<PAGE>
-----------------------------------------------
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
-----------------------------------------------
FORM 10-K
[X] ANNUAL REPORT ON FORM 10-K PURSUANT TO SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1996
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
COMMISSION FILE NO. 33-97722
NEUROMEDICAL SYSTEMS, INC.
(Exact name of registrant as specified in its charter)
<TABLE>
<S> <C>
DELAWARE 13-3526980
(State or other jurisdiction of incorporation or (I.R.S. Employer
organization) Identification No.)
TWO EXECUTIVE BOULEVARD, SUITE 306
SUFFERN, NEW YORK 10901-4164
(Address of principal executive offices) (Zip Code)
</TABLE>
(914) 368-3600
(Registrant's telephone number, including area code)
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
COMMON STOCK, $0.0001 PAR VALUE
-------------------------------
(Title of class)
PREFERRED STOCK PURCHASE RIGHTS
-------------------------------
(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 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. ____
The aggregate market value of the common stock, $0.0001 par value, of the
registrant (the "Common Stock") held by nonaffiliates as of February 28, 1997
was approximately $170,795,394. As of February 28, 1997 an aggregate of
30,897,792 shares of Common Stock were outstanding.
This Annual Report on Form 10-K incorporates by reference to Part III from
the registrant's 1997 Definitive Proxy Statement filed pursuant to Regulation
14A which has been, or will be, filed with the Commission within 120 days after
the end of the fiscal year covered by this Form 10-K.
<PAGE>
PART I
ITEM 1. BUSINESS
OVERVIEW
Neuromedical Systems, Inc., a Delaware corporation (the "Company") is a
healthcare technology company focused on diagnostic screening applications to
aid in the early detection of certain cancers. During the past five years, the
Company and its subsidiaries have been primarily engaged in the development,
manufacturing and marketing of the PAPNET(R) Testing System, and the scanning of
cervical smears at its slide processing facilities. The Company's first and, to
date, only product, the PAPNET(R) Testing System, was approved for commercial
use in the United States by the Food and Drug Administration ("FDA") on November
8, 1995 and, in January 1996, the Company initiated the first two stages of its
United States marketing program, to laboratories and clinicians. As of February
28, 1997, the PAPNET(R) test was available through 229 laboratories in the
United States alone. As of year-end 1996, PAPNET(R) testing was available in
more than 20 countries worldwide. While continuing to market to laboratories
and clinicians, the Company initiated the third stage of its United States
marketing program, direct-to-consumer advertising, in August 1996. See "--
Marketing." The Company's objective is to establish the use of its PAPNET(R)
Testing System as the new standard of care in cervical cancer screening.
The PAPNET(R) Testing System is a supplemental test in the United States to
aid laboratories in the detection of abnormal cells on Pap smears which were not
detected by standard manual microscopic inspection. When used to supplement
manual screening of Pap smears, PAPNET(R) testing has been shown to increase the
detection of cervical abnormality by up to 30% when compared to manual screening
with routine manual quality control rescreening. The Company believes that this
improved detection can result in more effective and less costly early treatment,
reduced morbidity and mortality for patients and reduced possibility of
malpractice litigation for the patient's doctor and laboratory. The PAPNET(R)
Testing System can achieve these improvements without requiring a modification
of the standard Pap smear sample due to its use of a patented combination of
algorithmic and adaptive processing technology, a form of artificial
intelligence. The Company and its subsidiaries manufacture the PAPNET(R)
Testing System and market and provide processing services which utilize the
PAPNET(R) Testing System.
Pap smears are widely used in North America, Europe and other developed
areas to aid in the early detection of cervical cancer and precancerous
conditions. The Company estimates that there are more than 50 million Pap
smears screened annually in the United States alone. Pap smears can reveal
early changes in cervical cells that precede or indicate the development of
cancer, thereby facilitating timely medical intervention. The Company estimates
that more than 2,000,000 cases of precancerous cervical abnormalities are
diagnosed in the United States annually. The American Cancer Society estimates
that there will be approximately 14,500 new cases of invasive cervical cancer
diagnosed in the United States in 1997 and approximately 65,000 cases of
cervical carcinoma in situ. In situ cancers are localized malignancies which
have not yet invaded the surrounding tissues. Women diagnosed with carcinoma in
situ typically are treated with either ablative therapy, conization (removal of
a portion of the cervix) or by hysterectomy, and women diagnosed with invasive
cervical cancer are treated with hysterectomy
2
<PAGE>
and/or radiotherapy. Approximately 4,800 women are expected to die of the
disease in the United States in 1997. Outside of the United States, where
cervical cancer screening is less prevalent, more than 450,000 new cases of
cervical cancer are diagnosed each year. Almost all deaths due to cervical
cancer could be prevented with early-stage detection and treatment.
When precancerous conditions are detected on Pap smears, they are usually
treatable using simple procedures in the physician's office. If abnormal cells
on the Pap smear are not detected by the laboratory, however, the patient may be
incorrectly told that her Pap smear is negative, and significant morbidity
(including, for example, hysterectomies) or mortality may occur as a result. In
addition, when a laboratory does fail to diagnose a positive Pap smear
correctly, its defense of any resulting lawsuit may be difficult, because all
Pap smear slides are retained in the laboratory's archive for five years
pursuant to federal law and therefore are available for re-examination.
Unlike most other high-volume laboratory tests, the cytological evaluation
(the visual examination of cells) of the cervical Pap smear is performed
manually. Specially trained medical technicians, known as cytotechnologists,
screen up to 100 Pap smears per day using standard light microscopes, usually at
100x magnification. Each of these smears may contain hundreds of thousands of
normal cells. The few smears that are abnormal may contain only a small number
of abnormal cells (as few as 20) scattered among the vast number of normal
cells. The manual screening of Pap smears has been appropriately characterized
as extremely taxing and inherently prone to error, and has often been compared
to searching for a needle in a haystack or to proofreading a long document to
find a few spelling errors. As a result, manual screening false-negative rates
ranging from 10% to 40% of true positives have been commonly reported in the
medical literature over the last 20 years. See "--The Cervical Pap Smear
Problem."
The PAPNET(R) Testing System is a computerized image processing service.
The laboratory performs PAPNET(R) testing when specifically requested by
clinicians, patients or third-party payers who wish to minimize the probability
of false negatives and their attendant medical and legal consequences. Slides
first diagnosed by a laboratory as "negative" using manual inspection are sent
to Scanning Centers for imaging on a PAPNET(R) Scanning Station, which is
designed to inspect the hundreds of thousands of cells and other objects on the
slide. The PAPNET(R) Scanning Stations' proprietary neural network computers
are designed to select color images of 128 potentially abnormal cells and cell
clusters from each slide for detailed video review (whether or not they are, in
fact, abnormal). These 128 images from each slide are recorded on a digital
tape cassette or CD-ROM which is returned to the client laboratory within
two to four working days along with the referred Pap smear slides.
At the laboratory, a certified cytotechnologist specially trained in the
use of the PAPNET(R) Testing System evaluates the 128 color images from each
slide on the PAPNET(R) Review Station. The PAPNET(R) Review Station's software
ensures that the cytotechnologist displays each image at 200x magnification
(twice normal screening power) and permits the user to expand any image to 400x
magnification. If all of the images appear normal, the cytotechnologist
classifies the slide as "negative," and no further examination is required. The
Company has found that cytotechnologists experienced in the use of the PAPNET(R)
Review
3
<PAGE>
Station can review negative cases in substantially less time than it takes to
perform a conventional manual re-examination.
If any one of the 128 images appears to the cytotechnologist to be
abnormal, the cytotechnologist classifies the slide as "review." The
cytotechnologist then refers to the "x, y" coordinates provided with each
PAPNET(R) image and uses the coordinates as a reference point to re-examine the
slide directly through the microscope. If, after direct inspection, the
cytotechnologist continues to believe that the slide contains abnormal cells, he
or she refers the slide to the laboratory's pathologist for a final diagnosis.
In no case does the Company or the PAPNET(R) Testing System make a diagnosis of
a slide or smear.
The PAPNET(R) Testing System is used in the United States as a supplement
to current practice and does not alter the clinician's procedure for the taking
of smears or the laboratory's method of staining or applying the coverslip. It
provides an additional and complementary level of screening for the purpose of
decreasing false negative Pap smear diagnoses.
The clinical trial conducted to support the Company's FDA application
involved a study of more than 10,000 Pap smears originally classified as
"negative" and retrieved from laboratory archives. The trial measured the
ability of PAPNET(R) testing to detect missed abnormalities on "negative" smears
from a population of women who had negative Pap smear histories but nevertheless
subsequently developed high grade lesions or invasive cervical cancer (the
"Case" group), and was also used to re-examine a series of routine "negative"
smears (the "Control" group). The trial results indicated that, when used as an
adjunct to manual screening, PAPNET(R) testing can increase the aggregate
cervical abnormality detected by up to 30% when compared to the combination of
manual screening and routine manual quality control rescreening. The trial
results also demonstrated that PAPNET(R) testing detected an abnormality which
had been originally missed by manual screening for 31.6% of the Case patients.
For 91.7% of such women, PAPNET(R) testing would have found the abnormality more
than a year prior to the biopsy that confirmed the patient's disease, and, for
38.9% of such women, more than two years earlier.
In October 1996, the Company received FDA approval to claim that PAPNET(R)
testing of routine, presumed negative Pap smears can be conservatively expected
to identify at least 7.1 times more false negatives than manual re-examination
of the same number of smears.
Management believes that the Company's technology can be adapted for use in
the early detection of cancers occurring at body sites in addition to the
uterine cervix, including the bladder, breast, esophagus, lung, oral cavity and
thyroid. Not all such cancers are commonly the subject of cytological analysis,
and the Company has not yet determined which of these other applications, if
any, it will be able to commercialize. The Company's patents cover application
of its technology to cytological screening for cancers occurring at all body
sites. See "--Potential Future Products."
The Company is a single segment business. See Items 6, 7 and 8 herein for
financial information regarding the Company. The Company believes that Pap
smear testing is not subject
4
<PAGE>
to any material degree of seasonality. The Company believes that compliance with
federal, state and local provisions which have been enacted or adopted
regulating the discharge of materials into the environment, or otherwise
relating to the protection of the environment, will not have a material effect
on capital expenditures, operations or competitive position of the Company and
its subsidiaries. The Company does not anticipate any material expenditure for
environmental control facilities for the remainder of its current fiscal year or
in the succeeding fiscal year.
THE CERVICAL PAP SMEAR PROBLEM
Cancer of the uterine cervix is preceded by a series of precancerous,
curable stages that may progress without symptoms over a period of years until
reaching an invasive stage. Treating uterine cervical cancer after it has
reached the invasive stage becomes more difficult and expensive, and may not be
successful. The Pap test, developed in the 1940s by Dr. George N.
Papanicolaou, is an effective manual screening procedure for the early detection
of precancerous and cancerous conditions of the uterine cervix. The Pap test's
goal is to identify abnormalities that may progress to a life-threatening
condition, thereby triggering medical procedures to prevent or treat cervical
cancer. With early detection, treatment is relatively inexpensive and almost
always successful. According to the American Cancer Society, the Pap test has
been the primary factor in a 70% reduction in the United States death rate from
cervical cancer over the past 40 years.
To obtain a Pap smear, a gynecologist, general practitioner or other
healthcare provider scrapes the surface of a woman's uterine cervix to collect a
sample of cells. The specimen is smeared onto a 1"x 3" glass slide and
preserved with a fixative agent such as alcohol. This Pap smear, along with
patient information, is then sent to a laboratory for staining, the application
of a coverslip, screening and diagnosis.
The most clinically significant type of error in manual Pap smear screening
is the failure to detect abnormal cells on a slide, and the resulting erroneous
classification of the smear as "negative." Studies have indicated that the false
negative rate varies widely, and in some laboratories may be as high as 40% of
true positive smears.
The high rate of false negative Pap smear screening errors is considered to
be a serious women's health problem. Screening errors may result in delayed
treatment for lesions, and may be especially dangerous for women who, for one
reason or another, do not undergo routine Pap smear testing at the recommended
intervals. A false negative smear report for these women, in particular, may
delay diagnosis and may allow the disease to progress with potentially tragic
consequences.
Current federal law requires laboratories to rescreen slides from at least
10% of the laboratory's Pap smears interpreted to be "negative" on initial
manual screening. Such rescreened slides must include negative cases selected
at random from the total caseload and from patients or groups of patients that
are identified as having a high probability of developing cervical cancer based
on available patient information.
5
<PAGE>
In addition, when a laboratory does fail to diagnose a positive Pap smear
containing an abnormality correctly, its defense of any resulting lawsuit may be
difficult. Because slides are retained in the laboratory's archive for five
years pursuant to federal law and therefore are available for re-examination, it
is not difficult for a plaintiff to demonstrate that her smear was misdiagnosed
and that she suffered damage as a consequence. Although she must also establish
that the laboratory was negligent in its misdiagnosis, laboratories often settle
such cases rather than argue to a jury that the misdiagnosis was not the result
of negligence.
THE PAPNET(R) TESTING SYSTEM
The PAPNET(R) Testing System utilizes both algorithmic and adaptive
processing computer technologies, including neural networks. Neural networks
represent a relatively new computer technology. Instead of the serial (single)
path of programming utilized by conventional computers, neural computers have
thousands of adaptively-formed paths linked in parallel, comprising a network
conceptually similar to the network of neurons in the human brain. Neural
networks can process immense quantities of information while mimicking the
neurological ability to learn from experience. After training on images of a
series of "abnormal" and "normal" cells, a neural network can recognize abnormal
cells even though they differ considerably from the training set. Neural
networks excel at solving complex pattern-recognition problems. Because the
PAPNET(R) Testing System includes neural networks, it can differentiate abnormal
cells from the overlapping normal cells, debris, lymphocytes, blood and
neutrophils found on the conventionally prepared Pap smear slide.
The PAPNET(R) Testing System searches for abnormal cells which may have
been missed on initial, manual screening. By isolating, magnifying and
centering for review 128 potentially abnormal cells and cell clusters, the
PAPNET(R) Testing System can assist the laboratory's cytologists in the
detection of even those abnormal Pap smears that are systematically likely to be
missed using the manual method -- those smears with particularly few and/or
particularly small abnormal cells. In this regard, PAPNET(R) testing
complements manual examination of the Pap smear, much the way that mammography
complements manual breast examination in the detection of breast lesions. The
system is semi-automated in that it does not attempt to provide a diagnosis, but
only points out potentially abnormal cells to the cytotechnologist, thus
enhancing the ability of trained cytotechnologists to evaluate and interpret
cytological evidence.
The PAPNET(R) Testing System includes two major subsystems: the PAPNET(R)
Scanning Station (and related equipment) and the PAPNET(R) Review Station. The
PAPNET(R) Scanning Stations are all located at Scanning Centers owned and
operated by the Company. The PAPNET(R) Review Stations are located at the
customers' laboratories.
The PAPNET(R) Scanning Station is the largest and most important component
of the PAPNET(R) Testing System. It scans each barcoded and labeled slide to
select and record color images of 128 cells and cell clusters deemed by the
Scanning Station's algorithmic and neural network computers to be among the most
potentially abnormal (whether or not the slide in fact contains abnormality).
The images are copied onto digital tape or CD-ROM and returned with the
slides to the laboratory.
6
<PAGE>
The PAPNET(R) Review Station is based upon personal computer technology and
includes a large, high-resolution monitor, digital tape or CD-ROM drive
and the Company's proprietary PAPNET(R) Review Station software.
MARKETING
The Company's objective is to establish the use of PAPNET(R) testing as the
new standard of care in cervical cancer screening. The Company believes that
the PAPNET(R) system's design, clinical claims and performance distinguish it
from both current practice and competitive products. Specifically, the Company
intends to market the system to laboratories, clinicians and women as a
separate, adjunctive test that, when combined with conventional manual Pap smear
screening, increases the aggregate detection of cancer and pre-cancerous
conditions of the cervix.
United States Marketing.
The Company believes that the United States represents the single largest
market for PAPNET(R) testing. To establish PAPNET(R) testing in the United
States as the standard of care in Pap smear analysis, the Company is executing a
three-step sequential marketing program that targets (i) its direct clients, the
clinical laboratories that perform Pap smear testing, (ii) gynecologists and
those primary care physicians and other clinicians who take Pap smears and can
order PAPNET(R) testing and (iii) women, to encourage them to request PAPNET(R)
testing or to agree to it if it is recommended by a clinician. The Company
believes that significant revenue growth in the United States depends upon
effective marketing to all three target audiences. The Company has also begun
discussions with insurers, managed care organizations and other third-party
payers concerning reimbursement for PAPNET(R) testing. At year-end 1996,
MagnaCare/MagnaHealth agreed to provide PAPNET(R) Testing as a covered benefit
for its more than 1.3 million enrollees in the New York area. In addition, in
February 1997, Blue Cross Blue Shield Mutual of Ohio, concluded an agreement
with the Company to cover the cost of the PAPNET(R) test for all of its members.
In order to make PAPNET(R) testing available to patients nationwide, the
Company first marketed PAPNET(R) testing to its prospective direct clients, the
laboratories in the United States that screen Pap smears. In January 1996, the
Company initiated its marketing program to laboratories following FDA approval.
In order for a laboratory to provide PAPNET(R) testing to its clients
(gynecologists and other clinicians who take Pap smears) the laboratory must
purchase or lease a PAPNET(R) Review Station (except for laboratories providing
PAPNET(R) on a referral basis) and arrange for its cytotechnologists and
pathologists to take the Company's training course in the use of the PAPNET(R)
system. The Company's strategy is to establish prices for the Review Station
and training so that it will be feasible for laboratories of virtually any size
to become providers of PAPNET(R) testing. Accordingly, the Company anticipates
that its primary source of revenue will be the per-slide charge that it will
receive from laboratories for each Pap smear rescreened on the PAPNET(R) Testing
System.
As of December 31, 1996, more than 200 laboratories in the United States
had been equipped with a PAPNET(R) Review Station and had trained
cytotechnologists to perform
7
<PAGE>
PAPNET(R) testing, or have made arrangements with other laboratories that can
perform PAPNET(R) testing on a reference basis. As of year end 1996, the Company
believes that PAPNET(R) testing is accessible to women in most metropolitan
areas of the United States.
In general, the Company does not expect to request that laboratories sign
contracts to provide minimum quantities of slides. Because PAPNET(R)
rescreening is an additional, separate test, however, laboratories will be able
to charge for it in addition to charging for a Pap smear. The Company believes
that, in order for PAPNET(R) testing to emerge as a significant source of
revenue for laboratories that provide it, the Company must create demand for
PAPNET(R) testing among gynecologists, other primary care physicians and women.
Since PAPNET(R) testing will be requested specifically by clinicians in much the
same way that pharmaceutical products are prescribed, the Company markets
directly to gynecologists and other relevant clinicians. In January 1996, the
Company also began marketing directly to physicians and providing them with
educational and promotional materials with the objective of establishing
PAPNET(R) testing as a routinely prescribed test. The Company expects that
physicians will be motivated to prescribe PAPNET(R) testing in order to provide
their patients with the highest level of care.
In addition, in September 1996, the Company entered into a co-promotion
agreement with the Women's Healthcare Group of the Parke-Davis division of
Warner-Lambert Company. Under the agreement, members of the Parke-Davis field
sales force are presenting PAPNET(R) testing promotional materials to physicians
when making sales calls regarding Parke-Davis Loestrin(R) oral contraceptives.
Although the Company does not expect that Parke-Davis's activities will have a
significant direct impact on sales, the Company believes that this program
has increased awareness of PAPNET(R) testing in the clinician's office.
Activities under the agreement began in late October 1996 and continued into
early 1997.
After the Company began to create awareness and a base of support for
PAPNET(R) rescreening among gynecologists and other primary care physicians, the
Company began marketing to women in August 1996 through direct-to-consumer
advertising while continuing to market to laboratories and clinicians. The
Company believes that many women will be willing to pay the expected additional
cost for PAPNET(R) rescreening in order to obtain the greater accuracy
demonstrated in the PAPNET(R) Testing System's clinical trials.
The Company believes that it may be better able to generate demand for
PAPNET(R) rescreening among clinicians and women if the cost to the patient is
reimbursed in whole or in part. Accordingly, the Company is also marketing
directly to insurers, managed care organizations and other third party payers
with the goal of persuading these entities to reimburse patients for PAPNET(R)
testing. The Company believes that its efforts in this regard may be aided by
recent efforts to measure the quality of care provided by health maintenance
organizations.
As of March 28, 1996, the Company believes its sales and marketing efforts
in the United States have generated considerable awareness about PAPNET(R)
testing among pathologists, cytotechnologists, gynecologists and women. The
Company believes that support and interest has been highest among women. Medical
specialties, however, are often reluctant to change clinical practice methods
and procedures, and early stage resistance is being experienced in the adoption
of PAPNET(R)
8
<PAGE>
testing. Among gynecologists and pathologists there has been, in general, a slow
adoption of the PAPNET(R) technology and some reluctance to use it even if a
woman inquires about or requests the test. The Company believes that this is due
to several factors, including controversy within the medical profession about
the public health consequences of Pap smear false negatives, the relative cost
of PAPNET(R) testing to the Pap smear, limited reimbursement by third party
payers and confusion in the marketplace about alternative technologies for
cervical cancer screening. In late 1996 and the first quarter of 1997, the
Company initiated medical and other communications designed to address each of
these considerations.
International Marketing.
The Company intends to continue to promote PAPNET(R) testing in
international markets in a manner essentially similar to the plan for the United
States market, although the success of PAPNET(R) testing in certain non-United
States markets may depend upon the extent to which government payers reimburse
for PAPNET(R) rescreening. In addition, the Company will be limited in its
ability to advertise directly to women in certain markets, including most of
western Europe.
In June 1994, the Company established its European base of operations in
Amsterdam and in November 1996 restructured its European business to allow for
more autonomous management. Such restructuring included the appointment of a
president of NSI Europe, B.V., the Company's European operations subsidiary.
The Company has increased its operations in Australia to six persons and
the Company has also established marketing arrangements with representatives in
Asia.
THIRD-PARTY REIMBURSEMENT
Some private third-party medical insurance payers and government 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 third-party
payers that do provide reimbursement varies considerably. Third-party payers
(Medicare/Medicaid, 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 for PAPNET(R) testing provided by such payers or by not
providing any reimbursement at all. Restrictions on reimbursement may limit the
price which the Company can charge for its services or reduce the demand for
PAPNET(R) testing. In addition, if Medicare and Medicaid do not provide for
reimbursement of PAPNET(R) testing, or, if the level of reimbursement is
significantly below the amount laboratories charge patients to perform PAPNET(R)
testing, the size of the potential market available to the Company may be
reduced. There can be no assurance that costs associated with PAPNET(R) testing
will ever become reimbursable or that the level of reimbursement to clinical
laboratories for PAPNET(R) testing will achieve or be maintained at levels
necessary to permit the Company to generate substantial revenues. In the
international market, reimbursement by third-party medical insurance payers,
including governmental insurers and providers, varies from country to country.
In certain
9
<PAGE>
countries, the Company's ability to achieve significant market penetration may
depend upon whether private third-party or governmental reimbursement is
available.
