR EACH OF THE THREE YEARS IN THE PERIOD ENDED DECEMBER 31,1996
<CAPTION>
1994 1995 1996
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $(284,000) $ 20,695 $(2,417,933)
Adjustments to reconcile net
income (loss) to net cash used
in operating activities:
Depreciation and amortization 3,932 14,634 20,815
Changes in assets and
liabilities:
Inventories (6,969) (164,937) 49,715
Prepaid advertising (99,000) (256,932) (23,163)
Other prepaid expenses 26,830 (22,688) (7,969)
Other receivables (13,072) (4,043) (29,489)
Deferred advertising (4,000) (186,396) 8,335
Deposits - (1,042) 312
Accounts payable 13,161 67,134 198,259
Accrued liabilities 4,026 57,617 (41,072)
Accrued interest payable 24,444 14,051 (43,051)
--------- --------- -----------
Net cash used in
operating activities (334,648) (461,907) (2,285,241)
--------- --------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES--
Purchase of furniture and fixtures (3,783) (90,884) (6,695)
--------- --------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Investment in related-party
partnership - (100,000) -
Deferred offering costs - (151,499) 174,261
Proceeds from convertible
note payable 200,000 - -
Proceeds from (payments to)
stockholder 40,000 (200,000) (114,247)
Net proceeds from issuance of
cumulative convertible
preferred stock 732,149 - -
F5a
<PAGE>
1994 1995 1996
Net proceeds from issuance of
common stock $ - $878,792 $4,090,158
Net proceeds from issuance of
common stock warrants - - 180,090
Net proceeds from issuance of common
stock upon exercise of options - - 140,679
Repurchases of common stock - - (45,419)
Payment of cash dividends (31,910) (90,249) (32,817)
-------- -------- ----------
Net cash provided by
financing activities 940,239 337,044 4,392,705
-------- -------- ----------
NET INCREASE (DECREASE)IN CASH
AND CASH EQUIVALENTS 601,808 (215,747) 2,100,769
CASH AND CASH EQUIVALENTS,
beginning of year 37,561 639,369 423,622
-------- -------- ----------
CASH AND CASH EQUIVALENTS,
end of year $ 639,369 $ 423,622 $2,524,391
======== ======== ==========
SUPPLEMENTAL DISCLOSURES OF
CASH FLOW INFORMATION:
Cash paid for income taxes $ 1,664 $ 5,000 $ 3,605
======== ======== ==========
Cash paid for interest $ - $ 10,000 $ 47,310
======== ======== ==========
SUPPLEMENTAL DISCLOSURES OF
NONCASH FINANCING ACTIVITIES:
Preferred dividends declared $ 20,634 $ 22,688 $ -
======== ======== ==========
Cumulative convertible preferred
stock converted to common stock $ - $ - $ 732,149
======== ======== ==========
Common stock issued in lieu of
commission $ - $ 2,500 $ -
======== ======== ==========
Note payable converted to
common stock $ - $ 200,000 $ -
======== ======== ==========
</TABLE>
The accompanying notes are an integral part of these financial statements.
F5b
WHITEWING LABS, INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1996
1. Summary of Operations
a. Organization and Business
Whitewing Labs (the Company) was incorporated on July 29, 1993 under
the state laws of California and was a development stage company until
December 31, 1993. From July 29, 1993 until February 24, 1995 (when
the Company sold shares of common stock to unrelated third parties),
the Company was a wholly-owned subsidiary of Acacia Research
Corporation (Acacia, the Parent or majority shareholder). The Company
is engaged in the development and distribution of healthcare products
using direct response marketing to individuals aged 40 and over.
Utilizing formulas that include only natural ingredients, the Company's
products offer alternatives to conventional treatments for symptoms
associated with the aging process.
b. Reincorporation in Delaware
On February 9, 1996, the Company merged with Whitewing Labs, Inc., a
Delaware corporation, which recently was formed as a wholly-owned
subsidiary of the Company and reincorporated in the State of Delaware
(the "Reincorporation"). As a result of the Reincorporation, each holder
of outstanding common stock of the Company, and each holder of the
outstanding preferred stock, received three shares of the Delaware
corporation's common stock for every two shares of the Company's common
stock or preferred stock held of record on the Effective Date of the
Reincorporation. The accompanying financial statements and per share
information give retroactive effect to the Reincorporation.
c. Proceeds from Completion of Initial Public Offering
On February 20, 1996, the Company completed its initial public offering
and issued 900,000 shares of common stock and 1,035,000 common stock
purchase warrants. On March 18, 1996, the Company issued an additional
135,000 shares of common stock which reflected shares of common stock
set aside to cover any over-allotments related to the public offering.
