SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-KSB
Annual Report Pursuant to Section 13 or 15(d) of
The Securities Exchange Act of 1934
For the fiscal year ended September 30, 1998
Commission file number 0-23837
SURMODICS, INC.
(Name of Small Business Issuer in its Charter)
Minnesota 41-1356149
(State or Other Jurisdiction of (IRS Employer Identification Number)
Incorporation or Organization)
9924 West 74th Street
Eden Prairie, Minnesota 55344
(Address of Principal Executive Offices; Zip Code)
Issuer's telephone number Including Area Code: (612) 829-2700
Securities registered Under Section 12(b) of the Act: None
Securities registered Under Section 12(g) of the Act: Common Stock
Check whether the Issuer (1) filed all reports required to be filed by Section
13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter
period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days.
X Yes ____ No
Check if no disclosure of delinquent filers pursuant to Item 405 of Regulation
S-B is contained in this form, and no disclosure will be contained, to the best
of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-KSB or any amendment to
this Form 10-KSB. [ X ]
The issuer's revenues for the fiscal year ended September 30, 1998 were
$9,778,661.
The aggregate market value of the Issuer's Common Stock held by non-affiliates
(persons other than officers, directors or holders of more than 5% of the
outstanding stock) as of December 14, 1998, was approximately $65.6 million
(based on the closing sale price of the Issuer's Common Stock on such date).
Shares of Common Stock outstanding on December 14, 1998: 7,242,325
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's Annual Report to Shareholders for the fiscal year
ended September 30, 1998 are incorporated into Part II of this Form 10-KSB.
Portions of the Registrant's Proxy Statement for its 1999 Annual Meeting of
Shareholders are incorporated by reference into Part III of this Form 10-KSB.
Transitional Small Business Disclosure Format (check one): Yes No X
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PART I
ITEM 1. DESCRIPTION OF BUSINESS
General
SurModics, Inc. ("SurModics" or the "Company") is a leading provider of
surface modification solutions to the medical device industry. The Company's
primary focus is the commercialization of its patented PhotoLink process through
third-party licensing arrangements. PhotoLink is a versatile, easily applied,
light-activated coating technology that modifies medical device surfaces by
creating covalent bonds between those surfaces and a variety of chemical agents.
Through the PhotoLink process, these chemical agents can impart many performance
enhancing characteristics, such as lubricity, hemocompatibility, infection
resistance and drug delivery, onto the surface of a medical device without
materially changing the dimensions or physical properties of the device. The
Company believes that medical device manufacturers who utilize the Company's
technology are able to significantly improve the performance of their products
and, in many cases, differentiate their products in a highly competitive
marketplace.
The Company focuses on providing high value-added surface modification
solutions to a variety of medical device markets and product categories.
Examples of products in the market or under development that incorporate the
PhotoLink technology include interventional cardiology catheters, vascular
stents, interventional neurology catheters, guide wires and shunts, cardiac
rhythm management devices, and urological and gynecological devices. The surface
properties created by the PhotoLink technology have greatly reduced treatment
times in catheter-based vascular procedures and have shown the potential to
enhance the long-term performance of implantable devices by improving infection
resistance and promoting host cell attachment, growth and subsequent tissue
integration. The Company believes further opportunities exist to commercialize
its PhotoLink technology for other market applications, such as biomolecule
immobilization for use in the emerging field of DNA-based diagnostics.
The Company has commercialized its PhotoLink technology through
licensing arrangements with medical device manufacturers which apply the
PhotoLink coatings to their own products. The Company believes this approach
allows it to focus its resources on further development of its technology and
expansion of its licensing activities, while leveraging the established
manufacturing, sales and marketing capabilities of its licensees. Revenues from
these arrangements include initial license fees, minimum royalties and earned
royalties based on a percentage of licensees' product sales. In addition to
licensing its PhotoLink technology, the Company also licenses certain diagnostic
technology to Abbott Laboratories for use with rapid point-of-care diagnostic
tests, such as pregnancy and strep tests. The Company also manufactures and
sells the chemical reagents used in the PhotoLink process, and offers a line of
stabilization products used to extend the shelf-life of immunoassay diagnostic
tests.
The Company was organized as a Minnesota corporation in June 1979 and
changed its name from BSI Corporation to SurModics, Inc. in June 1997.
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Markets and Need for Surface Modification
Recent trends in healthcare toward improved patient outcomes and
reduced total costs have resulted in intense competition for the development of
medical devices that demonstrate superior product performance, reduced procedure
times, improved outcomes and overall cost effectiveness. Medical device
manufacturers have attempted to address these competitive pressures by
developing innovative medical devices manufactured from a wide variety of
synthetic materials, including many new, expensive and exotic materials. In an
effort to further differentiate their products through improved product
performance, a growing number of medical device manufacturers are turning to the
emerging field of surface modification technology. Surface modification
technology enables device manufacturers to provide medical devices with desired
surface characteristics including improved lubricity, hemocompatability and
infection resistance, as well as the ability to deliver drugs and promote cell
growth and tissue integration.
Although it is an emerging field, surface modification technology has
been used to improve medical devices in many different industry segments. The
table below identifies several of these market segments and the surface
properties the Company believes are desired by each segment.
Market Segment Served Desired Surface Property and
Examples of Applications
Interventional cardiology Lubricity: catheters, guide wires
and vascular access Hemocompatability: vascular stents, catheters,
guide wires
Therapeutic drug delivery and release: vascular
stents, catheters
Infection resistance: catheters, implantable
ports
Cardiac rhythm management Lubricity: pacemaker and defibrillator leads,
electrophysiology devices
Hemocompatability: electrophysiology devices
Cardiothoracic surgery Infection resistance: heart valves
Hemocompatability: minimally invasive bypass
devices, vascular grafts, ventricular assist
devices
Cell growth and tissue integration: heart
valves, vascular grafts
Interventional neurology Lubricity: catheters, guide wires
and neurosurgery Infection resistance: catheters, shunts
Urology and gynecology Lubricity: urinary catheters, incontinence
devices, ureteral stents, fertility devices
Infection resistance: urinary catheters,
incontinence devices, ureteral stents,
fertility devices, penile implants
Orthopedics Cell growth and tissue integration: bone
regeneration
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In addition to the above-identified market segments, the Company
believes that one of the next areas of growth for surface modification
technology will be the diagnostic test market. Diagnostic tests utilizing
biomolecules, such as DNA, can be used to screen for new drugs, to sequence
unknown portions of the human genome, or to search for signs of viruses. The
Company believes manufacturers of these diagnostic tests may benefit from
surface modification technology to provide biomolecule immobilization and
wettability properties.
The PhotoLink Solution
PhotoLink is a versatile, easily applied, light-activated coating
technology that modifies medical device surfaces by creating covalent bonds
between those surfaces and a variety of chemical agents. The PhotoLink solution
to surface modification involves the utilization of proprietary, light sensitive
(photochemical) reagents. These reagents can consist of advanced polymers or
active biomolecules having desired surface characteristics and an attached
light-reactive chemical compound (photogroup). When the reagent is exposed to a
direct light source, typically ultraviolet, a photochemical reaction creates a
covalent bond between the photogroup and the surface of the medical device,
thereby imparting the desired property to the surface. A covalent bond is a very
strong chemical bond which results from the sharing of electrons between carbon
molecules of the substrate and the applied coating.
SurModics' proprietary PhotoLink reagents work on most polymer-based
(e.g., plastic) substrates, biological substrates (latex rubber, cellulose,
tissue and natural fibers), and metal and glass substrates. Metal and glass
substrates generally require pretreating with polymers to make a carbon-molecule
available for bonding prior to the application of the PhotoLink reagents. The
reagents are easily applied to a clean material surface by dipping, spraying,
roll coating, ink jetting or brushing. SurModics continues to develop
proprietary photochemical reagents providing new product features while
expanding the number and type of substrates on which the reagents can be
applied.
The Company believes that its proprietary PhotoLink process provides
its licensees with a number of benefits.
o Flexibility. PhotoLink coatings can be applied to many different kinds
of surfaces and can immobilize a variety of chemical, pharmaceutical
and biological agents, which allows licensees to be innovative in the
design of their products without significantly changing the dimensions
or physical properties of the devise.
o Variety of Surface Properties. The PhotoLink process can be tailored to
provide SurModics' licensees with the ability to improve the
performance of their devices by choosing the specific coating
properties desired for particular applications. The PhotoLink
technology also provides the medical device manufacturer with the
ability to combine multiple surface-enhancing characteristics on the
same device.
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o Ease of Use. The PhotoLink coating process is a relatively simple
process that does not require expensive special equipment or the use of
hazardous materials and does not subject the coated products to harsh
chemical, pressure or temperature conditions. Further, PhotoLink
coatings are compatible with all the generally accepted sterilization
processes, so the surface attributes are not lost when the medical
device is sterilized prior to usage.
Surface Properties
SurModics' PhotoLink process has been used by manufacturers of
pacemaker leads, drug infusion catheters, laser and balloon angioplasty
catheters, urinary drainage catheters, vascular closure devices, wound drains,
guide wires, angiography catheters, ureteral stents and hydrocephalic shunts,
among other devices. The PhotoLink process can be used to provide medical device
manufacturers with the following surface properties to improve product
performance:
o Lubricity. Low friction or lubricious coatings reduce the force and
time required for insertion, navigation and removal of devices in
vascular, neurological and urogenital applications. Lubricity also
reduces tissue irritation and damage caused by products such as
catheters, guide wires and endoscopy devices. Based on Company and
licensee testing, when compared to uncoated surfaces, the PhotoLink
process has reduced the friction on surfaces by as much as 85% to 95%,
depending on the substrate being coated.
o Hemocompatibility. Hemocompatible coatings help reduce adverse
reactions that may be created when a device is inserted into the body
and comes in contact with blood. Heparin has been used for decades as
an injectable drug to reduce blood clotting in patients. SurModics can
immobilize heparin on the surface of blood-contacting medical devices
thereby inhibiting blood clotting on the device surface, minimizing
patient risk and enhancing the performance of the device. PhotoLink
heparin coatings have been shown in Company and licensee testing to
reduce blood clotting by greater than 90% compared to uncoated
surfaces.
o Infection Resistance. Antimicrobial coatings are advantageous for most
implantable medical devices where risk of infection is a concern.
PhotoLink technology can apply passive coatings which significantly
reduce bacterial adhesion to the device or active coatings
incorporating antimicrobial agents which kill bacteria around the
device. Testing by the Company has demonstrated that a PhotoLink
coating can reduce the adherence of microorganisms to biomaterial
surfaces by 97% to over 99% depending on the base material of the
device. In addition, when compared to uncoated products, the PhotoLink
process has been shown to increase the uptake of antimicrobial agents
applied to the device just prior to implantation and prolong the
release of these agents.