MANUFACTURING; RESEARCH AND DEVELOPMENT
The Company's subsidiary, Neuromedical Systems Israel, Ltd. ("NSIL"),
based in Rehovot, Israel, manufactures the Scanning Stations, related equipment
and software. NSIL assembles components, optically aligns the automated
microscope, installs all software (including the Company's proprietary image
processing algorithm and neural network-based classifier) and tests the
completed system. Components of the Scanning Stations are either purchased
"off-the-shelf" or are manufactured by subcontractors to the Company's
specifications.
NSIL has been designated as an "Approved Enterprise" by the Investment
Center, a government agency of the Ministry of Industry and Commerce and the
Ministry of Finance of the Government of Israel. Such status makes NSIL
eligible to receive government guaranteed loans under certain terms and
conditions. The outstanding amount as of December 31, 1996, under long-term
loans derived from this program was approximately $2.2 million.
The PAPNET(R) Review Station is based on "off-the-shelf" personal computer
technology manufactured by third-party vendors and shipped to laboratories
unfinished. Final assembly is done at the laboratories by Company personnel who
install software, affix applicable labels and align the laboratory's microscope
to the "x, y" coordinates associated with the PAPNET(R) Testing System.
The Company expended approximately $6,785,000, $5,172,000 and $4,305,000 in
the years ended 1996, 1995 and 1994, respectively, on research and development
related to the PAPNET(R) Testing System.
PATENTS AND PROPRIETARY RIGHTS
The Company's first U.S. patent issued on October 23, 1990. The Company's
patents cover various technologies applicable to the Company's current and
planned businesses. Some of the technologies covered by the Company's patents
include the application of neural networks and adaptive processing to the
classification of cytological specimens generally. In addition, the Company
owns patents which cover interactive screening of specimens in which certain
cells from a specimen are automatically selected and displayed for focused human
review. The Company's PAPNET(R) Testing System is specifically disclosed and
claimed.
The Company has five issued United States patents and several pending
patent applications. The Company's issued United States patents do not begin to
expire until at least 2008. The Company also has been issued patents in several
foreign countries, including certain European countries, Canada and Australia,
and has applied for patent protection in numerous other foreign countries,
including Japan and certain European countries.
10
<PAGE>
The Company is not aware of any patents held by others that would prevent
the Company from manufacturing and commercializing, in the United States and
abroad, the PAPNET(R) Testing System as it currently exists.
The Company has trademark/service mark registrations for "Neuromedical
Systems," "NSI," "PAPNET," "Advancing the Vision of Cytology," "The Objective
Difference in Pap Smear Screening," "The Safety Net for Your Pap Smear," and the
Company's logo design and other marks in the United States. Applications to
register several of these marks have been filed in several foreign countries,
and the registrations for many of these already issued. One other United States
application is pending.
In May of 1995, a third party, whose identity has not been publicly
disclosed to the Company, filed with the Patent Office requests, which the
Patent Office granted, for re-examination of three of the Company's issued
United States patents which relate to technology on which the PAPNET(R) Testing
System is based. The re-examination process was completed in 1996 for each of
the re-examined patents and Re-examination Certificates have been received by
the Company from the Patent Office confirming or finding patentable all claims
of the re-examined patents. The Company also added claims to one patent during
the re-examination process.
TERRITORIAL LICENSES
From 1989 through 1991, the Company entered into various long-term
territorial license agreements (the "License Agreements" and each licensee
thereof, a "Licensee") for the states of Ohio, Kentucky, Nevada, Missouri,
Georgia, North Carolina, Utah, Arizona and the metropolitan areas of Chicago and
San Diego, which together account for approximately 20% of the population of the
United States. Each license expires on the later of (i) 17 years after its
execution and (ii) the expiration of the initial patent granted for the
PAPNET(R) system, and is renewable for an additional 17-year term at the
Licensee's option. The Company received net proceeds of approximately $3.5
million from the sale of the License Agreements.
Pursuant to the License Agreements, each Licensee is obligated to use its
best efforts to promote diligently the use of the PAPNET(R) Testing System in
its territory at the Licensee's expense. Each Licensee is entitled to receive
the greater of (i) royalties equal to 50% of the Net Slide Revenue generated
from participating laboratories within its territory, not to exceed the
Licensee's share of a specified number of slides annually (ranging from 175,000
to 3,000,000, and aggregating 12,175,000 among all of the Licensees); or (ii) a
specified percentage (ranging from 0.15% to 1.0%, and aggregating 4.15% for all
the Licensees) of the Company's annual slide processing revenues less certain
taxes, commissions and other enumerated expenses, up to specific annual monetary
limits for each Licensee (aggregating $23,000,000). The Company estimates that
the License Agreements will result in royalty expense to the Company of
approximately 10% of its United States revenues over the term of the License
Agreements, but there can be no assurance that the amount of such royalties will
not be more or less than such percentage.
In December 1995, the Company and the Licensees entered into a settlement
agreement (the "Settlement Agreement") and a warrant exercise agreement, the
effects of which included the
11
<PAGE>
clarification of previously disputed elements of prior license agreements, the
requirement for the Company to make payments of stock having a fair market value
equivalent to approximately $1,652,000, the irrevocable election by the
Licensees and acceptance by the Company for the cashless exercise of 826,032
outstanding warrants into 715,894 shares of Common Stock made in connection with
the closing of the Company's initial public offering of Common Stock in December
1995 (the "IPO") and consent by the Company of the merger of the Licensees and
related parties. Pursuant to the Settlement Agreement, the Company issued, in
the aggregate, 118,406 shares of Common Stock to the Licensees and related
parties. In connection with the Settlement Agreement, the Company and the
Licensees (including related parties) executed mutual general releases, which
include, among other things, the release of the claims previously made by the
Licensees.
In 1996, the Licensees and related parties merged into two territorial
entities, Netmed, Inc. ("Netmed", formerly Papnet of Ohio, Inc., consolidating
the Licensees for the states of Ohio, Kentucky, Missouri, Georgia, North
Carolina, and the metropolitan area of Chicago) and Cytology West,
Inc., ("Cytology West", consolidating the Licensees for the states of Nevada,
Utah, Arizona and the county of San Diego, California). In accordance with the
Settlement Agreement, the Company will enter into new licenses with Netmed and
Cytology West pursuant to which the rights and obligations of the Licensees have
been clarified but with respect to which the economic terms of the License
Agreements will not be materially altered (each, a "Restated License"). Each
Restated License will provide, however, that a slide received from multistate
national laboratories will be deemed to have been received from licensed
territories pro rata according to each territory's population and the percentage
of United States population. The Restated Licenses will expire on December 31,
2025.
In addition, the provisions of a promissory note dated October 3, 1990
(which was later converted to Series A Convertible Preferred Stock and
subsequently converted into Common Stock upon consummation of the Company's IPO)
granted the holder of the note certain rights to an agreement to be the
Company's sole licensee for distribution of the PAPNET(R) system in Canada. The
promissory note provides that such "licensee shall be entitled to terms which
are at least as favorable as those in any domestic United States of America
licenses." An agreement has not been negotiated. There can be no assurance that
the terms of such agreement, when it is negotiated, or the activities of the
licensee thereunder, will not have a material adverse effect on the
profitability of the Company's business in Canada. Joseph Salamon, a former
director of the Company whose term expired June 20, 1996, is the agent of the
record holder of the rights to the Canadian license.
DISTRIBUTION AGREEMENTS AND OTHER EXCLUSIVE ARRANGEMENTS
In addition to the exclusive customer relationships described above, the
Company has entered into an exclusive representation agreement with Papnet (Far
East) Ltd. ("PFEL"), a Cayman Islands corporation based in Hong Kong and
controlled by certain direct and indirect stockholders of the Company. The
president and an 18% stockholder of PFEL is Dr. Stephen Ng, a director of the
Company whose term ends at the 1997 annual meeting of Company stockholders.
12
<PAGE>
The representation agreement with PFEL (the "PFEL Agreement") provides that
PFEL will, in concert with the Company but at its own expense, market and sell
PAPNET(R) testing services in Hong Kong, Taiwan, Singapore, Thailand and the
cities of Beijing, Shanghai and Guangzhou in the People's Republic of China (the
"PFEL Territories"). During the term of the PFEL Agreement, the Company will pay
PFEL specified commissions in the form of a percentage of revenues received by
the Company from the PFEL Territories (generally 15%, but ranging up to 50%,
depending on price and other factors), regardless of whether such revenues are
derived from the efforts of PFEL or the Company. In addition, PFEL has the non-
exclusive right to market and sell PAPNET(R) testing elsewhere in the People's
Republic of China, but will receive commissions only to the extent that revenues
received by the Company are attributable to its efforts. The Company incurred
expenses of approximately $142,000, $136,000 and $116,000, in 1996, 1995 and
1994, respectively, in connection with the PFEL Agreement. Included as a portion
of the foregoing expenses were fees paid by the Company for management
assistance in connection with the establishment of the Company's Asia-Pacific
Scanning Center. The Company anticipates incurring management assistance
expenses in 1997 of approximately $25,000 in connection with the PFEL Agreement.
The term of the PFEL Agreement and PFEL's rights thereunder are variable in
duration, depending on the volume of sales from the various PFEL Territories.
Assuming all performance objectives are met, PFEL's rights may continue until
July 2000.
During the fourth quarter of 1996, PFEL proposed that the Company purchase
its business assets and those of affiliated entities, including Compuscreen
Medical Diagnostic Centre, a cytology laboratory, and terminate the PFEL
Agreement in connection with such acquisition. Negotiations for such an
acquisition are continuing, but no definitive agreement has yet been reached.
Pursuant to the existing treaty between the Government of the United
Kingdom and the People's Republic of China, Hong Kong will revert to and become
part of China in July 1997. The Company is uncertain as to the impact that such
a change in government will have on its business operations in Hong Kong.
From time to time in certain foreign markets, the Company has agreed to do
business exclusively with one or two local laboratories for a limited period of
time. The Company has entered into such commitments to secure certain minimum
quantities of business from such laboratories and investment from such
laboratories in local marketing and sales efforts. The only such agreement
presently outstanding relates to Indonesia.
GOVERNMENT REGULATION
United States.
The PAPNET(R) Testing System is a medical device 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, processing, packaging, labeling, distribution, promotion and
post-market surveillance of medical devices in the United States.
13
<PAGE>
Preclinical and clinical trials of medical devices must be conducted in
conformity with all applicable FDA regulations, including, with respect to
preclinical trials and Good Laboratory Practice 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 PAPNET(R) Testing System
is a Class III medical device, subject to the most stringent FDA review of any
medical devices to ensure that the device is safe and effective before
commencement of marketing, sales and distribution for clinical use in the United
States. A maker of Class III devices (such as the Company) must generally
subject its product to clinical trials, and thereafter submit to the FDA an
application supported by extensive data, including clinical trial data, to prove
the safety and effectiveness of the product. As part of the FDA application,
the device maker must submit a full description of the device and its
components, a full description of the methods, facilities and controls used for
manufacturing, and proposed labeling.
Because the PAPNET(R) Testing System has been approved by the FDA, the
Company is increasing the scale of its operations to commercial levels. The
Company is required to register with the FDA and to submit device listing
information for products in commercial distribution, and is subject to periodic
reinspection by the FDA for compliance with Good Manufacturing Practice
regulations with respect to manufacturing, testing, distribution, storage and
control activities. Labeling and promotional activities are also regulated by
the FDA. The Company will be required to provide the FDA with periodic reports
containing safety and effectiveness information.
Although the Company has received approval for the PAPNET(R) Testing System
from the FDA, there can be no assurance that the Company will obtain the
required regulatory approval for any future product that it may develop, on a
timely basis, if at all. Furthermore, additional regulatory requirements could
be imposed by legislation or regulation. If the FDA believes that the Company
is not in compliance with the law, the FDA can take one or more of the following
actions: withdraw previously approved applications; require notification to
users regarding newly found, unreasonable risks; request repair, refund or
replacement of faulty devices; request corrective advertisements, formal recalls
or temporary marketing suspension; refuse to review or approve applications to
market any of the Company's future products in the United States or to allow the
Company to enter into government supply contracts; 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 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.
In May 1996, the FDA issued a "warning letter" to Papnet of Ohio, Inc.
(subsequently consolidated with certain other Licensees of the Company into
NetMed, Inc.), concerning certain material posted on Papnet of Ohio's site on
the World Wide Web. Papnet of Ohio responded to the warning letter. Papnet of
Ohio is unrelated to the Company other than as
14
<PAGE>
a Licensee. Although the warning letter was addressed to Papnet of Ohio, it is
possible that, as a result of the resolution of this matter, the Company may be
required to modify certain of its promotional materials. See "--Territorial
Licenses."
International Markets
The Company's products are subject to a variety of regulations in certain
international markets, including Europe. Some European countries have
established national regulations relating to in vitro diagnostic medical
devices, such as the PAPNET(R) system. These regulations do not typically
require premarket approval, but may impose other requirements.
In vitro diagnostic medical devices such as the PAPNET(R) system are not
currently subject to medical device directives issued by the European Union
("EU"). The Company anticipates, however, that the EU will soon propose a
directive for in vitro diagnostic medical devices that would establish a basis
for harmonized regulation of such devices among EU member states. Such a
directive would likely establish a deadline 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. There can be no assurance that the PAPNET(R) Testing
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
In 1988, Congress adopted the Clinical Laboratory Improvement Amendments of
1988 ("CLIA"). CLIA directed the Department of Health and Human Services to
promulgate regulations to improve the quality of biomedical analytic services,
particularly the examination of Pap smears. The CLIA regulations require
laboratories to rescreen slides from at least 10% of the laboratory's Pap smears
interpreted to be "negative" on initial manual screening. Such rescreened
slides must include negative cases selected at random from the total caseload
and from patients or groups of patients that are identified as having a high
probability of developing cervical cancer based on available patient
information.
In addition, the Company's direct clients, clinical laboratories, are
subject to state regulation, inspection and licensing. In recent years, a
number of states, including New York and California, have adopted regulations
limiting the number of slides which can be manually examined by a
cytotechnologist in a given period. To the Company's knowledge, none of these
regulations explicitly limits the number of slides that may be examined in
connection with PAPNET(R) rescreening. There can be no assurance, however, that
such states or other states will not limit the number of slides which may be
examined using PAPNET(R) testing during any particular time period, or that any
such limitations will not have an adverse effect on the acceptance of PAPNET(R)
Testing System in the marketplace.
15
<PAGE>
COMPETITION
The Company is currently aware of three principal competitors which are
engaged in efforts to automate one or more aspects of cervical smear screening.
Two competitors, Cytyc Corporation ("Cytyc") and AutoCyte Inc. ("AutoCyte",
formerly a unit of Hoffman-La Roche's Roche Image Analysis Systems), are focused
on the development of devices for the production, and, in the case of AutoCyte,
imaging and automated analysis, of monolayer slides, a potential alternative to
the conventional Pap smear method of specimen collection and preparation.
AutoCyte has stated that it expects to file for FDA pre-market approval in 1997
of its slide preparation and imaging system. Cytyc received approval from the
FDA in May 1996 to market its ThinPrep(R) System to laboratories, for the
purpose of filtering out blood, mucus and other material from Pap smears for
cervical cancer screening as a replacement for the conventional Pap smear
method. In addition, Cytyc received FDA approval in November 1996 to expand its
product labeling to include the claim that the ThinPrep(R) System is
significantly more effective in detecting Low Grade Squamous Intraepithelal
Lesions and more severe lesions than the conventional Pap smear method. Cytyc
labeling may also indicate that the specimen quality using the ThinPrep(R)
System is significantly improved over that of the conventional Pap smear method.
PAPNET(R) is not currently indicated under its FDA label for the scanning of
ThinPrep(R) System slides. With monolayer techniques, clinicians are required to
prepare special slides, and only a fraction of the cells and background
information displayed on the conventional slide may be observed by the
cytotechnologist or clinician for analysis. Because the PAPNET(R) Testing System
uses the well-established methods of sample collection, it does not reduce the
diagnostic sample size or require clinicians to deviate from standard practice.
The other competitor of which the Company is aware, NeoPath, has stated
that it is developing a device for the fully automated primary screening of
conventional Pap smears, for which it submitted to the FDA a pre-market approval
supplemental application. The FDA Hematology and Pathology Devices Panel (the
"Panel") held a public meeting on September 27, 1996 to consider recommending
approval of such supplement. The Panel voted not to approve such supplement and
enumerated certain conditions that the Panel would want satisfied prior to
approval of such supplement. NeoPath has stated that it expects to meet such
conditions within the next several months.
On September 29, 1995, the FDA granted approval to NeoPath for
its AutoPap(R) System to be used as part of a laboratory's quality control
procedures. According to NeoPath, the AutoPap(R) System is designed to sort
purportedly "negative" Pap smear slides into two groups, one classified as
"negative" and one classified for "review." The group of slides classified for
review, which constitutes a specified percentage of the whole, is again reviewed
manually by the cytotechnologist through a conventional microscope. In contrast,
cytotechnologists trained in the use of the PAPNET(R) Testing System evaluate
the 128 color images from each purportedly negative slide on the PAPNET(R)
Review Station. If all of the images appear normal, the cytotechnologist
classifies the slide as "negative," and no further examination is required. If
any one of the 128 images appears to the cytotechnologist to be abnormal, the
cytotechnologist classifies the slide as "review." The cytotechnologist then
refers to the "x, y" coordinates provided with each PAPNET(R) image and uses the
coordinates as a reference point to re-examine the slide directly through the
microscope. Every slide rescreened
16
<PAGE>
using the PAPNET(R) system receives a directed, professional human analysis,
either of the PAPNET(R) images or of both the images and the slide.
The Company's known competitors or other companies may develop new products
and technologies that prove to be more effective than the PAPNET(R) Testing
System or that may be viewed by clinical laboratories as reducing operating
costs (for example, by reducing the number of cytotechnologists used in
screening). In addition, competitive products and technologies may be
manufactured and marketed more successfully than the PAPNET(R) Testing System.
Such developments could render the PAPNET(R) Testing System less competitive or
possibly obsolete, and could have a material adverse effect on the Company. The
Company will be required to compete with respect to product effectiveness,
price, manufacturing and slide processing efficiency, marketing capabilities and
customer service and support, areas in which it currently has limited
experience.
In addition to competitors attempting to develop fully automated or semi-
automated systems for the screening or rescreening of cervical samples, there
may in the future be alternate techniques or technologies for the detection or
prevention of cervical cancer. Although no such technique has been demonstrated
to be useful as a substitute for the Pap smear, there can be no assurance that
new techniques or technologies will not one day supplant or replace the Pap
smear in medical practice.
POTENTIAL FUTURE PRODUCTS
The Company believes that its technology can be adapted for use in the
early detection of cancers occurring at body sites in addition to the uterine
cervix, including the bladder, breast, esophagus, lung oral cavity and thyroid.
Not all such cancers are commonly the subject of cytological analysis, and the
Company has not yet determined which of these applications, if any, it will be
able to commercialize. The Company's patents cover applications of its
technology to cytological screening for cancers occurring at all body sites.
EMPLOYEES
As of February 28, 1997, the Company employed 231 persons, including 36
persons in product development and engineering, 11 persons in medical and
regulatory affairs, 47 persons in slide processing operations, 23 persons in
manufacturing and quality assurance, 67 persons in marketing, sales and customer
training and 47 persons in administrative capacities. The Company is not
subject to any collective bargaining agreements and believes that its
relationship with its employees is good.
CUSTOMERS
The Company's customer base is broadly diversified. Two customers each
account for more than 10% of the Company's revenues, Compuscreen Medical
Diagnostic Centre ("Compuscreen") and Laboratory Corporation of America.
Compuscreen is an affiliate of Papnet (Far East) Ltd., a representative of the
Company in Asia. See "--Distribution Agreements and Other Exclusive
Arrangements."
17
<PAGE>
CAUTIONARY STATEMENT FOR PURPOSES OF THE SAFE HARBOR
PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
Investment in the Company's securities involves a high degree of risk. In
evaluating an investment in the Company's securities, Company stockholders and
prospective investors should carefully consider the risk factors discussed in
Exhibit 99.1, which is attached hereto, and the information detailed in this
Form 10-K including, without limitation, Item 1 Business and Item 6 Management's
Discussion and Analysis of Financial Condition and Results of Operations, as
well as information contained in the Company's other filings with the Securities
and Exchange Commission.
This Form 10-K, the Company's Annual Report to Stockholders, any Form 10-Q
or any Form 8-K of the Company or any other written or oral statements made by
or on behalf of the Company may include forward-looking statements within the
meaning of Section 21E of the Securities Exchange Act of 1934 which reflect the
Company's current views with respect to further 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. For information regarding these risks
and uncertainties, see the Cautionary Statement set forth in Exhibit 99.1 and,
in addition, the other information included in this Annual Report on Form 10-K,
including, without limitation Item 1 Business and Item 6 Management's Discussion
and Analysis of Financial Condition and Results of Operations. The words
"believe", "expect", "anticipate", "estimate", "project" and similar expressions
identify 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.
ITEM 2. PROPERTIES
The Company's executive offices are located in Suffern, New York, in
approximately 23,500 square feet. The Company believes that, based on current
market conditions, any additional office and scanning center space that it may
require will be readily available at terms substantially similar to those with
respect to its current facilities.
In the third quarter 1996, in order to meet the anticipated initial
marketing demand of the PAPNET(R) Testing System launch in the United States,
the Company moved the United States Scanning Center to a location in New Jersey
that is approximately 26,500 square feet. The former Scanning Center located at
the Company's executive offices is being used for product development and
administrative purposes. The Company believes that the new Scanning Center
slide processing space will be adequate to meet anticipated demand for PAPNET(R)
testing through 1998. The Company anticipates that it will be required to
continue to expand its administrative offices and slide processing facilities in
future years as the expected market demand for PAPNET(R) testing increases.
18
<PAGE>
The European Scanning Center and the Company's European sales and marketing
staff are located in approximately 16,300 square feet in Amsterdam, The
Netherlands. The Company believes that its existing facility is adequate to
meet its requirements through 1998.
NSIL's manufacturing facility occupies an aggregate of approximately 25,900
square feet at Kiryat Weizmann, Rehovot, Israel. The Company believes that its
existing facility is adequate to meet the anticipated demand for PAPNET(R)
scanners and related equipment through 1997, although expansion of the facility
may be required. The Company believes that, based on current market conditions,
additional manufacturing space that it may require will be readily available on
terms similar to those of its current facility. Any new or expanded
manufacturing facility is subject to regulation by the Food and Drug
Administration and may require a facility inspection before it can be used to
manufacture medical devices for use in the United States.
The Asia-Pacific Scanning Center is located in the Hong Kong Institute of
Biotechnology, an affiliate of the Chinese University of Hong Kong in Shatin,
the New Territories, Hong Kong. The Hong Kong center occupies 5,925 square feet
of space. The Company anticipates that its existing facility is adequate to
meet its requirements for the foreseeable future.
The Company's Australia office occupies approximately 800 square feet which
the Company believes will be sufficient through 1997.
