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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-KSB
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ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended March 31, 1998
Commission File No. 0-28604
ELECTROSCOPE, INC.
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(Exact name of Issuer as specified in its charter)
Colorado 84-1162056
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(State or other jurisdiction of (I.R.S. Identification Number)
incorporation or organization)
4828 Sterling Drive, Boulder, Colorado 80301
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(Address of principal executive offices) (Zip Code)
Issuer's telephone number, including area code: (303) 444-2600
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Securities registered pursuant to Section 12(b) of the Act: None
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Securities registered pursuant to Section 12(g) of the Act:
Common Stock, no par value
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Check whether the Issuer (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding
12 months (or for such shorter period that the Issuer was required to file such
reports), and (2) has been subject to such filing requirements for the past 90
days.
Yes X No
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Check if there is no disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K (Section 229.405 of this chapter) in this form, and no disclosure
will be contained, to the best of Issuer'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 had total revenues of $1,315,915 for its fiscal year ended March
31, 1998.
As of June 8, 1998 assuming as a market value the price of $1.25 per share (the
last sales price of the Issuer's Common Stock on the NASDAQ market) the
aggregate market value of shares held by non-affiliates was $3,131,069.
As of June 8, 1998 the Issuer has outstanding 5,383,507 shares of Common Stock,
no par value.
Documents Incorporated by Reference: Definitive Proxy Statement for the 1998
Annual Shareholders' meeting to be filed with the Commission and incorporated by
reference as described in Part III and certain exhibits contained in
Registration Statement #333-4118-D declared effective with the SEC on June 25,
1996. The 1998 Proxy Statement will be filed within 120 days after the end of
the fiscal year ended March 31, 1998.
This Form 10-K consists of 37 pages.
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PART I
ITEM 1. BUSINESS.
THE COMPANY
Electroscope, Inc. ("Electroscope" or the "Company") was founded in 1991 to
address product opportunities in support of the increased usage of laparoscopic
(a type of minimally invasive surgery, or "MIS") monopolar electrosurgery. The
Company's initial approach to the market was to design, develop, manufacture and
market a patented monopolar electrosurgical shielding system, supplemented by
integrated electrosurgical instruments. The initial market opportunity was
created by the inherent risks of electrical burns to a patient undergoing
laparoscopic surgery. The Company's patented Active Electrode Monitoring system
("AEM-Registered Trademark-") protects the surgical patient from stray
electrical energy that can cause injury by actively and continuously monitoring
current flow through the shielding system and disabling the electrosurgical
current when potentially dangerous conditions exist. The EMS allows surgeons to
perform, more safely and more efficaciously, a broad range of surgical
procedures using laparoscopic monopolar electrosurgery.
Electrosurgery utilizes radio frequency ("RF") electrical energy to perform
surgical incisions and to control bleeding during surgery. Electrosurgical
techniques have been used in medicine since the 1930s in a broad range of open
surgical procedures and are now an integral part of virtually every surgeon's
practice. During the 1970s, gynecologists began using electrosurgery in MIS
procedures. Up until the late 1980s however, laparoscopic surgery - one of the
most common forms of minimally invasive surgery - was mainly limited to these
gynecological procedures (e.g. tubal ligation and the lysis of pelvic
adhesions). The development of the micro-camera, however, opened the door to
laparoscopic surgical procedures in a large number of other specialties,
including urologic, gastrointestinal, thoracic, general and orthopedic surgery.
Laparoscopy now accounts for a significant percentage of all surgical procedures
performed in the United States and because of the significant benefits of
minimally invasive surgery, the number of electrosurgically-based MIS procedures
is expected to continue to grow.
In MIS, the surgeon operates from outside the patient's body using
electrosurgical instruments and camera systems that are introduced through small
access ports. By nature of the camera system used, the surgeon is limited to a
small field of vision which may be only 1" - 2" in diameter. Given the
surgeon's restricted field of vision, there is the potential for unintended and
unobserved tissue burns from stray electrical current at non-targeted sites
outside the surgeon's viewing area. Stray electrical current can result from
insulation failure and/or capacitive coupling. These tissue and organ burns are
particularly dangerous because they may lead to unrecognized perforation or
infection of adjacent tissues and possible death.
The Company's approach to the market for electrosurgical MIS equipment is
to increase market awareness of the inherent hazards of laparoscopic surgical
procedures and to develop a sales force, including both employees and
independent sales representative organizations to reach the decision makers who
purchase such equipment. In 1995 the Company sought to market the products
using an exclusive distribution agreement with Valleylab, Inc., then a part of
the Hospital Products Group of Pfizer, Inc. Valleylab did not meet the minimum
purchase requirements in calendar year 1996, and hence lost its exclusivity.
The agreement was terminated by the Company in February of 1998.
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In addition to continuing to market and sell the original product line, the
Company is actively engaged in developing a line of disposable products, both
for the current surgical procedures that the Company addresses and for other
types of MIS procedures. The Company expects to introduce new products in
fiscal year 1999 and to continue to do so periodically thereafter. The Company
will pursue developing new products both internally and through acquisition of
existing product lines from third parties. The Company may also pursue the
acquisition of complimentary businesses. The Company is not currently engaged
in any negotiations to acquire such products or any such businesses, and has not
reached any definitive agreements to do so.
Market Development Overview
The Company believed that the most cost effective way to educate the market
to the hazards of monopolar electrosurgery and to generate significant revenues
for the Company was to replace the Company's direct sales effort with the
Valleylab sales force. Since the Valleylab agreement did not meet its
objectives the Company has taken steps to develop a sales force, made up of
Company employees and independent sales representative organizations, which
together provide market presence in most of the major market areas in the United
States. In addition, the Company has begun to establish a distribution network
outside of the United States. The Company believes that such measures, along
with increased marketing efforts and the introduction of new products, will
provide the basis for increased revenues and will ultimately lead to profitable
operations. Management does not expect that profitable operating levels will be
reached in fiscal year 1999. These measures, or any others that the company may
adopt, may not result in either increased revenues or profitable operations.
The Company was incorporated in February 1991. The Company's principal
offices are located at 4828 Sterling Drive, Boulder, CO 80301, and its telephone
number is (303) 444-2600.
THE PROBLEM: PATIENT SAFETY
INTRODUCTION
MIS offers substantial advantages over traditional open surgery. These
advantages, which have led to the widespread adoption of this surgical
technique, include less patient trauma due to minimal incisions, and shorter
periods of hospitalization and post-operative recovery. However, the Company
believes that there is a growing awareness in the medical community and
insurance industry about patient safety during the use of monopolar MIS
electrosurgical procedures because of the potential for internal injuries. It
has been determined that such injuries are sometimes caused by burns to
non-targeted tissue or organs at locations that can not be observed by the
surgeon during the surgical procedure. Further clinical investigation has
demonstrated that the burns result from failure of the insulation of the
surgical instruments or from a phenomenon known as capacitive coupling.
The shaft of the instrument (an active electrode) used for delivery of the
electrosurgical energy to the surgical site is covered with an insulating
material. Approximately 90% of the insulated portion of the shaft is beyond the
surgeon's view during the procedure. A breakdown in the insulation or an
incidence of capacitive coupling (through intact insulation) along the shaft can
create stray electrical energy, which can produce a severe burn to the patient
at a non-targeted site outside the surgeon's viewing area. In many cases this
injury cannot be detected by the surgeon at the time of the procedure. The
complication may present itself three to four days later in the form of a severe
infection, which nearly always results in a return to the hospital.
Breakdowns in insulation can occur through normal wear, improper handling,
or by the instrument being placed against trocar edges, or other sharp
instruments, during normal use. In addition, corona heating associated with
high frequency and high voltage has been documented to melt the insulation and
result in premature insulation breakdown on some instruments. Tiny insulation
defects are difficult to detect visually. Furthermore, tiny defects provide a
more concentrated current than larger defects. Tissue heating increases in
direct proportion to the concentration of the
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current. Accordingly, the more-difficult-to-detect tiny defects may present
more potential for unrecognized tissue burns than larger insulation defects.
A second concern is capacitive coupling, which can occur when two
conductors are separated by a non-conductor (insulation). In MIS, the
conductors are the instrument shaft and the metal cannula (through which the
electrosurgical instruments are introduced into the body), and the shaft
insulation is the non-conductor. Once a capacitor has been created, it is
possible for electrical current to transfer into the metal cannula and adjacent
tissue, even though the insulation is intact.
THE ELECTROSHIELD-Registered Trademark- SYSTEM SOLUTION
The Company has addressed the growing concern over stray energy injuries by
developing the Electroshield-Registered Trademark- Monitoring System, ("EMS") an
innovative, safe, and cost effective solution for use with monopolar
electrosurgery, the predominant method for minimally invasive surgical
applications. The EMS allows the free passage of Radio Frequency ("RF")
electrical energy to the cutting or coagulating tips of the electrosurgical
instruments while protecting the patient against dangerous stray energy by
continuously monitoring current flow in the patented instrument shield. The EMS
is based on the concept of Active Electrode Monitoring (AEM-Registered
Trademark-), developed and patented by the Company. Using AEM-Registered
Trademark-, the EMS dynamically monitors for stray electrical energy flowing in
the shield along the shaft of the instrument. Whenever abnormal electrical
current conditions are detected, the monitor signals the electrosurgical
generator to deactivate and sounds an alarm to notify the surgeon. The
Company's EMS operates somewhat like a "ground fault interrupt circuit breaker"
commonly found in home bathrooms and garages to protect users of electrical
appliances against stray current. Most importantly, the EMS protects the
patient from a risk that is out of the surgeon's view.
The Company provides a safe and efficacious solution to the risks presented
by the use of monopolar electrosurgery which is transparent to the surgeon and
is cost effective. The Company's EM2+ Electronic Monitoring units plug directly
into an operating room's existing electrosurgical generator without any
modifications. In addition, the Company's shielded electrosurgical instruments
function virtually identically to unshielded instruments currently in use. The
Company's approach therefore requires no change in the surgeon's technique and
little surgical staff training.
PRODUCTS
THE ELECTROSHIELD-Registered Trademark- MONITORING SYSTEM
The Company's Electroshield-Registered Trademark- Monitoring System is
based on the AEM-Registered Trademark- concept. The complete system consists of
the Company's EM2+ Electronic Monitor, ("EM2+") which plugs directly into a
standard electrosurgical generator, and integrated electrosurgical instruments
manufactured by the Company that incorporate the Company's shielding technology.
The Company also has developed a protective sheath incorporating its
AEM-Registered Trademark- technology for use with unshielded laparoscopic and
specialty instruments not manufactured by the Company. The AEM-Registered
Trademark- system is transparent to the surgeon, providing enhanced safety
without any change in the methodology used to perform MIS electrosurgery. The
system's attributes include:
- No change in surgical technique in most cases.
- Very little additional training for the surgeon. The use of the
Electroshield-Registered Trademark- instruments is identical to
those now being used, and are thus transparent to the surgeon.
- Very low additional capital equipment cost.
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THE EM2+ ELECTRONIC MONITOR
The EM2+ (a second generation product developed by the Company) protects
the patient against stray electrical energy that can cause injury by actively
and continuously monitoring current flow from the electrosurgical generator
through the electrosurgical instrument. The EM2+ dynamically protects against
stray electrical energy beyond the surgeon's field of vision during minimally
invasive surgical procedures. The EM2+ is the only device now available to
actively detect stray electrosurgical energy out of the view of the laparoscope.
It signals the electrosurgical unit to deactivate and alerts the surgeon
whenever abnormal electrical current conditions are detected.
The EM2+ is designed to be used with standard electrosurgical generators
that have return electrode monitoring capability. The EM2+ is based on an
advanced modular design with sophisticated, proprietary electronic circuitry.
The Company also offers standard electrosurgical cords that are used to connect
the EM2+ to the electrosurgical instruments.