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o Drug Delivery. PhotoLink technology can be used to create reservoirs to
entrap drugs on the surface of medical devices. These drugs can then be
released from the surface on a controlled basis by tailoring the
polymers, by adjusting the extent of crosslinking, or by using a
barrier coating to control diffusion. For example, SurModics has
developed a PhotoLink coating that would allow a coronary stent
manufacturer to incorporate a drug onto the stent directed at reducing
the incidence of restenosis (the re-narrowing of the artery).
o Wettability. PhotoLink hydrophilic coatings have been shown in tests by
the Company and its licensees to accelerate liquid flow rates on
normally hydrophobic (water repelling) materials by 75%. Rapid
point-of-care diagnostic tests, such as home monitoring or physician
monitoring of glucose levels in diabetics, are currently done by
pricking a patient's finger and carefully placing a drop of blood onto
a polymer strip which is then inserted into a blood glucose reader. The
Company believes that the time it takes for the blood to flow up the
strip to provide the patient with a readout can be dramatically reduced
and the consistency can be greatly improved with PhotoLink technology.
o Cell Growth, Tissue Integration and Other Tissue Engineering. Studies
have shown that attachment of extracellular matrix proteins and
peptides onto surfaces of implantable medical devices improves host
cell attachment, growth and subsequent tissue integration. PhotoLink
technology has been used to coat biomedical devices with photoreactive
collagens and other proteins upon which cells normally grow within the
body. Company studies have shown that biomedical devices (such as
vascular grafts and ocular implants) coated with such proteins, have
improved attachment, growth of cells and acceptance by surrounding
tissues. In addition, the Company is also using its PhotoLink
technology to produce three-dimensional scaffolds to promote bone
regeneration.
o Biomolecule Immobilization. During a DNA gene analysis, typically
hundreds of different probes need to be placed in a pattern on a
surface, called a DNA array. These arrays can be used by the
pharmaceutical industry to screen for new drugs, by genome mappers to
sequence unknown portions of the human genome, or by diagnostic
companies to search a patient sample for disease causing bacteria or
viruses. However, DNA does not readily adhere to most surfaces that are
important for DNA assays. The Company has demonstrated a versatile
method for the immobilization of DNA on various surfaces.
Current Licensing Arrangements
The Company has commercialized its PhotoLink technology through
licensing arrangements with medical device manufacturers who apply the PhotoLink
coatings to their own products in their own facility. The Company believes this
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approach allows it to focus its resources on further developing its technology
and expanding its licensing activities, while leveraging the established
manufacturing, sales and marketing capabilities of its licensees for the
marketing of the specific medical device utilizing the PhotoLink technology. The
Company's licensing agreements are designed to allow manufacturers to
incorporate the PhotoLink process into their own manufacturing processes without
the need to send product outside their facility.
The licensing process begins with the medical device manufacturer
specifying the surface characteristics it desires. Because each surface is
unique, the Company routinely conducts a feasibility study at no charge to the
customer to qualify each new potential product application. Once the feasibility
has been proven, the customer typically funds further development by SurModics
to optimize the coating formulation to meet the customer's technical needs. A
license agreement is then executed granting the licensee the rights to use the
technology. SurModics' technical personnel are then available to provide
services in the transfer of the PhotoLink technology into the licensee's
manufacturing process. Such services can include further coating optimization,
process control and trouble shooting which are billable to the licensee. The
Company also manufactures and sells the chemical reagents used by all licensees
in the PhotoLink process, thus creating another source of revenue.
The term of a license agreement is generally for a period of 15 years
or the life of SurModics' patents, whichever is longer, although an agreement
may be terminated for any reason upon prior written notice, typically required
at least 90 days before termination. The worldwide license can be either
exclusive or nonexclusive for a particular medical device, but over 75% of the
Company's licensed applications are nonexclusive. SurModics requires the payment
of a non-refundable license fee which has historically ranged from $25,000 to
$750,000 and quarterly "earned" royalties of 2% to 6% on the sales of products
incorporating SurModics' technology. The amount of license fees and the royalty
rate are based on whether the arrangement is exclusive or nonexclusive, the
perceived value of the PhotoLink application to the device and the size of the
potential market. Certain nonrefundable license and research and development
fees are recoverable by the licensees as offsets against a percentage of future
earned royalties. Most of SurModics' agreements also incorporate a minimum
royalty to be paid by the licensee while the medical devices are developed,
tested and commercialized. In most cases, payment of these minimum royalties
will not commence until several months after the execution of an agreement for a
particular application.
Other Products
Stabilization Products
Although the primary focus of the Company is the development and
marketing of its PhotoLink technology, the Company also develops and markets
stabilization products for use by manufacturers of immunoassay diagnostic tests.
SurModics' StabilCoat and StabilZyme Stabilizers are designed to maintain the
activity of biological components of the immunoassays, resulting in a longer
shelf-life. These products offer SurModics' customers the benefit of product
differentiation and improvement while providing the ultimate end users the
benefit of a faster test with fewer steps and fewer errors. In fiscal 1998,
SurModics generated $2.0 million of revenue from its stabilization products.
<PAGE>
Diagnostic Formats
The Company also licenses a format for in vitro diagnostic tests
developed during the early years of the Company. This format has found broad
application in the expanding area of rapid point-of-care diagnostic testing,
such as pregnancy and strep tests, and generated $2.6 million of royalty revenue
for the Company in fiscal 1998 pursuant to a license agreement with Abbott
Laboratories. Although this revenue is expected to grow in the future with the
increased sales of licensed products, limited additional SurModics-funded
research and development is being undertaken in this area.
Industrial Applications
While it is not the Company's primary focus, the Company occasionally
pursues industrial applications for its PhotoLink technology. The Company only
pursues those applications that are perceived to be high value applications in a
market that is not considered to be price sensitive. To date, revenue associated
with industrial applications has been immaterial and is not expected to be
significant in the foreseeable future.
Research and Development
SurModics' research and development department supports the sales and
marketing staff in performing feasibility studies, providing technical
assistance to potential licensees, optimizing the coating methodologies for
specific licensee applications, assisting in training licensees and integrating
the Company's technology and know-how into licensee manufacturing processes. In
addition, the research and development department works to enhance and expand
the PhotoLink technology through the development of new reagents and new
applications.
As medical devices become more sophisticated and complex, the Company
believes the need for optimized surface properties will grow. The Company
intends to continue its development efforts to expand its PhotoLink technology
to provide additional optimized surface properties to meet these needs. The
Company's technical strategy is to target selected coating characteristics for
further development, in order to facilitate and shorten the license cycle. The
Company has begun to perform research into applications for future products both
on its own and in conjunction with some of its licensees. Some of the research
and development projects currently being worked on include coatings designed to
improve the characteristics of long-term implants, site-specific drug release,
orthopedic repair materials and devices, long-term blood compatibility and DNA
immobilization methods. In addition to expanding the number of medical
applications that may use PhotoLink technology, the Company intends to broaden
the spectrum of surfaces on which reagents can be applied, improve the coating
process for metals and glass, develop a process for coating the interior
diameter of medical devices, expand the portfolio of PhotoLink reagents, and
develop additional proprietary products in which PhotoLink reagents serve as the
end product.
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The technical staff of the Company consists of 59 employees, including
ten with Ph.D. degrees, seven with Masters degrees and 36 with Bachelor degrees,
with expertise in chemistry, biomedical engineering, biology, microbiology, cell
biology and biochemistry. The technical staff is organized into five areas of
specialization: hydrophilicity, microbiology, hemocompatibility, biochemistry
and tissue engineering. In addition, a chemistry group supports the synthesis of
new reagents needed by the other five groups.
In fiscal 1997 and 1998, the Company's research and development
expenses were $3.6 million and $4.5 million, respectively. The Company's
research and development efforts are often funded by commercial licensees and
government agencies. Such research and development revenues were $2.0 million in
both years.
Since its founding, the Company has actively participated in the
federal government's Small Business Innovative Research ("SBIR") program to fund
development efforts. Since 1979, 140 research contracts resulting in revenues of
over $24.0 million have been awarded to SurModics, primarily under the SBIR
program. Grant proposals are generally directed toward the commercial strategies
of the Company. The Company retains commercial rights to discoveries and
technologies resulting from the research and development efforts funded by these
grants. Where possible, licensees' products or substrates are used when
performing research under the grant; thus the results are often directly
applicable to SurModics' licensees. Grant funding has also allowed SurModics to
maintain a larger and more technologically diverse employee base than would
otherwise be possible.
Patents and Proprietary Rights
The Company has taken steps intended to protect certain PhotoLink
related inventions through a series of patents covering a variety of coating
reagents and formulations, as well as particular medical device applications,
based on or employing the Company's proprietary photoreactive chemistry. The
patents related to the PhotoLink technology include 16 issued U.S. patents, ten
pending U.S. patent applications, ten issued foreign patents, and 40 pending
foreign patent applications. The Company generally files international patent
applications in parallel with its U.S. applications. The Company generally files
national or regional applications in Australia, Canada, Europe, Japan, and
Mexico. In addition to the patents related to the PhotoLink technology,
SurModics has five issued U.S. patents, two pending U.S. patent applications, 13
issued foreign patents and ten pending foreign patent applications related to
its diagnostic technology. There can be no assurance that any of the pending
patent applications will be allowed.
The Company also relies heavily upon trade secrets and unpatented
proprietary technology. The Company seeks to maintain the confidentiality of
such information by requiring employees, consultants and other parties to sign
confidentiality agreements and by limiting access by parties outside the Company
to such information. There can be no assurance, however, that these measures
will prevent the unauthorized disclosure or use of this information or that
others will not be able to independently develop such information. Additionally,
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there can be no assurance that any agreements regarding confidentiality and
non-disclosure will not be breached, or, in the event of any breach, that
adequate remedies would be available to the Company.
Marketing and Sales
The Company markets its PhotoLink technology throughout the world using
a direct sales force consisting of four licensing managers who focus on specific
markets such as cardiology devices, diagnostic products and urology products.
This specialization fosters an in-depth knowledge of the issues faced by
SurModics' licensees within these markets such as technology changes,
biomaterial changes and the regulatory environment.
Because the sales cycle can take several months from feasibility
demonstration to the execution of a license agreement, the Company focuses its
sales efforts on potential licensees with established market positions rather
than those with only development stage products which may never come to market.
Generally, the PhotoLink technology is licensed to medical device manufacturers
for use on specific products. This strategy enables the Company to license the
PhotoLink technology to multiple licensees in the same market. SurModics also
targets selling new applications to existing licensees. The Company believes the
sales cycle is much faster in these situations because the licensee is already
familiar with the technology and the general terms of the license have already
been negotiated.
As part of its marketing strategy, the Company publishes technical
literature on each surface capability of the PhotoLink technology (i.e.,
lubricity, hemocompatibility, etc.). In addition, the Company participates at
major trade shows and technical meetings, advertises in trade journals and
through its website, and conducts direct mailings to appropriate target markets.
The Company also offers ongoing customer service and technical support
throughout a licensee's relationship with SurModics. This service and support
includes a coating feasibility study at no charge to the licensee as well as
services in connection with the transfer of the technology to the licensee,
which can include billable services such as further coating optimization,
process control and trouble shooting. SurModics also generally assists the
licensee at no charge with FDA submissions for coated product approval.
