SECURITIES AND EXCHANGE COMMISSION
WASHINGTON D.C. 20549
___________________________
FORM 10-K
[X] Annual Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the Fiscal Year Ended December 31, 1997 or
[ ] Transition Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
Commission File Number: 0-25210
NeoPath, Inc.
(Exact name of registrant as specified in its charter)
Washington 91-1436093
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
8271 - 154th Avenue NE, Redmond, Washington 98052
(Address of principal executive offices) (Zip Code)
Registrant's telephone number,including area code: (425) 869-7284
Securities registered pursuant to Section 12(b) of the Act:
Name of each exchange
Title of each class on which registered
None N/A
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $.01 par value
(Title of Class)
Indicate by check mark whether the registrant (1) has filed
all reports required to be filed by Section 13 or 15(d) of the
Securities Exchange Act of 1934 during the preceding 12 months (or
for such shorter period that the registrant was required to file
such reports), and (2) has been subject to such filing
requirements for the past 90 days.
Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers
pursuant to Item 405 of Regulation S-K is not contained herein,
and will not be contained, to the best of registrant's knowledge,
in definitive proxy or information statements incorporated by
reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
Aggregate market value of voting and nonvoting stock held by
non-affiliates of the registrant as of February 27, 1998 was
$105,453,079.
Number of shares of Common Stock outstanding as of February
27, 1998: 14,419,604 shares.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the 1997 Annual Report to Shareholders are
incorporated by reference into Part II.
Part III is incorporated by reference to the definitive Proxy
Statement to be filed in connection with the Company's Annual
Meeting of Shareholders to be held on May 21, 1998.
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PART I
Item 1. BUSINESS
The following Business section contains "forward-looking
statements" within the meaning of the Private Securities
Litigation Reform Act of 1995. Such forward-looking
statements are subject to certain risks, uncertainties and
other factors that may cause actual results, performance and
achievements to differ materially from historical results or
those anticipated. See "Factors Affecting Future Results
and Forward-Looking Statements."
The Company
NeoPath, Inc. ("NeoPath" or the "Company"), a Washington
Corporation incorporated in 1989, develops and markets
visual intelligence technology to increase accuracy in
medical testing. NeoPath's initial products include (i) two
automated screening systems that integrate proprietary high-
speed image processing computers, video imaging technology
and sophisticated image interpretation software to capture
and analyze thousands of microscopic images from a
Papanicolaou ("Pap") smear slide for the early detection of
cervical cancer and (ii) the Pathfinder(R) System product-
line acquired in 1997.
In 1995, the United States Food and Drug Administration
(the "FDA") cleared for commercial use the Company's first
product, the AutoPap(R) 300 QC Automatic Pap Screener System
(the "AutoPap QC"). In early 1996, the Health Care
Financing Administration officially allowed clinical
laboratories to use the AutoPap QC in the quality control
review of Pap smear slides that have been initially screened
by cytologists and classified as normal. The decision
allows AutoPap QCs to be used in determining which slides
will be rescreened under the federally mandated rescreening
requirement.
NeoPath's second product is the AutoPap(R) Primary
Screener System (the "AutoPap Screener" and, in combination
with the AutoPap QC, the "AutoPap System"). The AutoPap
Screener utilizes the same hardware components as the
AutoPap QC; however, it uses enhanced software, including
additional cell-classification algorithms. During 1997,
NeoPath completed a prospective intended-use clinical study
to evaluate the performance of the AutoPap Screener as a
primary screening system. This study included analysis of
more than 25,000 Pap smear slides at five clinical
laboratories in the United States and Canada. In August
1997, NeoPath submitted the results of the study in an
amendment to its pending PreMarket Approval ("PMA")
Supplement to the FDA, for use of the AutoPap Screener as a
primary screener of Pap smear slides. In January 1998, the
Hematology and Pathology Devices Advisory Panel unanimously
recommended that the FDA approve, with conditions, the
supplement to NeoPath's PMA submission for use of the
AutoPap Screener as a primary Pap smear screener. As of
March 1998, the Company is awaiting FDA approval on this PMA
application.
NeoPath's Pathfinder System provides improved productivity
and quality assurance in the clinical cytology laboratory by
computerizing the cytotechnologists' microscopes, thereby
helping to eliminate screening errors and facilitating
critical cell identification in applications such as Pap
smear screening.
The Company believes that the AutoPap and Pathfinder
Systems can facilitate the earlier and more accurate
detection of precancerous conditions as well as cervical
cancer, thereby decreasing the risks of morbidity and
mortality.
Background
Cancer of the Uterine Cervix
Cancer of the uterine cervix is one of the most common
cancers among women throughout the world, with approximately
500,000 new cases reported each year. The American Cancer
Society projected that, in the United States in 1996,
approximately 14,500 new cases of cervical cancer would be
diagnosed and approximately 4,800 women would die of
cervical cancer. Almost all deaths due to cervical cancer
could be prevented with early-stage detection and treatment.
Cancer of the uterine cervix is preceded by a
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precancerous, curable stage that generally progresses
without symptoms over a period of years until it reaches an
invasive stage. Treating uterine cervical cancer after it
has reached the invasive stage becomes more difficult and
expensive, and may not be successful. Industry sources have
estimated that, of the approximately 50 million Pap tests
conducted annually in the United States, approximately 2.5
million, or 5%, are diagnosed with precancerous conditions
or cancer.
The Pap Test
The Pap test, developed in the 1940s by Dr. George N.
Papanicolaou, is a screening procedure for the early
detection of precancerous and cancerous conditions of the
uterine cervix. The Pap test was designed to identify
abnormalities that may progress to cervical cancer, thereby
facilitating early medical intervention. If early detection
is made, treatment is relatively inexpensive and almost
always successful. To obtain a Pap smear, a gynecologist or
general practitioner scrapes the surface of a woman's
uterine cervix to collect a sample of cells. The specimen is
smeared onto a microscope slide and preserved with a
fixative agent such as alcohol. This Pap smear, along with
patient information, is then sent to a clinical laboratory
for further preparation, screening and diagnosis.
At the laboratory, the specimen, which typically consists
of 50,000 to 300,000 cervical cells, is stained to highlight
important cellular features and sealed with a protective
coverslip. The Pap smear is then placed under a microscope
and examined by a cytotechnologist for signs of abnormality.
Cytotechnologists, medical professionals with special
training in cytology (the study of cells), generally require
five to ten minutes to screen each Pap smear slide and
complete related paperwork. Typically, about 90% to 95% of
all Pap smears are classified as normal. In the remaining
cases, a cytotechnologist has detected a suspicious
condition that must be reviewed by a senior
cytotechnologist. Those slides confirmed to have signs of
precancerous conditions or cancer, typically about 5% of all
cases, are referred to a cytopathologist, who carefully
reviews the Pap smear and makes a final diagnosis.
Despite the acknowledged success of the Pap test, there
are certain limitations in the current method of manual Pap
smear review. Pap smears are subject to a highly variable
false-negative rate (the percentage of abnormal smears that
are misclassified as normal). In certain laboratories, this
false-negative rate may exceed 25% (that is, one of four
abnormal Pap smears may be misclassified as normal). Partly
because physical and mental stress escalates with the number
of Pap smears examined, thereby increasing the risk of false-
negatives, federal regulations promulgated under the
Clinical Laboratory Improvement Amendments of 1988 ("CLIA")
generally limit the number of slides that a cytotechnologist
may screen each day to no more than 100. As an additional
quality control measure, the CLIA regulations also require
that laboratories rescreen a minimum of 10% of all Pap
smears initially classified as normal.
Treatment
In the United States, each Pap smear slide is typically
classified in accordance with The Bethesda System for
Reporting Cervical/Vaginal Cytologic Diagnoses. Any slide
classified as other than normal is considered abnormal and
may be precancerous or cancerous. Abnormalities evident in
Pap smears may indicate various conditions ranging from
atypical squamous cells of undetermined significance
("ASCUS") and atypical glandular cells of undetermined
significance ("AGUS"), both commonly referred to as
"atypia," and low-grade squamous intraepithelial lesions
("LSILs") to high-grade squamous intraepithelial lesions
("HSILs") and cancer. A woman whose Pap smear indicates the
presence of HSILs or cancer will typically receive a
colposcopic examination, and if necessary, a biopsy.
Treatment of early-stage noninvasive cervical cancer, which
is relatively curable, may be accomplished by epithelial
treatment in which the cancerous tissue is removed, for
example, by electrocautery. Once the cancer reaches an
invasive stage, the patient's chances for recovery are
diminished and typically require treatment such as radiation
therapy, surgery, or chemotherapy.
Market
The Company believes that clinical analysis of Pap smears
currently represents the largest nonautomated clinical
laboratory procedure. Industry statistics indicate that
U.S. clinical laboratories
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process over 50 million Pap smears annually and that
laboratories outside the United States process more than 60
million Pap smears annually. Pap smears are generally
processed in hospital-based or independent clinical
laboratories.
Laboratories that fail to accurately identify Pap smears
that contain indications of precancerous conditions or
cancer may be subject to malpractice suits. Because federal
law requires all Pap smears to be retained by laboratories
for five years, these laboratories face significant exposure
to liability. The Company believes that use of its AutoPap
System will substantially improve the current quality of
practice, thereby enabling those laboratories that use the
AutoPap System to reduce their exposure to such liability.
In addition, in recent years there has been an increasing
focus on improving the quality of women's healthcare. The
Company believes that the AutoPap System will allow
laboratories to better detect precancerous cervical
conditions and cervical cancer, thereby improving the
standard of care for their female patients. Earlier
detection will facilitate more timely treatment and will
lower risks of morbidity and mortality.
Products
NeoPath's AutoPap QC and AutoPap Screener employ identical
hardware components. The AutoPap Screener, however,
contains enhanced software, including additional cell-
classification algorithms, that allow it to be used for
primary screening. In addition to regulatory approvals in
the United States, the AutoPap System is approved for
primary screening and quality control rescreening in Japan,
Canada, Australia, New Zealand, The Netherlands, Italy, and
Hong Kong. The AutoPap QC is also approved for quality
control rescreening in Korea. See "Governmental
Regulation."
The AutoPap System is used on-site by general laboratory
personnel and is compatible with a wide range of staining
procedures used on conventionally prepared Pap smear slides.
The AutoPap System currently requires use of glass
coverslips, which are widely used by most laboratories and
provide consistent optical characteristics. The AutoPap
System analyzes a Pap smear in approximately the same time
as a cytotechnologist. The AutoPap System, which holds
approximately 300 Pap smear slides at a time, is easy to
load and unload, and is designed to operate continuously, or
with minimal intervention, for up to 24 hours per day. The
Company provides each clinical laboratory with on-site
training, system documentation, a comprehensive quality
assurance program, and ongoing customer and technical
support.
NeoPath believes that its automated image-interpretation
technology has substantial application for other diagnostic
tests that involve microscopic analysis of biological
specimens on glass slides, such as sputum, blood, tissue, or
urine samples. In addition, the Company has identified
several other potential applications for its technology,
including automated image interpretation for lung, breast,
bladder and skin cancers. The Company believes that the
technology embodied in the hardware platform of the AutoPap
System is appropriate for other applications involving
analysis of cellular images on microscope slides.
Developing systems for such applications primarily involves
adapting software algorithms developed for the analysis of
Pap smears to the analysis of other tissue specimens. The
Company continues to evaluate the indications on which it
may focus future development efforts, including non-medical
applications.
The Company's research and development expenses were $14.2
million, $11.2 million, and $9.4 million in the years ended
December 31, 1997, 1996, and 1995, respectively.
AutoPap 300 QC Automatic Pap Screener System
The AutoPap QC is designed to rescreen Pap smears that
have been previously screened and classified as normal by a
cytotechnologist. Its purpose is to improve the detection
of false-negatives and, thereby, improve diagnostic
accuracy. The AutoPap QC classifies slides based on their
likelihood of being abnormal; a percentage (10% or more) of
those slides showing the highest potential for abnormality
are identified as requiring additional review by a
cytotechnologist qualified to perform quality control. The
AutoPap QC is intended for use as either a quality-control
or an adjunct rescreening device for previously manually
screened Pap smears. This flexibility will allow
laboratories either to implement the AutoPap
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QC into their quality-control procedures or to offer Pap
smear rescreening by the AutoPap QC as an additional service
for those women who seek an additional review of their Pap
smears.
Preclinical and clinical trials demonstrated that the
AutoPap QC, operating in a quality-control mode, showed up
to a five-fold improvement in the detection of false
negative slides over a 10% random selection method. By the
same standard, the AutoPap QC achieved up to an eight-fold
improvement in the detection of biopsy-confirmed HSIL and
cancer slides. The Company believes that the substantial
improvement over current methodology demonstrated by the
AutoPap QC can result in consistent earlier detection of
precancerous conditions and cancer, thereby facilitating
more timely treatment and reducing the risk of morbidity and
mortality.
AutoPap Primary Screener System
During 1997, NeoPath completed a prospective intended-use
clinical study to evaluate the performance of the AutoPap
Screener. This study included more than 25,000 Pap smear
slides at five clinical laboratories in the United States
and Canada. The AutoPap Screener used in the clinical study
incorporates new diagnostic algorithms (not currently used
in the AutoPap QC) that provide a "second opinion" to
improve diagnostic accuracy in the primary screening of Pap
smear slides.
The clinical study was designed to compare the AutoPap
System-assisted practice to current practice, with the
results subjected to an extensive truth determination
process for slide diagnosis. The AutoPap System-assisted
practice identified up to approximately 25% of the lowest-
ranking slides as "within normal limits" and requiring no
further review; the remaining approximately 75% of slides
were subjected to manual screening with the assistance of
the AutoPap ranked review report which indicates the
relative scores of the processed slides (of which, at least
15% of the highest-ranking slides that were classified as
within normal limits by manual review underwent quality
control rescreening). "High-risk" slides (as defined by
each laboratory) were excluded from the study, as were other
slides that were unsuitable for AutoPap Screener processing.
As a result of the study, the AutoPap System-assisted
practice identified more abnormal slides compared to current
practice, and this difference was statistically significant
in favor of the AutoPap System-assisted practice. In
addition, the AutoPap System-assisted practice showed
improved specificity (the ability to correctly identify
normal slides) over current practice.
Based on the results of the study, in August 1997 NeoPath
submitted an amendment to its PMA Supplement to the FDA for
use of the AutoPap Screener as a primary screener of Pap
smear slides. In January 1998, the Hematology and Pathology
Devices Advisory Panel unanimously recommended that the FDA
approve, with conditions, NeoPath's PMA submission. As of
March 1998, the Company is awaiting FDA approval on this PMA
application.
NeoPath believes that the AutoPap Screener will become the
Company's principal product for the Pap smear screening
market. By reducing the number of Pap smears requiring
cytotechnologist review, the AutoPap Screener increases the
number of Pap smears a laboratory can process, potentially
reducing the per-slide processing cost while improving
overall laboratory accuracy.
The AutoPap Screener is designed to initial screen all of
the laboratory's eligible Pap smears and classify them
according to the likelihood of abnormality. Because the
AutoPap Screener is an upgrade, designed to incorporate the
features of the AutoPap QC, the AutoPap Screener allows the
laboratory to continue to perform its AutoPap QC-assisted
quality control rescreening without having to process Pap
smear slides twice through the AutoPap System. Because of
the AutoPap Screener's ability to act as a primary Pap smear
screener, the Company intends to charge higher fee-per-use
and sale prices for use of the AutoPap Screener than for the
AutoPap QC.
Pathfinder System
NeoPath's Pathfinder System provides improved quality
assurance in the clinical cytology laboratory by
computerizing the cytotechnologists' microscopes, thereby
helping to eliminate screening errors and facilitating
critical-cell relocation in applications such as Pap smear
screening. The Pathfinder System's
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position sensors attach to the microscope. As a
cytotechnologist examines a slide, the Pathfinder System
records the exact areas scanned, the location and identity
of any cells or cell clusters that were electronically
marked, and patient identification information. This data
can be accessed electronically by other laboratory personnel
or reviewed through report-writing features. The Pathfinder
System is not subject to FDA regulation.