Total proceeds related to the issuance of the 1,035,000 shares of
common stock and common stock purchase warrants were approximately
$4,270,000 which is net of $412,092 in offering costs and $699,660 in
broker discounts (See Note 8).
2. Summary of Significant Accounting Policies
a. Estimates Used by Management
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
F6
liabilities and disclosure of contingent assets and liabilities at the
date of the financial statements and the reported amounts of revenues
and expenses during the reported period. Actual results could differ
from those estimates.
b. Concentration of Risk
Production, order taking and order fulfillment are outsourced to an
outside company and two independent contractors, respectively, which
potentially subjects the Company to a concentration of supplier risk.
In addition, substantially all printing is handled by an outside
company and substantially all advertising placement, including purchase
of mailing lists for direct mail programs, is handled by an outside
service agency. Although these services are currently concentrated
with a few key suppliers, management believes that other suppliers
could provide similar services and comparable terms. A change in
suppliers however could cause delay in manufacturing, shipping,
advertising placements and implementation of direct mail programs and a
possible loss of sales which could affect operating results adversely.
c. Cash and Cash Equivalents
The Company considers cash equivalents to be short-term, highly liquid
investments that are both readily convertible to known amounts of cash,
and are so near their maturity that they present insignificant risk of
changes in value because of changes in interest rates. Cash
equivalents include only those investments with original maturities of
three months or less.
d. Inventories
Inventories consist of finished goods and shipping supplies.
Inventories are valued at the lower-of-invoiced-cost (determined by the
first-in, first-out method) or market.
<TABLE>
The following is a summary of inventories at December 31, 1995 and
1996:
<CAPTION>
1995 1996
<S> <C> <C>
Finished goods $176,206 $139,979
Shipping supplies 17,028 3,540
-------- --------
$193,234 $143,519
======== ========
</TABLE>
e. Prepaid and Deferred Advertising
In December 1993, the American Institute of Certified Public
Accountants issued Statement of Position 93-7 (SOP 93-7) entitled
"Reporting on Advertising Costs". The Company adopted SOP 93-7
effective January 1, 1995.
F7
Magazines, newspapers, weekly publications, and direct mailings
including postcard inserts, tear sheets, holiday special mailers and
the Journal of Natural Health "TM" comprise the main components of the
Company's direct-response marketing efforts and its primary purpose
is to elicit sales to customers. Payments to vendors in advance of the
run date are included in prepaid advertising. Respondents are logged
into a customer database which indicates the source of each customer's
response to the specific advertisement.
The Company's accounting policy for amortizing the costs of prepaid and
deferred advertising placements and mailings is based upon management's
estimates over the periods in which the related direct responses are
received. The Company evaluates the realizability of its direct-
response advertising by comparing the carrying amount of prepaid and
deferred advertising at each balance sheet date on a cost-pool-by-cost-
pool basis to the probable remaining future net revenues expected to
result from such advertising. Any excess carrying amount over probable
remaining future revenues is reported as advertising expense in the
current period. Newspaper and weekly publications are expensed in the
month of issue. Magazines and direct mailings which are available
prior to the middle of the month preceding the issue date are amortized
over a three month period. Magazines which are available subsequent to
the middle of the month preceding the issue date are amortized over a
four month period. The magazine amortization percentages used by the
Company amortize 90 to 100 percent of the deferred cost over three
months with 60 to 80 percent of the costs amortized over two months and
such costs are included in other assets as deferred advertising.
Substantially all of the deferred advertising costs will be fully
amortized within four months of December 31, 1996. In 1995 and 1996,
advertising expense was $1,304,251 and $2,684,795, respectively, which
includes a write-down to net realizable value of none and $123,396 in
1995 and 1996, respectively.