Competition
Competition in the medical device industry has resulted in an increase
in competition in the surface modification market. The Company's PhotoLink
technology competes with technologies developed by Carmeda (a division of Norsk
Hydro, Inc.), Specialty Coatings Systems, Spire Corporation and STS Biopolymers
Inc., among others. In addition, many medical device manufacturers have
developed or are engaged in efforts to develop surface modification technologies
for use on their own products. Most competitors marketing surface modification
to the outside marketplace are divisions of organizations with businesses in
addition to surface modification. Overall, the Company believes the worldwide
market is very fragmented with no competitor marketing to third parties having
more than a 10% market share. Many of the Company's existing and potential
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competitors (including medical device manufacturers pursuing coating solutions
through their own research and development efforts) have substantially greater
financial, technical and marketing resources than the Company.
SurModics attempts to differentiate itself from its competition by
providing what it believes is a high value-added solution to surface
modification. The Company believes that the primary factors customers consider
in choosing a particular surface modification technology are performance, ease
of manufacturing, ability to produce multiple properties from a single process,
compliance with manufacturing regulations, customer service and pricing. The
Company believes that its PhotoLink process competes favorably with respect to
these factors, enabling it to charge a premium price. The Company believes that
the cost and time required to obtain the necessary regulatory approvals
significantly reduces the likelihood of a manufacturer changing the coating
process it uses once a device has been approved for marketing.
Because a significant portion of the Company's revenue is dependent on
the receipt of royalties based on sales of medical devices incorporating
PhotoLink coatings, the Company is also affected by competition within the
markets for such devices. The Company believes that the intense competition
within the medical device markets creates opportunities for the Company's
coating technology as medical device manufacturers seek to differentiate their
products through new enhancements or to remain competitive with enhancements
offered by other manufacturers. Because the Company seeks to license its
technology on a non-exclusive basis, the Company may further benefit from
competition within the medical device markets by offering its PhotoLink
technology to multiple competing manufacturers of a device. However, competition
in the medical device markets could also have an adverse effect on the Company.
While the Company seeks to license its products to established manufacturers, in
certain cases the Company's licensees may compete directly with larger, dominant
manufacturers with extensive product lines and greater sales, marketing and
distribution capabilities. The Company also is unable to control other factors
that may impact commercialization of PhotoLink-coated devices, such as the
marketing and sales efforts of its licensees or competitive pricing pressures
within the particular device market. There can be no assurance that products
coated with the PhotoLink technology will be successfully commercialized by the
Company's licensees or that such licensees will otherwise be able to effectively
compete.
The primary competition for SurModics' stabilization products is its
customers' internally developed formulations. The consolidation of the
diagnostic industry increases the availability of internally developed
stabilizers to the market. There are several direct competitors that have
recently emerged, of which Pierce Medical Products, Inc. and Medix, Inc. are the
two largest. The Company believes that quick market penetration is the best
strategy for addressing these threats. As in the coating market, the Company
also believes that once its stabilization products are accepted in an
FDA-approved diagnostic test, the likelihood of change is reduced because of the
cost and time required to qualify a new component. SurModics' marketing strategy
for its stabilization products is to develop a strong market presence by
offering superior product performance and technical service.
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Manufacturing
In accordance with its licensing strategy, the Company does not perform
the actual coating of its licensees' medical devices, nor does it manufacture
any of these devices. The Company has, however, adopted a strategy of developing
and manufacturing the reagents itself, allowing it to maintain the quality of
the reagents and their proprietary nature, while providing an additional source
of revenue. PhotoLink reagents are specialty photoreactive chemicals that are
prepared using a proprietary formula in small batch processes (as contrasted
with commodity chemicals prepared by large continuous methods). Generally, all
PhotoLink reagents share a similar production process: a water soluble polymer
is synthesized in a glass reactor; reactive photochemical groups are attached to
the polymer; the solution is purified and freeze-dried, thus removing the water
and creating a solid; and the PhotoLink reagents are packaged in standard
quantities in light- and moisture-proof packaging. The reagents are sold dry,
requiring the licensee, in most cases, to simply add water or a water and
isopropyl alcohol mix before application. The Company has developed proprietary
testing and quality assurance standards for manufacturing the reagents and does
not disclose the reagent formulas or manufacturing methods. Although licensees
may purchase the requisite chemical reagents from any source, all have elected
to purchase them from the Company.
The Company also manufactures its stabilization products. These
products are a group of sterile-filtered liquids that generally share a
three-step production process. A standard recipe of chemicals is mixed in high
purity water, these liquids are sterile-filtered into specific container sizes
under aseptic conditions, and the resultant finished goods are packaged and
labeled.
The Company maintains multiple sources of supply for the key raw
materials used to manufacture reagents and stabilization products. The Company
does, however, purchase some raw materials from single sources, but it believes
that additional sources of supply are readily available.
Although not required to follow Good Manufacturing Practice quality
procedures, SurModics does follow such procedures in part to respond to requests
of licensees to establish compliance with their criteria. The Company has not
yet sought ISO 9001 certification but may do so in the future.
Government Regulation
Although PhotoLink technology itself is not directly regulated by the
FDA, the medical devices incorporating this technology are subject to FDA
regulation. The burden of demonstrating safety and efficacy of such medical
devices, the ultimate criteria applied by the FDA, rests with the Company's
licensees (the medical device manufacturers). Medical products incorporating the
PhotoLink technology may generally be marketed only after 510(k) or PMA
applications have been submitted and approved by the FDA, which process can take
anywhere from six months for a 510(k) application, to two or three years for a
PMA application. These applications are prepared by the manufacturer and contain
results of extensive laboratory toxicity, mutagenicity and clinical evaluations
on animals and humans conducted by the manufacturer.
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The Company maintains confidential Device Master Files at the FDA
regarding the nature, chemical structure and biocompatibility of the PhotoLink
reagents. Although the Company's licensees do not have access to these files,
the licensees may, with the permission of the Company, reference these files in
any medical device submission to the FDA. This process allows the FDA to
understand in confidence the details of the PhotoLink technology without the
Company having to share this highly confidential information with its licensees.
Recent U.S. legislation allows device manufacturers, prior to obtaining
FDA approval to market a medical device in the U.S., to manufacture such medical
device in the U.S. and export it for sale in international markets, which could
allow SurModics to realize earned royalties sooner. However, sales of medical
devices outside the U.S. are subject to international requirements that vary
from country to country. The time required to obtain approval for sale
internationally may be longer or shorter than that required by the FDA.
Employees
As of December 1, 1998, SurModics had 93 full-time and 5 part-time
employees of whom 58 were engaged in development or manufacturing positions,
with the remainder in marketing, quality or administrative positions. Of
SurModics' employees, 9 hold Ph.D. degrees and 14 hold Masters degrees. The
Company is not a party to any collective bargaining agreements and believes that
its employee relations are good.
Management believes that the future success of the Company will depend
in part on its ability to attract and retain qualified technical, management and
marketing personnel. Such experienced personnel are in high demand, and the
Company must compete for their services with other firms which may be able to
offer more favorable benefits.
ITEM 2. DESCRIPTION OF PROPERTY
SurModics leases approximately 35,000 square feet of office/warehouse
space in Eden Prairie, Minnesota under a lease that expires at the end of
calendar year 1999. SurModics has an option to extend this lease through the end
of 2001. The lease commitment for fiscal 1998 is approximately $210,000. Of the
total leased space, approximately 15,000 square feet is office space, 13,000
square feet is laboratory space and 7,000 square feet is manufacturing space.
Approximately 6,000 square feet of the manufacturing space is a HEPA-filtered,
highly controlled environment, but not certified as a "clean room" under FDA
standards. The Company believes that projected capacity of the manufacturing
area is adequate to service the needs of its licensees for the foreseeable
future.
ITEM 3. LEGAL PROCEEDINGS
The Company is not a party to nor is any of its property subject to any
material pending legal proceedings.
<PAGE>
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders
during the fourth quarter of fiscal 1998.
PART II
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
(a) Use of Proceeds for the period ending September 30, 1998.
(1) Effective Date: March 3, 1998
SEC File Number: 333-43217
(2) Offering Date: March 3, 1998
(4)(i) The offering has terminated; all securities registered were sold.
(4)(ii) Managing Underwriter: John G. Kinnard and Company,
Incorporated
(4)(iii) Title of Securities: Common Stock
(4)(iv) Amount Registered: 2,300,000
Aggregate Offering Price: $17,250,000
Amount Sold: 2,300,000
Aggregate Offering Price Sold: $17,250,000
(4)(v) Underwriting Discounts and Commissions $ 1,293,750
Other Expenses, $435,148; Total Expenses $ 1,728,898
All the above items represented direct or indirect payments to others.
(4)(vi) Net Offering Proceeds $15,521,102
(4)(vii) Use of Net Offering Proceeds:
Research and development $ 151,077
Sales and marketing $ 238,204
Equipment upgrades $ 391,992
Patent protection $ 0
Working capital and general corporate
purposes $ 268,131
Money market funds $14,471,698
All the above items represented direct or indirect payments to others.
(b) The information required by Item 5 relating to the Company's Common
Stock and other shareholder matters is incorporated herein by reference to the
section entitled "Stock Listing and Price History" which appears in the
Company's 1998 Annual Report to Shareholders.
<PAGE>
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATIONS
The Section entitled "Management's Discussion and Analysis of Financial
Condition and Results of Operations" in the 1998 Annual Report to Shareholders
is incorporated herein by reference.
ITEM 7. FINANCIAL STATEMENTS
The balance sheets as of September 30, 1998 and 1997 and the statements
of operations, stockholders' equity and cash flows for each of the three years
in the period ended September 30, 1998 together with the Report of Independent
Public Accountants contained on pages 13 through 22 of the Company's Annual
Report to Shareholders for the year ended September 30, 1998 are incorporated
herein by reference.
ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
PART III
ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;
COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT
The names, ages and positions of the Company's executive officers are
as follows:
Name Age Position
- ---- --- --------
Dale R. Olseth .............. 68 Chairman and Chief Executive Officer
James C. Powell ............. 49 President and Chief Operating Officer
Stephen C. Hathaway ......... 43 Vice President and Chief Financial Officer
Patrick E. Guire, Ph.D. ..... 62 Senior Vice President of Research and
Chief Scientific Officer
Andrew B. Summerville ....... 53 Vice President of Sales and Marketing
Walter H. Diers, Jr. ........ 47 Vice President of Corporate Development
Marie J. Versen ............. 37 Vice President of Quality Management and
Regulatory Compliance
<PAGE>
Dale R. Olseth joined the Company in 1986 as its President, Chief
Executive Officer and a director of the Company and has served as Chairman of
the Board since 1988. Mr. Olseth also serves on the Board of Directors of The
Toro Company and Graco, Inc. He served as Chairman or President and Chief
Executive Officer of Medtronic, Inc. from 1976 to 1986. From 1971 to 1976, Mr.
Olseth served as President and Chief Executive Officer of Tonka Corporation. Mr.
Olseth received a B.B.A. degree from the University of Minnesota in 1952 and an
M.B.A. degree from Dartmouth College in 1956.
James C. Powell joined the Company in 1987. He became Vice President of
Technical Operations in 1992 and was elected President and Chief Operating
Officer in 1998. He was employed at Precision-Cosmet Company, Inc., a
manufacturer of contact and intraocular lenses, from 1978 until he joined
SurModics. Mr. Powell received a B.S. degree in wood sciences from Texas A&M
University in 1972 and an M.S. degree in polymer science in 1975 from the
University of Washington.
