<PAGE>
As filed with the Securities and Exchange Commission on September 16, 1999
Registration No. 333-
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
-------------------
FORM S-3
REGISTRATION STATEMENT
UNDER
THE SECURITIES ACT OF 1933
-------------------
ArthroCare Corporation
(Exact name of registrant as specified in its charter)
<TABLE>
<S> <C>
Delaware 94-3180312
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
</TABLE>
595 North Pastoria Avenue
Sunnyvale, California 94086
(408) 736-0224
(Address, including zip code, and telephone number, including area code, of
registrant's principal executive offices)
-------------------
Michael A. Baker
President and Chief Executive Officer
ArthroCare Corporation
595 North Pastoria Avenue
Sunnyvale, California 94086
(408) 736-0224
(Name, address, including zip code, and telephone number, including area code,
of agent for service)
-------------------
Please send copies of all communications to:
<TABLE>
<S> <C>
Michael W. Hall, Esq. Elizabeth R. Flint, Esq.
Holly M. Bauer, Esq. Marc Taxay, Esq.
Christina Y. Lai, Esq. Daniel Yuen, Esq.
Latham & Watkins Wilson Sonsini Goodrich & Rosati
135 Commonwealth Drive 650 Page Mill Road
Menlo Park, California 94025 Palo Alto, California 94304
(650) 328-4600 (650) 493-9300
</TABLE>
-------------------
Approximate date of commencement of the proposed sale to the public: As
soon as practicable after the effective date of the Registration Statement.
If the only securities being registered on this form are being offered
pursuant to dividend or interest reinvestment plans, please check the
following box. [_]
If any of the securities being registered on this form are to be offered on
a delayed or continuous basis pursuant to Rule 415 under the Securities Act of
1933, other than securities offered only in connection with dividend or
interest reinvestment plans, check the following box: [_]
If this Form is filed to register additional securities for an offering
pursuant to Rule 462(b) under the Securities Act, please check the following
box and list the Securities Act registration statement number of the earlier
effective registration statement for the same offering. [_]
If this Form is a post-effective amendment filed pursuant to Rule 462(d)
under the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering. [_]
If delivery of the prospectus is expected to be made pursuant to Rule 434,
please check the following box. [_]
-------------------
CALCULATION OF REGISTRATION FEE
<TABLE>
- -----------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------
<CAPTION>
Proposed Proposed
Maximum Maximum Amount of
Title of Shares to be Amount to be Offering Price Aggregate Registration
Registered Registered (1) Per Share (2) Offering Price Fee
- -----------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Common Stock, $.001 par
value................. 1,150,000 $55.75 $64,112,500 $17,823.28
- -----------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------
</TABLE>
(1) Includes 150,000 shares of common stock that the underwriters have the
option to cover over-allotments, if any.
(2) Estimated solely for the purpose of calculating the registration fee
pursuant to Rule 457(c) under the Securities Act of 1933, as amended. The
maximum price per share is based on the average of the high and the low
sale prices of the registrant's common stock reported on the Nasdaq
National Market System on September 14, 1999.
-------------------
The registrant hereby amends this registration statement on such date or
dates as may be necessary to delay its effective date until the registrant
shall file a further amendment which specifically states that this
registration statement shall thereafter become effective in accordance with
Section 8(a) of the Securities Act of 1933 or until the registration statement
shall become effective on such date as the Commission, acting pursuant to said
Section 8(a), may determine.
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
<PAGE>
++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++
+The information in this prospectus is not complete and may be changed. We may +
+not sell these securities until the registration statement filed with the +
+Securities and Exchange Commission is effective. This prospectus is not an +
+offer to sell securities, and we are not soliciting offers to buy these +
+securities, in any state where the offer or sale is not permitted. +
++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++
SUBJECT TO COMPLETION, DATED SEPTEMBER , 1999
[Logo of ArthroCare Corporation]
1,000,000 Shares
Common Stock
ArthroCare Corporation is offering 1,000,000 shares of its common stock.
ArthroCare's common stock is traded on the Nasdaq National Market under the
symbol "ARTC." The last reported sale price of our common stock on the Nasdaq
National Market on September 15, 1999 was $58.88 per share.
--------------
Investing in the common stock involves risks.
See "Risk Factors" beginning on page 7.
--------------
<TABLE>
<CAPTION>
Per Share Total
--------- -----
<S> <C> <C>
Public Offering Price........................................... $ $
Underwriting Discounts and Commissions.......................... $ $
Proceeds to ArthroCare.......................................... $ $
</TABLE>
The Securities and Exchange Commission and state securities regulators have
not approved or disapproved these securities, or determined if this prospectus
is truthful or complete. Any representation to the contrary is a criminal
offense.
ArthroCare has granted the underwriters a 30-day option to purchase up to an
additional 150,000 shares of common stock to cover over-allotments.
--------------
BancBoston Robertson Stephens Bear, Stearns & Co. Inc.
The date of this prospectus is September , 1999.
<PAGE>
Inside Front Cover
Center Photo
Description: Arthrocare System 2000 - This photo shows our radio frequency
controller unit in front of a three-control foot pedal which the surgeon uses
to select power level and functionality. Attached to the front of the
controller is a cable that supplies power to the disposable device, which is
affixed to the other end of the cable. The device lies on top of the coiled
cable. It consists of a plastic handle, shaft and the housing for the
electrodes.
Caption: Our Coblation(TM)-based soft-tissue surgical system consists of an
assortment of disposable devices and a controller that supplies radio frequency
energy to the disposable devices.
Device Photos
Fanned beneath the center photo are three disposable devices. From left to
right they are the TurboVac, the Rejuvenation Stylet and the ENTec Plasma
Scalpel.
TurboVac(TM)
Description: The TurboVac shows the tip of the wand at a 90 degree angle to
the shaft. The tip displays four pins which hold a five-hole screen through
which loose tissue is suctioned.
Caption: The TurboVac combines suction with ablation for rapid removal of
soft tissue in arthroscopic surgery. Suction draws free floating tissue to the
electrodes for disintegration and removal from the surgical area.
Cosmetic Surgery Rejuvenation Stylet
Description: A wide curved handle with a channel on the underside. The
electrode array on the tip is a vertical array that protrudes about 1/8" from
the tip. Above the electrode array is a small hole for saline delivery which is
pumped through the channel in the handle.
Caption: The Cosmetic Surgery Rejuvenation Stylet for dermatologic use is
optimized for performing in a dry field surgical environment. Saline is
delivered to the surface of the electrodes by way of a small tube in the handle
of the device to a point above the electrode array.
ENTec(TM) Plasma Scalpel(TM)
Description: A thin handle with a vertical array of electrodes at the tip.
The tip curves about 35 degrees from the handle. There are channels both above
and below the tip for saline delivery and suction.
Caption: The ENTec Plasma Scalpel offers complete fluid management. The
Plasma Scalpel provides both saline delivery and suction capability in
conjunction with tissue removal and the sealing of bleeding vessels.
Caption at bottom of page
The
[Coblation Logo]
Company
<PAGE>
You should rely only on the information contained in this prospectus. We
have not authorized anyone to provide you with information different from that
contained in this prospectus. We are offering to sell, and seeking offers to
buy, shares of common stock only in jurisdictions where offers and sales are
permitted. The information contained in this prospectus is accurate only as of
the date of this prospectus, regardless of the time of delivery of this
prospectus or of any sale of our common stock. In this prospectus,
"ArthroCare," "we," "us," and "our" refer to ArthroCare Corporation, a
Delaware company (unless the context otherwise requires). Unless otherwise
noted, the information in this prospectus assumes that the underwriters will
not exercise their overallotment option.
---------------------
TABLE OF CONTENTS
<TABLE>
<CAPTION>
Page
----
<S> <C>
Summary.................................................................. 3
Risk Factors............................................................. 7
Special Note Regarding Forward-Looking Statements........................ 18
Use of Proceeds.......................................................... 19
Dividend Policy.......................................................... 19
Price Range of Common Stock.............................................. 20
Capitalization........................................................... 21
Dilution................................................................. 22
Selected Consolidated Financial Data..................................... 23
Management's Discussion and Analysis of Financial Condition and Results
of Operations........................................................... 24
Business................................................................. 31
Management............................................................... 48
Principal Stockholders................................................... 50
Description of Capital Stock............................................. 52
Underwriting............................................................. 55
Legal Matters............................................................ 57
Experts.................................................................. 57
Where You Can Find More Information...................................... 58
Index to Financial Statements............................................ F-1
</TABLE>
---------------------
We own the ACCESS, AngioCare, ArthroCare, CAPSure, CAPSX, Coblation, CoVac,
DisCoblator, ENTec, Eliminator, Hummingbird, LoPro, Microblator, Plasma
Scalpel, Reflex, Saber, SpineWand, TurboVac trademarks. In addition, Visage is
a registered trademark. This prospectus also includes trademarks owned by
other companies.
<PAGE>
SUMMARY
This summary highlights information contained elsewhere in this prospectus.
You should read the entire prospectus, including "Risk Factors" and the
consolidated financial statements and related notes, carefully before making an
investment decision.
ArthroCare
We are a medical device company that develops, manufactures and markets
products based on our patented Coblation(TM) technology. Our products allow
surgeons to operate with increased precision and accuracy, limiting damage to
surrounding tissue thereby reducing pain and speeding recovery for the patient.
Our products operate at lower temperatures than traditional electrosurgical or
laser surgery tools and enable surgeons to ablate or shrink soft tissue and to
simultaneously seal bleeding vessels. Ablation is the disintegration or removal
of tissue. Our soft-tissue surgery systems consist of a controller unit and an
assortment of disposable devices that are specialized for specific types of
surgery. We believe our Coblation technology can replace the multiple surgical
tools traditionally used in soft-tissue surgery procedures with one multi-
purpose surgical system.
Coblation technology is applicable across many soft-tissue surgical markets.
Our systems are used to perform many types of arthroscopic surgery. Our
strategy includes applying our patented Coblation technology to a broad range
of other soft-tissue surgical markets, including cosmetic surgery, ear, nose
and throat, or ENT, surgery, spinal surgery and various cardiology
applications. We have formed the following business units for commercialization
of our technology in non-orthopedic markets: Visage(R), to commercialize our
cosmetic surgery products for use in various cosmetic surgery procedures;
ENTecTM, to commercialize our ENT surgery products for use in head and neck
surgical procedures; and AngioCareTM, to commercialize our technology in the
cardiac surgery and interventional cardiology markets.
We have received 510(k) clearance to market our Arthroscopic System for use
in arthroscopic surgery of the knee, shoulder, ankle, elbow, wrist and hip, and
our Arthroscopic System is CE marked for use in arthroscopic surgery. The CE
Mark is a requirement to sell our products in most of western Europe. Our
Cosmetic Surgery System is CE marked for general dermatologic, skin resurfacing
and wrinkle reduction procedures, and we have received 510(k) clearance for use
of our Cosmetic Surgery System in general dermatologic procedures in the United
States. We are pursuing additional clearances that will allow our cosmetic
surgery products to be marketed in the United States specifically for skin
resurfacing and wrinkle reduction. Our ENT surgery system is CE marked, and we
have received 510(k) clearances for use of our ENT surgery system in general
head, neck, oral and sinus surgery procedures in the United States. Our Spinal
Surgery System is CE marked, and we have applied for 510(k) clearance in the
United States to market this system for spinal surgery. We have received 510(k)
clearance to market products based on Coblation technology for general surgery.
We commercially introduced our Arthroscopic System in December 1995 and have
derived significantly all of our sales from this system. As of July 3, 1999, we
had shipped more than 5,000 controller units and more than 450,000 disposable
devices for a variety of indications. We are marketing and selling our
arthroscopic and ENT surgery products in the United States through a network of
independent distributors supported by regional managers. We have more than 35
distributors representing more than 225 field sales representatives in the
United States. We have also established distribution capability in Europe,
Australia, New Zealand, Korea, Japan, Taiwan, Canada, Mexico, the Caribbean,
Russia, South Africa, the Middle East, Northern Africa and South and Central
America. In addition, we are marketing and selling our Spinal Surgery System
internationally and are building our domestic distribution capabilities in this
area in anticipation of 510(k) clearance. In order to market our spinal surgery
products, we plan to utilize existing distributors, add new distributors that
specialize in spinal surgery products and add additional regional managers both
domestically and internationally. We have signed an exclusive worldwide
distribution agreement with Collagen Aesthetics, Inc., recently acquired by
Inamed Corporation, for our cosmetic surgery products. In addition, we have
entered into a license agreement under which the SciMed division of Boston
Scientific Corporation will develop, obtain regulatory approval for and market
products based on Coblation technology for a specific application within
cardiology.
3
<PAGE>
The following is a current list of our Coblation-based disposable devices:
<TABLE>
<CAPTION>
Current
Date of # of
Product Families Introduction models
---------------- ------------ -------
<S> <C> <C>
Arthroscopy
90 Degree
Eliminator(TM) June 1998 1
LoPro(TM) April 1998 1
90 degree August 1995 3
Suction
CoVac(TM) June 1998 2
TurboVac(TM) December 1998 1
Shrinkage
CAPSX(TM) March 1998 1
CAPSure(TM) June 1999 1
Standard
TurboBevel December 1996 3
Saber(TM) June 1998 1
Small Joint December 1997 2
TurboDome July 1996 5
Spinal Surgery
ACCESS(TM) SpineWand(TM) September 1999 1
DisCoblator(TM) September 1999 1
Cosmetic Surgery
Rejuvenation Stylet June 1998 2
Plasma Scalpel(TM) February 1999 1
MicroElectrode Dissector February 1999 1
Microblator(TM) June 1999 1
Ear, Nose and Throat Surgery
Hummingbird(TM) March 1999 1
Plasma Scalpel March 1999 1
Reflex(TM) June 1999 1
General Surgery
Plasma Scalpel GS September 1999 1
</TABLE>
For information regarding the status of our regulatory approvals for our
products, see the information under the heading "Government Regulation" in the
section entitled "Business."
We were incorporated in California on April 29, 1993 and were reincorporated
in Delaware on November 22, 1995. Our principal executive offices are located
at 595 North Pastoria Avenue, Sunnyvale, California 94086, and our telephone
number is (408) 736-0224.
4
<PAGE>
The Offering
<TABLE>
<S> <C>
Common stock offered by ArthroCare........... 1,000,000 shares
Common stock to be outstanding after this 10,035,886 shares
offering....................................
Use of proceeds.............................. We intend to use the net
proceeds of this offering for
commercialization and further
development of our technology,
including our spinal surgery
products, and for corporate and
other general purposes.
Dividend policy.............................. We intend to retain our earnings
and we do not anticipate paying
dividends on our common stock in
the foreseeable future.
Risk factors................................. For a discussion of certain
considerations relevant to an
investment in our common stock,
see "Risk Factors" on page 7.
Nasdaq National Market symbol................ ARTC
</TABLE>
The number of shares of common stock to be outstanding after this offering
is based on the 9,035,886 shares outstanding as of July 3, 1999 and the
1,000,000 shares of common stock being sold by us in this offering and
excludes:
. 630,149 shares of common stock issuable upon exercise of options
outstanding at July 3, 1999 at a weighted average exercise price of
$11.89 per share;
. warrants to purchase 80,000 shares of our common stock at a purchase
price of $12.00 per share and warrants to purchase 40,000 shares of our
common stock at a purchase price of $14.00 per share; and
. any shares of common stock that may be sold by us to the underwriters
pursuant to the over-allotment option.
5
<PAGE>
Summary Consolidated Financial Data
In the table below, we provide you with our summary historical financial
data. We have prepared this information using the consolidated financial
statements for the three years ended January 2, 1999 and the six-month periods
ended July 3, 1999 and July 4, 1998. The consolidated financial statements for
the three years ended January 2, 1999 have been audited. The consolidated
financial statements for the six-month periods ended July 3, 1999 and July 4,
1998 have not been audited.
When you read this summary historical financial data, it is important that
you read it along with the historical consolidated financial statements and
related notes in our annual and interim consolidated financial statements
included and incorporated by reference in this prospectus, as well as the
section titled "Management's Discussion and Analysis of Financial Condition and
Results of Operations."
<TABLE>
<CAPTION>
Year Ended Six Months Ended
---------------------------------- ------------------
December 28, January 3, January 2, July 4, July 3,
1996 1998 1999 1998 1999
------------ ---------- ---------- -------- --------
(in thousands, except per share data)
<S> <C> <C> <C> <C> <C>
Statements of Operations
Data:
Revenues:
Product sales........... $ 6,022 $12,796 $24,624 $ 10,544 $ 19,177
License fees and
royalties.............. -- -- 3,292 2,625 2,750
------- ------- ------- -------- --------
Total revenues.......... 6,022 12,796 27,916 13,169 21,927
Cost of product sales.... 5,242 8,495 12,368 5,995 8,186
------- ------- ------- -------- --------
Gross profit............ 780 4,301 15,548 7,174 13,741
------- ------- ------- -------- --------
Operating expenses:
Research and
development............ 3,772 4,026 4,355 2,140 2,176
Sales and marketing..... 3,635 6,263 10,495 4,538 7,146
General and
administrative......... 2,582 3,112 3,775 1,924 3,028
------- ------- ------- -------- --------
Total operating
expenses............... 9,989 13,401 18,625 8,602 12,350
------- ------- ------- -------- --------
Income (loss) from
operations.............. (9,209) (9,100) (3,077) (1,428) 1,391
Interest income and
other, net.............. 1,505 1,413 937 587 215
------- ------- ------- -------- --------
Income (loss) before
taxes................... (7,704) (7,687) (2,140) (841) 1,606
Income tax provision..... 1 1 1 -- 65
------- ------- ------- -------- --------
Net income (loss)....... $(7,705) $(7,688) $(2,141) $ (841) $ 1,541
======= ======= ======= ======== ========
Basic net income (loss)
per common share........ $ (0.97) $ (0.87) $ (0.24) $ (0.09) $ 0.17
======= ======= ======= ======== ========
Diluted net income (loss)
per common share........ $ (0.97) $ (0.87) $ (0.24) $ (0.09) $ 0.16
======= ======= ======= ======== ========
Shares used in computing
basic net income (loss)
per common share........ 7,936 8,813 8,926 8,902 8,973
======= ======= ======= ======== ========
Shares used in computing
diluted net income
(loss) per common
share................... 7,936 8,813 8,926 8,902 9,547
======= ======= ======= ======== ========
</TABLE>
<TABLE>
<CAPTION>
July 3, 1999
----------------------
Actual As Adjusted(1)
------- --------------
(in thousands)
<S> <C> <C>
Balance Sheet Data:
Cash, cash equivalents and available-for-sale
securities............................................ $ 7,147 $61,990
Working capital........................................ 17,628 72,471
Total assets........................................... 29,764 84,607
Capital lease obligations, non-current................. 117 117
Total stockholders' equity............................. 24,576 79,419
</TABLE>
- --------
(1) As adjusted to reflect receipt of the estimated net proceeds from the sale
of 1,000,000 shares of common stock at an assumed offering price of $58.88
per share after deducting the underwriters' discounts and commissions and
estimated offering expenses. Actual proceeds and the actual number of
shares sold may differ.
6
<PAGE>
RISK FACTORS
Any investment in shares of our common stock involves a high degree of risk.
You should consider carefully the following information about these risks,
together with the other information contained in this prospectus, before you
decide to buy our common stock. If any of the following risks actually occur,
our business, financial condition, results of operations and future growth
prospects would likely be materially adversely affected. In these
circumstances, the market price of our common stock could decline, and you may
lose all or part of the money you paid to buy our common stock.
We Are Dependent Upon Our Arthroscopic System
We commercially introduced our Arthroscopic System in December 1995. Since
our Arthroscopic System accounts for substantially all of our product sales, we
are highly dependent on its sales. Our spinal surgery, cosmetic surgery, and
ENT surgery products have only recently become available, and to date, we have
sold only a small number of units. We cannot assure you that we will be able to
continue to manufacture arthroscopy products in commercial quantities at
acceptable costs, or that we will be able to continue to market such products
successfully.
To achieve increasing disposable device sales over time, we believe we must
continue to penetrate the market in knee procedures, expand physicians'
education with respect to Coblation technology and continue working on new
product development efforts specifically for knee applications. Furthermore, in
order to maintain and increase current market penetration we must be aggressive
in increasing our installed base of controllers to generate increased
disposable device revenue. To date, we have placed our arthroscopic controllers
at substantial discounts in order to stimulate demand for our disposable
devices.
We believe that surgeons will not use our products unless they determine,
based on experience, clinical data and other factors, that these systems are an
attractive alternative to conventional means of tissue ablation. There are only
a few independently published clinical reports and limited long-term clinical
follow-up to support the marketing efforts for our Arthroscopic System. We
believe that continued recommendations and endorsements by influential
arthroscopic surgeons are essential for market acceptance of our Arthroscopic
System. If our Coblation technology does not continue to receive endorsement by
influential surgeons or our long-term data does not support our current claims
of efficacy, our business, financial condition, results of operations and
future growth prospects could be materially adversely affected.
Commercial Success of Our Non-Arthroscopic Products Is Uncertain
We have developed several new applications for our Coblation technology in
spinal surgery, cosmetic surgery and ENT surgery. Additionally we have
established a program to explore the application of our Coblation technology in
various areas within cardiology. Our products for these non-arthroscopic
indications are in various stages of commercialization and development, and we
may be required to undertake time-consuming and costly commercialization,
development and additional regulatory approval activities. We are awaiting
510(k) clearance in the United States to market our Spinal Surgery System
specifically for use in spinal surgery and to market our Cosmetic Surgery
System specifically for skin resurfacing and wrinkle reduction. If we do not
receive these clearances we will be unable to market these products for these
specific indications and our business, financial condition, results of
operations and future growth prospects could be materially adversely affected.
We cannot assure you that product development will ever be successfully
completed, that regulatory clearances or approvals, if applied for, will be
granted by the Food and Drug Administration, the FDA, or foreign regulatory
authorities on a timely basis, if at all, or that the products will ever
achieve commercial acceptance.
We may have to make a significant investment in additional preclinical and
clinical testing, regulatory, physician training and sales and marketing
activities to further develop and commercialize the spinal surgery, cosmetic
surgery, ENT surgery and cardiology product lines. Although we believe that
these products offer
7
<PAGE>
certain advantages, we cannot assure you that these advantages will be
realized, or if realized, that these products will result in any meaningful
benefits to physicians or patients.
Development and commercialization of our current and future non-arthroscopic
products are subject to the risks of failure inherent in the development of new
medical devices. These risks include the following:
. that such products will not be easy to use, will require extensive
training or will not be cost-effective;
. that we will experience delays in testing or marketing;
. that such testing or marketing will result in unplanned expenditures or
in expenditures above those anticipated by us;
. that our products will not be proven safe or effective;
. that third parties will develop and market superior or equivalent
products;
. that such products will fail to receive necessary regulatory clearances
or approvals;
. that such products will be difficult or uneconomical to manufacture on a
commercial scale; and
. that proprietary rights of third parties will preclude us and our
collaborative partners from marketing such products.
In addition, the success of our non-arthroscopic products will depend on
their adoption as alternatives to conventional means of tissue ablation.
Clinical experience and follow-up data for our non-arthroscopic indications are
limited, and we have sold only a small number of units to date. We believe that
recommendations and endorsement of influential physicians are essential for
market acceptance of our products.
For information regarding the status of our regulatory approvals for our
products, see the information under the heading "Government Regulation" in the
section entitled "Business."
We Have Limited Marketing and Sales Experience
We currently have limited experience in marketing and selling our products.
To the extent that we have established or enter into distribution arrangements
for the sale of our products, we are and will be dependent upon the efforts of
third parties. We are marketing and selling our arthroscopic surgery and ENT
surgery product lines in the United States through a network of independent
distributors supported by regional sales managers and a small direct sales
force. These distributors sell arthroscopy and ENT surgery devices for a number
of other manufacturers. In addition, we are marketing and selling our Spinal
Surgery System internationally and are building our domestic distribution
capabilities in this area in anticipation of 510(k) clearance. In order to
market our spinal surgery products, we plan to utilize existing distributors,
add new distributors that specialize in spinal surgery products and add
additional regional managers, both domestically and internationally. We cannot
assure you that these distributors will commit the necessary resources to
effectively market and sell our arthroscopic surgery, spinal surgery or ENT
surgery product lines, or that they will be successful in selling our products.
We have recently established a marketing presence in various countries and
we cannot assure you that these newly established operations will be
successful. In order to successfully market our products internationally, we
will need to address many issues with which we have little or no experience,
including the securing of necessary regulatory approvals in international
markets and the potential reuse of our disposable devices by our customers.
Even if we are able to successfully deal with these issues, we cannot assure
you that we will be able to establish successful distribution capabilities
internationally or receive favorable pricing for our products. In addition, we
may face currency exchange risks as part of our international expansion. To the
extent our marketing and sales efforts are unsuccessful, our business,
financial condition, results of operations and future growth prospects may be
materially adversely affected.
8
<PAGE>
We Have Limited Manufacturing Experience
To be successful, we must manufacture our products in commercial quantities
in compliance with regulatory requirements at acceptable costs. At the present
time, we have limited manufacturing experience. Our manufacturing operations
consist of an in-house assembly operation for the manufacture of disposable
devices and controllers. We currently produce 32 models of disposable devices
utilizing different functionalities,
including suction and fluid management. As we increase the number of product
designs for our disposable devices, the complexity of our manufacturing
processes will increase. We manufacture three different controller models.
Although the manufacturing processes for the controllers designed to date are
substantially the same, we cannot be certain that we will be able to continue
to manufacture these controllers without additional expense and capabilities.
We could also encounter difficulties in manufacturing our current or future
products which could reduce yields, result in supply disruptions and adversely
affect our gross margins. If we have delays in manufacturing, we will not have
adequate finished inventory to meet our needs. If our quality assurance
programs do not continue to meet the demands of the complexity and capacity of
the products we manufacture, we may experience product returns.
We Are Dependent on Key Suppliers
We depend on several sole source suppliers for some of our product
components, including one component that we include in substantially all of our
disposable devices. If the supply of materials from a sole source supplier were
interrupted, replacement or alternative sources might not be readily obtainable
due to the regulatory requirements applicable to our manufacturing operations.
In addition, a new or supplemental filing with applicable regulatory
authorities may require clearance prior to our marketing a product containing
new material. This clearance process may take a substantial period of time and
we cannot assure you that we would be able to obtain the necessary regulatory
approval for the new material to be used in our products on a timely basis, if
at all. This could create supply disruptions that would materially adversely
affect our business, financial condition, results of operations and future
growth prospects.
In addition, we use a single subcontractor to sterilize the disposable
devices. We cannot assure you that we can identify and qualify an alternate
sterilizer. Our inability to secure an alternative sterilizer, if required,
would limit our ability to manufacture disposable devices and could have a
material adverse effect on our business, financial condition, results of
operations and future growth prospects.
We Face Intense Competition
The markets for our current and potential products are intensely
competitive. These markets include arthroscopy, spinal surgery, ENT surgery,
cosmetic surgery, and cardiology. We cannot assure you that other companies
will not succeed in developing technologies and products that are more
effective than ours or that would render our technology or products obsolete or
uncompetitive in these markets.
In arthroscopy, we compete against companies such as Johnson & Johnson,
Smith & Nephew, Inc., Conmed Corporation, Stryker Corp. and Oratec
Interventions, Inc. which market products to remove or shrink tissue.
Specifically, Johnson & Johnson is currently marketing a bipolar
electrosurgical system for tissue ablation worldwide. We are also aware of
additional competitors that may commercialize products using technology similar
to ours. In spinal surgery, we compete against companies which market products
to remove tissue and treat spinal disorders. In ENT surgery, we compete against
companies that offer manual instruments, such as Smith & Nephew, Inc., Stryker
Corp., Conmed Corporation, and Xomed Surgical Products, Inc., which was
recently acquired by Medtronic, Inc. In addition, we compete with companies
that develop and market lasers for various ENT surgery applications, including
ESC Medical Systems Ltd. Smaller companies, including Somnus Medical
Technologies Inc., Elmed Inc. and Ellman International, Inc. also sell medical
devices for the treatment of various ENT disorders including snoring and
obstructive sleep apnea. In cosmetic surgery, we compete against companies such
as Coherent Medical Group, and ESC Medical Systems Ltd. which market lasers for
use in this field. In addition, other large companies manufacture and sell
medical devices that use radio frequency energy for certain applications in
dermatology and cosmetic surgery. In cardiology, we may
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compete with companies which use lasers to treat cardiovascular disease. Other
approaches to alleviating cardiovascular disease, including drugs or other
surgical approaches, may also be competitive.
Many of our competitors have significantly greater financial, manufacturing,
marketing, distribution and technical resources than we do. Some of these
companies offer broad product lines that they may offer as a single package and
frequently offer significant discounts as a competitive tactic. For example, in
order to compete successfully, we anticipate that we may have to continue to
offer substantial discounts on our controllers in order to increase demand for
our disposable devices, and that this competition could have a material adverse
effect on our business, financial condition, results of operations and future
growth prospects. Furthermore, some of our competitors utilize purchasing
contracts that link discounts on the purchase of one product to purchases of
other products in their broad product lines. Many of the hospitals in the
United States have purchasing contracts with our competitors. Accordingly,
customers may be dissuaded from purchasing our products rather than the
products of these competitors to the extent the purchase would cause them to
lose discounts on products.
We Face Uncertainty Over Reimbursement
Failure by physicians, hospitals and other users of our products to obtain
sufficient reimbursement from health care payors for procedures in which our
products are used or adverse changes in governmental and private third-party
payors' policies toward reimbursement for such procedures would have a material
adverse effect on our business, financial condition, results of operations and
future growth prospects. Reimbursement for arthroscopic, spinal surgery and ENT
surgery procedures performed using devices that have received FDA approval has
generally been available in the United States. Typically, cosmetic surgery
procedures are not reimbursed.