ELECTROSURGICAL INSTRUMENTS
Electroscope designs and manufactures an array of the most common fixed tip
and hinged electrosurgical instruments, all of which incorporate AEM-Registered
Trademark- into the design. Examples of fixed tip instruments manufactured by
the Company include hooks, spatulas, and needles. Examples of hinged
instruments manufactured by the Company include scissors, graspers and
dissectors. The instruments are designed to replace other manufacturers'
unshielded electrosurgical instruments. The advanced design of the Company's
instruments is such that they have the look and feel similar to those of other
manufacturers' unshielded instruments, including similar dimensions and use of a
single connecting cord. Each of the instruments, fixed tip and hinged, are
modular in design, which permits disassembly for replacement of worn or damaged
parts when necessary and for effective cleaning and sterilization between uses.
The Company offers its electrosurgical instruments at prices comparable to other
manufacturers' unshielded, reusable instruments.
ADAPTIVE ELECTROSHIELD-Registered Trademark- SHEATHS
The Company also offers adaptive sheaths that permit unshielded
electrosurgical instruments and specialty instruments to utilize the Company's
AEM-Registered Trademark- technology. These adaptive sheaths allow the surgeon
to offer a uniform standard of care to all patients.
OTHER PRODUCTS
The Company has begun development on a series of new products to expand the
product line offered by the Company's sales force. These new products will take
advantage of the Company's expertise in understanding MIS procedures and the
needs of surgeons performing those procedures. The products will be targeted at
areas other than those served by AEM-Registered Trademark- technology and will
reduce the Company's dependence on market acceptance of AEM-Registered
Trademark- technology.
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MARKETING AND SALES
In an attempt to penetrate the market for electrosurgical equipment quickly
and effectively the Company decided to replace its initial direct sales efforts
by entering into an exclusive distribution agreement in September 1995 with
Valleylab Inc., then a part of the Hospital Products Group of Pfizer, Inc. Due
to Valleylab's failure to meet the minimum purchase requirements, the agreement
became non-exclusive for calendar year 1997. Valleylab was acquired by United
States Surgical Corporation, and pursuant to the terms of the agreement, the
Company terminated the agreement in February 1998.
The Company has found a mixed reception in the marketplace for the EM2+ and
related products. In certain instances, customers recognized the problem
associated with monopolar electrosurgery, and have readily accepted the
Company's solution to the problem. However, in other instances the Company has
found that selling the EM2+ product has been more difficult, and takes longer,
than originally believed. This is due to a variety of factors, including the
necessity to make surgeons and hospital risk managers aware of the potential for
electrical burns that can result from using unmonitored electrosurgical
instruments (with the resultant increase in potential litigation resulting from
such burns), the overall lack of single purchasing points in the industry (both
surgeons and hospitals need to be in substantial agreement as to potential for
injury) and the consequent need to make multiple sales calls on those with the
ability to commit to additional capital expenditures in the current medical
economic environment.
To expand market coverage while keeping costs under control the Company has
contracted with and trained a network of independent sales representative
organizations (each with several sales representatives) across the U.S. The
Company believes that the network of independent sales representative
organizations, with experience selling into the hospital operating room
environment and with the capability of addressing markets beyond the
laparoscopic field, offers the Company the best opportunity to broaden the
acceptance of its product line, and to generate increased revenues. In addition
to the efforts to broaden market acceptance in the United States, the Company
has contracted with independent distributors in Australia, Canada and Taiwan to
market the Company's products in those countries. While the Company believes
that this sales organization will result in additional and increasing revenues,
these efforts by the Company may not be successful in generating such additional
revenues.
RESEARCH & DEVELOPMENT
The Company employs five engineers in its research and product development
efforts. In addition to the development of other products outside the
AEM-Registered Trademark- product line, this group is exploring ways to broaden
the product line that the Company can offer to its sales force. This includes
developing products for other than laparoscopic procedures in addition to
increasing the styles of electrosurgical instruments available for MIS
applications. The Company believes that as MIS techniques are applied to
additional types of surgery, there will be a need to develop instruments capable
of performing such surgeries. The Company also believes that other surgical
equipment that uses RF electrical energy should be shielded and actively
monitored in order to make them safer. Future research and development efforts
will address such opportunities.
The Company recognizes that there are opportunities for new product
development beyond those that the company can pursue internally. The Company
intends to be active in exploring such opportunities, including acquisitions to
broaden the scope of products offered by the Company's sales force.
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MANUFACTURING, REGULATORY AFFAIRS AND QUALITY ASSURANCE
The Company engages in various manufacturing and assembly activities at its
facility in Boulder, Colorado. These operations include assembly of the EM2+
Electronic Monitors and fabrication, assembly and test operations for the
electrosurgical instruments, adaptive sheaths and cords. The Company also has
relationships with a number of outside suppliers which provide primary
sub-assemblies in addition to various electronic and sheet metal components,
machined and molded parts used in the Company's products. The Company has made
plans for the production, assembly and test operations required for the new
products that the Company plans to introduce in fiscal year 1999. The plans
include both expanding internal operations and outsourcing various preliminary
steps in the production process.
The Company believes that the use of both internal and external
manufacturing capabilities allows for increased flexibility in meeting its
customer delivery requirements, and significantly reduces the need for
investment in specialized or expensive capital equipment. The Company has
developed multiple sources of supply where possible and will continue to do so
as the Company expands its product offerings. The relationship between the
Company and its suppliers is generally limited to individual purchase order
agreements, supplemented as appropriate by contractual relationships to ensure
availability of certain products.
All components, materials and subassemblies used in the Company's products,
whether produced in-house or obtained from others, are inspected to ensure
compliance with Company specifications. All finished products are subjected to
quality assurance and performance testing procedures by Company personnel. As
discussed under the section on Government Regulation, the Company is subject to
the rules and regulations of the United States Food and Drug Administration. At
March 31, 1998 the production staff consisted of eight people and the regulatory
affairs and quality assurance staff consisted of five people.
The Company's leased facility of 11,246 square feet contains 7,150 square
feet of manufacturing, regulatory affairs and quality assurance space.
The facility is designed to comply with Current Good Manufacturing
Practices (CGMP) as specified in published FDA regulations. As noted below
(Government Regulation) the Company's facility has been inspected by the FDA and
has been found to be "...in substantial compliance with Good Manufacturing
Practices..." as of the most recent inspection.
PATENTS, PATENT APPLICATIONS AND PROPRIETARY RIGHTS
The Company's technical progress depends to a significant degree on its
ability to maintain patent protection for products and processes, to preserve
its trade secrets and to operate without infringing the proprietary rights of
third parties. The Company's policy is to attempt to protect its technology by,
among other things, filing patent applications for technology that it considers
important to the development of its business. The Company was granted a United
States patent having 42 claims on May 17, 1994. This patent relates to the
basic shielding and monitoring technologies that the Company now incorporates in
its products. The Company was granted a United States Patent on January 7, 1997
relating to specific implementations of shielding and monitoring in instruments.
Three additional United States patent applications are pending, one relating to
the incorporation of the shielding and monitoring technologies in various other
instrument configurations and two relating to bipolar laparoscopic devices.
Foreign patent applications relating to the basic shielding and monitoring
technologies have been filed in Australia, Canada, Japan and several European
countries and have been allowed in Australia, Canada and Japan. The validity
and breadth of claims covered in medical technology patents involve complex
legal and factual questions and, therefore, may be highly uncertain. Even with
the patents held by the Company, others may copy the Company's technology or
otherwise be able to incorporate the technology in their products.
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The Company requires its employees to execute non-disclosure agreements
upon commencement of employment with the Company. These agreements generally
provide that all confidential information developed or made known to the
individual by the Company during the course of the individual's employment with
the Company is to be kept confidential and not disclosed to third parties.
COMPETITION
READERS OF THIS 10-KSB ARE ENCOURAGED TO READ THIS SECTION ON COMPETITION IN
CONNECTION WITH THE SECTION ENTITLED "RISK FACTORS WHICH MAY AFFECT FUTURE
PERFORMANCE".
The electrosurgical products market is intensely competitive and tends to
be dominated by a relatively small group of large and well financed companies.
The Company competes directly for customers with those companies that currently
make unshielded monopolar electrosurgical instruments that are not actively
monitored for stray electrical energy. Several larger competitors include Karl
Storz Endoscopy America, Inc., Richard Wolf Medical Instruments Corp., United
States Surgical Corporation and Ethicon Endo-Surgery (a Division of Johnson &
Johnson, Inc.). While the Company knows of no other company (including those
referred to above) that provides for active electrode monitoring for stray
energy, it can be expected that the manufacturers of unshielded instruments will
resist any loss of market share which might result from the presence of the
Company's shielded products in the market. The Company has not yet introduced
its arthroscopic probe and is aware that there are at least two competitors
(Arthrocare and Mytek, a division of Johnson & Johnson, Inc.) currently offering
unshielded electrosurgical arthroscopic instruments.
The Company also believes that manufacturers of products based upon
surgical techniques that are alternatives to monopolar electrosurgery are
competitors of the Company. These techniques include bipolar electrosurgery,
laser surgery and the harmonic scalpel. Leading manufacturers include Everest
Medical Corporation (bipolar electrosurgery), Laserscope (laser surgery) and the
UltraCision Division of Johnson & Johnson, Inc., (harmonic scalpel). The
Company believes that monopolar electrosurgery currently offers certain
competitive advantages over the alternative methods that are available. However,
the risk exists that these alternative techniques may gain greater market share
and new competitive techniques may be developed and introduced.
As mentioned in the Marketing and Sales discussion, the competitive issues
involved in selling the Company's original EM2 product line do not primarily
revolve around a comparison of cost or features, but rather involve generating
an awareness of the inherent hazards of monopolar electrosurgery and the
potential for injury to the patient. This involves selling concepts, rather
than just a product, which results in higher sales costs than had been
originally anticipated by the Company. The Company's efforts to increase market
awareness of these hazards may not be successful, and the Company's competitors
may develop alternative strategies to counter the Company's marketing efforts.
Many of the Company's competitors and potential competitors have
significantly greater financial, technical, product development, marketing and
other resources and market recognition than the Company. The Company may not be
able to compete successfully against current and future competitors and
competitive pressures faced by the Company may materially adversely affect its
business, operating results and financial condition.
GOVERNMENT REGULATION
Government regulation in the United States and other countries is a
significant factor in the development and marketing of the Company's products
and in the Company's ongoing manufacturing, research and development activities.
The Company and its products are regulated by the FDA under a number of
statutes, including the Food, Drug and Cosmetics (FDC) Act.
Under the FDC Act, medical devices are classified as Class I, II or III on
the basis of the controls deemed necessary to reasonably ensure their safety and
effectiveness. Class I devices are subject to the least extensive controls, as
their safety and effectiveness can be reasonably assured through general
controls (e.g., labeling, pre-
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market notification and adherence to CGMP). For Class II devices, safety and
effectiveness can be assured through the use of special controls (e.g.,
performance standards, post-market surveillance, patient registries and FDA
guidelines). Class III devices (i.e., life-sustaining or life-supporting
implantable devices, or new devices which have been found not to be
substantially equivalent to legally marketed devices) require the highest level
of control, generally requiring pre-market approval by the FDA to ensure their
safety and effectiveness.
If a manufacturer or distributor of medical devices can establish that a
proposed device is "substantially equivalent" to a legally marketed Class I or
Class II medical device or to a Class III medical device for which the FDA has
not required a Pre-Market Approval application, the manufacturer or distributor
may seek FDA marketing clearance for the device by filing a 510(k) pre-market
notification. Following submission of the 510(k) notification, the manufacturer
or distributor may not place the device into commercial distribution in the
United States until an order has been issued by the FDA. The FDA's target for
issuing such orders is within 90 days of submission, but the process can take
significantly longer. The order may declare the FDA's determination that the
device is "substantially equivalent" to another legally marketed device and
allow the proposed device to be marketed in the United States. The FDA may,
however, determine that the proposed device is not substantially equivalent or
may require further information, such as additional test data, before making a
determination regarding substantial equivalence. Any adverse determination or
request for additional information could delay market introduction and have a
materially adverse effect on the Company's continued operations. The Company
has received 510(k) notification for its EM-2 Electronic Monitor, monopolar MIS
electrosurgical instruments with Electroshield-Registered Trademark-, its
Electroshield-Registered Trademark- Monitoring System and an Arthroscopic probe,
all of which are designated as Class II medical devices.