In June 1997, NeoPath acquired the Pathfinder System
product line from CompuCyte Corporation for an initial
purchase price of $4.1 million. The initial purchase price
included cash of $2.7 million (including transaction-related
expenses), a $500,000 short-term note paid in October 1997,
and 48,564 shares of NeoPath common stock. In addition,
48,563 shares of NeoPath common stock were issued and are
held in escrow contingent upon certain specific technology
decisions to be made within one year of closing. In
accordance with accounting rules, the value of the
contingent shares was excluded from the initial purchase
price allocation, and the 48,563 contingent shares are
excluded from the calculation of weighted average shares
outstanding. Including the value of contingent shares at the
closing date, which value the Company expects to recognize
as an intangible asset if the contingency is removed, the
total purchase price approximated $5.1 million.
As a result of the acquisition, the Company recognized
$3.8 million in acquired intangible assets which are
amortized over five years. NeoPath began selling the
Pathfinder System as a stand-alone product in the third
quarter of 1997 and continues to evaluate the integration of
the technology into the AutoPap System. Pathfinder System
sales accounted for less than three percent of total
revenues in 1997.
Marketing and Sales
On January 28, 1998, the FDA's Hematology and Pathology
Devices Advisory Panel unanimously recommended that the FDA
approve, with conditions, NeoPath's PMA supplement with
respect to the AutoPap Screener. Upon FDA approval, the
AutoPap Screener will become the first device approved in
the United States for the automated initial screening of Pap
smear slides. There can be no assurance that the FDA will
clear the AutoPap Screener for commercial use. The AutoPap
QC is the only fully automated Pap smear rescreening device
to receive regulatory clearance for marketing in the United
States. The AutoPap QC has been cleared by the FDA for
commercial use in either a quality-control rescreening mode
or an adjunct rescreening mode. The Company believes that
use of the AutoPap Screener or the AutoPap QC will serve to
distinguish its customers' laboratories as providing a
higher quality of Pap smear screening compared to those
laboratories that have not adopted the AutoPap System.
NeoPath's primary market includes domestic and foreign
clinical laboratories. Domestic revenues are generated
primarily through NeoPath's direct sales force, while
international revenues are derived primarily through
independent distributors. International product placements
accounted for 51% and 45% of total 1997 and 1996 revenues,
respectively. The Company's four largest customers
accounted for 65% and 86% of total 1997 and 1996 revenues,
respectively. The Company's market research indicates that
over 35% of all U.S. Pap smears are screened by the three
largest laboratories, including SmithKline Beecham Clinical
Laboratories, Quest Diagnostics Incorporated, and Laboratory
Corporation of America. Each of these companies operate
multiple laboratory facilities nationwide. The Company has
AutoPap QCs placed with each of these three large laboratory
corporations. SmithKline Beecham Clinical Laboratories,
with AutoPap QCs installed in eleven separate facilities, is
NeoPath's largest customer, based on total number of AutoPap
QCs placed; however, UniLab Corporation, with 13 AutoPap
QCs, represents the Company's largest single-site customer
to date.
NeoPath distributes AutoPap Systems in Japan through an
agreement with Nikon Corporation ("Nikon") whereby Nikon
markets products to customers and handles maintenance and
service. NeoPath provides training for Nikon sales
personnel and service engineers, who in turn train Japanese
customers. The Japanese market, with approximately 12
million Pap smear tests conducted annually, is second only
to the United States in current screening volume for a
country. Nikon was NeoPath's largest customer in 1997 and
1996, based on revenues.
In addition to Japan, the Company has also received
regulatory approvals to export and market the AutoPap System
in Canada, Australia, New Zealand, The Netherlands, Italy,
and Hong Kong. The
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AutoPap QC is also approved for quality control rescreening
in Korea. In 1997, NeoPath established NeoPath Europe,
located in Belgium, as its first international branch. The
Company intends to increase its marketing efforts in Europe
and other international locations in 1998.
NeoPath recognizes revenue on either a sale or fee-per-use
basis (subject to certain license agreements, lease
contracts, and minimum payments on fee-per-use contracts).
Under its fee-per-use program, the Company retains ownership
of AutoPap Systems placed at customer sites and assesses
customers a charge for each Pap smear slide analyzed.
NeoPath's AutoPap System placements have primarily consisted
of fee-per-use contracts in the United States and sales
contracts internationally. The Company anticipates that
future AutoPap System placements will continue to consist of
both fee-per-use and sale contracts; however, the Company
expects that revenues for the next several quarters will
continue to consist of greater sales of AutoPap Systems than
revenues generated from NeoPath's fee-per-use program.
The Company installs the AutoPap System at customer
laboratories. By providing this on-site service, the
Company believes that clinical laboratories will be better
able to integrate use of the AutoPap System into their
normal workflow. Installing the AutoPap System on site also
allows clinical laboratories to maintain control over
patient specimens and associated data, minimize slide
handling and avoid delays in reporting their test results.
The Company anticipates being able to upgrade an AutoPap
QC to an AutoPap Screener in the field. As the Company's
product development efforts improve the performance and
functionality of the AutoPap System, the Company intends,
subject to obtaining applicable regulatory approvals, to
market upgraded product versions to its customers. The
Company has not yet determined how it will charge for its
upgrade packages, but anticipates that upgrades will result
in increases in its fee-per-use and sale pricing.
Manufacturing
The Company's manufacturing operations are located at its
headquarters in Redmond, Washington and consist of final
assembly, integration and testing of electronic, mechanical
and optical components and modules comprising the AutoPap
System. In its manufacturing process, the Company is
required to meet and adhere to all applicable requirements
of U.S. and international regulatory agencies, including
Quality Systems Regulations ("QSR"), as promulgated by the
FDA. As part of the FDA regulatory process, the Company's
AutoPap System manufacturing processes and facilities are
subject to periodic FDA QSR inspections and may be subject
to further periodic inspections by U.S. and foreign
regulatory agencies. See "Governmental Regulation."
NeoPath's manufacturing operations have produced sufficient
AutoPap Systems to meet customer demand since commercial
operations began in 1996.
The Company purchases all components for the AutoPap
System and Pathfinder System from outside vendors. A major
component of the AutoPap System, the slide tray motion
system, is supplied by a sole-source vendor. Certain other
components, such as the video cameras, are currently
supplied by single source vendors, and components provided
by additional or replacement suppliers would require some
modification to be incorporated into the AutoPap System.
The establishment of additional or replacement sources of
supply for many AutoPap System components cannot be
accomplished quickly, and substitution of components could
require regulatory approval, the receipt of which cannot be
assured. Accordingly, a vendor's inability to supply
acceptable components in a timely manner and in the quantity
required could delay or halt the Company's manufacture of
its products. Any such delay or cessation could have a
material adverse effect on the Company.
Core AutoPap System Technology
The Company's core AutoPap System technology consists of a
means for acquiring high-quality images through an
integrated high-speed video microscope, comprehensive image
interpretation software to accurately analyze images and
classify cells and slides, and high-speed custom field-of-
view ("FOV") computers to run the software at high speed.
This technology is able to automatically analyze and extract
important features of cellular material and to classify a
specimen based on those features.
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High-Speed Video Microscope
To capture high-quality images, the Company has designed a
high-speed video microscope consisting of an integrated
mechanical/optical system with a custom microscope and video
cameras that focus, capture and digitize images from a Pap
smear. The microscope and three video cameras are
stationary while the platform holding the Pap smear is
moved, which allows the camera system to scan the Pap smear
in a continuous, systematic motion. The Pap smear is
illuminated by high-intensity, narrowband light from a
strobe that enhances cell contrast and freezes each image
without interrupting the motion of the platform holding the
Pap smear.
The mechanical/optical system is controlled by a custom-
designed image capture and focus module that incorporates
specialized integrated circuits and software. This module
calibrates the image acquisition system, automatically
focuses the system to obtain diagnostically relevant images
and adjusts for the non-uniform background and cell
distributions of a conventional Pap smear. The image capture
and focus module also digitizes images, evaluates image and
focus quality, decides whether to accept or reject the image
for analysis and identifies the location of a rejected image
for a repeat scan.
The mechanical/optical system generally scans the slide in
three separate operations. First, it performs a setup,
which consists of locating the slide, identifying the
coverslip area and mapping three-dimensional surface
irregularities of the Pap smear. The system then captures
and analyzes low-magnification images from the slide in a
systematic scan of the slide coverslip area. Finally, using
information from the low-magnification scan, the system
captures high-magnification images from those areas of the
slide having the greatest diagnostic interest.
Image-Interpretation Software
NeoPath's image-interpretation software integrates a
series of image-interpretation algorithms to examine slide
images and select and analyze those that are the most
relevant indicators of normality and abnormality. An image-
interpretation algorithm consists of multiple-step
mathematical and algorithmic processes that detect and
classify an object or collection of objects based on shape,
structure, optical density, contextual features and other
measurable characteristics. The process executed by the
image-interpretation software consists of five steps:
selecting images from a slide, segmenting the images into
objects, measuring object features, classifying objects and
classifying the slide.
Selection of Images. By analyzing images from a low-
magnification scan of the slide coverslip area, algorithms
first identify the areas most likely to contain cellular
material of diagnostic significance. This information
then guides the high-speed video microscope to analyze the
locations of greatest diagnostic interest in a separate
high-magnification scan. The AutoPap System also
accumulates and stores information gathered in this first
step for later use in the slide classification process.
Segmentation Into Objects. In the high-magnification
scan, the AutoPap System locates and segments the well-
defined cells or group of cells in each image into
objects, while excluding from further analysis poorly
defined objects and obvious artifacts (blood, mucus, dust
particles and similar matter).
Measurement of Object Features. Once objects or groups
of objects are segmented from other elements of the image,
algorithms measure more than 100 features from each
object. Features are characteristics of the objects that
independently or in combination provide effective
discrimination among normal cells, artifacts and abnormal
cells. The algorithms discriminate on the basis of
certain general categories of features, including the
following: density, texture, size, shape and context.
Density features are measures of the optical density of
various portions of the cell, such as the cytoplasm and
nucleus, and the ratios of these densities to each other.
Texture is a localized measure of optical density
variation. Size features refer to the physical areas of
the segmented objects and their ratios to each other.
Shape features measure the boundary complexity of the
segmented objects, can differentiate cell types, and are
used to discriminate among isolated and overlapping
objects. Context compares an object to its surroundings
and the proximity of objects to each other.
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Classification of Objects. Using the measured object
features, a series of algorithms then classifies the
objects contained in the images. Each classification
algorithm contains multiple stages that proceed from
easily identifiable objects to increasingly difficult
objects, adding more features at each level of
classification. Three complementary algorithms are used
to analyze the cells and cell groupings that could
indicate normality and abnormality: the single-cell
algorithm, the group algorithm and the thick-group
algorithm. An "anomaly likelihood" value is computed at
various steps of the classification process in which pre-
defined thresholds are applied to provide "alarms," which
identify objects that have a higher likelihood of being
abnormal cells. The results of the three algorithms are
integrated to achieve high overall classification
accuracy.
Classification of the Slide. All the gathered and
analyzed information from objects is compiled in a series
of scores that are used to classify the slide for purposes
of quality-control rescreening, adjunct rescreening or
primary screening. Other algorithms evaluate the
suitability of the slide for machine processing (quality
of staining, adequacy of cell collection, presentation of
material on the slide and image quality) and determine the
probable presence of certain important cellular material
such as endocervical, endometrial and squamous cells.
The AutoPap Screener utilizes new diagnostic algorithms
that provide an adjunctive evaluation score, in addition to
the original evaluation score, for superior detection of
glandular abnormalities. This was accomplished by the
development of new algorithms that classify clusters of
cells. The adjunctive evaluation score was implemented as a
second opinion to the decision of the original evaluation
score. The combination of the adjunctive evaluation score
and the original evaluation score produces an increased
detection sensitivity for all abnormal categories.
Field-of-View (FOV) Computer
Image-interpretation algorithms are implemented in
computer programs that must be executed by a high-speed
computing system. These algorithms must be run for each Pap
smear image, a process requiring significant computing
power. To address this requirement, NeoPath developed
specialized FOV computers, which are powerful image
processors that contain application-specific integrated
circuits and other processing components. The execution
speed of NeoPath's image-interpretation software is
accelerated through the use of these special-purpose
computers. The Company estimates that one FOV can perform
elemental pixel operations at a rate exceeding 1.6 billion
per second and at proportionately higher rates when several
FOVs are linked to run in parallel. The current
configuration for the AutoPap System contains 15 FOVs, and
the Company expects that future versions will be faster
(thus an AutoPap System may require fewer FOVs). The FOVs
are fully programmable and can be programmed to execute
algorithms for other applications.
Patents and Proprietary Rights
Because of the substantial length of time and expense
associated with bringing new products through development
and regulatory approval to the marketplace, the medical
device industry places considerable importance on obtaining
patent protection and protecting trade secrets for new
technologies, products and processes. Accordingly, the
Company files patent applications to protect technologies
that it believes are significant to the development of its
business. The Company holds 39 U.S. patents (issued or
allowed) and has 34 additional U.S. patent applications
pending. The patents and patent applications relate to
various aspects of the Company's high-speed image-
interpretation technology. The Company holds four foreign
patents and has applied for patent protection for certain
aspects of its technology in various foreign countries. The
Company intends to continue to pursue patent protection
where it is available and cost-effective, both in the United
States as well as in other countries.
The medical device industry has been characterized by
extensive litigation regarding patents and other
intellectual property rights, and the Company may institute
or otherwise be involved in such litigation to enforce its
patents, protect its trade secrets or know-how, challenge
the validity of proprietary rights of others or defend
against its alleged infringement of proprietary rights of
others. In July 1996, a patent
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infringement action was filed against the Company by a
competitor; in March 1997, the Company filed a patent
infringement lawsuit against that competitor. See "Item 3.
Legal Proceedings" and "Factors Affecting Future Results and
Forward-Looking Statements - Dependence on Patents and
Proprietary Rights; Risk of Third-Party Claims of
Infringement."
NeoPath relies on a combination of patents, trade secrets
and confidentiality agreements to protect its proprietary
technology, rights and know-how. The Company's policy is to
have each employee or consultant enter into a
confidentiality agreement containing provisions prohibiting
disclosure of confidential information to anyone outside the
Company. These provisions also require disclosure to the
Company of ideas, developments, discoveries or inventions
conceived during employment or consultation, and assignment
to the Company of proprietary rights to such matters related
to the business and technology of the Company.
The Company has two registered trademarks in the United
States, Australia, Japan, Canada, France, the Benelux
countries, Germany, The United Kingdom, Italy and Spain for
"NeoPath" and "AutoPap." The Company also has registered
trademarks for "Pathfinder," "Visual Intelligence,"
"AutoReview" and "PapMap" in the United States. NeoPath has
applied for registration of its trademarks in several other
foreign countries.
Third-Party Reimbursement
Some private third-party medical insurance providers and
governmental agencies offer reimbursement for laboratory
testing associated with routine medical examinations,
including Pap smears. In the United States, many Pap smears
are currently paid for by the patient, and the level of
reimbursement by those third-party payers that provide
reimbursement varies considerably. Third-party payers,
including Medicare and Medicaid, Blue Cross/Blue Shield,
private health insurance, health administration authorities
in foreign countries and other organizations, may affect the
pricing or relative attractiveness of the Company's products
and services by regulating the maximum amount of
reimbursement provided by such payers or by not providing
any reimbursement. Restrictions on reimbursement may limit
the price that the Company can charge for AutoPap System
screening or reduce the demand for AutoPap System screening.
In addition, if there is no provision for reimbursement of
the AutoPap System screening, or if the level of
reimbursement is significantly below the amount laboratories
charge patients to perform AutoPap System screening, the
size of the potential market available to the Company would
likely be reduced. There can be no assurance that costs
associated with AutoPap System screening will become widely
reimbursable or that the level of reimbursement to clinical
laboratories for AutoPap System screening will achieve or be
maintained at levels necessary to permit the Company to
generate substantial revenue. In the international market,
reimbursement by private third-party medical insurance
providers, including governmental insurers and providers,
varies by country. In certain countries, the Company's
ability to achieve significant market penetration may depend
on whether third-party or governmental reimbursement is
available. The Company intends to focus on obtaining
coverage and reimbursement from major national and regional
third-party payers in the United States.