We are unable to predict what changes will be made in the reimbursement
methods used by third-party health care payors. In addition, some health care
providers are moving toward a managed care system in which providers contract
to provide comprehensive health care for a fixed cost per person. Managed care
providers are attempting to control the cost of health care by authorizing
fewer elective surgical procedures. We anticipate that in a prospective payment
system, such as the diagnosis related group system utilized by Medicare, and in
many managed care systems used by private health care payors, the cost of our
products will be incorporated into the overall cost of the procedure and that
there will be no separate, additional reimbursement for our products. We
anticipate that hospital administrators and physicians will justify the use of
our products by the apparent cost savings and clinical benefits that we believe
will be derived from the use of our products. However, we cannot assure you
that this will be the case.
If we obtain the necessary international regulatory approvals, market
acceptance of our products in international markets would be dependent, in
part, upon the availability of reimbursement within prevailing health care
payment systems. Reimbursement and health care payment systems in international
markets vary significantly by country and include both government-sponsored
health care and private insurance. We intend to seek international
reimbursement approvals, although we cannot assure you that any such approvals
will be obtained in a timely manner, if at all.
Our Business Depends on Attracting and Retaining Collaborators and Licensors
In order to successfully develop and commercialize certain products, we may
enter into other collaborative or licensing arrangements with other medical
device companies and other entities to fund and complete our research and
development activities, pre-clinical and clinical testing, manufacturing,
regulatory approval activities and to achieve successful commercialization of
future products. We have signed an exclusive, worldwide distribution agreement
with Collagen Aesthetics, Inc. for our cosmetic surgery products. We have also
entered into a license agreement under which Boston Scientific Corporation will
help develop, obtain regulatory approval for and market products based on our
Coblation technology for myocardial revascularization procedures. See the
information under the heading "Collaborative Arrangements" in the section
entitled "Business" for a discussion of these arrangements.
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Our participation in collaborative and licensing arrangements with third
parties subjects us to a number of risks. Collaborative partners typically have
significant discretion in electing whether to pursue any of the planned
activities. We cannot control the amount and timing of resources our
collaborative partners may devote to our products, and we cannot assure you
that our partners will perform their obligations as expected. Business
combinations or significant changes in a corporate partner's business strategy
may adversely affect that partner's ability to meet its obligations under the
arrangements. For example, Collagen Aesthetics, Inc. was recently acquired by
Inamed Corporation. If a collaborative partner were to terminate or breach its
agreement with us, or otherwise fail to complete its obligations in a timely
manner, our business, financial condition, results of operations and prospects
would be materially adversely affected. To the extent that we are not able to
establish further collaborative arrangements or that any or all of our existing
collaborative arrangements are terminated, we would be required to seek new
collaborative arrangements or to undertake commercialization at our own
expense, which could significantly increase our capital requirements, place
additional strain on our human resource requirements and limit the number of
products which we would be able to develop and commercialize. In addition, we
cannot assure you that our existing and future collaborative partners will not
pursue alternative technologies or develop alternative products either on their
own or in collaboration with others, including our competitors.
We cannot assure you that disputes will not arise in the future with respect
to the ownership of rights to any technology or products developed with any
collaborative partner. Lengthy negotiations with potential new collaborative
partners or disagreements between established collaborative partners and us
could lead to delays in or termination of the research, development or
commercialization of certain products or result in litigation or arbitration
that would be time consuming and expensive. Failure by any collaborative
partner to commercialize successfully any product candidate to which it has
obtained rights from us, or the decision by a collaborative partner to pursue
alternative technologies or commercialize or develop alternative products,
either on its own or in collaboration with others, could have a material
adverse effect on our business, financial condition, results of operations and
future growth prospects.
Our Operating Results Will Fluctuate
We have experienced significant operating losses since inception and, as of
July 3, 1999, we had an accumulated deficit of $25.9 million. Results of
operations may fluctuate significantly from quarter to quarter due to many
factors, including the following:
. the introduction of new product lines;
. increased penetration in existing applications;
. product returns;
. achievement of research and development milestones;
. the amount and timing of receipt and recognition of license fees;
. manufacturing or supply disruptions;
. timing of expenditures;
. absence of a backlog of orders;
. receipt of necessary regulatory approvals;
. the level of market acceptance for our products;
. timing of the receipt of orders and product shipments; and
. promotional programs for our products.
We cannot assure you that future quarterly fluctuations will not adversely
affect our business, financial condition, results of operations or future
growth prospects. Our revenues and profitability will be critically
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dependent on whether or not we can successfully continue to market our
Coblation-based technology product lines. We cannot assure you that we will
maintain or increase our revenues or level of profitability.
We May Be Unable to Effectively Protect Our Intellectual Property
Our ability to compete effectively depends in part on developing and
maintaining the proprietary aspects of our Coblation technology. We believe
that our issued patents are directed at, among other things, the core
technology used in our soft-tissue surgery systems, including both multi-
electrode and single electrode configurations of our disposable devices, as
well as the use of Coblation technology in specific surgical procedures.
We cannot assure you that the patents we have obtained, or any patents we
may obtain as a result of our pending U.S. or international patent
applications, will provide any competitive advantages for our products. We also
cannot assure you that those patents will not be successfully challenged,
invalidated or circumvented in the future. In addition, we cannot assure you
that competitors, many of which have substantial resources and have made
substantial investments in competing technologies, have not already applied for
or obtained, or will not seek to apply for and obtain, patents that will
prevent, limit or interfere with our ability to make, use and sell our products
either in the United States or in international markets. Patent applications
are maintained in secrecy for a period after filing. We may not be aware of all
of the patents and patent applications potentially adverse to our interests.
A number of medical device and other companies and universities and research
institutions have filed patent applications or have issued patents relating to
monopolar and/or bipolar electrosurgical methods and apparatus. We have
received, and we may receive in the future, notifications of potential
conflicts of existing patents, pending patent applications or challenges to the
validity of existing patents. In addition, we have become aware of, and may
become aware of in the future, patent applications and issued patents that
relate to our products and/or the surgical applications and issued patents and,
in some cases, have obtained internal and/or external opinions of counsel
regarding the relevance of certain issued patents to our products. We do not
believe that our products currently infringe any valid and enforceable claims
of the issued patents that we have reviewed. However, if third-party patents or
patent applications contain claims infringed by our technology and such claims
are ultimately determined to be valid, we may not be able to obtain licenses to
those patents at a reasonable cost, if at all, or be able to develop or obtain
alternative technology. Our inability to do either would have a material
adverse effect on our business, financial condition, results of operations and
prospects. We cannot assure you that we will not have to defend ourselves in
court against allegations of infringement of third-party patents, or that such
defense would be successful.
In addition to patents, we rely on trade secrets and proprietary know-how,
which we seek to protect, in part, through confidentiality and proprietary
information agreements. We require our key employees and consultants to execute
confidentiality agreements upon the commencement of an employment or consulting
relationship with us. These agreements generally provide that all confidential
information, developed or made known to the individual during the course of the
individual's relationship with us, is to be kept confidential and not disclosed
to third parties. These agreements also generally provide that inventions
conceived by the individual in the course of rendering services to us shall be
our exclusive property. We cannot assure you that employees will not breach
such agreements, that we would have adequate remedies for any breach or that
our trade secrets will not otherwise become known to or be independently
developed by competitors.
We May Become Subject to Patent Litigation
The medical device industry has been characterized by extensive litigation
regarding patents and other intellectual property rights, and companies in the
medical device industry have employed intellectual property litigation to gain
a competitive advantage. We cannot assure you that we will not become subject
to patent infringement claims or litigation or interference proceedings
declared by the United States Patent and
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Trademark Office, the USPTO, to determine the priority of inventions. On
February 13, 1998, we filed a lawsuit against Ethicon, Inc., Mitek Surgical
Products, a division of Ethicon, Inc., and GyneCare, Inc. alleging, among other
things, infringement of several of our patents. The parties subsequently
settled this lawsuit. Under the terms of the settlement, Ethicon, Inc. has
licensed our U.S. patents for current products in the arthroscopy and
gynecology markets. The settlement agreement also established a procedure for
resolution of certain potential intellectual property disputes in these two
markets without litigation.
Defending and prosecuting intellectual property suits, USPTO interference
proceedings and related legal and administrative proceedings are costly and
time-consuming. Further litigation may be necessary to enforce our patents, to
protect our trade secrets or know-how or to determine the enforceability, scope
and validity of the proprietary rights of others. Any litigation or
interference proceedings will be costly and will result in significant
diversion of effort by technical and management personnel. An adverse
determination in any of the litigation or interference proceedings to which we
may become a party could subject us to significant liabilities to third
parties, require us to license disputed rights from third parties or require us
to cease using such technology, which would have a material adverse effect on
our business, financial condition, results of operations and future growth
prospects. Patent and intellectual property disputes in the medical device area
have often been settled through licensing or similar arrangements, and could
include ongoing royalties. We cannot assure you that we can obtain the
necessary licenses on satisfactory terms, if at all.
The Market Price of Our Stock May Be Highly Volatile
Within the last 12 months our common stock has traded between a range of
$11.25 and $62.00 per share. The market price of our common stock could
continue to fluctuate substantially due to a variety of factors, including:
. quarterly fluctuations in results of our operations;
. our ability to successfully commercialize our products;
. announcements regarding results of regulatory approval filings, clinical
studies or other testing, technological innovations or new commercial
products by us or our competitors;
. developments concerning government regulations, proprietary rights or
public concern as to the safety of technology;
. the execution of new collaborative agreements and material changes in our
relationships with our business partners;
. market reaction to acquisitions and trends in sales, marketing, and
research and development;
. changes in earnings estimates by analysts;
. sales of common stock by existing stockholders; and
. economic and political conditions.
The market price for our common stock may also be affected by our ability to
meet analysts' expectations. Any failure to meet such expectations, even
slightly, could have an adverse effect on the market price of our common stock.
In addition, the stock market is subject to extreme price and volume
fluctuations. This volatility has had a significant effect on the market prices
of securities issued by many companies for reasons unrelated to the operating
performance of these companies. In the past, following periods of volatility in
the market price of a company's securities, securities class action litigation
has often been instituted against the company. If similar litigation were
instituted against us, it could result in substantial costs and a diversion of
our management's attention and resources, which could have an adverse effect on
our business, results of operations and financial condition. See "Price Range
of Common Stock" and "Dividend Policy."
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We Are Involved In A Number Of Legal Proceedings
We are currently involved in ongoing litigation. In June 1998, we announced
that we had entered into an exclusive worldwide marketing and distribution
agreement with Xomed Surgical Products for our products in the ENT surgery
market. On February 4, 1999, Xomed filed a complaint against us alleging breach
of contract. On February 5, 1999, we terminated this agreement. Separately, on
March 24, 1999, one of our former employees filed a complaint of action for
sexual harassment. If these legal proceedings are adversely adjudicated or
settled, they could have a material adverse effect on our financial condition,
results of operations and future growth prospects. The defense of these actions
is expensive and may divert management's attention from our core business.
We Must Obtain Governmental Clearances Or Approvals Before We Can Sell Our
Products; We Must Continue To Comply With Applicable Laws and Regulations
United States
Our products are considered medical devices and are subject to extensive
regulation in the United States. We must obtain pre-market clearance or
approval by the FDA for each of our products and indications before they can be
commercialized. FDA regulations are wide ranging and govern, among other
things:
. product design and development;
. product testing;
. product labeling;
. product storage;
. premarket clearance or approval;
. advertising and promotion; and
. product sales and distribution.
Noncompliance with applicable regulatory requirements can result in
enforcement action, which may include:
. warning letters;
. civil penalties;
. injunctions;
. recall or seizure of products;
. failure of the government to grant premarket clearance or premarket
approval; and
. criminal prosecution.
Generally, before we can introduce a new medical device into the United
States market, we must obtain FDA clearance of a 510(k) premarket notification
or approval of a pre market approval application, or PMA application. If we can
establish that our device is "substantially equivalent" to a legally marketed
Class I or Class II device, or to a Class III device for which the FDA has not
called for PMAs, we may seek clearance from the FDA to market the device by
submitting a 510(k) premarket notification. The 510(k) premarket notification
will need to be supported by appropriate data, including, in some cases,
clinical data, establishing the claim of substantial equivalence to the
satisfaction of the FDA.
We have received 510(k) clearance to market our Arthroscopic System for
surgery of the knee, shoulder, elbow, wrist, hip and ankle joints. We have
submitted requests for 510(k) clearance in the United States to market our
Spinal Surgery System. In addition, we have received 510(k) clearance to market
our Cosmetic Surgery System in general dermatology procedures. We are also
pursuing additional clearances that will allow
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us to market our cosmetic surgery products for skin resurfacing and wrinkle
reduction. We have received 510(k) clearance to market the ENT surgery system
in general head and neck surgical procedures, as well as minimally-invasive
sinus surgery. We cannot assure you that we will be able to obtain necessary
clearances or approvals to market any other products, or existing products for
new intended uses, on a timely basis, if at all. Delays in receipt or failure
to receive clearances or approvals, the loss of previously received clearances
or approvals, or failure to comply with existing or future regulatory
requirements could have a material adverse effect on our business, financial
condition, results of operations and future growth prospects.
After a device receives 510(k) clearance, any modification that could
significantly affect its safety or effectiveness, or that would constitute a
major change in the intended use of the device, requires a new 510(k)
clearance. The FDA requires each manufacturer to make this determination in the
first instance, but the FDA can review any such decision. If the FDA disagrees
with a manufacturer's decision not to seek a new 510(k) clearance, the agency
may retroactively require the manufacturer to submit a premarket notification
requiring 510(k) clearance. The FDA also can require the manufacturer to cease
marketing and/or recall the modified device until 510(k) clearance is obtained.
We have modified some of our marketed devices, but have determined that, in our
view, new 510(k) clearances are not required. No assurance can be given that
the FDA would agree with any of our decisions not to seek 510(k) clearance. If
the FDA requires us to seek 510(k) clearance for any modification, the FDA also
may require us to cease marketing and/or recall the modified device until we
obtain a new 510(k) clearance.
If we cannot establish that a proposed device is substantially equivalent to
a legally marketed device, we must seek premarket approval through submission
of a PMA application. A PMA application must be supported by extensive data,
including, in many instances, preclinical and clinical trial data, as well as
extensive literature to prove the safety and effectiveness of the device. If
necessary, we will file a PMA application for approval to sell our potential
products. The PMA process can be expensive, uncertain and lengthy. We cannot
assure you that we will be able to obtain PMA approvals on a timely basis, if
at all, and delays in receipt or failure to receive approvals, could have a
material adverse effect on our business, financial condition, results of
operations and future growth prospects.
We are also required to demonstrate and maintain compliance with Quality
System Regulations, or QSRs. The QSR incorporates the requirements of Good
Manufacturing Practices and relates to product design testing and manufacturing
quality assurance, as well as the maintenance of records and documentation. The
FDA enforces the QSR through unannounced periodic inspections. Although we
believe we are in compliance with QSR, we cannot assure you that we or our key
component suppliers are or will continue to be in compliance, will not
encounter any manufacturing difficulties, or that we or any of our
subcontractors or key component suppliers will be able to maintain compliance
with regulatory requirements. Failure to do so will have a material adverse
effect on our business, financial condition, results of operations and future
growth prospects. Additionally, we may not promote or advertise our products
for uses not within the scope of our clearances or approvals.
International
International sales of our products are subject to strict regulatory
requirements. The regulatory review process varies from country to country. We
have obtained regulatory clearance to market the Arthroscopic System in Europe,
Japan, Australia, Taiwan, Korea, Canada and Mexico, to market our cosmetic
surgery products in Europe, Australia and Canada and to market our ENT surgery
products and our spinal surgery products in Europe, but we have not obtained
any other international regulatory approvals in other international markets. We
cannot assure you that we will obtain such clearances and approvals on a timely
basis, or at all.
For European distribution, we have received ISO 9001/EN46001 certification
and the EC Certificate pursuant to the European Union Medical Device Directive
93/42/EEC, allowing us to CE mark our products after assembling appropriate
documentation. ISO 9001/EN46001 certification standards for quality operations
have been developed to ensure that companies know the standards of quality on a
worldwide basis. Failure to
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maintain the CE Mark will preclude us from selling our products in Europe. We
cannot assure you that we will be successful in maintaining certification
requirements.
We Face Product Liability Risks and May Not Be Able to Obtain Adequate
Insurance
The development, manufacture and sale of medical products involves
significant risk of product liability claims. Our current product liability
insurance coverage limits are $7.0 million per occurrence and $7.0 million in
the aggregate. We cannot assure you that such coverage limits are adequate to
protect us from any liabilities we might incur in connection with the
development, manufacture and sale of our products. In addition, we may require
increased product liability coverage as potential products are successfully
commercialized. Product liability insurance is expensive and may not be
available to us in the future on acceptable terms, if at all. We have not
received any product liability claims to date. However, a successful product
liability claim or series of claims brought against us in excess of our
insurance coverage could have a material adverse effect on our business,
financial condition, results of operations and future growth prospects.
We May Be Unable to Attract and Retain Personnel
We are dependent upon a number of key management and technical personnel.
The loss of the services of one or more key employees or consultants could have
a material adverse effect on our business, financial condition, results of
operations and future growth prospects. Our success will also depend on our
ability to attract and retain additional highly qualified management and
technical personnel. We face intense competition for qualified personnel, many
of whom are often subject to competing employment offers, and we cannot assure
you we will be able to attract and retain such personnel. Furthermore, our
scientific advisory board members are all otherwise employed on a full-time
basis. As a result, the scientific advisory board members are not available to
devote their full time or attention to our business.
Delaware Law, Provisions in Our Charter and Our Stockholder Rights Plan Could
Make the Acquisition of Our Company By Another Company More Difficult
Our stockholder rights plan and certain provisions of our certificate of
incorporation and bylaws may have the effect of making it more difficult for a
third party to acquire, or of discouraging a third party from attempting to
acquire, control of our company. This could limit the price that certain
investors might be willing to pay in the future for shares of our common stock.
Some provisions of our certificate of incorporation and bylaws allow us to
issue preferred stock without any vote or further action by the stockholders to
eliminate the right of stockholders to act by written consent without a meeting
to specify procedures for director nominations by stockholders and submission
of other proposals for consideration at stockholder meetings, and to eliminate
cumulative voting in the election of directors. Some provisions of Delaware law
applicable to us could also delay or make more difficult a merger, tender offer
or proxy contest involving us, including Section 203, which prohibits a
Delaware corporation from engaging in any business combination with any
interested stockholder for a period of three years unless certain conditions
are met. Our stockholder rights plan, the possible issuance of preferred stock,
the procedures required for director nominations and stockholder proposals and
Delaware law could have the effect of delaying, deferring or preventing a
change in control of ArthroCare, including without limitation, discouraging a
proxy contest or making more difficult the acquisition of a substantial block
of our common stock. For a description of our certificate of incorporation,
bylaws and stockholder rights plan, see "Description of Capital Stock."
Future Sales By Current Stockholders Could Cause Our Common Stock Price to
Decline
The market price of our common stock could decline as a result of sales of a
large number of shares in the market after this offering or the perception that
such sales could occur. These sales could also make it more difficult for us to
sell equity securities in the future at a time and at a price that we deem
appropriate to raise funds through future offerings of common stock.
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We Face Uncertainty With Year 2000 Compliance
We rely on computers and computer software to run our business, as do our
vendors, suppliers and customers. These computers and computer software may not
be able to properly recognize the dates commencing in the Year 2000. We have
assigned a task force to handle the significant uncertainty that exists
concerning the potential effects associated with Year 2000 compliance. The task
force has formulated and begun to implement a plan to address Year 2000
compliance including the formulation of contingency plans. To date, we have not
found a material impact that may result from the failure of our computers and
computer software or that of our vendors, suppliers, and customers to recognize
dates. We have completed an upgrade of our information technology system
including our financial system, order processing, manufacturing and inventory
system which included Year 2000 compliance. We have not yet completed the steps
to quantify the effects of noncompliance of our customers, suppliers and/or our
service providers. Our goal is to complete all phases of our review and be Year
2000 compliant by December, 1999.
Any Year 2000 compliance problem affecting us, our suppliers, our service
providers or our customers could result in a material adverse effect on our
financial condition, results of operations and future growth prospects. We
cannot assure you that further assessment of our suppliers, data processing
systems or contingency plans will address all issues of Year 2000 compliance.
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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
Some statements contained in this prospectus including, without limitation,
statements containing the words "believes," "anticipates," "expects" and words
of similar meaning, constitute "forward-looking statements" within the meaning
of the Private Securities Litigation Reform Act of 1995, or the Reform Act.
These forward-looking statements involve known and unknown risks, uncertainties
and other factors which may cause our actual results, performance or
achievements, or industry results, to be materially different from any future
results, performance or achievements expressed or implied by these forward-
looking statements. These factors include, among others:
. our inability to manage our growth and successfully launch our products
and expand in new and existing markets;
. market acceptance of, and the level of demand for, our products;
. compliance with government standards and the obtaining of necessary
approvals;
. changes in general economic and business conditions;
. changes in our business strategies; and
. other factors referenced in this prospectus.
Some of these factors are discussed in more detail elsewhere in this
prospectus, including, without limitation, under the captions "Summary," "Risk
Factors," "Management's Discussion and Analysis of Financial Condition and
Results of Operations" and "Business." Given these uncertainties, you should
not place undue reliance on forward-looking statements. We disclaim any
obligation to update any of these factors or to publicly announce the result of
any revisions to any of the forward-looking statements contained herein to
reflect future events or developments.
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USE OF PROCEEDS
The net proceeds to us from the sale of the 1,000,000 shares of common stock
offered in this sale at an assumed public offering price of $58.8 per share are
estimated to be approximately $54.8 million ($63.1 million assuming the
underwriter's over-allotment option is exercised in full), after deducting the
underwriting discounts and commissions and estimated offering expenses payable
by us.
We anticipate using the net proceeds from this offering as follows:
approximately $15.0 million for sales, marketing and development efforts
associated with the commercialization of our spinal surgery product line and
the balance to fund the development, commercialization and associated working
capital requirements of applying our Coblation technology to a broad range of
other soft-tissue markets and for corporate and other general purposes.
Although we expect to incur expenditures for the above-mentioned activities,
we have not made specific allocations of the offering proceeds. Further, we
cannot assure you that commercial introduction of the spinal surgery products
will be successfully completed or that we will not exceed current spending
expectations. Although we may use a portion of the net proceeds to acquire new
products or technologies from others as well as to continue enforcing our
patent position, we currently do not have specific plans or commitments in this
regard. The amount and timing of our expenditures may vary depending upon
numerous factors, including market acceptance of our current and future
products, the timing of regulatory actions on our products and results of
clinical trials. Pending uses such as these, we intend to invest the net
proceeds in short-term, investment-grade, interest-bearing securities.
DIVIDEND POLICY
We have never declared nor paid cash dividends on our capital stock. We
currently expect to retain our future earnings, if any, for use in the
operation and expansion of our business and do not anticipate paying any cash
dividends in the foreseeable future. Our loan and security agreement prohibits
the payment of dividends without the consent of the lender.
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PRICE RANGE OF COMMON STOCK
Our common stock has been listed on the Nasdaq National Market since
February 1996. The trading symbol for our common stock is "ARTC." The following
table sets forth, for the periods indicated, the high and low closing prices
for the common stock as reported on the Nasdaq National Market:
<TABLE>
<CAPTION>
High Low
------- -------
<S> <C> <C>
Year Ended January 3, 1998:
First Quarter............................................. $10.625 $ 5.500
Second Quarter............................................ 9.500 5.500
Third Quarter............................................. 14.750 8.625
Fourth Quarter............................................ 13.563 9.500
Year Ended January 2, 1999:
First Quarter............................................. $15.375 $10.375
Second Quarter............................................ 18.625 13.750
Third Quarter............................................. 22.250 12.000
Fourth Quarter............................................ 21.750 11.250
Year Ending January 1, 2000:
First Quarter............................................. $21.000 $13.500
Second Quarter............................................ 22.125 14.940
Third Quarter (through September 15, 1999)................ 58.875 24.310
</TABLE>
The last sale price of the common stock on the Nasdaq National Market on
September 15, 1999 was $58.88 per share. As of September 14, 1999, we had 184
stockholders of record.
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CAPITALIZATION
The following table sets forth our capitalization as of July 3, 1999 on an
actual basis and as adjusted to give effect to the estimated net proceeds from
the sale of 1,000,000 shares of common stock at an assumed offering price of
$58.88 per share, after deducting the underwriters' discounts and commissions
and estimated offering expenses.
You should read this table in conjunction with the consolidated financial
statements and the notes to those statements and other financial information
included or incorporated by reference in this prospectus. The table does not
include the 630,149 shares of common stock issuable upon exercise of stock
options outstanding as of July 3, 1999 at a weighted average exercise price of
$11.89 per share, warrants to purchase 80,000 shares of our common stock at a
purchase price of $12.00 per share and warrants to purchase 40,000 shares of
our common stock at a purchase price of $14.00 per share.
<TABLE>
<CAPTION>
At July 3, 1999
------------------
As
Actual Adjusted
-------- --------
(in thousands)
<S> <C> <C>
Capital lease obligations, less current portion............ $ 117 $ 117
-------- --------
Stockholders' equity:
Preferred stock, par value $0.001; 5,000,000 shares
authorized; none issued and outstanding actual or as
adjusted................................................ -- --
Common stock, par value $0.001; 20,000,000 shares
authorized; 9,035,886 shares issued and outstanding
actual, 10,035,886 shares issued and outstanding as
adjusted................................................ 9 10
Additional paid-in capital............................... 50,553 105,395
Accumulated other comprehensive loss..................... (80) (80)
Accumulated deficit...................................... (25,906) (25,906)
-------- --------
Total stockholders' equity............................. 24,576 79,419
-------- --------
Total capitalization................................. $ 24,693 $ 79,536
======== ========
</TABLE>
21
<PAGE>
DILUTION
Purchasers of the common stock offered hereby will experience immediate and
substantial dilution in the net tangible book value per share of their common
stock. At July 3, 1999, our net tangible book value was approximately $24.6
million, or $2.72 per share of common stock. The net tangible book value per
share is equal to our total tangible assets less total liabilities, divided by
the number of shares of common stock outstanding at July 3, 1999. After giving
effect to the sale of 1,000,000 shares at an assumed public offering price of
$58.88 per share and after deducting underwriting discounts and commissions,
our net tangible book value at July 3, 1999 would have been approximately $79.4
million, or $7.91 per share. This represents the immediate increase in pro
forma net tangible book value of $5.19 per share to existing stockholders and
an immediate dilution of $50.97 per share to new investors purchasing shares of
common stock in this offering. Dilution to new investors is determined by
subtracting pro forma net tangible book value per share of common stock after
giving effect to this offering, from the price to be paid by new investors in
this offering for a share of common stock. The following table illustrates the
per share dilution to investors in this offering:
<TABLE>
<S> <C> <C>
Assumed offering price per share............................ $58.88
Net tangible book value per share as of July 3, 1999...... $2.72
Increase per share attributable to new investors in this
offering................................................. 5.19
-----
Net tangible book value per share after this offering....... 7.91
------
Dilution per share to new investors in this offering........ $50.97
======
</TABLE>
The discussion and table above assumes no exercise of any stock options and
warrants after July 3, 1999. As of July 3, 1999 there were 630,149 shares of
common stock issuable upon exercise of options outstanding at a weighted
average exercise price of $11.89 per share, and warrants to purchase 80,000 and
40,000 shares of our common stock at purchase prices of $12.00 per share and
$14.00 per share, respectively. To the extent that any of these options or
warrants are exercised, there will be further dilution to new investors.
22
<PAGE>
SELECTED CONSOLIDATED FINANCIAL DATA
The historical statement of operations data below for the three years ended
January 2, 1999, and the balance sheet data as of January 2, 1999 and January
3, 1998 are derived from our audited consolidated financial statements, which
are included elsewhere in this prospectus. The statement of operations data for
the two years ended December 31, 1995 and the balance sheet data at December
28, 1996, December 31, 1995 and 1994 are derived from audited consolidated
financial statements not included in this prospectus. The selected financial
data as of July 3, 1999 and for the six months ended July 4, 1998 and July 3,
1999, are derived from our unaudited consolidated financial statements included
elsewhere in this prospectus. These unaudited consolidated financial statements
have been prepared on the same basis as the audited consolidated financial
statements and, in the opinion of management, include all adjustments,
consisting only of normal recurring adjustments, necessary for a fair
presentation of the operating results and financial position for such periods.
The operating results for the six months ended July 3, 1999 are not necessarily
indicative of the results to be expected for any other interim period or for
any future fiscal year. You should read this data in conjunction with
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and the consolidated financial statements and the notes to these
statements included elsewhere in this prospectus.