Stephen C. Hathaway joined the Company as its Vice President and Chief
Financial Officer in September 1996. Prior to joining SurModics, he served as
Director of Finance for Ceridian Employer Services, Ceridian Corporation from
1995 to 1996. Prior to that, Mr. Hathaway was Vice President - Finance &
Operations for Wilson Learning Corporation from 1988 to 1995. He also spent ten
years with Arthur Andersen LLP. Mr. Hathaway received a B.S. degree in
accounting in 1977 from Miami University and became a Certified Public
Accountant in 1980.
Patrick E. Guire, Ph.D. is a co-founder of the Company and has served
as Senior Vice President of Research and Chief Scientific Officer and a director
since 1980. Dr. Guire is responsible for the research affairs of the Company.
Prior to founding SurModics, Dr. Guire was employed by Kallestad Laboratories,
Inc. as a senior scientist from 1978 to 1979 and was a researcher at the Midwest
Research Institute, Inc. in Kansas City, Missouri from 1972 to 1978. He received
a B.S. degree in Chemistry from the University of Arkansas, Fayetteville in 1958
and a Ph.D. in biochemistry from the University of Illinois in 1963.
Andrew B. Summerville joined the Company in 1994, and in 1995 became
its Vice President of Marketing. He held various sales and marketing positions
with Graco, Inc. from 1986 until joining SurModics. Prior to that, Mr.
Summerville held similar positions with 3M Company. Mr. Summerville received a
B.A. degree in applied science and a B.S. degree in material science from Lehigh
University in 1968 and an M.B.A. degree from Dartmouth College in 1970.
Walter H. Diers, Jr. joined the Company in 1988 and currently serves as
Vice President of Corporate Development. He served as a consultant to several
small, high technology companies from 1984 until he joined SurModics. Prior to
that, he was the Controller of the Laserdyne division of Data Card Corporation.
Mr. Diers received a B.S. degree in economics and a B.S. degree in business in
1977 and an M.B.A. degree in finance in 1979 from the University of Minnesota.
<PAGE>
Marie J. Versen joined the Company in 1987, and in 1996 became its Vice
President of Quality Management and Regulatory Compliance. She was previously
employed at Precision-Cosmet Company, Inc. from 1983 to 1986. Ms. Versen
received a B.S. degree in chemical engineering from the University of Minnesota
in 1983.
The executive officers of the Company are elected by and serve at the
discretion of the Board of Directors.
The information required by Item 9 relating to directors and compliance
with Section 16(a) is incorporated herein by reference to the sections entitled
"Election of Directors" and "Section 16(a) Beneficial Ownership Reporting
Compliance" which appear in the Company's definitive proxy statement for its
1999 Annual Meeting of Shareholders.
ITEM 10. EXECUTIVE COMPENSATION
The information required by Item 10 is incorporated herein by reference
to the section entitled "Executive Compensation" which appears in the Company's
definitive Proxy Statement for its 1999 Annual Meeting of Shareholders.
ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by Item 11 is incorporated herein by reference
to the section entitled "Shareholdings of Principal Shareholders and Management"
which appears in the Company's definitive Proxy Statement for its 1999 Annual
Meeting of Shareholders.
ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by Item 12 is incorporated herein by reference
to the section entitled "Certain Transactions" in the Company's definitive Proxy
Statement for its 1999 Annual Meeting of Shareholders.
ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits. See "Exhibit Index" on the page following signatures.
(b) Reports on Form 8-K. No reports on Form 8-K were filed during the
fourth quarter ended September 30, 1998.
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 of the Securities Exchange
Act of 1934, the Registrant has caused this Report to be signed on its behalf by
the undersigned, thereunto duly authorized.
SURMODICS, INC.
("Registrant")
Dated: December 22, 1998 By: /s/ Dale R. Olseth
Dale R. Olseth
Chairman and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934,
this Report has been signed by the following persons on behalf of the
Registrant, in the capacities, and on the dates, indicated.
(Power of Attorney)
Each person whose signature appears below constitutes and appoints DALE
R. OLSETH and STEPHEN C. HATHAWAY as his true and lawful attorneys-in-fact and
agents, each acting alone, with full power of substitution and resubstitution,
for him and in his name, place and stead, in any and all capacities, to sign any
or all amendments to this Annual Report on Form 10-KSB and to file the same,
with all exhibits thereto, and other documents in connection therewith, with the
Securities and Exchange Commission, granting unto said attorneys-in-fact and
agents, each acting alone, 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 to all intents and purposes as he might or could do in
person, hereby ratifying and confirming all said attorneys-in-fact and agents,
each acting alone, or his substitute or substitutes, may lawfully do or cause to
be done by virtue thereof.
<TABLE>
<CAPTION>
Signature Title Date
<S> <C> <C>
Chairman, Chief Executive Officer December 22, 1998
/s/ Dale R. Olseth and Director (Chief Executive
Dale R. Olseth Officer)
Vice President and Chief Financial December 22, 1998
/s/ Stephen C. Hathaway Officer
Stephen C. Hathaway (Chief Financial and Accounting
Officer)
/s/ Donald S. Fredrickson Director December 22, 1998
Donald S. Fredrickson, M.D.
/s/ James J. Grierson Director December 23, 1998
James J. Grierson
/s/ Patrick E. Guire Director December 22, 1998
Patrick E. Guire
/s/ Kenneth H. Keller Director December 23, 1998
Kenneth H. Keller
/s/ David A. Koch Director December 22, 1998
David A. Koch
/s/ Kendrick B. Melrose Director December 22, 1998
Kendrick B. Melrose
</TABLE>
<PAGE>
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
EXHIBIT INDEX TO FORM 10-KSB
For the Fiscal Year Ended September 30, 1998
SURMODICS, INC.
Exhibit
3.1 Restated Articles of Incorporation, as amended--incorporated by
reference to Exhibit 3.1 to the Company's Quarterly Report on Form
10-QSB for the quarter ended March 31, 1998, SEC. File No. 0-23837
3.2 Restated Bylaws--incorporated by reference to Exhibit 3.2 to the
Company's Registration Statement on form SB-2, Reg. No. 333-43217
10.1 Lease Agreement, dated November 18, 1991, relating to manufacturing and
office space located at 9924 West 74th Street, Eden Prairie,
Minnesota--incorporated by reference to Exhibit 10.1 to the Company's
Registration Statement on form SB-2, Reg. No. 333-43217
10.2* Company's Incentive 1987 Stock Option Plan, including specimen of
Incentive Stock Option Agreement--incorporated by reference to Exhibit
10.2 to the Company's Registration Statement on form SB-2, Reg. No.
333-43217
10.3* Company's Incentive 1997 Stock Option Plan, including specimen of
Incentive Stock Option Agreement--incorporated by reference to Exhibit
10.3 to the Company's Registration Statement on form SB-2, Reg. No.
333-43217
10.4* Form of Restricted Stock Agreement--incorporated by reference to
Exhibit 10.4 to the Company's Registration Statement on form SB-2, Reg.
No. 333-43217
10.5* Form of Non-qualified Stock Option Agreement--incorporated by reference
to Exhibit 10.5 to the Company's Registration Statement on form SB-2,
Reg. No. 333-43217
10.6 Form of License Agreement--incorporated by reference to Exhibit 10.6 to
the Company's Registration Statement on form SB-2, Reg. No. 333-43217
10.7 License Agreement with Abbott Laboratories dated November 20, 1990, as
amended--incorporated by reference to Exhibit 10.7 to the Company's
Registration Statement on form SB-2, Reg. No. 333-43217
<PAGE>
10.8 Form of Promissory Note from Walter H. Diers Jr. and James C.
Powell--incorporated by reference to Exhibit 10.8 to the Company's
Registration Statement on form SB-2, Reg. No. 333-43217
13 Portions of Annual Report to Shareholders for the fiscal year ended
September 30, 1998 incorporated by reference in this Form 10-KSB
23 Consent of Arthur Andersen LLP
24 Power of Attorney (included on signature page of this Form 10-KSB).
27 Financial Data Schedule
- ----------------
*Management contract or compensatory plan or arrangement
SURMODICS, INC
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
GENERAL
SurModics is a leading provider of surface modification solutions to medical
device manufacturers. The Company's revenues are derived from four primary
sources: fees from licensing its patented technology to customers; royalties
received from licensees; the sale of photoreactive chemical compounds to
licensees and stabilization products to the diagnostics industry; and research
and development fees generated on projects for commercial customers and
government grants. In March 1998, the Company completed an initial public
offering ("IPO") of 2.3 million shares of Common Stock which generated proceeds
of approximately $15.5 million, net of related offering costs.
Fiscal 1998 showed further evidence that SurModics' unique economic model,
based on the licensing of PhotoLink technology to the medical device industry,
can significantly impact the Company's financial performance. Revenues increased
29.0% to $9.8 million in fiscal 1998 from $7.6 million in fiscal 1997. The
financial results were led by growth in royalty revenues, which increased 64.2%
over the prior year to a record $4.8 million. The Company is continuing to see
significant increases in the usage of PhotoLink. PhotoLink royalties increased
52.3% to $2.2 million, and sales of reagents, those chemicals used by clients in
the PhotoLink coating process, increased 60.7% to almost $800,000 in fiscal
1998. Diagnostic royalties also showed an increase of 76.0% to almost $2.6
million. These revenue gains led to net income of $1.6 million, or $.24 per
diluted share, compared to $0.2 million, or $.04 per diluted share, in fiscal
1997.
RESULTS OF OPERATIONS
YEARS ENDED SEPTEMBER 30, 1998 AND 1997
REVENUES. The Company's revenues were $9.8 million in fiscal 1998, an increase
of 29.0% over fiscal 1997. The revenue components were as follows:
FISCAL FISCAL INCREASE % INCREASE
(DOLLARS IN THOUSANDS) 1998 1997 (DECREASE) (DECREASE)
- --------------------------------------------------------------------------------
Royalties:
Diagnostic........................ $2,578 $1,465 $1,113 76.0%
PhotoLink......................... 2,205 1,448 757 52.3%
------ ------ ------
Total royalties................ 4,783 2,913 1,870 64.2%
License fees......................... 222 540 (318) (58.9%)
Product sales:
Reagents 794 494 300 60.7%
Stabilization..................... 2,004 1,665 339 20.4%
------ ------ ------
Total product
sales....................... 2,798 2,159 639 29.6%
Research and
development:
Commercial........................ 891 742 149 20.1%
Government........................ 1,085 1,228 (143) (11.6%)
------ ------ ------
Total research and
development................. 1,976 1,970 6 0.3%
------ ------ ------
Total revenues................. $9,779 $7,582 $2,197 29.0%
The fiscal 1998 revenue increase was primarily due to an increase in
royalties received from licensed clients. The 76.0% increase in diagnostic
royalties was due primarily to the impact of two events in fiscal 1998: a
product acquisition by a licensee and the issuance of a new patent to SurModics,
both of which resulted in more of the licensee's sales being subject to
royalties. While these two events will continue to impact royalties into the
future, the most significant portion of the increase has already occurred;
therefore, diagnostic royalties are expected to produce more modest growth in
fiscal 1999. The 52.3% growth in PhotoLink royalties was due to increases in the
minimum royalty payments from certain clients, the introduction of ten
additional licensed products by the Company's clients, and increased earned
royalties from greater market penetration of coated products sold by licensees.
