UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE YEAR ENDED DECEMBER 31, 1997
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER 0-016607
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ADVANCED TISSUE SCIENCES, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 14-1701513
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(STATE OR OTHER JURISDICTION (I.R.S. EMPLOYER
OF INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
10933 NORTH TORREY PINES ROAD, LA JOLLA, CALIFORNIA 92037
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(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (619) 450-5730
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
COMMON STOCK, $.01 PAR VALUE
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(TITLE OF CLASS)
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Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes X No
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As of March 25, 1998 there were 39,323,373 shares of Common Stock
outstanding.
The aggregate market value of the Common Stock of the Registrant held by
non-affiliates on March 25, 1998 was approximately $476,315,255.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Company's Proxy Statement for the Annual Meeting of
Stockholders to be held on May 20, 1998, as filed with the Commission pursuant
to Regulation 14A, are incorporated by reference into Part III of this report.
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PART I
ITEM 1. BUSINESS
INTRODUCTION
This Annual Report on Form 10-K contains forward-looking statements that
involve risks and uncertainties. Actual results could differ materially from
any forward-looking statements and from past performance as a result of such
risks and uncertainties. See the "Factors That May Affect Future Results"
section of this Annual Report.
Advanced Tissue Sciences, Inc. (the "Company" or "Advanced Tissue
Sciences") is a leading tissue engineering company engaged in the development
of human-based tissue products for therapeutic applications. The Company is
currently focusing its efforts primarily on skin, cartilage and cardiovascular
products. Utilizing principles of cell biology, bioengineering, biochemistry,
and polymer and transplant science, the Company has developed and is applying
a proprietary core technology which permits living human cells to be cultured
ex vivo in a manner that allows the cells to develop and assemble into
functioning three-dimensional tissue. With this proprietary technology,
Advanced Tissue Sciences has successfully replicated a variety of human
tissues. The Company's two skin products, Dermagraft(R) and Dermagraft-TC(R),
are currently being sold in certain markets and the Company has other products
in various stages of development.
Advanced Tissue Sciences' objective is to redefine tissue repair and
transplantation by developing, manufacturing and marketing products produced
through tissue engineering. The Company's product strategy is to utilize its
patented core technology to develop multiple products which address unmet
therapeutic needs or offer improved, cost-effective alternatives to current
treatment modalities. By building upon its base of scientific knowledge
through the continued application of its proprietary core technology, the
Company believes it will be able to achieve significant synergies in the
development, clinical testing and manufacture of successive tissue products.
In addition, the Company is focusing its development programs on products
which are currently being or are expected to be regulated as medical devices.
Medical devices are generally subject to a shorter regulatory approval process
than biologics or pharmaceuticals.
Leading the Company's product development efforts are therapeutic skin
products which address the burn and skin ulcer markets. These products are
based on three-dimensional, human tissues designed by the Company as temporary
or permanent replacements for human dermis. These products were developed for
conditions where the dermis (the inner skin layer) has been injured or
destroyed, such as in severe burns and chronic skin ulcers. The dermis is
essential to normal skin function and healing and, unlike epidermis (the outer
skin layer), does not regenerate into normal tissue after injury.
The Company's first commercial product, Dermagraft-TC, a temporary
covering for burns, was first approved for commercial sale by the U.S. Food
and Drug Administration ("FDA") in March 1997 for full thickness burns and for
partial thickness burns in October 1997. Dermagraft for the treatment of
diabetic foot ulcers, a living, human dermal replacement, was approved for
sale in Canada in August 1997 and was launched in the United Kingdom late in
1997 through a joint venture with Smith & Nephew plc ("Smith & Nephew").
Dermagraft for the treatment of diabetic foot ulcers is currently being
reviewed by the FDA under its expedited review process. In January 1998, the
General and Plastic Surgery Devices Panel of the Medical Devices Advisory
Committee to the FDA recommended that the agency approve Dermagraft for the
treatment of diabetic foot ulcers with the condition that the Company perform
a post-marketing study to confirm efficacy and provide physician training.
The Company is currently working with the FDA to address manufacturing and
quality assurance concerns identified by the FDA following an inspection of
the Company's manufacturing facility and concerns raised by the FDA related
to its consideration of the Company's premarket approval ("PMA") application
for Dermagraft for the treatment of diabetic foot ulcers. Consideration of
the Company's PMA application by the FDA and sales of Dermagraft and
Dermagraft-TC may be adversely affected while the Company further investigates
and corrects the anufacturing and quality assurance issues raised by the FDA.
See "Factors That May Affect Future Results - Government Regulation."
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DERMAGRAFT-TC. Dermagraft-TC, originally developed as an alternative to
human cadaver skin to treat severely burned patients, is now being used to
treat partial thickness burns as well. Dermagraft-TC consists of a dermal
tissue with an ultra-thin synthetic covering that acts as a protective cover.
In full thickness burns, Dermagraft-TC is designed to help retain fluids and
reduce the risk of infection until a sufficient amount of the patient's own
skin becomes available for grafting. In partial thickness burns,
Dermagraft-TC, as compared to silver sulfadiazine, has been shown to
significantly reduce pain and to heal burns faster and with less scarring.
Of the approximately 1.2 million people who suffer burn injuries annually
in the United States, up to 13,000 are severely burned and require skin
grafts. Dermagraft-TC was initially approved to address the approximately
1,500 severely burned patients with burns exceeding 20% body surface area.
Another 30,000 to 40,000 burn victims, often children, suffer the partial to
mid-dermal burns also being addressed by Dermagraft-TC. These burns
frequently result from household hazards such as scalds from hot liquids,
faulty heating pads or misuse of ignition fluids. Dermagraft-TC for burns is
being marketed by Advanced Tissue Sciences through a direct sales force in the
United States. Dermagraft-TC was also approved in Canada for severe and
partial thickness burns in January 1998. Dermagraft-TC will be marketed for
burns in Canada and in the rest of the world, subject to regulatory approvals,
through a joint venture with Smith & Nephew. See "Products - Burn Products."
DERMAGRAFT. Dermagraft is a dermal replacement product grown on a
bioabsorbable scaffold. It is designed to provide a healthy, metabolically
active dermal matrix in chronic ulcers to support wound closure. Healing skin
ulcers faster can potentially reduce the risk of infection (and, in the case
of diabetic foot ulcers, the subsequent risk of amputation), the need for skin
grafting and reconstructive procedures. Chronic skin ulcers that may be
addressed by Dermagraft include diabetic foot ulcers, venous ulcers and
pressure ulcers. Approximately 800,000 diabetic foot ulcers are estimated to
be treated in the United States each year, approximately half of which are
believed to represent the target market for Dermagraft. It is estimated that
approximately 1.5 million patients are affected by pressure ulcers and
approximately 500,000 patients are diagnosed with venous ulcers in the United
States each year.
Dermagraft is being developed and commercialized through a fifty-fifty
joint venture with Smith & Nephew. Under the joint venture agreement,
Advanced Tissue Sciences has principal responsibility for manufacturing and
Smith & Nephew has primary responsibility for the worldwide sales and
marketing of Dermagraft. Smith & Nephew is a world leader in wound care sales
with an established sales force in over 90 countries. Building upon the
introduction of Dermagraft in the United Kingdom and approval in Canada, the
Company expects, subject to obtaining regulatory approvals, that the joint
venture will introduce Dermagraft in the United States through over 100 Smith
& Nephew sales representatives and dedicated Dermagraft specialists. Smith &
Nephew is known for its comprehensive training and customer education
programs, and has successfully launched several advanced wound care products.
The joint venture also expects to begin clinical trials of Dermagraft in the
treatment of venous ulcers and pressure ulcers during 1998. See "Products -
Skin Ulcer Products."
ORTHOPEDICS. Through a separate joint venture with Smith & Nephew, the
Company is developing tissue engineered cartilage for orthopedic applications
utilizing its proprietary three-dimensional culture system. Over the past
several years, most of the joint venture's activities have been directed
toward the development of a human tissue engineered articular cartilage
product. Tissue engineered articular cartilage could provide a significant
opportunity to treat patients at an earlier stage of joint degeneration,
thereby delaying, or in some cases eliminating, the need for total joint
replacements. The pace of development of a human-based, tissue engineered
articular cartilage slowed during 1997 as a result of the Company's focus on
optimizing the product. Efforts to optimize the product are continuing in
1998 as the basis for advancing into clinical trials. The joint venture has
also developed prototypes for a tissue engineered meniscus which it expects to
move into preclinical studies during 1998. There are over 1.2 million
arthroscopic procedures for repair of the knee, including procedures involving
articular cartilage, meniscus and ligament performed annually in the United
States. See "Products - Orthopedic Products."
CARDIOVASCULAR. Through the use of its tissue engineering technology,
Advanced Tissue Sciences is working on developing blood vessels which will
grow and repair normally. The Company's tissue engineered products may
provide enhanced biocompatibility and improved patency with a reduced need for
the anticoagulant drugs required with currently available products. In
October 1997, Advanced Tissue Sciences was awarded a
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$2 million Advanced Technology Program grant from the National Institute of
Standards and Technology. In collaboration with the Department of
Bioengineering at the University of California, San Diego ("UCSD"), the
Company is leading a multi-disciplinary effort to design, construct and
evaluate tissue engineered vascular grafts produced from cells grown on a
biocompatible scaffold. The grant is structured to support this development
program over a three-year period. The project will integrate current
advances in cell culture, bioreactor technology, biomaterials and in vivo
blood vessel mechanics to create a unique, living tissue replacement for
blood vessels. The successful integration of these technologies through the
collaboration between the Company and UCSD could lead to the development of
grafts to treat coronary and peripheral artery vascular diseases. See
"Products - Cardiovascular Products."
In the United States, over 900,000 people die each year from
cardiovascular disease. More specifically, 14 million people suffer from
coronary artery disease and over 500,000 coronary artery bypass procedures
are performed annually in the United States. Likewise, each year
approximately 70,000 patients undergo surgery for the replacement of
peripheral vascular grafts.
SMITH & NEPHEW PLC. In April 1996, the Company entered into an agreement
with Smith & Nephew to form a fifty-fifty joint venture for the worldwide
commercialization of Dermagraft in the treatment of diabetic foot ulcers (the
"Dermagraft Joint Venture"). Smith & Nephew is a worldwide healthcare company
with extensive sales and distribution capabilities. It develops, manufactures
and markets a wide range of tissue repair products, principally addressing the
areas of bone, joints, skin and other soft tissue. In January 1998, Advanced
Tissue Sciences and Smith & Nephew expanded the Dermagraft Joint Venture to
include venous ulcers, pressure ulcers, burns and other skin wounds. As
consideration for entering into the Dermagraft Joint Venture, Advanced Tissue
Sciences received a $10 million up front fee in 1996 and Smith & Nephew made
a $20 million equity investment in the Company in January 1998. The Company
will also receive an additional $15 million by January 1999 and could
receive, subject to the achievement of certain milestones related to
regulatory approvals, reimbursement and sales levels, additional payments of
up to $136 million. Advanced Tissue Sciences and Smith & Nephew are sharing
equally in the revenues and expenses of the Dermagraft Joint Venture, except
for $6 million in clinical and regulatory costs to be funded by Advanced
Tissue Sciences. See "Collaborations and Strategic Alliances."
In 1994, Smith & Nephew and Advanced Tissue Sciences entered into a
separate fifty-fifty joint venture for the worldwide development, manufacture
and marketing of human tissue engineered cartilage for orthopedic applications
(the "Cartilage Joint Venture"). Under the terms of the Cartilage Joint
Venture agreement, Advanced Tissue Sciences will be responsible for
supervising the manufacturing of cartilage tissue products. The Cartilage
Joint Venture will execute the research and development program, develop a
worldwide marketing plan, and will utilize Smith & Nephew's established
selling and distribution network to market the products. Smith & Nephew
Endoscopy, a world leader in arthroscopy, is separately responsible for
developing and manufacturing instrumentation that could be used for the
arthroscopic insertion of the joint venture's cartilage products. As
specified in the Cartilage Joint Venture agreement, Smith & Nephew contributed
the first $10 million in Cartilage Joint Venture funding and the Company
contributed certain technology licenses. Cartilage Joint Venture revenues and
expenditures in excess of the first $10 million are being shared equally by
the partners. See "Collaborations and Strategic Alliances."
Advanced Tissue Sciences, Inc. was incorporated under the laws of the
State of Delaware in 1987. The Company maintains its executive offices at
10933 North Torrey Pines Road, La Jolla, California 92037, and its telephone
number at that address is (619) 450-5730. Financial information regarding the
Company's financial condition and results of operations can be found in a
separate section of this Annual Report on Form 10-K beginning on page F-1.
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PROPRIETARY CORE TECHNOLOGY
The Company's tissue engineering technology involves the controlled ex
vivo growth of living tissues and organs on three-dimensional support
structures. The Company believes that its technology represents a major
advance in medical science. Over the last several decades, technologies have
been developed that have made possible the growth of many of the over 200
different types of cells found in the human body in laboratory containers
filled with nutrient media. When grown on two-dimensional surfaces, the
ability of cells to interact and organize themselves into functioning tissues
is limited. In contrast, a three-dimensional framework allows cells to
develop and assemble into tissues that more closely resemble their
counterparts in the body.
In normal growth and development, the body uses specialized connective
tissue cells to form "stroma" or a living matrix that provides the
three-dimensional structure for each organ. Stroma also provides attachment
sites and produces growth factors that promote the development of organ cells
into functioning tissues. While the specific components and configuration of
stroma may differ from organ to organ, the basic principle of three-
dimensional stromal support applies to most organs in the body.
The Company has developed a proprietary core technology that combines the
principles of cell biology, biochemistry and polymer science to create a
three-dimensional living support stroma ex vivo. The support stroma is made
by first seeding organ-specific stromal cells (cell biology) onto a mesh
framework (polymer science) in an environment that simulates the body. The
cells attach, divide and secrete extracellular matrix proteins and growth
factors (biochemistry), using the mesh as a scaffolding. This process results
in a completely human stromal tissue that, in turn, supports the growth of
organ cells into functional tissue. Advanced Tissue Sciences has been issued
United States and European patents covering its core technology and numerous
patents related to applications of this technology.
The Company believes that its tissue engineered products may offer some
or all of the following benefits, depending upon the particular application of
the product:
* Physiological Human Tissue -- The Company's patented core technology
allows the cells to grow on a scaffold and develop into a three-dimensional
human tissue. The Company's products may then be transplanted as a
physiological tissue, as contrasted with the transplantation of cells or
scaffolds alone.
* Multiple Factors For Healing -- The human cells produce multiple growth
factors and tissue matrix proteins, all of which the Company believes are
important in the tissue repair process. Living, metabolically active cells
may also respond to the surrounding environment.
* Human Tissue -- The tissue matrix proteins naturally secreted by the
cells consist of human collagens, glycosaminoglycans and other human
proteins, rather than animal-derived matrix proteins, which may cause
allergic or immune reactions which can occur in response to such animal-
derived matrix proteins.
* Safety Tested -- The human tissue materials used in the manufacture of
the Company's products are extensively tested at independent laboratories
for potential pathogens such as Hepatitis B and HIV. All final product is
tested for sterility by performing United States Pharmacopeia (U.S.P.)
sterility tests on each product's growth medium.
* Off-the-Shelf Products -- Medical research has shown that several
tissues, including dermal tissue and certain cartilage tissue applications,
are not subject to rejection by a recipient's body. These tissue
engineered products may, therefore, be utilized as universal, permanent
replacement products in such applications.
* Prolonged Shelf Life -- The Company's dermal products can be frozen for
long-term storage. Similarly, it is expected that cartilage and some of
the other tissues in development will be able to be cryopreserved for a
long shelf life.
* Ease of Use -- The Company's dermal products are easy for surgeons to
apply using routine surgical techniques. In addition, tissue engineered
cartilage is being developed to be delivered in a single arthroscopic
procedure.
PRODUCTS
The Company has a number of therapeutic tissue products which are in
various stages of commercialization, clinical trials, preclinical studies and
research. Currently, its primary product focus is directed toward skin (for
burns and ulcers), orthopedic cartilage and cardiovascular products. In
addition, based on available resources,
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clinical results, markets and other cost benefit considerations, the Company
intends to bring other potential products to market in the future.
BURN PRODUCTS
Although there have been many advances in the care and treatment of
severely burned patients, available alternatives remain fairly limited and
success is highly dependent on the skills of burn surgeons and nurses. As a
result of the need for improvements in patient care and the ability to closely
monitor product performance, the Company selected severe burns, often referred
to as third degree burns, as the target for its first therapeutic use of the
Company's tissue engineering technology. In addition, dermal tissue has
several advantages over other tissues or organs in that it is grown from
fibroblasts, which are both readily available and not subject to rejection
by the body. The Company's burn products are also regulated as devices and,
therefore, are generally subject to a shorter regulatory approval process
than biologics.
Currently, to treat large full thickness burns (where both the epidermis
and the dermis are destroyed), burn surgeons typically excise the damaged
tissue and cover the wound as soon as possible. Conventional treatment for
large full thickness burns usually involves the use of temporary coverings to
limit infection, reduce pain and prevent the loss of body fluids, followed by
grafting of the patient's own skin ("autograft") as it becomes available. In
most cases, permanent closure of severe burn wounds is achieved with
autografts obtained by surgically harvesting areas of the patient's skin which
are still intact ("donor sites"). The dermis at the donor site is typically
"split" so that the removed graft consists of the entire epidermis and the
upper portion of the dermis (a "split-thickness" graft), leaving the bottom
portion of the dermis in the donor site to facilitate healing.
In partial thickness burns, commonly known as second degree burns, the
dermis has not been entirely destroyed and grafting is generally not
required. In partial thickness burns, the effort is to close the wound as
quickly as possible to reduce pain, the incidence of infection and scarring.
Partial thickness burns are generally treated with antimicrobial agents, the
most common being silver sulfadiazine which is applied topically. Dressing
changes are generally performed twice a day and can be quite painful. At each
dressing change, the surgeons will typically remove any damaged tissue. Goals
in the treatment of these patients include achieving rapid healing and
reducing pain, inflammation and scarring.
BURN MARKET. Of the approximately 51,000 burn patients hospitalized
annually in the United States, up to 13,000 are severely burned and require
skin grafts. Dermagraft-TC was initially approved to address the
approximately 1,500 severely burned patients requiring skin grafts with burns
exceeding twenty percent of body surface area. Another 30,000 to 40,000 burn
victims, often children and the elderly, suffer partial to mid-dermal, or
second degree, burns each year in the United States. These burns frequently
result from household hazards such as scalds from hot liquids, faulty heating
pads or misuse of ignition fluids.
DERMAGRAFT-TC. Patients with extensive full thickness burns have only a
limited amount of undamaged skin which can be used as donor sites for
autografts. This shortage of donor sites prevents rapid closure of the burn
wounds leaving the patient susceptible to infections and fluid loss, both of
which can be life-threatening. When sufficient autograft is not available,
human cadaver skin is often used as a temporary covering for the excised
burns. However, cadaver skin may transmit infection and is immunologically
rejected generally within several weeks of application. As a result, the
patient may require additional surgical procedures to cover the wound,
increasing the overall cost of treatment. Rejection can also give rise to
complicating infections of the burn wounds and, in addition, repeated
applications of cadaver skin can cause more rapid rejection. Removal of
cadaver skin prior to autografting can be difficult and cause significant
bleeding.
As an alternative to human cadaver skin, the Company developed
Dermagraft-TC. Dermagraft-TC consists of Dermagraft dermal tissue with an
ultra-thin synthetic covering that acts as a temporary epidermis which helps
to retain fluids and prevent infections of the wound bed. As with cadaver
skin, Dermagraft-TC must ultimately be removed from the wound bed prior to
grafting. However, the Company believes that Dermagraft-TC offers significant
advantages over cadaver skin. Cadaver skin has a number of limitations, such
as limited availability, the potential for immunological rejections that
necessitate repeat applications, significant bleeding and inflammation of the
wound bed and the potential for disease transmission. However, the human
tissue materials used in the
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manufacture of Dermagraft products, including Dermagraft-TC, are extensively
tested for potential pathogens such as Hepatitis B and HIV.
In March 1997, the FDA gave the Company approval to begin commercial
sales of Dermagraft-TC in the United States for use as a temporary covering
for severe burn wounds. The approval was based on a pivotal clinical trial
which demonstrated that Dermagraft-TC was successful in adequately preparing
the wound bed for successful autografting, performing equal to or better than
the cadaver skin control. In addition, Dermagraft-TC performed significantly
better than the control with respect to important secondary endpoints such as
ease of removal, amount of excision required, amount of bleeding upon excision
and overall satisfaction rating as a temporary covering among clinical
investigators. Under the approval, the Company is to conduct post-marketing
surveillance to generate additional information relative to infection rates.
In October 1997, the Company also received approval from the FDA to begin
commercial sales of Dermagraft-TC in the United States for partial-thickness
burns. In a clinical trial under a physician's IDE, Dermagraft-TC was
evaluated as an alternative to silver sulfadiazine in the treatment of
patients with limited to moderate partial thickness burns. In the trial,
Dermagraft-TC was affixed to the burns with adhesive strips and remained until
the wound was closed. Dermagraft-TC was compared to silver sulfadiazine which
had twice daily dressing changes and wound debridement as per the burn
center's standard practice. The clinical trial results indicated that
Dermagraft-TC showed a substantially reduced time to 90% healing or
epithelialization, required less than half the time to heal, and produced less
scarring at both three and twelve months of follow-up.
The manufacture of products for which a PMA is granted, such as
Dermagraft-TC, is subject to routine inspection by the FDA and certain state
agencies for compliance with Good Manufacturing Practices (GMP) requirements,
adverse event reporting requirements, and other applicable regulations.
Following a recent inspection of the Company's manufacturing facility, the
FDA notified the Company of numerous objectionable observations with respect
to certain manufacturing processes and systems. On March 26, 1998, the FDA
issued a warning letter requiring the Company to investigate and correct the
objections identified by the FDA. In response to certain issues raised by
the FDA inspection, the Company is voluntarily recalling certain lots of
Dermagraft and Dermagraft-TC which contained a raw material that was out of
specification. All of the recalled lots complied with finished product
specifications. The Company is currently taking the steps and corrective
actions it believes are necessary to address the conditions identified by the
FDA. Sales of Dermagraft-TC may be affected while the Company further
investigates the manufacturing issues raised by the FDA. See "Factors That
May Affect Future Results - Government Regulation."
Dermagraft-TC can offer several advantages in the treatment of partial
thickness burns. As compared to silver sulfadiazine, Dermagraft-TC may reduce
the pain, time and cost associated with once or twice daily dressing changes
and excision. More rapid healing can also reduce the costs and time
associated with treatment and can potentially reduce the hypertropic scarring
often seen in these burn wounds.
SKIN ULCER PRODUCTS
Based on its early experience with Dermagraft in burns, chronic skin
ulcers were also selected as one of the Company's first therapeutic targets.
The Company believes that Dermagraft provides a healthy, metabolically active
dermal matrix in the ulcer bed that will support growth of the patient's
epidermis from the edges of the wound and promote wound closure. Dermagraft,
therefore, reduces the time required to heal these wounds and potentially
reduces the need for skin grafting and reconstructive procedures. The Company
is also able to benefit from the experience it has gained with Dermagraft-TC
as both products use common raw materials (e.g., cell source and growth
medias), manufacturing processes, freezing procedures, storage methods and
packaging concepts. No statistical differences have been seen in any clinical
trials of Dermagraft with respect to any safety issues and no incidents of
immunologic rejections have been observed with Dermagraft. In addition,
Dermagraft is regulated by the FDA as a medical device.
Traditionally, there have been two approaches to skin ulcer treatment.
The most common treatment for less advanced ulcers is to allow normal healing
to occur by using dressings and topical medications to protect the wound.
Even when successful, this therapy can require many months of repeated
treatments to achieve
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healing. The second approach utilizes conventional skin grafts and is
typically used for more advanced skin ulcers. However, the difficulty of
healing donor sites and the risks associated with general anesthesia in the
elderly, who suffer the large majority of chronic skin ulcers, often prevents
the use of skin grafts. Both treatment approaches have a high failure rate.
Dermagraft is a dermal replacement product grown on a bioabsorbable
scaffold. It is designed to provide a healthy, metabolically active dermal
matrix in chronic ulcers to support wound closure. Healing skin ulcers faster
can potentially reduce the risk of infection (and, in the case of diabetic
foot ulcers, the subsequent risk of amputation), the need for skin grafting
and reconstructive procedures. Chronic skin ulcers that may be addressed by
Dermagraft include diabetic foot ulcers, venous ulcers and pressure ulcers.
ULCER MARKET. Over 2.8 million cases of chronic, slow-healing or
non-healing skin ulcers are treated in the United States each year. In these
wounds, the skin breaks down as a result of disruption of blood flow caused
either by prolonged pressure over a localized area or by chronic diseases
which affect the circulatory or peripheral nervous systems. In many of these
patients, skin ulcers are open, often painful, wounds which are resistant to
healing for many months or years. In part because current therapies for skin
ulcers are often ineffective, the treatment of skin ulcers is an expensive
process. Individual patient treatment can cost thousands of dollars per year.
Published sources estimate that the United States healthcare system spends
more than $5 billion each year for the treatment of chronic skin ulcers.
Approximately 800,000 diabetics in the United States suffer from chronic,
non-healing diabetic foot ulcers each year, 400,000 of which are full
thickness plantar ulcers that represent the Company's initial target market.
Ulcers that do not heal leave the patients susceptible to infection, which may
lead to amputation of the foot or leg. At least 60,000 amputations occur each
year in the United States, 85% of which are preceded by a diabetic foot ulcer.
The five-year survival rate following amputation is only 50 percent. In
addition, it is estimated that approximately 1.5 million patients are
affected by pressure ulcers and approximately 500,000 patients are diagnosed
with venous ulcers in the United States each year.
DIABETIC FOOT ULCERS. Many diabetic patients experience circulatory
deficiencies and decreased nerve sensation in their legs and feet, which
prevent them from shifting their weight in response to wound-provoking
pressure. The patient may be unaware of some injuries and can leave wounds
unattended for days, resulting in an ulcer. Once the ulcer forms, it may heal
poorly due to the effects of diabetes on normal healing processes. Unhealed
diabetic ulcers can result in gangrenous infection that may lead to amputation
of the limb. Over the course of their disease, patients with diabetes lose
their ability to form normal collagens, glycosaminoglycans and growth factors.
Dermagraft is designed as a replacement to address these deficiencies in the
diabetic patient's own dermal tissue. Dermagraft contains extracellular
matrix proteins, growth factors and glycosaminoglycans normally found in
healthy human dermal tissue.
In January 1998, the General and Plastic Surgery Devices Panel of the
Medical Devices Advisory Committee to the FDA recommended that the agency
approve Dermagraft for the treatment of diabetic foot ulcers in the United
States, with the conditions that the Company perform a post-marketing study
to confirm efficacy and provide physician training. The recommendation was
based on results of a pivotal clinical trial enrolling 281 patients and a
50-patient supplemental trial. The supplemental trial was performed to
confirm the results of the pivotal clinical trial with product produced in
the Company's commercial manufacturing systems and to commercial
specifications. The Company is currently working with the FDA to address
concerns raised by the FDA related to its consideration of the Company's
premarket approval ("PMA") application for Dermagraft for the treatment of
diabetic foot ulcers. See "Factors That May Affect Future Results -
Government Regulation."
The patients enrolled in the treatment group of the pivotal clinical
trial and all the patients enrolled in the supplemental trial received a
dosing regimen of one piece of Dermagraft per week for up to eight weeks. In
the pivotal trial, Dermagraft was compared to a control treatment of
conventional therapy consisting of sharp debridement, infection control, moist
wound treatment and standardized off-weight bearing strategies. The primary
endpoint of both the trials was complete wound closure evaluated at twelve
weeks. Patients in both trials were also to be followed for a total of
thirty-two weeks to assess safety and long-term efficacy.
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In the pivotal clinical trial, 38.5% of the evaluable patients who
received Dermagraft healed completely in twelve weeks as compared to 31.7% of
the evaluable patients treated with conventional therapy. In addition, 50.8%
of those evaluable Dermagraft patients receiving product in the pivotal
clinical trial produced to commercial specifications (i.e., within a specific
"therapeutic range") achieved complete wound closure within twelve weeks. In
addition, at thirty-two weeks, or six months after the last application of
Dermagraft, 57.5% of the evaluable Dermagraft patients receiving product in
the pivotal trial manufactured to commercial specification achieved complete
wound closure as compared to only 42.4% of those receiving conventional
therapy alone.
Enrollment in the supplemental trial was completed in mid-1997. The
results of the supplemental trial at twelve weeks were closely consistent with
those seen in the pivotal clinical trial for the product produced to
commercial specifications. In the supplemental trial, 51.3% of the evaluable
Dermagraft patients achieved complete healing within twelve weeks as compared
to the 50.8% achieving complete healing in the pivotal clinical trial.
Dermagraft for the treatment of diabetic foot ulcers was approved for
sale in Canada in August 1997 and was commercially introduced in the United
Kingdom in October 1997. Dermagraft is to be marketed worldwide, subject to
regulatory approvals, through the Dermagraft Joint Venture with Smith &
Nephew. See "Collaborations and Strategic Alliances." Failure of the Company
to gain FDA approval of Dermagraft for the treatment of diabetic foot ulcers
in a timely manner or, if approved, to achieve significant market acceptance
of the product would have a material adverse effect on the Company's business,
financial condition and future results of operations.
As with Dermagraft-TC, the manufacture of Dermagraft must be in
compliance with GMP requirements, adverse event reporting requirements, and
other applicable regulations. As previously discussed, after a recent
inspection of the manufacturing facility in conjunction with the PMA
application, the FDA notified the Company of numerous objectionable
observations with respect to certain manufacturing processes and systems and
issued a warning letter requiring the Company to investigate and correct the
objections identified by the FDA. In response to certain issues raised by
the FDA inspection, the Company is voluntarily recalling certain lots of
Dermagraft and Dermagraft-TC which containted a raw material that was out of
specification. All of the recalled lots complied with finished product
specifications. The Company is currently taking the steps and corrective
actions it believes are necessary to address the conditions identified by
the FDA. The FDA has informed the Company that these problems will need to
be corrected or resolved to the agency's satisfaction in order for the FDA to
consider approving the Company's pending PMA application for Dermagraft.
Internatinal sales of Dermagraft by the Dermagraft Joint Venture could be
affected while the Company further investigates the manufacturing issues
raised by the FDA. See "Factors That May Affect Future Results -
Government Regulation."
VENOUS ULCERS. Venous ulcers result when damage to the valves of the
deep leg veins reduces their ability to return blood to the upper body,
leading to pooling of blood in the legs and subsequent breakdown of the skin.
Venous ulcers that do not respond to medical treatment often must be closed
surgically by the use of skin grafts.
In 1994, the Company completed a pivotal clinical trial of a single
application of Dermagraft under an Investigational Device Exemption (an "IDE")
from the FDA. In that trial, patients were tracked for a period of
twenty-four weeks to evaluate wound closure. Analysis of the data from the
pivotal trial showed no statistical differences between the patients in the
control group and those treated with a single application of Dermagraft.
Analysis of the six-month follow-up data from patients in this trial did,
however, show a statistically significant difference in the recurrence rate of
Dermagraft-treated patients (6%) versus control patients (20%) indicating a
positive effect on the quality and durability of the ulcers healed by
Dermagraft. As noted above for diabetic foot ulcers, an important goal in the
treatment of chronic skin ulcers is to prevent the recurrence of the wound,
which both lowers the cost of treatment and improves overall patient care.
Through the Dermagraft Joint Venture with Smith & Nephew, the Company
expects to begin a clinical trial of Dermagraft in the treatment of venous
ulcers during 1998. The trial is expected to evaluate the use of multiple
pieces of Dermagraft to achieve wound closure. In this trial, the Company
intends to capitalize on and
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apply the knowledge gained from the diabetic foot ulcer trials with respect
to product efficacy to venous ulcers. See "Diabetic Foot Ulcers" above.
PRESSURE ULCERS. Pressure ulcers are common in hospital and nursing home
patients. Pressure ulcers form in skin that is continually compressed under
the weight of a bedridden or wheelchair-bound patient, who does not
periodically turn or roll to relieve the compressed skin. The compressed skin
does not receive blood flow for hours at a time, ultimately forming a wound.
Severe pressure ulcers frequently must be closed by use of skin grafts or
major reconstructive surgery.
The Company, through the Dermagraft Joint Venture with Smith & Nephew,
anticipates beginning a pivotal clinical trial of Dermagraft for the treatment
of pressure ulcers within the next twelve months. The pivotal trial is to be
based on the results of an earlier pilot clinical trial. In the pilot
clinical trial, fifty patients were segregated into three dosing groups and
one control group. Wound closure was evaluated over a period of twelve weeks.
The treatment group showing the best results received two pieces of Dermagraft
every two weeks for a total of eight pieces. Complete wound healing was
achieved in 46% of these patients as compared to 25% of the patients in the
control group.
ORTHOPEDIC PRODUCTS
Much of the knowledge gained from developing the Company's existing skin
products has been applied to the growth of orthopedic tissues. The Company
believes that its core technology and proprietary manufacturing systems allow
the regulation of critical environmental factors, including oxygen tension,
pressure and media composition, that may provide the necessary conditions for
the production of a high tensile-strength cartilage capable of withstanding
the high shear and load forces present in human joints. Similar to the skin,
the Company believes, and scientific research supports, that tissue engineered
cartilage products will be non-immunogenic given a dense matrix around the
cartilage cells (chondrocytes).
Traumatic injuries often cause permanent damage to tissues in human
joints such as cartilage, ligaments, tendon and bone. The body has a limited
ability to repair these tissues on its own, and there are few treatment
options available to replace damaged tissue. The Company is focusing its
initial product development efforts on tissue engineered cartilage. Cartilage
serves diverse functions in many parts of the body such as providing a gliding
surface for smooth joint motion (articular cartilage), and serving to absorb
both impact and load-force transmitted to the axial skeleton (meniscus). In
many cases, damage to cartilage tissue subsequently leads to further
deterioration and osteoarthritis which can eventually require a total joint
replacement.
The Company is developing its orthopedic cartilage products through the
Cartilage Joint Venture with Smith & Nephew. See "Collaborations and
Strategic Alliances." The Cartilage Joint Venture also has a right of first
negotiation to develop other tissue engineered products for orthopedic
applications such as ligament, tendon and bone.
ORTHOPEDIC MARKETS. In the United States each year, there are over 1.2
million arthroscopic procedures of the knee performed, including procedures
involving articular cartilage, meniscus and ligaments. By intervening early
in the degenerative process, the Cartilage Joint Venture hopes to delay or
perhaps even avoid some of the 230,000 total knee replacement surgeries
performed annually in the United States. There are an additional
400,000 arthroscopic procedures performed each year in the United States in
joints such as the shoulder, elbow, wrist, hip and ankle which could also be
candidates for the joint venture's articular cartilage products.
ARTICULAR CARTILAGE. Articular (joint) cartilage covers the opposing
surfaces of all moving joints in the body. Even small defects in the
articular cartilage can cause pain and subsequent restriction of joint motion.
These defects greatly increase the probability of degenerative cartilage
problems, such as arthritis, later in life. The primary treatment for these
articular defects is to trim away intruding cartilage fragments via
arthroscopy which increases joint mobility but does not prevent long-term
degenerative changes. Injuries resulting from sports trauma are a common
cause of these cartilage defects. To the Company's knowledge, other than
autologous transplants of the patient's own cells, there are no commercially
available products either synthetic or natural which can replace damaged
cartilage in the human body. Tissue engineered articular cartilage could
provide a significant opportunity to treat patients at an earlier stage of
joint degeneration, thereby delaying, or
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in some cases eliminating, the need for total joint replacements. Products
to repair articular cartilage may ultimately be used in any joint in the
body, such as knees, shoulders, elbows, wrists, hips and ankles.
The pace of development of a human-based, tissue engineered articular
cartilage slowed during 1997 as a result of the Company's focus on optimizing
the product. The Company, as part of the Cartilage Joint Venture with Smith &
Nephew, had submitted an IDE in December 1996 requesting approval to begin a
human pilot clinical trial with human tissue engineered articular cartilage
for the repair of articular surfaces in knee joints. The FDA requested
additional information with respect to the IDE. However, as a result of
knowledge gained from the clinical trials of Dermagraft with respect to the
importance of metabolic activity, the Cartilage Joint Venture has been working
to further develop and identify those critical factors believed necessary for
the clinical success of an articular cartilage product. These efforts are
continuing and will be the basis for providing additional information to the
FDA under the IDE.
The IDE submission is based on a preclinical safety study using a small
animal model. Through twelve months of follow-up, no adverse events were
observed with the product. Additionally, significant improvement in the
repair of defects was observed in grafted versus ungrafted control sites. The
grafted tissue had a significantly more hyaline-like appearance, greater
content of sulfate glycosaminoglycans and smoother articular surface as
compared to the untreated defects. These results have demonstrated the safety
of the product and also that the repair tissue is of better quality and more
closely resembles adjacent normal tissue than allowing the defects to heal by
natural processes. The Cartilage Joint Venture has also performed a normal
healing study using a large animal model. The results of this study thus far
have demonstrated that untreated defects heal with scar tissue, as has been
shown in humans, and, therefore, the model may be representative of the
effects of tissue engineered cartilage on progression of degenerative joint
diseases.
MENISCAL CARTILAGE. The meniscus is a cushion that acts as a shock
absorber in the knee which is frequently damaged or destroyed by sports injury
or other trauma. Current repair procedures for avascular meniscal injuries
have limited success in producing a long-term repair. The Company believes
that its tissue engineering approach could offer a benefit in the repair and
eventual total replacement of the meniscus. The Cartilage Joint Venture has
conducted collaborative preclinical studies with scientists under a sponsored
research program which has shown that successful repair was achieved using
tissue engineered meniscal allografts, in comparison to failure to heal in a
control group. In pilot preclinical studies, further sponsored research
performed at Children's Hospital in Boston ("Children's Hospital") showed that
tissue engineered meniscus can be generated and may be used for total meniscal
replacement. In 1997, the joint venture developed prototypes for a tissue
engineered meniscus which it expects to move into preclinical studies during
1998.
LIGAMENT/TENDON. Frequently, sports injuries involve damage to ligaments
and tendons, particularly injury to the anterior cruciate ligament. The
Company has successfully utilized degradable polymers shaped into tendon-like
structures combined with fibroblasts to engineer a living ligament. Research
work on the optimization of this technique for replacement of ligament and
tendon was in collaboration with scientists at the Massachusetts Institute of
Technology ("MIT") and Children's Hospital. Through this sponsored research,
the Company has explored growth conditions that may allow it to grow tissue
engineered ligament and tendon with biomechanical properties similar to those
found in the human body.
BONE. In collaboration with researchers at MIT and Children's Hospital,
the Company has successfully grown tissue engineered bone. Research has shown
that three-dimensional bone grown ex vivo secreted extracellular matrix
proteins and retained biomechanical properties analogous to those tissues in
the human body, eliminating the need for extracting bone from other areas of
the patient's body. The use of tissue engineered bone to replace long bones,
such as the femur, has been successful in preclinical studies.
CARDIOVASCULAR PRODUCTS
Cardiovascular tissue consists of a number of cell types including
cardiac fibroblasts, smooth muscle cells and endothelial cells. Cardiac
fibroblasts are closely related to the dermal fibroblasts the Company uses to
manufacture its existing skin products. Accordingly, dermal fibroblasts may
be useful in the growth of vascular grafts and other cardiovascular products.
The Company is also investigating the utility of smooth muscle cells, a
functional component of the native artery, to add strength to the tissue
engineered vessels. Endothelial cells
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line the interior of blood vessels and are important to avoid clotting and
the build up of plaque, or atherosclerosis. Matrix proteins and growth
factors secreted by fibroblasts or smooth muscle cells may induce endothelial
cell migration into the tissue engineered grafts. The Company believes its
cardiovascular products will be regulated as medical devices, similar to its
skin and cartilage products.
CARDIOVASCULAR MARKET. In the United States, over 900,000 people die each
year from cardiovascular disease. More specifically, 14 million people suffer
from coronary artery disease and over 500,000 coronary artery bypass
procedures are performed annually in the United States. Likewise, each year
approximately 70,000 patients undergo surgery for the replacement of
peripheral vascular grafts. The application of tissue engineered vascular
grafts could provide these patients with a viable alternative treatment. An
aging population is likely to increase the incidence of these diseases and the
need for cost-effective treatments in the future. Another 60,000 patients or
more have prosthetic heart valves implanted each year. While there are many
effective treatments for these patients, there are also many problems to be
overcome such as biocompatibility, durability and availability. Tissue
engineered cardiovascular products, such as off-the-shelf blood vessels, may
potentially solve some of these issues.
BLOOD VESSELS. Vascular grafts are used to repair or replace segments of
arterial and venous blood vessels that are weakened, damaged or obstructed due
to trauma or disease such as aneurysms and atherosclerosis. Grafts are either
autografts (the patient's own veins or arteries), prosthetic grafts made of
synthetic materials such as polyesters or other composite materials, or
non-viable preserved biological tissue from cadavers or other species. The
harvesting of autografts requires extensive surgery which is time consuming,
costly and traumatic. In addition, patients requiring multiple bypass
surgeries may not have enough suitable vessels to harvest. Cyropreserved
allograft veins from cadavers are sometimes used, but availability is limited
and patency rates are lower than autograft vessels. Prosthetic vascular
grafts are generally used for large or medium diameter (>6mm) grafts as small
diameter synthetic grafts have generally demonstrated poor performance.
Prosthetic vascular grafts often show insufficient tissue integration and
re-endothelization. Problems associated with small diameter synthetic grafts
include stenosis (or a narrowing), pseudoaneurysm formation, and acute
occlusion due to platelet aggregation.
Many companies are attempting to develop small diameter vascular grafts
(3mm to 5mm) with characteristics similar to biological grafts. These
companies are employing a variety of technologies to reduce thrombosis and
promote a rapid ingrowth of tissue such as different weaves and knits,
chemical coatings and gelatins, and freeze drying. Advanced Tissue Sciences'
research has focused on using specialized polymer constructs, bioreactor
design and colonization techniques to create a completely human vessel.
Bioreactors have been developed to generate the mechanical forces similar to
that encountered in the body to stimulate the cells to align concentrically,
absorbing stress as in a normal vasculature, and to establish a configuration
native to blood vessels. Imposing such forces allows for greater structural
and mechanical integrity in the tissue engineered vascular grafts.
Biochemical and immunohistochemical analysis of bioengineered blood vessels
demonstrates an increase in tissue deposition over time in culture and the
synthesis of elastin and other matrix proteins which are essential to blood
vessel formation and function. These matrix proteins, along with various
growth factors which are naturally secreted by the grafts, should also induce
endothelial cell migration and host cell integration.
During 1997, the Company, both internally and through collaborations with
The Georgia Institute of Technology ("Georgia Tech"), MIT and Children's
Hospital, continued to work toward the development of tissue engineered blood
vessels in vitro that have adequate biomechanical and structural properties to
function in vivo and minimize or eliminate the potential for clotting or
thrombogenecity. Georgia Tech has performed biomechanical property tests of
the bioengineered vascular grafts and native coronary vessels. The data
generated are being used to guide the Company's vascular graft development.
As previously reported, through sponsored research with MIT and Children's
Hospital, feasibility studies were performed with small diameter (3mm to
3.5mm) bioengineered blood vessels. These blood vessels were created by
seeding a synthetic biodegradable tube with fibroblasts and other vascular
cell types. These blood vessels have been implanted into large animal models
and have shown normal function up to eight weeks. Researchers have also shown
the ability of large diameter (15mm) tissue engineered grafts to persist,
remain durable and grow normally in preclinical studies.
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In October 1997, Advanced Tissue Sciences was awarded a $2 million
Advanced Technology Program grant from the National Institute of Standards and
Technology. In collaboration with the Department of Bioengineering at UCSD,
the Company is leading a multi-disciplinary effort to design, construct and
evaluate tissue engineered vascular grafts produced from cells grown on a
biocompatible scaffold. The grant is structured to support this development
program over a three-year period. The collaboration will integrate current
advances in cellular mechanics, bioreactor technology, and blood vessel
mechanics to create a unique living tissue replacement for blood vessels.
HEART VALVES. The valves open and close with every beat of the heart.
When a valve becomes damaged or diseased, the heart must work harder to pump
the same volume of blood. As the condition worsens, the valve has to be
replaced. Currently, either mechanical or porcine valves are used to replace
the native human valves; however, each has its drawbacks. With mechanical
valves, patients are required to take anticoagulant medication for the rest of
their lives to reduce the likelihood of thromboembolic events (i.e., blood
clots). Porcine valves have problems with durability and calcification,
frequently requiring additional and costly surgery to implant replacement
valves.
The Company's past preclinical studies to develop tissue engineered
valves on synthetic scaffolds under sponsored research performed by
researchers at MIT and Children's Hospital demonstrated the feasibility of
utilizing tissue engineering to create heart valves using a three-dimensional
biodegradable scaffolding. In these feasibility studies, tissue engineered
valve leaflets were created by seeding a synthetic biodegradable fiber matrix
with fibroblasts, endothelial and other cells. The tissue engineered leaflets
were then implanted in large animals which were followed for up to eleven
weeks. The leaflets tolerated surgical handling and sutures, and were found
to increase in size to accommodate for valve growth over the period of
implant. Additionally, the valve exhibited no evidence of stenosis and had
trivial, clinical insignificant, regurgitation. Total protein and collagen
analysis showed the development of an extracellular matrix, including elastin,
and histologies of the constructs resembled native tissue.