<TABLE>
<CAPTION>
Six Months
Year Ended Ended
------------------------------------------------------------ ----------------
December 31, December 31, December 28, January 3, January 2, July 4, July 3,
1994 1995 1996 1998 1999 1998 1999
------------ ------------ ------------ ---------- ---------- ------- -------
(in thousands, except per share data)
<S> <C> <C> <C> <C> <C> <C> <C>
Statements of Operations
Data:
Revenues:
Product sales.......... $ -- $ 218 $ 6,022 $12,796 $24,624 $10,544 $19,177
License fees and
royalties............. -- -- -- -- 3,292 2,625 2,750
------- ------- ------- ------- -------- ------- -------
Total revenues......... -- 218 6,022 12,796 27,916 13,169 21,927
Cost of product sales... -- (447) 5,242 8,495 12,368 5,995 8,186
------- ------- ------- ------- -------- ------- -------
Gross profit........... -- (229) 780 4,301 15,548 7,174 13,741
------- ------- ------- ------- -------- ------- -------
Operating expenses:
Research and
development........... 2,119 4,009 3,772 4,026 4,355 2,140 2,176
Sales and marketing.... -- 1,351 3,635 6,263 10,495 4,538 7,146
General and
administrative........ 128 1,320 2,582 3,112 3,775 1,924 3,028
Non-recurring charge
for acquired
technology............ -- 260 -- -- -- -- --
------- ------- ------- ------- -------- ------- -------
Total operating
expenses.............. 2,247 6,940 9,989 13,401 18,625 8,602 12,350
------- ------- ------- ------- -------- ------- -------
Income (loss) from
operations............. (2,247) (7,169) (9,209) (9,100) (3,077) (1,428) 1,391
Interest income and
other, net............. 126 219 1,505 1,413 937 587 215
------- ------- ------- ------- -------- ------- -------
Income (loss) before
taxes.................. (2,121) (6,950) (7,704) (7,687) (2,140) (841) 1,606
Income tax provision.... -- -- 1 1 1 -- 65
------- ------- ------- ------- -------- ------- -------
Net income (loss)...... $(2,121) $(6,950) $(7,705) $(7,688) $ (2,141) $ (841) $ 1,541
======= ======= ======= ======= ======== ======= =======
Basic net income (loss)
per common share....... $ (0.64) $ (1.82) $ (0.97) $ (0.87) $ (0.24) $ (0.09) $ 0.17
======= ======= ======= ======= ======== ======= =======
Diluted net income
(loss) per common
share.................. $ (0.64) $ (1.82) $ (0.97) $ (0.87) $ (0.24) $ (0.09) $ 0.16
======= ======= ======= ======= ======== ======= =======
Shares used in computing
basic net income (loss)
per common share....... 3,298 3,812 7,936 8,813 8,926 8,902 8,973
======= ======= ======= ======= ======== ======= =======
Shares used in computing
diluted net income
(loss) per common
share.................. 3,298 3,812 7,936 8,813 8,926 8,902 9,547
======= ======= ======= ======= ======== ======= =======
</TABLE>
<TABLE>
<CAPTION>
Dec. 31, Dec. 31, Dec. 28, Jan. 3, Jan. 2, Jul. 3,
1994 1995 1996 1998 1999 1999
-------- -------- -------- ------- ------- -------
(in thousands)
<S> <C> <C> <C> <C> <C> <C>
Balance sheet data:
Cash, cash equivalents and
available-for-sale
securities................ $2,599 $4,774 $29,281 $19,872 $8,058 $7,147
Working capital............ 2,467 5,119 23,468 20,342 16,973 17,628
Total assets............... 2,917 7,800 33,297 26,675 27,760 29,764
Capital lease obligations,
non-current............... 15 53 21 -- 151 117
Total stockholders'
equity.................... 2,727 6,325 30,782 23,546 22,305 24,576
</TABLE>
23
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITIONS AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with the consolidated
financial statements and notes thereto appearing elsewhere in this prospectus.
Statements in this Management's Discussion and Analysis of Financial Condition
and Results of Operations which express that we "believe," "anticipate,"
"expect" or "plan to" as well as other statements which are not historical
fact, are forward-looking statements within the meaning of the Private
Securities Litigation Reform Act of 1995. Actual events or results may differ
materially as a result of the risks and uncertainties described herein and
elsewhere including, but not limited to, those factors discussed in "Risk
Factors" and elsewhere in the prospectus.
Overview
We are a medical device company that develops, manufactures and markets
products based on our patented Coblation technology. Our products allow
surgeons to operate with increased precision and accuracy, limiting damage to
surrounding tissue thereby reducing pain and speeding recovery for the patient.
Our products operate at lower temperatures than traditional electrosurgical or
laser surgery tools and enable surgeons to ablate or shrink soft tissue and to
simultaneously seal bleeding vessels. Our soft-tissue surgery systems consist
of a controller unit and an assortment of disposable devices that are
specialized for specific types of surgery. We believe our Coblation technology
can replace the multiple surgical tools traditionally used in soft-tissue
surgery procedures with one multi-purpose surgical system.
Coblation technology is applicable across many soft-tissue surgical markets.
Our systems are used to perform many types of arthroscopic surgery. Our
strategy includes applying our patented Coblation technology to a broad range
of other soft-tissue markets, including cosmetic surgery, ENT surgery, spinal
surgery and various cardiology applications.
In April 1998, we announced that we had entered the cosmetic surgery market
and formed a business unit called Visage to commercialize Coblation technology
in this field. In early 1999, we entered into a license and distribution
agreement with Collagen Aesthetics, Inc. Under this agreement, Collagen
Aesthetics, Inc. acquired exclusive, worldwide, marketing rights for our
cosmetic surgery line of products for the dermatology and cosmetic surgery
markets.
In May 1998, we announced that we had entered the ear, nose and throat
market and had formed a business unit called ENTec to commercialize Coblation
technology in this field. In June 1998, we entered into a license agreement
with Xomed Surgical Products, Inc. to market Coblation products in the ear,
nose and throat market. In February 1999, Xomed filed a suit against us
alleging breach of contract and seeking monetary damages. We then terminated
this agreement and have been marketing and selling the ENT surgery product line
through a network of distributors supported by regional sales managers.
In September 1999, we announced the introduction of a new product line using
Coblation technology for spinal surgery.
In early 1998, we formed a business unit, AngioCare, for the purpose of
further developing and for commercializing our technology in specific
applications in the field of cardiology. As part of those efforts, in February
1998, we entered into a license agreement under which Boston Scientific
Corporation will help develop, obtain regulatory approval for and market
products based on Coblation technology for myocardial revascularization
procedures.
We have received 510(k) clearance to market our Arthroscopic System for use
in arthroscopic surgery of the knee, shoulder, ankle, elbow, wrist and hip, and
our Arthroscopic System is CE marked for use in arthroscopic surgery. Our
Cosmetic Surgery System is CE marked for general dermatology, skin resurfacing
and wrinkle reduction procedures and we have received 510(k) clearance for use
of our Cosmetic Surgery System in general dermatology procedures in the United
States. We are pursuing additional clearances that will
24
<PAGE>
allow our Cosmetic Surgery System to be marketed in the United States
specifically for skin resurfacing and wrinkle reduction. Our ENT surgery system
is CE marked, and we have received 510(k) clearances for use of our ENT surgery
system in general head, neck, oral and sinus surgery procedures in the United
States. Our Spinal Surgery System is CE marked and we have applied for 510(k)
clearance in the United States to market this system for spinal surgery. We
have received 510(k) clearance to market Coblation technology for general
surgery.
In December 1995, we introduced our Arthroscopic System commercially in the
United States. Our strategy includes placing controller units, at substantial
discounts, to generate future disposable revenue. Our strategy also includes
applying our patented Coblation technology to a range of other soft-tissue
surgical markets including the products we have introduced in the fields of
spinal surgery, cosmetic surgery and ear, nose and throat surgery. We have
received 510(k) clearance for use of our technology in several fields. We
cannot be sure that any of our clinical studies in other fields will lead to
510(k) applications or that the applications will be cleared by the FDA on a
timely basis, if at all. In addition, we cannot be sure that the products, if
cleared for marketing, will ever achieve commercial acceptance.
Results of Operations
The following table sets forth certain statement of operations data
expressed as a percentage of product sales for the periods indicated:
<TABLE>
<CAPTION>
Six Months
Year Ended Ended
---------------------------------- ---------------
December 28, January 3, January 2, July 4, July 3,
1996 1998 1999 1998 1999
------------ ---------- ---------- ------- -------
<S> <C> <C> <C> <C> <C>
Product sales (in thousands
of dollars)............... $6,022 $12,796 $24,624 $10,544 $19,177
As a percentage of product
sales:
Cost of product sales.... 87% 66% 50% 57% 43%
Research and
development............. 63% 31% 18% 20% 11%
Sales and marketing...... 60% 49% 43% 43% 37%
General and
administrative.......... 43% 24% 15% 18% 16%
</TABLE>
Six Months Ended July 3, 1999 and July 4, 1998
Revenues
Product sales for the six months ended July 3, 1999 were $19.2 million,
representing an 82% increase, from $10.5 million for the same period of the
prior year. The increase in product sales resulted primarily from an increase
in the sales of both controllers and disposable devices. The higher unit volume
of sales resulted primarily from increased activity for newly introduced models
of disposable devices for arthroscopy and sales of disposable devices of new
product lines.
International product sales for the six months ended July 3, 1999 increased
to 11% compared to 9% of product sales for the same period in 1998. The
increase in international sales is primarily attributable to increased sales in
the Pacific Rim, as we received regulatory approval to market arthroscopic
products in Japan, and to increased sales in Europe.
Our strategy in arthroscopy has been, and continues to be, to increase
future disposable device sales by increasing the installed base of controllers
through promotional programs. Disposable devices are consistently sold at or
near list price, except for sales to international distributors and marketing
partners, which are currently sold at discounted prices. We expect these
discounts to continue in the future. Based on the estimated number of
procedures performed each year, we believe that knee procedures represent the
largest segment of the arthroscopic market. To achieve increasing disposable
device sales in arthroscopy over time, we believe we must continue to penetrate
the market in knee procedures, expand physicians' education with respect to
Coblation technology and continue to work on new product development efforts
specifically for knee
25
<PAGE>
applications. During the second half of fiscal year 1998, we introduced new
disposable devices, including the Saber and CoVac, which are designed primarily
to be used in arthroscopic knee procedures. We expect disposable device sales
to remain the primary component of product sales in the future.
License fees and royalties increased to $2.8 million for the six months
ended July 3, 1999 from $2.6 million for the six months ended July 4, 1998. The
increase is primarily due to the timing of license fees received as the result
of settlement of a patent infringement suit initiated by us against Ethicon,
Inc. partially offset by the timing of license fees received from our business
partners in the prior year. In February 1998, we entered into a license
agreement under which Boston Scientific Corporation was granted an exclusive
right to develop and market products based on Coblation technology for
myocardial revascularization procedures. Boston Scientific Corporation pays
license fees (a portion of which will be classified as prepaid royalties) to us
upon achievement of designated milestones and royalties on sales of resulting
products, if any. During the six-month period ending July 3, 1999 we recognized
$0.3 million of such payments as license fees and royalties. We received a
license payment from Boston Scientific Corporation of $3.0 million in February
1998 of which $2.3 million was recognized as revenue during the six-month
period ended July 4, 1998. In January 1999, we entered into a license and
distribution agreement with Collagen Aesthetics, Inc., which was expanded in
February 1999, whereby Collagen Aesthetics, Inc. acquired exclusive, worldwide,
marketing rights for our patented Coblation technology in the cosmetic surgery
market. Under the terms of the agreement, Collagen Aesthetics, Inc. pays us
license fees based upon the achievement of certain milestones and royalties on
sales of product to end-users. During the six-month period ended July 3, 1999,
we recognized $1.0 million of these payments as license fees and royalties.
Cost of Product Sales
Cost of product sales for the six months ended July 3, 1999 was $8.2 million
or 43% of product sales, as compared with $6.0 million or 57% of product sales
for the same period of the prior year. The increase in cost of product sales in
absolute dollars is attributable to increasing unit sales of both controllers
and disposable devices. The decrease in cost of product sales as a percentage
of product sales is attributable to increased manufacturing efficiency and
increased production volume. In addition, we continued controller placements
under a program whereby we maintain ownership of the controller, which resulted
in the cost being capitalized and amortized over future periods rather than
expensing the entire cost at the time of placement.
We cannot be sure that cost of product sales as a percentage of product
sales will remain at current levels or show improvement in the future due to
the distribution channels used, product mix, and fluctuation in manufacturing
production levels as new products are introduced. We believe our gross margin
will depend upon the mix of disposable device sales versus controller sales
and/or placements and the various distribution channels utilized to sell our
products in all commercialized fields. There can be no assurance that we will
be successful in maintaining the mix of disposable devices to controllers or in
increasing demand for our disposable devices. In addition, production of future
products, inefficiencies in manufacturing new products and the distribution
channels utilized to sell those products may adversely impact gross margin.
Operating Expenses
Research and development expense for the six months ended July 3, 1999, and
July 4, 1998, was $2.2 million and $2.1 million, respectively. In general,
overall spending in research and development increased slightly as we continued
to develop new products. Increases in research and development expense have
been partially offset by funding received from business partners for continued
product development. We believe that investment in our Coblation technology is
essential for us to maintain our competitive position. We expect to increase
the dollar amount of research and development spending through continued
expenditures on new product development, regulatory affairs, clinical studies
and patents, but anticipate expenses to continue to decrease as a percentage of
product sales.
Sales and marketing expense for the six months ended July 3, 1999, increased
to $7.1 million or 37% of product sales from $4.5 million or 43% of product
sales for the same period of the prior year. The increase in
26
<PAGE>
spending in absolute dollars resulted primarily from higher dealer commissions
resulting from increased sales, increased staffing and increased trade-show
related expense. We also incurred additional sales and marketing expenses
during the current-year period as we expanded operations in Europe.
We anticipate that sales and marketing spending will continue to increase in
absolute dollars due to expansion of our distribution capabilities to address
the spinal surgery market, higher dealer commissions from increased sales, the
additional cost of penetrating international markets, higher promotional,
demonstration and sample expenses, and additional investments in the sales,
marketing and support staff necessary to market our current products and to
commercialize future products.
For the six months ended July 3, 1999, and July 4, 1998, general and
administrative expense increased to $3.0 million, or 16% of product sales, from
$1.9 million or 18% of product sales, respectively. Overall, the most
significant increase was attributable to legal expenses related to the patent
infringement claims we brought against Ethicon. We expect that general and
administrative expenses will decrease as a result of the recent settlement of
this litigation, offset partially by an increase in additional business
development activities.
Interest and Other Income, net
Interest and other income, net decreased to $0.2 million in the current-year
period from $0.6 million in the comparable prior year period. The decrease
resulted primarily from a decrease in interest income from investments due to
the declining balance of cash and investments.
Income Tax Provision
The provision for income taxes was $65,000 for the six-month period ended
July 3, 1999, and was zero in the prior year period. Because we use net
operating loss carryforwards generated in prior years, our tax rate is below
the statutory rate. We have federal net operating loss carryforwards which
expire in the years 2004 through 2018, and state net operating loss
carryforwards which expire in the years 2000 through 2003. We are subject to
certain alternative minimum tax requirements in the current year for which an
estimate is made based on the anticipated effective tax rate at the end of the
fiscal year.
Net Income (Loss)
For the six months ended July 3, 1999, net income increased to $1.5 million
from a net loss of $0.8 million for the same period of the prior year. Net
income for the current period reflects an increase in product sales, license
fees and gross margin partially offset by increased spending in sales and
marketing and legal expenses. Although we have experienced substantial revenue
growth since inception and have been profitable on a quarterly basis since the
quarter ended April 3, 1999, due to our short operating history and numerous
other factors, we cannot be sure that we can sustain revenue growth or
profitability.
Years Ended January 2, 1999, January 3, 1998 and December 28, 1996
Revenues
Total revenue for the year ended January 2, 1999 was $27.9 million compared
to $12.8 million for the year ended January 3,1998 and $6.0 million for the
year ended December 28, 1996. Increases year-over-year were due to higher unit
volume sales of disposable devices resulting from continued controller
placement programs and a larger installed base of controllers along with
revenues received from licensing arrangements with corporate partners.
Substantially all revenue was derived domestically and from the sale of
disposable devices during these periods. We attribute increased disposable
device sales to our strategic plan to build market share in arthroscopy through
continued promotional programs of controllers.
27
<PAGE>
We received a nonrefundable license fee payment of $3.0 million from Boston
Scientific Corporation during the first quarter of 1998 of which $2.6 million
was recognized as license fee revenue during the year. During this period we
also recognized $0.4 million of license fees from Xomed and $0.3 million of
license fees from Collagen Aesthetics, Inc.
Cost of Product Sales
Cost of product sales for the year ended January 2, 1999 was $12.4 million
or 50% of product sales, as compared to $8.5 million, or 66% of product sales
for the year ended January 3, 1998. During the year ended December 28, 1996,
cost of product sales was $5.2 million, or 87% of product sales. The $3.9
million increase in cost of product sales for the year ended January 2, 1999
over the year ended January 3, 1998 and the $7.2 million increase over the year
ended December 28, 1996 were due to increased shipments of both disposable
devices and controllers.
Cost of product sales as a percentage of product sales decreased 16
percentage points during the year ended January 2, 1999 as compared to the
previous year and 37 percentage points as compared to the year ended December
28, 1996. The overall decrease in cost of product sales as a percentage of
product sales resulted from fixed and semi-fixed costs being spread over higher
manufacturing volumes, improvements to the manufacturing process and various
controller promotional programs.
In 1997 we began manufacturing our controllers in-house. We believe that
manufacturing our controllers in-house provided a positive impact to gross
margins during the year ended January 2, 1999.
Operating Expenses
Research and development expense increased 8% to $4.4 million in 1998, from
$4.0 million in 1997, and increased 7% in 1997, from $3.8 million in 1996. The
$0.4 million and $0.2 million increases in spending between 1998 and 1997 and
between 1997 and 1996, respectively, are attributed primarily to the
development and introduction of new disposable devices, the development of
products for additional markets, patent filings and increased clinical
expenses. The increases were partially offset by a reduction of quality
assurance expenses related to research and development during the year ended
January 2, 1999, as quality assurance activities now primarily relate to
manufacturing efforts rather than research and development efforts, and to
reimbursement of expenses by our business partners for some research and
development activities.
Sales and marketing expense increased to $10.5 million or 68% in 1998, from
$6.3 million in 1997, and increased 72% in 1997 from $3.6 million in 1996. The
$4.2 million and $2.6 million increases between 1998 and 1997, and 1997 and
1996, were primarily due to higher dealer commissions resulting from increased
sales, higher staffing expenses including the establishment of a European
headquarters, and promotional and trade show expenses reflecting an increased
level of sales and marketing activity.
General and administrative expense increased to $3.8 million or 21% in 1998,
from $3.1 million during 1997, and increased 21% in 1997, as compared to $2.6
million in 1996. The $0.7 million increase for the year ended January 2, 1999
over the year ended January 3, 1998 is primarily due to expenses we incurred in
association with the patent litigation we brought against Ethicon, Inc. and
increased staffing, partially offset by the expense, in the prior year, of
attracting, recruiting and relocating our chief executive officer. The $0.5
million increase in 1997, over 1996 resulted primarily from the increased cost
of general legal service, business development activities, increased staffing,
insurance and expenses necessary to expand the corporate infrastructure.
Interest and Other Income, net
Interest income and other, net decreased for the year ended January 2, 1999
to $0.9 million from $1.4 million for the year ended January 3, 1998 and from
$1.5 million for the year ended December 28, 1996. The $0.5 million decrease in
the most recently completed period was attributable to the conversion of
investments to
28
<PAGE>
cash for use in business operations during the year resulting in a lower
balance of investment on which to earn interest income. At the end of fiscal
1998, we had $8.1 million in cash, cash equivalents, and available-for-sale
securities as compared to $19.9 million at the end of fiscal 1997 and $29.3
million at the end of fiscal 1996.
Net Loss
Net loss decreased significantly to $2.1 million for the year ended January
2, 1999, from $7.7 million for each of the years ended January 3, 1998 and
December 28, 1996. The overall decrease in net loss was primarily due to an
overall improvement in our operating position. Specifically, we experienced a
significant increase in sales with an improvement in gross margin and reduced
costs associated with research and development, sales and marketing, and
general and administrative expenses as a percentage of revenues. License
payments received from our business partners also contributed to the reduced
net loss.
Liquidity and Capital Resources
On July 3, 1999, we had $17.6 million in working capital. The principal
source of liquidity consisted of $7.1 million in cash, cash equivalents and
available-for-sale securities. The cash and cash equivalents are highly liquid
with original maturities of 90 days or less. In addition, we have a $7.0
million line of credit. Available borrowings under this line of credit are
contingent upon and collateralized by some of our asset balances and are
subject to covenants related to financial ratios and profits. Borrowings under
the line of credit bear interest at the bank's prime rate plus one-quarter of
one percentage point. At July 3, 1999, we were in compliance with these
covenants and had no outstanding borrowings.
Net cash provided by operating activities for the six months ended July 3,
1999 was $1.2 million. Cash used in operating activities for the six months
ended July 4, 1998 was $1.8 million. The increase in cash provided by operating
activities year-over-year was primarily due to the net income of $1.5 million
for 1999 compared to a net loss in 1998 of $0.8 million, and an increase in the
depreciation amounts year-over-year.
Net accounts receivable increased to $7.4 million as of July 3, 1999 from
$6.0 million as of January 2, 1999. The increase in accounts receivable is
mainly attributable to the corresponding increase in product sales offset in
part by a decrease in the overall number of days sales outstanding.
Inventories increased slightly to $7.6 million as of July 3, 1999 from $7.1
million at January 2, 1999, due to the need to support higher anticipated
product sales activity. We expect future inventory levels to grow to support
sales volume increases, as a result of our expansion into the markets of spinal
surgery, ear, nose and throat surgery and cosmetic surgery.
Net property and equipment increased to $5.7 million as of July 3, 1999 from
$4.6 million on January 2, 1999. The increase is primarily attributable to the
capitalization of controllers placed under various promotional programs along
with an increase of computer software and equipment.
Our proceeds from the sale of the 1,000,000 shares of common stock we are
offering are estimated to be $54.8 million ($63.1 million if the underwriters'
over-allotment option is exercised in full) after deducting the underwriting
discounts and commissions and our estimated offering expenses. We believe that
the proceeds from this offering, together with our current cash balances, cash
equivalents, short-term investments and cash generated from our collaborative
arrangements will be sufficient to meet our operating and capital requirements
through the end of 2000. As of July 3, 1999, we had committed to capital
expenditures of approximately $0.3 million. Our future liquidity and capital
requirements will depend on numerous factors, including our success in
commercializing our products, development and commercialization of products in
fields other than arthroscopy, the ability of our suppliers to continue to meet
our demands at current prices, obtaining and enforcing patents important to our
business, the status of regulatory approvals and competition.
As of July 3, 1999, we had federal net operating loss carryforwards of
approximately $15.0 million. The net operating loss carryforwards will expire
in the years 2004 through 2018, if not utilized.
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Year 2000
We rely on computers and computer software to run our business, as do our
vendors, suppliers and customers. These computers and computer software may not
be able to properly recognize the dates commencing in the Year 2000. We have
assigned a task force to handle the significant uncertainty that exists
concerning the potential effects associated with Year 2000 compliance. The task
force has formulated and begun to implement a plan to address Year 2000
compliance, including the formulation of contingency plans. To date, we have
not found a material impact that may result from the failure of our computers
and computer software, or that of our vendors, suppliers, and customers, to
recognize dates. We have completed an upgrade of our information technology
system, including our financial, order processing, manufacturing and inventory
systems, which included Year 2000 compliance. To date we have spent
approximately $900,000 upgrading our computer system and related technology. We
have not yet completed the steps to quantify the effects of noncompliance of
our customers, suppliers and/or our service providers. Our goal is to complete
all phases of our review and be Year 2000 compliant by December 1999.
Any Year 2000 compliance problems affecting us, our suppliers, our service
providers or our customers could result in a material adverse effect on our
financial condition and operating results. We cannot be sure that further
assessment of our suppliers, data processing systems or contingency plans will
address all issues of Year 2000 compliance.
Recent Accounting Pronouncements
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Instruments
and Hedging Activities." SFAS No. 133 establishes accounting and reporting
standards for derivative instruments, including certain derivative instruments
embedded in other contracts, and for hedging activities. It requires that an
entity recognize all derivatives as either assets or liabilities in the
statement of financial position and measure those instruments at fair value. We
must adopt this standard no later than fiscal year 2001. To date, we do not
engage in hedging activities.
Market Risk
We have an investment portfolio of fixed income securities that are
classified as "available-for-sale securities." These securities, like all fixed
income instruments, are subject to interest rate risk and will fall in value if
market interest rates increase. We attempt to limit this exposure by investing
primarily in short-term securities.
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BUSINESS
Overview
We are a medical device company that develops, manufactures and markets
products based on our patented Coblation technology. Our products allow
surgeons to operate with increased precision and accuracy, limiting damage to
surrounding tissue thereby reducing pain and speeding recovery for the patient.
Our products operate at lower temperatures than traditional electrosurgical or
laser surgery tools and enable surgeons to ablate or shrink soft tissue and to
simultaneously seal bleeding vessels. Our soft-tissue surgery systems consist
of a controller unit and an assortment of disposable devices that are
specialized for specific types of surgery. We believe our Coblation technology
can replace the multiple surgical tools traditionally used in soft-tissue
surgery procedures with one multi-purpose surgical system.
Coblation technology is applicable across many soft-tissue surgical markets.
Our systems are used to perform many types of arthroscopic surgery. Our
strategy includes applying our patented Coblation technology to a broad range
of other soft-tissue markets, including cosmetic surgery, ENT surgery, spinal
surgery and various cardiology applications.
ArthroCare Strategy
Our objective is to use our patented Coblation technology to design,
develop, manufacture and sell innovative, clinically superior surgical devices
for the arthroscopic surgical treatment of joint injuries and for the surgical
treatment of other soft-tissue conditions throughout the body. The key elements
of our strategy include:
. EXPANDING OUR PRODUCT OFFERING TO ADDRESS A LARGER NUMBER OF ARTHROSCOPIC
PROCEDURES. We are continuously expanding our portfolio of products in
arthroscopy by enhancing our existing products to serve the needs of
physicians. For example, we have increased our penetration of arthroscopy
procedures in the knee through the addition of disposable devices with
suction capability.
. EXPANDING INTO ADDITIONAL SURGICAL MARKETS. Our systems are being used to
perform many types of arthroscopic surgery and also have been cleared for
use in certain types of cosmetic surgery and ENT surgery. In addition, we
have introduced our systems for use in the spinal surgery market and
anticipate FDA clearance by the end of 1999. We are developing our
Coblation technology for use in myocardial revascularization, a
cardiology procedure, with our partner, Boston Scientific Corporation.
. EXPANDING INTERNATIONAL PRESENCE. We have established an extensive
distributor network, supported by our regional managers, in selected
international markets. We have signed agreements with several marketing
partners to assist with regulatory requirements and to market and
distribute our products internationally.
. STRUCTURING FLEXIBLE STRATEGIES TO COMMERCIALIZE OUR COBLATION
TECHNOLOGY. We have chosen to adopt a customized distribution strategy to
optimize our commercialization efforts in each of our target markets. In
arthroscopy and ENT surgery, we utilize distributor relationships
supported by focused regional managers and a small direct sales force. In
the spinal surgery market, we will leverage our existing distributors,
add new distributors focused on spinal products, and increase the number
of our direct sales managers to support these distributors. In cosmetic
surgery, we have chosen to partner with a leading cosmetic surgery
company, Collagen Aesthetics, Inc. We have chosen to partner with Boston
Scientific Corporation to further develop and to commercialize our
technology in the myocardial revascularization application of cardiology.
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Coblation Technology
Our products are based on our patented soft-tissue surgical controlled
ablation technology, which we call Coblation. Coblation technology involves an
innovative use of radio frequency energy characterized by precision, accuracy,
ease of use and the capability of performing at a temperature lower than
current traditional electrosurgical tools.
Traditional electrosurgical tools rely upon heat to burn away targeted
tissue, which often results in thermal damage to tissue surrounding the
surgical area. Additionally, the lack of tactile feedback with these devices
makes it difficult for surgeons to control the depth of tissue penetration.
Coblation technology employs a lower temperature process that minimizes the
risk of thermal burn of tissue while increasing the surgeon's control and
precision.
Coblation technology uses an electrically conductive fluid typically
employed in surgeries, in the gap between the electrode and tissue. When
electrical current is applied to this fluid, it creates a charged layer of
particles. As the layer of charged particles comes into contact with the
targeted tissue, the molecular bonds within the cells of the targeted tissue
are broken. This process causes the cells to disintegrate molecule by molecule,
so that tissue is volumetrically removed. Because this effect is confined to
the surface layer of the targeted tissue, minimal damage occurs to surrounding
tissue, potentially resulting in reduced pain and faster recovery for the
patient. An additional advantage is that Coblation can be performed in a
continuous mode, resulting in efficient tissue ablation thereby reducing the
overall procedure time as compared to conventional methods. In addition to
achieving more precise tissue ablation or shrinkage and less damage to
surrounding tissue, surgical devices based on Coblation technology can achieve
simultaneous sealing of bleeding vessels near the surgical site.
We believe Coblation technology is applicable to soft-tissue surgery
throughout the body, and we have expanded its use into several non-arthroscopic
indications. In addition, we are continually exploring possibilities for the
use of Coblation technology in other markets.
The Arthroscopy Market
In 1998, approximately 2.3 million arthroscopic procedures were performed in
the United States. Due to patient demand for less invasive procedures, we
believe the number of arthroscopic procedures is growing. In addition, a
greater emphasis on physical fitness and an aging population is increasing the
incidence of joint injuries. Joints are susceptible to injuries from blows,
falls or twisting, as well as from natural deterioration and stiffening
associated with aging.
Historically, joint injuries have been treated using open surgery involving
large incisions, a hospital stay and a prolonged recovery period. In contrast,
arthroscopic surgery, which was introduced in the early 1980s, is performed
through several small incisions called portals and can be performed on an
outpatient basis. We believe that arthroscopic surgery has gained wide market
acceptance because it offers shorter hospital stays and reduced recovery time,
resulting in reduced costs and improved medical outcomes.