The Company's product sales increased 29.6%, to $2.8 million. The 20.4%
increase in stabilization sales was the result of greater market penetration due
to the Company's sales and marketing efforts. The sales of reagent chemicals,
those chemicals used by licensees in the PhotoLink coating process, increased
60.7%, which indicates growing production of PhotoLink-coated devices by
SurModics' clients. This increase should result in royalty growth in the future
as these coated products are sold by the Company's clients. Commercial research
and development revenue increased 20.1% between years due to more
customer-funded development projects related to PhotoLink coatings. Half of this
revenue was generated on projects for a single customer. Finally, license
revenue decreased due to the completion of fewer new license agreements in
fiscal 1998. Only three new license agreements were signed during the year. The
Company ended fiscal 1998 with a strong pipeline of new potential license
agreements and it expects to improve on the number of agreements executed in
fiscal 1999.
PRODUCT COSTS. The Company's product costs were $1.2 million for fiscal 1998, a
decrease of $238,000, or 16.7%, from fiscal 1997. Overall product margins
increased to 57.3% in fiscal 1998 from 33.7% in fiscal 1997. The margin
improvements were due to various manufacturing efficiencies achieved during the
year as a result of increased production volumes. The most significant factors
were: the transfer of stabilization production to a new manufacturing space
which increased efficiency; a change to a less costly raw material formulation
for the production of some stabilization products; and the increased market
demand for some of the Company's products that allowed the Company to establish
separate teams for stabilization and reagent production.
RESEARCH AND DEVELOPMENT EXPENSE. Research and development expense was $4.5
million for fiscal 1998, an increase of $925,000, or 25.7%, over fiscal 1997.
Most of this increase was due to the added compensation, benefit, and general
business expenses associated with the additional technical personnel hired by
the Company during the year. In addition, the Company incurred additional
depreciation expense associated with the build-out of additional laboratory
space. These cost increases were offset by a reduction in the amount of research
performed at external laboratories on government grants.
1
<PAGE>
SALES AND MARKETING EXPENSE. Sales and marketing expense was $1.4 million for
fiscal 1998, an increase of $321,000, or 29.2%, over fiscal 1997. This increase
was primarily due to the additional compensation, benefit, and travel expenses
associated with additional sales and marketing personnel hired during the year
and the cost of an external market study performed during the year on potential
genomics product applications.
GENERAL AND ADMINISTRATIVE EXPENSE. General and administrative expense was $1.7
million for fiscal 1998, an increase of $279,000, or 19.7%, over fiscal 1997.
The increase was primarily due to the cost of a new directors' and officers'
liability insurance policy that was entered into at the time of the IPO; new
expenses associated with being a public company, such as investor relations
costs, Nasdaq fees, and other external reporting expenses; and additional
expenses associated with certain consulting projects.
OTHER INCOME (EXPENSE), NET. The Company's net other income was $726,000 for
fiscal 1998, an increase of $517,000, or 246.9%, over fiscal 1997. The increase
in interest income was due to the earnings generated on the additional
investments resulting from the $15.5 million of proceeds received from the IPO
in March.
YEARS ENDED SEPTEMBER 30, 1997 AND 1996
Revenues. The Company's revenues were $7.6 million in fiscal 1997, an increase
of 22.6% over fiscal 1996. The revenue components were as follows:
FISCAL FISCAL INCREASE % INCREASE
(DOLLARS IN THOUSANDS) 1997 1996 (DECREASE) (DECREASE)
- --------------------------------------------------------------------------------
Royalties:
Diagnostic....................... $1,465 $1,288 $ 177 13.7%
PhotoLink........................ 1,448 1,052 396 37.6%
------ ------ ------
Total royalties............... 2,913 2,340 573 24.5%
License fees........................ 540 383 157 41.1%
Product sales:
Reagents......................... 494 358 136 38.0%
Stabilization.................... 1,665 1,283 382 29.8%
------ ------ ------
Total product
sales...................... 2,159 1,641 518 31.6%
Research and
development:
Commercial....................... 742 526 216 41.0%
Government....................... 1,228 1,293 (65) (5.0%)
------ ------ ------
Total research and
development................ 1,970 1,819 151 8.3%
------ ------ ------
Total revenues................ $7,582 $6,183 $1,399 22.6%
The revenue increase in fiscal 1997 was primarily due to increases in all
PhotoLink-related revenue sources: PhotoLink royalties increased 37.6%, license
fees increased 41.1%, reagent sales increased 38.0% and commercial research and
development increased 41.0% between years. The growth in PhotoLink royalties was
primarily due to increases in the minimum royalty payments from certain clients
and increased earned royalties from greater market penetration of coated
products sold by licensees. The increase in reagent chemical sales was due to
growing production of PhotoLink-coated devices by SurModics' clients. The
increase in commercial development revenue was due to more customer-funded
development projects related to PhotoLink coatings. Finally, the increase in
license revenue was due to ten new license agreements being signed in fiscal
1997 compared to five in fiscal 1996.
The 29.8% increase in stabilization sales was the result of greater market
penetration due to the Company's sales and marketing efforts.
PRODUCT COSTS. The Company's product costs were $1.4 million in fiscal 1997, an
increase of $217,000, or 17.9%, over fiscal 1996. Overall product margins
increased to 33.7% in fiscal 1997 from 26.0% in fiscal 1996. The margin
improvement was primarily due to manufacturing efficiencies achieved in
producing reagent chemicals due to the increased demand.
RESEARCH AND DEVELOPMENT EXPENSE. Research and development expense was $3.6
million in fiscal 1997, an increase of $280,000, or 8.5%, over fiscal 1996. Most
of this increase was due to increased patent-related costs, additional research
studies at external laboratories and the additional compensation and benefit
costs associated with the additional technical personnel hired by the Company
during the year.
SALES AND MARKETING EXPENSE. Sales and marketing expense was $1.1 million in
fiscal 1997, an increase of $186,000, or 20.5%, over fiscal 1996. This was
primarily due to the additional compensation, benefit, and travel expenses
associated with additional sales and marketing personnel hired during the year
and increased customer activities, which resulted in more travel and promotional
spending.
GENERAL AND ADMINISTRATIVE EXPENSE. General and administrative expense was $1.4
million in fiscal 1997, an increase of $263,000, or 22.8%, over fiscal 1996. The
increase was primarily due to the expenses associated with a new incentive
compensation program.
OTHER INCOME (EXPENSE), NET. The Company's net other income was $198,000 in
fiscal 1997, a decrease of $23,000, or 10.2% over fiscal 1996. This decrease was
due primarily to a reduced level of interest income from investments.
NET OPERATING LOSS CARRYFORWARDS
As of September 30, 1998, the Company had a net operating loss carryforward of
approximately $4.7 million, which expires in varying amounts through 2011. The
Company also had $490,000 of capital loss carryforwards at September 30, 1998,
which expire in 2001. A valuation allowance for the full amount of the deferred
tax asset has been established due to the uncertainty of realization.
YEAR 2000 COMPLIANCE
The Company has evaluated its information technology infrastructure for Year
2000 compliance. The Company does not utilize any mainframe technology, but
instead has an internal technical infrastructure comprised of client server
networks and desktop microcomputers. The applications which run on these
computers are primarily purchased software without any significant customized
programming. Over the last two years, the Company has routinely upgraded most of
its computer hardware, software and telecommunications systems. As a result of
its internal reviews,
2
<PAGE>
the Company does not anticipate any problems related to Year 2000 compliance
with its information technology infrastructure.
The Company is in the process of evaluating its non-information technology
systems with regard to Year 2000 compliance. This is especially important
related to embedded technology such as microcontrollers contained in various lab
equipment, and raw material suppliers who support the Company's manufacturing
process. Based upon information currently available, the Company does not
anticipate any material disruption in its operations as a result of any failure
by either non-information technology equipment or one of its suppliers to be in
compliance. Compliance should not be an issue with the Company's products, since
they are not date-sensitive.
Costs associated with Year 2000 compliance are expensed as incurred. To
date, those costs have not been material. Based upon currently available
information, the Company does not expect that the costs of addressing potential
Year 2000 problems will have a material impact on the Company's financial
condition or results of operations. The Company plans to devote the necessary
resources to resolve any significant Year 2000 issues by no later than the end
of fiscal year 1999.
Although the Company is committed to addressing any issues well in advance
of the Year 2000, there are risks if the Company's objectives are not met. The
most severe risk is business interruption. Specific examples of situations that
could cause business interruption include, among others, (i) computer hardware
or application software processing errors or failures; (ii) failure of lab or
manufacturing equipment; and (iii) outside suppliers who may not be Year 2000
compliant. Depending on the extent and duration of the business interruption
resulting from non-compliant Year 2000 systems, such interruption could have a
material adverse effect on the Company's financial condition and results of
operations.
LIQUIDITY AND CAPITAL RESOURCES
As of September 30, 1998, the Company had working capital of approximately $5.1
million and cash, cash equivalents and investments totaling approximately $21.1
million. The Company has generated positive cash flows from operating activities
of approximately $2.1 million in fiscal 1998, $0.5 million in fiscal 1997 and
$0.4 million in fiscal 1996. The increase in fiscal 1998 was primarily due to
the increased net income generated during the year. The significant increase in
investing activities during fiscal 1998 was due to the repositioning of the
public offering proceeds within an investment portfolio managed by an external
investment manager. The Company's investments principally consist of U.S.
government obligations and investment grade, interest-bearing corporate debt
securities with varying maturity dates, the majority of which are three years or
less. In addition, there was an increase in the Company's purchase of property
and equipment in fiscal 1998 due to the build-out of some additional
manufacturing and laboratory space and the purchase of additional equipment with
a portion of the proceeds from the offering. The most significant financing
activity over the last three years was the completion of the initial public
offering of 2.3 million shares of Common Stock in March 1998. In total, the IPO
generated net proceeds to the Company of approximately $15.5 million after
deducting all offering expenses.
As of September 30, 1998, the Company had no debt, nor did it have any
credit agreements. The Company believes that its existing capital resources will
be adequate to fund the Company's operations into the foreseeable future.
FORWARD-LOOKING STATEMENTS
Certain statements contained in this Annual Report and other written and oral
statements made from time to time by the Company do not relate strictly to
historical or current facts. As such, they are considered "forward-looking
statements" which provide current expectations or forecasts of future events.
These forward-looking statements are made pursuant to the safe harbor provisions
of the Private Securities Reform Act of 1995. Such statements can be identified
by the use of terminology such as "anticipate," "believe," "estimate," "expect,"
"intend," "may," "could," "possible," "plan," "project," "will," "forecast" and
similar words or expressions. The Company's forward-looking statements generally
relate to its growth strategy, financial results, product development programs,
sales efforts, and Year 2000 compliance. One must carefully consider
forward-looking statements and understand that such statements involve a variety
of risks and uncertainties, known and unknown, and may be affected by inaccurate
assumptions. Consequently, no forward-looking statement can be guaranteed and
actual results may vary materially. The Company undertakes no obligation to
update any forward-looking statement.