Labeling and promotional activities are subject to scrutiny by the FDA and,
in certain instances, by the Federal Trade Commission. The FDA also imposes
post-marketing controls on the Company and its products, and registration,
listing, medical device reporting, post-market surveillance, device tracking and
other requirements on medical devices. Failure to meet these pervasive FDA
requirements or adverse FDA determinations regarding the Company's clinical and
preclinical trials could subject the Company and/or its employees to injunction,
prosecution, civil fines, seizure or recall of products, prohibition of sales or
suspension or withdrawal of any previously granted approvals, which could lead
to a material adverse impact on the Company's financial position and results of
operations.
The FDC Act regulates the Company's quality control and manufacturing
procedures by requiring the Company and its contract manufacturers to
demonstrate compliance with Current Good Manufacturing Practices (CGMP) as
specified in published FDA regulations. The FDA monitors compliance with CGMP
by requiring manufacturers to register with the FDA, which subjects them to
periodic unannounced FDA inspections of manufacturing facilities. If violations
of applicable regulations are noted during FDA inspections of the Company's
manufacturing facilities or the facilities of its contract manufacturers, the
continued marketing of the Company's products may be adversely affected. Such
regulations are subject to change and depend heavily on administrative
interpretations. In April 1995, the FDA conducted a reinspection of the
Company's facilities for compliance with CGMP. All prior citations were cleared
and no new citations were noted. The Company believes it has the internal
resources and processes in place to be reasonably assured that it is in
compliance with all applicable regulations regarding the manufacture and sale of
medical devices. However, if the Company were to be found to not be in
compliance with CGMP, such findings could result in a material adverse impact on
the Company's financial condition and results of operations.
Sales of medical devices outside of the United States are subject to United
States export requirements and foreign regulatory requirements. Legal
restrictions on the sale of imported medical devices vary from country to
country. The time required to obtain approval by a foreign country may be
longer or shorter than that required for FDA approval, and the requirements may
differ. The Company has obtained a Certificate of Export from the United States
Department of Health and Human Services which states that the Company has been
found to be "...in substantial compliance with Good Manufacturing Practices..."
based on the most recent inspection. However a specific foreign country in
which the Company wishes to sell its products may not accept or continue to
accept the Export Certificate.
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ENVIRONMENTAL LAWS AND REGULATIONS
From time to time the Company receives materials returned from customers,
sales representatives and other sources which are potentially biologically
hazardous. These materials are segregated and handled in accordance with
specific procedures which minimize the potential exposure for employees. Such
materials are disposed of in accordance with specific procedures. The costs of
compliance with these procedures is not significant.
EMPLOYEES
As of March 31, 1998, the Company employed 31 individuals, 10 of which are
engaged directly in research, development and regulatory activities, 8 in
manufacturing, 8 in marketing and sales and 5 in administrative positions. None
of the Company's employees is covered by a collective bargaining agreement, and
the Company considers its relations with its employees to be good.
ITEM 2. PROPERTIES.
The Company leases 11,246 square feet of office and manufacturing space at
4828 Sterling Drive, Boulder, Colorado 80301. This lease expires on October
31, 1998. The Company is actively seeking new facilities, and expects to either
exercise its option to renew the lease on its present facility or move to new
facilities before the expiration of the current lease.
ITEM 3. LEGAL PROCEEDINGS.
On June 4, 1997, a class action lawsuit was filed in the United States
District Court for the District of Minnesota against the Company, the members of
the Board of Directors as of the date of the Company's initial public offering,
and John G. Kinnard and Company, Inc., the underwriter of the Company's initial
public offering. The complaint was filed by Avrom Gart, a former shareholder
of the Company, individually and on behalf of all others similarly situated.
The complaint alleged that the Company's Registration Statement which became
effective on or about June 25, 1996, of which the prospectus was a part, was
materially false and misleading, contained untrue statements of material facts,
omitted to state other facts necessary to make the statements therein not
misleading, and failed to disclose adequately material facts.
On March 24, 1998 the United States District Court in Minneapolis dismissed
the Complaint with Prejudice.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
There were no matters submitted to a shareholder vote during the fourth
quarter of the fiscal year ended March 31, 1998.
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PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
The Company's Common Stock is traded in the over-the-counter market on the
NASDAQ National Market system under the symbol ESCP. The quotations presented
below reflect inter-dealer prices, without retail mark-up, mark-down or
commissions and may not necessarily represent actual transactions. The
following table sets forth for the periods indicated, the high and low closing
sale prices for the Common Stock:
<TABLE>
<CAPTION>
HIGH LOW
- --------------------------------------------------------------------------------
<S> <C> <C>
FISCAL YEAR ENDED MARCH 31, 1997
First Quarter through June 30, 1996 10 3/4 10
Second Quarter through September 30, 1996 10 1/2 8
Third Quarter through December 31, 1996 9 4
Fourth Quarter through March 31, 1997 5 3 1/2
FISCAL YEAR ENDED MARCH 31, 1998
First Quarter through June 30, 1997 3 1/2 1 3/4
Second Quarter through September 30, 1997 3 2
Third Quarter through December 31, 1997 2 5/8 1 3/8
Fourth Quarter through March 31, 1998 1 7/8 1 3/8
</TABLE>
As of March 31, 1998 there were approximately 192 holders of record of the
Common Stock. This number does not reflect stockholders who beneficially own
Common Stock held in nominee or street name, which as of June 8, 1998
approximated 610 stockholders.
DIVIDEND POLICY
The Company has not paid cash dividends in the past and does not intend to
pay cash dividends in the foreseeable future. The Company presently intends to
retain any cash generated from operations in the future for use in its business,
with any future decision to pay cash dividends dependent upon the Company's
growth, profitability, financial condition, and other factors the Board of
Directors may deem relevant.
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
GENERAL
The Company manufactures and markets a line of proprietary electrosurgical
products that are designed to provide greater safety to patients who undergo
minimally invasive electrosurgery ("MIS"). The Company believes that its
patented Electroshield-Registered Trademark- Monitoring System offers surgeons
significant advantages compared to other electrosurgical systems in use because
of its ability to monitor dynamically for stray electrical energy out of the
view of the surgeon during MIS procedures. Stray electrical energy has been
shown to cause unintended burns which may result in hospitalization or death.
The Company has received four FDA Form 510(k) notifications for its products and
obtained patent protection for its products' basic shielding and monitoring
features. In September 1995, the Company entered into an exclusive worldwide
Distribution Agreement (the "Agreement") with Valleylab, then part of the
Hospital Products Group of Pfizer, Inc., pursuant to which Valleylab was
required to make minimum purchases through calendar year 1998 in order to retain
its exclusive distribution rights. Valleylab did not meet its minimum purchase
requirements in calendar 1996 and the Agreement became non-exclusive for 1997.
In accordance with the terms of the Agreement, the Company terminated the
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Agreement in February 1998 after the sale of Valleylab to US Surgical
Corporation. To replace the Valleylab distribution resources, the Company has
contracted with a network of independent sales representative organizations
across the U.S. and with independent distributors in Australia, Canada and
Taiwan to market the Company's products in those countries. The Company manages
and trains those representatives and distributors using a small internal group
of regional sales managers.
The Company recognizes that market awareness and acceptance of the hazards
inherent in monopolar electrosurgery has been slower to occur than the Company
had believed would be the case. The Company has modified its marketing
strategies to address the issues of market acceptance of the technology. The
Company has also undertaken efforts to broaden the product line offerings beyond
the original EM2 product and its accessories. The Company is developing a line
of disposable products, and intends to explore product development and
acquisition opportunities from third parties.
The Company also recognizes that its efforts to develop its own
distribution network through independent representative organizations and
international distributors will require significant increased usage of cash and
additional management resources beyond those which were necessary while
Valleylab had an exclusive right to distribute the Company's products.
HISTORICAL PERSPECTIVE
The Company was organized in February 1991. During its first two years, the
Company developed the EM2 Electronic Monitor and adaptive protective sheaths to
work with traditional electrosurgical instruments. During this period, the
Company applied for patents with the United States Patent Office and conducted
clinical trials. As the development program proceeded it became apparent that
the merging of electrical and mechanical engineering skills in the instrument
development process for the Company's patented, integrated electrosurgical
instruments was more difficult than was expected at first. As a result, the
development of the instruments with the Electroshield-Registered Trademark-
AEM-Registered Trademark- technology was not completed until 1995. The Company
introduced integrated instruments for the Electroshield-Registered Trademark-
Monitoring System in November 1995.
The installed base of the Company's EM2 and EM2+ Electronic Monitors has
not increased as rapidly as the Company had expected since the introduction of
the product in 1994. The Company believes the installed base has the potential
for increasing as the sales organization becomes more familiar with the
Electroshield-Registered Trademark- Monitoring System ("EMS") and sells the
system to their customers. The Company expects that the sales of
electrosurgical instruments and accessories will increase as additional EM2+
Electronic Monitors are installed. The Company continues to devote resources to
increasing market awareness of the inherent hazards of monopolar electrosurgery.
As a result of the lack of immediate market acceptance of the EM2+ EMS, the
Company has broadened its R&D efforts to reduce its dependence on products
involving AEM-Registered Trademark- technology.
Since the Valleylab Agreement did not meet its objectives the Company has
taken steps to develop a network of independent sales representative
organizations, which provides market presence in most of the major market areas
in the United States.
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OUTLOOK
STATEMENTS CONTAINED IN THIS SECTION ON OUTLOOK ARE NOT HISTORICAL FACTS,
INCLUDING STATEMENTS ABOUT THE COMPANY'S STRATEGIES AND EXPECTATIONS ABOUT NEW
AND EXISTING PRODUCTS AND MARKET DEMAND AND ACCEPTANCE OF NEW AND EXISTING
PRODUCTS, TECHNOLOGIES AND OPPORTUNITIES, MARKET AND INDUSTRY SEGMENT GROWTH,
AND RETURN ON INVESTMENTS IN PRODUCTS AND MARKETS. THESE STATEMENTS ARE FORWARD
LOOKING STATEMENTS WITHIN THE MEANING OF THE PRIVATE SECURITIES LITIGATION
REFORM ACT OF 1995 AND INVOLVE SUBSTANTIAL RISKS AND UNCERTAINTIES THAT MAY
CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE INDICATED BY THE FORWARD
LOOKING STATEMENTS. ALL FORWARD LOOKING STATEMENTS IN THIS SECTION ON OUTLOOK
ARE BASED ON INFORMATION AVAILABLE TO THE COMPANY ON THE DATE OF THIS DOCUMENT,
AND THE COMPANY ASSUMES NO OBLIGATION TO UPDATE SUCH FORWARD LOOKING STATEMENTS.
READERS OF THIS FORM 10-KSB ARE STRONGLY ENCOURAGED TO REVIEW THE SECTION
ENTITLED "RISK FACTORS WHICH MAY AFFECT FUTURE PERFORMANCE".
INSTALLED BASE OF MONITORING EQUIPMENT: The Company believes that the installed
base of EM2+ monitors has the potential for increasing as the network of
independent sales representatives and the Company's international distributors
become familiar with the EMS and sell the system to their customers. The
Company expects that the sales of electrosurgical instruments and accessories
should increase as additional EM2+ monitors are installed. The Company believes
that the measures taken to increase the number of sales representatives carrying
the AEM-Registered Trademark- product line, along with increased marketing
efforts and the introduction of new products, will provide the basis for
increased revenues and will ultimately lead to profitable operations. The
Company also believes that the investment made in training the network of
independent sales representatives will produce higher future revenues, at a
lower cost, than could be generated by a direct sales force employed by the
Company. Management does not expect that profitable operating levels will be
reached in fiscal year 1999, and these measures, or any others that the company
may adopt, may not result in either increased revenues or profitable operations.