STENTS. Stents are generally synthetic materials that are inserted in a
vessel after angioplasty (the mechanical removal of an occlusion by the
insertion and inflation of a balloon catheter) in an attempt to prevent
restenosis or re-occlusion of the vessel. Without stent intervention,
approximately 40% of patients will experience restenosis of the vessel within
two years of plaque removal. Using a living, bioengineered stent comprised of
healthy human cells, either alone or in conjunction with a mechanical stent,
could potentially provide a more stable vascular lining, thereby preventing or
reducing thrombosis or restenosis.
OTHER THERAPEUTIC TISSUES
Many other organ tissues have been successfully grown using the Company's
technology that could potentially be developed into therapeutic products.
Commercialization of these or other tissues, such as pancreas,
gastrointestinal and blood/brain barrier tissues, is dependent on a number of
factors, including the Company's assessment of each tissue type's market
potential and the availability of sufficient resources, either internally or
through collaborations with future corporate partners.
RECONSTRUCTIVE APPLICATIONS. There may be several applications for the
Company's cartilage and bone products in reconstructive surgery.
Reconstructive implants offer an important alternative at a time when silicon,
Teflon, and other implant materials are being taken off the market. Under
Company-sponsored research, scientists have performed pilot preclinical
studies with engineered cartilage and bone for reconstructive applications and
have even constructed an entire joint consisting of bone, cartilage and
ligament.
CARTILAGE. Studies sponsored by the Company have shown that cartilage
implants retain their shape for up to one year after implantation into the
facial regions of animals. In addition, researchers in this collaboration
have developed an injectable cartilage product that has been successfully
utilized to construct total ear and nose implants. Such implants have
persisted in animals for over twelve months. An injectable cartilage may also
be useful for cartilage augmentation, total meniscus replacement, and
intravertebral disc repair.
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BONE. An engineered bone tissue could be useful in joint replacement,
bone grafting and facial bone reconstruction. Scientists have shown that
three-dimensional bone grown in vitro secreted extracellular matrix proteins
and retained biomechanical properties analogous to those tissues in the human
body, eliminating the need for extracting bone from other areas of the
patient's body. Research has also advanced in the growth of bone/cartilage
composites which could offer additional solutions to reconstructive surgery.
Studies have shown that full thickness cranial bone defects in animals can be
corrected by implantation of tissue engineered bone. Scientists have
successfully replaced long bones, such as the femur, in preclinical studies.
LIVER. The liver is the body's major metabolic organ. The only
treatment for liver failure today is a liver transplant and currently there is
an insufficient supply of transplantable livers. It is currently estimated
that 26,000 people die each year from chronic liver disorders, including many
who are waiting for a transplant, while only 3,500 liver transplants are
performed each year.
Advanced Tissue Sciences has demonstrated the ability to culture
enzymatically active animal and human liver cells (hepatocytes) in long-term
cultures. The Company's system allows for the active growth of liver cells
which retain their ability to manufacture a variety of liver proteins and
enzymes required for normal hepatic function. The Company has reported
successful engraftment and persistence of liver tissue implanted in various
regions in rats, including subcutaneous, intraperitoneal, and supra hepatic
sites. In addition, the Company has conducted pilot preclinical trials that
involved implantation of engineered liver tissue into both small and large
animal models. In these trials, the implants have functioned well for
approximately three months (the duration of the experiment).
BONE MARROW. Bone marrow is ultimately responsible for the production of
all of the body's blood and immune cells. The Company believes that a
universal bone marrow cultured ex vivo could be used as a replacement in
patients whose bone marrow has been damaged or destroyed during radiation or
chemotherapy treatments. The Company has successfully replicated animal and
human bone marrow and natural killer cells (an anti-cancer cell component of
the immune system) and has conducted pilot preclinical trials involving the
infusion of replicated bone marrow cells. In addition, the Company has also
grown and grafted bone marrow cultures with high percentages of stem cells on
biodegradable polymer scaffolds.
COLLABORATIONS AND STRATEGIC ALLIANCES
The Company's strategy for the development, clinical testing, manufacture
and commercialization of certain of its proposed tissue replacement products
includes entering into various collaborations with corporate partners,
licensees and others from time to time. The Company is currently involved in
a number of collaborative arrangements in connection with its product
development activities.
SMITH & NEPHEW PLC. In April 1996, the Company entered into an agreement
with Smith & Nephew to form a fifty-fifty joint venture for the worldwide
commercialization of Dermagraft, the Company's tissue engineered dermal
replacement, for the treatment of diabetic foot ulcers (the "Dermagraft Joint
Venture"). Smith & Nephew is a worldwide healthcare company with extensive
sales and distribution capabilities. It manufactures a wide range of tissue
repair products, principally addressing the areas of bone, joints, skin and
other soft tissue. In January 1998, the Company and Smith & Nephew expanded
the Dermagraft Joint Venture to include, with certain exceptions, any products
using the Company's technology for the medical care and treatment of skin
tissue wounds, such as pressure and venous ulcers, burns and skin tissue
defects. The Company has retained the exclusive right and will continue to
market Dermagraft-TC as a temporary covering for full and partial thickness
burns in the United States, while the Dermagraft Joint Venture has the right
to market Dermagraft-TC for other skin wounds in the United States. Under
the terms of the Dermagraft Joint Venture agreements, Advanced Tissue Sciences
is responsible for supervising the manufacturing of Dermagraft and
Dermagraft-TC. Smith & Nephew's existing wound care sales force and
distribution network in over ninety countries is to be used to market the
products. See "Products -Burn Products" and "Products - Skin Ulcer Products."
As consideration for entering into the Dermagraft Joint Venture, Advanced
Tissue Sciences received a $10 million up front fee in 1996 and Smith & Nephew
made a $20 million equity investment in the Company in January 1998. The
Company will also receive an additional $15 million by January 1999 and could
receive,
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subject to the achievement of certain milestones related to regulatory
approvals, reimbursement and sales levels, additional payments of up to
$136 million. No assurance can be given that the Dermagraft Joint Venture or
the Company will receive FDA approvals, obtain reimbursement or successfully
commercialize such products. Accordingly, there can be no assurance that
the Company will receive any or all of these milestone payments. See
"Factors That May Affect Future Results."
Advanced Tissue Sciences and Smith & Nephew will share equally in the
expenses and revenues of the Dermagraft Joint Venture except, as provided in
the January 1998 agreement, the Company will fund the first $6 million of
expenses for conducting clinical trials and for regulatory support of
Dermagraft and Dermagraft-TC in the treatment of venous and pressure ulcers.
In 1994, Smith & Nephew and the Company entered into a separate
fifty-fifty joint venture for the worldwide development, manufacture and
marketing of human-based, tissue engineered cartilage for orthopedic
applications. Under the agreement, Smith & Nephew contributed the first $10
million in Cartilage Joint Venture funding and the Company contributed certain
technology licenses. Joint venture revenues and expenditures in excess of the
first $10 million are being shared equally by the partners. In addition, the
Company has been drawing against a $10 million loan commitment from Smith &
Nephew to fund the Company's share of the joint venture's expenditures. The
Cartilage Joint Venture also has the right of first negotiation to develop
tissue engineered bone, tendon and ligament for orthopedic applications.
Advanced Tissue Sciences has retained all rights to non-orthopedic cartilage
applications.
Under the terms of the Cartilage Joint Venture agreement, Advanced Tissue
Sciences will be responsible for supervising the manufacturing of the
cartilage tissue products. The Cartilage Joint Venture will execute the
research and development program, develop a worldwide marketing plan, and will
utilize Smith & Nephew's established selling and distribution network to
market the products. Smith & Nephew Endoscopy, a world leader in arthroscopy,
is separately responsible for developing and manufacturing instrumentation
that could be used for the arthroscopic insertion of the joint venture's
cartilage products. The Cartilage Joint Venture's initial product development
efforts are being focused on the repair or replacement of damaged articular
and meniscus cartilage in knee joints. See "Products - Orthopedic Products."
MASSACHUSETTS INSTITUTE OF TECHNOLOGY/CHILDREN'S HOSPITAL IN BOSTON. In
connection with an acquisition in September 1992, the Company entered into
sponsored research and license agreements with MIT and Children's Hospital.
Under the research agreement, the Company sponsored a minimum of $1 million a
year for early stage research conducted at MIT and Children's Hospital from
1993 through 1997. Although the Company substantially reduced its commitment
to MIT and Children's Hospital in 1998, under the license agreement, the
Company continues to have rights to certain MIT and Children's Hospital
patents and technology which relate to tissue engineering, organ
transplantation and polymer science. To retain these rights, the Company will
be required to meet certain diligence requirements with respect to advancing
the licensed technology. The Company also remains responsible for associated
patent application costs and related maintenance fees.
GEORGIA TECH. Georgia Tech is recognized as having a leading academic
program in biomedical engineering. In 1997, the Company entered into a
one-year research agreement providing for the investigation of the effect of
fluid flow on chondrocyte metabolism. The Company and Georgia Tech are
currently working on an extension of this research agreement. Georgia Tech
has also collaborated with the Company on its cardiovascular program,
performing biomechanical property tests of bioengineered vascular grafts as
compared to native coronary vessels. The relationship between the Company
and Georgia Tech is further strengthened by the Company's participation in
an internship program for students in the Bioengineering Program at Georgia
Tech. In addition, the Company is an active member of the Georgia Tech
Educational Partners Program.
UNIVERSITY OF CALIFORNIA, SAN DIEGO. In October 1997, Advanced Tissue
Sciences was awarded an Advanced Technology Program grant from the National
Institute of Standards and Technology to develop tissue engineered vascular
grafts for the treatment of coronary and peripheral artery vascular diseases.
The grant proposal was submitted in collaboration with the Department of
Bioengineering at University of California, San Diego. Under the award, the
Company is leading a multi-disciplinary effort in collaboration
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with the UCSD Bioengineering Department to design, construct and evaluate
tissue engineered vascular grafts produced from cells grown on a
biocompatible scaffold. The collaboration will integrate current advances
in cellular mechanics, bioreactor technology, and blood vessel mechanics to
create unique living tissue replacements for blood vessels.
SALES AND MARKETING
Dermagraft-TC was approved in the United States for use as a temporary
covering for excised full thickness burns in March 1997 and for use in
partial-thickness burns in October 1997. Dermagraft-TC is being marketed
through a direct sales force in the United States where the markets are
relatively concentrated in specialized burn centers. Eighty of the
approximately 140 specialized burn centers in the United States treat
approximately seventy-five percent of all burn patients. Dermagraft-TC has
also been approved in Canada for severe and partial thickness burns.
Dermagraft-TC will be marketed for burns in Canada and the in the rest of the
world, subject to regulatory approvals, through the Dermagraft Joint Venture
by Smith & Nephew. See "Collaborations and Strategic Alliances - Smith &
Nephew plc."
It is estimated that there are approximately 800,000 diabetic foot ulcer
patients treated each year in the United States. More than half of those
ulcer patients are believed to be treated by podiatrists, with approximately
ten percent of all podiatrists accounting for the treatment of over forty
percent of these patients. Subject to regulatory approvals, Dermagraft for
diabetic foot ulcers will be marketed through the Dermagraft Joint Venture by
Smith & Nephew. Dermagraft is currently being marketed through the Dermagraft
Joint Venture by Smith & Nephew in Canada, the United Kingdom and several
other countries in northern Europe. See "Collaborations and Strategic
Alliances - Smith & Nephew plc."
The Company has collected health economics data with respect to the
treatment of diabetic foot ulcers throughout the pivotal clinical trial.
Utilizing the data collected from the trial, economic models for each key
country have been completed or are being prepared to support the commercial
introduction of Dermagraft. The Company believes that doctors and third party
payors recognize the high cost of treating diabetic foot ulcers, and the
Company intends to price Dermagraft to be cost effective to the customer.
RESEARCH AND DEVELOPMENT
The Company has invested a substantial portion of its resources into
research related to the Company's core technology, the development and
clinical trials of products related to such technology, and the development of
manufacturing systems and processes. The Company has incurred research and
development costs of $17,984,000 $23,699,000 and $18,498,000 in the years
ended December 31, 1997, 1996 and 1995, respectively, of which approximately
$7,731,000, $3,564,000 and $2,378,000 represent costs incurred for customer
sponsored research. The Company expects to continue to incur substantial
research and development costs related to its core technology, clinical trials
of products related to such technology and the development of manufacturing
processes and systems.
The Company has established its own research and development laboratory
facilities, is collaborating with academic and medical institutions, and has
entered into agreements with several other companies and institutions to
assist in developing its technology. In the event the Company is unable to
obtain or maintain these arrangements, the Company may need to expand its own
facilities for research and development, and clinical testing. The Company
may also enter into additional arrangements with third parties for certain
proposed applications of its technology; however, there can be no assurance
that such arrangements can be obtained. The failure to obtain or maintain
such arrangements on desirable terms could have an adverse impact on the
Company.
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EMPLOYEES
As of February 1, 1998, the Company employed 238 people, of whom 68 were
engaged in research and development, 97 in operations, and 73 in sales,
marketing and administrative functions. The Company's staff includes
seventeen employees with Ph.D. or M.D. degrees. None of the Company's
employees are represented by a labor union, and the Company believes that its
employee relations are good.
FACTORS THAT MAY AFFECT FUTURE RESULTS
THIS ANNUAL REPORT ON FORM 10-K CONTAINS FORWARD-LOOKING STATEMENTS THAT
INVOLVE RISKS AND UNCERTAINTIES. SUCH STATEMENTS INCLUDE, BUT ARE NOT LIMITED
TO, STATEMENTS CONTAINING THE WORDS "BELIEVES," "ANTICIPATES," "EXPECTS,"
"ESTIMATES" AND WORDS OF SIMILAR IMPORT. THE COMPANY'S ACTUAL RESULTS COULD
DIFFER MATERIALLY FROM ANY FORWARD-LOOKING STATEMENTS, WHICH REFLECT
MANAGEMENT'S OPINIONS ONLY AS OF THE DATE HEREOF, AS A RESULT OF SUCH RISKS
AND UNCERTAINTIES. THE COMPANY UNDERTAKES NO OBLIGATION TO REVISE OR PUBLICLY
RELEASE THE RESULTS OF ANY REVISIONS TO THESE FORWARD-LOOKING STATEMENTS.
READERS SHOULD CAREFULLY REVIEW THE RISK FACTORS SET FORTH BELOW AND IN OTHER
DOCUMENTS THE COMPANY FILES FROM TIME TO TIME WITH THE SECURITIES AND EXCHANGE
COMMISSION, INCLUDING ITS QUARTERLY REPORTS ON FORM 10-Q.
UNCERTAINTY OF MARKET ACCEPTANCE
The Company believes that its profitability and growth over the next
several years will depend in large part upon broad market acceptance of
Dermagraft for the treatment of diabetic foot ulcers and, to a lesser extent,
of Dermagraft-TC in the United States and key international markets targeted
by the Company and Smith & Nephew. An FDA Advisory Panel recently recommended
approval of the Company's PMA application for Dermagraft for the treatment of
diabetic foot ulcers subject to certain conditions which may be satisfied
after the Company's commercial introduction of such product in the United
States. Such commercial introduction is still subject to final approval of
the Company's PMA application by the FDA. (See "Government Regulation.") The
Company has received FDA approval to market Dermagraft-TC and has been
marketing that product since March 1997. Accordingly, the commercial
acceptance of Dermagraft for the treatment of diabetic foot ulcers has yet to
be tested and Dermagraft-TC has been marketed and sold by the Company for only
a limited period of time.
Each of these products is based on new and innovative technologies and
there can be no assurance that such products will be broadly accepted by
either the medical community or the general population as alternatives to
existing methods of treatment. The acceptance of the Company's products may
be adversely affected by their respective cost, concerns related to efficacy,
the effectiveness of alternative methods of treatment and the insufficiency of
third-party reimbursement. Any future reported adverse events or other
unfavorable publicity involving patient outcomes from use of the Company's
products could also adversely affect acceptance of such products. The
Company has no direct experience marketing or obtaining third-party
reimbursement for its products.
In addition, the Company will have to establish an effective internal
sales and marketing organization and/or rely on Smith & Nephew or on
arrangements with others to market its products domestically and
internationally. Moreover, in the near term, the Company's success in
generating initial market acceptance of Dermagraft will depend in large part
on the marketing efforts of Smith & Nephew. The Company cannot control the
amount and timing of resources Smith & Nephew may devote to marketing and
selling Dermagraft products, and there can be no assurance that Smith & Nephew
will perform its obligations under the Dermagraft Joint Venture as expected.
The failure of the Company to achieve broad acceptance of Dermagraft for the
treatment of diabetic foot ulcers and, to a lesser extent, Dermagraft-TC would
have a material adverse effect on the Company's business, financial condition
and results of operations.
ABSENCE OF PROFITABLE OPERATIONS; NEED FOR ADDITIONAL FUNDS
To date, the Company has experienced significant operating losses in
funding the research, development, testing and marketing of its products and
expects to continue to incur substantial operating losses. The Company has
incurred cumulative net operating losses of $175.2 million through December
31, 1997. The Company's ability to achieve profitability depends in part upon
its ability, either independently or in collaboration with Smith
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& Nephew, to successfully manufacture and market Dermagraft for skin ulcers
and Dermagraft-TC for burns. There can be no assurance that the Company will
ever achieve a profitable level of operations or that profitability, if
achieved, can be sustained on an ongoing basis.
The further development of the Company's technology and products as well
as any further development of manufacturing capabilities or the establishment
of any additional sales, marketing and distribution capabilities will require
the commitment of substantial funds. While the Company believes that its
existing working capital, the milestone payments under the expanded Dermagraft
Joint Venture, its borrowing capacity under the Cartilage Joint Venture and a
bank credit facility, and its access to funds under an equity line will be
sufficient to meet its present operating and capital requirements for at least
the next twelve months, the Company may ultimately need to raise additional
funds to support its long-term product development and commercialization
programs. The Company could acquire such additional funding through
collaborative arrangements, the extension of existing arrangements, additional
public or private offerings of debt or equity securities or other means.
There can be no assurance that the Company will satisfy the milestones
for additional funds under the Dermagraft or Cartilage Joint Ventures or that
adequate funds will be available under other existing or future arrangements
when such funds are needed or, if available, on terms acceptable to the
Company. Insufficient funds may require the Company to delay, scale back or
eliminate certain of its research and product development programs or to
license third parties the right to commercialize products or technologies that
the Company would otherwise commercialize itself. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations -
Liquidity and Capital Resources."
UNCERTAINTY OF COLLABORATIVE ARRANGEMENTS AND STRATEGIC ALLIANCES
The Company is particularly dependent on Smith & Nephew with respect to
the Dermagraft and the Cartilage Joint Ventures. Although the Company
believes that Smith & Nephew has a significant economic motivation to succeed
in performing its contractual responsibilities under the Dermagraft and
Cartilage Joint Venture agreements, the amount and timing of resources to be
devoted to such performance are not within the control of the Company, and
there can be no assurance that Smith & Nephew will perform its obligations as
expected. Moreover, the Dermagraft and Cartilage Joint Ventures would be
materially and adversely affected if Smith & Nephew had a strategic shift in
its business focus. In addition, the Dermagraft and Cartilage Joint
Venture agreements provide that they may be terminated prior to their
expiration under certain circumstances that are outside the control of the
Company. A termination of such agreements, or a failure of Smith & Nephew to
adequately perform its obligations thereunder, would have a material adverse
effect on the Company's ability to successfully complete the development and
testing of the products covered thereby and to successfully penetrate the
markets for such products. Any such event could have a material adverse
effect on the Company's business, financial condition and results of
operations.
The Company continually seeks and considers collaborative arrangements to
obtain funding for the development of its products. Such arrangements may
involve the issuance of additional equity or debt securities and marketing
rights to the funding party. The Company may seek collaborative arrangements
and separate funding for its programs which may include joint ventures, third
party equity investments or other financing structures. There can be no
assurance however that the Company will be able to negotiate additional
collaborative arrangements in the future on acceptable terms, if at all, or
that such collaborative arrangements will be successful. To the extent that
the Company chooses not to or is unable to establish such arrangements, it
would experience increased capital requirements to undertake research,
development and marketing of its proposed products at its own expense. In
addition, the Company may encounter significant delays in introducing its
proposed products into certain markets or find that the development,
manufacture or sale of its proposed products in such markets is adversely
affected by the absence of such collaborative agreements.
STAGE OF PRODUCT DEVELOPMENT
Although Dermagraft-TC has been approved for commercial sale and
Dermagraft for the treatment of diabetic ulcers has received a recommendation
by an FDA advisory panel that the FDA approve the product, the remainder of
the Company's other products are at earlier stages of research, development
and testing. These products will require significant additional research and
development, including extensive preclinical and
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clinical testing, and regulatory approvals prior to commercialization. In
addition, notwithstanding the advisory panel recommendation, there can be no
assurance that FDA will approve the marketing of Dermagraft for the treatment
of diabetic foot ulcers or that it will not materially modify the
recommendation of the advisory panel. See "Government Regulation."
All of the Company's products are subject to the risks of failure
inherent in the development of products based on innovative technologies.
Such risks include the possibilities that any or all of these products are
found to be unsafe or ineffective or otherwise fail to receive necessary
regulatory approvals, that products are uneconomical to market, that third
parties may hold proprietary rights that preclude the Company from marketing
its products, or that the Company's products fail to achieve market acceptance
in light of competing technologies and products. See "Patents and Proprietary
Rights."
UNCERTAINTIES REGARDING HEALTHCARE REIMBURSEMENT AND REFORM
The Company's ability to commercialize products successfully may depend
in part on the extent to which reimbursement for the costs of such products
and related treatments will be available from government health administration
authorities, private health insurers and other organizations. In the United
States, government and other third-party payors are increasingly attempting to
contain healthcare costs by limiting both coverage and the level of
reimbursement for new products approved for marketing by the FDA, and by
refusing, in some cases, to provide any coverage for uses of approved products
for indications for which the FDA has not granted marketing approval.
Initiatives to reduce the federal deficit and to reform healthcare delivery
are increasing these cost containment efforts. As managed care organizations
continue to expand as a means of containing healthcare costs, the Company
believes there may be attempts by such organizations to restrict the use of,
delay authorization to use, or limit coverage and the level of reimbursement
for, new products, such as those being developed and commercialized by the
Company, pending completion of cost/benefit analyses of such products by those
managed care organizations. Internationally, where national healthcare
systems are prevalent, little if any funding may be available for new
products, and cost containment and cost reduction efforts can be more
pronounced than in the United States.
The Company has supported health economics studies and research and is
developing cost offset or cost-effectiveness models with respect to its
Dermagraft-TC and Dermagraft products in an effort to help obtain
appropriate and adequate third party coverage and reimbursement for these
products. However, these products are novel and as such are subject to
inherent uncertainty in the area of reimbursement. There can be no assurance
that adequate government or private payor coverage or levels of reimbursement
will be available for any of the Company's products or for the Company to
maintain price levels sufficient for the realization of an appropriate return
on its investment in such products. Failure to obtain sufficient coverage
and reimbursement levels for uses of the Company's products could have a
material adverse effect on the market acceptance of such products and the
Company's business, financial condition and results of operations.
PRODUCT LIABILITY CLAIMS AND INSURANCE
The use of any of the Company's products, whether for commercial
applications or during clinical trials, exposes the Company to an inherent
risk of product liability claims in the event such products cause injury,
disease or result in adverse effects. Such liability might result from claims
made directly by healthcare institutions, contract laboratories or others
selling or using such products. The Company currently maintains product
liability insurance coverage; however, there can be no assurance that the
level or breadth of any insurance coverage will be sufficient to fully cover
potential claims. Such insurance can be expensive and difficult to obtain.
There can be no assurance that adequate insurance coverage will be available
in the future at an acceptable cost, if at all, or in sufficient amounts to
protect the Company against such liability. The obligation to pay any product
liability claim in excess of whatever insurance the Company is able to acquire
could have a material adverse effect on the Company's business, financial
condition and results of operations.
The Company's tissue repair and transplantation products are complex and
must be manufactured under well-controlled and sterile conditions, in addition
to meeting strict product release criteria. Any manufacturing errors or
defects, or uncorrected impurity or variation in a raw material, either
unknown or undetected by the Company, could affect the quality and safety of
the Company's products. If any of the defects were material,
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the Company could be required to undertake a market withdrawal or recall of
the affected products. There can be no assurance a product recall will not
occur. The cost of a market withdrawal or product recall could be
significant and could have a material adverse effect on the Company's
business, financial condition and results of operations.
TECHNOLOGICAL CHANGE AND COMPETITION
The biomedical technology industry is subject to rapid, unpredictable and
significant technological change. Competition from universities, research
institutions and pharmaceutical, chemical and biotechnology companies is
intense. Many competitors or potential competitors have greater financial
resources, research and development capabilities and manufacturing and
marketing experience than the Company. In general, the first biomedical
product to be commercialized for a particular therapeutic indication is often
at a significant competitive advantage relative to later entrants to the
market. Accordingly, the relative speed with which the Company can develop
products, complete clinical trials, obtain regulatory approvals and develop
commercial manufacturing capability may be determinative factors in
establishing the Company's competitive position. The Company's ability to
attract and retain qualified scientific, manufacturing, marketing and other
personnel, obtain and maintain patent protection and secure funding are also
expected to be key competitive factors for the Company.
In the field of tissue engineering and the treatment of damaged or
diseased tissue, the Company competes with several companies which are
developing various tissue replacement products, including skin substitutes and
cultured cartilage. In addition, the Company is aware of a number of
biotechnology, pharmaceutical, medical device and chemical companies that are
developing other types of products as alternatives to tissue replacement for a
variety of indications, including burns and chronic skin ulcers. These
treatments employ a variety of approaches such as growth factors, tri-peptides
and completely synthetic materials.
In the area of burns, the Company competes primarily with cadaver skin or
porcine tissue. The Company is also aware of several companies that have
developed technologies involving processed cadaver skin used as a dermal
replacement (LifeCell Corporation), or sheets of epidermis grown from the
patient's own skin (Genzyme Tissue Repair and Cell Culture Technology). These
products have not required FDA approval and are, therefore, currently
available on the market for the treatment of severe burns. Integra Life
Sciences ("Integra") is marketing Integra Artificial Skin, consisting of a
bovine collagen and glycosaminoglycan matrix with a synthetic polymer
covering, for the treatment of burn wounds. In addition, the Company is
aware that Ortec International, Inc. is currently in clinical trials with its
composite cultured skin product, consisting of fibroblasts and keratinocytes
on a bovine collagen sponge, for the treatment of burn wounds. Several other
companies are also developing or plan to develop growth factors as a treatment
for partial thickness or small full-thickness wounds.
In the area of diabetic foot ulcers, Chiron Corporation ("Chiron") and
the Ortho-McNeil division of Johnson & Johnson, have received FDA approval and
recently began marketing a platelet-derived growth factor ("PDGF") for the
treatment of diabetic foot ulcers. In addition, Organogenesis, Inc.
("Organogenesis") has begun clinical trials for the use of Apligraf, a product
using cultured human cells seeded onto a bovine collagen matrix, for the
treatment of diabetic foot ulcers. Organogenesis has already submitted a PMA
application for Apligraf in the treatment of venous ulcers and received a
recommendation for approval from an FDA advisory panel in January 1998.
Organogenesis has entered into an alliance with Novartis Pharma AG for the
marketing of Apligraf.
With respect to cartilage repair, Genzyme Tissue Repair is currently
selling a service to process a patient's own cartilage cells as a treatment
for articular defects in the knee. The Company is aware that Integra and
Osiris Therapeutics, Inc. are also engaged in research on cultured cartilage
products. The Company is not aware of any competitor that is developing an
off-the-shelf, human cartilage tissue that can be arthroscopically inserted.
For all of its products, the Company expects to compete primarily on the
uniqueness of its technology and product features, on the quality and
cost-effectiveness of its products, and on the timing of commercial
introduction. The Company believes that its tissue engineered products may
have many attributes that
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differentiate it from other competitors, including the fact that the
Company's products are human-based tissue products designed to be available
"off-the-shelf" to the end-users. However, other factors such as its ability
to secure regulatory approval for its products, to implement production and
marketing plans and to secure adequate capital resources, will also impact
its competitive position. There can be no assurance that the Company will
have the resources to compete successfully with such companies or that
competition generally will not adversely affect the Company's results of
operations or ability to successfully market its products.
PATENTS AND PROPRIETARY RIGHTS
The Company's ability to compete effectively will depend, in part, on its
ability to maintain the proprietary nature of its technology and manufacturing
processes. The Company relies on patents, trade secrets and know-how to
maintain its competitive position. To date, the Company owns twenty issued
and five allowed patents in the United States. In addition, nineteen foreign
counterparts to some of the United States patents have issued in several
foreign countries. The United States patents expire at various times between
2005 and 2014.
In October 1990, the Company received a United States patent on its core
technology. This product patent covers three-dimensional living stromal
tissue produced by culturing stromal cells in vitro on a biocompatible
framework. The stromal tissue provides the growth factors and structural
proteins used in the Company's three-dimensional matrix to grow organ tissues.
This patent expires in October 2007. In September 1995, the Company was
granted a corresponding patent by the European Patent Office covering a
three-dimensional stromal tissue and methods of use to grow skin, bone marrow
and liver tissue. The patent will expire in April 2007.
In November 1993, the Company received a United States patent relating to
Dermagraft, covering both three-dimensional dermal tissue and full thickness
skin tissue cultured on living stromal tissue prepared in vitro and, in August
1995, received a United States patent covering the growth and implantation of
its Dermagraft dermal skin replacement. These patents expire in November 2010
and August 2012, respectively. In October 1995, a United States patent was
issued relating to Dermagraft-TC. This product patent covers a variety of
transitional burn coverings which use a synthetic membrane with an attached
dermal component. This patent will expire in October 2012.
The Company's other patents issued in the United States primarily allow
for a variety of tissue engineering products and processes for therapeutic
applications and laboratory testing. These patents expire between 2005 and
2014. The Company has additional United States and foreign patent
applications relating to its tissue engineering technology. In addition, the
Company has certain licensing rights to United States and foreign patents and
patent applications filed by MIT related to cell growth and organ
regeneration and repair, and biodegradable polymers, subject to certain
limitations as to applicable tissues and fields of use, and by the University
of Florida related to a stem cell proliferation factor.
There can be no assurance that any applications will result in issued
patents or that any current or future issued or licensed patents, trade
secrets or know-how will afford protection against competitors with similar
technologies or processes, or that any patents issued will not be infringed
upon or designed around by others. In addition, there can be no assurance
that others will not independently develop proprietary technologies or
processes which are the same as or substantially equivalent to those of the
Company. The Company could also incur substantial costs in defending itself
in suits brought against it on such patents or in bringing suits to protect
the Company's patents or patents licensed by the Company against infringement.
In addition to patent protection, the Company relies on trade secrets,
proprietary know-how and technological advances which the Company seeks to
protect in part by confidentiality agreements with its collaborative partners,
employees and consultants. There can be no assurance that these agreements
will not be breached, that the Company will have adequate remedies for any
breach, or that the Company's trade secrets will not otherwise become known or
independently discovered by competitors.
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GOVERNMENT REGULATION
Regulation by governmental authorities in the United States and foreign
countries is a significant factor in the manufacture and marketing of the
Company's present and proposed products and in its ongoing research and
product development activities. The Company's preclinical studies and
clinical trials and the manufacturing and marketing of its products are
subject to extensive, costly and rigorous regulation by various governmental
authorities in the United States and other countries. Many of the Company's
proposed products will require regulatory approval prior to commercializa-
tion. In particular, human therapeutic products are subject to rigorous
preclinical and clinical testing as a condition of approval by the FDA and
by similar authorities in foreign countries. The process of obtaining
required regulatory approvals by the FDA and other regulatory authorities
often takes many years, is expensive and can vary significantly based on the
type, complexity and novelty of the product. There can be no assurance that
any products developed by the Company, independently or in collaboration with
others, will meet applicable regulatory criteria to receive the required
approvals for manufacturing and marketing.
In the United States, the FDA regulates the clinical testing,
manufacture, distribution and promotion of medical devices and biologics
pursuant to the Federal Food, Drug and Cosmetic Act (the "FDC Act") and
regulations promulgated thereunder. The Company's Dermagraft-TC and
Dermagraft products and cartilage products are subject to regulation by the
FDA as medical devices. The Company's other tissue replacement products,
currently in various stages of development, could be regulated either as
medical devices or as biologic products. Legislative and regulatory
initiatives concerning the regulation of tissue and organ transplants are
ongoing and could possibly affect the future regulation of the Company's
tissue engineered products. It is not possible at the present time to
predict accurately either the time frame for such action, or the ultimate
effect that such initiatives could have, if any, on the products under
development by the Company. Unlike Premarket Approval ("PMA") submissions
for medical devices, the FDA has no regulatory time limit within which it
must review and act upon submissions treated as biologics. As a result, the
time period for final action often takes several years from submission,
usually exceeding that expected for a PMA application.
To obtain FDA approval to market medical devices, the FDA requires proof
of safety and efficacy in human clinical trials performed under an
Investigational Device Exemption (an "IDE"). An IDE application must contain
preclinical test data demonstrating the safety of the product for human
investigational use, information on manufacturing processes and procedures,
and proposed clinical protocols. If the IDE application is approved, human
clinical trials may begin. The results obtained from these trials, if
satisfactory, are accumulated and submitted to the FDA in support of a PMA
application. Premarket approval from the FDA is required before commercial
distribution of devices similar to those under development by the Company is
permitted in the United States.
The PMA application must be supported by extensive data, including
preclinical and human clinical trial data, to prove the safety and efficacy of
the device, and information about the device and its components including,
amoung other things, manufacturing, labeling and promotion. By regulation,
the FDA has 180 days to review a PMA application and during that time an
advisory committee may evaluate the application and provide recommendations
to the FDA. While the FDA has responded to PMA applications within the
allotted time period, reviews more often occur over a significantly
protracted period, usually twelve to thirty-six months, and a number of
devices for which a PMA application was submitted by other companies have
never been cleared for marketing. The review time is often significantly
exceeded as the FDA may need additional information or clarification of
information provided. The FDA may also make a determination that, based on
deficiencies in the application or its interpretation of the information
provided, additional clinical trials are required. This process is lengthy
and expensive and there can be no assurance that such FDA approval will be
obtained.
If the FDA's evaluation of the PMA application is favorable, the FDA
typically issues a letter requiring the applicant's agreement to specific
conditions (e.g., changes in labeling) or specific additional information to
secure final approval of the PMA application. Once the requirements are
satisfied, the FDA will issue a PMA for the approved indications, which can
be more limited than those originally sought by the manufacturer. The PMA
can include post-approval conditions that the FDA believes necessary to ensure
the safety and
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effectiveness of the device, such as restrictions on labeling, promotion,
sale and distribution. Failure to comply with the conditions of approval can
result in adverse enforcement action, including the loss or withdrawal of
the approval. Even after approval of a PMA, a new PMA or PMA supplement is
required in the event of a modification to the device, its labeling or its
manufacturing process.
In addition, FDA regulations obligate a manufacturer to inform the FDA
whenever there is reasonable evidence to suggest that one of its devices
may have caused or contributed to death or serious injury, or where one of
its devices malfunctions and, if the malfunction were to recur, the device
would be likely to cause or contribute to a death or serious injury.
In December 1996, the Company submitted a PMA application requesting
approval of Dermagraft for the treatment of diabetic foot ulcers. In
February 1997, the FDA accepted the application for filing. The PMA
submission was based on the results of a pivotal trial from patients
receiving Dermagraft within a therapeutic range identified retrospectively
from the clinical trial. Patients receiving Dermagraft within the
therapeutic range represented a majority but not all the evaluable patients
in the trial. The Company believes the data from patients receiving
Dermagraft within the therapeutic range demonstrate a statistically
significant improvement in complete healing at twelve and thirty-two weeks.
For all evaluable patients, although statistical significance was not seen
at twelve weeks in the pivotal clinical trial, a statistically significant
improvement in complete healing as compared to the control treatment was seen
at thirty-two weeks. See "Products - Skin Ulcer Products - Diabetic Foot
Ulcers."
In January 1998, the General and Plastic Surgery Devices Panel of the
Medical Devices Advisory Committee to the FDA recommended that the FDA
approve Dermagraft for the treatment of diabetic foot ulcers in the United
States, with the conditions that the Company perform a post-marketing study
to confirm product efficacy at twelve weeks and provide physician training.
During the advisory panel meeting, certain panel members and representatives
of the FDA raised questions and concerns regarding the use and nature of the
retrospective analyses performed by the Company in identifying the
therapeutic range. Nevertheless, the advisory panel recommended approval
of the product by a vote of seven to two (one of the dissenting panel
members voted against the recommendation on the grounds that a post-
marketing study was too burdensome).
Since the advisory panel meeting, the FDA has continued to raise
concerns about approving the PMA application based on the Company's
retrospective efficacy analysis of the twelve week data and the use of a post-
marketing study to confirm efficacy at twelve weeks. The Company is working
with the FDA to address these concerns and obtain approval of its PMA
application. There can be no assurance that the Company will satisfactorily
address the FDA's concerns and that the FDA will ultimately approve the PMA
application in a timely fashion, if at all. If the FDA concludes that the
clinial data are not adequate for PMA approval, the Company could be
required to conduct additional clinical studies to support PMA approval of
Dermagraft.
The Company has constructed a commercial manufacturing facility for its
Dermagraft-TC and Dermagraft products. This facility must be registered,
inspected, and licensed by various regulatory authorities, including the
California Department of Health and Human Services, and must comply with
FDA's Good Manufacturing Practices (GMP) requirements, which elaborate
testing, control, documentation and other quality assurance procedures. The
manufacturing facility was initially approved by the FDA in 1996, prior to
the approval of Dermagraft-TC for the treatment of full thickness burns.
Following a recent inspection of the manufacturing facility in
conjunction with the Company's PMA application for the approval of Dermagraft
for the treatment of diabetic foot ulcers, the FDA notified the Company of
numerous objectionable observations under a Form FDA 483 letter (the "483
Letter") with respect to the Company's manufacturing processes and systems
for Dermagraft and Dermagraft-TC. On March 26, 1998, the FDA issued a
warning letter requiring the Company to investigate and correct the
objections identified by the FDA. Specifically, the warning letter requires
the Company to address objectionable observations with respect to (i) the
control of environmental conditions, (ii) procedures for implementing
corrective and preventive actions, (iii) procedures for acceptance of
products, (iv) investigations of complaints, (v) compliance with medical
device reporting regulations, and (vi) justification of extended expiration
dates. In response to certain issues raised by the FDA inspection, the
Company is voluntarily recalling certain lots of
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Dermagraft and Dermagraft-TC which contained a raw material that was out of
specification. All of the recalled lots complied with finished product
specifications. The Company has not received any reports of patient injury
or complications that it believes are a result of the products being
recalled. However, the Company believes the recall is the prudent course of
action to ensure that patients receive product of the highest quality.
The Company has responded to the 483 Letter and has initiated corrective
actions to address the FDA's concerns. The Company believes that it can
resolve the problems raised in the 483 Letter and in the warning letter in
the near term and without material cost to the Company. However, there can
be no assurance that such corrective actions will satisfy the FDA's concerns,
that the FDA will not raise additional issues, or that other actions will not
be taken by the FDA relating to the 483 Letter, the warning letter or the
Company's manufacturing and quality assurance systems. The FDA has informed
the Company that these problems will need to be corrected or resolved to the
agency's satisfaction in order for the FDA to consider approving the
Company's pending PMA application for Dermagraft in the treatment of diabetic
foot ulcers.
In general, if as a result of FDA inspections, adverse event reports or
information derived from any other source, the FDA believes the Company is
not in compliance with laws or regulations or that the Company's products
pose any health risk, the FDA can refuse to approve pending PMA applications;
withdraw previously approved PMA applications; require notification to users
regarding risks; request corrective labeling, promotional or advertising
materials; issue warning letters; require the Company to temporarily suspend
marketing or undertake product recalls; impose civil penalties; or institute
legal proceedings to detain or seize products, enjoin future violations, or
seek criminal penalties against the Company, its officers or employees.
Civil penalties may not be imposed for GMP violations unless the violations
involve a significant or knowing departure from the requirements of the FDC
Act or a risk to public health. The FDA provides manufacturers with an
opportunity to be heard prior to the assessment of civil penalties. If civil
penalties are assessed, judicial review is available.
The Company exports, or intends to export, its products to foreign
countries. Exports of products that have market clearance from the FDA in
the United States do not require FDA authorization for export. However,
foreign countries often require, among other things, an FDA certificate for
products for export (a "CPE"). The FDA warning letter states that the agency
will refuse to issue a CPE until the outstanding GMP violations are corrected.
As discussed above, the Company believes it can resolve the problems raised
by the FDA in the 483 Letter and the warning letter in the near term.
With respect to the manufacture of products for which premarket approval
is granted, the Company will be subject to routine inspection by the FDA and
certain state agencies, including the California Department of Health and
Human Services, for compliance with GMP requirements, adverse event
reporting requirements, and other applicable regulations. In addition,
Congress has approved the Food and Drug Administration Modernization Act of
1997 (the "Modernization Act"). The Modernization Act makes changes to the
device provisions of the FDC Act and other provisions in the Modernization
Act affect the regulation of devices. Among other things, the changes will
affect the IDE and PMA processes, and also will affect device standards and
data requirements, procedures relating to humanitarian and breakthrough
devices, tracking and post-market surveillance, accredited third party
review, and the dissemination of off label information. The Company cannot
predict how or when these changes will be implemented or what effect the
changes will have on the regulation of the Company's products. There can be
no assurance that the Company will not incur significant costs to comply
with laws and regulations in the future or that laws and regulations
will not have a material adverse effect upon the Company's business,
financial condition or results of operations.
Although the FDA has classified Dermagraft-TC as a medical device, the
State of California and the State of New York have notified the Company that
it must register as a tissue bank in order to manufacture or distribute
Dermagraft-TC in those states. Although many states do not regulate tissue
banks, there are certain other states besides California and New York that do.
Such states take a position similar to California and New York with regard to
the regulatory status of Dermagraft-TC. In June 1997, the Company submitted
a request to the FDA for an advisory opinion that the FDA's regulation of
this product as a medical device preempts New York from regulating it as
human tissue under a different licensing scheme. Both New York and
Califoria have provided
23
<PAGE>
written submissions to the FDA urging the agency to deny the Company's
request. To date, the FDA has not ruled. If states are permitted to
regulate Dermagraft-TC as a human tissue, the Company and its customers
could be subjected to a costly new layer of regulation. In addition, under
the laws of some states that regulate tissue, including New York and Florida,
the sale of human tissues for valuable consideration is prohibited. The
Company is currently distributing Dermagraft-TC in the State of New York
under a provisional tissue banking license. Due to the similarities of the
products, regulations applicable to Dermagraft-TC are also expected to apply
to the Company's Dermagraft product as well.
Whether regulated by the FDA as a medical device or biologic, or
otherwise by any state or foreign authorities, the approval process for any of
the Company's products is expensive and time consuming and no assurance can be
given that the FDA or any regulatory agency will grant its approval. The
inability to obtain, or delays in obtaining, such approval would adversely
affect the Company's ability to commence marketing therapeutic applications
of its technology. There is no assurance that the Company will have
sufficient resources to complete the required testing and regulatory review
processes. Furthermore, the Company is unable to predict the extent of
adverse governmental regulation which might arise from future United States
or foreign legislative or administrative action. In addition, any products
distributed by the Company pursuant to the above authorizations are subject
to pervasive and continuing regulation by the FDA. Labeling and promotional
activities are subject to scrutiny by the FDA and, in certain instances, by
the Federal Trade Commission.
The Company's research and development activities and operations involve
the controlled use of small quantities of radioactive compounds, chemical
solvents and other hazardous materials. In addition, the Company's business
involves the growth of human tissues. Although the Company believes that its
safety procedures for handling and disposing of such materials comply with the
standards prescribed by federal, state and local regulations, the risk of
accidental contamination or injury from these materials cannot be completely
eliminated. In the event of such an accident, the Company could be held
liable for any damages that result and any liability could have a material
adverse effect on the Company's business, financial condition and results of
operations. The Company is also subject to various federal, state and local
laws, regulations and recommendations relating to such matters as safe working
conditions, laboratory and manufacturing practices. Although the Company
believes it is in compliance with these laws and regulations in all material
respects, there can be no assurance that the Company will not be required to
incur significant costs to comply with such laws or regulations in the future.
DEPENDENCE ON KEY PERSONNEL
The Company's success will depend in large part upon its ability to
attract and retain qualified scientific, management, marketing and sales
personnel as well as the continued contributions of its existing senior
management and scientific and technical personnel. The Company faces strong
competition for such personnel and there can be no assurance that the Company
will be able to attract or retain such individuals. In particular, the loss
of the services of either Arthur J. Benvenuto, the Company's Chairman and
Chief Executive Officer, or Dr. Gail K. Naughton, its President and Chief
Operating Officer, would have a material adverse effect on the Company.
DEPENDENCE ON CERTAIN SUPPLIERS
Although most of the raw materials used in the manufacture of the
Company's Dermagraft products are available from more than one supplier,
changes in certain critical components (such as the polymers used in
Dermagraft) could cause the FDA to require the Company to prove equivalency of
the materials or potentially to modify or perform additional clinical trials
for the Dermagraft products, which could have the effect of restricting
product available for sale. To date, the Company has not experienced
difficulty in obtaining necessary raw materials.