To perform arthroscopic surgery, a surgeon uses a tool to visualize the site
and other tools to perform the surgery. The tool used to visualize the site,
called an arthroscope, is a small fiber-optic viewing instrument made up of a
small lens, a light source and a video camera, which allows the surgeon to view
the surgical procedure on a video monitor. During the arthroscopic procedure,
an irrigant such as saline is flushed through the joint to permit clear
visualization through the arthroscope and to create the space within the joint
for the surgical procedure. The surgeon inserts the arthroscope into the joint
through a portal measuring approximately six millimeters, or 1/4 of an inch, in
length. Other portals are used for the insertion of surgical instruments to
perform the surgery and to facilitate the flow of irrigants. With small
incision sites and direct access to most areas of the joint, a surgeon can
diagnose and correct an array of joint problems such as cartilage tears,
ligament tears and removal of loose and degenerative tissue.
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The advantages of arthroscopic surgery over open surgery are often
significant. Due to the smaller incisions and reduced surgical trauma, the
patient might experience several benefits including reduced pain; treatment on
an outpatient basis; reduced or eliminated hospitalization times; immediate
joint mobility and less muscle atrophy; less surrounding tissue damage; lower
rate of complications; and generally quicker rehabilitation. In addition,
treatment on an outpatient basis and reduced operating time can significantly
lower hospital costs.
Knee
The knee is the most commonly injured joint. In 1998, knee injuries
accounted for approximately 1.5 million arthroscopic procedures in the United
States. Damage to a meniscus, a pad of cartilage that helps cushion the knee
joint, is a common form of knee injury. A meniscus can be torn by a twist of
the leg when the knee is flexed, displaced either inward toward the center of
the shin bone or outward beyond the surface of the thighbone, or worn down by
normal aging. The knee is also susceptible to partial or complete tears of the
ligaments and degeneration of the cartilage on the underside of the kneecap. In
addition, the cartilage covering the bony surfaces of the knee can become rough
or tear loose from the bone as a result of age or injury, causing pain and
interfering with smooth joint movement.
Shoulder
The shoulder joint, because of its range of motion, is susceptible to a
number of injuries. In 1998, approximately 600,000 arthroscopic procedures in
the shoulder were performed in the United States. We believe that shoulder
arthroscopy is the fastest-growing portion of the arthroscopy market. With
repetitive motion and lifting of the arm, such as that which occurs during a
tennis serve, a bone formation of the upper arm may pinch one of the shoulder
muscles and cause persistent pain, known as a rotator cuff injury.
Strengthening exercises and physiotherapy can treat this condition; however,
many rotator cuff injuries require surgical intervention. We believe that a
significant percentage of the population is born with a susceptibility to
rotator cuff injuries.
Elbow, Ankle, Wrist and Hip
The elbow, ankle, wrist and hip joints are also susceptible to certain
stress-related injuries and deterioration due to aging. In 1998, approximately
200,000 arthroscopic procedures were performed in the elbow, ankle, wrist and
hip in the United States. We believe that the current number of surgical
procedures in the elbow, ankle, wrist and hip is relatively small due to the
limitations of conventional arthroscopic surgical equipment.
Conventional Treatment Methodologies for Arthroscopic Procedures
Most arthroscopic procedures require the surgeon to probe, cut, sculpt and
shape tissue and seal bleeding vessels to achieve satisfactory results.
Surgeons frequently use a combination of instruments when performing an
arthroscopic procedure because each instrument is designed to perform a
specific function. Use of an assortment of tools requires the surgeon to insert
and remove each of the tools from the portals several times during the same
procedure.
Surgical procedures can employ one or more of four groups of surgical
instruments: (1) power or motorized instruments, such as cartilage and bone
shavers; (2) mechanical instruments, such as basket punches, graspers and
scissors; (3) electrosurgical systems; or (4) laser systems.
Power instruments are generally used to smooth tissue and cartilage defects
on the surface of the bones of the joint. The damaged tissue is removed from
the joint using suction through a tube surrounding the shaft of the tool, which
can become obstructed by bits of tissue and bone. Power shavers have rotating
cutters inside a tube and are available in a number of tip angles or sizes for
the precise shaving of tissue. Mechanical tools must be resharpened at regular
intervals and sterilized after each procedure.
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Conventional electrosurgical systems are used to seal blood vessels, which
is necessary to minimize bleeding and maximize the arthroscopic surgeon's
visibility of the procedure through the arthroscope. Conventional
electrosurgical systems contain two electrodes: the electrode tip held by the
surgeon and a dispersive pad that rests under the patient's body. The metal
electrode tip of the instrument, which resembles a pencil point, is placed on
or near the bleeding vessel to be sealed. A generator connected to the
electrode delivers high-frequency voltage that arcs between the electrode and
the target tissue, sealing blood vessels in its vicinity. After arcing, the
current travels through the remaining tissue of the patient's body, through the
skin to the dispersive electrode pad, before being directed back to the
generator.
Laser systems are used to remove tissue while simultaneously sealing
bleeding vessels. Because laser systems are not tactile tools, the surgeon
cannot feel how much tissue is being ablated. The surgeon must be extensively
trained to precisely position the laser to control the depth of tissue
penetration to minimize unintended tissue damage. In addition, the temperature
of the laser instrument is high and, as a result, can cause damage to
surrounding tissue and vascular areas. We believe that laser tools have not
received wide acceptance because of high capital cost and significant ongoing
maintenance and operating expenses, lack of tactile feedback for the surgeon,
required training and certification, and the concern about damage that may be
caused by the significant heat generated by these devices.
The ArthroCare Arthroscopic System
Our Arthroscopic System is a radio frequency surgical device intended to
perform tissue ablation or shrinkage while simultaneously sealing bleeding
vessels. Our Arthroscopic System is comprised of an assortment of disposable
bipolar multi-electrode and single electrode devices, a connecting cable, foot
pedal or switch and a radio frequency controller. We sell our Arthroscopic
System for use in all six major joints: knee, shoulder, elbow, ankle, wrist and
hip. Many types of tissue, including cartilage and ligaments, can be ablated
using our Arthroscopic System.
Our controller delivers radio frequency energy to the disposable device.
Surgeons can use the disposable device to ablate or shrink tissue or seal
bleeding vessels. The surgeon can control the mode of operation and power
setting with the foot pedal or keys on the front panel of the controller.
Accordingly, a surgeon using the Arthroscopic System does not need to remove
and insert a variety of instruments to perform different tasks as is required
when using conventional arthroscopic instruments. Our disposable devices are
approved for sale in tip sizes ranging from 1.5 mm to 4.5 mm, and in tip angles
ranging from zero to 90 degrees. We currently sell 21 models for arthroscopy in
various tip sizes, angles and shapes, enabling the surgeon to ablate different
volumes of tissue and to reach treatment sites not readily accessible by
existing mechanical instruments and motorized cutting tools. In addition, we
also produce disposable devices which provide other functionalities, including
suction and fluid management.
We commercially introduced the Arthroscopic System in December 1995. The
list price of the controller, including the cable, is approximately $7,500. The
disposable devices have list prices ranging from approximately $115 to $195,
and typically one disposable device is used per procedure.
The Spinal Market
Chronic back pain afflicts approximately nine million people in the U.S.
Approximately one-half of those afflicted suffer from disabling pain; chronic
back pain is the most common reason for disability for persons under age 50 and
is the second leading cause of workers' absenteeism. The major causes of
persistent, often disabling, back pain are disruption of a portion of the disc,
chronic inflammation of the disc, also known as herniation, or relative
instability of the vertebral bodies surrounding a given disc, such as the
instability that often occurs due to a degenerative disease. Intervertebral
discs mainly function to cushion and tether the vertebrae, providing
flexibility and stability to the patient's spine. As discs degenerate, they
lose their water
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content and height, bringing the adjoining vertebrae closer together. This
results in a weakening of the shock absorption properties of the disc and a
narrowing of the nerve openings in the sides of the spine which may pinch these
nerves. This disc degeneration can eventually cause back and leg pain.
Often, inflammation from disc herniation can be treated successfully by non-
surgical means, such as rest, therapeutic exercise, or through the use of anti-
inflammatory medications. In some cases, the disc tissue is irreparably
damaged, thereby necessitating a discectomy, the removal of a portion of the
disc or the entire disc to eliminate the source of inflammation and pressure.
In more severe cases, the adjacent vertebral bodies must be stabilized
following excision of the disc material to avoid recurrence of the disabling
back pain. One approach to stabilizing the vertebrae, termed spinal fusion, is
to insert an interbody graft or implant into the space vacated by the
degenerative disc. In this procedure, a small amount of bone may be grafted
from other portions of the body, such as the hip, and packed into the implants.
This allows the bone to grow through and around the implant, fusing the
vertebral bodies and alleviating the pain.
Another surgical treatment for degenerative disc disease, termed
laminectomy, involves cutting away the lamina, the bony plate that connects the
bony ridges of the spine, known as pedicles. This allows the nerve tissue to
shift position to release pressure.
Until recently, spinal discectomy, laminectomy and fusion procedures
resulted in major operations and traumatic dissection of muscle and bone
removal or bone fusion. The open surgical procedures are invasive and typically
require a team of surgeons due to the length and complexity of the procedure.
Recovery time is also lengthy. To overcome the disadvantages of traditional
traumatic spinal surgery, minimally-invasive spinal surgery was developed. In
minimally-invasive spinal procedures, the spinal canal is not penetrated and
therefore bleeding with ensuing scarring is minimized or completely avoided. In
addition, the risk of instability from ligament and bone removal is generally
lower in minimally-invasive procedures than with open discectomy. Further, less
trauma during surgery often results in rapid rehabilitation and fast recovery.
We believe that approximately 1.8 million spine procedures are performed
annually worldwide, including approximately 1.2 million discectomies and about
600,000 discectomies with fusion. We also believe that spinal surgery is the
most rapidly growing segment of orthopedic surgery.
Conventional Treatment Methodologies for Treatment of Spine Diseases and
Disorders
Techniques for the treatment of spinal diseases or disorders include laser
and mechanical techniques. These procedures can be "open" or minimally invasive
depending on the complexity, and generally require the surgeon to form a
passage or operating corridor from the external surface of the patient to the
spinal disc(s) for passage of surgical instruments and implants. Typically, the
formation of this operating corridor requires the removal of soft tissue,
muscle or other types of tissue. This tissue is usually removed with mechanical
or powered instruments, such as, graspers, cutters and drills. Multiple
mechanical and powered instruments must be used and are time-intensive. In
addition, these instruments sever blood vessels within this tissue, usually
causing profuse bleeding that obstructs the surgeon's view of the target site.
Once the operating corridor is established, the nerve root is retracted and
a portion or all of the disc is removed with mechanical or powered instruments.
These instruments are typically slow and tedious, and can require up to 40
minutes to remove a single disc. In addition, these instruments, particularly
powered instruments, are not extremely precise, and it is often difficult
during the procedure to differentiate between the target disc tissue and other
structures within the spine, such as bone, cartilage, ligaments, nerves and
surrounding tissue. Thus, the surgeon must be extremely careful to minimize
damage to the cartilage and bone within the spine, and to avoid damaging
nerves.
Both lasers and monopolar radio frequency devices have been used in spinal
surgery. We believe both have significant drawbacks. Lasers are expensive and
tedious to use. Another disadvantage with lasers is the difficulty in judging
the depth of tissue ablation. Because healthy tissue, bones, ligaments and
nerves often lie within close proximity of the spinal disc, it is essential to
maintain a minimum depth of tissue penetration.
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Monopolar radio frequency devices increase the risk of unwanted electrical
stimulation to portions of the patient's body by utilizing electric current
that disperses into the patient's body.
The ArthroCare Spinal Surgery System
In September 1999, we announced our expansion into the spinal surgery
market. Our Spinal Surgery System is CE marked, and we have applied for 510(k)
clearance for use of the system in spinal surgery procedures in the United
States. We anticipate receiving this 510(k) clearance by the end of 1999, but
we cannot assure you that this will occur. Our spinal surgery products, based
on our Coblation technology, include multi-functional disposable devices
optimized for spinal surgery. The disposable products are compatible with the
controller that is used for arthroscopic and ENT surgery procedures.
Our controller is used to deliver radio frequency energy to the disposable
devices. The disposable devices are intended for single use and utilize
multiple or single electrodes to ablate tissue while simultaneously sealing
bleeding vessels. In some cases, our disposable devices may also include one or
more tubes for the delivery of electrically conductive fluid to the target site
and/or for suction capability. The incorporation of ablation, suction and fluid
management into a single disposable device potentially reduces operative time
and expense. Although we have had limited clinical experience with these
products in spinal surgery procedures, we believe physician and patient
benefits experienced in arthroscopic surgery, such as more rapid recovery time,
reduced thermal injury to tissue and reduced post-operative pain when compared
to existing techniques, could apply to spinal surgery procedures.
Our disposable devices consist of the ACCESS SpineWand and the DisCoblator.
The ACCESS SpineWand is a bipolar electrosurgical device designed for
controlled ablation of soft tissue. We believe that the ACCESS SpineWand will
be an effective tool for creating precise incisions through connective tissue
to provide access to the disc in discectomy, laminectomy and fusion procedures.
In addition, we believe that the ACCESS SpineWand may be effectively used to
remove soft tissue from bones in preparation for fusion procedures.
The DisCoblator is a bipolar electrosurgical device designed for aggressive
ablation and removal of large tissue volumes. The DisCoblator includes fluid
delivery and suction capabilities and incorporates an active screen electrode
design to inhibit clogging. We plan to initially market the DisCoblator to
volumetrically remove a portion or all of the disc during discectomy and fusion
procedures. Although there has been limited clinical experience with this
product, we believe that the DisCoblator is capable of removing a disc in
substantially less time than mechanical instruments, such as graspers or
cutters.
The Ear, Nose and Throat (ENT) Market
We believe that in 1998, approximately 1.4 million ENT procedures were
performed worldwide. Surgical procedures are commonly used to treat ear, nose
and throat disorders, including obstructive sleep apnea, snoring and other
obstructions of the sinus and nasal passages. For example, surgical approaches
for the treatment of obstructive sleep apnea include the removal of excess
tissue from the upper airway or moving the lower jaw forward to widen the
patient's airway. These procedures are performed by highly specialized
surgeons, are expensive, are extremely painful for the patient and involve
lengthy recovery periods. Non-invasive treatment approaches include continuous
positive airway pressure, or CPAP, which requires the patient to wear a nasal
mask connected to an airflow generator that forces air through the nasal
passages during sleep.
Conventional treatment methodologies for ENT surgical procedures have been
performed by lasers, endoscopes and microsurgical tools. We believe our
Coblation technology can be used in numerous types of ENT procedures.
The ArthroCare ENT Surgery System
Our ENT surgery system uses the same technology as the Arthroscopic System,
which ablates tissue through a more precise and significantly cooler process
than that of traditional electrosurgery devices. Our ENT
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surgery system is a radio frequency, electrosurgical device intended to bring
improved control and functionality to ENT surgeons. The ENT surgery system
incorporates a disposable bipolar device, a connecting cable and radio
frequency controller. The controller is used to deliver radio frequency energy
to the disposable device. The disposable device is intended for single use and
utilizes multiple or single electrodes to ablate tissue while simultaneously
sealing bleeding vessels. We believe that our products will produce improved
surgical results, reduce pain and speed recovery for the patient.
Our ENT surgery system is CE marked, and we have received 510(k) clearances
for use of the system in general head, neck and oral surgical procedures and
minimally-invasive sinus surgery in the United States. We have been marketing
the ENT surgery products through a network of distributors and regional sales
managers in the United States and internationally since February 1999.
The Cosmetic Surgery Market
The cosmetic surgery market is primarily comprised of procedures to
rejuvenate, remove or reduce wrinkles of the skin, remove scarring or lesions
and perform traditional techniques such as face lifts or brow lifts. Of the
approximately 1.6 million cosmetic surgery procedures performed annually
worldwide, approximately 325,000 were laser resurfacing procedures performed in
the United States to reduce the wrinkled appearance of skin.
Conventional Treatment Methodologies for Cosmetic Surgery
Conventional methods of skin resurfacing include chemical peels,
dermabrasions and laser resurfacing. In chemical peels, an acid-based chemical
solution is used to improve texture of the skin by removing its damaged outer
layers. In dermabrasion, surgical scraping is used to remove the skin's top
layers. Chemical peels and dermabrasions have minimal effect on wrinkles, and
can cause scarring and pigmentary changes. Lasers are often used to achieve
wrinkle reduction and removal. The conventional continuous wave carbon dioxide,
or CO\\2\\, laser has been used successfully to resurface skin. However, the
excessive heat diffusion into surrounding skin during the use of this laser
results in unwanted cell death and unacceptable rates of scarring and impaired
wound healing. The new generation of pulsed lasers has proven to be an
effective method for the treatment of surface imperfections and irregularities,
including wrinkles, pigmented spots, and acne scars. These lasers permit
precise ablation of tissue with minimal accumulation and dispersion of heat
resulting in minimal thermal damage and char.
The ArthroCare Cosmetic Surgery System
Our Cosmetic Surgery System utilizes the same technology as the Arthroscopic
System, which removes tissue through a more precise and significantly cooler
process than traditional electrosurgery systems or dermatologic lasers. Our
Cosmetic Surgery System is a radio frequency, electrosurgical device for use in
skin resurfacing and other dermatologic and cosmetic procedures. Our Cosmetic
Surgery System incorporates a disposable bipolar device, a connecting
resterilizable handpiece with cable and a radio frequency controller. This
controller design differs from the controllers used in arthroscopy, ENT surgery
and spinal surgery. The controller delivers radio frequency energy to the
multi-electrode or single electrode disposable device. Clinical trials indicate
that our Cosmetic Surgery System may enable the physician to reduce wrinkles
and improve cosmetic appearance.
Our Cosmetic Surgery System is CE marked for skin resurfacing procedures,
and we have received 510(k) clearance for use of the system in general
dermatologic procedures in the United States. We are pursuing additional
clearances, which are anticipated by the end of 1999, that will allow the
system to be marketed in the United States specifically for skin resurfacing
and wrinkle reduction. We have been conducting clinical studies for use of the
Cosmetic Surgery System for skin resurfacing and wrinkle reduction since June
1998 and included the resulting data in our application for 510(k) clearance.
In January 1999, we entered into an exclusive distribution agreement with
Collagen Aesthetics, Inc. to license, market and distribute our Coblation-based
products for cosmetic surgical procedures, typically
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performed by cosmetic surgeons, dematologists and facial plastic surgeons,
including some ENT physicians. Under the terms of the agreement, Collagen
Aesthetics, Inc. is the exclusive worldwide distributor of our Cosmetic Surgery
System. Collagen Aesthetics, Inc. was recently acquired by Inamed Corporation.
ArthroCare's Cardiology Program
We have established a program to explore the application of our Coblation
technology in various areas within cardiology. One of our programs is in
myocardial revascularization, a newly-introduced procedure for treatment of
heart disease. Lasers have been recently introduced for use in myocardial
revascularization. However, we believe that the high capital cost associated
with lasers may impede the widespread adoption of this technology.
We believe that Coblation technology could be used to perform myocardial
revascularization. We have an agreement with Boston Scientific Corporation
under which they will further develop, seek regulatory approvals for and market
our Coblation technology for use in this application.
Benefits of Our Coblation Technology
Our patented Coblation technology, delivered in the form of multi-electrode
and single electrode, bipolar disposable devices, offers a number of benefits
that we believe may provide advantages over competing surgical methods and
devices. The principal benefits include:
. EASE OF USE. Our Coblation-based soft-tissue surgery systems perform
many of the functions of mechanical tools, power tools and electrosurgery
instruments, allowing the surgeon to use a single instrument. The
lightweight device is simple to use and complements the surgeon's
existing tactile skills without the need for extensive training.
. PRECISION. In contrast to conventional tools, our Coblation-based soft-
tissue surgery systems permit surgeons to perform more precise tissue
ablation and sculpting. We believe this may result in more rapid patient
rehabilitation.
. BENEFITS TO PATIENTS. Coblation technology operates at cooler
temperatures than traditional electrosurgical tools. This can lead to
significant benefits for patients treated with Coblation-based disposable
devices due to the minimal amount of thermal injury to surrounding
tissue. As a result, we believe that patients are likely to experience
less trauma and pain following surgery and may recover more quickly.
. SIMULTANEOUS ABLATION AND SEALING OF BLEEDING VESSELS. Our Coblation-
based soft-tissue surgery systems allow for the efficient sealing of
bleeding vessels without changing tools.
. COST REDUCTION. Our Coblation soft-tissue surgery systems eliminate the
need to introduce multiple instruments to remove and sculpt tissue and
seal bleeding vessels. We believe this may reduce operating time and
thereby produce cost savings for health care providers.
Collaborative Arrangements
Collagen Aesthetics, Inc. In early 1999, we entered into a license and
distribution agreement with Collagen Aesthetics, Inc. Under this agreement,
Collagen Aesthetics, Inc. acquired exclusive, worldwide marketing rights for
our cosmetic surgery products. Collagen Aesthetics, Inc. was recently acquired
by Inamed Corporation. We will continue to perform product development,
manufacturing, and clinical and regulatory functions for our Cosmetic Surgery
System.
Boston Scientific Corporation. In February 1998, we entered into a license
and distribution agreement under which Boston Scientific Corporation will help
to develop, obtain regulatory approval for and market products based on our
Coblation technology for myocardial revascularization procedures. Under the
agreement, Boston Scientific Corporation acquired exclusive licensing rights to
our intellectual property in this field.
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Boston Scientific Corporation will pay licensing fees to us upon achievement of
designated clinical and regulatory milestones, and royalties on sales of
resulting product. Boston Scientific Corporation will perform clinical and
regulatory functions, product development and sales and marketing. We will also
focus on product development, and will manufacture devices for Boston
Scientific Corporation.
Research And Development
We have focused our research and development efforts in two areas. First, in
response to physician feedback, we are continually working on enhancements to
designs of our products to provide greater versatility in existing features and
functions. In addition, we continue to design new disposable devices that
incorporate added functionalities. Second, we are exploring new applications of
our Coblation technology in other soft-tissue surgical markets. We have
undertaken preliminary studies and development for the use of our technology in
several fields.
Marketing And Sales
The company estimates that of the 18,500 orthopedic surgeons in the United
States, approximately 80% perform arthroscopy and approximately 40% consider
arthroscopy to be their major practice area. We shipped more than 5,000
controller units and approximately 450,000 disposable devices as of July 3,
1999. We use a combination of distributors supported by regional sales
managers, a small direct sales force and corporate partners to sell our
products both domestically and internationally.
We are marketing and selling our arthroscopic and ENT surgery products in
the United States through a network of independent distributors supported by
regional sales managers and a small direct sales force. We have more than 35
distributors representing more than 225 field sales representatives in the
United States. Collagen Aesthetics, Inc. is the exclusive, worldwide
distributor for our Cosmetic Surgery System.
We are marketing and selling our Spinal Surgery System internationally and
are building our domestic distribution capabilities in this area in
anticipation of 510(k) clearance. We will utilize some of our existing
distributors, add new specialized spinal surgery product distributors, and
increase the number of our regional managers to facilitate the introduction of
this new product line.
We have established distribution capability in certain countries by means of
exclusive and non-exclusive distribution agreements with corporations,
including with Arthrex for the distribution of our arthroscopy products in
Europe, South Africa, South and Central America and Russia; Kobayashi
Pharmaceutical for the distribution of our arthroscopy products in Japan; and
Smith & Nephew, Inc. for the distribution of our arthroscopy and ENT surgery
products in New Zealand and Australia. We have also established distribution
capability through relationships with distributors in Korea, Taiwan, Canada,
Mexico, the Caribbean, the Middle East and Northern Africa.
We believe the use of our products is generally intuitive to surgeons and
does not require extensive training. We frequently conduct training seminars
and demonstrations at regional training centers and trade shows. Our partners
also conduct training activities in their areas of responsibility.
At hospitals and surgical centers where several procedures can be performed
simultaneously, the procurement of multiple controllers is required. We have
offered our controllers at substantial discounts in the past and may be
required to continue to offer such discounts to generate demand for our
disposable devices. In addition, motorized and mechanical instruments, lasers
and electrosurgery systems currently used by hospitals, surgical centers and
private physicians have become widely accepted. If physicians do not determine
that our soft-tissue surgery systems are an attractive alternative to
conventional means, our business would be materially adversely affected.
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Manufacturing and Sole Source Suppliers
Our disposable devices and controllers are currently manufactured in our
10,000 square foot manufacturing facility in Sunnyvale, California. Our
products are manufactured from several components, some of which are supplied
to us by third parties.
Most of the components we use in the manufacture of our products are
available from more than one supplier. For some components, however, there are
relatively few alternate sources of supply and the establishment of additional
or replacement suppliers for such components may not be accomplished quickly.
With respect to a few components, we rely upon single source suppliers. For
example, one sole source supplier provides us with a component used in
substantially all of our disposable devices. In addition, we use a single
subcontractor to sterilize our disposable devices. If the services of this
subcontractor were interrupted, we cannot be sure that we would be able to
identify and qualify an alternate sterilizer prior to the occurrence of any
disruption in our manufacturing process. We do not believe any such disruption
is likely since this subcontractor has several facilities from which it is able
to provide sterilization services to us. We are dependent upon these third
parties for the manufacture of our products, and our profit margins and our
ability to develop and deliver such products on a timely basis may be adversely
affected by the lack of alternative sources of supply. See "Risk Factors--We
Have Limited Manufacturing Experience" for a description of the potential
disruption in supply of our products and risks to our operations resulting from
our reliance upon single source suppliers.
Manufacture of the controllers was brought in-house in late 1997 for
purposes of maintaining process control, ensuring adequate supply, and
leveraging fixed costs. We manufacture three different controller models for
which the manufacturing process is substantially the same.
We currently manufacture 32 different versions of our disposable devices.
Due to the various attributes of our disposable devices, which include, among
other functions, fluid management and suction, the manufacturing process is
varied. In order to improve yields, we have recently converted from batch
processing of our disposable devices to a continuous manufacturing process.
We have established quality assurance systems in conformance with the FDA's
Quality System Regulation, or QSR. Our facility has received ISO 9001/EN46001
certification and is in conformance with the Medical Device Directive, or MDD,
for sale of products in Europe.
Patents And Proprietary Rights
Our ability to compete effectively depends in part on developing and
maintaining the proprietary aspects of our Coblation technology. We own 19
issued U.S. patents and 10 issued international patents. In addition, we have
more than 60 pending U.S. patent applications and over 40 international patent
applications corresponding to 20 of the U.S. filings. The initial U.S. patent
is currently set to expire in 2008, three issued patents are currently expected
to expire between 2008 and 2012 and the other 15 U.S. patents are expected to
expire between 2014 and 2016. We believe that the issued patents are directed
at, among other things, both the core technology used in our soft-tissue
surgery systems, including both multi-electrode and single electrode
configurations of our disposable devices, as well as the use of Coblation
technology in specific surgical procedures.
The issued patents are directed at, among other things, the following:,
. systems and methods for applying radio frequency energy to tissue in
the presence of electrically conductive fluid such as isotonic saline;
. disposable devices having an electrode array and a system designed to
supply current independently to individual electrodes; and
. systems and methods for employing radio frequency energy in urology,
gynecology, ENT, cosmetic surgery and cardiac procedures.
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The pending patent applications include coverage for the fundamental tissue
ablation and cutting technology as well as methods and apparatus for specific
procedures.
We cannot assure you that the patents we have obtained, or any patents that
we may obtain as a result of our U.S. or international patent applications,
will provide any competitive advantages for our products or that they will not
be successfully challenged, invalidated or circumvented in the future. In
addition, we cannot assure you that competitors, many of whom have substantial
resources and have made substantial investments in competing technologies, will
not seek to apply for and obtain patents that will prevent, limit or interfere
with our ability to make, use and sell our products either in the United States
or in international markets.
A number of other companies and universities and research institutions have
filed patent applications or have issued patents relating to monopolar and/or
bipolar electrosurgical methods and apparatus. In addition, we have become
aware of, and may become aware of in the future, patent applications and issued
patents that relate to our products and/or the surgical applications and issued
patents and, in some cases, have obtained internal and/or external opinions of
counsel regarding the relevance of certain issued patents to our products. We
do not believe that our products currently infringe any valid and enforceable
claims of the issued patents that we have reviewed. However, if third-party
patents or patent applications contain claims infringed by our technology and
such claims are ultimately determined to be valid, we cannot assure you that we
would be able to obtain licenses to those patents at a reasonable cost, if at
all, or be able to develop or obtain alternative technology. The inability to
do either would have a material adverse effect on our business, financial
condition, and results of operations and future growth prospects. We cannot
assure you that we will not have to defend ourself in court against allegations
of infringement of third-party patents.
In addition to patents, we rely on trade secrets and proprietary know-how,
which we seek to protect, in part, through confidentiality and proprietary
information agreements. We require our key employees and consultants to execute
confidentiality agreements upon the commencement of an employment or consulting
relationship with us. These agreements generally provide that all confidential
information developed or made known to the individual by us during the course
of the individual's relationship with us, is to be kept confidential and not
disclosed to third parties. These agreements also generally provide that
inventions conceived by the individual in the course of rendering services to
us shall be our exclusive property. We cannot assure you that employees will
not breach the agreements, that we would have adequate remedies for any breach
or that our trade secrets will not otherwise become known to or be
independently developed by competitors.