Prepaid advertising includes approximately $184,000 of costs related to
the development of electronic in-home delivery of product advertising
which the Company has begun test airing in February, 1997. Additional
unpaid costs of electronic delivery advertising of $75,000 become due
and payable in 1997. The Company is obligated to pay related talent
costs of 3 percent of gross profits from sales generated in 1997 after
the test airing is completed. It is management's intention to expense
the costs related to the electronic in-home delivery of product
advertising beginning in 1997 and over a period not to exceed
the lesser of the revenue earning stream directly related to the
electronic in-home delivery of product advertising or one year, which
ever comes first.
f. Furniture and Fixtures
Furniture and fixtures are recorded at cost. Major additions and
improvements are capitalized. Depreciation is computed using the
straight-line method over the estimated useful lives which range from 5
to 7 years. When assets are sold or otherwise disposed of, the cost
F8
and related accumulated depreciation are removed from the accounts and
any resulting gain or loss is included in operations.
g. Organization Costs
Organization costs are recorded at cost and are amortized using the
straight-line method over a five-year period.
h. Income Taxes
The Company accounts for income taxes using the liability method in
accordance with Statement of Financial Accounting Standards (SFAS)
No. 109, "Accounting for Income Taxes."
i. Revenue Recognition
Revenue is recorded at the time of shipment.
j. Proforma and Income (Loss) per Common Share
For the year ended December 31, 1994, the proforma weighted average
number of common shares outstanding includes the weighted average of
210,533 shares of preferred stock outstanding without considering
preferred stock dividends paid or accrued, and the weighted average of
150 nonqualified stock options granted in November 1994 computed using
the treasury stock method. At December 31, 1995, the proforma weighted
average number of common shares outstanding includes the weighted
average of 272,250 shares of preferred stock outstanding without
considering preferred stock dividends paid or accrued as well as the
weighted average of 35,720 nonqualified stock options granted in
November 1994 and June 1995 computed using the treasury stock method.
All preferred stock outstanding was effectively converted into
shares of common stock on a one-for-one basis, upon consummation of the
reincorporation. The proforma weighted average number of common shares
outstanding also includes 74,268 shares that are deemed to have been
outstanding during the year ended December 31, 1994 as a consequence of
the issuance in 1995 of 249,626 shares of common stock at a price below
the $5.00 per share Subscription Price. For the year ended December
31, 1996, loss per common share is based on the historical weighted
average number of shares outstanding.
k. Reclassifications
Certain reclassifications have been made to the 1994 and 1995 financial
statements to conform to the 1996 presentation.
F9
3. Restricted Cash
As of December 31, 1995, the Company is required to maintain a reserve cash
account with a balance of approximately 5 percent of the preceding six
month's gross sales volume for credit card transactions. As of December 31,
1996, the required reserve is less than or equal to 5 percent of the prior
six months' gross sales volume for credit card transactions subject to
chargeback and return ratios. As of December 31, 1995 and 1996, the Company
maintained $51,585 and $31,234, respectively, of such restricted cash which
is included in cash and cash equivalents on the accompanying balance sheets.
4. Due to Shareholder
The Company had an unsecured loan payable to the majority shareholder. The
loan was due upon successful completion of the initial public offering. On
February 21, 1996, the remaining loan was paid. The Company recorded interest
expense related to this loan of $28,000, $15,000 and $4,000 in 1994, 1995
and 1996, respectively. Accrued interest payable related to this loan in 1995
and 1996 was approximately $43,000 and none, respectively.
5. Commitments and Contingencies
a. Lease
<TABLE>
The Company is obligated under an operating lease for the office space
it occupies which expires on October 1, 1998. The Company is also
obligated under an automobile operating lease which expires February
14, 1999. The Company's future minimum lease payments at December 31,
1996 are as follows:
<CAPTION>
<S> <C>
1997 $ 49,794
1998 49,794
1999 1,660
--------
$101,248
========
</TABLE>
Rent expense in 1994, 1995 and 1996 was approximately $17,800, $35,200
and $39,200, respectively.
b. Service
The Company has a fulfillment services agreement with Professional
Marketing Associates, Inc. (PMA) effective from September 22, 1993
through March 22, 1997 and is subject to automatic six month
extensions. Under the agreement, PMA acts as the Company's independent
contractor for the purposes of order processing, warehousing and
distribution of the Company's merchandise.
F10
c. Regulation
The U.S. Food and Drug Administration (FDA) is the primary agency that
regulates the healthcare industry.