ITEM 3. LEGAL PROCEEDINGS
On July 15, 1996, the Company filed a lawsuit against NeoPath, a competitor
of the Company (see "--Competition"), in the United States District Court for
the Southern District of New York, seeking damages and injunctive relief for
patent infringement, false advertising, unfair competition, intentional
interference with business relations and damage to business reputation. In the
lawsuit, the Company alleges that NeoPath willfully misappropriated the
Company's patented technology and used such technology in NeoPath's AutoPap(R)
System. The Company also alleges that NeoPath falsely characterized and made
misleading comparisons to consumers and securities analysts of the AutoPap(R)
System and the Company's PAPNET(R) Testing System. NeoPath has denied all
allegations and, in addition, it has filed counter-claims against the Company
seeking damages and injunctive relief for false advertising and unfair
competition. In the counter-claims, NeoPath alleges that statements made by the
Company characterizing the performance of the PAPNET(R) Testing System, and its
effectiveness relative to NeoPath's AutoPap(R) System, as well as other
statements, are false and misleading and constitute misrepresentations. The
Company believes that NeoPath's assertions are without merit. Although the
duration, costs and ultimate outcome of this lawsuit are unknown, the Company
expects that the costs of pursuing this lawsuit will be significant during 1997.
On December 4, 1995, the Company was served with a Summons and Complaint in
an action entitled Herbst et al. v. Neuromedical Systems, Inc. et al., in the
Supreme Court of the State of New York. The plaintiffs in this suit allege,
among other things, that pursuant to written contracts, which they claim the
Company has breached, they were entitled to be issued warrants exercisable for
the purchase of approximately 128,000 shares of Common Stock at various
19
<PAGE>
prices. They further allege that the Company and certain of its officers and
directors made fraudulent misrepresentations and took other allegedly improper
actions that diminished the value of the warrants they claim they are entitled
to under these contracts. On January 31, 1996, the plaintiffs served the Company
with an Amended Complaint alleging legal claims similar to those in the original
Summons and Complaint served on the Company, but adding one of the Company's
former directors as a defendant and specifying that the plaintiffs are seeking
compensatory damages from the Company and one of its officers and a former
director totaling $114 million and punitive damages totaling $175 million. On
February 23, 1996, the defendants moved to dismiss the Amended Complaint and on
November 27, 1996, the New York State Supreme Court issued an opinion dismissing
all of the plaintiff's claims that the Company and certain officers and
directors committed fraud and other improper actions that allegedly diminished
the value of the warrants plaintiffs claim they are entitled to receive. The
Court denied the Company's motion to dismiss plaintiffs' breach of contract
claim, and plaintiffs continue to seek $39 million in compensatory damages and
$75 million in punitive damages. The Company intends to continue to vigorously
defend this action. The Company believes that, in any event, the damages claimed
bear no relation to the harm alleged and believes an adverse judgment in this
case would not have a material adverse effect on the Company's operations,
financial position or cash flows.
The Company is a defendant in a lawsuit asserting a claim for finders' fees
relating to equity financing received by the Company from two specified
individuals between 1990 and 1994. The case, Myer Botnick, Yehuda Rosenblatt
and Ursula Lehmann v. Neuromedical Systems, Inc., was commenced against the
Company on April 10, 1995 in Ontario Court (General Division) in the Province of
Ontario, Canada. The Company believes that it has valid legal and factual
defenses, and that, even if liability is found, such proceeding will not have a
material adverse effect on the Company.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS
No matters were submitted to a vote of the security holders of the Company
during the fourth quarter of 1996.
PART I SUPPLEMENTAL ITEM: EXECUTIVE OFFICERS OF THE REGISTRANT
As of March 28, 1997, the following individuals are executive officers of
the Company serving in the respective capacities indicated:
NAME AGE POSITION(S)
- ---- --- -----------
Mark R. Rutenberg 45 Chairman of the Board, President and
Chief Executive Officer
Uzi Ish-Hurwitz 53 Executive Vice President, Chief of
Technical Operations; President,
Neuromedical Systems Israel, Ltd.;
Director
David Duncan, Jr. 48 Vice President, Finance and
Administration, Chief Financial Officer
Zeev Hadass 63 Vice President, Processing Operations
John B. Henneman, III 35 Vice President of Corporate Development,
General Counsel and Secretary
James M. Herriman 41 Vice President of Product Development
Laurie J. Mango, M.D. 34 Vice President and Medical Director
Andrew C. Panagy 46 Vice President, Marketing and Sales
Henk Snyman, M.D. 38 President, NSI Europe, B.V.
Howard M. Solomon, M.D. 40 Vice President, Medical Operations
Mark R. Rutenberg, age 45, invented the PAPNET(R) Testing System in 1987
and founded the Company in 1988. He has served as the Company's Chairman,
President and Chief Executive Officer since its inception. From 1980 to 1988,
Mr. Rutenberg was responsible for the management and marketing of several
advanced defense programs. Mr. Rutenberg is an inventor named in patents in the
areas of reliable system design, image analysis and cancer cell detection. Mr.
Rutenberg holds a B.A. from Oberlin College in neuropsychology, and received an
M.S. in Electrical Engineering from Cleveland State University. Mr. Rutenberg
is a first cousin of Carl Genberg, a member of the Board of Directors of the
Company.
20
<PAGE>
Uzi Ish-Hurwitz, age 53, is Executive Vice President, Chief of Technical
Operations of the Company and President of Neuromedical Systems Israel, Ltd., a
subsidiary of the Company, and has served as a Director of the Company since
June 1996. Mr. Ish-Hurwitz joined the Company in April 1993 and, during the
period from November 1992 to April 1993, acted as an independent consultant.
Mr. Ish-Hurwitz was the co-founder of Indigo Graphic Systems, Ltd. (Rehovot,
Israel), and served as its President from 1987 to 1992. From 1973 to 1986, Mr.
Ish-Hurwitz served as Vice President-Operations of Scitex Corporation, Ltd. Mr.
Ish-Hurwitz is also a member of the board of directors of Breasy Medical
Equipment (U.S.) Inc. Mr. Ish-Hurwitz is a graduate of the Technion-Israeli
Institute of Technology with a B.Sc. in Electrical Engineering and has completed
fellowship programs at the London Business School and the Harvard Business
School, Advanced Management Program, Fall 1986.
David Duncan, Jr., age 48, is Vice President, Finance and Administration
and Chief Financial Officer. Mr. Duncan joined the Company in November 1994.
Prior to joining the Company, Mr. Duncan served as Vice President, Finance and
Chief Financial Officer of Telios Pharmaceuticals (and held other financial
positions) since September 1988. He received his B.S. in 1971 and an M.B.A. in
1973, both from Indiana University.
Zeev Hadass, Ph.D., age 63, has been Vice President, Processing Operations
of the Company since March 1994. From 1991 to 1994, Mr. Hadass was Executive
Project Director of MedLink Europe, BV, a master distribution company that
establishes and manages European distribution networks for medical companies
based in the United States. From 1990 to 1991, Mr. Hadass was President of
Abiomed, Inc., a Danvers, Massachusetts maker of cardiac assist and periodontal
screening devices. Mr. Hadass received his Ph.D. in Aeronautical Engineering
from Stanford University, his M.Sc. in Nuclear Engineering from INSTN, France,
and his B.Sc. in Mechanical Engineering from the Technion-Israeli Institute of
Technology.
John B. Henneman, III, age 35, is Vice President of Corporate Development,
General Counsel and Secretary of the Company. For more than seven years prior
to joining the Company in February 1994, Mr. Henneman practiced law with the
Chicago office of Latham & Watkins. Mr. Henneman received his A.B. in Politics
from Princeton University and his J.D. from the University of Michigan Law
School.
James M. Herriman, age 41, is Vice President of Product Development of the
Company. Mr. Herriman joined the Company in November 1992. Mr. Herriman was
President of Aspex Incorporated from 1983, when it was founded, until November
1992. While at Aspex, Mr. Herriman was the chief designer of the PIPE(R) image
processor used in the first generation PAPNET(R) Scanning Station. Mr. Herriman
received his B.A. from Emory University.
Laurie J. Mango, M.D., age 34, is Vice President and Medical Director of
the Company. Prior to joining the Company in 1990, Dr. Mango was a resident in
anatomic pathology at the University of California, San Francisco and served as
a Cytology Fellow at Montefiore Medical Center under Dr. Leopold G. Koss. Dr.
Mango graduated from Rice University with a B.S. in electrical engineering and
received her M.D. from Baylor College of Medicine.
21
<PAGE>
Andrew C. Panagy, age 46, is Vice President, Marketing and Sales of the
Company. Prior to joining the Company in February 1994, Mr. Panagy served as
Executive Vice President and Chief Operating Officer of the MEDED Healthcare
Group, a healthcare marketing and consulting company. Prior to that, Mr. Panagy
held numerous marketing and sales positions with Ayerst Laboratories, a
pharmaceutical division of American Home Products Corp., including as head of
the female healthcare marketing group. Mr. Panagy received his B.S. in Biology
from Wagner College, and has participated in post-graduate business programs at
Long Island University in New York.
Henk Snyman, M.D., age 38, has been the European President of the Company
since November 1996. From April 1995 until joining the Company, Dr. Snyman was
General Manager of Serono Benelux, a subsidiary of Ares-Serono, a multinational
pharmaceutical company. From April 1993 until April 1995, Dr. Snyman was
European Business Director of Ares-Serono. Dr. Snyman participated in advanced
medical training from June 1992 until February 1993. Dr. Snyman obtained his
medical degree in South Africa at Orange Free State, Bloemfontein and qualified
as a surgeon at each of the Royal Colleges of Surgeons of Edinburgh and Glasgow,
respectively. Dr. Snyman has attended various business school programs in
London, Paris and Boston.
Howard M. Solomon, M.D., F.C.A.P., age 40, joined the Company as Vice
President of Medical Operations in March 1997. From 1994 to 1997 Dr. Solomon
was Vice President of Clinical Affairs of London International U.S. Holdings,
Inc., a medical device manufacturer. In 1993 Dr. Solomon was Director of
Regulatory Affairs at Becton Dickinson Cellular Imaging Systems. Prior to such
affiliations, Dr. Solomon was an Obstetric and Gynecologic Pathology Fellow at
St. John's Mercy Medical Center (St. Louis, Missouri). Dr. Solomon graduated
from University of Missouri with a B.S. in Chemical Engineering and received his
M.D. from the University of Missouri School of Medicine.
22
<PAGE>
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
(a) MARKET INFORMATION
The principal market on which the Common Stock of the Company is traded is
the Nasdaq National Market System, under the symbol "NSIX."
The high and low sales price for the Company's Common Stock during each
quarterly period in which the Common Stock has been publicly traded is set forth
in the table below:
<TABLE>
<CAPTION>
- --------------------------------------------------------
March 31 June 30 September 30 December 31
- --------------------------------------------------------
<S> <C> <C> <C> <C>
1995 * * * H: $21.50
L: $18.375
- --------------------------------------------------------
1996 H: $26.875 H: $23.25 H: $20.125 H: $19.25
L: $18.625 L: $14.00 L: $10.75 L: $11.75
- --------------------------------------------------------
</TABLE>
* No public market existed during these quarters for the trading of the
Company's securities.
As of March 14, 1997, the high and low sales price for the Company's Common
Stock during the first quarter 1997 was $13.75 and $7.375, respectively.
(b) HOLDERS
As of March 14, 1997, there were approximately 365 holders of record of the
Company's Common Stock, including Goldman, Sachs & Co. and its related
affiliates, who, as of February 28, 1997, beneficially owned 7,920,199 shares or
approximately 25.5% of total shares outstanding.
(c) DIVIDENDS
The Company has not paid and does not anticipate paying any cash dividends
in the foreseeable future and intends to retain future earnings for the
development and expansion of its business. Any future determination to pay
dividends will be at the discretion of the Company's Board of Directors and
subject to certain limitations under the General Corporation Law of the State of
Delaware and will depend upon the Company's results of operations, financial
condition, other contractual restrictions and other factors deemed relevant by
the Board of Directors.
23
<PAGE>
ITEM 6. SELECTED FINANCIAL DATA
The following selected consolidated financial data of the Company are
qualified by reference to and should be read in conjunction with "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
the Consolidated Financial Statements and Notes thereto included herein.
================================================================================
<TABLE>
<CAPTION>
SELECTED FINANCIAL DATA
Year ended December 31, 1996 1995 1994 1993 1992
------------ ------------ ------------ ----------- -----------
<S> <C> <C> <C> <C> <C>
Total revenues $ 4,729,000 $ 2,475,000 $ 1,238,000 $ 502,000 $ 216,000
Net loss (34,158,000) (29,428,000) (13,819,000) (6,782,000) (4,468,000)
Net loss per share* (1.17) (1.67) (0.84)
Total assets 104,204,000 127,348,000 13,173,000 12,863,000 3,758,000
Long-term debt and capital lease obligations 11,166,000 6,050,000 4,190,000 695,000 413,000
</TABLE>
* Net loss per share amounts for 1995 and 1994 are on a pro forma basis.
24
<PAGE>
- --------------------------------------------------------------------------------
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
The Company's principal activities since its founding in 1988 have been research
and product and organizational development. The Company was established to
develop, manufacture and market systems for computer-assisted screening of
cervical Papanicolaou ("Pap") smears and other cytological specimens. The
Company's revenues have been derived primarily from (i) sales of PAPNET(R)
testing services, (ii) sales of license agreements (prior to 1992) to the
Company's territorial licensees ("Licensees") and (iii) interest income.
The PAPNET(R) Testing System was approved by the United States Food and Drug
Administration (the "FDA") for commercial use in the United States on November
8, 1995. Prior to that time, the PAPNET(R) Testing System was permitted to be
utilized in the United States on an investigational basis only, and the Company
was permitted to derive revenue with respect thereto only to recover certain of
its costs. The Company, however, was previously selling PAPNET(R) testing
services for commercial use outside of the United States. The Company has
established three scanning facilities (the "Scanning Centers"), one each in
the United States, The Netherlands and Hong Kong. The Netherlands operation has
scanned slides from customers in Europe, South Africa, Israel and Canada, while
the Hong Kong operation has scanned slides from Asia and Australia. See Note 5
of Notes to Consolidated Financial Statements for the year ended December 31,
1996 for information regarding the Company's revenues, net loss and identifiable
assets by geographic area.
The Company has incurred net losses since inception through December 31, 1996 of
$94,508,000 and has to date generated only limited commercial revenues. Since
the approval of the PAPNET(R) Testing System by the FDA, the Company has been
increasing the scale of its operations to commercial levels in the United
States. Management of the Company believes that its existing cash resources will
be sufficient to fund the increase in the scale of the Company's operations and
to meet its cash requirements during the commercialization process. The
Company's past results of operations reflect its developmental or early
commercial stage and are not necessarily indicative of the results from
operations that may be expected as the scale of its operations increases.
Statements in this discussion which are not historical facts, including
statements about the Company's confidence and strategies and its expectations
about demand for and acceptance of the PAPNET(R) Testing System, are forward
looking statements that involve risks and uncertainties. The forward looking
statements are made pursuant to the safe harbor provisions of the Private
Securities Litigation Reform Act of 1995. Actual results may differ materially
due to a variety of factors which include, but are not limited to, the Company's
continuing negative cash flow, reliance on a single product, competition,
dependence on key personnel, the impact on the Company of its territorial
license agreements, dependence on patents and proprietary technology, government
regulation of both products and advertising, limited marketing and sales
history, the impact of third-party reimbursement decisions, risk of litigation
and other risks detailed in the Company's Securities and Exchange Commission
filings, including its 1996 Form 10-K.
RESULTS OF OPERATIONS
The Company's results of operations have fluctuated significantly from year to
year and quarter to quarter, principally due to variations in the level of
expenditures relating to its clinical trials, research projects, marketing and
sales programs and international expansion. The Company's results of operations
are expected to continue to fluctuate significantly and may continue to result
in substantial losses.
From inception through December 31, 1996, the Company has experienced negative
gross margins due to the significant underutilization of its scanning and
manufacturing operations which occurred as a result of the need to establish
these capabilities prior to FDA approval and the anticipated demand resulting
from expansion of the Company's marketing and sales activities since such
approval. Improvement in the Company's future gross margins will be dependent
upon the level of commercial acceptance of the PAPNET(R) Testing System.
The Company expects that its costs and expenses will increase substantially
during 1997, compared to 1996, as the Company continues to expand its commercial
operations, including its marketing, sales, manufacturing, slide processing,
research and adminis-
25
<PAGE>
================================================================================
trative activities, to meet the anticipated increase in market demand for
PAPNET(R) testing, expand its clinical claims and develop enhancements to the
PAPNET(R) Testing System. In addition, royalty payments will increase
proportionate to increases in the Company's revenues in the sales territories of
the Licensees.
To establish PAPNET(R) testing in the United States as the standard of care in
Pap smear analysis, the Company is executing a three-step sequential marketing
approach that targets (i) its direct clients, the clinical laboratories that
perform Pap smear testing, (ii) gynecologists and those primary care physicians
and other clinicians who take Pap smears and can order PAPNET(R) testing and
(iii) women, to encourage them to request PAPNET(R) testing or to agree to it if
it is recommended by a clinician. The Company believes that significant revenue
growth in the United States depends upon effective marketing to all three target
audiences.
During 1996, the Company made significant progress in building laboratory
distribution and physician awareness in the United States, increasing the number
of laboratories equipped to perform PAPNET(R) testing from 48 to 86, and
increasing the total number of laboratories offering PAPNET(R) testing
(including laboratories that have entered into reference arrangements) from 48
to 201. In addition, the Company increased its U.S. sales organization calling
on clinicians and laboratories from 18 to 32. Accordingly, the Company initiated
its direct-to-consumer advertising in August of 1996, while continuing to market
to laboratories and clinicians. The Company is also marketing to insurers,
managed care organizations and other third-party payers concerning reimbursement
for PAPNET(R) testing, and expects to increase its expenditures in this area
during 1997.
The Company also continued to expand its international laboratory distribution
in 1996. By December 31, 1996, PAPNET(R) testing was available in 23 countries
worldwide and was available through 47 laboratories in Europe and South Africa
and 10 laboratories in Australia. In Asia, the Company continued to expand its
business in Hong Kong, Taiwan and mainland China. By December 31, 1996, the
Company had received slide processing revenue from 42 laboratories and hospitals
in these countries.
In addition, in September 1996, the Company entered into a co-promotion
agreement with the Women's Healthcare Group of the Parke-Davis division of
Warner-Lambert Company. According to the terms of that agreement, members of the
Parke-Davis field sales force present PAPNET(R) testing promotional materials to
physicians when making sales calls regarding Parke-Davis Loestrin(R) oral
contraceptives. Although the Company does not expect that Parke-Davis's
activities will have a significant direct impact on sales, the Company believes
that this program has increased awareness of PAPNET(R) testing in the
clinician's office. Activities under the agreement began in late October 1996
and are expected to continue into early 1997.
The Company's sales and marketing efforts to date in the United States have
generated considerable awareness about PAPNET(R) testing among pathologists,
cytotechnologists, gynecologists and women. The Company believes support and
interest has been highest among women. Medical specialities, however, are often
reluctant to change clinical practice methods and procedures, and early stage
resistance is being experienced in the adoption of PAPNET(R) testing. Among
gynecologists and pathologists there has been, in general, a slow adoption of
the PAPNET(R) technology and some reluctance to use it even if a woman inquires
about or requests the test. The Company believes that this is due to several
factors, including controversy within the medical profession about the public
health consequences of Pap smear false negatives, the relative cost of PAPNET(R)
testing to the Pap smear, limited reimbursement by third-party payers and
confusion in the marketplace about alternative technologies for cervical cancer
screening. In late 1996 and the first quarter of 1997, the Company initiated
medical and other communications designed to address each of these
considerations.
Interest expense is expected to increase in the future as the Company borrows to
fund expansion of its manufacturing, slide processing and marketing
capabilities, including the installation of additional PAPNET(R) Scanning
Stations at the Company's Scanning Centers. It is expected that this increase
will continue to be substantially offset during 1997 by interest income from the
investment of the Company's cash. The Company expects that its interest income
will decline in 1997, compared to 1996, because of the significant use of cash
in 1996 and the anticipated use of cash in 1997.
The impact of inflation and changing prices on the Company's revenues and costs
has not been significant.
For the Years Ended December 31, 1996, 1995 and 1994
Revenues for the year ended December 31, 1996 were $4,729,000, compared to
$2,475,000 for 1995, an increase of $2,254,000 or 91%. This increase was due
primarily to significantly higher selling prices in 1996 compared to 1995 and to
higher unit volume in the United States, offset partially by slightly lower unit
volume in international markets. The 1995 revenues of $2,475,000 represented an
increase of $1,237,000 or 100% over the 1994 revenues of $1,238,000. This
increase was due to the expansion of the Company's sales in international
markets and expanded investigational use of the PAPNET(R) Testing System in the
United States.
26
<PAGE>
================================================================================
Total costs and expenses for the year ended December 31, 1996 were $42,266,000
compared to $31,687,000 in 1995, an increase of $10,579,000. This increase was
primarily the result of higher sales and marketing expenses, which increased to
$20,328,000 in 1996 from $6,268,000 in 1995. The increase in sales and
marketing expenses of $14,060,000 was due primarily to costs associated with the
launch of the PAPNET(R) Testing System in the United States, including salaries
for additional personnel and advertising and promotion costs required to
initiate the PAPNET(R) direct-to-consumer campaign. In addition, the Company's
cost of sales, research and development and general and administrative expenses
also increased during 1996, although at a slower rate than sales and marketing
expenses. These increases were due primarily to the expansion of the technical
and administative infrastructure of the Company to support commercial activities
in both the United States and overseas, along with the additional costs of being
a public company. These increases in expenses during 1996, compared to 1995,
were partially offset by the absence in 1996 of two non-cash charges that
occurred in 1995, totaling $7,752,000, resulting from the terms of a settlement
agreement entered into with the Licensees in December 1995 and the vesting of
568,058 employee performance stock options upon the completion of the Company's
initial public offering (the "IPO") in December 1995.
Total costs and expenses for the year ended December 31, 1995 were $31,687,000
compared to $14,837,000 in 1994. This increase was the result of increases in
research and clinical development programs associated with the support of the
Company's FDA application, expansion of the Company's marketing, slide
processing and manufacturing capabilities in anticipation of launching the
PAPNET(R) Testing System in the United States and other countries, expansion of
the administrative infrastructure needed to support commercial activities and
the expense of two non-cash charges totaling $7,752,000 that were recognized in
the fourth quarter of 1995. One of these non-cash charges, in the amount of
$1,652,000, resulted from the terms of a settlement agreement entered into with
the Licensees in December 1995. The other non-cash charge, in the amount of
$6,100,000, related to the vesting of 568,058 employee performance stock options
upon the completion of the IPO.
Interest income for the year ended December 31, 1996 was $5,208,000 compared to
$548,000 during 1995. This increase was due primarily to the Company's
significantly higher levels of cash and cash equivalent balances in 1996 as a
result of the Company's IPO, equity sales to private investors during the third
quarter of 1995 and the exercise of certain warrants by investors in December
1995. Interest income for the year ended December 31, 1995 was $548,000
compared to $170,000 in 1994. This increase was primarily related to higher
average cash and cash equivalent balances during 1995, primarily associated with
the IPO, equity sales to private investors and the exercise of certain warrants
by investors.