NeoPath believes that increased third-party reimbursement
of Pap smears in general, and increased reimbursement for
screening utilizing the AutoPap System in particular, will
significantly increase the Company's potential for revenues
in 1998 and beyond. In October 1997, the American Medical
Association published its revised Physicians' Current
Procedural Terminology (CPT-4) codes which included a code
that applies to the AutoPap QC for automated cervical cancer
rescreening. CPT codes are a universal system used by
physicians and clinical laboratories to identify specific
procedures when billing insurers for their services. In
early 1998, NeoPath formed a five-person team to work with
third-party insurers and managed care organizations to
establish and/or review and improve third-party
reimbursement levels for Pap smear screening with the
AutoPap System. These managed care specialists will work
closely with NeoPath's field sales personnel throughout the
United States.
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Governmental Regulation
United States
The AutoPap QC and the AutoPap Screener are medical
devices subject to extensive regulation in the United States
by the FDA and by other federal, state and local
authorities. The FDA regulates the research, development,
clinical studies, manufacturing, packaging, labeling,
distribution, promotion and postmarket surveillance of
medical devices in the United States. Preclinical and
clinical trials of medical devices must be conducted in
conformity with all applicable FDA regulations. In
addition, state and local permits may be required under
regulations relating to clinical activities.
Under the Federal Food, Drug, and Cosmetic Act, the
AutoPap System is a Class III medical device, subject to
stringent FDA review to ensure that the device is safe and
effective before commencement of marketing, sales and
distribution in the United States. Once a PMA application
receives FDA approval and the Company commences marketing
the applicable product, it is required to register with the
FDA and to submit device listing information for products in
commercial distribution. In addition, the FDA may impose
certain post-approval requirements in a PMA approval order
at the time of approval, with which NeoPath would be
required to comply. In conjunction with FDA approval of the
PMA application and supplements with respect to the AutoPap
System, the Company's manufacturing operations are subject
to FDA QSR inspection. The Company will continue to be
inspected on a routine basis by the FDA for compliance with
QSR regulations with respect to manufacturing, testing,
distribution, storage and control activities. Labeling and
promotional activities are also regulated by the FDA. The
Company is required to establish and maintain a system for
tracking AutoPap Systems through the chain of distribution
and to conduct postmarket surveillance, and is required to
provide periodic reports containing safety and effectiveness
information.
In addition, the Medical Device Reporting ("MDR")
regulations obligate medical device companies such as
NeoPath to provide information to the FDA whenever there is
evidence to reasonably suggest that a device may have caused
or contributed to a death or serious injury, or
malfunctioned and the device or a similar device marketed by
the company would be likely to cause or contribute to a
death or serious injury if the malfunction were to recur.
If, as a result of FDA inspections, MDR reports or
information derived from any other source, the FDA believes
that the Company is not in compliance with the law, it can
take one or more of the following actions: refuse to review
or clear applications to market the Company's product in the
United States or to allow the Company to enter into
government supply contracts; withdraw previously approved
applications; require notification to users regarding newly
found risks; request repair, refund or replacement of faulty
devices; request corrective advertisements, recalls or
temporary marketing suspension; or institute legal
proceedings to detain or seize products, enjoin future
violations or assess criminal penalties against the Company,
its officers or employees. Civil penalties for Food, Drug,
and Cosmetic Act violations may be assessed by the FDA in
lieu of or in addition to instituting other legal action.
Any such action by the FDA could result in disruption of the
Company's operations for an indeterminate period of time.
Various states in which the Company's products may be sold
in the future may impose additional regulatory requirements.
International Markets
A Class III medical device that has not been approved for
marketing in the United States may be exported for sale only
after the FDA has determined that the exportation of the
device is not contrary to public health and safety and that
the Company has received approval of the country to which
the device is intended for export. Approval of a device by a
comparable regulatory authority of a non-U.S. country must
generally be obtained prior to applying to the FDA for
clearance to export and commence marketing in that country.
Sales of medical devices outside of the United Sates are
subject to foreign regulatory requirements that vary widely
from country to country.
The Company has received the necessary regulatory
clearances from the FDA and the necessary regulatory
approvals from each country's regulatory agency to export
the AutoPap System to, and market it
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for commercial use in, Japan, Canada, Australia, New
Zealand, The Netherlands, Italy, and Hong Kong. The AutoPap
QC is also approved for quality control rescreening in
Korea. NeoPath intends to pursue additional product
registrations in other foreign countries.
The Company's products are subject to a variety of
regulations in Europe. In vitro diagnostic medical devices,
including the AutoPap System, are not currently subject to
medical device directives issued by the European Union
("EU"). The Company anticipates that the EU will finalize a
directive for in vitro diagnostic medical devices that would
establish a basis for harmonized regulation of such devices
among EU member states. NeoPath would be subject to this
directive, including any established deadlines for
compliance. If enacted, the directive would apply only to
member states of the EU and the European Economic Area.
Other European countries, however, may enact national laws
that would conform to the directive. Member states of the
EU and the European Economic Area may enact requirements in
addition to those imposed by the directive. Some European
countries have established national regulations relating to
in vitro diagnostic medical devices. EU directives and
national laws impose requirements for electrical safety and
electromagnetic compatibility that apply to the AutoPap
System. NeoPath has performed the requisite testing
procedures and related documentation to apply the European
"CE" mark to the AutoPap and Pathfinder Systems. There can
be no assurance that the AutoPap System or any other product
that the Company may develop will obtain any required
regulatory clearance or approval on a timely basis, if at
all.
Regulation of Cervical Pap Smear Analysis
Pursuant to CLIA, Congress directed the Department of
Health and Human Services to promulgate regulations designed
to improve the quality of biomedical analytic services,
particularly the examination of Pap smears. CLIA
regulations require clinical laboratories to rescreen at
least 10% of the Pap smears classified on initial manual
screen as normal; this 10% must include normal cases
selected at random from the laboratory's total caseload, as
well as from patients or groups of patients that are
identified as having a high probability of developing
cervical cancer based on available patient information. The
AutoPap System is not intended to replace a laboratory's
current practices regarding screening or rescreening Pap
smears of "high-risk" patients.
In addition, laboratories may be subject to state
regulations, inspection, and licensing. In recent years, a
few states, including New York and California, have adopted
regulations that limit the number of slides that may be
manually examined by a cytotechnologist within a given
period of time. There can be no assurance that states will
not directly regulate the AutoPap System in the future. The
Company cannot predict the effect, if any, that such
regulation may have on its business or operations.
In early 1996, the Health Care Financing Administration
officially allowed clinical laboratories to use the AutoPap
QC in the quality control review of Pap smear slides that
have been initially screened by cytologists and classified
as normal. The decision allows AutoPap QCs to be used in
determining which slides will be rescreened under the
federally mandated rescreening requirement.
Competition
Competition in the medical device industry is intense, and
the industry is characterized by rapid product development
and technological change. The AutoPap System competes with
existing manual methods of screening Pap smears as well as
with certain semi-automated systems. To compete
effectively, the AutoPap System must demonstrate comparable
or better accuracy as well as cost effectiveness relative to
manual review of Pap smears. The Company is currently aware
of three potential direct competitors: AutoCyte, Inc.
("AutoCyte"), which has focused on the development of a semi-
automated system to prepare and analyze liquid-based Pap
smears (a potential alternative to conventional Pap smears);
MorphoMetrix Technologies, Inc. ("MorphoMetrix") which has
developed an automated system to analyze monolayer Pap
smears; and Neuromedical Systems, Inc. ("NSI"), which is
engaged in marketing a device for the semi-automated
rescreening of conventional Pap smears and is reported to be
developing a semi-automated primary screener.
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AutoCyte announced the completion of clinical studies for
its liquid-based Pap smear preparation system and submitted
these results to the FDA under a PMA. Additionally, NeoPath
believes that AutoCyte may be conducting clinical trials of
a screening system for the automated analysis of its
monolayer slides. The Company believes that MorphoMetrix
may soon commence clinical trials for its monolayer
screening product. NSI is marketing its semi-automated Pap
smear rescreening service as an adjunct to human Pap smear
screening. NSI's system is currently a computerized image
processing service provided to laboratories for which
selected Pap smear slides are sent for processing to an NSI
processing center. NeoPath believes that NSI is changing
its system to be available for placement in the clinical
laboratory and that NSI also may be preparing for a clinical
trial for use of its system in primary screening. The NSI
system creates a color video picture of each of the 128
images of the Pap smear slide deemed by the NSI system to be
most likely to be abnormal. Under NSI's current practice,
these images are recorded on a digital tape cassette that,
together with the patient's Pap smear slide, is returned to
the clinical laboratory. Trained laboratory personnel then
evaluate each of the 128 video pictures for each Pap smear
slide. If the cytotechnologist believes that there might be
an abnormality indicated on NSI's images of the Pap smear,
then a cytotechnologist would manually rescreen the Pap
smear slide using a microscope.
In addition to direct competition, the Company faces
indirect competition through companies that manufacture
liquid-based or monolayer slide preparation systems and
devices that automate other aspects of cytology. In 1996,
Cytyc, Inc. received PMA approval from the FDA to market its
ThinPrep System which prepares slides for cervical cancer
screening using a liquid-based sampling and preparation
technique as a replacement for the conventional Pap smear
method.
The Company believes that the AutoPap System will compete
on the bases of accuracy and effectiveness, cost (including
both charges by the Company to the laboratory and the
laboratory's labor and overhead costs for its
cytotechnologists), convenience to the laboratory,
perception among influential cytopathologists and
laboratories and processing speed and reliability. The
Company believes that the AutoPap Screener will enable the
Company's customer laboratories to increase the number of
Pap smears processed while improving accuracy and allow them
to focus their cytotechnologists' attention on the careful
review of Pap smears that are most likely to contain
meaningful indication of abnormality.
There can be no assurance that the Company's competitors
will not develop new technologies and products that will
compete with, or will prove to be more effective than, the
AutoPap System. Furthermore, although the Company is
currently aware of only three direct competitors, there can
be no assurance that others will not purchase or develop
technologies that would compete with the AutoPap System or
render it obsolete. Competitors may manufacture, market and
sell their products or services more successfully than the
Company, which could have a material adverse effect on the
Company's business and results of operation.
Employees
At December 31, 1997, the Company employed 176 full-time
equivalent personnel, including 55 in research and
development and regulatory; 54 in administration, customer
service and support, and sales and marketing; and 67 in
manufacturing. None of the Company's employees are
represented by a union or other bargaining group. The
Company believes its relationship with its employees is
good.
Factors Affecting Future Results and Forward-Looking
Statements
The preceding "Business" section contains "forward-looking
statements" within the meaning of the Private Securities
Litigation Reform Act of 1995. Such forward-looking
statements reflect the Company's current views with respect
to future events and financial performance. These forward-
looking statements are subject to certain risks,
uncertainties and other factors that may cause the Company's
actual results, performance and achievements to differ
materially from historical results or those anticipated.
The words "plan," "expect," "anticipate," "believe" and
similar expressions identify forward-looking statements.
Readers are cautioned not to place undue reliance on these
forward-looking statements, which speak only as of their
dates. The Company undertakes no obligation to publicly
update or revise any forward-looking statements, whether as
a result of new information, future events, or otherwise.
Factors that could cause
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actual results to differ materially from historical results
or those anticipated include, without limitation, the items
that follow.
Limited Operating History; History of Losses
The Company has a limited operating history and, prior to
1996, was focused primarily on product development,
obtaining regulatory approvals and establishing
manufacturing capability. NeoPath began recognizing product
revenues in 1996.
The Company has incurred substantial losses since its
inception and, as of December 31, 1997, the Company had an
accumulated deficit of $87.8 million. The Company expects
continued losses in 1998 as it continues to expand its
sales, marketing, and customer service and support
capabilities and continues its research and development
activities (including additional clinical studies). There
can be no assurance that the Company will achieve
profitability or that the Company will not be required to
seek additional capital. There can be no assurance that
adequate funding will be available, if needed, or on terms
acceptable by the Company.
Uncertainty of Market Acceptance; Market Consolidation
The Company's success and growth depend on market
acceptance of the AutoPap System among clinical
laboratories, healthcare providers, third-party healthcare
payers and patients, of which there can be no assurance.
The Company's success also depends on customers' acceptance
of NeoPath's fee-per-use and sale programs. Even if the
Company's products were to gain market acceptance, the
amount of revenue to be derived by the Company from the
AutoPap System would depend to some extent on the
availability of reimbursement from third-party healthcare
payers such as government and private insurance plans.
There can be no assurance that the medical community or
third-party healthcare payers will accept an automated Pap
smear rescreening system to supplement or replace current
laboratory Pap smear review practices. Moreover, due in
part to a continued trend toward consolidation of clinical
laboratories, the Company expects that the number of
potential domestic customers for its products will decrease.
Due to the relative size of the largest U.S. laboratories, a
significant proportion of the Company's sales may be
concentrated among a relatively small number of customers.
These factors may increase the Company's dependence on sales
to the largest clinical laboratories and the bargaining
leverage of those potential customers.
Uncertainty of Product Regulatory Clearance
The manufacture and sale of medical diagnostic devices
intended for commercial use are subject to extensive
governmental regulation in the United States. Similar
requirements are imposed by comparable governmental agencies
in certain other countries. The Company's initial product,
the AutoPap QC, has been cleared for commercialization in
the United States. Both AutoPap Systems have been cleared
for commercial marketing in Japan, Canada, Australia, New
Zealand, The Netherlands, Italy, and Hong Kong. The AutoPap
QC is also approved for quality control rescreening in
Korea. In January 1998, the Hematology and Pathology
Devices Advisory Panel unanimously recommended that the FDA
approve, with conditions, the supplement to NeoPath's PMA
submission for use of the AutoPap Screener as a primary Pap
smear screener. There can be no assurance that applicable
governmental regulatory agencies in United States or
elsewhere will approve the AutoPap Screener for commercial
use on a timely basis, if at all. If clearance to market is
granted, there can be no assurance that it will cover all
the clinical indications for which the Company seeks
clearance or that it will not contain significant
limitations, which may include warnings, precautions or
contraindications, or requests for postmarket studies.
Additional regulatory requirements could be imposed by
legislation or regulation. The Company may also encounter
delays or rejections of its regulatory applications based on
changes in applicable regulatory policies or regulations.
Although the FDA has inspected the Company's manufacturing
operations with respect to the AutoPap QC for compliance
with QSR, the Company's manufacturing processes remain
subject to QSR regulation and inspection.
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Limited Marketing, Sales and Service Experience; Risks
Inherent in International Transactions
The Company markets, sells, services, and supports the
AutoPap System in countries where it has obtained regulatory
approval through a combination of a direct sales force
(primarily in North America) and independent foreign
distributors. The Company has limited marketing, sales and
service experience, and there can be no assurance that the
Company will be able to recruit and retain skilled sales,
marketing, service or support personnel or foreign
distributors, or that the Company's marketing and sales
efforts will be successful. With regard to international
distribution arrangements for the placement of AutoPap
Systems, the Company depends on the efforts of third
parties. There can be no assurance that such efforts will
be successful. In addition, a number of risks are inherent
in international transactions, including regulatory delays
or disapprovals with respect to the Company's products,
government controls, export license requirements, political
instability, price controls, trade restrictions, changes in
tariffs or difficulties with foreign distributors.
Sole or Limited Source of Supply; Governmental Regulation of
Manufacturing
The Company purchases all components for the AutoPap
System and Pathfinder System from outside vendors. A major
component of the AutoPap System, the slide tray motion
system, is supplied by a sole-source vendor. Certain other
components, such as the video cameras, are currently
supplied by single source vendors, and components provided
by additional or replacement suppliers would require some
modification to be incorporated into the AutoPap System.
The establishment of additional or replacement sources of
supply for many AutoPap System components cannot be
accomplished quickly, and substitution of components could
require regulatory approval, the receipt of which cannot be
assured. Accordingly, a vendor's inability to supply
acceptable components in a timely manner and in the quantity
required could delay or halt the Company's manufacture of
its products. Any such delay or cessation could have a
material adverse effect on the Company.
Manufacturers of medical diagnostic devices are subject to
strict federal regulations regarding validation and the
quality of manufacturing, including periodic FDA inspections
of the manufacturing facilities of diagnostic device
manufacturers to determine compliance with QSR regulations.
The Company's manufacturing operations, including any
expansion of such operations, will continue to be required
to comply with these and all other applicable regulations,
and with applicable regulations imposed by other
governments. The Company's failure to comply with QSR
regulations could result in civil or criminal penalties or
enforcement proceedings being imposed on the Company,
including the recall of a product or a "cease distribution"
order requiring the Company to stop placing its products in
service or selling its products, as the case may be.