The Company's products consist of natural ingredients which are
considered nutritional supplements and are classified as foods, thus
they do not require FDA approval. The Company's product labeling and
advertising copy, however, must be within the FDA's established
guidelines.
In November 1991, the FDA issued proposed regulations designed to
among other things, amend its food labeling regulations. The proposed
regulations met with substantial opposition. In October, 1994, the
"Dietary Supplement Health and Education Act of 1994" (the "Dietary
Supplement Law") was enacted. Section 11 of the Dietary Supplement Law
provided that the advance notice of proposed rule making by the FDA
concerning dietary supplements was null and void. FDA regulations that
became effective on June 1, 1994 would require standard format
nutrition labeling on dietary supplements. However, because the new
Dietary Supplement Law also addresses labeling of dietary supplements,
the FDA has indicated that it will not enforce its labeling regulations
until January 1, 1998. In the interim, new regulations are expected to
be proposed by the FDA. Because the FDA has not yet reconciled its
existing regulations with the new Dietary Supplement Law, the Company
cannot determine to what extent any changed or amended regulations will
affect its business.
The Dietary Supplement Law did not affect the July 1, 1994
effectiveness of the FDA's health claims regulations. Those
regulations prohibit any express or implied claims for dietary
supplements unless such claims are approved in advance by the FDA
through the promulgation of specific authorizing regulations. Such
approvals are rarely provided by the FDA. Therefore, no claim may be
made on a dietary supplement label or in printed sales literature,
"that expressly or by implication characterizes the relationship of any
substance to a disease or health-related condition". The Company
cannot determine what effect currently proposed FDA regulations, when
and if promulgated, will have on its business in the future. Such
regulations could, among other things, require expanded or different
labeling, the recall or discontinuance of certain products, additional
record keeping and expanded documentation of the properties of certain
products and scientific substantiation. In addition, the Company
cannot predict whether new legislation regulating its activities will
be enacted, which new legislation could have a material effect on the
Company.
F11
The Company has an ongoing compliance program with assistance from
experienced FDA counsel regarding the nature and scope of food and drug
legal matters affecting the Company's business and products. The
Company is unaware of any legal actions pending or threatened by the
FDA or any other governmental authority against the Company.
d. Pending Litigation
The Company was notified by letter dated January 12, 1996, that the
Federal Trade Commission (FTC) was conducting a preliminary, non-public
investigation regarding the advertising and sale of Prostsafe which
represents approximately 79% of total Company sales during the year
ended December 31, 1996. The Company did not believe that this
advertisement made any false or unsubstantiated claims and had
submitted a formal written response to the FTC inquiry. On March 26,
1997, the Company was notified by its legal counsel that the FTC
had concluded its investigation and closed its file without taking
any action.
On August 16, 1996, a former director of the Company and her husband,
filed a legal action against the Company and its largest shareholder
in the United States District Court in Los Angeles against the Company.
The suit alleges, among other things, that the Company improperly
refused to permit the exercise of an option to purchase 15,000 shares
of the Company's common stock and seeks $106,000 in damages from the
Company. Legal counsel has been jointly retained by the Company and
Acacia, the co-defendant, and Acacia has assumed primary defense
thereof as well as assuming sole responsibility for all litigation
costs incurred in connection with such joint representation. Although
the ultimate outcome of this litigation cannot be predicted with
certainty, the Company's management does not believe that this matter
will have a material effect on the Company's results of operations or
financial position.
e. Advertising
The Company has commitments for magazine placements of $261,000 at
December 31, 1996.
6. Income Taxes
The liability method requires the Company to provide income taxes for the tax
effect of temporary differences in recognizing certain income and expenses
for financial statement and income tax purposes.
F12
The provision for income taxes is comprised of the minimum franchise taxes
payable for state income taxes.
At December 31, 1996, the Company had net operating loss carryforwards of
approximately $3,400,000 for federal income tax purposes available to reduce
future federal taxable income through 2011.
At December 31, 1996, the Company had net operating loss carryforwards of
approximately $4,200,000 for state income tax purposes. Approximately
$1,500,000 and $2,700,000 are available to reduce future state taxable income
in California and Arizona, respectively. Such carryforwards expire through
2011.