Interest expense during 1996 was $1,095,000 compared to $924,000 during 1995.
This increase was due to higher levels of debt and capital lease obligations,
which the Company entered into in late 1996, incurred to finance capital
equipment additions, primarily related to the Company's PAPNET(R) Scanning
Stations. Interest expense for the year ended December 31, 1995 was $924,000
compared to $393,000 in 1994. This increase was primarily the result of
additional debt incurred to finance capital equipment additions, primarily
related to the Company's PAPNET(R) Scanning Stations and to government
guaranteed loans received under the State of Israel "Approved Enterprise"
program. The Company anticipates higher levels of interest expense in 1997
resulting from increased levels of debt and capital lease obligations.
The Company incurred a foreign exchange loss of $734,000 during the year ended
December 31, 1996 compared to foreign exchange gains of $160,000 during 1995 and
$3,000 in 1994. The 1996 loss and the 1995 and 1994 gains were caused primarily
by fluctuations in exchange rates on dollar-denominated intercompany loans.
The Company incurred a net loss during the year ended December 31, 1996 of
$34,158,000, or $1.17 per share, compared to a net loss of $29,428,000, or $1.67
per share (on a pro forma basis), for 1995. The increased net loss during 1996,
compared to 1995, was due primarily to an increase in marketing and sales
expenses associated with the launch of the PAPNET(R) Testing System in the
United States, following approval by the FDA in November 1995, including the
cost of the direct-to-consumer advertising campaign. In addition, the Company's
cost of sales, research and development and general and administrative expenses
also increased during 1996, although at a slower rate than sales and marketing
expenses. These increases in expenses during 1996, compared to 1995 were
partially offset by the absence in 1996 of the two non-cash charges, mentioned
above, that were recognized in the fourth quarter of 1995. The reduction in net
loss per share in 1996 reflects the net effect of the increased loss in 1996
offset by an increase in the weighted-average shares outstanding. The increase
in the weighted-average shares outstanding resulted from the issuance of shares
in the IPO in December 1995 and the exercise of certain common stock warrants
and options in late 1995 and 1996.
The net loss for 1995 was $29,428,000, or $1.67 per share (on a pro forma basis)
compared to a net loss of $13,819,000 or $.84 per
27
<PAGE>
================================================================================
share (on a pro forma basis) for 1994. The higher net loss during 1995 was
primarily the result of increases in research and clinical development programs
associated with the support and approval of the Company's FDA premarket approval
application, expansion of the Company's marketing, sales, slide processing and
manufacturing capabilities in anticipation of launching the PAPNET(R) Testing
System in the United States and other countries, expansion of the administrative
infrastructure needed to support commercial activities, and the cost of the two
non-cash charges.
LIQUIDITY AND CAPITAL RESOURCES
The Company has financed its operations since its inception primarily by the
issuance of equity securities, sales of PAPNET(R) Testing System services, funds
received for the territorial license agreements (prior to 1992), interest earned
on cash, cash equivalents and short-term investments and proceeds from notes,
bank loans and equipment leasing arrangements.
The Company's combined cash and cash equivalents totaled $83,391,000 at December
31, 1996, a decrease of $30,752,000 from December 31, 1995. During 1996, the
Company used $29,820,000 for operating activities, primarily to finance the
Company's loss, and used $8,643,000 for investing activities, while generating
net cash of $7,675,000 from financing activities. In addition, the effect of
exchange rate changes on cash was $36,000, which accounted for the remaining
change to the Company's cash balance.
The primary uses of cash and cash equivalents during 1996 were $34,158,000
(inclusive of $4,493,000 of non-cash expenses) to finance the Company's net
loss, $8,643,000 to purchase capital equipment, primarily for the manufacture of
PAPNET(R) Scanning Stations and related equipment to support the expansion of
the Company's commercial activities, $2,295,000 to repay notes, bank loans and
capital lease obligations, a deposit of $1,250,000 of cash into a restricted
certificate of deposit as security collateral on a letter of credit for the
lease of the Company's new Scanning Center in New Jersey, and $155,000 for
changes in operating assets and liabilities.
The primary sources of cash and cash equivalents during the year ended December
31, 1996 were $6,323,000 from proceeds of capital lease finance transactions
(sale/lease-backs), proceeds of $3,144,000 from notes and bank loans, primarily
associated with equipment financing transactions, and $1,753,000 from the
issuance of common stock, associated with the exercise of common stock warrants
and options.
During the year ended December 31, 1995, the Company used $16,799,000 for
operating activities and used $5,008,000 for investing activities, while
generating $134,950,000 from financing activities, primarily from the sale of
equity securities and the exercise of certain warrants by investors. The primary
uses of cash and cash equivalents during the year ended December 31, 1995 were
$29,428,000 (inclusive of $10,898,000 of non-cash expenses) to finance the
Company's net loss, $5,008,000 to purchase capital equipment, primarily for the
manufacture of PAPNET(R) Scanning Stations to support the expansion of the
Company's commercial activities and $1,647,000 to repay notes, bank loans and
capital lease obligations. The primary sources of cash and cash equivalents
during 1995 were $19,325,000 from the issuance of convertible preferred stock to
private investors (all of which automatically converted into common stock upon
the consummation of the IPO), $18,500,000 from the exercise of warrants by
investors, $1,354,000 from proceeds of lease finance transactions (sale/lease-
backs), $1,774,000 from notes and bank loans and $94,725,000 from the IPO.
Changes to the components of working capital and other items accounted for the
remainder of the net change in cash and cash equivalents.
The significant increase in cash used for operations during 1995 and 1996, when
compared with earlier years, is primarily the result of higher expenses for the
initiation and expansion of the Company's sales and marketing programs in the
United States and overseas, including the direct-to-consumer advertising
campaign, higher expenses for research and clinical development to support
product enhancements and the Company's FDA premarket approval application and
other FDA related activities, expansion of the Company's slide processing and
manufacturing capabilities in the United States, The Netherlands, Hong Kong and
Israel, and expansion of the administrative infrastructure needed to support
commercial activities following approval of the PAPNET(R) Testing System by the
FDA and the additional costs of being a public company.
As of December 31, 1996, the Company's debt and capital lease obligations
totaled $14,338,000. The amount of combined payments of the outstanding debt and
capital lease obligations, including related interest on capital leases, for the
five years succeeding December 31, 1996 is approximately $3,896,000 in 1997,
$5,266,000 in 1998, $3,443,000 in 1999, $1,932,000 in 2000 and $1,443,000 in
2001. The Company's commitments for payments under non-cancelable operating
leases for the five years succeeding December 31, 1996 are approximately
$1,964,000 in 1997, $1,788,000 in 1998, $1,613,000 in 1999, $1,235,000 in 2000
and $563,000 in 2001.
The Company anticipates that its use of cash will be substantial for the
foreseeable future. In particular, the Company anticipates that expenditures
will continue to increase substantially in 1997 due to the cost of the marketing
launch of the PAPNET(R) Testing System
28
<PAGE>
================================================================================
in the United States, the increased cost of marketing and sales programs in
overseas markets and the expansion of research and development programs for
additional clinical indications and claims. The Company estimates that, during
1997, it will invest approximately $5.0 million for working capital purposes and
approximately $7.0 million for capital expenditures and leasehold improvements,
primarily associated with the manufacture or purchase of PAPNET(R) Scanning
Stations and related equipment, PAPNET(R) Review Stations and facility leasehold
improvements. Although funding for these capital expenditures is expected to be
available out of the Company's cash resources, management of the Company
believes that it may be desirable for the Company to finance certain of such
capital expenditures through additional debt or capital lease obligations.
During 1996, the Company entered into a loan agreement with an equipment
financing company to provide the Company with a $5,000,000 line of credit to
finance certain of the Company's equipment purchases, primarily PAPNET(R)
Scanners and related equipment. During 1996, the Company borrowed $2,098,000
under the agreement, with loan terms of 60 months and with a final payment in
the amount equal to 10% of the original principal amount of such loan and with
an annual effective interest rate of 12.4%. Any future borrowings under this
line of credit will have similar loan terms provided, however, the annual
interest rate of 12.4% will be adjusted by the change in the weekly average of
the interest rates of five-year U.S. Treasury Securities, as published by the
Federal Reserve, from the week ending October 18, 1996 to the week preceding
each future loan commencement date. The loan is secured by a perfected first
priority interest in the financed equipment. The Company is required to maintain
certain financial covenants throughout the duration of the loan. The agreement
stipulates that additional funding can be denied in the event of a material
adverse change in the financial condition, operation or prospects of the
Company. The loan commitment expires on December 31, 1997. There can be no
assurance, however, that these financings, or any other financings, will
ultimately be obtained by the Company or, if they are obtained, that the terms
thereof will not change or will be reasonable.
The Company anticipates that its current cash and cash equivalents will be
sufficient to enable the Company to meet its future operating requirements for
at least two years. The Company does not expect to generate a positive internal
cash flow in the foreseeable future due to the expected increases in capital
expenditures, working capital requirements and ongoing losses during the next
year, including the expected cost of commercializing the PAPNET(R) Testing
System. The Company may need to arrange additional equity or debt financing for
the future operation of its business. There can be no assurance that such
financing can be obtained or, if it is obtained, that the terms thereof will be
reasonable. The Company plans to invest excess funds in short-term instruments,
including money market funds.
During 1996, the Company's operating results reflect foreign exchange losses of
$734,000 and its financial position as of December 31, 1996 reflects a foreign
currency translation effect of $474,000. As discussed in detail below, the
Company is subject to foreign currency exchange rate risk because (i) it has
investments in its foreign subsidiaries, (ii) it derives a significant portion
of its revenues and incurs a significant portion of its costs and expenses in
the local currencies of the countries in which its subsidiaries are transacting
business and (iii) it finances the operations of such subsidiaries substantially
through dollar-denominated intercompany loans which are recorded on the books of
the subsidiaries in their respective local currencies. Fluctuations in exchange
rates have not had a material impact on the Company's revenues or costs and
expenses, but have affected the value of its equity investments and intercompany
loans.
From inception through December 31, 1996, the Company's sales of PAPNET(R)
testing services for commercial use have been derived principally from foreign
sources. Although the Company expects United States revenues to increase faster
than non-United States revenues, the Company anticipates that international
sales will continue to represent a significant portion of its net sales as it
executes its plan to establish commercial use of the PAPNET(R) Testing System on
a worldwide basis. In addition, Neuromedical Systems, Inc., the United States
parent company, has provided a significant portion of the financing required for
its subsidiaries in the Netherlands, Australia, Israel and Hong Kong through
intercompany loans and equity investments denominated in United States dollars.
As a result of its international operations and its current financing approach,
the Company's operating results are subject to the impact of fluctuations in
exchange rates of the currencies in which its foreign operations conduct
business versus the United States dollar. The Company is exposed to gains and
losses with respect to Australian dollars and several European currencies
(predominately Dutch guilders) because the Company's subsidiaries invoice for
slide processing services and incur costs and expenses in local currencies. In
addition, although the Company's Israeli subsidiary maintains its books in U.S.
dollars, certain of its expenses are incurred in Israeli shekels and are subject
to exchange fluctuations. The revenues and expenses of the Company's Hong Kong
subsidiary are in Hong Kong dollars, the value of which is presently tied to the
United States dollar and, therefore, are not currently subject to material
fluctuations. There can be no assurance, however, that the exchange rate between
the United States dollar and the Hong Kong dollar will not fluctuate in the
future.
29
<PAGE>
================================================================================
To date, the Company has not implemented a program to hedge its foreign currency
risk, but may do so in the future.
At December 31, 1996, the Company had available United States net operating loss
carryforwards of approximately $65,000,000 that will expire in the years 2004
through 2011 and cumulative deductible temporary differences of approximately
$6,100,000. The Company also has foreign net operating losses of approximately
$9,000,000 that are available to offset the separate taxable incomes of certain
foreign subsidiaries. These losses may be carried forward indefinitely. In
addition, at December 31, 1996, the Company also had approximately $1,000,000 of
United States research and development credits available which will expire in
the years 2004 through 2011. The Tax Reform Act of 1986 enacted a complex set
of rules limiting the potential utilization of United States net operating loss
carryforwards and tax credit carryforwards in periods following a corporate
"ownership change." In general, an ownership change is deemed to occur if the
percentage of stock of a loss corporation owned (actually, constructively and,
in some cases, deemed) by one or more "5% Stockholders" has increased by more
than 50 percentage points over the lowest percentage of such stock owned during
a three-year testing period. As a result of changes in the Company's ownership,
the utilization of a substantial portion of the Company's available United
States net operating loss carryforwards and tax credit carryforwards will be
subject to annual limitations. It is management's belief, however, that, since
such annual limitations are determined based on the value of the Company
immediately prior to the ownership changes, a significant portion of the
carryforwards will be available annually should the Company become profitable in
future tax years.
On December 4, 1995, the Company was served with a Summons and Complaint in an
action entitled Herbst et al. v. Neuromedical Systems, Inc. et al., in the
Supreme Court of the State of New York. The plaintiffs in this suit allege,
among other things, that pursuant to written contracts, which they claim the
Company has breached, they were entitled to be issued warrants exercisable for
the purchase of approximately 128,000 shares of common stock at various prices.
They further allege that the Company and certain of its officers and directors
made fraudulent misrepresentations and took other allegedly improper actions
that diminished the value of the warrants they claim they are entitled to under
these contracts. On January 31, 1996, the plaintiffs served the Company with an
Amended Complaint alleging legal claims similar to those in the original Summons
and Complaint served on the Company, but adding one of the Company's former
directors as a defendant and specifying that the plaintiffs are seeking
compensatory damages from the Company and one of its officers and a former
director totaling $114 million and punitive damages totaling $175 million. On
February 23, 1996, the defendants moved to dismiss the Amended Complaint and on
November 27, 1996, the New York State Supreme Court issued an opinion dismissing
all of the plaintiff's claims that the Company and certain officers and
directors committed fraud and other improper actions that allegedly diminished
the value of the warrants plaintiffs claim they are entitled to receive. The
Court denied the Company's motion to dismiss plaintiffs' breach of contract
claim, and plaintiffs continue to seek $39 million in compensatory damages and
$75 million in punitive damages. The Company intends to continue to vigorously
defend this action. The Company believes that, in any event, the damages
claimed bear no relation to the harm alleged and believes an adverse judgment in
this case would not have a material adverse effect on the Company's operations,
financial position or cash flows.
On July 15, 1996, the Company filed a lawsuit against NeoPath Inc. ("Neopath"),
a competitor of the Company, in the United States District Court for the
Southern District of New York, seeking damages and injunctive relief for patent
infringement, false advertising, unfair competition, intentional interference
with business relations and damage to business reputation. In the lawsuit, the
Company alleges that NeoPath willfully misappropriated the Company's patented
technology and used such technology in NeoPath's AutoPap(R) System. The Company
also alleges that NeoPath falsely characterized and made misleading comparisons
to consumers and securities analysts of the AutoPap(R) System and the Company's
PAPNET(R) Testing System. NeoPath has denied all allegations and, in addition,
it has filed counter-claims against the Company seeking damages and injunctive
relief for false advertising and unfair competition. In the counter-claims,
NeoPath alleges that statements made by the Company characterizing the
performance of the PAPNET(R) Testing System, and its effectiveness relative to
NeoPath's AutoPap(R) System, as well as other statements, are false and
misleading and constitute misrepresentations. The Company believes that
NeoPath's assertions are without merit. Although the duration, costs and
ultimate outcome of this lawsuit are unknown, the Company expects that the costs
of pursuing this lawsuit will be significant during 1997.
30
<PAGE>
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
NEUROMEDICAL SYSTEMS, INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
PAGE
----
Report of Independent Auditors.............................. 32
Consolidated Balance Sheets at December 31, 1996 and 1995... 33
Consolidated Statements of Operations for the
years ended December 31, 1996, 1995 and 1994........ 34
Consolidated Statements of Cash Flows for the years ended
December 31, 1996, 1995 and 1994.................... 35
Consolidated Statements of Stockholders' Equity for
the years ended December 31, 1996, 1995 and 1994.... 36
Notes to Consolidated Financial Statements.................. 38
31
<PAGE>
Report of Independent Auditors
To the Stockholders and the Board of Directors
Neuromedical Systems, Inc.:
We have audited the accompanying consolidated balance sheets of
Neuromedical Systems, Inc. and subsidiaries as of December 31, 1996 and 1995,
and the related consolidated statements of operations, stockholders' equity and
cash flows for each of the three years in the period ended December 31, 1996.
Our audits also included the financial statement schedule listed in the Index at
Item 14(a). These financial statements and schedule are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements and schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present
fairly, in all material respects, the consolidated financial position of
Neuromedical Systems, Inc. and subsidiaries at December 31, 1996 and 1995, and
the consolidated results of their operations and their cash flows for each of
the three years in the period ended December 31, 1996 in conformity with
generally accepted accounting principles. Also, in our opinion, the related
financial statement schedule, when considered in relation to the basic financial
statements taken as a whole, present fairly in all material respects the
information set forth therein.
Hackensack, New Jersey Ernst & Young LLP
February 7, 1997
32
<PAGE>
CONSOLIDATED BALANCE SHEETS Neuromedical Systems, Inc.
and Subsidiaries
<TABLE>
<CAPTION>
December 31,
---------------------------------------
1996 1995
--------------- -----------------
<S> <C> <C>
Assets
Current assets:
Cash and cash equivalents $ 83,391,000 $114,143,000
Accounts receivable, net of allowance (Note 2) 1,650,000 900,000
Prepaid expenses 803,000 596,000
Other current assets 732,000 105,000
------------ ------------
Total current assets 86,576,000 115,744,000
Restricted cash 1,000,000 --
Property and equipment (Note 3) 16,388,000 11,216,000
Patent and patent application costs, net of accumulated
amortization (1996-$492,000, 1995-$325,000) 166,000 333,000
Other assets 74,000 55,000
------------ ------------
$104,204,000 $127,348,000
============ ============
Liabilities and Stockholders' Equtiy
Current liabilities:
Current portion of notes and bank loans payable (Note 6) $ 1,200,000 $ 583,000
Current portion of capital lease obligations (Note 4) 1,972,000 680,000
Accounts payable 2,256,000 2,045,000
Accrued liabilities (Note 2) 4,082,000 3,323,000
------------ ------------
Total current liabilities 9,510,000 6,631,000
Notes and bank loans payable--long-term (Note 6) 4,704,000 3,436,000
Notes payable--stockholder (Note 6) 600,000 600,000
Capital lease obligations, less current portion (Note 4) 5,862,000 2,014,000
Commitments and contingencies (Notes 4, 7 and 11)
Stockholders' equity (Notes 8 and 9):
Preferred stock, $.000l par value;
authorized--10,000,000 shares; none issued and outstanding -- --
Common stock, $.0001 par value; authorized--
100,000,000 shares; issued and outstanding--
29,795,049 shares in 1996 and 28,804,828 shares in 1995 3,000 3,000
Additional paid-in capital 177,559,000 175,237,000
Accumulated deficit (94,508,000) (60,350,000)
Foreign currency translation 474,000 (223,000)
------------ ------------
Total stockholders' equity 83,528,000 114,667,000
------------ ------------
$104,204,000 $127,348,000
============ ============
</TABLE>
See accompanying notes.
33
<PAGE>
CONSOLIDATED STATEMENTS OF OPERATIONS Neuromedical Systems, Inc. and
Subsidiaries
<TABLE>
<CAPTION>
Year Ended December 31,
--------------------------------------------
1996 1995 1994
----------- ------------ -------------
<S> <C> <C> <C>
Revenues:
Slide processing (Note 1) $ 4,729,000 $ 2,475,000 $ 1,238,000
------------ ------------ ------------
Total revenues 4,729,000 2,475,000 1,238,000
------------ ------------ ------------
Costs and Expenses:
Cost of sales 8,178,000 6,478,000 4,503,000
Marketing 20,328,000 6,268,000 2,878,000
Research and development 6,785,000 5,172,000 4,305,000
General and administrative 6,975,000 6,017,000 3,151,000
Stock issued pursuant to a settlement agreement -- 1,652,000 --
Vesting of performance options at initial public offering -- 6,100,000 --
------------ ------------ ------------
Total costs and expenses 42,266,000 31,687,000 14,837,000
------------ ------------ ------------
Loss from operations (37,537,000) (29,212,000) (13,599,000)
------------ ------------ ------------
Other income (expense):
Interest income 5,208,000 548,000 170,000
Interest expense (1,095,000) (924,000) (393,000)
Foreign exchange (734,000) 160,000 3,000
------------ ------------ ------------
Other income (expense)--net 3,379,000 (216,000) (220,000)
------------ ------------ ------------
Net loss $(34,158,000) $(29,428,000) $(13,819,000)
============ ============ ============
Net loss per share (amounts for 1995 and 1994 are on a pro
forma basis) (Note 1) $(1.17) $(1.67) $(0.84)
============ ============ ============
Shares used in computation of net loss per share 29,277,000 17,644,000 16,500,000
============ ============ ============
</TABLE>
See accompanying notes.
34
<PAGE>
CONSOLIDATED STATEMENTS OF CASH FLOWS Neuromedical Systems, Inc.
and Subsidiaries
<TABLE>
<CAPTION>
Year Ended December 31,
--------------------------------------------
1996 1995 1994
------------ ------------ ------------
<S> <C> <C> <C>
Operating Activities
Net Loss $(34,158,000) $(29,428,000) $(13,819,000)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization 3,415,000 2,936,000 1,886,000
Issuance of common stock warrants and options for services
rendered 341,000 210,000 29,000
Foreign exchange loss 737,000 -- --
Stock issued pursuant to a settlement agreement -- 1,652,000 --
Vesting of performance options at initial public offering -- 6,100,000 --
Changes in operating assets and liabilities:
(Increase) in accounts receivable (750,000) (252,000) (521,000)
Increase (decrease) in accounts payable 211,000 (110,000) 806,000
Increase in accrued liabilities 759,000 1,894,000 1,077,000
(Increase) decrease in prepaid expenses and other assets (375,000) 199,000 (420,000)
------------ ----------- -----------
Net cash used in operating activities (29,820,000) (16,799,000) (10,962,000)
------------ ----------- -----------
Investing Activities
Proceeds from the maturity of investments -- -- 2,996,000
Purchases of property and equipment (8,643,000) (5,008,000) (7,295,000)
Increase in patent and patent application costs -- -- (127,000)
------------ ----------- -----------
Net cash used in investing activities (8,643,000) (5,008,000) (4,426,000)
------------ ----------- -----------
Financing Activities
Restricted cash (1,250,000) 1,016,000 (1,016,000)
Exercise of stock warrants 8,000 18,500,000 --
Exercise of stock options 1,745,000 -- --
Issuance of common stock in initial public offering -- 94,725,000 --
Issuance of convertible preferred stock -- 19,325,000 7,500,000
Loans to officer -- -- (200,000)
Repayment of loans from officer -- -- 200,000
Repayments to licensees -- (97,000) (80,000)
Proceeds from notes and bank loans 3,144,000 1,774,000 3,326,000
Payment of notes and bank loans (1,250,000) (1,082,000) (139,000)
Payments on capital leases (1,045,000) (565,000) (142,000)
Proceeds from sale-leaseback transactions 6,323,000 1,354,000 1,349,000
------------ ----------- -----------
Net cash provided by financing activities 7,675,000 134,950,000 10,798,000
------------ ----------- -----------
Effect of exchange rate changes on cash 36,000 (235,000) --
------------ ----------- -----------
Net (decrease) increase in cash and cash equivalents (30,752,000) 112,908,000 (4,590,000)
------------ ----------- -----------
Cash and cash equivalents, beginning of period 114,143,000 1,235,000 5,825,000
------------ ----------- -----------
Cash and cash equivalents, end of period $ 83,391,000 $114,143,000 $ 1,235,000
============ ============ ============
Supplemental disclosures:
Non-cash financing activities:
Conversion of debt to common stock -- -- $ 250,000
Cash paid for interest $ 1,042,000 $ 893,000 $ 393,000
============ ============ ============
</TABLE>
See accompanying notes.