Similar results could occur if the Company were to violate
foreign regulations. There can be no assurance that the
Company will be able to attain or maintain compliance with
QSR requirements. Failure to maintain compliance with the
applicable manufacturing requirements of various regulatory
agencies would have a material adverse effect on the
Company.
Competition
Competition in the medical device industry is intense, and
the industry is characterized by rapid product development
and technological change. The AutoPap System competes with
existing manual methods of screening Pap smears as well as
with certain semi-automated systems. To compete
effectively, the AutoPap System must demonstrate comparable
or better accuracy and cost effectiveness relative to manual
review of Pap smears. The Company is currently aware of
three direct competitors: AutoCyte, which has focused on the
development of a semi-automated system to prepare and
analyze liquid-based Pap smears (a potential alternative to
conventional Pap smears); MorphoMetrix, which has developed
an automated system to analyze monolayer Pap smears; and
NSI, which is engaged in marketing a service for the semi-
automated rescreening of conventional Pap smears and is
reported to be developing a semi-automated primary screener.
In addition to direct competition, the Company faces
indirect competition through companies that manufacture
liquid-based or monolayer slide preparation systems and
devices that automate various aspects of cytology. In 1996,
Cytyc, Inc. received PMA approval from the FDA to market its
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ThinPrep System which prepares slides for cervical cancer
screening using a liquid-based sampling and preparation
technique as a replacement for the conventional Pap smear
method.
The Company believes that the AutoPap System will compete
on the bases of accuracy and effectiveness, cost (including
both charges by the Company to the laboratory and the
laboratory's labor and overhead costs for its
cytotechnologists), convenience to the laboratory,
perception among influential cytopathologists and
laboratories and processing speed and reliability.
There can be no assurance that the Company's competitors
will not develop new technologies and products that will
compete with, or will prove to be more effective than, the
AutoPap System. Furthermore, although the Company is
currently aware of only three direct competitors, there can
be no assurance that others will not purchase or develop
technologies that would compete with the AutoPap System or
render it obsolete. Competitors may manufacture, market and
sell their products or services more successfully than the
Company, which could have a material adverse effect on the
Company's business and results of operation. See "Business
- - Competition."
Dependence on Reimbursement; Potential Effect of Healthcare
Reform
Various third-party healthcare payers in the United States
are increasingly sensitive to containing healthcare costs
and have focused on new technology as being a primary factor
in increased healthcare costs. Third-party payers,
including Medicare and Medicaid, Blue Cross/Blue Shield,
private health insurance, health administration authorities
in foreign countries and other organizations, may affect the
pricing or relative attractiveness of the Company's products
and services by regulating the maximum amount of
reimbursement provided by such payers or by not providing
any reimbursement. Restrictions on reimbursement may limit
the price that the Company can charge for AutoPap System
screening or reduce the demand for AutoPap System screening.
In addition, if there is no provision for reimbursement of
the AutoPap System screening, or if the level of
reimbursement is significantly below the amount laboratories
charge patients to perform AutoPap System screening, the
size of the potential market available to the Company would
likely be reduced. There can be no assurance that costs
associated with AutoPap System screening will become widely
reimbursable or that the level of reimbursement to clinical
laboratories for AutoPap System screening will achieve or be
maintained at levels necessary to permit the Company to
generate substantial revenue. In addition, there can be no
assurance that future healthcare legislation or other
changes in the administration or interpretation of
government healthcare or third-party reimbursement programs
will not have a material adverse effect on the Company.
Foreign countries have various healthcare reimbursement
systems, and there can be no assurance that third-party
reimbursement will be made available for the AutoPap System
under any foreign reimbursement system.
Dependence on Single Product Line
To date, the Company has concentrated its efforts
primarily on development of the AutoPap System and has
performed only limited research on other applications of its
core technology. Accordingly, the Company will depend
primarily on the successful development and marketing of the
AutoPap System to generate revenues. There can be no
assurance that the AutoPap System will be successfully
commercialized.
Product Liability
The commercial screening of Pap smears has been
characterized by significant malpractice litigation. As a
result, the Company faces risk of exposure to product
liability, errors and omissions or other claims if use of
the AutoPap System or other products that may be developed
by the Company is alleged to have resulted in a false-
negative diagnosis. Although the Company currently has
product liability insurance, the medical device industry has
experienced increasing difficulty in obtaining and
maintaining reasonable product liability coverage, and
substantial increases in insurance premium costs in many
cases have rendered coverage economically impractical.
There can be no assurance that product liability insurance
will continue to be available to the Company when needed at
a reasonable cost, that insurance coverage
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<PAGE>
obtained by the Company will be adequate or that any product
liability claim would not have a material adverse effect on
the Company.
Dependence on Patents and Proprietary Rights; Risk of Third-
Party Claims of Infringement
NeoPath relies on a combination of patents, trade secrets
and confidentiality agreements to protect its proprietary
technology, rights and know-how. The Company holds four
foreign patents, 39 U.S. patents (issued or allowed), and
has 34 additional U.S. patents pending. There can be no
assurance that pending patent applications will ultimately
issue as patents or, if patents do issue, that the claims
allowed will be sufficiently broad to protect what the
Company believes to be its proprietary rights. In addition,
there can be no assurance that issued patents or pending
applications will not be challenged or circumvented by
competitors, or that the rights granted thereunder will
provide competitive advantages to the Company. There can be
no assurance that the obligations of employees of the
Company and third parties with whom the Company has entered
into confidentiality agreements to maintain the
confidentiality of trade secrets and proprietary information
will effectively prevent disclosure of the Company's
confidential information or provide meaningful protection
for the Company's confidential information if there is
unauthorized use or disclosure, or that the Company's trade
secrets or proprietary information will not be independently
developed by NeoPath's competitors.
On July 15, 1996, Neuromedical Systems, Inc. filed a
lawsuit against NeoPath, Inc. in the United States District
Court for the Southern District of New York. The complaint
alleges patent infringement, unfair competition, false
advertising, and related claims. On September 5, 1996, the
Company filed its answer and counter claims. The Company
believes it has a strong position in this action and
continues to defend itself vigorously. In September 1997, a
motion for preliminary injunction against the Company was
heard by a judge in the United States District Court for the
Southern District of New York. No decision has yet been
rendered.
On March 31, 1997, the Company filed a patent infringement
lawsuit against Neuromedical Systems, Inc. in the United
States District Court for the Western District of
Washington. The complaint alleges patent infringement and
seeks preliminary and permanent injunctions against
Neuromedical Systems, Inc. This suit is currently in the
discovery stage.
There can be no assurance as to the outcome of the
aforementioned litigation.
Dependence on Key Personnel
The Company is highly dependent on the principal members
of its management and scientific staff, the loss of whose
services might impede achievement of its strategic or
research and development objectives. The Company's success
will depend on its ability to retain key employees and to
attract additional qualified employees. Competition among
medical device companies for highly skilled scientific and
management personnel is intense, and the failure to recruit
such personnel or the loss of existing personnel could have
a material adverse effect on the Company. The Company does
not carry key person life insurance on its executives or
other key personnel.
Highly Volatile Stock Price; Potential Fluctuations in
Future Quarterly Results
The market price of shares of the Company's Common Stock,
like that of the common stock of many other small medical
device companies, may be highly volatile. Factors such as
the results of the Company's sales and marketing programs,
clinical trials by the Company or its competitors, concern
as to the safety or efficacy of the Company's products or
its competitors, announcements of technological innovations
or new products by the Company or its competitors,
governmental regulation, healthcare legislation,
developments in patent or other proprietary rights of the
Company or its competitors, fluctuations in the Company's
operating results, and general market and economic
conditions are likely to have a significant impact on the
future price of the Common Stock.
Page 16
<PAGE>
The Company expects that its operating results will
fluctuate significantly from quarter to quarter in the
future and will depend on a number of factors, many of which
are outside of the Company's control. These factors
include: the rate and extent of market acceptance of the
AutoPap System; the mixture of fee-per-use and sale
contracts; the rate and size of expenditures incurred as
NeoPath expands its domestic and foreign marketing and sales
programs and continues its research and development efforts;
the timing of approvals for AutoPap reimbursement; the
timing of domestic and foreign regulatory approvals; and the
introduction and market acceptance of competing products or
technologies.
Page 17
<PAGE>
Item 2.PROPERTIES
The Company leases approximately 72,000 square feet of
office and manufacturing space in Redmond, Washington under
operating leases expiring through January 2000, with various
renewal options. Management believes that the Redmond
facility and other available office space is adequate for
the Company's current needs. Management also believes that
additional space is available in the area, should it be
needed.
Item 3. LEGAL PROCEEDINGS
On July 15, 1996, Neuromedical Systems, Inc. filed a
lawsuit against NeoPath, Inc. in the United States District
Court for the Southern District of New York. The complaint
alleges patent infringement, unfair competition, false
advertising, and related claims. On September 5, 1996, the
Company filed its answer and counter claims. In September
1997, a motion for preliminary injunction against the
Company was heard by a judge in the United States District
Court for the Southern District of New York. No decision
has yet been rendered. The Company believes it has a strong
position in this action and continues to defend itself
vigorously.
On March 31, 1997, the Company filed a patent infringement
lawsuit against Neuromedical Systems, Inc. in the United
States District Court for the Western District of
Washington. The complaint alleges patent infringement and
seeks preliminary and permanent injunctions against
Neuromedical Systems, Inc. This suit is currently in the
discovery stage.
Item 4.SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders
during the fourth quarter of 1997.
Page 18
<PAGE>
PART II
Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
SHAREHOLDER MATTERS
The information required by Item 5 is hereby
incorporated by reference to the Company's 1997 Annual
Report to Shareholders, page 30.
Item 6. SELECTED FINANCIAL DATA
The information required by Item 6 is hereby
incorporated by reference to the Company's 1997 Annual
Report to Shareholders, page 9.
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
The information required by Item 7 is hereby
incorporated by reference to the Company's 1997 Annual
Report to Shareholders, pages 10-14.
Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
MARKET RISK
Not applicable.
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information required by Item 8 is hereby
incorporated by reference to the Company's 1997 Annual
Report to Shareholders, pages 15-29.
Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
Page 19
<PAGE>
PART III
Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by Item 10 is hereby
incorporated by reference to the section entitled "Election
of Directors and Management Information" in the Company's
definitive Proxy Statement relating to its 1998 annual
meeting of Shareholders (the "Proxy Statement"). Such Proxy
Statement will be filed within 120 days of the Company's
last fiscal year end, December 31, 1997.
Item 11. EXECUTIVE COMPENSATION
The information required by Item 11 is hereby
incorporated by reference to the section entitled "Executive
Compensation" in the Proxy Statement.
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
AND MANAGEMENT
The information required by Item 12 is hereby
incorporated by reference to the section entitled "Security
Ownership of Certain Beneficial Owners and Management" in
the Proxy Statement.
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Not applicable.
Page 20
<PAGE>
PART IV
Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND
REPORTS ON FORM 8-K
(a) Index to list of documents filed as part of this
report.
1. Financial Statements
The following financial statements of NeoPath, Inc.
are included in Item 8 by reference to the Company's 1997
Annual Report to Shareholders:
Annual Report
Page #
Balance Sheets at December 31, 1997 and 1996 15
Statements of Operations for the years ended
December 31, 1997, 1996 and 1995 16
Statements of Shareholders' Equity for the years
ended December 31, 1997, 1996 and 1995 17
Statements of Cash Flows for the years ended
December 31, 1997, 1996 and 1995 18
Notes to Financial Statements 19-27
2. Financial Statement Schedule
Schedule II - Valuation and Qualifying Accounts
All other schedules have been omitted because they
were not applicable.
3. Exhibits
3.1(1) Articles of Incorporation of the registrant
3.2(1) Bylaws of the registrant
10.1(7) NeoPath, Inc. 1989 Stock Option
Plan, Amended and Restated on December 10,
1996
10.2(7) NeoPath, Inc. Stock Option Plan for
Nonemployee Directors, Amended and Restated
on February 27, 1997
10.3(1) Form of Indemnification Agreement
for officers and directors of the registrant
10.4(1) Consolidated Amended and Restated
Shareholders Agreement dated March 27, 1992,
by and among NeoPath, Inc. and the
Shareholders listed on Exhibit A thereto and
First Amendment to Consolidated Amended and
Restated Agreement dated January 14, 1994
Page 21
<PAGE>
10.6(5) First Amendment to Lease by and
between Teachers Insurance & Annuity
Association and NeoPath, Inc. dated February
16, 1995, Second Amendment to Lease by and
between Teachers Insurance & Annuity and
NeoPath, Inc. dated November 21, 1995 and
Letter from Teachers Insurance & Annuity
dated December 15, 1995
10.7(5) Sublease (Tunturi, Inc./NeoPath)
dated December 22, 1995 by and between
NeoPath, Inc. and Tunturi, Inc.
10.8(1) Form of Agreement regarding
clinical study of the AutoPap 300 QC System:
Confidentiality of Records and
Indemnification
10.9(1) Agreement by and between NeoPath,
Inc. and Kyto Diagnostic, L.P. regarding
clinical study of the AutoPap 300 QC System:
Confidentiality of Records and
Indemnification
10.10(1) Product Development and Supply
Agreement between Applied Precision, Inc. and
NeoPath, Inc. dated January 1, 1992
10.14(2) Master Equipment Lease by and
between NeoPath, Inc. and Haworth Leasing
dated January 31, 1995
10.15(3) Master Equipment Lease between
NeoPath, Inc. and Pacific Office Automation
dated March 16, 1995
10.17(4) NeoPath, Inc. Proposal to
SmithKline Beecham Clinical Laboratories
dated as of October 4, 1995, countersigned by
SmithKline Beecham Clinical Laboratories on
October 4, 1995
10.18(4) NeoPath, Inc. Proposal to Corning
Clinical Laboratories Inc. executed as of
October 11, 1995, countersigned by Corning
Clinical Laboratories on October 13, 1995
10.19(4) Master Equipment Lease by and
between NeoPath, Inc. and Pacific Office
Automation dated as of September 30, 1995
10.20(6) NeoPath, Inc. Proposal to
SmithKline Beecham Clinical Laboratories,
accepted May 9, 1996
10.21(6) NeoPath, Inc. Proposal to
Laboratory Corporation of America Holdings,
accepted May 15, 1996
10.22(6) NeoPath, Inc. Amended and Restated
Proposal to Kaiser IMMC Agreement No. 0249,
accepted June 25, 1996
10.23(7) Form of Senior Management Employment Agreement
10.24(7) International Distribution
Agreement between NeoPath, Inc. and Nikon
Corporation, dated as of December 19, 1996
10.25(8) Purchase and Sale Agreement
between CompuCyte Corporation and NeoPath,
Inc., Dated as of June 23, 1997
10.26(8) NeoPath, Inc. Registration
Rights Agreement, Dated as of June 23, 1997
10.27(9) NeoPath, Inc. 1997 Employee Stock Purchase Plan
Page 22
<PAGE>
10.28 Third Amendment to Lease by and
between Teachers Insurance & Annuity
Association and NeoPath, Inc. dated November
6, 1997
13.1 1997 Annual Report to Shareholders
23.1 Consent of Ernst & Young LLP, Independent
Auditors
27 Financial Data Schedule
_____________________________
(1) Filed as an exhibit to the registrant's
Registration Statement on Form S-1 (File No.
33-86822) and incorporated herein by
reference.
(2) Filed as an exhibit to the registrant's
Report on form 10-Q filed on March 29, 1995
and incorporated herein by reference.
(3) Filed as an exhibit to the registrant's
Report on Form 10-Q filed on August 10, 1995
and incorporated herein by reference.
(4) Filed as an exhibit to the registrant's
Report on Form 10-Q filed on November 14,
1995 as amended on December 12, 1995 and
incorporated herein by reference.
(5) Filed as an exhibit to the registrant's
Registration Statement on Form S-1 (File No.
33-80377) and incorporated herein by
reference.
(6) Filed as an exhibit to the registrant's Report on Form
10-Q filed on August 14, 1996 and incorporated herein by
reference.
(7) Filed as an exhibit to the registrant's Report on Form
10-K filed on March 28, 1997 and incorporated herein by
reference.
(8) Filed as an exhibit to the registrant's Report on Form
10-Q filed on August 12, 1997 and incorporated herein by
reference.