The mesh framework used by the Company in Dermagraft is available under a
supply agreement with only one FDA-approved manufacturing source. Similarly,
the synthetic mesh framework used by the Company in Dermagraft-TC is only
available under a supply agreement with a different FDA-approved manufacturing
source. Because the FDA approval process requires manufacturers to specify
their proposed suppliers of active
24
<PAGE>
ingredients and certain component parts and packaging materials in their
applications, FDA approval of a new supplier would be required if these
materials become unavailable from the current supplier.
Although the Company has not experienced difficulty acquiring these
materials for the manufacture of its Dermagraft and Dermagraft-TC products, no
assurance can be given that interruptions in supplies will not occur in the
future or that the Company would not have to obtain substitute vendors for
these materials. Any significant supply interruption would adversely affect
the Company's clinical trials as well as its product development and marketing
programs. In addition, an uncorrected impurity or supplier's variation in a
raw material, either unknown to the Company or incompatible with the Company's
manufacturing process, could have a material adverse effect on the Company's
ability to manufacture products.
POSSIBLE VOLATILITY OF STOCK PRICE
The market price of the Company's Common Stock, like that of the
securities of other biotechnology companies, has fluctuated significantly in
recent years and is likely to fluctuate in the future. From time to time, the
market for securities of biotechnology companies has in fact experienced
significant price and volume fluctuations that are unrelated to the operating
performance of such companies. In addition, announcements by the Company or
others regarding scientific discoveries, technological innovations,
commercial products, patents or proprietary rights, the progress of clinical
trials or government regulation, public concern as to the safety of devices
or drugs, the issuance of securities analysts' reports and general market
conditions may all have a significant effect on the market price of the
Common Stock. Fluctuations in financial performance from period to period
also may have a significant impact on the market price of the Common Stock.
ITEM 2. PROPERTIES
The Company leases approximately 85,000 square feet of space at its
headquarters facility, of which approximately 96% is allocated to
manufacturing and research. The leases for this facility expire in September
2000, subject to an option to renew for an additional five years. In
addition, the Company leases approximately 6,900 square feet of manufacturing
and research space under a five-year lease which expires in 2002. The Company
also leases approximately 38,000 square feet which is used for both research
and administration. This lease expires in July 1998 but may be extended for
up to one year. During 1997, the Company executed a 15-year lease for
approximately 104,000 square feet of research and administration space in a
building currently under construction. The building is expected to be
completed, and the lease is expected to commence, in late 1998 or early 1999.
The Company's facilities are all located in San Diego, California.
The Company believes that its property and equipment are generally well
maintained, in good operating condition and, as noted above, adequate for its
current needs.
ITEM 3. LEGAL PROCEEDINGS
There is no material litigation pending against the Company.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to vote of security holders during the
quarter ended December 31, 1997.
25
<PAGE>
PART II
ITEM 5. MARKET FOR THE COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
MARKET INFORMATION
The Company's Common Stock is traded on the National Association of
Securities Dealers Automated Quotation ("Nasdaq") National Market under the
symbol ATIS. The last reported high and low sales prices as reported for the
Company's Common Stock by Nasdaq for the last two fiscal years are set forth
below.
HIGH LOW
---------- ---------
YEAR ENDED DECEMBER 31, 1997:
First Quarter $ 14.75 $ 9.88
Second Quarter 13.50 10.00
Third Quarter 18.50 11.63
Fourth Quarter 15.81 11.50
YEAR ENDED DECEMBER 31, 1996:
First Quarter $ 14.25 $ 9.25
Second Quarter 18.75 13.25
Third Quarter 18.00 11.38
Fourth Quarter 20.00 9.56
HOLDERS
As of December 31, 1997, there were 1,259 holders of record of the
Company's Common Stock.
DIVIDENDS
The Company has never paid cash dividends on its Common Stock and does
not expect to pay any cash dividends in the foreseeable future.
ITEM 6. SELECTED FINANCIAL DATA
The selected financial data of the Company appears in a separate section
of this Annual Report on Form 10-K on page F-1.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Management's discussion and analysis of financial condition and results
of operations appears in a separate section of this Annual Report on Form 10-K
beginning on page F-2.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Company's financial statements and schedules, as listed under Item
14, appear in a separate section of this Annual Report on Form 10-K beginning
on page F-7.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
During the two years prior to the date of the most recent financial
statements and the subsequent interim period, the Company has not had a change
in its independent auditors nor have there been any disagreements between the
Company and its independent auditors.
26
<PAGE>
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The sections titled "Directors and Nominees" and "Executive Officers"
appearing in the Company's Proxy Statement for the 1998 Annual Meeting of
Stockholders are incorporated herein by reference.
ITEM 11. EXECUTIVE COMPENSATION
The section titled "Executive Compensation" appearing in the Company's
Proxy Statement for the 1998 Annual Meeting of Stockholders is incorporated
herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The section titled "Principal Stockholders" appearing in the Company's
Proxy Statement for the 1998 Annual Meeting of Stockholders is incorporated
herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The section titled "Certain Transactions" appearing in the Company's
Proxy Statement for the 1998 Annual Meeting of Stockholders is incorporated
herein by reference.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a)(1) Financial Statements:
--------------------
The following financial statements of the Company and of the Dermagraft
Joint Venture are included in a separate section of this Annual Report on Form
10-K commencing on the pages referenced below:
Page
----------
Consolidated Financial Statements of Advanced
Tissue Sciences, Inc.:
Consolidated Balance Sheets as of December 31,
1997 and 1996 F-7
Consolidated Statements of Operations for the
Years Ended December 31, 1997, 1996 and 1995 F-8
Consolidated Statements of Cash Flows for the
Years Ended December 31, 1997, 1996 and 1995 F-9
Consolidated Statements of Stockholders' Equity for
the Years Ended December 31, 1997, 1996 and 1995 F-10
Notes to the Consolidated Financial Statements F-11 to F-22
Report of Ernst & Young LLP, Independent Auditors F-23
Combined Financial Statements of the Dermagraft
Joint Venture:
Combined Balance Sheets as of December 31,
1997 and 1996 F-24
Combined Statements of Operations for the Year
Ended December 31, 1997 and for the Period
April 29, 1996 (inception) to December 31, 1996 F-25
Combined Statements of Cash Flows for the Year
Ended December 31, 1997 and for the Period
April 29, 1996 (inception) to December 31, 1996 F-26
Combined Statements of Partners' Capital for the
Year Ended December 31, 1997 and for the Period
April 29, 1996 (inception) to December 31, 1996 F-27
Notes to the Combined Financial Statements F-28 to F-30
Report of Ernst & Young LLP, Independent Auditors F-31
(2) Financial Statement Schedules:
-----------------------------
All schedules have been omitted, since they are not applicable, not
required or the information is included in the financial statements or the
notes thereto.
27
<PAGE>
(3) Exhibits:
--------
Exhibit
No. Title Method of Filing
- ------- ----- ----------------
3.1 Restated Certificate of Incorporation of Incorporated by Reference
Advanced Tissue Sciences, Inc. as in to Exhibit 3.1 to the
effect on June 12, 1997 Registrant's Form 10-Q
for the Quarter Ended
June 30, 1997
3.2 Restated By-Laws of the Registrant Dated Incorporated by Reference
September 17, 1991 to Exhibit 3 to the
Registrant's Form 10-Q
for the Quarter Ended
October 31, 1991
4.1 Rights Agreement, Dated as of January 6, Incorporated by Reference
1995, between the Company and Chemical to Exhibit 1 to the
Trust Company of California, including Registrant's Current
the Certificate of Determination for the Report on Form 8-K Dated
Series A Junior Participating Preferred January 5, 1995
Stock as Exhibit A, the Form of Summary of
Rights to Right Certificate as Exhibit B
and the Purchase Preferred Shares as
Exhibit C
4.2 Investment Agreement between Advanced Incorporated by Reference
Tissue Sciences, Inc. and Ramius to Exhibit 4.1 to the
Hatteras Partners, L.P., Dated Registrant's Current
February 9, 1996 Report on Form 8-K dated
February 9, 1996
4.3 Amendment No. 1 to Investment Agreement Incorporated by Reference
between Advanced Tissue Sciences, Inc. to Exhibit 4.1 to the
and Hatteras Partners, L.P. (formerly Registrant's Current
Ramius Hatteras Partners, L.P.), Dated Report on Form 8-K
January 26, 1998 dated January 26, 1998
10.1 Form of Indemnification Agreement Between Incorporated by Reference
the Company and Each of the Directors of to Exhibit 10.6 to the
the Company Registrant's Annual
Report on Form 10-K for
the Year Ended
January 31, 1991
10.2 Nonqualified Stock Option Agreement, Incorporated by Reference
Dated June 3, 1991 between the Company to Exhibit 19.1 to the
and Arthur J. Benvenuto Registrant's Form 10-Q
for the Quarter Ended
July 31, 1991
10.3 Nonqualified Stock Option Agreement, Incorporated by Reference
Dated June 3, 1991 between the Company to Exhibit 19.2 to the
and Dr. Gail K. Naughton Registrant's Form 10-Q
for the Quarter Ended
July 31, 1991
10.4** Advanced Tissue Sciences, Inc. 1997 Stock Incorporated by Reference
Incentive Plan to Exhibit 99.1 to the
Registrant's Registration
Statement No. 333-36879
on Form S-8
10.4(a) Form of Stock Option Agreement Incorporated by Reference
to Exhibit 99.2 to the
Registrant's Registration
Statement No. 333-36879
on Form S-8
10.4(b) Form of Addendum to Stock Option Incorporated by Reference
Agreement re: Involuntary to Exhibit 99.3 to the
Termination Registrant's Registration
Statement No. 333-36879
on Form S-8
10.4(c) Form of Stock Issuance Agreement Incorporated by Reference
to Exhibit 99.4 to the
Registrant's Registration
Statement No. 333-36879
on Form S-8
28
<PAGE>
Exhibit
No. Title Method of Filing
- ------- ----- ----------------
10.4(d) Form of Addendum to Stock Issuance Incorporated by Reference
Agreement re: Involuntary Termination to Exhibit 99.5 to the
Registrant's Registration
Statement No. 333-36879
on Form S-8
10.4(e) Form of Automatic Stock Option Agreement Incorporated by Reference
to Exhibit 99.6 to the
Registrant's Registration
Statement No. 333-36879
on Form S-8
10.5 Form of Special Addendum to Certain Incorporated by Reference
Employee Stock Option Agreements to Exhibit 10.1 to the
Registrant's Form 10-Q
for the Quarter Ended
March 31, 1996
10.6(a) Licensing Agreement between the Incorporated by Reference
Massachusetts Institute of Technology to Exhibit 10.8(a) to the
and Advanced Tissue Sciences, Inc. Registrant's Transition
Dated July 24, 1992 Report on Form 10-K for
the Eleven Months Ended
December 31, 1992
10.6(b)* Sponsored Research Agreement between Incorporated by Reference
the Massachusetts Institute of to Exhibit 10.8(b) to the
Technology and Advanced Tissue Sciences, Registrant's Transition
Inc. Dated July 24, 1992 Report on Form 10-K for
the Eleven Months Ended
December 31, 1992
10.7* Agreement between Advanced Tissue Incorporated by Reference
Sciences, Inc. and Smith & Nephew plc to Exhibit 10.1 to the
Dated May 6, 1994 Registrant's Form 10-Q
for the Quarter Ended
March 31, 1994
10.8 Heads of Agreement between Advanced Incorporated by Reference
Tissue Sciences, Inc. and Smith & to Exhibit 10.1 to the
Nephew plc Dated April 29, 1996 Registrant's Form 10-Q
for the Quarter Ended
March 31, 1996
10.9 Promissory Note Between Advanced Incorporated by Reference
Tissue Sciences, Inc. and Smith & to Exhibit 10.1 to the
Nephew SNATS, Inc. Dated March 31, 1997 Registrant's Form 10-Q
for the Quarter Ended
March 31, 1997
10.10 Promissory Note Between Advanced Tissue Incorporated by Reference
Sciences, Inc. and Smith & Nephew SNATS, to Exhibit 10.2 to the
Inc. Dated June 11, 1997. Registrant's Form 10-Q
for the Quarter Ended
June 30, 1997
10.11 U.S. $16,000,000 Loan Facility to Incorporated by Reference
DermEquip, L.L.C. Provided by The Chase to Exhibit 10.1 to the
Manhattan Bank Dated August 12, 1997 Registrant's Form 10-Q
for the Quarter Ended
September 30, 1997
10.12 Guaranty Between Advanced Tissue Incorporated by Reference
Sciences, Inc. and The Chase Manhattan to Exhibit 10.2 to the
Bank Dated August 8, 1997 Registrant's Form 10-Q
for the Quarter Ended
September 30, 1997
10.13 Heads of Agreement Dated January 14, Incorporated by Reference
1998 between Advanced Tissue Sciences, to Exhibit 10.1 to the
Inc. and Smith & Nephew plc Current Report on
Form 8-K Dated
January 14, 1998
10.14 Common Stock Purchase Agreement, Dated Incorporated by Reference
January 14, 1998, between Advanced Tissue to Exhibit 10.2 to the
Sciences, Inc. and Smith & Nephew SNATS, Current Report on
Inc. Form 8-K Dated January
14, 1998
29
<PAGE>
Exhibit
No. Title Method of Filing
- ------- ----- ----------------
10.15* Lease Agreement Between TPSC II Limited Filed Herewith
Partnership (Landlord) and Advanced
Tissue Sciences, Inc. (Tenant) Dated
October 15, 1997
21 Subsidiaries of the Registrant Filed Herewith
23 Consent of Ernst & Young LLP, Indepen- Filed Herewith
dent Auditors
27 Financial Data Schedule Filed with Electronic
Copy Only
___________________
* The Company has requested confidential treatment with respect to certain
portions of these documents.
** Key employees (including officers and directors), non-employee Board
members and independent consultants are eligible to participate in the
1997 Stock Incentive Plan.
(b) Reports on Form 8-K
-------------------
During the fourth quarter ended December 31, 1997, the Company filed no
reports on Form 8-K.
30
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed
on its behalf by the undersigned thereunto duly authorized.
ADVANCED TISSUE SCIENCES, INC.
Date: March 30, 1998 By: /s/ Arthur J. Benvenuto
--------------- ----------------------------
Arthur J. Benvenuto
Chairman of the Board of Directors
and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been executed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE
--------- ----- ----
/s/ Arthur J. Benvenuto Chairman of the Board of March 30, 1998
- ---------------------------- Directors and Chief Executive
Arthur J. Benvenuto Officer (principal executive
officer)
/s/ Dr. Gail K. Naughton Director, President and Chief March 30, 1998
- ---------------------------- Operating Officer
Dr. Gail K. Naughton
/s/ Michael V. Swanson Vice President, Finance and March 30, 1998
- ---------------------------- Administration (principal
Michael V. Swanson financial and accounting officer)
/s/ Jerome E. Groopman, M.D. Director March 30, 1998
- ----------------------------
Jerome E. Groopman, M.D.
/s/ Jack L. Heckel Director March 30, 1998
- ----------------------------
Jack L. Heckel
/s/ Ronald L. Nelson Director March 30, 1998
- ----------------------------
Ronald L. Nelson
/s/ Dayton Ogden Director March 30, 1998
- ----------------------------
Dayton Ogden
/s/ David S. Tappan, Jr. Director March 30, 1998
- ----------------------------
David S. Tappan, Jr.
/s/ Dr. Gail R. Wilensky Director March 30, 1998
- ----------------------------
Dr. Gail R. Wilensky
31
<PAGE>
SELECTED FINANCIAL DATA
See Note 1 to the accompanying consolidated financial statements for a
discussion of the basis of presentation. This summary of selected financial
data should be read in conjunction with the consolidated financial statements
and notes presented on pages F-7 to F-22.
<TABLE>
<CAPTION>
Year Ended December 31,
-------------------------------------------------------
1997 1996 1995 1994 1993
-------- -------- -------- -------- --------
(In thousands, except per share amounts)
<S> <C> <C> <C> <C> <C>
Revenues:
Product sales (1) $ 2,166 $ 1,018 $ 1,177 $ 1,042 $ 1,401
Contracts and fees (2) (3) 10,985 13,574 2,388 923 3,493
Research and development
expenses 17,984 23,699 18,498 16,459 13,810
Equity in losses of joint
ventures (3) (11,990) -- -- -- --
Net loss (36,089) (24,401) (23,125) (22,775) (17,691)
Basic and diluted loss per
share $ (.96) $ (.61) $ (.72) $ (.75) $ (.67)
Weighted average shares used in
the calculation of basic and
diluted loss per share 37,548 36,556 32,266 30,250 26,453
</TABLE>
<TABLE>
<CAPTION>
December 31,
--------------------------------------------------------
1997 1996 1995 1994 1993
-------- -------- -------- -------- --------
(In thousands)
<S> <C> <C> <C> <C> <C>
Cash, cash equivalents and
short-term investments (4) $ 17,086 $ 40,217 $ 18,929 $ 22,033 $ 21,693
Working capital 13,216 35,984 15,747 19,037 17,529
Total assets 50,460 56,501 31,141 33,426 30,363
Long-term debt 26,157 61 25 36 46
Accumulated deficit (175,171) (139,082) (116,681) (93,556) (70,781)
Stockholders' equity (4) 13,966 48,380 25,900 28,350 24,863
- --------------
</TABLE>
(1) Product sales for the year ended December 31, 1997 include sales of
Dermagraft-TC(R) of $976,000 and sales of Dermagraft(R) at cost to a
related party in the amount of $1,190,000. Product sales in 1996 and
prior years are for sales of the Company's Skin2(R) laboratory testing
kits. The Company discontinued sales of its Skin2 laboratory testing
kits in October 1996.
(2) Contracts and fees for the year ended December 31, 1996 include a $10
million up front payment from Smith & Nephew upon the formation of a
joint venture for the commercialization of Dermagraft for the treatment
of diabetic foot ulcers.
(3) In April 1996, the Company formed a joint venture with Smith & Nephew
for the commercialization of Dermagraft for the treatment of diabetic foot
ulcers. The Company had formed a separate joint venture for the
commercialization of tissue engineered cartilage for orthopedic
applications in April 1994. Contracts and fees include revenues for
research and development, marketing and other activities performed for
the joint ventures. Advanced Tissue Sciences and Smith & Nephew began
sharing equally in the revenues and expenses of the joint ventures in
January 1997.
(4) In January 1998, Smith & Nephew acquired 1,533,115 shares of Advanced
Tissue Sciences' Common Stock for $20 million in conjunction with an
expansion of the Dermagraft Joint Venture. As the transaction occurred
subsequent to the end of the fiscal year, it is not reflected in the year
ended December 31, 1997.
F-1
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Advanced Tissue Sciences, Inc. (the "Company" or "Advanced Tissue
Sciences") is engaged in the development and manufacture of human-based tissue
products for tissue repair and transplantation using its proprietary tissue
engineering technology. The Company's leading therapeutic products are tissue
engineered skin products, Dermagraft-TC(R) for the temporary covering of severe
and partial thickness burns and Dermagraft(R) for the treatment of severe skin
ulcers. In addition to its Dermagraft-TC and Dermagraft skin products, the
Company is focusing its resources on the development of tissue engineered
cartilage and cardiovascular products.
In March 1997, the Company received marketing approval in the United
States from the U.S. Food and Drug Administration (the "FDA") for its first
therapeutic product, Dermagraft-TC, as a temporary covering for severe, full
thickness burns. In addition, in October 1997, the Company received FDA
approval to market Dermagraft-TC for partial thickness burns in the United
States. Dermagraft-TC is being marketed by Advanced Tissue Sciences through a
direct sales force in the United States. Dermagraft-TC will be marketed
throughout the rest of the world and for certain applications other than burns
in the United States under a recently expanded joint venture with Smith &
Nephew plc ("Smith & Nephew"). The Company has also submitted an application
to the FDA for approval to market its dermal skin replacement product,
Dermagraft for the treatment of diabetic foot ulcers. Dermagraft was
approved for sale in Canada in August 1997 and was launched in the United
Kingdom and several other European countries late in 1997 through the joint
venture with Smith & Nephew.
In April 1996, the Company entered into an agreement with Smith & Nephew
to form a fifty-fifty joint venture (the "Dermagraft Joint Venture") for the
worldwide commercialization of Dermagraft in the treatment of diabetic foot
ulcers. Beginning in January 1997, all expenses and revenues associated with
the development and commercialization of Dermagraft for diabetic foot ulcers
are being shared equally by the joint venture partners. In January 1998,
Advanced Tissue Sciences and Smith & Nephew expanded the Dermagraft Joint
Venture to include additional technology for the treatment of skin tissue
wounds and applications such as venous ulcers, pressure ulcers and burns.
Under the expanded joint venture, Advanced Tissue Sciences and Smith & Nephew
will continue to share equally in the expenses and revenues of the Dermagraft
Joint Venture, except the Company will fund the first $6 million in expense
for conducting clinical trials and regulatory support of Dermagraft and
Dermagraft-TC in the treatment of venous ulcers and pressure ulcers. See
Notes 3 and 15 to the consolidated financial statements.
In May 1994, the Company and Smith & Nephew entered into a separate,
fifty-fifty joint venture (the "Cartilage Joint Venture") for the worldwide
development, manufacture and marketing of human tissue engineered cartilage
for orthopedic applications. Smith & Nephew was responsible for funding the
first $10 million in costs incurred in the Cartilage Joint Venture. In
January 1997, the joint venture partners began sharing equally in the
Cartilage Joint Venture's expenses. See Note 3 to the consolidated financial
statements.
In October 1997, the Company was awarded a $2 million Advanced Technology
Program grant from the National Institute of Standards and Technology to fund
collaborative cardiovascular research with the University of California, San
Diego over a three-year period. The Company will begin receiving funding
under the grant in 1998. Grant funding is subject to annual approvals and
requires the Company to maintain certain funding levels (see Note 10 to the
consolidated financial statements). In 1994 and 1995, the Company worked with
St. Jude Medical, Inc. ("St. Jude Medical") on the development of tissue
engineered cardiovascular products. In 1996 and 1997, the Company funded all
of its cardiovascular research and development activities internally.
Since 1993, the Company has sponsored at least $1 million in early stage
research programs at the Massachusetts Institute of Technology ("MIT") and
Children's Hospital in Boston ("Children's Hospital") directed toward the
tissue engineering of cartilage, liver and numerous other tissues and several
polymer technologies. The Company has substantially reduced its commitment to
MIT and Children's Hospital in 1998; however, additional research is being
sponsored at several other academic institutions.
F-2
<PAGE>
In October 1996, the Company discontinued sales of its Skin2(R)
laboratory testing kits and took a charge of approximately $1 million
associated with the closure of this business. See Note 4 to the consolidated
financial statements.
The Company has incurred, and expects to continue to incur, substantial
expenditures in support of the commercialization, development and clinical
trials of its Dermagraft-TC and Dermagraft products for burn and skin ulcer
applications, for manufacturing systems, in building sales and marketing
capabilities and launching products, and in advancing other applications of
the Company's core technology.
RESULTS OF OPERATIONS
Year Ended December 31, 1997 as Compared to the Year Ended December 31, 1996
Product sales totaled $2,166,000 in 1997, as compared to $1,018,000 in
1996. Product sales to related parties reflect sales of Dermagraft to the
Dermagraft Joint Venture at cost (see Note 3 to the consolidated financial
statements). Sales to outside customers of $976,000 in 1997 are from sales of
Dermagraft-TC for full thickness burns introduced in April and for partial
thickness burns introduced in October, following marketing approvals from the
FDA. In addition to product attributes and competition, growth in sales in
1998 and beyond will be sensitive to success in obtaining product
reimbursement from both national healthcare systems and private insurers.
Sales in 1996 were from the Company's Skin2 product line which was
discontinued in October 1996 (see Note 4 to the consolidated financial
statements).
Sales of Dermagraft-TC fluctuated from quarter to quarter in 1997.
Although sales of $173,000 were down in the third quarter as compared to sales
of $450,000 in the introductory second quarter, sales increased to $353,000
in the fourth quarter primarily driven by approval of the partial thickness
indication. The Company focused its efforts during 1997 on educating the
market as to the benefits and attributes of Dermagraft-TC and in having
additional burn centers trial the product. Following the inspection by the
FDA in late March 1998, the Company initiated the recall of certain product
lots of Dermagraft and Dermagraft-TC upon determining one of the raw
materials used in the manufacturing proces was out of specification.
Although the effect on the 1997 results is not considered to be material, the
recall of product will result in increased costs and, potentially, lower
sales in the quarter ended March 31, 1998. The Company cannot predict with
any certainty what effect the recall may have on future sales of Dermagraft
and Dermagraft-TC. If the Company is delayed in addressing or unable to
adequately address issues raised by the FDA's inspection, the Company could
be prohibited from making Dermagraft and Dermagraft-TC available for sale or
export.
Revenues from related-parties for contracts and fees were $10,975,000 in
1997, as compared to $13,564,000 in 1996. Revenues reported for 1996 included
a $10 million up front fee from Smith & Nephew upon signing an agreement to
enter into the Dermagraft Joint Venture. Contract revenues, excluding the $10
million payment, increased $7,411,000 in 1997, principally reflecting contract
revenues recognized for research and development and other activities
performed for the Dermagraft Joint Venture. Such funding began in January
1997. See Note 3 to the consolidated financial statements. 1997 and 1996
also include revenues recognized for research and development performed for
the Cartilage Joint Venture.
Cost of goods sold in 1997 represents the cost of the Company's
Dermagraft-TC product since its introduction in April 1997 and the cost of
Dermagraft sold to the Dermagraft Joint Venture. Products are being sold to
the Dermagraft Joint Venture at cost to manufacture including period costs
(see Note 3 to the consolidated financial statements). Cost of goods sold is
expected to increase significantly in 1998 as the Company's expanded
manufacturing facility is brought into production and to support sales to the
Dermagraft Joint Venture. Cost of goods sold in 1996 represents the cost of
the Company's Skin2 laboratory testing kits. As noted above, the Company
discontinued its Skin2 business in October 1996.
Research and development expenditures decreased 24% to $17,984,000 in
1997, from $23,699,000 in 1996. The decrease in research and development costs
primarily reflects lower costs for both clinical trials and production for
clinical trials of Dermagraft-TC and Dermagraft for the development of
commercial
F-3
<PAGE>
manufacturing processes. These decreases were partially offset by increased
research and development costs to support the development of tissue
engineered cartilage.
Selling, general and administrative costs increased 35% to $14,773,000 in
1997, as compared to $10,911,000 in 1996. The increase in selling, general
and administrative expenses principally reflects higher selling and marketing
costs related to the commercialization of Dermagraft-TC and costs associated
with supporting the Dermagraft and Cartilage Joint Ventures. These increases
are reflected primarily in higher costs for selling and promotional materials,
and personnel and associated costs.
Professional and consulting costs for legal, accounting and other
consulting services incurred in 1997 were $2,941,000 as compared to $3,378,000
in 1996. The decrease in professional and consulting fees in 1997 principally
reflects the absence of fees paid to financial advisors related to the
Dermagraft Joint Venture and the Company's In Vitro Laboratory Testing
business in 1996 and lower fees for regulatory consultants. This was
partially offset by increased costs for marketing consultants and for the
recruitment of personnel.
Equity in losses of joint ventures was $11,990,000 in 1997, and represents
the Company's share of the losses of the Dermagraft and Cartilage Joint
Ventures. The Company began sharing in such costs in January 1997 (see Note 3
to the consolidated financial statements). The joint ventures' losses are
expected to continue to increase in 1998 as Dermagraft is commercially
introduced in certain markets, as venous and pressure ulcers enter into
clinical trials and as orthopedic cartilage research and development efforts
continue.
Interest and other income decreased to $1,961,000 in 1997 from $2,370,000
in 1996. The decrease primarily reflects a decline in interest income from
lower average cash balances in 1997 as compared to 1996. The decrease was
partially offset by interest charged to the Dermagraft Joint Venture for
capital employed.
Interest expense was $877,000 for 1997, as compared to $6,000 in 1996.
The increase reflects interest expense on borrowings from Smith & Nephew and
The Chase Manhattan Bank during 1997. See Note 8 to the consolidated financial
statements.
Year Ended December 31, 1996 as Compared to the Year Ended December 31, 1995
Revenues increased to $14,592,000 in 1996 from $3,565,000 in 1995. The
increase in 1996 primarily reflects a $10 million up front fee from Smith &
Nephew upon signing the agreement to enter into the Dermagraft Joint Venture.
In 1996, the Company also recognized contract revenues of $3,564,000 for
research and development of orthopedic applications of tissue engineered
cartilage performed for the Cartilage Joint Venture, as compared to $1,548,000
in 1995. In 1995, contract revenues also included $830,000 related to
research performed under the development agreement with St. Jude Medical.
Sales of the Company's Skin2 laboratory testing kits decreased to
$1,018,000 in 1996 compared to $1,177,000 in 1995. As discussed above, the
Company discontinued sales of its Skin2 products in October 1996.
Research and development expenditures increased 28% in 1996 to
$23,699,000 from $18,498,000 in 1995 due to higher costs associated with the
operation and maintenance of the Company's manufacturing facility,
expenditures in support of the scale up of Dermagraft manufacturing processes,
and increased levels of research and development in support of the Cartilage
Joint Venture. Increased costs for the operation of the manufacturing
facility reflect that the facility was not completed and clinical production
did not begin in the facility until mid-1995. Costs have increased in support
of the Cartilage Joint Venture primarily with respect to accelerating process
development activities and preclinical studies. Specifically, the increased
research and development costs are principally reflected in higher costs for
engineering services, operating costs of and depreciation associated with the
manufacturing facility, and additional personnel and rent.
Selling, general and administrative costs were $10,911,000 in 1996, a 78%
increase from $6,115,000 in 1995. The year ended December 31, 1996 includes
charges of approximately $1,000,000 associated with the closing of the
Company's In Vitro Laboratory Testing ("IVLT") business. The increase in
selling, general and administrative expenses also reflects (i) costs related
to building sales and marketing capabilities in anticipation
F-4
<PAGE>
of marketing approval of Dermagraft-TC and for Dermagraft; (ii) amortization
of the commitment fee associated with the equity line established in February
1996 (see Note 11 to the consolidated financial statements); (iii) increased
salaries and personnel; and (iv) higher relocation costs.
Professional and consulting costs for legal, accounting and other
consulting services incurred in 1996 were $3,378,000 compared to $1,897,000 in
1995. The increase in professional and consulting fees in 1996 principally
reflects fees paid to financial advisors and consultants related to forming
the Dermagraft Joint Venture and evaluating alternatives for the Company's
IVLT business. Professional and consulting costs for 1996 also included
higher fees for legal services related to the equity line, strategic alliances
and intellectual property, for regulatory and marketing consultants and for
the recruitment of personnel.
Cost of goods sold in 1996 and 1995 represents direct and indirect costs
of manufacturing the Company's Skin2 laboratory testing kits. Cost of goods
sold is net of the costs of products transferred to research and development
for use in developing additional applications of the Company's testing kits.
The cost of such products was included in research and development expenses
based upon estimated direct and indirect production costs assuming planned
production capacity.
Interest income in 1996 increased to $2,360,000 from $1,171,000
reflecting higher cash balances due to funds raised in a March 1996 public
offering and from the up front fee discussed above.
LIQUIDITY AND CAPITAL RESOURCES
As of December 31, 1997, the Company had available working capital of
$13,216,000, a decrease of $22,768,000 from December 31, 1996. In addition,
the Company raised $20 million in January 1998 through the sale of equity (see
Note 15 to the consolidated financial statements). The decrease in working
capital from 1996 principally reflects the use of funds for operations, for
capital expenditures and to support the Dermagraft and Cartilage Joint
Ventures offset by the Company's receipt of $28 million in loans from Smith &
Nephew and The Chase Manhattan Bank (see Note 8 to the consolidated financial
statements). Capital expenditures of $15,567,000 in 1997 relate primarily to
the expansion of the Company's manufacturing facility and related process
equipment.
The Company expects to use working capital at an accelerated rate as it
continues to incur substantial research and development expenses, increasing
support for the Dermagraft and Cartilage Joint Ventures, increasing selling,
general and administrative costs in support of product commercialization, and
additional expenditures for capital equipment and patents. These increases
are expected to be only partially offset by revenues received from the
Cartilage and Dermagraft Joint Ventures with Smith & Nephew and by revenues
from product sales.
In addition to available working capital, the Company has entered into an
equity line which could provide up to $50 million in funding through the sale
of Common Stock and, subject to certain conditions, is available through
February 1999 (see Note 11 to the consolidated financial statements). Any
decision to draw any funds under the equity line and the timing of any such
draw are solely at the Company's discretion. Also, under the expanded
Dermagraft Joint Venture, Smith & Nephew will pay the Company $15 million,
directly or through the Dermagraft Joint Venture, upon the earlier of (i) FDA
approval for the marketing of Dermagraft in the treatment of diabetic foot
ulcers or (ii) January 4, 1999 (see Note 15 to the consolidated financial
statements).
The Company currently believes it has sufficient funds, including those
available under the equity line, from available borrowings and through its
joint venture arrangements, to support its operations through 1998. To the
extent necessary, further sources of funds may include existing or future
strategic alliances or other joint venture arrangements which provide funding
to the Company, and additional public or private offerings of debt or equity
securities, among others. There can be no assurance, however, that funds will
be available when needed or on terms favorable to the Company, under existing
arrangements or otherwise, or that the Company will be successful in entering
into any other strategic alliances or joint ventures.
F-5
<PAGE>
The Company continually reviews its product development activities in an
effort to allocate its resources to those products the Company believes have
the greatest commercial potential. Factors considered by the Company in
determining the products to pursue include projected markets and need,
potential for regulatory approval and reimbursement under the existing
healthcare system as well as anticipated healthcare reforms, technical
feasibility, expected and known product attributes and estimated costs to
bring the product to market. Based on these and other factors which the
Company considers relevant, the Company may from time to time reallocate its
resources among its product development activities. Additions to products
under development or changes in products being pursued can substantially and
rapidly change the Company's funding requirements.
FINANCIAL CONDITION
Cash, cash equivalents and short-term investments as of December 31, 1997
decreased from December 31, 1996 reflecting the use of cash to fund
operations, capital expenditures and to support the Dermagraft and Cartilage
Joint Ventures, partially offset by proceeds of loans from Smith & Nephew and
The Chase Manhattan Bank. The current portion of long-term debt and long-term
debt increased by a total of $28.0 million from December 31, 1996 to December
31, 1997 reflecting such loans. Inventory at the end of 1997 increased
significantly from 1996 to support the marketing of Dermagraft-TC and
Dermagraft. The increase in property from year to year relates primarily to
the expansion of the Company's manufacturing facility and related process
equipment. The minority interest at December 31, 1997 reflects Smith &
Nephew's interest in DermEquip (see Note 1 to the consolidated financial
statements). The decrease in stockholders' equity from year to year
principally reflects the loss from operations.
YEAR 2000 COMPLIANCE
Many currently installed computer systems and software products are coded
to accept only two digit entries to represent years. These systems and
products will need to be able to accept four digit entries to distinguish
years beginning with 2000 from prior years. As a result, systems and products
that do not accept four digit year entries will need to be upgraded or
replaced to comply with such "Year 2000" requirements. Advanced Tissue
Sciences believes that its internal systems are Year 2000 compliant or will be
replaced in connection with previously planned upgrades to information systems
prior to the need to comply with Year 2000 requirements. However, a number of
the Company's customers and vendors may be affected by Year 2000 issues that
require that they expend significant resources to modify or replace their
existing systems.
OTHER INFORMATION
THE DISCUSSIONS IN THIS ANNUAL REPORT ON FORM 10-K, PARTICULARLY THOSE
RELATING TO STRATEGIC ALLIANCES (INCLUDING POTENTIAL REVENUES FROM CERTAIN
EXISTING JOINT VENTURES), THE USE OF WORKING CAPITAL, THE SUFFICIENCY AND
AVAILABILITY OF FUNDS TO SUPPORT OPERATIONS, AND COMMERCIALIZATION OF THE
COMPANY'S PRODUCTS, ARE FORWARD-LOOKING STATEMENTS INVOLVING RISKS AND
UNCERTAINTIES WITHIN THE MEANING OF THE SECURITIES ACT OF 1933 AND THE
SECURITIES EXCHANGE ACT OF 1934. NO ASSURANCE CAN BE GIVEN THAT THE COMPANY
WILL SUCCESSFULLY COMPLETE CLINICAL TRIALS, OBTAIN U.S. FOOD AND DRUG
ADMINISTRATION APPROVAL, SCALE UP MANUFACTURING PROCESSES, SUCCESSFULLY MARKET
SUCH PRODUCTS, ACHIEVE THE MILESTONES REQUIRED TO RECEIVE ADDITIONAL FUNDING,
OR ENTER INTO NEW STRATEGIC ALLIANCES. THESE AND OTHER RISKS ARE DETAILED IN
THE COMPANY'S PUBLICLY AVAILABLE FILINGS WITH THE SECURITIES AND EXCHANGE
COMMISSION, INCLUDING THIS ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED
DECEMBER 31, 1997. THE FORWARD-LOOKING STATEMENTS ARE QUALIFIED IN THEIR
ENTIRETY BY REFERENCE TO THE RISKS AND RISK FACTORS DESCRIBED IN SUCH REPORTS.
F-6
<PAGE>
ADVANCED TISSUE SCIENCES, INC.
CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
December 31,
---------------------------
1997 1996
------------ ------------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 15,086 $ 27,907
Short-term investments 2,000 12,310
Inventory 4,643 1,279
Other current assets 1,395 2,548
----------- -----------
Total current assets 23,124 44,044
Property - net 23,190 9,734
Patent costs - net 1,608 1,310
Other assets 2,538 1,413
------------ -----------
Total assets $ 50,460 $ 56,501
============ ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current portion of long-term debt and
capital lease obligations $ 1,939 $ 23
Accounts payable 958 2,232
Accrued expenses 7,011 5,805
------------ -----------
Total current liabilities 9,908 8,060
Long-term debt and capital lease obligations 26,157 61
Other long-term liabilities 245 --
Minority interest in consolidated subsidiary 184 --
------------ -----------
Total liabilities 36,494 8,121
------------ -----------
Commitments and contingencies
(Notes 8, 9 and 10)
Stockholders' equity:
Preferred Stock, $.01 par value; 1,000,000
shares authorized; none issued -- --
Common Stock, $.01 par value; 100,000,000
shares authorized; issued and outstanding,
37,673,983 shares at December 31, 1997
and 37,474,677 shares at December 31, 1996 377 375
Additional paid-in capital 189,679 188,006
Accumulated deficit (175,171) (139,082)
------------ -----------
14,885 49,299
Less note received in connection with
the sale of Common Stock (919) (919)
------------ -----------
Total stockholders' equity 13,966 48,380
------------ -----------
Total liabilities and stockholders' equity $ 50,460 $ 56,501
============ ===========
</TABLE>
See accompanying notes to the consolidated financial statements.
F-7
<PAGE>
ADVANCED TISSUE SCIENCES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
Year Ended December 31,
------------------------------------
1997 1996 1995
------------------------------------
<S> <C> <C> <C>
Revenues:
Product sales -
Related parties $ 1,190 $ -- $ --
Others 976 1,018 1,177
Contracts and fees -
Related parties 10,975 13,564 1,548
Others 10 10 840
--------- --------- ----------
Total revenues 13,151 14,592 3,565
--------- --------- ----------
Costs and expenses:
Research and development 17,984 23,699 18,498
Selling, general and administrative 14,773 10,911 6,115
Professional and consulting 2,941 3,378 1,897
Cost of goods sold 2,636 1,369 1,359
--------- --------- ----------
Total costs and expenses 38,334 39,357 27,869
--------- --------- ----------
Loss from operations before equity in
losses of joint ventures (25,183) (24,765) (24,304)
Equity in losses of joint ventures (11,990) -- --
--------- --------- ----------
Loss from operations (37,173) (24,765) (24,304)
Other income (expense):
Interest income and other 1,961 2,370 1,185
Interest expense (877) (6) (6)
--------- --------- ----------
Net loss $ (36,089) $ (22,401) $ (23,125)
========= ========= ==========
Basic and diluted loss per share $ (.96) $ (.61) $ (.72)
========= ========= ==========
Weighted average number of common
shares used in the computation of
basic and diluted loss per share 37,548 36,556 32,266
========= ========= ==========
</TABLE>
See accompanying notes to the consolidated financial statements.
F-8
<PAGE>
ADVANCED TISSUE SCIENCES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
<TABLE>
<CAPTION>
Year Ended December 31,
------------------------------------
1997 1996 1995
----------- ----------- ----------
<S> <C> <C> <C>
Operating activities:
Net loss $ (36,089) $ (22,401) $ (23,125)
Adjustments to reconcile net loss to cash
used in operating activities:
Depreciation and amortization 2,120 1,774 1,421
Compensation or services paid in stock
options or warrants 438 976 55
Equity in losses of joint ventures 11,990 -- --
Other adjustments to net loss 366 66 212
Changes in assets and liabilities:
Inventory (3,364) (761) (57)
Other current assets 1,153 (1,032) 67
Accounts payable (1,274) 1,049 (667)
Accrued expenses 1,206 1,783 842
--------- --------- ---------
Net cash used in operating
activities (23,454) (18,546) (21,252)
--------- --------- ---------
Investing activities:
Purchases of short-term investments (6,234) (45,730) (5,363)
Maturities and sales of short-term
investments 16,544 33,420 14,979
Acquisition of property (15,567) (3,104) (1,476)
Investment in joint ventures (11,040) -- --
Distributions from joint ventures 605 -- --
Patent application costs (439) (356) (323)
Other long-term assets (3,118) (114) (663)
--------- --------- ---------
Net cash provided by (used in)
investing activities (19,249) (15,884) 7,154
--------- --------- ---------
Financing activities:
Proceeds from borrowings 28,000 -- --
Payments of borrowings (38) (12) (10)
Net proceeds from sale of equity -- 40,253 19,515
Options and warrants exercised 1,675 3,167 1,105
Other long-term obligations 245 -- --
--------- --------- ---------
Net cash provided by financing
activities 29,882 43,408 20,610
--------- --------- ---------
Net increase (decrease) in cash and cash
equivalents (12,821) 8,978 6,512
Cash and cash equivalents at beginning of
year 27,907 18,929 12,417
--------- --------- ---------
Cash and cash equivalents at end of year $ 15,086 $ 27,907 $ 18,929
========= ========= =========
</TABLE>
See accompanying notes to the consolidated financial statements.
F-9
<PAGE>
ADVANCED TISSUE SCIENCES, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(IN THOUSANDS)
<TABLE>
<CAPTION>
Additional Total
Common Stock Paid-In Accumulated Note Stockholders'
-----------------
Shares Amount Capital Deficit Receivable Equity
-------- -------- ---------- ------------ ---------- -------------
<S> <C> <C> <C> <C> <C> <C>
Balance, December 31, 1994 30,569 $ 306 $ 121,600 $ (93,556) $ 28,350
Sale of Common Stock 2,614 26 19,489 19,515
Options and warrants
exercised 703 7 2,017 $ (919) 1,105
Options granted for services 55 55
Net loss (23,125) (23,125)
------ -------- ---------- ---------- --------- ----------
Balance, December 31, 1995 33,886 339 143,161 (116,681) (919) 25,900
Sale of Common Stock 3,224 32 39,595 39,627
Warrants issued as commitment
fee under equity line 875 875
Valuation adjustment of
Common Stock issued in
private placement 626 626
Warrants granted for services 500 500
Options and warrants
exercised 365 4 3,249 3,253
Net loss (22,401) (22,401)
------ -------- ---------- ---------- --------- ----------
Balance, December 31, 1996 37,475 375 188,006 (139,082) (919) 48,380
Options exercised 199 2 1,673 1,675
Net loss (36,089) (36,089)
------ -------- ---------- ---------- --------- ----------
Balance, December 31, 1997 37,674 $ 377 $ 189,679 $ (175,171) $ (919) $ 13,966
====== ======== ========== ========== ========= ==========
</TABLE>
See accompanying notes to the consolidated financial statements.
F-10
<PAGE>
ADVANCED TISSUE SCIENCES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - BASIS OF PRESENTATION
Organization - Advanced Tissue Sciences, Inc. (the "Company") is a tissue
engineering company utilizing its proprietary technology to develop and
manufacture human-based tissue products for tissue repair and
transplantation. The Company is focusing on the worldwide commercialization
of skin, cartilage and cardiovascular products. The Company's leading
therapeutic products are tissue engineered skin products for the temporary
covering of severe and partial thickness burns, approved for marketing in the
United States by the U.S. Food and Drug Administration (the "FDA"), and for
the treatment of diabetic foot ulcers, for which the Company has filed an
application with the FDA for marketing approval in the United States.
Principles of Consolidation - The consolidated financial statements include
the accounts of the Company, its wholly owned subsidiaries and DermEquip,
L.L.C. ("DermEquip"), a limited liability company owned jointly with Smith &
Nephew plc ("Smith & Nephew"). All intercompany accounts and transactions
have been eliminated. The Company's other interests in joint ventures with
Smith & Nephew are accounted for under the equity method (see Note 3).
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 of assets and liabilities and
related disclosures at the date of the financial statements, and the amounts
of revenues and expenses reported during the period. Actual results could
differ from those estimates.