35
<PAGE>
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY Neuromedical Systems, Inc.
and Subsidiaries
<TABLE>
<CAPTION>
Convertible Additional
Common Stock Preferred Paid-In
Shares Amount Stock Capital
--------- -------- ------------- -------------
<S> <C> <C> <C> <C>
Balance at January 1, 1994 4,101,526 -- $ 22,942,000 $ 4,007,000
Conversion of debt to common stock 26,596 250,000
Shares issued for services rendered 3,325 29,000
Sale of 2,500,000 shares of Series F Convertible Preferred Stock 5,000,000
Sale of 1,063,830 shares of Series G Convertible Preferred Stock 2,500,000
Net loss for the year ended December 31, 1994
---------- -------- ------------ ------------
Balance at December 31, 1994 4,131,447 -- 30,442,000 4,286,000
Sale of 7,782,634 shares of Series G Convertible Preferred Stock plus
a related share grant issuance cost of 119,092 shares, net of cash expenses 17,890,000
Compensation expense related to stock options 17,000
Sale of 610,574 shares of Series H Convertible Preferred Stock plus a
related share grant issuance cost of 17,018 shares, net of cash expenses 1,435,000
Exercise of 15,500,000 Series E Preferred Stock warrants 15,500,000
Shares issued pursuant to executive compensation 27,679 193,000
Exercise of stock warrants 750,000 3,000,000
Initial public offering, net of expenses 6,900,000 $ 1,000 94,724,000
Shares issued pursuant to a settlement agreement
and cashless exercise of stock warrants 834,300 1,652,000
Vesting of performance options at initial public offering 6,100,000
Conversion of preferred stock to common at
initial public offering 16,161,402 2,000 (65,267,000) 65,265,000
Net loss for the year ended December 31, 1995
Foreign currency translation
---------- ------- ------------ ------------
Balance at December 31, 1995 28,804,828 3,000 -- 175,237,000
Shares issued pursuant to exercise of stock warrants 619,641 8,000
Value of options and warrants issued for services rendered 569,000
Shares issued pursuant to exercise of stock options 370,580 1,745,000
Net loss for the year ended December 31, 1996
Foreign currency translation
---------- ------- ------------ ------------
Balance at December 31, 1996 29,795,049 $ 3,000 $ -- $177,559,000
========== ======= ============ ============
</TABLE>
See accompanying notes.
36
<PAGE>
Neuromedical Systems, Inc.
and Subsidiaries
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (continued)
<TABLE>
<CAPTION>
Foreign Total
Currency Accumulated Stockholders'
Translation Deficit Equity
----------- ------------ -------------
<S> <C> <C> <C>
Balance at January 1, 1994 $(17,103,000) $ 9,846,000
Conversion of debt to common stock 250,000
Shares issued for services rendered 29,000
Sale of 2,500,000 shares of Series F Convertible Preferred Stock 5,000,000
Sale of 1,063,830 shares of Series G Convertible Preferred Stock 2,500,000
Net loss for the year ended December 31, 1994 (13,819,000) (13,819,000)
Balance at December 31, 1994 (30,922,000) 3,806,000
Sale of 7,782,634 shares of Series G Convertible Preferred Stock plus
a related share grant issuance cost of 119,092 shares, net of cash expenses 17,890,000
Compensation expense related to stock options 17,000
Sale of 610,574 shares of Series H Convertible Preferred Stock plus a
related share grant issuance cost of 17,018 shares, net of cash expenses 1,435,000
Exercise of 15,500,000 Series E Preferred Stock warrants 15,500,000
Shares issued pursuant to executive compensation 193,000
Exercise of stock warrants 3,000,000
Initial public offering, net of expenses 94,725,000
Shares issued pursuant to a settlement agreement
and cashless exercise of stock warrants 1,652,000
Vesting of performance options at initial public offering 6,100,000
Conversion of preferred stock to common at
initial public offering --
Net loss for the year ended December 31, 1995 (29,428,000) (29,428,000)
Foreign currency translation $ (223,000) (223,000)
------------ ----------- ------------
Balance at December 31, 1995 (223,000) (60,350,000) 114,667,000
Shares issued pursuant to exercise of stock warrants 8,000
Value of options and warrants issued for services rendered 569,000
Shares issued pursuant to exercise of stock options 1,745,000
Net loss for the year ended December 31, 1996 (34,158,000) (34,158,000)
Foreign currency translation 697,000 697,000
============ =========== ============
Balance at December 31, 1996 $ 474,000 $(94,508,000) $ 83,528,000
</TABLE>
See accompanying notes.
37
<PAGE>
- --------------------------------------------------------------------------------
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
================================================================================
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Operations. The Company was organized in 1988 and commenced operations
January 1, 1989. The Company was established to develop, manufacture and market
systems for computer-assisted screening of cervical pap smears and other
cytological specimens. The Company's principal activities to date have been
research and development, recruiting of key personnel, seeking to obtain
required Food and Drug Administration ("FDA") approval, and manufacturing and
marketing the PAPNET(R) Testing System. The PAPNET(R) Testing System was
approved by the FDA for commercial use in the United States on November 8, 1995.
Basis of Presentation. The preparation of financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.
Principles of Consolidation. The consolidated financial statements include the
accounts of Neuromedical Systems, Inc. and all of its wholly-owned subsidiaries.
All intercompany transactions have been eliminated in consolidation.
Revenue Recognition. To date, the Company's revenue has been earned principally
from the processing of PAPNET(R) tests on a fee per slide basis and prior to
1992, the sale of territorial licenses. Slide processing service revenue is
recognized upon delivery of processed slides to third-party common carriers or
shipping services since the earning process is completed upon the performance of
these processing services.
Research and Development Costs. Research and development costs are expensed as
incurred.
Advertising and Promotion Costs. Advertising and promotion costs are expensed as
incurred. During 1996, the Company expensed approximately $11,625,000 of such
costs.
Cash Equivalents. Cash equivalents consist of highly liquid investments with a
maturity of three months or less when purchased. As of December 31, 1996, the
Company had approximately $77,000,000 in two money market mutual funds.
Concentration of Credit Risk. The Company provides computer-assisted screening
of Pap smears to laboratory facilities. Revenues are from all regions of the
United States as well as many foreign countries. The Company performs periodic
credit evaluations of its customers' financial condition. Credit losses have
been minimal and within management's expectations. There is no significant
concentration of the Company's accounts receivable portfolio in any customer or
geographical region that presents a risk to the Company based on that
concentration.
Property and Equipment. Property and equipment are stated at cost. Depreciation
is computed using the straight line method over the estimated useful lives of
the assets ranging from 2.5 to 10 years. PAPNET(R) Testing Systems are
depreciated over their useful life, generally 5 years. Assets acquired pursuant
to capital lease arrangements are generally amortized over the estimated useful
life of the asset. Leasehold improvements are amortized over the term of the
lease.
Patents. Effective January 1, 1995, additions to patent and patent application
costs are amortized over a twelve-month period. The net book value of patent and
patent application costs at January 1, 1995 is being amortized over 3 years
using the straight-line method. Prior to 1995, the amortization period was 12
years or the estimated life of the patent, if less, using the straight-line
method. These changes in accounting estimates resulted in an immaterial increase
in amortization expense and net loss in 1995.
Foreign Exchange. Each of the Company's foreign subsidiaries (with the exception
of its Israeli subsidiary, whose functional currency is the United States
dollar) uses its local currency as the functional currency and translates all
assets and liabilities at current exchange rates and all income and expenses at
average exchange rates. The adjustment resulting from this translation is
included in a separate component of stockholders' equity. Gains or losses
resulting from foreign currency transactions are included in the consolidated
statement of operations.
Net Loss Per Share. Net loss per share is computed using the weighted-average
number of shares of common stock outstanding. Historical net loss per share
information through December 31, 1995 is not considered meaningful due to the
significant changes in the Company's capital structure which occurred upon the
closing of the Company's initial public offering. Accordingly, such per share
information is not presented.
Pro Forma Net Loss Per Share. Except as noted below, pro forma net loss per
share is computed using the weighted-average number of shares of common stock
outstanding and convertible preferred stock outstanding. Common equivalent
shares from stock options and warrants are excluded from the computation as
their effect is anti-dilutive, except that, pursuant to the Securities and
Exchange Commission Staff Accounting Bulletins, common and common equivalent
shares issued at prices below the offering price during the twelve-month period
prior to the initial public offering in (December 1995) have been included in
the calculation as if they were outstanding for all periods prior to the initial
public offering (using the treasury stock method and the initial
38
<PAGE>
public offering price). Additionally, the effect of common shares issuable upon
conversion of convertible preferred stock is included in pro forma net loss per
share as outstanding since January 1, 1994 or from the date of issuance, if
later.
Employee Stock Based Compensation. The Company follows Accounting Principles
Board Statement No. 25 with regard to the accounting for stock issued as
compensation for employees.
Income Taxes. The liability method is used in accounting for income taxes. Under
this method, deferred tax assets and liabilities are determined based on
differences between financial reporting and tax bases of assets and liabilities
and are measured using the enacted tax rates and laws that will be in effect
when the differences are expected to reverse.
2. BALANCE SHEET
The allowance for doubtful accounts at December 31, 1996 and 1995 was $210,000
and $114,000, respectively. No amounts were charged to the reserve in 1996 and
1995.
Included in other current assets is $250,000 of restricted cash at December 31,
1996.
Accrued liabilities consist of the following:
<TABLE>
<CAPTION>
December 31,
----------------------------
1996 1995
----------- -----------
<S> <C> <C>
Compensation expenses $ 1,698,000 $ 1,223,000
Advertising and promotion 859,000 176,000
Professional fees 549,000 993,000
Taxes 328,000 --
Stock issuance cost -- 544,000
Other liabilities 648,000 387,000
----------- -----------
Total $ 4,082,000 $ 3,323,000
=========== ===========
</TABLE>
3. PROPERTY AND EQUIPMENT
Property and equipment consists of the following:
<TABLE>
<CAPTION>
December 31,
----------------------------
1996 1995
----------- -----------
<S> <C> <C>
PAPNET(R) systems and related equipment $18,228,000 $11,799,000
PAPNET(R) systems and related equipment
under construction 2,497,000 2,297,000
Furniture, fixtures and related equipment 5,291,000 3,595,000
----------- -----------
26,016,000 17,691,000
Accumulated depreciation and amortization (9,628,000) (6,475,000)
----------- -----------
$16,388,000 $11,216,000
=========== ===========
</TABLE>
A substantial portion of the Company's property and equipment has been pledged
as collateral in connection with outstanding borrowings or is subject to capital
lease arrangements.
Equipment under capital leases totaled approximately $9,496,000 and $3,356,000
at December 31, 1996 and 1995, respectively, and consists principally of
PAPNET(R) systems and related equipment. Included in accumulated depreciation
and amortization is approximately $1,874,000 and $854,000 related to assets
under capital leases at December 31, 1996 and 1995, respectively.
4. LEASES
The Company leases facilities and equipment under leases accounted for as
operating leases. Rent expense for the years ended December 31, 1996, 1995 and
1994 approximated $1,849,000, $1,099,000 and $560,000, respectively.
Minimum future lease payments under capital leases and non-cancelable operating
leases at December 31, 1996, are as follows:
<TABLE>
<CAPTION>
Capital Operating
Leases Leases
---------- ----------
<S> <C> <C>
1997 $2,696,000 $1,964,000
1998 2,749,000 1,788,000
1999 1,989,000 1,613,000
2000 1,262,000 1,235,000
2001 844,000 563,000
Thereafter -- 774,000
---------- ----------
Total minimum lease payments 9,540,000 $7,937,000
========== ==========
Less amount representing interest 1,706,000
----------
Present value of minimum lease payments $7,834,000
==========
</TABLE>
The facility leases include escalation clauses for operating expenses and real
estate taxes. Certain of the facility leases include renewal options for terms
ranging from two years to seven year periods.
5. BUSINESS SEGMENTS
The Company operates in a single industry segment. The Company's operations by
geographic area for the years ended December 31, 1996, 1995 and 1994 are
presented below:
<TABLE>
<CAPTION>
Identifiable
Total Revenues Net Loss Assets
-------------- -------- ------------
<S> <C> <C> <C>
Year ended December 31, 1996
United States $ 2,440,000 $(23,372,000) $119,427,000
Europe 1,070,000 (5,201,000) 5,140,000
Israel 7,163,000 (1,827,000) 6,121,000
Asia and Australia 1,219,000 (1,860,000) 2,883,000
Interarea Eliminations (7,163,000) (1,898,000) (29,367,000)
------------ ------------ ------------
$4,729,000 $(34,158,000) $104,204,000
============ ============ ============
Year ended December 31, 1995
United States $ 760,000 $(21,445,000) $133,399,000
Europe 969,000 (3,976,000) 4,828,000
Israel 2,133,000 (2,294,000) 4,341,000
Asia and Australia 740,000 (1,213,000) 2,111,000
Interarea Eliminations (2,127,000) (500,000) (17,331,000)
============ ============ ============
$ 2,475,000 $(29,428,000) $127,348,000
============ ============ ============
</TABLE>
39
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
================================================================================
<TABLE>
<CAPTION>
Identifiable
Total Revenues Net Loss Assets
-------------- -------- ------------
<S> <C> <C> <C>
Year ended December 31, 1994
United States $ 1,094,000 $ (9,656,000) $ 13,054,000
Europe 143,000 (2,100,000) 6,217,000
Israel 3,498,000 (943,000) 3,394,000
Asia and Australia 18,000 (765,000) 1,029,000
Interarea Eliminations (3,515,000) (355,000) (10,521,000)
----------- ------------ ------------
$ 1,238,000 $(13,819,000) $ 13,173,000
=========== ============ ============
</TABLE>
Transfers between geographic areas are accounted for at amounts which are
generally above cost and consistent with rules and regulations of governing tax
authorities. Such transfers are eliminated in the Consolidated Financial
Statements. Substantially all revenues, with the exception of those originating
in Israel which are interarea, are from unaffiliated customers. In 1996, two
customers accounted for 16% and 11% of total revenues, respectively.
6. DEBT
The Company's debt consists of the following:
<TABLE>
<CAPTION>
December 31,
-----------------------
1996 1995
---------- -----------
<S> <C> <C>
Notes:
Note payable at 12.4% due in monthly installments
of $44,000, including interest, with the final payment
of approximately $210,000 due in December 2001 $2,098,000 --
Note payable at 18.1% due in monthly installments
of $37,000, including interest, with a final payment
of $188,000 due July 1998 720,000 $1,004,000
Note payable at 16.0% due in monthly installments
of $15,000, including interest, with a final payment
of $77,000 due March 1999 389,000 496,000
Note payable at 10.0%, with interest payable
monthly, principal due in March 1998 300,000 300,000
Note payable at 10.0%, with interest payable
monthly, principal due in June 1998 300,000 300,000
Conditional grant 399,000 235,000
Bank loans:
Foreign loans payable at annual rates between 7.7%
and 9.1%, guaranteed by the State of Israel and
linked to the United States dollar, payments due
quarterly through 2003 2,193,000 2,065,000
Foreign note payable at 8.4% with interest and
principal due in quarterly installments of
approximately $11,000, through September 1998 76,000 129,000
Other borrowings 29,000 90,000
---------- ----------
6,504,000 4,619,000
---------- ----------
Less current portion 1,200,000 583,000
---------- ----------
$5,304,000 $4,036,000
========== ==========
</TABLE>
During 1996, the Company entered into a loan agreement with an equipment
financing company to provide the Company with a $5,000,000 line of credit to
finance certain of the Company's equipment purchases, primarily PAPNET(R)
scanners and related equipment. During 1996, the Company borrowed $2,098,000
under the agreement, with loan terms of 60 months and with a final payment in
the amount equal to 10% of the original principal amount of such loan and with
an annual effective interest rate of 12.4%. Any future borrowings under this
line of credit will have similar loan terms provided, however, the annual
interest rate of 12.4% will be adjusted by the change in the weekly average of
the interest rates of five-year U.S. Treasury Securities, as published by the
Federal Reserve, from the week ending October 18, 1996 to the week preceding
each future loan commencement date. The loan is secured by a perfected first
priority interest in the financed equipment. The Company is required to maintain
certain financial covenants throughout the duration of the loan. The agreement
stipulates that additional funding can be denied in the event of a material
adverse change in the financial condition, operation or prospects of the
Company. The loan commitment expires on December 31, 1997.
Foreign loans payable represent borrowings at Libor plus 2.4% to 3.1%. Payment
terms vary from payment commencing two years after issuance and then payable
quarterly over a two-year period until maturity to five years in equal quarterly
installments.
Maturities of the outstanding debt for the five years succeeding December 31,
1996 are $1,200,000 in 1997, $2,517,000 in 1998, $1,454,000 in 1999, $670,000 in
2000, and $599,000 in 2001.
Each of the $300,000 notes is payable to a stockholder of the Company and
convertible into common stock at a conversion rate of $12.00 per share at the
option of the noteholder.
The conditional grant was received during 1996 and 1995 from a private
foundation to finance certain product development projects. Repayment is
required if the project becomes a commercial success and is repayable over a
period of 2 to 6 years at approximately 8.0% per annum.
The Company believes that the carrying value of its debt approximates fair
value.
7. TERRITORIAL LICENSE AGREEMENTS
From 1989 through 1991, the Company entered into various long-term territorial
license agreements (the "License Agreements") for its semi-automated classifier,
the PAPNET(R) system. The Company received net proceeds of approximately
$3,500,000 from the sale of these territorial licenses. Each license expires on
the later of (i) 17 years after its execution or (ii) the expiration of the
initial patent granted for the PAPNET(R) system, and is renewable for an
additional 17-year term at the licensee's option. The Company does not expect to
enter into any additional territorial license agreements.
40
<PAGE>
================================================================================
Pursuant to the License Agreements, as amended, each licensee is obligated to
use its best efforts to promote the use of the PAPNET(R) system, in its
territory at the licensee's expense. Each licensee is entitled to receive
royalties equal to the greater of (i) 50% of the territory's net slide revenue
(as defined) generated from participating laboratories within its territory, not
to exceed the licensee's share of a specified number of slides annually (ranging
from 175,000 to 3,000,000, and aggregating 12,175,000 among all of the
licensees); or (ii) a specified percentage (ranging from 0.15% to 1.0%, and
aggregating 4.15% for all the licensees) of the net annual slide revenues (as
defined) up to specified annual monetary limits for each licensee (aggregating
$23,000,000 for all its licensees). Royalty expense under these agreements
amounted to $286,000 in 1996.
In December 1995, the Company and the entities which hold the United States
licenses (the "Licensees") entered into a Settlement Agreement and a Warrant
Exercise Agreement (the "Territorial Agreements"), the effect of which included
the clarification of previously disputed elements of prior license agreements,
the requirement for the Company to make payments of stock having a fair market
value equivalent to approximately $1,652,000 and the irrevocable election by the
Licensees and acceptance by the Company for the cashless exercise of 826,032
outstanding warrants into 715,894 shares of common stock in connection with the
closing of the Company's initial public offering.
Pursuant to the Settlement Agreement, the Company has consented to the merger of
all the Licensees and related parties. Following such merger, the Licensees and
the Company have agreed to enter into a new license pursuant to which the rights
and obligations of the parties have been clarified but, with respect to which,
the economic terms of the License Agreements will not be materially altered. The
Company and the Licensees have also executed mutual general releases, which
include, among other things, the release of claims previously made by the
Licensees. The new licenses will expire on December 31, 2025.
Provisions of a promissory note, dated October 3, 1990 (which was later
converted to Series A Convertible Preferred Stock), granted the holder of the
note certain rights to be the Company's sole licensee for distribution of the
PAPNET(R) system in Canada. Such promissory note provides that the licensee
shall be entitled to terms which are at least as favorable as those in any
domestic United States of America licenses. No agreement has been reached on the
terms of the license with the holder.
One of the Company's directors also holds beneficial interests in entities which
hold United States territorial licenses.
8. CAPITAL STOCK
General. The authorized capital stock of the Company consists of 100,000,000
shares of common stock, par value $.0001 per share, and 10,000,000 shares of
preferred stock, par value $.0001 per share.
Initial Public Offering/Conversion of Preferred Stock. In December 1995, the
Company completed an initial public offering of 6,900,000 shares of common stock
at $15.00 per share and converted all shares of its then outstanding Series A
through H Convertible Preferred Stock into 16,161,402 shares of common stock. As
a result of the Company's recapitalization in connection with its initial public
offering, the number of authorized shares of preferred stock was reduced to
10,000,000, none of which are issued or outstanding as of December 31, 1996.
Registration Rights. Certain of the former preferred stockholders have
registration rights under an agreement which continues to apply to the shares of
common stock into which such preferred stock was converted or which may be
issued upon the exercise of warrants. In addition, certain holders of common
stock issued upon conversion of preferred stock have limited rights to require
the Company to register their shares in a public offering.
Stockholder Rights Plan. The Board of Directors has adopted a Stockholder Rights
Plan, pursuant to which there has been issued with respect to each share of
common stock issued and outstanding one Preferred Stock Purchase Right (a
"Right"). Each Right entitles the registered holder to purchase from the Company
one one-hundredth of a share of Series A Preferred Stock at a price of $60.00
per one one-hundredth of a share, subject to adjustment. These Rights may have
the effect of discouraging a tender offer or other takeover attempts not
previously approved by the Board of Directors.