(9) Filed as an exhibit to the registrant's Registration
Statement on Form S-8 (File No. 333-40371) and incorporated
herein by reference.
(b) Reports on Form 8-K:
None.
Page 23
<PAGE>
SIGNATURES
Pursuant to the requirements 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 in the City of Redmond, State of Washington on
the 27th day of March, 1998.
NEOPATH, INC.
By: /s/ ALAN C. NELSON
_____________________________
Alan C. Nelson, Ph.D.
President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange
Act of 1934, this report has been signed below by the
following persons on behalf of the Registrant and in the
capacities indicated below on this 27th day of March, 1998.
Signature Title
/s/ALAN C. NELSON President, Chief Executive Officer and Director
______________________ (Principal Executive Officer)
Alan C. Nelson, Ph.D.
/s/WILLIAM L. SCOTT Vice President and Chief Financial Officer and
______________________ Director
William L. Scott
/s/ROBERT C. BATEMAN Corporate Controller and Treasurer
______________________ Principal Accounting Officer
Robert C. Bateman
/s/WALTER L. ROBB Chairman of the Board
______________________
Walter L. Robb, Ph.D.
/s/ALAN D. FRAZIER Director
_______________________
Alan D. Frazier
/s/CRISTINA H. KEPNER Director
________________________
Cristina H. Kepner
/s/DAVID A. THOMPSON Director
_______________________
David A. Thompson
/s/GAIL R. WILENSKY Director
_______________________
Gail R. Wilensky, Ph.D.
Page 24
<PAGE>
<TABLE>
<CAPTION>
SCHEDULE II
NEOPATH, INC.
VALUATION AND QUALIFYING ACCOUNTS
Balance
at Charged to Charged to Balance at
Description Beginning Costs & Other End of
of Period Expenses Accounts Deductions Period
- ----------------------------- -------- ---------- ---------- ------------ --------
<S> <C> <C> <C> <C> <C>
Allowance for doubtful accounts:
Year ended December 31, 1997 $175,000 $325,000 $ -- $ -- $500,000
Year ended December 31, 1996 -- 175,000 -- -- 175,000
Year ended December 31, 1995 -- -- -- -- --
</TABLE>
Page 25
<PAGE>
NEOPATH, INC.
INDEX TO EXHIBITS
Exhibit No. Description
__________ ____________________________________________________
3.1(1) Articles of Incorporation of the registrant
3.2(1) Bylaws of the registrant
10.1(7) NeoPath, Inc. 1989 Stock Option
Plan, Amended and Restated on December 10,
1996
10.2(7) NeoPath, Inc. Stock Option Plan for
Nonemployee Directors, Amended and Restated
on February 27, 1997
10.3(1) Form of Indemnification Agreement
for officers and directors of the registrant
10.4(1) Consolidated Amended and Restated
Shareholders Agreement dated March 27, 1992,
by and among NeoPath, Inc. and the
Shareholders listed on Exhibit A thereto and
First Amendment to Consolidated Amended and
Restated Agreement dated January 14, 1994
10.6(5) First Amendment to Lease by and
between Teachers Insurance & Annuity
Association and NeoPath, Inc. dated February
16, 1995, Second Amendment to Lease by and
between Teachers Insurance & Annuity and
NeoPath, Inc. dated November 21, 1995 and
Letter from Teachers Insurance & Annuity
dated December 15, 1995
10.7(5) Sublease (Tunturi, Inc./NeoPath)
dated December 22, 1995 by and between
NeoPath, Inc. and Tunturi, Inc.
10.8(1) Form of Agreement regarding
clinical study of the AutoPap 300 QC System:
Confidentiality of Records and
Indemnification
10.9(1) Agreement by and between NeoPath,
Inc. and Kyto Diagnostic, L.P. regarding
clinical study of the AutoPap 300 QC System:
Confidentiality of Records and
Indemnification
10.10(1) Product Development and Supply
Agreement between Applied Precision, Inc. and
NeoPath, Inc. dated January 1, 1992
10.14(2) Master Equipment Lease by and
between NeoPath, Inc. and Haworth Leasing
dated January 31, 1995
10.15(3) Master Equipment Lease between
NeoPath, Inc. and Pacific Office Automation
dated March 16, 1995
10.17(4) NeoPath, Inc. Proposal to
SmithKline Beecham Clinical Laboratories
dated as of October 4, 1995, countersigned by
SmithKline Beecham Clinical Laboratories on
October 4, 1995
Page 26
<PAGE>
10.18(4) NeoPath, Inc. Proposal to Corning
Clinical Laboratories Inc. executed as of
October 11, 1995, countersigned by Corning
Clinical Laboratories on October 13, 1995
10.19(4) Master Equipment Lease by and
between NeoPath, Inc. and Pacific Office
Automation dated as of September 30, 1995
10.20(6) NeoPath, Inc. Proposal to
SmithKline Beecham Clinical Laboratories,
accepted May 9, 1996
10.21(6) NeoPath, Inc. Proposal to
Laboratory Corporation of America Holdings,
accepted May 15, 1996
10.22(6) NeoPath, Inc. Amended and Restated
Proposal to Kaiser IMMC Agreement No. 0249,
accepted June 25, 1996
10.23(7) Form of Senior Management
Employment Agreement
10.24(7) International Distribution
Agreement between NeoPath, Inc. and Nikon
Corporation, dated as of December 19, 1996
10.25(8) Purchase and Sale Agreement
between CompuCyte Corporation and NeoPath,
Inc., Dated as of June 23, 1997
10.26(8) NeoPath, Inc. Registration
Rights Agreement, Dated as of June 23, 1997
10.27(9) NeoPath, Inc. 1997 Employee Stock
Purchase Plan
10.28 Third Amendment to Lease by and
between Teachers Insurance & Annuity
Association and NeoPath, Inc. dated November
6, 1997
13.1 1997 Annual Report to Shareholders
23.1 Consent of Ernst & Young LLP,
Independent Auditors
27 Financial Data Schedule
_____________________________
(1) Filed as an exhibit to the registrant's
Registration Statement on Form S-1 (File No.
33-86822) and incorporated herein by
reference.
(2) Filed as an exhibit to the registrant's
Report on form 10-Q filed on March 29, 1995
and incorporated herein by reference.
(3) Filed as an exhibit to the registrant's
Report on Form 10-Q filed on August 10, 1995
and incorporated herein by reference.
(4) Filed as an exhibit to the registrant's
Report on Form 10-Q filed on November 14,
1995 as amended on December 12, 1995 and
incorporated herein by reference.
(5) Filed as an exhibit to the registrant's
Registration Statement on Form S-1 (File No.
33-80377) and incorporated herein by
reference.
(6) Filed as an exhibit to the registrant's
Report on Form 10-Q filed on August 14, 1996
and incorporated herein by reference.
Page 27
<PAGE>
(7) Filed as an exhibit to the registrant's
Report on Form 10-K filed on March 28, 1997
and incorporated herein by reference.
(8) Filed as an exhibit to the registrant's
Report on Form 10-Q filed on August 12, 1997
and incorporated herein by reference.
(9) Filed as an exhibit to the registrant's
Registration Statement on Form S-8 (File No.
333-40371) and incorporated herein by
reference.
Page 28
<PAGE>
Third AMENDMENT TO LEASE
ADDITION OF SQUARE FEET
Teachers Insurance and Annuity Association, a New York corporation,
Landlord and NeoPath, Inc., a Washington corporation Tenant, being parties to
that certain Lease dated October 1, 1997 for premises located at 8271 154th
Avenue NE, Redmond, WA 98052, Building H, Units 8271 is amended this 6th
day of November, 1997 solely as hereinafter described.
Effective the 15th day of May, 1998, the portions of the Lease below shall be
amended as follows:
1. b. TENANT: NeoPath, Inc., a Washington Corporation
Address (Leased Premises): 8271 154th Avenue NE, Redmond, WA 98052
and 8210 154th Avenue NE, Redmond, WA 98052
Building/Units: H/8271, and K/8210
Address (For Notices): 8271 154th Avenue NE, Redmond, WA 98052
Building H Building K
8271 154th Avenue NE 8210 154th Avenue NE
Redmond, WA 98052 Redmond, WA 98052
e. PREMISES AREA: 39,064 rentable sq. ft. 30,000 rentable sq. ft.
f. PROJECT AREA: 42,172 rentable sq. ft. 52,153 rentable sq. ft.
g. TERM OF LEASE: Commencement: January 15, 1995 Commencement: May 15, 1998
Expiration: December 31, 1999 Expiration: December 31, 1999
h. BASE MONTHLY RENT
Effective Dates Base Monthly Effective Dates Base Monthly
Rent Rent
1st Month $0.00 5/15/98 through
2nd through 5th $11,837.00 12/31/99 $24,900.00
6th month $0.00
7th through 10th $25,680.00
11th through 12th $0.00
13th through 17th $30,271.00
18th month $10,703.00
19th month $36,383.00
20th through 22nd $37,661.00
23rd through 24th $11,981.00
25th through 29th $37,661.00
30th month $11,981.00
31st through 34th $37,661.00
35th through 36th $11,981.00
37th through 60th $39,441.00
2. a. PREMISES: Landlord leases to Tenant the additional expansion
premises as shown on Exhibit A-1, (the "Expansion Premises"). Landlord
reserves the right to modify Tenant's percentage of the Project as set forth
in Section 1 if the Project size is increased through the development of
additional property. By entry on the Premises, Tenant acknowledges that it
has examined the Premises and accepts the Premises in their present
condition, subject to any additional work Landlord has agreed to do.
All other terms and conditions of the above described Lease shall remain
in full force and effect.
Landlord: Teachers Insurance & Annuity Association
By: /s/ JAMES GAROFALO
____________________
James Garofalo
Its: Assistant Secretary
Tenant: NeoPath, Inc., a Washington Corporation
By: /s/ WILLIAM L. SCOTT
____________________
William L. Scott
Its: VP-CFO
<PAGE>
STATE OF New York )
)ss.
COUNTY OF New York )
I certify that I know or have satisfactory evidence that James Garofalo is the
person who appeared before me, and said person acknowledged that he/she
signed this instrument, on oath stated that he/she was authorized to execute
the instrument and acknowledge it as the Assistant Secretary of Teachers
Insurance & Annuity Association to be the free and voluntary act of such party
for the uses and purposes mentioned in the instrument.
Dated: Dec. 22, 1997
/s/ Gladys Bolella
__________________
(signature)
Gladys Bolella
Notary Public, State of N.Y.
No. 01BO4922705
Qualified in Rich County
Commission Expires 3/14/98
(Print Name)
Notary Public, in and for the State
of Washington, residing at __________
My Commission Expires ______
STATE OF Washington )
)ss.
COUNTY OF King )
I certify that I know or have satisfactory evidence that William Scott is the
person who appeared before me, and said person acknowledged that he/she
signed this instrument, on oath stated that he/she was authorized to execute
the instrument and acknowledge it as the Chief Financial Officer of NeoPath to
be the free and voluntary act of such party for the uses and purposes mentioned
in the instrument.
Dated: November 20th, 1997
/s/ Judith E. Sime
__________________
(Signature)
Judith E. Sime
[notary public seal] (Print Name)
Notary Public, in and for the State
of Washington, residing at 8271 - 154th
Redmond, WA
My Commission Expires 2-24-99
<PAGE>
EXHIBIT A-1
(The Expansion Premises)
[Diagram of the expansion premises of Westpark, Building K]
NEOPATH, INC.
Selected Five-Year Financial Data
(in thousands, except per share data)
year ended December 31,
<TABLE>
<CAPTION>
1997 1996 1995 1994 1993
__________________________________________________________________________________________
<S> <C> <C> <C> <C> <C>
Statement of Operations Data
Revenues $10,824 $3,062 $-- $-- $--
Gross margin 6,049 1,157 -- -- --
Operating expenses:
Research and development 14,249 11,202 9,384 9,183 4,792
Selling, general and administrative 17,746 11,295 6,626 3,320 1,413
Net loss (23,597) (17,655) (14,365) (12,324) (6,264)
Basic and diluted net loss per share (1) (1.66) (1.36) (1.59) -- --
Balance Sheet Data
Cash, cash equivalents, and
securities available-for-sale $28,719 $58,488 $23,430 $2,295 $1,001
Working capital 34,673 60,821 22,876 2,316 82
Total assets 58,941 76,132 28,016 5,193 1,662
Obligations under capital leases,
less current portion 102 183 258 176 216
Total shareholders' equity 53,228 71,602 25,133 3,602 489
</TABLE>
The comparability of the above data is affected by the Company's
initial public offering completed in February 1995 and second public
offering completed in January 1996. See Note 7 of Notes to Financial
Statements.
(1) The basis for determining the number of shares used
in computing basic and diluted net loss per share is described in Note 1
of Notes to Financial Statements. Basic and diluted net loss per share for
1994 and 1993 is not considered meaningful due to changes in
the Company's capital structure.
Page 9
<PAGE>
Management's Discussion and Analysis of Financial Condition and Results of
Operations
Overview
NeoPath, Inc. ("NeoPath" or the "Company") develops and markets visual
intelligence technology to increase accuracy in medical testing. NeoPath's
initial products include (i) two automated screening systems that integrate
proprietary high-speed image processing computers, video imaging technology
and sophisticated image interpretation software to capture and analyze
thousands of microscopic images from a Papanicolaou ("Pap") smear slide for
the early detection of cervical cancer and (ii) the Pathfinder(R) System
product-line acquired in 1997.
In 1995, the United States Food and Drug Administration (the "FDA")
cleared for commercial use the Company's first product, the AutoPap(R) 300
QC Automatic Pap Screener System (the "AutoPap QC"). In early 1996, the
Health Care Financing Administration officially allowed clinical
laboratories to use the AutoPap QC in the quality control review of Pap
smear slides that have been initially screened by cytologists and
classified as normal. The decision allows AutoPap QCs to be used in
determining which slides will be rescreened under the federally mandated
rescreening requirement.
NeoPath's second product is the AutoPap(R) Primary Screener System (the
"AutoPap Screener" and, in combination with the AutoPap QC, the "AutoPap
System"). The AutoPap Screener utilizes the same hardware components as the
AutoPap QC; however, it uses enhanced software, including additional
cell-classification algorithms. During 1997, NeoPath completed a
prospective intended-use clinical study to evaluate the performance of the
AutoPap Screener as a primary screening system. This study included
analysis of more than 25,000 Pap smear slides at five clinical laboratories
in the United States and Canada. In August 1997, NeoPath submitted the
results of the study in an amendment to its pending PreMarket Approval
("PMA") Supplement to the FDA, for use of the AutoPap Screener as a primary
screener of Pap smear slides. In January 1998, the Hematology and
Pathology Devices Advisory Panel of the FDA unanimously recommended that
the FDA approve, with conditions, the supplement to NeoPath's PMA
submission for use of the AutoPap Screener as a primary Pap smear screener.
As of March 1998, the Company is awaiting FDA approval on this PMA application.
NeoPath's Pathfinder System provides improved productivity and quality
assurance in the clinical cytology laboratory by computerizing the
cytotechnologists' microscopes, thereby helping to eliminate screening
errors and facilitating critical cell identification in applications such
as Pap smear screening.
Purchase of Pathfinder System Product Line
In June 1997, NeoPath purchased the Pathfinder System product line from
CompuCyte Corporation for an initial purchase price of $4.1 million. The
initial purchase price included cash of $2.7 million (including transaction-
related expenses), a $500,000 short-term note paid in October 1997, and
48,564 shares of NeoPath common stock. In addition, 48,563 shares of
NeoPath common stock were issued and are held in escrow contingent upon
certain specific technology decisions to be made by the Company within one
year of closing. In accordance with accounting rules, the value of the
contingent shares was excluded from the initial purchase price allocation,
and the 48,563 contingent shares are excluded from the calculation of
weighted average shares outstanding. Including the value of contingent
shares at the closing date, which value the Company expects to recognize as
an intangible asset if the contingency is removed, the total purchase price
approximated $5.1 million.
As a result of the purchase, the Company recognized $3.8 million in
acquired intangible assets which are amortized over five years. NeoPath
began selling the Pathfinder System as a stand-alone product in the third
quarter of 1997 and continues to evaluate the integration of the technology
into the AutoPap System.