Dependence on Certain Suppliers - The mesh frameworks used by the Company in
its therapeutic products are sourced from single manufacturers. Any
significant supply interruption would adversely affect the Company's product
manufacturing. In addition, an uncorrected impurity or supplier's variation
in raw material, either unknown to the Company or incompatible with the
Company's manufacturing process, could have a material adverse effect on the
Company's ability to manufacture its products.
Reclassification - Certain reclassifications have been made to prior year
amounts to conform to the presentation for the year ended December 31, 1997.
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Cash Equivalents and Short-term Investments - Cash equivalents consist
primarily of investments in commercial paper and obligations issued or
guaranteed by the United States Government with maturities of three months or
less at the date of acquisition. Cash equivalents were approximately
$15,064,000 and $27,880,000 as of December 31, 1997 and 1996, respectively.
Short-term investments are valued on the basis of quoted market value and
consist primarily of investments in commercial paper and obligations issued
or guaranteed by the United States Government with maturities of one year or
less but more than three months at the date of acquisition. Cash equivalents
and short-term investments are stated at amortized cost, which approximates
market value. As of December 31, 1997 and 1996, the Company's cash
equivalents and short-term investments were classified as available-for-sale
and consisted of (in thousands):
<TABLE>
<CAPTION>
1997 1996
---------- ----------
<S> <C> <C>
Debt securities of U.S. Government agencies $ 2,002 $ 23,574
United States treasury bills 1,984 7,799
Commercial paper -- 5,479
Money market funds 13,078 3,353
-------- --------
Total cash equivalents and short-term
investments $ 17,064 $ 40,205
======== ========
</TABLE>
F-11
<PAGE>
These investments all mature in less than one year. There were no significant
unrealized or realized gains or losses related to such securities during the
years ended December 31, 1997 or 1996. In January 1998, the Company received
$20 million from the sale of Common Stock to Smith & Nephew in conjunction
with the expansion of the Dermagraft Joint Venture (see Note 15).
Inventory - Inventories are stated at the lower of cost, principally standard
costs which approximate actual costs on a first-in, first-out basis, or
market.
Property is recorded at cost and is depreciated using estimated useful lives
which range from 3 to 10 years. For financial statement purposes,
depreciation is generally computed using the straight-line method. For tax
purposes, depreciation is generally computed by accelerated methods on
allowable useful lives. Amortization of capitalized leases is included with
depreciation expense. Costs related to the validation of new manufacturing
facilities and equipment are capitalized prior to the assets being placed in
service. In addition, interest is capitalized related to the construction of
such assets. Such costs and capitalized interest are amortized over the
estimated useful lives of the related assets. During 1997, $444,000 of
interest expense was capitalized. No interest was capitalized in 1996 or
1995. Depreciation expense for the years ended December 31, 1997, 1996 and
1995 amounted to approximately $2,077,000, $1,739,000 and $1,396,000,
respectively.
Patents - The Company owns and has patents pending in the United States and
abroad to protect the processes and products being developed by the Company.
Direct patent application and maintenance costs related to patents issued are
amortized over the estimated useful life of the patent, approximately 17
years. Such costs related to pending applications are deferred until the
patent is issued or charged to operations at the time a determination is made
not to pursue an application. Patents are presented net of accumulated
amortization of approximately $213,000 and $170,000 as of December 31, 1997
and 1996, respectively. Patent application and maintenance costs related to
licensing agreements are expensed as incurred.
Industry Segment and Geographic Information - The Company operates in a single
industry segment - the development and commercialization of human-based tissue
products for tissue repair and transplantation. Export sales of the Company's
laboratory testing kits (see Note 4), principally to Europe and Asia, totaled
approximately $621,000 and $622,000 in the years ended December 31, 1996 and
1995, respectively. During the year ended December 31, 1997, international
sales have been through the Dermagraft Joint Venture (see Note 3). The
Company has no foreign operations.
Revenue Recognition - Revenues from product sales to third parties are
recognized when products are shipped. Revenues from product sales to related
parties (see Note 3) are recognized at such time as the related party is
contractually obligated to purchase the product, generally upon the completion
of manufacture. Such product sales to the Dermagraft Joint Venture are equal
to the Company's cost. Revenues under collaborative research agreements are
recognized over the period specified in the related agreement. Revenues from
government grants are recognized based on the performance requirements of the
grant or as the grant expenditures are incurred. Expenses related to such
agreements and grants are classified as research and development expenses.
Major Customers - During 1997, the Dermagraft Joint Venture purchased
substantially all of the Company's production of Dermagraft as reflected under
product sales to related parties in the statement of operations (see Note 3).
The Company also had four unaffiliated customers whose individual purchases
represented at least 10% of product sales. These customers accounted for 28%,
18%, 17% and 12% of the Company's sales in the year ended December 31, 1997.
Research and Development Costs are expensed as incurred. Such costs include
proprietary research and development activities and expenses associated with
collaborative research agreements.
Basic and Diluted Loss Per Share - As required, the Company adopted Financial
Accounting Standards Board Statement No. 128, "Earnings Per Share," ("FAS No.
128") for the year ended December 31, 1997. FAS No. 128 changes the method
used to calculate earnings per share and requires the restatement of all prior
periods reported. Under FAS No. 128, the Company is required to present basic
and diluted earnings per share if
F-12
<PAGE>
applicable. Basic earnings per share are determined based on the weighted
average number of shares outstanding during the period. Diluted earnings
per share include the weighted average number of shares outstanding and give
effect to potentially dilutive common shares such as options and warrants
outstanding.
Both the basic and diluted loss per share for the years ended December 31,
1997, 1996 and 1995 are based on the weighted average number of shares of
Common Stock outstanding during the periods. Potentially dilutive securities
include options and warrants outstanding (see Notes 11 and 12) and debt
convertible into Common Stock (see Note 8); however, such securities have not
been included in the calculation of the diluted loss per share as their
effect is antidilutive. Since such securities are antidilutive, there
is no difference between basic and diluted loss per share for any of the
periods presented and none of the prior periods presented were required to be
restated.
In January 1998, Smith & Nephew acquired 1,533,115 shares of Common Stock in
conjunction with an expansion of the Dermagraft Joint Venture. As the
transaction occurred subsequent to the end of the fiscal year, it is not
reflected in the calculation of the basic and diluted loss per share for any
of the periods presented. See Note 15.
Stock Options - As permitted under Financial Accounting Standards Board
Statement No. 123, "Accounting for Stock-Based Compensation" ("FAS No. 123"),
the Company follows Accounting Principles Board (APB) Opinion No. 25,
"Accounting for Stock Issued to Employees," in accounting for outstanding
stock options and warrants. Under APB Opinion No. 25, compensation expense
relating to employee stock options is determined based on the excess of the
market price of the Company's stock over the exercise price on the date of
grant and does not require the recognition of compensation expense for stock
issued under plans defined as noncompensatory. Adoption of FAS No. 123
requires recognition of compensation expense for virtually all options based
on their computed "fair value" on the date of grant. See Note 12.
New Accounting Standards - In June 1997, the Financial Accounting Standards
Board issued FAS No. 130, "Reporting Comprehensive Income" and FAS No. 131,
"Segment Information." Both of these standards are effective for fiscal
years beginning after December 15, 1997. FAS No. 130 requires that all
components of comprehensive income, including net income, be reported in the
financial statements in the period in which they are recognized.
Comprehensive income is defined as the change in equity during a period from
transactions and other events and circumstances from non-owner sources. Net
income and other comprehensive income, including foreign currency translation
adjustments, and unrealized gains and losses on investments, shall be
reported, net of their related tax effect, to arrive at comprehensive
income. The Company believes that comprehensive income or loss will not be
materially different than net income or loss. FAS No. 131 amends the
requirements for public enterprises to report financial and descriptive
information about its reportable operating segments. Operating segments, as
defined in FAS No. 131, are components of an enterprise for which separate
financial information is available and is evaluated regularly by the Company
in deciding how to allocate resources and in assessing performance. The
financial information is required to be reported on the basis that is used
internally for evaluating the segment performance. As stated above, the
Company believes it operates in one business and operating segment and that
adoption of these standards will not have a material impact on the Company's
financial statements.
NOTE 3 - STRATEGIC ALLIANCES
In April 1996, the Company entered into an agreement with Smith & Nephew to
form a fifty-fifty joint venture for the worldwide commercialization of
Dermagraft(R), the Company's tissue engineered dermal skin replacement for
the treatment of diabetic foot ulcers (the "Dermagraft Joint Venture"). Upon
signing, Smith & Nephew paid an up front fee of $10 million and agreed to pay
the Company up to an additional $60 million on the achievement of certain
milestones. Smith & Nephew is a worldwide healthcare company with extensive
sales and distribution capabilities. It manufactures a wide range of tissue
repair products, principally addressing the areas of bone, joints, skin and
other soft tissue. The companies are sharing equally in the expenses and
revenues of the Dermagraft Joint Venture effective January 1, 1997. During
the year ended December 31, 1997, the Company recognized $7,041,000 in
contract revenues for research and development, marketing and other
F-13
<PAGE>
activities performed for the Dermagraft Joint Venture. In addition, during
the year ended December 31, 1997, the Company sold the Dermagraft Joint
Venture $1,190,000 of Dermagraft product, which was equal to the Company's
cost of goods sold for such product. See Note 15 regarding the expansion of
the Dermagraft Joint Venture in January 1998.
In 1994, Smith & Nephew and the Company entered into a separate joint venture
for the development of tissue engineered cartilage for orthopedic applications
(the "Cartilage Joint Venture"). Under the Cartilage Joint Venture, Smith &
Nephew contributed the first $10 million in funding and the Company
contributed certain technology licenses. The Cartilage Joint Venture's total
funding since inception reached $10 million in January 1997 and, as provided
in the joint venture agreement, the Company and Smith & Nephew began sharing
equally in Cartilage Joint Venture revenues and expenditures. During the
years ended December 31, 1997, 1996 and 1995, the Company recognized
$3,934,000, $3,564,000 and $1,548,000, respectively, in contract revenues for
research and development activities performed for the Cartilage Joint Venture.
The results of operations of the joint ventures for the years ended December
31, 1997, 1996 and 1995 are as follows (in thousands):
<TABLE>
<CAPTION>
1997 1996 1995
------------ ------------ ------------
<S> <C> <C> <C>
Dermagraft Joint Venture
- ------------------------
Net sales $ 36 $ -- $ --
Cost of good sold 824 -- --
Net loss (17,840) (10,000) --
Current assets 373 -- --
Non-current assets 304 -- --
Current liabilities 3,737 -- --
Partners' capital (3,060) -- --
Cartilage Joint Venture
- -----------------------
Net loss $ (7,150) $ (6,889) $ (3,034)
Current assets 79 82 883
Non-current assets 591 717 165
Current liabilities 535 1,554 513
Partners' capital 135 (755) 535
</TABLE>
NOTE 4 - IN VITRO LABORATORY TESTING BUSINESS
In October 1996, the Company closed its In Vitro Laboratory Testing ("IVLT")
business to focus all of its resources on its therapeutic programs. Although
the Company was a leader in the in vitro testing business and continuously
broadened applications of it products, the market for in vitro laboratory
testing products was evolving too slowly for the Company to continue to devote
its resources to this business. The statement of operations for the year
ended December 31, 1996 includes charges of approximately $1.0 million for
costs associated with the closure of the IVLT business (substantially all of
which are reflected in selling, general and administrative expenses).
Exclusive of these charges, costs associated with operations of the IVLT
business were $2,528,000 and $2,913,000 for the years ended December 31, 1996
and 1995, respectively.
F-14
<PAGE>
NOTE 5 - INVENTORIES
Inventories consist of the following components as of December 31, 1997 and
1996 (in thousands):
1997 1996
------------ ------------
Raw materials and supplies $ 3,295 $ 727
Work-in-process 347 552
Finished goods 1,001 --
--------- ---------
$ 4,643 $ 1,279
========= =========
NOTE 6 - PROPERTY
The major classes of property as of December 31, 1997 and 1996 are as follows
(in thousands):
1997 1996
------------ ------------
Equipment $ 11,645 $ 8,763
Furniture and fixtures 586 578
Leasehold improvements 6,254 5,972
Equipment under capital leases 110 116
Construction in progress 12,689 555
---------- ----------
31,284 15,984
Less accumulated depreciation
and amortization (8,094) (6,250)
---------- ----------
Net property $ 23,190 $ 9,734
========== ==========
Construction in progress primarily relates to an expansion of the Company's
manufacturing facilities and related process equipment that was placed in
service in January 1998.
NOTE 7 - ACCRUED EXPENSES
Accrued expenses as of December 31, 1997 and 1996 consisted of (in thousands):
1997 1996
------------ ------------
Salaries and benefits $ 2,606 $ 2,173
Sponsored research 1,562 915
Dermagraft Joint Venture 683 --
Clinical studies 667 1,245
Professional fees 285 396
Product and process engineering 159 139
Other 1,049 937
-------- --------
$ 7,011 $ 5,805
======== ========
NOTE 8 - LONG-TERM DEBT
In August 1997, DermEquip entered into a term loan agreement with The Chase
Manhattan Bank to borrow up to $16 million (the "Chase Loan") through June
1998. As of December 31, 1997, DermEquip had borrowed $14.6 million under the
Chase Loan. The Chase Loan bears interest payable quarterly at the 90-day
London Interbank Offered Rate ("LIBOR") plus 1/4 percent. Principal is
payable in equal quarterly installments beginning in June 1998 through
June 2004. DermEquip's obligations with respect to the Chase Loan are
jointly and severally guaranteed by Smith & Nephew and the Company. The
guaranties are secured by DermEquip's assets, having a carrying value of
$16,172,000 as of December 31, 1997, and by each company's interest in
DermEquip.
F-15
<PAGE>
In March 1997, the Company borrowed $10 million from Smith & Nephew pursuant
to a commitment as a part of the agreement to form the Dermagraft Joint
Venture (see Note 3). The loan is unsecured and bears interest at 90-day
LIBOR plus 4% and is due on the earlier of (i) March 2000 or (ii) the date on
which the Company no longer has an ownership interest in the Dermagraft Joint
Venture. At the option of the Company, the loan may be paid in cash or Common
Stock valued at the then current fair market value.
During 1997, the Company borrowed $3.4 million from Smith & Nephew pursuant to
a commitment as a part of the agreement to form the Cartilage Joint Venture
(see Note 3). Under the terms of that joint venture agreement, the Company
may borrow up to a total of $10 million. The loan is unsecured and bears
interest at 90-day LIBOR plus 4% and is due on the earlier of (i) June 2000
or (ii) the date on which the Company no longer has an ownership interest in
the Cartilage Joint Venture.
Debt and capital lease obligations as of December 31, 1997 and 1996 were as
follows (in thousands):
1997 1996
------------ ------------
Chase Loan $ 14,600 $ --
Smith & Nephew notes:
Dermagraft Joint Venture 10,000 --
Cartilage Joint Venture 3,400 --
Obligations under capital leases 96 84
Less current portion (1,939) (23)
--------- ---------
$ 26,157 $ 61
========= =========
Maturities of long-term debt and capital lease obligations over the next five
years are $1,939,000 in 1998, $2,582,000 in 1999, $15,987,000 in 2000,
$2,588,000 in 2001, $2,560,000 in 2002 and $2,440,000 thereafter. As
substantially all of the Company's debt carries interest at variable rates,
the fair market value of such instruments is estimated to approximate their
carrying value.
NOTE 9 - LEASE COMMITMENTS
Operating lease commitments relate primarily to the Company's manufacturing,
research and administrative facilities. The leases for the Company's primary
facility, which include manufacturing, research and administrative facilities,
expire in September 2000; however, these leases include an option to extend
the term for an additional five years. These leases include the cost of some
of the utilities and certain services, and provide for annual rental increases
ranging from a minimum of 3% to a maximum of 7% based on changes in the
Consumer Price Index.
The Company also leases two other facilities for manufacturing, research and
administration. One lease has a two-year term and expires in July 1998;
however, the Company has options to extend the term of the lease for up to one
year. The lease includes the operating costs for the facility and provides
for a 4% annual rent increase. The other lease has a five-year term and
expires in January 2002. The lease provides that the Company will pay rent,
which increases 4% annually, as well as the operating costs of the leased
facility.
In October 1997, the Company entered into a 15-year lease agreement for
additional research and administrative space. The facility is currently being
constructed and the lease is expected to begin on the completion of
construction in late 1998 or early 1999. The lease provides for a 4% annual
rent increase during the first five years, 3% during the second five years
and 2.5% during the final five years. Under the lease, the Company will also
be responsible for all operating costs. The Company also has options to
extend the term of the lease for two five-year periods.
F-16
<PAGE>
The following is a summary of the annual future minimum operating lease
commitments as of December 31, 1997. It includes the projected lease
commitments for the Company's new research and administration facility based
on the facility's estimated cost and expected occupancy date. These
commitments may vary based on the actual costs and occupancy date.
CAPITAL OPERATING
LEASES LEASES
------------ ------------
(in thousands)
Year Ending December 31:
1998 $ 36 $ 3,392
1999 36 5,384
2000 36 5,083
2001 30 3,687
2002 -- 3,618
Thereafter -- 46,653
--------- ----------
Total minimum lease payments 138 $ 67,817
==========
Less amount representing interest (42)
---------
Present value of net minimum
lease payments $ 96
=========
Rental expense charged to operations under operating leases for facilities and
equipment for the years ended December 31, 1997, 1996 and 1995 amounted to
approximately $3,412,000, $2,778,000 and $1,982,000, respectively.
NOTE 10 - COMMITMENTS AND CONTINGENCIES
Under agreements with several universities, the Company has entered into
commitments to sponsor research for a minimum of $1.0 million in 1998. In
addition, the Company has been awarded a $2 million grant by the National
Institute of Standards and Technology under their Advanced Technology program
to support the development of tissue engineered vascular grafts over a
three-year period. The grant requires the Company to meet certain minimum
levels of program funding in order to receive the grant funding. In
addition, the second and third years of funding will be contingent on the
availability of funds from Congress, subject to satisfactory performance by
the Company and at the sole discretion of the National Institute of Standards
and Technology.
The Company is also responsible for patent application costs and associated
maintenance fees related to inventions under certain licensing agreements.
The Company seeks to protect its proprietary technology through the use of
various aspects of United States and foreign patent law and contractual
arrangements. The Company owns 25 United States patents and has patent
applications pending both in the United States and internationally. However,
there can be no assurance that the Company's patents or patent applications
will afford protection against competitors with similar technology, nor can
there be any assurance that the Company's present patents will not be
infringed upon or designed around by others. Substantial costs could be
incurred to protect against infringement or defend the Company's patents and
licensed patents.
Under the terms of its joint venture agreements, the Company has agreed to
fund its share of the costs of the Dermagraft and Cartilage Joint Ventures.
See Notes 3 and 15.
NOTE 11 - CAPITAL STOCK
As of December 31, 1997, the Company had 8,318,751 shares of Common Stock
reserved for issuance under options and warrants. See Note 15 regarding
additional shares of Common Stock issued subsequent to December 1997.
In January 1995, the Company adopted a Shareholder Rights Plan and pursuant
thereto issued one preferred share purchase right ("Right") on each
outstanding share of Common Stock. The Rights are exercisable only if a
person or group acquires, or makes a tender offer to acquire, 15% or more of
the Company's Common Stock. In connection with the adoption of the
Shareholder Rights Plan, the Company's Board of Directors designated and
F-17
<PAGE>
reserved 500,000 shares of the Company's authorized Preferred Stock as Series
A Junior Participating Preferred Stock, par value $.01 per share (the "Series
A Preferred Stock"). The Rights have no voting privileges and expire on
January 6, 2005.
When exercisable, each Right entitles its holder to buy one-hundredth of a
share of the Series A Preferred Stock at an exercise price of $55, subject to
certain antidilution adjustments. In addition, if at any time after the
Rights become exercisable, should (i) the Company be acquired in a merger or
other business combination transaction, or sell 50% or more of its
consolidated assets or earnings power, each Right will entitle its holder to
purchase a number of the acquiring company's common shares having a market
value at the time of twice the Right's exercise price or (ii) a person or
group acquire 15% or more of the Company's outstanding Common Stock, each
Right will entitle its holder, other than the acquirer, to purchase, at the
Right's then-current exercise price, a number of shares of the Company's
Common Stock having a market value of twice the Right's exercise price. The
rights are redeemable for one cent per Right at any time up to and including
ten days after the acquisition of 15% of the then outstanding Common Stock.
In March 1996, the Company sold 3,000,000 shares of Common Stock at $13.25 per
share in an underwritten public offering. In addition, in April 1996, the
underwriters partially exercised the over-allotment option related to the
offering and purchased an additional 223,800 shares of Common Stock at $13.25
per share. In total, the Company received net proceeds of approximately $40.0
million from the offering.
In February 1996, the Company entered into an investment agreement (the
"Investment Agreement") with a newly formed investment group for an equity
line which allows the Company to access up to $50 million through sales of its
Common Stock. Subject to certain minimum requirements, the equity line will
remain available until February 1999 (see Note 15). The decision to draw any
funds under the Investment Agreement and the timing of any such draw are
solely at the Company's discretion.
The Investment Agreement provides that the Company can obtain up to $15
million at any one time through the sale of Common Stock. Any sales against
the equity line will be at a five percent discount to the average low sales
prices of the Company's Common Stock over a specified period of time as
determined by market volume at the time of the draw. The Company's ability to
draw under the Investment Agreement is subject to certain conditions
including, but not limited to, registration of the shares, a minimum trading
price of $2.00 per share, and certain limitations on the number of shares of
Common Stock held by the investment group at any point in time.
NOTE 12 - EMPLOYEE BENEFIT PLANS
At the 1997 Annual Meeting of Stockholders, the 1997 Stock Incentive Plan (the
"1997 Plan") was approved. The 1997 Plan makes an additional 3,000,000 shares
of Common Stock, or up to a maximum of 7,450,000 shares, available for grant.
Upon adoption of the 1997 Plan, shares granted under outstanding options and
available for grant under the 1992 Stock Option/Stock Issuance Plan (the "1992
Plan") were transferred to the 1997 Plan. All outstanding options under the
1992 Plan will continue to be governed by the terms and conditions of the
existing option agreements for those grants.
The 1997 Plan provides for the grant of incentive stock options, non-qualified
stock options and stock issuances to employees and consultants and automatic
50,000-share grants to non-employee directors. At December 31, 1997, a total
of 6,859,111 shares were outstanding under options or available for grant
under the 1997 Plan. The Company has elected to continue to account for its
employee stock option plans under APB Opinion No. 25 rather than adopt FAS No.
123 (see Note 2).
Under the 1997 Plan, all employees are granted stock options on their date of
employment and on promotion. The number of shares granted is based on the
employee's position and responsibilities. The options granted generally
become exercisable in equal annual amounts over five years. The options
generally have a term of ten years as long as the employee remains in the
service of the Company. The Company also began to make annual grants to
employees in 1997. Directors receive an automatic grant of 50,000 shares upon
joining the Board and
F-18
<PAGE>
generally every third year thereafter. The options generally are immediately
exercisable, become vested in equal annual amounts over three years and have
a term of ten years assuming continued service on the Board.
In addition to the 1997 Plan, the Company has issued options and warrants to
directors, consultants, employees and others as compensation for services.
These options vest and are exercisable over a variety of periods as determined
by the Company's Board of Directors.
The following table summarizes activity under the 1997 Plan and for other
options and warrants for Common Stock for the years ended December 31, 1997,
1996 and 1995:
<TABLE>
<CAPTION>
1997 Plan Other Options and Warrants
------------------------------ ------------------------------
Weighted Weighted
Number Average Price Number Average Price
of Shares Per Share of Shares Per Share
------------- --------------- ------------- ----------------
<S> <C> <C> <C> <C>
Outstanding, December 31, 1994 2,296,348 $ 6.37 1,898,334 $ 5.04
Granted 304,925 $ 7.95 235,299 $ 8.39
Exercised (112,783) $ 8.25 (590,000) $ 1.85
Canceled (170,975) $10.05 (83,334) $ 6.00
----------- -----------
Outstanding, December 31, 1995 2,317,515 $ 6.28 1,460,299 $ 6.81
Granted 1,660,450 $14.05 275,000 $10.50
Exercised (99,290) $ 8.87 (265,659) $ 8.61
Canceled (104,974) $ 8.10 -- --
----------- -----------
Outstanding, December 31, 1996 3,773,701 $ 9.58 1,469,640 $ 7.18
Granted 691,885 $13.82 -- --
Exercised (189,306) $ 8.75 (10,000) $ 1.69
Canceled (161,130) $11.48 -- --
----------- -----------
Outstanding, December 31, 1997 4,115,150 $10.26 1,459,640 $ 7.21
=========== ===========
</TABLE>
The weighted average fair value of options granted was $10.09, $9.60 and $5.29
under the 1997 Plan in 1997, 1996 and 1995, respectively, and $5.00 and $4.05
for other options and warrants in 1996 and 1995, respectively. Included in
other options and warrants granted during 1996 is a warrant issued to an
investment group exercisable for 175,000 shares of Common Stock at an exercise
price of $10.50 per share as a commitment fee for keeping the equity line
available (see Note 11). In addition, as a fee for consulting services, the
Company also issued a warrant exercisable for 100,000 shares of Common Stock
at an exercise price of $10.50 per share in 1996.
F-19
<PAGE>
The following table summarizes by price ranges the number of shares, weighted
average exercise price and weighted average remaining life (in years) of
options and warrants exercisable and outstanding as of December 31, 1997.
<TABLE>
<CAPTION>
Exercisable Total Outstanding
---------------------------------- ----------------------------------
Number of Weighted Average Number of Weighted Average
---------------------- ---------------------
Price Range Shares Exercise Price Life Shares Exercise Price Life
- --------------- ----------- -------------- ------ ------------ -------------- ------
<S> <C> <C> <C> <C> <C> <C>
1997 Plan:
$1.69 775,000 $ 1.69 1.5 775,000 $ 1.69 1.5
$3.25 - 3.63 51,540 $ 3.10 2.2 51,540 $ 3.55 2.2
$4.13 - 5.75 126,478 $ 4.84 4.8 164,085 $ 5.01 5.4
$5.88 - 8.63 189,735 $ 8.01 5.2 261,115 $ 7.91 5.6
$8.75 - 13.00 578,680 $10.26 5.7 954,500 $10.67 7.0
$13.06 - 18.50 359,877 $14.42 8.0 1,899,610 $14.46 8.5
$19.63 1,860 $19.63 8.8 9,300 $19.63 8.8
--------- ---------
Total 1997 Plan 2,083,170 $ 7.09 6.0 4,115,150 $10.26 7.7
========= =========
Other Options and
Warrants:
$1.47 - 1.67 300,000 $ 1.57 0.5 300,000 $ 1.57 0.5
$4.50 10,000 $ 4.50 2.7 10,000 $ 4.50 2.7
$8.11 - 10.50 1,149,640 $ 8.71 5.0 1,149,640 $ 8.71 5.0
--------- ---------
Total Other 1,459,640 $ 7.21 4.8 1,459,640 $ 7.21 4.8
========= =========
</TABLE>
The following table reflects the Company's pro forma net loss and basic and
diluted loss per share for the years ended December 31, 1997, 1996 and 1995
had the expense provisions of FAS No. 123 been implemented (in thousands
except per share amounts):
<TABLE>
<CAPTION>
1997 1996 1995
---------- ---------- ----------
<S> <C> <C> <C>
Net loss:
As reported $ (36,089) $ (22,401) $ (23,125)
Pro forma (43,224) (27,971) (24,574)
Basic and diluted loss per share:
As reported $ (.96) $ (.61) $ (.72)
Pro forma (1.15) (.77) (.76)
</TABLE>
Because the Statement 123 method of accounting has not been applied to options
granted prior to January 1, 1995, the above pro forma information may not be
representative of that to be expected in future years.
The fair value of each option grant has been estimated on the date of grant
using the Black-Scholes option pricing model. The following weighted average
assumptions were used for grants made under the 1997 Plan in 1997 and 1996:
(i) risk-free interest rates of 6.1% to 6.7% for 1997 and 5.3% for 1996; (ii)
expected lives of four to nine years for 1997 and seven years for 1996; and
(iii) volatility of 63% to 64% for 1997 and 64% for 1996. The estimated value
of warrants issued in 1996 for services was based on the value of the services
rendered. The Black-Scholes option pricing model was also used to estimate
value of other options and warrants issued in 1995 with the following weighted
average assumptions used: (i) risk-free interest rate of 5.9%; (ii) expected
life of two years; and (iii) volatility of 64%. It is assumed that no
dividends are paid on the stock.
During the years ended December 31, 1996 and 1995, $86,000 and $55,000,
respectively, were charged to expense in connection with options granted to
employees and consultants reflecting amortization of the difference between
the fair market value of the shares at the date of grant and the grant price
over the vesting period.
F-20
<PAGE>
The Company has a 401(k) Plan (the "401(k) Plan") under which employees
meeting certain eligibility requirements may elect to participate and
contribute to the 401(k) Plan. Under the 401(k) Plan, the Company may elect
to match a discretionary percentage of contributions. No such matching
contributions have been made to the 401(k) Plan since its inception.
NOTE 13 - INCOME TAXES
The Company has federal and California net operating loss carryforwards of
approximately $170 million and $25 million, respectively, as of December 31,
1997. The difference between the federal and California operating tax loss
carryforwards principally results from a fifty percent limitation on
California loss carryforwards, the Company not having operations in California
until late 1989 and the capitalization of certain research and development
expenses for California purposes. As of December 31, 1997, the Company also
has federal and California research and development tax credit carryforwards
of approximately $4.8 million and $1.8 million, respectively, and has
California manufacturer's investment tax credit carryforwards of approximately
$502,000. The federal net operating loss and research and development tax
credit carryforwards will begin expiring in 2000 and 2001, respectively, and
the California research and development tax credit carryforwards and the
California manufacturer's investment tax credit carryforwards will begin
expiring in 2004, unless previously utilized. California net operating loss
carryforwards of approximately $14 million expired in 1997, and $5.3 million
and $5.4 million will expire in 1998 and 1999, respectively, if not
previously utilized.
Utilization of future net operating loss carryforwards could be limited if
certain cumulative changes in the Company's ownership were to occur. Included
in the federal net operating loss carryforwards, and subject to an annual
limitation, are approximately $5 million of losses related to an acquisition.
Net deferred tax assets have been completely offset by a valuation allowance
as realization of the deferred tax assets is uncertain. During the year ended
December 31, 1997, the valuation allowance increased by $14,124,000.
Significant components of the Company's net deferred tax assets as of December
31, 1997 and 1996 are as follows (in thousands):
<TABLE>
<CAPTION>
1997 1996
------------ ------------
<S> <C> <C>
Deferred tax assets:
Net operating loss carryforwards $ 60,920 $ 48,409
Tax credit carryforwards 6,303 5,200
Capitalized research and development 4,472 3,771
Other 1,198 1,271
---------- ----------
Total deferred tax assets 72,893 58,651
---------- ----------
Deferred tax liabilities:
Patent expense (657) (539)
---------- ----------
Total deferred tax liability (657) (539)
---------- ----------
Net deferred tax assets before
valuation allowance 72,236 58,112
Valuation allowance (72,236) (58,112)
---------- ----------
Net deferred tax assets $ -- $ --
========== ==========
</TABLE>
Approximately $6.8 million of the valuation allowance for deferred tax assets
relates to benefits of stock option deductions which, when and if recognized,
will be allocated directly to additional paid-in capital.
NOTE 14 - SUPPLEMENTAL CASH FLOW INFORMATION
The following summarizes the significant non-cash investing and financing
activities of the Company and provides other supplemental cash flow
information.
Non-cash financing and investing activities during the year ended December 31,
1997 included the financing of $50,000 of equipment through capital leases.
During the year ended December 31, 1996, non-cash financing and investing
activities included the issuance of warrants exercisable for Common Stock as a
commitment fee and for consulting services, and the financing of $60,000 of
equipment through a capital lease. The commitment
F-21
<PAGE>
fee of 1.75% of the equity line (see Note 11), or $875,000, was negotiated
between the Company and the investment group providing the equity line and
represents the estimated fair value of the warrant. The warrant granted for
consulting services has been valued at an estimated fair market value of
$500,000 representing the estimated fair market value of the services to be
provided as negotiated between the parties. The value of the warrants is
being amortized over the commitment period and over the period the services
were provided. Other non-cash activities have involved the issuance of
compensatory stock options to employees and consultants (see Note 12).
Net cash from operating activities reflects cash payments for interest expense
of approximately $868,000, $6,000 and $6,000 for the years ended December 31,
1997, 1996 and 1995, respectively.
NOTE 15 - SUBSEQUENT EVENTS
Expansion of Strategic Alliance
In January 1998, the Company and Smith & Nephew expanded the Dermagraft Joint
Venture to include venous ulcers, pressure ulcers, burns and other skin
wounds. See Note 3. The Company retained the exclusive right to market
Dermagraft-TC(R), a temporary covering for full and partial thickness burns,
in the United States, while the Dermagraft Joint Venture has the right to
market Dermagraft-TC for other skin wounds in the United States. As a part
of the agreement to expand the Dermagraft Joint Venture, Smith & Nephew
purchased $20 million, or 1,533,115 newly-issued shares, of the Company's
Common Stock at approximately $13.05 per share in January 1998. In addition
to the equity investment, Smith & Nephew will pay the Company $15 million,
directly or through the Dermagraft Joint Venture, upon the earlier of (i) FDA
approval for the marketing of Dermagraft in the treatment of diabetic foot
ulcers or (ii) January 4, 1999. Smith & Nephew also agreed to pay, directly
or through the Dermagraft Joint Venture, up to an additional $76 million on
the achievement of certain milestones related to product approvals and
reimbursement, and based on worldwide product sales.
In the expanded joint venture, the Company and Smith & Nephew will continue to
share equally in the expenses and revenues of the Dermagraft Joint Venture,
except the Company will fund the first $6 million of expenses for conducting
clinical trials and for regulatory support of Dermagraft and Dermagraft-TC in
the treatment of ulcers and pressure sores. The Company will continue to
manufacture and Smith & Nephew will continue to market and sell the joint
venture products.
Equity Line Extension
In February 1998, the Company extended the Investment Agreement providing for
a $50 million equity line until February 1999 (see Note 11). In connection
with the extension, the Company granted the investment group a warrant to
purchase 50,000 shares of Common Stock at an exercise price of $14.00 per
share.
F-22
<PAGE>
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors and Stockholders
Advanced Tissue Sciences, Inc.
We have audited the accompanying consolidated balance sheets of Advanced
Tissue Sciences, Inc. as of December 31, 1997 and 1996, and the related
consolidated statements of operations, stockholders' equity and cash flows for
each of the three years in the period ended December 31, 1997. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Advanced Tissue
Sciences, Inc. at December 31, 1997 and 1996, and the consolidated results of
its operations and its cash flows for each of the three years in the period
ended December 31, 1997, in conformity with generally accepted accounting
principles.
ERNST & YOUNG LLP
San Diego, California
February 3, 1998
F-23
<PAGE>
DERMAGRAFT JOINT VENTURE
COMBINED BALANCE SHEETS
(IN THOUSANDS)
<TABLE>
<CAPTION>
December 31,
-------------------------
1997 1996
----------- -----------
<S> <C> <C>
ASSETS
Current assets:
Cash $ 12 $ --
Inventory 361 --
-------- ---------
Total current assets 373 --
Property - net 160 --
Organization costs 144 --
-------- ---------
Total assets $ 677 $ --
======== =========
LIABILITIES AND PARTNERS' CAPITAL
Current liabilities:
Payable to partners and affiliates $ 3,609 $ --
Accounts payable 35 --
Accrued expenses 93 --
-------- ---------
Total current liabilities 3,737 --
Partners' capital (3,060) --
-------- ---------
Total liabilities and partners' capital $ 677 $ --
======== =========
</TABLE>
See accompanying notes to the combined financial statements.
F-24
<PAGE>
DERMAGRAFT JOINT VENTURE
COMBINED STATEMENTS OF OPERATIONS
(IN THOUSANDS)
<TABLE>
<CAPTION>
April 29, 1996
Year Ended (inception) to
December 31, December 31,
1997 1996
---------------- ----------------
<S> <C> <C>
Product sales $ 36 $ --
------------ ------------
Operating expenses:
Research and development 5,118 --
Selling, general and administrative 11,204 --
Cost of goods sold 824 --
------------ ------------
Total operating expenses 17,146 --
------------ ------------
Loss from operations (17,110) --
Other income (expense):
Interest income 108 --
Interest charges from related parties (454) --
License fee to related party -- (10,000)
Other income (expense) (384) --
------------ ------------
Net loss $ (17,840) $ (10,000)
============ ============
</TABLE>
See accompanying notes to the combined financial statements.
F-25
<PAGE>
DERMAGRAFT JOINT VENTURE
COMBINED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
<TABLE>
<CAPTION>
April 29, 1996
Year Ended (inception) to
December 31, December 31,
1997 1996
---------------- -----------------
<S> <C> <C>
Operating activities:
Net loss $ (17,840) $ (10,000)
Adjustments to reconcile net loss to
cash used in operating activities:
Depreciation 3 --
Other adjustments to net loss 6 --
Changes in assets and liabilities:
Inventory (361) --
Accounts payable 35 --
Payable to partners and affiliates 3,609 --
Accrued expenses 93 --
------------ -------------
Net cash used in operating
activities (14,455) (10,000)
------------ -------------
Investing activities:
Acquisition of property (163) --
------------ -------------
Financing activities:
Contributions from partners 15,284 10,000
Distributions to partners (654) --
------------ -------------
Net cash provided by financing
activities 14,630 10,000
------------ -------------
Net increase in cash 12 --
Cash at beginning of year -- --
------------ -------------
Cash at end of year $ 12 $ --
============ =============
</TABLE>
See accompanying notes to the combined financial statements.
F-26
<PAGE>
DERMAGRAFT JOINT VENTURE
COMBINED STATEMENTS OF PARTNERS' CAPITAL
(IN THOUSANDS)
<TABLE>
<CAPTION>
Advanced
Tissue Smith &
Sciences, Inc. Nephew plc Total
---------------- ------------ ---------
<S> <C> <C> <C>
From April 29, 1996 (inception) to
December 31, 1996
Capital contributions $ 10,000 $ 10,000
Net loss (10,000) (10,000)
---------- ---------
Balance, December 31, 1996 -- --
Capital contributions $ 7,780 7,746 15,526
Capital distributions (390) (356) (746)
Net loss (8,920) (8,920) (17,840)
------------ ---------- ---------
Balance, December 31, 1997 $ (1,530) $ (1,530) $ (3,060)
============ ========== =========
</TABLE>
See accompanying notes to the combined financial statements.
F-27
<PAGE>
DERMAGRAFT JOINT VENTURE
NOTES TO THE COMBINED FINANCIAL STATEMENTS
NOTE 1 - BASIS OF PRESENTATION
Organization - Advanced Tissue Sciences, Inc. ("Advanced Tissue Sciences") and
Smith & Nephew plc ("Smith & Nephew") entered into a fifty-fifty joint venture
(the "Dermagraft Joint Venture") for the worldwide commercialization of
Dermagraft(R), a tissue engineered dermal replacement, for the treatment of
diabetic foot ulcers in April 1996. Advanced Tissue Sciences is a tissue
engineering company utilizing its proprietary core technology to develop and
manufacture living human tissue products for tissue repair and
transplantation. Smith & Nephew is a worldwide healthcare company with
extensive sales and distribution capabilities. It develops, manufactures
and markets a wide range of tissue repair products, principally addressing
the areas of bone, joints, skin and other soft tissue. The Dermagraft Joint
Venture became responsible for the further development and commercialization
of Dermagraft for diabetic foot ulcers effective January 1, 1997. Dermagraft
was introduced in the United Kingdom, Canada and several other European
countries in late 1997. Dermagraft for diabetic foot ulcers has been
submitted for marketing approval to the U.S. Food and Drug Administration
(the "FDA") and to regulatory authorities in several other countries.
References herein to Advanced Tissue Sciences and Smith & Nephew include
their subsidiaries and certain affiliates.
Principles of Combination - The combined financial statements include the
accounts of Dermagraft U.S. and Dermagraft International, which are Delaware
general partnerships formed between subsidiaries of Advanced Tissue Sciences
and Smith & Nephew, and the revenues and expenses of Advanced Tissue Sciences,
Smith & Nephew and their affiliates associated with the worldwide
commercialization of Dermagraft for diabetic foot ulcers. All intercompany
accounts and transactions have been eliminated.
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 of assets and liabilities and
related disclosures at the date of the financial statements, and the amounts
of revenues and expenses reported during the period. Actual results could
differ from those estimates.
Dependence on Certain Suppliers - The mesh framework used in the manufacture
of Dermagraft is sourced from a single manufacturer. Any significant supply
interruption would adversely affect product manufacturing. In addition, an
uncorrected impurity or supplier's variation in raw material, either unknown
or incompatible with the manufacturing process, could have a material adverse
effect on the manufacture of the product.
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Inventories are valued at the lower of cost or market using the first-in,
first-out method. The Dermagraft Joint Venture, under contractual obligation,
purchases product at cost from Advanced Tissue Sciences.
Property is recorded at cost and depreciation is calculated on a straight-line
basis using an estimated useful life of five years.
Organization costs are being amortized over a five-year period.
Revenue/Expense Recognition - Revenues from product sales are recognized when
products are shipped to the customer. Research and development costs are
expensed as incurred.
F-28
<PAGE>
NOTE 3 - INVENTORIES
Inventories consist of the following components as of December 31, 1997 (in
thousands):
1997
------------
Work-in-process $ 288
Finished goods 73
--------
$ 361
========
NOTE 4 - PROPERTY
The following is a summary of property and accumulated depreciation as of
December 31, 1997 (in thousands):
1997
------------
Equipment, at cost $ 163
Less accumulated depreciation (3)
--------
Net property $ 160
========
Depreciation expense charged to operations was $3,000 in 1997.
NOTE 5 - RELATED PARTY TRANSACTIONS
Under the joint venture agreements, Advanced Tissue Sciences is manufacturing
and Smith & Nephew is selling and marketing Dermagraft for the Dermagraft
Joint Venture. In addition, Advanced Tissue Sciences and Smith & Nephew are
providing research, development and administrative services to the Dermagraft
Joint Venture. All such expenses are reflected in the combined financial
statements at their estimated cost. The Dermagraft Joint Venture also pays
the partners interest on the use of their working capital in support of the
joint venture's operations. The following table summarizes related party
revenues and expenses for the year ended December 31, 1997 (in thousands):
<TABLE>
<CAPTION>
Advanced Smith
Tissue Sciences & Nephew
--------------- ------------
<S> <C> <C>
Sales $ -- $ 36
Cost of good sold 824 --
Research and development 4,476 642
Selling, general and administrative 2,750 7,101
</TABLE>
Upon entering into the Dermagraft Joint Venture in April 1996, Smith & Nephew
agreed to pay Advanced Tissue Sciences an up front fee of $10 million. This
fee was funded through a capital contribution to the Dermagraft Joint Venture
by Smith & Nephew and paid by the joint venture to Advanced Tissue Sciences.
Under the joint venture agreements, the $10 million expense is allocated to
Smith & Nephew's capital account. As the Dermagraft Joint Venture did not
begin operations until January 1, 1997, the $10 million fee represents the
only activity in the Dermagraft Joint Venture from April 29, 1996 (inception)
to December 31, 1996 (see Note 1). Smith & Nephew has also agreed to pay up
to an additional $60 million on the achievement of certain milestones related
to product approval, gaining product reimbursement and on attaining specific
sales milestones. These milestones, if achieved, are to be funded and paid
to Advanced Tissue Sciences either directly by Smith & Nephew or through the
Dermagraft Joint Venture in the same manner as the up front fee.
NOTE 6 - SUPPLEMENTAL CASH FLOW INFORMATION
The Joint Venture's non-cash investing and financing activities for the year
ended December 31, 1997 included $144,000 in organization costs and $98,000 in
interest charges contributed as capital by the partners and $92,000 in
payables treated as a distribution of capital to the partners during 1997.
F-29
<PAGE>
NOTE 7 - SUBSEQUENT EVENTS
In January 1998, Advanced Tissue Sciences and Smith & Nephew expanded the
Dermagraft Joint Venture to include, with certain exceptions, any products
using Advanced Tissue Sciences' technology for the medical care and treatment
of skin tissue wounds, such as pressure and venous ulcers, burns and skin
tissue defects. See Note 1. Advanced Tissue Sciences retained the exclusive
right to market Dermagraft-TC(R), a temporary covering for full and partial
thickness burns, in the United States, while the Dermagraft Joint Venture has
the right to market Dermagraft-TC for other skin wounds in the United States.
As part of the agreement to expand the Dermagraft Joint Venture, Smith &
Nephew will pay Advanced Tissue Sciences $15 million, directly or through the
Dermagraft Joint Venture, upon the earlier of (i) FDA approval for the
marketing of Dermagraft in the treatment of diabetic foot ulcers or (ii)
January 4, 1999. Smith & Nephew also agreed to pay, directly or through the
Dermagraft Joint Venture, up to an additional $76 million on the achievement
of certain milestones related to product approvals and reimbursement, and
based on worldwide product sales.