Temporary differences and carryforwards which give rise to a significant
portion of deferred tax assets and liabilities for 1995 and 1996 are as
follows:
<TABLE>
<CAPTION>
1995 1996
--------- ----------
<S> <C> <C>
Deferred tax assets:
Federal net operating loss
carryforwards $ 340,000 $1,156,000
State net operating loss
carryforwards--California 17,000 92,000
State net operating loss
carryforwards--Arizona 40,000 165,000
Other 33,000 8,000
Less - Valuation allowance (210,000) (1,201,000)
--------- ----------
Total deferred tax assets $ 220,000 $ 220,000
========= ==========
Deferred tax liabilities:
Prepaid advertising (216,000) (218,000)
Other (4,000) (2,000)
--------- ----------
Total deferred tax liabilities $(220,000) $ (220,000)
========= ==========
</TABLE>
The Company had approximately $1,000,000 of NOL carryovers ("pre change
NOL's") for federal tax return purposes at December 31, 1995. During 1995,
the Company's additional issuance of common stock to third parties and the
existence of cumulative convertible preferred stock held by third parties
caused a "change of ownership" of the Company pursuant to Section 382 of the
Internal Revenue Code. As a result of the ownership change, the Company's
utilization of its NOL carryovers that may be used to offset future income is
F13
estimated by the Company to be approximately $400,000 per year (the "annual
limitation"). In addition, during 1996, the Company had a public offering
which may have caused an additional "change of ownership". However, any
such additonal ownership change is not expected to materially change the
annual limitation. In the event the annual limitation is not fully utilized,
the Company is allowed to carryover such amount to subsequent years during
the carryover period.
7. Stock Option Plan
a. Qualified Stock Options
On November 16, 1993, the Board approved a qualified stock option plan
(the Plan) for officers and key employees. Under the terms of the
Plan, incentive stock options will be granted at the prevailing market
rate. Shares not exceeding 20 percent of the outstanding common shares
of the Company will be reserved for the issuance of options under the
terms of the Plan. Under the Plan, the options will generally vest and
become exercisable at the date of the grant and expire five years from
the date of grant, subject to employee termination. Upon termination,
individuals have three months from their termination date to exercise
their options.
During November 1994, the Company verbally agreed to grant a former
employee an additional extension through November 25, 1996 for 7,500
options which were scheduled to expire in February 1995. The remaining
15,000 shares expired in 1995. The options were exercised in November
1996.
b. Nonqualified Stock Options
In 1993 and 1994, the Company granted 256,200 options to officers, key
employees, directors, and consultants. Under the terms of the Plan,
options will be granted at the prevailing market rate and will
generally vest and become exercisable at the date of the grant. The
term of any option expires five years from the date of grant, subject
to the continuation of each person's employment or consulting
relationship with the Company. Under the terms of a separate
agreement, a former officer of the Company has until October 1997 to
exercise 15,000 options issued and outstanding. A consultant to the
Company also has a separate agreement which allows him to exercise 300
options within 60 months of terminating the consulting relationship
with the Company. Upon termination with the Company, all other
individuals have three months from their termination date to exercise
their options.
On June 1, 1995, the Company granted a total of 60,000 options to two
employees at $3.40 per share which was the market as determined by the
Board of Directors. Options vest at 6,000 per year and expire five
years after date of grant. On August 28, 1996, 30,000 options expired
after an employee terminated his employment.
F14
On January 5, 1996, the Company granted 75,000 options to an employee
and a director at an exercise price of $5.00. The options vested at
the date of grant and expire five years from the date of grant. In
addition, the Company granted 90,000 options to employees, directors
and an outside contractor at exercise prices ranging from $1.69 to
$5.00. The options vest at various dates as defined in the specific
stock option agreements and expire five years from the date of grant.
All options granted were approved by the Board of Directors.
On January 5, 1996, the Company issued 29,997 options to a consultant
at $4.33. The consultant entered into an arrangement with the Parent
(prior to the change in ownership) for which options issued to him
would be at approximately $1 below market price.