The medical device industry has been characterized by extensive litigation
regarding patents and other intellectual property rights, and companies in the
medical device industry have employed intellectual property litigation to gain
a competitive advantage. We cannot assure you that we will not become subject
to patent infringement claims or litigation or interference proceedings
declared by the United States Patent and Trademark Office, or USPTO, to
determine the priority of inventions. On February 13, 1998 we filed a lawsuit
against Ethicon, Inc., Mitek Surgical Products, a division of Ethicon, Inc.,
and GyneCare, Inc. alleging among other things, infringement of several of our
patents. The lawsuit has been settled. The defense and prosecution of this
lawsuit and intellectual property suits generally, USPTO interference
proceedings and related legal and administrative proceedings are both costly
and time-consuming. We believe that the lawsuit was necessary, and if others
violate our proprietary rights, further litigation may be necessary to enforce
our patents, to protect trade secrets or know-how owned by us or to determine
the enforceability, scope and validity of the proprietary rights of others. Any
litigation or interference proceedings will be costly and cause significant
diversion of effort by our technical and management personnel. An adverse
determination, other litigation or interference proceedings to which we may
become a party could subject to significant liabilities to third parties,
require disputed rights to be licensed from third parties or require us to
cease using such technology. Although patent and intellectual property disputes
in the medical device area have often been settled through licensing or similar
arrangements, costs associated with such arrangements may be substantial and
could include ongoing royalties. Furthermore, we cannot be sure that we could
obtain necessary licenses on satisfactory terms, if at all. Adverse
determinations in a judicial or administrative proceeding or failure to obtain
necessary licenses could prevent us
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from manufacturing and selling our products, which would have a material
adverse effect on our business, financial condition, results of operations, and
future growth prospects.
Competition
We believe that the principal competitive factors in the soft-tissue surgery
markets include:
. acceptance by leading physicians;
. improved patient outcomes;
. superior product quality;
. the publication of peer-reviewed clinical studies;
. product innovation;
. sales and marketing capability; and
. strong intellectual property.
Arthroscopy
We compete directly with the providers of tissue removal systems including
conventional electrosurgical systems, manual instruments, power shavers and
laser systems, in arthroscopic procedures. Smith & Nephew Endoscopy, which owns
Acufex Microsurgical, Inc. and Dyonics, Inc.; Conmed Corporation, including its
Linvatec unit; Medtronic, Inc., which owns Sofamor Danek; and Stryker Corp.
each have large shares of the market for manual instruments, power shavers and
arthroscopes.
Johnson & Johnson, including Mitek, a division of its Ethicon, Inc. unit, is
marketing a bipolar electrosurgical system developed by Gyrus Medical Ltd., a
company based in the United Kingdom. The bipolar electrosurgical system
marketed by Mitek competes directly with our tissue ablation and shrinkage
technology in arthroscopy. In addition, the Linvatec unit of Conmed Corporation
is marketing a monopolar electrosurgical tool for tissue ablation in
arthroscopy. Oratec Interventions Inc. manufactures and sells a monopolar
tissue shrinkage system that competes directly with our arthroscopic products.
The tissue shrinkage market represents a small portion of the overall market in
arthroscopy, for our products.
We believe that the Arthroscopic System, comprising the controller unit and
disposable devices, presents a competitive pricing structure compared to
alternative tools being used in arthroscopic procedures. While our disposable
devices perform many functions in one tool, most competitive disposable devices
only perform a single function. In such cases, multiple disposable or reusable
devices would be required. Laser systems have a significantly higher capital
cost than our controller and require significant ongoing maintenance and
operating expenses. We are also aware of additional competitors that may
commercialize products using technology similar to ours.
Spinal Surgery
We believe that Coblation technology will compete effectively against
conventional tissue removal technology used in spinal procedures, such as
mechanical instruments and powered instruments. We will compete with large
companies in the spinal surgery market, and are aware of several small
companies offering alternative treatments for back pain that may indirectly
compete with our products.
Ear, Nose and Throat Surgery
There are large companies, such as Smith & Nephew, Inc., Stryker Corp.,
Xomed Surgical Products, Inc., which was recently acquired by Medtronic, Inc.,
and Conmed Corporation which have shares of the market for manual and powered
instruments for minimally-invasive sinus surgery. In addition, we face
competition from
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laser companies, such as ESC Medical Systems Ltd., which develops and markets
lasers for various ENT surgery applications. We expect that competition from
these and other well-established competitors will increase as will competition
from smaller medical device companies, such as Somnus Medical Technologies,
Inc., Elmed Inc. and Ellman International, Inc. Somnus Medical Technologies,
Inc., manufactures and sells medical devices that utilize radio frequency
energy for the treatment of upper airway disorders, such as snoring and
obstructive sleep apnea. Elmed Inc. and Ellman International, Inc. both
manufacture and sell a variety of medical devices that use conventional radio
frequency energy for tissue removal, cutting and/or coagulation for the
treatment of snoring and other ENT surgery procedures.
Cosmetic Surgery
The cosmetic surgery industry includes a number of large and well
established companies that provide devices for rejuvenating skin, hair removal,
scar removal, the treatment of vascular and pigmented lesions and other
applications, including companies that manufacture and sell dermabrasion
equipment or chemical peels, and companies that manufacture and sell lasers. In
skin resurfacing, we will directly compete with much larger companies that
manufacture lasers for medical use, such as Coherent Medical Group and ESC
Medical Systems Ltd. ESC recently merged with Laser Industries, Ltd. The
combined company develops and markets lasers for a broad range of cosmetic
applications including the non-invasive treatment of varicose veins and other
benign vascular lesions, hair removal, skin rejuvenation and others. In
addition, other large companies manufacture and sell medical devices that use
radio frequency energy for certain applications in dermatology and cosmetic
surgery.
We cannot assure you that we can effectively convince surgeons and
physicians to adopt our Coblation technology in the face of competition. In
addition, we cannot be sure that these or other companies will not succeed in
developing technologies and products that are more effective than ours or that
would render our technology or products obsolete or uncompetitive. Many of
these competitors have significantly greater financial, manufacturing,
marketing, distribution and technical resources than us. We have received
510(k) clearances to market tissue ablation products to treat disorders in
other surgical fields that we may enter. These fields are intensely competitive
and we cannot assure you that these potential products would be successfully
marketed.
Third-Party Reimbursement
In the United States, health care providers, such as hospitals and
physicians, that purchase medical devices, such as our products, generally rely
on third-party payors, principally federal Medicare, state Medicaid and private
health insurance plans, to reimburse all or part of the cost of the procedure
in which the medical device is being used. Reimbursement for arthroscopic, ENT
surgery and spinal surgery procedures performed using devices that have
received FDA approval has generally been available in the United States.
Generally, cosmetic procedures are not reimbursed. In addition, some health
care providers are moving toward a managed care system in which providers
contract to provide comprehensive health care for a fixed cost per person.
Managed care providers are attempting to control the cost of health care by
authorizing fewer elective surgical procedures.
Legal Proceedings
On February 13, 1998, we filed a lawsuit against Ethicon, Inc., Mitek
Surgical Products, a division of Ethicon, Inc. and GyneCare, Inc. in the United
States District Court for the Northern District of California. We settled this
patent litigation on June 24, 1999. Under the terms of the settlement, Ethicon,
Inc. has licensed our U.S. patents in the arthroscopy and gynecology markets
and we have dismissed the legal action. Ethicon, Inc. has paid us a license fee
and will pay us ongoing royalties on sales in the United States of certain
arthroscopy and gynecology products. The settlement agreement also established
a procedure for resolution of certain potential intellectual property disputes
in these two markets without litigation.
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On February 4, 1999, Xomed Surgical Products, Inc. filed a complaint against
us in the Fourth Judicial Circuit, Duval County, Florida, alleging breach of
contract by us. In the complaint, Xomed has demanded a full refund of the
amounts paid for certain products Xomed bought from us, and for a portion of an
exclusive license fee Xomed paid pursuant to an exclusive license and
distribution agreement between Xomed and us. We terminated this license and
distribution agreement on February 5, 1999. We believe the suit is without
merit, and filed a Motion to Dismiss and Answer to the Complaint on May 3,
1999. In addition, we filed two counterclaims against Xomed for damages caused
by Xomed's failure to perform under the contract and for a certain milestone
payment owed to us by Xomed.
On March 24, 1999, one of our former employees filed a complaint of action
for sexual harassment in violation of the Fair Employment and Housing Act and
retaliation in violation of the Fair Employment and Housing Act. We filed a
response to the complaint on June 23, 1999. At the case management conference
on July 27, 1999 the parties stipulated mediation. According to the complaint,
the demand exceeds $25,000.
Government Regulation
United States
Our products are regulated in the United States as medical devices by the
FDA under the Federal Food, Drug, and Cosmetic Act, or the FDC Act, and require
premarket clearance or approval by the FDA prior to commercialization. Pursuant
to the FDC Act, the FDA regulates the research, testing, manufacture, safety,
labeling, storage, record keeping, advertising, distribution and production of
medical devices in the United States. Noncompliance with applicable
requirements can result in warning letters, fines, injunctions, civil
penalties, recall or seizure of products, total or partial suspension of
production, failure of the government to grant premarket clearance or premarket
approval for devices, and criminal prosecution. Failure to comply with the
regulatory requirements could have a material adverse effect on our business,
financial condition, results of operations and future growth prospects.
Unless an exemption applies, before a new device can be introduced into the
market in the United States, the manufacturer or distributor must obtain FDA
clearance of a 510(k) notification or approval of a PMA application. If a
medical device manufacturer or distributor can establish that a device is
"substantially equivalent" to a "predicate device," i.e. a legally marketed
Class I or Class II device, or to a preamendment Class III device (i.e. one
that was in commercial distribution before May 28, 1976) for which FDA has not
called for PMAs, the manufacturer or distributor may seek clearance from the
FDA to market the device by submitting a 510(k) notification. The 510(k)
notification will need to be supported by appropriate data establishing the
claim of substantial equivalence to the satisfaction of the FDA. The FDA
recently has been requiring a more rigorous demonstration of substantial
equivalence.
Following submission of the 510(k) notification, the manufacturer or
distributor may not place the device into commercial distribution until an
order is issued by the FDA. Currently, the FDA typically responds to the
submission of a 510(k) notification within 90 to 120 days, but it may take
significantly longer. An FDA order may declare that the device is substantially
equivalent to another legally marketed device and allow the proposed device to
be marketed in the United States. The FDA, however, may determine that the
proposed device is not substantially equivalent or require further information,
including clinical data, to make a determination regarding substantial
equivalence. Such determination or request for additional information could
delay market introduction of the products that are the subject of the 510(k)
notification. After a device receives 510(k) clearance, any modification that
could significantly affect its safety or effectiveness, or that would
constitute a major change in the intended use of the device, requires a new
510(k) clearance.
We have received 510(k) clearance to market our Arthroscopic System for
surgery of the knee, shoulder, elbow, wrist, hip and ankle joints. In addition,
we have received 510(k) clearance to market our Cosmetic Surgery System in
general dermatology procedures and are pursuing additional clearances that will
allow our Cosmetic Surgery System to be marketed in the United States
specifically for skin resurfacing wrinkle removal.
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With respect to our ENT surgery system, we have received 510(k) clearances to
market our ENT surgery system in general head, neck, oral and sinus surgical
procedures. We have applied for, but not yet received, 510(k) clearance to
market our Spinal Surgery System. We cannot assure you that we will be able to
obtain necessary clearances or approvals to market any other products on a
timely basis, if at all. Delays in receipt or failure to receive such
clearances or approvals, the loss of previously received clearances or
approvals, or failure to comply with existing or future regulatory requirements
could have a material adverse effect on our business, financial condition,
results of operations and future growth prospects.
After a device receives 510(k) clearance, any modification that could
significantly affect its safety or effectiveness, or that would constitute a
major change in the intended use of the device, requires a new 510(k)
clearance. The FDA requires each manufacturer to make this determination in the
first instance, but the FDA can review any such decision. If the FDA disagrees
with a manufacturer's decision not to seek a new 510(k) clearance, the agency
may retroactively require the manufacturer to submit a premarket notification
requiring 510(k) clearance. The FDA also can require the manufacturer to cease
marketing and/or recall the modified device until 510(k) clearance is obtained.
We have modified some of our marketed devices, but have determined that, in our
view, new 510(k) clearances are not required. No assurance can be given that
the FDA would agree with any of our decisions not to seek 510(k) clearance. If
the FDA requires us to seek 510(k) clearance for any modification, the FDA also
may require us to cease marketing and/or recall the modified device until we
obtain a new 510(k) clearance.
If a manufacturer or distributor of medical devices cannot establish that a
proposed device is substantially equivalent to a legally marketed predicate
device, the manufacturer or distributor must seek premarket approval of the
proposed device through submission of a PMA application. A PMA application must
be supported by extensive data, including, in many instances, preclinical and
clinical trial data, as well as extensive literature to prove the safety and
effectiveness of the device to the FDA's satisfaction. Following receipt of a
PMA application, if the FDA determines that the application is sufficiently
complete to permit a substantive review, the FDA will "file" the application.
Under the FDC Act, the FDA has 180 days to review a PMA application, although
the review of such an application more often occurs over a protracted time
period, and generally takes approximately two years or more from the date of
filing to complete.
The PMA application approval process can be expensive, uncertain and
lengthy. A number of devices for which premarket approval has been sought by
other companies have never been approved for marketing. The review time is
often significantly extended by the FDA, which may require more information or
clarification of information already provided in the submission. In addition,
the FDA will inspect the manufacturing facility to ensure compliance with the
FDA's QSR requirements prior to approval of an application. If granted, the
approval of the PMA application may include significant limitations on the
indicated uses for which a product may be marketed.
If necessary, we will file a PMA application with the FDA for approval to
sell our potential products commercially in the United States when we have
developed such products. We cannot assure you that we will be able to obtain
necessary PMA application approvals to market these products on a timely basis,
if at all, and delays in receipt or failure to receive these approvals, the
loss of previously received approvals, or failure to comply with existing or
future regulatory requirements could have a material adverse effect on our
business, financial condition, results of operations and future growth
prospects.
If human clinical trials of a device are required and if the device presents
a "significant risk," the manufacturer or the distributor of the device is
required to file an IDE application prior to commencing human clinical trials.
The IDE application must be supported by data, typically including the results
of animal and, possibly, mechanical testing. Sponsors of clinical trials are
permitted to sell investigational devices distributed in the course of the
study, provided such costs do not exceed recovery of the costs of manufacture,
research, development and handling. The clinical trials must be conducted under
the auspices of an independent Institutional Review Board, or IRB, established
pursuant to FDA regulations, and with appropriate informed consent of the
patient.
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We are also required to register as a medical device manufacturer with the
FDA and state agencies, such as the California Department of Health Services,
or CDHS, and to list our products with the FDA. As such, we are subject to
unannounced, periodic inspections by both the FDA and the CDHS for compliance
with the FDA's QSR requirements and other applicable regulations. These
regulations require that we maintain our documents in a prescribed manner and
follow quality assurance products with respect to manufacturing, testing and
control activities. Further, we and third party manufacturers of our products
are required to comply with various FDA requirements for design, safety,
advertising and labeling. We cannot assure you that we and our component
suppliers can avoid problems involving regulatory compliance, product recalls,
production yields, quality control and assurance.
Regulations regarding the manufacture and sale of our products are subject
to change. We cannot predict the effect, if any, that such changes might have
on our business, financial condition, results of operations and future growth
prospects.
We must comply with numerous federal, state and local laws relating to such
matters as safe working conditions, manufacturing practices, environmental
protection, fire hazard control and hazardous substance disposal. No assurance
can be given that we will not be required to incur significant costs to comply
with such laws and regulations in the future or that such laws or regulations
will not have a material adverse effect on our business, financial condition,
results of operations and future growth prospects.
International
International sales of our products are subject to strict regulatory
requirements. The regulatory review process varies from country to country. We
have obtained regulatory clearance to market the Arthroscopic System in
Australia, Europe, Japan, Canada and Mexico, to market our Cosmetic Surgery
System in Europe, Australia and Canada, to market our ENT surgery system in
Europe and to market our Spinal Surgery Systems in Europe, but have not
obtained any other international regulatory approvals permitting sales of our
products outside of the United States. We are seeking and we intend to seek
regulatory approvals in other international markets. We cannot assure you,
however, that we can obtain such approvals on a timely basis or at all.
For European distribution, we have received ISO 9001/EN46001 certification,
and the EC Certificate pursuant to the European Union Medical Device Directive
93/42/EEC, allowing us to CE Mark our products after assembling appropriate
documentation. ISO 9001/EN46001 certification standards for quality operations
have been developed to ensure that companies know, on a worldwide basis, the
standards of quality to which they will be held. The European Union has
promulgated rules requiring medical products to receive the CE Mark, an
international symbol of quality and compliance with applicable European medical
device directives. Failure to maintain the CE Mark will preclude us from
selling its products in Europe. ISO 9001/EN46001 certification in conjunction
with demonstrated performance to the medical device directive is one of the
alternatives available to meet the CE Mark requirements. We cannot assure you
that we will be successful in maintaining certification requirements.
Product Liability Risk and Insurance Coverage
The development, manufacture and sale of medical products entail significant
risk of product liability claims. Our current product liability insurance
coverage limits are $7,000,000 per occurrence and $7,000,000 in the aggregate.
We cannot assure you that such coverage limits are adequate to protect us from
any liabilities we might incur in connection with the development, manufacture
and sale of our products. In addition, we may require increased product
liability coverage as products are successfully commercialized in additional
applications. Product liability insurance is expensive and in the future may
not be available to us on acceptable terms, if at all. We have not received any
product liability claims to date. However, a successful product liability claim
or series of claims brought against us in excess of our insurance coverage
could have a material adverse effect on our business, financial condition,
results of operations and prospects.
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Employees
As of July 3, 1999, we had 229 employees of whom 143 were engaged in
manufacturing activities, 23 were engaged in research and development
activities, 30 were engaged in sales and marketing activities, 17 were engaged
in regulatory affairs and quality assurance and 16 were engaged in general and
administrative functions. No employees are covered by collective bargaining
agreements, and we believe we maintain good relations with our employees.
We are dependent upon a number of key management and technical personnel.
The loss of the services of one or more key employees or consultants could have
a material adverse effect on us. Our success will also depend on our ability to
attract and retain additional highly qualified management and technical
personnel. We face intense competition for qualified personnel, many of whom
often receive competing employment offers. We cannot assure you that we will be
able to attract and retain such personnel. Furthermore, our scientific advisory
board members are all otherwise employed on a full-time basis. As a result, the
scientific advisory board members are not available to devote their full time
or attention to our affairs.
Facilities
We lease approximately 32,000 square feet in two neighboring buildings in
Sunnyvale, California for administrative offices, general and administrative
purposes, manufacturing facilities and warehousing space. Our two leases for
these facilities will expire in February 2002. We believe that our existing
facilities are adequate for our immediate needs through 1999.
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MANAGEMENT
Directors and Officers of ArthroCare
The following table sets forth certain information concerning our directors
and executive officers:
<TABLE>
<CAPTION>
Name Age Position
---- --- --------
<S> <C> <C>
Michael A. Baker........ 40 President and Chief Executive Officer
Robert T. Hagan......... 53 Vice President, Manufacturing
Christine Hanni......... 39 Vice President, Finance and Chief Financial Officer
Bruce Prothro........... 37 Vice President, Regulatory Affairs and Quality Assurance
John R. Tighe........... 38 Vice President, Worldwide Sales and Marketing
Annette J. Campbell- 52 Director
White..................
C. Raymond Larkin, Jr... 51 Director
John S. Lewis........... 53 Director
Robert R. Momsen........ 52 Director
Hira V. Thapliyal, 50 Director
Ph.D...................
</TABLE>
Michael A. Baker has served as our President, Chief Executive Officer and a
director since July 1997. From 1989 to 1997, Mr. Baker held several positions
in planning, corporate development and senior management at Medtronic, Inc. a
multi-billion dollar medical technology company specializing in implantable and
invasive therapies. His most recent position at Medtronic, Inc., was Vice-
President, General Manager of Medtronic's Coronary Vascular Division. From 1988
to 1989, Mr. Baker was a management consultant at The Carroll Group. From 1986
to 1988, Mr. Baker was a Corporate Development Officer at American National
Bank & Trust Co. Prior to joining American National Bank & Trust Co., Mr. Baker
served in the United States Army from 1981 to 1986. Mr. Baker holds a bachelor
degree from the United States Military Academy at West Point and an M.B.A. from
the University of Chicago.
Robert T. Hagan joined our company in August 1995 as Vice President,
Manufacturing. From October 1992 to July 1995, Mr. Hagan was retired. From 1984
to September 1992, Mr. Hagan held several manufacturing oversight position with
Haemonetics Corporation, a manufacturer of blood processing equipment and
sterile disposable devices. His most recent position at Haemonetics Corporation
was Director of Advanced Manufacturing Technologies. Mr. Hagan also served as
Vice President of Manufacturing for Haemonetics and Medical and Scientific
Designs, Incorporated, a start-up reagent company. Mr. Hagan holds a B.S.
degree in Industrial Engineering from Tennessee Technological University.
Christine Hanni joined our company in January 1998 as Vice President,
Finance and Chief Financial Officer. From 1992 until 1997, Ms. Hanni first
served as Corporate Controller and then as Director of International Finance
and Sales Administration of Target Therapeutics, Inc., a leading manufacturer
of disposable medical devices for the treatment of various brain diseases.
Prior to joining Target, she held several finance and accounting positions with
Tandem Computers, Inc. including Marketing Accounting Manager. From 1983 to
1987, Ms. Hanni was an auditor for Coopers & Lybrand in San Jose, California
and Portland, Oregon. Ms. Hanni holds a B.S. degree in Accounting from Southern
Oregon University.
Bruce Prothro joined our company in October 1998 as Vice President,
Regulatory Affairs and Quality Assurance. From November 1992 to September 1998,
Mr. Prothro held various positions with KeraVision, Inc. where most recently he
served as the Director of Regulatory Affairs and Compliance. Prior to his
tenure at KeraVision, Inc. Mr. Prothro was Manager, Quality Engineering at
Advanced Cardiovascular Systems, Inc. and Manufacturing Manager at Diamon
Images, Inc. Mr. Prothro holds a B.S. degree in Chemistry from the University
of California, Berkeley.
John R. Tighe joined our company in January 1995 as the Director of Sales.
He was appointed Vice President of Worldwide Sales and Marketing in January
1999. From December 1988 to December 1994,
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<PAGE>
Mr. Tighe held various sales positions with Acufex Microsurgical, Inc., a
manufacturer of arthroscopic instruments. His most recent position at Acufex
Microsurgical, Inc. was National Sales Manager. Mr. Tighe holds a B.S. degree
in Civil Engineering from the University of Maryland.
Annette J. Campbell-White has been a director of our company since May 1993.
Since 1986, Ms. Campbell-White has been the Managing General Partner of
MedVenture Associates, a venture capital firm which invests primarily in
medical device companies. From July 1992 to July 1994, Ms. Campbell-White was a
general partner of Paragon Venture Partners II, a venture capital partnership.
Ms. Campbell-White has a B.Sc. degree in Chemical Engineering and an M.Sc.
degree in Physical Chemistry each from the University of Cape Town, South
Africa. Ms. Campbell-White serves on the board of directors of several
privately held companies.
C. Raymond Larkin, Jr. has been a director of our company since April 1996.
From 1983 to March 1998, he held various executive positions with Nellcor
Incorporated, a medical products company, for which he served as President and
Chief Executive Officer from 1989 until August 1995 when he became President
and Chief Executive Officer of Nellcor Puritan Bennett Incorporated upon the
merger of Nellcor Incorporated with Puritan-Bennett Corporation. Since July
1998, Mr. Larkin has been a principal of 3x NELL, a company which invests in
and provides consulting services to the medical device, biotechnology and
pharmaceutical industries. Mr. Larkin is also a director of Neuromedical
Systems, Inc. and Hangar Orthopedics M.D. He holds a B.S. degree from LaSalle
University.
John S. Lewis has been a director of our company since May 1993. Mr. Lewis
has been a Managing Director of Pacific Venture Group since September 1995, and
General Partner of Paragon Venture Partners since June 1983, both venture and
capital partnerships. Mr. Lewis currently serves on the board of directors of
several private companies. He holds a B.S. degree in Mechanical Engineering
from University of California at Berkeley and an M.B.A. degree from Harvard
University.
Robert R. Momsen has been a director of our company since January 1994.
Since 1982, he has been General Partner of InterWest Partners, a venture
capital firm which invests primarily in life sciences companies. Prior to 1981,
Mr. Momsen served as General Manger and Chief Financial Officer for Life
Instruments Corporation, a medical imaging company which he co-founded. Mr.
Momsen is also a director of COR Therapeutics, Inc., Coulter Pharmaceutical,
Inc., First Medical Inc., Innovasive Devices, Inc., Integ, Inc., Urologix,
Progenitor, Inc. and several private companies. Mr. Momsen holds an M.B.A.
degree from Stanford University.
Hira V. Thapliyal, Ph.D., a founder of our company, served as Chief
Technical Officer from July 1997 through October 1998 and from May 1993 to July
1997, served as President, Chief Executive Officer and has been a director of
our company since inception. From 1989 to 1993, Dr. Thapliyal was a President
and Chief Executive Officer of MicroBionics, Inc., a privately-held company
developing an in-vivo continuous blood gas monitor. In 1986, Dr. Thapliyal co-
founded Cardiovascular Imaging Systems, Inc. ("CVIS") and served as its
President until 1988. CVIS develops and markets catheters for ultrasonic
intraluminal imaging of human arteries. From 1984 to 1986, Dr. Thapliyal was
Vice-President, Engineering of Devices for Vascular Interventions, Inc. a
leader in marketing arthrectomy systems for treatment of atherosclerotic
disease. Dr. Thapliyal holds an M.S. degree in Electrical Engineering from the
University of Idaho and a Ph.D. in Materials Science & Engineering from Cornell
University.
49
<PAGE>
PRINCIPAL STOCKHOLDERS
We have described the "beneficial ownership" of our common stock in the
following tables according to the Securities and Exchange Commission's rules.
Those rules treat a stockholder as owning any shares covered by a stock option,
warrant or other convertible security that the stockholder could exercise
within 60 days after the date of this prospectus, even if they have not
actually been exercised. Such shares, however, are not deemed outstanding for
the purposes of computing the percentage ownership of each other person. Except
as described below, the stockholder listed is the only person who has the
authority to decide how to vote the shares they own, and if and when to sell
those shares, subject to community property laws where applicable.
Common Stock
The following table sets forth the beneficial ownership of our common stock
as of July 3, 1999:
. each person who is known by us to beneficially own more than five percent
of our common stock;
. each of our current directors and executive officers;
. all directors and executive officers as a group.
<TABLE>
<CAPTION>
Shares Beneficially
Owned
Prior to the Offering
----------------------
Name and Address Number (1) Percent (2)
- ---------------- ---------- -----------
<S> <C> <C>
Scudder Kemper Investments, Inc....................... 764,779 8.5%
345 Park Avenue
New York, NY 10154
Kern Capital Management LLC........................... 569,000 6.3%
114 West 47th Street, #1926
New York, NY 10036
Brown Investment Advisory & Trust Co.................. 521,705 5.8%
19 South Street
Baltimore, MD 21202-3232
Hira V. Thapliyal, Ph.D. (3).......................... 481,774 5.3%
Michael A. Baker (4).................................. 176,962 2.0%
John S. Lewis (5)..................................... 149,685 1.7%
Robert T. Hagan (6)................................... 131,838 1.5%
Annette J. Campbell-White (7)......................... 101,948 1.1%
Robert R. Momsen (8).................................. 44,662 *
Christine Hanni (9)................................... 36,578 *
John R. Tighe (10).................................... 31,260 *
C. Raymond Larkin, Jr. (11)........................... 21,458 *
Bruce Prothro......................................... -- *
All directors and executive officers as a group (10
persons)(12)......................................... 1,176,165 13.3%
</TABLE>
- --------
* Represents less than 1%.
(1) Except as otherwise indicated in the footnotes to this table and pursuant
to applicable community property laws, the persons named in the table have
sole voting and investment power with respect to all shares of Common
Stock shown as beneficially owned by them.
(2) Applicable percentage ownership is based on 9,035,886 shares of common
stock outstanding as of July 3, 1999 together with applicable options for
such stockholder. Beneficial ownership is determined in accordance with
the rules of the Securities and Exchange Commission, based on factors
including voting and investment power with respect to shares. Shares of
Common Stock subject to the options currently exercisable, or exercisable
within 60 days, are deemed outstanding for computing the percentage of
ownership of the person holding such options, but are not deemed
outstanding for computing the percentage ownership of any other person.
(3) Includes an aggregate of 200,000 shared held in trust for Dr. Thapliyal's
minor children, over which Dr. Thapliyal does not hold voting or
dispositive control, and 5,083 shares issuable to Dr. Thapliyal upon
exercise of stock options exercisable within 60 days.
(4) Consists of 20,657 shares held by Michael A. Baker, and 156,305 shares
issuable to Mr. Baker upon exercise of stock options exercisable within 60
days.
50
<PAGE>
(5) Consists of 127,560 shares held by John S. Lewis, 10,000 shares held by
John S. Lewis IRA Charles Schwab & Co. Inc., 5,000 shares which are held
by the Lewis Family Partnership, and 7,125 shares issuable to Mr. Lewis
upon exercise of stock options exercisable within 60 days.
(6) Consists of 117,881 shares held by Robert T. Hagan and Barbara Hagan as
joint tenants over which Mr. Hagan and Ms. Hagan hold voting and
dispositive control and 13,957 shares issuable to Mr. Hagan upon exercise
of stock options exercisable within 60 days.