In the expanded joint venture, Advanced Tissue Sciences and Smith & Nephew
will continue to share equally in the expenses and revenues of the Dermagraft
Joint Venture, except Advanced Tissue Sciences has agreed to fund the first $6
million of expenses for conducting clinical trials and for regulatory support
of Dermagraft and Dermagraft-TC in the treatment of venous ulcers and
pressure sores. Advanced Tissue Sciences will continue to manufacture and
Smith & Nephew will continue to market and sell the joint venture's products.
F-30
<PAGE>
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors
ATS Dermagraft, Inc. and Smith & Nephew SNATS, Inc.
We have audited the accompanying combined balance sheets of the Dermagraft
Joint Venture as of December 31, 1997 and 1996, and the related combined
statements of operations, partners' capital and cash flows for the year ended
December 31, 1997 and for the period April 29, 1996 (inception) through
December 31, 1996. These financial statements are the responsibility of the
Joint Venture's management. Our responsibility is to express an opinion on
these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the combined financial position of the Dermagraft Joint
Venture at December 31, 1997 and 1996, and the combined results of its
operations and its cash flows for the year ended December 31, 1997 and for the
period April 29, 1996 (inception) through December 31, 1996, in conformity
with generally accepted accounting principles.
ERNST & YOUNG LLP
San Diego, California
February 27, 1998
F-31
EXHIBIT 10.15
BUILD-TO-SUIT LEASE
LANDLORD: TPSC II LIMITED PARTNERSHIP
TENANT: ADVANCED TISSUE SCIENCES, INC.
DATE: October 15, 1997
<PAGE>
BUILD-TO-SUIT LEASE
TABLE OF CONTENTS
1. PROPERTY 6
1.1 Lease of Property 6
1.2 Landlord's Reserved Rights 7
1.3 Title 7
2. TERM 7
2.1 Term 7
2.2 Commencement Date 7
2.3 Early Possession 8
2.4 Delay In Possession 9
2.5 Acknowledgment Of Lease Commencement 10
2.6 Holding Over 10
2.7 Option To Extend Term 11
3. RENTAL 11
3.1 Basic Annual Rent 11
3.2 Other Obligations 12
3.3 Payments 12
3.4 Rent Increases 12
3.5 Extension Terms 12
3.6 Late Charge 13
4. DETERMINATION OF TOTAL PROJECT COST; ARBITRATION AND AUDIT 14
4.1 Landlord's Statement of Total Project Cost; Tenant Review 14
4.2 Arbitration of Dispute 14
5. DESIGN AND CONSTRUCTION 15
5.1 Construction of Improvements 15
5.2 Condition of Property 15
5.3 Compliance with Law 16
5.4 Union Labor 16
5.5 City Business Cooperation Program 16
6. EXPANSION OPTION - LOT 27 16
6.1 Option Grant 16
<PAGE>
Page
----
6.2 First Refusal Right 18
7. EXPANSION RIGHTS -- LOT 26 19
7.1 First Refusal Right 19
7.2 Exercise of Lot 27 Expansion Option During Pendency
of Lot 27 Offer; Option on Lot 26 20
7.3 Carrying Costs 21
7.4 Paydown 22
8. TAXES 22
8.1 Personal Property 22
8.2 Real Property 22
9. OPERATING EXPENSES 23
9.1 Liability For Operating Expenses 23
9.2 Definition Of Operating Expenses 23
9.3 Determination and Payment Of Operating Expenses 24
9.4 Proration 25
10. UTILITIES 25
10.1 Payment 25
10.2 Interruption 25
11. ALTERATIONS; SIGNS 26
11.1 Right To Make Alterations 26
11.2 Title To Alterations 26
11.3 Tenant Fixtures 27
11.4 No Liens 27
11.5 Signs 27
12. MAINTENANCE AND REPAIRS 27
12.1 Landlord's Work 27
12.2 Tenant's Obligation For Maintenance 27
13. USE OF PROPERTY 28
13.1 Permitted Use 28
13.2 No Nuisance 29
13.3 Compliance With Laws 29
13.4 Liquidation Sales 29
13.5 Environmental Matters 29
<PAGE>
Page
----
14. INSURANCE AND INDEMNITY 33
14.1 Liability and Property Insurance 33
14.2 Waiver Of Subrogation 34
14.3 Increase In Premiums 34
14.4 Indemnification 34
14.5 Blanket Policy 35
15. SUBLEASE AND ASSIGNMENT 35
15.1 Assignment And Sublease Of Property 35
15.2 Rights Of Landlord 36
15.3 Notice of Proposed Assignment or Sublease 36
16. RIGHT OF ENTRY AND QUIET ENJOYMENT 36
16.1 Right Of Entry 36
16.2 Quiet Enjoyment 37
17. CASUALTY AND TAKING 37
17.1 Damage or Destruction 37
17.2 Condemnation 39
17.3 Reservation Of Compensation 40
17.4 Restoration Of Improvements 40
18. DEFAULT 41
18.1 Events Of Default 41
18.2 Remedies Upon Tenant's Default 42
18.3 Remedies Cumulative 43
18.4 Landlord Default 43
19. SUBORDINATION, ATTORNMENT AND SALE 43
19.1 Subordination To Mortgage 43
19.2 Sale Of Landlord's Interest 43
19.3 Estoppel Certificates 43
19.4 Subordination to CC&R's 44
19.5 Mortgagee Protection 44
20. Intentionally Deleted 44
21. MISCELLANEOUS 44
21.1 Notices 44
21.2 Successors And Assigns 45
<PAGE>
Page
----
21.3 No Waiver 45
21.4 Severability 45
21.5 Litigation Between Parties 45
21.6 Surrender 45
21.7 Interpretation 45
21.8 Entire Agreement 46
21.9 Governing Law 46
21.10 No Partnership 46
21.11 Financial Information 46
21.12 Costs 46
21.13 Time 46
21.14 Brokers 46
21.15 Memorandum Of Lease 46
21.16 Corporate Authority 46
21.17 Execution and Delivery 46
21.18 Survival 46
21.19 Confidentiality 46
EXHIBITS
--------
EXHIBIT A Real Property Description (Site)
EXHIBIT B Site Plan
EXHIBIT C Work Letter
EXHIBIT D Estimated Construction Schedule
EXHIBIT E Acknowledgment of Lease Commencement
EXHIBIT F Forms of Subordination, Attornment and Nondisturbance
Agreement and Estoppel Certificate
EXHIBIT G Lot 27: Legal Description and Site Plan
EXHIBIT H Lot 26: Legal Description and Site Plan
EXHIBIT I Radioactive Materials
EXHIBIT J Synopsis of Relevant Provisions
EXHIBIT K Contractor/Subcontractor Requirements
<PAGE>
BUILD-TO-SUIT LEASE
-------------------
THIS BUILD-TO-SUIT LEASE ("Lease") is made and entered into as of the
15th day of October, 1997, by and between TPSC II LIMITED PARTNERSHIP, a
Delaware limited partnership ("Landlord"), and ADVANCED TISSUE SCIENCES, INC.,
a Delaware corporation ("Tenant").
THE PARTIES AGREE AS FOLLOWS:
DEFINITIONS
-----------
Actual Tender Date means the date Landlord actually tenders possession of
the Property to Tenant with the Interior Improvements Substantially Completed.
Annual Operating Expense Statement means a statement showing, in
reasonable detail, the actual Operating Expenses for the previous calendar
year.
Basic Annual Rent means base rent due from Tenant for its use of the
Property, on a triple net basis, in an amount equal to twelve and one-half
percent (12.5%) of the Total Project Cost, (all as described and determined in
accordance with the Work Letter) increased as provided in this Lease
(including, but not limited to, increases pursuant to Paragraph 3.4 hereof).
Carrying Costs means
(a) with respect to Lot 27, all costs incurred by Landlord with
respect to its acquisition, ownership and financing of Lot 27 which
shall be limited to the following: (i) interest expense on the aggregate
of $3,476,000, consisting of the purchase price (being $3,450,000) and
acquisition cost of Lot 27 (in the amount of $26,400), with interest
calculated at the Prime Rate plus one percent (1%); (ii) real property
taxes, assessments and insurance on or allocable to the Expansion
Building and/or Lot 27 (provided, however, that Carrying Costs shall not
include any increase in taxes or assessments attributable to a change in
ownership of Lot 27); (iii) assessments, dues and the like payable under
the Existing CC&Rs or to TOPSCA; and (iv) any maintenance of Lot 27
effected at the written request of Tenant, required under the Existing
CC&R's or required by any governmental body or entity having
jurisdiction over Lot 27;
(b) with respect to Lot 28, all costs incurred by Landlord with
respect to its acquisition, ownership and financing of Lot 28 which
shall be limited to the following: (i) interest expense on the aggregate
of $2,871,798, consisting of the purchase price (being $2,850,000) and
acquisition cost of Lot 28 (in the amount of $21,798), with interest
calculated at the Prime Rate plus one percent (1%); (ii) real property
taxes, assessments and insurance on or allocable to Lot 28 (provided,
however, that Carrying Costs shall not include any increase in taxes or
assessments attributable to a change in ownership of Lot 28); and (iii)
assessments, dues and the like payable under the Existing CC&Rs or to
TOPSCA; and
(c) with respect to Lot 26, all costs incurred by Lot 26 Owner with
respect to its acquisition, ownership and financing of Lot 26 which
shall be limited to the following: (i) interest expense on the aggregate
of $1,904,901, consisting of the purchase price (being $1,890,000) and
acquisition cost of Lot 26 (in the amount of $14,901), with interest
calculated at the Prime Rate plus one percent (1%); (ii) real property
taxes, assessments and insurance on or allocable to Lot 26 (provided,
however, that Carrying Costs shall not include any increase in taxes or
assessments attributable to a change in ownership of Lot 26); (iii)
assessments, dues and the like payable under the Existing CC&Rs or to
TOPSCA; and (iv) any maintenance of Lot 26 effected at the written
request of Tenant, required under the Existing CC&R's or required by any
governmental body or entity having jurisdiction over Lot 26.
<PAGE>
CC&Rs means recorded covenants, conditions, easements, and restrictions
affecting the Site and the Torrey Pines Science Center Signage Guidelines.
Commencement Date means that date Tenant takes possession of the
Property for purposes other than installing furniture, fixtures and equipment
and similar work preparatory to the commencement of Tenant's business, but
not later than thirty (30) days after the Actual Tender Date.
Completion Notice means a written notice of the date that Landlord
believes the Tenant Improvement Work will be Substantially Completed (a) with
respect to office space in the Initial Building, and (b) with respect to the
entire Initial Building. Landlord shall use its reasonable best efforts to
give written notice to Tenant at least thirty (30) days prior to such
Substantial Completion dates.
Existing CC&R's means CC&R's recorded as of the date of this Lease.
FF&E/Trade Fixtures shall mean furniture, fixtures and equipment,
including, but not limited to, trade fixtures, to be installed in the Initial
Building but which are not to be purchased or installed by Landlord. After
Substantial Completion, Tenant shall update Exhibit "E" to reflect the actual
FF&E/Trade Fixtures.
Force Majeure shall mean any prevention, delay or stoppage of work or any
other obligation to be performed by Landlord or Tenant hereunder arising after
the date this Lease is executed and delivered which is due to strikes by any
trade or trades affecting the Project in any way (including, but not limited
to, any materials or equipment ordered for the Project, and the
transportation, delivery or installation of any material or equipment for the
Project) other than as a result of Project specific conditions, labor disputes
by any trade or trades affecting the Project in any way (including, but not
limited to, any materials or equipment ordered for the Project, and the
transportation, delivery or installation of any material or equipment for the
Project) other than as a result of Project specific conditions, acts of God,
acts or failures to act of public agencies that cause delays despite the
applicable party's diligent efforts, freight embargoes due to generally
prevailing market conditions, rainy or stormy weather, inability to obtain
supplies, materials, fuels, machinery or equipment due to generally prevailing
market conditions, fire or other causes or contingencies beyond the reasonable
control of Landlord or Tenant, as applicable. Force Majeure shall also
include delays that occur despite Landlord's due diligence to apply for and
process applications and obtain permits or approvals due to the actions or
inaction of governmental authorities controlling the permitting of the Project
and of the reviewing bodies of the Coastal Development Permit or the actions
of private citizens or groups which alter the course of or results of the
Coastal Development Permit approval or any other governmental approvals.
Notwithstanding anything to the contrary contained herein, the party claiming
any delay due to Force Majeure shall make reasonable efforts to mitigate the
delay (for example obtaining substitute materials or suppliers) and shall
provide written notice to the other within five (5) business days after the
claiming party learns of such delay. The claiming party shall not be entitled
to any delay due to Force Majeure to the extent such claiming party fails to
use reasonable efforts to mitigate such delay. In addition, if the claiming
party fails to give such written notice to the other party, the claiming party
shall not be entitled to claim any delay due to Force Majeure for any period
prior to the date that claiming party actually gives such notice to the other
party.
Improvements means the Initial Building and the other improvements to be
constructed on the Site pursuant to Paragraph 5 hereof and the Work Letter.
Initial Building means the building to be constructed, pursuant to
Paragraph 5 hereof and the Work Letter, on the Site, to consist of a two-
story building containing approximately 104,000 square feet.
Interior Improvements shall mean all interior systems including partition
systems, interior floors and hardware, interior finishes, telecommunications
cabling, building alarm system wiring, life safety alarm system wiring, HVAC,
plumbing and electrical systems (including feeders from the meter section, and
main distribution panels), life safety systems, dock equipment and garage
equipment as set forth in the Construction Documents therefor; all as
2
<PAGE>
included in the Project Budget and paid for by Landlord (but subject to
maximum payments by Landlord pursuant to Section 12.1 of the Work Letter).
Emergency generators, boiler, cooling tower and trash and truck dock, are
also budgeted from Interior Improvements.
Landlord means TPSC II Limited Partnership, a Delaware limited partner-
ship.
Lease means this Build-To-Suit Lease, as amended from time to time,
and all exhibits (including, but not limited to, the Work Letter).
Lender means any entity which makes a loan to Landlord secured by the
Property.
Lot 26 means that certain real estate in Torrey Pines Site and Center,
the legal description of which is set forth on Exhibit H annexed hereto, which
real property is subject to the Lot 26 Expansion Option and Lot 26 Refusal
Right as set forth in Paragraph 7 hereof. Fee simple title to Lot 26 is
currently is held by TPSC Holdings Limited Partnership, a Delaware limited
partnership.
Lot 26 Exercise Notice means the written notice to Landlord by which
Tenant exercises the Lot 26 Expansion Option, all as referred to in Paragraph
7.2(a).
Lot 26 Exercise Period has the meaning set forth in Paragraph 7.2 hereof.
Lot 26 Expansion Building means the improvements to be constructed on
Lot 26 which shall consist of a single building which shall not be less than
60,000 square feet nor more than 65,000 square feet unless Landlord consents,
all as referred to in Paragraph 7.2(a).
Lot 26 Expansion Building Delivery Date means the date for delivery of the
Lot 26 Expansion Building as further referred to in Paragraph 7.2(a) hereof.
Lot 26 Expansion Option has the meaning set forth in Paragraph 7.2 hereof.
Lot 26 Lease has the meaning set forth in Paragraphs 7.1 and 7.2(b)(ii)
hereof.
Lot 26 Offer Notice has the meaning set forth in Paragraph 7.1(b).
Lot 26 Owner means TPSC Holdings Limited Partnership, a Delaware limited
partnership.
Lot 26 Refusal Right has the meaning set forth in Paragraph 7.1(a)
hereof.
Lot 26 Refusal Term has the meaning set forth in Paragraph 7.1(a) hereof.
Lot 27 means the real estate described on Exhibit G annexed hereto.
Lot 27 Exercise Notice means the written notice to Landlord by which
Tenant exercises the Lot 27 Expansion Option, all as referred to in Paragraph
6.1(a).
Lot 27 Exercise Period has the meaning set forth in Paragraph 6.1 hereof.
Lot 27 Expansion Building(s) means the improvements to be constructed on
Lot 27 after Tenant's exercise of its Lot 27 Expansion Option, which building or
buildings shall not be less than 102,000 square feet nor more than 124,400
square feet unless Landlord consents, all as referred to in Paragraph 6.2(a);
if there is more than one building, no building shall be less than 45,000
square feet.
Lot 27 Expansion Building Delivery Date means the date for delivery of the
Lot 27 Expansion Building as referred to in Paragraph 6.1(a)(i) hereof.
Lot 27 Expansion Option has the meaning set forth in Paragraph 6.1 hereof.
Lot 27 Lease means a lease of Lot 27 to be negotiated and executed as
provided in Paragraphs 6.1 or 6.2, as applicable, hereof.
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Lot 27 Offer Notice has the meaning set forth in Paragraph 6.2(b) hereof.
Lot 27 Refusal Right has the meaning set forth in Paragraph 6.2(a) hereof.
Lot 27 Refusal Term has the meaning set forth in Paragraph 6.2(a) hereof.
Management Fee means an annual fee of one percent (1%) of the Basic Annual
Rent for the first full year of this Lease, beginning on the Commencement
Date, which fee shall escalate annually, on a cumulative basis, in an amount
equal to three percent (3%) of the prior year's fee, each increase being
effective on each anniversary of the Commencement Date; such fee shall be
included in Operating Expenses.
MSDS's means Material Safety Data Sheets.
Offer has the meaning set forth in Paragraphs 6.2(b) and 7.1(b).
Offeror means a person or entity, other than Tenant, from which Landlord
has received or to whom Landlord delivers a bona fide written offer, which
Landlord wishes to accept, to purchase/sell or otherwise develop or lease Lot
26 or Lot 27, all as referred to in Paragraph 7.2 or 6.2, respectively.
Office Space Annual Rent means an amount equal to 12.5% of the sum of
(a) the Project Budget, in effect at the time Tenant takes possession of the
office area (reduced by the portion thereof attributable to tenant improve-
ments) multiplied by the Office Space Percentage, plus (b) $35.00 multiplied
by the size (in square feet) of the office area.
Office Space Percentage means a fraction, the denominator of which shall be
the aggregate area of the Initial Building and the numerator of which shall be
the square footage of the office area.
Operating Expenses means the total costs and expenses incurred by or
allocable to Landlord for ownership, operation and maintenance of the Improve-
ments and the Property, all as more fully set forth in Paragraph 9.2 hereof.
Outside Areas means the parking areas, driveways, sidewalks, landscaped
areas and other portions of the Site that lie outside the exterior walls of
the Initial Building, as depicted on the site plan attached hereto as Exhibit
B.
Parcel shall mean any other land, developed or undeveloped, owned by
Landlord, or any affiliate of Landlord, within the Torrey Pines Science Center.
Prime Rate means the highest rate of interest announced from time to
time by Chase Manhattan Bank, Citibank N.A., or Bank of America as its "prime
rate", changing as and when such rate changes, unless a lesser rate shall
then be the maximum rate permissible by law with respect thereto, in which
event such lesser rate shall be charged.
Project Schedule means the Project Schedule annexed to the Work Letter.
Projected Monthly Basic Annual Rent shall mean $264,855.
Property means the Improvements and the Site.
Qualified CPA means an independent Certified Public Accountant with at
least ten (10) years experience in construction matters from a "Big 6"
accounting firm affiliated with neither party.
Refusal Term means that period as described in Paragraph 6.2(a).
Rent means Basic Annual Rent (as modified from time to time pursuant
hereto) and such other sums as may be due and payable by Tenant to Landlord
hereunder, other than Operating Expenses and Taxes.
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Site means the real property described in Exhibit A attached hereto on
which the Initial Building will be constructed.
Site Improvements means improvements to the Site, other than the Building
Shell and Core or Interior Improvements, as specified in the plans and
specifications and including, but not limited to, site lighting, flag poles,
underground utilities, on-grade parking, landscaping and outdoor seating
areas.
Start of Construction means the date upon which mass excavation begins
on the Project. Landlord and Tenant agree construction of the Project shall
begin immediately following the completion of, and Tenant approval of, the
Construction Documents, approval by Landlord and Tenant of the GMP Change
Order for such mass excavation and Landlord's obtaining building permits and
government approvals required to commence construction.
Substantially Completed or Substantial Completion (or any other variant
of such terms) shall mean:
(a) with respect to the Project: (i) receipt by Landlord and delivery
to Tenant of written certification from the Architect that the Improvements
have been completed in accordance with the Final Construction Documents
(except for Punch List work and minor changes outlined in Section 10.3 of the
Work Letter); and (ii) approval to occupy, or its functional equivalent, is
obtained from the City of San Diego and all other applicable governmental
authorities; and
(b) with respect to the office area: (i) receipt by Landlord and
delivery to Tenant of written certification from the Architect that the
Building Shell and Core, Site Improvements to the extent necessary for
Tenant's use of the office area and, to the extent of the office area, the
Interior Improvements, all have been completed in accordance with the
Construction Documents (except for Punch List work and minor changes outlined
in Section 10.3 of the Work Letter); and (ii) approval to occupy, or its
functional equivalent, is obtained from the City of San Diego and from any
other applicable government authorities.
Target Commencement Date means November 27, 1998, subject to adjustment
as provided herein and in the Work Letter.
Target Start of Construction Date means November 21, 1997, subject to
adjustment as provided herein and in the Work Letter.
Target Substantial Completion Date for Office Area of Initial Building
means September 30, 1998, subject to adjustment as provided herein and in the
Work Letter.
Target Substantial Completion Date for Initial Building means October 25,
1998, subject to adjustment as provided herein and in the Work Letter.
Taxes means all taxes, assessments and the like as set forth in Paragraph
8 hereof.
Tenant means ADVANCED TISSUE SCIENCES, INC., a Delaware corporation, and
its permitted successors and assigns.
Tenant Delay means any action or failure to act of or by Tenant after the
date this Lease is executed and delivered which causes or results in a delay
in Substantial Completion of the Improvements, including, but not limited to,
the following (all further subject to Force Majeure delays): (i) material
errors or omissions in Tenant's information or communications to Landlord or
design team which affect the schedules for design or documentation; or (ii)
Tenant's failure to adhere to the dates or timing for delivery, response or
other actions as set forth in the Work Letter or the Project Schedule (to the
extent any delay is not caused by Landlord's failure to act in accordance with
the Project Schedule, Landlord's failure to adhere to applicable law in
existence at the time of entering into the Lease or Landlord's defective
work); or (iii) any Tenant requested change to the approved Construction
Documents after the scheduled decision periods in Section 7 of the Work Letter
("Project Decisions") (to the extent any delay is not caused by Landlord's
failure to act upon or process any such request in a reasonably diligent
manner,
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Landlord's failure to adhere to applicable law in existence at the time of
entering into the Lease or Landlord's defective work); (iv) a Tenant Delay as
described in Paragraphs 2.2(b) and 2.3 hereof; or (v) Tenant's presence on or
about the Property to the extent not permitted under this Lease or the Work
Letter. Notwithstanding anything to the contrary contained herein, Landlord
shall provide written notice to Tenant within five (5) business days after
Landlord learns of such delay. Landlord shall not be entitled to any delay
due to Tenant Delay for any period prior to the date Landlord delivers such
notice to Tenant if Landlord fails to do so within such five (5) business day
period.
Tenant Improvement Work means "Interior Improvements" as defined above.
Tenant's Operating Cost Share means the portion of Operating Expenses
which must be paid by Tenant, being one hundred percent (100%), except as
otherwise provided in Paragraph 9.1.
Tender Date means the date Landlord tenders possession of (a) the office
area of the Initial Building or (b) the Initial Building, as applicable, to
Tenant with the Improvements Substantially Completed. The Tender Date shall
be within two (2) days after Substantial Completion of the applicable building
area.
TOPSCA means Torrey Pines Science Center Association for Unit 2, a
California not-for-profit mutual benefit corporation, organized and existing
under, and pursuant to, the Existing CC&Rs.
Total Project Cost means the total of all costs of the entire Project
which shall consist of only the following: cost of site acquisitions, and
Landlord's actual out-of-pocket costs to design, construct and finance the
Project, consisting of the Land purchase price in the amount of $2,850,000.00
and related costs of acquisition, insurance, costs related to acceleration of
the Project Schedule as contemplated by Section 2.6(c) of the Work Letter,
costs incurred by Landlord pursuant to Paragraph 2.2(b) (concerning early use
of office area) hereof for maintenance and repair, costs of carry, interest,
cost of permits, expense of the loans obtained by Landlord for the Project,
landscaping, all sums paid to contractors or subcontractors, all costs and
expenses required to be paid to obtain necessary governmental permits and
approvals, engineering and architectural fees, the Project Management Fee,
cost deriving from Force Majeure, real estate, sales and use taxes, testing
and inspection costs required by governmental authorities to obtain permits
and approvals, utility costs and any other cost included in the Project Budget
and utilized in conjunction with the Project. Any utility company rebates
received by Landlord during the Development Period, either in cash or by
credit against utility bills, and any payment by Tenant pursuant to Section
12.5 of the Work Letter shall be deducted from Total Project Costs. Total
Project Costs shall not include any of the following: (a) defects in design or
construction unless the design responds to and satisfies any performance
criteria provided by Tenant and otherwise is not defective; (b) costs
attributable to Landlord's default (except for delays which are subject to
Paragraph 2.4(a)) unless same are minor, typical for similar construction
projects and do not materially detrimentally affect the construction of the
Improvements; provided however, that this subsection (b) shall not affect the
application of Paragraph 2.4(a) hereof; (c) any management fee (except the
Project Management Fee described in Section 12.4 of the Work Letter); (d) any
administrative fee or other overhead expense of Landlord; (e) any items which
are not in the Project Budget; or (f) costs that are specifically designated
to be costs borne by Landlord. Landlord may utilize contingencies and line
item cost savings against any cost overrun which does not derive from
Landlord's default hereunder to the extent provided in Section 2.4 of the Work
Letter.
Work Letter means the work letter attached hereto as Exhibit C, as same
may be amended from time to time.
1. PROPERTY
--------
1.1 Lease of Property.
-----------------
Landlord leases to Tenant and Tenant hires and leases from Landlord, on
the terms, covenants and conditions hereinafter set forth, the real property
described in Exhibit A attached
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hereto (the "Site") and the building (the "Initial Building") to be
constructed, pursuant to Paragraph 5 hereof and the Work Letter attached
hereto as Exhibit C (the "Work Letter"), on the Site, to consist of a two-
story building containing approximately 104,000 rentable square feet. The
area of the Initial Building shall be measured in accordance with a standard
reasonably acceptable to Landlord and Tenant. Landlord represents that it
has adequate financial resources to perform its obligations under this Lease.
The location of the Initial Building on the Site is intended to be
substantially as shown on the site plan attached hereto as Exhibit B. The
Initial Building and the other improvements to be constructed pursuant to
Paragraph 5 hereof and the Work Letter on the Site are sometimes referred to
collectively herein as the "Improvements," and the Improvements and the Site
are sometimes referred to collectively herein as the "Property." The parking
areas, driveways, sidewalks, landscaped areas and other portions of the Site
that lie outside the exterior walls of the Initial Building, as depicted on
the site plan attached hereto as Exhibit B, are sometimes referred to herein
as the "Outside Areas." The Site is part of the Torrey Pines Science Center
in La Jolla, California.
1.2 Landlord's Reserved Rights.
--------------------------
To the extent reasonably necessary to permit Landlord to exercise any
rights of Landlord and discharge any obligations of Landlord under this Lease,
Landlord shall have, in addition to the right of entry set forth in Paragraph
16.1 hereof, the following rights: (i) to close temporarily any of such areas
for maintenance or other reasonable purposes, provided that reasonable parking
and reasonable access to the Initial Building remain available; (ii) to use
such areas while engaged in making additional improvements, repairs or
alterations to the Property, or any portion thereof or any adjacent property;
(iii) to permit access to the Site, or any parts thereof, as are required or
permitted pursuant to any law, statute, ordinance, rule, regulation or the
like or, subject to Paragraph 1.3 below, by any recorded agreement, bearing on
the Property; (iv) to grant easements or licenses on, under or over the Site,
or portions thereof; and (v) to do and perform such other acts with respect to
such areas and the Property as may be necessary or appropriate; provided,
however, that notwithstanding anything to the contrary in this Paragraph 1.2,
Landlord's exercise of its rights hereunder, (w) shall not have any material
adverse permanent effect on the use of or access to the Improvements nor
visibility therefrom nor the amount of parking, (x) shall not cause any
material diminution of Tenant's rights, nor any material increase of Tenant's
obligations, under this Lease or with respect to the Improvements, (y) shall
not authorize Landlord to make any material, permanent alterations in the
Improvements without the prior written consent of Tenant, which consent shall
not be unreasonably withheld or delayed, and (z) shall be conducted in such a
manner as to minimize, to the extent reasonably possible, any disruption and
any adverse effect on Tenant's business operations on the Site, it being
agreed that Landlord and Tenant shall confer as to the scheduling of any work
or disruption and that Tenant's approval thereof shall not be unreasonably
withheld or delayed.
1.3 Title.
Landlord has delivered to Tenant, who acknowledges receipt and review,
a copy of a Policy of Title Insurance concerning the property dated May 7,
1997. Landlord shall not at any time after the date hereof permit or create
any additional exceptions to title or any modification to any existing
exceptions which will materially and adversely affect Tenant's rights and
obligations under this Lease; Landlord shall provide to Tenant a copy of any
instrument creating a new exception or modifying any existing exception prior
to such instrument becoming effective. Any mortgage, deed of trust or
similar encumbering instrument shall not be deemed to violate the provisions
of this Paragraph 1.3 if same is permitted pursuant to Paragraph 19 hereof.
Other than as shown on the Policy of Title Insurance, Landlord is not aware
of any other exception affecting title. Notwithstanding the immediately
preceding sentence, in the event Landlord breaches such representation, and
such exception has no adverse effect on Tenant's use of the Project as
permitted herein, such breach shall not be a default by Landlord under this
Lease and Tenant shall not be entitled to any remedies therefor.
2. TERM
----
2.1 Term. The term of this Lease shall commence on the Commencement
Date and shall end on the day immediately preceding the date fifteen (15)
years thereafter, unless sooner terminated or extended (if applicable) as
hereinafter provided.
2.2 Commencement Date.
-----------------
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(a) Commencement Date; Tender Date; Target Commencement Date.
--------------------------------------------------------
The "Commencement Date" shall be the date Tenant takes possession of the
Property for purposes other than installing furniture, fixtures and equipment
and similar work preparatory to the commencement of Tenant's business, but not
later than thirty (30) days after the Actual Tender Date of the entire Initial
Building. On the Actual Tender Date, all construction personnel, equipment
and materials that materially interfere with Tenant's fixturization, move-in
or other use of the Property, shall be removed from the Property. Landlord
shall use its reasonable best efforts to achieve the Target Commencement Date
and to give Tenant at least thirty (30) days prior written notice ("Completion
Notice") of the dates the Tenant Improvement Work will be Substantially
Completed (a) with respect to the office space (as referred to in Paragraph
2.2(b) hereof), and (b) with respect to the entire Initial Building. Carrying
Costs with respect to Lot 28 shall no longer accrue or be included in Total
Project Cost effective as of the Commencement Date.
(b) Early Use of Office Area. Tenant may elect, in its sole and
------------------------
absolute discretion, to commence occupancy of the office space within the
Initial Building prior to the Commencement Date upon issuance of a temporary
certificate of occupancy and Substantial Completion of the office space.
Landlord shall provide Tenant with written notice of the date upon which
Landlord anticipates Substantial Completion of the office area portion of the
Project, and shall continue to keep Tenant advised of progress towards such
Substantial Completion; Landlord shall use its good faith best effort to
provide notice of anticipated Substantial Completion at least thirty (30) days
prior to such Substantial Completion. Tenant shall provide Landlord with at
least fifteen (15) days written notice before taking such occupancy of the
office space. If Tenant so elects to occupy such office space, then all terms
and conditions of this Lease which are applicable upon and during Tenant's
occupancy shall have immediate effect with the following exceptions which
shall have effect only until the Commencement Date: (i) Tenant shall pay a
monthly base rent (in lieu of Basic Annual Rent) equal to one-twelfth (1/12)
of the Office Space Annual Rent for each month (pro-rata for partial months)
of such occupancy until the Commencement Date; (ii) Tenant shall pay a portion
of Operating Expenses (excluding therefrom the Management Fee and the costs of
maintenance and repair) equal to the product of the aggregate Operating
Expenses multiplied by the Office Space Percentage; (iii) Tenant shall pay a
portion of Taxes equal to the aggregate of Taxes multiplied by the Office
Space Percentage; and (iv) Landlord shall effect all necessary maintenance and
repair, the cost of same being added to the Project Budget (either by
inclusion of a new line item, addition of the costs to an existing line item
or some combination) and shall be a component of Total Project Cost. Tenant's
use and occupancy of the office space shall be conducted in such a manner so
as minimize interference with or delay of Landlord's construction of any
remaining portion of the Project, and Tenant shall coordinate and cooperate
with Landlord and its contractors in this regard. Tenant shall permit
Landlord reasonable access to the office area for purposes of effecting
construction of the Project. Any delay in construction or Substantial
Completion of the Property shall be a Tenant Delay if resulting from Tenant's
failure to permit such reasonable access, Tenant's failure to comply with any
reasonable directive from Landlord relating to construction of the Project or
any default by Tenant under this Lease. Early use of the office area pursuant
to this Paragraph 2.2(b) shall not affect the Commencement Date. From and
after the date Tenant's obligation to pay rent on the office area begins, for
purposes of calculating Total Project Costs, the portion of Carrying Costs of
Lot 28 based on the ratio between the Office Space Annual Rent and the Basic
Annual Rent for the entire Premises shall no longer continue to accrue.
2.3 Early Possession. In addition to Tenant's rights and obligations
----------------
pursuant to Paragraph 2.2(b) hereof, Tenant shall have the nonexclusive right
to occupy and take possession of the Property from and after Substantial
Completion of Building Shell and Core, subject to the approval of Landlord
and its contractor (which approval shall not be unreasonably withheld or
delayed and shall be deemed to be given unless Landlord shall deliver written
notice of disapproval within ten (10) business days of receipt of Tenant's
notice or request) solely for the purpose of staging for installation and
installing fixtures and equipment, moving furniture into the Property and
performing other similar work preparatory to the commencement of Tenant's
business on the Property, and Tenant shall not be required to pay Rent or
Operating Expenses by reason of such early access until the Commencement Date
otherwise occurs. Landlord shall give Tenant written notice of the date upon
which Landlord anticipates Substantial Completion of
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Building Shell and Core, and shall continue to keep Tenant advised of progress
towards such Substantial Completion; Landlord shall use its best efforts to
provide such notice at least thirty (30) days in advance of such Substantial
Completion. Tenant shall not unreasonably interfere with or delay Landlord's
contractors by any such early access, occupancy or possession and shall
coordinate and cooperate with Landlord and its contractors (who shall
similarly coordinate and cooperate with Tenant and its contractors) to
minimize any interference or delay by Tenant with respect to the Landlord's
work, and shall indemnify, defend and hold harmless Landlord and its agents
and employees from and against any and all claims, demands, liabilities,
actions, losses, costs and expenses, including (but not limited to) reasonable
attorneys' fees, to the extent not covered by insurance, resulting from
Tenant's negligence or willful misconduct in connection with such early entry
on the Property. Any delay in construction or Substantial Completion of the
Property resulting from Tenant's failure to comply with any reasonable
directive from Landlord related to construction of the Project or any default
by Tenant under this Lease shall be a Tenant Delay.
2.4 Delay In Possession.
-------------------
The dates and time periods set forth in this Paragraph 2.4 are not
subject to extension for delays due to Force Majeure except as otherwise
expressly provided herein.
(a) Landlord's Work; Target Commencement Date. Landlord agrees to
-----------------------------------------
use its best reasonable efforts to complete promptly its portion of the work
described in Paragraph 5.1 and the Work Letter; provided, however, except as
provided herein, Landlord shall not be liable for any damages caused by any
delay in the completion of such work, nor shall any such delay affect the
validity of this Lease or the obligations of Tenant hereunder. To the extent
Substantial Completion of the Project is delayed more than sixty (60) days
beyond the Target Commencement Date, for reasons other than Force Majeure and
Tenant Delay, *
(b) Relation to Matrix Lease. In addition, Landlord acknowledges
------------------------
that under Tenant's existing Industrial Multi-Tenant Lease dated July 15,
1996, with Matrix Pharmaceutical, Inc. (the "Matrix Lease"), *
* (i) Completion Notice.
-----------------
* (ii) Tender Date - Completion Notice Delivered.
-----------------------------------------
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* (iii) Tender Date - Completion Notice Not Delivered.
---------------------------------------------
* (c) Start of Construction.
---------------------
* (i)
* (ii)
* (iii)
*CONFIDENTIAL INFORMATION IS OMITTED*
2.5 Acknowledgment Of Lease Commencement. Upon commencement of the
------------------------------------
term of this Lease, Landlord and Tenant shall execute a written acknowledgment
of the Commencement Date, date of the termination and related matters,
substantially in the form attached hereto as Exhibit E (with appropriate
insertions), which acknowledgment shall be deemed to be incorporated herein
by this reference. Notwithstanding the foregoing requirement, the failure of
either party to execute such a written acknowledgment shall not affect the
determination of the Commencement Date, date of termination and related
matters in accordance with the provisions of this Lease.
2.6 Holding Over. If Tenant holds possession of the Property or any
------------
portion thereof after the term of this Lease with Landlord's written consent,
then except as otherwise specified in such consent, Tenant shall become a
tenant from month to month at one hundred ten percent (110%) of the Basic
Annual Rent and otherwise upon the terms herein specified for the period
immediately prior to such holding over and shall continue in such status
until the tenancy is terminated by either party upon not less than thirty
(30) days prior written notice. If Tenant holds possession of the Property
or any portion thereof after the term of this Lease without Landlord's
written consent, then Landlord in its sole discretion may elect (by written
notice to
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Tenant) to have Tenant become a tenant either from month to month or at will,
at two hundred percent (200%) of the Basic Annual Rent (prorated on a daily
basis for an at-will tenancy, if applicable) and otherwise upon the terms
herein specified for the period immediately prior to such holding over, or
may elect to pursue any and all legal remedies available to Landlord under
applicable law with respect to such unconsented holding over by Tenant and
may recover all damages resulting therefrom, including, but not limited to,
loss (including, but not limited to, loss of rent, contribution to taxes and
operating expenses), cost, liability, damages and attorneys' fees resulting
from Landlord's becoming in breach of, or failing to fulfill a prerequisite
to effectiveness or commencement of, a lease of the Property, or from the
termination of such a lease by the lessee because of Landlord's inability to
deliver possession of the premises at the required time and in the condition
required hereunder). Landlord shall advise Tenant in writing of the latest
date upon which the Property must be made available to Landlord in order to
place the Property in the condition required by any new tenant and of the
dates upon which any new tenant may terminate any new lease for failure to
achieve any target dates. Landlord shall use its reasonable best effort to
mitigate any damages including, but not limited to, attempting to secure a
tenant for the property as promptly as is reasonably possible. Tenant shall
indemnify and hold Landlord harmless from any loss, damage, claim, liability,
cost or expense (including reasonable attorneys' fees) resulting from any
delay by Tenant in surrendering the Property (except with Landlord's prior
written consent), including but not limited to any claims made by a
succeeding tenant by reason of such delay. Acceptance of rent by Landlord
following expiration or termination of this Lease shall not constitute a
renewal of this Lease.
2.7 Option To Extend Term. Tenant shall have the option to extend the
---------------------
term of this Lease, at the Basic Annual Rent set forth in Paragraph 3.5 and
otherwise upon all the terms and provisions set forth herein with respect to
the initial term of this Lease, for up to two (2) additional periods of five
(5) years each, the first extension commencing upon the expiration of the
initial term hereof and the second extension commencing upon the expiration
of the first extended term, if any. Exercise of such option with respect to
the first such extended term shall be by written notice to Landlord at least
nine (9) months prior to the expiration of the initial term hereof; exercise
of such option with respect to the second extended term, if the first
extension option has been duly exercised, shall be by like written notice to
Landlord at least nine (9) months prior to the expiration of the first
extended term hereof. If Tenant is in default beyond the expiration of any
applicable notice and cure period hereunder on the date of such notice
or on the date any extended term is to commence, or if this Lease has earlier
terminated for any reason, then the extension option, at Landlord's election,
shall be of no force or effect, the extended term shall not commence and this
Lease shall expire at the end of the then current term hereof (or at such
earlier time as Landlord may elect pursuant to the default provisions of this
Lease). Except as expressly set forth in this Paragraph 2.7, Tenant shall
have no right to extend the term of this Lease beyond its prescribed term.
3. RENTAL
------
3.1 Basic Annual Rent.
-----------------
(a) "Basic Annual Rent:" Calculation; Initial Estimate. Tenant
---------------------------------------------------
agrees to pay Landlord as "Basic Annual Rent" for the Property, on a triple
net basis, a sum equal to twelve and one-half percent (12.5%) of the Total
Project Cost, all as described and determined in accordance with the Work
Letter. The initial Project Budget (a copy of which is annexed to the Work
Letter), is subject to modification pursuant to the Work Letter; such
modifications of the Project Budget shall result in modification of the Basic
Annual Rent. Determination of the final Total Project Cost upon which
calculation of initial Basic Annual Rent will be based, and any disputes and
disagreements concerning same, shall be resolved by Arbitration (as described
in Paragraph 4 hereof); provided, however, amounts shall not be included in
the calculation of Rent until and unless actually expended. If there is not
agreement on the initial Basic Annual Rent by the Commencement Date, then
Tenant shall pay Basic Annual Rent in the amount of Projected Monthly Basic
Annual Rent per month; when agreement as to initial Basic Annual Rent has been
achieved or determined by Arbitration, then Tenant shall make payment of any
shortage within ten (10) days or Landlord shall pay within ten (10) days the
amount of any overpayment.
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(b) Payment in Monthly Installments. The Basic Annual Rent shall
-------------------------------
be paid in equal monthly installments in advance on the first day of each and
every calendar month during the term of the Lease; in the event the Commence-
ment Date is not the first day of a calendar month, then Tenant shall make a
pro rata payment for the remainder of the month during which the Commencement
Date occurs. Basic Annual Rent is also subject to adjustment as set forth in
Paragraph 3.4 hereof.
3.2 Other Obligations. In addition to Basic Annual Rent, Tenant agrees
-----------------
to pay to the Operating Expenses as provided in Paragraph 9 hereof and taxes
("Taxes") as provided in Paragraph 8 hereof.
3.3 Payments. Basic Annual Rent, Operating Expenses and Taxes shall be
--------
paid to Landlord, without abatement, deduction, or offset of any kind except
as otherwise provided herein, in lawful money of the United States of America,
at such place as Landlord may from time to time designate in writing;
initially such payments shall be sent to the place designated herein for the
delivery of notices to Landlord. In the event the term of this Lease
commences or ends on a day other than the first day of a calendar month, then
the Basic Annual Rent, Operating Expenses and Taxes for such fraction of a
month shall be prorated for such period and shall be paid at the then current
rate for such fractional month. If an increase in Basic Annual Rent becomes
effective on a day other than the first day of a calendar month, the Basic
Annual Rent for that month shall be the sum of the two applicable rates, each
prorated for the portion of the month during which such rate is in effect.
3.4 Rent Increases.
---------------
(a) Annual Percentage Increase. The Basic Annual Rent shall be
--------------------------
subject to a compounded annual increase as follows: (i) four percent (4%) for
each of the second, third, fourth and fifth years of the initial term of the
Lease, (ii) three percent (3%) for each of the sixth, seventh, eighth, ninth
and tenth years of the initial term of the Lease, and (iii) two and one-half
percent (2.5%) for each of the eleventh, twelfth, thirteenth, fourteenth and
fifteenth years of the initial term of the Lease. The first such adjustment
shall become effective commencing with that monthly installment of Rent which
is due on or after the first anniversary of the Commencement Date and
subsequent adjustments shall become effective on the same day of each calendar
year thereafter for so long as this Lease continues in effect.
(b) Subsequent Expenditures of Project Budget. It is
-----------------------------------------
acknowledged that amounts properly includable in Total Project Cost may not
have been expended (e.g., costs relating to permanent financing) at the time
that Basic Annual Rent is determined, by agreement or by arbitration. In
such event, the Basic Annual Rent shall be adjusted effective as of the date
of any such expenditures on a prospective basis. Landlord shall provide
Tenant with a written statement of any such expenditures along with a
calculation of the adjustment of Basic Annual Rent, the amount due and
documentation of the expenditure. Tenant shall have the same examinations
and audit rights as afforded with respect to Total Project Cost, and any
disagreement shall be treated in the same manner as a disagreement concerning
Total Project Cost.
3.5 Extension Terms.
----------------
(a) First Extension. The Basic Annual Rent during the first
---------------
extended term shall be equal to the greater of (i) the Basic Annual Rent
payable for the last month of the initial term of this Lease or (ii) the fair
market rental value of the Property (as defined below), determined as of the
commencement of such extended term in accordance with this paragraph. Such
Basic Annual Rent as determined under this Paragraph 3.5(a) shall be subject
to a compounded annual increase of three percent (3%) for each year of the
extended term after the first year, effective in the same manner as increases
during the initial term of this Lease.
(b) Second Extension. The Basic Annual Rent during the second
----------------
extended term shall be equal to the greater of (i) the Basic Annual Rent
payable for the last month of the first extended term of this Lease, or (ii)
the fair market rental value of the Property (as defined below), determined as
of the commencement of such extended term in accordance with this paragraph.
Such Basic Annual Rent as determined under this Paragraph 3.5(b) shall be
subject to
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a compounded annual increase of three percent (3%) for each year of the second
extended term after the first year thereof, effective in the same manner as
increases during the first extended term of this Lease.