PROBABILITY OF CONTINUED OPERATING LOSSES: The Company has incurred losses from
operations since inception and has an accumulated deficit of $10,123,977 as of
March 31, 1998. Due to the need to continue the development and training of a
sales and distribution network and the need to increase revenues to a level
adequate to cover fixed manufacturing costs, the Company believes that it may
continue to operate at a net loss for several quarters. The Company believes
its results of operations may fluctuate on a quarterly basis as a result of the
size and frequency of sales through the independent sales network and the
international distributors, resulting in higher levels of selling expenses.
Such fluctuations may be significant, and may result in the Company operating at
a loss in one or more quarters even after a period of profitability.
REVENUE GROWTH: The Company expects to introduce additional new products in
fiscal year 1999 which are expected to contribute to increased revenues in
fiscal 1999 and beyond. The Company also expects to increase the volume of
product sold internationally, and to generate increased revenues from the U.S.
as the independent network of representatives becomes more familiar with the
product and expands the installed base of Electroshield-Registered Trademark-
Monitoring Systems with resulting increases in sales of electrosurgical
instruments and adaptive sheaths used by this installed equipment.
GROSS PROFIT AND GROSS MARGINS: Gross profit and gross margin can be expected
to fluctuate from quarter to quarter, as a result of product sales mix and sales
volume. Gross margins are expected to be higher at higher levels of production
and sales. These higher gross margins are currently not being achieved because
of the expenses related to manufacturing capacity, which is currently
underutilized due to the reduced levels of product revenues and other, generally
fixed, manufacturing costs.
SALES AND MARKETING EXPENSES: The Company will continue its efforts to expand
its domestic and international distribution capability. The Company believes
that sales and marketing expenses will continue to increase as the Company
expands the networks of domestic sales representatives and international
distributors and increases its marketing programs. The use of independent sales
representatives, as compared to a direct sales force employed by the Company,
will result in a lower direct sales cost, and a higher level of commission
expenditures, as the independent sales representatives are paid only
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on the basis of commissions on their sales, whereas a direct sales force
employed by the Company would be compensated for travel and other expenses, in
addition to salaries and commissions. The Company also believes that sales and
marketing expenses will decrease as a percentage of net revenue with increasing
sales volume.
RESEARCH AND DEVELOPMENT EXPENSES: The Company has invested in new product
development which has resulted in the introduction of two new products in FY 98
with others anticipated to be introduced in FY 99. The Company intends to
explore additional product development and acquisition opportunities from third
parties. Research and development expenses are expected to increase in FY 99 to
support the Company's development of new products.
LIQUIDITY AND CAPITAL RESOURCES: The Company may use working capital to build
inventories, to ensure that orders can be filled in a timely manner, to support
the sales efforts of the Company's sales force and to accommodate anticipated
growth. While net proceeds from the Company's initial public offering are
currently invested primarily in money market instruments and government
securities, the Company may also use a substantial portion of the net proceeds
for the acquisition or development of complementary products or businesses, if
such acquisition or development opportunities arise. The Company currently has
no understanding, commitment or agreement with respect to any such acquisition
or development program. The Company anticipates that its cash on hand will be
sufficient to fund its operations, including the development of the sales force,
working capital and capital requirements for at least the next twelve months,
and that it has attracted and can continue to attract the additional human
resources necessary to manage the development of the sales force, the increased
marketing efforts, and the general growth of the business.
The Company anticipates that it will invest a significant amount of cash in
the development of its sales force, which will include substantial amounts of
training and an investment in demonstration equipment, and the increased
emphasis on marketing programs. The Company also anticipates that such
investments will generate increased sales and will ultimately lead to profitable
operations, although management does not anticipate that this level of
operations will be reached in FY 99.
RISK FACTORS WHICH MAY AFFECT FUTURE PERFORMANCE:
Among the factors which could cause future results to be materially different
from expectations are:
UNCERTAINTY OF MARKET ACCEPTANCE: The Company's success is dependent upon
acceptance of its products by the medical community as reliable, safe and
cost-effective for use in minimally invasive surgical (MIS) procedures, as well
as the recognition that current practices may not be entirely safe. The Company
is unable to predict how quickly or how broadly its products will be accepted by
the medical community, or if accepted, the number of MIS procedures that will be
performed using the Company's products. Achieving market acceptance will
require the Company to educate the marketplace about the potential hazards
involved in the use of existing electrosurgical products during MIS procedures
and the expected benefits associated with the use of the Company's products. It
may also require additional data to be accepted by the medical community as
evidence of the occurrence of such hazards. The Company may not be successful
in educating the marketplace about its products and available data concerning
these hazards may not create a demand by hospitals and surgeons for the
Company's products. The Company's future financial performance will depend in
large part on the extent to which the Company's products and enhancements are
accepted by the market in commercially viable quantities. If the Company's
products do not achieve market acceptance in these quantities, the Company's
business, financial condition and operating results will be materially adversely
affected.
ABILITY TO INCREASE REVENUES: The Company's attempts to develop and train a
network of independent sales representatives in the US and to expand its
international distribution efforts may take longer than expected, may not be as
successful as the Company anticipates, and, due to the independent nature of the
selling organizations in the US, may result in considerable amounts of
retraining effort as the organizations change their product lines and their
personnel. The Company may not be able to obtain full coverage of the US by
independent sales representatives as quickly as it currently anticipates. The
Company may also encounter more difficulties than anticipated in expanding its
international presence, due to regulatory issues and its ability to successfully
manage international operations.
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HISTORY OF OPERATING LOSSES AND CAPITAL AVAILABILITY: The Company was formed in
1991, and has incurred losses since its inception. Prior to fiscal year 1994,
the Company was principally engaged in research and development of its products.
The Company has primarily financed its research and development and operational
activities with sales of common stock. At March 31, 1998, the Company had an
accumulated deficit of $10,123,977. The Company has limited experience in the
manufacture and sale of its products, and is a relatively recent entrant into
the medical device market. As a result, the Company may experience significant
losses in the future as it expands and enhances its marketing and manufacturing
capabilities, and continues its product development activities to broaden its
product offerings, which may include acquisitions. The Company's business
strategy may not be successful and the Company may not be able to achieve or
sustain profitability on a quarterly or annual basis.
As of March 31, 1998, the Company had $6,199,755 in Cash and Cash
Equivalents and Short Term Investments available to fund future operations. The
Company believes it has sufficient cash available to fund operations through
March 31, 1999. However, the Company does not believe that it would be
successful in obtaining additional funds from the public markets should it be
required to do so in order to fund continuing operations.
COMPETITION: The electrosurgical products market is intensely competitive.
While the Company knows of no other company that markets electrosurgical
products that incorporate active electrode monitoring for stray electrical
energy, it can be expected that the manufacturers of unshielded electrosurgical
instruments will resist any loss of market share that might result from the
presence of the Company's shielded products in the market. The Company also
believes that manufacturers of products that are based upon surgical techniques
that are alternatives to monopolar electrosurgery are competitors of the
Company. These techniques include bipolar electrosurgery, laser surgery and the
harmonic scalpel. The alternative techniques may gain greater market share and
new competitive techniques may be developed and introduced. Many of the
Company's competitors and potential competitors have significantly greater
financial, technical, product development, marketing and other resources than
the Company. Many of the Company's competitors also currently have, or may
develop or acquire, substantial installed customer bases in the medical products
market and have significantly greater market recognition. As a result of these
factors, the Company's competitors may be able to respond more quickly to new or
emerging technologies and changes in customer requirements or to devote greater
resources to the development, promotion and sale of their products than the
Company. It is possible that new competitors or new alliances among competitors
may emerge and rapidly acquire significant market share. The Company may not be
able to compete successfully against current and future competitors and
competitive pressures faced by the Company may materially adversely affect its
business, operating results and financial condition.
POTENTIAL NEGATIVE IMPACT OF CHANGES IN OR FAILURE TO COMPLY WITH GOVERNMENT
REGULATIONS: The Company's research, manufacturing, marketing and distribution
of its products in the United States and other countries are subject to
extensive regulation by numerous governmental authorities including, but not
limited to, the Food and Drug Administration ("FDA"). The FDA administers the
Federal Food, Drug and Cosmetic Act (the "FDC Act"). Under the FDC Act, medical
devices must receive FDA clearance through the Section 510(k) pre-market
notification process or through the more lengthy pre-market approval ("PMA")
process before they can be sold in the United States. The Company has received
four 510(k) notifications covering its products. The process of obtaining FDA
and other required regulatory approvals is lengthy and has required and will
continue to require the expenditure of substantial resources. There can be no
assurance that the Company will be able to continue to obtain the necessary
approvals. As an important part of its strategy, the Company also intends to
pursue commercialization of its products in international markets. The
Company's products are subject to regulations that vary from country to country.
The process of obtaining foreign regulatory approvals in certain countries can
be lengthy and require the expenditure of substantial resources. The Company
may not be able to obtain necessary regulatory approvals or clearances on a
timely basis or at all, and delays in receipt of or failure to receive such
approvals or clearances, or failure to comply with existing or future regulatory
requirements, might cause the Company to miss market opportunities, and would
have a material adverse effect on the Company's business, financial condition
and results of operations.
MANUFACTURING SUBJECT TO GOVERNMENTAL REGULATIONS: Manufacturing of the
Company's products is subject to extensive regulatory requirements administered
by the FDA and other regulatory bodies. The Company believes it is in
compliance with the Current Good Manufacturing Practices ("CGMP") required by
the FDA, and passed its last inspection by the FDA
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in April 1995. FDA inspections can be conducted at any time, without notice.
Failure to comply with CGMP and these regulatory requirements could, among other
things, result in fines, suspensions or withdrawals of regulatory approvals,
product recalls, suspension of manufacturing, operating restrictions and
criminal prosecution. In addition, future changes in regulations or
interpretations made by the FDA or other regulatory bodies, with possible
retroactive effect, could adversely affect the Company. Furthermore, changes in
existing regulations or adoption of new regulation or policies could prevent the
Company from obtaining, or affect the timing of, future regulatory approvals or
clearances. The Company may not be able to obtain necessary regulatory
approvals or clearances on a timely basis in the future, or at all. Delays in
receipt of or failure to receive such approvals or clearances, or failure to
comply with existing or future regulatory requirements, would have a material
adverse effect on the Company's business, financial condition and results of
operations.
DEPENDENCE ON NEW PRODUCT DEVELOPMENT: The Company's future success and
financial performance will depend in part on the Company's ability to meet the
increasingly sophisticated needs of customers through the timely development and
successful introduction of product upgrades, enhancements and new products.
Such upgrades, enhancements and new products are subject to significant
technical risks. The medical device market is subject to rapid technological
change, resulting in frequent new product introductions and enhancements of
existing products, as well as the risk of product obsolescence. While the
Company is currently developing new products and enhancing its existing product
lines, the Company may not be successful in completing the development of such
new products or enhancements. In addition, to be competitive, the Company must
also respond effectively to technological changes by continuing to enhance its
existing products to incorporate emerging or evolving standards. The Company
may not be successful in developing and marketing product enhancements or new
products that respond to technological changes or evolving industry standards.
The Company may experience difficulties that could delay or prevent the
successful development, introduction and marketing of those products, and its
new products and product enhancements may not adequately meet the requirements
of the marketplace and achieve commercially viable levels of market acceptance.
If any potential new products or upgrades or enhancements are delayed, or if any
potential new products or upgrades or enhancements experience quality problems
or do not achieve such market acceptance, the Company's business, operating
results and financial condition will be materially adversely affected.