Page 10
<PAGE>
Results of Operations
`
Change from
(in thousands) 1997 prior year 1996
__________________________________________________________________________
Revenues $10,824 $7,762 $3,062
254%
NeoPath began recognizing product revenues in 1996. The Company
recognizes revenue on either a sale or fee-per-use basis (subject to
certain license agreements, lease contracts, and minimum payments on fee-
per-use contracts). Under its fee-per-use program, the Company retains
ownership of AutoPap Systems placed at customer sites and assesses
customers a charge for each Pap smear slide analyzed. The fee-per-use
program requires a significant capital commitment since the Company
retains ownership of the AutoPap Systems. The cost of each AutoPap System
is reclassified from inventories to depreciable equipment upon shipment to
a fee-per-use customer site. Such equipment, reflected on the balance
sheet under "fee-per-use systems, net," is depreciated on a straight-line
basis over a four-year period, commencing upon commercial operation.
NeoPath's AutoPap System placements have primarily consisted of fee-per-
use contracts in the United States and sale contracts internationally.
Approximately 65 percent of total revenues in 1997 and 1996, respectively,
consisted of AutoPap System sales worldwide and other revenues associated
with upgrades of previous international product placements. The remaining
35 percent of total revenues consisted of fee-per-use contract billings
and, in 1997, Pathfinder System sales. Pathfinder System sales accounted
for less than three percent of total 1997 revenues. The Company
anticipates that future AutoPap System placements will continue to consist
of both fee-per-use and sale contracts; however, the Company expects that
revenues for the next several quarters will continue to consist of greater
sales of AutoPap Systems than revenues generated from NeoPath's fee-per-
use program. The revenue mix may vary as product features and markets
mature, and as third-party reimbursement policies change.
Approximately 51 percent of NeoPath's revenues in 1997 represented sales
to customers outside of the United States, compared to approximately 45
percent in 1996. NeoPath's international revenues have included AutoPap
Systems placed in Japan, Korea, Hong Kong, Europe, and Australia. All of
the Company's international product placements have been denominated in
U.S. dollars; however, future product revenues may include customer
contracts subject to foreign exchange rate changes. In 1997, NeoPath
established NeoPath Europe, located in Belgium, as its first international
branch.
NeoPath believes that increased third-party reimbursement of Pap smears
in general, and increased reimbursement for screening utilizing the
AutoPap System in particular, will significantly increase the Company's
potential for revenues in 1998 and beyond. In October 1997, the American
Medical Association published its revised Physicians' Current Procedural
Terminology (CPT-4) codes which included a code that applies to the
AutoPap QC for automated cervical cancer rescreening. CPT codes are a
universal system used by physicians and clinical laboratories to identify
specific procedures when billing insurers for their services. In early
1998, NeoPath formed a five-person team to work with third-party insurers
and managed care organizations to establish or review and improve third-
party reimbursement levels for Pap smear screening with the AutoPap
System. These managed care specialists will work closely with NeoPath's
field sales personnel throughout the United States.
Page 11
<PAGE>
Percentage of Percentage of
(in thousands) 1997 revenues 1996 revenues
___________________________________________________________________________
Cost of revenues $4,775 44% $1,905 62%
Gross margin 6,049 56% 1,157 38%
The primary components of cost of revenues for fee-per-use systems
include depreciation and allocated service and support costs. For
AutoPap Systems sold, cost of revenues includes the related manufacturing
cost and estimated one-year warranty expense. Gross margin is expected to
continue to fluctuate depending on the mix of fee-per-use revenues,
AutoPap System sales, and other revenues, which in 1997 included revenues
recognized under an agreement with Nikon Corporation to upgrade AutoPap
Systems previously shipped. The continued development of the Company's
manufacturing, service and support functions, as well as its overall
production levels, are also expected to contribute to fluctuations in
gross margin. Therefore, the Company's historic gross margins are not
necessarily indicative of future gross margins.
<TABLE>
<CAPTION>
Change from Change from
(in thousands) 1997 prior year 1996 prior year 1995
_______________________________________________________________________________________
<S> <C> <C> <C> <C> <C>
Research and development
expenses $14,249 $3,047 $11,202 $1,818 $9,384
27% 19%
</TABLE>
NeoPath's research and development expenses include salaries and
benefits of scientific, engineering, and regulatory personnel; costs
relating to clinical studies and submission of applications to the FDA;
testing equipment; components used in prototypes; relevant consulting
services; and the costs of preparing and filing applications for patent
protection for the Company's technologies.
The increase in research and development expenses in 1997 resulted
primarily from NeoPath's completion of its clinical study and submission
of the data to the FDA in support of NeoPath's AutoPap Screener. The
increase is also attributable to increased costs incurred to prepare and
file applications for patent protection for the Company's technologies.
Increased research and development expenditures in 1996 were due
primarily to increased research and development personnel, project
development costs, and increased costs incurred to prepare and file for
patent protection for NeoPath technologies.
Change from Change from
(in thousands) 1997 prior year 1996 prior year 1995
_____________________________________________________________________________
Sales, general and
administrative
expenses $17,746 $6,451 $11,295 $4,669 $6,626
57% 70%
Sales, general and administrative expenses include salaries and
benefits of financial, administrative, sales and marketing personnel; non-
patent legal expenses; amortization of intangible assets; and certain
facility-related costs.
The increased spending in 1997 was due primarily to significant new
sales and marketing initiatives, costs related to the purchase and
integration of the Pathfinder System product line (including amortization
of approximately $190,000 per quarter), increased personnel-related
expenses, and increased legal expenses relating primarily to the
Neuromedical Systems, Inc. lawsuits (see Note 9 of Notes to Financial
Statements). The Company expects sales, general and administrative
expenses to increase in 1998 due primarily to sales and marketing
initiatives associated with the market launch of the AutoPap Screener, as
well as continued spending to market the Pathfinder System product line.
Increased expenditures in 1996 were primarily a result of increased
personnel and expanded sales, marketing and administrative functions.
Page 12
<PAGE>
Change from Change from
(in thousands) 1997 prior year 1996 prior year 1995
_____________________________________________________________________________
Interest income $2,399 $(1,343) $3,742 $2,012 $1,730
(36%) 116%
The decrease in interest income in 1997 is due to decreased cash
equivalents and securities available-for-sale resulting from NeoPath's
negative operating cash flow during the year. The Company expects that
its interest income will decline further in 1998 as a result of declining
cash available for investment purposes.
Interest income in 1996 increased due primarily to the investment of the
$61.7 million net proceeds from the Company's second public stock offering
completed in January 1996.
Limitation on Use of Net Operating Loss and Tax Credit Carryforwards
As of December 31, 1997, the Company had net operating loss
carryforwards of approximately $86.5 million and research and development
credit carryforwards of approximately $2.4 million for federal income tax
purposes, which expire between 2004 and 2012. Due to the issuance and
sale of shares of preferred stock and the Company's initial public
offering, the Company incurred "ownership changes" pursuant to applicable
regulations in effect under the Internal Revenue Code of 1986, as amended.
Therefore, the Company's use of losses incurred through the date of these
ownership changes will be limited during the carryforward period. The
Company estimates that the use of approximately $28.0 million of losses
incurred prior to one or more of the ownership changes would be limited to
approximately $6.4 million per year through 1998 and to lower amounts in
subsequent years. To the extent that any single-year loss is not utilized
to the full amount of the limitation, such unused loss is carried over to
subsequent years until the earlier of its utilization or the expiration of
the relevant carryforward period. See Note 6 of Notes to Financial
Statements.
Liquidity and Capital Resources
As of December 31, 1997, the Company had approximately $28.7 million in
cash, cash equivalents, and securities available-for-sale, representing 49
percent of total assets. As of December 31, 1997, the Company had
capital lease obligations, including interest, of $204,000 and operating
lease obligations of $1.7 million. Other than capitalized lease
obligations, the Company has no outstanding long-term debt.
The Company's cash used in operating activities was $28.7 million, $25.0
million, and $12.8 million, in the years ended December 31, 1997, 1996,
and 1995, respectively, including $6.6 million, $7.3 million, and $-0- for
inventories subsequently reclassified as either fee-per-use systems or
reclassified to property and equipment. The Company expended cash for
property and equipment of $1.0 million, $3.3 million, and $1.9 million in
the three years ended December 31, 1997, 1996, and 1995, respectively.
The Company expects negative cash flow from operations to continue at
least through the majority of 1998 as it manufactures AutoPap Systems to
support fee-per-use product placements, continues to expand its marketing,
sales, and customer service and support capabilities, continues its
research and development activities and conducts and analyzes data from
clinical trials. The Company currently estimates that its existing cash
resources and interest income will enable it to sustain operations for at
least the next 12 months. There can be no assurance, however, that the
Company will not be required to seek additional cash in the form of either
debt or equity at an earlier date. The Company's future capital
requirements will depend on many factors, including the extent and rate of
adoption of use of the AutoPap QC and, if approved by the FDA, the AutoPap
Screener; the increase in the Company's fee-per-use program; the mix of
fee-per-use and sale placements; the market acceptance of the Pathfinder
System; the availability of third-party reimbursement; the extent and rate of
development of the Company's marketing, sales, and customer service and
support capabilities; and the status of competing products. The Company
may, from time to time, seek additional funding through public or private
financing, including equity financing. There can be no assurance that
adequate funding will be available as needed or on terms acceptable to the
Company. If additional funds are raised by issuing
Page 13
<PAGE>
equity securities, existing shareholders will experience dilution.
Insufficient funds may require the Company to delay, scale back or eliminate
some or all of its manufacturing, sales and marketing, research and
development or clinical programs.
The Company is currently negotiating a bank financing facility to borrow
up to $10 million based on current and future fee-per-use AutoPap Systems
placed at customer sites. This facility is expected to be in place during
1998.
Impact of Year 2000
Some of the Company's internal and product software programs were
written using two digits rather than four to define the applicable year.
As a result, those computer programs have time-sensitive software that
recognize a date using "00" as the year 1900 rather than the year 2000.
The Company has completed a preliminary assessment of its computer
systems and will have to modify or replace portions of its internal and
product software so that its computer systems will function properly with
respect to dates in the year 2000 and thereafter. The project is
estimated to be completed not later than December 31, 1998, and the total
Year 2000 project cost is not expected to be material.
The Company believes that with modifications to existing software and
conversions to new software, the Year 2000 Issue will not pose
significant operational problems for its internal and product computer
systems. However, if such modifications and conversions are not made, or
are not completed timely, the Year 2000 Issue could have a material
impact on NeoPath's operations.
Forward-Looking Statements
The preceding Management's Discussion and Analysis of Financial
Condition and Results of Operations contains "forward-looking statements"
that reflect the Company's current views with respect to future events
and financial performance. These forward-looking statements are subject
to certain risks and uncertainties that could cause actual results to
differ materially from historical results or those anticipated. The
words "plan," "expect," "anticipate," "believe," and similar expressions
identify forward-looking statements. Readers are cautioned not to place
undue reliance on these forward-looking statements, which speak only as
of their dates. The Company undertakes no obligation to publicly update
or revise any forward-looking statements, whether as a result of new
information, future events, or otherwise. Factors that could cause
actual results to differ materially from historical results or those
anticipated include, without limitation, the following: the Company's
limited operating history and history of losses; market acceptance of the
Company's products; the acceptance of the Company's fee-per-use or sale
programs; product and manufacturing regulatory approvals; the Company's
limited marketing, sales, customer service and support capabilities;
uncertainties relating to international transactions; the Company's sole
or limited source of supply of certain components; the status of
competing products; dependence on third-party reimbursement; dependence
on single product line; product liability; dependence on patents and
property rights; the risk of third-party claims of infringement; and
dependence on key personnel. For a more detailed discussion of these
factors, see "Factors Affecting Future Results and Forward-Looking
Statements" in the Company's Form 10-K for the fiscal year ended December
31, 1997.
Page 14
<PAGE>
Balance Sheets
December 31,
1997 1996
_________________________________________________________________
Assets
Current assets:
Cash and cash equivalents $3,308,970 $7,871,401
Securities available-for-sale 25,409,633 50,616,477
Accounts receivable, net 3,863,818 840,256
Inventories 7,514,001 5,641,914
Other current assets 187,147 197,726
_______________________________
Total current assets 40,283,569 65,167,774
Fee-per-use systems, net 8,564,189 5,994,137
Property and equipment, net 5,979,849 4,813,745
Intangible assets, net 3,383,925 --
Deposits and other assets 729,280 155,899
_______________________________
Total assets $58,940,812 $76,131,555
===============================
Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable $2,173,179 $1,496,630
Salaries and wages payable 2,357,045 2,208,454
Customer deposits 431,877 164,330
Other accrued liabilities 567,759 401,609
Current portion of obligations
under capital leases 80,966 75,861
_______________________________
Total current liabilities 5,610,826 4,346,884
Obligations under capital leases,
less current portion 101,872 182,535
Commitments and contingencies
Shareholders' equity:
Preferred stock, $.01 par value;
10,000,000 shares authorized;
none issued and outstanding -- --
Common stock, $.01 par value;
40,000,000 shares authorized;
14,389,378 and 13,652,156 shares
issued and outstanding at
December 31, 1997 and 1996,
respectively 141,057,881 136,255,746
Deferred compensation -- (74,246)
Accumulated deficit (87,829,767) (64,579,364)
_______________________________
Total shareholders' equity 53,228,114 71,602,136
_______________________________
Total liabilities and
shareholders' equity $58,940,812 $76,131,555
===============================
See accompanying notes.
Page 15
<PAGE>
Statements of Operations
Year ended December 31,
1997 1996 1995
________________________________________________________________________
Revenues $10,824,380 $3,061,849 $--
Cost of revenues 4,774,920 1,904,559 --
____________________________________________
Gross margin 6,049,460 1,157,290 --
Operating expenses:
Research and development 14,248,669 11,202,375 9,384,177
Selling, general and
administrative 17,745,936 11,295,228 6,626,317
____________________________________________
31,994,605 22,497,603 16,010,494
____________________________________________
Loss from operations (25,945,145) (21,340,313) (16,010,494)
Interest income 2,399,117 3,741,843 1,730,094
Interest expense (50,884) (56,813) (84,986)
_____________________________________________
Net loss $(23,596,912) $(17,655,283) $(14,365,386)
=============================================
Basic and diluted net
loss per share $(1.66) $(1.36) $(1.59)
=============================================
Shares used in
computation of basic
and diluted net
loss per share 14,197,307 13,029,314 9,007,570
=============================================
See accompanying notes.
Page 16
<PAGE>
Statements of Shareholders' Equity
<TABLE>
<CAPTION>
Preferred Stock Common Stock
_______________________ ______________________
Number of Number of Deferred Accumulated
shares Amount shares Amount compensation deficit Total
______________________________________________________________________________________________________________
<S> <C> <C> <C> <C> <C> <C> <C>
Balance at
December 31, 1994 5,442,591 $32,929,062 528,374 $3,158,257 $(453,447) $(32,031,962) $3,601,910
Preferred stock
converted to
common stock (5,442,591) (32,929,062) 5,609,257 32,929,062 -- -- --
Initial public
offering --
common stock,
net of issuance
costs of
$3,209,734 -- -- 3,450,000 34,740,266 -- -- 34,740,266
Exercise of options
and warrants -- -- 206,856 472,386 -- -- 472,386
Amortization of
deferred
compensation -- -- -- -- 277,665 -- 277,665
Gift of original
issuance shares -- -- 25,000 350,000 -- -- 350,000
Unrealized appreciation
on securities
available-for-sale -- -- -- -- -- 56,370 56,370
Net loss -- -- -- -- -- (14,365,386) (14,365,386)
______________________________________________________________________________________________________________
Balance at December 31, 1995 -- -- 9,819,487 71,649,971 (175,782) (46,340,978) 25,133,211
Second public offering
-- common stock, net of
issuance costs of
$4,384,649 -- -- 2,875,000 61,740,351 -- -- 61,740,351
Exercise of options
and warrants -- -- 957,669 2,889,169 -- -- 2,889,169
Amortization of deferred
compensation -- -- -- (23,745) 101,536 -- 77,791
Unrealized loss on
securities
available-for-sale -- -- -- -- -- (583,103) (583,103)
Net loss -- -- -- -- -- (17,655,283) (17,655,283)
______________________________________________________________________________________________________________
Balance at December 31, 1996 -- -- 13,652,156 136,255,746 (74,246) (64,579,364) 71,602,136
Exercise of options
and warrants -- -- 688,658 3,952,135 -- -- 3,952,135
Amortization of deferred
compensation -- -- -- -- 74,246 -- 74,246
Common stock issued
on purchase of
Pathfinder System
product line -- -- 48,564 850,000 -- -- 850,000
Unrealized appreciation
on securities
available-for-sale -- -- -- -- -- 346,509 346,509
Net loss -- -- -- -- -- (23,596,912) (23,596,912)
______________________________________________________________________________________________________________
Balance at December 31, 1997 -- $-- 14,389,378 $141,057,881 $-- $(87,829,767) $53,228,114
==============================================================================================================
</TABLE>
See accompanying notes.