(c) Fair Market Rental Value. With respect to the determination
------------------------
of the fair market rental value of the Property, the parties shall have sixty
(60) days in which to agree on the fair market rental for the Property at the
commencement of the first extended term for the uses permitted hereunder. If
the parties agree on such fair market rental they shall execute an amendment
to this Lease stating the amount of the applicable Basic Annual Rental. If
the parties are unable to agree on such rental within such sixty (60) day
period, then within fifteen (15) days after the expiration of such period each
party, at its cost and by giving notice to the other party, shall appoint a
real estate appraiser who is a member in good standing of the Appraisal
Institute holding an "M.A.I." designation with at least five (5) years
experience appraising similar commercial properties in northern San Diego
County to appraise and set the fair market rental for the Property at the
commencement of the applicable extended term. If either party fails to
appoint an appraiser within the allotted time, the single appraiser appointed
by the other party shall be the sole appraiser. If an appraiser is appointed
by each party and the two appraisers so appointed are unable to agree upon a
fair market rental within thirty (30) days after the appointment of the
second, they shall appoint a third qualified appraiser within ten (10) days
after expiration of such 30-day period; if they are unable to agree upon a
third appraiser, either party may, upon not less than five (5) days notice to
the other party, apply to the Presiding Judge of the San Diego County Superior
Court for the appointment of a third qualified appraiser. Each party shall
bear its own legal fees in connection with appointment of the third appraiser
and shall bear one-half of any other costs of appointment of the third
appraiser and of such third appraiser's fee. The third appraiser, however
selected, shall be a person who has not previously acted for either party in
any capacity. Within thirty (30) days after the appointment of the third
appraiser, a majority of the three appraisers shall set the fair market rental
for the applicable extended term and shall so notify the parties. If a
majority are unable to agree within the allotted time, the three appraised
fair market rentals shall be added together and divided by three and the
resulting quotient shall be the fair market rental for the first extended
term, which determination shall be binding on the parties and shall be
enforceable in any further proceedings relating to this Lease. For purposes
of this Paragraph 3.5, the "fair market rental" of the Property shall be
determined with reference to the then prevailing market rental rates for
properties in northern San Diego County, for a renewing tenant, with shell and
standard office, research and development improvements and site (common area)
improvements comparable in age and character to those then existing in the
Initial Building and on the Property, taking into account the fact that Tenant
is taking the Property in "as is" condition (but that Tenant has the
maintenance and repair obligations set forth herein), that this Lease is a
triple net lease and such other matters as the appraisers deem appropriate.
The appraisers shall have no right to award a Tenant improvement allowance or
other monetary concessions, but shall take into account any such concessions
granted in connection with similar leases used for comparison in the
determination of Rent.
3.6 Late Charge. If Tenant fails to pay when due Rent or other amounts
-----------
due Landlord hereunder, such unpaid amounts shall bear interest for the
benefit of Landlord from the due date until paid at a rate equal to the
lesser of fifteen percent (15%) per annum or the maximum rate permitted by
law, from the thirtieth (30th) day after the date due to the date of payment.
In addition to such interest, Tenant shall pay to Landlord a late charge in
an amount equal to five percent (5%) of any installment of Rent and any other
amounts due Landlord if not paid in full on or before the fifth (5th) day
after Landlord notifies Tenant in writing that such Rent or other amount is
due. Tenant acknowledges that late payment by Tenant to Landlord of
rental or other amounts due hereunder will cause Landlord to incur costs not
contemplated by this Lease, including, without limitation, processing and
accounting charges and late charges which may be imposed on Landlord by the
terms of any loan relating to the Property. Tenant further acknowledges that
it is extremely difficult and impractical to fix the exact amount of such
costs and that the late charge set forth in this Paragraph 3.6 represents a
fair and reasonable estimate thereof. Acceptance of any late charge by
Landlord shall not constitute a waiver of Tenant's default with respect to
overdue rental or other amounts, nor shall such acceptance prevent Landlord
from exercising any other rights and remedies available to it. Acceptance of
rent or other payments by Landlord shall not constitute a waiver of late
charges or interest accrued with respect to such rent or other payments or any
prior installments thereof, nor of any other defaults
13
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by Tenant, whether monetary or non-monetary in nature, remaining uncured at
the time of such acceptance of rent or other payments.
4. DETERMINATION OF TOTAL PROJECT COST;
------------------------------------
ARBITRATION AND AUDIT
---------------------
4.1 Landlord's Statement of Total Project Cost; Tenant Review.
---------------------------------------------------------
As promptly as possible after Substantial Completion of the Project, Landlord
shall present to Tenant a written statement ("Total Project Cost Statement")
setting forth the Total Project Cost in a format which is consistent with the
Project Budget (as defined and referred to in the Work Letter). Landlord
shall also make available to Tenant supporting data and all documentation of
the Landlord's statement of Total Project Cost, and Tenant shall have a
period of sixty (60) days (or 90 days if Tenant performs an audit) to review
and audit the Total Project Cost Statement and all data and documentation
relating to Landlord's calculation of Total Project Cost. If Tenant, in its
reasonable discretion, disagrees with Landlord's determination of the amount
of any portion of the Total Project Cost which is part of the sum on which
the Rent will be calculated ("Disputed Items"), then Tenant shall give
written notice thereof to Landlord during such sixty (60) day (or 90 days if
Tenant performs an audit) period, stating the basis for such objection,
specifically identifying the line items, and the specific components,
elements and invoices thereof, and stating the amount which Tenant reasonably
believes to be the correct amount ("Tenant's Proposal"); Tenant shall permit
Landlord to review and copy all of its work papers, documentation and
calculations. If Landlord does not receive such written notice within such
sixty (60) day (or 90 days if Tenant performs an audit) period, then, for all
purposes, Tenant shall be deemed to have accepted Landlord's statement of
Total Project Cost and Landlord's calculation of initial Basic Rent; any line
item, or any component, element or invoice thereof, which is not objected to
in Tenant's Proposal shall be deemed to be accepted.
4.2 Arbitration of Dispute. If, after working in good faith to
----------------------
resolve the dispute, Landlord and Tenant have not agreed upon a resolution
within fifteen (15) days after Tenant's original notice, then with respect to
any unresolved matter identified in Tenant's Proposal either party may
commence arbitration proceedings with the American Arbitration Association
regional office in San Diego, California, or such other place as the parties
shall mutually agree in writing by filing a demand for arbitration in writing
with the American Arbitration Association office having jurisdiction thereof,
and by contemporaneously sending a copy of said demand to the other party, by
Certified Mail, Postage Prepaid, Return Receipt Requested. The arbitration
proceedings shall be governed by and decided in accordance with the
Construction Industry Arbitration Rules of the American Arbitration
Association, then in effect, unless the parties shall mutually agree
otherwise, in writing and as modified by this Paragraph 4.
(a) Panel Selection. Any claim shall be submitted to a balanced
---------------
panel, consisting of one attorney, who shall be the Chair of the Panel, one
contractor and one certified public accountant. The attorney panel member
shall be currently licensed to practice law and shall have actively engaged
in the practice of law for at least 10 years, and in the immediately preceding
five years, shall have devoted a substantial amount of his/her time to the
practice of construction law and shall have demonstrated an expertise in the
process of arbitration as an alternate dispute resolution method. The
contractor selected for the panel shall not have less than 10 years of
experience in the field, shall have experience in the type of construction
which is the subject of this Lease and shall be in a supervisory or management
role in their field. The accountant shall be a partner in a Big 6 accounting
firm with not less than ten (10) years' experience in the construction field,
in general, and shall have experience within the last three (3) years in the
review and calculation of project costs.
The panel shall commit to be available to allow the arbitration
sessions to proceed on a continuous basis and the parties recognize that such
a panel may require fees in excess of those suggested by the American
Arbitration Association.
(b) Scope of Award; No Authority to Award Punitive Damages. The
------------------------------------------------------
arbitrator(s) shall follow the substantive and evidentiary laws of the State
of California. Landlord and Tenant, during the arbitration, shall each
present a final proposal with respect to each line item, or component, element
or invoice thereof, reflected in Tenant's Proposal which remains unresolved;
the sole authority of the arbitrators shall be to select either the Landlord's
or
14
<PAGE>
the Tenant's final proposal which most closely approximates the amount
properly includable as part of Total Project Costs under the terms of this
Lease. The arbitrators shall have no authority to make an independent
determination of such matters; the arbitrator(s) shall have no authority to
award punitive damages nor make any ruling, finding or award that does not
conform to the terms and conditions of this Lease.
(c) Non-Disclosure. Neither party nor the arbitrator(s) may
--------------
disclose the results of any arbitration hereunder, without the prior written
consent of the parties; provided, however, that either Landlord or Tenant may
effect disclosure of such information to its existing and prospective lenders,
financial partners, consultants, advisors, attorneys, accountants,
underwriters and similar parties, to an entity involved in discussions
involving a merger, consolidation, acquisition or similar transaction
involving Tenant or Landlord, or as is required by law (including applicable
securities laws) or order of court of competent jurisdiction.
(d) Pre-Hearing Conference. The arbitrator shall order a pre-
----------------------
hearing exchange of information by the parties, including production of
requested documents reasonably required by the parties, exchange of summaries
of testimony of proposed witnesses, and the deposition of any experts. All
issues regarding discovery and compliance therewith shall be decided by the
arbitrator(s).
The panel shall require a pre-hearing meeting between the parties
at which each party shall present a memorandum disclosing the factual basis
of its claim and defenses and disclosing legal issues raised; Tenant's
memorandum shall contain and disclose the results, and all detail, of its
investigation, and any audit, conducted with respect to the Total Project
Cost Statement; Landlord's memorandum shall state in detail its response to
Tenant's Proposal. Each party's memorandum shall also disclose the names of
any expert a party may present as a witness in the proceedings. Failure to
disclose such experts on a timely basis shall bar their testimony at the
hearings.
(e) Discovery Rules. No discovery except depositions of experts
----------------
and reasonable document production. This provision does not affect Tenant's
audit rights.
(f) Award of Fees and Costs to Prevailing Party. The arbitrator(s)
-------------------------------------------
shall award to the prevailing party as determined by the arbitrator(s), all its
costs and fees. "Costs and fees" shall include the arbitrators' fees,
administrative expenses, witness fees and reasonable attorneys fees. Such
recovery shall be made part of any arbitration award.
(g) Finality of Award. The Award rendered by the arbitrator(s)
-----------------
shall be final and binding upon the parties absent manifest legal error and
judgment may be entered by any competent court having jurisdiction thereof.
(h) Written Opinion. The Award of the panel shall be accompanied
---------------
by a written, reasoned opinion. If the arbitrators do not agree, the decision
of two of the three arbitrators shall be determinative.
5. DESIGN AND CONSTRUCTION
-----------------------
5.1 Construction of Improvements. Landlord shall, at Landlord's cost
----------------------------
and expense (except as otherwise provided herein and in the Work Letter),
construct Landlord's Work as defined in and in accordance with the terms and
conditions of the Work Letter. Landlord shall use its best efforts to
complete such design and construction in accordance with the estimated
project schedule attached hereto as Exhibit D as the same may be modified or
revised from time to time in accordance with the Work Letter.
5.2 Condition of Property. On the Actual Tender Date, Landlord shall
---------------------
deliver the Building Shell and Core (as defined in the Work Letter), Interior
Improvements and other Improvements constructed by Landlord to Tenant in
reasonable condition for Tenant to install FF&E/Trade Fixtures, promptly upon
completion of construction thereof, and Landlord warrants to Tenant that the
Building Shell and Core, Interior Improvements and other Improvements
constructed by Landlord (i) shall be free from defects in design and defects
in construction and (ii) shall be constructed in compliance in all material
respects with any and all applicable plans
15
<PAGE>
and specifications mutually approved by Landlord and Tenant, subject to
any changes implemented in such specifications in accordance with the
procedures set forth in the Work Letter. Notwithstanding any provision hereof
to the contrary, Landlord shall not be liable for, or with respect to, any
defect in design to the extent the same responds to and satisfies any
performance criteria provided by Tenant and otherwise is not defective.
Further, Landlord has no responsibility for the propriety, suitability,
sufficiency or the like of the Improvements, or any element thereof, for
Tenant's use. If it is determined that this warranty has been violated in any
respect, then it shall be the obligation of Landlord, after receipt of written
notice from Tenant setting forth nature of the violation, to promptly, at
Landlord's sole cost, correct the condition(s) constituting such violation.
Tenant's failure to give such written notice to Landlord within one hundred
twenty (120) days after the Commencement Date shall be deemed a waiver by
Tenant of any right of Tenant to assert that Landlord has not complied with
all Landlord's obligations hereunder, except with respect to latent defects.
TENANT ACKNOWLEDGES THAT THE WARRANTY CONTAINED IN THIS PARAGRAPH IS IN LIEU
OF ALL OTHER WARRANTIES, EXPRESS OR IMPLIED, WITH RESPECT TO THE PHYSICAL
CONDITION OF THE IMPROVEMENTS TO BE CONSTRUCTED BY LANDLORD AND THAT LANDLORD
MAKES NO OTHER WARRANTIES EXCEPT AS EXPRESSLY SET FORTH IN THIS LEASE.
5.3 Compliance with Law. Landlord warrants to Tenant that the
-------------------
Building Shell, Core, Interior Improvements and other Improvements constructed
by Landlord (when constructed), as they exist on the Commencement Date, shall
not violate any covenants or restrictions of record or any applicable
building code, regulation or ordinance in effect on the Commencement Date,
and Landlord agrees to indemnify, defend and hold Tenant harmless from and
against any and all claims, losses, costs and damages arising as a result of
Landlord's breach of this warranty. Tenant warrants to Landlord that any
improvements constructed by Tenant from time to time shall not violate any
applicable building code, regulation or ordinance in effect on the
Commencement Date or at the time such improvements are placed in service, and
Tenant agrees to indemnify, defend and hold Landlord harmless from and
against any and all claims, losses, costs or damages arising as a result of
Tenant's breach of this warranty. If it is determined that this warranty has
been violated, then it shall be the obligation of the warranting party, after
written notice from the other party, to correct the condition(s) constituting
such violation promptly, at the warranting party's sole cost and expense.
Tenant acknowledges that neither Landlord nor any agent of Landlord has made
any representation or warranty as to the present or future suitability of the
Property for the conduct of Tenant's business or proposed business thereon.
5.4 Union Labor. See Paragraph 11.1 and Exhibit K.
-----------
5.5 City Business Cooperation Program. Landlord agrees to participate
---------------------------------
in, and to comply with any reasonable requirements imposed by the City of San
Diego, to the extent not inconsistent with Paragraph 5.4 above, in order to
qualify the Property under the City's Business Cooperation Program, including
requiring all contractors and subcontractors to prepare documentation
required by the City. Landlord shall, at the appropriate time after the
Commencement Date, apply for certain tax credits from the City of San Diego
with respect to construction of the Project. The benefit of any such credit
shall accrue to Tenant. Landlord shall take whatever reasonable efforts as
are necessary to obtain such tax credit.
6. EXPANSION OPTION - LOT 27
-------------------------
6.1 Option Grant. Landlord hereby grants to Tenant the option to cause
------------
Landlord to develop Lot 27 and to lease same ("Lot 27 Expansion Option") upon
the terms and conditions of this Paragraph 6. The Lot 27 Expansion Option
must be exercised on or before the end of the eighteenth (18th) month after
the Commencement Date of this Lease ("Lot 27 Exercise Period"); provided,
however, that Landlord may elect to have an affiliate effect the development
of Lot 27, in which case, such affiliate shall be bound and obligated by all
the terms and conditions hereof relating to the development and leasing of
Lot 27.
(a) Exercise.
--------
16
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(i) Method of Exercise. Tenant shall exercise the Lot 27
------------------
Expansion Option by delivery of written notice to Landlord during the Lot 27
Exercise Period ("Lot 27 Exercise Notice"); provided, however, that if Tenant
is in default under this Lease beyond any applicable notice and cure period at
the time of exercise of the Lot 27 Expansion Option or at the commencement of
the Lot 27 Lease, then Landlord may, at its sole option, terminate the Lot 27
Expansion Option, Tenant's rights under Paragraph 7 hereof or both which shall
then, along with any exercise of either, be null and void. Such Exercise
Notice shall include a statement of the gross square footage which Tenant
seeks to have developed on Lot 27 (the "Lot 27 Expansion Building"), the
proposed configuration of buildings and other improvements to be constructed
on Lot 27 and Tenant's proposed Lot 27 Expansion Building Delivery Date;
subject to Landlord's approval of the configuration of the buildings (which
will not unreasonably be withheld), the development of Lot 27 may include more
than a single building. No building on Lot 27 shall be less than 45,000
square feet, and the aggregate size of all buildings shall not be less than
102,000 square feet nor more than 124,400 square feet unless Landlord and
Tenant consent. The term of the Lot 27 Lease shall not be less than fifteen
(15) years.
(ii) Effect of Exercise. In the event Tenant effectively
------------------
exercises the Lot 27 Expansion Option, Landlord and Tenant shall enter into,
within sixty (60) days thereafter:
(A) a work letter regarding construction of the Lot 27
Expansion Building(s), with such terms and conditions as are mutually
agreed to between Landlord and Tenant substantially in the form of the
Work Letter, provided, however, that: (1) Tenant shall pay for twenty-
five percent (25%) of any Interior Improvements in excess of Ten Dollars
($10.00) per square foot in lieu of the Tenant Contribution provided for
in the Work Letter, but Landlord's obligation to pay for Interior
Improvements shall not exceed One Hundred Dollars ($100) per square foot;
and (2) the Expansion Building Delivery Date shall be mutually agreed
upon but shall be no earlier than nine (9) months and no later than
twenty one (21) months after execution of a lease for Lot 27, all
subject to Force Majeure and Tenant Delay; and (3) Tenant shall have the
right at any time prior to the Commencement Date of the Lot 27 Lease to
reimburse Landlord in cash for a portion of the Total Project Cost of
Lot 27, up to a maximum of fifteen percent (15%) of the Total Project
Costs for Lot 27, and if Tenant elects to do so, for purposes of
determining rent for Lot 27, the Total Project Costs for Lot 27 shall
be reduced by the amount so paid by Tenant.
(B) a lease (the "Lot 27 Lease") substantially in the
same form as this Lease other than with respect to Rent, obligations
relating to the Matrix Lease or any other lease of Tenant and such other
modifications as are necessary; provided, however, that Tenant shall
have the right at any time prior to the Commencement Date of the Lot 27
Lease to reimburse Landlord in cash for a portion of the Total Project
Cost of Lot 27, up to a maximum of fifteen percent (15%) of the Total
Project Costs for Lot 27, and if Tenant elects to do so, for purposes of
determining rent for Lot 27, the Total Project Costs for Lot 27 shall be
reduced by the amount so paid by Tenant.
(C) an amendment to this Lease making the term of this
Lease coterminous with the Lot 27 Lease; provided, however, that in no
event shall the term of this Lease be shortened without Landlord's
consent which may be withheld for any reason; and
(D) any other documentation reasonably required by
Tenant, Landlord or Landlord's prospective lender.
Rent shall be calculated on the same basis as Rent is calculated pursuant to
this Lease; the Total Project Cost for such purpose shall also include the
actual cost of Lot 27, which is $3,450,000, plus an amount equal to the
following: (A) the Carrying Costs of Lot 27; plus (B) $230,000 (being $2.00
for each of the 115,000 square feet of building area allocated to Lot 27); and
(C) minus any portion of Carrying Costs paid by Tenant to Landlord pursuant to
Paragraph 6.1(b) hereof. Landlord and Tenant shall enter into a lease and
work letter within such sixty (60) day period. If either party fails or
refuses to enter into such agreements in bad faith, the other party
may terminate negotiations and, in the event Landlord terminates negotiations,
Tenant's right to utilize or lease Lot 27 shall terminate and all rights under
Paragraph 7 hereof shall also terminate.
17
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(b) Carrying-Costs. As consideration for Landlord's grant of
--------------
the Lot 27 Expansion Option, Tenant shall pay or reimburse to Landlord
one-half (1/2) of all Carrying Costs for Lot 27 incurred by Landlord during or
with respect to the period from the Commencement Date of this Lease until the
expiration of the Lot 27 Expansion Option; provided, however, that such
payments shall continue during the period of any extension of the Lot 27
Expansion Option and, if the Lot 27 Expansion Option is exercised, until a
lease for Lot 27 is executed, and, provided further, that Tenant may at any
time waive the Lot 27 Expansion Option by written notice to Landlord, in which
case Tenant's obligation to pay such share of Carrying Costs shall terminate
thirty (30) days after the date of the notice. Tenant shall pay one-half
(1/2) of Landlord's estimate of the Carrying Costs to Landlord on a monthly
basis, in advance, on the due date for the monthly installments of Rent; such
payment shall be based upon Landlord's estimate which shall show the separate
components on a line item basis and shall show the calculations of any
calculated amount. Any failure to pay its portion of Carrying Costs for a
period of ten (10) days after written notice of such failure from Landlord
shall be deemed to be a waiver by Tenant of its rights under Paragraphs 6 and
7 hereof. Within ten (10) days after the end of the period for which Tenant
is to pay a portion of Carrying Costs for Lot 27, Landlord shall notify Tenant
in writing of Landlord's actual Carrying Costs for Lot 27 for the period with
respect to which Tenant is to pay a portion of Carrying Costs and within ten
(10) days after such notice either (I) Tenant shall pay Landlord the amount by
which such actual Carrying Costs exceeded the estimated Carrying Costs paid by
Tenant for such period, or (II) Landlord shall pay Tenant the amount by which
the estimated Carrying Costs paid by Tenant exceeded the actual Carrying Costs
for such period. If taxes or other Carrying Costs allocable to Lot 27 for
such period are increased or decreased (for example, by a tax reduction or an
additional tax assessment) following completion of the reconciliation process
described in the preceding sentence, Landlord shall promptly notify Tenant in
writing of such further increase or decrease and the parties shall make any
further adjustment payments in cash in the same manner contemplated in the
preceding sentence. Not more frequently than every six (6) months, and if
Tenant is current in its payment of Carrying Costs with respect to Lot 27,
Tenant shall have the right to review and audit all data and documentation
underlying the calculation of Carrying Costs; in the event that such audit
discloses that Tenant has underpaid, Tenant shall pay any amount due within
ten (10) days, likewise, Landlord shall remit any overpayment within ten (10)
days; provided, however, that if Landlord disagrees with the results of
Tenant's audit, the matter shall be submitted to a Qualified CPA for binding
determination. If the parties cannot agree upon a Qualified CPA within ten
(10) days, then each party shall identify a Qualified CPA and the two
Qualified CPAs shall select a third Qualified CPA who shall make the
determination.
6.2 First Refusal Right.
-------------------
(a) Grant of Refusal Right; Sale/Development Restriction.
----------------------------------------------------
Commencing upon the expiration, termination or waiver of the Lot 27 Expansion
Option, Tenant shall have a First Refusal Right (the "Lot 27 Refusal Right") on
Lot 27 as set forth in this Paragraph 6.2, which Lot 27 Refusal Right expires
on the tenth (10th) anniversary of the Commencement Date of this Lease (the
term of the Lot 27 Refusal Right being the "Lot 27 Refusal Term"). Landlord
shall not sell or enter into any development or leasing agreement with respect
to Lot 27 for a period beginning on the date of this Lease and ending ten (10)
years after the Commencement Date, except in compliance with this Paragraph 6;
provided, however, that the foregoing restrictions shall not apply and Tenant
shall not have any rights with respect to Lots 27 or 26: (a) during any
period in which Tenant is in default under this Lease beyond any applicable
notice and cure period; (b) when this Lease is not in full force and effect;
or (c) after negotiations for a lease of Lot 27 shall have been terminated by
Landlord because of Tenant's bad faith in relation to such negotiations.
(b) First Refusal Right. If, during the Lot 27 Refusal Term (but
-------------------
while this Lease is in full force and effect), Landlord receives or delivers a
bona fide written offer which Landlord wishes to accept ("Offer") from or to
an unaffiliated person or entity other than Tenant (the "Offeror") to
purchase/sell or otherwise develop or lease Lot 27, and if Tenant is not then
in default under this Lease beyond any applicable notice and cure period,
Landlord shall give written notice of such Offer to Tenant, providing a copy
of such Offer specifying the material terms on which the Offeror proposes to
purchase or develop/lease Lot 27, and shall offer to Tenant the opportunity
to lease Lot 27 on the terms as described below (a "Lot 27 Offer
18
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Notice"). For purposes of this Paragraph 6.2(b), an offer shall be sufficient
if it is contained in a letter or other writing signed by the Offeror and
Landlord and specifies the material terms of such proposed purchase,
development or lease.
Tenant shall have thirty (30) days after the giving of a Lot 27 Offer
Notice by Landlord in which to accept such Offer by written notice to
Landlord.
(i) If Tenant does not accept Landlord's Offer within the
allotted time, Landlord shall thereafter have the right to sell, develop
or lease Lot 27 to or for the Offeror, as evidenced by a signed lease,
signed development or construction agreement or signed sales contract,
at any time within three hundred (300) days after Landlord's delivery of
the Lot 27 Offer Notice, at a price and on other terms and conditions
not more favorable to the Offeror than the price and other terms of the
original Offer specified in Landlord's Lot 27 Offer Notice. If Landlord
effects such a transaction, then Tenant shall have no further refusal
rights or other rights with respect to Lot 27; if Landlord does not
effect such transaction within such time, then Tenant's refusal right
and Landlord's obligation with respect thereto shall continue.
(ii) If Tenant accepts the Offer, then Lot 27 shall be
leased to Tenant as follows: (i) if the Offer is for a lease of Lot 27,
on the terms set forth in Landlord's notice, and the parties shall
promptly execute an agreement containing the terms of Landlord's said
notice and such other reasonable and customary terms as the parties
shall agree; or (ii) if the Offer is other than for a lease of Lot 27,
the Offer shall be appropriately adjusted to reflect a lease transaction
with the property valued as set forth in the Offer and with the lease
terms as otherwise specified in Paragraph 6.1(a)(ii) hereof.
7. EXPANSION RIGHTS -- LOT 26
--------------------------
7.1 First Refusal Right.
-------------------
(a) Grant of Refusal Right; Sale/Development Restriction. Tenant
----------------------------------------------------
shall have a First Refusal Right on Lot 26 as set forth in this Paragraph 7.1
(the "Lot 26 Refusal Right"), which Lot 26 Refusal Right commences on the date
hereof and expires on the earlier to occur of: (i) the expiration,
termination or waiver of the Lot 27 Expansion Option; (ii) the exercise of the
Lot 27 Expansion Option during the thirty (30) day period after Landlord has
delivered an Offer for Lot 26 pursuant to Paragraph 7.1(b)(i) (in which event
the terms of Paragraph 7.2 shall apply); (iii) the sale, lease or other
disposition of Lot 26 as permitted by this Paragraph 7; or (iv) the tenth
(10th) anniversary of the Commencement Date of this Lease (the term of the Lot
26 Refusal Right being the "Lot 26 Refusal Term"). If the Lot 27 Expansion
Option is exercised during a period of time when there is not a Lot 26 Offer
Notice pending with respect to which Tenant may exercise its Lot 26 Refusal
Right, then the Lot 26 Refusal Right shall continue in full force and effect,
subject to expiration or termination as provided for in this Lease. Landlord
shall not sell or enter into any development or leasing agreement with respect
to Lot 26 during the Lot 26 Refusal Term, except in compliance with this
Paragraph 7; provided, however, that the foregoing restrictions shall not
apply and Tenant shall not have any rights with respect to Lots 27 or 26: (a)
during any period in which Tenant is in default under this Lease beyond any
applicable notice and cure period; (b) when this Lease is not in full force
and effect; or (c) after negotiations for a lease of Lot 27 shall have been
terminated by Landlord because of Tenant's bad faith in relation to such
negotiations.
(b) First Refusal Right. If, during the Lot 26 Refusal Term,
-------------------
Landlord receives or delivers a bona fide written offer which Landlord wishes
to accept ("Offer") from or to an unaffiliated person or entity other than
Tenant (the "Offeror") to purchase/sell or otherwise develop or lease Lot 26,
and if Tenant is not then in default under this Lease beyond any applicable
notice and cure period, Landlord shall give written notice of such Offer to
Tenant providing a copy of such Offer specifying the material terms on which
the Offeror proposes to purchase or develop/lease Lot 26, and shall offer to
Tenant the opportunity to lease Lot 26 (or exercise the Lot 27 Expansion
Option) on the terms as described below (a "Lot 26 Offer Notice"). For
purposes of this Paragraph 7.1(b), an offer shall be sufficient if it is
contained in a letter or other writing signed by the Offeror and Landlord
and specifies the material terms of such proposed purchase, development or
lease.
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(i) During Pendency of Lot 27 Expansion Option. If the
------------------------------------------
Lot 26 Offer Notice is delivered while the Lot 27 Expansion Option is in
effect and unexercised, then Tenant shall have thirty (30) days after
delivery of the Lot 26 Offer Notice by Landlord during which to either:
(A) Exercise the Lot 27 Expansion Option by delivery
of a Lot 27 Exercise Notice to Landlord during such thirty (30) day
period, in which event Paragraphs 6.1 and 7.2 shall control and
have effect; or
(B) Decline, fail or refuse to exercise the Lot 27
Expansion Option, in which event, Landlord shall thereafter have
the right to sell, develop or lease Lot 26 to or for the Offeror,
as evidenced by a signed lease, signed development or construction
agreement or signed sales contract, at any time within three
hundred (300) days after Landlord's delivery of the Lot 26 Offer
Notice, at a price and on other terms and conditions not more
favorable to the Offeror than the price and other terms of the
original Lot 26 Offer Notice. If Landlord effects such a trans-
action, then Tenant shall have no further refusal rights or other
rights with respect to Lot 26; if Landlord does not effect such
transaction within such time, then Tenant's Lot 26 Refusal Right
and Landlord's obligation with respect thereto shall continue.
(ii) Other than During Pendency of Lot 27 Expansion Option.
-----------------------------------------------------
If the Lot 26 Offer Notice is delivered at any time after the Lot 27
Expansion Option has been effectively exercised and while the Lot 26
Refusal Right is in force, then Tenant shall have thirty (30) days after
the date of giving of such Lot 26 Offer Notice in which to accept such
Offer by written notice to Landlord.
(A) If Tenant does not accept Landlord's Offer within
the allotted time, Landlord shall thereafter have the right to sell,
develop or lease Lot 26 to or for the Offeror, as evidenced by a
signed lease, signed development or construction agreement or
signed sales contract, at any time within three hundred (300) days
after Landlord's delivery of the Lot 26 Offer Notice, at a price
and on other terms and conditions not more favorable to the Offeror
than the price and other terms of the original Offer specified in
Landlord's Lot 26 Offer Notice. If Landlord effects such a trans-
action, then Tenant shall have no further refusal rights or other
rights with respect to Lot 26; if Landlord does not effect such
transaction within such time, then Tenant's Lot 26 Refusal Right
and Landlord's obligation with respect thereto shall continue.
(B) If Tenant accepts the Offer, then Lot 26 shall be
leased to Tenant as follows: (i) if the Offer is for a lease of Lot
26, on the terms set forth in Landlord's notice, and the parties
shall promptly execute an agreement containing the terms of
Landlord's said notice and such other reasonable and customary
terms as the parties shall agree; or (ii) if the Offer is other
than for a lease of Lot 26, the Offer shall be appropriately
adjusted to reflect a lease transaction with the property valued
as set forth in the Offer and with the lease terms as otherwise
specified in Paragraph 7.2(b) hereof.
7.2 Exercise of Lot 27 Expansion Option During Pendency of Lot 27
-------------------------------------------------------------
Offer; Option on Lot 26. If Tenant shall exercise the Lot 27 Expansion
- -----------------------
Option during the thirty (30) days after Landlord's giving a Lot 26 Offer
Notice, then the Lot 26 Refusal Right shall terminate and be null and
void, and Tenant shall, instead, commencing at that date and continuing until
the first anniversary of the Commencement Date of the Lot 27 Lease (the "Lot
26 Exercise Period"), have the option to cause Landlord to develop Lot 26 and
to lease same ("Lot 26 Expansion Option") upon the terms and conditions of
this Paragraph 7.2. Landlord may elect to have an affiliate effect the
development of Lot 26, in which case, such affiliate shall be bound and
obligated by all the terms and conditions hereof relating to the development
and leasing of Lot 26.
(a) Exercise. Tenant shall exercise the Lot 26 Expansion Option by
--------
delivery of written notice to Landlord and the Lot 26 Owner during the Lot 26
Exercise Period ("Lot 26 Exercise Notice"); provided, however, that if Tenant
is in default under this Lease or the Lot 27
20
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Lease, beyond any applicable notice and cure period at the time of exercise of
the Lot 26 Expansion Option, then Landlord may, at its sole option, terminate
the Lot 26 Expansion Option which shall then, along with any exercise
thereof, be null and void. Such Lot 26 Exercise Notice shall include a s
tatement of the gross square footage which Tenant seeks to have developed on
Lot 26 (the "Lot 26 Expansion Building") and Tenant's proposed Lot 26
Expansion Building Delivery Date; the development of Lot 26 shall consist of
a single building which shall not be less than 60,000 square feet nor more
than 65,000 square feet unless Landlord and Tenant consent. The term of the
lease shall not be less than fifteen (15) years.
(b) Effect of Exercise. In the event Tenant effectively exercises
------------------
the Lot 26 Expansion Option, Landlord and Tenant shall enter into, within
sixty (60) days thereafter:
(i) a work letter regarding construction of the Lot 26
Expansion Building on Lot 26, with such terms and conditions as are
mutually agreed to between Landlord and Tenant substantially in the
form of the Work Letter, provided, however, that: (A) Tenant shall pay
for twenty-five percent (25%) of any Interior Improvements in excess of
Ten Dollars ($10.00) per square foot in lieu of the Tenant Contribution
provided for in the Work Letter, but Landlord's obligation to pay for
Interior Improvements shall not exceed One Hundred Dollars ($100) per
square foot; and (B) the Lot 26 Expansion Building Delivery Date shall
be mutually agreed upon but shall be no earlier than nine (9) months and
no later than twenty one (21) months after execution of the Lot 26 Lease,
all subject to Force Majeure and Tenant Delay;
(ii) a lease (the "Lot 26 Lease") substantially in the
same form as this Lease other than with respect to Rent, to obligations
relating to the Matrix Lease or any other lease of Tenant and to such
other modifications as are necessary; provided, however, that this Lease
shall not be modified so as to be co-terminus with such lease.
(iii) any other documentation reasonably required by Tenant,
Landlord or Landlord's prospective lender.
Rent shall be calculated on the same basis as Rent is calculated pursuant to
this Lease; the Total Project Cost for such purpose shall also include the
actual cost of Lot 26, which is $1,890,000, plus an amount equal to the
following: (A) the Carrying Costs of Lot 26; plus (B) $126,000 (being $2.00
for each of the 63,000 square feet of building area allocated to Lot 26); and
(C) minus any portion of Carrying Costs paid by Tenant to Landlord pursuant to
Paragraph 7.3 hereof. Landlord and Tenant shall enter into a lease and work
letter within such sixty (60) day period. If either party fails or refuses to
enter into such agreements in bad faith, the other party may terminate
negotiations and, if negotiations are terminated by Landlord, Tenant's right
to utilize or lease Lot 26 shall terminate.
7.3 Carrying Costs. As consideration for Landlord's grant of the Lot
---------------
26 Expansion Option, Tenant shall pay or reimburse to Landlord one-half (1/2)
of all Carrying Costs for Lot 26 incurred by Landlord during or with respect
to the period from the Commencement Date of the Lot 27 Lease until the
expiration of the Lot 26 Expansion Option; provided, however, that such
payments shall continue during the period of any extension of the Lot 26
Expansion Option and, if the Lot 26 Expansion Option is exercised, until a
lease for Lot 26 is executed and provided further that Tenant may at any time
waive the Lot 26 Expansion Option by written notice to Landlord, in which
case Tenant's obligation to pay such share of Carrying Costs shall terminate
thirty (30) days after the date of the notice. Tenant shall pay one-half
(1/2) of Landlord's estimate of the Carrying Costs to Landlord on a monthly
basis, in advance, on the due date for the monthly installments of Rent; such
payment shall be based upon Landlord's estimate which shall show the separate
components on a line item basis and shall show the calculations of any
calculated amount. Any failure to pay its portion of Carrying Costs for a
period of ten (10) days after written notice of such failure from Landlord
shall be deemed to be a waiver by Tenant of its rights under this Paragraphs
6 and 7. Within ten (10) days after the end of the period for which Tenant
is to pay a portion of Carrying Costs for Lot 26, Landlord shall notify Tenant
in writing of Landlord's actual Carrying Costs for Lot 26 for the period with
respect to which Tenant is to pay a portion of Carrying Costs and within ten
(10) days after such notice either (I) Tenant shall pay Landlord the amount
by which such actual Carrying Costs exceeded the estimated Carrying Costs
paid by Tenant for such period, or (II) Landlord shall pay Tenant the amount
by which the
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<PAGE>
estimated Carrying Costs paid by Tenant exceeded the actual Carrying Costs for
such period. If taxes or other Carrying Costs allocable to Lot 26 for such
period are increased or decreased (for example, by a tax reduction or a
additional tax assessment) following completion of the reconciliation process
described in the preceding sentence, Landlord shall promptly notify Tenant
in writing of such further increase or decrease and the parties shall make any
further adjustment payments in cash in the same manner contemplated in the
preceding sentence. Not more frequently than every six (6) months, and if
Tenant is current in its payment of Carrying Costs with respect to Lot 26,
Tenant shall have the right to review and audit all data and documentation
underlying the calculation of Carrying Costs; in the event that such audit
discloses that Tenant has underpaid, Tenant shall pay any amount due within
ten (10) days, likewise, Landlord shall remit any overpayment within ten (10)
days; provided, however, that if Landlord disagrees with the results of
Tenant's audit, the matter shall be submitted to a Qualified CPA for binding
determination. If the parties cannot agree upon a Qualified CPA within ten
(10) days, then each party shall identify a Qualified CPA and the two
Qualified CPAs shall select a third Qualified CPA who shall make the
determination.
7.4 Paydown. Tenant shall have the right at any time prior to the
-------
Commencement Date of the Lot 26 Lease to reimburse Landlord in cash for a
portion of the Total Project Cost of Lot 26, up to a maximum of fifteen
percent (15%) of the Total Project Costs for Lot 26. If Tenant elects
to do so, for purposes of determining rent for Lot 26, the Total Project Costs
for Lot 26 shall be reduced by the amount so paid by Tenant.
8. TAXES
-----
8.1 Personal Property. Tenant shall be responsible for and shall pay
-----------------
prior to delinquency all taxes and assessments levied against or by reason
of (a) any and all alterations, additions and items installed or placed on
the Property and taxed as personal property rather than as real property,
and/or (b) all personal property, trade fixtures and other property placed by
Tenant on or about the Property. Upon request by Landlord, Tenant shall
furnish Landlord with satisfactory evidence of Tenant's payment thereof. If
at any time during the term of this Lease any of said alterations, additions
or personal property, whether or not belonging to Tenant, shall be taxed or
assessed as part of the Property, then such tax or assessment shall be paid
by Tenant to Landlord immediately upon presentation by Landlord of copies of
the tax bills in which such taxes and assessments are included and shall, for
the purposes of this Lease, be deemed to be personal property taxes or
assessments under this Paragraph 8.1.
8.2 Real Property. Taxes shall mean all taxes and assessments levied
-------------
against the Property, including, but not limited to, real and personal
property taxes and assessments or substitutes therefor levied or assessed
against the Property or any part thereof, including but not limited to any
possessory interest, use, business, license or other taxes or fees, any taxes
imposed directly on rents or services, any assessments or charges for police
or fire protection, housing, transit, open space, street or sidewalk
construction or maintenance or other similar services from time to time by
any governmental or quasi governmental entity, and any other new taxes
on Landlords in addition to taxes now in effect. Taxes shall not include,
however, any tax on income or the like of Landlord or any use, business,
license or other tax or fee not directly imposed on the ownership of the
Property or on rent. Tenant shall pay to Landlord on the first day of each
calendar month of the term of this Lease, one-twelfth (1/12) of Landlord's
good faith estimate of all taxes and assessments levied or to be levied on the
Property for such calendar year; unless Landlord is required to deposit real
estate tax estimates with any mortgage lender (and Landlord shall use its good
faith best efforts to persuade any such mortgage lender to waive any real
estate tax escrow requirement), Landlord shall hold Tenant's monthly payment
of Taxes in an interest bearing account with interest for the benefit of
Tenant. Landlord shall advise Tenant, from time to time, of Landlord's
estimate of taxes to be paid. During the first five years of the term of this
Lease, Tenant shall not be required to pay any portion of Taxes which are
attributable to a change in ownership of the Property. At no time shall
Tenant be responsible for any Taxes attributable to the third or subsequent
change of ownership of the Property during the initial term of this Lease nor
during the second or subsequent change of ownership during the extension terms
of this Lease.
22
<PAGE>
9. OPERATING EXPENSES
------------------
9.1 Liability For Operating Expenses.
--------------------------------
(a) Tenant shall pay to Landlord, at the time and in the manner
hereinafter set forth, an amount equal to one hundred percent (100%)
("Tenant's Operating Cost Share") of the Operating Expenses defined in
Paragraph 9.2.
(b) If Landlord incurs Operating Expenses for the Property and
Parcels other than the Site (consisting only of maintenance of landscaping,
maintenance of the jogging trail and paved areas, insurance expenses, any cost
resulting from the Existing CC&R's, or any other expense imposed by any
governmental body with authority over the Property and the Torrey Pines
Science Center) on a basis which does not separate those attributable to the
Property, Landlord shall make a reasonable determination regarding the
appropriate treatment of such expense items that are allocable both to the
Site and to any such additional buildings or properties. In determining such
percentage, a building shall be taken into account from and after the earlier
of (a) the date such expenses are first incurred with respect to such other
properties or (b) the date on which a tenant first enters into possession of
the building or a portion thereof, and the square footage of any such building
shall be measured or determined in accordance with the same standard
applicable to the measurement of the Initial Building. All such expenses
shall be allocated to the Initial Building based on the square footage thereof
relative to the square footage within and planned to be within the Parcels.
(c) Tenant shall pay the Management Fee to Landlord as part of
Operating Expenses. Landlord shall provide, or cause another entity to
provide, periodic reviews of the Property, payment of taxes and other Operating
Expenses, provision of Operating Expense Statements and effectuation of
repairs for which Landlord is responsible pursuant to this Lease.
9.2 Definition Of Operating Expenses.
--------------------------------
(a) Subject to the exclusions and provisions hereinafter contained,
the term "Operating Expenses" shall mean the total costs and expenses, capital
and ordinary, actually and reasonably incurred by or allocable to Landlord for
operation and maintenance of the Improvements and the Property, including
without limitation, costs and expenses of (i) operation, repair and
maintenance of the roof, exterior walls and other structural portions and
operating systems (including HVAC) of the Initial Building, provided that any
portion of such that is of a "capital" nature pursuant to the terms hereof,
shall be amortized as provided herein; (ii) liability, casualty, rent loss or
other insurance (including, but not limited to, earthquake insurance and
environmental insurance if Landlord elects to carry such insurance, which it
is Landlord's present intention to do) carried by Landlord with respect to the
Property, the Improvements or any portion thereof subject to Paragraph 14.1(b)
below; (iii) supplies, equipment, utilities and tools used in operation,
repair and maintenance of the roof (structural portions only), exterior walls
and other structural portions of the Initial Building; (iv) capital
improvements and repairs to the Property or the Improvements, amortized over
their respective useful lives (including, but not limited to those, (aa) which
reduce or will cause future reduction of other items of Operating Expenses for
which Tenant is otherwise required to contribute (but not in excess of the
cost savings realized) or (bb) which are required by law, ordinance,
regulation or order of any governmental authority enacted after the date of
this Lease); (v) the Management Fee; (vi) maintenance and repair of the
parking areas, driveways and paved areas outside the Initial Building; (vii)
any obligations of Landlord pursuant to Paragraph 12.1 hereof; and (viii) any
other costs (including, but not limited to, any parking or utilities fees or
surcharges) allocable to or paid by Landlord, as owner of the Property or
Improvements, pursuant to the Existing CC&Rs or to any applicable laws,
ordinances, regulations or orders of any governmental or quasi-governmental
authority, including without limitation any fees or assessments imposed by the
Torrey Pines Science Center Association. The distinction between items of
ordinary operating maintenance and repair and items of a capital nature shall
be made in accordance with generally accepted accounting principles applied on
a consistent basis by Landlord's accountants. Capital expenses authorized to
be included as part of Operating Expenses shall be amortized over the actual
useful life of such capital items. Landlord shall seek to have all
contracts in connection with Operating Expenses be at reasonable prices,
seeking competitive bids when Landlord deems same appropriate; all of the
foregoing is subject, however, to Landlord's use of contractors,
23
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subcontractors and labor which meets the requirements of Paragraph 2 of
Exhibit K annexed hereto.