Common Shares Reserved. As of December 31, 1996, the Company had reserved shares
of common stock for issuance as follows:
<TABLE>
<CAPTION>
Number of
Shares
<S> <C>
Exercise of common stock options 3,769,420
Exercise of common stock warrants 1,485,326
</TABLE>
Warrants. As of December 31, 1996, the Company had 1,485,326 outstanding common
stock warrants at exercise prices ranging from $.04 to $14.63 per share, all of
which were exercisable. The following summarizes these outstanding common stock
warrants, exercise prices and expiration dates:
41
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
<TABLE>
<CAPTION>
============================================================================================================================
Weighted-average
Number of Exercise Exercise Expiration
Warrants Price Price Date
--------- ------------ -------- ----------
<S> <C> <C> <C> <C>
Warrants issued in connection with Preferred Series A Stock 1,090,535 $ .04 $ .04 2/98
Warrants issued in connection with Preferred Series C Stock 157,443 $ 1.80-$1.98 $ 1.94 9/97-10/97
Warrants issued in connection with Preferred Series D Stock 51,876 $ 4.00 $ 4.00 6/98
Warrants issued in connection with equipment financing arrangements 70,072 $ 4.77-$8.00 $ 6.96 4/98-3/02
Other warrants issued 115,400 $4.00-$14.63 $10.52 9/98-1/00
--------- ------------ -------- ----------
Total warrants outstanding 1,485,326 $ 1.52
========= ========
</TABLE>
Most of the Company's outstanding warrants contain provisions allowing for the
conversion of such warrants into a lesser number of shares without the payment
of cash to the Company (so-called "cashless exercise" provisions). Accordingly,
there can be no assurance that, even if all of such warrants are exercised, the
Company will receive the proceeds from their exercise.
During 1996, 679,794 warrants were exercised, of which 675,720 warrants were
exercised under cashless exercise provisions, resulting in the issuance of
619,641 shares of common stock. During 1996, the Company issued 31,840 warrants,
primarily for consulting services, at a fair value of $56,000 and a weighted-
average exercise price of $13.78 per share.
9. STOCK OPTION PLAN
On November 17, 1993, the Board of Directors of the Company adopted the
Neuromedical Systems, Inc. 1993 Stock Option Plan which was amended and restated
October 25, 1995 as the Neuromedical Systems, Inc. 1993 Stock Incentive Plan
(the "Plan"). This amendment and restatement increased the maximum number of
shares with respect to which awards can be granted under the Plan to 4,140,000
shares, subject to adjustment in the event of a change in capitalization, with
no more than one-third of the total number of authorized shares to be issued as
grants of restricted stock and, provided that, over the term of the Plan, the
maximum number of shares with respect to which awards may be granted to any
individual is 2,000,000 and the maximum award per individual of dollar-
denominated performance units is $5,000,000. The Plan provides for award grants
in the form of non-qualified or incentive stock options, non-discretionary
director options, stock appreciation rights, dividend equivalent rights,
restricted stock, performance units and performance shares.
Under the terms of the Plan, a committee of the Company's Board of Directors may
grant options to purchase shares of the Company's common stock to employees,
directors and consultants of the Company at such prices as may be determined by
the Committee, principally equal to or greater than fair value at date of grant.
Options granted under the Plan vest over periods from immediate vesting to five
years at various rates and expire after ten years.
The Company has elected to follow Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees" (APB 25) and related Interpretations
in accounting for its employee stock options because, as discussed below, the
alternative fair value accounting provided for under 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. Under
APB 25, because the exercise price of the Company's employee stock options
equals the market price of the underlying stock on the date of grant, no
compensation expense is recognized.
Pro forma information regarding net loss and net loss per share is required by
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
option pricing model for 1996 and the Minimum Value Method for 1995 prior to
becoming a public company in December 1995. The following assumptions were made:
(i) weighted-average assumptions for risk-free interest rates of approximately
6.38% for 1996 and 6.30% for 1995, (ii) weighted-average volatility factor of
the expected market price of the Company's common stock of .42 for 1996, (iii)
weighted-average expected life of the options of 6 years for 1996 and 9 years
for 1995 and (iv) no dividends will be declared.
The Black-Scholes option valuation model was developed for use in estimating the
fair value of traded options which 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 employee stock options have characteristics significantly
different from those of traded options, and because changes in the subjective
input assumptions can materially affect the fair value estimate, in managment's
opinion, the existing models do not necessarily provide a reliable single
measure of the fair value of its employee stock options.
42
<PAGE>
================================================================================
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:
<TABLE>
<CAPTION>
1996 1995
------------- -------------
<S> <C> <C>
Pro forma net loss $(34,595,000) $(29,305,000)
Pro forma net loss per share: $ (1.18) $ (1.66)
</TABLE>
The Company's stock option activity under the Plan is as follows:
<TABLE>
<CAPTION>
1996 1995 1994
------------------------ ------------------------ ------
Weighted- Weighted-
Number Average Number Average Number
of Exercise of Exercise of
Shares Price Shares Price Shares
-------- -------- ---------- -------- ------
<S> <C> <C> <C> <C> <C>
Options outstanding, beginning of year 2,920,648 $ 7.49 1,712,000 $4.18 1,050,000
Options granted 235,000 17.65 1,218,898 12.11 662,000
Options exercised (370,580) 4.71 -- -- --
Options cancelled (25,950) 6.12 (10,250) 4.00 --
--------- --------- ---------
Options outstanding, end of year 2,759,118 8.74 2,920,648 7.49 1,712,000
========= ======== ========= ======= =========
Options exercisable at year end 1,508,279 $ 4.70 1,747,375 $4.23 455,138
========= ======== ========= ======= =========
</TABLE>
The number and weighted-average fair value of options
granted during 1996 and 1995 is as follows:
<TABLE>
<CAPTION>
1996 1995
------------------------------ ------------------------------
Weighted-average Weighted-average
Number of fair value Number of fair value
Shares of options granted Shares of options granted
--------- ------------------ --------- ------------------
<S> <C> <C> <C> <C>
Stock price equal to exercise price 235,000 $ 7.68 400,625 $2.02
Stock price equal to exercise price-performance based option 813,273 $ .49
Stock price greater than exercise price 5,000 $3.26
</TABLE>
The following table summarizes information about fixed price stock options
outstanding at December 31, 1996:
<TABLE>
<CAPTION>
Options Outstanding Options Exercisable
------------------------------------ -------------------------------------
Weighted-Average Number
Range of Number of Remaining Weighted-average Exercisable at Weighted-average
Exercise Prices Shares Contractual Life Exercise Price December 31, 1996 Exercise Price
- --------------- --------- ---------------- ---------------- ----------------- -----------------
<S> <C> <C> <C> <C> <C>
$ 4.00 1,314,683 7 years $ 4.00 1,314,683 $ 4.00
6.00 266,600 8 years 6.00 109,300 6.00
7.00 129,562 9 years 7.00 30,963 7.00
15.00 813,273 9 years 15.00 -- --
16.25-16.88 67,500 10 years 16.41 17,500 16.88
17.63-18.38 165,000 10 years 18.08 33,333 18.38
22.63 2,500 9 years 22.63 2,500 22.63
--------- ---------
$4.00-22.63 2,759,118 $ 8.74 1,508,279 $ 4.70
=========== ========= ======== ====== ========= ======
</TABLE>
43
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
================================================================================
During 1996, the Company issued 100,000 options for consulting services at a
fair value of $513,000. One-third of such options vested immediately upon
issuance and the remainder vests equally over the first and second anniversary
of the option issuance.
During 1995, the Company granted to its Chief Executive Officer a performance-
based option, under the Plan, for 813,273 shares of common stock at a per share
exercise price of $15.00. The grant is designed to produce an option value of
$12.5 million if at any time during the option's ten-year term either of the
following events (the "performance goal") occurs: (i) the Company's share price
over any 90 consecutive day period reaches a target price of $30.37 or (ii) all
or substantially all of the Company's shares are acquired at or above the target
price. The option provides for equitable adjustments to the performance goal,
the number of shares subject to the option and the exercise price in the event
of a change in capitalization as defined in the Plan. The exercisability of the
option will not accelerate upon the occurrence of a change in control, and the
option will terminate in connection with a change in control if the performance
goal is not attained prior to or in connection with the change in control.
If the performance goal is attained, the option will become exercisable as to
one-third of the number of shares subject thereto on the later of (i) December
7, 1998 or (ii) the date that the performance goal is attained (the "Initial
Vesting Date"), and will become exercisable as to an additional one-third of the
shares subject thereto on each of the first two anniversaries of the Initial
Vesting Date; provided, however, that, if the CEO's employment is terminated by
the Company without cause following a change in control that occurs following or
simultaneously with the attainment of the performance goal, the option will be
fully exercisable. No additional vesting will occur following the CEO's
termination of employment under any other circumstances or the expiration of the
option's ten-year term. If the performance goal is attained, the option will
result in a non-cash charge of $12.5 million to operations recognized over the
vesting period.
10. INCOME TAXES
The Company's pre-tax income (loss) is made up of the following:
<TABLE>
<CAPTION>
1996 1995 1994
------------ ------------ ------------
<S> <C> <C> <C>
U.S. $(25,270,000) $(21,945,000) $(10,011,000)
Foreign (8,888,000) (7,483,000) (3,808,000)
------------ ------------ ------------
$(34,158,000) $(29,428,000) $(13,819,000)
============ ============ ============
</TABLE>
A reconciliation of the Company's income tax expense (benefit) computed at U.S.
federal statutory tax rates to recorded income tax expense (benefit) is as
follows:
<TABLE>
<CAPTION>
1996 1995 1994
---- ---- ----
<S> <C> <C> <C>
Tax at U.S. statutory rate $(11,614,000) $(10,005,000) $(4,698,000)
State income taxes (1,402,000) (1,290,000) (882,000)
Effect of lower foreign
effective tax rates 1,760,000 1,435,000 1,063,000
Other (175,000) -- --
Valuation allowance recorded 11,431,000 9,860,000 4,517,000
------------ ------------ -----------
Recorded tax provision $ -- $ -- $ --
============ ============ ===========
</TABLE>
The components of the Company's deferred tax assets are as follows:
<TABLE>
<CAPTION>
December 31,
-----------------------------------------
1996 1995 1994
------------ ------------ -----------
<S> <C> <C> <C>
Deferred tax assets:
Cash (tax) versus accrual
basis of accounting $ 229,000 $ 340,000 $ 321,000
Employee stock options 1,358,000 2,500,000 --
Research and development
credits 1,060,000 950,000 900,000
Tax benefit of net operating
loss carryforwards 29,004,000 17,245,000 10,100,000
Other 1,015,000 200,000 54,000
------------ ------------ -----------
Total deferred tax assets 32,666,000 21,235,000 11,375,000
Less valuation allowance (32,666,000) (21,235,000) (11,375,000)
------------ ------------ ------------
Net deferred tax asset $ -- $ -- $ --
============ ============ ============
</TABLE>
At December 31, 1996, the Company had available U.S. net operating loss
carryforwards of approximately $65,000,000 that will expire in the years 2004
through 2011 and cumulative deductible temporary differences of approximately
$6,100,000. For financial reporting purposes, a valuation allowance has been
recognized to offset the deferred tax asset related to these carryforwards and
temporary differences.
The Company also has foreign net operating losses of $9,000,000 which are
available to offset the separate company taxable incomes of certain foreign
subsidiaries. These losses may be carried forward indefinitely. For financial
reporting purposes a valuation allowance has been recorded for these credits.
Certain foreign subsidiaries qualify for tax incentives in the countries of
incorporation. In order to realize these benefits, these foreign subsidiaries
will need to be profitable in future tax years.
In addition, as of December 31, 1996, the Company also had approximately
$1,000,000 of U.S. research and development credits available, which will expire
in 2004 through 2011. For financial reporting purposes, a valuation allowance
has been
44
<PAGE>
================================================================================
established for the full amount of the deferred tax asset recorded for these
credits.
The Tax Reform Act of 1986 enacted a complex set of rules limiting the potential
utilization of United States net operating loss carryforwards and tax credit
carryforwards in periods following a corporate "ownership change." In general,
an ownership change is deemed to occur if the percentage of stock of a loss
corporation owned (actually, constructively and, in some cases, deemed) by one
or more "5% stockholders" has increased by more than 50 percentage points over
the lowest percentage of such stock owned during a three-year testing period. As
a result of changes in the Company's ownership, the utilization of a substantial
portion of the Company's available United States net operating loss
carryforwards, and tax credit carryforwards will be subject to annual
limitations. It is management's belief, however, that, since this annual
limitation is determined based on the value of the Company immediately prior to
the ownership change, a significant portion of these carryforwards will be
available annually should the Company become profitable in future tax years.
11. COMMITMENTS AND CONTINGENCIES
In November 1993, the Company entered into an employment agreement with its
Chief Executive Officer for a period of five years. In addition to other
provisions, the agreement provides for a severance payment of 2.99 times base
salary upon termination other than for cause.
Each of the Company's executive officers has entered into a three-year
employment agreement with the Company. Each of the employment agreements was
amended as of October 25, 1995 to provide that, in the event that an employee is
terminated other than for "cause" or "disability" (as those terms are defined in
the applicable agreement), a portion of the employee's stock options will become
vested and exercisable to the extent that it would have had the employee
remained employed by the Company for a one-year period following his termination
of employment, and, subject to the employee's compliance with restrictive
covenants in his employment agreement, options held by the employee as of the
date of the termination of employment will remain exercisable (to the extent
those options either are vested on termination of employment or vest over the
succeeding year) until the earlier of the date one year following the
termination of employment or the expiration of the option's term. In addition,
the employment agreements provide for the continuation of salary for one year
after termination other than for cause. As of December 31, 1996, three of the
agreements have expired and the remaining four will expire during 1997.
On December 4, 1995, the Company was served with a Summons and Complaint in an
action entitled Herbst et al v. Neuromedical Systems, Inc. et al., in the
Supreme Court of the State of New York. The plaintiffs in this suit alleged,
among other things, that pursuant to written contracts, which they claim the
Company has breached, they were entitled to be issued warrants exercisable for
the purchase of approximately 128,000 shares of common stock at various prices.
They further alleged that the Company and certain of its officers and directors
made fraudulent misrepresentations and took other allegedly improper actions
that diminished the value of the warrants they claim they are entitled to under
these contracts. On January 31, 1996, the plaintiffs served the Company with an
Amended Complaint alleging legal claims similar to those in the original Summons
and Complaint served on the Company, but adding one of the Company's former
directors as a defendant and specifying that the plaintiffs are seeking
compensatory damages from the Company and one of its officers and a former
director totaling $114 million and punitive damages totaling $175 million. On
February 23, 1996, the defendants moved to dismiss the Amended Complaint and on
November 27, 1996, the New York State Supreme Court issued an opinion dismissing
all of the plaintiffs' claims that the Company and certain officers and
directors committed fraud and other improper actions that allegedly diminished
the value of the warrants plaintiffs claim they are entitled to receive. The
Court denied the Company's motion to dismiss plaintiffs' breach of contract
claim, and plaintiffs continue to seek $39 million in compensatory damages and
$75 million in punitive damages. The Company intends to continue to vigorously
defend this action. The Company believes that, in any event, the damages claimed
bear no relation to the harm alleged and believes an adverse judgement in this
case would not have a material adverse effect on the Company's operations,
financial position or cash flows.
On July 15, 1996, the Company filed a lawsuit against NeoPath, a competitor of
the Company, in the United States District Court for the Southern District of
New York, seeking damages and injunctive relief for patent infringement, false
advertising, unfair competition, intentional interference with business
relations and damage to business reputation. In the lawsuit, the Company alleges
that NeoPath willfully misappropriated the Company's patented technology and
used such technology in NeoPath's AutoPap(R) System. The Company also alleges
that NeoPath falsely characterized and made misleading comparisons to consumers
and securities analysts of the AutoPap(R) System and
45
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(continued)
================================================================================
the Company's PAPNET(R) Testing System. NeoPath has denied all allegations and,
in addition, it has filed counter-claims against the Company seeking damages and
injunctive relief for false advertising and unfair competition. In the counter-
claims, NeoPath alleges that statements made by the Company characterizing the
performance of the PAPNET(R) Testing System, and its effectiveness relative to
NeoPath's AutoPap(R) System, as well as other statements, are false and
misleading and constitute misrepresentations. The Company believes that
NeoPath's assertions are without merit. Although the duration, costs and
ultimate outcome of this lawsuit are unknown, the Company expects that the costs
of pursuing this lawsuit will be significant during 1997.
12. RELATED PARTY TRANSACTIONS
In January 1995, the Company issued 21,276 shares of Series G Stock to the
brother of a director of the Company, in consideration for assisting the Company
in raising approximately $1,000,000 in equity capital.
The Company has entered into an exclusive representation agreement with PAPNET
(Far East) Ltd. ("PFEL"), a Cayman Islands corporation based in Hong Kong and
controlled by certain direct and indirect stockholders of the Company. A
director of the Company is the president and a major stockholder of PFEL and is
also the President of Compuscreen Medical Diagnostic Centre, a subsidiary of
PFEL and a customer of the Company. During 1996 the Company recorded revenue
amounting to $531,000 from Compuscreen. In addition, PFEL is the record holder
of approximately 338,000 shares of the Company's common stock.
The representation agreement with PFEL (the "PFEL Agreement") provides that PFEL
will, in concert with the Company but at its own expense, market and sell
PAPNET(R) testing services in Hong Kong, Taiwan, Singapore, Thailand and the
cities of Beijing, Shanghai and Guangzhou in the People's Republic of China (the
"PFEL Territories"). During the term of the PFEL Agreement, the Company will pay
PFEL specified commissions in the form of a percentage of revenues received by
the Company from PFEL Territories, regardless of whether such revenues are
derived from the efforts of PFEL or the Company. In addition, PFEL has the non-
exclusive right to market and sell PAPNET(R) testing elsewhere in the People's
Republic of China, but will receive commissions only to the extent that revenues
received by the Company are attributable to its efforts. During 1996, the
Company paid commissions of $67,000 under the terms of the Agreement.
The term of the PFEL Agreement and PFEL's rights thereunder are variable in
duration, depending on the volume of sales from the various PFEL Territories.
Assuming all performance objectives are met, PFEL's rights may continue for up
to five years from July 1995. In addition, the PFEL Agreement provides that the
Company will pay PFEL fees for management assistance in connection with the
establishment of its Asia-Pacific Scanning Center. The Company paid PFEL $75,000
during 1996 and 1995 and $100,000 during 1994 in consideration for such
assistance.
In January 1994, the Company loaned its President, Chairman and Chief Executive
Officer $200,000, which loan was free of interest charges and approved by the
Board of Directors. Such amount was repaid in full in March 1994.
13. EMPLOYEE SAVINGS PLAN
The Company established a defined contribution savings plan (401k plan) for its
domestic employees retroactive to January 1, 1995. The plan allows participating
employees to contribute up to 15% of their salary, subject to annual limits. The
Board may, at its sole discretion, approve Company contributions. Through
December 31, 1996, the Company has made no contributions to the plan.
46
<PAGE>
NEUROMEDICAL SYSTEMS, INC. & SUBSIDIARIES
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
YEARS ENDED DECEMBER 31, 1996 AND 1995
<TABLE>
<CAPTION>
==========================================================================================
Col. A Col. B Col. C Col. D Col. E
- ------------------------ ------------ --------- ---------- -----------
Additions
Charged
Balance to Costs Balance at
at Beginning and End of
of Period Expenses Deductions Period
------------ -------- ---------- ----------
<S> <C> <C> <C> <C>
1996
Against trade receivables
for doubtful accounts............... $114,000 $ 96,000 - $210,000
1995
Against trade receivables
for doubtful accounts............... - 0 - $114,000 - $114,000
-------- --------
</TABLE>
47
<PAGE>
ITEM 9. CHANGES IN AND DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
On August 1, 1995, the Company, with the approval of the Company's Board of
Directors, dismissed Igal Brightman & Co., a member of Deloitte Touche Tohmatsu
International, as the independent accountants of Neuromedical Systems Israel
Ltd. ("NSIL"), a wholly owned subsidiary, the financial statements of which
reflect total assets constituting 11% at December 31, 1994 and net loss
constituting 9% of the respective consolidated total for the year then ended.
The report of Igal Brightman & Co. on the financial statements of NSIL for the
year ended December 31, 1994 did not contain an adverse opinion or disclaimer of
opinion and was not qualified or modified as to uncertainty, audit scope or
accounting principle. During the year ended December 31, 1994 and during the
period between December 31, 1994 and the date on which Igal Brightman & Co. was
dismissed, there was no disagreement between the Company and Igal Brightman &
Co. on any matter of accounting principles or practices, financial statement
disclosure or auditing scope or procedure, which disagreements, if not resolved
to the satisfaction of Igal Brightman & Co., would have caused Igal Brightman &
Co. to make reference to the subject matter of such disagreement in connection
with its report on NSIL's financial statements. The Company engaged Kost Levary
& Forer, a member of Ernst & Young International, as the new independent
auditors of NSIL as of August 17, 1995.
48
<PAGE>
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS
The information called for by Item 10 of this Form 10-K with respect to
Company directors and compliance with Section 16(a) of the Exchange Act is
hereby incorporated by reference from the registrant's 1996 definitive proxy
statement filed pursuant to Regulation 14A which has been, or will be, filed
with the Commission within 120 days after the end of the fiscal year covered by
this Form 10-K. The information called for by Item 10 of this Form 10-K
regarding executive officers is set forth above in Part I above under the
caption, "Part I Supplemental Item: Executive Officers of the Registrant" and is
hereto incorporated by reference from such section.
ITEM 11. EXECUTIVE COMPENSATION
The information called for by Item 11 of this Form 10-K is hereby
incorporated by reference from the registrant's 1997 definitive proxy statement
filed pursuant to Regulation 14A which has been, or will be, filed with the
Commission within 120 days after the end of the fiscal year covered by this Form
10-K.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information called for by Item 12 of this Form 10-K is hereby
incorporated by reference from the registrant's 1997 definitive proxy statement
filed pursuant to Regulation 14A which has been, or will be, filed with the
Commission within 120 days after the end of the fiscal year covered by this Form
10-K.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information called for by Item 13 of this Form 10-K is hereby
incorporated by reference from the registrant's 1997 definitive proxy statement
filed pursuant to Regulation 14A which has been, or will be, filed with the
Commission within 120 days after the end of the fiscal year covered by this Form
10-K.
49
<PAGE>
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(A) 1. FINANCIAL STATEMENTS
--------------------
See Index to Consolidated Financial Statements included on page 31.
----
2. FINANCIAL STATEMENT SCHEDULES
-----------------------------
The following consolidated Financial Statement Schedule of the Company
is included herein at the page indicated:
Schedule II - Valuation and Qualifying Accounts: page 47.
All other schedules are omitted because the information set forth
therein is not applicable or is shown in the Financial Statements or the Notes
thereto.
(B) REPORTS ON FORM 8-K
-------------------
None.
50
<PAGE>
(C) LIST OF EXHIBITS
----------------
Reference is made below to those exhibits indicated with a + symbol which
have heretofore been filed with the U.S. Securities and Exchange Commission as
an exhibit to the Registration Statement on Form S-1 of the Company (File No.
33-97722), filed with the Commission on October 3, 1995, as amended by Amendment
No. 1 thereto filed on November 13, 1995, by Amendment No. 2 thereto filed on
November 22, 1995, by Amendment No. 3 thereto filed on November 29, 1995, by
Amendment No. 4 thereto filed on December 5, 1995, by Amendment No. 5 thereto
filed on December 7, 1995 and by Post-Effective Amendment No.1 thereto filed on
September 30, 1996. Exhibits so referred to are incorporated herein by
reference.
In addition, exhibits indicated with a * symbol are an executive contract
or compensatory plan or arrangement filed pursuant to Item 14 of Form 10-K.