Page 17
<PAGE>
Statements of Cash Flows
Year ended December 31,
1997 1996 1995
_______________________________________________________________________________
Operating activities
Net loss $(23,596,912) $(17,655,283) $(14,365,386)
Adjustments to reconcile net loss
to net cash used in operating
activities:
Depreciation and amortization 4,326,157 1,994,064 539,217
Deferred compensation 74,246 77,791 277,665
Gift of original issuance shares -- -- 350,000
Accrued interest on securities
available-for-sale 1,152,187 660,623 (337,098)
Net change in operating accounts:
Accounts receivable (3,023,562) (840,256) --
Inventories and fee-per-use
systems (8,243,774) (11,093,253) (577,634)
Accounts payable and accrued
liabilities 1,208,837 1,839,915 1,421,009
Other (594,194) 40,888 (86,707)
_________________________________________
Net cash used in operating activities (28,697,015) (24,975,511) (12,778,934)
Investing activities
Purchases of securities
available-for-sale (5,349,511) (75,750,434) (35,663,513)
Maturities of securities
available-for-sale 29,750,677 43,169,070 19,073,237
Purchase of Pathfinder
System product line (2,696,114) -- --
Additions to property and equipment (950,424) (3,325,122) (1,885,813)
Other 3,379 166,396 85,115
_________________________________________
Net cash provided by (used in)
investing activities 20,758,007 (35,740,090) (18,390,974)
Financing activities
Proceeds from bank note -- -- 500,000
Payments on bank note -- -- (500,000)
Issuance of common stock, net -- 61,740,351 34,740,266
Payment on short-term note payable
issued in purchase of Pathfinder
System product line (500,000) -- --
Exercise of options and warrants 3,952,135 2,889,169 472,386
Proceeds from sale/leaseback
transactions -- -- 317,594
Principal payments on obligations
under capital leases (75,558) (193,441) (209,415)
_________________________________________
Net cash provided by financing
activities 3,376,577 64,436,079 35,320,831
_________________________________________
Net increase (decrease) in cash
and cash equivalents (4,562,431) 3,720,478 4,150,923
Cash and cash equivalents:
Beginning of year 7,871,401 4,150,923 --
_________________________________________
End of year $3,308,970 $7,871,401 $4,150,923
=========================================
Noncash transactions and supplemental disclosures
Inventories reclassified to
fee-per-use systems $4,152,386 $6,563,537 $--
Inventories reclassified to property
and equipment 2,457,367 729,362 --
The purchase of the Pathfinder System product line included 48,564 shares
of NeoPath common stock (see Note 4).
See accompanying notes.
Page 18
<PAGE>
Notes to Financial Statements
December 31, 1997
Note 1 Description of Business and Summary of Significant
Accounting Policies
Business
NeoPath, Inc. ("NeoPath" or the "Company") develops and markets visual
intelligence technology to increase accuracy in medical testing. The
Company's AutoPap(R) System is a medical device that integrates proprietary
high-speed image processing computers, video imaging technology, and
sophisticated image interpretation software to capture and analyze
thousands of microscopic images from a Papanicolaou ("Pap") smear slide for
the early detection of cervical cancer. The Company's Pathfinder(R) System
provides improved quality assurance in the clinical cytology laboratory by
computerizing the cytotechnologists' microscopes, thereby helping to
eliminate screening errors and facilitating critical-cell identification in
applications such as Pap smear screening.
Revenues and Markets
NeoPath's primary market includes domestic and foreign clinical
laboratories. Domestic revenues are generated primarily through
NeoPath's direct sales force; international revenues are derived
primarily through distributors. International product placements
accounted for 51% and 45% of total 1997 and 1996 revenues, respectively.
The Company's four largest customers accounted for 65% and 86% of total
1997 and 1996 revenues, respectively. The Company recognizes AutoPap
System fee-per-use revenue based on the number of customer slides
processed, subject to agreed-upon minimum processing levels or minimum
rental payments, beginning in the month an AutoPap System is initially
placed in commercial use at the customer site. Sales of AutoPap Systems
are recognized at date of shipment. Pathfinder System sales accounted
for less than three percent of total revenues in 1997 (see Note 4).
Cash Equivalents
Short-term investments with a purchased maturity of three months or
less are considered to be cash equivalents. Cash equivalents are carried
at cost, which approximates market value.
Securities Available-For-Sale
NeoPath's investment portfolio is classified as available-for-sale, and
such securities are stated at fair value, with the unrealized gains and
losses adjusted through accumulated deficit. Interest earned on
securities available-for-sale is included in interest income. The
amortized cost of investments in this category is adjusted for
amortization of premiums and accretion of discounts to maturity. Such
amortization and accretion are included in interest income. The cost of
securities sold is calculated using the specific identification method.
Inventories
Inventories are valued at the lower of cost or market (first in, first
out basis).
Fee-Per-Use Systems
AutoPap Systems manufactured for fee-per-use placements are carried in
inventories until the AutoPap Systems are placed in commercial use, at
which time they are reclassified to fee-per-use systems (non-current
assets). Fee-per-use systems are depreciated on a straight-line basis
over an estimated useful life of four years.
NeoPath purchases all components for the AutoPap and Pathfinder Systems
from outside vendors, including certain components from sole-source or
single vendors. The establishment of additional or replacement sources
of supply for the AutoPap System could require regulatory approval. In
addition, a vendor's inability to supply acceptable components in a
timely manner and in the quantity required could delay or halt the Company's
manufacture of its products.
Property and Equipment
Property and equipment are recorded at cost less accumulated
depreciation and amortization. Depreciation is calculated on a straight-
line basis over the estimated useful lives of the related assets, ranging
from three to seven years. Leasehold improvements are amortized over the
lesser of their estimated useful lives or the term of the lease.
Page 19
<PAGE>
Intangible Assets
Intangible assets include patents, trademarks, non-competition
agreements, and goodwill associated with NeoPath's purchase in 1997 of
the Pathfinder System product line from CompuCyte Corporation
("CompuCyte") (see Note 4). These intangible assets are amortized on a
straight-line basis over five years.
The Company periodically reviews the carrying value of its intangible
assets whenever events or changes in circumstances indicate that the
carrying value may not be recoverable. To the extent the estimated
future cash inflows attributable to the asset, less estimated future cash
outflows, are less than the carrying amount, an impairment loss would be
recognized.
Stock-Based Compensation
NeoPath has elected to follow the intrinsic value method prescribed by
Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued
to Employees," and related Interpretations in accounting for its stock
options because the alternative fair value accounting provided for under
Financial Accounting Standards Board ("FASB") Statement No. 123,
"Accounting for Stock-Based Compensation," requires use of option
valuation models that were not developed for use in valuing employee
stock options. Because the exercise price of the Company's stock options
generally equals the market price of the underlying stock on the date of
grant, no compensation expense has been recognized since NeoPath's
initial public stock offering. (See Note 7 for Statement 123 pro forma
disclosures.)
Basic and Diluted Net Loss Per Share
Basic and diluted net loss per share is computed based on the weighted
average number of shares of common stock outstanding.
In 1997, the FASB issued Statement No. 128, "Earnings per Share."
Statement 128 replaced the calculation of primary and fully diluted
earnings per share with basic and diluted earnings per share. Unlike
primary earnings per share, basic earnings per share excludes any
dilutive effects of options, warrants and convertible securities.
Diluted earnings per share is very similar to the previously designated
fully diluted earnings per share. Because NeoPath's stock options and
warrants are not dilutive (due to net losses) there is no difference
between basic net loss per share and diluted net loss per share, and no
restatement of prior-year amounts is required.
New Accounting Standards
In 1997, the FASB issued Statement No. 130, "Reporting Comprehensive
Income," which is required to be adopted for fiscal years beginning after
December 15, 1997. The new Statement requires that companies report and
display comprehensive income and its components, as defined in Statement
130, for all periods presented. Under the new requirements,
comprehensive income must be displayed with the same prominence as other
financial statements. NeoPath plans to adopt the new Statement in 1998.
In 1997, the FASB issued Statement No. 131, "Disclosures about Segments
of an Enterprise and Related Information," which is required to be
adopted for periods beginning after December 15, 1997. The new Statement
supersedes FASB Statement No. 14, "Financial Reporting for Segments of a
Business Enterprise." Companies will be required to report each
operating segment and related information, as defined in Statement 131,
in the company's notes to financial statements. NeoPath plans to adopt
the new Statement in 1998.
Concentrations of Credit Risk
The Company invests its excess cash in accordance with guidelines that
limit the credit exposure to any one financial institution and to any one
type of investment, other than securities issued by the United States
government. The guidelines also specify that the financial instruments
are issued by institutions with strong credit ratings. The securities
are generally not collateralized and mature within five years.
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 amounts reported in the financial statements
and accompanying notes. Actual results could differ from those
estimates.
Page 20
<PAGE>
Note 2 Securities Available-For-Sale
Securities available-for-sale consist of the following:
Gross Gross
Amortized Unrealized Unrealized
December 31, 1997 Cost Gains Losses Fair Value
____________________________________________________________________________
Corporate bonds $17,888,047 $835 $(112,479) $17,776,403
Government bonds 7,718,235 -- (85,005) 7,633,230
_______________________________________________________
$25,606,282 $835 $(197,484) $25,409,633
=======================================================
Gross Gross
Amortized Unrealized Unrealized
December 31, 1996 Cost Gains Losses Fair Value
____________________________________________________________________________
Corporate bonds $41,495,498 $2,130 $(373,817) $41,123,811
Government bonds 9,664,137 543 (172,014) 9,492,666
_______________________________________________________
$51,159,635 $2,673 $(545,831) $50,616,477
=======================================================
There were no realized gains or losses on sales of securities available-
for-sale for the years ended December 31, 1997 and 1996. The net
adjustment for unrealized holding gains and losses on securities
available-for-sale, included as a component of shareholders' equity, was
a gain of $346,509 for the year ended December 31, 1997 and a loss of
$583,103 for the year ended December 31, 1996. The fair value of
securities available-for-sale maturing within one year totals $6,557,721.
The fair value of securities available-for-sale maturing between one and
three years totals $18,851,912. The Company considers all securities
available-for-sale as available for use in current operations.
Page 21
<PAGE>
Note 3 Balance Sheet Information
Detailed balance sheet data is as follows:
December 31, 1997 1996
____________________________________________________________________
Accounts receivable
Receivables $4,363,818 $1,015,256
Allowance for doubtful accounts (500,000) (175,000)
_______________________________
$3,863,818 $840,256
===============================
Inventories
Raw materials $3,819,830 2,725,725
Work-in-process 1,061,900 166,437
Finished goods 2,632,271 2,749,752
_______________________________
$7,514,001 $5,641,914
===============================
Finished goods consist of AutoPap Systems that will be reclassified to
fee-per-use systems (non-current assets) when placed in commercial use,
AutoPap Systems to be sold, AutoPap Systems used internally on a temporary
basis, and Pathfinder Systems.
Fee-per-use systems
Systems $10,628,468 $6,563,537
Accumulated depreciation (2,064,279) (569,400)
_______________________________
$8,564,189 $5,994,137
===============================
Property and equipment
Laboratory and other equipment $8,206,222 $4,955,452
Furniture and fixtures 1,108,168 1,133,276
Leasehold improvements 1,210,930 1,154,922
_______________________________
Total property and equipment 10,525,320 7,243,650
Accumulated depreciation
and amortization (4,545,471) (2,429,905)
_______________________________
$5,979,849 $4,813,745
===============================
At December 31, 1997 and 1996, the Company held equipment under
capitalized leases with an original cost of $373,432 and $500,371, and a
net book value of $147,219 and $255,497, respectively.
Intangible assets
Intangible assets $3,759,917 $--
Accumulated amortization (375,992) --
_______________________________
$3,383,925 $--
===============================
Page 22
<PAGE>
Note 4 Purchase of Pathfinder System Product Line
In June 1997, NeoPath purchased the Pathfinder System product line from
CompuCyte for an initial purchase price of $4.1 million. The initial
purchase price included cash of $2.7 million (including transaction-
related expenses), a $500,000 short-term note paid in October 1997, and
48,564 shares of NeoPath common stock. In addition, 48,563 shares of
NeoPath common stock were issued and are held in escrow contingent upon
certain specific technology decisions to be made by the Company within
one year of closing. In accordance with accounting rules, the value of
the contingent shares was excluded from the initial purchase price
allocation, and the 48,563 contingent shares are excluded from the
calculation of weighted average shares outstanding. Including the value
of contingent shares at the closing date, which value the Company expects
to recognize as an intangible asset if the contingency is removed, the
total purchase price approximated $5.1 million.
As a result of the purchase, the Company recorded approximately
$240,000 in inventories and $100,000 in property and equipment, and it
recognized $3.8 million in acquired intangible assets.
Note 5 Lease Agreements
NeoPath leases certain property and equipment under capital leases
pursuant to master equipment lease agreements. Under such agreements, the
Company entered into multiple capital leases for property and equipment.
The agreements included lease terms ranging from 36 to 60 months and
purchase options at the end of each lease.
The Company leases office and operating facilities under operating leases
expiring in May 1998 through January 2000, with various renewal options,
and other leased items through 2002. Operating lease expense for the years
ended December 31, 1997, 1996, and 1995 was $831,983, $620,895, and
$496,190, respectively.
Minimum future lease payments as of December 31, 1997 are as follows:
Year ending December 31 Capital Leases Operating Leases
___________________________________________________________________
1998 $96,875 $870,123
1999 88,522 809,584
2000 19,050 34,105
2001 -- 21,941
2002 -- 705
___________________________________
Total minimum lease payments 204,447 $1,736,458
==========
Less amount representing
interest 21,609
________
Present value of minimum
lease payments 182,838
Current portion 80,966
________
Obligations under capital
leases,less current
portion $101,872
========
Interest rates on capitalized leases range from 10% to 19%.
Page 23
<PAGE>
Note 6 Income Taxes
As of December 31, 1997, the Company had net operating loss
carryforwards of approximately $86.5 million and research and development
credit carryforwards of approximately $2.4 million for federal income
tax purposes, which expire between 2004 and 2012. Due to the issuance
and sale of shares of preferred stock and the Company's initial public
offering, the Company incurred "ownership changes" pursuant to applicable
regulations in effect under the Internal Revenue Code of 1986, as
amended. Therefore, the Company's use of losses incurred through the
date of these ownership changes will be limited during the carryforward
period. The Company estimates that the use of approximately $28.0
million of losses incurred prior to one or more of the ownership changes
would be limited to approximately $6.4 million per year through 1998 and
to lower amounts in subsequent years. To the extent that any single-year
loss is not utilized to the full amount of the limitation, such unused
loss is carried over to subsequent years until the earlier of its
utilization or the expiration of the relevant carryforward period.
Approximately $4.9 million of the net operating loss carryforward is
attributed to the deduction for stock options, the tax effect of which
will be credited to common stock when recognized.
Deferred income taxes reflect the net tax effects of temporary
differences between the tax basis of assets and liabilities and the
corresponding financial statement amounts. Significant components of the
Company's deferred income tax assets at December 31, 1997 and 1996 are as
follows:
December 31, 1997 1996
_____________________________________________________________________
Net operating loss carryforwards $29,416,000 $21,281,000
Research and development credits 2,374,000 1,260,000
Research and development costs 633,000 759,000
Allowance for doubtful accounts 238,000 60,000
Accrued vacation 219,000 184,000
Deferred compensation 168,000 230,000
Charitable contribution carryforwards 125,000 124,000
Property and equipment 97,000 55,000
Other 387,000 234,000
Valuation allowance (33,657,000) (24,187,000)
_______________________________
$-- $--
===============================
Due to the uncertainty of the Company's ability to generate taxable
income to realize its deferred tax assets, a valuation allowance has been
established for financial reporting purposes equal to the amount of the
deferred tax assets. The Company's valuation allowance increased $9.5
million and $6.9 million for the years ended December 31, 1997 and 1996,
respectively.