(b) Operating Expenses shall not include: (a) any capital cost,
expense or improvement other than those expressly authorized above; (b) the
cost of any services, utilities or materials not provided to Tenant or not
used with respect to the Property, including, without limitation, the cost of
electricity, heating, ventilation and air conditioning (including all
maintenance, repair and similar costs associated therewith) and janitorial
services provided to the premises of any other tenants; (c) the cost of
investigating, monitoring or remedying any environmental condition or
hazardous substances presently existing or introduced to the Property by
Landlord; (d) any debt service (including principal and interest) or payments
of any judgments against Landlord or mechanics liens unless attributable to
actions or failures to act of Tenant; (e) any costs arising from a breach or
default by Landlord under this Lease or any other lease or agreement; (f) the
cost of curing violations or contesting such laws or violations caused by
Landlord or the costs of any voluntary traffic mitigation actions; (g) costs,
damage or repairs caused by or necessitated by the negligence or willful
misconduct of Landlord or its agents, contractors or employees; (h) any costs
which would have been reimbursed or paid for by warranties or by insurance
proceeds had Landlord maintained the insurance required under this Lease or
for any amounts with respect to judgments or other charges assessed against
Landlord in excess of insurance policy limits (including, without limitation,
any liability policy); (i) any costs reimbursed to Landlord by any other
tenant other than through the payment of Operating Expenses; (j) any costs to
renovate, decorate or paint vacant space or the space of any tenant (except
Tenant or any assignee or sublessee of Tenant or any person or entity
utilizing the Property under Tenant's right); (k) costs incurred in connection
with leases or construction of the Project or any other improvements within
the Parcels (including initial landscaping and paved areas) for any tenant or
occupant of the Parcels including Tenant (including, without limitation,
brokerage commissions and legal fees); (l) costs incurred in connection with a
financing, sale, ground leasing or sale-leaseback of all or any part of the
Parcels; (m) costs incurred in connection with lawsuits or other legal actions
(including, without limitation, arbitrations and mediation) instituted or
defended by Landlord unless Tenant is obligated under Paragraph 14.4(a) to
indemnify Landlord for the same; (n) sums incurred as late payment fees,
penalties or interest; (o) ground rent; or other ground lease payments; (p)
depreciation of any equipment or all or any part of the Initial Building or
any other improvements; (q) Landlord's advertising, entertainment and
promotional costs, including any political or charitable contributions; (r)
costs of acquiring, leasing, restoring, insuring or displaying sculptures,
paintings and other objects of art located within or outside the Parcels,
unless such object is contemplated in the Project Budget or approved by Tenant
in writing; (s) costs and expenses payable to Landlord or to an affiliate of
Landlord to the extent that such costs and expenses exceed competitive costs
and expenses for materials and services by unrelated persons or entities of
similar skill and experience; (t) repairs or replacements resulting from
latent defects in the design or construction of any Improvements unless the
design responds to and satisfies any performance criteria provided by Tenant
and otherwise is not defective; (u) any defect in construction of the Initial
Building (which is the fault of Landlord or its contractors, agents or
employees); and (v) any cost or expense relating to administration and
management, including but not limited to overhead, wages, salaries, other
compensation and benefits, office rental, office supplies, dues and
subscriptions, office utility charges, telephone charges and automobile
expenses other than the Management Fee (collectively, the "Excluded
Expenses"). In calculating Operating Expenses, no item charged to Tenant as
an Operating Expense or Building Expense shall be charged to Tenant as any
other type of expense or cost which, under the terms of this Lease, can be
charged to Tenant.
9.3 Determination and Payment Of Operating Expenses. Tenant shall pay
-----------------------------------------------
to Landlord on the first day of each calendar month of the term of this Lease,
one twelfth (1/12th) of Landlord's good faith estimate of Tenant's Operating
Expenses with respect to the Property for such calendar year. Landlord shall
advise Tenant, from time to time of Landlord's estimate of Operating Expenses,
either increasing or decreasing same; Landlord shall not modify its estimate
of Operating Expenses unless, in its good faith judgment, due to unanticipated
events, the aggregate of Operating Expenses for the particular year shall
change by twenty percent (20%) or more from the previous estimate.
24
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(a) Within ninety (90) days after the conclusion of each
calendar year, Landlord shall furnish to Tenant a statement (the "Annual
Operating Expense Statement") showing in reasonable detail including a
separate line item breakdown of each component of Operating Expenses, the
actual Operating Expenses for the previous calendar year, which were billed
to Tenant by Landlord. Any additional sum due from Tenant to Landlord shall be
due and payable within thirty (30) days of Tenant's receipt of such statement.
If the amounts paid by Tenant pursuant to this Paragraph 9.3 exceed Tenant's
Operating Expenses for the previous calendar year, Landlord shall accompany
said statement with payment for the amount of such difference.
(b) Any amount due under this Paragraph 9.3 for any period
which is less than a full month shall be prorated for such fractional month.
(c) Provided that Tenant shall have paid in full any amount
due from it reflected on the Annual Operating Expense Statement, Tenant shall
be entitled within one hundred twenty (120) days after receipt of the Annual
Operating Expense Statement, upon reasonable written notice to Landlord and
during normal business hours at Landlord's office in San Diego County, to copy,
inspect and examine those books and records of Landlord relating to the
determination and payment of Operating Expenses relating to this Lease, the
Property and/or any other properties described in Paragraph 9.1(b). If, after
inspection and examination of such books and records, Tenant disputes the
amount of any such Operating Expenses charged by Landlord and the parties are
not able to resolve such dispute by good faith negotiations within thirty (30)
days after Tenant notifies Landlord in writing of the disputed items, then
Tenant may, by written notice to Landlord, request an independent audit of
such books and records. The independent audit of the books and records shall
be conducted by a certified public accountant acceptable to both Landlord and
Tenant or, if the parties are unable to agree, by a "Big Six" accounting firm
designated by Landlord and not then employed by Landlord or Tenant. The audit
shall be limited to the determination of the amount of Operating Expenses
specified by Tenant in its notice of objection. If the audit discloses that
the amount of Operating Expenses billed to Tenant was in excess of the actual
amounts incurred by Landlord, Landlord shall promptly pay to Tenant the
overpayment. All costs and expenses of the audit shall be paid by Tenant
unless the audit shows that Landlord overstated Operating Expenses covered by
the audit by more than five percent (5%), in which case Landlord shall pay all
reasonable costs and expenses of the audit.
9.4 Proration. If the Commencement Date falls on a day other than the
---------
first day of an insurance coverage period, tax fiscal year or other period to
which an Operating Expense or Building Expense is allocable or attributable,
or if this Lease terminates on a day other than the last day of an insurance
coverage period, tax fiscal year or other period to which an Operating
Expense or Building Expense is allocable or attributable, then the amount of
Operating Expenses payable by Tenant with respect to such first or last
partial insurance coverage period, tax fiscal year or other period shall
be prorated on the basis which the number of days during such insurance
coverage period, tax fiscal year or other period in which this Lease is in
effect bears to the total number of days in such insurance coverage period,
tax fiscal year or other period. The obligation of Tenant to pay Operating
Expenses that occur during the Lease Term shall survive the termination of
this Lease by lapse of time or otherwise.
10. UTILITIES
---------
10.1 Payment. Commencing with the Commencement Date and thereafter
-------
throughout the term of this Lease, Tenant shall pay before delinquency, all
charges for water, gas, heat, light, electricity, power, sewer, telephone,
alarm system, janitorial and other services or utilities supplied to or
consumed in or upon the Property, including any taxes on such services and
utilities.
10.2 Interruption. In the event of interruption or failure of any
------------
service or utility furnished to or used in the Property for any reason
whatsoever, including, but not limited to, accident, making of repairs,
alterations or improvements, severe weather, difficulty or inability in
obtaining services or supplies, labor difficulties or any other cause (an
"Interruption") for more than five (5) consecutive days, the same shall cause
Rent and other charges required to be paid hereunder to abate, effective the
date such Interruption begins, but Landlord shall not be liable in
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damages or otherwise. Notwithstanding the foregoing, Tenant shall not be
entitled to any abatement (a) to the extent any such Interruption is caused by
the negligence or willful misconduct of Tenant or its agents, employees or
contractors or (b) to the extent such Interruption does not interfere with
Tenant's use of the Property. Tenant acknowledges and agrees that it shall
co-insure or self-insure against any risks it determines are necessary to be
insured against pursuant to this Paragraph 10.2. Notwithstanding anything to
the contrary contained in this Paragraph 10.2, in the event an Interruption
occurs and continues unabated for (a) ninety (90) consecutive days for an
Interruption that occurs during the last two (2) years of the term of this
Lease or (b) nine (9) consecutive months for an Interruption that occurs any
other time during the term of this Lease, then in either such event, Tenant
shall have the right to terminate this Lease.
11. ALTERATIONS; SIGNS
------------------
11.1 Right To Make Alterations. Tenant shall make no alternations,
-------------------------
additions or improvements, either with respect to initial occupancy or
subsequent thereto, to the Premises (other than interior, non-structural
alterations costing less than Twenty-Five Thousand Dollars ($25,000) in a
given instance) without the prior written consent of Landlord, which consent
shall not be unreasonably withheld or delayed and shall be deemed to be given
unless Landlord shall deliver to Tenant written notice of disapproval within
fifteen (15) days of receipt of Tenant's notice or request. All such
alterations, additions and improvements shall be completed with due diligence
in a first-class workmanlike manner, and if Landlord's consent is required as
above, in compliance with plans and specifications approved in writing by
Landlord, and in compliance with all applicable laws, ordinances, rules and
regulations and to the extent Landlord's consent is not otherwise required
hereunder for such alterations, additions or improvements, Tenant shall give
prompt written notice thereof to Landlord for purposes of Paragraph 11.2
hereof. In view of the requirement for first-class workmanship, any such
alterations, additions or improvements which involve the use of a contractor
or subcontractor shall be performed by a contractor or subcontractor that
employs skilled union labor, as further explained in Exhibit "K."
Tenant shall cause any contractors engaged by Tenant for work on the
Property to maintain public liability and property damage insurance, naming
Landlord and to the extent available its partners, shareholders, agents,
property manager and employees as additional insureds, and shall furnish
Landlord with certificates of insurance or other evidence that such coverage
is in effect. Notwithstanding any other provisions of this Paragraph 11.1,
under no circumstances shall Tenant make any structural alterations or
improvements, or any substantial changes to the roof or substantial equipment
installations on the roof, or any substantial changes or alterations to
building systems (other than the distribution portion thereof), without
Landlord's prior written consent.
For any individual project costing more than Twenty-Five Thousand Dollars
($25,000.00), Tenant shall maintain, and shall provide copies to Landlord of,
all plans, specifications, drawings (including, particularly, "as-builts") of
any and all improvements, alterations, additions, renovations, repairs,
installations of fixtures or other equipment and the like; Landlord shall be
permitted to observe any and all such work by Tenant on the Property in
accordance with the requirements of Paragraph 16.1. For purposes of this
Paragraph 11, the term "building systems" shall refer to the central plant
portions of the mechanical, electrical and heating, ventilation and air
conditioning systems of the Initial Building. Notwithstanding any provision
herein to the contrary, at the termination or expiration of this Lease, Tenant
shall provide Landlord with final, as-built, plans, specifications and
drawings of all alternations effected by Tenant.
11.2 Title To Alterations. All alterations, additions and
--------------------
improvements installed in, on or about the Property shall be part of the
Improvements and the property of Landlord, unless Landlord elects at the time
Tenant requests consent to require Tenant to remove the same upon the
termination of this Lease; provided, however, that the foregoing shall not
apply (i) to Tenant's equipment, furniture and trade fixtures, or (ii) to
any of the Interior Improvements (as defined in Exhibit C hereto), or any
subsequent improvements installed by Tenant at its own expense, which are
movable without material damage, are not an integral part of the
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Initial Building's structure or interior architectural improvements, and are
not an integral part of the Initial Building's HVAC, plumbing or electrical
systems or other standard operating systems. All of such items described in
clause (i) or (ii) of the preceding sentence (in all events including, but
not limited to, lab benches, fume hoods and cold rooms) may (and, if duly
elected by Landlord hereunder, shall) be removed by Tenant prior to or upon
the termination of this Lease. Tenant shall promptly repair any damage
caused by its removal of any such improvements. Notwithstanding anything to
the contrary contained herein, in no event shall Landlord have the right to
require Tenant to remove any of the Interior Improvements.
11.3 Tenant Fixtures. Notwithstanding the provisions of Paragraph 11.1
---------------
and 11.2, Tenant may install, remove and reinstall equipment, furniture and
trade fixtures without Landlord's prior written consent, except that any
fixtures which are affixed to the Property or which affect the exterior or
structural portions of the Initial Building or the building systems shall
require Landlord's written approval. The foregoing shall apply to Tenant's
signs, logos and insignia, all of which Tenant shall have the right to place
and remove and replace (a) only with Landlord's prior written consent as to
location, size and composition, which consent shall not be unreasonably
withheld or delayed, and (b) only in compliance with all restrictions and
requirements of applicable law and of any Existing CC&Rs applicable to the
Property. Notwithstanding the foregoing, Tenant shall have the right, in it
sole discretion, to direct Landlord to remove Tenant's signage at the
expiration or earlier termination of this Lease. Tenant shall remove all
such trade fixtures, signs, logos and insignia prior to or at the expiration
or earlier termination of the term of this Lease. Tenant shall immediately
repair any damage caused by installation and removal of fixtures under this
Paragraph 11.3. Landlord waives any Landlord's lien on any equipment,
furnishings, trade fixtures, inventory or other personal property of Tenant;
provided, however, that Landlord retains its lien and all rights it has
hereunder, at law or in equity with respect to any item in which Landlord
expressly has ownership rights under this Lease.
11.4 No Liens. Tenant shall at all times keep the Property free from
--------
all liens and claims of any contractors, subcontractors, materialmen,
suppliers or any other parties employed either directly or indirectly by
Tenant in construction work on the Property. Tenant may contest any claim of
lien, but only if, prior to such contest, Tenant either (i) posts security in
the amount of the claim, plus estimated costs and interest, or (ii) records a
bond of a responsible corporate surety in such amount as may be required to
release the lien from the Property. Tenant shall indemnify, defend and hold
Landlord harmless against any and all liability, loss, damage, cost and other
expenses, including, without limitation, reasonable attorneys' fees, arising
out of claims of any lien for work performed or materials or supplies
furnished at the request of Tenant or persons claiming under Tenant.
11.5 Signs. Without limiting the generality of the provisions of
-----
Paragraph 11.3 hereof, Tenant shall have the exclusive right to display only
its sign on the Site and on the Initial Building, subject to Landlord's prior
approval as to location, size and composition (which approval shall not be
unreasonably withheld or delayed) and subject to all restrictions and
requirements of applicable law and of any Existing CC&Rs applicable to the
Property. Subject to the conditions concerning the foregoing, Tenant may
also erect a monument sign containing its name at the entry to the Site as
part of Landlord's Work. Landlord shall use its reasonable best efforts to
obtain the necessary governmental or administrative approvals in order to
allow Tenant to have its name on the Building, subject to Landlord's approval
of signage as provided herein.
12. MAINTENANCE AND REPAIRS
-----------------------
12.1 Landlord's Work. Landlord shall repair and maintain or cause to be
---------------
repaired and maintained the roof, exterior walls and other structural portions
of the Initial Building, the parking areas, driveways and paved areas outside
the Initial Building. The actual cost of all work performed by Landlord under
this Paragraph 12.1 shall be included in Operating Expenses hereunder, except
to the extent such work (i) is required due to the negligence of Landlord, or
(ii) that portion of any expense that is an Excluded Expense.
12.2 Tenant's Obligation For Maintenance.
-----------------------------------
(a) Good Order, Condition And Repair. Except as provided in
--------------------------------
Paragraph 12.1
27
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hereof, Tenant at its sole cost and expense shall keep and maintain in good
and sanitary order, condition and repair the Property and every part thereof,
wherever located (normal wear and tear, damage and destruction by casualty
and condemnation excepted) the nonstructural portions of the Initial
Building, including but not limited to signs, interior, ceiling, electrical
system, plumbing system, life safety and telephone and communications systems
of the Initial Building, the HVAC equipment and related mechanical systems
serving the Initial Building (for which equipment and systems Tenant shall
enter into a service contract with a person or entity designated or approved
by Landlord), the items referred to in Paragraph 9.2(b) hereof, all doors,
door checks, windows, plate glass, door fronts, plumbing and sewage and
other utility facilities, fixtures, lighting, wall surfaces, floor surfaces
and ceiling surfaces of the Initial Building under or within the Initial
Building and all other interior repairs, foreseen and unforeseen, with
respect to the Initial Building, as required.
(b) Remedy. If either party, after notice from the other, fails
------
to promptly commence and thereafter proceed with reasonable diligence to
complete any material repairs, maintenance, or replacements which are the
obligation of such party hereunder, such failure shall be deemed a material
default by such party under this Lease and the other party shall have the
right, but shall not be required, to enter the Property and perform such work.
Immediately on demand from performing party, the cost of such repairs shall
be due and payable by the defaulting party. In the event of the reasonable
possibility of immediate injury to person or substantial harm to property,
either party may proceed to effect necessary repairs on an emergency basis,
providing notice to the other party as promptly as possible; in all other
circumstances, the party with the obligation to effect repair shall be
provided with written notice specifying a reasonable amount of time in which
to commence such repair, and such obligated party shall proceed with the
repairs with due diligence.
(c) Condition Upon Surrender. At the expiration or earlier
------------------------
termination of this Lease, in addition to any other obligations of Tenant
with respect to surrender and vacation of the Property in Paragraphs 2.6,
11.2, 13.5, 17.1 and 17.2. Tenant shall surrender the Property, including
any additions, alterations and improvements thereto, in good and sanitary
order, condition and repair, ordinary wear and tear, damage and destruction
by casualty and condemnation excepted, first, however, removing all goods and
effects of Tenant and all and fixtures and items required to be removed
pursuant to this Lease (including, but not limited to, any such removal
required as a result of an election by Landlord to require such removal as
contemplated in Paragraph 11.2), and repairing any damage caused by such
removal. At least thirty (30) days before the expiration or sooner
termination of this Lease, Landlord and Tenant shall conduct a walk-through
inspection of the Site and shall effect a preliminary identification of items
which Tenant is required to repair. Within seven (7) days after the date
that Tenant shall vacate the Premises, Landlord and Tenant shall conduct
another walk-through inspection of the Site and shall update, and
appropriately modify, the list of items requiring repair (including, repairs
on the initial list which were not completed and any repairs newly added).
Upon delivery to Tenant of such list, Tenant shall elect either (i) to effect
such repairs at Tenant's expense, or (ii) to request Landlord to effect such
repairs at Tenant's expense. Upon completion of all of such repairs to
Landlord's reasonable satisfaction, Tenant shall have no further obligations
to Landlord hereunder, except with respect to environmental matters specified
in Paragraph 13.5 hereof and with respect to conditions that are not
susceptible of discovery by a reasonably diligent and thorough, but non-
invasive, investigation. Tenant expressly waives any and all interest in any
fixtures and building systems (and their components), and in any personal
property and trade fixtures not removed from the Property by Tenant at the
expiration or termination of this Lease, agrees that any such personal
property and trade fixtures may, at Landlord's election, be deemed to
have been abandoned by Tenant, and authorizes Landlord (at its election and
without prejudice to any other remedies under this Lease or under applicable
law) to remove and either retain, store or dispose of such property at
Tenant's cost and expense, and Tenant waives all claims against Landlord for
any damages resulting from any such removal, storage, retention or disposal.
The provisions of Paragraph 13.5(c) shall also apply.
13. USE OF PROPERTY
---------------
13.1 Permitted Use. Subject to Paragraphs 13.3 and 13.4 hereof, Tenant
-------------
shall use the Property solely as a medical and biological research lab with
light production and manufacturing,
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<PAGE>
together with administrative, office and storage uses and for any other
purpose in accordance with the Scientific Research Zoning Ordinance of the
City of San Diego and the Torrey Pines Science Center Planned Industrial
Development, and for no other purpose without Landlord's written consent
(not to be unreasonably withheld or delayed).
13.2 No Nuisance. Tenant shall not use the Property for or carry on or
-----------
permit upon the Property or any part thereof any nuisance, nor commit or
allow to be committed any waste in, on or about the Property. Tenant shall
not do or permit anything to be done in or about the Property, nor bring nor
keep anything therein, which is not appropriate as a permitted use and will
in any way cause the Property to be uninsurable with respect to the insurance
required by this Lease.
13.3 Compliance With Laws. Tenant shall not use the Property or permit
--------------------
the Property to be used in whole or in part for any purpose or use that is in
violation of any applicable laws, ordinances, regulations or rules of any
governmental agency or public authority. Tenant shall keep the Property
equipped with all safety appliances required by law, ordinance or insurance
on the Property, or any order or regulation of any public authority, because
of Tenant's particular use of the Property. Tenant shall procure all
licenses and permits required for its particular use of the Property. Tenant
shall use the Property in accordance with all applicable ordinances, rules,
laws and regulations and shall comply with all requirements of all
governmental authorities now in force or which may hereafter be in force
pertaining to its particular use of the Property, including, without
limitation, regulations applicable to noise, water, soil and air pollution,
and making such nonstructural alterations and additions thereto as may be
required from time to time by such laws, ordinances, rules, regulations and
requirements of governmental authorities or insurers of the Property
(collectively, "Requirements") because of Tenant's construction of
improvements in or its particular use of the Property. Any structural
alterations or additions required from time to time by applicable Requirements
because of Tenant's construction of improvements in or other particular use of
the Property shall be made by Tenant, at Tenant's sole cost and expense, in
accordance with the procedures and standards set forth in Paragraph 11.1 for
alterations by Tenant and upon prior written notice to Landlord. The judgment
of any court, or the admission by Landlord or Tenant in any proceeding against
Landlord or Tenant, that Landlord or Tenant has violated any law, statute,
ordinance or governmental rule, regulation or requirement shall be conclusive
of such violation as between Landlord and Tenant.
13.4 Liquidation Sales. Tenant shall not conduct or permit to be
------------------
conducted any auction, bankruptcy sale, liquidation sale, or going out of
business sale, in, upon or about the Property, whether said auction or sale
be voluntary, involuntary or pursuant to any assignment for the benefit of
creditors, or pursuant to any bankruptcy or other insolvency proceeding.
13.5 Environmental Matters.
---------------------
(a) For purposes of this Paragraph, "hazardous substance" shall
mean the substances included within the definitions of the term "hazardous
substance" under (i) the Comprehensive Environmental Response, Compensation
and Liability Act of 1980, as amended, 42 U.S.C. Section 9601 et seq., and the
regulations promulgated thereunder, as amended, (ii) the California
Carpenter-Presley-Tanner Hazardous Substance Account Act, California Health &
Safety Code Section 25300 et seq., and regulations promulgated thereunder, as
amended, (iii) the Hazardous Materials Release Response Plans and Inventory
Act, California Heath & Safety Code Section 25500 et seq., and regulations
promulgated thereunder, as amended, and (iv) petroleum; "hazardous waste"
shall mean (i) any waste listed as or meeting the identified characteristics
of a "hazardous waste" under the Resource Conservation and Recovery Act of
1976, 42 U.S.C. Section 6901 et seq., and regulations promulgated pursuant
thereto, as amended (collectively, "RCRA"), (ii) any waste meeting the
identified characteristics of "hazardous waste;" "extremely hazardous waste"
or "restricted hazardous waste" under the California Hazardous Waste Control
Law, California Health & Safety Code Section 25100 et seq., and regulations
promulgated pursuant thereto, as amended (collectively, the "CHWCL"), and/or
(iii) any waste meeting the identified characteristics of "medical waste"
under California Health & Safety Code Sections 25015-25027.8, and regulations
promulgated thereunder, as amended; and "hazardous waste facility" shall
mean a hazardous waste facility as defined under the CHWCL.
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(b) Without limiting the generality of the obligations set forth
in Paragraph 13.3 of this Lease:
(i) Tenant covenants not to cause or permit any hazardous
substance or hazardous waste to be brought upon, kept, stored or used in or
about the Property without the prior written consent of Landlord, which
consent shall not be unreasonably withheld or delayed and shall be deemed to
be given unless Landlord shall deliver to Tenant written notice of disapproval
within ten (10) days of receipt of Tenant's notice or request, which notice
or request shall include written evidence of Tenant's compliance with any
permit process with which Tenant is required to comply, including without
limitation, submission of MSDS's, and except that Tenant, in connection with
its permitted use of the Property as provided in Paragraph 13.1, may keep,
store and use materials that constitute hazardous substances which are
customary for such permitted use, provided such hazardous substances are
kept, stored and used in quantities which are customary for such permitted
use and are kept, stored and used in full compliance with clauses (ii) and
(iii) immediately below.
(ii) Tenant covenants that it will comply with all
applicable laws, rules, regulations, orders, permits, licenses and operating
plans of any governmental authority with respect to the receipt, use,
handling, generation, transportation, storage, treatment and/or disposal of
hazardous substances or wastes by Tenant or its agents or employees, and
Tenant will provide Landlord with copies of all permits, licenses,
registrations and other similar documents that authorize Tenant to conduct
any such activities in connection with its authorized use of the Property on
the Commencement Date or later initial receipt thereof and annually thereafter.
(iii) Tenant agrees that it shall not (A) operate on or
about the Property any facility required to be permitted or licensed as a
hazardous waste facility or for which interim status as such is required, nor
(B) conduct any other activities on or about the Property that could result
in the Property being deemed to be a "hazardous waste facility" (including,
but not limited to, any storage or treatment of hazardous substances or
hazardous wastes which could have such a result).
(iv) Tenant agrees to comply with all applicable laws,
rules, regulations, orders and permits relating to underground storage tanks
installed by Tenant or its agents or employees (including any installation,
monitoring, maintenance, closure and/or removal of such tanks) as such tanks
are defined in California Health & Safety Code Section 25281(x), including,
without limitation, complying with California Health & Safety Code Section
25280-25299.7 and the regulations promulgated thereunder, as amended. Tenant
shall furnish to Landlord copies of all registrations and permits issued to
or held by Tenant from time to time for any and all underground storage tanks.
(v) If applicable, Tenant shall provide Landlord in
writing the following information and/or documentation at the commencement of
this Lease and within sixty (60) days of any change in or addition to the
required information and/or documentation (provided, however, that in the
case of the materials described in Paragraphs (A), (B), (C) and (E) below,
Tenant shall not be required to deliver copies of such materials to Landlord
but shall maintain copies of such materials to such extent and for such
periods as may be required by applicable law and shall permit Landlord or its
representatives to inspect such materials during normal business hours at any
time and from time to time upon reasonable notice to Tenant):
(A) A list of all hazardous substances and/or wastes
that Tenant receives, uses, handles, generates, transports, stores, treats or
disposes of from time to time in connection with its operations on the
Property.
(B) All Material Safety Data Sheets ("MSDS's"), if
any, required to be completed with respect to operations of Tenant at the
Property from time to time in accordance with Title 26, California Code of
Regulations Section 8-5194 or 42 U.S.C. Section 11021, or any amendments
thereto, and any Hazardous Materials Inventory Sheets that detail the MSDS's.
(C) All hazardous waste manifests (as defined in
Title 26, California Code of Regulations Section 22-66481), if any, that
Tenant is required to complete from time to time in connection with its
operations at the Property.
30
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(D) A copy of any Hazardous Materials Management Plan
required from time to time with respect to Tenant's operations at the Property,
pursuant to California Health & Safety Code Section 25500 et seq., and any
regulations promulgated thereunder, as amended.
(E) Copies of any Contingency Plans and Emergency
Procedures required of Tenant from time to time due to its operations in
accordance with Title 26, California Code of Regulations Section 22-67140 et
seq., and any amendments thereto, and copies of any Training Programs and
Records required under Title 26, California Code of Regulations, Section
22-67105, and any amendments thereto.
(F) Copies of any biennial reports required to be
furnished to the California Department of Health Services from time to time
relating to hazardous substances or wastes, pursuant to Title 26, California
Code of Regulations, Section 22-66493, and any amendments thereto.
(G) Copies of all industrial wastewater discharge
permits issued to or held by Tenant from time to time in connection with its
operations on the Property.
(H) Copies of any other lists or inventories of
hazardous substances and/or wastes on or about the Property that Tenant is
otherwise required to prepare and file from time to time with any
governmental or regulatory authority.
(vi) Tenant shall secure Landlord's prior written approval
for any proposed receipt, storage, possession, use, transfer or disposal of
"radioactive materials" or "radiation," as such materials are defined in Title
26, California Code of Regulations Section 17-30100, and/or any other
materials possessing the characteristics of the materials so defined, which
approval Landlord may withhold in its sole and absolute discretion; provided,
that such approval shall not be required for any radioactive materials for
which Tenant has secured prior written approval of the Nuclear Regulatory
Commission and delivered to Landlord a copy of such approval, nor for any
materials in such quantities set forth on Exhibit I hereof. Tenant, in
connection with any such authorized receipt, storage, possession, use,
transfer or disposal of radioactive materials or radiation, shall:
(A) Comply with all federal, state and local laws,
rules, regulations, orders, licenses and permits;
(B) Maintain, to such extent and for such periods as
may be required by applicable law, and permit Landlord or its representatives
to inspect during normal business hours at any time and from time to time upon
reasonable notice to Tenant, a list of all radioactive materials or radiation
received, stored, possessed, used, transferred or disposed of from time to
time, to the extent not already disclosed through delivery of a copy of a
Nuclear Regulatory Commission approval with respect thereto as contemplated
above; and
(C) Maintain, to such extent and for such periods as
may be required by applicable law, and permit Landlord or its representatives
to inspect during normal business hours at any time and from time to time upon
reasonable notice to Tenant, all licenses, registration materials, inspection
reports, governmental orders and permits in connection with the receipt,
storage, possession, use, transfer or disposal of radioactive materials or
radiation from time to time.
(vii) Tenant agrees to comply with any and all applicable
laws, rules, regulations and orders of any governmental authority with
respect to the release into the environment of any hazardous wastes or
substances or radiation or radioactive materials by Tenant or its agents or
employees. Tenant agrees to give Landlord immediate verbal notice of any
release in violation of applicable laws of any such hazardous wastes or
substances or radiation or radioactive materials into the environment, and to
follow such verbal notice with written notice to Landlord of such release
within twenty-four (24) hours of the time at which Tenant became aware of
such release.
(viii) Tenant shall indemnify, defend and hold Landlord
harmless from and against any and all claims, losses (including, but not
limited to, loss of rental income), damages, liabilities, costs, legal fees
and expenses of any sort arising out of or relating to (A) any failure by
Tenant to comply with any provisions of this Paragraph 13.5(b), or (B) any
receipt, use handling, generation, transportation, storage, treatment,
release and/or disposal of any hazardous substance or waste or any radioactive
material or radiation on or about the Property in connection with Tenant's
use or occupancy of the Property or as a result of any intentional or
negligent acts or omissions of Tenant or of any agent or employee of Tenant
whether discovered prior to or after the expiration or earlier termination of
this Lease. Landlord shall indemnify, defend and hold Tenant harmless from
and against any and all claims, losses, damages, liabilities, costs, legal fees
and expenses of any sort arising out of or relating to (A) the existence of
any "hazardous substance" on the Property at the Actual Tender Date, or (B)
the introduction of any "hazardous substance" by Landlord, its agents or
employees onto the Property after the Actual Tender Date.
(ix) Tenant agrees to cooperate with Landlord in
furnishing Landlord with complete information regarding Tenant's receipt,
handling, use, storage, transportation, generation, treatment and/or disposal
of any hazardous substances or wastes or radiation or radioactive materials.
Upon request, Tenant agrees to grant Landlord, subject to Paragraph 16.1,
reasonable access at reasonable times to the Property to inspect Tenant's
receipt, handling, use, storage, transportation, generation, treatment and/or
disposal of hazardous substances or wastes or radiation or radioactive
materials, without being deemed guilty of any disturbance of Tenant's use or
possession and without being liable to Tenant in any manner.
(x) Notwithstanding Landlord's rights of inspection and
review under this Paragraph 13.5(b), Landlord shall have no obligation or
duty to so inspect or review, and no third party shall be entitled to rely on
Landlord to conduct any sort of inspection or review by reason of the
provisions of this Paragraph (b).
(xi) If Tenant receives, handles, uses, stores, transports,
generates, treats and/or disposes of any hazardous substances or wastes or
radiation or radioactive materials on or about the Property at any time during
the term of this Lease, then within thirty (30) days after termination or
expiration of this Lease, Tenant at its sole cost and expense shall obtain and
deliver to Landlord an environmental study, performed by an expert selected by
Landlord and reasonably satisfactory to Tenant, evaluating the presence or
absence of hazardous substances and wastes, radiation and radioactive
materials on and about the Property. Such study shall be based on a
reasonable and prudent level of tests and investigations of the Property which
tests shall be conducted no earlier than the date of termination or expiration
of this Lease. Liability for any remedial actions required or recommended on
the basis of such study shall be that of Tenant unless any hazardous substance
discovered by such study existed on the Property at the Actual Tender Date or
was introduced onto the Property by Landlord, its agents or employees after
the Actual Tender Date. Upon satisfactory completion by Tenant of (i) any
remedial actions required or recommended by such study and (ii) any remedial
or other action required by any governmental agency (including, without
limitation, any actions required pursuant to Paragraph 13.5(c) below), Tenant
shall be released of all liability to Landlord under this Paragraph 13.
(c) With respect to any environmental, hazardous substance or
similar matter for which Tenant is responsible and liable hereunder, Tenant
shall surrender possession of the Property in compliance with all federal,
state and local laws, rules, regulations and orders regarding environmental
condition and cleanup ("Environmental Laws") including, without limitation,
receiving any clearances and/or certifications verifying compliance with all
Environmental Laws. In the event Tenant does not comply with the provisions
of this Paragraph 13.5(c) and deliver any necessary results and/or
certifications to Landlord and to any required governmental body, on the
expiration or earlier termination of this Lease, Tenant shall be held to the
terms of this Lease and required to pay Rent and shall be otherwise subject to
the holdover provisions in Paragraph 2.6 except Tenant shall only be obligated
to pay Rent at 110% of Basic Annual Rental; provided, however, that Tenant
shall only be obligated to pay any Rent for such period of time that Landlord
is prevented, by reason of Tenant's having not yet fully complied with the
certification requirements hereof, from effecting improvements, modifications
and
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repairs required by a written lease of the Premises. Notwithstanding the
foregoing, from the date, if any, upon which the only outstanding results
and/or certifications remaining to be delivered to Landlord upon expiration
or earlier termination of this Lease are informational and not substantive,
then Tenant shall no longer be subject to the holdover provisions hereof.
Further, Tenant shall indemnify, defend and hold Landlord harmless from and
against any and all claims, losses, damages, liabilities, costs, legal fees
and expenses of any sort arising out of or relating to Tenant's failure to
effect the clean up, and assessments, and to obtain the clearances and
certifications required by this Paragraph. If Tenant shall vacate the
Property without having effected such clean up and obtained such clearances
and certifications, then Landlord may obtain same at Tenant's cost;
Landlord's action in such regard shall not eliminate Tenant's liability to
pay for same or to pay Rent as a holdover under the conditions specified in
this Paragraph 13.5(c).
14. INSURANCE AND INDEMNITY
-----------------------
14.1 Liability and Property Insurance.
--------------------------------
(a) Landlord shall procure and maintain in full force and effect at
all times during the term of this Lease, at Landlord's cost and expense (but
reimbursable as an Operating Expense under Paragraph 9.2 hereof), with such
deductibles as Landlord reasonably elects, commercial general liability
insurance to protect against liability arising out of or related to the use of
or resulting from any accident occurring in, upon or about the Property, with
combined single limit of liability of not less than Five Million Dollars
($5,000,000) per occurrence for bodily injury and property damage.
(b) Landlord shall procure and maintain in full force and effect
at all times during the term of this Lease, at Landlord's cost and expense
(but reimbursable as an Operating Expense under Paragraph 9.2 hereof), fire
and extended coverage, boiler and machinery insurance for the Building Shell
(as defined in Exhibit C), Core, Interior Improvements and for the improvements
in the Outside Areas of the Property on a full replacement cost basis, and for
the Tenant Improvements in an amount not less than the total amount
contributed by Landlord toward the payment for the Interior Improvements
pursuant to Exhibit C. Landlord's insurance may include earthquake, flood,
environmental, excess umbrella liability, brush fire and land slide coverage
to the extent Landlord reasonably elects to carry such coverage, and shall
have such deductibles and other terms as Landlord reasonably determines to be
appropriate. Except as expressly set forth in this Paragraph (b), Landlord
shall have no obligation to insure the Tenant Improvements and shall, in all
events, have no obligation to insure any other alterations, additions or
improvements installed by Tenant on or about the Property. In addition to the
foregoing, and not by way of limitation, Landlord shall have the right to
procure and maintain any additional insurance coverage Landlord reasonably
deems appropriate at any time during the term of the Lease, at Landlord's cost
and expense (but reimbursable as an Operating Expense under Paragraph 9.2
hereof). Landlord shall consult with Tenant on an annual basis regarding the
insurance coverage for the Property to be maintained by Landlord, and Landlord
and Tenant agree to reasonably cooperate to obtain cost-effective coverage;
provided, however, that, in no circumstances shall the coverages be reduced
without Landlord's consent.
(c) Tenant, at Tenant's sole cost and expense, shall obtain and
keep in force during the Term:
(i) commercial general liability insurance, including
contractual liability and products/completed operations liability, covering
the legal liability of Tenant against claims for bodily injury, death or
property damage, occurring on, in or about the Property and the adjoining land,
in the minimum combined single limit amount of $1,000,000 with respect to any
one occurrence.
(ii) worker's compensation insurance and employer's
liability insurance (with a minimum limit of $500,000) covering all liability
imposed under the provisions of any worker's compensation law, employer's
liability act or similar laws of the State of California that may at any
time or from time to time be enacted;
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(iii) insurance covering all contents, and Tenant's trade
fixtures, machinery, equipment, furniture and furnishing in the Property to the
extent of at least 90% of their replacement cost under Special Form standard
fire and extended coverage insurance, including, without limitation,
vandalism and malicious mischief and sprinkler leakage endorsements, and
shall provide for a deductible not to exceed $10,000.00;
(iv) special form, business interruption or extra expense
insurance; and
(v) catastrophe excess - Umbrella liability insurance in
the amount of $10,000,000 with respect to the risks referred to in Paragraph
14.1(c)(i).
Tenant's insurance shall be written under policies issued by
insurers reasonably acceptable to Landlord. Tenant's commercial general
liability policy and its excess policies shall include an endorsement naming
Landlord, its partners, beneficiaries, agents and employees as additional
insureds. Tenant's insurance shall be primary.
(d) All policies of property insurance carried under Paragraphs
(b) and (c) of this Paragraph 14.1 shall provide protection against "all
perils of direct physical damage" (as detailed in the Insurance Services
Office commercial property program "Cause of Loss - Special Form CP1030" or
its equivalent) on all insured property. Replacement cost for purposes hereof
shall be determined according to insurance industry standards. Such insurance
policies (i) shall be written by companies rated B+ or better, with a
financial rating of not less than Class VII, in Best's Insurance Guide, and
authorized to do business in California; (ii) shall be written to apply to
covered property damage and other covered loss occurring during the policy
term, or the onset of which occurred or arose during such policy term; (iii)
shall provide that the respective coverages shall be primary and not
contributing with or in excess of any coverage that the other party may carry;
(iv) shall be endorsed to Landlord with not less than thirty (30) days' notice
of cancellation; and (v) in the case of policies carried or required to be
carried by Tenant, shall provide for a deductible of not to exceed $10,000
(except in the case of earthquake coverage). Each party shall deliver to the
other party, on or before the Commencement Date, and thereafter at least ten
(10) days before the expiration dates of expiring policies, certificates of
insurance or other satisfactory evidence of the continuation of such property
insurance coverage for the period indicated therein. If either party fails to
procure property insurance or to deliver certificates or other evidence
thereof as required hereunder, the other party may, at its option and in
addition to the other party's other remedies in the event of a default
hereunder, procure the same for the benefit of such party. If, pursuant to
the foregoing sentence, Tenant secures such insurance on Landlord's behalf,
Tenant shall not be entitled to reimbursement of cost thereof; if Landlord
secures such insurance on Tenant's behalf, Tenant shall reimburse Landlord for
the cost thereof within ten (10) business days after receipt of Landlord's
invoice therefor.
14.2 Waiver Of Subrogation. Landlord and Tenant each waive any right to
---------------------
recover against the other (i) damage to property, (ii) damage to the Property
or any part thereof, or (iii) claims arising by reason of any of the fore-
going, but only to the extent that any of the foregoing damages and claims
under subparts (i)-(iii) hereof are covered, and only to the extent of such
coverage, by insurance actually carried or required to be carried hereunder
by either Landlord or Tenant. This provision is intended to waive fully, and
for the benefit of each party, any rights and claims which might give rise to
a right of subrogation in any insurance carrier. Each party shall procure a
clause or endorsement on any property insurance policy denying to the insurer
rights of subrogation against the other party to the extent rights have been
waived by the insured prior to the occurrence of injury or loss. Coverage
provided by insurance maintained by Tenant shall not be limited, reduced or
diminished by virtue of the subrogation waiver herein contained.
14.3 Increase In Premiums. If Tenant uses or permits the Property to
--------------------
be used in a manner that is not a permitted use and which increases the
existing rate of any insurance on the Property carried by Landlord, Tenant
shall pay the amount of the increase in premium caused thereby, and
Landlord's costs of obtaining other replacement insurance policies, including
any increase in premium, within twenty (20) days after demand therefor by
Landlord.
14.4 Indemnification.
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(a) Tenant shall indemnify, defend by counsel reasonably
acceptable to Landlord and hold Landlord, its partners, shareholders, officers,
directors, agents and employees harmless from any and all liability for bodily
injury to or death of any person, or loss of or damage to the property of
persons, and all actions, claims, demands, costs (including, but not limited
to, reasonable attorneys' fees), damages or expenses arising therefrom which
may be brought or made against Landlord or which Landlord may pay or incur to
the extent such liabilities or other matters arise by reason of the use,
occupancy and enjoyment of the Property by Tenant or any invitees, sublessees,
agents or employees of Tenant from any cause whatsoever other than negligence
or willful misconduct or omission by Landlord, its agents or employees,
contractors or Landlord's breach of this Lease. Landlord, its partners,
shareholders, officers, directors, agents and employees shall not be liable
for, and Tenant hereby waives all claims against such persons for damages to
goods, wares and merchandise in or upon the Property, or for injuries to
Tenant, its agents or third persons in or upon the Property, from any cause
whatsoever other than negligence or willful misconduct or omission by
Landlord, its agents or employees or contractors or Landlord's breach of this
Lease. Tenant shall give prompt notice to Landlord of any casualty or
accident in, on or about the Property.
(b) Landlord shall indemnify, defend by counsel reasonably
acceptable to Tenant and hold Tenant, its shareholders, officers, directors,
agents and employees harmless from liability for bodily injury to or death of
any person, or loss of or damage to the property of persons, and all actions,
claims, demands, costs (including, but not limited to, reasonable attorneys'
fees), damages or expenses arising therefrom which may be brought or made
against Tenant or which Tenant may pay or incur, to the extent such liabilities
or other matters arise by reason of any negligence or willful misconduct or
omission by Landlord, its agents or employees or contractors or Landlord's
breach of this Lease including matters that arise (a) from the use of other
Parcels by Landlord, its agents, employees or contractors and (b) from the
performance by Landlord, its agents, employees or contractors of repair
obligations it is required or elects to perform hereunder.
14.5 Blanket Policy. Any policy required to be maintained hereunder by
--------------
Landlord or Tenant may be maintained under a so-called "blanket policy"
insuring other parties and other locations so long as the amount of insurance
required to be provided hereunder is not thereby diminished. The cost of
blanket policies maintained by Landlord shall be allocated to all property
covered thereby and Operating Expenses shall only include costs thereof
reasonably allocated to the Property.
15. SUBLEASE AND ASSIGNMENT
-----------------------
15.1 Assignment And Sublease Of Property. Tenant shall not have the
-----------------------------------
right or power to assign its interest in this Lease, or make any sublease of
the Property or any portion thereof, nor shall any interest of Tenant under
this Lease be assignable involuntarily or by operation of law, without on
each occasion obtaining the prior written consent of Landlord, which consent
shall not be unreasonably withheld or delayed; provided, however, that
Landlord may condition its consent upon receipt of a reasonably acceptable
agreement from any sublessee or assignee including, but not limited to, the
following provisions: (1) sublessee or assignee is bound by this Lease and
agrees that its sublease or assignment is subordinate hereto; and (2) Tenant
and sublessee or assignee agree that, upon written request of Landlord, after
a default by Tenant under this Lease and expiration of all applicable notice
and cure periods, all amounts payable under the sublease or assignment shall
be paid to Landlord for appropriate distribution and division between
Landlord and Tenant. Further, Tenant shall provide such information
concerning any proposed subtenant or assignee as Landlord may reasonably
request, including, but not limited to, financial statements, and a list of
officers, directors, shareholders, partners, or members. Notwithstanding any
subletting or assignment, Tenant shall remain fully and primarily liable for
the payment of all rental and other sums due, or to become due hereunder, and
for the full performance of all other terms, conditions, and covenants to be
kept and performed by Tenant under this Lease. Any purported sublease or
assignment of Tenant's interest in this Lease requiring but not having
received Landlord's consent thereto shall be void. Notwithstanding anything
to the contrary contained herein, the following events shall not require
Landlord's consent if the use of the proposed subtenant or assignee is within
the permitted uses specified in Paragraph 13.1: (i) any assignment and/or
sublease to any parent, subsidiary or
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affiliated company of Tenant; (ii) any assignment of this Lease to any company
which purchases all or substantially all of the assets of Tenant; (iii) any
assignment of this Lease in conjunction with any merger, consolidation, or
similar transaction involving Tenant or any parent, subsidiary or affiliated
company of Tenant; or (iv) any assignment of this Lease to any partnership,
limited liability company or corporation in which Tenant has at least a fifty
percent (50%) equity interest. If Landlord does not disapprove any proposed
assignment or sublease within fifteen (15) business days after Tenant's
request for consent, Landlord shall be irrevocably deemed to have approved
such sublease or assignment.