Although it is not possible to create a comprehensive list of all factors
that may cause actual results to differ from the Company's forward-looking
statements, such factors include, among others, (i) the trend of consolidation
in the medical device industry, resulting in more significant, complex and
long-term contracts than in the past and potentially greater pricing pressures;
(ii) the Company's ability to attract new licensees and to enter into agreements
for additional product applications with existing licensees, and the willingness
of potential customers to sign license agreements under the terms offered by the
Company; (iii) the success of existing licensees in selling products
incorporating SurModics' technology and the timing of new product introductions
by licensees; (iv) the difficulties and uncertainties associated with the
lengthy and costly new product development and foreign and domestic regulatory
approval processes, such as delays, difficulties or failures in achieving
acceptable clinical results or obtaining foreign or FDA marketing clearances,
which may result in lost market opportunities or postpone or preclude product
commercialization by licensees; (v) efficacy or safety concerns with respect to
products marketed by SurModics and its licensees, whether scientifically
justified or not, that may lead to product recalls, withdrawals or declining
sales; (vi) the development of new products or technologies by competitors,
technological obsolescence and other changes in competitive factors; (vii) the
Company's ability to successfully respond to Year 2000 issues, which depends, in
part, on the availability of personnel, the Company's ability to identify and
resolve issues, both foreseen and unforeseen, and the readiness of third parties
to resolve their issues; and (viii) economic factors over which the Company has
no control, including changes in inflation and consumer confidence. Investors
are advised to consult any further disclosures by the Company on this subject in
its filings with the Securities and Exchange Commission.
3
<PAGE>
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To SurModics, Inc.:
We have audited the accompanying balance sheets of SurModics, Inc. (a Minnesota
corporation) as of September 30, 1998 and 1997, and the related statements of
operations, stockholders' equity and cash flows for each of the three years in
the period ended September 30, 1998. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of SurModics, Inc. as of
September 30, 1998 and 1997, and the results of its operations and its cash
flows for each of the three years in the period ended September 30, 1998, in
conformity with generally accepted accounting principles.
/s/ ARTHUR ANDERSEN LLP
Minneapolis, Minnesota,
November 4, 1998
REPORT OF MANAGEMENT
The management of SurModics, Inc. is responsible for the integrity of the
financial statements and other financial information contained in this annual
report. The financial statements and related information were prepared in
accordance with generally accepted accounting principles and include some
amounts that are based on management's best estimates and judgments.
To meet its responsibility, management depends on its accounting systems
and related internal accounting controls. These systems are designed to provide
reasonable assurance, at an appropriate cost, that financial records are
reliable for use in preparing financial statements and that assets are
safeguarded. Qualified personnel throughout the organization maintain and
monitor these internal accounting controls on an ongoing basis.
The Company's financial statements have been audited by Arthur Andersen
LLP, independent public accountants, whose report thereon was based on audits
conducted in accordance with generally accepted auditing standards. As part of
their audits, the independent public accountants consider the Company's system
of internal accounting controls for the purpose of determining the nature, scope
and timing of audit tests to be performed.
The Audit Committee of the Board of Directors, composed entirely of
directors who are not employees of the Company, has met with the Company's
independent public accountants, as well as management, to review accounting,
auditing, internal control, financial reporting and other matters.
/s/ Dale R. Olseth
Chairman and Chief Executive Officer
/s/ Stephen C. Hathaway
Vice President and Chief Financial Officer
4
<PAGE>
SURMODICS, INC
BALANCE SHEETS
<TABLE>
<CAPTION>
AS OF SEPTEMBER 30 1998 1997
- -------------------------------------------------------------------------------------------------------
<S> <C> <C>
ASSETS
CURRENT ASSETS
Cash and cash equivalents .................................. $ 1,343,561 $ 491,624
Short-term investments ..................................... 3,526,493 1,455,976
Accounts receivable, net of allowance of $35,000 and $29,000 1,056,710 922,466
Inventories, net ........................................... 379,946 264,008
Prepaids and other ......................................... 255,456 74,124
------------ ------------
Total current assets ................................. 6,562,166 3,208,198
------------ ------------
PROPERTY AND EQUIPMENT
Laboratory fixtures and equipment .......................... 2,313,236 2,027,940
Office furniture and equipment ............................. 1,002,210 834,222
Leasehold improvements ..................................... 1,323,387 1,049,802
Less-Accumulated depreciation and amortization ............. (3,399,285) (2,846,954)
------------ ------------
Property and equipment, net .......................... 1,239,548 1,065,010
LONG-TERM INVESTMENTS ......................................... 16,248,914 1,874,118
OTHER ASSETS, NET ............................................. 254,361 302,930
------------ ------------
$ 24,304,989 $ 6,450,256
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Accounts payable ........................................... $ 304,706 $ 280,467
Accrued liabilities --
Compensation ............................................ 615,264 400,861
Other ................................................... 334,904 91,807
Deferred revenues .......................................... 227,725 308,143
------------ ------------
Total current liabilities ............................... 1,482,599 1,081,278
DEFERRED REVENUES AND OTHER, LESS CURRENT PORTION ............. 124,231 266,973
------------ ------------
Total liabilities .................................... 1,606,830 1,348,251
------------ ------------
COMMITMENTS AND CONTINGENCIES (NOTE 6)
STOCKHOLDERS' EQUITY
Series AConvertible Preferred Stock-$.05 par value;
none and 376,828 shares issued and outstanding .......... -- 18,841
Common Stock-$.05 par value, 15,000,000 shares authorized;
7,214,085 and 3,400,868 shares issued and outstanding ... 360,704 170,044
Additional paid-in capital .............................. 28,934,732 13,491,665
Unearned compensation ................................... (170,335) (259,000)
Stock purchase notes receivable ......................... (182,273) (160,000)
Unrealized gain on investments .......................... 278,244 --
Accumulated deficit ..................................... (6,522,913) (8,159,545)
------------ ------------
Total stockholders' equity ........................... 22,698,159 5,102,005
------------ ------------
$ 24,304,989 $ 6,450,256
============ ============
</TABLE>
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE BALANCE SHEETS.
5
<PAGE>
SURMODICS, INC.
STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
FOR THE YEARS ENDED SEPTEMBER 30 1998 1997 1996
- --------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
REVENUES
Royalties .................................. $ 4,782,626 $ 2,913,119 $ 2,340,187
License fees ............................... 222,500 540,000 382,500
Product sales .............................. 2,797,647 2,158,572 1,641,226
Research and development ................... 1,975,888 1,970,174 1,818,739
----------- ----------- -----------
Total revenues ....................... 9,778,661 7,581,865 6,182,652
----------- ----------- -----------
OPERATING COSTS AND EXPENSES
Product .................................... 1,193,178 1,431,675 1,214,526
Research and development ................... 4,521,689 3,597,061 3,316,767
Sales and marketing ........................ 1,419,028 1,098,316 911,622
General and administrative ................. 1,696,741 1,417,524 1,154,412
----------- ----------- -----------
Total operating costs and expenses ... 8,830,636 7,544,576 6,597,327
----------- ----------- -----------
INCOME (LOSS) FROM OPERATIONS ................. 948,025 37,289 (414,675)
----------- ----------- -----------
OTHER INCOME (EXPENSE)
Investment income and other, net ........... 698,193 209,204 275,849
Gain (loss) on sale of investments ......... 27,634 -- (54,901)
----------- ----------- -----------
Other income, net .................... 725,827 209,204 220,948
----------- ----------- -----------
NET INCOME (LOSS) BEFORE INCOME TAXES ......... 1,673,852 246,493 (193,727)
PROVISION FOR INCOME TAXES .................... 37,220 10,820 --
----------- ----------- -----------
NET INCOME (LOSS) ............................. $ 1,636,632 $ 235,673 $ (193,727)
=========== =========== ===========
NET INCOME (LOSS) PER SHARE
Basic ...................................... $ .26 $ .05 $ (.04)
Diluted .................................... $ .24 $ .04 $ (.04)
WEIGHTED AVERAGE SHARES OUTSTANDING
Basic ...................................... 6,224,362 4,853,558 4,775,598
Dilutive effect of outstanding stock options 574,271 531,780 --
----------- ----------- -----------
Diluted .................................... 6,798,633 5,385,338 4,775,598
</TABLE>
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.
6
<PAGE>
SURMODICS, INC
STATEMENTS OF STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
FOR THE YEARS ENDED SEPTEMBER 30, 1998, 1997 AND 1996
CONVERTIBLE PREFERRED STOCK COMMON STOCK
--------------------------- ---------------------------
SHARES AMOUNT SHARES AMOUNT
- -------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
BALANCE, SEPTEMBER 30, 1995 .................... 376,828 $ 18,841 3,218,420 $ 160,920
Common stock options exercised .............. -- -- 71,628 3,584
Conversion of nonvoting common stock to
common stock ............................. -- -- 26,232 1,312
Restricted stock canceled ................... -- -- (4,800) (240)
Amortization of unearned compensation ....... -- -- -- --
Unrealized loss on investments .............. -- -- -- --
Realized loss on investments ................ -- -- -- --
Net loss .................................... -- -- -- --
---------- ---------- ---------- ----------
BALANCE, SEPTEMBER 30, 1996 .................... 376,828 18,841 3,311,480 165,576
Common stock options exercised .............. -- -- 45,388 2,268
Restricted stock granted .................... -- -- 44,000 2,200
Amortization of unearned compensation ....... -- -- -- --
Net income .................................. -- -- -- --
---------- ---------- ---------- ----------
BALANCE, SEPTEMBER 30, 1997 .................... 376,828 18,841 3,400,868 170,044
Common stock options exercised .............. -- -- 25,905 1,296
Conversion of preferred stock to common stock (376,828) (18,841) 1,507,312 75,364
Issuance of common stock .................... -- -- 2,300,000 115,000
Restricted stock canceled ................... -- -- (20,000) (1,000)
Restricted stock extension .................. -- -- -- --
Net loan activity ........................... -- -- -- --
Amortization of unearned compensation ....... -- -- -- --
Unrealized gain on investments .............. -- -- -- --
Net income .................................. -- -- -- --
---------- ---------- ---------- ----------
BALANCE, SEPTEMBER 30, 1998 .................... -- $ -- 7,214,085 $ 360,704
========== ========== ========== ==========
</TABLE>
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.