EXHIBIT
NUMBER DESCRIPTION OF DOCUMENT
- ------ -----------------------
3.1 Amended and Restated Certificate of
Incorporation+
3.2 By-Laws+
4.1 Form of Rights Agreement+
4.2 Form of Stock Certificate+
10.1 Neuromedical Systems, Inc. 1993 Stock
Incentive Plan as Amended and Restated
October 25, 1995+*
10.2 Employment Agreement, dated November
19, 1993, between Neuromedical Systems,
Inc. and Mark R. Rutenberg+*
10.3 Employment Agreement, dated November
18, 1993, between Neuromedical Systems,
Inc. and Uzi Ish-Hurwitz+*
10.4 Employment Agreement, dated November
10, 1994, between Neuromedical Systems,
Inc. and David Duncan, Jr.+*
10.5 Employment Agreement, dated April 1,
1994, between Neuromedical Systems,
Inc. and Zeev Hadass+*
10.6 Employment Agreement, dated March 1,
1994, between Neuromedical Systems,
Inc. and John B. Henneman, III+*
10.7 Employment Agreement, dated November
19, 1993, between Neuromedical Systems,
Inc. and James M. Herriman+*
10.8 Employment Agreement, dated November
19, 1993, between Neuromedical Systems,
Inc. and Laurie J. Mango, M.D.+*
51
<PAGE>
10.9 Employment Agreement, dated February
14, 1994, between Neuromedical Systems,
Inc. and Andrew C. Panagy+*
10.10 Amendment to Employment Agreement
between Neuromedical Systems, Inc. and
Mark R. Rutenberg, dated as of October
25, 1995+*
10.11 Amendment to Employment Agreement
between Neuromedical Systems, Inc. and
Uzi Ish-Hurwitz, dated as of October
25, 1995+*
10.12 Amendment to Employment Agreement
between Neuromedical Systems, Inc. and
David Duncan, Jr., dated as of October
25, 1995+*
10.13 Amendment to Employment Agreement
between Neuromedical Systems, Inc. and
Zeev Hadass, dated as of October 25,
1995+*
10.14 Amendment to Employment Agreement
between Neuromedical Systems, Inc. and
John B. Henneman, III, dated as of
October 25, 1995+*
10.15 Amendment to Employment Agreement
between Neuromedical Systems, Inc. and
James M. Herriman, dated as of October
25, 1995+*
10.16 Amendment to Employment Agreement
between Neuromedical Systems, Inc. and
Laurie J. Mango, M.D., dated as of
October 25, 1995+*
10.17 Amendment to Employment Agreement
between Neuromedical Systems, Inc. and
Andrew C. Panagy, dated as of October
25, 1995+*
10.18 Employee Stock Bonus Plan+*
10.19 Form of Rutenberg Nonqualified Stock
Option Agreement+*
10.20 Form of Indemnification Agreement
between the Company and its directors
and officers+*
10.21 Exclusive Representation Agreement
between Neuromedical Systems, Inc. and
Papnet (Far East) Ltd.+
10.22 Territorial License Agreement between
Neuromedical Systems, Inc. and Papnet
of Ohio, Inc. (for the Territory of
Ohio)+
10.23 Territorial License Agreement between
Neuromedical Systems, Inc. and Papnet
of Ohio, Inc. (for the Territories of
Kentucky, Indiana and Chicago)+
10.24 Territorial License Agreement between
Neuromedical Systems, Inc. and ER
Group, Inc.+
10.25 Territorial License Agreement between
Neuromedical Systems, Inc. and Carolina
Cytology, Inc.+
10.26 Territorial License Agreement between
Neuromedical Systems, Inc. and Cytology
West, Inc.+
10.27 Territorial License Agreement between
Neuromedical Systems, Inc. and I-A
Cytology.+
52
<PAGE>
10.28 Settlement Agreement, dated as of
December 4, 1995, among Neuromedical
Systems, Inc. and Papnet of Ohio, Inc.,
Cytology Indiana, Inc., Indiana
Cytology Review Company, ER Group,
Inc., Cytology West, Inc., Carolina
Cytology Licensing Company, Papnet
Utah, Inc., Carolina Cytology Warrant
Partnership and GRK Partners.+
10.29 Warrant Exercise Agreement, dated as of
December 4, 1995, among Neuromedical
Systems, Inc. and Papnet of Ohio, Inc.,
Cytology Indiana, Inc., Indiana
Cytology Review Company, ER Group,
Inc., Carolina Cytology Warrant
Partnership and GRK Partners.+
11.0 Computation of Earnings per Share
12.0 Statements re: computation ratios+
16.0 Letter re: change in certifying
accountant+
21.1 Subsidiaries of the Registrant+
23.1 Consent of Independent Auditors
24.1 Powers of Attorney
27.1 Financial Data Schedule
99.1 Cautionary Statement
A copy of any of the exhibits included in this Annual Report on Form 10-K,
other than those as to which confidential treatment is pending or has been
granted by the Securities and Exchange Commission, upon payment of a fee to
cover the reasonable expenses of furnishing such exhibits, may be obtained by
written request to the Company, at the address set forth on the front cover,
attention General Counsel.
53
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
as amended, the Registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized on the 28th day of
March, 1997, in Suffern, New York.
NEUROMEDICAL SYSTEMS, INC.
/s/ David Duncan, Jr.
By: ___________________
David Duncan, Jr.
Vice President, Finance and
Administration and Chief Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934,
as amended, this Annual Report on Form 10-K has been signed below by the
following persons in the capacities and on the dates indicated.
<TABLE>
<CAPTION>
Signature Title Date
----- ----
<S> <C> <C>
/s/ Mark R. Rutenburg* Chairman of the Board, March 28, 1997
- --------------------------- President and Chief Executive Officer;
(Mark R. Rutenberg)
/s/ David Duncan, Jr. Vice President, Finance and Administration, March 28, 1997
- --------------------------- Chief Financial Officer and Principal
(David Duncan, Jr.) Accounting Officer
/s/ Elizabeth Cogan Fascitelli* March 28, 1997
- --------------------------- Director
(Elizabeth Cogan Fascitelli)
/s/ Stuart M. Essig* Director March 28, 1997
- ---------------------------
(Stuart M. Essig)
/s/ Carl Genberg* Director March 28, 1997
- ---------------------------
(Carl Genberg)
/s/ Arthur R. Herbst, M.D.* Director March 28, 1997
- ---------------------------
(Arthur R. Herbst, M.D.)
</TABLE>
<PAGE>
<TABLE>
<S> <C>
/s/ Uzi Ish-Hurwitz* Director March 28, 1997
- ---------------------------
(Uzi Ish-Hurwitz)
/s/ C. Raymond Larkin Jr.* Director March 28, 1997
- ---------------------------
(C. Raymond Larkin, Jr.)
/s/ Dr. Stephen K.C. Ng* Director March 28, 1997
- ---------------------------
(Dr. Stephen K.C. Ng)
</TABLE>
*By: /s/ David Duncan, Jr.
--------------------
David Duncan, Jr.
Individually and Attorney-in-Fact
<PAGE>
Exhibit 11.0
NEUROMEDICAL SYSTEMS, INC.
COMPUTATION OF PRIMARY EARNINGS PER SHARE
<TABLE>
<CAPTION>
Year Ended December 31, 1996
-----------------------------------------
<S> <C> <C> <C>
1996 1995(2) 1994(2)
---------- ---------- ----------
Weighted average number of common shares outstanding 29,277,083 5,840,761 4,103,979
Common shares issued from October 1994 to completion
of IPO (1) 0 53,969 57,599
Preferred stock issued from October 1994 to completion
of IPO (1) 0 2,247,162 2,398,287
Assumed exercise of stock options and warrants using
the treasury stock method (1) 0 237,084 316,980
Weighted average number of common shares representing
assumed conversion of Series A through F
from date of issuance 0 9,264,996 9,623,355
----------- ------------- -----------
Weighted average number of common and common
equivalent shares outstanding 29,277,083 17,643,972 16,500,200
=========== ============= ===========
Net loss for period $(34,158,000) $(29,428,000) $(13,819,000)
----------- ------------ -----------
Net loss per share (1995 and 1994 pro forma) $ (1.17) $ (1.67) $ (0.84)
============ ============ ============
</TABLE>
(1) Represents shares of common stock or common stock equivalents issued between
October 1994 and completion of the IPO at a price per share less than the
$15 per share price of common stock sold in the initial public offering.
Such shares are considered to be "cheap stock" and, accordingly, reflected
as outstanding for all periods presented prior to the initial public
offering, using the treasury stock method.
(2) On a pro forma basis, giving effect to the conversion of convertible
preferred stock to common.
Page 1 of 2
<PAGE>
NEUROMEDICAL SYSTEMS, INC.
COMPUTATION OF FULLY DILUTED EARNINGS PER SHARE
<TABLE>
<CAPTION>
Year Ended December 31, 1996
-----------------------------------------
<S> <C> <C> <C>
1996 1995(3) 1994(3)
---------- ---------- ----------
Weighted average number of common shares outstanding 29,277,083 5,840,761 4,103,979
Common shares issued from October 1994 to completion
of IPO (1) 0 53,969 57,599
Preferred stock issued from October 1994 to completion
of IPO (1) 0 2,247,162 2,398,287
Assumed exercise of stock options and warrants using
the treasury stock method (1) 0 237,084 316,980
Weighted average number of common shares representing
assumed conversion of Series A through F
from date of issuance 0 9,264,996 9,623,355
Assumed exercise of stock options and warrants using
the treasury stock method (2) 3,275,610 7,573,150 6,197,357
---------- ---------- ----------
Weighted average number of common and common
equivalent shares outstanding 32,552,693 25,217,122 22,697,557
========== ========== ==========
Net loss for period $(34,158,000) $(29,428,000) $(13,819,000)
---------- ---------- ----------
Net loss per share (1995 and 1994 pro forma) $ (1.05) $ (1.17) $ (0.61)
=========== ========== ==========
</TABLE>
(1) Represents shares of common stock or common stock equivalents issued between
October 1994 and completion of the IPO, at a price per share less than the
$15 per share price of common stock sold in the initial public offering.
Such shares are considered to be "cheap stock" and, accordingly, reflected
as outstanding for all periods presented prior to the initial public
offering, using the treasury stock method.
(2) For purposes of calculating the number of shares issuable upon exercise of
outstanding stock options and warrants, the daily average closing stock
price of $17.66 per share was used for 1996. The closing stock price of $20
1/8 was used for 1995, and $9.40 was used for 1994.
(3) On a pro forma basis, giving effect to the conversion of convertible
preferred stock to common.
Page 2 of 2
<PAGE>
Exhibit 23.1
CONSENT OF INDEPENDENT AUDITORS
We consent to the incorporation by reference in the Registration Statement
(Form S-8 No. 333-3168) pertaining to the Neuromedical Systems, Inc. 1993 Stock
Incentive Plan of our report dated February 7, 1997, with respect to the
consolidated financial statements and schedule of Neuromedical Systems, Inc.
included in the Annual Report (Form 10-K) for the year ended December 31, 1996.
ERNST & YOUNG LLP
Hackensack, N.J.
March 27, 1997
<PAGE>
Exhibit 24.1
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears
below hereby constitutes and appoints Mark R. Rutenberg, Uzi Ish-Hurwitz, David
Duncan, Jr. and John B. Henneman III, and each of them, as his true and lawful
attorneys-in-fact and agents, each acting alone, with full powers of
substitution and resubstitution, for him in his name, place and stead, in any
and all capacities, to sign the 1996 Annual Report on Form 10-K of Neuromedical
Systems, Inc. (the "Corporation"), filed pursuant to Section 13 of the
Securities Exchange Act of 1934, and any and all documents in connection
therewith, and to file the same, with all exhibits thereto, and any and all
amendments and any further documents in connection therewith, with the United
States Securities and Exchange Commission, granting unto said attorneys-in-fact
and agents full power and authority to do and perform each and every act and
thing requisite and necessary to be done in and about the premises, as fully as
he might or could do in person, and hereby ratifies, approves and confirms all
that his said attorneys-in-fact and agents, each acting alone, or his substitute
or substitutes, may lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities and Exchange Commission Rule
12b-11, this Power of Attorney for the execution of the Corporation's 1996
Annual Report on Form 10-K has been signed by the following persons on the dates
indicated, each in their respective capacities as members of the Corporation's
board of directors:
/s/ Mark R. Rutenberg March 26, 1997
____________________________ ____________________________
Mark R. Rutenberg Date
/s/ Elizabeth Cogan Fascitelli March 27, 1997
____________________________ ____________________________
Elizabeth Cogan Fascitelli Date
/s/ Stuart M. Essig March 26, 1997
____________________________ ____________________________
Stuart M. Essig Date
/s/ Carl Genberg March 27, 1997
____________________________ ____________________________
Carl Genberg Date
/s/ Dr. Arthur L. Herbst March 27, 1997
____________________________ ____________________________
Dr. Arthur L. Herbst Date
/s/ Uzi Ish-Hurwitz March 27, 1997
____________________________ ____________________________
Uzi Ish-Hurwitz Date
/s/ C. Raymond Larkin, Jr. March 27, 1997
____________________________ ____________________________
C. Raymond Larkin, Jr. Date
/s/ Stephen Ng, M.D. March 26, 1997
____________________________ ____________________________
Stephen Ng, M.D. Date
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<S> <C>
<MULTIPLIER> 1000
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-31-1996
<PERIOD-END> DEC-31-1996
<CASH> 83,391
<SECURITIES> 0
<RECEIVABLES> 1,860
<ALLOWANCES> (210)
<INVENTORY> 0
<CURRENT-ASSETS> 86,576
<PP&E> 26,016
<DEPRECIATION> (9,628)
<TOTAL-ASSETS> 104,204
<CURRENT-LIABILITIES> 9,510
<BONDS> 11,166
0
0
<COMMON> 3
<OTHER-SE> 83,525
<TOTAL-LIABILITY-AND-EQUITY> 104,204
<SALES> 0
<TOTAL-REVENUES> 4,729
<CGS> 0
<TOTAL-COSTS> 8,178
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 1,095
<INCOME-PRETAX> (34,158)
<INCOME-TAX> 0
<INCOME-CONTINUING> (34,158)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (34,158)
<EPS-PRIMARY> (1.17)
<EPS-DILUTED> (1.05)
</TABLE>
<PAGE>
Exhibit 99.1
CAUTIONARY STATEMENT FOR PURPOSES OF
THE SAFE HARBOR PROVISIONS OF THE
PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
Investment in the securities of Neuromedical Systems, Inc. (the "Company")
involves a high degree of risk. In evaluating an investment in the Company's
common stock, par value $.0001 per share (the "Common Stock"), Company
stockholders and prospective investors should carefully consider the risk
factors discussed in this Exhibit 99.1 and the information detailed in the
Company's 1996 Annual Report on Form 10-K including, without limitation, Item 1
Business and Item 6 Management's Discussion and Analysis of Financial Condition
and Results of Operations, as well as information contained in the Company's
other filings with the Securities and Exchange Commission.
The Company's Form 10-K and its Annual Report to Stockholders, any Form 10-
Q or any Form 8-K of the Company or any other written or oral statements made by
or on behalf of the Company may include forward-looking statements within the
meaning of Section 21E of the Securities Exchange Act of 1934 which reflect the
Company's current views with respect to further 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. For information regarding these risks
and uncertainties, see the Cautionary Statements set forth below and the
Company's 1996 Annual Report on Form 10-K, including, without limitation, Item 1
Business and Item 6 Management's Discussion and Analysis of Financial Condition
and Results of Operations. The words "believe", "expect", "anticipate",
"estimate", "project" and similar expressions identify 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.
EARLY COMMERCIAL STAGE COMPANY; HISTORY OF LOSSES; PROFITABILITY UNCERTAIN
The Company is in its early commercial stage and has generated limited
operating revenue to date and has incurred, from incorporation through December
31, 1996, net losses aggregating approximately $94.5 million. The Company does
not expect to generate a positive internal cash flow in the foreseeable future
due to the expected increases in capital expenditures, working capital
requirements and ongoing losses during the next year, including the expected
cost of commercializing the PAPNET(R) Testing System. The likelihood of the
success of the Company must be considered in light of the problems, expenses,
difficulties, complications and delays frequently encountered in connection with
the formation of a new business, the development of new products and the
competitive environment in which the Company operates. Although the Company is
deriving limited operating revenue from its current operations, there can be no
assurance that it will be able to develop significant additional sources of
revenue or that its operations will become profitable. Results of operations
may fluctuate significantly and will depend upon numerous factors, including
regulatory actions, market acceptance of the Company's products, efficient
manufacturing and slide processing operations, new product introductions and
competition.
1
<PAGE>
NEED FOR MARKET ACCEPTANCE OF THE PAPNET(R) TESTING SYSTEM
The Company's future performance will depend to a substantial degree upon
market acceptance of the PAPNET(R) Testing System. The extent of, and rate at
which, market acceptance and penetration are achieved by the PAPNET(R) Testing
System are functions of many variables including, but not limited to, price,
effectiveness, acceptance by patients, physicians and laboratories (including
the ability of laboratories to hire additional cytotechnologists),
manufacturing, slide processing and training capacity, reimbursement practice
and marketing and sales efforts. The Company believes that significant revenue
growth in the United States depends upon effective marketing to three target
audiences: clinical laboratories, clinicians and women. The Company has also
begun discussions with insurers, managed care organizations and other third-
party payers concerning reimbursement for PAPNET(R) testing.
The Company's sales and marketing efforts to date in the United States have
generated considerable awareness about PAPNET(R) testing among pathologists,
cytotechnologists, gynecologists and women. The Company believes support and
interest has been highest among women. Medical specialties, however, are often
reluctant to change clinical practice methods and procedures, and early stage
resistance is being experienced in the adoption of PAPNET(R) testing. Among
gynecologists and pathologists there has been, in general, a slow adoption of
the PAPNET(R) technology and some reluctance to use it even if a woman inquires
about or requests the test. The Company believes that this is due to several
factors, including controversy within the medical profession about the public
health consequences of Pap smear false negatives, the relative cost of PAPNET(R)
testing to the Pap smear, limited reimbursement by third party payers and
confusion in the marketplace about alternative technologies for cervical cancer
screening. In late 1996 and the first quarter of 1997, the Company initiated
medical and other communications designed to address each of these
considerations.
There can be no assurance that the PAPNET(R) Testing System will achieve or
maintain acceptance in its target markets. Similar risks may confront other
products developed by the Company in the future.
RELIANCE ON A SINGLE PRODUCT
The Company has concentrated its efforts primarily on the development of
the PAPNET(R) Testing System and will be dependent upon acceptance of that
product to generate revenues. The Company has performed only limited research
on other applications of its technology. There can be no assurance that the
PAPNET(R) Testing System will be successfully commercialized or that such other
applications will be developed.
COMPETITION
The Company is currently aware of three principal competitors which are
engaged in efforts to automate one or more aspects of cervical smear screening.
Two competitors, Cytyc Corporation ("Cytyc") and AutoCyte Inc. ("AutoCyte",
formerly a unit of Hoffman-La Roche's Roche Image Analysis Systems), are focused
on the development of devices for the production, and, in the case of AutoCyte,
imaging and automated analysis, of monolayer slides, a potential
2
<PAGE>
alternative to the conventional Pap smear method of specimen collection and
preparation. AutoCyte has stated that it expects to file for United States Food
and Drug Administration ("FDA") pre-market approval in 1997 of its slide
preparation and imaging system. Cytyc received approval from the FDA in May 1996
to market its ThinPrep(R) System to laboratories, for the purpose of filtering
out blood, mucus and other material from Pap smears for cervical cancer
screening as a replacement for the conventional Pap smear method. In addition,
Cytyc received FDA approval in November 1996 to expand its product labeling to
include the claim that the ThinPrep(R) System is significantly more effective in
detecting Low Grade Squamous Intraepithelal Lesions and more severe lesions than
the conventional Pap smear method. Cytyc labeling may also indicate that the
specimen quality using the ThinPrep(R) System is significantly improved over
that of the conventional Pap smear method. PAPNET(R) is not currently indicated
under its FDA label for the scanning of ThinPrep(R) System slides. With
monolayer techniques, clinicians are required to prepare special slides, and
only a fraction of the cells and background information displayed on the
conventional slide may be observed by the cytotechnologist or clinician for
analysis. Because the PAPNET(R) Testing System uses the well-established methods
of sample collection, it does not reduce the diagnostic sample size or require
clinicians to deviate from standard practice.
The other competitor of which the Company is aware, NeoPath, has stated
that it is developing a device for the fully automated primary screening of
conventional Pap smears, for which it submitted to the FDA a pre-market approval
supplemental application. The FDA Hematology and Pathology Devices Panel (the
"Panel") held a public meeting on September 27, 1996 to consider recommending
approval of such supplement. The Panel voted not to approve such supplement and
enumerated certain conditions that the Panel would want satisfied prior to
approval of such supplement. NeoPath has stated that it expects to meet such
conditions within the next several months.
On September 29, 1995, the FDA granted approval to NeoPath for the
AutoPap(R) System to be used as part of a laboratory's quality control
procedures. According to NeoPath, the AutoPap(R) System is designed to sort
purportedly "negative" Pap smear slides into two groups, one classified as
"negative" and one classified for "review." The group of slides classified for
review, which constitutes a specified percentage of the whole, is again reviewed
manually by the cytotechnologist through a conventional microscope. In contrast,
cytotechnologists trained in the use of the PAPNET(R) Testing System evaluate
the 128 color images from each purportedly negative slide on the PAPNET(R)
Review Station. If all of the images appear normal, the cytotechnologist
classifies the slide as "negative," and no further examination is required. If
any one of the 128 images appears to the cytotechnologist to be abnormal, the
cytotechnologist classifies the slide as "review." The cytotechnologist then
refers to the "x, y" coordinates provided with each PAPNET(R) image and uses the
coordinates as a reference point to re-examine the slide directly through the
microscope. Every slide rescreened using the PAPNET(R) system must receive a
directed, professional human analysis, either of the PAPNET(R) images or of both
the images and the slide.
The Company's known competitors or other companies may develop new products
and technologies that prove to be more effective than the PAPNET(R) Testing
System or that may be viewed by clinical laboratories as reducing operating
costs (for example, by reducing the number of cytotechnologists used in
screening). In addition, competitive products and technologies may
3
<PAGE>
be manufactured and marketed more successfully than the PAPNET(R) Testing
System. Such developments could render the PAPNET(R) Testing System less
competitive or possibly obsolete, and could have a material adverse effect on
the Company. The Company will be required to compete with respect to product
effectiveness, price, manufacturing and slide processing efficiency, marketing
capabilities and customer service and support, areas in which it currently has
limited experience.
In addition to competitors attempting to develop fully automated or semi-
automated systems for the screening or rescreening of cervical samples, there
may in the future be alternate techniques or technologies for the detection or
prevention of cervical cancer. Although no such technique has been demonstrated
to be useful as a substitute for the Pap smear, there can be no assurance that
new techniques or technologies will not one day supplant or replace the Pap
smear in medical practice.