DEPENDENCE ON PATENTS, PATENT APPLICATION AND PROPRIETARY RIGHTS: The
Company's success depends, and will continue to depend in part, on its
ability to maintain patent protection for its products and processes, to
preserve its trade secrets and to operate without infringing the proprietary
rights of third parties. The Company has two US patents on several
technologies embodied in its Electroshield Monitoring System and related
accessories and has applied for an additional US patent. In addition, the
Company has three issued foreign patents and one foreign patent application
pending for its AEM-Registered Trademark- technology and two applications
pending for bipolar laparoscopic devices. The validity and breadth of claims
coverage in medical technology patents involve complex legal and factual
questions and, therefore, may be highly uncertain. The Company's current
patents may not provide a competitive advantage, the pending applications may
not result in patents being issued, and competitors of the Company may design
around any patents issued to the Company. Furthermore, the Company's
non-disclosure agreements and invention assignment agreements may not protect
its proprietary information and know-how or provide adequate remedies for the
Company in the event of unauthorized use or disclosure of such information,
and others may be able to develop independently such information. There has
been substantial litigation regarding patent and other intellectual property
rights in the medical device industry. Litigation may be necessary to
enforce patents issued to the Company, to protect trade secrets or know-how
owned by the Company, to defend the Company against claimed infringement of
the rights of others or to determine the ownership, scope or validity of the
proprietary rights of the Company and others. Any such claims may require
the Company to incur substantial litigation expenses and to divert
substantial time and effort of management personnel. An adverse
determination in litigation involving the proprietary rights of others could
subject the Company to significant liabilities to third parties, could
require the Company to seek licenses from third parties, and could prevent
the Company from manufacturing, selling or using its products. The
occurrence of such litigation or the effect on the Company's business of such
litigation may materially adversely affect the Company's business, financial
condition and results of operations.
DEPENDENCE ON SINGLE SOURCE SUPPLIERS AND SUB-CONTRACTORS: The Company depends
on single source suppliers for certain of the key components used in
manufacturing its products. Although the Company believes that there are
alternative suppliers, any interruption in the supply of key components could
have a material adverse effect on the Company's ability to manufacture its
products until a new source of supply is located and, therefore, could have a
material adverse effect on the Company's business, operating results and
financial condition. The Company intends to carry an appropriate inventory of
critical materials, however, a sudden increase in demand may create a backorder
situation as lead times for some of the
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Company's critical materials are in excess of 12 weeks. The Company relies on
sub-contractors to provide much of its product, either in the form of finished
goods or sub-assemblies which the Company then assembles and tests. While these
sub-contractors reduce the cost of carrying manufacturing capabilities inside
the Company, they may not be as responsive to increased demand as the Company
would be if it had its manufacturing capacity entirely in-house.
LIMITED MANUFACTURING EXPERIENCE FOR LARGE SCALE PRODUCTION: For the Company to
be financially successful, it must manufacture its products in accordance with
regulatory requirements, in commercial quantities, at appropriate quality levels
and at acceptable costs. The Company has not yet been required to produce its
electrosurgical products in large quantities at competitive costs, and it may
not be able to do so. The Company may not be successful in making the
transition to large scale commercial production of these electrosurgical
products. The Company's failure to manufacture its product in commercial
quantities at acceptable costs would have a material adverse effect on the
Company's business, financial condition and results of operations.
POTENTIAL FLUCTUATIONS IN FUTURE QUARTERLY RESULTS: The Company expects that its
operating results will fluctuate significantly from quarter to quarter in the
future and will depend upon a number of factors, many of which are outside the
Company's control. These factors include the extent to which the Company's
Electroshield-Registered Trademark- Monitoring System and related accessories
gain market acceptance; investments by the Company in marketing, sales, research
and development and administrative personnel necessary to support the Company's
anticipated growth; the ability of the Company to expand its market share; and
general economic conditions.
UNCERTAINTY OF HEALTH CARE REFORM: The levels of revenue and profitability of
medical device companies may be affected by the continuing efforts of government
and third-party payors to contain or reduce the costs of health care through
various means. In the United States there have been, and the Company expects
that there will continue to be, a number of federal and state proposals to
control health care costs. These proposals contain measures intended to control
public and private spending on health care as well as to provide universal
public access to the health care system that could affect the levels of demand
for the Company's products.
PRODUCT LIABILITY RISK; LIMITED INSURANCE COVERAGE: The Company faces an
inherent business risk of exposure to product liability claims in the event that
the use of its products is alleged to have resulted in adverse effects to a
patient. The Company maintains a general liability insurance policy up to the
amount of $5,000,000 that includes coverage for product liability claims.
Liability claims may be excluded from such policy, may exceed the coverage
limits of such policy, and such insurance may not continue to be available on
commercially reasonable terms or at all. Consequently, a product liability
claim or other claim with respect to uninsured liabilities or in excess of
insured liabilities could have a material adverse effect on the Company's
business, financial condition and results of operations.
DEPENDENCE ON KEY PERSONNEL: The Company is highly dependent on a limited
number of key management personnel, particularly its Chief Executive Officer,
Patrick F. Crane, its Vice President of Research and Development, David W.
Newton, its Vice President of Finance & Administration, Karl Hawkins and its
Director of Manufacturing, James R. Cartwright. The Company's future success
will also depend, in part, on its ability to attract and retain highly qualified
personnel. There can be no assurance that the Company will be successful in
hiring or retaining qualified personnel. The loss of key personnel to death,
disability or termination, or the inability to hire and retain qualified
personnel, could have a material adverse effect on the Company's business,
financial condition and results of operations.
YEAR 2000
Computer programs that rely on two-digit date codes to perform computations
and decision-making functions may cause computer systems to malfunction due to
an inability of such programs to interpret the date code "00" as the year 2000.
The Company is conducting an initial assessment of its internal exposure to the
Year 2000 problem and expects to complete that assessment in the second quarter
of fiscal year 1999. The Company does not expect that the costs to be incurred
in that assessment will have a material effect on the financial results of the
Company.
Products manufactured by the Company do not incorporate any computer programs
that rely on two-digit date codes.
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The Company may also have exposure to other companies' Year 2000 problems. The
Company will initiate formal communications with its significant vendors with
respect to their compliance with Year 2000 programs.
The inability of the Company or any of its principal vendors to become Year 2000
compliant in a timely manner could have a material adverse effect on the
Company's financial condition or results of operations.
The expectations of the Company contained in this section on Year 2000 are
forward-looking statements within the meaning of the Private Securities
Litigation Reform Act of 1995 and involve substantial risks and uncertainties
that may cause actual results to differ materially from those indicated by the
forward looking statements. All forward looking statements in this section are
based on information available to the Company on the date of this document, and
the Company assumes no obligation to update such forward looking statements.
RESULTS OF OPERATIONS
NET REVENUES. Revenues for the fiscal year ended March 31, 1998 ("FY 98") were
$1,315,915, a decrease of 6% from the fiscal year ended March 31, 1997 ("FY
97"). Revenue from Valleylab represented less than 2% of FY 98 revenue, vs. 82%
of FY 97 revenue. The decrease in FY 98 revenues was due to the transition from
the exclusive Valleylab Agreement and a subsequent direct sales force to a
network of independent sales representatives.
Revenues for FY 97 were $1,398,184, a decrease of 36% from the fiscal year
ended March 31, 1996 ("FY 96"). This decrease was due to a combination of
factors, most importantly the transition from the exclusive Valleylab sales
effort to a direct sales force hired by the Company, which did not produce the
results the Company had anticipated. Revenue from Valleylab represented
$2,002,600 (92%) of FY 96 revenue.
GROSS PROFIT. Gross Profit in FY 98 was $97,573, which resulted in a Gross
Margin of 7.4% of Revenue. This was an improvement of $121,394 compared to FY
97, in which costs of revenue exceeded revenues by $23,821. The increase was
primarily the result of reduced costs of materials, including lower scrap costs,
in FY 98. The negative gross profit in FY 97 was a decrease of $746,529 from FY
96 gross profit of $722,708. This decrease was primarily due to the lower
revenue in FY 97, which was not adequate to fully cover manufacturing expenses.
The decrease was also attributable to costs incurred and expenses related to
excess manufacturing capacity, which resulted from expansions in facilities and
manufacturing staff in anticipation of higher future production volumes, as well
as higher manufacturing costs associated with early stage production of hinged
tip instruments. Gross profit as a percentage of revenue decreased from 33% in
FY 96 to a negative percentage in FY 97.
SALES AND MARKETING EXPENSES. Sales and marketing expenses were $1,834,806 in
FY 98, an increase of 21% from FY 97. The increase resulted from the Company's
efforts to replace Valleylab with a direct sales force, and subsequently
investing resources to contract with and train independent sales
representatives. Those resources included substantial expenditures for samples
of the Company's products. In addition, significant marketing resources were
devoted to increasing public awareness of the hazards inherent in laparoscopic
surgery.
Sales and marketing expense of $1,511,190 in FY 97 was an increase of 55%
compared to FY 96, primarily as a result of the Company's efforts to strengthen
its own sales capability and develop its own distribution network in the wake of
Valleylab's loss of exclusivity.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
decreased $148,799 (11%) from FY 97. Included in FY 97 expenses was a severance
settlement reached with a former Vice-President of Sales & Marketing, partially
offset in FY 98 by the hiring of a Chief Executive Officer in the 1st Quarter of
FY 98 and a Chief Financial Officer in the 2nd Quarter of FY 98.
General and administrative expenses increased 134% from FY 96 to $1,349,371 in
FY 97. This increase was primarily due to overall increased levels of business
activity, including activities related to being a public company. An additional
factor in the increase was a severance settlement reached with a former
vice-president of Sales and Marketing. Other contributors
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<PAGE>
to the increase were expenditures for business strategy consultants, increases
in regulatory affairs headcount, and an increase in expenses related to Board of
Directors activities.
RESEARCH AND DEVELOPMENT. Research and development expenses increased $35,569
(6%) from FY 97, reflecting increased spending on several product development
programs, partially offset by the completion of older development efforts.
Research and development expenses increased 20% from FY 96 to $616,730 in FY 97,
reflecting additional technical personnel dedicated to product development.
NET LOSS. Net Loss in FY 98 increased $291,100 (10%) to $3,194,731 from FY 97.
The improvement in Gross Profit of $121,394 was offset by a reduction of
$202,109 in Other Income and (Expense). This reflected the FY 97 amortization
into other income of a non-refundable payment made by Valleylab in connection
with the formerly exclusive Agreement. There was no such income in FY 98. As
discussed above, operating expenses increased by $210,385 from FY 97.
The net loss of $2,903,632 in FY 97 represents an increase of 122% from the FY
96 net loss. The FY 97 net loss resulted from the decline in revenue with the
resulting elimination of gross profits, the transition from the exclusive
Agreement with Valleylab, the costs of developing a direct sales force, and the
increased General and Administrative expenses.
LIQUIDITY AND CAPITAL RESOURCES
To date, operating funds have been provided primarily by sales of Common
Stock and Warrants to purchase Common Stock, which totaled approximately $17.3
Million through March 31, 1998, and, to a lesser degree, funds provided by sales
of the Company's products. The Company used $3,769,642 of cash in its
operations in FY 98, $2,283,765 in FY 97, and $1,674,263, in FY 96, which relate
primarily to the funding of the Company's annual net losses. The Company raised
$0, $13,437,102, and $1,469,239, from issuance's of its Common Stock in each of
Fiscal Years 98, 97 and 96, respectively.
Capital expenditures historically have been relatively minor, and have
consisted of specialized equipment, manufacturing equipment, office equipment
and leasehold improvements.
As of March 31, 1998, the Company had $6,199,755 in Cash and Cash
Equivalents and Short Term Investments available to fund future operations. As
noted in the section on Outlook, under Liquidity and Capital Resources, the
Company believes that its cash resources will be sufficient to fund its
operations for at least the next twelve months.