7
<PAGE>
<TABLE>
<CAPTION>
NONVOTING COMMON STOCK UNREALIZED TOTAL
- --------------------------- ADDITIONAL UNEARNED STOCK PURCHASE INVESTMENT GAIN ACCUMULATED STOCKHOLDERS'
SHARES AMOUNT PAID-IN CAPITAL COMPENSATION NOTES RECEIVABLE (LOSS) DEFICIT EQUITY
- ----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
26,232 $ 1,312 $ 12,898,473 $ (221,120) $ -- $ -- $ (8,201,491) $ 4,656,935
-- -- 214,448 -- -- -- -- 218,032
(26,232) (1,312) -- -- -- -- -- --
-- -- (18,960) 3,840 -- -- -- (15,360)
-- -- -- 74,560 -- -- -- 74,560
-- -- -- -- -- (54,901) -- (54,901)
-- -- -- -- -- 54,901 -- 54,901
-- -- -- -- -- -- (193,727) (193,727)
- ---------- ------------ ------------ ------------ ------------ ------------ ------------ ------------
-- -- 13,093,961 (142,720) -- -- (8,395,218) 4,740,440
-- -- 179,904 -- (160,000) -- -- 22,172
-- -- 217,800 (220,000) -- -- -- --
-- -- -- 103,720 -- -- -- 103,720
-- -- -- -- -- -- 235,673 235,673
- ---------- ------------ ------------ ------------ ------------ ------------ ------------ ------------
-- -- 13,491,665 (259,000) (160,000) -- (8,159,545) 5,102,005
-- -- 111,988 -- -- -- -- 113,284
-- -- (56,523) -- -- -- -- --
-- -- 15,406,102 -- -- -- -- 15,521,102
-- -- (34,500) 35,500 -- -- -- --
-- -- 16,000 (16,000) -- -- -- --
-- -- -- -- (22,273) -- -- (22,273)
-- -- -- 69,165 -- -- -- 69,165
-- -- -- -- -- 278,244 -- 278,244
-- -- -- -- -- -- 1,636,632 1,636,632
- ---------- ------------ ------------ ------------ ------------ ------------ ------------ ------------
-- $ -- $ 28,934,732 $ (170,335) $ (182,273) $ 278,244 $ (6,522,913) $ 22,698,159
========== ============ ============ ============ ============ ============ ============ ============
</TABLE>
8
<PAGE>
SURMODICS, INC
STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
FOR THE YEARS ENDED SEPTEMBER 30 1998 1997 1996
- ------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
OPERATING ACTIVITIES
Net income (loss) .............................................. $ 1,636,632 $ 235,67 $ (193,727)
Adjustments to reconcile net income (loss) to net cash
provided by operating activities-
Depreciation and amortization ............................ 617,536 460,039 427,274
Realized (gain)loss on investments ....................... (27,634) -- 54,901
Amortization of unearned compensation, net ............... 69,165 103,720 59,200
Change in deferred rent .................................. (17,742) (11,104) 2,174
Change in assets and liabilities:
Accounts receivable ................................... (134,244) (294,647) (67,849)
Inventories ........................................... (115,938) (3,240) (3,945)
Accounts payable and accrued liabilities .............. 481,739 446,729 (9,962)
Deferred revenue ...................................... (205,418) (393,416) 138,268
Prepaids and other .................................... (181,332) (12,701) (33,303)
------------ ------------ ------------
Net cash provided by operating activities .......... 2,122,764 531,053 373,031
------------ ------------ ------------
INVESTING ACTIVITIES
Purchase of property and equipment, net ........................ (775,402) (298,388) (201,580)
Purchases of available-for-sale investments .................... (33,595,043) (3,923,184) (1,497,290)
Sales/maturities of available-for-sale investments ............. 17,455,608 2,425,000 2,659,520
Issuance of stock purchase notes receivable,
net of repayments ........................................... (22,273) -- --
Other .......................................................... 31,897 (277,935) --
------------ ------------ ------------
Net cash provided by (used in) investing activities (16,905,213) (2,074,507) 960,650
------------ ------------ ------------
FINANCING ACTIVITIES
Issuance of common stock, net of offering costs ................ 15,634,386 22,172 218,032
Repayment of long-term debt and capital lease obligations ...... -- -- (16,917)
------------ ------------ ------------
Net cash provided by financing activities .......... 15,634,386 22,172 201,115
------------ ------------ ------------
Net increase (decrease) in cash and cash equivalents 851,937 (1,521,282) 1,534,796
CASH AND CASH EQUIVALENTS
Beginning of year .............................................. 491,624 2,012,906 478,110
------------ ------------ ------------
End of year .................................................... $ 1,343,561 $ 491,624 $ 2,012,906
============ ============ ============
SUPPLEMENTAL CASH FLOW INFORMATION
Interest paid .................................................. $ -- $ 1,700 $ 2,254
============ ============ ============
Non-cash investing and financing activity-
Issuance of stock purchase notes receivable from
exercised stock options .................................. $ -- $ 160,000 $ --
============ ============ ============
</TABLE>
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.
9
<PAGE>
SURMODICS, INC
NOTES TO FINANCIAL STATEMENTS
1. DESCRIPTION
SurModics, Inc. (the Company) develops, manufactures and markets innovative
surface modifications primarily for medical devices and diagnostic products. The
Company also produces and markets a line of proprietary biomolecule
stabilization products. Its revenues are derived from the following: fees from
licensing its patented technology to customers; royalties received from
licensees; the sale of photoreactive chemical compounds to licensees and
stabilization products to the diagnostic industry; and research and development
fees generated on projects for commercial customers and government grants. The
Company markets its products through a direct sales force primarily in the
United States and some international markets.
In March 1998, the Company completed an initial public offering of 2.3
million shares of Common Stock, including 300,000 shares purchased by the
underwriters pursuant to the exercise of an overallotment option. In total, the
offering generated net proceeds to the Company of approximately $15.5 million
after deducting all offering expenses.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
CASH AND CASH EQUIVALENTS
Cash and cash equivalents consist principally of money market instruments with
original maturities of three months or less and are stated at cost which
approximates fair value.
INVESTMENTS
Investments consist principally of U.S. government obligations and corporate
debt securities and are classified as available-for-sale as of September 30,
1998 and 1997. Available-for-sale investments are reported at fair value with
unrealized gains and losses excluded from operations and reported as a separate
component of stockholders' equity, except for other-than-temporary impairments,
which are reported as a charge to current operations and result in a new cost
basis for the investment.
The amortized cost, unrealized holding gains and losses, and fair value of
investments as of September 30, 1998, and the amortized cost of the investments,
which approximated fair value as of September 30, 1997, were as follows:
<TABLE>
<CAPTION>
SEPTEMBER 30, 1998 SEPTEMBER 30, 1997
--------------------------------------------------------------------- ------------------
AMORTIZED COST UNREALIZED GAINS UNREALIZED LOSSES FAIR VALUE AMORTIZED COST
------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
U.S. government obligations ...... $12,178,480 $243,326 $ -- $12,421,806 $ --
Corporate bonds .................. 5,638,397 5,755 (724) 5,643,428 3,330,094
Mortgage-backed securities ....... 1,286,413 28,784 (3,071) 1,312,126 --
Municipal bonds .................. 200,000 4,174 -- 204,174 --
Other debt securities ............ 193,873 -- -- 193,873 --
----------- --------------- ----------------- ----------- --------------
Total ....................... $19,497,163 $282,039 $ (3,795) $19,775,407 $ 3,330,094
=========== =============== ================== =========== ==============
</TABLE>
The amortized cost and fair value of investments by contracted maturity date at
September 30, 1998, was as follows:
AMORTIZED COST FAIR VALUE
-----------------------------
Debt securities due within:
One year .................. $ 3,526,493 $ 3,526,493
One to five years ......... 14,943,048 15,209,626
Five years or more ........ 1,027,622 1,039,288
----------- -----------
Total ................ $19,497,163 $19,775,407
=========== ===========
INVENTORIES
Inventories are stated at the lower of cost or market using the specific
identification method and include direct labor, materials and overhead.
Inventories consisted of the following components as of September 30:
1998 1997
---------------------
Raw materials ..................... $107,522 $ 67,099
Finished products ................. 272,424 196,909
-------- --------
Total ........................ $379,946 $264,008
======== ========
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost and are depreciated using the
straight-line method over three to five years, the estimated useful lives of the
assets. Amortization of leasehold improvements is recorded on a straight-line
basis over the estimated useful lives of the assets or the lease term, whichever
is shorter.
OTHER ASSETS
Other assets consist principally of patents, which are amortized over 7 to 12
years. Accumulated amortization was $40,000 and $23,000 as of September 30, 1998
and 1997, respectively.
REVENUE RECOGNITION
Royalty revenue is recognized as third-party licensees report sales of the
licensed product or as minimum royalties become due. Initial nonrefundable
license fees are recognized as revenue upon execution of the license agreement.
Certain nonrefundable license and research and development fees are recoverable
by the licensees as offsets against a percentage of future earned royalties.
10
<PAGE>
SURMODICS, INC
NOTES TO FINANCIAL STATEMENTS
Revenues on product sales are recognized as products are shipped and for
research and development as performance progresses under the applicable
contract.
Cash received prior to performance is recorded as deferred revenues in the
accompanying balance sheets. Deferred revenues also included advance payments
from a third-party licensee to the Company, which were applied as a reduction of
amounts otherwise due for earned royalties up to $75,000 per quarter and were
fully absorbed during fiscal 1998.
MAJOR CUSTOMERS
Revenues from customers which exceed 10% of total revenues were as follows for
the year ended September 30:
1998 1997 1996
------------------
U.S. government agencies....................... 11% 16% 21%
Company A...................................... 26% 21% 24%
INCOME TAXES
The Company utilizes the liability method to account for income taxes, and
deferred taxes are based on the estimated future tax effects of differences
between the financial statement and tax basis of assets and liabilities given
the provisions of the enacted tax laws.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and 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.
Ultimate results could differ from those estimates.
RECLASSIFICATION
Certain 1996 and 1997 amounts in the accompanying financial statements have been
reclassified to conform to the 1998 presentation. These reclassifications had no
effect on previously reported net income (loss) or stockholders' equity.
NEW ACCOUNTING PRONOUNCEMENTS
The Financial Accounting Standards Board has issued Statement of Financial
Accounting Standards (SFAS) No. 130, "Reporting Comprehensive Income," which
establishes standards for reporting and displaying comprehensive income and its
components in financial statements. The Company will adopt the provisions of
SFAS No. 130 in fiscal 1999.
SFAS No. 131, "Disclosure about Segments of an Enterprise and Related
Information," establishes standards for reporting information about operating
segments in annual and interim financial statements. Operating segments are
determined consistent with the way management organizes and evaluates financial
information internally for making decisions and assessing performance. The
Company will adopt the provisions of SFAS No. 131 in fiscal 1999.
3. STOCKHOLDERS' EQUITY
AUTHORIZED SHARES
The authorized capital stock of the Company consists of 20,000,000 shares of
capital stock, $.05 per share par value, of which 15,000,000 shares are Common
Stock and 5,000,000 shares are undesignated.
Each share of the Series A Convertible Preferred Stock was automatically
converted into four shares of voting Common Stock upon the closing of the
initial public offering. The authorized shares of Series A Convertible Preferred
Stock were eliminated and this class of stock was canceled.
STOCK SPLIT
On December 22, 1997, the Company's board of directors approved a 4-for-1 stock
split of all the Company's outstanding Common Stock. All share and per share
data have been restated for all periods presented to reflect the Common Stock
split.
RESTRICTED STOCK AWARDS
The Company has entered into restricted stock agreements with certain key
employees, covering the issuance of Common Stock (the Restricted Stock). The
Restricted Stock will be released to the key employees if they are employed by
the Company at the end of a five-year waiting period. Unearned compensation has
been recognized for the estimated fair value of the applicable common shares,
reflected as a reduction of stockholders' equity, and is being charged to
operations over the five-year waiting period.