DEPENDENCE ON KEY PERSONNEL
The Company's business is highly dependent on the principal members of its
management (including the President and Chief Executive Officer of the Company,
Mark R. Rutenberg), marketing and technical staffs, and the loss of their
services might impede the achievement of the Company's business objectives. In
addition, the Company's future success will depend in part upon its ability to
retain highly qualified management, scientific, technical and marketing
personnel. There can be no assurance that the Company will be successful in
retaining such qualified personnel or hiring additional qualified personnel.
Losses of key personnel could have a material adverse effect on the Company's
business.
IMPACT OF TERRITORIAL LICENSE AGREEMENTS
From 1989 through 1991, the Company entered into various long-term
territorial license agreements (the "License Agreements") for the PAPNET(R)
Testing System, relating to certain states and metropolitan areas, which
together account for approximately 20% of the population of the United States.
Pursuant to the License Agreements, each licensee ("Licensee") thereunder is
entitled to receive the greater of (i) royalties equal to 50% of the Net Slide
Revenue (as defined below) generated from participating laboratories within its
territory, not to exceed the Licensee's share of a specified number of slides
annually or (ii) a specified percentage of the Company's annual slide processing
revenues less certain taxes, commissions and other enumerated expenses, up to
specific annual monetary limits for each Licensee. "Net Slide Revenue" is
defined as the gross slide processing revenue minus certain costs related to
asset-based financing for PAPNET(R) Scanning Stations and related equipment (not
to exceed $1.00 per slide) and transportation costs. The Company estimates that
the License Agreements will result in royalty expense to the Company of
approximately 10% of its United States revenues over the term of the License
Agreements, but there can be no assurance that the amount of such royalties will
not be more or less than such percentage. In December 1995, the Company and the
Licensees entered into a settlement agreement (the "Settlement Agreement") and a
warrant exercise agreement, the effect of which included the clarification of
previously disputed elements of prior license agreements, the requirement for
the Company to make payments of stock having a fair market value equivalent to
approximately $1,652,000 and the
4
<PAGE>
irrevocable election by the Licensees and acceptance by the Company for the
cashless exercise of 826,032 outstanding warrants into 715,894 shares of Common
Stock in connection with the closing of the Company's initial public offering.
Pursuant to the Settlement Agreement, the Company has consented to the merger of
the Licensees and related parties. Following such merger, the Licensees and the
Company have agreed to enter into a new license pursuant to which the rights and
obligations of the parties will be clarified but, with respect to which, the
economic terms of the License Agreements will not be materially altered. The
Company and the Licensees have also executed mutual general releases, which
include, among other things, the release of claims previously made by the
Licensees. The new licenses will expire on December 31, 2025.
In addition, the provisions of a promissory note dated October 3, 1990
(which was later converted to Series A Convertible Preferred Stock and
subsequently automatically converted into Common Stock upon consummation of the
Company's initial public offering in December 1995) granted the holder of the
note certain rights to an agreement to be the Company's sole licensee for
distribution of the PAPNET(R) system in Canada. The promissory note provides
that such "licensee shall be entitled to terms which are at least as favorable
as those in any domestic United States of America licenses." An agreement has
not been negotiated. There can be no assurance that the terms of such agreement
when it is negotiated, or the activities of the licensee thereunder, will not
have a material adverse effect on the profitability of the Company's business in
Canada. Joseph Salamon, a director of the Company until June 20, 1996, is the
agent of the record holder of the rights to the Canadian license.
DEPENDENCE ON PATENTS AND PROPRIETARY TECHNOLOGY
The Company has depended and will continue to depend substantially on its
proprietary technology. The technology underlying the PAPNET(R) Testing System
is protected by five United States patents and similar corresponding foreign
patents granted to the Company. The Company also has filed several additional
patent applications as to certain other aspects of the Company's technology;
however, there can be no assurance that such applications will be granted.
There can be no assurance that the Company's issued patents or other patents
issued in the future will afford protection from material infringement or that
such patents will not be challenged. The Company also relies on trade secrets
and proprietary know-how, which it protects, in part, through confidentiality
agreements with employees, consultants and other parties. There can be no
assurance that these agreements will not be breached, that the Company would
have adequate remedies for any breach or that the Company's trade secrets will
not otherwise become known to, or independently developed by, competitors.
The medical device industry has been the subject of 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 alleged infringement by the Company of
proprietary rights of others. The Company has instituted such litigation
against NeoPath, a competitor of the Company (see "--Competition" and "--
Litigation"). An adverse determination in this or other such litigations could
limit the value of the Company's issued patents or result in invalidation of
those patents, subject the Company to significant liabilities to
5
<PAGE>
third parties, require the Company to seek licenses from third parties or
prevent the Company from manufacturing and selling its products, any of which
could have a material adverse effect on the Company's business, financial
condition and results of operations.
GOVERNMENT REGULATION
The Company's services, products and manufacturing activities are subject
to extensive and rigorous government regulation, including the provisions of the
Medical Device Amendments to the Federal Food, Drug and Cosmetic Act.
Commercial distribution in certain foreign countries is also subject to
government regulations. The process of obtaining required regulatory approvals
can be lengthy, expensive and uncertain. Moreover, regulatory approvals, if
granted, may include significant limitations on the indicated uses for which a
product may be marketed. The FDA actively enforces regulations prohibiting
marketing without compliance with the premarket approval provisions of products
and conducts periodic inspections to determine compliance with its Good
Manufacturing Practice regulations. Failure to comply with applicable
regulatory requirements can result in, among other things, fines, suspensions of
approvals, seizures or recalls of products, operating restrictions and criminal
prosecutions. Furthermore, changes in existing regulations or adoption of new
regulations could affect the timing of, or prevent the Company from obtaining,
future regulatory approvals. The effect of government regulation may be to
delay for a considerable period of time or to prevent the marketing and full
commercialization of future products or services that the Company may develop
and/or to impose costly requirements on the Company. There can also be no
assurance that additional regulations will not be adopted or current regulations
amended in such a manner as will materially adversely affect the Company.
LIMITED MARKETING AND SALES HISTORY
Until it received United States Food and Drug Administration ("FDA")
approval on November 8, 1995, the Company was prohibited from marketing the
PAPNET(R) Testing System in the United States. Although the Company has begun
marketing the PAPNET(R) Testing System, the Company is still in the process of
establishing commercial scale customer service, training and support
capabilities. The Company intends to market, sell, service and support
PAPNET(R) Testing System services through recruitment of its own direct sales
force and through cooperation with the existing sales personnel of client
clinical laboratories. There can be no assurance that the Company will be able
to recruit and retain skilled sales, marketing, service or support personnel or
establish satisfactory relationships with client laboratories, or that the
Company's marketing and sales efforts will be successful.
INTERNATIONAL SALES AND OPERATIONAL RISKS
The Company markets the PAPNET(R) Testing System to customers outside of
the United States. In addition, the Company manufactures its PAPNET(R) Scanning
Stations in Israel and operates Scanning Centers in Amsterdam and Hong Kong. A
number of risks are inherent in international transactions. International sales
and operations may be limited or disrupted by the regulatory approval process,
governmental controls, export license requirements, political instability, price
controls, trade restrictions, changes in tariffs or difficulties in staffing and
6
<PAGE>
managing international operations. Foreign regulatory agencies have
established, or may establish, product standards different from those in the
United States, and any inability to obtain foreign regulatory approvals on a
timely basis could have an adverse effect on the Company's international
business and its financial condition and results of operations. In addition,
the Company's business, financial condition and results of operations may be
adversely affected by limitations on its ability to repatriate funds, increases
in duty rates and difficulties in obtaining export licenses. Finally, certain
of the Company's operations are located in Hong Kong. Pursuant to the existing
treaty between the Government of the United Kingdom and the People's Republic of
China, Hong Kong will revert to and become part of China in July 1997. The
Company is uncertain as to the impact that such a change in government will have
on its business operations in Hong Kong. There can be no assurance that the
Company will be able to successfully commercialize the PAPNET(R) Testing System
or any future product in any foreign market.
FOREIGN EXCHANGE FLUCTUATIONS
The Company anticipates that international sales will continue to represent
a significant portion of its net sales as it executes its plan to establish
commercial use of the PAPNET(R) Testing System on a worldwide basis, including
in the United States. Neuromedical Systems, Inc., the United States parent
company, has provided a significant portion of the financing required for its
Netherlands and Hong Kong Scanning Centers through United States dollar-
denominated intercompany loans. The Company also maintains its PAPNET(R)
Testing System manufacturing facility in Israel. As a result of its
international operations and its current financing practices, the Company's
operating results are subject to the impact of fluctuations in exchange rates of
the currencies in which its foreign operations conduct business versus the
United States dollar. Future currency fluctuations, to the extent not
adequately hedged, could have an adverse effect on the Company's business,
financial condition and results of operations.
7
<PAGE>
LIMITED SLIDE PROCESSING AND MANUFACTURING HISTORY;
DEPENDENCE ON SOLE SOURCE SUPPLIERS
The Company has had limited experience with slide processing in commercial-
scale quantities and the manufacture and assembly of PAPNET(R) Scanning Stations
in the volumes that will be necessary for the Company to generate significant
revenues from the processing of slides on the PAPNET(R) Testing System. The
Company may encounter difficulties in scaling up its slide processing operations
or production or in hiring and training additional personnel to operate its
Scanning Centers or to manufacture its products. Future interruptions in supply
or other production problems could have a material adverse effect on the
Company's business, financial condition and results of operations. In addition,
the Company has qualified only single sources for certain essential components.
Interruptions in the supply of such components might result in production delays
and create the need for modifications of the design of the various components of
the PAPNET(R) Testing System, either of which could have a material adverse
effect on the Company's business, financial condition and results of operations.
IMPACT OF MEDICARE, MEDICAID AND OTHER THIRD-PARTY REIMBURSEMENT
In the United States, many Pap smears are currently paid for by the
patient, and the level of reimbursement by third-party payers that do provide
reimbursement varies considerably. Third-party payers (Medicare/Medicaid,
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 for PAPNET(R) testing provided by such payers or by not providing
any reimbursement at all. Restrictions on reimbursement may limit the price
which the Company can charge for its services or reduce the demand for PAPNET(R)
testing. In addition, if Medicare and Medicaid do not provide for reimbursement
of PAPNET(R) testing, or, if the level of such reimbursement is significantly
below the amount laboratories charge patients to perform PAPNET(R) testing, the
size of the potential market available to the Company may be reduced. There can
be no assurance that costs associated with PAPNET(R) testing will ever become
reimbursable or that the level of reimbursement to laboratories for PAPNET(R)
testing will achieve or be maintained at levels necessary to permit the Company
to generate substantial
8
<PAGE>
revenues. In the international market, reimbursement by private third-party
medical insurance providers, including governmental insurers and payers, varies
from country to country. In certain countries, the Company's ability to achieve
significant market penetration may depend upon the availability of third-party
or governmental reimbursement.
HEALTHCARE REFORM
Recent proposals before Congress have included plans to restructure the
delivery and financing of healthcare services in the United States. Such
proposals focus on the control and reduction of public and private spending on
healthcare, including Medicare and Medicaid, the reform of the methods of
payment for healthcare goods and services by both the public and private
sectors, and the provision of universal access to healthcare. The Company
cannot predict what form such legislation, if any, may take or the effect of
such legislation on its business. It is possible that legislation enacted by
Congress will contain provisions resulting in limitations which may adversely
affect the business, financial position and results of operations of the
Company. It is also possible that future legislation either could result in
modifications to the nation's public and private healthcare insurance systems,
which could affect reimbursement policies in a manner adverse to the Company, or
could encourage integration or reorganization of the healthcare delivery system
in a manner that could adversely affect the Company. The Company cannot predict
what other legislation, if any, relating to its business or to the healthcare
industry may be enacted, including legislation relating to third-party
reimbursement, or what effect any such legislation may have on its business,
financial position and results of operations.
FUTURE CAPITAL NEEDS AND UNCERTAINTY OF ADDITIONAL FINANCING
There can be no assurance that the Company will not be required to seek
additional equity or debt capital to finance its operations in the future. In
addition, there can be no assurance that any such financings, if needed, will be
available to the Company or that adequate funds for the Company's operations,
whether from the Company's revenues, financial markets, collaborative or other
arrangements with corporate partners or from other sources, will be available
when needed or on terms attractive to the Company. The inability to obtain
sufficient funds may require the Company to delay, scale back or eliminate some
or all of its research and product development programs, sales and marketing
efforts, manufacturing and slide processing operations, clinical studies and/or
regulatory activities or to license third parties to commercialize products or
technologies that the Company would otherwise seek to market and sell itself.
LITIGATION; POTENTIAL UNAVAILABILITY OF INSURANCE
The commercial screening of Pap smears has been characterized by
significant malpractice litigation. As a result, the Company faces a risk of
exposure to product liability, errors and omissions or other claims in the event
that the use of its PAPNET(R) Testing System or other future potential products
is alleged to have resulted in a false negative diagnosis. While PAPNET(R) is a
supplemental test and does not purport to diagnose any slide, there can be no
assurance that the Company will avoid significant liability. There also can be
no assurance that the Company will be able to obtain adequate insurance coverage
or that, if obtained, such
9
<PAGE>
coverage will continue to be available at an acceptable cost, if at all.
Consequently, such claims could have a material adverse effect on the business
or financial condition of the Company.
On July 15, 1996, the Company filed a lawsuit against NeoPath, a competitor
of the Company, in the United States District Court for the Southern District of
New York, seeking damages and injunctive relief for patent infringement, false
advertising, unfair competition, intentional interference with business
relations and damage to business reputation. In the lawsuit, the Company alleges
that NeoPath willfully misappropriated the Company's patented technology and
used such technology in NeoPath's AutoPap(R) System. The Company also alleges
that NeoPath falsely characterized and made misleading comparisons to consumers
and securities analysts of the AutoPap(R) System and the Company's PAPNET(R)
Testing System. NeoPath has denied all allegations and, in addition, it has
filed counter-claims against the Company seeking damages and injunctive relief
for false advertising and unfair competition. In the counter-claims, NeoPath
alleges that statements made by the Company characterizing the performance of
the PAPNET(R) Testing System, and its effectiveness relative to NeoPath's
AutoPap(R) System, as well as other statements, are false and misleading and
constitute misrepresentations. The Company believes that NeoPath's assertions
are without merit. Although the duration, costs and ultimate outcome of this
lawsuit are unknown, the Company expects that the costs of pursuing this lawsuit
will be significant during 1997.
On December 4, 1995, the Company was served with a Summons and Complaint in
an action entitled Herbst et al. v. Neuromedical Systems, Inc. et al., in the
Supreme Court of the State of New York. The plaintiffs in this suit allege,
among other things, that pursuant to written contracts, which they claim the
Company has breached, they were entitled to be issued warrants exercisable for
the purchase of approximately 128,000 shares of Common Stock at various prices.
They further allege that the Company and certain of its officers and directors
made fraudulent misrepresentations and took other allegedly improper actions
that diminished the value of the warrants they claim they are entitled to under
these contracts. On January 31, 1996, the plaintiffs served the Company with an
Amended Complaint alleging legal claims similar to those in the original Summons
and Complaint served on the Company, but adding one of the Company's former
directors as a defendant and specifying that the plaintiffs are seeking
compensatory damages from the Company and one of its officers and a former
director totaling $114 million and punitive damages totaling $175 million. On
February 23, 1996, the defendants moved to dismiss the Amended Complaint and on
November 27, 1996, the New York State Supreme Court issued an opinion dismissing
all of the plaintiff's claims that the Company and certain officers and
directors committed fraud and other improper actions that allegedly diminished
the value of the warrants plaintiffs claim they are entitled to receive. The
Court denied the Company's motion to dismiss plaintiffs' breach of contract
claim, and plaintiffs continue to seek $39 million in compensatory damages and
$75 million in punitive damages. The Company intends to continue to vigorously
defend this action. The Company believes that, in any event, the damages
claimed bear no relation to the harm alleged and believes an adverse judgment in
this case would not have a material adverse effect on the Company's operations,
financial position or cash flows.
10
<PAGE>
DILUTION; EFFECT OF OUTSTANDING OPTIONS AND WARRANTS
The Company has outstanding options and warrants to purchase Common Stock
at prices that may be below the per share price to purchasers of the Company's
Common Stock in the market. The exercise of such options and warrants may have
a dilutive effect on the purchaser's investment. As of February 28, 1997, the
Company had 30,897,792 issued and outstanding shares of Common Stock and
3,905,979 outstanding options and warrants exercisable into 3,905,979 additional
shares of Common Stock.
ANTI-TAKEOVER PROVISIONS; STOCKHOLDER RIGHTS PLAN
The Company's Amended and Restated Certificate of Incorporation (the
"Certificate") and By-Laws (the "By-Laws") contain provisions that may have the
effect of discouraging a third party from making an acquisition proposal for the
Company. The Certificate and By-Laws, among other things, (i) classify the
Board of Directors of the Company (the "Board") into three classes, with
directors of each class serving for a staggered three-year period, (ii) provide
that directors may be removed only for cause and only upon the affirmative vote
of at least 66-2/3% of the voting power of all the then outstanding shares of
stock entitled to vote, (iii) prohibit action by stockholders by written
consent, (iv) require advance notice of stockholder nominations and proposals
and (v) preclude stockholders from calling a special meeting of stockholders.
Such provisions would make the removal of incumbent directors more difficult and
time-consuming and may have the effect of discouraging a tender offer or other
takeover attempt not previously approved by the Board. The Board has the
authority to issue up to 10,000,000 shares of preferred stock in one or more
series and to fix the powers, preferences and rights of any such series without
stockholder approval. In addition, the Company has adopted a stockholder rights
plan. The stockholder rights plan, as well as the Certificate and By-Laws
provisions described above, could have the effect of discouraging unsolicited
acquisition proposals or making it more difficult for a third party to gain
control of the Company and could otherwise adversely affect the market price of
the Common Stock.
CONTROL BY EXISTING STOCKHOLDERS
As of February 28, 1997, officers and directors of the Company and
stockholders owning more than 5.0% of the Common Stock of the Company, together
with entities affiliated with them, beneficially owned approximately 55.7% of
the Common Stock of the Company. As of February 28, 1997, Goldman, Sachs & Co.,
and certain of its affiliates (including certain investment limited
partnerships), owned approximately 21.9 % of the Common Stock of the Company
(excluding shares held in managed accounts, shares acquired in the ordinary
course of business and shares issuable upon the exercise of warrants and options
to acquire Common Stock). In the event that certain entities affiliated with
Goldman, Sachs & Co. own in excess of 25% of the Common Stock of the Company
(but not including certain securities), Goldman, Sachs & Co. would be precluded
from making a market in the Common Stock. Officers and directors of the Company
and stockholders owning more than 5.0% of the Common Stock of the Company may be
able to control the election of all members of the Board and determine corporate
actions. Such concentration of ownership may have the effect of delaying,
deferring or preventing a change in control of the Company.
11
<PAGE>
SHARES ELIGIBLE FOR FUTURE SALE; REGISTRATION RIGHTS
Sales of substantial amounts of Common Stock in the public market could
have an adverse effect on the price of the Common Stock. As of February 28,
1997, the Company had outstanding 30,897,792 shares of Common Stock of which
22,694,619 shares of Common Stock were eligible for sale and not subject to
restriction. The remaining 8,203,173 shares of Common Stock, issued prior to
the IPO, are eligible for sale from time to time under Rule 144 ("Rule 144")
promulgated under the Securities Act of 1933, as amended (the "Securities Act").
The Securities and Exchange Commission enacted certain amendments to Rule 144
which become effective April 29, 1997 which will permit the resale of limited
amounts of restricted securities by any person after a one-year, rather than a
two-year holding period, and unlimited resales of restricted securities held by
non-affiliates of the Company after a holding period of two years, rather than
three years. Under such amendments, all of the Common Stock issued prior to the
IPO will become eligible for sale during 1997.
In addition, the Company has filed a registration statement under the
Securities Act, covering Common Stock issued pursuant to the Neuromedical
Systems, Inc. 1993 Stock Incentive Plan, as amended and restated October 25,
1995.
The Company may, and it may be obligated to, register 12,535,546 shares of
Common Stock for sale pursuant to registration rights which have been granted to
certain holders of the Company's securities. These registration rights could
prevent or limit the ability of the Company to sell shares for its own account,
could adversely affect the market price of the Common Stock and could require
the Company to incur significant expenses.
LIMITED PRIOR PUBLIC MARKET; LIQUIDITY; POSSIBLE VOLATILITY OF STOCK PRICE
The Common Stock is quoted on the Nasdaq National Market System, under the
symbol "NSIX." There can be no assurance that an active public market for the
Common Stock can be sustained. The market price of the Common Stock could
fluctuate significantly as a result of the Company's financial results,
regulatory approval filings, clinical studies, technological innovations or new
commercial products introduced by the Company or its competitors, developments
concerning patents or proprietary rights, trends in the healthcare industry or
in healthcare generally, litigation, the adoption of new laws or regulations or
new interpretations of existing laws or regulations and other factors. The
underwriters of the Company's IPO have informed the Company that, subject to
applicable laws and regulations, they intend to continue to make a market in the
Common Stock, however, they are not obligated to do so and any such market-
making may be discontinued at any time without notice. Moreover, because of the
affiliation of Goldman, Sachs & Co. with the Company, Goldman, Sachs & Co. is
required to deliver a current prospectus and otherwise comply with the
requirements of the Securities Act in connection with any secondary market sale
of the Common Stock, which may affect their ability to continue market-making
activities.
12
<PAGE>
DIVIDEND POLICY
The Company has not paid and does not anticipate paying any cash dividends
in the foreseeable future and intends to retain future earnings for the
development and expansion of its business. Any future determination to pay
dividends will be at the discretion of the Company's Board of Directors and
subject to certain limitations under the General Corporation Law of the State of
Delaware and will depend upon the Company's results of operations, financial
condition, other contractual restrictions and other factors deemed relevant by
the Board.
INVESTMENT COMPANY ACT CONSIDERATIONS
The Investment Company Act of 1940, as amended (the "1940 Act"), requires
the registration of, and imposes various substantive restrictions on, certain
companies that engage primarily, or propose to engage primarily, in the business
of investing, reinvesting or trading in securities, or that fail certain
statistical tests regarding the composition of assets and sources of income, and
are not primarily engaged in businesses other than investing, holding, owning or
trading securities. The Company believes that it is, and intends to remain,
primarily engaged in businesses other than investing, reinvesting, owning,
holding or trading in securities. The Company has temporarily invested the net
proceeds of the IPO, pending their use, in a manner so as to avoid becoming
subject to the registration requirements of the 1940 Act. Such investment may
result in the Company's obtaining lower yields on the funds invested than might
be available in the securities market generally. There can be, however, no
assurance that such investments and utilization can be maintained, or that any
other exemption would be available, so as to enable the Company to avoid the
registration requirements of the 1940 Act. If the Company were required to
register as an investment company under the 1940 Act, it would become subject to
substantial regulations with respect to its capital structure, management,
operations, transactions with affiliated persons (as defined in the 1940 Act)
and other matters. Application of the provisions of the 1940 Act would have a
material adverse effect on the Company.
13