(7) Consists of 84,823 shares held by Annette J. Campbell-White, 10,000 shares
held by Delaware Charter Guarantee & Trust Co., Cust. MedVenture Partners
fbo Annette J. Campbell-White Profit Sharing Plan and 7,125 shares
issuable upon exercise of stock options exercisable within 60 days.
(8) Consists of 37,537 shares held by Robert R. Momsen and 7,125 shares
issuable to Mr. Momsen upon exercise of stock options exercisable within
60 days.
(9) Consists of 4,391 shares held by Christine Hanni and 32,187 shares
issuable to Ms. Hanni upon exercise of stock options exercisable within 60
days.
(10) Consists of 325 shares held by John R. Tighe, and 30,935 shares issuable
to Mr. Tighe upon exercise of stock options exercisable within 60 days.
(11) Consists of 21,458 shares issuable to Mr. Larkin upon exercise of stock
options exercisable within 60 days.
(12) See footnotes (3) through (11) above.
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<PAGE>
DESCRIPTION OF CAPITAL STOCK
The following description of the material terms of our capital stock is
qualified by reference to our amended and restated certificate of incorporation
and our preferred shares rights agreement, dated as of November 14, 1996, as
amended October 2, 1998. See "Where You Can Find More Information."
Our authorized capital stock currently consists of 20,000,000 shares of
common stock, par value $0.001 per share, and 5,000,000 shares of preferred
stock, par value $0.001 per share. Each share of our common stock trades with
rights. See "--Rights Plan." As of July 3, 1999, there were outstanding
9,035,886 shares of our common stock and no shares of our Series A preferred
stock.
Common Stock
Holders of our common stock are entitled to receive dividends or
distributions that are lawfully declared by our board of directors, to have
notice of any authorized meeting of stockholders, and to one vote for each
share of our common stock on all matters which are properly submitted to a vote
of our stockholders. As a Delaware corporation, we are subject to statutory
limitations on the declaration and payment of dividends. In the event of our
liquidation or other dissolution, holders of our common stock will have the
right to a ratable portion of the assets that remain after the full payment of
amounts owed to our creditors, the payment of all our liabilities and the
aggregate liquidation preferences of any outstanding shares of our preferred
stock. The holders of our common stock have no conversion, redemption,
preemptive or cumulative voting rights. All outstanding shares of our common
stock are, and the shares of our common stock to be issued in this offering
will be, validly issued, fully paid and non-assessable.
Preferred Stock
Our charter authorizes our board of directors to issue preferred stock in
one or more series, to establish the number of shares in any series and to set
the designation and preferences of any series of preferred stock. Our board of
directors is also authorized to set the rights, qualifications, and
restrictions on each series of preferred stock.
In connection with the adoption of our stockholder rights plan, our board of
directors has designated shares of preferred stock as Series A
participating preferred stock. The Series A preferred shares purchasable upon
exercise of the rights issuable under the stockholder rights plan will not be
redeemable. Each share of Series A preferred stock will be entitled to an
aggregate dividend of 1,000 times the dividend declared per common share. If we
are liquidated, the holders of the Series A preferred shares will be entitled
to a preferential liquidation payment equal to accrued but unpaid dividends
plus 1,000 times the aggregate per share amount to be distributed with respect
to each share of our common stock. Each Series A preferred share will have
1,000 votes, voting together with the holders of our common stock, except as
required by law or the certificate of designation relating to the Series A
preferred stock. In a merger, consolidation or other transaction in which our
common stock is changed or exchanged, each Series A preferred share will be
entitled to receive 1,000 times the amount received per share of common stock.
These rights are protected by customary anti-dilution provisions. Because of
the nature of the dividend, liquidation and voting rights of the Series A
preferred shares, the value of the one one-thousandth interest in a share of
Series A preferred stock purchasable upon exercise of each Right should
approximate the value of one share of common stock.
Certain Anti-Takeover, Limited Liability and Indemnification Provisions
Delaware Anti-Takeover Law. We are a Delaware corporation subject to Section
203 of the Delaware General Corporation Law or DGCL. Under Section 203, certain
"business combinations" between a Delaware corporation whose stock generally is
publicly traded or held of record by more than 2,000 stockholders and an
"interested stockholder" are prohibited for a three-year period following the
date that such stockholder became an interested stockholder, unless (i) the
corporation has elected in its certificate of incorporation not to be governed
by Section 203 (we have not made such an election), (ii) the business
combination or the transaction
52
<PAGE>
which resulted in the stockholder becoming an interested stockholder was
approved by the board of directors of the corporation before such stockholder
became an interested stockholder, (iii) upon consummation of the transaction
that made such stockholder an interested stockholder, the interested
stockholder owned at least 85% of the voting stock of the corporation
outstanding at the commencement of the transaction (excluding voting stock
owned by directors who are also officers or held in employee benefit plans in
which the employees do not have a confidential right to tender stock held by
the plan in a tender or exchange offer) or (iv) the business combination is
approved by the board of directors of the corporation and authorized at a
meeting by two-thirds of the voting stock which the interested stockholder did
not own. The three-year prohibition also does not apply to certain business
combinations proposed by an interested stockholder following the announcement
or notification of certain extraordinary transactions involving the corporation
and a person who had not been an interested stockholder during the previous
three years or who became an interested stockholder with the approval of a
majority of the corporation's directors. The term "business combination" is
defined generally to include mergers or consolidations between a Delaware
corporation and an interested stockholder, transactions with an interested
stockholder involving the assets or stock of the corporation or its majority-
owned subsidiaries, and transactions which increase an interested stockholder's
percentage ownership of stock. The term "interested stockholder" is defined
generally as those stockholders who become beneficial owners of 15% or more of
a Delaware corporation's voting stock, together with the affiliates or
associates of that stockholder.
Limitation of Officer and Director Liability and Indemnification
Arrangements. Our certificate of incorporation provides that an officer or
director of ours will not be personally liable to us or our stockholders for
monetary damages for any breach of his or her fiduciary duty as an officer or
director, except in certain cases where liability is mandated by the DGCL. The
provision has no effect on any non-monetary remedies that may be available to
us or our stockholders, nor does it relieve us or our officers or directors
from compliance with federal or state securities laws. The certificate of
incorporation also generally provides that we shall indemnify, to the fullest
extent permitted by law, any person who was or is a party or is threatened to
be made a party to any threatened, pending or completed action, suit,
investigation, administrative hearing or any other proceeding by reason of the
fact that he or she is or was a director or officer of ours, or is or was
serving at our request as a director, officer, employee or agent of another
entity, against expenses incurred by him in connection with such proceeding. An
officer or director shall not be entitled to indemnification by us if (i) the
officer or director did not act in good faith and in a manner reasonably
believed to be in, or not opposed to, our best interests, or (ii) with respect
to any criminal action or proceeding, the officer or director had reasonable
cause to believe his conduct was unlawful.
Transfer Agent and Registrar
The transfer agent and registrar for our common stock is Norwest Bank
Minnesota, N.A.
Stockholder Rights Plan
Our board of directors has adopted a stockholder rights plan. The
stockholder rights plan provides for a dividend distribution of one right on
each outstanding share of common stock. Each right entitles stockholders to buy
1/1000th of a share of our Series A participating preferred stock at an
exercise price of $50.00. The rights will become exercisable following the
tenth day after a person or group announces acquisition of 15 percent or more
of our common stock, or announces commencement of a tender offer, the
consummation of which would result in ownership by the person or group of 15
percent or more of our common stock. We will be entitled to redeem the rights
at $0.01 per right at any time on or before the tenth day following acquisition
by a person or group of 15 percent or more of our common stock.
The stockholder rights plan is designed to assure that our stockholders
receive fair and equal treatment in the event of any proposed takeover of
ArthroCare and to guard against partial tender offers and other abusive tactics
to gain control of ArthroCare without paying all stockholders the fair value of
their shares, including a control premium. We believe that the stockholder
rights plan will permit us to develop our business and foster our long-term
growth without disruptions caused by the threat of a takeover not deemed by our
board to be in
53
<PAGE>
our stockholder's best interests. Generally, the stockholder rights plan will
encourage any potential acquirer to negotiate directly with our board. As a
result, the stockholder rights plan may have the effect of deterring third
parties from making proposals involving an acquisition or change of control of
ArthroCare, although such proposals, if made, might be considered desirable and
beneficial by a majority of our stockholders. The stockholders rights plan
could have the further anti-takeover effect of making it more difficult for
third parties to acquire a majority of our common stock or to cause the
replacement of our board of directors.
54
<PAGE>
UNDERWRITING
The underwriters named below, acting through their representatives,
BancBoston Robertson Stephens, Inc. and Bear, Stearns & Co. Inc. have severally
agreed with us, subject to the terms and conditions of the underwriting
agreement, to purchase from us the number of shares of common stock set forth
below opposite their respective names. The underwriters are committed to
purchase and pay for all shares if any are purchased.
<TABLE>
<CAPTION>
Number of
Underwriter Shares
----------- ---------
<S> <C>
BancBoston Robertson Stephens Inc. ................................
Bear, Stearns & Co. Inc............................................
---------
Total............................................................ 1,000,000
=========
</TABLE>
The representatives have advised us that the underwriters propose to offer
the shares of common stock to the public at the public offering price set forth
on the cover page of this prospectus and to certain dealers at that price less
a concession of not in excess of $ per share, of which $ may be
reallowed to other dealers. After this offering, the public offering price,
concession and reallowance to dealers may be reduced by the representatives. No
such reduction shall change the amount of proceeds to be received by us as set
forth on the cover page of this prospectus. The common stock is offered by the
underwriters as stated herein, subject to receipt and acceptance by them and
subject to their right to reject any order in whole or in part.
The underwriters do not intend to confirm sales to any accounts over which
they exercise discretionary authority.
Over-Allotment Option
We have granted to the underwriters an option, exercisable during the 30-day
period after the date of this prospectus, to purchase up to 150,000 shares of
common stock at the same price per share as will be paid for the 1,000,000
shares that the underwriters have agreed to purchase. If the underwriters
exercise their over-allotment option to purchase any of the additional 150,000
shares of common stock, the underwriters have severally agreed, subject to
certain conditions, to purchase approximately the same percentage thereof as
the number of shares to be purchased by each of them bears to the total number
of shares of common stock offered in this offering. If purchased, these
additional shares will be sold by the underwriters on the same terms as those
on which the shares offered hereby are being sold. We will be obligated,
pursuant to the over-allotment option, to sell shares to the underwriters to
the extent the over-allotment option is exercised. The underwriters may
exercise the over-allotment option only to cover over-allotments made in
connection with the sale of the shares of common stock offered in this
offering.
The following table summarizes the compensation to be paid to the
underwriters by us:
<TABLE>
<CAPTION>
Total
-------------------------
Without With
Per Over- Over-
Share allotment allotment
----- --------- ---------
<S> <C> <C> <C>
Underwriting Discounts and Commissions payable by
us................................................. $ $ $
</TABLE>
We estimate expenses payable by us in connection with this offering, other
than the underwriting discounts and commissions referred to above, will be
approximately $500,000.
Indemnity
The underwriting agreement contains covenants of indemnity among the
underwriters and us against certain civil liabilities, including liabilities
under the Securities Act, and liabilities arising from breaches of
representations and warranties contained in the underwriting agreement.
55
<PAGE>
Lock-Up Agreements
Each of our executive officers and directors have agreed, during the period
of 90 days after the effective date of this prospectus, subject to specified
exceptions, not to offer to sell, contract to sell, or otherwise sell, dispose
of, loan, pledge or grant any rights with respect to any shares of common
stock, any options or warrants to purchase any shares of common stock, or any
securities convertible into or exchangeable for shares of common stock now
owned as of the date of this prospectus or thereafter acquired directly by
those holders or with respect to which they have or thereafter acquire the
power of disposition, without the prior written consent of BancBoston Robertson
Stephens Inc. However, BancBoston Robertson Stephens Inc. may, in its sole
discretion and at any time or from time to time, without notice, release all or
any portion of the securities subject to lock-up agreements.
In addition, we have agreed that during the lock-up period we will not,
without the prior written consent of BancBoston Robertson Stephens Inc.,
subject to certain exceptions, consent to the disposition of any shares held by
stockholders subject to lock-up agreements prior to the expiration of the lock-
up period, or issue, sell, or otherwise dispose of, any shares of common stock,
any options or warrants to purchase any shares of common stock or any
securities convertible into, exercisable for or exchangeable for shares of
common stock other than our sale of shares in this offering, the issuance of
our common stock upon the exercise of outstanding options or warrants, and the
issuance of options under existing stock option and incentive plans provided
that those options do not vest prior to the expiration of the lock-up period.
Stabilization
The representatives have advised us that, pursuant to Regulation M under the
Securities Act of 1933, some persons participating in the offering may engage
in transactions, including stabilizing bids, syndicate covering transactions or
the imposition of penalty bids, that may have the effect of stabilizing or
maintaining the market price of the shares of common stock at a level above
that which might otherwise prevail in the open market. A "stabilizing bid" is a
bid for or the purchase of shares of common stock on behalf of the underwriters
for the purpose of fixing or maintaining the price of the common stock. A
"syndicate covering transaction" is the bid for or purchase of common stock on
behalf of the underwriters to reduce a short position incurred by the
underwriters in connection with the offering. A "penalty bid" is an arrangement
permitting the representatives to reclaim the selling concession otherwise
accruing to an underwriter or syndicate member in connection with the offering
if the common stock originally sold by such underwriter or syndicate member
purchased by the representatives in a syndicate covering transaction and has
therefore not been effectively placed by such underwriter or syndicate member.
The representatives have advised us that such transactions may be effected on
the Nasdaq National Market or otherwise and, if commenced, may be discontinued
at any time.
Passive Market Making
In connection with this offering and before the commencement of offers or
sales of the common stock, certain underwriters who are qualified market makers
on the Nasdaq National Market may engage in passive market making transactions
in the common stock on the Nasdaq National Market in accordance with Rule 103
of Regulation M under the Exchange Act, during the business day prior to the
pricing of the offering. Passive market makers must comply with applicable
volume and price limitations and must be identified as such. In general, a
passive market maker must display its bid at a price not in excess of the
highest independent bid for such security; if all independent bids are lowered
below the passive market maker's bid, however, such bid must then be lowered
when certain purchase limits are exceeded.
56
<PAGE>
LEGAL MATTERS
The validity of the common stock being offered will be passed upon for us by
Latham & Watkins, Menlo Park, California. Wilson, Sonsini Goodrich & Rosati,
Palo Alto, California, has acted as counsel for the underwriters in connection
with this offering.
EXPERTS
Our consolidated financial statements as of January 3, 1998 and January 2,
1999 and for each of the three years ended January 2, 1999 included and
incorporated by reference in this prospectus have been so included in this
prospectus in reliance on the report of PricewaterhouseCoopers LLP, independent
accountants, given on their authority as experts in accounting and auditing.
57
<PAGE>
WHERE YOU CAN FIND MORE INFORMATION
Available Information
We file annual, quarterly and special reports, as well as registration and
proxy statements and other information with the Securities and Exchange
Commission. You may read and copy any document filed by with the Securities and
Exchange Commission by us, including this registration statement on Form S-3
and exhibits, at the Public Reference Room at 450 Fifth Street, N.W.,
Washington, D.C. 20549 or at the Securities and Exchange Commission's Regional
Offices located at 7 World Trade Center, Suite 1300, New York, New York 10048
and at Citicorp Center, 500 West Madison Street, Suite 1400, Chicago, Illinois
60661. You can get further information from the Securities and Exchange
Commission's Public Reference Room by calling 1-800-SEC-0330. The SEC also
maintains a website at http://www.sec.gov which contains our reports,
registration statements and other information regarding registrants like us
that file electronically with the Securities and Exchange Commission.
This prospectus is part of a registration statement on Form S-3 filed by us
with the Securities and Exchange Commission under the Securities Act of 1933
with respect to this offering of common stock. As permitted by the Securities
and Exchange Commission, this prospectus, which constitutes part of the
registration statement on Form S-3, does not contain all of the information in
the registration statement filed with the Securities and Exchange Commission .
For a fuller understanding of this offering, you can look at the complete
registration statement on Form S-3 which may be obtained from the locations
described above.
Incorporation by Reference
The Securities and Exchange Commission allows us to "incorporate by
reference" the information we have filed with the Securities and Exchange
Commission, which means that we can disclose important information to you by
referring you to documents we filed with the Securities and Exchange
Commission. We incorporate by reference the documents listed below, and all
documents subsequently filed by us with the Securities and Exchange Commission
under Sections 13(a), 13(c), 14 or 15(d) of the Securities Exchange Act of 1934
after the date of the initial registration statement and prior to effectiveness
of the registration statement. The information we incorporate by reference is
part of this prospectus, and any later information that we file with the
Securities and Exchange Commission will automatically update and supersede this
information.
The documents we incorporate by reference are:
1. Our Annual Report on Form 10-K and related 10-K/A for the fiscal year
ended January 2, 1999;
2. Our Quarterly Report on Form 10-Q for the quarter ended April 4, 1999;
3. Our Quarterly Report on Form 10-Q for the quarter ended July 3, 1999;
4. Our Proxy Statement for our 1999 Annual Meeting of Stockholders; and
5. The description of our common stock set forth in our registration
statement on Form 8-A filed with the Securities and Exchange Commission
on January 11, 1996.
You can obtain the documents incorporated by reference from us without
charge, excluding all exhibits except those that have been specifically
incorporated by reference in this prospectus. You may obtain documents
incorporated by reference by requesting them in writing or by telephone from
ArthroCare Corporation, 595 North Pastoria Avenue, Sunnyvale, California 94086
(telephone 408/736-0224); attention: Investor Relations. Our internet address
is www.arthrocare.com.
58
<PAGE>
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<S> <C>
Report of Independent Accountants.......................................... F-2
Consolidated Balance Sheets................................................ F-3
Consolidated Statements of Operations...................................... F-4
Consolidated Statements of Stockholders' Equity............................ F-5
Consolidated Statements of Cash Flows...................................... F-6
Notes to Consolidated Financial Statements................................. F-7
Unaudited Condensed Consolidated Balance Sheets............................ F-17
Unaudited Condensed Consolidated Statements of Operations.................. F-18
Unaudited Condensed Consolidated Statements of Cash Flows.................. F-19
Notes to Unaudited Condensed Consolidated Financial Statements............. F-20
</TABLE>
F-1
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders
ArthroCare Corporation:
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations, of stockholders' equity and of cash
flows present fairly, in all material respects, the financial position of
ArthroCare Corporation and its subsidiaries (the "company") at January 3, 1998,
and January 2, 1999, and the results of their operations and their cash flows
for each of the three years in the period ended January 2, 1999, in conformity
with generally accepted accounting principles. These consolidated 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 of these statements in accordance with
generally accepted auditing standards, which require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for the
opinion expressed above.
PricewaterhouseCoopers LLP
San Jose, California
January 27, 1999
F-2
<PAGE>
ARTHROCARE CORPORATION
CONSOLIDATED BALANCE SHEETS
(in thousands, except per share amounts)
<TABLE>
<CAPTION>
January 3, January 2,
1998 1999
---------- ----------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents.............................. $ 8,188 $ 2,826
Available-for-sale securities.......................... 10,674 5,232
Accounts receivable, net of allowances of $594 in 1997
and $469 in 1998 ..................................... 2,223 5,972
Inventories............................................ 2,019 7,069
Prepaid expenses and other current assets.............. 210 1,038
-------- --------
Total current assets................................. 23,314 22,137
Available-for-sale securities............................ 1,010 --
Property and equipment, net.............................. 1,412 4,560
Related party receivables................................ 876 723
Other assets............................................. 63 340
-------- --------
Total assets......................................... $ 26,675 $ 27,760
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable....................................... $ 968 $ 1,797
Accrued liabilities.................................... 672 1,734
Accrued compensation................................... 1,315 1,056
Deferred revenue....................................... -- 517
Capital lease obligations, current portion............. 17 60
-------- --------
Total current liabilities............................ 2,972 5,164
Capital lease obligations, less current portion.......... -- 151
Deferred rent............................................ 157 140
-------- --------
Total liabilities.................................... 3,129 5,455
-------- --------
Commitments and contingencies (Note 5 and Note 14)
Preferred stock, par value $0.001:
Authorized: 5,000 shares;
Issued and outstanding: 0 shares in 1997 and 1998...... -- --
Common stock, par value $0.001:
Authorized: 20,000 shares;
Issued and outstanding: 8,869 shares in 1997 and 8,972
shares in 1998 ....................................... 9 9
Additional paid-in capital............................... 49,153 49,901
Notes receivable from stockholders....................... (92) (51)
Deferred compensation.................................... (228) (68)
Accumulated other comprehensive income (loss)............ 10 (39)
Accumulated deficit...................................... (25,306) (27,447)
-------- --------
Total stockholders' equity............................. 23,546 22,305
-------- --------
Total liabilities and stockholders' equity........... $ 26,675 $ 27,760
======== ========
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-3
<PAGE>
ARTHROCARE CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
<TABLE>
<CAPTION>
Year Ended
----------------------------------
December 28, January 3, January 2,
1996 1998 1999
------------ ---------- ----------
<S> <C> <C> <C>
Revenues:
Product sales............................ $ 6,022 $12,796 $24,624
License fees............................. -- -- 3,292
------- ------- -------
Total revenues......................... 6,022 12,796 27,916
Cost of product sales...................... 5,242 8,495 12,368
------- ------- -------
Gross profit........................... 780 4,301 15,548
------- ------- -------
Operating expenses:
Research and development................. 3,772 4,026 4,355
Sales and marketing...................... 3,635 6,263 10,495
General and administrative............... 2,582 3,112 3,775
------- ------- -------
Total operating expenses............... 9,989 13,401 18,625
------- ------- -------
Loss from operations................... (9,209) (9,100) (3,077)
Interest income and other, net............. 1,505 1,413 937
------- ------- -------
Loss before taxes.......................... (7,704) (7,687) (2,140)
Income tax provision....................... (1) (1) (1)
------- ------- -------
Net loss............................... $(7,705) $(7,688) $(2,141)
======= ======= =======
Basic and diluted net loss per common
share..................................... $ (0.97) $ (0.87) $ (0.24)
======= ======= =======
Shares used in computing basic and diluted
net loss per common share................. 7,936 8,813 8,926
======= ======= =======
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-4
<PAGE>
ARTHROCARE CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDER'S EQUITY
(in thousands, except per share data)
<TABLE>
<CAPTION>
Notes Accumulated
Preferred Stock Common Stock Additional Receivable Other
------------------ ---------------- Paid-In from Deferred Comprehensive Accumulated
Shares Amount Shares Amount Capital Stockholders Compensation Income/(loss) Deficit
---------- ------ --------- ------ ---------- ------------ ------------ ------------- -----------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
BALANCES,
DECEMBER 31,
1995............. 8,677,750 $ 9 1,792,725 $ 2 $16,869 $(92) $(550) $ -- $ (9,913)
Issuance of
common stock
through:
Initial public
offering at $
14.00 per share
in February
1996, net of
issuance costs
of $3,563....... -- -- 2,530,000 3 31,854 -- -- -- --
Conversion of
preferred stock
in connection
with the initial
public offering
in February
1996............ (8,677,750) (9) 4,338,875 4 5 -- -- -- --
Exercise of
options......... -- -- 106,643 -- 63 -- -- -- --
Employee stock
purchase plan... -- -- 10,101 -- 66 -- -- -- --
Deferred
compensation
related to
issuance of
common stock and
grants of stock
options......... -- -- -- -- 5 -- (5) -- --
Amortization of
deferred
compensation.... -- -- -- -- -- -- 167 -- --
Change in
unrealized gain
on available-
for-sale
securities...... -- -- -- -- -- -- -- 9 --
Net loss........ -- -- -- -- -- -- -- -- (7,705)
---------- --- --------- --- ------- ---- ----- ---- --------
BALANCES,
DECEMBER 28,
1996............. -- -- 8,778,344 9 48,862 (92) (388) 9 (17,618)
Issuance of
common stock
through:
Exercise of
options......... -- -- 74,287 -- 201 -- -- -- --
Employee stock
purchase plan... -- -- 16,865 -- 90 -- -- -- --
Amortization of
deferred
compensation.... -- -- -- -- -- -- 160 -- --
Change in
unrealized gain
on available-
for-sale
securities...... -- -- -- -- -- -- -- 1 --
Net loss........ -- -- -- -- -- -- -- -- (7,688)
---------- --- --------- --- ------- ---- ----- ---- --------
BALANCES, JANUARY
3, 1998.......... -- -- 8,869,496 9 49,153 (92) (228) 10 (25,306)
Issuance of
common stock
through:
Repayment of
notes receivable
from
stockholder..... -- -- -- -- -- 41 -- --
Exercise of
options......... -- -- 89,927 -- 586 -- -- -- --
Employee stock
purchase plan... -- -- 13,545 -- 162 -- -- -- --
Amortization of
deferred
compensation.... -- -- -- -- -- -- 160 -- --
Change in
unrealized gain
on available-
for-sale
securities...... -- -- -- -- -- -- -- (10) --
Currency
translation
adjustment...... -- -- -- -- -- -- -- (39) --
Net loss........ -- -- -- -- -- -- -- -- (2,141)
---------- --- --------- --- ------- ---- ----- ---- --------
BALANCES, JANUARY
2, 1999.......... -- $-- 8,972,968 $ 9 $49,901 $(51) $ (68) $(39) $(27,447)
========== === ========= === ======= ==== ===== ==== ========
<CAPTION>
Total
Stockholders' Comprehensive
Equity Income (loss)
------------- -------------
<S> <C> <C>
BALANCES,
DECEMBER 31,
1995............. $ 6,325
Issuance of
common stock
through:
Initial public
offering at $
14.00 per share
in February
1996, net of
issuance costs
of $3,563....... 31,857
Conversion of
preferred stock
in connection
with the initial
public offering
in February
1996............ --
Exercise of
options......... 63
Employee stock
purchase plan... 66
Deferred
compensation
related to
issuance of
common stock and
grants of stock
options......... --
Amortization of
deferred
compensation.... 167
Change in
unrealized gain
on available-
for-sale
securities...... 9 $ 9
Net loss........ (7,705) (7,705)
------------- -------------
BALANCES,
DECEMBER 28,
1996............. 30,782 $(7,696)
=============
Issuance of
common stock
through:
Exercise of
options......... 201
Employee stock
purchase plan... 90
Amortization of
deferred
compensation.... 160
Change in
unrealized gain
on available-
for-sale
securities...... 1 $ 1
Net loss........ (7,688) (7,688)
------------- -------------
BALANCES, JANUARY
3, 1998.......... 23,546 $(7,687)
=============
Issuance of
common stock
through:
Repayment of
notes receivable
from
stockholder..... 41
Exercise of
options......... 586
Employee stock
purchase plan... 162
Amortization of
deferred
compensation.... 160
Change in
unrealized gain
on available-
for-sale
securities...... (10) $ (10)
Currency
translation
adjustment...... (39) (39)
Net loss........ (2,141) (2,141)
------------- -------------
BALANCES, JANUARY
2, 1999.......... $22,305 $(2,190)
============= =============
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-5
<PAGE>
ARTHROCARE CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
<TABLE>
<CAPTION>
Year Ended
----------------------------------
December 28, January 3, January 2,
1996 1998 1999
------------ ---------- ----------
<S> <C> <C> <C>
Cash flows from operating activities:
Net loss................................... $ (7,705) $ (7,688) $ (2,141)
Adjustments to reconcile net loss to net
cash used in operating activities:
Depreciation and amortization............. 370 615 958
Provision for doubtful accounts receivable
and product returns...................... 313 276 (125)
Forgiveness of notes receivable........... -- 11 --
Provision for excess and obsolete
inventory................................ 50 249 (26)
Change in unrealized (gain) loss on
securities............................... -- -- (10)
Loss (gain) on disposal of property and
equipment................................ 309 19 (4)
Amortization of deferred compensation..... 167 160 160
Deferred rent............................. 9 -- (17)
Changes in operating assets and
liabilities:
Accounts receivable....................... (1,352) (1,248) (3,624)
Inventory................................. (293) (1,509) (5,024)
Prepaid expenses and other current
assets................................... 736 (55) (828)
Accounts payable.......................... 288 (87) 829
Accrued liabilities....................... 772 742 803
Deferred revenue.......................... -- -- 517
Other assets.............................. (20) 6 (273)
--------- -------- --------
Net cash used in operating activities.... (6,356) (8,509) (8,805)
--------- -------- --------
Cash flows from investing activities:
Purchases of property and equipment........ (1,028) (562) (3,893)
Purchases of available-for-sale
securities................................ (189,648) (20,656) (28,059)
Sales or maturities of available-for-sale
securities................................ 171,735 26,895 34,511
--------- -------- --------
Net cash provided by (used in) investing
activities.............................. (18,941) 5,677 2,559
--------- -------- --------
Cash flows from financing activities:
Issuance of notes receivable to related
parties................................... (75) (686) --
Repayment of capital leases................ (29) (41) (14)
Repayment of notes receivable from related
parties................................... -- 97 148
Repayment of notes receivable from
stockholder............................... -- -- 41
Proceeds from issuance of common stock and
preferred stock, net of issuance costs.... 31,923 90 162
Proceeds from exercise of options to
purchase common stock..................... 63 201 586
--------- -------- --------
Net cash provided by (used in) financing
activities.............................. 31,882 (339) 923
--------- -------- --------
Effect of exchange rate on changes in cash.. -- -- (39)
--------- -------- --------
Net increase (decrease) in cash and cash
equivalents................................ 6,585 (3,171) (5,362)
Cash and cash equivalents, beginning of
year....................................... 4,774 11,359 8,188
--------- -------- --------
Cash and cash equivalents, end of year...... $ 11,359 $ 8,188 $ 2,826
========= ======== ========
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-6
<PAGE>
ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
1. Formation and Business of the Company:
ArthroCare Corporation (the "company") was incorporated on April 29, 1993.