INCOME TAXES
Net operating loss carryforwards totaling approximately $10,205,000 are
available to reduce taxable income as of March 31, 1998. The net operating loss
carryforwards expire, if not previously utilized, at various dates beginning in
the year 2006. The Company has not paid income taxes since its inception. The
Tax Reform Act of 1986 and other income tax regulations contain provisions which
may limit the net operating loss carryforwards available to be used in any given
year, if certain events occur, including changes in ownership interests. The
Company has established a valuation allowance for the entire amount of its
deferred tax asset since inception due to its history of operating losses.
19
<PAGE>
ITEM 7. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The following financial statements are included in this Report:
<TABLE>
Page
----
<S> <C>
Report of Independent Public Accountants. . . . . . . . . . . . . F-1
Consolidated Balance Sheets as of March 31, 1998 and 1997 . . . . F-2
Consolidated Statements of Operations for the
years ended March 31, 1998, 1997 and 1996 . . . . . . . . . . . . F-3
Consolidated Statements of Stockholders' Equity for
the years ended March 31, 1998, 1997 and 1996 . . . . . . . . . . F-4
Consolidated Statements of Cash Flows for the years
ended March 31, 1998, 1997 and 1996 . . . . . . . . . . . . . . . F-5
Notes to Consolidated Financial Statements. . . . . . . . . . . . F-6
</TABLE>
20
<PAGE>
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Electroscope, Inc.:
We have audited the accompanying balance sheets of ELECTROSCOPE, INC. (a
Colorado corporation) as of March 31, 1998 and 1997, and the related statements
of operations, shareholders' equity and cash flows for each of the three fiscal
years in the period ended March 31, 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 Electroscope, Inc. as of March
31, 1998 and 1997, and the results of its operations and its cash flows for each
of the three fiscal years in the period ended March 31, 1998, in conformity with
generally accepted accounting principles.
Denver, Colorado, ARTHUR ANDERSEN LLP
May 20, 1998.
F-1
<PAGE>
ELECTROSCOPE, INC.
BALANCE SHEETS
MARCH 31, 1998 AND 1997
<TABLE>
<CAPTION>
ASSETS 1998 1997
------ ------------ -----------
<S> <C> <C>
CURRENT ASSETS:
Cash and cash equivalents $ 2,525,026 $ 527,015
Short-term investments, net of discount of $34,841 (1998) and $138,573
(1997) (Note 2) 3,674,729 9,631,573
Accounts receivable, net of allowance for doubtful
accounts of $7,500 (1998) and $25,000 (1997) 321,150 155,446
Inventory, net of reserve for obsolescence of $140,000 (1998)
and $102,596 (1997) 543,006 521,696
Prepaid expenses 63,259 110,777
---------- ----------
Total current assets 7,127,170 10,946,361
---------- ----------
EQUIPMENT, at cost:
Furniture, fixtures and equipment 621,607 503,871
Less- Accumulated depreciation (380,659) (258,983)
---------- ----------
Equipment, net 240,948 244,888
---------- ----------
PATENTS, net of accumulated amortization of $11,830 (1998) 186,454 138,078
and $9,270 (1997)
OTHER ASSETS 11,450 11,450
---------- ----------
Total assets $7,566,022 $11,340,777
---------- ----------
---------- ----------
LIABILITIES AND SHAREHOLDERS' EQUITY
------------------------------------
CURRENT LIABILITIES:
Accounts payable $ 99,430 $ 327,682
Accrued compensation 150,635 155,908
Other accrued liabilities 191,871 454,295
Customer deposits 4,376 20,223
Other current liabilities 6,639 6,639
---------- ----------
Total current liabilities 452,951 964,747
---------- ----------
LONG-TERM LIABILITIES:
Other long-term liabilities 5,331 17,593
---------- ----------
COMMITMENTS AND CONTINGENCIES (Notes 1, 4 and 6)
SHAREHOLDERS' EQUITY:
Preferred stock, no par value, 10,000,000 shares
authorized, no shares outstanding - -
Common stock, no par value, 100,000,000 shares authorized,
5,383,507 (1998) and 5,389,986 (1997) shares outstanding 16,941,317 16,997,282
Warrants for common stock 290,400 290,400
Accumulated deficit (10,123,977) (6,929,245)
---------- ----------
Total shareholders' equity 7,107,740 10,358,437
---------- ----------
Total liabilities and shareholders' equity $7,566,022 $ 11,340,777
---------- ----------
---------- ----------
</TABLE>
The accompanying notes to financial statements are an integral part of these
statements.
F-2
<PAGE>
ELECTROSCOPE, INC.
STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
For The Fiscal Year Ended March 31
------------------------------------------
1998 1997 1996
----------- ------------ -----------
<S> <C> <C> <C>
REVENUE, net $1,315,915 $1,398,184 $2,173,785
COST OF SALES 1,218,342 1,422,005 1,451,077
---------- ---------- ----------
Gross profit (loss) 97,573 (23,821) 722,708
---------- ---------- ----------
OPERATING EXPENSES:
Sales and marketing 1,834,806 1,511,190 971,838
General and administrative 1,200,572 1,349,371 576,802
Research and development 652,298 616,730 512,541
---------- ---------- ----------
Total operating expenses 3,687,676 3,477,291 2,061,181
---------- ---------- ----------
INCOME (LOSS) FROM OPERATIONS (3,590,103) (3,501,112) (1,338,473)
OTHER INCOME (EXPENSE):
Interest income 413,252 463,854 18,901
Other income (expense) (17,881) 133,626 14,297
---------- ---------- ----------
NET INCOME (LOSS) $(3,194,732) $(2,903,632) $(1,305,275)
---------- ---------- ----------
---------- ---------- ----------
NET INCOME (LOSS) PER SHARE (Note 2):
Basic and diluted net income (loss) per common
share $ (0.59) $ (0.58) $ (0.35)
---------- ---------- ----------
---------- ---------- ----------
Basic and diluted weighted average shares used
in computing net income (loss) per common share 5,377,493 5,045,128 3,704,031
---------- ---------- ----------
---------- ---------- ----------
</TABLE>
The accompanying notes to financial statements are an integral part of these
statements.
F-3
<PAGE>
ELECTROSCOPE, INC.
STATEMENTS OF SHAREHOLDERS' EQUITY
FOR THE FISCAL YEARS ENDED MARCH 31, 1998, 1997 AND 1996
<TABLE>
<CAPTION>
Accumulated
Shares Amount Warrants Deficit Total
--------- ---------- -------- ----------- ---------
<S> <C> <C> <C> <C> <C>
BALANCES, MARCH 31, 1995 3,592,362 $3,788,932 $ - $(2,720,338) $1,068,594
Issuance of common stock for cash
($6.00 per share), net of offering costs
of $3,132, in June 1995-February 1996 200,000 1,196,868 - - 1,196,868
Exercise of options for common stock for
cash ($2.50 per share), in November 1995
and March 1996 67,762 169,405 - - 169,405
Exercise of warrants for common stock
for cash ($3.00 per share), in March 1996 33,278 99,834 - - 99,834
Net income (loss) - - - (1,305,275) (1,305,275)
--------- ---------- ------- ----------- ---------
BALANCES, March 31, 1996 3,893,402 5,255,039 - (4,025,613) 1,229,426
Exercise of warrants for common stock for
cash ($3.00 per share), in April 1996 186,984 560,952 - - 560,952
Sale of common stock on initial public
offering in June 1996, net of offering
costs of $1,404,459 1,200,000 11,195,541 - - 11,195,541
Exercise of options for common stock for
cash ($2.50 per share), in April 1996-
December 1996 109,000 272,500 - - 272,500
Exercise of options for common stock for
cash ($6.00 per share), in September 1996 600 3,600 - - 3,600
Value of warrants to purchase common stock
for $12.50 per share, in conjunction with
initial public offering - - 290,400 - 290,400
Reduction of proceeds for value of warrants
issued in conjunction with initial
public offering (net of cash received) - (290,350) - - (290,350)
Net income (loss) - - - (2,903,632) (2,903,632)
--------- ---------- ------- ----------- ---------
BALANCES, March 31, 1997 5,389,986 16,997,282 290,400 (6,929,245) 10,358,437
Repurchase of shares from former officer (59,701) (156,715) - - (156,715)
Issuance of common stock in lieu of
cash as a hiring bonus in May 1997 22,222 40,000 - - 40,000
Issuance of common stock in lieu of
cash payment to vendor 15,000 33,750 - - 33,750
Issuance of common stock to directors
as compensation for services 16,000 27,000 - - 27,000
Net Income (Loss) - - - (3,194,732) (3,194,732)
--------- ---------- ------- ----------- ---------
BALANCES, March 31, 1998 5,383,507 $16,941,317 $290,400 $(10,123,977) $7,107,740
--------- ---------- ------- ----------- ---------
--------- ---------- ------- ----------- ---------
</TABLE>
The accompanying notes to financial statements are an integral part of these
statements.
F-4
<PAGE>
ELECTROSCOPE, INC.
STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
For The Fiscal Year Ended March 31
----------------------------------------
1998 1997 1996
---------- ---------- ----------
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $(3,194,732) $(2,903,632) $(1,305,275)
Adjustments to reconcile net income (loss) to net
cash used in operating activities-
Depreciation and amortization 187,586 154,673 68,574
Amortization of discount, net (199,692) (115,864) -
Common stock issued in lieu of cash 100,750 - -
Inventory reserve 37,404 37,596 55,000
Changes in operating assets and liabilities-
Accounts receivable (165,704) (44,981) 15,034
Inventory (58,714) 244,125 (487,131)
Prepaid expenses 47,518 (41,488) (49,983)
Accounts payable (228,252) 197,314 (116,288)
Accrued compensation and other accrued
liabilities (267,697) 422,646 (91,242)
Customer deposits (15,847) (96,298) 74,960
Deferred revenue - (135,703) 135,703
Other liabilities (12,262) (2,153) 26,385
---------- ---------- ----------
Net cash used in operating activities (3,769,642) (2,283,765) (1,674,263)
---------- ---------- ----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of short-term investments, net of discounts (4,813,463) (20,980,563) -
Sale of short-term investments 10,969,999 11,465,000 -
Purchases of equipment (181,223) (199,136) (182,256)
Patent costs (50,935) (45,872) (26,608)
---------- ---------- ----------
Net cash provided by (used in)
investing activities 5,924,368 (9,760,571) (208,864)
---------- ---------- ----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of common stock and warrants - 13,437,102 1,469,239
Repurchase of Common Stock (156,715) - -
Stock issuance costs - (1,404,459) (3,132)
---------- ---------- ----------
Net cash (used in) provided by
financing activities (156,715) 12,032,643 1,466,107
---------- ---------- ----------
NET INCREASE (DECREASE) IN CASH AND
CASH EQUIVALENTS 1,998,011 (11,693) (417,020)
CASH AND CASH EQUIVALENTS,
beginning of period 527,015 538,708 955,728
---------- --------- ---------
CASH AND CASH EQUIVALENTS, end of period $ 2,525,026 $527,015 $ 538,708
---------- ------- ---------
---------- ------- ---------
</TABLE>
The accompanying notes to financial statements are an integral part of these
statements.
F-5
<PAGE>
ELECTROSCOPE, INC.
NOTES TO FINANCIAL STATEMENTS
(1) ORGANIZATION AND NATURE OF BUSINESS
Electroscope, Inc. (the "Company") was incorporated as a Colorado corporation on
February 1, 1991. The Company designs, develops, manufactures and markets a
patented monopolar electrosurgical shielding system and integrated surgical
instruments, which are designed to provide greater safety to patients who
undergo laparoscopic surgery. The products can be used with most
electrosurgical instruments available today in the USA. It has also developed
and is marketing its own line of integrated, shielded five millimeter
electrosurgical instruments which incorporate the Company's proprietary
technology. These products monitor for stray electrical energy during
laparoscopy and deactivate the electrosurgical unit when this energy is detected
under potentially dangerous conditions. The Company's sales to date have been
made principally in the United States and were made primarily to Valleylab as a
distributor in fiscal years 1996 and 1997. As discussed below, sales to
Valleylab were immaterial in fiscal year 1998.