Note 7 Shareholders' Equity
Common Stock
In February 1995, the Company completed its initial public offering for
the sale of 3,450,000 shares of common stock at $11.00 per share. The
net proceeds, after underwriting discounts and offering expenses, from
the sale of the common stock was $34,740,266. Upon closing, all
outstanding shares of preferred stock converted into 5,609,257 shares of
common stock, and all preferred stock warrants converted into common
stock warrants.
In April 1995, the Company donated 25,000 shares of common stock to a
university.
In January 1996, the Company completed its second public offering for
the sale of 2,875,000 shares of common stock at $23.00 per share. The
net proceeds, after underwriting discounts and offering expenses, from
the sale of the common stock was $61,740,351.
Stock Option Plans
The Company has two stock option plans that provide for option grants
to em-ployees, directors, and others. The options generally vest over
four years or as otherwise determined by the plan administrator. Options
to purchase shares expire no later than ten years after the date of
grant.
Page 24
<PAGE>
A summary of the Company's stock option activity and related information
follows:
Outstanding Exercisable
______________________ _________________
Weighted Weighted
average average
exercise exercise
Shares price Shares price
____________________________________________________ _________________
Balance, January 1, 1995 883,512 $1.69
Granted 365,675 15.82
Exercised (153,268) 1.22
Canceled (68,677) 2.81
______________________
Balance, December 31, 1995 1,027,242 6.59 483,974 $1.66
=================
Granted 838,218 22.91
Exercised (195,429) 2.60
Canceled (65,811) 10.66
______________________
Balance, December 31, 1996 1,604,220 15.39 524,318 $5.12
=================
Granted 845,025 16.46
Exercised (225,165) 2.07
Canceled (285,532) 20.18
______________________
Balance, December 31, 1997 1,938,548 $16.68 655,156 $13.56
====================== =================
Available for grant at
December 31, 1997 321,542
=========
Outstanding and exercisable options by price range as of December 31, 1997
are as follows:
<TABLE>
<CAPTION>
Outstanding Exercisable
________________________________________ __________________________
Weighted Weighted Weighted
Range of Shares average average Shares average
exercise price as of remaining exercise as of exercise
per share Dec. 31, 1997 term (years) price Dec. 31, 1997 price
________________________________________________________ __________________________
<S> <C> <C> <C> <C> <C>
$0.60 - $1.20 86,729 5.53 $1.18 85,140 $1.18
1.80 - 2.40 150,380 6.52 2.35 142,416 2.35
4.00 - 6.00 9,346 6.81 4.08 7,312 4.07
7.20 - 9.00 5,520 7.16 8.31 3,757 8.33
11.25 - 16.50 650,210 8.94 14.91 157,995 14.93
17.00 - 25.50 947,538 8.83 20.73 227,555 22.74
25.75 - 30.25 88,825 8.60 27.83 30,981 27.65
________________________________________________________ __________________________
$0.60 -$30.25 1,938,548 8.51 $16.68 655,156 $13.56
======================================================================================
</TABLE>
Pro forma information regarding net loss and net loss per share is
required by FASB Statement 123 and has been determined as if the Company
had accounted for its employee stock options under the fair value method
of that Statement. The fair value for these options was estimated at the
date of grant using a Black-Scholes multiple option pricing model with
the following weighted-average assumptions for 1997, 1996, and 1995,
respectively: risk-free interest rates of 6.08%, 6.01%, and 6.27%;
dividend yields of 0%; volatility factors of the expected market price of
the Company's common stock of 0.6589, 0.5512, and 0.5512; and a weighted-
average expected life of the option of 1.47, 1.46, and 1.46 years from
vest date.
The Black-Scholes option value model was developed for use in
estimating the fair value of traded options that have no vesting
restrictions and are fully transferable. In addition, option valuation
models require the input of highly subjective assumptions, including the
expected stock price volatility. Because the Company's stock options
have characteristics significantly different from those of traded
options,
Page 25
<PAGE>
and because changes in the subjective input assumptions can materially
affect the fair value estimate, in management's opinion, the existing
models do not necessarily provide a reliable single measure of the fair
value of its stock options.
For purposes of pro forma disclosures, the estimated fair value of the
options is amortized to expense over the options' vesting period. The
Company's pro forma information follows:
Year ended December 31, 1997 1996 1995
______________________________________________________________________________
Pro forma net loss $(27,930,575) $(20,717,024) $(15,126,112)
Pro forma basic and diluted
net loss per share (1.97) (1.59) (1.68)
The FASB Statement 123 pro forma disclosures above are not necessarily
indicative of future pro forma disclosures because of the manner in which
FASB Statement 123 calculations are phased in over time.
The weighted average fair value for options granted during 1997, 1996,
and 1995 using the Black-Scholes multiple option pricing model is $8.81,
$10.86, and $7.72, respectively.
During 1994, the Company recorded deferred compensation for the
difference between the exercise price and the deemed fair value for
financial reporting purposes of the Company's common stock for options
granted in 1994. Such options were granted at prices ranging from $1.20
to $4.00 per share, with a deemed fair value ranging from $2.40 to $6.00
per share. This compensation expense aggregated $774,000 and was fully
amortized over the respective vesting periods.
Warrants
Warrants to purchase common stock were issued in connection with several
of the Company's preferred stock offerings. Common stock warrants
outstanding at December 31, 1997 totaled 223,526 at a weighted average
exercise price per share of $7.46. These warrants expire at various dates
through 2001.
During 1997, warrants were exercised to purchase 463,493 shares of the
Company's common stock, of which 13,273 shares were issued through "net
exercise" rights, for which the Company received no proceeds. Such rights
allow the warrant holder to exercise the warrant and "pay" the warrant
price through the intrinsic value of the warrants; therefore, fewer shares
of common stock are issued as a result. During 1996, warrants were
exercised to purchase 762,240 shares of the Company's common stock, of
which 346,468 shares were issued through net exercise rights. The
remaining warrants outstanding as of December 31, 1997 have net exercise
rights.
Common Stock Reserved
At December 31, 1997, common stock was reserved for the following purposes:
Common stock warrants 223,526
Stock options 2,260,090
Employee stock purchase plan 150,000
__________
2,633,616
===========
Page 26
<PAGE>
Note 8 Employee Benefits
The Company has a retirement plan covering substantially all employees
that provides for voluntary salary deferral contributions on a pre-tax
basis in accordance with Section 401(k) of the Internal Revenue Code of
1986, as amended. To date, the Company has made no contributions to the
plan.
In May 1997, NeoPath's shareholders approved the 1997 Employee Stock
Purchase Plan (the "ESPP") and authorized the issuance of up to 150,000
shares of the Company's common stock under the plan. The ESPP permits
eligible employees of the Company to purchase common stock at not less
than 85% of fair market value as defined in the ESPP through payroll
deductions of up to 15% of their compensation, provided that no employee
may purchase common stock worth more than $25,000 in any calendar year.
Participants are required to hold ESPP stock for a minimum of six months
following the purchase date. The ESPP will expire in 2007.
Note 9 Litigation
On July 15, 1996, Neuromedical Systems, Inc. ("Neuromedical") filed a
lawsuit against NeoPath
in the United States District Court for the Southern District of New
York. The complaint alleges patent infringement, unfair competition,
false advertising, and related claims. On September 5, 1996, the Company
filed its answer and counter claims. In September 1997, a motion for
preliminary injunction against the Company was heard by a judge in the
United States District Court for the Southern District of New York. No
decision has yet been rendered. The Company believes it has a strong
position in this action and continues to defend itself vigorously.
On March 31, 1997, the Company filed a patent infringement lawsuit
against Neuromedical in the United States District Court for the Western
District of Washington. The complaint alleges patent infringement and
seeks preliminary and permanent injunctions against Neuromedical. This
suit is currently in the discovery stage.
Note 10 Subsequent Events (Unaudited)
During 1997, NeoPath completed a prospective intended-use clinical study
that included analysis of more than 25,000 Pap smear slides at five
clinical laboratories in the United States and Canada to evaluate the
performance of the AutoPap Primary Screener System (the "AutoPap
Screener") as a primary screening device. Based on the results of the
study, in August 1997 NeoPath submitted an amendment to its pending
PreMarket Approval ("PMA") Supplement to the United States Food and Drug
Administration (the "FDA") for use of the AutoPap Screener as a primary
screener of Pap smear slides. In January 1998, the Hematology and
Pathology Devices Advisory Panel of the FDA unanimously recommended that
the FDA approve, with conditions, the supplement to NeoPath's PMA
submission for use of the AutoPap Screener as a primary Pap smear
screener. As of March 1998, the Company is awaiting FDA approval on this
PMA application.
The Company is currently negotiating a bank financing facility to borrow
up to $10 million based on current and future fee-per-use AutoPap Systems
placed at customer sites. This facility is expected to be in place during
1998.
Page 27
<PAGE>
Management's Statement of Financial Responsibility
The management of NeoPath, Inc. is responsible for the fair and accurate
presentation of the financial information in this annual report. The
financial statements and related notes have been prepared in accordance
with generally accepted accounting principles based on Company records and
other sources. Certain financial information is, of necessity, based on
judgment and estimation.
We believe that adequate accounting systems and financial controls are
maintained to ensure that the Company's records are free from material
misstatement and to protect the Company's assets from loss or unauthorized
use. In addition, the Audit Committee of the Board of Directors
periodically meets with Company management and with Ernst & Young LLP, the
Company's independent auditors.
/s/ ALAN C. NELSON
Alan C. Nelson, Ph.D.
President and
Chief Executive Officer
/s/ WILLIAM L. SCOTT
William L. Scott
Vice President and
Chief Financial Officer
/s/ ROBERT C. BATEMAN
Robert C. Bateman
Corporate Controller and
Treasurer
Page 28
<PAGE>
Report of Ernst & Young LLP, Independent Auditors
The Board of Directors and Shareholders
NeoPath, Inc.
We have audited the accompanying balance sheets of NeoPath, Inc. as of
December 31, 1997 and 1996, and the related statements of operations,
shareholders' equity, and cash flows for each of the three years in the
period ended December 31, 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 financial position of NeoPath, Inc.
as of December 31, 1997 and 1996, and the 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.
/s/ ERNST & YOUNG LLP
Seattle, Washington
January 21, 1998
Page 29
<PAGE>
Common Stock Information
The Company's common stock trades on The Nasdaq Stock Market under the
symbol "NPTH." The Nasdaq Stock Market or "Nasdaq" is a highly-regulated
electronic securities market comprised of competing Market Makers whose
trading is supported by a communications network linking them to quotation
dissemination, trade reporting, and other execution systems. As of
January 30, 1998, there were 261 holders of record of the common stock of
the Company and 14,417,741 shares outstanding. Since shares of NeoPath's
common stock are also held in street name, there are additional beneficial
holders of the Company's common stock.
The following table sets forth, for the periods indicated, the high and
the low trade prices for NeoPath's common stock as reported by Nasdaq:
1997 1996
___________________ ___________________
High Low High Low
___________________ ___________________
First Quarter $19.75 $13.50 $28.50 $21.50
Second Quarter 23.00 11.50 26.50 20.00
Third Quarter 20.00 15.00 30.50 16.13
Fourth Quarter 20.38 12.63 22.25 14.50
The Company has not declared or paid cash dividends on its common stock.
The Company currently intends to retain all earnings for use in its
business and does not anticipate paying cash dividends in the foreseeable
future.
Page 30
<PAGE>
Corporate Information
Directors
Walter L. Robb, Ph.D.
Chairman of NeoPath's Board of Directors
and President, Vantage Management, Inc.
Alan C. Nelson, Ph.D.
President and Chief Executive Officer
of the Company
William L. Scott
Vice President and Chief Financial Officer
of the Company
Alan D. Frazier
President, Frazier & Company, Inc.
Cristina H. Kepner
Director and Executive Vice President,
Invemed Associates, Inc.
David A. Thompson
Retired Senior Vice President,
Abbott Laboratories
Gail R. Wilensky, Ph.D.
John M. Olin Senior Fellow, Project HOPE
Officers
Alan C. Nelson, Ph.D.
President and Chief Executive Officer
William L. Scott
Vice President and Chief Financial Officer
Shih-Jong James Lee, Ph.D.
Vice President and Chief Technical Officer
Larry A. Nelson
Vice President, Intellectual Property and New Business Development
David H. Robison
Vice President, Operations
Kumar K. Shahani
Vice President, Marketing and Business Assessment
Robert C. Bateman
Corporate Controller and Treasurer
Page 31
<PAGE>
Corporate Information
Corporate Headquarters
NeoPath, Inc.
8271 - 154th Avenue NE
Phone: (425) 869-7284
Fax: (425) 869-5325
Legal Counsel
Perkins Coie LLP
1201 Third Avenue
Seattle, WA 98101
Transfer Agent
American Stock Transfer & Trust Company
40 Wall Street
New York, NY 10005
Independent Auditors
Ernst & Young LLP
999 Third Avenue, Suite 3500
Seattle, WA 98104
Annual Meeting
The Annual Meeting of Shareholders will be held at 8:30 a.m. (Pacific
Daylight Time) on Thursday,
May 21, 1998 at the Hyatt Regency Bellevue at Bellevue Place, 900 Bellevue
Way NE, Bellevue, WA 98004
Shareholder Inquiries
Copies of the Company's Form 10-K as filed with the Securities and
Exchange Commission may be obtained without charge by writing:
Attn: Investor Relations
Stacie D. Byars
NeoPath, Inc.
8271 - 154th Avenue NE
Redmond, WA 98052
Page 32
<PAGE>
Exhibit 23.1
CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
We consent to the incorporation by reference in this Annual Report (Form 10-K)
of NeoPath, Inc. of our report dated January 21, 1998, included in the 1997
Annual Report to Shareholders of NeoPath, Inc.
Our audits also included the financial statement schedule of NeoPath, Inc.
listed in Item 14(a). This schedule is the responsibility of the Company's
management. Our responsibility is to express an opinion based on our audits.
In our opinion, the financial statement schedule referred to above, when
considered in relation to the basic financial statements taken as a whole,
presents fairly in all material respects the information set forth therein.
We also consent to the incorporation by reference in the Registration
Statement (Form S-8) pertaining to the NeoPath, Inc. Stock Option Plan for
Nonemployee Directors, as amended and restated on February 27, 1997, the
NeoPath, Inc. 1989 Stock Option Plan, as amended and restated on December
10, 1996, and the NeoPath, Inc. 1997 Employee Stock Purchase Plan, of our
report dated January 21, 1998, with respect to the financial statements and
schedule included in or incorporated by reference in this Annual Report (Form
10-K) for the year ended December 31, 1997.
/s/ ERNST & YOUNG LLP
Seattle, Washington
March 27, 1998
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
This schedule contains summary financial information extracted from the
Form 10-K405 and documents incorporated by reference for the year ended
December 31, 1997, and is qualified in its entirety by reference to such
financial statements and footnotes.
</LEGEND>
<MULTIPLIER> 1
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> JAN-01-1997
<PERIOD-END> DEC-31-1997
<CASH> 3,308,970
<SECURITIES> 25,409,633
<RECEIVABLES> 4,363,818
<ALLOWANCES> 500,000
<INVENTORY> 7,514,001
<CURRENT-ASSETS> 40,283,569
<PP&E> 10,525,320
<DEPRECIATION> 4,545,471
<TOTAL-ASSETS> 58,940,812
<CURRENT-LIABILITIES> 5,610,826
<BONDS> 0
0
0
<COMMON> 141,057,881
<OTHER-SE> (87,829,767)
<TOTAL-LIABILITY-AND-EQUITY> 58,940,812
<SALES> 0
<TOTAL-REVENUES> 10,824,380
<CGS> 0
<TOTAL-COSTS> 4,774,920
<OTHER-EXPENSES> 31,994,605
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 50,884
<INCOME-PRETAX> (23,596,912)
<INCOME-TAX> 0
<INCOME-CONTINUING> (23,596,912)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (23,596,912)
<EPS-PRIMARY> (1.66)<F1>
<EPS-DILUTED> 0
<FN>
<F1>Basic and diluted net loss per share are the same amount. No restatement of
prior financial data schedules was necessary for adoption of Financial
Accounting Standards Board Statement No. 128, "Earnings Per Share."
</FN>
</TABLE>