The company designs, develops, manufactures and markets medical devices for use
in soft-tissue surgery. The company's principal operations commenced in August
1995, at which time it emerged from the development stage.
On November 22, 1995, the company was reincorporated in the state of
Delaware with the associated exchange of shares of each class and series of
stock of the predecessor company for one share of each identical class and
series of stock of the Delaware successor company having a par value of $0.001
per share for both common stock and preferred stock.
The company sold 2,530,000 shares of common stock (including 330,000 shares
from the exercise of the underwriter's over-allotment option) at $14.00 per
share through an initial public offering in February 1996. Net proceeds (after
underwriter's commissions and fees along with other costs associated with the
offering) totaled $31,857,000. Upon completion of the offering, all outstanding
shares of preferred stock (a total of 8,678,000 shares) were converted into
shares of common stock on a two-for-one basis.
The company intends to finance its operations primarily through its cash,
cash equivalents and available-for-sale securities, together with future
product sales and licensing fees. There can be no assurance that the company
will not require additional funding or that such funding will be available on
acceptable terms, if at all.
2. Summary of Significant Accounting Policies:
Basis of Presentation. The company maintains a fifty-two/fifty-three week
fiscal year cycle ending on a Saturday. To conform the company's fiscal year
ends, the company must add a fifty-third week to every fifth or sixth fiscal
year. Accordingly, fiscal 1998 and 1996 were fifty-two week years and fiscal
1997 was a fifty-three week year.
Use of Estimates. The preparation of financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts in the financial statements
and accompanying notes. Actual results could differ from those estimates.
Principles of Consolidation. The consolidated financial statements include
the accounts of ArthroCare and all of its wholly owned subsidiaries. All
significant inter-company transactions and accounts have been eliminated.
Cash and Cash Equivalents and Available-for-Sale Securities. The company
considers all highly liquid investments purchased with original maturities of
ninety days or less to be cash equivalents. Cash and cash equivalents include
money market funds and various deposit accounts.
The company has classified its investments as "available-for-sale." Such
investments are recorded at fair value and unrealized gains and losses, if
material, are recorded as a separate component of equity until realized.
Interest income is recorded using an effective interest rate, with the
associated premium or discount amortized to "interest income".
Inventories. Inventories are stated at the lower-of-cost-or-market, with
cost determined on a first-in, first-out basis.
Property and Equipment. Property and equipment, including equipment under
capital leases, is stated at cost and is depreciated on a straight-line basis
over the estimated useful lives of three to five years. The company places
controllers with customers in order to facilitate the sale of disposables.
Controllers placed with
F-7
<PAGE>
ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
customers are capitalized at cost and amortized over a three-year period.
Leasehold improvements are amortized over the shorter of the estimated useful
lives or the lease term. Maintenance and repair costs are charged to operations
as incurred.
Revenue Recognition. The company recognizes revenue upon shipment of product
to the customer, upon fulfillment of acceptance terms, if any, and when no
significant contractual obligations remain. Revenue is reported net of a
provision for estimated product returns. The company recognizes revenue from
its business partners upon the completion of certain milestones. The company
recognized license fees of $3.2 million which were received from business
partners during 1998.
Reclassification. Certain amounts in the prior financial statements have
been reclassified to conform to the current year presentation. These
reclassifications did not impact previously reported total assets, liabilities,
stockholders' equity or net loss.
Research and Development. Research and development costs are charged to
operations as incurred.
Foreign Currency Translation. The functional currency of each foreign
subsidiary is its local currency. Essentially all foreign assets and
liabilities are translated into U.S. dollars at year-end exchange rates, while
elements of the income statement are translated at average exchange rates in
effect during the year. Foreign currency transaction gains and losses are
included in the consolidated statement of operations. Adjustments arising from
the translation of net assets located outside the United States (gains and
losses) are recorded as a component of shareholders' equity.
Concentration of Risks and Uncertainties. Substantially all of the company's
cash and cash equivalents are maintained at financial institutions in the
United States. Deposits at these institutions may exceed the amount of
insurance provided on such deposits. The company has not experienced any losses
on its deposits of cash and cash equivalents.
The company's Sunnyvale facility currently accounts for all of its product
manufacturing. Disruption of operations at the company's production facility
could cause delays in, or an interruption of, production and shipment of
products which could have a material adverse impact on the company's business,
operating results and financial condition.
The company purchases certain key components of its products, from sole,
single or limited source suppliers. For some of these components there are few
alternative sources. A reduction or stoppage in supply of sole-source
components would limit the company's ability to manufacture certain products.
There can be no assurance that an alternate supplier could be established if
necessary or that available inventories would be adequate to meet the company's
production needs during any prolonged interruption of supply.
The company's products require approval from the United States Food and Drug
Administration (FDA) and international regulatory agencies prior to the
commencement of commercial sales. There can be no assurance that the company's
products will receive any of these required approvals. If the company was
denied such approvals, or if such approvals were delayed, it would have a
material adverse impact on the company's business.
Sales to both international and domestic customers are generally made on
open credit terms. Management performs ongoing credit evaluations of the
company's customers and maintains an allowance for potential credit losses when
needed but historically has not experienced any significant losses related to
individual customers or a group of customers in any particular geographic area.
F-8
<PAGE>
ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Fair Value of Financial Instruments. The carrying value of the company's
financial instruments approximate fair value.
Income Taxes. The company accounts for income taxes under SFAS No. 109,
"Accounting for Income Taxes," which prescribes the use of the liability method
whereby deferred tax asset or liability account balances are calculated at the
balance sheet date using current tax laws and rates in effect for the year in
which the differences are expected to affect taxable income. Valuation
allowances are established when necessary to reduce deferred tax assets to the
amounts expected to be realized.
Computation of Net Loss per Common Share. Basic and diluted net loss per
common share are computed using the weighted average number of shares of common
stock outstanding. Common equivalent shares from stock options, warrants and
preferred stock of 535,000 shares have been excluded from the computation of
net loss per common share-assuming dilution as their effect is antidilutive. No
additional shares are considered to be outstanding for either computation under
the provisions of SAB No. 98.
Comprehensive Income (Loss). The company adopted the provision of the
Financial Accounting Standards Board (FASB) SFAS No. 130, "Reporting
Comprehensive Income" in 1998. This statement establishes requirements for
disclosure of comprehensive income with reclassification of earlier financial
statements for comparative purposes. Comprehensive income generally represents
all changes in stockholders' equity except those resulting from investments or
contributions by stockholders.
Segment Information. In 1998, the company adopted Statement of Financial
Accounting Standard (SFAS) No. 131, "Disclosures about Segments of an
Enterprise and Related Information". SFAS No. 131 supersedes SFAS No. 14,
"Financial Reporting for Segments of a Business Enterprise" replacing the
"industry segment" approach with the "management" approach. The management
approach designates the internal organization that is used by management for
making operating decisions and assessing performance as the source of the
company's reportable segments. SFAS No. 131 also requires disclosures about
products and services, geographic areas, major customers. See Note 11 to the
consolidated financial statements.
Recent Accounting Pronouncements. In June 1998, the Financial Accounting
Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and
Hedging Activities". SFAS No. 133 establishes accounting and reporting
standards for derivative instruments, including certain derivative instruments
embedded in other contracts, and for hedging activities. It requires that an
entity recognize all derivatives as either assets or liabilities in the
statement of financial position and measure those instruments at fair value.
The company must adopt this standard no later than fiscal year 2001. To date,
the company does not engage in hedging activities.
3. Available-for-Sale Securities:
The company's investments consist primarily of corporate notes and bonds
with contractual maturities of less than one year. Gains and losses were
immaterial for all periods presented. At January 2, 1999, the amortized cost of
the investment approximates fair value.
F-9
<PAGE>
ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
4. Balance Sheet Detail:
<TABLE>
<CAPTION>
January 3, January 2,
1998 1999
---------- ----------
(in thousands)
<S> <C> <C>
Inventories:
Raw materials......................................... $ 921 $ 3,127
Work-in-process....................................... 165 1,852
Finished goods........................................ 933 2,090
------- -------
$ 2,019 $ 7,069
======= =======
Prepaid expenses and other current assets:
Prepaid insurance..................................... $ 125 $ 212
Prepaid rent.......................................... 28 --
Other................................................. 57 826
------- -------
$ 210 $ 1,038
======= =======
Property and equipment:
Machinery and equipment............................... $ 1,123 $ 1,672
Tooling and molds..................................... 216 343
Computer equipment.................................... 898 1,397
Controller placements................................. -- 2,637
Furniture and fixtures................................ 205 332
Leasehold improvements................................ 148 271
------- -------
2,590 6,652
Less accumulated depreciation and amortization........ (1,178) (2,092)
------- -------
$ 1,412 $ 4,560
======= =======
Equipment acquired under capital leases included in
property and equipment above:
Machinery and equipment............................... $ 109 $ 109
Computer equipment.................................... -- 217
Less accumulated depreciation......................... (85) (99)
------- -------
$ 24 $ 227
======= =======
Accrued liabilities:
Accrued professional fees............................. $ 164 $ 150
Accrued warranty...................................... 316 302
Other................................................. 192 1,282
------- -------
$ 672 $ 1,734
======= =======
</TABLE>
5. Commitments:
Capital Leases. The company has entered into capital lease agreements to
lease certain computer and related equipment. At January 2, 1999, the total
future minimum payments under capital leases is $239,000 with $28,000
representing interest.
<TABLE>
<S> <C>
1999..................................... $74
2000..................................... 74
2001..................................... 74
2002..................................... 17
</TABLE>
F-10
<PAGE>
ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Operating Leases. The company leases its facilities and certain equipment
under operating leases. The company recognizes rent expense on a straight-line
basis over the lease term. At January 2, 1999, total future minimum lease
payments are as follows (in thousands):
<TABLE>
<S> <C>
1999.................................... $583
2000.................................... 631
2001.................................... 645
2002.................................... 110
</TABLE>
Rent expense for the years ended December 28, 1996, January 3, 1998 and
January 2, 1999 and was $345,000, $349,000 and $437,000, respectively.
6. Supplemental Cash Flow Disclosures:
<TABLE>
<CAPTION>
Year Ended
----------------------------------
December 28, January 3, January 2,
1996 1998 1999
------------ ---------- ----------
(in thousands)
<S> <C> <C> <C>
Non-cash financing and investing activities:
Additions to property and equipment
acquired under capital lease............. $ -- $ -- $217
Cash paid during the period for:
Interest.................................. 9 5 1
Income Taxes.............................. 1 1 1
</TABLE>
7.Stockholders' Equity:
Preferred Stock. Under the company's certificate of incorporation, the
company is authorized to issue preferred stock. At January 2, 1999, 5,000,000
shares of preferred stock were authorized and no preferred stock was issued and
outstanding as the previously outstanding preferred stock was converted into
common stock in connection with the company's initial public offering during
1996.
Stock Option Plans. In May 1993, the company approved the 1993 Stock Plan
(1993 Plan) under which the Board of Directors of the company is authorized and
directed to enter into stock option agreements with selected individuals.
136,000 shares were authorized at the inception of the Plan with 250,000, and
1,150,025 additional shares authorized in 1994, and 1995, respectively. In May
1998, the stockholders of the company approved an increase in the number of
shares reserved for issuance under the Plan by an aggregate of 750,000 shares
for a total of 2,286,025. Options granted under the 1993 Plan generally become
exercisable over a 48-month period.
F-11
<PAGE>
ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Activity under the 1993 Plan is as follows:
<TABLE>
<CAPTION>
Shares Outstanding Options
Available ---------------------------
For Number Weighted-Average
Grant of Shares Exercise-Price
--------- --------- ----------------
<S> <C> <C> <C>
BALANCES, DECEMBER 31, 1995.............. 1,020,925 491,350 $ 1.69
Options granted.......................... (217,575) 217,575 13.18
Options exercised........................ -- (106,735) 0.32
Options canceled......................... 58,092 (58,092) 3.87
--------- ---------
BALANCES, DECEMBER 28, 1996.............. 861,442 544,098 6.32
Options granted.......................... (723,300) 723,300 8.43
Options exercised........................ -- (74,166) 2.71
Options canceled......................... 162,203 (162,203) 5.43
--------- ---------
BALANCES, JANUARY 3, 1998................ 300,345 1,031,029 8.20
Additional shares authorized............. 750,000 --
Options granted.......................... (601,950) 601,950 15.17
Options exercised........................ -- (89,927) 6.52
Options canceled......................... 111,650 (111,650) 8.89
--------- ---------
BALANCES, JANUARY 2, 1999................ 560,045 1,431,402 $11.18
========= =========
</TABLE>
At January 3, 1998 and January 2, 1999, there were 314,000 and 469,000
options, respectively, exercisable under the 1993 Plan.
In December 1995, the company adopted the Director Option Plan (Director
Plan) and reserved 100,000 shares of common stock for issuance to directors
under this plan. The plan allows for an initial grant and automatic annual
grants of options to outside directors of the company. As of January 3, 1998
and January 2, 1999 outstanding options under the Director Plan were 24,000 and
33,000, respectively, with 25,875 options exercisable as of January 2, 1999. In
February 1995, pursuant to a restricted stock purchase agreement, 100,000
shares of common stock were purchased by an officer of the company at $0.32 per
share. The restricted stock purchase agreement contains provisions for the
repurchase of common stock by the company in the event of termination of
employment during the four years following the date of the agreement. At
January 2, 1999, 1,667 shares were subject to repurchase under this restricted
stock purchase agreement. Those shares were released from the purchase
restriction in January 1999.
In August 1995, 90,000 shares of common stock were purchased by an officer
of the company at $0.80 per share pursuant to a restricted stock purchase
agreement. The restricted stock purchase agreement contains provisions for the
repurchase of common stock by the company in the event of termination of
employment during the four years following the date of the agreement. At
January 2, 1999, 10,938 shares were subject to repurchase under this restricted
stock purchase agreement. These shares will continue to be released ratably
over the remaining period.
Employee Stock Purchase Plan. In December 1995, the company approved the
Employee Stock Purchase Plan and reserved 150,000 shares of common stock for
issuance under this plan. For the years ended January 3, 1998 and January 2,
1999, 16,865 shares and 13,545 shares of common stock were sold under the
Employee Stock Purchase Plan, respectively.
Warrants. In January 1998, the company issued a warrant to purchase 80,000
shares of common stock at a purchase price of $12.00 per share to certain
foreign employees. The warrant becomes exercisable over a four-year period.
F-12
<PAGE>
ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Stockholders Rights Plan. In November 1996, the Board of Directors approved
a Stockholders Rights Plan declaring a dividend distribution of one Preferred
Share Purchase Right for each outstanding share of the company's Common Stock.
Each right will entitle stockholders to buy one-thousandth of one share of the
company's Series A Participating Preferred Stock at an exercise price of
$50.00. This Plan was designed to assure that the company's stockholders
receive fair and equal treatment in the event of any proposed takeover of the
company and to guard against partial tender offers and other abusive tactics to
gain control of the company without paying all stockholders the fair value of
their shares, including a "control premium".
Stock-Based Compensation. The company has adopted the disclosure-only
provisions of SFAS No. 123 "Accounting for Stock-Based Compensation" and
continues to account for options granted to employees under APB Opinion No. 25,
"Accounting for Stock Issued to Employees." Had compensation cost for the 1993
Plan, the Director Plan and the Employee Stock Purchase Plan been determined
based on the fair value at the grant date for awards in fiscal year 1996, 1997
and 1998 consistent with the provisions of SFAS No. 123, the company's net loss
per common share and per common share-assuming dilution for the years ended
December 28, 1996, January 3, 1998 and January 2, 1999 would have been
increased to the pro forma amounts indicated below:
<TABLE>
<CAPTION>
Year Ended
----------------------------------
December 28, January 3, January 2,
1996 1998 1999
------------ ---------- ----------
(in thousands, except per share
data)
<S> <C> <C> <C>
Net loss--as reported....................... $7,705 $7,688 $2,141
Net loss--pro forma......................... 7,962 8,466 3,650
Net loss per common share as reported....... 0.97 0.87 0.24
Net loss per common share pro forma......... 1.00 0.96 0.41
</TABLE>
The effects of the pro forma disclosure of applying SFAS No. 123 are not
likely to be representative of the effects of the pro forma disclosures of
future years. Because SFAS No. 123 reflects only options granted after January
1, 1995, the pro forma effect will not be fully reflected until 1999.
The fair value of each option grant is estimated on the date of grant using
the Black Scholes model with the following weighted average assumptions:
<TABLE>
<S> <C>
Risk-free interest rate.......... 4.98%-7.13%
Expected life.................... 4 years
Expected dividends............... --
Expected volatility.............. 52%
</TABLE>
F-13
<PAGE>
ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
The options outstanding and currently exercisable by exercise price for both
the 1993 Plan and the Director Plan at January 2, 1999 are as follows (in
thousands, except per share data and contractual life):
<TABLE>
<CAPTION>
Options Currently
Options Outstanding Exercisable
--------------------------------------------------------------------
Weighted
Average Weighted Weighted
Remaining Average Average
Exercise Number Contractual Exercise Number Exercise
Price Outstanding Life Price Exercisable Price
------------- ----------- ----------- -------- ----------- --------
<S> <C> <C> <C> <C> <C>
$ 0.20 40,059 4.4 $ 0.20 40,059 $ 0.20
0.32--0.40 39,615 6.3 0.39 35,777 0.39
0.80 7,725 6.5 0.80 6,599 0.80
1.60 23,450 6.6 1.60 20,242 1.60
3.00 2,750 6.7 3.00 2,286 3.00
3.01--7.38 141,664 7.5 6.97 73,351 6.96
7.39--11.88 707,035 8.2 9.68 246,581 9.44
11.89--19.75 474,454 9.2 16.69 52,062 16.79
19.76--24.25 27,650 7.4 24.25 18,198 24.25
--------- -------
1,464,402 8.3 $11.26 495,155 $ 8.53
========= =======
</TABLE>
Deferred compensation recognized as a result of stock options granted and
common stock issued subject to repurchase provisions as of January 2, 1999 is
$1,047,000. Deferred compensation is generally amortized over vesting periods
of one to four years, which resulted in compensation expense of $167,000,
$160,000 and $160,000 recognized in the years ended December 28, 1996, January
3, 1998 and January 2, 1999, respectively.
8. Related Parties:
In connection with the formation of the company, several of the founders and
a partnership of the founders entered into a licensing agreement to facilitate
patent transfers. As a result, the company acquired an exclusive worldwide
perpetual royalty-free license, with right of sublicense, to make, use and sell
products and use patent methods covered by the patent rights limited to
surgical orthopedic and arthroscopic applications.
Also in connection with its incorporation, the company entered into a
consulting agreement with a consulting and research firm, which is headed by
one of the company's founders. This consulting and research firm was contracted
to perform research related to the development of hand-held instruments used in
arthroscopic procedures. Research and development costs incurred on this
contract in fiscal 1996, 1997 and 1998 were approximately $456,000, $457,000
and $392,000, respectively.
In January 1995, the company loaned to an officer $120,000 pursuant to a
provision in the officer's employment agreement. The resulting promissory note
bears interest at 6% per annum and is due on the earlier of January 31, 1999 or
termination of employment. In December 1998, the officer paid the note in full.
In February 1995, the company agreed to loan this officer up to an additional
$144,000 in monthly increments of $3,000 at 6% per annum. In December 1997, the
company amended this officer's employment agreement to terminate the increments
effective January 31, 1998 and forgive 10% of the principal and interest at the
end of each fiscal year in which the officer is employed by the company and in
which the company meets certain performance targets. During fiscal year 1997,
$11,000 of principal and interest was forgiven. At January 2, 1999, $99,000 of
principal and interest was outstanding on this note. Both aforementioned notes
are secured by shares of the company's common stock and a mortgage on the
officer's residence and as of February 1999 have been paid in full.
F-14
<PAGE>
ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
In December 1995, the company loaned an employee $62,000 pursuant to a
provision in the employee's employment agreement. The resulting promissory note
bears interest at the rate of 6% per annum and is due on the earlier of July
24, 2000 or the termination of employment. The note also permits the company to
loan this employee up to an additional $34,000 in $2,000 monthly increments.
The aforementioned notes are secured by a pledge of this employee's option for
50,000 shares of the company's common stock and any shares issued upon exercise
of such options. In May 1997, all principal and interest were repaid in full.
In June 1997, the company loaned an officer $500,000 pursuant to a provision
in the officer's employment agreement. The promissory note, which bears no
interest, is secured by a mortgage on the officer's residence and is due and
payable upon either the officer's termination of employment or the sale of the
officer's residence. If the officer is terminated by the company or the company
is acquired, the loan is due and payable within 12 months thereafter. As of
January 2, 1999, $500,000 of principal was outstanding on this note.
In November 1997, the company issued a relocation loan of $130,000 to an
employee. This loan is secured by the employee's residence and is due and
payable upon either the sale or transfer of the property or the termination of
the officer's employment with the company. As of January 2, 1999, $130,000 of
principal was outstanding on this loan.
9. Income Taxes:
At January 2, 1999, the company has approximately $18,700,000 and $6,100,000
in federal and state net operating loss carryforwards, respectively, which
expire in the years 2004 through 2018 and 2000 through 2003, respectively.
The Tax Reform Act of 1986 substantially changed the rates relative to net
operating loss and tax credit carryforwards in the case of an "ownership
change" of a corporation. Any ownership changes, as defined, may restrict
utilization of carryforwards.
Temporary differences and carryforwards which gave rise to significant
portions of deferred tax assets and liabilities are as follows (in thousands):
<TABLE>
<CAPTION>
January 3, January 2,
1998 1999
---------- ----------
<S> <C> <C>
Deferred tax assets:
Net operating loss carryforwards................... $ 5,612 $ 6,726
Capitalized research and development costs......... 1,154 1,067
Capitalized start-up costs......................... 499 323
Research and development credit.................... 567 1,120
Allowances and reserves............................ 1,806 2,093
------- --------
Deferred tax assets.................................. 9,638 11,329
Less: valuation allowance............................ (9,638) (11,329)
------- --------
Net deferred tax assets............................ $ -- $ --
======= ========
</TABLE>
In accordance with generally accepted accounting principles, a valuation
allowance must be established for a deferred tax asset if it is more likely
than not that a tax benefit may not be realized from the asset in the future.
The company has established a valuation allowance to the extent of its deferred
tax assets since it is more likely than not that a benefit can not be realized
in the future due to the company's recurring operating losses.
F-15
<PAGE>
ARTHROCARE CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Continued)
10. Employee Benefit Plan:
The company maintains a Retirement Savings and Investment Plan (401(k) Plan)
which covers substantially all employees. Eligible employees may defer salary
(before tax) up to a specified maximum. The company, at its discretion, may
make matching contributions on behalf of the participants in the 401(k) Plan.
To date, the company has not made any contributions to the 401(k) Plan.
11. Segment Information:
The company is organized into four segments on the basis of product markets,
Arthroscopy, ENTec(TM), Visage(R) and AngioCare(TM). To date, substantially all
the company's product revenue was related to the Arthroscopic segment. During
fiscal 1998, approximately $2.6 million of the company's license revenue was
attributable to the AngioCare segment, $0.4 million was attributable to the
ENTec segment and $0.3 million was attributable to the Visage segment. Export
sales were approximately $0.9 million during fiscal 1997 and $2.3 million for
fiscal 1998.
12. Business Collaborations:
During the year ended January 2, 1999, the company formed a new business
division, AngioCare for the purpose of commercializing the company's technology
in the cardiac and interventional cardiology markets. As part of those efforts,
in February 1998, the company entered into a license and OEM agreement under
which Boston Scientific Corporation (BSC) will provide input into the
development of, obtain regulatory approval for and market products based on the
company's CoblationTM technology for myocardial revascularization procedures.
Under the agreement, BSC has paid license fees to the company based upon
achievement of designated milestones and royalties on sales of resulting
products. The first nonrefundable license payment of $3.0 million was received
during 1998 of which $2.6 million was recognized as license revenue.
In May 1998, the company announced that it had entered the
otorhinolaryngology (ear, nose and throat) market, and that it has formed a new
business unit called ENTec to commercialize the technology in this field. In
June 1998, the company entered into a license and OEM agreement with Xomed
Surgical Products (Xomed) to market the Coblation products in the
otorhinolaryngology market. This agreement was terminated by the company in
February 1999.
13. Subsequent Event:
In January 1999, the company entered into an exclusive worldwide license and
OEM agreement with Collagen to market and distribute ArthroCare's Coblation-
based product line for cosmetic, dermatologic and aesthetic surgical
applications. On February 8, 1999, the company announced that Collagen had
acquired expanded, exclusive, worldwide rights to market ArthroCare's Cosmetic
Surgery System to all physicians practicing dermatology, and cosmetic and
facial plastic surgery including ear, nose, and throat physicians who perform
such procedures.
14. Event Subsequent to the Date of the Independent Accountant's Report
(Unaudited)
On February 4, 1999, Xomed Surgical Products of Jacksonville, Florida filed
a complaint against the company in the Fourth Judicial Circuit, Duval County
Florida, alleging breach of contract by the company. In the complaint, Xomed
has demanded a full refund of the amounts paid for certain products bought by
Xomed from the company, and for a portion of an exclusive license fee paid by
Xomed pursuant to an exclusive license and distribution agreement between
Conmed Corporation and the company. This license and distribution agreement was
terminated by the company on February 5, 1999. The company believes that the
suit is without merit, and filed a Motion to Dismiss on February 24, 1999.
F-16
<PAGE>
ARTHROCARE CORPORATION
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
<TABLE>
<CAPTION>
January 2, July 3,
1999 1999
---------- --------
(Unaudited)
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents................................ $ 2,826 $ 2,831
Available-for-sale securities............................ 5,232 4,316
Accounts receivable, net of allowances................... 5,972 7,380
Inventories, net......................................... 7,069 7,632
Prepaid expenses and other current assets................ 1,038 405
-------- --------
Total current assets................................... 22,137 22,564
Property and equipment, net................................ 4,560 5,723
Related party receivables.................................. 723 1,205
Other assets............................................... 340 272
-------- --------
Total assets......................................... $ 27,760 $ 29,764
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable......................................... $ 1,797 $ 1,326
Accrued liabilities...................................... 1,734 1,201
Accrued compensation..................................... 1,056 1,892
Deferred revenue......................................... 517 458
Capital lease obligations, current portion............... 60 59
-------- --------
Total current liabilities.............................. 5,164 4,936
Capital lease obligations, less current portion............ 151 117
Deferred rent.............................................. 140 135
-------- --------
Total liabilities...................................... 5,455 5,188
-------- --------
Contingencies (Note 6)
Stockholders' equity:
Common stock............................................. 9 9
Additional paid-in capital............................... 49,901 50,553
Notes receivable from stockholders....................... (51) --
Deferred compensation.................................... (68) --
Accumulated other comprehensive loss..................... (39) (80)
Accumulated deficit...................................... (27,447) (25,906)
-------- --------
Total stockholders' equity............................. 22,305 24,576
-------- --------
Total liabilities and stockholders' equity........... $ 27,760 $ 29,764
======== ========
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements
F-17
<PAGE>
ARTHROCARE CORPORATION
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data )
<TABLE>
<CAPTION>
Six Months Ended
----------------
July 4, July 3,
1998 1999
------- -------
<S> <C> <C>
Revenues:
Product sales.............................................. $10,544 $19,177
License fees and royalties................................. 2,625 2,750
------- -------
Total revenues........................................... 13,169 21,927
Cost of product sales........................................ 5,995 8,186
------- -------
Gross profit............................................... 7,174 13,741
------- -------
Operating expenses:
Research and development................................... 2,140 2,176
Sales and marketing........................................ 4,538 7,146
General and administrative................................. 1,924 3,028
------- -------
Total operating expenses................................. 8,602 12,350
------- -------
Income (loss) from operations................................ (1,428) 1,391
Interest and other income, net............................... 587 215
------- -------
Income (loss) before taxes................................... (841) 1,606
Income tax provision......................................... -- 65
------- -------
Net income (loss).......................................... $ (841) $ 1,541
======= =======
Basic net income (loss) per common share..................... $ (0.09) $ 0.17
======= =======
Diluted net income(loss) per common share.................... $ (0.09) $ 0.16
======= =======
Shares used in computing basic net income (loss) per common
share....................................................... 8,902 8,973
======= =======
Shares used in computing diluted net income (loss) per common
share....................................................... 8,902 9,547
======= =======
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements
F-18
<PAGE>
ARTHROCARE CORPORATION
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
<TABLE>
<CAPTION>
Six Months Ended
-----------------
July 4, July 3,
1998 1999
-------- -------
<S> <C> <C>
Cash flows from operating activities:
Net income (loss).......................................... $ (841) $ 1,541
Adjustments to reconcile net income(loss) to net cash
provided by (used in) operating activities:
Depreciation and amortization............................. 282 1,057
Amortization of deferred compensation..................... 80 68
Provision for doubtful accounts receivable and product
returns.................................................. 50 131
Provision for excess and obsolete inventory............... 186 595
Deferred rent............................................. (7) (5)
Changes in operating assets and liabilities:
Accounts receivable...................................... (1,633) (1,539)
Inventories.............................................. (1,911) (1,158)
Prepaid expenses and other current assets................ (334) 633
Accounts payable......................................... 774 (471)
Accrued liabilities...................................... 660 302
Deferred revenue......................................... 875 (59)
Other assets............................................. (13) 68
-------- -------
Net cash provided by (used in) operating activities..... (1,832) 1,163
-------- -------
Cash flows from investing activities:
Purchases of property and equipment........................ (1,035) (2,220)
Purchases of available-for-sale securities................. (22,093) (85)
Sales or maturities of available-for-sale securities....... 26,550 1,001
-------- -------
Net cash provided by (used in) investing activities..... 3,422 (1,304)
-------- -------
Cash flows from financing activities:
Issuance of notes receivable to related parties............ (10) (575)
Repayment of capital leases................................ (15) (34)
Repayment of notes receivable from related parties......... 9 144
Proceeds from exercise of options to purchase common
stock..................................................... 537 652
-------- -------
Net cash provided by financing activities............... 521 187
-------- -------
Effect of exchange rate on changes in cash.................. -- (41)
-------- -------
Net increase in cash and cash equivalents................... 2,111 5
Cash and cash equivalents, beginning of period.............. 8,188 2,826
-------- -------
Cash and cash equivalents, end of period.................... $ 10,299 $ 2,831
======== =======
</TABLE>
The accompanying notes are an integral part of the condensed consolidated
financial statements
F-19
<PAGE>
ARTHROCARE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. Basis of Presentation:
In the opinion of management, the accompanying unaudited condensed
consolidated financial statements contain all adjustments (all of which are
normal and recurring in nature) necessary to present fairly the financial
position, results of operations and cash flows of ArthroCare Corporation (the
"company"or "ArthroCare") for the periods indicated. Interim results of
operations are not necessarily indicative of the results to be expected for the
full year or any other interim periods. The notes to the financial statements
contained in the Form 10-K for the year ended January 2, 1999 should be read in
conjunction with these condensed consolidated financial statements. The balance
sheet at January 2, 1999 was derived from audited financial statements;
however, these interim financial statements do not include all disclosures
required by generally accepted accounting principles.