The Company has incurred losses since its inception and has an accumulated
deficit of $10,123,977 at March 31, 1998. In calendar year 1996, the
exclusive distributor of the Company's products did not purchase products from
the Company in sufficient amounts to maintain the distributor's exclusivity. As
a result, the sales, marketing and market development activities conducted by
that distributor became the responsibility of the Company in FY 1997. During FY
1998 the Company developed a separate distribution channel. The Company's
operations are subject to certain risks and uncertainties, including that
commercial acceptance of the Company's products will have to occur in the
marketplace, in significant volumes, before the Company can attain profitable
operations. Other risks and uncertainties include the possibility of continued
substantial operating losses, the need to continue to develop a distribution
channel for the Company's products, current and potential competitors with
greater financial, technical and marketing resources, management's plans for
growth and expansion, governmental regulation and the Company's limited
manufacturing experience for large-scale production.
In September 1995, the Company entered into an exclusive Distribution Agreement
for the Company's products with Valleylab Inc., a part of Hospital Products
Group of Pfizer, Inc. ("Valleylab"). The terms of this agreement required
Valleylab to purchase minimum amounts of the Company's products in specified
time frames, in order to maintain exclusivity. Valleylab did not meet the
minimum purchase requirements for calendar year 1996, and the agreement became
non-exclusive until the Company terminated the Agreement in February of 1998,
after the purchase of Valleylab by United States Surgical Company.
During fiscal years 1998, 1997 and 1996, Valleylab accounted for approximately
$25,271, $1,145,900 and $2,002,600 of the total sales revenue of approximately
$1,316,000, $1,398,000 and $2,174,000, respectively.
F-6
<PAGE>
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
STOCK SPLIT
On March 26, 1996, the Company approved a two for one share common stock split
to be effective March 29, 1996. Common stock amounts, equivalent share amounts
and per share amounts have been adjusted retroactively for all periods presented
to give effect to this stock split.
USE OF ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions.
Such estimates and assumptions affect the reported amounts of assets and
liabilities as well as disclosure of contingent assets and liabilities at the
date of the financial statements, and the reported amounts of revenue and
expense during the reporting period. Actual results could differ from those
estimates.
CASH AND CASH EQUIVALENTS
For purposes of reporting cash flows, the Company considers all cash and highly
liquid investments with an original maturity of three months or less to be cash
equivalents.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The Company's financial instruments consist of cash, short-term investments and
short-term trade receivables and payables. The carrying values of cash,
short-term investments and short-term receivables and payables approximate their
fair value.
SHORT-TERM INVESTMENTS
As required under Statement of Financial Accounts Standards No. 115, "Accounting
for Certain Investments in Debt and Equity Securities," (SFAS 115) management
determines the appropriate classification of its investments in debt securities
at the time of purchase. At March 31, 1998, the Company's short-term
investments consist primarily of government securities which the Company
classifies as held-to-maturity.
The amortized cost of debt securities classified as held-to-maturity is adjusted
for amortization of premiums and accretion of discounts to maturity. Such
amortization and accretion of discounts are included in interest income.
CONCENTRATION OF CREDIT RISK
The Company has no significant off-balance sheet concentrations of credit risk
such as foreign exchange contracts, options contracts or other foreign hedging
arrangements. The Company maintains the majority of its cash balances with two
financial institutions, in the form of demand deposits and short-term
investments, primarily government securities.
The Company's accounts receivable balances are primarily domestic. The
Company's principal customer in 1997 and 1996, Valleylab, accounted for
approximately 15% and 74% of its total accounts receivable balance as of March
31, 1997 and 1996, respectively. There are no such concentrations as of March
31, 1998.
F-7
<PAGE>
INVENTORY
Inventories are stated at the lower of cost (first in, first out basis) or
market. At March 31, 1998 and 1997, inventory consisted of the following:
<TABLE>
1998 1997
------- -------
<S> <C> <C>
Raw Materials $ 448,486 $266,299
Work in Process - 225,353
Finished Goods 234,520 132,640
------- -------
683,006 624,292
Less - Reserve for Obsolescence (140,000) (102,596)
------- -------
$ 543,006 $521,696
------- -------
------- -------
</TABLE>
Due to the nature of the Company's manufacturing process, which features short
manufacturing cycle times and substantial reliance on a variety of
sub-contractors, the Company has reviewed the classification of its inventories
and has reclassified materials previously considered to be work-in process to
primarily raw materials, including sub-assemblies, and finished goods.
EQUIPMENT
Equipment is stated at cost, with depreciation computed primarily on a
straight-line basis over the estimated useful life of the asset, generally three
to five years. Leasehold improvements are depreciated over the shorter of the
remaining lease term or the estimated useful life of the asset.
PATENTS
The costs of applying for patents are capitalized and amortized on a
straight-line basis over the lesser of the patent's economic or legal life (17
years in the U.S.). Capitalized costs are expensed if patents are not granted.
The Company reviews the carrying value of its patents periodically to determine
whether the patents have continuing value.
INCOME TAXES
The Company accounts for income taxes under the provisions of Statement of
Financial Accounting Standards No. 109, "Accounting for Income Taxes"
("SFAS No. 109"). SFAS No. 109 requires recognition of deferred income tax
assets and liabilities for the expected future income tax consequences, based on
enacted tax laws, of temporary differences between the financial reporting and
tax bases of assets and liabilities. SFAS No. 109 requires recognition of
deferred tax assets for the expected future tax effects of all deductible
temporary differences, loss carryforwards and tax credit carryforwards.
Deferred tax assets are then reduced, if deemed necessary, by a valuation
allowance for the amount of any tax benefits which, more likely than not based
on current circumstances, are not expected to be realized (Note 5).
F-8
<PAGE>
REVENUE RECOGNITION
Revenue from product sales is recorded only when the product is shipped and the
earnings process is complete.
In September 1995, the Company received a $150,000 non-refundable payment from
Valleylab as part of the exclusive Distribution Agreement. This payment was
deferred and was being recognized into income ratably over the term of the
Distribution Agreement. As Valleylab did not meet the minimum purchase
requirements in calendar year 1996 and the agreement became non-exclusive, the
remaining balance of the non-refundable payment was recorded in income during
fiscal year 1997.
STOCK BASED COMPENSATION
The Company has adopted the disclosure-only provisions of Statement of Financial
Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS
123"), but applies Accounting Principles Board Opinion No. 25, "Accounting for
Stock Issued to Employees" ("APB 25"), and related interpretations in accounting
for stock options granted to employees. The Company has made pro forma
disclosures of what net loss and net loss per common share would have been had
the provisions of SFAS 123, based upon the fair value method, been applied to
the Company's stock option grants (Note 3).
NEW ACCOUNTING PRONOUNCEMENT
In February 1997, the Financial Accounting Standards Board, ("FASB") issued
Statement of Financial Accounting Standards No. 128, "Earnings Per Share". This
statement establishes standards for computing and presenting earnings per share.
The Company adopted this standard for its third fiscal quarter ending December
31, 1997.
LOSS PER COMMON SHARE AND COMMON EQUIVALENT SHARE
Loss per common share and common equivalent share for all fiscal years presented
is computed using the sum of the weighted average number of shares of common
stock and common stock equivalent shares from common stock options and warrants.
Options and warrants for the Company's common stock issued have been excluded as
they are antidilutive. For fiscal year 1998, the Company has reported earnings
per share in accordance with Statement of Financial Accounting Standards No.
128, "Earnings Per Share".
F-9
<PAGE>
(3) SHAREHOLDERS' EQUITY
STOCK OPTION PLAN
In 1991, the Company adopted a stock option plan (the "Plan") to provide
directors, officers, other employees and consultants options to purchase shares
of the Company's common stock. Under the terms of the Plan, the Board of
Directors may grant either "nonqualified" or "incentive" stock options, as
defined by the Internal Revenue Code and related regulations. Under the terms
of the Plan, the purchase price of a nonqualified option may be less than the
then fair market value of the stock. The purchase price of the shares subject to
an incentive stock option will be the fair market value of the Company's common
stock on the date the option is granted. If the grantee owns more than 10% of
the total combined voting power or value of all classes of stock on the date of
grant, the purchase price of an incentive stock option shall be at least 110% of
the fair market value at the date of grant and the exercise term will be up to
five years from the date of grant. Generally, vesting of stock options is
either immediate or occurs such that 20% becomes exercisable at the date of
grant and 20% become exercisable each year thereafter. However, certain options
under the Plan vest after a specified period of time, and may be accelerated
based on achieving specified events. Generally, all stock options must be
exercised within ten years from the date granted.
In July 1995, the Company's Board of Directors and shareholders approved an
increase in the number of shares authorized under the Plan. The number of
shares authorized for incentive stock options was increased from 750,000 to
850,000 shares and the number of authorized shares for nonqualified stock
options was increased from 150,000 to 200,000 shares. On March 31, 1996, the
Company's Board of Directors amended and restated the Plan, and designated an
additional 100,000 shares of the Company's common stock as reserved for future
issuance. This amendment was approved by the Company's shareholders on April
17, 1996.
On March 31, 1997 the Company's Board of Directors approved a 1997 Stock Option
Plan, which provided for an additional 800,000 shares. This Plan was approved
by the Company's shareholders on August 15, 1997.
STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 123
SFAS 123, "Accounting for Stock-Based Compensation," defines a fair value based
method of accounting for employee stock options or similar equity instruments.
However, SFAS 123 allows the continued measurement of compensation cost for such
plans using the intrinsic value method prescribed by APB 25, provided that pro
forma disclosures are made of net income or loss and net income or loss per
common share, assuming the fair value based method of SFAS 123 had been applied.
The Company has elected to account for its stock-based compensation plans for
employees under APB 25; accordingly, for purposes of the pro forma disclosures
presented below, the Company has computed the fair values of all options granted
during fiscal years 1998 and 1997, using the Black-Scholes option valuation
model and the following weighted average assumptions:
<TABLE>
1998 1997
---------- ----------
<S> <C> <C>
Risk-free interest rate 6.3% 6.2 %
Expected lives 3.8 4.0 years
Expected volatility 88.340% 56.065%
Expected dividend yield 0% 0%
</TABLE>
F-10
<PAGE>
To estimate expected lives of options for this valuation, it was assumed options
will be exercised upon becoming fully vested at the end of four years. All
options are initially assumed to vest. Cumulative compensation cost recognized
in pro forma net income or loss with respect to options that are forfeited prior
to vesting is adjusted as a reduction of pro forma compensation expense in the
period of forfeiture. The volatility of the stock is based on the volatility of
the Company's stock since it has been publicly traded. Fair value computations
are highly sensitive to the volatility factor assumed; the greater the
volatility, the higher the computed fair value of options granted.
The total fair value of options granted was computed to be approximately
$1,619,547, $173,848 and $1,173,848 for the years ended March 31, 1998, 1997
and 1996, respectively. These amounts are amortized ratably over the vesting
periods of the options. Pro forma stock-based compensation, net of the effect
of forfeitures, was $672,271, $193,564 and $120,665 for 1998, 1997 and 1996,
respectively. Because SFAS 123 has not been applied to options granted prior to
March 31, 1995, the resulting pro-forma compensation cost may not be
representative of that to be expected in future years. If the Company had
accounted for its stock-based compensation plans in accordance with SFAS 123,
the Company's net loss and pro forma net loss per common share would have been
reported as follows:
<TABLE>
<CAPTION>
Fiscal Year Ended
March 31,
1998 1997 1996
------------------------------------------------------
<S> <C> <C> <C>
Net Loss
As Reported $(3,194,732) $(2,903,632) $(1,305,275)
Pro forma $(3,867,003) $(3,097,196) $(1,425,940)
Pro Forma Net Loss Per Common Share
As Reported $ (0.59) $ (0.58) $ (0.35)
Pro Forma $ (0.72) $ (0.61) $ (0.39)
</TABLE>
Weighted average shares used to calculate pro forma net loss per share were
determined as described in Note 2, except in applying the treasury stock method
to outstanding options, net proceeds assumed received upon exercise were
increased by the amount of compensation cost attributable to future service
periods and not yet recognized as pro forma expense.