Transactions in restricted stock were as follows:
Outstanding at September 30, 1995............... 87,200
Canceled..................................... (4,800)
-------
Outstanding at September 30, 1996............... 82,400
Granted...................................... 44,000
-------
Outstanding at September 30, 1997............... 126,400
Granted...................................... 4,000
Canceled..................................... (24,000)
Exercised.................................... (42,400)
-------
Outstanding at September 30, 1998............... 64,000
=======
STOCK PURCHASE NOTES RECEIVABLE
The Company established a loan program during fiscal 1997 to assist employees in
purchasing shares of the Company's stock. The loans are collateralized by the
employees' purchased shares
11
<PAGE>
SURMODICS, INC
NOTES TO FINANCIAL STATEMENTS
and require annual interest payments at a rate equal to prime at the date of
issuance (8.5%) with principal and any unpaid interest due at the earlier of
five years after the date of issuance or three months after termination of
employment. Employees may borrow up to 100% of the option price for the shares
purchased or up to 100% of their previous investment in the Company's stock. No
further loans are being granted under this program.
4. STOCK-BASED COMPENSATION PLAN
Upon adoption of the Company's 1997 Incentive Stock Option Plan (the Plan),
600,000 shares of Common Stock were reserved for issuance to employees and
officers. The Plan requires that the option price per share cannot be less than
100% of the fair market value of the Common Stock (as determined by the board of
directors) on the date of the grant of the option or 110% with respect to
optionees who own more than 10% of the total combined voting power of all
classes of stock. Options expire in five to seven years or upon termination of
employment and are exercisable at a rate of 20% per year from the date of grant
or 20% per year commencing one year after the date of grant. In addition,
options representing a total of 272,900 shares remain outstanding from the
Company's 1987 Incentive Stock Option Plan which was replaced by the 1997 Plan.
Under the Company's Nonqualified Stock Option Plan, 972,240 shares of
Common Stock were reserved for issuance to outside directors, employees and
officers. The options have been granted at fair market value as determined by
the board of directors on the date of grant. Options expire in five to ten years
and are exercisable at a rate of 20% per year from the date of grant or 20% per
year commencing two years after the date of grant.
As of September 30, 1998, there were 575,500 additional shares available
for grant under the stock plans. Information regarding stock options under all
plans is summarized as follows:
<TABLE>
<CAPTION>
--------------------------------------------------------------------------------------------
1998 1997 1996
--------------------------------------------------------------------------------------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
OPTIONS SHARES EXERCISE PRICE SHARES EXERCISE PRICE SHARES EXERCISE PRICE
- ------------------------------------------------------------------ ---------------------------- ----------------------------
<S> <C> <C> <C> <C> <C> <C>
Outstanding, beginning of period.... 1,204,800 $ 4.60 1,163,600 $ 4.52 1,396,280 $ 4.35
Granted........................ 137,300 6.98 157,400 5.00 5,400 5.00
Exercised...................... (26,220) 4.47 (45,388) 4.01 (71,628) 3.04
Canceled....................... (46,240) 4.78 (70,812) 4.51 (166,452) 3.78
---------- -------------- ---------- -------------- ---------- --------------
Outstanding, end of period.......... 1,269,640 $ 4.86 1,204,800 $ 4.60 1,163,600 $ 4.52
========== ============== ========== ============== ========== ==============
Exercisable, end of period.......... 757,860 $ 4.49 589,320 $ 4.42 436,760 $ 4.26
========== ============== ========== ============== ========== ==============
Weighted average fair value
of options granted............. $ 4.91 $ 3.30 $ 3.23
========== ========== ==========
</TABLE>
The options outstanding at September 30, 1998 have exercise prices ranging
between $4.00 and $7.75, with a weighted average exercise price of $4.86 and a
weighted average remaining contractual life of 3.44 years.
The fair value of each option grant is estimated on the date of grant using
the Black-Scholes option pricing model with the following weighted-average
assumptions used for grants in 1998 and 1997, respectively: risk-free interest
rates of 5.00% and 6.24%; expected lives of 6.4 and 5.6 years; and expected
volatility of 73% for both years.
The Company accounts for the options under APB Opinion No. 25, under which
no compensation cost has been recognized. Had compensation cost for the options
been determined consistent with SFAS No. 123, "Accounting for Stock-Based
Compensation," the Company's net income (loss) would have been the following pro
forma amounts for the years ended September 30:
1998 1997 1996
-----------------------------------------
Net income (loss):
As reported................. $1,636,632 $235,673 $(193,727)
Pro forma................... $1,506,492 $155,541 $(194,890)
Net income (loss)
per share:
As reported
diluted................... $ .24 $ .04 $ (.04)
Pro forma diluted........... $ .22 $ .03 $ (.04)
Because the SFAS No. 123 method of accounting has not been applied to options
granted prior to October 1, 1995, the resulting pro forma information may not be
representative of that to be expected in future periods.
12
<PAGE>
SURMODICS, INC
NOTES TO FINANCIAL STATEMENTS
5. INCOME TAXES
Deferred income taxes consisted of the following as of September 30:
1998 1997
----------------------------
Deferred tax assets................. $ 2,615,000 $ 3,242,000
Less- Valuation allowance........... (2,615,000) (3,242,000)
----------- -----------
Net deferred tax assets........ $ -- $ --
=========== ===========
These deferred tax assets result from differences in the recognition of
transactions for income tax and financial reporting purposes. The principal
temporary differences relate to certain financial reserves not deductible for
tax purposes until paid, a capital loss carryforward and net operating loss
carryforwards.
The Company's net operating loss carryforwards of approximately $4.7
million at September 30, 1998 expire in varying amounts through 2011. The
Company also had $490,000 of capital loss carryforwards at September 30, 1998,
which expire in 2001. A valuation allowance for the full amount of the deferred
tax asset has been established due to the uncertainty of realization.
During fiscal year 1998 and 1997, the Company utilized approximately $1.7
million and $64,000 of net operating loss carryforwards to offset the current
year income tax liability.
6. COMMITMENTS AND CONTINGENCIES
OPERATING LEASES
The Company leases its office and laboratory space under an operating lease that
expires in 1999. The lease provides for base monthly payments, which increase
annually, and additional amounts to cover the Company's share of common area
expenses and property taxes. The Company is responsible for maintenance,
insurance and other normal operating costs. Rental expense for the base monthly
payments and additional costs was approximately $296,000, $290,000 and $290,000
for the years ended September 30, 1998, 1997 and 1996, respectively.
Future commitments under the operating lease are as follows as of September
30, 1998:
1999.............. $216,000
2000.............. 54,000
--------
$270,000
========
GOVERNMENT CONTRACTS
Under provisions contained in the government research contracts, representatives
of the government agencies have the right to access and review the Company's
underlying records of contract costs. The government retains the right to reject
expenses considered unallowable under the terms of the contract. The Defense
Contract Audit Agency has reviewed the contracts through 1989. In the opinion of
management, future amounts due, if any, with respect to open contract years will
not have a material impact on the financial position or results of operations of
the Company.
7. DEFINED CONTRIBUTION PLAN
The Company has a 401(k) retirement and savings plan for the benefit of
qualified employees. Under the plan, qualified employees may elect to defer up
to 20% of their compensation, subject to a maximum limit determined by the
Internal Revenue Service. The Company, at the discretion of the board of
directors, may elect to make an additional contribution. Additional
contributions totaling $117,000, $86,000 and $78,000 have been charged to
operations for the years ended September 30, 1998, 1997 and 1996, respectively.
8. QUARTERLY FINANCIAL DATA
(UNAUDITED, IN THOUSANDS EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
FISCAL 1998
---------------------------------------------------------------
FIRST QUARTER SECOND QUARTER THIRD QUARTER FOURTH QUARTER
------------- -------------- ------------- --------------
<S> <C> <C> <C> <C>
Revenues.................... $1,909 $2,579 $2,672 $2,619
Income from
operations............. 101 288 330 229
Net income.................. 151 376 566 544
Net income per share:
Basic.................. .03 .07 .08 .08
Diluted................ .03 .06 .07 .07
<CAPTION>
FISCAL 1998
---------------------------------------------------------------
FIRST QUARTER SECOND QUARTER THIRD QUARTER FOURTH QUARTER
---------------------------------------------------------------
Revenues.................... $1,655 $1,866 $1,954 $2,107
Income (loss) from
operations............. (13) 17 19 14
Net income.................. 26 68 73 69
Net income per share:
Basic.................. .01 .01 .01 .01
Diluted................ .00 .01 .01 .01
</TABLE>
13
<PAGE>
STOCK LISTING AND PRICE HISTORY
On March 4, 1998, the Company completed its initial public offering of Common
Stock at a price of $7.50 per share. The stock is trading on the Nasdaq National
Market under the symbol "SRDX." The following table sets forth the range of high
and low closing sale prices for the Company's Common Stock, as reported by
Nasdaq:
FISCAL QUARTER ENDED HIGH LOW
- -------------------------------------------------------------------------------
December 31, 1997........................... N/A N/A
March 31, 1998.............................. $ 9 3/4 $ 7 3/4
June 30, 1998............................... $ 11 3/4 $ 8 1/4
September 30, 1998.......................... $ 14 1/8 $ 7 3/16
According to the records of the Company's transfer agent, as of November 25,
1998, the Company had 258 holders of record of the Company's Common Stock
(excluding beneficial owners of shares registered in nominee or street name).
The Company has never paid any cash dividends on its Common Stock and does not
anticipate doing so in the foreseeable future. SurModics, Inc.
EXHIBIT 23
CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS
As independent public accountants, we hereby consent to the incorporation of our
report incorporated by reference in this Form 10-KSB, into the Company's
previously filed Registration Statements File Nos. 33-64171 and 33-64173.
/s/ ARTHUR ANDERSEN LLP
Minneapolis, Minnesota,
December 22, 1998
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
This schedule contains summary financial information extracted from the
financial statements for the year ended September 30, 1998 and is qualified
in its entirety by reference to such financial statements.
</LEGEND>
<MULTIPLIER> 1,000
<CURRENCY> U.S. Dollars
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> SEP-30-1998
<PERIOD-START> OCT-01-1997
<PERIOD-END> SEP-30-1998
<EXCHANGE-RATE> 1
<CASH> 1,344
<SECURITIES> 3,526
<RECEIVABLES> 1,092
<ALLOWANCES> 35
<INVENTORY> 380
<CURRENT-ASSETS> 6,562
<PP&E> 4,639
<DEPRECIATION> 3,399
<TOTAL-ASSETS> 24,305
<CURRENT-LIABILITIES> 1,483
<BONDS> 0
0
0
<COMMON> 361
<OTHER-SE> 22,337
<TOTAL-LIABILITY-AND-EQUITY> 24,305
<SALES> 2,798
<TOTAL-REVENUES> 9,779
<CGS> 1,193
<TOTAL-COSTS> 8,831
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> 1,674
<INCOME-TAX> 37
<INCOME-CONTINUING> 1,637
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 1,637
<EPS-PRIMARY> 0.26
<EPS-DILUTED> 0.24
</TABLE>