15.2 Rights Of Landlord. Consent by Landlord to one or more assignments
------------------
of this Lease, or to one or more sublettings of the Property or any portion
thereof, or collection of Rent by Landlord from any assignee or sublessee,
shall not operate to exhaust Landlord's rights under this Paragraph 15, nor
constitute consent to any subsequent assignment or subletting. No assignment
of Tenant's interest in this Lease and no sublease shall relieve Tenant of
its obligations hereunder, notwithstanding any waiver or extension of time
granted by Landlord to any assignee or sublessee, or the failure of Landlord
to assert its rights against any assignee or sublessee, and regardless of
whether Landlord's consent thereto is given or required to be given hereunder.
In the event of a default by any assignee, sublessee or other successor of
Tenant in the performance of any of the terms or obligations of Tenant under
this Lease, Landlord may proceed directly against Tenant without the necessity
of exhausting remedies against any such assignee, sublessee or other
successor. In addition, Tenant immediately and irrevocably assigns to Land-
lord, as security for Tenant's obligations under this Lease, all rent from
any subletting of all or a part of the Property as permitted under this Lease,
and Landlord, as Tenant's assignee and as attorney-in-fact for Tenant, or any
receiver for Tenant appointed on Landlord's application, may collect such
rent and apply it toward Tenant's obligations under this Lease; except that,
until the occurrence of a default by Tenant and the expiration of any
applicable notice and cure period, Tenant shall have the right to collect
such rent and to share equally with Landlord any sublease rents. In the
event of a subletting or an assignment by Tenant to any person or entity
other than an entity as described in the last sentence of Paragraph 15.1
hereof, fifty percent (50%) of any amount of Rent which Tenant receives in
excess of the aggregate of Tenant's out-of-pocket expenses of the subleasing
or assigning and the Rent due hereunder, shall be paid over to Landlord on a
monthly basis.
15.3 Notice of Proposed Assignment or Sublease. Tenant shall, by notice
-----------------------------------------
in writing, advise Landlord of its intention from, on and after a stated date
(which shall not be less than sixty (60) nor more than one hundred eighty
(180) days after the date of the giving of Tenant's notice to Landlord) to
assign this Lease or sublet all or any part of the Property for the balance
or any part of the term of this Lease, and, in such event, Landlord shall
have the right, to be exercised by giving written notice to Tenant within
fifteen (15) business days after its receipt of Tenant's notice, to approve
or reasonably disapprove the proposed sublease or assignment. Tenant's
notice shall include the name and address of the proposed assignee or
subtenant, a true and complete copy of the proposed assignment or sublease
and sufficient information, as Landlord deems reasonably necessary, to permit
Landlord to determine (i) the financial responsibility and character and the
nature of the business of the proposed assignee or subtenant, and (ii) whether
Landlord has the right under this Lease to withhold consent to the proposed
assignment or sublease.
16. RIGHT OF ENTRY AND QUIET ENJOYMENT
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16.1 Right Of Entry. Landlord and its authorized representatives shall
--------------
have the right to enter the Property at any time during the term of this
Lease during normal business hours and upon not less than two (2) business
days prior notice, except in the case of emergency (in which event no prior
notice shall be required and entry may be made at any time but Landlord shall
give Tenant notice as soon as possible after any such entry), for the purpose
of inspecting and determining the condition of the Property or for any other
proper purpose including, without limitation, to make repairs, replacements
or improvements which Landlord may deem reasonably necessary, to show the
Property to prospective purchasers, to show the Property to prospective tenants
(but only during the final year of the term of this Lease), and to post
notices of nonresponsibility. Landlord shall not be liable for inconvenience,
annoyance, disturbance, loss of business, quiet enjoyment or other damage or
loss to Tenant by reason of making any repairs
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or performing any work upon the Initial Building or the Property or by reason
of erecting or maintaining any protective barricades in connection with any
such work, and the obligations of Tenant under this Lease shall not thereby
be affected in any manner whatsoever, provided, however, Landlord shall use
reasonable efforts to minimize the inconvenience to Tenant's normal business
operations caused thereby. Notwithstanding the foregoing, Landlord shall be
liable to Tenant for any damages incurred as a result of the negligence,
willful misconduct or breach of this Lease by Landlord or its agents,
employees and contractors in connection with any such entry. In connection
with any entry by Landlord pursuant to this Paragraph 16.1 or any other
provision of this Lease, (a) Landlord shall use reasonable efforts to
minimize any interference with Tenant's use and enjoyment of the Property,
(b) Landlord shall give notice to Tenant as soon as reasonably possible if
Landlord enters the Property in connection with an emergency, (c) except in
cases of an emergency, Landlord shall not be authorized to enter Tenant's
clean room within the Property, (d) Landlord shall comply with all reasonable
requirements of Tenant in connection with any entry onto the Property,
including having all of Landlord's representatives and other parties wear
gowns and any other necessary safety equipment and complying with other
reasonable safety measures required by Tenant. In addition, Tenant shall
have the right to require Landlord and any other parties entering the
Property to be escorted and supervised by a representative of Tenant.
16.2 Quiet Enjoyment. Landlord covenants that Tenant, upon paying the
---------------
Rent and performing its obligations hereunder and subject to all the terms
and conditions of this Lease, shall peacefully and quietly have, hold and
enjoy the Property throughout the term of this Lease, or until this Lease is
terminated as provided by this Lease.
17. CASUALTY AND TAKING
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17.1 Damage or Destruction.
---------------------
(a) If the Initial Building, or the Outside Areas of the Property
necessary for Tenant's use and occupancy of the Initial Building, are damaged
or destroyed in whole or in part under circumstances in which (i) repair and
restoration is permitted under applicable governmental laws, regulations and
building codes then in effect, and under any mortgage or the like encumbering
the Property, (ii) if the Lease has more than two (2) years remaining in the
Term, repair and restoration reasonably can be completed within a period of
nine (9) months following the date of the occurrence, (iii) if the Lease has
two (2) years or less remaining in the term, repair and restoration reasonably
can be completed within ninety (90) days following the date of the occurrence,
and (iv) insurance proceeds sufficient to reimburse Landlord for the cost of
such repair and restoration are available to Landlord, then Landlord, as to
Outside Areas and the Building Shell and Core, and Tenant, as to the Interior
Improvements (in which case Landlord shall make all insurance proceeds
relating thereto available to Tenant), shall commence and complete, with all
due diligence and as promptly as is reasonably practicable under the
conditions then existing, all such repair and restoration as may be required
to return the affected portions of the Property to the condition existing
immediately prior to the occurrence; all repairs, replacements, construction
and the like effected by Tenant shall receive the prior approval of Landlord
(which will not be unreasonably withheld or delayed), as to plans,
specifications, nature, scope, contractors, subcontractors and the like, and
shall be effected in compliance with the provisions of Paragraph 5.4 hereof.
In connection with any such reconstruction of the Interior Improvements,
Landlord shall use its commercially reasonable best efforts (including,
without limitation, any necessary negotiation or intercession with Landlord's
Lender, if any) to promptly make any proceeds of Landlord's property insurance
with respect to the Interior Improvements available to Tenant for such
reconstruction, subject only to such payment controls as Landlord and its
Lender and insurer, or any of them, may reasonably require in order to ensure
the proper application of such proceeds toward the reconstruction of the
Interior Improvements pursuant to this Paragraph 17.1. In the event of damage
or destruction the repair of which is not permitted under applicable
governmental laws, regulations and building codes then in effect, if such
damage or destruction (despite being corrected to the extent then permitted
under applicable governmental laws, regulations and building codes) would
still materially and adversely affect Tenant's use of the Initial Building or
its ability to conduct its business in the Initial Building, then Tenant may
terminate this Lease as of the date of the occurrence by giving written
notice to the Landlord within thirty (30) days after receipt of written
notice from Landlord of such
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restrictions; if Tenant does not timely elect such termination or if such
damage or destruction does not materially impair Tenant's use of the Initial
Building or its ability to conduct its business in the Initial Building, then
this Lease shall continue in full force and effect, except that there shall
be an equitable adjustment in monthly installments of Basic Annual Rent,
based upon the extent to which Tenant's use of the Initial Building or its
ability to conduct its business in the Initial Building is adversely
affected, and Landlord and Tenant respectively shall restore the Building
Shell and the Interior Improvements to a complete architectural whole and to
a functional condition. In the event of damage or destruction which cannot
reasonably be repaired within nine (9) months following the date of the
occurrence then Tenant, at its election, may terminate this Lease as of the
date of the occurrence by giving written notice to Landlord within thirty
(30) days after receipt of written notice from Landlord of its estimate of
the time to repair (which estimate of time to repair shall be delivered to
Tenant within thirty (30) days after the date of the occurrence); if Tenant
does not timely elect such termination, then this Lease shall continue in
full force and effect and Landlord and Tenant shall each repair and restore
applicable portions of the Property in accordance with the first sentence of
this Paragraph 17.1. Notwithstanding the foregoing, Landlord shall use its
best efforts to ensure, and if required by California law shall require,
that the repair of any damage or destruction and the use of all insurance
proceeds for such repair shall be permitted under any mortgage or the like
unless and to the extent the mortgagee's security is impaired.
In the event of damage or destruction in the last two (2) years of
the term of the Lease which cannot reasonably be repaired within ninety (90)
days following the date of the occurrence and Tenant has not exercised its
option to extend the term of this Lease:
(A) Tenant may, by giving written notice to Landlord within
thirty (30) days after receipt of written notice from Landlord of its
estimate of the time to repair (which estimate shall be delivered to Tenant
within thirty (30) days after the date of the occurrence): (a) terminate this
Lease as of the date of the occurrence; or (b) exercise its option to extend
so long as Tenant can timely exercise within the time frame set out in
Paragraph 2.7 hereof.
(B) In the event Tenant elects to exercise its option to extend,
if available, then this Lease shall continue in full force and effect and
Landlord and Tenant shall each repair and restore applicable portions of the
Property in accordance with the first sentence of this Paragraph 17.1.
(C) In the event Tenant does not timely elect to terminate this
Lease or timely exercise its option to extend provided herein, Landlord shall
have the right to either: (a) terminate this Lease as of the date of the
occurrence or (b) elect to repair, in which event this Lease shall continue
in full force and effect and Landlord and Tenant shall each repair and
restore applicable portions of the Property in accordance with the first
sentence of this Paragraph 17.1.
(b) The respective obligations of Landlord and Tenant pursuant to
Paragraph 17.1(a) are subject to the following limitations:
(i) If the occurrence results from a peril which is
required to be insured pursuant to Paragraph 14.1(b) and (c) above, the
obligations of either party shall not exceed the amount of insurance proceeds
received from insurers by reason of such occurrence, plus the amount of the
party's permitted deductible (provided that each party shall be obligated to
use its best efforts to recover any available proceeds from the insurance
which it is required to maintain pursuant to the provisions of Paragraph
14.1(b) or (c), as applicable), and, if such proceeds are insufficient,
either party may terminate the Lease unless the other party promptly elects
and agrees, in writing, to contribute the amount of the shortfall; and
(ii) If the occurrence results from a peril which is not
required to be insured pursuant to Paragraph 14.1(b) and (c) above, Landlord
shall be required to repair and restore the Building Shell and Common Areas
to the extent necessary for Tenant's continued use and occupancy of the
Initial Building, and Tenant shall be required to repair and restore the
Interior Improvements to the extent necessary for Tenant's continued use and
occupancy of the Initial Building, provided that each party's obligation to
repair and restore shall not exceed an amount equal to five percent (5%) of
the replacement cost of the Building Shell and Common Area improvements, as
to Landlord, or five percent (5%) of the replacement cost of the Interior
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Improvements, as to Tenant; if the replacement cost as to either party
exceeds such amount, then the party whose limit has been exceeded may
terminate this Lease unless the other party promptly elects and agrees, in
writing, to contribute the amount of the shortfall.
(c) If this Lease is terminated pursuant to the foregoing
provisions of this Paragraph 17.1 following an occurrence which is a peril
required to be insured against pursuant to Paragraph 14.1(c) and (d),
Landlord and Tenant agree (and any Lender shall be asked to agree) that there
shall be paid from such insurance proceeds (i) to Landlord, the proceeds of
Landlord's property insurance on the Building Shell, (ii) to Landlord, a
portion of the aggregate proceeds of Landlord's and Tenant's property
insurance on the Interior Improvements equal to a fraction, the numerator of
which is the insurable value, immediately prior to the occurrence, of the
Interior Improvements that would have belonged to Landlord upon termination
of this Lease in accordance with the provisions of Paragraph 11.2 and the
denominator of which is the total insurable value, immediately prior to the
occurrence, of all of the Interior Improvements, and (iii) to Tenant, a
portion of the aggregate proceeds of Landlord's and Tenant's property
insurance on the Interior Improvements equal to a fraction, the numerator of
which is the insurable value, immediately prior to the occurrence, of the
Interior Improvements that would have belonged to Tenant upon termination of
this Lease in accordance with the provisions of Paragraph 11.2 and the
denominator of which is the total insurable value, immediately prior to the
occurrence, of all of the Interior Improvements.
(d) From and after the date of an occurrence resulting in damage
to or destruction of the Initial Building or of the Common Areas necessary for
Tenant's use and occupancy of the Initial Building, and continuing until
repair and restoration thereof are completed, there shall be an equitable
abatement of Basic Annual Rent and of Tenant's Operating Cost Share of
Operating Expenses based upon the degree to which Tenant's ability to conduct
its business in the Initial Building is impaired and Tenant's use is otherwise
materially and adversely affected.
(e) In the event Landlord is required or elects to repair the
Property pursuant to Paragraph 17.1, and such repair is not completed within
the estimated time frame (which estimated time frame shall be within the time
period required for such repair hereunder or, if longer, only upon the prior
written consent of Tenant) ("Repair Completion Date"), subject to Force
Majeure delays and Tenant Delays, then Tenant shall have the right to
terminate this Lease as of the Repair Completion Date by delivering written
notice to Landlord of such election within thirty (30) days after the Repair
Completion Date; however in the event Tenant does not timely elect to
terminate or if Landlord completes the required repair prior to Landlord's
receipt of Tenant's election to terminate, then Tenant's election to terminate
shall be void and of no force or effect and this Lease shall continue in full
force and effect and Landlord and Tenant shall each repair and restore
applicable portions of the Property in accordance with the first sentence of
Paragraph 17.1.
17.2 Condemnation.
------------
(a) If during the term of this Lease the Property or Improvements,
is taken by eminent domain or by reason of any public improvement or
condemnation proceeding, or in any manner by exercise of the right of eminent
domain (including any transfer in avoidance of an exercise of the power of
eminent domain), or receives irreparable damage by reason of anything lawfully
done under color of public or other authority, then at Landlord's election by
written notice given to Tenant within thirty (30) days after the nature, scope
and date of the taking is finally determined, (i) this Lease shall terminate
as to the entire Property as of the date of the taking or (ii) if less than
all of the Property is taken, this Lease shall terminate as to the portion
taken and rent shall abate proportionately. At Tenant's election, by written
notice given to Landlord within thirty (30) days after the nature and extent
of the taking have been finally determined, this Lease shall terminate as to
the entire Property, if the portion of the Property taken is of such extent
and nature as substantially to handicap, impede or permanently impair Tenant's
use of the balance of the Property. If Tenant elects to terminate this Lease,
Tenant shall also notify Landlord of the date of termination, which date shall
not be earlier than thirty (30) days nor later than ninety (90) days after
Tenant has notified Landlord of Tenant's election to terminate, except that
this Lease shall terminate on the date of taking if such date falls on any
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date before the date of termination designated by Tenant. If neither party
elects to terminate this Lease as hereinabove provided, this Lease shall
continue in full force and effect (except that there shall be an equitable
abatement of Basic Annual Rent and of Tenant's Operating Cost Share of
Operating Expenses based upon the degree to which Tenant's ability to conduct
its business in the Initial Building) and/or its use is adversely affected),
Landlord shall restore the Building Shell and Common Area improvements to a
complete architectural whole and a functional condition and as nearly as
reasonably possible to the condition existing before the taking, and Tenant
shall restore the Interior Improvements and Tenant's other alterations,
additions and improvements to a complete architectural whole and a functional
condition and as nearly as reasonably possible to the condition existing
before the taking. In connection with any such restoration, each party shall
use its respective best efforts (including, without limitation, any necessary
negotiation or intercession with its respective lender, if any) to ensure
that any severance damages or other condemnation awards intended to provide
compensation for rebuilding or restoration costs are promptly collected and
made available to Landlord and Tenant in portions reasonably corresponding to
the cost and scope of their respective restoration obligations, subject only
to such payment controls as either party or its lender may reasonably require
in order to ensure the proper application of such proceeds toward the
restoration of the Improvements. Each party waives the provisions of Code of
Civil Procedure Section 1265.130, allowing either party to petition the
Superior Court to terminate this Lease in the event of a partial condemnation
of the Property.
(b) The respective obligations of Landlord and Tenant pursuant to
Paragraph 17.2(a) are subject to the following limitations:
(i) Each party's obligation to repair and restore shall
not exceed, net of any condemnation awards or other proceeds available for
and allocable to such restoration as contemplated in Paragraph 17.2(a), an
amount equal to five percent (5%) of the replacement cost of the Building
Shell and Common Area improvements, as to Landlord, or five percent (5%) of
the replacement cost of the Interior Improvements, as to Tenant; if the
replacement cost as to either party exceeds such amount, then the party whose
limit has been exceeded may terminate this Lease unless the other party
promptly elects and agrees, in writing, to contribute the amount of the
shortfall; and
(ii) If this Lease is terminated pursuant to the foregoing
provisions of this Paragraph 17.2, or if this Lease remains in effect but any
condemnation awards or other proceeds become available as compensation for the
loss or destruction of any of the Improvements, then Landlord and Tenant agree
(and any Lender shall agree) that there shall be paid from such award or
proceeds (i) to Landlord, the award or proceeds attributable or allocable to
the Building Shell and/or Common Area improvements, and (ii) to Landlord and
Tenant, respectively, portions of the award or proceeds attributable or
allocable to the Interior Improvements, in the respective proportions in which
Landlord and Tenant would have shared, under Paragraph 17.1(c), the proceeds
of any insurance proceeds following loss or destruction of such Interior
Improvements by an insured casualty.
17.3 Reservation Of Compensation. Landlord reserves, and Tenant waives
---------------------------
and assigns to Landlord, all rights to any award or compensation for damage
to the Improvements, the Property and the leasehold estate created hereby,
accruing by reason of any taking in any public improvement, condemnation or
eminent domain proceeding or in any other manner by exercise of the right of
eminent domain or of anything lawfully done by public authority, except that
(a) Tenant shall be entitled to any and all compensation or damages paid for
or on account of Tenant's moving expenses, trade fixtures and equipment, and
(b) any condemnation awards or proceeds described in Paragraph 17.2(b)(ii)
shall be allocated and disbursed in accordance with the provisions of
Paragraph 17.2(b)(ii), notwithstanding any contrary provisions of this
Paragraph 17.3.
17.4 Restoration Of Improvements. In connection with any repair or
---------------------------
restoration of Improvements by either party following a casualty or taking as
hereinabove set forth, the party responsible for such repair or restoration
shall, to the extent possible, return such Improvements to a condition
substantially equal to that which existed immediately prior to the casualty
or taking. To the extent such party wishes to make material modifications to
such Improvements,
40
<PAGE>
such modifications shall be subject to the prior written approval of the
other party (not to be unreasonably withheld or delayed), except that no
such approval shall be required for modifications that are required by
applicable governmental authorities as a condition of the repair or
restoration, unless such required modifications would impair or impede
Tenant's conduct of its business in the Initial Building (in which case any
such modifications in Landlord's work shall require Tenant's consent, not
unreasonably withheld or delayed) or would materially and adversely affect
the exterior appearance, the structural integrity or the mechanical or other
operating systems of the Initial Building (in which case any such
modifications in Tenant's work shall require Landlord's consent, not
unreasonably withheld or delayed).
18. DEFAULT
-------
18.1 Events Of Default. The occurrence of any of the following shall
-----------------
constitute an event of default on the part of Tenant:
(a) Nonpayment. Failure to pay, when due, any amount payable to
----------
Landlord hereunder, such failure continuing for a period of ten (10) days
after notice from Landlord that such payment is past due; provided, however,
that it shall be an Event of Default if Tenant shall fail to pay when due any
amount payable to Landlord hereunder if Tenant has received three notices from
Landlord as contemplated by the preceding clause hereof within twelve (12)
months of such failure to pay;
(b) Other Obligations. Failure to perform any obligation,
-----------------
agreement or covenant under this Lease other than those matters specified in
Paragraph (a) hereof, such failure continuing for thirty (30) days after
written notice of such failure; provided, however, that if such failure is
curable in nature but cannot reasonably be cured within such 30-day period,
then Tenant shall not be in default if, and so long as, Tenant promptly (and
in all events within such 30-day period) commences such cure and thereafter
diligently pursues such cure to completion;
(c) General Assignment. A general assignment by Tenant for the
------------------
benefit of creditors;
(d) Bankruptcy. The filing of any voluntary petition in
----------
bankruptcy by Tenant, or the filing of an involuntary petition by Tenant's
creditors, which involuntary petition remains undischarged for a period of
ninety (90) days. In the event that under applicable law the trustee in
bankruptcy or Tenant has the right to affirm this Lease and continue to
perform the obligations of Tenant hereunder, such trustee or Tenant shall, in
such time period as may be permitted by the bankruptcy court having
jurisdiction, cure all defaults of Tenant hereunder outstanding as of the
date of the affirmance of this Lease and provide to Landlord such adequate
assurances as may be necessary to ensure Landlord of the continued
performance of Tenant's obligations under this Lease. Specifically, but
without limiting the generality of the foregoing, such adequate assurances
must include assurances that the Property continues to be operated only for
the use permitted hereunder. The provisions hereof are to assure that the
basic understandings between Landlord and Tenant with respect to Tenant's use
of the Property and the benefits to Landlord therefrom are preserved,
consistent with the purpose and intent of applicable bankruptcy laws:
(e) Receivership. The employment of a receiver appointed by court
------------
order to take possession of substantially all of Tenant's assets or the
Property, if such receivership remains undissolved for a period of ninety
(90) days;
(f) Attachment. The attachment, execution or other judicial
----------
seizure of all or substantially all of Tenant's assets or the Property, if
such attachment or other seizure remains undismissed or undischarged for a
period of ninety (90) days after the levy thereof;
(g) Insolvency. The admission by Tenant in writing of its
----------
inability to pay its debts as they become due, the filing by Tenant of a
petition seeking any reorganization or arrangement, composition, readjustment,
liquidation, dissolution or similar relief under any present or future
statute, law or regulation, the filing by Tenant of an answer admitting or
failing timely to contest a material allegation of a petition filed against
Tenant in any such proceeding or, if within ninety (90) days after the
commencement of any proceeding against Tenant seeking any reorganization or
arrangement, composition, readjustment, liquidation, dissolution or similar
41
<PAGE>
relief under any present or future statute, law or regulation, such
proceeding shall not have been dismissed; or
(h) Default under other Leases. The default by Tenant, or any
--------------------------
successor in interest to Tenant through merger or acquisition or subtenant of
Tenant, after applicable notice and cure periods, under any other lease with
Landlord), or with an affiliate of Landlord, including without limitation any
lease or other agreement between Landlord, or with an affiliate of Landlord,
and Tenant pursuant to Paragraphs 6 and 7 hereof.
18.2 Remedies Upon Tenant's Default.
------------------------------
(a) Upon the occurrence of any event of default described in
Paragraph 18.1 hereof, Landlord, in addition to and without prejudice to any
other rights or remedies it may have, shall have the immediate right to
re-enter the Property or any part thereof and repossess the same, expelling
and removing therefrom all persons and property (which property may be stored
in a public warehouse or elsewhere at the cost and risk of and for the account
of Tenant), using such force as may be necessary to do so (as to which Tenant
hereby waives any claim for loss or damage that may thereby occur). In
addition to or in lieu of such re-entry, and without prejudice to any other
rights or remedies it may have, Landlord shall have the right either (i) to
terminate this Lease and recover from Tenant all damages incurred by Landlord
as a result of Tenant's default, as hereinafter provided, or (ii) to continue
this Lease in effect and recover rent and other charges and amounts as they
become due.
(b) Even if Tenant has breached this Lease or abandoned the
Property, this Lease shall continue in effect for so long as Landlord does
not terminate Tenant's right to possession under Paragraph (a) hereof and
Landlord may enforce all of its rights and remedies under this Lease,
including the right to recover rent as it becomes due, and Landlord, without
terminating this Lease, may exercise all of the rights and remedies of a
lessor under California Civil Code Section 1951.4 (lessor may continue lease
in effect after lessee's breach and abandonment and recover rent as it
becomes due, if lessee has right to sublet or assign, subject only to
reasonable limitations), or any successor Code section. Acts of maintenance,
preservation or efforts to relet the Property or the appointment of a
receiver upon application of Landlord to protect Landlord's interests under
this Lease shall not constitute a termination of Tenant's right to possession.
(c) If Landlord terminates this Lease pursuant to this Paragraph
18.2, Landlord shall have all of the rights and remedies of a Landlord provided
by Section 1951.2 of the Civil Code of the State of California, or any
successor Code section, which remedies include Landlord's right to recover
from Tenant (i) the worth at the time of award of the unpaid rent, unpaid
Operating Expenses, unpaid Taxes and any other amounts due Landlord hereunder
which had been earned at the time of termination; (ii) the worth at the time
of award of the amount by which the unpaid rent, unpaid Operating Expenses,
unpaid Taxes and any other amounts due Landlord hereunder which would have
been earned after termination until the time of award exceeds the amount of
such rental loss that Tenant proves could have been reasonably avoided, (iii)
the worth at the time of award of the amount by which the unpaid rent unpaid
Operating Expenses, unpaid Taxes and any other amounts due Landlord hereunder
for the balance of the term after the time of award exceeds the amount of such
rental loss that Tenant proves could be reasonably avoided, and (iv) any other
amount necessary to compensate Landlord for all the detriment proximately
caused by Tenant's failure to perform its obligations under this Lease or
which in the ordinary course of things would be likely to result therefrom,
including, but not limited to, the cost of recovering possession of the
Property, expenses of reletting, including necessary repair, renovation and
alteration of the Property, reasonable attorneys' fees, and other reasonable
costs provided that if the term of any releasing extends beyond the term of
this Lease, Tenant shall only be responsible for the amortized portion
thereof based on the then remaining term of this Lease and the term of the
releasing. The "worth at the time of award" of the amounts referred to in
clauses (i) and (ii) above shall be computed by allowing interest at ten
percent (10%) per annum from the date such amounts accrued to Landlord. The
"worth at the time of award" of the amounts referred to in clause (iii) above
shall be computed by discounting such amount at one percentage point above
the discount rate of the Federal Reserve Bank of San Francisco at the time
of award.
42
<PAGE>
18.3 Remedies Cumulative. All rights, privileges and elections or
-------------------
remedies of Landlord contained in this Lease are cumulative and not
alternative to the extent permitted by law and except as otherwise provided
herein.
18.4 Landlord Default. The default by Landlord or an afiliate of
----------------
Landlord, after applicable notice and cure periods, under any other lease
with Tenant or any successor in interest to Tenant through merger or
acquisition, including without limitation, any lease or other agreement
between Landlord or affiliate of Landlord and Tenant pursuant to Paragraphs
6 and 7, hereof shall be a default by Landlord hereunder.
19. SUBORDINATION, ATTORNMENT AND SALE
----------------------------------
19.1 Subordination To Mortgage. As of the date herof, Landlord
-------------------------
represents and warrants that the only mortgage or deed of trust on the
Property is the one shown on the Policy of Title Insurance dated May 7, 1997
and delivered to Tenant. This Lease, and any sublease entered into by Tenant
under the provisions of this Lease, shall be subject and subordinate to any
mortgage or deed of trust, now or hereafter placed upon the Initial Building,
the Property, or both, and the rights of any mortgagee, trustee, beneficiary
and to any and all advances made on the security thereof and to all renewals,
modifications, consolidations, replacements and extensions thereof. If any
mortgagee, trustee, beneficiary elects to have this Lease be an encumbrance
upon the Property prior to the lien of its mortgage, deed of trust, and gives
notice thereof to Tenant, this Lease shall be deemed prior thereto, whether
this Lease is dated prior or subsequent to the date thereof or the date of
recording thereof. Tenant, and any sublessee, shall execute such documents
as may reasonably be requested by any mortgagee, trustee to evidence the
subordination herein set forth, subject to the conditions set forth above,
or to make this Lease prior to the lien of any mortgage, deed of trust, as
the case may be. Upon any default by Landlord in the performance of its
obligations under any mortgage, deed of trust, Tenant (and any sublessee)
shall, notwithstanding any subordination hereunder, attorn to the mortgagee,
trustee, beneficiary, thereunder upon demand and become the tenant of the
successor in interest to Landlord, at the option of such successor in
interest, and shall execute and deliver any instrument or instruments
confirming the attornment herein provided for. Notwithstanding anything to
the contrary contained herein, the subordination of this Lease, Tenant's
attornment obligation and any other obligations of Tenant under this
Paragraph shall be subject to and expressly conditioned upon Tenant's receipt
from each such existing and future holder of any such mortgage, deed of trust
or other right executing and delivering to Tenant a commercially reasonable
non-disturbance agreement. As a condition to Tenant's obligations hereunder,
Landlord shall deliver to Tenant within thirty (30) days after the date hereof
a non-disturbance agreement acceptable to Tenant executed by any lenders
currently holding a lien on the Parcels and/or the Property.
19.2 Sale Of Landlord's Interest. Upon sale, transfer or assignment of
---------------------------
Landlord's entire interest in the Improvements and Property after Substantial
Completion of the Initial Building, other than for security purposes,
Landlord shall be relieved of its obligations hereunder with respect to
liabilities accruing from and after the date of such sale, transfer or
assignment, except as otherwise expressly provided in Paragraph 21.2 hereof;
provided, however, as a condition to any such release, the purchaser shall
assume in a written agreement in favor of and reasonably acceptable to Tenant
the obligations of Landlord under this Lease (including Landlord's obligation
hereunder to repair defects in design and construction).
19.3 Estoppel Certificates.
---------------------
(a) Tenant shall provide Landlord, within five (5) business days
after written request, with an Estoppel Certificate in a form as attached
hereto as Exhibit F, which is intended for use in connection with a building
under construction.
(b) In addition to the Estoppel Certificate to be provided
pursuant to subparagraph (a) above, either Tenant or Landlord (the
"certifying party") shall at any time and from time to time, within ten (10)
business days after written request by the other party (the "requesting
party"), execute, acknowledge and deliver to the requesting party a
certificate in writing stating substantially the matters provided in Exhibit
F, modified to reflect the state of construction or completion and
occupancy and other
43
<PAGE>
matters at that time, along with such other matters as may reasonably be
requested by the requesting party or by any institutional lender, mortgagee,
trustee, beneficiary, or prospective purchaser of the Property or of Tenant's
leasehold interest therein.
(c) Any such certificate provided under this Paragraph 19.3 may
be relied upon by any lender, mortgagee, trustee, beneficiary assignee or
successor in interest to the requesting party, by any prospective purchaser,
by any purchaser on foreclosure or sale, by any grantee under a deed in lieu
of foreclosure of any mortgage or deed of trust on the Property, or by any
other third party. Failure to execute and return within the required time
any estoppel certificate requested hereunder shall be deemed to be an
admission of the truth of the matters set forth in the form of certificate
submitted to the certifying party for execution.
19.4 Subordination to CC&R's. This Lease, and any permitted sublease
-----------------------
entered into by Tenant under the provisions of this Lease, shall be subject
and subordinate to the Existing CC&Rs; provided, however, that following the
execution of this Lease, Landlord shall not record or agree to any new
covenants, conditions or restrictions or any changes to the Existing CC&Rs
affecting the Property and which adversely affect Tenant's right under this
Lease in any material respect without the prior written consent of Tenant,
which consent shall not be unreasonably withheld or delayed. Tenant agrees
to execute, upon request by Landlord, any documents reasonably required from
time to time to evidence such subordination. With respect to any such CC&Rs
and any associations or the like with any control over the Site, Landlord
shall represent the Site on any committees or boards established in
connection therewith.
19.5 Mortgagee Protection.
--------------------
(a) Tenant's obligations to attorn and subordinate under this
Lease shall be conditioned on Tenant's concurrent receipt, from the ground
lessor, mortgagee, trustee, beneficiary or leaseback lessor, of a Non-
Disturbance Agreement in a form as attached hereto as Exhibit F confirming,
among other things, that so long as Tenant is not in default hereunder,
Tenant's rights hereunder shall not be disturbed by such person or entity.
(b) In addition to the Non-Disturbance Agreement to be provided
pursuant to subparagraph (a) above, within ten (10) business days after
written request by Landlord, in the event of a sale or further financing of
the Project by Landlord, Tenant shall execute and deliver concurrently with
Landlord and any institutional lender, mortgagee, trustee or beneficiary a
Non-Disturbance Agreement in form substantially similar to that attached as
Exhibit F, along with such other matters as may reasonably be requested by
Landlord or by any institutional lender, mortgagee, trustee, beneficiary,
assignee or successor in interest to Landlord.
20. INTENTIONALLY DELETED
---------------------
21. MISCELLANEOUS
-------------
21.1 Notices. All notices, consents, waivers and other communications
-------
which this Lease requires or permits either party to give to the other shall
be in writing and shall be deemed given when delivered personally or when
personal delivery is refused (including delivery by private courier or
express delivery service), or the next business day after facsimile
transmission with indication of receipt to the sending party through the
facsimile system or two (2) business days after deposit in the United States
mail, registered or certified mail, postage prepaid, addressed to the parties
at their respective addresses as follows:
To Tenant: (until Commencement Date)
Advanced Tissue Sciences, Inc.
10933 North Torrey Pines Road
La Jolla, CA 92037
Attn: Director of Facilities
cc: Legal Department
(after Commencement Date)
[AT THE INITIAL BUILDING --
ADDRESS TO BE SUPPLIED]
44
<PAGE>
Attn: Director of Facilities
cc: Legal Department
with copy to: Luce, Forward, Hamilton & Scripps LLP
600 W. Broadway, Suite 2600
San Diego, CA 92101
Attn: David M. Hymer, Esq.
To Landlord: TPSC II Limited Partnership
c/o Slough Parks Incorporated
33 West Monroe, Suite 2000
Chicago, IL 60603
Attn: William Rogalla
with copy to: Bell, Boyd & Lloyd
70 West Madison, Suite 3100
Chicago, IL 60602
Attn: Lawrence M. Mages
or to such other address as may be contained in a notice at least fifteen (15)
days prior to the address change from either party to the other given pursuant
to this Paragraph. Rental payments and other sums required by this Lease to
be paid by Tenant shall be delivered to Landlord at Landlord's address
provided in this Paragraph, or to such other address as Landlord may from time
to time specify in writing to Tenant, and shall be deemed to be paid only upon
actual receipt.
21.2 Successors And Assigns. The obligations of this Lease shall run
----------------------
with the land, and this Lease shall be binding upon and inure to the benefit
of the parties hereto and their respective successors and assigns, except
that the original Landlord named herein and each successive Landlord under
this Lease shall be liable only for obligations accruing during the period of
its ownership of the Property, said liability terminating upon termination of
such ownership and passing to the successor.
21.3 No Waiver. The failure of Landlord or Tenant to seek redress for
---------
violation, or to insist upon the strict performance, of any covenant or
condition of this Lease shall not be deemed a waiver of such violation, or
prevent a subsequent act which would originally have constituted a violation
from having all the force and effect of an original violation.
21.4 Severability. If any provision of this Lease or the application
------------
thereof is held to be invalid or unenforceable, the remainder of this Lease
or the application of such provision to persons or circumstances other than
those as to which it is invalid or unenforceable shall not be affected
thereby, and each of the provisions of this Lease shall be valid and
enforceable, unless enforcement of this Lease as so invalidated would be
unreasonable or grossly inequitable under all the circumstances or
would materially frustrate the purposes of this Lease.
21.5 Litigation Between Parties. In the event of any litigation or
--------------------------
other dispute resolution proceedings between the parties hereto arising out
of or in connection with this Lease, the prevailing party shall be reimbursed
for all reasonable costs, including, but not limited to, reasonable
accountants' fees and attorneys' fees, incurred in connection with such
proceedings (including, but not limited to, any appellate proceedings
relating thereto) or in connection with the enforcement of any judgment or
award rendered in such proceedings.
21.6 Surrender. A voluntary or other surrender of this Lease by Tenant,
---------
or a mutual termination thereof between Landlord and Tenant, shall not result
in a merger but shall, at the option of Landlord, operate either as an
assignment to Landlord of any and all existing subleases and subtenancies,
or a termination of all or any existing subleases and subtenancies. This
provision shall be contained in any and all assignments or subleases made
pursuant to this Lease.
21.7 Interpretation. The provisions of this Lease shall be construed
--------------
as a whole, according to their common meaning, and not strictly for or
against Landlord or Tenant. The
45
<PAGE>
captions preceding the text of each Paragraph and subparagraph hereof are
included only for convenience of reference and shall be disregarded in the
construction or interpretation of this Lease.
21.8 Entire Agreement. This written Lease, together with the
----------------
exhibits hereto, contains all the representations and the entire understanding
between the parties hereto with respect to the subject matter hereof. Any
prior correspondence, memoranda or agreements are replaced in total by this
Lease and the exhibits hereto. This Lease may be modified only by an
agreement in writing signed by each of the parties.
21.9 Governing Law. This Lease and all exhibits hereto shall be
-------------
construed and interpreted in accordance with and be governed by all the
provisions of the laws of the State of California.
21.10 No Partnership. The relationship between Landlord and Tenant is
--------------
solely that of a lessor and lessee. Nothing contained in this Lease shall
be construed as creating any type or manner of partnership, joint venture or
joint enterprise with or between Landlord and Tenant.
21.11 Financial Information. From time to time Tenant shall promptly
---------------------
provide directly to prospective lenders and purchasers of the Property
designated by Landlord financial information as filed with the Securities
and Exchange Commission.
21.12 Costs. If Tenant requests the consent of Landlord, to any
-----
assignment or subletting of the Property, Tenant shall, as a condition
to doing any such act and the receipt of such consent, reimburse Landlord
promptly for any and all reasonable costs and expenses incurred by Landlord in
connection therewith, including, without limitation, reasonable attorneys'
fees not to exceed $1,500.
21.13 Time. Time is of the essence of this Lease, and of every term and
----
condition hereof.
21.14 Brokers. Landlord agrees to pay a brokerage commission to John
-------
Burnham & Company in connection with the consummation of this Lease in
accordance with a separate agreement. Each party represents and warrants
that no other broker participated in the consummation of this Lease and
agrees to indemnify, defend and hold the other party harmless against any
liability, cost or expense, including, without limitation, reasonable
attorneys' fees, arising out of any claims for brokerage commissions or other
similar compensation in connection with any conversations, prior negotiations
or other dealings by the indemnifying party with any other broker.
21.15 Memorandum Of Lease. At any time during the term of this Lease,
-------------------
either party, at its sole expense, shall be entitled to record a memorandum
of this Lease and, if either party so elects, both parties agree to cooperate
in the preparation, execution, acknowledgment and recordation of such
document in reasonable form. Any such memorandum of this Lease shall include
Tenant's Expansion Option and First Refusal Right and in connection therewith
Tenant shall provide Landlord with quit claim deeds to be deposited with
Landlord upon execution of this Lease, to be recorded upon the expiration of
Tenant's Expansion Option and First Refusal Right, respectively.
21.16 Corporate Authority. The person signing this Lease on behalf of
-------------------
Tenant warrants that he or she is fully authorized to do so and, by so doing,
to bind Tenant.
21.17 Execution and Delivery. This Lease may be executed in one or more
----------------------
counterparts and by separate parties on separate counterparts, but each such
counterpart shall constitute an original and all such counterparts together
shall constitute one and the same instrument.
21.18 Survival. Without limiting survival provisions which would
--------
otherwise be implied or construed under applicable law, the provisions of
Paragraphs 2.6, 9.4, 11.2, 11.3, 11.4, 13.5, 14.4 and 21.14 hereof shall
survive the termination of this Lease with respect to matters occurring prior
to the expiration of this Lease.
21.19 Confidentiality.
---------------
46
<PAGE>
(a) Landlord's Obligations. Landlord shall, and Landlord shall
----------------------
cause its officers, directors, employees, agents, consultants, advisors and
representatives to, maintain in strict confidence, not disclosing any such
information, or providing copies thereof, any of the following: (i) financial
information concerning Tenant which is not publicly available or has not been
disclosed by other sources; and (ii) any matters of building design which are
unique to Tenant, the manner in which it conducts its business or which would
provide third parties with information as to any proprietary system, method,
process or the like of Tenant; provided, however, that Landlord may make
disclosure of such information to its existing and prospective lenders,
financial partners, consultants, advisors, attorneys, accounts, underwriters
and similar parties, to an entity involved in discussions concerning a merger,
consolidation, acquisition or similar transaction with Landlord (in which case
Landlord shall secure from such party a confidentiality undertaking, similar
to Landlord's obligation hereunder) or as is required by law (including
applicable securities laws) or order of court of competent jurisdiction.
(b) Tenant's Obligations. Tenant shall, and shall cause its
--------------------
officers, directors, employees, agents, consultants, advisors and
representatives to, maintain the financial and significant business terms of
this Lease, and all exhibits hereto, in strict confidence, not disclosing
any of such information, or providing copies of this Lease or any exhibits
hereto, to any person or entity without the written permission of Landlord;
provided, however, that Tenant may make disclosure of such information to
its existing and prospective lenders, financial partners, consultants,
advisors, attorneys, accounts, underwriters and similar parties, to an
entity involved in discussions concerning a merger, consolidation,
acquisition or similar transaction with Tenant (in which case Tenant shall
secure from such party a confidentiality undertaking, similar to Tenant's
obligation hereunder) or as is required by law (including applicable
securities laws) or order of court of competent jurisdiction.
IN WITNESS WHEREOF, the parties hereto have executed this Lease as
of the day and year first set forth above.
"Landlord" "Tenant"
TPSC II LIMITED PARTNERSHIP, a ADVANCED TISSUE SCIENCES, INC., a
Delaware limited partnership Delaware corporation
By:__________________________ By:______________________________
Its:_________________________ Its:_____________________________
47
<PAGE>
EXHIBITS
--------
EXHIBIT A Real Property Description (Site)
EXHIBIT B Site Plan
EXHIBIT C Work Letter
EXHIBIT D Estimated Construction Schedule
EXHIBIT E Acknowledgment of Lease Commencement
EXHIBIT F Form of Subordination, Attornment and
Nondisturbance Agreement and Estoppel
Certificate
EXHIBIT G Lot 27: Legal Description and Site Plan
EXHIBIT H Lot 26: Legal Description and Site Plan
EXHIBIT I Radioactive Materials
EXHIBIT J Synopsis of Relevant Provisions
EXHIBIT K Contractor/Subcontractor Requirements
EXHIBIT 21
ADVANCED TISSUE SCIENCES, INC.
SUBSIDIARIES
State of Incorporation
Subsidiary or Formation Ownership
- --------------------- ---------------------- ---------
ATS Orthopedics, Inc. California 100%
ATS Dermagraft, Inc. California 100%
Segenix, Inc. Delaware 100%
DermEquip, L.L.C. Delaware 50%
EXHIBIT 23
CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
We consent to the incorporation by reference in the Registration Statements
(Form S-8 No. 33-39446) pertaining to the 1987 Incentive Stock Option and
Appreciation Plan, 1990 Stock Option Plan for Non-Employee Directors and
Options Granted to Certain Officers, Directors, Consultants and Scientific
Advisory Board Members under Written Compensation Agreements; (Form S-8 No.
33-48044) pertaining to Options Granted Certain Officers, Directors,
Consultants and Scientific Advisory Board Members under Written Compensation
Agreements; (Form S-8 No. 33-50156 and No. 33-82310) pertaining to the 1992
Stock Option/Stock Issuance Plan; (Form S-8 No. 333-36879) pertaining to the
1997 Stock Incentive Plan; (Form S-3 No. 33-55520, No. 33-61935 and No.
333-08659) pertaining to the registration of shares of Advanced Tissue
Sciences, Inc. Common Stock of our report dated February 3, 1998, with
respect to the consolidated financial statements of Advanced Tissue Sciences,
Inc., and our report dated February 27, 1998, with respect to the combined
financial statements of the Dermagraft Joint Venture included in the Annual
Report (Form 10-K) of Advanced Tissue Sciences, Inc. for the year ended
December 31, 1997.
ERNST & YOUNG LLP
San Diego, California
March 27, 1998
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
This schedule contains summary financial information extracted from the
Form 10-K for the year ended December 31, 1997 and is qualified in its
entirety by reference to such financial statements.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
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0
0
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</TABLE>