<TABLE>
The following is a summary of qualified and nonqualified options from
December 31, 1994 to December 31, 1996:
<CAPTION>
Exercise
Price Options Options
Qualified Options: (At Market) Granted Vested
<S> <C> <C> <C>
Balance, December 31, 1994 $ 0.089 225,000 225,000
Expired $ 0.089 (15,000) (15,000)
------- -------
Balance, December 31, 1995 $ 0.089 210,000 210,000
------- -------
Exercised $ 0.089 (67,000) (67,000)
------- -------
Balance, December 31, 1996 $ 0.089 143,000 143,000
======= =======
Nonqualified Options:
Balance, December 31, 1994 $ 0.089 - 4.00 256,200 256,200
Granted $ 3.40 60,000 12,000
------- -------
Balance, December 31, 1995 $ 0.089 - 4.00 316,200 268,200
------- -------
Granted $ 1.69 - 5.00 194,997 113,000
Exercised $ 0.089 - 5.00 (82,512) (82,512)
Expired $ 3.40 - 5.00 (50,000) (5,000)
------- -------
Balance, December 31, 1996 $ 0.089 - 5.00 378,685 293,688
======= =======
</TABLE>
F15
The Company accounts for the Plan with regards to the Company's employees,
officers and directors under Accounting Principles Board Opinion No. 25 and
related Interpretations. Accordingly, no compensation cost has been
recognized for these individuals under the Plan. Had compensation cost for
these individuals been determined based on the fair value at the grant dates
consistent with the method under SFAS No. 123, the Company's net income
(loss) and earnings per share would have been reduced to the pro forma amounts
indicated below:
<TABLE>
<CAPTION>
1995 1996
------- -----------
<S> <C> <C>
Net income (loss): As Reported $20,695 $(2,417,083)
Pro Forma $10,975 $(2,529,721)
Primary earnings per share: As Reported $0.01 $(0.90)
Pro Forma $0.01 $(0.94)
Fully diluted earnings per share: As Reported $0.01 $(0.90)
Pro Forma $0.01 $(0.94)
</TABLE>
The fair value of each option grant is estimated on the date of grant using
an option pricing model with the following weighted-average assumptions used
for grants in 1995 and 1996: risk-free interest rate of 8.0 percent; no
expected dividend yield; expected lives of 5 years; expected volatility of 34
percent for options granted after the public offering and .01 for options
granted prior to the public offering.
8. Capitalization
a. Capital Stock
The Board of Directors authorized 500,000 shares of 10 percent
cumulative convertible preferred stock which converted into one share
of the Company's common stock upon the completion of the initial public
offering on February 20, 1996.
On January 16, 1995, the Company filed an amended articles of
incorporation which increased the number of shares of common stock
authorized from 5,000,000 to 10,000,000 shares and changed the par
value on its common and cumulative convertible preferred stock to
$.001.
b. Warrants and Stock Options
In conjunction with the initial public offering in February 1996, the
Company issued 1,035,000 common stock purchase warrants at $0.20 per
share which had to be purchased together on the basis of one share of
common stock and one warrant, but tradable separately thereafter. Two
F16
warrants entitle the holder to purchase one share of common stock at a
price of $7.00 during the three year period commencing on February
14, 1996. The warrants may be redeemed by the Company under certain
circumstances. As of December 31, 1996, none had been exercised. In
connection with the Company's initial public offering, the
representatives of the underwriters acquired 90,000 warrants.
In conjunction with the initial public offering in February 1996, the
Company granted 90,000 options to the representatives of the
underwriters at an exercise price of $6.00. The options become
exercisable on February 9, 1997, and expire on February 9, 2001.
c. Stock Repurchase
During 1996, the Company acquired 17,600 shares of its common stock for
approximately $45,000 in connection with a stock repurchase program in
which up to 200,000 shares or 7% of outstanding shares of the Company's
common stock may be acquired in the open market.
9. Investment in Related-Party Partnership
The Company invested $100,000 in a limited partnership (the Partnership)
which currently invests in equity securities in which the Company's largest
shareholder has a majority interest. Although the Partnership currently
invests in equity securities, it is subject to the risks associated with
short sales, hedging, option trading, trading on margin and other leverage
transactions. As of December 31, 1995 and 1996, the fair value of the
Company's investment was valued at approximately $116,000 and $127,000,
respectively. The future success of the Partnership is dependent upon the
largest shareholder's ability to raise additional capital investment in the
Partnership. As the general partner of the Partnership, the Company's
largest shareholder earns a management fee based upon the value of
investments held by the Partnership.
10. Subsequent Events
Subsequent to year end, the Company has repurchased 15,400 shares of common
stock for $22,322 and has authorized a repurchase of up to an additional
14,600 shares during the first quarter of 1997 and may or may not make future
repurchases depending on the cash flows.
F17