The Black-Scholes option valuation model was developed for use in estimating the
fair value of traded options which have no vesting restrictions and are fully
transferable. In addition, option valuation models require the input of highly
subjective assumptions including the expected stock price volatility. Because
the Company's employee stock options have characteristics significantly
different than those of traded options, and because changes in the subjective
input assumptions can materially affect the fair value estimate, in management's
opinion, the existing models do not necessarily provide a reliable single
measure of the fair value of its employee stock options.
The pro forma results may not be representative of the future impact of applying
SFAS 123 due to the phase-in provisions of the Statement and actual vesting
experience.
F-11
<PAGE>
A summary of the Company's stock option activity, and related information for
each of the three fiscal years ended March 31, 1998 is as follows:
<TABLE>
<CAPTION>
Weighted
Average
Exercise
Outstanding Price
--------------- ------------
<S> <C> <C>
BALANCE, as of March 31, 1995 855,600 $2.57
------- ----
------- ----
EXERCISABLE, as of March 31, 1995 340,467 $2.50
Granted 361,200 $5.92
Exercised (67,762) $2.50
Canceled (170,000) $2.85
--------
BALANCE, as of March 31, 1996 979,038 $3.76
------- ----
------- ----
EXERCISABLE, as of March 31, 1996 432,118 $3.03
Granted 62,000 $5.66
Exercised (109,600) $2.52
Canceled (208,038) $3.88
-------
BALANCE, as of March 31, 1997 723,400 $4.08
------- ----
------- ----
EXERCISABLE, as of March 31, 1997 368,720 $3.47
------- ----
------- ----
Granted 1,174,800 $3.16
Exercised - -
Canceled (660,600) $4.25
--------
BALANCE, as of March 31, 1998 1,237,600 $3.12
--------- ----
--------- ----
EXERCISABLE, as of March 31, 1998 470,044 $3.33
------- ----
------- ----
</TABLE>
The weighted average exercise prices and weighted average fair values of options
granted during fiscal years 1998, 1997 and 1996 are as follows: (Exercise
Prices equal to Market Prices)
<TABLE>
<CAPTION>
Number of Fair Exercise
Options Value Price
----------- --------- ----------
<S> <C> <C> <C>
Fiscal Year 1996 361,200 $3.25 $5.92
Fiscal Year 1997 62,000 $2.80 $5.66
Fiscal Year 1998 1,174,800 $1.38 $3.16
</TABLE>
F-12
<PAGE>
The following table summarizes information about employee stock options
outstanding and exercisable at March 31, 1998:
<TABLE>
<CAPTION>
Options Outstanding Options Exercisable
----------------------------------------------------- ---------------------------------
Number of Weighted
Options Average Weighted Number Weighted
Range of Outstanding Remaining Average Exercisable Average
Exercise At March 31, Contractual Exercise At March 31, Exercise
Prices 1998 Life in Years Price 1998 Price
- ------------- ------------- ------------- ------------- ------------- -------------
<S> <C> <C> <C> <C> <C>
$2.25-$2.50 980,600 6.1 $ 2.34 357,444 $ 2.46
$4.50-$6.60 245,000 7.2 $ 5.88 107,800 $ 5.90
$10.50 12,000 8.2 $10.50 4,800 $10.50
</TABLE>
Of the 1,237,600 options for the Company's common stock at March 31, 1998,
527,624 represent nonqualified stock options and 709,976 represent incentive
stock options. The exercise price of all options granted through March 31,
1998, has been equal to or greater than the fair market value, as determined by
the Company's Board of Directors or based upon publicly quoted market values of
the Company's common stock on the date of the grant. At March 31, 1998, options
for 531,838 of the Company's common stock are available for grant under the
plan.
PRIVATE PLACEMENT OFFERING
On May 10, 1995 the Company offered 200,000 shares of common stock at $6 per
share in a private placement in order to raise additional capital. The sale of
these shares was completed on February 28, 1996. This sale of common stock was
effected as a sale of units, each unit consisting of one share of common stock
and a two year warrant which allows the holder of such warrant to purchase
one-half of one share of the Company's common stock at a per share price of
$7.50. These warrants expired on various dates ending February 28, 1998 and
none were exercised. No value was ascribed to the warrants.
OUTSTANDING WARRANTS
In conjunction with the Company's Initial Public Offering (IPO) in June, 1996,
the Company agreed to sell to John G. Kinnard and Company, Incorporated as the
representative of the several Underwriters, for a nominal purchase price, a
five-year warrant to purchase up to 120,000 shares of the Common Stock of the
Company, exercisable at 120% of the IPO price of $10.50 per share. As of March
31, 1998, none of the warrants had been exercised.
(4) COMMITMENTS AND CONTINGENCIES
The Company currently leases its office space under a noncancelable lease
agreement which requires payments of $8,435 per month from November 1, 1997
through October 31, 1998, at which time the lease expires if not renewed by the
Company.
Rent expense for the fiscal years ended March 31, 1998, 1997 and 1996 was
$99,663, $116,011 and $87,769 respectively.
The Company is subject to regulation by the United States Food and Drug
Administration ("FDA"). The FDA provides regulations governing the manufacture
and sale of the Company's products and regularly inspects the Company and other
manufacturers to determine their compliance with these regulations.
F-13
<PAGE>
The Company was last inspected in April 1995, and has not, at March 31, 1998,
been notified of any deficiencies from that inspection. FDA inspections are
conducted approximately every two years after approval is obtained or on a more
frequent basis, at the discretion of the FDA. The Company was granted a
Certificate to Foreign Government in December 1996 which states in part that,
based on the last periodic inspection, the Company was in substantial compliance
with CGMP.
(5) INCOME TAXES
From its inception, the Company has generated losses for both financial
reporting and tax purposes. Deferred tax assets (approximately $3.6 million as
of March 31, 1998) for the Federal and state tax benefit of the net operating
loss carryforward and research and development carryovers have been completely
offset by a valuation allowance because the realization criteria set forth in
SFAS No. 109 are not currently satisfied, primarily due to the Company's history
of operating losses.
For income tax return reporting purposes, the Company may utilize approximately
$10.2 million of net operating loss carryforwards which expire, if not
previously utilized, at various dates beginning in the year 2006. The Tax Reform
Act of 1986 contains provisions which may limit the net operating loss
carryforwards available to be used in any given year if certain events occur,
including changes in ownership interests. In addition, the Company also has
certain research and development tax credit forwards available to it.
The Company's effective tax rate differs from the Federal statutory tax rate
primarily due to non-deductible expenditures.
(6) LEGAL MATTERS
On June 4, 1997, a class action lawsuit was filed against the Company, the
members of the Board of Directors as of the date of the Company's initial public
offering, and John G. Kinnard and Company, Inc., the underwriter of the
Company's initial public offering. The complaint was filed by Avrom Gart, a
former shareholder of the Company, individually and on behalf of all others
similarly situated. The complaint alleged that the Company's Registration
Statement which became effective on or about June 25, 1996, of which the
prospectus was a part, was materially false and misleading, contained untrue
statements of material facts, omitted to state other facts necessary to make the
statements therein not misleading, and failed to disclose adequately material
facts.
On March 24, 1998, the United States District Court in Minneapolis, Minnesota
dismissed the Complaint with Prejudice.
(7) RETIREMENT PLAN
On January 1, 1998 the Company adopted a 401(K) Profit Sharing Plan which covers
all full-time employees who have completed six-months of full-time continuous
service and are age eighteen or older. Participants may defer up to 20% of
their gross pay up to a maximum limit determined by law ($10,000 in calendar
1998). Participants are immediately vested in their contributions.
The Company may make discretionary contributions based on corporate financial
results for the fiscal year. Vesting in the profit sharing contribution account
(the company's contribution) is based on years of service, with a participant
fully vested after five years of credited service.
F-14
<PAGE>
ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
There have been no disagreements between the Company and its independent
accountants on any matter of accounting principles or practices or financial
statement disclosure since the Company's inception.
PART III
ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;
COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT
Information in response to this item is incorporated by reference from the
Registrant's Definitive Proxy Statement to be filed within 120 days after the
close of the Registrant's fiscal year.
ITEM 10. EXECUTIVE COMPENSATION.
Information in response to this item is incorporated by reference from the
Registrant's Definitive Proxy Statement to be filed within 120 days after the
close of the Registrant's fiscal year.
ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
Information in response to this item is incorporated by reference from the
Registrant's Definitive Proxy Statement to be filed within 120 days after the
close of the Registrant's fiscal year.
ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
Information in response to this item is incorporated by reference from the
Registrant's Definitive Proxy Statement to be filed within 120 days after the
close of the Registrant's fiscal year.
ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K.
(a) Exhibits - The following exhibits are attached to this report on Form
10KSB or are incorporated by reference:
----------------------------
3.1 Articles of Incorporation of the Company, as amended (Incorporated by
reference from Registration Statement #333-4118-D dated June 25, 1996.)
3.2 Bylaws of the Company. (Incorporated by reference from Registration
Statement #333-4118-D dated June 25, 1996)
4.1 Form of certificate for shares of Common Stock. (Incorporated by
reference from Registration Statement #333-4118-D dated June 25, 1996)
10.1 Distribution Agreement dated September 8, 1995 between Electroscope, Inc.
and Valleylab Inc. (Incorporated by reference from Registration Statement
#333-4118-D dated June 25, 1996)
10.2 Lease Agreement dated September 11, 1995 between Electroscope, Inc. and
Sterling Partnership.(Incorporated by reference from Registration
Statement #333-4118-D dated June 25, 1996)
10.3 Electroscope, Inc. Stock Option Plan, as amended. (Incorporated by
reference from Registration Statement #333-4118-D dated June 25, 1996).
10.4 Electroscope, Inc. 1997 Stock Option Plan. (Incorporated by reference
from Proxy Statement dated July 15, 1997.
10.5 Employment Agreement dated May 5, 1997, with Patrick F. Crane. (Filed as
Exhibit 10.4 to Form 10-KSB for the year ended March 31, 1997, and
incorporated herein by reference).
E-1
<PAGE>
(b) Reports on Form 8-K. No reports on Form 8-K were filed during the
last quarter of the period covered by this report.
E-2
<PAGE>
SIGNATURES
In accordance with the Exchange Act, the registrant caused this Report to
be signed on its behalf by the undersigned, thereunto duly authorized.
Dated: May 29, 1998. ELECTROSCOPE, INC.
By:/s/ Patrick F. Crane
---------------------
Patrick F. Crane
Chief Executive Officer and President
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
/s/ Patrick F. Crane
- ----------------------
Patrick F. Crane Chief Executive Officer (Principal
Executive Officer) and Director May 29, 1998
/s/ Karl Hawkins
- ----------------------
Karl Hawkins Chief Financial Officer (Principal May 29, 1998
Financial and Accounting Officer)
/s/ Vern D. Kornelsen Director June 11, 1998
- ----------------------
Vern D. Kornelsen
/s/ David W. Newton Vice President, Research and Develop- May 29, 1998
- ---------------------- ment and Director
David W. Newton
/s/ Roger C. Odell Director May 29, 1998
- ----------------------
Roger C. Odell
/s/ Donald R. Temple Director June 2, 1998
- ----------------------
Donald R. Temple, M.D.
/s/ Joe W. Tippett Director June 2, 1998
- ----------------------
Joe W. Tippett, M.D.
/s/ Robert D. Tucker Director June 10, 1998
- ----------------------
Robert D. Tucker, M.D.
/s/ C. Randle Voyles Director June 11, 1998
- ----------------------
C. Randle Voyles, M.D.
E-3