2. Computation of Net Income (Loss) Per Share:
Basic net income (loss) per share is computed using the weighted average
number of shares of common stock. Diluted net income (loss) per share is
computed using the weighted average number of shares of common stock and common
equivalent shares outstanding during the period. Common equivalent shares
consist of stock options. Common equivalent shares are excluded from the
computation if their effect is anti-dilutive.
The following is a reconciliation of the computation for basic and diluted
net income (loss) per share (in thousands, except per share data):
<TABLE>
<CAPTION>
Six Months Ended
-------------------
July 4, July 3,
1998 1999
-------- --------
<S> <C> <C>
Net income (loss)........................................ $ (841) $ 1,541
======== ========
Shares calculation:
Weighted average basic shares outstanding.............. 8,902 8,973
Options................................................ -- 574
-------- --------
Total shares used to compute diluted net income
(loss) per share.................................... 8,902 9,547
======== ========
Net income (loss) per basic share........................ $ (0.09) $ 0.17
======== ========
Net income (loss) per diluted share...................... $ (0.09) $ 0.16
======== ========
</TABLE>
Options to purchase 62,631 shares of common stock at prices ranging from
$18.25-$24.25 per share were outstanding during the six month period ended July
4, 1998, but were not included in the computation of diluted net loss per share
because inclusion of such options would have been anti-dilutive. Options to
purchase 331,681 shares of common stock at prices ranging from $17.625-$24.25
per share were outstanding during the six-month period ending July 3, 1999, but
were not included in the computation of diluted net income per share because
inclusion of such options would have been anti-dilutive.
F-20
<PAGE>
ARTHROCARE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)
3. Comprehensive Income (Loss):
Comprehensive income (loss) is comprised of net income and other
comprehensive income (loss) such as foreign currency translation gain/loss and
unrealized gains or losses on available-for-sale marketable securities. The
company's unrealized gains and losses on available for sale marketable
securities have been insignificant for all periods presented. ArthroCare's
total comprehensive income (loss) was as follows (in thousands):
<TABLE>
<CAPTION>
Six Months Ended
------------------
July 4, July 3,
1998 1999
-------- --------
<S> <C> <C>
Net income (loss).................................... $ (841) $ 1,541
Other comprehensive income (loss) :
Unrealized gains and losses on available for sale
marketable securities............................. (17) --
Foreign currency translation adjustment............ -- (41)
------- --------
Comprehensive net income (loss).................. $ (858) $ 1,500
======= ========
</TABLE>
4. Balance Sheet Detail (in thousands):
<TABLE>
<CAPTION>
January 2, July 3,
1999 1999
---------- -------
<S> <C> <C>
Inventories:
Raw materials......................................... $3,127 $3,292
Work-in-process....................................... 1,852 1,546
Finished goods........................................ 2,090 2,794
------ ------
$7,069 $7,632
====== ======
Accrued liabilities:
Accrued professional fees............................. $ 150 $ 188
Accrued warranty...................................... 302 302
Other................................................. 1,282 711
------ ------
$1,734 $1,201
====== ======
</TABLE>
5. Line of Credit:
In June 1999, the company entered into a $7.0 million revolving line of
credit that expires in June 2000. Borrowings under the line of credit bear
interest at the bank's prime rate plus one-quarter of one percentage point.
Borrowings under this line are secured by certain of the company's assets and
are subject to certain covenants related to financial ratios and profits. At
July 3, 1999 the company was in compliance with these covenants. No borrowings
were outstanding as of July 3, 1999.
6. Litigation:
On February 13, 1998, the company filed a lawsuit against Ethicon, Inc.,
Mitek Surgical Products, a division of Ethicon, Inc., and GyneCare, Inc. ("the
Defendants") in the United States District Court for the Northern District of
California. The lawsuit alleged, among other things, that the Defendants have
been and are
F-21
<PAGE>
ARTHROCARE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)
currently infringing four patents issued to the company in December 1997.
Specifically, the Defendants use, market and sell two separate electrosurgical
systems under the names of "VAPR" and "VersaPoint" which the company believes
infringe these patents. The Company settled this patent litigation with the
Defendants on June 24, 1999. Under the terms of the settlement, Ethicon, Inc.
has licensed the company's United States patents in the arthroscopy and
gynecology markets and ArthroCare has dismissed the legal action. Both
companies will remain active in the marketplace. Ethicon, Inc. has paid
ArthroCare a license fee and will pay ongoing royalties on sales in the United
States of certain arthroscopy and gynecology products. The settlement agreement
also establishes a procedure for resolution of certain potential future
intellectual property disputes in these two markets without litigation.
On February 4, 1999, Xomed Surgical Products ("Xomed") of Jacksonville,
Florida filed a complaint against the company in the Fourth Judicial Circuit,
Duval County, Florida, alleging breach of contract by the company. In the
complaint, Xomed has demanded a full refund of the amounts paid for certain
products bought by Xomed from the company, and for a portion of an exclusive
license fee paid by Xomed pursuant to an exclusive license and distribution
agreement between Xomed and the company. This license and distribution
agreement was terminated by the company on February 5, 1999. The company
believes the suit is without merit, and filed a Motion to Dismiss and Answer to
the Complaint on May 3, 1999. In addition, the company filed two counterclaims
against Xomed for damages caused by Xomed's failure to perform under the
contract and for a certain milestone payment owed to ArthroCare by Xomed.
On March 24, 1999, a former employee of the Company filed a complaint
against the Company in Santa Clara County Superior Court alleging causes of
action for sexual harassment in violation of the Fair Employment and Housing
Act and retaliation in violation of the Fair Employment and Housing Act. The
Company filed a response to the complaint on June 23, 1999 and had a case
management conference July 27 at which the parties stipulated to mediation.
According to the complaint, the demand exceeds $25,000.
7. Recent Accounting Pronouncements:
In June 1998, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for
Derivative Instruments and Hedging Activities." SFAS No. 133 establishes
accounting and reporting standards for derivative instruments, including
certain derivative instruments embedded in other contracts, and for hedging
activities. It requires that an entity recognize all derivatives as either
assets or liabilities in the statement of financial position and measure those
instruments at fair value. The company must adopt this standard no later than
fiscal year 2001. To date, the company does not engage in hedging activities.
8. Segment Information:
The company is organized into four business units based on product markets:
arthroscopy, ear nose and throat, cosmetic surgery and cardiology. To date,
substantially all the company's product sales were related to the Arthroscopy
segment. Licensing fees are primarily attributable to the Arthroscopy segment.
However, during the six-month period ended July 3, 1999, approximately $0.3
million of the company's license revenue was attributable to the AngioCare(TM)
segment and $1.0 million was attributable to the Visage(R) segment. During the
six-month period ended July 4, 1998, approximately $2.3 million of the
company's license revenue was attributable to the AngioCare segment.
F-22
<PAGE>
[LOGO OF ARTHROCARE CORPORATION]
Until , 1999, all dealers, whether or not participating in this
offering, that effect transactions in these securities may be required to
deliver a prospectus. This requirement is in addition to the dealer's
obligation to deliver a prospectus when acting as an underwriter in this
offering and when selling previously unsold allotments or subscriptions.
<PAGE>
PART II
INFORMATION NOT REQUIRED IN PROSPECTUS
Item 14. Other Expenses of Issuance and Distribution
The following table sets forth the various expenses, all of which will be
borne by the registrant, in connection with the sale and distribution of the
securities being registered, other than the underwriting discounts and
commissions. All amounts shown are estimates except for the Securities and
Exchange Commission registration fee and the NASD filing fee.
<TABLE>
<S> <C>
SEC Registration Fee............................................... $ 17,823
NASD Filing Fee.................................................... 6,911
Nasdaq National Market Listing Fee................................. 17,500
Transfer Agent Fees................................................ 2,500
Accounting Fees and Expenses....................................... 75,000
Legal Fees and Expenses............................................ 250,000
Printing and Mailing Expenses...................................... 125,000
Miscellaneous...................................................... 5,266
--------
Total............................................................ $500,000
========
</TABLE>
Item 15. Indemnification of Directors and Officers
Section 145 of the General Corporation Law of the State of Delaware
("Section 145") permits a Delaware corporation to indemnify any person who was
or is a party or is threatened to be made a party to any threatened, pending,
or completed action, suit, or proceeding, whether civil, criminal,
administrative, or investigative (other than an action by or in the right of
the corporation) by reason of the fact that such person is or was a director,
officer, employee, or agent of the corporation, or is or was serving at the
request of the corporation as a director, officer, employee, or agent of
another corporation, partnership, joint venture, trust, or other enterprise,
against expenses (including attorneys' fees), judgments, fines and amounts
paid in settlement actually and reasonably incurred by such person in
connection with such action, suit, or proceeding if such person acted in good
faith and in a manner such person reasonably believed to be in or not opposed
to the best interests of the corporation, and, with respect to any criminal
action or proceeding, had no reasonable cause to believe such person's conduct
was unlawful.
In the case of an action by or in the right of the corporation, Section 145
permits the corporation to indemnify any person who was or is a party or is
threatened to be made a party to any threatened, pending, or completed action
or suit by or in the right of the corporation to procure a judgment in its
favor by reason of the fact that such person is or was a director, officer,
employee or agent of the corporation, or is or was serving at the request of
the corporation as director, officer, employee or agent of another
corporation, partnership, joint venture, trust or other enterprise against
expenses (including attorneys' fees) actually and reasonably incurred by such
person in connection with the defense or settlement of such action or suit if
he acted in good faith and in a manner such person reasonably believed to be
in or not opposed to the best interest of the corporation. No indemnification
may be made in respect of any claim, issue, or matter as to which such person
shall have been adjudged to be liable to the corporation unless and only to
the extent that the Court of Chancery or the court in which such action or
suit was brought shall determine upon application that, despite the
adjudication of liability but in view of all the circumstances of the case,
such person is fairly and reasonably entitled to indemnity for such expenses
which the Court of Chancery or such other court shall deem proper.
To the extent that a present or former director or officer of a corporation
has been successful on the merits or otherwise in defense of any action, suit
or proceeding referred to in the preceding two paragraphs, Section 145
requires that such person be indemnified against expenses (including
attorneys' fees) actually and reasonably incurred by such person in connection
therewith; and that indemnification provided by, or granted pursuant to,
II-1
<PAGE>
Section 145 shall not be deemed exclusive of any other rights to which those
seeking indemnification may be entitled.
Section 145 provides that expenses (including attorneys' fees) incurred by
an officer or director in defending any civil, criminal, administrative, or
investigative action, suit or proceeding may be paid by the corporation in
advance of the final disposition of such action, suit or proceeding upon
receipt of any undertaking by or on behalf of such director or officer to
repay such amount if it shall ultimately be determined that such person is not
entitled to be indemnified by the corporation as authorized in Section 145.
Section 145 further empowers the corporation to purchase and maintain
insurance on behalf of any person who is or was serving at the request of the
corporation as a director, officer, employee or agent of another corporation,
partnership, joint venture, trust or other enterprise, against any liability
asserted against him and incurred by him in any such capacity, or arising our
of his status as such, whether or not the corporation would have the power to
indemnify him against such liabilities under Section 145.
Our certificate of incorporation limits the liability of directors for
monetary damages arising from breach of their fiduciary duty to the maximum
extent permitted by the Delaware General Corporate Law ("the Law") and
provides for the indemnification of directors, officers and employees of the
registrant to the fullest extent permitted by the Law.
Our bylaws also provide we shall indemnify its directors and officers to
the fullest extent permitted by the Law, including circumstances in which
indemnification is otherwise discretionary under the Law.
We have entered into indemnification agreements with its directors
containing provisions which are in some respects broader than the specific
indemnification provisions contained in the Law. The indemnification
agreements may require us to indemnify its directors against certain
liabilities that may arise by reason of their status or service as directors
(other than liabilities arising from willful misconduct of a culpable nature),
to advance their expenses incurred as a result of any proceeding against them
as to which they could be indemnified, and to obtain director's insurance if
available on reasonable terms.
We believe that the limitation provision in our certificate of
incorporation and the indemnification provisions in our certificate of
incorporation, bylaws and indemnification agreements will facilitate our
ability to continue to attract and retain qualified individuals to serve as
directors. It is the opinion of the Securities and Exchange Commission that
indemnification provisions such as those contained in the certificate of
incorporation, the bylaws and these agreements have no effect on a directors'
or officers' ability under the federal securities laws. We have also obtained
directors' and officers' liability insurance covering, subject to exceptions,
actions taken by our directors and officers in their capacities as such.
Item 16. Exhibits and Financial Statement Schedules
(a) Exhibits
The following exhibits are filed herewith or incorporated herein by
reference.
<TABLE>
<CAPTION>
Exhibit
Number Description
------- -----------
<C> <S>
*1.1 Underwriting Agreement
3.1 Restated Certificate of Incorporation of ArthroCare Corporation.
(Incorporated herein by reference to Exhibit 3.2 filed previously with
our Registration Statement on Form 8-A (Registration No.000-27422))
3.2 Amended and Restated Bylaws of ArthroCare Corporation. (Incorporated
herein by reference to Exhibit 3.3 filed previously with our Quarterly
Report on Form 10-Q for the period ended October 3, 1998)
4.1 Specimen Common Stock Certificate. (Incorporated herein by reference
to the Exhibit filed previously with our Registration Statement on
Form 8-A (Registration No. 000-27422))
</TABLE>
II-2
<PAGE>
<TABLE>
<CAPTION>
Exhibit
Number Description
------- -----------
<C> <S>
*5.1 Opinion of Latham & Watkins as to the legality of the securities being
registered
10.1 Form of Indemnification Agreement between ArthroCare Corporation and
each of its directors and officers. (Incorporated herein by reference
to the same-numbered exhibit filed previously with our Registration
Statement on Form S-1 (Registration No. 33-80453))
10.2 Incentive Stock Plan and form of Stock Option Agreement thereunder.
(Incorporated herein by reference to the same-numbered exhibit filed
previously with our Registration Statement on Form S-1 (Registration
No. 33-80453 ))
10.3 Director Option Plan and form of Director Stock Option Agreement
thereunder. (Incorporated herein by reference to the same-numbered
exhibit filed previously with our Registration Statement on Form S-1
(Registration No. 33-80453))
10.4 Employee Stock Purchase Plan and forms of agreements thereunder.
(Incorporated herein by reference to the same-numbered exhibit filed
previously with our Registration Statement on Form S-1 (Registration
No. 33-80453))
10.5 Form of Exclusive Distribution Agreement. (Incorporated herein by
reference to the same-numbered exhibit filed previously with our
Registration Statement on Form S-1 (Registration No. 33-80453))
10.6 Form of Exclusive Sales Representative Agreement. (Incorporated herein
by reference to the same-numbered exhibit filed previously with our
Registration Statement on Form S-1 (Registration No. 33-80453))
10.7 Consulting Agreement, dated May 10, 1993, between ArthroCare
Corporation and Philip E. Eggers, and amendment thereto. (Incorporated
herein by reference to the same-numbered exhibit filed previously with
our Registration Statement on Form S-1 (Registration No. 33-80453))
10.8 Consulting Agreement, dated May 20, 1993, between ArthroCare
Corporation and Eggers & Associates, Inc., and amendment thereto.
(Incorporated herein reference to the same-numbered exhibit filed
previously with our Registration Statement on Form S-1 (Registration
No. 33-80453))
10.9 Lease Agreement, dated September 15, 1994, between ArthroCare
Corporation and The Arrillaga Foundation and the Perry Foundation for
our facility located at 595 North Pastoria Avenue, Sunnyvale,
California 94086. (Incorporated herein by reference to Exhibit 10.10
filed previously with our Registration Statement on Form S-1
(Registration No. 33-80453))
10.10 Employment Letter Agreement, dated July 18, 1995, between ArthroCare
Corporation and Robert T. Hagan. (Incorporated herein by reference to
Exhibit 10.16 filed previously with our Registration Statement on Form
S-1 (Registration No. 33-80453))
10.11 Restricted Stock Purchase and Security Agreement, dated August 1,
1995, between ArthroCare Corporation and Robert T. Hagan.
(Incorporated herein by reference to Exhibit 10.17 filed previously
with our Registration Statement on Form S-1 (Registration No. 33-
80453))
10.12+ Radiation Services Agreement, dated September 13, 1995, between
ArthroCare Corporation and SteriGenics International. (Incorporated
herein by reference to Exhibit 10.19 filed previously with our
Registration Statement on Form S-1 (Registration No. 33-80453))
10.13 Amended and Restated Stockholder Rights Agreement, dated October 16,
1995, between ArthroCare Corporation and certain holders of the
Registrant's securities. (Incorporated herein by reference to Exhibit
10.20 filed previously with our Registration Statement on Form S-1
(Registration No. 33-80453))
10.14 Contribution Agreement, dated March 31, 1995, by and among Philip E.
Eggers, Robert S. Garvie, Anthony J. Manlove, Hira V. Thapliyal, and
ArthroCare Corporation. (Incorporated herein by reference to Exhibit
10.21 filed previously with our Registration Statement on Form S-1
(Registration No. 33-80453))
</TABLE>
II-3
<PAGE>
<TABLE>
<CAPTION>
Exhibit
Number Description
------- -----------
<C> <S>
10.15 Amended Rights Agreement, dated October 2, 1998, between ArthroCare
Corporation and Norwest Bank Minnesota, N.A. (Incorporated herein by
reference to Exhibit 1 previously filed with our Registration
Statement on Form 8-A filed October 21, 1998 (Registration number 000-
27422))
10.16 Amended Distribution Agreement, between ArthroCare Corporation and
Arthrex, GmbH. effective October 2, 1998. (Incorporated herein by
reference to Exhibit 10.20 previously filed with our Quarterly Report
on Form 10-Q for the period ended April 3, 1999)
10.17 Employment Letter Agreement, dated June 20, 1997, between ArthroCare
Corporation and Michael A. Baker. (Incorporated herein by reference to
Exhibit 10.24 previously filed with Amendment No. 1 to our Quarterly
Report on Form 10-Q for the period ended June 28, 1997)
10.18+ Exclusive Distributor Agreement, dated August 21, 1997, between
ArthroCare Corporation and Kobayashi Pharmaceutical Company, Ltd.
(Incorporated herein by reference to Exhibit 10.25 previously filed
with our Quarterly Report on Form 10-Q for the period ended September
27, 1997)
10.19+ License Agreement dated February 9, 1998, between ArthroCare
Corporation and Boston Scientific Corporation. (Incorporated herein by
reference to Exhibit 10.26 previously filed with our Annual Report on
Form 10-K for the period ended January 3, 1998)
10.20+ Development and Supply Agreement dated February 9, 1998, between
ArthroCare Corporation and Boston Scientific Corporation.
(Incorporated herein by reference to Exhibit 10.26 previously filed
with our Annual Report on Form 10-K for the period ended January 3,
1998)
10.21+ Lease Agreement dated March 25, 1998 between ArthroCare Corporation
and Aetna Life Insurance company for our facility located at 840 Del
Rey Avenue, Sunnyvale, California 94086. (Incorporated herein by
reference to Exhibit 10.28 previously filed with our Annual Report on
Form 10-K for the period ended January 3, 1998)
10.22 Term sheet for License and Distribution Agreement between Xomed
Surgical Products and ArthroCare Corporation dated June 25, 1998.
(Incorporated herein by reference to Exhibit 10.29 previously filed
with our Quarterly Report on Form 10-Q for the period ended July 4,
1998)
10.23++ License Agreement dated February 9, 1999 between ArthroCare
Corporation and Collagen Aesthetics, Inc. (Incorporated herein by
reference to Exhibit 10.27 previously filed with our Annual Report on
Form 10-K for the period ended January 2, 1999)
10.24 Change of Control Agreement between ArthroCare Corporation and Michael
A. Baker. (Incorporated herein by reference to Exhibit 10. 28
previously filed with our Annual Report on Form 10-K for the period
ended January 2, 1999)
10.25 The form of "VP Continuity Agreement" between ArthroCare Corporation
and its vice presidents. (Incorporated herein by reference to Exhibit
10.29 previously filed with our Annual Report on Form 10-K for the
period ended January 2, 1999)
10.26 Letter Agreement, between ArthroCare Corporation and Collagen
Aesthetics, Inc. dated February 9, 1999. (Incorporated herein by
reference to Exhibit 10.30 previously filed with our Annual Report on
Form 10-K/A for the period ended January 2, 1999)
10.27 Employment Letter Agreement, between ArthroCare Corporation and John
R. Tighe dated January 26, 1999. (Incorporated herein by reference to
Exhibit 10.30 previously filed with our Quarterly Report on Form 10-Q
for the period ended April 3, 1999)
10.28 Employment Letter Agreement, between ArthroCare Corporation and
Christine E. Hanni dated May 12, 1999. (Incorporated herein by
reference to Exhibit 10.31 previously filed with our Quarterly Report
on Form 10-Q for the period ended April 3, 1999)
10.29 Employment Letter Agreement, between ArthroCare Corporation and Bruce
Prothro amended May 19, 1999. (Incorporated herein by reference to
Exhibit 10.32 previously filed with our Quarterly Report on Form 10-Q
for the period ended April 3, 1999)
</TABLE>
II-4
<PAGE>
<TABLE>
<CAPTION>
Exhibit
Number Description
-------- -----------
<C> <S>
10.30++ Litigation Settlement Agreement, between ArthroCare Corporation and
ETHICON, Inc. dated June 24, 1999. (Incorporated herein by reference
to Exhibit 10.33 previously filed with our Quarterly Report on Form
10-Q for the period ended July 3, 1999)
10.31 Relocation Loan Agreement, between ArthroCare Corporation and John R.
Tighe dated May 1,1999. (Incorporated herein by reference to Exhibit
10.34 previously filed with our Quarterly Report on Form 10-Q for the
period ended July 3, 1999)
10.32 Line of Credit Agreement between ArthroCare Corporation and Silicon
Valley Bank dated June 11, 1999. (Incorporated herein by reference to
Exhibit 10.35 previously filed with our Quarterly Report on Form 10-Q
for the period ended July 3, 1999)
23.1 Consent of PricewaterhouseCoopers LLP, independent accountants
*23.2 Consent of Latham & Watkins (included in Exhibit 5.1)
24.1 Power of Attorney (included on signature page hereto)
</TABLE>
- --------
+Confidential treatment granted
++Confidential treatment requested
*To be filed by amendment
Item 17. Undertakings
A. Insofar as indemnification for liabilities arising under the Securities
Act of 1933, as amended, may be permitted to directors, officers and
controlling persons of the registrant pursuant to the foregoing provisions, or
otherwise, the registrant has been advised that in the opinion of the
Securities and Exchange Commission such indemnification is against public
policy as expressed in the Act and is, therefore, unenforceable. In the event
that a claim for indemnification against such liabilities (other than the
payment by the registrant of expenses incurred or paid by a director, officer,
or controlling person of the registrant in the successful defense of any
action, suit or proceeding) is asserted by such director, officer or
controlling person in connection with the securities being registered, the
registrant will, unless in the opinion of its counsel the matter has been
settled by controlling precedent, submit to a court of appropriate
jurisdiction the question whether such indemnification by it is against public
policy as expressed in the Act and will be governed by the final adjudication
of such issue.
B. The undersigned hereby undertakes that, for purposes of determining any
liability under the Securities Act of 1933, each filing of the registrant's
annual report pursuant to Section 13(a) or Section 15(d) of the Securities
Exchange Act of 1934 (and, where applicable, each filing of an employee
benefit plan's annual report pursuant to Section 15(d) of the Securities
Exchange Act of 1934) that is incorporated by reference in the registration
statement shall be deemed to be a new registration statement relating to the
securities offered therein, and the offering of such securities at that time
shall be deemed to be the initial bona fide offering thereof.
C. The undersigned hereby undertakes that:
(1) For purposes of determining any liability under the Securities Act
of 1933, the information omitted from the form of prospectus filed as part
of this registration statement in reliance upon Rule 430A and contained in
a form of prospectus filed by the registrant pursuant to Rule 424(b)(1) or
(4) or 497(h) under the Securities Act shall be deemed to be part of this
registration statement as of the time it was declared effective.
(2) For the purpose of determining any liability under the Securities
Act of 1933, each post-effective amendment that contains a form of
prospectus shall be deemed to be a new registration statement relating to
the securities offered therein, and the offering of such securities at that
time shall be deemed to be the initial bona fide offering thereof.
II-5
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Act of 1933, the registrant
certifies that it has reasonable grounds to believe that it meets all of the
requirements for filing on Form S-3 and has duly caused this registration
statement to be signed on its behalf by the undersigned, thereunto duly
authorized, in the City of Sunnyvale, State of California, on September 16,
1999.
ARTHROCARE CORPORATION.
/s/ Michael A. Baker
By: _________________________________
Michael A. Baker
President and Chief Executive
Officer
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below does hereby constitute and appoint Michael A. Baker and
Christine Hanni with full power of substitution and full power to act without
the other, his true and lawful attorney-in-fact and agent to act for him in
his name, place and stead, in any and all capacities, to sign a registration
statement on Form S-3 and any or all amendments thereto (including without
limitation any post-effective amendments thereto), and any registration
statement for the same offering that is to be effective under Rule 462(b) of
the Securities Act, and to file each of the same, with all exhibits thereto,
and other documents in connection therewith, with the Securities and Exchange
Commission, granting unto said attorney-in-fact and agent full power and
authority to do and perform each and every act and thing requisite and
necessary to be done in and about the premises in order to effectuate the same
as fully, to all intents and purposes, as he might or could do in person,
hereby ratifying and confirming all that said attorney-in-fact and agent may
lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Act of 1933, this
registration statement has been signed by the following persons in the
capacities and on the dates indicated:
<TABLE>
<CAPTION>
Signature Title Date
--------- ----- ----
<S> <C> <C>
/s/ Michael A. Baker President, Chief Executive September 16, 1999
____________________________________ Officer and Director
Michael A. Baker (Principal Executive
Officer)
/s/ Christine Hanni Vice President, Finance, September 16, 1999
____________________________________ Chief Financial Officer and
Christine Hanni Assistant Secretary
(Principal Financial and
Accounting Officer)
/s/ Hira V. Thapliyal Director September 16, 1999
____________________________________
Hira V. Thapliyal
/s/ Annette J. Campbell-White Director September 16, 1999
____________________________________
Annette J. Campbell-White
/s/ C. Raymond Larkin, Jr. Director September 16, 1999
____________________________________
C. Raymond Larkin, Jr.
/s/ John S. Lewis Director September 16, 1999
____________________________________
John S. Lewis
Director September , 1999
____________________________________
Robert R. Momsen
</TABLE>
II-6
<PAGE>
EXHIBIT INDEX
<TABLE>
<C> <S>
1.1* Underwriting Agreement
5.1* Opinion of Latham & Watkins as to the legality of the securities being
registered
23.1 Consent of PricewaterhouseCoopers LLP, independent accountants
23.2* Consent of Latham & Watkins (included in Exhibit 5.1)
24.1 Power of Attorney (included on signature page hereto)
</TABLE>
- --------
* To be filed by amendment
<PAGE>
EXHIBIT 23.1
CONSENT OF INDEPENDENT ACCOUNTANTS
We hereby consent to the incorporation by reference and use in this
Registration Statement on Form S-3 of our reports dated January 27, 1999
relating to the consolidated financial statements, which appear in ArthroCare
Corporation's Annual Report on Form 10-K for the year ended January 2, 1999 and
also appear in such Registration Statement. We also consent to the
incorporation by reference in this Registration Statement of our report dated
January 27, 1999 relating to the financial statement schedule, which appears in
ArthroCare Corporation's Annual Report on Form 10-K for the year ended January
2, 1999. We also consent to the reference to us under the heading "Experts" in
such Registration Statement.
PricewaterhouseCoopers LLP
San Jose, California
September 15, 1999
